UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
ANNUAL REPORT PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For The Fiscal Year Ended June 28, 2002
Commission File Number: 0-28562
VERILINK CORPORATION
(Exact name of registrant as specified in its charter)
| Delaware (State or other jurisdiction of incorporation or organization) |
94-2857548 (IRS Employer Identification No.) |
127 Jetplex Circle, Madison, Alabama 35758-8989
(Address of principal executive offices)
(256) 327-2001
(Registrant’s telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $.01 per share
Series A Junior Participating Preferred Stock Purchase Rights
(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 the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. [ ]
The aggregate market value of the voting stock held by non-affiliates of the Registrant, based on the closing sale price of the Common Stock on August 23, 2002, as reported by the Nasdaq SmallCap Market was $6,679,062. Shares of Common Stock held by each officer and director and by each person believed by the Company to own 5% or more of the outstanding Common Stock have been excluded from this computation in that such persons may be deemed to be affiliates. This determination of affiliate status is not a conclusive determination for other purposes.
As of August 23, 2002, the registrant had outstanding 14,996,534 shares of Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE
Parts of the following document are incorporated by reference in this Annual Report on Form 10-K: the Proxy Statement for the Registrant’s Annual Meeting of Stockholders to be held November 13, 2002 (the “Proxy Statement”), (Part III).
PART I
Item 1. Business
Overview
Verilink Corporation (the “Company”) provides voice and data network access solutions to service providers and enterprise customers for DDS, T1/E1, NxT1, T3 and G.SHDSL communication services. The Company develops, manufactures and markets customer premise equipment (“CPE”) and central site solutions for data and telecommunication centers. The Company offers a variety of application-specific solutions for time-division multiplexing, inverse multiplexing, digital cross-connect and IP bridging and routing, as well as converged solutions for access to Frame Relay, ATM and IP-based networks. The Company’s customers include equipment integrators, network service providers (“NSPs”) and enterprise customers consisting of wireline and wireless providers, inter-exchange carriers (“IXCs”), local exchange carriers (“LECs”), Internet service providers (“ISPs” ), Fortune 500 companies and various local, state and federal government agencies. The Company was founded in San Jose, California in 1982 and is a Delaware corporation.
Industry Background
Network service providers, both of wireline and wireless, have historically been the main consumers of network access equipment. Capital spending by these companies comprises the majority of telecommunications spending, and determines the overall direction and financial health of the industry. Capital spending by carriers in calendar 2002 is expected to drop significantly to between $40-60 billion from an all time high of $113 billion in calendar 2000, according to data provided by Soundview and SG Cowen. This decline in spending was the consequence of the IXCs and LECs overbuilding their backbone networks in the last half of 1999 and throughout calendar 2000. According to Soundview, capital spending estimates have continued to be lowered since January of 2002 for the largest providers, and may continue to decline through calendar 2003 as the telecommunication downturn may force more carriers into bankruptcy.
The outlook for the next 12 to 18 months for telecommunication equipment is still unclear based on the uncertainty of demand forecasts, capital spending projections, and the viability of certain service providers as ongoing businesses. Most market watchers still predict consolidation in both the equipment and service provider spaces, which may result in only a limited set of companies remaining as standalone entities. Opportunities for wholesale replacement of network gear are remote as companies and providers make only incremental investments in both equipment and infrastructure.
Material Changes in the Business
Several changes were implemented in fiscal 2002 by the Company to address this general downturn in the telecommunication industry, and the lack of visibility for future business. The Company believes that these changes will allow the Company to reduce operating expenses, to focus on customers that provide profitable longer-term business opportunities, and to enhance the ability of the Company to generate positive cash flow in future periods and to return to profitability at lower revenue levels.
Optical Network Access Project
In October 2001, the Company suspended its development activities related to the development of an optical network access product that targeted fiber-to-the-business (“FTTB”) applications. Based on the market conditions and the projected outlook for fiber deployments, the Company closed its operations in Boston, Massachusetts and archived all development work. The Company and Beacon Telco sought additional funding for this project through January 2002, but were unsuccessful. The Company owns the rights to all the optical network access development work completed during this project, and could restart the program in the future if market conditions and the outlook for FTTB applications improve.
Staff Reductions
Headcount decreased from 212 employees at September 29, 2001 to 63 employees at August 23, 2002 as the Company adjusted its cost structure for reduced revenue levels. Changes were also made to the management
team during this period that resulted in the appointment of a new President and CEO in January 2002 when Leigh S. Belden returned to that position. Mr. Belden founded the Company with Steven C. Taylor and served as its President and CEO from its inception in 1982 until his retirement in March 1999. Other executive positions were eliminated during this period, which results in the current executive management team of Leigh S. Belden, President and CEO, C. W. Smith, Vice President and CFO, and S. Todd Westbrook, Vice President Operations.
Facilities
With the reduced number of employees, the Company relocated to a smaller leased facility in Madison, Alabama at the end of June 2002. In August 2002, the Company signed an agreement with The Boeing Company to lease its facility located at 950 Explorer Boulevard in Huntsville’s Cummings Research Park, and will continue to seek a prospective buyer for this facility. In addition, the Company is in the process of moving the manufacturing activities of its Access System 2000 products to the facility in Madison from a contract manufacturing firm in California in order to improve overall operational efficiencies.
The Market Opportunity
Industry Direction – Incremental Investments to Address Network and Application Migration
Business customers today are searching for ways to improve the operation of their networks by increasing bandwidth and adding productivity-enhancing applications, while lowering the overall cost of owning and operating an enterprise network. Applications are increasingly IP-based, including VPNs for remote LAN access and packetized voice, and require improved security, encryption, traffic prioritization and network management. Many enterprise networks today are also experiencing technology obsolescence issues, and are without a clear path for migration to replacement or newer service offerings. Examples of these dynamics can be found in almost every segment of industry, creating communications problems that demand solutions to increase performance, facilitate migration to newer less costly services, and improve operations without economic penalty. The Company’s aim is to provide intelligent access solution s that allow enterprise customers to move forward with newer access technologies, but at an affordable pace.
Opportunity – Evolution of Managed Services and Carrier-bundled CPE
Today, integrated network solutions, including access equipment, are being offered by the major network service providers to target specific service and application needs. These bundles generally include all the necessary elements that an enterprise will need for service including the communication facility, termination equipment, network management, maintenance and support, and verifiable service level agreements. Bundles exist today for all major services including TDM services for private line applications and frame relay, ATM, and IP services for converged voice and data connectivity. Part of the Company’s core strategy is to work with the major service providers to gain certification for network access equipment to be included as part of their integrated networking solution offerings.
Communication traffic from enterprise customers continues to increase as cost effective data-centric applications provide new revenue opportunities for service providers and improved productivity for the enterprise. Business-to-Business connectivity, E-commerce, packet-voice, lower costs of bandwidth and the critical need to access information are key drivers of the growth in enterprise communication traffic.
Emerging Opportunities – Improvements for Copper-based Service Delivery
New services enabled by the emerging international DSL standard (G.SHDSL) over existing copper infrastructure are predicted to provide new services and CPE opportunities over the next several years. Carriers work with digital subscriber loop access multiplexer (“DSLAM”) providers to implement new facilities for broadband services that include ADSL, SDSL, G.SHDSL and T1/E1 interfaces. In many international markets, T1/E1 replacement via G.SHDSL interfaces on the DSLAM provides a carrier with a less expensive alternative for providing business services for voice and data. In North America, G.SHDSL offers a migration technology for older HDSL loop systems that has improved reach and spectral compatibility as requested by the FCC. The Company is currently working with several leading DSLAM vendors to certify its WANsuite CPE devices, and to establish market partnerships for distribution of equipment to th e network service providers for both domestic and international markets.
Growth - Improved Outlook for Wireless Data Services
Demand for wireless communication services has grown from 1999 through 2002 with continued growth expected for the foreseeable future. Next-generation data services based on incremental technologies such as 1XRTT for CDMA systems, and the migration to 3G broadband services will drive incremental demand for access equipment to wireless carriers’ networks. This trend is driven by the availability of new low cost digital services, the shift in long distance voice services to wireless carriers, and the intense competition among service providers. Service providers seeking delivery of new communication services in developing nations are also increasingly choosing wireless technology as the most cost-effective solution. The Company expects that future growth in the wireless market will come from a further increase in the number of subscribers, an increase in the total minutes of use, the increased implementation of wireless local loop systems in developing nations and the emergence of data services for mobile Internet, e-mail and messaging in developed nations.
The Verilink Solution – Intelligent WAN Access
The Company’s goal is to combine expertise in broadband access technologies with web-based application-level software to provide cost effective, scalable, integrated voice and data access solutions to yesterday’s and tomorrow’s communications services. In the past, access devices were typically used to terminate communications circuits and did not have the processing power needed to obtain higher-level statistics and provide service level monitoring of the new packet based services. The Company’s latest generation access solutions include such capabilities, and are often available with network management software so as to provide greatly improved network visibility and performance monitoring for service providers and their enterprise customers. Our WANsuite® family solutions are software based, often allowing no cost upgrades as our customers migrate from their TDM, or leased line facili ties, to Frame Relay, ATM or IP networks, while maintaining the highest levels of network management and information.
Products
Verilink offers a portfolio of products appropriate for a wide range of applications. The Company’s products are both modular in design, such as the Access System 2000 product family, as well as stand-alone devices, such as the WANsuite product family and PRISM series of channel service/data service unit devices.
WANsuite Product Family
The Company’s WANsuite product family is a suite of software programmable intelligent integrated access devices that target customer premise applications for improving “last mile” or network edge broadband communications. The WANsuite platform supports copper-based transmission services such as DDS, T1, E1 and G.SHDSL, and includes software support for ATM, Frame Relay and IP service and application monitoring and control. The WANsuite product line combines integral channel service/data service units (“CSU/DSU”), routing, probe and network monitoring capabilities. WANsuite products also utilize an embedded web server to provide an innovative user interface that aligns with the Internet for ease-of-use by service providers. The increased flexibility of WANsuite products allows quick delivery of customer specific requirements. Some key WANsuite features include a powerful web interface fo r simplified configuration, performance monitoring and diagnostics for all service layers, and access routing, bridging, and switching for Frame Relay, ATM, Ethernet and IP applications.
Access System 2000
The Company’s Access System 2000 (“AS2000™”) is a flexible network access and management solution that provides cost-effective integrated access to a broad range of network services. AS2000 products are installed at the origination and termination points at which service providers provide communications services to their corporate customers. AS2000 systems provide transmission link management, multiplexing and inverse multiplexing functions for T1 (1.5 MBPS), E1, multi-T1, multi-E1 and T3 (45 MBPS) access links. A key feature of the AS2000 is its flexibility and adaptability made possible by a modular architecture that allows customers to access new services or expanded network capacity simply by configuring or changing circuit cards. In a single platform, the AS2000 combines the functions of a T1 CSU/DSU, E1 NTU, inverse multiplexer, cross-connect, T3 CSU/DSU, automatic protection switch an d a Simple Network Management Protocol
(“SNMP”) management agent. A WANsuite gateway card is also available for the AS2000 for SCADA, IP routing and CSU/DSU applications.
PRISM Product Family
The Company’s PRISM product family supports legacy TDM applications at transmission rates ranging from DDS through T1. Products included in this family are the NEBs compliant 1024 shelf system, 1051 shelf, 3030/3060 intelligent channel bank, 2000 & 2100 CSU’s and 3111/3112 CSU/DSUs. These devices provide physical layer performance monitoring and diagnostic functions. Management of the PRISM product family ranges from SNMP through simple DIP switches. The Company’s PRISM products are produced to carrier-grade standards of quality and are typically found deployed in the mission-critical applications used by wireline and wireless carriers, banks, utilities, government and other corporate enterprises.
ISNP – Industry Standard Product Portfolio
In fiscal 2002, the Company worked with Interlink Communications Systems to launch a family of industry standard network access devices to target enterprise customers via the reseller channel in North America. The product portfolio consists of standards-based access equipment for DDS and T1 services, and incorporates interfaces for asynchronous and synchronous applications and network support for Frame Relay and IP services. This family of “generic-like” access devices provides the reseller community with opportunities to provide high quality access solutions and improve their operating margins in the process.
Sales, Marketing and Customer Support
Sales and Marketing
The Company sells its products and services to network service providers and wireless equipment manufacturers primarily through a direct sales force located in major U.S. metropolitan areas. A direct sales effort, supported by sales engineers who provide customers with pre- and post-sale technical assistance, allows the Company to gain a more in-depth knowledge of customers’ network access requirements. The Company believes this knowledge helps it to build long-term relationships and alliances with key customers.
The Company also sells its products and services to North American enterprises primarily through indirect channels, which include distributors, systems integrators and value-added resellers. These include a master-distributor relationship with Interlink Communication Systems, and Premier partnerships with Phillips Communications, Integrated Communications, Inc., Inter-Tel, Primary Telecommunications, Inc., Allencom and Nextira. With the addition of more intelligent integrated access devices and CPE products, the Company believes that sales through indirect channels will become increasingly more important.
The Company believes that entry into international markets for advanced digital network products will be enabled through strategic relationships and in-country distribution channels that reach both enterprise and NSP customers. Over the last year, the Company has had minimal direct sales to international customers. In addition to the specific sales efforts directed at network service providers, the Company’s marketing activities include participating in industry trade shows and conferences, distribution of sales and product literature, media relations, advertising in trade journals, direct mail and ongoing communications with customers and industry analysts.
In fiscal 2002, net sales to Nortel Networks and Interlink Communications Systems accounted for 36% and 15% of the Company’s net sales, respectively, and the Company’s top five customers accounted for 71% of the Company’s net sales. In fiscal 2001, net sales to Nortel Networks accounted for 37% of the Company’s net sales, and net sales to the Company’s top five customers accounted for 66% of the Company’s net sales. In fiscal 2000, net sales to Nortel Networks and WorldCom accounted for 30% and 19% of the Company’s net sales, respectively, and net sales to the Company’s top five customers accounted for 61% of the Company’s net sales. Other than Nortel Networks, Interlink Communications Systems and WorldCom, no customer accounted for more than 10% of the Company’s net sales in fiscal years 2002, 2001 or 2000. On a quarterly basis in fiscal 2002, net sales to Nort el Networks of legacy products has accounted for as much as 64% of the Company’s net sales that quarter. There can be no assurance that the Company’s current customers will continue to place orders with the Company, that orders by existing customers will continue at the levels of previous periods, or that the
Company will be able to obtain orders from new customers. The economic climate and conditions in the telecommunication equipment industry are expected to remain unpredictable in fiscal 2003 and 2004. WorldCom filed a bankruptcy petition under Chapter 11 of the Bankruptcy Code in July 2002. A bankruptcy filing by one or more of the Company’s other major customers would materially adversely affect the Company’s business, financial condition and results of operations. See “Item 7. Factors Affecting Future Results – Customer Concentration”.
Customer Service and Support
The Company maintains 24-hour, 7-day a week telephone support for all of its customers. The Company provides, for a fee, direct installation and service of its products utilizing its own resources or resources available under a Worldwide Equipment Support agreement with Vital Network Services, Inc. The Company provides product training and support to its customers dealing with the installation, operation and maintenance of the Company’s products.
The Company also offers various levels of maintenance agreements to its customers for a fee, which provide for on-site service in response to customer reported difficulties.
Research and Development
The Company’s research and development efforts are focused on developing new products, core technologies and enhancements to existing products. During the past year, product development activities included enhancements of the existing WANsuite intelligent integrated access product family and development related to the optical network access project. The enhancements to the WANsuite product family included advanced protocol development and customer application inclusion, as well as the development of new offerings for ATM services over G.SHDSL. These WANsuite family additions take advantage of ATM’s fixed cell size to deliver reliable voice and data services over G.SHDSL. The Company’s product development strategy has focused on the development of modular software and hardware products that can be integrated and adapted to the changing standards and requirements of the communications and internetw orking industries and on the development of low-cost CPE devices that leverage advancements in hardware and software technology.
In October 2001, the Company terminated its agreements with Beacon Telco, L.P. and the Boston University Photonics Center that established the product development center at the Photonics Center during fiscal 2001, and suspended its optical network access development project.
During fiscal 2002, 2001 and 2000, total research and development expenditures were $5,505,000, $19,682,000 and $8,950,000, respectively. Research and development expenditures in fiscal 2002 and 2001 related to the optical network access product were $688,000 and $11,538,000, respectively. All research and development expenses are charged to expense as incurred. See Note 8 to the Consolidated Financial Statements regarding the accounting treatment of warrants and bonuses associated with the optical network access project.
The markets for the Company’s products have historically been characterized by rapidly changing technology, evolving industry standards, continuing improvements in telecommunication service offerings, and changing demands of the Company’s customer base. During the fiscal year, the markets for the company’s products have been slower in accepting newer technologies as capital spending by carriers and enterprises has been reduced. However, the Company expects to continue its investment in research and development in fiscal 2003 for product development of specific technologies, such as IP, QoS, xDSL and network management, as well as to respond to market demand and new service offerings from service providers. Research and development activities may also include development of new products and markets based on the Company’s expertise in telecommunications network access technologies. See “I tem 7. Factors Affecting Future Results — Dependence on Recently Introduced Products and New Product Development”.
Manufacturing and Quality
The Company has an agreement with an electronics manufacturing services provider to outsource substantially all of its procurement, assembly and system integration operations for the Company’s AS2000 product family. Under the terms of the agreement, the Company maintains a bonded warehouse on the services provider’s premises and ships products directly to the Company’s customers. In April 2002, the Company announced plans to terminate this contract and transfer the manufacture of these products to its manufacturing
operations in Madison, Alabama. The Company expects to complete this transition in the second quarter of fiscal 2003.
The Company’s manufacturing operations located in Madison primarily support the manufacturing of all other product lines, and consist primarily of material requirements planning, materials procurement and final assembly, test and quality control of subassemblies and systems. The Company performs virtually all aspects of its manufacturing process for the products at its Madison facility, with the exception of surface mounted printed circuit board assembly. The Company achieved TL 9000 registration in March 2002. TL 9000, which includes ISO 9001:2000, established by the Quality Excellence for Suppliers of Telecommunications (QuEST) Forum is an industry-specific standard fostering quality system requirements and metrics for the design, development, production, delivery, installation and service, emphasizing customer/supplier relations, continuous improvement, standardization metrics and cost reduction. Increasingly, TL 9000 is a contractual requirement in the telecommunications industry.
Competition
The market for telecommunications network access equipment is characterized as highly competitive with price erosion on aging technologies. This market, in the past, has been subject to rapid technological change, regulatory developments and new entrants. The market for integrated access devices, such as the Access System 2000 and WANsuite product lines, and for enterprise termination devices, such as the PRISM product line, is subject to rapid change. The Company believes that the primary competitive factors in this market are the development and rapid introduction of products based on new technologies, high product value in price versus performance comparisons, support for multiple types of communication services, increased network monitoring and control, product reliability, and quality of customer support. There can be no assurance that the Company’s current products and future products will be able to compete successfully with respect to these or other factors.
The Company’s principal competition for its current product offerings are Adtran, Inc., Paradyne Inc., Kentrox (owned by Platinum Equity Holdings), Vina Technologies, Inc., Quick Eagle Networks, Larscom, Inc. and Cisco Systems, Inc. for access routing with integrated WAN interface cards (WIC’s). Industry consolidation could lead to competition with fewer, but stronger competitors. In addition, advanced termination products are emerging, which represent both new market opportunities, as well as a threat to the Company’s current products. Furthermore, basic line termination functions are increasingly being integrated by competitors, such as Cisco, Lucent Technologies, Inc. and Nortel Networks, into other equipment such as routers and switches. These include direct WAN interfaces in certain products, which may erode the addressable market for separate network termination products. To the extent that current or potential competitors can expand their current offerings to include products that have functionality similar to the Company’s products and planned products, the Company’s business, financial condition and results of operations could be materially adversely affected.
The Company believes that the market for basic network termination products is mature and that margins are eroding, but the market for feature-enhanced network termination and high bandwidth network access products may continue to grow and expand, as more “capability” and “intelligence” moves outward from the central office to the enterprise. The Company expects emerging broadband standards and technologies like G.SHDSL, ATM, Ethernet and IP Services to start the next wave of spending in this market as carriers and enterprises update services to the network edge.
Many of the Company’s current and potential competitors have substantially greater technical, financial, manufacturing and marketing resources than the Company. In addition, many of the Company’s competitors have long-established relationships with network service providers. There can be no assurance that the Company will have the financial resources, technical expertise, manufacturing, marketing, distribution and support capabilities to compete successfully in the future. See “Item 7. Factors Affecting Future Results — Competition”.
Intellectual Property and Other Proprietary Rights
The Company relies upon a combination of patent, trade secret, copyright, and trademark laws as well as contractual restrictions to establish and protect proprietary rights in its products and technologies. The Company has been issued certain U.S., Canadian, and European patents with respect to limited aspects of its network access technology. The Company has not yet obtained significant patent protection for its Access System or
WANsuite technologies. There can be no assurance that third parties have not, or will not, develop equivalent technologies or products without infringing the Company’s patents or that a court having jurisdiction over a dispute involving such patents would hold the Company’s patents valid, enforceable, and infringed by such other technologies or products. The Company also typically enters into confidentiality and invention assignment agreements with its employees and independent contractors, and enters into non-disclosure agreements with its suppliers, distributors and appropriate customers so as to limit access to and disclosure of its proprietary information. There can be no assurance that these statutory and contractual arrangements will deter misappropriation of the Company’s technologies or discourage independent third-party development of similar technologies. In the event such arrangements are insufficient, the Company’s business, financial condition and r esults of operations could be materially adversely affected. The laws of certain foreign countries in which the Company’s products are or may be developed, manufactured, or sold may not protect the Company’s products or intellectual property rights to the same extent as do the laws of the United States and thus, make the possibility of misappropriation of the Company’s technology and products more likely. See “Item 7. Management’s Discussion and Analysis of Financial Conditions and Results of Operations” and “Factors Affecting Future Results — Limited Protection of Intellectual Property”.
The network access and telecommunications equipment industries are characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. From time to time, third parties may assert exclusive patent, copyright, trademark and other intellectual property rights to technologies that are important to the Company. The Company has not conducted a formal patent search relating to the technology used in its products, due in part to the high cost and limited benefits of a formal search. In addition, since patent applications in the United States are not publicly disclosed until the patent issues and foreign patent applications generally are not publicly disclosed for at least a portion of the time that they are pending, applications may have been filed which, if issued as patents, would relate to the Company’s products. Software comprises a substantial porti on of the technology in the Company’s products. The scope of protection accorded to patents covering software-related inventions is evolving and is subject to a degree of uncertainty which may increase the risk and cost to the Company if the Company discovers third party patents related to its software products or if such patents are asserted against the Company in the future. Patents have been granted on fundamental technologies in software, and patents may be issued which relate to fundamental technologies incorporated into the Company’s products. The Company may receive communications from third parties in the future asserting that the Company’s products infringe or may infringe the proprietary rights of third parties. In its distribution agreements, the Company typically agrees to indemnify its customers for all expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. In the event of litigation to determine the validity of any thir d-party claims, such litigation, whether or not determined in favor of the Company, could result in significant expense to the Company and divert the efforts of the Company’s technical and management personnel from productive tasks. In the event of an adverse ruling in such litigation, the Company might be required to discontinue the use and sale of infringing products, or to expend significant resources to develop non-infringing technology or obtain licenses from third parties. There can be no assurance that licenses from third parties would be available on acceptable terms, if at all. In the event of a successful claim against the Company and the failure of the Company to develop or license a substitute technology, the Company’s business, financial condition, and results of operations would be materially adversely affected. See “Item 7. Factors Affecting Future Results — Risk of Third Party Claims Infringement”.
Employees
As of June 28, 2002, the Company had 85 full-time employees worldwide, of whom 22 were employed in engineering, 24 in sales, marketing and customer service, 27 in manufacturing and 12 in general and administration. All of the employees are located in the United States except one employee in Canada. The Company reduced staff further in August 2002 as the Company adjusted its cost structure. See “Staff Reductions” above.
Management believes that the future success of the Company will depend in part on its ability to attract and retain qualified employees, including management, technical, and design personnel. Any lengthy delay in filling new positions could lead to delays in the research and development associated with potential new products. See “Item 7. Management’s Discussion and Analysis of Financial Conditions and Results of Operations” and “Factors Affecting Future Results — Dependence on Key Personnel”.
Backlog
The Company manufactures its products based, in part, upon its forecast of customer demand and typically builds finished products in advance of or at the time firm orders are received from its customers. Orders for the Company’s products are generally placed by customers on an as-needed basis and the Company has typically been able to ship these products within 30 days after the customer submits a firm purchase order. Because of the possibility of customer changes in delivery schedules or cancellation of orders, the Company’s backlog as of any particular date may not be indicative of sales in any future period.
Item 2. Properties
During fiscal 2002, the Company’s headquarters and principal administrative, engineering, and manufacturing facility was located in a building owned by the Company containing about 113,000 square feet on approximately 19 acres in Cummings Research Park West at 950 Explorer Boulevard, Huntsville, Alabama. The Company also leased an additional 11,000 square feet of warehouse space in Madison, Alabama under a lease that terminated on June 30, 2002.
In addition, the Company has two sales offices located in the United States, and an engineering office in Canada. These properties are occupied under operating leases that expire on various dates through the year 2003, with options to renew in most instances.
On July 1, 2002, the Company relocated its headquarters and principal administrative, engineering and manufacturing operations to a leased facility containing approximately 37,500 square feet in Madison, Alabama. On August 2, 2002, the Company leased its facility located at 950 Explorer Boulevard to The Boeing Company under a lease that expires November 2007. The lease allows the lessee to terminate the lease at the end of the 40th month, but also includes the option to extend the lease term for five additional two-year periods.
Item 3. Legal Proceedings
The Company is not currently involved in any legal actions expected to have a material adverse effect on the financial conditions or results of operations of the Company. From time to time, however, the Company may be subject to claims and lawsuits arising in the normal course of business.
Item 4. Submission of Matters to a Vote of Security Holders
No matters were submitted to a vote of the security holders of the Company during the fourth quarter ended June 28, 2002.
Executive Officers of the Company
Set forth below is certain information concerning executive officers of the Company. Unless otherwise indicated, the information set forth is as of June 28, 2002.
Mr. Leigh S. Belden, age 52, has served as the Company’s President and Chief Executive Officer since he re-joined the Company in January 2002 and from its inception in December 1982 until his prior retirement from this position in March 1999. Mr. Belden co-founded the Company and has served as a Director since its inception in December 1982. From 1980 to 1982, he was Vice President of Marketing for Cushman Electronics, a manufacturer of telephone central office and two-way radio test equipment. Previously, he held various international and domestic sales and marketing management positions for California Microwave. Mr. Belden received a B.S. in Electrical Engineering from the University of California at Berkeley and an M.B.A. from Santa Clara University.
Mr. S. Todd Westbrook, age 40, has served the Company as Vice President, Operations since February 2000. From July 1998 until joining the Company, Mr. Westbrook served as the president of ZAE Research, Inc., a firm engaged in electronics design. From April 1987 to July 1998, Mr. Westbrook held several positions at Avex Electronics, Inc. including Vice President of North America Operations from March 1996 to July 1998. Mr. Westbrook received a B.S. in Industrial Engineering from Auburn University.
Mr. James B. Garner, age 35, served as Vice President, Marketing from March 2000 to August 2002. Mr. Garner joined the Company in November 1998 as Director of Engineering of the Company’s Huntsville
operations. In November 1999, he transferred to the position of Director of Marketing for the Company. From March 1998 until joining the Company, Mr. Garner served as Director of Engineering for TxPort, Inc. From September 1988 to March 1998, Mr. Garner held various technical and management positions within Motorola including Senior Marketing Manager for Motorola’s Transmission Products Division. Mr. Garner received a B.S. in Electrical Engineering from the University of Alabama in Huntsville.
Mr. C. W. Smith, age 48, has served as Vice President and Chief Financial Officer of the Company since November 2001. Mr. Smith joined the Company in November 1998 as Controller of the Company’s Huntsville operations. In September 1999, Mr. Smith was promoted to the position of Vice President and Corporate Controller. From February 1995 until joining the Company, Mr. Smith served as Vice President, Finance for TxPort, Inc. Mr. Smith received a B.S. in Accounting from the University of Alabama.
Mr. Ronald W. Caines, age 47, served the Company as Vice President, Worldwide Sales from May 2002 to August 2002. Mr. Caines joined the Company in August 2000 as Vice President of Indirect Sales. From 1991 until joining the Company, he held various sales and management positions within Intermec Technologies Canada Ltd. Mr. Caines received a DEC (Diplome D’Etudes Collegiales) in Science from Champlain College, Montreal, Quebec.
There are no family relationships among any of the directors or executive officers of the Company.
All officers are elected annually by and serve at the pleasure of the Board of Directors of the Company.
PART II
Item 5. Market for the Registrant’s Common Equity and Related Stockholder Matters
The Company’s Common Stock began trading on The Nasdaq SmallCap Market (“Nasdaq”) under the symbol “VRLK” on July 1, 2002. Prior to this date, the Company’s Common Stock traded on The Nasdaq National Market. As of September 4, 2002, the Company had 132 shareholders of record and approximately 3,800 beneficial owners of shares held in street name. The following table shows the high and low sale prices per share for the Common Stock as reported by Nasdaq for the periods indicated:
| Fiscal 2002 — Quarter Ended | June 28 | March 29 | December 28 | September 28 | |||||||||
| Market Price: High | $0.55 | $0.99 | $2.00 | $4.06 | |||||||||
| Low | $0.18 | $0.41 | $0.77 | $1.45 | |||||||||
| Fiscal 2001 — Quarter Ended | June 29 | March 30 | December 29 | September 29 | |||||||||
| Market Price: High | $4.95 | $3.94 | $6.56 | $13.25 | |||||||||
| Low | $1.41 | $1.06 | $1.75 | $ 3.94 | |||||||||
The Company has never declared or paid dividends on its capital stock and does not intend to pay dividends in the foreseeable future.
Item 6. Selected Consolidated Financial Data
The following selected consolidated financial data concerning the Company for and as of the end of each of the fiscal years are derived from the audited consolidated financial statements of the Company. The selected financial data are qualified in their entirety by the more detailed information and financial statements, including the notes thereto. The financial statements of the Company as of June 28, 2002 and June 29, 2001, and for each of the three years in the period ended June 28, 2002, and the report of PricewaterhouseCoopers LLP thereon, are included elsewhere in this report.
Financial Information by Year
(in thousands, except per share amounts and number of employees)
| Fiscal Year Ended | ||||||||||||||||
| June 28, 2002 |
June 29, 2001(1) |
June 30, 2000(2) |
June 27, 1999(3) |
June 28, 1998 |
||||||||||||
| Results of Operations Data: | ||||||||||||||||
| Net sales | $ | 23,413 | $ | 44,956 | $ | 67,661 | $ | 59,553 | $ | 50,915 | ||||||
| Gross profit | 8,016 | 20,541 | 33,698 | 27,729 | 25,121 | |||||||||||
| Loss from operations | (17,449 | ) | (17,183 | ) | (5,759 | ) | (14,901 | ) | (3,745 | ) | ||||||
| Net income (loss) | $ | (17,240 | ) | $ | (22,755 | ) | $ | 25 | $ | (13,666 | ) | $ | (1,071 | ) | ||
| Per share amounts: | ||||||||||||||||
| Net income (loss): | ||||||||||||||||
| Basic | $ | (1.09 | ) | $ | (1.51 | ) | $ | 0.00 | $ | (0.98 | ) | $ | (0.08 | ) | ||
| Diluted | $ | (1.09 | ) | $ | (1.51 | ) | $ | 0.00 | $ | (0.98 | ) | $ | (0.08 | ) | ||
| Number of weighted average shares outstanding: | ||||||||||||||||
| Basic | 15,816 | 15,095 | 14,238 | 13,929 | 13,742 | |||||||||||
| Diluted | 15,816 | 15,095 | 15,192 | 13,929 | 13,742 | |||||||||||
| Cash dividends (4) | — | — | — | — | — | |||||||||||
| Research and development as a percentage of sales | 23.5 | % | 43.8 | % | 13.2 | % | 22.5 | % | 24.5 | % | ||||||
| Balance Sheet and Other Data: | ||||||||||||||||
| Cash, cash equivalents and short-term investments | $ | 6,228 | $ | 15,735 | $ | 10,696 | $ | 17,961 | $ | 42,415 | ||||||
| Working capital | 6,290 | 16,251 | 26,352 | 25,960 | 45,163 | |||||||||||
| Capital expenditures | 340 | 5,304 | 7,333 | 2,586 | 2,752 | |||||||||||
| Total assets | 22,180 | 42,941 | 58,720 | 54,281 | 63,828 | |||||||||||
| Long-term debt | 4,480 | 5,210 | 3,521 | — | — | |||||||||||
| Total stockholders’ equity | $ | 12,117 | $ | 29,600 | $ | 45,114 | $ | 40,139 | $ | 53,810 | ||||||
| Employees | 85 | 201 | 219 | 310 | 250 | |||||||||||
| (1) | Includes establishment of an income tax valuation allowance of $(13,381). |
| (2) | Includes restructuring charges of $7,891 and reversal of the $3,424 income tax valuation allowance established in 1999. |
| (3) | Includes in-process research and development charge of $3,330 related to acquisition, restructuring charges of $3,200, and establishment of an income tax valuation allowance of $(3,424). |
| (4) | The Company has never declared or paid dividends on its capital stock and does not intend to pay dividends in the foreseeable future. |
Summarized Quarterly Financial Data (Unaudited)
The following table presents unaudited quarterly operating results for each of the Company’s last eight fiscal quarters. This information has been prepared by the Company on a basis consistent with the Company’s audited financial statements and includes all adjustments, consisting of normal recurring adjustments, that the Company considers necessary for a fair presentation of the data.
Financial Information by Quarter (Unaudited)
(in thousands, except per share amounts)
| Three Months Ended | |||||||||||||
| Fiscal 2002 | June 28 | March 29 | December 28 | September 28 | |||||||||
| Net sales | $ | 8,001 | $ | 3,704 | $ | 6,187 | $ | 5,521 | |||||
| Gross profit | 3,812 | 433 | 1,835 | 1,936 | |||||||||
| Income (loss) from operations | 168 | (9,433 | ) | (4,314 | ) | (3,870 | ) | ||||||
| Net income (loss) | $ | 152 | $ | (9,355 | ) | $ | (4,282 | ) | $ | (3,755 | ) | ||
| Per share amounts: | |||||||||||||
| Net income (loss): | |||||||||||||
| Basic | $ | 0.01 | $ | (0.59 | ) | $ | (0.27 | ) | $ | (0.24 | ) | ||
| Diluted | $ | 0.01 | $ | (0.59 | ) | $ | (0.27 | ) | $ | (0.24 | ) | ||
| Number of weighted average shares outstanding: | |||||||||||||
| Basic | 15,629 | 15,945 | 15,945 | 15,744 | |||||||||
| Diluted | 15,634 | 15,945 | 15,945 | 15,744 | |||||||||
| Three Months Ended | |||||||||||||
| Fiscal 2001 | June 29 | March 30 | December 29 | (1) September 29 |
|||||||||
| Net sales | $ | 13,801 | $ | 10,290 | $ | 9,036 | $ | 11,829 | |||||
| Gross profit | 6,777 | 3,985 | 3,332 | 6,447 | |||||||||
| Income (loss) from operations | 11 | (3,715 | ) | (12,644 | ) | (835 | ) | ||||||
| Net income (loss) | $ | 34 | $ | (3,620 | ) | $ | (12,333 | ) | $ | (6,836 | ) | ||
| Per share amounts: | |||||||||||||
| Net income (loss): | |||||||||||||
| Basic | $ | 0.00 | $ | (0.24 | ) | $ | (0.84 | ) | $ | (0.46 | ) | ||
| Diluted | $ | 0.00 | $ | (0.24 | ) | $ | (0.84 | ) | $ | (0.46 | ) | ||
| Number of weighted average shares outstanding: | |||||||||||||
| Basic | 15,633 | 15,312 | 14,719 | 14,715 | |||||||||
| Diluted | 16,094 | 15,312 | 14,719 | 14,715 | |||||||||
| (1) | Provision for income taxes of $(6,311) includes establishment of income tax valuation allowance. |
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) should be read in conjunction with the 2002 Consolidated Financial Statements and Notes thereto.
This MD&A contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth herein, including those set forth in “Factors Affecting Future Results” below.
The Company’s fiscal year is the 52- or 53-week period ending on the Friday nearest to June 30. Fiscal 2002 and 2001 consisted of 52 weeks and fiscal 2000 consisted of 53 weeks with a 14-week period for Q1 as compared to 13 weeks for all other quarterly periods.
Overview
Verilink Corporation (the “Company”) provides voice and data network access solutions to service providers and enterprise customers for DDS, T1/E1, NxT1, T3 and G.SHDSL communication services. The Company develops, manufactures and markets customer premise equipment (“CPE”) and central site solutions for data and telecommunication centers. The Company offers a variety of application-specific solutions for time-division multiplexing, inverse multiplexing, digital cross-connect and IP bridging and routing, as well as converged solutions for access to Frame Relay, ATM and IP-based networks. The Company’s customers include equipment integrators, network service providers (“NSPs”) and enterprise customers consisting of wireline and wireless providers, inter-exchange carriers (“IXCs”), local exchange carriers (“LECs”), Internet service providers (“ISPs” ), Fortune 500 companies and various local, state and federal government agencies. The Company was founded in San Jose, California in 1982 and is a Delaware corporation currently headquartered in Madison, Alabama.
The overall economic environment and the downturn in the telecommunication industry that continued throughout fiscal 2002 were worse than we had anticipated at the beginning of the fiscal year. Capital spending budgets and headcount were reduced, and projects and programs were delayed by many of our customers. Additionally, carriers and other service providers continued to review opportunities to maximize the use of their existing copper-based infrastructure in order to effectively operate in these difficult times.
The Company implemented cost reduction programs in fiscal 2002 as a result of the reduced revenue levels. The optical network access development project was terminated in October 2001, headcount was reduced at times during the year to align operating spending with lower revenue levels and certain administrative tasks were outsourced to further reduce costs. The Company reported a quarterly profit in the fourth quarter of fiscal 2002, due in part to the positive impact of these cost reduction efforts.
The majority of sales continue to be provided by the Company’s legacy products, primarily the AS2000 product line that provided 53% of net sales in fiscal 2002. Net sales of the WANsuite product family, which is a full line of access devices ranging from CSU/DSUs to software programmable intelligent integrated access devices with integrated routing and multi-tier reporting, increased 217% in fiscal 2002 over fiscal 2001 to $1.9 million. The Company anticipates that net sales from legacy products will shrink in the future.
The Company believes that period-to-period comparisons of its financial results are not necessarily meaningful and should not be relied upon as an indication of future performance. In addition, the Company’s results of operations have and may continue to fluctuate significantly from period-to-period in the future.
Results of Operations
Sales
| Fiscal Year Ended | ||||||||||
| June 28, 2002 |
June 29, 2001 |
June 30, 2000 |
||||||||
| (thousands) | ||||||||||
| Net sales | $ | 23,413 | $ | 44,956 | $ | 67,661 | ||||
| Percentage change from preceding year | (48 | )% | (34 | )% | 14 | % | ||||
Net sales for fiscal 2002 decreased 48% to $23,413,000 from net sales of $44,956,000 in fiscal 2001. This decrease in net sales resulted from a decrease in sales volume to most of the Company’s product markets. Carrier and carrier access products net sales, primarily AS2000 products, decreased 56% to $12,611,000 in fiscal 2002 from $28,900,000 in fiscal 2001 and Enterprise access products decreased 33% to $10,802,000 in fiscal 2002 from $16,056,000 in fiscal 2001. These decreases were primarily a result of additional reduced capital spending by our large telecommunication infrastructure customers, which was a result of both economic and industry-wide factors, including financial constraints affecting our customers and over-capacity in our customers’ markets. The Company anticipates that reduced capital spending by our customers will continue to affect sales until an overall recovery in the telecommuni cations market begins, which is not expected until at least 2004. In any event, it is challenging to predict in the current environment. These large infrastructure customers have traditionally contributed more than half of the Company’s revenue base. Net sales for fiscal 2001 decreased 34% from fiscal 2000 to $44,956,000. This decrease was also due primarily to reduced capital spending by our large telecommunication infrastructure customers that began in fiscal 2001. During fiscal 2002, shipments of the AS2000 product line accounted for approximately 53% of net sales compared to 61% during 2001 and 58% in 2000.
The Company’s business is characterized by a concentration of sales to a limited number of key customers. Sales to the Company’s top five customers accounted for 71%, 66% and 61% of sales in fiscal 2002, 2001, and 2000, respectively. The Company’s five largest customers in fiscal 2002 were Ericsson, Interlink Communications Systems, Nortel Networks, Verizon and WorldCom. See Note 1 of “Notes to Consolidated Financial Statements” and “Factors Affecting Future Results — Customer Concentration”.
The Company sells its products primarily in the United States through a direct sales force and through a variety of resellers, including original equipment manufacturers, system integrators, value-added resellers, and distributors. Sales to value-added resellers and distributors accounted for approximately 31% of sales in fiscal 2002, as compared to approximately 26% in fiscal 2001 and 24% in fiscal 2000. In fiscal 2002, direct sales outside of North America have not been significant. However, the Company intends to expand the marketing of its products to markets outside of North America.
Gross Profit
| Fiscal Year Ended | ||||||||||
| June 28, 2002 |
June 29, 2001 |
June 30, 2000 |
||||||||
| (thousands) | ||||||||||
| Gross Profit | $ | 8,016 | $ | 20,541 | $ | 33,698 | ||||
| Percentage of Sales | 34.2 | % | 45.7 | % | 49.8 | % | ||||
Gross profit, as a percentage of sales, in fiscal 2002 was 34.2% as compared to 45.7% in fiscal 2001 and 49.8% in fiscal 2000. The decrease in gross profit margin in fiscal year 2002 was due to less favorable product sales mix, additional inventory reserves of $1,570,000 for excess inventories, severance costs totaling $250,000 and the impact to depreciation expense of $287,000 for the change in lives of IT assets described in Note 13 of “Notes to Consolidated Financial Statements”. The decrease in gross profit margin in fiscal 2001 was a result of significantly lower sales volume and the impact of unabsorbed manufacturing overhead. In future periods, the Company’s gross profit will vary depending upon a number of factors, including the cost of products manufactured at subcontract facilities, the channels of distribution, the price of products sold, discounting
practices, the mix of products sold, price competition, increases in material costs and changes in other components of cost of sales. As the Company introduces new products, it is possible that such products may have lower gross profit margins than other established products in high volume production. Accordingly, gross profit as a percentage of sales may vary.
Research and Development
| Fiscal Year Ended | ||||||||||
| June 28, 2002 |
June 29, 2001 |
June 30, 2000 |
||||||||
| (thousands) | ||||||||||
| Research and development | $ | 5,505 | $ | 19,682 | $ | 8,950 | ||||
| Percentage of Sales | 23.5 | % | 43.8 | % | 13.2 | % | ||||
Research and development (“R&D”) expenses decreased to $5,505,000, or 23.5% of sales in fiscal 2002 compared to $19,682,000, or 43.8% of sales in fiscal 2001. This decrease was due primarily to the suspension of the optical network access development project in October 2001 and the impact of cost reduction measures that resulted in a decrease in other product development. The decrease in R&D expense in fiscal year 2002 as a percentage of sales compared to fiscal 2001 was due to reduced actual expenses on lower sales volume. The increase in spending and the increase in R&D as a percentage of sales in fiscal 2001 from fiscal 2000 was due primarily to the optical network access development project initiated in October 2000, and refocusing R&D resources to key product development activities such as WANsuite.
In October 2001, the Company terminated its agreements with Beacon Telco, L.P. and the Boston University Photonics Center discussed below and suspended its optical network access development project. Research and development expenditures in fiscal 2002 and 2001 related to the optical network access product were $688,000 and $11,538,000, respectively.
In October 2000, the Company entered into agreements with Beacon Telco, L.P. and the Boston University Photonics Center to establish a product development center at the Photonics Center to develop new optical network access products. As part of the agreements, the Company issued Beacon Telco warrants for 2,249,900 shares of the Company’s Common Stock at an exercise price of $4.75 per share that were exercisable at various dates, and scheduled to expire on October 13, 2003. Warrants for 200,000 and 749,900 shares were exercised during fiscal 2002 and 2001, respectively. The remaining warrants were cancelled in connection with the termination of the agreements with Beacon Telco, L.P. and the Boston University Photonics Center.
The agreements provided Beacon Telco the opportunity to receive two bonus payments based in part on meeting certain milestones and the market price of the Company’s Common Stock. The first bonus payment of $3,562,500 was earned on October 13, 2000 and paid on February 9, 2001 in the form of a note that Beacon Telco used in conjunction with the exercise of warrants for 749,900 shares of the Company’s Common Stock. The second bonus payment was waived in connection with the October 2001 termination of these agreements.
The Company recorded a charge to research and development expenses in fiscal 2001 of $8,335,000 for the warrants and the first bonus payment used in the exercise of the warrants for 749,900 shares. The second bonus, of up to $7,125,000, was payable in full upon the completion of the final milestone in the optical network access project, or if the agreements were terminated, a pro-rata portion was payable based on the extent to which the milestones had been completed. The second bonus would be reduced if the price of the Company’s Common Stock was below $4.75 per share at the time the bonus payment was made. The Company accrued the pro-rata portion of the second bonus related to a milestone in the period that the milestone was achieved. The bonus accrual was adjusted for changes, either increases or decreases, in the closing market price of the Company’s Common Stock when the price was below $4.75 per share. For fiscal 2001, research and development expenses include $850,000 for the accrual of the pro-rata portion of the second bonus related to the milestones achieved during the fiscal year and based upon the closing market price of the Company’s Common Stock on June 29, 2001 of $3.40 per share.
The Company considers product development expenditures to be important to future sales, but expects research and development expenditures to decrease in fiscal 2003, while such expenditures as a percentage of sales may vary. There can be no assurance that the Company’s research and development efforts will result in
commercially successful new technology and products in the future, and those efforts may be affected by other factors as noted below. See “Factors Affecting Future Results — Dependence on Recently Introduced Products and Products Under Development”.
Selling, General and Administrative
| Fiscal Year Ended | ||||||||||
| June 28, 2002 |
June 29, 2001 |
June 30, 2000 |
||||||||
| (thousands) | ||||||||||
| Selling, general and administrative | $ | 14,581 | $ | 18,042 | $ | 22,616 | ||||
| Percentage of Sales | 62.2 | % | 40.1 | % | 33.4 | % | ||||
The Company’s selling, general and administrative (“SG&A”) expenses decreased to $14,581,000, or 62.2% of sales in fiscal 2002 from $18,042,000, or 40.1% of sales in fiscal 2001. The decrease in absolute dollars in fiscal 2002 compared to fiscal 2001 was due primarily to reduced headcount between the two periods, lower variable sales compensation on lower sales volume and other cost reduction programs implemented during the current and prior fiscal years, offset by a charge for bad debts related to amounts outstanding from WorldCom of approximately $368,000. The increase in SG&A as a percentage of sales in fiscal 2002 was due entirely to lower sales volume. SG&A decreased in fiscal 2001 to $18,042,000 from $22,616,000 in fiscal 2000 due to lower variable sales compensation on lower sales volume, cost reduction programs implemented during fiscal 2001 that included a headcount reduction in March 2001, and the impact of the plan that consolidated the Company in Huntsville which was completed in fiscal 2000. The increase in SG&A spending as a percentage of sales in fiscal 2001 compared to fiscal 2000 is due to the decrease in dollar spending at lower sales levels. The Company expects that SG&A expenses will decrease in fiscal 2003 and decrease as a percentage of sales.
Impairment of Long-lived Assets
During fiscal 2002, the Company completed a review of certain long-lived assets,