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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(Mark One)
X QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ------- EXCHANGE ACT OF 1934
For the quarterly period ended June 28, 2002
-------------
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ------ EXCHANGE ACT OF 1934
For the transition period ended or
---------------------------- ---
Commission File Number 0-15323
NETWORK EQUIPMENT TECHNOLOGIES, INC.
------------------------------------
(Exact name of registrant as specified in its charter)
DELAWARE 94-2904044
- ---------------------------- -----------------------------
(State or other jurisdiction (I.R.S. Employer
of incorporation or Identification Number)
organization)
6900 PASEO PADRE PARKWAY
FREMONT, CA 94555-3660
(510) 713-7300
(Address, including zip code, and telephone number
including area code, of registrant's
principal executive offices)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports) and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No___
The number of shares outstanding of the registrant's Common Stock, par
value $.01, on July 26, 2002 was 22,335,927.
================================================================================
Page 1
NETWORK EQUIPMENT TECHNOLOGIES, INC.
INDEX
-----
Page
Number
------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets at June 28, 2002 and March 29, 2002 3
Condensed Consolidated Statements of Operations and
of Comprehensive Loss - Quarters ended
June 28, 2002 and June 29, 2001 4
Condensed Consolidated Statements of Cash Flows -
Quarters ended June 28, 2002 and June 29, 2001 5
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Results of Operations and Financial Condition 9
Item 3. Quantitative and Qualitative Disclosures about Market Risk 20
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 21
Item 6. Exhibits and Reports on Form 8-K 21
SIGNATURES 22
Page 2
PART I
FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
NETWORK EQUIPMENT TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands except par value)
JUNE 28, MARCH 29,
2002 2002
- -------------------------------------------------------------------------------------------------------------------
ASSETS (unaudited) (1)
Current assets:
Cash and cash equivalents $ 22,466 $ 15,879
Restricted cash 1,555 3,255
Short-term investments 71,266 75,763
Accounts receivable, net of allowances of $2,063 at June 28, 2002 and
$1,896 at March 29, 2002 17,527 19,501
Inventories 16,989 14,804
Prepaid expenses and other assets 5,691 7,262
- -------------------------------------------------------------------------------------------------------------------
Total current assets 135,494 136,464
- -------------------------------------------------------------------------------------------------------------------
Property and equipment, net 37,672 37,972
Software production costs, net 361 563
Goodwill, net - 9,592
Other assets 2,837 2,831
- -------------------------------------------------------------------------------------------------------------------
$ 176,364 $ 187,422
===================================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 6,614 $ 7,870
Accrued liabilities 19,964 21,470
Current portion of capital lease obligation 16 53
- -------------------------------------------------------------------------------------------------------------------
Total current liabilities 26,594 29,393
- -------------------------------------------------------------------------------------------------------------------
Long-term liabilities:
71/4% redeemable convertible subordinated debentures 24,706 24,706
Other long-term liabilities 1,848 2,016
- -------------------------------------------------------------------------------------------------------------------
Total long-term liabilities 26,554 26,722
- -------------------------------------------------------------------------------------------------------------------
Stockholders' equity:
Preferred stock, $.01 par value
Authorized: 5,000 shares
Outstanding: none - -
Common stock, $.01 par value
Authorized: 50,000 shares
Outstanding: 22,336 shares at June 28, 2002 and
22,215 shares at March 29, 2002 223 222
Additional paid-in capital 183,759 184,401
Treasury stock (4,531) (5,581)
Accumulated other comprehensive loss (217) (611)
Retained deficit (56,018) (47,124)
- -------------------------------------------------------------------------------------------------------------------
Total stockholders' equity 123,216 131,307
- -------------------------------------------------------------------------------------------------------------------
$176,364 $ 187,422
===================================================================================================================
See accompanying notes to condensed consolidated financial statements
(1) Derived from the March 29, 2002 audited consolidated financial statements
Page 3
NETWORK EQUIPMENT TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(In thousands, except per share amounts - unaudited)
QUARTERS ENDED
--------------
JUNE 28, JUNE 29,
2002 2001
- -------------------------------------------------------------------------------------------------------------------
Revenue:
Product revenue $ 22,001 $ 16,333
Service and other revenue 5,227 7,536
- -------------------------------------------------------------------------------------------------------------------
Total revenue 27,228 23,869
- -------------------------------------------------------------------------------------------------------------------
Cost of sales:
Cost of product revenue 11,026 9,851
Cost of service and other revenue 4,932 7,222
- -------------------------------------------------------------------------------------------------------------------
Total cost of sales 15,958 17,073
- -------------------------------------------------------------------------------------------------------------------
Gross margin 11,270 6,796
Operating expenses:
Sales and marketing 8,516 9,313
Research and development 6,483 10,553
General and administrative 2,865 3,315
Amortization of goodwill and other intangible assets - 861
Restructure costs 170 -
- -------------------------------------------------------------------------------------------------------------------
Total operating expenses 18,034 24,042
- -------------------------------------------------------------------------------------------------------------------
Loss from operations (6,764) (17,246)
Interest income 747 1,758
Interest expense (509) (468)
Gain on sale of Federal Services Business 5,000 -
Other income 2,199 2,210
- -------------------------------------------------------------------------------------------------------------------
Income (loss) before income taxes 673 (13,746)
Income tax provision (benefit) (25) 26
- -------------------------------------------------------------------------------------------------------------------
Net income (loss) before cumulative change in
accounting principle, relating to goodwill 698 (13,772)
- -------------------------------------------------------------------------------------------------------------------
Cumulative effect of change in accounting principle,
relating to goodwill (9,592) -
- -------------------------------------------------------------------------------------------------------------------
Net loss $ (8,894) $ (13,772)
===================================================================================================================
Loss per share, basic and diluted:
Net income (loss) before cumulative change in accounting principle,
relating to goodwill $ 0.03 $ (0.63)
Cumulative effect of change in accounting principle, relating to goodwill $ (0.43) $ -
Net loss $ (0.40) $ (0.63)
===================================================================================================================
Shares used in per share computation:
Basic and diluted 22,296 21,928
===================================================================================================================
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
- -------------------------------------------------------------------------------------------------------------------
Net loss $ (8,894) $ (13,772)
Other comprehensive income (loss), net of tax:
Cumulative translation adjustments 42 50
Net unrealized gains (losses) on securities,
net of taxes of $0 (352) (213)
- -------------------------------------------------------------------------------------------------------------------
Comprehensive loss $ (8,500) $ (13,935)
===================================================================================================================
See accompanying notes to condensed consolidated financial statements
Page 4
NETWORK EQUIPMENT TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands - unaudited)
QUARTERS ENDED
--------------
JUNE 28, JUNE 29,
2002 2001
- -------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at beginning of period $ 15,879 $ 20,471
Cash flows from operating activities:
Net loss (8,894) (13,772)
Adjustments required to reconcile net loss to net
cash used for operating activities:
Depreciation and amortization 2,414 3,833
Amortization of goodwill and intangibles - 861
Gain on sale of Federal Services Business (5,000) -
Stock compensation - 3
Loss on disposition of property and equipment 7 314
Gain on insurance proceeds (2,187) -
Insurance proceeds 3,258 -
Cumulative effect of change in accounting principle,
relating to goodwill 9,592 -
Changes in operating assets and liabilities:
Accounts receivable 1,974 7,039
Inventories (2,185) (3,178)
Prepaid expenses and other assets 569 (1,819)
Accounts payable (1,286) (872)
Accrued liabilities (1,798) (2,360)
- -------------------------------------------------------------------------------------------------------------------
Net cash used for operating activities (3,536) (9,951)
- -------------------------------------------------------------------------------------------------------------------
Cash flows from investing activities:
Purchases of short-term investments (13,605) (21,307)
Proceeds from maturities of short term investments 18,454 33,169
Purchases of property and equipment (1,849) (4,271)
Proceeds from sale of Federal Services Business 5,000 -
(Increase) decrease in restricted cash 1,700 (513)
Other 2 (128)
- -------------------------------------------------------------------------------------------------------------------
Net cash provided by investing activities 9,702 6,950
- -------------------------------------------------------------------------------------------------------------------
Cash flows from financing activities:
Sale of common stock 410 557
- -------------------------------------------------------------------------------------------------------------------
Net cash provided by financing activities 410 557
- -------------------------------------------------------------------------------------------------------------------
Effect of exchange rate changes on cash 11 77
- -------------------------------------------------------------------------------------------------------------------
Net increase (decrease) in cash and cash equivalents 6,587 (2,367)
- -------------------------------------------------------------------------------------------------------------------
Cash and cash equivalents at end of period $ 22,466 $ 18,104
===================================================================================================================
Other cash flow information: Cash paid (refunded) during the period:
Interest $ 952 $ 902
Income taxes $ (28) $ (55)
Non-cash investing and financing activities:
Unrealized gain (loss) on available-for-sale securities $ 352 $ (213)
See accompanying notes to the condensed consolidated financial statements
Page 5
NETWORK EQUIPMENT TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The condensed consolidated financial statements include the accounts of Network
Equipment Technologies, Inc. and subsidiaries doing business as net.com
("net.com"). Intercompany accounts and transactions have been eliminated.
In the opinion of management, the accompanying unaudited condensed consolidated
financial statements contain all adjustments (consisting only of normal
recurring adjustments) considered necessary to present fairly the financial
position as of June 28, 2002, and the results of operations and cash flows for
the quarters ended June 28, 2002 and June 29, 2001. These financial statements
should be read in conjunction with the March 29, 2002 audited consolidated
financial statements and notes thereto. The results of operations for the
quarter ended June 28, 2002 are not necessarily indicative of the results to be
expected for the fiscal year ending March 28, 2003.
2. INVENTORIES
Inventories are stated at lower of cost (first-in, first-out) or market and
include material, labor and manufacturing overhead costs. Inventories at June
28, 2002 and March 29, 2002 consisted of the following:
(Dollars in thousands) June 28, 2002 March 29, 2002
- --------------------------------------------------------------------------------
Purchased components $ 5,831 $ 5,388
Work-in-process 9,369 8,345
Finished goods 1,789 1,071
- --------------------------------------------------------------------------------
$ 16,989 $ 14,804
================================================================================
3. LOSS PER SHARE
Basic loss per share has been computed based upon the weighted average number of
common shares outstanding for the periods presented. For diluted earnings per
share, shares used in the per share computation include weighted average common
and potentially dilutive shares outstanding. Potentially dilutive shares consist
of shares issuable upon the assumed exercise of dilutive stock options. These
shares totaled 371,000 and 67,000 for the quarters ended June 28, 2002 and June
29, 2001, respectively. The shares for the quarters ended June 28, 2002 and June
29, 2001 were excluded from the per share computation because they were
anti-dilutive. Additionally, there were 784,000 shares of common stock issuable
upon conversion of debentures. These shares, and the related effect of the
accrued interest on the debentures, were not included in the calculation of
diluted earnings per share for the periods June 28, 2002 and June 29, 2001, as
their inclusion would have been anti-dilutive in both periods.
4. OTHER COMPREHENSIVE LOSS
Other comprehensive loss at June 28, 2002 and March 29, 2002 is comprised of
cumulative foreign translation adjustments of ($560,000) and ($602,000),
respectively, and cumulative net unrealized gains (losses) on available-for-sale
securities of $343,000 and ($9,000), respectively.
5. RESTRUCTURE COSTS
During fiscal 2000, net.com recorded two charges in the amount of $3.4 million
and $12.2 million to provide for severance, outplacement and office closure
costs associated with its plan of business reorganization. In fiscal 2001, $1.4
million of these charges were reversed. In fiscal 2002, net.com recorded a
restructuring charge of $1.2 million. This charge included $887,000 for
severance and $300,000 for outplacement costs. The remaining liability for
restructure charges is $503,000 at June 28, 2002. net.com believes that all
costs associated with its plan of business reorganization will be paid no later
than the end of fiscal 2003.
Page 6
6. RECENTLY ISSUED ACCOUNTING STANDARDS
In August 2001, the Financial Accounting Standards Board (FASB) issued Statement
of Financial Accounting Standards (SFAS) No. 144, ACCOUNTING FOR THE IMPAIRMENT
OR DISPOSAL OF LONG-LIVED ASSETS, which addresses financial accounting and
reporting for the impairment or disposal of long-lived assets. While SFAS No.
144 supersedes SFAS No. 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS
AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF, it retains many of the fundamental
provisions of SFAS No. 121. SFAS No. 144 also supersedes the accounting and
reporting provisions of APB No. 30, REPORTING THE RESULTS OF OPERATIONS -
REPORTING THE EFFECTS OF DISPOSAL OF A SEGMENT OF A BUSINESS, AND EXTRAORDINARY,
UNUSUAL AND INFREQUENTLY OCCURRING EVENTS AND TRANSACTIONS, for the disposal of
a segment of a business. However, it retains the requirement in APB No. 30 to
report separately discontinued operations and extends that reporting to a
component of an entity that either has been disposed of (by sale, abandonment,
or in a distribution to owners) or is classified as held for sale. SFAS No. 144
was effective for fiscal years beginning after December 15, 2001 and interim
periods within those fiscal years. The adoption of SFAS No. 144 did not have a
material impact on net.com's consolidated financial statements.
Effective July 1, 2001, the Company adopted SFAS No. 141, BUSINESS COMBINATIONS.
SFAS 141 requires that the purchase method of accounting be used for all
business combinations initiated after June 30, 2001. The adoption of SFAS 141
did not have an impact on the results of operations, financial position or
liquidity of the Company.
In June 2002, the FASB issued SFAS 146, ACCOUNTING FOR COSTS ASSOCIATED WITH
EXIT OR DISPOSAL ACTIVITIES, which addresses financial accounting and reporting
for costs associated with exit or disposal activities and nullifies Emerging
Issues Task Force (EITF) Issue No. 94-3, "Liability Recognition for Certain
Employee Termination Benefits and Other Costs to Exit an Activity (including
Certain Costs Incurred in a Restructuring)." SFAS 146 requires that a liability
for a cost associated with an exit or disposal activity be recognized when the
liability is incurred. Under Issue 94-3, a liability for an exit cost as defined
in Issue 94-3 was recognized at the date of an entity's commitment to an exit
plan. SFAS 146 also establishes that the liability should initially be measured
and recorded at fair value. net.com will adopt the provisions of SFAS 146 for
exit or disposal activities that are initiated after December 31, 2002 and the
adoption will not have an impact on the historical results of operations,
financial position or liquidity of the Company.
7. SALE OF N.E.T. FEDERAL, INC.'S PROFESSIONAL SERVICE BUSINESS
On December 1, 2000, net.com sold the assets of its Federal Services Business
(FSB) to CACI International Inc (CACI) for cash consideration of $40.0 million.
The assets sold were comprised mainly of Federal Government service contracts,
accounts receivable, spares inventory and fixed assets. The total net gain on
the sale to date is $24.9 million. The cash received from CACI to date is $37.0
million. During the quarter ended June 28, 2002 net.com earned and recorded a
gain of $5.0 million as a result of meeting certain milestones. The remaining
$3.0 million is payable in $1.5 million installments during the first quarters
of fiscal 2004 and 2005 and is not contingent upon meeting any milestones.
Additionally, CACI and net.com as a result of the sale, have an existing
agreement whereby net.com will receive royalties based on maintenance contract
revenue.
8. GOODWILL AND OTHER INTANGIBLE ASSETS - ADOPTION OF STATEMENT NO. 142
In July 2001, the FASB issued SFAS No. 142 GOODWILL AND OTHER INTANGIBLE
ASSETS, which establishes financial accounting and reporting for acquired
goodwill and other intangible assets and supercedes APB Opinion No.17 ,
INTANGIBLE ASSETS. net.com adopted SFAS No. 142 on March 30, 2002, the
beginning of its fiscal year. SFAS No. 142 requires that goodwill and intangible
assets that have indefinite useful lives not be amortized but, instead, tested
at least annually for impairment. Accordingly, net.com ceased amortization of
all goodwill on March 30, 2002. Intangible assets that have finite useful lives,
consisting primarily of patents, continue to be amortized over their useful
lives. Any impairment loss will be measured as of the date of adoption and
recognized as the cumulative effect of a change in accounting principle.
The standard requires that goodwill be tested for impairment annually. In the
year of adoption, the standard required a transitional goodwill impairment
evaluation, which was a two-step process. The first step of the goodwill
impairment test, used to identify potential impairment, compares the fair value
of a reporting unit with its carrying amount, including goodwill. If the fair
value of a reporting unit exceeds its carrying amount, goodwill of the reporting
unit is considered not impaired, thus the second step of the impairment test is
unnecessary. If the carrying
Page 7
amount of a reporting unit exceeds its fair value, the second step of the
goodwill impairment test shall be performed to measure the amount of impairment
loss. During the quarter ended June 28, 2002, net.com completed this first step,
which indicated that the goodwill could be impaired.
The second step of the goodwill impairment test used to measure the amount of
impairment loss compares the implied fair value of goodwill with the carrying
amount of the goodwill. If the carrying amount of the goodwill exceeds the
implied fair value of the goodwill, an impairment loss shall be recognized in
amount equal to that excess. As of June 28, 2002, net.com completed this second
step and measured and recognized a transitional impairment loss of $9.6 million
as a cumulative change in accounting principle in its statement of operations.
The following table represents the impact on net loss and basic and diluted per
share from the reduction of amortization of goodwill as if SFAS No. 142 was
adopted in the first quarter of fiscal 2002:
QUARTERS ENDED
--------------
JUNE 28, JUNE 29,
(Dollars in thousands, except for per share amounts) 2002 2001
- ------------------------------------------------------------------------------------
Reported net loss $ (8,894) $ (13,772)
Workforce amortization - 24
Goodwill amortization - 837
- ------------------------------------------------------------------------------------
Adjusted net loss $ (8,894) $ (12,911)
====================================================================================
Basic and diluted loss per share:
Reported basic and diluted loss per share $ (0.40) $ (0.63)
Workforce amortization per share - -
Goodwill amortization per share - 0.04
- ------------------------------------------------------------------------------------
Adjusted basic and diluted loss per share $ (0.40) $ (0.59)
====================================================================================
Common and common equivalent shares used in calculation:
Basic and diluted 22,296 21,928
====================================================================================
Page 8
ITEM 2.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF RESULTS OF OPERATIONS AND FINANCIAL CONDITION
This discussion and analysis should be read in conjunction with Part II of our
Form 10-K for the fiscal year ended March 29, 2002.
Statements contained in this Form 10-Q, which are not historical facts, are
forward-looking statements within the meaning of the federal securities laws
that relate to future events of our financial performance. A forward-looking
statement may contain words such as "plans," "hopes," "believes," "estimates,"
"will continue to be," "will be," "continue to," "expect to," "anticipate that,"
"to be," or "can impact", including statements that relate to products,
customers, operations and contingent payments. Forward-looking statements are
based upon management expectations and involve risks and uncertainties that may
cause actual results to differ materially from those anticipated in the
forward-looking statements. Many factors may cause actual results to vary
including, but not limited to, the factors discussed in this Form 10-Q. net.com
expressly disclaims any obligation or undertaking to revise or publicly release
any updates or revisions to any forward-looking statement contained in this Form
10-Q. Investors should carefully review the risk factors described in this
document along with other documents net.com files from time to time with the
Securities and Exchange Commission.
RESULTS OF OPERATIONS
The following table depicts selected data derived from our consolidated
statements of operations expressed as a percentage of revenue for the periods
presented:
Fiscal years ended: June 28, June 29,
Percent of revenue 2002 2001
- -------------------------------------------------------------------------------------------
Product revenue 80.8% 68.4%
Service and other revenue 19.2 31.6
- -------------------------------------------------------------------------------------------
Total revenue 100.0 100.0
- -------------------------------------------------------------------------------------------
Product revenue gross margin 49.9 39.7
Service and other revenue gross margin 5.6 4.2
- -------------------------------------------------------------------------------------------
Total gross margin 41.4 28.5
- -------------------------------------------------------------------------------------------
Sales and marketing 31.3 39.0
Research and development 23.8 44.2
General and administrative 10.5 13.9
Amortization of intangibles - 3.6
Restructuring costs (benefits) .6 -
- -------------------------------------------------------------------------------------------
Total operating expenses 66.2 100.7
- -------------------------------------------------------------------------------------------
Loss from operations (24.8) (72.3)
Other income (expense), net 26.4 9.3
Interest income (expense), net .9 5.4
- -------------------------------------------------------------------------------------------
Income (loss) before income taxes 2.5 (57.6)
Tax provision (benefit) (0.1) 0.1
- -------------------------------------------------------------------------------------------
Income (loss) before accounting principle change 2.6 (57.7)
Cumulative effect of change in accounting principle (35.2) -
- -------------------------------------------------------------------------------------------
Net loss (32.7)% (57.7)%
- -------------------------------------------------------------------------------------------
Page 9
REVENUE
Total revenue for the first quarter of fiscal 2003 increased 14.1% or $3.4
million to $27.2 million from $23.9 million for the first quarter of fiscal
2002. Product revenue increased 34.7% or $5.7 million to $22.0 million from
$16.3 million compared to the same period in fiscal 2002. Product revenues are
generated primarily from our circuit switched product line, Promina, which
accounts for the majority of product sales worldwide. These revenues remained
strong in the first quarter of fiscal 2003 due to government defense
initiatives, which positively impacted our Federal business, as well as
increased revenues from our international channels. We anticipate this will
continue in the next couple of quarters. We have developed new service creation
products for the broadband equipment and Internet Protocol (IP) telephony
markets. The product revenue from these products in the first quarter of fiscal
2003 was not significant, however, we expect this revenue to increase in the
future.
Service and other revenue for the first quarter of fiscal 2003 decreased 30.6%
to $5.2 million from $7.5 million for the first quarter of fiscal 2002. The
decrease in service and other revenue is primarily the result of a decline in
the non Federal business installed base of equipment that requires ongoing
service support, in addition to the impact of our customers reducing their
operating costs by lowering their levels of service support. As part of our
broadband strategy, we have developed new service creation solutions that we
expect will expand our service offerings and offset part of the decline in
service and other revenue from our narrowband service offerings.
GROSS MARGIN
Total gross margin, comprised of product and service margin, increased as a
percentage of total revenue to 41.4% in the first quarter of fiscal 2003
compared to 28.5% in the first quarter of fiscal 2002. Total gross margins
improved primarily due to the higher volume of product sales and the relatively
fixed cost of operations. Product revenue gross margins in the first quarter of
fiscal 2003 improved to 49.9% from 39.7% in the first quarter of fiscal 2002.
The increase in product gross margin resulted from unfavorable manufacturing
variances mainly due to lower product revenue and a charge of $690,000 for
additional inventory write downs that were required for excess narrowband
inventory in the first quarter of fiscal 2002.
Service and other revenue gross margins increased to 5.6% in the first quarter
of fiscal 2003 as compared to 4.2% in the first quarter of fiscal 2002. There
are a significant amount of services costs that are fixed, and thus lower
revenues may impact margins.
Gross margins may be adversely affected in the future due to increases in
competition, material and labor costs, subcontractor costs and changes in the
mix of products we sell. The new products we introduced recently have lower
gross margins than our Promina product line. In addition, if product sales
decrease as a percentage of total revenue, overall margins may decrease because
service revenue has a lower margin than product sales. Also, to the extent we
expand our sales through product resellers and strategic partnerships, we expect
to earn lower gross margins.
OPERATING EXPENSES
Operating expenses in the first quarter of fiscal 2003 decreased $6.0 million to
$18.0 million compared to $24.0 million in the first quarter of fiscal 2002.
Operating expenses as a percentage of total revenue decreased to 66.2% in the
first quarter of fiscal 2003, compared to 100.7% in the first quarter of fiscal
2002. The lower operating expenses are primarily a result of tightly managed
expenses across all functions.
Sales and marketing expenses in the first quarter of fiscal 2003 decreased
$800,000 to $8.5 million compared to $9.3 million in the first quarter of fiscal
2002. Sales and marketing expenses as a percentage of total revenue decreased to
31.3% in the first quarter of fiscal 2003, compared to 39.0% in the first
quarter of fiscal 2002. The decrease in spending is primarily the result of a
decrease in sales meeting events of $274,000, a decrease in depreciation and
amortization costs of $310,000 and a decrease in facility and information
technology costs of $119,000. We expect sales and marketing expenses to vary as
a percentage of sales volume for the remainder of the fiscal year.
Page 10
Research and development expense in the first quarter of fiscal 2003 decreased
$4.1 million to $6.5 million compared to $10.6 million in the first quarter of
fiscal 2002. Research and development expense as a percentage of total revenue
decreased to 23.8% in the first quarter of fiscal 2003 from 44.2% in the first
quarter of fiscal 2002. The decrease in spending is primarily the result of
higher spending in the first quarter of fiscal 2002 for labor and prototype
material expenses that were required for the new broadband products development.
Decreases occurred primarily in salary related expenses of $2.0 million, a
decrease in engineering material and testing expenses of $1.4 million and a
decrease in depreciation and amortization expenses of $679,000. We expect
research and development spending in future periods to remain constant or to
decrease slightly compared to the first quarter of fiscal 2003 as we balance the
priority of cost control and the importance of development for the new broadband
products.
General and administrative expense in the first quarter of fiscal 2003 decreased
$450,000 to $2.9 million compared to $3.3 million in first quarter of fiscal
2002. General and administrative expense as a percentage of total revenue
decreased to 10.5% in the first quarter of fiscal 2003 from 13.9% in the first
quarter of fiscal 2002. The decrease in spending is primarily the result of
decreased salary related expenses of $154,000, a decrease in legal costs of
$191,000 and a decrease in facility and information technology costs of
$103,000. We expect general and administrative spending to decline slightly due
to continued focus on cost control.
Amortization of goodwill and other intangibles expense in the first quarter of
fiscal 2002 was $861,000. The amortization expense in the first quarter of
fiscal 2002 was a result of two acquisitions, FlowWise Networks, Inc. that
occurred in the third quarter of fiscal 2000 and Convergence Equipment Company
that occurred in the first quarter of fiscal 2001. During the first quarter of
fiscal 2003 we adopted SFAS 142. SFAS 142 requires goodwill to be tested for
impairment under certain circumstances, and written down when impaired, rather
than being amortized as previous standards required. We completed our
implementation test, which resulted in a determination that goodwill was
impaired, causing a charge of $9.6 million in the first quarter of fiscal 2003.
This charge is presented as a cumulative effect of change in accounting
principle, relating to goodwill.
NON-OPERATING ITEMS
Interest income, primarily related to short-term investments decreased $1.0
million in the first quarter of fiscal 2003 to $747,000 compared to $1.8 million
in the first quarter of fiscal 2002. The decrease in interest income is the
result of declining interest rates and lower cash balances.
Interest expense in the first quarter of fiscal 2003 was $509,000 compared to
$468,000 in the first quarter of fiscal 2002. The most significant component of
our interest expense is the interest on the 7 1/4% convertible subordinated
debentures, which was $447,000 for both first quarters of fiscal 2003 and 2002.
Other income in the first quarter of fiscal 2003 increased $5.0 million to $7.2
million compared to $2.2 million in the first quarter of fiscal 2002. Other
income in the first quarter of fiscal 2003 consisted principally of a $5.0
million gain as a result of certain milestones being met as part of the sale of
the Federal Services Business to CACI International Inc, and $2.2 million from
insurance proceeds received for construction costs associated with our new
corporate headquarters in Fremont, California. We do not expect to receive any
additional significant insurance proceeds related to the new corporate
headquarters. Other income in the first quarter of fiscal 2002 consisted
principally of a $2.5 million gain as a result of certain milestones being met
regarding contract renewals as part of the sale of the Federal Services Business
to CACI International Inc.
The first quarter of fiscal 2003 included a tax benefit of $25,000 compared to a
tax provision of $26,000 in the first quarter of fiscal 2002.
SIGNIFICANT ACCOUNTING POLICY JUDGMENTS AND ESTIMATES
The preparation of financial statements in accordance with accounting principles
generally accepted in the United States requires that we make estimates and
judgments, which affect the reported amounts of assets, liabilities, revenues
and expenses, and related disclosures of contingent assets and liabilities. On
an on-going basis, we evaluate our estimates, including those related to sales
returns, bad debts, inventories, investments, intangible assets, income
Page 11
taxes, warranty obligations, restructuring charges, contingencies such as
litigation, and contract terms that have multiple elements and other
complexities typical in the telecommunications equipment industry. We base our
estimates on historical experience and other assumptions that we believe are
reasonable under the circumstances. Actual results may differ from these
estimates under different assumptions or conditions.
We believe the following critical accounting policies affect the more
significant judgments and estimates used in the preparation of our financial
statements.
REVENUE RECOGNITION: We recognize revenue, generally upon shipment, when all
four of the following criteria are met:
1) we have a contract with our customer,
2) when delivery has occurred and risk of loss passes to the customer,
3) when our price is fixed or determinable, and
4) when collection of the receivable is reasonably assured.
For transactions where we have not yet obtained customer acceptance, revenue is
generally deferred until the terms of acceptance are satisfied. Revenue for
installation or other services, except maintenance contact revenue, is
recognized upon completion of the service. Maintenance contract revenue is
recognized ratably over the period of the contract, which is typically one
quarter. A reserve for sales returns is established based on historical trends
in product returns. If the actual future returns differ from historical levels,
our revenue could be adversely affected.
ALLOWANCE FOR DOUBTFUL ACCOUNTS: The allowance for doubtful accounts receivable
is based on our assessment of the collectibility of specific customer accounts
and the aging of accounts receivable. If there is a deterioration of a major
customer's credit worthiness or actual defaults are higher than our historical
experience, our estimates of the recoverability of amounts due us could be
adversely affected.
INVENTORY PROVISIONS: Inventory purchases and commitments are based upon future
demand forecasts. If there is a significant decrease in demand for our products
or there is a higher risk of inventory obsolescence because of rapidly changing
technology and customer requirements, we may be required to make lower of cost
or market adjustments and our gross margin could be adversely affected.
WARRANTY ACCRUALS: We accrue for warranty costs based on the expected material
and labor costs to fulfill our warranty obligations. If we experience an
increase in warranty claims, which are higher than our historical experience,
our gross margin could be adversely affected.
DEFERRED TAXES: We have incurred tax losses in the last four fiscal years and,
at June 28, 2002, we have an estimated $64.8 million of federal net operating
loss carryforwards and an estimated $20.0 million of state operating loss
carryforwards expiring in the years 2020 through 2023. We have provided a full
valuation allowance against our tax assets, given the uncertainty as to their
realization. In future years, these benefits are available to reduce or
eliminate taxes on future taxable income. In addition, if we were to be acquired
by a third-party, these tax losses could be a significant factor in their
valuation of us should they be available to reduce future tax liabilities for
the acquiring company.
IMPAIRMENT OF INTANGIBLE ASSETS: In assessing the recoverability of our
goodwill, we must make assumptions regarding estimated future cash flows and
other factors to determine the fair value of the respective assets. If these
estimates or their related assumptions change in the future, we may be required
to record impairment charges for this asset. On March 30, 2002, we adopted SFAS
No. 142. "GOODWILL AND OTHER INTANGIBLE ASSETS," and completed the analysis of
our goodwill for impairment issues. We recorded an impairment of $9.6 million
during the quarter ended June 28, 2002 related to goodwill.
LIQUIDITY AND CAPITAL RESOURCES
As of June 28, 2002, we had cash and cash equivalents of $22.5 million,
restricted cash of $1.5 million and short-term investments of $71.3 million for
a total of $95.3 million as compared to $94.9 million at the end of fiscal 2002.
The Company benefited from the aforementioned $5.0 million payment received from
CACI, insurance building proceeds of $3.3 million and strong customer cash
collections. This was primarily offset by the result of the net operating losses
and the related effect on cash.
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Net cash used in operating activities in the first quarter of fiscal 2003 was
$3.5 million compared to net cash used in operating activities of $10.0 million
in the first quarter of fiscal 2002. The net decrease in cash used by operations
in the first quarter of fiscal 2003 resulted primarily from a net loss of $8.9
million, an increase in inventory of $2.2 million, a gain on the sale of the
Federal Services Business of $5.0 million, a gain on building insurance proceeds
of $2.2 million, and decreases in accrued liabilities and accounts payable
totaling $3.1 million. Net cash provided by operations included a reduction in
accounts receivable of $2.0 million, a decrease in prepaid expenses of $569,000,
the adjustment for depreciation and amortization of $2.4 million, the receipt
of $3.3 million in cash in relation to our insurance settlement for construction
defects at our previous campus and the cumulative change in accounting principle
for our goodwill write-off of $9.6 million.
Net cash provided from investing activities was $9.7 million in the first
quarter of fiscal 2003, compared to net cash provided from investing activities
of $7.0 million in the first quarter of fiscal 2002. Net cash provided from
investing activities in the first quarter of fiscal 2003 consisted primarily of
proceeds from maturing short term investments of $18.5 million, a decrease in
restricted cash of $1.7 million, and an increase in proceeds received from the
sales of the Federal Services Business of $5.0 million. This is partially offset
by net cash used for investing activities for purchases of short-term
investments of $13.6 million and purchases of property and equipment of $1.8
million.
Net cash provided by financing activities in the first quarter of fiscal 2003
was $410,000 compared to net cash provided by investing activities of $557,000
in the first quarter of fiscal 2002. The $410,000 in the first quarter of fiscal
2003 resulted from the sale of common stock from the employee stock purchase
plan.
We believe that our current cash and cash equivalents, temporary cash
investments and cash flows from operations will be sufficient to fund
operations, purchases of capital equipment and research and development programs
currently planned at least through the next 12 months.
BUSINESS ENVIRONMENT AND RISK FACTORS
Our business is subject to the risks and uncertainties described below. Although
we have tried to identify the material risks to our business, this is not an
all-inclusive list. There may be additional risks not described because either
they have not yet been identified or they are not material now, although they
could arise or become material in the future. Any one of the risks identified
below could materially impact our business, results of operations or financial
condition.
WE HAVE INCURRED NET LOSSES IN THE PAST AND EXPECT TO INCUR LOSSES FOR THE
FORESEEABLE FUTURE.
For each of the past four fiscal years, we have incurred net losses. Our ability
to achieve profitability on a continuing basis will depend upon the successful
design, development, testing, introduction, marketing, and broad commercial
distribution of our new products, specifically our SCREAM(TM) product line and
our SHOUTIP(TM) product line. We expect to continue to incur significant product
development, sales and marketing and administrative expenses as we continue to
maintain support of our existing products and customers while launching new
products. Many of our operating expenses are fixed in the short term making it
difficult to reduce expenses rapidly. At current revenue levels, our operating
expenses continue to be too high to enable us to be profitable. In order to
achieve profitability, we need to generate significant sales growth from our
SCREAM and SHOUTIP product lines or decrease expenses.
OUR OPERATING RESULTS MAY CONTINUE TO FLUCTUATE.
Our operating results vary significantly from quarter to quarter. These
fluctuations are the result of a number of factors, including:
o the volume and timing of orders from and shipments to our customers;
Page 13
o the length and variability of the sales cycle of our products;
o the timing of and our ability to obtain new customer contracts;
o the timing of new products and services;
o the timing and level of prototype expenses;
o the availability of products and services;
o the overall capital expenditures of our customers;
o the market acceptance of new and enhanced versions of our products and
services or variations in the mix of products and services we sell;
o the availability and cost of key components;
o the timing of revenue recognition/deferrals;
o the adoption of new accounting standards;
o the obsolescence of inventories;
o the timing and size of Federal Government budget approvals; and
o general economic conditions as well as those specific to the
telecommunications, Internet and related industries.
Due to the foregoing factors, we believe that quarter-to-quarter comparisons of
our operating results are not a good indication of our future performance. Any
shortfall in revenue may impact our business, results of operations and
financial condition. You should not rely on our results or growth for one
quarter as any indication of our future performance.
OUR STOCK PRICE MAY BE VOLATILE.
Our common stock has experienced substantial price volatility, particularly as a
result of variations between our actual or anticipated financial results and the
published expectations of analysts, and as a result of announcements by our
competitors and us. Volatility in the trading volume for our common stock
results in greater stock price volatility. Futhermore, the stock market has
experienced extreme price and volume fluctuations that have affected the market
price of many companies, in particular technology companies, and that have often
been unrelated to the operating performance of these companies. These factors,
as well as general economic, industry specific, and political conditions may
materially adversely affect the market price of our common stock in the future.
Additionally, volatility or a lack of positive performance in our stock price
may adversely affect our ability to retain key employees, all of whom have been
granted stock options.
WE ARE DEPENDENT ON REVENUE FROM THE PROMINA PRODUCT LINE UNTIL REVENUE FROM OUR
SCREAM AND SHOUTIP PRODUCT LINES INCREASES SUBSTANTIALLY.
Currently, we derive the majority of our product revenue from our Promina
product line, a circuit-based technology. We believe that the market for
circuit-based technology has declined and will continue to decline in the future
as new networks will likely employ packet-based technology. The migration from
circuit to packet-based technology has happened more dramatically in the United
States commercial markets than in the Federal Government market and the rest of
the world. The decline of our business in the United States commercial markets
since fiscal 1999 continues to have a material adverse affect on our business
and results of operations. Should this decline extend into our international and
Federal Government markets in a similar fashion before we gain traction on our
new SCREAM and SHOUTIP product lines, our revenue may not increase to profitable
levels.
A SIGNIFICANT PORTION OF OUR REVENUE IS GENERATED FROM SALES TO THE FEDERAL
GOVERNMENT.
A significant portion of our total revenue from product sales comes from
contracts with the Federal Government, most of which do not include long-term
purchase commitments. Historically, the Federal Government has been slower to
adopt new technology, such as packet-based technology, which has had the effect
of extending the product life of our older products. If the Federal Government
accelerated adoption of new technology by replacing the
Page 14
Promina product line in their networks with products other than ours, our
product revenue would decline sharply. We anticipate that our past experience
will result in future contracts with the Federal Government; however, we face
significant competition in this endeavor. If we fail in renewing a significant
number of Federal Government contracts or if sales to the Federal Government
decline sharply, our revenue may not increase to profitable levels.
RECENT DECLINES IN PURCHASES BY TELECOMMUNICATIONS SERVICE PROVIDERS AND THE
OVERALL DECLINE OF PRODUCT SALES IN THIS MARKET COULD IMPACT SALES OVER THE NEXT
SEVERAL QUARTERS.
Over the last twenty-four months, the financial health of many of the
telecommunications service providers, including many of the companies classified
as CLECs began to deteriorate. In addition, the more established service
providers have cut back on equipment purchases as part of an overall slow down
in economic growth. We believe that many telecommunications equipment companies,
including net.com, are impacted by this decline. In addition, the timing and
volume of purchases by emerging service providers can be unpredictable due to
other factors, including their need to build a customer base and to expand their
capacity while working within their budgetary constraints. Our ability to
recognize revenue from emerging service providers will depend on the relative
financial strength of the particular customer. We may be required to write off
or decrease the value of our accounts receivable from a customer whose financial
condition materially deteriorates. Decreases in purchasing volume of emerging
service providers or changes in the financial condition of emerging service
provider customers could have a material impact on our results of operations and
financial condition in future periods. In addition, the selling cycle of our
SCREAM and SHOUTIP product families could be extended as our service provider
customers reduce their capital budgets.
OUR SUCCESS DEPENDS ON OUR ABILITY TO CONTINUE TO DEVELOP NEW PRODUCTS AND
PRODUCT ENHANCEMENTS THAT WILL ACHIEVE MARKET ACCEPTANCE.
Our operating results will depend to a significant extent on the successful
design, development, testing, introduction, marketing, and broad commercial
distribution of our new broadband equipment products, specifically our SCREAM
product line and to a lesser extent on our SHOUTIP product line. The success of
these and other new products is dependent on several factors, including proper
new product definition, competitive product cost, timely completion and
introduction of new products, differentiation of new products from those of our
competitors and market acceptance of these products. The markets for our
products are characterized by rapidly changing technology, evolving industry
standards, frequent new product introductions and evolving methods of building
and operating networks. Our SCREAM and SHOUTIP product lines target start-up
telecommunications companies and long established domestic carriers such as
AT&T, BellSouth, SBC Communications, Sprint, and Verizon. We may not
successfully identify new product opportunities, develop and bring new products
to market in a timely manner, or achieve market acceptance of our products.
Products and technologies developed by others may render our products or
technologies obsolete or non-competitive which in turn could adversely affect
our ability to achieve profitability.
OUR ABILITY TO SUCCESSFULLY COMMERCIALIZE SCREAM WILL DEPEND HEAVILY ON THE
WIDESPREAD ACCEPTANCE OF SERVICE CREATION AS A MEANS OF ACHIEVING MAXIMUM
NETWORK PRODUCTIVITY AND ON APPROPRIATE REGULATORY INCENTIVES.
Over the last five years, carriers generated revenue by adding more customers or
by offering additional services to existing customers. Offering additional
services to an existing subscriber base is generally a preferred approach to
generating additional revenue, but these services typically require network
upgrades and the purchase of expensive equipment. Over time, however, carriers'
aggressive price discounts, expensive direct marketing campaigns, and massive
capital outlays for infrastructure expansions have offset whatever incremental
revenue increases were generated by the new services and have eroded the
profitability of these companies. Since the second quarter of fiscal 2000, we
have spent the majority of our research and development and marketing resources
to position ourselves and our SCREAM family of products as the next generation
of telecommunications equipment that will enable carriers to maximize the
delivery of new services while leveraging their existing networks and ensuring
quality of service. The future success of the SCREAM product will depend in
large measure on carriers' acceptance of service creation as the vehicle that
will deliver revenue increases sought after by them. Failure to achieve this
acceptance could affect our ability to sell the SCREAM product and grow overall
revenue.
In addition, without deregulation in the United States and overseas, the
economic incentive for the incumbent carrier to actively engage in changing
their service delivery model to the service creation delivery model is low.
While the 1999 decision by the FCC not to force incumbent local exchange
carriers to unbundle their ATM infrastructure, thus
Page 15
allowing incumbents to deny competitive carriers access to their ATM networks,
has made the service creation model viable for carrier revenue growth, it
remains to be seen whether or not the regulatory structure in other countries
will set the stage for the service creation model to take hold. Failure to
achieve the regulatory structure favorable to the service creation model
overseas could affect our ability to sell the SCREAM product overseas and to
grow overall revenue.
TO SUCCESSFULLY MARKET OUR PRODUCTS, WE WILL NEED TO SIGN UP SIGNIFICANT NEW
STRATEGIC PARTNERS WHO CAN HELP SELL OUR PRODUCTS INTO THE SERVICE PROVIDER
MARKET.
In order to successfully market our products, we will need to sign up new
strategic partners, such as software application partners, systems integrators
and product original equipment manufacturers (OEMs), or resellers. The
importance of the software application partners is that they provide critical
functions, such as billing, mediation, provisioning and configuration that are
needed to create a total service creation solution for our customers. Product
OEM or resale partners will be needed to supplement and enhance our existing
direct sales force both in the United States and overseas. Service providers
rely on systems integrators to support new equipment or services into their
network. These integrators are important in the large incumbent carrier networks
and could facilitate our entry into those networks. While we have begun the
process of identifying and signing software application, system integrator and
OEM or resale partners, more partners may be necessary in all these areas for us
to be successful. In particular, we may need to find strategic partners to
assist us with the integration of security functions, such as digital
certificates, third-party firewall, intrusion detection and public key
management to meet evolving security needs, as well as to counter rival efforts
to assert differentiation in the security area. Additionally, we may need to
pursue partnerships with vendors who have optical core and core routing
technologies in order to counter the end-to-end solution providers, such as
Alcatel, Cisco, Lucent, Nortel, and Siemens, as well as to bolster our
co-marketing efforts. Failure to sign up these new strategic partners could
affect our ability to grow overall revenue.
GROSS MARGINS COULD DECLINE OVER FUTURE PERIODS.
Due to increases in competition, material and labor costs, subcontractor costs
and changes in the mix of products we sell, we expect that our gross margins
could decline in future quarters. The new products we introduced recently have
lower gross margins than our Promina product line. In addition, if product sales
decrease as a percentage of total revenue, overall margins may decrease because
service revenue has a lower margin than product sales. Also, to the extent we
expand our sales through product resellers and strategic partnerships, we expect
to earn lower gross margins.
FACTORS BEYOND OUR CONTROL COULD AFFECT OUR ABILITY TO SELL INTO INTERNATIONAL
MARKETS.
As a general rule, international sales tend to have risks that are difficult to
foresee and plan for, including political and economic stability, regulatory
changes, currency exchange rates, changes in tax rates and structures, and
collection of accounts receivable. Further, our international markets are served
primarily by non-exclusive resellers who themselves may be severely impacted by
economic or market changes within a particular country or region. Unforeseen or
unpredictable changes in international markets could have a material adverse
effect on our business, results of operations and financial condition.
THE DIVESTITURE OF OUR FEDERAL SERVICES BUSINESS MAY NOT BE SUCCESSFUL.
On December 1, 2000, we closed the sale of our FSB to CACI, which will continue
to provide maintenance and other services to our Federal Government customers.
We continue to sell net.com products directly to the Federal Government and,
additionally, have a strategic alliance with the acquirer, CACI, to jointly
market each other's products and services. For the divestiture to be successful,
CACI must continue to provide the level of service to which our customers have
become accustomed. Should CACI experience difficulties in providing those
services, it could impact purchasing decisions for our product and cause
customers to seek products from other vendors.
INCREASED COMPETITION IS LIKELY IN THE FUTURE.
The market for telecommunication equipment is highly competitive, dynamic and
characterized by rapid changes to and the convergence of technologies, and a
worldwide migration from existing circuit technology to the new packet-based
technologies. We compete directly internationally and domestically with many
different companies, some of
Page 16
which are large, established suppliers of end-to-end solutions, such as Alcatel,
Cisco, Lucent, Nortel, and Siemens. In addition, there are a number of smaller
companies that are targeting this market, including Celox, Clarent, CoSine,
Ellacoya, Juniper, Nuera, Quarry, and others. Some of our competitors have
significantly greater financial, marketing and technical resources than we have
and offer a wider range of networking products than we offer. They are often
able to devote greater resources to the development, marketing and sale of their
products and to use their equity or significant cash reserves to acquire other
companies with technology and/or products that compete directly with ours. They
often can compete favorably on price because their large product selection
allows them to bundle multiple solutions together without significantly
impacting their overall product margins. The smaller companies have more ability
than net.com to focus their resources on a particular product development
unencumbered by the requirements to support an existing product line. As a
result of the flexibility of their market strategies, our competitors may be
able to obtain strategic advantages that may adversely affect our business,
financial condition or results of operations.
In addition, the networking equipment market has seen the constant introduction
of new technologies that has reduced the value of older technology solutions.
This has created pricing pressure on older products while increasing the
performance expectations of newer networking equipment. Moreover, broadband
technology standards are constantly evolving and alternative technologies or
technologies with greater capability are constantly introduced and sought by our
customers. It is possible that the introduction of other technologies will
either supplant our current technologies and technologies we have in development
or will require us to significantly lower our prices in order to remain
competitive. To remain competitive, we must continue to evolve our SCREAM and
SHOUTIP product lines to meet the ever-changing technology needs of the
networking market while ensuring that they can be sold at a competitive price.
We also must enhance our Promina product line to provide needed features that
increase their overall value proposition for the customer while keeping the
price competitive. Due to the competitive nature of the market and the relative
age of our Promina product offerings as well as the competitive pressure being
exerted on our SCREAM and SHOUTIP technologies, we may not be able to maintain
prices for them at levels that will sustain profitability over the short or long
term.
OUR INABILITY TO SIGN COMPETITIVE RESALE PARTNERS INTERNATIONALLY COULD
SIGNIFICANTLY AFFECT FUTURE PRODUCT AND SERVICE REVENUE.
Because the transition from circuit to packet technology is slower outside the
United States, we expect international sales will continue to account for a
significant portion of our Promina product sales (other than that sold in the
Federal channel) in future periods. Our international sales are made almost
entirely through indirect channels that include distributors and resellers
worldwide. They do not have minimum purchase requirements that they must meet.
While we require them to use their best efforts to resell our products, because
our product line is small, our distributors and resellers must often resell
product lines from other networking companies, including our competitors, such
as Cisco, in order to sustain a profit. Because of the size of Cisco and its
dominant position in the network equipment market, it is difficult for us to
find a distributor or reseller who does not resell Cisco products. Because our
distributors and resellers often have pre-existing competitive relationships,
our distributors and resellers are not always successful in promoting our
products thereby impacting the sustainability of our international product
sales. If we cannot develop relationships with distributors and resellers that
can effectively market and sell our products and services, we may not be able to
meet our forecasted revenue in future quarters.
OUR PRODUCTS HAVE LONG SALES CYCLES, MAKING IT DIFFICULT TO PREDICT WHEN A
CUSTOMER WILL PLACE AN ORDER AND WHEN TO FORECAST REVENUE FROM THE RELATED SALE.
Our products are very complex pieces of networking equipment and represent a
significant capital expenditure to our customers. The purchase of our products
can have a significant impact on how a customer designs its network and provides
services either within its own organization or to an external customer.
Consequently, our customers often engage in extensive testing and evaluation of
products before purchase. There are also numerous financial and budget
considerations and approvals that the customer often must obtain before it will
issue a purchase order. As a result, the length of our sales cycle can be quite
long, up to a year in some cases. In addition, our customers, including
resellers, have the contractual right to delay scheduled order delivery dates
with minimal penalties and to cancel orders within specified time frames without
penalty. The ability to delay or cancel orders makes it difficult to predict
whether or not an order may actually ship. Moreover, while customers may tell us
that they are planning to purchase our products, to ensure a purchase order is
placed, we often must incur substantial sales and marketing expense. If the
order is not placed in the quarter forecasted because approvals took longer than
anticipated by the customer, our sales may not meet forecast and revenues may
continue to be insufficient to meet expenses.
Page 17
OUR BACKLOGGED PRODUCT ORDERS HAVE BEEN UNPREDICTABLE; MAKING IT DIFFICULT FOR
US TO ACCURATELY FORECAST SALES AND CREATES A RISK OF CARRYING TOO MUCH OR TOO
LITTLE INVENTORY.
Historically, the majority of our revenue in each quarter has resulted from
orders received and shipped in that quarter. While we do not believe that
backlog is necessarily indicative of future revenue levels, our customers'
ordering patterns and the absence of backlogged orders create a significant risk
that we could carry too much or too little inventory if orders do not match
forecasts. Rather than base forecasts on orders received, we have been forced to
schedule production and commit to certain expenses based more upon forecasts of
future sales, which are difficult to predict in the telecommunications industry.
Furthermore, if large orders do not close when forecasted or if near-term demand
weakens for the products we have available to ship, our operating results for
that quarter or subsequent quarters would be materially adversely affected.
IF WE ARE UNABLE TO RETAIN EXISTING EMPLOYEES AND ATTRACT, RECRUIT AND RETAIN
KEY PERSONNEL, THEN WE MAY NOT BE ABLE TO SUCCESSFULLY MANAGE OUR BUSINESS.
Our success continues to be dependent on our being able to attract and retain
highly skilled engineers, managers and other key employees. If there is a sharp
upturn in the economy, especially in the telecommunications industry, we may not
be able to continue to attract, recruit and retain key personnel, particularly
engineers and sales and marketing employees, and therefore we may be unable to
meet important company objectives such as product delivery deadlines and sales
targets.
WE RELY ON A NUMBER OF SOLE SOURCE SUPPLIERS FOR OUR COMPONENT PARTS.
We purchase key components from single source suppliers, in particular, our back
planes, ASICs and power supplies. If our sole source suppliers or we fail to
obtain components in sufficient quantities when required, delivery of our
products could be delayed resulting in decreased revenues. In addition, if one
of these suppliers were no longer able to supply a required component, we may
have to significantly reengineer the affected product. Further, variability in
demand and cyclical shortages of capacity in the semiconductor industry have
caused lead times for ordering parts to increase from time to time. If we
encounter shortages or delays in receiving ordered components or if we are not
able to accurately forecast our ordering requirements, we may be unable to ship
ordered products in a timely manner.
WE SINGLE SOURCE OUR MANUFACTURING PROCESS, A FAILURE OR DELAY BY THAT VENDOR
COULD IMPACT OUR ABILITY TO SHIP OUR PRODUCTS TIMELY.
We currently subcontract some testing and all product manufacturing to one
company, Solectron. Final test and assembly is generally performed at our
Fremont, California facility. While subcontracting creates substantial cost
efficiencies in the manufacturing process, it also exposes us to delays in
product shipments should Solectron be unable to perform under our contract. In
addition, should Solectron in some future period decide not to renew our
contract with them, it would be difficult for us to quickly transfer our
manufacturing requirements to another vendor, likely causing substantial delays
in customer product shipments and impacting revenue and our results of
operations.
OUR INTELLECTUAL PROPERTY RIGHTS MAY NOT BE ADEQUATE TO PROTECT OUR BUSINESS.
Our future success depends upon our proprietary technology. Although we attempt
to protect our proprietary technology through patents, copyrights, and trade
secrets, we cannot predict whether such protection will be adequate, or whether
our competitors can develop similar technology independently without violating
our proprietary rights. As competition in the communications equipment industry
increases and the functionality of the products in this industry further
overlap, we believe that companies in the communications equipment industry may
become increasingly subject to infringement claims. We have received and may
continue to receive notice from third parties, including some of our
competitors, claiming that we are infringing their patents or their other
proprietary rights. We cannot predict whether we will prevail in any litigation
over third-party claims, or that we will be able to license any valid and
infringed patents on commercially reasonable terms. Any of these claims, whether
with or without merit, could result in costly litigation, divert our
management's time, attention and resources, delay our product shipments or
require us to enter into royalty or licensing agreements. In addition, a
third-party may not be willing to enter into a royalty or licensing agreement on
acceptable terms, if at all. If a claim
Page 18
of product infringement against us is successful and we fail to obtain a license
or develop or license non-infringing technology, we may be unable to market the
affected product.
WE NEED TO CONTINUE TO LICENSE PRODUCTS FROM THIRD PARTIES.
For our Promina, SCREAM and SHOUTIP products, we license some of our technology
from third parties. If the relevant licensing agreement expires or is terminated
without our being able to renew that license on commercially reasonable terms,
or if we cannot obtain a license for our new and legacy products or enhancements
on our existing products we may be unable to market the affected product.
WE FACE RISKS ASSOCIATED WITH CHANGES IN TELECOMMUNICATIONS REGULATIONS AND
TARIFFS.
Changes in domestic and international telecommunications requirements could
affect the sales of our products. In the United States, our products must comply
with various FCC requirements and regulations. In countries outside of the
United States, our products must meet various requirements of local
telecommunications authorities. Changes in tariffs or failure by us to obtain
timely approval of products could impact our ability to market the affected
product.
In addition, there are currently few laws or regulations that govern access or
commerce on the Internet. If individual countries, or groups of countries,
acting in concert, began to impose regulations or standards on Internet access
or commerce including voice-over-IP, our ability to sell our new SCREAM and
SHOUTIP products or other new products would be adversely impacted if the
regulations or standards resulted in decreased demand or increased costs for our
products.
In North America, the former Regional Bell Operating Companies (RBOCs) require
that Telcordia certify equipment under their Osmine program in order to ensure
interoperability with other network elements and operational support systems.
This is a very expensive and lengthy process. We have initiated plans to become
Osmine certified. Any delays or problems with attaining this certification could
have a material adverse impact on our business, operating results, and financial
condition.
WE ARE EXPOSED TO FLUCTUATIONS IN THE EXCHANGE RATES OF FOREIGN CURRENCY.
As a global concern, we face exposure to adverse movements in foreign currency
exchange rates. These exposures may change over time as business practices
evolve and could have a material adverse impact on our financial results.
Historically, our primary exposures have been related to non-dollar denominated
sales in the United Kingdom, France, and Germany and non-dollar denominated
operating expenses in Europe, Latin America, and Asia where we sell primarily in
United States dollars. The use of the Euro as a common currency for members of
the European Union could impact our foreign exchange exposure. We will continue
to monitor our exposure and may hedge against these or any other emerging market
currencies as necessary. In fiscal 2003 we commenced using foreign exchange
contracts to hedge significant accounts receivable and intercompany account
balances denominated in foreign currencies. Market value gains and losses on
these hedge contracts are substantially offset by fluctuations in the underlying
balances being hedged.
THE LOCATION OF OUR FACILITIES SUBJECTS US TO THE RISK OF EARTHQUAKE AND FLOODS.
Our corporate headquarters, including most of our research and development
operations and our manufacturing facilities, are located in the Silicon Valley
area of Northern California, a region known for seismic activity. These
facilities are located near the San Francisco Bay where the water table is quite
close to the surface and where we have experienced water intrusion problems in
the facilities we recently vacated. In particular, unknown defects in the
construction of our new facilities combined with the proximity to water may
result in future water infiltration problems for net.com. A significant natural
disaster, such as an earthquake or flood, could have a material adverse impact
on our business, operating results, and financial condition.
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ITEM 3.
QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK
In the first quarter of fiscal 2003 we began using foreign exchange contracts to
hedge significant accounts receivable and intercompany account balances
denominated in foreign currencies. Market value gains and losses on these hedged
contracts are substantially offset by fluctuations in the underlying balances
being hedged. The net financial impact of foreign exchange gains and losses has
not been material. A 10% increase or decrease in the foreign currency rates
would not have a significant effect on our business, operating results and
financial condition. Our policy is to not use hedges or other derivative
financial instruments for speculative purposes.
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PART II.
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On May 4, 2000, net.com reached an agreement of settlement and release with
Vigilant Insurance Company under a commercial insurance coverage policy in
connection with a water infiltration problem affecting our former facilities.
Pursuant to the settlement, we subrogated our claims against third parties for
damages from the water infiltration problem to Vigilant. This subrogation made
it possible for Vigilant to file a complaint in the Superior Court of California
for the County of Alameda on January 11, 2002 against, among other parties,
South Bay Construction Company, Inc. for recovery of damages in connection with
the water infiltration problem. On April 3, 2002, South Bay filed a cross
complaint against us in this action alleging breach of contract and negligence
and seeking indemnity, a declaratory judgment regarding the parties respective
rights and obligations under their respective contracts, and damages for breach
of contract and negligence. Vigilant has agreed to enter a defense on behalf of
net.com to the cross complaint.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
99.1 Certification Pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002, filed herewith.
99.2 Certification Pursuant to 18 U.S.C. Section 1350, as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act
of 2002, filed herewith.
(b) Report on Form 8-K
None
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SIGNATURES
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.
NETWORK EQUIPMENT
TECHNOLOGIES, INC.
Dated: August 9, 2002 /s/ Hubert A.J. Whyte
---------------------------------
Hubert A.J. Whyte
President and Chief Executive Officer
/s/ John F. McGrath, Jr.
---------------------------------
John F. McGrath, Jr.
Vice President and
Chief Financial Officer
(Principal Financial and
Accounting Officer)
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