Our business continues to be characterized by a concentration of sales to a limited number of key customers. Net sales to our top five customers increased 7% in the three months ended September 30, 2005 to $8,066,000 from $7,559,000 in the comparable prior year period. Net sales to all other customers decreased by 39% in the three-month period ended September 30, 2005 from the comparable prior year period. Our top five customers did not remain the same over these periods. Sales to Verizon and Interlink Communications, Inc. accounted for 41% and 12% of net sales in the three months ended September 30, 2005. In the comparable prior year period, sales to Verizon accounted for 41% of net sales. No other customer accounted for more than 10% of net sales in these two periods.
Gross Profit. Gross profit margin increased to 38.1% of net sales for the three months ended September 30, 2005 as compared to 30.8% for the three months ended October 1, 2004. This increase is attributable to a number of factors, including the change in product and services sales mix between the periods, lower manufacturing overhead as a result of consolidation efforts, and a decrease in the provision for inventory reserves. Manufacturing overhead in the three months ended September 30, 2005 decreased by 28% to $1,081,000 as compared to the comparable prior year period. The provision for inventory reserves decreased by $619,000 in the three months ended September 30, 2005 as compared to the same period last year. Gross margin related to service net sales decreased to 55.3% for the three months ended September 30, 2005 as compared to 62.5% for the three months ended October 1, 2004. We adopted SFAS No. 123R, Share Based Payment, effective as of July 2, 2005. Stock based compensation totaling $71,000 was included in cost of sales for the three months ended September 30, 2005. Gross margin in our second fiscal quarter may be temporarily impacted by our consolidation of manufacturing locations and the integration of recently acquired product lines. We expect improved margins after these changes are fully implemented, although margins are highly dependent on product sales mix in any given quarter.
Research and Development. Research and development expenses for the three months ended September 30, 2005 decreased 35% to $1,457,000 from $2,252,000 for the same period in the prior year, and decreased as a percentage of sales from 18.3% to 13.3%. The decrease in spending for the three months ended September 30, 2005 compared to the same quarter in the prior fiscal year is a result of our efforts to match spending plans with anticipated revenue and the reduction in staff from the consolidation of engineering in the Santa Barbara, California and Aurora, Colorado offices into our offices in Madison, Alabama and Newark, California, which was completed in December 2004. Stock based compensation totaling $55,000 was included in research and development expenses for the three months ended September 30, 2005. We believe that a significant level of investment in product development is required to remain competitive and that such expenses will vary over time as a percentage of net sales. However, we will continue to monitor the level of our investment in research and development activities and adjust quarterly spending levels, upward or downward, based upon anticipated sales volume.
Selling, General and Administrative. Selling, general and administrative (“SG&A”) expenses for the three months ended September 30, 2005 decreased 34% to $3,395,000 from $5,107,000 in the comparable period in the prior fiscal year and decreased as a percentage of sales from 41.6% to 31.0%. The decrease over the same period in the prior year is primarily due to decreased headcount and related expenses primarily attributable to the consolidation of certain manufacturing and administrative functions into our Madison, Alabama facility. In addition to the decrease in spending associated with headcount, discretionary spending in many areas, including outside services, expense for customer demonstration units, and tradeshows are below prior year levels due to cost containment programs we implemented this fiscal year. Stock based compensation totaling $266,000 was included in SG&A expenses for the three months ended September 30, 2005. Amortization of deferred compensation totaled zero and $121,000 for the three months ended September 30, 2005 and October 1, 2004, respectively. SG&A expenses for the three months ended October 1, 2004 includes a total of $452,000 related to charges associated with acquisitions, consisting of compensation charges for retention bonuses and restricted stock awards, and other direct acquisition related expenses.
Amortization of Acquired Intangible Assets. Amortization of acquired intangible assets for the three months ended September 30, 2005 totaled $564,000 as compared to $572,000 for the comparable periods of the prior fiscal year.
Impairment Charge Related to Goodwill. During the three months ended October 1, 2004, we completed an interim test for the impairment of goodwill and determined that the carrying value was impaired. Therefore, an impairment charge related to goodwill totaling $19,984,000 was recorded in the three months ended October 1, 2004.
Restructuring Charges. During the three months ended October 1, 2004, we announced plans to consolidate our engineering functions into two locations and to consolidate certain Larscom manufacturing and administrative functions in Newark, California to our Madison, Alabama facility. We recorded net charges related to restructuring activities for the three month period ended October 1, 2004 totaling $443,000, respectively. These restructuring activities were substantially completed during the quarter ended December 31, 2004.
Interest and Other Income, Net. Interest and other income, net decreased 22% to $166,000 for the three months ended September 30, 2005 from $213,000 in the comparable period in the prior fiscal year due to the income recorded in that year ago period of $86,000 from the forgiveness of a portion of the convertible notes associated with the XEL acquisition. No such income was recorded in the three months ended September 30, 2005. Rental income, net of expenses, is included in interest and other income, net and totaled $164,000 and $135,000 for the three months ended September 30, 2005 and October 1, 2004.
20
Interest Expense. Interest expense increased 510% to $702,000 for the three months ended September 30, 2005 from $115,000 three months ended October 1, 2004 due to the interest expense related to the $10,000,000 senior convertible notes issued on March 21, 2005.
Provision for Income Taxes. No tax provision or tax benefits were recognized for the three month periods ended September 30, 2005 or October 1, 2004, due to the valuation allowance provided against the net change in deferred tax assets. During fiscal 2001, we established a full valuation allowance against our deferred tax assets due to the net operating loss carry forwards from prior years and the operating losses incurred in fiscal 2001.
Net Income (Loss). Net loss for the three months ended September 30, 2005 was $1,771,000 compared to $24,471,000 for the three months ended October 1, 2004. The changes between the periods are a result of the above factors, primarily due to the impairment charge related to goodwill recorded in the prior fiscal year, offset by the decrease in selling, general and administrative expenses, the decrease in amortization of acquired intangible assets and the increase in the gross profit between the periods. Net loss as a percentage of sales for the three months ended September 30, 2005 was (16.1)% compared to (199.2)% for the three months ended October 1, 2004.
LIQUIDITY AND CAPITAL RESOURCES
On September 30, 2005, our principal source of liquidity included $2,502,000 of unrestricted cash and cash equivalents.
Cash Flows
During the three months ended September 30, 2005, cash provided by operating activities was $365,000 compared to cash used in operating activities of $4,008,000 for the three months ended October 1, 2004. Net cash provided by operating activities in the current period reflected the collection of accounts receivable which provided cash of $2,154,000 compared to $2,652,000 provided in the comparable period in the prior fiscal year. The decrease in accounts receivable in the three months ended September 30, 2005 is due to the decline in sales. The change in inventories provided $111,000 of cash in the three months ended September 30, 2005 compared to cash provided in the same period last year of $314,000. Accounts payable and accrued expenses used $1,751,000 of cash in the three months ended September 30, 2005 compared to cash used of $4,367,000 in the comparable period in the prior fiscal year. The decline in accounts payable and accrued expenses in the three months ended September 30, 2005 is a result of lower sales volume, reduced headcount and fewer weeks of accrued payroll at the end of the period.
Cash used in investing activities was $225,000 for the three months ended September 30, 2005 compared to cash provided by investing activities of $3,622,000 for the three months ended October 1, 2004. The funds used in investing activities during the three months ended September 30, 2005 are due to the earn-out payment related to the NetEngine product line acquisition totaling $239,000 and capital expenditures of $15,000 offset by cash received from disposal of property, plant and equipment of $29,000. The funds provided in investing activities during the three months ended October 1, 2004 are the results of net cash acquired in the Larscom acquisition of $5,292,000 offset by expenses relating to the acquisition of $1,300,000, earn-out payments related to the NetEngine and Miniplex product line acquisitions totaling $255,000, and capital expenditures of $115,000.
Cash used in financing activities was $1,139,000 for the three months ended September 30, 2005 and $230,000 for the three months ended October 1, 2004. Funds used in financing activities during the three months ended September 30, 2005 resulted from repayments of long-term debt of $1,117,000 and the purchase of treasury shares related to tax withholdings totaling $35,000 on restricted stock awards offset by cash received from the exercise of stock options of $13,000. For the three months ended October 1, 2004, funds used in financing activities resulted from payments on long-term debt of $120,000 and the purchase of treasury shares related to tax withholdings totaling $127,000 on restricted stock awards, offset by proceeds from the issuance of common stock under our stock plans totaling $17,000.
21
Senior Convertible Notes
In March 2005, we entered into a securities purchase agreement for the private placement of up to $15,000,000 of senior convertible notes to six institutional investors. We issued an initial $10,000,000 of senior convertible notes, which can be converted into common stock at an initial price of $3.01 per share. The conversion price of the senior convertible notes will be subject to broad-based anti-dilution provisions in connection with certain future issuances of our securities as well as for adjustments for stock splits and the like. The senior convertible notes may not be converted into more than 20% of the number of shares or voting power of our common stock outstanding as of the closing of the financing until such conversion or exercise has been approved by our stockholders. As of September 30, 2005, a total of $9,000,000 in face value of senior convertible notes was outstanding. These senior convertible notes are recorded in the condensed consolidated balance sheet at September 30, 2005, at the discounted amount of $7,016,000. See Note 8 – Long-term Debt to the condensed consolidated financial statements.
We amended the terms of the senior convertible notes per Amendment Agreements (“Amendments”) dated October 31, 2005 with all the holders of these notes. Pursuant to the Amendments, the “target working capital” amounts under the terms of the notes is reduced to $6,500,000 for the quarter ended September 30, 2005, and for subsequent quarters, to the sum of $6,800,000 plus 80% of the aggregate principal amount of any notes purchased pursuant to the exercise of the holders’ additional investment rights to purchase additional notes minus (B) 80% of any notes redeemed or converted as of such date other than amounts redeemed or converted prior to the date of the Amendments. At September 30, 2005, “tested working capital”, as defined in the senior convertible notes, was $6,772,000.
The Amendments further provide that 50% of the net proceeds (after satisfaction of the first mortgage, commissions, closing costs and escrows for repairs) from a sale of the Property must be paid to the holders to reduce the outstanding principal amount of the notes. The Amendments delete the requirement for us to hold $1,000,000 of the proceeds from the sale of such Property in a restricted cash collateral account securing the senior convertible notes. The Amendments modify the restricted payment provisions of the notes to prohibit us from making principal payments on other indebtedness without the approval of the holders of the notes subject to limited exceptions, and revise the cross-default provision of the notes.
The Amendments reduce the exercise price of the warrants for 830,563 shares of common stock issued under the securities purchase agreement dated March 20, 2005 to $0.93 per share of our common stock.
As part of the initial purchase of these notes and warrants in March 2005, the holders acquired additional investment rights to purchase up to an aggregate of $5,000,000 in principal amount of additional notes. Pursuant to the Amendments, the conversion price of the additional notes that would be issued if the holders exercise their additional investment rights has been reduced to $1.00 per share of common stock, and we extended the expiration of the holders’ right to exercise their additional investment rights to June 29, 2006. The conversion price of the $8,000,000 principal amount of notes outstanding as of the date of the Amendments is $3.01 per share and has not been amended.
The senior convertible notes bear interest at a rate of six percent per annum and are repayable in ten quarterly installments beginning in July 2005, or earlier upon the occurrence of certain events. Payment of both principal and interest may be made in either cash or, provided that we have obtained stockholder approval to the extent necessary, by the delivery of shares of common stock at a price equal to the lower of (i) the conversion price of $3.01 or (ii) 90% of the weighted average sale price of our common stock for the fifteen consecutive trading days ending on the fourth trading day immediately preceding the applicable interest or installment payment date. Such issuance of common stock will not result in anti-dilution adjustments to the conversion price of the senior convertible notes. If by November 21, 2005, which has been extended to December 16, 2005 pursuant to the Amendments, we have not obtained stockholder approval of the issuance of the senior convertible notes, the warrants and the shares of common stock to be issued thereunder and an increase in our authorized capital of at least 10,000,000 shares of common stock, we will be required to make at least 50% of interest and installment payments made after such date in cash.
In addition to regularly scheduled installment payments, if, as of the end of each fiscal quarter during the period in which the senior convertible notes are outstanding, we fail to maintain certain minimum working capital requirements, as defined in the notes, as amended, the holders of the senior convertible notes may require us to make an additional installment payment under the senior convertible notes which shall be, at the option of each holder, such holder’s pro rata portion of one of the following: (1) the difference between (A) the unpaid principal, interest and any late charges then remaining under the senior
22
convertible notes and (B) 60% of our working capital amount, as determined in accordance with the terms of the senior convertible notes, (2) $2,000,000 or (3) such lesser amount if reduced in accordance with the terms of the senior convertible notes. The payment of any such additional installment amounts may also be paid, at our option, by the delivery of shares of common stock calculated using the same conversion price formula set forth above for regularly scheduled installment payments. The ability to elect to pay installment amounts or interest in shares of common stock is subject to conditions relating to the registration of the shares to be issued, compliance with the effective minimum listing maintenance requirements of The Nasdaq National Market and certain other conditions set forth in the senior convertible notes. The Nasdaq Marketplace Rules generally require us to maintain a minimum bid price per share of $1.
Substantially all of our assets are pledged as collateral for amounts outstanding under the senior convertible notes. Furthermore, substantially all of our cash is held in accounts subject to a control agreement between us and the financial institution that maintains these accounts. We have agreed that upon a continuing event of default related to our senior convertible notes, the collateral agent for the holders of our senior convertible notes may instruct this financial institution to send to the collateral agent amounts credited to our account with the financial institution.
Convertible Promissory Notes
In February 2004, we issued two convertible promissory notes totaling $10,480,000 in connection with our acquisition of XEL Communications, Inc. In May 2004, the holder of the $10,000,000 convertible promissory note converted $7,250,000 of the outstanding principal amount of the note into 1,361,758 shares of our common stock. These convertible promissory notes earn interest at a rate of 7% per annum and mature February 5, 2006. The holders may convert the note in whole or in increments of at least $1,000,000 into our common stock at a conversion price of $5.324 per share. As of September 30, 2005, the amount outstanding under the convertible promissory notes totaled $2,880,000.
Mortgaged Property Held for Sale
The final balloon payment of approximately $3,046,000 is due on February 1, 2006 on a note secured by our facility leased to The Boeing Company located at 950 Explorer Boulevard in Huntsville, Alabama (the “Property”). In November 2005, after the end of the quarter to which this Quarterly Report on Form 10-Q relates, we amended the lease agreement with The Boeing Company, which among other things, extends the term of the lease, amends the schedule of rents and requires us to contribute certain amounts toward the cost of repairing or replacing the HVAC system servicing the Property. We also entered into a Purchase and Sale Agreement for the sale of our interest in this Property. See Note 13 – Subsequent Events to the condensed consolidated financial statements for additional information.
Liquidity Generally
We incurred losses from operations in the current quarterly period and the last two fiscal years, and as of September 30, 2005, our current liabilities exceeded our current assets by $2,176,000. These factors raise substantial doubt about our ability to continue as a going concern. Management instituted a cost reduction program during the quarter ended September 30, 2005 that included a decrease in headcount and curtailment of other discretionary non-payroll costs. In addition, we increased sales prices on certain products, obtained more favorable material costs for certain material components, and redesigned certain product lines to reduce manufacturing costs. We continue to rationalize product lines, which could result in the potential sale and/or acquisition of product line(s). Management believes these factors will contribute toward achieving positive cash flow from operations. We have also amended the lease terms of the facility related to the Property and entered into an agreement to sell this facility. We are required to use 50% of the net proceeds from the sale of the Property to reduce the outstanding principal amount of the senior convertible notes, with the remainder of the net proceeds available to fund operations subject to restrictions on the use of proceeds to pay indebtedness.
We have significant contractual obligations over the next six months as described above. Additional special installment payments could also be required on the senior convertible notes if we fail to maintain the targeted working capital amounts. The terms of the senior convertible notes as amended generally prohibit payments on the convertible promissory notes due February 2006 unless (i) our net cash balance exceeds the outstanding principal amount of the senior convertible notes, (ii) the closing sale price for our common stock exceeds $1.50 for 20 consecutive trading days out of the 30 trading days prior to payment, or (iii) the holders of a majority in principal amount of the senior convertible notes have consented to the payment or an amendment to the convertible promissory notes permitting such payment thereon.
23
In view of our limited liquidity and the restrictions under the senior convertible notes, we will attempt to negotiate an extension or other restructuring of the convertible promissory notes due February 2006. The convertible promissory notes are unsecured and provide for a default interest rate of 10% during the existence of any event of default. The amendment or restructuring of the convertible promissory notes would generally require the consent of the holders of such notes and the holders of the senior convertible notes. We may not be successful in our efforts to negotiate a restructuring or refinancing of our indebtedness. If we are not successful in restructuring or refinancing our indebtedness on a negotiated basis, we may need to consider other restructuring options.
On a quarterly basis, management will continue to evaluate revenue outlook and plans to adjust spending levels as indicated. We believe that our cash and cash equivalents, anticipated cash flow from operations and proceeds from the sale of the Property will be sufficient to fund our operating activities (excluding the note payment contractual obligations described above) through the next twelve months, although no such assurance can be given. If we do not substantially meet our current operating plan or to otherwise provide additional liquidity, we may implement additional cost containment measures, consider seeking additional financing or renegotiate our contractual obligations. The issuance of additional equity would result in dilution to our stockholders.
SUBSEQUENT EVENT – ACQUISITION OF ARCADACS/SECHTOR PRODUCT LINE
Effective October 1, 2005, we acquired the inventories, fixed assets and intellectual property rights relating to Zhone Technologies, Inc.’s ArcaDACS™ 100 Digital Access Cross-Connect System (DACS) and Sechtor® 300 Multiservice Edge Concentrator product lines and assumed certain liabilities, including warranty obligations. We issued 2,000,000 shares of our common stock to Zhone at the closing of the agreement. This acquisition was strategic to us in that it represents an integral part of the solution we provide to our largest customer, and it also complements the margin improvement initiatives that we launched in recent quarters. Prior to the acquisition, we purchased this product from Zhone under an OEM agreement dated January 1, 2001.
The acquisition was recorded under the purchase method of accounting, and the purchase price was allocated based on the fair value of the assets acquired and liabilities assumed. The total purchase price of $2,178,000 consisted of (a) 2,000,000 shares of our common stock issued at closing and valued at approximately $2,076,000, using a fair value per share of $1.038, and (b) assumptions of certain liabilities totaling $102,000. The purchase price was allocated to the individual assets acquired based on the relative fair value of the assets acquired and liabilities assumed. A summary of the total purchase consideration is as follows (in thousands):
Value of common stock issued | | $ | 2,076 | |
Assumed liabilities | | | 102 | |
| |
|
| |
Total purchase consideration | | $ | 2,178 | |
| |
|
| |
CRITICAL ACCOUNTING POLICIES
Our 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. We base our 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 we believe are among the critical accounting policies most affected by significant management estimates and judgments:
Accounting for Acquisitions: We account for acquisitions as a purchase in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations. As such, we report all acquired tangible and intangible assets and liabilities at fair value. We recognize the fair value of the purchased intangible assets as operating expenses over the estimated useful life of each separate intangible asset. We recognize the fair value associated with any in-process technology as an operating expense in the period an acquisition is consummated. We value any employee stock options assumed as part of the acquisition using the Black-Scholes valuation model. The value of assumed vested options and the value of assumed unvested options in excess of the intrinsic value of such unvested options are included as part of the purchase price consideration. We report the intrinsic value of any unvested options as deferred compensation and record it as an operating expense over the remaining vesting period of the options. We value our stock issued as part of the consideration using the 5-day average price surrounding the date the acquisition was announced.
24
Impairment of Long-Lived Assets and Goodwill. We assess 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.’s 144 and 142, respectively. Our long-lived assets include, but are not limited to, the property held for lease, furniture and equipment, software licenses, and goodwill and intangible assets related to acquisitions. We assess the impairment of goodwill at least annually or whenever events or changes in circumstances indicate that the carrying value may not be recoverable under the guidance prescribed by SFAS No. 142.
Due to circumstances that occurred during the first quarter of fiscal 2005, we completed a test for impairment of goodwill in connection with the preparation of our interim financial statements that quarter. These circumstances include the loss of product revenues from a significant customer, the low level of liquidity noted in the going concern opinion issued late in the quarter on our fiscal 2004 consolidated financial statements and the low market price of our common stock following the end of the quarter. Based on this review, we determined that the carrying value of our goodwill was impaired and recorded an impairment charge related to goodwill of $19,984,000. The impairment charge was based on a projected discounted cash flow model using a discount rate commensurate with the risk inherent in our current business model.
Inventories. We value 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 we may increase or decrease the provision required for excess and obsolete inventory in future periods. During the first quarter of fiscal 2006, we recorded a provision for inventory reserves totaling $111,000. Inventory reserves totaled $8,672,000 and $8,633,000 as of September 30, 2005 and July 1, 2005, respectively.
Revenue Recognition. We recognize a sale when persuasive evidence of an arrangement exists, the product has been delivered or services have been performed, the price to the purchaser is fixed or determinable, and collection of the resulting receivable is reasonably assured. 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 our products. The reserve for future product returns was $811,000 and $557,000 as of September 30, 2005 and July 1, 2005, respectively. Service revenue earned from providing maintenance, installation, training or other miscellaneous services is recognized when those services are provided to the customer, if there is persuasive evidence of an arrangement, the fee is fixed and determinable and collection of the receivable is reasonably assured.
Warranty Provision. We record 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 that totaled $1,225,000 and $1,290,000 as of September 30, 2005 and July 1, 2005, respectively.
Allowance for Doubtful Accounts. We estimate losses resulting from the inability of our customers to make payments for amounts billed. The collectibility 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 customer data. Should our actual experience with respect to collections differ from these assessments, there could be adjustments to our allowance for doubtful accounts, which totaled $1,080,000 and $1,200,000 as of September 30, 2005 and July 1, 2005, respectively.
Deferred Tax Assets. We have provided a full valuation reserve related to our deferred tax assets. In the future, if sufficient evidence of our ability to generate sufficient future taxable income in certain tax jurisdictions becomes apparent, we may be required to reduce our valuation allowances, resulting in income tax benefits in our consolidated statement of operations. Management evaluates the realizability of the deferred tax assets and assesses the need for the valuation allowance each reporting period. The valuation allowance related to our deferred tax assets was $60,586,000 and $59,803,000 as of September 30, 2005 and July 1, 2005, respectively.
25
Stock Based compensation. Prior to July 2, 2005, we generally granted stock options to our employees at an exercise price equal to the fair value of the underlying shares of common stock at the date of grant and accounted for these stock option grants in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations. Under APB Opinion No. 25, no compensation expense was recognized in our statement of operations for stock options issued with an exercise price equal to the market price of the underlying stock on the date of grant. However, we disclosed the pro forma compensation expense in the notes to our financial statements that would have been recognized based on the estimated fair value of stock options through the use of option pricing models. In determining the variables used in the option pricing model, we make several subjective estimates about the characteristics of the underlying stock and the expected timing of option exercise. Changes to these estimates could change the fair value disclosures in our financial statements.
Effective July 2, 2005, we adopted the fair value recognition provisions of SFAS 123R using the modified prospective transition method. Under that transition method, compensation cost recognized in fiscal year 2006 includes compensation cost for all share-based compensation granted subsequent to July 1, 2005, based on the grant date fair value estimated in accordance with the provisions of SFAS 123 for options and awards issued prior to July 2, 2005 and SFAS 123R for options and awards issued on or after that date. Our results of operations due to adopting SFAS 123R for periods prior to July 2, 2005 have not been restated.
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 Quarterly 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: the adequacy of our liquidity and capital resources for the next twelve months; the potential need to obtain credit or other financing or to renegotiate contractual obligations; the sale of our facility at 950 Explorer Boulevard in Huntsville, Alabama; satisfaction of future financial obligations, including the senior convertible notes, convertible promissory notes, and note payable on real estate; receipt and shipment of delayed orders from customers; growth of our market segments; improvement in gross margins; selling, general and administrative expenses; research and development expenditures; total budgeted capital expenditures; engineering consolidation plans; payment of lease obligations by our subtenants; and the impact of recently issued accounting pronouncements. These forward-looking statements involve risks and uncertainties, and it is important to note that our 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 and in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q, 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 us as of the date hereof, and we assume no obligation to update any forward-looking statement or risk factor. The risk factors described herein should be read in conjunction with the risk factors more fully discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q.
• | Continued Listing Requirements. Our common stock is currently traded on The Nasdaq National Market. Failure to meet the applicable quantitative and/or qualitative maintenance requirements of Nasdaq could result in our common stock being delisted from The Nasdaq National Market. For continued listing, The Nasdaq National Market requires, among other things, that listed securities maintain a minimum bid price of not less than $1.00 per share. Nasdaq may commence procedures to delist securities from The Nasdaq National Market which do not meet these continued listing requirements for a period of 30 consecutive trading days. Since October 12, 2005, our common stock has traded below the $1.00 minimum bid on occasion, but not for 30 consecutive trading days. If delisted from The Nasdaq National Market, our common stock may be eligible for trading on The Nasdaq SmallCap Market, the OTC Bulletin Board or on other over-the-counter markets, although there can be no assurance that our common stock will be eligible for trading on any alternative exchanges or markets. Among other consequences, failure to meet the continue listing requirements of The Nasdaq National Market would require the payment of amounts due under the senior convertible notes in cash, and may cause a further decline in our stock price, reduced liquidity in the trading market for our common stock, and difficulty in obtaining future financing. |
26
• | We may need to restructure our indebtedness or obtain additional financing. We anticipate that we will need to restructure our indebtedness, especially our convertible promissory notes due February 2006, or obtain additional financing. Because substantially all of our assets are encumbered and as a result of our financial condition, we believe we are unlikely to obtain any material amount of additional debt financing. Additional equity financing would be dilutive to stockholders. The conversion price of the senior convertible notes and the exercise price of the associated warrants are subject to broad-based anti-dilution adjustments in the event equity is issued at an effective price less than the then applicable conversion or exercise price. In addition, the holders of the senior convertible notes have certain rights to participate in future equity financings. As result of the foregoing, any equity financing, if possible, will be more difficult to complete and more dilutive. We cannot assure investors that we will successfully negotiate a restructuring of our indebtedness. If we are not successful in restructuring our indebtedness on a negotiated basis, we may need to consider other restructuring options. |
| |
• | Our Indebtedness and Debt Service Obligations May Adversely Affect Our Cash Flow. To the extend we are unable to satisfy our interest and installment payment obligations under our senior convertible notes by the payment of shares of common stock, we will be required to pay those obligations in cash. If we are unable to generate sufficient cash to meet these obligations, we may have to restructure or limit our operations. Our indebtedness could have significant additional negative consequences, including, but not limited to: (i) requiring the dedication of a substantial portion of the our expected cash flow from operations to service the indebtedness, thereby reducing the amount of expected cash flow available for other purposes, including capital expenditures, (ii) increasing our vulnerability to general adverse economic and industry conditions, (iii) limiting our ability to obtain additional financing, (v) limiting our flexibility to plan for, or react to, changes in its business and the industry in which it competes, and (vi) placing us at a possible competitive disadvantage to competitors with less debt obligations and competitors that have better access to capital resources. |
| |
• | Issuance of the Shares of Common Stock Upon Conversion or Repayment of Senior Convertible Notes, Payment of Interest, and Exercise of Warrants Will Dilute The Ownership Interest of Existing Stockholders and Could Adversely Affect The Market Price of Our Common Stock. We may issue shares of common stock to the holders of our senior convertible notes (i) upon conversion of some or all of the senior secured convertible notes, (ii) in satisfaction of our installment obligations under the notes, in lieu of cash payments, (iii) in satisfaction of our interest obligations under the notes, in lieu of cash payments, and (iv) upon exercise of the warrants. Any of these issuances will dilute the ownership interests of existing stockholders. Any sales in the public market of this common stock could adversely affect prevailing market prices of the common stock. In addition, the existence of these notes and warrants may encourage short selling by market participants. |
| |
• | The Senior Convertible Notes Provide That Upon The Occurrence of Various Events of Default and Change of Control Transactions, The Holders Would Be Entitled To Require Us To Redeem The Notes For Cash, Which Could Leave Us With Little or No Working Capital for Operations or Capital Expenditures. The senior convertible notes allow the holders to require redemption of the notes upon the occurrence of various events of default, such as the termination of trading of our common stock on The Nasdaq National Market, or specified change of control transactions. In such a situation, we may be required to redeem all or part of the notes, including any accrued interest and penalties, within 5 business days after receipt of a demand for such redemption. Some of the events of default include matters over which we may have some, little or no control. If an event of default or a change of control occurs, we may be unable to pay the full redemption price in cash. Even if we were able to pay the redemption price in cash, any such redemption could leave us with little or no working capital for our business. We have not established a sinking fund for payment of our obligations under the notes, nor do we anticipate doing so. |
| |
• | If We Cannot Obtain The Required Stockholder Approval To Issue Common Stock in Satisfaction of Our Interest and Installment Obligations Under The Senior Convertible Notes, We Must Satisfy at Least 50% of These Obligations In Cash. After December 16, 2005, stockholder approval will be required for us to make certain interest and installment payments under the senior convertible notes with shares of common stock. In the event that stockholder approval is not obtained by this date, we will be required to make at least 50% of such interest and installment payments in cash. Any such payments could leave us with insufficient working capital for our business. |
27
• | The Senior Convertible Notes Are Secured by Substantially All of Our Assets. The holders of our senior convertible notes received a security interest in and a lien on substantially all of our assets, including our existing and future accounts receivable, cash, general intangibles (including intellectual property) and equipment. As a result of this security interest and lien, if we fail to meet our payment or other obligations under the notes, the holders would be entitled to foreclose on and liquidate substantially all of our assets. Under those circumstances, we may not have sufficient funds to service our day-to-day operational needs. Any foreclosure by the holders of our senior convertible notes would have a material adverse effect on our financial condition. In addition, we generally may not sell assets securing such notes without consent, other than the sale of inventory in the ordinary course of business. |
| |
• | If Tested Working Capital Falls Below Certain Defined Levels, We May Be Required To Make Additional Payments To The Holders Of The Senior Convertible Notes. We may be required to make additional payments under the senior convertible notes if, as of the end of each fiscal quarter during the period in which the senior convertible notes are outstanding, we fail to maintain certain minimum working capital requirements. In that event, we must provide notice of the working capital deficiency to the noteholders on the date of our quarterly results announcement. For a period of seven business days after our notice to the noteholders, each holder may provide us a notice requiring us to pay such holder’s pro rata portion of one of the following: (1) the difference between (A) the unpaid principal, interest and any late charges then remaining under the senior convertible notes and (B) 60% of our working capital amount, as determined in accordance with the terms of the senior convertible notes, (2) $2,000,000 or (3) such lesser amount if reduced in accordance with the terms of the senior convertible notes. Our payment of these additional amounts may be in cash and/or common stock pursuant to similar terms as the payment of regular installment amounts. Any requirement that we make any such payments in cash could leave us with insufficient working capital for our business. |
| |
• | Independent Registered Public Accounting Firm’s Report Includes a “Going Concern” Explanatory Paragraph. Our independent registered public accounting firm included in its report on our consolidated financial statements for the fiscal year ended July 1, 2005, a going concern explanatory paragraph, which refers to our working capital deficiency, operating loss and negative cash flow from operations that raise substantial doubt about our ability to continue as a going concern. Our ability to continue as a going concern is dependent upon our ability to obtain adequate financing and achieve a level of revenues and cash flow adequate to support our capital and operating requirements. |
| |
• | Evolving Regulation of Corporate Governance and Public Disclosure May Result in Additional Expenses and Continuing Uncertainty. Changing laws, regulations and standard relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq National Market rules are creating uncertainty for public companies. We continually evaluate and monitor developments with respect to new and proposed rules and cannot predict or estimate the amount of the additional costs we may incur or the timing of such costs. These new or changed laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we have invested resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, regulatory authorities may initiate legal proceedings against us and we may be harmed. |
| |
• | Dependence on Legacy and Recently Introduced Products and New Product Development. Our future results of operations are dependent on market acceptance of existing and future applications for our existing products, products that we have acquired and new products in development. In prior fiscal years, the majority of sales were provided by our legacy products, primarily the AS2000 product line. The Miniplex product line acquired from Terayon Communication Systems, Inc. can also be classified as a legacy product. We experienced a significant decline of legacy sales in fiscal 2005 compared to fiscal 2004 and we expect sales to further decline in the future. While we believe we have positioned Verilink to offset the loss of legacy sales over the long-term, reduced legacy sales will impact our results of operations in the near-term, and sales of new products will often be at lower margins than legacy sales. Our future results of operations are dependent on market acceptance of existing and future applications for our existing products and new products in development. |
28
• | Risks Associated With Acquisitions, Potential Acquisitions and Joint Ventures. One element of our strategy is to consider acquisition prospects and joint venture opportunities. Acquisitions of this nature by us could result in potentially dilutive issuance of equity securities, use of cash, the incurring of debt and the assumption of contingent liabilities, significant demands on management attention, and/or business risks associated with integrating other businesses into us, any of which could have a material adverse effect on our business and operating results and/or the price of our common stock. |
| |
• | Customer Concentration. A small number of customers have historically accounted for a majority of our sales, with a single customer’s orders for legacy products accounting for a majority of sales in many fiscal quarters. There can be no assurance that our current customers will continue to place orders with us, that orders by existing customers will continue at the levels of previous periods, or that we will be able to obtain orders from new customers. |
| |
• | Dependence on Key Personnel. Our future success will depend to a large extent on the continued contributions of our executive officers and key management, sales, marketing and technical personnel. In prior years, we implemented a temporary salary reduction program to conserve cash together with special equity incentive grants. Our current financial condition and salary reductions may make it more difficult to attract and retain key personnel. |
| |
• | Dependence on Key Suppliers and Component Availability. The loss of a key supplier, loss of a contract manufacturer, an increase in required lead times, adverse change in payment practices or other terms and conditions, an increase in prices of component parts, interruptions in the supply of any components, our inability or our third party sub-contractor to procure components from alternative sources at acceptable prices and within a reasonable time, could have a material adverse effect upon our business, financial condition and results of operations. |
| |
• | Potential Volatility of Stock Price. The trading price of our Common Stock has been and may continue to be subject to wide fluctuations in response to quarter-to-quarter variations in operating results, announcements of technological innovations or new products by us or our competitors, developments with respect to patents or proprietary rights, general conditions in the telecommunication network access and equipment industries, or other events or factors. |
| |
• | Competition. The market for telecommunications network access equipment addressed by our product families can be characterized as highly competitive, with intensive price pressure. Many of our current and potential competitors have substantially greater technical, financial, manufacturing and marketing resources than us, and many have long-established relationships with network service providers. |
| |
• | Rapid Technological Change. The network access and telecommunications equipment markets are characterized by rapidly changing technologies and frequent new product introductions. Our business, financial condition and results of operations would be materially adversely affected if we were to be unsuccessful, or to incur significant delays in developing and introducing new products or enhancements. |
| |
• | Compliance with Regulations and Evolving Industry Standards. The market for our 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. The failure of our products to comply, or delays in compliance, with the various existing and evolving industry standards could delay introduction of our products. |
| |
• | Risks Associated With Entry into International Markets. Historically, we have little experience in International markets, but are expanding sales of our products outside of North America and expect to grow 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, higher costs, unexpected changes in regulatory requirements and tariffs, difficulties in staffing and managing foreign operations, greater difficulty in receivables collection and potentially adverse tax consequences. |
| |
• | Risk of Third Party Claims of Infringement; Limited Protection of Intellectual Property. 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. In the event of a successful claim against us and our failure to develop or license a substitute technology, our business, financial condition and results of operations could be materially adversely affected. We rely upon a combination of statutory and contractual restrictions to establish and protect proprietary rights in our products and technologies. There can be no assurance that these statutory and contractual arrangements will deter misappropriation of our technologies or discourage independent third-party development of similar technologies. |
29
Item 3. | Quantitative and Qualitative Disclosures About Market Risk. |
We are subject to interest rate risks on the long-term debt secured by our property located at 950 Explorer Boulevard, Huntsville, Alabama. If market interest rates were to increase immediately and uniformly by 10% from levels as of September 30, 2005, the additional interest expense would not be material. We believe that the effect, if any, of reasonably possible near-term changes in interest rates on our financial position, results of operations and cash flows would not be material.
Item 4. | Controls and Procedures. |
(a) Evaluation of disclosure controls and procedures. Our Chief Executive Officer and Chief Financial Officer are responsible for establishing and maintaining “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 Rules 13a-15(e) and 15d-15(e)) for the company. Our Chief Executive Officer and Chief Financial Officer, after evaluating the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Quarterly Report on Form 10-Q, have concluded that our disclosure controls and procedures are effective.
(b) Changes in internal control over financial reporting. There were no changes in our internal control over financial reporting identified in management’s evaluation that occurred during our most recent fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Exhibits Index:
| Exhibit Number | | Description of Exhibit |
|
| |
|
| 31.1 | | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934 |
| | | |
| 31.2 | | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934 |
| | | |
| 32.1 | | 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 |
30
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 |
| | |
Date: November 14, 2005 | By: | /s/ Timothy R. Anderson |
| |
|
| | Timothy R. Anderson |
| | Vice President and Chief Financial Officer |
| | (Principal Financial and Accounting Officer) |
31
