margin sales and by eliminating certain low profit legacy products, a decline on our professional services revenues, and a decrease in sales of our 6000/8000 Series IADS. Service net sales for the three months ended December 30, 2005 decreased by $789,000 to $2,161,000 from $2,950,000 for the three months ended December 31, 2004. Service net sales for the six months ended December 30, 2005 decreased by $798,000 to $4,718,000 from $5,516,000 for the six months ended December 31, 2004.
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 1% in the three months ended December 30, 2005 to $8,646,000 from $8,579,000 in the comparable prior year period, and increased 5% in the six months ended December 30, 2005 to $16,712,000 from $15,969,000 in the comparable prior year period. Net sales to all other customers decreased by 55% and 48% in the three months and six months ended December 30, 2005, respectively, from the comparable prior year period. Our top five customers did not remain the same over these periods. Sales to Verizon (excluding MCI) and Interlink Communications, Inc. accounted for 40% and 12% of net sales in the six months ended December 30, 2005. In the comparable prior year period, sales to Verizon accounted for 43% of net sales. No other customer accounted for more than 10% of net sales in these two periods.
Mergers among certain of our customers, including the Verizon/MCI and SBC/AT&T mergers, may impact sales in future periods as these customers complete internal review of programs and their integration plans. Shipments to these customers during the month of January 2006 were significantly lower than sales to them in the month of October 2005. If this trend continues during our third fiscal quarter, revenues for the three months ending March 31, 2006 are expected to be lower than revenues for the three months ended December 30, 2005.
development expenses for the three months ending March 31, 2006 to be significantly less than the $1,556,000 spent for the three months ended December 30, 2005. 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 December 30, 2005 decreased 24% to $3,217,000 from $4,221,000 in the comparable period in the prior fiscal year and decreased as a percentage of sales from 31.8% to 29.9%. Selling, general and administrative expenses for the six months ended December 30, 2005 decreased 29% to $6,612,000 from $9,328,000 in the comparable period in the prior fiscal year and decreased as a percentage of sales from 36.5% to 30.4%. These decreases over the same periods in the prior year are primarily due to decreased headcount and related expenses primarily attributable to the consolidation of certain 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 $174,000 and $440,000 was included in SG&A expenses for the three months and six months ended December 30, 2005. Amortization of deferred compensation totaled zero in the three and six months ended December 30, 2005 compared to $13,000 and $134,000 for the three months and six months ended December 31, 2004. SG&A expenses for the six months ended December 31, 2004 includes a total of $476,000 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 and six months ended December 30, 2005 totaled $576,000 and $1,140,000, respectively, as compared to $684,000 and $1,256,000 for the comparable periods of the prior fiscal year.
Impairment Charge Related to Other Intangible Assets. During the three months ended December 30, 2005, we recognized $1,985,000 in impairment losses on certain identified intangible assets (existing technology) acquired in connection with the Larscom acquisition. See Note 6 — Other Intangible Assets in the Notes to Condensed Consolidated Financial Statements.
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 months and six months ended December 31, 2004 totaling $291,000 and $734,000, respectively. These restructuring activities were substantially completed during the quarter ended December 31, 2004. As described in Note 14 – Subsequent Events, we announced a plan to close our Newark, California facility, which will result in restructuring charges to be recorded in the three months ending March 31, 2006 of approximately $2,000,000.
Interest and Other Income, Net. Interest and other income, net decreased 5% to $150,000 for the three months ended December 30, 2005 from $158,000 in the comparable period in the prior fiscal year. Interest and other income, net decreased 15% to $316,000 for the six months ended December 30, 2005 from $371,000 in the comparable period in the prior fiscal year due to the income recorded in that year ago period of $110,000 from the forgiveness of a portion of the convertible notes associated with the XEL acquisition. No such income was recorded in the three months or six months ended December 30, 2005. Rental income, net of expenses, is included in interest and other income, net and totaled $166,000 and $136,000 for the three months ended December 30, 2005 and December 31, 2004. Rental income, net of expenses, totaled $330,000 and $271,000 for the six months ended December 30, 2005 and December 31, 2004.
Interest Expense. Interest expense, including amortization of loan discount and costs, increased 529% to $786,000 for the three months ended December 30, 2005 from $125,000 for the three months ended December 31, 2004, and increased 520% to $1,488,000 for the six months ended December 30, 2005 from $240,000 for the six months ended December 31, 2004 due to the interest expense related to the $10,000,000 senior secured convertible notes issued on March 21, 2005. Amortization of loan discount and costs associated with the senior secured convertible notes totaled $574,000 and $1,013,000 for the three months and six months ended December 30, 2005, respectively.
Provision for Income Taxes. A benefit for income taxes of $10,000 was recorded in the three months and six months ended December 30, 2005. However, no tax provision or tax benefit was recognized for any other period presented 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.
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Net Income (Loss). Net loss for the three months ended December 30, 2005 was $3,584,000 compared to $2,159,000 for the three months ended December 31, 2004. Net loss for the six months ended December 30, 2005 was $5,355,000 compared to $26,630,000 for the six months ended December 31, 2004.The changes between the periods are a result of the above factors, primarily due to the impairment charge related to other intangible assets, 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 December 30, 2005 was (33.3)% compared to (16.3)% for the three months ended December 31, 2004, and net loss as a percentage of sales for the six months ended Dec ember 30, 2005 was (24.6)%, compared to (104.2)% for the six months ended December 31, 2004.
LIQUIDITY AND CAPITAL RESOURCES
On December 30, 2005, our principal source of liquidity included $1,031,000 of unrestricted cash and cash equivalents.
Cash Flows
During the six months ended December 30, 2005, cash provided by operating activities was $170,000 compared to cash used in operating activities of $5,911,000 for the six months ended December 31, 2004. Net cash provided by operating activities in the current period reflected the collection of accounts receivable which provided cash of $1,967,000 compared to $1,902,000 provided in the comparable period in the prior fiscal year. The decrease in accounts receivable in the six months ended December 30, 2005 is due to the decline in sales. The change in inventories used $1,051,000 of cash in the six months ended December 30, 2005 compared to cash provided in the same period last year of $1,209,000. Accounts payable and accrued expenses used $831,000 of cash in the six months ended December 30, 2005 compared to cash used of $5,620,000 in the comparable period in the prior fiscal year. The decline in accounts payable and accrued expenses in the six months ended December 30, 2005 is a result of lower sales volume, reduced headcount and timing of inventory purchases at the end of the period.
Cash used in investing activities was $379,000 for the six months ended December 30, 2005 compared to cash provided by investing activities of $3,294,000 for the six months ended December 31, 2004. The funds used in investing activities during the six months ended December 30, 2005 are due to the earn-out payment related to the NetEngine product line acquisition totaling $239,000 and capital expenditures of $169,000 offset by cash received from disposal of property, plant and equipment of $29,000. The funds provided in investing activities during the six months ended December 31, 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 $481,000, and capital expenditures of $217,000.
Cash used in financing activities was $2,259,000 for the six months ended December 30, 2005 compared to cash provided by financing activities of $1,135,000 for the six months ended December 31, 2004. Funds used in financing activities during the six months ended December 30, 2005 resulted from repayments of long-term debt of $2,235,000 and the purchase of treasury shares related to tax withholdings totaling $36,000 on restricted stock awards offset by cash received from the exercise of stock options of $12,000. For the six months ended December 31, 2004, funds provided by financing activities resulted from borrowings under a bank line of credit of $1,454,000 and proceeds from the issuance of common stock under our stock plans totaling $71,000 reduced by payments on long-term debt of $263,000 and the purchase of treasury shares related to tax withholdings totaling $127,000 on restricted stock awards.
Senior secured convertible notes
In March 2005, we entered into a securities purchase agreement for the private placement of up to $15,000,000 of senior secured convertible notes to six institutional investors. We issued an initial $10,000,000 of senior secured convertible notes, which can be converted into common stock at an initial price of $3.01 per share. The conversion price of the senior secured convertible notes is 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. As of December 30, 2005, a total of $8,000,000 in face value of senior secured convertible notes was outstanding. These senior secured convertible notes are recorded in the condensed consolidated balance sheet at December 30, 2005, at the discounted amount of $6,484,000. See Note 9 – Long-term Debt to the condensed consolidated financial statements.
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We amended the terms of the senior secured 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.
In addition to regularly scheduled installment payments, if, as of the end of each fiscal quarter during the period in which the senior secured 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 secured convertible notes may require us to make an additional installment payment under the senior secured 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 secured convertible notes and (B) 60% of our working capital amount, as determined in accordance with the terms of the senior secured convertible notes, (2) $2,000,000 or (3) such lesser amount if reduced in accordance with the terms of the senior secured 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 secured convertible notes.
At December 30, 2005, “tested working capital”, as defined in the senior secured convertible notes, of $4,539,000 was less than the target. The holders have exercised their rights to require us to make additional installment payments on March 1, 2 and 6, 2006 totaling $2,614,000. On January 9, 2006, Nasdaq notified us that we had failed to maintain the continued listing requirements under the Nasdaq Marketplace Rules since the closing price of our common stock had been below the $1 minimum bid price per share for thirty consecutive trading days. As a result of such notice, we were not permitted to elect to make these additional installment payments in stock rather than cash without the consent of the holders, even though Nasdaq has provided us a 180-day grace period to regain compliance with its minimum price requirement.
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. On January 11, 2006, we paid $1,694,000 to the note holders as their share of the net proceeds from the sale of the Property. 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 senior secured 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 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 secured convertible notes.
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Substantially all of our assets are pledged as collateral for amounts outstanding under the senior secured 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 secured convertible notes, the collateral agent for the holders of our senior secured 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 were originally scheduled to mature in February 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 December 30, 2005, the amount outstanding under the convertible promissory notes totaled $2,880,000.
On February 6, 2006, we entered into an amendment to the convertible promissory notes issued in connection with our acquisition of XEL Communications, Inc. in February 2004. The amendment extended the maturity of these notes to the earlier of (i) the one year following the payment, conversion or redemption of our outstanding senior secured convertible notes in full, and (ii) February 6, 2009. In addition, the amendment increased the rate of interest on these notes from 7% to 10%, and will require us to pay the principal amount outstanding on the notes in twelve monthly installments commencing on the payment, conversion or redemption of our outstanding senior secured convertible notes in full. The amendment also generally prohibits the incurrence of additional liens and additional indebtedness senior or on par in right of payment to the convertible promissory notes, with certain exceptions.
Mortgaged Property Held for Sale
The amount due under the note secured by our facility leased to The Boeing Company located at 950 Explorer Boulevard in Huntsville, Alabama (the “Property”) totaling $3,115,000 was paid on January 11, 2006 in connection with the sale of the Property.
Liquidity Generally
We incurred losses from operations in the current year-to-date period and the last two fiscal years, and as of December 30, 2005, our current liabilities exceeded our current assets by $5,442,000. As a result of our failure to maintain the targeted working capital amount required under the senior secured convertible notes as of December 30, 2005, the holders have exercised their rights to require us to make $2,614,000 of additional installment payments in early March 2006 as more fully discussed above. These factors raise substantial doubt about our ability to continue as a going concern.
Management instituted a cost reduction program during the first half of fiscal 2006 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. On a quarterly basis, management will continue to evaluate revenue outlook and plans to adjust spending levels as indicated. Management believes these factors will contribute toward achieving positive cash flow from operations.
While these steps are designed to improve our cash flow from operations, we do not have sufficient cash or other sources of liquidity to make the $2,614,000 of additional installment payments that the holders of the senior secured convertible notes have demanded in early March 2006, and our ability to make subsequent installment payments will be substantially dependent on operating performance and timing of customer payments. Accordingly, we have been in discussions with the largest holder of such notes regarding proposed amendment terms, including, among other things, a reduction in the targeted working capital requirement, elimination of the March special installment payment requirement, reduction of future quarterly installment payments, reduction in the conversion price, increase in the coupon interest rate, elimination of the additional investment rights to purchase up to an additional $5 million of secured notes, prepayment terms and the issuance of additional warrants. The issuance of equity or equity rights to the note holders as a result of this amendment would have a dilutive impact on stockholders. Although we are seeking to restructure these notes on a negotiated basis, we cannot assure investors that such negotiations will be successful. If we are not successful in restructuring or refinancing our indebtedness on a negotiated basis, we may pursue other restructuring options.
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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 | |
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Total purchase consideration | | $ | 2,178 | |
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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.
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.
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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.
In the quarter ended December 30, 2005, we recognized $1,985,000 in impairment loss on certain identified intangible assets (existing technology) acquired in connection with the Larscom acquisition. Projected sales of some of the acquired products have been lower than expected. As a result, projected future cash flows related to the existing technology intangible assets were determined to be less than the carrying values. The revised carrying values of these intangible assets were calculated using discounted estimated future cash flows.
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 three months and six months ended December 30, 2005, we recorded provisions for inventory reserves totaling $276,000 and $386,000, respectively and recorded inventory reserves of $1,261,000 in connection with the acquisition of the ArcaDACS inventory acquired from Zhone. Inventory reserves totaled $10,111,000 and $8,633,000 as of December 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 $912,000 and $557,000 as of December 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 $1,232,000 and $1,290,000 as of December 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 $1,005,000 and $1,200,000 as of December 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 $60,975,000 and $59,803,000 as of December 30, 2005 and July 1, 2005, respectively.
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.
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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 need to renegotiate contractual obligations or obtain other financing; satisfaction of future financial obligations, including the senior secured convertible notes; 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 notified us on January 9, 2006 that we have failed to maintain the minimum bid price listing requirement and we have until July 10, 2006 to regain compliance. If, at anytime before July 10, 2006, the bid price of our common stock closes at $1.00 per share or more for a minimum of 10 consecutive business days, Nasdaq will provide written notification that we have achieved compliance with its rules. If we do not regain compliance by July 10, 2006, Nasdaq will provide written notification that our securities will be delisted. At that time, we may appeal Nasdaq’s determination to delist our securities to a Listing Qualifications Panel. If delisted from The Nasdaq National Market, our common stock may be eligible for trading on The Nasdaq Capital 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, our failure to meet the continue listing requirements of The Nasdaq National Market does not allow us the option of making payments of amounts due under the senior secured convertible notes in our common stock, 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. |
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• | If Tested Working Capital Falls Below Certain Defined Levels, We May Be Required To Make Additional Payments To The Holders Of The Senior secured convertible notes. We may be required to make additional payments under the senior secured convertible notes if, as of the end of each fiscal quarter during the period in which the senior secured 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 secured convertible notes and (B) 60% of our working capital amount, |
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| as determined in accordance with the terms of the senior secured convertible notes, (2) $2,000,000 or (3) such lesser amount if reduced in accordance with the terms of the senior secured 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. As discussed above, we did not meet the targeted working capital amount as of December 30, 2005, and the holders have exercised their rights to demand additional installment payments totaling $2,614,000. |
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• | We will need to restructure our indebtedness or obtain additional financing. We anticipate that we will need to restructure our indebtedness, 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 secured 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 secured 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. |
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• | Our Indebtedness and Debt Service Obligations May Adversely Affect Our Cash Flow. To the extent we are unable to satisfy our interest and installment payment obligations under our senior secured 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. |
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• | Issuance of the Shares of Common Stock Upon Conversion or Repayment of Senior secured 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 secured 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. |
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• | The Senior secured 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 secured 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 Nasdaq, 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. |
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• | The Senior secured convertible notes Are Secured by Substantially All of Our Assets. The holders of our senior secured 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 secured 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. |
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• | Consolidation Among Our Customers May Adversely Affect Sales. There has been a continuing consolidation trend in the telecommunications carrier industry, which accounts for the largest volume of our sales. Recently, Verizon Communications, our largest customer, acquired MCI, and SBC Communications acquired AT&T. Customers involved in such transactions could temporarily delay or reduce their purchases of our products as they assess and address merger integration issues and related distractions. In addition, the combined entities may re-evaluate their existing programs in connection with merger integration and delay or abandon projects that had been expected to utilize our products. |
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• | We May Not Achieve Targeted Cost Reductions. We have announced a consolidation plan and continue to implement cost reductions. We have agreed to reduce product pricing to a major customer. We may experience unforeseen costs associated with our consolidation plan, or may not fully realize the cost reductions targeted. In such event, our liquidity position would be further limited. |
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• | 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. |
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• | 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. |
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• | 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 of legacy products 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. |
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• | 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. |
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• | 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. |
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• | 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. |
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• | 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. |
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• | 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. |
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• | 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. |
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• | 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. |
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• | 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. |
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• | 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. |
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
We were subject to interest rate risks on the long-term debt secured by our property located at 950 Explorer Boulevard, Huntsville, Alabama. This obligation was paid in full on January 11, 2006 in connection with our sale of this property. Therefore, near-term market changes in interest rates for long-term debt would not impact our financial position, results of operations or cash flows.
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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
Item 4. Submission of Matters to a Vote of Security Holders
(a) | The Annual Meeting of Stockholders of Verilink Corporation was held on November 30, 2005 (the “Annual Meeting”). The voting of holders of record of 21,398,842 shares of our Common Stock outstanding at the close of business on October 3, 2005 was solicited by proxy pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended. |
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(c) | The matters voted upon at the Annual Meeting are as follows: |
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| • | To elect two (2) Class III directors to hold office until the 2008 Annual Meeting of Stockholders or until his successor has been duly elected or appointed. Leigh S. Belden: FOR: 20,683,333; WITHHELD: 715,509. Steven C. Taylor: FOR: 20,612,182; WITHHELD: 786,660. The other four members of our Board of Directors, John E. Major, John A. McGuire, Howard Oringer and Desmond P. Wilson III, have terms that continued after the meeting. |
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| • | To ratify the selection of Ehrhardt Keefe Steiner & Hottman PC as our independent registered public accounting firm for the fiscal year ending June 30, 2006. FOR: 20,757,909; AGAINST: 344,597; ABSTAINED: 296,336. |
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| • | To approve an amendment to the Company’s Amended and Restate Certificate of Incorporation to increase the authorized number of shares of common stock from 40,000,000 to 60,000,000 shares. FOR: 18,562,501; AGAINST: 2,775,691; ABSTAINED: 60,649. |
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| • | To approve the potential issuance of shares of common stock (i) upon the conversion of convertible notes and the exercise of warrants issued and issuable pursuant to a private financing completed in March 2005 and (ii) in satisfaction of certain principal and interest payment obligations under such convertible notes. FOR: 7,903,162; AGAINST: 2,731,059; ABSTAINED: 105,008; BROKER NON-VOTES: 10,659,613. |
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Item 6. Exhibits
Exhibits Index:
| Exhibit Number | | Description of Exhibit |
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| 3.1 | | Amendment to Amended and Restated Certificate of Incorporation, dated as of December 1, 2005 |
| 10.1 | | Form of Amendment Agreement dated October 31, 2005 (incorporated by reference to Exhibit 10.1 to Form 8-K dated October 31, 2005) |
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| 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 |
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| 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 |
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| 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 |
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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 |
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Date: February 21, 2006 | By: | /s/ Timothy R. Anderson |
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| | Timothy R. Anderson |
| | Vice President and Chief Financial Officer |
| | (Principal Financial and Accounting Officer) |
