UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
--------------------
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2001
or
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _______________ to _______________
Commission File Number 0-31857
ALLIANCE FIBER OPTIC PRODUCTS, INC.
(Exact name of registrant as specified in its charter)
Delaware 77-0554122
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification number)
735 North Pastoria Avenue, Sunnyvale, California 94085
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (408) 736-6900
--------------------
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [ ]
On November 9, 2001, 35,467,024 shares of the Registrant's Common Stock, $0.001
par value per share, were outstanding.
ALLIANCE FIBER OPTIC PRODUCTS, INC.
FORM 10-Q
QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001
INDEX
Page
----
Part I: Financial Information............................................... 1
Item 1: Financial Statements............................................. 1
Consolidated Balance Sheets at December 31, 2000 and
September 30, 2001............................................... 1
Consolidated Statements of Operations for the Three and
Nine Months Ended September 30, 2000 and 2001.................... 2
Consolidated Statements of Cash Flows for the Nine Months
Ended September 30, 2000 and 2001................................ 3
Notes to Consolidated Financial Statements.......................... 4
Item 2: Management's Discussion and Analysis of Financial
Condition and Results of Operations................................. 7
Item 3: Quantitative and Qualitative Disclosures About Market
Risk and Interest Rate Risk......................................... 21
Part II: Other Information................................................... 21
Item 6: Exhibits and Reports on Form 8-K................................. 21
Signature.................................................................... 22
Exhibit Index................................................................ 23
i
PART I: FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
ALLIANCE FIBER OPTIC PRODUCTS, INC.
CONSOLIDATED BALANCE SHEETS
(Unaudited, in thousands, except share data)
DEC. 31, SEPT. 30,
2000 2001
--------- ---------
ASSETS
Current assets:
Cash and cash equivalents $ 42,548 $ 13,910
Short-term investments 24,129 39,253
Accounts receivable, net 5,302 2,779
Inventories 6,792 6,946
Prepaid expense and other current assets 835 946
--------- ---------
Total current assets 79,606 63,834
Property and equipment, net 8,590 7,223
Other assets 329 689
--------- ---------
Total assets $ 88,525 $ 71,746
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 3,234 $ 1,734
Income tax payable 401 233
Accrued expenses 2,210 1,908
--------- ---------
Total current liabilities 5,845 3,875
Long-term liabilities 181 169
--------- ---------
Total liabilities 6,026 4,044
--------- ---------
Commitments and contingencies (Note 5)
Stockholders' equity
Common stock, $0.001 par value: 250,000,000 shares authorized at
December 31, 2000 and September 30, 2001; and 34,644,300 and
35,314,895 shares issued and outstanding at December 31, 2000
and September 30, 2001, respectively 35 35
Additional paid-in-capital 114,984 109,383
Receivables from stockholders (1,950) (1,832)
Deferred stock-based compensation (20,813) (8,732)
Accumulated deficit (9,576) (31,101)
Accumulated other comprehensive loss (181) (51)
--------- ---------
Stockholders' equity 82,499 67,702
--------- ---------
Total liabilities and stockholders' equity $ 88,525 $ 71,746
========= =========
The accompanying notes are an integral part of these
consolidated financial statements
1
ALLIANCE FIBER OPTIC PRODUCTS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited, in thousands, except per share data)
THREE MONTHS ENDED SEPT. 30, NINE MONTHS ENDED SEPT. 30,
2000 2001 2000 2001
-------- -------- -------- --------
Revenues $ 5,961 $ 4,280 $ 13,375 $ 16,217
Cost of revenues 3,613 2,919 7,750 22,743
Non-cash compensation expense 269 318 377 1,230
-------- -------- -------- --------
Total cost of revenues 3,882 3,237 8,127 23,973
-------- -------- -------- --------
Gross profit (loss) 2,079 1,043 5,248 (7,756)
Operating Expenses
Research and development 823 1,744 2,731 5,202
Non-cash compensation expense 617 448 854 2,970
-------- -------- -------- --------
Total research and development 1,440 2,192 3,585 8,172
Sales and marketing 520 612 1,335 2,154
Non-cash compensation expense 117 6 192 591
-------- -------- -------- --------
Total sales and marketing 637 618 1,527 2,745
General and administrative 527 999 1,349 3,106
Non-cash compensation charge 2,653 (248) 3,817 1,488
-------- -------- -------- --------
Total general and administrative 3,180 751 5,166 4,594
-------- -------- -------- --------
Total operating expenses 5,257 3,561 10,278 15,511
-------- -------- -------- --------
Loss from operations (3,178) (2,518) (5,030) (23,267)
Interest and other income, net 337 347 526 1,966
-------- -------- -------- --------
Loss before income taxes (2,841) (2,171) (4,504) (21,301)
Income tax provision 87 97 158 223
-------- -------- -------- --------
Net loss (2,928) (2,268) (4,662) (21,524)
Deemed preferred stock dividend (14,758) -- (14,758) --
-------- -------- -------- --------
Net loss attributable to common stockholders $(17,686) $ (2,268) $(19,420) $(21,524)
======== ======== ======== ========
Net loss per share attributable to common stockholders:
Basic and diluted $ (3.34) $ (0.07) $ (3.68) $ (0.65)
======== ======== ======== ========
Shares used in computing net loss per share attributable to
common stockholders:
Basic and diluted 5,295 33,439 5,284 33,021
======== ======== ======== ========
The accompanying notes are an integral part of these
consolidated financial statements
2
ALLIANCE FIBER OPTIC PRODUCTS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited, in thousands)
NINE MONTHS ENDED
SEPTEMBER 30
------------------------
2000 2001
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss: $ (4,662) $(21,524)
Adjustments to reconcile net loss to net cash used
in operating activities:
Depreciation 618 37
Amortization of deferred compensation 5,240 6,279
Impairment in property and equipment -- 5,200
Provision for inventory -- 6,543
Changes in assets and liabilities:
Accounts receivable, net (1,522) 2,575
Inventories (3,201) (6,733)
Prepaid expenses and other assets (397) (537)
Accounts payable 2,067 (1,510)
Income tax payable and accrued expenses 1,297 (478)
Other long-term liabilities 80 (11)
-------- --------
Net cash used in operating activities (480) (10,159)
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of short-term investments -- (14,946)
Purchase of property and equipment (3,716) (3,870)
-------- --------
Net cash used in investing activities (3,716) (18,816)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from bank borrowings 459 --
Repayments of bank borrowings (60) --
Proceeds from issuance of Series B preferred stock 280 --
Proceeds from issuance of Series C preferred stock 27,441 --
Proceeds from issuance of common stock under ESPP -- 212
Proceeds from the exercise of common stock options 64 108
-------- --------
Net cash provided by financing activities 28,184 320
-------- --------
Effect of exchange rate changes on cash and cash equivalents 10 17
-------- --------
Net increase (decrease) in cash and cash equivalents 23,998 (28,638)
Cash and cash equivalents at beginning of period 6,139 42,548
-------- --------
Cash and cash equivalents at end of period $ 30,137 $ 13,910
======== ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Income taxes paid $ 158 $ 391
======== ========
The accompanying notes are an integral part of these
consolidated financial statements
3
ALLIANCE FIBER OPTIC PRODUCTS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. THE COMPANY AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
THE COMPANY
Alliance Fiber Optic Products, Inc. (the "Company") was incorporated in
California on December 12, 1995 and reincorporated in Delaware on October 19,
2000. The Company designs, manufactures and markets fiber optic components for
communications equipment manufacturers. The Company's principal business
location is Sunnyvale, California. The Company has manufacturing and product
development capabilities in the United States and Taiwan as well as a training
facility in China.
BASIS OF PRESENTATION
The consolidated financial information as of September 30, 2001 included
herein is unaudited and has been prepared by the Company in accordance with
generally accepted accounting principles and reflects all adjustments,
consisting only of normal recurring adjustments, which in the opinion of
management are necessary to state fairly the Company's consolidated financial
position, results of its consolidated operations, and consolidated cash flows
for the periods presented. The December 31, 2000 balance sheet was derived from
audited financial statements on that date.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and the
disclosure of contingent assets and liabilities at the date of the financial
statements as well as the reported amounts of revenue and expenses during the
reporting period. Actual results will differ from those estimates, and such
differences may be material to the financial statements.
These financial statements should be read in conjunction with the
Company's audited consolidated financial statements for the year ended December
31, 2000 included in the Company's Annual Report on Form 10-K, as filed on April
2, 2001, with the Securities and Exchange Commission ("SEC"). The results of
operations for the three and nine months ended September 30, 2001 are not
necessarily indicative of the results to be expected for any future periods.
REVENUE RECOGNITION
The Company recognizes revenue upon the shipment of its products to the
customer, provided that the Company has received a purchase order, the price is
fixed and collection of the resulting receivable is probable. Subsequent to the
sale of its products, the Company has no obligation to provide any modification
or customization upgrades, enhancements or postcontract customer support.
Provisions for return allowances and warranties are recorded at the time revenue
is recognized based on the Company's historical experience.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board (" FASB") issued
Statement of Financial Accounting Standards No. 133, "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 established new standards of
accounting and reporting for derivative instruments and hedging activities. SFAS
No. 133 requires that all derivatives be recognized at fair value in the
statement of financial position, and that the corresponding gains or losses be
reported either in the statement of operations or as a component of
comprehensive income, depending on the type of hedging relationship that exists.
The Company adopted SFAS No. 133 in the first quarter of fiscal year 2001 and
the adoption of SFAS No. 133 did not have a material effect on the Company's
consolidated financial statements.
4
In June 2001, the FASB issued two Statements: Statement No. 141,
"Business Combinations"; and Statement No. 142, "Goodwill and Other Intangible
Assets". The Statements:
- Prohibit use of the pooling-of-interest method. All business
combinations must be accounted for using the purchase method of
accounting.
- Establish a new accounting standard for goodwill acquired in a
business combination. Goodwill will continue to be recognized as
an asset but will not be amortized as currently required by APB
No. 17, "Intangible Assets."
- Establish a new method of testing goodwill for impairment.
Goodwill must be separately tested for impairment using a
fair-value-based approach. Goodwill must be tested for impairment
at a level referred to as a reporting unit, which is generally a
level lower than that of the total entity.
SFAS No. 141 applies to all business combinations completed after June
30, 2001. SFAS No. 142 is effective for fiscal years beginning after December
15, 2001. These new Statements are not expected to affect the Company's
financial statements.
2. INVENTORIES (IN THOUSANDS)
DECEMBER 31, SEPTEMBER 30,
2000 2001
------------ -------------
Finished goods $ 2,107 $ 1,939
Work-in-process 2,471 3,239
Raw materials 2,214 1,768
------- -------
$ 6,792 $ 6,946
======= =======
3. LOSS PER SHARE
NET LOSS PER SHARE ATTRIBUTABLE TO COMMON STOCKHOLDERS
Basic net loss per share is computed by dividing net loss attributable
to common stockholders for the period by the weighted average number of shares
of common stock outstanding during the period. Diluted net loss per share is
computed by dividing the net loss for the period by the weighted average number
of common and potential common equivalent shares outstanding during the period.
The calculation of diluted net loss per share excludes potential common shares
if the effect is anti-dilutive. Potential common shares are composed of shares
of common stock subject to repurchase rights, common stock issuable upon the
exercise of stock options and common stock issuable upon conversion of
mandatorily redeemable convertible preferred stock.
5
The following table sets forth the computation of basic and diluted net
loss per share for the periods indicated (in thousands, except for per share
data):
4. NET LOSS PER SHARE
NINE MONTHS ENDED SEPT. 30,
---------------------------
2000 2001
-------- --------
Numerator:
Net loss attributable to common stockholders $(19,420) $(21,524)
======== ========
Denominator:
Shares used in computing net loss per share:
Weighted average of common shares outstanding 6,062 34,926
Less: Weighted average of shares subject to repurchase right (778) (1,905)
-------- --------
Basic and diluted 5,284 33,021
======== ========
Net loss per share attributable to common stockholders:
Basic and diluted $ (3.68) $ (0.65)
======== ========
Anti-dilutive securities, including options, warrants and
mandatorily redeemable convertible preferred stock, not
included in net loss per share calculation 24,993 2,907
======== ========
The following outstanding options and mandatorily redeemable convertible
preferred stock were excluded from the computation of diluted net loss per
share (in thousands):
NINE MONTHS ENDED SEPT. 30,
---------------------------
2000 2001
------ -----
Options to purchase common stock 2,593 2,907
Mandatorily redeemable convertible preferred stock 22,400 --
------ -----
24,993 2,907
====== =====
5. GEOGRAPHIC SEGMENT INFORMATION
The Company operates in a single industry segment. This industry segment
is characterized by rapid technological change and significant competition.
Certain components used in manufacturing the Company's products have relatively
few alternative sources of supply, and establishing additional or replacement
suppliers for such components cannot be accomplished quickly.
6
The following is a summary of the Company's revenues generated from, and
identifiable assets situated in, geographic segments (in thousands):
NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------
2000 2001
-------- --------
REVENUES
United States $ 12,340 $ 14,593
Taiwan 1,035 1,624
-------- --------
Total $ 13,375 $ 16,217
======== ========
DECEMBER 31, SEPTEMBER 30,
2000 2001
------------ -------------
IDENTIFIABLE ASSETS
United States $ 80,548 $ 62,391
Taiwan 7,771 9,011
China 206 344
-------- --------
Total $ 88,525 $ 71,746
======== ========
6. COMMITMENTS AND CONTINGENCIES
From time to time, the Company may be involved in litigation in the
normal course of business. Management believes that the outcome of any such
matters to date will not have a material adverse effect on the Company's
consolidated financial statements.
7. IMPAIRMENT ON PROPERTY AND EQUIPMENT AND PROVISION FOR INVENTORY
Due to the decline in business conditions, the Company determined that
demand for DWDM products will be significantly lower in the future than it
originally expected and, therefore, that the carrying value of certain property
and equipment used in the manufacture of its DWDM products was impaired. The
Company recorded a charge of $5.2 million during the second quarter of 2001
related to the impairment, measured as the amount by which the carrying amount
exceeded the present value of the estimated future cash flows for DWDM products.
The Company also recorded a provision for inventory totaling $6.5
million during the second quarter of 2001, of which substantially all related to
an excess inventory charge. This excess inventory charge was due to a sudden and
significant decrease in forecasted revenue and was calculated in accordance with
the Company's policy of reserving against inventory levels in excess of 12-month
demand for each specific product.
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
When used in this discussion, the words, "expects," "anticipates,"
"believes," "estimates," "plans," and similar expressions are intended to
identify forward-looking statements. These statements, which include statements
as to our profitability, statements as to our net losses, our sources of revenue
and anticipated revenue, the need for future inventory write-downs, our ability
to maintain and develop supplier relationships, demand for our products, the
fluctuation of our cost of revenues as a percentage of revenues, our ability to
collect accounts receivable in the People's Republic of China and the
possibility of additional allowances, the impact of the power crisis in
California, the impact of terrorist attacks in the United States and conflicts
worldwide on the economy and demand for our products, the effects of a further
slowdown in the economy, our plans to expand our product development efforts,
7
our plans to expand our operations domestically and internationally, our need to
increase international sales, our plans to hire additional employees, our
exposure to currency rate fluctuations, the amount and mix of our anticipated
expenditures, our need for additional financing, our ability to establish and
maintain relationships with key customers, our competitors, further
consolidation in our industry, our reliance on certain of our products to
generate revenues, our ability to maintain appropriate inventory, our
investments and the effects of interest rate risk on our investments, the
effects of changes in foreign currency exchange rates, and factors that affect a
customer's decision to chose a supplier, are subject to risks and uncertainties
that could cause actual results to differ materially from those projected. These
risks and uncertainties include, but are not limited to, those risks discussed
below, as well as the competition from other entities including the impact of
competitive products and pricing, timely design acceptance by our customers, our
success attracting new customers, our customers adopting our new products,
timely introduction of new technologies, the need for and magnitude of future
inventory write-downs or impairment charges, our ability to ramp new products
into volume production, our ability to attract and retain highly skilled
personnel, industry wide shifts in supply and demand for optical components and
modules, industry overcapacity, further terrorist attacks in the United States
and resulting conflict worldwide, financial stability in foreign markets, a
further decline in the United States economy, and the matters discussed in
"Factors That May Affect Results." These forward-looking statements speak only
as of the date hereof. The Company expressly disclaims any obligation or
undertaking to release publicly any updates or revisions to any forward-looking
statements contained herein to reflect any change in the Company's expectations
with regard thereto or any change in events, conditions or circumstances on
which any such statement is based.
This Management's Discussion and Analysis of Financial Condition and
Results of Operations should be read in conjunction with the section entitled
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" in the Company's Annual Report on Form 10-K, and the notes thereto,
for the year ended December 31, 2000.
OVERVIEW
We were founded in December 1995 and commenced operations to design,
manufacture and market fiber optic interconnect products, which we term our
Optical Path Integration Solution, or OPIS, products. We also distributed a
cable television transmission product line, which we discontinued in 1997. Since
1997, we have broadened our OPIS product line which now includes attenuators and
fused fiber products. Most of these products were introduced between 1997 and
1999. In early 1999, we started developing our dense wavelength division
multiplexing, or DWDM, and other wavelength management products based in part on
our proprietary technology. We started selling our DWDM devices in limited
production quantities in July 2000.
Substantially all of our OPIS products are manufactured by our Taiwan
subsidiary and substantially all of our DWDM products are manufactured in our
Sunnyvale, California facility.
From our inception, we have derived nearly all of our revenues from our
OPIS products. For the year ended December 31, 2000, revenues from our DWDM
products represented approximately 8.3% of revenues. In the first nine months of
2001, our DWDM-related products contributed revenues of $1.5 million, or 9.1% of
total revenues.
We market and sell our products predominantly through our direct sales
force. Although we derived a significant portion of our revenues between 1996
and 1998 from overseas customers, an increasing percentage of our sales since
early 1999 have been in North America. For the nine months ended September 30,
2000 and 2001, the revenues we derived from sales outside of North America were
16.4% and 17.7%, respectively. For the three months ended September 30, 2001,
sales to Ortronics represented 10.1% of our total sales. For the nine months
ended September 30, 2001, no single customer represented 10% or more of our
total sales.
Demand for products in the telecommunications industry, including our
products, declined dramatically during the first quarter of 2001 and continued
to decline through third quarter of 2001. During the first two quarters of 2001,
we experienced a slowdown in customer orders as well as cancellations and
rescheduling of orders to future quarters. As a result, our revenues have
declined in each of the first two quarters of 2001. Customer order rates began
to stabilize in the third quarter of 2001, resulting in some stabilization of
revenue. Additionally, sales to customers located in the People's Republic of
China, net of allowances, were approximately $1.3 million for the
8
nine months ended September 30, 2001, and net accounts receivables at that date
were $985,000. Although we believe this amount is collectible, additional
allowances may have to be taken against this amount in the future.
In November 2000, we completed our initial public offering by issuing
4,500,000 shares of common stock at a price of $11.00 per share. The proceeds of
the offering, net of costs associated with the registration and issuance of the
shares, totaled $44.4 million. Subsequent to the offering and in accordance with
the terms of the agreement with the underwriters, we repurchased approximately
76,000 shares of common stock at an aggregate purchase price of $782,000.
In December 2000, we established a subsidiary in the People's Republic
of China and commenced operations in a facility near the city of Shenzhen. We
entered into a lease for a facility in April 2001 but cancelled the lease,
without penalty, in the third quarter of 2001. In the same period, we entered
into a lease for a new site, consisting of approximately 3,229 square feet, near
Shenzhen, that operates as a manufacturing training facility.
Several personnel changes transpired in the third quarter of 2001. Mr.
John M. Harland, the Chief Financial Officer, left the Company to pursue other
interests. Mr. James Lee, General Manager for the Taiwan subsidiary, also
resigned, and has been replaced by Mr. Robinson Chien. On November 1, 2001, Mr.
Peter Morris resigned from our Board of Directors effective as of November 14,
2001.
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
financial data as a percentage of revenues:
THREE MONTHS ENDED SEPT. 30, NINE MONTHS ENDED SEPT. 30,
---------------------------- ---------------------------
2000 2001 2000 2001
------ ----- ------ ------
Revenues ...................................... 100.0% 100.0% 100.0% 100.0%
Cost of revenues .............................. 65.1% 75.6% 60.8% 147.8%
------ ----- ------ ------
Gross profit (loss) ........................... 34.9% 24.4% 39.2% (47.8%)
Operating Expenses
Research and development ................. 24.2% 51.2% 26.8% 50.4%
Sales and marketing ...................... 10.7% 14.4% 11.4% 16.9%
General and administrative ............... 53.3% 17.6% 38.6% 28.3%
------ ----- ------ ------
Total operating expenses ............ 88.2% 83.2% 76.8% 95.6%
------ ----- ------ ------
Loss from operations .......................... (53.3%) (58.8%) (37.6%) (143.4%)
Interest and other income, net ................ 5.7% 8.1% 3.9% 12.1%
------ ----- ------ ------
Loss before income taxes ...................... (47.6%) (50.7%) (33.7%) (131.3%)
Income tax provision .......................... 1.5% 2.3% 1.2% 1.4%
------ ----- ------ ------
Net loss ...................................... (49.1%) (53.0%) (34.9%) (132.7%)
Deemed preferred stock dividend ............... (247.6%) -- (110.3%) --
------ ----- ------ ------
Net loss attributable to common stockholders .. (296.7%) (53.0%) (145.2%) (132.7%)
====== ===== ====== ======
Revenues. Revenues were $6.0 million and $4.3 million for the three
months ended September 30, 2000 and 2001, respectively. Revenues decreased 28.2%
from 2000 to 2001 due primarily to adverse market conditions that lead to lower
overall demand for our products. Revenues from our DWDM-related products were
$373,000 for the three months ended September 30, 2001. Our revenues were $13.4
million and $16.2 million for the nine months ended September 30, 2000 and 2001,
respectively. Revenues for the nine months ended September 30, 2001 increased
21.2% from the same period in 2000 due to higher volume sales of our OPIS
products and, to a lesser extent, the stabilizing sales of our DWDM products and
the introduction of our VOA products. Our DWDM-related products accounted for
$1.5 million in revenues for the nine months ended September 30, 2001.
9
Gross Profit (Loss). Gross profit (loss), including non-cash
compensation expense, decreased in absolute dollars from $2.1 million, or 34.9%
of revenues, for the three months ended September 30, 2000 to $1.0 million, or
24.4% of revenues, for the same period in 2001. Excluding non-cash compensation
expense, gross profit decreased from $2.3 million, or 39.4% of revenues for the
three months ended September 30, 2000, to $1.4 million, or 31.8% of revenues,
for the same period in 2001. Gross profit (loss), including non-cash
compensation expense, decreased in absolute dollars from $5.2 million, or 39.2%
of revenues, for the nine months ended September 30, 2000 to a loss of $7.8
million, or (47.8%) of revenues, for the same period in 2001. Excluding non-cash
compensation expense, gross profit (loss) decreased from $5.6 million, or 42.1%
of revenues for the nine months ended September 30, 2000, to a loss of $6.5
million, or (40.2%) of revenues, for the same period in 2001.
The decrease in margins was primarily due to unabsorbed overhead in our
DWDM manufacturing operations as a result of low production volumes during the
third quarter of 2001. In the second quarter of 2001, we recorded an excess
inventory charge of $6.5 million and an asset impairment charge of $5.2 million
primarily related to DWDM products.
Due to the unforeseeable and significant decrease in demand for our
products, inventory levels exceeded our requirements based on current 12-month
sales forecasts. This excess inventory charge was calculated based on the
inventory levels in excess of 12-month demand for each specific product. We do
not anticipate that the excess inventory subject to this provision will be used
at a later date based on our current 12-month demand forecast.
We expect our gross profit as a percentage of revenues to continue to be
negatively impacted in the near term due to low production volumes and
unabsorbed overhead. The anticipated growth of our DWDM product sales has been
significantly impacted by the overall industry slowdown. After the excess
inventory charge in the second quarter of 2001, we had approximately $2.4
million in DWDM-related inventory on hand at September 30, 2001. Although we
continue to take steps to attempt to manage future inventory levels, there is a
risk that additional write-downs of our inventory may have to be taken in future
periods.
Research and Development Expenses. Research and development expenses,
including non-cash compensation expense, increased from $1.4 million, or 24.2%
of revenues, for the three months ended September 30, 2000 to $2.2 million, or
51.2% of revenues, for the same period in 2001. Excluding non-cash compensation
expense, research and development expenses increased from $823,000, or 13.8% of
revenues, for the three months ended September 30, 2000 to $1.7 million, or
40.7% of revenues, for the same period in 2001. Research and development
expenses, including non-cash compensation expense, increased from $3.6 million,
or 26.8% of revenues, for the nine months ended September 30, 2000 to $8.2
million, or 50.4% of revenues, for the same period in 2001. Excluding non-cash
compensation expense, research and development expenses increased from $2.7
million, or 20.4% of revenues, for the nine months ended September 30, 2000 to
$5.2 million, or 32.1% of revenues, for the same period in 2001. Excluding
non-cash compensation expense, these increases in absolute dollars were
primarily due to costs related to the development of new products and increases
in the number of research and development personnel and related costs. We expect
our research and development expenses to increase in absolute dollars in 2001.
Sales and Marketing Expenses. Sales and marketing expenses, including
non-cash compensation expense, decreased from $637,000, or 10.7% of revenues,
for the three months ended September 30, 2000 to $618,000, or 14.4% of revenues,
for the same period in 2001. Excluding non-cash compensation expense, sales and
marketing expenses increased from $520,000, or 8.7% of revenues, for the three
months ended September 30, 2000 to $612,000, or 14.3% of revenues, for the three
months ended September 30, 2001. This increase was due to the expansion of our
sales and marketing efforts in the third quarter of 2001. Sales and marketing
expenses, including non-cash compensation expense, increased from $1.5 million,
or 11.4% of revenues, for the nine months ended September 30, 2000 to $2.7
million, or 16.9% of revenues, for the same period in 2001. Excluding non-cash
compensation expense, sales and marketing expenses increased from $1.3 million,
or 10.0% of revenues, for the nine months ended September 30, 2000 to $2.2
million, or 13.3% of revenues, for the same period in 2001. This increase was
due to hiring additional sales and marketing personnel and expanding our sales
and marketing efforts. These increases were attributable primarily to the
expansion of our sales and marketing efforts. We expect our sales and marketing
expenses to continue to be relatively flat over the balance of 2001.
General and Administrative Expenses. General and administrative
expenses, including non-cash compensation expense, decreased in absolute dollars
from $3.2 million, or 53.3% of revenues, for the three months
10
ended September 30, 2000 to $751,000, or 17.6% of revenues, for the same period
in 2001. Excluding non-cash compensation expense, general and administrative
expenses increased from $527,000, or 8.8% of revenues, for the three months
ended September 30, 2000 to $999,000, or 23.3% of revenues, for the same period
in 2001. General and administrative expenses, including non-cash compensation
expense, decreased in absolute dollars from $5.2 million, or 38.6% of revenues,
for the nine months ended September 30, 2000 to $4.6 million, or 28.3% of
revenues, for the same period in 2001. Excluding non-cash compensation expense,
general and administrative expenses increased from $1.3 million, or 10.1% of
revenues, for the nine months ended September 30, 2000 to $3.1 million, or 19.2%
of revenues, for the nine months ended September 30, 2001. These increases were
primarily due to hiring additional personnel and associated expenses necessary
to support our increased scale of operations and the requirements of being a
public company. We expect our general and administrative expenses to be lower
over the next two quarters in absolute dollars.
Interest and Other Income, Net. Interest and other income, net, was
$337,000 and $347,000 for the three months ended September 30, 2000 and 2001,
respectively. Interest and other income, net, was $526,000 and $2.0 million for
the nine months ended September 30, 2000 and 2001, respectively. The increases
from 2000 to 2001, for both period, were the result of significantly higher
average cash balances resulting from proceeds from a private round of preferred
stock financing in July 2000 and our initial public offering of common stock in
November 2000.
Income Taxes. Income taxes were $87,000 and $97,000 for the three months
ended September 30, 2000 and 2001, respectively, and $158,000 and $223,000 for
the nine months ended September 30, 2000 and 2001, respectively. The income tax
expense in these periods was the result of taxable income from our Taiwan
subsidiary. Non-cash compensation charges are not deductible for income tax
purposes, which contributed in the taxable income position.
LIQUIDITY AND CAPITAL RESOURCES
Since inception, we have financed our operations primarily through
private sales of convertible preferred stock and bank debt. Additionally, in
November 2000, we completed our initial public offering of common stock, raising
approximately $44.4 million, net of costs and expenses. At September 30, 2001,
we had cash and cash equivalents of $13.9 million and short-term investments of
$39.3 million.
Net cash used in operating activities was $10.2 million for the nine
months ended September 30, 2001 and was primarily attributable to our net loss
of $21.5 million and an increase in inventories of $6.7 million, partially
offset by non-cash stock-based compensation expense of $6.3 million, non-cash
impairment charge for property and equipment of $5.2 million and provision for
excess inventories of $6.5 million. Net cash used in operating activities was
$480,000 for the nine months ended September 30, 2000 and was primarily
attributable to our net loss of $4.7 million, an increase in inventories of $3.2
million and an increase in accounts receivable of $1.5 million, largely offset
by non-cash stock-based compensation expense of $5.2 million, an increase in
accounts payable of $2.1 million and an increase in income tax payable of $1.3
million. The increase in inventories, accounts receivable and accounts payable
was the result of the expansion of operations during the period. Income tax
payable increased as a result of the increase in taxable income.
Cash used in investing activities was $3.7 million and $18.8 million for
the nine months ended September 30, 2000 and 2001, respectively. In the nine
months ended September 30, 2000, all of $3.7 million was used to acquire
property and equipment. In the nine months ended September 30, 2001, $14.9
million was invested in high-grade, short-term investments, while $3.9 million
was used to acquire property and equipment.
Cash generated by financing activities was $28.2 million for the nine
months ended September 30, 2000, primarily the result of $27.4 million in
proceeds from the sale of shares of our Series C preferred stock. Other
contributing factors were $459,000 from bank loans, $280,000 in proceeds from
the sale of shares of our Series B preferred stock, and $64,000 in proceeds from
the exercise of common stock options, which was offset by the repayment of bank
loans of $60,000. For the nine months ended September 30, 2001, cash generated
by financing activities was $320,000, resulting from proceeds from the exercise
of common stock options and stock issued through our employee stock purchase
plan.
We believe that our current cash, cash equivalents and short-term
investments will be sufficient to meet our anticipated cash needs for working
capital and capital expenditures for at least the next 12 months. However, our
11
future growth, including potential acquisitions, may require additional funding.
If cash generated from operations is insufficient to satisfy our long-term
liquidity requirements, we may need to raise capital through additional equity
or debt financings or additional credit facilities. If additional funds are
raised through the issuance of securities, these securities could have rights,
preferences and privileges senior to holders of common stock, and the terms of
any debt facility could impose restrictions on our operations. The sale of
additional equity or debt securities could result in additional dilution to our
stockholders, and additional financing may not be available in amounts or on
terms acceptable to us, if at all. If we are unable to obtain additional
financing, we may be required to reduce the scope of our planned product
development and marketing efforts, which could harm our business, financial
condition and operating results.
FACTORS THAT MAY AFFECT RESULTS
WE HAVE A HISTORY OF LOSSES, EXPECT FUTURE LOSSES AND MAY NOT BE ABLE TO
GENERATE SUFFICIENT REVENUES IN THE FUTURE TO ACHIEVE AND SUSTAIN PROFITABILITY.
We incurred operating losses of approximately $4.7 million and $21.5
million in the first nine months of fiscal 2000 and 2001, respectively, and
expect that our net losses and negative cash flows will continue for the
foreseeable future as we continue to invest in our business. As of September 30,
2001, we had an accumulated deficit of approximately $31.1 million.
Although we are currently experiencing decreased demand for our products
and are not currently expanding our manufacturing capacity, we are hopeful that
demand will increase in the future. If this happens, we expect to incur
significant and increasing expenses for expansion of our manufacturing
operations, research and development, sales and marketing, and administration,
and in developing direct sales and distribution channels. In particular, given
our early stage of development, our increasing operating expenses, and the rate
at which competition in our industry continues to intensify and the significant
downturn in demand for our products, we may not be able to adequately control
our costs and expenses or achieve or maintain adequate operating margins. As a
result, to achieve and maintain profitability, we will need to generate and
sustain substantially higher revenues while maintaining reasonable cost and
expense levels. We may not be able to achieve and sustain profitability on a
quarterly or an annual basis.
OUR QUARTERLY AND ANNUAL FINANCIAL RESULTS HAVE HISTORICALLY FLUCTUATED DUE
PRIMARILY TO INTRODUCTION OF, DEMAND FOR, AND SALES OF OUR PRODUCTS, AND FUTURE
FLUCTUATIONS MAY CAUSE OUR STOCK PRICE TO DECLINE.
We believe that period-to-period comparisons of our operating results
are not a good indication of our future performance. Our quarterly operating
results have fluctuated in the past and are likely to fluctuate significantly in
the future due to a number of factors. For example, the timing and expenses
associated with product introductions, the timing and extent of product sales,
the mix of products sold and significant decreases in the demand for our
products have caused our operating results to fluctuate in the past. Because we
incur operating expenses based on anticipated revenue trends, and a high
percentage of our expenses are fixed in the short term, any delay in generating
or recognizing revenues or any decrease in revenues could significantly harm our
quarterly results of operations. Other factors, many of which are more fully
discussed in other risk factors below, may also cause our results to fluctuate.
Many of the factors that may cause our results to fluctuate are outside of our
control. If our quarterly or annual operating results do not meet the
expectations of investors and securities analysts, the trading price of our
common stock could significantly decline.
OUR OPTICAL PATH INTEGRATION SOLUTION (OPIS) PRODUCTS HAVE HISTORICALLY
REPRESENTED SUBSTANTIALLY ALL OF OUR REVENUES, AND IF WE ARE UNSUCCESSFUL IN
COMMERCIALLY SELLING OUR DWDM-RELATED PRODUCTS, OUR BUSINESS WILL BE SERIOUSLY
HARMED.
Sales of our OPIS products accounted for over 90% of our revenues in the
nine months ended September 30, 2001 and substantially all of our historical
revenues. We expect to substantially depend on these products for our near-term
revenues. Any significant decline in the price of, or demand for, these
products, or failure to increase their market acceptance, would seriously harm
our business. In addition, we believe that our future growth and a significant
portion of our future revenues will depend on the commercial success of our
DWDM-related products, which we began shipping commercially in July 2000. Demand
for these products declined sharply during the second quarter of 2001, and
continued to decline in the third quarter of 2001. Based on the reduced demand
and
12
reduced revenue projections for this product line, we took a charge of $6.5
million against excess DWDM inventory in the quarter ended June 30, 2001. In
addition, we recorded an impairment charge of $5.2 million for the property and
equipment used to manufacture our DWDM-related products in the period ended June
30, 2001. If demand does not increase and our target customers do not adopt and
purchase our DWDM-related products, our revenues may decline further and we may
have to write-off additional inventory currently on our books.
IF WE CANNOT ATTRACT MORE OPTICAL COMMUNICATIONS EQUIPMENT MANUFACTURERS TO
PURCHASE OUR PRODUCTS, WE MAY NOT BE ABLE TO INCREASE OR SUSTAIN OUR REVENUES.
Our future success will depend on our ability to migrate existing
customers to our new products and our ability to attract additional customers.
Many of our present customers are relatively new companies. The growth of our
customer base could be adversely affected by:
- customer unwillingness to implement our products;
- any delays or difficulties that we may incur in completing the
development and introduction of our planned products or product
enhancements;
- the success of our customers;
- new product introductions by our competitors;
- any failure of our products to perform as expected; or
- any difficulty we may incur in meeting customers' delivery
requirements or product specifications
The recent downturn of the economy has affected the telecommunications
industry. Telecommunications companies have cut back on their capital
expenditure budgets, which could further decrease demand for equipment and
parts, including our products. This may have an adverse effect on the demand for
fiber optic products and may negatively impact the growth of our customer base.
THE MARKET FOR FIBER OPTIC COMPONENTS IS INCREASINGLY COMPETITIVE, AND IF WE ARE
UNABLE TO COMPETE SUCCESSFULLY OUR REVENUES COULD DECLINE.
The market for fiber optic components is intensely competitive. We
believe that our principal competitors are the major manufacturers of optical
components and integrated modules, including vendors selling to third parties
and business divisions within communications equipment suppliers. Our principal
competitors in the components market include Avanex, Corning, DiCon Fiberoptics,
Gould, JDS Uniphase, which acquired E-TEK Dynamics and SDL, Lucent, Luminent,
New Focus, Nortel, Oplink, Stratos Lightwave and Tyco Electronics. We believe
that we primarily compete with diversified suppliers for the majority of our
product line and to a lesser extent with niche companies that offer a more
limited product line. Competitors in any portion of our business may also
rapidly become competitors in other portions of our business. In addition, our
industry has recently experienced significant consolidation, and we anticipate
that further consolidation will occur. This consolidation has further increased
competition.
Many of our current and potential competitors have significantly greater
financial, technical, marketing, purchasing, manufacturing and other resources
than we do. As a result, these competitors may be able to respond more quickly
to new or emerging technologies and to changes in customer requirements, to
devote greater resources to the development, promotion and sale of products, to
negotiate lower prices on raw materials and components, or to deliver
competitive products at lower prices.
Several of our existing and potential customers are also current and
potential competitors of ours. These companies may develop or acquire additional
competitive products or technologies in the future and subsequently reduce or
cease their purchases from us. In light of the consolidation in the optical
networking industry, we also believe that the size of suppliers will be an
increasingly important part of a purchaser's decision-making criteria in the
future. We may not be able to compete successfully with existing or new
competitors, nor can we ensure that the
13
competitive pressures we face will not result in lower prices for our products,
loss of market share, or reduced gross margins, any of which could harm our
business.
New and competing technologies are emerging due to increased competition
and customer demand. The introduction of products incorporating new or competing
technologies or the emergence of new industry standards could make our existing
products noncompetitive. For example, there are technologies for the design of
wavelength division multiplexers that compete with the technology that we
incorporate in our products. If our products do not incorporate technologies
demanded by customers, we could lose market share and our business would suffer.
IF WE FAIL TO EFFECTIVELY MANAGE OUR OPERATIONS, SPECIFICALLY GIVEN THE RECENT
SUDDEN AND DRAMATIC DOWNTURN IN DEMAND FOR OUR PRODUCTS, OUR OPERATING RESULTS
COULD BE HARMED.
We had rapidly expanded our operations domestically and internationally
in the final two quarters of 2000. We have had to carefully manage and
re-evaluate this expansion given the sudden and dramatic downturn in demand for
our products experienced in the first three quarters of 2001. Additionally, we
implemented a reduction in force during the second and third quarter of 2001 to
more closely match our operations to this decreased demand for our products. As
of September 30, 2001, we had a total of 146 full-time employees in Sunnyvale,
California, 230 full-time employees in Taiwan, and 33 full-time employees in
China. Matching the scale of our operations with the recent demand fluctuations,
combined with the challenges of expanding and managing geographically dispersed
operations, has placed, and will continue to place, a significant strain on our
management and resources. To manage the expected fluctuations in our operations
and personnel, we will be required to:
- improve existing and implement new operational, financial and
management controls, reporting systems and procedures;
- hire, train, motivate and manage additional qualified personnel,
especially if we experience a significant increase in demand for
our products;
- effectively expand or reduce our manufacturing capacity,
attempting to adjust it to customer demand; and
- effectively manage relationships with our customers, suppliers,
representatives and other third parties.
In addition, we will need to coordinate our domestic and international
operations and establish the necessary infrastructure to implement our
international strategy. If we are not able to manage our growth in an efficient
and timely manner, our business will be severely harmed.
Our success also depends, to a large degree, on the efficient and
uninterrupted operation of our facilities. We have expanded our manufacturing
facilities in Taiwan and manufacture many of our products there. Although we
terminated the lease for our China manufacturing site, recently we established a
new manufacturing training facility in China. There is significant political
tension between Taiwan and China. If there is an outbreak of hostilities between
Taiwan and China, our manufacturing operations may be disrupted or we may have
to relocate our manufacturing operations. Tensions between Taiwan and China may
also affect our training facility in China. We plan to lease additional
facilities, as necessary, to support our growth. Relocating a portion of our
employees could cause temporary disruptions in our operations and divert
management's attention. Because of past shortages of office and manufacturing
space in Northern California, we cannot assure you that we will be able to
locate suitable space on acceptable terms or at all in the future.
BECAUSE OF THE TIME IT TAKES TO DEVELOP FIBER OPTIC COMPONENTS, WE INCUR
SUBSTANTIAL EXPENSES FOR WHICH WE MAY NOT EARN ASSOCIATED REVENUES.
The development of new or enhanced fiber optic products is a complex and
uncertain process. We may experience design, manufacturing, marketing and other
difficulties that could delay or prevent the development, introduction or
marketing of new products and enhancements. Development costs and expenses are
incurred before we generate revenues from sales of products resulting from these
efforts. Our total research and development expenses, excluding non-cash
compensation expenses, were approximately $2.7 million and $5.2 million for the
first
14
nine months of 2000 and 2001, respectively. We intend to continue to invest a
substantial amount of funds in our research and product development efforts,
which could have a negative impact on our earnings in future periods.
IF WE ARE UNABLE TO DEVELOP NEW PRODUCTS AND PRODUCT ENHANCEMENTS THAT ACHIEVE
MARKET ACCEPTANCE, SALES OF OUR FIBER OPTIC COMPONENTS COULD DECLINE, WHICH
COULD REDUCE OUR REVENUES.
The communications industry is characterized by rapidly changing
technology, frequent new product introductions, changes in customer
requirements, evolving industry standards and, more recently, significant
variations in customer demand. Our future success depends on our ability to
anticipate market needs and develop products that address those needs. As a
result, our products could quickly become obsolete if we fail to predict market
needs accurately or develop new products or product enhancements in a timely
manner. Our failure to predict market needs accurately or to develop new
products or product enhancements in a timely manner will harm market acceptance
and sales of our products. If the development or enhancement of these products
or any other future products takes longer than we anticipate, or if we are
unable to introduce these products to market, our sales will not increase. Even
if we are able to develop and commercially introduce these new products, the new
products may not achieve widespread market acceptance necessary to provide an
adequate return on our investment.
THE OPTICAL NETWORKING COMPONENT INDUSTRY HAS IN THE PAST, IS NOW, AND MAY IN
THE FUTURE EXPERIENCE DECLINING AVERAGE SELLING PRICES, WHICH COULD CAUSE OUR
GROSS MARGINS TO DECLINE.
The optical networking component industry has in the past experienced
declining average selling prices as a result of increasing competition and
greater unit volumes as communication service providers continue to deploy fiber
optic networks. Average selling prices are currently decreasing and may continue
to decrease in the future in response to product introductions by competitors,
price pressures from significant customers, greater manufacturing efficiencies
achieved through increased automation in the manufacturing process and inventory
build-up due to decreased demand. Average selling price declines may contribute
to a decline in our gross margins, which could harm our results of operations.
WE MAY EXPERIENCE A DECREASE IN MARKET DEMAND DUE TO AN IMMINENT RECESSION IN
THE UNITED STATES AS THE SLUMPING ECONOMY IS FURTHER STYMIED BY THE RECENT
OUTBREAK OF INTERNATIONAL TERRORISM, WAR AND POLITICAL INSTABILITY.
United States economy has been experiencing a drastic slowdown in
consumption and demand for the last two quarters. On September 11, 2001,
terrorist attacks occurred on American soil, resulting in a further decline in
the economy. The war on terrorism, along with the effects of the terrorist
attack and other similar events worldwide, could have contributed to the further
slowdown of the already slumping market demand for goods, including fiber optics
equipment. We may experience further decreases in the demand for our products
due to an imminent recession as the general fiber optics industry copes with the
effects of terrorism, war and political instability. The duration of war is
unknown and may adversely affect the economy if prolonged.
WE WILL NOT ATTRACT NEW ORDERS FOR OUR FIBER OPTIC COMPONENTS UNLESS WE CAN
DELIVER SUFFICIENT QUANTITIES OF OUR PRODUCTS TO OPTICAL COMMUNICATIONS
EQUIPMENT MANUFACTURERS.
Communications service providers and optical systems manufacturers
typically require that suppliers commit to provide specified quantities of
products over a given period of time. If we are unable to commit to deliver
quantities of our products to satisfy a customer's anticipated needs, we will
lose the order and the opportunity for significant sales to that customer for a
lengthy period of time. We are presently able to fill substantially all of our
customers' orders. However, if we do not increase our manufacturing capacity to
meet the future production requirements of our customers, growth of our business
will be negatively impacted. In addition, we would be unable to fill large
orders if we do not have sufficient manufacturing capacity to enable us to
commit to provide customers with specified quantities of products. However, if
we build our manufacturing capacity and inventory in excess of demand, as we
have done in the past, we may produce excess inventory that may have to be
written off.
15
WE DEPEND ON A LIMITED NUMBER OF THIRD PARTIES TO SUPPLY KEY MATERIALS,
COMPONENTS AND EQUIPMENT, SUCH AS FERRULES AND LENSES, AND IF WE ARE NOT ABLE TO
OBTAIN SUFFICIENT QUANTITIES OF THESE ITEMS AT ACCEPTABLE PRICES, OUR ABILITY TO
FILL ORDERS WOULD BE LIMITED AND OUR OPERATING RESULTS COULD BE HARMED.
We depend on third parties to supply the raw materials and components we
use to manufacture our products. To be competitive, we must obtain from our
suppliers, on a timely basis, sufficient quantities of raw materials and
components at acceptable prices. We obtain most of our critical raw materials
and components from a single or limited number of suppliers and generally do not
have long-term supply contracts with them. As a result, our suppliers could
terminate the supply of a particular material or component at any time without
penalty. Finding alternative sources may involve significant expense and delay,
if these sources can be found at all. Difficulties in obtaining raw materials or
components in the future may delay or limit our product shipments, which could
result in lost orders, increase our costs, reduce our control over quality and
delivery schedules and require us to redesign our products. If a supplier became
unable or unwilling to continue to manufacture or ship materials or components
in required volumes, we would have to identify and qualify an acceptable
replacement. A delay or reduction in shipments or any need to identify and
qualify replacement suppliers would harm our business. All of our graded index,
or GRIN, lenses, which are incorporated into substantially all of our
filter-based DWDM products, are obtained from one supplier, Nippon Sheet Glass.
We also depend on a limited number of manufacturers and vendors that
make and sell the complex equipment we use in our manufacturing process. In
periods of high market demand, the lead times from order to delivery of this
equipment could be significant. Delays in the delivery of this equipment or
increases in the cost of this equipment could harm our operating results.
BECAUSE WE EXPERIENCE LONG LEAD TIMES FOR MATERIALS AND COMPONENTS, WE MAY NOT
BE ABLE TO EFFECTIVELY MANAGE OUR INVENTORY LEVELS, WHICH COULD HARM OUR
OPERATING RESULTS.
Because we experience long lead times for materials and components and
are often required to purchase significant amounts of materials and components
far in advance of product shipments, we may not effectively manage our inventory
levels, which could harm our operating results. We recorded significant charges
for excess inventory in the quarter ended June 30, 2001. If we underestimate our
raw material requirements, we may have inadequate inventory, which could result
in delays in shipments and loss of customers. If we purchase raw materials and
increase production in anticipation of orders that do not materialize or that
shift to another quarter, we will, as we have in the past, have to carry or
write off excess inventory and our gross margins will decline. Either situation
could cause our results of operations to be below the expectations of investors
and public market analysts, which could, in turn, cause the price of our common
stock to decline. The time our customers require to incorporate our products
into their own can vary significantly and generally exceeds several months,
which further complicates our planning processes and reduces the predictability
of our forecasts. Even if we receive these orders, the additional manufacturing
capacity that we add to meet our customer's requirements may be underutilized in
a subsequent quarter.
In order to facilitate the rapid deployment of anticipated projects, our
customers have, in the past and may in the future, build significant inventory.
If, after building a significant inventory of our products, these projects are
delayed, our customers will be required to maintain a significant inventory of
our products for longer periods than they originally anticipated, which would
reduce further purchases by these customers of our products until deployment of
the delayed projects commences. These reductions, in turn, could cause
fluctuations in our future results of operations and severely harm our business
and financial condition.
WE DEPEND ON KEY PERSONNEL TO OPERATE OUR BUSINESS EFFECTIVELY IN THE RAPIDLY
CHANGING FIBER OPTIC COMPONENTS MARKET, AND IF WE ARE UNABLE TO HIRE AND RETAIN
APPROPRIATE MANAGEMENT AND TECHNICAL PERSONNEL, OUR ABILITY TO DEVELOP OUR
BUSINESS COULD BE HARMED.
Our success depends to a significant degree upon the continued
contributions of the principal members of our technical sales, marketing,
engineering and management personnel, many of whom perform important management
functions and would be difficult to replace. We particularly depend upon the
continued services of our executive officers, particularly Peter Chang, our
President and Chief Executive Officer, David Hubbard, our Vice President, Sales
and Marketing, and other key engineering, sales, marketing, finance,
manufacturing and support personnel. In addition, we depend upon the continued
services of key management personnel at our Taiwanese
16
subsidiary. None of our officers or key employees is bound by an employment
agreement for any specific term, and may terminate their employment at any time.
In addition, we do not have "key person" life insurance policies covering any of
our employees.
In order to continue to expand our product offerings both in the U.S.
and abroad, we must hire a number of research and development personnel. In
addition, in order to continue strengthening our research and development
efforts in the United States, we must hire a significant number of additional
manufacturing and research development personnel. Hiring technical sales
personnel in our industry is very competitive due to the limited number of
people available with the necessary technical skills and understanding of our
technologies. Our ability to continue to attract and retain highly skilled
personnel will be a critical factor in determining whether we will be successful
in the future. We may have difficulty hiring skilled engineers at our
manufacturing facility in Taiwan. If we are not successful in attracting,
assimilating or retaining qualified personnel to fulfill our current or future
needs, our business may be harmed.
IF WE ARE NOT ABLE TO ACHIEVE ACCEPTABLE MANUFACTURING YIELDS AND SUFFICIENT
PRODUCT RELIABILITY IN THE PRODUCTION OF OUR FIBER OPTIC COMPONENTS, WE MAY
INCUR INCREASED COSTS AND DELAYS IN SHIPPING PRODUCTS TO OUR CUSTOMERS, WHICH
COULD IMPAIR OUR OPERATING RESULTS.
Complex and precise processes are required for the manufacture of our
products. Changes in our manufacturing processes or those of our suppliers, or
the inadvertent use of defective materials, could significantly reduce our
manufacturing yields and product reliability. Because the majority of our
manufacturing costs are relatively fixed, manufacturing yields are critical to
our results of operations. Lower than expected production yields could delay
product shipments and impair our operating results. We may not obtain acceptable
yields in the future.
In some cases, existing manufacturing techniques, which involve
substantial manual labor, may not allow us to cost-effectively meet our
production goals so that we maintain acceptable gross margins while meeting the
cost targets of our customers. We will need to develop new manufacturing
processes and techniques that will involve higher levels of automation to
increase our gross margins. We may not achieve adequate manufacturing cost
efficiencies.
Because we plan to introduce new products and product enhancements
regularly, we must effectively transfer production information from our product
development department to our manufacturing group and coordinate our efforts
with those of our suppliers to rapidly achieve volume production. In our
experience, our yields have been lower during the early stages of introducing
new product to manufacturing. If we fail to effectively manage this process or
if we experience delays, disruptions or quality control problems in our
manufacturing operations, our shipments of products to our customers could be
delayed.
BECAUSE THE QUALIFICATION AND SALES CYCLE ASSOCIATED WITH FIBER OPTIC COMPONENTS
IS LENGTHY AND VARIED, IT IS DIFFICULT TO PREDICT THE TIMING OF A SALE OR
WHETHER A SALE WILL BE MADE, WHICH MAY CAUSE US TO HAVE EXCESS MANUFACTURING
CAPACITY OR INVENTORY AND NEGATIVELY IMPACT OUR OPERATING RESULTS.
In the communications industry, service providers and optical systems
manufacturers often undertake extensive qualification processes prior to placing
orders for large quantities of products such as ours, because these products
must function as part of a larger system or network. This process may range from
three to six months and sometimes longer. Once they decide to use a particular
supplier's product or component, these potential customers design the product
into their system, which is known as a design-in win. Suppliers whose products
or components are not designed in are unlikely to make sales to that customer
until at least the adoption of a future redesigned system. Even then, many
customers may be reluctant to incorporate entirely new products into their new
systems, as this could involve significant additional redesign efforts. If we
fail to achieve design-in wins in our potential customers' qualification
processes, we will lose the opportunity for significant sales to those customers
for a lengthy period of time.
In addition, some of our customers require that our products be
subjected to standards-based qualification testing, which can take up to nine
months or more. While our customers are evaluating our products and before they
place an order with us, we may incur substantial sales and marketing and
research and development expenses, expend significant management efforts,
increase manufacturing capacity and order long lead-time supplies. Even
17
after the evaluation process, it is possible a potential customer will not
purchase our products. In addition, product purchases are frequently subject to
unplanned processing and other delays, particularly with respect to larger
customers for which our products represent a very small percentage of their
overall purchase activity. Accordingly, our revenues and operating results may
vary significantly and unexpectedly from quarter to quarter.
IF OUR CUSTOMERS DO NOT QUALIFY OUR MANUFACTURING LINES FOR VOLUME SHIPMENTS,
OUR OPTICAL NETWORKING COMPONENTS MAY BE DROPPED FROM SUPPLY PROGRAMS AND OUR
REVENUES MAY DECLINE.
Customers generally will not purchase any of our products, other than
limited numbers of evaluation units, before they qualify our products, approve
our manufacturing process and approve our quality assurance system. Our existing
manufacturing lines, as well as each new manufacturing line, must pass through
various levels of approval with our customers. For example, customers may
require that we be registered under international quality standards. Our
products may also have to be qualified to specific customer requirements. This
customer approval process determines whether the manufacturing line achieves the
customers' quality, performance and reliability standards. Delays in product
qualification may cause a product to be dropped from a long-term supply program
and result in significant lost revenue opportunity over the term of that
program.
OUR FIBER OPTIC COMPONENTS ARE DEPLOYED IN LARGE AND COMPLEX COMMUNICATIONS
NETWORKS AND MAY CONTAIN DEFECTS THAT ARE NOT DETECTED UNTIL AFTER OUR PRODUCTS
HAVE BEEN INSTALLED, WHICH COULD DAMAGE OUR REPUTATION AND CAUSE US TO LOSE
CUSTOMERS.
Our products are designed for deployment in large and complex optical
networks. Because of the nature of these products, they can only be fully tested
for reliability when deployed in networks for long periods of time. Our fiber
optic products may contain undetected defects when first introduced or as new
versions are released, and our customers may discover defects in our products
only after they have been fully deployed and operated under peak stress
conditions. In addition, our products are combined with products from other
vendors. As a result, should problems occur, it may be difficult to identify the
source of the problem. If we are unable to fix defects or other problems, we
could experience, among other things:
- loss of customers;
- damage to our reputation;
- failure to attract new customers or achieve market acceptance;
- diversion of development and engineering resources; and
- legal actions by our customers.
The occurrence of any one or more of the foregoing factors could cause
our net loss to increase.
IF WE FAIL TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, COMPETITORS MAY BE ABLE
TO USE OUR TECHNOLOGIES, WHICH COULD WEAKEN OUR COMPETITIVE POSITION, REDUCE OUR
REVENUES OR INCREASE OUR COSTS.
The fiber optic component market is a highly competitive industry in
which we, and most other participants, rely on a combination of patent,
copyright, trademark and trade secret laws, confidentiality procedures and
licensing arrangements to establish and protect proprietary rights. The
competitive nature of our industry, rapidly changing technology, frequent new
product introductions, changes in customer requirements and evolving industry
standards heighten the importance of protecting proprietary technology rights.
Since the United States Patent and Trademark Office keeps patent applications
confidential until a patent is issued, our pending patent applications may
attempt to protect proprietary technology claimed in a third party patent
application. Our existing and future patents may not be sufficiently broad to
protect our proprietary technologies as policing unauthorized use of our
products is difficult and we cannot be certain that the steps we have taken will
prevent the misappropriation or unauthorized use of our technologies,
particularly in foreign countries where the laws may not protect our proprietary
rights as fully as U.S. laws. Our competitors may independently develop similar
technology, duplicate our products, or design around any of our patents or other
intellectual property. If we are unable to adequately protect our proprietary
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technology rights, others may be able to use our proprietary technology without
having to compensate us, which could reduce our revenues and negatively impact
our ability to compete effectively.
Litigation may be necessary to enforce our intellectual property rights
or to determine the validity or scope of the proprietary rights of others. As a
result of any such litigation, we could lose our proprietary rights and incur
substantial unexpected operating costs. Any action we take to protect our
intellectual property rights could be costly and could absorb significant
management time and attention. In addition, failure to adequately protect our
trademark rights could impair our brand identity and our ability to compete
effectively.
IF WE FAIL TO INCREASE SALES OF OUR PRODUCTS TO OPTICAL COMMUNICATIONS EQUIPMENT
MANUFACTURERS OUTSIDE OF NORTH AMERICA, GROWTH OF OUR BUSINESS MAY BE HARMED.
For the nine months ended September 30, 2000 and 2001, sales to
customers located outside of North America were 16.4% and 17.7% of our revenues,
respectively. In order to expand our business, we must increase our sales to
customers located outside of North America. We have limited experience in
marketing and distributing our products internationally and in developing
versions of our products that comply with local standards. Our international
sales will be limited if we cannot establish relationships with international
distributors, establish additional foreign operations, expand international
sales channels, hire additional personnel and develop relationships with
international communications equipment manufacturers. Even if we are able to
successfully continue international operations, we may not be able to maintain
or increase international market demand for our products.
WE MAY EXPERIENCE POWER BLACKOUTS AND HIGHER ELECTRICITY PRICES AS A RESULT OF
CALIFORNIA'S CURRENT ENERGY CRISIS, WHICH COULD DISRUPT OUR MANUFACTURING
OPERATIONS AND INCREASE OUR EXPENSES.
California is in the midst of an energy crisis that could disrupt our
manufacturing operations and increase our expenses. We rely on the major
Northern California public utility, Pacific Gas & Electric Company, or PG&E, to
supply electric power to our facilities in Northern California. Due to problems
associated with the deregulation of the power industry in California and
shortages in wholesale electricity supplies, customers of PG&E have been faced
with increased electricity prices, power shortages and rolling blackouts.
Increased energy prices will increase our expenses incurred in manufacturing
which will increase our cost of revenues and decrease our gross profits. If
blackouts interrupt our power supply, we may be temporarily unable to continue
our manufacturing operations at our facilities. Any such interruption in our
ability to continue our manufacturing operations could delay our ability to
develop new products, manufacture our existing products or provide services.
Such disruptions could damage our reputation and result in lost revenue, either
of which could substantially harm our business and results of operations.
BECAUSE OUR MANUFACTURING OPERATIONS ARE LOCATED IN ACTIVE EARTHQUAKE FAULT
ZONES IN CALIFORNIA AND TAIWAN, AND OUR TAIWAN LOCATION IS SUSCEPTIBLE TO THE
EFFECTS OF A TYPHOON, WE FACE THE RISK THAT A NATURAL DISASTER COULD LIMIT OUR
ABILITY TO SUPPLY PRODUCTS.
Our primary manufacturing operations are located in Sunnyvale,
California and Tu-Cheng City, Taiwan, both active earthquake fault zones. These
regions have experienced large earthquakes in the past and may likely experience
them in the future. In September 2001, a typhoon hit Taiwan causing businesses,
including our manufacturing facility, and the financial markets to close for two
days. Because the majority of our manufacturing operations are located in
Taiwan, a large earthquake or typhoon in Taiwan could disrupt our manufacturing
operations for an extended period of time, which would limit our ability to
supply our products to our customers in sufficient quantities on a timely basis,
harming our customer relationships.
WE MAY BE SUBJECT TO INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS THAT ARE COSTLY
TO DEFEND AND COULD LIMIT OUR ABILITY TO USE SOME TECHNOLOGIES IN THE FUTURE.
Our industry is very competitive and is characterized by frequent
intellectual property litigation based on allegations of infringement of
intellectual property rights. Numerous patents in our industry have already been
issued, and as the market further develops and participants in our industry
obtain additional intellectual property protection, litigation is likely to
become more frequent. From time to time, third parties may assert patent,
copyright, trademark and other intellectual property rights to technologies or
rights that are important to our business. In addition, we may in the future
enter into agreements to indemnify our customers for any expenses or
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liabilities resulting from claimed infringements of patents, trademarks or
copyrights of third parties. Any litigation arising from claims asserting that
our products infringe or may infringe the proprietary rights of third parties,
whether the litigation is with or without merit, could be time-consuming,
resulting in significant expenses and diverting the efforts of our technical and
management personnel. We do not have insurance against our alleged or actual
infringement of intellectual property of others. These claims could cause us to
stop selling our products, which incorporate the challenged intellectual
property and could also result in product shipment delays or require us to
redesign or modify our products or to enter into licensing agreements. These
licensing agreements, if required, would increase our product costs and may not
be available on terms acceptable to us, if at all.
Although we are not aware of any intellectual property lawsuits filed
against us, we have been advised that we may infringe a patent and may owe
royalties. We may be a party to litigation regarding this or other matters in
the future. We may not prevail in any such actions, given their complex
technical issues and inherent uncertainties. Insurance may not cover potential
claims of this type or may not be adequate to indemnify us for all liability
that may be imposed. If there is a successful claim of infringement or we fail
to develop non-infringing technology or license the proprietary rights on a
timely basis, our business could be harmed.
WE DEPEND ON THE CONTINUED GROWTH AND SUCCESS OF THE INTERNET AND THE
COMMUNICATIONS INDUSTRY, WHICH IS EXPERIENCING RAPID CONSOLIDATION AND
REALIGNMENT AND AN OVERSUPPLY OF PRODUCT INVENTORY AND MAY NOT CONTINUE TO
DEMAND FIBER OPTIC PRODUCTS, THEREBY REDUCING DEMAND FOR OUR PRODUCTS.
Our future success depends on the continued growth of the Internet as a
widely used medium for communications and commerce, and the growth of optical
networks to meet the increased demand for capacity to transmit data, or
bandwidth. If the Internet does not continue to expand as a medium for
communications and commerce, the need to significantly increase bandwidth across
networks and the market for fiber optic components may not continue to develop.
If this growth does not continue, sales of our products may decline and would
adversely affect our revenues. Additionally, if growth in demand for our
products exceeds the demand for our customers' products, our customers may
experience an oversupply of inventory and decrease orders of our products.
Future demand for our products is uncertain and will depend heavily on the
continued growth and upgrading of optical networks, especially in the
metropolitan and last mile access segments of the networks. The rate at which
communication service providers and other fiber optic network users have built
new fiber optic networks or installed new systems in their existing fiber optic
networks has fluctuated in the past and these fluctuations may continue in the
future. These fluctuations may result in reduced demand for new or upgraded
fiber optic systems that utilize our products and, therefore, may result in
reduced demand for our products.
The communications industry is also experiencing rapid consolidation and
realignment, as industry participants seek to capitalize on the rapidly changing
competitive landscape developing around the Internet and new communications
technologies such as fiber optic networks. As the communications industry
consolidates and realigns to accommodate technological and other developments,
our customers may consolidate or align with other entities in a manner that
harms our business.
THE MARKET FOR FIBER OPTIC COMPONENTS IS NEW AND UNPREDICTABLE AND CHARACTERIZED
BY RAPID TECHNOLOGICAL CHANGES, EVOLVING STANDARDS AND, MORE RECENTLY,
SIGNIFICANT DECREASES IN CUSTOMER DEMAND, AND IF THIS MARKET DOES NOT DEVELOP
AND RESUME ITS EXPANSION AS WE ANTICIPATE, DEMAND FOR OUR PRODUCTS MAY CONTINUE
TO DECLINE, WHICH COULD ADVERSELY IMPACT OUR REVENUES.
The market for fiber optic components is new and characterized by rapid
technological change, frequent new product introductions, changes in customer
requirements and evolving industry standards. Because this market is new, it is
difficult to predict its potential size or future growth rate. Widespread
adoption of optical networks, especially in the metropolitan and last mile
access segments of the networks, is critical to our future success. Potential
end-user customers who have invested substantial resources in their existing
copper lines or other systems may be reluctant or slow to adopt a new approach,
such as optical networks. Our success in generating revenues in this emerging
market will depend on:
- the education of potential end-user customers and network service
providers about the benefits of optical networks; and
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- the continued growth of the metropolitan and last mile access
segments of the communications network.
If we fail to address changing market conditions, sales of our products
may decline, which would adversely impact our revenues.
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK AND INTEREST
RATE RISK
INTEREST RATE SENSITIVITY
We currently maintain our funds primarily in money market funds and
highly liquid marketable securities. We do not have any derivative financial
instruments. As of September 30, 2001, $12.2 million, or 23.7% of our
investments, matured in less than three months. We plan to continue to invest a
significant portion of our existing cash in interest bearing, investment grade
securities, with maturities of less than 12 months. We do not believe that our
investments, in the aggregate, have significant exposure to interest rate risk.
EXCHANGE RATE SENSITIVITY
We currently have operations in the United States, Taiwan, and China.
The functional currency of our subsidiaries in Taiwan and China is the local
currency, and we are subject to foreign currency exchange rate fluctuations
associated with translation to U.S. dollars. Though some expenses are incurred
by our Taiwan and China operations, all of our substantial sales are made in
U.S. dollars; hence, we have minimal exposure to foreign currency rate
fluctuations relating to sales transactions.
While we expect our international revenues to continue to be denominated
predominately in U.S. dollars, an increasing portion of our international
revenues may be denominated in foreign currencies in the future. In addition, we
plan to continue to expand our overseas operations. As a result, our operating
results may become subject to significant fluctuations based upon changes in
exchange rates of certain currencies in relation to the U.S. dollar. We will
analyze our exposure to currency fluctuations and may engage in financial
hedging techniques in the future to attempt to minimize the effect of these
potential fluctuations; however, exchange rate fluctuations may adversely affect
our financial results in the future.
PART II: OTHER INFORMATION
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
10.11 Agreement and Release of Claim by and between the Registrant and
John M. Harland dated August 23, 2001.
(b) Reports on Form 8-K.
The Company did not file any reports on Form 8-K with the Securities and
Exchange Commission during the quarter ended September 30, 2001.
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SIGNATURE
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.
Dated: November 12, 2001
ALLIANCE FIBER OPTIC PRODUCTS, INC.
By /s/ ANITA HO
------------------------------------
Anita Ho
Controller
(Principal Financial and Accounting
Officer and Duly Authorized Signatory)
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EXHIBIT INDEX
TO
ALLIANCE FIBER OPTIC PRODUCTS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 2001
Exhibit No. Exhibit Description
- ----------- -------------------
10.11 Agreement and Release of Claim by and between the Registrant and
John M. Harland dated August 23, 2001.
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