DZS INC. - Annual Report: 2018 (Form 10-K)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

(Mark One)

For the fiscal year ended December 31, 2018

OR

For the transition period from                      to              

Commission File Number: 000-32743

DASAN ZHONE SOLUTIONS, INC.

(Exact name of registrant as specified in its charter)

7195 Oakport Street

Oakland, California 94621

(Address of principal executive office)

Registrant’s telephone number, including area code: (510) 777-7000

Securities registered pursuant to Section 12(b) of the Exchange Act:

Securities registered pursuant to Section 12(g) of the Exchange Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ☐    No  ☒

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Exchange Act.    Yes  ☐    No  ☒

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  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted 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 such files).    Yes  ☒    No  ☐

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ☒

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

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.    ☐

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

As of March 6, 2019, there were 16,596,483 shares outstanding of the registrant’s common stock, $0.001 par value. As of June 30, 2018 (the last business day of the registrant’s most recently completed second fiscal quarter), the aggregate market value of the common stock held by non-affiliates of the registrant was approximately $51,712,507.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant's definitive Proxy Statement for its 2019 Annual Meeting of Stockholders are incorporated by reference into Part III where indicated.

TABLE OF CONTENTS

Forward-looking Statements

This Annual Report on Form 10-K, 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 (the “Securities Act”) and the Securities Exchange Act of 1934 (the “Exchange Act”). These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate, and reflect the beliefs and assumptions of our management as of the date hereof. We use words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “forecast,” “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 in future periods; anticipated growth and trends in our business or key markets; cost synergies, growth opportunities and other potential financial and operating benefits of the merger with Dasan Network Solutions, Inc. and the acquisition of Keymile GmbH; future growth and revenues from our products; our ability to refinance or repay our existing indebtedness prior to the applicable maturity dates; future economic conditions and performance; anticipated performance of products or services; plans, objectives and strategies for future operations; other characterizations of future events or circumstances; and all other statements that are not statements of historical fact, are forward-looking statements within the meaning of the Securities Act and the Exchange Act. Readers are cautioned that these forward-looking statements are only predictions and are subject to assumptions and to risks and uncertainties that are difficult to predict, including those identified under the heading “Risk Factors” in Item 1A of this Annual Report on Form 10-K, and in our other filings with the Securities and Exchange Commission (the “SEC”). Our 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, our ability to realize the anticipated cost savings, synergies and other benefits of the merger with Dasan Network Solutions, Inc. and the acquisition of Keymile GmbH, any integration risks relating to the acquisition of Keymile, the ability to generate sufficient revenue to achieve or sustain profitability, our ability to raise additional capital to fund existing and future operations or to refinance or repay our existing indebtedness, defects or other performance problems in our products, any economic slowdown in the telecommunications industry that restricts or delays the purchase of our products by our customers, commercial acceptance of our 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, any failure to comply with the periodic report filing and other requirements of The Nasdaq Stock Market for continued listing, material weaknesses or other deficiencies in our internal control over financial reporting, the initiation of any civil litigation, regulatory proceedings, government enforcement actions or other adverse effects relating to the Audit Committee investigation or errors in the consolidated financial statements of Legacy Zhone (as defined below) and other factors identified elsewhere in this Annual Report on Form 10-K. We undertake no obligation to revise or update any forward-looking statements for any reason.

PART I

DASAN Zhone Solutions, Inc. (“DZS” or the “Company,” formerly known as Zhone Technologies, Inc.) was incorporated under the laws of the state of Delaware in June 1999. On September 9, 2016, DZS acquired Dasan Network Solutions, Inc. a California corporation (“DNS”), through the merger of a wholly owned subsidiary of Zhone Technologies, Inc. with and into DNS, with DNS surviving as our wholly owned subsidiary. We refer to this transaction as the “Merger.” At the effective date of the Merger, all issued and outstanding shares of capital stock of DNS held by its sole shareholder, DASAN Networks, Inc. (“DNI”), a company incorporated under the laws of the Republic of Korea (“Korea”), were canceled and converted into the right to receive shares of our common stock equal to 57.3% of our issued and outstanding common stock immediately following the Merger. In connection with the Merger, Zhone Technologies, Inc. changed its name to DASAN Zhone Solutions, Inc. The mailing address of our worldwide headquarters is 7195 Oakport Street, Oakland, California 94621, and our telephone number at that location is (510) 777-7000. As used in this Annual Report on Form 10-K, unless the context suggests otherwise, the terms “we,” “us” or “our” refer to (i) DNS and its consolidated subsidiaries for periods through September 8, 2016 and (ii) DZS and its consolidated subsidiaries for periods on or after September 9, 2016, the effective date of the Merger. For periods through September 8, 2016, Zhone Technologies, Inc. is referred to as “Legacy Zhone.”

Company Overview

We are a global provider of ultra-broadband network access solutions and communications platforms deployed by advanced Tier 1, 2 and 3 service providers and enterprise customers.  Our solutions are deployed by over 900 customers in more than 80 countries worldwide. Our ultra-broadband solutions are focused on creating significant value for our customers by delivering innovative solutions that empower global communication advancement by shaping the internet connection experience.  Every connection matters, and the first connection to the internet and cloud services applications matters the most. Our principal focus is centered around enabling our customers to connect everything and everyone to the internet-cloud economy via ultra-broadband connectivity solutions.

We research, develop, test, sell, manufacture and support platforms in five major areas: broadband access, mobile backhaul, Ethernet switching with Software Defined Networking (“SDN”) capabilities, new enterprise solutions based on Passive Optical LAN (“POL”), and new generation of SDN/ Network Function Virtualization (“NFV”) solutions for unified wired and wireless networks. We have extensive regional development and support centers around the world to support our customer needs.

Keymile Acquisition

On January 3, 2019, ZTI Merger Subsidiary III Inc., a Delaware corporation and our wholly owned subsidiary, acquired all of the outstanding shares of Keymile GmbH, a limited liability company organized under the laws of Germany (“Keymile”), from Riverside KM Beteiligung GmbH, also a limited liability company organized under the laws of Germany, pursuant to a share purchase agreement.  We refer to this transaction as the “Keymile Acquisition.” The aggregate cash purchase price paid for all of the shares of Keymile and certain of its subsidiaries was EUR 10,250,000 ($11.8 million), which was paid with a combination of cash, a loan from DNI, and a draw under our Wells Fargo Bank (“Wells Fargo”) credit facility (as amended, the “Wells Fargo Facility”). Following the closing of the Keymile Acquisition, Keymile became our indirect wholly owned subsidiary.

Keymile is a leading solution provider and manufacturer of telecommunication systems for broadband access. We believe the Keymile Acquisition complements and strengthens our portfolio of broadband access solutions, which now includes a series of multi-service access platforms, including ultra-fast broadband copper access based on very-high-bit-rate DSL (“VDSL/Vectoring”) & G. Fast technology.

Broadband Access

Our broadband access products are at the core of our product strategy and offer a variety of options for carriers and service providers to connect residential and business customers. Our solutions allow carriers and service providers to either use high-speed fiber or leverage their existing deployed copper networks to offer broadband services to customer premises. Once our broadband access products are deployed, the service provider can offer voice, high-definition and ultra-high-definition video, high-speed internet access and business class services to their customers. We develop our broadband access products for all aspects of carrier and service provider access networks: customer premise equipment. Products include digital subscriber line (“DSL”) modems, Ethernet access demarcation devices, Gigabit passive optical network (“GPON”) terminals, 10 Gigabit (“10G”) passive optical network (“GPON/GEPON/XGPON1/XGSPON/NGPON2/10GEPON”) units and, Gigabit and 10G point-to-point Active Ethernet optical network terminals (“ONTs”). We also develop central office products, such as broadband loop carriers for DSL and voice-grade telephone service (“POTS”), high-speed digital subscriber line access multiplexers (“DSLAMs”) with G. Fast and VDSL capabilities, optical line terminals (“OLTs”) for passive optical distribution networks like GPONs, 10G passive optical networks and 10G point-to-point Active Ethernet.

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Ethernet Switching

Our Ethernet switching products provide a high switching performance and manageable solution that bridges the gap from carrier access technologies to the core network. Over the past ten (10) years carriers have migrated access infrastructure to Ethernet from time-division multiplexing and asynchronous transfer mode systems. Our products can also be deployed in data centers, blurring the line between central office and data center. Our products support pure Ethernet switching as well as layer 3 IP and multiprotocol label switching (“MPLS”) and are currently being developed as part of the new programmable SDNs networks.

Mobile Backhaul

Our mobile backhaul products provide a robust, manageable and scalable solution for mobile operators that enable them to upgrade their mobile backhaul systems and migrate from 5G networks and beyond. We provide our mobile backhaul products to mobile operators or carriers who provide the transport for mobile operators. Our mobile backhaul products may be collocated at the radio access node base station and can aggregate multiple radio access node base stations into a single backhaul for delivery of mobile traffic to the radio access node network controller. We provide standard Ethernet/IP or MPLS interfaces and interoperate with other vendors in these networks. In recent years, mobile backhaul networks have been providing carriers with significant revenue growth, which has led to mobile backhaul becoming one of the most important parts of their networks.

Enterprise Passive Optical LAN

Our FiberLAN^TM portfolio of POL products are designed for enterprise, campus, hospitality and entertainment arena usage. Our portfolio includes high-performance, high-bandwidth switches connected to port extenders, which include units with integrated Power over Ethernet (“PoE”) to power a wide range of PoE-enabled access devices.

Our environmentally friendly FiberLAN POL solutions are one of the most cost-effective LAN technologies that can be deployed, allowing IT network managers to deploy a future-proof, low-maintenance, manageable solution that requires less space, air conditioning, copper and electricity than other alternatives.

The FiberLAN™  2.0  portfolio is focused on a “plug and play” architecture for a new generation of distributed enterprise IT infrastructure that is both highly secure and bandwidth scalable with unified management of wireless and wireline end points/devices from a central network operations center with full visibility and management control of remote sites. Additionally, with SDN upgrades enterprise networks can be software programmed to autonomously monitor, reconfigure, diagnose and authenticate without the need for human intervention.

Software Defined Networks

Our SDN/NFV strategy is to develop tools and building blocks that will allow customers to migrate their networks’ full complement of legacy control plane and data plane devices to a centralized intelligent controller that can reconfigure the services of hundreds of network elements in real time for more controlled and efficient provision of services and bandwidth on a web scale basis.  The latest evolution of our hardware-based solution are designed to support SDN/NFV architectures.

The adoption of SDN/NFV is a slow process in the service provider space, but is viewed as providing a better service for subscribers and a more efficient and cost-effective use of hardware resources for service providers. We will leverage our broadband access, mobile backhaul and Ethernet switching expertise to extract and virtualize many of the traditional legacy control and data plane functions to allow them to be run from the Cloud.  

Industry Background

We believe that expansion in our worldwide business is driven by the increased demand of subscribers and cloud service providers for mobile and fixed network access solutions and communications equipment that enable or support access to higher speed bandwidth access to the internet. Furthermore, increased competition between service providers for the subscriber business has resulted in significant investment pressure to upgrade network infrastructure to meet the growing bandwidth needs. Broadband access networks must be multiservice in nature and must have an extensive quality of service guarantees in order to support 5G mobile backhaul, symmetric business services and residential services as well as virtual overlay networks for alternative operators and wholesale access.

In recent years, the growth of social communications and networking has placed significant demands on legacy access infrastructure, which has been challenging for the industry, even for the newest and most advanced subscribers. Increased subscriber usage of smartphone, video streaming services, PC gaming services and high definition and ultra-high definition televisions has increased the demand for music, pictures, user-generated content (as found on many video-sharing sites) and high definition video, which have all become a growing part of subscribers’ regular exchange of information. Trends such as SaaS, Cloud, IoT, and 5G have also increased the demand for broadband network access. All of these new technologies share a common dependency on high-bandwidth communication networks and sophisticated traffic management tools. As bandwidth demands continue to increase, carriers need to continue to upgrade their network infrastructure to support such demand. The infrastructure upgrade cycle typically has the effect of moving bandwidth bottlenecks from one part of the network to another (such as a carrier’s access network, core network or data centers), depending on the selection of technology and costs.

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It is widely acknowledged in the industry that a fiber-optic broadband access network is the preferred network architecture for a broadband fixed network. This network architecture is commonly called Fiber to the Premises (“FTTP”) for business subscribers or Fiber to the Home (“FTTH”) for residential subscribers. With FTTH all services are generally delivered at the premise through smart optical networking units (ONT).  The Fiber to the Node (“FTTN”) architecture is also deployed where the fiber-optic cable terminates at a street cabinet which contains a DSLAMs or Multiple Service Access Node (“MSAN”) that then provides higher speed services to their customers over the last mile legacy copper wireline infrastructure. With the shift away from the legacy copper telephone TDM switches (used in carrier networks from the 1980’s to the early 2000’s): many carriers that continue to provide services over copper wireline networks are decommissioning their legacy telephone switches and moving services over to Voice over Internet Protocol (“VoIP”) platforms via an MSAN/Softswitch solution. Our broadband access products and solutions are designed to address all these fiber configurations commonly referred to as (FTTX) by allowing carriers and service providers to either use fiber-optic networks or leverage their existing deployed copper networks to offer broadband services to customer premises.

With respect to mobile wireless networks, the popularity of mobile smartphones and increasing demand for mobile data has forced mobile network operators to upgrade their mobile access technologies from 3rd generation wireless (“3G”) to 4th generation wireless (“4G” or “LTE”) and to plan for 5th generation wireless technologies (“5G”). These technology upgrades are typically accompanied by network infrastructure upgrades, including upgrades to the carriers’ access networks (referred to as “mobile backhaul”), core networks and data centers. Our mobile backhaul products, which have features for time sensitive networks, provide a robust, manageable and scalable solution for mobile network operators that enable them to upgrade their mobile backhaul systems and migrate to 4G and 5G.

Another growing industry trend is the desire of carriers and service providers to simplify network operation and reduce costs. Increasingly, we see network operators seeking to reduce the number of active components in their networks and to centralize network data and control in data centers, both of which require network redesigns and upgrades. Our FiberLAN portfolio of POL products, as well as our Ethernet switching products and SDN and NFV tools and building blocks, are designed to address these market trends, with POL emerging as a popular customer choice for network upgrades.

Our Strategy

We are a global provider of ultra-broadband network access solutions and communications platforms deployed by advanced Tier 1, 2 and 3 service providers and enterprise customers. We provide a wide array of reliable, cost-effective networking technologies that include broadband access, Ethernet switching, mobile backhaul, passive optical LAN and software-defined networks. 

The principal elements of our strategy include:

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Customers

For our core business, we generally sell our products and services directly to carriers and service providers that offer voice, data and video services to businesses, governments, utilities and residential subscribers. Our global customer base includes regional, national and international carriers and service providers. To date, our products have been deployed by over 900 carriers and service providers worldwide.

For our Enterprise FiberLAN™ business, we sell solutions indirectly to end customers through system integrators and distributors to the hospitality, education, stadiums, manufacturing and business enterprises as well as to the government and military. Our global FiberLAN™ customer base includes hotels, universities, sports arenas, military bases, government institutions, manufacturing facilities and Fortune 500 businesses.

For the year ended December 31, 2018, one (1) customer, SK Broadband, Inc. represented 11% of net revenue. For the year ended December 31, 2017, no customer represented 10% or more of net revenue. For the year ended December 31, 2016, three (3) customers, SK Broadband, Inc., DNI (a related party) and LGU Plus Corp., represented 16%, 14% and 10% of net revenue, respectively.

Research and Development

The industry in which we compete is subject to rapid technological developments, evolving industry standards, changes in customer requirements, and continuing developments in communications service offerings. Our continuing ability to adapt to these changes, and to develop new and enhanced products, is a significant factor in maintaining or improving our competitive position and our prospects for growth. Therefore, we continue to make significant investments in product development.

We have core research and development teams located in the United States (Oakland, California; Seminole, Florida; Alpharetta, Georgia), Korea, Vietnam, India and Hannover, Germany through the acquisition of Keymile. In all of these centers, we develop and test both our hardware and software solutions. We continue to invest heavily in automated and scale testing capabilities for our products to better emulate our customers’ networks.

Our product development activities focus on products to support both existing and emerging technologies in the segments of the communications industry that we consider represent viable revenue opportunities. We are actively engaged in continuing to refine our solution architecture, introducing new products using the various solutions we support, and in creating additional interfaces and protocols for both domestic and international markets.

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We continue our commitment to invest in leading edge technology research and development for new products and innovative solutions that align with our business strategy. Our research and product development expenses were $35.3 million, $36.0 million, and $25.8 million in 2018, 2017 and 2016, respectively.

Intellectual Property

We seek to establish, maintain and protect our proprietary rights in our technology and products through the use of patents, copyrights, trademarks and trade secrets. We also seek to maintain our trade secrets and confidential information by nondisclosure policies and through the use of appropriate confidentiality agreements. We have obtained a number of patents and trademarks in the United States of America (“United States”) and in other countries. There can be no assurance, however, that these rights can be successfully enforced against competitive products in every jurisdiction or any particular jurisdiction. Although we believe the protection afforded by our patents, copyrights, trademarks and trade secrets has value, the rapidly changing technology in the networking industry and uncertainties in the legal process make our future success dependent primarily on the innovative skills, technological expertise, and management abilities of our employees rather than on the protection afforded by patent, copyright, trademark, and trade secret laws.

Many of our products include intellectual property licensed from third parties. While it may be necessary in the future to seek or renew licenses relating to various aspects of our products, we believe, based upon past experience and standard industry practice, that such licenses generally could be obtained on commercially reasonable terms. Nonetheless, there can be no assurance that the necessary licenses would be available on acceptable terms, if at all. Our inability to obtain certain licenses or other rights or to obtain such licenses or rights on favorable terms, or the need to engage in litigation regarding these matters, could have a material adverse effect on our business, operating results and financial condition. The communications industry is characterized by rapidly changing technology, a large number of patents, and frequent claims and related litigation regarding patent and other intellectual property rights. We cannot assure you that our patents or other proprietary rights will not be challenged, invalidated or circumvented, that others will not assert intellectual property rights to technologies that are relevant to us, or that our rights will give us a competitive advantage. In addition, the laws of some foreign countries may not protect our proprietary rights to the same extent as the laws of the United States.

Sales and Marketing

We have a global sales presence with customers from over 80 countries, and we sell our products and services both directly and indirectly through channel partners with support from our sales force. Channel partners include distributors, value added resellers, system integrators and service providers. These partners sell directly to and service end customers and often provide additional value added services such as system installation, technical support, and professional support services in addition to equipment sales. Our sales efforts are generally organized and fitted according to geographical regions for target carriers, service providers, municipalities and enterprise customers. 

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Our marketing team works closely with our sales, research and product development organizations, and our customers by providing communications that keep the market current on our products and features. Marketing also identifies and sizes new target markets for our products, creates awareness of our company and products, generates contacts and leads within these targeted markets, performs outbound education and public relations, and participates in industry associations and standard industry bodies to promote the growth of the overall industry.

Our backlog consists of purchase orders for products and services that we expect to ship or perform within the next year. Our backlog may fluctuate based on the timing of when purchase orders are received. As of December 31, 2018, our backlog was $47.3 million, compared to $24.4 million at December 31, 2017. We consider backlog to be an indicator, but not the sole predictor, of future sales because our customers may cancel or defer orders without penalty.

Competition

We compete in communications equipment markets, providing products and services for the delivery of voice, data and video services. These markets are characterized by rapid change, converging technologies and a migration to solutions that offer superior advantages. These market factors represent both an opportunity and a competitive threat to us. We compete with numerous vendors in our core business, including ADTRAN, Calix, Huawei, Nokia, and ZTE, among others. In our FiberLAN business, our competitors include Cisco, Nokia, and Tellabs, among others. In our Ethernet switching business, our competitors include Arris, Cisco and Juniper Networks, among others. In addition, a number of companies have introduced products that address the same network needs that our products and solutions address, both domestically and internationally. The overall number of our competitors may increase, and the identity and composition of competitors may change. As we continue to expand our sales globally, we may see new competition in different geographic regions. Barriers to entry are relatively low, and new ventures to create products that do or could compete with our products are regularly formed. Many of our competitors have greater financial, technical, sales and marketing resources than we do.

The principal competitive factors in the markets in which we presently compete and may compete in the future include:

While we believe that we compete successfully with respect to each of these factors, we expect to face intense competition in our markets. In addition, the inherent nature of communications networking requires interoperability. As such, we must cooperate and at the same time compete with many companies.

Manufacturing and Operations

Operationally, we use a global sourcing procurement program to purchase and manage key raw materials and subassemblies through qualified suppliers, sub-contractors, original equipment and design manufacturers and electronic manufacturing service vendors. The manufacturing process uses a strategic combination of procurement from qualified suppliers and in-house manufacturing, throughout the process we manage the assembly, quality assurance, customer testing, final inspection and shipping of our products

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We manufacture our low volume, high mix products at our manufacturing facility in the Florida, USA and Hannover, Germany, through the acquisition of Keymile. For certain products, we rely on subcontractors and original design manufacturers for high volume, low mix products.

Some completed products are procured to our specifications and shipped directly to our customers. We also acquire completed products from certain suppliers, which we configure and ship from our facility. Some of these purchases are significant. We purchase both standard off-the-shelf parts and components, which are generally available from more than one supplier, and single-source parts and components. We have generally been able to obtain adequate supplies to meet customer demand in a timely manner from our current vendors, or, when necessary, from alternate vendors. We believe that alternate vendors can be identified if current vendors are unable to fulfill our needs, or design changes can be made to employ alternate parts.

We design, specify, and monitor all of the tests that are required to meet our quality standards. Our manufacturing and test engineers work closely with our design engineers to ensure manufacturability and testability of our products, and to ensure that manufacturing and testing processes evolve along with our technologies. Our manufacturing engineers specify, build, or procure our test stations, establish quality standards and protocols, and develop comprehensive test procedures and processes to assure the reliability and quality of our products. Products that are procured complete or partially complete are inspected, tested, or audited for quality control.

Our Quality Management System is compliant with, and we are certified to, ISO-9001:2015 by our external registrar, National Standards Authority of Ireland. ISO-9001:2015 requires that our processes be documented, followed and continuously improved. Internal audits are conducted on a regular schedule by our quality assurance personnel, and external audits are conducted by our external registrar each year. Our quality system is based upon our model for quality assurance in production and service to ensure our products meet rigorous quality standards.

We believe that we have sufficient production capacity to meet current and future demand for our product offerings through a combination of existing and added capacity, additional employees and the outsourcing of products or components.

Compliance with Regulatory and Industry Standards

Our products must comply with a significant number of voice and data regulations and standards which vary by jurisdiction. Standards for new services continue to evolve, and we may need to modify our products or develop new versions to meet these standards. Standards setting and compliance verification in the United States are determined by the Federal Communications Commission, Underwriters Laboratories, Quality Management Institute, Telcordia Technologies, Inc., and other communications companies. In international markets, our products must comply with standards issued, implemented and enforced by the regulatory authorities of foreign jurisdictions, as applicable, such as the European Telecommunications Standards Institute (“ETSI”), among others.

Environmental Matters

Our operations and manufacturing processes are subject to federal, state, local and foreign environmental protection laws and regulations. Such laws and regulations relate to the presence, use, handling, storage, discharge and disposal of certain hazardous materials and wastes, the pre-treatment and discharge of process waste waters and the control of process air pollutants. Under certain laws of the United States, we can be held responsible for cleanup costs at currently or formerly owned or operated locations or at third party sites to which our wastes were sent for disposal.  To date, liabilities relating to contamination have not been significant, and have not had a material impact on our operations or results. We believe that our operations and manufacturing processes currently comply in all material respects with applicable environmental protection laws and regulations. If we fail to comply with any present or future laws or regulations, we could be subject to liabilities, the suspension of production or a prohibition on the sale of our products. In addition, such regulations could require us to incur significant expenses to comply with environmental laws or regulations, including expenses associated with the redesign of any non-compliant product or the development or installation of additional pollution control technology. From time to time new laws or regulations are enacted, and it is difficult to anticipate how such laws or regulations will be implemented and enforced, or the impact they will have on our operations or results. For example, in 2003 the European Union enacted the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment Directive and the Waste Electrical and Electronic Equipment Directive, for implementation in European Union member states. Similar legislation could be currently in force or that are being considered in the United States or other countries, such as Japan and China. We are aware of and are taking suitable action to comply with the new European Union Restriction of Hazardous Substances standards. Our failure to comply with any regulatory requirements or contractual obligations relating to environmental matters or hazardous materials could result in us being liable for costs, fines, penalties and third-party claims, and could jeopardize our ability to conduct business in the jurisdictions where such laws or the regulations apply.

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Audit Committee Investigation

On March 21, 2017, our Audit Committee concluded, in consultation with management and after informing our former independent registered public accounting firm, that Legacy Zhone's unaudited condensed consolidated financial statements contained in its Amendment No. 2 to Quarterly Report on Form 10-Q/A for the quarter ended June 30, 2016 should no longer be relied upon due to material errors associated with the sale and subsequent return of certain products sold in December 2014.

In connection with such findings, our Audit Committee commenced an independent investigation to determine whether any Legacy Zhone financial statements prior to the quarter ended June 30, 2016 contained material errors.  In July 2017, our Audit Committee concluded, in consultation with management and after informing our former independent registered public accounting firm, that Legacy Zhone's unaudited condensed consolidated financial statements contained in its Quarterly Reports on Form 10-Q for the quarters ended March 31, 2015, June 30, 2015, September 30, 2015 and March 31, 2016, and Legacy Zhone's audited consolidated financial statements and assessments of internal control over financial reporting for the years ended December 31, 2015 and 2014 contained in its Annual Reports on Form 10-K should no longer be relied upon.

The errors in Legacy Zhone's financial statements for pre-Merger periods do not impact DZS’s financial statements after the closing of the Merger because DNS is treated as an accounting acquirer of DZS.

Matters relating to or arising from our Audit Committee investigation, and the associated material weaknesses identified in our internal control over financial reporting, including adverse publicity, (a) have caused us to incur significant legal, accounting and other professional fees and other costs, (b) have exposed us to greater risks associated with civil litigation, regulatory proceedings and government enforcement actions, (c) have diverted resources and attention that would otherwise be directed toward our operations and implementation of our business strategy and (d) may have impacted our ability to attract and retain customers, employees and vendors.

Employees

As of December 31, 2018, we employed over 670 staff members worldwide. We consider the relationships with our employees to be positive. Competition for technical personnel in our industry is intense. We believe that our future success depends in part on our continued ability to hire, assimilate and retain qualified personnel. To date, we believe that we have been successful in recruiting qualified employees, but there is no assurance that we will continue to be successful in the future.

Website and Available Information

Our investor website address is http://investor-dzsi.com. The information on our website does not constitute part of this Annual Report on Form 10-K, or any other report, schedule or document we file or furnish to the SEC. On the “Investor Relations” section of our website at http://investor-dzsi.com, we make available the following filings available free of charge as soon as reasonably practicable after they are electronically filed with or furnished to the SEC: our Annual Report on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act.

Set forth below and elsewhere in this Annual Report on Form 10-K and in other documents we file with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this Annual Report on Form 10-K.

Our level of indebtedness could adversely affect our business, operations, financial condition, and liquidity

We have a significant amount of indebtedness. As of December 31, 2018, the aggregate principal amount of our outstanding indebtedness was $45.9 million, consisting of $31.8 million in principal amount of outstanding borrowings under our short-term debt obligations and $14.1 million in long-term related party borrowings. We may incur additional indebtedness in the future, including additional borrowings under our credit facilities with PNC Bank, National Association, and Citibank, N.A. as lenders, and PNC Bank as agent for the lenders, which we entered into on February 27, 2019 (the “PNC Facility”) or other future credit facilities with other financial institutions.

Even if we are able to obtain new financing upon a default under the secured loan agreement, it may not be on commercially reasonable terms or on terms that are acceptable to us. The level of indebtedness could have important consequences and could materially and adversely affect us in a number of ways, including:

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The PNC Facility and the instruments governing our other indebtedness contain certain covenants, limitations, and conditions with respect to the Company that could restrict our ability to operate our business.  The covenants include a maximum leverage ratio, a minimum fixed charge coverage ratio, and a minimum liquidity covenant, as well as financial reporting obligations, and usual and customary events of default. If an event of default occurs under the PNC Facility, the agent and the lenders will be entitled to take various actions, including requiring the immediate repayment of all outstanding amounts, terminating commitments to make additional advances and selling our assets to satisfy the obligations under the outstanding indebtedness.

In the past, we have violated the covenants in our credit facilities and received waivers for these violations. As of December 31, 2017, we were in technical violation of covenants under the Wells Fargo Facility to pledge the stock of certain foreign subsidiaries and transfer certain funds to Wells Fargo bank accounts. On March 19, 2018, we executed an agreement with Wells Fargo, which cured the breach.

We cannot assure you that we will be able to comply with our financial or other covenants in the future, or that any covenant violations will be waived in the future. Any acceleration of amounts due could have a material adverse effect on our business, operations, financial condition, and liquidity.

We cannot assure you that we will be able to generate cash flow 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, purchase credit insurance 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.

Our ability to obtain additional capital could require us to reduce our operations and product development and result in harm to our financial condition, our operations, our prospects and our ability to grow and compete effectively

We need sufficient capital to fund our ongoing operations. Our ability to meet our obligations will depend on our ability to access funds. We cannot be certain that additional funds will be available to us on favorable terms when required, or at all. If we cannot raise additional funds when we need them, our business, operations, financial condition, and liquidity could be materially and adversely affected.

As of December 31, 2018, we had approximately $27.7 million in cash and cash equivalents and $45.9 million in aggregate principal amount of outstanding indebtedness, as described in the preceding Risk Factor. Our cash and cash equivalents as of December 31, 2018 included $7.1 million in cash balances held by our international subsidiaries. Our current lack of liquidity could harm us by:

Our current lack of liquidity could be further harmed, and we may incur significant losses or expend significant amounts of capital if:

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To meet our liquidity needs and to finance our capital expenditures and working capital needs for our business, we may be required to raise substantial additional capital or reduce our operations. Raising additional capital could require selling assets, issuing debt or equity securities, purchasing credit insurance, borrowing additional capital or other methods. Additional capital, if required, may not be available on acceptable terms, or at all.  

If we elect to raise additional capital through the issuance of debt securities or other debt financing, if we are able to incur additional debt at all, the terms of such debt may include unfavorable covenants, restrictions and financial ratios that may restrict our ability to operate our business.

If we elect to raise additional capital through the issuance of equity securities, such issuance may be dilutive to existing stockholders and could reduce the trading price of our common stock. Volatility in our stock price may make it difficult and costly for us to raise capital through the issuance of common stock, preferred stock or other equity securities. Moreover, in connection with any registration statement for the sale of shares of our common stock or other securities, we may be required to include audited annual and unaudited interim historical financial statements of Legacy Zhone and/or Keymile, which may make raising additional capital through a public offering of securities more costly and time consuming.

Our ability to grow our business requires a significant commitment of capital, and we currently lack liquid funds. If we are unable to meet our liquidity needs through obtaining additional capital on acceptable terms or reducing costs, we may become unable to maintain our existing operations, pay ordinary expenses, fund our business expansion or product innovation, pursue future business opportunities, respond to unanticipated capital requirements, or respond to competitive pressures, any of which could have a material adverse effect on our business, operations, financial condition, and liquidity. In addition, we may be required to reduce the scope of our planned product development and sales and marketing efforts beyond the reductions that we have previously taken, and reduce operations in low margin regions, including reductions in headcount, which could have a material adverse effect on our business, operations, financial condition and liquidity.

DNI, the majority owner of our outstanding common stock, controls our ability to obtain financing and other matters requiring stockholder approval, and DNI’s interests may conflict with our interests and the interests of other stockholders

As of December 31, 2018, DNI owned approximately 57.2% of the outstanding shares of our common stock. Accordingly, as long as DNI and its affiliates hold shares representing a majority of the votes entitled to be cast by the holders of our outstanding common stock at a stockholder meeting, (a) DNI generally will have the ability to control the outcome of any matter submitted for the vote of our stockholders, except in certain circumstances set forth in our certificate of incorporation or bylaws, and (b) DNI will be able to freely nominate and elect all the members of our board of directors, subject only to a requirement that a certain number of directors qualify as “independent directors” under Nasdaq listing rules and applicable laws.

We have elected to be treated as a “controlled company” under Nasdaq Marketplace Rules because more than fifty percent (50%) of the voting power for the election of directors is held by DNI. As a “controlled company,” we may rely on exemptions from certain corporate governance requirements under Nasdaq Marketplace Rules, including the requirement that we have a majority of independent directors on the Board of Directors and requirements with respect to compensation and nominating and corporate governance committees.

The directors elected by DNI have the authority to make decisions affecting our capital structure, including the issuance of additional capital stock or options, the incurrence of additional indebtedness, the implementation of stock repurchase programs, and the declaration of dividends. The interests of DNI may conflict with the interests of our other stockholders or with holders of our indebtedness. As a result of DNI’s controlling vote over matters submitted to our stockholders for approval (subject to any applicable limitations in our certificate of incorporation and bylaws), we may take actions that our stockholders or holders of our indebtedness do not view as beneficial. In addition, the existence of a controlling stockholder may make it more difficult for a third party to acquire us or discourage a third party from seeking to acquire us. A potential third party acquirer would be required to negotiate any such transaction with DNI, and the interests of DNI with respect to such transaction may be different from the interests of our other stockholders or with holders of our indebtedness. In addition, provisions of our certificate of incorporation, bylaws and applicable laws, including Delaware law, could make it more difficult for a third party to acquire us, even if doing so would be beneficial to certain stockholders.

We have experienced significant losses and we may incur losses in the future. If we fail to generate sufficient revenue to sustain our profitability, our stock price could decline

We had net income of $2.8 million and $1.2 million for the years ended December 31, 2018 and 2017. However, we incurred significant losses in prior years. We have an accumulated deficit of $15.8 million as of December 31, 2018. 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

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respond to industry trends. We may also incur significant new costs related to acquisitions and the integration of new technologies and other acquisitions that may occur in the future. We may not be able to adequately manage costs and expenses or achieve or maintain adequate operating margins. As a result, our ability to sustain profitability in future periods will depend on our ability to generate and sustain higher revenue while maintaining reasonable costs and expense levels. If we fail to generate sufficient revenue to sustain profitability in future periods, we may incur operating losses, which could be substantial, and our stock price could decline.

In connection with the Keymile Acquisition, we assumed certain of Keymile’s liabilities, which could harm our business, operations, financial condition, and liquidity

Pursuant to the definitive agreement for the Keymile Acquisition, we assumed certain of Keymile’s liabilities, including tax and pension liabilities, and any liabilities that may arise related to representations and warranties of Keymile in connection with a prior sale of assets with representations and warranties that survive through 2022. Although the definitive agreement for the Keymile Acquisition entitles us to indemnification for losses incurred related to any such claims or liabilities, our right to indemnification may be limited to the purchase price of Keymile, or EUR 10,250,000 and our and third party provided warranty and indemnity liability insurance coverage of up to EUR 35,285,000. If such claims or losses exceed such amount, or if they are not indemnifiable under the Keymile Acquisition definitive agreement, any such losses could negatively impact our financial situation. In addition, our closing of the Keymile Acquisition could give rise to substantial tax liabilities under German law, which could negatively impact our financial condition and liquidity.

We may not realize the anticipated benefits of the Keymile Acquisition if the integration of Keymile is not implemented successfully or cost-effectively

Our ability to realize the anticipated benefits of the Keymile Acquisition will depend, to a large extent, on our ability to successfully integrate Keymile with our businesses. Integrating and coordinating certain aspects of the operations and personnel of Keymile involves complex operational, technological and personnel-related challenges. Such integration may require a significant amount of management’s time and attention. The potential difficulties, and resulting costs and delays, relating to the integration of Keymile include, among others:

If we are unable to implement and maintain an effective system of internal controls, the existence of one or more internal control deficiencies could result in errors in our financial statements, and substantial costs and resources may be required to rectify internal control deficiencies. If we cannot produce reliable financial reports, investors could lose confidence in our reported financial information, the market price of our stock could decline significantly, we may be unable to obtain additional financing to operate and expand our business, and our business, operations, financial condition, and liquidity could be materially harmed. In addition, the integration process may cause an interruption of, or loss of momentum in, the activities of our business. If our management is not able to effectively manage the integration process, or if any significant business activities are interrupted as a result of the integration process, our business could suffer and its results of operations, financial condition, and liquidity may be harmed.

Even if Keymile is successfully integrated into our businesses, we may not realize the full benefits of the Keymile Acquisition, including anticipated cost synergies, growth opportunities and other financial and operating benefits, within the expected timeframe or at all. In addition, we expect to incur significant integration and restructuring expenses to realize these synergies. However, many of the expenses that will be incurred are, by their nature, difficult to estimate accurately. These expenses could, particularly in the near term, exceed the savings that we expect to achieve from elimination of duplicative expenses and the realization of economies of scale and cost savings. Although we expect that the realization of efficiencies related to the integration of the businesses may offset incremental transaction, Keymile Acquisition-related and restructuring costs over time, we cannot give any assurance that this net benefit will be achieved in the near term, or at all. Any of these matters could adversely affect our business, operations, financial condition, and liquidity.

Any strategic acquisitions or investments we make could disrupt our operations and harm our business, operations, financial condition, and liquidity

Integrating acquired organizations and their products and services, including the integration of completed acquisitions, may be expensive, time-consuming and a strain on our resources and our relationships with employees, customers, distributors and

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suppliers, and ultimately may not be successful. The benefits or synergies we may expect from the acquisition of complementary or supplementary businesses may not be realized to the extent or in the time frame we initially anticipated. Mergers and acquisitions of high-technology companies are inherently risky and subject to many factors outside of our control, and we cannot be certain that our previous or future acquisitions will be successful and will not materially adversely affect our business, operations, financial condition, and liquidity. Any failure to successfully acquire and integrate acquired organizations and their products and services could seriously harm our business, operations, financial condition, and liquidity.

Some of the risks that could affect our ability to successfully integrate acquired businesses, including Keymile’s telecommunication systems business, include those associated with:

In addition, if we do complete future acquisitions, we could:

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We have identified material weaknesses in our internal control over financial reporting, and we cannot provide assurances that these weaknesses will be effectively remediated or that additional material weaknesses will not occur in the future. If our internal control over financial reporting or our disclosure controls and procedures are not effective, we may not be able to accurately report our financial results, prevent fraud or file our periodic reports in a timely manner, which may cause investors to lose confidence in our reported financial information and which may lead to a decline in our stock price

We are responsible for establishing and maintaining adequate internal control over financial reporting to provide reasonable assurance regarding the reliability of our financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. We assessed the effectiveness of our internal control over financial reporting as of December 31, 2018, the end of our fiscal year. In making this assessment, management used the criteria established in Internal Control - Integrated Framework (2013) issued by the Committee Sponsoring Organizations of the Treadway Commission. Based on our assessment, we have concluded that, as of December 31, 2018, our internal control over financial reporting was not effective because of the unremediated material weaknesses in our internal control over financial reporting described below.

On February 20, 2017, our Audit Committee concluded, in consultation with management, and after informing our independent registered public accounting firm, that, due to incorrect application of generally accepted accounting principles that resulted in material misstatements and a restatement of our unaudited condensed consolidated financial statements, our previously issued interim unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2016 should no longer be relied upon.

On March 21, 2017, our Audit Committee concluded, in consultation with management and after informing our former independent registered public accounting firm, that Legacy Zhone's unaudited condensed consolidated financial statements for the quarter ended June 30, 2016 should also no longer be relied upon due to material errors associated with the sale and subsequent return of certain products sold in December 2014.

In connection with such findings, our Audit Committee commenced an independent investigation to determine whether any Legacy Zhone financial statements prior to the quarter ended June 30, 2016 contained material errors.  In July 2017, our Audit Committee concluded, in consultation with management and after informing our former independent registered public accounting firm, that Legacy Zhone's unaudited condensed consolidated financial statements contained in its Quarterly Reports on Form 10-Q for the quarters ended March 31, 2015, June 30, 2015, September 30, 2015 and March 31, 2016, and Legacy Zhone's audited consolidated financial statements and assessments of internal control over financial reporting for the years ended December 31, 2015 and 2014 contained in its Annual Reports on Form 10-K should no longer be relied upon. See “Business - Audit Committee Investigation” above for additional information. Furthermore, as discussed in “Part II, Item 9A. Controls and Procedures,” our management has identified material weaknesses in our internal control over financial reporting, which were unremediated as of December 31, 2018. A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the registrant’s annual or interim financial statements will not be prevented or detected on a timely basis.

Based on our investigations and our discovery that incorrect applications of generally accepted accounting principles had resulted in material misstatements and a restatement of our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2016, we identified material weaknesses in our internal control over financial reporting as of December 31, 2016, which continue to exist at December 31, 2018. One such weakness was that we lacked personnel with the appropriate accounting knowledge, experience and competence to control our financial close process, which resulted in an incorrect application of generally accepted accounting principles.  In addition, we did not design and maintain effective controls to determine the completeness and accuracy of the accounting for complex transactions, specifically related to the Merger that occurred on September 9, 2016, which resulted in an incorrect application of generally accepted accounting principles and a restatement of our unaudited condensed consolidated financial statements for the three and nine months period ended September 30, 2016 to correct material misstatements. These material weaknesses could result in a material misstatement in the annual or interim consolidated financial statements that would not be prevented or detected.

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Our future operating results are difficult to predict and our stock price may continue to be volatile

As a result of a variety of factors discussed in this Annual Report on Form 10-K, our revenues for a particular quarter are difficult to predict. 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 could affect our results of operations include the following:

Any of the foregoing factors, or any other factors discussed elsewhere herein, could have a material adverse effect on our business, operations, financial condition and liquidity that could adversely affect our stock price. We anticipate that our stock price and trading volume may continue to be volatile in the future, whether due to the factors described above, volatility in public stock markets generally (particularly in the technology sector) or otherwise.

Between December 2016 and February 2017, the bid price for our common stock traded below the $1.00 minimum per share bid price required for continued inclusion on the Nasdaq Capital Market under Marketplace Rule 5550(a)(2).  We have received letters from Nasdaq requiring us to regain compliance within a specified period. A failure to regain compliance could result in our stock being delisted, subject to a right of appeal. On February 28, 2017, we effected a one-for-five reverse stock split of our outstanding shares of common stock. As a result of this, in March 2017, we received written notification from Nasdaq advising us that we had regained compliance with the minimum bid price rule as the closing bid price of our common stock had been $1.00 per share or greater for ten consecutive business days. There can be no assurance that our stock price will remain above the minimum bid price or that we will be able to regain compliance if our stock price falls below the minimum bid price again in the future. In addition, if our average market capitalization falls below the carrying value of our assets for an extended period of time as it has done during recent years, this may indicate that the fair value of our net assets is below their carrying value, and may result in recording impairment charges.

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The long and variable sales cycles for our products could 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 focused primarily 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 expenses 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 could deploy our products over extended periods of time. 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 and integration required 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 could vary significantly from quarter to quarter.

The market we serve is highly competitive and we could not be able to compete successfully

Competition in communications equipment markets is intense. These markets are characterized by rapid change, converging technologies and a migration to networking solutions that offer superior advantages. 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 in our core business include ADTRAN, Calix, Huawei, Nokia and ZTE, among others. In our FiberLAN business, our competitors include Cisco, Nokia and Tellabs. In our Ethernet switching business, our competitors include Arris, Cisco, and Juniper. We also may face competition from other communications equipment companies or other companies that may enter our markets in the future. In addition, a number of companies have introduced products that address the same network needs that our products and solutions address, both domestically and internationally. 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. In particular, we are encountering price-focused competitors from Asia, especially China, which places pressure on us to reduce our prices. If we are forced to reduce prices in order to secure customers, we may be unable to sustain gross margins at desired levels or achieve profitability. Competitive pressures could result in increased pricing pressure, reduced profit margins, increased sales and marketing expenses and failure to increase, or the loss of, market share, any of which could reduce our revenue and adversely affect our financial results. 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, principal competitive factors include:

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 could have a material adverse effect on our business, operations, financial condition, and liquidity.

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If demand for our products and solutions does not develop as we anticipate, then our business operations, financial condition, and liquidity will be adversely affected

Our future revenue depends significantly on our ability to successfully develop, enhance and market our products and solutions to our target markets. 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 in limited stages or over extended periods of time. A decision by a customer to purchase our products will involve a significant capital investment. We must convince our service provider customers that they will achieve substantial benefits by deploying our products for future upgrades or expansions. We may experience difficulties with product reliability, partnering, and sales and marketing efforts that could adversely affect our business and divert management attention and resources from our core business. We do not know whether a viable market for our products and solutions will develop or be sustainable in our businesses. If these markets do not develop or develop more slowly than we expect, our business, operations, financial condition and liquidity will be materially harmed.

We depend upon the development of new products and enhancements to existing products, and if we fail to predict and respond to emerging technological trends and customers’ changing needs, our operating results and market share may suffer

The markets for our products are characterized by rapidly changing technology, evolving industry standards, changes in end-user requirements, frequent new product introductions and changes in communications offerings from network service provider customers. Our future success depends 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 customers’ changing needs and technological trends, manage long development cycles or develop, introduce and market new products and enhancements. The process of developing new technology is complex and uncertain, and if we fail 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, operations, financial condition and liquidity would be materially adversely affected.

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

We produce highly complex products that incorporate leading-edge technology, including both hardware and software. Software typically contains defects or programming flaws that can unexpectedly interfere with expected operations. In addition, 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, and there is no assurance that our pre-shipment testing programs will be adequate to detect all defects. As a result, our customers may discover errors or defects in our hardware or software, or our products may not operate as expected. If we are unable to cure a product defect, we could experience damage to our reputation, reduced customer satisfaction, loss of existing customers and failure to attract new customers, failure to achieve market acceptance, reduced sales opportunities, loss of revenue and market share, increased service and warranty costs, diversion of development resources, legal actions by our customers, and increased insurance costs. 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, operations, financial condition and liquidity. A product liability claim brought against us, even if unsuccessful, would likely be time consuming and costly. The occurrence of any of these problems would seriously harm our business, operations, financial condition and liquidity.

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

We rely on contract manufacturers to perform a portion of the manufacturing operations for our products. These contract manufacturers build products for other companies, including our competitors. In addition, we do not have contracts in place with some of these providers and may not be able to effectively manage those relationships. We cannot be certain that our contract manufacturers will be able to fill our orders in a timely manner. We face a number of risks associated with this dependence on contract manufacturers including reduced control over delivery schedules, the potential lack of adequate capacity during periods of excess demand, poor manufacturing yields and high costs, quality assurance, increases in prices, and the potential misappropriation of our intellectual property. 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.

A shortage of adequate component supply or manufacturing capacity could increase our costs or cause a delay in our ability to fulfill orders, and our failure to estimate customer demand properly could result in excess or obsolete component inventories that could adversely affect our gross margins

Occasionally, we may experience a supply shortage, or a delay in receiving, certain component parts as a result of strong demand for the component parts and/or capacity constraints or other problems experienced by suppliers. If shortages or delays persist, the price of these components may increase, or the components may not be available at all, and we may also encounter shortages if we do not accurately anticipate our needs. Conversely, we may not be able to secure enough components at

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reasonable prices or of acceptable quality to build new products in a timely manner in the quantities or configurations needed. Accordingly, our revenue and gross margins could suffer until other sources can be developed. Our operating results would also be adversely affected if, anticipating greater demand than actually develops, we commit to the purchase of more components than we need. Furthermore, as a result of binding price or purchase commitments with suppliers, we may be obligated to purchase components at prices that are higher than those available in the current market. In the event that we become committed to purchase components at prices in excess of the current market price, our gross margins could decrease. In the past we experienced component shortages that adversely affected our financial results and in the future may continue to experience component shortages.

We depend on a limited source of 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 a limited number of suppliers. If any of our limited source of suppliers become insolvent, cease business or experience capacity constraints, work stoppages or any other reduction or disruption in output, they may be unable to meet our delivery schedules. 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. If we do not receive critical components from our limited source of 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 materially adversely affect our business, operations, and financial condition and liquidity and could materially damage customer relationships.

Sales to communications service providers are especially volatile, and weakness in sales orders from this industry could harm our business, operations, financial condition and liquidity

Sales activity in the service provider industry depends upon the stage of completion of expanding network infrastructures, the availability of funding, and the extent to which service providers are affected by regulatory, economic and business conditions in the country of operations. Although some service providers may be increasing capital expenditures over the depressed levels that have prevailed over the last few years, weakness in orders from this industry could have a material adverse effect on our business, operations, financial condition and liquidity. Slowdowns in the general economy, overcapacity, changes in the service provider market, regulatory developments and constraints on capital availability have had a material adverse effect on many of our service provider customers, with many of these customers going out of business or substantially reducing their expansion plans. These conditions have materially harmed our business and operating results, and we expect that some or all of these conditions may continue for the foreseeable future. Finally, service provider customers typically have longer implementation cycles; require a broader range of services including design services; demand that vendors take on a larger share of risks; often require acceptance provisions, which can lead to a delay in revenue recognition; and expect financing from vendors. All these factors can add further risk to business conducted with service providers.

We rely on the availability of third party licenses

Many of our products are designed to include software or other intellectual property licensed from third parties. It may be necessary in the future to seek or renew licenses relating to various elements of the technology used to develop these products. We cannot assure you that our existing or 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.

Our intellectual property rights could prove difficult to protect and enforce

We generally rely on a combination of copyrights, patents, trademarks and trade secret laws and commercial agreements containing restrictions on disclosure and other appropriate terms to protect our intellectual property rights. We enter into confidentiality, employee, contractor and commercial agreements with our employees, consultants and corporate partners, and control access to and distribution of our proprietary information and use of our intellectual property and technology. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products, technology or intellectual property. Monitoring unauthorized use of our technology and intellectual property is difficult, and we do not know whether the steps we have taken will prevent unauthorized use of our technology, particularly in foreign countries or jurisdictions where laws may not protect our proprietary rights as extensively as in the United States. We cannot assure you that our pending, or any future, patent applications will be granted, that any existing or future patents will not be challenged, invalidated, or circumvented, or that any existing or future patents will be enforceable or that infringement by third parties will even be detected. While we are not dependent on any individual patents, if we are unable to protect our proprietary rights, we may find ourselves at a competitive disadvantage to others who need not incur the substantial expense, time and effort required to create the innovative products.

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Claims that our current or future products or components contained in our products infringe the intellectual property rights of others may be costly and time consuming to defend and could adversely affect our ability to sell our products

The communications equipment industry is characterized by the existence of a large number of patents and frequent claims and related litigation regarding patent, copyright, trademark and other intellectual property rights, that may relate to technologies and related standards that are relevant to us. From time to time, we receive correspondence from companies claiming that our products are using technology covered by or related to the intellectual property rights of these companies and inviting us to discuss or demanding licensing or royalty arrangements for the use of the technology or seeking payment for damages, injunctive relief and other available legal remedies through litigation. These companies also include third-party non-practicing entities (also known as patent trolls) that focus on extracting royalties and settlements by enforcing patent rights through litigation or the threat of litigation. These companies typically have little or no product revenues and therefore our patents could provide little or no deterrence against such companies filing patent infringement lawsuits against us. In addition, third parties have initiated and could continue to initiate litigation against our manufacturers, suppliers, distributors or even our customers alleging infringement or misappropriation of their proprietary rights with respect to existing or future products, or components of our products. For example, various proceedings have been commenced against Broadcom Corporation and other parties alleging patent infringement in various jurisdictions, and in some cases the courts have issued rulings adverse to Broadcom enjoining Broadcom from offering, distributing, using or importing products that include the challenged intellectual property. Although we are not party to these proceedings, adverse rulings or injunctive relief awarded against Broadcom or other key suppliers of components for our products could result in delays or stoppages in the shipment of affected components, or require us to recall, modify or redesign our products containing such components. Regardless of the merit of claims against us or our manufacturers, suppliers, distributors or customers, intellectual property litigation can be time consuming and costly, and result in the diversion of the attention of technical and management personnel. Any such litigation could force us to stop manufacturing, selling, distributing, exporting, incorporating or using products or components that include the challenged intellectual property, or to recall, modify or redesign such products. 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. If we are unsuccessful in any such litigation, we could be subject to significant liability for damages and loss of our proprietary rights. Any of these events or results could have a material adverse effect on our business, operations, financial condition and liquidity.

Adverse resolution of litigation may harm our business, operations, financial condition, and liquidity

We are a party to various lawsuits and claims in the normal course of our business. 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, operations, financial condition, and liquidity.

Decreased effectiveness of share-based compensation could adversely affect our ability to attract and retain employees

We have historically used restricted stock and stock options as a key component of our employee compensation program in order to align the interests of our employees with the interests of our stockholders, encourage employee retention and provide competitive compensation and benefit packages. If the trading price of our common stock declines, this would reduce the value of our share-based compensation to our present employees and could adversely affect our ability to retain existing or attract prospective employees.  Difficulties relating to obtaining stockholder approval of equity compensation plans could also make it harder or more expensive for us to grant share-based payments to employees in the future.

Our success largely depends on our ability to retain and recruit key personnel, and any failure to do so could harm our ability to meet key objectives

Our future success depends upon the continued services of our Chief Executive Officer and other key employees, and our ability to identify, attract and retain highly skilled technical, managerial, sales and marketing personnel who have critical industry experience and relationships that we rely on to build and operate our business. The loss of the services of any of our key employees, including our Chief Executive Officer, could delay the development and production of our products and negatively impact our ability to maintain customer relationships, which could harm our business, operations, financial condition and liquidity. Moreover, our inability to attract and retain sufficient qualified accounting personnel with expertise in generally accepted accounting principles in the United States (“U.S. GAAP”) following the Merger could adversely affect our ability to maintain an effective system of internal controls or our ability to produce reliable financial reports, which could materially and adversely affect our business.

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Future sales of our common stock could lower our stock price and dilute existing stockholders

We issued a total of approximately 9.5 million shares (post reverse stock split) of our common stock to DNI in connection with the Merger, and could issue additional shares of common stock to finance future acquisitions through the use of equity. DNI has the right to require us to register with the SEC resales of the shares issued in connection with the Merger from time to time. In the event that DNI exercises its registration rights with respect to such shares, such shares would become eligible for resale upon registration. Additionally, shares of our common stock are available for future sale pursuant to awards granted under our equity incentive plans. Our stock price could suffer a significant decline as a result of any sudden increase in the number of shares sold in the public market or market perception that the increased number of shares available for sale will exceed the demand for our common stock.

The limitation of liability and indemnification provisions could harm our stockholders’ investments and discourage them from suing our directors for breach of their fiduciary duties

The limitation of liability and indemnification provisions in our certificate of incorporation, as restated, may discourage stockholders from bringing a lawsuit against directors for breach of their fiduciary duties. They may also reduce the likelihood of derivative litigation against directors and officers, even though an action, if successful, might benefit us and our stockholders. A stockholder’s investment may be harmed to the extent we pay the costs of settlement and damage awards against directors and officers pursuant to these indemnification provisions. Insofar as indemnification for liabilities under the Securities Act may be permitted to directors, officers or persons controlling us pursuant to the foregoing provisions, we have been informed that in the opinion of the SEC such indemnification is against public policy as expressed in the Securities Act and is therefore unenforceable. There is no pending litigation or proceeding naming any of our directors or officers as to which indemnification is being sought, nor are we aware of any pending or threatened litigation that may result in claims for indemnification by any director or officer.

There is a limited public market of our common stock

There is a limited public market for our common stock. The average daily trading volume in our common stock during the 12 months ended December 31, 2018 was approximately 23,063 shares (post reverse stock split) per day. We cannot provide assurances that a more active trading market will develop or be sustained. As a result of low trading volume in our common stock, the purchase or sale of a relatively small number of shares of our common stock could result in significant price fluctuations and it may be difficult for holders to sell their shares without depressing the market price of our common stock.

Changes in government regulations could harm our business, operations, financial condition, and liquidity

Our operations are subject to various laws and regulations, including those regulations promulgated by the Federal Communications Commission (“FCC”). The 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. Changes to current FCC rules and regulations and future FCC rules and regulations could negatively affect our business. Non-compliance with the FCC’s rules and regulations would expose us to potential enforcement actions, including monetary forfeitures, and could damage our reputation among potential customers. The uncertainty associated with future FCC decisions may cause network service providers to delay decisions regarding their capital expenditures for equipment for broadband services. In addition, international regulatory bodies establish standards that may govern our products in foreign markets. The SEC has adopted disclosure rules regarding the use of “conflict minerals” mined from the Democratic Republic of Congo and adjoining countries and procedures regarding a manufacturer’s efforts to prevent the sourcing of such conflict minerals. These rules may have the effect of reducing the pool of suppliers who can supply “conflict free” components and parts, and we may not be able to obtain “conflict free” products or supplies in sufficient quantities for our operations. Also, we may face reputational challenges with our customers, stockholders and other stakeholders if we are unable to sufficiently verify the origins for the conflict minerals used in our products. In addition, governments and regulators in many jurisdictions have implemented or are evaluating regulations relating to cyber security, privacy and data protection, which can affect the markets and requirements for networking and communications equipment. We are unable to predict the scope, pace or financial impact of government regulations and other policy changes that could be adopted in the future, any of which could negatively impact our operations and costs of doing business. Because of our smaller size, legislation or governmental regulations can significantly increase our costs and affect our competitive position. Changes to or future domestic and international regulatory requirements could result in postponements or cancellations of customer orders for our products and services, which could harm our business, operations, financial condition and liquidity. Further, we cannot be certain that we will be successful in obtaining or maintaining regulatory approvals that could, in the future, be required to operate our business.

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Compliance or the failure to comply with current and future environmental regulations could cause us significant expense

We are subject to a variety of federal, state, local and foreign environmental regulations. If we fail to comply with any present or future regulations, we could be subject to liabilities, the suspension of production or prohibitions on the sale of our products. In addition, such regulations could require us to incur other significant expenses to comply with environmental regulations, including expenses associated with the redesign of any non-compliant product. From time to time new regulations are enacted, and it is difficult to anticipate how such regulations will be implemented and enforced and the impact that they could have on our operations or results. For example, in 2003 the European Union enacted the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment Directive and the Waste Electrical and Electronic Equipment Directive, for implementation in European Union member states. We are aware of similar legislation that is currently in force or has been considered in the U, S., as well as other countries, such as Japan and China. Our failure to comply with any such regulatory requirements or contractual obligations could result in us being liable for costs, fines, penalties or third-party claims, and could jeopardize our ability to conduct business in countries or jurisdictions where such regulations apply.

Our business and future operating results are subject to global economic and market conditions

Market turbulence and weak economic conditions, as well as concerns about energy costs, geopolitical issues, the availability and cost of credit, business and consumer confidence, and unemployment could impact our business in a number of ways, including:

Potential deferment of purchases and orders by customers: Uncertainty about global economic conditions could cause consumers, businesses and governments to defer purchases in response to flat revenue budgets, tighter credit, decreased cash availability and weak consumer confidence. Accordingly, future demand for our products could differ materially from our current expectations.

Customers’ inability to obtain financing to make purchases and/or maintain their business: Some of our customers require substantial financing in order to finance their business operations, including capital expenditures on new equipment and equipment upgrades, and make purchases from us. The potential inability of these customers to access the capital needed to finance purchases of our products and meet their payment obligations to us could adversely impact our business, operations, financial condition, and liquidity. While we monitor these situations carefully and attempt to take appropriate measures to protect ourselves, including factoring credit arrangements to financial institutions, it is possible that we may have to defer revenue until cash is collected or write-down or write-off uncollectible accounts. Such write-downs or write-offs, if large, could have a material adverse effect on our business, operations, financial condition, and liquidity. If our customers become insolvent due to market and economic conditions or otherwise, it could have a material adverse effect on our business, operations, financial condition and liquidity.

Negative impact from increased financial pressures on third-party dealers, distributors and retailers: We make sales in certain regions through third-party dealers, distributors and retailers. These third parties may be impacted, among other things, by a significant decrease in available credit. If credit pressures or other financial difficulties result in insolvency for these third parties and we are unable to successfully transition end customers to purchase our products from other third parties, or from us directly, it could adversely impact our business, operations, financial condition, and liquidity.

Negative impact from increased financial pressures on key suppliers: Our ability to meet customers’ demands depends, in part, on our ability to obtain timely and adequate delivery of quality materials, parts and components from our suppliers. Certain of our components are available only from a single source or limited sources. If certain key suppliers were to become capacity constrained or insolvent, it could result in a reduction or interruption in supplies or a significant increase in the price of supplies and adversely impact our financial condition and results of operations. In addition, credit constraints of key suppliers could result in accelerated payment of accounts payable by us, impacting our cash flow.

We may experience material adverse impacts on our business, operations, financial condition, and liquidity as a result of weak or recessionary economic or market conditions in the United States, Korea, Germany, or the rest of the world.

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Due to the international nature of our business, political or economic changes or other factors in a specific country or region could harm our future revenue, costs and expenses and financial condition

We currently have significant operations in India, Korea, and Vietnam, as well sales and technical support teams in various locations around the world. Many of our international sales may be denominated in foreign currencies. Because we do not currently engage in material foreign currency hedging transactions related to international sales, a decrease in the value of foreign currencies relative to the U.S. dollar could result in losses from transactions denominated in foreign currencies. We expect to continue expanding our international operations in the future. The successful management and expansion of our international operations requires significant human effort and the commitment of substantial financial resources. Further, our international operations may be subject to certain risks, disruptions and challenges that could materially harm our business, operations, financial condition, and liquidity, including:

In addition, some of our customer purchase agreements are governed by foreign laws and regulations, which may differ significantly from the laws and regulations of the United States. We may be limited in our ability to enforce our rights under these agreements and to collect damages, if awarded. Any of these factors could harm our existing international operations and business or impair our ability to continue expanding into international markets.

We face exposure to foreign currency exchange rate fluctuations

We conduct significant business in Korea, Japan, India, Vietnam, and Latin America, all of which subject us to foreign currency exchange rate risk.

We currently operate a limited hedging program to mitigate the impact of foreign currency exchange rate fluctuations. The use of such hedging activities may not offset any or more than a portion of the adverse financial effects of unfavorable movements in foreign currency exchange rates over the limited time the hedges are in place. Moreover, the use of hedging instruments may introduce additional risks if we are unable to structure effective hedges with such instruments, which could adversely affect our business, operations, financial condition, and liquidity.

As such, our results of operations and our cash flows could be impacted by changes in foreign currency exchange rates.

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Industry consolidation may lead to increased competition and could harm our operating results

There has been a trend toward industry consolidation in the communications equipment market for several years. We expect this trend to continue as companies attempt to strengthen or hold their market positions in an evolving industry and as companies are acquired or are unable to continue operations. We believe that industry consolidation may result in stronger competitors that are better able to compete as sole-source vendors for customers. This could have a material adverse effect on our business, operations, financial condition, and liquidity. Furthermore, rapid consolidation could result in a decrease in the number of customers we serve. The loss of a major customer could have a material adverse effect on our business, operations, financial condition, and liquidity.

The market we serve is highly competitive and we could not be able to compete successfully

Competition in communications equipment markets is intense. These markets are characterized by rapid change, converging technologies and a migration to networking solutions that offer superior advantages. 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 in our core business include ADTRAN, Calix, Huawei, Nokia, and ZTE, among others. In our FiberLAN^TM business, our competitors include Cisco, Nokia and Tellabs. In our Ethernet switching business, our competitors include Arris, Cisco, and Juniper. We also may face competition from other communications equipment companies or other companies that may enter our markets in the future. In addition, a number of companies have introduced products that address the same network needs that our products and solutions address, both domestically and internationally. 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. In particular, we are encountering price-focused competitors from Asia, especially China, which places pressure on us to reduce our prices. If we are forced to reduce prices in order to secure customers, we may be unable to sustain gross margins at desired levels or achieve profitability. Competitive pressures could result in increased pricing pressure, reduced profit margins, increased sales and marketing expenses and failure to increase, or the loss of, market share, any of which could reduce our revenue and adversely affect our financial results. 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.

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 could have a material adverse effect on our business, operations, financial condition, and liquidity.

If we experience a significant disruption in, or breach in security of, our information technology systems, our business could be adversely affected

We rely on several centralized information technology systems to provide products and services, maintain financial records, process orders, manage inventory, process shipments to customers and operate other critical functions. If we experience a prolonged system disruption in the information technology systems that involve our interactions with customers or suppliers, it could result in the loss of sales and customers and significant incremental costs, which could adversely affect our business. In addition, our information technology systems could be susceptible to damage, disruptions or shutdowns due to power outages, hardware failures, computer viruses, attacks by computer hackers, telecommunication failures, user errors, catastrophes or other unforeseen events. Furthermore, security breaches of our information technology systems could result in the misappropriation or unauthorized disclosure of confidential information belonging to the company or our employees, partners, customers or suppliers, which could result in significant financial, legal or reputational damage to the company.

Threats from cybersecurity attacks, computer viruses or acts of terrorism could disrupt our operations and harm our business, operations, financial condition, and liquidity

Despite our implementation of network security measures, our network could be vulnerable to cybersecurity attacks, computer viruses, break-ins and similar disruptions. Cybersecurity attacks, in particular, are evolving and include, but are not limited to, malicious software, attempts to gain unauthorized access to data, and other electronic security breaches that could lead to disruptions in systems, unauthorized release of confidential or otherwise protected information and corruption of data. Any such event could have a material adverse effect on our business, operations, financial condition and liquidity

Our daily business operations require us to retain sensitive data such as intellectual property, proprietary business information and data related to customers, suppliers and business partners within our networking infrastructure. The ongoing maintenance and security of this information is pertinent to the success of our business operations and our strategic goals.

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Our networking infrastructure and related assets could be subject to unauthorized access by hackers, employee errors, or other unforeseen activities. Such issues could result in the disruption of business processes, network degradation and system downtime, along with the potential exploitation by third parties of our critical assets such as intellectual property, proprietary business information and data related to our customers, suppliers and business partners. To the extent that such disruptions occur, they may cause delays in the manufacture or shipment of our products and the cancellation of customer orders and, as a result, our business, operations, financial condition and liquidity could be materially and adversely affected resulting in a possible loss of business or brand reputation.

In addition, the effects of war or acts of terrorism could have a material adverse effect on our business, operations, financial condition and liquidity. Continued threats from acts of terrorism and the heightened security and military action in response to such threats threat, or future acts of terrorism, could cause further disruption to the economy and create further uncertainties in the economy. Energy shortages, such as shortages of gas or electricity, could have similar negative impacts. To the extent that such disruptions or uncertainties result in delays or cancellations of customer orders or the manufacture or shipment of our products, our business, operations, financial condition and liquidity could be materially and adversely affected.

Our business and operations are especially subject to the risks of earthquakes, hurricanes and other natural catastrophic events

Our corporate headquarters, including a significant portion of our research and development operations, are located in Northern California, a region known for seismic activity. Additionally, some of our facilities, including our manufacturing facility in Florida, are located near geographic areas that have experienced hurricanes in the past. For example, Hurricane Irma caused substantial damage and devastation in South Florida in September 2017, including in Seminole, the location of our manufacturing facility.   Natural disasters, such as earthquakes, hurricanes, fires, floods or other catastrophic events, could severely affect our ability to conduct normal business operations, and consequently, our future operating results could be materially and adversely affected.

None.

We lease our worldwide headquarters, which are located in Oakland, California. We also lease facilities for manufacturing, research and development purposes at locations in the United States including Seminole, Florida and Alpharetta, Georgia; and Hannover, Germany through the acquisition of Keymile and contract manufacturers located in China, India, Korea and Vietnam. We maintain smaller offices to provide sales and customer support at various domestic and international locations. We manufacture many of our more complex products at our manufacturing facility in Florida.  We believe that our existing facilities are suitable and adequate for our present purposes.

From time to time, 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, we do not expect that the ultimate costs to resolve any pending 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.

Not applicable.

Executive Officers of the Registrant

Set forth below is information concerning our executive officers as of December 31, 2018.

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Il Yung Kim has served as our President and Chief Executive Officer since September 11, 2017.  Mr. Kim joined us in connection with the Merger and has served as a member of our Board of Directors since September 9, 2016 and as Co-Chief Executive Officer from September 9, 2016 to September 11, 2017, and Acting Chief Financial Officer from September 11, 2017 to December 1, 2017.  Prior to the Merger, Mr. Kim served as a consultant to DNI in connection with the Merger.  From September 2014 to August 2016, Mr. Kim served as Chief Executive Officer of TukTak in Korea, an online startup company, which enables people with creative talents to collaborate and produce goods and services online. From December 2014 to August 2016, he also served as a strategic adviser for InMobi, a global mobile advertising platform provider. Previously, Mr. Kim held various positions with Korea Telecom, including President and executive board member from 2013 to 2014, and Chief Strategy Officer from 2010 to 2013. Mr. Kim commenced his career with British Telecom in 1982, where he held senior positions, including Vice President of Technology and Innovation and Programme Director and Head of Technology and Investment. Mr. Kim holds a Bachelor of Science (with Honors) in Electronic Engineering and a Master of Science Degree in Microwave and Modern Optics from University College, University of London.

Michael Golomb was appointed Chief Financial Officer, Corporate Treasurer and Corporate Secretary of DZS on December 1, 2017. Prior to joining DZS, Mr. Golomb co-founded and was the managing partner of ICO Governance Foundation, a non-profit decentralized global organization with a protocol-based global community mission that performs a self-regulatory function for ICOs in decentralized capital markets. From June 2015 to May 2017, he served as the Chief Financial Officer of Breathometer, a pioneer in breath analysis technology. From December 2013 to April 2015, Mr. Golomb was Chief Financial Officer and Board Member of BitFury Group Ltd., a market leading full-service Blockchain technology company, and one of the largest private infrastructure providers in the Blockchain ecosystem. From 2011 to 2013, Mr. Golomb was an independent Senior Financial Consultant. From 2008 to 2011, Mr. Golomb was Co-Founder, Board Member, and Co-President (Finance/Operations/Business Development) at Mayak Real Estate, a joint venture between Morgan Stanley, MCP, and Mr. Golomb. From 2005 to 2007, Mr. Golomb was Chief Financial Officer of Sistema Hals Real Estate Joint-Stock Company, a publicly traded company on the London Stock Exchange. From 2002 to 2005, Mr. Golomb was Sr. Finance Manager / Head of Compliance at Trimble Navigation Ltd., a global leader in GPS technology and a publicly traded company on NASDAQ. From 2000 to 2002, Mr. Golomb was Corporate Controller at Entegrity Solutions Corporation, a security software company. Prior to his public and private company experience, Mr. Golomb was a Senior Consultant at PricewaterhouseCoopers. Mr. Golomb holds a Master of Science in Management from Stanford University Graduate School of Business, a Masters of Business Administration from Santa Clara University, and a Bachelor of Science, with a double major in Economics and Diplomacy & World Affairs, from Occidental College. He is also a CPA (inactive) in California.

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PART II

Our common stock is listed on the Nasdaq Capital Market under the symbol “DZSI” (formerly “ZHNE” prior to the Merger).

As of March 6, 2019, there were 412 registered stockholders of record. A substantially greater number of holders of DZS common stock are “street name” or beneficial holders, whose shares are held of record by banks, brokers or financial institutions.

Dividend Policy

We have never paid or declared any cash dividends on our common stock or other securities and do not anticipate paying cash dividends in the foreseeable future. Any future determination to pay cash dividends will be at the discretion of the Board of Directors, subject to any applicable restrictions under our debt and credit agreements, and will be dependent upon our financial condition, results of operations, capital requirements, general business condition and such other factors as the Board of Directors may deem relevant.

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The following selected financial data has been derived from our consolidated financial statements and should be read in conjunction with the consolidated financial statements and notes thereto, and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations.”

The Merger has been accounted for as a reverse acquisition under which DNS was considered the accounting acquirer of DZS.  As such, the selected financial data below comprises the operating results of DNS and its consolidated subsidiaries for periods through September 8, 2016 and DZS and its consolidated subsidiaries for periods on or after September 9, 2016, the effective date of the Merger.

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Overview

We are a global provider of ultra-broadband network access solutions and communications platforms deployed by advanced Tier 1, 2 and 3 service providers and enterprise customers. We research, develop, test, sell, manufacture and support communications equipment in five major areas: broadband access, Ethernet switching, mobile backhaul, Passive Optical LAN and SDN/NFV solutions:

Going forward, our key financial objectives include the following:

Reverse Merger

On September 9, 2016, we acquired DNS through a reverse merger of a wholly owned subsidiary of Zhone Technologies, Inc. with and into DNS, with DNS surviving as our wholly owned subsidiary. In connection with the reverse merger, Zhone Technologies, Inc. changed its name to DASAN Zhone Solutions, Inc.

At the effective time of the Merger, all issued and outstanding shares of capital stock of DNS held by its sole shareholder, DNI, were canceled and converted into the right to receive shares of our common stock in an amount equal to 57.3% of the issued and outstanding shares of our common stock immediately following the Merger. Accordingly, at the effective time of the Merger, we issued 9,493,016 shares (post reverse stock split) of our common stock to DNI as consideration in the Merger, of which 949,302 shares (post reverse stock split) are being held in escrow as security for claims for indemnifiable losses in accordance with the merger agreement relating to the Merger. As a result, immediately following the effective time of the Merger, DNI held 57.3% of the outstanding shares of our common stock and the holders of our common stock immediately prior to the Merger retained, in the aggregate, 42.7% of the outstanding shares of our common stock. See Note 2 to the consolidated financial statements set forth in Part II, Item 8 of this Annual Report on Form 10-K for additional information regarding the Merger.

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Common Control Transaction

On December 31, 2017, DNS (our wholly owned subsidiary) acquired 100% and 99.99% of the common stock of D-Mobile Limited (“D-Mobile”) and DASAN India Private Limited (“DASAN India”), respectively, from DNI. D-Mobile and DASAN India are resellers of our products in Taiwan and India, respectively. The consideration paid to DNI for the common stock is the net book value of D-Mobile and DASAN India at December 31, 2017. The net book value of D-Mobile and DASAN India was an aggregate of $0.8 million. We accounted for these transactions as common control transactions, with the net assets transferred recorded at historical cost. The transactions did not result in a change in reporting entity and hence were accounted for prospectively.

Impact of Inflation and Changing Price

The financial statements and related data presented herein have been prepared in accordance with U.S. GAAP, which requires the measurement of financial position and operating results in terms of historical dollars without considering changes in the relative purchasing power of money over time due to inflation. Although our operations are influenced by general economic conditions, we do not believe that inflation had a material effect on our results of operations during our fiscal year ended December 31, 2018.

Critical Accounting Policies and Estimates

Management’s discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these consolidated 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 could differ materially from such estimates under different assumptions or conditions.

Revenue Recognition

We recognize revenues when we transfer control of promised goods or services to our customers in an amount that reflects the consideration to which we expect to be entitled to in exchange for those goods or services.

We generate revenue primarily from sales of products and services, including, extended warranty service and customer support. Our revenue from product sales is recognized at a point in time when control of the goods is transferred to our customers, generally occurring upon shipment or delivery, dependent upon the terms of the underlying contract. Our revenue from services is generally recognized over time on a ratable basis over the contract term, using an output measure of progress, as the contracts usually provide our customers equal benefit throughout the contract period. We typically invoice customers for support contracts in advance, for periods ranging from one (1) to five (5) years.

Our transaction price is calculated as selling price net of variable consideration. Our sales to certain distributors are made under arrangements which provide our distributors with volume discounts, price adjustments, and other allowances under certain circumstances. These adjustments and allowances are accounted for as variable consideration. To estimate variable consideration, we analyze historical data, channel inventory levels, current economic trends and changes in our customer demand for our products, among other factors. Historically, variable consideration has not been a significant component of our contracts with customers.

Some of our contracts with customers contain multiple performance obligations. For these contracts, we account for the promises separately as individual performance obligations if they are distinct. In determining whether performance obligations meet the criteria for being distinct, we consider a number of factors, including the degree of interrelation and interdependence between obligations and whether or not the good or service significantly modifies or transforms another good or service in the contract. After identifying the separate performance obligations, we allocate transaction price to the separate performance obligations on a relative standalone selling price basis. Standalone selling prices for products are determined using either an adjusted market assessment or expected cost-plus margin. For customer support and extended warranty services, standalone selling price is primarily based on the prices charged to our customers. Our remaining performance obligations represent the transaction price allocated to performance obligations that are unsatisfied or partially unsatisfied as of the end of the reporting period. Unsatisfied and partially unsatisfied performance obligations primarily consist of backlog, which are products and services for which our customer purchase orders have been accepted and that are in the process of being delivered.

We record contract assets when it has a right to consideration and records accounts receivable when it has an “unconditional” right to consideration. We record deferred revenue when cash payments received (or unconditional rights to receive cash) in advance of fulfilling our performance obligations.

Our payment terms vary by the type and location of our customer and the products or services offered. The term between invoicing and when payment is due is not significant. For certain products or services and customer types, we require payment before the products or services are delivered to the customer.

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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 accrued and other liabilities at December 31, 2018 and allowance against our accounts receivable at December 31, 2017. 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. The allowance for doubtful accounts is recorded as a charge to general and administrative expenses. 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 deteriorates, resulting doubts about their ability to make payments.

Inventories

Inventories are stated at the lower of cost or net realizable value, with cost being determined using the first-in, first-out (FIFO) method. In assessing the net realizable value of inventories, we are 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 we experience a higher incidence of inventory obsolescence due to rapidly changing technology and customer requirements, we may incur significant charges for excess inventory.

Goodwill and Other Acquisition-Related Intangible Assets

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 or 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. 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. 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 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 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 period, the net carrying value of the related intangible asset will be reduced to fair value and the remaining amortization period may be adjusted.  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.

Business Combination

We allocate the fair value of purchase consideration to the tangible assets acquired, liabilities assumed and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is recorded as goodwill. When determining the fair values of assets acquired and liabilities assumed, management makes significant estimates and assumptions, especially with respect to intangible assets and certain tangible assets such as inventory acquired as part of the Merger.

Critical estimates in valuing certain tangible and intangible assets include but are not limited to future expected cash flows from the underlying assets and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates.

Income Tax

We estimate our income tax provision or benefit in each of the jurisdictions in which we operate, including estimating exposures related to examinations by taxing authorities. We also make judgments regarding the realization of deferred tax assets, and establish valuation allowances where we believe it is more likely than not that future taxable income in certain jurisdictions will be insufficient to realize these deferred tax assets. Our estimates regarding future taxable income and income tax provision or benefit may vary due to changes in market conditions, changes in tax laws, or other factors. If our assumptions, and consequently our estimates, change in the future, the valuation allowances we have established may be increased or decreased, potentially impacting future income tax expense.

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RESULTS OF OPERATIONS

We list in the table below the historical consolidated statement of comprehensive income (loss) as a percentage of total net revenue for the periods indicated.

2018 COMPARED WITH 2017

Net Revenue

The following table presents our revenues by source (in millions):

Net revenue increased by $35.2 million in 2018 compared to 2017.  The increase in net revenue was primarily due an increase in product sales that resulted from the combined impact of our broad geographical base and diverse product offerings. From a product net revenue perspective, we saw increased sales across our five product offerings (broadband access, Ethernet switching, mobile backhaul, POL and SDN).

Service revenue represents revenue from maintenance and other services associated with product shipments. The increase in service revenue was primarily related to a greater number of products under contract for maintenance and extended warranty.

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Information about our net revenue by geography is summarized below (in millions):

Net revenue increased 14.2% or $35.2 million to $282.3 million for 2018 compared to $247.1 million for 2017. The increase in net revenue was primarily due to increased products sales in Other Asia Pacific, primarily in India and Vietnam and in EMEA, offset by decreased product sales in Korea.

Across international markets, Asia-Pacific (including Korea) contributed approximately 58.4% of net revenue in 2018. We are seeing strong customer traction in EMEA and Latin America, which collectively accounted for approximately 22.1% of 2018 net revenue. International net revenue increased 17.9% or $34.4 million to $227.1 million for 2018 compared to $192.7 million for 2017, and represented 80.4% of total net revenue compared with 78.0% in 2017. The increase in international net revenue was primarily related to increased product sales in Other Asia Pacific, primarily in India and Vietnam.

Additionally, we have increasingly seen customers signing longer multi-year deals across wide ranging deployments, including GPON deployments and expansions, EPON deployments, and VDSL/Vectoring deployments across the United States, EMEA, Latin America, and Asia Pacific.

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 Profit

Total cost of revenue increased by $26.7 million or 16.2% to $191.0 million for 2018, compared to $164.3 million for 2017. Total cost of revenue was 67.7% of net revenue for 2018, compared to 66.5% of net revenue for 2017, which resulted in a decrease in gross profit percentage to 32.3% in 2018 from 33.5% in 2017. The increase in total cost of revenue, as a percentage of sales, was primarily due to an increase in revenues in Other Asia Pacific customers that generated lower gross margin.

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, with longer term gross margin expansion expected to come from product cost reductions and manufacturing economies of scale resulting from the Merger. In addition, continued competitive and economic pressures could cause us to reduce our prices, adjust the carrying values of our inventory, or record inventory expenses relating to discontinued products and excess or obsolete inventory.

Research and Product Development Expenses

Research and product development expenses decreased by 2.1% or $0.8 million to $35.3 million for 2018 compared to $36.1 million for 2017. The decrease in research and product development expenses was primarily due to cost containment initiatives and more focused product development activities. 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.

Selling, Marketing, General and Administrative Expenses

Selling, marketing, general and administrative expenses increased 8.2% or $3.7 million to $48.3 million for 2018 compared to $44.6 million for 2017. Selling, marketing, general and administrative expenses include personnel costs for sales, marketing, administration, finance, information technology, human resources and general management as well as legal and accounting expenses, rent, utilities, trade show expenses and related travel costs. The increase in selling, marketing, general and administrative expenses was primarily due to higher personnel expenses due to increased headcount, as well as increased legal, accounting and outside service fees due to the Keymile Acquisition of $1.4 million. As a percentage of sales, selling, marketing, general and administrative expenses were at 17.1% in 2018 and 18.1% in 2017.

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Interest Expense, net

Interest expense, net for 2018 and 2017 was $1.5 million and $0.9 million, respectively. This increase was primarily related to an increase in our outstanding debt balance to $45.9 million at December 31, 2018 from $29.6 million at December 31, 2017. Interest rates on our borrowings were relatively flat during 2018 and 2017.

Other Expense, net

Other expense, net for 2018 was $1.1 million compared to $0.7 million in 2017. This includes $1.3 million of currency exchange loss in 2018 compared to currency exchange loss of $0.4 million in 2017.

Income Tax Provision (Benefit)

We recorded an income tax expense of $1.7 million for the year ended December 31, 2018 compared to an income tax benefit of $2.1 million for the year ended December 31, 2017. In fiscal year 2017, we released the valuation allowance against our net deferred tax assets in Korea. Management determined that it is more likely than not that the net deferred tax assets will be realized in this tax jurisdiction.

On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (the “Tax Act”) into law. The Tax Act decreased the U.S. corporate federal income tax rate from 35% to 21% effective January 1, 2018. The reduction in tax rate resulted in a $5.3 million reduction in net deferred tax assets at December 31, 2017. There was no impact on recorded deferred tax balances as the remeasurement of net deferred tax assets was offset by a corresponding change in valuation allowance. The Tax Act also imposes a one-time deemed repatriation tax on undistributed foreign earnings. We did not have a deemed repatriation due to our cumulative foreign earnings deficits. The Tax Act also includes a number of other provisions, including the elimination of loss carrybacks, limitations on the use of future losses, repeal of the Alternative Minimum Tax regime, and the introduction of a base erosion and anti-abuse tax. These provisions are not expected to have any immediate material effect on us.

OTHER PERFORMANCE MEASURES

In managing our business and assessing our financial performance, we supplement the information provided by our U.S. GAAP results with adjusted earnings before stock-based compensation, interest, taxes, and depreciation, or Adjusted EBITDA, a non-U.S. GAAP financial measure. We define Adjusted EBITDA as net income (loss) plus (i) interest expense, net, (ii) provision (benefit) for taxes, (iii) depreciation and amortization, (iv) stock-based compensation, and (v) material non-recurring transactions or events, such as merger and acquisition transaction costs or a 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.

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

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 U.S. GAAP or as a measure of liquidity. Management understands these limitations and compensates for these limitations by relying primarily on our U.S. GAAP results and using Adjusted EBITDA only as a supplemental measure.

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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):

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.

The Company had net income of $2.8 million and $1.2 million for the years ended December 31, 2018 and 2017. However, we had significant losses in prior years. As of December 31, 2018, we had an accumulated deficit of $15.8 million and working capital of $75.3 million. As of December 31, 2018, we had $27.7 million in cash and cash equivalents, which included $7.1 million in cash balances held by our international subsidiaries, and $45.9 million in aggregate principal amount of short-term debt obligations, other long-term debt and long-term related party borrowings. In addition, as of December 31, 2018, we had $3.8 million committed as security for letters of credit under our revolving credit facilities leaving $22.5 million in aggregate borrowing availability under these facilities. Our current lack of liquidity could harm us by:

However, we plan to focus on cost management, operating efficiency and restrictions on discretionary spending. In addition, if necessary, we may sell assets, issue debt or equity securities or purchase credit insurance. We may also reduce the scope of our planned product development, reduce sales and marketing efforts and reduce our operations in low margin regions, including reductions in headcount. Since December 31, 2018, we obtained a new loan, as described more fully in Note (18) to the consolidated financial statements set forth in Part II, Item 8 of this Annual Report on Form 10-K, Subsequent Events. Based on our current plans and current business conditions, we believe that these measures along with our existing cash, cash equivalents and available credit facilities will be sufficient to satisfy our anticipated cash requirements for at least the next twelve (12) months from the date of this Annual Report on Form 10-K.

Our ability to meet our obligations as they become due in the ordinary course of business for the next twelve (12) months will depend on our ability to achieve forecasted results and our ability to access funds approved under existing facilities.  Management’s belief that they will achieve these results assumes that, among other things, we will continue to be successful in implementing our business strategy and that there will be no material adverse development in our business, liquidity or capital requirements.  If one or more of these factors do not occur as expected, it could cause us to fail to meets our obligations as they come due.

Operating Activities

Net cash used for operating activities was $12.2 million in 2018, compared to net cash provided by operating activities of $1.9 million in 2017. The decline in cash from changes in operating assets and liabilities was primarily due to increase in accounts receivable and inventories balances at year-end.  

Investing Activities

Cash flow used in investing activities of $1.2 million in 2018 consists primarily of changes in the purchase of property, plant and equipment, compared with $1.8 million of cash flow provided by investing activities in 2017.

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Financing Activities

Cash flow from financing activities consist primarily of proceeds and repayments of borrowings. For fiscal year 2018, net cash provided by financing activities totaled $19.0 million and consisted primarily of proceeds from short-term borrowings of $55.5 million offset by repayments of borrowings of $49.5 million and proceeds from borrowings from related party of $12.1 million.

Cash Management

Our primary source of liquidity comes from our cash and cash equivalents, which totaled $27.7 million at December 31, 2018, as well as our credit facilities, under which we had aggregate borrowings of $45.9 million as of December 31, 2018. Our cash and cash equivalents as of December 31, 2018 included $7.1 million in cash balances held by our international subsidiaries.

Debt Facilities

PNC Bank

On February 27, 2019, the Company and ZTI Merger Subsidiary III, Inc., a wholly owned subsidiary of the Company (“ZTI”, and together with the Company, the “Borrowers”), and certain direct and indirect subsidiaries of the Borrowers, as guarantors, entered into that certain Revolving Credit, Term Loan, Guaranty and Security Agreement (the “Domestic Credit Agreement”) and that certain Export-Import Revolving Credit, Guaranty and Security Agreement (the “Ex-Im Credit Agreement,” and together with the Domestic Credit Agreement, the “Credit Agreements”), in each case with PNC Bank, National Association (“PNC Bank”) and Citibank, N.A. as lenders, and PNC as agent for the lenders. We refer to such transactions as the “PNC Facility.”

The Credit Agreements provide for a $25 million term loan and a $15 million revolving line of credit (including subfacilities for Ex-Im transactions, letters of credit and swing loans) with a $10 million incremental increase option. The amount the Company is able to borrow on the revolving line of credit at any time is based on eligible accounts receivable and other conditions, less certain reserves. Borrowings under the Credit Agreements bear interest at a floating rate equal to either the PNC prime rate or the LIBOR rate for the applicable period, plus a margin that is based on the type of advance.

The Company used a portion of the funds borrowed from the term loan under the Credit Agreements to (i) repay $5.0 million existing related party indebtedness with DNI plus accrued interest, (ii) repay $1.5 million revolving line of credit outstanding balance plus accrued interest and fees and cash collateralized $3.6 million outstanding letter of credit under the Wells Fargo Credit Facility, and (iii) repay $5.6 million short-term debt in Korea and Japan. The Company will use the remaining funds for ongoing working capital needsThe Company’s obligations under the Credit Agreements are secured by substantially all of the personal property assets of the Borrowers and the subsidiaries that guarantee the Credit Agreements, including their intellectual property.

The maturity date under the Credit Agreements is February 27, 2022, which reflects a three-year term. Repayment of the term loan shall in be in eight quarterly installments of $625,000 beginning June 30, 2019, followed by quarterly installments of $937,500 beginning on June 30, 2021, with all remaining unpaid principal and accrued interest due on the maturity date. Repayment of the revolving line of credit shall be due and payable on the maturity date.

The Credit Agreements contain certain covenants, limitations, and conditions with respect to the Company, including a maximum leverage ratio, a minimum fixed charge coverage ratio, and a minimum liquidity covenant, as well as financial reporting obligations, and usual and customary events of default. If an event of default occurs, the Agent and Lenders will be entitled to take various actions, including requiring the immediate repayment of all outstanding amounts under the Credit Agreements, terminating commitments to make additional advances and selling the assets of the Borrowers and their subsidiary guarantors to satisfy the obligations under the Credit Agreements. We make no assurances that we will be in compliance with the PNC Facility covenants in the future.

Wells Fargo

On July 12, 2018, we entered into the Amended and Restated Domestic Credit Agreement and the Amended and Restated Ex-Im Credit Agreement with Wells Fargo, which amended and replaced our previous senior secured revolving line of credit and letter of credit facilities with Wells Fargo and revised certain reporting and compliance provisions. The Wells Fargo Facility provided for a revolving line of credit of $25.0 million (including up to $5.0 million of letters of credit), with the amount that we were able to borrow based on eligible accounts receivable and inventory, less outstanding letter of credit usage. As of December 31, 2018, we had $7.0 million in outstanding borrowings under the revolving line of credit, and $1.3 million outstanding letter of credit usage. Based on our eligible accounts receivable and inventory, we had $11.6 million of financing availability under the Wells Fargo Facility as of December 31, 2018. Subsequently, on January 8, 2019, we fully repaid the $7.0 million outstanding borrowings under the revolving line of credit.

The revolving line of credit borrowed under the Wells Fargo Facility bore interest, payable monthly, at a floating rate equal to the three-month LIBOR plus a margin based on our average excess availability (as calculated under the Wells Fargo Facility). The interest rate on the Wells Fargo Facility was 5.1% at December 31, 2018. The unused commitment fee was 0.25% per annum and the unused letter of credit fee was 1.25% per annum.  These are recorded as interest expenses in our financial results presented in this Annual Report on Form 10-K.

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Our obligations under the Wells Fargo Facility were secured by substantially all of the assets of the Company and our subsidiaries that guaranteed the Wells Fargo Facility, including intellectual property. The Wells Fargo Facility contained certain financial covenants, and customary affirmative and negative covenants.

As of December 31, 2018, we were in compliance with the covenants under the Wells Fargo Facility. In the past, we had violated covenants under the Wells Fargo Facility and received waivers from Wells Fargo for such violations. On July 3, 2017, we were in violation of the requirement to deliver audited financials for the year ended December 31, 2016, and we executed an agreement with Wells Fargo to extend the due date to September 27, 2017. As of December 31, 2017, we were in technical violation of covenants under the Wells Fargo Facility to pledge the stock of certain foreign subsidiaries and transfer certain funds to Wells Fargo bank accounts. On March 19, 2018, we executed an agreement with Wells Fargo, which cured the breach. Effective March 27, 2018, the Company and Wells Fargo modified the definition of Liquidity Trigger Event (as defined in the Wells Fargo Facility) from $10.0 million to $5.0 million on March 31, 2018 or $10.0 million for subsequent quarters. Effective March 30, 2018, the Company and Wells Fargo amended the Wells Fargo Facility to extend the maturity date from March 31, 2019 to July 15, 2019.

On February 27, 2019, we repaid $1.5 million outstanding borrowing on the revolving line of credit plus accrued interest and fees and cash collateralized $3.6 million outstanding letters of credit under the Wells Fargo Facility with some of the proceeds of the PNC Facility. On February 27, 2019, we also terminated the Wells Fargo Facility.

Bank and Trade Facilities - Foreign Operations

Certain of our foreign subsidiaries have entered into various financing arrangements with foreign banks and other lending institutions consisting primarily of revolving lines of credit, trade facilities, term loans and export development loans. These facilities are renewed on an annual basis and are generally secured by a security interest in certain assets of the applicable foreign subsidiaries and supported by guarantees given by DNI or third parties. Payments under such facilities are made in accordance with the given lender’s amortization schedules.  As of December 31, 2018 and December 31, 2017, we had an aggregate outstanding balance of $24.8 million and $22.8 million, respectively, under such financing arrangements, and the interest rate per annum applicable to outstanding borrowings under these financing arrangements as of December 31, 2018 and December 31, 2017 ranged from 0% to 6.08% and 1.58% to 8.90%, respectively.

Related-Party Debt

In connection with the Merger, on September 9, 2016, we entered into a loan agreement with DNI for a $5.0 million unsecured subordinated term loan facility. Under the loan agreement, we were permitted to request drawdowns of one or more term loans in an aggregate principal amount not to exceed $5.0 million. As of December 31, 2018, $5.0 million in term loans was outstanding under the facility. The interest rate as of December 31, 2018 under this facility was 4.6% per annum. On or about February 27, 2019, the entire outstanding balance on this term loan was repaid with some of the proceeds of the PNC Facility.

In February 2016, DNS California borrowed $1.8 million from DNI for capital investment, which amount was outstanding as of December 31, 2018. This loan was due to mature in March 2018 with an option of renewal by mutual agreement, and bore interest at a rate of 4.6% per annum, payable annually.  Effective January 31, 2018, we amended the terms of this loan to extend the repayment date from March 2018 to July 2019 and maintain an interest rate of 4.6%. On February 27, 2019, we amended the terms of this loan to extend the repayment date until 90 days after the maturity of the PNC Facility.

On March 27, 2018, DASAN Network Solutions, Inc., a corporation organized under the laws of the Republic of Korea (“DNS Korea”) borrowed KRW 6.5 billion from DNI, of which $4.5 million was repaid on August 8, 2018. As of December 30, 2018, $1.3 million remained outstanding. The loan bears interest at a rate of 4.6% and is secured by certain accounts receivable of DNS Korea. On February 27, 2019, we amended the terms of this loan to extend the repayment date until 90 days after the maturity of the PNC Facility.

On December 27, 2018, we entered into a Loan Agreement with DNI for a $6.0 million secured term loan with an interest rate of 4.6% per annum.  On February 27, 2019, we amended the terms of the term loan to extend the repayment date until 90 days after the maturity of the PNC Facility and to terminate any security granted to DNI with respect to such loan.

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.

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.

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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 December 31, 2018, two (2) customers, APSFL and SK Broadband, Inc., accounted for 11% and 10%, respectively, of our net accounts receivable. Our receivables from customers in countries other than the U.S represented 88% of 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.

Contractual Commitments and Off-Balance Sheet Arrangements

At December 31, 2018, our future contractual commitments by fiscal year were as follows (in thousands):

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 December 31, 2018.

Short-term Debt

The short-term debt obligations have been recorded as liabilities on our balance sheet, and comprise of $31.8 million in outstanding borrowings under the credit facilities. The short-term debt obligation amount shown above represents scheduled principal repayments, but not the associated interest payments which may vary based on changes in market interest rates. At December 31, 2018, the interest rate per annum applicable to outstanding borrowings under the trade facilities of our foreign subsidiaries ranged from 0% to 6.08%. See above under “Cash Management” for further information about these facilities.

Long-term Debt - Related Party

As of December 31, 2018, we had borrowed an aggregate of $14.1 million from DNI, which consisted of (a) a $5.0 million unsecured subordinated term loan facility (On or about February 27, 2019, the entire outstanding balance on this term loan was paid with some of the proceeds of the PNC Facility), (b) a $6.0 million secured term loan, which matures 90 days after the maturity of the PNC Facility, is pre-payable at any time by us without premium or penalty, (c) a $1.8 million loan for capital investment which matures 90 days after the maturity of the PNC Facility, and (d) a secured loan outstanding of $1.3 million which matures 90 days after the maturity of the PNC Facility. All four loans bear interest at a rate of 4.6% per annum.

See above under “Cash Management” for further information about our related-party debt.

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Cash and Cash Equivalents

We consider all cash and highly liquid investments purchased with an original maturity of less than three (3) months to be cash equivalents.

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 financial deposits 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.

For the year ended December 31, 2018, one (1) customer, SK Broadband, Inc., represented 11% of net revenue. For the year ended December 31, 2017, no customer represented 10% or more of net revenue. For the year ended December 31, 2016, three (3) customers, SK Broadband, Inc., DNI (a related party) and LG Uplus Corp., represented 16%, 14% and 10% of net revenue, respectively.

As of December 31, 2018, two (2) customers APSFL and SK Broadband, Inc., accounted for 11% and 10% of net accounts receivable, respectively.  As of December 31, 2017, two (2) customers accounted for 20% (related party) and 10% of net accounts receivable, respectively. As of December 31, 2018 and 2017, receivables from customers in countries other than the United States represented 88% and 84%, respectively, of net accounts receivable.

Interest Rate Risk

Our exposure to market risk for changes in interest rates relates primarily to our outstanding short-term debt. As of December 31, 2018, our outstanding short-term debt balance was $31.8 million. Amounts borrowed under the short-term debt bear interest ranging from 0% to 6.08% as of December 31, 2018. Assuming the outstanding balance on our variable rate debt remains constant over a year, a 1% increase in the interest rate would decrease pre-tax income and cash flow by approximately $0.3 million.

Foreign Currency Risk

We transact business in various foreign countries, and a significant portion of our assets is located in Korea. We have sales operations throughout Asia, EMEA and Latin America. We are exposed to foreign currency exchange rate risk associated with foreign currency denominated assets and liabilities, primarily intercompany receivables and payables. Accordingly, our operating results are exposed to changes in exchange rates between the U.S. dollar and those currencies. During fiscal years 2017 and 2016, we did not hedge any of our foreign currency exposure.

We have performed a sensitivity analysis as of December 31, 2018 using a modeling technique that measures the impact on the balance sheet 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 analysis indicated that a hypothetical 10% adverse movement in foreign currency exchange rates would result in a foreign exchange loss of $3.7 million at December 31, 2018. 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.

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DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

No financial statement schedules are required because all the relevant data is included elsewhere in this Annual Report on Form 10-K.

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Report of Independent Registered Public Accounting Firm

To the Board of Directors and Stockholders of DASAN Zhone Solutions, Inc.

Opinion on the Financial Statements

We have audited the accompanying consolidated balance sheets of DASAN Zhone Solutions, Inc. and its subsidiaries (the “Company”) as of December 31, 2018 and 2017, and the related consolidated statements of comprehensive income (loss), of stockholders’ equity and non-controlling interest and of cash flows for each of the three years in the period ended December 31, 2018, including the related notes (collectively referred to as the “consolidated financial statements”). In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 2018 and 2017, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2018 in conformity with accounting principles generally accepted in the United States of America.

Change in Accounting Principles

As discussed in Note 1 to the consolidated financial statements, the Company changed the manner in which it accounts for revenue from contracts with customers and the manner in which it accounts for restricted cash in 2018.

Basis for Opinion

These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on the Company’s consolidated financial statements based on our audits. We are a public accounting firm registered with the Public Company Accounting Oversight Board (United States) (PCAOB) and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the Securities and Exchange Commission and the PCAOB.

We conducted our audits of these consolidated financial statements in accordance with the standards of the PCAOB. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free of material misstatement, whether due to error or fraud. The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. As part of our audits we are required to obtain an understanding of internal control over financial reporting but not for the purpose of expressing an opinion on the effectiveness of the Company's internal control over financial reporting. Accordingly, we express no such opinion.

Our audits included performing procedures to assess the risks of material misstatement of the consolidated financial statements, whether due to error or fraud, and performing procedures that respond to those risks. Such procedures included examining, on a test basis, evidence regarding the amounts and disclosures in the consolidated financial statements. Our audits also included evaluating the accounting principles used and significant estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that our audits provide a reasonable basis for our opinion.

/s/ PricewaterhouseCoopers LLP

San Jose, California

March 12, 2019

We have served as the Company's auditor since 2016.

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DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES

Consolidated Balance Sheets

(In thousands, except par value)

See accompanying notes to consolidated financial statements.

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DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES

Consolidated Statements of Comprehensive Income (Loss)

(In thousands, except per share data)