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FORM 10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

(Mark One)

For the quarterly period ended September 30, 2003

OR

Commission file number 0-15135

TEKELEC

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 [   ]

     Indicate by check mark whether the registrant is an accelerated filer. Yes [X] No [   ]

     As of November 7, 2003, there were 61,520,692 shares of the registrant’s common stock, without par value, outstanding.

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TABLE OF CONTENTS
TEKELEC
FORM 10-Q
INDEX

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PART I — FINANCIAL INFORMATION

Tekelec
Consolidated Balance Sheets

See notes to consolidated financial statements.

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Tekelec
Consolidated Statements of Operations
(unaudited)

See notes to consolidated financial statements.

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Tekelec
Consolidated Statements of Comprehensive Income
(unaudited)

See notes to consolidated financial statements.

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Tekelec
Consolidated Statements of Cash Flows
(unaudited)

See notes to consolidated financial statements.

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

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 statement of our financial condition, operating results and cash flows for the interim periods. The consolidated financial statements include the accounts and operating results of our wholly owned subsidiaries and our majority owned subsidiary, Santera, less minority interest from the acquisition date of June 10, 2003. See note B — Acquisition of Majority Interest in Santera.

     As more fully described in Note C – 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 and nine months ended September 30, 2003 and 2002 are for the thirteen and thirty-nine weeks ended September 26, 2003 and September 27, 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 our Annual Report on Form 10-K for the year ended December 31, 2002.

Recent Accounting Pronouncements

     In February 2003, the Financial Accounting Standards Board (“FASB”) issued Emerging Issues Task Force (“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. Adoption of EITF Issue No. 00-21 did not have a material impact on our financial position, results of operations or cash flows.

     In April 2003, the FASB issued Statement of Financial Accounting Standard (“SFAS”) No. 149, “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” SFAS No. 149 amends and clarifies the accounting guidance on derivative instruments (including certain derivative instruments embedded in other contracts) and hedging activities that fall within the scope of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 149 is effective for all contracts entered into or modified after June 30, 2003, with certain exceptions, and for hedging relationships designated after June 30, 2003. The guidance is to be applied prospectively. Currently, we do not enter into these types of transactions and therefore this pronouncement did not have an impact on our financial position, results of operations or cash flows.

     In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 changes the accounting for certain financial instruments that under previous

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

guidance could be classified as equity, or “mezzanine” equity, by now requiring those instruments to be classified as liabilities in the statement of financial position. Further, SFAS No. 150 requires disclosure regarding the terms of those instruments and settlement alternatives. SFAS No. 150 was generally effective for all financial instruments entered into or modified after May 31, 2003, and was otherwise effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of SFAS No. 150 did not have a material impact on our financial position, results of operations, or cash flows.

     In January 2003, FASB issued Interpretation (“FIN”) No. 46, “Consolidation of Variable Interest Entities-an Interpretation of ARB No. 51.” The Interpretation clarified the application of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” to certain entities in which equity investors 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. The provisions of this Interpretation are effective for all enterprises with variable interest entities created after January 31, 2003. On October 8, 2003, the FASB deferred the implementation date of Interpretations No. 46 from the third quarter of 2003 to the fourth quarter of 2003. The adoption of Interpretation No. 46 will not have a material impact on our financial position, results of operations, or cash flows.

B. Acquisition of Majority Interest in Santera

     On June 10, 2003, we acquired a 51.6% controlling voting ownership interest (57.5% on an as converted basis) in Santera in exchange for cash contribution of $28.0 million and the contribution of the business operations and certain assets and liabilities of Tekelec’s Packet Telephony Business Unit (“PTBU”). As part of the acquisition and combination, Santera was recapitalized and Tekelec contributed the $28.0 million in cash to Santera in exchange for 28,000 shares of Santera’s Series B Preferred Stock. In addition, Tekelec received 38,000 shares of Santera’s Series A Preferred Stock and one share of Santera’s common stock in exchange for the PTBU. Santera’s existing shareholders received 62,000 shares of Series A Preferred Stock in exchange for their existing shares in Santera and made an additional cash contribution to Santera of $12.0 million. Each share of Santera’s Series B Preferred Stock has a liquidation preference equal to $2,000 and is convertible into 1.63 shares of Santera’s common stock. Each share of Santera’s Series A Preferred Stock has a liquidation preference equal to $1,000 and is convertible into one share of Santera’s common stock. In accordance with consolidation accounting, the capital structure of Santera has been eliminated in consolidation and the minority shareholders’ interest in Santera is reflected in our consolidated balance sheet as minority interest. The minority shareholders’ interest in Santera is reflected at the fair value of the Santera assets acquired. Santera develops, markets and sells solutions for carrier-class, next-generation switches.

     The transaction has been accounted for using the purchase method of accounting, and resulted in a step-up of approximately $56.9 million of Santera’s assets and liabilities to fair value as follows:

     The total purchase price step-up were allocated among the Santera assets acquired and liabilities assumed based on their estimated fair values determined by a third party appraisal as follows:

     The PTBU assets and liabilities contributed remain at historical cost.

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

     Based on the purchase price allocation, $2.9 million of the purchase price represented acquired in-process research and development (“IPRD”) that had not yet reached technological feasibility and had no alternative future use. This amount was recorded as an expense in the second quarter of 2003. The identifiable intangible assets created as a result of the acquisition will be amortized over their estimated useful lives of 15 years, with the exception of acquired backlog which has an estimated life of one year. Amortization expense of purchased technology and other intangible assets of Santera, including the intangible assets contributed by PTBU, amounted to $1.9 million and $2.2 million for the three and nine months ended September 30, 2003, respectively.

     The following table shows our pro forma revenue, net income and net income per share giving effect to the Santera acquisition as of the beginning of 2002, excluding the impact of the one-time IPRD charge:

     The net income and losses of Santera are allocated between us and minority interest based on the relative interest in the equity of Santera and the related liquidation preferences. This approach requires net losses to be allocated first to the Series A Preferred Stock until fully absorbed and then to the Series B Preferred Stock. Subsequent net income will be allocated first to the Series B Preferred Stock to the extent of previously recognized net losses allocated to Series B Preferred Stock. Additional net income will then be allocated to the Series A Preferred Stock to the extent of previous recognized losses allocated to Series A Preferred Stock and then to Series A and B Preferred Stock in proportion to relative ownership. The loss allocated to minority interest of Santera for the period of June 10, 2003 through September 30, 2003 was computed as follows (dollars in thousands):

     In addition to the initial ownership interest, we have the right to increase our ownership to up to 56.0% of Santera’s outstanding shares (62.5% on an as converted basis) for a per share purchase price equal to the per share purchase price of our original investment. We also have certain rights, exercisable during the period from July 1, 2005 through December 31, 2007, to acquire the remaining outstanding shares of Santera from the holders thereof at a price determined in accordance with the terms of the definitive agreements (the “Tekelec Option Price”). In addition, the other shareholders of Santera will have the right, exercisable during the period from January 2006 through February 2008, to require us to purchase their shares at a price equal to 80% of the Tekelec Option Price, provided Santera has been profitable for the two calendar quarters preceding such exercise.

C. 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 cash in the amount of $42.5 million and convertible subordinated promissory notes (the “Notes”) issued by Catapult’s wholly owned Irish subsidiary and guaranteed by Catapult in the total principal amount of $17.3 million. The sale resulted in a pre-tax gain of approximately $41.7 million ($28.3 million after taxes) in 2002. During the third quarter of 2003, an additional $3.3 million gain on the sale was recognized based on post closing adjustments, including working capital, resulting from the final settlement with Catapult in accordance with the asset purchase

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

agreement. 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 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 were initially 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 Notes is being adjusted to the redemption amount at maturity based on an effective interest amortization method, with periodic charges to interest. The fair values of the Notes and the conversion option are as follows:

D. Certain Balance Sheet Items

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

E. Financial Instruments

     We conduct business in a number of foreign countries, with certain transactions denominated in local currencies. During the nine months ended September 30, 2003, we entered into forward contracts to mitigate exposures associated with sale contracts denominated in currencies other than the U.S. 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 September 30, 2003, we had one foreign currency forward contract outstanding to sell approximately 2,800,000 Euros in order to hedge certain receivables denominated in those currencies. These contracts had an expiration date of October 3, 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 and nine months ended September 30, 2003, our income (loss), net from foreign currency forward contracts was $10,000 and ($412,000), respectively. We did not enter into forward contracts for the three and nine months ended September 30, 2002.

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

F. Income Taxes

     The income tax provisions from continuing operations for the three and nine months ended September 30, 2003 were $5.0 million and $7.6 million, respectively, and reflected the effect of non-deductible acquisition-related costs, partially offset by benefits of $557,000 and $2.6 million, respectively, from the utilization of deferred tax liabilities related to certain of these acquisition-related costs.

     The provision for income taxes does not include any benefit from the losses generated by Santera due to their losses not being included on our federal consolidated tax return because our ownership interest in Santera does not meet the threshold to consolidate under income tax rules and regulations and a full valuation is provided on the tax benefits generated by Santera as a result of their historical operating losses.

     Excluding the effect of acquisition-related items and Santera’s operating results, an effective tax rate of 34% and 35% was applied to continuing operations for the three and nine-month periods ended September 30, 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.

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

G. Lines of Credit, Notes Payable 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, excluding the assets of Santera, bears interest at or, in some cases, below the lender’s prime rate (4.0% at September 30, 2003) and expires on August 31, 2004, if not renewed. Under the terms of this credit 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.

     As a result of the Santera transaction (see note B — Acquisition of Majority Interest in Santera), we have two notes payable to U.S. financial institutions. One of the notes has an outstanding balance of $3.7 million and is secured by the assets purchased under the note, bears interest at 10% and matures in February 2005. The second note for $3.5 million is secured by the assets purchased under the note and substantially all of Santera’s assets, excluding the assets secured under the $3.7 million note, bears interest at 6.36% and matures in November 2005. Under the terms of this facility, we are required to maintain certain financial reporting covenants. We believe we are in compliance with these requirements.

     In November 1999, we completed the private placement of $135.0 million principal amount at maturity of 3.25% convertible subordinated discounted 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). The discounted notes were called and subsequently redeemed on July 19, 2003.

     In June 2003, we completed the private placement of $125.0 million principal amount of 2.25% Senior Subordinated Convertible notes due in 2008.

H. 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 Tekelec in the United States District Court for the Eastern District of Texas, Sherman Division. The complaint alleged that Tekelec makes and sells 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 a particular software application offered by Tekelec as a feature on its STP for routing query messages in wireless networks. Alcatel sought a permanent injunction enjoining the Company from infringing the patents at issue, unspecified general and exemplary damages, and an award of costs.

     In September 2000, Tekelec filed an answer and counterclaim to Alcatel’s complaint denying Alcatel’s claims of infringement and raising several affirmative defenses. Tekelec asserted several counterclaims against Alcatel seeking declaratory relief that Tekelec has not infringed the Alcatel patents and that such patents are invalid and unenforceable. Tekelec defended the action vigorously, asserting defenses to Alcatel’s claims on the grounds of invalidity, non-infringement and inequitable conduct by Alcatel.

     In April 2002, Tekelec 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 Tekelec. After a hearing held in May 2003, the District Judge partially upheld and partially overruled the Magistrate Judge’s recommendation. By letter, the Judge indicated he would find summary judgment of non-infringement for Tekelec on some claims of the patents, but would deny summary judgment on other claims. The Court also indicated it would deny Alcatel’s Motion for Summary Judgment of infringement.

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

     In August 2003, the Magistrate Judge heard and subsequently denied cross-motions for summary judgment filed by Alcatel and Tekelec on the Company’s defenses of invalidity and inequitable conduct.

     In September 2003, Tekelec and Alcatel reached a settlement under which Tekelec received from Alcatel, in exchange for the payment by Tekelec of a lump sum, a license under the patents-in-suit and under other related patents, as well as a covenant not to sue for other unrelated patents which had been asserted against an affiliate of Tekelec. The lawsuit has been dismissed with prejudice. The terms of the settlement are confidential.

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 us, 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.

Syndia Corporation

     In January 2002, Syndia Corporation (“Syndia”) sent a letter to us accusing Tekelec of infringing two patents and offering to license these and other patents to us. The patents at issue relate to integrated circuit technology. Syndia 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 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 because future payment is not probable.

I. Stock-Based Compensation

     As of September 30, 2003, we have five stock-based employee compensation plans. We account for employee stock option plans in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, “Accounting for Stock Issued to Employees” and the related FASB interpretation 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

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Tekelec
Notes to Consolidated Financial Statements
(unaudited)

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 because 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 No. 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 85% and 90%, respectively, for 2003 and 2002, (iii) weighted average risk-free interest rates of 2.2% and 3.7% for 2003 and 2002, respectively, (iv) weighted average expected option lives of 5.0 and 4.9 years for 2003 and 2002, respectively, and (v) assumed forfeiture rate of 47% and 50% for 2003 and 2002, respectively.

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