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DZS INC. - Quarter Report: 2004 September (Form 10-Q)

For The Quarterly Period Ended September 30, 2004
Table of Contents

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 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, 2004

 

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from              to             

 

000-32743

(Commission File Number)

 


 

ZHONE TECHNOLOGIES, INC.

(Exact name of registrant as specified in its charter)

 


 

Delaware   22-3509099

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification Number)

7001 Oakport Street

Oakland, California

  94621
(Address of principal executive offices)   (Zip code)

 

(510) 777-7000

(Registrant’s telephone number, including area code)

 

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  ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

 

As of October 31, 2004, there were 96,106,000 shares of the Registrant’s Common Stock issued and outstanding.

 



Table of Contents

Zhone Technologies, Inc.

FORM 10-Q

Quarterly Period Ended September 30, 2004

 

 

Table of Contents

 

Part I.

   Financial Information     

Item 1.

  

Financial Statements (Unaudited)

    
    

Condensed Consolidated Balance Sheets at September 30, 2004 and December 31, 2003

   2
    

Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2004 and September 30, 2003

   3
    

Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2004 and September 30, 2003

   4
    

Notes to Condensed Consolidated Financial Statements

   5

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   17

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   37

Item 4.

  

Controls and Procedures

   37

Part II.

  

Other Information

    

Item 1.

  

Legal Proceedings

   38

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

   38

Item 3.

  

Defaults Upon Senior Securities

   38

Item 4.

  

Submission of Matters to a Vote of Security Holders

   39

Item 5.

  

Other Information

   39

Item 6.

  

Exhibits

   39
    

Signatures

   40

 

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PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Condensed Consolidated Balance Sheets

(In thousands, except par value)

 

     September 30,
2004


    December 31,
2003


 
     (unaudited)        
Assets                 

Current assets:

                

Cash and cash equivalents

   $ 42,128     $ 32,547  

Short-term investments

     26,490       65,709  

Accounts receivable, net of allowances for sales returns and doubtful accounts of $4,397 and $3,505, respectively

     19,367       10,693  

Inventories

     37,165       24,281  

Prepaid expenses and other current assets

     9,588       3,905  
    


 


Total current assets

     134,738       137,135  

Property and equipment, net

     23,217       22,585  

Goodwill

     157,792       100,337  

Other acquisition-related intangible assets, net

     20,709       12,877  

Restricted cash

     758       622  

Other assets

     817       1,013  
    


 


Total assets

   $ 338,031     $ 274,569  
    


 


Liabilities and Stockholders’ Equity                 

Current liabilities:

                

Accounts payable

   $ 17,576     $ 19,998  

Line of credit

     14,500       4,800  

Current portion of long-term debt

     5,019       1,351  

Accrued and other liabilities

     22,869       28,685  
    


 


Total current liabilities

     59,964       54,834  

Long-term debt, less current portion

     43,056       32,040  

Other long-term liabilities

     1,599       816  
    


 


Total liabilities

     104,619       87,690  
    


 


Stockholders’ equity:

                

Common stock, $0.001 par value. Authorized 900,000 shares; issued and outstanding 94,102 and 76,629 shares as of September 30, 2004 and December 31, 2003, respectively

     94       77  

Additional paid-in capital

     862,229       787,567  

Notes receivable from stockholders

     (550 )     (550 )

Deferred compensation

     (710 )     (4,444 )

Other comprehensive loss

     (91 )     (14 )

Accumulated deficit

     (627,560 )     (595,757 )
    


 


Total stockholders’ equity

     233,412       186,879  
    


 


Total liabilities and stockholders’ equity

   $ 338,031     $ 274,569  
    


 


 

See accompanying notes to condensed consolidated financial statements.

 

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Table of Contents

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

 

Unaudited Condensed Consolidated Statements of Operations

 

(In thousands, except per share data)

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 

Net revenue

   $ 27,006     $ 22,240     $ 69,066     $ 59,849  

Cost of revenue

     15,603       12,118       39,332       33,014  

Stock-based compensation

     33       131       181       (155 )
    


 


 


 


Gross profit

     11,370       9,991       29,553       26,990  
    


 


 


 


Operating expenses:

                                

Research and product development (excluding non-cash stock-based compensation expense of $154, $366, $520 and $(344) respectively)

     5,705       5,513       17,306       15,711  

Sales and marketing (excluding non-cash stock-based compensation expense of $135, $285, $408 and $(373) respectively)

     6,825       4,513       16,670       13,061  

General and administrative (excluding non-cash stock-based compensation expense of $49, $112, $337 and $50 respectively)

     3,429       1,228       8,849       3,152  

Purchased in-process research and development

     2,446       —         8,631       —    

Litigation settlement

     —         1,600       —         1,600  

Stock-based compensation

     338       763       1,265       (667 )

Amortization and impairment of intangible assets

     2,862       2,053       7,270       5,889  
    


 


 


 


Total operating expenses

     21,605       15,670       59,991       38,746  
    


 


 


 


Operating loss

     (10,235 )     (5,679 )     (30,438 )     (11,756 )

Other income (expense), net

     (798 )     (879 )     (1,222 )     (1,964 )
    


 


 


 


Loss before income taxes

     (11,033 )     (6,558 )     (31,660 )     (13,720 )

Income tax (benefit) provision

     (26 )     (3,064 )     143       (2,967 )
    


 


 


 


Net loss

     (11,007 )     (3,494 )     (31,803 )     (10,753 )

Accretion on preferred stock (Note 5)

     —         —         —         (12,700 )
    


 


 


 


Net loss applicable to holders of common stock

   $ (11,007 )   $ (3,494 )   $ (31,803 )   $ (23,453 )
    


 


 


 


Basic and diluted net loss per share applicable to holders of common stock

   $ (0.12 )   $ (0.49 )   $ (0.38 )   $ (3.42 )

Weighted average shares outstanding used to compute basic and diluted net loss per share applicable to holders of common stock

     93,767       7,149       82,998       6,865  

 

All per share amounts have been retroactively adjusted to reflect the one-for-ten reverse split of common stock and the effect of the Tellium merger. (See Note 1(b)).

 

See accompanying notes to condensed consolidated financial statements.

 

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ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

 

Unaudited Condensed Consolidated Statements of Cash Flows

 

(In thousands)

 

     Nine months ended
September 30,


 
     2004

    2003

 

Cash flows from operating activities:

                

Net loss

   $ (31,803 )   $ (10,753 )

Adjustments to reconcile net loss to net cash used in operating activities:

                

Depreciation and amortization

     8,194       6,925  

Provision for doubtful accounts

     302       (110 )

Stock-based compensation

     1,446       (822 )

Purchased in-process research and development

     8,631       —    

Changes in operating assets and liabilities, net of effect of acquisitions:

                

Accounts receivable

     (5,783 )     5,317  

Inventories

     (6,805 )     (3,725 )

Prepaid expenses and other current assets

     1,402       (374 )

Other assets

     295       (71 )

Accounts payable

     (4,651 )     2,738  

Accrued liabilities and other

     (15,112 )     (13,901 )
    


 


Net cash used in operating activities

     (43,884 )     (14,776 )
    


 


Cash flows from investing activities:

                

Net cash acquired in acquisitions

     5,617       —    

Purchases of property and equipment

     (1,685 )     (462 )

Purchases of short-term investments

     (135,197 )     —    

Proceeds from sale and maturities of short-term investments

     174,327       —    

Change in restricted cash

     363       —    
    


 


Net cash provided by (used in) investing activities

     43,425       (462 )
    


 


Cash flows from financing activities:

                

Net borrowings under credit facilities

     9,700       6,207  

Proceeds from issuance of common stock

     1,447       49  

Repayment of debt

     (1,119 )     (3,196 )

Borrowings under loans from officers

     —         4,079  
    


 


Net cash provided by financing activities

     10,028       7,139  
    


 


Effect of exchange rate changes on cash

     12       (13 )
    


 


Net increase (decrease) in cash and cash equivalents

     9,581       (8,112 )

Cash and cash equivalents at beginning of period

     32,547       10,614  
    


 


Cash and cash equivalents at end of period

   $ 42,128     $ 2,502  
    


 


Supplemental disclosures of cash flow information:

                

Non-cash investing and financing activities:

                

Common stock and options issued for acquisitions

   $ 75,677     $ —    

Series B redeemable convertible preferred stock issued for acquisition

     —         10,125  

 

See accompanying notes to condensed consolidated financial statements.

 

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Table of Contents

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

(1) Organization and Summary of Significant Accounting Policies

 

  (a) Description of Business

 

Zhone Technologies, Inc. and its subsidiaries (collectively, “the Company”) designs, develops and markets telecommunications hardware and software products for network service providers. The Company has developed an integrated hardware and software architecture designed to simplify the way network service providers deliver communication services to their subscribers. The Company’s products enable service providers to use their existing networks to deliver voice, video, data, and entertainment services to their customers. The Company was incorporated under the laws of the state of Delaware in June 1999. The Company began operations in September 1999 and is headquartered in Oakland, California.

 

  (b) Basis of Presentation

 

The condensed consolidated financial statements are unaudited and reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the current interim period are not necessarily indicative of results to be expected for the current year or any other period. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K for the year ended December 31, 2003.

 

In July 2002, in conjunction with the Company’s equity restructuring, the Company’s Board of Directors approved a reverse stock split of the Company’s common stock at a ratio of one-for-ten (the “Reverse Split”), causing each outstanding share of common stock to convert automatically into one-tenth of a share of common stock. In November 2003, the Company consummated its merger with Tellium, Inc. (“Tellium”). As a result of the merger with Tellium, stockholders of Zhone prior to the merger received 0.47 of a share of Tellium common stock for each outstanding share of Zhone common stock, following the conversion of all outstanding shares of Zhone preferred stock into Zhone common stock. Immediately following the closing of the merger, the combined company was renamed Zhone.

 

For accounting purposes, the merger with Tellium was treated as a reverse merger, in which Zhone was treated as the acquirer based on factors including the relative voting rights, board control, and senior management composition. The financial statements of the combined company after the merger reflect the financial results of Zhone on a historical basis after giving effect to the merger exchange ratio to historical share-related data. The results of operations for Tellium were included in Zhone’s results of operations from the effective date of the merger.

 

Stockholders’ equity has been restated to give retroactive recognition to the Reverse Split and the effect of the Tellium merger for all periods presented by reclassifying the excess par value resulting from the reduced number of shares from common stock to paid-in capital. All references to preferred share, common share and per common share amounts for all periods presented have been retroactively restated to reflect the Reverse Split and the effect of the Tellium merger.

 

  (c) Use of Estimates

 

The preparation of the condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.

 

  (d) Revenue Recognition

 

The Company recognizes revenue when the earnings process is complete. The Company recognizes product revenue upon shipment of product under contractual terms which transfer title to customers upon shipment, under normal credit terms, or under sales-type leases, net of estimated sales returns and allowances at the time of shipment. Revenue is deferred if there are significant post-delivery obligations, if collection is not considered reasonably assured at the time of sale, or if the fees are not fixed or determinable. When significant post-delivery obligations exist, revenue is deferred until such obligations are fulfilled. The Company’s arrangements generally do not have any significant post-delivery obligations. The Company offers products and services such as support, education and training, hardware upgrades and extended

 

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warranty coverage. For multiple element revenue arrangements, the Company establishes the fair value of these products and services based primarily on sales prices when the products and services are sold separately. When collectibility is not reasonably assured, revenue is recognized when cash is collected. Revenue from education services and support services is recognized over the contract term or as the service is performed. The Company makes certain sales to product distributors. These customers are given certain privileges to return a portion of inventory. The Company recognizes revenue on sales to distributors that have contractual return rights when the products have been sold by the distributors, unless there is sufficient customer specific sales and sales returns history to support revenue recognition upon shipment. Revenue from sales of software products is recognized provided that a purchase order has been received, the software has been shipped, collection of the resulting receivable is probable, and the amount of the related fees is fixed or determinable. To date, revenue from software transactions has not been significant. The Company accrues for warranty costs, sales returns, and other allowances at the time of shipment based on historical experience and expected future costs.

 

  (e) Allowances for Sales Returns and Doubtful Accounts

 

The Company has an allowance for sales returns for estimated future product returns related to current period product revenue. The Company bases its allowance on periodic assessment of historical trends in product return rates and current approved returned products. If the actual future returns were to deviate from the historical data on which the reserve had been established, the Company’s revenue could be adversely affected.

 

The Company has an allowance for doubtful accounts for estimated losses resulting from the inability of customers to make payments. The Company bases its allowance on periodic assessment of its customers’ liquidity and financial condition through analysis of information obtained from credit rating agencies, financial statement reviews, and historical collection trends. Additional allowances may be required if the liquidity or financial condition of its customers were to deteriorate.

 

  (f) Inventories

 

Inventories are stated at the lower of cost or market, with cost being determined using the first-in, first-out (FIFO) method. In assessing the net realizable value of inventories, the Company is required to make judgments as to future demand requirements and compare these with the current or committed inventory levels. Once inventory has been written down to its estimated net realizable value, its carrying value cannot be increased due to subsequent changes in demand forecasts. To the extent that a severe decline in forecasted demand occurs, or the Company experiences a higher incidence of inventory obsolescence due to rapidly changing technology and customer requirements, the Company may incur significant charges for excess inventory.

 

  (g) Concentration of Risk

 

The Company’s customers include competitive and incumbent local exchange carriers, competitive access providers, Internet service providers, wireless carriers, and resellers serving these markets. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Allowances are maintained for potential doubtful accounts. For the three and nine months ended September 30, 2004, sales to one customer represented 19% and 15% of net revenue, respectively. For the three months ended September 30, 2003, sales to two customers represented 16% and 14% of net revenue, respectively. For the nine months ended September 30, 2003, sales to two customers represented 18% and 12% of net revenue, respectively. As of September 30, 2004, the Company had accounts receivable balances from two customers individually representing 21% and 19% of accounts receivable, respectively. As of December 31, 2003, the Company had accounts receivable balances from two customers individually representing 31% and 11% of accounts receivable, respectively.

 

  (h) Accounting for Stock-Based Compensation

 

The Company has elected to account for employee stock options using the intrinsic-value method in accordance with Accounting Principles Board Opinion No. 25 (“APB 25”) and related interpretations. Under this method, compensation expense is recorded on the date of grant only if the current fair value exceeds the exercise price. SFAS No. 123, Accounting for Stock-Based Compensation, established accounting and disclosure requirements using a fair-value-based method of accounting for stock-based employee compensation plans. As allowed by SFAS No. 123, the Company has elected to continue to apply the intrinsic-value-based method of accounting described above, and has adopted the disclosure requirements of SFAS No. 123, as amended.

 

In March 2004, the Financial Accounting Standards Board (“FASB”) issued an exposure draft on the Proposed SFAS, “Share-Based Payment - an amendment of FASB Statements No. 123 and 95”. The proposed statement addresses the accounting for share-based payment transactions. The proposed standard would eliminate the ability to account for share-based compensation transactions using APB No. 25, and generally would require that such transactions be accounted for using a fair-value-based method. If the final standard is approved as currently drafted in the exposure draft, it may have a material impact on the amount of earnings we report for interim periods beginning after June 15, 2005. We are currently determining the impact that the proposed statement will have on our results of operations and financial position.

 

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Table of Contents

For the nine month periods ended September 30, 2004 and 2003, the fair value of the Company’s stock-based awards to employees was estimated using the following weighted average assumptions: expected option life 4.0 years; dividend yield of 0%; risk-free interest rate of 3.2% and 4.5%, respectively; and volatility of 89% and 80%, respectively.

 

The following table illustrates the effect on net loss and net loss per share if the fair-value-based method had been applied to all outstanding and unvested awards in each period (in thousands, except per share data):

 

     Three months ended
September 30,


    Nine months ended
September 30,


 
     2004

    2003

    2004

    2003

 

Net loss, as reported

   $ (11,007 )   $ (3,494 )   $ (31,803 )   $ (23,453 )
    


 


 


 


Add: Stock-based compensation expense included in reported net loss

     371       894       1,446       (822 )

Deduct: Total stock-based compensation benefit (expense) determined under fair value method for all awards

     (2,234 )     (1,502 )     (5,513 )     267  
    


 


 


 


Pro forma net loss

   $ (12,870 )   $ (4,102 )   $ (35,870 )   $ (24,008 )
    


 


 


 


Loss per share applicable to holders of common stock:

                                

As reported – basic and diluted

   $ (0.12 )   $ (0.49 )   $ (0.38 )   $ (3.42 )
    


 


 


 


Pro forma – basic and diluted

   $ (0.14 )   $ (0.57 )   $ (0.43 )   $ (3.50 )
    


 


 


 


 

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Table of Contents
(2) Acquisitions

 

Sorrento

 

In July 2004, the Company completed the acquisition of Sorrento Networks Corporation (“Sorrento”) in exchange for total consideration of $97.8 million, consisting of common stock valued at $57.7 million, options and warrants to purchase common stock valued at $12.3 million, assumed liabilities of $26.8 million, and acquisition costs of $1.0 million. The Company acquired Sorrento to obtain its line of Optical Transport products and enhance its competitive position with cable operators. One of the Company’s directors is a partner of a venture capital firm which is a major stockholder of Zhone, and which also held warrants to purchase Sorrento common stock that were assumed by Zhone.

 

The purchase consideration was allocated to the fair values of the assets acquired as follows: net tangible assets - $23.3 million, amortizable intangible assets - $14.8 million, purchased in-process research and development - $2.4 million, goodwill - $57.1 million and deferred compensation - $0.2 million. The amount allocated to purchased in-process research and development was charged to expense during the third quarter of 2004, because technological feasibility had not been established and no future alternative uses for the technology existed. The estimated fair value of the purchased in-process research and development was determined using a discounted cash flow model, based on a discount rate which took into consideration the stage of completion and risks associated with developing the technology. Of the amount allocated to amortizable intangible assets, $9.2 million was allocated to core technology, which is being amortized over an estimated useful life of 5 years. The remaining $5.6 million was allocated to customer relationships, which is being amortized over an estimated useful life of 4 years.

 

Assumed liabilities related to the Sorrento acquisition totaled $26.8 million, the most significant component of which was long-term debt and debentures totaling $15.8 million. The assumed liabilities also included employee severance and exit costs totaling $2.2 million, which were recorded based on Emerging Issues Task Force (“EITF”) 95-3, “Recognition of Liabilities in Connection with a Purchase Business Combination”. A rollforward of the EITF 95-3 related activity was comprised as follows (in thousands):

 

     Severance

    Exit Costs

    Total

 

Liability recorded at acquisition date

   $ 1,255     $ 948     $ 2,203  

Cash payments

     (1,146 )     (829 )     (1,975 )
    


 


 


Balance at September 30, 2004

   $ 109     $ 119     $ 228  
    


 


 


 

The remaining costs accrued under EITF 95-3 are expected to be paid by the first quarter of 2005.

 

This preliminary purchase price allocation is subject to revision as more detailed analysis is completed and additional information as to the fair value of Sorrento assets and liabilities becomes available in the fourth quarter of 2004.

 

The following table reflects the unaudited pro forma combined results of operations of the Company on the basis that the acquisition of Sorrento had taken place at the beginning of each period presented (in thousands, except per share data).

 

     Three months ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 

Net Revenue

   $ 27,006     $ 28,966     $ 79,613     $ 78,912  

Net Loss

     (11,007 )     (11,567 )     (58,755 )     (26,852 )

Net Loss per share – basic and diluted

   $ (0.12 )   $ (0.51 )   $ (0.63 )   $ (1.19 )

Number of shares used in computation – basic and diluted

     93,767       22,796       93,429       22,512  

 

In conjunction with the acquisition of Sorrento, the Company has classified certain acquired facilities held for sale in accordance with SFAS No. 144 “Accounting for the Impairment or Disposal of Long Lived Assets”. The Company intends to sell these facilities within the next year in an effort to consolidate operations. As of September 30, 2004, the Company has entered into an agreement to sell certain of these facilities subject to final negotiations. The recorded fair value of all acquired assets held for sale as of September 30, 2004 was $6.9 million. Accordingly, the mortgage obligation associated with these assets has been classified as current.

 

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Gluon

 

In February 2004, the Company acquired the assets of Gluon Networks, Inc. (“Gluon”) in exchange for total consideration of $6.49 million, consisting of common stock valued at $5.74 million, $0.65 million of cash and $0.1 million of acquisition related costs. One of the Company’s directors is a partner of a venture capital firm which is a major stockholder of Zhone, and which was also a major stockholder of Gluon. The transaction was accounted for as an asset acquisition rather than a business combination, since only assets were acquired, which consisted primarily of Gluon’s intellectual property. Gluon was a development stage company that had developed a product for customer trials but had not generated any revenue to date. The Company agreed to acquire Gluon’s intellectual property and hired approximately ten of the former Gluon employees. The Company intends to incorporate elements of the Gluon technology into its future product offerings but does not anticipate generating material revenue from such products until the second half of 2005.

 

The purchase price for the Gluon transaction was allocated to purchased in-process research and development - $6.19 million, and acquired workforce - $0.3 million. The amount allocated to purchased in-process research and development was charged to expense during the first quarter of 2004, because technological feasibility had not been established and no future alternative uses for the technology existed. The estimated fair value of the purchased in-process research and development was determined using a discounted cash flow model, based on a discount rate which took into consideration the stage of completion and risks associated with developing the technology. Because the transaction did not constitute a business combination, no goodwill was recorded and a portion of the purchase price was allocated to the acquired workforce, which was being amortized over a two year period. An impairment charge of $0.2 million was subsequently recorded in the second quarter of 2004 relating to the Gluon acquired workforce, because the majority of the former Gluon employees were no longer employed by the Company.

 

Tellium

 

In November 2003, the Company completed the acquisition of Tellium in exchange for total consideration of approximately $173.3 million, consisting of common stock valued at $119.4 million, options and warrants to purchase common stock valued at $7.9 million, assumed liabilities of $42.8 million, and acquisition costs of $3.2 million. The transaction was treated as a reverse merger for accounting purposes, in which the Company was treated as the acquirer based on factors including the relative voting rights, board control, and senior management composition. The purchase price was allocated to the fair values of the assets acquired as follows: net tangible assets - $144.4 million, goodwill - $25.7 million and deferred compensation - $3.1 million. During the quarter ended September 30, 2004, the Company recorded an adjustment to increase the recorded goodwill by $0.4 million, relating to additional severance incurred as a result of the resolution of a contingent liability. A rollforward of the severance and exit costs recorded under EITF 95-3 was comprised as follows (in thousands):

 

     Severance

    Exit Costs

    Total

 

Balance at December 31, 2003

   $ 3,242     $ 2,372     $ 5,614  

Cash payments

     (3,332 )     (1,581 )     (4,913 )

Adjustments

     400       —         400  
    


 


 


Balance at September 30, 2004

   $ 310     $ 791     $ 1,101  
    


 


 


 

The remaining costs accrued under EITF 95-3 are expected to be paid by the first quarter of 2005.

 

(3) Long-lived Assets, Goodwill and Other Acquisition-Related Intangible Assets

 

As of January 1, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires that goodwill no longer be amortized, but should be tested for impairment at least annually. The Company completed its transitional and first annual goodwill impairment test as of January 2002 and November 2002, respectively. As the Company has determined that it operates in a single segment with one operating unit, the fair value of its reporting unit was performed at the Company level using a combination of the income, or discounted cash flows, approach and the market approach, which utilizes comparable companies’ data. As of November 2003, the Company performed the annual goodwill impairment test using the market approach, reflecting the fact that the Company’s stock was publicly traded following the consummation of the Tellium merger. At September 30, 2004 and December 31, 2003, the Company had goodwill with a carrying value of $157.8 million and $100.3 million, respectively. No goodwill impairment charges have been recorded since the initial adoption of SFAS No. 142.

 

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In accordance with SFAS No. 144, the Company reviews long-lived assets, including intangible assets other than goodwill, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable based on expected undiscounted cash flows attributable to that asset. The amount of any impairment is measured as the difference between the carrying value and the fair value of the impaired asset.

 

The Company estimates the fair value of its long-lived assets based on a combination of the market, income and replacement cost approaches. In the application of the impairment testing, the Company is required to make estimates of future operating trends and resulting cash flows and judgments on discount rates and other variables. Actual future results and other assumed variables could differ from these estimates.

 

Details of the Company’s acquisition-related intangible assets are as follows:

 

     September 30, 2004

     Gross
Amount


   Accumulated
Amortization


    Net

   Weighted Average
Useful Life


          (in thousands)          (in years)

Developed technology

   $ 35,596    $ (32,304 )   $ 3,292    3.7

Core technology

     21,342      (11,961 )     9,381    5.0

Others

     16,570      (8,534 )     8,036    3.8
    

  


 

    

Total

   $ 73,508    $ (52,799 )   $ 20,709     
    

  


 

    

 

     December 31, 2003

     Gross
Amount


   Accumulated
Amortization


    Net

   Weighted Average
Useful Life


          (in thousands)          (in years)

Developed technology

   $ 35,596    $ (29,907 )   $ 5,689    3.7

Core technology

     12,104      (9,683 )     2,421    5.0

Others

     11,008      (6,241 )     4,767    3.6
    

  


 

    

Total

   $ 58,708    $ (45,831 )   $ 12,877     
    

  


 

    

 

Amortization expense of acquisition-related intangible assets was $2.9 million and $2.1 million for the three months ended September 30, 2004 and 2003, respectively, and $7.1 million and $5.9 million for the nine months ended September 30, 2004 and 2003, respectively. In addition, during the nine months ended September 30, 2004, the Company recorded an impairment charge of $0.2 million relating to the Gluon acquired workforce.

 

Projected future amortization expense for the fiscal years ending December 31 is as follows: 2004 (remainder of year) - $2.9 million, 2005 - $7.6 million, 2006 - $3.5 million, 2007 - $3.3 million, 2008 - $2.5 million and 2009 - $0.9 million.

 

The changes in the carrying amount of goodwill are as follows (in thousands):

 

     Nine months ended
September 30,


 
     2004

   2003

 

Beginning balance

   $ 100,337    $ 70,828  

Goodwill acquired

     57,055      4,232  

Adjustments

     400      (170 )
    

  


Ending balance

   $ 157,792    $ 74,890  
    

  


 

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(4) Inventories

 

Inventories as of September 30, 2004 and December 31, 2003 are as follows (in thousands):

 

     September 30,
2004


   December 31,
2003


Inventories:

             

Raw materials

   $ 29,513    $ 19,681

Work in process

     4,963      3,088

Finished goods

     2,689      1,512
    

  

     $ 37,165    $ 24,281
    

  

 

(5) Redeemable Convertible Preferred Stock

 

During the three and nine months ended September 30, 2003, the Company had Series AA and Series B redeemable convertible preferred stock outstanding, and was recording accretion relating to this preferred stock as described below. There were no shares of preferred stock outstanding during the three and nine months ended September 30, 2004. All outstanding shares of preferred stock were converted to common stock prior to the consummation of the Tellium merger in November 2003.

 

Prior to April 17, 2003, the Company’s Series AA and Series B redeemable convertible preferred stock contained a redemption feature, such that holders of the redeemable convertible preferred stock could require the Company to redeem the preferred stock at, or any time after, November 1, 2004, 2005, and 2006, in three annual installments, that number of shares of redeemable convertible preferred stock equal to not less than 33.3%, 66.7%, and 100%, respectively. On April 17, 2003, the terms of the redeemable convertible preferred stock were changed to eliminate the redemption feature. Upon the elimination of the redemption feature, the convertible preferred stock was reclassified to stockholders’ equity.

 

Prior to April 17, 2003, the Company was accreting the redeemable convertible preferred stock to its stated redemption price. The Company accreted, by charging paid in capital, $12.7 million on all outstanding Series AA and Series B redeemable convertible preferred stock through April 17, 2003, which was reflected as an increase in the carrying value of the preferred stock. Upon the elimination of the redemption feature for the Series AA and Series B preferred shares, the Company stopped recording accretion on the convertible preferred stock. The accretion of the redemption value of the redeemable convertible preferred stock for the three and nine months ended September 30, 2003 was zero and $12.7 million, respectively.

 

(6) Net Loss Per Share

 

The following table sets forth the computation of basic and diluted net loss per share (in thousands, except per share data):

 

     Three months ended
September 30,


    Nine months ended
September 30,


 
     2004

    2003

    2004

    2003

 

Numerator:

                                

Net loss

   $ (11,007 )   $ (3,494 )   $ (31,803 )   $ (10,753 )

Accretion on preferred stock

                       (12,700 )
    


 


 


 


Net loss applicable to holders of common stock

   $ (11,007 )   $ (3,494 )   $ (31,803 )   $ (23,453 )
    


 


 


 


Denominator:

                                

Weighted average common stock outstanding

     93,926       7,361       83,173       7,335  

Adjustment for common stock issued subject to repurchase

     (159 )     (212 )     (175 )     (470 )
    


 


 


 


Denominator for basic and diluted calculation

     93,767       7,149       82,998       6,865  
    


 


 


 


Basic and diluted net loss per share applicable to holders of common stock

   $ (0.12 )   $ (0.49 )   $ (0.38 )   $ (3.42 )

 

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The following table sets forth potentially dilutive securities that have been excluded from the diluted net loss per share calculation because their effect would be antidilutive for the periods indicated (in thousands, except exercise price data):

 

     Three Months
Ended
September 30, 2004


   Weighted
Average
Exercise
price


  

Nine Months

Ended
September 30, 2004


   Weighted
Average
Exercise
price


Weighted average common stock issued subject to repurchase

   159    $ 1.99    175    $ 1.99

Convertible debentures

   1,948      6.02    1,948      6.02

Warrants

   3,030      9.20    3,030      9.20

Outstanding stock options granted

   9,635      6.69    9,635      6.69
    
         
      
     14,772           14,788       
    
         
      

 

     Three Months
Ended
September 30, 2003


   Weighted
Average
Exercise
price


  

Nine Months

Ended
September 30, 2003


   Weighted
Average
Exercise
price


Convertible preferred stock

   38,996      N/M    38,996      N/M

Weighted average common stock issued subject to repurchase

   212    $ 1.77    470    $ 1.77

Warrants

   80      27.60    80      27.60

Outstanding stock options granted

   1,655      1.77    1,655      1.77
    
         
      
     40,943           41,201       
    
         
      
(7) Comprehensive Loss

 

 

The components of comprehensive loss, net of tax, for the three and nine months ended September 30, 2004 and 2003 were as follows (in thousands):

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 

Net loss

   $ (11,007 )   $ (3,494 )   $ (31,803 )   $ (10,753 )

Other comprehensive loss:

                                

Change in unrealized loss on investments

     (33 )           (90 )      

Foreign currency translation adjustments

     98       (38 )     12       (13 )
    


 


 


 


Total comprehensive loss

   $ (10,942 )   $ (3,532 )   $ (31,881 )   $ (10,766 )
    


 


 


 


 

(8) Commitments and Contingencies

 

Line of Credit and Long-Term Debt

 

The Company has a $25.0 million line of credit agreement, under which $14.5 million was outstanding at September 30, 2004, and an additional $8.4 million was committed as security for obligations under the Company’s secured real estate loan facility and other letters of credit. Borrowings under the line of credit agreement bear interest at the financial institution’s prime rate or LIBOR plus 2.9%, at the Company’s election. The interest rate was 4.8% at September 30, 2004. As part of the agreement, the Company must also comply with certain financial covenants which have been waived by the financial institution for the period ended September 30, 2004.

 

At September 30, 2004, the Company had $32.3 million of debt outstanding under a secured real estate loan facility which matures in April 2006. The interest rate on this debt was 8.0% at September 30, 2004.

 

The Company also assumed debt and convertible debentures relating to the acquisition of Sorrento totaling $15.8 million. The interest rate of these obligations approximates 7.5%. The outstanding principal amount of the convertible debentures was $11.7 million as of September 30, 2004 and matures in August 2007. The debentures are callable by the Company at any time, and can be converted into common stock at the option of the holder at a conversion price of $6.02 per share. Other debt represents the mortgage obligation on assets held for sale which has been classified as current.

 

As of September 30, 2004 the annual contractual commitments on the $48.1 million debt is as follows: $4.3 million for the remainder of 2004, $1.0 million in 2005, $31.1 million in 2006, and $11.7 million in 2007.

 

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Leases

 

The Company has entered into operating leases for certain office space and equipment, some of which contain renewal options.

 

Future minimum lease payments under all non-cancelable operating leases with terms in excess of one year are as follows (in thousands):

 

     Operating leases

Year ending December 31:

      

2004 (remainder of the year)

   $ 2,011

2005

     1,223

2006

     425

2007

     342
    

Total minimum lease payments

   $ 4,001
    

 

The amount shown above for 2004 includes projected payments and obligations for leases that the Company is no longer utilizing, most of which relate to excess facilities obtained through acquisitions. At September 30, 2004, $2.6 million was accrued relating to excess facilities.

 

Warranties & Other Commitments

 

The Company accrues for warranty costs based on historical trends for the expected material and labor costs to provide warranty services. Warranty periods are generally one year from the date of shipment.

 

The following table reconciles changes in the Company’s accrued warranties and related costs for the nine months ended September 30, 2004 and 2003 (in thousands):

 

     Nine Months ended September 30,

 
     2004

    2003

 

Beginning balance

   $ 5,856     $ 6,040  

Charged to operations

     305       313  

Warranty reserve from acquired companies

     1,800       1,537  

Reductions

     (1,068 )     (1,980 )
    


 


Ending balance

   $ 6,893     $ 5,910  
    


 


 

The Company depends on sole source and limited source suppliers for several key components and on contract manufacturers to manufacture certain product lines. If the Company was unable to obtain these components on a timely basis, or if its contract manufacturers were unable to meet the Company’s delivery requirements, the Company’s operating results could be materially adversely affected.

 

The Company has agreements with various contract manufacturers which include inventory repurchase commitments on excess material based on the Company’s sales forecasts. The Company has recorded a liability of $4.8 million and $4.6 million related to these arrangements as of September 30, 2004 and December 31, 2003, respectively.

 

In connection with the acquisition of Sorrento, the Company has recorded assumed liabilities for possible contingencies related to the resolution of a pension plan. In 2000, Sorrento sold one of its subsidiaries to Entrada Networks, Inc. In connection with this transaction, Entrada assumed all responsibilities for a defined benefit plan. Although Entrada is the sponsor of the benefit plan, it disclaims responsibility for the minimum funding contributions to the benefit plan and insists that the Company is responsible for any liability related thereto. The Company has reserved an estimated amount which the Company feels is sufficient to cover potential claims regarding the resolution of the benefit plan.

 

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Letters of Credit

 

The Company has issued letters of credit to ensure its performance or payment to third parties in accordance with specified terms and conditions, which amounted to $0.3 million and $0.6 million as of September 30, 2004 and December 31, 2003, respectively. The Company has recorded restricted cash equal to the amount outstanding under these letters of credit.

 

Legal Proceedings

 

The Company is involved in various litigation matters relating to the operations of Tellium prior to the merger as described below.

 

On various dates between approximately December 10, 2002 and February 27, 2003, numerous class-action securities complaints were filed against Tellium in the United States District Court, District of New Jersey. These complaints allege, among other things, that Tellium and its then-current directors and executive officers and its underwriter violated the Securities Act of 1933 by making false and misleading statements preceding its initial public offering and in its registration statement prospectus relating to the securities offered in the initial public offering. The complaints further allege that these parties violated the Securities Exchange Act of 1934 by acting recklessly or intentionally in making the alleged misstatements. The actions seek damages in an unspecified amount, including compensatory damages, costs, and expenses incurred in connection with the actions and equitable relief as may be permitted by law or equity. On May 19, 2003, a consolidated amended complaint representing all of the actions was filed. On August 4, 2003, Tellium and its underwriters filed motions to dismiss the complaint. On April 1, 2004, the Court issued its decision granting Tellium’s and the underwriters’ motions to dismiss, while allowing plaintiffs an opportunity to seek leave to file a further amended complaint. On May 14, 2004, the plaintiffs filed a second consolidated and amended class action complaint. On June 25, 2004, the Company, as Tellium’s successor-in-interest, moved to have the second consolidated and amended class action complaint dismissed with prejudice. The motion to dismiss has been fully briefed, and the parties are awaiting the Court’s decision on the motion. It remains too early in the legal process to determine what impact, if any, these suits will have upon the Company’s business, financial condition, or results of operations. The Company intends to continue vigorously defending against the claims made in these actions.

 

On January 8, 2003 and January 27, 2003, two shareholder derivative complaints were filed on behalf of Tellium in the Superior Court of New Jersey. These complaints were made by plaintiffs who purport to be Tellium shareholders on behalf of Tellium, alleging, among other things, that Tellium directors breached their fiduciary duties to the company by engaging in stock transactions with individuals associated with Qwest Communications International Inc., and in making materially misleading statements regarding Tellium’s relationship with Qwest. The actions seek damages in an unspecified amount, including imposition of a constructive trust in favor of Tellium for the amount of profits allegedly received through stock sales, disgorgement of proceeds in connection with the stock option exercises, damages allegedly sustained by Tellium in connection with alleged breaches of fiduciary duties, costs, and expenses incurred in connection with the actions. These cases have been stayed by the court pending the resolution of motions to dismiss in the above-referenced federal court securities actions. It is too early in the legal process to determine what impact, if any, these suits will have upon the Company’s business, financial condition, or results of operations. The Company intends to vigorously defend the claims made in these actions, which have been consolidated.

 

The Denver, Colorado regional office of the SEC is conducting two investigations titled In the Matter of Qwest Communications International Inc. and In the Matter of Issuers Related to Qwest. The first of these investigations does not involve any allegation of wrongful conduct on the part of Tellium. In connection with the second investigation, the SEC is examining various transactions and business relationships involving Qwest and eleven companies having a vendor relationship with Qwest, including Tellium. This investigation, insofar as it relates to Tellium, appears to focus generally on whether Tellium’s transactions and relationships with Qwest were appropriately disclosed in Tellium’s public filings and other public statements. In addition, the United States Attorney in Denver is conducting an investigation involving Qwest, including Qwest’s relationships with certain of its vendors, including Tellium. In connection with that investigation, the U.S. Attorney has sought documents and information from Tellium and has sought interviews and/or grand jury testimony from persons associated or formerly associated with Tellium, including certain of its officers. The U.S. Attorney has indicated that, while aspects of its investigation are in an early stage, neither Tellium nor any of the Company’s current or former officers or employees is a target of the investigation. The Company is cooperating fully with these investigations. The Company is not able, at this time, to say when the SEC or U.S. Attorney investigations will be completed and resolved, or what the ultimate outcome with respect to the Company will be. These investigations could result in substantial costs and a diversion of management’s attention and may have a material and adverse effect on the Company’s business, financial condition, and results of operations.

 

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The Company is subject to other legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company’s results of operations or financial position.

 

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Table of Contents
(9) Segment Information

 

Zhone designs, develops and markets telecommunications hardware and software products for network service providers. The Company derives substantially all of its revenues from the sales of the Zhone product family. The Company’s chief operating decision maker is the Company’s chief executive officer, or CEO. The CEO reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance. The Company has determined that it has operated within one discrete reportable business segment since inception. The Company is required to disclose certain information about geographic concentrations and revenue by product family.

 

     Three Months ended
September 30,


   Nine Months ended
September 30,


     2004

   2003

   2004

   2003

     (in thousands)    (in thousands)

Revenue:

                           

North America

   $ 19,309    $ 20,411    $ 54,194    $ 54,799

International

     7,697      1,829      14,872      5,050
    

  

  

  

Total revenue

   $ 27,006    $ 22,240    $ 69,066    $ 59,849
    

  

  

  

 

     Three Months ended
September 30,


   Nine Months ended
September 30,


     2004

   2003

   2004

   2003

     (in thousands)    (in thousands)

Revenue by Product Family:

                           

SLMS

   $ 5,612    $ 4,449    $ 19,552    $ 14,406

Legacy and Service

     17,183      17,791      45,303      45,443

Optical Transport

     4,211      —        4,211      —  
    

  

  

  

Total revenue

   $ 27,006    $ 22,240    $ 69,066    $ 59,849
    

  

  

  

 

During the quarter ended September 30, 2004, the Company completed the acquisition of Sorrento and began selling optical transport products for the first time. Concurrently with this development, management implemented a new internal product categorization, in which the next-generation, internally developed SLMS products are the first category. The second product category, Legacy and Service, is comprised of product lines acquired in previous acquisitions, as well as service revenue. The Legacy and Service product category includes the former MUX and DLC product categories and one legacy product line acquired from Sorrento. The third product category is Optical Transport, which consists of the majority of the product lines acquired from Sorrento. All historical product line information has been restated to reflect the new product categories.

 

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Item 2.     Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this report. In addition to historical information, this report contains forward-looking statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in these forward-looking statements. We use words such as “anticipate”, “believe”, “could”, “estimate”, “expect”, “intend”, “may”, “should”, “will”, “would” and similar expressions to identify forward-looking statements. Factors that might cause such a difference include, but are not limited to, our ability to obtain additional capital to fund our existing and future operations, the rate of product purchases by current and prospective customers, general economic conditions, conditions specific to the telecommunications and related industries, new product introductions and enhancements by us and our competitors, competition, manufacturing and sourcing risks. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Readers are referred to risks and uncertainties identified below, under “Risk Factors” and elsewhere herein. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.

 

OVERVIEW

 

We were founded in 1999 to offer network service providers a simplified, comprehensive architectural approach to delivering services over their access networks.

 

We have developed hardware and software that simplify the way network service providers deliver communication services to their subscribers. Our Single Line Multi-Service Architecture, or SLMS, is a simplified network architecture that provides broadband and narrowband services over a scalable next-generation local-loop infrastructure. SLMS is designed to extend the speed, reliability and cost-efficiencies currently achieved in the core of the communications network to business and consumer subscribers. Our products enable service providers to use their existing networks to deliver voice, data, video, and entertainment services to their customers. We have designed our products to interoperate with different types of wiring and equipment already deployed in service providers’ networks.

 

Our Zhone Management System, or ZMS, provides the software tools necessary to manage all of the products, services and subscribers in a SLMS network. ZMS is a single management tool that enables network service providers to allow instant delivery and upgrade of network services. In addition, ZMS is capable of interfacing with and managing other vendors equipment already deployed in service providers’ networks.

 

Our revenue consists of three product categories: SLMS, Legacy and Service, and Optical Transport. SLMS consists of our next generation, internally developed products. Legacy and Service is comprised of legacy product lines acquired in acquisitions, including the former MUX and DLC product categories and one legacy product line acquired from Sorrento, as well as service revenue. Optical Transport consists of the majority of the product lines acquired from Sorrento.

 

We believe that we have assembled the employee base, technological breadth and market presence to provide a simple yet comprehensive set of solutions to the complex problems encountered by network service providers when delivering communications services to subscribers.

 

Since inception, we have incurred significant operating losses and have an accumulated deficit of $627.6 million at September 30, 2004. The global telecommunications market has deteriorated significantly over the last several years. Many of our customers and potential customers have reduced their capital spending during this period and many others have ceased operations. Additional capital spending reductions have continued due to continued uncertainties regarding the state of the global economy, network overcapacity, customer bankruptcies, network build-out delays and limited capital availability. In response to the challenging environment, we have taken the actions that we believe are necessary for our future success. In particular, we have significantly reduced our operating costs through workforce reductions and careful cost controls. We have also taken significant write-downs of inventory, intangible assets and property and equipment. Due to our restructuring activities and careful expense controls, our net loss decreased from $108.6 million in 2002 to $17.2 million in 2003. For the nine months ended September 30, 2004, our net loss was $31.8 million. We do not expect any significant reductions in our overall workforce for at least through the period ending December 2004.

 

Going forward, our key objectives include the following:

 

  Increasing revenue while continuing to carefully control costs;

 

  Continued investments in strategic research and product development activities that will provide the maximum potential return on investment;

 

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Table of Contents
  Minimizing consumption of our cash and short-term investments; and

 

  Analyzing and pursuing strategic acquisitions that will allow us to expand our customer, technology and/or revenue base.

 

Basis of Presentation

 

In November 2003, we consummated our merger with Tellium. Tellium was the surviving entity under corporate law and following the merger its name was changed to Zhone Technologies, Inc. However, due to various factors, including the relative voting rights, board control, and senior management composition of the combined company, the transaction was treated as a reverse merger for accounting purposes, and Zhone was treated as the “acquirer”. As a result, the financial statements of the combined company after the merger reflect the financial results of Zhone on a historical basis after giving effect to the merger exchange ratio to historical share-related data. The results of operations for Tellium were included in the combined company’s results of operations from the effective date of the merger.

 

In July 2002, in conjunction with our equity restructuring, our Board of Directors approved a reverse stock split of our common stock at a ratio of one-for-ten (the “Reverse Split”), causing each outstanding share of common stock to convert automatically into one-tenth of a share of common stock. As a result of the merger with Tellium, stockholders of Zhone prior to the merger received 0.47 of a share of Tellium common stock for each outstanding share of Zhone common stock, following the conversion of all outstanding shares of our preferred stock into common stock.

 

Stockholders’ equity has been restated to give retroactive recognition to the Reverse Split and the effect of the Tellium merger for all periods presented by reclassifying the excess par value resulting from the reduced number of shares from common stock to paid-in capital. All references to preferred share, common share and per common share amounts for all periods presented have been retroactively restated to reflect the Reverse Split and the effect of the Tellium merger.

 

In October 2003, in response to an inquiry from the SEC, we restated our consolidated financial statements and related disclosures for the year ended December 31, 2002 and for the quarters ended June 30, 2003 and March 31, 2003. All information, discussions and comparisons in this report reflect the restatement. The restatement reflected increased non-cash stock-based compensation expense resulting from a change in the estimated fair value of our common stock from $0.21 per share to $3.19 per share. We also adjusted the Series AA redeemable preferred stock to reflect a decrease in the estimated fair value from $170.7 million to $126.5 million, or $5.81 per share to $4.31 per share as of July 1, 2002.

 

Acquisitions

 

As of September 30, 2004, we had completed eleven acquisitions of complementary companies, products or technologies to supplement our internal growth. To date, we have generated a significant amount of our revenue from sales of products obtained through acquisitions.

 

We are likely to acquire additional businesses, products and technologies in the future. If we complete additional acquisitions in the future, we could consume cash, incur substantial additional debt and other liabilities, incur amortization expenses related to acquired intangible assets or incur large write-offs related to impairment of goodwill and long-lived assets. In addition, future acquisitions may have a significant impact on our short term results of operations, materially impacting revenues or expenses and making period to period comparisons of our results of operations less meaningful.

 

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Table of Contents

Critical Accounting Policies and Estimates

 

Management’s discussion and analysis of its financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. The policies discussed below are considered by management to be critical because changes in such estimates can materially affect the amount of our reported net income or loss. For all of these policies, management cautions that actual results may differ materially from these estimates under different assumptions or conditions.

 

Revenue Recognition

 

We recognize revenue when the earnings process is complete. We recognize product revenue upon shipment of product under contractual terms which transfer title to customers upon shipment, under normal credit terms, or under sales-type leases, net of estimated sales returns and allowances at the time of shipment. Revenue is deferred if there are significant post-delivery obligations, if collection is not considered reasonably assured at the time of sale, or if the fees are not fixed or determinable. When significant post-delivery obligations exist, revenue is deferred until such obligations are fulfilled. Our arrangements generally do not have any significant post delivery obligations. We offer products and services such as support, education and training, hardware upgrades and extended warranty coverage. For multiple element revenue arrangements, we establish the fair value of these products and services based primarily on sales prices when the products and services are sold separately. When collectibility is not reasonably assured, revenue is recognized when cash is collected. Revenue from education services and support services is recognized over the contract term or as the service is performed. We make certain sales to product distributors. These customers are given certain privileges to return a portion of inventory. We recognize revenue on sales to distributors that have contractual return rights when the products have been sold by the distributors, unless there is sufficient customer specific sales and sales return history to support revenue recognition upon shipment. Revenue from sales of software products is recognized provided that a purchase order has been received, the software has been shipped, collection of the resulting receivable is probable, and the amount of the related fees is fixed or determinable. To date, revenue from software transactions and sales-type leases has not been significant. We accrue for warranty costs, sales returns, and other allowances at the time of shipment based on historical experience and expected future costs. In the event that our actual costs and sales returns exceeded our estimates, our revenue and gross margins would be adversely affected.

 

Allowances for Sales Returns and Doubtful Accounts

 

We record an allowance for sales returns for estimated future product returns related to current period product revenue. The allowance for sales returns is recorded as a reduction of revenue and an allowance against our accounts receivable. We base our allowance for sales returns on periodic assessments of historical trends in product return rates and current approved returned products. If the actual future returns were to deviate from the historical data on which the reserve had been established, our future revenue could be adversely affected.

 

We record an allowance for doubtful accounts for estimated losses resulting from the inability of customers to make payments for amounts owed to us. We base our allowance on periodic assessments of our customers’ liquidity and financial condition through analysis of information obtained from credit rating agencies, financial statement reviews, and historical collection trends. Additional allowances may be required in the future if the liquidity or financial condition of our customers were to deteriorate, resulting in an impairment in their ability to make payments.

 

Valuation of Long-Lived Assets, including Goodwill and Other Acquisition-Related Intangible Assets

 

Our long-lived assets consist primarily of goodwill, other acquisition-related intangible assets and property and equipment. We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Such events or circumstances include, but are not limited to, a significant decrease in the benefits realized from the acquired business, difficulty and delays in integrating the business, or a significant change in the operations of the acquired business or use of an asset. Goodwill and other acquisition-related intangible assets not subject to amortization are tested annually for impairment using a two-step approach, and are tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset’s fair value.

 

We estimate the fair value of our long-lived assets based on a combination of the market, income and replacement cost approaches. In the application of the impairment testing, we are required to make estimates of future operating trends and resulting cash flows and judgments on discount rates and other variables. Actual future results and other assumed variables could differ from these estimates.

 

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As of September 30, 2004 we have $157.8 million of goodwill, $20.7 million of other acquisition-related intangible assets and $23.2 million of property and equipment. Other acquisition-related intangible assets are comprised mainly of purchased developed technology and customer relationships. Many of the entities acquired by us do not have significant tangible assets; as a result, a significant portion of the purchase price is typically allocated to intangible assets and goodwill. Our future operating performance will be impacted by the future amortization of intangible assets, potential charges related to purchased in-process research and development for future acquisitions, and potential impairment charges related to goodwill. Accordingly, the allocation of the purchase price of the acquired companies to intangible assets and goodwill has a significant impact on our future operating results. The allocation process requires management to make significant estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets and the appropriate discount rate for these cash flows. Should different conditions prevail, we would have to perform an impairment review that might result in material write-downs of intangible assets and/or goodwill. Other factors we consider important which could trigger an impairment review, include, but are not limited to, significant changes in the manner of use of our acquired assets, significant changes in the strategy for our overall business or significant negative economic trends. If this evaluation indicates that the value of an intangible asset or long-lived asset may be impaired, an assessment of the recoverability of the net carrying value of the asset over its remaining useful life is made. If this assessment indicates that the cost of an intangible asset or long-lived asset is not recoverable, based on the estimated undiscounted future cash flows or other comparable market valuations of the entity or technology acquired over the remaining amortization or depreciation period, the net carrying value of the related intangible asset or long-lived asset will be reduced to fair value and the remaining amortization or depreciation period may be adjusted. For example, we recorded significant impairment charges during 2001, including $41.7 million related to goodwill and other acquired intangibles. In addition, in the fourth quarter of 2002, we recorded approximately $50.8 million of impairment in property, plant and equipment and other assets. Due to uncertain market conditions and potential changes in our strategy and product portfolio, it is possible that forecasts used to support our intangible assets may change in the future, which could result in additional non-cash charges that would adversely affect our results of operations and financial condition.

 

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RESULTS OF OPERATIONS

 

We list in the tables below the historical condensed consolidated statement of operations data as a percentage of revenue for the periods indicated.

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 

Net revenue

   100 %   100 %   100 %   100 %

Cost of revenue

   58 %   55 %   57 %   55 %
    

 

 

 

Gross profit

   42 %   45 %   43 %   45 %

Operating expenses:

                        

Research and product development

   21 %   25 %   25 %   26 %

Sales and marketing

   25 %   20 %   24 %   22 %

General and administrative

   13 %   5 %   13 %   5 %

Purchased in-process research and development

   9 %   0 %   12 %   0 %

Litigation settlement

   0 %   7 %   0 %   3 %

Stock-based compensation

   1 %   4 %   2 %   (1 )%

Amortization and impairment of intangible assets

   11 %   9 %   11 %   10 %
    

 

 

 

Total operating expenses

   80 %   70 %   87 %   65 %
    

 

 

 

Operating loss

   (38 )%   (25 )%   (44 )%   (20 )%

Other income (expense), net

   (3 )%   (4 )%   (2 )%   (3 )%
    

 

 

 

Loss before income taxes

   (41 )%   (29 )%   (46 )%   (23 )%

Income tax (benefit) provision

   0 %   ( 14 )%   0 %   ( 5 )%
    

 

 

 

Net loss

   (41 )%   (15 )%   (46 )%   (18 )%
    

 

 

 

 

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Table of Contents

Revenue

 

Information about our revenue for products and services for the three and nine months ended September 30, 2004 and 2003 is summarized below (in millions):

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2004

   2003

   Increase
(Decrease)


   % change

    2004

   2003

  

Increase

(Decrease)


   % change

 

Products

   $ 24.5    $ 20.0    $ 4.5    22 %   $ 63.0    $ 54.0    $ 9.0    17 %

Services

     2.5      2.2      0.3    16 %     6.1      5.9      0.2    4 %
    

  

  

        

  

  

      

Total

   $ 27.0    $ 22.2    $ 4.8    21 %   $ 69.1    $ 59.9    $ 9.2    15 %
    

  

  

        

  

  

      

 

Information about our revenue for North America and International markets for the three and nine months ended September 30, 2004 and 2003 is summarized below (in millions):

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2004

   2003

  

Increase

(Decrease)


    % change

    2004

   2003

  

Increase

(Decrease)


    % change

 

North America

   $ 19.3    $ 20.4    $ (1.1 )   (5 )%   $ 54.2    $ 54.8    $ (0.6 )   (1 )%

International

     7.7      1.8      5.9     321 %     14.9      5.1      9.8     195 %
    

  

  


       

  

  


     

Total

   $ 27.0    $ 22.2    $ 4.8     21 %   $ 69.1    $ 59.9    $ 9.2     15 %
    

  

  


       

  

  


     

 

Information about our revenue by product line for the three and nine months ended September 30, 2004 and 2003 is summarized below (in millions):

 

    

Three Months Ended

September 30,


   

Nine Months Ended

September 30,


 
     2004

   2003

   Increase
(Decrease)


    % change

    2004

   2003

  

Increase

(Decrease)


    % change

 

SLMS

   $ 5.6    $ 4.4    $ 1.2     26 %   $ 19.6    $ 14.4    $ 5.2     36 %

Legacy and Service

     17.2      17.8      (0.6 )   (3 )%     45.3      45.5      (0.2 )   (<1 )%

Optical Transport

     4.2      0.0      4.2     N/M       4.2      0.0      4.2     N/M  
    

  

  


       

  

  


     
     $ 27.0    $ 22.2    $ 4.8     21 %   $ 69.1    $ 59.9    $ 9.2     15 %
    

  

  


       

  

  


     

 

For the three months ended September 30, 2004, revenue increased 21% or $4.8 million to $27.0 million from $22.2 million for the same period last year. For the nine months ended September 30, 2004, revenue increased 15% or $9.2 million to $69.1 million from $59.9 million for the same period last year. The increases were primarily due to stabilizing demand for our products compared to the same periods last year, and incremental revenue relating to the acquisition of Sorrento during the three months ended September 30, 2004.

 

Product revenue accounted for the majority of the total increase in revenue in each period, while service revenue increased modestly in each period. Revenue from international customers increased significantly in both periods of the current year, while revenue from North American customers declined modestly in each period. International revenue represented 29% and 22% of total revenue for the three and nine months ended September 30, 2004, respectively, as compared to 8% of revenue for both the three and nine months ended September 30, 2003. The significant increase in international revenue in each period reflects the increasing opportunity for our next generation products in greenfield deployments at international carriers, whereas the North American market is more mature and currently consists primarily of sales of legacy type products and services.

 

Revenue for our SLMS product family increased by $1.2 million, or 26% for the three months ended September 30, 2004 and by $5.2 million, or 36% for the nine months ended September 30, 2004 as compared to the same periods last year, respectively. Revenue for our Legacy and Service product family, which includes the former MUX and DLC product categories, decreased by $0.6 million, or 3% in the three months ended September 30, 2004 and $0.2 million, or less than 1% in the nine months ended September 30, 2004 as compared to the same periods last year, respectively. Revenue for our Optical Transport product family was $4.2 million for the three and nine months ended September 30, 2004. There was no Optical Transport product family revenue for either period in the prior year.

 

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While we anticipate focusing our sales and marketing efforts on our SLMS and Optical Transport product families, revenue from the Legacy and Service product family is expected to continue to represent the majority of our total revenue, at least in the near term, given the current trends in service provider capital spending, which tend to focus more on supporting legacy type revenue generating activities rather than investing in newer, more technologically advanced types of products. We expect that over time, the product mix will continue to shift towards next generation products in SLMS and Optical Transport, with Legacy and Service revenues remaining flat or declining as a percentage of total revenues. However in any given quarter, revenue from the Legacy and Service product family may fluctuate significantly, due to seasonal and other variations in the purchasing patterns for the major customers of these products.

 

During the three and nine months ended September 30, 2004, one customer accounted for 19% and 15% of total revenue, respectively. No other customer accounted for 10% or more of total revenue in either period. During the nine months ended September 30, 2003, two customers accounted for 18% and 12% of total revenue. Although our largest customers have varied over time, we anticipate that our results of operations in any given period will continue to depend to a great extent on sales to a small number of large accounts. As a result, our revenue for any quarter may be subject to significant volatility based upon changes in orders from one or a small number of key customers.

 

Cost of Revenue

 

For the three months ended September 30, 2004, cost of revenue increased $3.4 million to $15.6 million compared to $12.2 million for the same period last year. Total cost of revenue was 58% of revenue for the three months ended September 30, 2004, compared to 55% of revenue for the same period last year. For the nine months ended September 30, 2004, cost of revenue increased $6.6 million to $39.5 million compared to $32.9 million for the same period last year. Total cost of revenue was 57% of revenue for the nine months ended September 30, 2004, compared to 55% of revenue for the same period last year.

 

For the nine months ended September 30, 2004, cost of revenue was higher as a percentage of revenue due primarily to higher charges for excess inventory, the impact of stock-based compensation expense on cost of revenue, and a shift in product mix towards a higher percentage of revenue from lower margin products. These factors were partially offset by the favorable impact of a specific revenue transaction for which the inventory had been previously written down.

 

We expect that our cost of revenue will vary as a percentage of net revenue depending on the mix and average selling prices of products sold. We anticipate that competitive and economic pressures could cause us to reduce our prices, adjust the carrying values of our inventory, or record inventory charges relating to discontinued products and excess or obsolete inventory.

 

Research and Product Development Expenses

 

For the three months ended September 30, 2004, research and product development expenses increased 3% or $0.2 million to $5.7 million compared to $5.5 million for the same period last year. For the nine months ended September 30, 2004, research and product development expenses increased 10% or $1.6 million to $17.3 million compared to $15.7 million for the nine months ended September 30, 2003. The increases were primarily attributable to higher compensation related expenses.

 

Sales and Marketing Expenses

 

For the three months ended September 30, 2004, sales and marketing expenses increased 51% or $2.3 million to $6.8 million compared to $4.5 million for the same period last year. For the nine months ended September 30, 2004, sales and marketing expenses increased 28% or $3.6 million to $16.7 million compared to $13.1 million for the same period last year. The increases were primarily attributable to higher salaries and commissions, travel, trade shows and other marketing promotions.

 

General and Administrative Expenses

 

For the three months ended September 30, 2004, general and administrative expenses increased 179% or $2.2 million to $3.4 million compared to $1.2 million for the same period last year. For the nine months ended September 30, 2004, general and administrative expenses increased 181% or $5.7 million to $8.8 million compared to $3.1 million for the same period last year. The significant increases were primarily due to increased costs associated with being an SEC registrant, personnel costs, subsequently incurred legal expenses related to acquisitions, and charges related to lease terminations for multiple excess facilities.

 

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Table of Contents

Purchased In-Process Research and Development Expense

 

For the three months ended September 30, 2004, we recorded $2.4 million for purchased in-process research and development expense relating to the acquisition of Sorrento. For the nine months ended September 30, 2004, we recorded $8.6 million for purchased in-process research and development expense relating to acquisitions of Sorrento and the assets of Gluon Networks. These amounts were charged to expense because technological feasibility had not been established and no future alternative uses for the technology existed. The estimated fair value of the purchased in-process research and development was determined using a discounted cash flow model, based on a discount rate which took into consideration the stage of completion and risks associated with developing the technology. No charges for purchased in-process research and development were recorded in the same periods of last year.

 

Stock-Based Compensation Expense

 

Stock-based compensation expense was $0.4 million for the three months ended September 30, 2004, compared to $0.9 million for the same period last year. For the nine months ended September 30, 2004, stock-based compensation expense was $1.4 million compared to a $0.8 million benefit for the same period last year. Stock-based compensation expense primarily resulted from the difference between the fair value of our common stock and the exercise price for stock options granted to employees on the date of grant. We amortize the resulting deferred compensation over the vesting periods of the applicable options using an accelerated method, which can result in a net credit to stock-based compensation expense during a particular period, if the amount reversed due to the forfeiture of unvested shares exceeds the amortization of deferred compensation. During the nine months ended September 30, 2003, the amount reversed due to the forfeiture of unvested shares exceeded the amortization of deferred compensation, resulted in a net benefit of $0.8 million.

 

For the three and nine months ended September 30, 2004 and 2003, stock-based compensation expense consisted of (in thousands):

 

     Three Months Ended

    Nine Months Ended

 
     September 30,
2004


    September 30,
2003


    September 30,
2004


    September 30,
2003


 

Amortization of deferred compensation

   $ 365     $ 844     $ 1,570     $ 4,407  

Benefit due to reversal of previously recorded stock-based compensation expense on forfeited shares

     (20 )     (80 )     (112 )     (5,365 )

Other

     26       130       (12 )     136  
    


 


 


 


     $ 371     $ 894     $ 1,446     $ (822 )
    


 


 


 


 

Amortization and Impairment of Intangibles

 

For the three and nine months ended September 30, 2004, amortization and impairment of intangibles increased by $0.8 million and $1.4 million, respectively, compared to the same periods in the previous year. The increases were primarily due to the incremental amortization relating to the Sorrento acquisition. In addition, for the nine months ended September 30, 2004, amortization and impairment of intangibles also increased due to an impairment charge of $0.2 million relating to the Gluon acquired workforce, and incremental amortization relating to the acquisition of eLuminant which closed in February 2003.

 

Other Income (Expense), Net

 

For the three and nine months ended September 30, 2004 and 2003, other income (expense), net was comprised as follows (in thousands):

 

     Three Months Ended
September 30,


    Nine Months Ended
September 30,


 
     2004

    2003

    2004

    2003

 

Interest expense

   $ (1,162 )   $ (961 )   $ (2,977 )   $ (2,966 )

Interest income

     300       25       1,069       121  

Other income (expense)

     64       57       686       881  
    


 


 


 


     $ (798 )   $ (879 )   $ (1,222 )   $ (1,964 )
    


 


 


 


 

Interest expense increased for the three months ended September 30, 2004 as compared to the same period last year due primarily to an increase in borrowings relating to the acquisition of Sorrento. For the nine months ended September 30, 2004, interest expense was relatively flat, as the impact of the additional Sorrento debt was offset by a decrease in other outstanding borrowings.

 

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Table of Contents

Interest income increased for the three and nine months ended September 30, 2004 as compared to the same periods last year due primarily to higher average balances of cash and short-term investments.

 

Income Tax (Benefit) Provision

 

During the three and nine months ended September 30, 2004, no material provision or benefit for income taxes was recorded, due to our recurring operating losses and the significant uncertainty regarding the realization of our net deferred tax assets, against which we have recorded a full valuation allowance. During the three months ended September 30, 2003, we recorded a current tax benefit of $3.1 million, relating to the final resolution of tax refund claims for net operating loss carrybacks of post-acquisition losses incurred by Premisys. We had originally received the tax refunds related to Premisys in previous years, but did not recognize any income tax benefit at that time due to the substantial uncertainty regarding whether the benefit could be sustained upon examination by tax authorities.

 

Liquidity and Capital Resources

 

Historically, we have financed our operations through private sales of capital stock and borrowings under various debt arrangements. Following the completion of our merger with Tellium in November 2003, in which our common stock became publicly traded, we have financed and expect to continue to finance our operations through a combination of our existing cash, cash equivalents and short-term investments, available credit facilities, and sales of equity and debt instruments, based on our operating requirements and market conditions.

 

At September 30, 2004, cash, cash equivalents and short-term investments, all of which are available to fund current operations, were $68.6 million. This amount includes cash and cash equivalents of $42.1 million, as compared with $32.5 million at December 31, 2003. The increase in cash and cash equivalents was attributable to cash provided by investing activities of $43.4 million and cash provided by financing activities of $10.0 million, offset by cash used in operating activities of $43.9 million.

 

Net cash provided by investing activities consisted primarily of net maturities of short-term investments of $39.1 million, and net cash acquired in acquisitions of $5.6 million. Net cash provided by financing activities consisted primarily of net borrowings under our line of credit of $9.7 million. Net cash used in operating activities consisted of the net loss of $31.8 million, adjusted for non-cash charges totaling $18.6 million and changes in operating assets and liabilities totaling $30.7 million. The most significant components of the changes in operating assets and liabilities were a decrease in accrued expenses of $15.1 million primarily due to payment of acquisition related accruals and increase in inventories and accounts receivable of $6.8 million and $5.8 million, respectively.

 

As a result of the financial demands of major network deployments and the difficulty in accessing capital markets, network service providers continue to request financing assistance from their suppliers. From time to time we may provide or commit to extend credit or credit support to our customers. This financing may include extending credit to customers or guaranteeing the indebtedness of customers to third parties. Depending upon market conditions, we may seek to factor these arrangements to financial institutions and investors to free up our capital and reduce the amount of our financial commitments for such arrangements. Our ability to provide customer financing is limited and depends upon a number of factors, including our capital structure, the level of our available credit and our ability to factor commitments to third parties. Any extension of financing to our customers will limit the capital that we have available for other uses. Currently, we do not have any significant customer financing related commitments.

 

Our primary source of liquidity comes from our cash and cash equivalents and short-term investments, which totaled $68.6 million at September 30, 2004, and our $25.0 million line of credit agreement, under which $14.5 million was outstanding at September 30, 2004, and an additional $8.4 million was committed as security for obligations under our secured real estate loan facility and other letters of credit. Borrowings under the line of credit agreement bear interest at the financial institution’s prime rate or LIBOR plus 2.9%, at the election of the borrower. Our short-term investments are classified as available-for-sale and consist of securities that are readily convertible to cash, including certificates of deposits, commercial paper and government securities, with original maturities at the date of acquisition ranging from 90 days to one year. At current revenue levels, we anticipate that some portion of our existing cash and cash equivalents and investments will continue to be consumed by operations.

 

In March 2004, we filed a Form S-3 Registration Statement which allows us to sell, from time to time, up to $100 million of our common stock or other securities. Although we may use this multi-purpose shelf registration to raise additional capital, there can be no certainty as to when or if we may offer any securities under the shelf registration or what the terms of any such offering would be.

 

Our accounts receivable, while not considered a primary source of liquidity, represents a concentration of credit risk because a significant portion of the accounts receivable balance at any point in time typically consists of a relatively small number of customer

 

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Table of Contents

account balances. At September 30, 2004, two customers represented 21% and 19%, respectively, of our total accounts receivable balance. Our fixed commitments for cash expenditures consist primarily of payments under operating leases, inventory purchase commitments, and payments of principal and interest for debt obligations. We do not currently have any material commitments for capital expenditures, or any other material commitments aside from operating leases for our facilities, inventory purchase commitments and debt. We currently intend to fund our operations for the foreseeable future using our existing cash, cash equivalents and short-term investments and liquidity available under our line of credit agreement.

 

Based on our current plans and business conditions, we believe that our existing cash, cash equivalents and short-term investments and available credit facilities will be sufficient to satisfy our anticipated cash requirements for at least the next twelve months.

 

Contractual Commitments and Off-Balance Sheet Arrangements

 

At September 30, 2004, our future contractual commitments by fiscal year were as follows (in thousands):

 

     Total

   Remainder of
2004


   2005

   2006

   2007

   2008

   2009 and
After


Operating leases

   $ 4,001    $ 2,011    $ 1,223    $ 425    $ 342    —      —  

Line of credit

     14,500      14,500      —        —        —      —      —  

Debt

     48,075      4,285      990      31,072      11,728    —      —  

Inventory purchase commitments

     4,757      4,757      —        —        —      —      —  
    

  

  

  

  

  
  

Total future contractual commitments

   $ 71,333    $ 25,553      2,213      31,497      12,070    —      —  
    

  

  

  

  

  
  

 

The amounts shown above represent off-balance sheet arrangements to the extent that a liability is not already recorded on our balance sheet. For operating lease commitments, a liability is generally not recorded on our balance sheet unless the facility represents an excess facility for which an estimate of the facility exit costs has been recorded on our balance sheet. Payments made under operating leases will be treated as rent expense for the facilities currently being utilized. For debt obligations, the amounts shown above represent the scheduled principal repayments, but not the associated interest payments which may vary based on changes in market interest rates. At September 30, 2004, the interest rate on our outstanding debt obligations ranged from 7.5% to 8.0%. Inventory purchase commitments represent the amount of excess inventory purchase commitments that have been recorded on our balance sheet at September 30, 2004.

 

We also had commitments under outstanding letters of credit totaling $0.3 million at September 30, 2004. We have recorded restricted cash on our balance sheet equal to the amount outstanding under these letters of credit.

 

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Table of Contents

RISK FACTORS

 

You should carefully consider the following risk factors, in addition to the other information set forth in this report, before making any investment decisions regarding our company. Each of these risk factors could adversely affect our business, financial condition and results of operations.

 

We have incurred significant losses to date and expect that we will continue to incur losses in the foreseeable future. If we fail to generate sufficient revenue to achieve or sustain profitability, our stock price could decline.

 

We have incurred significant losses to date and expect that we will to continue to incur losses in the foreseeable future. Our net losses for 2003 and 2002 were $17.2 million and $108.6 million, respectively. Our net loss for the nine months ended September 30, 2004 was $31.8 million, and we had an accumulated deficit of $627.6 million at September 30, 2004.

 

We have not generated positive cash flow from operations since inception, and expect this to continue for the foreseeable future. We have significant fixed expenses and expect that we will continue to incur substantial manufacturing, research and product development, sales and marketing, customer support, administrative and other expenses in connection with the ongoing development of our business. In addition, we may be required to spend more on research and product development than originally budgeted to respond to industry trends. We may also incur significant new costs related to acquisitions and the integration of new technologies, including our ongoing integration of Sorrento, and other acquisitions that may occur in the future. Further, as 2004 is the first full year that we are subject to SEC reporting obligations, and given the increased costs associated with compliance with the Sarbanes-Oxley Act of 2002, we have incurred and are likely to continue to incur increased expenses related to regulatory and legal compliance. We may not be able to adequately control costs and expenses or achieve or maintain adequate operating margins. As a result, our ability to achieve and sustain profitability will depend on our ability to generate and sustain substantially higher revenue while maintaining reasonable cost and expense levels. If we fail to generate sufficient revenue to achieve or sustain profitability, we will continue to incur substantial operating losses and our stock price could decline.

 

We have been, and may continue to be, adversely affected by recent unfavorable developments in the communications industry, world events and the economy in general.

 

Our customers and potential customers continue to experience a severe economic slowdown that has led to significant decreases in their revenues. For most of the last five years, the markets for our equipment have been influenced by the entry into the communications services business of a substantial number of new telecommunications companies. In the United States, this was due largely to changes in the regulatory environment, in particular those brought about by the Telecommunications Act of 1996. These new companies raised significant amounts of capital, much of which they invested in new equipment, causing acceleration in the growth of the markets for telecommunications equipment. More recently, there has been a reversal of this trend, including the failure of a large number of the new entrants and a sharp contraction of the availability of capital to the industry. This industry trend has been compounded by the slowing not only of the U.S. economy, but the economies in virtually all of the countries in which we market our products. As a result of these factors, our revenue declined by 26% from 2002 to 2003, and we expect that these economic conditions will likely continue to impact our business.

 

The continuing acts and threats of terrorism and the geo-political uncertainties in other continents are also having an adverse effect on the U.S. economy and could possibly induce or accelerate the advent of a more severe economic downturn. The U.S. government’s political, social and economic policies and policy changes as a result of these circumstances could have consequences that we cannot predict, including causing further weaknesses in the economy. The long-term impact of these events on our business is uncertain. Additionally, the amount of debt incurred by our customers, and the continued reductions in capital spending, puts the businesses of certain of our customers and potential customers in jeopardy. As a result, our operating results and financial condition could be materially adversely affected.

 

If we are unable to favorably assess the effectiveness of our internal control over financial reporting, or if our independent auditors are unable to provide an unqualified attestation report on our assessment, our stock price could be adversely affected.

 

Pursuant to Section 404 of the Sarbanes-Oxley Act of 2002 and beginning with our Annual Report on Form 10-K for the year ending December 31, 2004, our management will be required to report on, and our independent auditors to attest to, the effectiveness of our internal control over financial reporting as of the end of 2004. The rules governing the standards that must be met for management to assess our internal control over financial reporting are new and complex, and require significant documentation, testing and possible remediation. We are currently in the process of reviewing, documenting and testing our internal control over financial reporting, which has and will likely continue to result in increased expenses and the devotion of significant management resources. We may encounter problems or delays in completing the implementation of any changes necessary to make a favorable assessment of our

 

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internal control over financial reporting. In addition, in connection with the attestation process by our independent auditors, we may encounter problems or delays in completing the implementation of any requested improvements and receiving a favorable attestation. If we cannot favorably assess the effectiveness of our internal control over financial reporting, or if our independent auditors are unable to provide an unqualified attestation report on our assessment, investor confidence and our stock price could be adversely affected.

 

Capital constraints in the telecommunications industry could restrict the ability of our customers to buy our products.

 

As a result of the economic slowdown affecting the telecommunications industry and the technology industry in general, our customers and potential customers have significantly reduced the rate of their capital expenditures, and as result, our revenue declined by 26% from 2002 to 2003. During the nine months ended September 30, 2004, excluding the impact of incremental revenue associated with the acquisition of Sorrento, revenue increased modestly compared to the same period in 2003. Any reduction of capital equipment acquisition budgets or the inability of our current and prospective customers to obtain capital could cause them to reduce or discontinue purchase of our products, and as a result we could experience reduced revenues and our operating results could be adversely impacted. In addition, many of the current and prospective customers for our products are emerging companies with limited operating histories. These companies require substantial capital for the development, construction and expansion of their businesses. Neither equity nor debt financing may be available to these companies on favorable terms, if at all. To the extent that these companies are unable to obtain the financing they need, our ability to make future sales to these customers and realize revenue from any such sales could be harmed. In addition, to the extent we choose to provide financing to these prospective customers, we will be subject to additional financial risk which could cause our expenses to increase.

 

Our future operating results are difficult to predict due to our limited operating history.

 

We began operations in September 1999. Although we expect that our next-generation, internally developed Single Line Multi-Service, or SLMS, product line will account for a substantial portion of our revenue in the future, to date we have generated a significant portion of our revenue from sales of products from our Legacy and Service product lines that we acquired from other companies. Due to our limited operating history, we have difficulty accurately forecasting our revenue, and we have limited historical financial data upon which to base our operating expense budgets. Our revenue and operating results may vary significantly from quarter to quarter due to a number of factors, many of which are outside of our control. The primary factors that may affect our results of operations include the following:

 

  commercial acceptance of our SLMS products, and our ability to successfully market the Optical Transport products acquired from Sorrento;

 

  fluctuations in demand for network access products;

 

  new product introductions, enhancements or announcements by our competitors;

 

  the length and variability of the sales cycles for our products;

 

  the timing and size of sales of our products;

 

  our customers’ ability to finance their purchase of our products as well as their own operations;

 

  our ability to forecast demand for our products;

 

  the ability of our company and our contract manufacturers to attain and maintain production volumes and quality levels for our products;

 

  our ability to obtain sufficient supplies of sole or limited source components;

 

  changes in our pricing policies or the pricing policies of our competitors;

 

 

  increases in the prices of the components we purchase, or quality problems associated with these components;

 

  our ability to develop, introduce and ship new products and product enhancements that meet customer requirements in a timely manner;

 

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  the timing and magnitude of prototype expenses;

 

  unanticipated changes in regulatory requirements which may require us to redesign portions of our products;

 

  regulatory and compliance costs associated with being a publicly-traded company;

 

  changes in accounting rules, such as any future requirement to record stock-based compensation expense for employee stock option grants made at fair market value;

 

  our ability to attract and retain key personnel;

 

  our sales of common stock or other securities in the future;

 

  costs related to acquisitions of technologies or businesses; and

 

• general economic conditions as well as those specific to the communications, Internet and related industries.

 

If demand for our SLMS products does not develop, then our results of operations and financial condition will be adversely affected.

 

Our future revenue depends significantly on our ability to successfully develop, enhance and market our SLMS products to the network service provider market. Most network service providers have made substantial investments in their current infrastructure, and they may elect to remain with their current architectures or to adopt new architectures, such as SLMS, in limited stages or over extended periods of time. A decision by a customer to purchase our SLMS products will involve a significant capital investment. We will need to convince these service providers of the benefits of our products for future upgrades or expansions. We do not know whether a viable market for our SLMS products will develop or be sustainable. If this market does not develop or develops more slowly than we expect, our business, financial condition and results of operations will be seriously harmed.

 

Our target customer base is concentrated, and the loss of one or more of our customers could harm our business.

 

The target customers for our products are network service providers that operate voice, data and video communications networks. There are a limited number of potential customers in our target market. During the nine months ended September 30, 2004, one customer accounted for 15% of our revenue. During the year ended December 31, 2003, two customers accounted for 17% and 11% of our revenue, respectively. A significant portion of our future revenue will depend on sales of our products to a limited number of customers. Any failure of one or more customers to purchase products from us for any reason, including any downturn in their businesses, would seriously harm our business, financial condition and results of operations.

 

Acquisitions are an important part of our strategy, and any strategic acquisitions or investments we make could disrupt our business and seriously harm our financial condition.

 

As of September 30, 2004, we have acquired eleven companies or product lines, and we may acquire additional businesses, products or technologies in the future. On an ongoing basis, we may evaluate acquisitions of, or investments in, complementary companies, products or technologies to supplement our internal growth. In the future, we may encounter difficulties identifying and acquiring suitable acquisition candidates on reasonable terms.

 

If we do complete future acquisitions, we could:

 

  issue stock that would dilute our current stockholders’ percentage ownership;

 

  consume cash;

 

  incur substantial debt;

 

  assume liabilities;

 

  increase our ongoing operating expenses and level of fixed costs;

 

  record goodwill and non-amortizable intangible assets that will be subject to impairment testing and potential periodic impairment charges;

 

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  incur amortization expenses related to certain intangible assets;

 

  incur large and immediate write-offs; or

 

  become subject to litigation.

 

Any acquisitions or investments that we make in the future will involve numerous risks, including:

 

  problems combining the acquired operations, technologies or products;

 

  unanticipated costs;

 

  diversion of management’s time and attention from our existing business;

 

  adverse effects on existing business relationships with suppliers and customers;

 

  risks associated with entering markets in which we have no or limited prior experience; and

 

  potential loss of key employees, particularly those of acquired companies.

 

We do not know whether we will be able to successfully integrate the businesses, products, technologies or personnel that we might acquire in the future or that any strategic investments we make will meet our financial or other investment objectives. Any failure to do so could seriously harm our business, financial condition and results of operations.

 

The market we serve is highly competitive and, as a relatively early stage company, we may not be able to compete successfully.

 

Competition in the communications equipment market is intense. We are aware of many companies in related markets that address particular aspects of the features and functions that our products provide. Currently, our primary competitors include large equipment companies, such as Advanced Fibre Communications, Alcatel, and Lucent Technologies. We also may face competition from other large communications equipment companies or other companies with significant market presence and financial resources that may enter our market in the future. In addition, a number of new public and private companies have announced plans for new products to address the same network needs that our products address, both domestically and abroad. Some of these companies may have lower cost structures than us.

 

Many of our competitors have longer operating histories, greater name recognition, larger customer bases and greater financial, technical, sales and marketing resources than we do and may be able to undertake more extensive marketing efforts, adopt more aggressive pricing policies and provide more customer financing than we can. Moreover, our competitors may foresee the course of market developments more accurately than we do and could develop new technologies that render our products less valuable or obsolete.

 

In our markets, competitive factors include:

 

  performance;

 

  reliability and scalability;

 

  ease of installation and use;

 

  interoperability with existing products;

 

  upgradeability;

 

  geographic footprints for products;

 

  ability to provide customer financing;

 

  breadth of services;

 

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  price;

 

  technical support and customer service; and

 

  brand recognition.

 

If we are unable to compete successfully against our current and future competitors, we may have difficulty obtaining or retaining customers, and we could experience price reductions, order cancellations, increased expenses and reduced gross margins, any of which would harm our business, financial condition and results of operations.

 

The long and variable sales cycles for our products may cause revenue and operating results to vary significantly from quarter to quarter.

 

The target customers for our products have substantial and complex networks that they traditionally expand in large increments on a periodic basis. Accordingly, our marketing efforts are largely focused on prospective customers that may purchase our products as part of a large-scale network deployment. Our target customers typically require a lengthy evaluation, testing and product qualification process. Throughout this process, we are often required to spend considerable time and incur significant expense educating and providing information to prospective customers about the uses and features of our products. Even after a company makes the final decision to purchase our products, it may deploy our products slowly. The timing of deployment of our products varies widely, and depends on a number of factors, including:

 

  our customers’ skill sets;

 

  geographic density of potential subscribers;

 

  the degree of configuration necessary to deploy our products; and

 

  our customers’ ability to finance their purchase of our products as well as their operations.

 

As a result of any of these factors, our revenue and operating results may vary significantly from quarter to quarter.

 

The success of our business depends on our executive officers and key employees, and the loss of the services of one or more of them could harm our business.

 

Our future success depends upon the continued services of our executive officers and other key engineering, manufacturing, operations, sales, marketing and support personnel who have critical industry experience and relationships that we rely on to build our business, including Morteza Ejabat, our co-founder, Chairman and Chief Executive Officer, Jeanette Symons, our Chief Technical Officer, and Kirk Misaka, our Chief Financial Officer. The loss of the services of any of our key employees, including Mr. Ejabat, Ms. Symons and Mr. Misaka, could delay the development and production of our products and negatively impact our ability to maintain customer relationships, which would harm our business, financial condition and results of operations.

 

If we are unable to successfully manage and expand our international operations, our business could be harmed.

 

We currently have international operations consisting of sales, technical support and marketing teams in various locations worldwide. We expect to continue expanding our international operations in the future. The successful management and expansion of our international operations requires significant human and financial resources. Further, our international operations may be subject to certain risks and challenges that could harm our operating results, including:

 

  expenses associated with developing and customizing our products for foreign countries;

 

  unexpected changes in regulatory requirements, taxes, trade laws and tariffs;

 

  fluctuations in currency exchange rates;

 

  longer sales cycles for our products;

 

  greater difficulty in accounts receivable collection and longer collection periods;

 

  difficulties and costs of staffing and managing foreign operations;

 

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  reduced protection for intellectual property rights;

 

  potentially adverse tax consequences; and

 

  changes in a country’s or region’s political and economic conditions.

 

Any of these factors could harm our existing international operations and business or impair our ability to continue expanding into international markets.

 

We have significant debt obligations, which could adversely affect our business, operating results and financial condition.

 

As of September 30, 2004, we had approximately $43.1 million in long-term debt, including approximately $11.7 million of long-term debt that we assumed through our acquisition of Sorrento. Our debt obligations could materially and adversely affect us in a number of ways, including:

 

  limiting our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions or general corporate purposes;

 

  limiting our flexibility to plan for, or react to, changes in our business or market conditions;

 

  requiring us to use a significant portion of any future cash flow from operations to repay or service the debt, thereby reducing the amount of cash available for other purposes;

 

  making us more highly leveraged than some of our competitors, which may place us at a competitive disadvantage; and

 

  making us more vulnerable to the impact of adverse economic and industry conditions and increases in interest rates.

 

We cannot assure you that we will generate sufficient cash flow or be able to borrow funds in amounts sufficient to enable us to service our debt or to meet our working capital and capital expenditure requirements. If we are unable to generate sufficient cash flow from operations or to borrow sufficient funds to service our debt, due to borrowing base restrictions or otherwise, we may be required to sell assets, reduce capital expenditures, refinance all or a portion of existing debt or obtain additional financing. We cannot assure you that we will be able to engage in any of these actions on reasonable terms, if at all.

 

Because our products are complex and are deployed in complex environments, our products may have defects that we discover only after full deployment, which could seriously harm our business.

 

Our products are complex and are designed to be deployed in large quantities across complex networks. Because of the nature of these products, they can only be fully tested when completely deployed in large networks with high amounts of traffic. Our customers may discover errors or defects in our hardware or software, or our products may not operate as expected, after they have been fully deployed. If we are unable to fix defects or other problems that may be identified after full deployment, we could experience:

 

  loss of revenue and market share;

 

  loss of existing customers;

 

  failure to attract new customers or achieve market acceptance;

 

  diversion of development resources;

 

  increased service and warranty costs;

 

  legal actions by our customers; and

 

  increased insurance costs.

 

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Defects, integration issues or other performance problems in our products could also result in financial or other damages to our customers. Our customers could seek damages for related losses from us, which could seriously harm our business, financial condition and results of operations. A product liability claim brought against us, even if unsuccessful, would likely be time consuming and costly and would put a strain on our management and resources. The occurrence of any of these problems would seriously harm our business, financial condition and results of operations.

 

If we fail to enhance our existing products or develop and introduce new products that meet changing customer requirements and technological advances, our ability to sell our products would be materially adversely affected.

 

Our target markets are characterized by rapid technological advances, evolving industry standards, changes in end-user requirements, frequent new product introductions and changes in communications offerings from network service providers. Our future success, if any, will significantly depend on our ability to anticipate or adapt to such changes and to offer, on a timely and cost-effective basis, products that meet changing customer demands and industry standards. We may not have sufficient resources to successfully and accurately anticipate technological and market trends, manage long development cycles or develop, introduce and market new products and enhancements. We currently license certain technology, and from time to time, we may be required to license additional technology from third parties to sell or develop our products and product enhancements. We cannot assure you that our existing and future third-party licenses will be available to us on commercially reasonable terms, if at all. Our inability to maintain or obtain any third-party license required to sell or develop our products and product enhancements could require us to obtain substitute technology of lower quality or performance standards or at greater cost. If we are not able to develop new products or enhancements to existing products on a timely and cost-effective basis, or if our new products or enhancements fail to achieve market acceptance, our business, financial condition and results of operations would be materially adversely affected.

 

The communications industry is subject to government regulations, which could harm our business.

 

The Federal Communications Commission, or FCC, has jurisdiction over the entire communications industry in the United States and, as a result, our existing and future products and our customers’ products are subject to FCC rules and regulations. Current and future FCC rules and regulations affecting communications services could negatively affect our business. The uncertainty associated with future FCC decisions may result in network service providers delaying decisions regarding expenditures for equipment for broadband services. In addition, international regulatory bodies establish standards that may govern our products in foreign markets. Domestic and international regulatory requirements could result in postponements or cancellations of product orders, which would harm our business, financial condition and results of operations. Further, we cannot be certain that we will be successful in obtaining or maintaining any regulatory approvals that may, in the future, be required to operate our business.

 

We face certain litigation risks.

 

We are a party to lawsuits and claims in the normal course of our business. In addition, we are currently involved in several litigation matters which we inherited as a result of our acquisition of Tellium. Litigation can be expensive, lengthy, and disruptive to normal business operations. Moreover, the results of complex legal proceedings are difficult to predict. An unfavorable resolution of a particular lawsuit could have a material adverse effect on our business, operating results, or financial condition. For additional information regarding litigation in which we are involved, see Part II, Item 1 - “Legal Proceedings”.

 

Our business will be adversely affected if we are unable to protect our intellectual property rights from third-party challenges.

 

We rely on a combination of copyrights, patents, trademarks and trade secret laws and restrictions on disclosure to protect our intellectual property rights. We also enter into confidentiality or license agreements with our employees, consultants and corporate partners and control access to and distribution of our software, documentation and other proprietary information. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. Monitoring unauthorized use of our technology is difficult, and we do not know whether the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States.

 

In the future we may become involved in disputes over intellectual property, which could subject us to significant liability, divert the time and attention of our management and prevent us from selling our products.

 

We or our customers may be party to litigation in the future to protect our intellectual property or to respond to allegations that we infringe others’ intellectual property. We may receive in the future communications from third parties inquiring about their interest in licensing certain intellectual property to us or more generally identifying intellectual property that may be the basis of a future infringement claim. We have received letters from Lucent Technologies claiming that many of our products are using technology covered by or related to Lucent patents and inviting us to discuss a licensing arrangement with Lucent. To date, no lawsuit or other formal action has been filed by Lucent. However, we cannot assure you that we would be successful in defending against any Lucent infringement claims. To the extent we are not successful in defending such claims, we may be subject to substantial damages (including possible treble damages and attorneys’ fees).

 

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If any party accuses us of infringing upon its proprietary rights, we would have to defend ourselves and possibly our customers against the alleged infringement. We cannot assure you that we would prevail in any intellectual property litigation, given its complex technical issues and inherent uncertainties. If we are unsuccessful in any such litigation, we could be subject to significant liability for damages and loss of our proprietary rights. Intellectual property litigation, regardless of its outcome, would likely be time consuming and expensive to resolve. Any such litigation could force us to stop selling, incorporating or using our products that include the challenged intellectual property, or redesign those products that use the technology. In addition, if a party accuses us of infringing upon its proprietary rights, we may have to enter into royalty or licensing agreements, which may not be available on terms acceptable to us, if at all. Any of these results could have a material adverse effect on our business, financial condition and results of operations.

 

We rely on contract manufacturers for a significant portion of our manufacturing requirements.

 

Through the third quarter of 2003, we utilized Solectron for the majority of our manufacturing requirements for all product lines. During the fourth quarter of 2003, we transitioned the manufacturing of certain product lines to another contract manufacturer, and for another product line, transitioned the manufacturing process internally. We continue to use Solectron to manufacture certain product lines under the terms of an agreement which expired in March 2004, on a purchase order basis with no minimum purchase commitments. While we have become somewhat less dependent on Solectron for our manufacturing requirements, we expect to continue to rely on contract manufacturers to fulfill a significant portion of our product manufacturing requirements.

 

Any manufacturing disruption could impair our ability to fulfill orders. Our future success will depend, in significant part, on our ability to have Solectron or other contract manufacturers produce our products cost-effectively and in sufficient volumes. We face a number of risks associated with this dependence on third-party manufacturers including:

 

  reduced control over delivery schedules;

 

  the potential lack of adequate capacity during periods of excess demand;

 

  manufacturing yields and costs;

 

  quality assurance;

 

  increases in prices; and

 

  the potential misappropriation of our intellectual property.

 

We have no long-term contracts or arrangements with any of our vendors that guarantee product availability, the continuation of particular payment terms or the extension of credit limits. We have experienced in the past, and may experience in the future, problems with our contract manufacturers, such as inferior quality, insufficient quantities and late delivery of products. To date, these problems have not materially adversely affected us. We may not be able to obtain additional volume purchase or manufacturing arrangements on terms that we consider acceptable, if at all. If we enter into a high-volume or long-term supply arrangement and subsequently decide that we cannot use the products or services provided for in the agreement, our business will be harmed. We cannot assure you that we will be able to effectively manage our relationship with our contract manufacturers, or that these manufacturers will meet our future requirements for timely delivery of products of sufficient quality or quantity. Any of these difficulties could harm our relationships with customers and cause us to lose orders.

 

While our existing contract with Solectron expired in March 2004, we continue to use Solectron to manufacture products under the terms of the expired agreement. If we decide not to continue to use Solectron for these manufacturing requirements, we will be required to either manufacture these products internally or find another contract manufacturer. In addition, we may decide in the future to change contract manufacturers or transition manufacturing operations internally. If we fail to successfully transition manufacturing operations internally, or fail to locate and qualify suitable contract manufacturers capable of satisfying our product specifications or quantity requirements, then we may experience product shortages and, as a result, may be unable to fulfill customer orders accurately and timely which could negatively affect our customer relationships and operating results.

 

We depend on sole or limited source suppliers for several key components. If we are unable to obtain these components on a timely basis, we will be unable to meet our customers’ product delivery requirements, which would harm our business.

 

We currently purchase several key components from single or limited sources pursuant to limited term supply contracts. If any of our sole or limited source suppliers experiences capacity constraints, work stoppages or any other reduction or disruption in output, they

 

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may be unable to meet our delivery schedule. Our suppliers may enter into exclusive arrangements with our competitors, be acquired by our competitors, stop selling their products or components to us at commercially reasonable prices, refuse to sell their products or components to us at any price or be unable to obtain or have difficulty obtaining components for their products from their suppliers.

 

In these events, we could be forced to commence a time consuming and difficult process of identifying and qualifying an alternative supplier of the key components. There is no guarantee that such a search would be successful. If we do not receive critical components from our suppliers in a timely manner, we will be unable to meet our customers’ product delivery requirements. Any failure to meet a customer’s delivery requirements could harm our reputation and decrease our sales, which would harm our business, financial condition and results of operations.

 

If we fail to attract and retain qualified personnel, our business might be harmed.

 

Our future success will depend in large part upon our ability to identify, attract and retain qualified individuals, particularly research and development and customer service engineers and sales and marketing personnel. Our products are generally of a highly technical nature, and therefore require a sophisticated sales effort targeted at several key people within each prospective customer’s organization. Our target customers are large network service providers that require high levels of service and support from our customer service engineers and our sales and marketing personnel. Competition for these employees in our industry and in the San Francisco Bay Area in particular, as well as other areas in which we recruit, may be intense, and we may not be successful in attracting or retaining these personnel. If we are not able to hire the kind and number of research and development, sales and marketing and customer service personnel required to support our product offerings and customers, we may not reach the level of sales necessary to achieve profitability or may be impaired from meeting existing customer demands, either of which could materially harm our business.

 

Our business will suffer if we fail to properly manage our growth and continually improve our internal controls and systems.

 

We have expanded our operations rapidly since our inception. The number of our employees has grown from eight as of September 30, 1999 to 275 as of September 30, 2004. As our business grows, we expect to increase the scope of our operations and the number of our employees. Our ability to successfully offer our products and implement our business plan in a rapidly evolving market requires an effective planning and management process. To manage our growth properly, we must:

 

  hire, train, manage and retain qualified personnel, including engineers and research and development personnel;

 

  carefully manage and expand our manufacturing relationships and related controls and reporting systems;

 

  effectively manage multiple relationships with our customers, suppliers and other third parties;

 

  implement additional operational and financial controls, reporting and financial systems and procedures; and

 

  successfully integrate employees of acquired companies.

 

Failure to do any of the above in an efficient and timely manner could seriously harm our business, financial condition and results of operations.

 

If we are unable to obtain additional capital to fund our existing and future operations, we may be required to reduce the scope of our planned product development and marketing and sales efforts, which would harm our business, financial condition and results of operations.

 

The development and marketing of new products and the expansion of our direct sales operation and associated support personnel requires a significant commitment of resources. We may continue to incur significant operating losses or expend significant amounts of capital if:

 

  the market for our products develops more slowly than anticipated;

 

  we fail to establish market share or generate revenue at anticipated levels;

 

  our capital expenditure forecasts change or prove inaccurate; or

 

  we fail to respond to unforeseen challenges or take advantage of unanticipated opportunities.

 

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As a result, we may need to raise substantial additional capital. Additional capital, if required, may not be available on acceptable terms, or at all. If additional capital is raised through the issuance of debt securities, the terms of such debt could impose financial or other restrictions on our operations. If we are unable to obtain additional capital or are required to obtain additional capital on terms that are not favorable to us, we may be required to reduce the scope of our planned product development and sales and marketing efforts, which would harm our business, financial condition and results of operations.

 

Your ability to influence key transactions, including changes of control, may be limited by significant insider ownership, provisions of our charter documents and provisions of Delaware law.

 

At September 30, 2004, our executive officers, directors and entities affiliated with them beneficially owned, in the aggregate, approximately 39% of our outstanding common stock. These stockholders, if acting together, will be able to influence significantly all matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. Circumstances may arise in which the interests of these stockholders could conflict with the interests of our other stockholders. These stockholders could delay or prevent a change in control of our company even if such a transaction would be beneficial to our other stockholders. In addition, provisions of our amended and restated certificate of incorporation, by-laws, and Delaware law could make it more difficult for a third party to acquire us, even if doing so would be beneficial to certain stockholders.

 

Our stockholders will incur dilution as a result of the exercise of outstanding options and warrants and any future sale of equity or equity-linked debt securities.

 

The exercise of outstanding options and warrants and the future sale of any equity or equity-linked debt securities, including any additional securities issued in connection with acquisitions or in connection with our shelf registration statement, will result in dilution to our then-existing stockholders. Any dilution resulting from the future sale of equity or equity-linked debt securities will be more substantial if the price paid for such securities is less than the price paid by our then-existing stockholders for our outstanding capital stock.

 

We do not plan to pay dividends in the foreseeable future.

 

We do not anticipate paying cash dividends to our stockholders in the foreseeable future. We expect to retain future earnings, if any, for the future operation and expansion of the business. In addition, our ability to pay dividends may be limited by any applicable restrictions under our debt and credit agreements. Accordingly, our stockholders must rely on sales of their capital stock after price appreciation, which may never occur, as the only way to realize a return on their investment.

 

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

Cash, Cash Equivalents and Short-Term Investments

 

Cash, cash equivalents and short-term investments consisted of the following as of September 30, 2004 and December 31, 2003 (in thousands):

 

    

September 30,

2004


   December 31,
2003


Cash and cash equivalents

   $ 42,128    $ 32,547

Short-term investments

     26,490      65,709
    

  

     $ 68,618    $ 98,256
    

  

 

Concentration of Credit Risk

 

Financial instruments which potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents and accounts receivable. Cash and cash equivalents consist principally of demand deposit and money market accounts, commercial paper, and debt securities of domestic municipalities with credit ratings of AA or better. Cash and cash equivalents are principally held with various domestic financial institutions with high-credit standing. As of September 30, 2004, we had accounts receivable balances from two customers individually representing 21% and 19% of accounts receivable, respectively.

 

Interest Rate Risk

 

Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio and long-term debt. We do not use derivative financial instruments in our investment portfolio. We do not hold financial instruments for trading or speculative purposes. We manage our interest rate risk by maintaining an investment portfolio primarily consisting of debt instruments of high credit quality and relatively short average maturities. Under our investment policy, short-term investments have a maximum maturity of one year from the date of acquisition, and the average maturity of the portfolio cannot exceed six months. Due to the relatively short maturity of the portfolio, a 10% increase in market interest rates at September 30, 2004 would decrease the fair value of the portfolio by less than $0.1 million.

 

Foreign Currency Exchange Risk

 

While substantially all of our assets are located in the United States, we have sales operations located in Europe, Asia, the Middle East and Latin America. Accordingly, our operating results are also exposed to changes in exchange rates between the U.S. dollar and those currencies. Although a significant portion of our international sales are in U.S. dollars, as sales in foreign currencies increase, the exposure to changes in exchange rates will also increase. Since inception, we have not hedged any of our local currency cash flows. While our financial results to date have not been materially affected by any changes in currency exchange rates, devaluation of the U.S. dollar against these currencies may affect our future operating results.

 

Item 4. Controls and Procedures

 

Evaluation of Disclosure Controls and Procedures. Under the supervision and with the participation of our management, including our Chief Executive Officer and our Chief Financial Officer, we evaluated the effectiveness of our disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this report. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

 

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PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

 

The Company is involved in various litigation matters relating to the operations of Tellium prior to the merger as described below.

 

On various dates between approximately December 10, 2002 and February 27, 2003, numerous class-action securities complaints were filed against Tellium in the United States District Court, District of New Jersey. These complaints allege, among other things, that Tellium and its then-current directors and executive officers and its underwriter violated the Securities Act of 1933 by making false and misleading statements preceding its initial public offering and in its registration statement prospectus relating to the securities offered in the initial public offering. The complaints further allege that these parties violated the Securities Exchange Act of 1934 by acting recklessly or intentionally in making the alleged misstatements. The actions seek damages in an unspecified amount, including compensatory damages, costs, and expenses incurred in connection with the actions and equitable relief as may be permitted by law or equity. On May 19, 2003, a consolidated amended complaint representing all of the actions was filed. On August 4, 2003, Tellium and its underwriters filed motions to dismiss the complaint. On April 1, 2004, the Court issued its decision granting Tellium’s and the underwriters’ motions to dismiss, while allowing plaintiffs an opportunity to seek leave to file a further amended complaint. On May 14, 2004, the plaintiffs filed a second consolidated and amended class action complaint. On June 25, 2004, the Company, as Tellium’s successor-in-interest, moved to have the second consolidated and amended class action complaint dismissed with prejudice. The motion to dismiss has been fully briefed, and the parties are awaiting the Court’s decision on the motion. It remains too early in the legal process to determine what impact, if any, these suits will have upon the Company’s business, financial condition, or results of operations. The Company intends to continue vigorously defending against the claims made in these actions.

 

On January 8, 2003 and January 27, 2003, two shareholder derivative complaints were filed on behalf of Tellium in the Superior Court of New Jersey. These complaints were made by plaintiffs who purport to be Tellium shareholders on behalf of Tellium, alleging, among other things, that Tellium directors breached their fiduciary duties to the company by engaging in stock transactions with individuals associated with Qwest Communications International Inc., and in making materially misleading statements regarding Tellium’s relationship with Qwest. The actions seek damages in an unspecified amount, including imposition of a constructive trust in favor of Tellium for the amount of profits allegedly received through stock sales, disgorgement of proceeds in connection with the stock option exercises, damages allegedly sustained by Tellium in connection with alleged breaches of fiduciary duties, costs, and expenses incurred in connection with the actions. These cases have been stayed by the court pending the resolution of motions to dismiss in the above-referenced federal court securities actions. It is too early in the legal process to determine what impact, if any, these suits will have upon the Company’s business, financial condition, or results of operations. The Company intends to vigorously defend the claims made in these actions, which have been consolidated.

 

The Denver, Colorado regional office of the SEC is conducting two investigations titled In the Matter of Qwest Communications International Inc. and In the Matter of Issuers Related to Qwest. The first of these investigations does not involve any allegation of wrongful conduct on the part of Tellium. In connection with the second investigation, the SEC is examining various transactions and business relationships involving Qwest and eleven companies having a vendor relationship with Qwest, including Tellium. This investigation, insofar as it relates to Tellium, appears to focus generally on whether Tellium’s transactions and relationships with Qwest were appropriately disclosed in Tellium’s public filings and other public statements. In addition, the United States Attorney in Denver is conducting an investigation involving Qwest, including Qwest’s relationships with certain of its vendors, including Tellium. In connection with that investigation, the U.S. Attorney has sought documents and information from Tellium and has sought interviews and/or grand jury testimony from persons associated or formerly associated with Tellium, including certain of its officers. The U.S. Attorney has indicated that, while aspects of its investigation are in an early stage, neither Tellium nor any of the Company’s current or former officers or employees is a target of the investigation. The Company is cooperating fully with these investigations. The Company is not able, at this time, to say when the SEC or U.S. Attorney investigations will be completed and resolved, or what the ultimate outcome with respect to the Company will be. These investigations could result in substantial costs and a diversion of management’s attention and may have a material and adverse effect on the Company’s business, financial condition, and results of operations.

 

The Company is subject to other legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company’s results of operations or financial position.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

 

Not applicable.

 

Item 3. Defaults Upon Senior Securities

 

Not applicable.

 

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Item 4. Submission of Matters to a Vote of Security Holders

 

Not applicable.

 

Item 5. Other Information

 

Not applicable.

 

Item 6. Exhibits

 

Exhibit

 

Description


31.1   Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2   Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32   Certification of Chief Executive Officer and Chief Financial Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

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SIGNATURES

 

Pursuant to the requirements of Section 12 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.

 

   

ZHONE TECHNOLOGIES, INC.

Date: November 12, 2004

 

By:

 

/s/ MORTEZA EJABAT


   

Name:

 

Morteza Ejabat

   

Title:

 

Chief Executive Officer

   

By:

 

/s/ KIRK MISAKA


   

Name:

 

Kirk Misaka

   

Title:

 

Chief Financial Officer

 

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