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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
(MARK ONE)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2002
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: 000-23699
VISUAL NETWORKS, INC.
(Exact Name of Registrant as Specified in Its Charter)
Delaware 52-1837515
(State or Other Jurisdiction of (IRS Employer
Incorporation or Organization) Identification No.)
2092 Gaither Road, Rockville, Maryland 20850
(Address of Principal Executive Office) (Zip Code)
Registrant's telephone number, including area code: (301) 296-2300
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 $0.01 per share
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 |_|
Documents incorporated by reference: Specified portions of the Definitive
Proxy Statement filed with the Commission pursuant to Regulation 14A in
connection with the 2003 Annual Meeting are incorporated herein by reference
into Part III of this Report.
Documents Incorporated by Reference
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will 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. |X|
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes |_| No |X|
The aggregate market value of the voting stock held by non-affiliates of
the Registrant as of March 21, 2003 was approximately $52,846,591. The number of
outstanding shares of the Registrant's common stock as of March 21, 2003 was
32,442,180 shares.
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VISUAL NETWORKS, INC. FORM 10-K
TABLE OF CONTENTS
Page
----
PART I
Item 1. Business 1
Introduction 1
Industry Background 2
The Visual Networks Solution 4
The Visual Networks Strategy 5
Products and Technology 6
Visual UpTime 6
Visual IP InSight 8
Marketing and Sales 9
Key Customers and Strategic Relationships 11
Customer Service 11
Research and Development 12
Manufacturing 12
Competition 12
Proprietary Rights 13
Employees 14
Item 2. Properties 14
Item 3. Legal Proceedings 14
Item 4. Submission of Matters to a Vote of Security Holders 15
PART II
Item 5. Market for Our Common Stock and Related Stockholder Matters 15
Item 6. Selected Consolidated Financial Data 16
Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations 17
Item 7A. Quantitative and Qualitative Disclosure about Market Risk 35
Item 8. Financial Statements and Supplementary Data 35
Item 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure 36
PART III
Item 10. Our Directors and Executive Officers 37
Item 11. Executive Compensation 37
Item 12. Security Ownership of Certain Beneficial Owners and
Management 37
Item 13. Certain Relationships and Related Transactions 37
Item 14. Controls and Procedures 37
PART IV
Item 15. Exhibits, Financial Statement Schedules and Reports on Form 8-K 38
Signatures 42
Certifications 43
i
FORWARD LOOKING STATEMENTS
IN ADDITION TO HISTORICAL INFORMATION, THIS ANNUAL REPORT ON FORM 10-K
CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND UNCERTAINTIES THAT
COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY. FACTORS THAT MIGHT CAUSE OR
CONTRIBUTE TO SUCH DIFFERENCES INCLUDE, BUT ARE NOT LIMITED TO, THOSE DISCUSSED
IN THE SECTION ENTITLED "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS." READERS SHOULD CAREFULLY REVIEW THE RISKS
DESCRIBED IN OTHER DOCUMENTS THE COMPANY FILES FROM TIME TO TIME WITH THE
SECURITIES AND EXCHANGE COMMISSION, INCLUDING THE QUARTERLY REPORTS ON FORM 10-Q
TO BE FILED BY THE COMPANY IN 2003. READERS ARE CAUTIONED NOT TO PLACE UNDUE
RELIANCE ON THE FORWARD-LOOKING STATEMENTS, WHICH SPEAK ONLY AS OF THE DATE OF
THIS ANNUAL REPORT ON FORM 10-K. THE COMPANY UNDERTAKES NO OBLIGATION TO
PUBLICLY RELEASE ANY REVISIONS TO THE FORWARD-LOOKING STATEMENTS OR REFLECT
EVENTS OR CIRCUMSTANCES AFTER THE DATE OF THIS DOCUMENT.
ii
PART I
In addition to historical information, our annual report on Form 10-K
contains forward-looking statements that involve risks and uncertainties that
could cause our actual results to differ materially from our expectations.
Factors that might cause or contribute to such differences include, but are not
limited to, those discussed in the section entitled "Management's Discussion and
Analysis of Financial Condition and Results of Operations." Readers should
carefully review the risks described in other documents we file from time to
time with the Securities and Exchange Commission, including our quarterly
reports on Form 10-Q to be filed by us in 2003. We caution you not to place
undue reliance on these forward-looking statements, which speak only as of the
date of this annual report on Form 10-K. We undertake no obligation to revise
the forward-looking statements to reflect events or circumstances after the date
of this document.
Item 1. Business.
Introduction.
We design, manufacture, sell and support performance management systems
for communications networks. Our products, Visual UpTime and Visual IP InSight,
allow providers of network services, which we call service providers, and the
businesses and organizations, which we call enterprises, that use the network
products and services provided by the service providers, to measure the
performance of their networks, to determine whether a network is performing
consistent with the requirements of the applications running on that network and
to determine whether the level of service being provided is meeting the
requirements of the enterprise. Our systems also help enterprises to plan
network capacity. Our systems constantly monitor the data traffic traveling
between service providers' and enterprises' networks. Network operators using
our systems can quickly identify and isolate network problems without sending
personnel to their customers' sites or their own remote sites. By knowing how
much traffic is traveling on the network and understanding the type of data on
the network, network operators can effectively address network capacity issues.
Network performance is critical to enterprises because networks carry data and
applications that are vital to an enterprise's operations. Enterprises require
tools to ensure the availability of their networks, to predict and validate
network performance and to optimize the price/performance balance of their
networks.
Many service providers are designing their networks to cost effectively
transport data traffic by using both private and public networks. Private
networks, such as frame relay, asynchronous transfer mode (ATM), and private
Internet Protocol (IP) networks, are networks that connect the sites of an
enterprise over the network facilities of a single service provider. A public IP
network is a network that uses the Internet, or multiple providers' IP network
facilities, or backbones, to connect an enterprise's remote offices and
branches, remote users, business partners and public Web sites.
The networking market is intensely competitive, and service providers are
constantly trying to increase revenue and reduce operating costs. Service
providers require tools to efficiently turn on service for their customers,
trouble-shoot problems collaboratively with their customers, offer and validate
the network performance that might be promised in a customer contract, and
effectively plan their customers' network requirements.
We market our products to enterprises and service providers. Enterprises
use our products to enhance the performance of their networked applications,
improve their network efficiency and validate the network performance promised
by their service providers. As of December 31, 2002, we had shipped systems to
manage over 160,000 data transport circuits, or connections between service
providers' networks and enterprises' networks, and 13 million remote Internet
access users.
Service providers use our products to create services that are
differentiated from their competitors and to reduce their operating costs and
the costs associated with initiating service for a customer. Our major service
provider customers include, among others: AT&T, BellSouth, Earthlink, Equant,
SBC, Sprint, Verizon, and WorldCom. The revenue we generated by selling our
products to service providers was 70%, 77%, and 82% of our consolidated revenue
in 2000, 2001 and 2002, respectively.
Despite the growth of demand for data networking services, 2002 was a
challenging year as businesses continued to reduce spending. One of our most
significant customers, WorldCom, filed for bankruptcy in July 2002. Despite the
bankruptcy of
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WorldCom and a number of emerging service providers, and the general economic
downturn of the telecommunications market, we were able to achieve and maintain
profitability, limit our bad debt write-offs and improve our cash balances. We
were able to accomplish this due primarily to the following factors:
o Our business is not related to the build-out of telecommunications
infrastructure, but rather is tied to the sale and deployment of
data networking services to enterprises.;
o In March 2002, we issued $10.5 million in convertible debentures to
improve our cash position;
o Throughout 2002, we significantly reduced our operating expenses and
realigned them with lower revenue expectations. Our research and
development expense, sale and marketing expense and general and
administrative expense declined from $61.7 million in 2001 to $39.7
million in 2002; and
o In July 2002, we executed an agreement, later amended, with WorldCom
that stipulated payment terms while WorldCom is in bankruptcy,
enabling us to continue to sell our products to WorldCom during its
restructuring period. We generated $6.3 million in revenue from
WorldCom during 2002, and incurred $0.7 million in bad debts. We
cannot assure you that we will continue to generate this level of
revenue from sales of our products to WorldCom during 2003.
We were incorporated in Maryland in August 1993 under the name Avail
Networks, Inc. and reincorporated in Delaware in December 1994 as Visual
Networks, Inc. In 1998, we acquired Net2Net Corporation to accelerate the time
to market for our ATM performance management products. Products resulting from
that acquisition form the basis of our ATM analysis in the Visual UpTime and
CellTracer product lines. In 1999, we acquired Inverse Network Technology in
order to enter the performance management space for the public Internet. In this
acquisition, we acquired the Visual IP InSight product and the Visual Internet
Benchmark service. In 2000, we acquired Avesta Technologies, Inc. in order to
expand our network management portfolio to include products that could identify
the underlying primary causes of network problems. With this acquisition, we
acquired the Visual Trinity and Visual eWatcher products. As we refined our
strategic direction during 2001, we determined that certain of these products
did not fit our strategy or were not as far along in development as we had
anticipated, and we began to divest or discontinue certain products. In 2001, we
sold the Visual Internet Benchmark service and discontinued the Visual Trinity
product. In 2002, the remaining customer for our CellTracer product, Network
Associates placed what they indicated would be final orders with us for this
product. Also, in 2002, we continued to evaluate the future of the Visual
eWatcher and CellTracer products. In their current form, neither product
produced significant revenue for the year ended December 31, 2002. We believe
that the technology of both products may be useful to other products in the
future and we are exploring alternatives for these technologies. However, we
decided not to focus our development or sales efforts on these products in 2003.
Therefore, we do not anticipate any significant revenue from these products
during 2003. The following table indicates our revenue from the discontinued
products for the periods indicated:
Years Ended December 31,
----------------------------
2000 2001 2002
------- ------- ------
(in thousands)
Visual Internet Benchmark ......... $ 4,607 $ 4,025 $ 814
Visual Trinity and eWatcher ....... 7,268 3,591 699
CellTracer ........................ 7,946 2,980 2,232
------- ------- ------
Discontinued product revenue ... $19,821 $10,596 $3,745
======= ======= ======
Our principal executive offices are located at 2092 Gaither Road,
Rockville, Maryland, 20850. Our telephone number is (301) 296-2300. You may
obtain copies of this Form 10-K, quarterly reports on Form 10-Q, current reports
on Form 8-K, and amendments to those reports free of charge on our corporate Web
site at www.visualnetworks.com.
Industry Background.
Software applications used to operate enterprises, such as enterprise
resource planning, transaction processing, supply chain management, customer
relationship management, file transfers, software distribution, and e-commerce
have grown in number and complexity over the past decade. Many of these
applications require communication systems in order to work, resulting in
increased activity or "data traffic" across Wide Area Networks (WANs). This
growth in data traffic has led service providers to create, and sell to their
customers, data networking services that can cost effectively handle this data
traffic. Service providers provide both private and public networks.
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A private network connects an enterprise's internal sites over a single
service provider's network facilities, or backbone. A service provider will
often use the facilities of the local telephone company to connect the customer
to the backbone. In order to make this connection work well for the customer,
the main network facility needs to have a minimum capacity level and needs to be
able to provide additional capacity to accommodate the customer's increase in
traffic during peak usage times. Most private networks utilize one of two
technologies to move data: (1) frame relay; or (2) asynchronous transfer mode
(ATM). Existing frame relay or ATM networks are being modified to handle IP
traffic between the customer's internal sites. These networks are known as
"private IP networks" because they use the IP backbone of only a single service
provider who guarantees the security and performance of the customer's network
connections between its internal sites. Businesses often choose to use a private
IP network when they are concerned with network performance issues, such as
network availability, security and privacy.
A public IP network is a network that uses the Internet, or multiple
service providers' IP networks, to interconnect sites. Businesses use public IP
networks to connect remote and mobile users to their corporate network, to
connect remote sites in situations where private network connections are not
available, such as in countries without frame relay or ATM networks, or cost
effective, to connect to the networks of business partners, and to connect to
public Web sites. A business might choose to use a public IP network when
performance guarantees and security are less critical, when cost is a major
issue, and when it needs to interconnect with suppliers and customers.
Enterprises need networks that provide:
High network availability. When networks are not available, businesses
incur increased costs and reduced revenue. Businesses want tools that will
warn them of pending network problems, quickly identify the source of
problems, and cost-effectively trouble-shoot any problems that do occur.
Predictable performance. The network must support the performance
requirements of the business applications running on them. Businesses need
tools that show them how the network is being utilized, what impact
applications are having on the network, whether the network has adequate
capacity to support the applications, and what the end user's experience
is with the performance of the network.
Appropriate price/performance. Business managers must also control network
costs and validate that the network is performing as promised. They need
tools to measure the performance of the network that may be the subject of
a guarantee contained in their agreement with their service provider. They
also need to be able to identify areas of the network where excess
capacity exists.
Competition for network services is intense. To improve their competitive
position, service providers are looking for ways to attract customers by
offering new and differentiated services. In addition, the service providers are
looking to improve their profitability by lower operating costs and increasing
revenue. As a result, service providers need:
Efficient ways to install and maintain network services. Service providers
need to install services quickly and efficiently. They need tools that
enable them to verify that the newly installed network service is
operational, independent of the readiness of the customer's networking
equipment. The goal is to reduce the costs associated with installing
network services and decrease the delay between service installation and
when the service provider can begin billing the customer.
Collaborative trouble-shooting. Service providers are typically the first
place a customer will call with a network problem, regardless of the
source of that problem. Service providers need tools that enable them to
rapidly identify problems without sending personnel to the customers'
locations. These tools must be able to identify whether the problem exists
on the portion of the network provided by the service provider, the local
telephone company or the customer. This would allow the customer to
understand the source of the problem, rather than assuming that the
problem is being caused by either the service provider or the local
telephone company.
Verifiable service performance. Because public and private networks use
shared resources among all customers, a service provider must be able to
offer the customers the ability to verify the quality of the service that
is being provided. The service provider needs tools to accurately measure
the class and level of service it provides and to report the performance
levels to the customer. Many service providers actually enter into service
level agreements, or SLA, with their customers which guarantee certain
levels of performance. Without the ability to actually measure the service
levels being provided, however, an SLA is meaningless.
3
Effective network planning. The service provider and the customer can work
together to create a network that satisfies the customer's requirements.
The service provider needs tools to identify places on the customer
network that have either insufficient or excess capacity and how software
applications can affect capacity and performance, allowing the service
provider to make recommendations to the customer for enhancing the
efficiency and utilization of their network.
Scalable management. Enterprises require networks that are scaleable to
support their growth. Service providers and their customers need
performance management tools that are scaleable to support future growth.
The Visual Networks Solution.
We provide performance management systems for frame relay, ATM and private
and public IP networks. Our systems measure and analyze the performance of these
networks at the point on the network that divides the portion provided by the
service provider from the portion provided by the customer. We call this point
the service demarcation, or "demarc." Service providers and customers manage
network performance from this point of view because it is the place that defines
the service offering for which customers are paying.
We provide software and hardware components that are placed at the demarc
to monitor and analyze network traffic, and utilization and performance. This
information is then stored in a database located in a network operations center,
either at the customer's location or at the service provider's location. We also
provide tool sets to the employees runoff an enterprise who are responsible for
the network, the network operators. These tool sets include customer care,
troubleshooting, service level monitoring and management, and network planning,
which network operators use to manage the performance of network services. The
network operator is also able to use the stored network performance history in
the database to observe times when the network may have been experiencing
performance problems. The network operator can use this information to help
solve problems that tend to be intermittent when they occur on data networks.
The network operator also has the ability to monitor network performance in real
time.
Enterprises may either buy our products and operate them on their own, or
they may purchase from a service provider a service offering that includes our
performance management system. Enterprises use our systems to improve network
availability and performance, to insure that the performance levels that the
service provider has guaranteed are being met, to test and monitor the impact
business applications are having on network capacity and utilization, and to
reduce the total cost of network operations. Our solutions provide the following
capabilities:
Performance monitoring and reporting. For frame relay and ATM networks,
our systems monitor and report information on a number of service factors
that are often contractually promised to the customer by the service
providers. For private IP networks, our systems measure and report on
these same metrics for a particular level or class of service. We also
offer Service Advisor(TM) which gives a real time view of the service
quality metrics. For public IP networks, our systems execute and report on
tests that measure the availability and performance of IP services and
protocols. In addition, for remote dial Internet access, our systems
monitor and report on the connection and network performance from the
user's point of view. These performance-monitoring tools enable a business
to have an early indication of potential network problems.
Network utilization. Our systems monitor and report on network utilization
by type of service. Businesses use this capability for network planning to
determine the impact that various applications have on network capacity
and performance. In addition, a business can determine whether the
applications and networking equipment are properly configured. One of the
modules we offer is Burst Advisor(TM), which provides a view of the
network usage in one-second increments. A business can use this
information to determine if network capacity is sized appropriately for
its needs, if more bandwidth should be procured, or if too much bandwidth
has been provided.
Trouble-shooting. Network operators can program the system to provide an
early warning of potential problems if certain metrics are exceeded. When
the established thresholds are exceeded, the system generates alarms to
alert the network operator to the problem. The alarms can be automatically
forwarded to an external fault management system. Our system then provides
a number of trouble-shooting tools that enable the user to identify the
source of the performance problem and to identify where the problem
exists: on the equipment or service of the network service provider, the
access line service provider, the customer equipment, or at the
application. Our system can capture data traffic at the demarc and
diagnose difficult problems. In addition to receiving a real-time view,
the network operator can look back at the condition of the network at the
point when the problem actually occurred. Using our system, a network
operator can resolve performance problems without the need to dispatch
technicians to a particular
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site, with expensive analysis equipment, and can quickly identify and
diagnose hard-to-find, intermittent problems. The use of our system
results in higher network availability and performance and lower operating
costs.
Planning and reporting. Our system generates a number of summary and
detailed reports on network performance which a network operator can use
for short and long-term network planning. Information Technology (IT)
executives use the reports to assess the quality of the network services
being provided and verify that service providers' contractual performance
obligations are being met.
Service providers purchase our systems in an effort to reduce their
operating costs and differentiate their services through better network
performance. Service providers also use our systems to offer and validate
service performance guarantees. In addition, service providers offer value-added
services by deploying our agents at the service demarc, hosting and operating
the system, and providing businesses with access to the tools sets and their
data for analysis. We provide the following additional capabilities to our
service providers:
Service Creation. We assist service providers in defining and creating
service offerings that incorporate our solutions. We help define the
elements to be provided in the service, develop the methods and procedures
for implementing and deploying the service, calculate the service
provider's return on investment, develop marketing and sales materials,
train the service provider sales force and generate demand for the new
service.
Service Validation. Service providers incorporate network performance
metrics into their customer contracts and use the information provided by
our solutions to validate the service quality they are contractually
obligated to provide. These standards normally include delay of network
traffic flow, availability of access ports, percentage of traffic dropped,
validation of type of service provided and availability and performance of
IP services and protocols. Our system's ability to measure service
performance metrics allows the service provider to validate the service it
is providing to customers and also provides a justification for the
service provider's premium pricing on certain services.
Collaborative Management. The service provider is typically the first to
receive a trouble call if a business' network application is performing
poorly. In many cases, the source of the problem is not the service
provider, but rather the access line provided by the local telephone
company, the configuration of the customer's equipment, or the application
itself. Our systems enable the customer and the service provider to
collaborate when solving network problems. For the private networks, the
service provider and the enterprise will have access to the same data and
trouble-shooting tools. The service provider can quickly isolate the
source of the problem and demonstrate this to the customer, thus avoiding
confusion as to the source of the problem and dispatching a technician. In
addition, they will both have access to the same network utilization
information, so that the proper network capacity can be established for
the customer's applications. In the case of public IP networks, the
service provider has access to configuration information on the end-user's
workstation and has access to data on the end-user's usage experience. The
service provider's customer care organization is able to quickly assist
the user in resolving performance problems.
Provisioning. Establishing initial service can be a lengthy and costly
process. Typically, a service provider must wait until the customer has
installed networking equipment at its business location before the service
can be finally tested and billing can begin. This can often result in
technicians visiting a customer's location multiple times prior to the
time the service is fully operational. A service provider using our system
can establish the service and test its availability independent of the
customer's networking equipment.
Scalability. Our systems can be increased in capacity to manage multiple
customers' networks, large numbers of sites and vast amounts of traffic.
The Visual Networks Strategy.
Our primary objective is to maximize shareholder value by maximizing the
number of network sites that are managed by our systems. Key elements of the
strategy include:
Make it Visual Partner Program. Through our Make it Visual Partner Program
(MIVPP), we are seeking to have our systems deployed on the greatest number of
network access sites possible. We seek to partner with leading providers of
network access equipment to have components of our technology embedded into
their equipment. To date, we have entered into strategic relationships with
Cisco Systems and Kentrox, both of which are leading providers of network access
equipment. We intend to expend development, marketing, and sales resources to
support and expand these relationships and to extend the program to other
5
providers of private and public data networking access equipment.
Private IP. We seek to have our systems further deployed as service
providers expand and enhance their private IP service offerings. Major service
providers such as AT&T, Sprint, WorldCom and Equant have introduced IP
capabilities to their frame relay services. In 2002, we introduced significant
enhancements to Visual UpTime to manage the performance of these services. We
see opportunities for additional revenue as these services grow and as existing
frame relay and ATM customers add IP capabilities. We intend to continue to
enhance our systems for use with these networks.
Channel management. We intend to capitalize on our relationships with
major service providers to assist them in defining and selling service offerings
based on our systems. Service providers are the predominant means for the
deployment of service performance management capability for private networks,
and are an increasingly important provider of service performance management for
public IP networks. Our solutions are ideally suited for service provider
deployment and for collaborative management between the service provider and
their customers. Additionally, we intend to expand our market coverage in the
Value-Added Reseller (VAR) channel by supporting the marketing programs of our
master reseller, Interlink Communications Systems, and through our Cisco
relationship.
Managed routers. We intend to have our solutions used by service providers
in outsourced network services, including those service providers that use the
router as the demarc, rather than the data service unit, or DSU, that serves as
the demarc in most service providers' offerings. Many service providers and
managed network service vendors offer complete packages of network services to
large businesses. Through the MIVPP initiatives described earlier, our solutions
can be used in these networks through the customer's router equipment. In other
offerings, our stand-alone analysis service elements, or ASE, are used as a
clearly-defined service demarc, even though the service provider also provides
further services and equipment on the customers' premises. We intend to expend
marketing and sales resources to create and market Visual Networks-based
performance management services for these offerings.
Global expansion. We intend to use our customer relationships with large,
multinational corporations to expand our coverage outside the United States. We
intend to focus on service providers that have the largest share of frame relay,
ATM and private IP, and direct and remote Internet access markets, and by
leveraging our relationships with equipment providers. We are also establishing
reseller relationships globally with local and regional VARs and increasing our
international sales resources.
Site-to-site public IP VPN. We intend to increase the revenue that we
receive from enterprises and service providers that deploy public IP VPNs as
part of their networking solution. In 2002, we introduced enhancements to Visual
IP InSight to manage the performance of public IP VPNs. We intend to continue to
enhance our solutions for use in these networks.
Products and Technology.
We have two flagship products: Visual UpTime, which is a performance
management system for private data networks, including frame relay, ATM and
private IP, and Visual IP InSight, which is a performance management system for
public IP networks.
Visual UpTime.
Visual UpTime is a performance management system for private data networks
which use frame relay, ATM, and private IP. It consists of the following tightly
integrated tools:
o Performance monitoring is an early warning system, alerting network
operators to impending service degradation that allows them to take
corrective action before application performance degrades.
o Trouble-shooting enables a network operator to rapidly perform
detailed diagnostics to identify the cause of service level
problems.
o Planning and reporting is a report generation tool that creates a
wide variety of network performance reports.
o Visual Service Advisor proactively manages the status of network
service level agreement requirements.
o Visual Burst Advisor accurately sizes wide area network bandwidth.
Service providers use Visual UpTime to improve the performance of their
own networks, reduce network operating costs, differentiate their services from
other providers, validate contractual performance obligations and create
value-added services that are then sold to businesses. Several service providers
have based their value added services on Visual UpTime, including the following
services: AT&T Frame Relay Plus, AT&T IP-enabled Frame Relay Plus (IPeFR Plus),
Sprint Web-based Network Manager, Sprint Managed DSU, WorldCom Frame Relay
Platinum, WorldCom Private IP Platinum, and Verizon Frame Watch. Service
providers also resell the Visual UpTime system to businesses which host the
system and manage their own networks. Businesses use Visual
6
UpTime to improve their network availability, properly size their network
capacity, reduce their operating costs, and validate their service provider's
performance of its contractual obligations.
We license private-label versions of Visual UpTime to Cisco. Visual UpTime
is the basis for their WAN Access Performance Management System (WAPMS). Our
private label version currently manages ATM networks, and Cisco plans to expand
into frame relay network management in 2003.
The Visual UpTime system is composed of the following components: Analysis
Service Elements (ASE), the Performance Archive Manager (PAM), license keys, and
Platform Applicable Clients (PAC).
ASE. The ASE is a combination of proprietary software and hardware that
performs detailed analyses of network performance at the service demarc. Most
versions of the ASE also provide the functionality of wide area network, or WAN,
access equipment known as a channel service unit/data service unit, or CSU/DSU.
A CSU/DSU is a "digital modem" that connects customers' networks to their
service providers' network. The ASE uses sophisticated, proprietary software in
conjunction with networking-specific microprocessors and integrated circuits to
perform detailed analyses of every bit of data traversing the demarc. The ASE
generally stores the analyses locally in memory and wait for the PAM, described
below, to request the results. When the ASE detects an anomalous condition on
the network, it alerts the network operator who can take prompt action to remedy
the situation. Our core ASE technology can be deployed in a number of
configurations and data speeds depending on customer requirements. The ASE can
also be deployed with restricted access to the management data. The customer can
remove the restrictions by purchasing and deploying license keys that "unlock"
the restricted area. Service providers use this arrangement when they make the
ASEs the default WAN access equipment deployed when they install a circuit, but
do not initially provide the management capabilities of Visual UpTime to their
customer, and subsequently purchase the management capability when value-added
services are sold to their customer
PAM. The PAM is our system database, and it manages requests between the
PAC, described below, and either the database or an ASE. Traditional management
data collection architectures depend on the continuous gathering of data, a
bandwidth consuming process. In contrast, Visual UpTime distributes most of the
processing burden to the ASE, allowing the PAM-ASE data sharing to take place
less frequently, typically once a day. This feature is critical in WAN
environments where costly bandwidth makes continuous management data collection
impractical. The PAM is a partitioned database with secure access control,
meaning that only certain users can access certain parts of the database. This
enables a service provider to serve multiple customers from a single PAM.
License keys. In order to use the management tools of Visual UpTime that
are embedded in the hardware components, a customer or a service provider needs
a software "key". These license keys are used in conjunction with the equipment
that is manufactured by Cisco and Kentrox and on which our system resides.
PAC. The PAC is software used for packaging and presenting the data stored
in the PAM and the ASE and enables access to the Visual UpTime toolsets,
including:
o Performance monitoring. This toolset is an early warning system
which alerts the network operator to impending service degradation
and allows the network operator to take corrective action before the
end-user's application performance degrades. This toolset displays
network performance related events and alarms. The performance
monitoring toolset is tightly linked to the trouble-shooting
toolset, allowing an operator to evaluate quickly and precisely the
conditions that caused the event or alarm.
o Trouble-shooting. This toolset enables a network operator to rapidly
perform detailed diagnostics to identify the cause of service
problems. This toolset displays real-time and historical network
performance statistics. The trouble-shooting toolset can capture the
data communication traffic and provide analysis capability used by
network operators to isolate problems arising from the interplay
between a customer's equipment or application and the WAN service.
o Planning and reporting. This toolset is a report-generation tool
that creates a wide variety of reports from the network performance
data stored in the PAM. This toolset is used primarily for capacity
planning, network engineering, management of contractual performance
obligations, and executive reporting from the network operations
staff to senior management.
o Visual Service Advisor. This tool proactively manages the status of
network performance obligations. Service Advisor provides a
real-time view into availability, throughput and delay. This enables
the network manager to more effectively ascertain when contractual
performance obligations are being met by specific sites in the
network.
7
o Visual Burst Advisor. This tool accurately establishes WAN
bandwidth. It archives usage of the network over one-second
intervals and compiles a clear, detailed picture of usage
distribution. It also automatically makes recommendations on proper
bandwidth allocation. This eliminates the guesswork for determining
the proper bandwidth for WAN circuits. With this tool, customers can
reduce monthly expenditures if they are currently paying for more
bandwidth than they are using or they can increase their bandwidth
if it is insufficient to support the applications running on the
network.
We sell Visual UpTime as a complete system which includes at with a
minimum one PAM, one PAC and one ASE, or a license key, deployed at the demarc
point of each network circuit on which a customer or service provider wishes to
monitor and manage service levels. We are continuously enhancing Visual UpTime
with new features to support our equipment manufacturers, and to address service
performance requirements for private IP VPNs, higher network speeds, and new
applications and services.
Visual IP InSight.
Visual IP InSight is a service performance management system for public IP
networks. It enables service providers and enterprises to manage IP connectivity
and accessibility to IP network services from the end-user's perspective. It
helps manage IP connectivity across all IP access technologies, including dial,
dedicated, broadband (DSL, wireless, cable and ISDN), and VPN connections.
o Visual IP InSight Dial Suite helps service providers and
businesses measure and monitor the performance of IP
connectivity and IP network services.
o Visual IP InSight Broadband Suite helps service providers and
businesses measure and monitor the performance of broadband
connections and remote access IP VPNs.
o Visual IP InSight Dedicated Suite solves the performance
management concerns associated with running mission-critical
applications across the public Internet by providing service
providers and their customers with the ability to view and
understand the functioning of dedicated IP connections and
site-to-site IP VPN service.
Visual IP InSight contains three service performance management
applications.
o Visual IP InSight Service Operations provides information
regarding problems in real-time and monitors connection
performance and the performance of IP applications.
o Visual IP InSight Service Level Manager allows Internet
service providers, or ISP, to automatically monitor the
customer requirements with respect to service levels on a
customer-by-customer basis.
o Visual IP InSight Customer Care provides a look into the end
user's experiences by gathering connection history, system
configuration, and current network status from the end user's
personal computer.
We license Visual IP InSight to public IP service providers to enable them
to improve the performance of their network, reduce network operating costs,
differentiate their services, validate contractual performance obligations and
create value-added services. We have several public IP service providers using
Visual IP InSight for performance management including BellSouth.Net dial
service, Earthlink Fastlane, Verizon On-Line and SBC dial and broadband
services. Value-added services that are based on Visual IP InSight include
WorldCom Dial Analysis and WorldCom Dedicated Analysis.
System components for Visual IP InSight include agents, data collectors
and a data repository. These components communicate with each other over an IP
network providing real-time information. These components are packaged into
application suites that address various public IP networking environments: Dial
Suite, Broadband Suite, and Dedicated Suite. Visual IP InSight's architecture is
distributed, fault-tolerant, and scalable to carrier-class networks.
Agents. Agents are the software clients that actually perform the tests
and collect the data used by the Visual IP InSight system. The system's agents
are the origin of quality of service and test data. There are two types of
agents: dedicated agents and client agents. Dedicated agents are embedded in
hardware devices called IP Service Elements (ISE). An ISE is connected to the
network at a suitable monitoring point and performs active tests on command as
configured by the network manager. Client agents are installed on the PC of
service subscribers. The software runs transparently until end-user assistance
is required. Context-sensitive online "help" suggests solutions to more than 150
dial-access problems and keeps a descriptive error log that customer care
personnel can use to solve problems that end users cannot resolve on their own.
In parallel, the client agent can passively monitor user activity on the network
or perform active tests when requested by the network manager. The client agent
can be deployed in any remote access environment - dial modem, cable modem, DSL,
ISDN or wireless services. All varieties of dedicated and client agents can be
used together in the same network with the same Visual IP InSight system.
Visual IP InSight Collectors. The collectors gather data from the various
agents and transfer it to the Visual IP InSight
8
Aggregator, described below. A collector can be deployed either on the LAN side
of a firewall or at key points in the public IP network. A single collector can
handle hundreds of thousands of active agents.
Visual IP InSight Aggregators. The aggregators are servers positioned at
key locations in the network data center. Collectors pass the agent data they
have gathered to one or more aggregators for data validation and loading into
various data repositories. All of the performance data gathered is stored in a
high performance relational database. Data is presented using a secure Web
interface, allowing detailed information on the performance of the network and
applications to be quickly distributed throughout an organization or between
customers and partners.
Visual IP InSight Service Operations. This application provides
information regarding problems in real-time and monitors connection performance
and the performance of IP applications, such as e-mail and domain name servers.
Visual IP InSight Service Level Manager. This application allows an ISP to
define specific contractual arrangements with customers that are automatically
monitored on a customer-by-customer basis. It generates detailed service
reports, showing the end-user's actual experiences compared to the performance
metrics agreed upon by the customer and the ISP. Within the enterprise, an
internal IT department uses it to manage the performance of multiple ISP on a
partitioned basis, and to manage service level objectives across business
services. Visual IP InSight Service Level Manager helps service managers by
automating the service-monitoring process; measuring actual performance against
thresholds; and generating hourly, daily, weekly and monthly reports.
Visual IP InSight Customer Care. This application monitors the end user's
experiences by gathering the connection history, system configuration, and
current network status from the end user's personal computer. This gives
customer care representatives the ability to more accurately identify problems,
effectively diagnose their cause and rapidly resolve the issues.
Visual IP InSight Performance Management Suites. The capabilities of
Visual IP InSight are organized into application suites that address various
public IP networking environments:
o Visual IP InSight Dial Suite. This product helps service providers
and businesses measure and monitor the performance of IP
connectivity and IP network services.
o Visual IP InSight Broadband Suite. This product helps service
providers and businesses measure and monitor the performance of
broadband connections and remote access IP VPNs.
o Visual IP InSight Dedicated Suite. This product solves the
performance management concern associated with running
mission-critical applications across the public Internet by
providing service providers and their customers with visibility into
dedicated IP connections and site-to-site IP VPN service.
We license Visual IP InSight as a complete system which requires at least
one back-end data base system, a Collector, an Aggregator, and the Service
Operation application per deployment along with one ISE or agent license for
each performance management point. System pricing is dependent on the number of
ISE and client agent management licenses authorized, and the applications
utilized.
Marketing and Sales.
Our marketing programs are designed to generate demand for our products at
the enterprise - those organizations and businesses with network management
needs. Our sales force is responsible for this effort. These enterprises
purchase our products either through a service provider or one of our authorized
value-added resellers, or VARs. We have several support programs to educate the
sales forces of our service providers and VARs which are designed to shorten
sales cycles.
We have also implemented an indirect channel strategy to businesses and
organizations and a direct channel strategy to service providers. Enterprises
that want to host their own systems procure them through a service provider
resale program or through a VAR. VARs place their orders with our master
distributor, Interlink Communication Systems (ICS). We have approximately 16
authorized VARs who have been instructed to purchase our products through ICS
under terms and conditions of our contracts with them. Other VARs, approved by
ICS, pursuant to ICS' Visual Networks Affiliate VAR Program, purchase our
products from ICS under terms and conditions established between ICS and the
approved VAR. At the end of 2002, ICS had 45 Visual Networks Affiliate VARs.
Revenue generated from our shipments to ICS for distribution to authorized and
affiliate VARs, was less than 10% of consolidated revenue for each of the three
years ended December 31, 2000, 2001 and 2002.
9
Pursuant to agreements with us, our service provider customers purchase
our products for internal use, for resale to their customers or to serve as the
basis for a value-added service offering. Our major service provider customers
include AT&T, BellSouth, Earthlink, Equant, SBC, Sprint, Verizon and WorldCom.
Revenue related to our shipment of products to service providers represented
70%, 77% and 82% of our total revenue in 2000, 2001 and 2002, respectively. In
2002, AT&T, Sprint, Verizon and WorldCom represented 34%, 10%, 11% and 10% of
our total revenue, respectively. We describe below the terms of our contracts
with these providers. Although our service provider contracts do not require
minimum purchases and may be terminated by the service providers at any time, we
believe that our products support the service providers' high-margin product and
service offerings and that we will continue to receive orders from the service
providers in accordance with the terms and conditions contained in the
contracts. The loss of any one of these major service provider customers would
have a material adverse effect on our revenues and profitability.
Although our business is predominantly within the United States, we market
our products to customers outside the United States pursuant to agreements with
international VARs. Currently, our most significant international reseller
partners are located in Canada and the United Kingdom. Although revenue from
international customers was less than 10% of our consolidated revenue for each
of the years ended December 31, 2000, 2001 and 2002, we have reorganized our
sales organization partly in order to allow us to aggressively pursue
international opportunities.
Our sales organization consists of five groups, one sales group whose
members focus on all opportunities within a particular region in North America,
another sales group that focuses on North American channels, an international
sales group that addresses both enterprise sales support and developing and
supporting relationships with global channels, a systems engineering
organization that provides pre-sales technical support for the sales groups, and
a sales operations group that facilitates the efficient operation of the sales
organization.
The North American regional sales group consists of sales people who
generate and cultivate leads. A regional sales person qualifies opportunities,
presents the value proposition to the prospective enterprise customer,
ascertains the preferred procurement alternative (the purchase of a product or a
service), determines the preferred channel partner or service provider, and
works with the selected channel to close the transaction. The group consists of
field sales people, systems engineers, and an inside sales organization. We
rarely take a product order directly from an enterprise customer.
The North American channel sales group consists of dedicated account teams
that support individual service providers, including AT&T, Bellsouth, Equant,
SBC, Sprint and WorldCom, other Local Exchange Carriers, or LECs, and our
Value-Added Resellers, or VARs. The account teams work with the service
providers and LECs to create services based on our products, ensure that the
service providers' own sales teams are proficient in presenting the value
proposition to enterprise customers, and assure that sales opportunities are
closed in a timely fashion.
The international sales group is responsible for both channel and
enterprise sales and relationship management in various regions throughout the
world. International sales regions from which we derive sales today include
Europe and the Asia-Pacific region, with other regions currently in various
stages of development.
The individual members of the systems engineering organization are
assigned to specific sales teams to provide pre-sales technical support. The
systems engineers are responsible for making technical sales presentations,
answering technical questions from channel partners, supporting the product
certification and other evaluation efforts of existing and prospective
customers, and supporting the channel partners as required by their customers.
The marketing group is responsible for generating leads for our solutions
and developing and delivering support programs to service providers and channel
partners. We use road shows, advertising, trade shows, Webinars, public
relations programs, our web page and inside sales programs to generate leads. We
have also developed a number of service creation templates and programs for both
public and private networks, to assist the service providers in developing,
implementing, and selling services based on our solutions.
As of December 31, 2002, we employed 65 people in sales and marketing. In
addition, our senior management team and our product management organization
devote significant time furthering the business relationship with service
providers and channel partners. Our expenditures for sales and marketing
activities were approximately $41.9 million, $33.5 million and $20.5 million in
2000, 2001 and 2002, respectively. We intend to continue to invest significant
marketing and sales resources.
10
Key Customers and Strategic Relationships.
AT&T. In December 1997, we entered into a non-exclusive procurement
agreement with AT&T. The agreement had an initial term of three years, but
continues indefinitely with the right by either party to terminate the agreement
upon thirty days notice. The discounted prices for most of the software licensed
and equipment purchased by AT&T are established in the contract. The contract
also contains the other terms and conditions of purchase by AT&T of the products
for incorporation into a service offering or for resale, including payment
terms, software licenses, product warranties and product support
responsibilities. If we offer more favorable prices and terms under a supply
agreement to any other customer for the same quantities of similar products
during the term of the agreement, we are obligated to provide AT&T with the same
or comparable overall terms. AT&T GNS, a group within AT&T, uses the Visual IP
InSight product pursuant to the terms and conditions of a separate software
agreement.
Sprint. In May 2000, we entered into a master agreement with Sprint for
the purchase of equipment and services with a three-year term that Sprint may
terminate at any time with thirty days' prior notice. This succeeded a similar
agreement between the parties that was signed in August 1996. The discounted
prices for most of the Visual UpTime software licensed and equipment purchased
by Sprint are established in the contract. The contract, as amended, also
contains the other terms and conditions of purchase by Sprint of the product for
incorporation into a service offering or for resale, including payment terms,
software licenses, product warranties and product support responsibilities.
Under the contract, Sprint is entitled to a price rebate in the event that it
was determined that we provided more favorable prices or other terms and
conditions to another customer acquiring like quantities of our products. Sprint
uses the Visual IP InSight product pursuant to the terms and conditions of a
separate software agreement.
Verizon. In July 1997, we entered into a non-exclusive integrator
agreement with Verizon, and a related support agreement, that was amended in
June 1999 to extend the term for five years. Unless terminated at the end of the
term, or any renewal term, the contract will renew automatically for successive
one-year terms. The discounted prices for most of the Visual UpTime software
licensed and equipment purchased by Verizon are established in the contract. The
contract, as amended, also contains the other terms and conditions of purchase
by Verizon of the products for incorporation into a service offering or for
resale, including payment terms, software licenses, product warranties and
product support responsibilities. Verizon uses the Visual IP InSight product
pursuant to the terms and conditions of a separate software license agreement.
WorldCom. In August 1997, we entered into a non-exclusive
reseller/integration agreement with MCI Telecommunications, now WorldCom. The
agreement had an initial term of three years, but renews automatically for
successive one-year terms with the right by either party to terminate the
agreement for convenience at any time. The discounted prices for most of the
Visual UpTime software licensed and equipment purchased by WorldCom are
established in the contract. The contract, as amended, also contains the other
terms and conditions of purchase by WorldCom of the product for incorporation
into a service offering or for resale, including payment terms, software
licenses, product warranties, and product support responsibilities. The contract
contains our agreement to reduce WorldCom's prices if we offer lower prices to
another customer for the same quantities of products supplied over a similar
period of time under like conditions. Subsequent to WorldCom's Chapter 11
bankruptcy filing, in July 2002, we executed an agreement, as amended, that
documents the payment terms related to the fulfillment of orders received from
WorldCom. WorldCom uses the Visual IP InSight software product pursuant to the
terms and conditions of a separate software license agreement.
Make it Visual Partner Program (MIVPP). In October 2000 and December 2000,
we entered into agreements with ADC, since sold and renamed Kentrox, and Cisco,
respectively, under which these hardware manufacturers are authorized to embed
certain Visual UpTime functionality into their hardware products. Both
agreements required either a license key from us or authorization under a
subsequent agreement for the embedded Visual UpTime functionality to be
activated and/or managed. We have been selling licenses to manage Kentrox
devices since the fourth quarter of 2001. In December 2002, we entered into an
OEM relationship with Cisco under which we provide a Cisco-branded version of
the Visual UpTime server product to Cisco which, when appropriate license keys
have been entered, is able to manage Visual UpTime-enabled Cisco devices as well
as all of the other devices that our current PAMs can manage. In addition to
these two existing relationships, we are pursuing various other opportunities
for further Visual UpTime and Visual IP InSight MIVPP relationships, both
domestically and internationally.
Customer Service.
Our customer service organization provides 24 hour a day technical support
for products under warranty or maintenance contract. Level 1 and 2 support is
provided by our Visual Technical Assistance Center (VTAC). Problems that cannot
be resolved by VTAC are escalated to our engineering organization for level 3
problem resolution. We sell software maintenance and emergency equipment
replacement services to customers, typically under one-year contracts. Software
maintenance contracts entitle a customer to VTAC access, bug fixes, and product
upgrades. Equipment replacement contracts entitle customers to the emergency
replacement of problem units within 4 or 24 hours, on average, depending on the
level of the prearranged service. The customer services organization also
11
provides fee-based product training for the network managers and operators of
our service provider and other channel partners, and their customers. We
outsource our hardware installation and our emergency equipment replacement
service. Our customers continue to rank the quality of our customer service very
highly in our customer satisfaction surveys. We will continue to invest in
customer service to maintain or improve the quality of our service and to assure
that we have satisfied customers with minimal service outages. As of December
31, 2002, we employed six people in customer service.
Research and Development.
The demands for performance management capability are constantly growing
and changing as new access technologies are deployed, new applications and
services create the demand for higher transmission speeds, and new networking
technologies result in lower cost alternatives for transporting mission-critical
information. We utilize a number of sources as input to our product development
process, including input from customers, our analysis of market and technical
trends, and data from industry analysts and market research. Research and
product development are critical to our continued success.
In recent years, we have made significant investments in system
architecture and product enhancements. We have updated our products to
incorporate new client technologies such as Java, and new server technologies
such as symmetrical multiprocessor arrays. We have enhanced our architecture to
facilitate relationships with companies which seek to embed our technology into
their product offerings, which we call our "Make It Visual Partnership Program,"
(MIVPP). We have added support for new network access technologies such as DSL
and higher transmission speeds. We have expanded the product line to manage the
performance of private IP networks and public IP VPNs. We have also continued to
improve the ability to expand our systems.
We plan to continue to devote significant research and development
resources to enhance our existing products and introduce new service management
capabilities. We plan to make additional architectural enhancements in order to
integrate our private and public network solutions, to facilitate our MIVPP and
to integrate with operations support systems. We plan to continue to enhance our
private and public IP VPN management, including performance management details
by class of service and voice over IP, or VOIP, performance management. We will
continue to invest to support higher speed access to ATM and private IP
networks. We will continue to focus on the scalability that is required for
wide-scale deployment by service providers. Additionally, we expect to invest in
system modifications that will increase the marketability of our products
outside North America.
As of December 31, 2002, we had 52 employees in our research and
development group. Our research and development expenditures were approximately
$27.3 million, $19.3 million and $12.3 million in 2000, 2001 and 2002,
respectively.
Manufacturing.
We outsource the manufacture and repair of our proprietary hardware
products to contract manufacturers. To mitigate the risks associated with our
prior dependency on a sole source manufacturer, we have established a
manufacturing supply contract with a second source. We acquire the hardware
platform for our ISE product from a third party. We generally use standard parts
and components in the manufacture of our products and acquire them from
suppliers in the United States. However, we currently acquire several key
components from sole, single or limited sources. Our engineering and
manufacturing personnel coordinate activities in order to replace unavailable
parts on a timely basis and acquire sufficient quantities of obsolete parts. To
date, we have not experienced any significant delays or material unanticipated
costs related to our use of a sole source subcontract manufacturer or an
inability to obtain required parts when needed. To support our manufacturing
partners, we provide material resource planning, quality assurance,
manufacturing and test engineering, and product and component planning and
purchasing. As of December 31, 2002, there were six employees in manufacturing
operations.
Because we are embedded in network service offerings of many service
providers, high quality is essential to our continued success. Our Rockville,
Maryland facility is ISO 9001-1994 certified for the design and manufacture of
wide area network service management systems.
Competition.
The market for network management solutions is intensely competitive. Our
products integrate key functionality found in six distinct market segments: WAN
access equipment; bandwidth management equipment; network test and analysis
equipment; performance management reporting software; telecommunications
operations support systems (OSSs); and client-based network management and
Internet infrastructure test beds. We believe our products are the only systems
that integrate functional attributes from all these market segments to provide
cost-effective WAN service performance management. We expect to encounter
increased
12
competition from current and potential participants in each of these segments.
Increased competition may result in price reductions, reduced profit margins,
reduced profitability, and the loss of market share, any of which would have a
material adverse effect on our business, financial condition, and results of
operations.
WAN access equipment. Our introduction of our ASE products redefined the
WAN access equipment market by adding superior analysis capability for frame
relay, ATM, and private IP networks. This caused vendors in this space to lose
market share and counter our products with improvements to their own products.
The leading vendors in the segment include Kentrox, Paradyne and Adtran. These
companies may partner with companies offering network test and analysis
products, or performance reporting products in order to better compete with us.
Additionally, router vendors may integrate WAN access equipment and agent
technology in their routers, which may adversely affect Visual UpTime's cost
justification. We are working to mitigate these risks through our MIVPP
partnerships with Cisco and Kentrox.
Bandwidth management equipment. The primary purpose of this equipment is
to adjust the flows of customer traffic into the network to improve the
perceived performance of the network services. To understand and manage the
traffic flows, this equipment must provide a certain degree of functionality,
which is also found in performance management systems. The major supplier in
this market is Packeteer.
Network test and analysis. An essential element of WAN service performance
management is technology and expertise associated with network test and
analysis. Products in the market include portable and distributed protocol
analyzers, transmission test instruments, active testing agents, and passive
monitoring probes. The major suppliers in this market segment include Network
Associates, Agilent Technologies, Acterna, Fluke, Spirent and NetScout.
Performance management reporting software. These software systems provide
a broad reporting capability of network and equipment status and performance
based on polling standard management information bases resident in network and
customer premises equipment. The major vendors in this market segment include
Concord, InfoVista, Agilent and Quallaby.
Telecommunications operational support systems (OSS). OSS are systems
related to service deployment including provisioning systems, billing systems,
trouble-ticketing systems, and fault and performance management systems. OSS
have been developed by the in-house staffs of the service providers and have
sometimes been a source of competitive advantage to service providers. Providers
of switching, routing, and transmission equipment such as Lucent, Nortel, and
Cisco also provide OSS to support their systems. A number of vendors also
produce suites of OSS components for the service providers market. Major vendors
in this market segment include Telcordia, Agilent, Micromuse, Amdocs and Narus.
Our products provide a significant portion of the functionality that might
otherwise be found in a fault and performance management system for public and
private data network services.
Client-based network management and Internet infrastructure test-beds. An
emerging trend in network management is increased emphasis on visibility of
actual user experience. Installing clients on end user desktops is an effective
way to gather this type of data. This technology can be deployed either as a
service offering using simulated desktops or sold as stand-alone software. Major
suppliers of stand-alone software include Lucent, NetIQ, Concord, Jyra Research
and NetScout. The major supplier of service-based solutions is Keynote Software.
We intend to compete by offering superior features, performance,
reliability and flexibility at competitive prices. We also intend to compete on
the strength of our relationships with service providers. These relationships
and the services that have been built around our products constitute high
barriers to entry. As competition in the service performance management
intensifies, we may encounter price competition. In response to competitive
trends, we expect to continue to reduce the cost of our systems to avoid
deterioration of gross margins.
Proprietary Rights.
Our success depends significantly upon our proprietary technology. We rely
on a combination of patent, copyright, trademark and trade secret laws,
non-disclosure agreements and other contractual provisions to establish,
maintain and protect our proprietary rights. However, use of contractual,
statutory and common law protections of our proprietary technologies offers only
limited protection.
We have five issued U.S. patents and two pending U.S. patent applications,
as well as their various foreign counterparts. We have been informed that one of
our pending U.S. patent applications has been allowed and expect the patent to
be issued shortly; however, we cannot ensure that patents will issue from our
pending applications or from any future applications, or that, if issued, any
claims will be sufficiently broad to protect our technology. In addition, we
cannot ensure that any patents that have been or may be issued
13
will not be challenged, invalidated, or circumvented, or that any rights granted
by those patents would protect our proprietary rights. Failure of any patents to
protect our technology may make it easier for our competitors to offer
equivalent or superior technology.
We have twenty registered U.S. trademarks and three pending U.S. trademark
registration applications, as well as their various foreign counterparts. We
will continue to evaluate the registration of additional trademarks as
appropriate. Despite our efforts to protect our proprietary rights, unauthorized
parties may attempt to copy aspects of our products or services, or to obtain
and use information that we regard as proprietary. Third parties may also
independently develop similar technology without breach of our proprietary
rights.
In addition, the laws of some foreign countries do not protect proprietary
rights to as great an extent as do the laws of the United States. In addition,
some on our products are licensed under end user license agreements that are not
signed by licensees. The law governing the enforceability of these "shrink wrap"
license agreement is not settled in most jurisdictions. There can be no
guarantee that we would achieve success in enforcing one or more shrink wrap
license agreements if we sought to do so in a court of law.
Employees.
As of December 31, 2002, we had a total of 158 employees; 65 in sales and
marketing; 12 in customer service and manufacturing; 52 in research and
development; and 29 in finance, human resources, and information technology. Our
future success will depend in significant part on the continued service of our
key technical, sales and senior management personnel. Competition for such
personnel is intense and there can be no assurance that we can retain our key
managerial, sales and technical employees, or that we can attract, assimilate or
retain other highly qualified technical, sales and managerial personnel in the
future. None of our employees are represented by a labor union. We have not
experienced any work stoppages and consider our relations with our employees to
be good.
Item 2. Properties.
Our principal administrative, sales and marketing, research and
development and customer support facilities are located in approximately 75,000
square feet of office space in Rockville, Maryland, that we occupy under leases
that expire in December 2006. A third party currently occupies approximately
21,000 square feet of this space under a sublease that expires in December 2003.
Item 3. Legal Proceedings.
In July, August and September 2000, several purported class action
complaints were filed against us and certain former executives (collectively,
the "defendants"). These complaints were combined into a single consolidated
amended complaint (the "complaint"). The complaint alleged that between February
7, 2000 and August 23, 2000, the defendants made false and misleading
statements, which had the effect of inflating the market price of our stock, in
violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. On
August 20, 2002, United States District Judge Deborah K. Chasanow entered an
order in the United States District Court for the District of Maryland
dismissing the complaint. On September 17, 2002, the plaintiffs appealed the
District Court's decision to the United States Court of Appeals for the Fourth
Circuit. On December 30, 2002, the appeal was dismissed by the United States
Court of Appeals for the Fourth Circuit. This decision ends the matter.
We are periodically a party to disputes arising from normal business
activities including various employee-related matters. In the opinion of
management, resolution of these matters will not have a material adverse effect
upon our financial position or future operating results.
14
Item 4. Submission of Matters to a Vote of Security Holders.
None.
PART II
Item 5. Market for Our Common Stock and Related Stockholder Matters.
On May 28, 2002, our common stock began to trade on the Nasdaq SmallCap
Market under the symbol "VNWK." Prior to May 28, 2002, our common stock traded
on the Nasdaq National Market. The following table sets forth, for the indicated
periods, the range of high and low closing per share sales prices for the common
stock as reported on the Nasdaq National Market and the Nasdaq SmallCap Market.
High Low
----- -----
2001
First Quarter ................................. $6.53 $2.50
Second Quarter ................................ 8.75 3.03
Third Quarter ................................. 8.61 2.12
Fourth Quarter ................................ 4.62 1.77
2002
First Quarter ................................. $4.94 $2.94
Second Quarter ................................ 2.97 1.13
Third Quarter ................................. 1.50 0.69
Fourth Quarter ................................ 1.84 0.65
2003
First Quarter (from January 1, 2003 through
March 21, 2003) .............................. $2.07 $1.40
On March 21, 2003, the last reported sale price of our common stock was
$1.69 per share. As of March 21, 2003, we had approximately 511 stockholders of
record.
We have never paid or declared any cash dividends on our common stock. It
is our present policy to retain cash flow from operations, if any, to finance
the growth and development of the business and, therefore, we do not anticipate
declaring or paying cash dividends on our common stock in the foreseeable
future.
15
Item 6. Selected Consolidated Financial Data.
The selected consolidated financial data below should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" and the consolidated financial statements, notes
thereto and other financial information included elsewhere in this Form 10-K.
The selected consolidated financial data for the years ended December 31, 2000
and 2001 is derived from our consolidated financial statements for those
periods, which were audited by Arthur Andersen LLP, an independent public
accounting firm which has ceased operations. The selected consolidated financial
data for the year ended December 31, 2002 is derived from our consolidated
financial statements for that period, which have been audited by
PricewaterhouseCoopers LLP, independent public accountants. The selected
consolidated financial data for the years ended December 31, 1998 and 1999 is
derived from our audited consolidated financial statements not included in this
Form 10-K.
Years Ended December 31,
-------------------------------------------------------------
1998 1999 2000 2001 2002
-------- -------- --------- -------- --------
(in thousands, except per share data)
Consolidated Statement of Operations Data:
Revenue .......................................... $ 56,088 $ 91,719 $ 89,041 $ 74,248 $ 61,461
Cost of revenue .................................. 20,829 30,888 32,515 29,431 17,205
-------- -------- --------- -------- --------
Gross profit ................................. 35,259 60,831 56,526 44,817 44,256
-------- -------- --------- -------- --------
Operating expenses:
Research and development ..................... 13,771 16,677 27,277 19,320 12,301
Write-off of in process research and
development(1) ............................. -- -- 39,000 -- --
Sales and marketing .......................... 19,759 24,447 41,907 33,484 20,541
General and administrative ................... 5,528 7,928 11,247 8,895 6,821
Merger-related costs(2) ...................... 4,318 6,776 -- -- --
Restructuring and impairment charges(3)(4) ... 751 -- 335,810 9,328 --
Amortization of acquired intangibles(1) ...... -- -- 53,426 805 --
-------- -------- --------- -------- --------
Total operating expenses ................ 44,127 55,828 508,667 71,832 39,663
-------- -------- --------- -------- --------
Income (loss) from operations .................... (8,868) 5,003 (452,141) (27,015) 4,593
Interest income (expense), net ................... 2,413 2,270 2,598 325 (1,187)
-------- -------- --------- -------- --------
Income (loss) before income taxes ................ (6,455) 7,273 (449,543) (26,690) 3,406
Benefit (provision) for income taxes ............. -- (3,722) 34,058 (272) --
-------- -------- --------- -------- --------
Net income (loss) ................................ (6,455) 3,551 (415,485) (26,962) 3,406
Dividends and accretion on preferred stock ....... (171) -- -- -- --
-------- -------- --------- -------- --------
Net income (loss) attributable to common
stockholders ................................... $ (6,626) $ 3,551 $(415,485) $(26,962) $ 3,406
======== ======== ========= ======== ========
Basic earnings (loss) per share .................. $ (0.30) $ 0.14 $ (14.46) $ (0.85) $ 0.11
======== ======== ========= ======== ========
Diluted earnings (loss) per share ................ $ (0.30) $ 0.13 $ (14.46) $ (0.85) $ 0.11
======== ======== ========= ======== ========
Basic weighted-average shares(5) ................. 21,946 24,583 28,733 31,585 32,139
======== ======== ========= ======== ========
Diluted weighted-average shares(5) ............... 21,946 26,547 28,733 31,585 32,434
======== ======== ========= ======== ========
Consolidated Balance Sheet Data:
Cash and cash equivalents ........................ $ 51,655 $ 54,629 $ 17,369 $ 5,921 $ 12,708
Working capital .................................. 43,146 50,353 (2,482) (6,576) 10,341
Total assets ..................................... 71,780 83,154 74,057 28,902 30,759
Long-term debt, net of current portion(6) ........ 1,011 782 243 -- 7,963
Stockholders' equity (deficit) ................... 48,322 58,252 26,085 (515) 6,627
(1) In 2000, we acquired Avesta Technologies, Inc. ("Avesta") in a purchase
business combination. The purchase price allocation included $39.0 million
of in-process technology, which was expensed as of the acquisition date.
The amortization of acquired intangibles in 2000 and 2001 relates to
goodwill and other intangible assets recorded in connection with the
Avesta acquisition. See Notes 1 and 6 of Notes to Consolidated Financial
Statements.
(2) In 1998, we incurred certain merger-related costs in connection with our
acquisition of Net2Net Corporation ("Net2Net"). In 1999, we incurred
certain merger-related costs in connection with our acquisition of Inverse
Network Technology ("Inverse").
(3) In 1998, we recorded a restructuring charge related to the consolidation
of certain functions and the discontinuation of certain
16
product development efforts related to the acquisition of Net2Net. In
2000, we recorded a restructuring charge of $7.0 million that consisted
primarily of severance and other termination benefits related to a
workforce reduction and lease costs and associated leasehold improvement
write-offs related to the closure of certain facilities. In the second
quarter of 2001, we reversed $0.7 million of the restructuring charge
recorded in the fourth quarter of 2000, primarily as a result of lower
than estimated lease costs. In the second quarter of 2001, we also
recorded a restructuring charge of $3.9 million that consisted primarily
of employee termination costs including severance and other benefits,
lease costs and associated leasehold improvement write-offs related to the
closure of certain facilities resulting from the discontinuation of the
Visual Trinity product, other contractual obligations and the write-off of
an investment. During the fourth quarter of 2001, we reversed $1.2 million
of the restructuring charge recorded in the second quarter of 2001 due to
lower than estimated facility closure costs and other contractual
obligations. During the fourth quarter of 2001, we also recorded a
restructuring charge of $0.4 million that consisted of severance and other
termination benefits related to a workforce reduction. See Notes 1 and 7
of Notes to Consolidated Financial Statements.
(4) In 2000, we recorded an impairment charge of $328.8 million for the
write-off of goodwill and other intangibles related to the acquisition of
Avesta. In 2001, we recorded an impairment charge of $7.0 million related
to all of the remaining intangible assets from the Avesta acquisition
based on the discontinuation of the Visual Trinity product and plans for
the Visual eWatcher product. The impairment charge also included the
write-off of an investment of $3.7 million. See Notes 1, 6 and 7 of Notes
to Consolidated Financial Statements.
(5) For an explanation of the determination of the weighted-average number of
shares used in computing earnings (loss) per share amounts. See Note 1 of
Notes to Consolidated Financial Statements.
(6) In 2002, we issued senior secured convertible debentures in the amount of
$10.5 million that become due in March 2006. See Note 3 of Notes to
Consolidated Financial Statements.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
The following discussion of our financial condition and results of
operations should be read in conjunction with our consolidated financial
statements, the related notes thereto, and other financial information included
elsewhere in this Form 10-K. References to "we", "us" or "our" refer to Visual
Networks, Inc. on a consolidated basis.
Overview
From our incorporation in August 1993 through December 1996, our principal
objective was to secure sufficient equity financing to enable us to accelerate
product development efforts of Visual UpTime for frame relay deployment and
create the corporate infrastructure necessary to support these efforts. We first
shipped Visual UpTime in mid-1995 and began generating significant revenue
during 1996. Since our inception, we have focused on establishing relationships
with service providers with the goal of having these service providers include
our products into their infrastructure or in their service offerings to their
subscribers. Consistent with this goal, we have established agreements with
major service providers such as: AT&T, BellSouth, Earthlink, Equant, SBC,
Sprint, Verizon and WorldCom. During 1998, 1999 and 2000, we continued to focus
on selling Visual UpTime and added to our product portfolio as a result of a
series of acquisitions -- the Net2Net product, CellTracer, in 1998; the Inverse
products, Visual IP InSight and Visual Internet Benchmark, in 1999; and the
Avesta products, Visual Trinity and Visual eWatcher, in 2000. During 2001, we
discontinued development and sales efforts of Visual Trinity and sold the Visual
Internet Benchmark service. In 2002, the remaining customer for our CellTracer
product, Network Associates, placed what they indicated would be final orders.
Also, in 2002, we continued to evaluate the future of the Visual eWatcher and
CellTracer products. In their current form, neither product produced significant
revenue for the year ended December 31, 2002. We believe that the technology of
both products may be useful to other products in the future and we are exploring
alternatives for these products. However, we decided not to focus our
development or sales efforts on these products in 2003. Therefore, we do not
anticipate any significant revenue from these products during 2003. We continue
to focus our sales efforts on Visual UpTime and Visual IP InSight.
We acquired Avesta Technologies, Inc. (Avesta) on May 24, 2000. We
believed that the acquisition of Avesta would provide critical pieces to our
strategy to become one of the largest network performance management vendors
with one of the industry's broadest portfolios of products and functionality. We
also anticipated that the merger would bring us closer to providing a
single-vendor solution to the internet infrastructure management needs of
customers, especially our intended integration of networks, systems and
applications into a unified service view for service providers and their
enterprise subscribers. We expected to generate revenue from the Avesta products
of approximately $30 million in 2000. Instead, these products generated revenue
of only $7.3 million in
17
2000, and significantly increased our operating expenses. Subsequent to the
acquisition, we concluded that, without significant modifications, the primary
Avesta product, Trinity, was not a viable solution for our strategic service
provider customers. The product was more specifically targeted to direct
enterprise customers, which did not fit with our service provider focused
business plan. As a result of an analysis performed in early 2001 by a
company-wide task force, we determined that the time and expense required to
make the Visual Trinity product competitive in its market space and more
suitable to our service provider customers would be prohibitive. These factors,
in conjunction with revenue declines in our other products, resulted in a $328.8
million impairment charge and $7.0 million in restructuring charges in 2000. In
2001, we discontinued the Visual Trinity product, resulting in $3.3 million in
additional impairment charges related to the remaining intangible assets from
the Avesta acquisition, $3.7 million in a write-down related to an investment
that was acquired with Avesta that was determined to be impaired as of December
31, 2001 and $2.3 million (net of reversals) in restructuring charges. We did
not have any significant remaining assets related to Avesta included in our
balance sheet as of December 31, 2001 or 2002.
Following the acquisition of Avesta, we allowed our business strategy to
become less focused, which increased the complexity of our business and
adversely affected our results of operations. We incurred significant losses
from the second quarter of 2000 through the fourth quarter of 2001. The
deterioration of our operating results that began in 2000, excluding the effects
of the impairment and restructuring charges and the write-off of in-process
research and development, was due primarily to decreased revenue and increased
operating expenses following the Avesta acquisition. In response, we made
significant reductions in operating expenses in the remainder of 2000, 2001 and
2002 by closing three facilities and by reducing our workforce by approximately
290 employees from October 2000 through December 2002, including approximately
60 of whom were terminated during 2002.
Despite the growth of data networking, 2002 was a challenging year as our
customers continued reducing spending. One of our most significant customers,
WorldCom, filed Chapter 11 bankruptcy in July 2002. Even with the bankruptcies
of WorldCom and a number of emerging service providers, and the general economic
downturn of the telecommunications market, we were able to achieve
profitability, limit our accounts receivable losses and maintain our cash
balances. This was accomplished due primarily to the following factors:
o Our business is not related to the build-out of
telecommunications infrastructure, but rather is tied to the
sale and deployment of data networking services to
enterprises;
o In March 2002, we issued $10.5 million in convertible
debentures to improve our cash position;
o Throughout 2002, we significantly reduced operating expenses
and realigned them with our lower revenue expectations.
Research and development expense, sales and marketing expense
and general and administrative expense declined from $61.7
million in 2001 to $39.7 million in 2002; and
o In July 2002, we executed an agreement, later amended, with
WorldCom that stipulated payment terms while WorldCom is in
bankruptcy, enabling us to continue to sell our products to
WorldCom during its restructuring period. We generated $6.3
million in revenue from WorldCom during 2002, and incurred
$0.7 million in bad debts. We cannot assure you that we will
continue to generate this level of revenue from sales of our
products to WorldCom during 2003.
We returned to profitability for the three months ended March 31, 2002 and
have remained profitable since then. However, we have continued to experience
declining revenue from $74.2 million for the year ended December 31, 2001 to
$61.5 million for the year ended December 31, 2002, including a reduction in the
sale of each of our major products. Visual UpTime revenue decreased by $5.8
million due to a decrease in demand reflecting: 1) the overall downturn in the
telecommunications industry, which was reflected in a slowdown in demand for
telecommunications products and services, including those based on our products;
2) tighter inventory control at our service provider customers, specifically
AT&T; and 3) the loss of business to competitors. Revenue from the Visual IP
InSight product decreased $0.6 million resulting from decreased demand due to
the bankruptcies of many of the new Internet Service Providers ("ISPs") that
were our primary targets for Visual IP InSight. In addition, revenue from the
Visual IP InSight product often fluctuates significantly from year to year due
to the sizeable orders from a limited number of service providers that we are
dependent upon for sales of that product. Such fluctuations can also
significantly affect our gross margin percentage because our software costs of
revenue are so insignificant. The $6.9 million decrease in revenue from Visual
Internet Benchmark, Visual Trinity, Visual eWatcher and CellTracer reflects,
respectively, the sale of Visual Internet Benchmark and the discontinuation of
sales of Visual Trinity, Visual eWatcher and CellTracer.
We have refocused our sales, marketing and other efforts on our core
Visual UpTime and Visual IP InSight products, our core service provider
customers and service creation over resale to end users. We have directed our
Visual IP InSight development efforts at making the product more suitable for
our core service provider customers and enabling the use of our product in
higher-margin broadband networks over, for
18
example, cable lines and Digital Subscriber Lines (DSL). We have also
aggressively reduced our operating expenses to be more in line with our reduced
revenue projections. While we do not know when the downturn in
telecommunications industry will end, or how robust the recovery will be once or
if it does begin, we have revised our business plan to reflect lower projected
revenue and reduced our operating expenses as we seek to remain profitable even
with this reduced demand. There can be no assurance that we will remain
profitable.
Based on our current cost structure, including changes made during the
fourth quarter of 2002, our ability to generate net income in the future is, in
large part, dependent on our success in achieving quarterly revenue of at least
$13.0 million, achieving quarterly gross margins of 70% to 75% and maintaining
or further reducing operating expenses. Due to market conditions, competitive
pressures, and other factors beyond our control, there can be no assurances that
we will be able to meet these goals. In the event that the anticipated revenue
goals are not met, we may not be profitable and we may be required to further
reduce our cost structure.
Results of Operations
The following table presents certain consolidated statement of operations
data as a percentage of our revenue:
Years Ended December 31,
------------------------------
2000 2001 2002
------ ------ ------
Revenue:
Hardware ................................................ 73.6% 69.8% 68.4%
Software ................................................ 11.4 8.4 11.2
Support and services .................................... 15.0 21.8 20.4
------ ------ ------
Total revenue .......................................... 100.0 100.0 100.0
------ ------ ------
Cost of revenue:
Product ................................................. 28.0 29.3 24.6
Support and services .................................... 8.5 10.3 3.4
------ ------ ------
Total cost of revenue .................................. 36.5 39.6 28.0
------ ------ ------
Gross profit .............................................. 63.5 60.4 72.0
------ ------ ------
Operating expenses:
Research and development ............................. 30.6 26.0 20.0
Write-off of in-process research and development ..... 43.8 -- --
Sales and marketing .................................. 47.1 45.0 33.4
General and administrative ........................... 12.6 12.0 11.1
Restructuring and impairment charges ................. 377.2 12.6 --
Amortization of acquired intangibles ................. 60.0 1.1 --
------ ------ ------
Total operating expenses ........................ 571.3 96.7 64.5
------ ------ ------
Income (loss) from operations ............................. (507.8) (36.3) 7.5
Interest income (expense), net ............................ 2.9 0.4 (2.0)
------ ------ ------
Net income (loss) before income taxes ..................... (504.9) (35.9) 5.5
Benefit (provision) for income taxes ...................... 38.3 (0.4) --
------ ------ ------
Net income (loss) ......................................... (466.6)% (36.3)% 5.5%
====== ====== ======
The following table presents revenue by product (in thousands):
Years Ended December 31,
-----------------------------
2000 2001 2002
------- ------- -------
Visual UpTime ........................ $59,754 $55,557 $49,797
Visual IP InSight .................... 9,466 8,095 7,477
------- ------- -------
Continuing product revenue ..... 69,220 63,652 57,274
------- ------- -------
Visual Internet Benchmark ............ 4,607 4,025 814
Visual Trinity and eWatcher .......... 7,268 3,591 699
CellTracer ........................... 7,946 2,980 2,232
------- ------- -------
Discontinued product revenue ... 19,821 10,596 3,745
------- ------- -------
Royalties ...................... -- -- 442
------- ------- -------
Total revenue .................. $89,041 $74,248 $61,461
======= ======= =======
19
The following table presents revenue attributable to customers that
individually represented more than 10% of our total revenue (in thousands):
Years Ended December 31,
-----------------------------
2000 2001 2002
------- ------- -------
AT&T ...................................................... $17,500 $21,689 $20,753
Sprint .................................................... 16,263 10,159 6,356
Verizon ................................................... * * 6,893
WorldCom .................................................. 12,263 7,598 6,319
All other customers (each individually less than 10%) ..... 43,015 34,802 21,140
------- ------- -------
Total revenue ........................................... $89,041 $74,248 $61,461
======= ======= =======
* Less than 10%.
Our primary sales and marketing strategy depends predominantly on sales of
Visual UpTime and Visual IP InSight to telecommunications service providers.
Service providers use our products as operations tools in their own network
infrastructures,base value-added services on our products and resell our
products to their customers. Pressure on capital expenditures and the decline in
the telecommunications markets may delay the rollout of new services based on
our products. Furthermore, any potential reduction in demand for value-added
services or products from the service providers' customers would directly impact
the volume of our products purchased.
We expect that a significant portion of our revenue in 2003 will be
attributable to sales of Visual UpTime and Visual IP InSight to service
providers. The loss of any one of AT&T, Sprint or WorldCom, which together have
historically provided a majority of our revenue, would result in a substantial
loss of revenue that could have a material adverse effect on our business. For
the year ended December 31, 2002, AT&T, Sprint and WorldCom represented 34%, 10%
and 10%, respectively, our consolidated revenue. Revenue related to all service
providers represented 70%, 77%, and 82% of our consolidated revenue for the
years ended December 31, 2000, 2001 and 2002, respectively. This concentration
should continue because our customer base consists predominantly of service
providers. Existing service provider customers are not easily replaced because
of the relatively few participants in that market. High barriers to entry due to
extraordinary capital requirements and the increased possibility that existing
service providers may merge or fail because of the current downturn in the
telecommunications industry, may further reduce their number and make replacing
a significant network service provider customer very difficult in the future.
Furthermore, the small number of network service providers means that the
reduction, delay or cancellation of orders or a delay in shipment of our
products to any one service provider customer could have a material adverse
effect on our revenue for a quarter. Our anticipated dependence on sizable
orders from a limited number of service provider customers will make the
relationship between us and each service provider critically important to our
business. Further, because none of our agreements contain minimum purchase
requirements, there can be no assurance that the issuance of a purchase order
will result in significant recurring business.
2002 Compared with 2001
Revenue.
Our revenue can be divided into three types: hardware, software, and
support and services. Each of our products has components of each revenue type.
Sales of Visual UpTime are primarily classified as hardware revenue. We also
sell licenses related to Visual UpTime that are classified as software revenue.
Sales of Visual IP InSight are primarily classified as software revenue.
However, sales of our newest hardware product, the IP Service Element (ISE),
which embeds certain Visual IP InSight functionality in a hardware device, are
classified as hardware revenue. Sales of Visual eWatcher, prior to
discontinuation in 2002, are classified as software revenue. Sales of Visual
Trinity, prior to discontinuation in May 2001, were classified as software
revenue. Sales of our Visual IP InSight subscription service, which we no longer
offer to our customers, were classified as support and services revenue. Sales
of the Visual Internet Benchmark service, prior to sale of that product in June
2001, were classified as support and services revenue. Royalties from the Visual
Internet Benchmark service are classified as support and services revenue. Sales
of CellTracer are classified as hardware revenue. Sales of technical support,
professional services and training for all of our products are classified as
support and services revenue.
Total revenue was $74.2 million in 2001 compared to $61.5 million in 2002,
a decrease of $12.7 million. Sales to all service providers increased from
approximately 77% of revenue in 2001 to 82% in 2002. We anticipate that the
percentage of revenue attributable to our service providers for 2003 will be
consistent with the levels achieved during 2002.
Hardware revenue. Hardware revenue was $51.9 million in 2001 compared to
$42.1 million in 2002, a decrease of $9.8 million.
20
The decrease was due primarily to a decrease in demand for Visual UpTime from
AT&T, Sprint and WorldCom. We believe, in general, that the decrease in demand
for Visual UpTime was primarily the result of the overall downturn in the
telecommunications industry, which was reflected in a slowdown in demand for
telecommunications products and services and reduced spending. More
specifically, we believe that revenue from AT&T decreased due to tighter
inventory control and revenue from Sprint and WorldCom decreased due to the loss
of market share of these customers to their competitors coupled with our loss of
business to our competitors. We do not believe that the recent events at
WorldCom had a significant impact on our revenue from WorldCom for 2002.
However, there is a risk that WorldCom's bankruptcy could adversely affect our
future revenue. The decrease was also due to decreased revenue from CellTracer
of $1.5 million due to decreased demand from NAI.
Software revenue. Software revenue was $6.2 million in 2001 compared to
$6.9 million in 2002, an increase of $0.7 million. The increase in software
revenue was due primarily to an increase of $0.9 million in licenses for Visual
UpTime resulting from Kentrox licenses, Cisco licenses and other license
upgrades for Visual UpTime. In addition, even though total Visual IP InSight
revenue decreased in 2002, license revenue related to that product increased by
$0.3 million. This increase is due to more license sales that replaced the sale
of the Visual IP InSight subscription service in 2002 following the
discontinuation of our subscription service. Since 2001, we sell Visual IP
InSight as a software license only. Prior to September 30, 2001, we offered both
a subscription service and software licenses for that product. These combined
increases are offset by decreases in license revenue of $0.5 million from Visual
Trinity and Visual eWatcher following the discontinuation of those products.
Support and services revenue. Support and services revenue was $16.1
million in 2001 and $12.5 million in 2002, a decrease of $3.6 million. The
decrease in support and services revenue was due primarily to decreased revenue
from the Visual Trinity product, Visual eWatcher product and Visual Internet
Benchmark service of $4.9 million due to expired contracts that have not renewed
as a result of the discontinuation of these products. Subscription fees for
Visual IP InSight decreased by approximately $1.9 million as customers have
migrated to a perpetual license for that product. The larger installed base of
our Visual UpTime product for which we are selling technical support and the
accelerated recognition of terminated technical support for CellTracer as a
result of the transfer of the source code to NAI offsets these combined
decreases. We will continue to recognize revenue from the Visual Internet
Benchmark service that was sold during 2001, for existing contracts under which
we are still required to perform services through May 2003, all of which is
currently in deferred revenue. We also receive royalty payments from the
purchaser on new contracts.
Cost of revenue and gross profit.
Cost of revenue consists of subcontracting costs, component parts,
warehouse costs, direct compensation costs, warranty and other contractual
obligations, royalties, license fees and other overhead expenses related to the
manufacturing operations. Product cost of revenue includes both hardware and
software cost of revenue in the accompanying consolidated statements of
operations. Cost of revenue related to software sales has not been significant.
Sup