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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
For the Fiscal Year Ended March 30, 2001
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
For the transition period from ______________ to ______________
Commission File Number 0-15323
NETWORK EQUIPMENT TECHNOLOGIES, INC.
(Exact name of registrant as specified in its charter)
Delaware 94-2904044
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
6530 Paseo Padre Parkway
Fremont, California 94555
(510) 713-7300
(Address of principal executive offices, including zip code,
area code, and telephone number)
Securities registered pursuant to Section 12(b) of the Act:
Common Stock, $0.01 Par Value New York Stock Exchange
----------------------------- -----------------------
(Title of each class) (Name of each exchange on which registered)
Securities registered pursuant to Section 12(g) of the Act:
7 1/4% Convertible Subordinated Debentures
(Title of Class)
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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.|_|
The aggregate market value of the voting stock held by non-affiliates of the
registrant on June 15, 2001, based on the closing price of such stock on that
date was $64,654,829, calculated by excluding holders of 10% and more, directors
and current executive officers.
The number of shares outstanding of the Common Stock, $0.01 par value, on June
15, 2001 was 21,972,002.
DOCUMENTS INCORPORATED BY REFERENCE:
The registrant's definitive Proxy Statement for the Annual Meeting of
Stockholders to be held on August 14, 2001 is incorporated by reference in Part
III of this Form 10-K to the extent stated herein.
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PART I
FORWARD-LOOKING STATEMENTS
Statements contained in this Form 10-K, which are not historical facts, are
forward-looking statements within the meaning of Section 21E of the Securities
Exchange Act of 1934, as amended. A forward-looking statement may contain words
such as "plans," "hopes," "believes," "estimates," "will continue to be," "will
be," "continue to," "expect to," "anticipate that," "to be," or "can impact."
Forward-looking statements are based upon management expectations and involve
risks and uncertainties that may cause actual results to differ materially from
those anticipated in the forward-looking statements. Many factors may cause
actual results to vary including, but not limited to, the factors discussed in
this Form 10-K. net.com expressly disclaims any obligation or undertaking to
revise or publicly release any updates or revisions to any forward-looking
statement contained in this Form 10-K. Investors should carefully review the
risk factors described in this document along with other documents net.com files
from time to time with the Securities and Exchange Commission.
Item 1. Business
OVERVIEW
Network Equipment Technologies, Inc., doing business as net.com ("net.com"), is
a leading innovator of service creation, providing broadband technology
platforms that enable carriers and service providers to rapidly create and
deliver revenue-generating applications, content and network services to
business and residential customers while maximizing existing infrastructure
investment. Service creation is the ability for end users and service providers
to dynamically define, deliver, manage and profit from network services.
net.com's service creation products reside at the intersection of networks or at
the economic edge where carriers and content providers converge to offer a new
range of communications experiences to end users.
Over the past several years we have seen our revenue decline as traditional
narrowband wide area networks ("WANs"), for which our historical products have
been designed, have been replaced by next generation packetized networks.
Narrowband WANs rely on circuit-switched technology to provide infrastructure
and capability to link local area networks ("LANs"), campus networks, voice
traffic, video and other applications to each other via service provider
transmission facilities or services. Next generation networks in contrast make
use of the Internet Protocol ("IP") to enable convergence or the bundling of
voice, data, and video over a single public carrier infrastructure. By breaking
information into smaller pieces, packet switching enables information to be
moved more swiftly through the network and enables more traffic to be sent in a
shorter time. Convergence of disparate applications onto a single packet
infrastructure has proven to be a more cost-effective solution and ultimately
enables new value added services. The decline in the market for circuit switched
technology, which includes our historical product lines, prompted us to invest
in new technology and to target a new market opportunity over this past year.
With the introduction of our first service creation platform, the SCREAM200(TM),
in June 2000, we announced our strategy to redirect our development and
marketing efforts towards serving the needs of service providers who can no
longer derive a sustainable source of revenue and profitability from basic
access services. In April 2001 we announced two new service creation platforms,
the SCREAM50(TM) and SCREAM100(TM), that are optimized specifically for the
carrier market. Our service creation products sit at the edge or intersection of
networks, allowing telecommunications service providers to manage and create
services across their networks and, ultimately, allow users to determine the
services they require. Traditional providers of transmission facilities such as
carriers, cable operators, wireless service providers and network service
providers recognize today the need to offer broadband access and to
differentiate their services in order to remain competitive and profitable. We
believe that our SCREAM(TM) product line offers service providers the capability
to drive revenue, lower provisioning costs, increase customer retention and
build competitive differentiation.
Our legacy narrowband equipment is used in mission critical multi-service wide
area networks that allow customers to integrate voice, data, image and video
traffic for Asynchronous Transfer Mode ("ATM"), frame relay, IP and ISDN
services across a single network infrastructure. In addition, the new
SHOUTIP(TM) product line offers an effective way to transmit circuit voice over
an IP packet network and to rapidly create and deliver telephony services over a
packet infrastructure. net.com's WAN products are used by enterprise, service
provider and government customers worldwide.
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Consistent with our strategy of redirecting our development and marketing
efforts, during the third quarter of fiscal 2001, we sold our Federal
Professional Services Business ("FSB") to CACI International Inc("CACI").
Network Equipment Technologies, Inc., doing business as net.com, was
incorporated in California in 1983 and was reincorporated in Delaware in 1986.
Our principal offices are located at 6530 Paseo Padre Parkway, Fremont,
California 94555, U.S.A. and our telephone number at that location is (510)
713-7300. Our home page on the Internet is at www.net.com. We have approximately
542 employees worldwide. Our Common Stock is publicly traded on the New York
Stock Exchange under the symbol NWK.
NETWORKING INDUSTRY BACKGROUND
The networking industry has enjoyed an extended period of seemingly unlimited
access to capital and related investment and growth. This growth is the result
of broad-based adoption of the Internet and increases in demand for data, voice
and video communications services by businesses, governments and consumers. This
demand has fueled the development and deployment of large-scale network
infrastructure and massive increases in available bandwidth or information
carrying capacity. In the last decade, long-distance markets have become
extremely competitive, with AT&T, WorldCom, Sprint and hundreds of resellers
competing for consumer telecom spending. Long-distance service has essentially
evolved into a commodity, where competitive price is a minimum requirement and
competitors endeavor to differentiate based on perceptions, hourly pricing
plans, convenience and promotions. As long-distance evolves into a pure
commodity, the ability to bundle services or differentiate will become even more
important.
With the rapid growth of the Internet and the development of advanced
communications applications such as digital, video and audio programs, wireless
access, and video conferencing from personal computers, video e-mail, video on
demand, distance learning, telemedicine and high speed imaging, consumers and
business are demanding faster, better communications services. Consumers
increasingly find dial-up modem speeds unacceptable. Communications networks
increasingly are required to transmit more rapidly large volumes of Internet,
data and video traffic to meet customers' demands with respect to sharing
information, conducting business and delivering entertainment. In response to
this increase in demand, alternative broadband access technologies have been
developed and commercialized, including Digital Subscriber Line ("DSL"), cable,
fiber to the curb and wireless (fixed and mobile).
As consumers and business have demanded more broadband applications from
providers of Internet, data, video and voice communications services, new
service providers have entered the market. The entry of these new competitive
providers and the proliferation of alternative access technologies into
previously regulated markets are rapidly changing the market for broadband
services. Carriers and service providers rapidly built out their infrastructure
to accommodate surges in IP traffic, yet increased competition has further
commoditized bandwidth resulting in incoming revenue streams rising only
modestly. Deregulation in the telecommunications industry together with
homogeneity and commoditization of transport services has created a
hyper-competitive environment that has prevented some service providers from
earning an adequate return on their investment even as we see a significant
shift in traffic from traditional voice to new data-oriented services. This
situation has recently forced many network operations to temporarily scale back
capital spending budgets and it has forced others, such as Northpoint
Communications, to file for bankruptcy.
As the Broadband subscriber base grows, service providers face customers who
increasingly regard high speed Internet access as a commodity. To compete
successfully, broadband service providers must differentiate themselves by
offering a range of value-added services, including multiline, toll-quality,
voice service, virtual private networks ("VPNs"), frame relay, video streaming
and emerging productivity and entertainment applications such as multiplayer
online gaming and streaming music. As the deployment of broadband access
steadily increases, competition between service providers will continue to
intensify as they face the challenge of how to profit from the thousands of
directly connected high-speed users. Intelligent service creation solutions are
required to allow the service provider to offer a new layer of network
intelligence that supports the widespread deployment of comprehensive and
affordable integrated service packages that can be dynamically selected and self
provisioned. A new broadband access network is emerging to satisfy subscribers'
desires for high-speed telecommunications services.
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BUSINESS STRATEGY
Net.com's mission statement is:
"Enabling competitive differentiation through the rapid creation and delivery of
services"
Our objective is to become an industry leader in the telecommunications
equipment industry by providing service creation solutions that enable
competitive differentiation through the rapid creation and delivery of services.
Service creation is the ability for end users and service providers to
dynamically define, deliver, manage and profit from network services.
Service creation also defines a new business model--for service providers and
end users. For service providers the ability to deliver differentiated IP based
broadband services allows them to manage and bill for content or applications
based on their relative value on as needed and or as used rather than simply at
a flat rate. We anticipate this model will enable service providers to generate
incremental revenue and to develop potentially more profitable premium services.
For service providers, the new model encompasses lower provisioning costs,
streamlined service configuration and fast provisioning of services. For end
users, the next business model encompasses one overriding advantage--service
selection. Five key components comprise this new model:
o Open, non-proprietary interfaces for the development of applications
o Distributed architecture for easy programmability and deployment
o The ability to rate, allocate and measure service selection
o A marketing front-end moving service to and drawing service selection from
the customer
o Automated service provisioning and billing
To achieve this objective, our business strategy includes the following key
elements:
o Design and develop industry leading broadband hardware and software
service creation solutions. We consider our technological and
product leadership to be critical to our future success. We employed
next generation network processor and custom ASIC technology in
order to achieve the deterministic performance. In addition, we
designed the SCREAM100 platform with a, SplitPlane(TM) architecture
that provides a logical and physical separation of the control plane
(intelligence) and data plane (packet processing). This distributed
architecture enables services to be programmed or initiated directly
onto the network in real time. Finally, we developed an Open
Programming Interface ("OPI"(TM)) to provide bi-directional
interface capability that enables third party solutions to be
implemented quickly on the SCREAM platform using industry standards
such as CORBA, JAVA and XML.
o Leverage market position and revenue contribution of our narrowband
technology. net.com pioneered the concept of multi-service
networking and has been delivering these mission critical
capabilities for over seventeen years. With more than 25,000
multi-service systems sold around the globe, net.com serves
approximately 1,750 customers in more than 75 countries. Following
this year's market correction, access to capital has become more
difficult for emerging start-ups. The financial strength of our
balance sheet and proven reputation of net.com provides us with a
strategic advantage that we expect to continue to leverage as we
target new service provider customers.
In specific markets where the rate of broadband deployment is
slower, we will continue to provide support for our legacy
multi-service platforms and customers. The installed base and
revenue contribution from our legacy Promina product line continues
to be significant and generates significant cash flow for the
Company. In particular the United States Federal Government
("Federal Government") has been slow to
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adopt new broadband technology and the use of public infrastructure
due to concerns over quality of service and security. As new
standards evolve for quality of service and security for the
Internet, we expect the Federal Government to adopt newer technology
and to become a customer of our new service creation and voice over
IP platforms. We anticipate that our expertise in government
contracting together with the relationships that we have built up
over an extended period of time will provide us with leverage should
the Federal Government eventually make this transition. In addition,
in some parts of the developing world where deregulation has lagged,
or where circuit switched technology continues to be the technology
of choice, our multi-service platforms continue to be a very
appropriate solution.
o Leverage relationships with Key Partners. We are continually seeking
to establish relationships with third-party application software
vendors and product OEM's or resellers, and our customers. SCREAM
offers open programmability at the element, service, management and
control layers through the OPI and allows a service provider or
third-party developer to quickly develop new applications sought by
end-users. The importance of software application partners is that
they provide critical functions such as billing, mediation,
provisioning and configuration that are needed to create a total
service creation solution for our customers. Product OEM or resale
partners are needed to supplement and enhance our existing direct
sales force both in the United States and overseas as they may have
pre-existing relationships with our target customers and be able to
accelerate our time to volume. We also work closely with our
customers from initial product design through to manufacturing and
delivery. By engaging with our customers at every level, we seek to
partner with them at the early stages of system development so that
we may provide them with all of their requirements. Maintaining
strong customer relationships is critical to our company's growth
and every effort is made to ensure that our customers' needs are
met.
o Provide Value-added Service and System Integration Capabilities.
Since its inception, net.com has viewed customer service and support
as a key element of its overall strategy and a critical component of
its long-term relationship with customers. Customers around the
world turn to net.com not only for the reliability and performance
of our products but also for our comprehensive support services that
optimizes the value of those products. As we work more closely with
prospective service provider customers and third party application
software vendors, we will continue to provide various consulting
services that allow those customers and vendors to integrate new
functions onto existing operational support systems ("OSS") and our
SCREAM platform's open programming interface to create new
value-added network services.
o Improve Business Operations and Return to Profitability. We are in
the process of upgrading and consolidating our core business process
systems onto a new Oracle ERP platform that is scheduled to go live
in the July to August 2001 time frame. The scope of this project
includes our order management, financial, human resources, quality
and manufacturing systems, and encompasses our global operations.
The purpose of the project is to allow us to support our customers
better and to help enable us to return to profitability sooner. When
complete, it will consolidate several legacy systems into one,
enable more effective decision support capabilities and allow us to
scale our business more cost effectively. In addition to higher
efficiencies and related operating expense improvements contemplated
from this project, our ability to achieve profitability on a
continuing basis will depend on the successful design, development,
testing, introduction, marketing and broad commercial distribution
of our new broadband equipment products, specifically our SCREAM
product line and to a lesser extent our SHOUTIP product line.
PRODUCTS
BROADBAND
net.com's new Service Creation Manager(TM) platform, known as SCREAM(TM), is a
universal broadband services switch, offering integrated broadband aggregation,
subscriber management, powerful packet and cell processing, high-touch IP, and
broadband service creation. Aggregation involves taking in large numbers of
tributary lines, such as T1s and forwarding on the data to large routers in the
core of the network. Our SCREAM platform takes in thousands of connections from
access equipment such as DSL access multiplexers ("DSLAMs"), cable modem
aggregation equipment and wireless backhaul equipment. Our platform offers
existing carriers the ability to migrate
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legacy services to an IP infrastructure, thus preserving the carrier's existing
investments. Finally, our service creation platform is loaded with processing
power to apply special handling instructions to subscriber traffic so that our
platform can look closely at packet information to detect specific attributes.
At wire speed our platform can apply class of service differentiation by
examining the label or header information attached to an IP packet. This enables
service providers to differentiate broadband subscribers based on the
applications they use, as well as to detect and report billable events in
real-time. With this capability service providers can tailor premium packages
for individuals or groups which we believe may generate additional sources of
revenue for those providers.
The newest additions to the SCREAM product family, announced on April 25, 2001,
are the SCREAM100 and SCREAM50 systems. They feature an advanced packet engine
in a central office-ready form factor, on an open, non-proprietary platform.
Optimized for the carrier environment, the new SCREAM systems offer high
switching capacity and port density in a small footprint, as well as front
access and low power consumption. To meet the rigorous demands of service
providers, the new systems deliver packet processing at OC-48 line rate.
Despite a small footprint, SCREAM100 delivers 40 Gbps of IP throughput, scalable
to 80 Gbps. It supports up to 256,000 broadband subscribers (or 512,000 in
extended-shelf configuration). Six SCREAM100 systems can be configured
back-to-back in a standard telco rack to manage more than one and a half million
subscribers.
SCREAM's SplitPlane architecture provides a logical and physical separation of
the network control plane (intelligence) and the network data plane (packet
processing) that facilitates service creation. SCREAM's separate control plane
and OPI offer easy integration with existing operational support systems. The
separate data plane delivers processing efficiency and support for multiple
transport technologies.
Unlike other platforms, SCREAM offers open programmability at the service,
management, and control layers. The OPI allows a service provider or third-party
developer to quickly develop new applications sought by end-users.
The SCREAM platform is capable of ensuring bandwidth delivery by using network
processor technology and a set of custom ASICs to provide deterministic
performance. It can shape and/or ensure bandwidth at a subscriber level and at
an individual flow level, such as streaming video or interactive gaming flows.
SCREAM can shape or guarantee flows individually at the same customer
premises--such as a VPN connection in the corporate network and regular Internet
traffic.
NARROWBAND
net.com designs, develops and supplies multi-service WANs that integrate voice,
data, image and video traffic across a single network infrastructure. net.com
multi-service WAN networks offer ATM, frame relay, IP, ISDN switching, advanced
voice compression and extensive network management capabilities. Traditional
narrowband WANs rely on circuit switched technology to provide the
infrastructure and capability to link LANs, campus networks, voice traffic,
video and other applications to each other via service provider transmission
facilities or services. WAN products may be located at both the service provider
and the enterprise premises.
Historically, the majority of net.com's product revenue has been generated by
net.com's IDNX(R) and its replacement, Promina(R) Multi-service Bandwidth
Managers. In fiscal years 2001, 2000, and 1999, net.com's IDNX and Promina
accounted for 81.9%, 95.4%, and 93.9% of product revenue respectively. As of
April 30, 1999 IDNX products were replaced by our Promina products and net.com's
Panavue(TM) network management systems.
PROMINA 800
net.com's Promina 800 Series family of multi-service access platforms adapt and
aggregate voice, data, video and fax traffic for access to ATM and other WAN
services. The Promina 800 Series enables standards-based connection of
carrier-located equipment or customer-premise equipment through one of the
industry's broadest range of user-side interfaces. From a trunk-side
perspective, the multi-service systems offer single-platform delivery of
feature-rich services such as virtual private networks that could be based on
ATM networking, frame relay or Internet Protocol (IP).
The Promina 800 network incorporates intelligence both at its core and in
signaling to attached devices. This feature allows the network to quickly
reroute traffic automatically in the event of a failure. ATM adaptation of
various types of traffic is accomplished via net.com's CellXpress(TM), an
internal ATM module option. The CellXpress module provides Class of Service
support for constant bit rate and variable bit rate ("CBR/VBR") traffic in
addition to inverse multiplexing over ATM ("IMA").
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net.com has an industry-leading set of voice compression products marketed under
its PrimeVoice(TM) name. Toll-quality voice compression improves cost
efficiencies for emerging international voice resellers and enterprises alike.
Combined with the CellXpress ATM access capability, the voice compression
capabilities found in the Promina 800 family creates a differentiator allowing
enterprises and carriers to take advantage of ATM service offerings.
IP traffic is carried over the multi-service network via an internal
multi-protocol router based on Cisco IOS(R) source code. This means that the IP
capabilities are well matched to some 70 percent of the routers deployed
throughout the world. Frame relay traffic is also supported via an internal
frame relay switching module. This combination of voice, data and video
capabilities means that customers are not locked to a particular technology, a
somewhat unique form of investment protection.
SHOUTIP INTRANET TELEPHONY PLATFORM
During the first quarter of fiscal 2001, net.com acquired the assets of
Convergence Equipment Company. Those assets included a small voice-over-IP
platform and related software. SHOUTIP is a voice-over-IP product that provides
an effective means of transmitting circuit voice over an IP packet network.
The SHOUTIP platform integrates trunking, signaling, gatekeeper/call agent
functions, packet aggregation, network management, and configuration tasks in a
single distributed system. Application modules offer additional capabilities
such as real-time, web-accessible billing; integrated voice response ("IVR") and
administration; and authentication and authorization. Switching technologies
include IP, TDM, and ATM. Special networking features include "look-ahead"
signaling and dynamic "hairpinning" to minimize dropped cells.
Designed for next-generation service providers, the SHOUTIP platform enables the
rapid creation and delivery of telephony services over a packet infrastructure.
The SHOUTIP platform is a response to shifting business models in which service
providers are experiencing diminishing margins for access-based services and
decreasing customer loyalty. To create new revenue streams and maintain market
share, service providers need to deliver new, differentiated services -- above
and beyond flat-rate monthly offerings.
The SHOUTIP platform has next-generation architecture with distributed
processing and open programmability. SHOUTIP distributed nodes perform network
functions and call processing within a single node. Routing intelligence is
distributed across the network, rather than combined into an expensive, complex,
centralized network. In addition to simplifying operations, the distributed
architecture achieves greater network resilience by eliminating a single point
of failure that could render all or a significant portion of a service
provider's network inoperative. Also, because the network's intelligence is
carried in each node, performance remains consistent regardless of network size.
The SHOUTIP platform's open applications programming interfaces are designed for
easy third-party development. The platform's open programmability supports the
rapid rollout of new revenue-generating services such as voice-mail, fax mail,
and call-center services.
NETWORK MANAGEMENT
The net.com Panavue and Screamvue Network Management System provides Simple
Network Management Protocol ("SNMP"), based management capabilities featuring
web-based user interfaces. Its open design based on industry standards provides
scalability. The platform's user interface lowers the cost of network ownership
by reducing training time, improving access and streamlining operations
throughout the network. The platform supports the main family of net.com
products. Additionally, the platform's Advanced Fault Management System ("AFMS")
provides unified fault management plus integrated service and network management
for devices in the network including those from other vendors.
CUSTOMERS AND MARKETS
net.com pioneered the concept of multi-service networking and has been
delivering these capabilities for seventeen years. With more than 25,000
multi-service systems sold around the globe, net.com serves approximately 1,750
customers in more than 75 countries. The focus of our narrowband product-line
has been on large enterprises and carriers for their enterprise business. The
initial focus of our new SCREAM broadband product family is on service providers
while ultimately the service creation features may also be attractive to
enterprise customers. For both
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net.com's broadband and narrowband products, we focus primarily on information
and communication intensive organizations. These customers may be local,
national, multinational or global in their operations.
Within the service provider market, we have targeted the following vertical
markets for our SCREAM service creation platforms:
1) Traditional incumbent service providers and interexchange carriers ("RBOC",
"ILEC", "ITCO" and "IXC"). These are the companies providing local and long
distance communications services of various kinds to both consumers and
business;
2) Competitive local exchange carriers ("CLEC"). A subset of the service
provider market, these are telecommunications companies providing services to
local consumers and business in competition with the traditional incumbent
service providers;
3) Application service providers ("ASP" and "ISP") and data centers. These
companies provide host application services over the network;
4) Integration Communication Providers ("ICP"). One of the new categories of
service providers who are building next generation networks both domestically
and globally.
We have targeted our Promina product line at service providers and at enterprise
and government customers. In the service provider marketplace, global carriers
use net.com networks for subscriber services as do a variety of emerging
carriers, cellular providers and international voice resellers and PTTS (Post
Telephone and Telegraph). net.com's strategy for enterprise customers is to
provide an integrated range of solutions and alternatives with which to address
the complexity required to successfully grow a network by maximizing bandwidth
use. We address the needs of government customers for reliable, mission critical
communications solutions. Current enterprise customers include corporations
representing the financial, banking, insurance, energy, transportation,
manufacturing and retail sectors. Government customers represent a variety of
federal and international agencies and organizations including the United States
Department of Defense ("DOD"), NATO, and ministries throughout the world,
including Austria, China and Thailand.
Sales to the Federal Government represented 53.5%, 50.4%, and 37.6% of net.com's
revenue in fiscal 2001, 2000, and 1999, respectively. We sell to the Federal
Government through net.com's wholly owned subsidiary, N.E.T. Federal, Inc.
("Federal"), which sells products both directly and through collaborative
government contracting and subcontracting arrangements. Government contracts
with Federal are for various terms, but most may be terminated by the
contracting government agency at their convenience or at annual intervals. Sales
to the Federal Government include sales under contracts with certain agencies
within the DOD. These DOD contracts may be used by other government agencies to
purchase net.com products and services. See discussion in Business Risk Factors
in this Form 10-K.
In addition to government customers, the Promina product line currently sees
more demand outside the United States especially in emerging markets such as
China and Eastern Europe where the telecommunications infrastructure is still
being developed. Applications that can be enabled by Promina based solutions
include Digital Data Networks ("DDN") that provide basic data services in these
emerging markets. International sales represented 28.5%, 28.1%, and 32.2%, of
net.com's revenue in fiscal 2001, 2000, 1999, respectively.
Other than orders from the Federal Government, no other single customer
accounted for more than ten percent of net.com revenue in fiscal 2001, 2000, or
1999.
COMPETITION
The market for telecommunications equipment is highly competitive and dynamic,
it is characterized by the easy entrance of new start-up companies, rapid
changes to and the convergence of technologies and a worldwide migration from
existing circuit technology to the new packet based technologies. We compete
directly both internationally and domestically with many different companies,
some of which are large, established suppliers of end-to-end solutions such as
Cisco, Lucent, Alcatel, and Nortel. Many of the large suppliers have greater
financial, marketing and technical resources and offer a wider range of
networking products than we have. These suppliers can often provide a complete
network solution rather than a partial solution that may make their products
more attractive to potential net.com customers. In addition, there are a number
of new start-ups that are targeting the aggregation, IP service, service
creation and the Voice over IP market, including Cosine, Ellacoya, Quarry,
Gotham, Celox, and Clarent.
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SALES
We sell our products and services through both direct and indirect sales
channels into more than 75 countries. We believe that to effectively market and
sell our products a local direct sales organization is beneficial to understand
the business and network environment of local countries. We also believe that a
direct sales force effort, supported by sales engineers who provide customers
with pre-sale and post-sale technical assistance, allows net.com to gain more
in-depth knowledge of customers' network requirements. We have more than 111
direct sales personnel located in 11 countries. This sales effort is supported
through more than 50 channel partners.
We sell products and services in North America primarily through direct channels
although we make use of a small number of distributors in some markets. Our
International sales are made almost entirely through indirect channels that are
augmented by the efforts of a local direct sales force. In addition to the
marketing and sale of products, international resellers provide system
installation and technical support. In most cases, international resellers have
non-exclusive agreements to resell net.com products within particular geographic
areas. Resale agreements do not contain a sales commitment or required sales
quota.
net.com has two strategic reseller partnerships, Ericsson Business Networks AB
of Sweden ("Ericsson") and Datacraft Asia Ltd. ("Datacraft"). Ericsson is a
worldwide partner reselling net.com's narrowband products in Europe, Asia and
Latin America. Datacraft resells net.com's narrowband products throughout Asia
and is responsible for a significant portion of net.com sales in China. Both
Ericsson and Datacraft provide service support for the products they sell. None
of these agreements has a required sales commitment and all come up for renewal
on a periodic basis. While a failure to renew any one of our international
reseller agreements would not have a significant impact on net.com's financial
results, failure to renew a significant number of these agreements on favorable
terms and conditions could have a material impact on our financial results.
N.E.T. Federal supports sales to the United States government's defense and
civilian sectors and to government agencies worldwide. Sales to Federal
customers are almost entirely direct. We are, however, a subcontractor on a
number of government contracts and resell third party products to the Federal
Government, as required.
Our direct selling model makes use of our field sales, engineering, and
executive personnel to establish and maintain customer contacts at multiple
levels within a customer organization. We believe the successful execution of
this multi-tiered selling model is important to our success.
net.com's business is not seasonal in nature and sales are generated throughout
the year.
BACKLOG
net.com manufactures its products based upon its forecast of customer demand and
typically builds finished products in advance of receiving firm orders from its
customers. Orders for net.com's products are generally placed by customers on an
as-needed basis and we have typically been able to ship these products within
30-90 days after the customer submits a firm purchase order. Because of the
possibility of customer changes in delivery schedules or cancellation of orders,
net.com's backlog as of any particular date may not be indicative of sales in
any future period. See discussion in Business Risk Factors in this Form 10-K.
CUSTOMER SERVICE
The markets, customers and complex challenges of the networking industry
described above require not only hardware and software based solutions, but also
significant support, service and other assistance in the development, operation
and expansion of a customer network. Since its inception, net.com has viewed
customer service and support as a key element of its overall strategy and a
critical component of its long-term relationship with customers. Customers
around the world turn to net.com not only for the reliability and performance of
our products, but also for our comprehensive support services that optimizes the
value of those products. Customers rely on net.com to help maintain the highest
possible availability for their mission-critical networks.
net.com's SCREAM Care service offerings provide a wide range of service and
support options to customers and resellers of net.com products. Service
offerings include product installation, a choice of different hardware and
software maintenance programs to meet the varying needs of our customers, parts
repair, remote and on-site technical assistance and customer training. In
addition, net.com provides web-based customer support services through our
Electronic Support Center. Services available over the web include first-line
troubleshooting information for net.com products, technical information, such as
trouble shooting guides and frequently asked
Page 9
questions, and a web-based interface to net.com's Technical Assistance Center
("TAC") through an online case management system.
TAC is staffed 24 hours a day seven days a week by engineers trained in
networking products. TAC assists customers remotely over the telephone and has
language facility in many languages including Spanish, Chinese, French and
German. TAC engineers have the ability to replicate customer problems and test
proposed solutions prior to implementation. As part of net.com's January 2000
restructuring, net.com consolidated its TAC services worldwide into its Ashburn,
Virginia, U.S.A. facility. net.com continues to invest in its TAC operations,
adding tools, equipment and capabilities to enhance its support services.
Maintenance support from net.com's TAC, whether provided over the web or over
the telephone, is fee based under either an annual fee contract or on a time and
materials basis.
Customer training on net.com products is provided to both end-users and
resellers worldwide. net.com has training facilities at its Fremont, California,
U.S.A. headquarters and in its facilities in: Ashburn, Virginia, U.S.A.;
Crawley, United Kingdom; and Singapore. In addition, net.com trainers travel to
customer and reseller facilities to provide training. net.com training services
can be customized to meet the special requirements of its customers. Customers
are charged per person per class for net.com training. In addition, certain
net.com resellers provide training to net.com end-users on behalf of net.com.
Over the years, net.com has developed expertise in certain professional services
such as staging, system integration and managed network services. These services
assist customers in optimizing their network investments, allowing them to
outsource selected network operations to net.com and provide additional
expertise on a project basis. Professional services from net.com are utilized
throughout the network life cycle from planning and design to implementation.
They are generally charged on a per project basis.
A significant amount of net.com's revenue and profits are generated by its
service and support offerings. In fiscal years 2001, 2000, and 1999 service and
support offerings accounted for 28.8%, 48.5% and 40.4%, respectively, of net.com
revenue. In the third quarter of fiscal 2001, net.com completed the divestiture
of its Federal Professional Services business, which accounted for revenue of
$34.3 million, $49.7 million and $43.2 million in fiscal 2001 fiscal 2000 and
fiscal 1999, respectively. net.com cannot guarantee that customers will continue
in the future to require service support on net.com network to the extent that
they have in the past. In particular, maintenance contracts for older IDNX
networks may not be renewed to the extent customers replace those networks with
networking products from other vendors, or deploy packet based technology.
Consistent with our business strategy as discussed above, during the third
quarter of fiscal 2001, we completed the divestiture of our FSB and sold its
assets to CACI for cash consideration of up to $40.0 million. The assets sold
are comprised mainly of service contracts with the Federal Government, accounts
receivable, spares inventory and fixed assets. The strength of net.com has
historically been to provide enterprise-focused wide area networking (WAN)
solutions. The new direction for net.com is targeted towards service providers
and in January 2001, we launched our service creation message with the
introduction of the SCREAM platform for broadband networking, and followed with
the introduction of the SHOUTIP platform for packet telephony. The divestiture
of the well-regarded government services business to CACI allows net.com to
concentrate on the execution of these product strategies. Net.com will continue
to sell products directly to the Federal Government while CACI will now provide
maintenance and other services to our Federal customers. In addition we have a
strategic alliance with CACI to jointly market each other's products and
services.
MANUFACTURING
net.com has one manufacturing facility located at its Fremont, California
facility. Assembly of printed circuit boards and circuit testing of net.com
designed products are outsourced to a single subcontractor, Solectron. For our
legacy products, final assembly, quality control and final testing are performed
in the Fremont manufacturing facility. We anticipate that as the demand for our
new SCREAM product increases, we will outsource many of these
final-manufacturing steps to Solectron and drop ship equipment directly to
customers. net.com maintains control over parts procurement, design,
documentation and selection of approved suppliers. We have a multi-year contract
with Solectron that requires it to meet defined performance specifications.
Because Solectron is a sole source vendor, any interruption in Solectron's
manufacturing processes or a failure to renew our contract could have a material
adverse effect on our financial results and operations.
Currently, several key components of our Promina and SCREAM products are
available only from a single source, including certain ASICs and power supplies.
In addition, some components are in short supply generally throughout the
industry. Depending upon the component, there may or may not be alternative
sources or substitutes. Some of
Page 10
these components are purchased through purchase orders without an underlying
long-term supply contract. Any delay or difficulty in obtaining needed
components could seriously impact our ability to ship products.
We maintain sufficient inventory to ship products quickly, normally within 30 to
90 days after receipt of an order. Scheduling of production and inventory supply
is based on internal sales forecasts. Generally, our customer contracts allow
the customers to reschedule delivery dates or cancel orders within certain time
frames before shipment without penalty and outside those time frames with a
penalty. Because of these and other factors, there are risks of excess or
inadequate inventory that could materially impact expenses, revenue and
earnings.
net.com is focused on continually enhancing the quality of products and services
delivered to customers worldwide. This includes improving the quality of
supplied components, subassemblies and internal processes. As part of this
continuing process, net.com is ISO 9002 certified.
RESEARCH AND DEVELOPMENT
We believe that our long-term success depends on our ability to maintain product
and technology leadership. The networking equipment industry is characterized by
rapid technological change, evolving industry standards, frequent new product
introductions, enhancements to products currently in the market and constantly
changing customer requirements. To compete effectively, net.com must be able to
bring new products to market in a timely and cost effective manner and enhance
existing products to extend their useful life. Along with making continued
investments in our internal research and development, we will also consider
strategic acquisitions where appropriate to provide needed technology and
resources.
net.com continually monitors relevant markets, its customers' businesses and
technology developments in order to develop products that proactively address
customer needs. net.com's new SCREAM products were designed with an open
architecture to facilitate the development by third parties of products that
will enhance the capabilities of SCREAM. Further, we design to industry
standards and support industry standards bodies in their endeavors. Despite our
efforts, however, there is no guarantee that we will be able to successfully
develop new products or that our customers or our targeted markets will accept
any products we develop.
During the latter half of fiscal 2001 we eliminated the formal separation of our
business into Broadband and Narrowband business units and merged all product
development activities into a single development organization. As of March 30,
2001, we had an engineering staff of 107 engineers working on our SCREAM,
Promina or SHOUTIP products. The majority of our research and development
activity is focused on the SCREAM product line and on our new voice over IP
solution, SHOUTIP. We continue, however, to provide engineering support to
Promina and to provide feature enhancements required to maintain Promina's
viability. While most product development activity is undertaken in-house,
external development organizations are used to shorten time to market.
In fiscal 2001, 2000, and 1999, net.com's research and development expenditures
were $40.4, $41.6 million and $45.2 million, respectively. net.com expensed
in-process research and development of $879,000 in fiscal year 2000 as a result
of the FlowWise Networks acquisition. No in-process research and development
costs were expensed in fiscal year 2001 or 1999.
INTELLECTUAL PROPERTY
Our ability to invent and develop new technologies and then to protect these
technologies from abuse by others outside our company is an important part of
our success. We use all available means to protect our proprietary technology
including patents, trade secrets, trademarks and copyrights. All our employees
sign confidentiality and invention disclosure agreements and anyone outside our
company receiving information either signs a non-disclosure agreement prior to
receiving information or is a net.com licensee. To foster disclosure of
patentable inventions, we provide financial incentives to employees. We believe
that ownership of patents, copyrights and trade secrets is important to our
ability to compete and to defend ourselves against patent infringement
allegations.
Over the past 18 years, a number of patents have been issued to net.com in the
United States, Europe and Japan. These include some very early basic ATM
inventions that comport with ATM Forum standards. In the last fiscal year, we
began a highly focused effort to identify and patent our proprietary SCREAM and
SHOUTIP technology. We expect to continue filing patent applications as our
development process for SCREAM and SHOUTIP moves forward. In addition, as part
of our acquisition of FlowWise Networks in December 1999, we became the
successor to several filed patent applications relating to the FlowWise product.
We are also working to file patent applications for inventions obtained as part
of the purchase of the assets of Convergence Equipment Company.
Page 11
Although we have a number of patent applications pending, we cannot guarantee
that any one will result in the issuance of a patent. Even if issued, the patent
may later be found to be invalid or may be infringed without our knowledge. It
is difficult to monitor use of our technology by others. If we do not
effectively protect our intellectual property, it could have a material adverse
effect on our competitive position and sales of our products.
In June 2000, net.com entered into its first patent cross-licensing agreement.
The agreement is with Lucent Technologies whereby net.com and Lucent licensed
patents to the other. Under the terms of the cross-licensing agreement, each
company will receive a license under all patents related to its product markets.
net.com's portfolio includes patents in basic networking and ATM technologies
supported by the ATM Standards Forum and other standard setting bodies. This
cross-license agreement with Lucent has a five-year term.
Item 2. Properties
net.com is headquartered in Fremont, California. In April 1997, we entered into
a twelve year lease for three buildings totaling 290,000 square feet of office,
R&D and manufacturing space in an industrial park ("1997 Lease Agreement"). In
May 2000, we consolidated into two buildings, the R&D building and the
manufacturing building. This consolidation resulted from 1) the January 2000
restructuring of net.com's business and 2) the settlement of the ground water
intrusion problem affecting all three buildings. Our landlord released us from
the obligation to pay rent on the third building at that time. In March 2000, an
agreement was reached with the landlord and our insurance carrier that will
allow us to move out of the damaged facilities upon completion of a new
build-to-suit facility that is being constructed near by to the current
facilities. net.com believes that substantially all the costs associated with
the move and the build out of the new facility will be covered by insurance
proceeds from the agreement reached with our insurance carrier. In December
2000, we entered into a lease termination and settlement agreement ("Settlement
Agreement") and a 10 year lease for two buildings totaling 185,790 square feet
of office, R&D and manufacturing space on a new campus ("Lease Agreement"). The
buildings on the new campus will be leased to net.com under substantially the
same economic terms as the terms in our 1997 Lease Agreement. The Settlement
Agreement may be terminated if certain contingencies are not met and our move
into the new facility, which is scheduled to take place sometime in the first
half of the 2002 calendar year, may be impacted.
net.com and its subsidiaries also lease sales and service offices at other
locations in the United States, Canada, United Kingdom, France, Germany, Mexico,
Singapore, Uruguay, Brazil, China Japan, and Hong Kong. As a result of the
January 2000 restructuring, net.com vacated its Crawley, United Kingdom facility
and entered into a surrender agreement with the landlord in March 2001. The
sales and service operations that we maintain there have been relocated to a
smaller facility in the Crawley area. In June 2001, we terminated our lease in
Mexico City and have relocated the remaining employees to a smaller facility. We
are also in the process of closing our Boston and New Jersey offices and are
attempting to sublease those facilities.
Item 3. Legal Proceedings
net.com is not aware of any material pending legal proceedings. From time to
time net.com may be involved in employment or other litigation or in activities
including litigation needed to collect past due receivables. Generally, we do
not consider these litigation matters and or collection activities to be
material.
Item 4. Submission of Matters to a Vote of Security Holders
None.
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters
See Note 8 in the "Notes to Consolidated Financial Statements". At June 15,
2001, there were approximately 527 stockholders of record of net.com.
Page 12
MARKET PRICE
net.com's Common Stock is traded on the New York Stock Exchange under the symbol
NWK. The following table sets forth, for the quarterly periods indicated, the
high and low sale prices:
Fiscal 2001 High Low
----------------------------------------------------------
First quarter $12.00 $7.50
Second quarter 12.44 9.25
Third quarter 10.69 5.38
Fourth quarter 6.88 3.75
----------------------------------------------------------
Fiscal 2000 High Low
----------------------------------------------------------
First quarter $11.00 $7.31
Second quarter 11.63 8.19
Third quarter 14.81 8.88
Fourth quarter 12.50 9.25
----------------------------------------------------------
net.com has never declared or paid dividends on its capital stock and does not
intend to pay dividends in the foreseeable future. In addition, the Company's 7
1/4% convertible subordinated debentures trade in the over-the-counter market.
Item 6. Selected Financial Data
Five year financial summary:
(Dollars in thousands, except per share amounts)
Fiscal years ended 2001 2000 1999 1998 1997
- -------------------------------------------------------------------------------------------------------------------
Revenue $144,286 $225,686 $263,835 $308,721 $324,438
Income (loss) from continuing operations (20,790) (40,070) (7,054) 14,350 23,302
Diluted earnings (loss) per share (0.96) (1.86) (0.32) 0.65 1.08
7 1/4% convertible subordinated debentures 24,706 24,706 24,706 25,821 25,821
Total assets 235,346 259,994 313,112 334,557 301,653
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
The following discussion should be read in conjunction with the Consolidated
Financial Statements and the accompanying notes. The discussion contains
forward-looking statements that involve risk and uncertainties. These statements
relate to future events or our future financial results. Forward-looking
statements can often be identified by words such as "may", "will", "should",
"expect", "anticipate", "believe", "estimate" or words of similar import. Our
actual results may differ significantly from those anticipated by any
forward-looking statement as a result of a number of factors, trends, and risks
- - many beyond our control. These factors and risks are discussed further within
"Business Environment" and "Risk Factors" below and elsewhere in this Form 10-K.
Page 13
SALE OF N.E.T. FEDERAL, INC.'S PROFESSIONAL SERVICE BUSINESS
On December 1, 2000, we sold the assets of our federal services business ("FSB")
to CACI International Inc ("CACI") for a cash consideration of up to $40.0
million. The assets sold are comprised mainly of service contracts with the
United States Federal Government ("Federal Government"), accounts receivable,
spares inventory and fixed assets. The purchase price will be paid out over time
beginning with $24.9 million paid at the closing, $1.0 million six months after
closing and $1.0 million held in escrow and payable one year after closing (if
no successful indemnification claims are made). The net gain on the sale to date
is $14.9 million. The remaining $13.0 million is payable contingent upon
transfer to CACI of work performed under certain net.com federal contracts.
Additionally CACI and net.com have entered into an agreement whereby net.com
will receive royalties based on maintenance contract revenue.
RESULTS OF OPERATIONS
The following table depicts data derived from the Consolidated Statements of
Operations expressed as a percentage of revenue:
Years ended: Mar. 30, Mar. 31, Mar. 31,
Percent of Revenue 2001 2000 1999
- --------------------------------------------------------------------------------
Product revenue 53.4% 58.1% 63.9%
Service and other revenue 46.6 41.9 36.1
- --------------------------------------------------------------------------------
Total revenue 100.0 100.0 100.0
- --------------------------------------------------------------------------------
Product gross margin 42.8 50.9 56.6
Service and other revenue gross margin 33.7 38.4 36.9
- --------------------------------------------------------------------------------
Total gross margin 38.6 45.7 49.5
- --------------------------------------------------------------------------------
Sales and marketing 31.0 30.6 32.5
Research and development 28.0 18.4 17.1
General and administrative 8.8 6.5 5.5
Facility relocation costs 0.0 0.0 0.1
Other operating expense 2.3 0.8 0.0
Restructuring costs (1.0) 6.7 1.8
- --------------------------------------------------------------------------------
Total operating expenses 69.2 63.0 57.1
- --------------------------------------------------------------------------------
Loss from operations (30.6) (17.3) (7.6)
Interest income 5.5 3.2 2.5
Interest expense (1.3) (1.0) (0.7)
Other 10.4 3.0 0.3
- --------------------------------------------------------------------------------
Loss before income taxes (15.9) (12.1) (5.6)
Income tax provision (benefit) (1.5) 5.7 (2.9)
- --------------------------------------------------------------------------------
Extraordinary gain 0.0 0.0 0.1
- --------------------------------------------------------------------------------
Net loss (14.4)% (17.8)% (2.6)%
================================================================================
Page 14
COMPARISON OF 2001, 2000 & 1999
Revenue Total revenue decreased 36.1% to $144.3 million in fiscal 2001 as
compared to $225.7 million in fiscal 2000. Fiscal 2000 was a decrease of 14.5%
compared to the $263.8 million in fiscal 1999. Product revenue decreased 41.3%
to $77.0 million in fiscal 2001 as compared to $131.2 million in fiscal 2000.
Fiscal 2000 product revenue was a decrease of 22.2% compared to the $168.6
million in fiscal 1999. The decrease in product revenue is primarily the result
of lower sales of our circuit switched or "narrowband" product line, Promina(R),
which accounts for the majority of the product sales worldwide. Promina sales
decreased in all sales channels as part of a general decline in the overall
market for circuit switched products. Product revenue for the North America
sales channel decreased 50.7% to $10.6 million in fiscal 2001 compared to $21.6
million in fiscal 2000. Fiscal 2000 product revenue for the North America sales
channel was a decrease of 57.2% compared to the $50.5 million in fiscal 1999.
Product revenue for the Asia Pacific/Latin America sales channel decreased 52.6%
to $9.6 million compared to $20.2 million in fiscal 2000. Fiscal 2000 product
revenue for the Asia Pacific/Latin America sales channel was a decrease of 6.0%
compared to $21.5 million in fiscal 1999. Product revenue for the European sales
channel decreased 37.7% to $16.8 million in fiscal 2001 compared to $27.0
million in fiscal 2000. Fiscal 2000 product revenue for the European sales
channel was a decrease of 39.4% compared to the $44.6 million in fiscal 1999.
Product revenue for the United States Federal sales channel, which includes
sales to the United States government and United States government contractors
decreased 34.7% to $42.8 million in fiscal 2001 compared to $65.7 million in
fiscal 2000. Product revenue for the United States Federal sales channel in
fiscal 2000 increased 17.2% compared to $56.0 million in fiscal 1999. Net.com is
currently developing new products for the broadband equipment market that are
intended to offset the decline in product revenue of our Promina product line.
We expect the new broadband products to begin generating additional product
revenue in the upcoming fiscal year.
Service and other revenue sales decreased 28.8% to $67.3 million in fiscal 2001
as compared to $94.5 million in fiscal 2000. Fiscal 2000 was a decrease of 0.7%
compared to the $95.2 million in fiscal 1999. The decrease in service and other
revenue is primarily the result of the following:
1) our sale of the FSB to CACI in the third quarter of fiscal 2001, which
accounted for $14.8 million of the decrease in fiscal 2001. The FSB service and
other revenue in fiscal 2001 was $34.3 million, $49.7 million in fiscal 2000,
and $43.2 million in fiscal 1999.
2) a decline in the installed base of Promina equipment that requires on-going
service support.
As part of the broadband strategy, we are developing new service creation
solutions that we expect will expand our service offerings in the new fiscal
year and offset part of the service and other revenue decline in fiscal 2001.
Although we expect incremental service and other revenue from the broadband
offerings, we expect the service and other revenue to decline in the new fiscal
year compared to fiscal 2001 as a result of the sale of FSB
Gross Margin Total gross margin, comprised of product and service margin,
decreased as a percentage of total revenue to 38.6% in fiscal 2001 compared to
45.7% in fiscal 2000 and 49.5% in fiscal 1999. The decrease in total gross
margin is primarily the result of the following:
1) lower product gross margin. Product gross margin decreased to 42.8% in fiscal
2001, compared to 50.9% in fiscal 2000 and 56.6% in fiscal 1999. The decrease in
product gross margin is primarily the result of unfavorable manufacturing
variances that resulted from lower product revenues. In addition, a charge of
$1.4 million for inventory reserves in connection with the end of life and
subsequent obsolescence of the STM and the Router Accelerator product lines were
taken in fiscal 2001.
2) lower product revenue as a percent of total revenue for fiscal 2001 as
compared to fiscal 2000 and 1999. Product revenue as a percentage of total
revenue was 53.4% in fiscal 2001 compared to 58.1% in fiscal 2000 and 63.9% in
fiscal 1999. Since gross margins are higher for product revenue than for service
revenue, the decline in the percentage of product revenue had an unfavorable
impact on total gross margins.
Service and other revenue gross margin decreased to 33.7% in fiscal 2001,
compared to 38.4 % in fiscal 2000. Fiscal 2000 gross margin increased compared
with fiscal 1999 gross margin of 36.9%. The decrease in service and other
revenue gross margin in fiscal 2001 is primarily the result of lower service
contract revenues and relatively fixed service support expenses. The gross
margin increase in fiscal 2000 compared to fiscal 1999 resulted from reduced
headcount for service support.
Page 15
Operating Expenses Operating expenses in fiscal 2001 decreased $42.3 million to
$99.8 million compared to $142.1 million in fiscal 2000 and $150.7 million in
fiscal 1999. Operating expenses as a percentage of total revenue increased to
69.2% in fiscal 2001, compared to 63.0% in fiscal 2000 and 57.1% in fiscal 1999.
The increase in operating expenses as a percentage of total revenue is primarily
a result of lower revenue. In the second and fourth quarter of fiscal 2000, we
completed two separate restructurings that included a reduction in our
workforce. These reductions contributed to lower operating expenses in fiscal
2001. The restructure expense in fiscal 2001 was a credit of $1.4 million
compared to an expense of $15.2 million in fiscal 2000 and an expense of $4.7
million in fiscal 1999. The credit in fiscal 2001 resulted from lower costs than
initially estimated related to the closure of field offices. The increase in
operating expenses as a percentage of total revenue resulted primarily from the
lower revenues in fiscal 2001 compared to both prior periods.
Sales and marketing expenses in fiscal 2001 decreased $24.3 million to $44.7
million compared to $69.0 million in fiscal 2000 and $85.8 million in fiscal
1999. Sales and marketing spending as a percentage of total revenue in fiscal
2001 increased to 31.0% compared to 30.6% in fiscal 2000 and decreased from
32.5% in fiscal 1999. The decrease in fiscal 2001 spending resulted from reduced
headcount, lower travel expenses, and lower sales related costs. We expect sales
and marketing expense to decline slightly in fiscal 2002 as we balance the
priorities of cost control and the importance of marketing activities associated
with the introduction of our new broadband products.
Research and development expenses in fiscal 2001 decreased $1.2 million to $40.4
million, compared to $41.6 million in fiscal 2000 and $45.2 million in fiscal
1999. Research and development spending as a percentage of total revenue
increased to 28.0% in fiscal 2001 compared to 18.4% in fiscal 2000 and 17.1% in
fiscal 1999. The decrease in spending in fiscal 2001 compared to 2000 is
primarily from reduced facility related costs. In fiscal 2001, we focused
research and development resources on the development and release of our
broadband technology offerings. We expect personnel related costs tied to the
FlowWise Networks, Inc. acquisition to decline and as a result, total research
and development spending to decline slightly in the new fiscal year.
General and administrative expense in fiscal 2001 decreased $2.0 million to
$12.7 million, compared to $14.7 million in fiscal 2000 and $14.5 million in
fiscal 1999. General and administrative spending as a percentage of total
revenue increased to 8.8% in fiscal 2001 compared to 6.5% in fiscal 2000 and
5.5% in fiscal 1999. The decrease in general and administrative spending is a
result of lower headcount and reduced consulting expenses. We expect general and
administrative spending to decline slightly from continued focus on cost
control.
The amortization of goodwill and other intangible assets was $3.4 million in
fiscal 2001 compared to $801,000 in fiscal 2000 and zero in fiscal 1999. The
amortization is a result of two acquisitions, FlowWise Networks Inc. in the
third quarter of fiscal 2000 and Convergence Equipment Company in the first
quarter of fiscal 2001. Goodwill and other intangibles will be amortized on a
straight-line basis over five years. A charge of $879,000 was recorded in fiscal
2000 for purchased in-process technology that arose from the acquisition of
FlowWise.
Non-Operating Items Interest income, primarily related to cash investments,
increased $679,000 to $8.0 million in fiscal 2001 compared to $7.3 million in
fiscal 2000 and $6.6 million in fiscal 1999. The increase in interest income is
primarily the result of higher yields from our investment portfolio in fiscal
2001 compared to fiscal 2000. The increase in fiscal 2000 compared to fiscal
1999 is primarily the result of a shift in the investment portfolio from
tax-exempt securities to taxable securities.
Interest expense from: 1) the 7 1/4% convertible subordinated debentures, and 2)
the debt obligations assumed by net.com as part of acquisition of FlowWise
decreased in fiscal 2001 $387,000 to $1.9 million, compared to $2.3 million in
fiscal 2000 and $2.0 million in fiscal 1999. The decrease in interest expense is
primarily related to the reduction in principal for the debt obligations. We do
not expect an increase in interest expense in fiscal 2001.
Other income in fiscal 2001 increased $8.4 million to $15.0 million, compared to
$6.7 million in fiscal 2000 and $738,000 in fiscal 1999. Other income in fiscal
2001 included a gain of $14.9 million from the sale of the Federal Services
Business. Other income in fiscal years 2000 and 1999 includes gains of $7.2
million and $1.0 million, respectively, primarily from the sale of all of the
equity securities held in a publicly traded company.
Fiscal 2001 included a tax benefit of $2.2 million as compared to tax provision
of $12.8 million in fiscal 2000 and a tax benefit of $7.6 million in fiscal
1999. In fiscal 2001, we reevaluated the adequacy of our tax liability reserves
taking into account the statute of limitations on previously filed tax returns
as well as our expected fiscal year 2001 net losses. The result of this
reevaluation was to reduce the amount of necessary reserves and to record a tax
benefit of $2.2 million.
Page 16
LIQUIDITY AND CAPITAL RESOURCES
As of March 31, 2001, we had cash and cash equivalents of $20.5 million,
restricted cash of $540,000 and short term investments of $112.8 million for a
total of $133.8 million as compared to $124.9 million at the end of fiscal 2000
and $154.6 million at the end of fiscal 1999. The increase resulted primarily
from the sale of the Federal Services Business and insurance proceeds, both of
which will be discussed below.
Net cash used by operations was $9.6 million in fiscal 2001, compared to $2.2
million used in the prior year. This compares to net cash provided by operations
of $19.0 million in fiscal 1999. The decrease in 2001 resulted primarily from a
net loss of $20.8 million, an adjustment for the sale of the Federal Service
Business of $14.9 million, an increase in inventory of $2.4 million and a
decrease in accrued liabilities of $7.5 million. Partially offsetting the
reductions was the adjustment for depreciation and amortization of $21.5 million
and the $15.0 million in cash received from insurance proceeds associated with
the settlement of construction defects at our Fremont campus. Pursuant to our
settlement agreement, we will be eligible to receive additional insurance
proceeds as a function of costs incurred for moving and replacement of tenant
improvements.
Net cash provided from investment activities was $13.3 million in fiscal 2001,
compared to $2.9 million in fiscal 2000. This compares to net cash used for
investing activities of $63.2 million in fiscal 1999. Net cash provided by
investment activities consisted primarily of the proceeds from maturing
temporary cash investments of $84.6 million, $24.9 million cash received from
the sale of the Federal Services Business and a decrease in restricted cash of
$12.6 million mostly due to our closing our line of credit. Net cash used for
investing activities was $99.1 million in purchases of temporary cash
investments and the net use of $12.1 million cash for the purchases of property
and equipment.
Net cash provided by financing activities was $1.5 million in fiscal 2001,
compared to $286,000 in fiscal 2000. This compares to net cash used for
financing activities of $1.3 million in fiscal 1999. In fiscal 2001, cash
provided by financing activities was $2.9 million from the sale of common stock,
which was partially offset by the use of $1.4 million in cash for the repurchase
of common stock.
The Board of Directors re-authorized a share repurchase program in October of
1999. In fiscal 2001, 170,800 common shares at an average price of $8.27 per
common share were repurchased. We intend to continue the share repurchase
program in fiscal 2002 and from time to time will reenter the market to
repurchase shares.
We believe that our existing current cash and cash equivalents, temporary cash
investments and cash flows from operations will be sufficient to fund
operations, purchases of capital equipment and research and development programs
currently planned at least through the next 12 months.
BUSINESS ENVIRONMENT AND RISK FACTORS
net.com's business is subject to the risks below. Although we have tried to
identify the material risks to our business, this is not an all-inclusive list.
There may be additional risks not listed because either they have not yet been
identified or they are not material now, although they could become material in
the future. Any one of the risks identified below could materially impact our
business, results of operations or financial condition.
WE HAVE INCURRED NET LOSSES IN FISCAL YEAR 2000 AND 2001 AND EXPECT TO INCUR
FUTURE LOSSES.
For the past two fiscal years we have incurred net losses. Our ability to
achieve profitability on a continuing basis will depend on the successful
design, development, testing, introduction, marketing, and broad commercial
distribution of our new broadband equipment products, specifically our
SCREAM(TM) product line and to a lesser degree our SHOUTIP product line. We
expect to continue to incur significant product development, sales and marketing
and administrative expenses as we continue to maintain support of our existing
products and customers while launching new products. Although we have taken a
number of measures to reduce expenditures, most of our operating expenses are
fixed in the short term making it difficult to reduce expenses rapidly. At the
current revenue levels our operating expenses are too high to enable us to be
profitable. In order to achieve profitability, we need to generate significant
sales growth from our SCREAM product line or decrease expenses, in order to
offset declines in our existing Promina product line.
Page 17
OUR OPERATING RESULTS FLUCTUATE SIGNIFICANTLY.
Our operating results vary significantly from quarter to quarter. These
fluctuations are the result of a number of factors including:
o the volume and timing of orders from and shipments to our customers;
o the length and variability of the sales cycle of our products;
o the timing of and our ability to obtain new customer contracts;
o the timing of new products and services;
o the timing and level of prototype expenses;
o the availability of products and services;
o the overall capital expenditures of our customers;
o the market acceptance of new and enhanced versions of our products
and services or variations in the mix of products and services we
sell;
o the availability and cost of key components;
o the timing of revenue recognition/deferrals;
o the timing and size of Federal budget approvals; and
o general economic conditions as well as those specific to the
telecommunications, Internet and related industries.
Due to the foregoing factors, we believe that quarter-to-quarter comparisons of
our operating results are not a good indication of our future performance. Any
shortfall in revenue may impact our business, results of operations and
financial condition. You should not rely on our results or growth for one
quarter as any indication of our future performance.
OUR STOCK PRICE MAY BE VOLATILE.
Our common stock has experienced substantial price volatility, particularly as a
result of variations between our actual or anticipated financial results and the
published expectations of analysts, and as a result of announcements by our
competitors and us. In addition, the stock market has experienced extreme price
and volume fluctuations that have affected the market price of many companies,
in particular technology companies, and that have often been unrelated to the
operating performance of these companies. These factors, as well as general
economic, industry specific, and political conditions, may materially adversely
affect the market price of our common stock in the future. Additionally,
volatility or a lack of positive performance in our stock price may adversely
affect our ability to retain key employees, all of who have been granted stock
options.
THE COMPANY'S SUCCESS DEPENDS ON ITS ABILITY TO DEVELOP NEW PRODUCTS AND PRODUCT
ENHANCEMENTS THAT WILL ACHIEVE MARKET ACCEPTANCE.
Our operating results will depend to a significant extent on the successful
design, development, testing, introduction, marketing, and broad commercial
distribution of our new broadband equipment products, specifically our SCREAM
product line and to a lesser extent on our SHOUTIP product line. The success of
these and other new products is dependent on several factors, including proper
new product definition, competitive product cost, timely completion and
introduction of new products, differentiation of new products from those of our
competitors and market acceptance of these products. The markets for our
products are characterized by rapidly changing technology, evolving industry
standards, frequent new product introductions and evolving methods of building
and operating networks. Our SCREAM and SHOUTIP product lines target start-up
telecommunications companies and long established domestic carriers such as
AT&T, Worldcom, SBC Communications, and Sprint. There can be no assurance that
we will successfully identify new product opportunities, develop and bring new
products to market in a timely manner, or achieve market acceptance of our
products or that products and technologies developed by others will not render
our products or technologies obsolete or non-competitive. That in turn could
have a material adverse effect on our business, results of operation, and
financial condition.
Page 18
WE ARE DEPENDENT ON REVENUE FROM THE PROMINA PRODUCT LINE UNTIL WE GAIN REVENUE
TRACTION ON THE SCREAM PRODUCT LINE.
Currently, we derive the majority of our product revenue from our Promina(R)
product line, a circuit-based technology. We believe that the market for
circuit-based technology has declined and will continue to decline in the future
as new networks will likely employ packet based technology. The migration from
circuit to packet-based technology has happened more dramatically in the United
States commercial markets than in the United States Federal Government market
and the rest of the world. The decline of our business in the United States
commercial markets since fiscal 1999 has had a material adverse affect on our
business and results of operations. Should this migration extend into our
international and Federal Government markets in a similar fashion before we gain
traction on our new SCREAM product line, it could have a material adverse effect
on our business, results of operations, and financial condition.
A SIGNIFICANT PORTION OF OUR REVENUE IS GENERATED FROM SALES TO THE FEDERAL
GOVERNMENT.
A significant portion of our total revenue from product sales comes from
contracts with the United States Federal Government ("Federal Government"), most
of which do not include long-term purchase commitments. Historically, the
Federal Government has been slower to adopt new technology, such as packet based
technology, which has had the effect of extending the product life of our older
products. If the Federal Government accelerated adoption of new technology by
replacing the Promina(R) product line in their networks our product revenue
would decline sharply. Should we not be successful in renewing a significant
number of Federal Government contracts, and if sales to the Federal Government
were to decline sharply, it could have a material adverse impact on our
business, results of operations and financial condition.
OUR ABILITY TO SUCCESSFULLY COMMERCIALIZE SCREAM AND SHOUTIP WILL DEPEND HEAVILY
ON THE WIDESPREAD ACCEPTANCE OF SERVICE CREATION AS A MEANS OF ACHIEVING MAXIMUM
NETWORK PRODUCTIVITY AND ON APPROPRIATE REGULATORY INCENTIVES.
Over the last five years, carriers generated revenue by adding more customers or
by offering additional services to existing customers. Offering additional
services to an existing subscriber base is generally a preferred approach to
generating additional revenue, but these services typically require network
upgrades and the purchase of expensive equipment. Over time, however, carriers'
aggressive price discounts, expensive direct marketing campaigns, and massive
capital outlays for infrastructure expansion have offset whatever incremental
revenue increases were generated by the new services and have eroded the
profitability of these companies. Since the second quarter of fiscal 2000, we
have spent the majority of our R & D and Marketing resources to position
ourselves and our SCREAM family of products as the next generation of
telecommunications equipment that will enable carriers to maximize the delivery
of new services while leveraging their existing networks and ensuring quality of
service. The future success of SCREAM and SHOUTIP will depend in large measure
on carriers' acceptance of service creation as the vehicle that will deliver
revenue increases sought after by the carriers. Failure to achieve this
acceptance could affect our ability to sell the SCREAM and SHOUTIP products and
grow overall revenue, which could have a material adverse effect on our
business, results of operations, and financial condition.
In addition, without deregulation, in the United States and overseas, the
economic incentive for the incumbent carrier to actively engage in changing
their service delivery model to the service creation delivery model is low.
While the 1999 decision by the United States Federal Telecommunications
Commission's to decline to force incumbent local exchange carriers to unbundle
their ATM infrastructure, thus allowing incumbents to deny competitive carriers
access to their ATM networks, has made the service creation model viable for
carrier revenue growth, it remains to be seen whether or not the regulatory
structure in other countries will set the stage for the service creation model
to take hold. Failure to achieve the regulatory structure favorable to the
service creation model overseas could affect our ability to sell the SCREAM and
SHOUTIP products overseas and to grow overall revenue, which could have a
material adverse effect on our business, results of operations, and financial
condition.
Page 19
OUR SHOUTIP PRODUCT LINE MAY NEVER GENERATE SIGNIFICANT REVENUE.
Our SHOUTIP product is a voice over IP product that we acquired from the
purchase of the assets of Convergence Technologies in May 2000. While we
continue to believe that the technology is good, and that there is a market for
the SHOUTIP product, it has not yet generated significant sales. Due to the
competitive nature of this market segment there can be no assurances that this
product will generate significant sales in the short term, if ever.
TO SUCCESSFULLY MARKET SCREAM, WE WILL NEED TO SIGN UP SIGNIFICANT NEW STRATEGIC
PARTNERS WHO CAN HELP SELL OUR PRODUCTS INTO THE SERVICE PROVIDER MARKET.
In order to successfully market our SCREAM product, we will need to sign up new
strategic partners, such as software application partners and product OEM's or
resellers. The importance of the software application partners is that they
provide critical functions, such as billing, mediation, provisioning and
configuration that are needed to create a total service creation solution for
our customers. Product OEM or resale partners will be needed to supplement and
enhance our existing direct sales force both in the United States and overseas.
While we have begun the process of identifying and signing both software
application and OEM or resale partners, more partners may be necessary in all
these areas for us to be successful. In particular, we may need to find
strategic partners to assist us with integration of security functions, such as
digital certificates, third party firewall, intrusion detection and public key
management to meet evolving security needs, as well as to counter rival efforts
to assert differentiation in the security area. Additionally, we may need to
pursue partnerships with vendors who have optical core and core routing
technologies in order to counter the end-to-end solution providers, such as
Nortel, Cisco and Lucent as well as to bolster the company's co-marketing
efforts. Failure to sign up these new strategic partners could impact on our
ability to sell the SCREAM product and grow overall revenue, which could
adversely impact our business, results of operations and financial condition.
A CONTINUATION OF THE DOWN TURN IN THE NATIONAL ECONOMY COULD MATERIALLY IMPACT
OUR REVENUE AND AS A RESULT, EARNINGS AND OUR STOCK PRICE.
Growth in the United States economy slowed significantly in the third quarter.
Companies in many different market sectors have been impacted by the slow down.
Telecommunications and other technology related markets in particular have seen
growth slow significantly. This slow growth has led to decreased revenue or
earnings, which in turn has led to declines in the stock price for the
technology sector as a whole. We have seen our stock price decrease along with
our competitors and others in technology. Should the United States economy
continue its slow down, our revenues, earnings and ultimately our stock price
could be materially affected.
THE RECENT DECLINES IN PURCHASES BY TELECOMMUNICATIONS SERVICE PROVIDERS AND THE
OVERALL DECLINE OF PRODUCT SALES IN THIS MARKET COULD IMPACT SALES OVER THE NEXT
SEVERAL QUARTERS.
Over the last twelve months, the financial health of many of the newly emerging
telecommunications service providers, including many of the companies classified
as Competitive Local Exchange Carriers or "CLECs" began to deteriorate. In
addition, there is evidence that other more established service providers are
cutting back on equipment purchases as part of an overall slow down in economic
growth. We believe that many telecommunications equipment companies, including
net.com, were impacted by this decline. In addition, the timing and volume of
purchases by emerging service providers can be unpredictable due to other
factors, including their need to build a customer base and capacity while
working within their budgetary constraints. Our ability to recognize revenue
from emerging service providers will depend on the relative financial strength
of the particular customer. We may be required to write off or decrease the
value of our accounts receivable from a customer whose financial condition
materially deteriorates. Decreases in purchasing volume of emerging service
providers or changes in the financial condition of emerging service provider
customers could have a material impact on our results of operations and
financial condition in future periods. In addition, the selling cycle of our
SCREAM product family could be extended as our service provider customers reduce
their capital budgets.
Page 20
WE EXPECT GROSS MARGINS TO DECLINE OVER FUTURE PERIODS.
Due to increases in competition, material and labor costs, subcontractor costs
and changes in the mix of products we sell, we expect that our gross margins
could decrease in future quarters. Some of the new products we introduced
recently have lower gross margins than our Promina product line. However, we
expect that new product offerings slated for introduction in the second half of
fiscal 2002 will have gross margins similar to or higher than our Promina
product line. In addition, if product sales continue to decrease as a percentage
of total revenue, overall margins may decrease because service revenue has a
lower margin than product sales. In addition, to the extent we expand our sales
through product resellers and strategic partnerships, we expect to earn lower
gross margins. Recently our subcontractor manufacturer increased our material
costs by 10% due to increased demand and an overall shortage of capacity in the
semiconductor and other component industries. The current economic slowdown may
help alleviate some of the pricing pressure on component parts, although there
is no assurance that these benefits will be passed on to us from our suppliers
or contract manufacturer. Any one of these factors by themselves or all of them
in combination may decrease our product margins and our overall gross margins.
FACTORS BEYOND OUR CONTROL COULD AFFECT OUR ABILITY TO SELL INTO INTERNATIONAL
MARKETS
As a general rule, international sales tend to have risks that are difficult to
foresee and plan for including political and economic stability, regulatory
changes, currency exchange rates, changes in tax rates and structures, and
collection of accounts receivable. Unforeseen events in various areas of the
globe may have an adverse impact on us. Further, our international markets are
served primarily by non-exclusive resellers who themselves may be severely
impacted by economic or market changes within a particular country or region.
Unforeseen or unpredictable changes in international markets could have a
material adverse effect on our business, results of operations and financial
condition.
WE CANNOT GUARANTEE THAT OUR DIVESTITURE OF OUR FEDERAL SERVICES BUSINESS WILL
PROVE SUCCESSFUL.
On December 1, 2000, we closed the sale of our Federal Services Business ("FSB")
to CACI International Inc ("CACI"), who will continue to provide maintenance and
other services to our federal customers. We continue to sell net.com products
directly to the Federal Government and, additionally, have a strategic alliance
with the acquirer, CACI, to jointly market each other's products and services.
For the divestiture to be successful, CACI must continue to provide the level of
service to which our customers have become accustomed. Should CACI experience
difficulties in providing those services, it could impact purchasing decisions
for our product and cause federal customers to seek products from other vendors.
In addition, in order to realize the full economic benefits of the sale, net.com
must facilitate the assignment and extension of certain contracts with the
Federal Government that trigger up to an additional $13.0 million of
consideration under the divestiture agreement. If the divestiture of our FSB
proves unsuccessful, it could have an adverse impact on our business, financial
condition or results of operation.
INCREASED COMPETITION IS LIKELY IN THE FUTURE.
The market for telecommunication equipment is a highly competitive and dynamic
market characterized by the easy entrance of new start-up companies, rapid
changes to and the convergence of technologies and a worldwide migration from
existing circuit technology to the new packet based technologies. We compete
directly both internationally and domestically with many different companies,
some of which are large, established suppliers of end-to-end solutions such as
Cisco, Lucent, Alcatel and Nortel. In addition, there are a number of new
start-ups that are targeting this market, including CoSine, Ellacoya, Quarry,
Gotham, Celox and others. Many of the large suppliers have greater financial,
marketing and technical resources and offer a wider range of networking products
than we offer. They are often able to devote greater resources to the
development, marketing and sale of their products and to use their equity or
significant cash reserves to acquire other companies with technology and/or
products that compete directly with ours. They often can compete favorably on
price because their large product selection allows them to bundle multiple
solutions together without significantly impacting their overall product
margins. Small start-up ventures are better able than net.com to focus their
resources on a particular product development unencumbered by the requirements
to support an existing product line. Through these acquisitions,
Page 21
competitors can obtain strategic advantages that may adversely affect our
business, financial condition or results of operations.
In addition, the networking equipment market has seen the constant introduction
of new technologies that has reduced the value of older technology solutions.
This has created pricing pressure on older products while increasing the
performance expectations of newer networking equipment. Moreover, broadband
technology standards are constantly evolving and alternative technologies or
technologies with greater capability are constantly introduced and sought by our
customers. It is possible that the introduction of other technologies will
either supplant our current technologies and those technologies we have in
development or that it will require us to significantly lower our prices in
order to remain competitive. To remain competitive, we need to develop new
products that meet the ever-changing technology needs of the networking market
but that can be sold at a competitive price. We also must enhance our current
products to provide needed features that increase their overall value
proposition for the customer while keeping the price competitive. Due to the
competitive nature of the market and the relative age of our current product
offerings, we may not be able to maintain prices for our products at levels that
will sustain profitability over the short or long term. That may have a material
adverse effect on our business, results of operations and financial condition.
OUR INABILITY TO SIGN COMPETITIVE RESALE PARTNERS INTERNATIONALLY COULD
SIGNIFICANTLY AFFECT FUTURE PRODUCT AND SERVICE REVENUE.
Because the transition from circuit to packet technology is slower outside the
United States, we expect international sales will continue to account for a
significant portion of our Promina(R) product sales (other than that sold in the
Federal channel) in future periods. Our International sales are made almost
entirely through indirect channels that include distributors and resellers
worldwide. They do not have minimum purchase requirements that they must meet.
While we require them to use their best efforts to resell our products, because
our product line is small, our distributors and resellers must often resell
product lines from other networking companies, including our competitors, such
as Cisco, in order to sustain a profit. Because of the size of Cisco and its
dominant position in the network equipment market, it is difficult for us to
find a distributor or reseller who does not resell Cisco products. Due to the
difficulty of signing up distributors and resellers without pre-existing
competitive relationships, our distributors and resellers are not always
successful in promoting our products thereby impacting the sustainability of our
international product sales. If we cannot develop relationships with
distributors and resellers that can effectively market and sell our products and
services, we may not be able to meet our forecasted sales and revenue in future
quarters.
OUR PRODUCTS HAVE LONG SALES CYCLES MAKING IT DIFFICULT TO PREDICT WHEN A
CUSTOMER WILL PLACE AN ORDER AND WHEN TO FORECAST REVENUE FROM THE RELATED SALE.
Our products are very complex pieces of networking equipment and represent a
significant capital expenditure to our customers. The purchase of our products
can have a significant impact on how a customer designs its network and provides
services either within its own organization or to an external customer.
Consequently, our customers often engage in extensive testing and evaluation of
products before purchase. There are also numerous financial and budget
considerations and approvals that the customer often must obtain before it will
issue a purchase order. As a result, the length of our sales cycle can be quite
long, up to a year in some cases. In addition, our customers, including
resellers, have the contractual right to delay scheduled order delivery dates
with minimal penalties and to cancel orders within specified time frames without
penalty. The ability to delay or cancel orders makes it difficult to predict
whether or not an order may actually ship. Moreover, while customers may tell us
that they are planning to purchase our products, to ensure a purchase order is
placed, we often must incur substantial sales and marketing expense. If the
order is not placed in the quarter forecasted because approvals took longer than
anticipated by the customer, our sales may not meet forecast and revenues may be
insufficient in that quarter to meet expenses.
OUR LACK OF BACKLOGGED PRODUCT ORDERS MAKE IT DIFFICULT FOR US TO ACCURATELY
FORECAST SALES AND CREATES A RISK OF CARRYING TOO MUCH OR TOO LITTLE INVENTORY
Historically, the majority of our revenue in each quarter has resulted from
orders received and shipped in that quarter. However, for the last two years, we
have not started a quarter with a sufficient amount of backlogged orders to meet
the sales forecast for that quarter. While we do not believe that backlog is
necessarily indicative of future revenue levels, our customers' ordering
patterns and the absence of backlogged orders create a significant risk
Page 22
that we could carry too much or too little inventory if orders do not match
forecasts. Rather than base forecasts on orders received, we have been forced to
schedule production and commit to certain expenses based more upon forecasts of
future sales, which are difficult to predict in the telecommunications industry.
Furthermore, if large orders do not close when forecasted or if near-term demand
weakens for the products we have available to ship, our operating results for
that or subsequent quarters would be materially adversely affected.
WE HAVE OFFERED AND MAY CONTINUE TO OFFER CUSTOMER FINANCING ARRANGEMENTS.
Historically, our customers have been comprised of larger corporate enterprises
or well-established service providers. Over the past three fiscal years, we have
targeted several emerging global carriers, international voice resellers and
smaller rural incumbent local exchange carriers ("ILECS") and CLECS. These
companies generally do not have substantial operating histories or significant
capital resources and often do not qualify for credit from traditional lending
sources. Consequently, vendor-financing programs have become a competitive
factor in obtaining business. We have worked with customers and third-party
financial institutions to finance projects through negotiated financing
arrangements or leases. This program includes a loss sharing provision under
which there is limited recourse to us in the event of default. In addition, we
entered into a loss sharing agreement with one of our resellers wherein we share
in a percentage of any loss arising from a customer's failure to pay the
reseller for our equipment. Both of these programs are for companies based in
the United States only. As of March 30, 2001 we had $5.5 million of outstanding
lease financing that was subject to limited recourse provisions. We have
experienced losses due to customers failing to meet their obligations and
demands by lessors under recourse provisions. Any significant increase in the
use of vendor financing by our customers or any further degradation of the
market in which our customers compete could increase our exposure to credit risk
and have a material adverse effect on our operating results and financial
condition.
IF WE ARE UNABLE TO HIRE QUALIFIED NEW EMPLOYEES OR TO RETAIN EXISTING
EMPLOYEES, THEN WE MAY NOT BE ABLE TO SUCCESSFULLY MANAGE OUR BUSINESS.
Our success is dependent on being able to attract and retain highly skilled
engineers, managers and other key employees. In the past two years we have seen
a large turnover in our direct sales force in North America. This turnover has
negatively impacted our ability to sell products in the United States. Until
very recently, the tight job market made competition for employees very intense
for all employers. The large job growth in the San Francisco Bay Area and the
competition for employees from both established and start-up companies has made
it difficult for many departments in net.com including Marketing and Engineering
to attract and recruit new employees in a timely manner. The recent lay-offs at
Internet and telecommunications companies have improved somewhat our employee
retention and recruitment concerns. While we have put additional focus and
resources into our recruitment activities and have taken steps including the
introduction of compensation packages and other incentives that we hope will
mitigate these competitive advantages, we cannot say that in the current economy
our increased efforts will substantially improve the recruitment and retention
issues faced by our company at this time. Our inability to attract, recruit and
retain key personnel, particularly engineers and sales and marketing employees,
could impact our ability to meet important company objectives such as product
delivery deadlines and sales targets. That in turn could significantly impact
our business, results of operations and financial condition.
WE RELY ON A NUMBER OF SOLE SOURCE SUPPLIERS FOR OUR COMPONENT PARTS.
We purchase key components from single source suppliers, in particular, our back
planes, ASICS and power supplies. If our sole source suppliers or we fail to
obtain components in sufficient quantities when required, delivery of our
products could be delayed resulting in decreased revenues. In addition, if one
of these suppliers were no longer able to supply a required component, it could
result in our having to significantly reengineer the affected product. Further,
due to increased demand and cyclical shortages of capacity in the semiconductor
industry, lead times for ordering parts have increased from time to time. If we
encounter shortages or delays in receiving ordered components or if we are not
able to accurately forecast our ordering requirements, this could adversely
impact our ability to ship ordered products and could ultimately negatively
impact our results of operations and financial condition.
Page 23
THE AVAILABILITY OF UNINTERRUPTED ELECTRIC POWER COULD IMPACT OUR ABILITY AND
OUR SUPPLIERS' ABILITY TO MAINTAIN OUR OPERATIONS IN CALIFORNIA.
Recently, the public electric utility that provides power to our facilities and
many of our suppliers' facilities has been subject to shortages of electric
power. These shortages have led to dramatic increases in operating costs and
have subjected us to unpredictable rolling blackouts where power has been
completely interrupted for extended periods of time. Should this power shortage
persist, and the frequency of outages increase, it may become more difficult for
our subcontract manufacturer and other suppliers to meet delivery commitments.
In addition, continued interruptions of power may impact our ability to deliver
new products to the market place on a timely basis. Should the electric utility
not be able to secure sufficient power supplies in the future, it could have a
material adverse impact on our financial condition and results of operations.
WE SINGLE SOURCE OUR MANUFACTURING PROCESS SO THAT A FAILURE OR DELAY BY THAT
VENDOR COULD IMPACT OUR ABILITY TO TIMELY SHIP OUR PRODUCTS.
We currently subcontract some testing and all product manufacturing to one
company, Solectron. Final test and assembly is generally performed at our
Fremont, California facility. While subcontracting creates substantial cost
efficiencies in the manufacturing process, it also exposes us to delays in
product shipments should Solectron be unable to perform under our contract. In
addition, should Solectron in some future period decide not to renew our
contract with them, it would be difficult for us to quickly transfer our
manufacturing requirements to another vendor likely causing substantial delays
in customer product shipments and impacting revenue and our results of
operations.
OUR INTELLECTUAL PROPERTY RIGHTS MAY NOT BE ADEQUATE TO PROTECT OUR BUSINESS.
Our future success depends upon our proprietary technology. Although we attempt
to protect our proprietary technology through patents, copyrights, and trade
secrets, we cannot predict whether such protection will be adequate, or whether
our competitors can develop similar technology independently without violating
our proprietary rights. As competition in the communications equipment industry
increases and the functionality of the products in this industry further
overlap, we believe that companies in the communications equipment industry may
become increasingly subject to infringement claims. We have received and may
continue to receive notice from third parties, including some of our
competitors, claiming that we are infringing their patents or their other
proprietary rights. We cannot predict whether we will prevail in any litigation
over third-party claims, or that we will be able to license any valid and
infringed patents on commercially reasonable terms. Any of these claims, whether
with or without merit, could result in costly litigation, divert our
management's time, attention and resources, delay our product shipments or
require us to enter into royalty or licensing agreements. In addition, a third
party may not be willing to enter into a royalty or licensing agreement on
acceptable terms, if at all. If a claim of product infringement against us is
successful and we fail to obtain a license or develop or license non-infringing
technology, it could have a material adverse affect on our business, results of
operations and financial condition.
WE NEED TO CONTINUE TO LICENSE PRODUCTS FROM THIRD PARTIES.
For our Promina, SHOUTIP and SCREAM products, we license some of our technology
from third party suppliers. If the relevant licensing agreement expires or is
terminated without our being able to renew that license, that failure to renew
the license could impact our ability to market the affected product and that, in
turn, could materially impact our results of operations and financial condition.
WE FACE RISKS ASSOCIATED WITH CHANGES IN TELECOMMUNICATIONS REGULATIONS AND
TARIFFS.
Changes in domestic and international telecommunications requirements could
affect the sales of our products. In the United States, our products must comply
with various Federal Communications Commission requirements and regulations. In
countries outside of the United States, our products must meet various
requirements of local telecommunications authorities. Changes in tariffs or
failure by us to obtain timely approval of products could have a material
adverse effect on our business, operating results, and financial condition.
In addition, there are currently few laws or regulations that govern access or
commerce on the Internet. If individual countries, or groups of countries,
acting in concert began to impose regulations or standards on Internet access or
Page 24
commerce including voice over IP, this could materially impact our ability to
sell our new SCREAM and SHOUTIP products or other new products if the
regulations or standards resulted in decreased demand or increased costs for our
products. This, in turn, could have a material adverse effect on our business,
results of operations and financial condition.
WE ARE EXPOSED TO FLUCTUATIONS IN THE EXCHANGE RATES OF FOREIGN CURRENCY.
As a global concern, we face exposure to adverse movements in foreign currency
exchange rates. These exposures may change over time as business practices
evolve and could have a material adverse impact on our financial results.
Historically, our primary exposures have related to non-dollar denominated sales
in the United Kingdom, France, and Germany and non-dollar denominated operating
expenses in Europe, Latin America, and Asia where we sell primarily in United
States dollars. The increasing use of the Euro as a common currency for members
of the European Union could impact our foreign exchange exposure. We will
continue to monitor our exposure and may hedge against these or any other
emerging market currencies as necessary. We are currently not hedging our
exposure to the Euro or any other foreign currency but will continue to evaluate
the impact of foreign currency fluctuations on our future foreign exchange
exposure as well as our internal systems.
THE LOCATION OF OUR FACILITIES SUBJECTS US TO THE RISK OF EARTHQUAKE AND FLOODS.
Our corporate headquarters, including most of our research and development
operations and our manufacturing facilities, are located in the Silicon Valley
area of Northern California, a region known for seismic activity. Additionally,
these facilities are located near the San Francisco Bay where the water table is
quite close to the surface and where we have experienced water intrusion
problems. In particular, defects in the construction of our facilities combined
with the proximity to water will force us to move out of these facilities in the
first half of the 2002 calendar year. A significant natural disaster, such as an
earthquake or flood, could have a material adverse impact on our business,
operating results, and financial condition.
THE COMPLETION OF THE ACTIVITIES NECESSARY TO EFFECT THE MOVE TO OUR NEW COMPUS
MAY CAUSE INTERRUPTION TO OUR BUSINESS
A new building campus is currently under construction and will become the new
corporate headquarters for net.com sometime in the first half of the 2002
calendar year. Moving substantially all of our R&D development activities
including the development labs, and all of our in-house manufacturing capability
represents significant risk as it exposes the company to potential disruptions
and delays in business, engineering, and manufacturing operations. While the
costs of construction, and the move will be substantially paid for out of
insurance proceeds, problems with the move could interrupt communications
preventing the company from processing orders, or it could impact engineering
development schedules, or prevent manufacturing operations from shipping
product. In addition, certain contingencies associated with our negotiated move
out of our current facilities, not all of which have been satisfied, may result
in our move not proceeding as planned. Any problems, interruptions or delays
associated with the move could have a material adverse impact on business,
operating results, and financial condition.
THE UPGRADE OF OUR INFORMATION TECHNOLOGY INFRASTRUCTURE MAY EXPOSE THE COMPANY
TO DISRUPTION OF OPERATIONS.
We are in the process of upgrading and consolidating our core business process
systems onto a new Oracle ERP platform that is scheduled to go live in the July
to August 2001 time frame. We expect to incur significant costs relating to this
upgrade. The scope of this project includes our order management, financial,
human resource, quality, and manufacturing systems, and encompasses our global
operations. The purpose of the project is to consolidate several legacy systems
into one, to enable more effective decision support capabilities and to allow us
to scale our business more cost effectively. Any significant problems
experienced with the turn-on of the new systems could prevent us from timely
processing orders and shipping products. These problems could impact the
quarter's revenue and customer relations and could have a material adverse
impact on business, operating results, and financial condition.
Page 25
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
The following table represents the hypothetical changes in fair market values in
the financial instruments held by us at March 30, 2001 that are sensitive to
changes in interest rates. These instruments are not leveraged and are held for
purposes other than trading. The modeling technique used measures the change in
fair values arising from selected potential changes in interest rates. Market
changes reflect immediate hypothetical parallel shifts in the yield curve of
plus or minus 50 basis points (BPS), 100 BPS and 150 BPS over a six-month
horizon. Beginning fair values represent the market principal plus accrued
interest, dividends and certain interest rate sensitive securities considered
cash and equivalents for financial reporting purposes at March 30, 2001. Ending
fair values comprise the market principal and accrued interest, dividends and
reinvestment income at a six-month horizon. This table estimates the fair value
of the portfolio at a six-month time horizon:
Valuation of securities No change Valuation of securities
given an interest rate in interest given an interest rate
decrease of x basis points rates increase of x basis points
- ------------------------------------------------------------------------------------------------------------------
(Dollars in thousands) (150) BPS (100) BPS (50) BPS 50 BPS 100 BPS 150 BPS
- ------------------------------------------------------------------------------------------------------------------
Cash Equivalents $ 32,034 $ 32,074 $ 32,114 $ 32,154 $ 32,194 $ 32,234 $ 32,275
Treasuries/Agencies 23,111 23,074 23,037 23,000 22,965 22,929 22,893
Corporates 33,074 33,039 33,006 32,972 32,938 32,905 32,872
Asset Backed 26,090 25,998 25,906 25,816 25,726 25,637 25,545
Auction Rate Securities 19,463 19,488 19,512 19,536 19,561 19,585