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

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 27, 2002

Commission file number: 0-28562

127 Jetplex Circle, Madison, Alabama 35758

(256) 327-2001
(Registrant’s telephone number, including area code)

950 Explorer Boulevard, Huntsville, Alabama 35806
(Former Address)

     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 o

     The number of shares outstanding of the issuer’s common stock as of October 25, 2002 was 14,996,747.

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INDEX
VERILINK CORPORATION
FORM 10-Q

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PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

VERILINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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VERILINK CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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VERILINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 1 – Basis of Presentation

     The accompanying unaudited interim condensed consolidated financial statements of Verilink Corporation (the “Company”) have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, these statements include all adjustments, consisting of normal and recurring adjustments, considered necessary for a fair presentation of the results for the periods presented. The results of operations for the periods presented are not necessarily indicative of results which may be achieved for the entire fiscal year ending June 27, 2003. The unaudited interim condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K for the fiscal year ended June 28, 2002 as filed with the Securities and Exchange Commission.

Note 2 – Comprehensive Income Loss

     The Company records gains or losses on the Company’s foreign currency translation adjustments and unrealized gains or losses on the Company’s available-for-sale investments and presents it as accumulated other comprehensive income (loss) in the accompanying condensed consolidated balance sheets. For the three months ended September 27, 2002 comprehensive income amounted to $249,000 while comprehensive loss for the period ended September 28, 2001 amounted to $3,763,000.

Note 3 – Inventories

     Inventories are stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. Inventories consisted of the following (in thousands):

Note 4 – Earnings (Loss) Per Share

     Basic earnings (loss) per share is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share gives effect to all dilutive potential common shares outstanding during a period. In computing diluted earnings (loss) per share, the average price of the Company’s Common Stock for the period is used in determining the number of shares assumed to be purchased from exercise of stock options and stock warrants. The following table sets forth the computation of basic and diluted earnings (loss) per share for the three months ended September 27, 2002 and September 28, 2001 (in thousands, except per share amounts):

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Note 6 – Recently Issued Accounting Pronouncements

     In August 2001, the Financial Accounting Standards Board issued SFAS No.143, Accounting for Asset Retirement Obligations (“ARO”), which has an effective date for financial statements for fiscal years beginning after June 15, 2002. This statement addresses the diversity in practice for recognizing asset retirement obligations and requires that obligations associated with the retirement of a tangible long-lived asset be recorded as a liability when those obligations are incurred, with the amount of the liability initially measured at fair value. Upon initially recognizing a liability for an ARO, an entity must capitalize the cost by recognizing an increase in the carrying amount of the related long-lived asset. Over time, the liability is accreted to its present value each period, and the capitalized cost is depreciated over the useful life of the related asset. Upon settlement of the liability, an entity either settles the obligation for its recorded amount or incurs a gain or loss upon settlement. The impact of SFAS No. 143 is not expected to be material to the Company’s financial statements.

     In October 2001, the Financial Accounting Standards Board issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, which has an effective date for financial statements for fiscal years beginning after December 15, 2001. This statement, which supercedes SFAS No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of, requires that long-lived assets that are to be disposed of by sale be measured at the lower of book value or fair value less cost to sell. Additionally, this statement expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. The impact of SFAS No. 144 is not expected to be material to the Company’s financial statements.

     In April 2002, the Financial Accounting Standards Board issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections, which has an effective date for transactions occurring after May 15, 2002. This statement rescinds or amends several existing statements related to the extinguishment of debt, intangible assets of motor carriers, certain lease transactions and several other technical corrections to existing pronouncements. The impact of SFAS No. 145 is not expected to be material to the Company’s financial statements.

     In July 2002, the Financial Accounting Standards Board issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, which has an effective date for exit or disposal activities that are initiated after December 31, 2002. This statement provides that cost associated with an exit or disposal activity must be recognized when the liability is incurred. The impact of SFAS No. 146 is not expected to be material to the Company’s financial statements.

Note 7 – Property Held for Lease

     The Company owns a facility in Huntsville, Alabama located at 950 Explorer Boulevard. In August 2002, the Company entered into an agreement with The Boeing Company (“Boeing”) to lease this facility through November 2007. The lease allows Boeing the option of terminating the lease at the end of the 40^th month, but also provides an option for Boeing to extend the lease term for five additional two-year periods. Rental income totaled $131,000 for the three months ended September 27, 2002.

Property held for lease consists of the following at September 27, 2002 and June 28, 2002:

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Future minimum rental income on this operating lease over the non-cancelable period is as follows:

Note 8 – Related Party Transaction

     In September 2002, the company approved providing its President and Chief Executive Officer with additional relocation benefits of approximately $300,000 in connection with the sale of his California residence. The President has advised the Company that he has committed to make a payment of $675,000 against his outstanding notes receivable to the Company following the sale of his California residence.

Note 9 – Subsequent Event

     On October 23, 2002, the Company announced a program to repurchase up to $1,000,000 of its Common Stock. The program, which is open ended, will allow the Company to repurchase shares on the open market based on market conditions, availability of cash consistent with the Company’s operating plan, and in accordance with the requirements of the Securities and Exchange Commission.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

     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”) consisting of wireline and wireless providers, inter-exchange carriers (“IXCs”), local exchange carriers (“LECs”), Internet service providers (“ISPs”), enterprise customers, 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 information in this Item 2 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements, including, without limitation, statements relating to the Company’s revenues, expenses, margins, liquidity and capital needs. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed elsewhere herein under the caption “Factors Affecting Future Results”.

     RESULTS OF OPERATIONS

     The following table presents the percentages of net sales represented by certain line items from the Condensed Consolidated Statements of Operations for the periods indicated.

     Sales. Net sales for the three months ended September 27, 2002 increased 57.8% to $8,713,000 from $5,521,000 in the comparable period of the prior fiscal year. This increase in net sales primarily resulted from an increase in sales volume of the Company’s carrier and carrier access product lines. Net sales of carrier and carrier access products, primarily AS2000 products, increased 110.6% to $6,351,000 in the three months ended September 27, 2002 from $3,016,000 in the comparable prior year period. Net sales of enterprise access products declined by 5.7% in the three months ended September 27, 2002 to $2,362,000 from $2,505,000 for the same period last year. This decrease in enterprise access products was primarily a result of decreased spending by our customers, which we believe to be a result of both economic and industry-wide factors, including financial constraints affecting our customers and over-capacity in our customers’ markets. The Company

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anticipates that reduced capital spending by our customers will continue to affect sales until an overall recovery in the telecommunications market begins, which is not expected until at least 2004. In any event, it is challenging to forecast in the current environment.

     The Company’s business continues to be characterized by a concentration of sales to a limited number of key customers. Net sales to the Company’s top five customers increased 109.7% to $7,515,000 in the three months ended September 27, 2002 from $3,584,000 in the comparable period in the prior year. Net sales to all other customers declined by 38.2% in the three-month period ended September 27, 2002 from the comparable period in the prior fiscal year. The Company’s top five customers did not remain the same over these periods.

     Gross Profit. Gross profit increased to 51.8% of net sales for the three months ended September 27, 2002 as compared to 35.1% for the three months ended September 28, 2001. This increase is primarily attributable to the increased sales volume and the benefit from cost reduction measures enacted during the period from January 2001 through September 2002, including productivity gains and lower fixed manufacturing costs, particularly facilities costs.

     Research and Development. Research and development expenditures for the three months ended September 27, 2002 decreased 60% to $848,000 from $2,121,000 in the comparable period in the prior fiscal year, and decreased as a percentage of sales from 38.4% to 9.7%. These decreases were the result of the suspension of the company’s optical network access project in October 2001, staff reductions and other cost reduction measures. The Company believes that a significant level of investment in product development is required to remain competitive and that such expenses will vary over time as a percentage of net sales. However, the Company will continue to monitor the level of its investment in research and development activities and adjust spending levels, either upward or downward, based upon anticipated sales volume. The Company currently expects research and development spending to increase in the three months ending December 27, 2002 over the amounts spent in the three months ended September 27, 2002.

     Selling, General and Administrative. Selling, general and administrative expenses for the three months ended September 27, 2002 decreased 39.4% to $2,233,000 from $3,685,000 in the comparable period in the prior fiscal year and decreased as a percentage of sales from 66.8% to 25.6%. The decrease in absolute dollars over the same period in the prior year is primarily due to reduced headcount between the two periods and other cost reduction measures implemented by the Company in fiscal 2002 and 2003. The significant decrease as a percentage of sales is due to lower spending on increased sales dollars. The Company expects the dollar amount of selling, general and administrative expenses to decrease in the next quarter due to the impact of cost reductions, and expects that such expenses will vary over time as a percentage of sales.

     Amortization of goodwill and other intangible assets in the three months ended September 27, 2002 and September 28, 2001 was $75,600 and $252,000, respectively. The amortization for the three months ended September 28, 2001 included $116,000 related to goodwill and assembled work force. As of June 29, 2002, the Company adopted SFAS No. 142 and completed the transitional impairment test of its goodwill. As a result, the Company determined that its goodwill was impaired, resulting in a charge of $1,232,900 in the three months ended September 27, 2002. This charge is presented in the condensed consolidated statement of operations as a cumulative effect of change in accounting principle, relating to goodwill.

     Interest and Other Income, Net, and Interest Expense. Interest and other income, net, declined 49.3% to $102,000 for the three months ended September 27, 2002 from $201,000 in the comparable period in the prior fiscal year. This decline was a result of lower interest rates and lower interest bearing assets. Rental income, net of expenses, of $23,000 is included in interest and other income, net in the three months ended September 27, 2002 as a result of the lease agreement signed with Boeing. See Note 7 of Notes to Condensed Consolidated Financial Statements for additional information on the Boeing lease.

     Interest expense declined 38.4% to $53,000 for the three months ended September 27, 2002 from $86,000 in the same period in the prior fiscal year as a result of lower interest rates and the lower principle balance on the Company’s debt obligations.

     Provision for Income Taxes. No tax provision or tax benefits were provided in the three months ended September 27, 2002 or September 28, 2001 due to the valuation allowance provided against the net change in deferred tax assets. During fiscal 2001, the Company established a full valuation allowance against its deferred tax assets due to the net operating loss carryforwards from prior years and the operating loss incurred in fiscal 2001. The Company does not expect to recognize a

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provision for income taxes in the current year due to its net operating loss carryforwards that totaled approximately $34,500,000 at June 28, 2002.

     LIQUIDITY AND CAPITAL RESOURCES

     On September 27, 2002, the Company’s principal sources of liquidity included $7,502,000 of unrestricted cash, cash equivalents and short-term investments.

     During the three months ended September 27, 2002, cash provided by operating activities was $1,711,000 compared to $3,559,000 used in operating activities during the three months ended September 28, 2001. Net cash provided by operating activities this period was primarily due to net operating income before depreciation, amortization and the cumulative effect of change in accounting principle, which totaled $1,773,000. The increase in accounts receivable used cash of $91,000 in the three months ended September 27, 2002 compared to cash provided of $768,000 in the comparable period in the prior fiscal year. The increase in inventories for the three months ended September 27, 2002 used $678,000 of cash compared to $199,000 of cash used in the same period last year. Inventories increased during the three months ended September 27, 2002 due to inventory purchases as the Company transitions all its manufacturing operations to Madison, Alabama. Accounts payable and accrued expenses increased $1,059,000 in the three-month period ended September 27, 2002 compared to a decrease of $1,079,000 in the comparable period in the prior fiscal year. The changes in accounts payable and accrued expenses for the three months ended September 27, 2002 and the comparable prior year period were primarily due to the timing of inventory purchases and the resulting payments to vendors.

     Cash provided by investing activities was $241,000 for the three months ended September 27, 2002 compared to $161,000 used for the three months ended September 28, 2001. The funds provided by investing activities during the three months ended September 27, 2002 are a result of the maturity of short-term investments of $497,000 reduced by capital expenditures of $256,000. For the three months ended September 28, 2001, cash was used to purchase short-term investments of $72,000 and property, plant and equipment of $89,000.

     Cash used in financing activities was $181,000 for the three months ended September 27, 2002 and $177,000 for the three months ended September 28, 2001. Payments on long-term debt obligations were $180,000 for the three months ended September 27, 2002 and September 28, 2001. Proceeds from the issuance of Common Stock under the Company’s stock plans provided $11,000 of cash in the prior fiscal year.

     The Company believes that its cash and investment balances, along with anticipated cash flows from operations based upon current operating plans will be adequate to finance the Company’s operations, capital expenditures, research and development programs and stock repurchase program currently planned for at least the next twelve months. The Company’s future capital needs will depend on the Company’s ability to meet its current operating forecast, market demand for the Company’s products and the overall economic condition of our customers in the telecommunication sector. In the event that results of operations do not substantially meet the Company’s current operating forecast, the Company may evaluate further cost containment measures, reduce investments or delay R&D, which could adversely affect the Company’s ability to bring new products to market. The Company from time to time investigates the possibility of generating financial resources through committed credit agreements, technology or manufacturing partnerships, joint ventures, equipment financing and offerings of debt and equity securities. To the extent that the Company obtains additional financing, the terms of such financing may involve rights, preferences or privileges senior to the Company’s Common Stock and stockholders may experience dilution.

     Critical Accounting Policies

     The Company’s financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. Management bases its estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods might be based upon amounts that differ from those estimates. The following represent what the Company believes are among the critical accounting policies most affected by significant management estimates and judgments:

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     Impairment of Long-Lived Assets and Goodwill. The Company assesses the impairment of long-lived assets and goodwill whenever events or changes in circumstances indicate that the carrying value may not be recoverable under the guidance prescribed by SFAS No. 144. The Company’s long-lived assets include, but are not limited to, the facility located at 950 Explorer Boulevard, related furniture and equipment, software licenses, goodwill and intangible assets related to an acquisition.

     In assessing the recoverability of the Company’s long-lived assets, the Company obtained a third-party appraisal during fiscal 2002 for its facility located at 950 Explorer Boulevard, and made assumptions regarding future cash flows and other factors to determine the fair value of the respective assets. If these estimates or their related assumptions change in the future, the Company may be required to record impairment charges for these assets not previously recorded. On June 29, 2002, the Company adopted SFAS No. 142, Goodwill and Other Intangible Assets, and completed the analysis of its goodwill for impairment. The Company recorded an impairment charge of $1,232,900 during the three months ended September 27, 2002 related to goodwill.

     Inventories. The Company values inventory at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. Inventory quantities on hand are reviewed on a quarterly basis and a provision for excess and obsolete inventory is recorded based primarily on our estimated forecast of product demand for the next twelve months. Management’s estimates of future product demand may prove to be inaccurate, in which case the Company may increase or decrease the provision required for excess and obsolete inventory in future periods.

     Revenue Recognition. The Company recognizes a sale when the product has been shipped, no material vendor or post-contract support obligations remain outstanding, except as provided by a separate service agreement, and collection of the resulting receivable is probable. A reserve for future product returns is established at the time of the sale based on historical return rates and return policies, including stock rotation for sales to distributors that stock the Company’s products.

     Warranty Provision. The Company records a warranty provision at the time of the sale based on our best estimate of the amounts necessary to settl