- -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 ---------------- FORM 10-Q QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 ---------------- For the Quarter Ended March 31, 2000 Commission File Number 333-48817 ---------------- PHASE METRICS, INC. (registrant) ---------------- Incorporated in the State of Delaware I.R.S. Employer Identification Number 33-0328048 10260 Sorrento Valley Road, San Diego, California 92121 (858) 646-4800 ---------------- 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 [_] The number of shares outstanding of the Registrant's securities as of March 31, 2000 are as follows: Common Stock............................................. 5,609,839 shares Series A Preferred Stock................................. 8,250,000 shares Series B Preferred Stock................................. 3,857,280 shares Series C Preferred Stock................................. 7,610,000 shares - -------------------------------------------------------------------------------- - -------------------------------------------------------------------------------- PHASE METRICS, INC. FORM 10-Q FOR THE QUARTER ENDED MARCH 31, 2000 INDEX PART I. FINANCIAL INFORMATION Page ---- ITEM 1. Financial Statements (unaudited) Condensed Consolidated Balance Sheets as of December 31, 1999 and March 31, 2000............................................. 3 Condensed Consolidated Statements of Operations for the three months ended March 31, 1999 and 2000........................... 4 Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 1999 and 2000........................... 5 Notes to Condensed Consolidated Financial Statements........... 6 Management's Discussion and Analysis of Financial Condition and ITEM 2. Results of Operations.......................................... 8 ITEM 3. Quantitative and Qualitative Disclosures about Market Risk..... 22 PART II. OTHER INFORMATION ITEM 1. Legal Proceedings.............................................. 22 ITEM 2. Changes in Securities.......................................... 22 ITEM 3. Defaults Upon Senior Securities................................ 22 ITEM 4. Submission of Matters to a Vote of Security Holders............ 22 ITEM 5 Other Information.............................................. 22 ITEM 6. Exhibits and Reports on Form 8-K............................... 22 Signatures........................................................................... 23 2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS PHASE METRICS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands) December 31, March 31, 1999 2000 ------------ ----------- (Unaudited) ASSETS Current assets: Cash and cash equivalents.......................... $ 8,942 $ 5,271 Accounts receivable, net........................... 7,044 4,589 Inventories........................................ 14,500 15,271 Prepaid expenses and other......................... 1,225 2,005 --------- --------- Total current assets............................. 31,711 27,136 Property, plant and equipment, net................... 10,494 8,448 Intangible and other assets.......................... 4,446 4,261 --------- --------- Total assets..................................... $ 46,651 $ 39,845 ========= ========= LIABILITIES, REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' DEFICIT Current liabilities: Accounts payable................................... $ 2,397 $ 1,352 Accrued expenses and other liabilities............. 19,895 18,963 Current portion of debt............................ 1,205 1,123 --------- --------- Total current liabilities........................ 23,497 21,438 Long-term liabilities: Long-term debt..................................... 114,531 114,487 Accrued expenses and interest...................... 10,236 10,314 Series B redeemable preferred stock.................. 12,081 12,265 Series C redeemable preferred stock.................. 34,184 34,966 Commitments and contingencies Stockholders' deficit: Series A preferred stock........................... 3 3 Common stock....................................... 6,892 6,992 Retained deficit................................... (154,222) (159,607) Accumulated other comprehensive loss............... (551) (1,013) --------- --------- Total stockholders' deficit...................... (147,878) (153,625) --------- --------- Total liabilities, redeemable preferred stock and stockholders' deficit............................... $ 46,651 $ 39,845 ========= ========= See accompanying notes to unaudited condensed consolidated financial statements. 3 PHASE METRICS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, unaudited) Three Months Ended March 31, -------------------- 1999 2000 --------- --------- Net sales................................................ $ 11,355 $ 11,156 Cost of sales............................................ 9,582 6,150 --------- -------- Gross profit......................................... 1,773 5,006 Operating expenses: Research and development............................... 6,390 3,343 Selling, general and administrative.................... 3,002 2,756 Amortization of intangible assets...................... 93 9 --------- -------- Total operating expenses............................. 9,485 6,108 --------- -------- Loss from operations..................................... (7,712) (1,102) Interest expense......................................... 3,338 3,380 Other income, net........................................ (287) (62) --------- -------- Net loss................................................. $ (10,763) $ (4,420) ========= ======== Accretion for redemption value and dividends on Series B and C redeemable preferred stock........................ (894) (965) --------- -------- Net loss attributable to common stockholders............. $ (11,657) $ (5,385) ========= ======== Comprehensive loss: Net loss............................................... $ (10,763) $ (4,420) Other comprehensive loss--foreign currency translation adjustment............................................ (530) (462) --------- -------- Comprehensive Loss....................................... $ (11,293) $ (4,882) ========= ======== See accompanying notes to unaudited condensed consolidated financial statements. 4 PHASE METRICS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands, unaudited) Three Months Ended March 31, -------------------- 1999 2000 --------- --------- OPERATING ACTIVITIES: Net cash used for operating activities.............. $ (6,289) $ (3,220) --------- --------- INVESTING ACTIVITIES: Acquisition of property, plant and equipment.......... (703) (119) Proceeds from sale of property, plant and equipment... 328 -- --------- --------- Net cash used for investing activities.............. (375) (119) --------- --------- FINANCING ACTIVITIES: Payments on capital lease obligations................. (351) (309) Proceeds from issuance of common stock, net of repurchases.......................................... 2 -- --------- --------- Net cash used for financing activities.............. (349) (309) --------- --------- Effect of exchange rate changes on cash and cash equivalents............................................ (42) (23) --------- --------- Net decrease in cash and cash equivalents............... (7,055) (3,671) Cash and cash equivalents, beginning of period.......... 24,714 8,942 --------- --------- Cash and cash equivalents, end of period................ $ 17,659 $ 5,271 ========= ========= See accompanying notes to unaudited condensed consolidated financial statements. 5 PHASE METRICS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) Note 1. Basis of Presentation The accompanying unaudited condensed consolidated financial statements of Phase Metrics, Inc. (the "Company") have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments considered necessary for a fair presentation (consisting of normal recurring accruals) have been included. Operating results for the three months ended March 31, 2000 are not necessarily indicative of the results that may be expected for the fiscal year ending December 31, 2000. For further information, refer to the consolidated financial statements and footnotes thereto for the year ended December 31, 1999 included in the Company's 1999 Annual Report on Form 10-K. The Company's first, second and third fiscal quarters end on the Sunday closest to March 31, June 30 and September 30, respectively. For ease of reference, such quarter end dates are used herein. Note 2. Balance Sheet Details Inventories Inventories consist of the following (in thousands): December 31, March 31, 1999 2000 ------------ --------- Raw materials and components........................ $ 3,374 $ 2,024 Work-in-process..................................... 4,403 6,312 Finished goods...................................... 6,723 6,935 ------- ------- $14,500 $15,271 ======= ======= Property, Plant and Equipment Property, plant and equipment consist of the following (in thousands): December 31, March 31, 1999 2000 ------------ --------- Equipment and furniture............................ $ 30,742 $ 30,012 Leasehold improvements............................. 5,462 5,535 -------- -------- 36,204 35,547 Accumulated depreciation and amortization............ (25,710) (27,099) -------- -------- $ 10,494 $ 8,448 ======== ======== Customer Advance--The Company entered into an advance payment agreement with one of its customers. The agreement provided for an initial advance of $8.0 million, to be offset by future purchases of the Company's equipment and services through June 30, 2000, and is secured by certain inventory. In the event the advance is not fully offset by June 30, 2000, the full amount will become due with interest accruing at 7% per annum thereafter. As of December 31, 1999 and March 31, 2000, the customer advance balance was $5.4 million and $0.9 million, respectively. Note 3. Industry and Geographic Information The Company operates in one reportable segment. Sales to customers outside the United States (primarily Asia) totaled 54% and 77% of net sales for the three months ended March 31, 1999 and 2000, respectively. As 6 PHASE METRICS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued) (Unaudited) of December 31, 1999 and March 31, 2000, balances due from foreign customers were $3.8 million and $2.6 million, respectively. The Company had sales to individual customers in excess of 10% of net sales, as follows: Three Months Ended March 31, ------------------ 1999 2000 --------- --------- Customer: A ................................................... 33% 56% B.................................................... --% 12% C.................................................... 13% -- D.................................................... 12% -- As of December 31, 1999 and March 31, 2000, accounts receivable from individual customers with balances due in excess of 10% of total accounts receivable totaled $3.4 million and $2.6 million, respectively. For the three months ended March 31, 2000, the Company recorded revenue from customers in the United States and Asia. The following presents net sales for the three months ended March 31, 1999 and 2000 and long-lived assets as of December 31, 1999 and March 31, 2000 by geographic territory: Long-Lived Assets Net Sales ---------------------- ----------------------------- Three Months Ended March 31, December 31, March 31, ---------------------------- 1999 2000 1999 2000 ------------ --------- -------------- -------------- United States operations: Domestic.............. $13,324 $11,912 $ 5,223 $ 2,576 Foreign............... -- -- 4,841 5,465 Asia operations......... 1,616 797 1,291 3,115 ------- ------- -------------- -------------- Total................... $14,940 $12,709 $ 11,355 $ 11,156 ======= ======= ============== ============== Note 4. Subsequent Event The Company was unable to make the interest payment on the $110 million Senior Notes ("the Notes") due on February 1, 2000 and is not in compliance with certain covenants of the Notes and the Indenture governing the Notes. On April 26, 2000, the Company announced that it had entered into an agreement in principle with an informal committee representing approximately 81% of holders to restructure the Notes. Under the restructuring, the $110.0 million principal amount of Notes, plus accrued interest, would be exchanged for New Common Stock representing 97.5% of the Company's outstanding common stock after the restructuring. Holders of the existing Senior Subordinated Convertible Notes, existing Series A, B and C Preferred Stock and existing Common Stock would receive the remaining 2.5% of New Common Stock, as well as warrants to purchase additional shares representing up to 10% of the Company's then outstanding New Common Stock upon certain circumstances. The restructuring will not in any way affect the Company's obligation to pay its trade creditors or other vendors. The agreement in principle is subject to a number of customary conditions. In addition, holders of all or some of the Notes will provide the Company with a $10.0 million New Credit Facility in conjunction with the restructuring. The New Credit Facility will be secured by a pledge of substantially all of the Company's assets other than certain secured assets and customer deposits. The commitment to provide the New Credit Facility is subject to a number of customary conditions. There is no assurance that the proposed restructuring will be completed as described above or at all. The accompanying unaudited condensed consolidated financial statements do not purport to reflect or provide for the consequences of the proposed restructuring. 7 PHASE METRICS, INC. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ITEM 2. Statements in this discussion and analysis and elsewhere in this report, including, but not limited to, statements regarding our strategy, financial performance and revenue sources, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995, Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, and are subject to the safe harbors created by those sections. These and any other forward-looking statements contained in this report are based on current expectations and involve various risks and uncertainties that could cause actual results to differ materially from those expressed in such forward-looking statements. Our actual results could differ materially from the results anticipated in these forward-looking statements as a result of certain factors set forth under "Risk Factors" and elsewhere in this report. Readers are also urged to carefully review and consider the various risk factor disclosures made in our other reports and filings with the SEC, including our 1999 Annual Report on Form 10-K. Readers are cautioned not to place undue reliance on these forward-looking statements to reflect events or circumstances occurring after the date of this filing. The following discussion should be read in conjunction with our condensed consolidated financial statements and notes thereto included elsewhere in this report. Overview We are facing severe liquidity problems. We were unable to make the interest payment on the Notes due on February 1, 2000 and are not in compliance with certain covenants of the Notes and the Indenture governing the Notes. On April 26, 2000, we announced that we had entered into an agreement in principle with an informal committee of Noteholders to restructure the Notes. Under the restructuring, the $110.0 million principal amount of Notes, plus accrued interest, would be exchanged for New Common Stock representing 97.5% of our outstanding common stock after the restructuring. Holders of the existing Senior Subordinated Convertible Notes, existing Series A, B and C Preferred Stock and existing Common Stock would receive the remaining 2.5% of New Common Stock, as well as warrants to purchase additional shares representing up to 10% of our then outstanding New Common Stock if we achieve certain financial targets. The restructuring will not in any way affect our obligation to pay our trade creditors or other vendors. The agreement in principle is subject to a number of customary conditions. In addition, holders of all or some of the Notes will provide us with a $10.0 million New Credit Facility in conjunction with the restructuring. The New Credit Facility will be secured by a pledge of substantially all of our assets. The commitment to provide the New Credit Facility is subject to a number of customary conditions. There is no assurance that the proposed restructuring will be completed as described above or at all. We anticipate that the restructuring will take three to five months to complete. During that time, we will face a number of risks over which we may have limited or no control, including the risk that trade creditors or vendors may discontinue providing us with trade credit, the risk that customers may decrease the amount of business that they do with us and the risk that, in spite of not paying interest on the Notes, we will not be able to generate the liquidity necessary to maintain operations. In addition, we face the risk that holders of Notes or other interests in us will refuse to accept our restructuring proposal when made to them. For these and other reasons, we may be forced to file for protection under Chapter 11 without the benefit of an agreement in principle with the Noteholders, our creditors may file an involuntary Chapter 11 case against us or we may be forced to liquidate our business without the benefit of a reorganization. 8 The accompanying unaudited condensed consolidated financial statements do not purport to reflect or provide for the consequences of the proposed restructuring. Business We are a leading supplier of process and production-test equipment for the data storage industry. Our systems are used primarily by manufacturers of disk drives, thin-film disks and read/write heads to manage and improve their respective product yields by analyzing product and process quality at critical stages in their production processes. We were formed in 1989 as a single product supplier to the data storage industry. Since 1993, we expanded our product lines through the acquisition of seven specialized suppliers of complementary systems for the disk drive and disk drive component industries. We believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indicators of future performance. Quarterly results in the future may fluctuate due to the factors discussed above or other factors. Customer Concentration There are a relatively small number of data storage manufacturers throughout the world and we derive a significant portion of our net sales from a relatively small number of customers. We expect that our dependence on relatively few key customers will continue in the future. Approximately 75.1% of our net sales were derived from sales to our three largest customers for the three months ended March 31, 2000. Even though our customer mix will likely change from period to period in the future, for the three months ended March 31, 2000, Seagate Technology, Inc. ("Seagate"), Yamaha Corporation ("Yamaha") and Alps Electric Company, Ltd. ("Alps") accounted for 55.5%, 11.9% and 7.7% of net sales, respectively. If net sales to these or any of our other significant customers were to decrease in any material amount in the future, our business, operating results and financial condition would be materially adversely affected. Results of Operations Net Sales Net sales consist primarily of revenue from sales of our process and production-test equipment and related upgrades, and to a lesser extent, parts and services. Net sales decreased from $11.4 million for the first quarter of 1999 to $11.2 million for the first quarter of 2000. Gross Profit Cost of sales includes material costs, direct labor and overhead costs related to the production and installation of our products, including warranty and other service costs. Gross profit increased from $1.8 million for the first quarter of 1999 to $5.0 million for the first quarter of 2000. Gross profit as a percentage of net sales ("gross margin") increased from 15.6% for the first quarter of 1999 to 44.8% for the first quarter of 2000. The increase was primarily due to (1) lower gross profit on products shipped in the first quarter of 1999 in connection with the Settlement Agreement discussed below (2) underutilization of manufacturing capacity in the first quarter of 1999 and (3) a customer cancellation fee in the first quarter of 2000. In April 1998, we entered into a settlement agreement to reimburse a major customer for costs incurred in connection with the customer's cancellation of a contract with a third party to purchase upgrades to certain production test equipment originally purchased from us. We took this action to protect our intellectual property and preserve a valued customer relationship. We concluded that such action was necessary in order to discourage further unauthorized use of our intellectual property in the future by this or other third parties. We made the reimbursement provided for under the settlement agreement by providing a credit to the customer for products purchased by the customer. Products purchased under the settlement agreement were at favorable pricing which negatively impacted our gross profit margin during the first quarter of 1999. We are unable to control with any degree of certainty our product sales volume, linearity or mix from period to period and therefore our gross margin in future periods may fluctuate from those achieved in past periods. In 9 any period when we experience an unfavorable product sales volume, linearity or mix and/or provide significant volume pricing discounts or provision for warranty costs, our gross margin may decrease. Research and Development Expense Research and development expense consists primarily of salaries and related costs of personnel and consultants, project materials and other costs associated with our ongoing research and product development. Research and development expense decreased from $6.4 million for the first quarter of 1999 to $3.3 million for the first quarter of 2000. Research and development expense as a percentage of net sales decreased from 56.3% for the first quarter of 1999 to 30.0% for the first quarter of 2000. This percentage decrease was primarily due to a decrease in personnel costs as a result of workforce reductions in July and October 1999, closure of our Concord facility and a decrease in project material costs. We anticipate that we will continue to devote a significant amount of financial resources to research and development for the foreseeable future. Selling, General and Administrative Expense Selling, general and administrative expense consists primarily of salaries and related costs of personnel and professional services, including certain acquisition related earnout costs. Selling, general and administrative expense decreased from $3.0 million for the first quarter of 1999 to $2.8 million for the first quarter of 2000. Selling, general and administrative expense as a percentage of net sales decreased from 26.4% for the first quarter of 1999 to 24.7% for the first quarter of 2000. This percentage decrease was primarily due to a decrease in personnel costs as a result of workforce reductions in July and October 1999. Amortization of Intangible Assets Amortization of intangible assets decreased from $0.1 million for the first quarter of 1999 to $9,000 for the first quarter of 2000. This decrease was due to intangible assets becoming fully amortized. Interest Expense Interest expense for the first quarter of 1999 and 2000 relates primarily to interest incurred on the senior and subordinated notes. Other Income, Net Other income was $0.3 million for the first quarter of 1999 as compared to $0.1 million for the first quarter of 2000. These amounts consisted primarily of earnings on invested funds. Liquidity and Capital Resources We have financed our capital requirements through sales of common and preferred stock, borrowings under the senior notes and subordinated, term and revolving credit facilities. Our principal requirements for cash are debt service requirements, capital expenditures and working capital. As of March 31, 2000, our outstanding indebtedness included $106.4 million of senior notes, net of $3.6 million of unamortized debt issuance costs, $8.0 million of convertible subordinated notes and $1.2 million of capital lease obligations. At March 31, 2000, we had $7.9 million and $8.3 million of accrued interest outstanding on the senior notes and convertible subordinated notes, respectively. The convertible subordinated notes, including all accrued interest, are convertible into 5,142,720 shares of common stock at the option of the holders and will automatically convert upon a public equity offering. As of the date of this filing, we do not have a working capital credit facility in place. 10 We were unable to make the interest payment on the Notes due on February 1, 2000 and are not in compliance with certain covenants of the Notes and the Indenture governing the Notes. On April 26, 2000, we announced that we had entered into an agreement in principle with an informal committee representing approximately 81% of holders to restructure the Notes. Under the restructuring, the $110.0 million principal amount of Notes, plus accrued interest, would be exchanged for New Common Stock representing 97.5% of our outstanding common stock after the restructuring. Holders of the existing Senior Subordinated Convertible Notes, existing Series A, B and C Preferred Stock and existing Common Stock would receive the remaining 2.5% of New Common Stock, as well as warrants to purchase additional shares representing up to 10% of our then outstanding New Common Stock upon certain circumstances. The restructuring will not in any way affect our obligation to pay our trade creditors or other vendors. The agreement in principle is subject to a number of customary conditions. In addition, holders of all or some of the Notes will provide us with a $10.0 million New Credit Facility in conjunction with the restructuring. The New Credit Facility will be secured by a pledge of substantially all of our assets other than certain secured assets and customer deposits. The commitment to provide the New Credit Facility is subject to a number of customary conditions. There is no assurance that the proposed restructuring will be completed as described above or at all. The accompanying unaudited condensed consolidated financial statements do not purport to reflect or provide for the consequences of the proposed restructuring. The senior notes and the related indenture do not contain ongoing quarterly or annual financial covenant requirements but do contain customary covenants restricting our ability to, among other things, incur additional indebtedness, create liens or other encumbrances, pay dividends or make other restricted payments, make investments, loans and guarantees or sell or otherwise dispose of a substantial portion of assets to, or merge or consolidate with, another entity. Cash used for operating activities was $6.3 million and $3.2 million for the first quarter of 1999 and 2000, respectively. Period to period fluctuations in operations impacting these amounts were a smaller net loss in 2000, a decrease in depreciation and amortization, a decrease in accounts receivable, increases in inventories and prepaid expenses and other assets and smaller decreases in accounts payable and other accrued expenses and other liabilities. Cash used for investing activities was $0.4 million for the first quarter of 1999 and $0.1 million for the first quarter of 2000 and consisted of acquisition of property, plant and equipment and net of proceeds from sale of property, plant and equipment in 1999. Cash used for financing activities was $0.3 million for the first quarter of 1999 and $0.3 million for the first quarter of 2000. In the first quarter of 1999 and 2000, financing activities consisted of payments on capital lease obligations. We believe that cash generated from operations, borrowings under the proposed New Credit Facility and existing cash balances will be adequate to fund our operations for at least the next 12 months. While operating activities may provide cash in certain periods, we may require additional sources of financing. We may also from time to time consider additional acquisitions of complementary businesses, products or technologies, which may require additional financing. Additional sources of funding could include additional debt and/or equity financings. We will continue to have limited capital resources and significant future obligations and expect that we will require additional capital to support future growth, if any. There can be no assurance that we will be able to obtain alternative sources of financing on favorable terms, if at all, at such time or times as we may require such capital. See "Risk Factors--As a Result of Adverse Industry Conditions, We Are Experiencing Liquidity Problems and We Failed to Make the Last Interest Payment on the Notes; Unless We Complete Our Proposed Restructuring, We May Be Forced to Seek Protection Under the Bankruptcy Laws." 11 RISK FACTORS You should consider carefully the following risks in your evaluation of us. The risks and uncertainties described below are not the only ones facing our company. Additional risks and uncertainties may also adversely impact and impair our business. If any of the following risks actually occurs, our business, operating results or financial condition would likely suffer. As a Result of Adverse Industry Conditions, We Are Experiencing Liquidity Problems and We Failed to Make the Last Interest Payment on the Notes; Unless We Complete Our Proposed Restructuring, We May Be Forced to Seek Protection Under the Bankruptcy Laws The data storage industry has experienced prolonged and intense competition, pricing erosion and overcapacity. Such adverse market conditions have resulted, and may in the future result, in the delay, reschedule or cancellation of orders and fluctuation in demand for our products. These adverse market conditions have had a material adverse effect on our results of operations and financial condition over the last several quarters and are expected to continue through 2000. For the three months ended March 31, 2000 our earnings were inadequate to cover our fixed charges by $5.4 million. As a result of these losses and deficiencies, we were unable to make the interest payment on the Notes due on February 1, 2000 and we are not in compliance with certain covenants of the Notes and the Indenture governing the Notes. On April 26, 2000, we announced that we had entered into an agreement in principle with an informal committee representing approximately 81% of holders (the "Noteholders") of the Notes to restructure the Notes. Under the restructuring, the $110.0 million principal amount of Notes, plus accrued interest, would be exchanged for new common stock ("New Common Stock") representing 97.5% of our outstanding common stock after the restructuring. Holders of our existing Senior Subordinated Convertible Notes, existing Series A, B and C Preferred Stock and existing Common Stock would receive the remaining 2.5% of New Common Stock, as well as warrants to purchase additional shares representing up to 10% of our then outstanding New Common Stock upon certain circumstances. The restructuring will not in any way affect our obligation to pay our trade creditors or other vendors. The agreement in principle is subject to a number of customary conditions. In addition, holders of all or some of the Notes will provide us with a $10.0 million working capital credit facility (the "New Credit Facility") in conjunction with the restructuring. The New Credit Facility will be secured by a pledge of substantially all of our assets other than certain secured assets and customer deposits. The commitment to provide the New Credit Facility is subject to a number of customary conditions. There is no assurance that the proposed restructuring will be completed as described above or at all. We anticipate that the restructuring will take three to five months to complete. During that time, we will face a number of risks over which we may have limited or no control, including the risk that trade creditors or vendors may discontinue providing us with trade credit, the risk that our customers may decrease the amount of business that they do with us and the risk that, in spite of not paying interest on the Notes, we will not be able to generate the liquidity necessary to maintain operations. In addition, we face the risk that holders of Notes or other interests in us will refuse to accept our restructuring proposal when made to them. For these and other reasons, we may be forced to file for protection under Chapter 11 without the benefit of our agreement in principle with the Noteholders, our creditors may file an involuntary Chapter 11 case against us or we may be forced to liquidate our business without the benefit of a reorganization. The accompanying unaudited condensed consolidated financial statements do not purport to reflect or provide for the consequences of the proposed restructuring. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." 12 Existing Financing Covenants Impose Restrictions on our Operations Which we May Not Be Able to Comply with Due to Reasons Beyond our Control The Indenture related to the Notes contains a number of covenants that significantly restrict our operations, such as our ability to: . incur indebtedness; . make prepayments of certain indebtedness; . pay dividends; . make investments; . engage in transactions with stockholders and affiliates; . create liens; . sell assets; and . engage in mergers and other consolidations. Funds May Not Be Available to Make Payments to Holders of the Notes Due to Senior Rights of Other Existing and Future Indebtedness As of March 31, 2000, the Notes and the Note Guarantees were effectively subordinated to approximately $1.2 million of secured indebtedness under our capital lease obligations. If we incur any additional senior indebtedness in the future that is not subordinated to the indebtedness outstanding under the Notes, even if such indebtedness were not secured, the holders of such debt would be entitled to share ratably with the holders of the Notes in any proceeds distributed in connection with any insolvency, liquidation, reorganization, dissolution or other winding-up of our business. This may have the effect of reducing the amount of proceeds available to pay to holders of the Notes upon the occurrence of any such events. We Have Experienced Significant Losses We incurred net losses of approximately $4.4 million for the three months ended March 31, 2000. Such losses and accrual of certain preferred stock dividends and accretion for the redemption value and dividends of such preferred stock have contributed to a retained deficit of approximately $159.6 million as of March 31, 2000. In addition, we used cash for operating activities of approximately $3.2 million for 2000. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Our Operating Results are Subject to Wide Variations and Continued Losses In the past, we have experienced wide fluctuations in our quarterly and annual operating results and have experienced net losses for the past several quarters. We may continue to experience net losses and fluctuations in our business due to a number of factors, not all of which are in our control. These factors include, without limitation, the following: . the continuing adverse market conditions in the data storage industry; . the size, timing and rescheduling or cancellation of orders from, and shipments to, major customers; . the timing of introductions of our new products and product enhancements or our competitors' introduction of new products or product enhancements; . our ability to develop, introduce and market new, technologically advanced products; . the cyclicality of the data storage industry; 13 . the rescheduling or cancellation of capital expenditures by our customers; . variations in our customer base and product mix; . the level of any of our significant volume pricing discounts; . the availability and cost of key production materials and components; . our ability to effectively manage our inventory and control costs; . the financial stability of our major customers; . personnel changes; . expenses associated with acquisitions; . restructurings; . fluctuations in amortization and write-downs of intangible assets; and . foreign currency exchange rate fluctuations and general economic factors in the United States and certain foreign countries, including Japan, South Korea, Singapore, Malaysia, Thailand and other parts of Southeast Asia. The data storage industry has experienced prolonged and intense competition, pricing erosion and overcapacity. Such adverse market conditions have resulted, and may in the future result, in the delay, reschedule or cancellation of orders and fluctuation in demand for our products. These adverse market conditions have had a material adverse effect on our results of operations and financial condition over the last several quarters and are expected to continue through 2000. Quarterly results in the future may fluctuate due to the factors discussed above or other factors. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." Dependence on and Cyclicality of Data Storage Industry May Lead to Continued Losses Our business depends almost entirely upon capital expenditures by our customers, which in turn depend upon market demand for their products. Our industry is cyclical and historically has experienced varying growth rates and periods of oversupply causing higher than anticipated inventory levels and intense price competition. The data storage industry is currently experiencing intense competition, significant price erosion and overcapacity. As a result of these adverse market conditions, there is significantly reduced demand for our products. These adverse market conditions in the disk storage industry generally, and the slowdown in our customers' orders in the last several quarters has had a material adverse effect on our business, operating results and financial condition. It is likely that these adverse market conditions will continue for the foreseeable future and, as a result, our customers will likely continue to delay or cancel orders for our products and our business, operating results and financial condition will be materially adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." We Have Had to Restructure Operations and May Have to Again in the Future The data storage industry has experienced intense competition, pricing erosion and overcapacity. Such adverse market conditions have resulted, and may in the future result, in the delay, reschedule or cancellation of orders and fluctuation in demand for our products. These adverse market conditions have had a material adverse effect on the our results of operations and financial condition over the last several quarters and are expected to continue through 2000. In June 1998, we implemented a workforce reduction of approximately 155 employees, relocated and consolidated much of our Concord, California operations to our Fremont, California facility and consolidated our San Diego facility. In November 1998, we reduced our workforce by approximately 60 employees and consolidated our Fremont, California facilities. In the second quarter of 1999 we further consolidated a significant portion of our Fremont facilities, and in July 1999, implemented a workforce reduction 14 of approximately 25 employees. Due to the continued effects of the weakness in demand for data storage products, in the fourth quarter of 1999, we consolidated our Fremont facilities and implemented a workforce reduction of approximately 24 employees. In the second quarter of 1998, we recorded $3.0 million of restructuring charges. The significant components included $0.9 million for employee severance costs, $2.0 million in asset impairment costs related to property, plant and equipment obsoleted due to restructuring activities, and $0.1 million of other costs. In the fourth quarter of 1998, we recorded $1.1 million of restructuring charges. The significant components included $0.3 million for employee severance costs, $0.6 million in asset impairment costs related to property, plant and equipment obsoleted due to restructuring activities and $0.2 million of other costs. In the second quarter of 1999, we recorded $2.0 million of restructuring charges. The significant components included $0.7 million for future lease costs of consolidated facilities and $1.3 million in asset impairment costs related to facilities consolidation. In the fourth quarter of 1999, we recorded a restructuring charge of $1.1 million. The significant components included $0.6 million for employee severance costs, $0.4 million for future lease costs of consolidated facilities and $0.1 million in asset impairment costs related to facilities consolidation. While we believe our cost-cutting measures are appropriate given our current and anticipated levels of net sales, there can be no assurance that such measures will be sufficient and that additional cost- cutting measures will not be necessary, or that the 1998 and 1999 restructuring activities or future cost-cutting measures will not have a material adverse effect on our ability to increase our net sales. If We Are Not Able to Adapt to Rapid Technological Change, We May Lose Customers Rapid technological changes and evolving industry standards characterize the data storage industry. Our customers frequently introduce new products and enhancements, with relatively short product life cycles, typically between nine and 18 months. In addition, our customers often develop multiple products simultaneously, such that new products could be introduced as frequently as every three months. Our customers' new product introductions typically result in new technological challenges for us, both with respect to our installed base and with respect to our next generation products. As a result, we must continue to enhance our existing products and develop and manufacture new products with improved capabilities. These technological changes require us to make substantial investments in research and development. Although we continually develop new products, there can be no assurance that we will be able to accurately anticipate technological advances in the disk drive market and develop products incorporating such advances in a timely manner or at all. Our failure to develop, manufacture and market new or enhanced products, would have a material adverse effect on our business, operating results and financial condition. In addition, we are highly dependent on our close working relationships with our key customers to advance our technologies. The termination of any one of these key relationships could have a material adverse effect on our ability to anticipate and develop necessary technological changes to our products. Our customers are constantly striving to improve their production processes, including improving the manufacturing of substrates, the deposition of material on the substrate, the finish processing of magnetic media, and head fabrication. If our customers modify their own design and internal production processes without our products, demand for our equipment would likely decline. Further, unless we are able to effectively respond to such changes, manufacturing process changes for disk drives, disks and read/write heads could also have a material adverse effect on our business, operating results and financial condition. Future technological innovations may reduce demand for disk drives. Competing technologies to disk drive based data storage exist, including solid state memory (flash memory), tape memory and re-writable optical technology (CD and DVD technology). Although the current core technology for rotating magnetic disk drive data storage has been the predominant technology in the industry for many years, it is likely that some day this technology will be replaced by an alternate technology. Our products may not be adaptable to any successor technology. Our business, operating results and financial condition could be materially adversely affected by any significant migration toward technology that would replace disk drives as a computer data storage medium. 15 Because We Depend on a Small Number of Customers, Any Decrease in Net Sales to or a Loss of a Customer Will Have a Significant Negative Impact on Our Business There are a relatively small number of data storage manufacturers throughout the world and we derive a significant portion of our net sales from a relatively small number of customers. We expect that our dependence on relatively few key customers will continue in the future. Approximately 75.1% of our net sales were derived from sales to our three largest customers for the three months ended March 31, 2000. Even though our customer mix will likely change from period to period in the future, Seagate, Yamaha and Alps have accounted for 55.5%, 11.9%, and 7.7% of net sales, respectively. If net sales to these or any of our other significant customers were to decrease in any material amount in the future, our business, operating results and financial condition would be materially adversely affected. In general, we do not enter into long-term purchase agreements with our customers. If completed orders are not replaced on a timely basis by new orders from the same or other customers, our net sales would be materially adversely affected. In addition, the following could have a material adverse effect on our business, operating results and financial condition: . the loss of a key customer; . any reduction, cancellation or rescheduling of an order from any key customer, including reductions, delays or cancellations due to customer departures from recent buying patterns; and . economic or competitive conditions in our industry. Any failure to collect payment or delay in collecting payment on accounts receivable from customers could have a material adverse effect on our business, operating results and financial condition. See "Management's Discussion and Analysis of Financial Condition and Results of Operations." There has been a trend toward consolidation in the disk drive industry and we expect this trend to continue. Some of our customers have been, and may continue to be acquired by competitors, causing further consolidation. Previous acquisitions in the disk drive industry have often caused the purchasing departments of the combined companies to reevaluate their purchasing decisions. Such acquisitions may result in a change in a current customer's purchasing habits, including a loss of the customer, a decrease in orders from that customer or a rescheduling or cancellation of orders previously made by a customer. Moreover, acquisitions involving existing customers may cause the concentration of our customer revenues to increase thereby increasing our dependence on fewer customers. We Have a High Risk of Inventory Obsolescence Which can Adversely Affect Operating Results by Increasing Cost of Sales Due to the cyclical nature of and rapid technological change in our industry, our inventory is subject to substantial risk of obsolescence. To address these risks, we monitor our inventories on a periodic basis and provide inventory write-downs intended to cover these risks. Despite our precautions, we may be required to take significant inventory charges which, in turn, could materially and adversely affect our business, operating results and financial condition due to the following: . our dependence on a few customers and a limited number of product programs for each customer; . the magnitude of our commitment to support our customers' programs; . our limited remedies in the event a customer cancels or materially reduces one or more product orders; and . the possibility that a customer may experience financial difficulties. 16 The significant downturn in the data storage industry negatively impacted our operations, and for the years ended December 31, 1998 and 1999, the Company recorded $19.8 million and $5.0 million, respectively in charges to cost of sales to write down excess and obsolete inventory. We may be required to take additional inventory write-downs in the future due to our inability to obtain necessary product acceptance, or due to further cancellations by customers. Our Industry is Highly Competitive The disk drive process and production-test equipment industry is highly competitive. In each of our product lines, we face substantial competition from established merchant suppliers of process and production-test equipment, some of which have greater financial, engineering, manufacturing, research and development and marketing resources. For example, we face competition from Zyratex, General Disk and Hitachi DECO for servowriters; Hitachi DECO and Sony Techtronics for disk certifiers; Integral Solutions International and Veeco for quasi-static MR head testers; Koyo Precision Instruments, Inc. and Zygo Corporation for flying height testers, and Technistar for automation technology. Historically, there has also been competition from entrepreneurs with focused market knowledge and new technology. We experience intense competition world-wide from Hitachi DECO, a large, full-line manufacturer of process and production-test equipment. Hitachi DECO has substantially greater financial, technical, marketing, manufacturing, research and development and other resources. We also experience competition from other full-line and partial-line manufacturers of process and production-test equipment. Our competitors may develop enhancements to, or future generations of, competitive products that will offer price or performance features superior to our products, or new competitors may enter our markets. Finally, as many of our competitors are based in foreign countries, they have cost structures and equipment prices based on foreign currencies. Accordingly, currency fluctuations could cause our dollar-priced products to be less competitive than our competitors' products priced in other currencies. Many of our competitors are investing heavily in the development of new and enhanced products aimed at applications currently addressed by our products. We expect our competitors to continue to improve the design and performance of their products and to introduce new products with competitive price/performance characteristics. Competitive pressures often necessitate price reductions which can adversely affect operating results. We will be required to make significant investments in product development and research, sales and marketing and ongoing customer service and support to remain competitive. We cannot be certain that we will have sufficient resources to continue to make such investments or that we will be able to achieve the technological advances necessary to maintain our competitive position. We believe that our future success will be dependent, in part, upon our ability to compete successfully in the Japanese, South Korean and Southeast Asian markets. Our largest competitor, Hitachi DECO, is headquartered in Japan which gives it a competitive advantage in that market to the extent buying decisions are influenced by Hitachi DECO's local presence. In addition, our ability to compete in Japan, South Korea and Southeast Asia in the future is dependent upon continuing free trade between these countries and the United States, our continuing ability to develop in a timely manner products that meet the technical requirements of our foreign customers and our continuing ability to develop and maintain satisfactory relationships with leading companies in our industry in these areas. Moreover, our sales in these areas will be affected by the overall economies of Japan, South Korea and Southeast Asia. To the extent that recent economic troubles in Asian markets have negatively impacted the capacity expansion and upgrade plans of our customers or potential customers in affected regions, then such economic troubles have also negatively impacted our operations. With respect to existing customers, we do not believe that such Asian economic troubles have had a significant impact on our operations. With respect to potential customers, we are unable to quantify the impact that such Asian economic troubles will have on our operations. In addition to the competition from our competitors, most of our customers develop at least a portion of their own process and production-test equipment needs internally, especially servowriters and read/write head test equipment. Accordingly, we must compete against the internal development efforts of this captive market. 17 Manufacturers within this captive market are often reluctant to change their production lines to incorporate merchant-supplied process and production-test technology. Moreover, rapid changes in data storage technology, and the development of new process and production-test equipment may be so closely linked to our customers' product development cycles that certain customers and potential customers will find it more efficient to develop their own process and production-testing equipment needs internally, thereby placing us at a competitive disadvantage. Because of the foregoing competitive factors, we may not be able to compete successfully in the future. Increased competitive pressure could cause us to lower our prices which would have an adverse effect on our business, financial condition and results of operations. Because We Sell a Small Number of Products, A Reduction in Demand For Any One of These Products May Have a Significant Negative Effect on Our Business We derive revenues primarily from sales of our process and production-test systems and parts for such systems. Our products can generally be categorized into four principal areas: . disk (media) testing and processing; . read/write head testing; . disk drive processing; and . automation. We derive a significant portion of our net sales from a relatively small number of products. For the three months ended March 31, 2000, we derived approximately 53.3% of our net sales, from sales of our media certifier products (excluding parts and service). Although we expect that net sales from our media certifier products, including our MG series and our MC series, will continue to account for a substantial portion of our total net sales in the foreseeable future, we realize that the downturn in the data storage industry is caused, in part, by the overcapacity of media certifiers in the market today. Any material reduction in demand for our media certifier products would have a material adverse effect on our business, operating results and financial condition. We May Not Be Able to Adequately Protect Our Proprietary Technology or May Be Subject to Claims of Infringement Our success is heavily dependent upon the establishment and maintenance of proprietary technologies. We currently attempt to protect our intellectual property rights through patents, copyrights, trade secrets and other measures. These efforts may not be adequate to prevent misappropriation by third parties and may not be adequate under the laws of some foreign countries which may not protect our proprietary rights to the same extent as do laws of the United States. Our competitors may be able to independently develop products that are substantially equivalent or superior to our products, or design around our patents. Any such adverse circumstances could have a material adverse effect on our business, operating results and financial condition. Although we do not believe any of our products or proprietary rights infringe the rights of third parties, infringement claims may be asserted against us in the future. Any such claims, with or without merit, could divert the attention of management, result in costly litigation, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on acceptable terms, or at all. If infringement were established, we could be required to pay damages or be enjoined from making, using or selling the infringing product. Likewise, a third party's product, if infringing on our proprietary rights, may not be prevented from doing so without litigation. Any of the foregoing could have a material adverse effect on our business, operating results and financial condition. We cannot be certain that the claims allowed on any of our patents will be sufficiently broad to protect our technology. Moreover, any patent we own could be invalidated, deemed unenforceable, circumvented or challenged. Also, we cannot be certain that our patent rights will provide us competitive advantages or that any 18 of our pending or future patent applications will be issued with claims of the scope that we desire, if at all. Furthermore, others may develop similar products, duplicate our products or design around the patents we own. In addition, foreign intellectual property laws or our agreements may not protect our intellectual property rights in any foreign country. Any failure to protect our intellectual property rights could have a material adverse effect on our business, operating results and financial condition. We require each of our employees to enter into a proprietary rights and non- disclosure agreement in which the employee agrees to maintain the confidentiality of all of our proprietary information and, subject to certain exceptions, to assign to us all rights in any proprietary information or technology made or contributed by the employee during his or her employment. In addition, we regularly enter into non-disclosure agreements with third parties, such as consultants, potential joint venture partners and customers. In spite of these precautions, it may be possible for third parties to copy, develop or otherwise obtain and use our proprietary technology without authorization or to develop similar technology independently. The Complexity and Customization of our Products May Lead to Technical Difficulties and Unanticipated Costs Our products have a large number of components and are highly complex. We have experienced and may continue to experience manufacturing delays due to technical difficulties. In addition, many of our products must be semi- customized to meet individual product specification requirements. The customization of a customer order may require new technical capabilities not previously incorporated successfully into our products. As a result, we may be unable to complete our customers' customized development or technical specifications in a timely manner. Any significant failure in this regard would have a material adverse effect on our business, operating results and financial condition as well as our customer relationships. In addition, due to the semi-customized nature of many of our products, we have incurred and may continue to incur substantial unanticipated costs in a product's development and production which cannot be passed on to the customer. Such unanticipated costs include the increased cost of components due to expediting charges, other purchasing inefficiencies and greater than expected engineering, quality control, installation, upgrade, post-installation service and support and warranty costs. The occurrence of any of these events could materially adversely affect our business, operating results and financial condition. In certain instances we rely on a single source or a limited group of suppliers for certain components and subassemblies used in our products. The partial or complete loss of these sources could have at least a temporary material adverse effect on our results of operations and damage customer relationships due to the complexity of the products they supply and the significant amount of time required to qualify new suppliers. In addition, long lead times are often required to obtain critical components and subassemblies used in certain of our products from these and other suppliers which could impede our ability to quickly respond to changes in demand and product specifications. Shortages of critical components and subassemblies used in our products have occurred in the past and may occur in the future. Also, the availability of materials may have longer lead times. In addition, our manufacture and timely delivery of products is often dependent on the ability of certain suppliers to deliver subassemblies and other components in a timely manner. The failure of such suppliers to deliver these components in a timely manner may delay our product delivery until alternative sourcing may be developed. Alternative sources may not be located in time to avoid penalties or cancellation of our product orders. If a significant order or orders were cancelled for this reason it could have a material adverse effect on our business, operating results and financial condition. Further, a significant increase in the price of one or more components used to produce our products would increase our production costs. Risks Associated with Acquisitions While we currently have no commitments, agreements or understandings with respect to any future acquisitions, our business strategy includes the expansion of our business, products lines and technology through 19 acquisitions. We regularly review various acquisition prospects, including companies, technologies or products complementary to our business and periodically engage in discussions regarding such possible acquisitions. Acquisitions involve numerous risks, including: . evaluating new technologies; . difficulties in the assimilation of the operations, products, personnel and cultures of the acquired companies; . the ability to manage geographically remote units; . the diversion of management's attention from other day-to-day business concerns; . the risks of entering markets in which we have limited or no direct experience; . the potential loss of key employees of the acquired companies; . dilutive issuances of equity securities; . the incurrence of additional debt; . reduction of existing cash balances; and . amortization expenses related to goodwill and other intangible assets and other charges to operations that may materially adversely affect our results of operations. Moreover, any equity or debt financings proposed in connection with any acquisition may not be available to us on acceptable terms or at all, when, and if, suitable strategic acquisition opportunities arise. Although management expects to carefully analyze any opportunity before committing our resources, there can be no assurance that any completed acquisition will result in long-term benefits or that our management will be able to manage effectively the resulting business. Any Future Inability to Obtain Additional Financing Will Have a Significant Negative Effect on Our Business To achieve our long-term strategic objectives and maintain our competitive position, we will need additional financial resources over the next several years to fund acquisitions, service debt, make capital expenditures, fund working capital and pay for research and development. We are continually investing in new technologies and our international infrastructure and, as a result, our fixed costs may increase in the foreseeable future, depending on the timing of any recovery in demand for our products. Our fixed costs may also increase if we expand our infrastructure in South Korea, Japan, other parts of Asia, or other locations. Any liquidity deficiency in the future could delay or change our future plans, including curtailing potential acquisitions, capital expenditures, facilities expansion and research and development expenditures, which could materially adversely affect our ability to pay our debts (including indebtedness and interest under the Notes) and our business, operating results and financial condition. We continue to have limited cash resources and significant future obligations. The precise amount and timing of our capital needs will depend upon a number of factors, including: . the market demand for our products; . the availability of strategic opportunities; . the progress of our product development efforts; . technological challenges in connection with existing and future products; and . the success of our working capital and inventory management. We may not be able to obtain additional financing as needed on acceptable terms or at all. If we are unable to obtain sufficient capital, potential acquisitions, capital expenditures, facilities expansion and research and 20 development expenditures would be materially and adversely affected. See "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Liquidity and Capital Resources." In August 1998, we issued and sold an aggregate of 6,360,000 shares of our Series C Preferred Stock in our Series C Financing for $25.4 million in gross proceeds. Immediately following the consummation of the Series C Financing, we used $7.1 million of the proceeds from the offering to repay all outstanding indebtedness under the credit facility that we entered into in January 1998 and subsequently terminated such facility. As of the date of this filing, we have no revolving or other type of credit facility for working capital. In September 1998, one of the investors in the Series C Financing purchased an additional 1,250,000 shares of Series C Preferred Stock for an aggregate of $5.0 million. We believe that cash generated from operations, borrowings under the proposed New Credit Facility and existing cash balances will be adequate to fund our operations for at least the next 12 months. While operating activities may provide cash in certain periods, we may require additional sources of financing. We may also from time to time consider additional acquisitions of complementary businesses, products or technologies, which may require additional financing. Additional sources of funding could include additional debt and/or equity financings. We will continue to have limited capital resources and significant future obligations and expect that we will require additional capital to support future growth, if any. There can be no assurance that we will be able to obtain alternative sources of financing on favorable terms, if at all, at such time or times as we may require such capital. See "Risk Factors--As a Result of Adverse Industry Conditions, We Are Experiencing Liquidity Problems and We Failed to Make the Last Interest Payment on the Notes; Unless We Complete Our Proposed Restructuring, We May Be Forced to Seek Protection Under the Bankruptcy Laws." Because We are Subject to Many Environmental Regulations, Any Violation will Subject us To Significant Liabilities We are subject to a variety of governmental regulations relating to the use, storage, discharge, handling, emission, generation, manufacture, treatment and disposal of toxic or other hazardous substances, chemicals, materials or waste. We believe that we are in compliance, in all material respects, with such regulations. Any failure to comply with current or future regulations could result in civil penalties or criminal fines being imposed upon us, or our officers, directors or employees, suspension of production, alteration of our manufacturing process or cessation of operations. Such regulations could require expensive remediation or abatement actions to comply with environmental regulations. Any failure to properly manage the use, disposal or storage of, or adequately restrict the release of, hazardous or toxic substances could subject us to significant liabilities. 21 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK There have been no material changes during the three months ended March 31, 2000. PART II. OTHER INFORMATION ITEM 1. LEGAL PROCEEDINGS Phase Metrics is subject to various legal matters in the normal course of its business. While the results of litigation and claims cannot be predicted with certainty, Phase Metrics believes that the final outcome of these other matters will not have a material adverse effect on its business, operating results or financial condition. ITEM 2. CHANGES IN SECURITIES None. ITEM 3. DEFAULTS UPON SENIOR SECURITIES Not Applicable. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. ITEM 5. OTHER INFORMATION Not applicable. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits. Financial Data Schedule. (b) Reports on Form 8-K. Not applicable. 22 PHASE METRICS, INC. 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. PHASE METRICS, INC. (Registrant) /s/ Dewey Hockemeyer By: _________________________________ Dewey Hockemeyer Vice President, Finance, Chief Financial Officer and Assistant Secretary 23