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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, 2004
 
 
 
 
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 000-29661

 


 

UTSTARCOM, INC.

(Exact name of registrant as specified in its charter)

 

DELAWARE

 

52-1782500

(State of Incorporation)

 

(I.R.S. Employer Identification No.)

 

 

 

1275 HARBOR BAY PARKWAY
ALAMEDA, CALIFORNIA

 

94502

(Address of principal executive offices)

 

(zip code)

 

 

 

Registrant’s telephone number, including area code:  (510) 864-8800

 


 

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 Exchange Act of 1934).  Yes   ý  No   o

 

As of June 30, 2004 there were 113,912,641 shares of the registrant’s common stock outstanding, par value $0.00125.

 

 



 

TABLE OF CONTENTS

 

PART I.

FINANCIAL INFORMATION

 

 

 

 

Item 1.

Condensed Consolidated Financial Statements

 

 

 

 

 

Condensed Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003 (unaudited)

 

 

 

 

 

Condensed Consolidated Statements of Operations for the three and six month periods ended June 30, 2004 and 2003 (unaudited)

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows for the six month periods ended June 30, 2004 and 2003 (unaudited)

 

 

 

 

 

Notes to Condensed Consolidated Financial Statements (unaudited)

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures about Market Risk

 

 

 

 

Item 4.

Controls and Procedures

 

 

 

 

PART II.

OTHER INFORMATION

 

 

 

 

Item 1.

Legal Proceedings

 

 

 

 

Item 2.

Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities

 

 

 

 

Item 3.

Defaults Upon Senior Securities

 

 

 

 

Item 4.

Submission of Matters to a Vote of Security Holders

 

 

 

 

Item 5.

Other Information

 

 

 

 

Item 6.

Exhibits and Reports on Form 8-K

 

 

 

 

 

Signatures

 

 

 

 

 

Exhibit Index

 

 

2



 

PART I—FINANCIAL INFORMATION

 

ITEM 1—CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

UTSTARCOM, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)

(In thousands, except share and per share data)

 

 

 

June 30,
2004

 

December 31,
2003

 

ASSETS

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

484,767

 

$

373,974

 

Short-term investments

 

76,979

 

48,617

 

Accounts receivable, net of allowances for doubtful accounts of $40,317 and $31,172 at June 30, 2004 and December 31, 2003, respectively

 

509,608

 

324,921

 

Accounts receivable, related parties

 

29,884

 

43,944

 

Notes receivable

 

43,392

 

11,362

 

Inventories

 

435,552

 

257,038

 

Deferred costs/Inventories at customer sites under contracts

 

335,640

 

558,977

 

Prepaids

 

117,995

 

136,262

 

Restricted cash and short-term investments

 

42,633

 

24,404

 

Other current assets

 

39,147

 

52,408

 

Total current assets

 

2,115,597

 

1,831,907

 

Property, plant and equipment, net

 

226,009

 

186,076

 

Long-term investments

 

24,504

 

24,066

 

Goodwill

 

113,429

 

100,180

 

Intangible assets, net

 

64,191

 

44,052

 

Other long-term assets

 

47,735

 

40,677

 

Total assets

 

$

2,591,465

 

$

2,226,958

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

389,094

 

$

251,176

 

Income taxes payable

 

28,106

 

16,780

 

Customer advances

 

149,243

 

458,654

 

Deferred revenue

 

49,493

 

44,958

 

Other current liabilities

 

205,137

 

173,139

 

Total current liabilities

 

821,073

 

944,707

 

 

 

 

 

 

 

Convertible subordinated notes

 

402,500

 

402,500

 

Total liabilities

 

1,223,573

 

1,347,207

 

 

 

 

 

 

 

Commitments and contingencies (Note 16)

 

 

 

 

 

Minority interest in consolidated subsidiaries

 

647

 

560

 

Stockholders’ equity:

 

 

 

 

 

Common stock: $0.00125 par value; authorized: 750,000,000 shares; issued and outstanding: 113,912,641 and 104,272,477 at June 30, 2004 and December 31, 2003, respectively

 

143

 

131

 

Additional paid-in capital

 

1,114,632

 

653,624

 

Deferred stock compensation

 

(7,315

)

(7,761

)

Retained earnings

 

255,385

 

229,777

 

Accumulated other comprehensive income

 

4,400

 

3,420

 

Total stockholders’ equity

 

1,367,245

 

879,191

 

Total liabilities, minority interest and stockholders’ equity

 

$

2,591,465

 

$

2,226,958

 

 

See accompanying notes to condensed consolidated financial statements.

 

3



 

UTSTARCOM, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)

(In thousands, except per share data)

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Net sales

 

 

 

 

 

 

 

 

 

Unrelated parties

 

$

668,552

 

$

345,684

 

$

1,279,282

 

$

617,687

 

Related parties

 

21,076

 

60,150

 

32,637

 

118,667

 

 

 

689,628

 

405,834

 

1,311,919

 

736,354

 

 

 

 

 

 

 

 

 

 

 

Cost of sales

 

513,358

 

268,330

 

959,614

 

486,165

 

Gross profit

 

176,270

 

137,504

 

352,305

 

250,189

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Selling, general and administrative

 

67,830

 

34,963

 

134,773

 

72,546

 

Research and development

 

52,592

 

36,078

 

98,250

 

62,890

 

In-process research and development

 

1,400

 

9,328

 

1,400

 

10,648

 

Amortization of intangible assets

 

3,334

 

1,483

 

6,307

 

2,178

 

Total operating expenses

 

125,156

 

81,852

 

240,730

 

148,262

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

51,114

 

55,652

 

111,575

 

101,927

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

1,838

 

699

 

3,191

 

1,642

 

Interest expense

 

(1,139

)

(2,210

)

(2,221

)

(2,849

)

Other income, net

 

4,263

 

154

 

13,048

 

4,340

 

Equity in loss of affiliated companies

 

(1,201

)

(1,745

)

(2,198

)

(2,720

)

Income before income taxes and minority interest

 

54,875

 

52,550

 

123,395

 

102,340

 

Income tax expense

 

10,975

 

13,138

 

24,679

 

25,585

 

Minority interest in earnings (loss) of consolidated subsidiaries

 

(37

)

 

(87

)

 

 

 

 

 

 

 

 

 

 

 

Net income

 

$

43,863

 

$

39,412

 

$

98,629

 

$

76,755

 

 

 

 

 

 

 

 

 

 

 

Basic earnings per share

 

$

0.39

 

$

0.39

 

$

0.86

 

$

0.74

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings per share

 

$

0.33

 

$

0.33

 

$

0.73

 

$

0.65

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares used in per-share calculation:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

- Basic

 

113,773

 

100,698

 

114,193

 

104,009

 

 

 

 

 

 

 

 

 

 

 

- Diluted

 

136,095

 

124,360

 

137,709

 

119,641

 

 

See accompanying notes to condensed consolidated financial statements.

 

4



 

UTSTARCOM, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)

(In thousands)

 

 

 

Six months ended June 30,

 

 

 

2004

 

2003

 

CASH FLOWS FROM OPERATING ACTIVITIES:

 

 

 

 

 

Net income

 

$

98,629

 

$

76,755

 

Adjustments to reconcile net income to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

33,988

 

17,729

 

Non-qualified stock option exercise tax benefits

 

3,541

 

8,231

 

Net loss on sale of assets

 

66

 

690

 

In-process research and development costs

 

1,400

 

10,648

 

Amortization of debt issuance costs

 

1,166

 

777

 

Warrants adjustment to fair value

 

32

 

(158

)

Loss on sale of investment

 

 

73

 

Net  loss on long-term investments

 

469

 

 

Stock compensation expense

 

245

 

3,074

 

Provision for doubtful accounts

 

9,485

 

1,123

 

Inventory provision

 

15,853

 

(8,105

)

Equity in loss of affiliated companies

 

2,198

 

2,720

 

Deferred income taxes

 

(4,546

)

(1,686

)

Minority interest in earnings of consolidated subsidiary

 

87

 

 

Changes in operating assets and liabilities:

 

 

 

 

 

Accounts receivable

 

(179,074

)

(42,259

)

Inventories

 

(192,985

)

(254,076

)

Deferred costs/Inventories at customer sites under contracts

 

223,337

 

(405,853

)

Other current and non-current assets

 

2,112

 

(121,038

)

Accounts payable

 

136,856

 

165,590

 

Income taxes payable

 

11,326

 

(8,122

)

Customer advances

 

(309,772

)

9,188

 

Deferred revenue

 

4,493

 

362,240

 

Other current liabilities

 

22,549

 

26,525

 

Net cash used in operating activities

 

(118,545

)

(155,934

)

CASH FLOWS FROM INVESTING ACTIVITIES:

 

 

 

 

 

Additions to property, plant and equipment

 

(62,466

)

(41,192

)

Investment in affiliates, net of cash acquired

 

(1,000

)

(1,000

)

Purchase of businesses, net of cash acquired

 

(44,711

)

(109,520

)

Proceeds from disposal of property

 

 

21

 

Purchase of intellectual property licenses

 

(3,540

)

 

Change in restricted cash

 

(8,677

)

(4,032

)

Purchase of short-term investments

 

(132,654

)

(37,307

)

Proceeds from sale of short-term investments

 

97,369

 

150,278

 

Net cash used in investing activities

 

(155,679

)

(42,752

)

CASH FLOWS FROM FINANCING ACTIVITIES:

 

 

 

 

 

Issuance of stock, net of expenses

 

17,672

 

34,959

 

Purchase of bond hedge and call option

 

 

(43,792

)

Net proceeds from borrowing

 

 

391,431

 

Repurchase of stock

 

(107,567

)

(139,609

)

Proceeds from stockholder notes

 

 

7

 

Proceeds from equity offering

 

474,554

 

 

NET CASH PROVIDED BY FINANCING ACTIVITIES

 

384,659

 

242,996

 

Effect of exchange rate changes on cash

 

358

 

(276

)

Net increase in cash and cash equivalents

 

110,793

 

44,034

 

CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD

 

373,974

 

231,944

 

CASH AND CASH EQUIVALENTS AT END OF PERIOD

 

$

484,767

 

$

275,978

 

 

See accompanying notes to condensed consolidated financial statements.

 

5



 

UTSTARCOM, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

 

1.                                      BASIS OF PRESENTATION:

 

The accompanying unaudited condensed consolidated financial statements include the accounts of UTStarcom, Inc. (the “Company”) and its wholly and majority owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in the preparation of the condensed consolidated financial statements. The minority interests in consolidated subsidiaries and equity in affiliated companies are shown separately in the condensed consolidated financial statements. Investments in affiliated companies are accounted for using the cost or equity method, as applicable.

 

The accompanying financial statements as of June 30, 2004 and for the three and six months ended June 30, 2004 and 2003 have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. The December 31, 2003 balance sheet was derived from audited financial statements, but does not include all disclosures required by generally accepted accounting principles. These condensed consolidated financial statements should be read in conjunction with the Company’s audited December 31, 2003 financial statements, including the notes thereto, and the other information set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003. Certain reclassifications have been made to prior period balances in order to conform to the current year presentation.

 

In the opinion of management, the accompanying condensed consolidated financial statements reflect all adjustments (consisting of only normal recurring adjustments) considered necessary for a fair presentation of the Company’s financial condition, the results of its operations and its cash flows for the periods indicated. The results of operations for the three and six months ended June 30, 2004 are not necessarily indicative of the operating results for the full year.

 

2.                                      REVENUE RECOGNITION:

 

Revenues from sales of telecommunications equipment are recognized when persuasive evidence of an arrangement exists, delivery of the product has occurred, customer acceptance has been obtained, the fee is fixed or determinable and collectability is reasonably assured. If the payment due from the customer is not fixed or determinable due to extended payment terms, revenue is recognized as payments become due from the customer, assuming all other criteria for revenue recognition are met. Any payments received prior to revenue recognition are recorded as customer advances. Normal payment terms differ for various reasons amongst different customer regions, depending upon common business practices for customers within a region. Shipping and handling costs are recorded as revenues and costs of revenues. Any expected losses on contracts are recognized immediately.

 

Sales may be generated from complex contractual arrangements that require significant revenue recognition judgments, particularly in the areas of multiple element arrangements. Where multiple elements exist in an arrangement, the arrangement fee is allocated to the different elements based upon verifiable objective evidence of the fair value of the elements, as governed under EITF 00-21, and SEC Staff Accounting Bulletin No. 104 “SAB 104.” Multiple element arrangements primarily involve the sale of Personnel Access Systems (“PAS”), a family of wireless access handsets, wireless consumer products and core infrastructure equipment or Internet Protocol-based PAS (“iPAS”) wireless access systems that employ micro cell radio technology and specialized handsets, allowing service providers to offer subscribers both mobile and fixed access to telephone services. These multiple element arrangements include the sale of PAS or iPAS equipment with handsets, installation and training and the provision of such equipment to different locations for the same customer. Revenue is recognized as each element is earned, namely upon installation and acceptance of equipment or delivery of handsets, provided that the fair value of the undelivered element(s) has been determined, the delivered element has stand-alone value, there is no right of return on delivered element(s), and the vendor is in control of the undelivered element(s).

 

Final acceptance is required for revenue recognition when installation services are not considered perfunctory. Final acceptance indicates that the customer has fully accepted delivery of equipment and the Company is entitled to the full payment. The Company will not recognize revenue before final acceptance is granted by the customer if acceptance is considered substantive to the transaction. Additionally, the Company does not recognize revenue when cash payments are received from customers for transactions that do not have the customer’s final acceptance. The Company records these cash receipts as customer ad vances, and defers revenue recognition until final acceptance is received.

 

Where multiple elements exist in an arrangement that includes software and the software is considered more than incidental to the equipment or services in the arrangement, software and software-related elements are recognized under the

 

6



 

provisions of Statement of Position 97-2, as amended, and Emerging Issues Task Force Issue No. 03-05. The Company allocates revenues to each element of software arrangements based on vendor-specific objective evidence (“VSOE”). VSOE of each element is based on the price charged when the same element is sold separately. The Company uses the residual method to recognize revenue when an arrangement includes one or more elements to be delivered at a future date and VSOE of the fair value of all the undelivered elements exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. If evidence of fair value of one or more undelivered elements does not exist, revenue is deferred and recognized when delivery of those elements occurs or when fair value can be established.

 

The Company recognizes revenue for system integration, installation and training upon completion of performance if all other revenue recognition criteria are met. Other service revenue, such as that related to maintenance and support contracts, is recognized ratably over the contract term. Revenues from services were less than 10% of revenues for all periods.

 

The Company also sells products through resellers. Revenue is generally recognized when the standard price protection period, which ranges from 30 to 90 days, has lapsed. If collectability cannot be reasonably assured in a reseller arrangement, revenue is recognized upon sell-through to the end customer and receipt of cash. There may be additional obligations in reseller arrangements such as inventory rotation, or stock exchange rights on the product. As such, revenue is recognized in accordance with Statement of Financial Accounting Standards No. 48 “Revenue Recognition When Right of Return Exists” (“SFAS 48”). The Company has developed reasonable estimates for stock exchanges. Estimates are derived from historical experience with similar types of sales of similar products.

 

The assessment of collectability is also a factor in determining whether revenue should be recognized. The Company assesses collectability based on a number of factors, including payment history and the credit-worthiness of the customer. The Company does not request collateral from its customers. In international sales, the Company often requires letters of credit from its customers that can be drawn on demand if the customer defaults on its payment. If the Company determines that collection of a payment is not reasonably assured, the Company recognizes revenue at the time collection becomes reasonably assured, which is generally upon receipt of cash.

 

Because of the nature of doing business in China and other emerging markets, the Company’s billings and/or customer payments may not correlate with the contractual payment terms and the Company generally does not enforce contractual payment terms prior to final acceptance. Accordingly, accounts receivable are not booked until the Company recognizes the related customer revenue.  Advances from customers are recognized when the Company has collected cash from the customer, prior to recognizing revenue. Deferred revenue is recorded if there are undelivered elements after final acceptance has been obtained.

 

The Company provides a warranty on its equipment and handset sales for a period generally ranging from one to three years from the time of final acceptance. The Company provides for the expected cost of product warranties at the time that revenue is recognized, based on an assessment of past warranty experience.

 

3.                                      EARNINGS PER SHARE:

 

Basic earnings per share is computed by dividing net income available to holders of common stock by the weighted average number of shares of the Company’s common stock outstanding during the period. Diluted earnings per share is determined by adjusting net income as reported by the effect of dilutive securities and increasing the number of shares by potentially dilutive shares of common stock outstanding during the period. Potentially dilutive shares of common stock consist of employee stock options, a written call option, warrants, convertible subordinated notes and unvested acquisition-related stock options.

 

The following is a summary of the calculation of basic and diluted earnings per share (in thousands, except per share data):

 

7



 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

Numerator:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (for basic EPS computation)

 

$

43,863

 

$

39,412

 

$

98,629

 

$

76,755

 

 

 

 

 

 

 

 

 

 

 

Effect of Dilutive Securities

 

 

 

 

 

 

 

 

 

7/8% Convertible Subordinated Notes

 

884

 

1,092

 

1,798

 

1,375

 

 

 

 

 

 

 

 

 

 

 

Net income adjusted for dilutive securities

 

$

44,747

 

$

40,504

 

$

100,427

 

$

78,130

 

 

 

 

 

 

 

 

 

 

 

Denominator:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shares used to compute basic EPS

 

113,773

 

100,698

 

114,193

 

104,009

 

Dilutive common stock equivalent shares:

 

 

 

 

 

 

 

 

 

Stock options

 

5,010

 

6,086

 

5,668

 

4,823

 

Written call option

 

 

 

523

 

 

Conversion of convertible subordinated notes

 

16,919

 

16,919

 

16,919

 

10,151

 

Warrants

 

5

 

29

 

17

 

29

 

Unvested acquisition-related stock

 

388

 

628

 

389

 

629

 

Shares used to compute diluted EPS

 

136,095

 

124,360

 

137,709

 

119,641

 

Basic earnings per share

 

$

0.39

 

$

0.39

 

$

0.86

 

$

0.74

 

Diluted earnings per share

 

$

0.33

 

$

0.33

 

$

0.73

 

$

0.65

 

 

8



 

Certain potential shares related to employee stock options and warrants outstanding during the three and six months ended June 30, 2004 and 2003 were excluded in the diluted per share computations, since their exercise prices were greater than the average market price of the Company’s common stock during the period and, accordingly, their effect is anti-dilutive. For the three months ended June 30, 2004 and 2003, these shares totaled 2.0 million with a weighted average exercise price of $36.56 per share and 1.9 million shares with a weighted average exercise price of $28.67 per share, respectively. For the six months ended June 30, 2004 and 2003, these shares totaled 1.8 million with a weighted average exercise price of $37.49 per share and 3.2 million shares with a weighted average exercise price of $26.89 per share, respectively. 

 

On June 30, 2004, each of the Company’s 7/8% convertible subordinated notes outstanding was eligible for conversion into shares of common stock. For each $1,000 of aggregate principal amount of notes converted, the Company will deliver approximately 42.0345 shares of common stock, if the Company’s stock price exceeds a specified threshold of $26.10. At June 30, 2004, the closing price of the Company’s common stock exceeded the specified threshold, which had the effect of increasing the denominator for diluted earnings per share by 16.9 million.  In the June 30, 2003 10-Q, the earnings per share calculation for the six months ended June 30, 2003 was calculated as if the convertible bond had been outstanding for the entire six months rather than for the period from issuance on March 12, 2003 through June 30, 2003.  This calculation was corrected in the September 30, 2003 10-Q filing.  As a result, in this filing, the calculation of the weighted average number of dilutive shares attributable to the convertible bond for the six months ended June 30, 2003 decreased from 16.9 million to 10.2 million shares resulting in an increase in the June 30, 2003 dilutive earnings per share of three cents from $0.62 per share to $0.65 per share.  The Company entered into convertible bond hedge and call option transactions to reduce the potential dilution from conversion of the notes. Both the bond hedge and call option transactions may be settled at the Company’s option either in cash or net shares and expire on March 1, 2008.

 

Additionally, during the three months ended June 30, 2004, the average price of the Company’s stock exceeded the specified strike price of the convertible bond hedge that the Company entered into to reduce the potential dilution from conversion of the notes. Using the treasury stock method, under Statement of Financial Accounting Standards No. 128, “Earnings Per Share” (“SFAS 128”), this would have the effect of decreasing the denominator for diluted earnings per share by 2.9 million for the three months ended June 30, 2004. This would have the effect of decreasing the denominator for diluted earnings per share by 1.6 million for the three months ended June 30, 2003.

 

For the six months ended June 30, 2004, the dilutive and anti-dilutive effects of the call option and the bond hedge were derived by taking the weighted average effects of the first and second quarters, in accordance with SFAS 128. For the six months ended June 30, 2004, this would have the effect of decreasing the denominator for diluted earnings per share by 4.0 million shares for the bond hedge transaction, and increasing the denominator for diluted earnings per share by 0.5 million shares for the call option transaction. For the six months ended June 30, 2003, this would have the effect of decreasing the denominator for diluted earnings per share by 0.8 million shares for the bond hedge transaction. However, only the dilutive effect of the 0.5 million shares with respect to the call option transaction was included in the Company’s diluted earnings per share calculation above. The convertible bond hedge, under SFAS 128, is always anti-dilutive.

 

The net income for the diluted EPS computation reflects the reduction in interest expense of $0.9 million and $1.8 million for the three and six months ended June 30, 2004, respectively, that would result from an assumed conversion of the 7/8% convertible subordinated notes. The net income for the diluted EPS computation reflects the reduction in interest expense of $1.1 million and $1.4 million for the three and six months ended June 30, 2003, respectively, that would result from an assumed conversion of the 7/8% convertible subordinated notes.

 

4.                                      STOCK-BASED COMPENSATION:

 

The Company accounts for employee stock option grants in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB 25”) and has adopted the disclosure-only alternative of SFAS No. 123, as amended by SFAS No. 148, “Accounting for Stock- Based Compensation” (“SFAS 123”). Under APB 25, compensation expense is based on the difference, if any, on the date of grant between the fair value of the common stock and the exercise price of the option.

 

The fair value of warrants, options or stock exchanged for services from non-employees is expensed over the period benefited. The warrants and options are valued using the Black-Scholes option-pricing model.

 

9



 

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock-based employee compensation (in thousands, except per share data):

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

Basic

 

 

 

 

 

 

 

 

 

Net income:

 

 

 

 

 

 

 

 

 

As reported

 

$

43,863

 

$

39,412

 

$

98,629

 

$

76,755

 

 

 

 

 

 

 

 

 

 

 

Add:  Stock-based employee compensation expense included  in reported net income, net of related tax effects

 

120

 

1,681

 

175

 

2,181

 

 

 

 

 

 

 

 

 

 

 

Deduct: Total compensation expense determined under fair value based method for all awards, net of related tax effects

 

(9,092

)

(7,786

)

(17,057

)

(14,202

)

 

 

 

 

 

 

 

 

 

 

Pro forma net income

 

$

34,891

 

$

33,307

 

$

81,747

 

$

64,734

 

 

 

 

 

 

 

 

 

 

 

Basic income per share:

 

 

 

 

 

 

 

 

 

As reported

 

$

0.39

 

$

0.39

 

$

0.86

 

$

0.74

 

Pro forma

 

$

0.31

 

$

0.33

 

$

0.72

 

$

0.62

 

 

 

 

 

 

 

 

 

 

 

Diluted

 

 

 

 

 

 

 

 

 

Net income:

 

 

 

 

 

 

 

 

 

As reported

 

$

43,863

 

$

39,412

 

$

98,629

 

$

76,755

 

 

 

 

 

 

 

 

 

 

 

Effect of dilutive securities

 

 

 

 

 

 

 

 

 

7/8% Convertible subordinated notes

 

884

 

1,092

 

1,798

 

1,375

 

 

 

 

 

 

 

 

 

 

 

Add:  Stock-based employee compensation expense included  in reported net income, net of related tax effects

 

120

 

1,681

 

175

 

2,181

 

 

 

 

 

 

 

 

 

 

 

Deduct: Total compensation expense determined under fair value based method for all awards, net of related tax effects

 

(9,092

)

(7,786

)

(17,057

)

(14,202

)

 

 

 

 

 

 

 

 

 

 

Pro forma net income

 

$

35,775

 

$

34,399

 

$

83,545

 

$

66,109

 

 

 

 

 

 

 

 

 

 

 

Diluted income per share:

 

 

 

 

 

 

 

 

 

As reported

 

$

0.33

 

$

0.33

 

$

0.73

 

$

0.65

 

Pro forma

 

$

0.27

 

$

0.29

 

$

0.62

 

$

0.57

 

 

5.                                      COMPREHENSIVE INCOME:

 

The reconciliation of net income to comprehensive income for the three and six months ended June 30, 2004 and 2003 is as follows (in thousands):

 

10



 

 

 

Three Months Ended June 30,

 

Six Months Ended June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

Net income

 

$

43,863

 

$

39,412

 

$

98,629

 

$

76,755

 

Unrealized gains (losses) on investments

 

712

 

609

 

479

 

1,183

 

Change in cumulative translation adjustments

 

(173

)

(10

)

501

 

(44

)

Total comprehensive income

 

$

44,402

 

$

40,011

 

$

99,609

 

$

77,894

 

 

6.                                      CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS:

 

Cash and cash equivalents consist of instruments with maturities of three months or less at the date of purchase. There were no available-for-sale securities included in cash and cash equivalents at June 30, 2004 or December 31, 2003. Short-term investments, consisting entirely of available-for-sale securities, were $77.0 million and $48.6 million at June 30, 2004 and December 31, 2003, respectively. These available-for-sale securities consist of government-backed notes, commercial paper, floating rate corporate bonds and fixed income corporate bonds. These investments are recorded at fair value. Any unrealized holding gains or losses are reported as a component of comprehensive income. Realized gains and losses are reported in earnings.

 

The Company accepts bank notes receivable with maturity dates between three and six months from its customers in China in the normal course of business. Bank notes receivable were $100.0 million and $11.5 million at June 30, 2004 and December 31, 2003, respectively, and have been included in cash and cash equivalents and short-term investments. The Company may discount these notes with banking institutions in China. A sale of these notes is reflected as a reduction of cash and cash equivalents or short-term investments and the proceeds of the settlement of these notes are included in cash flows from operating activities in the consolidated statement of cash flows. There were no bank notes receivable sold during the three and six months ended June 30, 2004; there were $82.3 million and $111.3 million of bank notes receivable sold during the three and six months ended June 30, 2003, respectively.  Any notes that have been sold are not included in the Company’s consolidated balance sheets as the criteria for sale treatment established by Statement of Financial Accounting Standards No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities” (“SFAS 140”), has been met. Under SFAS 140, upon a transfer, the transferor or entity must derecognize financial assets when control has been surrendered and the transferee obtains control over the assets. In addition, the transferred assets have been isolated from the transferor, beyond the reach of its creditors, and the transferee has the right, without conditions or constraints, to pledge or exchange the assets it has received. The costs of settling or transferring these notes receivable were $0.4 million for both the three and six months ended June 30, 2003.

 

7.                                      RESTRICTED CASH AND SHORT-TERM INVESTMENTS:

 

At June 30, 2004, the Company had restricted cash and short-term investments of $42.6 million primarily comprised of $27.4 million of restricted short-term investments and $8.5 million of restricted cash for standby letters of credit, $2.9 million of restricted cash held in escrow as it relates to the Company’s acquisition of TELOS and restricted cash of a $3.7 million time deposit required for Japanese tax purposes.  At December 31, 2003, the Company had restricted cash and short-term investments of $24.4 million primarily comprised of $20.5 million of restricted short-term investments for standby letters of credit and restricted cash of a $3.7 million time deposit required for Japanese tax purposes.

 

The Company issues standby letters of credit primarily to support international sales activities outside of China. When the Company submits a bid for a sale, often the potential customer will require that the Company issue a bid bond or a standby letter of credit to demonstrate its commitment through the bid process.  In addition, the Company may be required to issue standby letters of credit as guarantees for advance customer payments upon contract signing or performance guarantees. The standby letters of credit usually expire six to nine months from date of issuance without being drawn by the beneficiary thereof. Finally, the Company may issue commercial letters of credit in support of purchase commitments.

 

8.                                      ACCOUNTS AND NOTES RECEIVABLE:

 

The Company accepts commercial notes receivable with maturity dates between three and six months from its customers in China in the normal course of business. Notes receivable available for sale were $42.9 million and $11.4 million at June 30, 2004 and December 31, 2003, respectively. The Company may discount these notes with banking institutions in China. A sale of these notes is reflected as a reduction of notes receivable and the proceeds of the settlement of these notes are included in cash flows from operating activities in the consolidated statement of cash flows. There were no notes receivable sold during the three and six months ended June 30, 2004; there were $25.3 million and $44.5 million of notes receivable sold during the three and six months ended June 30, 2003, respectively.  Any notes that have been sold are not included in the Company’s consolidated balance sheets as the criteria for sale treatment established by SFAS 140, has been met. The costs of settling or transferring these notes receivable were $0.3 million and $0.5 million for the three and six months ended June 30,

 

11



 

2003, respectively, and were included in other income, net in the Consolidated Statements of Operations.

 

9.                                      SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:

 

 

 

Six months ended June 30,

 

(in thousands)

 

2004

 

2003

 

 

 

 

 

 

 

Cash paid during the period for:

 

 

 

 

 

Interest

 

$

1,773

 

$

508

 

Income taxes

 

$

3,818

 

$

21,606

 

 

 

 

Six months ended June 30,

 

(in thousands)

 

2004

 

2003

 

Non-cash operating activities were as follows:

 

 

 

 

 

Accounts receivable transferred to notes receivable

 

$

55,876

 

$

25,258

 

 

10.                               INVENTORIES AND DEFERRED COSTS/INVENTORIES AT CUSTOMER SITES UNDER CONTRACTS:

 

As of June 30, 2004 and December 31, 2003, total inventories and deferred costs/inventories at customer sites under contracts consist of the following:

 

 

 

June 30,

 

December 31,

 

 

 

2004

 

2003

 

 

 

(in thousands)

 

Inventories

 

 

 

 

 

Raw materials

 

$

164,601

 

$

66,753

 

Work-in-process

 

84,461

 

51,116

 

Finished goods

 

63,827

 

48,206

 

Inventories at customer sites without contracts

 

122,663

 

90,963

 

 

 

$

435,552

 

$

257,038

 

 

 

 

 

 

 

Deferred costs/Inventories at customer sites under contracts

 

$

335,640

 

$

558,977

 

 

11.                               ACQUISITIONS

 

TELOS Technology, Inc.

 

On May 19, 2004, the Company completed its acquisition of substantially all of the assets and certain liabilities of TELOS Technology, Inc. (“TELOS”) and its subsidiaries.  TELOS is a provider of mobile switching products and services for voice and data communication networks to developing rural, enterprise and emerging wireless markets. The total consideration for the acquisition, funded from cash on hand, was approximately $30.3 million.  The Company paid $29.0 million in cash, in addition to $1.3 million of acquisition-related transaction costs. Within one year of the acquisition date, additional payments totaling a maximum of $19.0 million may become payable based upon revenue recognized from the sale of TELOS products. In the event these revenue milestones are met, the original purchase price will be adjusted for the amount of the contingent payment in accordance with Statement of Financial Accounting Standards No. 141 (“SFAS 141”), “Business Combinations.”

 

The existing technology acquired included the entire TELOS product family of code division multiple access (or “CDMA”) softswitch technology products, supporting servers and operations maintenance centers. CDMA technology is the common platform on which third-generation wireless data services and applications are built. By assigning unique codes to each communication to differentiate it from others in the same spectrum, CDMA technology allows many users to occupy the same time and frequency allocations in a given band or space. The TELOS product line will be integrated with the Company’s suite of CDMA products, strengthening the Company’s existing CDMA product portfolio. In addition to developed product technology, the Company acquired fixed assets, in-process research and development (“IPR&D”), an

 

12



 

assembled workforce of approximately 60 employees, customer relationships and recorded goodwill.

 

Subsequent to the May 19, 2004 acquisition of TELOS, the Company completed the allocation of the purchase price based in part upon an independent valuation. The amount of the purchase price allocated to IPR&D of $1.4 million was charged to the Company’s results of operations, as no alternative future uses existed at the acquisition date. The Company recorded goodwill of $6.6 million in connection with the acquisition. The results of operations of TELOS have been included in the Company’s consolidated results of operations beginning on the acquisition date of May 19, 2004.

 

In assessing TELOS’s IPR&D projects, the Company considered key product characteristics including the product’s development stage at the acquisition date, the product’s life cycle and the product’s future prospects. The Company also considered the rate at which technology changes in the telecommunications equipment industry, the industry’s competitive environment and the economic outlook for both local and global markets.

 

As of the acquisition date, TELOS had two projects under development that qualified for IPR&D: the Sonata SE product family and the iCell product. The objective of both projects is to enhance the functionality of products designed to comply with the CDMA2000 technology standard. Specifically, the objective of the Sonata SE product family is to provide additional features to operation maintenance center products. The objective of the iCell product is to enhance iCell base station features.

 

The projects under development are enhancements to existing products that do not affect the functionality of those existing products. As such, the significant risk the Company faces is to complete these projects within the scope of the budget. As of the closing date, the Sonata SE and the iCell projects were approximately 20% and 30% complete, respectively.  As of June 30, 2004, anticipated completion dates and estimated costs to complete the Sonata SE and iCell projects were June 2005 and $1.1 million and December 2004 and $0.2 million, respectively.

 

The following table summarizes the allocation of the purchase price for TELOS based upon the independent valuation:

 

 

 

May 19, 2004

 

 

 

(in thousands)

 

Fair value of tangible net assets

 

 

 

Inventory

 

$

1,382

 

Property, plant and equipment

 

2,010

 

Other tangible assets

 

1,369

 

Customer relationships

 

5,000

 

Existing technology

 

15,900

 

In-process research and development

 

1,400

 

Liabilities assumed

 

(3,380

)

Excess of costs of acquiring TELOS over fair value of identified net assets acquired (goodwill)

 

6,625

 

 

 

 

 

 

 

$

30,306

 

 

The estimated useful lives of the customer relationships and existing technology intangible assets are five years.

 

Refer to the consolidated table below for the pro forma results of operations reflecting the combined results of the Company and TELOS for the three and six months ended June 30, 2004 and 2003 as if the business combination occurred at the beginning of the period.  These results do not purport to be indicative of what would have occurred had the acquisition been made as of that date or the results of operations which may occur in future periods.

 

Hyundai Syscomm, Inc.

 

On April 27, 2004, the Company completed its acquisition of the assets, substantially all of the intellectual property, certain employees and certain contracts related to Hyundai Syscomm, Inc.’s (“HSI”) CDMA infrastructure business for markets outside of Korea.  Subject to the attainment of certain milestones and the transfer of certain know-how, the total

 

13



 

consideration for this transaction was approximately $12.3 million excluding transaction costs of $1.8 million. There was $7.3 million in cash payable at the closing date and an additional $3.0 million in cash payable one year from the closing date. The remaining purchase price was comprised of $2.0 million payable upon the completion of technical training by HSI employees to Company manufacturing staff in China under the terms of a Training Services Agreement and $1.8 million of transaction costs. Not included in the purchase price was $2.0 million payable upon the completion of certain revenue milestones. In the event these revenue milestones are met, the original purchase price will be adjusted for the amount of the contingent payment in accordance with Statement of Financial Accounting Standards No. 141 (“SFAS 141”), “Business Combinations.” In conjunction with this transaction, the Company loaned HSI $3.2 million at an effective interest rate of 12% per annum, which was used by HSI to satisfy outstanding debt obligations. The principal amount of the loan is due in April 2005. The Company may contractually offset HSI’s payment obligations against the outstanding $3.0 million of the purchase price and any other liabilities.

 

Under the terms of the transaction with HSI, the Company acquired existing technologies and entered into non-compete and licensing agreements. The existing technologies acquired were the base transceiver station (“BTS”) and base station controllers (“BSC”) product lines.  BTS is the antenna and radio equipment that enables wireless devices to communicate with a land-based transmission network in a given range. BSC performs radio signal management functions for BTS, managing functions such as frequency assignment and handoff. As part of the asset purchase agreement, the Company and HSI entered into a training services agreement, whereby HSI employees will provide technical training to Company manufacturing staff in China for the sixth-month period subsequent to the acquisition. This technology and technological know-how will strengthen the Company’s existing CDMA product portfolio and the development of future CDMA technology.

 

In addition to acquiring existing technology, the Company entered non-compete and licensing agreements.  The non-compete agreement prohibits HSI from competing against the Company in all countries except Korea for three years from the valuation date. The licensing agreement requires that HSI pay the Company 1% of revenue as royalty for the usage of the intellectual property that the Company acquired under the terms of the acquisition for fifteen years subsequent to the valuation date.

 

Subsequent to the April 27, 2004 acquisition of HSI, the Company completed the allocation of the purchase price based in part upon an independent valuation. The Company recorded goodwill of $6.8 million in connection with the acquisition. The results of operations of HSI have been included in the Company’s consolidated results of operations beginning on the acquisition date of April 27, 2004.

 

The following table summarizes the final allocation of the purchase price for HSI based upon the final independent valuation:

 

 

 

April 27, 2004

 

 

 

(in thousands)

 

Fair value of tangible net assets

 

 

 

Property, plant and equipment

 

$

1,440

 

Other tangible assets

 

673

 

Existing technology

 

3,559

 

Non-compete intangible asset

 

760

 

IP license agreement

 

890

 

Excess of costs of acquiring HSI over fair value of identified net assets acquired (goodwill)

 

6,750

 

 

 

 

 

 

 

$

14,072

 

 

The intangible assets have estimated useful lives ranging from three to five years as follows: existing technology, five years; non-compete agreement, three years; intellectual property license agreement, three years.

 

Refer to the consolidated table below for pro forma results of operations reflecting the combined results of the Company and HSI for the three and six months ended June 30, 2004 and 2003 as if the business combination occurred at the beginning of the period.  These results do not purport to be indicative of what would have occurred had the acquisition been made as of that date or the results of operations which may occur in future periods.

 

14



 

The pro forma results of operations include historical operations of the Company, TELOS and HSI. Certain non-recurring charges were recorded by TELOS and included $2.3 million of expense for warrants issued in conjunction with an issuance of senior convertible notes in the second quarter of 2003 and $0.1 million of restructuring costs incurred in the first quarter of 2003.

 

 

 

UT Starcom, Inc.

 

TELOS Technology, Inc.

 

Hyundai Syscomm, Inc.

 

Pro Forma adjustments to
reflect depreciation and
amortization of acquired assets

 

Pro Forma Results

 

(In thousands,
except per share

 

Three Months
Ended
June 30,

 

Three Months
Ended
June 30,

 

For the period
from April 1
to May 19,

 

Three Months
Ended
June 30,

 

For the period
from April 1
to April 27,

 

Three Months
Ended
June 30,

 

Three Months
Ended
June 30,

 

Three Months
Ended
June 30,

 

Three Months
Ended
June 30,

 

Three Months
Ended
June 30,

 

data)

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Pro forma adjusted net revenue

 

$

689,628

 

$

405,834

 

$

364

 

$

510

 

$

953

 

$

5,780

 

 

 

 

 

$

690,945

 

$

412,124

 

Pro forma adjusted net income (loss)

 

$

43,863

 

$

39,412

 

$

(1,695

)

$

(3,095

)

$

(276

)

$

(2,134

)

$

(792

)

$

(1,331

)

$

41,100

 

$

32,852

 

Pro forma adjusted basic earnings (loss) per share

 

$

0.39

 

$

0.39

 

 

 

 

 

 

 

 

 

 

 

 

 

$

0.36

 

$

0.33

 

Pro forma adjusted diluted earnings (loss) per share

 

$

0.33

 

$

0.33

 

 

 

 

 

 

 

 

 

 

 

 

 

$

0.31

 

$

0.27

 

 

 

 

UT Starcom, Inc.

 

TELOS Technology, Inc.

 

Hyundai Syscomm, Inc.

 

Pro Forma adjustments to
reflect depreciation and
amortization of acquired assets

 

Pro Forma Results

 

 

 

Six Months

 

Six Months

 

For the period

 

Six Months

 

For the period

 

Six Months

 

Six Months

 

Six Months

 

Six Months

 

Six Months

 

(In thousands,

 

Ended

 

Ended

 

from January 1

 

Ended

 

from January 1

 

Ended

 

Ended

 

Ended

 

Ended

 

Ended

 

except per

 

June 30,

 

June 30,

 

to May 19,

 

June 30,

 

to April 27,

 

June 30,

 

June 30,

 

June 30,

 

June 30,

 

June 30,

 

share data)

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Pro forma adjusted net revenue

 

$

1,311,919

 

$

736,354

 

$

1,689

 

$

1,842

 

$

2,872

 

$

11,252

 

 

 

 

 

$

1,316,480

 

$

749,448

 

Pro forma adjusted net income (loss)

 

$

98,629

 

$

76,755

 

$

(3,953

)

$

(6,177

)

$

(4,548

)

$

(7,518

)

$

(2,123

)

$

(2,662

)

$

88,005

 

$

60,398

 

Pro forma adjusted basic earnings (loss) per share

 

$

0.86

 

$

0.74

 

 

 

 

 

 

 

 

 

 

 

 

 

$

0.77

 

$

0.58

 

Pro forma adjusted diluted earnings (loss) per share

 

$

0.73

 

$

0.65

 

 

 

 

 

 

 

 

 

 

 

 

 

$

0.65

 

$

0.52

 

 

15



 

Audiovox Communications, Inc.

 

On June 14, 2004, the Company announced an agreement to acquire select assets of Audiovox Communications Corporation, the wireless handset division of Audiovox Corporation. The Company will acquire select assets and liabilities, including inventories, prepaids, third-party payables, accrued expenses and the right to hire approximately 270 employees for $165.1 million in cash. The Company will acquire Audiovox Communications Corporation’s sales, service and support infrastructure, its CDMA handset brand, access to supply-chain channels, product marketing expertise and key relationships with CDMA operators in North and South America. Closing of the transaction is subject to satisfaction of certain conditions outlined in the purchase agreement. The Company anticipates closing to occur in the fourth quarter of 2004.

 

12.                               GOODWILL AND INTANGIBLE ASSETS:

 

As of June 30, 2004 and December 31, 2003, goodwill and other acquired intangible assets consisted of the following (in thousands):

 

(in thousands)

 

June 30, 2004

 

December 31, 2003

 

 

 

 

 

 

 

Goodwill

 

$

126,252

 

$

113,003

 

Less accumulated amortization

 

(12,823

)

(12,823

)

 

 

$

113,429

 

$

100,180

 

 

 

 

 

 

 

Identified intangible assets:

 

 

 

 

 

 

 

 

 

 

 

Existing technology

 

$

43,089

 

$

23,630

 

Less accumulated amortization

 

(10,630

)

(7,254

)

 

 

$

32,459

 

$

16,376

 

 

 

 

 

 

 

Customer relationships

 

$

32,820

 

$

27,820

 

Less accumulated amortization

 

(3,097

)

(1,623

)

 

 

$

29,723

 

$

26,197

 

 

 

 

 

 

 

Trade names

 

$

940

 

$

940

 

Less accumulated amortization

 

(509

)

(274

)

 

 

$

431

 

$

666

 

 

 

 

 

 

 

Backlog

 

$

1,950

 

$

1,950

 

Less accumulated amortization

 

(1,950

)

(1,137

)

 

 

$

 

$

813

 

 

 

 

 

 

 

Non-compete agreement

 

$

760

 

$

-

 

Less accumulated amortization

 

(42

)

 

 

 

$

718

 

$

 

 

 

 

 

 

 

Royalty licenses

 

$

890

 

$

-

 

Less accumulated amortization

 

(30

)

 

 

 

$

860

 

$

 

 

 

 

 

 

 

Total intangible assets

 

$

64,191

 

$

44,052

 

 

Amortization expense was $3.5 million and $1.5 million for the three months ended June 30, 2004 and 2003, respectively, and was $6.0 million and $2.2 million for the six months ended June 30, 2004 and 2003, respectively. The estimated aggregate amortization expense for intangibles for each of the five years beginning the year ended December 31, 2005 through 2009 is $12.1 million, $11.0 million, $10.8 million, $9.0 million and $4.8 million.

 

16



 

The net increase in goodwill during the six months ended June 30, 2004 was $13.3 million, due to a $13.4 million increase from $6.6 million and $6.8 million of goodwill recorded on the acquisitions of TELOS and HSI, respectively, offset by a $0.1 million reduction in goodwill resulting from the settlement of an outstanding liability related to the CommWorks acquisition for $0.1 million less than had been accrued. Intangibles increased by $26.1 million during the six months ended June 30, 2004 due to $20.9 million and $5.2 million of intangibles recorded on the acquisitions of TELOS and HSI, respectively. 

 

The estimated useful life of purchased technology is from one to five years, the estimated useful life of customer relationships is five years to ten years, the estimated useful life of non-compete agreements is three years, the estimated useful lives of backlog and trade names are from one to two years and the estimated useful lives of royalty licenses are five years.

 

13.                               LONG-TERM INVESTMENTS:

 

The Company’s investments are as follows (in thousands):

 

 

 

June 30, 2004

 

December 31, 2003

 

Softbank China

 

$

5,294

 

$

5,308

 

Cellon International

 

8,000

 

8,000

 

Restructuring Fund No. 1

 

1,838

 

1,861

 

Global Asia Partners L.P.

 

1,150

 

1,653

 

Fiberxon Inc.

 

3,000

 

2,000

 

InterWave Communications International Ltd.

 

3,678

 

3,319

 

Joint Venture with Matsushita

 

 

517

 

Others

 

1,544

 

1,408

 

 

 

 

 

 

 

Total

 

$

24,504

 

$

24,066

 

 

Softbank China

 

The Company has a $5.3 million investment in Softbank China, an investment fund established by SOFTBANK CORP. focused on investments in Internet companies in China. This investment is intended to enable the Company to participate in the anticipated growth of Internet-related businesses in China. SOFTBANK CORP. and its related companies are significant stockholders of the Company. The Company’s investment constitutes 10% of the funding for Softbank China, with SOFTBANK CORP. contributing the remaining 90%. The fund has a separate management team, and none of the Company’s employees are employed by the fund. Many of the fund’s investments are and will be in privately held companies, many of which are still in the start-up or development stages. These investments are inherently risky as the markets for the technologies or products the companies have under development are typically in the early stages and may never materialize. The Company accounts for this investment under the cost method and recorded no losses and insignificant losses in the carrying value of this investment during the three and six months ended June 30, 2004, respectively. The Company recorded insignificant losses and losses of $0.1 million due to an other-than-temporary decline in the carrying value of this investment during the three and six months ended June 30, 2003, respectively.

 

Cellon

 

In September 2001, the Company invested $2.0 million in Cellon International Holdings Corporation (“Cellon”).  Cellon designs wireless terminals and related technology for handset manufacturers and private distributors. The Company invested an additional $3.0 million in each of April and December 2002. As of June 30, 2004, the Company had a 9% ownership interest in Cellon. This investment is accounted for under the cost method, and its carrying value is evaluated for possible impairment based on the achievement of business objectives and milestones, the financial condition and prospects of the company and other relevant factors. As of June 30, 2004, the Company has not recorded any impairment of this investment. The Company has outstanding purchase commitments with Cellon. Refer to Note 19, Related Party Transactions.

 

Restructuring Fund No. 1

 

During fiscal 2002, the Company invested $2.0 million in Restructuring Fund No. 1, a venture capital investment limited partnership established by SOFTBANK INVESTMENT CORP., an affiliate of SOFTBANK CORP. SOFTBANK

 

17



 

America Inc., an entity affiliated with SOFTBANK CORP., is a significant stockholder of the Company. The fund focuses on leveraged buyout investments in companies in Asia undergoing restructuring or bankruptcy procedures. The total fund offering is expected to be between approximately $150.0 million and $226.0 million, with each investor contributing a minimum of $0.8 million. The fund has a separate management team, and none of the Company’s employees are employed by the fund. The Company accounts for this investment under the equity method of accounting.  There were no gains or losses and insignificant losses during the three and six months ended June 30, 2004, respectively.

 

Global Asia Partners, L.P.

 

In June 2002, the Company invested $1.0 million in Global Asia Partners L.P., and an additional $1.0 million in June 2003, with a commitment to invest up to a maximum of $5.0 million. The remaining amount is due at such times and in such amounts as shall be specified in one or more future capital calls to be issued by the general partner. The fund size is anticipated to be $10.1 million and the fund was formed to make private equity investments in private or pre-IPO technology and telecommunications companies. The fund’s geographic focus is on technology investments in Asia, in particular India and China. The Company accounts for this investment under the equity method of accounting. There were $0.5 million of losses for the three and six months ended June 30, 2004 and no gains or losses for the three and six months ended June 30, 2003.

 

Fiberxon

 

In September 2002, the Company invested $2.0 million in Fiberxon, Inc., a company that develops and sells optical modules and related systems. In March 2004, the Company invested an additional $1.0 million in Fiberxon. This investment is accounted for under the cost method, and its carrying value is evaluated for possible impairment based on the achievement of business objectives and milestones, the financial condition and prospects of the company and other relevant factors. As of June 30, 2004, the Company has not recorded any impairment in respect of this investment. The Company has outstanding purchase commitments with Fiberxon. Refer to Note 19, Related Party Transactions.

 

Interwave

 

During 2002, the Company purchased approximately 5.8 million shares of common stock of InterWave Communications, International Ltd. Inc., a technology company listed on Nasdaq, for approximately $3.0 million. In addition, the Company received warrants to purchase 2.0 million shares of InterWave’s common stock at $0.21 per share. The Company’s holdings were adjusted for a 1:10 reverse stock split on April 30, 2003, and were 0.6 million shares of common stock and warrants to purchase 0.2 million shares of InterWave’s common stock at $2.10 per share. The fair value of Company’s common stock investment in InterWave was $3.0 million as of June 30, 2004. Changes in the fair value of the stock are reflected in other comprehensive income in equity as unrealized gains or losses. The Company recorded increases of $0.7 million and $0.6 million for the three months ended June 30, 2004 and 2003, respectively, in other comprehensive income in equity.  The Company recorded increases of $0.4 million for both the six months ended June 30, 2004 and 2003, respectively in other comprehensive income in equity. The warrants were valued at $0.7 million at June 30, 2004, using the Black-Scholes option-pricing model. The Company recorded income of $0.2 million for both the three months ended June 30, 2004 and 2003, to reflect the change in the fair value of the warrants. The Company recorded insignificant losses for the six months ended June 30, 2004 and income of $0.2 million for the six months ended June 30, 2003, to reflect the change in the fair value of the warrants. On July 27, 2004, Alvarion, Ltd. agreed to acquire InterWave for $5.75 per share.

 

Matsushita

 

In July, 2002, the Company entered into a joint venture agreement with Matsushita Communication Industrial Co., Ltd., a stockholder of the Company, to jointly design and develop, manufacture and sell telecommunication products. The Company has a 49% ownership interest in the joint venture company, which has a registered share capital of $10.0 million. The cash consideration of $4.9 million payable by the Company was paid in October 2002. As the Company does not have voting control over significant matters of the joint venture company, the investment in and results of operations of the joint venture company are accounted for using the equity method of accounting.

 

Pursuant to the joint venture agreement with Matsushita, the Company is jointly liable for the losses incurred in the operations of the joint venture up to the maximum of its investment in the entity. At June 30, 2004, the losses had exceeded this amount; however, the Company accrued additional losses of approximately $1.2 million and $2.2 million during the three and six months ended June 30, 2004, respectively. The Company has cumulative losses of $2.2 million recorded within other current liabilities. The Company has committed to funding an additional $9.3 million during the fiscal year 2004.

 

Other investments

 

The Company has also invested directly in a number of private technology-based companies in the early stages of development. These investments are accounted for on the cost basis. The Company continually evaluates the carrying value of these investments for possible impairment based on the achievement of business objectives and milestones, the financial

 

18



 

condition and prospects of these companies and other relevant factors. During the three and six months ended June 30, 2004 and 2003, there were no valuation adjustments in respect of these private technology investments. The Company also invests in publicly traded technology-based companies and accounts for these as available-for-sale securities on a fair market value basis. There were insignificant changes in the value of these investments for the three and six months ended June 30, 2004 and 2003.

 

In July 2004, the Company invested $3.0 million in Series D Preferred Stock, for approximately a 2% ownership interest, in Infinera, Corp., a company that develops and manufactures optical networking systems.

 

14.                               DEBT:

 

The following represents the outstanding borrowings at June 30, 2004 and December 31, 2003 (in thousands):

 

Note

 

Rate

 

Maturity

 

June 30, 2004

 

December 31, 2003

 

Notes Payable

 

0%

 

July-September 2004

 

$

1,500

 

$

1

 

Convertible Subordinated Notes

 

7/8%

 

March 1, 2008

 

402,500

 

402,500

 

Total Debt

 

 

 

 

 

$

404,000

 

$

402,501

 

Long-term debt

 

 

 

 

 

402,500

 

402,500

 

Short-term debt

 

 

 

 

 

$

1,500

 

$

1

 

 

Occasionally, the Company issues short-term notes payable to its vendors in lieu of trade accounts payable.  The payment terms are normally three to six months and are typically non-interest bearing.  The Company had $1.5 million of these notes at June 30, 2004 included in other current liabilities.

 

The Company has available borrowing facilities of $566.8 million as of June 30, 2004. $264.8 million of these facilities expire in 2004 and $302.0 million of these facilities expire between 2008 and 2010 with an interest rate of 5.31%, and the Company has not guaranteed any debt not included in the consolidated balance sheet.

 

On March 12, 2003, the Company completed an offering of $402.5 million of convertible subordinated notes due March 1, 2008 to qualified buyers pursuant to Rule 144A under the Securities Act of 1933. The notes bear interest at a rate of 7/8% per annum and are convertible into the Company’s common stock at a conversion price of $23.79 per share and are subordinated to all present and future senior debt of the Company. Holders of the notes may convert their notes only if: (i) the price of the Company’s common stock issuable upon conversion of a note reaches a specified threshold, (ii) specified corporate transactions occur, or (iii) the trading price for the notes falls below certain thresholds. At the initial conversion price, each $1,000 principal amount of notes will be convertible into approximately 42.0345 shares of common stock. Expenses associated with the convertible subordinated notes issuance were $11.1 million and have been recorded with in other long-term assets and are being amortized over the life of the notes.

 

Concurrent with the issuance of the convertible notes, the Company entered into a convertible bond hedge and call option transaction at a cost of $43.8 million. The convertible bond hedge allows the company to purchase 16,918,873 shares of its common stock at $23.79 per share from the other party to the agreement. The written call option allows the holder to purchase 16,918,873 shares of the Company’s common stock from the Company at $32.025 per share. Both the bond hedge and call option transactions may be settled at the Company’s option either in cash or net shares and expire on March 1, 2008. The Company recorded these instruments at cost, and their carrying value at June 30, 2004 approximates their original cost. The convertible bond hedge and call option transactions are expected to reduce the potential dilution from conversion of the notes. The options have been included in stockholders’ equity in accordance with the guidance in Emerging Issues Task Force Issue No. 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”

 

15.                               WARRANTY OBLIGATIONS AND OTHER GUARANTEES:

 

Warranty obligations are as follows (in thousands):

 

19



 

 

 

Three months ended June 30,

 

Six Months Ended June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

 

 

 

 

 

 

 

 

Beginning of period

 

$

29,524

 

$

12,524

 

$

26,267

 

$

13,297

 

Accruals for warranties issued during the period

 

15,714

 

8,427

 

25,555

 

16,710

 

Adjustments to accruals for changes in estimates

 

(622

)

 

(455

)

(4,552

)

Settlements made during the period

 

(10,380

)

(4,523

)

(17,131

)

(9,027

)

Balance at end of period

 

$

34,236

 

$

16,428

 

$

34,236

 

$

16,428

 

 

Warranty obligations:

 

Certain of the Company’s sales contracts include provisions under which customers would be indemnified by the Company in the event of, among other things, a third-party claim against the customer for intellectual property rights infringement related to the Company’s products. There are no limitations on the maximum potential future payments under these guarantees. The Company has accrued no amounts in relation to these provisions as no such claims have been made and the Company believes it has valid, enforceable rights to the intellectual property embedded in its products.

 

Standby letters of credit:

 

The Company issues standby letters of credit primarily to support international sales activities outside of China. When the Company submits a bid for a sale, often the potential customer will require that the Company issue a bid bond or a standby letter of credit to demonstrate its commitment through the bid process. In addition, the Company may be required to issue standby letters of credit as guarantees for advance customer payments upon contract signing or performance guarantees. The standby letters of credit usually expire six to nine months from date of issuance without being drawn by the beneficiary thereof. The Company may issue commercial letters of credit in support of purchase commitments.

 

16.                               COMMITMENTS AND CONTINGENCIES:

 

Joint Venture Funding:

 

Pursuant to the joint venture agreement with Matsushita, the Company is jointly liable for the losses incurred in the operations of the joint venture up to the maximum of its investment in the entity.  At June 30, 2004, the losses had exceeded this amount; however, the Company had accrued additional losses of approximately $1.2 million and $2.2 million during the three and six months ended June 30, 2004 due to its commitment to fund an additional investment of $9.3 million during the fiscal year 2004.

 

Investment Commitments:

 

As of June 30, 2004, the Company had invested a total of $2.0 million in Global Asia Partners L.P. The fund size is anticipated to be $10.1 million and the fund was formed to make private equity investments in private or pre-IPO technology and telecommunications companies in Asia. The Company has a commitment to invest up to a maximum of $5.0 million. The remaining amount is due at such times and in such amounts as shall be specified in one or more future capital calls to be issued by the general partner.

 

Purchase Commitments:

 

The Company is obligated to purchase raw materials and work-in-process inventory under various orders from three suppliers, all of which should be fulfilled without adverse consequences material to the operations or financial condition of the Company. As of June 30, 2004, total open commitments under these purchase orders were approximately $39.6 million, including $16.9 million of open purchase orders with Fiberxon.

 

Litigation:

 

On October 31, 2001, a complaint was filed in United States District Court for the Southern District of New York against the Company, some of its directors and officers and various underwriters for its initial public offering. Substantially similar actions were filed concerning the initial public offerings for more than 300 different issuers, and the cases were coordinated as In re Initial Public Offering Securities Litigation, 21 MC 92. In April 2002, a consolidated amended complaint

 

20



 

was filed in the matter against the Company, captioned In re UTStarcom, Initial Public Offering Securities Litigation, Civil Action No. 01-CV-9604. Plaintiffs allege violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 through undisclosed improper underwriting practices concerning the allocation of IPO shares in exchange for excessive brokerage commissions, agreements to purchase shares at higher prices in the aftermarket, and misleading analyst reports. Plaintiffs seek unspecified damages on behalf of a purported class of purchasers of the Company’s common stock between March 2, 2000 and December 6, 2000. The Company’s directors and officers were dismissed without prejudice pursuant to a stipulation. On February 19, 2003, the Court granted in part and denied in part a motion to dismiss brought by defendants including the Company. The order dismissed all claims against the Company except for a claim brought under Section 11 of the Securities Act of 1933, which alleges that the Company’s initial public offering registration statement contained untrue statements of material fact and omitted to state material facts required to be stated in the registration statement, or necessary to make the statements therein not misleading.

 

In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including the Company, was submitted for preliminary approval by the Court. Under the settlement, the plaintiffs would dismiss and release all claims against participating defendants in exchange for a contingent payment undertaking by the insurance companies collectively responsible for insuring the issuer defendants in the coordinated action, and the assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. Pursuant to the undertaking, the insurers would be required to pay the amount, if any, by which $1.0 billion exceeds the total amount ultimately collected by the plaintiffs from the non-settling defendants in the coordinated action. The settlement is subject to a number of conditions including Court approval.

 

If the settlement does not occur, and litigation against UTStarcom continues, the Company believes it has valid defenses and intends to defend the case vigorously. The Company is unable to currently estimate the loss, if any, associated with the above litigation.

 

The Company has filed a patent infringement suit against Starent Networks Corporation (“Starent”) in the U.S. District Court for the Northern District of California.  In its Complaint, the Company asserts that Starent infringes two UTStarcom patents through the manufacture, offer for sale, and sale of Starent’s ST-16 Intelligent Mobile Gateway.  On June 3, 2004, the Company served its complaint on Starent.  On July 30, 2004, Starent filed and served its answer and counterclaims.  In its counterclaims, Starent asserts that the patents are not infringed, are invalid, and are unenforceable and asserts unfair competition against the Company.  The Court is scheduled to hold an initial case management conference on October 12, 2004.  Although the Company cannot reliably predict the outcome of this litigation, it believes that any liability arising from Starent’s counterclaims will not have a material adverse effect on the business, financial condition, or results of operations of the Company.

 

The Company is a party to other litigation matters and claims that are normal in the course of operations, and while the results of such litigation matters and claims cannot be predicted with certainty, the Company believes that the final outcome of such matters will not have a material adverse impact on its financial position or results of operations.

 

17.                               STOCKHOLDERS’ EQUITY:

 

On January 14, 2004, the Company sold 12.1 million shares of common stock at $39.25 per share in a privately negotiated transaction to an institution, for net proceeds of approximately $474.6 million. The net proceeds are intended to fund strategic and general corporate activities, including, but not limited to, acquisitions, investments, working capital or capital expenditures.

 

On March 12, 2004, the Company’s Board of Directors approved a stock repurchase program, authorizing the Company’s repurchase of up to 5,000,000 shares of its outstanding common stock over a period of 6 months. The Board approved an additional repurchase of 1,623,000 shares in a privately negotiated transaction with an institution which was completed in March 2004.  As of June 30, 2004, the Company repurchased a total of approximately 3.6 million shares at a weighted average price of $30.25 per share, for a total cash outflow of $107.6 million.

 

For the three months ended June 30, 2004 and 2003, the Company had $8.3 million and $30.9 million of net proceeds from the exercise of stock options, respectively. For the six months ended June 30, 2004 and 2003, the Company had $17.6 million and $35.0 million of net proceeds from the exercise of stock options, respectively. Additionally, the Company issued 32,000 shares of common stock pursuant to the exercise of a warrant at an exercise price of $2.50 per share for proceeds of $0.1 million during the second quarter of 2004.

 

18.                               SEGMENT REPORTING:

 

The Company sells wireless, wireline and switching product suites to telecommunications service providers in both emerging growth and established telecommunications markets around the world. The Company primarily operates in two geographic areas, China and other regions. The chief operating decision makers evaluate performance, make operating decisions, and allocate resources based on consolidated financial data. Gross profit, operating income, income from operations, and income taxes are not allocated to specific individual departments within the organization. In accordance with SFAS No. 131 “Disclosures about Segments of an Enterprise and Related Information,” the Company is considered a single

 

21



 

reportable segment. The Company is required to disclose certain information about product revenues, information about geographic areas, information about major customers, and information about long-lived assets.

 

China sales accounted for 90% and 91% of net sales for the three and six months ended June 30, 2004, respectively, and 82% of net sales for both the three and six months ended June 30, 2003. The Company groups all of its China customers together by province and treats each province as one customer since that is the level at which purchasing decisions are made. At June 30, 2004 and 2003, there were approximately 30 and 31 such customers, respectively. Giving effect to this consolidation, the Jiangsu and Hei Long Jiang provinces accounted for 15% and 10% of net sales, respectively, for the three months ended June 30, 2004. The Hei Long Jiang, Zhejiang and Hebei provinces accounted for 13%, 11% and 10% of net sales, respectively, for the three months ended June 30, 2003. The Guangdong, Jiangsu and Hei Long Jiang provinces accounted for 16%, 11% and 10%, of net sales, respectively, for the six months ended June 30, 2004. The Hei Long Jiang province accounted for 13% of net sales for the six months ended June 30, 2003.

 

Geographical area and product sales data are as follows (in thousands):

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2004

 

 

 

2003

 

 

 

2004

 

 

 

2003

 

 

 

 

 

(in thousands)

 

Sales by region

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

China

 

$

618,323

 

90

%

$

332,548

 

82

%

$

1,188,889

 

91

%

$

601,478

 

82

%

Japan

 

22,104

 

3

%

60,546

 

15

%

41,531

 

3

%

120,366

 

16

%

Other

 

49,201

 

7

%

12,740

 

3

%

81,499

 

6

%

14,510

 

2

%

TOTAL NET SALES

 

$

689,628

 

100

%

$

405,834

 

100

%

$

1,311,919

 

100

%

$

736,354

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales by product line

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Wireless infrastructure

 

$

427,659

 

62

%

$

143,490

 

35

%

$

764,176

 

58

%

$

267,850

 

36

%

Subscriber handsets

 

194,313

 

28

%

187,128

 

46

%

430,733

 

33

%

327,088

 

44

%

Wireline products

 

67,656

 

10

%

75,216

 

19

%

117,010

 

9

%

141,416

 

20

%

TOTAL NET SALES

 

$

689,628

 

100

%

$

405,834

 

100

%

$

1,311,919

 

100

%

$

736,354

 

100

%

 

Long-lived assets by geography, consisting of property, plant and equipment, goodwill and intangible assets, are as follows (in thousands):

 

 

 

June 30,
2004

 

December 31,
2003

 

U.S.

 

$

143,894

 

$

155,241

 

Foreign

 

259,735

 

175,067

 

Total long-lived assets

 

$

403,629

 

$

330,308

 

 

19.                               RELATED PARTY TRANSACTIONS:

 

Softbank

 

The Company recognized revenue of $21.1 million and $32.6 million for the three and six months ended June 30, 2004, respectively, and $60.2 million and $118.7 million for the three and six months ended June 30, 2003, respectively, with respect to sales of telecommunications equipment to SBBC, an affiliate of SOFTBANK America Inc., which is a significant stockholder of the Company. SBBC offers asynchronous digital subscriber line (“ADSL”) coverage throughout Japan, which is marketed under the name “YAHOO BB!”. The Company provides ADSL technology to SBBC. The contract was competitively bid and the terms of this contract were on terms no more favorable than those with unrelated parties. Included in accounts receivable at June 30, 2004 and December 31, 2003 were $29.9 million and $43.9 million, respectively, related to this agreement. There were insignificant amounts included in deferred revenue in respect of this agreement at June 30, 2004 and no amounts included in deferred revenue in respect of this agreement at December 31, 2003.

 

The Company has invested in Softbank China and Restructuring Fund No. 1, which are investment vehicles established by SOFTBANK CORP and its affiliates. See Note 13.

 

On July 17, 2003, the Company entered into a Mezzanine Loan Agreement with BB Modem Rental PLC (“BB Modem”), an affiliate of SOFTBANK America, Inc. Under the terms of the agreement the Company loaned BB Modem $10.1 million at an effective interest rate of 12.01% per annum, for the purposes of investing in a portfolio of ADSL modems and associated modem rental agreements, from SOFTBANK BB CORP., formerly BB Technologies, an affiliate of SOFTBANK America, Inc. SOFTBANK BB CORP. will continue to service such modems and modem rental agreements. The Company’s loan is subordinated to certain senior lenders of BB Modem, and repayments are payable to the Company over a forty-two month period through January 31, 2007, with a substantial portion of the principal amount of the loan schedule to be repaid during the last 16 months of this period. The Company’s recourse for nonpayment of the loan is limited to the assets of BB Modem, the account into which subscriber payments are made and its rights under the securitization transaction documents. The value of BB Modem’s modems that serve as collateral for the loan may decrease over time and may not be sufficient upon sale to pay the outstanding amounts on the loans. The Company assesses the loan for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. The Company periodically reviews the underlying quality of the asset pool securing the loan to assess whether impairment has incurred and needs to be recorded. During three and six months ended June 30, 2004, the Company recorded $0.3 million and $0.7 million, respectively, in interest income in respect of this loan. The loan receivable at June 30, 2004 was approximately $11.2 million and is included in other long-term assets.

 

22



 

On April 5, 2003, the Company repurchased 8.0 million shares of common stock beneficially owned by SOFTBANK America Inc., at a purchase price of $17.385 per share. The total cost of the repurchase was $139.6 million including transaction fees. In connection with this repurchase transaction, SOFTBANK America Inc. entered into an agreement with the Company not to offer, sell or otherwise dispose of the Company’s common stock for a period of one year, subject to a number of exceptions. As of June 30, 2004, SOFTBANK America Inc. beneficially owned approximately 12.9% of the Company’s outstanding stock.

 

Cellon

 

In October 2002, the Company entered into a license and a royalty agreement with Cellon International Holding Corporation (“Cellon”), in which the Company has a 9% ownership interest. The Company paid $0.8 million to license certain technology for the development of certain handset products in China. Per the terms of the royalty agreement, the Company is required to pay Cellon $3 per unit shipped for a minimum of 0.5 million units. This agreement is not material to the overall financial results of Cellon. The Company has evaluated its relationship with Cellon under FASB Interpretation ("FIN") 46, Consolidation of Variable Interest Entities, and determined that consolidation is not necessary.

 

Fiberxon

 

The Company has an outstanding purchase commitment with Fiberxon, in which the Company has an 11% ownership interest, to purchase component parts for optical networking products. In addition, the Company provided a letter of credit for $5.0 million to purchase raw materials for the manufacture of these component parts. This commitment should be fulfilled without adverse consequences material to the operations or financial condition of the Company. As of June 30, 2004, total open commitments under these purchase orders were $16.9 million, which are due at the end of this year.

 

20.                               COUNTRY RISKS:

 

Approximately 90% and 91% of the Company’s net sales for the three and six months ended June 30, 2004 and 82% for both the three and six months ended June 30, 2003, respectively, were made in China. Accordingly, the Company’s business, financial condition and results of operations are likely to be influenced by the political, economic and legal environment in China and by the general state of China’s economy. As such, the Company’s operations in China are subject to special considerations and significant risks not typically associated with companies in the United States. The Company’s results may be adversely affected by, among other things, changes in the political, economic, competitive and social conditions in China, including changes in governmental policies with respect to laws and regulations, changes in China’s telecommunications industry and regulatory rules and policies, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation.

 

Under China’s current regulatory structure, the communications products that the Company offers in China must meet government and industry standards, and a network access license for the equipment must be obtained. Without the license, the equipment may not be connected to public telecommunications networks or sold in China. Moreover, the Company must ensure that the quality of the telecommunications equipment for which it has obtained a network access license is stable and reliable, and may not lower the quality or performance of other installed licensed products. China’s State Council’s product quality supervision department, in concert with China’s Ministry of Information Industry, performs spot checks to track and supervise the quality of licensed telecommunications equipment and publishes the results of such spot checks.

 

Approximately 3% of the Company’s sales for both the three and six months ended June 30, 2004 and approximately 15% and 16% of the Company’s sales for the three and six months ended June 30, 2003, respectively, were made in Japan. Accordingly, the political, economic and legal environment and the general state of Japan’s economy may influence the Company’s business, financial condition and results of operations.

 

21.                               INCOME TAX ASSETS AND LIABILITIES:

 

In establishing its deferred income tax assets and liabilities, the Company makes judgments and interpretations based on the enacted tax laws and published tax guidance applicable to its operations.  The Company records deferred tax assets and liabilities and evaluates the need for valuation allowances to reduce the deferred tax assets to realizable amounts.  The likelihood of a material change in the Company’s expected realization of these assets is dependent on future taxable income, its ability to use foreign tax credit carryforwards and carrybacks, and the effectiveness of its tax planning strategies

 

23



 

in the various relevant jurisdictions.  Changes to the Company’s income tax provision or in the valuation of the deferred tax assets and liabilities may affect its annual effective income tax rate.

 

22.                               ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES:

 

The Company uses derivative financial instruments to manage its exposures to foreign currency exchange rate changes. The derivative instruments are accounted for pursuant to SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” as amended by SFAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities.” As amended, SFAS No. 133 requires that an entity recognize all derivatives as either assets or liabilities on the balance sheet, measure those instruments at fair value and recognize changes in the fair value of derivatives in earnings in the period of change unless the derivative qualifies as an effective hedge that offsets certain exposures. Such contracts are designated at inception to the related foreign currency exposures being hedged. Beginning in the first quarter of 2004, the Company hedges certain of its Japanese Yen-denominated balance sheet exposures against future movements in foreign currency exchange rates by using foreign currency forward contracts. Hedged transactions are denominated in U.S. dollars on behalf of these transactions denominated in Japanese Yen. Pursuant to its foreign currency exchange hedging policy, the Company may hedge anticipated transactions and the related payables denominated in foreign currencies using forward foreign currency exchange rate contracts.  Gains and losses on these fair value hedges are intended to offset gains and losses from the revaluation of Japanese Yen-denominated recognized liabilities. The net result of these gains and losses on contracts and revaluation included in interest and other income (expense) was insignificant for the three and six months ended June 30, 2004. The Company’s foreign currency forward contracts generally mature within three months. These derivative financial instruments are not held for trading purposes. There were no foreign currency forward contracts open at June 30, 2004.

 

23.                               RECENT ACCOUNTING PRONOUNCEMENTS:

 

In November 2003, the EITF issued EITF No. 03-6 “ Participating Securities and the Two-Class Method under FASB Statement No. 128,” which provides for a two-class method of calculating earnings per share computations that relate to certain securities that would be considered to be participating in conjunction with certain common stock rights. This guidance was applicable to the Company starting with the second quarter beginning April 1, 2004. The Company evaluated the impact of this pronouncement and determined that there was no effect on its financial statements.

 

On April 9, 2004, the FASB issued FASB Staff Position (“FSP”) to SFAS 129-1, Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Securities to provide disclosure guidance for contingently convertible securities, including those instruments with contingent conversion requirements that have not been met and otherwise are not required to be included in the computation of diluted earnings per share. The FSP addresses concerns that disclosures relating to contingently convertible securities are inconsistent between companies or may be inadequate. FSP SFAS 129-1 states that to comply with the requirements of SFAS 129, the significant terms of the conversion features of the contingently convertible security should be disclosed to enable users of financial statements to understand the circumstances of the contingency and the potential impact of conversion.  The Company evaluated the impact of this pronouncement and has enhanced its disclosures as required. Refer to Note 3, Earnings Per Share.

 

ITEM 2—MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

FORWARD-LOOKING STATEMENTS

 

This Report on Form 10-Q contains forward-looking statements within the meaning of the federal securities laws. These statements are based on information that is currently available to management. We intend such forward-looking statements to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, and we are including this statement for purposes of complying with those provisions. The forward-looking statements include, without limitation, those concerning the following: our expectations as to the nature of possible trends, including our expectations about continuing growth in the number of subscribers for telecommunications products in other countries in which we do business; our expectations regarding continued growth in our business and operations; our expectation that there will be fluctuations in our overall gross profit, gross margin, product mix, quarter to quarter results, customer base and selling prices; our plans for expanding the direct sales organization and our selling and marketing campaigns and activities; our expectation

 

24



 

that we may use our cash, debt or securities to acquire or invest in complementary businesses, technologies or product offerings; our expectations regarding trends in customer acceptance of our products; our expectation that there will be increases in selling, marketing, research and development, and general and administrative expenses; our expectations regarding future growth of our business and operations; our expectations regarding our ability to take advantage of strategic investment opportunities; our expectation that we will continue to invest significantly in research and development; our expectations regarding the status of products under development; our expectations about anticipated Sarbanes-Oxley compliance costs and our compliance with that Act; our expectations regarding our future investments; our expectations regarding our future levels of cash and cash equivalents, as well as our expectation that existing cash and cash equivalents will be sufficient to finance our operations for the foreseeable future; our expectations regarding licensing requirements and our ability to receive licenses in China for our PAS system and other products; our expectations regarding the development of 3G networks; our expectations regarding the impact of a reorganization of China Netcom International Corporation Ltd. (“China Netcom”); our expectation that our business will continue to be significantly influenced by the political, economic and legal environment in China, as well as expectations about the nature of political, economic and legal reform in China; our expectations regarding the future allocation of net sales by product group; our expectations regarding efficiencies we hope to achieve in supply chain management and inventory purchasing, as well as trends in inventory growth; and our expectations regarding our expansion into new markets around the world. Additional forward-looking statements may be identified by the words, “anticipate,” “expect,” “believe,” “intend,” “will” and similar expressions, as they relate to us or our management. Investors are cautioned that these forward-looking statements are inherently uncertain. These statements are subject to risks and uncertainties that may cause actual results and events to differ materially. For a detailed discussion of these risks and uncertainties, see the “Factors Affecting Future Operating Results” section of this Form 10-Q. We do not guarantee future results and undertake no obligation to update the forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-Q.

 

EXECUTIVE SUMMARY

 

We design, manufacture and sell telecommunications equipment and products and provide services associated with their operation. Our products are deployed and installed globally primarily by wireless and wireline telecommunications service providers. We provide an extensive range of products for transportation of voice, data and video traffic for these service providers. We are currently operating in China, Japan, India, the Central and Latin American region, North America, the European, Middle Eastern and African region and southeastern and northern Asia.

 

We differentiate ourselves with products designed to reduce network complexity, integrate high performance capabilities and allow a simple transition to next generation networks. We design our products to facilitate cost-effective and efficient deployment, maintenance and upgrades.

 

Our technologies and products fall into these major categories:

 

                                          wireless infrastructure, a technology that enables end users, or subscribers, to send and receive data, voice and media while mobile and using wireless devices;

 

                                          wireline infrastructure, a technology that enables subscribers to send and receive data, voice and media transport and carriage in a fixed location; and

 

                                          subscriber terminal products, including handsets and customer premise equipment (“CPE”), which receive data, voice and media transmissions.

 

Historically, substantially all of our sales have been to service providers in China. 90% and 91% of our sales for the three and six months ended June 30, 2004, respectively, were derived from China. For the three and six months ended June 30, 2004, we had $618.3 million and $1.2 billion of revenue, respectively, an 86% and 98% increase over the corresponding periods in 2003. This growth in revenue was driven by China’s continued demand for our products and services to meet the needs of its increased subscriber base and its expanding telecommunications market. We use subscriber growth statistics to gauge future inventory purchasing requirements as well as to forecast our anticipated revenue growth. We expect this subscriber growth to continue throughout 2004 since China’s teledensity rates, or the number of telephones per person in a region, remain low in comparison to that of developed countries. However, we do expect this growth to be at a slower rate than the first half of the year.

 

The number of competitors for communications access and switching systems and handsets in China has grown in line with China’s growing telecommunications market. This growth has led to competitive pricing pressure, causing average selling prices to decrease during the three and six months ended June 30, 2004 relative to those in the comparative period in 2003. This pricing pressure affected both our infrastructure and handset product lines, contributing to lower margins overall.

 

25



 

We strive to develop products with more advanced features and to enhance the features of our existing products, which we believe will enable us to offer our customers more advanced products at higher average selling prices than otherwise would be possible in the future sale. In addition, during the first half of 2004, we continued to strive to reduce the cost of manufacturing our products by streamlining our design functions.

 

During the second quarter 2004, we signed approximately $300 million of international sales contracts, and we intend to continue to expand our global sales outside of China. We expect to recognize the majority of revenue from these contracts during the second half of 2004. International deployments for the second quarter of 2004 were delayed by longer-than-average delivery times. As we expand, we need to improve our supply chain and inventory management processes to ensure timely deliveries. We engaged consultants to assist with these efforts, and expect to reduce our delivery times as a result of these improvements.

 

KEY TRANSACTIONS

 

Acquisitions

 

During the second quarter of 2004, we closed two acquisitions and announced a third acquisition with Audiovox, which we anticipate will close in the fourth quarter of 2004.  We consider all three of these acquisitions to be important elements of our long-term global wireless strategy. Specifically, they provide the core features of our new code division multiple access (or "COMA") product portfolio.

 

TELOS Technology, Inc.

 

On May 19, 2004, we completed the acquisition of substantially all of the assets and certain liabilities of TELOS Technology, Inc. (“TELOS”) and its subsidiaries.  TELOS is a provider of mobile switching products and services for voice and data communication networks to developing rural, enterprise and emerging wireless markets. The total consideration for the acquisition, funded from cash on hand, was approximately $30.3 million.  We paid $29.0 million in cash, in addition to $1.3 million of acquisition-related transaction costs. Within one year of the acquisition date, additional payments totaling a maximum of $19.0 million may become payable based upon revenue recognized from the sale of TELOS products. In the event these revenue milestones are met, the original purchase price will be adjusted for the amount of the contingent payment in accordance with Statement of Financial Accounting Standards No. 141 (“SFAS 141”), “Business Combinations.”

 

The existing technology acquired included the entire TELOS product family of CDMA softswitch technology products, supporting servers and operations maintenance centers. CDMA technology is the common platform on which third-generation wireless data services and applications are built. By assigning unique codes to each communication to differentiate it from others in the same spectrum, CDMA technology allows many users to occupy the same time and frequency allocations in a given band or space. The TELOS product line will be integrated with our suite of CDMA products, strengthening our existing CDMA product and infrastructure portfolio. In addition to developed product technology, the Company acquired fixed assets, in-process research and development (“IPR&D”), an assembled workforce of approximately 60 employees, customer relationships and goodwill.

 

Hyundai Syscomm, Inc.

 

On April 27, 2004, we completed the acquisition of the assets, substantially all of the intellectual property, certain employees and certain contracts related to Hyundai Syscomm, Inc.’s (“HSI”) CDMA infrastructure business for markets outside of Korea.  Subject to the attainment of certain milestones and the transfer of certain know-how, the total consideration for this transaction was approximately $12.3 million, excluding transaction costs of $1.8 million. There was $7.3 million in cash payable at the closing date and an additional $3.0 million in cash payable one year from the closing date. The remaining purchase price was comprised of $2.0 million payable upon the completion of technical training by HSI employees to our manufacturing staff in China under the terms of a Training Services Agreement and $1.8 million of transaction costs. Not included in the purchase price was $2.0 million payable upon the completion of certain revenue milestones. In the event these revenue milestones are met, the original purchase price will be adjusted for the amount of the contingent payment in accordance with SFAS 141.

 

Under the terms of the transaction with HSI, we acquired existing technologies and entered into non-compete and licensing agreements. The existing technologies acquired were the base transceiver station (“BTS”) and base station controllers (“BSC”) product lines.  BTS is the antenna and radio equipment that enables wireless devices to communicate

 

26



 

with a land-based transmission network in a given range. BSC performs radio signal management functions for BTS, managing functions such as frequency assignment and handoff. As part of the asset purchase agreement, we entered into a training services agreement with HSI, whereby HSI employees will provide technical training to our manufacturing staff in China for the sixth-month period subsequent to the acquisition. This technology and technological know-how will strengthen our CDMA existing product portfolio and the development of future CDMA technology.

 

In addition to acquiring existing technology, we entered into non-compete and licensing agreements.  The non-compete agreement prohibits HSI from competing against us in all countries except Korea for four years from the valuation date. The licensing agreement requires that HSI pay us 1% of revenue as royalty for the usage of the intellectual property that we acquired under the terms of the acquisition for fifteen years subsequent to the valuation date.

 

Audiovox Communications, Inc.

 

On June 14, 2004, we announced an agreement to acquire select assets of Audiovox Communications Corporation (“Audiovox”), the wireless handset division of Audiovox Corporation. We will acquire select assets and liabilities, including inventories, prepaids, third-party payables, accrued expenses and the right to hire approximately 270 employees for $165.1 million in cash. We will acquire the Audiovox’s sales, service and support infrastructure, its CDMA handset brand, access to supply-chain channels, product marketing expertise and key relationships with CDMA operators primarily in North and South America. Closing of the transaction is subject to satisfaction of certain conditions outlined in the purchase agreement.

 

Stockholders’ Equity

 

On March 12, 2004, our Board of Directors approved a stock repurchase program, authorizing the repurchase of up to 5,000,000 shares of our outstanding common stock over a period of 6 months. The Board approved an additional repurchase of 1,623,000 shares in a privately negotiated transaction with an institution.  As of June 30, 2004, we repurchased a total of approximately 3.6 million shares under this program at an average price of $30.25 per share, for a total cash outflow of $107.6 million.

 

Transactions with Softbank and Affiliated Entities

 

We recognized revenue of $21.1 million and $32.6 million for the three and six months ended June 30, 2004, respectively, and revenue of $60.2 million and $118.7 million for the three and six months ended June 30, 2003, respectively with respect to sales of telecommunications equipment to Softbank BB Corporation (“SBBC”), an affiliate of SOFTBANK CORP. and SOFTBANK America Inc., a significant stockholder of ours. SBBC offers asynchronous digital subscriber line (“ADSL”) coverage throughout Japan, which is marketed under the name “YAHOO BB!”. The majority of the products we provide to SBBC is associated with ADSL technology. The contract was competitively bid and the terms of this contract were on terms no more favorable than those with unrelated parties. Included in accounts receivable at June 30, 2004 and December 31, 2003 were $29.9 million and $43.9 million, respectively, related to this agreement. There were insignificant amounts included in deferred revenue in respect to this agreement at June 30, 2004 and no amounts included in deferred revenue in respect to this agreement at December 31, 2003.

 

During 2000, we invested $10.0 million in Softbank China, an investment fund established by SOFTBANK CORP. focused on investments in Internet companies in China. This investment is intended to enable us to participate in the anticipated growth of Internet-related businesses in China. Our investment constitutes 10% of the funding for Softbank China, with SOFTBANK CORP. contributing the remaining 90%. The fund has a separate management team, and none of our employees are employed by the fund. Many of the fund’s investments are and will be in privately held companies, many of which are still in the start-up or development stages. These investments are inherently risky as the market for the technologies or products the companies have under development are typically in the early stages and may never materialize. We account for this investment under the cost method and recorded no losses and insignificant losses in the carrying value of this investment during the three and six months ended June 30, 2004, respectively. We recorded insignificant losses and losses of $0.1 million due to an other-than-temporary decline in the carrying value of this investment during the three and six months ended June 30, 2003, respectively. The balance in this investment was $5.3 million at June 30, 2004.

 

On July 17, 2003, we entered into a Mezzanine Loan Agreement with BB Modem Rental PLC (“BB Modem”), an affiliate of SOFTBANK America, Inc.  Under the terms of the agreement we loaned BB Modem $10.1 million at an effective interest rate of 12.01% per annum, for the purposes of investing in a portfolio of ADSL modems and associated modem rental agreements, from SOFTBANK BB CORP., formerly BB Technologies, an affiliate of SOFTBANK America, Inc.  SOFTBANK BB CORP. will continue to service such modems and modem rental agreements.  Our loan is subordinated to certain senior lenders of BB Modem, and repayments are payable to us over a forty-two month period through January 31, 2007, with a substantial portion of the principal amount of the loan schedule to be repaid during the last 16 months of this period.  Our recourse for nonpayment of the loan is limited to the assets of BB Modem, the account into which subscriber payments are made and its rights under the securitization transaction documents.  The value of BB Modem’s modems that serve as collateral for the loan may decrease over time and may not be sufficient upon sale to pay the outstanding amounts on the loans.  We assess the loan for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable.  We periodically review the underlying quality of the asset pool securing the loan to assess whether impairment has incurred and needs to be recorded.  During three and six months ended June 30, 2004, we recorded $.3 million and $.7 million, respectively, in interest income in respect of this loan.  The loan receivable at June 30, 2004 was approximately $11.2 million and is included in other long-term assets.

 

During the first quarter of fiscal 2002, we invested $2.0 million in Restructuring Fund No. 1, a venture capital investment limited partnership established by SOFTBANK INVESTMENT CORP., an affiliate of SOFTBANK CORP. The fund focuses on leveraged buyout investments in companies in Asia undergoing restructuring or bankruptcy proceedings. The total fund offering is expected to be between approximately $150.0 million and $226.0 million, with each investor contributing a minimum of $0.8 million. The fund has a separate management team, and none of our employees are employed by the fund. We account for this investment under the equity method of accounting. The balance in this investment

 

27



 

was $1.8 million at June 30, 2004.

 

On April 5, 2003, we repurchased 8.0 million shares of our common stock beneficially owned by SOFTBANK America Inc., at a purchase price of $17.385 per share. The total cost of the repurchase was $139.6 million including transaction fees. In connection with this repurchase transaction, SOFTBANK America Inc. entered into an agreement with us not to offer, sell or otherwise dispose of our common stock for a period of one year, subject to a number of exceptions. As of June 30, 2004, SOFTBANK America Inc. beneficially owned approximately 12.9 % of our outstanding stock.

 

RESULTS OF OPERATIONS

 

Our net sales consist of product and service sales within three broad telecommunications product lines: wireless infrastructure; wireline infrastructure and subscriber terminals including handsets and CPE.  Wireless infrastructure is primarily comprised of the Personal Access System (“PAS”); iPAS; and CDMA products.  Wireline infrastructure is primarily comprised of the AN2000, IPDSLAM, and other wireline products.  The subscriber terminal products include PAS handsets, CPE and will include CDMA handsets beginning in 2005.  During the second quarter of 2004, we experienced 70% growth in net sales over the second quarter of 2003.  Net sales may not grow at the same rate or may even decline in the future.  With many of our product sales, we provide installation services.  Additionally, we provide maintenance services for some products.  In all periods, total services sales were less than 10% of net sales.

 

Cost of sales consists primarily of material costs, payments to agents, costs associated with manufacturing, assembly and testing of products, costs associated with installation and customer training and overhead and warranty costs. Cost of sales also includes import taxes and tariffs on components and assemblies. Some components and materials used in our products are purchased from a single supplier or a limited group of suppliers and, in some cases, are subject to our obtaining Chinese import permits and approvals. We also rely on third party manufacturers in China to manufacture and assemble the majority of our products.

 

Our gross profit has been affected by competitive pricing pressure, product mix and material costs. Our gross profit, as a percentage of net sales, varies among our product families. We expect that our overall gross profit, as a percentage of net sales, will fluctuate from period to period as a result of shifts in product mix, anticipated decreases in average selling prices from competitive pricing pressure and our ability to reduce cost of sales.

 

Selling, general and administrative expenses include compensation and benefits, professional fees, sales commissions, provision for doubtful accounts receivable and travel and entertainment costs. A large percentage of our costs are fixed and are difficult to quickly reduce in periods of reduced sales. We intend to pursue aggressive selling and marketing campaigns and to expand our direct sales organization, and, as a result, our sales and marketing expenses will increase in absolute dollars in future periods. We also expect that in support of our continued growth, general and administrative expenses will continue to increase in absolute dollars for the foreseeable future.

 

Research and development expenses consist primarily of salaries and related costs of employees engaged in research, design and development activities, the cost of parts for prototypes, equipment depreciation and third party development expenses. A large percentage of our costs is fixed and difficult to quickly reduce in periods of reduced sales. Our research and development efforts are focused on developing both next-generation products as well as working to upgrade our existing systems and products. We believe that continued investment in research and development is critical to our long-term success. Accordingly, we expect that our research and development expenses will increase in absolute dollars in future periods.

 

Income tax expense is based upon a blended effective tax rate based upon our expectation of the amount of income to be earned in each tax jurisdiction.  The primary drivers for income tax expense includes both the total amount and location of the income earned.  The Company uses tax-planning strategies to minimize its income tax expense.  Income tax expense as a percentage of income before taxes will increase if relatively more income is earned in higher tax environments.

 

28



 

THREE AND SIX MONTHS ENDED JUNE 30, 2004 AND 2003

 

NET SALES

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2004

 

 

 

2003

 

 

 

2004

 

 

 

2003

 

 

 

 

 

(in thousands)

 

Sales by region

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

China

 

$

618,323

 

90

%

$

332,548

 

82

%

$

1,188,889

 

91

%

$

601,478

 

82

%

Japan

 

22,104

 

3

%

60,546

 

15

%

41,531

 

3

%

120,366

 

16

%

Other

 

49,201

 

7

%

12,740

 

3

%

81,499

 

6

%

14,510

 

2

%

TOTAL NET SALES

 

$

689,628

 

100

%

$

405,834

 

100

%

$

1,311,919

 

100

%

$

736,354

 

100

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales by product line

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Wireless infrastructure

 

$

427,659

 

62

%

$

143,490

 

35

%

$

764,176

 

58

%

$

267,850

 

36

%

Subscriber handsets

 

194,313

 

28

%

187,128

 

46

%

430,733

 

33

%

327,088

 

44

%

Wireline products

 

67,656

 

10

%

75,216

 

19

%

117,010

 

9

%

141,416

 

20

%

TOTAL NET SALES

 

$

689,628

 

100

%

$

405,834

 

100

%

$

1,311,919

 

100

%

$

736,354

 

100

%

 

Three months ended June 30, 2004 and 2003

 

In the second quarter of 2004, net sales increased by $283.8 million or 70% over the second quarter of 2003.  This increase was primarily driven by increases in wireless infrastructure sales of $284.2 million.  The increase was attributable to increased demand from carriers in China as a result of the increased number of subscribers.  Total PAS subscribers increased from approximately 20 million at June 30, 2003 to approximately 54 million at June 30, 2004.  We believe that PAS subscriber growth will continue to grow to between 65 and 70 million subscribers by the end of 2004.  Wireless infrastructure revenues are directly affected by the timing of customer acceptance.  In the second quarter of 2004, our customers accepted wireless infrastructure projects faster than we have historically experienced.  This was consistent with our expectation of a quickening pace of the sales cycle for our China customers as they move from initial system implementation to system expansion. 

 

We group all of our China customers together by province and treat each province as one customer since that is the level at which purchasing decisions are made. At June 30, 2004 and 2003, we had 30 and 31 such customers, respectively. The Jiangsu and Hei Long Jiang provinces accounted for 15% and 10% of our net sales, respectively, for the three months ended June 30, 2004. The Hei Long Jiang, Zhejiang and Hebei provinces accounted for 13%, 11% and 10% of our net sales, respectively, for the three months ended June 30, 2003.

 

Six months ended June 30, 2004 and 2003

 

For the first six months of 2004, net sales increased by $575.6 million or 78% over the first six months of 2003.  This increase in sales was primarily attributable to increased demand for our products and services resulting from an increased number of subscribers. Net sales growth was primarily due to an increase in subscribers, requiring telecommunication providers to expand their telecommunication infrastructures. Wireless infrastructure revenues are directly affected by the timing of customer acceptance. In the first half of 2004,  our customers accepted wireless infrastructure expansion projects faster than we have historically experienced, increasing the percentage of net sales derived from wireless infrastructure products that were sold during the six months ended June 30, 2004 than in the comparative period in 2003.

 

We group all of our China customers together by province and treat each province as one customer since that is the level at which purchasing decisions are made. At June 30, 2004 and 2003, we had 30 and 31 such customers, respectively. The Guangdong, Jiangsu and Hei Long Jiang provinces accounted for 16%, 11% and 10% of our net sales, respectively, for the six months ended June 30, 2004. The Hei Long Jiang province accounted for 13% of our net sales for the six months ended June 30, 2003.

 

The decrease in wireline sales was attributable to several factors.  Sales of wireline products for the six months ended June 30, 2004 were lower than the comparative period in the prior year due to high levels of wireline product sales in the first half of 2003 due to Japan’s expansion of its wireline infrastructure base in that period.

 

29



 

Some wireline product shipments and customer acceptances were delayed until after the second quarter due to some supply chain difficulties, thereby reducing the wireline revenues recorded during the six months ended June 30, 2004.

 

Over the second six months of 2004, we expect wireless infrastructure revenues to remain consistent with the first six months.  We expect our sales growth for the second six months of 2004 to occur principally in our wireline products revenues and secondly in our handset revenues.

 

GROSS PROFIT

 

 

 

Three months ended March 31,

 

Six months ended June 30,

 

 

 

2004

 

2003

 

2004

 

2003

 

 

 

(in thousands)

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

Gross profit

 

$

176,270

 

$

137,504

 

$

352,305

 

$

250,189

 

Gross profit percentage

 

26

%

34

%

27

%

34

%

 

Three months ended June 30, 2004 and 2003

 

Our gross profit varies across our different product lines and is affected by product mix, average selling prices and the cost of materials.  We attribute the decrease in gross profit as a percent of net sales for the three months ended June 30, 2004 from the corresponding period in 2003 mostly to declining margins on our handset products. The declining margins resulted from increased competitive market pricing pressures throughout the telecommunications market in the second quarter of 2004. The declining margins on our handset products were slightly offset by the decreased percentage of handset sales, from 46% of net sales for the second quarter of 2003 to 28% of net sales for the second quarter of 2004. Secondly, the decline in gross profit for the second quarter 2004 as compared to the second quarter in 2003 was due to a smaller percentage of sales of our higher margin wireline products, from 19% of net sales during the second quarter of 2003 to 10% of net sales for the same period in 2004.  In addition to having a lower percentage of wireline sales this period, our margins decreased due to lower margins on a specific contract upon which revenues were recognized in this period. This gross margin decline was offset by both higher margins and an increased percentage of our sales from iPAS/PAS systems.

 

Six months ended June 30, 2004 and 2003

 

Our gross profit varies across our different product lines and is affected by product mix, average selling prices and the cost of materials. The decrease in gross profit for the six months ended 2004 as compared to the same period in 2003 was due to a smaller percentage of sales of our higher margin wireline products, from 20% of net sales for the six months ended June 30, 2003 to 9% of net sales for the same period in 2004.  In addition to having a lower percentage of wireline sales this period, our margins decreased due to lower margins on a specific contract upon which revenues were recognized in this period.  We also attribute the decline in gross profit as a percent of net sales for the six months ended June 30, 2004 from the corresponding period in 2003 to declining margins on our handset products.  The declining margins resulted from increased competitive market pricing pressures throughout the telecommunications market during the first half of 2004. The declining margins on our handset products were slightly offset by the decreased percentage of handset sales, from 44% of net sales for the six months ended June 30, 2003 to 33% of net sales for the same period in 2004.  This gross margin decline was offset by higher margins on our iPAS/PAS systems. Also offsetting declining gross margins was the increased percentage of our sales derived from iPAS/PAS systems, from 36% for the six months ended June 30, 2003 to 58% for the six months ended June 30, 2004.

 

We believe that our overall gross profit as a percentage of net sales will continue to fluctuate from period to period as a result of shifts in product mix, anticipated decreases in average selling prices as a result of competition and our ability to reduce cost of sales. We expect that there will be continued competitive market pricing pressures on our products in line with current trends in the industry. 

 

30



 

OPERATING EXPENSES

 

The following table summarizes our operating expenses:

 

 

 

Three months ended June 30,

 

Six months ended June 30,

 

 

 

2004

 

% of net
sales

 

2003

 

% of net
sales

 

2004

 

% of net
sales

 

2003

 

% of net
sales

 

 

 

(in thousands)

 

(in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selling, general and administrative (“SG&A”)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

expenses

 

$

67,830

 

10

%

$

34,963

 

9

%

$

134,773

 

10

%

$

72,546

 

10

%

Research and development (“R&D”)

 

52,592

 

8

%

36,078

 

9

%

98,250

 

8

%

62,890

 

9

%

In-process research and development (“IPR&D”)

 

1,400

 

0

%

9,328

 

2

%

1,400

 

0

%

10,648

 

1

%

Amortization of intangible assets

 

3,334

 

0

%

1,483

 

0

%

6,307

 

0

%

2,178

 

0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

TOTAL OPERATING EXPENSES

 

$

125,156

 

18

%

$

81,852

 

20

%

$

240,730

 

18

%

$

148,262

 

20

%

 

SELLING, GENERAL AND ADMINISTRATIVE

 

The Company manages selling general and administrative expenses as a percentage of net sales.  In the current quarter and six months, selling general and administrative expenses remained consistent with prior periods at approximately 10% of net sales.

 

Three months ended June 30, 2004 and 2003

 

The increase of 94% in absolute dollars in selling, general and administrative expenses was primarily due to the hiring of additional personnel to support our increased business activities both in China and globally.  Selling, general and administrative headcount increased approximately 41% from an average of 2,088 employees for the three months ended June 30, 2003 to an average of 2,947 employees for the three months ended June 30, 2004.  Secondly, bad debt expense is generally a function of the size of the accounts receivable balance.  Gross accounts receivable increased 100% over June 30, 2003, which resulted in an increase of approximately $10 million in bad debt expense between the second quarter of 2004 compared to the second quarter of 2003.  Finally, the Company incurred additional professional services fees related to Sarbanes-Oxley compliance and supply chain management, which resulted in an increase of approximately $7.0 million for professional services fees in the second quarter of 2004.

 

Six months ended June 30, 2004 and 2003

 

The increase of 86% in absolute dollars in selling, general and administrative expenses was primarily due to the hiring of additional personnel to support our increased business activities both in China and globally. Selling, general and administrative headcount increased approximately 48% from an average of 1,895 employees for the six months ended June 30, 2003 to an average of 2,801 employees for the six months ended June 30, 2004.  Additionally, increases in professional services fees of $10.7 million and bad debt expense of $8.5 million for the first six months of 2004 compared to the first six months of 2003 contributed to the increase.

 

RESEARCH AND DEVELOPMENT

 

The Company manages research and development expenses as a percentage of net sales.  In the current quarter and six months, research and development expenses decreased compared with prior periods.  The decrease of research and development expenses as a percentage of net sales was due to increased economies of scale associated with increased business levels. The majority of the new personnel being hired in China, where labor costs are less expensive than in the United States, also contributed to the decrease in research and development expenses as a percentage of net sales.

 

We expect research and development expense to remain constant as a percentage of net sales for the near future.

 

Three months ended June 30, 2004 and 2003

 

The 46% increase in absolute dollars of research and development expenses was primarily due to hiring additional technical personnel to support both product enhancements and new product development. Research and development headcount increased approximately 52% from an average of 1,787 employees for the three months ended June 30, 2003 to an

 

31



 

average of 2,719 employees for the three months ended June 30, 2004.  The significant majority of the increase in research and development expenses from the three months ended June 30, 2003 to the three months ended June 30, 2004 was attributable to higher payroll and payroll-related costs resulting from our continued expansion of our research and development teams in China, from a full quarter’s salaries for CommWorks personnel as compared to one month’s salaries in the same period in the prior year and from additional employees hired in conjunction with the acquisitions of TELOS and HSI.

 

Six months ended June 30, 2004 and 2003

 

The increase in absolute dollars of research and development expenses of 56% was primarily due to hiring additional technical personnel to support both product enhancements and new product development. Research and development headcount increased approximately 57% from an average of 1,591 employees for the six months ended June 30, 2003 to an average of 2,492 employees for the six months ended June 30, 2004. The significant majority of the increase in research and development expenses from the six months ended June 30, 2003 to the six months ended June 30, 2004 was attributable to higher payroll and payroll-related costs resulting from our continued expansion of our research and development teams in China, from a full six months of salaries for CommWorks personnel as compared to one month’s salaries in the same period in the prior year and from additional employees hired in conjunction with the acquisitions of TELOS and HSI.

 

IN-PROCESS RESEARCH AND DEVELOPMENT

 

Three months ended June 30, 2004 and 2003

 

The $1.4 million charge to in-process research and development (“IPR&D”) for the three months ended June 30, 2004 was from our acquisition of TELOS. Of the $9.3 million charge to IPR&D for the three months ended June 30, 2003, $1.3 million, $6.2 million and $1.9 million were due to the CommWorks, RollingStreams and Xebeo acquisitions, respectively.  All charges to IPR&D were based upon independent valuations.

 

Six months ended June 30, 2004 and 2003

 

The $1.4 million charge to IPR&D for the six months ended June 30, 2004 was from our acquisition of TELOS. Of the $10.7 million charge to IPR&D for the six months ended June 30, 2003, $1.3 million, $6.2 million, $1.9 million and $1.3 million were due to the CommWorks, RollingStreams, Xebeo and Shanghai Yi Yun acquisitions, respectively. All charges to IPR&D were based upon independent valuations.

 

AMORTIZATION OF INTANGIBLE ASSETS

 

Three months ended June 30, 2004 and 2003

 

The increase in the amortization of intangible assets for the three months ended June 30, 2004 was due to a full three months of amortization expense associated with the $44.9 million of intangibles recorded upon our May 2003 CommWorks acquisition as compared to one month of expense for the comparative period in the prior year. Additionally, the increase in amortization of intangible assets expense was due to additional amortization expenses related to $20.9 million and $5.2 million of intangible assets recorded upon our acquisitions of TELOS and HSI, respectively. The estimated useful lives of these purchased intangibles are from one to ten years.

 

Six months ended June 30, 2004 and 2003

 

The increase in the amortization of intangible assets for the six months ended June 30, 2004 was due to a full six months of amortization expense associated with the $44.9 million of intangibles recorded upon our May 2003 CommWorks acquisition as compared to one month of expense for the comparative period in the prior year. Additionally, the increase in amortization of intangible assets expense was due to additional amortization expenses related to $20.9 million and $5.2 million of intangible assets recorded upon our acquisitions of TELOS and HSI, respectively. The estimated useful lives of these purchased intangibles are from one to ten years.

 

We anticipate additional amortization expense will be incurred in the third and fourth quarters of 2004 as the third quarter will include a full three months of amortization related to TELOS and HSI and the fourth quarter will include

 

32



 

amortization expense related to the Audiovox transaction.

 

OTHER INCOME (EXPENSES)

 

INTEREST INCOME

 

Three months ended June 30, 2004 and 2003

 

Interest income was $1.8 million and $0.7 million for the three months ended June 30, 2004 and 2003, respectively. The increase in interest income was due to higher average cash balances for the three months ended June 30, 2004 as compared to the corresponding period in 2003.

 

Six months ended June 30, 2004 and 2003

 

Interest income was $3.2 million and $1.6 million for the six months ended June 30, 2004 and 2003, respectively. The increase in interest income was due to higher average cash balances for the six months ended June 30, 2004 as compared to the corresponding period in 2003.

 

INTEREST EXPENSE

 

Three months ended June 30, 2004 and 2003

 

Interest expense was $1.1 million and $2.2 million for the three months ended June 30, 2004 and 2003, respectively.

 

Six months ended June 30, 2004 and 2003

 

Interest expense was $2.2 million and $2.8 million for the six months ended June 30, 2004 and 2003, respectively.

 

OTHER INCOME (EXPENSE), NET

 

Three months ended June 30, 2004 and 2003

 

Net other income was $4.3 million and $0.2 million for the three months ended June 30, 2004 and 2003, respectively. Net other income for the three months ended June 30, 2004 was primarily due to a $2.1 million tax refund received in China.  Additionally, we had a currency exchange gain of $0.9 million for the second quarter 2004 as compared to a currency exchange loss of $2.3 million for the second quarter 2003. We also earned a $0.5 million dividend from one of our investments during the three months ended June 2004. Net other income for the three months ended June 30, 2003 was primarily due to a tax refund received in China of $2.6 million.

 

Six months ended June 30, 2004 and 2003

 

Net other income was $13.0 million and $4.3 million for the six months ended June 30, 2004 and 2003, respectively. Net other income for the six months ended June 30, 2004 was primarily due to our receiving a $7.8 million financial subsidy from the local Chinese government during the first quarter of 2004.  This subsidy was to encourage our investment in local research and development and manufacturing activities.  We also recorded a currency exchange gain of $0.5 million for the six months ended 2004 as compared to a currency exchange loss of $1.5 million for the six months ended 2003. Additionally, we had a Japanese consumption tax refund of $1.4 million during the first quarter of 2004. Net other income for the six months ended June 30, 2003 was primarily due to a $3.9 million reinvestment incentive payment and a $2.6 million tax refund received in China.

 

33



 

EQUITY IN NET LOSS OF AFFILIATED COMPANIES

 

Three months ended June 30, 2004 and 2003

 

Equity in net loss of affiliated companies was $1.2 million and $1.7 million for the three months ended June 30, 2004 and 2003, respectively, and primarily resulted from losses incurred at our joint venture with Matsushita Communication Industrial Co., Ltd., and Matsushita Electric Industrial Co., Ltd.

 

Six months ended June 30, 2004 and 2003

 

Equity in net loss of affiliated companies was $2.2 million and $2.7 million for the six months ended June 30, 2004 and 2003, respectively, and primarily resulted from losses incurred at our joint venture with Matsushita Communication Industrial Co., Ltd., and Matsushita Electric Industrial Co., Ltd.

 

INCOME TAX EXPENSE

 

Three months ended June 30, 2004 and 2003

 

Income tax expense was $11.0 million and $13.1 million for the three months ended June 30, 2004 and 2003, respectively. The primary reason for the decrease in income tax expense was due to our overall effective tax rate decreasing to 20% for 2004 from 25% in 2003.  This decrease was a result of continued tax holidays in China as well as a greater proportion of income in countries with low tax rates.  We expect that our income tax expense will grow in absolute dollars in line with anticipated increases in pretax income.

 

Six months ended June 30, 2004 and 2003

 

Income tax expense was $24.7 million and $25.6 million for the six months ended June 30, 2004 and 2003, respectively. The primary reason for the decrease in income tax expense despite the fact that our income before taxes increased 20% for the six months ended June 30, 2004 from the corresponding period in 2003 was that the overall effective tax rate for 2004 decreased to 20% from 25% in 2003.  This decrease was a result of continued tax holidays in China as well as a greater proportion of income in countries with low tax rates.  We expect that our income tax expense will grow in absolute dollars in line with anticipated increases in pretax income.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Operating Activities

 

2004

 

Net cash used in operating activities for the six months ended June 30, 2004 was $118.5 million. Operating cash was affected by changes in customer advances, inventory and accounts receivable offset by net income and non-cash charges including depreciation and amortization and changes in deferred costs and accounts payable. 

 

The $179.1 million increase in accounts receivable was attributable to a larger volume of sales, from $736.4 million for the six months ended June 30, 2003 to $1.3 billion for the same period in 2004. Also contributing to a larger accounts receivable balance was that we had longer collection periods during the six months ended June 30, 2004 as compared to the same period in the prior year; our days sales outstanding was 70 days at June 30, 2004 as compared to 58 days at June 30, 2003.   We project that our days sales outstanding will fluctuate between 60 and 80 days for the remainder of 2004.

 

Inventory, net of inventory provision, increased by $193.0 million, also decreasing our operating cash.  As we expect sales to increase in subsequent quarters, we continued to build our inventory supply in this period to meet the anticipated demand in future periods. 

 

The $309.8 million decrease in customer advances also decreased operating cash for the period.  Customer advances, which represent cash deposits we have received from our customers for orders that have not yet received final acceptance, decreased due to an increased amount of customer acceptances.  As our customers in China transition from new system installations to system expansions, we believe that the period between customer advance and acceptance will shorten which will result in smaller customer advance balances for those customers.

 

34



 

Offsetting the activity that decreased operating cash for the period were net income and non-cash charges including depreciation and amortization and changes in deferred costs and accounts payable. Net income was $98.6 million, adjusted for non-cash charges including $34.0 million of depreciation and amortization.  Deferred costs, or inventory at customer sites awaiting final acceptance, decreased by $223.3 million.  The decrease in deferred costs was also a result of increased revenues and a greater number of customer acceptances, corresponding to the decrease in customer advances.  Accounts payable increased by $136.9 million, consistent with increased inventory purchasing.

 

2003

 

Net cash used in operations for the six months ended June 30, 2003 of $155.9 million was primarily due to an increase in inventory, deferred costs, accounts receivable and other current and non-current assets of $254.1 million, $405.9 million, $42.3 million and $121.0 million, respectively.  This was partially offset by net income of $76.8 million, adjusted for non-cash charges including depreciation and amortization expense of $17.7 million and in-process research and development costs of $10.6 million, as well as growth in deferred revenue of $362.2 million, accounts payable of $165.6 million, other current liabilities of $26.5 million and customer advances of $9.2 million.

 

Investing Activities

 

2004

 

Net cash used in investing activities for the six months ended June 30, 2004 of $155.7 million was primarily due to purchases of property, plant and equipment to support our expansion.  Of the total $62.5 million invested in property, plant and equipment, construction costs incurred on our Hangzhou manufacturing facility were $35.1 million during the period.  The Company anticipates a total investment for the Hangzhou facility of $138 million of which an additional $31 million is expected to be incurred.    Also contributing to net cash used in investing activities was our purchases of TELOS and HSI, which resulted in a cash outflow of $44.7 million.   The Company anticipates that the Audiovox transaction will close early in the fourth quarter of 2004 and will require a cash payment of $165.1 million at that time.   Finally, net purchases of short-term investments of $35.3 million contributed to cash used in investment activities.

 

2003

 

Net cash used in investing activities for the six months ended June 30, 2003 of $42.8 million was primarily due to business acquisitions of $109.5 million and purchases of property, plant and equipment of $41.2 million, offset by net sales of short-term investments of $113.0 million.

 

Financing Activities

 

2004

 

Net cash provided by financing activities was $384.7 million for the six months ended June 30, 2004.  This was primarily due to proceeds raised from our selling 12.1 million shares of common stock at $39.25 per share to Banc of America Securities, LLC, for net proceeds of approximately $474.6 million. In addition to the sale of stock, we received $17.7 million for the issuance of common stock through stock option and warrant exercises. Offsetting cash provided by financing activities, we used a portion of the capital raised to repurchase a total of 3.6 million shares of our common stock at an average price of $30.25 per share for a total cost of $107.6 million, including transaction fees.

 

2003

 

Net cash provided by financing activities for the six months ended June 30, 2003 of $243.0 million was primarily due to the offering of convertible subordinated notes of $391.4 million and proceeds from the exercise of stock options of $35.0 million, offset by the repurchase of shares from Softbank of $139.6 million and purchases of call options for $43.8 million.

 

Liquidity

 

Our working capital was $1.3 billion and $779.6 million at June 30, 2004 and 2003, respectively. This increase in working capital is due to increased cash on hand, to $484.8 million in cash and cash equivalents and $77.0 of short-term investments at June 30, 2004, from $276.0 million of cash and cash equivalents and $5.3 million of short-term investments at June 30, 2003. Our working capital also increased due to larger accounts receivable and inventory balances and lower customer advances, offset by smaller deferred costs balances, and higher accounts payable and deferred revenue balances. Cash on hand increased due to remaining proceeds from $474.6 million of net proceeds received from our equity offering in January 2004. We believe that this cash

 

35



 

 positions us to take advantage of strategic investment opportunities.

 

Our China sales are generally denominated in local currency. Due to the limitations on converting Renminbi, we are limited in our ability to engage in foreign currency hedging activities in China. Sales outside China are generally denominated in US dollars. We cannot guarantee that fluctuations in foreign currency exchange rates in the future will not have a material adverse effect on revenues from international sales and, correspondingly, on our business, financial condition and results of operations. We have contracts negotiated in Japanese Yen and we maintain a bank account in Japanese Yen for purchasing portions of our inventories and supplies. The balance of this Japanese Yen account at June 30, 2004 was approximately $36.7 million. Beginning in the first quarter of 2004, we hedge certain Japanese Yen-denominated balance sheet exposures against future movements in foreign currency exchange rates by using foreign currency forward contracts. Gains and losses on these fair value hedges are intended to offset gains and losses from the revaluation of our Japanese Yen-denominated recognized liabilities. In accordance with Statement of Financial Accounting Standards No. 133 (“SFAS 133”), “Accounting for Derivative Instruments and Hedging Activities,” we recognize derivative instruments and hedging activities as either assets or liabilities on the balance sheet and measure them at fair value. The net result of gains and losses on contracts and revaluation included in interest and other income (expense) was insignificant for the three and six months ended June 30, 2004. Our foreign currency forward contracts generally mature within three months. We do not intend to utilize derivative financial instruments for trading purposes. There were no foreign currency forward contracts held at June 30, 2004.

 

We believe that our existing cash and cash equivalents, short-term investments and cash from operations will be sufficient to finance our operations through at least the next 12 months. As of June 30, 2004, we had cash, restricted cash, short-term investments and restricted short-term investments of $604.4 million and lines of credit totaling $566.8 million available for future borrowings. $264.8 million of these facilities expire in 2004 and $302.0 million of these facilities expire between 2005 and 2010.   Of our total cash balance, $174.0 million is held in China where currency exchange controls exist.  As a result, our ability to make payments in other jurisdictions could be limited by our ability to move money from China to the other jurisdictions. 

 

In the event that our current cash balances, future cash flows from operations and current lines of credit are not sufficient to meet our obligations or strategic needs or in the event that market conditions are favorable, we would consider raising additional funds in the capital or equity markets. If additional financing is needed, there can be no assurance that such financing will be available to us on commercially reasonable terms, or at all.

 

Income taxes

 

Our subsidiaries and joint ventures located in China enjoy tax benefits which are generally available to foreign investment enterprises, including full exemption from national enterprise income tax for two years starting from the first profit making year and a 50% reduction in national income tax rate for the following three years. In addition, local enterprise income tax is often waived or reduced during this tax holiday/incentive period. Under current regulations in China, foreign investment enterprises that have been accredited as advanced and high-tech enterprises are entitled to additional tax incentives. These tax incentives vary in different locales and could include preferential national enterprise income tax treatment at 50% of the usual rates for different periods of time. The tax holidays discussed above are applicable to UTStarcom (Chongqing) Co., Ltd. (“CUTS”), UTStarcom Telecom Co., Ltd. (“HUTS”), Hangzhou UTStarcom Telecom Co., Ltd. (“HSTC”) and UTStarcom China Co., Ltd. (“UTSC”), our active subsidiaries in China, as those entities qualify as accredited advanced and high-tech enterprises. Specifically, HUTS currently enjoys a 15% tax rate that will continue indefinitely provided they continue to qualify their status as an advanced and high-tech enterprise and the Government does not change the tax laws. UTSC currently enjoys a 10% holiday tax rate that expires on December 31, 2005, at which point they will be subject to a 15% tax rate provided they continue to qualify as an advanced and high-tech enterprise and the Government does not change the tax laws. HSTC and CUTS are currently exempt from income tax until December 31, 2004, at which point they will be subject to a 7.5% tax rate, which will expire on December 31, 2007.

 

We are working to implement a research and development cost sharing arrangement among our key worldwide entities.  The purpose of cost sharing is to enable its participants to jointly develop and own intangibles.  Under research and development cost sharing, the total research and development expense is paid by cost-sharing participants in proportion to each participant’s future sales.  The benefit is that there is greater certainty with respect to transfer pricing and defined ownership of IP. Cost sharing in China is a new concept and we are working closely with the China Tax and Regulatory Authorities to gain approval for cost sharing.

 

36



 

Contractual obligations and other commitments

 

Our obligations under contractual obligations and commercial commitments are primarily with regard to leasing arrangements and standby letters of credit and are as follows:

 

 

 

June 30, 2004
Payments Due by Period

 

(in thousands)

 

Total

 

Less than
1 year

 

1-3 years

 

3-5 years

 

Contractual Obligations

 

 

 

 

 

 

 

 

 

Notes Payable

 

$

1,500

 

$

1,500

 

$

 

$

 

Convertible Subordinated Notes

 

$

402,500

 

$

 

$

 

$

402,500

 

Operating leases

 

$

24,885

 

$

11,322

 

$

13,145

 

$

418

 

Other Commercial Commitments

 

 

 

 

 

 

 

 

 

Standby letters of credit

 

$

35,874

 

$

35,874

 

$

 

$

 

Purchase commitments

 

$

39,600

 

$

39,600

 

 

 

 

 

 

Notes payable

 

Occasionally, the Company issues short-term notes payable to its vendors in lieu of trade accounts payable.  The payment terms are normally three to six months and are typically non-interest bearing. 

 

Convertible subordinated notes

 

Our $402.5 million of convertible subordinated notes, due March 1, 2008, bear interest at a rate of 7/8% per annum, payable semiannually on May 1 and September 1, are convertible into the Company’s common stock at a conversion price of $23.79 per share and are subordinated to all present and future senior debt of the Company. The principal is due only at maturity of the notes.

 

Operating leases

 

We lease certain facilities under non-cancelable operating leases that expire at various dates through 2008.

 

Audiovox purchase price payable

 

Upon the closing of the Audiovox purchase transaction, which is anticipated during the fourth quarter of 2004, we will be required to pay approximately $165.1 million in cash. The closing of the transaction is subject to satisfaction of certain conditions outlined in the purchase agreement.

 

Standby letters of credit

 

We issue standby letters of credit primarily to support international sales activities outside of China. When we submit a bid for a sale, often the potential customer will require that we issue a bid bond or a standby letter of credit to demonstrate our commitment through the bid process. In addition, we may be required to issue standby letters of credit as guarantees for advance customer payments upon contract signing or performance guarantees. The standby letters of credit usually expire six to nine months from date of issuance without being drawn by the beneficiary thereof.

 

Purchase commitments

 

We are obligated to purchase raw materials and work-in-process inventory under various orders from three suppliers, all of which should be fulfilled without adverse consequences material to our operations or financial condition. As of June 30, 2004, total open commitments under these purchase orders were approximately $39.6 million.

 

Joint venture funding

 

Pursuant to the joint venture agreement with Matsushita, we are jointly liable for the losses incurred in the operations of the joint venture up to the maximum of our investment in the entity.  At June 30, 2004, the losses had exceeded this amount; however, we had accrued additional losses of approximately $1.2 million during the three months ended June

 

37



 

30, 2004 due to our commitment to fund an additional investment of $9.3 million. We have cumulative losses of $2.2 million recorded within other current liabilities.

 

Investment commitments

 

As of June 30, 2004, we had invested a total of $2.0 million in Global Asia Partners L.P. that is recorded as a long-term investment. The fund size is anticipated to be $10.1 million and the fund was formed to make private equity investments in private or pre-IPO technology and telecommunications companies in Asia. We have a commitment to invest up to a maximum of $5.0 million. The remaining amount is due at such times and in such amounts as shall be specified in one or more future capital calls to be issued by the general partner.

 

Intellectual property

 

Certain sales contracts include provisions under which customers would be indemnified by us in the event of, among other things, a third-party claim against the customer for intellectual property rights infringement related to our products. There are no limitations on the maximum potential future payments under these guarantees. We have not accrued any amounts in relation to these provisions as no such claims have been made and we believe we have valid enforceable rights to the intellectual property embedded in our products.

 

Accounts receivable transferred to notes receivable

 

We accept commercial notes receivable with maturity dates between three and six months from our customers in China in the normal course of business. We may discount these notes with banking institutions in China. Notes receivable available for sale were $42.9 million and $11.4 million at June 30, 2004 and December 31, 2003, respectively. A sale of these notes is reflected as a reduction of notes receivable and the proceeds of the settlement of these notes are included in cash flows from operating activities in the consolidated statement of cash flows. There were no notes receivable sold during the three and six months ended June 30, 2004; there were $25.3 million and $44.5 million of notes receivable sold during the three and six months ended June 30, 2003, respectively.  These notes are not included in our consolidated balance sheets as the criteria for sale treatment established by SFAS 140, has been met. The costs of settling or transferring these notes receivable were $0.3 million and $0.5 million for the three and six months ended June 30, 2003, and were included in other income, net in the Consolidated Statements of Operations.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

In November 2003, the EITF issued EITF No. 03-6 “Participating Securities and the Two-Class Method under FASB Statement No. 128,” which provides for a two-class method of calculating earnings per share computations that relate to certain securities that would be considered to be participating in conjunction with certain common stock rights. This guidance was applicable to the Company starting with the second quarter beginning April 1, 2004. We have evaluated the impact of this pronouncement and determined that there was no effect on our financial statements.

 

On April 9, 2004, the FASB issued FASB Staff Position (“FSP”) to SFAS 129-1, Disclosure Requirements under FASB Statement No. 129, Disclosure of Information about Capital Structure, Relating to Contingently Convertible Securities to provide disclosure guidance for contingently convertible securities, including those instruments with contingent conversion requirements that have not been met and otherwise are not required to be included in the computation of diluted earnings per share. The FSP addresses concerns that disclosures relating to contingently convertible securities are inconsistent between companies or may be inadequate. FSP SFAS 129-1 notes that to comply with the requirements of SFAS 129, the significant terms of the conversion features of the contingently convertible security should be disclosed to enable users of financial statements to understand the circumstances o f the contingency and the potential impact of conversion. We have evaluated the impact of this pronouncement and have enhanced our disclosures as required.  For additional information about our outstanding convertible securities, please refer to Note 14 of our Condensed Consolidated Financial Statements, Debt.

 

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FACTORS AFFECTING FUTURE OPERATING RESULTS

 

RISKS RELATED TO OUR COMPANY

 

Our future product sales are unpredictable and, as a result, our operating results are likely to fluctuate from quarter to quarter.

 

Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate in the future due to a variety of factors, some of which are outside of our control. Factors that may affect our future operating results, in addition to those described below, include:

 

                                          the timing and size of the orders for our products;

 

                                          changes in our customers’ subscriber growth rate;

 

                                          the lengthy and unpredictable sales cycles associated with sales of our products;

 

                                          cancellation, deferment or delay in implementation of large contracts;

 

                                          our revenue recognition, which is based on acceptance, is unpredictable;

 

                                          a seasonal reoccurrence of an outbreak of severe acute respiratory syndrome (SARS) or other illnesses affecting areas in which we operate;

 

                                          the decline in business activity we typically experience during the Chinese Lunar New Year holiday, which leads to decreased sales during our first fiscal quarter relative to historical and expected year-long trends; and

 

                                          changes in accounting rules, such as recording expenses related to employee stock option compensation plans.

 

As a result of these and other factors, period-to-period comparisons of our operating results are not necessarily meaningful or indicative of future performance. Furthermore, it is possible that in some future quarters our operating results will fall below the expectations of securities analysts or investors. If this occurs, the trading price of our common stock could decline.

 

Competition in our markets may lead to reduced prices, revenues and market share.

 

We believe that we will continue to face intense competition from both domestic and international companies in our target markets, many of which may operate under lower cost structures or may be given preferential treatment by applicable governmental regulators and policies and have much larger sales forces than we do. Additionally, other companies not presently offering competing products may also enter our target markets. Many of our competitors have significantly greater financial, technical, product development, sales, marketing and other resources than we do. As a result, our competitors may be able to respond more quickly to new or emerging technologies and changes in service provider requirements. Our competitors may also be able to devote greater resources than we can to the development, promotion and sale of new products. These competitors may be able to offer significant financing arrangements to service providers, which may give them a competitive advantage in selling systems to service providers with limited financial and currency resources. In many of the developing markets in which we operate or intend to operate, relationships with local governmental telecommunications agencies are important to establish and maintain. In many such markets, our competitors may have or be able to establish better relationships with local governmental telecommunications agencies than we have, which could result in their ability to influence governmental policy formation and interpretation to their advantage. Additionally, our competitors might have better relationships with their third-party suppliers and obtain component parts at a reduced rate, allowing them to offer their end products at reduced prices. Increased competition is likely to result in price reductions, reduced gross profit as a percentage of net sales and loss of market share, any one of which could materially harm our business, financial condition, cash flows, and results of operations.

 

The average selling prices of our products may decrease, which may reduce our revenues and our gross profit. As a result, we must introduce new products and reduce our costs in order to maintain profitability.

 

The average selling prices for communications access and switching systems and handsets have historically declined as a result of a number of factors, including:

 

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                                          increased competition;

 

                                          aggressive price reductions by competitors; and

 

                                          rapid technological change.

 

The average selling prices of our products may continue to decrease in the future in response to product introductions by us or our competitors or other factors, including price pressures from customers. Therefore, we must continue to develop and introduce new products and enhancements to existing products that incorporate features that can be sold at higher average selling prices. Failure to do so could cause our revenues and gross profit to decline.

 

Our cost reduction efforts may not allow us to keep pace with competitive pricing pressures or lead to improved gross profit, as a percentage of net sales. In order to be competitive, we must continually reduce the cost of manufacturing our products through design and engineering changes. We may not be successful in these efforts or in delivering our products to market in a timely manner. In addition, any redesign may not result in sufficient cost reductions to allow us to reduce the prices of our products to remain competitive or to improve or maintain our gross profit, as a percentage of net sales, which would cause our financial results to suffer.

 

Sales in China have accounted for most of our total sales, and our business, financial condition and results of operations are to a significant degree subject to economic, political and social events in China.

 

Approximately $618.3 million, or 90%, and $1.2 billion, or 91%, of our net sales for the three and six months ended June 30, 2004, respectively, occurred in China. Approximately $332.5 million, or 82%, and $601.5 million, or 82%, of our net sales for the three and six months ended June 30, 2003, respectively, occurred in China. While we anticipate expansion into other foreign markets, a significant majority of our net sales will be derived from China for the foreseeable future. In addition, we plan to continue to make further investments in China in the future. Therefore, our business, financial condition and results of operations are to a significant degree subject to economic, political, legal and social developments and other events in China. Please read the risks detailed below under the heading “Risks Related to Conducting Business in China” for additional information about the risks we face in connection with our China operations.

 

Our market is subject to rapid technological change, and to compete effectively, we must continually introduce new products and product enhancements that achieve market acceptance.

 

The market for communications equipment is characterized by rapid technological developments, frequent new product introductions and evolving industry and regulatory standards. Our success will depend in large part on our ability to enhance our network and broadband access and switching technologies and develop and introduce new products and product enhancements that anticipate changing service provider requirements and technological developments. We may need to make substantial capital expenditures and incur significant research and development costs to develop and introduce new products and enhancements. If we fail to develop and introduce new products or enhancements to existing products that effectively respond to technological change on a timely basis, our business, financial condition and results of operations could be materially adversely affected. Moreover, from time to time, our competitors or we may announce new products or product enhancements, technologies or services that have the potential to replace or shorten the life cycles of our products and that may cause customers to defer purchasing our existing products, resulting in inventory obsolescence. Future technological advances in the communications industry may diminish or inhibit market acceptance of our existing or future products or render our products obsolete.

 

Even if we are able to develop and introduce new products, they may not gain market acceptance. Market acceptance of our products will depend on various factors, including:

 

                                          our ability to obtain necessary approvals from regulatory organizations within the countries in which we operate and for any new technologies that we introduce;

 

                                          the length of time it takes service providers to evaluate our products, causing the timing of purchases to be unpredictable;

 

                                          our products being compatible with legacy technologies and standards existing in previously deployed network equipment;

 

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                                          our ability to attract customers who may have preexisting relationships with our competitors;

 

                                          product cost relative to performance; and

 

                                          the level of customer service available to support new products.

 

If our products fail to obtain market acceptance in a timely manner, our business could suffer.

 

We depend on some sole source and other key suppliers, as well as international sources, for handsets, base stations, components and materials used in our products. If we cannot obtain adequate supplies of high quality products at competitive prices or in a timely manner from these suppliers or sources, our competitive position, reputation and business could be harmed.

 

We have contracts with a single supplier or with a limited group of suppliers to purchase some components and materials used in our products. If any supplier is unwilling or unable to provide us with high-quality components and materials in the quantities required and at the costs specified by us, we may not be able to find alternative sources on favorable terms, in a timely manner, or at all. Our inability to obtain or to develop alternative sources if and as required could result in delays or reductions in manufacturing or product shipments. From time to time, there could be shortages of different components or materials used in our products. For example, in 2001 and 2002 there was a worldwide shortage of handset components resulting from our third-party manufacturers’ inability to assemble and manufacture a sufficient quantity of handsets to keep pace with consumer demand. Moreover, our suppliers may supply us with inferior quality products. If an inferior product supplied by a third party is embedded in our end product and causes a problem, it might be difficult to identify the source of the problem as being due to the component parts. If any of these events occur, our competitive position, reputation and business could suffer.

 

Our ability to source a sufficient quantity of high-quality, cost-effective components used in our products may also be limited by import restrictions and duties in the foreign countries in which we manufacture our products. We require a significant number of imported components to manufacture our products, and imported electronic components and other imported goods used in the operation of our business may be limited by a variety of permit requirements, approval procedures, import duties and registration requirements. Moreover, import duties on such components increase the cost of our products and may make them less competitive.

 

If we seek to secure additional financing and are not able to do so, our ability to expand strategically may be limited. If we are able to secure additional financing, our stockholders may experience dilution of their ownership interest, or we may be subject to limitations on our operations and increased leverage.

 

We currently anticipate that our available cash resources, which include existing cash and cash equivalents, short-term investments and cash from operations, will be sufficient to meet our anticipated needs for working capital and capital expenditures for the foreseeable future. If we are unable to generate sufficient cash flows from operations, we may need to raise additional funds to develop new or enhanced products, respond to competitive pressures, take advantage of acquisition opportunities or raise capital for strategic purposes. If we raise additional funds through the issuance of equity securities, our stockholders will experience dilution of their ownership interest, and the newly issued securities may have rights superior to those of common stock. If we raise additional funds by issuing debt, we may be subject to limitations on our operations and increase our leverage. For example, in connection with the sale of convertible debt securities in March 2003, we incurred $402.5 million of indebtedness. As a result of this indebtedness, our principal and interest payment obligations have increased substantially. The degree to which we are leveraged could materially and adversely affect our ability to obtain financing for working capital, acquisitions or other purposes and could make us more vulnerable to industry downturns and competitive pressures. Our ability to meet our debt service obligations will be dependent upon our future performance, which will be subject to financial, business and other factors affecting our operations, many of which are beyond our control. Finally, additional sources of financing may not be available on reasonable terms or at all if and when we require it, which could harm our business.

 

Our recent growth has strained our resources, and if we are unable to manage and sustain our growth, our operating results will be negatively affected.

 

We have recently experienced a period of rapid growth and anticipate that we must continue to expand our operations to address potential market opportunities. Our expansion has placed and will continue to place a significant strain on our management, operational, financial and other resources. To manage our growth effectively, we will need to take various actions, including:

 

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                                          enhancing management information systems and forecasting procedures;

 

                                          further developing our operating, administrative, financial and accounting systems and controls;

 

                                          managing our working capital and sources of financing to fund our expansion;

 

                                          maintaining close coordination among our engineering, accounting, finance, marketing, sales and operations organizations;

 

                                          expanding, training and managing our employee base;

 

                                          improving and sustaining our supply chain capability;

 

                                          managing the expansion of both our direct and indirect sales channels in a cost-efficient and competitive manner; and

 

                                          fully review our new customers’ credit histories and ensure their financial stability before finalizing contracts.

 

If we fail to implement or improve systems or controls or to manage any future growth and expansion effectively, our business could suffer.

 

Our success is dependent on continuing to hire and retain qualified personnel, and if we are not successful in attracting and retaining these personnel, our business will suffer.

 

The success of our business depends in significant part upon the continued contributions of key technical and senior management personnel, many of whom would be difficult to replace. In particular, our success depends in large part on the knowledge, expertise and services of Hong Liang Lu, our Chairman of the Board, President and Chief Executive Officer, and Ying Wu, our Chairman and Chief Executive Officer of China Operations. The loss of any key employee, the failure of any key employee to perform satisfactorily in his or her current position or our failure to attract and retain other key technical and senior management employees could have a significant negative impact on our operations.

 

To effectively manage our recent growth as well as any future growth, we will need to recruit, train, assimilate, motivate and retain qualified employees both locally and internationally. Competition for qualified employees is intense, and the process of recruiting personnel with the combination of skills and attributes required to execute our business strategy can be difficult, time-consuming and expensive. As we grow globally, we must implement hiring and training processes that are capable of quickly deploying qualified local residents to knowledgeably support our products and services. Alternatively, if there is an insufficient number of qualified local residents available, we might incur substantial costs importing expatriates to service new global markets. For example, we have historically experienced difficulty finding qualified accounting personnel knowledgeable in both U.S. and Chinese accounting standards who are Chinese residents. If we fail to attract, hire, assimilate or retain qualified personnel, our business would be harmed.

 

Competitors and others have in the past, and may in the future, attempt to recruit our employees. In addition, companies in the telecommunications industry whose employees accept positions with competitors frequently claim that the competitors have engaged in unfair hiring practices. We may be the subject of these types of claims in the future as we seek to hire qualified personnel. Some of these claims may result in material litigation and disruption to our operations. We could incur substantial costs in defending ourselves against these claims, regardless of their merit.

 

Any acquisitions that we undertake could be difficult to integrate, disrupt our business, dilute our stockholders and harm our operating results.

 

We have acquired other businesses, products and technologies. For  example, during the second quarter, we completed our acquisitions of TELOS and HSI for $30.3 million and $14.1 million.  Additionally, in June, 2004, we announced our acquisition of certain assets of Audiovox for $165.1 million, an acquisition that we expect to close in the fourth quarter of 2004.  Any anticipated benefits of these acquisitions may not be realized. We have in the past and will continue to evaluate acquisition prospects that would complement our existing product offerings, augment our market coverage, enhance our technological capabilities, or that may otherwise offer growth opportunities. Acquisitions may result in dilutive issuances of equity securities, use of our cash resources, the incurrence of debt and the amortization of expenses related to intangible assets. In addition,

 

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acquisitions involve numerous risks, including difficulties in the assimilation of operations, technologies, products and personnel of the acquired company, diversion of management’s attention from other business concerns, risks of entering markets in which we have no direct or limited prior experience, the potential loss of key employees of the acquired company, unanticipated costs and, in the case of the acquisition of financially troubled businesses, challenges as to the validity of such acquisitions from third party creditors of such businesses.

 

We may be unable to adequately protect the loss or misappropriation of our intellectual property, which could substantially harm our business.

 

We rely on a combination of patents, copyrights, trademarks, trade secret laws and contractual obligations to protect our technology. We have applied for patents in the United States and internationally. Additional patents may not be issued from our pending patent applications, and our issued patents may not be upheld. In addition, we have, from time to time, chosen to abandon previously filed applications. Moreover, we may face difficulties in registering our existing trademarks in new jurisdictions in which we operate. We cannot guarantee that the intellectual property protection measures that we have taken will be sufficient to prevent misappropriation of our technology or trademarks or that our competitors will not independently develop technologies that are substantially equivalent or superior to ours. In addition, the legal systems of many foreign countries do not protect or honor intellectual property rights to the same extent as the legal system of the United States. For example, in China, the legal system in general, and the intellectual property regime in particular, are still in the development stage. It may be very difficult, time-consuming and costly for us to attempt to enforce our intellectual property rights in these jurisdictions.

 

We may be subject to claims that we infringe the intellectual property rights of others, which could substantially harm our business.

 

The industry in which we compete is moving towards aggressive assertion, licensing, and litigation of patents and other intellectual property rights. From time to time, we have become aware of the possibility or have been notified that we may be infringing certain patents or other intellectual property rights of others. Regardless of their merit, responding to such claims could be time consuming, divert management’s attention and resources and cause us to incur significant expenses. In addition, although some of our supplier contracts provide for indemnification from the supplier with respect to losses or expenses incurred in connection with any infringement claim, some of our contracts do not provide for such protection. Moreover, certain of our sales contracts provide that we must indemnify our customers against claims by third parties for intellectual property rights infringement related to our products. There are no limitations on the maximum potential future payments under these guarantees. Therefore, we may incur substantial costs related to any infringement claim, which may substantially harm our results of operations and financial condition.

 

We may, in the future, become subject to litigation to defend against claimed infringements of the rights of others or to determine the scope and validity of the proprietary rights of others. Future litigation may also be necessary to enforce and protect our trade secrets and other intellectual property rights. Any intellectual property litigation or threatened intellectual property litigation could be costly, and adverse determinations or settlements could result in the loss of our proprietary rights, subject us to significant liabilities, require us to seek licenses from or pay royalties to third parties which may not be available on commercially reasonable terms, if at all, and/or prevent us from manufacturing or selling our products, which could cause disruptions to our operations.

 

In the event that there is a successful claim of infringement against us and we fail to develop non-infringing technology or license the propriety rights on commercially reasonable terms and conditions, our business, results of operations or financial condition could be materially and adversely impacted.

 

Our multinational operations subject us to various economic, political, regulatory and legal risks.

 

We market and sell our products globally, with the majority of our sales made in China. The expansion of our existing multinational operations and entry into new markets will require significant management attention and financial resources. Multinational operations are subject to a variety of risks, such as:

 

                                          the burden of complying with a variety of foreign laws and regulations;

 

                                          the burden of complying with United States laws and regulations for foreign operations, including the Foreign Corrupt Practices Act;

 

                                          difficulty complying with continually evolving and changing global product and communications standards

 

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and regulations for both our end products and their component technology;

 

                                          market acceptance of our new products, including longer product acceptance periods in new markets into which we enter;

 

                                          reliance on local original equipment manufacturers (OEMs), third-party distributors and agents to effectively market and sell our products;

 

                                          unusual contract terms required by customers in developing markets;

 

                                          changes in local governmental control or influence over our customers;

 

                                          changes to import and export regulations, including quotas, tariffs, licensing restrictions and other trade barriers;

 

                                          evolving and unpredictable nature of the economic, regulatory, competitive and political environments;

 

                                          reduced protection for intellectual property rights in some countries;

 

                                          longer accounts receivable collection periods; and

 

                                          difficulties and costs of staffing and managing multinational operations, including but not limited to internal control and compliance.

 

We do business in markets that are not fully developed, which subjects us to various economic, political, regulatory and legal risks unique to developing economies.

 

Less developed markets present additional risks, such as the following:

 

                                          customers that may be unable to pay for our products in a timely manner or at all;

 

                                          new and unproven markets for our products and the telecommunications services that our products enable;

 

                                          inconsistent infrastructure support;

 

                                          lack of a large, highly trained workforce;

 

                                          difficulty in controlling local operations from our headquarters;

 

                                          variable ethical standards and an increased potential for fraud;

 

                                          unstable political and economic environments; and

 

                                          a lack of a secure environment for our personnel, facilities and equipment.

 

In particular, these factors create the potential for physical loss of inventory and operating assets. We have in the past experienced cases of vandalism and armed theft of our equipment that had been or was being installed in the field. If disruptions for any of these reasons become too severe in any particular market, it may become necessary for us to terminate contracts and withdraw from that market and suffer the associated costs and lost revenue.

 

We are subject to risks relating to currency rate fluctuations and exchange controls.

 

Because most of our sales are made in foreign countries, we are exposed to market risk for changes in foreign exchange rates on our foreign currency-denominated accounts and notes receivable balances. We do not currently hedge our foreign currency-denominated transactions. Historically, the majority of our sales have been made in China and denominated in Renminbi. The impact of currency fluctuations of Renminbi thus far has been insignificant as it is fixed to the U.S. dollar.

 

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However, in the future, China could choose to devalue the Renminbi versus the U.S. dollar, or the Renminbi-U.S. dollar exchange rate could float, and the Renminbi could depreciate relative to the U.S. dollar. Fluctuations in currency exchange rates in the future may have a material adverse effect on our results of operations.

 

We enter into transactions that may expose us to foreign currency rate fluctuation risk. Historically, the largest component of our foreign currency exchange loss has resulted from our purchasing inventory denominated in foreign currencies. If we continue to purchase inventory in foreign currencies, we may incur additional foreign currency exchange losses, causing our operating results to suffer.

 

Moreover, some of the foreign countries in which we do business might impose currency restriction that may limit the ability of our subsidiaries and joint ventures in such countries to obtain and remit foreign currency necessary for the purchase of imported components and may limit our ability to obtain and remit foreign currency in exchange for foreign earnings. For example, China employs currency controls restricting Renminbi conversion, limiting our ability to engage in currency hedging activities in China. Various foreign exchange controls may also make it difficult for us to repatriate earnings, which could have a material adverse effect on our ability to conduct business globally.

 

Business interruptions could adversely affect our business.

 

Our operations are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, external interference with our information technology systems, incidents of terrorism and other events beyond our control. For example, our Hangzhou manufacturing facility’s ability to produce sufficient products is dependent upon a continuous power supply, and the power required to source our manufacturing operations is inconsistent. The Hangzhou facility has in the past been subject to power shortages, which has affected our ability to produce and ship sufficient products. We do not have a detailed disaster recovery plan, and the occurrence of any events like these that disrupt our business could harm our operating results.

 

We may suffer losses with respect to equipment held at customer sites, which could harm our business.

 

We face the risk of loss relating to our equipment held at customer sites. In some cases, our equipment held at customer sites is under contract, pending final acceptance by the customer. We do not hold title or risk of loss on such equipment, as title and risk of loss are typically transferred to the customer upon delivery of our equipment. However, we do not recognize revenue and accounts receivable with respect to the sale of such equipment until we obtain acceptance from the customer. If we do not obtain final acceptance, we may not be able to collect the contract price and recover this equipment or its associated costs. In other cases, particularly in China, where governmental approval is required to finalize certain contracts, inventory not under contract may be held at customer sites. We hold title and risk of loss on this inventory until the contracts are finalized and, as such, are subject to any losses incurred resulting from any damage to or loss of this inventory. If our contract negotiations fail or if the government of China otherwise delays approving contracts, we may not recover or receive payment for this inventory. Moreover, our insurance may not cover all losses incurred if our inventory at customer sites not under contracts is damaged prior to contract finalization. If we incur a loss relating to inventory for any of the above reasons, our operating results could be harmed.

 

We have been named as a defendant in securities litigation.

 

We and various underwriters for our initial public offering are defendants in a purported shareholder class action. The complaint alleges undisclosed improper underwriting practices concerning the allocation of IPO shares, in violation of the federal securities laws. Similar complaints have been filed concerning the IPOs of more than 300 companies, and the litigation has been coordinated in United States District Court for the Southern District of New York as In re Initial Public Offering Securities Litigation, 21 MC 92. Although we believe we have valid defenses to the claims against us and intend to defend the litigation vigorously, until the matter is resolved, it will be necessary for us to continue to expend time and financial resources on the matter. Moreover, an adverse judgment in the litigation could materially harm our operations.

 

Standards for compliance with Section 404 of the Sarbanes-Oxley Act of 2002 are uncertain, and if we fail to comply in a timely manner, our business could be harmed and our stock price could decline.

 

We must comply with the rules promulgated under Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”) by December 31, 2004. Rules describing the requirements for our auditors to be able to attest to our compliance under Section 404 were adopted in June, 2004, and we, along with our external service providers, are currently interpreting what qualifies as compliance with Section 404. Because the matter of Section 404 compliance is new, there is no precedent or proven method for such compliance, and our management must exercise significant judgment in our effort to comply with

 

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Section 404. As a result of this uncertainty, we cannot be certain that we will comply with the requirements of Section 404 in a timely manner. If we fail to comply in a timely manner, public perception of our internal controls could be damaged, causing our financial results to suffer and our stock price to decline.

 

Recently enacted and proposed changes in securities laws and regulations are likely to increase our costs.

 

The Sarbanes-Oxley Act of 2002 has required and will continue to require changes in some of our corporate governance and securities disclosure or compliance practices. That Act also requires the SEC to promulgate new rules on a variety of subjects, in addition to rule proposals already made, and The Nasdaq National Market has revised its requirements for companies that are Nasdaq-listed. We expect these developments (i) will require us to devote additional resources to our operational, financial and management information systems procedures and controls to ensure our continued compliance with current and future laws and regulations, (ii) will make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage, increase our level of self-insurance, or incur substantially higher costs to obtain coverage, and (iii) could make it more difficult for us to attract and retain qualified members of our board of directors, or qualified executive officers. We are presently evaluating and monitoring regulatory developments and cannot estimate the timing or magnitude of additional costs we may incur as a result.

 

Changes in accounting rules.

 

We prepare our financial statements in conformity with accounting principles generally accepted in the United States of America. These principles are subject to interpretation by the Securities and Exchange Commission and various bodies formed to interpret and create appropriate accounting policies. A change in these policies can have a significant effect on our reported results and may even retroactively affect previously reported transactions. In particular, changes to Financial Accounting Standards Board (FASB) guidelines relating to accounting for stock-based compensation will likely increase our compensation expense, could make our net income less predictable in any given reporting period and could change the way we compensate our employees or cause other changes in the way we conduct our business.

 

RISKS RELATED TO CONDUCTING BUSINESS IN CHINA

 

China’s governmental and regulatory reforms may impact our ability to do business in China.

 

The Chinese government, through the Ministry of Information Industry, the Chinese telecommunication industry’s regulating body, has broad discretion and authority over all aspects of the telecommunications and information technology industry in China, with the power to permit or prohibit the sales of any of our products. Since 1978, the Chinese government has been in a state of evolution and reform. The reforms have resulted in and are expected to continue to result in significant economic and social development in China. Many of the reforms are unprecedented or experimental and may be subject to change or readjustment due to a variety of political, economic and social factors. While we anticipate that the basic principles underlying the reforms will remain unchanged, any of the following changes in China’s political and economic conditions and governmental policies could have a substantial impact on our business:

 

                                          the promulgation of new laws and regulations and the interpretation of those laws and regulations;

 

                                          inconsistent enforcement and application of the telecommunications industry’s rules and regulations by the Chinese government between foreign and domestic companies;

 

                                          the introduction of measures to control inflation or stimulate growth;

 

                                          the introduction of new guidelines for tariffs and service rates, which affect our ability to competitively price our products and services;

 

                                          changes in the rate or method of taxation;

 

                                          the imposition of additional restrictions on currency conversion and remittances abroad; or

 

                                          any actions which limit our ability to develop, manufacture, import or sell our products in China, or to finance

 

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and operate our business in China.

 

For example, in the year 2000, the Ministry of Information Industry temporarily halted deployment of our PAS systems and handsets, pending its review of personal handyphone system (“PHS”)-based telecommunications equipment, a microcellular wireless communications technology. The Ministry of Information Industry later allowed the continued deployment of PHS-based systems, such as our PAS systems and handsets, in China’s county-level cities, towns and villages but limited deployments within large and medium-sized cities to very limited areas of dense population, such as campuses, commercial buildings and special development zones. If in the future the Ministry of Information Industry determines to prohibit the sale or deployment of our PAS systems and handsets or our other products, or if it imposes additional limitations on their sale, our business and financial condition could suffer.

 

In addition to modifying the existing telecommunications regulatory framework, the Chinese government is currently preparing a draft of a standard, national telecommunications law (the “Telecommunications Law”) to provide a uniform regulatory framework for the telecommunications industry. We do not yet know the final nature or scope of the regulation that would be created if the Telecommunications Law is passed. Accordingly, we cannot predict whether it will have a positive or negative effect on us or on some or all aspects of our business.

 

China’s changing economic environment may impact our ability to do business in China.

 

Since 1978, the Chinese government has been reforming the economic system in China to increase emphasis placed on decentralization and the utilization of market forces in the development of China’s economy. These reforms have resulted in significant economic growth. However, any economic reform policies or measures in China may from time to time be modified or revised by the Chinese government. While we may be able to benefit from the effects of some of these policies, these policies and other measures taken by the Chinese government to regulate the economy could also have a significant negative impact on economic conditions in China, which would result in a negative impact on our business. More recently, China’s economic environment has been changing as a result of China’s entry into the World Trade Organization (WTO), which was effective in December of 2001. Entry into the WTO requires that China reduce tariffs and eliminate non-tariff barriers, including quotas, licenses and other restrictions, by 2005 at the latest, and we cannot predict the impact of these changes on China’s economy. Moreover, although China’s entry into the WTO and the related relaxation of trade restrictions may lead to increased foreign investment, it may also lead to increased competition in China’s markets from other foreign companies. If China’s entry into the WTO results in increased competition or has a negative impact on China’s economy, our business could suffer. In addition, although China is increasingly according foreign companies and foreign investment enterprises established in China the same rights and privileges as Chinese domestic companies as a result of its admission into the WTO, special laws, administrative rules and regulations governing foreign companies and foreign investment enterprises in China may still place foreign companies at a disadvantage in relation to Chinese domestic companies and may adversely affect our competitive position.

 

Uncertainties with respect to the Chinese legal system may adversely affect us.

 

We conduct our business in China primarily through our wholly-owned subsidiaries incorporated in China. Our subsidiaries are generally subject to laws and regulations applicable to foreign investment in China. Accordingly, our business might be affected by China’s developing legal system. Since 1978, many new laws and regulations covering general economic matters have been promulgated in China, and government policies and internal rules promulgated by governmental agencies may not be published in time, or at all. As a result, we may operate our business in violation of new rules and policies without having any knowledge of their existence. In addition, there are uncertainties regarding the interpretation and enforcement of laws, rules and policies in China. The Chinese legal system is based on written statutes, and prior court decisions have limited precedential value. Because many laws and regulations are relatively new and the Chinese legal system is still evolving, the interpretations of many laws, regulations and rules are not always uniform. Moreover, the relative inexperience of China’s judiciary in many cases creates additional uncertainty as to the outcome of any litigation, and the interpretation of statutes and regulations may be subject to government policies reflecting domestic political changes. Finally, enforcement of existing laws or contracts based on existing law may be uncertain and sporadic, and it may be difficult to obtain swift and equitable enforcement, or to obtain enforcement of a judgment by a court of another jurisdiction. Any litigation in China may be protracted and result in substantial costs and diversion of resources and management attention.

 

We only have trial licenses to sell certain of our network access products in China.

 

Under China’s current regulatory structure, the communications products that we offer in China must meet government and industry standards, and a network access license for the equipment must be obtained. Without a license, telecommunications equipment is not allowed to be connected to public telecommunications networks or sold in China. Moreover, we must ensure that the quality of the telecommunications equipment for which we have obtained a network access license is stable and reliable,

 

47



 

and will not lower the quality or performance of other installed licensed products. China’s State Council’s product quality supervision department, in concert with China’s Ministry of Information Industry, performs spot checks to track and supervise the quality of licensed telecommunications equipment and publishes the results of such spot checks.

 

We have obtained a probationary network access license for our mSwitch product, and after the trial period, we anticipate that an official network access license will be issued if the trial demonstrates that mSwitch satisfies all the applicable government and industry standards. However, we cannot be certain that we will receive this license. Moreover, we only have trial licenses for our PAS systems and handsets. We have applied for, but have not yet received, a final official network access license for our PAS systems and handsets. Based upon conversations with China’s Ministry of Information Industry, we understand that our PAS systems and handsets are considered to still be in the trial period and that sales of our PAS systems and handsets may continue to be made by us during this trial period, but that a license will ultimately be required. If we fail to obtain the required licenses, we could be prohibited from making further sales of the unlicensed products, including our PAS systems and handsets, in China, which would substantially harm our business, financial condition and results of operations. The regulations implementing these requirements are not very detailed, have not been applied by a court and may be interpreted and enforced by regulatory authorities in a number of different ways. Our counsel in China has advised us that China’s governmental authorities may interpret or apply the regulations with respect to which licenses are required and the ability to sell a product while a product is in the trial period in a manner that is inconsistent with the information received by our counsel in China, and either of these conditions could have a material adverse effect on our business, financial condition and results of operations.

 

If China Telecom Corporation (“China Telecom”) or China Netcom International Corporation Ltd. (“China Netcom”) obtains licenses allowing them to deliver mobile services, our ability to sell our PAS mobile systems and handsets could be impaired.

 

China Telecom and China Netcom hold and operate the fixed line telephone and data communications assets in China, and currently do not have the licenses necessary to offer mobile services. However, China’s media sources have widely reported that China’s Ministry of Information Industry may grant mobile licenses to China Telecom or China Netcom, or to both toward the end of 2004. Furthermore, it is anticipated that the mobile license granted by the government will be used for 3G mobile network deployments.

 

If China Telecom or China Netcom obtain 3G mobile licenses, they may direct capital expenditures to build-out 3G networks, and capital expenditures to build-out PAS networks that utilize our existing products may decline. Moreover, they may elect not to deploy our PAS systems and handsets or other mobile services that we may offer in the future. In addition, it is possible that current PAS frequency bands utilized by PAS networks may be reallocated for use by 3G networks, which would have the effect of restricting or shutting down PAS networks. If this were to occur, we could lose current and potential future customers for our products, and our financial condition and results of operations could be significantly harmed.

 

Promotional or incentive programs offered by mobile operators such as China Mobile and China Unicom may adversely impact the competitiveness and pricing of our PAS systems and related products.

 

The official tariffs and per-minute usage rates charged to mobile users in China are generally set by the Ministry of Information Industry and the National Development and Reform Commission, and are usually adhered to by mobile operators. However, from time to time, certain mobile operators such as China Mobile and China Unicom have offered special promotional pricing or incentives to customers, such as free incoming calls or free mobile-to-mobile calls. The continued use of such incentive programs by mobile operators may adversely impact the competitiveness and pricing of our PAS systems and related products and their rollout by the new China Telecom and China Netcom. Such incentive programs may continue or be expanded in the future. We cannot be certain as to what impact such incentive programs may have on our financial condition. However, it is possible that the continuation or expansion of such programs may have a material adverse effect on our business or results of operations.

 

If tax benefits available to our subsidiaries located in China are reduced or repealed, our business could suffer.

 

The Chinese government is considering the imposition of a “unified” corporate income tax that would phase out, over time, the preferential tax treatment to which foreign investment enterprises, such as our company, are currently entitled. While it is not certain whether the government will implement such a unified tax structure or whether our company will be grandfathered into any new tax structure, if a new tax structure is implemented, a new tax structure may adversely affect our financial condition. Moreover, certain of our subsidiaries and joint ventures located in China enjoy tax benefits in China that are generally available to foreign investment enterprises. If these tax benefits are reduced or repealed due to changes in tax laws, our business could suffer. We are currently applying for the ability to share research and development costs among our key worldwide entities.  This is a new concept in China, and we are working closely with the China Tax and Regulatory Authorities to gain approval for this cost sharing. If the cost sharing is not approved by China, our effective tax rate may increase.

 

48



 

RISKS RELATED TO OUR STOCK PERFORMANCE AND

CONVERTIBLE DEBT SECURITIES

 

Our stock price is highly volatile.

 

The trading price of our common stock has fluctuated significantly since our initial public offering in March of 2000. Our stock price could be subject to wide fluctuations in the future in response to many events or factors, including those discussed in the preceding risk factors relating to our operations, as well as:

 

                                          actual or anticipated fluctuations in operating results, actual or anticipated gross profit as a percentage of net sales, levels of inventory, our actual or anticipated rate of growth and our actual or anticipated earnings per share;

 

                                          changes in expectations as to future financial performance or changes in financial estimates or buy/sell recommendations of securities analysts;

 

                                          changes in governmental regulations or policies in China, such as the temporary suspension of sales of our PAS systems that occurred in May and June of 2000, which caused our stock price to drop;

 

                                          our, or a competitor’s, announcement of new products, services or technological innovations;

 

                                          the operating and stock price performance of other comparable companies; and

 

                                          news and commentary emanating from the media, securities analysts or government bodies in China relating to us and to the industry in general.

 

General market conditions and domestic or international macroeconomic factors unrelated to our performance may also affect our stock price. For these reasons, investors should not rely on recent trends to predict future stock prices or financial results. In addition, following periods of volatility in a company’s securities, securities class action litigation against a company is sometimes instituted. This type of litigation could result in substantial costs and the diversion of management time and resources.

 

In addition, public announcements by China Telecom and China Netcom, each of which exert significant influence over many of our major customers in China, may contribute to volatility in the price of our stock. In 2002, China Telecom completed its initial public offering, which has caused that entity to issue press releases more frequently than in prior years. The price of our stock may react to such announcements. More recently, it has been reported that China Netcom has been restructuring its operations for its own initial public offering. More frequent public announcements from China Netcom relating to or resulting from their initial public offering could cause the price of our stock to become even more volatile.

 

SOFTBANK CORP. and its related entities, including SOFTBANK America Inc., have significant influence over our management and affairs, which it could exercise against your best interests.

 

SOFTBANK CORP. and its related entities, including SOFTBANK America Inc. (collectively, “SOFTBANK”), beneficially owned approximately 12.9% of our outstanding stock as of June 30, 2004. As a result, SOFTBANK has the ability to influence all matters submitted to our stockholders for approval, as well as our management and affairs. Matters that could require stockholder approval include:

 

                                          election and removal of directors;

 

                                          merger or consolidation of our company; and

 

                                          sale of all or substantially all of our assets.

 

This concentration of ownership may delay or prevent a change of control or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of our company, which could decrease the market price of our common stock.

 

49



 

Delaware law and our charter documents contain provisions that could discourage or prevent a potential takeover, even if the transaction would benefit our stockholders.

 

Other companies may seek to acquire or merge with us. An acquisition or merger of our company could result in benefits to our stockholders, including an increase in the value of our common stock. Some provisions of our Certificate of Incorporation and Bylaws, as well as provisions of Delaware law, may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include:

 

                                          authorizing the board of directors to issue additional preferred stock;

 

                                          prohibiting cumulative voting in the election of directors;

 

                                          limiting the persons who may call special meetings of stockholders;

 

                                          prohibiting stockholder action by written consent;

 

                                          creating a classified board of directors pursuant to which our directors are elected for staggered three year terms; and

 

                                          establishing advance notice requirements for nominations for election to the board of directors and for proposing matters that can be acted on by stockholders at stockholder meetings.

 

The holders of our convertible subordinated notes due in 2008 and we face a variety of risks related to the notes.

 

Holders of our convertible subordinated notes due 2008 (the “notes”) and we face a variety of risks with respect to the notes, including the following:

 

                                          we may be limited in our ability to purchase the notes in the event of a change in control, either for cash or stock, which could result in our defaulting on the notes at the time of the change in control and purchases for stock would be subject to market risk;

 

                                          an event of default under our senior debt, including one of our subsidiaries, could restrict our ability to purchase or pay any or all amounts due on notes, and after paying our senior debt in full, we may not have sufficient assets remaining to pay any or all amounts due on the notes;

 

                                          there is no listed trading market for the notes, which could have a negative impact on the market price of the notes;

 

                                          we have significantly increased our leverage as a result of the sale of the notes which could have an adverse impact on our ability to obtain additional financing for working capital;

 

                                          hedging transactions related to the notes and our common stock and other transactions, as well as changes in interest rates and our creditworthiness, may affect the value of the notes and of our common stock; and

 

                                          the notes might not be rated or may receive a lower rating than anticipated by investors, ultimately having a negative affect on the price of the notes and of our common stock.

 

ITEM 3—QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS

 

We are exposed to the impact of interest rate changes, changes in foreign currency exchange rates and changes in the stock market.

 

Interest Rate Risk.  Our exposure to market risk for changes in interest rates relates primarily to our investment

 

50



 

portfolio. The fair value of our investment portfolio would not be significantly affected by either a 10% increase or decrease in interest rates due mainly to the short-term nature of most of our investment portfolio. However, our interest income can be sensitive to changes in the general level of U.S. interest rates since the majority of our funds are invested in instruments with maturities less than one year. Our policy is to limit the risk of principal loss and ensure the safety of invested funds by generally attempting to limit market risk. Funds in excess of current operating requirements are mostly invested in government-backed notes, commercial paper, floating rate corporate bonds, fixed income corporate bonds and tax-exempt instruments. In accordance with our investment policy, all short-term investments are invested in “investment grade” rated securities with minimum A or better ratings. Currently, most of our short-term investments have AA or better ratings.

 

The table below represents carrying amounts and related weighted-average interest rates of our investment portfolio at June 30, 2004:

 

(in thousands except interest rates)

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

484,767

 

Average interest rate

 

0.95

%

Restricted cash

 

15,249

 

Average interest rate

 

0.51

%

Restricted short-term investments

 

27,384

 

Average interest rate

 

1.04

%

Short-term investments

 

76,979

 

Average interest rate

 

1.39

%

Total investment securities

 

$

604,379

 

Average interest rate

 

1.002

%

 

Concentration of Credit Risk and Major Customers: The table below outlines our sales to, and the accounts receivable balances with respect to our largest customers:

 

For the three months ended June 30,

 

For the six months ended June 30,

 

2004

 

% of Net
Sales

 

% of
Accounts
Receivable

 

2004

 

% of Net
Sales

 

% of
Accounts
Receivable

 

B

 

15%

 

15%

 

A

 

16%

 

9%

 

C

 

10%

 

14%

 

B

 

11%

 

15%

 

 

 

 

 

 

 

C

 

10%

 

14%

 

 

 

 

 

 

 

 

 

 

 

 

 

2003

 

 

 

 

 

2003

 

 

 

 

 

C

 

13%

 

7%

 

C

 

13%

 

7%

 

D

 

11%

 

9%

 

 

 

 

 

 

 

E

 

10%

 

5%

 

 

 

 

 

 

 

 

The Company extends credit to its customers in China generally without requiring collateral. In global sales outside of China, the Company often requires letters of credit from its customers. The Company monitors its exposure for credit losses and maintains allowances for doubtful accounts.

 

Foreign Exchange Rate Risk.  We are exposed to foreign currency exchange rate risk because most of our sales in China are denominated in Renminbi. Due to the limitations on converting Renminbi, we are limited in our ability to engage in foreign currency hedging activities in China.  Beginning in the first quarter of 2004, we hedge certain Japanese Yen-denominated balance sheet exposures against future movements in foreign currency exchange rates by using foreign currency forward contracts. Gains and losses on these fair value hedges are intended to offset gains and losses from the revaluation of our Japanese Yen-denominated recognized liabilities. In accordance with Statement of Financial Accounting Standards No. 133 (“SFAS 133”), “Accounting for Derivative Instruments and Hedging Activities,” we recognize derivative instruments and hedging activities as either assets or liabilities on the balance sheet and measure them at fair value. The net result of gains and losses on contracts and revaluation included in interest and other income (expense) was insignificant for the three and six months ended June 30, 2004. Our foreign currency forward contracts generally mature within three months. We do not intend

 

51



 

to utilize derivative financial instruments for trading purposes. There were no foreign currency forward contracts held at June 30, 2004. Movements in currency exchange rates could cause variability in our other income (expense).

 

Although the impact of currency fluctuations of Renminbi to date has been insignificant, fluctuations in foreign currency exchange rates in the future may have a material adverse effect on our results of operations. We maintain a bank account in Japanese Yen for purchasing portions of our inventories and supplies. The balance of this Japanese Yen account as of June 30, 2004 was approximately $36.7 million.

 

ITEM 4—CONTROLS AND PROCEDURES

 

During the preparation of the Company's Quarterly Report on Form 10-Q, an equipment sale transaction was identified in a single geographical sales market, outside of China, in the amount of approximately $1.9 million that was initially included as revenue in the Company's proposed internal draft financial statements for the second quarter.  Upon further analysis, it was determined that this transaction did not qualify as recognizable revenue and as such, the Company did not include such revenue in the financial statements for the quarter ended June 30, 2004.

 

Upon identification of this matter, management and the audit committee initiated a full review and analysis of the facts and circumstances surrounding this transaction.  No additional discrepancies were noted related to the recording or reporting of revenue.  The findings of this review have led management to conclude that certain significant control deficiencies exist related to the review and evaluation of criteria related to revenue recognition, including process deficiencies with respect to obtaining evidence of delivery.

 

In connection with the above findings and in an effort to address the weaknesses identified in the Company’s internal controls, management has determined that it will take immediate corrective actions.  Such actions will include:

 

      a centralized review, analysis and control of all non-China revenue recognition by U.S. corporate management, including receipt of 3rd party evidence of delivery and final acceptance certificate issued by the customer;

      limitations of local signature approval authority for signing contracts; and

 

      additional reconciliation and review of customer site inventory balances.

 

Separate from the review, the Company discovered that certain inventory transactions recorded in the quarter ended June 30, 2004 were in error.  The Company recorded an adjustment reflected in the Financial Statements to increase inventory and decrease cost of sales by $0.8 million for the three and six months ended June 30, 2004 and to increase earnings per share by $0.01.

 

In addition, the Company is undertaking a thorough review of its internal controls as part of the Company’s preparation for compliance with the requirements of Section 404 of the Sarbanes-Oxley Act of 2002.  Rules describing the requirements for the Company's independent auditors to be able to attest to our compliance under Section 404 were adopted in June 2004 and we, along with our external service providers, are currently interpreting compliance requirements under Section 404.  As a result of this uncertainty, as well as the significant control deficiencies noted above, the Company cannot be certain that we will be able to comply with the requirements of Section 404 by the December 31, 2004 deadline.

 

Our management, including the Chief Executive Officer and the Chief Financial Officer, has conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures, pursuant to Exchange Act Rule 13a-15(e) and 15d-15(e) as of June 30, 2004.  Based on that evaluation, combined with a consideration of the additional procedures described above, the Chief Executive Officer and the Chief Financial Officer concluded that, notwithstanding the significant control weakness described above, our disclosure controls and procedures are effective in ensuring that all material information required to be disclosed in this quarterly report has been made known to them in a timely fashion and no changes are required at this time.

 

In connection with the evaluation by our management, including the Chief Executive Officer and Chief Financial Officer, of our internal control over financial reporting, except as noted above, no changes during the quarter ended June 30, 2004 were identified that have materially affected or are reasonably likely to materially affect our internal control over financial reporting.

 

 

PART II—OTHER INFORMATION

 

ITEM 1—LEGAL PROCEEDINGS

 

On October 31, 2001, a complaint was filed in United States District Court for the Southern District of New York against us, some of its directors and officers and various underwriters for its initial public offering. Substantially similar actions were filed concerning the initial public offerings for more than 300 different issuers, and the cases were coordinated as In re Initial Public Offering Securities Litigation, 21 MC 92. In April 2002, a consolidated amended complaint was filed in the matter against us, captioned In re UTStarcom, Initial Public Offering Securities Litigation, Civil Action No. 01-CV-9604. Plaintiffs allege violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 through undisclosed improper underwriting practices concerning the allocation of IPO shares in exchange for excessive brokerage commissions, agreements to purchase shares at higher prices in the aftermarket, and misleading analyst reports. Plaintiffs seek unspecified damages on behalf of a purported class of purchasers our common stock between March 2, 2000 and December 6, 2000. Our directors and officers were dismissed without prejudice pursuant to a stipulation. On February 19, 2003, the Court granted in part and denied in part a motion to dismiss brought by defendants including us. The order dismissed all claims against us except for a claim brought under Section 11 of the Securities Act of 1933, which alleges that our initial public offering registration statement contained untrue statements of material fact and omitted to state material facts required to be stated in the registration statement, or necessary to make the statements therein not misleading.

 

In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including us, was submitted for preliminary approval by the Court. Under the settlement, the plaintiffs would dismiss and release all claims against participating defendants in exchange for a contingent payment undertaking by the insurance companies collectively responsible for insuring the issuer defendants in the coordinated action, and the assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. Pursuant to the undertaking, the insurers would be required to pay the amount, if any, by which $1.0 billion exceeds the total amount ultimately collected by the plaintiffs from the non-settling defendants in the coordinated action. The settlement is subject to a number of conditions including Court approval.

 

If the settlement does not occur, and litigation against UTStarcom continues, we believe it has valid defenses and intends to defend the case vigorously. We are unable to currently estimate the loss, if any, associated with the above litigation.

 

We have filed a patent infringement suit against Starent Networks Corporation (“Starent”) in the U.S. District Court for the Northern District of California.  In its Complaint, we assert that Starent infringes two UTStarcom patents through the manufacture, offer for sale, and sale of Starent’s ST-16 Intelligent Mobile Gateway.  On June 3, 2004, we served our complaint on Starent.  On July 30, 2004, Starent filed and served its answer and counterclaims.  In its counterclaims, Starent asserts that the patents are not infringed, are invalid, and are unenforceable and asserts unfair competition against us.  The Court is scheduled to hold an initial case management conference on October 12, 2004.  Although we cannot reliably predict the outcome of this litigation, it believes that any liability arising from Starent’s counterclaims will not have a material adverse effect on the business, financial condition, or results of our operations.

 

We are a party to other litigation matters and claims that are normal in the course of our operations, and while the results of such litigation matters and claims cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse impact on our financial position or results of operations.

 

52



 

ITEM 2—CHANGES IN SECURITIES, USE OF PROCEEDS AND ISSUER PURCHASES OF EQUITYSECURITIES

 

(e) Stock repurchased for the quarter ended June 30, 2004 is as follows:

 

Period

 

Total Number
of shares
purchased (1)

 

Average
purchase price
per share

 

Total Number of shares
purchased as part of a publicly
announced program (1)

 

Maximum number of shares
that may yet be purchased
under the repurchase plan

 

 

 

 

 

 

 

 

 

 

 

April 1, 2004 - April 30, 2004

 

987,566

 

$

29.79

 

987,566

 

3,067,434

 

 

 

 

 

 

 

 

 

 

 

May 1, 2004 - May 31, 2004

 

 

 

 

3,067,434

 

 

 

 

 

 

 

 

 

 

 

June 1, 2004 - June 30, 2004

 

 

 

 

3,067,434

 

Total

 

987,566

 

 

 

987,566

 

3,067,434

 

 


(1)          On March 12, 2004, the Company announced a program to repurchase up to 5,000,000 shares of its outstanding common stock over a period of six months, until September, 2004 (the “Repurchase Program”).

 

ITEM 3—DEFAULTS UPON SENIOR SECURITIES

 

[None.]

 

ITEM 4—SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

On May 14, 2004, the Company held its annual meeting of stockholders.  As of March 29, 2004, the record date for the annual meeting, there were 117,198,949 shares of common stock of the Company issued and outstanding and entitled to vote at the annual meeting.  The following proposals were submitted to a vote of the stockholders:

 

(i)                                     To elect the following two Class I members currently serving on the Board of Directors to serve until the date on which the annual meeting of stockholders is held in the year 2007.

 

Election of Directors

 

Votes for

 

Votes Withheld

Thomas J. Toy

 

 

97,292,989

 

 

1,806,649

Ying Wu

 

 

84,582,857

 

 

14,516,781

 

As a result, Messrs. Toy and Wu were elected as Directors of the Company. 

 

53



 

(ii)                                  To ratify and approve the appointment of PricewaterhouseCoopers LLP as the independent public accountants of the Company for the fiscal year ending December 31, 2004

 

For

 

Against

 

Abstain

 

Broker Non-votes

 

 

97,242,212

 

 

1,775,213

 

 

82,213

 

 

 

 

ITEM 5—OTHER INFORMATION

 

Our directors, officers, or employees have entered, and may from time to time enter, into good faith trading plans pursuant to SEC Rule 10b5-1(c).

 

54



 

ITEM 6—EXHIBITS AND REPORTS ON FORM 8-K

 

(a)                                  Exhibits:

 

NUMBER

 

EXHIBIT DESCRIPTION

10.100

 

Asset Purchase Agreement among UTStarcom, Inc., Telos Technology, Inc., Telos Technology (Canada), Inc., Telos Technology (Bermuda) Ltd. and Telos Engineering Limited dated April 21, 2004

10.101

 

Asset Purchase Agreement by and among Audiovox Communications Corp., Quintex Mobile Communications Corporation, Audiovox Communications Canada Co., UTStarcom, Inc., UTStarcom Canada Company and Audiovox Corporation, dated as of June 11, 2004

31.1

 

Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2

 

Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1

 

Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 


(b)                                 Reports on Form 8-K:

 

1.               Report on Form 8-K dated on April 22, 2004 (filed on April 23, 2004) under Item 5, relating to the Company’s press release entitled “UTStarcom Agrees to Acquire TELOS Technology, Leading Provider of Industry-Proven Packet Core Networks for CDMA 2000.”

 

2.               Report on Form 8-K dated and filed on April 27, 2004 under Item 5 and Item 7, relating to the Company announcing its results of operation for the first quarter of 2004.

 

3.               Report on Form 8-K dated and filed on June 14, 2004 under Item 5 and Item 7, relating to the Company’s press release entitled “UTStarcom Agrees to Acquire Select Assets of Audiovox Handset Division for $165.1 Million.” 

 

55



 

UTSTARCOM, INC.

 

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 

 

 

UTSTARCOM, INC.

 

 

 

 

Date: August 16, 2004

By:

/s/  Hong Liang Lu

 

 

 

 

 

Hong Liang Lu

 

 

President, Chief Executive Officer and Director

 

 

(Principal Executive Officer)

 

 

 

 

 

 

 

 

 

 

 

 

Date:  August 16, 2004

By:

/s/  Michael J. Sophie

 

 

 

 

 

Michael J. Sophie

 

 

Senior Vice President of Finance and Chief Financial Officer

 

 

(Principal Financial Officer)

 

56



 

UTSTARCOM, INC.

EXHIBIT INDEX

 

NUMBER

 

EXHIBIT DESCRIPTION

10.100

 

Asset Purchase Agreement among UTStarcom, Inc., Telos Technology, Inc., Telos Technology (Canada), Inc., Telos Technology (Bermuda) Ltd. and Telos Engineering Limited dated April 21, 2004

10.101

 

Asset Purchase Agreement by and among Audiovox Communications Corp., Quintex Mobile Communications Corporation, Audiovox Communications Canada Co., UTStarcom, Inc., UTStarcom Canada Company and Audiovox Corporation, dated as of June 11, 2004

31.1

 

Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2

 

Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1

 

Certification Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002