Back to GetFilings.com
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 For the Fiscal Year Ended March 28, 2003
OR
|_| 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 0-15323
NETWORK EQUIPMENT TECHNOLOGIES, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 94-2904044
-------- ----------
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
6900 PASEO PADRE PARKWAY
FREMONT, CALIFORNIA 94555-3660
(510) 713-7300
(Address of principal executive offices, including zip code
and telephone number, including area code)
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
COMMON STOCK, $0.01 PAR VALUE NEW YORK STOCK EXCHANGE
----------------------------- -----------------------
(Title of Each Class) (Name of Each Exchange on Which Registered)
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
7 1/4% CONVERTIBLE SUBORDINATED DEBENTURES
(Title of Class)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. Yes |X| No |_|
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. |X|
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes |X| No |_|
The aggregate market value of voting and non-voting common stock held by
non-affiliates of the registrant (based on the closing price for the common
stock on the New York Stock Exchange on September 26, 2002, which is the last
business day of the Registrant's most recently completed second fiscal quarter)
was approximately $82,066,300. Shares of common stock held by each officer and
director and by each person who owns 5% or more of the outstanding common stock
have been excluded in that such persons may be deemed to be affiliates. This
determination of affiliate status is not necessarily a conclusive determination
for other purposes.
The number of shares outstanding of the Common Stock, $0.01 par value, on June
9, 2003 was 22,921,814.
DOCUMENTS INCORPORATED BY REFERENCE:
The registrant's definitive Proxy Statement for the Annual Meeting of
Stockholders to be held on August 12, 2003 is incorporated by reference in Part
III of this Form 10-K to the extent stated herein.
NETWORK EQUIPMENT TECHNOLOGIES, INC
FORM 10-K
March 28, 2003
TABLE OF CONTENTS
Page
----
PART I
Item 1. Business..................................................................................2
Item 2. Properties................................................................................9
Item 3. Legal Proceedings.........................................................................9
Item 4. Submission of Matters to a Vote of Security Holders......................................9
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters....................9
Item 6. Selected Financial Data ................................................................10
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations...10
Item 7A Quantitative and Qualitative Disclosures About Market Risk..............................24
Item 8. Financial Statements and Supplementary Data.............................................25
Item 9. Changes and Disagreements with Accountants on Accounting and Financial Disclosure.......45
PART III
Item 10. Directors and Executive Officers of the Registrant......................................45
Item 11. Executive Compensation .................................................................46
Item 12. Security Ownership of Certain Beneficial Owners and Management..........................46
Item 13. Certain Relationships and Related Transactions .........................................47
Item 14. Controls and Procedures ................................................................47
Item 15. Principal Accountants Fees and Services ................................................47
PART IV
Item 16. Exhibits and Reports on Form 8-K........................................................47
Signatures..............................................................................50
Financial Statement Schedules...........................................................53
PART I
FORWARD-LOOKING STATEMENTS
Statements contained in this Form 10-K that are not historical facts are
forward-looking statements within the meaning of the federal securities laws
that relate to future events of our financial performance. A forward-looking
statement may contain words such as "plans," "hopes," "believes," "estimates,"
"will continue to be," "will," "continue to," "expect to," "anticipate that,"
"to be," or "can impact." Forward-looking statements are based upon management
expectations and involve risks and uncertainties that may cause actual results
to differ materially from those anticipated in the forward-looking statements.
Many factors may cause actual results to vary including, but not limited to, the
factors discussed in this Form 10-K. We expressly disclaim any obligation or
undertaking to revise or publicly release any updates or revisions to any
forward-looking statement contained in this Form 10-K. Investors should
carefully review the risk factors described in this document along with other
documents we file from time to time with the Securities and Exchange Commission.
ITEM 1. BUSINESS
OVERVIEW
Network Equipment Technologies, Inc., doing business as net.com, is a global
provider of networking technology platforms that are used for mission-critical
communications solutions. Our multiservice wide area networking (WAN) products,
comprising the Promina product line, use circuit-switched technology to provide
an effective platform for developing reliable and secure networks. In response
to the growth of next-generation networks using packet-switching technologies
and the Internet protocol (IP), we developed our service creation platforms for
broadband, IP telephony, and multiservice networks. These broadband platforms
allow network service providers to rapidly create and deliver new service
offerings that we believe can help them to accelerate the return on their
network investment, reduce capital and operating expenditures, and achieve
greater profits. Network Equipment Technologies, Inc. was founded in 1983 and
has been doing business as net.com since 2000.
We have a worldwide customer base that includes governmental entities,
telecommunications service providers, and enterprise customers in North America,
Latin America, Europe and Asia. Our growth over the past seven quarters was
primarily due to our government business. Our government customers include but
are not limited to U.S. defense and intelligence agencies, civilian agencies
such as the Federal Emergency Management Agency, the Federal Aviation
Administration, and international organizations such as NATO, the World Health
Organization, and the British Ministry of Defence.
Our global support and service organization, along with third-party service
organizations, provides installation, maintenance, technical assistance and
customer training.
INDUSTRY BACKGROUND
Among the significant advances in networking technologies over the past decade
is the increasing use of packet switching to divide information into relatively
small packets for transportation over a network. Packet switching enables
convergence of disparate applications onto a single packet infrastructure,
allows use of public infrastructure rather than requiring dedicated network
lines, and is particularly well suited to the fast transmission of high volumes
of information, often referred to as "broad bandwidth" or "broadband"
communications. In contrast, circuit-switching is generally suitable only for
low-to-medium volumes of information, often referred to as "narrow bandwidth" or
"narrowband" communications.
Due to its capabilities for the fast transmission of high volumes of
information, there has been an increasing adoption of packet-switched networks
and equipment. This technology transition was slowed somewhat by the upheaval in
the telecommunications market over the past few years, as well as the renewed
interest in secure communications following the events of September 11, 2001.
Also, telecommunications service providers have historically made incremental
changes with proven technology, including circuit-switched equipment, rather
than wholesale changes to their networks. Despite some expectations to the
contrary during the Internet boom, this trend appears to be continuing.
Nonetheless, we believe that as economic conditions improve and new technologies
mature, telecommunications equipment customers ultimately will adopt newer
technology that leverages the inherent benefits of packet-switching, for greater
capacity, greater flexibility, and lower cost.
2
Telecommunications service providers have faced a number of difficult challenges
resulting from changes in the telecommunications market in recent years. With
the rapid growth of the Internet and the development of advanced communications
applications such as video and audio content on demand, wireless access, and
video conferencing, the telecommunications industry foresaw enormous growth in
the demand for network capacity. Carriers and service providers rapidly built
out their core infrastructure to accommodate expected surges in IP traffic. In
addition, alternative broadband access technologies were developed and
commercialized, including Digital Subscriber Line (DSL) and digital cable.
Although demand for broadband communications has continually increased, numerous
factors created a hyper-competitive telecommunications environment that has
prevented many service providers from earning an adequate return on their
capital expenditures. These factors include deregulation in the
telecommunications industry, homogeneity and commoditization of transport
services, and excess capacity from over-investment. The pressure on carriers has
been exacerbated by the high costs and difficulties in deploying DSL services,
which slowed the rate of adoption and limited revenue growth, as well as the
success of cable providers in capturing a large share of new residential
broadband customers. These challenges have come at the same time that carriers
are experiencing a decline in revenue from their voice networks, as households
increasingly turn to other sources for voice connections, such as wireless
communications.
Although the still-growing demand for broadband communications is expected to
gradually absorb the market's current excess capacity, and the industry shakeout
may lessen some of the competitive pressures, incumbent carriers must examine
their business models, focusing on architectural changes that can make their
investments in broadband profitable. In mid-2002, the North American incumbent
carriers (BellSouth, SBC Communications, Verizon Communication, and Bell Canada)
together submitted a proposed draft document to the DSL Forum, which is
primarily composed of equipment vendors. This draft became Working Texts (WT)
080 and 081 of the DSL Forum and offered a proposal for a unified architecture
for DSL connections, enabling them to deliver a standard level of service across
multiple networks and via multiple carriers, and provided a roadmap for
competing with cable providers. The proposal increases the number of services
available via DSL and offers a real-time, on-demand capability for the users.
Ideally, the new architecture will enable carriers to create a new layer of
network intelligence that supports the widespread deployment of comprehensive
and affordable integrated service packages that can be dynamically selected and
self-provisioned by DSL customers. This new network architecture represents a
potential opportunity for telecommunications equipment providers to deliver new
products that carriers can use at the edge of their existing networks to create
and deliver new, differentiated DSL services.
BUSINESS STRATEGY
Our objective is to become a leader in the telecommunications equipment industry
by providing service creation solutions that enable service providers to achieve
a greater potential for profit through the creation and delivery of
differentiated services. We are addressing service provider needs to lower the
cost of operations through automation and on demand provisioning and to increase
revenue from new services, together with the consolidation of multiple
technologies onto a single platform. To achieve these objectives, our business
strategy includes the following key elements:
o DESIGN AND DEVELOP INDUSTRY LEADING BROADBAND HARDWARE AND SOFTWARE
SERVICE CREATION SOLUTIONS TO MEET THE OPPORTUNITIES IN THE CUSTOMERS'
NETWORKS. We consider our technological and product leadership to be
critical to our future success. Having developed the essential product
platforms that address our target markets, additional refinements will
enable us to meet increasing customer requirements. We must continue
to enhance our SCREAM platform to meet the service providers' current
rollout plans for new technology in their networks, especially as it
relates to the initiatives for a unified architecture for DSL
connections proposed in WT-080 and 081 of the DSL Forum. Additionally,
new developments for certain of our products, including Promina and
SCREAMlink are designed so that current customers can leverage their
investments and more cost-effectively migrate to our new broadband
technologies.
o LEVERAGE MARKET POSITION AND REVENUE CONTRIBUTION OF OUR PROMINA
CUSTOMER BASE. net.com was a pioneer of the concept of multi-service
networking and has been delivering these mission-critical capabilities
for nearly twenty years.
The installed base and revenue contribution from our narrowband
Promina product line continues to be the majority of our revenue
today. In particular, the Federal Government has continued to deploy
new networks based on this technology, due in part to its time-proven
ruggedness and reliability.
As new standards evolve for quality of service and security for the
Internet, we expect the government customers to adopt newer technology
and purchase our new service creation and IP telephony platforms. In
the interim, our product development strategy incorporates
technologies that enable us to leverage this installed base. In
particular, our SCREAMlink program and our secure voice enhancements
to the SHOUT
3
platform are aimed at our installed base, particularly the government.
Further, our new SCREAM platform is currently being sold to government
customers globally.
We anticipate that our expertise in government contracting together
with the relationships that we have built up over an extended period
of time will allow us to successfully migrate this customer base to
our new technology when they require it. In addition, in some parts of
the developing world where deregulation has lagged, or where
circuit-switched technology continues to be the technology of choice,
our multi-service platforms continue to be an appropriate solution.
o LEVERAGE RELATIONSHIPS WITH KEY PARTNERS. We continually seek to
establish relationships with third-party application software vendors,
product original equipment manufacturers (OEMs), resellers and our
customers. net.com also seeks relationships with the large incumbent
vendors globally that could facilitate our entry and success in
incumbent carriers' networks. Further, SCREAM's open programmability
through the open programming interface allows a service provider or
third-party developer to develop new applications sought by end-users.
In June 2002, net.com co-founded the Service Creation Community(TM)
along with Accenture, ADC Telecommunications, Microsoft, Oracle,
Paradyne, and Siemens. The Community is an independent alliance of
equipment vendors, technology and infrastructure suppliers,
integrators, and service/content providers dedicated to the rapid
creation and delivery of new content and communications services. We
have taken a leadership position within the Community, engaging
service provider end customers to define pilot solutions that member
companies can develop and deliver.
o PROVIDE VALUE-ADDED SERVICE AND SYSTEM INTEGRATION CAPABILITIES. Since
our inception, we have viewed customer service and support as a key
element of our overall strategy and a critical component for our
long-term relationship with customers. Customers around the world turn
to us not only for the reliability and performance of our products but
also for our comprehensive support services that optimize the value of
those products. Additionally, by offering an upgrade path to new
products in lieu of costly "time and materials" options for
long-discontinued products, we are able to reintroduce ourselves to
customers who recognize our tradition for building high performance,
reliable and well-supported products.
o CONTINUE TO IMPROVE BUSINESS OPERATIONS AND PROFITABILITY. We have
upgraded and consolidated our core business process systems onto an
Oracle enterprise platform, including order management, financial,
human resource and quality and manufacturing systems, encompassing
global operations. In addition, net.com invested this year in
certification under the ISO 9001:2000 standards, a refined product
life cycle process, and new service solutions. Other company
initiatives continue to focus on supply chain management to lower
supply costs and to better manage inventory levels. Collectively,
these initiatives are designed to allow us to reduce our operating
costs and increase gross margins, operating income and cash flow.
PRODUCTS
PROMINA -- NARROWBAND MULTISERVICE ACCESS PLATFORMS
Our Promina family of multi-service access platforms integrates voice, data,
image and video traffic across a single network infrastructure. The Promina
platform relies on circuit-switched technology to provide mission-critical
support for a wide variety of communications applications and traffic types,
including asynchronous transfer mode (ATM), frame relay, IP, and integrated
services digital network (ISDN) signaling. Promina products offer a broad range
of user-side interfaces, enabling standards-based connection of communications
equipment, whether located at a service provider's switching facility or at an
enterprise or government customer's premises.
The Promina platform features advanced network management services, which
provide a high degree of visibility into network operations. For fault tolerance
and high network reliability, our Promina products can be configured with
redundant power, memory, common logic, and port interfaces. Internally, these
products incorporate distributed network intelligence that allows the network to
quickly and automatically reroute traffic in the event of failure of a
component. Additionally, Promina's modular design, with application and
interface modules that are interchangeable across the product series, provides
great flexibility and scalability, especially important in a quickly changing
communications environment and also in rapid deployment for field operations.
The Promina product family includes the Promina 800 Series, Panavue network
management platform, and various processor, application, and interface modules.
We now offer a broadband migration path for Promina customers with the
SCREAMlink program. SCREAMlink allows Promina customers to protect their
investments in existing architectures while accommodating immediate needs
through a logical migration to a hybrid Promina/SCREAM
4
solution, monitored and controlled by an integrated network management solution
that is currently under development.
In fiscal 2003, 2002, and 2001, our Promina products accounted for 80.9%, 87.1%,
and 81.9% of product revenue, respectively.
SCREAM -- BROADBAND SERVICE CREATION MANAGER
Announced in June 2000, the SCREAM(R) (Service Creation Manager) platform
enables service providers to dynamically define, deliver, and manage new
broadband services. SCREAM is a universal broadband services switch designed to
support a broad array of services delivered through DSL. Built for the carrier
environment, SCREAM is also well suited for government and enterprise customers
wishing to add or connect broadband services to their existing networks. The
SCREAM platform's processing power can closely examine DSL subscriber traffic,
and apply special handling instructions at wire speed, which is as fast as
transmission. This enables service providers to differentiate broadband
subscribers based on their identity or use, tailor the services provided to
individual subscribers or groups of subscribers, and monitor and report billable
events, all in real time. As a result, service providers using SCREAM have a
means to generate incremental revenue from innovative services based on factors
such as broadband content delivery, IP quality-of-service (QoS) guarantees,
class-of-service (CoS) subscriptions, and dynamic bandwidth allocation. These
capabilities fulfill many of the requirements identified by WT 080 and 081 of
the DSL Forum for a new unified DSL network architecture.
SCREAM delivers single-platform integration of broadband aggregation, subscriber
management, IP services, ATM switching, edge routing, and broadband service
creation. By aggregating a broad range of services and historically disparate
technologies on a single platform, SCREAM can help service providers reduce
their capital equipment expenditures while they advance their DSL offerings.
SCREAM functions at the edge of a service provider's network, where service
providers can launch new services directly to customers without re-architecting
their core network.
The SCREAM platform is architected to enable service provider or third-party
solutions to be readily implemented using an open programming interface, which
allows for a rapid and cost-effective integration to operational and business
support systems. Through this open programming interface, application developers
can control network resources and every characteristic of the SCREAM platform as
part of a larger hosted business or consumer network solution.
SHOUTIP -- IP TELEPHONY GATEWAY
The SHOUTIP platform integrates trunking, signaling, gatekeeper/call agent
functions, packet aggregation, network management, and configuration tasks in a
single system. The carrier-class SHOUT2500 platform, announced in April 2002,
supports one to 32 T1/E1 connections or up to 960 simultaneous voice calls. This
platform offers integrated SIP/H.323 interoperability and protocol conversion,
along with integrated SS7/C7 signaling, interactive voice response, call
control, media conversion and billing record generation, all in a five-inch high
chassis that can be easily configured for a variety of services. The SHOUT2500
platform reduces space requirements by eliminating multiple stand-alone devices
and the complex integration efforts required by other solutions on the market.
In October 2002, net.com expanded the SHOUTIP family with the SHOUT900 platform.
The SHOUT900 supports one to eight T1/E1 connections or 240 simultaneous voice
calls, with support for secure telephone units (STU) and calling card
applications, in a chassis 1.75 inches high.
CUSTOMERS AND MARKETS
net.com pioneered the concept of multiservice networking and has been delivering
these capabilities for nearly 20 years. The focus of our narrowband Promina
product has been on governments and large enterprises, as well as carriers for
their enterprise business and the delivery of leased-line service. The primary
focus of our broadband SCREAM product family is on telecommunications carriers,
while the SCREAMlink program has generated interest among our government and
enterprise customers. For both our broadband and narrowband products, we focus
primarily on information and communication-intensive organizations. These
customers may be local, national, or global in their operations.
SCREAM is designed for the demands of the carrier market. The specific physical
requirements of the SCREAM platform meet the demanding specifications of the
incumbent carriers' environment, including a small footprint, all front access,
and reduced power consumption.
We have targeted our Promina product line at government customers, service
providers and enterprises. In the service provider marketplace, carriers use
Promina networks for backbone services. Current enterprise customers include
corporations representing the financial, banking, insurance, energy,
transportation, manufacturing and retail
5
sectors. Government customers represent a variety of federal and international
agencies and organizations, including civilian and defense agencies.
Sales to the Federal government and its agencies represented 65%, 50%, and 54%
of net.com's revenue in fiscal 2003, 2002, and 2001, respectively. The
Department of Defense (DoD) contracts may be used by other government agencies
to purchase net.com products and services. See discussions in Business
Environment and Risk Factors in this Form 10-K. Beyond government customers, the
Promina product line currently has more demand outside the United States than
within the United States, especially in emerging markets such as Eastern Europe,
China, and Latin America where telecommunications infrastructure is still being
developed. Applications that can be enabled by Promina-based solutions include
digital data networks (DDNs) that provide basic data services in these emerging
markets. International sales represented 25%, 31%, and 28% of net.com's revenue
in fiscal 2003, 2002, and 2001, respectively.
Other than orders from a variety of agencies in the U.S. Federal Government, no
single customer accounted for more than ten percent of net.com's revenue in
fiscal 2003, 2002 or 2001.
COMPETITION
The market for telecommunications equipment is highly competitive and dynamic
and has been characterized by the easy entrance of new start-up companies, rapid
changes to and the convergence of technologies and a worldwide migration from
existing circuit technology to the new packet-based technologies. The severe
downturn in the market for telecommunications equipment that began in April 2001
has seen a decline in spending of nearly 50%. We compete directly, both
internationally and domestically, with many different companies, some of which
are large established suppliers of end-to-end solutions such as Alcatel, Cisco,
Juniper, Lucent, Nortel and Siemens. Most of the large suppliers have greater
financial, marketing and technical resources and offer a wider range of
networking products than we do. These suppliers can often provide a complete
network solution rather than a partial solution that may make their products
more attractive to potential net.com customers. However, these companies have
also suffered from the industry decline, and many have eliminated entire
divisions, leaving the carriers with concerns about support for the larger
vendors' products, as well as for the ability of smaller companies to support
them. SCREAM competitors include Juniper, Cisco, Cosine, Nortel, Copper
Mountain, Advanced Fiber Communications, and Redback. For our SHOUTIP product
line, competition includes the established market leader, Cisco, and smaller
companies such as Nuera.
SALES
We sell our products and services through both direct and indirect sales
channels worldwide. We believe that to effectively market and sell our products,
a local sales organization is beneficial to understand the business and network
environment of local countries. We also believe that a sales force effort
supported by sales engineers who provide customers with pre-sale and post-sale
technical assistance allows net.com to gain more in-depth knowledge of
customers' network requirements. We have approximately 60 sales personnel
located in nine countries. This sales effort is supported through a variety of
channel partners. Our business is generally not seasonal.
We sell products and services in North America primarily through direct
channels, although we make use of a small number of distributors in some
markets, especially for the SHOUTIP product line. Our international sales are
made almost entirely through indirect channels that are augmented by the efforts
of a local sales force. In addition to the marketing and sale of products,
international resellers provide system installation and technical support. In
most cases, international resellers have non-exclusive agreements to resell
net.com products within particular geographic areas. Resale agreements do not
contain a sales commitment or required sales quota.
We sell to governments through net.com's wholly owned subsidiary, N.E.T.
Federal, Inc.( N.E.T. Federal), which sells products both directly and through
collaborative government contracting and by contracting agencies at their
convenience or at annual intervals. N.E.T. Federal supports sales to the Federal
Government's defense and civilian sectors and to government agencies worldwide.
Sales to governments include sales under contracts with certain agencies within
the DoD intelligence and civilian agencies.
Our selling model makes use of our field sales, engineering, product management,
and executive personnel to establish and maintain customer contacts at multiple
levels within a customer organization. We believe the successful execution of
this multi-tiered selling model is important to our success.
BACKLOG
We manufacture our products based upon our forecast of customer demand and we
typically build products in advance of receiving firm orders from our customers.
Orders for net.com's products are generally placed by customers on an as-needed
basis and we typically have been able to ship these products within 30-90 days
after the customer submits a firm purchase order. As a U.S.-based company,
Federal Government rated "defense-expedite"
6
(DX) orders may cause the backlog of other customers' orders to become
delinquent. Because of the possibility of customer changes in delivery schedules
or cancellation of orders, net.com's backlog as of any particular date may not
be indicative of sales in any future period.
CUSTOMER SERVICE
The markets, customers and complex challenges of the networking industry
described above require not only hardware and software based solutions, but also
support, service and other assistance in the development, operation and
expansion of a customer network. Since our inception, we have viewed customer
service and support as a key element of our overall strategy and a critical
component of our long-term relationship with customers. Customers around the
world turn to net.com not only for the reliability and performance of our
products, but also for our comprehensive support services that optimize the
value of those products. Customers rely on net.com to help maintain the highest
possible availability of their mission-critical networks.
We provide a wide range of service and support options to customers and
resellers of net.com products. Service offerings include product installation, a
choice of different hardware and software maintenance programs to meet the
varying needs of our customers, parts repair, remote and on-site technical
assistance, and customer training. In addition, net.com provides web-based
customer support services through our Electronic Support Center. Services
available over the web include first-line troubleshooting information for
net.com products; technical information, such as trouble shooting guides and
frequently asked questions; and a web-based interface to net.com's Technical
Assistance Center (TAC) through an online case management system.
TAC is staffed 24 hours a day, seven days a week by engineers trained in
networking products. TAC assists customers remotely over the telephone and has
multiple language capabilities, including Spanish, Portuguese, Italian,
Mandarin, French and German. TAC engineers have the ability to replicate
customer problems and test proposed solutions prior to implementation.
Maintenance support from TAC, whether provided over the web or over the
telephone, is fee-based under either an annual fee contract or on a
time-and-materials basis.
Customer training on net.com products, OEM products and the underlying
technologies is provided to both end-users and resellers worldwide. We have
training facilities at our Fremont, California, U.S. headquarters and in our
facilities in Ashburn, Virginia; London, U.K.; and Singapore. In addition,
net.com trainers travel to customer and reseller facilities to provide training.
Our training services can be customized to meet the special requirements of our
customers. Customers are charged per person per class for net.com training. In
addition, certain net.com resellers provide training to net.com end-users on
behalf of net.com.
Historically, a significant amount of net.com's revenue and profits have been
generated by our service and support offerings. In fiscal 2003, 2002 and 2001,
service and support offerings accounted for 16.5%, 26.4%, and 46.6%,
respectively, of net.com's revenue. Consistent with our business strategy,
during fiscal 2001, we divested our Federal Services Business (FSB) and sold its
assets to CACI International Inc. (CACI). The divestiture of our government
services business to CACI allowed net.com to concentrate on the execution of our
product strategies, and develop a good strategic alliance for our Federal
business in CACI. We will continue to sell products directly to the Federal
Government while CACI provides maintenance and other services to our Federal
customers.
MANUFACTURING
We have one manufacturing facility located at our Fremont, California facility.
Assembly of printed circuit boards and circuit testing of net.com-designed
products are outsourced to a single subcontractor, Solectron. We plan in the
near term to transition some of our product manufacturing to another vendor,
with contract terms that will likely involve some of the same provisions for
compensation of the vendor as we have with Solectron. For our Promina products,
final assembly, quality control and final testing are performed in the Fremont
manufacturing facility. We maintain control over parts procurement, design,
documentation and selection of approved suppliers. We have a multi-year contract
with Solectron that requires it to meet defined performance specifications.
Because Solectron is a sole source vendor, any interruption in Solectron's
manufacturing processes or a failure to renew our contract could have a material
adverse effect on our financial results and operations.
Currently, several key components of our Promina and SCREAM products are
available only from a single source, including certain integrated circuits and
power supplies. In addition, some components are in short supply generally
throughout the industry. Depending upon the component, there may or may not be
alternative sources or substitutes. Some of these components are purchased
through purchase orders without an underlying long-term supply contract. Any
delay or difficulty in obtaining needed components could seriously impact our
ability to ship products.
We maintain sufficient inventory to ship products quickly, normally within 30 to
90 days after receipt of an order. Scheduling of production and inventory supply
is based on internal sales forecasts. Generally, our customer
7
contracts allow the customers to reschedule delivery dates or cancel orders
within certain time frames before shipment without penalty and outside those
time frames with a penalty. Because of these and other factors, there are risks
of excess or inadequate inventory that could materially impact our expenses,
revenue and earnings. Additionally, DX-rated orders from the Federal Government
can interrupt scheduled shipments to our other customers.
We anticipate achieving improved margins based on increased sales of new
products, while also achieving better pricing based on larger volumes of
components.
We are focused on continually enhancing the quality of products and services
delivered to customers worldwide. This includes improving the quality of
supplied components, subassemblies and internal processes. As part of this
continuing process, net.com is ISO 9001:2000 certified.
RESEARCH AND DEVELOPMENT
We believe that our long-term success depends on our ability to maintain product
and technology leadership. The networking equipment industry is characterized by
rapid technological change, evolving industry standards, frequent new product
introductions, enhancements to products currently in the market and constantly
changing customer requirements. To compete effectively, net.com must be able to
bring new products to market in a timely and cost-effective manner and enhance
existing products to extend their useful life. Along with making continued
investments in our internal research and development, we will also consider
strategic acquisitions where appropriate to provide needed technology and
resources.
We continually monitor relevant markets and our customers' businesses and
technology developments in order to develop products that proactively address
customer needs. Our SCREAM products were designed with an open architecture to
facilitate the development by third parties of products that will enhance the
capabilities of SCREAM. Further, we design to industry standards and support
industry standards bodies in their endeavors. Despite our efforts, however,
there is no guarantee that we will be able to successfully develop new products
or that our customers or our targeted markets will accept any products we
develop.
The majority of our research and development activity is focused on our
broadband products, primarily the SCREAM product line. The development costs for
SCREAM have declined in the most recent fiscal year, reflected in lower research
and development spending, while development costs for SHOUTIP were relatively
constant. We continue to provide engineering support to Promina and to provide
feature enhancements required to maintain Promina's viability, and to invest in
the SCREAMlink migration program. While most product development activity is
undertaken in-house, external development organizations are sometimes used to
shorten time to market.
In fiscal 2003, 2002, and 2001, net.com's research and development expenditures
were $26.0 million, $33.0 million, and $40.4 million, respectively.
EMPLOYEES
As of March 28, 2003, we had 428 full-time employees. None of our employees are
represented by a labor union. We consider our employee relations to be good.
GEOGRAPHIC INFORMATION
See Note 14 to our consolidated financial statements.
INTELLECTUAL PROPERTY
Our ability to invent and develop new technologies and then to protect these
technologies from abuse by others outside net.com is an important part of our
success. We use all available means to protect our proprietary technology
including patents, trade secrets, trademarks and copyrights. All of our
employees sign confidentiality and invention disclosure agreements and anyone
outside net.com receiving information either signs a non-disclosure agreement
prior to receiving information or is a net.com licensee. To foster disclosure of
patentable inventions, we provide financial incentives to employees. We believe
that ownership of patents, copyrights and trade secrets is important to our
ability to compete and to defend ourselves against patent infringement
allegations.
Over the past twenty years, a number of patents have been issued to net.com in
the United States, Europe and Japan. These include some very early basic ATM
inventions that conform to ATM Forum standards. We have a highly focused effort
to identify and patent our proprietary SCREAM and SHOUTIP technology. We expect
to continue filing patent applications as our development process for SCREAM and
SHOUTIP moves forward. In addition, as part of our acquisition of FlowWise
Networks (FlowWise) in December 1999, we became the successor to several filed
patent applications relating to the FlowWise product.
8
Although we have a number of patent applications pending, we cannot guarantee
that any one will result in the issuance of a patent. Even if issued, the patent
may later be found to be invalid or may be infringed without our knowledge. It
is difficult to monitor use of our technology by others. If we do not
effectively protect our intellectual property, it could have a material adverse
effect on our competitive position and sales of our products.
We have not historically pursued claims against other companies based on
possible infringements of our patent portfolio, but we believe that our
investment in intellectual property protection can offer defenses and bargaining
positions in the event other companies pursue such claims against us. In June
2000, we entered into our first patent cross-licensing agreement. The agreement
is with Lucent Technologies, ARL Corporation (Lucent), whereby net.com and
Lucent licensed patents to each other. Lucent will receive a license under all
of our patents relating to our data networking products and/or our access system
products and we will receive a license under all of Lucent's patents relating to
any and all of Lucent's products and services. Our portfolio includes patents in
basic networking and ATM technologies supported by the ATM Standards Forum and
other standard setting bodies. This cross-license agreement with Lucent has a
five-year term.
WHERE YOU CAN FIND MORE INFORMATION
We make our annual report on From 10-K, quarterly reports on Form 10-Q, current
reports on Form 8-K, and all amendments to such reports filed pursuant to
Section 13(a) or 15(d) of the Exchange Act, available free of charge on or
through our Internet website located at WWW.NET.COM, as soon as reasonably
practicable after they are filed with or furnished to the SEC.
ITEM 2. PROPERTIES
net.com is headquartered in Fremont, California. In December 2000, we entered
into a ten-year lease for two buildings totaling 185,790 square feet for our
headquarters and research and development personnel as well as to house our
manufacturing operations. net.com and our subsidiaries also lease sales and
service offices at other locations in the United States, Canada, United Kingdom,
France, Mexico, Singapore, Uruguay, China, Japan, and Hong Kong.
ITEM 3. LEGAL PROCEEDINGS
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the shareholders during the quarter ended
March 28, 2003.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
See Note 9 and 10 in the "Notes to Consolidated Financial Statements." At June
9, 2003, there were approximately 500 registered stockholders of record of
net.com.
9
MARKET PRICE
net.com's common stock is traded on the New York Stock Exchange under the symbol
"NWK." The following table sets forth, for the quarterly periods indicated, the
high and low sale prices of our common stock:
Fiscal 2003 High Low
-----------------------------------------------------------------
First quarter $ 5.98 $ 4.00
Second quarter 4.30 3.23
Third quarter 4.60 2.84
Fourth quarter $ 7.24 $ 3.80
-----------------------------------------------------------------
Fiscal 2002 High Low
-----------------------------------------------------------------
First quarter $ 4.95 $ 3.00
Second quarter 4.35 2.80
Third quarter 5.10 2.40
Fourth quarter $ 5.81 $ 4.60
-----------------------------------------------------------------
net.com has never declared or paid dividends on our capital stock and does not
intend to pay dividends in the foreseeable future. In addition, our 7 1/4%
convertible subordinated debentures trade in the over-the-counter market.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial information has been derived from the audited
consolidated financial statements. The information set forth below is not
necessarily indicative of results of future operations and should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the consolidated financial statements and related
notes thereto included elsewhere in this Form 10-K.
(In thousands, except per share amounts)
FISCAL YEARS ENDED 2003 2002 2001 2000 1999
- -------------------------------------------------------------------------------------------------------------
Total revenue $122,100 $101,546 $144,286 $225,686 $263,835
Net loss (18,448) (37,398) (20,790) (40,070) (7,054)
Diluted loss per share (0.82) (1.69) (0.96) (1.86) (0.32)
7 1/4% convertible subordinated debentures 24,706 24,706 24,706 24,706 24,706
Total assets $164,818 $187,422 $235,346 $259,994 $313,112
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion should be read in conjunction with the consolidated
financial statements and the accompanying notes. Statements contained in this
discussion that are not historical facts are forward-looking statements within
the meaning of the federal securities laws that relate to future events of our
financial performance. A forward-looking statement may contain words such as
"plans," "hopes," "believes," "estimates," "will continue to be," "will,"
"continue to," "expect to," "anticipate that," "to be," or "can impact."
Forward-looking statements are based upon management expectations and involve
risks and uncertainties that may cause actual results to differ materially from
those anticipated in the forward-looking statements. Many factors may cause
actual results to vary
10
including, but not limited to, the factors discussed in this discussion. Net.com
expressly disclaims any obligation or undertaking to revise or publicly release
any updates or revisions to any forward-looking statement contained in this
discussion. Investors should carefully review the risk factors described in this
document along with other documents net.com files from time to time with the
SEC.
RESULTS OF OPERATIONS
The following table depicts data derived from the consolidated statements of
operations expressed as a percentage of revenue:
Fiscal years ended:
Mar. 28, Mar. 29, Mar. 30,
Percent of revenue 2003 2002 2001
- ----------------------------------------------------------------------------------------------------------
Product revenue 83.5% 73.6% 53.4%
Service and other revenue 16.5 26.4 46.6
- ----------------------------------------------------------------------------------------------------------
Total revenue 100.0 100.0 100.0
- ----------------------------------------------------------------------------------------------------------
Product revenue gross margin 48.5 37.5 42.8
Service and other revenue gross margin 9.2 10.0 33.7
- ----------------------------------------------------------------------------------------------------------
Total gross margin 42.0 30.3 38.5
- ----------------------------------------------------------------------------------------------------------
Sales and marketing 26.3 32.5 31.0
Research and development 21.3 32.5 28.0
General and administrative 9.2 12.0 8.8
Restructure costs (benefits) 1.7 1.2 (1.0)
Amortization of goodwill and other intangible assets - 3.4 2.3
- ----------------------------------------------------------------------------------------------------------
Total operating expenses 58.5 81.6 69.1
- ----------------------------------------------------------------------------------------------------------
Loss from operations (16.5) (51.3) (30.6)
Interest income 2.1 5.6 5.5
Interest expense (1.7) (1.9) (1.3)
Other 5.7 8.8 10.4
- ----------------------------------------------------------------------------------------------------------
Loss before income taxes (10.4) (38.8) (16.0)
Income tax benefit (3.1) (2.0) (1.5)
- ----------------------------------------------------------------------------------------------------------
Loss before cumulative change in accounting
principle, relating to goodwill (7.3) (36.8) (14.5)
- ----------------------------------------------------------------------------------------------------------
Cumulative change in accounting principle, relating to goodwill (7.8) - -
- ----------------------------------------------------------------------------------------------------------
Net loss (15.1)% (36.8)% (14.5)%
==========================================================================================================
COMPARISON OF 2003, 2002 & 2001
REVENUE Total revenue increased 20.2% to $122.1 million in fiscal 2003 compared
to $101.5 million in fiscal 2002, due to increased product revenue. Fiscal 2002
total revenue decreased 29.2% from $144.3 million in fiscal 2001, due mostly to
a decrease in service revenue, which was substantially reduced by the sale of
our federal services business in that year, as well as slightly reduced product
revenue.
Product revenue increased 36.3% to $101.9 million in fiscal 2003, as compared to
$74.8 million in fiscal 2002. Fiscal 2002 product revenue decreased 2.9% from
$77.0 million in fiscal 2001. Product revenue is generated primarily from our
circuit-switched product line, Promina, which accounts for the majority of our
worldwide product sales. Product revenue increased in fiscal 2003 primarily due
to the strength of our Promina sales to government agencies, both domestically
and internationally. In addition, product sales of our new broadband products
SCREAM and SHOUTIP, contributed to the product revenue increase in fiscal 2003
but remain less than 10% of total revenues. Product revenue declined in 2002
primarily as a result of a general decline in the overall
11
market for circuit-switched products. Product revenue was also impacted in 2002
by the end of life for our SONET Transmission Manager (STM), product line, which
accounted for $9.3 million in revenue in fiscal 2001 and no revenue in fiscal
2002. The 2002 decrease was partially offset by revenue growth in our Federal
business, fueled by increased government defense spending and increased security
initiatives after the events of September 11, 2001.
Product revenue for the Federal Government sales channel, which includes sales
to the U.S. Government and government contractors, increased 59.0% to $76.8
million in fiscal 2003 from $48.3 million in fiscal 2002, which was an increase
of 17.0% compared to $41.3 million in fiscal 2001. The revenue growth for the
Federal Government sales channel is partially a result of our SCREAMlink
program. In fiscal 2003, we announced our SCREAMlink program that combines the
Promina platform and SCREAM under a single management architecture and allows
our customers who use our narrowband product to migrate to a broadband ATM/IP
network. The SCREAMlink strategy is partially responsible for the renewed demand
in our Promina product line and some of the initial interest in our new SCREAM
product line from our traditional government customers. Product revenue for the
North America (other than government) sales channel was $1.8 million in fiscal
2003 representing a decrease of 46% compared to $3.3 million in fiscal 2002,
which represented a decrease of 68.0% from $10.3 million in fiscal 2001. Product
revenue for the Asia Pacific/Latin America sales channel was $6.0 million in
fiscal 2003, representing a decrease of 26.0% compared to $8.1 million in fiscal
2002, which represented a decrease of 12% from $9.2 million in fiscal 2001.
Product revenue for the European sales channel was $17.3 million in fiscal 2003,
representing an increase of 15.0% compared to $15.1 million in fiscal 2002,
which represented a decrease of 7.0% compared to the $16.2 million in fiscal
2001.
Service and other revenue decreased 24.6% to $20.2 million in fiscal 2003, as
compared to $26.8 million in fiscal 2002, as the result of enterprise customers
lowering service levels to reduce costs. Fiscal 2002 service and other revenue
decreased 60.2% compared to $67.3 million in fiscal 2001, primarily due to the
sale of our Federal Services Business (FSB) to CACI International Inc. (CACI) in
the third quarter of fiscal 2001. The FSB revenue in fiscal 2003, 2002, and 2001
was $2.6 million, $1.9 million and $34.3 million, respectively.
We have developed service creation solutions that expand our service offerings
for our newer product lines, SCREAM and SHOUTIP, which may offset part of the
decline in service and other revenue experienced in fiscal 2003 and 2002. In
addition, we have recently announced the end of life for service on our IDNX
product line, and to the extent customers make network upgrades to our current
products, we would expect a level of related service revenue. Despite
incremental service and other revenue from the new product offerings and the
network upgrades, we believe service and other revenue will remain relatively
flat or decrease in fiscal 2004, compared to fiscal 2003, as a result of a
decline in the installed base of Promina equipment.
GROSS MARGIN Total gross margin, comprised of product and service margin,
increased as a percentage of total revenue to 42.0% in fiscal 2003 compared to
30.3% in fiscal 2002 and 38.5% in fiscal 2001. The increase in total gross
margin in fiscal 2003 is primarily the result of the following:
1) Higher product margins. Product gross margins as a percentage of
product revenue increased to 48.5% in fiscal 2003 compared to 37.5% in
fiscal 2002. The increase in product gross margins resulted from the
higher product revenue and lower manufacturing variances compared to
fiscal 2002. Manufacturing variances were reduced, primarily by lower
charges for excess and obsolete inventory, which was $2.3 million in
fiscal 2003 compared to $6.3 million in fiscal 2002. The $2.3 million
charge in fiscal 2003 resulted primarily from the obsolescence of a
first-generation printed circuit assembly used in the SHOUTIP product
line.
2) A mix of total revenue that included a lower percentage of service and
other revenue and a higher percentage of product revenue. Service and
other revenue gross margins are lower than product revenue gross
margins. The percentage of service revenue to total revenue was 16.5%
in fiscal 2003 compared to 26.4% in fiscal 2002.
The decrease in total gross margin in fiscal 2002 compared to fiscal 2001 is
primarily the result of the following:
1) Lower product revenue gross margins. Product gross margin decreased to
37.5% in fiscal 2002, compared to 42.8% in fiscal 2001. In fiscal
2002, we incurred charges of $6.3 million related to the write-off of
excess and obsolete inventory. In fiscal 2001, a charge of $1.4
million was taken in connection with the end of life and subsequent
obsolescence of the STM and the Router Accelerator product lines.
Additionally, in fiscal 2002 and 2001, product margins were impacted
by unfavorable manufacturing variances resulting from lower revenues.
2) Lower service and other revenue gross margin. Services and other
revenue gross margin decreased to 10.0% of revenue in fiscal 2002 from
33.7% in fiscal 2001. The decrease in service and other revenue gross
margin in fiscal 2002 primarily resulted from lower services contract
revenues resulting from the sale
12
of our federal service business (FSB) to CACI in the third quarter of
fiscal 2001. A significant portion of service costs are fixed, and
thus margins will continue to be low while service revenue remains
low.
Gross margins may be adversely affected in the future by increases in material
or labor costs, excess inventory, obsolescence charges, changes in shipment
volume, loss of cost savings, increased price competition, geographic mix and
changes in channels of distribution or in the mix of products and services sold.
If product or related warranty costs associated with our products are greater
than we have previously experienced, gross margin would also be adversely
affected.
OPERATING EXPENSES Total operating expenses decreased to $71.4 million in
fiscal 2003 from $82.9 million in fiscal 2002 and $99.8 million in fiscal 2001.
Operating expenses as a percentage of total revenue decreased to 58.5% in fiscal
2003, compared to 81.6% in fiscal 2002 and 69.1% in fiscal 2001. The decrease in
operating expenses as a percentage of total revenue is partly due to tightly
managed expenses, but in fiscal 2003 is also due to higher total revenue over
fiscal 2002 and the completion of amortization of certain assets in fiscal 2002.
The increase in operating expenses as a percentage of total revenue for fiscal
2002 over fiscal 2001 is due to the sharp reduction in revenue in fiscal 2002,
as well as restructuring expense in fiscal 2002 compared to a credit in fiscal
2001. In the third and fourth quarters of fiscal 2002, we completed two separate
restructurings that each included a reduction in our workforce. These reductions
contributed to lower operating expenses in fiscal 2003 and 2002. In addition,
each quarter of fiscal 2003 included small restructurings of either reductions
in our workforce or downsizing of field offices. The restructure expense in
fiscal 2003 was a charge of $2.1 million compared to $1.2 million in fiscal 2002
and a credit of $1.4 million in fiscal 2001. The credit in fiscal 2001 resulted
from lower costs than initially estimated related to the closure of field
offices.
Sales and marketing expenses in fiscal 2003 decreased $867,000 to $32.1 million
compared to $33.0 million in fiscal 2002 and $44.7 million in fiscal 2001. Sales
and marketing spending as a percentage of total revenue in fiscal 2003 decreased
to 26.3% compared to 32.5% in fiscal 2002 and decreased from 31.0% in fiscal
2001. The decrease in fiscal 2003 spending compared to 2002 resulted primarily
from the following:
o a reduction of $763,000 in depreciation and amortization,
o a reduction of $373,000 in advertising expense,
o a reduction of $300,000 in facility and information systems expenses,
o a reduction of $129,000 in third party service costs for international
sales offices,
o a decrease in recruiting expense of $125,000, and
o a decrease in communications costs of $68,000.
These decreases were offset in part by an increase in salary and related costs
of $1.0 million, primarily related to sales commissions. The decrease in fiscal
2002 spending, compared to 2001, resulted from a decrease in salary and related
costs of $5.9 million, a decrease in travel expenses of $518,000, a decrease in
depreciation costs of $1.7 million, and a decrease of $1.2 million in lower
sales and marketing related costs consistent with decreased revenue.
Research and development expenses in fiscal 2003 decreased $7.0 million to $26.0
million, compared to $33.0 million in fiscal 2002 and $40.4 million in fiscal
2001. Research and development spending as a percentage of total revenue
decreased to 21.3% in fiscal 2003 compared to 32.5% in fiscal 2002 and 28.0% in
fiscal 2001. The decrease in fiscal 2003 spending, compared to 2002, resulted
from a reduction of $3.0 million in salary related expenses, a decrease of $1.8
million in depreciation and amortization costs and a reduction of $1.6 million
in engineering-related materials expenses. In fiscal 2003, 2002 and 2001, we
focused research and development resources on the development and release of our
broadband and IP-telephony product offerings. The decrease in fiscal 2002
spending, compared to 2001 resulted from a reduction of $4.9 million in salary
related expenses, a decrease of $1.5 million in depreciation costs and a
reduction of $1.2 million in engineering-related materials expenses. In fiscal
2004, we expect that research and development expenses will remain flat or
increase slightly as we balance cost control with the development and
introduction of enhancements to our new products.
General and administrative expenses in fiscal 2003 decreased $1.0 million to
$11.2 million, compared to $12.2 million in fiscal 2002 and $12.7 million in
fiscal 2001. General and administrative spending as a percentage of total
revenue decreased to 9.2% in fiscal 2003 compared to 12.0% in fiscal 2002 and
increased from 8.8% in fiscal 2001. The decrease in general and administrative
spending in fiscal 2003 compared to 2002 was the result of reduction of $556,000
in salary related expenses, a decrease in recruiting and relocation expense of
$271,000 and a decrease in facility and information systems expenses of
$146,000. The decrease in general and administrative spending in fiscal 2002
compared to 2001, was the result of decreased salary related expenses of $1.5
million, offset by an
13
increase of $912,000 in information technology related expenses. We expect
general and administrative spending to remain relatively flat or decline
slightly due to continued focus on cost control.
The restructuring charge of $2.1 million recorded during fiscal 2003 consisted
of $730,000 for employee separation costs, $818,000 for lease termination costs,
$286,000 for office closure costs, and $245,000 for other charges. The remaining
liability for restructuring charges is $904,000 at March 28, 2003.
The restructuring charge of $1.2 million recorded during fiscal 2002 consisted
of $1.0 million for employee separation costs and $153,000 for other charges.
The remaining liability for restructuring charges was $584,000 at March 29,
2002.
Components of accrued restructuring charges, which are included in accrued
liabilities in the accompanying balance sheet, and changes in accrued amounts
related to this restructuring program during the fiscal years ended March 29,
2002, March 28, 2003 and as of March 20, 2001 were as follows (in thousands):
---------------------------------------------------------------------------------------
EMPLOYEE OFFICE OTHER
SEPARATION LEASE CLOSURE RESTRUCTURING
COSTS WRITE-OFF COSTS COSTS TOTAL
---------------------------------------------------------------------------------------
Balance at March
30, 2001 $ 847 $ - $ 471 $ - $ 1,318
Provision 1,034 - - 153 1,187
Payments 1,707) - (214) - (1,921)
----------------------------------------------------------------
Balance at March
29, 2002 174 - 257 153 584
----------------------------------------------------------------
Provision 730 818 286 245 2,079
Payments (744) (204) (507) (304) (1,759)
----------------------------------------------------------------
Balance at March
28, 2003 $ 160 $ 614 $ 36 $ 94 $ 904
================================================================
We believe that all costs associated with our plan of business reorganization
will be paid no later than the end of fiscal 2005.
As a result of the adoption of SFAS 142 in the first quarter of fiscal 2003,
goodwill and other intangible assets were written off. Amortization of goodwill
ceased, and therefore there was no amortization of goodwill in fiscal 2003.
Amortization of goodwill and other intangible assets in fiscal 2002 and 2001 was
$3.4 million in each year. The amortization expense in fiscal 2002 and fiscal
2001 was a result of two acquisitions, Convergence Equipment Company, which
occurred in the first quarter of fiscal 2001, and FlowWise Networks, Inc., which
occurred in the third quarter of fiscal 2000.
SFAS 142 requires goodwill to be tested for impairment under certain
circumstances. If the carrying amount of the goodwill exceeds the implied fair
value of the goodwill, an impairment loss shall be recognized in an amount equal
to that excess, and written down when impaired, rather than being amortized as
previous standards required. We completed our implementation test, which
determined that goodwill was impaired, resulting in a charge of $9.6 million in
the first quarter of fiscal 2003. This charge is presented as a cumulative
effect of change in accounting principle, relating to goodwill.
NON-OPERATING ITEMS Interest income, primarily related to cash and short-term
investments, decreased $3.2 million to $2.5 million in fiscal 2003 from $5.7
million in fiscal 2002 and $8.0 million in fiscal 2001. The decrease in interest
income is primarily the result of declining yields as well as lower cash
balances of our investment portfolio in fiscal 2003 and 2002 compared to fiscal
2001. Although cash balances may increase in fiscal 2004, we expect interest
income to decline as a result of declining yields from our investment portfolio.
Interest expense increased $121,000 to $2.0 million in fiscal 2003, compared to
$1.9 million in both fiscal 2002 and fiscal 2001. Interest expense is primarily
attributable to the 7 1/4% convertible subordinated debentures. Interest expense
for the debentures remained constant in fiscal 2003, 2002, and 2001 at $1.8
million in each year. The increase in interest expense in fiscal 2003 resulted
from debt obligations assumed by net.com as part of the building repair for our
former Fremont, California campus.
Other income in fiscal 2003 decreased $1.9 million to $7.0 million, compared to
$8.9 million in fiscal 2002 and $15.0 million in fiscal 2001. Other income in
fiscal 2003 included a gain of $2.4 million from insurance proceeds received for
construction costs associated with our new Fremont campus and a gain of $5.0
million from the CACI
14
agreement for the divestiture of our FSB. Other income in fiscal 2002 included a
gain of $3.7 million from insurance proceeds associated with our new Fremont
campus and a gain of $5.0 million from the sale of our FSB. Other income in
fiscal 2001 included a gain of $14.9 million from the sale of our FSB. We expect
further gains in fiscal 2004 and fiscal 2005 of $1.5 million each year, related
to the CACI agreement for the divestiture of our FSB.
We received tax benefits of $3.8 million in fiscal 2003, $2.0 million in fiscal
2002 and $2.2 million in fiscal 2001. Each year, we evaluate the adequacy of our
tax liability reserves taking into account the statute of limitations on
previously filed tax returns as well as our expected net losses. The result of
this reevaluation was to reduce the amount of reserves and to record a tax
benefit in each of the past three fiscal years.
SUMMARY DISCLOSURES ABOUT CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS
The following table provides a summary of our contractual cash obligations and
other commercial commitments as of March 28, 2003 (in thousands):
LESS THAN 1-3 4-5 AFTER
CONTRACTUAL OBLIGATIONS TOTAL 1 YEAR YEARS YEARS 5 YEARS
- -------------------------------------- --------------------------------------------------------------
Long-Term Debt $ 24,706 $ - $ - $ - $ 24,706
Interest on Long-Term Debt 19,703 1,791 3,582 3,582 10,748
Operating Leases 35,130 5,621 7,446 6,568 15,495
--------------------------------------------------------------
Total Contractual Obligations $ 79,539 $ 7,412 $ 11,028 $ 10,150 $ 50,949
==============================================================
SIGNIFICANT ACCOUNTING POLICY JUDGMENTS AND ESTIMATES
The preparation of financial statements in accordance with accounting principles
generally accepted in the United States requires that we make estimates and
judgments, which affect the reported amounts of assets, liabilities, revenues
and expenses, and related disclosures of contingent assets and liabilities. On
an on-going basis, we evaluate our estimates, including those related to sales
returns, bad debts, inventories, investments, intangible assets, income taxes,
warranty obligations, restructuring charges, contingencies, such as litigation,
and contract terms that have multiple elements and other complexities typical in
the telecommunications equipment industry. We base our estimates on historical
experience and other assumptions that we believe are reasonable under the
circumstances. Actual results may differ from these estimates under different
assumptions or conditions.
We believe the following critical accounting policies affect the more
significant judgments and estimates used in the preparation of our financial
statements.
REVENUE RECOGNITION: We recognize revenue, generally upon shipment, when all
four of the following criteria are met:
1) we have a contract with our customer;
2) when delivery has occurred and risk of loss passes to the customer;
3) when our price is fixed or determinable; and
4) when collection of the receivable is reasonably assured.
For transactions where we have not yet obtained customer acceptance, revenue is
generally deferred until the terms of acceptance are satisfied. Revenue for
installation or other services is recognized upon completion of the service.
Maintenance contracts are sold separately from the products and revenue is
recognized ratably over the period of the contracts. A reserve for sales returns
is established based on historical trends in product returns. If the actual
future returns differ from historical levels, our revenue could be adversely
affected.
ALLOWANCE FOR DOUBTFUL ACCOUNTS: The allowance for doubtful accounts receivable
is based on our assessment of the collectibility of specific customer accounts
and the aging of accounts receivable. If there is a deterioration of a major
customer's credit worthiness or actual defaults are higher than our historical
experience, our estimates of the recoverability of amounts due us could be
adversely affected.
INVENTORY PROVISIONS: Inventory purchases and commitments are based upon future
demand forecasts. If there is a significant decrease in demand for our products
or there is a higher risk of inventory obsolescence because of rapidly changing
technology and customer requirements, we may be required to make adjustments to
write down our inventory to the lower of cost or market, and our gross margin
could be adversely affected.
15
WARRANTY ACCRUALS: We generally warrant hardware product sales for twelve
months and software for three months. We accrue warranty expense based on
historical expense trends calculated as a percentage of new product sales.
Actual expenses are charged against the accrual in the period they are incurred.
On a quarterly basis, the warranty accrual is analyzed for adequacy based on
actual trends and subsequent adjustments are made to the liability balance.
Components of the warranty accrual, which are included in accrued liabilities in
the accompanying balance sheet, during fiscal 2003 were as follows (in
thousands):
----------------------------------------------------------------------------------------------------
BALANCE AT CHARGES TO CHARGES TO OTHER BALANCE
BEGINNING OF COST OF WARRANTY ADJUSTMENTS END OF
PERIOD GOODS SOLD ACCRUAL (1) THE PERIOD
----------------------------------------------------------------------------------------------------
Year ended March
28, 2003 $ 639 $ 210 $ (338) $ (307) $ 204
----------------------------------------------------------------------------------------------------
(1) Adjustment resulted from a change in warranty cost estimates primarily from
lower hourly costs of labor to repair products and frequency of warranty claims.
STOCK BASED COMPENSATION: We account for stock-based awards to employees using
the intrinsic value method in accordance with Accounting Principles Board (APB)
Opinion No. 25, Accounting for Stock Issued to Employees, and its related
interpretations. Accordingly, no charges were taken in fiscal years 2003, 2002,
and 2001 as all stock options were granted at market price.
DEFERRED TAXES: We have incurred tax losses in the last four fiscal years and,
at March 28, 2003, we have an estimated $89.9 million of federal net operating
loss carryforwards and $18.3 million of state operating loss carryforwards
available to reduce tax payments in future periods. We have provided a full
valuation allowance against our tax assets, given the uncertainty as to their
realization. In future years, these benefits are available to reduce or
eliminate taxes on future taxable income. Current federal and state tax laws
include provisions that could limit the annual use of our net operating loss
carryforwards in the event of certain defined changes in stock ownership. Our
issuances of common and preferred stock may have resulted in such a change.
Accordingly, the annual use of our net operating loss carryforwards may be
reduced by these provisions. Management has not yet determined the extent of the
limitation, and this limitation may result in the loss of carryforward benefits
due to their expiration.
LIQUIDITY AND CAPITAL RESOURCES
As of March 28, 2003, we had cash and cash equivalents of $20.6 million,
restricted cash of $1.4 million and short-term investments of $72.6 million for
a total of $94.6 million as compared to $94.9 million at the end of fiscal 2002
and $133.8 million at the end of fiscal 2001. In fiscal 2003, the days sales
outstanding (DSO) decreased 27 days to 39 days from 66 days at the end of fiscal
2002. The lower DSO resulted in a decrease in accounts receivable of $4.9
million to $14.6 million at the end of fiscal 2003 compared to $19.5 million at
the end of fiscal 2002. The lower accounts receivable combined with the $5.0
million payment received from CACI and the insurance proceeds of $3.5 million
offset our net operating losses, thus keeping cash and investment balances
relatively flat year-over-year. The fiscal 2002 reduction was primarily the
result of cash used to fund operations, as well as $12.4 million used to build
our new Fremont campus.
Net cash used in operations was $1.8 million in fiscal 2003, compared to $18.8
million in fiscal 2002 and $9.4 million in fiscal 2001. In fiscal 2003, cash
used in operations resulted primarily from a net loss of $18.4 million, a
decrease in accounts payable of $2.5 million and a decrease in accrued
liabilities of $3.8 million. Net cash provided by operations included a
reduction in accounts receivable of $4.9 million, a decrease in inventory of
$235,000 and a decrease in prepaid expenses and other assets of $2.2 million.
Net non-cash operating activity included the adjustment for depreciation and
amortization of $9.5 million, a gain recognized from proceeds relating to the
sale of our FSB of $5.0 million, a gain recognized of $2.4 million from the
insurance settlement relating to our new Fremont campus, cash proceeds from the
insurance settlement of $3.5 million and the cumulative change in accounting
principle for goodwill impairment of $9.6 million. In fiscal 2002, cash used in
operations resulted primarily from a net loss of $37.4 million and a decrease in
accrued liabilities of $11.8 million. Net cash provided by operations in fiscal
2002, resulted primarily from a decrease in accounts receivable of $10.3
million, a decrease in inventory of $5.3 million, and a decrease in prepaid
assets of $1.3 million. Net non-cash operating activity in fiscal 2002, included
the adjustments for depreciation and amortization of $16.7 million, a gain
recognized from proceeds
16
relating to the sale of our FSB of $5.0 million, a gain recognized of $3.7
million from the insurance settlement relating to our new Fremont campus, and
cash proceeds from the insurance settlement of $5.3 million.
Net cash provided by investment activities was $5.0 million in fiscal 2003,
compared to $13.0 million in fiscal 2002 and $13.3 million in fiscal 2001. Cash
provided by investment activities was primarily from maturing temporary
investments, net of new purchases, of $3.5 million; $5.0 million received from
the sale of our FSB and a decrease in restricted cash of $1.9 million, offset by
$5.9 million of cash used for the purchases of fixed assets, net of retirements.
Net cash provided by investment activities in fiscal 2002 consisted primarily of
the proceeds from maturing temporary cash investments, net of new purchases, of
$36.1 million, and $5.0 million received from the sale of our FSB, offset by
$24.9 million of cash used for the purchases of fixed assets, most of which were
leasehold improvements on our new Fremont campus, and an increase in restricted
cash of $2.7 million used primarily to secure a line of credit required by the
lease provisions.
Net cash provided by financing activities was $1.5 million in fiscal 2003
compared to $1.1 million in fiscal 2002 and $1.3 million in fiscal 2001. In
fiscal 2003, cash provided by financing activities was $1.6 million from the
sale of common stock, offset by the use of $53,000 in cash for the payment of
capital leases. In fiscal 2002, cash provided by financing activities was $1.3
million from the sale of common stock, offset by the use of $154,000 in cash for
the payment of capital leases. In fiscal 2001, cash provided by financing
activities was $2.9 million from the sale of common stock, which was partially
offset by the use of $1.4 million in cash for the repurchase of common stock and
$154,000 in cash for the payment of capital lease.
We believe that our existing current cash and cash equivalents, short-term
investments and cash flows from operations will be sufficient to fund
operations, purchases of capital equipment and research and development programs
currently planned at least through the next 12 months.
RECENTLY ISSUED ACCOUNTING STANDARDS
In May 2003, the Financial Accounting Standards Board (FASB) issued Statement of
Financial Accounting Standards (SFAS) No. 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity. SFAS 150
improves the accounting for certain financial instruments that, under previous
guidance, issuers could account for as equity. SFAS 150 requires that those
instruments be classified as liabilities in statements of financial position.
SFAS 150 is effective for interim periods beginning after June 15, 2003. We are
currently evaluating the effect of SFAS 150 on our balance sheet, results of
operations and cash flows.
In April 2003, the FASB issued, Amendment of Statement 133 on Derivative
Instruments and Hedging Activities, which amends SFAS 133 for certain decisions
made by the FASB Derivatives Implementation Group. In particular, SFAS 149 (1)
clarifies under what circumstances a contract with an initial net investment
meets the characteristic of a derivative, (2) clarifies when a derivative
contains a financing component, (3) amends the definition of an "underlying" to
conform it to language used in FASB Interpretation No. (FIN) 45, and (4) amends
certain other existing pronouncements. SFAS 149 is effective for contracts
entered into or modified after June 30, 2003, and for hedging relationships
designated after June 30, 2003. In addition, most provisions of SFAS No. 149 are
to be applied prospectively. We are currently evaluating the effect of this
statement on our balance sheet, results of operations and cash flows.
In December 2002, FASB issued SFAS 148, Accounting for Stock-Based
Compensation-Transition and Disclosure, which amends SFAS 123, Accounting for
Stock-Based Compensation. SFAS 148 provides alternative methods of transition
for a voluntary change to the fair value based method of accounting for
stock-based employee compensation. In addition, SFAS 148 amends the disclosure
requirements of SFAS 123 to require more prominent and more frequent disclosures
in financial statements about the effects of stock-based compensation. SFAS 148
is effective for fiscal years ending after December 15, 2002. We adopted the
disclosure provisions of SFAS 148 as of March 28, 2003. We have not yet
determined the effect that the transition provisions of SFAS 148 would have on
our operating results or financial position, if any.
In November 2002, the FASB issued FIN 45, Guarantor's Accounting and Disclosure
Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of
Others, which elaborates on the disclosures to be made by guarantor in its
interim and annual financial statements about its obligations under certain
guarantees that it is issued. We adopted the disclosure requirement of FIN 45.
We are currently determining what effect if any, the other provisions of FIN 45
will have on our operating results or financial condition.
In June 2002, the FASB issued SFAS 146, Accounting for Costs Associated with
Exit or Disposal Activities, which addresses financial accounting and reporting
for costs associated with exit or disposal activities and nullifies Emerging
Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain
Employee Termination
17
Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred
in a Restructuring). SFAS 146 requires that a liability for a cost associated
with an exit or disposal activity be recognized when the liability is incurred.
Under EITF 94-3, a liability for an exit cost was recognized at the date of an
entity's commitment to an exit plan. SFAS 146 also establishes that the
liability should initially be measured and recorded at fair value. We have
adopted the provisions of SFAS 146 for exit or disposal activities that are
initiated after December 31, 2002. The adoption of SFAS 146 did not have an
impact on our historical consolidated financial statements.
In August 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets, which addresses financial accounting and
reporting for the impairment or disposal of long-lived assets. While SFAS 144
supersedes SFAS 121, Accounting for the Impairment of Long-Lived Assets and for
Long-Lived Assets to Be Disposed Of, it retains many of the fundamental
provisions of SFAS 121. SFAS 144 also supersedes the accounting and reporting
provisions of APB 30, Reporting the Results of Operations - Reporting the
Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and
Infrequently Occurring Events and Transactions, for the disposal of a segment of
a business. However, it retains the requirement in APB 30 to report separately
discontinued operations and extends that reporting to a component of an entity
that either has been disposed of (by sale, abandonment, or in a distribution to
owners) or is classified as held for sale. We adopted SFAS 144 on March 30 2002.
The adoption of SFAS 144 did not have a material impact on our consolidated
financial statements.
BUSINESS ENVIRONMENT AND RISK FACTORS
Our business is subject to the risks and uncertainties described below. Although
we have tried to identify the material risks to our business, this is not an
all-inclusive list. There may be additional risks that have not yet been
identified and risks that are not material now but could become material. Any
one of these risks could hurt our business, results of operations or financial
condition.
WE HAVE INCURRED NET LOSSES IN THE PAST AND MAY CONTINUE TO INCUR LOSSES IN THE
FUTURE.
For each of the past five fiscal years, we have incurred net losses. Although
the Company has reduced operating expenses over the past few years, we will need
revenues to continue to grow in order to achieve profitability. Our narrowband
product line, Promina, currently provides the bulk of our revenue, but we expect
revenue from that product line to decline over the next few years. Our newer
broadband and IP-telephony product lines, SCREAM and SHOUTIP, have not yet
achieved market acceptance or broad commercial sales, and we are incurring
substantial product development and marketing expenses for those product lines.
Accordingly, we will not likely be profitable unless our newer product lines
achieve commercial success that outpaces the anticipated decline of our Promina
product line. In addition, we must contain our operating expenses, many of which
are fixed in the short term making it difficult to reduce expenses rapidly in
response to shortfalls in revenue.
OUR OPERATING RESULTS MAY CONTINUE TO FLUCTUATE.
Our operating results vary significantly from quarter to quarter. These
fluctuations may result from a number of factors, including:
o the volume and timing of orders from and shipments to our customers;
o the length and variability of the sales cycle of our products;
o the timing of and our ability to obtain new customer contracts;
o the timing of new products and services;
o the mix of sales among products and services,
o the timing and level of prototype expenses;
o the availability of products and services;
o the overall capital expenditures of our customers;
o the market acceptance of new and enhanced versions of our products and
services or variations in the mix of products and services we sell;
o the availability and cost of key components;
o the timing of revenue recognition/deferrals;
o the adoption of new accounting standards, such as the potential
requirement to record expenses for employee stock option grants;
18
o changes to revenue recognition rules or changing interpretations of
such rules as they apply to our sales;
o the obsolescence of inventories;
o the timing and size of Federal Government budget approvals; and
o general economic conditions as well as those specific to the
telecommunications, Internet and related industries.
Due to the foregoing factors, we believe that quarter-to-quarter comparisons of
our operating results are not a good indication of our future performance. Any
shortfall in revenue may adversely affect our business, results of operations
and financial condition. Investors should not rely on our results or growth for
one quarter as any indication of our future performance.
OUR STOCK PRICE MAY BE VOLATILE AND COULD DECLINE SUBSTANTIALLY.
The market price of our common stock has fluctuated significantly in the past,
will likely continue to fluctuate in the future and may decline. Fluctuations or
a decline in our stock price may occur regardless of our performance. Among the
factors that could affect our stock price, in addition to our performance, are:
o variations between our operating results and the published
expectations of securities analysts;
changes in financial estimates or investment recommendations by securities
analysts following our business;
o announcements by us or our competitors of significant contracts, new
products or services, acquisitions, or other significant transactions;
o our sale of common stock or other securities in the future;
o the inclusion or exclusion of our stock in various indices or
investment categories, especially as compared to the investment
profiles of our stockholders at a given time;
o changes in economic and capital market conditions;
o changes in business regulatory conditions; and
o the trading volume of our common stock.
WE ARE DEPENDENT ON REVENUE FROM THE PROMINA PRODUCT LINE.
Currently, we derive the majority of our product revenue from our Promina
product line, a circuit-based narrowband technology. The market for our Promina
product is expected to decline as networks are expected to increasingly employ
packet-based broadband technology. This technology migration has already
resulted in a significant drop in sales of our Promina products in the
commercial markets over the last three years. If this decline extends into our
government markets in a similar fashion before we gain traction on our newer
packet-based broadband product lines, our revenue will decrease, and our
business and results of operations will suffer.
A SIGNIFICANT PORTION OF OUR REVENUE IS GENERATED FROM SALES TO GOVERNMENTAL
AGENCIES.
A significant portion of our total revenue from product sales comes from
contracts with governmental agencies, most of which do not include long-term
purchase commitments. Historically, the government has been slower to adopt new
technology, such as packet-based technology, which has had the effect of
extending the product life of our Promina product. However, the government has
purchased and is evaluating some of our new products for broader deployment. If
the government accelerated adoption of new technology, and replaced the Promina
product line in their networks with products other than ours, our product
revenue would decline sharply. We anticipate that our past experience will
result in future contracts with the Federal Government; however, we face
significant competition in this endeavor. If we fail in renewing a significant
number of Federal Government contracts or if sales to the Federal Government
decline sharply, our revenue may not increase to profitable levels.
CONTINUED DECLINES IN PURCHASES BY OUR COMMERCIAL CUSTOMERS AND THE OVERALL
DECLINE OF PRODUCT SALES IN THE SERVICE PROVIDER MARKET COULD NEGATIVELY AFFECT
OUR OPERATIONS AND FINANCIAL RESULTS.
Over the last three years, the financial health of many of our commercial
customers, particularly telecommunications service providers, has deteriorated,
resulting in a decreased demand for our products. In addition, the timing and
volume of purchases by service providers can be unpredictable due to their need
to generate new revenue with sharply reduced capital budgets while reducing
operating expenses. Further, our ability to recognize revenue on sales to these
customers will depend on our meeting various acceptance criteria imposed on the
company in connection with these products by our early adopter customers, and on
the relative financial condition of these customers and whether receivables
balances from them are deemed to be collectible. Also, the selling cycle of our
19
SCREAM and SHOUTIP product lines could be extended if our service provider
customers continue to reduce their capital budgets. Declines in revenue as a
result of any of these factors could cause a material adverse effect on our
business, operating results and financial condition.
OUR SUCCESS DEPENDS ON OUR ABILITY TO DEVELOP NEW PRODUCTS AND PRODUCT
ENHANCEMENTS THAT WILL ACHIEVE MARKET ACCEPTANCE.
Our operating results will depend on the successful design, development,
testing, introduction, marketing, and broad commercial distribution of our newer
packet-based products, the SCREAM and SHOUTIP product lines. The success of
these and other new products is dependent on several factors, including proper
product definition, competitive pricing, timely completion and introduction to
the market, differentiation from competitors' products, and broad market
acceptance. The markets for our products are characterized by rapidly changing
technology, evolving industry standards, frequent new product introductions and
evolving methods of building and operating networks. Our SCREAM product line is
targeted at long-established incumbent carriers, such as BellSouth, SBC
Communications, Sprint, Verizon, British Telecom and France Telecom, who
typically have stringent product requirements and who are reluctant to purchase
products from vendors lacking a large market capitalization. Our SHOUTIP product
line is largely targeted at start-up telecommunications companies who demand
highly competitive pricing. We may not successfully identify new product
opportunities, develop and bring new products to market in a timely manner, or
achieve market acceptance of our products. Products and technologies developed
by others may render our products or technologies obsolete or non-competitive,
which in turn could adversely affect our ability to achieve profitability.
THE SUCCESS OF OUR SCREAM PRODUCT LINE DEPENDS LARGELY ON IT BEING CHOSEN BY
SERVICE PROVIDERS AS A PLATFORM FOR THE DELIVERY OF NEW SERVICES.
Since the second quarter of our fiscal year 2000, we have spent the majority of
our research and development and marketing resources to position ourselves, and
our SCREAM family of products, as the next generation of telecommunications
equipment that will enable carriers to optimize the delivery of differentiated
services. The future success of the SCREAM product line will depend in large
measure on service providers choosing to invest in products, such as SCREAM,
that can be used to deliver new services such as quality-of-service guarantees,
class-of-service subscriptions, or bandwidth-on-demand, to increase their
revenue and lower their operating expenses. If service providers do not
meaningfully invest in such new technologies, or do not choose the SCREAM
product line for such investment, our revenues from SCREAM will be negatively
affected, which will in turn have a negative effect on our business and
operating results.
WE NEED PARTNERSHIPS TO ACCELERATE THE ACCEPTANCE OF OUR NEW PRODUCTS BY SERVICE
PROVIDERS.
Building relationships with partners, such as software application partners,
system integrators, OEMs or resellers can accelerate the sales of new products.
The importance of the software application partners is that they provide
functions, such as billing, mediation, provisioning and configuration that are
needed to create a total solution for our customers. We need product OEM or
resale partners to supplement and enhance our sales force both in the United
States and overseas. Service providers rely on systems integrators to support
new equipment or services into their network. These integrators are important in
the large incumbent carrier networks and could facilitate our entry into those
networks. While we have begun the process of identifying and signing software
application, system integrator and OEM or resale partners, more partners may be
necessary in all these areas for us to be successful. We may need to pursue
strategic partnerships with vendors who have broader technology or product
offerings in order to compete with the end-to-end solution providers, as well as
to bolster our co-marketing efforts. Failure to sign up these new strategic
partners could affect our ability to grow overall revenue.
GROSS MARGINS COULD DECLINE OVER FUTURE PERIODS.
Due to increases in competition, material and labor costs, subcontractor costs,
change in absorption rate and changes in the mix of products we sell, our gross
margins could decline in future quarters. Our newer product lines, SCREAM and
SHOUTIP, currently have lower gross margins than our Promina product line. These
lower gross margins are a result of higher discounts awarded to early adopter
customers and higher component costs due to low purchase volumes of these
components. A decline in our gross margins could have a material adverse effect
on our business, results of operations and financial condition.
FACTORS BEYOND OUR CONTROL COULD AFFECT OUR ABILITY TO SELL INTO INTERNATIONAL
MARKETS.
We conduct significant sales and customer support operations in countries
outside of the United States and depend on non-US operations of our subsidiaries
and distribution partners. In addition, we also maintain a satellite research
and development facility in Ottawa, Province of Ontario, Canada and, on a
case-by-case basis, we outsource research and development activities to third
parties here in the US and abroad. As a general rule, international sales
20
tend to have risks that are difficult to foresee and plan for, including
political and economic stability, regulatory changes, currency exchange rates,
changes in tax rates and structures, and collection of accounts receivable.
Further, our international markets are served primarily by non-exclusive
resellers who themselves may be severely affected by economic or market changes
within a particular country or region. Our future results could be materially
adversely affected by a variety of uncontrollable and changing factors that
could affect these activities, including, among others, the outbreak of
infectious diseases such as severe acute respiratory syndrome (SARS). Unforeseen
or unpredictable changes in international markets could have a material adverse
effect on our business, results of operations and financial condition.
THE DIVESTITURE OF OUR FEDERAL SERVICES BUSINESS HAS REDUCED OUR ABILITY TO
CONTROL THE QUALITY OF SERVICE PROVIDED TO OUR FEDERAL GOVERNMENT CUSTOMERS.
On December 1, 2000, we closed the sale of our federal service business to CACI,
who subsequently provides maintenance and other services to our Federal
Government customers. We continue to sell net.com products directly to the
Federal Government and we rely on CACI to perform staging and integration
services for them. Additionally, we have a strategic alliance with CACI to
jointly market each other's products and services. As a result of these
arrangements, we are dependent on CACI to provide the level of service to which
our customers have become accustomed. If CACI experiences difficulties in
providing those services, or for any other reason leaves our mutual customers
unsatisfied, it could adversely affect purchasing decisions for our products and
cause our Federal Government customers to seek products from other vendors.
THE MARKET FOR OUR PRODUCTS IS HIGHLY COMPETITIVE AND MANY OF OUR COMPETITORS
HAVE GREATER RESOURCES THAN US.
The market for telecommunication equipment is highly competitive, dynamic and
characterized by rapid changes to and the convergence of technologies, and a
worldwide migration from existing circuit technology to the new packet-based
technologies. We compete directly internationally and domestically with many
different companies, some of which are large, established suppliers of
end-to-end solutions, such as Alcatel, Cisco, Lucent, Nortel, Juniper and
Siemens. In addition, there are a number of other smaller companies that are
targeting the same market, including CoSine, Nuera, Copper Mountain, Advanced
Fiber Communications, Redback, and others. Some of our larger competitors have
significantly greater financial, marketing and technical resources than we have
and offer a wider range of networking products than we offer. They are often
able to devote greater resources to the development, marketing and sale of their
products and to use their equity or significant cash reserves to acquire other
companies with technology and/or products that compete directly with ours. They
often can compete favorably on price because their large product selection
allows them to bundle multiple solutions together without significantly
impacting their overall product margins. The smaller companies have more ability
than net.com to focus their resources on a particular product development
unencumbered by the requirements to support an existing product line. As a
result of the flexibility of their market strategies, our competitors may be
able to obtain strategic advantages that may adversely affect our business,
financial condition or results of operations.
In addition, the networking equipment market has seen the constant introduction
of new technologies that has reduced the value of older technology solutions.
This has created pricing pressure on older products while increasing the
performance expectations of newer networking equipment. Moreover, broadband
technology standards are constantly evolving and alternative technologies or
technologies with greater capability are constantly introduced and sought by our
customers. It is possible that the introduction of other technologies will
either supplant our current technologies and technologies we have in development
or will require us to significantly lower our prices in order to remain
competitive. To remain competitive, we must continue to evolve our SCREAM and
SHOUTIP product lines to meet the ever-changing technology needs of the
networking market while ensuring that they can be sold at a competitive price.
We also must enhance our Promina product line to provide needed features that
increase their overall value for the customer while keeping the price
competitive. Due to the competitive nature of the market and the relative age of
our Promina product offerings as well as the competitive pressure being exerted
on our SCREAM and SHOUTIP technologies, we may not be able to maintain prices
for them at levels that will sustain profitability.
IF WE ARE UNABLE TO SIGN COMPETITIVE RESALE PARTNERS, OUR FUTURE PRODUCT AND
SERVICE REVENUE WILL BE ADVERSELY AFFECTED.
Our international sales are made almost entirely through indirect channels that
include distributors and resellers worldwide, and our business strategy includes
leveraging resale partners in the United States as well. Our reseller agreements
do not have minimum purchase requirements that they must meet. While we require
them to use their best efforts to resell our products, because our product line
is small, our distributors and resellers often also resell product lines from
other companies, including our competitors. Because of the size of some of these
competitors and their strong market position relative to net.com, it is often
difficult for us to find a distributor or reseller who is willing and
contractually able to resell our products. If we cannot develop relationships
with distributors and
21
resellers that can effectively market and sell our products and services, we may
not be able to meet our forecasted revenue in future quarters.
OUR PRODUCTS HAVE LONG SALES CYCLES, MAKING IT DIFFICULT TO PREDICT WHEN A
CUSTOMER WILL PLACE AN ORDER AND WHEN TO FORECAST REVENUE FROM THE RELATED SALE.
Our products are very complex and represent a significant capital expenditure to
our customers. The purchase of our products can have a significant impact on how
a customer designs its network and provides services either within its own
organization or to an external customer. Consequently, our customers often
engage in extensive testing and evaluation of products before purchase. There
are also numerous financial and budget considerations and approvals that the
customer often must obtain before it will issue a purchase order. As a result,
the length of our sales cycle can be quite long, extending beyond twelve months
in some cases. In addition, our customers, including resellers, often have the
contractual right to delay scheduled order delivery dates with minimal penalties
and to cancel orders within specified time frames without penalty, which makes
it difficult to predict whether or not an order may actually ship. We often must
incur substantial sales and marketing expense to ensure a purchase order is
placed. If the order is not placed in the quarter forecasted, our sales may not
meet forecast and revenue may be insufficient to meet expenses.
BECAUSE IT IS DIFFICULT FOR US TO ACCURATELY FORECAST SALES, PARTICULARLY WITHIN
A GIVEN TIME FRAME, WE FACE A RISK OF CARRYING TOO MUCH OR TOO LITTLE INVENTORY.
Typically, the majority of our revenue in each quarter has resulted from orders
received and shipped in that quarter. While we do not believe that backlog is
necessarily indicative of future revenue levels, our customers' ordering
patterns and the possible absence of backlogged orders create a significant risk
that we could carry too much or too little inventory if orders do not match
forecasts. Rather than base forecasts on orders received, we have been forced to
schedule production and commit to certain expenses based more upon forecasts of
future sales, which are difficult to predict in the telecommunications industry.
Furthermore, if large orders do not close when forecasted or if near-term demand
weakens for the products we have available to ship, our operating results for
that quarter or subsequent quarters would be materially adversely affected.
IF WE ARE UNABLE TO RETAIN EXISTING EMPLOYEES AND ATTRACT, RECRUIT AND RETAIN
KEY PERSONNEL, THEN WE MAY NOT BE ABLE TO SUCCESSFULLY MANAGE OUR BUSINESS.
Our success continues to be dependent on our being able to attract and retain
highly skilled engineers, managers and other key employees. Despite the economic
slowdown, we must continue to compete for the most qualified personnel for new
positions and to replace departing employees. Any restrictions on our ability to
use stock options as a key component of employee compensation, such as changes
in accounting treatment, stockholder actions, or changes in corporate
regulations, could severely impair our ability to recruit and retain personnel.
If we are not able to continue to attract, recruit and retain key personnel,
particularly in engineering, sales and marketing positions, we may be unable to
meet important company objectives such as product delivery deadlines and sales
targets.
WE RELY ON A NUMBER OF SOLE SOURCE SUPPLIERS FOR OUR COMPONENT PARTS AND THIRD
PARTY PRODUCTS WHICH COULD AFFECT OUR ABILITY TO SHIP OUR PRODUCTS IN A TIMELY
MANNER.
We purchase key components from single source suppliers, in particular, our back
planes, integrated circuits, and power supplies. If we or our sole source
suppliers fail to obtain components in sufficient quantities when required,
delivery of our products could be delayed resulting in decreased revenues. In
addition, if one of these suppliers were no longer able to supply a required
component, we may have to significantly reengineer the affected product.
Further, variability in demand and cyclical shortages of capacity in the
semiconductor industry have caused lead times for ordering parts to increase
from time to time. If we encounter shortages or delays in receiving ordered
components or if we are not able to accurately forecast our ordering
requirements, we may be unable to ship ordered products in a timely manner.
WE SINGLE SOURCE OUR MANUFACTURING PROCESS; A FAILURE OR DELAY BY THAT VENDOR
COULD AFFECT OUR ABILITY TO SHIP OUR PRODUCTS TIMELY.
We currently subcontract some testing and all product manufacturing to
Solectron. Final test and assembly is generally performed at our Fremont,
California facility. While subcontracting creates substantial cost efficiencies
in the manufacturing process, it also exposes us to delays in product shipments
should Solectron be unable to perform under our contract. Pursuant to our
contract with Solectron, we have agreed to compensate Solectron in the event of
a termination or a cancellation of orders, discontinuance of product or excess
material created by an engineering change. Also, should Solectron in some future
period decide not to renew our contract with them, it would be difficult for us
to quickly transfer our manufacturing requirements from Solectron to another
vendor, likely causing substantial delays in customer product shipments and
impacting revenue and our results of operations. We plan in
22
the near term to transition some of our product manufacturing to another vendor,
with contract terms that will likely involve some of the same provisions for
compensation of the vendor as we have with Solectron. Although this transition
will diversify some of the outsourcing risk, the transition itself, and the lack
of experience with the new vendor, could cause delays in customer product
shipments or otherwise negatively affect our results of operations.
OUR INTELLECTUAL PROPERTY RIGHTS MAY NOT BE ADEQUATE TO PROTECT OUR BUSINESS.
Our future success depends in part upon our proprietary technology. Although we
attempt to establish and maintain rights in proprietary technology and products
through patents, copyrights, and trade secrets laws, we cannot predict whether
such protection will be adequate, or whether our competitors can develop similar
technology independently without violating our proprietary rights. As
competition in the communications equipment industry increases and the
functionality of the products in this industry further overlap, we believe that
companies in the communications equipment industry may become increasingly
subject to infringement claims. We have received and may continue to receive
notice from third parties, including some of our competitors, claiming that we
are infringing their patents or their other proprietary rights. We cannot
predict whether we will prevail in any litigation over third-party claims, or
that we will be able to license any valid and infringed patents on commercially
reasonable terms. Any of these claims, whether with or without merit, could
result in costly litigation, divert our management's time, attention and
resources, delay our product shipments or require us to enter into royalty or
licensing agreements. In addition, a third-party may not be willing to enter
into a royalty or licensing agreement on acceptable terms, if at all. If a claim
of product infringement against us is successful and we fail to obtain a license
or develop or license non-infringing technology, we may be unable to market the
affected product.
WE NEED TO CONTINUE TO LICENSE PRODUCTS FROM THIRD PARTIES.
For our Promina, SCREAM and SHOUTIP products, we license some of our technology
from third parties. These licenses are generally limited in duration or by the
volume of shipments of the licensed technology. In addition, some of these
licenses contain limitations on distribution of the licensed technology or
provide for expiration upon certain events, such as a change in control of the
company. If the relevant licensing agreement expires or is terminated without
our being able to renew that license on commercially reasonable terms, or if we
cannot obtain a license for our products or enhancements on our existing
products we may be unable to market the affected product.
WE FACE RISKS ASSOCIATED WITH CHANGES IN TELECOMMUNICATIONS REGULATIONS AND
TARIFFS, INCLUDING REGULATION OF THE INTERNET.
Changes in domestic and international telecommunications requirements could
affect the sales of our products. In the United States, our products must comply
with various Federal Communication Commission (FCC) requirements and
regulations. In countries outside of the United States, our products must meet
various requirements of local telecommunications authorities. Changes in tariffs
or failure by us to obtain timely approval of products could impact our ability
to market the affected product.
The demand for our broadband products could also be affected by rulings of the
FCC regarding services offered by service providers to their customers, such as
differentiated broadband services. If rulings or regulations of the FCC diminish
the attractiveness of offering such services, then service providers would
likely have less need for our products.
In addition, there are currently few laws or regulations that govern access or
commerce on the Internet. If individual countries, or groups of countries,
acting in concert, began to impose regulations or standards on Internet access
or commerce including IP telephony, our ability to sell our new SCREAM and
SHOUTIP products or other new products would be adversely impacted if the
regulations or standards resulted in decreased demand or increased costs for our
products.
In North America, the former Regional Bell Operating Companies (RBOCs) recommend
that Telcordia Technologies, Inc. certify telecommunications equipment under
their Operations Systems Modifications for the Integration of Network Elements
(OSMINE) program in order to ensure interoperability with other network elements
and operational support systems. We have initiated the process for our product
lines to become OSMINE certified, but this is a very expensive and lengthy
process. Any delays or problems with attaining this certification could have a
material adverse impact on our business, operating results, and financial
condition.
WE ARE EXPOSED TO FLUCTUATIONS IN THE EXCHANGE RATES OF FOREIGN CURRENCY.
As a global concern, we face exposure to adverse movements in foreign currency
exchange rates. These exposures may change over time as business practices
evolve and could have a material adverse impact on our financial results. In
fiscal 2003, we commenced using for