VERILINK CORP - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended January 2, 2004

Commission file number: 000-28562

VERILINK CORPORATION
(Exact name of registrant as specified in its charter)

Delaware		94-2857548
(State of incorporation)		(I.R.S. Employer Identification No.)

127 Jetplex Circle, Madison, Alabama 35758
(Address of principal executive offices, including zip code)

(256) 327-2001
(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports) and (2) has been subject to such filing requirements for the past 90 days.

Yes x

No o

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

Yes o

No x

The number of shares outstanding of the issuer’s common stock as of January 30, 2004 was 14,758,133.

INDEX
VERILINK CORPORATION
FORM 10-Q

		Page

PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited):

	Condensed Consolidated Statements of Operations for the three months and six months ended January 2, 2004 and December 27, 2002	3

	Condensed Consolidated Balance Sheets as of January 2, 2004 and June 27, 2003	4

	Condensed Consolidated Statements of Cash Flows for the six months ended January 2, 2004 and December 27, 2002	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	17

Item 4.	Controls and Procedures	17

PART II.	OTHER INFORMATION

Item 4.	Submission of Matters to a Vote of Security Holders	17

Item 6.	Exhibits and Reports on Form 8-K	18

SIGNATURE		19

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

VERILINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)

	Three months ended						Six months ended

	January 2, 2004			December 27, 2002			January 2, 2004			December 27, 2002

Net sales	$	9,089		$	6,145		$	18,684		$	14,858
Cost of sales		4,888			2,953			9,359			7,151

Gross profit		4,201			3,192			9,325			7,707

Operating expenses:
Research and development		1,448			706			2,832			1,554
Selling, general and administrative		2,690			1,956			4,936			4,189

Total operating expenses		4,138			2,662			7,768			5,743

Operating income		63			530			1,557			1,964
Interest and other income, net		236			122			416			224
Interest expense		(35	)		(47	)		(73	)		(100	)

Income before provision for income taxes		264			605			1,900			2,088
Provision for income taxes		—			—			—			—

Net income before cumulative change in accounting principle, relating to goodwill		264			605			1,900			2,088
Cumulative effect of change in accounting principle, relating to goodwill		—			—			—			(1,233	)

Net income	$	264		$	605		$	1,900		$	855

Basic earnings per share:
Net income before cumulative change in accounting principle, relating to goodwill	$	0.02		$	0.04		$	0.13		$	0.14
Less: Cumulative effect of change in accounting principle, relating to goodwill		—			—			—			(0.08	)

Net income	$	0.02		$	0.04		$	0.13		$	0.06

Diluted earnings per share:
Net income before cumulative change in accounting principle, relating to goodwill	$	0.02		$	0.04		$	0.12		$	0.14
Less: Cumulative effect of change in accounting principle, relating to goodwill		—			—			—			(0.08	)

Net income	$	0.02		$	0.04		$	0.12		$	0.06

Weighted average shares outstanding:
Basic		14,768			14,966			14,751			14,981

Diluted		16,385			15,378			16,193			15,250

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

VERILINK CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share amounts)
(unaudited)

	January 2, 2004			June 27, 2003

ASSETS
Current assets:
Cash and cash equivalents	$	10,445		$	8,503
Short-term investments		127			101
Accounts receivable, net		3,719			3,621
Inventories, net		3,690			2,296
Other current assets		330			319

Total current assets		18,311			14,840
Property held for lease, net		6,365			6,462
Property, plant and equipment, net		1,389			1,350
Restricted cash		1,000			1,000
Other intangible assets, net		2,563			2,132
Other assets		448			525

	$	30,076		$	26,309

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Current portion of long-term debt and capital lease obligations	$	733		$	730
Accounts payable		2,390			1,558
Accrued expenses		4,635			4,373
Accrued purchase consideration		1,853			1,800

Total current liabilities		9,611			8,461
Long-term debt and capital lease obligations		3,381			3,749

Total liabilities		12,992			12,210

Stockholders’ equity:
Preferred Stock, $0.01 par value, 1,000,000 shares authorized; no shares issued and outstanding		—			—
Common Stock, $0.01 par value; 40,000,000 shares authorized; 14,728,974 and 14,670,525 shares outstanding		147			147
Additional paid-in capital		49,845			51,100
Note receivable from stockholder		—			(2,375	)
Deferred compensation related to stock options		(33	)		—
Accumulated other comprehensive loss		(34	)		(32	)
Accumulated deficit		(32,841	)		(34,741	)

Total stockholders’ equity		17,084			14,099

	$	30,076		$	26,309

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

VERILINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

	Six Months Ended

	January 2, 2004			December 27, 2002

Cash flows from operating activities:
Net income	$	1,900		$	855
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		922			562
Amortization of deferred compensation		39			—
Accrued interest on note receivable from stockholder, net of reserve		(193	)		(88	)
Loss on retirement of property, plant and equipment		6			—
Cumulative effect of change in accounting principle, relating to goodwill		—			1,233
Changes in assets and liabilities:
Accounts receivable, net		(98	)		2,466
Inventories, net		(1,394	)		(627	)
Other assets		66			(8	)
Accounts payable		832			(882	)
Accrued expenses		604			101

Net cash provided by operating activities		2,684			3,612

Cash flows from investing activities:
Purchases of property, plant and equipment		(394	)		(469	)
Sale (purchase) of short-term investments		(26	)		497
Payments related to product line acquisitions		(690	)		—
Proceeds from repayment of notes receivable		140			150

Net cash provided by (used in) investing activities		(970	)		178

Cash flows from financing activities:
Payments on long-term debt and capital lease obligations		(365	)		(361	)
Repurchase of Common Stock		—			(49	)
Proceeds from issuance of common stock		595			3
Proceeds for repayments of notes receivable from stockholders		—			675
Change in other comprehensive income		(2	)		1

Net cash provided by financing activities		228			269

Net increase in cash and cash equivalents		1,942			4,059
Cash and cash equivalents at beginning of period		8,503			5,630

Cash and cash equivalents at end of period	$	10,445		$	9,689

Supplemental disclosures:
Cash paid for interest	$	74		$	99
Cash paid for income taxes	$	59		$	17
Non-cash financing activities:
Repayment of notes receivable from stockholder	$	2,428		$	—

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

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 1 – Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements of Verilink Corporation (the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, these statements include all adjustments, consisting of normal and recurring adjustments, considered necessary for a fair presentation of the results for the periods presented. The results of operations for the periods presented are not necessarily indicative of results which may be achieved for the entire fiscal year ending July 2, 2004. The unaudited interim condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the fiscal year ended June 27, 2003 as filed with the Securities and Exchange Commission.

Note 2 – Comprehensive Income (Loss)

The Company records gains or losses on the Company’s foreign currency translation adjustments and presents it as accumulated other comprehensive income (loss) in the accompanying condensed consolidated balance sheets. For the three months ended January 2, 2004 and December 27, 2002, comprehensive income amounted to $264,000 and $607,000, respectively. For the six months ended January 2, 2004 and December 27, 2002, comprehensive income amounted to $1,898,000 and $856,000, respectively.

Note 3 – Earnings Per Share

Basic earnings per share is computed by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings per share gives effect to all dilutive potential common shares outstanding during a period. In computing diluted earnings per share, the average price of the Company’s Common Stock for the period is used in determining the number of shares assumed to be purchased from exercise of stock options. The following table sets forth the computation of basic and diluted earnings per share for the three months and six months ended January 2, 2004 and December 27, 2002 (in thousands, except per share amounts):

	Three Months ended				Six Months ended

	January 2, 2004		December 27, 2002		January 2, 2004		December 27, 2002

Net income	$	264	$	605	$	1,900	$	855

Weighted average shares outstanding:
Basic		14,768		14,966		14,751		14,981
Effect of potential common stock from the exercise of stock options		1,617		412		1,442		269

Diluted		16,385		15,378		16,193		15,250

Basic earnings per share	$	0.02	$	0.04	$	0.13	$	0.06

Diluted earnings per share	$	0.02	$	0.04	$	0.12	$	0.06

Number of option shares excluded from computation of diluted earnings per share because their effect is anti-dilutive		242		2,306		310		2,426

Note 4 – Inventories

Inventories are stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. Inventories consisted of the following (in thousands):

	January 2, 2004			June 27, 2003

Inventories:
Raw materials	$	3,357		$	3,159
Work in process		122			32
Finished goods		1,366			1,813
Miniplex inventory purchase commitment		1,369			—

		6,214			5,004
Less: Inventory reserves		(2,524	)		(2,708	)

Inventories, net	$	3,690		$	2,296

Note 5 – Acquisition of Miniplex Product Line

On July 22, 2003, the Company acquired the fixed assets and intellectual property rights relating to Terayon Communication System, Inc.’s Miniplex product line for telecom carriers for up to $868,000, plus the assumption of certain liabilities. Per the acquisition agreement, the Company paid Terayon $443,000 at the closing of the agreement and will pay up to an additional $425,000 based on the sale of Miniplex products through December 31, 2004 (the “Earn-Out Period”). The Company will make quarterly payments to Terayon during the Earn-Out Period at the rate of 4.6% of net sales of Miniplex products, provided, however, that the maximum payments will not exceed $425,000 or be less than $300,000. In addition to the purchase consideration, the Company agreed to purchase Terayon’s Miniplex related inventories totaling approximately $2,100,000 on the earlier of the date used by the Company or December 31, 2004. The Company has purchased $731,000 of this Miniplex inventory from Terayon and the remaining purchase commitment of $1,369,000 is included in inventories and accounts payable on the condensed consolidated balance sheet as of January 2, 2004.

The purchase price was allocated to the individual assets acquired based on the relative fair value of the assets acquired and liabilities assumed. A summary of the total purchase consideration is as follows (in thousands):

Cash paid at closing	$	443
Quarterly payment		51
Remaining estimated purchase price obligation		249
Transaction costs		50
Assumed liabilities		114

Total purchase consideration	$	907

The purchase consideration was allocated to the estimated fair values of the assets acquired. The purchase price allocation is as follows (in thousands):

	Purchase Price Allocation		Amortization Life

Tangible assets	$	29		various
Developed technology		134		3 years
Customer relations		716		4 years
Trademarks		28		4 years

Total purchase price allocation	$	907

The acquisition was funded through available cash. The remaining estimated purchase price obligation is included in accrued purchase consideration on the condensed consolidated balance sheet as of January 2, 2004.

Note 6 – Other Intangible Assets

Acquired other intangible assets subject to amortization are as follows (in thousands):

	January 2, 2004				June 27, 2003

	Gross Carrying Costs		Accumulated Amortization		Gross Carrying Costs		Accumulated Amortization

Customer relations	$	3,460	$	1,780	$	2,744	$	1,472
Developed technology		1,705		935		1,572		808
Trademarks		133		20		104		8

	$	5,298	$	2,735	$	4,420	$	2,288

The approximate estimated annual amortization for other intangibles is (in thousands):

Fiscal years ending June:
2004	$	781
2005	$	666
2006	$	666
2007	$	537
2008	$	231

Note 7 – Warranty Liability

The Company records a warranty provision at the time of the sale. The Company warrants its products for a five-year period. A reconciliation of the changes in warranty liability for the six months ended January 2, 2004 is (in thousands):

Beginning balance, as of June 27, 2003	$	1,374
Additions:
Additions charged to income		94
Less deductions from the reserves		(152	)

Ending balance, as of January 2, 2004	$	1,316

Note 8 – Stock Based Compensation

The Company accounts for stock-based awards to employees using the intrinsic value method in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees. Accordingly, no compensation expense has been recognized for options granted with an exercise price equal to market value at the date of grant.

Had the Company recorded compensation based on the estimated grant date fair value, as defined by SFAS No. 123, Accounting for Stock-Based Compensation, for awards granted under its stock option plan and stock purchase plan, the Company’s net income and earnings per share would have been reduced to the pro forma amounts below for the respective periods (in thousands, except per share amounts):

	Three months ended						Six months ended

	January 2, 2004			December 27, 2002			January 2, 2004			December 27, 2002

Net income, as reported	$	264		$	605		$	1,900		$	855
Add: Stock-based employee compensation expense included in reported net income, net of related tax effects		7			—			23			—
Deduct: Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		(206	)		(88	)		(329	)		37

Pro forma net income	$	65		$	517		$	1,594		$	892

Earnings per share:
Basic – as reported	$	0.02		$	0.04		$	0.13		$	0.06

Basic – pro forma	$	0.00		$	0.03		$	0.11		$	0.06

Diluted – as reported	$	0.02		$	0.04		$	0.12		$	0.06

Diluted – pro forma	$	0.00		$	0.03		$	0.10		$	0.06

In the first quarter of fiscal 2004, the Company recorded deferred compensation expense of $43,000 in connection with the grant of stock options to certain employees in California who joined the Company as part of the NetEngine acquisition in January 2003. Although the Company planned to award these options promptly upon completion of the Net Engine acquisition, regulatory permits necessary to grant options to California residents were not obtained until August 2003, at which point the fair market value of the common stock had increased. The Company therefore issued these options at less than fair market value as of the date of grant and provided a fixed cash award totaling $126,000 that is contingent upon the exercise of the underlying stock option award. During the three and six months ended January 2, 2004, the Company recognized total compensation expense of $11,000 and $39,000, respectively, related to these options. The deferred compensation and fixed cash award are charged to expense over the vesting period of the underlying options. At January 2, 2004, the remaining deferred compensation totaled $33,000.

The Company issued 95,631 shares of common stock in the first quarter of fiscal 2004 as stock bonuses to executive officers and certain key employees. These stock bonuses were awarded in recognition of the Company’s fiscal 2003 performance, and the associated expense was recorded in fiscal 2003.

Note 9 – Related Party Transactions

In September 2003, the net after tax portion of the fiscal 2003 discretionary bonus provided to the Company’s President and Chief Executive Officer, totaling approximately $141,000, was applied against his outstanding note to the Company. In November 2003, the Company’s President and Chief Executive Officer paid the remaining principal balance of this note plus accrued interest, totaling $2,287,000, by delivering 343,034 shares of common stock to the Company as contemplated by the loan documentation. As a result of these repayments, all of the promissory notes of the President and Chief Executive Officer have been repaid.

Note 10 – Recently Issued Accounting Pronouncements

In April 2003, the FASB issued SFAS 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which amends SFAS 133 for certain decisions made by the FASB Derivatives Implementation Group. In particular, SFAS 149 (1) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, (2) clarifies when a derivative contains a financing component, (3) amends the definition of underlying to conform it to language used in FASB interpretation number (FIN) 45, and (4) amends certain other existing pronouncements. SFAS 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. In addition, most provisions of SFAS 149 are to be applied prospectively. SFAS No. 149 does not currently impact the Company’s financial statements.

In May 2003, the FASB issued SFAS 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity. SFAS 150 improves the accounting for certain financial instruments that, under previous guidance,

issuers could account for as equity. SFAS 150 requires that those instruments be classified as liabilities in statements of financial position. SFAS 150 is effective for interim periods beginning after June 15, 2003. In its October 2003 meeting, the FASB Board decided to defer the effective date of certain provisions of SFAS 150. SFAS No. 150 does not currently impact the Company’s financial statements.

On January 15, 2003, the FASB completed its re-deliberations of the project related to the consolidation of variable interest entities which culminated with the issuance of FASB Interpretation No. 46 (“FIN 46”), Consolidation of Variable Interest Entities. FIN 46 states that if a business enterprise has a controlling financial interest in a variable interest entity, the assets, liabilities, and results of the activities of the variable interest entity should be included in the consolidated financial statements of the business enterprise. FIN 46 explains how to identify variable interest entities and how an enterprise assesses its interests in a variable interest entity to determine whether to consolidate that entity. FIN 46 also requires existing unconsolidated variable interest entities to be consolidated by their primary beneficiaries if the entities do not effectively disperse risks among the parties involved. Variable interest entities that effectively disperse risks will not be consolidated unless a single party holds an interest or a combination of interests that effectively recombines risks that were previously dispersed. FIN 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. FIN 46 originally applied in the first fiscal year or interim period beginning after June 15, 2003, to variable interest entities in which an enterprise holds a variable interest that it acquired before February 1, 2003. However, in December 2003, the FASB issued FIN 46R, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51, which revised FIN 46 and required the adoption of FIN 46 or FIN 46R for periods ending after December 15, 2003. FIN 46 and FIN 46R do not currently impact the Company’s financial statements.

Note 11 – Subsequent Event

On February 5, 2004, the Company acquired all the outstanding stock of XEL Communications, Inc. (“XEL”) for up to $17,650,000 in consideration consisting of $7,650,000 paid in cash at closing and $10,000,000 in the form of a note which may be converted into common stock of the Company at a conversion price of $5.324 per share. Following the closing, the Company issued certain employees of XEL a total of 187,826 shares of common stock, 187,826 shares of restricted common stock and $350,000 in cash bonuses. The Company incurred estimated transaction costs of approximately $675,000 in the transaction. In connection with the issuance of the shares of stock and payment of bonuses, the Company expects to record compensation expense of $1,350,000 immediately following the closing. The compensation expense related to the restricted stock issuance totaling $1,000,000 will be charged to expense over the three year vesting period.

The acquisition will be recorded under the purchase method of accounting, and the purchase price will be allocated based on the fair value of the assets and liabilities acquired. The Company expects to complete the preliminary allocation of the purchase price during the third quarter of fiscal 2004.

Item 2.

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

Verilink provides telecommunications products that address the wireless infrastructure, voice and data integrated access, and wireline service delivery markets. The Company develops, manufactures, and markets integrated access devices, centralized access systems, and infrastructure service enabling equipment for network service providers, enterprise customers, and original equipment manufacturer partners. These products are deployed worldwide as targeted solutions for applications involving voice over IP, voice over ATM, wireless backhaul aggregation, Frame Relay, point-to-point services, Internet protocol (“IP”) access routing, and the evolving transition from time-division multiplexing to IP. The Company’s customers include Regional Bell Operating Companies, interexchange carriers, incumbent local exchange carriers, competitive local exchange carriers, international post, telephone, and telegraph administrations, wireless service providers, equipment vendors, enterprise customers, and various local, state, and federal government agencies. The Company was founded in California in 1982 and is a Delaware corporation currently headquartered in Madison, Alabama.

The information in this Item 2 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements, including, without limitation, statements relating to the Company’s revenues, expenses, margins, liquidity and capital needs. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed elsewhere herein under the caption “Factors Affecting Future Results”.

RESULTS OF OPERATIONS

The following table presents the percentages of net sales represented by certain line items from the Condensed Consolidated Statements of Operations for the periods indicated.

	Three months ended						Six months ended

	January 2, 2004			December 27, 2002			January 2, 2004			December 27, 2002

Net sales		100.0	%		100.0	%		100.0	%		100.0	%
Cost of sales		53.8			48.1			50.1			48.1

Gross profit		46.2			51.9			49.9			51.9

Operating expenses:
Research and development		15.9			11.5			15.2			10.5
Selling, general and administrative		29.6			31.8			26.4			28.2

Total operating expenses		45.5			43.3			41.6			38.7

Operating income		0.7			8.6			8.3			13.2
Interest and other income, net		2.6			2.0			2.2			1.5
Interest expense		(0.4	)		(0.8	)		(0.3	)		(0.6	)

Income before provision for income taxes		2.9			9.8			10.2			14.1
Provision for income taxes		—			—			—			—

Net income before cumulative change in accounting principle, relating to goodwill		2.9			9.8			10.2			14.1
Cumulative effect of change in accounting principle, relating to goodwill		—			—			—			(8.3	)

Net income		2.9	%		9.8	%		10.2	%		5.8	%

Sales. Net sales for the three months ended January 2, 2004 increased 48% to $9,089,000 from $6,145,000 in the comparable period of the prior fiscal year. This increase is attributable to the acquisition of the NetEngine integrated access device product line (January 2003) and Miniplex product line for telecom carriers (July 2003), which provided sales of $3,352,000 for the period. Net sales for the six months ended January 2, 2004 increased 26% to $18,684,000 from $14,858,000 for the same period of the prior year. The Net Engine and Miniplex product lines provided net sales of $5,388,000 for the current six-month period. Net sales of carrier and carrier access products increased 46% to $5,345,000 in

the three months ended January 2, 2004 from $3,650,000 in the comparable prior year period and increased 20% for the six months ended January 2, 2004 to $12,005,000 from $10,001,000 in the comparable prior year period. This increase was due to the addition of the Miniplex product line, offset by a decrease of $403,000 in sales to the Company’s largest customer, which can fluctuate between quarters based upon the timing of its projects. Net sales of enterprise access products increased by 50% in the three months ended January 2, 2004 to $3,743,000 from $2,495,000 and increased by 37% in the six months ended January 2, 2004 to $6,678,000 from $4,857,000 for the same periods last year. These increases were the result of the addition of the NetEngine product line, which contributed $1,734,000 and $2,658,000 for the three and six months ended January 2, 2004, respectively. Excluding NetEngine sales, sales of enterprise access products decreased by 20% and 17% in the three and six months ended January 2, 2004, respectively, compared to the comparable periods in the prior year, which reflects an overall decline in legacy product sales to enterprise customers that has not been offset by a corresponding increase in sales of WANsuite products.

The Company’s business continues to be characterized by a concentration of sales to a limited number of key customers. Net sales to the Company’s top five customers increased in the three months ended January 2, 2004 to $6,019,000 from $5,184,000 in the comparable period in the prior year and increased to $13,512,000 for the six months ended January 2, 2004 from $12,658,000 for the six months ended December 27, 2002. Net sales to all other customers increased by 219% in the three-month period ended January 2, 2004 and increased 135% in the six month period ended January 2, 2004 from the comparable periods in the prior fiscal year. The Company’s top five customers did not remain the same over these periods. Sales to Nortel Networks accounted for 35% and 44% of net sales in the three and six months ended January 2, 2004, respectively, compared to 51% and 59% in the comparable periods of the prior fiscal year.

Gross Profit. Gross profit decreased to 46.2% of net sales for the three months ended January 2, 2004 as compared to 51.9% for the three months ended December 27, 2002. This decrease is primarily attributable to the product sales mix during this period with a higher sales volume of NetEngine products, which carry a lower margin than sales of our carrier and carrier access products. Gross profit for the six months ended January 2, 2004 decreased to 49.9% as compared to 51.9% in the comparable period of the prior fiscal year, again due to product sales mix.

Research and Development. Research and development expenditures for the three months ended January 2, 2004 increased 105.1% to $1,448,000 from $706,000 for the same period in the prior year, and increased as a percentage of sales from 11.5% to 15.9%. Research and development expenditures for the six months ended January 2, 2004 increased 82.2% to $2,832,000 from $1,554,000 for the same period in the prior year, and increased as a percentage of sales from 10.5% to 15.2%. These increases are a result of the staff added in connection with the NetEngine acquisition and to support continued IAD development projects. The Company believes that a significant level of investment in product development is required to remain competitive and that such expenses will vary over time as a percentage of net sales. However, the Company continues to monitor the level of its investment in research and development activities and adjusts spending levels, upward or downward, based upon anticipated sales volume.

Selling, General and Administrative. Selling, general and administrative expenses for the three months ended January 2, 2004 increased 37.5% to $2,690,000 from $1,956,000 in the comparable period in the prior fiscal year and decreased as a percentage of sales from 31.8% to 29.6%. Selling, general and administrative expenses for the six months ended January 2, 2004 increased 17.8% to $4,936,000 from $4,189,000 in the comparable period in the prior fiscal year and decreased as a percentage of sales from 28.2% to 26.4%. The increases over the same period in the prior year are due to increased headcount and related expenses, and on a year-to-date basis are partially offset by a credit of $135,000 for collection of notes receivable from former employees that were fully reserved in prior years. The decrease as a percentage of sales is due entirely to the impact of increased sales dollars.

Interest and Other Income, Net. Interest and other income, net, increased 93.4% to $236,000 for the three months ended January 2, 2004 from $122,000 in the comparable period in the prior fiscal year and increased 85.7% to $416,000 for the six months ended January 2, 2004 from $224,000 in the comparable period in the prior fiscal year. The increase for the current three month period is primarily due to the forfeiture of earnest money by the potential buyer of our former headquarters building at 950 Explorer Boulevard in the amount of $75,000. Additionally, the increase in the six month period is also due to net rental income related to property held for lease, which totaled $271,000 for the six months ended January 2, 2004 compared to $180,000 for the six months ended December 27, 2002.

Interest Expense. Interest expense declined 25.5% to $35,000 for the three months ended January 2, 2004 from $47,000 in the same period in the prior fiscal year and declined 27% to $73,000 for the six months ended January 2, 2004 from $100,000 in the same period in the prior fiscal year as a result of lower interest rates and lower principal balances on the Company’s debt obligations.

Provision for Income Taxes. No tax provision or tax benefits were provided in the three- or six- months ended January 2, 2004 or December 27, 2002 due to the valuation allowance provided against the net change in deferred tax assets. During fiscal 2001, the Company established a full valuation allowance against its deferred tax assets due to the net operating loss carry forwards from prior years and the operating losses incurred in fiscal 2001. The Company had net operating loss carry forwards of approximately $31,600,000 as of June 27, 2003.

Cumulative effect of change in accounting principle, relating to goodwill. As of June 29, 2002, the Company adopted SFAS No. 142, ceased amortizing goodwill and completed its transitional impairment test of goodwill. As a result, the Company determined that its goodwill was impaired and recorded a charge of $1,232,900 in the quarter ended September 27, 2002. This charge is presented in the condensed consolidated statement of operations as a cumulative effect of change in accounting principle, relating to goodwill.

Net Income. Net income for the three months ended January 2, 2004 was $264,000 compared to $605,000 for the three months ended December 27, 2002, as a result of the above factors, including the increase in the Company’s revenues and decrease in margins, as well as an increase in selling, general and administrative charges. Net income as a percentage of sales for the three months ended January 2, 2004 was 2.9%, compared to 9.8% for the three months ended December 27, 2002. Net income for the first six months of 2004 was $1,900,000 compared to $855,000 for the first six months of 2003, as a result of the above factors. Net income as a percentage of sales for the first six months of 2004 was 10.2%, compared to 5.8% for the first six months of 2003.

LIQUIDITY AND CAPITAL RESOURCES

On January 2, 2004, the Company’s principal sources of liquidity included $10,572,000 of unrestricted cash, cash equivalents and short-term investments.

During the six months ended January 2, 2004, cash provided by operating activities was $2,684,000 compared to $3,612,000 for the six months ended December 27, 2002. Net cash provided by operating activities in the current period was due to income before depreciation and amortization, which totaled $2,822,000. The increase in accounts receivable used cash of $98,000 in the six months ended January 2, 2004 compared to $2,466,000 provided in the comparable period in the prior fiscal year. The increase in inventories for the six months ended January 2, 2004 used $1,394,000 of cash compared to cash used in the same period last year of $627,000. Accounts payable and accrued expenses increased $1,436,000 in the six-month period ended January 2, 2004 compared to a decrease of $781,000 in the comparable period in the prior fiscal year. The changes in accounts payable and accrued expenses for the six months ended January 2, 2004 and the comparable prior year period were primarily due to the timing of inventory purchases and the resulting payments to vendors. Additionally, the increase in inventories and accounts payable for the six months ended January 2, 2004 included $1,369,000 for inventories that the Company is required to purchase from Terayon as disclosed in note 5 of notes to condensed consolidated financial statements.

Cash used in investing activities was $970,000 for the six months ended January 2, 2004 compared to cash provided by investing activities of $178,000 for the six months ended December 27, 2002. The funds used in investing activities during the six months ended January 2, 2004 are a result of current year payments related to the NetEngine and Miniplex acquisitions of $690,000, capital expenditures of $394,000 and the purchase of short-term investments of $26,000, offset by proceeds from the repayment of notes receivable of $140,000. For the six months ended December 27, 2002, cash was used to purchase property, plant and equipment of $469,000, offset by the maturity of short-term investments of $497,000 and proceeds from the repayment of notes receivable of $150,000.

Cash provided by financing activities was $228,000 for the six months ended January 2, 2004 as compared to $269,000 for the six months ended December 27, 2002. Payments on long-term debt and capital lease obligations were $365,000 and $361,000 for the six months ended January 2, 2004 and December 27, 2002, respectively. Proceeds from the issuance of common stock under the Company’s stock plans provided $595,000 and $3,000 of cash in the six months ended January 2, 2004 and December 27, 2002, respectively. Proceeds from repayments of notes receivable from stockholders provided $675,000 of cash in the six months ended December 27, 2002.

The Company’s former headquarters facility in Cummings Research Park West in Huntsville, Alabama, currently leased to The Boeing Company, provides a potential source of capital. The Company is seeking to sell this facility, and if the facility is not sold in the near term, the Company will seek to refinance the long-term debt to obtain additional cash to be used in its business.

The Company believes that its cash and investment balances, along with anticipated cash flows from operations will be adequate to finance the Company’s operations, capital expenditures, and research and development programs for at least the next twelve months. In the event that results of operations do not substantially meet the Company’s current operating forecast, the Company may evaluate cost containment measures, reduce investments or delay R&D, which could adversely affect the Company’s ability to bring new products to market. The Company from time to time investigates the possibility of generating financial resources through committed credit agreements, technology or manufacturing partnerships, joint ventures, equipment financing and offerings of debt and equity securities.

SUBSEQUENT EVENT

Subsequent to the date of this Report, the Company used approximately $8 million of its cash in connection with the acquisition of all the capital stock of XEL Communications, Inc. The Company also issued a convertible promissory note in the principal amount of $10 million with a maturity date of February 5, 2006. With the combined cash flow from operations of the Company’s existing business and the acquired business added by XEL, the Company believes that its current cash and investment balances, along with anticipated cash flows from operations will be adequate to finance the Company’s operations, capital expenditures, and research and development programs for at least the next twelve months. The Company is also seeking to obtain a working capital line of credit to augment its financial resources. In the event that results of operations do not substantially meet the Company’s current operating forecast, the Company may evaluate cost containment measures, reduce investments or delay R&D, which could adversely affect the Company’s ability to bring new products to market. The Company may also seek additional sources of capital to meet its obligations including offerings of debt or equity securities.

PRODUCT LINE ACQUISITION

On July 22, 2003, the Company acquired the fixed assets and intellectual property rights relating to Terayon Communication System, Inc.’s Miniplex product line for telecom carriers for up to $868,000, plus the assumption of certain liabilities. This product line gives telephone companies the capability to provide multiple plain old telephone services (“POTS”) connections over a single copper pair – a more cost-effective alternative to resolving copper exhaust problems than the installation of new copper cable.

Per the acquisition agreement, the Company paid Terayon $443,000 at the closing of the agreement and will pay up to an additional $425,000 based on the sale of Miniplex products through December 31, 2004 (the “Earn-Out Period”). The Company will make quarterly payments to Terayon during the Earn-Out Period at the rate of 4.6% of net sales of Miniplex products, provided, however, that the maximum payments will not exceed $425,000 or be less than $300,000. In addition to the purchase consideration, the Company agreed to purchase Terayon’s Miniplex related inventories totaling approximately $2,100,000 on the earlier of the date used by the Company or December 31, 2004. The Company has purchased $731,000 of this Miniplex inventory from Terayon and the remaining purchase commitment of $1,369,000 is included in inventories and accounts payable on the condensed consolidated balance sheet as of January 2, 2004.

Critical Accounting Policies

The Company’s financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods might be based upon amounts that differ from those estimates. The following represent what the Company believes are among the critical accounting policies most affected by significant management estimates and judgments:

Impairment of Long-Lived Assets and Goodwill. The Company assesses the impairment of long-lived assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable under the guidance prescribed by SFAS No. 144 and 142, respectively. The Company’s long-lived assets include, but are not limited to, the facility located at 950

Explorer Boulevard, related furniture and equipment, software licenses, goodwill and intangible assets related to acquisitions.

Inventories. The Company values inventory at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. Inventory quantities on hand are reviewed on a quarterly basis and a provision for excess and obsolete inventory is recorded based primarily on our estimated forecast of product demand for the next twelve months. Management’s estimates of future product demand may prove to be inaccurate, in which case the Company may increase or decrease the provision required for excess and obsolete inventory in future periods. Inventory reserves totaled $2,524,000 and $2,708,000 as of January 2, 2004 and June 27, 2003, respectively.

Revenue Recognition. The Company recognizes a sale when the product has been shipped, no material vendor or post-contract support obligations remain outstanding, except as provided by a separate service agreement, and collection of the resulting receivable is probable. A reserve for future product returns is established at the time of the sale based on historical return rates and return policies, including stock rotation for sales to distributors that stock the Company’s products. The reserve for future product returns was $232,000 and $382,000 as of January 2, 2004 and June 27, 2003, respectively.

Warranty Provision. The Company records a warranty provision at the time of the sale based on our best estimate of the amounts necessary to settle future claims on products sold. While we believe that our warranty reserve is adequate and that the judgment applied is appropriate, actual product failure rates, material usage or other rework costs could differ from our estimates, which could result in revisions to our warranty liability that totaled $1,316,000 and $1,374,000 as of January 2, 2004 and June 27, 2003, respectively.

Allowance for Doubtful Accounts. The Company estimates losses resulted from the inability of our customers to make payments for amounts billed. The collectability of outstanding invoices is continually assessed. Assumptions are made regarding the customer’s ability and intent to pay, and are based on historical trends, general economic conditions and current customer data. Should our actual experience with respect to collections differ from these assessments, there could be adjustments to our allowance for doubtful accounts, which totaled $512,000 and $532,000 as of January 2, 2004 and June 27, 2003, respectively.

Valuation of Notes Receivable. The Company continually assesses the collectability of assets classified as outstanding notes receivable. Assumptions are made regarding the counter party’s ability and intent to pay and are based on historical trends and general economic conditions, and current data. Should our actual experience with respect to collections differ from our initial assessment, adjustments in the reserves will be recorded. The allowance for notes receivable was $282,000 and $421,000 as of January 2, 2004 and June 27, 2003, respectively.

Deferred Tax Assets. The Company has provided a full valuation reserve related to its deferred tax assets. In the future, if sufficient evidence of the Company’s ability to generate sufficient future taxable income in certain tax jurisdictions becomes apparent, the Company may be required to reduce its valuation allowances, resulting in income tax benefits in the Company’s consolidated statement of operations. Management evaluates the realizability of the deferred tax assets and assesses the need for the valuation allowance each quarter. The valuation allowance related to the Company’s deferred tax assets was $16,491,000 as of June 27, 2003.

Factors Affecting Future Results

As described by the following factors, past financial performance should not be considered to be a reliable indicator of future performance.

This Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements using terminology such as “may”, “will”, “expects”, “plans”, “anticipates”, “estimates”, “potential”, or “continue”, or the negative thereof or other comparable terminology regarding beliefs, plans, expectations or intentions regarding the future. Forward-looking statements include statements regarding: reduced customer concentration in future periods; the expected increases in research and development expenses; the requirement of a significant level of investment in product development; and the adequacy of the Company’s cash position for the near-term. These forward-looking statements involve risks and uncertainties, and it is important to note that the Company’s actual results could differ materially from those in such forward-

looking statements. Among the factors that could cause actual results to differ materially are the factors described below and in the Company’s Annual Report on Form 10-K, as well as the other factors set forth in Item 2 hereof. All forward-looking statements and risk factors included in this document are made as of the date hereof, based on information available to the Company as of the date hereof, and the Company assumes no obligation to update any forward-looking statement or risk factor.

•	Dependence on Legacy and Recently Introduced Products and New Product Development. The majority of sales continue to be provided by the Company’s legacy products. The Company’s future results of operations are dependent on market acceptance of existing and future applications for the Company’s existing products and new products in development.

•	Risks Associated With Acquisitions, Potential Acquisitions and Joint Ventures. An important element of the Company’s strategy is to consider acquisition prospects and joint venture opportunities. Transactions of this nature by the Company could result in potentially dilutive issuance of equity securities, use of cash, the incurring of debt and the assumption of contingent liabilities, significant demands on management attention, and/or business risks associated with integrating other businesses into the Company.

•	Customer Concentration. A small number of customers have historically accounted for a majority of the Company’s sales, with a single customer’s orders for legacy products accounting for a majority of sales in many fiscal quarters. There can be no assurance that the Company’s current customers will continue to place orders with the Company, that orders by existing customers will continue at the levels of previous periods, or that the Company will be able to obtain orders from new customers.

•	Dependence on Key Personnel. The Company’s future success will depend to a large extent on the continued contributions of its executive officers and key management, sales, marketing and technical personnel.

•	Dependence on Key Suppliers and Component Availability. The loss of a key supplier, loss of a contract manufacturer, an increase in required lead times, an increase in prices of component parts, interruptions in the supply of any components, or the inability of the Company or its third party sub-contractor to procure components from alternative sources at acceptable prices and within a reasonable time, could have a material adverse effect upon the Company’s business, financial condition and results of operations.

•	Potential Volatility of Stock Price. The trading price of the Company’s Common Stock has been and may continue to be subject to wide fluctuations in response to quarter-to-quarter variations in operating results, announcements of technological innovations or new products by the Company or its competitors, developments with respect to patents or proprietary rights, general conditions in the telecommunication network access and equipment industries, changes in earnings estimates by analysts, or other events or factors.

•	Competition. The market for telecommunications network access equipment addressed by the Company’s product families can be characterized as highly competitive, with intensive price pressure. Many of the Company’s current and potential competitors have substantially greater technical, financial, manufacturing and marketing resources than the Company, and many have long-established relationships with network service providers.

•	Rapid Technological Change. The network access and telecommunications equipment markets are characterized by rapidly changing technologies and frequent new product introductions. The Company’s business, financial condition and results of operations would be materially adversely affected if the Company were to be unsuccessful, or to incur significant delays in developing and introducing new products or enhancements.

•	Compliance with Regulations and Evolving Industry Standards. The market for the Company’s products is characterized by the need to meet a significant number of communications regulations and standards, some of which are evolving as new technologies are deployed. The failure of the Company’s products to comply, or delays in compliance, with the various existing and evolving industry standards could delay introduction of the Company’s products.

•	Risks Associated With Entry into International Markets. The Company has little experience in the International markets, but intends to expand sales of its products outside of North America and to enter certain international markets, which

	will require significant management attention and financial resources. Conducting business outside of North America is subject to certain risks, including longer payment cycles, unexpected changes in regulatory requirements and tariffs, difficulties in staffing and managing foreign operations, greater difficulty in receivables collection and potentially adverse tax consequences.

•	Risk of Third Party Claims of Infringement; Limited Protection of Intellectual Property. The network access and telecommunications equipment industries are characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. In the event of a successful claim against the Company and the failure of the Company to develop or license a substitute technology, the Company’s business, financial condition and results of operations could be materially adversely affected. The Company relies upon a combination of statutory and contractual restrictions to establish and protect proprietary rights in its products and technologies. There can be no assurance that these statutory and contractual arrangements will deter misappropriation of the Company’s technologies or discourage independent third-party development of similar technologies.

Item 3.

Quantitative and Qualitative Disclosures About Market Risk.

At January 2, 2004, the Company’s investment portfolio consisted of fixed income securities of $127,000. These securities, like all fixed income instruments, are subject to interest rate risk and will decline in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels as of January 2, 2004, the decline in the fair value of the portfolio would not be material. Additionally, the Company has the ability to hold its fixed income investments until maturity and therefore, the Company would not expect to recognize such an adverse impact in income or cash flows. The Company invests its cash balances in excess of operating requirements in short-term securities, generally with maturities of 90 days or less.

The Company is subject to interest rate risks on its long-term debt. If market interest rates were to increase immediately and uniformly by 10% from levels as of January 2, 2004, the additional interest expense would not be material. The Company believes that the effect, if any, of reasonably possible near-term changes in interest rates on the Company’s financial position, results of operations and cash flows would not be material.

Item 4.

Controls and Procedures.

As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s President and Chief Executive Officer, and Vice President and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Company’s President and Chief Executive Officer, and Vice President and Chief Financial Officer, have concluded that the Company’s disclosure controls and procedures are effective. There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect these controls subsequent to the date of their evaluation. Management necessarily applied its judgment in assessing the costs and benefits of such controls and procedures, which, by their nature, can provide only reasonable assurance regarding management’s control objectives.

PART II. OTHER INFORMATION

Item 4.

Submission of Matters to a Vote of Security Holders

(a)

The Annual Meeting of Stockholders of the Company was held on November 13, 2003 (the “Annual Meeting”). The voting of holders of record of 14,808,367 shares of the Company’s Common Stock outstanding at the close of business on September 30, 2003 was solicited by proxy pursuant to Regulation 14A under the Securities Exchange Act of 1934, as amended.

(b)	The following individual was elected as Class I Director of the Company at the Annual Meeting:

Class III Director	Votes For	Votes Withholding Authority

John E. Major	12,322,433	70,374

	The following Directors’ terms of office as Director continued after the meeting: Howard Oringer, Leigh S. Belden, Steven C. Taylor and John A. McGuire.

(c)	The appointment of PricewaterhouseCoopers LLP as the Company’s independent certified public accountants for fiscal year 2004 was ratified. The stockholders’ vote on such appointment was 12,264,991 shares FOR; 49,626 shares AGAINST; 78,190 shares ABSTAINED from voting; and 0 shares NO VOTE.

Item 6.	Exhibits and Reports on Form 8-K

(a)	Exhibits Index:

Exhibit Number		Description of Exhibit

31.1		Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934

31.2		Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934

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

(b)	The Company filed no reports on Form 8-K during the quarter ended January 2, 2004.

	On October 14, 2003, the Company furnished a Form 8-K, which attached a press release announcing the Company’s financial results for the quarter ended October 3, 2003.

SIGNATURES

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

		VERILINK CORPORATION

February 17, 2004	By:

		C. W. Smith Vice President and Chief Financial Officer (Principal Financial and Accounting Officer)