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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 

ý

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

 

For the quarterly period ended March 31, 2004

 

Commission File Number: 000-25291

 


 

TUT SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

Delaware

 

94-2958543

(State or other jurisdiction of
incorporation or organization)

 

(I.R.S. Employer
Identification No.)

 

 

 

6000 SW Meadows Rd, Suite 200
Lake Oswego, Oregon

 

97035

(Address of principal executive offices)

 

(Zip Code)

 

 

 

Registrant’s telephone number, including area code: (503) 594-1400

 


 

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  ý  No  o

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

Yes  ý  No  o

 

As of April 30, 2004, 20,375,838 shares of the Registrant’s common stock, par value $0.001 per share, were issued and outstanding.

 



 

TUT SYSTEMS, INC.

 

FORM 10-Q

 

INDEX

 

PART I.

FINANCIAL INFORMATION

 

 

 

 

Item 1.

Condensed Consolidated Financial Statements (unaudited):

 

 

 

 

 

Condensed Consolidated Balance Sheets as of December 31, 2003 and March 31, 2004

 

 

 

 

 

Condensed Consolidated Statements of Operations for the three months ended March 31, 2003 and  March 31, 2004

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2003 and March 31, 2004

 

 

 

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

 

 

 

 

Item 4.

Controls and Procedures

 

 

 

 

PART II.

OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings

 

 

 

 

Item 2.

Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

 

 

 

 

Item 3.

Defaults Upon Senior Securities

 

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

 

 

 

 

Item 5.

Other Information

 

 

 

 

Item 6.

Exhibits and Reports on Form 8-K

 

 

 

 

Signatures

 

 

 

2



 

PART I. FINANCIAL INFORMATION

 

ITEM 1.                                  CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except per share amounts)

 

 

 

December 31,
2003

 

March 31,
2004

 

 

 

 

 

(unaudited)

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

14,370

 

$

12,270

 

Accounts receivable, net of allowance for doubtful accounts of $47 and $45 in 2003 and 2004, respectively

 

7,062

 

6,083

 

Insurance settlement receivable

 

10,725

 

10,000

 

Inventories, net

 

4,181

 

3,972

 

Prepaid expenses and other

 

1,026

 

1,627

 

Total current assets

 

37,364

 

33,952

 

Property and equipment, net

 

1,722

 

2,078

 

Intangibles and other assets

 

3,685

 

3,103

 

Total assets

 

$

42,771

 

$

39,133

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

3,055

 

$

3,732

 

Accrued liabilities

 

1,516

 

2,097

 

Legal settlement liability

 

10,725

 

10,000

 

Deferred revenue

 

253

 

368

 

Total current liabilities

 

15,549

 

16,197

 

Note payable

 

3,523

 

3,603

 

Other liabilities

 

44

 

31

 

Total liabilities

 

19,116

 

19,831

 

Commitments and contingencies (Note 6)

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock, $0.001 par value, 5,000 shares authorized, no shares issued and outstanding in 2003 and 2004, respectively

 

 

 

Common stock, $0.001 par value, 100,000 shares authorized, 20,274 and 20,329 shares issued and outstanding in 2003 and 2004, respectively

 

20

 

20

 

Additional paid-in capital

 

305,777

 

305,865

 

Accumulated other comprehensive loss

 

(89

)

(80

)

Accumulated deficit

 

(282,053

)

(286,503

)

Total stockholders’ equity

 

23,655

 

19,302

 

Total liabilities and stockholders’ equity

 

$

42,771

 

$

39,133

 

 

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

 

3



 

TUT SYSTEMS, INC.

 

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share amounts)

(unaudited)

 

 

 

Three Months Ended
March 31,

 

 

 

2003

 

2004

 

Revenues:

 

 

 

 

 

Product

 

$

6,401

 

$

6,159

 

License and royalty

 

200

 

18

 

Total revenues

 

6,601

 

6,177

 

Cost of goods sold:

 

3,259

 

5,129

 

Gross profit

 

3,342

 

1,048

 

Operating expenses:

 

 

 

 

 

Sales and marketing

 

1,927

 

1,905

 

Research and development

 

2,086

 

1,822

 

General and administrative

 

1,202

 

1,117

 

Impairment of intangible assets

 

¾

 

202

 

Amortization of intangible assets

 

459

 

396

 

Total operating expenses

 

5,674

 

5,442

 

Loss from operations

 

(2,332

)

(4,394

)

Interest and other income (expense), net

 

101

 

(56

)

Net loss

 

$

(2,231

)

$

(4,450

)

Net loss per share, basic and diluted (Note 3)

 

$

(0.11

)

$

(0.22

)

Shares used in computing net loss per share, basic and diluted (Note 3)

 

19,801

 

20,297

 

 

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

 

4



 

TUT SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

 

 

Three Months Ended
March 31,

 

 

 

2003

 

2004

 

Cash flows from operating activities:

 

 

 

 

 

Net loss

 

$

(2,231

)

$

(4,450

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation

 

235

 

328

 

Noncash interest income

 

10

 

 

Provision for (recovery of) doubtful accounts

 

(15

)

13

 

Provision for excess and obsolete inventory and abandoned products

 

 

974

 

Impairment of intangible assets

 

 

202

 

Amortization of intangible assets

 

459

 

396

 

Deferred interest on note payable

 

64

 

80

 

Change in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(185

)

966

 

Inventories

 

48

 

(765

)

Prepaid expenses and other assets

 

(467

)

(608

)

Accounts payable and accrued liabilities

 

(2,044

)

1,245

 

Deferred revenue

 

(229

)

115

 

Net cash used in operating activities

 

(4,355

)

(1,504

)

Cash flows from investing activities:

 

 

 

 

 

Purchase of property and equipment

 

(267

)

(684

)

Net cash used in investing activities

 

(267

)

(684

)

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuances of common stock, net

 

11

 

88

 

Net cash provided by financing activities

 

11

 

88

 

Net decrease in cash and cash equivalents

 

(4,611

)

(2,100

)

Cash and cash equivalents, beginning of period

 

25,571

 

14,370

 

Cash and cash equivalents, end of period

 

$

20,960

 

$

12,270

 

 

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

 

5



TUT SYSTEMS, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(in thousands, except per share amounts)

 

NOTE 1—DESCRIPTION OF BUSINESS:

 

The Company designs, develops, and sells digital video processing systems that enable telephony-based service providers to deliver broadcast quality digital video signals over their networks. The Company also offers video processing systems that enable private enterprise and government entities to transport video signals over satellite, fiber, radio, or copper networks for surveillance, distance learning, and TV production applications. The Company also designs, develops and markets broadband transport and service management products that enable the provisioning of high speed Internet access and other broadband data services over existing copper networks within hotels and private campus facilities.

 

Historically, the Company derived most of its sales from its broadband transport and service management products. In November 2002, the Company acquired VideoTele.com, or VTC, from Tektronix, Inc. to extend its product offerings to include digital video processing systems. Video-based products now represent a majority of the Company’s sales.

 

The Company has incurred substantial losses and negative cash flows from operations since inception. For the three months ended March 31, 2004, the Company incurred a net loss of $4,450 and negative cash flows from operating activities of $1,504, and has an accumulated deficit of $286,503 at March 31, 2004. Management believes that the cash and cash equivalents as of March 31, 2004 are sufficient to fund its operating activities and capital expenditure needs for the next twelve months.  However, in the event that general economic conditions worsen, the Company may require additional cash to fund its operations. The Company plans to seek additional equity funding to provide working capital, fund potential acquisitions and potentially redeem the VTC acquisition indebtedness.  The Company cannot assure that such funding efforts will be successful. Failure to generate positive cash flow in the future could have a material impact on the Company’s ability to achieve its intended business objectives.

 

NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:

 

Basis of presentation

 

The accompanying condensed consolidated financial statements as of March 31, 2004 and December 31, 2003 and for the three months ended March 31, 2003 and 2004 are unaudited. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position as of December 31, 2003 and March 31, 2004, its results of operations for the three months ended March 31, 2003 and 2004 and its cash flows for the three months ended March 31, 2003 and 2004. These condensed consolidated financial statements and the accompanying notes are unaudited and should be read in conjunction with the Company’s audited financial statements included in the Company’s Annual Report on Form 10-K/A, filed with the Securities and Exchange Commission on April 7, 2004. The balance sheet as of December 31, 2003 was derived from audited financial statements but does not include all disclosures required by generally accepted accounting principles. The results for the three months ended March 31, 2004 are not necessarily indicative of the expected results for any other interim period or the year ending December 31, 2004.

 

Revenue recognition

 

The Company generates revenue primarily from the sale of hardware products, including third-party products, through professional services, and through the sale of its software products. The Company sells products through direct sales channels and through distributors. Generally, product revenue is

 

6



 

generated from the sale of video processing systems and components and the sale of broadband transport and service management products. Turnkey solution revenue is principally generated by the sale of complete end-to-end video processing systems that are designed, developed and produced according to a buyer’s specifications.

 

Product revenues

 

Product revenue is generated primarily from the sale of complete end-to-end video processing systems generally referred to as turnkey solutions. Turnkey solutions are multi-element arrangements, which consist of hardware products, software products, professional services and post-contract support. Sales of turnkey solutions are classified as product revenue in the statement of operations.

 

Product revenue is also generated from the sale of video processing component products and the sale of broadband transport and service management products. The Company sells these products through its own direct sales channels and also through distributors.

 

The Company’s revenue recognition policies for turnkey solutions are in accordance with SOP 97-2, Software Revenue Recognition, as amended, which is the authoritative guidance for recognizing revenue on software transactions and transactions in which software is more than incidental to the arrangement. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as hardware, software products, maintenance services, installation, training or other elements. Under SOP 97-2, the determination of fair value is based on objective evidence that is specific to the vendor. If such evidence of fair value for any undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered, subject to certain limited exceptions set forth in SOP 97-2, as amended. SOP 97-2 was amended in February 1998 by SOP 98-4, Deferral of the Effective Date of a Provision of SOP 97-2, and was amended again in December 1998 by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions. Those amendments deferred and then clarified, respectively, the specification of what was considered vendor specific objective evidence of fair value for the various elements in a multiple element arrangement.

 

In the case of software arrangements which require significant production, modification or customization of software, which encompasses all of the Company’s turnkey arrangements, SOP 97-2 refers to the guidance in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. The Company recognizes revenue for all turnkey arrangements in accordance with SOP 97-2 and SOP 81-1. Excluding the PCS element, for which the Company has established vendor specific objective evidence of fair value (as defined by SOP 97-2), revenue from turnkey solutions is generally recognized using the percentage-of-completion method, as stipulated by SOP 81-1. The percentage-of-completion method reflects the portion of the anticipated contract revenue that has been earned that is equal to the ratio of labor effort expended to date to the anticipated final labor effort, based on current estimates of total labor effort necessary to complete the project. Revenue from the PCS element of the arrangement is deferred at the point of sale and recognized over the term of the PCS period. Generally, the terms of the turnkey solution sales provide for billing of approximately 90% of the contract value of the arrangement prior to the time of delivery to the customer site, with an additional approximately 9% of the contract value billed upon substantial completion of the project and the balance upon customer acceptance. The contractual arrangements relative to turnkey solutions include customer acceptance provisions. However, such provisions are generally considered to be incidental to the arrangement in its entirety because customers are fully obligated with respect to approximately 99% of the contract value irrespective of whether acceptance occurs or not.

 

7



 

For direct sales of video processing systems component products not included as part of turnkey solutions and the direct sale of broadband transport and service management products, the Company recognizes revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is reasonably assured.

 

Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period. The Company follows specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, the Company assesses a number of factors, including specific contract and purchase order terms, completion and timing of delivery to the common-carrier, past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of the assessment, the Company may recognize revenue when the products are shipped or defer recognition of revenue until evidence of sell-through occurs and cash is received. In order to recognize revenue, the Company must also make a judgment regarding collectibility of the arrangement fee. Management’s judgment of collectibility is applied on a customer-by-customer basis pursuant to the Company’s credit review policy. The Company sells to customers for which there is a history of successful collection and to new customers for which no similar history may exist. New customers are subject to a credit review process, which evaluates the customers’ financial position and ability to pay. New customers are typically assigned a credit limit based on a review of their financial position. Such credit limits are increased only after a successful collection history with the customer has been established. If it is determined from the outset of an arrangement that collectibility is not probable based upon the Company’s credit review process, no credit is extended and revenue is recognized on a cash-collected basis.

 

The Company also maintains accruals and allowances for all cooperative marketing and other programs, as necessary. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized, as necessary. The Company’s products generally carry a one year warranty from the date of purchase. To date, warranty costs have been insignificant to the overall financial statements taken as a whole.

 

License and Royalty Revenue

 

License and royalty revenue consists of non-refundable up-front license fees, some of which may offset initial royalty payments, and royalties received by the Company for products sold by its licensees. Currently, the majority of the Company’s license and royalty revenue is comprised of non-refundable license fees paid in advance. Such revenue is recognized ratably over the period during which post-contract customer support is expected to be provided or upon delivery and transfer of agreed upon technical specifications in contracts where essentially no further support obligations exist. Future license and royalty revenue is expected to consist primarily of royalties received by the Company for products sold by its licensees.

 

Should changes in conditions cause us to determine that the criteria for revenue recognition are not met for certain future transactions, revenue recognition for any reporting period could be adversely affected.

 

8



 

Inventories

 

Inventories are stated at the lower of cost or market. Cost is computed using standard cost which approximates actual cost on a first-in, first-out basis. The Company records provisions to write down its inventory and related purchase commitments for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about the future demand and market conditions. If actual future demand or market conditions are less favorable than those estimated by the Company, additional inventory provisions may be required.

 

Allowance for doubtful accounts

 

The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make payments. These estimated allowances are periodically reviewed and take into account customers’ payment history and information regarding customers’ creditworthiness that is known to the Company. If the financial condition of any of its customers were to deteriorate, resulting in their inability to make payments, an additional allowance would be required.

 

Accounting for long-lived assets

 

The Company periodically assesses the impairment of long-lived assets. An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

 

Factors considered important which could trigger an impairment review include, but are not limited to, significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, significant negative industry or economic trends, a significant decline in the stock price for a sustained period and the Company’s market capitalization relative to net book value.

 

When management determines that the carrying value may not be recoverable based upon the existence of one or more of the above indicators of impairment, any impairment measured is based on a projected discounted cash flow method using a discount rate commensurate with the risk inherent in the Company’s current business model.

 

During the three months ended March 31, 2004, the Company determined that certain of the technology acquired as part of the purchase of the Viagate Technologies, Inc. assets in September 2001 had become impaired. As a result, the Company incurred a loss of $202 to write-off the technology.

 

Future events could cause the Company to conclude that impairment indicators exist. Any resulting impairment loss could have a material adverse impact on the Company’s financial condition and results of operations.

 

9



 

Accounting for stock based compensation

 

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

 

The Company amortizes stock-based compensation using the straight-line method over the remaining vesting periods of the related options, which is generally four years. Pro forma information regarding net loss and earnings per share is presented and has been determined as if the Company had accounted for employee stock options under the fair value method of SFAS No. 123, as amended by SFAS No. 148.

 

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

 

 

 

Three Months Ended
March 31,

 

 

 

2003

 

2004

 

Net loss – as reported

 

$

(2,231

)

$

(4,450

)

Total stock-based employee compensation expense determined under a fair value based method for all grants, net of related tax effects

 

(1,067

)

(812

)

Net loss – pro forma

 

$

(3,298

)

$

(5,262

)

Basic and diluted net loss per share – as reported

 

$

(0.11

)

$

(0.22

)

Basic and diluted net loss per share – pro forma

 

$

(0.17

)

$

(0.26

)

 

The fair value of options and shares issued pursuant to the option plans and at the grant date were estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. The Company uses projected volatility rates, which are based upon historical volatility rates trended into future years. Because employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the

 

10



 

fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of options.

 

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

 

Recent accounting pronouncements

 

In January 2003, the Financial Accounting Standards Board, the (“FASB”) issued FASB Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, Consolidated Financial Statements,” which was subsequently revised in December 2003 with the issuance of FIN46-R. This interpretation requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Application of this Interpretation is required in financial statements for periods ending after March 15, 2004. The adoption of this Interpretation in the period ended March 31, 2004 did not have a material impact on the Company’s results of operations, financial position or cash flows.

 

Reclassifications

 

Certain reclassifications have been made to prior period balances in order to conform to the current period presentation.

 

NOTE 3—NET LOSS PER SHARE:

 

Basic and diluted net loss per share is computed using the weighted average number of common shares outstanding. Options were not included in the computation of diluted net loss per share because the effect would be antidilutive.

 

11



 

The calculation of net loss per share follows:

 

 

 

Three Months Ended
March 31,

 

 

 

2003

 

2004

 

Net loss per share, basic and diluted:

 

 

 

 

 

Net loss

 

$

(2,231

)

$

(4,450

)

Net loss per share, basic and diluted

 

$

(0.11

)

$

(0.22

)

Shares used in computing net loss per share, basic and diluted

 

19,801

 

20,297

 

Antidilutive securities not included in net loss per share calculations

 

4,096

 

4,446

 

 

NOTE 4—COMPREHENSIVE LOSS:

 

Comprehensive loss includes net loss, unrealized gains and losses on investments, and foreign currency translation adjustments that have been previously excluded from net loss and reflected instead in stockholders’ equity. The following table sets forth the calculation of comprehensive loss:

 

 

 

Three Months Ended
March 31,

 

 

 

2003

 

2004

 

Net loss

 

$

(2,231

)

$

(4,450

)

Unrealized gains on investments

 

12

 

16

 

Foreign currency translation adjustments

 

(5

)

(7

)

Net change in other comprehensive loss

 

7

 

9

 

Total comprehensive loss

 

$

(2,224

)

$

(4,441

)

 

12



 

NOTE 5—BALANCE SHEET COMPONENTS:

 

 

 

December 31,
2003

 

March 31,
2004

 

Inventories, net:

 

 

 

 

 

Finished goods

 

$

4,015

 

$

4,762

 

Raw materials

 

391

 

100

 

Allowance for excess and obsolete inventory and abandoned product

 

(225

)

(890

)

 

 

$

4,181

 

$

3,972

 

Property and equipment:

 

 

 

 

 

Computers and software

 

$

1,328

 

$

1,527

 

Test equipment

 

2,277

 

2,760

 

Office equipment

 

41

 

41

 

 

 

3,646

 

4,328

 

Less: accumulated depreciation

 

(1,924

)

(2,250

)

 

 

$

1,722

 

$

2,078

 

Accrued liabilities:

 

 

 

 

 

Professional Services

 

494

 

947

 

Compensation

 

652

 

800

 

Other

 

370

 

350

 

 

 

$

1,516

 

$

2,097

 

 

The Company recorded a provision for inventory within cost of goods sold totalling $974 in the three months ended March 31, 2004, related to the costs of raw materials and finished goods in excess of what the Company reasonably expected to sell in the foreseeable future as of the first quarter of 2004.  The Company also reduced inventory costs to market value.

 

Intangible and other assets:

 

 

 

As of December 31, 2003

 

 

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

Net
Intangibles

 

Intangible and other assets:

 

 

 

 

 

 

 

Completed technology and patents

 

$

8,125

 

$

(5,003

)

$

3,122

 

Contract backlog

 

247

 

(247

)

 

Customer list

 

86

 

(14

)

72

 

Maintenance contract renewals

 

50

 

(12

)

38

 

Trademarks

 

315

 

(52

)

263

 

 

 

$

8,823

 

$

(5,328

)

3,495

 

 

 

 

 

 

 

 

 

Other non-current assets

 

 

 

 

 

190

 

 

 

 

 

 

 

$

3,685

 

 

13



 

 

 

As of March 31, 2004

 

 

 

Gross
Carrying
Amount

 

Accumulated Amortization

 

Net
Intangibles

 

Amortized intangible assets:

 

 

 

 

 

 

 

Completed technology and patents

 

$

7,922

 

$

(5,382

)

$

2,540

 

Contract backlog

 

247

 

(247

)

 

Customer list

 

86

 

(17

)

69

 

Maintenance contract renewals

 

50

 

(14

)

36

 

Trademarks

 

315

 

(64

)

251

 

 

 

$

8,620

 

$

(5,724

)

2,896

 

 

 

 

 

 

 

 

 

Other non-current assets

 

 

 

 

 

207

 

 

 

 

 

 

 

$

3,103

 

 

During the three months ended March 31, 2004, the Company determined that certain of the technology acquired as part of the purchase of the Viagate Technologies, Inc. assets in September 2001 had become impaired.  As a result, the Company incurred a loss of $202 to write-off the technology.

 

The aggregate amortization expense for the three months ended March 31, 2003 and 2004 was $459 and $396, respectively.

 

Minimum future amortization expense as of March 31, 2004 is as follows:

 

Remainder of 2004

 

$

1,129

 

2005

 

875

 

2006

 

424

 

2007

 

363

 

Thereafter

 

105

 

 

 

$

2,896

 

 

14



 

NOTE 6—COMMITMENTS AND CONTINGENCIES:

 

Lease obligations

 

The Company leases equipment and office, assembly and warehouse space under non-cancelable operating leases that expire from 2004 through 2005.

 

Minimum future lease payments under operating leases as of March 31, 2004 are as follows:

 

Remainder of 2004

 

$

694

 

2005

 

266

 

Thereafter

 

 

 

 

$

960

 

 

Purchase commitments

 

The Company had non-cancelable commitments to purchase finished goods inventory totaling $1,009 and $364 in aggregate at December 31, 2003 and March 31, 2004, respectively.

 

Contingencies

 

Whalen v. Tut Systems, Inc. et al

 

On October 30, 2001, the Company and certain of its current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et al., Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District Court for the Southern District of New York. An amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts that the prospectuses from the Company’s January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against the Company and certain of its current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, and under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, and alleges claims against certain of its current and former officers and directors under Sections 15 and 20(a) of the Securities Act. The complaint also names as defendants the underwriters for the Company’s initial public offering and secondary offering. Similar suits were filed in the Southern District of New York challenging over 300 other initial public offerings and secondary offerings conducted in 1999 and 2000. Therefore, for pretrial purposes, the Whalen action is being coordinated with the approximately 300 other suits before United States District Court Judge Shira Scheindlin of the Southern District of New York under the matter In Re Initial Public Offering Securities Litigation. The individual defendants in the Whalen action, namely, Nelson Caldwell, Salvatore D’Auria and Matthew Taylor, were dismissed without prejudice by an October 9, 2002 Order of the Court, approving the parties’ October 1, 2002 Stipulation of Dismissal. On February 19, 2003, the Court issued an Opinion and Order denying the Company’s motion to dismiss.

 

In June and July 2003, nearly all of the issuers named as defendants in the In Re Initial Public Offering Securities Litigation (collectively, the “issuer-defendants”), including the Company, approved a tentative settlement proposal that is reflected in a memorandum of understanding. The Company’s Board of Directors approved the memorandum of understanding in June 2003 on certain conditions, including the number of issuers participating in the settlement. The memorandum of understanding is not a legally

 

15



 

binding agreement. Further, any final settlement agreement would be subject to a number of conditions, most of which would be outside of the Company’s control, including approval by the Court. The underwriter-defendants in the In Re Initial Public Offering Securities Litigation (collectively, the “underwriter-defendants”), including the underwriters in the Whalen suit, are not parties to the memorandum of understanding.

 

The memorandum of understanding provides that, in exchange for a release of claims against the settling issuer-defendants, the insurers of all of the settling issuer-defendants will provide a surety undertaking to guarantee plaintiffs a $1 billion recovery from the non-settling defendants, including the underwriter-defendants. The ultimate amount, if any, that may be paid on behalf of the Company will therefore depend on the final terms of the settlement agreement, including the number of issuer-defendants that ultimately approve the final settlement agreement, and the amounts, if any, recovered by the plaintiffs from the underwriter-defendants and other non-settling defendants. In the event that all or substantially all of the issuer-defendants approve the final settlement agreement, the amount that the Company would be required to pay to the plaintiffs could range from zero to approximately $3.5 million, depending on plaintiffs’ recovery from the underwriter-defendants and from other non-settling parties. If the plaintiffs recover at least $1 billion from the underwriter-defendants, the Company would have no liability for settlement payments under the proposed terms of the settlement. If the plaintiffs recover less than $1 billion, the Company believes that its insurance will likely cover some or all of its share of any payments towards satisfying plaintiffs’ $1 billion recovery deficit. Management estimates that its range of loss relative to this matter is zero to $3.5 million. Presently there is no more likely point estimate of loss within this range. As a consequence of the uncertainties described above regarding the amount the Company will ultimately be required to pay, if any, as of March 31, 2004, the Company has not accrued a liability for this matter.

 

In re Tut Systems, Inc. Securities Litigation, Civil Action No. C-01-2659-JCS (the “Securities Litigation Action”).

 

Beginning July 12, 2001, nine putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of California against the Company and certain of its current and former officers and directors. The complaints were filed on behalf of a purported class of investors who purchased the Company’s stock during the period between July 20, 2000 and January 31, 2001, seeking unspecified damages. The complaints allege that the Company and certain of its current and former officers and directors made false and misleading statements about the Company’s business during the putative class period. Specifically, the complaints allege violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints were consolidated under the name In re Tut Systems, Inc. Securities Litigation, Master File No. C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and lead counsel for plaintiffs were appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on March 29, 2002. On August 15, 2002, the Court granted in part and denied in part the Motion to Dismiss. On September 23, 2002, plaintiffs filed an amended complaint. Defendants filed a Motion to Dismiss the amended complaint, and on August 6, 2003 the Court granted in part that Motion. On September 24, 2003, defendants answered the remaining allegations of the amended complaint. Defendants reached a settlement of the Securities Litigation Action in December 2003. Subject to preliminary and final approval by the Court, the Company’s insurance carriers agreed to pay $10 million, on behalf of the Company, to settle the suit. The settlement includes a release of all defendants. The Company has recorded a liability in its financial statements for the proposed amount of the settlement. In addition, because the insurance carriers agreed to pay the entire $10 million settlement amount and, therefore, recovery from the insurance carriers was probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amounts of the settlement and the insurance recovery fully offset each other. The insurance carriers paid the settlement amount to plaintiffs’ escrow agent in January 2004. The Court preliminarily approved the settlement on February 24, 2004. The settlement amount will be paid out of escrow if and when the Court finally approves the settlement. A hearing before the Court to consider final approval of the terms of

 

16



 

settlement is currently scheduled for May 14, 2004. Because the settlement is subject to Court approval, there is no guarantee the settlement will become final.

 

Lefkowitz v. D’Auria, et al

 

On March 19, 2003, Chesky Lefkowitz, a stockholder of the Company, filed a derivative complaint entitled Lefkowitz v. D’Auria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of the Company’s current and former officers and directors. The complaint alleges causes of action for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment, and improper insider stock trading based on the same factual allegations contained in the Securities Litigation Action. The complaint seeks unspecified damages against the individual defendants on behalf of the Company, equitable relief, and attorneys’ fees. On May 21, 2003, the Company and the individual defendants filed separate demurrers to the complaint. The Company and the individual defendants reached a settlement of the derivative action in December 2003. The settlement involves the Company’s adoption of certain corporate governance measures and payment of attorneys’ fees and expenses to the derivative plaintiff’s counsel in the amount of $722,000 and an incentive award to the derivative plaintiff in the amount of $3,000. The Company has recorded a liability in its financial statements for the proposed amount of the settlement. In addition, because the insurance carrier involved in this suit agreed to pay the entire $725,000 settlement amount and, therefore, recovery from the insurance carrier was probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amounts of the settlement and the insurance recovery fully offset each other. The settlement was approved by the Court on January 12, 2004, and, shortly thereafter, the insurance carrier paid the settlement amount to the derivative plaintiff’s counsel. Therefore, in the first quarter of 2004, the $725,000 was removed from the insurance settlement receivable and the legal settlement liability.  The settlement includes a release of the Company and the individual defendants.

 

The Company is subject to other legal proceedings, claims and litigation arising in the ordinary course of business. The Company’s management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company’s consolidated financial position, results of operations, or cash flows.

 

NOTE 7—SEGMENT INFORMATION:

 

The Company currently targets its sales and marketing efforts to both public and private service providers and users across two related markets. The Company currently operates in a single business segment as there is only one measurement of profitability for its operations. Revenues are attributed to the following countries based on the location of customers:

 

17



 

 

 

Three Months Ended
March 31,

 

 

 

2003

 

2004

 

United States

 

$

5,731

 

$

5,488

 

International:

 

 

 

 

 

Canada

 

120

 

299

 

Ireland

 

253

 

145

 

Japan

 

164

 

123

 

All other countries

 

333

 

122

 

 

 

$

6,601

 

$

6,177

 

 

Two customers, Atlantic Telephone Membership Corporation and Home Telephone Company accounted for 12% and 11%, respectively of the Company’s revenue for the three months ended March 31, 2003.  One customer, Pioneer Long Distance Inc., accounted for 10% of the Company’s revenue for the three months ended March 31, 2004.

 

Products

 

The Company designs, develops, and sells video processing systems and broadband transport and service management products. Video processing systems include both digital TV headend systems and video systems. The digital TV headend system enables telephony-based service providers to transport broadcast quality digital video signals across their networks and our digital video transmission systems optimize the delivery of video signals across enterprise, government and education networks. The broadband transport and service management products enable the transmission of broadband data over existing hotels and private campus networks.

 

Revenue relating to the broadband transport and service management products was $1,658 and $1,936 for the three months ended March 31, 2003 and 2004, respectively. Revenue related to video processing systems was $4,943 and $4,241 for the three months ended March 31, 2003 and 2004, respectively.

 

18



 

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

 

The section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” set forth below contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. When used herein, the words “anticipates,” “believes,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “seeks,” “should,” “will” or the negative of these terms or similar expressions are generally intended to identify forward-looking statements. We have based these forward-looking statements on our current expectations and projections about future events. Such forward-looking statements are subject to various risks and uncertainties that could cause actual results to differ materially from those projected in such statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. The forward-looking statements contained in this quarterly report include statements about the following: (1) our belief that video products will provide most of our growth opportunities for the foreseeable future, (2) our belief that the number of telco video subscribers will grow significantly between 2004 and 2007 and that this market space will continue to become more competitive, (3) our expectation that we will compete with larger public companies as we begin to target larger telco customers, (4) our expectation that digital subscriber line or DSL technology will continue to dominate telco broadband networks for the foreseeable future, (5) our belief that new controls and procedures have addressed the conditions identified by our auditors as material weaknesses, (6)  our expectation that sales related to VTC products will continue to increase in 2004 and sales relating to our broadband transport and service management products will also increase in 2004, but at a lower rate of increase, (7) our expectation that capital expenditures for research and development will decrease in 2004, (8) our expectation that capital expenditures in 2004 will be comparable to 2003 and that these capital expenditures will be funded from operations, (9) our belief that our cash and cash equivalents as of March 31, 2004 are sufficient to fund our operating activities and capital expenditure needs for the next twelve months, (10) our expectation that working capital will begin to increase in future periods, (11) our expectation that the amount of cash used to fund our operations will decrease in 2004, (12) our expectation that we will seek additional equity funding in the second quarter of 2004, (13) our expectation that future license and royalty revenue will consist primarily of royalties received by us for products sold by our licensees and that such license and royalty revenue will not constitute a substantial portion of our revenue in future periods, (14) our expectation that we will incur losses in the near future, (15) our expectation that some competitors will market some of their products for use in TV over DSL applications, (16) our anticipation that our sales and operating margins will continue to fluctuate, (17) our anticipation that we will generally continue to invoice foreign sales in U.S. dollars, (18) our intention to continue to evaluate new acquisition candidates, divesture and diversification strategies, and (19) our expectation that customers outside of the United States will represent a significant and growing portion of our revenue.

 

The cautionary statements contained under the caption “Additional Risk Factors that Could Affect Our Operating Results and the Market Price of Our Stock” and other similar statements contained elsewhere in this report, identify important factors with respect to such forward-looking statements, including certain risks and uncertainties that could cause our actual results, performance or achievements expressed or implied by such forward-looking statements.

 

Although we believe that the expectations reflected in such forward-looking statements are based upon reasonable assumptions, no assurance can be given that such expectations will be attained or that any deviations will not be material. We disclaim any obligation or undertaking to disseminate any updates or revision to any forward-looking statement contained herein or reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.

 

19



 

Overview

 

Our Business

 

We design, develop, and sell digital video processing systems that enable telephony-based service providers to deliver broadcast quality digital video signals across their networks. We refer to these systems as digital TV headends or video content processing systems. We also offer digital video processing systems that enable private enterprise and government entities to transport video signals across satellite, fiber, radio, or copper facilities for surveillance, distance learning, and TV production applications.

 

We also offer broadband transport and service management products that enable the provisioning of high speed Internet access and other broadband data services over existing copper networks within hotels and private campus facilities.

 

Our History

 

Prior to November 2002, most of our sales were derived from our broadband transport and service management products. In 2000 and 2001, we acquired three companies (FreeGate Corporation, Xstreamis Limited and ActiveTelco, Inc.) and the assets from two other companies (OneWorld Systems, Inc. and ViaGate Technologies, Inc.) in order to expand our sales of broadband transport and service management products. However, the significant downturn in the world economy in general, and the telecommunications market in particular, beginning in late 2000 had a severe and sustained adverse effect on our business, financial condition and results of operations. Our sales of broadband transport and service management products decreased substantially beginning in 2001, which required us to take a number of restructuring efforts and incur significant impairment and other charges in order to realign our cost structure in light of the economic environment. For the period January 1, 2001 through December 31, 2002, we incurred an aggregate of $32.6 million in intangible asset impairment charges and $11.5 million in restructuring charges. In 2003, sales from our broadband transport and service management products stabilized, as we began to experience an improvement in sales of broadband transport and service management products to the hospitality industry.

 

With our November 2002 acquisition of Tektronix’s subsidiary VTC, we extended our product offerings to add video processing systems for digital TV headends and for the transmission of video signals over private and government networks. The acquisition of VTC resulted in significant changes in our business, including: (1) changes in our organizational structure and employee staffing; (2) relocation of our administrative offices, executive offices (as of January 2004) and a significant portion of our operations from Pleasanton, California to Lake Oswego, Oregon, the prior headquarters of VTC; (3) an expansion of our sales and marketing efforts to include VTC products; and (4) a reprioritization of our research and development efforts to focus on products that we acquired in our acquisition of VTC. With our acquisition of VTC, sales of video processing systems now represent a majority of our total revenues and will provide most of our growth opportunities for the foreseeable future.

 

We earn revenue primarily by selling video content processing systems both directly and through resellers to telecommunications service providers. We also earn revenue by selling video transmission systems to TV broadcasters, government agencies and educational institutions, and by selling broadband transport and service management products directly and through distributors to the hospitality industry and to owners of private multi-tenant campus facilities.

 

Prior to our acquisition of VTC, international sales represented 56.3% and 43.0% of our total sales in 2001 and 2002, respectively. Since our acquisition of VTC, international sales have represented a smaller percentage of our overall business relative to prior years, though international sales are still a material portion of our total sales. In 2003, international sales represented 18.4% of our total sales and for the three months ended March 31, 2004, international sales represented 11.2% of our total sales.

 

Material Trends and Uncertainties

 

We pay close attention to and monitor various trends and uncertainties emerging in the markets we serve. There is a growing demand by independent operating telephone companies to offer video services to

 

20



 

their customer base. According to a report released by InStat/MDR in April 2003, the number of telco video subscribers worldwide will increase from 572,000 at the end of 2003 to over 19.0 million by the end of 2007. While this growing market presents opportunities to serve a larger customer base, we are also seeing the emergence of intense competition as more companies compete to sell digital TV headend products. We expect this market space will continue to become more competitive in the future. As we begin to target larger telco customers, we expect to compete with larger public companies, including Harmonic, Motorola and Tandberg Television. Our immediate competitors in the digital TV headend markets are primarily small private companies that are focused on a more narrow product line than ours and thereby may be able to devote substantially more targeted resources to developing, marketing and selling new products than we are able to. In addition, these companies may become targets for acquisition by larger companies, in which case we would face competitors with substantially greater name recognition, and technical, financial and marketing resources than we have.

 

The emergence of new technologies to serve the digital TV headend market means that we must continue to invest in these new technologies to maintain our market position.  Digital subscriber line (“DSL”) technologies use sophisticated modulation schemes to pack data onto copper wires.  DSL technologies are sometimes referred to as “last mile” technologies because they are used only for connections from a telephone switching station to a home or office, not between switching stations.  The limitations on the amount of data that can be transmitted in a fixed amount of time (“bandwidth”) and distance limitations of the copper based last mile constrain both the number of video channels that may be delivered simultaneously over a DSL network and the number of customers that are reachable from a telco central office.  Emerging advancements in video compression technology will soon enable high quality video streams to be transported at lower data transfer rates or “bit rates” than currently deployed.  These emerging compression advancements also introduce the possibility of delivering high-definition television over bandwidth constrained asymmetric DSL, or ADSL, lines for the first time.  ADSL is a new technology that allows more data to be sent over existing copper telephone lines.  Additionally, there are DSL advancements emerging that expand the available bandwidth from the telco to the subscriber thereby supporting higher DSL bit rates over longer distances.  As our products continue to incorporate these new technological advancements we expect demand for our products will increase since they will enable more telcos to reach a higher percentage of their customers with a larger number of video channels.

 

While DSL technologies will continue to dominate telco broadband networks for the foreseeable future, telephone companies are beginning to construct fiber optic networks to their customers’ homes. Though fiber-to-the-home will eliminate bandwidth limitations on delivering higher speed data services and high-quality video offerings, telephone companies deploying fiber-to-the-home will require advanced video processing systems, such as our Astria Product line, to convert signals between multiple protocols used in their networks.

 

The digital media industry continues to be intensely competitive.  We are continuing to focus on developing technologies and introducing new products and we expect that our research and development expenses will increase throughout the remainder of 2004. We continue to aggressively market our new and existing products and to expand our marketing efforts domestically and internationally.  Nevertheless, our operations have been subject, and will continue to be subject, to pressure from weakness in the overall technology sector as well as the digital media industry.  During the first quarter of 2004 our sales cycle generally increased and customers delayed purchasing decisions.  The deferral of customer orders reduced our revenue in the first quarter of 2004.  We believe this lengthening of the decision making process is the result of an increasing variety of other products that interface with our systems. We have been operating at a loss since inception and, based on expected revenues, we anticipate that we will continue to operate at loss during the remainder of 2004.  As we announced on April 26, 2004, we expect revenues during the second quarter of 2004 to increase by 5% and our gross margin to increase to approximately 40%.  However, the deferral of customer orders we experienced during the first quarter may continue, which may result in reduced revenues in the future.

 

Internal Controls and Disclosure Controls and Procedures

 

Our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of March 31, 2004. This evaluation included various steps that our Chief Executive Officer and Chief Financial Officer undertook in an effort to ensure that information required to be disclosed in our SEC reports is recorded, processed, summarized and reported within the time periods specified by the SEC and accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosure.  This evaluation also included consideration of our internal controls and procedures for the preparation of our financial statements.  There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention of the controls and procedures.  Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives.  Notwithstanding these limitations, as of the end of the period covered by this report, based upon the evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.

 

During the three months ended March 31, 2004, we implemented the following measures:

 

                                          Perform quarterly physical inventory counts at all locations;

 

                                          Established improved inventory systems and accounting controls, hired additional qualified personnel, improved intra-company communications, implemented appropriate organizational and line of reporting changes; and

 

                                          Established improved procedures for the timely reconciliation and confirmation of accounts payable balances.

 

21



 

We implemented these measures because in connection with the completion of PricewaterhouseCoopers LLP’s audit of our financial statements for the year ended December 31, 2003, PricewaterhouseCoopers LLP advised management and the audit committee of the Board of Directors that it had identified deficiencies in our internal controls and processes relating to inventory management and reporting that it considered to be material weaknesses, as defined by Statement on Auditing Standards No. 60, “Communication of Internal Control Related Matters Noted in an Audit.” PricewaterhouseCoopers LLP identified the following two material weaknesses in our internal controls and processes:

 

1.                                       Our internal controls were inadequate to properly record our inventory quantities in an accurate and timely manner; and

 

2.                                       Our accounts payable process failed to adequately reconcile our accounts payable records with suppliers’ records, considering what the suppliers had shipped to us prior to period end.

 

Management believes its new controls and procedures have addressed the conditions identified by PricewaterhouseCoopers LLP as material weaknesses.  We plan to continue to monitor the effectiveness of our internal controls and procedures on an ongoing basis and will take further action as appropriate.

 

Definitions for Discussion of Results of Operations

 

Our discussion of our results of operations focuses on the following items from our income statement: Total revenues consists of product sales, and license and royalty fees. Product revenue consists of sales of our video processing systems, which includes both digital TV headend and video transmission systems. Product revenue also consists of revenue from our broadband transport and service management products. License and royalty fees consist of non-refundable license fees and royalties received by us for products sold by our licensees. Since our acquisition of VTC, a large part of our quarterly revenue has been associated with the sale of digital TV headends. Furthermore, each individual headend sale has represented a significant portion of our revenue for each quarter. If we were to sell even one less system than our forecasted number of headend sales per quarter, our quarterly revenue would be materially impacted. As we have not entered into any new license or royalty agreements since 2000, we expect that our license and royalty revenue will decrease in the foreseeable future. Cost of goods sold, or COGS, consists of costs related to raw materials, contract manufacturing, personnel, overhead, test and quality assurance for products, and the cost of licensed technology included in our products. Raw materials, contract manufacturing and licensed technology are the principal elements of COGS and vary directly with product sales. Sales and marketing expense consists primarily of selling and marketing personnel costs, including sales commissions, travel, trade shows, promotions and outside services. Research and development expense consists primarily of personnel and facilities costs, contract consultants, outside testing services, and equipment and supplies associated with enhancing existing products and developing new products. General and administrative expense consists primarily of personnel costs for administrative officers and support personnel, professional services and insurance expenses. Amortization of intangible assets consists primarily of expenses associated with the amortization of technology and patents related to prior years’ acquisitions.

 

Results of Operations

 

The following table sets forth items from our statements of operations as a percentage of total revenues for the periods indicated:

 

 

 

Three months ended
March 31,

 

 

 

2003

 

2004

 

Total revenues

 

100.0

%

100.0

%

Cost of goods sold

 

49.4

 

83.0

 

Gross profit (loss)

 

50.6

 

17.0

 

Operating expenses:

 

 

 

 

 

Sales and marketing

 

29.2

 

30.8

 

Research and development

 

31.6

 

29.5

 

General and administrative

 

18.2

 

18.1

 

Impairment of intangible assets

 

 

3.3

 

Amortization of intangible assets

 

7.0

 

6.4

 

Total operating expenses

 

86.0

 

88.1

 

Loss from operations

 

(35.3

)

(71.1

)

Interest and other income, net

 

1.5

 

(0.9

)

Net loss

 

(33.8

)%

(72.0

)%

 

22



 

Three Months Ended March 31, 2003 and 2004

 

Total Revenues.  For the three months ended March 31, 2004, our total revenues decreased by 6.4% to $6.2 million from $6.6 million for the three months ended March 31, 2003. During this same period, our product revenue decreased by 3.8% to $6.2 million from $6.4 million for the three months ended March 31, 2003. This $0.2 million decrease in product revenue was due primarily to the adverse effect of several digital TV headend sales not closing in the quarter as expected.  While the market for digital TV headend sales continues to expand, we are seeing an increase in a variety of factors that is causing many prospective customers to delay their purchase decision.  Sales of broadband transport and service management products increased from $1.7 million in the first quarter of 2003 to $1.9 million in the first quarter of 2004.   For the three months ended March 31, 2004, our license and royalty revenue decreased to $18 thousand from $0.2 million for the three months ended March 31, 2003.

 

Cost of Goods Sold.  For the three months ended March 31, 2004, our cost of goods sold increased by $1.8 million to $5.1 million from $3.3 million for the three months ended March 31, 2003. The increase in cost of goods sold was due to a $1.0 million increase in our reserves for obsolete inventory and a lower of cost or market adjustment for certain inventory components, an increase in material costs of $0.2 million, direct labor and other direct expenses of $0.5 million related to completion of certain project installations, and other miscellaneous expenses of $0.1 million.   Our gross profit decreased by $2.3 million to $1.0 million for the three months ended March 31, 2004 from $3.3 million for the three months ended March 31, 2003.  This decrease in gross profit is due to an increase of $1.0 million in inventory reserves and a gross margin decrease of $1.5 million relating to our video content processing products.  The decrease in our gross margin was partially offset by an increase of $0.2 million attributable to our broadband transport and service management products.

 

Sales and Marketing.  For the three months ended March 31, 2004 and 2003, our sales and marketing expenses remained consistent at $1.9 million.

 

Research and Development.  For the three months ended March 31, 2004, our research and development expense decreased by 12.7% to $1.8 million from $2.1 million for the three months ended March 31, 2003. The $0.3 million decrease in our research and development expense for the first quarter of 2004 when compared with the same period in 2003 was due to a decrease of $0.3 million in personnel related costs. We continued to reduce research and development expenses in the first quarter of 2004 to bring them into better alignment with our current revenues. We expect that our research and development expenses will increase throughout the remainder of 2004. Our capital expenditures for research and development were $0.1 million and $0.3 million for the three months ended March 31, 2003 and 2004, respectively. We expect capital expenditures for research and development to decrease in 2004.

 

General and Administrative.  For the three months ended March 31, 2004, our general and administrative expense decreased by 7.1% to $1.1 million from $1.2 million for the three months ended March 31, 2003. The $0.1 million decrease in our general and administrative expense for the first quarter of 2004 when compared with the same period in 2003 was due to decreases of $0.2 million in personnel costs from a workforce reduction in the third quarter of 2003 and $0.1 million in insurance expenses, partially offset by an increase of $0.2 million in professional services.

 

Impairment of Intangible Assets.  During the first quarter of 2004, we determined that certain of the technology acquired as part of the purchase of the ViaGate Technology assets had become impaired. As a result, we recorded an impairment charge of $0.2 million to write off the book value of the intangible assets associated with this technology. There was no such impairment for the three months ended March 31, 2003.

 

Amortization of Intangible Assets.  Amortization of intangible assets is comprised of intangibles related to the acquisitions of Xstreamis Limited in 2000, and VTC in 2002. The remaining intangible assets subject to amortization from these acquisitions consist primarily of completed technology and patents. For

 

23



 

the three months ended March 31, 2004, amortization of intangible assets decreased by 13.7% to $0.4 million from $0.5 million for the three months ended March 31, 2003.  The $0.1 decrease for the first quarter of 2004 when compared with the same period in 2003 was due to a reduction in amortization expense, from an intangible asset reaching full amortization in the fourth quarter of 2003.

 

Interest and Other Income, Net.  Interest and other income, net consists primarily of interest income and expense and foreign currency exchange gains and losses. For the three months ended March 31, 2004, our interest and other income, decreased to a net expense of $0.1 million from a net interest and other income of $0.1 million for the three months ended March 31, 2003. The decrease in the first quarter of 2004 of $0.2 million compared with the first quarter of 2003 was primarily the result of lower interest rates on lower average cash balances and increased interest expense associated with the $3.2 million note issued in connection with our purchase of VTC in November 2002.

 

Liquidity and Capital Resources

 

Cash and cash equivalents totaled $12.3 million at March 31, 2004, compared with cash and cash equivalents of $14.4 million at December 31, 2003, reflecting a net reduction in cash and cash equivalents of $2.1 million.

 

Cash used in operating activities was $1.5 million for the three months ended March 31, 2004, compared with $4.4 million for the three months ended March 31, 2003. The reduced cash used in operating activities was primarily due to a decrease in accounts receivable due to lower revenue levels in the first quarter of 2004 and an increase in accounts payable and accrued liabilities due to an increase in end of quarter purchases offset by an increase in prepaid expenses.  We recorded a provision for inventory within cost of goods sold totaling $1.0 million in the first quarter of 2004, related to the costs of raw materials and finished goods in excess of what we reasonably expected to sell in the foreseeable future as of the first quarter of 2004.  We also reduced inventory costs to market value.

 

Additions to property and equipment were $0.7 million in the first quarter of 2004, compared with $0.3 million in the first quarter of 2003, primarily reflecting an increased investment in research and development assets. In 2004 we expect capital expenditures to be comparable to 2003. We expect these capital expenditures to be funded from operations.

 

The following table sets forth our contractual obligations as of March 31, 2004:

 

 

 

Payments due by period

 

Contractual
Obligations

 

Total

 

Remainder
of 2004

 

2005
to
2006

 

2007
to
2008

 

Thereafter

 

Long-Term Debt Obligations

 

$

3,603

 

$

 

$

 

$

3,603

 

$

 

Operating Lease Obligations

 

960

 

694

 

266

 

 

 

Purchase Obligations

 

364

 

364

 

 

 

 

Other Long-Term Liabilities

 

31

 

 

31

 

 

 

Total

 

$

4,958

 

$

1,058

 

$

297

 

$

3,603

 

$

 

 

We do not have any off balance sheet arrangements.

 

As part of our acquisition of VTC from Tektronix in November 2002, we issued a note payable to Tektronix for $3.2 million, with repayment in sixty months, or by November 2007. The interest rate on this note is 8% and is compounded annually. Through January 31, 2006, the accrued interest is added to the principal balance of the note. Thereafter, we will pay accrued interest on this note commencing on January 31, 2006 and on each April 30, July 31 and October 31 thereafter until the principal balance is paid in full. Principal and accrued interest on the note payable is $3.6 million at March 31, 2004.  Accrued interest in the first quarter of 2004 was $0.1 million.

 

In connection with the settlement of certain legal matters in December 2003, we have recorded a liability and a receivable, each in the amount of $10.7 million, in our December 31, 2003 balance sheet. This amount will be paid by our insurance carriers, and accordingly, such liability is not reflected in the above table. The settlement amount will be reversed from our balance sheet during 2004, at such time as the settlements are formally approved by the respective courts.  One of the settlements was formally approved by the courts in the first quarter of 2004, and therefore, we reversed $0.7 million relating to that settlement from the balance sheet.  As of March 31, 2004, we have a receivable and liability of $10.0, respectively, on our balance sheet.

 

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We have incurred substantial losses and negative cash flows from operations since inception. For the three months ended March 31, 2004, we incurred a net loss of $4.5 million, negative cash flows from operating activities of $1.5 million, and have an accumulated deficit of $286.5 million.

 

We believe that the cash and cash equivalents as of March 31, 2004 are sufficient to fund our operating activities and capital expenditure needs for the next twelve months. However, in the event that general economic conditions worsen, we may require additional cash to fund our operations. We plan to seek additional equity funding to provide working capital, fund potential acquisitions and potentially redeem the VTC acquisition indebtedness. We cannot assure that such funding efforts will be successful. Failure to generate positive cash flow in the future could have a material adverse effect on our ability to achieve our intended business objectives.

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

We have identified the policies below as critical to our business operations and the understanding of our results of operations.

 

Revenue recognition.  We generate revenue primarily from the sale of hardware products, including third-party products, through professional services, and through the sale of our software products. We sell products through direct sales channels and through distributors. Generally, product revenue is generated from the sale of video processing systems and components and the sale of broadband transport and service management products. Turnkey solution revenue is principally generated by the sale of complete end-to-end video processing systems that are designed, developed and produced according to a buyer’s specifications.

 

Product revenue is generated primarily from the sale of complete end-to-end video processing systems generally referred to as turnkey solutions. Turnkey solutions are multi-element arrangements, which consist of hardware products, software products, professional services and post-contract support. Sales of turnkey solutions are classified as product revenue in the statement of operations.

 

Product revenue is also generated from the sale of video processing component products and the sale of broadband transport and service management products. We sell these products through our own direct sales channels and also through distributors.

 

Our revenue recognition policies for turnkey solutions are in accordance with SOP 97-2, Software Revenue Recognition, as amended, which is the authoritative guidance for recognizing revenue on software transactions and transactions in which software is more than incidental to the arrangement. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as hardware, software products, maintenance services, installation, training or other elements. Under SOP 97-2, the determination of fair value is based on objective evidence that is specific to the vendor. If such evidence of fair value for any undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered, subject to certain limited exceptions set forth in SOP 97-2, as amended. SOP 97-2 was amended in February 1998 by SOP 98-4, Deferral of the Effective Date of a Provision of SOP 97-2 and was amended again in December 1998 by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions.    Those amendments deferred and then clarified, respectively, the

 

25



 

specification of what was considered vendor specific objective evidence of fair value for the various elements in a multiple element arrangement.

 

In the case of software arrangements that require significant production, modification or customization of software, which encompasses all of our turnkey arrangements, SOP 97-2 refers to the guidance in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. We recognize revenue for all turnkey arrangements in accordance with SOP 97-2 and SOP 81-1. Excluding the PCS element of the multi-element arrangement, for which we have established vendor specific objective evidence of fair value (as defined by SOP 97-2), revenue from turnkey solutions is generally recognized using the percentage-of-completion method, as stipulated by SOP 81-1. The percentage-of-completion method reflects the portion of the anticipated contract revenue that has been earned that is equal to the ratio of labor effort expended to date to the anticipated final labor effort, based on current estimates of total labor effort necessary to complete the project. Revenue from the PCS element of the arrangement is deferred at the point of sale and recognized over the term of the PCS period. Generally, the terms of the turnkey solution sales provide for billing of approximately 90% of the contract value prior to the time of delivery to the customer site, with an additional approximately 9% of the contract value billed upon substantial completion of the project and the balance upon customer acceptance.  The contractual arrangements relative to turnkey solutions include customer acceptance provisions. However, such provisions are generally considered to be incidental to the arrangement in its entirety because customers are fully obligated with respect to approximately 99% of the contract value irrespective of whether acceptance occurs or not.

 

For direct sales of video processing systems component products not included as part of turnkey solutions and the direct sale of broadband transport and service management products, we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collection is reasonably assured.

 

Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period. We follow specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, we assess a number of factors, including specific contract and purchase order terms, completion and timing of delivery to the common-carrier, past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of the assessment, we may recognize revenue when the products are shipped or defer recognition of revenue until evidence of sell-through occurs and cash is received. In order to recognize revenue, we must also make a judgment regarding collectibility of the arrangement fee.  Management’s judgment of collectibility is applied on a customer-by-customer basis pursuant to our credit review policy.  We sell to customers for which there is a history of successful collection and to new customers for which such history may not exist.  New customers are subject to a credit review process, which evaluates the customers’ financial position and ability to pay. New customers are typically assigned a credit limit based on a review of their financial position.  Such credit limits are only increased after a successful collection history with the customer has been established.  If it is determined from the outset of an arrangement that collectibility is not probable based upon our credit review process, no credit is extended and revenue is recognized on a cash-collected basis.

 

We also maintain accruals and allowances for all cooperative marketing and other programs, as necessary. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized, as necessary. Our products generally carry a one year warranty from the date of purchase. To date, warranty costs have been insignificant to the overall financial statements taken as a whole.

 

License and royalty revenue consists of non-refundable up-front license fees, some of which may offset initial royalty payments, and royalties received by us for products sold by our licensees. Currently, the majority of our license and royalty revenue is comprised of non-refundable license fees paid in advance. Such revenue is recognized ratably over the period during which post-contract customer support is expected to be provided or upon delivery and transfer of agreed upon technical specifications in contracts where essentially no further support obligations exist. Future license and royalty revenue is expected to consist primarily of royalties received by us for products sold by our licensees. We expect that such license and royalty revenue will not constitute a substantial portion of our revenue in future periods.

 

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Inventories.  Inventories are stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. We record provisions to write down our inventory and related purchase commitments for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about the future demand and market conditions. If actual future demand or market conditions are less favorable than we estimate, additional inventory provisions may be required.

 

Allowance for doubtful accounts.  We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make payments. These estimated allowances are periodically reviewed, analyzing the customers’ payment history and information regarding the customers’ creditworthiness known to us. If the financial condition of any of our customers were to deteriorate, resulting in their inability to make payments, an additional allowance would be required.

 

Accounting for long-lived assets.  We are required to periodically assess the impairment of long-lived assets. An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable.

 

Factors considered important which could trigger an impairment review include, but are not limited to, significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, significant negative industry or economic trends, a significant decline in the stock price for a sustained period, and our market capitalization relative to net book value.

 

When our management determines that the carrying value may not be recoverable based upon the existence of one or more of the above indicators of impairment, any impairment measured is based on a projected discounted cash flow method using a discount rate commensurate with the risk inherent in our current business model.

 

No such impairment was recorded in the first quarter of 2003.  During 2004, we determined that certain intangible long-lived assets were impaired and recorded a loss of $0.2 million under SFAS No. 144. Future events could cause us to conclude that impairment indicators once again exist. Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations.

 

Legal contingencies.     We are currently involved in certain legal proceedings as discussed in note 6. Because of uncertainties related to both the potential amount and range of loss from the pending litigation, management is unable to make a reasonable estimate of the liability that could result if there is an unfavorable outcome in certain of these legal proceedings. We recorded a liability for the In re Tut Systems, Inc. Securities Litigation matter, as well as an equal and corresponding receivable. We have not recorded a liability for the Whalen matter as a consequence of several uncertainties. As additional information becomes available, we will assess the potential liability related to these litigation matters and may revise our estimates accordingly. Revisions of our estimates of such potential liability could materially impact our results of operations, financial condition or cashflows.

 

Recent Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board, the (“FASB”) issued FASB Interpretation No. 46 (FIN 46), “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51, Consolidated Financial Statements,” and subsequently revised in December 2003 with the issuance of FIN 46-R. This interpretation requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. Application of this Interpretation is required in financial statements for periods ending after March 15, 2004.  The adoption of this Interpretation in the period ended March 31, 2004 did not have a material impact on our results of operations, financial position or cash flows.

 

27



 

 

ADDITIONAL RISK FACTORS THAT COULD AFFECT OUR OPERATING RESULTS AND THE MARKET PRICE OF OUR STOCK

 

We have a history of significant losses, and we may never achieve profitability.

 

We have incurred substantial net losses and experienced negative cash flow for each quarter since our inception. As of March 31, we had an accumulated deficit of $286.5 million. We expect to incur losses in the near future. Moreover, we may never achieve profitability and, if we do so, we may not be able to maintain profitability. We may not be able to generate a sufficient level of revenue to offset our current level of expenditures. Moreover, because our expenditures for sales and marketing, research and development, and general and administrative functions are relatively fixed in the short term, we may be unable to adjust our spending in a timely manner to respond to any unanticipated decline in revenue. If we fail to achieve profitability within the timeframe expected by securities analysts or investors, then the market price of our common stock will likely decline.

 

Each sale of our headend systems represents a significant portion of our revenue for any given quarter. Our failure to meet our quarterly forecast of sales of headend systems in any given quarter could have a material adverse impact on our financial results for a given quarter.

 

Since we acquired VTC in November 2002, a large part of our quarterly revenue is associated with the sale of headend systems. Each sale represents a significant portion of our revenue for each quarter. We base our operating forecast on our historical sales. Because of the high cost per unit of our headend systems, if we were to sell even one less system than our forecasted number of headend sales per quarter, such a decrease in sales would have a material and adverse impact on our revenue for that quarter, and we may fail to meet investor expectations.

 

We operate in an intensely competitive marketplace, and many of our competitors have better resources than we do.

 

Our primary competitors in the digital TV headend market are small private companies that are focused on a more narrow product line than ours, thereby allowing these competitors to devote substantially more targeted resources to developing and marketing new products than we can. As we begin to target larger telco customers for our video content processing systems, we expect more competition from large public companies like Harmonic, Inc., Tandberg Television ASA, and Motorola, Inc., all of which have substantially greater financial, technical and other resources than we do. These competitors have

 

28



 

achieved success in providing headend components for cable multiple system operators and satellite TV providers and we expect these competitors to market some of their products for use in TV over DSL applications. For example, in the past, Harmonic provided video content processing systems to SaskTel, a large Canadian telephone service provider. Harmonic also recently announced that it will provide video content processing systems to Video Networks Limited, a video-over-DSL provider in the United Kingdom.

 

Our competition in the market for video transmission processing products primarily comes from small private companies such as SkyStream Networks and public companies such as Optibase Inc. and Tandberg Television that together offer a wide array of products with special features and functions. Our broadband transport and service management business tends to compete against public, private and foreign network equipment companies.

 

To the extent that any of these current or potential future competitors enter or expand further into our markets, develop superior technology and products or offer superior prices or performance features relative to our products, such competition could result in lost sales and severe downward pressure on our pricing, either of which would adversely affect our revenue and profitability.

 

Commercial acceptance of any technological solution that competes with technology based on communication over copper telephone wire could materially and adversely impact demand for our products, our revenue and growth strategy.

 

The markets for video content processing, transmission and high-speed data access systems and services are characterized by several competing communication technologies, including fiber optic cables, coaxial cables, satellites and other wireless facilities. Many of our products are based on communication over copper telephone wire. Because there are physical limits to the speed and distance over which data can be transmitted over copper wire, our products may not be a viable solution for customers requiring service at performance levels beyond the current limits of copper telephone wire. Our customer base is concentrated on telephone service providers that have a large investment in copper wire technology. If these customers lose market share to their competitors who use competing technologies that are not as constrained by physical limitations as copper telephone wire, and that are able to provide faster access, greater reliability, increased cost-effectiveness or other advantages, demand for our products will decrease. Moreover, to the extent that our customers choose to install fiber optic cable or other transmission media as part of their infrastructure, or to the extent that homes and businesses install other transmission media within buildings, demand for our products may decline. The occurrence of any one or more of these events would harm demand for our products, which would thereby adversely affect our revenue and growth strategy.

 

If the projected growth in demand for video services from telephone service providers does not materialize or if our customers find alternative methods of delivering video services, future sales of our video content processing systems will suffer.

 

We manufacture video content processing systems that enable telephone service providers to offer video services to their customers. Our customers, the telephone service providers, face competition from cable companies, satellite service providers and wireless companies. For some users, these competing solutions provide fast access, high reliability and cost-effective solutions for delivering data, including video services. Telephone service providers hope to maintain their market share in their core business of voice telephony as well as increase their revenue per customer by offering their customers more services, including video services and high-speed data services. However, if the telephone service providers find alternative ways of maintaining and growing their market share in their core business that do not require that they offer video services, demand for our products will decrease substantially. Moreover, if technological advancements are developed that allow our customers to provide video services without upgrading their current system infrastructure, or that offer our customers a more cost-effective method of delivering video services, sales of our video content processing systems will suffer. Alternatively, even if the telephone service providers choose our video content processing systems, the service providers may not be successful in marketing video services to their customers, in which case our sales would decrease substantially.

 

29



 

Our operating results fluctuate significantly from quarter to quarter, and this may cause the price of our stock to decline.

 

Over the last 12 quarters, our sales per quarter have fluctuated between $9.2 million and $2.0 million. Over the same periods, our loss from operations as a percentage of revenue has fluctuated between approximately 5.2% and 1,274% of revenue. We anticipate that our sales and operating margins will continue to fluctuate. We expect this fluctuation to continue for a variety of reasons, including:

 

                                          the timing of customers’ purchase decisions, acceptance of our new products and possible cancellations;

 

                                          competitive pressures, including pricing pressures from our partners and competitors;

 

                                          delays or problems in the introduction of our new products;

 

                                          announcements of new products, services or technological innovations by us or our competitors; and

 

                                          management of inventory levels.

 

The sales cycle for video content processing systems is long and unpredictable, which requires us to incur high sales and marketing expenses with no assurance that a sale will result.

 

The sales cycle for our headend systems can be as long as 12-18 months. Additionally, with respect to the sale of our products to U.S. and foreign government organizations, we may experience long sales cycles as a result of government procurement processes. As a result, while we continue to incur costs associated with a particular sale prior to payment from the customer, we may not recognize revenue from efforts to sell particular products for extended periods of time.

 

As a result, our quarter-to-quarter comparisons of our revenue and operating results may not be meaningful and may not provide an accurate indicator of our future performance. Our operating results in one or more future quarters may fail to meet the expectations of investment research analysts or investors, which could cause an immediate and significant decline in the trading price of our common stock.

 

If we fail to accurately forecast demand for our products, our revenue, profitability and reputation could be harmed.

 

We rely on contract manufacturers and third-party equipment manufacturers, or OEMs, to manufacture, assemble, test and package our products. We also depend on third-party suppliers for the materials and parts that constitute our products. Our reliance on contract manufacturers, OEMs and third-party suppliers requires us to accurately forecast the demand for our products and coordinate our

efforts with those of our contract manufacturers, OEMs and suppliers. We often make significant up-front financial commitments with our contract manufacturers, OEMs and suppliers in order to procure the raw materials and begin manufacturing and assembly of the products. If we fail to accurately forecast demand or coordinate our efforts with our suppliers, OEMs and contract manufacturers, we may face supply, manufacturing or testing capacity constraints. These constraints could result in delays in the delivery of our products, which could lead to the loss of existing or potential customers and could thereby result in lost sales and damage to our reputation, which would adversely affect our revenue and profitability. Further, we outsource the manufacturing of our products based on forecasts of sales. If orders for our products exceed our forecasts, we may have difficulty meeting customers’ orders in a timely manner, which could damage our reputation or result in lost sales. Conversely, if our forecasts exceed the orders we actually receive and we are unable to cancel future purchase and manufacturing commitments in a timely manner, our inventory levels would increase. This could expose us to losses related to slow moving and obsolete inventory, which would have a material adverse effect on our profitability.

 

30



 

If we fail to develop and introduce new products in response to the rapid technological changes in the markets in which we compete, we will not remain competitive.

 

The markets for video content processing, transmission and high-speed data access systems are characterized by rapid technological developments, frequent enhancements to existing products and new product introductions, changes in end-user requirements and evolving industry standards. To remain competitive, we must continually improve the performance, features and reliability of our products. For example, advancements in compression technology are leading the video content processing industry to begin the transition to next generation compression standards. These advances will allow for further reductions in the bandwidth required to deliver standard definition video channels and introduce the possibility of delivering high-definition television over bandwidth constrained ADSL lines for the first time. Further advances in compression technology, or the emergence of new industry standards would require that we further redesign our products to incorporate, and remain compatible with, emerging technologies and industry standards.

 

We cannot assure you that we will be able to respond quickly and effectively to technological change. We may have only limited time to enter certain markets, and we cannot assure you that we will be successful in achieving widespread acceptance of our products before competitors can offer products and services similar or superior to our products. If we fail to introduce new products that address technological changes or if we experience delays in our product introductions, our ability to compete would be adversely affected, thereby harming our revenue, profitability and growth strategy.

 

We depend on international sales for a significant portion of our revenue, which subjects our business to a number of risks. If we are unable to generate significant international sales, our revenue, profitability and share price could be materially and adversely affected.

 

Sales to customers outside of the United States accounted for approximately 13.2% and 11.2% for the three months ended March 31, 2003 and 2004, respectively. Sales and operating activities outside of the United States are subject to inherent risks, including fluctuations in the value of the United States dollar relative to foreign currencies; tariffs, quotas, taxes and other market barriers; political and economic instability; restrictions on the export or import of technology; potentially limited intellectual property protection; difficulties in staffing and managing international operations and potentially adverse tax consequences. Any of these factors may have a material adverse effect on our ability to grow or maintain international revenue.

 

We expect sales to customers outside of the United States to represent a significant and growing portion of our revenue. However, we cannot assure you that foreign markets for our products will develop at the rate or to the extent that we anticipate. If we fail to generate significant international sales, our revenue, profitability and share price could be materially and adversely affected.

 

Fluctuations in interest and currency exchange rates may decrease demand for our products.

 

Substantially all of our foreign sales are invoiced in U.S. dollars. As a result, fluctuations in currency exchange rates could cause our products to become relatively more expensive for international customers, thereby reducing demand for our products. We anticipate that we will generally continue to invoice foreign sales in U.S. dollars. We do not currently engage in foreign currency hedging transactions. However, as we expand our current international operations, we may allow payment in foreign currencies and, as a result, our exposure to foreign currency transaction losses may increase. To reduce this exposure, we may purchase forward foreign exchange contracts or use other hedging strategies. However, we cannot assure you that any currency hedging strategy would be successful in avoiding exchange-related losses. Any such losses would adversely impact our profitability.

 

If our contract manufacturers, third-party OEMs and third-party suppliers fail to produce quality products or parts in a timely manner, we may not be able to meet our customers’ demands.

 

We do not manufacture our products. We rely on contract manufacturers and OEMs to manufacture, assemble, package and test substantially all of our products and to purchase most of the raw materials and components used in our products. Additionally, we depend on third-party suppliers to provide quality parts and materials to our contract manufacturers and OEMs, and we obtain some of the key components and sub-assemblies used in our products from a single supplier or a limited group of suppliers. Neither we nor our contract manufacturers or OEMs have any guaranteed supply arrangements with the

 

31



 

suppliers. If our suppliers fail to provide a sufficient supply of key components, we could experience difficulties in obtaining alternative sources at reasonable prices, if at all, or in altering product designs to use alternative components. Moreover, if our contract manufacturers or OEMs fail to deliver quality products in a timely manner, such failure would harm our ability to meet our scheduled product deliveries to customers. Delays and reductions in product shipments could increase our production costs, damage customer relationships and harm our revenue and profitability. In addition, if our contract manufacturers and OEMs fail to perform adequate quality control and testing of our products, we would experience increased production costs for product repair and replacement, and our profitability would be harmed. Moreover, defects in products that are not discovered in the quality assurance process could damage customer relationships and result in product returns or product liability claims, each of which could harm our revenue, profitability and reputation.

 

Design defects in our products could harm our reputation and our revenue, profitability and reputation.

 

Any defect or deficiency in our products could reduce the functionality, effectiveness or marketability of our products. These defects or deficiencies could cause customers to cancel or delay their orders for our products, reduce revenue or render our product designs obsolete. In any of these events, we would be required to devote substantial financial and other resources for a significant period of time to develop new product designs. We cannot assure you that we would be successful in addressing any design defects in our products or in developing new product designs in a timely manner, if at all. Any of these events, individually or in the aggregate, could harm our revenue, profitability and reputation.

 

Our business depends on the integrity of our intellectual property rights. If we fail to adequately protect our intellectual property, our revenue, profitability, reputation or growth strategy could be adversely affected.

 

We attempt to protect our intellectual property and proprietary technology through patents, trademarks and copyrights, by generally entering into confidentiality or license agreements with our employees, consultants, vendors, strategic partners and customers as needed, and by generally limiting access to and distribution of our trade secret technology and proprietary information. However, any of our pending or future patent or trademark applications may not ultimately be issued as patents or trademarks of the scope that we sought, if at all, and any of our patents, trademarks or copyrights may be invalidated, deemed unenforceable, or otherwise challenged. In addition, other parties may circumvent or design around our patents and other intellectual property rights, may misappropriate our proprietary technology, or may otherwise develop similar, duplicate or superior products. Further, the intellectual property laws and our agreements may not adequately protect our intellectual property rights and effective intellectual property protection may be unavailable or limited in certain foreign countries in which we do business or may do business in the future.

 

The telecommunications and data communications industries are characterized by the existence of extensive patent portfolios and frequent intellectual property litigation. From time to time, we have received, and may in the future receive, claims that we are infringing third parties’ intellectual property rights. Any present or future claims, with or without merit, could be time-consuming, result in costly litigation, divert management time and attention and other resources, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us. In addition, any such litigation could force us to cease selling or using certain products or services, or to redesign such products or services. Further, we may in the future initiate claims or litigation against third-parties for infringement of our intellectual property rights or to determine the scope and validity of our intellectual property rights or those of competitors. Such litigation could result in substantial costs and diversion of resources. Any of the foregoing could have an adverse effect upon our revenue, profitability, reputation or growth strategy.

 

If we fail to provide our customers with adequate and timely customer support, our relationships with our customers could be damaged, which would harm our revenue and profitability.

 

Our ability to achieve our planned sales growth and retain customers will depend in part on the quality of our customer support operations. Our customers generally require significant support and

 

32



 

training with respect to our products, particularly in the initial deployment and implementation stage. As our systems and products become more complex, we believe our ability to provide adequate customer support will be increasingly important to our success. We have limited experience with widespread deployment of our products to a diverse customer base, and we cannot assure you that we will have adequate personnel to provide the levels of support that our customers may require during initial product deployment or on an ongoing basis. Our failure to provide sufficient support to our customers could delay or prevent the successful deployment of our products. Failure to provide adequate support could also have an adverse impact on our reputation and relationship with our customers, could thereby prevent us from gaining new customers and could harm our revenue and profitability.

 

If we fail to manage our expanding operations, our ability to increase our revenues and improve our results of operations could be harmed.

 

We anticipate that, in the future, we may need to expand certain areas of our business to grow our customer base and exploit market opportunities. In particular, we expect to face numerous challenges in the implementation of our business strategy to focus on selling our products to the larger, more established service providers. To manage our operations, we must, among other things, continue to implement and improve our operational, financial and management information systems, hire and train additional qualified personnel, continue to expand and upgrade core technologies and effectively manage multiple relationships with various customers, suppliers and other third-parties. We cannot assure you that our systems, procedures or controls will be adequate to support our operations or that our management will be able to achieve the rapid execution necessary to exploit fully the market for our products or systems. If we are unable to manage our operations effectively, our revenue, operations and share price could be harmed.

 

If we are unable to address the material weaknesses in our internal controls that our auditors identified in the fourth quarter of fiscal 2003, such weaknesses could materially and adversely affect our ability to provide the public with timely and accurate material information about our company, which could harm our reputation and share price.

 

In January 2004, our auditors identified deficiencies in our internal controls that they considered to be material weaknesses. Based on these weaknesses, our CEO and CFO determined that, as of December 31, 2003, our disclosure controls and procedures were not sufficient to record, process, summarize and report information required to be reported within the time periods specified by the SEC.  These material weaknesses related to our inventory and our accounts payable processes, both of which affect our balance sheet and may also affect our income statement reporting.  (See page 20 of the Form 10-K/A for further discussion of these weaknesses.)  In order for investors and the equity analyst community to make informed investment decisions and recommendations about our securities, it is important that we provide them with accurate and timely information in accordance with the Exchange Act and the rules promulgated thereunder.  If we cannot do so, investors will sell our shares and industry analysts will either make incorrect recommendations about our company or else end coverage of our company altogether, any of which results could harm our reputation and adversely impact our share price.

 

We are currently engaged in two securities class action lawsuits, either of which, if they were to result in an unfavorable resolution, could adversely affect our reputation, profitability and share price.

 

We are currently engaged as a defendant in two lawsuits (i.e., In re Tut Systems, Inc. Securities Litigation and Whalen v. Tut Systems, Inc. et al.) that allege securities law violations against us and certain of our current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended. While we have reached settlements with the plaintiffs in these lawsuits, the settlements are subject to certain contingencies, including court approval of the terms of settlement. If the courts do not approve these settlements, or any other applicable contingencies are not resolved or otherwise addressed, we would be required to resume litigation in these matters. If we were to resume litigation in these matters, there is no assurance that we would prevail and, if either of the outcomes of such litigation were unfavorable to us, our reputation, profitability and share price could be adversely affected.

 

33



 

If our products do not comply with complex government regulations, our product sales will suffer.

 

We and our customers are subject to varying degrees of federal, state and local as well as foreign governmental regulation. Our products must comply with various regulations and standards defined by the Federal Communications Commission, or FCC. The FCC has issued regulations that set installation and equipment standards for communications systems. Our products are also required to meet certain safety requirements. For example, Underwriters Laboratories must certify certain of our products in order to meet federal safety requirements relating to electrical appliances to be used inside the home. In addition, certain products must be Network Equipment Building Standard certified before certain of our customers may deploy them. Any delay in or failure to obtain these approvals could harm our business, financial condition or results of operations. Outside of the United States, our products are subject to the regulatory requirements of each country in which our products are manufactured or sold. These requirements are likely to vary widely. If we do not obtain timely domestic or foreign regulatory approvals or certificates, we would not be able to sell our products where these regulations apply, which could prevent us from maintaining or growing our revenue or achieving profitability.

 

In addition, regulation of our customers may adversely impact our business, operating results and financial condition. For example, FCC regulatory policies affecting the availability of data and Internet services and other terms on which telecommunications companies conduct their business may impede our entry into certain markets. In addition, the increasing demand for communications systems has exerted pressure on regulatory bodies worldwide to adopt new standards, generally following extensive investigation of competing technologies. The delays inherent in this governmental approval process may cause the cancellation, postponement or rescheduling of the installation of communications systems by our customers, which in turn may harm our sale of products to these customers.

 

If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to manage our business successfully, which could materially and adversely affect our growth strategy, reputation and share price.

 

We depend on the performance of Salvatore D’Auria, our President, Chief Executive Officer and Chairman of the Board, and on other senior management and technical personnel with experience in the video and data communications, telecommunications and high-speed data access industries. The loss of any one of them could harm our ability to execute our business strategy, which could adversely affect our reputation and share price. Additionally, we do not have employment contracts with any of our executive officers. We believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand. We cannot assure you that we will be able to do so.

 

We routinely evaluate acquisition candidates and other diversification strategies.

 

We have completed a number of acquisitions as part of our efforts to expand and diversify our business. For example, we acquired our video content processing and video transmission businesses from Tektronix in November 2002 when we purchased its subsidiary, VTC. We intend to continue to evaluate new acquisition candidates, divestiture and diversification strategies, and if we fail to manage the integration of acquired companies, it could adversely affect our operations and growth strategy. Any acquisition involves numerous risks, including difficulties in the assimilation of the acquired company’s employees, operations and products, uncertainties associated with operating in new markets and working with new customers, and the potential loss of the acquired company’s key employees. Additionally, we may incur unanticipated expenses, difficulties and other adverse consequences relating to the integration of technologies, research and development, and administrative and other functions. Any future acquisitions may also result in potentially dilutive issuances of our equity securities, acquisition or divestiture related write-offs and the assumption of debt and contingent liabilities. Any of the above factors could adversely affect our revenue, profitability, operations or growth strategy.

 

Our stock price is volatile, and, if you invest in our company, you may suffer a loss of some or all of your investment.

 

The market price and trading volume of our common stock has been subject to significant volatility, and this trend may continue. In particular, trading volume historically has been low and the market price of our common stock has increased dramatically in recent months. Since the announcement of

 

34



 

our acquisition of VTC, the closing price of our common stock, as traded on the Nasdaq National Market, has fluctuated from a low of $1.22 to a high of $7.49 per share. The value of our common stock may decline regardless of our operating performance or prospects. Factors affecting our market price include:

 

                                          our perceived prospects;

 

                                          variations in our operating results and whether we have achieved our key business targets;

 

                                          the limited number of shares of our common stock available for purchase or sale in the public markets;

 

                                          differences between our reported results and those expected by investors and securities analysts;

 

                                          announcements of new contracts, products or technological innovations by us or our competitors; and

 

                                          market reaction to any acquisitions, joint ventures or strategic investments announced by us or our competitors.

 

Recent events have caused stock prices for many companies, including ours, to fluctuate in ways unrelated or disproportionate to their operating performance. The general economic, political and stock market conditions that may affect the market price of our common stock are beyond our control. The market price of our common stock at any particular time may not remain the market price in the future. In the past, securities class action litigation has been instituted against companies following periods of volatility in the market price of their securities. Any such litigation, if instituted against us, could result in substantial costs and a diversion of management’s attention and resources.

 

Future sales of shares of our common stock could cause our stock price to decline.

 

Substantially all of our common stock may be sold without restriction in the public markets, subject only in the case of shares held by our officers and directors and affiliates to volume and manner of sale restrictions (other than as described in the following sentence). The approximately 3.3 million shares of common stock that we issued to Tektronix in connection with our November 2002 acquisition of VTC are restricted securities, as that term is defined in Rule 144 under the Securities Act, and therefore subject to certain restrictions. However, we are contractually obligated to file and keep effective a registration statement in order to allow Tektronix to sell these shares to the public. Likewise, Tektronix has the right (subject to certain exceptions) to include these shares in certain registration statements pursuant to which we may sell shares of our common stock.

 

Sales of a substantial number of shares of common stock in the public market, or the perception that these sales could occur could materially and adversely affect our stock price and make it more difficult for us to sell equity securities in the future at a time and price we deem appropriate.

 

Our charter, bylaws, retention and change of control plans and Delaware law contain provisions that could delay or prevent a change in control.

 

Certain provisions of our charter and bylaws and our retention and change of control plans, the “Plans,” may have the effect of making it more difficult for a third-party to acquire, or of discouraging a third-party from attempting to acquire, control of us. The provisions of the charter and bylaws and the Plans could limit the price that certain investors may be willing to pay in the future for shares of our common stock. Our charter and bylaws provide for a classified board of directors, eliminate cumulative voting in the election of directors, restrict our stockholders from acting by written consent and calling special meetings, and provide for procedures for advance notification of stockholder nominations and proposals. In addition, our Board has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further

 

35



 

vote or action by the stockholders. The issuance of preferred stock, while providing flexibility in connection with possible financings or acquisitions or other corporate purposes, could have the effect of making it more difficult for a third-party to acquire a majority of our outstanding voting stock. The Plans provide for severance payments and accelerated stock option vesting in the event of termination of employment following a change of control. The provisions of the charter and bylaws, and the Plans, as well as Section 203 of the Delaware General Corporation Law, to which we are subject, could discourage potential acquisition proposals, delay or prevent a change of control and prevent changes in our management.

 

ITEM 3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We are exposed to changes in interest rates primarily from our investments in certain cash equivalents. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest-sensitive financial instruments at March 31, 2004.

 

We have no investments, nor are any significant sales, expenses, or other financial items denominated in foreign country currencies. All of our international sales are denominated in U.S. dollars. An increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive and, therefore, reduce the demand for our products.

 

ITEM 4.     CONTROLS AND PROCEDURES

 

(a)           Our Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of March 31, 2004. This evaluation included various steps that our Chief Executive Officer and Chief Financial Officer undertook in an effort to ensure that information required to be disclosed in our SEC reports is recorded, processed, summarized and reported within the time periods specified by the SEC and accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosure.  This evaluation also included consideration of our internal controls and procedures for the preparation of our financial statements.  There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention of the controls and procedures.  Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives.  Notwithstanding these limitations, as of the end of the period covered by this report, based upon the evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.

 

During the three months ended March 31, 2004, we implemented the following measures:

 

                                          Perform quarterly physical inventory counts at all locations;

 

                                          Established improved inventory systems and accounting controls, hired additional qualified personnel, improved intra-company communications, implemented appropriate organizational and line of reporting changes; and

 

                                          Established improved procedures for the timely reconciliation and confirmation of accounts payable balances.

 

We implemented these measures because in connection with the completion of PricewaterhouseCoopers LLP’s audit of our financial statements for the year ended December 31, 2003, PricewaterhouseCoopers LLP advised management and the audit committee of the Board of Directors that it had identified deficiencies in our internal controls and processes relating to inventory management and reporting that it considered to be material weaknesses, as defined by Statement on Auditing Standards No. 60, “Communication of Internal Control Related Matters Noted in an Audit.” PricewaterhouseCoopers LLP identified the following two material weaknesses in our internal controls and processes:

 

1.                                       Our internal controls were inadequate to properly record our inventory quantities in an accurate and timely manner; and

 

2.                                       Our accounts payable process failed to adequately reconcile our accounts payable records with suppliers’ records, considering what the suppliers had shipped to us prior to period end.

 

Management believes its new controls and procedures have addressed the conditions identified by PricewaterhouseCoopers LLP as material weaknesses.  We plan to continue to monitor the effectiveness of our internal controls and procedures on an ongoing basis and will take further action as appropriate.

 

36



 

PART II. OTHER INFORMATION

 

ITEM 1.     LEGAL PROCEEDINGS

 

Whalen v. Tut Systems, Inc. et al

 

On October 30, 2001, we and certain of our current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et al., Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District Court for the Southern District of New York. An amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts that the prospectuses from our January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against us and certain of our current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, and under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, and alleges claims against certain of our current and former officers and directors under Sections 15 and 20(a) of the Securities Act. The complaint also names as defendants the underwriters for our initial public offering and secondary offering. Similar suits were filed in the Southern District of New York challenging over 300 other initial public offerings and secondary offerings conducted in 1999 and 2000. Therefore, for pretrial purposes, the Whalen action is being coordinated with the approximately 300 other suits before United States District Court Judge Shira Scheindlin of the Southern District of New York under the matter In Re Initial Public Offering Securities Litigation. The individual defendants in the Whalen action, namely, Nelson Caldwell, Salvatore D’Auria and Matthew Taylor, were dismissed without prejudice by an October 9, 2002 Order of the Court, approving the parties’ October 1, 2002 Stipulation of Dismissal. On February 19, 2003, the Court issued an Opinion and Order denying our motion to dismiss.

 

In June and July 2003, nearly all of the issuers named as defendants in the In Re Initial Public Offering Securities Litigation (collectively, the “issuer-defendants”), including our Company, approved a tentative settlement proposal that is reflected in a memorandum of understanding. Our Board of Directors approved the memorandum of understanding in June 2003 on certain conditions, including the number of issuers participating in the settlement. The memorandum of understanding is not a legally binding agreement. Further, any final settlement agreement would be subject to a number of conditions, most of which would be outside of our control, including approval by the Court. The underwriter-defendants in the In Re Initial Public Offering Securities Litigation (collectively, the “underwriter-defendants”), including the underwriters named in the Whalen suit, are not parties to the memorandum of understanding.

 

The memorandum of understanding provides that, in exchange for a release of claims against the settling issuer-defendants, the insurers of all of the settling issuer-defendants will provide a surety undertaking to guarantee plaintiffs a $1 billion recovery from the non-settling defendants, including the underwriter-defendants. The ultimate amount, if any, that may be paid on our behalf will therefore depend on the final terms of the settlement agreement, including the number of issuer-defendants that ultimately approve the final settlement agreement, and the amounts, if any, recovered by the plaintiffs from the underwriter-defendants and other non-settling defendants. In the event that all or substantially all of the

 

37



 

issuer-defendants approve the final settlement agreement, the amount that we would be required to pay to the plaintiffs could range from zero to approximately $3.5 million, depending on plaintiffs’ recovery from the underwriter-defendants and from other non-settling parties. If the plaintiffs recover at least $1 billion from the underwriter-defendants, we would have no liability for settlement payments under the proposed terms of the settlement. If the plaintiffs recover less than $1 billion, we believe that our insurance will likely cover some or all of our share of any payments towards satisfying plaintiffs’ $1 billion recovery deficit. Management estimates that its range of loss relative to this matter is zero to $3.5 million. Presently there is no more likely point estimate of loss within this range. As a consequence of the uncertainties described above regarding the amount we will ultimately be required to pay, if any, as of March 31, 2004, we have not accrued a liability for this matter.

 

In re Tut Systems, Inc. Securities Litigation, Civil Action No. C-01-2659-JCS (the “Securities Litigation Action”).

 

Beginning July 12, 2001, nine putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of California against us and certain of our current and former officers and directors. The complaints were filed on behalf of a purported class of investors who purchased our stock during the period between July 20, 2000 and January 31, 2001, seeking unspecified damages. The complaints allege that we and certain of our current and former officers and directors made false and misleading statements about our business during the putative class period. Specifically, the complaints allege violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints were consolidated under the name In re Tut Systems, Inc. Securities Litigation, Master File No. C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and lead counsel for plaintiffs were appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on March 29, 2002. On August 15, 2002, the Court granted in part and denied in part the Motion to Dismiss. On September 23, 2002, plaintiffs filed an amended complaint. Defendants filed a Motion to Dismiss the amended complaint, and on August 6, 2003 the Court granted in part that Motion. On September 24, 2003, defendants answered the remaining allegations of the amended complaint. Defendants reached a settlement of the Securities Litigation Action in December 2003. Subject to preliminary and final approval by the Court, our insurance carriers agreed to pay $10 million, on our behalf, to settle the suit. The settlement includes a release of all defendants. The Company has recorded a liability in its financial statements for the proposed amount of the settlement. In addition, because the insurance carriers agreed to pay the entire $10 million settlement amount and, therefore, recovery from the insurance carriers was probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amounts of the settlement and the insurance recovery fully offset each other. The insurance carriers paid the settlement amount to plaintiffs’ escrow agent in January 2004. The Court preliminarily approved the settlement on February 24, 2004. The settlement amount will be paid out of escrow if and when the Court finally approves the settlement. A hearing before the Court to consider final approval of the terms of settlement is currently scheduled for May 14, 2004.  Because the settlement is subject to Court approval, there is no guarantee the settlement will become final.

 

Lefkowitz v. D’Auria, et al

 

On March 19, 2003, Chesky Lefkowitz, one of our stockholders, filed a derivative complaint entitled Lefkowitz v. D’Auria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of our current and former officers and directors. The complaint alleges causes of action for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment, and improper insider stock trading based on the same factual allegations contained in the Securities Litigation Action. The complaint seeks unspecified damages against the individual defendants on our behalf, equitable relief, and attorneys’ fees. On May 21, 2003, we and the individual defendants filed separate demurrers to the complaint. We and the individual defendants reached a settlement of the derivative action in December 2003. The settlement involves our adoption of certain corporate governance measures and payment of attorneys’ fees and expenses to the derivative plaintiff’s counsel in the amount of $722,000 and an incentive award to the derivative plaintiff in the amount of $3,000. We have recorded a liability in our financial statements for the proposed amount of the settlement. In addition, because the insurance carrier involved in this suit agreed to pay the entire $725,000 settlement amount and, therefore, recovery from the insurance carrier was probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amounts of the settlement and the insurance recovery

 

38



 

fully offset each other. The settlement was approved by the Court on January 12, 2004, and, shortly thereafter, the insurance carrier paid the settlement amount to the derivative plaintiff’s counsel. Therefore, in the first quarter of 2004, the $725,000 was removed from the insurance settlement receivable and the legal settlement liability.  The settlement includes a release of our company and the individual defendants.

 

We are subject to other legal proceedings, claims and litigation arising in the ordinary course of business. Our management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on our consolidated financial position, results of operations, or cash flows.

 

ITEM 2.     CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

None

 

ITEM 3.     DEFAULTS UPON SENIOR SECURITIES

 

None

 

ITEM 4.     SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

None 

 

ITEM 5.     OTHER INFORMATION  

 

None

 

ITEM 6.     EXHIBITS AND REPORTS ON FORM 8-K

 

(a) Exhibits

 

Exhibit
Number

 

Description

 

 

 

2.1

 

 

Agreement and Plan of Merger by and among Tut Systems, Inc., Tiger Acquisition Corporation, Tektronix, Inc. and VideoTele.com, Inc. dated as of October 28, 2002.(8)

 

 

 

 

3.1

 

 

Second Amended and Restated Certificate of Incorporation of the Company.(1)

 

 

 

 

3.2

 

 

Bylaws of the Company, as currently in effect.

 

 

 

 

4.1

 

 

Specimen Common Stock Certificate.(1)

 

 

 

 

10.1*

 

 

1992 Stock Plan, as amended, and form of Stock Option Agreement thereunder.(1)

 

 

 

 

10.2*

 

 

1998 Stock Plan and forms of Stock Option Agreement and Stock Purchase Agreement thereunder.(1)

 

 

 

 

10.3*

 

 

1998 Employee Stock Purchase Plan, as amended.(2)

 

 

 

 

10.4*

 

 

1998 Stock Plan Inland Revenue Approved Rules for UK Employees.(3)

 

 

 

 

10.5

 

 

American Capital Marketing, Inc. 401(k) Plan.(1)

 

 

 

 

10.6

 

 

Form of Indemnification Agreement entered into between the Company and each director and officer.(1)

 

39



 

Exhibit
Number

 

Description

 

 

 

 

10.7

 

 

Agreement and General Release between the Company and And Yet, Inc. dated July 31, 1998.(1)

 

 

 

 

10.8

 

 

Home Phoneline Promoters Agreement by and between the Company and IBM Corporation, Hewlett-Packard Company, Compaq Computer Corporation, Advanced Micro Devices, Inc., Intel Corporation, Epigram, Inc., AT&T Wireless Services Inc., 3Com Corporation, Rockwell Semiconductor Systems, Inc. and Lucent Technologies Inc. dated June 1, 1998.(1)

 

 

 

 

10.9

 

 

Master Agreement between the Company and Compaq Computer Corporation dated April 21, 1998 including supplements thereto.(1)

 

 

 

 

10.10

 

 

Extension Agreement among the Company, And Yet, Inc. and Marty Graham dated December 21, 1998.(1)

 

 

 

 

10.11

 

 

Commercial Office Lease between Las Positas LLC and the Company, dated March 8, 2000.(4)

 

 

 

 

10.12*

 

 

Executive Retention and Change of Control Plan.(6)

 

 

 

 

10.13*

 

 

Non-Executive Retention and Change of Control Plan and Summary Plan Description.(6)

 

 

 

 

10.14*

 

 

Non-Qualified Stock Option Agreement issued to Mark Carpenter on March 3, 2000.(6)

 

 

 

 

10.15*

 

 

1999 Non-Statutory Stock Option Plan(7)

 

 

 

 

10.16

 

 

Office Lease Agreement between Kruse Way Office Associates Limited Partnership and VideoTele.com dated April 28, 2000.(9)

 

 

 

 

10.17

 

 

Office Lease Agreement between The Richard Oppenheimer Living Trust, The Maurice Oppenheimer Living Trust, The Helene Oppenheimer Living Trust, and Tut Systems Inc. dated November 2002.(9)

 

 

 

 

10.18

 

 

Agreement for the sale and purchase of the entire share capital of Xstreamis plc, by and among the Company, the shareholders of Xstreamis plc and Philip Corbishley.(5)

 

 

 

 

11.1

 

 

Calculation of net loss per share (contained in Note 3 of Notes to Unaudited Condensed Consolidated Financial Statements).

 

 

 

 

31.1

 

 

Certification of Chief Executive Officer Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.

 

 

 

 

31.2

 

 

Certification of Chief Financial Officer Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.

 

 

 

 

32.1

 

 

Certification of Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

 

32.2

 

 

Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

40



 


(1)                                  Incorporated by reference to our Registration Statement on Form S-1 (File No. 333-60419) as declared effective by the Securities and Exchange Commission on January 28, 1999.

 

(2)                                  Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended March 31, 1999.

 

(3)                                  Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 1999.

 

(4)                                  Incorporated by reference to our Registration Statement on Form S-1 (File No. 333-31446) as declared effective by the Securities and Exchange Commission on March 23, 2000.

 

(5)                                  Incorporated by reference to our Current Report on Form 8-K dated May 26, 2000 as filed June 9, 2000.

 

(6)                                  Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2000.

 

(7)                                  Incorporated by reference to our Schedule TO (File No. 005-58093) filed May 11, 2001.

 

(8)                                  Incorporated by reference to our Current Report on Form 8-K dated October 29, 2002.

 

(9)                                  Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2002.

 

*                                         Indicates management contracts or compensatory plans and arrangements.

 

(b) Reports on Form 8-K.

 

The Company filed the following Current Reports on Forms 8-K during the quarter ended March 31, 2004:

 

On February 2, 2004, the Company furnished a Current Report on Form 8-K regarding the Company’s issuance of a press release stating its earnings for the fourth quarter and year ended December 31, 2003.

 

On April 2, 2004, the Company furnished a Current Report on Form 8-K regarding the Company’s issuance of a press release regarding its preliminary revenue for the first quarter ended March 31, 2004.

 

SIGNATURE

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

TUT SYSTEMS, INC.

 

 

 

 

 

 

 

By:

/s/    RANDALL K. GAUSMAN

 

 

Randall K. Gausman
Vice-President, Finance and
Administration, Chief Financial
Officer and Secretary
(Principal Financial and Accounting
Officer and Duly Authorized
Officer)

 

 

 

Date: May 7, 2004

 

 

 

41



 

INDEX TO EXHIBITS

 

Exhibit
Number

 

Description

 

 

 

2.1

 

 

Agreement and Plan of Merger by and among Tut Systems, Inc., Tiger Acquisition Corporation, Tektronix, Inc. and VideoTele.com, Inc. dated as of October 28, 2002.(8)

 

 

 

 

3.1

 

 

Second Amended and Restated Certificate of Incorporation of the Company.(1)

 

 

 

 

3.2

 

 

Bylaws of the Company, as currently in effect.

 

 

 

 

4.1

 

 

Specimen Common Stock Certificate.(1)

 

 

 

 

10.1*

 

 

1992 Stock Plan, as amended, and form of Stock Option Agreement thereunder.(1)

 

 

 

 

10.2*

 

 

1998 Stock Plan and forms of Stock Option Agreement and Stock Purchase Agreement thereunder.(1)

 

 

 

 

10.3*

 

 

1998 Employee Stock Purchase Plan, as amended.(2)

 

 

 

 

10.4*

 

 

1998 Stock Plan Inland Revenue Approved Rules for UK Employees.(3)

 

 

 

 

10.5

 

 

American Capital Marketing, Inc. 401(k) Plan.(1)

 

 

 

 

10.6

 

 

Form of Indemnification Agreement entered into between the Company and each director and officer.(1)

 

 

 

 

10.7

 

 

Agreement and General Release between the Company and And Yet, Inc. dated July 31, 1998.(1)

 

 

 

 

10.8

 

 

Home Phoneline Promoters Agreement by and between the Company and IBM Corporation, Hewlett-Packard Company, Compaq Computer Corporation, Advanced Micro Devices, Inc., Intel Corporation, Epigram, Inc., AT&T Wireless Services Inc., 3Com Corporation, Rockwell Semiconductor Systems, Inc. and Lucent Technologies Inc. dated June 1, 1998.(1)

 

 

 

 

10.9

 

 

Master Agreement between the Company and Compaq Computer Corporation dated April 21, 1998 including supplements thereto.(1)

 

 

 

 

10.10

 

 

Extension Agreement among the Company, And Yet, Inc. and Marty Graham dated December 21, 1998.(1)

 

 

 

 

10.11

 

 

Commercial Office Lease between Las Positas LLC and the Company, dated March 8, 2000.(4)

 

 

 

 

10.12*

 

 

Executive Retention and Change of Control Plan.(6)

 

 

 

 

10.13*

 

 

Non-Executive Retention and Change of Control Plan and Summary Plan Description.(6)

 

 

 

 

10.14*

 

 

Non-Qualified Stock Option Agreement issued to Mark Carpenter on March 3, 2000.(6)

 

 

 

 

10.15*

 

 

1999 Non-Statutory Stock Option Plan(7)

 

 

 

 

10.16

 

 

Office Lease Agreement between Kruse Way Office Associates Limited Partnership and VideoTele.com dated April 28, 2000.(9)

 

 

 

 

10.17

 

 

Office Lease Agreement between The Richard Oppenheimer Living Trust, The Maurice Oppenheimer Living Trust, The Helene Oppenheimer Living Trust, and Tut Systems Inc. dated November 2002.(9)

 

 

 

 

10.18

 

 

Agreement for the sale and purchase of the entire share capital of Xstreamis plc, by and among the Company, the shareholders of Xstreamis plc and Philip Corbishley.(5)

 

42



 

Exhibit
Number

 

Description

 

 

 

 

11.1

 

 

Calculation of net loss per share (contained in Note 3 of Notes to Unaudited Condensed Consolidated Financial Statements).

 

 

 

 

31.1

 

 

Certification of Chief Executive Officer Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.

 

 

 

 

31.2

 

 

Certification of Chief Financial Officer Pursuant to Section 302(a) of the Sarbanes-Oxley Act of 2002.

 

 

 

 

32.1

 

 

Certification of Chief Executive Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

 

 

 

32.2

 

 

Certification of Chief Financial Officer Pursuant to 18 U.S.C. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 


(1)                                  Incorporated by reference to our Registration Statement on Form S-1 (File No. 333-60419) as declared effective by the Securities and Exchange Commission on January 28, 1999.

 

(2)                                  Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended March 31, 1999.

 

(3)                                  Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 1999.

 

(4)                                  Incorporated by reference to our Registration Statement on Form S-1 (File No. 333-31446) as declared effective by the Securities and Exchange Commission on March 23, 2000.

 

(5)                                  Incorporated by reference to our Current Report on Form 8-K dated May 26, 2000 as filed June 9, 2000.

 

(6)                                  Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2000.

 

(7)                                  Incorporated by reference to our Schedule TO (File No. 005-58093) filed May 11, 2001.

 

(8)                                  Incorporated by reference to our Current Report on Form 8-K dated October 29, 2002.

 

(9)                                  Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2002.

 

*                                         Indicates management contracts or compensatory plans and arrangements.

 

43