UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington D.C. 20549

FORM 10-Q

(Mark One)

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

For the Quarterly Period Ended 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: 1-12491

LARSCOM INCORPORATED

(Address of principal executive offices, zip code and telephone number)

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

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

The number of the registrant’s shares outstanding as of May 7, 2004, was 5,100,255 of Common Stock.

LARSCOM INCORPORATED
FORM 10-Q

TABLE OF CONTENTS

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Part I: Financial Information

LARSCOM INCORPORATED

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

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

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LARSCOM INCORPORATED

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

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LARSCOM INCORPORATED

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1—Basis of Presentation:

     The condensed consolidated financial statements for the three months ended March 31, 2004 and 2003, presented in this Quarterly Report on Form 10-Q, are unaudited. In the opinion of management, these statements include all adjustments necessary for a fair statement of the results for the interim periods presented. The condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Larscom Incorporated (“Larscom”) Report on Form 10-K for the year ended December 31, 2003. The results of operations for the three months ended March 31, 2004 are not necessarily indicative of the results to be expected for the full year. The condensed consolidated balance sheet at December 31, 2003 has been derived from the audited consolidated financial statements at that date, but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

     The accompanying consolidated financial statements have been prepared on a going concern basis, which contemplates continuity of operations, realization of assets and the satisfaction of liabilities in the normal course of business and do not reflect adjustments that might result if we were not to continue as a going concern. The auditors report on our financial statements as of December 31, 2003 included an explanatory paragraph, which refers to our recurring operating losses and net capital deficiency and notes that these matters raise substantial doubt about our ability to continue as a going concern.

     On April 29, 2004, we signed a definitive merger agreement with Verilink Corporation (NASDAQ: VRLK). Under the terms of the definitive agreement, Verilink will acquire Larscom for approximately 6 million shares of Verilink common stock, with each Larscom share being converted into 1.166 Verilink shares, subject to certain adjustments. The merger has been approved by the boards of directors of each company, but is subject to the approval of each company’s stockholders and other customary closing conditions. If the Company’s stockholders approve the merger and all other conditions to closing are satisfied or waived, the merger is expected to be completed in the summer of 2004. However, because many of the closing conditions are beyond the Company’s control, there can be no assurance that the merger will be completed by the summer of 2004, if at all.

     We believe that our cash and cash equivalents and cash flow from operations will be sufficient to fund our operations through 2004. If the proposed merger with Verilink is delayed or not ultimately consummated, we will need to raise additional capital to fund our operations and capital spending before we become profitable. If cash flows from operations are lower than expected, including as a result of customer reaction to the proposed merger, if we incur unanticipated expenses or if we are unable to effectively manage our inventory level, we may need to obtain additional capital sooner than expected or be forced to further reduce our costs through personnel cuts or other measures. We are currently exploring opportunities to raise additional capital through various financial vehicles, but sufficient funds may not be available to us on terms that we deem acceptable or at all.

Note 2—Acquisitions:

     On June 5, 2003, we completed the acquisition of VINA Technologies, Inc. (“VINA”). The consideration consisted of approximately 2,393,894 shares of Larscom common stock, 454,752 warrants and options to purchase common stock and the assumption of the liabilities and obligations of VINA. See the Company’s Form 10-K for the year ended December 31, 2003.

Note 3 —Recent Accounting Pronouncements:

     In December 2003, the Securities and Exchange Commission released Staff Accounting Bulletin (“SAB”) 104, “Revenue Recognition”. SAB 104 revises or rescinds portions of the interpretative guidance related to revenue recognition included in Topic 13 of the codification of the staff accounting bulletins. We have assessed the impact of SAB 104 and concluded that the adoption of SAB 104 by us did not have a material impact on our financial statements.

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Note 4—Balance Sheet Components:

     Inventories consist of the following (in thousands):

     Amortized intangible assets consist of the following (in thousands):

     The aggregate amortization expense for the three months ended March 31, 2004 was $152,000. Amortization expense of $44,000 is included as a component of cost of revenues and $108,000 is included in operating expenses.

     Minimum future amortization expense at March 31, 2004 is as follows (in thousands):

     During the three months ended March 31, 2004, the company determined that the VINA tradenames/trademarks acquired as part of the merger with VINA in June 2003 had become impaired. The impairment is based on a projected discounted cash flow model using a discount rate commensurate with the risk inherent in our current business model. As a result, we recorded an impairment charge of $44,000 included in operating expenses to write-down the technology to the net present value of the expected cash flows related to the tradename/trademarks.

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Note 5—Restructuring and Cost of Revenues Charges:

     After the VINA merger, on June 5, 2003, we completed a restructuring that resulted in restructuring costs of $2,458,000 during 2003. Those restructuring costs consist of $1,535,000 in facility consolidation costs associated principally with moving our headquarters from Milpitas, CA, to Newark, CA, $425,000 in impairment charges related to fixed assets and leasehold improvements at the Milpitas location and $747,000 from reductions in force, partially offset by $249,000 of rent collected from Silicon Wireless Corporation.

     As part of an earlier closing of our facility in Durham, North Carolina, we remain responsible for the existing lease. The reserve for this lease is reduced as we make monthly payments. We entered into a sublease agreement with Silicon Wireless Corporation, a start-up company, which had a commencement date of February 15, 2002 and is for the entire 27,000 square-foot facility in Durham, North Carolina. Due to the uncertainty of the receipt of income under the sublease, we reduce restructuring expenses as the sublease income is received. During the first quarter of 2004 and 2003, our restructuring expenses were reduced by $62,000 in each period as a result of rent collected from Silicon Wireless Corporation. We expect the remaining real estate lease obligation, which comprises the remainder of the June, 2001 reserve balance, will be paid-out by January 2007. We do not expect there to be any additional costs related to the North Carolina restructuring.

     We abandoned our lease at the former Larscom headquarters in Milpitas, CA as of September 2003 and remain responsible for the balance of the lease, which expires in August of 2004. We expect that by the end of 2004 we will pay out the remaining reserve balance for the 2003 restructurings, which consist principally of the remaining lease payments on our former Milpitas facility.

     During the first quarter of 2004 we continued our expense reduction efforts and reduced our staff by five people; two in the manufacturing area and three in sales, general and administrative functions. This resulted in a charge to restructuring expense of $56,000, offset by rent collected from Silicon Wireless Corporation of $63,000.

     The following table provides beginning balances, activity and remaining balances included in other current and non-current liabilities for the quarter ended March 31, 2004:

Note 6—Deferred Tax Assets:

     Deferred tax assets include temporary differences related to intangible assets associated with the acquisition of NetEdge Systems Inc. in 1997, inventory write-downs, accrued expenses and net operating losses that carry forward. We established a deferred tax asset valuation allowance due to the uncertainty of realizing the tax loss carry-forwards and other deferred tax assets in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 109, “Accounting for Income Taxes.” Our assessment was based principally on the historical losses experienced by us in the U.S., unfavorable macro-economic conditions and capital expenditure reductions announced by several service providers. The deferred tax asset balance at March 31, 2004 amounted to $32,715,000, which was fully offset by a valuation allowance.

     As part of the merger with VINA, we recorded a deferred tax liability for the value of the intangibles acquired, a deferred tax asset for the net operating loss (“NOL”), credit carry-forwards and a difference in the accounting and tax basis of the VINA assets. The net deferred tax asset related to the merger has been fully reserved due to the

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uncertainty surrounding its realization. Because the merger with VINA is an “ownership change” as broadly defined in Section 382 of the Internal Revenue Code (“IRC”) of 1986, as amended, the tax asset (before reserves) relating to the VINA NOL carryforwards has been limited in accordance with the provisions of IRC Section 382.

     Additional deferred tax assets may be recognized in future periods to the extent that we can reasonably expect such assets to be realized. We will evaluate the probability of realizing our deferred tax assets on a quarterly basis. If we determine that an additional portion or all of the deferred tax assets are realizable, we will reduce the income tax valuation allowance accordingly.

Note 7—Net (Loss)/Income Per Share:

     Basic net (loss)/income per share is computed using the weighted-average number of shares of Common Stock outstanding during the period. Diluted net (loss)/income per share is computed using the weighted-average number of shares of Common Stock outstanding and the dilutive effect of options to purchase shares of Common Stock. In computing diluted earnings per share, the average price of our Common Stock for the period is used in determining the number of shares assumed to be purchased from the exercise of stock options. In the net loss per share computation, the effect of options to purchase shares of Common Stock is excluded, as their effect is antidilutive.

     The following table shows how basic and diluted net loss per share is computed:

     Outstanding stock options and warrants totaling 870,372 shares at March 31, 2004 and outstanding stock options totaling 343,703 shares at March 31, 2003 are not included in the calculation of diluted weighted average Common Stock outstanding because their effect would have been antidilutive for both periods presented. These stock options and warrants could be dilutive in the future.

Note 8—Accounting for Stock-Based Compensation

     We account for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board (“APB”) Opinion No. 25, and “Accounting for Stock Issued to Employees,” Financial Accounting Standard Board Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB 25.” Under APB No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of our stock and the exercise price.

     We amortize stock-based compensation using the straight-line method over the vesting period of the options. The risk-free interest rate used in the calculations was 3.18% for the first quarter of 2004 and 2.58% for the first quarter of 2003. The expected volatility was 90%, the expected life was 5 years and the dividend rate was zero for the first quarter of 2004 and 2003. Pro forma information regarding net loss and earnings per share is presented and has been determined as if we had accounted for employee stock options under the fair value method of SFAS No. 123, as amended by SFAS No. 148.

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     The fair value of options and shares issued pursuant to the option plans and at the grant date were estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions including the expected stock-price volatility. We use projected volatility rates, which are based upon historical volatility rates. Because employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of options.

     The effects of applying pro forma disclosures of net loss and net loss per share are not likely to be representative of the pro forma effects on net loss/income and earnings per share in the future years, as the number of future shares to be issued under these plans is not known and the assumptions used to determine the fair value can vary significantly.

     The following table illustrates the effect on net loss and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123, as amended by SFAS No. 148, to stock-based employee compensation (in thousands except for per share data) (unaudited):

Note 9—Accumulated Other Comprehensive Income/(Loss):

     “Accumulated other comprehensive income/(loss)” includes all changes in equity from non-owner sources during the period. The items of adjustment from net loss to comprehensive net loss for the periods presented relate to foreign currency translation adjustments.

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Note 10—Commitments and Contingencies:

     Commitments:

     Operating lease commitments are related principally to our buildings in Newark, California and Durham, North Carolina and have terms that expire in 2008 and 2007, respectively. In addition, as part of the merger with VINA, we have a facility in Milpitas, California (our former headquarters) with a lease that will expire in August 2004. Total rent expense in the first quarter of 2004 and 2003, was $801,000 and $669,000, respectively. Sublease rental income was $214,000 and $218,000 in the first quarter of 2004 and 2003, respectively. Future annual minimum lease payments under all non-cancelable operating leases and sublease rental income as of March 31, 2004 are as follows (in thousands):

     Contingencies:

     On April 29, 2004, we signed a definitive merger agreement with Verilink Corporation (NASDAQ: VRLK). The merger has been approved by the boards of directors of each company, but is subject to the approval of each company’s stockholders and other customary closing conditions. If the Company’s stockholders approve the merger and all other conditions to closing are satisfied or waived, the merger is expected to be completed in the summer of 2004. However, because many of the closing conditions are beyond the Company’s control, there can be no assurance that the merger will be completed by the summer of 2004, if at all.

     In our sales agreements, we typically agree to indemnify our customers for any expenses or liability resulting from claimed infringements of patents, trademarks or copyrights of third parties. The terms of these indemnification agreements are generally perpetual any time after execution of the agreement. The maximum amount of potential future indemnification is unlimited. To date we have not paid any amounts to settle claims or defend lawsuits.

     As part of the merger with VINA we have assumed a liability recorded on the books of VINA for California sales taxes for the period January 1, 1999 through March 31, 2000 resulting from a sales and use tax audit by the California State Board of Equalization. We have paid a substantial portion of the assessment to the State of California and the remainder of $55,000 is currently under appeal.

     Note 11—Segment Information:

     The Company operates under a single segment. Revenue related to operations in the United States and other countries for the three months ended March 31, 2004 and 2003 are as follows (in thousands):

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Long-lived assets as of March 31, 2004 and December 31, 2003 are as follows (in thousands):

(a) Revenues are reported by shipment to the final destination as determined by records required to comply with U.S. Department of Commerce regulations

Note 12—Guarantees and Warranty Obligations:

     Guarantees:

     We account for guarantees under Financial Accounting Standards Board Interpretation No. 45 (“FIN 45”), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires that a liability be recorded in the guarantor’s balance sheet upon issuance of a guarantee. In addition, FIN 45 requires disclosures about the guarantees that an entity has issued, including a reconciliation of changes in the entity’s product warranty liabilities.

     We, as the guarantor, entered into one category of guarantee, namely performance guarantees. Performance guarantees include contracts that contingently require us to make payments to the beneficiary of the guarantee based on our failure to perform under an obligating agreement. These obligating agreements consist primarily of manufacturing services agreements, non-cancelable and non-returnable purchase orders, and technology acquisition agreements.

     The term of the guarantees is less than one year. We have not recorded any liabilities for these potential future payments either because it is not probable or we have yet to incur the expense. The guarantees do not have a third party recourse provision.

     The following table discloses our obligations under guarantees as of March 31, 2004 (in thousands):

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Warranty Obligations:

     As permitted under Delaware law and in accordance with our bylaws, we indemnify our officers and directors for certain events or occurrences, subject to certain limits, while the officer or director is or was serving at our request in such capacity. The term of the indemnification period is for the officer’s or director’s lifetime. The maximum amount of potential future indemnification is unlimited; however, we have a director and officer insurance policy that limits our exposure and enables us to recover a portion of any future amounts paid. In addition, as part of the merger with VINA, we have indemnified the former officers and directors against claims against them in their former roles at VINA. We purchased a director’s and officer’s insurance policy to cover former directors and officers of VINA for a period of six years following the merger for events that may occur, related to the former VINA business. The maximum amount of potential future indemnification is unlimited; however, we believe the policies we purchased limit our exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the fair value of these indemnification agreements is minimal.

     In our sales agreements, we typically agree to indemnify our customers for any expenses or liability resulting from claimed infringements of patents, trademarks or copyrights of third parties. The terms of these indemnification agreements are generally perpetual any time after execution of the agreement. The maximum amount of potential future indemnification is unlimited. To date we have not paid any amounts to settle claims or defend lawsuits.

     We provide a three-year warranty for most of our products and a five-year warranty for the Terra and IAD product lines. The following table depicts product warranty activity during the three months ended March 31, 2004 (in thousands):

Note 13—Changes in Stockholders’ Equity:

     Reclassification of Class A and Class B Common Shares:

     On June 3, 2003, Larscom’s stockholders approved a proposal to reclassify its Class A and Class B Common Stock into a single class of common stock. The old Class B Common Stock had rights of four votes per share and was owned by one stockholder, Axel Johnson, Inc. (“Axel Johnson”). These additional voting rights gave Axel Johnson control of 82% of the voting interest prior to the merger with VINA. After issuance of 2,393,894 shares in connection with the VINA merger, and the reclassification of the Class B Common Stock into Common Stock with one vote per share, Axel Johnson’s control of the voting interest was reduced to 28%. Additionally, as a result of the shares issued to VINA shareholders, entities affiliated with Sierra Ventures V. L.P. received Larscom shares resulting in beneficial ownership of another 28% interest in Larscom.

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     Reverse Split of Class A Common Shares:

     On June 3, 2003 Larscom’s shareholders approved a proposal to amend Larscom’s certificate of incorporation to effect a reverse split of Larscom’s Common Stock in a ratio to be determined by the Board of Directors. The Board subsequently voted on June 5, 2003 to effect a reverse split with a 7-for-1 ratio with effect from June 6, 2003. All share and per share data has been retroactively restated for the reverse stock split.

     Larscom Stock Options:

     As part of the merger with VINA, the existing VINA stock options and warrants were assumed and converted into Larscom stock options and warrants, containing the exact terms, price and earned vesting percentages, as those held immediately prior to the merger (after the post-merger, post-split exchange ratio of 0.03799 shares of Larscom common stock for each share of VINA common stock).

     The VINA options and warrants were converted into 454,752 Larscom options and warrants. Additionally, as a result of the change of control resulting from the reclassification of shares previously discussed, and the VINA merger, a large part of the outstanding stock options previously issued by Larscom became fully vested due to a change-in-control provision contained in most of the outstanding option agreements. This acceleration caused 61,818 additional shares to become vested and exercisable on June 5, 2003 with an average exercise price of approximately $19.72.

Note 14—Related Party Transactions:

     As a result of the change in control as described in Note 13 above, Larscom no longer participates in the various benefit programs sponsored by Axel Johnson. These programs included medical, dental and life insurance, and workers’ compensation insurance. Larscom was also provided certain administrative services including tax, accounting, treasury, legal and human resources under an administrative services agreement. These services have now been secured by us, on a separate basis, from various third parties. The credit agreement we entered into with Axel Johnson was cancelled effective June 5, 2003. Additionally, Axel Johnson has assumed Larscom’s liability for any future funding liabilities for past participation by Larscom employees under the Axel Johnson Inc. Retirement Plan and the Axel Johnson Inc. Retirement Restoration Plan. Larscom’s employees had ceased to accrue benefits under these retirement plans after March 28, 1998.

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

Overview

     We manufacture and market high-speed network-access products for telecommunication service providers (“SPs”), and corporate enterprise users. Our product offerings support bandwidth requirements ranging from full and fractional T1/E1 to OC-3 (1.5 Mbps to 155 Mbps). Additionally, our solutions support a number of networking protocols such as frame relay, asynchronous transfer mode (“ATM”), inverse multiplexing over ATM (“IMA”), Ethernet and the Internet Protocol.

     The accompanying financial statements have been prepared on a going concern basis which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business and do not reflect adjustments that might result if we were not to continue as a going concern. The auditor’s report on our financial statements as of December 31, 2003 contains an explanatory paragraph, which refers to our recurring operating losses and net capital deficiency and notes that these matters raise substantial doubt about our ability to continue as a going concern.

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     The results for the prior year quarter ended March 31, 2003 do not include the results of VINA, as the VINA acquisition did not occur until June 5, 2003.

Merger Agreement with Verilink Corporation

     On April 28, 2004, the Company signed a definitive merger agreement with Verilink Corporation (NASDAQ: VRLK). Under the terms of the definitive agreement, Verilink will acquire Larscom for approximately 6 million shares of Verilink common stock, with each Larscom share being converted into 1.166 Verilink shares, subject to certain adjustments. The merger has been approved by the boards of directors of each company, but is subject to the approval of each company’s stockholders and other customary closing conditions. If the Company’s stockholders approve the merger and all other conditions to closing are satisfied or waived, the merger is expected to be completed in the summer of 2004. However, because many of the closing conditions are beyond the Company’s control, there can be no assurance that the merger will be completed by the summer of 2004, if at all.

     We believe that our cash and cash equivalents and cash flow from operations will be sufficient to fund our operations through 2004. If the proposed merger with Verilink is delayed or not ultimately consummated, we will need to raise additional capital to fund our operations and capital spending before we become profitable. If cash flows from operations are lower than expected, including as a result of customer reaction to the proposed merger, if we incur unanticipated expenses or if we are unable to effectively manage our inventory level, we may need to obtain additional capital sooner than expected or be forced to further reduce our costs through personnel cuts or other measures. We are currently exploring opportunities to raise additional capital through various financial vehicles, but sufficient funds may not be available to us on terms that we deem acceptable or at all.

Summary of Critical Accounting Policies

     Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to uncollectible receivables, investment values, income taxes, restructuring and contingencies. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions.

     We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements:

     Revenue Recognition and Deferred Revenue:

     Revenue from product sales is generally recognized upon delivery to our customers when there is persuasive evidence of an arrangement, the fee is fixed and determinable and collection of the receivable is reasonably assured. However, some of our distributors, who maintain significant inventories of our products, have a right to return products that remain unsold. In the case