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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 


 

FORM 10-Q

 


 

Quarterly Report Under Section 13 or 15(d)

of the Securities Exchange Act of 1934

 

(Mark One)

 

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

 

For the quarterly period ended March 31, 2004

 

OR

 

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

 

For the transition period from              to             

 

Commission file number 000-30865

 


 

AVICI SYSTEMS INC.

(Exact Name of Registrant as Specified in Its Charter)

 


 

Delaware   02-0493372
(State or Other Jurisdiction of Organization)   (I.R.S. Employer Identification No.)

 

101 Billerica Avenue

North Billerica, Massachusetts 01862

(Address of Principal Executive Offices) (Zip Code)

 

Registrant’s Telephone Number, Including Area Code (978) 964-2000

 


 

Indicate by check x whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days    Yes  x    No  ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2).    Yes  ¨    No  x

 

At May 6, 2004, 12,632,127 shares of the registrant’s Common Stock, par value $0.0001 per share, were outstanding.


Table of Contents

AVICI SYSTEMS INC.

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2004

TABLE OF CONTENTS

 

               PAGE

PART I. FINANCIAL INFORMATION

    
     ITEM 1.    Financial Statements (Unaudited)     
         

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

   3
         

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

   4
         

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

   5
         

Notes to Consolidated Financial Statements

   6
     ITEM 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations    12
     ITEM 3.    Quantitative and Qualitative Disclosures About Market Risk    20
     ITEM 4.    Controls and Procedures    20

PART II. OTHER INFORMATION

    
     ITEM 1.    Legal Proceedings    20
     ITEM 2.    Changes in Securities and Use of Proceeds    *
     ITEM 3.    Defaults Upon Senior Securities    *
     ITEM 4.    Submission of Matters to a Vote of Security Holders    *
     ITEM 5.    Other Information    *
     ITEM 6.    Exhibits and Reports on Form 8-K    22

SIGNATURE

   23

* No information provided due to inapplicability of item.

 

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PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

AVICI SYSTEMS INC.

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

(unaudited)

 

    

March 31,

2004


   

December 31,

2003


 

ASSETS

                

Current assets:

                

Cash and cash equivalents

   $ 40,237     $ 22,374  

Marketable securities

     32,378       41,240  

Trade accounts receivable, net

     4,445       6,620  

Inventories

     1,748       1,206  

Prepaid expenses and other current assets

     1,007       1,200  
    


 


Total current assets

     79,815       72,640  

Property and equipment, net

     8,847       10,658  

Long-term marketable securities

     21,204       32,316  

Contract distribution rights

     5,794       —    

Other assets

     244       432  
    


 


Total assets

   $ 115,904     $ 116,046  
    


 


LIABILITIES AND STOCKHOLDERS’ EQUITY

                

Current liabilities:

                

Current maturities of capital lease obligations

   $ —       $ 46  

Accounts payable

     7,200       5,539  

Accrued payroll and payroll-related costs

     2,340       3,869  

Accrued restructuring costs

     251       412  

Accrued other

     2,783       3,264  

Deferred revenue

     2,519       2,689  
    


 


Total current liabilities

     15,093       15,819  
    


 


Commitments and contingencies

                

Stockholders’ equity:

                

Preferred stock, $0.01 par value: Authorized – 5,000,000 shares Issued and outstanding – none

     —         —    

Common stock, $0.0001 par value: Authorized – 250,000,000 shares Issued– 13,104,172 shares at March 31, 2004 and 12,715,941 shares at December 31, 2003

     1       1  

Additional paid-in capital

     462,098       458,567  

Common stock warrants

     18,521       12,200  

Subscription receivable

     (2,500 )     (2,500 )

Treasury Stock, at cost-482,308 shares at March 31, 2004 and December 31, 2003

     (2,108 )     (2,108 )

Deferred compensation

     (505 )     (315 )

Accumulated deficit

     (374,696 )     (365,618 )
    


 


Total stockholders’ equity

     100,811       100,227  
    


 


Total liabilities and stockholders’ equity

   $ 115,904     $ 116,046  
    


 


 

See accompanying notes.

 

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AVICI SYSTEMS INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

(unaudited)

 

    

Three months ended

March 31,


 
     2004

    2003

 

Revenue:

                

Product

   $ 5,820     $ 6,663  

Service

     1,134       927  
    


 


Total gross revenue

     6,954       7,590  

Common stock warrant discount-Product

     (527 )     (817 )
    


 


Net revenue

     6,427       6,773  
    


 


Cost of revenue – product

     2,056       3,261  

Cost of revenue – service

     594       762  
    


 


Total cost of revenue

     2,650       4,023  
    


 


Gross margin

     3,777       2,750  
    


 


Operating expenses:

                

Research and development (1)

     9,085       11,341  

Sales and marketing (1)

     2,705       2,801  

General and administrative (1)

     1,335       1,541  

Stock-based compensation

     137       452  
    


 


Total operating expenses

     13,262       16,135  
    


 


Loss from operations

     (9,485 )     (13,385 )

Interest income, net

     407       685  
    


 


Net loss

   $ (9,078 )   $ (12,700 )
    


 


Net loss per share:

                

Basic and diluted

   $ (0.73 )   $ (1.03 )
    


 


Weighted average common shares used in computing net loss per share:

                

Basic and diluted

     12,431,081       12,340,912  
    


 


(1) Excludes noncash, pre-IPO stock-based compensation, as follows:

                

Research and development

     100     $ 276  

Sales and marketing

     22       88  

General and administrative

     15       88  
    


 


     $ 137     $ 452  
    


 


 

See accompanying notes.

 

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AVICI SYSTEMS INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(unaudited)

 

     Three Months Ended
March 31,


 
     2004

    2003

 

Cash Flows from Operating Activities:

                

Net loss

   $ (9,078 )   $ (12,700 )

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

                

Depreciation and amortization

     3,414       5,698  

Expense associated with issuance of common stock warrants

     527       817  

Compensation expense associated with stock based compensation to employees and consultants

     248       452  

Changes in current assets and liabilities:

                

Trade accounts receivable

     2,175       (1,730 )

Inventories

     (542 )     303  

Prepaid expenses and other current assets

     381       35  

Accounts payable

     1,661       779  

Accrued payroll and payroll related

     (1,529 )     296  

Accrued restructuring costs

     (161 )     (270 )

Accrued other

     (477 )     (630 )

Deferred revenue

     (170 )     (3,311 )
    


 


Cash used in operating activities

     (3,551 )     (10,261 )
    


 


Cash Flows from Investing Activities:

                

Maturity of marketable securities

     26,013       18,827  

Purchases of marketable securities

     (6,039 )     (5,080 )

Purchases of property and equipment

     (1,603 )     (1,502 )
    


 


Cash provided by investing activities

     18,371       12,245  
    


 


Cash Flows from Financing Activities:

                

Proceeds from employee stock plans

     3,089       4  

Repurchase of stock

     —         (384 )

Payments on capital lease obligations

     (46 )     (251 )
    


 


Cash provided by (used in) financing activities

     3,043       (631 )
    


 


Net increase in Cash and Cash Equivalents

     17,863       1,353  

Cash and Cash Equivalents, Beginning of Period

     22,374       28,707  
    


 


Cash and Cash Equivalents, End of Period

   $ 40,237     $ 30,060  
    


 


 

See accompanying notes.

 

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AVICI SYSTEMS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(all tabular amounts are in thousands except per share data)

 

NOTE 1. BASIS OF PRESENTATION

 

The financial information included herein has been prepared by Avici Systems Inc., pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) and includes the accounts of Avici Systems Inc. and subsidiaries (“Avici” or the “Company”). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted in accordance with such rules and regulations. In the opinion of Avici, the accompanying consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the financial position at March 31, 2004 and December 31, 2003 and the operating results and cash flows for the periods ended March 31, 2004 and 2003. These consolidated financial statements and notes should be read in conjunction with Avici’s consolidated audited financial statements and notes thereto for the year ended December 31, 2003, which appear in Avici’s Annual Report on Form 10-K. The consolidated balance sheet at December 31, 2003 has been derived from the audited consolidated financial statements as of that date.

 

The results of operations for the three months ended March 31, 2004 are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year ending December 31, 2004.

 

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

 

(a) Revenue Recognition

 

Avici recognizes revenue from product sales upon shipment, provided that a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed or determinable and collectibility is deemed probable. If uncertainties regarding customer acceptance exist, Avici recognizes revenue when those uncertainties are resolved. For arrangements that include the delivery of multiple elements, revenue is allocated to the various elements based on vendor-specific objective evidence of fair value (VSOE). Avici uses the residual method when VSOE does not exist for one of the delivered elements in an arrangement. Revenue from support and maintenance contracts is recognized ratably over the period of the related agreements. Revenue from installation and other services is recognized as the work is performed. Amounts collected or billed prior to satisfying the above revenue recognition criteria are recorded as deferred revenue.

 

(b) Cost of Revenue – Service

 

Cost of Revenue – Service includes internal costs associated with providing customer support and maintenance services. As personnel responsible for providing such services are also engaged in other activities such as sales and marketing and product development, Avici aggregates certain costs, including payroll, fringe, overhead and depreciation, and allocates a portion of those costs to Cost of Revenue – Service. Such allocation is based on an estimation of time devoted towards supporting the service programs, which Avici believes to be reasonable.

 

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(c) Guarantees and Product Warranties

 

In the normal course of business, Avici may agree to indemnify other parties, including customers, lessors and parties to other transactions with Avici, with respect to certain matters. Avici has agreed to hold these other parties harmless against losses arising from a breach of representations or covenants, or other claims made against these parties. Historically, payments made by Avici, if any, under these agreements have not had a material impact on Avici’s operating results or financial position.

 

Avici establishes warranty reserves for costs expected to be incurred after the sale and delivery of product for deficiencies as required under specific product warranty provisions. The warranty reserves are determined based on the actual trend of historical charges incurred over the prior twelve-month period excluding any significant or infrequent issues, which are specifically identified and reserved for. The warranty liability is established when it is probable that customers will make claims and when a reasonable estimate of costs can be made. Warranty reserves are included in accrued other in the accompanying consolidated balance sheets.

 

Balance at December 31, 2003

   $ 1,116  

Warranties issued during the period

     160  

Settlements made during the period

     (295 )
    


Balance at March 31, 2004

   $ 981  
    


 

(d) Cash and Cash Equivalents and Marketable Securities

 

Avici has classified its cash equivalents and marketable securities as held-to-maturity and recorded them at amortized cost, which approximates market value. Avici considers all highly liquid investments with original maturities of three months or less at the date of acquisition to be cash equivalents. Cash and cash equivalents and marketable securities include money markets, certificates of deposit and commercial paper. Long-term marketable securities include commercial paper, corporate bonds and U.S. government obligations with remaining maturities greater than one year.

 

Cash, cash equivalents and marketable securities consist of the following:

 

     March 31,
2004


   December 31,
2003


Cash and cash equivalents

   $ 40,237    $ 22,374

Marketable securities

     32,378      41,240
    

  

Subtotal

     72,615      63,614

Long-term marketable securities

     21,204      32,316
    

  

     $ 93,819    $ 95,930
    

  

 

(e) Use of estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions, including certain allocations of costs, that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.

 

 

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(f) Inventories

 

Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following:

 

     March 31,
2004


   December 31,
2003


Finished goods

   $ 1,577    $ 1,055

Raw materials

     171      151
    

  

     $ 1,748    $ 1,206
    

  

 

Avici regularly reviews inventory quantities on hand and inventory commitments with suppliers and records a provision for excess and obsolete inventory based primarily on the estimated forecast of product demand for the next twelve months.

 

(g) Net Loss per Share

 

Basic and diluted net loss per common share was determined by dividing net loss available for common stockholders by the weighted average common shares outstanding during the period, less shares subject to repurchase. Basic and diluted net loss per share are the same because all outstanding common stock options have been excluded, as they are considered antidilutive.

 

(h) Comprehensive Income

 

Comprehensive income (loss) is the total of net income and all other nonowner changes in equity, including items such as unrealized gains (losses) on securities classified as available for sale, foreign currency translation adjustments and minimum pension liability adjustments. Comprehensive loss equaled net loss for all period presented.

 

(i) Stock-Based Compensation

 

Avici accounts for stock-based compensation for employees under APB Opinion No. 25, “Accounting for Stock Issued to Employees” and elected the disclosure-only alternative under SFAS No. 123, “Accounting for Stock Based Compensation,” and SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an Amendment to FASB No. 123,” which requires disclosure of the pro forma effects on earnings as if the fair-value-based method of accounting under SFAS No. 123 had been adopted, as well as certain other information.

 

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If compensation cost had been determined for stock option grants to employees based on the provisions of SFAS No. 123 the effect on net loss and net loss per share would have been as follows:

 

     Three months ended

 
     March 31,
2004


    March 31,
2003


 

Net loss, as reported

   $ (9,078 )   $ (12,700 )

Deduct: Stock-based employee compensation expense included in reported net loss

     137       452  

Add: Stock-based employee compensation expense determined under fair value based method for all awards

     (920 )     (1,588 )
    


 


Pro forma net loss

   $ (9,861 )   $ (13,836 )
    


 


Basic and diluted net loss per share:

                

As reported

   $ (0.73 )   $ (1.03 )

Pro forma

   $ (0.79 )   $ (1.12 )

 

In January 2004, Avici granted 30,000 shares of restricted stock to certain key employees of the Company. The shares vest on a quarterly basis over four quarters ending in January 2005. The value of the shares at the date of grant was $0.4 million and will be charged to expenses on a straight-line basis over the vesting period commencing in the first quarter of 2004 and is included in sales and marketing, general and administrative and research and development expenses.

 

(j) Recent Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46 (FIN No. 46), “Consolidation of Variable Interest Entities,” which is an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” and addresses consolidation by business enterprises of variable interest entities. FIN No. 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed. FIN No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after March 15, 2004, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. FIN No. 46 applies to public enterprises as of the beginning of the applicable interim or annual period. Avici has not created, nor has an interest in a variable interest entity. As a result, the provisions of FIN No. 46 did not have a material impact on Avici’s consolidated financial position or results of operations.

 

NOTE 3. STOCKHOLDERS’ EQUITY

 

Common Stock Warrant Discount - Product

 

In January 2004, in connection with three-year strategic OEM agreement with Nortel Networks, Avici issued a warrant to purchase 800,000 shares of Avici common stock at an exercise price of $8.03 per share. The agreement provides Nortel Networks with the ability, but not the obligation, to purchase equipment and services from Avici for its own use or for resale. The warrant is nonforfeitable and has a term of approximately seven years from the date of issuance and is exercisable after seven years. The right to exercise the warrant may be accelerated if Nortel Networks achieves certain performance milestones. The fair value of the warrant was calculated to be approximately

 

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$6.3 million using the Black-Scholes valuation model, and is recorded as a reduction of revenue on a systematic basis, currently straight-line, over the economic life of the agreement, which is expected to be three years. The unamortizied balance of $5.8 million is recorded as a Contract Distribution Right in the accompanying balance sheet.

 

In December 2000, in connection with the execution of a nonexclusive systems and services agreement with AT&T, Avici issued a warrant to purchase 212,500 shares of Avici’s common stock at a per-share exercise price of $110.92. The agreement provides AT&T with the ability, but not the obligation, to purchase equipment and services from Avici. The warrant is nonforfeitable, fully exercisable and has a term of five years from the date of issuance. The fair value of the warrant was calculated to be $9.8 million using the Black-Scholes valuation model, and was deferred as a reduction to equity and was amortized as an offset to gross revenue on a straight-line basis over the three-year term of the agreement. The fair value of the warrant was fully amortized at December 31, 2003.

 

NOTE 4. RESTRUCTURING AND OTHER CHARGES

 

Avici implemented restructuring programs during the third and fourth quarters of 2001 and during the third quarter of 2002, designed to decrease operating expenses and align resources with future growth opportunities. The restructuring programs included workforce reductions, disposal of redundant assets and accrual of lease payments associated with excess facilities. As a result of these programs, Avici recorded net charges of $1.1 million in 2001 and $0.9 million in 2002. Prior to December 31, 2003, Avici made all cash payments relating to the restructuring programs except for those associated with future lease payments on excess facility. During the quarter ended March 31, 2004, Avici paid $0.2 million in lease payments associated with such excess facility. As of March 31, 2004 reserves for future lease payments on this facility are approximately $0.3 million.

 

Additionally, in the third quarter of 2001, Avici recorded a charge of $17.2 million as an element of product cost of revenue to reflect a write down of inventories and inventory commitments for long lead-time items that were considered to be in excess of the then foreseeable demand. The charge included commitments to suppliers including ASICs, module components, and TSR bay components totaling approximately $9.6 million and inventory components and finished goods on hand relating to the TSR product, totaling approximately $7.6 million which were identified as in excess of the then forecasted demand for the next 12 months. Since the end of the third quarter of fiscal 2001, Avici has paid approximately $9.4 million to settle inventory commitments with suppliers, and has discarded approximately $6.3 million of the excess inventory on hand. Since 2001, Avici has utilized approximately $4.8 million of this inventory including approximately $0.4 million during the first quarter of 2004. Such utilization has been recorded and disclosed primarily as a reduction of cost of revenue in the period utilized. Avici does not expect significant utilization of such inventory in the future.

 

NOTE 5. LITIGATION

 

In addition to claims in the normal course of business, twelve purported securities class action lawsuits were filed against Avici and one or more of Avici’s underwriters in Avici’s initial public offering, and certain officers and directors of Avici. The lawsuits alleged violations of the federal securities laws and were docketed in the U.S. District Court for the Southern District of New York (the “Court”) as: Felzen, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3363; Lefkowitz, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3541; Lewis, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3698; Mandel, et. al v. Avici Systems Inc., et al., C.A. No. 01-CV-3713; Minai, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3870; Steinberg, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3983; Pelissier, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-4204; Esther, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-4352; Zhous, et al. v. Avici Systems Inc. et al., C.A. No. 01-CV-4494; Mammen, et al. v. Avici Systems Inc., et. al., C.A. No. 01-CV-5722; Lin, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-5674; and Shives, et al. v. Banc of America Securities, et al., C.A. No. 01-CV-4956. On April 19, 2002, a consolidated amended class action complaint (the “Complaint”), which superseded these twelve purported securities class action lawsuits, was filed in the Court. The Complaint is captioned “In re Avici Systems, Inc. Initial Public Offering Securities Litigation” (21 MC 92, 01 Civ. 3363 (SAS)) and names as defendants Avici, certain of the underwriters of Avici’s initial public offering, and certain of Avici’s officers and directors. The Complaint, which seeks unspecified damages, alleges violations of the federal securities laws, including among other things, that the underwriters of Avici’s initial public offering (“IPO”) improperly required their customers to pay the underwriters excessive

 

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commissions and to agree to buy additional shares of Avici’s stock in the aftermarket as conditions of receiving shares in Avici’s IPO. The Complaint further claims that these supposed practices of the underwriters should have been disclosed in Avici’s IPO prospectus and registration statement. In addition to the Complaint against Avici, various other plaintiffs have filed other substantially similar class action cases against approximately 300 other publicly traded companies and their IPO underwriters in New York City, which along with the case against Avici have all been transferred to a single federal district judge for purposes of case management. Avici and its officers and directors believe that the claims against Avici lack merit, and have defended the litigation vigorously. In that regard, on July 15, 2002, Avici, together with the other issuers named as defendants in these coordinated proceedings, filed a collective motion to dismiss the consolidated amended complaints against them on various legal grounds common to all or most of the issuer defendants.

 

On October 9, 2002, the Court dismissed without prejudice all claims against the individual current and former officers and directors who were named as defendants in our litigation, and they are no longer parties to the lawsuit. On February 19, 2003, the Court issued its ruling on the motions to dismiss filed by the issuer defendants and separate motions to dismiss filed by the underwriter defendants. In that ruling, the Court granted in part and denied in part those motions. As to the claims brought against Avici under the antifraud provisions of the securities laws, the Court dismissed all of these claims with prejudice, and refused to allow the plaintiffs an opportunity to re-plead these claims against Avici. As to the claims brought under the registration provisions of the securities laws, which do not require that intent to defraud be pleaded, the Court denied the motion to dismiss these claims as to Avici and as to substantially all of the other issuer defendants as well. The Court also denied the underwriter defendants’ motion to dismiss in all respects.

 

In June 2003, Avici elected to participate in a proposed settlement agreement with the plaintiffs in this litigation. If ultimately approved by the Court, this proposed settlement would result in a dismissal, with prejudice, of all claims in the litigation against Avici and against any of the other issuer defendants who elect to participate in the proposed settlement, together with the current or former officers and directors of participating issuers who were named as individual defendants. The proposed settlement does not provide for the resolution of any claims against the underwriter defendants, and the litigation against those defendants is continuing. The proposed settlement provides that the class members in the class action cases brought against the participating issuer defendants will be guaranteed a recovery of $1 billion by insurers of the participating issuer defendants. If recoveries totaling $1 billion or more are obtained by the class members from the underwriter defendants, however, the monetary obligations to the class members under the proposed settlement will be satisfied. In addition, Avici and any other participating issuer defendants will be required to assign to the class members certain claims that they may have against the underwriters of their IPOs.

 

The proposed settlement contemplates that any amounts necessary to fund the settlement or settlement-related expenses would come from participating issuers’ directors and officers liability insurance policy proceeds as opposed to funds of the participating issuer defendants themselves. A participating issuer defendant could be required to contribute to the costs of the settlement if that issuer’s insurance coverage were insufficient to pay that issuer’s allocable share of the settlement costs. Avici expects that its insurance proceeds will be sufficient for these purposes and that it will not otherwise be required to contribute to the proposed settlement. Consummation of the proposed settlement is conditioned upon, among other things, negotiating, executing, and filing with the Court final settlement documents, and final approval by the Court. Formal settlement documents for submission to the Court are currently being drafted. If the proposed settlement described above is not consummated, Avici intends to continue to defend the litigation vigorously. Moreover, if the proposed settlement is not consummated, Avici believes that the underwriters may have an obligation to indemnify Avici for the legal fees and other costs of defending this suit and that Avici’s directors’ and officers’ liability insurance policies would also cover the defense and potential exposure in the suit. While Avici can make no promises or guarantees as to the outcome of these proceedings, Avici believes that the final result of these actions will have no material effect on Avici’s consolidated financial condition, results of operations or cash flows.

 

The Securities and Exchange Commission (the “SEC”) is conducting several investigations relating to Qwest Communications (“Qwest”) and its business relationships. In the SEC investigation entitled “Issuers Related to Qwest,” Avici understands that it is one of eleven companies whose business dealings with Qwest are being investigated. Avici has cooperated with these investigations and there has been no wrong doing by Avici alleged in any of these investigations. How long these investigations may continue and their ultimate outcome cannot be determined.

 

 

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

 

Except for the historical information contained herein, certain matters discussed in this Report on Form 10-Q constitute forward-looking statements that involve risks and uncertainties. Avici’s actual results could differ materially from those stated or implied in forward-looking statements due to a number of factors, including without limitation those discussed under the caption “Factors That May Affect Future Results” included in Avici’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003 as filed with the Securities and Exchange Commission on March 12, 2004 and elsewhere herein. Forward-looking statements include statements regarding the future or Avici’s expectations, beliefs, intentions or strategies regarding the future and may be identified by the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will,” and “would” and similar expressions. There may be events in the future that could affect these matters.

 

Overview

 

Avici Systems provides high-speed data networking equipment that enables telecommunications companies and Internet service providers to transmit high volumes of information across their networks.

 

Since our inception, we have incurred significant losses. As of March 31, 2004, we had an accumulated deficit of $374.7 million. Our operating activities from inception through 1999 were primarily devoted to research and development, including the design and development of our proprietary application specific integrated circuits, or ASICs, and software, and system testing our Terabit Switch Router (TSR®). Revenue was first recognized during the first quarter of 2000. Since then we have also built our administrative, marketing, sales, customer support and manufacturing organizations and developed strategic relationships with systems integrators, distributors, customers and complementary vendors. We have not achieved profitability on a quarterly or an annual basis and anticipate that we will continue to incur operating losses in the foreseeable future. We have a lengthy sales cycle for our products and, accordingly, we expect to incur significant selling and other expenses before we realize the related revenue. During 2001 and 2002 we took actions to realign our cost structure in reaction to industry conditions resulting in a significant decrease in capital spending by telecommunications service providers. We expect that sales and marketing, research and development, and general and administrative expenses will increase as our business expands. As a result, we will need to generate significant revenues to achieve and maintain profitability.

 

During the fourth quarter of 1999, we introduced the TSR which is purpose-built for the stresses of carrier core routing in large IP networks. The first TSR sale occurred during the first quarter of 2000. During 2001, we introduced the Avici Stackable Switch Router (SSR), a rack-mountable scalable router for carriers and service providers with smaller core networks. The first SSR sale occurred during the fourth quarter of 2001. During the fourth quarter of 2002, we introduced the Avici Quarter-rack Scalable Router (QSR), which provides customers with one of the smallest footprint, highest density routers commercially available. The first QSR sale occurred during the fourth quarter of 2003. We currently market our products to major carriers in North America through our direct sales force and third party distribution partners. We also market our products internationally through sales agents, systems integrators and distributors, and through a direct sales force in Europe and Asia. We currently provide product installation and customer field support through our internal customer service organization and third-party support organizations. During 2003, we entered into a strategic relationship with Huawei Technologies (Huawei) for sale of our products in Greater China and distribution arrangements with several resellers. In January 2004, we entered into a worldwide strategic relationship with Nortel Networks (Nortel) to market, sell and support our products.

 

Our target end-user customers include incumbent local exchange carriers, inter-exchange carriers, postal telephone and telegraph operators (PTTs or international incumbent operators), international competitive carriers, Internet service providers, and agencies of the United States government. Our products have been deployed at AT&T Corp. (AT&T), Qwest Communications (Qwest), several agencies of the United States government, and in laboratory environments including the France Telecom R&D VTHD research network and Chung Hwa Telecom, among

 

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others. Our products are currently in trials and tests with additional prospective customers, both internationally and domestically. There can be no assurance as to the timing of the completion of these trials and tests or that their outcome will be favorable.

 

Revenue

 

We expect that in the foreseeable future, substantially all of our revenue will continue to depend on sales of our TSR, SSR, and QSR products to current customers and a limited number of potential new customers. We also expect to generate revenue through our distribution and OEM partnering arrangements. Generally, these customers and partners are not contractually committed to purchase any minimum quantities of products from us.

 

The initial term of our procurement agreement with AT&T continued through December 2003. The agreement remains in effect unless terminated by either party. We have no current intention to terminate the agreement and we are not aware of any intention of AT&T to terminate the agreement. The agreement describes the conditions under which AT&T may acquire equipment from us. The agreement has no minimum purchase commitment associated with it.

 

In April 2003, we entered into a strategic relationship with Huawei. The agreement describes the terms and conditions under which Huawei may acquire equipment from us for sales and distribution in Greater China. The agreement has no minimum purchase commitment associated with it.

 

In January 2004, we entered into a worldwide three-year strategic agreement with Nortel. Under this agreement, Nortel will market, sell and support Avici’s carrier-class core routers as part of its converged network solutions based on Internet Protocol (IP) technology. The agreement has no minimum purchase commitment associated with it.

 

Common Stock Warrant Discount - Product

 

In January 2004, in connection with three-year strategic OEM agreement with Nortel Networks, Avici issued a warrant to purchase 800,000 shares of Avici common stock at an exercise price of $8.03 per share. The agreement provides Nortel Networks with the ability, but not the obligation, to purchase equipment and services from Avici for its own use or for resale. The warrant is nonforfeitable and has a term of approximately seven years from the date of issuance and is exercisable after seven years. The right to exercise the warrant may be accelerated if Nortel Networks achieves certain performance milestones. The fair value of the warrant was calculated to be approximately $6.3 million using the Black-Scholes valuation model, and is recorded as a reduction of revenue on a systematic basis, currently straight-line, over the economic life of the agreement, which is expected to be three years. The unamortized balance of $5.8 million is recorded as a Contract Distribution Right in the accompanying balance sheet.

 

In December 2000, in connection with the execution of a nonexclusive systems and services agreement with AT&T, Avici issued a warrant to purchase 212,500 shares of Avici’s common stock at a per-share exercise price of $110.92. The agreement provides AT&T with the ability, but not the obligation, to purchase equipment and services from Avici. The warrant is nonforfeitable, fully exercisable and has a term of five years from the date of issuance. The fair value of the warrant was calculated to be $9.8 million using the Black-Scholes valuation model, and was deferred as a reduction to equity and was amortized as an offset to gross revenue on a straight-line basis over the three-year term of the agreement. The fair value of the warrant was fully amortized at December 31, 2003.

 

Cost of Revenue

 

Cost of Revenue - Product includes material cost, provision for warranty, rework, depreciation and provision for excess and obsolete inventory. Cost of Revenue – Service includes costs associated with providing customer support and maintenance services.

 

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Restructuring Charges

 

Avici implemented restructuring programs during the third and fourth quarters of 2001 and during the third quarter of 2002, designed to decrease operating expenses and align resources with future growth opportunities. The restructuring programs included workforce reductions, disposal of redundant assets and accrual of lease payments associated with excess facilities. As a result of these programs, we recorded net charges of $1.1 million in 2001 and $0.9 million in 2002. Prior to December 31, 2003, we made all cash payments relating to the restructuring programs except for those associated with future lease payments on excess facility. During the quarter ended March 31, 2004, we paid $0.2 million in lease payments associated with such excess facility. As of March 31, 2004 reserves for future lease payments on this facility are approximately $0.3 million.

 

Additionally, in the third quarter of 2001, we recorded a charge of $17.2 million as an element of product cost of revenue to reflect a write down of inventories and inventory commitments for long lead-time items that were considered to be in excess of the then foreseeable demand. The charge included commitments to suppliers including ASICs, module components, and TSR bay components totaling approximately $9.6 million and inventory components and finished goods on hand relating to the TSR product, totaling approximately $7.6 million which were identified as in excess of the then forecasted demand for the next 12 months. Since the end of the third quarter of fiscal 2001, we had paid approximately $9.4 million to settle inventory commitments with suppliers, and have discarded approximately $6.3 million of the excess inventory on hand. Since 2001, we have utilized approximately $4.8 million of this inventory including approximately $0.4 million during the first quarter of 2004. Such utilization has been recorded and disclosed primarily as a reduction of cost of revenue in the period utilized. We do not expect significant utilization of such inventory in the future.

 

We expect telecommunications service providers to continue to maintain conservative levels of capital spending in the near term. However, any decline in spending for certain telecommunications equipment, or any change in our business strategy could necessitate further restructuring and such restructuring could have an adverse impact on the results of operations and financial condition of Avici.

 

We outsource our manufacturing operations to contract manufacturers that assemble and test our products in accordance with our specifications. Accordingly, a significant portion of our product cost of revenue involves payment to these entities. Avici’s cost of revenue also includes overhead costs, primarily for material procurement associated with our manufacturing. Warranty costs and inventory provisions are expensed as cost of revenue-product.

 

Research and Development

 

Research and development expenses consist primarily of salaries and related employee costs, depreciation expense on laboratory equipment, prototype equipment, materials costs and third-party costs and fees related to the development and prototyping of our proprietary technology. Depreciation expenses have also decreased as prior additions become fully depreciated. In the future, research and development expenses may increase as demand for our products, product features and functionality increases.

 

Sales and Marketing

 

Sales and marketing expenses consist primarily of salaries and related employee costs, sales commissions, travel, public relations, training and other costs associated with marketing material and tradeshows. In the future, we expect annual sales and marketing expenses may increase in absolute dollars as demand for our products increases and we broaden our sales infrastructure, establish sales offices in new locations domestically and internationally and initiate new marketing programs.

 

General and Administrative

 

General and administrative expenses consist primarily of salaries and related costs for executive, finance, legal, facilities, human resources and information technology personnel and professional fees. In the future, we expect that general and administrative expenses may increase in absolute dollars as we add personnel and incur additional costs related to the growth of our business.

 

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Stock-based Compensation

 

Through December 31, 2001, Avici had recorded cumulative non-cash deferred compensation, relating to pre-IPO stock option grants, as an element of stockholders’ equity, representing the aggregate difference between the deemed fair value of Avici’s common stock and the exercise price of stock options and restricted stock granted and the selling price of stock sold. The deferred compensation is being recognized as an expense over the vesting period of the stock options and restricted stock. Avici expects to recognize compensation expense of approximately $0.2 million during the remainder of 2004 related to these grants.

 

In January 2004, Avici granted 30,000 shares of restricted stock to certain key employees of the Company. The shares vest on a quarterly basis over four quarters ending in January 2005. The value of the shares at the date of grant was $0.4 million and will be charged to expenses on a straight-line basis over the vesting period commencing in the first quarter of 2004 and is included in sales and marketing, general and administrative and research and development expenses. Avici expects to recognize compensation expense of approximately $0.3 million during the remainder of 2004 related to these grants.

 

Critical Accounting Policies

 

Avici considers the following accounting policies related to revenue recognition, inventory valuation, warranty liabilities, and long-lived assets to be critical accounting policies due to the estimation processes and judgments involved in each. Avici bases its estimates on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

 

Revenue Recognition

 

Avici recognizes revenue from product sales upon shipment, provided that a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed or determinable and collectibility is deemed probable. If uncertainties regarding customer acceptance exist, Avici recognizes revenue when those uncertainties are resolved. For arrangements that include the delivery of multiple elements, revenue is allocated to the various elements based on vendor-specific objective evidence of fair value (VSOE). Avici uses the residual method when VSOE does not exist for one of the delivered elements in an arrangement. We also generate revenue from support and maintenance as well as installation and service. We defer revenue from support and maintenance contracts and recognize it ratably over the period of the related agreements. We recognize revenue from installation and other services as the work is performed. In the event the Company is unable to meet one or all of the above criteria on a timely basis, revenue recognized for any reporting period could be adversely affected.

 

Cost of Revenue – Service

 

Cost of Revenue – Service includes internal costs associated with providing customer support and maintenance services. As personnel responsible for providing such services are also engaged in other activities such as sales and marketing and product development, Avici aggregates certain costs, including payroll, fringe, overhead and depreciation, and allocates a portion of those costs to Cost of Revenue – Service. Such allocation is based on an estimation of time devoted towards supporting the service programs, which Avici believes to be reasonable.

 

Inventory Valuation

 

We value our inventory at the lower of the actual cost to purchase or the current estimated market value. We regularly review inventory quantities on hand and inventory commitments with suppliers and record a provision for potentially excess and obsolete inventory based primarily on our estimated forecast of product demand for up to the next twelve months. As demonstrated during 2001, demand for our products can fluctuate suddenly and significantly due to changes in economic and business conditions. A significant increase in demand for our products could result

 

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in a short-term increase in the cost of inventory purchases while a significant decrease in demand could result in an increase in the amount of excess inventory on hand and at suppliers. In addition, our industry is characterized by rapid technological change, frequent new product development, and rapid product obsolescence that could result in an increase in the amount of obsolete inventory on hand and at suppliers. Therefore, although we make every effort to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could have a significant impact on the value of our inventory and our reported operating results.

 

Warranty Liabilities

 

Our warranties require us to repair or replace defective products returned to us during the warranty period at no cost to the customer. We record an estimate for warranty related costs at the time of sale based on our actual historical return rates and repair costs. While our warranty costs have historically been within our expectations and the provisions established, we cannot guarantee we will continue to experience the same warranty return rates or repair costs that we have in the past. A significant increase in product return rates, or a significant increase in the costs to repair our products, could have a material adverse impact on future operating results for the period or periods in which such returns or additional costs materialize and thereafter.

 

Long-lived Assets

 

We review property, plant, and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of such an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to future undiscounted cash flows the assets are expected to generate over the remaining economic life. If such assets are considered to be impaired, the impairment to be recognized in earnings equals the amount by which the carrying value of the assets exceeds their fair market value determined by either a quoted market price, if any, or a value determined by utilizing a discounted cash flow technique. Although we have recognized no material impairment adjustments related to our property, plant, and equipment, except those made in conjunction with restructuring actions, deterioration in our business in the future could lead to such impairment adjustments in future periods. Evaluation of impairment of long-lived assets requires estimates of future operating results that are used in the preparation of the expected future undiscounted cash flows. Actual future operating results and the remaining economic lives of our long-lived assets could differ from the estimates used in assessing the recoverability of these assets. These differences could result in impairment charges, which could have a material adverse impact on our results of operations.

 

Results of Operations

 

Revenue

 

Total gross revenue decreased $0.6 million to $7.0 million for the first quarter of 2004 from $7.6 million for the first quarter of 2003.

 

Gross product revenue decreased $0.9 million to $5.8 million in the first quarter of 2004 from $6.7 million in the first quarter of 2003 primarily due to a decrease in our product volume from our customers as a result of uneven customer order patterns from period to period. Net product revenue, after warrant amortization of $0.5 million and $0.8 million in the first quarter of 2004 and 2003 respectively, decreased $0.6 million to $5.3 million in the 2004 period from $5.9 million in the 2003 period.

 

Service revenue increased $0.2 million to $1.1 million in the first quarter of 2004 from $0.9 million in the first quarter of 2003. Service revenue increased in the 2004 period primarily due to a larger installed base of products.

 

Two customers accounted for more than 10% of net revenue each in the 2004 period. Three customers accounted for more than 10% of net revenue each in the 2003 period.

 

 

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Cost of Revenue

 

Total cost of revenue decreased $1.3 million to $2.7 million in the first quarter of 2004 from $4.0 million in the first quarter of 2003. Product cost of revenue was 39% and 56% of product net revenue in the 2004 and 2003 periods, respectively. Product cost of revenue in the 2004 period is net of credits for the utilization of inventory previously reserved of $0.2 million related to the one time $17.2 million inventory related charge recorded in 2001 as a result of industry downturn. The lower percentage in 2004 is primarily due to lower costs associated with changes in our product mix in 2004, cost reductions achieved with key suppliers and reductions of fixed costs, as well as larger inventory utilization credits in 2004.

 

Product cost of revenue as a percentage of product net revenue is affected by changes in the mix of products sold, discounts, channels of distribution, changes in material costs, excess inventory and obsolescence charges, changes in volume and pricing competition. We anticipate product cost of revenue as a percentage of product net revenue will increase in the future due to an expected increase in sales through distribution channels, which are typically at a higher discount.

 

Service cost of revenue was 52% and 82% of service revenue in the 2004 and 2003 periods, respectively. The lower percentage in the 2004 is primarily the result of lower depreciation costs on service related capital equipment.

 

Research and Development

 

Research and development expenses decreased $2.2 million to $9.1 million for the first quarter of 2004 from $11.3 million for the first quarter of 2003. The decrease in the first quarter of 2004 was primarily due to a reduction in depreciation expenses, lower project and personnel related costs, and other discretionary spending reductions, partially offset by an increase in outside contract services.

 

Sales and Marketing

 

Sales and marketing expenses decreased $0.1 million to $2.7 million for the first quarter of 2004 from $2.8 million for the first quarter of 2003. The decrease in the first quarter of 2004 was primarily due to a reduction in recruiting costs.

 

General and Administrative

 

General and administrative expenses decreased $0.2 million to $1.3 million for the first quarter of 2004 from $1.5 million for the first quarter of 2003. The decrease in the first quarter of 2004 was primarily due to a reduction in depreciation expenses and other spending decreases.

 

Stock-Based Compensation

 

Stock-based compensation, associated with pre-IPO stock option grants, decreased $0.4 million to $0.1 million for the first quarter of 2004 from $0.5 million for the first quarter of 2003. The decrease in the first quarter of 2004 is primarily the result of certain option grants becoming fully vested and the related compensation becoming fully amortized, as well as the forfeiture of stock options associated with employee terminations.

 

Interest Income, Net

 

Interest income decreased $0.3 million to $0.4 million for the first quarter of 2004 from $0.7 million for the first quarter of 2003. The decrease in the first quarter of 2004 is primarily due to the decrease in invested cash balances resulting from the use of cash to fund operations and lower investment yields available in the market.

 

Liquidity and Capital Resources

 

Since our inception, we have financed our operations through private sales of equity securities, an initial public offering in July 2000, and, to a lesser extent, equipment lease financing. From inception through March 31, 2004,

 

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we raised approximately $410.3 million from these equity offerings. During the first three months of 2004, we used $3.6 million in cash for operating activities, compared to $10.3 million used during the first three months of 2003. The decrease in cash usage in the 2004 period as compared to the 2003 period is a result of reduced operating losses and a decrease in working capital net of $0.4 million of product purchases at March 31, 2004 reclassified as inventory from property and equipment. We expect working capital requirements will increase further in the future if product sales increase, creating larger customer receivable balances and the need to build inventory in advance of shipment. In addition, we expect to selectively invest in infrastructure costs needed to support the scale of operations. We also anticipate the accrual for excess facility costs of $0.3 million to be fully paid by the end of the third quarter of 2004.

 

Purchases of property and equipment were $1.6 million during the first three months of 2004 and comparable to $1.5 million for the first three months of 2003. The timing and amount of future capital expenditures will depend primarily on our future growth. We expect that capital expenditures will be between $6 million and $8 million during the remaining nine months of 2004. Proceeds from employee stock plans provided $3.1 million during the first three months of 2004.

 

We expect that working capital and capital expenditure requirements may increase if product sales increase, creating larger customer receivable balances, the need to build inventory in advance of shipment and the need for increased levels of test and management information systems equipment. At March 31, 2004, we had cash and cash equivalents of $40.2 million, short-term marketable securities of $32.4 million, and long-term marketable securities of $21.2 million, totaling $93.8 million. In addition, $0.4 million of restricted cash is included in the current and long-term portions of other assets as deposits for facility related obligations. We believe that our existing cash, cash equivalents and marketable securities will be sufficient to meet our normal operating and capital requirements for the next 24 months. However, we could be required, or could elect, to raise additional funds during that period and we may need to raise additional capital in the future. We may not be able to obtain additional capital on terms favorable to us or at all. The issuance of additional equity or equity-related securities would be dilutive to our stockholders. If we cannot raise funds on acceptable terms, or at all, we may not be able to develop or enhance our products or respond appropriately to competitive pressures, which would seriously limit our ability to increase our revenue and grow our business.

 

Contractual Obligations

 

At March 31, 2004 our contractual obligations, which consist entirely of contractual commitments for operating leases and inventory purchase commitments, were as follows (in thousands):

 

Fiscal Year


  

Operating

Leases


  

Inventory
Purchase

Commitment


   Total

2004 (remainder of the year)

   $ 1,016    $ 6,866    $ 7,882

2005

     1,061      —        1,061

2006

     1,115      —        1,115

2007

     743      —        743

Thereafter

     —        —        —  
    

  

  

Total future contractual commitments

   $ 3,935    $ 6,866    $ 10,801
    

  

  

 

Payments made under operating leases will be treated as rent expense for the facilities currently being utilized, or as a reduction of the restructuring liability for payments associated with the excess facility. We outsource the manufacture and assembly of our products. During the normal course of business, in order to maintain competitive lead times for customers and adequate supply of components, we enter into agreements with certain suppliers to procure inventory based upon criteria defined by us.

 

 

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Off-Balance Sheet Arrangements

 

As of March 31, 2004, we did not have any off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

 

Factors That May Affect Future Results

 

This Form 10-Q contains forward-looking statements that involve risks and uncertainties. These forward-looking statements include management’s plans and objectives for future operations, as well as statements regarding the strategy and plans of Avici. Our actual experience may differ materially from that discussed in the forward-looking statements. Factors that might cause such a difference or otherwise affect our future results of operations include the limited number of customers; continuing acceptance of our products and product enhancements; customer purchasing patterns and commitments; the size, timing and recognition of revenue from customers; our ability to develop new products and product enhancements; market acceptance of new product offerings and enhancements to our products and our ability to predict and respond to market developments; the failure to keep pace with the rapidly changing requirements of our customers; our ability to attract and retain key personnel; the development and expansion of our direct sales force and/or other distributor channels; risks associated with management of growth; risks associated with international expansion; our ability to obtain component parts; our being held liable for defects or errors in our products; our ability to identify, acquire and integrate acquisition targets; our ability to obtain additional financing; our failure to comply with the listing requirements of the Nasdaq National Market System; the expense of defending and the outcome of pending and future litigation and investigations (including whether or not the Court approves the proposed settlement with the plaintiffs in the New York securities litigation); the adequacy of our insurance to cover our obligations with respect to the ultimate resolution of any pending or future litigation matters; as well as risks of a further downturn in economic conditions generally, and in the telecommunications industry specifically, and risks associated with competition and competitive pricing pressures. For a more detailed description of the risk factors associated with Avici, please refer to our Annual Report on Form 10-K for the fiscal year ended December 31, 2003 as filed with the Securities and Exchange Commission on March 12, 2004.

 

Recent Accounting Pronouncements

 

In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46 (FIN No. 46), “Consolidation of Variable Interest Entities,” which is an interpretation of Accounting Research Bulletin No. 51, “Consolidated Financial Statements,” and addresses consolidation by business enterprises of variable interest entities. FIN No. 46 requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among parties involved. Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or combination of interests that effectively recombines risks that were previously dispersed. FIN No. 46 applies immediately to variable interest entities created after January 31, 2003, and to variable interest entities in which an enterprise obtains an interest after that date. It applies in the first fiscal year or interim period beginning after March 15, 2004, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. FIN No. 46 applies to public enterprises as of the beginning of the applicable interim or annual period. Avici has not created, nor has an interest in a variable interest entity. As a result, the provisions of FIN No. 46 did not have a material impact on Avici’s consolidated financial position or results of operations.

 

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments for speculative or trading purposes.

 

Interest Rate Sensitivity

 

We maintain an investment portfolio consisting mainly of investment grade money market funds, corporate obligations, federal agency obligations, state and municipal bonds with a weighted-average maturity of less than one year. These held-to-maturity securities are subject to interest rate risk and will fall in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels at March 31, 2004, the fair market value of these investments would decline by an immaterial amount. We have the ability to hold our fixed income investments until maturity. Therefore, we would not expect our operating results or cash flows to be affected to any significant degree by a sudden change in market interest rates on our securities portfolio.

 

Exchange Rate Sensitivity

 

We operate primarily in the United States, and international sales historically have been in U.S. dollars and are expected to continue in U.S. dollars. Accordingly, there has not been any material exposure to foreign currency rate fluctuations. If we expand our presence in foreign markets and consummate sales denominated in foreign currencies, our exposure to foreign currency rate fluctuations could be material in the future.

 

Avici has no off balance sheet concentrations such as foreign exchange contracts, option contracts or other foreign hedging arrangements.

 

ITEM 4. CONTROLS AND PROCEDURES

 

Evaluation of disclosure controls and procedures

 

Avici, under the supervision and with the participation of Avici’s management, including the principal executive officer and principal financial officer, have evaluated the effectiveness of Avici’s disclosure controls and procedures as of the end of the period covered by this quarterly report (the “Evaluation Date”) pursuant to Rule 13a-15(b) and 15d-15(b) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on this evaluation, Avici’s principal executive officer and principal financial officer have concluded, that, as of the Evaluation Date, Avici’s disclosure controls and procedures effectively ensure that information required to be disclosed in our filings and submissions under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

 

Changes in internal control over financial reporting

 

There were no changes in Avici’s internal control over financial reporting during Avici’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect Avici’s internal control over financial reporting.

 

PART II. OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

In addition to claims in the normal course of business, twelve purported securities class action lawsuits were filed against Avici and one or more of Avici’s underwriters in Avici’s initial public offering, and certain officers and directors of Avici. The lawsuits alleged violations of the federal securities laws and were docketed in the U.S. District Court for the Southern District of New York (the “Court”) as: Felzen, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3363; Lefkowitz, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3541; Lewis, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3698; Mandel, et. al v. Avici Systems Inc., et al., C.A. No. 01-CV-3713; Minai, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3870; Steinberg, et al. v. Avici Systems Inc., et al., C.A.

 

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No. 01-CV-3983; Pelissier, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-4204; Esther, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-4352; Zhous, et al. v. Avici Systems Inc. et al., C.A. No. 01-CV-4494; Mammen, et al. v. Avici Systems Inc., et. al., C.A. No. 01-CV-5722; Lin, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-5674; and Shives, et al. v. Banc of America Securities, et al., C.A. No. 01-CV-4956. On April 19, 2002, a consolidated amended class action complaint (the “Complaint”), which superseded these twelve purported securities class action lawsuits, was filed in the Court. The Complaint is captioned “In re Avici Systems, Inc. Initial Public Offering Securities Litigation” (21 MC 92, 01 Civ. 3363 (SAS)) and names as defendants Avici, certain of the underwriters of Avici’s initial public offering, and certain of Avici’s officers and directors. The Complaint, which seeks unspecified damages, alleges violations of the federal securities laws, including among other things, that the underwriters of Avici’s initial public offering (“IPO”) improperly required their customers to pay the underwriters excessive commissions and to agree to buy additional shares of Avici’s stock in the aftermarket as conditions of receiving shares in Avici’s IPO. The Complaint further claims that these supposed practices of the underwriters should have been disclosed in Avici’s IPO prospectus and registration statement. In addition to the Complaint against Avici, various other plaintiffs have filed other substantially similar class action cases against approximately 300 other publicly traded companies and their IPO underwriters in New York City, which along with the case against Avici have all been transferred to a single federal district judge for purposes of case management. Avici and its officers and directors believe that the claims against Avici lack merit, and have defended the litigation vigorously. In that regard, on July 15, 2002, Avici, together with the other issuers named as defendants in these coordinated proceedings, filed a collective motion to dismiss the consolidated amended complaints against them on various legal grounds common to all or most of the issuer defendants.

 

On October 9, 2002, the Court dismissed without prejudice all claims against the individual current and former officers and directors who were named as defendants in our litigation, and they are no longer parties to the lawsuit. On February 19, 2003, the Court issued its ruling on the motions to dismiss filed by the issuer defendants and separate motions to dismiss filed by the underwriter defendants. In that ruling, the Court granted in part and denied in part those motions. As to the claims brought against Avici under the antifraud provisions of the securities laws, the Court dismissed all of these claims with prejudice, and refused to allow the plaintiffs an opportunity to re-plead these claims against Avici. As to the claims brought under the registration provisions of the securities laws, which do not require that intent to defraud be pleaded, the Court denied the motion to dismiss these claims as to Avici and as to substantially all of the other issuer defendants as well. The Court also denied the underwriter defendants’ motion to dismiss in all respects.

 

In June 2003, Avici elected to participate in a proposed settlement agreement with the plaintiffs in this litigation. If ultimately approved by the Court, this proposed settlement would result in a dismissal, with prejudice, of all claims in the litigation against Avici and against any of the other issuer defendants who elect to participate in the proposed settlement, together with the current or former officers and directors of participating issuers who were named as individual defendants. The proposed settlement does not provide for the resolution of any claims against the underwriter defendants, and the litigation against those defendants is continuing. The proposed settlement provides that the class members in the class action cases brought against the participating issuer defendants will be guaranteed a recovery of $1 billion by insurers of the participating issuer defendants. If recoveries totaling $1 billion or more are obtained by the class members from the underwriter defendants, however, the monetary obligations to the class members under the proposed settlement will be satisfied. In addition, Avici and any other participating issuer defendants will be required to assign to the class members certain claims that they may have against the underwriters of their IPOs.

 

The proposed settlement contemplates that any amounts necessary to fund the settlement or settlement-related expenses would come from participating issuers’ directors and officers liability insurance policy proceeds as opposed to funds of the participating issuer defendants themselves. A participating issuer defendant could be required to contribute to the costs of the settlement if that issuer’s insurance coverage were insufficient to pay that issuer’s allocable share of the settlement costs. Avici expects that its insurance proceeds will be sufficient for these purposes and that it will not otherwise be required to contribute to the proposed settlement. Consummation of the proposed settlement is conditioned upon, among other things, negotiating, executing, and filing with the Court final settlement documents, and final approval by the Court. Formal settlement documents for submission to the Court are currently being drafted. If the proposed settlement described above is not consummated, Avici intends to continue to defend the litigation vigorously. Moreover, if the proposed settlement is not consummated, Avici believes that the

 

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underwriters may have an obligation to indemnify Avici for the legal fees and other costs of defending this suit and that Avici’s directors’ and officers’ liability insurance policies would also cover the defense and potential exposure in the suit. While Avici can make no promises or guarantees as to the outcome of these proceedings, Avici believes that the final result of these actions will have no material effect on Avici’s consolidated financial condition, results of operations or cash flows.

 

The Securities and Exchange Commission (the “SEC”) is conducting several investigations relating to Qwest Communications (“Qwest”) and its business relationships. In the SEC investigation entitled “Issuers Related to Qwest,” Avici understands that it is one of eleven companies whose business dealings with Qwest are being investigated. Avici has cooperated with these investigations and there has been no wrong doing by Avici alleged in any of these investigations. How long these investigations may continue and their ultimate outcome cannot be determined.

 

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

 

(a) List of Exhibits

 

Exhibit No.

 

Exhibit Description


31.1   Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2   Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1   Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2   Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

(b) Reports on Form 8-K

 

Avici filed a Report on Form 8-K dated January 7, 2004 reporting Avici’s agreement to enter into an OEM Purchase and Sales Agreement with, and to issue a warrant to purchase 800,000 shares of Avici common stock to, Nortel Networks Ltd.

 

Avici filed a Report on Form 8-K dated January 29, 2004 to furnish a press release whereby Avici provided its first quarter financial results and announced that it planned to hold a conference call regarding its financial results for the quarter ended December 31, 2003 on January 29, 2004.

 

Avici filed a Report on Form 8-K dated March 19, 2004 to furnish a press release whereby Avici provided its expected gross revenue and other information for the quarter ended March 31, 2004.

 

Avici filed a Report on Form 8-K dated April 22, 2004 to furnish a press release whereby Avici provided its first quarter financial results and announced that it planned to hold a conference call regarding its financial results for the quarter ended March 31, 2004 on April 22, 2004.

 

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SIGNATURE

 

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

 

   

AVICI SYSTEMS INC.

Date May 10, 2004

 

By:

 

/s/ Paul F. Brauneis


       

Paul F. Brauneis

Chief Financial Officer, Treasurer, Senior Vice President

of Finance and Administration, and Principal Accounting Officer

 

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EXHIBIT INDEX

 

Exhibit No.

 

Exhibit Description


31.1   Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2   Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1   Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2   Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

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