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 December 31, 2004

Commission file number: 000-28562

VERILINK CORPORATION

11551 E. Arapahoe Rd., Suite 150
Centennial, CO 80112-3833
(Address of principal executive offices, including zip code)

303.968.3000
(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 þ 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 þ

     The number of shares outstanding of the issuer’s common stock as of January 28, 2005 was 22,875,027.

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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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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 1 – Basis of Presentation

     The accompanying unaudited interim condensed consolidated financial statements of Verilink Corporation 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 our Annual Report on Form 10-K for the fiscal year ended July 2, 2004 as filed with the Securities and Exchange Commission. We have 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. We have 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 we were not to continue as a going concern. The auditor’s report on our 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 our ability to continue as a going concern. Sales of legacy products to our 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 two quarters of fiscal 2005.

     We have prepared for reduced legacy sales through our recent acquisitions, by investment in next generation broadband access products, and the alignment of our 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.

     Our line of credit with RBC Centura Bank (“RBC”) terminates and all borrowings thereunder are due April 7, 2005, unless accelerated or extended by RBC. (See Note 10) We 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. We have been in discussions with potential alternative sources of financing to repay and replace the RBC line of credit. We are currently in negotiations and expect to obtain alternative financing in the coming weeks. Since we do not yet have binding commitments, we cannot assure you that we will obtain alternative financing on terms favorable to us or at all. If additional credit or other financing is not available on terms acceptable to us, we may seek to renegotiate certain of our contractual obligations.

Note 2 – Comprehensive Income (Loss)

     We record gains or losses on our 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 December 31, 2004 totaled $2,159,000 and comprehensive income for the three months ended January 2, 2004 totaled $264,000. Comprehensive income (loss) for the three months ended December 31, 2004 and January 2, 2004 consists of net income (loss) for the comparable periods. Comprehensive loss for the six months ended December 31, 2004 totaled $26,635,000 and comprehensive income for the six months ended January 2, 2004 totaled $1,898,000. Comprehensive loss for the six months ended December 31, 2004 consists of $26,630,000 of net loss and $5,000 of foreign currency translation adjustments. Comprehensive income for the six months ended January 2, 2004 of $1,898,000 consists of $1,900,000 of net income and $2,000 of foreign currency translation adjustments. As of December 31, 2004 and July 2, 2004, total accumulated other comprehensive loss was $44,000 and $39,000, respectively.

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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 price of our 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 and six months ended December 31, 2004 and January 2, 2004 (in thousands, except per share amounts):

     Outstanding restricted common stock held by employees as of December 31, 2004 totaling 56,394 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 December 31, 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, we completed our acquisition of Larscom Incorporated (“Larscom”) and issued approximately 5,948,652 shares of our Common Stock for all the outstanding stock of Larscom. We 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 our strategy to pursue revenue

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growth, and brings a complementary customer base and product synergies. The results for the six months ended December 31, 2004 include the results of Larscom since July 29, 2004, the first date after the closing of the acquisition.

     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 our review of goodwill for impairment. The total purchase price of $27,852,000 consisted of (a) approximately 5,948,652 shares of Verilink common stock issued upon consummation and valued at approximately $26,043,000, using a fair value per share of $4.378, (b) approximately $516,000 of consideration for options 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 our results 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).

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Note 6 – Impairment of Goodwill

     During the first quarter of fiscal 2005, we completed an interim test for impairment of goodwill due to triggering events that occurred during the quarter that we believe would more likely than not, reduce the fair value of goodwill below our 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 independent registered public accounting firm’s report on our fiscal 2004 consolidated financial statements which were filed in our Form 10-K on October 1, 2004, and (c) the low market price of our common stock following the end of the first quarter. Based on the initial impairment assessment, we determined that the fair value of our reporting unit was less than our carrying value after considering a combination of quoted market prices and discounted cash flows. In order to determine the amount of the goodwill impairment, we prepared a purchase price allocation using a discounted cash flow model utilizing the assistance of a third party valuation specialist. The projected discounted cash flow model was prepared using a discount rate commensurate with the risk inherent in our current business model. As a result, we recorded an impairment charge related to goodwill of $19,984,000.

     Prior to the first quarter of fiscal 2005, our annual impairment assessment considered the carrying value of our equity to our market capitalization calculated by multiplying our outstanding shares by our current share price, disregarding anomalies in share price that we 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 our share price from the end of our 2004 fiscal year through the filing of our Quarterly Report on Form 10-Q for the first quarter of fiscal 2005, and our low level of liquidity, we 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 our fair value, 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):