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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 December 27, 2002
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________________ to ______________________
Commission File Number 0-15323
NETWORK EQUIPMENT TECHNOLOGIES, INC.
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(Exact name of registrant as specified in its charter)
Delaware 94-2904044
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(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
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(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 |_|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act):
Yes |X| No |_|
The number of shares outstanding of the registrant's Common Stock, par
value $.01, on February 6, 2003 was 22,633,193.
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NETWORK EQUIPMENT TECHNOLOGIES, INC.
INDEX
Page
Number
------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets at December 27, 2002
and March 29, 2002 3
Condensed Consolidated Statements of Operations and
Comprehensive Loss - Quarter and Nine Months ended
December 27, 2002 and December 28, 2001 4
Condensed Consolidated Statements of Cash Flows -
Nine Months ended December 27, 2002 and December 28, 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 21
Item 4. Disclosure Controls and Procedures 21
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 21
Item 6. Exhibits and Reports on Form 8-K 22
SIGNATURES 22
PART I
FINANCIAL INFORMATION
Item 1. Financial Statements
NETWORK EQUIPMENT TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited -in thousands, except par value)
December 27, March 29,
2002 2002
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(1)
Assets
Current assets:
Cash and cash equivalents $ 14,993 $ 15,879
Restricted cash 1,364 3,255
Short-term investments 72,080 75,763
Accounts receivable, net of allowances of $985 at
December 27, 2002 and $1,896 at March 29, 2002 19,046 19,501
Inventories 16,336 14,804
Prepaid expenses and other assets 4,623 7,262
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Total current assets 128,442 136,464
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Property and equipment, net 36,111 37,972
Software production costs, net 169 563
Goodwill, net -- 9,592
Other assets 2,766 2,831
============================================================================================
$ 167,488 $ 187,422
============================================================================================
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 7,067 $ 7,870
Accrued liabilities 19,994 21,470
Current portion of capital lease obligation -- 53
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Total current liabilities 27,061 29,393
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Long-term liabilities:
7 1/4% redeemable convertible subordinated debentures 24,706 24,706
Other long-term liabilities 1,807 2,016
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Total long-term liabilities 26,513 26,722
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Stockholders' equity:
Preferred stock, $.01 par value
Authorized: 5,000 shares
Outstanding: none -- --
Common stock, $.01 par value
Authorized: 50,000 shares
Outstanding: 22,489 shares at December 27, 2002 and
22,215 shares at March 29, 2002 225 222
Additional paid-in capital 183,520 184,401
Treasury stock (3,408) (5,581)
Accumulated other comprehensive income (loss) 23 (611)
Accumulated deficit (66,446) (47,124)
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Total stockholders' equity 113,914 131,307
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$ 167,488 $ 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)
Quarter ended Nine months ended
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Dec. 27, Dec. 28, Dec. 27, Dec. 28,
2002 2001 2002 2001
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Revenue:
Product revenue $ 27,991 $ 19,379 $ 73,087 $ 54,072
Service and other revenue 5,014 6,731 15,212 20,758
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Total revenue 33,005 26,110 88,299 74,830
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Cost of sales:
Cost of product revenue 14,195 14,042 39,295 35,781
Cost of service and other revenue 4,582 5,680 14,315 19,110
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Total cost of sales 18,777 19,722 53,610 54,891
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Gross margin 14,228 6,388 34,689 19,939
Operating expenses:
Sales and marketing 7,880 7,476 24,279 25,293
Research and development 6,366 6,905 19,533 26,784
General and administrative 2,707 2,836 8,479 9,211
Amortization of goodwill and other intangible assets -- 861 -- 2,583
Restructuring costs 689 899 1,861 899
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Total operating costs 17,642 18,977 54,152 64,770
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Loss from operations (3,414) (12,589) (19,463) (44,831)
Interest income 566 972 1,929 4,593
Interest expense (491) (468) (1,504) (1,395)
Gain on sale of federal services business -- 2,500 5,000 5,000
Other income (expense) 167 61 2,348 (1)
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Loss before income taxes (3,172) (9,524) (11,690) (36,634)
Income tax provision (benefit) 32 (1,347) (2,297) (1,330)
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Loss before cumulative change in
accounting principle, relating to goodwill (3,204) (8,177) (9,393) (35,304)
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Cumulative effect of change in accounting principle,
relating to goodwill -- -- (9,592) --
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Net loss $ (3,204) $ (8,177) $(18,985) $(35,304)
=======================================================================================================
Basic and diluted loss per share:
Loss before cumulative effect of change in
accounting principle relating to goodwill $ (0.14) $ (0.37) $ (0.42) $ (1.60)
Cumulative effect of change in accounting
principle relating to goodwill -- -- (0.43) --
Net loss $ (0.14) $ (0.37) $ (0.85) $ (1.60)
=======================================================================================================
Shares used in per share computation:
Basic and diluted 22,476 22,116 22,383 22,052
=======================================================================================================
Consolidated Statements of Comprehensive Loss
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Net loss $ (3,204) $ (8,177) $(18,985) $(35,304)
Other comprehensive income (loss), net of tax:
Cumulative translation adjustments (7) 41 47 41
Net unrealized gains (losses) on securities,
net of taxes of $0 14 (486) 588 (338)
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Comprehensive loss $ (3,197) $ (8,622) $(18,350) $(35,601)
=======================================================================================================
See accompanying notes to condensed consolidated financial statements
Page 4
NETWORK EQUIPMENT TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands - unaudited)
Nine months ended
-----------------
Dec. 27, Dec. 28,
2002 2001
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Cash and cash equivalents at beginning of period $ 15,879 $ 20,471
Cash flows from operating activities:
Net loss (18,985) (35,304)
Adjustments required to reconcile net loss to net
cash used for operating activities:
Depreciation and amortization 7,027 10,199
Amortization of goodwill and other intangibles -- 2,583
Gain on sale of federal services business (5,000) (5,000)
Stock compensation -- 9
Loss on disposition of property and equipment 7 536
Gain on insurance proceeds for construction cost (2,380) --
Insurance proceeds for construction costs 3,451 --
Cumulative effect of change in accounting principle,
relating to goodwill 9,592 --
Changes in operating assets and liabilities:
Accounts receivable 455 7,934
Inventories (1,532) 4,661
Prepaid expenses and other assets 1,709 3,132
Accounts payable (844) 1,465
Accrued liabilities (1,905) (7,814)
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Net cash used for operating activities (8,405) (17,599)
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Cash flows from investing activities:
Purchases of short-term investments (45,032) (67,592)
Proceeds from maturities of short term investments 49,340 101,036
Purchases of property and equipment (4,659) (19,847)
Proceeds from sale of Federal Services Business 5,000 5,000
(Increase) decrease in restricted cash 1,891 (10,658)
Other 30 (566)
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Net cash provided by investing activities 6,570 7,373
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Cash flows from financing activities:
Sale of common stock 958 1,022
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Net cash provided by financing activities 958 1,022
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Effect of exchange rate changes on cash (9) (95)
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Net decrease in cash and cash equivalents (886) (9,299)
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Cash and cash equivalents at end of period $ 14,993 $ 11,172
==========================================================================================================================
Other cash flow information: Cash paid (refunded) during the period:
Interest $ 1,930 $ 1,803
Income taxes $ (1,067) $ (921)
Non-cash investing and financing activities:
Unrealized gain (losses) on available-for-sale securities $ 588 $ (338)
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" or the "Company"). 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 December 27, 2002, the results of operations for the quarter and
nine months ended December 27, 2002 and December 28, 2001, and the cash flows
for the nine months ended December 27, 2002 and December 28, 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 and nine months ended December 27, 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
December 27, 2002 and March 29, 2002 consisted of the following:
(Dollars in thousands) December 27, 2002 March 29, 2002
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Purchased components $ 5,749 $ 5,388
Work-in-process 6,522 8,345
Finished goods 4,065 1,071
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$ 16,336 $ 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 121,000 and 23,000 for the quarters ended December 27, 2002 and
December 28, 2001, respectively. The shares for the quarters ended December 27,
2002 and December 28, 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 December 27, 2002 and December 28,
2001, as their inclusion would have been anti-dilutive in both periods.
4. ACCUMULATED OTHER COMPREHENSIVE LOSS
Accumulated other comprehensive loss at December 27, 2002 and March 29, 2002 is
comprised of cumulative foreign translation adjustments of ($556,000) and
($602,000), respectively, and cumulative net unrealized gains (losses) on
available-for-sale securities of $579,000 and ($9,000), respectively.
5. RESTRUCTURING COSTS
In the third quarter of fiscal 2003, net.com recorded a restructuring charge of
$689,000. This charge included $418,000 for severance, $155,000 for outplacement
costs, and $116,000 for office closure costs. The remaining liability for
restructuring charges is $846,000 at December 27, 2002.
Page 6
Components of accrued restructuring charges, which are included in accrued
liabilities in the accompanying balance sheet, and changes in accrued amounts
related to this restructuring program during the first nine months of fiscal
2003 and as of March 29, 2002 were as follows (in thousands):
====================================================================================
Employee Office Other
Separation Lease Closure Restructuring
Costs Write-off Costs Costs Total
====================================================================================
Balance at March 29, 2002 $ 174 $ -- $ 257 $ 153 $ 584
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Provision 730 $ 563 286 282 1,861
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Payments (684) (103) (507) (305) (1,599)
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Balance at December 27, 2002 $ 220 $ 460 $ 36 $ 130 $ 846
====================================================================================
net.com believes that all costs associated with its plan of business
reorganization will be paid no later than the end of fiscal 2005.
6. RECENTLY ISSUED ACCOUNTING STANDARDS
In December 2002, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards (SFAS) No. 148, "Accounting for
Stock-Based Compensation-Transition and Disclosure", which amends SFAS 123,
"Accounting for Stock-Based Compensation". SFAS 148 provides alternative methods
of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. In addition, SFAS 148 amends
the disclosure requirements of SFAS 123 to require more prominent and more
frequent disclosures in financial statements about the effects of stock-based
compensation. SFAS 148 is effective for fiscal years ending after December 15,
2002, and disclosures are effective for the first fiscal quarter beginning after
December 15, 2002. The disclosure requirements are effective for net.com
beginning with our Annual Report on Form 10-K for the year ended March 28, 2003.
In November 2002, the FASB issued FASB interpretation number (FIN) 45,
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others", which elaborates on the
disclosures to be made by guarantor in its interim and annual financial
statements about its obligations under certain guarantees that it is issued. The
impact for net.com is to disclose the accounting and methodology along with a
tabular reconciliation of changes in the liability for our Product Warranty.
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 EITF 94-3, a liability for an exit cost 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. The adoption of SFAS 146
will not have an impact on net.com's historical consolidated financial
statements.
In August 2001, the FASB issued 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. The Company
adopted SFAS No. 144 on March 30 2002. The adoption of SFAS No. 144 did not have
a material impact on net.com's consolidated financial statements.
Page 7
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 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 cash received from
CACI to date is $37.0 million. 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. 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 total net gain on the sale to date is $24.9 million. In
addition, under an ongoing agreement with CACI, net.com will continue to receive
royalties on maintenance 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 estimated
useful lives. Any impairment loss was 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 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
(which represented the write off of the entire goodwill balance) 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 loss
per share from the reduction of amortization of goodwill as if SFAS No. 142 was
adopted in the first quarter of fiscal 2002:
Three months ended Nine months ended
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Dec. 27, Dec. 28, Dec. 27, Dec. 28,
(Dollars in thousands, except for per share amounts) 2002 2001 2002 2001
- -------------------------------------------------------------------------------------------------------
Reported net loss $ (3,204) $ (8,177) $(18,985) $(35,304)
Workforce amortization -- 24 -- 72
Goodwill amortization -- 837 -- 2,511
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Adjusted net loss $ (3,204) $ (7,316) $(18,985) $(32,721)
=======================================================================================================
Basic and diluted loss per share:
Reported basic and diluted loss per share $ (0.14) $ (0.37) $ (0.85) $ (1.60)
Workforce amortization per share -- -- -- --
Goodwill amortization per share -- 0.04 -- 0.11
- -------------------------------------------------------------------------------------------------------
Adjusted basic and diluted loss per share $ (0.14) $ (0.33) $ (0.85) $ (1.49)
=======================================================================================================
Common and common equivalent shares used in calculation:
Basic and diluted 22,476 22,116 22,383 22,052
=======================================================================================================
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, including statements that relate to products,
customers, operations and contingent payments. 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,". 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 Form 10-Q 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
condensed statements of operations expressed as a percentage of revenue for the
periods presented:
Quarter ended Nine months ended
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Dec. 27, Dec. 28, Dec. 27, Dec. 28,
Percent of revenue 2002 2001 2002 2001
- ------------------------------------------------------------------------------------------------
Product revenue 84.8% 74.2% 82.8% 72.3%
Service and other revenue 15.2 25.8 17.2 27.7
- ------------------------------------------------------------------------------------------------
Total revenue 100.0 100.0 100.0 100.0
- ------------------------------------------------------------------------------------------------
Product revenue gross margin 49.3 27.5 46.2 33.8
Service and other revenue gross margin 8.6 15.6 5.9 7.9
- ------------------------------------------------------------------------------------------------
Total gross margin 43.1 24.5 39.3 26.6
- ------------------------------------------------------------------------------------------------
Sales and marketing 23.9 28.6 27.5 33.8
Research and development 19.3 26.5 22.1 35.8
General and administrative 8.2 10.9 9.6 12.3
Amortization of goodwill and other intangibles -- 3.3 -- 3.5
Restructuring costs 2.1 3.4 2.1 1.2
- ------------------------------------------------------------------------------------------------
Total operating costs 53.5 72.7 61.3 86.6
- ------------------------------------------------------------------------------------------------
Loss from operations (10.4) (48.2) (22.0) (60.0)
Other income, net 0.5 9.8 8.3 6.7
Interest income, net 0.3 1.9 0.5 4.3
- ------------------------------------------------------------------------------------------------
Loss before income taxes (9.6) (36.5) (13.2) (49.0)
Income tax Provision/(Benefit) 0.1 (5.2)2) (2.6) (1.8)
- ------------------------------------------------------------------------------------------------
Loss before cumulative change in accounting
principle, relating to goodwill (9.7) (31.3) (10.6) (47.2)
Cumulative effect of change in accounting
principle, relating to goodwill -- -- (10.9) --
- ------------------------------------------------------------------------------------------------
Net loss (9.7)% (31.3)% (21.5)% (47.2)%
================================================================================================
Page 9
Revenue
Total revenue for the third quarter of fiscal 2003 increased 26.4% or $6.9
million to $33.0 million from $26.1 million for the third quarter of fiscal
2002, and increased 18.0% or $13.5 million to $88.3 million from $74.8 million
on a fiscal year to date basis.
Product revenue increased 44.4% or $8.6 million to $28.0 million from $19.4
million compared to the same period in fiscal 2002, and increased 35.2% or $19.0
million to $73.1 million from $54.1 million on a fiscal year to date basis. The
increase in product revenue was primarily from the Federal Sales Channel, which
increased $10.7 million in the third quarter of fiscal 2003 in comparison to the
third quarter of fiscal 2002 and $19.8 million for the first nine months of
fiscal 2003 compared to the nine months ended December 28, 2001. This increase
was offset by a $2.1 million decrease and a $832,000 decrease from international
and North America product revenue in the third quarter and the first nine months
of fiscal year 2003, respectively, compared to the same periods in fiscal 2002.
Product revenues are generated primarily from our circuit switched product line,
Promina. These revenues increased in the third quarter of fiscal 2003 due to
continued government initiatives, which positively impacted our federal
business. We anticipate the current federal demand will remain through the end
of fiscal 2003 and into fiscal 2004. We have also developed Service Creation
products for the broadband market and Internet Protocol (IP) telephony markets.
The product revenue from these products in the third quarter and first nine
months of fiscal 2003 was less than 10% of total revenue, however, we expect
this revenue may increase as a percentage of revenue in the future.
Service and other revenue for the third quarter of fiscal 2003 decreased 25.5%
to $5.0 million from $6.7 million for the third quarter of fiscal 2002, and
decreased 26.7% to $15.2 million from $20.8 million on a fiscal year to date
basis. 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. However, as
part of our new product strategy, we have developed service creation platforms
that we expect will expand our service offerings and offset part of the decline
in service and other revenue from our narrowband service offerings in the
future. In addition, we have recently announced the end of life for service on
our IDNX product line that could stimulate new network upgrades together with
related service revenue.
Gross Margin
Total gross margin, comprised of product and service margin, increased as a
percentage of total revenue to 43.1% and 39.3% in the third quarter and first
nine months of fiscal 2003, respectively, compared to 24.5% and 26.6% for the
comparable periods in fiscal 2002. Total gross margins improved primarily due to
the higher volume of product sales and the relatively flat cost of operations.
Product revenue gross margins were 49.3% and 46.2% in the third quarter and
first nine months of fiscal 2003, respectively, compared to 27.5% and 33.8% for
the comparable periods in fiscal 2002. The increase in product gross margin
resulted primarily from unfavorable manufacturing variances in fiscal 2002
mainly due to lower product revenue and increased excess capacity. In addition,
charges for excess and potentially obsolete inventory in the third quarter and
first nine months of fiscal 2003 were $345,000 and $2.2 million compared to $4.1
million and $6.0 million, respectively, for the comparable periods in the prior
year.
Service and other revenue gross margins were 8.6% and 5.9% in the third quarter
and first nine months of fiscal 2003, respectively, compared to 15.6% and 7.9%
for the comparable periods in fiscal 2002. There are a significant amount of
services costs that are fixed, and thus lower service revenues have and will
continue to impact margins.
Gross margins may be adversely affected in the future due to increase in
competition, material and labor costs, subcontractor costs, change in absorption
rates and changes in the mix of products we sell. The new products we introduced
recently, our SCREAMTM and SHOUT IPTM product lines, have lower gross margins
than our Promina product line. The lower gross margins are a result of customary
discounting for early customers and higher costs due to low purchase volumes of
components, and we expect these margins to increase to historical levels as
additional quantities are shipped. New product introductions also may result in
excess or obsolete inventories, which may reduce our gross margin. Furthermore,
if product or related warranty costs associated with these new products are
greater than we have experienced, gross margin may be adversely affected. In
addition, if product sales decrease as
Page 10
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 would expect to
realize lower gross margins.
Operating Expenses
Operating expenses in the third quarter and first nine months of fiscal 2003
decreased $1.3 million to $17.6 million, and $10.6 million to $54.2 million,
respectively, from the comparable periods in fiscal 2002. Operating expenses as
a percentage of total revenue were 53.5% and 61.3% in the third quarter and
first nine months of fiscal 2003, respectively, compared to 72.7% and 86.6% in
the third quarter and first nine months of fiscal 2002. Overall, lower operating
expenses are primarily a result of our continued focus on managing expenses
across all functions of the Company.
Sales and marketing expense in the third quarter of fiscal 2003 increased
$404,000 to $7.9 million compared to $7.5 million in the third quarter of fiscal
2002, and decreased $1.0 million to $24.3 million for the first nine months of
fiscal 2003 compared to $25.3 million, for the comparable period of fiscal 2002.
Sales and marketing expenses as a percentage of total revenue were 23.9% and
27.5% in the third quarter and first nine months of fiscal 2003, respectively,
compared to 28.6% and 33.8% in the third quarter and first nine months of fiscal
2002. The increase in spending in the third quarter of fiscal 2003 from the
comparable period in fiscal 2002 is primarily the result of an increase in total
sales compensation expense of $427,000 on higher product revenue and bookings,
an increase in travel and entertainment expense of $101,000, and an increase in
sales events expense of $205,000. Partially offsetting the increase in sales and
marketing expense is a decrease in depreciation expense of $140,000, a decrease
in advertising costs of $65,000 and a decrease in office rent of $103,000. The
decrease in spending in the first nine months of fiscal 2003 from the comparable
period in fiscal 2002 is primarily the result of a decrease in travel and
entertainment costs of $120,000, a decrease in depreciation costs of $650,000,
and a decrease in advertising costs of $307,000. We expect sales and marketing
expenses in the fourth quarter of fiscal 2003 to remain constant or to decrease
slightly compared to the third quarter of fiscal 2003.
Research and development expense in the third quarter and first nine months of
fiscal 2003 decreased $539,000 to $6.4 million and $7.3 million to $19.5
million, respectively, from the comparable periods in fiscal 2002. Research and
development expense as a percentage of total revenue decreased to 19.3% and
22.1% in the third quarter and first nine months of fiscal 2003, respectively,
compared to 26.4% and 35.8% in the third quarter and first nine months of fiscal
2002. The decrease in spending in the third quarter of fiscal 2003 from the
comparable period in fiscal 2002 is primarily the result of a decrease in salary
related costs of $207,000, and a decrease in depreciation and amortization
expenses of $505,000, partially offset by an increase in engineering material
expense of $198,000. The decrease in the first nine months of fiscal 2003 from
the comparable period in fiscal 2002 is primarily the result of a decrease in
salary related costs of $1.7 million, a decrease in consulting costs of $1.4
million, a decrease in recruiting costs of $389,000, a decrease in engineering
material and testing expenses of $1.9 million and a decrease in depreciation and
amortization expenses of $1.6 million. We expect research and development
spending in future periods to remain relatively constant compared to the third
quarter of fiscal 2003 as we balance cost control and the importance of new
product development.
General and administrative expense in the third quarter and first nine months of
fiscal 2003 decreased $129,000 to $2.7 million and $732,000 to $8.5 million,
respectively, from the comparable periods of fiscal 2002. General and
administrative expense as a percentage of total revenue was 8.2% and 9.6% in the
third quarter and first nine months of fiscal 2003, respectively, compared to
10.9% and 12.3% in the third quarter and first nine months of fiscal 2002. The
decrease in spending in the third quarter of fiscal 2003 from the comparable
period in fiscal 2002 is primarily the result of decreased salary related and
consulting expenses of $160,000 and a decrease in recruiting costs of $124,000,
partially offset by an increase in outside legal expenses of $156,000. The
decrease in spending in the first nine months of fiscal 2003 from the comparable
period in fiscal 2002 is primarily the result of decreased salary related and
consulting expenses of $442,000 and a decrease in recruiting costs of $269,000.
We expect general and administrative expenses in the fourth quarter of fiscal
2003 to remain constant or to decrease slightly compared to the third quarter of
fiscal 2003
As a result of the adoption of SFAS 142 in the first quarter of fiscal 2003,
goodwill and other intangible assets were written off. Amortization of goodwill
ceased and therefore there was no amortization of goodwill in the third quarter
and first nine months of fiscal 2003. Amortization of goodwill and other
intangible assets in the third quarter and first nine months of fiscal 2002 was
$861,000 and $2.6 million, respectively. The amortization expense in the third
quarter and first nine months of fiscal 2002 was a result of two acquisitions,
FlowWise Networks, Inc.
Page 11
which occurred in the third quarter of fiscal 2000 and Convergence Equipment
Company which occurred in the first quarter of fiscal 2001.
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, resulting in 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.
In the third quarter and first nine months of fiscal 2003, restructuring charges
were $689,000 and $1.9 million, respectively, compared to $899,000 for both
periods from the prior year. The restructuring charge in the third quarter of
fiscal 2003 was primarily due to severance related costs from a reduction in
workforce that occurred during the quarter. The restructuring charge in the
first nine months of fiscal 2003 included restructuring charges for the
following: 1) severance related costs from reductions in workforce that occurred
in the first, second and third quarters of fiscal 2003, and 2) a reduction in
leased office space at our sales and service facilities in Vienna and Ashburn,
Virginia.
Non-Operating Items
Interest income, which is primarily related to short-term investments, decreased
$406,000 to $566,000 and $2.7 million to $1.9 million in the third quarter and
first nine months of fiscal 2003, respectively, from the comparable periods of
fiscal 2002. The decrease in interest income is the result of declining interest
rates and lower cash balances.
Interest expense increased $23,000 to $468,000 and $109,000 to $1.5 million in
the third quarter and first nine months of fiscal 2003, respectively, from the
comparable periods of fiscal 2002. The most significant component of our
interest expense is the interest on the 7 1/4% convertible subordinated
debentures, which was $448,000 and $1.3 million for the third quarter and the
first nine months of fiscal 2003, respectively. The increase in the third
quarter and first nine months of fiscal 2003 is a result of a $2.0 million note
payable to our landlord for building repairs related to the former Fremont,
California campus. The note bears interest at 10% and is payable in monthly
installments over 10 years.
The gain on the sale of the federal services business in the first nine months
of fiscal 2003 was $5.0 million, compared to $5.0 million in the first nine
months of fiscal 2002, principally as a result of certain milestones being met
as part of the sale of the federal services business to CACI International Inc.
Other income (expense) in the third quarter and the first nine months of fiscal
2003 was income of $167,000 and income of $2.3 million, respectively, compared
to income of $61,000 and an expense of $1,000 in the third quarter and first
nine months of fiscal 2002, respectively. Other income in the third quarter and
first nine months of fiscal 2003 consisted principally of $193,000 and $2.4
million, respectively, for gains from insurance proceeds received for
construction costs associated with our new corporate headquarters in Fremont,
California.
Tax provision (benefit) in the third quarter and the first nine months of fiscal
2003 was a provision of $32,000 and net benefit of $2.3 million, compared to a
benefit of $1.3 million from the comparable periods in fiscal 2002. In both the
second quarter of fiscal 2003 and third quarter of fiscal 2002, we reevaluated
the adequacy of our tax liability taking into account the previously filed tax
returns as well as our expected fiscal year net losses. The net result of
these reevaluations was to reduce the amount of necessary tax liabilities and to
record a tax benefit of $2.3 million in fiscal 2003 and $1.3 million in 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 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.
Page 12
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 year.
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 increase our
inventory provision adjustments and our gross margin could be adversely
affected.
Warranty Accruals: net.com generally warrants hardware product sales for twelve
months and software for a period of three months. The methodology is to accrue
warranty expense based on historical expense trends calculated as a percentage
of new product sales. Actual expenses are charged against the accrual in the
period they are incurred. On a quarterly basis, the warranty accrual is analyzed
for adequacy based on actual trends and subsequent adjustments are made to the
liability balance.
Components of the warranty accrual, which are included in accrued liabilities in
the accompanying balance sheet, during the first nine months of fiscal 2003 were
as follows (in thousands):
===========================================================================================================
Balance at Charges to
beginning of Charges to Cost warranty Other Balance end
period of Goods Sold accrual Adjustments(1) of the Period
===========================================================================================================
Balance at March 29, 2002 $639 $95 $(58) $(140) $536
- -----------------------------------------------------------------------------------------------------------
(1) Adjustment resulted from a change in warranty cost estimates primarily from
lower hourly costs of labor to repair products and frequency of warranty claims.
Deferred Taxes: We have incurred tax losses in each of the last four fiscal
years and, at December 27, 2002, we have an estimated $86.5 million of federal
net operating loss carryforwards and an estimated $24.7 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
Page 13
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: 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 charge of $9.6 million
during the quarter ended June 28, 2002 related to goodwill.
LIQUIDITY AND CAPITAL RESOURCES
As of December 27, 2002, we had cash and cash equivalents of $15.0 million,
restricted cash of $1.4 million and short-term investments of $72.1 million for
a total of $88.4 million as compared to $94.9 million at the end of fiscal 2002.
In fiscal 2003, the Company benefited from the aforementioned $5.0 million
payment received in the first quarter from CACI and insurance proceeds of $3.5
million of which $193,000 was received in the third quarter. This was primarily
offset by net operating losses and the related effect on cash.
Net cash used in operating activities in the first nine months of fiscal 2003
was $8.4 million compared to net cash used in operating activities of $17.6
million in the first nine months of fiscal 2002. The change in cash used by
operations in the first nine months of fiscal 2003 resulted primarily from a net
loss of $19.0 million, an increase in inventory of $1.5 million, and a decrease
in accrued liabilities and accounts payable totaling of $2.7 million. Net cash
provided by operations included a reduction in accounts receivable of $455,000,
a decrease in prepaid expenses of $1.7 million, and the receipt of $3.5 million
in cash from our insurance settlement for construction defects at our previous
campus. Net non-cash operating activity included a gain on the sale of the
federal services business of $5.0 million, a gain on building insurance proceeds
of $2.4 million, the adjustment for depreciation and amortization of $7.0
million and the cumulative change in accounting principle for our goodwill
impairment of $9.6 million.
Net cash provided from investing activities was $6.6 million in the first nine
months of fiscal 2003, compared to net cash provided from investing activities
of $7.4 million in the first nine months of fiscal 2002. Net cash provided from
investing activities in the first nine months of fiscal 2003 consisted primarily
of proceeds from maturing short term investments of $49.3 million, a decrease in
restricted cash of $1.9 million and an increase in proceeds received from the
sale 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 $45.0 million and purchases of property and equipment of $4.7
million.
Net cash provided by financing activities in the first nine months of fiscal
2003 was $958,000 compared to net cash provided by investing activities of $1.0
million in the first nine months of fiscal 2002. The $958,000 in the first nine
months of fiscal 2003 resulted from the sale of common stock to employees under
the 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 a
comprehensive list. There may be additional risks not described because 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 MAY CONTINUE TO INCUR LOSSES IN THE
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, in part upon the
marketing and broad commercial distribution of our new products, specifically
our SCREAM product line and our SHOUTIP product line. We expect to continue to
incur product development, sales and marketing and administrative expenses as we
continue to maintain support of our existing products and customers while
focusing on increasing sales of our 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
Page 14
expenses continue to be too high to enable us to be profitable. In order to
achieve profitability, we need to generate sales growth from our SCREAM and
SHOUTIP as well as legacy product lines and /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;
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. Investors 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.
Currently, we derive the majority of our product revenue from our Promina
product line, a circuit-based technology. The market for circuit-based
technology has declined and we believe that it 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 effect 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 decrease.
Page 15
A SIGNIFICANT PORTION OF OUR REVENUE IS GENERATED FROM SALES TO GOVERNMENTAL
AGENCIES.
A significant portion of our total revenue from product sales comes from
contracts with government, most of which do not include long-term purchase
commitments. Historically, the 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 Promina product. However, the government has
purchased and is evaluating some of our new products for broader deployment. If
the government accelerated adoption of new technology, and replaced the 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 competitive local exchange carriers (CLECs) have deteriorated. 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 service providers
can be unpredictable due to other factors, including their need to generate new
revenue and to expand their capacity while working within their budgetary
constraints. Our ability to recognize revenue from 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 an 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 incumbent carriers such as
AT&T, BellSouth, SBC Communications, Verizon, British Telecom and France
Telecom. 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
ACCEPTANCE OF SERVICE CREATION AS A MEANS OF ACHIEVING OPTIMAL 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
Page 16
generated by the new services and have eroded the profitability of these
companies. Since the second quarter of our 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 optimize 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' investment in new markets that will enable them to build a
foundation for a more flexible network architecture and on their ability to
realize revenue increases and operating cost reduction as a result implementing
the model of service creation. Failure to successfully market and to obtain
acceptance of the service creation model could affect our ability to sell the
SCREAM product and grow overall revenue.
In North America, SCREAM deployment depends to a large extent on incumbent
carriers' ability to compete on a level playing field against cable companies
and may require changes in the regulatory environment. Failure of service
providers at home and abroad to build the more flexible broadband network
framework and to benefit from new future service creation opportunities could
affect our ability to sell the SCREAM platform and grow overall revenue.
WE NEED STRATEGIC PARTNERSHIPS TO ACCELERATE THE ACCEPTANCE OF OUR NEW PRODUCTS
INTO THE SERVICE PROVIDERS.
Building relationships with strategic partners, such as software application
partners, system integrators, original equipment manufacturers (OEM's) or
resellers can accelerate the sales of new products. The importance of the
software application partners is that they provide 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. We may
need to pursue partnerships with vendors who have optical core and core routing
technologies in order to compete with the end-to-end solution providers, 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,
change in absorption rate a
nd changes in the mix of products we sell, our gross
margins could decline in future quarters. The new products we recently
introduced initially have lower gross margins than our Promina product line.
These lower gross margins are a result of higher discounts awarded to early
adopter customers and higher component costs due to low purchase volumes of
these components.
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 federal service business 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. We also
rely on CACI to perform staging and integration services for net.com products
and third party products sold to our federal government customers. For the
divestiture to be successful, CACI must continue to provide the level of service
to which our customers have become accustomed. Should CACI
Page 17
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 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 other smaller companies that are targeting this
market, including CoSine, 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.
We expect international sales will continue to account for a significant portion
of our Promina product sales (other than that sold in the government 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
Page 18
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.
OUR BACKLOGGED PRODUCT ORDERS HAVE BEEN UNPREDICTABLE, MAKING IT DIFFICULT FOR
US TO ACCURATELY FORECAST SALES AND CREATING A RISK OF CARRYING TOO MUCH OR TOO
LITTLE INVENTORY.
Typically, 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 possible 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 AND THIRD
PARTY PRODUCTS WHICH COULD AFFECT OUR ABILITY TO SHIP OUR PRODUCTS IN A TIMELY
MANNER.
We purchase key components from single source suppliers, in particular, our back
planes, ASICs and power supplies. If we or our sole source suppliers 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.
Pursuant to our contract with Solectron, we have agreed to compensate Solectron
in the event of a termination or a cancellation of orders, discontinuance of
product or excess material created by an engineering change. Also, 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
Page 19
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
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 Federal Communication Commission 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. In
fiscal 2003, we commenced using foreign exchange contracts to hedge significant
accounts receivable and intercompany account balances denominated in foreign
currencies. Although we have established foreign exchange contracts for
non-dollar denominated sales and operating expenses in the United Kingdom,
France, Germany and Japan, exposures remain for non-dollar denominated operating
expenses in Latin America and Asia. We will continue to monitor our exposure and
may hedge against these or any other emerging market currencies as necessary.
Market value gains and losses on 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 tenants have experienced water intrusion problems
in the facilities nearby. In particular, unknown defects in the construction of
our new facilities combined with the proximity to water may result in future
water infiltration
Page 20
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.
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.
Item 4.
DISCLOSURE CONTROLS AND PROCEDURES
In accordance with Section 302 of the Sarbanes-Oxley Act of 2002 and the
Securities Exchange Act of 1934 Section 13(a) or Section 15(d), we implemented
disclosure controls and procedures pursuant to which management under the
supervision and with the participation of the chief executive officer ("CEO")
and chief financial officer ("CFO") carried out, within 90 days prior to the
filing of this quarterly report, a review and evaluation of the effectiveness of
these controls and procedures. Based on this review, our CEO and CFO have
concluded that our disclosure controls and procedures are effective in timely
alerting them to material changes in information required to be included in our
periodic Securities and Exchange Commission filings.
We intend to review and evaluate the design and effectiveness of our disclosure
controls and procedures on an ongoing basis and to improve our controls and
procedures over time and to correct any deficiencies that we may discover in the
future. Our goal is to ensure that our senior management has timely access to
all material financial and non-financial information concerning our business.
While we believe the present design of our disclosure controls and procedures is
effective to achieve our goal, future events affecting our business may cause us
to significantly modify our disclosure controls and procedures.
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 (the "Court") on January 11, 2002 against, among other
parties, South Bay Construction Company, Inc. and M. Arthur Gensler, Jr. &
Associates 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
Page 21
rights and obligations under their respective contracts, and damages for breach
of contract and negligence. Vigilant entered a demurrer to the cross complaint
on behalf of net.com which the Court sustained without leave to amend on August
22, 2002. On November 1, 2002 the Court approved a settlement and release
Vigilant reached with Gensler to which net.com was also a party. In connection
with this settlement, net.com released any claim that it might have against
Gensler.
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.
Report on Form 8-K
None
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: February 7, 2003 /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)
Page 22
CERTIFICATION
I, Hubert A. J. Whyte, President and Chief Executive Officer of Network
Equipment Technologies, Inc., certify that:
1. I have reviewed this quarterly report on Form 10-Q of Network Equipment
Technologies, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) Designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared; and
b) Evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) Presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) Significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls;
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.
Page 23
February 7, 2003
/s/ Hubert A. J. Whyte
-------------------------------------
Hubert A. J. Whyte
President and Chief Executive Officer
Page 24
CERTIFICATION
I, John F. McGrath, Jr., Vice President and Chief Financial Officer of
Network Equipment Technologies, Inc., certify that:
1. I have reviewed this quarterly report on Form 10-Q of Network Equipment
Technologies, Inc.;
2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have:
a) Designed such disclosure controls and procedures to ensure that material
information relating to the registrant, including its consolidated subsidiaries,
is made known to us by others within those entities, particularly during the
period in which this quarterly report is being prepared; and
b) Evaluated the effectiveness of the registrant's disclosure controls and
procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
c) Presented in this quarterly report our conclusions about the effectiveness of
the disclosure controls and procedures based on our evaluation as of the
Evaluation Date;
5. The registrant's other certifying officers and I have disclosed, based on our
most recent evaluation, to the registrant's auditors and the audit committee of
registrant's board of directors (or persons performing the equivalent function):
a) All significant deficiencies in the design or operation of internal controls
which could adversely affect the registrant's ability to record, process,
summarize and report financial data and have identified for the registrant's
auditors any material weaknesses in internal controls; and
b) Any fraud, whether or not material, that involves management or other
employees who have a significant role in the registrant's internal controls;
6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent
Page 25
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
February 7, 2003
/s/ John F. McGrath, Jr.
------------------------------------------
John F. McGrath, Jr.
Vice President and Chief Financial Officer
Page 26