DZS INC. - Quarter Report: 2014 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)



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

For the quarterly period ended September 30, 2014



¨	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)

7195 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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.



Large accelerated filer	¨	Accelerated filer	¨
Non-accelerated filer	¨ (Do not check if a smaller reporting company)	Smaller reporting company	x

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

As of November 1, 2014, there were approximately 32,498,067 shares of the registrant’s common stock outstanding.

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		Page
PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements	3
	Unaudited Condensed Consolidated Balance Sheets	3
	Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss)	4
	Unaudited Condensed Consolidated Statements of Cash Flows	5
	Notes to Unaudited Condensed Consolidated Financial Statements	6
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	22
Item 4.	Controls and Procedures	22

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	24
Item 1A.	Risk Factors	24
Item 6.	Exhibits	24
	Signatures	25

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Balance Sheets

(In thousands, except par value)



	September 30, 2014			December 31, 2013
Assets
Current assets:
Cash and cash equivalents	$	13,539		$	15,686
Accounts receivable, net of allowances for sales returns and doubtful accounts of $1,247 as of September 30, 2014 and $1,452 as of December 31, 2013	34,165			33,328
Inventories	17,669			19,562
Prepaid expenses and other current assets	3,191			2,269
Total current assets	68,564			70,845
Property and equipment, net	802			718
Other assets	255			254
Total assets	$	69,621		$	71,817
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable	$	13,382		$	12,689
Line of credit	10,000			10,000
Accrued and other liabilities	8,021			8,865
Total current liabilities	31,403			31,554
Other long-term liabilities	2,064			2,704
Total liabilities	33,467			34,258
Stockholders’ equity:
Common stock, $0.001 par value. Authorized 180,000 shares; issued and outstanding 32,390 and 32,249 shares as of September 30, 2014 and December 31, 2013, respectively	32			32
Additional paid-in capital	1,074,953			1,074,294
Other comprehensive income	35			65
Accumulated deficit	(1,038,866		)	(1,036,832		)
Total stockholders’ equity	36,154			37,559
Total liabilities and stockholders’ equity	$	69,621		$	71,817

See accompanying notes to unaudited condensed consolidated financial statements.

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ZHONE TECHNOLOGIES, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss)

(In thousands, except per share data)



	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2014			2013			2014			2013
Net revenue	$	29,436		$	31,515		$	90,467		$	89,942
Cost of revenue	18,682			19,608			57,834			55,919
Gross profit	10,754			11,907			32,633			34,023
Operating expenses:
Research and product development	4,611			3,934			12,921			11,514
Sales and marketing	4,775			4,644			14,257			14,539
General and administrative	4,024			1,702			7,357			4,916
Total operating expenses	13,410			10,280			34,535			30,969
Operating income (loss)	(2,656		)	1,627			(1,902		)	3,054
Interest expense	(36		)	(25		)	(57		)	(74		)
Other expense, net	—			—			(9		)	(20		)
Income (loss) before income taxes	(2,692		)	1,602			(1,968		)	2,960
Income tax provision	13			6			66			78
Net income (loss)	(2,705		)	1,596			(2,034		)	2,882
Other comprehensive loss	(16		)	(30		)	(30		)	(113		)
Comprehensive income (loss)	$	(2,721	)	$	1,566		$	(2,064	)	$	2,769
Basic and diluted net income (loss) per share	$	(0.08	)	$	0.05		$	(0.06	)	$	0.09
Weighted average shares outstanding used to compute basic net income (loss) per share	32,384			31,480			32,346			31,273
Weighted average shares outstanding used to compute diluted net income (loss) per share	32,384			33,344			32,346			32,599

See accompanying notes to unaudited 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,
	2014			2013
Cash flows from operating activities:
Net income (loss)	$	(2,034	)	$	2,882
Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities:
Depreciation and amortization	285			266
Stock-based compensation	531			367
Provision for (recovery of) sales returns and doubtful accounts	(205		)	1,203
Changes in operating assets and liabilities:
Accounts receivable	(632		)	(4,739		)
Inventories	1,893			225
Prepaid expenses and other assets	(923		)	136
Accounts payable	693			4,316
Accrued and other liabilities	(1,484		)	(1,217		)
Net cash (used in) provided by operating activities	(1,876		)	3,439
Cash flows from investing activities:
Purchases of property and equipment	(369		)	(325		)
Net cash used in investing activities	(369		)	(325		)
Cash flows from financing activities:
Proceeds from exercise of stock options	128			181
Net cash provided by financing activities	128			181
Effect of exchange rate changes on cash	(30		)	(113		)
Net (decrease) increase in cash and cash equivalents	(2,147		)	3,182
Cash and cash equivalents at beginning of period	15,686			11,119
Cash and cash equivalents at end of period	$	13,539		$	14,301

See accompanying notes to unaudited condensed consolidated financial statements.

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Notes to Unaudited Condensed Consolidated Financial Statements


(1)	Organization and Summary of Significant Accounting Policies


(a)	Description of Business

Zhone Technologies, Inc. (sometimes referred to, collectively with its subsidiaries, as “Zhone” or the “Company”) designs, develops and manufactures communications networking equipment for enterprises and telecommunications operators worldwide. The Company’s products enable both enterprises and network service providers to deliver high speed fiber access, while transporting voice, video and data to the end user. 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 in accordance with accounting principles generally accepted in the United States of America (“GAAP”). All significant inter-company transactions and balances have been eliminated in consolidation. 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, 2013.


(c)	Risks and Uncertainties

The accompanying condensed consolidated financial statements have been prepared assuming that the Company will continue as a going concern. Although the Company generated net income for the year ended December 31, 2013, the Company has incurred net losses in prior years and for the three and nine months ended September 30, 2014, and there can be no assurance that the Company will continue to generate net income in any future period. As of September 30, 2014, the Company had approximately $13.5 million in cash and cash equivalents and $10.0 million in current debt outstanding under its revolving line of credit and letter of credit facility (the “WFB Facility”) with Wells Fargo Bank (“WFB”). The Company currently expects to repay the WFB Facility within the next twelve months. The Company entered into its WFB Facility to provide liquidity and working capital through March 31, 2016, as discussed in Note 5.

The Company’s current lack of liquidity could harm it by:


•	increasing its vulnerability to adverse economic conditions in its industry or the economy in general;


•	requiring substantial amounts of cash to be used for debt servicing, rather than other purposes, including operations;


•	limiting its ability to plan for, or react to, changes in its business and industry; and


•	influencing investor and customer perceptions about its financial stability and limiting its ability to obtain financing or acquire customers.

In order to meet the Company’s liquidity needs and finance its capital expenditures and working capital needs for the business, the Company may be required to sell assets, issue debt or equity securities or borrow on unfavorable terms. If additional capital is raised through the issuance of debt securities or other debt financing, the terms of such debt may include covenants, restrictions and financial ratios that may restrict the Company’s ability to operate its business. Likewise, any equity financing could result in additional dilution of the Company’s stockholders. If the Company is unable to sell assets, issue securities or access additional financing to meet these needs on favorable terms, or at all, the Company may become unable to pay its ordinary expenses, including its debt service, on a timely basis and may be required to reduce the scope of its planned product development and sales and marketing efforts beyond the reductions it has previously taken. In addition, the Company may be required to reduce its operations in low margin regions, including reductions in headcount. Based on the Company’s current plans and business conditions, it believes that its existing cash, cash equivalents and available credit facilities will be sufficient to satisfy its anticipated cash requirements for at least the next twelve months.

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In addition, global economic and market conditions could impact the Company’s business in a number of ways, including:


•	Potential deferment of purchases and orders by customers;


•	Customers’ inability to obtain financing to make purchases from the Company and/or maintain their business;


•	Negative impact from increased financial pressures on third-party dealers, distributors and retailers;


•	Intense competition in the communication equipment market;


•	Commercial acceptance of the Company’s Single Line Multi-Service (“SLMS”) products; and


•	Negative impact from increased financial pressures on key suppliers.

The Company may experience material adverse impacts on its business, operating results and financial condition as a result of weak or recessionary economic or market conditions in the United States or the rest of the world.


(d)	Use of Estimates

The preparation of the condensed consolidated financial statements in conformity with generally accepted accounting principles 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 condensed consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.


(e)	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, net of estimated sales returns and allowances at the time of shipment. Revenue is deferred if there are significant post-delivery obligations 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. If the Company’s arrangements include customer acceptance provisions, revenue is recognized upon obtaining the signed acceptance certificate from the customer, unless the Company can objectively demonstrate that the delivered products or services meet all the acceptance criteria specified in the arrangement prior to obtaining the signed acceptance. In those instances where revenue is recognized prior to obtaining the signed acceptance certificate, the Company uses successful completion of customer testing as the basis to objectively demonstrate that the delivered products or services meet all the acceptance criteria specified in the arrangement. The Company also considers historical acceptance experience with the customer, as well as the payment terms specified in the arrangement, when revenue is recognized prior to obtaining the signed acceptance certificate. When collectability is not reasonably assured, revenue is recognized when cash is collected.

The Company makes certain sales to product distributors. These customers are given certain privileges to return a portion of inventory. Return privileges generally allow distributors to return inventory based on a percent of purchases made within a specific period of time. 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. In those instances when revenue is recognized upon shipment to distributors, the Company uses historical rates of return from the distributors to provide for estimated product returns.

The Company derives revenue primarily from stand-alone sales of its products. In certain cases, the Company’s products are sold along with services, which include education, training, installation, and/or extended warranty services. As such, some of the Company’s sales have multiple deliverables. The Company’s products and services qualify as separate units of accounting and are deemed to be non-contingent deliverables as the Company’s arrangements typically do not have any significant performance, cancellation, termination and refund type provisions. Products are typically considered delivered upon shipment. Revenue from services is recognized ratably over the period during which the services are to be performed.

For multiple deliverable revenue arrangements, the Company allocates revenue to products and services using the relative selling price method to recognize revenue when the revenue recognition criteria for each deliverable are

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met. The selling price of a deliverable is based on a hierarchy and if the Company is unable to establish vendor-specific objective evidence of selling price (“VSOE”) it uses third-party evidence of selling price (“TPE”), and if no such data is available, it uses a best estimated selling price (“BSP”). In most instances, particularly as it relates to products, the Company is not able to establish VSOE for all deliverables in an arrangement with multiple elements. This may be due to infrequently selling each element separately, not pricing products within a narrow range, or only having a limited sales history. When VSOE cannot be established, the Company attempts to establish the selling price of each element based on TPE. Generally, the Company’s marketing strategy differs from that of the Company’s peers and the Company’s offerings contain a significant level of customization and differentiation such that the comparable pricing of products with similar functionality cannot be obtained. Furthermore, the Company is unable to reliably determine what similar competitor products’ selling prices are on a stand-alone basis. Therefore, the Company is typically not able to determine TPE for the Company’s products.

When the Company is unable to establish selling price using VSOE or TPE, the Company uses BSP. The objective of BSP is to determine the price at which the Company would transact a sale if the product or service were sold on a stand-alone basis. The BSP of each deliverable is determined using average discounts from list price from historical sales transactions or cost plus margin approaches based on the factors, including but not limited to, the Company’s gross margin objectives and pricing practices plus customer and market specific considerations.

The Company has established TPE for its training, education and installation services. TPE is determined based on competitor prices for similar deliverables when sold separately. These service arrangements are typically short term in nature and are largely completed shortly after delivery of the product. Training and education services are based on a daily rate per person and vary according to the type of class offered. Installation services are based on daily rate per person and vary according to the complexity of the products being installed.

Extended warranty services are priced based on the type of product and are sold in one to five year durations. Extended warranty services include the right to warranty coverage beyond the standard warranty period. In substantially all of the arrangements with multiple deliverables pertaining to arrangements with these services, the Company has used and intends to continue using VSOE to determine the selling price for the services. The Company determines VSOE based on its normal pricing practices for these specific services when sold separately.


(f)	Fair Value of Financial Instruments

The Company had no financial assets and liabilities as of September 30, 2014 and December 31, 2013 recorded at fair value. The following financial instruments are not measured at fair value on the Company’s condensed consolidated balance sheet as of September 30, 2014 and December 31, 2013, but require disclosure of their fair values: cash and cash equivalents, accounts receivable, accounts payable, accrued liabilities, and debt. The estimated fair value of such instruments at September 30, 2014 and December 31, 2013 approximated their carrying value as reported on the condensed consolidated balance sheet. The fair value of such financial instruments is determined using the income approach based on the present value of estimated future cash flows. The fair value of these instruments would be categorized as Level 2 in the fair value hierarchy, with the exception of cash and cash equivalents, which would be categorized as Level 1.


(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 months ended September 30, 2014 and 2013, two customers represented 23% of net revenue. For the nine months ended September 30, 2014 and 2013, two customers represented 24% and 23% of net revenue, respectively.

As of September 30, 2014 and December 31, 2013, three customers accounted for 52% and 56% of net accounts receivable, respectively.

As of September 30, 2014 and December 31, 2013, receivables from customers in countries other than the United States represented 83% and 82%, respectively, of net accounts receivable.

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(h)	Comprehensive Income

There have been no items reclassified out of accumulated other comprehensive income and into net income. The Company’s other comprehensive income (loss) for the three and nine months ended September 30, 2014 is comprised of only foreign exchange translations.

(i) Recent Accounting Pronouncements

On May 28, 2014, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard is effective for the Company on January 1, 2017. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is evaluating the effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures. The Company has not yet selected a transition method nor has it determined the effect of the standard on its ongoing financial reporting.

In August 2014, the FASB issued ASU No. 2014-15, Disclosure of Uncertainties about an Entity's Ability to Continue as a Going Concern, which describes how an entity should assess its ability to meet obligations and sets rules for how this information should be disclosed in financial statements. The new standard is effective for the Company on January 1, 2017. Early application is permitted. The Company is evaluating the effect that ASU 2014-15 will have on its consolidated financial statements and related disclosures.


(2)	Inventories

Inventories as of September 30, 2014 and December 31, 2013 were as follows (in thousands):



	September 30, 2014		December 31, 2013
Raw materials	$	11,029	$	11,722
Work in process	1,567		1,724
Finished goods	5,073		6,116
	$	17,669	$	19,562


(3)	Property and Equipment, net

Property and equipment, net, as of September 30, 2014 and December 31, 2013 were as follows (in thousands):



	September 30, 2014			December 31, 2013
Machinery and equipment	$	9,843		$	9,610
Computers and acquired software	3,951			3,830
Furniture and fixtures	262			247
Leasehold improvements	2,066			2,066
	16,122			15,753
Less accumulated depreciation and amortization	(15,320		)	(15,035		)
	$	802		$	718

Depreciation and amortization expense associated with property and equipment amounted to $0.3 million for each of the nine months ended September 30, 2014 and 2013.


(4)	Net Income (Loss) Per Share

Basic net income (loss) per share is computed by dividing the net income (loss) applicable to holders of common stock for the period by the weighted average number of shares of common stock outstanding during the period. The calculation of diluted net income (loss) per share gives effect to common stock equivalents; however, potential common equivalent

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shares are excluded if their effect is antidilutive. Potential common equivalent shares are composed of incremental shares of common equivalent shares issuable upon the exercise of stock options and warrants.

The following table is a reconciliation of the numerator and denominator in the basic and diluted net income (loss) per share calculation (in thousands, except per share data):



	Three Months Ended September 30,					Nine Months Ended September 30,
	2014			2013		2014			2013
Net income (loss):	$	(2,705	)	$	1,596	$	(2,034	)	$	2,882
Weighted average number of shares outstanding:
Basic	32,384			31,480		32,346			31,273
Effect of dilutive securities:
Stock options and share awards	—			1,864		—			1,326
Diluted	32,384			33,344		32,346			32,599
Net income (loss) per share:
Basic	$	(0.08	)	$	0.05	$	(0.06	)	$	0.09
Diluted	$	(0.08	)	$	0.05	$	(0.06	)	$	0.09

The following tables set forth potential common stock that is not included in the diluted net income (loss) per share calculation because their effect would be antidilutive for the periods indicated (in thousands, except exercise price per share data):



	Three Months Ended September 30, 2014	Weighted Average Exercise Price		Nine Months Ended September 30, 2014	Weighted Average Exercise Price
Outstanding stock options and unvested restricted shares	1,295	$	3.72	1,295	$	3.72



	Three Months Ended September 30, 2013	Weighted Average Exercise Price		Nine Months Ended September 30, 2013	Weighted Average Exercise Price
Warrants	7	$	116.54	7	$	116.54
Outstanding stock options and unvested restricted shares	541	$	4.98	541	$	4.98
	548			548


(5)	Debt

As of September 30, 2014, the Company had a $25.0 million revolving line of credit and letter of credit facility with WFB to provide liquidity and working capital through March 31, 2016. The amount that the Company is able to borrow under the WFB Facility varies based on eligible accounts receivable and inventory, as defined in the agreement, as long as the aggregate amount outstanding does not exceed $25.0 million less the amount committed as security for letters of credit. At September 30, 2014, the Company's borrowing base was $16.6 million. To maintain availability of funds under the WFB Facility, the Company pays a commitment fee on the unused portion. The commitment fee is 0.25% per annum and is recorded as interest expense.

The Company had $10.0 million outstanding at September 30, 2014 under its WFB Facility. In addition, $3.4 million was committed as security for letters of credit. The Company had $3.2 million of borrowing availability under the WFB Facility as of September 30, 2014. The amounts borrowed under the WFB Facility bear interest, payable monthly, at a floating rate equal to the three-month LIBOR plus a margin of 3.0%. The interest rate on the WFB Facility was 3.23% at September 30, 2014.

The Company’s obligations under the WFB Facility are secured by substantially all of its personal property assets and those of its subsidiaries that guarantee the WFB Facility, including their intellectual property. The WFB Facility contains certain financial covenants, and customary affirmative covenants and negative covenants. If the Company defaults under

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the WFB Facility due to a covenant breach or otherwise, WFB may be entitled to, among other things, require the immediate repayment of all outstanding amounts and sell the Company’s assets to satisfy the obligations under the WFB Facility. As of September 30, 2014, the Company was in compliance with these covenants.


(6)	Commitments and Contingencies

Operating Leases

The Company has entered into operating leases for certain office space and equipment, some of which contain renewal options. Estimated future lease payments under all non-cancelable operating leases with terms in excess of one year, including taxes and service fees, are as follows (in thousands):



	Operating Leases
Year ending December 31:
2014 (remainder of the year)	$	439
2015	1,483
2016	541
2017	83
2018 and thereafter	—
Total minimum lease payments	$	2,546

Warranties

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, 2014 and 2013 (in thousands):



	Nine Months Ended September 30,
	2014			2013
Beginning balance	$	1,265		$	1,499
Charged to cost of revenue	208			466
Claims and settlements	(507		)	(719		)
Ending balance	$	966		$	1,246

Performance Bonds

In the normal course of operations, the Company arranges for the issuance of various types of surety bonds, such as bid and performance bonds, which are agreements under which the surety company guarantees that the Company will perform in accordance with contractual or legal obligations. The Company had no such surety bonds as of September 30, 2014.

Purchase Commitments

The Company has agreements with various contract manufacturers which include non-cancellable inventory purchase commitments. The Company’s inventory purchase commitments typically allow for cancellation of orders 30 days in advance of the required inventory availability date as set by the Company at time of order. The amount of non-cancellable purchase commitments outstanding was $6.4 million as of September 30, 2014.

Royalties

The Company has certain royalty commitments associated with the shipment and licensing of certain products. Royalty expense is generally based on a dollar amount per unit shipped or a percentage of the underlying revenue and is recorded in cost of revenue.

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Legal Proceedings

The Company is subject to various legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, the Company does not expect that the ultimate costs to resolve these matters will have a material adverse effect on its consolidated financial position or results of operations. However, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.


(7)	Enterprise-Wide Information

The Company designs, develops and manufactures communications 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. The Chief Executive Officer 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 following tables summarize required disclosures about geographic concentrations and revenue by products and services (in thousands):



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2014		2013		2014		2013
Revenue by Geography:
United States	$	10,770	$	9,691	$	28,267	$	28,941
Canada	696		881		2,011		2,691
Total North America	11,466		10,572		30,278		31,632
Latin America	5,600		8,317		15,367		20,610
Europe, Middle East, Africa	11,539		11,770		42,097		35,048
Asia Pacific	831		856		2,725		2,652
Total International	17,970		20,943		60,189		58,310
	$	29,436	$	31,515	$	90,467	$	89,942



	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2014		2013		2014		2013
Revenue by Products and Services:
Products	$	27,869	$	29,653	$	85,456	$	83,699
Services	1,567		1,862		5,011		6,243
Total	$	29,436	$	31,515	$	90,467	$	89,942


(8)	Income Taxes

The total amount of unrecognized tax benefits, including interest and penalties, at September 30, 2014 was not material. The amount of tax benefits that would impact the effective income tax rate, if recognized, is not expected to be material. There were no significant changes to unrecognized tax benefits during the quarters and nine months ended September 30, 2014 and 2013. The Company does not anticipate any significant changes with respect to unrecognized tax benefits within the next 12 months.

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The Company or one of its subsidiaries files income tax returns in the U.S. federal jurisdiction, and various state and foreign jurisdictions. The open tax years for the major jurisdictions are as follows:



• Federal		2010 –2013

• California and Canada		2009 – 2013

• Brazil		2008 – 2013

• Germany		2010 – 2013

• United Kingdom		2009 – 2013

However, due to the fact the Company had net operating losses and credits carried forward in most jurisdictions, certain items attributable to technically closed years are still subject to adjustment by the relevant taxing authority through an adjustment to tax attributes carried forward to open years.

In addition, to the extent the Company is deemed to have a sufficient connection to a particular taxing jurisdiction to enable that jurisdiction to tax the Company but the Company has not filed an income tax return in that jurisdiction for the year(s) at issue, the jurisdiction would typically be able to assert a tax liability for such years without limitation on the number of years it may examine.

The Company is not currently under examination for income taxes in any material jurisdiction.


(9)	Executive Compensation

On July 17, 2014, Morteza Ejabat, the Company's President, Chief Executive Officer and Chairman of Zhone's Board of Directors (the "Board"), resigned from his position as President and Chief Executive Officer and was appointed by the Board to serve as Executive Chairman. Effective July 17, 2014, the Board appointed James Norrod as the Company’s President and Chief Executive Officer and as a member of the Board.

In connection with this transition, the Company paid Mr. Ejabat a one-time performance bonus in the amount of $1.7 million on July 17, 2014. The performance bonus was expensed during the three month period ended September 30, 2014. In addition, the Compensation Committee of the Board approved the grant of an inducement award to Mr. Norrod consisting of a stock option to purchase 1,250,000 shares of the Company’s common stock at an exercise price equal to the closing price of the Company’s common stock on the grant date, which stock option was granted on July 21, 2014. The estimated fair value of the stock option award at the grant date was $3.0 million and will be amortized to expense over the service period of four years.

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

Forward-Looking Statements

This report, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933 and the Securities Exchange Act of 1934. These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. We use words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “goal,” “intend,” “may,” “plan,” “project,” “seek,” “should,” “target,” “will,” “would,” variations of such words, and similar expressions to identify forward-looking statements. In addition, statements that refer to projections of earnings, revenue, costs or other financial items; anticipated growth and trends in our business or key markets; future growth and revenues from our Single Line Multi-Service (SLMS) and FiberLAN products; our ability to refinance or repay our existing indebtedness prior to the applicable maturity date; future economic conditions and performance; anticipated performance of products or services; plans, objectives and strategies for future operations; and other characterizations of future events or circumstances, are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties and assumptions that are difficult to predict, including those identified under the heading “Risk Factors” in Part II, Item 1A, elsewhere in this report and our other filings with the Securities and Exchange Commission (the SEC). Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Factors that might cause such a difference include, but are not limited to, the ability to generate sufficient revenue to achieve or sustain profitability, the ability to raise additional capital to fund existing and future operations or to refinance or repay our existing

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indebtedness, defects or other performance problems in our products, the economic slowdown in the telecommunications industry that has restricted the ability of our customers to purchase our products, commercial acceptance of our SLMS and FiberLAN products, intense competition in the communications equipment market from large equipment companies as well as private companies with products that address the same networks needs as our products, higher than anticipated expenses that we may incur, and other factors identified elsewhere in this report and in our most recent reports on Forms 10-K, 10-Q and 8-K. We undertake no obligation to revise or update any forward-looking statements for any reason.

OVERVIEW

We believe that we are the first company dedicated solely to developing the full spectrum of next-generation access network solutions to cost-effectively deliver high bandwidth services while simultaneously preserving the investment in today’s networks. Our next-generation solutions are based upon our SLMS architecture. From its inception, this SLMS architecture was specifically designed for the delivery of multiple classes of subscriber services (such as voice, data and video distribution), rather than being based on a particular protocol or media. In other words, our SLMS products are built to support the migration from legacy circuit to packet technologies and from copper to fiber technologies. This flexibility and versatility allows our products to adapt to future technologies while allowing service providers to focus on the delivery of additional high bandwidth services. Because this SLMS architecture is designed to interoperate with existing legacy equipment, service providers can leverage their existing networks to deliver a combination of voice, data and video services today, while they migrate, either simultaneously or at a future date, from legacy equipment to next-generation equipment with minimal interruption. We believe that our SLMS solution provides an evolutionary path for service providers from their existing infrastructures, as well as gives newer service providers the capability to deploy cost-effective, multi-service networks that can support voice, data and video.

In addition to our established product offerings in our core business, we launched our new FiberLAN Passive Optical LAN in 2012, which provides an alternative to switched copper-based LANs. Target customers of our FiberLAN business include hospitality, government, education, manufacturing and business enterprises. We believe FiberLAN Passive Optical LAN is one of the most cost-effective, efficient and environmentally friendly alternatives to existing copper-based Ethernet LAN infrastructure. Our FiberLAN Passive Optical LAN is comprised of our MXK Optical Line Terminals (OLT) and zNID Optical Network Terminals (ONT), and delivers Gigabit Passive Optical Network (GPON) and Active Ethernet-based LAN services to enterprises. Both our core business and FiberLAN business leverage the same R&D efficiencies. Our FiberLAN solution (including FiberLAN OLT and ONT Passive Optical Network (PON)) was granted JITC (Joint Interoperability Test Command) certification by the Defense Information Systems Agency. This certification provides new sales opportunities in military and government markets, while helping to demonstrate the capabilities and security aspects of our FiberLAN solution.

Our global customer base for our core business includes regional, national and international telecommunications carriers. To date, our products are deployed by over 750 network service providers on six continents worldwide. Our global FiberLAN customer base includes hotels, universities, military bases, government institutions, manufacturing facilities and businesses. We believe that we have assembled the employee base, technological breadth and market presence to provide a simple yet comprehensive set of next-generation solutions to the bandwidth bottleneck in the access network and the other problems encountered by network service providers when delivering communications services to subscribers.

Going forward, our key financial 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; and


•	Minimizing consumption of our cash and cash equivalents.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

There have been no material changes to our critical accounting policies and estimates from the information provided in Part II, “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates” included in our Annual Report on Form 10-K for the year ended December 31, 2013.

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RESULTS OF OPERATIONS

We list in the table below the historical condensed consolidated statement of comprehensive income (loss)

data as a percentage of net revenue for the periods indicated.



	Three Months Ended September 30,				Nine Months Ended September 30,
	2014		2013		2014		2013
Net revenue	100	%	100	%	100	%	100	%
Cost of revenue	63	%	62	%	64	%	62	%
Gross profit	37	%	38	%	36	%	38	%
Operating expenses:
Research and product development	16	%	13	%	14	%	13	%
Sales and marketing	16	%	15	%	16	%	16	%
General and administrative	14	%	5	%	8	%	6	%
Total operating expenses	46	%	33	%	38	%	35	%
Operating income (loss)	(9	)%	5	%	(2	)%	3	%
Interest expense	0	%	0	%	0	%	0	%
Other expense, net	0	%	0	%	0	%	0	%
Income (loss) before income taxes	(9	)%	5	%	(2	)%	3	%
Income tax provision	0	%	0	%	0	%	0	%
Net income (loss)	(9	)%	5	%	(2	)%	3	%
Other comprehensive loss	0	%	0	%	0	%	0	%
Comprehensive income (loss)	(9	)%	5	%	(2	)%	3	%

Net Revenue

Information about our net revenue for products and services for the three and nine months ended September 30, 2014 and 2013 is summarized below (in millions):



	Three Months Ended September 30,									Nine Months Ended September 30,
	2014		2013		Increase/ (Decrease)			% change		2014		2013		Increase/ (Decrease)			% change
Products	$	27.8	$	29.7	$	(1.9	)	(6.4	)%	$	85.5	$	83.7	$	1.8		2.2	%
Services	1.6		1.8		(0.2		)	(11.1	)%	5.0		6.2		(1.2		)	(19.4	)%
Total	$	29.4	$	31.5	$	(2.1	)	(6.7	)%	$	90.5	$	89.9	$	0.6		0.7	%

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Information about our net revenue for North America and international markets for the three and nine months ended September 30, 2014 and 2013 is summarized below (in millions):



	Three Months Ended September 30,									Nine Months Ended September 30,
	2014		2013		Increase (Decrease)			% change		2014		2013		Increase (Decrease)			% change
Revenue by geography:
United States	$	10.8	$	9.7	$	1.1		11.3	%	$	28.3	$	28.9	$	(0.6	)	(2.1	)%
Canada	0.7		0.9		(0.2		)	(22.2	)%	2.0		2.7		(0.7		)	(25.9	)%
Total North America	11.5		10.6		0.9			8.5	%	30.3		31.6		(1.3		)	(4.1	)%
Latin America	5.6		8.3		(2.7		)	(32.5	)%	15.4		20.6		(5.2		)	(25.2	)%
Europe, Middle East, Africa	11.5		11.8		(0.3		)	(2.5	)%	42.1		35.0		7.1			20.3	%
Asia Pacific	0.8		0.8		—			—	%	2.7		2.7		—			—	%
Total International	17.9		20.9		(3.0		)	(14.4	)%	60.2		58.3		1.9			3.3	%
Total	$	29.4	$	31.5	$	(2.1	)	(6.7	)%	$	90.5	$	89.9	$	0.6		0.7	%

For the three months ended September 30, 2014, net revenue decreased 7% or $2.1 million to $29.4 million from $31.5 million for the same period last year. For the three months ended September 30, 2014, product revenue decreased 6% or $1.9 million to $27.8 million, compared to $29.7 million for the same period last year. The decreases in net revenue and product revenue for the three months ended September 30, 2014 were primarily due to decreased sales of our MXK products. For the nine months ended September 30, 2014, net revenue increased 1% or $0.6 million to $90.5 million from $89.9 million for the same period last year. For the nine months ended September 30, 2014, product revenue increased 2% or $1.8 million to $85.5 million, compared to $83.7 million for the same period last year. The increases in net revenue and product revenue for the nine months ended September 30, 2014 were primarily due to increased sales of our ONT and MXK products during the first and second quarters of 2014.

For the three months ended September 30, 2014, service revenue decreased by 11% or $0.2 million to $1.6 million, compared to $1.8 million for the same period last year. For the nine months ended September 30, 2014, service revenue decreased by 19% or $1.2 million to $5.0 million, compared to $6.2 million for the same period last year. Service revenue represents revenue from maintenance and other services associated with product shipments. The decrease in service revenue for the three and nine months ended September 30, 2014 was primarily due to decreased sales of installation services due to the completion of a large broadband development project in 2013.

International net revenue decreased 14% or $3.0 million to $17.9 million for the three months ended September 30, 2014 from $20.9 million for the same period last year, and represented 61% of total net revenue compared with 66% during the same period of 2013. International net revenue increased 3% or $1.9 million to $60.2 million for the nine months ended September 30, 2014 from $58.3 million for the same period last year. The decrease in international net revenue for the three months ended September 30, 2014 was primarily due to decreased sales to two customers in Latin America. The increase in international net revenue for the nine months ended September 30, 2014 was primarily due to increased sales to a customer in the Middle East.

For the three months ended September 30, 2014 and 2013, two customers represented 23% of net revenue. For the nine months ended September 30, 2014 and 2013, two customers represented 24% and 23% of net revenue, respectively. We anticipate that our results of operations in any given period may depend to a large 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 and Gross Margin

Total cost of revenue, including stock-based compensation, decreased 5% or $0.9 million to $18.7 million for the three months ended September 30, 2014, compared to $19.6 million for the three months ended September 30, 2013, primarily due to decreased sales in the current year period. Cost of revenue increased 3% or $1.9 million to $57.8 million for the nine months ended September 30, 2014 compared to $55.9 million for the same period last year primarily due to higher shipments of ONT products, during the current year period. Gross margin decreased during the three and nine months ended September 30, 2014 compared to prior year periods, primarily due to greater sales of products with lower gross margin, such as ONT products.

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We expect that in the future our cost of revenue as a percentage of net revenue will vary depending on the mix and average selling prices of products sold. In addition, continued 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

Research and product development expenses increased 17% or $0.7 million to $4.6 million for the three months ended September 30, 2014 compared to $3.9 million for the three months ended September 30, 2013, and increased 12% or $1.4 million to $12.9 million for the nine months ended September 30, 2014 compared to $11.5 million for the nine months ended September 30, 2013. The increase in the three months ended September 30, 2014 was primarily due to $0.3 million in higher personnel-related expenses and $0.2 million of higher machine tooling expenses. The increase in the nine months ended September 30, 2014 was primarily due to $0.7 million of higher personnel-related expenses and $0.2 million of higher consultant expenses. The increase in personnel-related expenses for the nine months ended September 30, 2014 was primarily due to a higher headcount in 2014 compared to 2013, as well as $0.3 million in higher health benefit expenses due to a credit recorded in 2013. We recorded a $0.6 million credit to our statement of comprehensive income in the quarter ended March 31, 2013 as a result of a vendor refund received in 2013 which related to overpayments for health benefits made in 2012. We allocated $0.3 million of the credit to research and product development expenses. There was no similar credit in the current year period. We intend to continue to invest in research and product development to attain our strategic product development objectives while seeking to manage the associated costs through expense controls.

Sales and Marketing Expenses

Sales and marketing expenses increased 3% or $0.2 million to $4.8 million for the three months ended September 30, 2014 compared to $4.6 million for the three months ended September 30, 2013, and decreased 2% or $0.2 million to $14.3 million for the nine months ended September 30, 2014 compared to $14.5 million for the nine months ended September 30, 2013. The increase in the three months ended September 30, 2014 was primarily due to higher travel expenses. The decrease in the nine months ended September 30, 2014 was primarily due to a decrease in consulting expenses of $0.6 million, which was offset by $0.2 million in higher personnel-related expenses and $0.2 million in higher travel expenses.

General and Administrative Expenses

General and administrative expenses increased 136% or $2.3 million to $4.0 million for the three months ended September 30, 2014 compared to $1.7 million for the three months ended September 30, 2013, due primarily to restructuring costs of $1.7 million, $0.3 million in higher stock-based compensation expense, and $0.2 million in higher accounting and legal fees. General and administrative expenses increased 51% or $2.5 million to $7.4 million for the nine months ended September 30, 2014 compared to $4.9 million for the nine months ended September 30, 2013, due primarily to $1.7 million in restructuring costs and $0.4 million in higher accounting and legal fees.

Income Tax Provision

During the three and nine months ended September 30, 2014 and 2013, no material provision or benefit for income taxes was recorded, due to our previous operating losses and the significant uncertainty regarding the realization of our net deferred tax assets, against which we have continued to record a full valuation allowance.

OTHER PERFORMANCE MEASURES

In managing our business and assessing our financial performance, we supplement the information provided by our GAAP results with adjusted earnings before stock-based compensation, interest, taxes, and depreciation, or Adjusted EBITDA, a non-GAAP financial measure. We define Adjusted EBITDA as net income (loss) plus (i) interest expense, (ii) provision (benefit) for taxes, (iii) depreciation and amortization, (iv) non-cash equity-based compensation expense, and (v) material non-recurring non-cash transactions, such as gain (loss) on sale of assets or impairment of fixed assets. We believe that the presentation of Adjusted EBITDA enhances the usefulness of our financial information by presenting a measure that management uses internally to monitor and evaluate our operating performance and to evaluate the effectiveness of our business strategies. We believe Adjusted EBITDA also assists investors and analysts in comparing our performance across reporting periods on a consistent basis because it excludes the impact of items that we do not believe reflect our core operating performance.

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Adjusted EBITDA has limitations as an analytical tool. Some of these limitations are:


•	Adjusted EBITDA does not reflect our cash expenditures, or future requirements, for capital expenditures or contractual requirements;


•	Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs;


•	Adjusted EBITDA does not reflect the interest expense, or the cash requirements necessary to service interest or principal payments, on our debts;


•	although depreciation and amortization are non-cash charges, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements;


•	non-cash compensation is and will remain a key element of our overall long-term incentive compensation package, although we exclude it as an expense when evaluating our ongoing operating performance for a particular period; and


•	other companies in our industry may calculate Adjusted EBITDA and similar measures differently than we do, limiting its usefulness as a comparative measure.

Because of these limitations, Adjusted EBITDA should not be considered in isolation or as a substitute for net income (loss) or any other performance measures calculated in accordance with GAAP or as a measure of liquidity. Management understands these limitations and compensates for these limitations by relying primarily on our GAAP results and using Adjusted EBITDA only supplementally.

Set forth below is a reconciliation of net income (loss) to Adjusted EBITDA, which we consider to be the most directly comparable GAAP financial measure to Adjusted EBITDA (in thousands):



	Three Months Ended September 30,					Nine Months Ended September 30,
	2014			2013		2014			2013
Net income (loss)	$	(2,705	)	$	1,596	$	(2,034	)	$	2,882
Add:
Interest expense	36			25		57			74
Provision for taxes	13			6		66			78
Depreciation and amortization	102			92		285			266
Non-cash equity-based compensation expense	364			55		531			367
Adjusted EBITDA	$	(2,190	)	$	1,774	$	(1,095	)	$	3,667

LIQUIDITY AND CAPITAL RESOURCES

Our operations are financed through a combination of our existing cash, cash equivalents, available credit facilities, and sales of equity and debt instruments, based on our operating requirements and market conditions.

At September 30, 2014, cash and cash equivalents were $13.5 million compared to $15.7 million at December 31, 2013. The $2.2 million decrease in cash and cash equivalents was attributable to net cash used in operating and investing activities of $1.9 million and $0.4 million, respectively, partially offset by net cash provided by financing activities of $0.1 million.

Operating Activities

Net cash used in operating activities for the nine months ended September 30, 2014 consisted of a net loss of $2.0 million, adjusted for non-cash charges totaling $0.6 million and an increase in net operating assets totaling $0.5 million. The most significant components of the changes in net operating assets were a decrease in accrued liabilities of $1.5 million and an increase in prepaid expenses of $0.9 million offset by a decrease of inventory of $1.9 million. The decrease in accrued liabilities was primarily due to reduced consulting expenses and lower warranty reserves. The increase in prepaid expenses was primarily related to prepaid software maintenance. The decrease in inventory was due to better utilization of inventory in the current year period.

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Net cash provided by operating activities for the nine months ended September 30, 2013 consisted of net income of $2.9 million, adjusted for non-cash charges totaling $1.8 million and offset by an increase in net operating assets totaling $1.3 million. The most significant components of the changes in net operating assets were an increase of $4.7 million in accounts receivable offset by an increase of $4.3 million in accounts payable. The increase in accounts receivable was primarily the result of increased sales to several large customers. The increase in accounts payable was primarily due to the timing of payments to vendors.

Investing Activities

Net cash used in investing activities for the nine months ended September 30, 2014 and 2013 consisted of purchases of property and equipment.

Financing Activities

Net cash provided by financing activities for the nine months ended September 30, 2014 and 2013 consisted of proceeds related to exercises of stock options.

Cash Management

Our primary source of liquidity comes from our cash and cash equivalents which totaled $13.5 million at September 30, 2014, and our $25.0 million revolving line of credit and letter of credit facility with WFB. At current revenue levels, we anticipate that some portion of our existing cash and cash equivalents may be consumed by operations.

As of September 30, 2014, we had a $25.0 million revolving line of credit and letter of credit facility with WFB to provide liquidity and working capital through March 31, 2016. The amount that we are able to borrow under the WFB Facility varies based on eligible accounts receivable and inventory, as defined in the agreement, as long as the aggregate principal amount outstanding does not exceed $25.0 million less the amount committed as security for letters of credit. In addition, under the WFB Facility, we are able to utilize the facility as security for letters of credit. At September 30, 2014, our borrowing base was $16.6 million. To maintain availability of funds under the WFB Facility, we pay a commitment fee on the unused portion. The commitment fee is 0.25% and is recorded as interest expense.

We had $10.0 million outstanding at September 30, 2014 under the WFB Facility. In addition, $3.4 million was committed as security for letters of credit. We had $3.2 million of borrowing availability under the WFB Facility as of September 30, 2014. The amounts borrowed under the WFB Facility bear interest, payable monthly, at a floating rate equal to the three-month LIBOR plus a margin of 3.0%. The interest rate on the WFB Facility was 3.23% at September 30, 2014.

Our obligations under the WFB Facility are secured by substantially all of our personal property assets and those of our subsidiaries that guarantee the WFB Facility, including our intellectual property. The WFB Facility contains certain financial covenants, and customary affirmative covenants and negative covenants. If we default under the WFB Facility due to a covenant breach or otherwise, WFB may be entitled to, among other things, require the immediate repayment of all outstanding amounts and sell our assets to satisfy the obligations under the WFB Facility. As of September 30, 2014, we were in compliance with these covenants. We make no assurances that we will be in compliance with these covenants in the future.

Future Requirements and Funding Sources

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. Our operating lease commitments include $1.3 million of future minimum lease payments spread over the three-year lease term under the lease agreement we entered into in July 2013 for our manufacturing facility in Largo, Florida. In addition, we have $0.6 million of future minimum lease payments spread over the remaining lease period with respect to our Oakland, California campus following the sale of our campus in a sale-leaseback transaction. The total remaining operating lease commitments relate to our various other offices around the world.

From time to time, we may provide or commit to extend credit or credit support to our customers. This financing may include extending the terms for product payments to customers. Any extension of financing to our customers will limit the capital that we have available for other uses.

Our accounts receivable, while not considered a primary source of liquidity, represent 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 account balances. As of September 30, 2014, three customers accounted for 52% of net

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accounts receivable and receivables from customers in countries other than the United States of America represented 83% of net accounts receivable. 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.

Although we generated net income of $4.3 million for the year ended December 31, 2013, we have incurred net losses in prior years and for the three and nine months ended September 30, 2014, and there can be no assurance that we will continue to generate net income or have positive cash flows from operations in any future period. In order to meet our liquidity needs and finance our capital expenditures and working capital needs for our business, we may be required to sell assets, issue debt or equity securities or borrow on potentially unfavorable terms. In addition, we may be required to reduce our operations in low margin regions, including reductions in headcount. We may be unable to sell assets, issue securities or access additional financing to meet these needs on favorable terms, or at all. If additional capital is raised through the issuance of debt securities or other debt financing, the terms of such debt may include covenants, restrictions and financial ratios that may restrict our ability to operate our business. Likewise, any equity financing could result in additional dilution of our stockholders. 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 beyond the reductions we have previously taken. In addition, we may be required to reduce our operations in low margin regions, including reductions in headcount.Based on our current plans and business conditions, we believe that our existing cash, cash equivalents 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, 2014, our future contractual commitments by fiscal year were as follows (in thousands):



			Payments due by period
	Total		2014		2015		2016		2017		2018 and thereafter
Operating leases	$	2,546	$	439	$	1,483	$	541	$	83	$	—
Purchase commitments	6,386		6,386		—		—		—		—
Line of credit (1)	10,000		10,000		—		—		—		—
Total future contractual commitments	$	18,932	$	16,825	$	1,483	$	541	$	83	$	—


(1)	The specified payment period reflects our current intent to repay all outstanding borrowings within the current year. The maturity date under the WFB Facility is March 31, 2016.

Operating Leases

The operating lease amounts shown above represent primarily off-balance sheet arrangements. 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, net of estimated sublease income. For operating leases that include contractual commitments for operating expenses and maintenance, estimates of such amounts are included based on current rates. Payments made under operating leases will be treated as rent expense for the facilities currently being utilized.

Purchase Commitments

The purchase commitments shown above represent non-cancellable inventory purchase commitments as of September 30, 2014. The inventory purchase commitments typically allow for cancellation of orders 30 days in advance of the required inventory availability date as set by us at time of order.

Line of Credit

The line of credit obligation has been recorded as a liability on our balance sheet. The line of credit obligation amount shown above represents the scheduled principal repayment, but not the associated interest payments which may vary based on changes in market interest rates. At September 30, 2014, the interest rate under the WFB Facility was 3.23%.

As of September 30, 2014, we had $10.0 million outstanding under our line of credit under the WFB Facility and an additional $3.4 million committed as security for letters of credit. See above under “Cash Management” for further information about the WFB Facility.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk

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. Cash and cash equivalents are principally held with various domestic financial institutions with high credit standing. We perform ongoing credit evaluations of our customers and generally do not require collateral. Allowances are maintained for potential doubtful accounts.

We anticipate that our results of operations in any given period may depend to a large 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.

For the three months ended September 30, 2014 and 2013, two customers represented 23% of net revenue. As of September 30, 2014 and December 31, 2013, three customers accounted for 52% and 56% of net accounts receivable, respectively.

As of September 30, 2014, and December 31, 2013, receivables from customers in countries other than the United States represented 83% and 82%, respectively, of net accounts receivable.

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our outstanding debt. As of September 30, 2014, our outstanding debt balance under our WFB Facility was $10.0 million. Amounts borrowed under the WFB Facility bear interest, payable monthly, at a floating rate equal to the three-month LIBOR plus a margin of 3.0%. The interest rate on our WFB Facility was 3.23% as of September 30, 2014. Assuming the outstanding balance on our variable rate debt remains constant over a year, a 2% increase in the interest rate would decrease pre-tax income and cash flow by approximately $0.2 million.

Foreign Currency Risk

We transact business in various foreign countries. Substantially all of our assets are located in the United States. We have sales operations throughout Europe, Asia, the Middle East and Latin America. We are exposed to foreign currency exchange rate risk associated with foreign currency denominated assets and liabilities, primarily inter-company receivables and payables. Accordingly, our operating results are exposed to changes in exchange rates between the U.S. dollar and those currencies. During 2014 and 2013, we did not hedge any of our foreign currency exposure.

We have performed sensitivity analyses as of September 30, 2014 using a modeling technique that measures the impact arising from a hypothetical 10% adverse movement in the levels of foreign currency exchange rates relative to the U.S. dollar, with all other variables held constant. The sensitivity analyses indicated that a hypothetical 10% adverse movement in foreign currency exchange rates would result in a foreign exchange loss of $0.4 million at September 30, 2014. This sensitivity analysis assumes a parallel adverse shift in foreign currency exchange rates, which do not always move in the same direction. Actual results may differ materially.

Item 4. Controls and Procedures

Disclosure Controls and Procedures

We conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. The controls evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer. Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that, subject to the limitations noted in this Part I, Item 4, as of the end of the period covered by this report, our disclosure controls and procedures were effective to provide reasonable assurance that information required to be disclosed in our reports under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified by the SEC, and that material information relating to Zhone and its consolidated subsidiaries is made known to management, including our Chief Executive Officer and Chief Financial Officer, particularly during the period when our periodic reports are being prepared.

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Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

Inherent Limitations on Effectiveness of Controls

Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within the company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

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PART II. OTHER INFORMATION

Item 1. Legal Proceedings

We are subject to various legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, we do not expect that the ultimate costs to resolve these matters will have a material adverse effect on our consolidated financial position or results of operations. However, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.

Item 1A. Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2013, as updated by our Quarterly Report on Form 10-Q for the quarter ended June 30, 2014, which could materially affect our business, financial condition or future results. There have been no material changes to the risk factors described in the “Risk Factors” section in our Annual Report on Form 10-K for the year ended December 31, 2013, as so updated. The risks described in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q are not the only risks facing our company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.

Item 6. Exhibits

The Exhibit Index on page 26 is incorporated herein by reference as the list of exhibits required as part of this report.

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SIGNATURES

Pursuant to the retirements 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 6, 2014	By:	/s/ JAMES NORROD
	Name:	James Norrod
	Title:	Chief Executive Officer

	By:	/s/ KIRK MISAKA
	Name:	Kirk Misaka
	Title:	Chief Financial Officer

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EXHIBIT INDEX



Exhibit Number	Description


10.1	Third Amended and Restated Employment Agreement dated as of July 17, 2014 by and between Zhone Technologies, Inc. and Morteza Ejabat (incorporated by reference to Exhibit 10.1 of registrant's Current Report on Form 8-K dated July 17, 2014 filed on July 17, 2014)

10.2	Employment Agreement dated as of July 17, 2014 by and between Zhone Technologies, Inc. and James Norrod (incorporated by reference to Exhibit 10.2 of registrant's Current Report on Form 8-K dated July 17, 2014 filed on July 17, 2014)

31.1	Certification of Chief Executive Officer Pursuant to Rule 13a-14(a)/15d-14(a)

31.2	Certification of Chief Financial Officer Pursuant to Rule 13a-14(a)/15d-14(a)

32.1	Section 1350 Certification of Chief Executive Officer and Chief Financial Officer

101.INS	XBRL Instance Document

101.SCH	XBRL Taxonomy Extension Schema

101.CAL	XBRL Taxonomy Extension Calculation Linkbase

101.DEF	XBRL Taxonomy Extension Definition Linkbase

101.LAB	XBRL Taxonomy Extension Labels Linkbase

101.PRE	XBRL Taxonomy Extension Presentation Linkbase