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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2001.
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to .
COMMISSION FILE NUMBER 000-29661
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UTSTARCOM, INC.
(Exact name of Registrant as specified in its charter)
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DELAWARE 52-1782500
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
1275 HARBOR BAY PARKWAY,
ALAMEDA, CALIFORNIA 94502
(Address of principal (Zip Code)
executive offices)
Registrant's telephone number, including area code: (510) 864-8800
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act: Common Stock,
$0.00125 par value
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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 if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of voting stock held by non-affiliates of the
registrant as of January 31, 2002, was approximately $1,370,189,831 based upon
the closing price of $25.92 reported for such date on The Nasdaq National
Market. For purposes of this disclosure, shares of Common Stock held by persons
who hold more than 5% of the outstanding shares of Common Stock and shares held
by officers and directors of the registrant, have been excluded in that such
persons may be deemed to be affiliates. This determination is not necessarily
conclusive.
As of January 31, 2002, registrant had outstanding 109,577,835 shares of
Common Stock.
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DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement for the Annual Meeting of Shareholders to be
held on May 10, 2002 are incorporated herein by reference in Part III.
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UTSTARCOM, INC.
TABLE OF CONTENTS
Page
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PART I.
Item 1. Business............................................................................. 3
Item 2. Facilities........................................................................... 20
Item 3. Legal Proceedings.................................................................... 21
Item 4. Submission of Matters to a Vote of Security Holders.................................. 21
Executive Officers................................................................... 21
PART II.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters................ 24
Item 6. Selected Financial Data.............................................................. 25
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations 26
Item 7A. Quantitative and Qualitative Disclosures About Market Risks.......................... 53
Item 8. Financial Statements and Supplementary Data.......................................... 53
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. 86
PART III.
Item 10. Directors and Executive Officers of the Registrant................................... 86
Item 11. Executive Compensation............................................................... 86
Item 12. Security Ownership of Certain Beneficial Owners and Management....................... 86
Item 13. Certain Relationships and Related Transactions....................................... 86
PART IV.
Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K..................... 86
Exhibit Index........................................................................ 87
Signatures........................................................................... 93
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PART I
FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements within
the meaning of the federal securities laws. These statements are based on
information that is currently available to management. We intend such
forward-looking statements to be covered by the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995, and we are including this
statement for purposes of complying with those provisions. The forward-looking
statements include those concerning the following: our expectation regarding
continued growth in our business and operations; our expectation that our PAS
network access system will continue to be allowed in China's county-level
cities and counties; our expectation that there will be no penalties or fines
for our non-compliance with the licensing requirements in China for our PAS
system and other products; our expectation that there will be fluctuations in
our overall gross profit, gross margin, product mix and selling prices; our
plans for expanding the direct sales organization and our selling and marketing
campaigns and activities; our expectation that we may use part of the net
proceeds of our initial and follow on public offerings to acquire or invest in
complementary businesses, technologies or product offerings; our expectation
that there will be increases in selling, marketing, research and development,
general and administrative expenses; our expectation that we will continue to
invest significantly in research and development; our expectation that we will
fill the majority of our current backlog orders; our expectation regarding our
future investments, particularly in Softbank China; and our expectation that
existing cash and cash equivalents will be sufficient to finance our operations
for at least the next 12 months. Additional forward-looking statements may be
identified by the words, "anticipate," "expect," "believe," "intend," "will"
and similar expressions, as they relate to us or our management. Investors are
cautioned that these forward-looking statements are inherently uncertain. These
statements are subject to risks and uncertainties that may cause actual results
and events to differ materially. For a detailed discussion of these risks and
uncertainties, see the "Factors Affecting Future Operating Results" section of
this Form 10-K. We do not guarantee future results and undertake no obligation
to update the forward-looking statements to reflect events or circumstances
occurring after the date of this Form 10-K.
ADDITIONAL INFORMATION
UTStarcom is registered as a trademark in the United States. UTStarcom and
PAS are registered as trademarks in China. We have applied to register the
mSwitch and Netman trademarks in China. This prospectus also includes product
names, trade names and trademarks of other companies. All other product names,
trade names and trademarks appearing in this prospectus are the property of
their respective holders.
In this Annual Report on Form 10-K, references to and statements regarding
China refer to mainland China, references to "U.S. dollars" or "$" are to
United States Dollars, and references to "Renminbi" are to Renminbi, the legal
currency of China.
Unless specifically stated, information in this Annual Report on Form 10-K
assumes an exchange rate of 8.3 Renminbi for one U.S. dollar, the exchange rate
in effect as of December 31, 2001.
ITEM 1--BUSINESS
Overview
We design, manufacture and market wireline and wireless broadband access and
switching equipment that enables migration to next generation IP-based
networks. Historically, substantially all of our sales have been to service
providers in China, however we are currently expanding to include other growing
communications markets outside of China. Our integrated suite of products
provides migration to next generation networks and allows service providers to
offer efficient and expandable voice, data and Internet access services.
Because our systems are based on widely adopted international communications
standards, service providers can easily
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integrate our systems into their existing networks and deploy our systems in
new broadband, Internet Protocol and wireless network rollouts. Internet
Protocol, or IP, refers to a set of rules developed for communicating
information over the Internet.
We provide a range of network service solutions based on three principle
technology platforms: mSwitch, PAS and AN-2000. mSwitch is an IP-based,
multiservice softswitch designed to provide voice and data switching and
gateway functions either integrated with PAS or AN-2000 or on a standalone
basis. PAS allows service providers to offer voice, data and value-added
services over mobile and fixed wireless networks using specially designed PAS
handsets. As of December 31, 2001, we had sold approximately 6.6 million lines
of PAS equipment servicing approximately 3.0 million subscribers in 210 cities
in China. Based on our knowledge of China's communications market, we believe
that PAS is the most widely deployed wireless local access system in China. In
the Taiwan market, there were approximately 160,000 subscribers using our PAS
systems as of December 31, 2001. For wireline networks, we provide a
broadband-ready platform called AN-2000. As of December 31, 2001, approximately
3.2 million lines of our wireline AN-2000 access platform have been deployed in
China, including deployments in the six largest regional communications
markets. Another 800,000 lines of our AN-2000 access platform have been
deployed in markets outside of China.
Industry Background
Growth in China's Communications Market. China has one of the fastest
growing communications markets in the world. Growth in China's communications
equipment and services markets is being driven by the government of China's
commitment to developing a communications infrastructure, strong demand for
communications services and robust economic growth.
China's demand for communications services is highlighted by its relatively
low teledensity rate, which is a measure of the number of lines per hundred
people. The International Telecommunication Union reported as of January 2001
that China, with a population of approximately 1.3 billion, had a fixed-line
teledensity rate of only 11.2%. In contrast, according to the International
Telecommunication Union, fixed-line teledensity rates in 2001 for the United
Kingdom, France, Hong Kong and the United States were 58.2%, 58.0%, 57.8% and
70.0%, respectively. While growth in China's communications market is currently
driven predominantly by voice services, the increasing demand for data services
also presents a growing opportunity both in China and in other international
markets. The Gartner Group estimates that Internet users in China will grow
from 20.0 million in 2001 to 51.0 million in 2004, representing a compound
annual growth rate of 36.6%. In order to support this anticipated growth in
data traffic, service providers in China must continue to expand their
networks. We believe this is best achieved by deploying IP-based equipment.
China's ability to invest heavily in its communications infrastructure is
fueled by the country's strong economic activity. According to the Economist
Intelligence Unit, China's gross domestic product, or GDP, grew 7.3% in 2001.
The Economist Intelligence Unit also estimates that China's GDP will grow at a
compound annual growth rate of 7.5% from 2001 to 2005.
Communications Needs of Developing Countries. Demand for voice and data
communications services in developing countries continues to grow rapidly and
is driven by both public sector infrastructure investment and private sector
business growth. The governments of many developing countries have identified
the development of a communications infrastructure as a key driver of
modernization and economic growth. According to a 2001 report by the
International Telecommunication Union, in 1999 developing countries invested
$55.9 billion in communications infrastructure, representing 29.6% of all
communications infrastructure spending worldwide. Governments are increasingly
implementing and funding infrastructure development through privatization of
state-owned telecommunications service providers. These service providers, in
turn, are deploying advanced networks for voice and data services. In addition,
increasingly affluent businesses and residential consumers in the highest
growth regions of these countries are demanding state-of-the-art voice and data
communications solutions to interact and compete on a global basis.
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Communications Network Architecture in China. The development of China's
communications infrastructure involves installing a nationwide network of
high-bandwidth fiber-optic backbone networks and connecting each business and
residential subscriber to this backbone. The wireline and wireless systems that
link local subscribers to these backbone networks are referred to as the last
mile or the local access network. The high growth rate, geographic dispersion
and diverse communications needs of residences and businesses in China means
that the direct wiring of subscribers to the backbone network using traditional
copper connections is a lengthy, costly and inefficient process. Direct wiring
of subscribers to traditional telephone switches often locks those subscribers
into a limited set of communications services and limits expandability and
migration to other services. In contrast, service providers in China require
communications equipment that allows them to provide services quickly,
efficiently and cost-effectively. Given the relative absence of a legacy
communications infrastructure in China, these service providers are less
constrained and thus often seek to deploy the latest best-of-breed systems with
the flexibility to handle voice and data services.
Needs of Service Providers. Voice and data service providers require
network solutions that address all of their access needs and offer easy
migration to next generation networks. These service providers require products
that enable them to quickly, and with minimal incremental investment, address
the changing demands of their subscribers for expanded or more advanced
services. Given the rapid growth in emerging communications markets such as
China, network solutions must be scalable so that the same architecture can
provide an affordable entry level solution to initially serve a few hundred
subscribers, yet economically scale to serve several hundred thousand
subscribers over time. In addition, service providers require the following:
. IP-Based Networks. An increasing amount of voice and data traffic travels
across IP-based networks instead of traditional circuit-based networks.
The principal advantages of IP-based networks over circuit-based networks
are lower cost, higher speed and the support of multiple applications,
including e-mail, short-messaging, Internet access, video and voice in a
single network. Because of these advantages, investment in IP-based
networks is increasing while investment in circuit-based networks is
decreasing.
. Return on Investment. As competition intensifies, service providers
require the ability to offer advanced and flexible services to their
customers. Service providers must ensure these new services drive
subscriber growth and ultimately revenue and profitability. As a result,
service providers are focused on return on investment, enabling them to
deploy technology that provides increased services today while also
providing a cost-effective migration path to future expansion and
functionality.
. Integrated Voice and Data Solutions. Service providers are increasingly
looking to expand their service offerings beyond traditional voice
services to provide data and other value-added services. As advanced high
speed data networks are deployed, service providers will require solutions
that can be upgraded to adapt to new technologies while preserving the
investment in their existing infrastructure. These networks will enable
service providers to differentiate their service offerings, build customer
loyalty and generate incremental revenue.
. Rapid Deployment. Given the rapid growth in emerging communications
markets such as China, service providers are focused on quickly deploying
solutions to meet customer needs. Wireless access solutions allow for
rapid deployment of relatively inexpensive networks that give service
providers significant revenue potential and cost advantages over wireline
networks. In addition, service providers require wireless networks that
will allow for convergence of voice and data and migration to third
generation networks, referred to as 3G networks.
. Commitment to Local Markets. Service providers value equipment vendors
that have made a strong commitment to their local markets. This commitment
includes direct sales forces and local service organizations to respond to
the needs of service providers and their subscribers.
Although markets such as China represent substantial opportunities for
communications equipment vendors, few companies have delivered products that
have the ability to smoothly migrate to next generation technologies, coupled
with the local presence that service providers require.
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The UTStarcom Solution
We design, manufacture and market wireline and wireless broadband access and
switching equipment that enables migration to next generation IP-based
networks. We believe our key competitive advantages are:
Migration to Next Generation IP Networks. Our products are designed with
the flexibility to allow service providers to deliver voice and data services
over today's circuit-based networks and offer the ability to migrate to next
generation broadband wireline and wireless networks based on IP and open
standards. As a result, service providers can preserve their investment in
existing networks and generate significant incremental revenue from their
investment in our products while migrating to next generation networks over
time. Our products enable service providers to effectively time their network
equipment expenditures, expand voice and data capacity and rapidly introduce
new services as demand warrants.
Cost-Effective Solutions. Our products are designed to provide operators
with a high return on their investment. By reducing network complexity,
integrating high performance capabilities and providing a flexible migration
path to next generation networks, our products cost less to deploy and maintain
than most alternative technologies.
Convergence of Voice and Data Services. We have designed our systems to
offer a high degree of flexibility in terms of subscriber capacity and types of
traffic delivered. Our equipment can be flexibly configured to offer a variety
of services in response to subscriber demand. This flexibility is particularly
important in China, as the communications services market is undergoing rapid
change and growth. As Internet usage achieves greater penetration in China, we
believe service providers will desire systems that are designed to deliver
high-speed data capability. Our access systems allow service providers to
quickly and cost-effectively implement upgrades for new services, including
high-speed data capability, compared to alternative solutions which may require
the purchase of an entirely new system to provide these services.
Wireless Access Networks. Our wireless access solutions are ideally suited
for the requirements of service providers in emerging communications markets.
Service providers can deploy our products quickly to cost-effectively meet
customer demand. Our systems allow service providers to rapidly add new
subscribers and to scale network capacity in response to demand. Our IP-based
wireless access solutions also provide a platform for service providers to
migrate to 3G mobile networks.
Local Presence. We have established a strong local presence in China that
allows us to be responsive to the needs of service providers and their
subscribers. We manufacture our products primarily at our facility in Hangzhou
in Zhejiang province. By using local facilities in China, we have helped create
new jobs within the provinces and have strengthened our relationships with the
Telecommunications Administrations in some of China's most modern and rapidly
growing provinces. We also maintain 15 sales and customer support sites in
China that allow us to deploy a customer support representative onsite anywhere
in China within 24 hours. Our sales force develops direct relationships with
decision makers at both the provincial and local levels through pre-sales
design and consulting services. Additionally, through our relationships at the
national, provincial and local levels we receive a flow of information
regarding market changes and insight into unique service provider needs and
related opportunities. As part of this strategy to develop a local presence in
markets that we serve, we also have sales, support and engineering personnel in
Taiwan and India.
Strategy
Our objective is to be a leading provider of wireline and wireless broadband
access and switching equipment. The principal elements of our strategy are as
follows:
Capitalize on the Emerging IP-based Switching Market. We believe the
increase in Internet usage, particularly voice over IP traffic, has resulted in
a market need for a next-generation, IP-based switching platform. Accordingly,
we are making a substantial investment in developing our mSwitch platform,
which is
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designed to integrate with our existing products and can be scaled in response
to increased demand. We believe that mSwitch can deliver value to service
providers, both as a stand-alone system and in combination with our PAS system
and AN-2000 platform. We intend to incorporate additional functionality into
the mSwitch platform in the future, which we believe will enable us to enter
new markets in China and around the world.
Leverage Our Installed Base to Capitalize on Demand for Wireless and
Wireline Broadband Services. We believe we are well positioned to leverage our
installed base of systems and service provider relationships to capitalize on
an increasing demand for data and broadband services. To meet this demand, we
intend to:
. leverage our installed base of AN-2000 platforms and our working
relationships with providers to offer our wireless access systems;
. continue to enhance functionality and increase features of our mSwitch
IP-based, multiservice softswitch platform, which is designed to enable
geographically dispersed gateways and servers to interact over high speed
IP networks to serve millions of subscribers;
. enhance our PAS systems and handsets to enable the provisioning of
high-speed data services over 128 Kilobits per second, or Kbps, wireless
links;
. focus our development efforts on products that enable migration to 3G
wireless technologies;
. continue to provide broadband upgrades to our installed base of AN-2000
platforms to enable the delivery of broadband services over copper
connections through digital subscriber line, or xDSL, technologies;
. broaden our PAS systems to enable value-added services, such as wireless
content and applications which our customers offer in China under the
brand name C-Mode and in Taiwan under the brand name MiMi; and
. work with original equipment manufacturers to offer service providers a
complete solution for IP-based networks.
Expand Our Presence in China. We intend to further capitalize on favorable
market conditions in China, including its large population, low teledensity and
strong demand for communications services. Since our inception, we have focused
our engineering, product development and sales and marketing efforts primarily
on communications equipment for China. This focus has enabled us to be a leader
in this market by quickly identifying the needs of service providers in China
and rapidly developing market-specific products to address those needs. We
intend to expand our presence in this market by:
. increasing the number of sales and support staff and offices in China;
. developing new products to address the demands of our existing and future
customer base;
. migrating our installed base from voice to data and from wireline to
wireless as market demand warrants; and
. increasing our local research and development and manufacturing
capabilities.
Penetrate Other Growing Communications Markets Worldwide. We have started
offering our products in other growing communications markets outside of
mainland China. We anticipate penetrating these markets in several ways,
through direct sales offices located in key market regions, by licensing our
technology to local manufacturers where import taxation favors this approach,
through the development of local sales agency and distributor relationships
within specific market regions, and through original equipment manufacturer
sales relationships. Our sales division is currently targeting expansion into
Africa, Europe, India, Japan, Latin America, Taiwan, and other Pacific Rim
markets. We have established regional offices to focus on non-China market
development with sales and customer support operations in Hanoi, Manila, Miami,
New Delhi, New Jersey, Shanghai, Taipei, Tel Aviv, and Tokyo and plan to
establish local direct sales representative offices in
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key regions around the world. To date, we have deployed our products in a
number of growing communications markets outside of mainland China, including
India, Japan and Taiwan.
Products
We provide communications equipment for service providers that operate
wireless and wireline networks. Our wireless and wireline access networks and
IP-based switching systems use our three principal technology platforms:
. mSwitch--our IP-based multiservice softswitch;
. PAS--our wireless access system which includes handsets; and
. AN-2000--our broadband access platform.
Each comprises multiple hardware and software subsystems that can be offered
in various combinations to suit individual customer needs. In addition, through
original equipment manufacturer relationships, we provide customers in China
with equipment for deployment in metropolitan area networks.
Our IP-Based Multiservice Softswitch (mSwitch)
mSwitch is an IP-based, multiservice softswitch designed to replace
traditional central office switches. mSwitch provides voice over IP gateway
functions, broadband and narrowband remote access services and associated
billing, provisioning and service management operations support systems.
mSwitch combines softswitch functionality with our wireless technology to
provide highly scalable, mobile switching centers, which can operate with our
PAS system.
mSwitch networks are distributed, which means that many geographically
dispersed gateways and servers can interact over a high speed, IP-based network
to serve millions of subscribers. Gateways provide hardware resources to
process voice and data and support widely used interface protocols. Servers
provide functions like call routing, accounting, authorization, billing,
provisioning, fault monitoring and recovery.
We have developed an advanced and comprehensive operations support system
for management of mSwitch equipment, billing for mSwitch services and customer
care for mSwitch subscribers. This operations support system uses an online
Internet-based user interface, which enables service provider personnel and
individual subscribers to access provisioning and billing information through
the Internet from an ordinary web-browser.
We are also working to develop a set of capabilities including mobile
switching center, radio network controller and general packet radio service
node in support of 3G wireless technologies. To that end, in November 2001,
UTStarcom was selected by China's Ministry of Information Industry, or MII, as
one of a select group of participants in China's technical trial of 3G mobile
networks based on the 3GPP WCDMA standard. mSwitch applications are also being
developed to provide wireline local exchange functionality, voice over IP
gateways to enable legacy public networks to connect to low-cost IP-based long
distance trunk lines, and also to provide modem and fax pools that would allow
mSwitch to act as a remote access server for dial-up users who wish to access
IP networks. We are also developing IP routing capabilities to integrate in our
mSwitch platform to further improve functionality and reduce cost to our
customers. We intend to continue to enhance mSwitch with many applications in
response to evolving market requirements and technology trends.
Our Wireless Access System (PAS)
PAS is a wireless access system that uses microcellular radios and
specialized handsets to offer mobile and fixed access. When compared to
macrocellular systems like GSM and CDMA, PAS offers lower costs, easier radio
planning, higher traffic capacity, better voice quality, faster data
transmission speeds, lighter handsets with lower power requirements and better
support of advanced information services. PAS is a low mobility system,
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which means it is designed for deployment in high capacity urban and suburban
areas, rather than larger regional areas covered by GSM and CDMA system
deployments. For additional coverage or capacity, PAS can easily be deployed in
indoor spaces such as office buildings, airports and shopping malls. PAS can
provide wireless mobile phone service at densities of upwards of 15,000
subscribers per square kilometer.
The PAS wireless access network employs a mobile switching network based on
our AN-2000 platform. The wireless access network formed by PAS components
connects to the central office switch to provide local and long distance
telephone service over a standard digital interface or an analog 2-wire
interface. These open interfaces to the central office allow PAS to access any
of the operator's installed switching capacity and to deliver existing switch
based services, such as caller ID, call forwarding, and voice mail, to wireless
subscribers. IP-based PAS uses the mSwitch platform instead of the AN-2000
platform. This eliminates the dependence on an existing local exchange switch
and permits PAS to be installed in a greenfield environment where existing
switching capacity is not available. IP-based PAS also brings many important
benefits associated with our mSwitch platform, including scalability. Both PAS
and IP-based PAS support 64Kbps mobile Internet access along with voice. In
2001, we deployed 1.2 million lines of mSwitch-based PAS systems in several
cities in China, and two locations outside of China.
We also design and manufacture handsets that are specifically configured to
support PAS services. In 2001, we introduced a new PAS handset primarily
designed by UTStarcom. We expect to continue to invest in this area and
introduce several additional handset models in 2002. We also manufacture
several models based on designs licensed from other handset manufacturers. We
compliment our handset design and manufacturing capabilities with additional
handset models directly from leading vendors. Our strategy of designing,
licensing, manufacturing and direct sourcing of handset components provides us
with the flexibility to meet demand, and allows us to offer the broadest line
of PAS handsets in China.
In conjunction with our PAS system, we enable wireless content and
applications similar to NTT DoCoMo's iMode service. To date, this service has
been launched by our customers in Xian and Hangzhou in China and in Taipei,
Taiwan. This service, known in China as C-mode and in our Taiwan market as
Mobile Information, Mobile Internet, or MiMi, utilizes a high function handset
with expanded LCD display that can be used to browse the worldwide web, and
send and receive e-mail and short messages. Chinese as well as English
characters are supported, and local content providers in Taiwan and China are
accumulating hundreds of information services including news, stock quotes and
sports results, job postings, dating services, chat rooms, and fortune telling.
MiMi can accurately determine a user's location and can list local restaurants,
hospitals or other location-sensitive information when queried.
Our Netman network management system, which is integrated with our network
access products, provides for centralized management of our PAS products.
Netman provides the ability to manage individual network components and to
report on the status of the network as a whole. With Netman, a service provider
can add and drop subscribers and continuously monitor all access network
elements, providing for real-time reporting and alarms in addition to
performance management, optimization and distribution of software updates.
Netman uses scalable client/server architecture in a Windows NT environment.
Server hardware may be scaled to handle several thousand nodes. Netman can also
be installed on a portable personal computer and may be used as the local
onsite maintenance terminal wherever remote nodes are installed.
As of December 31, 2001, service providers have installed our PAS system in
210 locations in China, representing a total installed capacity of
approximately 6.6 million lines with approximately 3.0 million subscribers. In
Taiwan, the number of subscribers using PAS systems reached approximately
160,000 as of December 31, 2001.
Our Broadband Access Platform (AN-2000)
AN-2000 is a broadband access platform supporting a mix of services that
include:
. traditional analog voice;
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. voice and data in digital format over integrated services digital network,
or ISDN, lines;
. analog and digital leased lines;
. business data over integrated digital subscriber lines, or IDSL, and
high-data-rate digital subscriber lines, or HDSL; and
. high-performance, always-on Internet access for residential and business
subscribers using advanced asymmetric digital subscriber line, or ADSL,
technology.
Our AN-2000 platform contains both central office terminals and remote
terminals that are linked together by fiber, microwave radio or copper to form
a digital access network. The remote terminals are located close to the
subscribers and offer last-mile wireline connections for voice and data
services to the subscribers. Each remote terminal, which is scalable from 16 to
1,520 lines, can be connected into a ring to form a metropolitan access network
of up to 23,000 subscriber lines. By connecting multiple metropolitan access
networks, a metropolitan service network can potentially service hundreds of
thousands of subscribers.
The AN-2000 platform offers a V5.2 exchange interface that benefits service
providers by shifting network intelligence out into the access network,
reducing reliance on costly proprietary distributed central office switch
architectures. For service providers whose switches are not yet V5.2 compliant,
we provide a migration capability whereby the AN-2000 terminates analog and
ISDN ports in the central office, effectively creating a V5.2 interface to the
remote AN-2000 platforms.
For broadband services based on ADSL, the AN-2000 platform has integral
multiplexing capability for up to 384 users to share 155Mbps of Asynchronous
Transfer Mode, or ATM, bandwidth to the Internet or, alternatively, 1.6Gbps in
our IP over Ethernet version. The AN-2000 platforms can serve as a
multi-service access node in which ADSL is delivered from a remote location
combined with voice and leased line services or it can be configured as a pure
central-office based Digital Subscriber Loop Access Multiplexer (DSLAM). Other
DSLs including HDSL and G.SHDSL are also available. We also offer a Broadband
Remote Access Server (B-RAS) to provide service management features, including
authorization, accounting, virtual networking, and protocol translation. As
with PAS, our integrated Netman network management system provides centralized
management of the AN-2000 platforms. The ADSL service is compatible with most
customer premise modems provided by third-party vendors. As of December 31,
2001, service providers have deployed approximately 4.0 million AN-2000 lines
worldwide.
In 2001, we introduced our IP-DSLAM product, based on an extension of our
AN-2000 technology. This product, which began shipping in the fourth quarter of
2001 to a customer in Japan, provides extremely high density and high
functionality at a very attractive price. This product represents a new
generation of DSLAM, which does not require ATM networking, and is therefore
compatible with IP-based networks. Our IP-DSLAM lowers operator costs by
eliminating the need for traditional high cost ATM-based networks.
Our OEM Products for Metropolitan Area Networks (MANS)
We partner with original equipment manufacturers, or OEMs, which allows us
to offer our customers a broader range of products. This OEM strategy allows us
to provide benefits to our customers and also allows us to learn about specific
technologies and market segments that may help us to shape our overall
strategic planning. One such initiative is our program to penetrate China's
Metropolitan Area Networks, or MANs, to provide Layer2/Layer3 switches.
Our ACD Products
In addition, we now have in-house system-on-chip (SoC) and application
specific integrated circuit (ASIC) design capabilities focusing on LAN and IP
switching technology to enhance our network switching and broadband access IC
technologies. These capabilities will enable us to continue to develop leading
carrier class broadband access solutions.
10
Markets and Customers
We provide our communications equipment to local Telecommunications Bureaus
in a wide variety of provinces of China. Market opportunities within China's 31
provinces vary greatly by region, with the more densely populated coastal
provinces experiencing the strongest economic development. To date, we have
focused primarily on the eastern coastal regions of China including Guangdong,
Zhejiang, Fujian, Shandong, Jiansu, and Shanghai. These provinces and
municipalities represent a disproportionately high percentage of China's
telecommunications subscribers, and influence adoption of technology elsewhere
in China. According to a report published by the Ministry of Information
Industry, China's 10 eastern provinces and municipalities accounted for
approximately 47.7% of China's total telecom investment for the six months
ended June 30, 2001. More recently we have expanded our marketing focus to
include several inland provinces. While each of the Telecommunications Bureaus
is part of the China Telecom system and subject to its ultimate control,
equipment purchasing decisions are generally made at the individual
Telecommunications Bureau level.
The following table is a list of our customers who purchased more than $1.0
million of our products in 2001.
Beijing Municipality Heilongjiang Province Shanxi Province
Beijing Telecommunication Haerbin Telecommunication Taiyuan Telecommunication
Bureau Bureau Bureau
Wuzhong Telecommunication
Fujian Province Henan Province Bureau
Hezhou Telecommunication Jiaozuo Telecommunication Xian Telecommunication
Bureau Bureau Bureau
Meizhou Telecommunication Xinxiang
Bureau Telecommunication Bureau Sichuan Province
Putian Telecommunication Xinhui Telecommunication
Bureau Hubei Province Bureau
Quanzhou Huzhou Telecommunication
Telecommunication Bureau Bureau Xinjiang Autonomous
Province
Guangdong Province Hunan Province Hami Telecommunication
Dongguan Zhangzhou Bureau
Telecommunication Bureau Telecommunication Bureau Hechi Telecommunication
Fuoshan Telecommunication Bureau
Bureau Nei Mon Gol Autonomous Shihezi Telecommunication
Guangdong UT Starcom Province Bureau
Jiangmen Huhehaote
Telecommunication Bureau Telecommunication Bureau Yunnan Province
Luoyang Telecommunication Banna Telecommunication
Bureau Jiangsu Province Bureau
Qingyuan Lianyungang Chuxiong
Telecommunication Bureau Telecommunication Bureau Telecommunication Bureau
Shanwei Telecommunication Qinghua Ziguan Biwei Net Dali Telecommunication
Bureau Corp.--Taian Bureau
Shaoguan Xuzhou Telecommunication Diqing Telecommunication
Telecommunication Bureau Bureau Bureau
Shenzhen Yancheng Kunming Telecommunication
Telecommunication Bureau Telecommunication Bureau Bureau
Yunfu Telecommunication Yancheng Zhongxin Lijiang Telecommunication
Bureau Communication Ind. Bureau
Zhaoqing Lincang Telecommunication
Telecommunication Bureau Jiangxi Province Bureau
Zhongshan Shangrao Nujiang Telecommunication
Telecommunication Bureau Telecommunication Bureau Bureau
Zhuhai Telecommunication Yunan Telecommunication
Bureau Jilin Province Bureau
Siping Telecommunication
Guangxi Autonomous Bureau Zhejiang Province
Province Fuyang Telecommunication
Guangxi Baise Liaoning Province Bureau
Telecommunication Bureau Benxi Telecommunication Hangzhou
Guilin Telecommunication Bureau Telecommunication Bureau
Bureau Liaoyang Jiaxing Telecommunication
Qinhzhou Telecommunication Bureau Bureau
Telecommunication Bureau Jinhua Telecommunication
Wuzhou Telecommunication Ningxia Autonomous Bureau
Bureau Province NingBo Telecommunication
Liuzhou Telecommunication Shizuishan Bureau
Bureau Telecommunication Bureau Quzhou Telecommunication
Yinchuan Bureau
Hainan Province Telecommunication Bureau Ruian Telecommunication
Haikou Telecommunication Bureau
Bureau Shaanxi Province Shaoxing
Qiongshan Kuitun Telecommunication Telecommunication Bureau
Telecommunication Bureau Bureau Taizhou Telecommunication
Sanya Telecommunication Bureau
Bureau Shandong Province Wenzhou Telecommunication
Dongying Bureau
Hebei Province Telecommunication Bureau Wenzhou Zongheng Corp.
Baoding Telecommunication Jinan Telecommunication Xiaoshan
Bureau Bureau Telecommunication Bureau
Dongsheng Taizhou Telecommunication Yuhang Telecommunication
Telecommunication Bureau Bureau Bureau
Qinhuangdao Zhejiang
Telecommunication Bureau Telecommunication Bureau
Xingtai Telecommunication
Bureau Outside Mainland China
Zhangjiakou BB Technologies
Telecommunication Bureau Corporation
First International
Telecom Corp.
Himichal Futuristic
Communications Ltd.
NEC USA
Mitsubishi Electric
Corporation
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For the year ended December 31, 2001, no single customer accounted for more
than 10% of our net sales. However, approximately 89.9% of our net sales during
2001 were to entities affiliated with the government of China.
We also sell our network access equipment to service providers in high
growth communications markets outside of China. These markets accounted for
approximately 9.7% of our net sales in 2001. We have shipped equipment to
service providers in Bangladesh, India, Japan, Mauritius, Russia, Taiwan,
Thailand and Venezuela. We have also begun trial deployments in the United
States and Vietnam.
As of December 31, 2001, our backlog totaled approximately $360.7 million,
compared to approximately $191.2 million as of December 31, 2000. We include in
our backlog contracts and purchase orders for which we anticipate delivery to
occur within 12 months and products delivered but for which final acceptance
has not yet been received. Because contracts and purchase orders are generally
subject to cancellation or delay by customers with limited or no penalty, our
backlog is not necessarily indicative of future revenues or earnings.
Sales, Marketing and Customer Support
We pursue a direct sales and marketing strategy in China, targeting sales to
individual Telecommunications Bureaus and to manufacturers or equipment
distributors with closely associated customers. We maintain sales and customer
support sites in Beijing, Chengdu, Fuzhou, Guangzhou, Hangzhou, Jinan, Kunming,
Nanning, Nanjing, Nei Mon Gol, Shanghai, Shenyang, Wuhan, Xian, and Zhengzhou.
We also sell through relationships with regional government-owned
telecommunications manufacturing companies, which act as agents in the sale of
our products to Telecommunications Bureaus.
We believe our customer support services in China allow us to distinguish
ourselves from competing equipment providers and build customer loyalty. Our
customer service operation in Hangzhou is co-located with our manufacturing
joint venture and serves as both a technical resource and liaison to our
product development organization. In China, customer service technicians are
distributed in the regional sales and customer support sites to provide a local
presence. We provide additional support on a 24-hour, 365-day basis from our
customer support center in Hangzhou in the form of field dispatch personnel,
who also provide training on installation, operation and maintenance of
equipment. As of December 31, 2001, we employed over 800 people in sales,
marketing and customer support in China.
Our sales efforts in markets outside of mainland China combine direct sales,
original equipment manufacturers, distributors, resellers, agents and
licensees. We maintain sales and customer support sites in Iselin, New Jersey
to address North American markets; in Tokyo, Japan to address the Japan market;
in New Delhi, India to address the Indian market; in Miami, Florida to address
Latin American markets; in Tel Aviv, Israel to address European and African
markets; in Manila, the Philippines to address the Philippine market; in
Taipei, Taiwan to address the Taiwan market; in Hanoi, Vietnam to address the
Vietnam market; and in Shanghai, China to address other Pacific Rim markets.
Our customer service operations in the U.S. and Hangzhou, China support our
customers outside of mainland China with training, project supervision and
problem resolution. We maintain and will continue to expand our staff of local
personnel near customers who require support on a 24-hour, 365-day basis. In
many cases our local in-country sales partners also provide customer support.
Technology
We believe the following key technologies have been instrumental in our
ability to provide leading broadband wireline and wireless access networks and
IP-based switching systems.
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X-over-IP. X-over-IP refers to the transmission of various forms of
traffic, including voice, video, fax, music and broadcast, over IP networks. An
X-over-IP network requires the following equipment:
. media gateways at the edge of the network that convert legacy media like
telephone lines, fax and data modems, or other non-IP data interfaces to
IP and incorporate quality of service functionality designed to avoid
delay and packet loss due to congestion;
. softswitching servers that perform address translation, service monitoring
and assurance, billing, authorization, supplementary services like call
forwarding, conferencing, and other signaling translations; and
. an IP network that provides high speed IP routing and transmission.
Our mSwitch platform provides the media gateway and the softswitching server
and, when combined with industry-standard IP routers, creates a complete
X-over-IP network.
The mSwitch gateway converts incoming TDM formats from POTS, ISDN, SS7 and
leased lines into packetized voice over IP. The packetization process utilizes
programmable digital signal processors that can code voice, fax and standard
56Kbps modem signals into IP. The gateway also terminates the associated TDM
format signaling protocols and generates IP based signaling protocols like
H.323, MGCP and SIP. The mSwitch gateway also provides IP routing functions
that allow the IP packets to penetrate deeper into the core network with
queuing, and route selection, consistent with the desired quality of service
for each particular call.
The mSwitch softswitch provides switching intelligence to manage the calls
in the network as they progress from gateway to gateway. The mSwitch operations
support system provides the database management for service provisioning,
authorization and flexible billing.
Service providers are increasingly offering X-over-IP services to reduce
costs, reduce obsolescence, provide easier upgrades and generate incremental
revenue through value-added voice and data services.
Softswitch Mobility Management. We are a founding member of the
International Softswitch Consortium, an industry group formed to promote
compatibility and interoperability of softswitch technologies. Based on our
knowledge of the industry, we believe we are one of the first companies to
develop a softswitch architecture to support mobile applications.
Softswitches control the signaling and call management functions in an
X-over-IP network. Of the many possible types of softswitching services, mobile
telephony and information delivery services are among the most demanding and
complex. Mobile networks must track subscribers' locations dynamically whether
or not they are on a call. They must provide real-time handovers between base
stations, perform authorization of roaming visitors, provide real-time billing
for pre-paid services and flexible routing to its roamers in foreign networks
and support messaging, file transfer and assignment of data bandwidths. Based
on our knowledge of the industry, we believe that our mSwitch platform is one
of the first systems to provide mobile switching functionality.
mSwitch employs our proprietary, object oriented signaling protocol for
mobility, known as SNSP, which we believe provides advantages over other
similar protocols. mSwitch is commercially deployed with mobility support for
our PAS wireless infrastructure. The mSwitch gateway is also being developed to
support the future WCDMA and TD-SCDMA radio network control protocols as well
as the payload protocols for 3G. mSwitch will serve as an IP-based, mobile
switching center and IP-based radio network controller. With this focus on
mobility services, mSwitch is targeting one of the most complex and
commercially important segments of softswitch applications.
PAS Value-Added Services. PAS offers a full suite of integrated value added
services, which are easily customized, including short message services,
location services, web browsing, e-mail, voice mail, and 64Kbps
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Internet access. As part of our current research and development efforts, we
are focusing on developing 128Kbps and 256Kbps packet mode wireless data
delivery.
We have licensed certain protocols and architectures that support the web
browsing functions from KDDI, a Japanese service provider, and have optimized
them for performance, hardware simplicity and Chinese character support as well
as integrated them with PAS. We have developed additional protocols and
architecture used in this technology.
Research and Development
We believe that continued and timely development and introduction of new and
enhanced products are essential if we are to maintain our competitive position.
While we use competitive analyses and technology trends as factors in our
product development plans, the primary input for new products and product
enhancements comes from soliciting and analyzing information about service
providers' needs. Our Ministry of Information Industry, Telecommunications
Administration and Telecommunications Bureau relationships and full-service
post-sale customer support provide our research and development organization
with insight into trends and developments in the marketplace. The insight
provided from these relationships allows us to develop market-driven products
such as PAS and mSwitch. We maintain a strong relationship between our research
centers in the U.S. and China. Projects are typically designed and developed in
the United States by one team and tested in China by another, allowing us to
conduct research and development activities 24 hours a day. We rotate engineers
between the U.S. and China to further integrate our research and development
operations. We have been able to cost-effectively hire highly skilled technical
employees from a large pool of qualified candidates in China.
In the past we have made, and expect to continue to make, significant
investments in research and development. Our research and development
expenditures totaled $59.8 million in 2001, $41.5 million in 2000 and $18.6
million in 1999.
Manufacturing, Assembly and Testing
We manufacture or engage in the final assembly and testing of our mSwitch,
PAS systems and handsets and AN-2000 products at the facilities of our two
manufacturing joint ventures in the Chinese provinces of Guangdong and
Zhejiang. These manufacturing operations consist of circuit board assembly,
final system assembly, software installation and testing. We assemble circuit
boards primarily using surface mount technology. Assembled boards are
individually tested prior to final assembly and tested again at the system
level prior to system shipment. We use internally developed functional and
parametric tests for quality management and process control and have developed
an internal system to track quality statistics at a serial number level.
Both the Guangdong and the Zhejiang manufacturing facilities are ISO 9002
certified. ISO 9002 certification requires that the certified entity establish,
maintain and follow an auditable quality process including documentation
requirements, development, training, testing and continuous improvement and
which is periodically audited by an independent outside auditor.
We have recently entered into agreements with both our Guangdong and
Zhejiang joint venture partners to acquire their respective interests in the
joint ventures. Pending final approval by relevant Chinese governmental
regulatory authorities, we anticipate these transactions to be completed during
2002.
We contract with third parties in China to undertake high volume assembly
and manufacturing of our handsets and we conduct final assembly, testing and
packaging at our own facilities. In addition, we generally use third parties
for high volume assembly of circuit boards. HonXun Electrical Industry in
Hangzhou, a subsidiary of Foxconn Group, manufactures our PAS handsets; Eastcom
Communications manufactures our PAS handsets; and Shanghai Jingling Electronic
manufactures line cards for our IP-ADSL product.
14
We have also contracted with Matsushita Electric Industrial Co., Ltd., which
distributes products under the Panasonic brand, to manufacture the PAS wireless
infrastructure components and handsets for distribution under the UTStarcom
label. Other suppliers include Wistron NeWeb Corporation, Japan Radio Co.,
Ltd., Kyocera Corporation and Sanyo Electric Co., Ltd., which provide handsets
under the UTStarcom label, and Sharp Corporation, which provides handsets and
repeaters under the UTStarcom label. Our AN-2000 product line integrates some
third party products for subscriber premises equipment and testing. In China,
we undertake final assembly and test our wireless infrastructure products at
our own facilities and have recently begun to manufacture some of these
products ourselves.
Structure and Regulation of the Telecommunications Industry in China
Structure of China's Telecommunications Industry. Historically, the China
Telecom system was the sole provider of public telecommunications services in
China. In 1993, the State Council, in an effort to promote competition, began
issuing licenses to new telecommunications operators including China United
Telecommunications Corporation, or Unicom, a provider of mobile communication
services, and Jitong Communications Co., Ltd., a provider of data
communications and Internet access services. In February 1999, the State
Council approved a restructuring plan for the China Telecom system. The plan
separated the telecommunications operations of the China Telecom system along
four business lines: fixed line, mobile, paging and satellite communications
services. Under the new structure, a new state-owned company, China Mobile,
holds and operates the nationwide mobile communications assets. China Mobile
also controls China Mobile (Hong Kong) Limited, a public company, that operates
cellular services in thirteen of China's provinces. A new state-owned company,
China Satellite, holds and operates the satellite assets. The paging operations
have been merged into Unicom. China Telecom holds and operates the fixed line
telephone and data communications assets.
The Ministry of Information Industry confirmed in December 2001 that the
State Council had approved a plan to restructure China Telecom. The Ministry of
Information Industry has been authorized to execute the plan. China Telecom
will be split into two regional entities. The assets of the present China
Telecom in North China's Beijing and Tianjin municipalities, the Inner Mongolia
Autonomous Region and Hebei and Shanxi provinces, Northeast China's Liaoning,
Jilin and Heilongjiang provinces, Central China's Henan Province and East
China's Shandong Province will merge with China Netcom Co. Ltd. and China
Jitong Network Communications Co. Ltd. The new company will be named China
Netcom Group Corp., or New CNC. China Telecom's assets in the other 21
provinces, municipalities and autonomous regions will retain the brand name and
intangible assets of the old China Telecom. We refer to this entity as the New
China Telecom. The New CNC will inherit 30% of the old China Telecom's national
backbone network, with the rest going to the New China Telecom. As the
announcement of this change is very recent and its implementation is ongoing,
we cannot be certain what impact the restructuring will have on our business
operations. However, we may experience a decline in orders and related revenues
during such restructuring as a result of uncertainty among our customers
presently operating under China Telecom.
New CNC and New China Telecom will continue to operate through each of their
own regional networks of approximately 2,400 local level telephone companies
called Telecommunications Bureaus. Telecommunications Bureaus are responsible
for purchasing, installing and operating the voice and data communications
services in their local markets. Local telephone companies are funded by their
own operational revenue from local telephone charges, a portion of shared long
distance revenue through settlement, and headquarter allocation and cross
subsidy, particularly in remote and poor regions. Among the funding sources,
local revenue accounts for the majority of the revenue for local telephone
companies.
Government Regulation of the Telecommunications Industry. The China
telecommunications industry is regulated at the national, provincial and local
levels. At the national level, the Ministry of Information Industry regulates
the industry. The Ministry of Information Industry was established in March
1998 to assume the regulatory, administrative and other governmental duties of
the former Ministry of Posts and Telecommunications. The Ministry of
Information Industry has broad discretion and authority to regulate all
15
aspects of the telecommunications and information technology industry in China,
including managing spectrum bandwidths, setting network equipment
specifications and standards and drafting laws and regulations related to the
electronics and telecommunications industries. Additionally, the Ministry of
Information Industry can decide what types of equipment may be connected to the
national telecommunications networks, the forms and types of services that may
be offered to the public, the rates that are charged to subscribers for those
services and the content of material available in China over the Internet.
Based on our industry experience, we believe that the Ministry of Information
Industry's general telecommunications equipment strategy is to ensure that
China's infrastructure is based on advanced open architectures that are
expandable, cost efficient and quickly deployed.
The Ministry of Information Industry also oversees the 33 Telecommunications
Administrations that have regulatory responsibility over the telecommunications
industry in their respective provinces. In China today, each Telecommunications
Administration approves a subset of telecommunications products that meet
Ministry of Information Industry standards from which Telecommunications
Bureaus can then select the specific products they purchase, install and
operate. Although historically the Ministry of Information Industry has shared
regulation and operation of China's telecommunications industry with the China
Telecom system, as part of the Chinese government's industry restructuring, the
regulatory functions of the Ministry of Information Industry and the
Telecommunications Administrations have been separated from the operational
functions of the state-owned Telecommunications Bureaus under their control.
The Ministry of Information Industry acts exclusively as the industry regulator
and the local Telecommunications Bureaus act exclusively as operators. Given
the multi-level regulatory environment, equipment providers in China must
generally market intensively to all three levels of the communications industry.
Statutory Framework. China does not yet have a national telecommunications
law. However, with China's recent entry into the World Trade Organization, or
WTO, the Ministry of Information Industry, under the direction of the State
Council, must shortly present the first draft of the Telecommunications Law of
the People's Republic of China for ultimate submission to the National People's
Congress for review and adoption. In order to comply with the WTO, subsets of
draft telecommunications regulations were published in December 2001. One of
the most significant of the draft regulations is the "Regulation of Foreign
Investment over Telecom Enterprises." In December 2001, the State Council
promulgated the Provisions on the Regulation of Foreign Invested
Telecommunications Enterprises, which lifts the restrictions on foreign
investment in the telecommunication industry, subject to certain equity ratio
and geographic limitations. Also in December 2001, the Ministry of Information
Industry issued the Measures on Regulation of Telecommunication Business
Operation Permits, which details the procedures for obtaining permits for the
operation of telecommunications businesses and makes it possible for those
conducting telecommunications business to obtain the relevant permits. As we
provide equipment rather than services, these two regulations should not have a
direct effect on our business. Nevertheless, as the two regulations came into
effect only recently, we are uncertain whether we will be indirectly affected
by the impact of the two regulations on telecom service providers.
Currently, the governing regulation over telecommunications in China is the
Telecommunications Regulations of the People's Republic of China issued by the
State Counsel in September 2000. This set of regulations is known as the
Telecom Regulations. The Telecom Regulations govern telecommunications services
and market regulations, pricing, interconnection and connection, as well as
telecommunications construction and security issues. These regulations are not
very detailed, have not been applied by a court and may be interpreted and
enforced by regulatory authorities in a number of different ways. As with the
Telecommunications Law, we are uncertain what effect, if any, the Telecom
Regulations will have on our business as presently conducted.
Licenses for Communication Equipment. Beginning January 1, 1999, China's
government required that all telecommunications equipment connected to public
or private telecommunications networks within China, which includes equipment
that we sell in China, be approved by the Ministry of Information Industry, and
the manufacturer of the equipment obtain a network access license for each of
its products. Subsequently, the State Council issued the Telecom Regulations in
September 2000. In May 2001, the Ministry of Information Industry issued the
Administrative Measures of Network Access Licenses, known as the Access License
Measures, to
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implement the Telecom Regulations and to replace the old access license
regulation. Both the Telecom Regulations and the Access License Measures
require the government to implement license systems for telecommunications
terminal equipment, wireless communications equipment and equipment used in
network interconnection that is connected to public telecommunications
networks. The above equipment must meet government and industry standards, and
a network access license for the equipment must be obtained. Without the
license, the equipment is not allowed to be connected to public networks or
sold in China. The Telecom Regulations require that manufacturers ensure that
the quality of the telecommunications equipment for which they have obtained a
network access license is stable and reliable, and they may not lower the
quality or performance of other installed licensed products. The State
Council's product quality supervision department, in concert with the Ministry
of Information Industry, performs spot checks to track and supervise the
quality of telecommunications equipment for which a network access license has
been obtained and publishes the results of such spot checks.
The regulations implementing these requirements are not very detailed, have
not been applied by a court and may be interpreted and enforced by regulatory
authorities in a number of different ways. We have obtained the required
network access licenses for our AN-2000 platform. We have applied for, but have
not yet received, a network access license for our PAS system. Based upon
conversations with the Ministry of Information Industry, we understand that our
PAS system is considered to still be in the trial period and that sales of our
PAS system may continue to be made by us during this trial period, but a
license will ultimately be required. Network access licenses will also be
required for most additional products that we are selling or may sell in China,
including our mSwitch platform. If we fail to obtain the required licenses, we
could be prohibited from making further sales of the unlicensed products,
including our PAS system, in China, which would substantially harm our
business, financial condition and results of operations. Our counsel in China
has advised us that China's governmental authorities may interpret or apply the
regulations with respect to which licenses are required and the ability to sell
a product while a product is in the trial period in a manner that is
inconsistent with information received by our counsel in China, either of which
could have a material adverse effect on our business, financial condition and
results of operations.
Software Registration. On October 27, 2000, the Ministry of Information
Industry issued the Administrative Regulations on Software Products, known as
the Software Regulations, to enhance software product management and stimulate
the development of the software industry in China. Under the Software
Regulations, the government imposes a registration and filing system on
software and products incorporating software. Software cannot be produced and
sold in China without registration and filing. The developers and producers of
the software are responsible for the registration and filing of domestic
software products. Registration under the Software Regulations is valid for
five years and can be renewed upon expiration. The Ministry of Information
Industry is responsible for the overall management of software. The local
offices of the Ministry of Information Industry at the provincial level are
responsible for the management and examination of and approval for the
registration of the domestic software within their own territories. The
designated agencies authorized by these local offices are responsible for
acceptance for registration of software. Before registration is approved by the
government agencies, software products need to be tested by the authorized
testing institutions.
We are in the process of applying for registration for our software. Based
upon verbal advice received from the Ministry of Information Industry, we
believe that we will be able to continue to sell our products incorporating our
software during the period in which these regulations are being implemented and
our application is pending. However, this implementation period may not last
long enough for us to complete the registration of our software. Moreover, the
Chinese government may interpret or apply the Software Regulations in such a
way as to prohibit sales of products incorporating our unregistered software
prior to registration. If the government prohibits sales pending registration,
or if we fail in our efforts to register our software, we could be prohibited
from making further sales of products incorporating the unregistered software
in China, which could substantially harm our business and financial condition.
17
Competition
We face intense competition in our target markets and expect competition to
increase. Our principal competitors in our various product lines include:
. mSwitch: Alcatel Alsthom CGE, S.A.; Cisco Systems, Inc.; Clarent
Corporation; Ericsson LM Telephone Co.; Huawei Technology Co., Ltd.;
Lucent Technologies, Inc.; Motorola, Inc.; Nokia Corporation; Nortel
Networks Corporation; Nuera Communications, Inc.; Siemens AG; Sonus
Networks, Inc.; and Zhongxing Telecommunications Equipment.
. PAS systems and handsets: Lucent Technologies, Inc. and Zhongxing
Telecommunications Equipment.
. AN-2000: Advanced Fibre Communications, Inc.; Alcatel Alsthom CGE, S.A.;
Datang Telecom Technology Co. Ltd.; Huawei Technology Co., Ltd.; Lucent
Technologies, Inc.; and Zhongxing Telecommunications Equipment.
We are increasingly facing competition from domestic companies in China. We
believe that our strongest competition comes from these companies, many of
which operate under lower cost structures and more favorable governmental
policies and have much larger sales forces than we do. Furthermore, other
companies not presently offering competing products may also enter our target
markets, particularly with the reduction of trade restrictions as a result of
China's admission to the WTO. Many of our existing and potential competitors
may have significantly greater financial, technical, product development,
sales, marketing and other resources than we do. As a result, our competitors
may be able to respond more quickly to new or emerging technologies and changes
in service provider requirements. Our competitors may also be able to devote
greater resources than we can to the development, promotion and sale of new
products and offer significant discounts on handsets or other products. These
competitors may also be able to offer significant financing arrangements to
service providers, in some cases facilitated by government policies, which is a
competitive advantage in selling systems to service providers with limited
financial and foreign currency resources. Increased competition is likely to
result in price reductions, reduced gross profit as a percentage of net sales
and loss of market share, any one of which could materially harm our business,
financial condition and results of operations.
Moreover, current and potential competitors have established or may
establish cooperative relationships among themselves or with third parties,
including Telecommunications Administrations, Telecommunications Bureaus and
other local organizations, to increase their ability to address the needs of
prospective customers in our target markets. Accordingly, alliances among
competitors or between competitors and third parties may emerge and rapidly
acquire significant market share. To remain competitive, we believe that we
must continue to partner with Telecommunications Administrations and other
local organizations, maintain a high level of investment in research and
development and in sales and marketing, and manufacture and deliver products to
service providers on a timely basis and without significant defects. If we fail
to meet any of these objectives, our business, financial condition and results
of operations could be harmed.
The introduction of inexpensive wireless telephone service or other
competitive services in China may also have an adverse impact on sales of our
PAS systems in China. We may not be able to compete successfully against
current or future competitors. In addition, competitive pressures in the future
may materially adversely affect our business, financial condition and results
of operations.
We believe that the principal competitive factors affecting the market for
our network access products include:
. total initial cost of solution;
. for PAS, the availability, cost and functionality of our handsets;
. short delivery and installation intervals;
. design and installation support;
18
. ease of integration with the backbone network;
. flexibility in supporting multiple interfaces and services;
. operational cost and reliability; and
. manageability of the solution and scalability.
We may not be able to compete effectively against current and future
competitors based on these or any other competitive factors in the future, and
the failure to do so would have a material adverse affect on our business,
financial condition and results of operations.
Intellectual Property
Our success and ability to compete is dependent in part on our proprietary
technology. We rely on a combination of patent, copyright, trademark and trade
secret laws, as well as confidentiality agreements and licensing arrangements,
to establish and protect our proprietary rights. To date, we have relied
primarily on proprietary processes and know-how to protect our intellectual
property. We presently hold three U.S. patents for existing products. The terms
of one of these patents will expire in 2016, while the terms of the remaining
two patents will expire in 2019. We have submitted 12 additional U.S. patent
applications and 27 foreign patent applications. In addition, we have, from
time to time, chosen to abandon previously filed applications. Patents may not
issue and any patents issued may not cover the scope of the claims sought in
the applications. Our U.S. patents do not afford any intellectual property
protection in China or other international jurisdictions. Moreover, we have
applied for but have not yet obtained patents in China and Taiwan. We may not
be able to obtain patents in China on our products or the technology that we
use to manufacture our products. KDDI, a Japanese service provider, has
licensed key technology to us that serves as the base for the MiMi service in
Taiwan. Our joint ventures in China rely upon our trademarks, technology and
know-how to manufacture and sell our products. Under the terms of our joint
venture agreements, any modifications or enhancements to or derivatives of our
intellectual property developed by the joint ventures will be owned by the
joint ventures. Any infringement of our proprietary rights could result in
significant litigation costs, and any failure to adequately protect our
proprietary rights could result in our competitors offering similar products,
potentially resulting in loss of a competitive advantage and decreased
revenues. Despite our efforts to protect our proprietary rights, existing
patent, copyright, trademark and trade secret laws afford only limited
protection. In addition, the legal systems of some foreign countries, including
China, do not protect our proprietary rights to the same extent as does the
legal system of the United States.
Attempts may be made to copy or reverse engineer aspects of our products or
to obtain and use information that we regard as proprietary. Accordingly, we
may not be able to prevent misappropriation of our technology or deter others
from developing similar technology. Furthermore, policing the unauthorized use
of our products is difficult. Litigation may be necessary in the future to
enforce our intellectual property rights or to determine the validity and scope
of the proprietary rights of others. This litigation could result in
substantial costs and diversion of resources and could significantly harm our
business.
The communications industry is characterized by the existence of a large
number of patents and frequent litigation based on allegations of patent
infringement. From time to time, third parties may assert patent, copyright,
trademark and other intellectual property rights to technologies and in various
jurisdictions that are important to our business. Any claims asserting that our
products infringe or may infringe proprietary rights of third parties, if
determined adversely to us, could significantly harm our business. Any claims,
with or without merit, could be time-consuming, result in costly litigation,
divert the efforts of our technical and management personnel, cause product
shipment delays or require us to enter into royalty or licensing agreements,
any of which could significantly harm our business. Royalty or licensing
agreements, if required, may not be available on terms acceptable to us, if at
all. In the event a claim against us was successful and we could not obtain a
license to the relevant technology on acceptable terms or license a substitute
technology or redesign our products to avoid infringement, our business would
be significantly harmed.
19
ITEM 2--FACILITIES
Square Date of
Location Functions Footage Lease Expiration
- -------- --------- ------- ----------------
HEADQUARTERS
Alameda, CA Administration, Sales/Customer Support and Research and
Development 25,576 January, 2003
Alameda, CA Research and Development 7,534 January, 2004
Fremont, CA Research and Development 9,688 May 2005
Iselin, NJ Sales/Customer Support and Research and Development 43,409 July, 2004
Shenzhen, China Research and Development 107,596 November, 2004
Shenzhen, China Research and Development 10,764 February, 2002
Shenzhen, China Research and Development 18,678 May, 2003
Hefei, China Research and Development 3,606 June, 2002
Hefei, China Research and Development 3,767 July, 2002
Hangzhou, China Administration, Sales/Customer Support, Engineering and
Manufacturing 83,926 March, 2002
Hangzhou, China Administration, Sales/Customer Support, Research and
Development, and Manufacturing 89,340 February, 2002
Hangzhou, China Administration, Sales/Customer Support, Research and
Development, and Manufacturing 168,444 December, 2003
Beijing, China UTSC Headquarters Administration, Sales/Customer
Support 16,695 July, 2003
Shanghai, China Sales/Customer Support 8,214 April, 2003
Wuhan, China Sales/Customer Support 1,066 April, 2003
Chengsha, China Sales/Customer Support 592 March, 2002
Guangzhou, China Sales/Customer Support 11,964 April, 2004
Chengdu, China Sales/Customer Support 1,851 December, 2002
Jinan, China Sales/Customer Support 3,229 March, 2002
Kunming, China Sales/Customer Support 2,676 February, 2003
Xian, China Sales/Customer Support 4,155 December, 2002
Shenyang, China Sales/Customer Support 3,122 May, 2003
Fuzhou, China Sales/Customer Support 6,030 June, 2002
Zhengzhou, China Sales/Customer Support 2,422 October, 2002
Taipei, Taiwan Sales/Customer Support 7,769 September, 2004
Hong Kong, China Sales/Customer Support 800 June, 2002
NanNing, China Sales/Customer Support 2293 August, 2003
NanJing, China Sales/Customer Support 3014 May, 2002
Nei Mon Gol, China Sales/Customer Support 500 December, 2002
Gurgaon, India Sales/Customer Support 5,722 June, 2004
Herzlia, Israel Sales/Customer Support 969 May, 2002
Miramar, Florida Sales/Customer Support 4796 April, 2006
Tokyo, Japan Sales/Customer Support 3217 February, 2004
Hanoi, Vietnam Sales/Customer Support 732 September, 2003
We purchased the rights to use approximately 49 acres of land located in
Zhejiang Science and Technology Industry Garden of Hangzhou Hi-tech Industry
Development Zone for a period of 50 years. We completed the design layout and
the construction cost estimate for a new manufacturing facility. Construction
of the new manufacturing facility is expected to be completed in late 2003. In
addition, as we expand into markets outside of China, our facility needs may
increase according to business needs.
20
ITEM 3--LEGAL PROCEEDINGS
On October 31, 2001, a complaint captioned Lacek v. UTStarcom, Inc., et.
al., Civil Action No. 01-CV-9604, was filed in United States District Court for
the Southern District of New York against our company, some of our directors
and officers and various underwriters for our initial public offering.
Plaintiffs allege undisclosed improper underwriting practices concerning the
allocation of IPO shares in exchange for excessive brokerage commissions or
agreements to purchase shares at higher prices in the aftermarket, in violation
of the Securities Act of 1933 and the Securities Exchange Act of 1934.
Substantially similar actions have been filed concerning the initial public
offerings for more than 300 different issuers, and the cases have been
coordinated as In re Initial Public Offering Securities Litigation, 21 MC 92.
The complaint against us seeks unspecified damages on behalf of a purported
class of purchasers of our common stock between March 2, 2000 and December 6,
2000. We believe that we have meritorious defenses to this lawsuit and will
defend this lawsuit vigorously.
ITEM 4--SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not applicable.
EXECUTIVE OFFICERS
Our executive officers and directors, and their ages as of December 31,
2001, are as follows:
Name Age Position
- ---- --- --------
Masayoshi Son...... 44 Chairman of the Board of Directors
Hong Liang Lu...... 47 President, Chief Executive Officer and Director
Ying Wu............ 42 Vice Chairman of the Board of Directors, Executive Vice
President and Chief Executive Officer, China Operations
Michael Sophie..... 44 Vice President of Finance, Chief Financial Officer and
Assistant Secretary
Bill Huang......... 39 Senior Vice President and Chief Technology Officer
Shao-Ning J. Chou.. 39 Senior Vice President and Chief Operating Officer, China
Operations
Paul Berkowitz..... 49 Vice President, International Sales
Gerald Soloway..... 53 Senior Vice President, Engineering
Thomas J. Toy...... 47 Director
Chauncey Shey...... 44 Director
Larry D. Horner.... 67 Director
Howard Kwock....... 52 Vice President, Engineering
Masayoshi Son has served as our Chairman of the Board of Directors since
October 1995. For more than 16 years, Mr. Son served as President and Chief
Executive Officer and as a director of SOFTBANK CORP., a leading global
provider of Internet content, technology and services. Mr. Son also serves as a
director of BB Technologies Corporation, Yahoo Japan Corporation and Aozora
Bank, Ltd. Mr. Son also serves as Chairman of the Board of Directors and Chief
Executive Officer of SOFTBANK Holdings Inc. and Chairman of the Board of
Directors of SOFTBANK America Inc. From April 1998 to October 1999, Mr. Son
served as a director of Ziff-Davis, Inc. Mr. Son holds a B.A. in Economics from
the University of California at Berkeley.
Hong Liang Lu has served as our President and Chief Executive Officer and as
a director since June 1991. Mr. Lu co-founded UTStarcom under its prior name,
Unitech Telecom, Inc., in June 1991 which subsequently acquired StarCom Network
Systems, Inc. in September 1995. From 1986 through December 1990, Mr. Lu served
as President and Chief Executive Officer of Kyocera Unison, a majority-owned
subsidiary of Kyocera International, Inc. From 1983 until its merger with
Kyocera in 1986, he served as President and Chief Executive
21
Officer of Unison World, Inc., a software development company. From 1979 to
1983, he served as Vice President and Chief Operating Officer of Unison World,
Inc. Mr. Lu holds a B.S. in Civil Engineering from the University of California
at Berkeley.
Ying Wu has served as our Executive Vice President and Vice Chairman of the
Board of Directors since October 1995. Mr. Wu has also served as the President
and Chief Executive Officer of one of our subsidiaries, UTStarcom China, since
October 1995. Mr. Wu was a co-founder of, and from February 1991 to September
1995 served as Senior Vice President of, StarCom Network Systems, Inc., a
company that marketed and distributed third party telecommunications equipment.
From 1988 to 1991, Mr. Wu served as a member of the technical staff of Bellcore
Laboratories. From 1987 through 1988, Mr. Wu served as a consultant at AT&T
Bell Labs. He holds a B.S. in Electrical Engineering from Beijing Industrial
University and an M.S. in Electrical Engineering from the New Jersey Institute
of Technology.
Michael Sophie has been our Vice President of Finance and Chief Financial
Officer since August 1999. Prior to joining our company, Mr. Sophie held
executive positions at P-Com, Inc. from August 1993 to August 1999 as Vice
President Finance, Chief Financial Officer and Group President. From 1989
through 1993, Mr. Sophie was Vice President of Finance at Loral Fairchild
Corporation. He holds a B.S. degree from California State University, Chico and
an M.B.A. from the University of Santa Clara.
Bill Huang has been our Chief Technology Officer since September 1999. He
was appointed Senior Vice President in September 2001. From December 1996 to
September 1999, he was our Vice President of Strategic Product Planning. From
June 1995 to December 1996, Mr. Huang served as our Vice President, China
Operations. From 1994 to June 1995, Mr. Huang was our Director, Engineering.
From 1992 to 1994, he was a Member of the Technical Staff and Project Leader at
AT&T Systems. Mr. Huang serves on the board of Shenzhen Gin De (Group) Ltd., a
real estate investment company in China. Mr. Huang holds a B.S. in Electrical
Engineering from Huazhong University of Science & Technology, and an M.S. in
Electrical Engineering and Computer Sciences from the University of Illinois.
Shao-Ning J. Chou has been our Executive Vice President and Chief Operating
Officer of China Operations since January 1999. He was appointed Senior Vice
President in September 2001. From March 1997 to December 1998, he was Vice
President of China Operations and from February 1996 to March 1997, he served
as Vice President of Engineering. From March 1995 to June 1996, he was Director
of Engineering for wireless systems and software with Lucent Technologies
Microelectronics IC group. From April 1993 to March 1995, he was a Technical
Manager for the Global Wireless product group with AT&T consumer products where
he led multiple development teams for handset and wireless personal base
station products. From February 1985 to April 1993, Mr. Chou was team leader
and a member of the technical staff for advanced digital communication research
in AT&T Bell Laboratories where he led and engaged in data communication
equipment and multimedia product development. Mr. Chou holds a B.S. in
Electrical Engineering from City College of New York, an M.S. in Engineering
from Princeton University and an M.B.A. from the State University of New
Jersey, Rutgers.
Paul Berkowitz has been our Vice President of International Sales since
November 1998. From February 1996 to November 1998, he was our Vice President
of Product Management & Planning, and from December 1995 to June 1996, he
served as our Vice President of Engineering. From 1994 to 1995, Mr. Berkowitz
was Director of Application Software of AT&T Network Systems where he managed,
among other things, an international team in marketing, architecture, and
development of software involving a portfolio of advanced GUI and client-server
products for telecommunications services. Between 1992 and 1994, he led the
planning and development effort for a 1 Gigabit/sec Asynchronous Transfer Mode
switch support Wide Area Network services including TDM and Frame Relay in the
AT&T Paradyne Unit. Mr. Berkowitz has been granted four patents and holds a
B.S. and an M.S. in Electrical Engineering from Columbia University.
Gerald Soloway has been our Vice President of Engineering since January
1999. He was appointed Senior Vice President of Engineering in September 2001.
From April 1998 to January 1999, he served as our Director of
22
Strategic Marketing. Prior to this, Dr. Soloway worked for Lucent Technologies,
formerly Bell Labs, for 29 years. At Lucent, Dr. Soloway held executive
positions in Consumer Products, Business Terminal Development, PBX Systems
Engineering, Key System Development and Access Systems Development. He holds a
Ph.D. from Polytechnic Institute of New York, an M.S. from New York University,
and a B.S. from Cooper Union, all in Electrical Engineering. Dr. Soloway also
holds seven patents in communications and computer graphics technology.
Thomas J. Toy has served as a director since February 1995. Since March
1999, Mr. Toy has served as Managing Director of Pacrim Venture Partners, a
professional venture capital firm specializing in investments in the
information technology sector. Prior to that he was a partner at Technology
Funding, a professional venture capital firm, from January 1987 to March 1999.
While at Technology Funding, Mr. Toy was Managing Director of Corporate Finance
and headed the firm's investment committee. Mr. Toy also serves as a director
of White Electronic Designs Inc. and several private companies. Mr. Toy holds
B.A. and M.M. degrees from Northwestern University.
Chauncey Shey has served as a director since October 1995. Mr. Shey has
served as President of SOFTBANK China Holdings since December 1999. From
February 1999 to December 1999, he served as President of DirecTouch
Communications Limited. From October 1995 to February 1999, Mr. Shey served as
our Executive Vice President in charge of Research and Development. From March
to October 1995, he served as Executive Vice President of StarCom Network
Systems, Inc., where he worked in research and development as well as in
operation and strategy planning. From March 1991 to March 1995, he served as
Executive Vice President of StarCom Products, Inc., a consulting business that
developed software products and provided expertise in the fields of computers
and telecommunications. In that position he was responsible for operations,
financial management and marketing. From December 1990 to December 1991, Mr.
Shey served as a consultant at Bell Labs. He holds a B.S. in Electrical
Engineering from Shanghai Jiao Tong University and an M.S. in Computer Science
from the State University of New York at New Paltz.
Larry D. Horner has served as a director since January 2000. From 1994 until
June 2001, Mr. Horner served as Chairman of Pacific USA Holdings Corp. and as
Chairman of the Board and Chief Executive Officer of Asia Pacific Wire & Cable
Corporation Limited. He is a director of Phillips Petroleum Company, Atlantis
Plastics, Inc. and Newmark Homes Corp. Mr. Horner formerly served as Chairman
and Chief Executive Officer of KPMG Peat Marwick from 1984 to 1990. Mr. Horner
is a Certified Public Accountant, holds a B.S. from the University of Kansas
and is a graduate of the Stanford Executive Program.
Howard Kwock was appointed our Vice President of Engineering in September
2001. From March 2001 to September 2001, he served as our Senior Director of
Engineering. From February 2000 to February 2001, Mr. Kwock worked as Director
of Engineering at Zhone Technologies. From June 1995 to January 2001, Mr. Kwock
served as Director of Engineering at Lucent Technologies, formerly Ascend
Communications. Mr. Kwock holds a B.A. in Business Administration from
California State University, Fullerton.
23
PART II
ITEM 5--MARKET FOR UTSTARCOM, INC.'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Fiscal 2000 High Low
----------- ------ ------
First Quarter (from March 3, 2000)............... $93.50 $41.00
Second Quarter................................... 77.63 16.75
Third Quarter.................................... 32.88 18.00
Fourth Quarter................................... 23.00 12.31
Fiscal 2001
-----------
First Quarter.................................... $28.00 $13.56
Second Quarter................................... 27.28 12.50
Third Quarter.................................... 25.61 12.98
Fourth Quarter................................... 31.43 15.51
Fiscal 2002
-----------
First Quarter (through February 8, 2002)......... $35.66 $20.67
Our common stock has been traded on The Nasdaq Stock Market under the symbol
UTSI since our initial public offering on March 3, 2000. The preceding table
sets forth the high and low closing sales prices per share of our common stock
as reported on The Nasdaq National Market for the periods indicated. As of
December 31, 2001 we had approximately 205 stockholders of record.
To date, we have not paid any cash dividends on our common stock. We
currently anticipate that we will retain any available funds to finance the
growth and operation of our business and we do not anticipate paying any cash
dividends in the foreseeable future. Certain present or future agreements may
limit or prevent the payment of dividends on our common stock.
24
ITEM 6--SELECTED CONSOLIDATED FINANCIAL DATA
You should read the selected consolidated financial data set forth below in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and our Consolidated Financial Statements and the
Notes thereto included elsewhere in this report. Historical results are not
necessarily indicative of results that may be expected for any future period.
Year Ended December 31,
--------------------------------------------------
1997 1998 1999 2000 2001
-------- -------- -------- -------- ----------
(in thousands, except per share data)
Consolidated Statement of Operations Data:
Net sales................................................. $ 75,597 $105,167 $187,516 $368,646 $ 626,840
Gross profit.............................................. 26,802 41,025 74,813 128,181 224,548
Operating income (loss)................................... (3,390) 3,013 16,719 33,780 76,728
Income (loss) from continuing operations.................. (1,383) 593 13,119 27,993 56,954
Net income (loss) available to common stockholders........ 30 (300) (18,514) 27,013 56,954
Basic earnings (loss) per share:
Income (loss) from continuing operations............... $ (0.19) 0.08 $ (1.94) $ 0.35 $ 0.56
Income (loss) from discontinued operations............. 0.19 (0.12) (0.19) -- --
Cumulative effect on prior years of the application of
SAB 101 "Revenue Recognition in Financial
Statements".......................................... -- -- -- (0.01) --
-------- -------- -------- -------- ----------
Net income (loss)...................................... $ -- $ (0.04) $ (2.13) $ 0.34 $ 0.56
======== ======== ======== ======== ==========
Diluted earnings (loss) per share:
Income (loss) from continuing operations............... $ (0.19) $ 0.01 $ (1.94) $ 0.28 $ 0.52
Income (loss) from discontinued operations............. 0.19 (0.01) (0.19) -- --
Cumulative effect on prior years of the application of
SAB 101 "Revenue Recognition in Financial
Statements".......................................... -- -- -- (0.01) --
-------- -------- -------- -------- ----------
Net income (loss)...................................... $ -- $ -- $ (2.13) $ 0.27 $ 0.52
======== ======== ======== ======== ==========
Pro forma amounts assuming application of SAB 101
"Revenue Recognition in Financial Statements" is
applied retroactively:
Net income (loss) available to common
stockholders......................................... $ 30 $ (300) $(19,494) $ 27,993 $ 56,954
======== ======== ======== ======== ==========
Earning (loss) per share:
--Basic............................................ $ -- $ (0.04) $ (2.25) $ 0.35 $ 0.56
======== ======== ======== ======== ==========
--Diluted.......................................... $ -- $ -- $ (2.25) $ 0.27 $ 0.52
======== ======== ======== ======== ==========
Weighted average shares used in per-share calculations:
--Basic............................................ 7,320 7,582 8,678 79,696 101,433
======== ======== ======== ======== ==========
--Diluted.......................................... 7,320 77,050 8,678 101,867 108,612
======== ======== ======== ======== ==========
As of December 31,
--------------------------------------------------
1997 1998 1999 2000 2001
-------- -------- -------- -------- ----------
(in thousands)
Consolidated Balance Sheet Data:
Cash and cash equivalents(1).............................. $ 35,049 $ 17,626 $ 87,364 $149,112 $ 321,136
Working capital........................................... 59,076 57,416 128,973 369,861 591,103
Total assets.............................................. 101,097 142,121 271,788 591,837 1,005,880
Total short-term debt..................................... 1,579 38,426 43,338 43,381 58,434
Total long-term debt...................................... -- -- -- 12,048 12,048
Total stockholders' equity................................ 72,513 72,336 165,720 412,319 681,887
- --------
(1) Includes restricted cash of $5.2 million as of December 31, 2001.
25
ITEM 7--MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-K contains forward-looking statements within
the meaning of the federal securities laws. These statements are based on
information that is currently available to management. We intend such
forward-looking statements to be covered by the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995, and we are including this
statement for purposes of complying with those provisions. The forward-looking
statements include those concerning the following: our expectation regarding
continued growth in our business and operations; our expectation that our PAS
network access system will continue to be allowed in China's county-level
cities and counties; our expectation that there will be no penalties or fines
for our non-compliance with the licensing requirements in China for our PAS
system and other products; our expectation that there will be fluctuations in
our overall gross profit, gross margin, product mix and selling prices; our
plans for expanding the direct sales organization and our selling and marketing
campaigns and activities; our expectation that we may use part of the net
proceeds of our initial and follow on public offerings to acquire or invest in
complementary businesses, technologies or product offerings; our expectation
that there will be increases in selling, marketing, research and development,
general and administrative expenses; our expectation that we will continue to
invest significantly in research and development; our expectation that we will
fill the majority of our current backlog orders; our expectation regarding our
future investments, particularly in Softbank China; and our expectation that
existing cash and cash equivalents will be sufficient to finance our operations
for at least the next 12 months. Additional forward-looking statements may be
identified by the words, "anticipate," "expect," "believe," "intend," "will"
and similar expressions, as they relate to us or our management. Investors are
cautioned that these forward-looking statements are inherently uncertain. These
statements are subject to risks and uncertainties that may cause actual results
and events to differ materially. For a detailed discussion of these risks and
uncertainties, see the "Factors Affecting Future Operating Results" section of
this Form 10-K. We do not guarantee future results and undertake no obligation
to update the forward-looking statements to reflect events or circumstances
occurring after the date of this Form 10-K.
Overview
We design, manufacture and market wireline and wireless broadband access and
switching equipment that enables migration to next generation IP-based
networks. Our operations are conducted primarily by our foreign subsidiaries
that manufacture, distribute and support our products, principally in China.
Our systems and products allow service providers to offer cost-efficient and
expandable voice, data and Internet access services. Because our systems are
based on widely adopted international communications standards, service
providers can easily integrate our systems into their existing networks and
deploy our systems in new broadband, Internet Protocol and wireless network
rollouts.
We incorporated in Delaware in 1991. Since our incorporation, we have
focused our resources on developing products for China's communications market.
We shipped our first network access products in 1993. In 1995, we acquired
StarCom Network Systems, Inc. and changed our name to UTStarcom, Inc. In 1996,
we introduced our advanced, V5.1 and V5.2 compliant, multi-service network
access platform, the AN-2000. Late in 1996, we introduced our PAS wireless
access system. In December 1999, we completed the acquisition of the portion of
our Wacos, Inc. subsidiary owned by the minority shareholders. Wacos, Inc. is a
research and development subsidiary that develops IP-based switching systems.
In November 2001, we completed the acquisition of Advanced Communications
Devices Corporation, or ACD, for $21.3 million. In addition, we issued shares
of restricted common stock valued at $5.0 million to ACD employees who will
continue to perform services for us, vesting over a period of five years or
upon the achievement of certain performance milestones. The first milestone was
met in December 2001, resulting in a charge of $1.3 million to operations. ACD
is a System- on-Chip (SoC) semiconductor company focusing on LAN and IP
switching technology. We conduct our operations in China through wholly owned
subsidiaries and two joint ventures.
26
We have derived substantially all of our revenues from sales of
telecommunications equipment to service providers in China. However, we are
currently expanding our sales to service providers in other growing
communications markets outside of China. Our customers often make a large
initial purchase of our equipment followed by supplemental purchases of
enhancements and upgrades. As a result, our largest revenue-producing customers
typically vary from period to period. The evaluation period for our products by
potential customers may span a year or more and our business generally depends
on a relatively small number of large deployments. We sell our products in
China through a direct sales force.
Approximately 90.3% of our net sales for the year ended December 31, 2001
and approximately 98.8% of our net sales for the year ended December 31, 2000
were made in China. Accordingly, our business, financial condition and results
of operations are likely to be influenced by the political, economic and legal
environment in China, and by the general state of China's economy. Our results
may be adversely affected by, among other things, changes in the political,
economic, competitive and social conditions in China, including changes in
governmental policies with respect to laws and regulations, changes in
telecommunications industry and regulatory rules and policies,
anti-inflationary measures, currency conversion and remittance abroad, and
rates and methods of taxation. Our first and second largest customers accounted
for 6.6% and 5.9% of our net sales for the year ended December 31, 2001, and
9.0% and 5.0% of accounts receivable, respectively, as of December 31, 2001.
Our first and second largest customers accounted for 12.1% and 6.0% of our net
sales, respectively, for the year ended December 31, 2000 and 7.0% and 0.2% of
the accounts receivable, respectively, as of December 31, 2000. Our first and
second largest customers accounted for 30.2% and 10.7% of our net sales,
respectively, in 1999 and 39.0% and 6.0% of the accounts receivable,
respectively, as of December 31, 1999. 89.9% of our net sales during 2001 were
to entities affiliated with the government of China. Accounts receivable
balances from these entities or state owned enterprises were $192.8 million as
of December 31, 2001. We extend credit to our customers in China without
requiring collateral. We monitor our exposure for credit losses and maintain
allowances for doubtful accounts.
Under China's current regulatory structure, the communications products that
we offer in China must meet government and industry standards, and a network
access license for the equipment must be obtained. Without a license, the
equipment is not allowed to be connected to public telecommunications networks
or sold in China. Moreover, we must ensure that the quality of the
telecommunications equipment for which we have obtained a network access
license is stable and reliable, and may not lower the quality or performance of
other installed licensed products. The State Council's product quality
supervision department, in concert with the Ministry of Information Industry,
performs spot checks to track and supervise the quality of licensed
telecommunications equipment and publishes the results of such spot checks.
The regulations implementing these requirements are not very detailed, have
not been applied by a court and may be interpreted and enforced by regulatory
authorities in a number of different ways. We have obtained the required
network access licenses for our AN-2000 platform. We have applied for, but have
not yet received, a network access license for our PAS systems and handsets.
Based upon conversations with the Ministry of Information Industry, we
understand that our PAS systems and handsets are considered to still be in the
trial period and that sales of our PAS systems and handsets may continue to be
made by us during this trial period, but a license will ultimately be required.
Network access licenses will also be required for most additional products that
we are selling or may sell in China, including our mSwitch platform. If we fail
to obtain the required licenses, we could be prohibited from making further
sales of the unlicensed products, including our PAS systems and handsets, in
China, which would substantially harm our business, financial condition and
results of operations. Our counsel in China has advised us that China's
governmental authorities may interpret or apply the regulations with respect to
which licenses are required and the ability to sell a product while a product
is in the trial period in a manner that is inconsistent with the information
received by our counsel in China, either of which could have a material adverse
effect on our business, financial condition and results of operations.
Remittances from China, which are of a capital nature, such as the repayment
of bank loans denominated in foreign currencies, require approval from
appropriate governmental authorities before Renminbi can be used to
27
purchase foreign currency. Although the payment of cash dividends is permitted
so long as our subsidiaries have sufficient reserves and adequate amounts of
Renminbi to purchase foreign currency, regulations restrict the ability of our
subsidiaries to transfer funds to us through intercompany loans and advances.
Additionally, business activity in China and many other countries in Asia
declines considerably during the first quarter of each year in observance of
the Lunar New Year. As a result, sales during the first quarter of our fiscal
year have typically been lower than sales during the fourth quarter of the
preceding year, and we expect this trend to continue. We do not have the
ability to forecast with any degree of certainty the impact of the decreased
business activity during the Lunar New Year on our sales and operating results.
Revenues from sales of telecommunications equipment are recognized when
persuasive evidence of an agreement exists, delivery of the product has
occurred as evidenced by customer acceptance, the fee is fixed or determinable
and collectibility is reasonably assured. Where multiple elements exist in an
arrangement, revenue is allocated to the different elements based upon
verifiable objective evidence of the fair value of the elements. Revenues from
sales of telecommunications equipment involving significant production,
modification or customization of the product or where services being provided
are deemed to be essential to the functionality of the product are recognized
using the percentage of completion method if the project cost can be reasonably
estimated. If the cost cannot be reasonably estimated, the completed contract
method is applied. Any payments received prior to revenue recognition are
recorded as deferred revenue.
Revenues from sales of telecommunications equipment incorporating software
not considered incidental to the product as a whole ("software contracts") are
recognized when persuasive evidence of an agreement exists, the product has
been delivered as evidenced by customer acceptance, the fee is fixed or
determinable and collectability is probable. Revenues from software contracts
with multiple elements are recognized using the residual method when there is
vendor specific objective evidence of the fair value of all undelivered
elements in an arrangement but vendor specific objective evidence of fair value
does not exist for one or more of the delivered elements in an arrangement.
Under the residual method, the fair value of the undelivered elements, as
indicated by vendor specific objective evidence, is deferred and the difference
between the total arrangement fee and the amount deferred for the undelivered
elements is recognized as revenue related to the delivered elements regardless
of any separate prices stated within the contract for each element. If the fee
due from the customer is not fixed or determinable due to extended payment
terms, revenue is recognized as payments become due from the customer, assuming
all other criteria for revenue recognition are met.
Revenues from engineering service contracts are recognized upon completion
of the project, or using the percentage of completion method when project costs
can be reasonably estimated.
Effective January 1, 2000, we adopted Staff Accounting Bulletin 101 ("SAB
101") issued by the Securities and Exchange Commission in December 1999. In
light of the guidance issued in SAB 101, we changed our method of recognizing
revenue for some contracts. We previously recognized revenue as contract stages
were completed and accepted. We now recognize revenue upon final acceptance of
the contract. In addition, some of our contracts include service requirements
for which revenue was previously recognized, and costs accrued, on contractual
acceptance. In consideration of SAB 101, revenues associated with these service
requirements are being deferred until the service obligations are completed. We
recorded a cumulative adjustment in the first quarter of fiscal 2000 of $1.0
million. The impact of the cumulative adjustment was a decrease in net income
of $1.0 million or $0.01 per share, basic and diluted, for the year ended
December 31, 2000.
Cost of sales consists primarily of material costs, third party commissions,
costs associated with manufacturing, assembly and testing of products, costs
associated with installation and customer training and overhead and warranty
costs. Cost of sales also includes import taxes and tariffs on components and
assemblies. Some components and materials used in our products are purchased
from a single supplier or a limited group of suppliers and, in some cases, are
subject to our obtaining Chinese import permits and approvals. We also rely on
third party manufacturers in China to manufacture and assemble most of our
handsets.
28
Our gross profit has been affected by product mix, average selling prices
and material costs. Our gross profit, as a percentage of net sales, varies
among our product families. The gross profit, as a percentage of net sales, on
our handsets is very low compared to our other products. We expect that our
overall gross profit, as a percentage of net sales, will fluctuate from period
to period as a result of shifts in product mix, anticipated decreases in
average selling prices and our ability to reduce cost of sales.
Selling, general and administrative expenses include compensation and
benefits, professional fees, sales commissions, provision for doubtful accounts
receivable and travel and entertainment costs. A large percentage of our costs
are fixed and are difficult to quickly reduce in periods of reduced sales. We
intend to pursue aggressive selling and marketing campaigns and to expand our
direct sales organization, and, as a result, our sales and marketing expenses
will increase in future periods. We also expect that in support of our
continued growth, general and administrative expenses will continue to increase
for the foreseeable future.
Research and development expenses consist primarily of salaries and related
costs of employees engaged in research, design and development activities, the
cost of parts for prototypes, equipment depreciation and third party
development expenses. A large percentage of our costs are fixed and are
difficult to quickly reduce in periods of reduced sales. We believe that
continued investment in research and development is critical to our long-term
success. Accordingly, we expect that our research and development expenses will
increase in future periods.
Net deferred stock compensation represents the difference between the fair
value of common stock and the option exercise price for the options at the date
of grant. Deferred compensation is presented as a reduction of stockholders'
equity, with amortization recorded over the vesting period of the option, which
is generally four years. In connection with the grant of stock options to our
employees, we recorded $5.0 million, $2.4 million and $15.9 million of net
deferred stock compensation during the years ended December 31, 2001, 2000 and
1999, respectively. In connection with grants to non-employees during 1999, we
recorded deferred compensation of $7.4 million. We recorded stock compensation
expense of approximately $5.2 million during the year ended December 31, 2001,
$11.6 million during the year ended December 31, 2000, and $5.6 million during
the year ended December 31, 1999. At December 31, 2001, approximately $6.0
million of deferred stock compensation remained to be amortized.
Amortization of intangible assets consists primarily of the amortization of
intangible assets associated with acquisitions in China, our acquisition of a
minority interest in Wacos, Inc. and our acquisitions of Stable Gain
International Ltd. and ACD.
Consolidated equity in net income (loss) of affiliated companies comprises
our 51.0% share of the earnings from our Guangdong manufacturing subsidiary,
which is accounted for using the equity method, as we do not have voting
control over all significant matters. We have entered into an agreement to
purchase the remaining 49.0% equity interest and we are in the process of
applying for the relevant governmental approvals.
Under current regulations in China, foreign investment enterprises that have
been accredited as technologically advanced enterprises are entitled to
additional tax incentives. These tax incentives vary in different locales and
could include preferential national enterprise income tax treatment at 50% of
the usual rates for different periods of time. All of our active subsidiaries
in China were accredited as technologically advanced enterprises. The tax
holidays applicable to our wholly-owned subsidiary, UTStarcom China, and our
joint venture, Hangzhou UTStarcom, which together accounted for approximately
90.1% of our revenues in 2001, will expire at the end of 2002. At that time,
the tax rates for these two subsidiaries will increase from 7.5% to 15%, and
from 10% to 15%, respectively, which will negatively impact our financial
condition and results of operations by increasing our tax rate. Additionally,
the Chinese government is considering the imposition of a "unified" corporate
income tax that would phase out, over time, the preferential tax treatment to
which foreign-funded enterprises, such as UTStarcom, are currently entitled. It
is not certain whether the government will implement such a unified tax
structure, or if implemented whether it will adversely affect our financial
results.
29
Minority interest in (earnings) loss of consolidated subsidiaries represents
the share of earnings in Hangzhou UTStarcom, our Zhejiang manufacturing joint
venture, that is owned by our joint venture partner.
Results of Operations
The following table sets forth the percentage of net sales represented by
certain items reflected in our consolidated statements of operations:
Years Ended December 31,
--------------------------
1999 2000 2001
------- ------- -------
Percentage of Net Sales
Net sales.............................................................. 100.0% 100.0% 100.0%
Cost of sales.......................................................... 60.1 65.2 64.2
------- ------- -------
Gross profit........................................................... 39.9 34.8 35.8
Operating expenses:
Selling, general and administrative................................. 18.7 13.1 12.1
Research and development............................................ 10.0 11.2 9.5
Amortization of goodwill and intangible assets...................... 0.2 1.3 1.2
In-process research and development costs........................... 2.1 -- 0.8
------- ------- -------
Total operating expenses........................................ 31.0 25.6 23.6
Operating income....................................................... 8.9 9.2 12.2
Interest and other income (expenses)................................... (1.2) 2.9 0.5
Equity in net income (loss) of affiliated companies.................... 0.7 (0.1) (0.2)
------- ------- -------
Income before income taxes and minority interest....................... 8.4 12.0 12.5
Income tax expense..................................................... 0.3 3.8 3.2
Minority interest in earnings of consolidated subsidiaries............. (1.1) (0.6) (0.2)
------- ------- -------
Income from continuing operations...................................... 7.0 7.6 9.1
Loss from discontinued operations...................................... (0.9) -- --
------- ------- -------
Net income before cumulative effect of change in accounting principle.. 6.1 7.6 9.1
Beneficial conversion feature of Series F preferred stock.............. (16.0) -- --
Cumulative effect on prior years of the application of SAB 101 "Revenue
Recognition in Financial Statements"................................. -- (0.3) --
------- ------- -------
Net income (loss) available to common stockholders..................... (9.9)% 7.3% 9.1%
======= ======= =======
Comparison of years ended December 31, 2001 and December 31, 2000
Net Sales. Our net sales increased 70.0% to $626.8 million in 2001 from
$368.6 million in 2000. This increase was primarily due to an increase in sales
volume of our PAS and IP-based PAS systems. Sales of telecommunications
equipment for the year ended December 31, 2001 were $438.9 million, an increase
of $176.9 million or 67.5%, as compared to the corresponding period in 2000.
Sales of subscriber handsets for the year ended December 31, 2001 were $187.9
million, an increase of $81.3 million or 76.3%, as compared to the
corresponding period in 2000. Sales of telecommunications equipment and
subscriber handsets increased due to the continued growth in spending on
telecommunications infrastructure in China, as China continues to modernize
such infrastructure. In 2001, no customer accounted for more than 10% our net
sales. In 2000, sales to Hangzhou Telecommunications Bureau accounted for 12.1%
of our net sales.
Gross Profit. Gross profit increased 75.2% to $224.5 million in 2001 from
$128.2 million in 2000. Gross profit, as a percentage of net sales, increased
to 35.8% in 2001 from 34.8% in 2000. The increase in gross profit, as a
percentage of net sales, was primarily due to increased margins on our
handsets, which comprised 30.0% of net sales in 2001 compared to 28.9% in 2000.
30
Selling, General and Administrative. Selling, general and administrative
expenses increased 57.7% to $75.8 million in 2001 from $48.1 million in 2000.
The increase in selling, general and administrative expenses was primarily due
to increased sales and administrative personnel and related expenses, including
sales commissions, associated with the growth in net sales and the expansion of
our overall level of business activities. This increase was partly offset by a
decrease in non-cash stock compensation expense which decreased to $2.5 million
in 2001 from $4.7 million in 2000. Selling, general and administrative expenses
as a percentage of net sales decreased to 12.1% in 2001 from 13.1% in 2000. The
decrease in selling, general and administrative expenses as a percentage of net
sales was primarily due to economies of scale associated with the significant
increases in net sales. We expect our selling, general and administrative
expenses to increase in absolute dollar amounts in future periods as sales and
marketing activities increase and we further invest in infrastructure and incur
additional expenses related to the anticipated growth of our business and
operations.
Research and Development. Research and development expenses increased 44.3%
to $59.8 million in 2001 from $41.5 million in 2000. The increase in research
and development expenses was primarily due to the hiring of additional
technical personnel, increased prototype expenses and licensing fees to support
our research and development efforts, partly offset by a decrease in non-cash
stock compensation expense which decreased to $2.7 million in 2001 from $6.8
million in 2000. As a percentage of net sales, research and development
expenses decreased to 9.5% in 2001 from 11.2% in 2000. This reduction was
attributable to the decrease in non-cash compensation expense and an increase
in sales in 2001. We expect our research and development expenses to increase
in absolute dollar amounts in future periods as we expand our research and
development organization to support new product development.
Amortization of Intangible Assets. Amortization of intangible assets
increased to $7.5 million in 2001 from $4.9 million in 2000. The increase in
amortization of intangible assets was primarily due to the amortization of
additional goodwill associated with the acquisition of Stable Gain, a software
development company, for $11.0 million in the first quarter of 2001.
In-Process Research and Development Costs. In-process research and
development costs resulted from our acquisition of ACD in November 2001. The
aggregate purchase price of ACD was approximately $21.3 million which, based
upon an independent appraisal by Willamette Management Associates of the assets
acquired and liabilities assumed, was allocated to the specifically
identifiable tangible and intangible assets acquired. In connection with the
ACD acquisition, $4.7 million of in-process research and development costs were
charged to operations in November 2001. There were no in-process research and
development charges in 2000.
Interest Income (Expense), Net. Interest income was $8.6 million in 2001
compared to interest income of $12.2 million in 2000. Interest expense was $3.9
million in 2001 compared to $3.3 million in 2000. Interest income decreased in
2001 due to lower interest rates, which was partially offset by higher average
cash balances as a result of the completion of our follow-on public offering in
July 2001. Interest expense increased due to higher borrowings in 2001 as
compared to 2000.
Other Income (Expenses), Net. Net other expense was $2.0 million in 2001
and net other income was $1.9 million in 2000. The decrease in other income in
2001 was primarily due to impairment write-downs of $3.4 million relating to
our investment portfolio.
Equity in Net Income (Loss) of Affiliated Companies. Consolidated equity in
net loss of affiliated companies was $1.3 million in 2001 and $0.3 million in
2000. The change between the two periods was primarily due to the increase in
losses at our Guangdong manufacturing subsidiary.
Income Tax Expense. Income tax expense was $19.8 million in 2001 and $14.0
million in 2000. The increase in income tax expense was due to our increasing
income. Our effective tax rate improved from 32% in 2000 to 25% in 2001
primarily due to a favorable settlement with the Internal Revenue Service upon
examination of our corporate income tax returns filed for the years 1997, 1998
and 1999.
31
Minority Interest in Earnings of Consolidated Subsidiaries. Minority
interest in earnings of consolidated subsidiaries was $1.3 million in 2001 and
$2.3 million in 2000. The change between the two periods was primarily due to
the increased profitability at our Zhejiang manufacturing subsidiary.
Comparison of years ended December 31, 2000 and December 31, 1999
Net Sales. Our net sales increased 96.6% to $368.6 million in 2000 from
$187.5 million in 1999. This increase was primarily due to an increase in sales
volume of our PAS system. Sales of telecommunications equipment for the year
ended December 31, 2000 were $262.1 million, an increase of $92.7 million or
54.7%, as compared to the corresponding period in 1999. Sales of subscriber
handsets for the year ended December 31, 2000 were $106.6 million, an increase
of $88.5 million or 489.0%, as compared to the corresponding period in 1999. In
2000, sales to Hangzhou Telecommunications Bureau accounted for 12.1% of our
net sales. In 1999, sales to Xian Telecommunications Bureau and Kunming
Telecommunications Bureau accounted for 30.2% and 10.7% of our net sales,
respectively.
Gross Profit. Gross profit increased 71.3% to $128.2 million in 2000 from
$74.8 million in 1999. Gross profit, as a percentage of net sales, decreased to
34.8% in 2000 from 39.9% in 1999. The decrease in gross profit, as a percentage
of net sales, was primarily due to increases in sales of lower margin handsets,
which comprised 28.9% of net sales in 2000 compared to 9.6% in 1999.
Selling, General and Administrative. Selling, general and administrative
expenses increased 36.8% to $48.1 million in 2000 from $35.1 million in 1999.
The increase in selling, general and administrative expenses was primarily due
to increased sales and administrative personnel and related expenses, including
sales commissions, associated with the growth in net sales and the expansion of
our overall level of business activities. Selling, general and administrative
expenses as a percentage of net sales decreased to 13.1% in 2000 from 18.7% in
1999. The decrease in selling, general and administrative expenses as a
percentage of net sales was primarily due to economies of scale associated with
the significant increases in net sales.
Research and Development. Research and development expenses increased
122.3% to $41.5 million in 2000 from $18.6 million in 1999. The increase in
research and development expenses was primarily due to the hiring of additional
technical personnel, increased prototype expenses and licensing fees to support
our research and development efforts, and non-cash stock compensation expense
which increased to $6.8 million in 2000 from $1.3 million in 1999. As a
percentage of net sales, research and development expenses increased to 11.2%
in 2000 from 10.0% in 1999.
Amortization of Intangible Assets. Amortization of intangible assets
increased to $4.9 million in 2000 from $0.3 million in 1999. The increase in
amortization of intangible assets was due to the increase in amortization
associated with our December 1999 acquisition of the portion of our Wacos, Inc.
subsidiary owned by the minority shareholders.
In-Process Research and Development Costs. There were no in-process
research and development charges in 2000. In-process research and development
costs in 1999 resulted from our acquisition of the portion of our Wacos, Inc.
subsidiary owned by the minority shareholders in December 1999. The aggregate
purchase price of Wacos, Inc. was approximately $28.0 million which, based upon
an independent appraisal by Willamette Management Associates of all the assets
acquired and liabilities assumed, was allocated to the specifically
identifiable tangible and intangible assets acquired. In connection with the
Wacos acquisition, $4.0 million of in-process research and development costs
were charged to operations in December 1999.
Interest Income (Expense), Net. Net interest income was $8.9 million in
2000 and net interest expense was $1.0 million in 1999. The increase in
interest income was primarily due to increased interest income from higher
average cash balances as a result of the completion of our initial public
offering in March 2000 and sale of our preferred stock in November and December
1999.
32
Other Income (Expenses), Net. Net other income was $1.9 million in 2000 and
net other expenses were $1.2 million in 1999. The increase in other income was
primarily due to a one-time gain on non-trade receivables which related to
receipts of balances previously considered doubtful.
Equity in Net Income (Loss) of Affiliated Companies. Consolidated equity in
net loss of affiliated companies was $0.3 million in 2000 and consolidated
equity in net income of affiliated companies was $1.3 million in 1999. The
change between the two periods was primarily due to the decrease in net income
at our Guangdong manufacturing subsidiary.
Income Tax Expense. Income tax expense was $14.0 million in 2000 and $0.6
million in 1999. The increase in the income tax expense was due to our
increasing income.
Minority Interest in Earnings of Consolidated Subsidiaries. Minority
interest in earnings of consolidated subsidiaries was $2.3 million in 2000 and
$2.1 million in 1999. The change between the two periods was primarily due to
the increased profitability at our Zhejiang manufacturing subsidiary.
Beneficial Conversion Feature. The issuance of Series F preferred stock in
1999 included a beneficial conversion feature pursuant to which the preferred
shares converted into common shares on a one-for-one basis at a price below the
expected offering price upon the completion of our initial public offering.
This resulted in a charge to net income in 1999 of approximately $30.0 million,
reducing diluted earnings per share available to common stockholders by $3.45.
Liquidity and Capital Resources
Prior to our initial public offering we financed our operations through the
sales of preferred stock and, to a lesser extent, bank lines of credit. In
November and December 1999, we secured private equity financing totaling $55.0
million. In March 2000, we raised $189.4 million in net proceeds from our
initial public offering in which we sold 11,500,000 shares of common stock. On
August 3, 2001, we completed a follow-on public offering and sold an aggregate
of 7,400,000 shares of common stock in which we raised net proceeds of
$139.9 million.
As of December 31, 2001 we had lines of credit totaling $260.2 million of
which our total borrowings were $70.5 million, with the remainder available for
future borrowings. Of the amount borrowed, $12.0 million was included in
long-term debt. We are not a guarantor of any debt not included in the
consolidated balance sheet. As of December 31, 2001, we had working capital of
$591.1 million, including $321.1 million of cash and cash equivalents, $86.2
million of short-term investments and $58.4 million of Renminbi-denominated
bank borrowings.
During 2000, we invested $8.0 million and during 2001, we invested an
additional $2.0 million in Softbank China (the "fund"), an investment fund
established by SOFTBANK CORP. focused on investments in Internet companies in
China. This investment permits us to participate in the anticipated growth of
Internet-related businesses in China. An entity affiliated with SOFTBANK CORP.,
SOFTBANK America Inc., is a significant stockholder in our company. Our
investment constitutes 10.0% of the funding for Softbank China, with SOFTBANK
CORP. contributing the remaining 90.0%. We are a passive investor and have no
decision-making authority with respect to investments by the fund. The fund has
a separate management team, and none of our employees is employed by the fund.
One of our directors serves as the Chief Executive Officer of the fund. Our
Chief Executive Officer is the chairman of the board of the fund but has not
participated in day-to-day management of the fund. Many of the fund's
investments are and will be in privately held companies, many of which can
still be considered in the start-up or development stages. These investments
are inherently risky as the market for the technologies or products the
companies have under development are typically in the early stages and may
never materialize. During the year ended December 31, 2001, based upon a review
of the carrying value of this investment, an impairment charge of $1.7 million
was recognized to provide for the other than temporary decline in the fair
value below the carrying value of this investment. The balance remaining in
this investment as of December 31, 2001 was $8.3 million.
33
We have also invested directly in a number of private technology-based
companies in the early stages of development. We continually evaluate the
carrying value of these investments for possible impairment based on
achievement of business objectives and milestones, the financial condition and
prospects of these companies and other relevant factors. During the fourth
quarter of 2001, based upon a review of the carrying value of these
investments, an impairment charge of $1.7 million was recognized to provide for
the other than temporary decline in the fair value below the carrying value of
these investments. Due to the risky nature of these investments, we may
experience further losses in connection with our investment in Softbank China
and our other investments in private technology companies.
Net cash provided by operations in 2001 of $40.2 million was primarily due
to net income of $57.0 million adjusted for depreciation and amortization
expense of $18.5 million, amortization of deferred stock compensation expense
of $5.2 million, non-qualified stock option exercise tax benefits of $15.3
million, inventory reserve of $11.1 million, allowance for doubtful accounts of
$6.2 million and an increase in accounts payable, income taxes payable and
other current liabilities and deferred revenue of $39.1 million, $3.4 million
and $86.2 million, respectively. This was partially offset by an increase in
inventories, accounts receivable and other current and non-current assets of
$121.2 million, $39.2 million and $52.6 million, respectively. Net cash used in
operations in 2000 of $46.2 million was primarily due to an increase in
inventories, accounts receivable and other current and non-current assets of
$63.5 million, $87.2 million and $4.9 million, respectively. The uses of cash
were partially offset by net income of $27.0 million plus depreciation and
amortization expense of $9.5 million, non-qualified stock option exercise tax
benefits of $7.6 million, amortization of deferred stock compensation expense
of $11.6 million, inventory reserve of $2.8 million, allowance for doubtful
accounts of $6.0 million and an increase in accounts payable and other current
liabilities and deferred revenue of $14.1 million and $28.0 million,
respectively.
Net cash used in investing activities in 2001 of $43.7 million was primarily
due to purchases of property, plant and equipment of $30.2 million, investments
in affiliates of $9.8 million, and net purchases of short-term investments of
$2.1 million. Net cash used in investing activities in 2000 of $111.4 million
was primarily due to the acquisition of property, plant and equipment of $19.5
million, investment in affiliates of $8.2 million, which included our $8.0
million investment in Softbank China, and net purchases of short-term
investments of $83.8 million.
We have purchased the rights to use 49 acres of land located in Zhejiang
Science and Technology Industry Garden of Hangzhou Hi-tech Industry Development
Zone. We have completed the design layout for a new manufacturing facility.
Construction of the new facility is expected to be completed in 2003 at a
projected cost of $70.0 million.
We have entered into agreements to purchase the remaining minority interests
in two of our joint ventures. In December 2001, we agreed to acquire the
remaining 49% ownership in Guangdong UTStarcom, Ltd. for a total of
$3.6 million in cash payable in 2002. In January 2002, we agreed to acquire the
remaining 12% ownership in UTStarcom (Hangzhou) Telecommunication Company, Ltd.
for a total of $14.5 million in cash payable in 2002.
Net cash provided by financing activities in 2001 of $175.5 million was
primarily due to $160.6 million of proceeds from our follow-on public offering
of common stock in August 2001 and exercise of stock options, and net proceeds
from borrowings under our line of credit arrangements of $15.1 million. Net
cash provided by financing activities in 2000 of $219.3 million was primarily
due to net proceeds of $198.2 million from the issuance of common stock through
our initial public offering and exercise of stock options, and net proceeds of
$20.8 million from borrowing under our lines of credit.
Our international sales are generally denominated in local currencies. Due
to the limitations on converting Renminbi, we are limited in our ability to
engage in currency hedging activities in China. As of December 31, 2001, we
were not engaged in any hedging activities and did not hold any derivative
financial instruments.
34
Although the impact of currency fluctuations to date has been insignificant, we
cannot guarantee that fluctuations in currency exchange rates in the future
will not have a material adverse effect on revenues from international sales
and, correspondingly, on our business, financial condition and results of
operations. We also have contracts negotiated in Japanese Yen for purchasing
portions of our inventories and supplies. We have a multi-currency bank account
in Japanese Yen for purchasing portions of our inventories and supplies. The
balance of this Japanese Yen account as of December 31, 2001 was approximately
$6.7 million.
We believe that our existing cash and cash equivalents, short-term
investments and cash from operations will be sufficient to finance our
operations through at least the next 12 months. If additional financing is
needed, there can be no assurance that such financing will be available to us
on commercially reasonable terms, or at all.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board (the "FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivatives and Hedging Activities", as amended by SFAS No. 138. SFAS No. 133
established accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts, and for
hedging activities. We adopted SFAS No. 133 on January 1, 2001, and the
adoption had no impact on our consolidated financial statements.
In July 2001, the FASB issued SFAS No. 141, "Business Combinations," and
SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 requires
that the purchase method of accounting be used for all business combinations
initiated or completed after June 30, 2001. SFAS No. 141 also specifies the
criteria that intangible assets acquired in a business combination must meet to
be recognized and reported apart from goodwill. SFAS No. 142 requires that
goodwill and intangible assets with indefinite useful lives no longer be
amortized, but instead tested for impairment at least annually. SFAS No. 142
also requires that intangible assets with definite useful lives be amortized
over their respective estimated useful lives to their estimated residual
values, and reviewed for impairment in accordance with SFAS No. 121,
"Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to Be Disposed Of" (SFAS No. 121).
SFAS No. 141 is effective immediately, except with regard to business
combinations that were initiated prior to July 1, 2001, which we accounted for
using the purchase method of accounting. SFAS No. 142 will be effective for
fiscal years beginning after December 15, 2001, and was adopted by us on
January 1, 2002. The adoption of these accounting standards will eliminate
amortization of goodwill commencing January 1, 2002. However, impairment
reviews may result in future periodic write-downs. We expect, due to the
elimination of goodwill amortization expense effective January 1, 2002, that
net income will increase by approximately $7.3 million in 2002 because existing
goodwill from the Wacos acquisition will no longer be amortized. SFAS No. 142
will also require us to perform a transitional assessment by June 30, 2002, to
determine whether there is an impairment of goodwill. Any such transitional
impairment loss will be recognized as a change in accounting principle in the
consolidated statement of operations. We have not yet performed the initial
goodwill impairment test prescribed in SFAS No. 142. However, we do not
anticipate that such test will result in a significant impairment charge.
On October 3, 2001, the FASB issued SFAS No. 144, "Accounting for the
Impairment or Disposal of Long-Lived Assets." SFAS No. 144 is effective for
financial statements issued for fiscal years beginning after December 15, 2001
and interim periods within those fiscal years. This statement supercedes SFAS
No. 121, and amends APB 30 "Reporting the Results of Operations--Reporting the
Effects of Disposal of a Segment of a Business." SFAS No. 144 requires that
long-lived assets that are to be disposed of by sale be measured at the lower
of book value or fair value less cost to sell. Additionally, SFAS No. 144
expands the scope of discontinued operations to include all components of an
entity with operations that (1) can be distinguished from the rest of the
entity and (2) will be eliminated from the ongoing operations of the entity in
a disposal transaction. We do not expect that the adoption of SFAS No. 144 will
have a significant impact on our consolidated financial statements.
35
Risks Relating to Our Company
Our future product sales are unpredictable, our operating results are likely to
fluctuate from quarter to quarter, and if we fail to meet the expectations of
securities analysts or investors, our stock price could decline significantly
Our quarterly and annual operating results have fluctuated in the past and
are likely to fluctuate in the future due to a variety of factors, some of
which are outside of our control. As a result, period-to-period comparisons of
our operating results are not necessarily meaningful or indicative of future
performance. Furthermore, it is likely that in some future quarters our
operating results will fall below the expectations of securities analysts or
investors. If this occurs, the trading price of our common stock could decline.
Factors that may affect our future operating results include:
. the timing, number and size of orders for our products, as well as the
relative mix of orders for each of our products, particularly the volume
of lower margin handsets;
. cancellation, deferment or delay in implementation of large contracts;
. the evolving and unpredictable nature of the economic, regulatory,
competitive and political environments in China and other countries in
which we market or plan to market our products;
. price reductions by our competitors;
. changes in our customers' subscriber growth rate;
. currency fluctuations;
. market acceptance of our products and product enhancements;
. the lengthy and unpredictable sales cycles associated with sales of our
products combined with the impact of this variability on our suppliers'
ability to provide us with components on a timely basis;
. longer collection periods of accounts receivable in China and other
countries; and
. the decline in business activity we typically experience during the Lunar
New Year, which leads to decreased sales during our first fiscal quarter.
The limited performance history of some of our products, our limited
forecasting experience and processes and the emerging nature of our target
markets make forecasting our future sales and operating results difficult. Our
expense levels are based, in part, on our expectations regarding future sales,
and these expenses are largely fixed, particularly in the short term. In
addition, to enable us to promptly fill orders, we maintain inventories of
finished goods, components and raw materials. As a result, we commit to
considerable costs in advance of anticipated sales. In the past, a substantial
portion of our sales in each quarter resulted from orders received and shipped
in that quarter, and we have operated with a limited backlog of unfilled
orders. Accordingly, we may not be able to reduce our costs in a timely manner
to compensate for any unexpected shortfall between forecasted and actual sales.
Any significant shortfall of sales may require us to maintain higher levels of
inventories of finished goods, components and raw materials than we require,
thereby increasing our risk of inventory obsolescence and corresponding
inventory write-downs and write-offs.
Competition in our markets may lead to reduced prices, revenues and market share
We are increasingly facing intense competition in our target markets,
especially from domestic companies in China. We believe that our strongest
competition in the future may come from these companies, many of which operate
under lower cost structures and more favorable governmental policies and have
much larger sales forces than we do. Furthermore, other companies not presently
offering competing products may also enter our target markets, particularly
with the reduction of trade restrictions as a result of China's admission to
the World Trade Organization, or WTO. Many of our competitors have
significantly greater financial, technical, product
36
development, sales, marketing and other resources than we do. As a result, our
competitors may be able to respond more quickly to new or emerging technologies
and changes in service provider requirements. Our competitors may also be able
to devote greater resources than we can to the development, promotion and sale
of new products. These competitors may also be able to offer significant
financing arrangements to service providers, in some cases facilitated by
government policies, which is a competitive advantage in selling systems to
service providers with limited financial and currency resources. Increased
competition is likely to result in price reductions, reduced gross profit as a
percentage of net sales and loss of market share, any one of which could
materially harm our business, financial condition and results of operations.
Moreover, current and potential competitors have established or may
establish cooperative relationships among themselves or with third parties,
including Telecommunications Administrations, Telecommunications Bureaus and
other local organizations, to increase the ability of their products to address
the needs of prospective customers in our target markets. Accordingly,
alliances among competitors or between competitors and third parties may emerge
and rapidly acquire significant market share. To remain competitive, we believe
that we must continue to partner with Telecommunications Administrations and
other local organizations, maintain a high level of investment in research and
development and in sales and marketing, and manufacture and deliver products to
service providers on a timely basis and without significant defects. If we fail
to meet any of these objectives, our business, financial condition and results
of operations could be harmed.
The introduction of inexpensive wireless telephone service or other
competitive services in China may also have an adverse impact on sales of our
PAS systems and handsets in China. We may not be able to compete successfully
against current or future competitors, and competitive pressures in the future
may materially adversely affect our business, financial condition and results
of operations.
Because contracts and purchase orders are generally subject to cancellation or
delay by customers with limited or no penalty, our backlog is not necessarily
indicative of future revenues or earnings
As of December 31, 2001, our backlog totaled approximately $360.7 million,
compared to approximately $191.2 million as of December 31, 2000. We include in
our backlog contracts and purchase orders for which we anticipate delivery to
occur within 12 months and products delivered but for which final acceptance
has not yet been received. Because contracts and purchase orders are generally
subject to cancellation or delay by customers with limited or no penalty, our
backlog is not necessarily indicative of future revenues or earnings. In
addition, we have a number of large contracts under which realization of our
backlog is dependent on the successful implementation of our products by our
customers and in some cases, the successful development of regional
infrastructures.
Our business may suffer if we are unable to collect payments from our customers
on a timely basis
Our customers often must make a significant commitment of capital to
purchase our products. As a result, any downturn in a customer's business that
affects the customer's ability to pay us could harm our financial condition.
Moreover, accounts receivable collection cycles historically tend to be much
longer in China than in other markets. The failure of any of our customers to
make timely payments could require us to write-off accounts receivable or
increase our accounts receivable reserves, either of which could adversely
affect our financial condition.
Our market is subject to rapid technological change, and to compete
effectively, we must continually introduce new products that achieve market
acceptance
The emerging market for communications equipment in developing countries is
characterized by rapid technological developments, frequent new product
introductions and evolving industry and regulatory standards. Our success will
depend in large part on our ability to enhance our network access and switching
technologies and develop and introduce new products and product enhancements
that anticipate changing service provider
37
requirements and technological developments. We may need to make substantial
capital expenditures and incur significant research and development costs to
develop and introduce new products and enhancements. If we fail to timely
develop and introduce new products or enhancements to existing products that
effectively respond to technological change, our business, financial condition
and results of operations could be materially adversely affected.
From time to time, our competitors or we may announce new products or
product enhancements, technologies or services that have the potential to
replace or shorten the life cycles of our products and that may cause customers
to defer purchasing our existing products, including the possible adoption and
implementation of third generation, or 3G systems, resulting in inventory
obsolescence. Future technological advances in the communications industry may
diminish or inhibit market acceptance of our existing or future products or
render our products obsolete.
Even if we are able to develop and introduce new products, they may not gain
market acceptance. Market acceptance of our products will depend on various
factors including:
. our ability to obtain necessary approvals from regulatory organizations;
. the perceived advantages of the new products over competing products;
. our ability to attract customers who have existing relationships with our
competitors;
. product cost relative to performance; and
. the level of customer service available to support new products.
Specifically, sales of PAS, our wireless access system, will depend in part
upon consumer acceptance of the mobility limitations of this service relative
to other wireless service systems, such as GSM or CDMA. If our existing or new
products fail to achieve market acceptance for any reason, our business could
be seriously harmed.
Our business will suffer if we are unable to deliver quality products on a
timely and cost effective basis
Our operating results depend on our ability to manufacture products on a
timely and cost effective basis. In the past, we have experienced reductions in
yields as a result of various factors, including defects in components and
human error in assembly. If we experience deterioration in manufacturing
performance or a delay in production of any of our products, we could
experience delays in shipments and cancellations of orders. Moreover,
networking products frequently contain undetected software or hardware defects
when first introduced or as new versions are released. In addition, our
products are often embedded in or deployed in conjunction with service
providers' products, which incorporate a variety of components produced by
third parties. As a result, when a problem occurs, it may be difficult to
identify the source of the problem. These problems may cause us to incur
significant warranty and repair costs, divert the attention of our engineering
personnel from our product development efforts and cause significant customer
relation problems or loss of customers, any one of which could harm our
business.
We contract with third parties in China to undertake high volume
manufacturing and assembly of our handsets. In addition, we sometimes use third
parties for high volume assembly of circuit boards. We do not have any long
term contracts with these third party manufacturers, and in the event that
these manufacturers are unable or unwilling to continue to manufacture our
products, we may be unable to secure alternative manufacturers or could
experience delays in qualifying new manufacturers. We currently manufacture
internally only a very limited quantity of our handsets. However, if future
demand for our handsets requires additional manufacturing capacity, we may
invest in and build additional manufacturing facilities, most likely in China.
However, new manufacturing facilities may not attain the same quality or level
of efficiencies as those of our existing third party manufacturers.
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We depend on some sole source and other key suppliers for handsets, components
and materials used in our products, and if these suppliers fail to provide us
with adequate supplies of high quality products at competitive prices, our
competitive position, reputation and business could be harmed
Some components and materials used in our products are purchased from a
single supplier or a limited group of suppliers. If any supplier is unwilling
or unable to provide us with high quality components and materials in the
quantities required and at the costs specified by us, we may not be able to
find alternative sources on favorable terms, in a timely manner, or at all. Our
inability to obtain or to develop alternative sources if and as required could
result in delays or reductions in manufacturing or product shipments. Moreover,
these suppliers may delay product shipments or supply us with inferior quality
products. If any of these events occur, our competitive position, reputation
and business could suffer.
Our ability to source a sufficient quantity of high quality components used
in our products may be limited by China's import restrictions and duties. We
require a significant number of imported components to manufacture our products
in China. Imported electronic components and other imported goods used in the
operation of our business are subject to a variety of permit requirements,
approval procedures, import duties and registration requirements. Non-payment
of required import duties could subject us to penalties and fines and could
adversely affect our ability to manufacture and sell our products in China. In
addition, import duties increase the cost of our products and may make them
less competitive.
In particular, an integral component of our PAS system is the handset used
by subscribers to make and receive mobile telephone calls. Our inability to
obtain a sufficient number of high quality components and assemblies for
handsets could severely harm our business. From time to time, there has been a
worldwide shortage of handsets, and there currently exists a shortage of
low-priced handsets, which we have found to be popular with many consumers in
China. We have only used third parties to assemble and manufacture handsets in
China for us for a limited period of time. These manufacturers may be unable to
produce adequate quantities of high-quality handsets to meet the demand of our
customers.
If we are unable to expand our direct sales operation in China and indirect
distribution channels elsewhere or successfully manage our expanded sales
organization, our operating results may suffer
Our distribution strategy focuses primarily on developing and expanding our
direct sales organization in China and our indirect distribution channels
outside of China. We may not be able to successfully expand our direct sales
organization in China and the cost of any expansion may exceed the revenue
generated from these efforts. Even if we are successful in expanding our direct
sales organization in China, we may not be able to compete successfully against
the significantly larger and better-funded sales and marketing operations of
current or potential competitors. In addition, if we fail to develop
relationships with significant international resellers or manufacturers'
representatives, or if these resellers or representatives are not successful in
their sales or marketing efforts, we may be unsuccessful in our expansion
efforts outside China.
We expect average selling prices of our products to decrease which may reduce
our revenues, and, as a result, we must introduce new products and reduce our
costs in order to maintain profitability
The average selling prices for communications access and switching systems
and subscriber terminal products, such as handsets, in China have been
declining as a result of a number of factors, including:
. increased competition;
. aggressive price reductions by competitors; and
. rapid technological change.
We anticipate that average selling prices of our products will decrease in
the future in response to product introductions by us or our competitors or
other factors, including price pressures from customers. Therefore, we
39
must continue to develop and introduce new products and enhancements to
existing products that incorporate features that can be sold at higher average
selling prices. Failure to do so could cause our revenues and gross profit, as
a percentage of net sales, to decline.
Our cost reduction efforts may not allow us to keep pace with competitive
pricing pressures or lead to improved gross profit, as a percentage of net
sales. In order to be competitive, we must continually reduce the cost of
manufacturing our products through design and engineering changes. We may not
be successful in these efforts or delivering our products to market in a timely
manner. Any redesign may not result in sufficient cost reductions to allow us
to reduce the prices of our products to remain competitive or to improve or
maintain our gross profit, as a percentage of net sales.
Shifts in our product mix may result in declines in gross profit, as a
percentage of net sales
Our gross profit, as a percentage of net sales, varies among our product
groups. Our gross profit, as a percentage of net sales, is generally higher on
our access network system products and is significantly lower on our handsets.
We also anticipate that the gross profit, as a percentage of net sales, may be
lower for our newly developed products due to start-up costs and may improve as
unit volumes increase and efficiencies can be realized. Our overall gross
profit, as a percentage of net sales, has fluctuated from period to period as a
result of shifts in product mix, the introduction of new products, decreases in
average selling prices for older products and our ability to reduce
manufacturing costs. As a result of a growth in sales of lower margin handsets
we have experienced a decline in overall gross profit, as a percentage of net
sales. We are likely to continue to experience downward pressure on our gross
profit, as a percentage of net sales.
Service providers sometimes evaluate our products for long and unpredictable
periods which causes the timing of purchases and our results of operations to
be unpredictable
The period of time between our initial contact with a service provider and
the receipt of an actual purchase order may span a year or more. During this
time, service providers may subject our products to an extensive and lengthy
evaluation process before making a purchase. The length of these qualification
processes may vary substantially by product and service provider, making our
results of operations unpredictable. We may incur substantial sales and
marketing expenses and expend significant management effort during this
process, which ultimately may not result in a sale. These qualification
processes often make it difficult to obtain new customers, as service providers
are reluctant to expend the resources necessary to qualify a new supplier if
they have one or more existing qualified sources.
Our inability to exercise complete control over a subsidiary may be detrimental
to our business
A considerable portion of our operations is and will continue to be
conducted through direct and indirect subsidiaries. For example, we currently
own a 51.0% interest in a joint venture that operates the Guangdong
manufacturing facility. However, even though we own a majority interest in this
joint venture, we do not have sole power to control all of the policies and
decisions of this jointly-owned subsidiary. Under the law of China governing
Sino-foreign joint ventures, equity holders exercise rights primarily through
the board of directors, which constitutes the highest authority of the joint
venture. Although we own a majority of the Guangdong joint venture, we are only
entitled to appoint a minority of the directors to the joint venture's board of
directors, which prevents us from controlling the actions of the board. China
law requires unanimous approval of the board of directors for some significant
corporate actions, including:
. amendment of the Articles of Association of the joint venture;
. liquidation or dissolution of the joint venture;
. any increase, decrease or transfer of equity interests of any party to the
joint venture; and
. a merger of the joint venture with another economic entity.
40
Our operating results and cash flow depend on the operating results and cash
flow of our subsidiaries and the payment of funds by those subsidiaries to us.
These subsidiaries are separate and distinct legal entities and have no
obligation, contingent or otherwise, to pay dividends or otherwise provide
financial benefits to us. Moreover, with respect to our Guangdong manufacturing
joint venture, any payment of dividends to us must be agreed to by our joint
venture partner, whose interests in receiving dividend distributions may not
coincide with ours. In addition, applicable law in some countries including
China limits the ability of a subsidiary to pay dividends for various reasons
including the absence of sufficient distributable reserves. In the event of any
insolvency, bankruptcy or similar proceedings, creditors of the subsidiaries
would generally be entitled to priority over us with respect to assets of the
affected subsidiary.
Our multi-national operations subject us to various economic, political,
regulatory and legal risks
We market and sell our products in China and other markets, including Taiwan
and India. The expansion of our existing multi-national operations and entry
into additional international markets will require significant management
attention and financial resources. Multi-national operations are subject to
inherent risks, including:
. difficulties in designing products that are compatible with varying
international communications standards;
. longer accounts receivable collection periods and greater difficulty in
accounts receivable collection;
. unexpected changes in regulatory requirements or the regulatory
environment;
. changes in governmental control or influence over our customers;
. changes to import and export regulations, including quotas, tariffs and
other trade barriers;
. delays or difficulties in obtaining export and import licenses;
. potential foreign exchange controls and repatriation controls on foreign
earnings;
. exchange rate fluctuations and currency conversion restrictions;
. the burdens of complying with a variety of foreign laws and regulations;
. difficulties and costs of staffing and managing multi-national operations;
. reduced protection for intellectual property rights in some countries;
. potentially adverse tax consequences; and
. political and economic instability.
Multi-national companies are required to establish intercompany pricing for
transactions between their separate legal entities operating in different
taxing jurisdictions. These intercompany transactions are subject to audit by
taxing authorities in the jurisdictions in which multinational companies
operate. An additional tax liability may be incurred if it is determined that
intercompany pricing was not done at arm's length. We believe we have
adequately estimated and recorded our liability arising from intercompany
pricing, but an additional tax liability may result from audits of our
intercompany pricing policies.
In markets outside of China, we rely on a number of original equipment
manufacturers, or OEMs, and third-party distributors and agents to market and
sell our network access products. If these OEMs, distributors or agents fail to
provide the support and effort necessary to service developing markets
effectively, our ability to maintain or expand our operations outside of China
will be negatively impacted. We may not successfully compete in these markets,
our products may not be accepted and we may not successfully overcome the risks
associated with international operations.
We are subject to risks relating to currency exchange rate fluctuations
We are exposed to foreign exchange rate risk because our sales to China are
denominated in Renminbi and portions of our accounts payable are denominated in
Japanese Yen. Due to the limitations on converting
41
Renminbi, we are limited in our ability to engage in currency hedging
activities in China. Although the impact of currency fluctuations of Renminbi
to date has been insignificant, fluctuations in currency exchange rates in the
future may have a material adverse effect on our results of operations.
Our failure to meet international and governmental product standards could be
detrimental to our business
Many of our products are required to comply with numerous government
regulations and standards, which vary by market. As standards for products
continue to evolve, we will need to modify our products or develop and support
new versions of our products to meet emerging industry standards, comply with
government regulations and satisfy the requirements necessary to obtain
approvals. Our inability to obtain regulatory approval and meet established
standards could delay or prevent our entrance into or force our departure from
particular markets.
Our recent growth has strained our resources, and if we are unable to manage
and sustain our growth, our operating results will be negatively affected
We have recently experienced a period of rapid growth and anticipate that we
must continue to expand our operations to address potential market
opportunities. If we fail to implement or improve systems or controls or to
manage any future growth and expansion effectively, our business could suffer.
Our expansion has placed and will continue to place a significant strain on
our management, operational, financial and other resources. To manage our
growth effectively, we will need to take various actions, including:
. enhancing management information systems and forecasting procedures;
. further developing our operating, administrative, financial and accounting
systems and controls;
. maintaining close coordination among our engineering, accounting, finance,
marketing, sales and operations organizations;
. expanding, training and managing our employee base; and
. expanding our finance, administrative and operations staff.
We have only recently become profitable and may not be able to sustain
profitability
We have only recently become profitable and may not be able to remain
profitable in future periods. We anticipate continuing to incur significant
sales and marketing, research and development and general and administrative
expenses and, as a result, we will need to generate higher revenues to remain
profitable. Numerous factors could negatively impact our results of operations,
including a decrease in sales, price pressures and significant fixed costs. Our
past results should not be relied on as an indication of our future performance.
Our success is dependent on continuing to hire and retain qualified personnel,
and if we are not successful in attracting and retaining these personnel, our
business would be harmed
The success of our business depends in significant part upon the continued
contributions of key technical and senior management personnel, many of whom
would be difficult to replace. In particular, our success depends in large part
on the knowledge, expertise and services of Hong Liang Lu, our President and
Chief Executive Officer, and Ying Wu, our Executive Vice President and Chief
Executive Officer of China Operations. The loss of any key employee, the
failure of any key employee to perform satisfactorily in his or her current
position or our failure to attract and retain other key technical and senior
management employees could have a significant negative impact on our operations.
To effectively manage our recent growth as well as any future growth, we
will need to recruit, train, assimilate, motivate and retain qualified
employees. Competition for qualified employees is intense, and the
42
process of recruiting personnel with the combination of skills and attributes
required to execute our business strategy can be difficult, time-consuming and
expensive. We are actively searching for research and development engineers and
sales and marketing personnel, who are in short supply. Additionally, we have a
need for and have experienced difficulty in finding qualified accounting
personnel knowledgeable in U.S. and China accounting standards who are resident
in China. If we fail to attract, hire, assimilate or retain qualified
personnel, our business would be harmed.
Competitors and others have in the past and may in the future attempt to
recruit our employees. In addition, companies in the communications industry
whose employees accept positions with competitors frequently claim that the
competitors have engaged in unfair hiring practices. We may be the subject of
these types of claims in the future as we seek to hire qualified personnel.
Some of these claims may result in material litigation and disruption to our
operations. We could incur substantial costs in defending ourselves against
these claims, regardless of their merit.
Any acquisitions that we undertake could be difficult to integrate, disrupt our
business, dilute our stockholders and harm our operating results
We may acquire complementary businesses, products and technologies. For
example, in November 2001, we acquired Advanced Communication Devices
Corporation, a system on chip semiconductor company. Any anticipated benefits
of an acquisition may not be realized. We have in the past and will continue to
evaluate acquisition prospects that would complement our existing product
offerings, augment our market coverage, enhance our technological capabilities,
or that may otherwise offer growth opportunities. Acquisitions of other
companies may result in dilutive issuances of equity securities, the incurrence
of debt and the amortization of expenses related to goodwill and other
intangible assets. In addition, acquisitions involve numerous risks, including
difficulties in the assimilation of operations, technologies, products and
personnel of the acquired company, diversion of management's attention from
other business concerns, risks of entering markets in which we have no direct
or limited prior experience, and the potential loss of key employees of the
acquired company.
We may be unable to adequately protect our intellectual property and may be
subject to claims that we infringe the intellectual property of others, either
of which could substantially harm our business
We rely on a combination of patents, copyrights, trademarks, trade secret
laws and contractual obligations to protect our technology. We have applied for
patents in the United States, three of which have been issued. We have also
filed patent applications in other countries. Additional patents may not be
issued from our pending patent applications and our issued patents may not be
upheld. In addition, we have, from time to time, chosen to abandon previously
filed applications. Moreover, we have not yet obtained, and may not be able to
obtain, patents in China on our products or the technology that we use to
manufacture our products. Our subsidiaries and joint ventures in China rely
upon our trademarks, technology and know-how to manufacture and sell our
products. We cannot guarantee that these and other intellectual property
protection measures will be sufficient to prevent misappropriation of our
technology or that our competitors will not independently develop technologies
that are substantially equivalent or superior to ours. In addition, the legal
systems of many foreign countries, including China, do not protect intellectual
property rights to the same extent as the legal system of the United States. If
we are unable to adequately protect our proprietary information and technology,
our business, financial condition and results of operations could be materially
adversely affected.
The increasing dependence of the communications industry on proprietary
technology has resulted in frequent litigation based on allegations of the
infringement of patents and other intellectual property. In the future we may
be subject to litigation to defend against claimed infringements of the rights
of others or to determine the scope and validity of the proprietary rights of
others. Future litigation also may be necessary to enforce and protect our
trade secrets and other intellectual property rights. Any intellectual property
litigation could be costly and could cause diversion of management's attention
from the operation of our business. Adverse determinations in any litigation
could result in the loss of our proprietary rights, subject us to significant
liabilities or require us
43
to seek licenses from third parties which may not be available on commercially
reasonable terms, if at all. We could also be subject to court orders
preventing us from manufacturing or selling our products.
Business interruptions could adversely affect our business
Our operations are vulnerable to interruption by fire, earthquake, power
loss, telecommunications failure and other events beyond our control. We do not
have a detailed disaster recovery plan. Our headquarters facility in the State
of California is currently subject to electrical blackouts as a consequence of
a shortage of available electrical power. In the event these blackouts continue
or increase in severity, they could disrupt the operations at our headquarters.
In addition, we do not carry sufficient business interruption insurance to
compensate us for losses that may occur and any losses or damages incurred by
us could have a material adverse effect on our business.
We have been named as a defendant in securities litigation
On October 31, 2001, a putative stockholder class action lawsuit was filed
against our company, some of our directors and officers and various
underwriters for our initial public offering. The complaint alleges undisclosed
improper underwriting practices concerning the allocation of IPO shares, in
violation of the federal securities laws. Similar complaints have been filed
concerning the IPOs of more than 300 companies, and the litigation has been
coordinated in federal court for the Southern District of New York as In re
Initial Public Offering Securities Litigation, 21 MC 92. We believe we have
meritorious defenses to the claims against us and intend to defend the
litigation vigorously. However, as litigation is by its nature uncertain, an
unfavorable resolution of the lawsuit could have a material adverse effect on
our business, results of operations, or financial condition.
Risks Relating to the Structure and Regulation of China's Telecommunications
Industry
China's telecommunications industry is subject to extensive government
regulation
China's telecommunications industry is heavily regulated by the Ministry of
Information Industry. The Ministry of Information Industry has broad discretion
and authority to regulate all aspects of the telecommunications and information
technology industry in China, including managing spectrum bandwidths, setting
network equipment specifications and standards and drafting laws and
regulations related to the electronics and telecommunications industries.
Additionally, the Ministry of Information Industry can decide what types of
equipment may be connected to the national telecommunications networks, the
forms and types of services that may be offered to the public, the rates that
are charged to subscribers for those services and the content of material
available in China over the Internet. If the Ministry of Information Industry
sets standards with which we are unable to comply or which render our products
noncompetitive, our ability to sell products in China may be limited, resulting
in substantial harm to our operations.
At the end of May 2000, we became aware of an internal notice, circulated
within the Ministry of Information Industry, announcing a review of PHS-based
telecommunications equipment for future installation into China's
telecommunications infrastructure. The Ministry of Information Industry
requested service providers to temporarily halt new deployments of PHS-based
telecommunications equipment, including our PAS systems and handsets, pending
conclusion of a review by the Ministry of Information Industry. Subsequently,
at the end of June 2000, the Ministry of Information Industry issued a notice
stating that it had concluded its review of PHS-based equipment and that the
continued deployment of PHS-based systems, such as our PAS systems and
handsets, in China's county-level cities and towns and villages would be
permitted. In addition, the notice stated that deployments within large and
medium-sized cities would only be allowed in very limited areas of dense
population, such as campuses, commercial buildings and special development
zones. The notice confirmed, however, that new citywide deployments of our PAS
system in large and medium cities would not be permitted. Failure of the
Ministry of Information Industry to permit the sale or deployment of our PAS
systems and handsets, or the sale or deployment of our other products, or the
imposition of additional limitations on their sale
44
in the future could have a material adverse effect on our business and
financial condition. The Ministry of Information Industry may conduct further
reviews or evaluations of PHS-based telecommunications equipment or may change
its position regarding PHS-based systems in the future.
China's telecommunications regulatory framework is in the process of being
developed, which has led to uncertainties regarding how to conduct our business
in China
China does not yet have a national telecommunications law. However, with
China's recent admission into the WTO the Ministry of Information Industry,
under the direction of the State Council, must shortly present the first draft
of the Telecommunications Law of the People's Republic of China for ultimate
submission to the National People's Congress for review and adoption. We do not
know the nature and scope of regulation that the Telecommunications Law would
create. Accordingly, we cannot predict whether it will have a positive or
negative effect on us or on some or all aspects of our business.
China's telecommunications regulatory framework is in the process of being
developed. In September 2000, the State Council issued the Telecommunications
Regulations of the People's Republic of China, known as the Telecom
Regulations. The Telecom Regulations cover telecommunications services and
market regulations, pricing, interconnection and connection, as well as
telecommunications construction and security issues. In May 2001, the Ministry
of Information Industry issued the Administrative Measures of Network Access
Licenses to implement the Telecom Regulations. Regulations in this area often
require subjective interpretation and, given the relative infancy of the
Telecom Regulations and the implementing regulations, we do not know how the
regulations will be interpreted or enforced. As a result, our attempts to
comply with these regulations may be deemed insufficient by the appropriate
regulatory agencies, which could subject us to penalties that adversely affect
our business.
Our business may suffer as a result of the recent restructuring of China Telecom
In February 1999, the State Council approved a restructuring plan for the
China Telecom system, under which the telecommunications operations of the
China Telecom system were separated along four business lines: fixed line,
mobile, paging and satellite communications services. Following the
announcement, we observed a reduction in orders from Telecommunications
Bureaus, which we attributed to the uncertainties surrounding the restructuring
and the ultimate impact the restructuring would have on the Telecommunications
Bureaus.
On December 11, 2001, the Chinese government announced that China Telecom
would be further split into two entities by region, Northern and Southern. The
10 Northern provinces, municipalities and autonomous regions of China Telecom
will be merged with China Netcom Co. Ltd. and China Jitong Network
Communications Co. Ltd. to form a new company which we refer to as the New CNC.
The remaining 21 provinces, municipalities and autonomous regions will
constitute the Southern entity, which will keep the name of China Telecom. The
New CNC will inherit 30% of the old China Telecom's national backbone network,
with the rest going to the New China Telecom. As this change is very recent and
its implementation is ongoing, we cannot be certain what impact the
restructuring will have on our business operations. However, we may experience
another decline in orders and related revenues similar to that which we
experienced following the 1999 restructuring, resulting from uncertainty among
our Telecommunications Bureau customers associated with the restructuring.
Moreover, following any restructuring, the New CNC, the New China Telecom or
any other entity that may replace it as a result of any subsequent
restructuring may restrict or prohibit the sales of our products, which could
cause substantial harm to our business.
We do not have some of the licenses we are required to have to sell our network
access products in China
Under China's current regulatory structure, the communications products that
we offer in China must meet government and industry standards, and a network
access license for the equipment must be obtained. Without the license, the
equipment is not allowed to be connected to public telecommunications networks
or sold in
45
China. Moreover, we must ensure that the quality of the telecommunications
equipment for which we have obtained a network access license is stable and
reliable, and may not lower the quality or performance of other installed
licensed products. The State Council's product quality supervision department,
in concert with the Ministry of Information Industry, performs spot checks to
track and supervise the quality of licensed telecommunications equipment and
publishes the results of such spot checks.
The regulations implementing these requirements are not very detailed, have
not been applied by a court and may be interpreted and enforced by regulatory
authorities in a number of different ways. We have obtained the required
network access licenses for our AN-2000 platform. We have applied for, but have
not yet received, a network access license for our PAS systems and handsets.
Based upon conversations with the Ministry of Information Industry, we
understand that our PAS systems and handsets are considered to still be in the
trial period and that sales of our PAS systems and handsets may continue to be
made by us during this trial period, but a license will ultimately be required.
Network access licenses will also be required for most additional products that
we are selling or may sell in China, including our mSwitch platform. If we fail
to obtain the required licenses, we could be prohibited from making further
sales of the unlicensed products, including our PAS systems and handsets, in
China, which would substantially harm our business, financial condition and
results of operations. Our counsel in China has advised us that China's
governmental authorities may interpret or apply the regulations with respect to
which licenses are required and the ability to sell a product while a product
is in the trial period in a manner that is inconsistent with the information
received by our counsel in China, either of which could have a material adverse
effect on our business and financial condition.
Software incorporated in our products has not been registered in accordance
with relevant Chinese regulations, and our ability to sell the products
incorporating the software may be affected
In October 2000, the Ministry of Information Industry issued regulations
which prohibit the production and sale of software products, or products
incorporating software, in China unless the software is registered with the
government. We are in the process of applying for registration of our software.
Based upon verbal advice received from the Ministry of Information Industry, we
believe that we will be able to continue to sell products incorporating our
software during the period in which the regulations are being implemented and
our applications are pending. However, this implementation period may not last
long enough for us to complete the registration of our software. Moreover, the
Chinese government may interpret or apply the regulations in such a way as to
prohibit sales of products incorporating our unregistered software prior to
registration. If the government prohibits sales pending registration, or if we
fail in our efforts to register our software, we could be prohibited from
making further sales of products incorporating our unregistered software in
China, which could substantially harm our business and financial condition.
Most of our customers in China are part of the China Telecom system and are
subject to its ultimate control, and, following the restructuring of China
Telecom, most will be part of the New China Telecom or the New CNC and will be
subject to their ultimate control
Our main customers in China are the local Telecommunications Bureaus, which
operate under China Telecom, China's state-owned fixed line operator, and are
subject to its ultimate control. The Telecommunications Bureaus will operate
under the ultimate control of the New China Telecom or the New CNC after the
restructuring of China Telecom. Policy statements may be issued, or decisions
may be made by these entities, which govern the equipment purchasing decisions
of most of our customers in China. For example, in late 1999 China Telecom
prohibited all Telecommunications Bureaus from purchasing PHS systems, such as
our PAS systems, for implementation in large cities, even before these sales
were prohibited by the Ministry of Information Industry. As most of our sales
are generated from our operations in China, any decisions by China Telecom and,
thereafter, the New China Telecom or the New CNC, restricting or prohibiting
the sales or deployment of our products could cause substantial harm to our
business.
46
Our ability to sell our PAS wireless systems and handsets could be
significantly impaired if China Telecom or the resulting organizations
following the reorganization of China Telecom are granted or otherwise acquire
mobile licenses, which will allow China Telecom or such resulting entities to
deliver cellular services
China Telecom holds and operates and, after the restructuring, the New China
Telecom and the New CNC will hold and operate, the fixed line telephone and
data communications assets in China and will be prohibited from offering
cellular services. To offer wireless services to end users, the
Telecommunications Bureaus must offer services that can be delivered over
wireline networks, such as those delivered over our PAS wireless systems and
handsets. China's media sources have widely reported that after the
restructuring of China Telecom, the Ministry of Information Industry may grant
mobile licenses to either one or both of the New CNC and the New China Telecom.
If the Ministry of Information Industry does grant a mobile license to the New
China Telecom or the New CNC, or if such entities otherwise acquire mobile
licenses, local Telecommunications Bureaus will be free to offer cellular
services, such as GSM or CDMA, to their customers and they may therefore elect
not to deploy our PAS systems and handsets. If this were to occur, we could
lose current and potential customers for our PAS systems and handsets, and our
financial condition and results of operations could be harmed.
Changes in telecommunications rates or pricing policies may result in decreased
demand for our products
In November 2000, the Ministry of Information Industry announced significant
changes in rates for telecommunications services in China. While long distance,
international, leased line and Internet connection fees were cut by up to 70%,
the rates for local telephone services, which include certain types of wireless
access services such as those offered over our PAS systems and handsets, were
increased, from approximately $0.01 per minute to approximately $0.02 per
minute. The increase in rates may result in a reduced demand by end users for
wireless services delivered over our PAS system and a corresponding decline in
demand for our products. Additionally, the Ministry of Information Industry may
implement future rate changes for wireline or wireless services in China or
change telecommunications pricing policies, including allowing carriers to set
prices based on market conditions, any of which may lead to reduced demand for
our systems and products and result in a material adverse effect on our
business or results of operations.
Risks Relating to Conducting Operations in China
Sales in China have accounted for most of our sales, and therefore, our
business, financial condition and results of operations are to a significant
degree subject to economic, political and social events in China
Approximately $565.9 million, or 90.3%, of our net sales in fiscal 2001,
$364.0 million, or 98.8%, of our net sales in fiscal 2000, and $183.6 million,
or 97.9%, of our net sales in fiscal 1999, occurred in China. Additionally, a
substantial portion of our fixed assets are located in China. Of our total
fixed assets, approximately 75.3% as of December 31, 2001, 75.0% as of December
31, 2000, and 53.7% as of December 31, 1999 were in China. We expect to make
further investments in China in the future. Therefore, our business, financial
condition and results of operations are to a significant degree subject to
economic, political and social events in China.
Devaluation in the value of the Renminbi and fluctuations in exchange rates
could adversely affect our financial results
Exchange rate fluctuations could have a substantial negative impact on our
financial condition and results of operations. We purchase substantially all of
our materials in the United States and Japan and a significant portion of our
cost of goods sold is incurred in U.S. dollars and Japanese yen. A significant
portion of our operating expenses are incurred in U.S. dollars. At the same
time, most of our sales are denominated in Renminbi. The value of the Renminbi
is fixed by China's national government and is subject to changes in China's
47
governmental policies and to international economic and political developments.
China may choose to devalue the Renminbi against the U.S. dollar. Additionally,
China's government has considered from time to time whether to partially or
fully abandon the official exchange rate for Renminbi to the U.S. dollar. The
abandonment of this official exchange rate policy may lead to sharp
depreciation of the Renminbi against the U.S. dollar and other foreign
currencies and to significantly more volatility in the Renminbi exchange rate
in the future, both of which would adversely affect our financial results and
make our future results more subject to fluctuation.
In the past, financial markets in many Asian countries have experienced
severe volatility and, as a result, some Asian currencies have experienced
significant devaluation from time to time. The devaluation of some Asian
currencies may have the effect of rendering exports from China more expensive
and less competitive and therefore place pressure on China's government to
devalue the Renminbi. Any devaluation of the Renminbi could result in an
increase in volatility of Asian currency and capital markets. Future volatility
of Asian financial markets could have an adverse impact on our ability to
expand our product sales into Asian markets outside of China. Moreover, due to
the limitations on the convertibility of Renminbi, we are limited in our
ability to engage in currency hedging activities in China and do not currently
engage in currency hedging activities with respect to international sales
outside of China.
Currency restrictions in China may limit the ability of our subsidiaries and
joint ventures in China to obtain and remit foreign currency necessary for the
purchase of imported components and may limit our ability to obtain and remit
foreign currency in exchange for Renminbi earnings
China's government imposes controls on the convertibility of Renminbi into
foreign currencies and, in certain cases, the remittance of currency out of
China. Under the current foreign exchange control system, sufficient foreign
currency may not be available to satisfy our currency needs. Shortages in the
availability of foreign currency may restrict the ability of our Chinese
subsidiaries to obtain and remit sufficient foreign currency to pay dividends
to us, or otherwise satisfy their foreign currency denominated obligations,
such as payments to us for components which we export to them and for
technology licensing fees. We may also experience difficulties in completing
the administrative procedures necessary to obtain and remit needed foreign
currency.
Our business could be substantially harmed if we are unable to convert and
remit our sales received in Renminbi into U.S. dollars. Under existing foreign
exchange laws, Renminbi held by our China subsidiaries can be converted into
foreign currencies and remitted out of China to pay current account items such
as payments to suppliers for imports, labor services, payment of interest on
foreign exchange loans and distributions of dividends so long as the
subsidiaries have adequate amounts of Renminbi to purchase the foreign
currency. Expenses of a capital nature such as the repayment of bank loans
denominated in foreign currencies, however, require approval from appropriate
governmental authorities before Renminbi can be used to purchase foreign
currency and then remitted out of China. This system could be changed at any
time by executive decision of the State Council to impose limits on current
account convertibility of the Renminbi or other similar restrictions. Moreover,
even though the Renminbi is intended to be freely convertible under the current
account, the State Administration of Foreign Exchange, which is responsible for
administering China's foreign currency market, has a significant degree of
administrative discretion in implementing the laws. From time to time, the
State Administration of Foreign Exchange has used this discretion in ways which
effectively limit the convertibility of current account payments and restrict
remittances out of China. Furthermore, in many circumstances the State
Administration of Foreign Exchange must approve foreign currency conversions
and remittances. Under the current foreign exchange control system, sufficient
foreign currency may not be available at a given exchange rate to satisfy our
currency demands.
China subjects foreign investors in the telecommunications industry to
ownership and geographic limitations
China's government and its agencies, including the Ministry of Information
Industry and the State Council, regulate foreign investment in the
telecommunications industry through the promulgation of various laws and
regulations and the issuance of various administrative orders and decisions.
Currently, foreign investors may
48
engage in such activities only in accordance with certain ownership and
geographic limitations. China may promulgate new laws or regulations, or issue
administrative or judicial decisions or interpretations, which would further
restrict or bar foreigners from engaging in telecommunications-related
activities. The promulgation of laws or regulations or the issuance of
administrative orders or judicial decisions or interpretations restricting or
prohibiting telecommunications activities by foreigners could have a
substantial impact on our ongoing operations.
Governmental policies in China could impact our business
Since 1978, China's government has been and is expected to continue
reforming its economic and political systems. These reforms have resulted in
and are expected to continue to result in significant economic and social
development in China. Many of the reforms are unprecedented or experimental and
may be subject to change or readjustment due to a number of political, economic
and social factors. We believe that the basic principles underlying the
political and economic reforms will continue to be implemented and provide the
framework for China's political and economic system. New reforms or the
readjustment of previously implemented reforms could have a significant
negative effect on our operations. Changes in China's political, economic and
social conditions and governmental policies which could have a substantial
impact on our business include:
. new laws and regulations or the interpretation of those laws and
regulations;
. the introduction of measures to control inflation or stimulate growth;
. changes in the rate or method of taxation;
. the imposition of additional restrictions on currency conversion and
remittances abroad; and
. any actions which limit our ability to develop, manufacture, import or
sell our products in China, or to finance and operate our business in
China.
Economic policies in China could impact our business
The economy of China differs from the economies of most countries belonging
to the Organization for Economic Cooperation and Development in various
respects such as structure, government involvement, level of development,
growth rate, capital reinvestment, allocation of resources, self-sufficiency,
rate of inflation and balance of payments position. In the past, the economy of
China has been primarily a planned economy subject to one- and five-year state
plans adopted by central government authorities and largely implemented by
provincial and local authorities, which set production and development targets.
Since 1978, increasing emphasis had been placed on decentralization and the
utilization of market forces in the development of China's economy. Economic
reform measures adopted by China's government may be inconsistent or
ineffectual, and we may not in all cases be able to capitalize on any reforms.
Further, these measures may be adjusted or modified in ways which could result
in economic liberalization measures that are inconsistent from time to time or
from industry to industry or across different regions of the country. China's
economy has experienced significant growth in the past decade. This growth,
however, has been accompanied by imbalances in China's economy and has resulted
in significant fluctuations in general price levels, including periods of
inflation. China's government has implemented policies from time to time to
increase or restrain the rate of economic growth, control periods of inflation
or otherwise regulate economic expansion. While we may be able to benefit from
the effects of some of these policies, these policies and other measures taken
by China's government to regulate the economy could also have a significant
negative impact on economic conditions in China with a resulting negative
impact on our business.
China's entry into the World Trade Organization creates uncertainty as to the
future economic and business environments in China
China's entry into the WTO was approved in September 2001. Entry into the
WTO will require China to further reduce tariffs and eliminate non-tariff
barriers, which include quotas, licenses and other restrictions by
49
2005 at the latest. While China's entry into the WTO and the related relaxation
of trade restrictions may lead to increased foreign investment, it may also
lead to increased competition in China's markets from international companies.
China's entry into the WTO could have a negative impact on China's economy with
a resulting negative impact on our business.
If tax benefits available to our subsidiaries located in China are reduced or
repealed, our business could suffer
Our subsidiaries and joint ventures located in China enjoy tax benefits in
China which are generally available to foreign investment enterprises,
including full exemption from national enterprise income tax for two years
starting from the first profit-making year and/or a 50% reduction in national
income tax rate for the following three years. In addition, local enterprise
income tax is often waived or reduced during this tax holiday/incentive period.
Under current regulations in China, foreign investment enterprises that have
been accredited as technologically advanced enterprises are entitled to
additional tax incentives. These tax incentives vary in different locales and
could include preferential national enterprise income tax treatment at 50% of
the usual rates for different periods of time. All of our active subsidiaries
in China were accredited as technologically advanced enterprises. Two of our
principal subsidiaries, UTStarcom China and Hangzhou UTStarcom, accounted for
approximately 90.1% of our revenues in 2001. The tax holidays applicable to,
UTStarcom China will expire at the end of 2002. At that time, the tax rate will
increase from 7.5% to 15% and will negatively impact our financial condition
and results of operations. The tax holiday applicable to our other principal
subsidiary, Hangzhou UTStarcom, expired in 2001 and is now subject to annual
review. Consequently, its tax rate could increase from 10% to 15% if it is
unable to maintain a tax holiday in 2002. If we are unable to extend this tax
holiday to 2002, our financial condition and results of operations may be
negatively impacted. Additionally, the Chinese government is considering the
imposition of a "unified" corporate income tax that would phase out, over time,
the preferential tax treatment to which foreign-funded enterprises, such as
UTStarcom, are currently entitled. While it is not certain whether the
government will implement such a unified tax structure or whether, if
implemented, UTStarcom will be grandfathered into the new tax structure, if the
new tax structure is implemented, it will adversely affect our financial
condition.
We may be exposed to contingent tax liabilities in China resulting from our
failure to withhold sufficient amounts for China's income tax purposes
We employ a number of U.S. citizens who work on a full time basis in China.
These expatriate employees participate in our stock option plans and have
exercised a number of options granted under the plans. The option exercises
generated income that may be subject to personal income taxes under China's
income tax laws. We did not withhold China income taxes on the option
exercises, and the employees have not yet paid any taxes in China that may be
due. Should the employees fail to pay the income taxes, we may be liable for
such taxes in our capacity as withholding agent. In the event that it is
determined that taxes are due in China, we, on behalf of our employees, will
apply for a refund from the U.S. tax authorities corresponding to the amount of
the foreign tax credit which would then be applicable. The refund amounts are
required to be paid to us by the employees who receive them. In addition, our
failure to collect and remit China withholding tax may also subject us to
penalties.
China's legal system embodies uncertainties that could negatively impact our
business
China has a civil law system. Decided court cases do not have binding legal
effect on future decisions. Since 1979, many new laws and regulations covering
general economic matters have been promulgated in China. Despite this activity
to develop the legal system, China's system of laws is not yet complete. Even
where adequate law exists in China, enforcement of existing laws or contracts
based on existing law may be uncertain and sporadic and it may be difficult to
obtain swift and equitable enforcement, or to obtain enforcement of a judgment
by a court of another jurisdiction. The relative inexperience of China's
judiciary in many cases creates additional uncertainty as to the outcome of any
litigation. Further, interpretation of statutes and regulations may be subject
to government policies reflecting domestic political changes. Moreover,
government policies and
50
internal rules promulgated by governmental agencies may not be published in
time, or at all. As a result, we may operate our business in violation of new
rules and policies without having any knowledge of their existence.
China has adopted a broad range of related laws, administrative rules and
regulations that govern the conduct and operations of foreign investment
enterprises and restrict the ability of foreign companies to conduct business
in China. These laws, rules and regulations provide some incentives to
encourage the flow of investment into China, but also subject foreign
companies, and foreign investment enterprises, including our subsidiaries in
China, to a set of restrictions that may not always apply to domestic companies
in China. As a result of its admission into the WTO, China is increasingly
according foreign companies and foreign investment enterprises established in
China the same rights and privileges as Chinese domestic companies. These
special laws, administrative rules and regulations governing foreign companies
and foreign investment enterprises may still place us and our subsidiaries at a
disadvantage in relation to Chinese domestic companies and may adversely affect
our competitive position. Moreover, as China's legal system develops, the
promulgation of new laws, changes to existing laws and the pre-emption of local
regulations by national laws may adversely affect foreign investors and
companies.
Many of our activities and products in China are subject to administrative
review and approval by various national and local agencies of China's
government. Because of the changes occurring in China's legal and regulatory
structure, we may not be able to secure the requisite governmental approval for
our activities and products. Failure to obtain the requisite government
approval for any of our activities or products could substantially harm our
business.
Risks Relating to Our Stock Performance
Our stock price is highly volatile
The trading price of our common stock has fluctuated significantly since our
initial public offering in March 2000. Our stock price could be subject to wide
fluctuations in the future in response to many events or factors, including
those discussed in the preceding risk factors relating to our operations, as
well as:
. actual or anticipated fluctuations in operating results;
. changes in expectations as to future financial performance or changes
in financial estimates or buy/sell recommendations of securities
analysts;
. changes in governmental regulations or policies in China, such as the
temporary suspension of sales of our PAS systems that occurred in May
and June of 2000, which caused our stock price to drop;
. our, or a competitor's, announcement of new products, services or
technological innovations; and
. the operating and stock price performance of other comparable companies.
General market conditions and domestic or international macroeconomic
factors unrelated to our performance may also affect our stock price. For these
reasons, investors should not rely on recent trends to predict future stock
prices or financial results. In addition, following periods of volatility in a
company's securities, securities class action litigation against a company is
sometimes instituted. This type of litigation could result in substantial costs
and the diversion of management time and resources.
SOFTBANK CORP. and its related entities, including SOFTBANK America Inc., has
significant influence over our management and affairs, which it could exercise
against your best interests
SOFTBANK CORP. and its related entities, including SOFTBANK America Inc.,
beneficially own 40.85% of our outstanding stock. As a result, SOFTBANK CORP.
and its related entities, including SOFTBANK America Inc., have the ability to
exercise significant influence over all matters submitted to our stockholders
for
51
approval and exert significant influence over our management and affairs. This
concentration of ownership may delay or prevent a change of control or
discourage a potential acquiror from making a tender offer or otherwise
attempting to obtain control of our company, which could decrease the market
price of our common stock. Matters that could require stockholder approval
include:
. election and removal of directors;
. merger or consolidation of our company; and
. sale of all or substantially all of our assets.
The interests of SOFTBANK America Inc. may not always coincide with our
interests. SOFTBANK America Inc., acting through its designees on the Board of
Directors and through its ownership of voting securities, will have the ability
to exercise significant influence over our actions irrespective of the desires
of our other stockholders or directors.
Delaware law and our charter documents contain provisions that could discourage
or prevent a potential takeover, even if the transaction would benefit our
stockholders
Other companies may seek to acquire or merge with us. An acquisition or
merger of our company could result in benefits to our stockholders, including
an increase in the value of our common stock. Some provisions of our
Certificate of Incorporation and Bylaws, as well as provisions of Delaware law,
may discourage, delay or prevent a merger or acquisition that a stockholder may
consider favorable. These provisions include:
. authorizing the Board of Directors to issue additional preferred stock;
. prohibiting cumulative voting in the election of directors;
. limiting the persons who may call special meetings of stockholders;
. prohibiting stockholder action by written consent;
. creating a classified Board of Directors pursuant to which our directors
are elected for staggered three year terms; and
. establishing advance notice requirements for nominations for election to
the Board of Directors and for proposing matters that can be acted on by
stockholders at stockholder meetings.
52
ITEM 7A--QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
UTStarcom is exposed to the impact of interest rate changes and changes in
foreign currency exchange rates.
Interest Rate Risk. Our exposure to market risk for changes in interest
rates relates primarily to our investment portfolio. The fair value of our
investment portfolio would not be significantly affected by either a 10%
increase or decrease in interest rates due mainly to the short term nature of
our investment portfolio. However, our interest income can be sensitive to
changes in the general level of U.S. interest rates since the majority of our
funds are invested in instruments with maturities of less than one year. Our
policy is to limit the risk of principal loss and ensure the safety of invested
funds by limiting market risk. Funds in excess of current operating
requirements are invested in government sponsored entities' notes, commercial
paper, floating rate corporate bonds, fixed income corporate bonds and tax
exempt instruments. In accordance with our investment policy, all short-term
investments are invested in "investment grade" rated securities with minimum A
or better ratings. Currently, most of our short-term investments have AA or
better ratings.
The table below represents carrying amounts and related weighted-average
interest rates of our investment portfolio at December 31, 2001:
(In thousands, except interest rates)
Cash and cash equivalents........................ $321,136
Average interest rate............................ 1.2%
Short-term investments........................... $ 86,176
Average interest rate............................ 3.8%
Total investment securities...................... $407,312
Average interest rate............................ 1.8%
Foreign Exchange Rate Risk. We are exposed to foreign exchange rate risk
because most of our sales in China are denominated in Renminbi and portions of
our accounts payable are denominated in Japanese Yen. Due to the limitations on
converting Renminbi, we are limited in our ability to engage in currency
hedging activities in China. Although the impact of currency fluctuations of
Renminbi to date has been insignificant, fluctuations in currency exchange
rates in the future may have a material adverse effect on our results of
operations. We have a multi-currency bank account in Japanese Yen for
purchasing portions of our inventories and supplies. The balance of this
Japanese Yen account as of December 31, 2001 was approximately $6.7 million.
ITEM 8--FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Index to Consolidated Financial Statements
Page
----
Financial Statements:
Report of Independent Accountants........................................................... 54
Consolidated Balance Sheets at December 31, 2001 and December 31, 2000...................... 55
Consolidated Statements of Operations for the years ended December 31, 2001, 2000 and 1999.. 56
Consolidated Statements of Stockholders' Equity for the years ended December 31, 2001, 2000
and 1999.................................................................................. 57
Consolidated Statements of Cash Flows for the years ended December 31, 2001, 2000 and 1999.. 59
Notes to Consolidated Financial Statements.................................................. 60
53
REPORT OF INDEPENDENT ACCOUNTANTS
To the Board of Directors and Stockholders of UTStarcom, Inc.:
In our opinion, the accompanying consolidated balance sheets and the related
consolidated statements of operations, stockholders' equity and cash flows
present fairly, in all material respects, the financial position of UTStarcom,
Inc. and its subsidiaries (the Company) at December 31, 2001 and 2000, and the
results of their operations and their cash flows for each of the three years in
the period ended December 31, 2001 in conformity with accounting principles
generally accepted in the United States of America. These financial statements
are the responsibility of the Company's management; our responsibility is to
express an opinion on these financial statements based on our audits. We
conducted our audits of these statements in accordance with auditing standards
generally accepted in the United States of America, which require that we plan
and perform the audit to obtain reasonable assurance about whether the
financial statements are free of material misstatement. An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, and evaluating the overall financial
statement presentation. We believe that our audits provide a reasonable basis
for our opinion.
As discussed in Note 3 to the Consolidated Financial Statements, in 2000 the
Company changed its method of accounting for revenue recognition.
/s/ PRICEWATERHOUSECOOPERS LLP
San Francisco, California
January 14, 2002
54
UTSTARCOM, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)
December 31,
--------------------
2001 2000
---------- --------
ASSETS
Current assets:
Cash and cash equivalents.................................................... $ 321,136 $149,112
Short-term investments....................................................... 86,176 83,858
Accounts receivable, net of allowances for doubtful accounts of $19,053 and
$12,835 at December 31, 2001 and 2000, respectively........................ 193,046 161,330
Receivable from related parties.............................................. 1,670 406
Inventories, net............................................................. 229,050 118,995
Other current assets......................................................... 65,397 17,674
---------- --------
Total current assets............................................................ 896,475 531,375
Property, plant and equipment, net.............................................. 43,942 21,999
Long-term investments........................................................... 17,818 12,397
Goodwill and intangible assets, net............................................. 38,992 20,238
Other long-term assets.......................................................... 8,653 5,828
---------- --------
Total assets............................................................. $1,005,880 $591,837
========== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable............................................................. $ 83,649 $ 44,564
Short-term debt.............................................................. 58,434 43,381
Income taxes payable......................................................... 10,536 7,170
Deferred revenue............................................................. 76,424 31,678
Other........................................................................ 76,329 34,721
---------- --------
Total current liabilities....................................................... 305,372 161,514
---------- --------
Long-term debt.................................................................. 12,048 12,048
Minority interest in consolidated subsidiaries.................................. 6,573 5,956
Commitments and Contingencies (Note 19)
Stockholders' equity:
Preferred stock: $.00125 par value; authorized: 5,000,000 shares; issued and
outstanding: none at December 31, 2001 and 2000............................ -- --
Common stock: $.00125 par value; authorized: 250,000,000 shares; issued and
outstanding: 109,302,816 at December 31, 2001 and 95,032,657 at
December 31, 2000.......................................................... 138 120
Additional paid-in capital................................................... 638,697 426,665
Deferred stock compensation.................................................. (6,045) (6,491)
Retained earnings (accumulated deficit)...................................... 49,146 (7,808)
Notes receivable from stockholders........................................... (381) (314)
Accumulated other comprehensive income....................................... 332 147
---------- --------
Total stockholders' equity...................................................... 681,887 412,319
---------- --------
Total liabilities and stockholders' equity............................... $1,005,880 $591,837
========== ========
See accompanying notes to consolidated financial statements.
55