upon the timing of its projects. Net sales of enterprise access products increased by 50.3% in the three months ended March 28, 2003 to $3,671,000 from $2,443,000 for the same period last year. This increase was the result of the acquisition of the NetEngine products, which contributed $2,000,000 of sales this quarter. Excluding NetEngine sales, sales of enterprise access products decreased by 31.6% in the three months ended March 28, 2003 compared to the comparable period in the prior year, which we believe to be the lingering impact of both economic and industry-wide factors as well as the effect of one customer shifting to the use of integrated WAN interface cards with routers. Additionally, this decrease also reflects a continuing overall decline in legacy product sales, which has not been offset by a corresponding increase in sales of our newer WANsuite products.
Net sales for the nine months ended March 28, 2003 increased 31.7% to $20,305,000 from $15,412,000 for the first nine months of the prior fiscal year. This increase in net sales for the nine-month period ended March 28, 2003 resulted from an increase in sales volume of the Company’s carrier and carrier access product lines, as well as sales generated from the purchase of the NetEngine product line. The carrier and carrier access product lines increased 69.6% to $11,777,000 in the nine months ended March 28, 2003 from $6,943,000 in the comparable prior year period due primarily to an increase in sales to the Company’s largest customer. Net sales of enterprise access products, including NetEngine product sales, increased slightly in the nine months ended March 28, 2003 to $8,529,000 from $8,469,000 for the same period last year. As noted above, this net increase is due to the addition of NetEngine products, offset by a decrease in spending by our customers from the impact of economic and industry-wide factors, as well as the overall decline in legacy product sales. The Company anticipates that reduced capital spending by our customers may continue to impact sales until an overall recovery in the telecommunications market begins, which is not expected until at least 2004. In any event, it remains challenging to forecast future revenue trends in the current environment.
The Company’s business continues to be characterized by a concentration of sales to a limited number of key customers. Net sales to the Company’s top five customers increased 42.1% to $3,744,000 in the three months ended March 28, 2003 from $2,635,000 in the comparable period in the prior year, and increased 57.9% to $15,444,000 for the nine months ended March 28, 2003 from $9,780,000 in the comparable period of the prior year. Net sales to all other customers increased by 59.3% in the three-month period and declined by 13.7% in the nine-month period ended March 28, 2003 from the comparable periods in the prior fiscal year. The Company’s top five customers did not remain the same over these periods. The Company expects that sales of NetEngine products will provide additional customer diversification in future quarters. Two of the top five customers during the three months ended March 28, 2003 were NetEngine customers.
percentage of sales from 112% to 26.8%. Selling, general and administrative expenses for the nine months ended March 28, 2003 decreased 52.2% to $5,649,000 from $11,824,000 in the comparable period in the prior fiscal year and decreased as a percentage of sales from 76.7% to 27.8%. The decrease in absolute dollars over the same period in the prior year is primarily due to reduced headcount between the two periods, accrued severance costs in the prior year periods, and other cost reduction measures implemented by the Company in fiscal 2002 and 2003. Additionally, selling, general and administrative expenses in the three months ended March 28, 2003 were reduced in total by $443,000 to reflect the collection of notes receivable from former employees that were fully reserved in prior years and to adjust incentive compensation accrual to reflect the lower operating results achieved during the quarter ended March 28, 2003. The significant decrease as a percentage of sales is due to lower spending on increased sales dollars. The Company expects that selling, general and administrative expenses will vary over time as a percentage of sales, and expects selling, general and administrative expenses to increase in the three months ending June 27, 2003 to a level consistent with the three months ended March 28, 2003 excluding the $443,000 credit discussed above.
Amortization of goodwill and other intangible assets in the three months ended March 28, 2003 and March 29, 2002 was $148,000 and $144,000, respectively. Amortization of goodwill and other intangible assets in the nine months ended March 28, 2003 and March 29, 2002 was $299,000 and $628,000, respectively. Amortization for the three and nine months ended March 29, 2002 included $68,400 and $301,200 related to goodwill and assembled work force. As of June 29, 2002, the Company adopted SFAS No. 142, ceased amortizing goodwill and completed its transitional impairment test of goodwill. As a result, the Company determined that its goodwill was impaired and recorded a charge of $1,232,900 in the quarter ended September 27, 2002. This charge is presented in the condensed consolidated statement of operations as a cumulative effect of change in accounting principle, relating to goodwill.
In-process Research and Development. The in-process research and development expense of $316,000 in the three months ended March 28, 2003 is the acquisition costs of the NetEngine product line attributable to in-process technologies. The charges for in-process technologies are non-recurring.
Impairment of Long-lived Assets. The Company completed a review of certain long-lived assets during the three months ended March 29, 2002 and recorded an impairment charge to write down the carrying value of these specific assets by $4,815,000. These assets included the facility located in Cummings Research Park West at 950 Explorer Boulevard, Huntsville, Alabama; furniture and equipment; an investment in a software development company; and software licenses.
Interest and Other Income, Net, and Interest Expense. Interest and other income, net, increased 89% to $257,000 for the three months ended March 28, 2003 from $136,000 in the comparable period in the prior fiscal year. Interest and other income, net, increased 9.3% to $481,000 for the nine months ended March 28, 2003 from $440,000 in the comparable period in the prior fiscal year. Rental income, net of expenses, of $137,000 and $317,000 for the three and nine months ended March 28, 2003, respectively, is included in interest and other income, net, as a result of the lease agreement signed with Boeing.
Interest expense declined 27.6% to $42,000 for the three months ended March 28, 2003 from $58,000 in the same period in the prior fiscal year and declined 34% to $142,000 from $215,000 for the nine months ended March 28, 2003. These decreases are a result of lower interest rates and the lower principal balance on the Company’s debt obligations.
Provision for Income Taxes. No tax provision or tax benefits were provided in the three or nine months ended March 28, 2003 or March 29, 2002 due to the valuation allowance provided against the net change in deferred tax assets. During fiscal 2001, the Company established a full valuation allowance against its deferred tax assets due to the net operating loss carryforwards from prior years and the operating loss incurred in fiscal 2001. The Company does not expect to recognize a provision for income taxes in the current year due to its net operating loss carryforwards that totaled approximately $34,500,000 at June 28, 2002.
LIQUIDITY AND CAPITAL RESOURCES
On March 28, 2003, the Company’s principal sources of liquidity included $7,365,000 of unrestricted cash, cash equivalents and short-term investments.
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During the nine months ended March 28, 2003, cash provided by operating activities was $2,342,000 compared to $7,290,000 used in operating activities during the nine months ended March 29, 2002. Net cash provided by operating activities in the current period was due to income before depreciation, amortization and the cumulative effect of change in accounting principle, which totaled $2,767,000. The decrease in accounts receivable provided cash of $463,000 in the nine months ended March 28, 2003 compared to $1,371,000 provided in the comparable period in the prior fiscal year. The increase in inventories for the nine months ended March 28, 2003 used $1,235,000 of cash compared to $1,805,000 of cash provided in the same period last year. Inventories increased during the nine months ended March 28, 2003 due to inventory purchases related to the transfer of manufacturing of the Company’s AS2000 products from an outside electronics manufacturing services provider to the Company’s facility in Madison, Alabama, and due to purchases made in connection with the NetEngine product line acquisition. Accounts payable and accrued expenses increased $201,000 in the nine-month period ended March 28, 2003 compared to a decrease of $1,483,000 in the comparable period in the prior fiscal year. The changes in accounts payable and accrued expenses for the nine months ended March 28, 2003 and the comparable prior year period were primarily due to the timing of inventory purchases and the resulting payments to vendors.
Cash used in investing activities was $787,000 for the nine months ended March 28, 2003 compared to $188,000 used for the nine months ended March 29, 2002. The funds used in investing activities during the nine months ended March 28, 2003 are a result of the NetEngine acquisition of $1,000,000 and capital expenditures of $544,000 reduced by maturity of short-term investments of $497,000 and proceeds from the repayment of notes receivable of $260,000. For the nine months ended March 29, 2002, cash was used to purchase short-term investments of $82,000 and property, plant and equipment of $106,000.
Cash provided by financing activities was $79,000 for the nine months ended March 28, 2003 as compared to cash used in financing activities of $539,000 for the nine months ended March 29, 2002. Payments on long-term debt and capital lease obligations were $543,000 and $539,000 for the nine months ended March 28, 2003 and March 29, 2002, respectively. Proceeds from the issuance of common stock under the Company’s stock plans provided $3,000 of cash in the current year and $11,000 in the prior fiscal year. Repayment of notes from stockholders provided $675,000 in the nine months ended March 28, 2003 (See Note 12 of Notes to Condensed Consolidated Financial Statements).
In April 2003, the Company entered into a letter of intent (“LOI”) to sell its facility in Huntsville, Alabama located at 950 Explorer Boulevard. The LOI is subject to a number of conditions, including among others, the purchaser’s ability to obtain appropriate financing and the execution of a binding Purchase and Sale Contract. In connection with the sell of this facility, the Company expects to retire all its long-term debt.
In October 2002, the Company’s Board of Directors approved a program to repurchase up to $1,000,000 of its Common Stock. The program, which is open ended, allows the Company to repurchase shares on the open market based on market conditions, availability of cash consistent with the Company’s operating plan, and in accordance with the requirements of the Securities and Exchange Commission. Under this program, the Company re-purchased 50,000 shares of its Common Stock in the nine months ended March 28, 2003, at a total cost of $49,000.
The Company believes that its cash and investment balances, along with anticipated cash flows from operations based upon current operating plans will be adequate to finance the Company’s operations, capital expenditures, research and development programs and stock repurchase program for at least the next twelve months. The Company’s future capital needs will depend on the Company’s ability to meet its current operating forecast, market demand for the Company’s products and the overall economic condition of our customers in the telecommunication sector. In the event that results of operations do not substantially meet the Company’s current operating forecast, the Company may evaluate further cost containment measures, reduce investments or delay R&D, which could adversely affect the Company’s ability to bring new products to market. The Company from time to time investigates the possibility of generating financial resources through committed credit agreements, technology or manufacturing partnerships, joint ventures, equipment financing and offerings of debt and equity securities.
NETENGINE PRODUCT LINE ACQUISITION
On January 28, 2003, the Company acquired the net assets used in and directly relating to Polycom, Inc.’s line of NetEngine integrated access devices (“IADs”) for up to $3,000,000, plus the assumption of service and warranty obligations for existing NetEngine customers as of the closing of the acquisition. The NetEngine family of IADs (integrated access
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devices) and routers enable enterprise customers to access broadband and voice over broadband (“VoB”) services. NetEngine products support a wide range of broadband transmission standards and end user requirements, and are interoperable with the products of a variety of leading broadband equipment vendors. The Company paid Polycom $1 million at the closing of the agreement and will pay an additional $250,000 upon the one-year anniversary of the closing and up to $1.75 million in quarterly installments based upon 10 percent of the sales of NetEngine products. The remaining estimated purchase price obligation is included in accrued purchase consideration on the condensed consolidated balance sheet as of March 28, 2003. In addition, the Company has agreed to purchase Polycom’s NetEngine related inventories on an as-needed basis. The value of such inventory as of the closing date is approximately $1.9 million. The Company’s overall gross margins in future periods can be expected to decline as a result of the acquisition.
Critical Accounting Policies
The Company’s financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods might be based upon amounts that differ from those estimates. The following represent what the Company believes are among the critical accounting policies most affected by significant management estimates and judgments:
Impairment of Long-Lived Assets and Goodwill.The Company assesses the impairment of long-lived assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable under the guidance prescribed by SFAS No. 144. The Company’s long-lived assets include, but are not limited to, the facility located at 950 Explorer Boulevard, related furniture and equipment, software licenses, goodwill and intangible assets related to a acquisitions.
In assessing the recoverability of the Company’s long-lived assets, the Company obtained a third-party appraisal during fiscal 2002 for its facility located at 950 Explorer Boulevard, and made assumptions regarding future cash flows and other factors to determine the fair value of the respective assets. In April 2003, the Company entered into a letter of intent to sell this facility as discussed above. If these estimates or their related assumptions change in the future, the Company may be required to record impairment charges for these assets not previously recorded. On June 29, 2002, the Company adopted SFAS No. 142,Goodwill and Other Intangible Assets, and completed the analysis of its goodwill for impairment. The Company recorded an impairment charge of $1,232,900 during the three months ended September 27, 2002 related to goodwill.
Inventories.The Company values inventory at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. Inventory quantities on hand are reviewed on a quarterly basis and a provision for excess and obsolete inventory is recorded based primarily on our estimated forecast of product demand for the next twelve months. Management’s estimates of future product demand may prove to be inaccurate, in which case the Company may increase or decrease the provision required for excess and obsolete inventory in future periods.
Revenue Recognition.The Company recognizes a sale when the product has been shipped, no material vendor or post-contract support obligations remain outstanding, except as provided by a separate service agreement, and collection of the resulting receivable is probable. A reserve for future product returns is established at the time of the sale based on historical return rates and return policies, including stock rotation for sales to distributors that stock the Company’s products.
Warranty Provision.The Company records a warranty provision at the time of the sale based on our best estimate of the amounts necessary to settle future claims on products sold. While we believe that our warranty reserve is adequate and that the judgment applied is appropriate, actual product failure rates, material usage or other rework costs could differ from our estimates, which could result in revisions to our warranty liability.
Allowance for Doubtful Accounts.The Company estimates losses resulted from the inability of our customers to make payments for amounts billed. The collectability of outstanding invoices is continually assessed. Assumptions are made regarding the customer’s ability and intent to pay, and are based on historical trends, general economic conditions and current
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customer data. Should our actual experience with respect to collections differ from these assessments, there could be adjustments to our allowance for doubtful accounts.
Valuation of Notes Receivable.The Company continually assesses the collectability of assets classified as outstanding notes receivable. Assumptions are made regarding the counter party’s ability and intent to pay and are based on historical trends and general economic conditions, and current data. Should our actual experience with respect to collections differ from our initial assessment, adjustments in the reserves will be recorded.
Deferred Tax Assets.The Company has provided a full valuation reserve related to its deferred tax assets. In the future, if sufficient evidence of the Company’s ability to generate sufficient future taxable income in certain tax jurisdictions becomes apparent, the Company may be required to reduce its valuation allowances, resulting in income tax benefits in the Company’s consolidated statement of operations. Management evaluates the realizability of the deferred tax assets and assesses the need for the valuation allowance each quarter.
Factors Affecting Future Results
As described by the following factors, past financial performance should not be considered to be a reliable indicator of future performance and investors should not use historical trends to anticipate results or trends in future periods.
This Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements using terminology such as “may”, “will”, “expects”, “plans”, “anticipates”, “estimates”, “potential”, or “continue”, or the negative thereof or other comparable terminology regarding beliefs, plans, expectations or intentions regarding the future. Forward-looking statements include statements regarding anticipated reduced spending by the Company’s customers; the expected increase in research and development expenses; a significant level of investment in product development; and the adequacy of the Company’s cash position for the near-term. These forward-looking statements involve risks and uncertainties, and it is important to note that the Company’s actual results could differ materially from those in such forward-looking statements. Among the factors that could cause actual results to differ materially are the factors detailed below as well as the other factors set forth in Item 2 hereof. All forward-looking statements and risk factors included in this document are made as of the date hereof, based on information available to the Company as of the date hereof, and the Company assumes no obligation to update any forward-looking statement or risk factor. You should consult the risk factors listed from time to time in the Company’s Reports on Forms 10-Q and the Company’s Annual Report on Form 10-K.
Dependence on Legacy Products, Recently Introduced Products and New Product Development.The Company’s future results of operations are highly dependent on market acceptance of existing and future applications for the Company’s WANsuite family of integrated access devices, the recently acquired NetEngine products and new products in development. The majority of sales continue to be provided by the Company’s legacy products, primarily the AS2000 product line which represented approximately 53% of net sales in fiscal 2002, 61% of net sales in fiscal 2001 and 58% of net sales in fiscal 2000. Sales of WANsuite products represented approximately 8% and 2% of net sales in fiscal 2002 and 2001, respectively. The Company anticipates that net sales of its legacy products will continue to shrink as newly introduced products by the Company and its competitors capture market share.
Market acceptance of both the Company’s current and future product lines is dependent on a number of factors, not all of which are in the Company’s control, including the continued growth in the use of bandwidth intensive applications, continued deployment of new telecommunications services, market acceptance of integrated access devices and systems in general, the availability and price of competing products and technologies, and the success of the Company’s sales and marketing efforts. Failure of the Company’s products to achieve market acceptance would have a material adverse effect on the Company’s business, financial condition and results of operations. The market for the Company’s products are characterized by rapidly changing technology, evolving industry standards, continuing improvements in telecommunication service offerings, and changing demands of the Company’s customer base. Failure to introduce new products in a timely manner could cause companies to purchase products from competitors and have a material adverse effect on the Company’s business, financial condition and results of operations. Due to a variety of factors, the Company may experience delays in developing its planned products.
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New products may require additional development work, enhancement and testing or further refinement before the Company can make them commercially available. The Company has in the past experienced delays in the introduction of new products, product applications and enhancements due to a variety of internal factors, such as reallocation of priorities, difficulty in hiring sufficient qualified personnel and unforeseen technical obstacles, as well as changes in customer requirements. Such delays have deferred the receipt of revenue from the products involved. If the Company’s products have performance, reliability or quality shortcomings, then the Company may experience reduced orders, higher manufacturing costs, delays in collecting accounts receivable and additional warranty and service expenses.
Risks Associated With Acquisitions, Potential Acquisitions and Joint Ventures.An important element of the Company’s historical strategy has been to review acquisition prospects and joint venture opportunities that would complement its existing product offerings, augment its market coverage, enhance its technological capabilities or offer growth opportunities. As noted above, on January 28, 2003, the Company acquired the net assets used in and directly relating to Polycom, Inc.’s line of NetEngine integrated access devices (“IADs”) for up to $3,000,000, plus the assumption of service and warranty obligations for existing NetEngine customers as of the closing of the acquisition. Transactions of this nature by the Company could result in potentially dilutive issuance of equity securities, use of cash and/or the incurring of debt and the assumption of contingent liabilities, any of which could have a material adverse effect on the Company’s business and operating results and/or the price of the Company’s Common Stock. Acquisitions entail numerous risks, including difficulties in the assimilation of acquired operations, technologies and products, diversion of management’s attention from other business concerns, risks of entering markets in which the Company has limited or no prior experience and potential loss of key employees of acquired organizations. Joint ventures entail risks such as potential conflicts of interest and disputes among the participants, difficulties in integrating technologies and personnel, and risks of entering new markets. The Company’s management has limited prior experience in assimilating such transactions. No assurance can be given as to the ability of the Company to successfully integrate the businesses, products, technologies or personnel acquired in the NetEngine acquisition or those of other entities that may be acquired in the future or to successfully develop any products or technologies that might be contemplated by any future joint venture or similar arrangement. The failure of the Company to integrate the NetEngine product line acquisition or to integrate future potential acquisitions could have a material adverse effect on the Company’s business, financial condition and results of operations.
Customer Concentration.A small number of customers continue to account for a majority of the Company’s sales. In fiscal 2002, net sales to Nortel Networks and Interlink Communications Systems accounted for 36% and 15% of the Company’s net sales, respectively, and the Company’s top five customers accounted for 71% of the Company’s net sales. In fiscal 2001, net sales to Nortel Networks accounted for 37% of the Company’s net sales, and net sales to the Company’s top five customers accounted for 66% of the Company’s net sales. In fiscal 2000, net sales to Nortel Networks and WorldCom accounted for 30% and 19% of the Company’s net sales, respectively, and net sales to the Company’s top five customers accounted for 61% of the Company’s net sales. Other than Nortel Networks, Interlink Communications Systems and WorldCom, no customer accounted for more than 10% of the Company’s net sales in fiscal years 2002, 2001 or 2000. On a quarterly basis in fiscal 2002, net sales to Nortel Networks of legacy products has accounted for as much as 64% of the Company’s net sales that quarter. There can be no assurance that the Company’s current customers will continue to place orders with the Company, that orders by existing customers will continue at the levels of previous periods, or that the Company will be able to obtain orders from new customers. The economic climate and conditions in the telecommunication equipment industry are expected to remain unpredictable in fiscal 2003 and 2004. WorldCom filed a bankruptcy petition under Chapter 11 of the Bankruptcy Code in July 2002. A bankruptcy filing by one or more of the Company’s other major customers would materially adversely affect the Company’s business, financial condition and results of operations.
Certain customers of the Company have been or may be acquired by other existing customers. The impact of such acquisitions on net sales to such customers is uncertain, but there can be no assurance that such acquisitions will not result in a reduction in net sales to those customers. In addition, such acquisitions could have in the past and could in the future, result in further concentration of the Company’s customers. The Company has in the past experienced significant declines in net sales it believes were in part related to orders being delayed or cancelled as a result of pending acquisitions relating to its customers. There can be no assurance that future merger and acquisition activity among the Company’s customers will not have a similar adverse affect on the Company’s net sales and results of operations. The Company’s customers are typically not contractually obligated to purchase any quantity of products in any particular period. Product sales to major customers have varied widely from period to period. In some cases, major customers have abruptly terminated purchases of the Company’s products. Loss of, or a material reduction in orders by, one or more of the Company’s major customers would
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materially adversely affect the Company’s business, financial condition and results of operations. See “Competition” and “Fluctuations in Quarterly Operating Results”.
Nasdaq SmallCap Market Continued Listing Requirements.If the Company’s common stock trades below a $1.00 minimum bid price for 30 consecutive trading days, the Company would receive a Nasdaq deficiency notice for failure to meet the continued listing criteria of the Nasdaq SmallCap Market. If Nasdaq issues a deficiency notice, the Company will have 180 days to regain compliance with the minimum bid price requirement. If the Company is unable to regain compliance with the $1.00 minimum bid price within that 180 day period, it may be eligible to receive an additional 180 days to regain compliance if the Company maintains stockholders’ equity in excess of $5 million. If delisted from the Nasdaq SmallCap Market, the Company’s common stock may be eligible for trading on the OTC Bulletin Board or on other over-the-counter markets, although there can be no assurance that the Company’s common stock will be eligible for trading on any alternative exchanges or markets. Among other consequences, delisting from the Nasdaq SmallCap Market may cause a decline in the stock price, reduced liquidity in the trading market for the common stock, and difficulty in obtaining future financing.
Dependence on Key Personnel.The Company’s future success will depend to a large extent on the continued contributions of its executive officers and key management, sales, and technical personnel. The Company is a party to agreements with its executive officers to help ensure the officer’s continual service to the Company in the event of a change-in-control. Each of the Company’s executive officers, and key management, sales and technical personnel would be difficult to replace. The Company implemented significant cost and staff reductions during fiscal 2002, which may make it more difficult to attract and retain key personnel. The loss of the services of one or more of the Company’s executive officers or key personnel, or the inability to attract qualified personnel could delay product development cycles or otherwise could have a material adverse effect on the Company’s business, financial condition and results of operations.
Dependence on Key Suppliers and Component Availability.The Company generally relies upon contract manufacturers to buy finished goods for certain product families and component parts that are incorporated into board assemblies used in its products. On-time delivery of the Company’s products depends upon the availability of components and subsystems used in its products. Currently, the Company and third party sub-contractors depend upon suppliers to manufacture, assemble and deliver components in a timely and satisfactory manner. The Company has historically obtained several components and licenses for certain embedded software from single or limited sources. There can be no assurance that these suppliers will continue to be able and willing to meet the Company and third party sub-contractors requirements for any such components. The Company and third party sub-contractors generally do not have any long-term contracts with such suppliers, other than software vendors. Any significant interruption in the supply of, or degradation in the quality of, any such item could have a material adverse effect on the Company’s results of operations. Any loss in a key supplier, increase in required lead times, increase in prices of component parts, interruption in the supply of any of these components, or the inability of the Company or its third party sub-contractor to procure these components from alternative sources at acceptable prices and within a reasonable time, could have a material adverse effect upon the Company’s business, financial condition and results of operations.
The loss of any of the Company’s outside contractors could cause a delay in the Company’s ability to fulfill orders while the Company identifies a replacement contractor. Because the establishment of new manufacturing relationships involves numerous uncertainties, including those relating to payment terms, cost of manufacturing, adequacy of manufacturing capacity, quality control, and timeliness of delivery, the Company is unable to predict whether such relationships would be on terms that the Company regards as satisfactory. Any significant disruption in the Company’s relationships with its manufacturing sources would have a material adverse effect on the Company’s business, financial condition, and results of operations.
Purchase orders from the Company’s customers frequently require delivery quickly after placement of the order. As the Company does not maintain significant component inventories, delay in shipment by a supplier could lead to lost sales. The Company uses internal forecasts to manage its general materials and components requirements. Lead times for materials and components may vary significantly, and depend on factors such as specific supplier performance, contract terms, and general market demand for components. If orders vary from forecasts, the Company may experience excess or inadequate inventory of certain materials and components, and suppliers may demand longer lead times, higher prices or termination of contracts. From time to time, the Company has experienced shortages and allocations of certain components, resulting in delays in fulfillment of customer orders. Such shortages and allocations may occur in the future, and could have a material adverse
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effect on the Company’s business, financial condition and results of operations. See “Fluctuations in Quarterly Operating Results”.
Fluctuations in Quarterly Operating Results.The Company’s sales are subject to quarterly and annual fluctuations due to a number of factors resulting in more variability and less predictability in the Company’s quarter-to-quarter sales and operating results. For example, sales to Nortel Networks during fiscal 2002 and 2001 have varied between quarters by as much as $6.2million, and order volatility by this customer had a significant impact on the Company in fiscal 2002. Most of the Company’s sales are in the form of large orders with short delivery times. The Company’s ability to affect and judge the timing of individual customer orders is limited. The Company has experienced large fluctuations in sales from quarter-to-quarter due to a wide variety of factors, such as delay, cancellation or acceleration of customer projects, and other factors discussed below. The Company’s sales for a given quarter may depend to a significant degree upon planned product shipments to a single customer, often related to specific equipment deployment projects. The Company has experienced both acceleration and slowdown in orders related to such projects, causing changes in the sales level of a given quarter relative to both the preceding and subsequent quarters.
Delays or lost sales can be caused by other factors beyond the Company’s control, including late deliveries by the third party subcontractors the Company is using to outsource its manufacturing operations (as well as by other vendors of components used in a customer’s system), changes in implementation priorities, slower than anticipated growth in demand for the services that the Company’s products support and delays in obtaining regulatory approvals for new services and products. Delays and lost sales have occurred in the past and may occur in the future. The Company believes that sales in the past have been adversely impacted by merger activities by some of its top customers. In addition, the Company has experienced delays as a result of the need to modify its products to comply with unique customer specifications. These and similar delays or lost sales could materially adversely affect the Company’s business, financial condition and results of operations. See “Customer Concentration” and “Dependence on Key Suppliers and Component Availability”.
The Company’s backlog at the beginning of each quarter typically is not sufficient to achieve expected sales for that quarter. To achieve its sales objectives, the Company is dependent upon obtaining orders in a quarter for shipment in that quarter. Furthermore, the Company’s agreements with certain of its customers typically provide that they may change delivery schedules and cancel orders within specified timeframes, typically up to 30 days prior to the scheduled shipment date, without significant penalty. The Company’s customers have in the past built, and may in the future build, significant inventory in order to facilitate more rapid deployment of anticipated major projects or for other reasons. Decisions by such customers to reduce their inventory levels could lead to reductions in purchases from the Company in certain periods. These reductions, in turn, could cause fluctuations in the Company’s operating results and could have an adverse effect on the Company’s business, financial condition and results of operations in the periods in which the inventory is reduced.
The Company’s industry is characterized by declining prices of existing products, and therefore continual improvement of manufacturing efficiencies and introduction of new products and enhancements to existing products are required to maintain gross margins. In response to customer demands or competitive pressures, or to pursue new product or market opportunities, the Company may take certain pricing or marketing actions, such as price reductions, volume discounts, or provision of services at below-market rates. These actions could materially and adversely affect the Company’s operating results.
Operating results may also fluctuate due to a variety of factors, particularly:
- delays in new product introductions by the Company;
- market acceptance of new or enhanced versions of the Company’s products;
- changes in the product or customer mix of sales;
- changes in the level of operating expenses;
- competitive pricing pressures;
- the gain or loss of significant customers;
- increased research and development and sales and marketing expenses associated with new product introductions; and
- general economic conditions.
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All of the above factors are difficult for the Company to forecast, and these or other factors can materially and adversely affect the Company’s business, financial condition and results of operations for one quarter or a series of quarters. The Company’s expense levels are based in part on its expectations regarding future sales and are fixed in the short term to a certain extent. Therefore, the Company may be unable to adjust spending in a timely manner to compensate for any unexpected shortfall in sales. Any significant decline in demand relative to the Company’s expectations or any material delay of customer orders could have a material adverse effect on the Company’s business, financial condition, and results of operations. There can be no assurance that the Company will be able to sustain profitability on a quarterly or annual basis. In addition, the Company has had, and in some future quarter may have operating results below the expectations of public market analysts and investors. In such event, the price of the Company’s Common Stock would likely be materially and adversely affected. See “Potential Volatility of Stock Price”.
The Company’s products are covered by warranties and the Company is subject to contractual commitments concerning its products. If unexpected circumstances arise such that the product does not perform as intended and the Company is not successful in resolving product quality or performance issues, there could be an adverse effect on the Company’s business, financial condition and results of operations.
Potential Volatility of Stock Price.The trading price of the Company’s Common Stock could be subject to wide fluctuations in response to quarter-to-quarter variations in operating results, announcements of technological innovations or new products by the Company or its competitors, developments with respect to patents or proprietary rights, general conditions in the telecommunication network access and equipment industries, changes in earnings estimates by analysts, or other events or factors. In addition, the stock market has experienced extreme price and volume fluctuations, which have particularly affected the market prices of many technology companies and which have often been unrelated to the operating performance of such companies. Company-specific factors or broad market fluctuations may materially adversely affect the market price of the Company’s Common Stock. The Company has experienced significant fluctuations in its stock price and share trading volume in the past and may continue to do so.
Competition.The market for telecommunications network access equipment is characterized as highly competitive with price erosions on certain aging technologies. This market, in the past, has been subject to rapid technological change, regulatory developments and new entrants. The market for integrated access devices, such as the Access System 2000, WANsuite and NetEngine product lines, and for enterprise termination devices, such as the PRISM product line, is subject to rapid change. The Company believes that the primary competitive factors in this market are the development and rapid introduction of products based on new technologies, high product value in price versus performance comparisons, support for multiple types of communication services, increased network monitoring and control, product reliability, and quality of customer support. There can be no assurance that the Company’s current products and future products will be able to compete successfully with respect to these or other factors.
The Company’s principal competition for its current product offerings are Adtran, Inc., Paradyne Inc., Kentrox (owned by Platinum Equity Holdings), Vina Technologies, Inc., Quick Eagle Networks, Larscom, Inc., Carrier Access Corporation, Netopia, RAD and Cisco Systems, Inc. for access routing with integrated WAN interface cards (WIC’s). Industry consolidation could lead to competition with fewer, but stronger competitors. In addition, advanced termination products are emerging, which represent both new market opportunities, as well as a threat to the Company’s current products. Furthermore, basic line termination functions are increasingly being integrated by competitors, such as Cisco, Lucent Technologies, Inc. and Nortel Networks, into other equipment such as routers and switches. These include direct WAN interfaces in certain products, which may erode the addressable market for separate network termination products. To the extent that current or potential competitors can expand their current offerings to include products that have functionality similar to the Company’s products and planned products, the Company’s business, financial condition and results of operations could be materially adversely affected.
The Company believes that the market for basic network termination products is mature and that margins are eroding, but the market for feature-enhanced network termination and high bandwidth network access products may continue to grow and expand, as more “capability” and “intelligence” moves outward from the central office to the enterprise. The Company expects emerging voice services such as VoIP, VoDSL, VoATM and IP Centrex, as well as continued data demands will drive the next wave of spending in this market, if and when it occurs.
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Many of the Company’s current and potential competitors have substantially greater technical, financial, manufacturing and marketing resources than the Company. In addition, many of the Company’s competitors have long-established relationships with network service providers. There can be no assurance that the Company will have the financial resources, technical expertise, manufacturing, marketing, distribution and support capabilities to compete successfully in the future. See “Factors Affecting Future Results — Competition”.
Rapid Technological Change.The network access and telecommunications equipment markets are characterized by rapidly changing technologies and frequent new product introductions. The rapid development of new technologies increases the risk that current or new competitors could develop products that would reduce the competitiveness of the Company’s products. The Company’s success will depend to a substantial degree upon its ability to respond to changes in technology and customer requirements. This will require the timely selection, development and marketing of new products and enhancements on a cost-effective basis. The development of new, technologically advanced products is a complex and uncertain process, requiring high levels of innovation. The Company may need to supplement its internal expertise and resources with specialized expertise or intellectual property from third parties to develop new products. The development of new products for the WAN access market requires competence in the general areas of telephony, data networking, network management and wireless telephony as well as specific technologies such as DSL, ISDN, Frame Relay, ATM and IP.
Furthermore, the communications industry is characterized by the need to design products that meet industry standards for safety, emissions and network interconnection. With new and emerging technologies and service offerings from network service providers, such standards are often changing or unavailable. As a result, there is a potential for product development delays due to the need for compliance with new or modified standards. The introduction of new and enhanced products also requires that the Company manage transitions from older products in order to minimize disruptions in customer orders, avoid excess inventory of old products and ensure that adequate supplies of new products can be delivered to meet customer orders. There can be no assurance that the Company will be successful in developing, introducing or managing the transition to new or enhanced products, or that any such products will be responsive to technological changes or will gain market acceptance. The Company’s business, financial condition and results of operations would be materially adversely affected if the Company were to be unsuccessful, or to incur significant delays in developing and introducing such new products or enhancements. See “Dependence on Recently Introduced Products and New Product Development”.
Compliance with Regulations and Evolving Industry Standards.The market for the Company’s products is characterized by the need to meet a significant number of communications regulations and standards, some of which are evolving as new technologies are deployed. In the United States, the Company’s products must comply with various regulations defined by the Federal Communications Commission and standards established by Underwriters Laboratories and Bell Communications Research. For some public carrier services, installed equipment does not fully comply with current industry standards, and this noncompliance must be addressed in the design of the Company’s products. Standards for new services such as Frame Relay, performance monitoring services and DSL have evolved, such as the G.SHDSL standard. As standards continue to evolve, the Company will be required to modify its products or develop and support new versions of its products. The failure of the Company���s products to comply, or delays in compliance, with the various existing and evolving industry standards could delay introduction of the Company’s products, which could have a material adverse effect on the Company’s business, financial condition and results of operations.
Government regulatory policies are likely to continue to have a major impact on the pricing of existing as well as new public network services and therefore are expected to affect demand for such services and the telecommunications products that support such services. Tariff rates, whether determined by network service providers or in response to regulatory directives, may affect the cost effectiveness of deploying communication services. Such policies also affect demand for telecommunications equipment, including the Company’s products.
Risks Associated With Entry into International Markets.The Company to date has had minimal direct sales to customers outside of North America. The Company has little experience in the European and Far Eastern markets, but with the acquisition of the NetEngine products in January 2003, intends to expand sales of its products outside of North America and to enter certain international markets, which will require significant management attention and financial resources.Conducting business outside of North America is subject to certain risks, including longer payment cycles, unexpected changes in regulatory requirements and tariffs, difficulties in staffing and managing foreign operations, greater difficulty in accounts receivable collection and potentially adverse tax consequences. To the extent any Company sales are denominated in foreign currency, the Company’s sales and results of operations may also be directly affected by fluctuations in foreign
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currency exchange rates. In order to sell its products internationally, the Company must meet standards established by telecommunications authorities in various countries, as well as recommendations of the Consultative Committee on International Telegraph and Telephony. A delay in obtaining, or the failure to obtain, certification of its products in countries outside the United States could delay or preclude the Company’s marketing and sales efforts in such countries, which could have a material adverse effect on the Company’s business, financial condition and results of operations.
Risk of Third Party Claims of Infringement.The network access and telecommunications equipment industries are characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. From time to time, third parties may assert exclusive patent, copyright, trademark and other intellectual property rights to technologies that are important to the Company. The Company has not conducted a formal patent search relating to the technology used in its products, due in part to the high cost and limited benefits of a formal search. In addition, since patent applications in the United States are not publicly disclosed until the related patent is issued and foreign patent applications generally are not publicly disclosed for at least a portion of the time that they are pending, applications may have been filed which, if issued as patents, could relate to the Company’s products. Software comprises a substantial portion of the technology in the Company’s products. The scope of protection accorded to patents covering software-related inventions is evolving and is subject to a degree of uncertainty which may increase the risk and cost to the Company if the Company discovers third party patents related to its software products or if such patents are asserted against the Company in the future. Patents have been granted recently on fundamental technologies in software, and patents may be issued which relate to fundamental technologies incorporated into the Company’s products.
The Company may receive communications from third parties asserting that the Company’s products infringe or may infringe the proprietary rights of third parties. In its distribution agreements, the Company typically agrees to indemnify its customers for any expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. In the event of litigation to determine the validity of any third-party claims, such litigation, whether or not determined in favor of the Company, could result in significant expense to the Company and divert the efforts of the Company’s technical and management personnel from productive tasks. In the event of an adverse ruling in such litigation, the Company might be required to discontinue the use and sale of infringing products, expend significant resources to develop non-infringing technology or obtain licenses from third parties. There can be no assurance that licenses from third parties would be available on acceptable terms, if at all. In the event of a successful claim against the Company and the failure of the Company to develop or license a substitute technology, the Company’s business, financial condition, and results of operations could be materially adversely affected.
Limited Protection of Intellectual Property.The Company relies upon a combination of patent, trade secret, copyright, and trademark laws and contractual restrictions to establish and protect proprietary rights in its products and technologies. The Company has been issued certain U.S. and Canadian patents with respect to limited aspects of its single purpose network access technology. The Company has not obtained significant patent protection for its Access System or WANsuite technologies. There can be no assurance that third parties have not or will not develop equivalent technologies or products without infringing the Company’s patents or that a court having jurisdiction over a dispute involving such patents would hold the Company’s patents valid, enforceable and infringed. The Company also typically enters into confidentiality and invention assignment agreements with its employees and independent contractors, and non-disclosure agreements with its suppliers, distributors and appropriate customers so as to limit access to and disclosure of its proprietary information. There can be no assurance that these statutory and contractual arrangements will deter misappropriation of the Company’s technologies or discourage independent third-party development of similar technologies. In the event such arrangements are insufficient, the Company’s business, financial condition and results of operations could be materially adversely affected. The laws of certain foreign countries in which the Company’s products are or may be developed, manufactured or sold may not protect the Company’s products or intellectual property rights to the same extent as do the laws of the United States and thus, make the possibility of misappropriation of the Company’s technology and products more likely.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
At March 28, 2003, the Company’s investment portfolio consisted of fixed income securities of $101,000. These securities, like all fixed income instruments, are subject to interest rate risk and will decline in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels as of March 28, 2003, the decline in the fair value of the portfolio would not be material. Additionally, the Company has the ability to hold its fixed
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income investments until maturity and therefore, the Company would not expect to recognize such an adverse impact in income or cash flows. The Company invests its cash balances in excess of operating requirements in short-term securities, generally with maturities of 90 days or less.
The Company is subject to interest rate risks on its long-term debt. If market interest rates were to increase immediately and uniformly by 10% from levels as of March 28, 2003, the additional interest expense would not be material. The Company believes that the effect, if any, of reasonably possible near-term changes in interest rates on the Company’s financial position, results of operations and cash flows would not be material.
Item 4. Controls and Procedures.
Within 90 days prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s President and Chief Executive Officer, and Vice President and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-14. Based upon that evaluation, the Company’s President and Chief Executive Officer, and Vice President and Chief Financial Officer, have concluded that the Company’s disclosure controls and procedures are effective. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures, which, by their nature, can provide only reasonable assurance regarding management’s control objectives.
PART II. OTHER INFORMATION
Item 5. Other Information
On January 28, 2003, the Company signed a purchase agreement to acquire the net assets used in and directly relating to Polycom, Inc.’s line of NetEngine integrated access devices (“IADs”) for up to $3,000,000, plus the assumption of service and warranty obligations for existing NetEngine customers as of the closing of the acquisition. See Note 5 of Notes to Condensed Consolidated Financial Statements and “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations – NetEngine Product Line Acquisition.”
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits Index:
| | Exhibit Number | | Description of Exhibit |
| |
| |
|
| | 99.1 | | Certification of Chief Executive Officer and Chief Financial Officer, Pursuant to18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
| | | | |
| | 99.2 | | Certification of Chief Executive Officer and Chief Financial Officer, Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |
(b) No reports on Form 8-K were filed during the quarter ended March 28, 2003.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | | VERILINK CORPORATION |
| | | |
| May 9, 2003 | By: |  |
| | |
|
| | | C. W. Smith
Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer) |
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CERTIFICATIONS
I, Leigh S. Belden, certify that:
1.
| I have reviewed this quarterly report on Form 10-Q of the registrant;
|
2.
| Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
|
3.
| Based on my knowledge, the financial statements and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
|
4.
| The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d- 14) for the registrant and we have:
|
| | (a)
| designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
|
| | (b)
| evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
|
| | (c)
| presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
|
5.
| The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the board of directors (or persons fulfilling the equivalent function):
|
| | (a)
| all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
|
| | (b)
| any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
|
6.
| The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
|
Date: May 9, 2003
| | |  |
| | By: |
|
| | | Leigh S. Belden
President and Chief Executive Officer
(Principal Executive Officer) |
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I, C. W. Smith, certify that:
1.
| I have reviewed this quarterly report on Form 10-Q of the registrant;
|
2.
| Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;
|
3.
| Based on my knowledge, the financial statements and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report;
|
4.
| The registrant’s other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d- 14) for the registrant and we have:
|
| | (a)
| designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared;
|
| | (b)
| evaluated the effectiveness of the registrant’s disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the “Evaluation Date”); and
|
| | (c)
| presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date;
|
5.
| The registrant’s other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant’s auditors and the audit committee of the board of directors (or persons fulfilling the equivalent function):
|
| | (a)
| all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant’s ability to record, process, summarize and report financial data and have identified for the registrant’s auditors any material weaknesses in internal controls; and
|
| | (b)
| any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal controls; and
|
6.
| The registrant’s other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.
|
Date: May 9, 2003
| | | |
| | By: |
|
| | | C. W. Smith
Vice President and Chief Financial Officer
(Principal Financial and Accounting Officer) |
27
