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FORM 10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

(Mark One)

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

For the quarterly period ended March 31, 2003

OR

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

Commission file number 0-15135

TEKELEC
(Exact name of registrant as specified in its charter)

26580 W. Agoura Road, Calabasas, California 91302
(Address and zip code of principal executive offices)

(818) 880-5656
(Registrant’s telephone number, including area code)

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

     Indicate by check mark whether the registrant is an accelerated filer. Yes x No o

     As of May 7, 2003, there were 61,034,755 shares of the registrant’s common stock, without par value, outstanding.

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TEKELEC
FORM 10-Q
INDEX

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PART I — FINANCIAL INFORMATION

Tekelec

Continued on next page

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Tekelec
Consolidated Balance Sheets

See notes to consolidated financial statements.

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Tekelec

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Tekelec
Consolidated Statements of Operations
(unaudited)

See notes to consolidated financial statements.

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Tekelec

See notes to consolidated financial statements.

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Tekelec

See notes to consolidated financial statements

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Tekelec

A.

Basis of Presentation

     The consolidated financial statements are unaudited, other than the consolidated balance sheet at December 31, 2002, and reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair presentation of our financial condition, operating results and cash flows for the interim periods.

     As more fully described in Note B — Disposition of Network Diagnostics Business, we sold our Network Diagnostics Division (“NDD”) effective August 30, 2002. Accordingly, comparative 2002 financial results and notes have been restated to reflect NDD as a discontinued operation. All significant intercompany balances and transactions have been eliminated in consolidation.

     The results of operations for the current interim periods are not necessarily indicative of results to be expected for the current year. Certain items shown in the prior financial statements have been reclassified to conform with the presentation of the current period.

     We operate under a thirteen-week calendar quarter. For financial statement presentation purposes, however, the reporting periods are referred to as ended on the last calendar day of the quarter. The accompanying consolidated financial statements for the three months ended March 31, 2003 and 2002 are for the thirteen weeks ended March 28, 2003 and March 29, 2002, respectively.

     These consolidated financial statements should be read in conjunction with the consolidated financial statements for the year ended December 31, 2002 and the notes thereto in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.

Recent Accounting Pronouncements

     In June 2002, the FASB issued SFAS No. 146, “Accounting for Cost Associated with Exit or Disposal Activities.” SFAS No. 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for pursuant to the guidance that the Emerging Issues Task Force (“EITF”) has set forth in 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).” The scope of SFAS No. 146 also includes (1) costs related to terminating a contract that is not a capital lease and (2) termination benefits that employees who are involuntarily terminated receive under the terms of a one-time benefit arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS No. 146 is effective for exit or disposal activities that are initiated after December 31, 2002. We adopted SFAS No. 146 effective January 1, 2003 with no material impact on our financial position, results of operations or cash flows.

     In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition Disclosure — an amendment of FAS 123.” This statement amends

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock-based employee compensation. In addition, this Statement amends the disclosure requirements of SFAS No. 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based employee compensation and the effect of the method used on reported results. The provisions of SFAS No. 148 are effective for financial statements for fiscal years ending after December 15, 2002, and disclosure requirements are effective for interim periods beginning after December 15, 2002. We intend to continue to account for stock-based compensation to our employees and directors using the intrinsic value method prescribed by APB Opinion No. 25, and related interpretations. We have made certain disclosures required by SFAS No. 148 in the consolidated financial statements for the year ended December 31, 2002 and made the additional disclosures required by SFAS No. 148 in the first quarter of 2003. Adoption of SFAS No. 148 did not impact our financial position, results of operations or cash flows.

     In November 2002, the FASB issued interpretation (“FIN”) No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others.” This interpretation elaborates on the disclosures required in financial statements concerning obligations under certain guarantees. It also clarifies the requirements related to the recognition of liabilities by a guarantor at the inception of certain guarantees. The disclosure requirements of this interpretation were effective for us on December 31, 2002 but did not require any additional disclosures. The recognition provisions of the interpretation are effective for us in 2003 are applicable only to guarantees issued or modified after December 31, 2002. We adopted FIN No. 45 as of January 1, 2003 with no material impact on our financial position, results of operations or cash flows.

     In February 2003, the FASB issued EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables.” EITF Issue No. 00-21 requires revenue arrangements with multiple deliverables to be divided into separate units of accounting. If the deliverables in the arrangement meet certain criteria, arrangement consideration should be allocated among the separate units of accounting based on their relative fair values. Applicable revenue recognition criteria should be considered separately for separate units of accounting. The guidance in EITF Issue No. 00-21 is effective for revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We are currently in the process of reviewing EITF Issue No. 00-21. We do not expect the adoption of EITF Issue No. 00-21 to have a material impact on our financial position, results of operations or cash flows.

B.

Disposition of Network Diagnostics Business

     On August 30, 2002, we completed the sale of NDD to Catapult Communications Corporation (“Catapult”) for $59.8 million, consisting of $42.5 million in cash and convertible subordinated promissory notes (the “Notes”) issued by Catapult’s wholly owned Irish subsidiary and guaranteed by Catapult in the total amount of $17.3 million, subject to certain adjustments. The sale resulted in a pre-tax gain of approximately $41.7 million ($28.3 million after taxes). This gain is subject to future adjustment depending on the final resolution of certain contingencies under the asset purchase agreement. Any differences between these estimates and their actual settlement will change the gain accordingly. In accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” the sale of the NDD business segment has been presented as a discontinued business and our historical financial results for periods prior to

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

disposition have been revised to reflect NDD as a discontinued operation. Accordingly, the revenues, costs and expenses, assets and liabilities, and cash flows of NDD have been condensed in the accompanying consolidated statements of operations, balance sheets and cash flows.

     Revenues and loss from our discontinued operation were as follows:

     The Notes have a principal amount of $17.3 million bearing interest at 2% per annum and are due on August 30, 2004. We have the option of converting the Notes into Catapult common stock after August 30, 2003 through maturity at a conversion rate (subject to certain adjustments) of 62.50 shares of Catapult common stock per $1,000 in principal (approximately 1.1 million shares). Catapult also has the option of repaying one of the Notes at maturity in the principal amount of $10.0 million by delivery of shares of Catapult common stock valued at a 17.5% discount from trading prices at the time of repayment.

     The Notes are reflected in the consolidated balance sheet at their estimated fair value using a third party appraisal which computed the fair value by discounting the face amount to present value using a fair value rate of interest and then determining the fair value of the conversion option using the Black-Scholes valuation model. The fair value of the note is being adjusted to the redemption amount at maturity based on an effective amortization method. The fair values of the Notes and the conversion option are as follows (in millions):

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

C.

Certain Balance Sheet Items

D.

Financial Instruments

     We conduct business in a number of foreign countries, with certain transactions denominated in local currencies. During the first quarter of 2003, we entered into forward contracts to mitigate exposures associated with sale contracts denominated in currencies other than the US Dollar. These contracts are used to reduce our risk associated with exchange rate movements, as gains and losses on these contracts are intended to offset exchange losses and gains on underlying exposures. Changes in the fair value of these forward contracts are recorded immediately in earnings.

     The purpose of our foreign currency management policy is to minimize the effect of exchange rate fluctuations on certain foreign denominated anticipated cash flows. The terms of currency instruments used for hedging purposes are consistent with the timing of the transactions being hedged. We do not use derivative financial instruments for trading or speculative purposes.

     As of March 31, 2003, we had two foreign currency forward contracts outstanding to sell approximately 800,000 Euros and 759,000 Canadian Dollars in order to hedge certain receivable balances denominated in those currencies. These contracts had an expiration date of April 4, 2003 and did not meet specific hedge accounting requirements.

     Corresponding gains and losses on these contracts, as well as gains and losses on the items being hedged, are included as a component of other income and expense in our consolidated statement of operations. For the three months ended March 31, 2003, our net loss from foreign currency forward contracts was $159,000. We did not enter into forward contracts for the three months ended March 31, 2002.

     We may continue to use foreign currency forward contracts to manage foreign currency exchange risks in the future.

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

E. Income Taxes

     The income tax provisions from continuing operations for the three months ended March 31, 2003 and 2002 were $632,000 and $1.2 million, respectively, and reflected the effect of non-deductible acquisition-related costs, partially offset by benefits of $1.1 million for each period end, from the utilization of deferred tax liabilities related to certain of these acquisition-related costs.

     Excluding the effect of acquisition-related items, an effective tax rate of 34% and 35% was applied to continuing operations for the three months ended March 31, 2003 and 2002, respectively, and represented federal, state and foreign taxes on our income, reduced primarily by research and development credits, foreign tax credits, and other benefits from foreign sourced income.

F. Lines of Credit and Long-Term Convertible Debt

     We have a $20.0 million line of credit with a U.S. bank. Our $20.0 million credit facility is collateralized by substantially all of our assets, bears interest at or, in some cases, below the lender’s prime rate (4.25% at March 31, 2003) and expires on August 31, 2004. Under the terms of this facility, we are required to maintain certain financial ratios and meet certain net worth and indebtedness covenants. We believe we are in compliance with these requirements. There have been no borrowings under this credit facility.

     In November 1999, we completed the private placement of $135.0 million principal amount at maturity of 3.25% convertible subordinated discount notes due in 2004, issued at 85.35% of their face amount (equivalent to gross proceeds of approximately $115.2 million at issuance before discounts and expenses). These convertible notes became callable as of November 2002.

G. Commitments and Contingencies

Legal Claims

Alcatel USA, Inc. and Alcatel USA Sourcing, L.P. vs Tekelec

     In August 2000, Alcatel USA, Inc. and Alcatel USA Sourcing, L.P. (collectively, “Alcatel”) filed a complaint against us in the United States District Court for the Eastern District of Texas, Sherman Division. The complaint alleges that we make and sell products that infringe two patents owned by Alcatel Sourcing. The patents at issue relate to a system and method for application location register routing in a telecommunications network. Alcatel’s allegations relate to three particular software applications offered by us as a feature on our EAGLE STP for routing query messages in wireless networks. Alcatel seeks a permanent injunction enjoining us from infringing the patents at issue, unspecified general and exemplary damages, and an award of costs.

     In September 2000, we filed an answer and counterclaim to Alcatel’s complaint denying Alcatel’s claims of infringement and raising several affirmative defenses. We have also asserted several counterclaims against Alcatel seeking declaratory relief that we have not infringed the Alcatel patents and that such patents are invalid and unenforceable. We believe that we have

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

strong defenses to Alcatel’s claims on the grounds of invalidity, noninfringement and inequitable conduct by Alcatel, and are defending the action vigorously.

     A trial date was originally scheduled for June 2002. In April 2002, we filed a motion for summary judgment for non-infringement and Alcatel filed a motion for summary judgment for infringement. The Court referred both motions to the Magistrate Judge for consideration. After a hearing on both motions before the Magistrate Judge in May 2002, the Magistrate Judge issued a report and recommendation of non-infringement in favor of us. The Court subsequently entered an order rescinding the June 2002 trial setting and all remaining deadlines, indicating that after the Court has ruled on the Magistrate Judge’s report and recommendation, the Court will enter such orders as are deemed appropriate for the final disposition of the case. The Court has not yet ruled on the Magistrate Judge’s report and recommendation. We currently believe that the ultimate outcome of the lawsuit will not have a material adverse effect on our financial condition, results of operations or cash flows.

Lemelson Medical, Education and Research Foundation, Limited Partnership vs. Tekelec

     In March 2002, the Lemelson Medical, Education & Research Foundation, Limited Partnership (“Lemelson”) filed a complaint against thirty defendants, including Tekelec, in the United States District Court for the District of Arizona. The complaint alleges that all defendants make, offer for sale, sell, import, or have imported products that infringe eighteen patents assigned to Lemelson, and the complaint also alleges that the defendants use processes that infringe the same patents. The patents at issue relate to computer image analysis technology and automatic identification technology. Lemelson has not identified the specific Tekelec products or processes that allegedly infringe the patents at issue, and we are currently investigating which products and/or processes might be subject to the lawsuit. At present, the lawsuit is stayed pending a non-appealable resolution of a lawsuit involving the same patents that is pending in the United States District Court for the District of Nevada. We currently believe that the ultimate outcome of the lawsuit will not have a material adverse effect on our financial condition, results of operations or cash flows.

     In January 2002, Syndia Corporation (“Syndia”) sent a letter to Tekelec accusing Tekelec of infringing two patents and offering to license these and other patents to Tekelec. The patents at

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

issue relate to integrated circuit technology. Syndia has not identified the specific Tekelec products or processes that allegedly infringe the patents at issue, and Tekelec is currently investigating which products and/or processes might be subject to Syndia’s claims.

Indemnities, Commitments and Guarantees

     In the normal course of our business, we make certain indemnities, commitments and guarantees under which we may be required to make payments in relation to certain transactions. These indemnities, commitments and guarantees include, among others, intellectual property indemnities to our customers in connection with the sale of our products and licensing of our technology, indemnities for liabilities associated with the infringement of other parties’ technology based upon our products and technology, guarantees of timely performance of our obligations, and indemnities to our directors and officers to the maximum extent permitted by law. The duration of these indemnities, commitments and guarantees varies, and in certain cases, is indefinite. The majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments that we could be obligated to make. We have not recorded a liability for these indemnities, commitments or guarantees in the accompanying balance sheets, as future payment is not probable.

H.

Stock-Based Compensation

     As of March 31, 2003, we have five stock-based employee compensation plans. We account for employee stock option plans in accordance with the provisions of Accounting Principals Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and the related interpretations of FIN No. 44, “Accounting for Certain Transactions Involving Stock Compensation.” Accordingly, compensation expense related to employee stock options is recorded, if on the date of the grant, the fair value of the underlying stock exceeds the exercise price.

     To date, options have been granted at exercise prices that equal or exceed market value of the underlying common stock on the grant date. However, we have modified certain option grants that did require remeasurement on the modification date and accordingly have resulted in stock-based compensation as the exercise prices were below the fair market value on the date of the modification. We account for stock issued to non-employees in accordance with the provisions of SFAS No. 123 and EITF Issue No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and Services.”

     SFAS No. 123 encourages but does not require companies to record compensation cost for stock-based employee compensation plans at fair value for awards granted subsequent to December 31, 1995. We have chosen to continue to account for stock-based compensation using the intrinsic value method prescribed in related interpretations. However, in accordance with the disclosure only requirements of SFAS 123, we have computed the fair value of our stock option grants using the Black-Scholes option-pricing model with the following assumptions: (i) dividend yield of 0%, (ii) expected volatility of 86% and 90%, respectively, for 2003 and 2002, (iii) weighted average risk-free interest rates of 2.6% and 3.7% for 2003 and 2002, respectively, (iv) weighted average expected option lives of 5.8 and 4.9 years for 2003 and 2002, respectively, and (v) assumed forfeiture rate of 41% and 50% for 2003 and 2002, respectively.

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

     The following table illustrates the effect on stock-based compensation, net income and earnings (loss) per share if we had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation.

I.

Operating Segment Information

     The Network Systems operating segment develops, markets and sells our Eagle signaling products based on our high capacity Eagle 5 Signaling Application System (SAS) platform that has recently been expanded to include TekWare and TekServer architecture, a high-density, high-speed processing platform that is backward compatible with existing technology; the IP7 Secure Gateway, an SS7/IP gateway for signaling in converged networks, and other IP7 convergence products; Sentinel, a complete network monitoring and revenue assurance system; and network systems products resulting from our acquisition of IEX, including ASi 4000 Service Control Point, an advanced database server used for the provisioning of telephony applications, and VXi Media Gateway Controller, a controller for converged networks.

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     The Contact Center operating segment develops, markets and sells software-based solutions for call centers, including TotalView Workforce Management and TotalNet Call Routing.

     As discussed in Note B — Disposition of Network Diagnostics Business, we sold the Network Diagnostics operating segment and the Japan Diagnostics operating segment, (collectively “NDD”). NDD is reflected as a discontinued operation and accordingly the historical operating segment data has been restated to exclude the discontinued operation.

     Transfers between operating segments are made at prices reflecting market conditions. The allocation of revenues from external customers by geographical area is determined by the destination of the sale.

     Our operating segments and geographical information are as follows (in thousands):

Operating Segments

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

Enterprise-Wide Disclosures

     The following table sets forth, for the periods indicated, revenues from external customers by principal product line:

     The following table sets forth, for the periods indicated, revenues from external customers by geographic territory:

     The following table sets forth, for the periods indicated, long-lived assets by geographic area in which we hold assets:

     Sales to two customers individually accounted for 15% and 14% of revenues for the three months ended March 31, 2003 and included sales from the network systems and contact center operating segments. Sales to one customer accounted for 13% of the revenues for the three months ended March 31, 2002 and included sales from the network systems operating segment.

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

J.

Earnings Per Share

     The following table provides a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations for the three month period ended March 31, 2003 and 2002:

     The computation of diluted number of shares for the three months ended March 31, 2003 excludes unexercised stock options and warrants and potential shares issuable upon conversion of our convertible subordinated discount notes that are anti-dilutive. The numbers of such shares excluded were 20.8 million for the three months ended March 31, 2003.

K.

Subsequent Event

     On April 30, 2003 we announced a definitive agreement to combine our existing packet telephony business operations with Santera Systems, Inc. The business will be a majority owned subsidiary of Tekelec and will be called Santera, a Tekelec Company.

     Under terms of the agreement, we will contribute $28.0 million in cash and our existing packet telephony business assets. Santera’s current investors will contribute an additional $12.0 million in cash. Initially, the subsidiary will be 52% owned by us. We will also have the right to increase our ownership percentage in the new subsidiary up to 62.5% (on an as converted basis) and have the option to purchase the entire remaining interest during the period from July 1, 2005 through December 31, 2007. The transaction is expected to close before the end of the second quarter, pending U.S. anti-trust approval.

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

     The following discussion should be read in conjunction with, and is qualified in its entirety by, the consolidated financial statements and the notes thereto included in Item 1 of this Quarterly Report and the Consolidated Financial Statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s Annual Report on Form 10-K for the year ended December 31, 2002. Historical results and percentage relationships among any amounts in the financial statements are not necessarily indicative of trends in operating results for any future periods.

     As more fully described in Note B — Disposition of Network Diagnostics Business to the Consolidated Financial Statements, we completed the sale of our Network Diagnostics Division (“NDD”) to Catapult Communications Corporation (“Catapult”) effective August 30, 2002 for $59.8 million, consisting of $42.5 million in cash and convertible subordinated promissory notes issued by Catapult’s wholly owned Irish subsidiary and guaranteed by Catapult in the total amount of $17.3 million, subject to certain adjustments. The sale resulted in a pre-tax gain of approximately $41.7 million ($28.3 million after taxes). As a result, our 2002 financial results have been restated to reflect the NDD as a discontinued operation. The discussion and figures below are based on this restated presentation.

     Our logo, IEX and Eagle are registered trademarks of Tekelec. Tekelec, IP7, IP7 Secure Gateway, ASi 4000, VXi, TekWare, TekServer, TotalView and TotalNet are trademarks of Tekelec.

Overview

     Our product offerings are currently organized into two distinct product lines: network systems and contact center.

     Network Systems. Our network systems product line consists principally of the Eagle 5 SAS and products, features and applications based on the Eagle platform, including TekWare and TekServer, the IP7 Secure Gateway and the Company’s local number portability solution, Sentinel, ASi 4000 Service Control Point, VXi Media Gateway Controller and other convergence products.

     Contact Center. Our IEX contact center products provide planning, management and call routing and control tools for single contact centers and for complex, multiple site contact center environments. This product line includes the TotalView Workforce Management and TotalNet Call Routing solutions.

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Results of Operations

     The following table sets forth, for the periods indicated, the percentages that certain income statement items bear to total revenues: