DZS INC. - Quarter Report: 2020 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

☒

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

For the quarterly period ended September 30, 2020

☐

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

For the transition period from to

000-32743

(Commission File Number)

DZS INC.

(Exact name of registrant as specified in its charter)

Delaware		22-3509099
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification Number)

5700 Tennyson Parkway, Suite 400 Plano, Texas		75024
(Address of principal executive offices)		(Zip code)

(469) 327-1531

(Registrant’s telephone number, including area code)

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

Title of each class	Trading Symbol(s)	Name of each exchange on which registered

Common stock, $0.001 par value	DZSI	The Nasdaq Stock Market LLC

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 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 the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in rule 12b-2 of the Exchange Act.

Large accelerated filer	☐	Accelerated filer	☒
Non-accelerated filer	☐	Smaller reporting company	☒
		Emerging growth company	☐

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 October 30, 2020, there were 21,640,274 shares outstanding of the registrant’s common stock, $0.001 par value.

TABLE OF CONTENTS

		Page
PART I. FINANCIAL INFORMATION

Item 1.	Financial Statements	3
	Unaudited Condensed Consolidated Balance Sheets	3
	Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss)	4
	Unaudited Condensed Consolidated Statements of Stockholders' Equity and Non-Controlling Interest	5
	Unaudited Condensed Consolidated Statements of Cash Flows	6
	Notes to Unaudited Condensed Consolidated Financial Statements	7
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	26
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	38
Item 4.	Controls and Procedures	38

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	39
Item 5.	Other Information	39
Item 6.	Exhibits	39
	Signatures	41

PART I. FINANCIAL INFORMATION

Item 1.

Financial Statements

DZS INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Balance Sheets

(In thousands, except par value)

	September 30, 2020			December 31, 2019
Assets
Current assets:
Cash and cash equivalents	$	31,307		$	28,747
Restricted cash		9,087			4,646
Accounts receivable - trade, net of allowance for doubtful accounts of $664 as of September 30, 2020 and $393 as of December 31, 2019		103,982			96,865
Other receivables		9,743			8,124
Contract assets		5,772			16,680
Inventories		43,899			35,439
Prepaid expenses and other current assets		5,745			4,185
Total current assets		209,535			194,686
Property, plant and equipment, net		7,170			6,769
Right-of-use assets from operating leases		18,663			20,469
Goodwill		3,977			3,977
Intangible assets, net		10,344			12,381
Deferred tax assets		1,828			1,622
Other assets		5,293			6,243
Total assets	$	256,810		$	246,147
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable - trade	$	40,850		$	41,585
Short-term debt - bank, trade facilities and secured borrowings		23,341			17,484
Contract liabilities		3,836			3,567
Operating lease liabilities		4,347			4,201
Accrued and other liabilities		16,508			12,964
Total current liabilities		88,882			79,801
Long-term debt
Bank and trade facilities		—			9,937
Related party		28,152			9,096
Contract liabilities		2,854			3,230
Operating lease liabilities		16,337			18,154
Pension liabilities		17,976			17,671
Other long-term liabilities		1,764			1,710
Total liabilities		155,965			139,599
Commitments and contingencies (Note 14)
Stockholders’ equity:
Common stock, authorized 36,000 shares, 21,622 and 21,419 shares outstanding as of September 30, 2020 and December 31, 2019, respectively, at $0.001 par value		22			21
Additional paid-in capital		144,272			139,700
Accumulated other comprehensive loss		(5,173	)		(3,939	)
Accumulated deficit		(38,276	)		(29,234	)
Total stockholders’ equity		100,845			106,548
Total liabilities and stockholders’ equity	$	256,810		$	246,147

See accompanying notes to unaudited condensed consolidated financial statements.

DZS INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss)

(In thousands, except per share data)

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
	2020			2019			2020			2019
Net revenue:
Third parties	$	93,395		$	71,292		$	209,882		$	227,407
Related parties		552			232			2,077			1,870
Total net revenue		93,947			71,524			211,959			229,277
Cost of revenue:
Products and services - third parties		64,937			48,755			141,090			151,805
Products and services - related parties		408			190			1,713			1,427
Amortization of intangible assets		410			402			1,201			1,216
Total cost of revenue		65,755			49,347			144,004			154,448
Gross profit		28,192			22,177			67,955			74,829
Operating expenses:
Research and product development		8,903			9,898			26,865			29,512
Selling, marketing, general and administrative		16,925			15,716			43,845			45,684
Amortization of intangible assets		387			464			1,130			1,406
Total operating expenses		26,215			26,078			71,840			76,602
Operating income (loss)		1,977			(3,901	)		(3,885	)		(1,773	)
Interest income		14			374			98			524
Interest expense		(446	)		(1,124	)		(1,503	)		(3,239	)
Loss on extinguishment of debt		—			—			(1,369	)		—
Other income (expense), net		(41	)		944			69			2,517
Income (loss) before income taxes		1,504			(3,707	)		(6,590	)		(1,971	)
Income tax provision		1,619			289			2,452			1,098
Net income (loss)		(115	)		(3,996	)		(9,042	)		(3,069	)
Net income (loss) attributable to non-controlling interest		—			37			—			194
Net income (loss) attributable to DZS Inc.		(115	)		(4,033	)		(9,042	)		(3,263	)

Foreign currency translation adjustments		1,112			(2,426	)		(1,519	)		(4,123	)
Actuarial gain (loss)		—			38			285			(1,115	)
Comprehensive income (loss)		997			(6,384	)		(10,276	)		(8,307	)
Comprehensive income (loss) attributable to non- controlling interest		—			31			—			209
Comprehensive income (loss) attributable to DZS Inc.	$	997		$	(6,415	)	$	(10,276	)	$	(8,516	)

Net income (loss) per share attributable to DZS Inc.
Basic	$	(0.01	)	$	(0.19	)	$	(0.42	)	$	(0.17	)
Diluted	$	(0.01	)	$	(0.19	)	$	(0.42	)	$	(0.17	)
Weighted average shares outstanding used to compute basic net income (loss) per share		21,592			21,384			21,532			18,732
Weighted average shares outstanding used to compute diluted net income (loss) per share		21,592			21,384			21,532			18,732

See accompanying notes to unaudited condensed consolidated financial statements.

DZS INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Stockholders' Equity and Non-Controlling Interest

(In thousands, except per share data)

	Common stock				Additional paid-in			Accumulated other comprehensive			Accumulated			Total stockholders'			Non- controlling			Total stockholders' equity and non- controlling
	Shares		Amount		capital			income (loss)			deficit			equity			interest			interest
For the Nine-Month Period Ended September 30, 2020:
Balance as of December 31, 2019		21,419	$	21	$	139,700		$	(3,939	)	$	(29,234	)	$	106,548		$	—		$	106,548
Exercise of stock awards and employee stock plan purchases		94		—		709			—			—			709			—			709
Stock-based compensation		—		—		782			—			—			782			—			782
Net loss		—		—		—			—			(8,771	)		(8,771	)		—			(8,771	)
Other comprehensive loss		—		—		—			(1,979	)		—			(1,979	)		—			(1,979	)
Balance as of March 31, 2020		21,513		21		141,191			(5,918	)		(38,005	)		97,289			—			97,289
Exercise of stock awards and employee stock plan purchases		46		—		284			—			—			284			—			284
Stock-based compensation		—		—		868			—			—			868			—			868
Net loss		—		—		—			—			(156	)		(156	)		—			(156	)
Other comprehensive loss		—		—		—			(367	)		—			(367	)		—			(367	)
Balance as of June 30, 2020		21,559	$	21	$	142,343		$	(6,285	)	$	(38,161	)	$	97,918		$	—		$	97,918
Exercise of stock awards and employee stock plan purchases		39		1		269			—			—			270			—			270
Stock-based compensation		24		—		1,660			—			—			1,660			—			1,660
Net income (loss)		—		—		—			—			(115	)		(115	)		—			(115	)
Other comprehensive loss		—		—		—			1,112			—			1,112			—			1,112
Balance as of September 30, 2020		21,622	$	22	$	144,272		$	(5,173	)	$	(38,276	)	$	100,845		$	—		$	100,845

For the Nine-Month Period Ended September 30, 2019:
Balance as of December 31, 2018		16,587	$	16	$	93,192		$	(192	)	$	(15,777	)	$	77,239		$	615		$	77,854
Stock-based compensation		9		—		825			—			—			825			—			825
Net loss		—		—		—			—			(1,638	)		(1,638	)		181			(1,457	)
Other comprehensive loss		—		—		—			(1,124	)		—			(1,124	)		(1	)		(1,125	)
Balance as of March 31, 2019		16,596		16		94,017			(1,316	)		(17,415	)		75,302			795			76,097
Issuance of common stock in public offering, net of issuance costs		4,718		5		42,504			—			—			42,509			—			42,509
Exercise of stock awards and employee stock plan purchases		55		—		473			—			—			473			—			473
Stock-based compensation		11		—		811			—			—			811			—			811
Net income (loss)		—		—		—			—			2,408			2,408			(24	)		2,384
Other comprehensive income (loss)		—		—		—			(1,748	)		—			(1,748	)		23			(1,725	)
Balance as of June 30, 2019		21,380	$	21	$	137,805		$	(3,064	)	$	(15,007	)	$	119,755		$	794		$	120,549
Purchase of non-controlling interest in subsidiary		—		—		(127	)		—			—			(127	)		(823	)		(950	)
Stock-based compensation		8		—		1,182			—			—			1,182			—			1,182
Net income (loss)		—		—		—			—			(4,033	)		(4,033	)		37			(3,996	)
Other comprehensive loss		—		—		—			(2,381	)		—			(2,381	)		(8	)		(2,389	)
Balance as of September 30, 2019		21,388	$	21	$	138,860		$	(5,445	)	$	(19,040	)	$	114,396		$	—		$	114,396

See accompanying notes to unaudited condensed consolidated financial statements.

DZS INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Cash Flows

(In thousands)

	Nine Months Ended
	September 30,
	2020			2019
Cash flows from operating activities:
Net income (loss)	$	(9,042	)	$	(3,069	)
Adjustments to reconcile net income (loss) to net cash Used in operating activities:
Depreciation and amortization		3,935			4,110
Loss on extinguishment of debt		1,343			—
Amortization of deferred financing costs		147			453
Stock-based compensation		3,310			2,818
Provision for inventory write-down		4,079			2,289
Allowance for doubtful accounts		446			148
Provision for sales returns		556			413
Unrealized gain on foreign currency transactions		(405	)		(2,080	)
Deferred taxes		(224	)		884
Bargain purchase gain on acquisition		—			(334	)
Changes in operating assets and liabilities:
Accounts receivable		(16,582	)		(29,724	)
Contract assets		11,609			819
Inventories		(11,984	)		(3,454	)
Prepaid expenses and other assets		(1,958	)		3,859
Accounts payable		2,558			9,275
Contract liabilities		(131	)		(4,246	)
Accrued and other liabilities		1,348			(4,049	)
Net cash used in operating activities		(10,995	)		(21,888	)
Cash flows from investing activities:
Purchases of property, plant and equipment		(1,947	)		(1,461	)
Acquisition of business, net of cash acquired		—			(4,697	)
Net cash used in investing activities		(1,947	)		(6,158	)
Cash flows from financing activities:
Proceeds from short-term borrowings and line of credit		13,774			25,884
Repayments of short-term borrowings and line of credit		(12,077	)		(38,486	)
Proceeds from long-term borrowings		—			25,000
Repayments of long-term borrowings		(13,125	)		(1,250	)
Proceeds from related party term loan		18,361			—
Proceeds from factored accounts receivable		11,645			—
Repayments of related party term loan		—			(5,000	)
Deferred financing costs		(20	)		(1,998	)
Proceeds from issuance of common stock in public offering, net of issuance costs		—			42,509
Purchase of non-controlling interest		—			(950	)
Proceeds from exercise of stock awards and employee stock plan purchases		1,262			473
Net cash provided by financing activities		19,820			46,182
Effect of exchange rate changes on cash, cash equivalents, and restricted cash		47			(984	)
Net increase in cash, cash equivalents and restricted cash		6,925			17,152
Cash, cash equivalents and restricted cash at beginning of period		33,635			35,648
Cash, cash equivalents and restricted cash at end of period	$	40,560		$	52,800

Reconciliation of cash, cash equivalents and restricted cash to statement of financial position
Cash and cash equivalents	$	31,307		$	47,851
Restricted cash		9,087			4,448
Long-term restricted cash		166			501
	$	40,560		$	52,800

Supplemental disclosure of cash flow information:
Shares of the Company's common stock held in escrow		—			—
Cash paid during the period for:
Interest - bank and trade facilities	$	616		$	2,223
Interest - related party	$	888		$	404
Income taxes	$	2,587		$	1,996

See accompanying notes to unaudited condensed consolidated financial statements.

Notes to Unaudited Condensed Consolidated Financial Statements

(1)

Organization and Summary of Significant Accounting Policies

(a)

Description of Business

DZS Inc. (referred to, collectively with its subsidiaries, as “DZS” or the “Company”) is 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. On August 26, 2020, the Company filed a Certificate of Amendment to our Restated Certificate of Incorporation with the Delaware Secretary of State reflecting a company name change from Dasan Zhone Solutions, Inc to DZS Inc. The Company provides a wide array of reliable, cost-effective networking technologies, including broadband access, Ethernet switching, mobile backhaul, Passive Optical LAN and software-defined networks, to a diverse customer base that includes more than 1,000 customers in more than 100 countries worldwide.

DZS was incorporated under the laws of the state of Delaware in June 1999, under the name Zhone Technologies, Inc. The Company is headquartered in Plano, Texas with flexible in-house production facilities in Seminole, Florida and Hannover, Germany, and contract manufacturers located in China, India, Korea and Vietnam. The Company also maintains offices to provide sales and customer support at global locations.

(b)

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. GAAP for interim financial information and with the instructions to Form 10-Q and Article 8 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. These financial statements include the accounts of the Company, its wholly owned subsidiaries and a subsidiary in which it had a controlling interest. All intercompany transactions and balances have been eliminated in consolidation.

Certain prior-year amounts have been reclassified to conform to the current-quarter presentation. The unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented. The results of operations for the current interim period are not necessarily indicative of results to be expected for the current year or any other period. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements of the Company and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2019 filed with the Securities and Exchange Commission (“SEC”) on March 24, 2020. For a complete description of what the Company believes to be the critical accounting policies and estimates used in the preparation of its unaudited condensed consolidated financial statements, refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2019.

(c)

Risks and Uncertainties

The accompanying unaudited condensed consolidated financial statements have been prepared in conformity with U.S. GAAP, assuming the Company will continue as a going concern.

The Company had net loss of $0.1 million and net loss of $9.0 million for the three and nine months ended September 30, 2020. Additionally, the Company had a net loss of $13.3 million for the year ended December 31, 2019 and incurred significant losses in years prior to 2019. As of September 30, 2020, the Company had an accumulated deficit of $38.3 million and working capital of $120.7 million. As of September 30, 2020, the Company had $31.3 million in cash and cash equivalents, which included $13.7 million in cash balances held by its international subsidiaries, and $51.5 million in aggregate principal debt of which $23.3 million was reflected in current liabilities.

The Company’s liquidity could be impacted by:

•

its vulnerability to adverse economic conditions in its industry or the economy in general, including those conditions resulting from the ongoing COVID-19 pandemic;

•

debt servicing requiring substantial amounts of cash, rather than being available for other purposes, including operations;

•

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

•

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

The Company’s ability to meet its obligations as they become due in the ordinary course of business for the next twelve (12) months will depend on its ability to (i) achieve forecasted results of operations, (ii) access funds approved under existing or new credit facilities and/or raise additional capital through sale of the Company’s common stock to the public, and (iii) effectively manage working capital requirements. If the Company cannot raise additional funds when it needs or want them, or if customers are unable or unwilling to pay on a timely basis, its operations and prospects could be negatively affected. Management’s belief that it will achieve forecasted results of operations assumes that, among other things, the Company will continue to be successful in implementing its business strategy. If one or more of these factors do not occur as expected, it could cause the Company to fail to meet its obligations as they come due.

In December 2019, a strain of coronavirus, now known as COVID-19, was reported to have surfaced in Wuhan, China. Since that time, the widespread and sustained transmission of the virus has reached global pandemic status. In response to the pandemic, many national and international health agencies have recommended, and many countries and state, provincial and local governments have implemented, various measures, including travel bans and restrictions, limitations on public and private gatherings, business closures or operating restrictions, social distancing, and shelter-in-place orders. The health effects of the pandemic and the above measures taken in response thereto have had an effect on the global economy in general and have materially impacted and will likely continue to impact the Company’s financial condition, results of operations and cash flows. Given the ongoing and dynamic nature of the virus and the worldwide response related thereto, it is difficult to predict the full impact of the COVID-19 pandemic on our business. Due to the uncertainty around the future economic impact of the pandemic, the fair value measurements used in the Company’s impairment assessments could be negatively impacted and could result in future impairments of goodwill, intangibles and other long-lived assets. For the nine months ended September 30, 2020 the Company’s revenues decreased by approximately 8% compared to the same period of last year in part due to the COVID-19 pandemic. However, during the quarter ended September 30, 2020, the Company’s revenues increased by 31% compared to the quarter ended September 30, 2019 and 33% compared to the quarter ended June 30, 2020. The impact of a continued COVID-19 pandemic or sustained measures taken to limit or contain the outbreak could continue to have a material and adverse effect on our business, financial condition, results of operations, and cash flows.

Based on the Company's current plans and current business conditions, as of the date of this Quarterly Report on Form 10-Q, the Company believes that its existing cash, cash equivalents and available credit facilities will be sufficient to satisfy its anticipated cash requirements for at least the next twelve months from the date of this Quarterly Report on Form 10-Q.

(d)

Use of Estimates

The preparation of the unaudited condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the unaudited condensed consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.

(e)

Revenue Disaggregation Information

The following table presents the revenues by source (in thousands):

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2020		2019		2020		2019
Revenue by source:
Products	$	88,910	$	66,447	$	197,832	$	214,891
Services		5,037		5,077		14,127		14,386
Total	$	93,947	$	71,524	$	211,959	$	229,277

The following summarizes required disclosures about geographical concentrations (in thousands):

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
	2020		2019		2020		2019
Revenue by geography:
United States	$	10,566	$	9,662	$	27,543	$	28,993
Canada		1,319	$	1,062		4,395		2,950
Total North America		11,885	$	10,724		31,938		31,943
Latin America		5,094	$	6,273		12,089		18,829
Europe, Middle East, Africa		19,911	$	15,838		47,526		59,429
Korea		15,423	$	20,877		39,090		55,682
Japan		32,966	$	9,308		66,288		28,680
Other Asia Pacific		8,668	$	8,504		15,028		34,714
Total International		82,062	$	60,800		180,021		197,334
Total	$	93,947	$	71,524	$	211,959	$	229,277

Contract Balances

The Company records contract assets when it has a right to consideration and records accounts receivable when it has an unconditional right to consideration. Contract liabilities consist of cash payments received (or unconditional rights to receive cash) in advance of fulfilling performance obligations.

The opening and closing balances of contract assets and contract liabilities related to contracts with customers are as follows:

	Contract Assets			Contract Liabilities
December 31, 2019	$	16,680		$	6,797
September 30, 2020		5,772			6,690
Increase (decrease)	$	(10,908	)	$	(107	)

The decrease in contract assets during the nine months ended September 30, 2020 was primarily due to invoicing that occurred in 2020 from unbilled balances reflected as contract assets as of December 31, 2019.

The decrease in contract liabilities during the nine months ended September 30, 2020 was primarily due to the deferral of revenue due to shipments not meeting the criteria for revenue recognition as of September 30, 2020, as compared to December 31, 2019. The amount of revenue recognized in the nine months ended September 30, 2020 that was included in the prior period contract liability balance was $2.8 million. This revenue consists of products and services provided to customers who had been invoiced prior to the current year.

(f)

Concentration of Risk

Financial instruments, which potentially subject the Company to concentrations of credit risk, consist primarily of cash, cash equivalents and restricted cash which totaled $40.6 million at September 30, 2020, including $17.8 million held by international subsidiaries. Cash and cash equivalents consist of financial deposits and money market accounts that are principally held with various domestic and international financial institutions with high credit standing.

The Company’s customers include competitive and incumbent local exchange carriers, competitive access providers, internet service providers, wireless carriers and resellers serving these markets. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Allowances are maintained for potential doubtful accounts.

For the three months ended September 30, 2020, two customers accounted for 35% of net revenue in the aggregate. For the nine months ended September 30, 2020, one customer accounted for 16% of net revenue. For the three months ended September 30, 2019, one customer accounted for 11% of net revenue. For the nine months ended September 30, 2019, no single customer accounted for 10% or more of net revenue.

As of September 30, 2020, three customers each represented 17%, 16% and 16% of net accounts receivable, respectively. As of December 31, 2019, two customers represented 18% and 11% of net accounts receivable, respectively.

As of September 30, 2020 and December 31, 2019, receivables from customers in countries other than the United States represented 93% and 94%, respectively, of net accounts receivable.

The Company is currently evaluating the collectability of certain accounts receivable totaling $17.1 million that are due from a customer with a favorable payment history, located in India, that are past due under the original sales terms. It is difficult to determine when this receivable will be collected and the ultimate amount to be collected. The Company is actively working with the customer to arrange payment. The Company is currently unable to determine whether any loss will ultimately occur in connection with the resolution of this matter and has not accrued any loss in the accompanying unaudited condensed consolidated financial statements based on its current expectations regarding the collectability of the receivable. Management will continue to evaluate the collectability of this receivable as more information becomes available.

(g)

Business Combinations

The Company allocates the fair value of purchase consideration to the tangible and identifiable intangible assets acquired and liabilities assumed 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.

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.

(h)

Defined Benefit Plans and Plan Assumptions

The Company provides certain defined benefit pension plans to employees in Germany and Japan. Pension accounting is intended to reflect the recognition of future benefit costs over the employees' average expected future service to the Company based on the terms of the plans and investment and funding decisions. To estimate the impact of these future payments and the Company’s decisions concerning funding of these obligations, the Company is required to make assumptions using actuarial concepts within the framework of U.S. GAAP. The critical assumption is the discount rate and other important assumptions include expected future salary increases, expected future increases to benefit payments, expected retirement dates, employee turnover, retiree mortality rates and portfolio composition. The Company evaluates these assumptions at least annually, or more frequently when certain qualifying events occur, such as a significant change in interest rates.

(i)

Recent Accounting Pronouncements

In June 2016, FASB issued ASU 2016-13, Financial Instruments - Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments, which requires the Company to measure and recognize expected credit losses for financial assets held and not accounted for at fair value through net income. In November 2018, April 2019 and May 2019, the FASB issued ASU No. 2018-19, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, ASU No. 2019-04, Codification Improvements to Topic 326, Financial Instruments - Credit Losses, and ASU No. 2019-05, Financial Instruments - Credit Losses (Topic 326): Targeted Transition Relief, which provided additional implementation guidance on the previously issued ASU. The updated guidance is effective for the Company on January 1, 2022, and requires a modified retrospective adoption method. Early adoption is permitted. The Company is currently assessing the potential impact of adopting this new guidance on its condensed consolidated financial statements.

In August 2018, the FASB issued ASU 2018-14, Disclosure Framework-Changes to the Disclosure Requirements for Defined Benefit Plans, which amends ASC 715 to add, remove, and clarify disclosure requirements related to defined benefit pension and other postretirement plans. The updated guidance is effective for the Company on January 1, 2021, with early adoption permitted. The Company is currently assessing the potential impact of adopting this new guidance but does not expect adoption to have a material impact on the Company’s consolidated financial statements.

In November 2019, the FASB issued ASU 2019-08, Compensation - Stock Compensation (ASC 718). This ASU requires an entity measure and classify share-based payment awards granted to a customer by applying the guidance in ASC 718. The amount of the share-based payment award that is recorded as a reduction of the transaction price is required to be measured at the grant-date fair value in accordance with ASC 718. The Company adopted this guidance as of January 1, 2020. There was no material impact on the Company’s consolidated financial statements or disclosures resulting from the adoption of this standard.

In August 2018, the FASB issued ASU 2018-15, Intangibles - Goodwill and Other Internal-Use Software - Customer's Accounting for Implementation Costs Incurred in a Cloud Computing Arrangement. The update reduces complexity for the accounting for costs of implementing a cloud computing service arrangement and aligns the requirements for capitalizing implementation costs incurred in a hosting arrangement that is a service contract with the requirements for capitalizing implementation costs incurred to develop or obtain internal-use software. The standard is effective for annual and interim periods beginning after December 15, 2019, and retrospective or prospective application is permitted. The Company adopted this guidance as of January 1, 2020. There was no material impact on the Company’s consolidated financial statements or disclosures resulting from the adoption of this standard.

In January 2017, FASB issued ASU 2017-04, Simplifying the Test for Goodwill Impairment, which removes Step 2 of the goodwill impairment test, which requires a hypothetical purchase price allocation. A goodwill impairment will now be the amount by which a reporting unit’s carrying value exceeds its fair value, not to exceed the carrying amount of goodwill. The Company adopted this guidance as of January 1, 2020. There was no material impact on the Company’s consolidated financial statements or disclosures, resulting from the adoption of this standard.

On August 28, 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820), which removes, modifies, and adds certain disclosure requirements related to fair value measurements in ASC 820. The Company adopted this guidance as of January 1, 2020. There was no material impact on the Company’s consolidated financial statements or disclosures, resulting from the adoption of this standard.

In December 2019, the FASB issued ASU 2019-12: Simplifying the Accounting for Income Taxes (Topic 740), which removes certain exceptions to the general principles in Topic 740 and improves consistent application of and simplifies GAAP for other areas of Topic 740 by clarifying and amending existing guidance. This ASU is effective for fiscal years beginning after December 15, 2020, and interim periods within those fiscal years, with early adoption permitted. The Company is evaluating the effect of adopting this new accounting standard but does not expect adoption to have a material impact on the Company's consolidated financial statements or disclosures.

(2)	Business Combination

Keymile Acquisition

On January 3, 2019, ZTI Merger Subsidiary III Inc., a Delaware corporation and a wholly owned subsidiary of the Company (“ZTI”), acquired all of the outstanding shares of Keymile GmbH (“Keymile”), a limited liability company organized under the laws of Germany, from Riverside KM Beteiligung GmbH, a limited liability company organized under the laws of Germany, pursuant to a share purchase agreement (the “Keymile Acquisition”) for a final adjusted acquisition price of $9.3 million. Following the closing of the acquisition, Keymile became a wholly owned subsidiary of the Company.

(3)	Fair Value Measurement

The Company utilizes a fair value hierarchy that is intended to increase consistency and comparability in fair value measurements and related disclosures. The fair value hierarchy is based on inputs to valuation techniques that are used to measure fair value that are either observable or unobservable. Observable inputs reflect assumptions market participants would use in pricing an asset or liability based on market data obtained from independent sources while unobservable inputs reflect a reporting entity’s pricing based upon their own market assumptions. The fair value hierarchy consists of the following three levels:

Level 1

Inputs are quoted prices in active markets for identical assets or liabilities.

Level 2

Inputs are quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable and market-corroborated inputs which are derived principally from or corroborated by observable market data.

Level 3

Inputs are derived from valuation techniques in which one or more significant inputs or value drivers are unobservable.

The following financial instruments are not measured at fair value on the Company’s condensed consolidated balance sheet as of September 30, 2020 and December 31, 2019, but require disclosure of their fair values: cash and cash equivalents, restricted cash, accounts and other receivables, accounts payable, accrued liabilities, lease liabilities and debt. The carrying values of financial instruments such as cash and cash equivalents, restricted cash, accounts and other receivables, accounts payable and accrued liabilities approximate their fair values based on their short-term nature. The carrying value of the Company's lease liabilities and debt approximates their fair values based on the current rates available to the Company for debt of similar terms and maturities.

(4)	Cash, Cash Equivalents and Restricted Cash

As of September 30, 2020 and December 31, 2019, the Company's cash and cash equivalents consisted of financial deposits. Restricted cash consisted primarily of cash restricted for performance bonds, warranty bonds and collateral for borrowings, and Long-term restricted cash is included in other assets. Long-term restricted cash was $0.2 million as of September 30, 2020 and December 31, 2019.

(5)	Balance Sheet Details

Balance sheet detail as of September 30, 2020 and December 31, 2019 is as follows:

Inventories consisted of the following (in thousands):

	September 30, 2020		December 31, 2019
Raw materials	$	14,940	$	15,774
Work in process		2,876		1,458
Finished goods		26,083		18,207
Total inventories	$	43,899	$	35,439

Inventories provided as collateral for borrowings from Export-Import Bank of Korea amounted to $8.9 million and $6.7 million as of September 30, 2020 and December 31, 2019, respectively.

Property, plant and equipment consisted of the following (in thousands):

	September 30, 2020			December 31, 2019
Furniture and fixtures	$	11,548		$	10,803
Machinery and equipment		3,020			2,550
Leasehold improvements		4,315			4,267
Computers and software		2,298			1,990
Other		617			660
		21,798			20,270
Less: accumulated depreciation and amortization		(14,285	)		(13,130	)
Less: government grants		(343	)		(371	)
Total property, plant and equipment, net	$	7,170		$	6,769

Depreciation expense associated with property, plant and equipment for the three and nine months ended September 30, 2020 was $0.6 million and $1.6 million, respectively. Depreciation expense associated with property, plant and equipment for the three and nine months ended September 30, 2019 was $0.5 million and $1.5 million, respectively.

The Company receives grants from various government entities mainly to support capital expenditures. Such grants are deferred and are generally refundable to the extent the Company does not utilize the funds for qualifying expenditures. Once earned, the Company records the grants as a contra amount to the assets and amortizes such amount over the useful lives of the related assets as a reduction to depreciation expense.

(6)	Goodwill and Intangible Assets

Goodwill was as follows (in thousands):

	September 30, 2020			December 31, 2019
Gross carrying amount	$	4,980		$	4,980
Less: accumulated impairment		(1,003	)		(1,003	)
Goodwill, net	$	3,977		$	3,977

As of September 30, 2020 and December 31, 2019, the net carrying value of goodwill is all attributable to the Company’s US reporting unit. As of March 31, 2020, the Company performed a goodwill impairment assessment for the US reporting unit, due to operating losses incurred by the US reporting unit during the first quarter of 2020 amid the worldwide effects of the COVID-19 pandemic. The fair value of the US reporting unit was estimated using an equal weighting of the guideline company and discounted cash flow methods.

As of September 30, 2020, no indicators of impairment were identified regarding goodwill and intangible assets for the US reporting unit.

The Company did not recognize any impairment of goodwill and intangible assets during the three and nine months ended September 30, 2020 or 2019.

Intangible assets consisted of the following (in thousands):

	September 30, 2020
	Gross Carrying Amount		Accumulated Amortization			Net
Developed technology	$	8,218	$	(4,304	)	$	3,914
Customer relationships		8,956		(3,440	)		5,516
Trade name		1,407		(493	)		914
Total intangible assets, net	$	18,581	$	(8,237	)	$	10,344

	December 31, 2019
	Gross Carrying Amount		Accumulated Amortization			Net
Developed technology	$	7,994	$	(3,027	)	$	4,967
Customer relationships		8,795		(2,458	)		6,337
Trade name		1,346		(269	)		1,077
Total intangible assets, net	$	18,135	$	(5,754	)	$	12,381

Amortization expense associated with intangible assets for the three and nine months ended September 30, 2020 was $0.9 million and $2.3 million, respectively. Amortization expense associated with intangible assets for the three and nine months ended September 30, 2019 was $0.9 million and $1.8 million, respectively.

The following table presents the future amortization expense of the Company’s intangible assets as of September 30, 2020 (in thousands):


Remainder of 2020	$	798
2021		2,988
2022		2,580
2023		2,580
2024		524
Thereafter		874
Total	$	10,344

Weighted average remaining life:
Developed technology	2.9 years
Customer relationships	4.7 years
Trade name	3.3 years

(7)

Debt

The following tables summarize the Company’s debt (in thousands):

	September 30, 2020
	Short-term		Long-term			Total
Bank, Trade Facilities and Secured Borrowings - Foreign Operations	$	23,341	$	—		$	23,341
Related Party		—		28,167			28,167
		23,341		28,167			51,508
Less: unamortized deferred financing costs		—		(15	)		(15	)
	$	23,341		28,152		$	51,493

	December 31, 2019
	Short-term			Long-term			Total
PNC Credit Facilities	$	2,500		$	10,625		$	13,125
Bank and Trade Facilities - Foreign Operations		15,779			—			15,779
Related Party		—			9,096			9,096
		18,279			19,721			38,000
Less: unamortized deferred financing costs on the PNC Credit Facilities		(795	)		(688	)		(1,483	)
	$	17,484		$	19,033		$	36,517

The future principal maturities of our term loans for each of the next five years are as follows (in thousands):

Year ended December 31, 2020	$	5,940
2021		17,401
2022		28,167
2023		—
2024		—
Total	$	51,508

Bank, Trade Facilities and Secured Borrowings - Foreign Operations

On June 1, 2020, DZS Japan entered into an assignment agreement with JECC Corporation to factor 1,258,822,828 YEN (approximately $11.6 million) of accounts receivables from one of its customers. JECC assessed a discount equivalent to 5,964,328 YEN (approximately $0.05 million) (or approximately 0.474% of the amount factored, with a stated factoring rate of 1.575% based on the days remaining from factoring to expected receivable collection). DZS Japan received 1,252,858,500 YEN (approximately $11.65 million) on June 19, 2020. In accordance with ASC 860, Transfers and Servicing of Financial Assets, this agreement is accounted for as a secured borrowing. The expected collection of the underlying accounts receivable is before the end of 2020. As of September 30, 2020, the secured borrowing balance was $5.9 million.

Certain of the Company's 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 as they mature 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 September 30, 2020 and December 31, 2019, the Company had an aggregate outstanding balance of $23.3 million and $15.8 million, respectively, under such financing arrangements. The maturity dates and interest rates per annum applicable to outstanding borrowings under these financing arrangements are listed in the tables below (amount in thousands).

September 30, 2020

Maturity Date

Denomination

Interest rate (%)

Amount

(in U.S.

dollars)

JECC Corporation

Secured borrowing

12/26/2020

JPN

1.575

5,940

Korea Development Bank

Term loan

8/10/2021

KRW

2.28

4,261

LGUPlus

Term loan

6/17/2021

KRW

1,704

Korea Development Bank

Credit facility

8/7/2021

USD

1.70 - 3.20

3,150

NongHyup Bank

Credit facility

9/30/2021

USD

1.90 - 2.00

1,148

The Export-Import Bank of Korea

Export development loan

5/4/2021

KRW

1.99

6,818

Industrial Bank of Korea

Credit facility

4/27/2021

USD

3.00 - 3.30

320

23,341

December 31, 2019

Maturity Date

Denomination

Interest rate (%)

Amount

(in U.S.

dollars)

NongHyup Bank

Credit facility

09/30/2020

USD

3.50 ~ 4.50

2,091

The Export-Import Bank of Korea

Export development loan

07/01/2020

KRW

2.75

5,182

Korea Development Bank

Term loan

08/08/2020

KRW

4,319

Korea Development Bank

Credit facility

08/07/2020

USD

3.00 ~ 3.15

2,460

LGUPlus

Term loan

06/17/2020

KRW

1,727

15,779

As of September 30, 2020 and December 31, 2019, the Company had $0.2 million and $0.8 million committed as security for letters of credit under the Company's $19.0 million credit facilities with certain foreign banks. As of September 30 2020, the Company had approximately $14.4 million available to draw under its credit facilities.

Related Party Debt

In February 2016, Dasan Network Solutions, Inc. (“DNS California”), a wholly-owned, direct subsidiary of the Company and the sole stockholder of Dasan Network Solutions, Inc. (“DNS Korea”), borrowed $1.8 million from Dasan Networks, Inc. (“DNI”) for capital investment with an interest rate of 4.6% per annum, payable annually. On February 27, 2019, in connection with the entry into the PNC Credit Facilities, the Company amended the terms of this loan to extend the repayment date to May 27, 2022. As of September 30, 2020, $1.8 million was outstanding.

In September 2016, the Company entered into a loan agreement with DNI for a $5.0 million unsecured subordinated term loan facility. The term loan was scheduled to mature in September 2021 and was pre-payable at any time by the Company without premium or penalty. The interest rate under this facility was 4.6% per annum. In February 2019, the Company repaid the term loan in full plus accrued interest in connection with the entry into the PNC Credit Facilities, thereby terminating the loan agreement.

In March 2018, DNS Korea borrowed $5.8 million from DNI of which $4.5 million was repaid on August 8, 2018. The loan bears interest at a rate of 4.6%. On February 27, 2019, in connection with the entry into the PNC Credit Facilities, the Company and DNI amended the terms of this loan to extend the repayment date to May 27, 2022. As of September 30, 2020, $1.3 million was outstanding.

In December 2018, the Company entered into a Loan Agreement with DNI for a $6.0 million term loan with an interest rate of 4.6% per annum. On February 27, 2019, in connection with the entry into the PNC Credit Facilities, the Company and DNI amended the terms of the term loan to extend the repayment date until May 27, 2022 and to terminate any security granted to DNI with respect to such term loan. As of September 30, 2020, $6.0 million was outstanding.

The modifications resulting from the amendments described in the four preceding paragraphs were limited to the extension of the maturity dates and removal of the collateral on the outstanding term loans with DNI. There were no fees paid to DNI or external costs otherwise incurred in connection with these modifications.

In March 2020, DNS Korea, the Company’s wholly-owned, indirect subsidiary entered into a Loan Agreement with DNI (the “March 2020 DNI Loan”). The March 2020 DNI Loan was negotiated and approved on behalf of the Company and its subsidiaries by a special committee of the Board of Directors of the Company (the “Special Committee”) consisting of directors determined to be independent from DNI. The March 2020 DNI Loan consists of a term loan in the amount of KRW 22.4 billion (approximately $18.5 million) with interest payable semi-annually at an annual rate of 4.6% and maturing on March 11, 2022. No principal payments are due on the March 2020 DNI Loan until the maturity date, but DNS Korea may prepay the loan, or a portion thereof, without penalty. As of September 30, 2020, $19.1 million was outstanding.

As security for the March 2020 DNI Loan (and other existing loans between DNI and DNS Korea and/or DNS California), (i) DNS California agreed to pledge the outstanding shares of DNS Korea to DNI and (ii) DNS Korea granted a security interest in its personal property assets, accounts receivable and intellectual property assets to DNI. The March 2020 DNI Loan includes certain covenants consisting of financial reporting obligations, a maintenance covenant whereby DNS Korea agreed to maintain a minimum stockholders’ equity value in an amount equal to or greater than KRW 43.3 billion (approximately $35.8 million), and customary events of default. If an event of default occurs and is not remedied within the applicable cure period, DNI will be entitled to take various actions, including requiring the immediate repayment of all outstanding amounts under the March 2020 DNI Loan and selling the shares or assets of DNS Korea.

DNS Korea loaned the funds borrowed under the March 2020 DNI Loan to the Company, and the Company utilized a portion of such funds to repay in full and terminate the PNC Credit Facilities.

As of September 30, 2020, the Company had borrowings of $28.2 million outstanding from related parties. The outstanding balance at September 30, 2020 consisted of the March 2020 DNI Loan of KRW 22.4 billion (approximately $19.1 million), a $6.0 million unsecured subordinated term loan facility which matures in March 2022, a $1.8 million loan for capital investment which matures in May 2022, and KRW 1.5 billion (approximately $1.3 million) outstanding under a secured loan from DNS Korea which matures in May 2022. All four loans bear interest at a rate of 4.6% per annum.

Interest expense on these related party borrowings was $0.3 million and $0.8 million for the three and nine months ended September 30, 2020, respectively. Interest expense on these related party borrowings was $0.1 million and $0.3 million for the three and nine months ended September 30, 2019, respectively.

PNC Credit Facilities

On February 27, 2019, the Company and ZTI (collectively, the “Borrowers”), and certain direct and indirect subsidiaries of the Borrowers, as guarantors, entered into a Revolving Credit, Term Loan, Guaranty and Security Agreement (the “Domestic Credit Agreement”) and an 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”) and Citibank, N.A. as lenders, and PNC as agent for the lenders (the “PNC Credit Facilities”), which replaced the Company’s former senior secured credit facilities with Wells Fargo Bank (the “Former WFB Facility”). We refer to such transactions and the agreements referenced above as the “PNC Credit Facilities.”

The PNC Credit Facilities provided 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 was able to borrow on the revolving line of credit at any time was based on eligible accounts receivable and other conditions, less certain reserves. Borrowings under the PNC Credit Facilities bore interest at a floating rate equal to either the PNC prime rate or the LIBOR rate for the applicable period, plus a margin that was based on the type of advance.

The Company used a portion of the funds borrowed from the term loan under the PNC Credit Facilities to (i) repay $5.0 million of 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 collateralize $3.6 million in outstanding letters of credit under the Former WFB Facility, and (iii) repay $5.6 million in short-term debt in Korea and Japan. The Company’s obligations under the PNC Credit Facilities were secured by substantially all of the personal property assets of the Company and its subsidiaries that were co-borrowers or guarantors under the PNC Credit Facilities, including their intellectual property.

The PNC Credit Facilities had a three-year term and was scheduled to mature on February 27, 2022. The PNC Credit Facilities contemplated repayment of the term loan in quarterly installments over the term of the loan, with the balance of the term loan and revolving line of credit due at maturity.

As of December 31, 2019, the Company had $13.1 million in outstanding term loan borrowings under the PNC term loan, and no outstanding borrowings under the revolving line of credit. The interest rate on the term loan was 8.12% at December 31, 2019.

On March 26, 2020, the Company paid the outstanding term loan borrowings in full and terminated the PNC Credit Facilities. In association with this debt repayment, the Company recorded a loss on extinguishment of debt of $1.4 million during the three months ended March 31, 2020.

(8)	Defined Benefit Plans

The Company sponsors defined benefit plans for its employees in Germany and Japan. Defined benefit plans provide pension benefits based on compensation and years of service. The Germany plans were frozen as of September 30, 2003 and have not been offered to new employees after that date. The Company has recorded the underfunded status as of September 30, 2020 and December 31, 2019, respectively, as a long-term liability on the unaudited condensed consolidated balance sheets. The accumulated benefit obligation for the plans was $18.0 million and $17.7 million as of September 30, 2020 and December 31, 2019, respectively.

Periodic benefit costs were as follows (in thousands):

	Three months ended September 30,				Nine months ended September 30,
	2020		2019		2020		2019
Interest costs	$	50	$	43	$	127	$	129
Net amortization costs		—		—		10		—
Period costs	$	50	$	43	$	137	$	129

As of June 30, 2020, the Company performed a voluntary interim measurement of the plan obligations, due to a significant decrease in the discount rate since the measurement date on March 31, 2020, and recorded an actuarial loss

on pension plan of $1.2 million, as reflected on the unaudited condensed consolidated statement of comprehensive (loss) income during the three months ended June 30, 2020. No such remeasurements were performed as of September 30, 2020.

The Company holds life insurance contracts, with the Company as beneficiary, in the amount of $3.3 million as of September 30, 2020, related to individuals under the pension plans. These insurance contracts are classified as other assets on the Company’s consolidated balance sheet. The Company intends to use any proceeds from these policies to fund the pension plans. However, since the Company is the beneficiary on these policies, these assets have not been designated pension plan assets.

The weighted average assumptions used in determining the benefit obligation related to the plans are as follows:

		September 30, 2020			December 31, 2019
Discount rate		0.9%			0.9%

(9)	Non-Controlling Interests

Non-controlling interests were as follows (in thousands):

	Nine Months Ended September 30,
	2019
Beginning non-controlling interests	$	615
Net income attributable to non-controlling interests		194
Purchase of noncontrolling interest in subsidiary		(823	)
Foreign currency translation adjustments (OCI)		14
Ending non-controlling interests	$	—

On July 31, 2019, the Company acquired the remaining 30.94% non-controlling interest of Dasan Network Solutions Japan, Inc. (“DZS Japan”).

(10)	Related Party Transactions

Related Party Debt

As of September 30, 2020 and December 31, 2019, the Company had $28.2 million and $9.1 million, respectively, outstanding from related party borrowings from DNI. See Note 7 Debt for further information about the Company’s related party debt.

Other Related Party Transactions

Sales, cost of revenue, manufacturing (included in cost of revenue), research and product development, selling, marketing, general and administrative, interest expense and other expenses to and from related parties were as follows (in thousands) for the three months ended September 30, 2020 and 2019:

		Three Months Ended September 30, 2020
Counterparty	DNI ownership interest	Sales		Cost of revenue		Manufacturing (cost of revenue)*		Research and product development		Selling, marketing, general and administrative		Interest expense		Other expenses
DNI	N/A	$	552	$	408	$	-	$	-	$	906	$	324	$	93
		$	552	$	408	$	-	$	-	$	906	$	324	$	93

		Three Months Ended September 30, 2019
Counterparty	DNI ownership interest	Sales		Cost of revenue		Manufacturing (cost of revenue)*		Research and product development		Selling, marketing, general and administrative		Interest expense		Other expenses
DNI	N/A	$	232	$	190	$	—	$	—	$	966	$	104	$	84
Tomato Soft Ltd.**	100%		—		—		29		—		—		—		—
Tomato Soft (Xi'an) Ltd.**	100%		—		—		—		137		—		—		—
Chasan Networks Co., Ltd.**	100%		—		—		279		16		—		—		—
		$	232	$	190	$	308	$	153	$	966	$	104	$	84

		Nine Months Ended September 30, 2020
Counterparty	DNI ownership interest	Sales		Cost of revenue		Manufacturing (cost of revenue)*		Research and product development		Selling, marketing, general and administrative		Interest expense		Other expenses
DNI	N/A	$	2,077	$	1,713		—		—	$	2,047	$	763	$	263
DASAN Ventures	33%		—		—		20		81		55		—		—
		$	2,077	$	1,713	$	20	$	81	$	2,102	$	763	$	263

		Nine Months Ended September 30, 2019
Counterparty	DNI ownership interest	Sales		Cost of revenue		Manufacturing (cost of revenue)*		Research and product development		Selling, marketing, general and administrative		Interest expense		Other expenses
DNI	N/A	$	1,828	$	1,346	$	—	$	—	$	2,984	$	349	$	255
Tomato Soft Ltd.**	100%		—		—		88		—		—		—		—
Tomato Soft (Xi'an) Ltd.**	100%		—		—		—		392		—		—		—
Chasan Networks Co., Ltd.**	100%		—		—		837		55		—		—		—
J-Mobile Corporation**	90.47%		42		81		—		—		—		—		—
		$	1,870	$	1,427	$	925	$	447	$	2,984	$	349	$	255

Manufacturing costs represent product purchases from related parties and manufacturing activities performed by related parties, and are included in Cost of revenue on the unaudited consolidated statement of comprehensive (loss) income.

Entity no longer a related party as of September 30, 2020.

The Company has entered into sales agreements with DNI and certain of its subsidiaries. Sales and cost of revenue to DNI, DASAN France, DASAN INDIA Private Limited, and D-Mobile, represent finished goods produced by the Company that are sold to these related parties who sell the Company's products in Korea, France, India and Taiwan, respectively.

The Company has entered into an agreement with CHASAN Networks Co., Ltd. to provide manufacturing and research and development services for the Company. Under the agreement with CHASAN Networks., Ltd., the Company is charged a cost plus 7% fee for the manufacturing and development of certain deliverables.

The Company has entered into an agreement with Tomato Soft Ltd, a wholly owned subsidiary of DNI, to provide manufacturing and research and development services for the Company.

The Company has entered into an agreement with Tomato Soft (Xi'an) Ltd. to provide research and development services for the Company. Under the agreement with Tomato Soft (Xi'an) Ltd., the Company is charged an expected annual fee of $0.8 million for the development of certain deliverables.

On September 9, 2016, DZS acquired DNS California, through the merger of a wholly owned subsidiary of Zhone Technologies, Inc. with and into DNS California, with DNS California surviving as the Company’s wholly-owned subsidiary (the “Merger”). Prior to the Merger, as DNS California was then a wholly owned subsidiary of DNI, DNI had sales agreements with certain customers on DNS California's behalf. Since the Merger, due to these prior sales agreements, the Company has entered into an agreement with DNI in which DNI acts as a sales channel to these customers. Sales to DNI necessary for DNI to fulfill agreements with its customers are recorded net of royalty fees in related party revenue.

The Company shares office space with DNI and certain of DNI's subsidiaries. Prior to the Merger, DNS California, then a wholly owned subsidiary of DNI, shared human resources, treasury and other administrative support with DNI. As such, the Company entered into certain service sharing agreements with DNI and certain of its subsidiaries for the shared office space and shared administrative services. Expenses related to rent and administrative services are allocated to the Company based on square footage occupied and headcount, respectively.

Other expenses to related parties represent expenses to DNI for its payment guarantees relating to the Company's borrowings. The Company pays DNI a guarantee fee which is calculated as 0.9% of the guaranteed amount. Refer to Note 14 Commitments and Contingencies for more details about obligations guaranteed by DNI.

Balances of Receivables and Payables with Related Parties

Balances of receivables and payables arising from sales and purchases of goods and serviced with related parties as of September 30, 2020 and December 31, 2019 were included in the following balance sheet captions on the unaudited consolidated balance sheet, as follows (in thousands):

		As of September 30, 2020
Counterparty	DNI ownership interest	Account receivables		Other receivables		Deposits for lease *		Loan Payable		Accounts payable		Other payables		Accrued and other liabilities
DNI	N/A	$	898	$	247	$	700	$	28,152	$	-	$	979	$	11
		$	898	$	247	$	700	$	28,152	$	—	$	979	$	11

		As of December 31, 2019
Counterparty	DNI ownership interest	Account receivables		Other receivables		Deposits for lease*		Loan Payable		Accounts payable		Other payables		Accrued and other liabilities
DNI	N/A	$	—	$	32	$	709	$	9,096	$	—	$	1,475	$	119
Tomato Soft Ltd.**	100%		—		—		—		—		—		10		—
Tomato Soft (Xi'an), Ltd**	100%		—		—		—		—		—		45		—
Chasan Networks Co., Ltd.**	100%		—		—		—		—		96		—		—
		$	—	$	32	$	709	$	9,096	$	96	$	1,530	$	119

The related party receivables and payables balances are reflected in the respective balance sheet captions noted in the table headers above, other than:

Deposits for leases are included in Other assets in the unaudited condensed consolidated balance sheets as of September 30, 2020 and December 31, 2019.

Entity no longer a related party as of September 30, 2020.

(11)

Common Stock

On May 20, 2019, the Company completed a public offering of 4,717,949 shares of its common stock, inclusive of 615,384 shares sold upon full exercise of the underwriters’ option to purchase additional shares of common stock, at a price to the public of $9.75 per share. All shares of common stock were sold by the Company. The total gross proceeds from the offering, before deducting underwriting discounts, commissions and offering expenses, were approximately $46.0 million. After deducting the underwriters’ discount, commissions and other offering expenses, the net proceeds were approximately $42.5 million.

(12)	Net Income Per Share Attributable to DZS Inc.

Basic net income per share attributable to DZS Inc. is computed by dividing the net income attributable to DZS Inc. for the period by the weighted average number of shares of common stock outstanding during the period. The calculation of diluted net income per share attributable to DZS Inc. gives effect to common stock equivalents; however, potential common stock equivalents are excluded if their effect is antidilutive. Potential common stock equivalents are composed of incremental shares of common stock issuable upon the exercise of stock options and the vesting of restricted stock units. In periods when a net loss is reported, all common stock equivalents are excluded from the calculation because they would have an anti-dilutive effect, meaning the loss per share would be reduced. Therefore, in periods when a loss is reported, basic and dilutive loss per share are the same.

The following table is a reconciliation of the numerator and denominator in the basic and diluted net income (loss) per share calculation (in thousands, except per share data) for the three and nine months ended September 30, 2020 and 2019:

	Three Months Ended September 30,						Nine Months Ended September 30,
	2020			2019			2020			2019
Net income (loss) attributable to DZS Inc.	$	(115	)	$	(4,033	)	$	(9,042	)	$	(3,263	)
Weighted average number of shares outstanding:
Basic		21,592			21,384			21,532			18,732
Effect of dilutive securities: *
Stock options, restricted stock units and share awards		—			—			—			—
Diluted		21,592			21,384			21,532			18,732
Net income (loss) per share attributable to DZS Inc.:
Basic	$	(0.01	)	$	(0.19	)	$	(0.42	)	$	(0.17	)
Diluted	$	(0.01	)	$	(0.19	)	$	(0.42	)	$	(0.17	)

* For the three and nine months ended September 30, 2020, approximately 160 and 302 anti-dilutive shares were excluded from the diluted net loss per share calculation, respectively.

(13)

Leases

The Company leases certain properties and buildings (including manufacturing facilities, warehouses, and office spaces) and equipment under various arrangements which provide the right to use the underlying asset and require lease payments for the lease term. The Company’s lease portfolio consists of operating leases which expire at various dates through 2027.

On August 1, 2020, the Company completed its relocation of its corporate headquarters from Oakland, California to Plano, Texas and establish a new U.S.-based Engineering Center of Excellence in Plano. On February 24, 2020, in connection with the planned relocation of the Company headquarters to Plano, the Company entered into two separate sublease agreements for office and laboratory space in Plano, TX. The commencement date of these leases occurred in the second quarter of 2020. On the commencement date of these leases, the Company recognized an aggregate of approximately $1.3 million in right-of-use assets and operating lease liabilities in connection with these leases. In September 2020, the Company entered into a lease agreement for additional office space at its headquarters in Plano, TX. The commencement date is expected to occur during the three months ended December 31, 2020.

The components of lease expense were as follows (in thousands):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
Operating lease cost	$	1,335	$	1,064	$	4,024	$	3,327
Variable lease cost		159		194		473		520
Short-term lease cost		93		—		279		—
Total net lease cost	$	1,587	$	1,258	$	4,776	$	3,847

Supplemental cash flow information related to the Company’s operating leases was as follows (in thousands):

	Three Months Ended September 30,				Nine Months Ended September 30,
	2020		2019		2020		2019
Operating cash outflows from operating leases	$	1,357	$	1,265	$	3,903	$	3,888
ROU assets obtained in exchange for operating lease obligations	$	-	$	35	$	1,364	$	35

The following table presents the weighted average remaining lease term and weighted average discount rates related to the Company’s operating leases as of September 30, 2020 and December 31, 2019, respectively:

	September 30, 2020			December 31, 2019
Weighted average remaining lease term	4.8 years			5.5 years
Weighted average discount rate		5.7	%		5.5	%

The following table presents the maturity of the Company’s operating lease liabilities as of September 30, 2020 (in thousands):

Remainder of 2020	$	1,601
2021		5,283
2022		4,859
2023		4,424
2024		3,958
Thereafter		3,720
Total operating lease payments		23,845
Less: imputed interest		(3,161	)
Total operating lease liabilities	$	20,684

(14)	Commitments and Contingencies

Warranties

The Company accrues warranty costs based on historical trends for the expected material and labor costs to provide warranty services. Warranty periods are generally one to five years from the date of shipment. The following table reconciles changes in the Company’s accrued warranties and related costs included in accrued and other liabilities (in thousands) for the nine months ended September 30, 2020 and 2019:

	Nine Months Ended September 30,
	2020			2019
Beginning balance	$	1,610		$	1,319
Assumed balance from Keymile		—			230
Charged to cost of revenue		341			732
Claims and settlements		(1,026	)		(782	)
Foreign exchange impact		(15	)		(27	)
Ending balance	$	910		$	1,472

Performance Bonds

In the normal course of operations, from time to time, the Company arranges for the issuance of various types of surety bonds, such as bid and performance bonds, which are agreements under which the surety company guarantees that the Company will perform in accordance with contractual or legal obligations. As of September 30, 2020, the Company had $7.4 million of surety bonds guaranteed by third parties.

Purchase Commitments

The Company’s inventory purchase commitments typically allow for cancellation of orders 30 days in advance of the required inventory availability date as set by the Company at time of order. However, the Company has agreements with various contract manufacturers which include non-cancellable inventory purchase commitments. The amount of non-cancellable purchase commitments outstanding, net of reserve, was $4.7 million as of September 30, 2020.

Royalties

The Company has certain royalty commitments associated with the shipment and licensing of certain products. Royalty expense is generally based on a dollar amount per unit shipped or a percentage of the underlying revenue and is recorded in cost of revenue. For the three months ended September 30, 2020 and 2019, the Company incurred $1.6 million and $0.1 million of royalty expense. For the nine months ended September 30, 2020 and 2019, the Company incurred $2.7 million and $0.5 million of royalty expense.

Payment Guarantees provided by Third Parties and DNI

The following table sets forth payment guarantees of the Company's indebtedness and other obligations as of September 30, 2020 that have been provided by third parties and DNI. DNI owns approximately 44.0% of the outstanding shares of the Company's common stock. The amount guaranteed exceeds the principal amounts of outstanding obligations due to collateral requirements by the banks.

Guarantor	Amount Guaranteed (in thousands)		Description of Obligations Guaranteed
DNI	$	8,400	Credit facility from Industrial Bank of Korea
DNI		2,045	Purchasing Card from Industrial Bank of Korea
DNI		8,400	Credit facility from Korea Development Bank
DNI		5,113	Borrowings from Korea Development Bank
DNI		6,000	Credit facility from NongHyup Bank
DNI		5,699	Borrowings from Export-Import Bank of Korea
DNI		3,000	Payment Guarantee from Shinhan Bank
DNI		1,636	Backed Loan from Shinhan Bank
Seoul Guarantee Insurance Co.		4,353	Performance Bond, Warranty Bond, etc. (*)
Industrial Bank of Korea		269	Bank Guarantee
Korea Development Bank		3,283	Letter of Credit
NongHyup Bank		1,139	Letter of Credit
Woori Bank		509	Bank Guarantee
Shinhan Bank		269	Purchasing Card
Shinhan Bank		1,418	Payment Guarantee
PNC		4,860	Collateral for Standby Letter of Credit
Citibank		291	Collateral for Standby Letter of Credit
Shinhan Bank Vietnam		12	Contract performance guarantee for VINITIS
Shinhan Bank Vietnam		44	Contract warranty obligation guarantee for MPI
	$	56,740

*The Company is generally responsible for warranty liabilities for a period of two years with respect to major product sales and has, therefore, contracted for surety insurance for a portion of the warranty liabilities.

Litigation

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, the Company records an accrual for legal contingencies that it has determined to be probable to the extent that the amount of the loss can be reasonably estimated. The Company does not expect that the ultimate costs to resolve these matters will have a material adverse effect on its consolidated financial position, results of operations or cash flows. 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 and cash flows of the reporting period in which the ruling occurs, or future periods.

(15)	Income Taxes

Income tax expense for the three and nine months ended September 30, 2020 was approximately $1.6 million and $2.5 million respectively, on pre-tax income of $1.5 million and pretax loss of $6.6 million, respectively. Income tax expense for the three and nine months ended September 30, 2019 was approximately $0.3 million and $1.1 million respectively, on pre-tax loss of $3.7 million and $2.0 million, respectively.

As of September 30, 2020, the income tax rate varied from the United States statutory income tax rate primarily due to valuation allowances in the United States and taxable income generated by the Company’s wholly-owned foreign subsidiaries.

The total amount of unrecognized tax benefits, including interest and penalties, at September 30, 2020 was $1.0 million. There were no significant changes to unrecognized tax benefits during the three and nine months ended September 30, 2020 and 2019. The Company does not anticipate any significant changes with respect to unrecognized tax benefits within the next twelve months.

On March 27, 2020, the “Coronavirus Aid, Relief and Economic Security (CARES) Act” was signed into law. The Act includes provisions relating to refundable payroll tax credits, deferment of the employer portion of certain payroll taxes, net operating loss carryback periods, alternative minimum tax credit refunds, modifications to the net interest deduction limitations and technical corrections to tax depreciation methods for qualified improvement property. The Company has analyzed the impact of these changes and concluded that none of the changes has a significant impact on the Company's tax positions. In addition, in May 2020, the U.S. House passed another proposed legislation, Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act in response to the COVID-19 pandemic, which includes expansion of unemployment benefits, additional individual stimulus checks, health care aids and payroll tax credits. In July 2020, the Senate Republicans also proposed Health, Economic Assistance, Liability Protection and Schools (HEALS) Act which includes the similar tax reliefs in respond to the COVID-19. The HEROES and HEALS Acts are currently under negotiations by the Congress but the Company does not expect any significant income tax impacts from the Acts. The Company utilized the payroll tax deferral which deferred cash payroll tax by $0.2 million and $0.5 million for the three and nine months ended September 30, 2020.

On June 29, 2020, the California Governor signed Assembly Bill 85 (“A.B. 85”), which now becomes California law. A.B. 85, which includes several tax measures, provides for a three-year suspension of the use of net operating losses for medium and large businesses and a three-year cap on the use of business incentive tax credits to offset no more than $5 million of tax per year. Generally, A.B. 85 suspends the use of net operating losses for taxable years 2020, 2021, and 2022 for taxpayers with taxable income of $1 million or more. Since the Company is not expected to generate California source taxable income of more than $1 million, no material impact is anticipated at this time.

(16)	Enterprise-Wide Information

The Company is 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. There are no segment managers who are held accountable for operations, operating results and plans for levels or components below the Company unit level. Accordingly, the Company is considered to be in a single reporting segment and operating unit structure. The Company’s chief operating decision maker is the Company’s Chief Executive Officer, who reviews financial information presented on a consolidated basis accompanied with disaggregated revenues by geographic region for purposes of making operating decisions and assessing financial performance.

The Company attributes revenue from customers to individual countries based on location shipped. Refer to Note 1(e) Revenue disaggregation information, for the required disclosures about geographical concentrations and revenue by products and services and geography.

The Company's property, plant and equipment, net of accumulated depreciation, were located in the following geographical areas (in thousands) as of September 30, 2020 and December 31, 2019:

	September 30, 2020		December 31, 2019
United States	$	2,911	$	2,809
Korea		2,445		2,020
Japan and Vietnam		996		1,074
Germany		800		842
Taiwan and India		18		24
	$	7,170	$	6,769

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

As used in this Quarterly Report on Form 10-Q, unless the context suggests otherwise, the terms “DZS,” the “Company” “we,” “our” and “us” refer to DZS Inc. and its subsidiaries.

Forward-Looking Statements

This Quarterly Report on Form 10-Q, 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, the negative 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; our ability to satisfy our short- and long-term cash requirements; anticipated growth and trends in our business, industry or key markets; cost synergies, growth opportunities and other potential financial and operating benefits of the Merger and the acquisition of Keymile; future growth and revenues from our products; our plans and our ability to refinance or repay our existing indebtedness prior to the applicable maturity dates; our ability to access other capital to fund our future operations; future economic conditions and performance; the impact of the global outbreak of COVID-19; the impact of interest rate and foreign currency fluctuations; the impact of the completed relocation of our corporate headquarters to Texas; anticipated performance of products or services; competition; plans, objectives and strategies for future operations, including our pursuit or strategic acquisitions and our continued investment in research and development; 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. Although we believe that the assumptions underlying the forward-looking statements are reasonable, we can give no assurance that our expectations will be attained. Factors which could have a material adverse effect on our operations and future prospects or which could cause actual results to differ materially from our expectations include, but are not limited to:

•

the impact of the global COVID-19 pandemic on the Company’s business and operations, including as a result of travel bans related thereto, the health and wellbeing of our employees in affected areas, disruption of our supply chain and softening of demands for our products;

•

our ability to realize the anticipated cost savings, synergies and other benefits of the Merger and the acquisition of Keymile and any integration risks relating to the acquisition of Keymile;

•

our 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;

•

our ability to hire and retain key management and other personnel;

•

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, or delays in payments of accounts receivable 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 network 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; and

•

additional factors discussed in our Annual Report on Form 10-K for the year ended December 31, 2019 and from time to time in our other reports filed with the SEC.

You are urged to consider these factors carefully in evaluating the forward-looking statements herein and are cautioned not to place undue reliance on such forward-looking statements, which are qualified in their entirety by this cautionary statement.

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 operate in a single reporting segment. We research, develop, test, sell, manufacture and support communications equipment in five major areas: mobile transport, broadband access, switching and routing, connected premises and SDN (“Software Defined Networking”) Orchestration solutions:

•

Our mobile transport products provide a robust, manageable and scalable solution for mobile operators that enable them to upgrade their mobile fronthaul/backhaul systems and migrate to 5G and beyond. 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 Multiprotocol Label Switching (“MPLS”) interfaces and interoperate with other vendors in these networks.

•

Our broadband access products offer a variety of solutions for carriers and service providers to connect residential and business customers, either using high-speed fiber or leveraging 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.

•

Our switching and routing products provide a high-performance and manageable solution that bridges the gap from carrier access technologies to the core network. Our products support pure Ethernet switching as well as layer 3 IP and MPLS and are currently being developed for deployment as part of SDNs.

•

Our connected premises products are designed for high bandwidth services being deployed to the home or business. Our connected premises portfolio consists of indoor/outdoor Optical Network Terminal (“ONT”) gateways delivering best-in-class data throughout to support the most demanding Fiber To The X (“FTTx”) applications. The product feature set gives service providers an elegant migration path from legacy to softswitch architectures without replacing ONTs.

•

Our SDN Orchestration strategy is to develop tools and building blocks that will allow service providers 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 the hundreds of network elements in real time for more controlled and efficient provision of bandwidth and latency across the network. The migration move to SDN/Network Function Virtualization (“NFV”) will provide better service for end customers and a more efficient and cost-effective use of hardware resources for service providers.

Going forward, our key financial objectives include the following:

•

Increasing revenue while continuing to carefully control costs;

•

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

•

Minimizing consumption of our cash and cash equivalents.

As of September 30, 2020, we employed over 750 personnel 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.

RECENT DEVELOPMENTS

On August 24, 2020, our board approved an amendment to our Certificate of Incorporation to change our name from Dasan Zhone Solutions, Inc. to “DZS Inc.”. On August 26, 2020, we filed a Certificate of Amendment to our Restated Certificate of Incorporation with the Delaware Secretary of State reflecting the above action. The name change took effect upon filing. The Company’s trading symbol “DZSI” did not change.

Effective August 1, 2020, Charlie Vogt was appointed as the President and Chief Executive Officer of the DZS, Inc.. In addition, Mr. Vogt was elected as a new member of the Board, also effective August 1, 2020. In connection with Mr. Vogt’s appointment, Il Yung Kim ceased to serve as President and Chief Executive Officer of DZS, Inc. and as a member of the Board

effective July 31, 2020. Prior to joining the Company, Mr. Vogt was most recently President and Chief Executive Officer of ATX Networks, a leader in broadband access and media distribution, where he led the company through extensive transformation and growth since February 2018 and will remain a member of the board. From July 2013 to January 2018, Mr. Vogt served as President and Chief Executive Officer of Imagine Communications, where he directed the company through change as it evolved its core technology, including large-scale restructuring and rebranding and multiple technology acquisitions as he implemented a vision and growth strategy. Before joining Imagine Communications, Mr. Vogt was President and Chief Executive Officer of GENBAND (today known as Ribbon Communications), where he transformed the company from a startup to a global leader in voice over IP and real-time IP communications solutions. His professional career has also included leadership roles at Taqua (Tekelec), Lucent Technology (Nokia), Ascend Communications (Lucent), ADTRAN, Motorola and IBM.

On August 1, 2020, the Company completed the relocation of its corporate headquarters from California to Plano, Texas. In connection with the relocation, the Company entered into sublease agreements with Huawei Technologies, Inc. and Futurewei Technologies, Inc. to sublease an aggregate of approximately 16,300 square feet located at 5700 Tennyson Parkway, Plano, Texas. In September 2020, the Company entered into a lease agreement for approximately 10,300 square feet of additional office space at its headquarters in Plano, TX.

On June 1, 2020, DZS Japan, Inc. (“DZS Japan”) entered into an assignment agreement with JECC Corporation to factor 1,258,822,828 YEN (approximately $11.6 million) of accounts receivables from one of its customers. JECC assessed a discount equivalent to 5,964,328 YEN (approximately $0.05 million) (or approximately 0.474% of the amount factored, with a stated factoring rate of 1.575% based on the days remaining from factoring to expected receivable collection). DZS Japan received 1,252,588,500 YEN (approximately $11.65 million) on June 19, 2020. As of September 30, 2020, the secured borrowing balance was $5.9 million.

On March 5, 2020, Dasan Network Solutions, Inc. (“DNS Korea”) entered into a Loan Agreement with DNI, pursuant to which DNS Korea borrowed KRW 22.4 billion ($18.5 million) from DNI. DNS Korea subsequently loaned all of such borrowed funds to the Company, a portion of which were used to repay and terminate the PNC Credit Facilities.

RESULTS OF OPERATIONS

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

	Three Months Ended September 30,						Nine Months Ended September 30,
	2020			2019			2020			2019
Net revenue:
Third parties		99	%		100	%		99	%		99	%
Related parties		1	%		—			1	%		1	%
Total net revenue		100	%		100	%		100	%		100	%
Cost of revenue:
Products and services - third parties		69	%		68	%		67	%		66	%
Products and services - related parties		—			—			1	%		1	%
Amortization of intangible assets		1	%		1	%		—			1	%
Total cost of revenue		70	%		69	%		68	%		68	%
Gross profit		30	%		31	%		32	%		32	%
Operating expenses:
Research and product development		10	%		14	%		13	%		13	%
Selling, marketing, general and administrative		18	%		22	%		21	%		20	%
Amortization of intangible assets		—			1	%		—			1	%
Total operating expenses		28	%		37	%		34	%		34	%
Operating income (loss)		2	%		(6	)%		(2	)%		(2	)%
Interest income		—			1	%		0	%		—
Interest expense		—			(2	)%		(1	)%		(1	)%
Loss on extinguishment of debt		—			—			—			—
Other income (expense), net		—			1	%		—			1	%
Income (loss) before income taxes		2	%		(6	)%		(3	)%		(2	)%
Income tax provision		2	%		—			1	%		(1	)%
Net income (loss)		—			(6	)%		(4	)%		(1	)%
Net income (loss) attributable to non-controlling interest		—			—			—			—
Net income (loss) attributable to DZS Inc.		—			(6	)%		(4	)%		(1	)%

Net Revenue

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

	Three Months Ended September 30,										Nine Months Ended September 30,
	2020		2019		Increase/ (Decrease)			% change			2020		2019		Increase/ (Decrease)			% change
Products	$	88.9	$	66.4	$	22.5			34	%	$	197.8	$	214.9	$	(17.1	)		(8	)%
Services		5.0		5.1		(0.1	)		(2	)%		14.1		14.4		(0.3	)		(2	)%
Total	$	93.9	$	71.5	$	22.4			31	%	$	211.9	$	229.3	$	(17.4	)		(8	)%

For the three months ended September 30, 2020, product revenue increased by 34% or $22.5 million to $88.9 million from $66.4 million in the same period last year. The increase in product revenue during the period was primarily attributable to increased demand in broadband and mobile transport products. For the three months ended September 30, 2020, service revenue decreased by 2% or $0.1 million to $5.0 million from $5.1 million in the same period last year.

For the nine months ended September 30, 2020, product revenue decreased by 8% or $17.1 million to $197.8 million from $214.9 million in the same period last year. The decrease in product revenue during the period was primarily attributable to impacts from the worldwide COVID-19 pandemic, which resulted in disruptions to our supply chain, as well as decreased business operations by certain of our customers earlier in 2020. For the nine months ended September 30, 2020, service revenue decreased by 2% or $0.3 million to $14.1 million from $14.4 million in the same period last year.

Information about our net revenue for North America and international markets is summarized below (in millions):

	Three Months Ended September 30,										Nine Months Ended September 30,
	2020		2019		Increase/ (decrease)			% change			2020		2019		Increase/ (decrease)			% change
Revenue by geography:
United States	$	10.6	$	9.7	$	0.9			9	%	$	27.5	$	29.0	$	(1.5	)		(5	)%
Canada		1.3		1.1		0.2			24	%		4.4		3.0		1.4			49	%
Total North America		11.9		10.8		1.1			11	%		31.9		32.0		(0.1	)		0	%
Latin America		5.1		6.3		(1.2	)		(19	)%		12.1		18.8		(6.7	)		(36	)%
Europe, Middle East, Africa		19.9		15.8		4.1			26	%		47.5		59.4		(11.9	)		(20	)%
Korea		15.4		20.9		(5.5	)		(26	)%		39.1		55.7		(16.6	)		(30	)%
Japan		33.0		9.3		23.7			254	%		66.3		28.7		37.6			131	%
Other Asia Pacific		8.6		8.4		0.2			2	%		15.1		34.7		(19.6	)		(57	)%
Total International		82.0		60.7		21.3			35	%		180.1		197.3		(17.2	)		(9	)%
Total	$	93.9	$	71.5	$	22.4			31	%	$	212.0	$	229.3	$	(17.3	)		(8	)%

From a geographical perspective, the increase in net revenue for the three months ended September 30, 2020, was primarily attributable to increased demand in most regions, most notably Japan, and was largely attributed to increased demand in broadband and mobile transport products. From a geographical perspective, the decrease in revenue for the nine months ended September 30, 2020, by geography was mainly attributable to a decrease in almost all markets and was largely attributed to the impacts from the worldwide COVID-19 pandemic earlier in 2020.

International net revenue for the three months ended September 30, 2020 increased 35% or $21.3 million to $82.0 million from $60.7 million from the same period last year and represented 87% of total net revenue compared with 85% during the same period of 2019. International net revenue for the nine months ended September 30, 2020 decreased 9% or $17.2 million to $180.1 million from $197.3 million for the same period last year and represented 85% of total net revenue compared with 86% during the same period of 2019.

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 customers. 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 33% or $16.5 million to $65.8 million for the three months ended September 30, 2020, compared to $49.3 million for the same period in 2019. Total cost of revenue was 70% and 69% of net revenue for the three months ended September 30, 2020 and September 30, 2019, respectively. Total cost of revenue decreased 7% or $10.4 million to $144.0 million for the nine months ended September 30, 2020, compared to $154.4 million for the same period in 2019. Total cost of revenue was 68% of net revenue for the nine months ended September 30, 2020 and 2019, respectively.

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

Research and Product Development Expenses

Research and product development expenses decreased 10% or $1.0 million to $8.9 million for the three months ended September 30, 2020, compared to $9.9 million for the same period in 2019. Research and product development expenses were 10% and 14% of net revenue for the three months ended September 30, 2020 and 2019, respectively. Research and product development expenses decreased 9% or $2.6 million to $26.9 million for the nine months ended September 30, 2020 compared to $29.5 million for the same period in 2019. Research and product development expenses were 13% of net revenue for the

nine months ended September 30, 2020 and 2019, respectively. The decrease in research and development expenses were mainly attributable to the restructuring activities, and reduction in force, during 2019.

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 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.

Selling, marketing, general and administrative expenses increased 8% or $1.2 million to $16.9 million for the three months ended September 30, 2020, compared to $15.7 million for the same period in 2019. Selling, marketing, general and administrative expenses were 18% and 22% as a percentage of sales, for the three months ended September 30, 2020 and 2019, respectively. The increase in selling, general and administrative expenses for the three months ended September 30, 2020 compared to the same period in 2019 was largely the result of incremental sales commission compensation in the 2020 period, related to higher revenue, as well as to certain executive hires, and was offset by the impact of restructuring activities undertaken during the second half of 2019.

Selling, marketing, general and administrative expenses decreased 4% or $1.9 million to $43.8 million for the nine months ended September 30, 2020, compared to $45.7 million for the same period in 2019. Selling, marketing, general and administrative expenses were 21% and 20% of net revenue for the nine months ended September 30, 2020 and 2019, respectively. The decrease in selling, general and administrative expenses for the nine months ended September 30, 2020 compared to the same period in 2019 was largely the result of lower sales commission expense associated with lower revenues for the 2020 period, as well as the impact of restructuring activities undertaken during the second half of 2019.

Income Tax Provision

Income tax expense for the three and nine months ended September 30, 2020 was $1.6 million and $2.5 million, respectively, on pre-tax income of $1.5 million and pre-tax loss of $6.5 million, respectively. Income tax expense for the three and nine months ended September 30, 2019 was $0.3 million and $1.1 million, respectively, on pre-tax loss of $3.7 million and $2.0 million, respectively. For the three and nine months ended September 30, 2020, the effective income tax rate varied from the United States statutory income tax rate primarily due to valuation allowances in the United States and the mix of earnings generated by our wholly-owned foreign subsidiaries, including higher pre-tax income in Japan during the nine month ended September 30, 2020, as a result of increased revenue.

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) the impact of material transactions or events that we believe are not indicative of our core operating performance, such as merger and acquisition transaction costs, inventory valuation step-up amortization, purchase price adjustments, restructuring and other charges, goodwill impairment, bargain purchase gain, gain (loss) on sale of assets, impairment of long-lived assets or loss on debt extinguishment, any of which may or may not be recurring in nature. 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:

•

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

•

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

•

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

•

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

•

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

•

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

Because of these limitations, Adjusted EBITDA should not be considered in isolation or as a substitute for net income (loss) or any other performance measures calculated in accordance with 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.

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

	Three Months Ended September 30,						Nine Months Ended September 30,
	2020			2019			2020			2019
Net income (loss)	$	(115	)	$	(3,996	)	$	(9,042	)	$	(3,069	)
Add (less):
Interest expense, net		432			750			1,405			2,715
Income tax expense		1,619			289			2,452			1,098
Depreciation and amortization		1,386			1,343			3,935			4,110
Stock-based compensation		1,660			1,182			3,310			2,818
Headquarters relocation		35			—			35			—
Executive transition		1,383			—			1,383			—
Acquisition costs		—			—			—			337
Inventory step-up valuation amortization		—			175			—			577
Bargain purchase gain		—			—			—			(334	)
Loss on debt extinguishment		—			—			1,369			—
Adjusted EBITDA	$	6,400		$	(257	)	$	4,847		$	8,252

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

For a complete description of what we believe to be the critical accounting policies and estimates used in the preparation of our unaudited condensed consolidated financial Statements, refer to Note 1, Organization and Summary of Significant Accounting Policies, in the notes to our audited consolidated financial statements in our Annual Report on Form 10-K for the year ended December 31, 2019, as supplemented by Note 1, Organization and Summary of Significant Accounting Policies, in the notes to our unaudited condensed consolidated financial statements in Part I, Item 1 of this Quarterly Report on Form 10-Q.

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 following table summarizes the information regarding our cash and cash equivalents and working capital (in thousands):

	September 30, 2020		December 31, 2019
Cash and cash equivalents	$	31,307	$	28,747
Working capital		120,653		114,885

The Company had a net loss of $9.0 million for the nine months ended September 30, 2020 and a net loss of $13.3 million for the year ended December 31, 2019. Additionally, the Company incurred significant losses in years prior to 2019. As of September 30, 2020, the Company had an accumulated deficit of $38.3 million and working capital of $120.7 million.

In March 2020, as described below under the header Related Party Debt, we entered into a Loan Agreement with DNI, and used a portion of such funds to repay in full and terminate the Company’s existing credit facility with PNC Bank. In June 2020, we entered into an assignment agreement with a third party to factor accounts receivables from a customer, and we received approximately $11.6 million from this arrangement.

As of September 30, 2020, the Company had $31.3 million in cash and cash equivalents, which included $13.7 million held by its international subsidiaries; and $51.5 million in aggregate principal debt, of which $23.3 million was reflected in current liabilities.

If our liquidity proves to be insufficient, our business could suffer due to:

•

increased vulnerability to adverse economic conditions in our industry or the economy in general, including those conditions resulting from the ongoing COVID-19 pandemic;

•

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

•

limitations on our ability to plan for, or react to, changes in our business and industry; and

•

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

However, we continue 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. Based on our current plans and current business conditions, as of the date of this Quarterly Report on Form 10-Q, we believe that these measures along with our existing cash and cash equivalents will be sufficient to satisfy our anticipated cash requirements for at least the next twelve months from the date of this Quarterly Report on Form 10-Q.

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 (i) achieve forecasted results of operations, (ii) access funds under new borrowing arrangements and/or raise additional capital through sale of our common stock to the public, and (iii) effectively manage working capital requirements. If we cannot raise additional funds when we need or want them, our operations and prospects could be negatively affected. While we believe that we are likely to achieve forecasted results of operations if we are successful in implementing our business strategies, the impact of the COVID-19 pandemic provides great uncertainty with respect to our future operations, could result in a material decline in our operating cash flows and could cause us to fail to meet our obligations as they come due.

In December 2019, a strain of coronavirus, now known as COVID-19, was reported to have surfaced in Wuhan, China. Since that time, the widespread and sustained transmission of the virus has reached global pandemic status. In response to the pandemic, many national and international health agencies have recommended, and many countries and state, provincial and local governments have implemented, various measures, including travel bans and restrictions, limitations on public and private gatherings, business closures or operating restrictions, social distancing, and shelter-in-place orders. The health effects of the pandemic and the above measures taken in response thereto have had an effect on the global economy in general and has materially impacted and will likely continue to impact the Company’s financial condition, results of operations and cash flows. Given the ongoing and dynamic nature of the virus and the worldwide response related thereto, it is difficult to predict the full impact of the COVID-19 pandemic on our business. During the nine months ended September 30, 2020, the Company’s revenues declined relative to its prior expectations, in part due to the COVID-19 pandemic. Due to the uncertainty around the future economic impact of the pandemic, the fair value measurements used in the Company’s impairment assessments could be negatively impacted and could result in future impairments of goodwill, intangibles and other long-lived assets. The impact of a continued COVID-19 pandemic or sustained measures taken to limit or contain the outbreak could continue to have a material adverse effect on our business, financial condition, results of operations, and cash flows. We are currently evaluating the collectability of certain accounts receivable totaling $17.1 million that are due from a customer located in India that are past due under the original sales terms. It’s difficult to determine when this receivable will be collected and the ultimate amount to be collected. We are actively working with the customer to arrange payment. We are currently unable to determine whether any loss will ultimately occur in connection with the resolution of this matter and has not accrued any loss in the accompanying condensed consolidated financial statements based on its current expectations regarding the collectability of the receivable. We will continue to evaluate the collectability of this receivable as more information becomes available.

Operating Activities

Net cash used in operating activities decreased by $10.9 million to $11.0 million for the nine months ended September 30, 2020 from net cash used in operating activities of $21.9 million for the nine months ended September 30, 2019. The improvement in cash from changes in operating assets and liabilities was primarily due to collection of accounts receivables, including amounts previously reflected in contract assets, partially offset by increases in inventory.

Investing Activities

Net cash used in investing activities decreased by $4.2 million to $1.9 million for the nine months ended September 30, 2020 from $6.2 million for the nine months ended September 30, 2019. This decrease was primarily due to cash used in the acquisition of Keymile in 2019.

Financing Activities

Net cash provided by financing activities totaled $19.8 million for the nine months ended September 30, 2020 and consisted primarily of proceeds from a related party loan, factored accounts receivable accounted for as a secured borrowing, and proceeds from short-term borrowings, partially offset by a net outflow associated with the repayment of the PNC Credit Facilities and other short-term borrowings. This is in comparison to cash provided by financing activities of $46.2 million for the nine months ended September 30, 2019 and consisted primarily of proceeds from a public stock offering in May 2019 in which we received $42.5 million in net proceeds.

Cash Management

Our primary source of liquidity comes from our cash, cash equivalents and restricted cash, which totaled $40.6 million at September 30, 2020. Our cash, cash equivalents and restricted cash as of September 30, 2020 included $17.8 million held by our international subsidiaries.

Debt Facilities

Bank, Trade Facilities and Secured Borrowings - Foreign Operations

On June 1, 2020, DZS Japan entered into an assignment agreement with JECC Corporation to factor 1,258,822,828 YEN (approximately $11.6 million USD) of accounts receivables from a customer. JECC assessed a discount equivalent to 5,964,328 YEN (approximately $0.05 million USD) (or approximately 0.474% of the amount factored, with a stated factoring rate of 1.575% based on the days remaining from factoring to expected receivable collection). DZS Japan received 1,252,858,500 YEN (approximately $11.65 million USD) on June 19, 2020. In accordance with ASC 860, Transfers and Servicing of Financial Assets, this agreement is accounted for as a secured borrowing. The expected collection of the underlying accounts receivable is before the end of 2020. As of September 30, 2020, the secured borrowing balance was $5.9 million.

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 September 30, 2020 and December 31, 2019, we had an aggregate outstanding balance of $23.3 million and $15.8 million, respectively, under such financing arrangements, and the interest rate per annum applicable to outstanding borrowings under these financing arrangements ranged from 0% to 3.30% as of September 30, 2020.

Related Party Debt

In February 2016, DNS California borrowed $1.8 million from DNI for capital investment with an interest rate of 4.6% per annum. On February 27, 2019, in connection with the entry into the PNC Credit Facilities, the Company amended the terms of this loan to extend the repayment date to May 27, 2022. As of September 30, 2020, the $1.8 million was outstanding.

In March 2018, DNS Korea borrowed $5.8 million from DNI, of which $4.5 million was repaid on August 8, 2018. The loan bears interest at a rate of 4.6%. On February 27, 2019, in connection with the entry into the PNC Credit Facilities, the Company amended the terms of this loan to extend the repayment date to May 27, 2022. As of September 30, 2020, $1.2 million was outstanding.

In December 2018, the Company entered into a loan agreement with DNI, for a $6.0 million term loan with an interest rate of 4.6% per annum. On February 27, 2019, in connection with the entry into the PNC Credit Facilities, the Company amended the terms of the term loan to extend the repayment date to May 27, 2022 and to terminate any security granted to DNI with respect to such term loan. As of September 30, 2020, the $6.0 million was outstanding.

On March 5, 2020, DNS Korea, the Company’s wholly-owned, indirect subsidiary entered into a Loan Agreement with DNI (the “March 2020 DNI Loan”). The March 2020 DNI Loan was negotiated and approved on behalf of the Company and its subsidiaries by a special committee of the Board of Directors of the Company (the “Special Committee”) consisting of directors determined to be independent from DNI. The March 2020 DNI Loan consists of a term loan in the amount of KRW 22.4 billion ($18.5 million USD) with interest payable semi-annually at an annual rate of 4.6% and maturing on March 11, 2022. No principal payments are due on the March 2020 DNI Loan until the maturity date, but DNS Korea may prepay the loan, or a portion thereof, without penalty. As of September 30, 2020, $19.1 million was outstanding.

As security for the March 2020 DNI Loan (and other existing loans between DNI and DNS Korea and/or DNS California), (i) DNS California, a wholly-owned, direct subsidiary of the Company and the sole stockholder of DNS Korea, agreed to pledge the outstanding shares of DNS Korea to DNI and (ii) DNS Korea granted a security interest in its personal property assets, accounts receivable and intellectual property assets to DNI. The March 2020 DNI Loan includes certain covenants consisting of financial reporting obligations, a maintenance covenant whereby DNS Korea agreed to maintain a minimum stockholders’ equity value in an amount equal to or greater than KRW 43.3 billion ($35.8 million), and customary events of default. If an event of default occurs and is not remedied within the applicable cure period, DNI will be entitled to take various actions,

including requiring the immediate repayment of all outstanding amounts under the March 2020 DNI Loan and selling the shares or assets of DNS Korea.

DNS Korea loaned the funds borrowed under the March 2020 DNI Loan to the Company, and the Company used a portion of such funds to repay in full and terminate the PNC Credit Facilities, described above.

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.

Our accounts receivable, while not considered a primary source of liquidity, represent a concentration of credit risk because a significant portion of the accounts receivable balance at any point in time typically consists of a relatively small number of customer account balances. As of September 30, 2020, three customers each represented 17%, 16% and 16% of net accounts receivable, respectively, and receivables from customers in countries other than the United States represented 93% of net accounts receivable. We do not currently have any material commitments for capital expenditures, or any other material commitments aside from operating leases for our facilities, inventory purchase commitments and debt.

Contractual Commitments

At September 30, 2020, our future contractual commitments by fiscal year were as follows (in thousands):

			Payments due by period
	Total		2020		2021		2022		2023		2024		Thereafter
Operating lease payments	$	23,845	$	1,601	$	5,283	$	4,859	$	4,424	$	3,958	$	3,720
Short-term debt		23,341		5,940		17,401				—		—		—
Purchase commitments		4,663		4,663		—		—		—		—		—
Long-term debt - related party		28,167		—		—		28,167		—		—		—
Total future contractual commitments	$	80,016	$	12,204	$	22,684	$	33,026	$	4,424	$	3,958	$	3,720

Operating Leases

Future minimum operating lease obligations in the table above include primarily payments for our office locations and manufacturing, research and development locations, which expire at various dates through 2027. See Note 13 “Leases” of the Notes to Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q for further discussion regarding our operating leases.

Purchase Commitments

The purchase commitments shown above represent non-cancellable inventory purchase commitments as of September 30, 2020.

Short-term and Long-term Debt

The 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. See Note 7 “Debt” of the Notes to Unaudited Condensed Consolidated Financial Statements included in this Quarterly Report on Form 10-Q for further discussion regarding our debt agreements.

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

Not required.

Item 4.

Controls and Procedures

Disclosure Controls and Procedures

We are required to maintain disclosure controls and procedures designed to provide reasonable assurance of achieving the objective that information required to be disclosed in our reports filed or submitted pursuant to the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow for timely decisions regarding required disclosures. Our disclosure controls and procedures include those components of our internal control over financial reporting intended to provide reasonable assurance that transactions are recorded as necessary to permit preparation of financials in accordance with U.S. GAAP. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

As required by Rule 13a-15(b) under the Exchange Act, we conducted an evaluation of the effectiveness of our disclosure controls and procedures as of September 30, 2020, the end of the period covered by this Quarterly Report on Form 10-Q. The evaluation was done under the supervision and with the participation of management, including our principal executive officer and principal financial officer. In the course of the evaluation of our disclosure controls and procedures, our principal executive officer and principal financial officer concluded that, because of the unresolved material weaknesses in our internal control over financial reporting as described below, our disclosure controls and procedures were not effective as of September 30, 2020.

Material Weaknesses in Internal Control Over Financial Reporting

In connection with the Company’s annual evaluation of its internal control over financial reporting conducted in accordance with SEC Rule 13a-15(c), the Company’s management, including our Chief Executive Officer and Chief Financial Officer, identified material weaknesses in the Company’s internal control over financial reporting, and as a result thereof, determined that the Company’s internal control over financial reporting was not effective as of December 31, 2019.

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. Management determined that the Company did not maintain a sufficient complement of personnel with appropriate accounting knowledge, experience and training in the application of US GAAP, including accounting for significant unusual transactions. In addition, the Company did not maintain an effective control environment as it did not appropriately identify internal controls over inventory valuation and revenue. Also, Management determined that the Company did not design and maintain effective controls over the financial closing process, including controls surrounding monitoring and review of the activity of its foreign subsidiaries.

We continue to evaluate and assess the design and operation of our controls and are taking steps to modify processes related to the accounting for significant and unusual transactions as well as enhancing monitoring and oversight controls in the application of accounting guidance related to such transactions. In connection therewith, we have hired and we anticipate that we will hire additional accounting personnel with relevant skills, training and experience, and conduct further training of our accounting and finance personnel.

Changes in Internal Control over Financial Reporting

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

PART II. OTHER INFORMATION

Item 1.

Legal Proceedings

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

Item 5.

Other Information

None.

Item 6.

Exhibits

The exhibits required to be filed with this quarterly report on Form 10-Q are listed in the Exhibit Index attached hereto and are incorporated herein by reference.

EXHIBIT INDEX

Exhibit Number		Description

3.1		Restated Certificate of Incorporation of DASAN Zhone Solutions, Inc. (incorporated by reference to Exhibit 3.1 to the Company’s Annual Report on Form 10-K filed with the SEC on September 27, 2017).

3.2		Certificate of Amendment to the Restated Certificate of Incorporation of DZS Inc. (incorporated by reference to Exhibit 3.1 to the Company’s Current Report on Form 8-K filed with the SEC on August 27, 2020).

3.3		Amended and Restated Bylaws of DASAN Zhone Solutions, Inc. (incorporated by reference to Exhibit 3.2 to the Company’s Current Report on Form 8-K filed with the SEC on September 12, 2016).

10.1+		Employment Agreement, dated as of June 18, 2020, by and between Dasan Zhone Solutions, Inc. and Philip John Yim (incorporated by reference to Exhibit 10.1 to the Company’s Current Report on Form 8 K filed with the SEC on June 19, 2020).

10.2*+		Employment Agreement dated August 1, 2020, by and between DASAN Zhone Solutions, Inc. and Charles Daniel Vogt.

10.3+		Stock Option Agreement dated August 1, 2020, by and between DASAN Zhone Solutions, Inc. and Charles Daniel Vogt.

10.4+		Stock Option Agreement dated August 1, 2020, by and between DASAN Zhone Solutions, Inc. and Charles Daniel Vogt.

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

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

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

101.INS		Inline XBRL Instance Document – the instance document does not appear in the Interactive Data File because XBRL tags are embedded within the Inline XBRL document

101.SCH		Inline XBRL Taxonomy Extension Schema

101.CAL		Inline XBRL Taxonomy Extension Calculation Linkbase

101.DEF		Inline XBRL Taxonomy Extension Definition Linkbase

101.LAB		Inline XBRL Taxonomy Extension Labels Linkbase

101.PRE		Inline XBRL Taxonomy Extension Presentation Linkbase

104		Cover Page Interactive Data File (embedded within the Inline XBRL document and included in Exhibit 101)

*		Filed herewith.
+		Indicates management contract or compensatory plan, contract or arrangement.

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	DZS INC.

Date: November 6, 2020
	By:	/s/ CHARLES DANIEL VOGT
	Name:	Charles Daniel Vogt
	Title:	President and Chief Executive Officer

	By:	/s/ THOMAS J. CANCRO
	Name:	Thomas J. Cancro
	Title:	Chief Financial Officer
		(Principal Financial and
		Accounting Officer)