WESTELL TECHNOLOGIES INC - Quarter Report: 2005 September (Form 10-Q)

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

OR

EXCHANGE ACT OF 1934

Commission File Number 0-27266

Westell Technologies, Inc.

(Exact name of registrant as specified in its charter)

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check or mark whether the registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days. Yes X No .

Indicate the number of shares outstanding of each of the issuer’s classes of common stock as of October 24, 2005:

Class A Common Stock, $0.01 Par Value – 55,051,057 shares

Class B Common Stock, $0.01 Par Value – 14,741,872 shares

WESTELL TECHNOLOGIES, INC. AND SUBSIDIARIES

FORM 10-Q

INDEX

PART II OTHER INFORMATION

Safe Harbor Statement

Certain statements contained in this Quarterly Report of Form 10-Q regarding matters that are not historical facts or that contain the words “believe”, “expect”, “intend”, “anticipate” or derivatives thereof and other words of similar meaning, are forward-looking statements. Such forward-looking statements include risks and uncertainties, and actual results may differ materially from those expressed in or implied by such forward-looking statements. Factors that could cause actual results to differ materially include, but are not limited to, those discussed under “Risk Factors” set forth in Westell Technologies, Inc.’s Annual Report on Form 10-K for the fiscal year ended March 31, 2005. Our actual results may differ from these forward-looking statements. Westell Technologies, Inc. undertakes no obligation to publicly update these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events or otherwise.

LIABILITIES AND STOCKHOLDERS' EQUITY

The accompanying notes are an integral part of these Consolidated Financial Statements.

WESTELL TECHNOLOGIES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

The accompanying notes are an integral part of these Consolidated Financial Statements

WESTELL TECHNOLOGIES, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

The accompanying notes are an integral part of these Consolidated Financial Statements

Note 1. Basis of Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles in the United States for complete financial statements. It is suggested that these consolidated financial statements be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended March 31, 2005.

In the opinion of management, the unaudited interim financial statements included herein reflect all adjustments, consisting of normal recurring adjustments, necessary to present fairly the Company’s consolidated financial position and the results of operations and cash flows at September 30, 2005 and for all periods presented. The results of operations for the three and six month period ended September 30, 2005 are not necessarily indicative of the results that may be expected for the fiscal year ending March 31, 2006 ("fiscal year 2006").

Certain amounts in previously issued financial statements have been reclassified to conform to the current year presentation.

Note 2. Computation of Income Per Share

The computation of basic earnings per share is computed using the weighted average number of common shares outstanding during the period. Diluted earnings per share includes the number of additional common shares that would have been outstanding if the dilutive potential common shares had been issued. The following table sets forth the computation of basic and diluted earnings per share:

Options to purchase 5,025,588 and 3,823,723 shares of common stock for the three months ended September 30, 2005 and September 30, 2004, respectively, and options to purchase 4,723,041 and 2,632,891 shares of common stock for the six months ended September 30, 2005 and September 30, 2004, respectively, were not included in the computation of diluted shares because the options’ exercise prices were greater than the average market price of the common shares.

Note 3. Restructuring Charge

The Company recognized a restructuring expense of $2.6 million in fiscal year 2003. This charge included personnel and facility costs related primarily to the closing of a Conference Plus, Inc. facility and personnel and facility charges at Westell Limited. Approximately 25 employees were impacted by these reorganizations. In fiscal year 2005, the Company terminated a lease that was partially reserved for in the 2003 restructuring. This termination resulted in the reversal of $0.5 million of restructuring for facility costs. As of September 30, 2005, the Company paid approximately $2.1 million of these accrued restructuring costs leaving a balance of $35,000.

The Company's restructuring accrual balances, all of which are legal, facility and other costs are presented in the following table:

Note 4. Interim Segment Information

Westell’s reportable segments are strategic business units that offer different products and services. They are managed separately because each business requires different technology and market strategies. They consist of:

Performance of these segments is evaluated utilizing revenue, operating income and total asset measurements. The accounting policies of the segments are the same as those for Westell Technologies, Inc. Segment information for the three-month and six periods ended September 30, 2004 and 2005, are as follows:

Reconciliation of Operating income for the reportable segments to income before income taxes and minority interest:

Note 5. Comprehensive Income

The disclosure of comprehensive income, which encompasses net income and foreign currency translation adjustments, is as follows:

Note 6. Inventories

The components of inventories are as follows:

Note 7. Stock Options

The Company has elected to follow Accounting Principle Board Opinion No. 25 “Accounting for Stock Issued to Employees” (APB No. 25) and related interpretations in accounting for its employee stock options and awards. Under APB No. 25, employee stock options are valued using the intrinsic method, and no compensation expense is recognized since the exercise price of the options equals or is greater than the fair market value of the underlying stock as of the date of the grant. The following table shows the effect on net income and income per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, “Accounting for Stock Based Compensation.”

The fair value of each option is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions for grants in fiscal 2005 and 2006:

Note 8. Warranty Reserve

Most of the Company’s products carry a limited warranty ranging from one to seven years. The specific terms and conditions of those warranties vary depending upon the product sold. Factors that enter into the estimate of the Company’s warranty reserve include the number of units shipped historical and anticipated rates of warranty claims, and cost per claim. The Company periodically assesses the adequacy of its recorded warranty liability and adjusts the reserve as necessary. The Company reports warranty reserve as both current and long term liabilities. The following table presents the changes in the Company’s product warranty reserve:

Note 9. Deferred Compensation

The Company has a deferred compensation program with the Chief Executive Officer that is funded through a rabbi trust. The rabbi trust qualifies as a Variable Interest Entity under FASB Interpretation No. 46, Consolidation of Variable Interest Entities and as such is consolidated in the Company's financial statements. Approximately $1.3 million of cash has been funded into the rabbi trust as of September 30, 2005 and the Company has recorded a $1.7 million short term liability to accrue for the deferred compensation liability. The rabbi trust is subject to the creditors of the Company. All amounts deferred under this compensation program vest on the earlier of March 31, 2006, the executive's death, permanent disability or a change in control of the Company.

Note 10. Guarantee

In conjunction with a sale of product lines and specified fixed assets in fiscal year 2005, the Company provided an unconditional guarantee in the amount of $1.62 million relating to a 10 year term note payable to the lender that financed the transaction. This guarantee will stay in place until the note is paid in full. The Company must pay all amounts due under the note payable upon demand from the lender. In fiscal year 2005, the Company assessed its obligation under this guarantee pursuant to the provisions of FIN 45, "Guarantor's Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others" and recorded a $300,000 liability for the value of the guarantee. The Company will evaluate the liability periodically and adjust the value as required. No adjustments in the liability have been made to date.

Note 11. New Accounting Pronouncements

In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123R, “Share-Based Payment” (“SFAS 123R”). Under this new standard, companies will no longer be able to account for share-based compensation transactions using the intrinsic value method in accordance with APB 25.  Instead, companies will be required to account for such transactions using a fair-value method and recognize the expense over the service period.  SFAS 123R allows for several alternative transition methods, but the Company has not yet determined the transition method it will use.  On April 14, 2005, the Securities and Exchange Commission announced the adoption of a rule that defers the required effective date of SFAS 123R for registrants to the beginning of the first fiscal year beginning after June 15, 2005.  The Company expects to adopt this statement in the first quarter of its 2007 fiscal year. The adoption of SFAS 123R will have an impact on the Company’s results of operations, although it will have no incremental impact on the Company’s overall financial position.

In January 2005, the Financial Accounting Standards Board (FASB) issued revised Statement of Financial Accounting Standards (SFAS) No. 151, Inventory Costs, an amendment of ARB No. 43. The amendments made by SFAS 151 clarify that abnormal amounts of idle facility expense, freight, handling costs, and wasted materials (spoilage) should be recognized as current-period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. SFAS 151 will be effective for the Company beginning in fiscal year 2007. The impact of SFAS 151 is not expected to have a significant impact to the consolidated financial statements.

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATION

Overview

The Company is comprised of two segments: telecommunications equipment manufacturer and teleconference services bureau. The equipment manufacturing segment consists of two product lines: Customer Networking Equipment (CNE) products and Network Service Access (NSA) products. The CNE product line includes broadband and digital subscriber line (DSL) technology products that allow the transport of high-speed data over the local loop and enable telecommunications companies to provide broadband services over existing copper infrastructure. The Company’s NSA product line consists of manageable and non-manageable T1 transmission equipment, associated mountings and special service plugs for the legacy copper telephone network. Westell realizes the majority of its revenues from the North American market.

The Company’s teleconference service segment is comprised of a 91.5% owned subsidiary, Conference Plus, Inc. Conference Plus provides audio, video, and web conferencing services. Businesses and individuals use these services to hold voice, video or web conferences with many people at the same time. Conference Plus sells its services directly to large customers, including Fortune 1000 companies, and serves other customers indirectly through its private label reseller program.

The equipment manufacturing segment of the Company’s business consists of two product lines, offering a broad range of products that facilitate the broadband transmission of high-speed digital and analog data between a telephone company's central office and end-user customers. These two product lines are:

Below is a table that compares equipment and service revenues for the quarter and six months ended September 30, 2005 with the quarter and six months ended September 30, 2004 by product line.

The prices for the products within each market group vary based upon volume, customer specifications and other criteria and are subject to change due to competition among telecommunications manufacturers and service providers. Increasing competition, in terms of the number of entrants and their size, and increasing size of the Company’s customers because of past mergers, continues to exert downward pressure on prices for the Company's products. The Company expects average selling prices on its CNE products to decline less than 20% in fiscal year 2006.

The Company's customer base is highly concentrated and comprised primarily of the Regional Bell Operating Companies (RBOCs), independent domestic local exchange carriers and public telephone administrations

located outside the U.S. Due to the stringent quality specifications of its customers and the regulated environment in which its customers operate, the Company must undergo lengthy approval and procurement processes prior to selling its products. Accordingly, the Company must make significant upfront investments in product and market development prior to actual commencement of sales of new products.

To remain competitive, the Company must continue to invest in new product development and invest in targeted sales and marketing efforts to cover new product lines. Failure to increase revenues from new products, whether due to lack of market acceptance, competition, technological change or otherwise, would have a material adverse effect on the Company's business and results of operations. The Company expects to continue to evaluate new product opportunities and engage in extensive research and development activities.

The Company is focusing on expanding its product offerings in the equipment segment from basic high speed broadband to more sophisticated applications such as networking, VoIP, wireless systems, video, multimedia distribution and control and user interfaces. This will require the Company to continue to invest in research and development and sales and marketing, which could adversely affect short-term results of operations. The Company is currently increasing research and development investment levels in the areas of video, VoIP and home networking applications. In view of the Company’s reliance on the DSL market for revenues and the unpredictability of orders and pricing pressures, the Company believes that period-to-period comparisons of its financial results are not necessarily meaningful and should not be relied upon as an indication of future performance. Revenues from NSA products such as NIUs have declined in recent years due primarily to reduced demand resulting from the migration by telephone companies to high-speed digital transmission products and the sale of Data Station Termination product lines that occurred in the first quarter of fiscal 2005.

In the equipment manufacturing segment, the Company is focusing on new product opportunities such as the DSL wireless gateway, voice/media-over-IP, and vertical applications. The Company has introduced new products including Ultraline^TM, ProLine^TM, VersaLink^TM, TriLink^TM and TR-069 compliant software which are targeted at the home networking, small office/home office (SOHO) and small business markets. The Company continues to support the Verizon One product, a multimedia gateway. Revenue is expected from these products in fiscal year 2006 but a greater impact in fiscal year 2007 is anticipated. The Company has multiple evaluations and is entering trials for TriLink^TM, UltraLine^TM and the Westell Media Gateway, a variation of the Verizon One product marketed outside of the United States. The Company continues to focus on expanding existing and new products into the international markets such as the Europe, Canada, Mexico and the Pacific Rim.

The Company expects DSL service promotions by several customers to generate stronger demand for ProLine^TM modems in the December 31, 2005 quarter than it has experienced in the past. As a result of the stronger demand for ProLine^TM modems, the demand for VersaLink^TM modems, which has a higher selling price than ProLine^TM modems, has correspondingly declined. The Company believes that its customers continue to expect growth in the broadband market that the Company’s CNE products serve. More users are subscribing to DSL services and some subscribers currently using DSL technology desire new DSL technology as the older modems cannot deliver newer applications that require higher broadband speed.

The NSA market continues to decline as the transition to high-speed digital service continues. The Company expects the NSA market to continue to decline 10% to 15% per year which could impact the Company’s future revenue. The Company’s goal is to increase market share in mountings and NIUs in the NSA market to offset in part reduced prices for NIUs and mountings. The Company is investing in new products in the NSA product line that complement the broadband market products such as PowerSpan that may support the deployment of VoIP in residential markets and partnership derived products such as VirtualEdge^TM.

Results of Operations

CNE revenue increased in the second quarter of fiscal 2006 compared to the same quarter in the prior year due to a 9.3% increase in the number of units shipped offset in part by a 1.7% decrease in selling price per unit. CNE revenue increased in the first half of fiscal 2006 compared to the same period in the prior year due to a 25.1% increase in the number of units shipped and a 5.5% increase in selling price per unit. The selling price per unit in fiscal year 2006 was positively impacted by the sale of VersaLink^TM product that has a higher selling price per unit than traditional modems. Traditional modems unit sales decreased 6.6% and 8.5% and the average selling price per unit decreased 9.9% and 11.4% in the second quarter and first half of fiscal 2006 compared to the same periods last year. NSA revenues decreased due to lower unit sales and lower selling prices per unit. In addition, NSA product revenue in the first half of fiscal 2005 included an $883,000 contractual settlement from a customer, $900,000 of non-recurring revenue and approximately $500,000 of revenue from a product line subsequently sold. The overall decrease in NSA product revenue is due to reduced demand resulting from the migration by telephone companies to high-speed digital transmission products. Revenue in the services segment increased due to an increase in minutes billed in the fiscal year 2006 offset in part by lower revenue per minute at the Company’s Conference Plus, Inc. subsidiary.

Gross margin as a percent of sales in the equipment segment increased in the second quarter of fiscal 2006 compared to the same period in fiscal 2005 due primarily to non recurring expediting and other costs related to the introduction of the VersaLink^TM product in the second quarter of fiscal 2005. This more than offset the change in sales mix from higher margin NSA products to lower margin CNE products and a $600,000 charge taken for excess and obsolete inventory in the second fiscal quarter of 2006. The decrease in equipment margin percentage in the first half of fiscal 2006 when compared to the same period in fiscal 2005 was due primarily to a higher mix of lower margin CNE sales compared to NSA sales and a $600,000 charge taken for excess and obsolete inventory. In addition, the September 30, 2004 margin includes the $883,000 contractual settlement mentioned above. The Company believes continued pricing pressures and continued reduction of NSA sales affecting its equipment segment could continue to adversely impact margins in the future. The service margins decrease in the second quarter of fiscal 2006 compared to the same period in fiscal 2005 is due to increased overhead costs related to web outsourcing and credit card fees. The increase in services margin for the first half of fiscal 2006 compared to the same period in fiscal 2005 is primarily due to a reduction in long distance expense which more than offset increases in overhead expenses. It is the Company’s strategy to offset the effects of these anticipated price reductions with continued cost reductions and introducing new products that have higher sales prices and margins.

The equipment segment sales and marketing expenses were relatively flat in the second quarter and first half of fiscal 2006 compared to the same periods last year. Sales and marketing expense increased in the Company’s services segment in the second quarter and first half of fiscal 2006 compared to the same periods last year due primarily to more employees at Conference Plus. The Company believes that sales and marketing expense in the future will continue to be a significant percent of revenue and will be required to expand its product lines, bring new products to market and service customers.

Engineering expenses have increased in the second quarter and first half of fiscal year 2006 compared to the same periods in fiscal year 2005. The increase is due in part to recording a $900,000 credit for customer reimbursed engineering costs offset in part by a $300,000 expense for engineering period performed by a third party in fiscal year 2005. No such offset existed in fiscal year 2006. In addition, there were approximately 17% more engineering employees in fiscal year 2006 which resulted in $413,000 and $773,000 more salary expense in the second quarter and first half of fiscal 2006 compared to same periods in fiscal 2005. In fiscal year 2005, the Company capitalized $570,000 and $929,000 of engineering expenses as an intangible asset for TR-069 compliant software in the three and six months ended September 30, 2004. No costs were capitalized in the periods ended September 30, 2005. The Company believes that research and development expenses will increase in fiscal year 2006 as the Company continues to expand its product offerings. Areas of focus include VoIP, video, multimedia distribution and control, wireless systems, user interfaces and other broadband applications.