Form 10-Q for ZHONE TECHNOLOGIES INC
12-Nov-2004
Quarterly Report
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
The following discussion and analysis should be read in conjunction with our condensed consolidated financial statements and related notes included elsewhere in this report. In addition to historical information, this report contains forward-looking statements. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those reflected in these forward-looking statements. We use words such as "anticipate", "believe", "could", "estimate", "expect", "intend", "may", "should", "will", "would" and similar expressions to identify forward-looking statements. Factors that might cause such a difference include, but are not limited to, our ability to obtain additional capital to fund our existing and future operations, the rate of product purchases by current and prospective customers, general economic conditions, conditions specific to the telecommunications and related industries, new product introductions and enhancements by us and our competitors, competition, manufacturing and sourcing risks. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties, and assumptions that are difficult to predict. Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Readers are referred to risks and uncertainties identified below, under "Risk Factors" and elsewhere herein. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.
OVERVIEW
We were founded in 1999 to offer network service providers a simplified, comprehensive architectural approach to delivering services over their access networks.
We have developed hardware and software that simplify the way network service providers deliver communication services to their subscribers. Our Single Line Multi-Service Architecture, or SLMS ™, is a simplified network architecture that provides broadband and narrowband services over a scalable next-generation local-loop infrastructure. SLMS is designed to extend the speed, reliability and cost-efficiencies currently achieved in the core of the communications network to business and consumer subscribers. Our products enable service providers to use their existing networks to deliver voice, data, video, and entertainment services to their customers. We have designed our products to interoperate with different types of wiring and equipment already deployed in service providers' networks.
Our Zhone Management System, or ZMS ™, provides the software tools necessary to manage all of the products, services and subscribers in a SLMS network. ZMS is a single management tool that enables network service providers to allow instant delivery and upgrade of network services. In addition, ZMS is capable of interfacing with and managing other vendors equipment already deployed in service providers' networks.
Our revenue consists of three product categories: SLMS, Legacy and Service, and Optical Transport. SLMS consists of our next generation, internally developed products. Legacy and Service is comprised of legacy product lines acquired in acquisitions, including the former MUX and DLC product categories and one legacy product line acquired from Sorrento, as well as service revenue. Optical Transport consists of the majority of the product lines acquired from Sorrento.
We believe that we have assembled the employee base, technological breadth and market presence to provide a simple yet comprehensive set of solutions to the complex problems encountered by network service providers when delivering communications services to subscribers.
Since inception, we have incurred significant operating losses and have an accumulated deficit of $627.6 million at September 30, 2004. The global telecommunications market has deteriorated significantly over the last several years. Many of our customers and potential customers have reduced their capital spending during this period and many others have ceased operations. Additional capital spending reductions have continued due to continued uncertainties regarding the state of the global economy, network overcapacity, customer bankruptcies, network build-out delays and limited capital availability. In response to the challenging environment, we have taken the actions that we believe are necessary for our future success. In particular, we have significantly reduced our operating costs through workforce reductions and careful cost controls. We have also taken significant write-downs of inventory, intangible assets and property and equipment. Due to our restructuring activities and careful expense controls, our net loss decreased from $108.6 million in 2002 to $17.2 million in 2003. For the nine months ended September 30, 2004, our net loss was $31.8 million. We do not expect any significant reductions in our overall workforce for at least through the period ending December 2004.
Going forward, our key objectives include the following:
• Increasing revenue while continuing to carefully control costs;
• Continued investments in strategic research and product development activities that will provide the maximum potential return on investment;
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• Minimizing consumption of our cash and short-term investments; and
• Analyzing and pursuing strategic acquisitions that will allow us to expand our customer, technology and/or revenue base.
Basis of Presentation
In November 2003, we consummated our merger with Tellium. Tellium was the surviving entity under corporate law and following the merger its name was changed to Zhone Technologies, Inc. However, due to various factors, including the relative voting rights, board control, and senior management composition of the combined company, the transaction was treated as a reverse merger for accounting purposes, and Zhone was treated as the "acquirer". As a result, the financial statements of the combined company after the merger reflect the financial results of Zhone on a historical basis after giving effect to the merger exchange ratio to historical share-related data. The results of operations for Tellium were included in the combined company's results of operations from the effective date of the merger.
In July 2002, in conjunction with our equity restructuring, our Board of Directors approved a reverse stock split of our common stock at a ratio of one-for-ten (the "Reverse Split"), causing each outstanding share of common stock to convert automatically into one-tenth of a share of common stock. As a result of the merger with Tellium, stockholders of Zhone prior to the merger received 0.47 of a share of Tellium common stock for each outstanding share of Zhone common stock, following the conversion of all outstanding shares of our preferred stock into common stock.
Stockholders' equity has been restated to give retroactive recognition to the Reverse Split and the effect of the Tellium merger for all periods presented by reclassifying the excess par value resulting from the reduced number of shares from common stock to paid-in capital. All references to preferred share, common share and per common share amounts for all periods presented have been retroactively restated to reflect the Reverse Split and the effect of the Tellium merger.
In October 2003, in response to an inquiry from the SEC, we restated our consolidated financial statements and related disclosures for the year ended December 31, 2002 and for the quarters ended June 30, 2003 and March 31, 2003. All information, discussions and comparisons in this report reflect the restatement. The restatement reflected increased non-cash stock-based compensation expense resulting from a change in the estimated fair value of our common stock from $0.21 per share to $3.19 per share. We also adjusted the Series AA redeemable preferred stock to reflect a decrease in the estimated fair value from $170.7 million to $126.5 million, or $5.81 per share to $4.31 per share as of July 1, 2002.
Acquisitions
As of September 30, 2004, we had completed eleven acquisitions of complementary companies, products or technologies to supplement our internal growth. To date, we have generated a significant amount of our revenue from sales of products obtained through acquisitions.
We are likely to acquire additional businesses, products and technologies in the future. If we complete additional acquisitions in the future, we could consume cash, incur substantial additional debt and other liabilities, incur amortization expenses related to acquired intangible assets or incur large write-offs related to impairment of goodwill and long-lived assets. In addition, future acquisitions may have a significant impact on our short term results of operations, materially impacting revenues or expenses and making period to period comparisons of our results of operations less meaningful.
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Critical Accounting Policies and Estimates
Management's discussion and analysis of its financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. The policies discussed below are considered by management to be critical because changes in such estimates can materially affect the amount of our reported net income or loss. For all of these policies, management cautions that actual results may differ materially from these estimates under different assumptions or conditions.
Revenue Recognition
We recognize revenue when the earnings process is complete. We recognize product revenue upon shipment of product under contractual terms which transfer title to customers upon shipment, under normal credit terms, or under sales-type leases, net of estimated sales returns and allowances at the time of shipment. Revenue is deferred if there are significant post-delivery obligations, if collection is not considered reasonably assured at the time of sale, or if the fees are not fixed or determinable. When significant post-delivery obligations exist, revenue is deferred until such obligations are fulfilled. Our arrangements generally do not have any significant post delivery obligations. We offer products and services such as support, education and training, hardware upgrades and extended warranty coverage. For multiple element revenue arrangements, we establish the fair value of these products and services based primarily on sales prices when the products and services are sold separately. When collectibility is not reasonably assured, revenue is recognized when cash is collected. Revenue from education services and support services is recognized over the contract term or as the service is performed. We make certain sales to product distributors. These customers are given certain privileges to return a portion of inventory. We recognize revenue on sales to distributors that have contractual return rights when the products have been sold by the distributors, unless there is sufficient customer specific sales and sales return history to support revenue recognition upon shipment. Revenue from sales of software products is recognized provided that a purchase order has been received, the software has been shipped, collection of the resulting receivable is probable, and the amount of the related fees is fixed or determinable. To date, revenue from software transactions and sales-type leases has not been significant. We accrue for warranty costs, sales returns, and other allowances at the time of shipment based on historical experience and expected future costs. In the event that our actual costs and sales returns exceeded our estimates, our revenue and gross margins would be adversely affected.
Allowances for Sales Returns and Doubtful Accounts
We record an allowance for sales returns for estimated future product returns related to current period product revenue. The allowance for sales returns is recorded as a reduction of revenue and an allowance against our accounts receivable. We base our allowance for sales returns on periodic assessments of historical trends in product return rates and current approved returned products. If the actual future returns were to deviate from the historical data on which the reserve had been established, our future revenue could be adversely affected.
We record an allowance for doubtful accounts for estimated losses resulting from the inability of customers to make payments for amounts owed to us. We base our allowance on periodic assessments of our customers' liquidity and financial condition through analysis of information obtained from credit rating agencies, financial statement reviews, and historical collection trends. Additional allowances may be required in the future if the liquidity or financial condition of our customers were to deteriorate, resulting in an impairment in their ability to make payments.
Valuation of Long-Lived Assets, including Goodwill and Other Acquisition-Related Intangible Assets
Our long-lived assets consist primarily of goodwill, other acquisition-related intangible assets and property and equipment. We review long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. Such events or circumstances include, but are not limited to, a significant decrease in the benefits realized from the acquired business, difficulty and delays in integrating the business, or a significant change in the operations of the acquired business or use of an asset. Goodwill and other acquisition-related intangible assets not subject to amortization are tested annually for impairment using a two-step approach, and are tested for impairment more frequently if events and circumstances indicate that the asset might be impaired. An impairment loss is recognized to the extent that the carrying amount exceeds the asset's fair value.
We estimate the fair value of our long-lived assets based on a combination of the market, income and replacement cost approaches. In the application of the impairment testing, we are required to make estimates of future operating trends and resulting cash flows and judgments on discount rates and other variables. Actual future results and other assumed variables could differ from these estimates.
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As of September 30, 2004 we have $157.8 million of goodwill, $20.7 million of other acquisition-related intangible assets and $23.2 million of property and equipment. Other acquisition-related intangible assets are comprised mainly of purchased developed technology and customer relationships. Many of the entities acquired by us do not have significant tangible assets; as a result, a significant portion of the purchase price is typically allocated to intangible assets and goodwill. Our future operating performance will be impacted by the future amortization of intangible assets, potential charges related to purchased in-process research and development for future acquisitions, and potential impairment charges related to goodwill. Accordingly, the allocation of the purchase price of the acquired companies to intangible assets and goodwill has a significant impact on our future operating results. The allocation process requires management to make significant estimates and assumptions, including estimates of future cash flows expected to be generated by the acquired assets and the appropriate discount rate for these cash flows. Should different conditions prevail, we would have to perform an impairment review that might result in material write-downs of intangible assets and/or goodwill. Other factors we consider important which could trigger an impairment review, include, but are not limited to, significant changes in the manner of use of our acquired assets, significant changes in the strategy for our overall business or significant negative economic trends. If this evaluation indicates that the value of an intangible asset or long-lived asset may be impaired, an assessment of the recoverability of the net carrying value of the asset over its remaining useful life is made. If this assessment indicates that the cost of an intangible asset or long-lived asset is not recoverable, based on the estimated undiscounted future cash flows or other comparable market valuations of the entity or technology acquired over the remaining amortization or depreciation period, the net carrying value of the related intangible asset or long-lived asset will be reduced to fair value and the remaining amortization or depreciation period may be adjusted. For example, we recorded significant impairment charges during 2001, including $41.7 million related to goodwill and other acquired intangibles. In addition, in the fourth quarter of 2002, we recorded approximately $50.8 million of impairment in property, plant and equipment and other assets. Due to uncertain market conditions and potential changes in our strategy and product portfolio, it is possible that forecasts used to support our intangible assets may change in the future, which could result in additional non-cash charges that would adversely affect our results of operations and financial condition.
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RESULTS OF OPERATIONS
We list in the tables below the historical condensed consolidated statement of
operations data as a percentage of revenue for the periods indicated.
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------ ---------------------
2004 2003 2004 2003
------- ------- ------- ----
Net revenue 100 % 100 % 100 % 100 %
Cost of revenue 58 % 55 % 57 % 55 %
------- ---- ------- -- ------- ---- ---- --
Gross profit 42 % 45 % 43 % 45 %
Operating expenses:
Research and product development 21 % 25 % 25 % 26 %
Sales and marketing 25 % 20 % 24 % 22 %
General and administrative 13 % 5 % 13 % 5 %
Purchased in-process research and
development 9 % 0 % 12 % 0 %
Litigation settlement 0 % 7 % 0 % 3 %
Stock-based compensation 1 % 4 % 2 % (1 )%
Amortization and impairment of intangible
assets 11 % 9 % 11 % 10 %
------- ---- ------- -- ------- ---- ---- --
Total operating expenses 80 % 70 % 87 % 65 %
------- ---- ------- -- ------- ---- ---- --
Operating loss (38 )% (25 )% (44 )% (20 )%
Other income (expense), net (3 )% (4 )% (2 )% (3 )%
------- ---- ------- -- ------- ---- ---- --
Loss before income taxes (41 )% (29 )% (46 )% (23 )%
Income tax (benefit) provision 0 % ( 14 )% 0 % ( 5 )%
------- ---- ------- -- ------- ---- ---- --
Net loss (41 )% (15 )% (46 )% (18 )%
------- ---- ------- -- ------- ---- ---- --
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Revenue
Information about our revenue for products and services for the three and nine
months ended September 30, 2004 and 2003 is summarized below (in millions):
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------------------------- -----------------------------------------
Increase Increase
2004 2003 (Decrease) % change 2004 2003 (Decrease) % change
------ ------ ------------ -------- ------ ------ ------------ --------
Products $ 24.5 $ 20.0 $ 4.5 22 % $ 63.0 $ 54.0 $ 9.0 17 %
Services 2.5 2.2 0.3 16 % 6.1 5.9 0.2 4 %
- ---- - ---- --- -------- - ---- - ---- --- --------
Total $ 27.0 $ 22.2 $ 4.8 21 % $ 69.1 $ 59.9 $ 9.2 15 %
- ---- - ---- --- -------- - ---- - ---- --- --------
Information about our revenue for North America and International markets for the three and nine months ended September 30, 2004 and 2003 is summarized below (in millions):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------------------ ------------------------------------------
Increase Increase
2004 2003 (Decrease) % change 2004 2003 (Decrease) % change
------ ------ ----------- -------- ------ ------ ----------- --------
North America $ 19.3 $ 20.4 $ (1.1 ) (5 )% $ 54.2 $ 54.8 $ (0.6 ) (1 )%
International 7.7 1.8 5.9 321 % 14.9 5.1 9.8 195 %
- ---- - ---- -- -------- - - ---- - ---- -- -------- -
Total $ 27.0 $ 22.2 $ 4.8 21 % $ 69.1 $ 59.9 $ 9.2 15 %
- ---- - ---- -- -------- - - ---- - ---- -- -------- -
Information about our revenue by product line for the three and nine months ended September 30, 2004 and 2003 is summarized below (in millions):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------------------------ ------------------------------------------
Increase Increase
2004 2003 (Decrease) % change 2004 2003 (Decrease) % change
------ ------ ----------- -------- ------ ------ ----------- --------
SLMS $ 5.6 $ 4.4 $ 1.2 26 % $ 19.6 $ 14.4 $ 5.2 36 %
Legacy and Service 17.2 17.8 (0.6 ) (3 )% 45.3 45.5 (0.2 ) (<1 )%
Optical Transport 4.2 0.0 4.2 N/M 4.2 0.0 4.2 N/M
- ---- - ---- -- -------- - - ---- - ---- -- -------- -
$ 27.0 $ 22.2 $ 4.8 21 % $ 69.1 $ 59.9 $ 9.2 15 %
- ---- - ---- -- -------- - - ---- - ---- -- -------- -
For the three months ended September 30, 2004, revenue increased 21% or $4.8 million to $27.0 million from $22.2 million for the same period last year. For the nine months ended September 30, 2004, revenue increased 15% or $9.2 million to $69.1 million from $59.9 million for the same period last year. The increases were primarily due to stabilizing demand for our products compared to the same periods last year, and incremental revenue relating to the acquisition of Sorrento during the three months ended September 30, 2004.
Product revenue accounted for the majority of the total increase in revenue in each period, while service revenue increased modestly in each period. Revenue from international customers increased significantly in both periods of the current year, while revenue from North American customers declined modestly in each period. International revenue represented 29% and 22% of total revenue for the three and nine months ended September 30, 2004, respectively, as compared to 8% of revenue for both the three and nine months ended September 30, 2003. The significant increase in international revenue in each period reflects the increasing opportunity for our next generation products in greenfield deployments at international carriers, whereas the North American market is more mature and currently consists primarily of sales of legacy type products and services.
Revenue for our SLMS product family increased by $1.2 million, or 26% for the three months ended September 30, 2004 and by $5.2 million, or 36% for the nine months ended September 30, 2004 as compared to the same periods last year, respectively. Revenue for our Legacy and Service product family, which includes the former MUX and DLC product categories, decreased by $0.6 million, or 3% in the three months ended September 30, 2004 and $0.2 million, or less than 1% in the nine months ended September 30, 2004 as compared to the same periods last year, respectively. Revenue for our Optical Transport product family was $4.2 million for the three and nine months ended September 30, 2004. There was no Optical Transport product family revenue for either period in the prior year.
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