DOT HILL SYSTEMS CORP - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

(Mark One)
ý	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2003
OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to

Commission file number 1-13317

DOT HILL SYSTEMS CORP.
(Exact name of registrant as specified in its charter)

Delaware (State or other jurisdiction of incorporation or organization)		13-3460176 (I.R.S. Employer Identification No.)
6305 El Camino Real, Carlsbad, CA (Address of principal executive offices)		92009 (Zip Code)
(760) 931-5500 (Registrant's telephone number, including area code)
(Former name, former address and former fiscal year, if changed since last report)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Securities Exchange Act of 1934). Yes o No ý

Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

Common Stock, $0.001 par value, 32,474,273 shares outstanding as of August 5, 2003.

DOT HILL SYSTEMS CORP.

FORM 10-Q

For the Quarter Ended June 30, 2003

INDEX

Part I. Financial Information		1
Item 1.	Financial Statements	1
	Condensed Consolidated Balance Sheets—December 31, 2002 and June 30, 2003	1
	Condensed Consolidated Statements of Operations and Comprehensive Operations—Three months ended June 30, 2002 and 2003 and six months ended June 30, 2002 and 2003	2
	Condensed Consolidated Statements of Cash Flows—Six months ended June 30, 2002 and 2003	3
	Notes to Condensed Consolidated Financial Statements	4
Item 2.	Management's Discussion and Analysis of Financial Condition and Results of Operations	12
Item 3.	Quantitative and Qualitative Disclosures About Market Risk	27
Item 4.	Controls and Procedures	28
Part II. Other Information		29
Item 1.	Legal Proceedings	29
Item 2.	Changes in Securities and Use of Proceeds	29
Item 3.	Defaults Upon Senior Securities	29
Item 4.	Submission of Matters to a Vote of Security Holders	29
Item 5.	Other Information	29
Item 6.	Exhibits and Reports on Form 8-K	30
Signatures		31

Part I. Financial Information

Item 1. Financial Statements

DOT HILL SYSTEMS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited—in thousands, except per share information)

			December 31, 2002			June 30, 2003
ASSETS
Current Assets:
	Cash and cash equivalents		$	10,082		$	20,632
	Restricted cash			2,000			—
	Short-term investments			—			10,045
	Accounts receivable, net of allowance of $751 and $825			6,304			14,803
	Inventories			6,959			3,495
	Prepaid expenses and other			2,313			3,314

		Total current assets		27,658			52,289
Property and equipment, net				4,110			4,400
Other assets				460			1,405

		Total assets	$	32,228		$	58,094

LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
	Accounts payable		$	14,446		$	24,587
	Accrued compensation			1,754			2,619
	Accrued expenses			1,614			2,539
	Deferred revenue			1,110			1,362
	Income taxes payable			1,020			942
	Short-term debt			4,552			—
	Current portion of restructuring accrual			407			384

		Total current liabilities		24,903			32,433
Restructuring accrual, net of current portion				1,179			919
Borrowings under lines of credit				275			266
Other long-term liabilities				86			70

		Total liabilities		26,443			33,688

Contingencies (Note 11)
Stockholders' Equity:
	Preferred stock, $0.001 par value, 10,000 shares authorized, 6 and 0 shares issued and outstanding at December 31, 2002 and June 30, 2003, respectively			—			—
	Common stock, $0.001 par value, 100,000 shares authorized, 25,172 and 32,273 shares issued and outstanding at December 31, 2002 and June 30, 2003, respectively			25			32
	Additional paid-in capital			109,562			127,405
	Deferred compensation			(48	)		(38	)
	Accumulated other comprehensive loss			(318	)		(511	)
	Accumulated deficit			(103,436	)		(102,482	)

		Total stockholders' equity		5,785			24,406

		Total liabilities and stockholders' equity	$	32,228		$	58,094

See accompanying notes to condensed consolidated financial statements.

DOT HILL SYSTEMS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE OPERATIONS
(unaudited—in thousands, except per share information)

			Three Months Ended June 30,						Six Months Ended June 30,
			2002			2003			2002			2003
Net Revenue			$	11,206		$	48,428		$	22,096		$	78,950
Cost of Goods Sold				10,933			38,415			19,459			63,400

Gross Profit				273			10,013			2,637			15,550

Operating Expenses:
	Sales and marketing			8,636			3,391			13,495			6,812
	Research and development			2,517			2,841			4,867			4,897
	General and administrative			1,490			1,610			2,814			3,071

		Total operating expenses		12,643			7,842			21,176			14,780

Operating Income (Loss)				(12,370	)		2,171			(18,539	)		770

Other Income (Expense):
	Interest income			188			97			287			123
	Interest expense			(33	)		(23	)		(66	)		(70	)
	Gain (loss) on foreign currency transactions, net			31			320			(25	)		302
	Other income (expense), net			2			6			(19	)		(18	)

		Total other income, net		188			400			177			337

Income (Loss) Before Income Taxes				(12,182	)		2,571			(18,362	)		1,107
Income Tax Benefit (Expense)				3,300			(11	)		3,300			(11	)

Net Income (Loss)			$	(8,882	)	$	2,560		$	(15,062	)	$	1,096

Net Income (Loss) Attributable to Common Stockholders:
	Net income (loss)		$	(8,882	)	$	2,560		$	(15,062	)	$	1,096
	Dividends on preferred stock			—			36			—			141

		Net income (loss) attributable to common stockholders	$	(8,882	)	$	2,524		$	(15,062	)	$	955

Net Income (Loss) Per Share:
	Basic		$	(0.36	)	$	0.08		$	(0.61	)	$	0.03

	Diluted		$	(0.36	)	$	0.07		$	(0.61	)	$	0.03

Weighted Average Shares Used to Calculate Net Income (Loss) Per Share:
	Basic			24,913			31,576			24,854			28,877

	Diluted			24,913			35,669			24,854			32,954

Comprehensive Operations:
	Net income (loss)		$	(8,882	)	$	2,560		$	(15,062	)	$	1,096
	Foreign currency translation adjustments			(167	)		(92	)		(53	)		(177	)
	Net unrealized loss on short-term investments			(71	)		(16	)		(150	)		(16	)

		Comprehensive income (loss)	$	(9,120	)	$	2,452		$	(15,265	)	$	903

See accompanying notes to condensed consolidated financial statements.

DOT HILL SYSTEMS CORP. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited—in thousands)

		Six Months Ended June 30,
		2002			2003
Cash Flows From Operating Activities:
Net income (loss)		$	(15,062	)	$	1,096
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
	Depreciation and amortization		693			1,042
	Loss on disposal of property and equipment		—			27
	Provision for doubtful accounts and note receivable		468			74
	Stock-based sales and marketing expenses		3,647			—
	(Gain) loss on sales of short-term investments		(71	)		1
	Stock-based compensation expense		26			10
Changes in operating assets and liabilities:
	Accounts receivable		(1,057	)		(8,573	)
	Inventories		4,954			3,464
	Prepaid expenses and other assets		254			(1,946	)
	Accounts payable		756			10,141
	Accrued compensation and other expenses		(180	)		1,790
	Deferred revenue		(157	)		252
	Income taxes payable		(2,388	)		(78	)
	Restructuring accrual		(785	)		(283	)
	Other liabilities		24			(16	)

Net cash provided by (used in) operating activities			(8,878	)		7,001

Cash Flows From Investing Activities:
	Purchases of property and equipment		(348	)		(1,359	)
	Sales of short-term investments		8,637			1,530
	Purchases of short-term investments		(44	)		(11,592	)

Net cash provided by (used in) investing activities			8,245			(11,421	)

Cash Flows From Financing Activities:
	(Increase) decrease in restricted cash and investments		(7,268	)		2,000
	Proceeds from bank and other borrowings		16,261			22,848
	Payments on bank and other borrowings		(9,005	)		(27,409	)
	Proceeds from issuance of common stock and stock warrants, net of issuance costs		—			16,543
	Proceeds from exercise of stock options		—			958
	Proceeds from sale of stock to employees		133			348
	Dividends paid to preferred stockholders		—			(141	)

Net cash provided by financing activities			121			15,147

Effect of Exchange Rate Changes on Cash			(53	)		(177	)

Net Increase (Decrease) in Cash and Cash Equivalents			(565	)		10,550
Cash and Cash Equivalents, beginning of period			7,785			10,082

Cash and Cash Equivalents, end of period		$	7,220		$	20,632

Supplemental Disclosures of Cash Flow Information:
	Cash paid for interest	$	54		$	61

	Cash paid for income taxes	$	51		$	95

See accompanying notes to condensed consolidated financial statements.

DOT HILL SYSTEMS CORP. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

1. Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared by Dot Hill Systems Corp. ("Dot Hill", "we", "our" or "us") pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC"). Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, all adjustments and reclassifications considered necessary for a fair and comparable presentation have been included and are of a normal recurring nature. Certain reclassifications have been made to the prior year financial statements to conform with the current year financial statement presentation. The unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K/A for the year ended December 31, 2002. Operating results for the six months ended June 30, 2003 are not necessarily indicative of the results that may be expected for the year ending December 31, 2003.

The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates under different assumptions and conditions.

2. Recent Accounting Pronouncements

In November 2002, the Emerging Issues Task Force, or EITF, reached a consensus on Issue 00-21, Revenue Arrangements with Multiple Deliverables. EITF Issue 00-21 provides guidance on how to account for arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The provisions of EITF Issue 00-21 will apply to revenue arrangements entered into in fiscal periods beginning after June 15, 2003. We do not expect the adoption of EITF Issue 00-21 to have a significant effect on our financial statements.

In May 2003, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Account Standards, or SFAS, No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. This statement establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. This statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for the first interim period beginning after June 15, 2003, with certain exceptions. The adoption of this statement, effective July 1, 2003, is expected to have an insignificant effect on our financial statements.

3. Stock-Based Compensation

We account for stock-based employee compensation using the intrinsic value method prescribed in Accounting Principles Board ("APB") Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations for all periods presented. Accordingly, compensation cost for stock options issued to employees is measured as the excess, if any, of the fair value of our stock at the date of grant over the amount an employee must pay to acquire the stock.

Had compensation cost for our stock option awards been determined based upon the fair value at the date of grant in accordance with SFAS No. 123, Accounting for Stock-Based Compensation, our net

income (loss) and basic and diluted net income (loss) per share would have been the following amounts (in thousands, except per share information):

		Three Months Ended June 30,						Six Months Ended June 30,
		2002			2003			2002			2003
Net income (loss) attributable to common stockholders as reported		$	(8,882	)	$	2,524		$	(15,062	)	$	955
Stock-based employee compensation expense included in reported net income (loss) attributable to common stockholders			13			5			26			10
Stock-based employee compensation expense determined under fair value based method			(306	)		(530	)		(1,077	)		(1,304	)

Pro forma net income (loss) attributable to common stockholders		$	(9,175	)	$	1,999		$	(16,133	)	$	(339	)

Basic net income (loss) per share:
	As reported	$	(0.36	)	$	0.08		$	(0.61	)	$	0.03
	Pro forma	$	(0.37	)	$	0.06		$	(0.65	)	$	(0.01	)
Diluted net income (loss) per share:
	As reported	$	(0.36	)	$	0.07		$	(0.61	)	$	0.03
	Pro forma	$	(0.37	)	$	0.06		$	(0.65	)	$	(0.01	)

The fair value of each option grant was estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions:

	Six Months Ended June 30,
	2002		2003
Risk free interest rate	3.03	%	2.52	%
Expected dividend yield	—		—
Expected life	5 years		5 years
Expected volatility	105	%	82	%

4. Earnings Per Share

Basic net income (loss) per share is calculated by dividing net income (loss) attributable to common stockholders by the weighted average number of common shares outstanding during the period. Diluted net income (loss) per share reflects the potential dilution of securities by including other common stock equivalents, such as stock options, stock warrants and convertible preferred stock, in the weighted average number of common shares outstanding for a period, if dilutive.

The following table sets forth a reconciliation of the basic and diluted number of weighted average shares outstanding used in the calculation of net income (loss) per share (in thousands):

	Three Months Ended June 30,		Six Months Ended June 30,
	2002	2003	2002	2003
Shares used in computing basic net income (loss) per share	24,913	31,576	24,854	28,877
Dilutive effect of stock options and stock warrants	—	3,464	—	2,843
Dilutive effect of convertible preferred stock	—	629	—	1,234

Shares used in computing diluted net income (loss) per share	24,913	35,669	24,854	32,954

For the three months ended June 30, 2003 and 2002, outstanding options to purchase 290,437 and 3,581,736 shares of our common stock, respectively, and outstanding warrants to purchase 0 and 1,239,527 shares of our common stock, respectively, were not included in the calculation of diluted net income (loss) per share because their effect was antidilutive.

For the six months ended June 30, 2003 and 2002, outstanding options to purchase 480,691 and 3,581,736 shares of our common stock, respectively, and outstanding warrants to purchase 0 and 1,239,527 shares of our common stock, respectively, were not included in the calculation of diluted net income (loss) per share because their effect was antidilutive.

5. Short-Term Investments

The following table summarizes our short-term investments as of June 30, 2003 (in thousands):

	Cost		Net Unrealized Losses		Net Unrealized Gains		Fair Value
U.S. Government securities	$	7,137	$	31	$	7	$	7,113
Commercial paper		2,924		—		8		2,932

	$	10,061	$	31	$	15	$	10,045

The cost and fair value at June 30, 2003 by contractual maturity are shown below (in thousands). Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to prepay obligations without prepayment penalties.

	Cost		Fair Value
Due in one year or less	$	5,492	$	5,477
Due after one year through two years		4,569		4,568

	$	10,061	$	10,045