DITECH NETWORKS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. DESCRIPTION OF BUSINESS
Ditech Networks, Inc. (the “Company”) designs, develops and markets telecommunications equipment for use in wireline, wireless, satellite and IP telecommunications networks. The Company’s products enhance and monitor voice quality and provide security in the delivery of voice services. The Company has established a direct sales force that sells its products in the U.S. and internationally. In addition, the Company is expanding its use of value added resellers and distributors in an effort to broaden its sales channels, and this expanded use of value added resellers and distributors has occurred primarily in the Company’s international markets.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Presentation
The condensed consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated. The accompanying condensed consolidated financial statements as of January 31, 2007, and for the three and nine month periods ended January 31, 2007 and 2006, together with the related notes, are unaudited but include all adjustments (consisting only of normal recurring adjustments) which, in the opinion of management, are necessary for the fair statement, in all material respects, of the financial position and the operating results and cash flows for the interim date and periods presented. Results for the interim period ended January 31, 2007 are not necessarily indicative of results for the entire fiscal year or future periods. These condensed consolidated financial statements should be read in conjunction with the financial statements and related notes thereto for the year ended April 30, 2006, included in the Company’s Annual Report on Form 10-K, filed with the Securities and Exchange Commission on July 7, 2006, file number 000-26209.
Reclassifications
Certain items in the condensed consolidated financial statements for the three and nine months ended January 31, 2006 have been reclassified to conform to classifications used in the current fiscal year.
Computation of Income (Loss) per Share
Basic income (loss) per share is calculated based on the weighted average number of shares of common stock outstanding during the period less shares subject to repurchase, which are considered contingently issuable shares. Diluted income per share is calculated based on the weighted average number of shares of common stock and common stock equivalents outstanding, including the dilutive effect of stock options, using the treasury stock method, and common stock subject to repurchase. Under the treasury stock method, the amount that the employee must pay for exercising stock options, the amount of compensation cost for future services that the Company has not yet recognized, and the amount of tax benefit that would be recorded in additional paid-in capital when the award becomes deductible are assumed to be used to repurchase shares. Also included in diluted shares for the three and nine months ended January 31, 2007 are the weighted average effect of the potential conversion to common stock of $4.0 million of convertible notes issued as part of the Jasomi Networks, Inc. (“Jasomi”) acquisition that either mature or convert into the Company’s common stock at the election of the holder. At January 31, 2007, the notes potentially convert to a maximum of 447,000 shares of common stock (See also Note 3). Diluted loss per share for the three and nine months ended January 31, 2006 is calculated excluding the effects of all common stock equivalents, as their effect would be anti-dilutive.
A reconciliation of the numerator and denominator used in the calculation of the historical basic and diluted net income (loss) per share follows (in thousands, except per share amounts):
| | Three months ended
January 31, | | Nine months ended
January 31, | |
| | 2007 | | 2006 | | 2007 | | 2006 | |
Historical net income (loss) per share, basic and diluted: | | | | | | | | | |
Net income (loss) | | $ | 2,007 | | $ | (67 | ) | $ | 4,601 | | $ | (3,390 | ) |
| | | | | | | | | |
Basic: | | | | | | | | | |
Weighted average shares of common stock outstanding | | 32,641 | | 32,302 | | 32,519 | | 32,200 | |
Less stock subject to repurchase | | — | | (2 | ) | — | | (2 | ) |
Shares used in calculation of basic per share amounts | | 32,641 | | 32,300 | | 32,519 | | 32,198 | |
| | | | | | | | | |
Net income (loss) per share | | $ | 0.06 | | $ | (0.00 | ) | $ | 0.14 | | $ | (0.11 | ) |
| | | | | | | | | |
Diluted: | | | | | | | | | |
Shares used in calculation of basic per share amounts | | 32,641 | | 32,300 | | 32,519 | | 32,198 | |
Shares subject to repurchase | | — | | — | | — | | — | |
Dilutive effect of stock plans | | 730 | | — | | 965 | | — | |
Dilutive effect of convertible debentures | | 447 | | — | | 447 | | — | |
Shares used in calculation of diluted per share amounts | | 33,819 | | 32,300 | | 33,931 | | 32,198 | |
| | | | | | | | | |
Net income (loss) per share | | $ | 0.06 | | $ | (0.00 | ) | $ | 0.14 | | $ | (0.11 | ) |
4
Comprehensive Income (Loss)
For the three and nine months ended January 31, 2007, comprehensive income was $2.0 million and $4.6 million, respectively, and included the impact of unrealized gains and losses on available for sale investments, net of tax. For the three and nine months ended January 31, 2006, there was no difference between net loss and comprehensive loss.
Accounting for Stock-Based Compensation
On May 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123 (revised 2004), Share-Based Payment, (“SFAS 123R”) which requires the measurement and recognition of compensation expense for all stock-based payment awards made to employees and directors including employee stock options, restricted stock, restricted stock units (“RSUs”) and employee stock purchases under the Company’s Employee Stock Purchase Plan based on estimated fair values. SFAS 123R supersedes the previous accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (“APB 25”), as allowed under Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), for periods beginning in 2006. In March 2005, the Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 (“SAB 107”) relating to SFAS 123R. The Company has applied the provisions of SAB 107 in conjunction with its adoption of SFAS 123R.
The Company adopted SFAS 123R using the modified prospective transition method, which requires the application of the accounting standard as of May 1, 2006, the first day of the Company’s fiscal year 2007. The Company’s Condensed Consolidated Financial Statements as of and for the three and nine months ended January 31, 2007 reflect the impact of SFAS 123R. In accordance with the modified prospective transition method, the Company’s Condensed Consolidated Financial Statements for periods prior to fiscal 2007 have not been restated to reflect, and do not include, the impact of SFAS 123R.
SFAS 123R requires companies to estimate the fair value of stock-based payment awards on the date of grant using an option-pricing model. The Company uses the Black-Scholes option-pricing model to determine the fair-value of stock based awards under SFAS 123R, consistent with that used for pro forma disclosures under SFAS 123. The value of the portion of the award that is ultimately expected to vest is recognized as expense over the requisite service periods in the Company’s consolidated statement of operations.
Stock-based compensation expense recognized during the period is based on the fair value of the actual awards vested or expected to vest. Stock-based compensation expense recognized in the Company’s consolidated statement of operations for the three and nine months ended January 31, 2007 included compensation expense for stock-based payment awards granted prior to, but not yet vested as of, April 30, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123 and compensation expense for the stock-based payment awards granted subsequent to April 30, 2006 based on the grant date fair value estimated in accordance with the provisions of SFAS 123R. In conjunction with the adoption of SFAS 123R, the Company changed its accounting policy of attributing the fair value of stock-based compensation to expense from the accelerated multiple-option approach provided by APB 25, as allowed under SFAS 123, to the straight-line single-option approach. Compensation expense for all stock-based payment awards expected to vest that were granted on or prior to April 30, 2006 will continue to be recognized using the accelerated attribution method. Compensation expense for all stock-based payment awards expected to vest that were granted or modified subsequent to April 30, 2006 is recognized on a straight-line basis. SFAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. In the Company’s pro forma information required under SFAS 123 for the periods prior to fiscal 2007, the Company accounted for forfeitures as they occurred.
Prior to the adoption of SFAS 123R, the Company accounted for grants of equity instruments to employees using the intrinsic value method described in Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (APB 25) and complied with the disclosure provisions of SFAS 123. Accordingly, compensation cost for stock options recorded in the Company’s condensed consolidated statement of operations was measured as the excess, if any, of the quoted market price of the Company’s stock at the date of the grant over the amount an employee was required to pay to acquire the stock and was recognized over the vesting period of the related shares. Under APB 25, the Company recorded deferred stock compensation and associated amortization for assumed options and restricted stock granted in conjunction with its acquisition of Jasomi in the amounts of $263,000 and $634,000 for the three and nine months ended January 31, 2006, respectively.
As a result of adopting SFAS 123R, stock-based compensation expense recognized during the nine months ended January 31, 2007 totaled approximately $4.8 million ($3.2 million net of taxes), or approximately a $0.10 and $0.09, respectively, per share decrease to basic and diluted net income per common share, and consisted of stock option, restricted stock unit and restricted stock expense. For the three months ended January 31, 2007, stock-based compensation expense recognized totaled approximately $1.2 million ($862,000 net of taxes), or approximately a $0.03 and $0.02, respectively, per share decrease to basic and diluted net income per common share. A contra-equity balance of $2.1 million in “Deferred stock compensation” on the Condensed Consolidated Balance Sheet was reversed as a change in accounting policy upon the adoption of SFAS 123R to “Additional paid-in capital” as of May 1, 2006. The total compensation cost at January 31, 2007 related to unvested stock option, restricted stock unit and restricted stock
5
awards was $4.5 million and that future expense will be recognized over the expected life of the stock option, restricted stock unit and restricted stock awards, which currently extends to January 31, 2011. The weighted average remaining vesting period of those awards is 1.2 years. The total tax benefit from the exercise of stock options related to deductions in excess of compensation cost recognized was approximately $252,000 during the first nine months of fiscal 2007. Prior to the adoption of SFAS 123R, the Company presented all tax benefits of deductions resulting from the exercise of stock options as an operating cash flow, in accordance with Emerging Issues Task Force (“EITF”) Issue No. 00-15, Classification in the Statement of Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a Nonqualified Employee Stock Option. SFAS 123R requires the Company to reflect the tax savings resulting from tax deductions in excess of expense reflected in its financial statements as a financing cash flow.
If the Company had applied the fair value recognition provisions of SFAS 123, the Company’s net loss for the three and nine months ended January 31, 2006 would have been adjusted to the pro forma amounts indicated in the following table (in thousands, except per share amounts):
| | Three Months
Ended January
31, | | Nine Months
Ended January
31, | |
| | 2006 | | 2006 | |
Net loss as reported | | $ | (67 | ) | $ | (3,390 | ) |
| | | | | |
Add: Stock-based compensation expense included in reported net loss, net of applicable tax effects | | 163 | | 393 | |
| | | | | |
Deduct: Stock-based compensation determined under the fair value method for all stock awards, net of applicable taxes | | (1,527 | ) | (4,663 | ) |
| | | | | |
Pro forma net loss | | $ | (1,431 | ) | $ | (7,660 | ) |
| | | | | |
Basic net loss per share: | | | | | |
| | | | | |
As reported | | $ | (0.00 | ) | $ | (0.11 | ) |
| | | | | |
Pro forma | | $ | (0.04 | ) | $ | (0.24 | ) |
| | | | | |
Diluted net loss per share: | | | | | |
| | | | | |
As reported | | $ | (0.00 | ) | $ | (0.11 | ) |
| | | | | |
Pro forma | | $ | (0.04 | ) | $ | (0.24 | ) |
In response to a number of derivative complaints filed against it surrounding its stock option practices, the Company, with the assistance of outside counsel, conducted an internal review of the circumstances surrounding the stock option grants identified in the derivative complaints as well as certain of the Company’s historical stock option practices. The internal review identified non-material errors of approximately $1.0 million in stock-based compensation expense in a few stock option awards which, due to administrative errors, were incorrectly recorded in our financial statements. The internal review uncovered no evidence of intentional misconduct. The stock compensation expense was determined based on difference in the intrinsic value per option on the new measurement date versus on the original measurement date (determined by the difference of the option price and the closing price per share) multiplied by the number of shares in the options. The adjustment for these nonmaterial errors will be reflected in the Company’s Annual Report on Form 10-K for its fiscal year ending April 30, 2007.
The following table provides the impact to pre-tax and net income/(loss) of the stock-based compensation expense error for years 2000-2003 (in thousands):
| | FY00 | | FY01 | | FY02 | | FY03 | | Total | |
Continuing Operations | | | | | | | | | | | |
Pre-Tax Income/(Loss) | | $ | (81,236 | ) | $ | (236,470 | ) | $ | (216,228 | ) | $ | (80,153 | ) | $ | (614,087 | ) |
Tax | | 33,226 | | 94,588 | | (127,814 | ) | 0 | | 0 | |
Net Income/(Loss) | | (48,010 | ) | (141,882 | ) | (344,042 | ) | (80,153 | ) | (614,087 | ) |
Discontinued Operations | | | | | | | | | | | |
Pre-Tax Income/(Loss) | | (43,781 | ) | (188,857 | ) | (125,725 | ) | (71,877 | ) | (430,240 | ) |
Tax | | 17,906 | | 75,543 | | (93,449 | ) | 0 | | 0 | |
Net Income/(Loss) | | (25,875 | ) | (113,314 | ) | (219,174 | ) | (71,877 | ) | (430,240 | ) |
| | | | | | | | | | | |
Total - Net Income/(Loss) Impact | | $ | (73,885 | ) | $ | (255,196 | ) | $ | (563,216 | ) | $ | (152,030 | ) | $ | (1,044,327 | ) |
The adjustment increased April 30, 2006 additional paid-in capital and increased April 30, 2006 accumulated deficit, as follows (in thousands):
| | As Reported | | With
Adjustment | |
| | April 30, 2006 | | April 30, 2006 | |
| | | | | |
Additional paid-in-capital | | $ | 291,329 | | $ | 292,373 | |
| | | | | |
Accumulated deficit | | $ | (90,640 | ) | $ | (91,684 | ) |
The adjustment relates to non-material errors totaling approximately $1.0 million in stock based compensation expense over fiscal years 2000-2003.
6
Goodwill
The Company’s methodology for allocating a portion of the purchase price to goodwill in connection with the purchase of Jasomi was based on established valuation techniques in the high-technology communications equipment industry. Goodwill was measured as the excess of the cost of acquisition over the sum of the amounts assigned to tangible and identifiable intangible assets acquired less liabilities assumed. Goodwill is not amortized. The goodwill recorded in the Condensed Consolidated Balance Sheet as of January 31, 2007 was $12.6 million.
Impairment of Long-lived Assets
The Company evaluates the recoverability of its long-lived assets, including goodwill, on an annual basis in the fourth quarter, or more frequently if indicators of potential impairment arise. Following the criteria of SFAS 131 “Disclosure about Segments of an Enterprise and Related Information” and SFAS 142 “Goodwill and Other Intangible Assets”, the Company views itself as having a single operating segment and consequently has evaluated goodwill and purchased intangible assets for impairment based on an evaluation of the fair value of the Company as a whole. The Company’s quoted share price from NASDAQ is the basis for measurement of that fair value as the Company’s market capitalization based on share price best represents the amount at which the Company could be bought or sold in a current transaction between willing parties. We evaluate the recoverability of our amortizable purchased intangible assets based on an estimate of undiscounted future cash flows resulting from the use of the related asset group and its eventual disposition. The asset group represents the lowest level for which cash flows are largely independent of cash flows of other assets and liabilities. Measurement of an impairment loss for long-lived assets that the Company expects to hold and use is based on the difference between the fair value and carrying value of the asset. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell.
Recent Accounting Pronouncements
In June 2006, the FASB reached consensus on Emerging Issues Task Force (“EITF”) No. 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should be Presented in the Income Statement (“EITF 06-3”). The scope of EITF 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer and may include, but is not limited to, sales, use, value added, and excise taxes. The Task Force affirmed its conclusion that entities should present these taxes in the income statement on either a gross or a net basis, based on their accounting policy, which should be disclosed pursuant to Accounting Principles Board Opinion (“APB”) No. 22, Disclosure of Accounting Policies. If those taxes are significant, and are presented on a gross basis, the amounts of those taxes should be disclosed. The consensus on EITF 06-3 will be effective for interim and annual reporting periods beginning after December 15, 2006. The Company currently records transaction-based taxes on a net basis in its condensed consolidated statements of operations. Should the Company conclude that these amounts are more appropriately presented on a gross basis, it could have a material impact on total net revenues and cost of sales, although income or loss from operations and net income or loss would not be affected.
In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109.” Interpretation 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with Statement 109 and prescribes a recognition threshold and measurement attribute for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Additionally, Interpretation 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Interpretation 48 is effective for fiscal years beginning after December 15, 2006, with early adoption permitted. The Company is currently evaluating whether the adoption of Interpretation 48 will have a material effect on its overall results of operations or financial position.
In September 2006, the SEC released Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides guidance on the process of quantifying materiality of financial statement misstatements. SAB 108 is effective for fiscal years ending after November 15, 2006, with early application for the first interim period ending after November 15, 2006. The application of SAB 108 did not have a material impact on its overall results of operations or financial position.
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework and guidance regarding the methods for measuring fair value, and expands related disclosures about those measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. The Company is currently assessing the impact that SFAS 157 will have on its results of operations and financial position.
In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment to FAS 115 (“SFAS 159”). SFAS 159 allows entities to choose, at specified election dates, to measure eligible financial assets and liabilities at fair value in situations in which they are not otherwise required to be measured at fair value. If a company elects the fair value option for an eligible item, changes in that item’s fair value in subsequent reporting periods must be recognized in current earnings. SFAS 159 also establishes presentation and disclosure requirements designed to draw comparison between entities that elect different measurement attributes for similar assets and liabilities. SFAS 159 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing the impact that SFAS 159 will have on its results of operations and financial position.
7
3. GOODWILL AND PURCHASED INTANGIBLES
Changes in the Company’s goodwill were as follows (in thousands):
Balance as of April 30, 2006 | | $ | 9,913 | |
Goodwill acquired during the period | | — | |
New additions to existing goodwill | | 2,724 | |
Balance as of January 31, 2007 | | $ | 12,637 | |
New additions to existing goodwill in the nine months of fiscal 2007 were the result of payment of the non-employee investor portion of the $3.0 million first tranche of convertible notes plus accrued interest due to former Jasomi shareholders. The entire $3.0 million plus accrued interest was not recorded in goodwill as $402,000 of the notes was paid to employee-shareholders, and was recorded as a reduction in accrued expense. The remaining portion of the unpaid first tranche of notes will be paid as certain employees vest into early exercised stock options. The $4.0 million second tranche of notes either mature or convert into the Company’s common stock at the election of the holder in June 2007. The notes bear an interest rate of 5%, payable on maturity or conversion, and are convertible at $9.84 per share. The payment of the full $4.0 million principal amount of the convertible notes is contingent on the retention of a specified number of designated employees. The convertible notes may also be used to satisfy any claims for indemnification that the Company may make for certain breaches of representations, warranties and covenants set forth in the acquisition agreements. In accordance with Statement of Financial Accounting Standards No. 141 (SFAS 141), the Company has not recorded the $4.0 million as acquisition consideration as, at the date of acquisition, the Company believed the retention of the designated employees was not assured beyond a reasonable doubt.
The carrying value of intangible assets acquired in the Jasomi business combination was as follows (in thousands):
| | January 31, 2007 | |
| | Gross
Value | | Accumulated
Amortization | | Impairment | | Net Value | |
Purchased Intangible Assets | | | | | | | | | |
Core technology | | $ | 2,900 | | $ | (1,148 | ) | $ | — | | $ | 1,752 | |
Customer relationships | | 1,100 | | (349 | ) | — | | 751 | |
Trade name and trademarks | | 200 | | (63 | ) | — | | 137 | |
Goodwill | | 12,637 | | — | | — | | 12,637 | |
Total | | $ | 16,837 | | $ | (1,559 | ) | $ | — | | $ | 15,277 | |
In the first nine months of fiscal 2007 and 2006, the Company recorded $739,000 and $575,000, respectively, of amortization of Jasomi acquisition-related intangible assets
Estimated future amortization expense of purchased intangible assets as of January 31, 2007 is as follows (in thousands):
| | Years ended April 30, | |
| | | |
2007 (3 months) | | $ | 246 | |
2008 | | 985 | |
2009 | | 985 | |
2010 | | 381 | |
2011 | | 43 | |
| | | |
| | $ | 2,640 | |
Other intangible assets included as a component of Other Assets, comprised (in thousands):
| | January 31, 2007 | | April 30, 2006 | |
| | Gross Value | | Accumulated
Amortization | | Net
Value | | Gross Value | | Accumulated
Amortization | | Net
Value | |
| | | | | | | | | | | | | |
Software licenses | | $ | 3,359 | | $ | (3,246 | ) | $ | 113 | | $ | 3,239 | | $ | (3,219 | ) | $ | 20 | |
| | | | | | | | | | | | | | | | | | | |
Amortization expense related to software licenses was $27,000 and $600,000, respectively, in the first nine months of fiscal 2007 and 2006, respectively.
4. BALANCE SHEET ACCOUNTS
Inventories comprised (in thousands):
| | January 31,
2007 | | April 30,
2006 | |
| | | | | |
Raw materials | | $ | 2,842 | | $ | 2,125 | |
Work in progress | | 266 | | — | |
Finished goods | | 5,762 | | 6,193 | |
| | | | | |
Total | | $ | 8,870 | | $ | 8,318 | |
8
Stock-based compensation included in inventories at January 31, 2007 was $22,000.
Accrued expenses comprised (in thousands):
| | January 31,
2007 | | April 30,
2006 | |
| | | | | |
Accrued employee related | | $ | 4,644 | | $ | 4,303 | |
Accrued warranty | | 684 | | 1,157 | |
Accrued restructuring costs | | 3 | | 28 | |
Accrued professional services | | 353 | | 504 | |
Other accrued expenses | | 1,307 | | 1,098 | |
| | | | | |
Total | | $ | 6,992 | | $ | 7,090 | |
Warranties. The Company provides for future warranty costs upon shipment of its products. The specific terms and conditions of those warranties may vary depending upon the product sold, the customer and the country in which it does business. However, the Company’s warranties generally start from the shipment date and continue for a period of one to five years.
Because the Company’s products are manufactured to a standardized specification and products are internally tested to these specifications prior to shipment, the Company historically has experienced minimal warranty costs. Factors that affect the Company’s warranty liability include the number of installed units, historical experience and management’s judgment regarding anticipated rates of warranty claims and cost per claim. The Company assesses the adequacy of its recorded warranty liabilities every quarter and makes adjustments to the liability, if necessary. In the third quarter of fiscal 2007, gross margin benefited from the reversal of warranty reserves associated with some specific program for which costs were not as high as originally estimated.
Changes in the warranty liability, which is included as a component of “Accrued expenses” on the Condensed Consolidated Balance Sheet, during the periods are as follows (in thousands):
| | Three months ended
January 31, | | Nine months ended
January 31, | |
| | 2007 | | 2006 | | 2007 | | 2006 | |
| | | | | | | | | |
Balance as of the beginning of the fiscal period | | $ | 1,157 | | $ | 1,796 | | $ | 1,157 | | $ | 2,010 | |
Provision for warranties issued during fiscal period | | 64 | | 72 | | 64 | | 295 | |
Warranty costs incurred during fiscal period | | (101 | ) | (72 | ) | (142 | ) | (295 | ) |
Other adjustments to the liability (including changes in estimates for pre-existing warranties) during fiscal period | | (436 | ) | — | | (395 | ) | (214 | ) |
| | | | | | | | | |
Balance as of January 31 | | $ | 684 | | $ | 1,796 | | $ | 684 | | $ | 1,796 | |
Guarantees and Indemnifications. As is customary in the Company’s industry and as required by law in the U.S. and certain other jurisdictions, certain of the Company’s contracts provide remedies to its customers, such as defense, settlement, or payment of judgment for intellectual property claims related to the use of the Company’s products. From time to time, the Company indemnifies customers against combinations of losses, expenses, or liabilities arising from various trigger events related to the sale and the use of the Company’s products and services. In addition, from time to time the Company also provides protection to customers against claims related to undiscovered liabilities, additional product liability or environmental obligations. In the Company’s experience, claims made under those types of indemnifications are rare.
As permitted or required under Delaware law and to the maximum extent allowable under that law, the Company has certain obligations to indemnify its current and former officers and directors for certain events or occurrences while the officer or director is, or was serving at the Company’s request in that capacity. These indemnification obligations are valid as long as the director or officer acted in good faith and in a manner that a person reasonably believed to be in or not opposed to the best interests of the Company, and, with respect to any criminal action or proceeding, had no reasonable cause to believe his or her conduct was unlawful. The maximum potential amount of future payments the Company could be required to make under these indemnification obligations is unlimited; however, the Company has a director and officer insurance policy that limits the Company’s exposure and enables the Company to recover a portion of any future amounts paid. As a result of the Company’s insurance policy coverage, the Company believes the estimated fair value of these indemnification obligations is minimal.
9
5. STOCKHOLDERS’ EQUITY
Employee Equity Plans
Employee Stock Purchase Plan
In March and April 1999, the Board adopted, and the stockholders approved, the Company’s 1999 Employee Stock Purchase Plan (the “Purchase Plan”) under which an aggregate of 1,816,666 shares of common stock has been reserved as of January 31, 2007. Employees who participate in the one-year offering period can have up to 15% of their earnings withheld for purchased of maximum of 700 shares per six-month purchase period, whichever is less, pursuant to the Purchase Plan. The amount withheld will then be used to purchase shares of common stock on specified dates determined by the Board. The price of common stock purchased under the Purchase Plan will be equal to 85% of the lower of the fair market value of the common stock on the commencement date of the offering or end date of the purchase period. In the first nine months of fiscal 2007, 159,361 shares were purchased under the Purchase Plan. As of January 31, 2007, 468,357 shares remain available for issuance under the Purchase Plan.
Stock Option and Restricted Stock Plans
The Company’s 1997 Stock Option Plan serves as the successor equity incentive program to the Company’s 1987 Stock Option Plan and the Supplemental Stock Option Plan (the “Predecessor Plans”). All outstanding stock options under the Predecessor Plans continue to be governed by the terms and conditions of the 1997 Stock Option Plan. The Company reserved 4,000,000 shares of common stock for issuance under the 1997 Stock Option Plan. Under the 1997 Stock Option Plan, the Board of Directors could grant incentive or non-statutory stock options at a price not less than 100% or 85%, respectively, of fair market value of common stock, as determined by the Board of Directors, at grant date. In November 1998, the Company adopted its 1998 Stock Option Plan and determined not to grant any further options under its 1997 Stock Option Plan. The Company has reserved a total of 4,856,082 shares of common stock for issuance under the 1998 Stock Option Plan, under terms similar to those of the 1997 Stock Option Plan. During fiscal 2000, the Company adopted two non-statutory stock option plans under which a total of 1,350,000 shares were reserved for issuance. The terms of non-statutory options granted under these plans are substantially consistent with non-statutory options granted under the 1997 and 1998 plans. Shares issued through early option exercises are subject to the Company’s right of repurchase at the original exercise price. The number of shares subject to repurchase generally decreases by 25% of the option shares one year after the grant date, and thereafter, ratably over 36 months. As of January 31, 2007, no shares were subject to repurchase.
On July 25, 2000, the Company purchased the net assets of Atmosphere Networks, and assumed all outstanding stock options that had been granted under the Atmosphere Networks 1997 Stock Plan (the “Atmosphere Plan”). The option shares under the Atmosphere Plan were converted into 122,236 options to purchase the Company’s common stock. The calculation of the conversion of option shares was determined using the approximate fair market values of the Atmosphere Networks and the Company’s common stock prices within a one-week period up to the date of the acquisition. After July 25, 2000, no new options are permitted to be granted under the Atmosphere Plan. The options granted under this plan are substantially consistent with the terms of options granted under the Company’s stock option plans.
In August 2000, the Board of Directors adopted the 2000 Non-Qualified Stock Plan. A total of 5,000,000 shares were reserved under this plan as of April 30, 2006. The terms of options granted under this plan are substantially consistent with options granted under the 1997 and 1998 plans. However, the new plan allows for the grant of other types of equity awards, including restricted stock and restricted stock units. In September 2006, the Board of Directors amended the 2000 Non-Qualified Stock Plan and re-named it the 2006 Equity Incentive Plan, as described below.
On June 30, 2005, the Company acquired Jasomi and assumed all outstanding stock options that had been granted under the Jasomi Networks 2001 Stock Plan (the “Jasomi Plan”). The option shares under the Jasomi Plan were converted into 191,111 options to purchase the Company’s common stock. The calculation of the conversion of option shares was determined using the approximate fair market values of the Jasomi and the Company’s common stock prices within a one-week period up to the date of the acquisition. After June 30, 2005, no new options are permitted to be granted under the Jasomi Plan. The options granted under this plan are substantially consistent with the terms of options granted under the Company’s stock option plans.
In connection with the acquisition of Jasomi on June 30, 2005, the Board of Directors adopted the 2005 New Recruit Stock Plan. This plan allows for up to 500,000 shares of restricted stock and restricted stock units to be granted to newly hired employees. The Jasomi Canada employees hired by the Company received shares with a vesting schedule of 1/3 of the shares vesting on the first anniversary of the acquisition date, and the remaining vesting in eight (8) successive equal quarterly installments over the two (2)-year period measured from the first anniversary of the closing date.
In November of 2005 the Board also adopted the 2005 New Recruit Stock Option Plan. A total of 200,000 shares were approved for issuance as non-qualified stock options to new hired employees only. The terms of the plan are substantially consistent with the non-qualified stock options granted under the Company’s other stock option plans, except that the plan does not allow the early exercise of stock options. In February of 2006, another 300,000 shares were approved and added to the reserve in connection with the hiring of the new vice president of worldwide sales. As of January 31, 2007, there is a reserve of 500,000 shares under the plan.
In September 2006, the Board of Directors amended the 2000 Non-Qualified Stock Plan and re-named it the 2006 Equity Incentive
10
Plan, reserving an additional 2,000,000 shares. As a result of the increase, a total of 7,000,000 shares have been reserved under this plan as of January 31, 2007. The terms of non-statutory options granted under this plan are substantially consistent with non-statutory options granted under the 2000 plan. However, the new plan allows for the grant of other types of equity awards, including restricted stock and restricted stock units. Restricted stock and restricted stock units generally vest over four years with 25% vesting after the first year and the remaining shares vesting ratably every six months thereafter..
All options under the option plans described above have a ten-year term.
Directors Stock Option Plan
In March 1999, the Company adopted the 1999 Non-Employee Directors’ Stock Option Plan. Under this stock option plan an aggregate of 650,000 shares are reserved as of January 31, 2007. Options granted under the plan have a 5-year term. One-time initial automatic grants of 50,000 shares each are made upon a director’s initial appointment and are subject to annual vesting over a four-year period. Annual automatic grants of 10,000 shares each are made on the date of each annual meeting of stockholders to each incumbent director (provided they have served as a director for at least six months) and are fully vested at the grant date.
Activity under the stock option plans referenced above was as follows (in thousands, except life and exercise price amounts):
| | | | Outstanding Options | |
| | Shares
Available For
Grant (1) | | Number of
Shares | | Exercise Price | | Aggregate Price | | Weighted
Average
Exercise Price | | Aggregate
Intrinsic Value | |
| | | | | | | | | | | | | |
Balances, April 30, 2006 | | 968 | | 6,929 | | $0.36 - $76.00 | | $ | 55,099 | | $ | 7.95 | | | |
Reservation of shares | | 2,000 | | | | | | | | | | | |
Restricted stock and restricted stock units issued | | (44 | ) | | | | | | | | | | |
Restricted stock and restricted stock units forfeited | | 52 | | | | | | | | | | | |
Options granted | | (177 | ) | 177 | | $6.62 - $8.46 | | $ | 1,432 | | $ | 8.08 | | | |
Options exercised | | — | | (108 | ) | $0.36 - $8.76 | | $ | (426 | ) | $ | 3.96 | | $ | 447 | |
Options forfeited | | 186 | | (186 | ) | $0.36 - $18.75 | | $ | (1,597 | ) | $ | 8.62 | | | |
Options expired | | 36 | | (36 | ) | $6.49 - $24.68 | | $ | (476 | ) | $ | 13.07 | | | |
| | | | | | | | | | | | | |
Balances, January 31, 2007 | | 3,021 | | 6,776 | | $0.36 - $76.00 | | $ | 54,032 | | $ | 7.97 | | | |
| | | | | | | | | | | | | | | | |
| | Number of
Shares | | Weighted
Average
Exercise Price | | Aggregate Intrinsic
Value | | Aggregate
Fair Value | | Weighted
Average
Remaining
Contractual
Term | |
| | | | | | | | | | | |
Fully vested and expected to vest options | | 6,426 | | $ | 7.97 | | $ | 5,127 | | | | 6.18 | |
Options vested during the period | | 4,969 | | $ | 7.89 | | $ | 4,445 | | $ | 27,146 | | 5.57 | |
| | | | | | | | | | | | | | |
(1) Shares available for grant includes shares from the 2005 New Recruit Stock Plan and the 2006 Equity Incentive Plan that may be issued as either stock options, restricted stock or restricted stock units. Shares issued under the 2006 Equity Incentive Plan as stock bonus awards, stock purchase awards, stock unit awards, or other stock awards in which the issue price is less than the fair market value on the date of grant of the award count as the issuance of 1.3 shares for each share of common stock issued pursuant to these awards for purposes of the share reserve.
Options outstanding and exercisable at January 31, 2007 (in thousands, except life and exercise price amounts):
| | Options Outstanding | | | | Options Exercisable | |
Range of Exercise Prices | | Number of
Shares | | Weighted Average Exercise
Price | | Weighted Average Remaining
Contractual Life (in Years) | | Number of Shares | | Weighted Average Exercise
Price | |
| | | | | | | | | | | |
$0.36 - $2.92 | | 815 | | $ | 2.41 | | 4.96 | | 781 | | $ | 2.50 | |
$3.75 - $6.45 | | 175 | | $ | 5.55 | | 6.59 | | 119 | | $ | 5.19 | |
$6.49 | | 1,578 | | $ | 6.49 | | 8.27 | | 799 | | $ | 6.49 | |
$6.75 - $8.56 | | 772 | | $ | 7.40 | | 5.23 | | 619 | | $ | 7.27 | |
$8.57-8.76 | | 1,564 | | $ | 8.76 | | 5.73 | | 1,409 | | $ | 8.76 | |
$8.77 - $9.00 | | 757 | | $ | 8.95 | | 5.60 | | 426 | | $ | 8.98 | |
$9.01 - $13.37 | | 908 | | $ | 12.04 | | 6.67 | | 655 | | $ | 11.83 | |
$13.38 - $21.92 | | 195 | | $ | 17.25 | | 5.91 | | 149 | | $ | 17.79 | |
$24.93 - $76.00 | | 12 | | $ | 31.38 | | 1.00 | | 12 | | $ | 31.38 | |
| | | | | | | | | | | |
$0.36 - $76.00 | | 6,776 | | $ | 7.97 | | 6.30 | | 4,969 | | $ | 7.89 | |
11
Restricted stock and restricted stock units outstanding at January 31, 2007 (in thousands, except life):
| | Restricted Stock and Restricted Stock Units Outstanding | |
| | Number of
Shares or
Units | | Weighted Average
Grant Date Fair
Value | | Aggregate Intrinsic
Value | | Weighted Average
Remaining
Contractual Term | |
Nonvested restricted stock and restricted stock units, April 30, 2006 | | 369 | | | | | | | |
Restricted stock and restricted stock units granted | | 40 | | | | | | | |
Restricted stock and restricted stock units vested | | (170 | ) | | | | | | |
Restricted stock and restricted stock units forfeited | | (52 | ) | | | | | | |
| | | | | | | | | |
Nonvested restricted stock and restricted stock units, January 31, 2007 | | 187 | | | | | | | |
| | | | | | | | | |
Fully vested and expected to vest restricted stock and restricted stock units | | 161 | | $ | — | | $ | 1,155 | | 1.6 | |
Fully vested restricted stock and restricted stock units currently exercisable | | — | | — | | — | | — | |
| | | | | | | | | | | |
For the nine month period ended January 31, 2007, the total intrinsic value of restricted stock and restricted stock units (“RSUs”) vested was $1.4 million and the total fair value of shares vested was $1.1 million.
As of January 31, 2007, approximately $4.5 million of total unrecognized compensation cost related to stock options and restricted stock/RSUs is expected to be recognized over a weighted-average period of 1.2 years.
The assumptions used and the resulting estimates of weighted-average fair value per share of options granted and for employee stock purchases under the ESPP during those periods are as follows:
| | Three months ended January 31, | | Nine months ended January 31, | |
| | 2007 | | 2006 | | 2007 | | 2006 | |
Stock options: | | | | | | | | | |
Dividend yield | | — | | — | | — | | — | |
Volatility factor | | 0.70 | | 0.86 | | 0.71 | | 0.82 | |
Risk-free interest rate | | 4.5 | % | 4.4 | % | 4.7 | % | 4.0 | % |
Expected life (years) | | 4.9 | | 4.2 | | 4.9 | | 3.7 | |
Weighted average fair value of options granted during the period | | $ | 4.39 | | $ | 4.49 | | $ | 4.99 | | $ | 3.87 | |
| | | | | | | | | |
Employee stock purchase plan: | | | | | | | | | |
Dividend yield | | — | | — | | — | | — | |
Volatility factor | | 0.45 | | 0.72 | | 0.46 | | 0.93 | |
Risk-free interest rate | | 4.9 | % | 4.8 | % | 5.0 | % | 4.5 | % |
Expected life (years) | | 0.75 | | 0.76 | | 0.71 | | 0.5 | |
Weighted average fair value of employee stock purchases during the period | | $ | 2.14 | | $ | 3.47 | | $ | 2.24 | | $ | 3.65 | |
| | | | | | | | | |
Restricted stock and restricted stock units: | | | | | | | | | |
Weighted average fair value of restricted stock and RSUs granted during the period | | $ | 7.25 | | $ | n/a | | $ | 7.97 | | $ | 6.49 | |
6. BORROWING AGREEMENT
In September 2006, the Company renewed its $2.0 million operating line of credit with its bank. The renewed line of credit, which expires on July 31, 2007, carries the same basic terms as the original line of credit and financial covenants related to minimum effective tangible net worth and cash and cash equivalent and short-term investment balances. As of January 31, 2007, the Company had no borrowings outstanding under the line of credit.
7. INCOME TAXES
The Company recorded tax expense of $694,000 and $2.6 million, respectively, for the three and nine months ended January 31, 2007 for an effective tax rate of 26% and 36%, respectively. The Company recorded a tax expense (benefit) of $278,000 and ($1.7) million, respectively, for the three and nine months ended January 31, 2006 resulting in effective tax rates of 132% and 33%, respectively. The effective tax rate for the three and nine months ended January 31, 2007 benefited from the extension of the Federal R&D tax credit as well as the Company’s determination that the California R&D tax credit would also provide meaningful tax savings. The effective tax rates for those periods also reflected the Company’s inability to deduct for tax purposes (1) stock-based compensation expense associated with (i) most non-U.S. employees and (ii) incentive stock option grants and (2) amortization of debentures associated with the Jasomi acquisition that are payable to employee-investors. The effective tax rates for the three and nine month periods ended January 31, 2006 reflected the net effect of the effective tax rate applied to the Company’s loss for the quarter and the Company’s inability to deduct for tax purposes $700,000 for in-process R&D related to the acquisition of Jasomi. The Company recognized a credit to additional paid-in capital for the tax benefit from employee stock option transactions. These benefits totaled
12
$68,000 and $252,000, respectively, for the three and nine months ended January 31, 2007, and $8,000 and $100,000, respectively, for the three and nine months ended January 31, 2006.
8. COMMITMENTS AND CONTINGENCIES
Legal Proceedings
Beginning on June 14, 2005, several class action lawsuits were filed in the United States District Court for the Northern District of California, purportedly on behalf of a class of investors who purchased the Company’s stock between August 25, 2004 and May 26, 2005. The complaints allege claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against the Company and its Chief Executive Officer and Chief Financial Officer in connection with alleged misrepresentations concerning VQA orders and the potential effect on the Company of the merger between Sprint and Nextel. All of the lawsuits were consolidated into a single action entitled In re Ditech Communications Corp. Securities Litigation, No. C 05-02406-JSW, and a consolidated amended complaint was filed on February 2, 2006. The defendants moved to dismiss the complaint, and the motion was granted on August 10, 2006, with leave to amend. A second consolidated amended complaint was filed on September 11, 2006. The defendants moved to dismiss the complaint and the motion has been fully briefed and under submission to the court since December 2006.
On June 20, 2005, the first of two shareholder derivative complaints was filed in the California Superior Court for the County of Santa Clara. Both complaints were purportedly brought derivatively by shareholders on behalf of the Company against several executives of the Company and all members of its board of directors, and named the Company as a nominal defendant. The plaintiffs alleged that the defendants breached their fiduciary duties to the Company in connection with alleged misrepresentations concerning VQA orders and the potential effect on the Company of the merger between Sprint and Nextel, that certain of the defendants improperly sold the Company’s stock while in possession of material nonpublic information, and that the defendants were liable to the Company for damages as a result thereof. Both lawsuits were consolidated into a single action entitled In re Ditech Communications Corp. Derivative Litigation, No. 105-CV-043429. The defendants filed a demurrer to the consolidated complaint, which was granted by the court with leave to amend. The plaintiffs elected not to amend the complaint, and voluntarily dismissed the action without prejudice on February 14, 2006. The Company has made no provisions for potential losses from these lawsuits.
On August 23, 2006, August 25, 2006, and November 3, 2006, three actions were filed in United States District Court for the Northern District of California (Case Nos. C06-05157, C06-05242, and C06-6877) purportedly as derivative actions on behalf of the Company against certain of the Company’s current and former officers and directors alleging that between 1999 and 2001 certain stock option grants were backdated; that these options were not properly accounted for; and that as a result false and misleading financial statements were filed. These three actions have been consolidated under case number C06-05157. On December 1, 2006, a fourth derivative complaint making similar allegations against many of the same defendants was filed in California Superior Court for the County of Santa Clara (Case No.106-CV-075695). The Company’s motion to stay the state court action pending the outcome of the federal consolidated actions is currently before the California Superior Court.
The defendants named in the derivative actions are Timothy Montgomery, Gregory Avis, Edwin Harper, William Hasler, Andrei Manoliu, David Sugishita, William Tamblyn, Caglan Aras, Toni Bellin, Robert DeVincenzi, James Grady, Lee House, Serge Stepanoff, Gary Testa, Lowell Trangsrud, Kenneth Jones, Pong Lim, Glenda Dubsky, Ian Wright, and Peter Chung. These derivative complaints raise claims under Section 10(b) and 10b-5 of the Securities Exchange Act, Section 14(a) of the Securities Act, and California Corporations Code Section 25403, as well as common law claims for breach of fiduciary duty, unjust enrichment, waste of corporate assets, gross mismanagement, constructive fraud, and abuse of control. The plaintiffs seek remedies including money damages, disgorgement of profits, accounting, rescission, and punitive damages. With respect to the consolidated federal actions, the plaintiffs filed an amended consolidated complaint on March 2, 2007, adding new allegations regarding another stock option grant. The Company will respond to the amended consolidated complaint on or before April 2, 2007. These actions are in their preliminary stages; no discovery has taken place and no trial date has been set.
Lease Commitments
At January 31, 2007, future minimum payments under the Company’s current leases are as follows (in thousands):
| | Years ended April 30, | |
2007 (3 months) | | $ | 266 | |
2008 | | 1,080 | |
2009 | | 1,112 | |
2010 | | 1,163 | |
2011 | | 1,173 | |
Thereafter | | 276 | |
| | $ | 5,070 | |
13
9. REPORTABLE SEGMENTS AND GEOGRAPHIC INFORMATION
The Company currently operates in a single segment - voice processing products.
Geographic revenue information comprises (in thousands):
| | Three months ended January 31, | | Nine months ended January 31, | |
| | 2007 | | 2006 | | 2007 | | 2006 | |
USA | | $ | 14,074 | | $ | 13,548 | | $ | 42,934 | | $ | 31,455 | |
Middle East/Africa | | 4,889 | | — | | 14,672 | | — | |
Canada | | 17 | | 63 | | 1,956 | | 1,907 | |
Europe | | 38 | | 108 | | 600 | | 1,162 | |
Far East | | 290 | | 26 | | 956 | | 70 | |
Latin America | | 2,770 | | 250 | | 3,677 | | 271 | |
| | | | | | | | | |
Total | | $ | 22,078 | | $ | 13,995 | | $ | 64,795 | | $ | 34,865 | |
Sales for the three months ended January 31, 2007 included three customers that represented greater than 10% of total revenue (60%, 22% and 12%). Sales for the nine months ended January 31, 2007 included two customers that represented greater than 10% of total revenue (60% and 23%). Sales for the three months ended January 31, 2006 included one customer that represented greater than 10% of total revenue (82%). Sales for the nine months ended January 31, 2006 included one customer that represented greater than 10% of total revenue (80%). As of January 31, 2007, the Company had two customers that represented greater than 10% of accounts receivable (both at 33%). At April 30, 2006, two customers represented greater than 10% of accounts receivable (48% and 23%).
The Company maintained its long-lived assets in the following countries (in thousands):
| | January 31, 2007 | | April 30, 2006 | |
| | | | | |
USA | | $ | 5,293 | | $ | 4,320 | |
Canada | | 393 | | 395 | |
Rest of World | | 13 | | 25 | |
| | | | | |
Total | | $ | 5,699 | | $ | 4,740 | |
14
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and Notes thereto for the year ended April 30, 2006, included in our Annual Report on Form 10-K, filed with the Securities and Exchange Commission on July 7, 2006. The discussion in this Report on Form 10-Q contains forward-looking statements that involve risks and uncertainties, such as statements of our future financial operating results, plans, objectives, expectations and intentions. Our actual results could e3differ materially from those discussed here. See “Future Growth and Operating Results Subject to Risk” at the end of this Item 2 for factors that could cause future results to differ materially.
Overview
We design, develop and market telecommunications equipment for use in canceling echo and enhancing voice quality in voice calls over wireline, wireless and internet protocol (IP) telecommunications networks. Our products monitor and enhance voice quality and provide connectivity through voice format transcoding and security in the delivery of voice services. Since entering the voice processing market, we have continued to refine our offerings to meet the needs of the ever-changing telecommunications marketplace. Our more recent product introductions have leveraged the processing capacity of our newer hardware platforms to offer not only echo cancellation but also enhanced VQA features including noise reduction, acoustic echo cancellation, voice level control, noise compensation and enhanced voice intelligibility. Since becoming a public company in June 1999, our financial success has been primarily predicated on the macroeconomic environment of U.S. wireline and, more recently, wireless carriers as well as our success in selling to the larger carriers. Since the beginning of calendar year 2004, large North American telecommunications service providers have engaged in merger and acquisition activity. This activity largely drove our fiscal 2006 revenue decline of 42% as one of our two largest fiscal 2005 U.S. customers was involved in post-merger integration and, consequently, orders from that customer in fiscal 2006 were nominal. Our revenue continues to be heavily influenced by the buying trends of Verizon Wireless, our largest customer in fiscal 2006 at 79% of our total worldwide revenue. In the first nine months of fiscal 2007, our revenue from Verizon Wireless was $38.9 million, or 60%, of total worldwide revenue. Our revenue has become less dependent on sales of our BVP-Flex, which accounted for 56% of our revenue in the first nine months of fiscal 2007 compared to 81% of revenue in fiscal 2006. In an attempt to diversify our customer base, in fiscal 2004 and fiscal 2005, we added sales and marketing resources to focus on new large account opportunities globally. We believe that our continued focus on voice quality in the competitive wireless services landscape and the continued expansion of wireless networks will be key factors in adding new customers and driving our revenue growth. Internationally, we continue to invest in customer trials. We developed our VQA feature set to target the international GSM market. In fiscal 2006, Orascom Telecom Holding (Orascom) became our largest VQA sale to-date, as well as a step toward our goal of greater customer diversification. We have also added other international customers. Although our fiscal 2006 international revenue was only $6.9 million, we generated $3.5 million of that revenue in the fourth quarter of fiscal 2006 and $21.9 million of international revenue in the first nine months of fiscal 2007. Those international sales were largely driven by sales to Orascom. We continue to focus on international mobile carriers who might best apply our VQA solution.
We expect additional long-term opportunities for growth will occur in VoIP-based network deployments as there is a growing trend of service providers transitioning from traditional circuit-switched network infrastructure to VoIP. We have therefore directed the majority of our R&D spending, since the beginning of fiscal 2005, towards the development of our Packet Voice Processor, a new platform targeting VoIP-based network deployments. The Packet Voice Processor introduces cost-effective voice format transcoding capabilities and utilizes our VQA software to improve call quality and clarity by eliminating acoustic echo, hybrid echo, background noise and voice level imbalances and reducing packet loss, delay and jitter. To further develop a presence in the VoIP market, we acquired Jasomi Networks, Inc. Jasomi’s currently available PeerPoint C100 session border controller enables VoIP calls to traverse Network Address Translation (NAT) and protects networks from external attacks by admitting only authorized sessions, ensuring that reliable VoIP service can be provided. We plan to combine the Packet Voice Processor and session border controller technologies to provide a more comprehensive solution to carriers’ border services needs. In fiscal 2006 and the first nine months of fiscal 2007, we recognized modest revenue from PeerPoint and sold our first Packet Voice Processor unit in the fourth quarter of fiscal 2006 and have recognized modest revenue from the Packet Voice Processor in fiscal 2007.
Acquisition History. In June 2005, we acquired Jasomi, which developed and sold session border controllers that enable VoIP calls to traverse the NAT and protect networks from external attacks by admitting only authorized sessions, ensuring that reliable VoIP service can be provided to them. The combination of Ditech’s Packet Voice Processor and Jasomi’s session border control technology may enable Ditech to provide a more comprehensive solution to carriers’ border service needs. Consideration for the acquisition included $14.8 million in cash, escrow payments, vested options assumed, acquisition costs, and net liabilities assumed plus $7.0 million in non-transferable convertible notes. The $3.0 million first tranche of convertible notes, plus interest accrued at 5%, was paid in the first quarter of fiscal 2007 while payment of the remaining $4.0 million principal amount of the convertible notes is contingent on the retention of a specified number of designated employees and is not reflected in the purchase price. We additionally issued shares of Ditech restricted stock to new employees hired as part of the acquisition.
Our Customer Base. Historically, the majority of our sales have been to customers in the United States. These customers accounted for approximately 66% of our revenue in the first nine months of fiscal 2007, and 87% and 91% of our revenue in fiscal 2006 and 2005, respectively. However, sales to some of our customers in the U.S. may result in our products purchased by these customers eventually being deployed internationally, especially in the case of any original equipment manufacturer that distributes overseas. To date, the vast majority of our international sales have been export sales and denominated in U.S. dollars. We continue to pursue expansion of our international revenue with shipments of our newer voice processing products targeted at GSM networks.
15
Our revenue historically has come from a small number of customers. Our largest customer accounted for approximately 60% of revenue in the first nine months of fiscal 2007, and 79% and 49% of our revenue in fiscal 2006 and 2005, respectively. Our five largest customers accounted for approximately 90% of revenue in the first nine months of fiscal 2007, and 88% and 91% of our revenue in fiscal 2006 and 2005, respectively. Consequently, the loss of any one of these customers, without an offsetting increase in revenue from existing or new customers, would have a negative and substantial effect in our business. This was evidenced in fiscal 2006 as revenue for the year was 58% of our fiscal 2005 revenue primarily due to a lack of orders from one of our two largest fiscal 2005 customers. This caused fiscal 2006 to result in a net loss.
Critical Accounting Policies and Estimates. The preparation of our financial statements requires us to make certain estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses and related disclosures. We evaluate these estimates on an ongoing basis, including those related to our revenues, allowance for bad debts, provisions for inventories, warranties and recovery of deferred income taxes receivable. Estimates are based on our historical experience and other assumptions that we consider reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual future results may differ from these estimates in the event that facts and circumstances vary from our expectations. To the extent there are material differences between our ongoing estimates and the ultimate actual results, our future results of operations will be affected as adjustments to our estimates are required. We believe that the following critical accounting policies affect the most significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition—In applying our revenue recognition and allowance for doubtful accounts policies that are described in our Annual Report on Form 10-K filed on July 7, 2006, the level of judgment is generally relatively limited, as the vast majority of our revenue has been generated by a handful of relatively long-standing customer relationships. These customers are some of the largest wire-line and wireless carriers and our relationships with them are documented in contracts, which clearly highlight potential revenue recognition issues, such as passage of title and risk of loss. We also closely evaluate the credit risk of our customers. In those cases where credit risk is deemed to be high, we either mitigate the risk by having the customer post a letter of credit, which we can draw against on a specified date to effectively provide reasonable assurance of collection, or we defer the revenue until customer payment is received. At January 31, 2007, we had $6.8 million of deferred revenue. However, only to the extent that we have received cash for a given deferred revenue transaction is the deferred revenue recorded on the Condensed Consolidated Balance Sheet. Of the $6.8 million of revenue deferred at January 31, 2007, approximately $1.6 million was associated with maintenance contracts, which are recognized ratably over the term of the maintenance period.
Investments—Investment securities that have maturities of more than three months at the date of purchase but remaining maturities of less than one year and auction rate securities, which we are able to liquidate on 28 or 35 day auction cycles, are considered short-term investments. Other investment securities with remaining maturities of one year or more are considered long-term investments. Short-term and long-term investments consist primarily of U.S. Government securities and corporate bonds, as well as, commercial paper, asset backed securities and certificates of deposit. We have classified our short-term and long-term investments as available-for-sale securities in the accompanying consolidated financial statements. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported in a separate component of stockholders’ equity. Realized gains and losses and declines in value judged to be other-than-temporary, if any, on available-for-sale securities are included in interest income based on specific identification. Interest on securities classified as available-for-sale is also included in interest income.
Inventory Valuation Allowances—In conjunction with our ongoing analysis of inventory valuation allowances, we are constantly monitoring projected demand on a product by product basis. Based on these projections we evaluate the levels of allowances required both for inventory on hand, as well as inventory on order from our contract manufacturers. Although we believe we have been reasonably successful in identifying allowance requirements in a timely manner, sudden changes in future buying patterns from our customers, either due to a shift in product interest and/or a complete pull back from their expected order levels has resulted in some larger than anticipated write-downs being recognized, such as the OC-3 write-down recorded in fiscal 2002. In the case of the OC-3 write-down, the complete pull back from the forecasted demand by the primary customer for this product resulted in a $3.5 million write-down of the OC-3 inventory. However, beginning in 2003, the addition of a few new major customers helped to utilize a large portion of the inventory that had been written down resulting in approximately $2.2 million and $455,000 of previously written down inventory being sold in fiscal 2004 and 2003, respectively. For the three and nine months ended January 31, 2007, we sold $166,000 and $477,000, respectively, of previously written-down inventory. For the three and nine months ended January 31, 2006, we sold $300,000 and $323,000, respectively, of previously written-down inventory. Fiscal 2006 sales of previously written-down inventory had a negligible impact on gross margin as the inventory was sold for approximately its net book value.
Cost of Warranty—At the time that we recognize revenue, we accrue for the estimated costs of the warranty we offer on our products. We currently offer hardware warranties on our products ranging from one to five years and one year software warranties. The warranty generally provides that we will repair or replace any defective product and provide software bug fixes within the term of the warranty. Our accrual for the estimated warranty is based on our historical experience and expectations of future conditions. To the extent we experience increased warranty claim activity or increased costs associated with servicing those claims, we may revise our estimated warranty accrual to reflect these additional exposures, which would result in a decrease in gross profits. As of January 31, 2007, we had recorded $684,000 of accruals related to estimated future warranty costs. See Note 4 of the Notes to the Condensed Consolidated Financial Statements.
16
Goodwill—Our methodology for allocating a portion of the purchase price to goodwill in connection with the purchase of Jasomi was determined through established valuation techniques in the high-technology communications equipment industry. Goodwill was measured as the excess of the cost of acquisition over the sum of the amounts assigned to tangible and identifiable intangible assets acquired less liabilities assumed. We perform goodwill impairment tests on an annual basis in the fourth quarter of our fiscal year. The goodwill recorded in the Condensed Consolidated Balance Sheet as of January 31, 2007 was $12.6 million. Goodwill increased $2.7 million from $9.9 million recorded at April 30, 2006 as we recorded the payment of the non-employee investor portion of the $3.0 million first tranche of convertible notes plus accrued interest.
Impairment of Long-lived Assets—We evaluate the recoverability of our long-lived assets, including goodwill, on an annual basis or more frequently if indicators of potential impairment arise. Following the criteria of SFAS 131 “Disclosure about Segments of an Enterprise and Related Information” and SFAS 142 “Goodwill and Other Intangible Assets”, we view Ditech as having a single operating segment and consequently have evaluated goodwill and purchased intangible assets for impairment based on an evaluation of the fair value of Ditech as a whole. Ditech’s quoted share price from NASDAQ is the basis for measurement of that fair value as Ditech’s market capitalization based on share price best represents the amount at which Ditech could be bought or sold in a current transaction between willing parties. We evaluate the recoverability of our amortizable purchased intangible assets based on an estimate of undiscounted future cash flows resulting from the use of the related asset group and its eventual disposition. The asset group represents the lowest level for which cash flows are largely independent of cash flows of other assets and liabilities. Measurement of an impairment loss for long-lived assets that we expect to hold and use is based on the difference between the fair value and carrying value of the asset. Long-lived assets to be disposed of are reported at the lower of carrying amount or fair value less costs to sell.
Accounting for Stock-based Compensation — Effective May 1, 2006, we adopted the fair value recognition provisions of SFAS 123R, using the modified prospective transition method, and therefore have not restated prior period results in our Condensed Consolidated Financial Statements. In accordance with SFAS 123R, we recognize compensation expense, net of estimated forfeitures, for all stock-based payments (1) granted after May 1, 2006 and (2) prior to but not vested as of May 1, 2006.
In response to a number of derivative complaints filed against us surrounding our stock option practices, we with the assistance of outside counsel, have conducted an internal review of the circumstances surrounding the stock option grants identified in the derivative complaints as well as certain of our historical stock option practices.
The internal review identified non-material errors of approximately $1.0 million in stock-based compensation expense in a few stock option awards which, due to administrative errors, were incorrectly recorded in our financial statements. The internal review uncovered no evidence of intentional misconduct. The stock compensation expense was determined based on difference in the intrinsic value per option on the new measurement date versus on the original measurement date (determined by the difference of the option price and the closing price per share) multiplied by the number of shares in the options. The adjustment for these nonmaterial errors will be reflected in the Company’s Annual Report on Form 10-K for its fiscal year ending April 30, 2007.
The following table provides the impact to pre-tax and net income/(loss) of the stock-based compensation expense error for years 2000-2003 (in thousands):
| | FY00 | | FY01 | | FY02 | | FY03 | | Total | |
Continuing Operations | | | | | | | | | | | |
Pre-Tax Income/(Loss) | | $ (81,236 | ) | $ (236,470 | ) | $ (216,228 | ) | $ (80,153 | ) | $ (614,087 | ) |
Tax | | 33,226 | | 94,588 | | (127,814 | ) | 0 | | 0 | |
Net Income/(Loss) | | (48,010 | ) | (141,882 | ) | (344,042 | ) | (80,153 | ) | (614,087 | ) |
Discontinued Operations | | | | | | | | | | | |
Pre-Tax Income/(Loss) | | (43,781 | ) | (188,857 | ) | (125,725 | ) | (71,877 | ) | (430,240 | ) |
Tax | | 17,906 | | 75,543 | | (93,449 | ) | 0 | | 0 | |
Net Income/(Loss) | | (25,875 | ) | (113,314 | ) | (219,174 | ) | (71,877 | ) | (430,240 | ) |
| | | | | | | | | | | |
Total - Net Income/(Loss) Impact | | $ (73,885 | ) | $ (255,196 | ) | $ (563,216 | ) | $ (152,030 | ) | $ (1,044,327 | ) |
The April 30, 2006 additional paid-in capital and accumulated deficit balances have been adjusted as follows:
| | As Reported | | With Adjustment | |
| | April 30, 2006 | | April 30, 2006 | |
| | | | | |
Additional paid-in-capital | | $ 291,329 | | $ 292,373 | |
| | | | | |
Accumulated deficit | | $ (90,640 | ) | $ (91,684 | ) |
Under SFAS 123R, stock-based compensation cost is estimated at the grant date based on the award’s fair value as calculated by the Black-Scholes-Merton option-pricing model and is recognized as expense, net of estimated forfeitures, ratably over the requisite service period. Given our employee stock options have certain characteristics that are significantly different from traded options and, because changes in the subjective assumptions can materially affect the estimated value, in our opinion the existing valuation models may not provide an accurate measure of the fair value of our employee stock options. Although we determine the fair value of employee stock options in accordance with SFAS 123R and SAB 107 using the Black-Scholes option-pricing model, that value may not be indicative of the fair value observed between a willing buyer and a willing seller in a market transaction.
The Black-Scholes model requires various highly judgmental assumptions including expected option life and volatility. If any of the assumptions used in the Black-Scholes model or the estimated forfeiture rate changes significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.
Accounting for Income Taxes— We estimate our actual current tax exposure together with our temporary differences resulting from differing treatment of items such as valuation allowances for bad debts and inventory, for tax and accounting purposes. These temporary differences, in conjunction with net operating loss and tax credit carryforwards, result in deferred tax assets and liabilities. Of our $48.8 million deferred tax assets at April 30, 2006, $35.1 million and $8.5 million, respectively, are associated with net operating loss and tax credit carryforwards. The remaining $5.2 million of deferred tax assets are associated with temporary differences. At least once per quarter, we assess the likelihood that our net deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is no longer more likely than not, we establish a valuation allowance. Significant management judgment is required in determining our provision for income taxes, our deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. On an annual basis, or more frequently if warranted by adverse changes in our business, we review income projections to ensure that our pre-tax income is sufficient to recover our deferred tax
17
assets. We specifically review the timing of our pre-tax income in relation to the expiration of our net operating loss carryforwards and tax credits. On a quarterly basis, we review the expiration dates of our net operating loss carryforwards that we believe to be at near-term risk. In addition, we complete a study on the impact of Section 382 of the Internal Revenue Code on at least a semi-annual basis to determine whether a change in ownership may limit the value of our net operating loss carryforwards. However, as noted below in “Future Growth and Operating Results Subject to Risk,” there are risks to our future financial performance and the financial impact of the risks may be difficult to anticipate. Consequently, there is a possibility that we may not meet the minimum level of U.S. pre-tax income to utilize our net operating loss carryforwards such that all or a portion of our deferred tax assets will become impaired. In order to evaluate the sensitivity of possible impairment, we applied a hypothetical 10% decrease to future pre-tax income. This hypothetical decrease would not result in the impairment of our deferred tax assets.
Beginning in fiscal 2002, we determined that a valuation allowance against our then existing deferred tax asset position was necessary. We based this decision on the fact that in the fourth quarter of 2002, we generated sufficient operating losses on a tax basis to fully recover all taxes paid in prior years. In addition, our expectations of limited profitability, if any, due to the softness in the telecommunication industry during fiscal 2003, combined with the significant tax losses generated by the sale of our echo cancellation software technology led us to conclude that the recovery of our deferred tax assets was no longer more likely than not. In the second quarter of 2005, based on the level of historical taxable income and projections for future taxable income over the periods that our deferred tax assets are deductible, we determined that it was more likely than not that our deferred tax assets would be realized and therefore released our valuation allowance of $51.6 million in fiscal 2005.
Recent Accounting Pronouncements In June 2006, the FASB reached consensus on Emerging Issues Task Force (“EITF”) No. 06-3, How Taxes Collected from Customers and Remitted to Governmental Authorities Should be Presented in the Income Statement (“EITF 06-3”). The scope of EITF 06-3 includes any tax assessed by a governmental authority that is directly imposed on a revenue-producing transaction between a seller and a customer and may include, but is not limited to, sales, use, value added, and excise taxes. The Task Force affirmed its conclusion that entities should present these taxes in the income statement on either a gross or a net basis, based on their accounting policy, which should be disclosed pursuant to Accounting Principles Board Opinion (“APB”) No. 22, Disclosure of Accounting Policies. If those taxes are significant, and are presented on a gross basis, the amounts of those taxes should be disclosed. The consensus on EITF 06-3 will be effective for interim and annual reporting periods beginning after December 15, 2006. We currently record transaction-based taxes on a net basis in our condensed consolidated statements of operations. Should we conclude that these amounts are more appropriately presented on a gross basis, it could have a material impact on total net revenues and cost of sales, although income or loss from operations and net income or loss would not be affected.
In July 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109.” Interpretation 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with Statement 109 and prescribes a recognition threshold and measurement attribute for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Additionally, Interpretation 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. Interpretation 48 is effective for fiscal years beginning after December 15, 2006, with early adoption permitted. We are currently evaluating whether the adoption of Interpretation 48 will have a material effect on our overall results of operations or financial position.
In September 2006, the SEC released Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides guidance on the process of quantifying materiality of financial statement misstatements. SAB 108 is effective for fiscal years ending after November 15, 2006, with early application for the first interim period ending after November 15, 2006. We do not believe that the application of SAB 108 will have a material effect on our overall results of operations or financial position..
In September 2006, the FASB issued Statement No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework and guidance regarding the methods for measuring fair value, and expands related disclosures about those measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. We are currently assessing the impact that SFAS 157 will have on our results of operations and financial position.
In February 2007, the FASB issued Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities — including an amendment to FAS 115 (“SFAS 159”). SFAS 159 allows entities to choose, at specified election dates, to measure eligible financial assets and liabilities at fair value in situations in which they are not otherwise required to be measured at fair value. If a company elects the fair value option for an eligible item, changes in that item’s fair value in subsequent reporting periods must be recognized in current earnings. SFAS 159 also establishes presentation and disclosure requirements designed to draw comparison between entities that elect different measurement attributes for similar assets and liabilities. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact that SFAS 159 will have on our results of operations and financial position.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, the components of the results of operations, as reflected in our statement of operations, as a percentage of sales.
18
| | Three months ended January 31, | | Nine months ended January 31, | |
| | 2007 | | 2006 | | 2007 | | 2006 | |
Revenue | | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |
Cost of goods sold | | 36.1 | | 30.6 | | 32.9 | | 30.4 | |
Gross Profit | | 63.9 | | 69.4 | | 67.1 | | 69.6 | |
Operating expenses: | | | | | | | | | |
Sales and marketing | | 25.2 | | 30.2 | | 28.4 | | 36.4 | |
Research and development | | 23.0 | | 32.0 | | 24.3 | | 37.9 | |
General and administrative | | 10.1 | | 12.3 | | 9.9 | | 15.2 | |
Amortization of purchased intangibles | | 1.1 | | 1.8 | | 1.1 | | 1.6 | |
In-process R&D | | — | | — | | — | | 2.0 | |
Total operating expenses | | 59.4 | | 76.3 | | 63.7 | | 93.1 | |
Income (loss) from operations | | 4.5 | | (6.9 | ) | 3.4 | | (23.5 | ) |
Other income, net | | 7.7 | | 8.4 | | 7.7 | | 9.0 | |
Income (loss) before provision for (benefit from) income taxes | | 12.2 | | 1.5 | | 11.1 | | (14.5 | ) |
Provision for (benefit from) for income taxes | | 3.1 | | 2.0 | | 4.0 | | (4.8 | ) |
Net income (loss) | | 9.1 | % | (0.5 | )% | 7.1 | | (9.7 | )% |
THREE AND NINE MONTHS ENDED JANUARY 31, 2007 AND 2006.
Revenue.
| | Three months ended January 31, | | Nine months ended January 31, | | Increase From Prior Year, | |
$s in thousands | | 2007 | | 2006 | | 2007 | | 2006 | | 3 Month
Period | | 9 Month
Period | |
Revenue | | $ 22,078 | | $ 13,995 | | $ 64,795 | | $ 34,865 | | $ 8,083 | | $ 29,930 | |
The increase in revenue during the three and nine months ended January 31, 2007 was due to an increase in sales to our largest domestic customer, Verizon Wireless, and an increase in our international revenue. Verizon accounted for approximately 60% of our revenue for the three and nine months ended January 31, 2007 as compared to 82% and 80%, respectively, of our revenue for the three and nine months ended January 31, 2006. Our international revenue, accounted for 36% and 34%, respectively, of our revenue in our three and nine months ended January 31, 2007 as compared to 3% and 10%, respectively, of the revenue for the three and nine months ended January 31, 2006. Our five largest customers accounted for 97% and 90%, respectively, of our revenue for the three and nine months ended January 31, 2007 compared to 94% and 93%, respectively, for the three and nine months ended January 31, 2006. The primary source of product revenue continues to be from our Broadband Voice Processor Flex (“BVP-Flex”), which has become the primary system purchased by our domestic customers, although sales of our QVP product, which includes our new voice quality features targeted at international customers, grew as a percentage of total revenue compared to the three and nine months ended January 31, 2006. In addition, in the first nine months of fiscal 2007, we generated our first revenue from maintenance contracts.
Geographically, our domestic revenue for the three and nine months ended January 31, 2007 of 64% and 66%, respectively, of total worldwide revenue was lower than the domestic revenue of 97% and 90%, respectively, realized for the three and nine months ended January 31, 2006. The increase in the international portion of our revenue was driven by sales of our VQA product, most significantly to Orascom.
Following the success of our BVP-Flex, revenue over the last three fiscal years and the first nine months of fiscal 2007 has been generated largely from domestic sales. Our international growth has primarily been dependent on our success in selling VQA. Our success in selling to international markets was limited until the fourth quarter of fiscal 2006. In the last four quarters we have begun to realize more sales of our VQA applications and have recognized international revenue of $3.5 million, $6.7 million, $7.2 million and $8.0 million, respectively, in the fourth quarter of fiscal 2006 and first, second and third quarters of fiscal 2007. We plan to continue to invest in our international infrastructure and in customer trials as we believe there are material international revenue opportunities. However, we expect that sales of our BVP-Flex to domestic customers will continue to represent the majority of our revenue in the foreseeable future. We expect revenue in the fourth quarter to be approximately 5% higher than the revenue levels of the third quarter.
Cost of Goods Sold.
| | Three months ended January 31, | | Nine months ended January 31, | | Increase From Prior Year, | |
$s in thousands | | 2007 | | 2006 | | 2007 | | 2006 | | 3 Month
Period | | 9 Month
Period | |
Cost of Goods Sold | | $ 7,976 | | $ 4,280 | | $ 21,347 | | $ 10,608 | | $ 3,696 | | $ 10,739 | |
19
Cost of goods sold consists of direct material costs, personnel costs for test, configuration and quality assurance, costs of licensed technology incorporated into our products, post-sales installation costs, provisions for inventory and warranty expenses and other indirect costs. The increase in cost of goods sold was primarily driven by the increase in business volume during the three and nine months ended January 31, 2007 as compared to the three and nine months ended January 31, 2006. Our analysis of gross profit below discusses the other factors driving changes in cost of good sold.
Gross Profit.
| | Three months ended January 31, | | Nine months ended January 31, | | Increase (Decrease) From Prior
Year, | |
$s in thousands | | 2007 | | 2006 | | 2007 | | 2006 | | 3 Month
Period | | 9 Month
Period | |
Gross Profit | | $ 14,102 | | $ 9,715 | | $ 43,448 | | $ 24,257 | | $ 4,387 | | $ 19,191 | |
Gross Margin % | | 63.9 | % | 69.4 | % | 67.1 | % | 69.6 | % | (5.5) | % pts | (2.5 | )% pts |
Our gross margin was lower in the fiscal 2007 periods compared to the prior year periods as a result of our customer, product and geographic sales mix. In the first nine months of fiscal 2007, our sales to international customers, which have lower gross margins due to sales being made through value-added resellers and distributors, grew to 34% from 10% in the first nine months of fiscal 2006. In addition, in the third quarter of fiscal 2007, we recognized revenue from low-margin upgrades at some of our customers. Partially offsetting these causes for the decline in our gross margin in the current year three and nine month periods, our installation service cost as a percentage of sales was lower than the prior year three and nine month periods because, although support costs were higher than in those periods of fiscal 2006, our total revenue in those periods of fiscal 2007 was substantially higher. In addition, third quarter fiscal 2007 gross margin benefited from the reversal of warranty reserves associated with some specific programs for which costs were not as high as originally estimated.
We expect that gross margins will rise to approximately 67% in the coming quarter based on product and customer mix. Over the next several quarters, with successful international deployment, we could expect pricing pressures to continue as we expand the distribution of our products through value-added resellers and distributors, which could cause our gross margins to decrease further.
Sales and Marketing.
| | Three months ended January 31, | | Nine months ended January 31, | | Increase (Decrease) From Prior
Year, | |
$s in thousands | | 2007 | | 2006 | | 2007 | | 2006 | | 3 Month
Period | | 9 Month
Period | |
Sales & Marketing Expense | | $ 5,557 | | $ 4,234 | | $ 18,390 | | $ 12,692 | | $ 1,323 | | $ 5,698 | |
% of Revenue | | 25.2 | % | 30.3 | % | 28.4 | % | 36.4 | % | (5.1) | % pts | (8.0 | )% pts |
Sales and marketing expenses primarily consist of personnel costs, including commissions and costs associated with customer service, travel, trade shows and outside consulting services. The increase in sales and marketing expense for the three and nine months ended January 31, 2007 was largely due to increases of $332,000 and $2.0 million, respectively, in other salary and related expense due to incremental hiring of sales, marketing, pre-sales support engineers, including a field engineering team to support the Packet Voice Processor launch and a new Vice President of Sales, and milestone-based bonuses and increases in stock-based compensation expense of $433,000 and $1.8 million, respectively, due to the adoption of SFAS 123R. Agent fees, which are third party commissions tied to some of our international sales, increased approximately $120,000 and $858,000, respectively, for the three and nine months ended January 31, 2007, due to the increase in Asia and Middle East revenue in those periods. The amortization of demonstration and field units increased $113,000 and $412,000, respectively, for the three and nine months ended January 31, 2007, as the prior three and nine month periods benefited from the completion of customer trials and the return of demonstration and field units. Since the first quarter of fiscal 2006, we have increasingly shipped customer demonstration units to support Packet Voice Processor trials. Travel-related expense increased $284,000 for the nine months ended January 31, 2007 due to the larger workforce and greater international activity. Finally, market and product research expenses grew $142,000 and $176,000, respectively, for the three and nine month periods. We expect sales and marketing expenses to increase in the fourth quarter of fiscal 2007 due to the timing of tradeshows and the hiring of sales, marketing and customer service headcount targeted at domestic opportunities. Agent fees may also increase depending on the level of sales through international channels. Additionally, stock-based compensation charges will vary from quarter to quarter depending on the timing and magnitude of equity incentive grants during each quarter. However, we expect fourth quarter stock-based compensation expense to be higher than the third quarter, due to the effect of new grants.
20
Research and Development.
| | Three months ended January 31, | | Nine months ended January 31, | | Increase (Decrease) From Prior
Year, | |
$s in thousands | | 2007 | | 2006 | | 2007 | | 2006 | | 3 Month
Period | | 9 Month
Period | |
Research & Development Expense | | $ 5,077 | | $ 4,479 | | $ 15,715 | | $ 13,211 | | $ 598 | | $ 2,504 | |
% of Revenue | | 23.0 | % | 32.0 | % | 24.9 | % | 24.3 | % | (9.0) | % pts | (13.6 | )% pts |
Research and development expenses primarily consist of personnel costs, contract consultants, materials and supplies used in the development of voice processing products. Of the increase in spending for the three and nine months ended January 31, 2007, $475,000 and $1.4 million, respectively, was related to the hiring of engineers and having the full effect of the addition of employees that resulted from the acquisition of Jasomi. Those payroll-related increases in spending were primarily associated with our continued research and development efforts for our new packet-based voice products. Stock-based compensation expense increased $326,000 and $1.2 million, respectively, for the three and nine months ended January 31, 2007 following the adoption of SFAS 123R. Depreciation expense increased $147,000 and $435,000, respectively, for the three and nine months ended January 31, 2007 due to purchases of lab equipment required for the development of the packet-based voice products. Outside engineering service expense increased $251,000 for the nine months ended January 31, 2007 due to resources required in the development of the packet voice processor. Partially offsetting the increases in expense, prototype materials expense decreased $387,000 and $735,000, respectively, for the three and nine month periods, based on the stage of development of the packet-based products. We expect increases in our research and development spending in the fourth quarter as we continue to selectively invest in our packet-based products and on-going mobile opportunities. Additionally, stock-based compensation charges will vary from quarter to quarter depending on the timing and magnitude of equity incentive grants during each quarter. However, we expect fourth quarter stock-based compensation expense to be higher than the third quarter, due to the effect of new grants.
General and Administrative.
| | Three months ended January 31, | | Nine months ended January 31, | | Increase (Decrease) From Prior
Year, | |
$s in thousands | | 2007 | | 2006 | | 2007 | | 2006 | | 3 Month
Period | | 9 Month
Period | |
General & Administrative Expense | | $ 2,232 | | $ 1,720 | | $ 6,407 | | $ 5,291 | | $ 512 | | $ 1,116 | |
% of Revenue | | 10.1 | % | 12.3 | % | 9.9 | % | 15.2 | % | (2.2) | % pts | (5.3 | )% pts |
General and administrative expenses primarily consist of personnel costs for corporate officers, finance and human resources personnel, as well as insurance, legal, accounting and consulting costs. The increase in general and administrative spending was largely due to stock-based compensation expense following the adoption of SFAS 123R of $158,000 and $927,000, respectively, for the three and nine months ended January 31, 2007. Other payroll-related expense, due to hiring, annual raises and performance-related bonuses grew $186,000 and $442,000, respectively, for the three and nine month periods. Bad debt expense grew $143,000 for the nine month period as we had higher accounts receivable balances and more customers than in the prior year. Partially offsetting the nine month period increases, consulting expense was $266,000 lower due to prior year work on Sarbanes-Oxley compliance and tax issues that was not repeated in fiscal 2007. We expect general and administrative expenses to decrease somewhat in the fourth quarter compared to the third quarter due to an expected decrease in professional fees. Additionally, stock-based compensation charges will vary from quarter to quarter depending on the timing and magnitude of equity incentive grants during each quarter. However, we expect fourth quarter stock-based compensation expense to be higher than the third quarter, due to the effect of new grants.
Stock-based Compensation.
Stock based compensation expense recognized under SFAS 123R in fiscal 2007 and APB 25 in fiscal 2006 was as follows:
| | Three months ended
January 31, | | Nine months ended
January 31, | |
| | 2007 | | 2006 | | 2007 | | 2006 | |
| | | | | | | | | |
Cost of Sales | | $ 71 | | $ — | | $ 285 | | $ — | |
Sales and marketing | | 458 | | 77 | | 1,928 | | 179 | |
Research and development | | 511 | | 186 | | 1,635 | | 455 | |
General and administrative | | 158 | | — | | 927 | | — | |
Total operating expense | | 1,127 | | 263 | | 4,490 | | 634 | |
Total | | $ 1,198 | | $ 263 | | $ 4,775 | | $ 634 | |
Compensation expense in the third quarter and first nine months of fiscal 2006 related solely to the vesting of assumed stock options and restricted stock grants made in connection with the Jasomi acquisition and were accounted for in accordance with the provisions of APB 25.
Amortization of purchased intangible assets.
| | Three months ended January 31, | | Nine months ended January 31, | | Increase (Decrease) From Prior
Year, | |
$s in thousands | | 2007 | | 2006 | | 2007 | | 2006 | | 3 Month
Period | | 9 Month
Period | |
Amortization of purchased intangible assets | | $ 246 | | $ 246 | | $ 739 | | $ 575 | | $ — | | $ 164 | |
% of Revenue | | 1.1 | % | 1.8 | % | 1.1 | % | 1.6 | % | (0.7) | % pts | (0.5 | )% pts |
21
In the first nine months of fiscal 2006, we recorded only seven months of amortization of purchased intangible assets related to the Jasomi acquisition, as the acquisition was not completed until the end of the second month of our fiscal year, whereas in the first nine months of fiscal 2007, we recorded a full nine months worth of amortization. Purchased intangible assets are being amortized to operating expense over their estimated useful lives which range from four to five years.
In-process research and development.
| | Three months ended January 31, | | Nine months ended January 31, | | Increase (Decrease) From Prior
Year, | |
$s in thousands | | 2007 | | 2006 | | 2007 | | 2006 | | 3 Month
Period | | 9 Month
Period | |
In-process research and development | | $ — | | $ — | | $ — | | $ 700 | | $ — | | $ (700 | ) |
% of Revenue | | 0.0 | % | 0.0 | % | 0.0 | % | 3.4 | % | 0.0 | % pts | (3.4 | )% pts |
In the first quarter of fiscal 2006, we incurred a charge of $700,000 for in-process research and development acquired as part of our acquisition of Jasomi. The amount of the purchase price for Jasomi allocated to in-process research and development was determined through established valuation techniques in the high-technology communications equipment industry. In-process R&D is expensed upon acquisition because technological feasibility has not been established and no future alternative uses exist.
Other Income, Net.
| | Three months ended January 31, | | Nine months ended January 31, | | Increase (Decrease) From Prior
Year, | |
$s in thousands | | 2007 | | 2006 | | 2007 | | 2006 | | 3 Month
Period | | 9 Month
Period | |
Other income, net | | $ 1,711 | | $ 1,175 | | $ 5,028 | | $ 3,154 | | $ 536 | | $ 1,874 | |
% of Revenue | | 7.7 | % | 8.4 | % | 7.8 | % | 9.0 | % | (0.6 | )% pts | (1.3 | )% pts |
Other income, net consists of interest income on our invested cash and cash equivalent balances, foreign currency activities, and a nominal amount of interest expense. The year-over-year increases in other income, net were primarily attributable to higher interest income, due to a significant improvement in the return on our invested cash.
Income Taxes.
| | Three months ended January 31, | | Nine months ended January 31, | | Increase (Decrease) From Prior
Year, | |
$s in thousands | | 2007 | | 2006 | | 2007 | | 2006 | | 3 Month
Period | | 9 Month
Period | |
Provision for (benefit from) income taxes | | $ 694 | | $ 278 | | $ 2,624 | | $ (1,668 | ) | $ 416 | | $ 4,292 | |
% of Revenue | | 3.1 | % | 2.0 | % | 4.0 | % | (4.8 | )% | 1.1 | % pts | 8.8 | % pts |
Income taxes consist of federal, state and foreign income taxes. The effective tax rate for the three months ended January 31, 2007 was approximately 26% compared to 132% for the three months ended January 31, 2006. The effective tax rate for the nine months ended January 31, 2007 was approximately 36% compared to 33% for the nine months ended January 31, 2006. The effective tax rate for the three and nine months ended January 31, 2007 benefited from the extension of the Federal R&D tax credit as well as our determination that the California R&D tax credit would also provide meaningful tax savings. The effective tax rates for those periods ended January 31, 2007 reflected our inability to deduct for tax purposes (1) stock-based compensation expense associated with (i) most non-U.S. employees and (ii) incentive stock option grants and (2) amortization of debentures associated with the Jasomi acquisition that are payable to employee-investors. The effective tax rates for the three and nine months ended January 31, 2006 reflected the net effect of the effective tax rate applied to our loss for the periods and, for the year-to-date period only, our inability to deduct for tax purposes $700,000 for in-process R&D related to the acquisition of Jasomi.
LIQUIDITY AND CAPITAL RESOURCES
As of January 31, 2007, we had cash, cash equivalents and short-term investments of $131.7 million compared to $136.0 million at April 30, 2006. In September 2006, we renewed our $2 million line of credit facility with our bank. The line of credit expires in July 2007.
Since March 1997, we have satisfied our liquidity requirements through cash flow generated from operations, funds received from stock issued under our various stock plans and the proceeds from our initial and follow-on public offerings in fiscal 2000.
$s in thousands | | Nine months ended
January 31, | |
| | 2007 | | 2006 | |
Cash flow from operating activities | | $ (835 | ) | $ 497 | |
22
Although net income was $4.6 million in the first nine months of fiscal 2007, we used $835,000 in cash for operations. This was primarily due to the fact that we had received payment from customers in fiscal 2006 for products from which we recognized approximately $10.9 million of revenue in the first nine months of fiscal 2007. In those sales transactions, primarily with Verizon and Orascom, we shipped product during fiscal 2006 but were unable to recognize revenue because we had not completed required installations. The installations were completed in the nine months of fiscal 2007 and we were consequently able to recognize revenue. This compares to about $1.9 million of cash being received in the first nine months of fiscal 2007 for which revenue will be recognized later. In addition, accounts receivable increased $8.3 million based on the timing of our sales transactions during the nine month period. Favorably impacting our first nine months of fiscal 2007 cash flow from operations by approximately $3.2 million was the timing of payments to our inventory suppliers. We paid those inventory suppliers after the end of the third quarter when we normally would have paid them prior to the end of the third quarter. In addition, we delayed payment to other non-inventory suppliers, further driving up our accounts payable balance.
Our accounts receivable days sales outstanding at January 31, 2007 was approximately 56 days compared to 24 days at April 30, 2006.
Our cash flow from operations in the fourth quarter will be dependent on the timing of our sales during the quarter. Over the next few quarters, we expect increases in operating expenses and inventory levels as we invest to grow our VoIP products, which will adversely impact our cash flows from operations.
$s in thousands | | Nine months ended
January 31, | |
| | 2007 | | 2006 | |
Cash flow from investing activities | | $ (4,428 | ) | $ (12,959 | ) |
We used $4.4 million in cash for our investing activities in the first nine months of fiscal 2007 primarily as a result of paying $2.7 million to Jasomi’s former non-employee investors for principal and interest under the first tranche of the convertible notes issued in the Jasomi acquisition. The payment of the notes held by employee-shareholders is included in cash flow from operating activities. Additionally impacting cash flows from investing activities was the purchase of $2.9 million of equipment, primarily to support our development of the Packet Voice Processor. We plan to continue to invest in capital assets related to new product features and to support our efforts to sell our VoIP products.
$s in thousands | | Nine months ended
January 31, | |
| | 2007 | | 2006 | |
Cash flow from financing activities | | $ 1,525 | | $ 1,012 | |
We generated $1.5 million of cash from financing activities in the first nine months of fiscal 2007 primarily due to funds received from the employee stock purchase plan and stock option exercises. Although we expect to continue to have positive cash flows from financing activities due to employee stock plan activity, the level of cash flow will vary depending on market conditions.
We have no material commitments other than obligations under operating leases, particularly our facility leases, and normal purchases of inventory, capital equipment and operating expenses, such as materials for research and development and consulting, and remaining obligations under the notes issued in the Jasomi acquisition. We currently occupy approximately 61,000 square feet of space in the two buildings that form our Mountain View, California headquarters. In September 2005, we renegotiated our Mountain View, California lease, which extended the lease term through July 31, 2011 and reduced the rent cost. We additionally have leased office space in Calgary, Canada, primarily for R&D operations, under an operating lease expiring January 31, 2011.
The following table sets forth our contractual commitments as of January 31, 2007 ($s in thousands):
| | Payments due by period | |
Contractual Obligations | | Total | | Less than
1 year | | 2 to 3
years | | 4 to 5
years | | Over 5
years | |
| | | | | | | | | | | |
Operating leases | | $ 5,070 | | $ 1,082 | | $ 2,245 | | $ 1,743 | | $ — | |
Purchase commitments | | 9,485 | | 9,485 | | — | | — | | — | |
| | | | | | | | | | | |
Total | | $ 14,555 | | $ 10,567 | | $ 2,245 | | $ 1,743 | | $ — | |
Jasomi acquisition consideration included $7.0 million in non-transferable convertible notes, divided into two tranches with principal amounts of $3.0 million and $4.0 million, respectively. The $3.0 million notes matured on June 30, 2006 and were paid in the first quarter of fiscal 2007. The $4.0 million second tranche of notes either mature or convert into Ditech common stock at the election of the holder in June 2007. The payment of the full $4.0 million principal amount of the second tranche of convertible notes is contingent on (1) the retention of a specified number of designated employees and (2) the amount of any indemnification claims made by Ditech for breaches of representations, warranties and covenants, and so is not reflected in the table above. The notes bear an interest rate of 5%, payable on maturity or conversion, and are convertible at $9.84 per share.
We believe that we will be able to satisfy our cash requirements for at least the next two years from our existing cash, cash equivalents
23
and short-term investments. In September 2006, we renewed our $2.0 million operating line of credit with our bank. The ability to fund our operations beyond the next two years will be dependent on the overall demand of telecommunications providers for new capital equipment. Should our customers significantly reduce their purchases of our products compared to current levels of purchases, we could need to find additional sources of cash during early fiscal 2009 or be forced to reduce our spending levels to protect our cash reserves.
Future Growth and Operating Results Subject to Risk
Our business and the value of our stock are subject to a number of risks, which are set out below. If any of these risks actually occur, our business, financial condition or operating results could be materially adversely affected, which would likely have a corresponding impact on the value of our common stock. These risk factors should be carefully reviewed.
WE DEPEND ON A LIMITED NUMBER OF CUSTOMERS, THE LOSS OF ANY ONE OF WHICH COULD CAUSE OUR REVENUE TO DECREASE.
Our revenue historically has come from a small number of customers. Our five largest customers accounted for approximately 90% of our revenue in the first nine months of fiscal 2007 and 88% and 91% of our revenue in fiscal 2006 and 2005, respectively. Our largest customer accounted for approximately 60% of our revenue in the first nine months of fiscal 2007 and 79% of our revenue in fiscal 2006. A customer may stop buying our products or significantly reduce its orders for our products for a number of reasons, including the acquisition of a customer by another company, a delay in a scheduled product introduction, completion of a network expansion or upgrade, or a change in technology or network architecture. If this happens, our revenue could be greatly reduced, which would materially and adversely affect our business. In addition, our customer concentration exposes us to credit risk as, for example, 66% of our accounts receivable balance at January 31, 2007 was from two customers.
Since the beginning of calendar year 2004, North American telecommunication service providers have been involved in a series of merger and acquisition activities and some affected telecommunication service providers are still assessing the network technology and deployment plans. In any merger, product purchases for network deployment may be reviewed, postponed or canceled based on revised plans for technology or network expansion for the merged entity. We believe this is what happened at Nextel when, in December 2004, they announced a plan to merge with Sprint. Consequently, our fiscal 2006 revenue from Sprint-Nextel was nominal compared to 37% of our total worldwide revenue, or $34.9 million, in fiscal 2005. If this situation occurs at other customers, it may result in the delay of product purchases or the loss of those customers.
WE FACE INTENSE COMPETITION, WHICH COULD ADVERSELY AFFECT OUR ABILITY TO MAINTAIN OR INCREASE SALES OF OUR PRODUCTS.
The markets for our products are intensely competitive, continually evolving and subject to rapid technological change. We may not be able to compete successfully against current or future competitors. We expect that competition will increase in the future. We may not have the financial resources, technical expertise or marketing, manufacturing, distribution and support capabilities to compete successfully.
We face competition from two direct manufacturers of stand-alone voice processing products, Tellabs and Natural Microsystems. Tellabs also produces Digital Cross Connect devices that are widely deployed. Tellabs offers both stand-alone and integrated voice processing products. A widespread adoption of voice processing capabilities integrated into digital cross connects by Tellabs or other manufacturers presents a competitive threat if the net result is a decline in the usage of our stand-alone voice processing systems.
The other competition in these markets comes from voice switch manufacturers. These switch manufacturers do not sell stand-alone voice processing products or compete in the voice processing product market, but some integrate voice processing functionality within their switches, either as hardware modules or as software running on chips. A more widespread adoption of internal voice processing solutions would present an increased competitive threat to us, if the net result was the elimination of demand for our voice processing system products.
Many of our competitors and potential competitors have long-standing relationships with our existing and potential customers, and have substantially greater name recognition and technical, financial and marketing resources than we do. These competitors may undertake more extensive marketing campaigns, adopt more aggressive pricing policies and devote substantially more resources to developing new products than we will.
WE ARE RELIANT PRIMARILY ON OUR VOICE QUALITY BUSINESS TO GENERATE REVENUE GROWTH AND PROFITABILITY, WHICH COULD LIMIT OUR RATE OF FUTURE REVENUE GROWTH.
We expect that, at least through fiscal 2007, our primary business will be the design, development and marketing of voice processing products. However, the relatively small size of the overall echo cancellation portion of the voice market, which is where we have derived the majority of our revenue to date, could limit the rate of growth of our business. In addition, certain telecommunication service providers may utilize different technologies, such as VoIP, which would further limit demand for products we sold in the first nine months of fiscal 2007, fiscal 2006 and fiscal 2005, which are deployed in mobile and wireline networks. Although we have begun to distribute for trial our Packet Voice Processor targeted at the VoIP market, we have generated only nominal revenue to date and
24
there is no guarantee that we will be successful in selling the Packet Voice Processor in volume into those VoIP networks.
OUR OPERATING RESULTS HAVE FLUCTUATED SIGNIFICANTLY IN THE PAST, AND WE ANTICIPATE THAT THEY MAY CONTINUE TO DO SO IN THE FUTURE, WHICH COULD ADVERSELY AFFECT OUR STOCK PRICE.
Our quarterly operating results have fluctuated significantly in the past and may fluctuate in the future as a result of several factors, some of which are outside of our control. If revenue significantly declines, as we experienced in the first nine months of fiscal 2006, our operating results will be adversely affected because many of our expenses are relatively fixed. In particular, sales and marketing, research and development and general and administrative expenses do not change significantly with variations in revenue in a quarter. Adverse changes in our operating results could adversely affect our stock price. For example, when we announced in May 2005 that we expected our revenue for the first quarter of fiscal 2006 would be less than half of our revenue in the last quarter of fiscal 2005, our stock price dropped from a closing price of $12.59 just prior to our announcement to a closing price of $7.79 per share on the day following our announcement.
OUR REVENUE MAY VARY FROM PERIOD TO PERIOD.
Factors that could cause our revenue to fluctuate from period to period include:
· changes in capital spending in the telecommunications industry and larger macroeconomic trends;
· the timing or cancellation of orders from, or shipments to, existing and new customers;
· the loss of, or a significant decline in orders from, a customer;
· delays outside of our control in obtaining necessary components from our suppliers;
· delays outside of our control in the installation of products for our customers;
· the timing of new product and service introductions by us, our customers, our partners or our competitors;
· delays in timing of revenue recognition, due to new contractual terms with customers;
· competitive pricing pressures;
· variations in the mix of products offered by us; and
· variations in our sales or distribution channels.
Sales of our products come from our major customers ordering large quantities with deployment or growth of a switching center. Consequently, we may get one or more large orders in one quarter from a customer and then no orders in the next quarter. As a result, our revenue may vary significantly from quarter to quarter.
Our customers may delay or rescind orders for our existing products in anticipation of the release of our or our competitors’ new products, due to merger and acquisition activity or if they are unable to put credit facilities in place. Further, if our or our competitors’ new products substantially replace the functionality of our existing products, our existing products may become obsolete, which could result in inventory write-downs, and/or we could be forced to sell them at reduced prices or even at a loss.
In addition, the sales cycle for our products is typically lengthy. Before ordering our products, our customers perform significant technical evaluations of up to 180 days or more for our newer VQA product offering. Once an order is placed, delivery times can vary depending on the product ordered and the timing of installations or product acceptance may be delayed by our customers. As a result, revenue forecasted for a specific customer for a particular quarter may not occur in that quarter. Because of the potential large size of our customers’ orders, this would adversely affect our revenue for the quarter.
OUR EXPENSES MAY VARY FROM PERIOD TO PERIOD.
Many of our expenses do not vary with our revenue. Factors that could cause our expenses to fluctuate from period to period include:
· the extent of marketing and sales efforts necessary to promote and sell our products;
· the timing and extent of our research and development efforts;
· the availability and cost of key components for our products;
· the timing of personnel hiring;
· the timing of external accounting expenses supporting annual audit;
· the timing of the grant of equity awards and completion of amortization of existing equity awards; and
· the timing of mergers and acquisitions activity or reductions-in-force.
If we incur these additional expenses in a quarter in which we do not experience increased revenue, our operating results would be adversely affected.
IF WE DO NOT SUCCESSFULLY DEVELOP AND INTRODUCE NEW PRODUCTS, OUR PRODUCTS MAY BECOME OBSOLETE WHICH COULD CAUSE OUR SALES TO DECLINE.
We operate in an industry that experiences rapid technological change, and if we do not successfully develop and introduce new products and our existing products become obsolete due to product introductions by competitors, our revenues will decline. Even if we are successful in developing new products, we may not be able to successfully produce or market our new products in commercial
25
quantities, or increase our overall sales levels. These risks are of particular concern when a new generation product is introduced. Although we believe we will meet our product introduction timetables, there is no guarantee that delays will not occur. We realized our first modest levels of revenue from our new voice quality features, which are being offered on our BVP-Flex and Quad Voice Processor (QVP) voice processing hardware platforms, in the fourth quarter of fiscal 2004 and are currently experiencing numerous customer evaluations of these features around the world. These evaluations have typically taken longer than we first anticipated and we did not generate significant revenue from international customers that purchased the VQA platform until the fourth quarter of fiscal 2006. However, should the product not meet the customers’ expectations, the timing of our realization of future revenue expected from the VQA platform could be delayed or not materialize at all.
The Packet Voice Processor provides voice processing functionality to enable the deployment of end-to-end VoIP services. This is the first packet-based product developed by us. The product may not be accepted in the market due to feature or capabilities mis-matches with customer requirements, pricing of the product, or limitations of our sales and marketing organizations to properly interact with customers to communicate the benefits of the product.
We have in the past experienced, and in the future may experience, unforeseen delays in the development of our new products. For example, an unexpected drop in demand for our OC-3 product led to the write down of $3.5 million of excess inventory in the third quarter of fiscal 2002. Although we were eventually able to sell a majority of this product after having written it down, there can be no assurances that we will be able to sell additional written-down units in the future.
We must devote a substantial amount of resources in order to develop and achieve commercial acceptance of our new products, most recently our Packet Voice Processor and our voice quality features offered on our BVP-Flex and QVP hardware platforms. Our new and/or existing products may not be able to address evolving demands in the telecommunications market in a timely or effective way. Even if they do, customers in these markets may purchase or otherwise implement competing products.
WE OPERATE IN AN INDUSTRY EXPERIENCING RAPID TECHNOLOGICAL CHANGE, WHICH MAY MAKE OUR PRODUCTS OBSOLETE.
Our future success will depend on our ability to develop, introduce and market enhancements to our existing products and to introduce new products in a timely manner to meet our customers’ requirements. The markets we target are characterized by:
· rapid technological developments;
· frequent enhancements to existing products and new product introductions;
· changes in end user requirements; and
· evolving industry standards.
WE MAY NOT BE ABLE TO RESPOND QUICKLY AND EFFECTIVELY TO THESE RAPID CHANGES. The emerging nature of these products and their rapid evolution will require us to continually improve the performance, features and reliability of our products, particularly in response to competitive product offerings. We may not be able to respond quickly and effectively to these developments. The introduction or market acceptance of products incorporating superior technologies or the emergence of alternative technologies and new industry standards could render our existing products, as well as our products currently under development, obsolete and unmarketable. In addition, we may have only a limited amount of time to penetrate certain markets, and we may not be successful in achieving widespread acceptance of our products before competitors offer products and services similar or superior to our products. We may fail to anticipate or respond on a cost-effective and timely basis to technological developments, changes in industry standards or end user requirements. We may also experience significant delays in product development or introduction. In addition, we may fail to release new products or to upgrade or enhance existing products on a timely basis.
WE MAY NEED TO MODIFY OUR PRODUCTS AS A RESULT OF CHANGES IN INDUSTRY STANDARDS. The emergence of new industry standards, whether through adoption by official standards committees or widespread use by service providers, could require us to redesign our products. If these standards become widespread, and our products are not in compliance, our current and potential customers may not purchase our products. The rapid development of new standards increases the risk that our competitors could develop and introduce new products or enhancements directed at new industry standards before us.
ACQUISITIONS AND INVESTMENTS MAY ADVERSELY AFFECT OUR BUSINESS.
From time to time, we 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 June 2005 we acquired Jasomi. Acquisitions or investments could result in a number of financial consequences, including:
· 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;
· the assumption of significant liabilities; and
· amortization expenses related to other acquisition related intangible assets and impairment of goodwill.
26
Furthermore, acquisitions involve numerous operational risks, including:
· 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.
WE ANTICIPATE THAT AVERAGE SELLING PRICES FOR OUR PRODUCTS WILL DECLINE IN THE FUTURE, WHICH COULD ADVERSELY AFFECT OUR ABILITY TO BE PROFITABLE.
We expect that the price we can charge our customers for our products will decline as new technologies become available, as we expand the distribution of products through value-added resellers and distributors internationally and as competitors lower prices either as a result of reduced manufacturing costs or a strategy of cutting margins to achieve or maintain market share. If this occurs, our operating results will be adversely affected. We expect price reductions to be more pronounced due to our planned expansion internationally. While we intend to reduce our manufacturing costs in an attempt to maintain our margins and to introduce enhanced products with higher selling prices, we may not execute these programs on schedule. In addition, our competitors may drive down prices faster or lower than our planned cost reduction programs. Even if we can reduce our manufacturing costs, many of our operating costs will not decline immediately if revenue decreases due to price competition.
In order to respond to increasing competition and our anticipation that average-selling prices will decrease, we are attempting to reduce manufacturing costs of our new and existing products. If we do not reduce manufacturing costs and average selling prices decrease, our operating results will be adversely affected. Manufacturing is currently outsourced to primarily one contract manufacturer. We believe that our current contract manufacturing relationship provides us with competitive manufacturing costs for our products. However, if we or this contract manufacturer terminates our relationship, or if we otherwise establish new relationships, we may encounter problems in the transition of manufacturing to another contract manufacturer, which could temporarily increase our manufacturing costs and cause production delays.
IF WE LOSE THE SERVICES OF ANY OF OUR KEY MANAGEMENT OR KEY TECHNICAL PERSONNEL, OR ARE UNABLE TO RETAIN OR ATTRACT ADDITIONAL TECHNICAL PERSONNEL, OUR ABILITY TO CONDUCT AND EXPAND OUR BUSINESS COULD BE IMPAIRED.
We depend heavily on key management and technical personnel for the conduct and development of our business and the development of our products. However, there is no guarantee that if we lost the services of one or more of these people for any reason, that it would not adversely affect our ability to conduct and expand our business and to develop new products. We believe that our future success will depend in large part upon our continued ability to attract, retain and motivate highly skilled technical employees. Moreover, in the current market, it has become more difficult to recruit technical professionals with the expertise we need. These recruiting and retention challenges could hinder our ability to develop and sell our products.
WE DO NOT HAVE THE RESOURCES TO ACT AS A SYSTEMS INTEGRATOR, WHICH MAY BE REQUIRED TO WIN DEALS WITH SOME LARGE U.S. AND INTERNATIONAL TELECOMMUNICATIONS SERVICES COMPANIES.
When implementing significant technology upgrades, large U.S. and international telecommunications services companies often require one major equipment supplier to act as a “systems integrator”(SI) to ensure interoperability of all the network elements. Normally the SI would provide the most crucial network elements and also take responsibility for the interoperation of their own equipment with the equipment provided by other suppliers. We are not in a position to take a lead SI position and therefore we may have to partner with an SI (other, much larger, telecommunication equipment supplier) to have a chance to win with certain customers. As a result, we may experience delays in revenue because it could take a long time to agree to terms with the necessary SI. Moreover, there is no guarantee that we will reach agreement with a SI.
IF INCUMBENT AND EMERGING COMPETITIVE SERVICE PROVIDERS AND THE TELECOMMUNICATIONS INDUSTRY AS A WHOLE EXPERIENCE A DOWNTURN OR REDUCTION IN GROWTH RATE, THE DEMAND FOR OUR PRODUCTS WILL DECREASE, WHICH WILL ADVERSELY AFFECT OUR BUSINESS.
Our success will continue to depend in large part on development, expansion and/or upgrade of voice and communications networks. We are subject to risks of growth constraints due to our current and planned dependence on U.S. and international telecommunications service providers. In fiscal 2001, for example, we experienced, as did other companies in our sector, a slowdown in infrastructure spending by our customers. These potential customers may be constrained for a number of reasons, including their limited capital resources, economic conditions, changes in regulation and mergers or consolidations which we have seen in North America since calendar year 2004. New service provides (E.g., Skype, Google and Yahoo) are beginning to compete against our traditional customers with new business models that are substantially reducing the prices charged to end users. This competition may force network operators to reduce capital expenditures.
27
WE MAY EXPERIENCE UNFORESEEN PROBLEMS AS WE DIVERSIFY OUR INTERNATIONAL CUSTOMER BASE, WHICH WOULD IMPAIR OUR ABILITY TO GROW OUR BUSINESS.
Historically, we have sold mostly to customers in North America. We are continuing to execute on our plans to expand our international presence through the establishment of new relationships with established international value-added resellers and distributors. However, we may still be required to hire additional personnel for the overseas market, may invest in markets that ultimately generate little or no revenue, and may incur other unforeseen expenditures related to our international expansion. As a result of these efforts, to date our expansion overseas has met with limited success and there is no guarantee of future success. As we expand our sales focus farther into international markets, we will face new and complex issues that we may not have faced before, such as expanded risk to currency fluctuations, longer payment cycles, manufacturing overseas, political or economic instability, potential adverse tax consequences and broadened import/export controls, which will put additional strain on our management personnel. In the past, the vast majority of our international sales have been denominated in U.S. dollars; however, in the future, we may be forced to denominate a greater amount of international sales in foreign currencies.
The number of installations we will be responsible for may increase as a result of our continued international expansion and recognition of revenue may be dependent on acceptances. In addition, we may not be able to establish more relationships with international value-added resellers and distributors. If we do not, our ability to increase sales could be materially impaired.
SOME OF THE KEY COMPONENTS USED IN OUR PRODUCTS ARE CURRENTLY AVAILABLE ONLY FROM SOLE SOURCES, THE LOSS OF WHICH COULD DELAY PRODUCT SHIPMENTS.
We rely on certain suppliers as the sole source of certain key components that we use in our products. For example, we rely on Texas Instruments as the sole source supplier for the digital signal processors used in our echo cancellation and voice enhancement products. We have no guaranteed supply arrangements with our suppliers. Any extended interruption in the supply of these components would affect our ability to meet scheduled deliveries of our products to customers. If we are unable to obtain a sufficient supply of these components, we could experience difficulties in obtaining alternative sources or in altering product designs to use alternative components.
Resulting delays or reductions in product shipments could damage customer relationships, and we could lose customers and orders. Additionally, because these suppliers are the sole source of these components, we are at risk that adverse increases in the price of these components could have negative impacts on the cost of our products or require us to find alternative, less expensive components, which would have to be designed into our products in an effort to avoid erosion in our product margin.
WE NOW LICENSE OUR ECHO CANCELLATION SOFTWARE FROM TEXAS INSTRUMENTS, AND IF WE DO NOT RECEIVE THE LEVEL OF SUPPORT WE EXPECT FROM TEXAS INSTRUMENTS, IT COULD ADVERSELY AFFECT OUR ECHO CANCELLATION SYSTEMS BUSINESS.
In April 2002, we sold our echo cancellation software technology and future revenue streams from our licenses of acquired technology to Texas Instruments, in return for cash and a long-term license of the echo cancellation software. The license had an initial four-year royalty-free period after which, in March 2006, we (1) extended the royalty-free period through December 31, 2007 primarily to support Ditech’s remaining warranty obligation for our end-of-life products and (2) negotiated new pricing based on the purchase of chips bundled with the echo software for our current products. Although the licensing agreement has strong guarantees of support for the software used in our products, if Texas Instruments were to breach that agreement in some fashion, and not deliver complete and timely support to us, our success in the echo cancellation systems business could be adversely affected.
IF TEXAS INSTRUMENTS LICENSES ITS ECHO CANCELLATION SOFTWARE TO OTHER ECHO CANCELLATION SYSTEMS COMPANIES, THIS COULD INCREASE THE COMPETITIVE PRESSURES ON OUR ECHO CANCELLATION SYSTEMS BUSINESS.
Under the terms of the sale agreement of our echo cancellation software to Texas Instruments, Texas Instruments was precluded from licensing the software to two specified competitors for a period of four years from the date of the sale, a restriction which expired in April 2006. If Texas Instruments were to license its echo cancellation software to other echo cancellation systems companies or the two specified competitors, it could increase the level of competition and adversely affect our success in our echo cancellation systems business.
SOME SUPPLIERS OF KEY COMPONENTS MAY REDUCE THEIR INVENTORY LEVELS WHICH COULD RESULT IN LONGER LEAD TIMES FOR FUTURE COMPONENT PURCHASES AND ANY DELAYS IN FILLING OUR DEMAND MAY REDUCE OR DELAY OUR EXPECTED PRODUCT SHIPMENTS AND REVENUES.
Although we believe there are currently ample supplies of components for our products, it is possible that in the near-term component manufacturers may reduce their inventory levels and require firm orders before they manufacture components. This reduction in stocking levels could lead to extended lead times in the future. If we are unable to procure our planned quantities of materials from all prospective suppliers, and if we cannot use alternative components, we could experience revenue delays or reductions and potential harm to customer relationships. An example of this risk occurred in the third quarter of fiscal 2001 as two suppliers supplying us with components used in our OC-3 product did not meet our total demand. As a result, the scheduled shipment of our OC-3 product was delayed, which contributed to our revenue shortfall in that quarter.
28
OUR ABILITY TO COMPETE SUCCESSFULLY WILL DEPEND, IN PART, ON OUR ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, WHICH WE MAY NOT BE ABLE TO PROTECT.
We may rely on a combination of patents, trade secrets, copyright and trademark laws, nondisclosure agreements and other contractual provisions and technical measures to protect our intellectual property rights. Nevertheless, those measures may not be adequate to safeguard the technology underlying our products. In addition, employees, consultants and others who participate in the development of our products may breach their agreements with us regarding our intellectual property, and we may not have adequate remedies for those breaches. In addition, we may not be able to effectively protect our intellectual property rights in certain countries. We may, for a variety of reasons, decide not to file for patent, copyright or trademark protection outside of the United States. We also realize that our trade secrets may become known through other means not currently foreseen by us. Notwithstanding our efforts to protect our intellectual property, our competitors may be able to develop products that are equal or superior to our products without infringing on any of our intellectual property rights.
IF WE ARE UNSUCCESSFUL IN MANUFACTURING PRODUCT THAT COMPLIES WITH ENVIRONMENTAL REQUIREMENTS, IT MAY LIMIT OUR ABILITY TO SELL IN EUROPEAN UNION (EU) COUNTRIES AND TERRITORIES.
As part of our 14001-certified management system and our overall commitment to the environment we are investigating the requirements set forth by the RoHS directive. Based on some independent industry benchmarking, and guidance offered by the UK’s Department of Trade and Industry, we believe that our product, telecommunication network infrastructure equipment, qualifies for the lead-in-solder exemption of the RoHS Directive. Consequently, we are pursuing what is commonly called “5 of 6” compliance. We will continue to monitor the evolution of the EC/95 and related industry activities and will take appropriate action for those products that we sell into EU countries and territories. Moreover, we will continue to monitor the evolution of the EC/96 and related industry activities and will take appropriate action for those products that we sell into EU countries and territories. There is no guarantee that we will be successful in complying with these evolving environmental requirements. If we are unsuccessful in complying with these environmental requirements, it would limit our ability to sell into EU countries and territories.
WE CURRENTLY ARE, AND IN THE FUTURE MAY BE, SUBJECT TO SECURITIES CLASS ACTION LAWSUITS DUE TO DECREASES IN OUR STOCK PRICE.
We are at risk of being subject to securities class action lawsuits if our stock price declines substantially. Securities class action litigation has often been brought against a company following a decline in the market price of its securities. For example, in May 2005, we announced that we expected our first quarter fiscal 2006 revenue to be approximately one half of our last quarter fiscal 2005 revenue, and our stock price declined dramatically. On June 14, 2005, a lawsuit entitled Richard E. Jaffe v. Ditech Communications Corp., Timothy K. Montgomery and William J. Tamblyn, Case No. C 05 02406 was filed in the United States District Court for the Northern District of California, purportedly on behalf of a class of investors who purchased Ditech’s stock between August 25, 2004 and May 26, 2005. The complaint alleged claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Ditech and our Chief Executive Officer and Chief Financial Officer. Several similar lawsuits were filed and all of the cases were consolidated into a single action. In addition, a shareholder’s derivative suit was filed against our directors and the same two executive officers, and named Ditech nominally as a defendant, making similar allegations. This shareholder’s derivative suit was subsequently voluntarily dismissed without prejudice, which means that the shareholder is able to refile the shareholder’s derivative suit at any time. We cannot predict whether the plaintiffs in the shareholder’s derivative suit will refile complaints. If our stock price declines substantially in the future, we may be the target of similar litigation. Any future securities litigation could result in substantial costs and divert management’s attention and resources, and could seriously harm our business. Any current or future litigation could result in difficulties meeting compliance with SEC reporting requirements and NASDAQ listing requirements.
WE CURRENTLY ARE, AND IN THE FUTURE MAY BE, SUBJECT TO ADDITIONAL SECURITIES LAWSUITS.
We are at risk of being subject to other lawsuits as a result of being a public company. Four actions have been filed purportedly as derivative actions on behalf of Ditech Networks against certain of our current and former officers and directors. The complaints allege that between 1999 and 2001 a number of stock option grants were backdated, and that as a result the defendants breached their fiduciary duties to Ditech Networks and violated provisions of federal securities laws and California statutory and common law. The complaints also allege that some of our officers and former officers were unjustly enriched. These lawsuits could result in substantial costs and divert management’s attention and resources, and thus could seriously harm our business.
OUR PRODUCTS EMPLOY TECHNOLOGY THAT MAY INFRINGE ON THE PROPRIETARY RIGHTS OF THIRD PARTIES, WHICH MAY EXPOSE US TO LITIGATION.
Although we do not believe that our products infringe the proprietary rights of any third parties, third parties may still assert infringement or invalidity claims (or claims for indemnification resulting from infringement claims) against us. These assertions could materially adversely affect our business, financial condition and results of operations. In addition, irrespective of the validity or the successful assertion of these claims, we could incur significant costs in defending against these claims.
29
THERE IS RISK THAT WE WILL NOT BE ABLE TO FULLY UTILIZE THE DEFERRED TAX ASSETS RECORDED ON OUR BALANCE SHEET.
In accordance with Statement of Financial Accounting Standard (SFAS) No. 109, “Accounting for Income Taxes,” we are required to establish a valuation allowance against our deferred tax assets if it is more likely than not that some portion or all of the deferred tax assets will not be realized. The valuation allowance should be sufficient to reduce the deferred tax asset to the amount that is more likely than not to be realized. At January 31, 2007, we had $46.6 million in net deferred tax assets, which we believe are realizable based on the requirements of SFAS 109. However, because we incurred pre-tax losses in the first nine months of fiscal 2006, have shown volatile operating results in the past and because there is no guarantee that the amount and timing of our net profits will be sufficient to fully utilize our deferred tax assets, there is a risk that we will have to record valuation allowances in the future. Moreover, there is a risk that unfavorable audits of, for example, tax credit or NOL carryforwards by government agencies or change of ownership limitations (Section 382) may reduce the value of our deferred tax assets. If any of these events were to occur, our financial results for one or more periods would be adversely affected.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk due to changes in the general level of United States interest rates relates primarily to our cash equivalents and short-term investment portfolios. Our cash, cash equivalents, and short-term investments are primarily maintained at five major financial institutions in the United States. As of January 31, 2007 and April 30, 2006, we did not hold any derivative instruments. The primary objective of our investment activities is the preservation of principal while maximizing investment income and minimizing risk, and we attempt to achieve this by diversifying our portfolio in a variety of highly rated investment securities that have limited terms to maturity. We do not hold any instruments for trading purposes.
Investment securities that have maturities of more than three months at the date of purchase but current maturities of less than one year and auction rate securities, which management is able to liquidate on 28 or 35 day auction cycles, are considered short-term investments. Short-term investments consist primarily of corporate bonds and asset backed securities. Short-term investments are maintained at three major financial institutions, are classified as available-for-sale, and are recorded on the accompanying Consolidated Balance Sheets at fair value. If we sell our short-term investments prior to their maturity, we may incur a charge to operations in the period the sale took place. In the first nine months of fiscal 2007, we realized no gains or losses on our short-term investments.
The following table presents the hypothetical changes in fair values of our investments as of January 31, 2007, based on discounted cash flow calculation over the remaining term of each investment that are sensitive to changes in interest rates (dollars in thousands):
| | Valuation of Securities Given
an Interest Rate Decrease of
X Basis Points | | Fair Value as of
January 31, 2007 | | Valuation of Securities Given
an Interest Rate Increase of
X Basis Points | |
| | (150 BPS) | | (100 BPS) | | (50 BPS) | | | | 50 BPS | | 100 BPS | | 150 BPS | |
Total investments | | $ 99,710 | | $ 99,710 | | $ 99,710 | | $ 99,710 | | $ 99,710 | | $ 99,710 | | $ 99,710 | |
This compares to the hypothetical changes in fair values of our investments as of April 30, 2006, based on a discounted cash flow calculation over the remaining term of each investment, that are sensitive to changes in interest rates (dollars in thousands):
| | Valuation of Securities Given
an Interest Rate Decrease of
X Basis Points | | Fair Value as of
January 31, 2007 | | Valuation of Securities Given
an Interest Rate Increase of
X Basis Points | |
| | (150 BPS) | | (100 BPS) | | (50 BPS) | | | | 50 BPS | | 100 BPS | | 150 BPS | |
Total investments | | $ 100,325 | | $ 100,325 | | $ 100,325 | | $ 100,325 | | $ 100,325 | | $ 100,325 | | $ 100,325 | |
These instruments are not leveraged. The modeling technique used measures the change in fair values arising from selected potential changes in interest rates. Market changes reflect immediate hypothetical parallel shifts in the yield curve of plus or minus 50 basis points (BPS), 100 BPS, and 150 BPS over the remaining life of the investments, which shifts are representative of the historical movements in the Federal Funds Rate.
The following table presents our cash equivalents and short-term and long-term investments subject to interest rate risk and their related weighted average interest rates as of January 31, 2007 and April 30, 2006 (in thousands). Carrying value approximates fair value.
| | January 31, 2007 | | April 30, 2006 | |
| | Carrying
Value | | Average
Interest Rate | | Carrying
Value | | Average
Interest Rate | |
Cash and cash equivalents | | $ 31,969 | | 4.28 | % | $ 35,707 | | 3.59 | % |
Short-term investments | | 99,710 | | 5.25 | % | 100,325 | | 4.67 | % |
| | | | | | | | | |
Total | | $ 131,679 | | 5.01 | % | $ 136,032 | | 4.39 | % |
To date, the vast majority of our sales have been denominated in U.S. dollars. As only a small amount of foreign invoices are paid in
30
currencies other than the U.S. dollar, our foreign exchange risk is considered immaterial to our consolidated financial position, results of operations or cash flows.
ITEM 4. CONTROLS AND PROCEDURES
Limitations of Disclosure Controls and Procedures and Internal Control Over Financial Reporting. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. For example, controls can be circumvented by a person’s individual acts, by collusion of two or more people or by management override of the control. Because a cost-effective control system can only provide reasonable assurance that the objectives of the control system are met, misstatements due to error or fraud may occur and not be detected.
Disclosure Controls and Procedures. We carried out an evaluation, under the supervision and with the participation of Timothy Montgomery, our principal executive officer, and William Tamblyn, our principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Securities Exchange Act Rules 13a-15(e) and 15d-15(e)) as of January 31, 2007. Based on this evaluation, Messrs. Montgomery and Tamblyn concluded that our disclosure controls and procedures were effective to provide a reasonable assurance that the information required to be disclosed by us in our reports that we file with the Securities and Exchange Commission is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission’s rules and forms, and that this information is accumulated and communicated to management, including our chief executive officer and chief financial officer, as appropriate to allow timely decisions regarding required disclosure.
Internal Control Over Financial Reporting. In addition, we reviewed our internal control over financial reporting, and there were no changes in our internal control over financial reporting during the quarter ended January 31, 2007, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Part II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Beginning on June 14, 2005, several class action lawsuits were filed in the United States District Court for the Northern District of California, purportedly on behalf of a class of investors who purchased the Company’s stock between August 25, 2004 and May 26, 2005. The complaints allege claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against the Company and its Chief Executive Officer and Chief Financial Officer in connection with alleged misrepresentations concerning VQA orders and the potential effect on the Company of the merger between Sprint and Nextel. All of the lawsuits were consolidated into a single action entitled In re Ditech Communications Corp. Securities Litigation, No. C 05-02406-JSW, and a consolidated amended complaint was filed on February 2, 2006. The defendants moved to dismiss the complaint, and the motion was granted on August 10, 2006, with leave to amend. A second consolidated amended complaint was filed on September 11, 2006. The defendants moved to dismiss the complaint and the motion has been fully briefed and under submission to the court since December 2006. This class action was also discussed in our Annual Report on Form 10-K for our fiscal year ended April 30, 2006 and Quarterly Report on Form 10-Q for our quarter ended July 31, 2006, October 31, 2006.
On August 23, 2006, August 25, 2006, and November 3, 2006, three actions were filed in United States District Court for the Northern District of California (Case Nos. C06-05157, C06-05242, and C06-6877) purportedly as derivative actions on behalf of the Company against certain of the Company’s current and former officers and directors alleging that between 1999 and 2001 certain stock option grants were backdated; that these options were not properly accounted for; and that as a result false and misleading financial statements were filed. These three actions have been consolidated under case number C06-05157. These derivative actions were also discussed in our Quarterly Report on Form 10-Q for our quarter ended October 31, 2006. On December 1, 2006, a fourth derivative complaint making similar allegations against many of the same defendants was filed in California Superior Court for the County of Santa Clara (Case No.106-CV-075695). The Company’s motion to stay the state court action pending the outcome of the federal consolidated actions is currently before the California Superior Court.
The defendants named in the derivative actions are Timothy Montgomery, Gregory Avis, Edwin Harper, William Hasler, Andrei Manoliu, David Sugishita, William Tamblyn, Caglan Aras, Toni Bellin, Robert DeVincenzi, James Grady, Lee House, Serge
31
Stepanoff, Gary Testa, Lowell Trangsrud, Kenneth Jones, Pong Lim, Glenda Dubsky, Ian Wright, and Peter Chung. These derivative complaints raise claims under Section 10(b) and 10b-5 of the Securities Exchange Act, Section 14(a) of the Securities Act, and California Corporations Code Section 25403, as well as common law claims for breach of fiduciary duty, unjust enrichment, waste of corporate assets, gross mismanagement, constructive fraud, and abuse of control. The plaintiffs seek remedies including money damages, disgorgement of profits, accounting, rescission, and punitive damages. With respect to the consolidated federal actions, the plaintiffs filed an amended consolidated complaint on March 2, 2007, adding new allegations regarding another stock option grant. The Company will respond to the amended consolidated complaint on or before April 2, 2007. These actions are in their preliminary stages; no discovery has taken place and no trial date has been set.
ITEM 1A. RISK FACTORS
We include in Part I, Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Future Growth and Operating Results Subject to Risk” a description of risk factors related to our business in order to enable readers to assess, and be appropriately apprised of, many of the risks and uncertainties applicable to the forward-looking statements made in this Quarterly Report on Form 10-Q. We do not claim that the risks and uncertainties set forth in that section are all of the risks and uncertainties facing our business, but do believe that they reflect the more important ones.
The risk factors set forth in Part I, Item 1A of our Annual Report on Form 10-K for the year ended April 30, 2006, as filed with the SEC on July 7, 2006, have not substantively changed, except for the following risk factors:
1. The risk factor “We Depend On A Limited Number Of Customers, The Loss Of Any One Of Which Could Cause Our Revenue To Decrease,” was revised to include first half of fiscal 2007 financial information and to include credit risk associated with our customer concentration.
2. The risk factor “We Face Intense Competition, Which Could Adversely Affect Our Ability To Maintain Or Increase Sales Of Our Products” was revised to update the competitive risks facing our company.
3. The risk factor “We Are Reliant Primarily On Our Voice Quality Business To Generate Revenue Growth And Profitability, Which Could Limit Our Rate Of Future Revenue Growth,” was revised to include a statement that there is no guarantee that we will be successful in selling the Packet Voice Processor in volume into VoIP networks.
4. The risk factor “Our Expenses May Vary From Period To Period,” was revised to include the expense timing risks of (1) the grant of equity awards and completion of amortization of existing equity awards and (2) mergers and acquisitions activity or reductions-in-force
5. The risk factor “If We Do Not Successfully Develop And Introduce New Products, Our Products May Become Obsolete Which Could Cause Our Sales To Decline.” was revised to update the description of the revenues generated from our VQA platform.
6. The risk factor “If We Lose The Services Of Any Of Our Key Management Or Key Technical Personnel, Or Are Unable To Retain Or Attract Additional Technical Personnel, Our Ability To Conduct And Expand Our Business Could Be Impaired,” was revised to include a statement that in the current market, it has become more difficult to recruit technical professionals with the expertise we need, and that these recruiting and retention challenges could hinder our ability to develop and sell our products.
7. The risk factor “Acquisitions And Investments May Adversely Affect Our Business,” was revised to include the financial risk of the assumption of significant liabilities
8. The risk factor “We Currently Are, And In The Future May Be, Subject To Securities Class Action Lawsuits Due To Decreases In Our Stock Price” and “We Currently Are, And In The Future May Be, Subject To Additional Securities Lawsuits” have been updated to describe the current status of the lawsuits.
9. The risk factor “There Is Risk That We Will Not Be Able To Fully Utilize The Deferred Tax Assets Recorded On Our Balance Sheet.” was revised to update the figure for net deferred tax assets.
10. The risk factor “Beginning May 1, 2006, we will be required to record compensation expense for stock options. As a result, our financial results will be adversely affected.” was deleted, as we have now implemented FAS 123R.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
None.
ITEM 3. DEFAULTS ON SENIOR SECURITIES
None.
32
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS
Exhibit | | Description of document | | |
| | | |
2.1(1) | | Asset Purchase Agreement, dated as of April 16, 2002, by and between Ditech and Texas Instruments | |
2.2(2) | | Asset Purchase Agreement, dated as of July 16, 2003, by and between Ditech Communications Corporation and JDS Uniphase Corporation | |
2.3(3) | | Agreement and Plan of Merger, dated as of June 6, 2005, among Ditech, Spitfire Acquisition Corp., Jasomi Networks, Inc., Jasomi Networks (Canada), Inc., Daniel Freedman, Cullen Jennings and Todd Simpson. | |
3.1(4) | | Restated Certificate of Incorporation of Ditech Networks, Inc. | |
3.2(5) | | Bylaws of Ditech Networks, Inc., as amended and restated | |
| | | | |
4.1 | | Reference is made to Exhibits 3.1 and 3.2 | |
4.2(7) | | Specimen Stock Certificate | |
4.3(6) | | Rights Agreement, dated as of March 26, 2001 among Ditech Communications Corporation and Wells Fargo Bank Minnesota, N.A. | |
4.4(6) | | Form of Rights Certificate | | |
10.1 | | Form of Ditech Networks, Inc. 2006 Equity Incentive Plan Restricted Stock Award Agreement | |
10.2 | | Form of Ditech Networks, Inc. 2006 Equity Incentive Plan Restricted Stock Unit Award Agreement | |
| | | |
31.1 | | Certification by Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
31.2 | | Certification by Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 | |
32 | | Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 | |
| | | | | | | |
(1) Incorporated by reference from the exhibit with corresponding number from Ditech’s Current Report on Form 8-K (File No. 000-26209), filed April 30, 2002.
(2) Incorporated by reference from the exhibit with corresponding number from Ditech’s Current Report on Form 8-K (File No. 000-26209) filed July 30, 2003.
(3) Incorporated by reference from the exhibit with corresponding number from Ditech’s Annual Report on Form 10-K for the fiscal year ended April 30, 2005 (File No. 000-26209), filed July 14, 2005.
(4) Incorporated by reference from the exhibit with corresponding number from Ditech’s Current Report on Form 8-K (File No. 000-26209), filed May 22, 2006.
(5) Incorporated by reference from the exhibit with corresponding number from Ditech’s Annual Report on Form 10-K for the fiscal year ended April 30, 2006 (File No. 000-26209), filed July 7, 2006.
(6) Incorporated by reference from the exhibit with corresponding title from Ditech’s Current Report on Form 8-K (File No. 000-26209), filed March 30, 2001.
(7) Incorporated by reference from the exhibit with corresponding descriptions from Ditech’s Registration Statement (No. 333-75063), declared effective on June 9, 1999.
33
