UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

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

For the quarterly period ended October 1, 2004

Commission file number: 000-28562

VERILINK CORPORATION

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 October 29, 2004 was 22,789,284.

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INDEX
VERILINK CORPORATION
FORM 10-Q

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

VERILINK CORPORATION

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

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VERILINK CORPORATION

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

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VERILINK CORPORATION

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

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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 1, 2005. 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 July 2, 2004 as filed with the Securities and Exchange Commission. The Company has evaluated, and will periodically re-evaluate, our business in light of the segment reporting requirements prescribed by SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. The Company has determined that we should report our operations as a single operating segment.

     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 the Company were not to continue as a going concern. The auditor’s report on the Company’s financial statements as of July 2, 2004 contains an explanatory paragraph, which refers to uncertain revenue streams and a low level of liquidity and notes that these matters raise substantial doubt about the Company’s ability to continue as a going concern. Sales of legacy products to the Company’s largest customer in fiscal 2004 declined from 54% of net sales in the first quarter of fiscal 2004 to 16% of net sales in the fourth quarter of fiscal 2004, and declined to zero in the first quarter of fiscal 2005. Liquidity would be further limited if the Company’s line of credit with RBC Centura Bank (“RBC”) were to be accelerated or becomes unavailable.

     The Company has been preparing, and continues to prepare, for reduced legacy sales through its recent acquisitions by investment in next generation broadband access products and the alignment of its operating costs with management’s revenue expectations in light of current conditions in the telecommunications industry. On a quarterly basis, management will continue to evaluate revenue outlook and plans to adjust spending levels as necessary.

     The Company’s line of credit terminates and all borrowings thereunder are due April 7, 2005 unless extended or renewed by RBC. If the line of credit is not extended, the Company will need other sources of credit or financing in early calendar 2005 to repay borrowings under the line of credit and to provide working capital. If additional credit or other financing is needed but not available on terms acceptable to the Company, the Company may seek to renegotiate certain of its contractual obligations. Arrangements for additional credit or financing or renegotiation of contractual obligations may not be available on terms acceptable to us, if at all.

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. Comprehensive loss for the three months ended October 1, 2004 of $24,476,000 consists of $24,471,000 of net loss and $5,000 of foreign currency translation adjustments. Comprehensive income for the three months ended October 3, 2003 of $1,634,000 consists of $1,636,000 of net income and $2,000 of foreign currency translation adjustments. As of October 1, 2004 and July 2, 2004, total accumulated other comprehensive loss was $44,000 and $39,000, respectively.

Note 3 – Earnings (Loss) Per Share

     Basic earnings (loss) per share is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share gives effect to all dilutive potential common shares outstanding during a period. In computing diluted earnings (loss) per share, the average

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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 (loss) per share for the three months ended October 1, 2004 and October 3, 2003 (in thousands, except per share amounts):

     Outstanding restricted common stock held by employees as of October 1, 2004 totaling 66,019 shares has been excluded from the computation of basic earnings (loss) per share since the shares are not vested and remain subject to forfeiture.

     Potential common shares from conversion of the convertible notes as of October 1, 2004 totaling 606,687 shares were not included in the computation of diluted earnings (loss) per share because the inclusion of such shares would have been antidilutive.

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):

Note 5 – Acquisition of Larscom Incorporated

     On July 28, 2004, the Company completed its acquisition of Larscom Incorporated (“Larscom”) and issued approximately 5,946,897 shares of its Common Stock for all the outstanding stock of Larscom. The Company also assumed all outstanding stock options and warrants of Larscom. Larscom manufactures and markets high-speed network-access products for telecommunication service providers and corporate enterprise users. This acquisition reflects the Company’s strategy to pursue revenue growth, and brings a complementary customer base and product synergies. The results for the first quarter of fiscal 2005 include the results of Larscom for the two-month period from July 29, 2004 through October 1, 2004.

     The acquisition was recorded under the purchase method of accounting, and the purchase price was allocated based on the fair value of the assets acquired and liabilities assumed. The goodwill recorded as a result of the acquisition will not be amortized but will be included in the Company’s review of goodwill for impairment. The total purchase price of $27,852,000 consisted of (a) approximately 5,946,897 shares of Verilink common stock issued upon consummation and valued at approximately $26,036,000, using a fair value per share of $4.378, (b) approximately $516,000 of consideration for options

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and warrants to purchase approximately 983,306 equivalent shares of Verilink common stock assumed as part of the acquisition, and (c) direct transaction costs of approximately $1,300,000. The fair value of Verilink’s common stock issued was determined using the five-trading-day average price surrounding the date the acquisition was announced (April 29, 2004). The fair value of options and warrants assumed in the transaction was determined using the Black-Scholes option-pricing model and the following assumptions: (i) options assumed that are expected to terminate within one year following the date of closing – expected life of 0.57 years, risk-free interest rate of 1.20%, expected volatility of 85.37% and no expected dividend yield, (ii) all other options assumed – expected life of 3.06 years, risk-free interest rate of 2.99%, expected volatility of 143.10% and no expected dividend yield, and (iii) warrants assumed – remaining contractual life of 0.26 years, risk-free interest rate of 1.20% and expected volatility of 85.37%. A summary of the total purchase consideration is as follows (in thousands):

     The purchase consideration was allocated to the estimated fair values of the assets acquired and liabilities assumed. Based upon management’s estimate of fair value, which was based upon an independent valuation, the purchase price allocation is as follows (in thousands, except years):

     The acquisition was funded through the issuance of common stock and available cash.

     Pro Forma Financial Information – The following unaudited pro forma summary combines the results of the Company as if the acquisition of Larscom had occurred on June 28, 2003. Certain adjustments have been made to reflect the impact of the purchase transaction. These pro forma results have been prepared for comparative purposes only and are not indicative of what would have occurred had the acquisition been made at the beginning of the respective periods, or of the results which may occur in the future (in thousands, except per share amounts).

Note 6 – Impairment of Goodwill

     During the first quarter of fiscal 2005, the Company completed an interim test for impairment of goodwill due to triggering events that occurred during the quarter that the Company believes would more likely than not, reduce the fair value of goodwill below its carrying value. These triggering events were (a) the loss of product revenues from a significant customer, (b) the low level of liquidity noted in an explanatory paragraph included in the audit report from our independent registered public accounting firm on the Company’s fiscal 2004 consolidated financial statements which were filed in our Annual Report on Form 10-K on October 1, 2004, and (c) the low market price of the Company’s common stock following the end of the quarter. Based on the initial impairment assessment, the Company determined that the fair value of its reporting unit was less than its carrying value after considering a combination of quoted market prices and discounted cash flows. In order to determine the amount of goodwill impairment, the Company, utilizing the assistance of a third party valuation specialist, prepared a purchase price allocation using a discounted cash flow model. The

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projected discounted cash flow model was prepared using a discount rate commensurate with the risk inherent in our current business model. As a result, the Company recorded an impairment charge related to goodwill of $19,984,000.

     Prior to the first quarter of fiscal 2005, the Company’s annual impairment assessment considered the Company’s carrying value of its equity to its market capitalization calculated by multiplying the Company’s outstanding shares by its current share price, disregarding anomalies in share price that it deemed were temporary in nature. Due to the changes in facts and circumstances caused by the loss of product revenues from a significant customer, the significant volatility in the Company’s share price since the end of its 2004 fiscal year, and its low level of liquidity, the Company considered both quoted market prices and discounted cash flows as fair value models and concluded that a projected discounted cash flow model is a better indicator of the fair value of the Company, as that term is contemplated in SFAS 142, Goodwill and Other Intangibles, than the market capitalization model used historically.

Note 7 – Other Intangible Assets

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

     For the three months ended October 1, 2004 and October 3, 2003, amortization of other intangible assets totaled $572,000 and $233,000, respectively. The approximate estimated annual amortization for other intangibles is (in thousands):

Note 8 – Warranty Liability

     The Company records a warranty provision at the time of each sale. The Company generally warrants its products from one to five years based on product line. A reconciliation of the changes in warranty liability for the three months ended October 1, 2004 and October 3, 2003 is (in thousands):

Note 9 – Restructuring Charges

     During fiscal 2004 following the acquisition of XEL Communications, the Company announced its plans to consolidate certain manufacturing and administrative activities in Aurora, Colorado with its operations in Madison, Alabama. The Company recorded pretax restructuring charges totaling $390,000 in the third and fourth quarters of fiscal 2004 and $26,000 in the first quarter of fiscal 2005 in the consolidated statement of operations in connection with these restructuring activities which include severance and other termination benefits. This restructuring resulted in a reduction in workforce of approximately 17 employees, or 10% of the Company’s total workforce. The Company completed these consolidation activities during the first quarter of fiscal 2005.

     In September 2004, the Company announced plans to consolidate its engineering functions in the Company’s Madison, Alabama and Newark, California facilities. As a result of this engineering resource alignment, the Company will close its Santa Barbara, California office and will transition engineering currently located in Aurora, Colorado to the appropriate

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facility in either Madison, Alabama or Newark, California. The Aurora, Colorado facility was acquired as part of the Company’s acquisition of XEL in February 2004 and the Santa Barbara, California office was acquired as part of the acquisition of the NetEngine product line in January 2003. As part of this engineering consolidation plan, the Company will reduce its workforce by approximately 5%. This restructuring is expected to be completed by November 30, 2004 and is expected to result in total charges of approximately $700,000, including cash expenditures of $500,000 for one-time termination benefits for departing personnel and $200,000 for other costs associated with office and resource re-alignment. In connection with these plans, the Company recorded a restructuring charge of $260,000 in the first quarter of fiscal 2005 and expects to record $440,000 in the second quarter of fiscal 2005.

     In connection with the acquisition of Larscom on July 28, 2004, the Company assumed restructuring accruals totaling $2,811,000 recorded as restructuring charges by Larscom in periods prior to the acquisition date, which included the following items explained in more detail below: (i) real estate lease related to the closure of the Larscom facility in Durham, North Carolina, (ii) real estate lease related to the abandonment of the former Larscom headquarters in Milpitas, California, and (iii) charges related to the planned reduction in work force of certain Larscom positions in connection with the acquisition of Larscom by the Company.

     During 2001, Larscom closed its facility in Durham, North Carolina, but remained financially responsible for the existing lease and recorded the remaining lease payments as a restructuring charge. Larscom entered into a sublease agreement for the entire 27,000 square foot facility with Silicon Wireless Corporation (a start-up company) that had a commencement date of February 15, 2002. Due to the uncertainty of the receipt of income under the sublease, restructuring expenses are reduced as the sublease income is received. As of July 28, 2004, the balance in the restructuring accrual totaled $1,299,000. The Company made monthly payments during the first quarter of fiscal 2005 totaling $55,000 which reduced the accrual. Sublease payments received during the first quarter of fiscal 2005 totaling $43,000 were recorded as a reduction in restructuring charges recorded on the condensed consolidated statement of operations. The Company expects the remaining lease obligation will be paid out by January 2007. No additional restructuring costs are expected to be incurred related to this lease.

     During 2003, Larscom abandoned its former headquarters in Milpitas, California. As of July 28, 2004, the balance in the accrual related to this abandonment totaled $42,000, which relates to final payment of costs for the lease that expired in August 2004. The Company expects that the remaining balance will be paid out by December 2004.

     In connection with the Larscom acquisition, the Company announced its plan to eliminate redundant positions and to consolidate certain manufacturing and administrative positions in Newark, California with its operations in Madison, Alabama. The Company assumed a liability totaling $1,470,000 for employment termination costs as of the acquisition date recorded in accordance with EITF 95-3. The Company expects to record restructuring charges in the first and second quarters of fiscal 2005 totaling approximately $475,000 related to additional employment termination costs, of which $200,000 was recorded as a restructuring charge in the first quarter of fiscal 2005.

     The following table provides details of the activity and remaining balances for restructuring charges as of October 1, 2004 (in thousands):

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