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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549-0001
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FORM 10-Q
(MARK ONE)
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the three months ended March 31, 2003
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File Number 000-23699
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VISUAL NETWORKS, INC.
(Exact name of registrant as specified in its charter)
Delaware 52-1837515
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
2092 Gaither Road, Rockville, MD 20850-4013
(Address of principal executive offices) (Zip code)
Registrant's telephone number, including area code: (301) 296-2300
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to the
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 |_| No |X|
The number of outstanding shares of the Registrant's Common Stock, par
value $.01 per share, as of May 7, 2003 was 32,445,594 shares.
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1
VISUAL NETWORKS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED
MARCH 31, 2003
TABLE OF CONTENTS
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Consolidated Balance Sheets -- December 31, 2002
and March 31, 2003 ............................................... 3
Consolidated Statements of Operations -- Three months ended
March 31, 2002 and 2003 .......................................... 4
Consolidated Statements of Cash Flows -- Three months
ended March 31, 2002 and 2003 ..................................... 5
Notes to Consolidated Financial Statements ......................... 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations ................................ 15
Item 3. Qualitative and Quantitative Disclosure about
Market Risk ........................................................ 25
Item 4. Controls and Procedures ....................................... 25
PART II. OTHER INFORMATION
Items 1 -- 6 .......................................................... 26-27
Signatures ............................................................ 29
Certifications ........................................................ 30
2
PART I: FINANCIAL INFORMATION
Item 1: Financial Statements
VISUAL NETWORKS, INC.
CONSOLIDATED BALANCE SHEETS
(Unaudited)
(In thousands, except share data)
December 31, March 31,
2002 2003
------------ ---------
ASSETS
Current assets:
Cash and cash equivalents ............................................. $ 12,708 $ 14,338
Restricted short-term investment ...................................... 2,503 2,000
Accounts receivable, net of allowance of $358 ......................... 7,647 3,883
Inventory, net ........................................................ 3,393 2,959
Other current assets .................................................. 259 675
--------- ---------
Total current assets .......................................... 26,510 23,855
Property and equipment, net ............................................. 3,481 3,359
Deferred debt issuance costs ............................................ 768 709
--------- ---------
Total assets .................................................. $ 30,759 $ 27,923
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses ................................. $ 9,733 $ 7,130
Deferred revenue ...................................................... 6,436 5,767
Customer deposits ..................................................... -- 250
--------- ---------
Total current liabilities ..................................... 16,169 13,147
Convertible debentures, net of unamortized debt discount of $2,537 and
$2,342, respectively .................................................. 7,963 8,158
--------- ---------
Total liabilities ............................................. 24,132 21,305
--------- ---------
Commitments and Contingencies (Note 5)
Stockholders' equity:
Common stock, $.01 par value, 200,000,000 shares
authorized, 32,398,856 and 32,447,560 shares issued
and outstanding as of December 31, 2002 and
March 31, 2003, respectively ....................................... 324 325
Additional paid-in capital ............................................ 474,719 474,799
Warrants .............................................................. 2,087 2,087
Deferred compensation ................................................. (2) --
Accumulated deficit ................................................... (470,501) (470,593)
--------- ---------
Total stockholders' equity .................................... 6,627 6,618
--------- ---------
Total liabilities and stockholders' equity .................... $ 30,759 $ 27,923
========= =========
See accompanying notes to consolidated financial statements.
3
VISUAL NETWORKS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share data)
For the Three Months
Ended March 31,
----------------------
2002 2003
-------- --------
Revenue:
Hardware ......................................... $ 11,061 $ 6,574
Software ......................................... 1,391 296
Support and services ............................. 4,341 2,334
-------- --------
Total revenue .............................. 16,793 9,204
-------- --------
Cost of revenue:
Product .......................................... 4,232 1,978
Support and services ............................. 744 276
-------- --------
Total cost of revenue ...................... 4,976 2,254
-------- --------
Gross profit ....................................... 11,817 6,950
-------- --------
Operating expenses:
Research and development ......................... 3,325 2,747
Sales and marketing .............................. 5,935 3,443
General and administrative ....................... 1,767 948
-------- --------
Total operating expenses ................. 11,027 7,138
-------- --------
Income (loss) from operations ...................... 790 (188)
Other income ....................................... -- 452
Interest expense, net .............................. (109) (356)
-------- --------
Net income (loss) .................................. $ 681 $ (92)
======== ========
Basic earnings (loss) per share .................... $ 0.02 $ (0.00)
======== ========
Diluted earnings (loss) per share .................. $ 0.02 $ (0.00)
======== ========
Basic weighted-average shares outstanding .......... 31,958 32,429
======== ========
Diluted weighted-average shares outstanding ........ 32,987 32,429
======== ========
See accompanying notes to consolidated financial statements.
4
VISUAL NETWORKS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands)
For the Three Months
Ended March 31,
----------------------
2002 2003
-------- --------
Cash flows from operating activities:
Net income (loss) ....................................................... $ 681 $ (92)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization ........................................ 971 465
Non-cash interest expense ............................................ -- 254
Translation gain from foreign subsidiary ............................. (21) --
Changes in assets and liabilities:
Accounts receivable .................................................. (1,231) 3,764
Inventory ............................................................ 175 434
Other assets ......................................................... 506 (416)
Accounts payable and accrued expenses ................................ 1,524 (2,601)
Deferred revenue ..................................................... (1,706) (669)
Customer deposits .................................................... (3,588) 250
-------- --------
Net cash provided by (used in) operating activities ................ (2,689) 1,389
-------- --------
Cash flows from investing activities:
Net sales of short-term investments ..................................... -- 503
Expenditures for property and equipment ................................. (491) (343)
-------- --------
Net cash provided by (used in) investing activities ................ (491) 160
-------- --------
Cash flows from financing activities:
Exercise of stock options and employee stock purchase
plan ................................................................. 99 81
Net repayments under credit agreements .................................. (2,039) --
Proceeds from issuance of convertible debentures and warrants,
net of issuance costs ................................................ 9,705 --
Principal payments on capital lease obligations ......................... (285) --
-------- --------
Net cash provided by financing activities .......................... 7,480 81
-------- --------
Net increase in cash and cash equivalents ................................. 4,300 1,630
Cash and cash equivalents, beginning of period ............................ 5,921 12,708
-------- --------
Cash and cash equivalents, end of period .................................. $ 10,221 $ 14,338
======== ========
Supplemental cash flow information:
Cash paid for interest .................................................. $ 161 $ 139
======== ========
See accompanying notes to consolidated financial statements.
5
VISUAL NETWORKS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2003
(Unaudited)
1. Nature of Operations and Summary of Significant Accounting Policies:
Visual Networks, Inc. ("Visual" or the "Company") designs, manufactures,
sells and supports systems that manage the level of service provided over
telecommunications networks, including networks that support the Internet.
Risks and Other Important Factors
The Company incurred significant losses from the second quarter of 2000
through the fourth quarter of 2001. The deterioration of the Company's operating
results in 2000, excluding the effects of impairment and restructuring charges
and the write-off of in-process research and development ("IPR&D"), was due
primarily to decreased revenue and increased operating expenses compared to
1999. The Company made significant reductions in operating expenses in 2000 and
2001, including those resulting from the closure of three facilities and the
reduction of its workforce by approximately 230 employees through the end of
2001. During 2002, the Company reduced its workforce by approximately 60
additional employees, approximately 10 of whom were terminated during the three
months ended March 31, 2002. There were no workforce reductions during the three
months ended March 31, 2003. However, the Company has continued to reduce
operating expenses through other non-employee cost savings measures such as
revised bonus and commission plans and reduced marketing and other discretionary
spending. The Company incurred a net loss of $0.1 million for the three months
ended March 31, 2003 due to significantly decreased revenue that declined from
$16.8 million for the three months ended March 31, 2002 to $9.2 million for the
three months ended March 31, 2003, reflecting a reduction in sales for each of
the Company's major products.
The success of the Company is dependent on its ability to generate
adequate cash for operating and capital needs. The Company is relying on its
existing cash and cash equivalents, together with future sales and the
collection of the related accounts receivable to meet its future cash
requirements. If cash provided by these sources is not sufficient to fund future
operations, the Company will be required to further reduce its expenditures for
operations or to seek additional capital through other means which may include
the sale of assets, the sale of equity securities or additional borrowings.
There can be no assurances that additional capital will be available, or
available on terms that are reasonable or acceptable to the Company,
particularly in light of its accumulated deficit position.
Under the terms of the senior secured convertible debentures (the
"Debentures") issued by the Company in March 2002 (see Note 3), a number of
events could force early repayment of 115% of the outstanding principal plus
accrued and unpaid interest owed under the Debentures. In addition, if the
Company's earnings before interest, taxes, depreciation and amortization, less
capital expenditures, for the year ended December 31, 2003 are less than $6.5
million, the debenture holders may require that the Company prepay all or a
portion of up to 100% of the outstanding principal amount of their Debentures,
plus accrued interest. The Company's earnings before interest, taxes,
depreciation and amortization, less capital expenditures ("adjusted EBITDA") for
the three months ended March 31, 2003 was $0.4 million, as shown in the
following table (unaudited, in thousands):
Net loss, as reported ....................... $ (92)
-----
Interest expense ............................ 393
Depreciation and amortization ............... 465
Capital expenditures ........................ (343)
-----
Adjusted EBITDA ............................. $ 423
=====
If the Company is required to make an early payment on the Debentures and
does not have sufficient cash to repay these amounts, the Company may be
required to seek additional capital through the sale of additional securities,
through additional borrowings or through the sale of assets, none of which may
be available on terms reasonably acceptable to the Company.
6
The Company's operations are subject to certain other risks and
uncertainties, including among others, its accumulated deficit, uncertainty
about future profitability, substantial dilution if the Company is required to
raise capital through the sale of equity, dependence on major service provider
customers during a general economic downturn in the telecommunications industry,
unanticipated delays from subcontract manufacturers, potential failure to comply
with Nasdaq listing requirements, sufficiency of cash to repay the debenture
holders if early repayment is required, successful incorporation of the
Company's products into service providers' infrastructures, long sales cycles,
changes in the market's acceptance of and demand for the Company's products,
rapidly changing technology, current and potential competitors with greater
financial, technological, production, and marketing resources, potential errors
in the Company's products or services, dependence on sole and limited source
suppliers, limited protection of intellectual property and proprietary rights,
dependence on key management personnel, ability to recruit and retain employees,
difficulties assimilating future acquisitions and uncertainty of future
financial results.
Financial Statement Presentation
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities, the
disclosure of contingent assets and liabilities at the date of statements and
the reported amounts of revenue and expenses during the reporting periods.
Actual results could differ from those estimates.
These financial statements are unaudited and have been prepared by the
Company pursuant to the rules and regulations of the Securities and Exchange
Commission regarding interim financial reporting. Accordingly, they do not
include all of the information and footnotes required by generally accepted
accounting principles for complete financial statements, and it is suggested
that these financial statements be read in conjunction with the financial
statements, and notes thereto, included in the Company's Annual Report on Form
10-K for the year ended December 31, 2002. In the opinion of management, the
comparative financial statements for the periods presented herein include all
adjustments that are normal and recurring which are necessary for a fair
presentation of results for the interim periods. The results of operations for
the three months ended March 31, 2003 are not necessarily indicative of the
results that will be achieved for the entire year ending December 31, 2003.
Principles of Consolidation
The consolidated financial statements include the accounts of Visual
Networks, Inc. and its wholly owned subsidiaries. All intercompany account
balances and transactions have been eliminated in consolidation.
Investments
The Company holds a certificate of deposit in the amount of $2.0 million
that matures on May 31, 2003. The certificate of deposit, the balance of which
was $2.5 million as of December 31, 2002, has been included as a restricted
short-term investment (see Note 2) in the accompanying consolidated balance
sheets as of December 31, 2002 and March 31, 2003. The certificate of deposit is
held by a bank to collateralize a $2.0 million letter of credit issued in favor
of one of the Company's contract manufacturers that expires on September 30,
2003.
Inventory and Cost of Revenue
Cost of revenue consists of subcontracting costs, component parts,
warehouse costs, direct compensation costs, warranty and other contractual
obligations, royalties, license fees and other overhead expenses related to the
manufacturing operations. Product cost of revenue includes both hardware and
software cost of revenue in the accompanying consolidated statements of
operations. Cost of revenue related to software sales has not been significant.
Support and services cost of revenue includes benchmark services, professional
services and technical support costs in the accompanying consolidated statements
of operations.
Inventory is stated at the lower of average cost or market, with costs
determined on the first-in, first-out basis, consists of the following
(unaudited, in thousands):
December 31, March 31,
2002 2003
------------ ---------
Raw materials .................... $2,846 $2,386
Work-in-progress ................. 61 215
Finished goods ................... 486 358
------ ------
$3,393 $2,959
====== ======
7
The Company records a provision for excess and obsolete inventory whenever
such an impairment has been identified.
Accounts Payable and Accrued Expenses
Accounts payable and accrued expenses consist of the following (unaudited,
in thousands):
December 31, March 31,
2002 2003
------------ ---------
Accounts payable ................. $3,429 $1,260
Accrued compensation ............. 1,223 205
Accrued restructuring ............ 580 537
Other accrued expenses ........... 4,501 5,128
------ ------
$9,733 $7,130
====== ======
Revenue Recognition
The Company's network performance management products and services include
hardware, software, professional services and technical support. The Company
continues to recognize revenue for existing benchmark services contracts, under
which the Company is still required to perform services. Benchmark services,
professional services and technical support revenues are reported as service
revenue in the accompanying consolidated statements of operations. The Company
recognizes revenue from the sale or license of its products in accordance with
SOP No. 97-2, "Software Revenue Recognition" and SAB No. 101, "Revenue
Recognition and Financial Statements," which summarizes existing accounting
literature and requires that four criteria be met prior to the recognition of
revenue. The accounting policies regarding revenue recognition are written to
comply with the following criteria: 1) persuasive evidence of an arrangement
exists; 2) delivery has occurred; 3) the fee is fixed or determinable; and 4)
collectibility is probable. The third and fourth criteria may require the
Company to make significant judgments or estimates.
To determine if a fee is fixed or determinable, the Company evaluates
rights of return, customer acceptance rights, if applicable, and
multiple-element arrangements of products and services to determine the impact
on revenue recognition. The Company's agreements generally have not included
rights of return except in certain reseller relationships that include stock
rotation rights. If offered, rights of return only apply to hardware. If an
agreement provides for a right of return, the Company typically recognizes
revenue when the right has expired or the product has been resold by the master
distributor. If the Company has sufficient historical information to allow it to
make an estimate of returns in accordance with SFAS No. 48, "Revenue Recognition
When Right of Return Exists," the Company defers an estimate for such returns
and recognizes the remainder at the date of shipment. If an agreement provides
for evaluation or customer acceptance, the Company recognizes revenue upon the
completion of the evaluation process, acceptance of the product by the customer
and completion of all other criteria. Most of the Company's sales are
multiple-element arrangements and include hardware, software, and technical
support. The Company's software sales sometimes include professional services
for implementation but these services are not a significant source of the
Company's revenue. Training is also offered but is not a significant source of
the Company's revenue. Revenue from multiple-element arrangements is recognized
using the residual method whereby the fair value of any undelivered elements,
such as customer support and services, is deferred and any residual value is
allocated to the software and recognized as revenue upon delivery. The fair
values of any undelivered elements, typically professional services, technical
support and training, have been determined based on the Company's specific
objective evidence of fair value, which is based on the price that the Company
charges customers when the element is sold separately.
The Company's technical support contracts require it to provide technical
support and unspecified software updates to customers on a when and if available
basis. The Company recognizes customer support revenue, including support
revenue that is bundled with product sales, ratably over the term of the
contract period, which generally ranges from one to three years. The Company
recognizes revenue from services when the services are performed. Subscription
fees for the Company's Visual Internet Benchmark reports are recognized upon
delivery of the reports. The remaining deferred subscription fee revenue will be
recognized in the three months ended June 30, 2003 when the final contract under
which the Company is obligated to provide service will be completed. The Company
receives royalty payments from the purchaser of the Visual Internet Benchmark
service on new contracts, which are included in support and services revenue in
the accompanying statements of operations for the three months ended March 31,
2002 and 2003.
8
The Company sells its products directly to service providers, through
indirect channels ("resellers") and to end-user customers. Certain reseller
customers have stock rotation rights, under which the customer can exchange
previously purchased products for other products of equal or greater cost,
subject to certain limitations, based on their end-user customers' requirements.
The Company recognizes revenue under these arrangements once the stock rotation
right expires or the product has been resold by the distributor.
The Company also examines the specific facts and circumstances of all
sales arrangements with payment terms extending beyond its normal payment terms
to make a determination of whether the sales price is fixed or determinable and
whether collectibility is probable. Payment terms are not tied to milestone
deliverables or customer acceptance. The evaluation of the impact on revenue
recognition, if any, includes the Company's history with the particular customer
and the specific facts of each arrangement. It is generally not the Company's
practice to offer payment terms that differ from its normal payment terms, and
the Company has not written off any accounts receivable related to extended
payment term arrangements.
The Company has agreements with certain service providers that provide
price protection in the event that more favorable prices and terms are granted
to any other similarly situated customer. When required, reserves for estimated
price protection credits are established by the Company concurrently with the
recognition of revenue. The Company monitors the factors that influence the
pricing of its products and service provider inventory levels and makes
adjustments to these reserves when management believes that actual price
protection credits may differ from established estimates.
In May 2001, the Company announced the discontinuation of the Visual
Trinity product, the primary product acquired with Avesta, and stopped all
development efforts. The Company provided technical support for the Visual
Trinity product through September 2002 and has no remaining technical support
obligations to the Visual Trinity customers. As a result, revenue related to
this product subsequent to May 2001 consisted primarily of technical support
revenue, all of which was recognized over the terms of the relevant agreements.
In 2002, the remaining customer for the CellTracer product, Network
Associates, placed what they indicated would be final orders. Also, in 2002, the
Company continued to evaluate the future of the Visual eWatcher and CellTracer
products. In their current form, neither product produced significant revenue
for the three months ended March 31, 2002. The Company believes that the
technology of both products may be useful to other products in the future and
the Company is exploring alternatives for these technologies. However, the
Company decided not to focus its development or sales efforts on these products
in 2003.
Credit Risk
Financial instruments that potentially subject the Company to significant
concentrations of credit risk consist principally of accounts receivable. The
Company generally sells its products to large telecommunications and Internet
service provider companies primarily in the United States of America. The
Company grants credit terms without collateral to its customers and, prior to
the bankruptcy of one of the Company's significant customers during 2002 as
described below, has not experienced any significant credit related losses.
Accounts receivable include allowances to record receivables at their estimated
net realizable value. As of March 31, 2003, two customers individually
represented 27% and 11% of accounts receivable.
A significant customer of the Company, WorldCom, filed for bankruptcy on
July 21, 2002. Sales to WorldCom represented approximately $6.3 million in
revenue for the year ended December 31, 2002. The Company wrote off
approximately $0.7 million of accounts receivable due from WorldCom against the
allowance for bad debts during 2002. The Company entered into an agreement to
sell these previously written-off receivables to an unrelated third party for
approximately $0.3 million, which is recorded as a reduction to bad debt expense
in general and administrative expense in the accompanying consolidated results
of operations for the three months ended March 31, 2003.
Due to the relationship that the Company has with WorldCom and its
customers, the Company is continuing to sell products to WorldCom during its
bankruptcy. The Company has taken steps to limit its financial exposure. In July
2002, the Company signed an agreement (the "July Agreement") with WorldCom that
established new terms and conditions under which the Company shipped products to
WorldCom during the initial weeks of WorldCom's bankruptcy. After WorldCom made
timely payment of the related invoices, the Company entered into a subsequent
amendment (the "August Amendment") that changed WorldCom's payment terms to
substantially those that existed prior to the bankruptcy filing. WorldCom
complied with the terms of the July Agreement and August Amendment during the
year ended December 31, 2002 and continues to be in compliance as of May 7,
2003.
9
Warranty
The Company warrants its hardware products for periods of up to five
years. The Company estimates its warranty obligation at the end of each period
and charges changes to the liability to cost of revenue in the respective
period. Such estimates are based on actual warranty cost experience.
In November 2002, the FASB issued FASB Interpretation No. 45 ("FIN 45"),
"Guarantor's Accounting and Disclosure Requirements for Guarantees, Including
Indirect Guarantees of Indebtedness of Others." FIN 45 requires the accounting
for and disclosure of guarantees and clarifies the requirements of FASB No. 5,
"Accounting for Contingencies." The disclosure requirements of this
interpretation are effective for periods ending after December 15, 2002 and
accounting for guarantees is required for periods beginning after December 15,
2002. Accordingly, the Company adopted the requirements of FIN 45 for the three
months ended March 31, 2003. The adoption did not have a material effect on the
Company's financial position or results of operations.
The following is a summary of the change in the company's accrued warranty
during the three months ended March 31, 2003 (unaudited, in thousands):
Balance as of December 31, 2002 ............. $ 402
Provisions for warranty ..................... 35
Settlements made ............................ (16)
-----
Balance, March 31, 2003 .................... $ 421
=====
Income Taxes
The Company accounts for income taxes in accordance with SFAS No. 109,
"Accounting for Income Taxes." Under SFAS No. 109, deferred tax assets and
liabilities are computed based on the difference between the financial statement
and income tax bases of assets and liabilities using the enacted marginal tax
rate. SFAS No. 109 requires that the net deferred tax asset be reduced by a
valuation allowance if, based on the weight of available evidence, it is more
likely than not that some portion or all of the net deferred tax asset will not
be realized.
Segment Reporting and Significant Customers
SFAS No. 131, "Disclosure about Segments of an Enterprise and Related
Information," establishes standards for the way that public business enterprises
report information about operating segments in annual financial statements and
requires that these enterprises report selected information about operating
segments in interim financial reports. Management has concluded that the
Company's operations occur in one segment only based upon the information used
by management in evaluating the performance of the business. SFAS No. 131 also
establishes standards for related disclosures about products and services,
geographic areas and major customers. The revenue and assets of the Company's
foreign subsidiaries have not been significant. For the three months ended March
31, 2002, two customers individually represented 34% and 12% of revenue. For the
three months ended March 31, 2003, two customers individually represented 36%
and 23% of revenue. The agreements with the Company's significant customers do
not obligate these customers to make any minimum purchases from the Company.
The following table presents the Company's revenue by product (unaudited,
in thousands):
Three Months Ended
March 31,
------------------
2002 2003
------- ------
Visual UpTime ....................... $13,617 $8,227
Visual IP InSight ................... 1,552 861
------- ------
Continuing products ......... 15,169 9,088
------- ------
Visual Internet Benchmark ........... 395 34
Visual Trinity and eWatcher ......... 374 --
Visual Cell Tracer .................. 767 --
------- ------
Discontinued products ..... 1,536 34
------- ------
Royalties ........................... 88 82
------- ------
Total revenue ............ $16,793 $9,204
======= ======
Basic and Diluted Earnings (Loss) Per Share
SFAS No. 128, "Earnings Per Share," requires dual presentation of basic
and diluted earnings (loss) per share. Basic earnings
10
(loss) per share includes no dilution and is computed by dividing net income
(loss) available to common stockholders by the weighted-average number of common
shares outstanding for the period.
Diluted earnings (loss) per share includes the potential dilution that
could occur if securities or other contracts to issue common stock were
exercised or converted into common stock. The treasury stock effect of options
and warrants to purchase 8,207,881 shares of common stock that were outstanding
at March 31, 2002 has been included in the computation of diluted earnings per
share for the three months ended March 31, 2002. The effect of the convertible
debentures issued in March 2002 (see Note 3) that are convertible into 2,986,093
shares of common stock has been included in the computation of diluted earnings
per share for the three months ended March 31, 2002. Options and warrants to
purchase 8,591,321 shares of common stock that were outstanding as of March 31,
2003 were not included in the computation of diluted loss per share for the
three months ended March 31, 2003 as their effect would be anti-dilutive. The
effect of the convertible debentures has not been included in the computation of
diluted earnings per share for the three months ended March 31, 2003 as their
effect would be anti-dilutive.
The following details the computation of the earnings (loss) per share
(unaudited, in thousands, except per share data):
Three Months Ended
March 31,
------------------
2002 2003
------- --------
Net income (loss) ............................ $ 681 $ (92)
======= ========
Basic weighted-average shares outstanding:
Average number of shares of common stock
outstanding ............................. 31,958 32,429
Diluted weighted-average shares outstanding:
Treasury stock effect of options and
warrants ................................ 863 --
Effect of convertible debentures ........... 166 --
------- --------
Diluted weighted-average shares outstanding .. 32,987 32,429
======= ========
Earnings (loss) per common share:
Basic earnings (loss) per share ............ $ 0.02 $ (0.00)
======= ========
Diluted earnings (loss) per share .......... $ 0.02 $ (0.00)
======= ========
New Accounting Pronouncements
In August 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." It 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 No. 146
requires that a liability for a cost associated with an exit or disposal
activity be recognized when the liability is incurred and establishes that fair
value is the objective for initial measurement of the liability. Under EITF
Issue No. 94-3, a liability for an exit cost was recognized at the date of an
entity's commitment to an exit plan. The new standard is effective for exit or
disposal activities that are initiated after December 31, 2002. The Company
believes that SFAS No. 146 will not have a material impact on the Company's
financial position or results of operations.
In November 2002, the EITF reached a consensus on Issue No. 00-21,
"Revenue Arrangements with Multiple Deliverables." EITF Issue No. 00-21 provides
guidance on how to account for arrangements that involve the delivery or
performance of multiple products, services and/or rights to use assets. The
provisions of EITF Issue No. 00-21 will apply to revenue arrangements entered
into in fiscal periods beginning after June 15, 2003. The Company believes that
the adoption of this standard will not have a material impact on the Company's
financial position or results of operations.
In April 2003, the FASB issued SFAS No. 149, "Amendment of Statement 133
on Derivative Instruments and Hedging Activities." SFAS No. 149 amends and
clarifies accounting for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities under SFAS
No. 133. The statement requires that contracts with comparable characteristics
be accounted for similarly and clarifies when a derivative contains a financing
component that warrants special reporting in the statement of cash flows. SFAS
No. 149 is effective for contracts entered into or modified after June 30, 2003,
except in certain circumstances, and for hedging relationships designated after
June 30, 2003. The Company believes that the adoption of this standard will not
have a material effect on the Company's financial position or results of
operations.
Reclassifications
Certain prior period amounts have been reclassified to conform to current
period presentation.
11
2. Credit Agreements and Long-Term Debt:
During 2001 through March 2002, the Company maintained a credit facility,
as amended, that included an accounts receivable-based arrangement providing for
borrowings up to the lesser of $10.0 million or 80% of eligible accounts
receivable (as defined in the credit facility and determined by the bank). The
bank credit facility included an equipment financing arrangement. In connection
with the issuance of the convertible debentures (see Note 3), the Company repaid
the outstanding balance of the credit facility, and the related loan agreements
were terminated.
In December 2000, the bank issued a standby letter of credit, as amended,
in favor of the Company's contract manufacturer, that expires on September 30,
2003 (the original expiration date was March 31, 2002) in the amount of $2.0
million. The letter of credit was $2.5 million as of December 31, 2002. The
Company secured the letter of credit with a pledge of a certificate of deposit
in the amount of $2.0 million that expires on May 31, 2003, as amended from $2.5
million. Upon maturity of the existing certificate of deposit, the Company
expects to use the proceeds to obtain a new certificate of deposit that would
expire on September 30, 2003, and would also be pledged to secure the letter of
credit. The certificate of deposit is recorded as a restricted short-term
investment in the accompanying consolidated balance sheets as of December 31,
2002 and March 31, 2003.
3. Convertible Debentures:
In March 2002, the Company issued senior secured convertible debentures in
the aggregate amount of $10.5 million in a private placement. The Debentures are
due March 25, 2006, are payable in common stock or cash, at the Company's option
provided certain conditions are satisfied, and bear interest at an annual rate
of 5% payable quarterly in common stock or cash, at the Company's option,
provided certain conditions are satisfied. To date, all quarterly interest
payments under the Debentures have been made in cash. The Debentures may be
converted initially into 2,986,093 shares of the Company's common stock at the
option of the holders at a price of $3.5163 per share, subject to certain
adjustments. The conversion price of the Debentures will adjust if the Company
issues additional shares of common stock or instruments convertible into common
stock at a price that is less than the then-effective conversion price of the
Debentures. The Company has the right to require the holders to convert their
Debentures into common stock if the closing price of the Company's common stock
exceeds 175% of the conversion price for 20 consecutive days after September 26,
2003.
In connection with the issuance of the Debentures, the Company issued to
the holders warrants to purchase 828,861 shares of its common stock at an
initial exercise price of $4.2755 per share. The exercise price will be adjusted
if the Company issues additional shares of common stock or instruments
convertible into common stock at a lower price than the then-effective exercise
price. The warrants expire on March 25, 2007.
The holders of the Debentures also received the right to purchase shares
of to-be-created Series A preferred stock (the "Preferred Stock Rights") at
certain dates in the future. The first Preferred Stock Right to purchase 575
shares for $5.8 million expired on May 6, 2002. The holders did not exercise the
right to purchase these shares of Series A preferred stock. A second Preferred
Stock Right to purchase 307 shares for $3.1 million may be exercised at any time
after September 2002 and prior to June 2003. A third Preferred Stock Purchase
Right to purchase 170 shares for $1.7 million expired on May 6, 2002. The
holders did not exercise the right to purchase these shares of Series A
preferred stock. The Debenture holders were also granted certain equity
participation and registration rights.
Under the terms of the Debentures, a number of events could trigger the
Debenture holders' right to force early repayment of 115% of the outstanding
principal plus accrued and unpaid interest owed under the debentures. Events
constituting a triggering event include:
o default by the Company on other indebtedness or obligations under
any other debenture, mortgage, credit agreement or other facility,
indenture agreement, factoring agreement or other instrument under
which there may be issued, or by which there may be secured or
evidenced, any indebtedness for borrowed money or money due under
any long term leasing or factoring arrangement in an amount
exceeding $500,000;
o failure by the Company to have its common stock listed on an
eligible market;
o bankruptcy of the Company;
12
o engagement by the Company in certain change in control, sale of
assets or redemption transactions;
o failure by the Company to timely file its 2003 annual report on Form
10-K; and
o certain other failures by the Company to perform obligations under
the Debenture agreement and/or the related agreements.
In addition, the Debentures include certain financial covenants related to
the Company's financial performance during 2003. If the Company's adjusted
EBITDA for the year ended December 31, 2003 are less than $6.5 million, the
Debenture holders may require that the Company prepay all or a portion of up to
100% of the outstanding principal amount of their Debentures, plus accrued
interest. The redemption may be made in common stock or cash at the Company's
option provided certain conditions are satisfied. The Company's adjusted EBITDA
for the three months ended March 31, 2003 was $0.4 million.
If the Company is required to repay the Debentures early due to the
occurrence of a triggering or other event and does not have sufficient cash to
do so, the Company may be required to seek additional capital through a sale of
additional securities, additional borrowings or a sale of assets, none of which
may be available on terms reasonably acceptable to the Company.
The aggregate amount of the Debentures, $10.5 million, is included in the
accompanying balance sheets as of December 31, 2002 and March 31, 2003, net of
unamortized debt discount of approximately $2.5 million and $2.3 million,
respectively. The net amount represents the fair market value after allocating
the proceeds to the various additional components of the debt. Approximately
$2.1 million in proceeds from the Debentures were allocated to the value of the
warrants. The fair value of the warrants was determined using the Black-Scholes
valuation model with the following assumptions: no dividend yield, expected
volatility of 129%, risk-free interest rate of 4.85% and a term of five years.
Approximately $0.3 million in proceeds from the Debentures was allocated to the
value of the Preferred Stock Rights as determined by an appraisal. On the date
of issuance of the Debentures, the conversion price of the Debentures, after
taking into consideration the allocation of proceeds to the warrants and
Preferred Stock Rights, was less than the quoted market price of the Company's
common stock. Accordingly, approximately $1.0 million in proceeds from the
Debentures was allocated to additional paid-in capital to recognize this
beneficial conversion feature. The discount on the Debentures resulting from the
allocation of proceeds to the value of the warrants, Preferred Stock Rights and
beneficial conversion is being amortized as a charge to interest expense over
the four-year period until the Debentures become due in March 2006.
4. Stock-Based Compensation
In October 1995, the FASB issued SFAS No. 123, "Accounting for Stock-Based
Compensation" that defines a "fair value based method" of accounting for
stock-based compensation. Under the fair value based method, compensation cost
is measured at the grant date based on the fair value of the award and is
recognized over the service period. Prior to the issuance of SFAS No. 123,
stock-based compensation was accounted for under the "intrinsic value method" as
defined by Accounting Principles Board ("APB") Opinion No. 25, "Accounting for
Stock Issued to Employees." Under the intrinsic value method, compensation is
the excess, if any, of the market price of the stock at grant date or other
measurement date over the amount an employee must pay to acquire the stock.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation -- Transition and Disclosure." It provides additional
transition guidance for those companies that elect to voluntarily adopt the
accounting provisions of SFAS No. 123. SFAS No. 148 does not change the
provisions of SFAS No. 123 that allow companies to continue to apply the
intrinsic value method of APB No. 25. The new standard is effective for fiscal
years beginning after December 15, 2002. The standard also contains interim
disclosure provisions that are effective for the first interim period beginning
after December 15, 2002. The Company currently accounts for stock-based
compensation under APB 25 and does not plan to adopt the provisions of SFAS No.
123. However, the Company has adopted the additional disclosure requirements
required under SFAS No. 148.
The Company recorded deferred compensation of approximately $93,000
related to stock option grants during the three months ended March 31, 2002. The
Company amortized approximately $88,000 and $2,000 of deferred compensation
during the three months ended March 31, 2002 and 2003, respectively.
If compensation expense had been determined based on the fair value of the
options at the grant dates consistent with the method of accounting under SFAS
No. 123, the Company's net income (loss) and earnings (loss) per share would
have decreased or increased to the pro forma amounts indicated below (unaudited,
in thousands, except per share amounts):
13
Three Months Ended
March 31,
-------------------
2002 2003
------- -------
Net income (loss), as reported .............................. $ 681 $ (92)
Add: Stock-based employee compensation expense
included in reported net income (loss) .................... 88 2
Deduct: Total stock-based employee compensation
expense determined under fair value based method for all
awards .................................................... (2,375) (1,408)
------- -------
Pro forma net loss .......................................... $(1,606) $(1,498)
======= =======
Earnings (loss) per share:
Basic: as reported ........................................ $ 0.02 $ (0.00)
======= =======
Basic: pro forma .......................................... $ (0.05) $ (0.05)
======= =======
Diluted: as reported ...................................... $ 0.02 $ (0.00)
======= =======
Diluted: pro forma ........................................ $ (0.05) $ (0.05)
======= =======
The fair value of each option is estimated on the date of grant using the
Black-Scholes option-pricing model with the following assumptions used for
grants during the three months ended March 31, 2002 and 2003: no dividend yield,
expected volatility from 120% to 297%, risk-free interest rates from 3.0% to
3.8% and an expected term of 5 years.
5. Commitments and Contingencies:
Litigation
The Company is periodically a party to disputes arising from normal
business activities including various employee-related matters. In the opinion
of management, resolution of these matters will not have a material adverse
effect upon the Company's financial position or future operating results.
14
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Overview
From our incorporation in August 1993 through December 1996, our principal
objective was to secure sufficient equity financing to enable us to accelerate
product development efforts of Visual UpTime for frame relay deployment and
create the corporate infrastructure necessary to support these efforts. We first
shipped Visual UpTime in mid-1995 and began generating significant revenue
during 1996. Since our inception, we have focused on establishing relationships
with service providers with the goal of having these service providers include
our products into their infrastructure or in their service offerings to their
subscribers. Consistent with this goal, we have established agreements with
major service providers such as: AT&T, BellSouth, Earthlink, Equant, SBC,
Sprint, Verizon and WorldCom. During 1998, 1999 and 2000, we continued to focus
on selling Visual UpTime and added to our product portfolio as a result of a
series of acquisitions -- the Net2Net product, CellTracer, in 1998; the Inverse
products, Visual IP InSight and Visual Internet Benchmark, in 1999; and the
Avesta products, Visual Trinity and Visual eWatcher, in 2000. During 2001, we
discontinued development and sales efforts of Visual Trinity and sold the Visual
Internet Benchmark service. In 2002, the remaining customer for our CellTracer
product, Network Associates, placed what they indicated would be final orders.
Also, in 2002, we continued to evaluate the future of the Visual eWatcher and
CellTracer products. In their current form, neither product produced significant
revenue for the year ended December 31, 2002. We believe that the technology of
both products may be useful to other products in the future and we are exploring
alternatives for these products. However, we decided not to focus our
development or sales efforts on these products in 2003. Therefore, we do not
anticipate any significant revenue from these products during 2003. We continue
to focus our sales efforts on Visual UpTime and Visual IP InSight.
We acquired Avesta Technologies, Inc. ("Avesta") on May 24, 2000. We
believed that the acquisition of Avesta would provide critical pieces to our
strategy to become one of the largest network performance management vendors
with one of the industry's broadest portfolios of products and functionality. We
also anticipated that the merger would bring us closer to providing a
single-vendor solution to the internet infrastructure management needs of
customers, especially our intended integration of networks, systems and
applications into a unified service view for service providers and their
enterprise subscribers. We expected to generate revenue from the Avesta products
of approximately $30 million in 2000. Instead, these products generated revenue
of only $7.3 million in 2000, and significantly increased our operating
expenses. Subsequent to the acquisition, we concluded that, without significant
modifications, the primary Avesta product, Trinity, was not a viable solution
for our strategic service provider customers. The product was more specifically
targeted to direct enterprise customers, which did not fit with our service
provider focused business plan. As a result of an analysis performed in early
2001 by a company-wide task force, we determined that the time and expense
required to make the Visual Trinity product competitive in its market space and
more suitable to our service provider customers would be prohibitive. These
factors, in conjunction with revenue declines in our other products, resulted in
a $328.8 million impairment charge and $7.0 million in restructuring charges in
2000. In 2001, we discontinued the Visual Trinity product, resulting in $3.3
million in additional impairment charges related to the remaining intangible
assets from the Avesta acquisition, $3.7 million in a write-down related to an
investment that was acquired with Avesta that was determined to be impaired as
of December 31, 2001 and $2.3 million (net of reversals) in restructuring
charges. We did not have any significant remaining assets related to Avesta
included in our balance sheet as of December 31, 2002 or March 31, 2003.
Following the acquisition of Avesta, we allowed our business strategy to
become less focused, which increased the complexity of our business and
adversely affected our results of operations. We incurred significant losses
from the second quarter of 2000 through the fourth quarter of 2001. The
deterioration of our operating results that began in 2000, excluding the effects
of the impairment and restructuring charges and the write-off of in-process
research and development, was due primarily to decreased revenue and increased
operating expenses following the Avesta acquisition. In response, we made
significant reductions in operating expenses in the remainder of 2000, 2001 and
2002 by closing three facilities and by reducing our workforce by approximately
290 employees from October 2000 through December 2002.
We returned to profitability for the three months ended March 31, 2002 and
remained profitable for each quarter in 2002. However, we incurred a net loss of
$0.1 million for the three months ended March 31, 2003 due to significantly
decreased revenue that declined from $16.8 million for the three months ended
March 31, 2002 to $9.2 million for the three months ended March 31, 2003,
reflecting a reduction in sales for each of our major products. Visual UpTime
revenue decreased by $5.4 million due to a decrease in demand reflecting: 1) the
overall downturn in the telecommunications industry, which was reflected in a
slowdown in demand for telecommunications products and services, including those
based on our products; 2) tighter inventory control at our service provider
customers, particularly AT&T; and 3) the loss of business to competitors.
Revenue from the Visual IP InSight
15
product decreased $0.7 million resulting from decreased demand due to the
bankruptcies of many of the new Internet Service Providers ("ISPs") that were
our primary targets for Visual IP InSight. In addition, revenue from the Visual
IP InSight product often fluctuates significantly from quarter to quarter due to
the timing of sizeable orders placed by a limited number of service providers.
Such fluctuations can also significantly affect our gross margin because our
software costs of revenue are so insignificant. The $1.5 million decrease in
revenue during the quarter from Visual Internet Benchmark, Visual Trinity,
Visual eWatcher and CellTracer reflects, respectively, the sale of Visual
Internet Benchmark and the discontinuation of sales of Visual Trinity, Visual
eWatcher and CellTracer.
We have refocused our sales, marketing and other efforts on our core
Visual UpTime and Visual IP InSight products, our core service provider
customers and service creation over resale to end users. We have directed our
Visual IP InSight development efforts at making the product more suitable for
our core service provider customers and enabling the use of our product in
higher-margin broadband networks over, for example, cable lines and Digital
Subscriber Lines (DSL). We have also aggressively reduced our operating expenses
to be more in line with our reduced revenue projections by revising bonus and
commission plans, revising employee benefits, and significantly reducing
marketing and other discretionary spending. While we do not know when the
downturn in telecommunications industry will end, or how robust the recovery
will be once or if it does begin, we have revised our business plan to reflect
lower projected revenue and reduced our operating expenses as we seek to return
to profitability even with this reduced demand. There can be no assurance that
we will return to profitability.
Based on our current cost structure, our ability to generate net income in
the future is, in large part, dependent on our success in achieving quarterly
revenue of at least $11.0 million to $12.0 million, achieving quarterly gross
margins of 70% to 75% and maintaining or further reducing operating expenses.
Due to market conditions, competitive pressures, and other factors beyond our
control, there can be no assurances that we will be able to meet these goals. In
the event that the anticipated revenue goals are not met, we may not be
profitable and we may be required to further reduce our cost structure.
Our adjusted EBITDA for the quarter ended March 31, 2003 was $0.4 million.
In order for us to meet the financial covenant for 2003 under the Debentures we
must achieve adjusted EBITDA during the remainder of 2003 in excess of $6.1
million. If we are unsuccessful in achieving this financial target, the
Debenture-holders may require us to prepay any or all of the Debentures at any
time after the filing of our annual report on Form 10-K for the year ended
December 31, 2003.
Results of Operations
The following table presents certain consolidated statement of operations
data as a percentage of our revenue:
Three Months Ended
March 31,
------------------
2002 2003
------ ------
Revenue:
Hardware ........................... 65.8% 71.4%
Software ........................... 8.3 3.2
Support and services ............... 25.9 25.4
------ ------
Total revenue .............. 100.0 100.0
------ ------
Cost of revenue:
Product ............................ 25.2 21.5
Support and services ............... 4.4 3.0
------ ------
Total cost of revenue ...... 29.6 24.5
------ ------
Gross profit ....................... 70.4 75.5
------ ------
Operating expenses:
Research and development ........... 19.8 29.8
Sales and marketing ................ 35.3 37.4
General and administrative ......... 10.6 10.3
------ ------
Total operating expenses ... 65.7 77.5
------ ------
Income (loss) from operations ........ 4.7 (2.0)
Other income ......................... -- 4.9
Interest expense, net ................ (0.6) (3.9)
------ ------
Net income (loss) .................... 4.1% (1.0)%
====== ======
16
The following table presents the revenue by product (unaudited, in
thousands):
Three Months Ended
March 31,
------------------
2002 2003
------- ------
Visual UpTime .......................................... $13,617 $8,227
Visual IP InSight ...................................... 1,552 861
------- ------
Continuing products ............................ 15,169 9,088
------- ------
Visual Internet Benchmark .............................. 395 34
Visual Trinity and eWatcher ............................ 374 --
Visual Cell Tracer ..................................... 767 --
------- ------
Discontinued products ........................ 1,536 34
------- ------
Royalties .............................................. 88 82
------- ------
Total revenue ............................... $16,793 $9,204
======= ======
The following table presents the hardware, software, and support and
services revenue attributable to customers that individually represented more
than 10% of our total revenue for each period presented (unaudited, in
thousands):
Three Months Ended
March 31,
------------------
2002 2003
------- ------
AT&T ................................................... $ 5,641 $3,291
Equant ................................................. 2,052 *
Interlink Communications Systems ....................... * 1,041
Sprint ................................................. * 2,080
All other customers (each individually less than 10%) .. 9,100 2,792
------- ------
Total revenue ....................................... $16,793 $9,204
======= ======
*Less than 10%
Our primary sales and marketing strategy depends predominantly on sales of
Visual UpTime and Visual IP InSight to telecommunications service providers.
Service providers use our products as operations tools in their own network
infrastructures, base value-added services on our products and resell our
products to their customers. Pressure on capital expenditures and the decline in
the telecommunications markets may delay the rollout of new services based on
our products. Furthermore, any potential reduction in demand for value-added
services or products from the service providers' customers would directly impact
the volume of our products purchased.
We expect that a significant portion of our revenue in 2003 will be
attributable to sales of Visual UpTime and Visual IP InSight to service
providers. The loss of any one of AT&T, Sprint or WorldCom, which together have
historically provided a majority of our revenue, would result in a substantial
loss of revenue that could have a material adverse effect on our business. For
the three months ended March 31, 2003, AT&T and Sprint represented 36% and 23%,
respectively, of our consolidated revenue. Revenue related to all service
providers represented 82% and 84% of our consolidated revenue for the three
months ended March 31, 2002 and 2003, respectively. This concentration should
continue because our customer base consists predominantly of service providers.
Existing service provider customers are not easily replaced because of the small
number of participants in that market. High barriers to entry due to
extraordinary capital requirements and the increased possibility that existing
service providers may merge or fail because of the current downturn in the
telecommunications industry, may further reduce their number and make replacing
a significant network service provider customer very difficult. Furthermore, the
small number of network service providers means that the reduction, delay or
cancellation of orders or a delay in shipment of our products to any one service
provider customer could have a material adverse effect on our revenue for a
quarter. Our anticipated dependence on sizable orders from a limited number of
service provider customers will make the relationship between us and each
service provider critically important to our business. Further, because none of
our agreements contain minimum purchase requirements, there can be no assurance
that the issuance of a purchase order will result in significant recurring
business.
Our operations and financial position are subject to certain other risks
and uncertainties, including among others, our accumulated deficit, uncertainty
of future profitability and possible fluctuations in financial results, our
potential inability to meet the financial covenant in our Debentures during
2003, substantial fixed operating costs, possible dilution to our common
stockholders due to the conversion features of our convertible debentures,
dependence on sales to key customers, dependence on WorldCom as a significant
customer, dependence on a sole-source subcontract manufacturer, potential
delisting and reduced liquidity of our shares resulting from failure to meet
Nasdaq listing requirements, the potential triggering of early repayment of our
debentures, the continued downturn in the telecommunications industry, long
sales cycles, improvements to the infrastructure of the Internet, rapid
technological change, growing competition from several market segments, errors
in our products, dependence upon sole and limited source suppliers,
17
potential fluctuations in component pricing, potential claims of patent
infringement by third parties, potential failure to protect our intellectual
property rights, dependence upon key employees and the ability to retain
employees. Failure to meet any of these and other challenges could adversely
affect our future operating results.
Results of Operations for the Three Months Ended March 31, 2002 Compared with
the Three Months Ended March 31, 2003
Revenue.
Our revenue can be divided into three types: hardware, software, and
support and services. Each of our products has components of each revenue type.
Sales of Visual UpTime are primarily classified as hardware revenue. We also
sell licenses related to Visual UpTime that are classified as software revenue.
Sales of Visual IP InSight are primarily classified as software revenue.
However, sales of our newest hardware product, the IP Service Element (ISE),
which embeds certain Visual IP InSight functionality in a hardware device, are
classified as hardware revenue. Sales of Visual eWatcher and Visual Trinity,
both discontinued products, were classified as software revenue. Sales of our
Visual IP InSight subscription service, which we no longer offer to our
customers, were classified as support and services revenue. Sales of the Visual
Internet Benchmark service, which was sold in 2001, were classified as support
and services revenue. Royalties from the Visual Internet Benchmark service are
classified as support and services revenue. Sales of CellTracer are classified
as hardware revenue. Sales of technical support, professional services and
training for all of our products are classified as support and services revenue.
Total revenue was $16.8 million for the three months ended March 31, 2002
compared to $9.2 million for the three months ended March 31, 2003, a decrease
of $7.6 million. The share of our revenue related to service providers increased
from approximately 82% of revenue for the three months ended March 31, 2002 to
84% for the three months ended March 31, 2003. We anticipate that the percentage
of revenue attributable to our service providers for the remainder of 2003 will
be consistent with the levels achieved during the first quarter of 2003.
Hardware revenue. Hardware revenue was $11.1 million for the three months
ended March 31, 2002 compared to $6.6 million for the three months ended March
31, 2003, a decrease of $4.5 million. The decrease was due primarily to a
decrease in demand for Visual UpTime from AT&T, Equant, WorldCom and our
reseller channel. We believe, in general, that the decrease in demand for Visual
UpTime was primarily the result of the overall downturn in the
telecommunications industry, which was reflected in a slowdown in demand for
telecommunications products and services and reduced spending. More
specifically, we believe that revenue from AT&T and Equant decreased due to
tighter inventory control and revenue from WorldCom decreased due to the loss of
market share of this customer to its competitors coupled with our loss of
business to our competitors. The decrease was also due to decreased revenue from
CellTracer of $0.8 million due to decreased demand from NAI.
Software revenue. Software revenue was $1.4 million for the three months
ended March 31, 2002 compared to $0.3 million in 2003, a decrease of $1.1
million. The decrease in software revenue was due primarily to a decrease in
Visual IP InSight license revenue reflecting the typical quarterly fluctuation
in revenue from the sale of that product due to the timing of sizeable orders
from a limited number of service providers. License revenue for Visual UpTime
was essentially flat from the three months ended March 31, 2002 to the three
months ended March 31, 2003.
Support and services revenue. Support and services revenue was $4.3
million for the three months ended March 31, 2002 and $2.3 million for the three
months ended March 31, 2003, a decrease of $2.0 million. The decrease in support
and services revenue was due primarily to decreased technical support revenue
for the Visual UpTime product of $1.3 million due to expired contracts that were
not renewed. Support and services revenue from the Visual Trinity product,
Visual eWatcher product and Visual Internet Benchmark service also decreased by
$0.8 million due to expired contracts that have not renewed as a result of the
discontinuation of these products. We will continue to recognize revenue from
the Visual Internet Benchmark service that was sold during 2001, for existing
contracts under which we are still required to perform services through May
2003, all of which is currently in deferred revenue. We also receive royalty
payments from the purchaser on new contracts.
18
Cost of revenue and gross profit.
Cost of revenue consists of subcontracting costs, component parts,
warehouse costs, direct compensation costs, warranty and other contractual
obligations, royalties, license fees and other overhead expenses related to the
manufacturing operations. Product cost of revenue includes both hardware and
software cost of revenue in the accompanying consolidated statements of
operations. Cost of revenue related to software sales has not been significant.
Support and services cost of revenue includes outsourced benchmark services,
professional services and technical support costs.
Total cost of revenue was $5.0 million for the three months ended March
31, 2002 compared to $2.3 million for the three months ended March 31, 2003, a
decrease of $2.7 million. Gross profit was $11.8 million for the three months
ended March 31, 2002 compared to $7.0 million for the three months ended March
31, 2003, a decrease of $4.8 million. Gross profit margin was 70.4% of revenue
for the three months ended March 31, 2002 as compared to 75.5% of revenue for
the three months ended March 31, 2003. The increase in gross profit margin
percentage was due primarily to decreased fixed costs (such as fees paid to
third parties to provide the Visual Internet Benchmark service to customers for
which we had existing contracts), increased high gross profit margin revenue
related to the recognition of technical support and overall decreased fixed
costs in our manufacturing and support operations due to our cost reduction
initiatives implemented since the fourth quarter of 2000. Our future gross
margins may be affected by a number of factors, including product mix, the
proportion of sales to service providers, competitive pricing, manufacturing
volumes and an increase in the cost of component parts. Based on our current
product offerings and the level of fixed cost reductions that has been achieved
to date, we expect our future gross margins to be in the range of 70% to 75%.
Product cost of revenue. Product cost of revenue, which includes both
hardware and software cost of revenue, was $4.2 million for the three months
ended March 31, 2002 compared to $2.0 million for the three months ended March
31, 2003, a decrease of $2.2 million. Our software costs of revenue are
insignificant. The gross profit margin attributable to products was 66.0% and
71.2% for the three months ended March 31, 2002 and 2003, respectively. The
increase in gross profit margin was due primarily to the overall decreased fixed
costs in our manufacturing and support operations due to our cost cutting
initiatives implemented since the fourth quarter of 2000.
Support and services cost of revenue. Support and services cost of
revenue, which includes Visual Internet Benchmark services, professional
services and technical support costs, was $0.7 million for the three months
ended March 31, 2002 compared to $0.3 million for the three months ended March
31, 2003, a decrease of $0.4 million. The gross profit margin attributable to
support and services was 82.9% and 88.2% for the three months ended March 31,
2002 and 2003, respectively. The increase in gross profit margin was due
primarily to decreased fixed costs such as fees paid to third parties to provide
the Visual Internet Benchmark service to customers for which we had existing
contracts.
Operating Expenses.
Research and development expense. Research and development expense
consists primarily of compensation for research and development staff,
depreciation of test and development equipment, certain software development
costs and costs of prototype materials. Research and development expense was
$3.3 million for the three months ended March 31, 2002 compared to $2.7 million
for the three months ended March 31, 2003, a decrease of $0.6 million. The
decrease in research and development expense was due primarily to the workforce
reductions and other cost cutting initiatives implemented during 2002 and 2003.
Research and development expense was 19.8% and 29.8% of revenue for the three
months ended March 31, 2002 and 2003, respectively. We intend to incur research
and development expense at or below the level of such expense in the first
quarter of 2003 as a result of our continued focus on the control of operating
expenses.
Sales and marketing expense. Sales and marketing expense consists of
compensation for the sales and marketing staff, commissions, pre-sales support,
travel and entertainment expense, trade shows and other marketing programs.
Sales and marketing expense was $5.9 million for the three months ended March
31, 2002 compared to $3.4 million for the three months ended March 31, 2003, a
decrease of $2.5 million. The decrease in sales and marketing expense was due
primarily to the workforce reductions and other cost cutting initiatives
implemented during 2002 and 2003. Sales and marketing expense was 35.3% and
37.4% of revenue for the three months ended March 31, 2002 and 2003,
respectively. We intend to incur sales and marketing expense at or below the
level of such expense in the first quarter of 2003 as a result of our continued
focus on the control of operating expenses.
General and administrative expense. General and administrative expense
consists of the costs of executive management, finance, administration and other
activities. General and administrative expense was $1.8 million for the three
months ended March 31, 2002 compared to $0.9 million for the three months ended
March 31, 2003, a decrease of $0.9 million. The decrease in general and
19
administrative expense was due primarily to the workforce reductions and other
cost cutting initiatives implemented during 2002 and 2003. In addition, we sold
the previously written-off receivables related to the bankruptcy of WorldCom to
an unrelated third party for $0.3 million and recorded the sale as a reduction
to bad debt expense in general and administrative expense. General and
administrative expense was 10.6% and 10.3% of revenue for the three months ended
March 31, 2002 and 2003, respectively. We intend to incur general and
administrative expense at the level of such expense in the first quarter of 2003
as a result of our continued focus on the control of operating expenses.
However, general and administrative expense may increase slightly from the level
achieved in the first quarter of 2003 due to the reversal of bad debt expense
during the first quarter of 2003, which was a one-time cost savings.
Other income. Other income was $0.5 million for the three months ended
March 31, 2003, which consisted of a gain on the sale of a previously
written-off investment.
Interest expense, net. Interest expense, net, was $0.1 million for the
three months ended March 31, 2002 compared to $0.4 million for the three months
ended March 31, 2003. The increase of $0.3 million was primarily due to both
cash and non-cash interest expense related to the convertible debentures we
issued in March 2002 (see Note 3 of Notes to the Consolidated Financial
Statements).
Net income (loss). Net income for the three months ended March 31, 2002
was $0.7 million as compared to net loss of $0.1 million for the three months
ended March 31, 2003, a decrease in income of $0.8 million. The decrease was due
primarily to decreased revenue offset by decreases in cost of revenue and
operating expenses and increases in other income.
Liquidity and Capital Resources
At December 31, 2002, our unrestricted cash balance was $12.7 million
compared to $14.3 million as of March 31, 2003, an increase of $1.6 million.
This increase was due primarily to cash generated from operations of $1.4
million due to the reduction in accounts receivable of $3.8 million and the
receipt of a customer deposit of $0.3 million. We used $0.3 million of cash to
purchase equipment and other fixed assets. Cash provided by the reduction of our
restricted short-term investment (see Notes 1 and 2) was $0.5 million and cash
provided by the sale of common stock pursuant to the exercise of employee stock
options and our employee stock purchase plan was $0.1 million.
We require substantial working capital to fund our business, particularly
to finance inventories, accounts receivable, research and development activities
and capital expenditures. To date, we have financed our operations and capital
expenditures primarily with the proceeds from our initial public offering
completed in February 1998, our operating income, bank borrowings and the
proceeds from the issuance of convertible debentures in March 2002. Our future
capital requirements will depend on many factors, including our ability to
sustain revenue, the rate of future revenue growth, if any, as well as our gross
margins and our levels of operating expenses, including product research and
development, sales and marketing and general and administrative expenses.
Our revenue for the three months ended March 31, 2003 was $9.2 million,
which was a decrease of $7.6 million compared to the three months ended March
31, 2002. In response to the trends of decreasing revenue and increasing
operating expenses that began in the second quarter of 2000 following our
acquisition of Avesta, we initiated a restructuring plan in the fourth quarter
of 2000 to realign our product portfolio, streamline our operations and devote
resources to the markets and products that we believe have the greatest
opportunity for growth. In 2001, we announced a plan to discontinue development
and sales efforts on the Visual Trinity product, the primary product acquired
from Avesta, and eliminate the related costs. Also in 2001, we sold the Visual
Internet Benchmark service and discontinued our subscription service of Visual
IP InSight. In 2002, the remaining customer for our CellTracer product, Network
Associates placed what they indicated would be final orders with us for this
product. Also, in 2002, we continued to evaluate the future of the Visual
eWatcher and CellTracer products. In their current form, neither product
produced significant revenue for the three months ended March 31, 2003. We
believe that the technology of both products may be useful to other products in
the future and we are exploring alternatives for these technologies. However, we
decided not to focus our development or sales efforts on these products in 2003.
Therefore, we do not anticipate any significant revenue from these products
during the remainder of 2003. Since 2000, we made significant reductions in
staff and other operating costs such as bonus and commission plans, employee
benefits, marketing and other discretionary spending. As a result of these
actions and the reduction of general and administrative expense due to the
reversal of bad debt expense of $0.3 million, our operating expenses were
reduced from a level of $11.0 million for the three months ended March 31, 2002
to $7.1 million for the three months ended March 31, 2003. As a result of these
cost reductions, we returned to profitability in the first quarter of 2002 and
remained profitable for each quarter in 2002. However, due to the significant
reduction in revenue in the first quarter of 2003, we incurred a net loss of
$0.1 million.
20
Our ability to generate operating income in the future is dependent upon
not only our continued success in reducing operating expenses, but also our
ability to sustain revenue. General market conditions, competitive pressures and
other factors beyond our control may adversely affect our ability to generate
sufficient revenue to enable us to remain profitable. Our ability to sustain
revenue may be negatively affected by our dependence on sales to our service
providers. Pressure on capital expenditures and the decline in the
telecommunications industry may delay the rollout of new services offered by our
service providers based on our products. Furthermore, any potential reduction in
demand for value added services or products from the service providers'
customers directly impacts the volume of our products purchased and may impact
our ability to sustain revenue.
The current level of our operating expenses, which include a substantial
fixed component in the form of compensation, other employee-related costs,
occupancy costs and other costs incurred under contractual arrangements, is
based, in part, on our expectation of future revenue. In the event that the
anticipated cost reductions are not realized or we do not meet our revenue
goals, we may be required to further reduce our cost structure. While we are
able to further reduce these expenses, should reductions become appropriate, it
would take at least thirty to ninety days for the full effects of any such
further expense reductions to be realized. If revenue levels are below
expectations, operating results are likely to be materially and adversely
affected because we may not be able to reduce operating expenses in sufficient
time to compensate for an unexpected reduction in revenue. There can be no
assurances that we will be able to sustain revenue or return to profitability.
Failure to sustain revenue and return to profitability coupled with our limited
capital resources and significant accumulated deficit could also result in our
inability to continue as a going concern.
The significant operating losses incurred by us since the second quarter
of 2000 through the end of 2001 resulted in a significant reduction in our cash.
In order to strengthen our financial position and provide cash for working
capital purposes, in March 2002, we issued senior secured convertible debentures
in the aggregate amount of $10.5 million in a private placement. The debentures
are due March 25, 2006, are payable in common stock or cash, at our option
provided certain conditions are satisfied, and bear interest at an annual rate
of 5% payable quarterly in common stock or cash, at our option, provided certain
conditions are satisfied. To date, all quarterly interest payments under the
debentures have been made in cash. The debentures may be converted currently
into 2,986,093 shares of our common stock at the option of the holders at a
price of $3.5163 per share, subject to certain adjustments. The conversion price
will adjust if we issue certain additional shares of our common stock or
instruments convertible into common stock at a price that is less than the
conversion price of the debentures. We have the right to require the holders to
convert their debentures into common stock if the closing price of our common
stock exceeds 175% of the conversion price for 20 consecutive days after
September 26, 2003.
In connection with the issuance of the debentures, we also issued warrants
to purchase 828,861 shares of our common stock at an exercise price of $4.2755
per share. The exercise price may be adjusted if we issue certain additional
shares of our common stock or instruments convertible into common stock at a
lower price than the initial exercise price. The warrants expire on March 25,
2007. The holders of the debentures also received the right to purchase shares
of to-be-created Series A preferred stock (the "Preferred Stock Rights") at
certain dates in the future. The first Preferred Stock Right to purchase 575
shares for $5.8 million expired on May 6, 2002. The holders did not exercise the
right to purchase these shares of Series A preferred stock. A second Preferred
Stock Right to purchase 307 shares for $3.1 million may be exercised at any time
after the six-month anniversary but before the fifteen-month anniversary of the
issuance of the debentures. A third Preferred Stock Purchase Right to purchase
170 shares for $1.7 million expired on May 6, 2002. The holders did not exercise
the right to purchase these shares of Series A preferred stock. The debenture
holders were also granted certain equity participation and registration rights.
Under the terms of the debentures, a number of events could trigger the
debenture holders' right to force early repayment of 115% of the outstanding
principal plus accrued and unpaid interest owed under the debentures. Events
constituting a triggering event include:
o our default on other indebtedness or obligations under any other
debenture, any mortgage, credit agreement or other facility,
indenture agreement, factoring agreement or other instrument under
which there may be issued, or by which there may be secured or
evidenced, any indebtedness for borrowed money or money due under
any long term leasing or factoring arrangement in an amount
exceeding $0.5 million;
o failure to have our common stock listed on an eligible market;
o our bankruptcy;
21
o engaging in certain change in control, sale of assets or redemption
transactions;
o failure to timely file our 2003 annual report; and
o certain other failures to perform our obligations under the
debenture agreement and/or the related agreements.
In addition, the debentures include certain financial covenants related to
our financial performance during 2003. If adjusted EBITDA for the year ended
December 31, 2003 are less than $6.5 million, our debenture holders may require
that we prepay all or a portion of up to 100% of the outstanding principal
amount of their debentures, plus accrued interest. The redemption may be made in
common stock or cash at our option provided certain conditions are satisfied.
Our adjusted EBITDA for the quarter ended March 31, 2003 was $0.4 million.
If we do not have sufficient cash to repay these amounts early and are
required to do so, we may be required to seek additional capital through a sale
of assets, sale of additional securities or through additional borrowings, none
of which may be available on terms reasonably acceptable to us.
In connection with the issuance of the debentures, the outstanding amounts
borrowed from the bank under our accounts receivable-based and our equipment
financing arrangements were repaid, and the related loan agreements were
terminated. The standby letter of credit, as amended, issued by the bank in
December 2000, in the amount of $2.0 million with an expiration date of
September 30, 2003 remains outstanding and secured with our pledge of a
certificate of deposit in the amount of $2.0 million that matures on May 31,
2003. As the result of an updated analysis of their inventory and credit risk,
our subcontract manufacturer agreed in the first quarter to a reduction of the
letter of credit from $2.5 million to $2.0 million. The corresponding $500,000
reduction in the amount of the pledged certificate of deposit was a source of
cash for us in the first quarter. We do not expect this requirement to change
again during the remainder of the year.
Proceeds from the issuance of the $10.5 million of debentures
significantly improved our cash position and working capital; and our cash
position and working capital have continued to improve as a result of our cash
flow from operations. Our balance of cash and cash equivalents was $14.3 million
as of March 31, 2003, up $1.6 million from December 31, 2002. Accounts payable
and accrued expenses totaled $7.1 million at March 31, 2003, down $2.6 million
from December 31, 2002, and current assets exceeded current liabilities by
approximately $10.7 million as of March 31, 2003.
Based on our current cost structure, our ability to generate net income in
the future is, in large part, dependent on our success in achieving quarterly
revenue of at least $11.0 million to $12.0 million, achieving quarterly gross
margins of 70% to 75% and maintaining or further reducing operating expenses.
Due to market conditions, competitive pressures, and other factors beyond our
control, there can be no assurances that we will be able to meet these goals. In
the event that the anticipated revenue goals are not met, we may be required to
further reduce our cost structure. If we cannot achieve these operating goals
during 2003, we may not be able to meet the financial covenant contained in the
Debentures and may be subject to early repayment of the Debentures.
Future minimum payments as of March 31, 2003 under the debentures and
non-cancelable operating leases are as follows (in thousands):
Operating
Debentures Leases
---------- ---------
2003 ...................................... $ 396 $1,312
2004 ...................................... 528 1,883
2005 ...................................... 528 1,863
2006 ...................................... 10,622 1,886
Thereafter ................................ -- --
-------- ------
Total minimum payments .......... 12,074 $6,944
======
Interest element of payment ............... (1,574)
--------
Present value of future minimum payments .. 10,500
Unamortized debt discount ................. (2,342)
Current portion ........................... --
--------
Long-term portion ......................... $ 8,158
========
22
We have purchase commitments for inventory purchased by certain suppliers
on our behalf. If such inventory is not used within a specified period of time,
we discontinue a product for which the suppliers have made purchases or we
terminate a relationship with the supplier for which we have set minimum
inventory requirements, we are required to purchase the inventory from the
suppliers. Additionally, if we cancel a purchase order placed on a supplier, we
may be subject to certain costs and fees.
We do not engage in any off-balance sheet financing arrangements. In
particular, we do not have any interest in so-called limited purpose entities,
which include special purpose entities and structured finance entities.
The future success of our Company will be dependent upon, among other
factors, our ability to generate adequate cash for operating and capital needs.
We are relying on our existing balance of cash and cash equivalents together
with future sales and the collection of the related accounts receivable, at
least at the levels set forth in our business plan, to meet our future cash
requirements for at least the next twelve months. If cash provided by these
sources is not sufficient, we will be required to further reduce our
expenditures for operations or to seek additional capital through other means
that may include the sale of assets, the sale of equity securities or additional
borrowings. There can be no assurance that additional capital will be available,
or available on terms that are reasonable or acceptable to us. If we are unable
to generate additional cash, our business and financial condition may be
materially and adversely affected such that we may need to consider other
alternatives for our future.
Critical Accounting Policies and Estimates
Our significant accounting policies are described in Note 1 of Notes to
Consolidated Financial Statements. We consider the accounting policies related
to revenue recognition and inventory valuation to be critical to the
understanding of our results of operations. Our critical accounting policies
also include the areas where we have made the most difficult, subjective or
complex judgments in making estimates, and where these estimates can
significantly impact our financial results under different assumptions and
conditions. We prepare our financial statements in conformity with generally
accepted accounting principles in the United States. As such, we are required to
make certain estimates, judgments and assumptions that we believe are reasonable
based upon the information available. These estimates and assumptions affect the
reported amounts of assets and liabilities at the date of the financial
statements and the reported amounts of revenue and expenses during the periods
presented. Actual results could differ from those estimates.
Revenue Recognition
We recognize revenue from hardware, software and support and services. Our
revenue recognition policies follow the American Institute of Certified Public
Accountants Statement of Position ("SOP") No. 97-2, "Software Revenue
Recognition" and SEC Staff Accounting Bulletin ("SAB") No. 101, "Revenue
Recognition in Financial Statements," which summarizes existing accounting
literature and requires that four criteria be met prior to the recognition of
revenue. Our accounting policies regarding revenue recognition are written to
comply with the following criteria (see Note 1 of Notes to Consolidated
Financial Statements): 1) persuasive evidence of an arrangement exists; 2)
delivery has occurred; 3) the fee is fixed or determinable; and 4)
collectibility is probable. The third and fourth criteria may require us to make
significant judgments or estimates.
To determine if a fee is fixed or determinable, we evaluate rights of
return, customer acceptance rights, if applicable, and multiple-element
arrangements of products and services to determine the impact on revenue
recognition. Our agreements generally have not included rights of return except
in certain reseller relationships that include stock rotation rights. If
offered, rights of return only apply to hardware. If an agreement provides for a
right of return, we typically recognize revenue when the right has expired or
the product has been resold by the master distributor. If we have sufficient
historical information to allow us to make an estimate of returns in accordance
with Statement of Financial Accounting Standards ("SFAS") No. 48, "Revenue
Recognition When Right of Return Exists," we defer an estimate for such returns
and recognize the remainder at the date of shipment. If an agreement provides
for evaluation or customer acceptance, we recognize revenue upon the completion
of the evaluation process, acceptance of the product by the customer and
completion of all other criteria. Most of our sales are multiple-element
arrangements and include hardware, software, and technical support. Our software
sales sometimes include professional services for implementation but these
services are not a significant source of our revenue. Training is also offered
but is not a significant source of our revenue. Revenue from multiple-element
arrangements is recognized using the residual method whereby the fair value of
any undelivered elements, such as customer support and services, is deferred and
any residual value is allocated to the software and recognized as revenue upon
delivery. The fair values of any undelivered elements, typically professional
services, technical support and training, have been determined based on our
specific objective evidence of fair value, which is based on the price that we
charge customers when the element is sold separately.
23
Our technical support contracts require us to provide technical support
and unspecified software updates to customers on a when and if available basis.
We recognize customer support revenue, including support revenue that is bundled
with product sales, ratably over the term of the contract period, which
generally ranges from one to three years. We recognize revenue from services
when the services are performed. Subscription fees for our benchmark reports are
recognized upon delivery of the reports. The remaining subscription fees will be
complete in May 2003 when the final contract under which we are obligated to
provide service will be complete.
We sell our products directly to service providers, through indirect
channels and to end-user customers. Certain reseller customers have stock
rotation rights, under which the customer can exchange previously purchased
products for other products of equal or greater cost, subject to certain
limitations, based on their end-user customers' requirements. We recognize
revenue under these arrangements once the stock rotation right expires or the
product has been resold by our master distributor.
We also examine the specific facts and circumstances of all sales
arrangements with payment terms extending beyond our normal payment terms to
make a determination of whether the sales price is fixed or determinable and
whether collectibility is probable. Payment terms are not tied to milestone
deliverables or customer acceptance. Our evaluation of the impact on revenue
recognition, if any, includes our history with our customers and the specific
facts of each arrangement. It is generally not our practice to offer payment
terms that differ from our normal payment terms, and we have not written off any
accounts receivable related to extended payment term arrangements.
Inventory
Because of the order lead times required to obtain manufactured product,
we must maintain sufficient quantities of inventory of all of our products to
meet expected demand. If actual demand is much lower than forecasted, we may not
be able to dispose of our inventory at or above its cost. We write down our
inventory for estimated excess and obsolete amounts to the lower of cost or
market value. The estimates are based on historical trends, forecasts and
specific customer or transaction information. It is generally our policy to
write-down inventory to the amount that we expect to sell within a one-year
period. If future demand is lower than currently estimated, additional
write-downs of our inventory may be required.
Allowance for Bad Debt
We grant credit terms without collateral to our customers and, prior to
2002, had not experienced any significant credit related losses. During 2002,
the Company wrote-off approximately $0.7 million in receivable balances due from
WorldCom, following WorldCom's bankruptcy filing, against the allowance for bad
debts. During the three months ended March 31, 2003, we sold the previously
written-off receivables for WorldCom to an unrelated third party for
approximately $0.3 million. Accounts receivable include allowances to record
receivables at their estimated net realizable value, which is determined based
on estimates for bad debt. The estimates are based on historical information and
specific review of outstanding receivables at the end of each reporting period.
If future events occur that impact our customers, additional write-downs of our
accounts receivable may be required.
Factors That May Affect Future Results
Our operations and financial condition are subject to certain other risks
and uncertainties, including among others, our accumulated deficit and
uncertainty of future profitability and possible fluctuations in financial
results, our potential inability to meet the financial covenant in our
Debentures during 2003, dependence on network service providers, substantial
fixed operating costs, possible dilution to our common stockholders, dependence
on sales to key customers, including WorldCom, dependence on a sole-source
subcontract manufacturer, potential delisting and reduced liquidity of our
shares resulting from failure to meet Nasdaq listing requirements, the potential
triggering of early repayment of our debentures, the downturn in the
telecommunications industry, long sales cycles, improvements to the
infrastructure of the Internet, rapid technological change, growing competition
from several market segments, errors in our products, dependence upon sole and
limited source suppliers, potential fluctuations in component pricing, potential
claims of patent infringement by third parties, potential failure to protect our
intellectual property rights, dependence upon key employees and our ability to
retain employees. In addition the military actions being taken against Iraq by
the United States and its allies have increased the already substantial economic
and political uncertainties that could have an adverse effect on Visual
Networks' business. The market for our products is growing and our business
environment is characterized by rapid technological changes, changes in customer
requirements and new emerging market segments. Consequently, to compete
effectively, we must make
24
frequent new product introductions and enhancements and deploy sales and
marketing resources to take advantage of new business opportunities. Failure to
meet any of these and other challenges could adversely affect our future
operating results.
This Quarterly Report on Form 10-Q contains forward-looking information
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934, and is subject to the safe harbor
created by those sections. Our future results may be impacted by the various
important factors summarized in this Quarterly Report and more fully discussed
in our Annual Report on Form 10-K for the year ended December 31, 2002.
Item 3. Qualitative and Quantitative Disclosure About Market Risk
During 2002, we issued long-term debt in the form of the convertible
debentures discussed in Note 3 of Notes to Consolidated Financial Statements.
The convertible debentures bear interest at a fixed annual rate of 5%. We are
also exposed to market risk from changes in interest rates. Our investment
policy restricts us to investing only in investment-grade securities. A failure
of these investment securities to perform at their historical levels could
reduce the interest income realized by us. As of March 31, 2003, the fair value
of our long-term debt did not differ materially from its carrying value.
While substantially all of our product sales to date have been made to
customers in the United States, we plan to sell our products to foreign
customers at prices denominated in U.S. dollars. However, if we commence selling
material volumes of product to such customers at prices not denominated in U.S.
dollars, we intend to adopt a strategy to hedge against fluctuations in foreign
currency.
Item 4. Controls and Procedures
Our management, under the supervision and with the participation of Peter
J. Minihane, our President and Chief Executive Officer and principal financial
officer during the three months ended March 31, 2003, performed an evaluation of
the effectiveness of the design and operation of our disclosure controls and
procedures within 90 days before the filing of this quarterly report. Based on
that evaluation, Mr. Minihane concluded that our disclosure controls and
procedures are effective. There have been no significant changes in our internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation.
25
PART II -- OTHER INFORMATION
Item 1. Legal Proceedings
We are periodically a party to disputes arising from normal business
activities including various employee-related matters. In the opinion of
management, resolution of these matters will not have a material adverse effect
upon our financial position or future operating results.
Item 2. Changes in Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Submission of Matters to Vote of Security Holders
None.
Item 5. Other Information
None.
26
Item 6. (a) Exhibits
The following exhibits are filed or incorporated by reference as stated
below:
Exhibit Number Description
3.1$ Amended and Restated Certificate of Incorporation of the
Company.
3.1.1@ Certificate of Amendment to Amended and Restated Certificate
of Incorporation.
3.2* Restated By-Laws of the Company.
4.1@@ Registration Rights Agreement, dated as of March 25, 2002,
between Visual Networks Inc. and the Purchasers named therein
(filed as Exhibit 99.3 to the Form 8-K).
4.2@@ Form of 5% Senior Secured Convertible Debenture of Visual
Networks, Inc. due March 25, 2006 (filed as Exhibit 99.2 to
the Form 8-K).
4.3@@ Form of Warrant of Visual Networks, Inc., dated March 25, 2002
(filed as Exhibit 99.4 to the Form 8-K).
10.1* 1994 Stock Option Plan.
10.2* 1997 Omnibus Stock Plan, as amended.
10.2.1** Amendment No. 2 to the 1997 Omnibus Stock Plan (related to
Exhibit 10.2).
10.3* Amended and Restated 1997 Directors' Stock Option Plan.
10.3.1** Amendment No. 2 to the 1997 Directors' Stock Option Plan
(related to Exhibit 10.3).
10.4!! 2000 Stock Incentive Plan, as amended.
10.4.1** Amendment No. 1 to the 2000 Stock Incentive Plan (related to
Exhibit 10.4).
10.5*+ Reseller/Integration Agreement, dated August 29, 1997, by and
between the Company and MCI Telecommunications Corporation.
10.5.1$$$++ Second Amendment, dated November 4, 1998, to the
Reseller/Integration Agreement between the Company and MCI
Telecommunications Corporation (relating to Exhibit 10.5).
10.5.2&& Agreement, dated July 25, 2002, by and between the Company and
MCI WorldCom Network Services, Inc.
10.5.3! Amendment to the Agreement by and between the Company and MCI
WorldCom Network Services, Inc. (related to Exhibit 10.5.2).
10.6****++ Master Purchase of Equipment and Services Agreement, dated as
of May 22, 2000, between Sprint/United Management Company and
the Company.
10.7*+ General Agreement for the Procurement of Equipment, Services
and Supplies, dated November 26, 1997, between the Company and
AT&T Corp.
10.8* Lease Agreement, dated December 12, 1996, by and between the
Company and The Equitable Life Assurance Society of the United
States.
10.8.1* Lease Amendment, dated September 2, 1997, by and between the
Company and The Equitable Life Assurance Society of the United
States (related to Exhibit 10.8).
10.8.2$$$ Second Lease Amendment, dated February 8, 1999, by and between
the Company and TA/Western, LLC, successor to The Equitable
Life Assurance Society of the United States (relating to
Exhibit 10.8).
10.8.3*** Third Lease Amendment, dated January 10, 2000, by and between
the Company and TA/ Western, LLC (relating to Exhibit 10.8).
10.8.4!! Fourth Lease Amendment, dated May 17, 2000, by and between the
Company and TA/ Western, LLC (relating to Exhibit 10.8).
10.11!! Lease Agreement, dated April 7, 2000, by and between Visual
Networks, Inc. and TA/ Western, LLC.
10.20$$ 1999 Employee Stock Purchase Plan, as amended April 11, 2001
and January 9, 2002.
10.28 Employment Agreement, dated April 28, 2003, by and between the
Company and Lawrence S. Barker.
10.29 Nonstatutory Stock Option Grant Agreement, dated April 28,
2003, by and between the Company and Lawrence S. Barker.
10.30!!! Terms of Employment, dated July 27, 2000, by and between the
Company and Steve Hindman.
10.33@@ Securities Purchase Agreement, dated as of March 25, 2002,
between Visual Networks, Inc. and the Purchasers named therein
(filed as Exhibit 99.1 to the Form 8-K).
27
10.34@@ Security Agreement, dated as of March 25, 2002, between Visual
Networks, Inc. and the Secured Parties named therein (filed as
Exhibit 99.5 to the Form 8-K).
10.35@@ IP Security Agreement, dated as of March 25, 2002, between
Visual Networks, Inc., its subsidiaries and the Secured
Parties named therein (filed as Exhibit 99.6 to the Form 8-K).
10.36++& Agreement for Electronic Manufacturing Services, dated March
1, 2000, by and between Visual Networks Operations, Inc. and
Celestica Corporation.
10.37** OEM Software License Agreement between Cisco Systems, Inc. and
the Company, dated December 3, 2002.
10.37.1** Amendment No. 1 to the OEM Software License Agreement between
Cisco and the Company, effective December 3, 2002 (related to
Exhibit 10.37).
21.1**** List of subsidiaries of the Company.
99.1 Certification pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
* Incorporated herein by reference to the Company's Registration
Statement on Form S-1, No. 333-41517.
** Incorporated herein by reference to the Company's Annual
Report on Form 10-K for the year ended December 31, 2002.
*** Incorporated herein by reference to the Company's Annual
Report on Form 10-K for the year ended December 31, 1999.
**** Incorporated herein by reference to the Company's Annual
Report on Form 10-K for the year ended December 31, 2000.
@ Incorporated herein by reference to the Company's Registration
Statement on Form S-4, No. 333-33946.
@@ Incorporated herein by reference to the Company's Current
Report on Form 8-K filed March 27, 2002.
$ Incorporated herein by reference to Exhibit 3.1 to the
Company's Quarterly Report on Form 10-Q for the three months
ended June 30, 1999.
$$ Incorporated herein by reference to the Company's Definitive
Proxy Statement on Schedule 14A filed April 24, 2002.
$$$ Incorporated herein by reference to the Company's Annual
Report on Form 10-K for the year ended December 31, 1998.
+ Portions of this Exhibit were omitted and have been filed
separately with the Secretary of the Commission pursuant to
the Company's Application Requesting Confidential Treatment
under Rule 406 of the Securities Act, filed on December 22,
1997, January 28, 1998 and February 4, 1998.
++ Portions of this Exhibit were omitted and have been filed
separately with the Secretary of the Commission pursuant to
the Company's Application Requesting Confidential Treatment
under Rule 24b-2 of the Securities Exchange Act.
!! Incorporated herein by reference to the Company's Quarterly
Report on Form 10-Q for the three months ended June 30, 2000.
!!! Incorporated herein by reference to the Company's Quarterly
Report on Form 10-Q for the three months ended June 30, 2001.
!!!! Incorporated herein by reference to the Company's Annual
Report on Form 10-K/A for the year ended December 31, 2001.
& Incorporated herein by reference to the Company's Quarterly
Report on Form 10-Q for the three months ended March 31, 2002.
&& Incorporated herein by reference to the Company's Quarterly
Report on Form 10-Q for the three months ended June 30, 2002.
! Incorporated by reference herein by reference to the Company's
Quarterly Report on Form 10-Q for the three months ended
September 30, 2002
(b) Reports on Form 8-K
(1) On January 7 2003, we filed an Item 5 8-K announcing the appointment
of Patrick Clark and Steven Hindman as executive officers and
announcing the dismissal of our class action lawsuit.
(2) On March 27, 2003, we filed an Item 7 8-K attaching the 906
Certification under Sarbanes-Oxley Act by Mr. Minihane.
28
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Company has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
VISUAL NETWORKS, INC.
By: /s/ Peter J. Minihane
--------------------------------------
Peter J. Minihane
Executive Officer and Director
May 7, 2003
29
CERTIFICATIONS
I, Peter J. Minihane, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Visual Networks, Inc.
(the "registrant");
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. I am responsible for establishing and maintaining disclosure controls and
procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the
registrant and I 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 me by others within those entities, particularly
during the period in which this quarterly report is being prepared;
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 my conclusions about the
effectiveness of the disclosure controls and procedures based on my evaluation
as of the Evaluation Date;
5. I have disclosed, based on our most recent evaluation, to the registrant's
auditors and the audit committee of the 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; and
6. 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.
May 7, 2003 By: /s/ Peter J. Minihane
------------------------------------
Name: Peter J. Minihane
Title: President, Chief Executive
Officer and Director
(Principal Executive Officer
and Principal Financial and
Accounting Officer) during
the three months ended
March 31, 2003
30