SONUS NETWORKS INC - 10-Q Quarterly Report

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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 September 30, 2002

Commission File Number 000-30229

SONUS NETWORKS, INC.
(Exact name of Registrant as specified in its charter)

DELAWARE
(State or other jurisdiction of
incorporation or organization)

04-3387074
(I.R.S. employer identification no.)

5 Carlisle Road, Westford, Massachusetts 01886
(Address of principal executive offices, including zip code)

(978) 392-8100
(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 ý No o

As of October 31, 2002, there were 204,884,659 shares of $0.001 par value per share, common stock, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

None

SONUS NETWORKS, INC.
FORM 10-Q
QUARTER ENDED SEPTEMBER 30, 2002

TABLE OF CONTENTS

		Page
PART I—FINANCIAL INFORMATION
Item 1:	Financial Statements
	Condensed Consolidated Balance Sheets as of September 30, 2002 (unaudited) and December 31, 2001	1
	Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2002 and 2001 (unaudited)	2
	Condensed Consolidated Statement of Stockholders' Equity for the Nine Months Ended September 30, 2002 (unaudited)	3
	Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2002 and 2001 (unaudited)	4
	Notes to Condensed Consolidated Financial Statements (unaudited)	5
Item 2:	Management's Discussion and Analysis of Financial Condition and Results of Operations	17
	Cautionary Statements	24
Item 3:	Quantitative and Qualitative Disclosures About Market Risk	33
Item 4:	Controls and Procedures	33
PART II—OTHER INFORMATION
Item 1:	Legal Proceedings	34
Item 6:	Exhibits and Reports on Form 8-K	35
	Signatures and Certifications	36

PART I—FINANCIAL INFORMATION

Item 1: Financial Statements

SONUS NETWORKS, INC.

Condensed Consolidated Balance Sheets

(In thousands, except share data)

			September 30, 2002			December 31, 2001
			(unaudited)
Assets
Current assets:
	Cash and cash equivalents		$	29,762		$	49,123
	Marketable securities			62,345			75,944
	Accounts receivable, net			2,957			9,440
	Inventories			9,427			18,865
	Other current assets			2,456			2,952

		Total current assets		106,947			156,324
Property and equipment, net				13,950			23,335
Goodwill, net				—			1,673
Purchased intangible assets, net				1,707			2,863
Other assets, net				485			689

			$	123,089		$	184,884

Liabilities and Stockholders' Equity
Current liabilities:
	Accounts payable		$	3,228		$	8,630
	Accrued expenses			23,201			27,671
	Accrued restructuring expenses			4,479			8,596
	Deferred revenue			10,941			13,349
	Current portion of long-term obligations			1,845			1,055

		Total current liabilities		43,694			59,301
Long-term obligations, less current portion				3,682			12,698
Convertible subordinated notes				10,000			10,000
Commitments and contingencies (Note 9)
Stockholders' equity:
	Preferred stock, $0.01 par value; 5,000,000 shares authorized, none issued and outstanding			—			—
	Common stock, $0.001 par value; 600,000,000 shares authorized, 206,725,624 and 205,181,085 shares issued and 204,860,910 and 204,167,335 shares outstanding at September 30, 2002 and December 31, 2001, respectively			207			205
	Capital in excess of par value			860,111			860,883
	Accumulated deficit			(785,048	)		(729,398	)
	Deferred compensation			(9,345	)		(28,721	)
	Treasury stock, at cost; 1,864,714 and 1,013,750 common shares at September 30, 2002 and December 31, 2001, respectively			(212	)		(84	)

		Total stockholders' equity		65,713			102,885

			$	123,089		$	184,884

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

SONUS NETWORKS, INC.

Condensed Consolidated Statements of Operations

(In thousands, except per share data)

(unaudited)

			Three months ended September 30,						Nine months ended September 30,
			2002			2001			2002			2001
Revenues:
	Product		$	3,256		$	34,783		$	34,864		$	119,115
	Service			4,189			5,503			15,034			15,221

		Total revenues		7,445			40,286			49,898			134,336

Cost of revenues(1):
	Write-off of inventory and purchase commitments			—			—			9,434			—
	Product			2,246			11,591			16,152			43,161
	Service			2,501			6,538			8,418			15,139

		Total cost of revenues		4,747			18,129			34,004			58,300

Gross profit				2,698			22,157			15,894			76,036
Operating expenses:
	Research and development(1)			9,685			18,746			36,525			49,362
	Sales and marketing(1)			5,520			12,660			22,207			31,763
	General and administrative(1)			2,445			3,330			5,601			9,272
	Stock-based compensation			3,962			39,069			15,655			68,339
	Amortization of goodwill and purchased intangible assets			367			41,368			1,156			107,279
	Write-off of goodwill and purchased intangible assets			1,673			376,719			1,673			376,719
	Restructuring charges (benefit), net			987			25,807			(10,141	)		25,807
	In-process research and development			—			3,800			—			43,800

		Total operating expenses		24,639			521,499			72,676			712,341

Loss from operations				(21,941	)		(499,342	)		(56,782	)		(636,305	)
Interest expense				(163	)		(147	)		(438	)		(428	)
Interest income				466			1,328			1,570			4,702

Net loss			$	(21,638	)	$	(498,161	)	$	(55,650	)	$	(632,031	)

Basic and diluted net loss per share			$	(0.11	)	$	(2.81	)	$	(0.30	)	$	(3.71	)

Shares used in computing net loss per share (Note 1(i))				191,823			177,313			188,620			170,220


(1) Excludes non-cash, stock-based compensation expense as follows:
Cost of revenues			$	176		$	535		$	574		$	1,157
Research and development				2,147			23,391			8,498			39,773
Sales and marketing				1,338			8,127			5,010			16,021
General and administrative				301			7,016			1,573			11,388

			$	3,962		$	39,069		$	15,655		$	68,339

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

SONUS NETWORKS, INC.

Condensed Consolidated Statement of Stockholders' Equity

(In thousands, except share data)

(unaudited)

		Common Stock												Treasury Stock
		Common Stock			Capital in Excess of Par Value			Accumulated Deficit			Deferred Compensation			Treasury Stock				Total Stockholders' Equity
		Shares	Par Value		Capital in Excess of Par Value			Accumulated Deficit			Deferred Compensation			Shares	Cost			Total Stockholders' Equity
Balance, December 31, 2001		205,181,085	$	205	$	860,883		$	(729,398	)	$	(28,721	)	1,013,750	$	(84	)	$	102,885
	Issuance of common stock in connection with employee stock purchase plan	1,199,247		2		2,841			—			—		—		—			2,843
	Exercise of stock options	345,292		—		108			—			—		—		—			108
	Amortization of deferred compensation	—		—		—			—			14,188		—		—			14,188
	Deferred compensation for terminated employees (Note 2)	—		—		(3,721	)		—			5,188		—		—			1,467
	Repurchase of common stock	—		—		—			—			—		850,964		(128	)		(128	)
	Net loss	—		—		—			(55,650	)		—		—		—			(55,650	)

Balance, September 30, 2002		206,725,624	$	207	$	860,111		$	(785,048	)	$	(9,345	)	1,864,714	$	(212	)	$	65,713

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

SONUS NETWORKS, INC.

Condensed Consolidated Statement of Cash Flows

(In thousands)

(unaudited)

					Nine months ended September 30,
					2002			2001
Cash flows from operating activities:
	Net loss				$	(55,650	)	$	(632,031	)
	Adjustments to reconcile net loss to net cash used in operating activities:
		Depreciation and amortization				12,047			11,036
		Write-off of inventory				7,026			—
		Stock-based compensation				15,655			68,339
		Amortization of goodwill and purchased intangible assets				1,156			107,279
		Write-off of goodwill and purchased intangible assets				1,673			376,719
		Non-cash restructuring charge				(16,557	)		—
		In-process research and development				—			43,800
		Changes in current assets and liabilities:
			Accounts receivable			6,483			9,006
			Inventories			2,412			(2,960	)
			Other current assets			496			281
			Accounts payable			(5,402	)		(6,179	)
			Accrued expenses			(2,937	)		23,034
			Deferred revenue			(2,408	)		(1,181	)

				Net cash used in operating activities		(36,006	)		(2,857	)

Cash flows from investing activities:
	Purchases of property and equipment					(2,435	)		(21,427	)
	Maturities of marketable securities					35,631			26,287
	Purchases of marketable securities					(22,032	)		(61,204	)
	Other assets					(23	)		(30	)
	Acquisitions, net of cash acquired					—			(6,125	)

				Net cash provided by (used in) investing activities		11,141			(62,499	)

Cash flows from financing activities:
	Proceeds from sale of common stock in connection with employee stock purchase plan.					2,843			7,866
	Proceeds from exercise of stock options					108			3,650
	Payment of stock subscriptions receivable					—			238
	Additions to long-term obligations					3,300			12,460
	Payments of long-term obligations					(619	)		(386	)
	Payment of note payable to bank					—			(8,000	)
	Proceeds from issuance of convertible subordinated notes					—			10,000
	Repurchase of common stock					(128	)		(17	)

				Net cash provided by financing activities		5,504			25,811

Net decrease in cash and cash equivalents						(19,361	)		(39,545	)
Cash and cash equivalents, beginning of period						49,123			87,108

Cash and cash equivalents, end of period					$	29,762		$	47,563

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

SONUS NETWORKS, INC.

Notes to Condensed Consolidated Financial Statements

(unaudited)

(1) Summary of Significant Accounting Policies

(a) Basis of Presentation and Principles of Consolidation

The accompanying unaudited condensed consolidated financial statements have been prepared by Sonus Networks, Inc. (Sonus) and reflect all adjustments, consisting only of normal recurring adjustments, which in the opinion of management are necessary for a fair statement of the results for the interim periods. The unaudited condensed consolidated financial statements have been prepared in accordance with the regulations of the Securities and Exchange Commission (SEC), and omit or condense certain information and footnote disclosures pursuant to existing SEC rules and regulations. Results for the interim periods are not necessarily indicative of results to be expected for the entire fiscal year. These statements should be read in conjunction with the consolidated financial statements and related footnotes included in Sonus' Annual Report on Form 10-K for the year ended December 31, 2001 filed with the SEC.

The unaudited condensed consolidated financial statements include the accounts of Sonus and its wholly-owned subsidiaries. All material intercompany transactions and balances have been eliminated.

(b) Cash Equivalents and Marketable Securities

Cash equivalents are stated at cost plus accrued interest, which approximates market value, and have maturities of three months or less at the date of purchase.

Marketable securities are classified as held-to-maturity, as Sonus has the intent and ability to hold to maturity. Marketable securities are reported at amortized cost. Cash equivalents and marketable securities are invested in high-quality credit instruments, primarily U.S. Government obligations and corporate obligations with contractual maturities of less than one year. There have been no gains or losses to date.

(c) Concentrations of Credit and Off-Balance Sheet Risk, Significant Customers and Limited Suppliers

The financial instruments that potentially subject Sonus to concentrations of credit risk are cash, cash equivalents, marketable securities and receivables. Sonus has no off-balance sheet concentrations such as foreign exchange contracts, options contracts or other foreign hedging arrangements. Sonus' cash and cash equivalent holdings are diversified between four financial institutions.

We expect that for the foreseeable future, the majority of our revenues will depend on sales of our products to a limited number of customers. For the nine months ended September 30, 2002 and 2001, two and four customers each contributed more than 10% of our revenues and collectively represented an aggregate of 43% and 69% of total revenues. As of September 30, 2002 and 2001, three and two customers each accounted for more than 10% of Sonus' accounts receivable balance. International revenues, primarily attributable to Asia and Europe, were 21% of total revenues for both the nine months ended September 30, 2002 and 2001. Certain components and software licenses from third-parties used in Sonus' products are procured from a single source. The failure of a supplier, including a subcontractor, to deliver on schedule could delay or interrupt Sonus' delivery of products and thereby adversely affect Sonus' revenues and operating results.

(d) Goodwill and Purchased Intangible Assets

In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 eliminated the amortization of goodwill and certain other intangibles with indefinite lives and instead subjects these assets to periodic impairment assessments. SFAS No. 142 was effective for all goodwill and certain other intangibles acquired after June 30, 2001 and commenced on January 1, 2002 for all goodwill and certain other intangibles existing on June 30, 2001. In accordance with SFAS No. 142, in response to unfavorable business conditions, Sonus re-evaluated the fair value of its goodwill and as a result recorded a non-cash impairment charge of $1,673,000 in the third quarter of fiscal 2002 (Notes 2(d), 3 and 4).

Purchased intangible assets are carried at cost less accumulated amortization. Amortization is computed over the estimated useful lives of the respective assets, two and three years.

(e) Revenue Recognition

Sonus recognizes revenue from product sales to end users, resellers and distributors upon shipment, provided there are no uncertainties regarding acceptance, persuasive evidence of an arrangement exists, the sales price is fixed or determinable and collection of the related receivable is probable. If uncertainties exist, Sonus recognizes revenue when those uncertainties are resolved. In multiple element arrangements, in accordance with Statement of Position 97-2 and 98-9, Sonus uses the residual method when vendor-specific objective evidence does not exist for one of the delivered elements in the arrangement. Service revenue is recognized as the services are provided. Revenue from maintenance and support arrangements is recognized ratably over the term of the contract. Amounts collected prior to satisfying the revenue recognition criteria are reflected as deferred revenue. Warranty costs are estimated and recorded by Sonus at the time of product revenue recognition.

In December 1999, the SEC issued Staff Accounting Bulletin No. 101, Revenue Recognition in Financial Statements. This bulletin established guidelines for revenue recognition. Sonus' revenue recognition policy complies with this pronouncement.

(f) Stock-Based Compensation

Sonus uses the intrinsic value-based method of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, to account for all of its employee stock-based compensation plans and uses the fair value method to account for all non-employee stock-based compensation.

(g) Comprehensive Loss

Sonus applies SFAS No. 130, Reporting Comprehensive Income. The comprehensive loss for the three and nine months ended September 30, 2002 and 2001 does not differ from the reported loss.

(h) 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 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 expenses during the reporting period. Actual results could differ from those estimates.

(i) Net Loss Per Share

Basic net loss per share is computed by dividing the net loss for the period by the weighted average number of shares of unrestricted common stock outstanding during the period. Diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of shares of unrestricted common stock and potential common stock outstanding during the period, if dilutive. Potential common stock consists of restricted shares of common stock, shares of common stock issuable upon the exercise of stock options, conversion of convertible subordinated notes and shares of common stock issued in connection with our acquisition of TTI subject to the achievement of milestones and employee retention (Note 3). There were no dilutive shares of potential common stock for the three and nine months ended September 30, 2002 and 2001 as Sonus incurred a net loss in each period.

The following table sets forth the computation of shares used in calculating the net loss per share, in thousands:

	Three months ended September 30,				Nine months ended September 30,
	2002		2001		2002		2001
Weighted average common shares outstanding	204,663		203,537		204,250		200,034
Less weighted average restricted common shares outstanding	(12,840	)	(26,224	)	(15,630	)	(29,814	)

Shares used in computing net loss per share	191,823		177,313		188,620		170,220

Excluded from the shares used in calculating the net loss per share in the above table are options to purchase shares of common stock and shares of common stock issuable upon conversion of convertible subordinated notes representing an aggregate of 23,170,000 and 21,394,000 as of September 30, 2002 and 2001, as their effects would have been anti-dilutive.

(j) Recent Accounting Pronouncements

In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which supersedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of, and the accounting and reporting provisions of APB No. 30, Reporting the Results of Operations—Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets and is effective for fiscal years beginning after December 15, 2001, and interim periods within those fiscal years. The implementation of this statement did not have any effect on Sonus' condensed consolidated financial statements.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS 146 addresses the recognition, measurement and reporting of costs associated with exit and disposal activities, including restructuring activities that are currently accounted for in accordance with Emerging Issues Task Force Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and OtherCosts to Exit an Activity (including Certain Costs Incurred in a Restructuring). The scope of SFAS 146 includes costs related to terminating a contract that is not a capital lease, costs to consolidate facilities or relocate employees, and certain termination benefits provided to employees who are involuntarily terminated. SFAS 146 is effective for exit or disposal activities initiated after December 31, 2002. Sonus does not expect the implementation of this statement will have a material impact on its consolidated financial position or results of operations.

(k) Reclassifications

Certain reclassifications have been made to prior year's consolidated financial statements to conform to the 2002 presentation.

(2) Restructuring Charges (Benefit) and Write-off of Goodwill and Purchased Intangible Assets

Commencing in the third quarter of fiscal 2001, in response to unfavorable business conditions primarily caused by significant declines in capital spending by telecommunications service providers, Sonus has implemented restructuring plans designed to reduce expenses and align its cost structure with its revised business outlook. The restructuring plans include worldwide workforce reductions, consolidations of excess facilities and the write-off of excess inventory and purchase commitments. Additionally, in the third quarter of fiscal 2001 and 2002, Sonus recorded write-offs of goodwill and purchased intangible assets in connection with the acquisitions of TTI and Linguateq (Notes 3 and 4) and in the first quarter of fiscal 2002, recorded a non-cash restructuring benefit for a lease renegotiation. Sonus' restructuring related reserves as of September 30, 2002 are summarized as follows, in thousands:

			Current Operating Activity
	Dec. 31, 2001 Accrual Balance		Current Operating Activity											Sept. 30, 2002 Accrual Balance
	Dec. 31, 2001 Accrual Balance		Additions		Non-cash Benefit			Total			Cash Payments			Sept. 30, 2002 Accrual Balance		Current Portion		Long-term Portion
Workforce reduction	$	871	$	4,000	$	—		$	4,000		$	(4,708	)	$	163	$	163	$	—
Consolidation of facilities and other charges (benefit)		20,185		2,416		(16,557	)		(14,141	)		(1,807	)		4,237