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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

For the Quarterly Period Ended June 30, 2003

OR

For the Transition Period from                    to                     

Commission File Number: 1-12491

LARSCOM INCORPORATED

1845 McCandless Drive
Milpitas, CA 95035
(408) 941-4000

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

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

The number of the registrant’s shares outstanding as of July 31, 2003, was 5,095,776 of Common Stock.

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LARSCOM INCORPORATED
FORM 10-Q

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Part I: Financial Information

Item 1: Financial Statements (Unaudited)

LARSCOM INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands) (Unaudited)

The accompanying notes are an integral part of these financial statements.

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LARSCOM INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data) (Unaudited)

The accompanying notes are an integral part of these financial statements.

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LARSCOM INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands) (Unaudited)

The accompanying notes are an integral part of these financial statements.

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LARSCOM INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1—Basis of Presentation:

     The condensed consolidated financial statements for the three months and six months ended June 30, 2003 and 2002, presented in this Quarterly Report on Form 10-Q, are unaudited. In the opinion of management, these statements include all adjustments necessary for a fair statement of the results for the interim periods presented. The condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Larscom Incorporated Report on Form 10-K for the year ended December 31, 2002. The results of operations for the three months and six months ended June 30, 2003 are not necessarily indicative of the results to be expected for the full year. The condensed consolidated balance sheet at December 31, 2002 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

Note 2—Acquisitions:

     On June 5, 2003, we completed the acquisition of VINA Technologies, Inc. (“VINA”). The consideration consisted of approximately 2,393,894 shares of Larscom common stock and the assumption of certain liabilities and obligations of VINA, including those arising under its stock option plans.

     VINA is a leading developer of multi-service broadband access communications equipment that enables communications service providers to deliver bundled voice and data services. VINA’s products integrate various broadband access technologies, including existing circuit-based and emerging packet-based networks, onto a single platform to alleviate capacity constraints in communications networks.

     The total purchase price we recorded was approximately $7,132,000 consisting of (a) a total of approximately 2,393,894 shares of Larscom common stock issued upon consummation and valued at approximately $5,329,000, using a fair value per share of $2.23, (b) approximately $883,000 of consideration for options and warrants to purchase approximately 454,752 equivalent shares of Larscom common stock assumed as part of the merger, and (c) direct transaction costs of approximately $920,000. The fair value of Larscom’s common stock issued was determined using the 5-day average price surrounding the date the acquisition was announced. The fair value of the options assumed in the transaction was determined using the Black-Scholes option-pricing model and the following assumptions: expected life of 4.92 years, risk-free interest rate of 2.20%, expected volatility of 90% and no expected dividend yield. The following assumptions were used to perform the calculations for the warrants assumed: remaining contractual life of 1.63 years, risk-free interest rate of 1.30% and expected volatility of 90%. This acquisition was accounted for as a purchase. The purchase price of the VINA merger is as follows (in thousands):

     Under the purchase method of accounting, the total purchase price is allocated to VINA’s net tangible and intangible assets based upon their fair value as of the date of completion of the merger. Based upon the preliminary allocation of the purchase price and management’s estimate of fair value based upon the preliminary independent valuation, the purchase price allocation, which is subject to change based on Larscom’s final analysis, is as follows (in thousands):

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     Of the purchase price of VINA, $155,000 represented acquired in-process research and development (“IPRD”), which had not yet reached technological feasibility and has no alternative future use as of the date of acquisition. Accordingly, this amount was immediately charged to expense upon consummation of the acquisition. The estimate of in-process research and development costs involved one project, which was 87% complete and a discount rate of 30% was used to value the project.

     A preliminary estimate of $4,422,000 has been allocated to amortizable intangible assets with useful lives ranging from 6 months to 6 years as follows: Developed technology — 5 to 6 years; Trade name / trademarks — 3 years; Customer contracts/relationships — 3 to 5 years; and Order backlog — 6 months. During the three and six month periods ended June 30, 2003, we recorded $93,000 in operating expense related to the amortization of merger-related intangibles. Amortization charged to income for the subsequent five years is estimated, based on the June 5, 2003 intangible asset values, to be: 2003 — $635,682, 2004 — $956,755, 2005 — $956,755, 2006 — $775,748 and 2007 — $646,456.

     An independent valuation of the purchased assets was performed to assist in determining the fair value of each identifiable tangible and intangible asset and in allocating the purchase price among the acquired assets including the portion of the purchase price attributed to acquired IPRD projects. Standard valuation procedures and techniques were utilized in determining the fair value.

     Developed technology and in-process technology were identified and valued through analysis of VINA’s current development projects, their respective stages of development, the time and resources needed to complete them, their expected income-generating ability, their target markets and the associated risks.

     The income approach, which includes an analysis of the markets, cash flows and risks associated with achieving such cash flows, was the methodology utilized in valuing IPRD, developed technology and trade names/trademarks. Each intangible asset is valued based upon the estimated impact on our expected future after-tax cash flows. The net changes in our expected future after-tax cash flows generated by the respective IPRD, developed technology and trade names/trademarks were then discounted to present value. The discount was based on an analysis of the weighted-average cost of capital for the industry.

     Customer contracts/relationships and order backlog were valued using the cost method. The cost to develop the customer contracts and relationships and to earn the order backlog were estimated and valued on an after-tax basis.

     Supplemental pro forma information reflecting the acquisition of VINA as if it occurred on December 31, 2001 is as follows for the six months ended June 30, 2003 and 2002 (in thousands, unaudited):

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Such information is not necessarily representative of the actual results that would have occurred for those periods.

Note 3 —Recent Accounting Pronouncements:

     In April 2003, the Financial Accounting Standards Board (“FASB”) issued SFAS 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities”, which amends SFAS 133 for certain decisions made by the FASB Derivatives Implementation Group. In particular, SFAS 149 (1) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, (2) clarifies when a derivative contains a financing component, (3) amends the definition of “an underlying” to conform it to language used in FASB Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, and (4) amends certain other existing pronouncements. This Statement is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. In addition, most provisions of SFAS 149 are to be applied prospectively. We do not expect the adoption of SFAS 149 to have a material impact upon our financial position, cash flows or results of operations.

     In May 2003, the FASB issued SFAS 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity”. SFAS 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). SFAS 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the Statement and still existing at the beginning of the interim period of adoption. Restatement is not permitted. We do not expect the adoption of SFAS 150 to have a material impact upon our financial position, cash flows or results of operations.

     In July 2002, the FASB issued SFAS 146, “Accounting for Costs Associated with Exit or Disposal Activities.” SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred. SFAS 146 eliminates the definition and requirement for recognition of exit costs in Emerging Issues Task Force (“EITF”) Issue No. 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring),” where a liability for an exit cost was recognized at the date of an entity’s commitment to an exit plan. This statement is effective for exit or disposal activities initiated after December 31, 2002 and it has been implemented in our financial statements.

     In November 2002, the FASB issued FASB Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities. The initial recognition and initial measurement provisions of FIN 45 are applicable on a prospective basis to guarantees issued or modified after December 31, 2002, irrespective of the guarantor’s fiscal year-end. The disclosure requirements of FIN 45 are effective for financial statements of interim or annual periods ending after December 15, 2002, and have been implemented in our financial statements.

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     In November 2002, the EITF reached a consensus on Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of this standard is not expected to have a material impact on our financial statements.

     In December 2002, the FASB issued SFAS 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” SFAS No. 148 provides alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. SFAS No. 148 also requires that disclosures of the pro forma effect of using the fair value method of accounting for stock-based employee compensation be displayed more prominently and in a tabular format. Additionally, SFAS No. 148 requires disclosure of the pro forma effect in interim financial statements. The transition and annual disclosure requirements of SFAS No. 148 are effective for fiscal years ended after December 15, 2002. The interim disclosure requirements are effective for interim periods beginning after December 15, 2002. The interim disclosure requirements of SFAS No. 148 have been included in our financial statements.

     In January 2003, the FASB issued FASB Interpretation No. 46 (“FIN 46”), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51.” FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective immediately for all new variable interest entities created or acquired after January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provisions of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. The adoption of this standard has not had a material impact on our financial statements.

Note 4—Inventories:

     Inventories consist of the following (in thousands):

Note 5—Restructuring and Cost of Revenues Charges:

     During 2001 we announced two corporate restructuring programs in response to our own reduced revenues, negative macro-economic conditions and declining demand in our markets. These initiatives were focused on improving operating performance by reducing expenses. The restructuring programs included workforce reductions of approximately 42% (88 people), the closing of our facility in Durham, North Carolina and the write-off of fixed assets due primarily to the workforce reduction and facility closing. Implementing these programs led to charges to results in the second and fourth quarters of 2001 totaling $5,772,000. In May and October of 2002, we announced additional corporate restructuring as a result of the ongoing stagnation of the telecom market. Consequently, 30 positions were eliminated from our workforce with a charge to operating results of $570,000. Partially offsetting this charge was a $194,000 reduction to the prior restructuring reserves primarily for outplacement services, which were not fully utilized by some of the laid-off employees and cumulatively, $246,000 in rent collected under the sublease agreement with Silicon Wireless Corporation described below. After the VINA merger, on June 5, 2003, a restructuring was effected which resulted in a reduction of 19 positions and a charge to operating results of $212,000.

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     In connection with the closing of our facility in Durham, North Carolina, we remain responsible for the existing lease. We entered into a sublease agreement on February 27, 2002, between us and Silicon Wireless Corporation, a start-up company that had a commencement date of February 15, 2002 and is for the entire 27,000 square-foot facility in Durham, North Carolina. The agreement included an initial four-and-one-half-months free-rent period. Due to the uncertainty of the receipt of income under the sublease, we have decided to release the associated real-estate accrual as the sublease income is received. During the second quarter of 2003, our restructuring expenses were reduced by $61,000 as a result of rent collected from Silicon Wireless Corporation. We expect the remaining real estate lease obligation will be paid-out by January 2007.

     The following table provides details on the activity and remaining balances of the 2001, 2002 and 2003 restructuring charges as of June 30, 2003:

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     We expect the remaining employee termination costs to be paid-out by the end of 2003.

     The following table provides details on the staff reductions for our restructuring and reduction-in-force programs in 2003, 2002 and 2001:

Note 6—Deferred Tax Assets:

     Deferred tax assets include temporary differences related to intangible assets associated with the acquisition of NetEdge Systems Inc. in 1997, inventory write-downs, accrued expenses and net operating losses that carry forward. We have concluded that a deferred tax asset valuation allowance should be established due to the uncertainty of realizing the tax loss carry-forwards and other deferred tax assets in accordance with Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes.” Our assessment was based principally on the historical losses experienced by us in the U.S., unfavorable macro-economic conditions and capital expenditure reductions announced by several service providers. The valuation allowance was reduced by $1,894,000 in the first quarter of 2002 due to our ability to utilize additional net operating loss carry-backs against taxes paid in 1996, 1997 and 1998. This is a result of the 2002 change in the federal income tax code for tax loss carry-back provisions. A federal tax filing was made during the third quarter of 2002 and a refund was received during that quarter for the entire $1,894,000 amount. The deferred tax asset balance at June 30, 2003 amounted to $26,296,000 and the valuation allowance balance was $26,296,000.

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     As part of the merger with VINA, we recorded a deferred tax liability for the value of the intangibles acquired, and a deferred tax asset for the NOL and credit carryforwards acquired and the difference in the accounting and tax basis’ of the VINA assets. The net deferred tax asset related to the merger has been fully reserved due to the uncertainty surrounding its realization. Because the merger with VINA is an “ownership change” as broadly defined in Section 382 of the Internal Revenue Code of 1986, as amended, utilization of the NOL carryforwards may be subject to an annual limitation which could defer the timing or limit the total tax carryforwards ultimately utilized in the future.

     Additional deferred tax assets will be recognized in future periods to the extent that we can reasonably expect such assets to be realized. We will evaluate the probability of realizing our deferred tax assets on a quarterly basis. If we determine that an additional portion or all of the deferred tax assets are realizable, we will reduce the income tax valuation allowance accordingly.

Note 7—Net (Loss)/Income Per Share:

     Basic net (loss)/income per share is computed using the weighted-average number of shares of Common Stock outstanding during the period. Diluted net (loss)/income per share is computed using the weighted-average number of shares of Common Stock outstanding and the dilutive effect of options to purchase shares of Common Stock. In computing diluted earnings per share, the average price of our Common Stock for the period is used in determining the number of shares assumed to be purchased from the exercise of stock options. In the net loss per share computation, the effect of options to purchase shares of Common Stock is excluded, as their effect is antidilutive.

     The following table shows how basic and diluted net loss per share is computed (in thousands, except per share data):

Note 8—Accounting for stock-based compensation

     We account for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, and “Accounting for Stock Issued to Employees,” Financial Accounting Standard Board Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB 25,” and comply with the disclosure provisions of SFAS No. 148, “Accounting for Stock-Based Compensation, Transition and Disclosure.” Under APB No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of our stock and the exercise price. We account for stock issued to non-employees in accordance with the provisions of SFAS No. 148 and the EITF Issue No. 96-18, “Accounting for Equity Instruments that are Issued to other than Employees for Acquiring, or in Conjunction with Selling Goods or Services.”

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     We amortize stock-based compensation using the straight-line method over the vesting period of the options. The risk-free interest rate used in the calculations were 2.56% for the first quarter of 2003 and 2.20 % for the second quarter of 2003; 4.20% for the first quarter of 2002 and 4.30% for the second quarter of 2002. The expected volatility was 90% for the all periods. A zero dividend rate was used for all periods. The expected life was 4.93 years for the first quarter of 2003 and 4.92 for the second quarter of 2003; 4.73 years was used for the first and second quarters of 2002. Pro forma information regarding net loss and earnings per share is presented and has been determined as if we had accounted for employee stock options under the fair value method of SFAS No. 123, as amended by SFAS No. 148.

     The following table illustrates the effect on net loss and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123, as amended by SFAS No. 148, to stock-based employee compensation (in thousands except for per share data):

     The fair value of options and shares issued pursuant to the option plans and at the grant date were estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock-price volatility. We use projected volatility rates, which are based upon historical volatility rates. Because employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of options.

     The effects of applying pro forma disclosures of net loss and net loss per share are not likely to be representative of the pro forma effects on net loss/income and earnings per share in the future years, as the number of future shares to be issued under these plans is not known and the assumptions used to determine the fair value can vary significantly.

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Note 9—Comprehensive Income/(Loss):

     “Comprehensive Income/(Loss)” includes all changes in equity from non-owner sources during the period. There were two items of adjustment from net loss to comprehensive net loss for the periods presented, which relate to unrealized gains on short-term investments and foreign currency translation adjustments. Amounts for unrealized gains on short-term investments and foreign currency translation adjustments were immaterial for the periods presented.

Note 10—Commitments and Contingencies:

     Commitments:

     Operating lease commitments are related principally to our buildings in Milpitas, California and Durham, North Carolina and have terms that expire in 2004 and 2007, respectively. In addition, as part of the merger with VINA, we have leased facilities in Newark, California and Nashua, New Hampshire with leases that expire in 2007 and 2003 respectively. Total rent expense in the second quarter of 2003 and 2002, was $520,000 and $485,000, respectively. For the six months ended June 30, rent expense was $1,011,000 and $972,000 for 2003 and 2002, respectively. Sublease rental income was $144,000 and $250,000 in the second quarter of 2003 and 2002, respectively. Sublease rental income was $299,000 for the six months ended June 30, 2003 and $490,000 for the six months ended June 30, 2002. Future annual minimum lease payments under all non-cancelable operating leases and sublease rental income as of June 30, 2003 are as follows (in thousands):

     Contingencies:

     In our sales agreements, we typically agree to indemnify our customers for any expenses or liability resulting from claimed infringements of patents, trademarks or copyrights of third parties. The terms of these indemnification agreements are generally perpetual any time after execution of the agreement. The maximum amount of potential future indemnification is unlimited. To date we have not paid any amounts to settle claims or defend lawsuits.

     As part of the merger with VINA we have assumed a liability recorded on the books of VINA for California sales taxes for the period January 1, 1999 through March 31, 2000 resulting from a sales and use tax audit by the California State Board of Equalization. The assessment is currently under appeal.

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Note 11—Geographic Information:

     Revenue related to operations in the United States and other countries for the three months and six months ended June 30, 2003 and 2002 (in thousands):

     Long-lived assets as of June 30, 2003 and December 31, 2002 are as follows (in thousands):