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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2000
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: 000-28843
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TURNSTONE SYSTEMS, INC.
(Exact name of Registrant as specified in its charter)
DELAWARE 77-0473640
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
2220 CENTRAL EXPRESSWAY
SANTA CLARA, CALIFORNIA 95050
(Address of principal executive offices, including zip code)
(408) 907-1400
(Registrant's telephone number, including area code)
274 FERGUSON DRIVE, MOUNTAIN VIEW, CALIFORNIA 94043
(Former name, former address and former fiscal year,
if changed since last report)
----------------------------------
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 [ ]
There were 30,560,559 shares of the Company's Common Stock, par value
$.001, outstanding on July 31, 2000.
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TURNSTONE SYSTEMS, INC.
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION PAGE NO.
------- --------------------- --------
<S> <C> <C>
Item 1. Financial Statements (Unaudited)
Condensed Balance Sheets as of June 30, 2000
and December 31, 1999............................................ 3
Condensed Statements of Operations for the Three and Six Months
Ended June 30, 2000 and 1999..................................... 4
Condensed Statements of Cash Flows for the Six
Months Ended June 30, 2000 and 1999.............................. 5
Notes to Condensed Financial Statements.............................. 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations............................................ 10
Item 3. Quantitative and Qualitative Disclosures About Market Risk........... 23
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.................................................... 24
Item 2. Changes in Securities and Use of Proceeds............................ 24
Item 3. Default Upon Senior Securities....................................... 25
Item 4. Submission of Matters to Vote for Securities Holders................. 25
Item 5. Other Information.................................................... 26
Item 6. Exhibits and Reports on Form 8-K..................................... 26
Signatures.......................................................................... 27
</TABLE>
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TURNSTONE SYSTEMS, INC.
CONDENSED BALANCE SHEETS
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
2000 1999
--------- ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 55,254 $ 8,063
Short-term investments 49,509 --
Accounts receivable, net 20,186 6,439
Inventory 9,665 2,939
Prepaid expenses and other current assets 4,163 599
--------- ---------
Total current assets 138,777 18,040
Property and equipment, net 2,256 1,085
Restricted cash 3,639 --
Other assets 207 132
--------- ---------
Total assets $ 144,879 $ 19,257
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current obligations under capital leases $ 221 $ 229
Accounts payable 10,352 783
Accrued compensation and benefits 2,637 920
Income tax payable 2,610 --
Customer deposits 905 1,328
Other current liabilities and accrued expenses 2,422 1,679
Deferred revenue 3,770 2,132
--------- ---------
Total current liabilities 22,917 7,071
Long-term obligations under capital leases, net of current portion 125 260
Other long-term liabilities 35 35
--------- ---------
Total liabilities 23,077 7,366
--------- ---------
Stockholders' equity:
Convertible preferred stock -- 30
Common stock, $.001 stated value, 200,000 shares authorized;
60,752 and 22,814 shares issued and outstanding at
June 30, 2000 and December 31, 1999, respectively 60 23
Additional paid-in capital 123,363 26,520
Deferred stock compensation (10,246) (9,701)
Accumulated other comprehensive loss (31) --
Retained earnings (accumulated deficit) 8,656 (4,981)
--------- ---------
Total stockholders' equity 121,802 11,891
--------- ---------
Total liabilities and stockholders' equity $ 144,879 $ 19,257
========= =========
</TABLE>
The accompanying notes are an integral part of the financial statements.
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TURNSTONE SYSTEMS, INC.
CONDENSED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
<TABLE>
<CAPTION>
THE THREE MONTHS ENDED THE SIX MONTHS ENDED
JUNE 30, JUNE 30,
-----------------------------------------------------
2000 1999 2000 1999
-----------------------------------------------------
<S> <C> <C> <C> <C>
Net revenues $ 41,053 $ 4,719 $ 64,160 $ 5,671
Cost of revenues 17,076 2,510 25,832 3,086
-------- -------- -------- --------
Gross profit 23,977 2,209 38,328 2,585
Operating expenses:
Research and development (Exclusive of non-cash compensation of
$1,073 and $200 for the three months ended June 30, 2000 and
1999 and $2,131 and $229 for the six months ended June 30,
2000 and 1999, respectively) 3,622 1,023 6,350 1,853
Sales and marketing (Exclusive of non-cash compensation of
$551 and $107 for the three months ended June 30, 2000 and
1999 and $1,052 and $169 for the six months ended June 30,
2000 and 1999, respectively) 3,635 821 5,713 1,329
General and administrative (Exclusive of non-cash compensation of
$372 and $879 for the three months ended June 30, 2000 and
1999 and $631 and $885 for the six months ended June 30, 2000
and 1999, respectively) 1,113 308 1,896 499
Amortization of deferred stock compensation 1,996 1,186 3,814 1,283
-----------------------------------------------------
Total operating expenses 10,366 3,338 17,773 4,964
-----------------------------------------------------
Operating income (loss) 13,611 (1,129) 20,555 (2,379)
Interest income (expense) and other, net 1,475 41 2,393 83
-----------------------------------------------------
Income (loss) before income tax 15,086 (1,088) 22,948 (2,296)
Income tax expense (6,034) -- (9,311) --
-----------------------------------------------------
Net income (loss) 9,052 (1,088) 13,637 (2,296)
Basic net earnings (loss) per share of common stock $ .18 $ (.14) $ .31 $ (.34)
Diluted net earnings (loss) per share of common stock $ .14 $ (.14) $ .21 $ (.34)
Weighted-average shares of common stock outstanding used in
computing basic net earnings (loss) per share 51,344 7,578 44,108 6,800
Weighted-average shares of common stock outstanding used in
computing diluted net earnings (loss) per share 65,632 7,578 64,234 6,800
</TABLE>
The accompanying notes are an integral part of the financial statements.
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TURNSTONE SYSTEMS, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
THE SIX MONTHS ENDED
JUNE 30,
-----------------------
2000 1999
-------- --------
<S> <C> <C>
OPERATING ACTIVITIES
Net income (loss) $ 13,637 $ (2,296)
Adjustments to reconcile net income (loss) to net cash provided (used) in
operating activities:
Depreciation 297 119
Amortization of deferred stock compensation 3,814 1,283
Common stock issued for services -- 13
Provision for doubtful accounts and sales returns 139 97
Gain on disposal of property and equipment (19) --
Changes in assets and liabilities:
Accounts receivable (13,886) (3,051)
Inventory (6,726) (279)
Prepaid expenses and other current assets (3,564) (92)
Accounts payable 9,569 1,038
Accrued compensation and benefits 1,717 468
Income tax payable 2,610 --
Accrued expenses and other current and long-term liabilities 743 338
Deferred revenue 1,638 700
Customer deposits (423) --
-------- --------
Net cash provided (used) in operating activities 9,546 (1,662)
INVESTING ACTIVITIES
Acquisition of property and equipment (1,487) (100)
Proceeds from disposal of property and equipment 9 --
Purchases of available-for-sale investments (57,540) --
Proceeds from sales and maturities of available-for-sale investments 8,000 --
Increase in other assets (75) (106)
Allocation to restricted cash (3,639) --
-------- --------
Net cash used in investing activities (54,732) (206)
FINANCING ACTIVITIES
Net proceeds from issuance of common stock 92,491 472
Net proceeds from issuance of convertible preferred stock -- 6,174
Principal payments of capital lease obligations (114) (71)
-------- --------
Net cash provided by financing activities 92,377 6,575
Net increase in cash and cash equivalents 47,191 4,707
Cash and cash equivalents at beginning of period 8,063 1,338
-------- --------
Cash and cash equivalents at end of period $ 55,254 $ 6,045
======== ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest 17 14
Cash paid for income tax 6,741 --
NONCASH INVESTING AND FINANCING ACTIVITIES:
Equipment purchases under capital leases -- 170
Deferred stock compensation 4,359 4,210
</TABLE>
The accompanying notes are an integral part of the financial statements.
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TURNSTONE SYSTEMS, INC.
NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS
June 30, 2000
1. Basis of Presentation
The accompanying unaudited condensed financial statements have been prepared
by Turnstone Systems, Inc., pursuant to the rules and regulations of the
Securities and Exchange Commission. Certain information and footnote
disclosures, normally included in financial statements prepared in
accordance with generally accepted accounting principles, have been
condensed or omitted pursuant to such rules and regulations. While in the
opinion of the Company, the unaudited financial statements reflect all
adjustments (consisting only of normal recurring adjustments) necessary for
a fair presentation of the financial position at June 30, 2000, the
operating results for the three and six months ended June 30, 2000 and 1999
and cash flows for the six months ended June 30, 2000 and 1999, these
financial statements and notes should be read in conjunction with the
Company's audited financial statements and notes thereto, included in the
Company's Registration Statement on Form S-1 filed with the Securities and
Exchange Commission. The condensed balance sheet at December 31, 1999 has
been derived from audited financial statements as of that date.
The results of operations for the three and six months ended June 30, 2000
and 1999 are not necessarily indicative of results that may be expected for
any other interim period or for the full fiscal year ending December 31,
2000.
During July 2000, the Board of Directors authorized a two-for-one stock
split of the Company's common stock, to be effected in the form of a stock
dividend to be paid on or about August 23, 2000 to holders of record as of
the close of business on August 9, 2000. The financial information included
in the accompanying financial statements and notes thereto have been
retroactively adjusted to give effect to this stock split.
2. Completion of Initial Public Offering
In February 2000, the Company completed its initial public offering. The
Company issued 6.9 million shares of common stock in exchange for net
proceeds of approximately $92.1 million. Upon the completion of the initial
public offering, all outstanding convertible preferred stock converted into
an aggregate of 29.7 million shares of common stock. Upon the completion of
the initial public offering, the company was authorized to issue 200,000,000
shares of common stock, $0.001 par value, and 5,000,000 shares of
undesignated preferred stock, $0.001 par value.
3. Summary of Significant Accounting Policies
Revenue Recognition
The Company recognizes revenue from product sales upon shipment, assuming
collectibility of the resulting receivable is probable. When the arrangement
with the customer includes future obligations or obtaining customer
acceptance, revenue is recognized when those obligations have been met or
customer acceptance has been received. Revenue from services and support
provided under the Company's comprehensive maintenance programs is deferred
and recognized on a straight line basis over the period of the contract.
Deferred revenue represents amounts received from customers in respect of
the comprehensive maintenance program in advance of services and support to
be provided. Revenue from
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transactions involving the Company's software application products is
accounted for in accordance with Statement of Position (SOP) 97-2, Software
Revenue Recognition, and SOP 98-9, Software Revenue Recognition with Respect
to Certain Arrangements. Accordingly, the Company recognizes revenue from
licenses of software application products provided that a purchase order has
been received, the software and related documentation have been shipped,
collection of the resulting receivable is deemed probable, and the fee is
fixed or determinable. To date, revenue from such transactions has not been
significant.
Cash Equivalents and Short-Term Investments
The Company considers all highly liquid investments with a maturity of 90
days or less when acquired to be cash equivalents. Cash equivalents as of
June 30, 2000 and December 31, 1999 consist primarily of cash on deposit
with banks, money market funds, commercial paper and government debt
securities.
The Company has adopted Statement of Financial Accounting Standards ("SFAS")
No. 115, Accounting for Certain Investments in Debt and Equity Securities.
SFAS No. 115 requires entities to classify investments in debt and equity
securities with readily determined fair values as "held-to-maturity,"
"available-for-sale" or "trading" and establishes accounting and reporting
requirements for each classification. The Company has classified its
investment securities as available-for-sale. Available-for-sale securities
are carried at fair value, which approximates amortized cost for debt
securities. Realized gains and losses are computed using the specific
identification method.
Inventory
At June 30, 2000 and December 31, 1999, inventory consisted of the following
(in thousands):
<TABLE>
<CAPTION>
JUNE 30, DECEMBER 31,
2000 1999
-------- ------------
<S> <C> <C>
Raw materials $2,296 $ 85
Finished goods 7,369 2,854
--------------------
$9,665 $2,939
--------------------
</TABLE>
4. Net Earnings (Loss) per Share
Basic and diluted net earnings (loss) per share have been computed in
accordance with SFAS No. 128, Earnings Per Share. Basic net earnings
(loss) per share is computed using the weighted-average number of
outstanding shares of common stock excluding weighted-average number of
shares of restricted stock subject to repurchase. Diluted net earnings
(loss) per share is computed using the weighted-average number of shares of
common stock outstanding and, when dilutive, shares of restricted common
stock subject to repurchase, potential shares of common stock from options
and warrants using the treasury stock method and from convertible securities
using the "as-if converted basis". The following table presents the
calculation of basic and diluted net earnings (loss) per share (in
thousands, except per share amounts):
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------------------------------------------------
2000 1999 2000 1999
---------------------------------------------------
<S> <C> <C> <C> <C>
Numerator:
Net earnings (loss) $ 9,052 $ (1,088) $ 13,637 $ (2,296)
Denominator:
Weighted average shares - basic 51,344 7,578 44,108 6,800
Effect of dilutive securities
</TABLE>
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<TABLE>
<S> <C> <C> <C> <C>
Shares issuable under stock options 5,014 -- 4,906 --
Restricted stock subject to repurchase 9,250 -- 10,070 --
Shares issuable pursuant to warrants 24 -- 88 --
Shares of convertible preferred stock -- -- 5,062 --
---------------------------------------------------
Weighted average shares - diluted 65,632 7,578 64,234 6,800
---------------------------------------------------
Net earnings (loss) per share - basic $ .18 $ (.14) $ .31 $ (.34)
---------------------------------------------------
Net earnings (loss) per share - diluted $ .14 $ (.14) $ .21 $ (.34)
---------------------------------------------------
</TABLE>
Options to purchase 4,070,500 shares of common stock at a weighted-average
exercise price of $.23 at June 30, 1999, warrants to purchase 270,000 shares
of convertible preferred stock at an average per share exercise price of
$.25, and 29,713,860 shares of convertible preferred stock have not been
included in the computation of diluted net loss per share for the three and
six months ended June 30, 1999, as their effect would have been
antidilutive.
5. Comprehensive Income
The following table presents the calculation of comprehensive income as
required by SFAS No. 130. The components of comprehensive income, net of
tax, are as follows (in thousands):
<TABLE>
<CAPTION>
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
----------------------------------------------------
2000 1999 2000 1999
----------------------------------------------------
<S> <C> <C> <C> <C>
Net income (loss) $ 9,052 $ (1,088) $ 13,637 $ (2,296)
Change in net unrealized gain (loss)
on available-for-sale investments 5 -- (31) --
----------------------------------------------------
Total comprehensive income $ 9,057 $ (1,088) $ 13,606 $ (2,296)
----------------------------------------------------
</TABLE>
6. Commitments
In May 2000, the Company entered into an operating lease agreement for new
corporate facilities. The lease term commences July 1, 2000 and extends
through June 30, 2010. Lease payments will be made on an escalating basis
for total minimum lease payments of $42.7 million over the lease term. In
May 2000, the Company was required to make an advance lease payment for the
first twelve months of the lease. This payment, totaling $3.6 million, has
been classified as prepaid expenses and other current assets on our balance
sheet at June 30, 2000.
Upon execution of the lease agreement in May 2000 and extending through the
duration of the lease term, the Company is required to maintain a standby
letter of credit in the amount of $3.6 million. This letter of credit is
held as a certificate of deposit with a financial institution. The Company
has classified this letter of credit as restricted cash on the balance sheet
at June 30, 2000.
7. Subsequent Event
In July 2000, the Company announced a definitive agreement to acquire
Paragon Solutions Limited, an engineering company that specializes in
designing telecommunications products, for up to a maximum of $10 million in
cash. The acquisition, which has been approved by both companies' Board of
Directors, is
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expected to be completed during the Company's quarter ending September 30,
2000 and will be accounted for under the purchase method.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
In addition to the other information in this report, certain statements
in the following Management's Discussion and Analysis of Financial Condition and
Results of Operations (MD&A) are forward looking statements. When used in this
report, the word "expects," "anticipates," "estimates," and similar expressions
are intended to identify forward looking statements. Such statements are subject
to risks and uncertainties that could cause actual results to differ materially
from those projected. Such risks and uncertainties are set forth below under
"Factors Affecting Future Operating Results." The following discussion should be
read in conjunction with the Condensed Financial Statements and notes thereto
included elsewhere in this report.
Overview
From inception on January 2, 1998 through December 1998, our operating
activities consisted primarily of research and development and building our
management team. We introduced our first products in October 1998, and entered
live service trials in November 1998. In January 1999, our CX100 successfully
completed Network Equipment Building Standards (NEBS) testing, a
telecommunications industry standard. We began shipping our products in the
first quarter of 1999.
To date, we have derived substantially all of our revenues from sales of our
CX100. Revenues from our CrossWorks software have not been material. Our success
will depend on our ability to sell our CX100 to additional customers as well as
our ability to develop and sell additional products.
We recognize product revenues at the time of shipment unless we have future
obligations or customer acceptance is required, in which case revenue is
recognized when these obligations have been met or the customer accepts the
product. Revenues from maintenance contracts are deferred and recognized ratably
over the term of the contracts. Currently, all of our product sales and service
arrangements provide for pricing and payment in U.S. dollars.
We sell our products to domestic and international local exchange carriers
through our direct sales force and through an indirect original equipment
manufacturer channel. A customer's network planning and purchase decisions
normally involve a significant commitment of its resources and a lengthy
evaluation and product qualification process. Since the decision to purchase the
CX100 is made as part of this network planning process, our sales cycle is
lengthy, often as long as one year or more. Substantially all of our sales are
made on the basis of purchase orders rather than long-term agreements. As a
result, we commit resources to the development and production of products
without having received advance purchase commitments from customers.
To date, a significant portion of our revenues has resulted from a small
number of relatively large orders from a limited number of customers. We
anticipate that our operating results for any given period will continue to be
dependent to a significant extent on large purchase orders, which can be delayed
or cancelled by our customers without penalty. In addition, we anticipate that
our operating results for a given period will continue to be dependent on a
small number of customers. If we fail to receive a significant purchase order
that we expect for a given quarter, our revenues for that quarter, and possibly
following quarters, will be adversely affected. Furthermore, if any of our
customers experience financial difficulties, our sales to that customer may be
reduced and we may have difficulty in collecting accounts receivable from that
customer.
We currently use A-Plus Manufacturing, a contract manufacturer, to
manufacture our products. This subcontracting arrangement includes material
procurement, board level assembly, final assembly, test and shipment to our
customers. If our contract with A-Plus Manufacturing is terminated, we would be
required to purchase any excess inventory held by them. In addition, the
development of new or enhanced products could cause inventory held by A-Plus
Manufacturing to
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become obsolete. In that event, we would also be obligated to purchase that
inventory from them. We use a combination of standard parts and components, that
are generally available from more than one vendor, and certain key components
that are purchased from sole or limited source vendors for which alternative
sources are not currently available. In addition, lead times for some of the
materials and components we use are very long. These long lead times have in the
past, and may in the future, cause us to attempt to mitigate these lead times by
purchasing inventories of some parts ourselves. Further, the market for
components used in telecommunications equipment has been characterized by
frequent shortages of many components. We will purchase components ahead of
demand to limit our exposure to a shortage in any given components. If we
purchase components in excess of actual demand we may have to write-off the
unused inventory. Any subsequent write-off of inventory could harm our results
of operations and financial condition.
We continue to develop additional products and product features based on our
assessment of the needs of our customers. This has resulted in increased
research and development expenses and may result in reduced operating margins on
our products and a longer sales cycle.
Currently, competition in our market is intense. Due to competition and
potential pricing pressures from large customers in the future, we expect that
the average selling price and gross margins for our products will decline over
time. If we fail to reduce our production costs, our gross margins will decline
rapidly.
In connection with the granting of stock options to our employees, we
recorded deferred stock-based compensation totaling approximately $17.6 million
from inception through June 30, 2000. This amount represents the difference
between the exercise price and the deemed fair value of our common stock for
accounting purposes on the date these stock options were granted. This amount is
included as a component of stockholders' equity and is being amortized on an
accelerated basis by charges to operations over the vesting period of the
options, consistent with the method described in Financial Accounting Standards
Board Interpretation No. 28. During 1999 and 1998, we recorded related
stock-based compensation amortization expense of $3.5 million and $29,000,
respectively, and during the three and six months ended June 30, 2000, we
recorded $2.0 million and $3.8 million, respectively, of related stock-based
compensation amortization expense. As of June 30, 2000, we had an aggregate of
$10.2 million of related deferred compensation to be amortized. The amortization
of the remaining deferred stock-based compensation will result in additional
charges to operations through 2004. The amortization of stock-based compensation
is presented as a separate component of operating expenses in our statements of
operations.
RESULTS OF OPERATIONS
THREE AND SIX MONTHS ENDED JUNE 30, 2000 AND 1999
NET REVENUES
Net revenues increased 770.0% to $41.1 million for the quarter ended June 30,
2000 from $4.7 million for the comparable quarter in 1999. Net revenues
increased 1,031.4% to $64.2 million for the six months ended June 30, 2000 from
$5.7 million for the comparable period in 1999. The increase in net revenues is
primarily the result of increased shipments of our CX100 due to the expansion of
our sales force and to a larger domestic and international customer base. Our
revenues to date have been recognized from a small number of customers. We
expect that the majority of our revenue will continue to depend on sales of the
CX100 to a small number of customers and that our net revenues will continue to
be dependent on timing of orders and shipments to such customers. Currently our
net revenues from international customers are not a significant portion of our
total net revenues. In future periods net revenues derived from international
customers are expected to increase as a percentage of total net revenues.
COST OF REVENUES
Cost of revenues includes amounts paid to A-Plus Manufacturing and related
overhead expenses, consisting primarily of salary and other expenses for
personnel engaged in procurement, vendor management and quality assurance. Cost
of revenues increased to $17.1 million, or 41.6% of net revenues, for the three
months ended June 30, 2000 from $2.5 million,
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or 53.2% of net revenues, in the comparable period of 1999. Cost of revenues
increased to $25.8 million, or 40.3% of net revenues, for the six months ended
June 30, 2000 from $3.1 million, or 54.4% of net revenues, in the comparable
period of 1999. The increase in cost of revenues reflected the increase in CX100
sales. Cost of revenues as a percentage of net revenues has decreased due to
increased unit shipments and associated manufacturing efficiencies and cost
savings from volume purchasing.
RESEARCH AND DEVELOPMENT
Research and development expenses, net of non-cash compensation expense of
$1.1 million and $200,000 for the three months ended June 30, 2000 and 1999,
respectively, consist primarily of salaries and related expenses for personnel
engaged in research and development, fees paid to consultants and outside
service providers, cost of certification and compliance testing and material
costs for prototype and test units. They also include other expenses related to
the design, development, testing and enhancements of our products. We expense
all of our research and development costs as they are incurred. Research and
development expenses increased 254.1% to $3.6 million for the three months ended
June 30, 2000 from $1.0 million in the comparable period of 1999. Research and
development expenses increased 242.7% to $6.4 million for the six months ended
June 30, 2000 from $1.9 million in the comparable period of 1999. The increase
was due primarily to a significant increase in personnel and related costs
associated with new product development, verification testing, certification and
compliance testing and other engineering expenses. Development is essential to
our future success and we expect that research and development expenses will
increase in absolute dollars in future periods.
SALES AND MARKETING
Sales and marketing expenses, net of non-cash compensation expense of
$551,000 and $107,000 for the three months ended June 30, 2000 and 1999,
respectively, consist primarily of salaries, commissions, and related expenses
for personnel engaged in marketing, sales and customer support functions. These
expenses also include costs associated with trade shows, promotional activities
and public relations.
Sales and marketing expenses increased 242.8% to $3.6 million for the three
months ended June 30, 2000 from $821,000 in the comparable period of 1999. Sales
and marketing expenses increased 329.9% to $5.7 million for the six months ended
June 30, 2000 from $1.3 million in the comparable period of 1999. This increase
was primarily due to an increase in the number of sales and marketing personnel,
increased commissions associated with higher net revenues, increased sales and
sales support personnel, increased trade show activities and marketing expenses,
and other customer-related costs.
We intend to expand our sales and marketing operations and efforts
substantially, both domestically and internationally, in order to increase
market awareness and to generate sales of our products. We expect that sales and
marketing expenses will increase in absolute dollars in future periods.
GENERAL AND ADMINISTRATIVE
General and administrative expenses, net of non-cash compensation expense of
$372,000 and $879,000 for the three months ended June 30, 2000 and 1999,
respectively, consist primarily of salaries and related expenses for executive,
finance, accounting, professional fees, and costs associated with expanding our
information systems.
General and administrative expenses increased 261.4% to $1.1 million for the
three months ended June 30, 2000 from $308,000 in the comparable period of 1999.
General and administrative expenses increased 280.0% to $1.9 million for the six
months ended June 30, 2000 from $499,000 in the comparable period of 1999. This
increase was primarily due to an increase in the number of general and
administrative personnel, increased facilities costs, and increased legal and
accounting expenses associated with our growing business activities.
We expect these expenses to increase in absolute dollars as we add personnel
and incur additional costs related to growing our business, expanding our
information infrastructure and operating as a public company.
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AMORTIZATION OF DEFERRED STOCK COMPENSATION
At June 30, 2000 and December 31, 1999, deferred stock compensation for stock
options granted at prices subsequently deemed to be below fair value on the date
of grant totaled $10.2 million and $9.7 million, respectively.
We are amortizing the deferred stock compensation over the vesting periods of
the applicable options and the repurchase periods for restricted stock
purchases. The service period over which deferred stock compensation is
amortized is determined separately for each 25% portion of the total award, in
accordance with Financial Accounting Standards Board Interpretation No. 28. The
result of this accounting treatment is that approximately 52% of the unearned
deferred compensation will be amortized in the first year, 27% in the second
year, 15% in the third year and 6% in the fourth year following the date of the
grant. We amortized a total of approximately $2.0 million and $1.2 million of
deferred stock compensation in the three months ended June 30, 2000 and 1999,
respectively.
INTEREST INCOME (EXPENSE) AND OTHER, NET
Interest income (expense) and other, net includes income from our cash
investments net of expenses related to our lease financing obligations. We had
net interest and other income of $1.5 million for the three months ended June
30, 2000 and net interest and other income of $41,000 for the comparable period
in 1999. We had net interest and other income of $2.4 million for the six months
ended June 30, 2000 and net interest and other income of $83,000 for the
comparable period in 1999. Interest income increased primarily from interest
earned on the net cash proceeds of approximately $92.1 million received in
connection with the Company's completion of its initial public offering in
February 2000. In future periods we expect interest income (expense) and other,
net to vary depending upon changes in the amount and mix of interest-bearing
investment and short and long-term debt outstanding during each period.
INCOME TAX EXPENSE
We have recorded a tax provision of $6.0 million for the quarter ended June
30, 2000 for a total of $9.3 million for the six months ended June 30, 2000. We
did not provide for income tax expense in 1999 due to our net loss for that
period. The provision for income tax consists primarily of federal and state
taxes at an effective tax rate of 40%.
LIQUIDITY AND CAPITAL RESOURCES
Our principal source of liquidity as of June 30, 2000 consisted of $55.3
million in cash and cash equivalents and $49.5 million in short-term
investments. As of June 30, 2000, we had $346,000 in obligations under capital
leases to be repaid over a period of three years from lease inception. Since our
inception, we have financed our operations through private and public sales of
securities and, to a lesser extent, equipment lease financing.
During the six months ended June 30, 2000, we generated $9.5 million from
operating activities compared to the same period in 1999 in which we used $1.7
million in operating activities. This positive cash flow resulted primarily from
our net income for the six months ended June 30, 2000 and from increases in
accounts payable and accrued compensation and benefits, income tax payable and
deferred revenue, partially offset by increases in our inventory, accounts
receivable and prepaid expense and other current asset balances.
Net cash used in investing activities for the six months ended June 30, 2000
was $54.7 million compared to net cash used in investing activities of $206,000
in the same period in 1999. Cash used in investing activities in the six months
ended June 30, 2000 was due primarily to the purchases of available-for-sale
investments of $57.5 million, net of proceeds from sales and maturities of $8.0
million. There were no maturities or sales of available-for-sale investments in
the six months ended June 30, 1999.
Capital expenditures increased $1.4 million for the six months ended June 30,
2000 compared to the same period in 1999 due primarily to additions of office
equipment and computer software and hardware associated with our increases in
staffing. We expect that our capital expenditures will continue to increase in
future periods. In May 2000, the
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<PAGE> 14
Company entered into an operating lease agreement for new corporate facilities.
Upon execution of the lease agreement in May 2000 and extending through the
duration of the lease term, we are required to maintain a standby letter of
credit in the amount of $3.6 million. This letter of credit is held as a
certificate of deposit with a financial institution. Net cash used in investing
activities for the six months ended June 30, 2000 included an allocation to
restricted cash of $3.6 million for the certificate of deposit associated with
this standby letter of credit.
The lease term commences July 1, 2000 and extends through June 30, 2010.
Lease payments will be made on an escalating basis for total minimum lease
payments of $42.7 million over the lease term. In May 2000, the Company was
required to make an advance lease payment for the first twelve months of the
lease. This payment, totaling $3.6 million, has been included in prepaid
expenses and other current assets on our balance sheet at June 30, 2000.
Net cash provided by financing activities for the six months ended June 30,
2000 was $92.4 million compared to $6.6 million for the comparable period in
1999. Cash provided by financing activities in the six months ended June 30,
2000 was primarily due to net proceeds of $92.1 million from our initial public
offering in February 2000, partially offset by payments on capital lease
obligations. Cash provided by financing activities in the six months ended June
30, 1999 was primarily due to net proceeds of $6.2 million from the issuance of
convertible preferred stock and net proceeds of $472,000 from the issuance of
common stock, partially offset by principal payments on capital lease
obligations.
The Company expects to devote substantial capital and operating resources to
continue its research and development efforts, to hire and expand the sales,
support, marketing and product development organizations, to expand marketing
programs, to establish operations worldwide and for other general corporate
activities. Although the Company believes that current cash balances will be
sufficient to fund operations for at least the next 12 months, there can be no
assurance that the Company will not require additional financing within this
time frame or that such additional funding, if needed, will be available on
acceptable terms. Any additional issuance of equity or equity-related securities
will be dilutive to our stockholders.
FACTORS AFFECTING FUTURE RESULTS
WE HAVE LOST MONEY IN THE PAST AND MAY EXPERIENCE LOSSES IN THE FUTURE, WHICH
COULD CAUSE THE MARKET PRICE OF OUR COMMON STOCK TO DECLINE.
We may not succeed in generating revenue growth consistent with our recent
experience, and our revenues may not be sufficient to sustain profitability. If
we incur losses, the market price of our common stock may decline substantially.
We only recently became profitable on a quarterly basis. We may not maintain or
increase our profitability in the future. We expect to continue to incur
significant product development, sales and marketing and administrative
expenses. In particular, we anticipate that our expenses will increase
substantially in the next 12 months as we:
- increase our sales and marketing activities, particularly by expanding our
direct sales force;
- develop our technology, expand our existing product lines and add new
features to penetrate new markets; and
- develop additional infrastructure and hire additional management to keep
pace with our growth.
Our operating expenses are largely based on currently anticipated revenue
trends, which may not be realized, and a high percentage of our expenses are and
will continue to be fixed in the short term. We will need to generate
significant revenues to maintain profitability.
IF DSL TECHNOLOGY FAILS TO GAIN WIDESPREAD MARKET ACCEPTANCE, THE DEMAND FOR OUR
PRODUCTS MAY DECREASE.
If DSL technology fails to gain widespread acceptance, our revenues and
results of operations will be harmed. Our products are primarily used by local
exchange carriers who offer DSL-based services. Our future success is
substantially dependent upon whether DSL technology gains widespread market
acceptance by local exchange carriers, of which there are a limited number, and
by end users of their services. Local exchange carriers are continuously
evaluating alternative
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<PAGE> 15
high-speed data access technologies and may at any time adopt technologies other
than DSL. Numerous other high-speed access technologies, including cable modems,
wireless technology and satellite technologies compete with DSL-based services.
Cable modem service can theoretically provide faster download speeds than DSL.
Both wireless and satellite technologies enable users to transmit and receive
information using radio frequencies at speeds close or comparable to DSL
transmission speeds. These competing technologies may ultimately prove to be
superior to DSL-based services and reduce or eliminate the demand for our
products.
IF OUR CUSTOMERS ARE UNABLE TO ACQUIRE AND RETAIN DSL SUBSCRIBERS, THEY MAY
CURTAIL THEIR DSL DEPLOYMENT PLANS AND REDUCE THEIR PURCHASES OF OUR PRODUCTS.
To date, our customers have deployed DSL equipment, including our products,
in substantially larger volumes than their current subscriber count. The
inability of our current or future competitive local exchange carrier customers
to acquire and retain subscribers as planned, or to respond to competition for
their services or reduced demand for their services, could cause them to reduce
or eliminate their DSL deployment plans. A competitive local exchange carrier is
a company that, following the Telecommunications Act of 1996, is authorized to
compete in the local communications services market. If our customers are forced
to reduce or eliminate their DSL deployment plans, our sales to them will
decline.
THE CX100 IS CURRENTLY OUR ONLY VOLUME PRODUCT, AND IF IT FAILS TO GAIN MARKET
ACCEPTANCE, WE WILL NOT BE ABLE TO GROW OUR REVENUES.
Our future growth and a significant portion of our future revenue depend on
the success of our CX100, which is the only volume product that we currently
offer. Accordingly, failure of the CX100 or future products to maintain and
achieve meaningful levels of market acceptance and customer satisfaction would
limit our sales and our revenue growth. We only began shipping the CX100 in the
first quarter of 1999, and the CX100 may not gain widespread market acceptance.
Many potential customers who have evaluated the CX100 have not yet deployed the
product in production network environments and may choose not to deploy our
current product or any of our future products. Other potential customers may
have already deployed another technology and may therefore be unwilling to
deploy the CX100.
Even when customers do purchase and deploy our product, due to the variety
and complexity of environments in which the CX100 is installed, it may not
operate as expected. Failure of the CX100 to operate as expected could delay or
prevent its volume deployment, which could decrease our revenues and increase
our expenses as we devote additional development resources to improving product
performance. The success and deployment into our customers' networks of the
CX100 will also depend on customer satisfaction with our products and numerous
other factors, including:
- the realization of operating cost efficiencies for our customers when
CX100 products are deployed and our customers' ability to quantify these
operational efficiencies;
- our successful development of systems and software that address customer
infrastructure requirements; and
- our customers' successful integration of our CrossWorks software into
their operational support systems.
WE DERIVE OUR REVENUES FROM A SMALL NUMBER OF CUSTOMERS, AND ANY DECREASE IN
REVENUES FROM A MAJOR CUSTOMER COULD PREVENT US FROM MEETING SECURITIES
ANALYSTS' EXPECTATIONS AND CAUSE OUR STOCK PRICE TO FALL.
We began recognizing revenues from the CX100 in the quarter ended March 31,
1999. Our revenues to date have been recognized from a small number of
customers. Purchases by large customers and, therefore, our revenues, may vary
significantly from quarter to quarter. The loss of any one of our major
customers or a reduction or delay in purchases of our products from any one of
these customers would cause our revenues to decline and could cause our stock
price to decline if our revenues are below analysts' expectations. Revenues from
significant customers as a percentage of our total revenues for the six months
ended June 30, 2000 and the year ended December 31, 1999 were as follows:
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<PAGE> 16
<TABLE>
<CAPTION>
SIX MONTHS YEAR ENDED
ENDED JUNE 30, DECEMBER 31,
2000 1999
--------------------------------
<S> <C> <C>
Lucent Technologies 21% 15%
Rhythms NetConnections 15% 41%
Network Access Solutions Less than 10% 19%
Covad Communications Less than 10% 11%
</TABLE>
We expect that the majority of our revenues will continue to depend on sales
of the CX100 to a small number of customers, specifically competitive local
exchange carriers. To date, our customers have consisted principally of these
carriers. In addition, a small number of customers may account for substantially
all of our revenues in any particular quarter, and these customers may change
from quarter to quarter. We have no long term contracts with any customers for
the purchase of the CX100, and customers may reduce or discontinue purchases at
any time. Customers may also delay or cancel purchase orders without penalty.
There are a limited number of local exchange carriers that are potential
customers, and this number may not increase in the future. Accordingly, our
future revenues will depend significantly upon the timing and size of future
purchase orders from our largest customers.
In addition, because we are dependent on a limited number of customers, we
expect to experience volatility and seasonality relating to the budgeting cycles
of our customers and the telecommunications industry in general. Based on our
limited operating history, we believe that on a relative basis, purchases by our
customers tend to be lower in the fourth calendar quarter. We cannot be certain,
however, that such seasonal trend will continue. Adverse changes in our revenues
or operating results as a result of these budgeting cycles or such seasonality
or any other reduction in capital expenditures by our large customers could
substantially reduce the trading price of our common stock.
Our customers tend to be significantly larger than us and are able to exert a
high degree of influence over us. They have sufficient bargaining power to
demand low prices and other terms and conditions that may negatively affect our
business and results of operations.
SUBSTANTIALLY ALL OF OUR REVENUES COME FROM NEW AND EMERGING COMPETITIVE LOCAL
EXCHANGE CARRIERS, WHOSE INABILITY TO OBTAIN CAPITAL COULD CAUSE THEM TO REDUCE
OR DISCONTINUE THE PURCHASE OF OUR PRODUCTS AT ANY TIME.
Because our customer base consists principally of new and emerging
businesses, we will not be able to increase our revenues if our customers'
business models, which are largely unproven, are not successful or if the
financial condition of our customers deteriorates. To date, our customers have
consisted principally of competitive local exchange carriers. These carriers
require substantial capital for the development, construction and expansion of
their networks and the introduction of their services. Financing may not be
available to emerging competitive local exchange carriers on favorable terms, if
at all. A reduction in the financing available to our customers, or the
inability of our customers to obtain financing, could impair our ability to make
future sales as well as to collect for sales we have already made. In addition,
we may choose to provide financing to our customers, which will subject us to
additional financial risk and may reduce our profitability. The
telecommunications service provider industry has recently experienced
consolidation. The loss of a customer, through industry consolidation or
otherwise, could reduce or eliminate our sales to that customer.
THE LONG SALES CYCLE FOR THE CX100 MAY CAUSE OUR REVENUES AND OPERATING RESULTS
TO VARY SIGNIFICANTLY FROM QUARTER TO QUARTER.
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<PAGE> 17
Because the sales cycle for our CX100 is long, our revenues in a given
quarter may not meet market expectations if we experience delays in customer
orders. In addition, we may have incurred substantial sales and marketing
expenses during that quarter, without offsetting revenues. As a result, delays
resulting from our lengthy sales cycle could reduce our revenues and decrease
our profits, or result in a loss. Specifically, our customers' network planning
and purchase decisions normally involve a significant commitment of resources
and a lengthy evaluation and product qualification process. The decision to
purchase the CX100 is made as part of this network planning process, and our
sales cycle can be as long as one year or more. Throughout the sales cycle, we
often spend considerable time and resources educating and providing information
to prospective customers regarding the use and benefits of the CX100. Even after
making the decision to purchase the CX100, our customers may delay or cancel the
deployment of the CX100. Timing of deployment is unpredictable, can vary widely
and depends on a number of factors, many of which are beyond our control,
including:
- customers' current network deployment procedures;
- customers' level of expertise;
- status and performance of customers' other network equipment;
- degree of software development and integration necessary for the customer
to deploy the CX100; and
- financial and administrative resources of the customer.
INTENSE COMPETITION IN OUR INDUSTRY COULD RESULT IN OUR LOSING CUSTOMERS OR
BEING UNABLE TO ATTRACT NEW CUSTOMERS. AS A RESULT, OUR REVENUE COULD DECLINE OR
WE COULD EXPERIENCE LOSSES.
The market for telecommunications equipment is highly competitive. If we are
unable to compete effectively, our revenues could decline, our expenses could
increase, and our earnings could decrease or we could experience losses. A
number of companies produce products that compete with ours, including Harris
Corporation, Hekimian Laboratories, Agilent Technologies, Lucent Technologies,
Nortel Networks, Teradyne Corporation and Tollgrade Communications. Many of our
current and potential competitors have significantly greater sales and
marketing, technical, manufacturing, financial and other resources. In addition,
a number of smaller companies are expected to produce products that compete with
ours. Due to the rapidly evolving market in which we compete, additional
competitors with significant market presence and financial resources, including
other large telecommunications equipment manufacturers, may enter that market,
thereby further intensifying competition.
We also compete with DSL equipment providers, including Alcatel, Lucent,
Nokia and Nortel, who have each announced plans to incorporate competitive
features and functionality into their DSL access multiplexers. A DSL access
multiplexer is a network device, usually located at a telephone company's
central office, that receives signals from multiple DSL connections and puts the
signal on a larger, high-speed transmission line. Lucent has announced plans to
produce DSL access multiplexer products that will include some of the same
features and functions as our CX100 product. If our current and potential
customers choose to deploy DSL access multiplexers that include features and
functions that are competitive with our products, or delay purchases of our
products to evaluate these DSL access multiplexers, our business could be
seriously harmed. To the extent we expand the capabilities of our products to
incorporate functionality traditionally contained in other equipment, we may
also face increased competition from other vendors.
WE EXPECT AVERAGE SELLING PRICES AND GROSS MARGINS OF OUR PRODUCTS TO DECREASE,
AND WE MAY NOT BE SUCCESSFUL IN REDUCING OUR COSTS OR REDESIGNING OUR PRODUCTS
TO REMAIN COMPETITIVE.
The market for telecommunications equipment is characterized by declining
prices due to increased competition, new products and increasing unit volumes.
Due to competition and potential pricing pressures from large customers in the
future, we expect that the average selling price and gross margins for our
products will decline over time. If we fail to
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<PAGE> 18
reduce our production costs, our gross margins will decline rapidly. We may not
be successful in redesigning our products or achieving cost reductions in a
timely manner, particularly as we introduce new products. In addition, redesign
may not provide sufficient cost reductions to allow us to remain competitive.
IF WE FAIL TO ENHANCE EXISTING PRODUCTS OR DEVELOP AND SELL NEW PRODUCTS THAT
MEET CUSTOMER REQUIREMENTS, OUR SALES WILL SUFFER.
Our failure to develop products or offer services that satisfy customer
requirements would reduce our sales and harm our operating results. Many of our
current and potential customers may require product features that our CX100
product does not have. For instance, some of our potential customers,
particularly incumbent local exchange carriers, require management and testing
capabilities for traditional analog telephone services, and our products do not
currently offer this functionality. An incumbent local exchange carrier is a
communications company that held an exclusive license to offer local telephone
services prior to the Telecommunications Act of 1996. In addition, some
potential customers have sought to use our products for uses we have not
anticipated, and we have been required to determine whether the requested
functionality could be integrated into our product. To the extent we are
required to add features to our products in order to achieve a sale, our sales
cycle will lengthen, and we will incur increased development costs for our
products. To increase our sales, we must effectively anticipate and adapt to
customer requirements and offer products and services that meet customer
demands.
IF WE DO NOT MANAGE NEW PRODUCT INTRODUCTIONS EFFECTIVELY, WE COULD EXPERIENCE
CANCELLED ORDERS OR PRODUCT RETURNS OR BE REQUIRED TO PURCHASE OBSOLETE
INVENTORY FROM OUR CONTRACT MANUFACTURER.
The introduction of new or enhanced products requires that we manage the
transition from older products in order to minimize disruption in customer
ordering patterns and ensure that adequate supplies of new products can be
delivered to meet anticipated customer demand. Our inability to effectively
manage a product transition may cause material delays in the deployment of DSL
services by our customers, which could cause our customers to cancel orders or
return our products. The introduction of new and enhanced products may cause
certain customers to defer or cancel orders for, or to return, existing
products. Although we maintain reserves for product returns, these reserves may
not be adequate. In addition, the development of new or enhanced products could
cause inventory held by our contract manufacturer, A-Plus Manufacturing, to
become obsolete. In that event, we could be obligated to purchase that inventory
from A-Plus Manufacturing.
OUR PRODUCTS MAY NOT FUNCTION AS EFFECTIVELY OR AT ALL IN A LINE SHARING NETWORK
ARRANGEMENT.
On November 18, 1999, the Federal Communications Commission, or FCC, ordered
that line sharing, a network arrangement in which incumbent local exchange
carriers must share the existing subscriber line with competitive local exchange
carriers, be made available to competitive local exchange carriers by June 6,
2000. Some of the functions of our CX100 product line may not function as
effectively or at all in a shared line configuration. To the extent that
competitive local exchange carriers elect to provide DSL services on shared
lines that they would have otherwise deployed on separate lines, the demand for
our products could be significantly reduced or eliminated. In addition, we may
need to redesign or modify our products for shared line configurations.
Adjustments to the FCC's regulations regarding line sharing, new FCC
regulations or regulations set forth by other regulatory bodies may also reduce
demand for our products. Because the competitive local exchange carriers do not
have access to the incumbent local exchange carriers' line maintenance systems,
the competitive local exchange carriers have typically implemented an
independent line maintenance system and several have deployed the CX100 as a key
component of this system. In the future, the FCC may expand line sharing to give
competitive local exchange carriers access to incumbent local exchange carriers'
line maintenance infrastructure, which would eliminate or reduce the need for
our products.
IF WE FAIL TO ACCURATELY PREDICT OUR MANUFACTURING REQUIREMENTS, WE COULD INCUR
ADDITIONAL COSTS OR EXPERIENCE MANUFACTURING DELAYS.
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<PAGE> 19
We have a supply contract with A-Plus Manufacturing to build our products. We
provide product demand forecasts to A-Plus Manufacturing no less than six months
prior to scheduled delivery of products to our customers. If we overestimate our
requirements, A-Plus Manufacturing may have excess inventory, which we could be
obligated to purchase. If we underestimate our requirements, A-Plus
Manufacturing may have inadequate inventory, which could interrupt manufacturing
of our products and result in delays in shipments and revenues, or add
additional costs to our products to expedite delivery of certain long lead time
components.
In addition, lead times for some of the materials and components used in our
products are very long and availability can be very limited and depend on
factors such as the specific supplier, contract terms and demand for each
component at a given time. Long lead times or limited availability for some
materials and components have in the past, and may in the future, cause us to
purchase inventories of some parts ourselves, increasing our costs and risk of
the parts' obsolescence. If we or A-Plus Manufacturing fail to carry a
sufficient inventory of long lead time items, if lead times increase or if
demand for our products increases unexpectedly, we may have insufficient access
to components necessary to meet demand for our products on a timely basis.
WE DEPEND ON A SINGLE CONTRACT MANUFACTURER THAT HAS NO OBLIGATION TO PROVIDE US
WITH FIXED PRICING OR QUANTITIES. IF WE ARE UNABLE TO OBTAIN SUFFICIENT PRODUCTS
FROM OUR CONTRACT MANUFACTURER ON ECONOMICAL TERMS, WE MAY NOT BE ABLE TO TIMELY
FILL CUSTOMER ORDERS.
We rely on a single contract manufacturer, A-Plus Manufacturing, to build our
products. If A-Plus Manufacturing is unable to provide us with adequate supplies
of high-quality products, or terminates its relationship with us, we may be
unable to fulfill customer orders on a timely basis, which may delay the DSL
deployment schedule of our customers and strain our relationships with them.
Because we currently do not have a long-term supply contract with A-Plus
Manufacturing, they are not obligated to supply products to us for any specific
period, in any specific quantity or at any certain price, except as may be
specified in a particular purchase order. Our current supply contract with
A-Plus Manufacturing can be terminated by either party with 120 days notice for
any reason. If the contract is terminated, we would be required to purchase any
excess inventory held by A-Plus Manufacturing, they would no longer be obligated
to manufacture products for us and our ability to supply products to our
customers could be seriously harmed. We may be unable to develop alternative
manufacturing arrangements on a timely basis, or at all. In addition, A-Plus
Manufacturing may not meet our future requirements for product quality or timely
delivery.
SOME KEY COMPONENTS IN OUR PRODUCTS COME FROM SOLE OR LIMITED SOURCES OF SUPPLY,
WHICH EXPOSES US TO POTENTIAL SUPPLY INTERRUPTIONS THAT COULD PREVENT THE
MANUFACTURE AND SALE OF OUR PRODUCTS.
Our contract manufacturer currently purchases a number of key components used
in the manufacture of our CX100 product from sole or limited sources of supply
for which alternative sources are not currently qualified and may not be
available. We and our contract manufacturer have no guaranteed supply
arrangement with these suppliers, and we or our contract manufacturer may fail
to obtain these supplies in a timely manner in the future. Financial or other
difficulties faced by these suppliers or significant changes in market demand
for these components could limit the availability to us of these components. Any
interruption or delay in the supply of any of these components could:
- adversely affect our ability to meet scheduled product deliveries to our
customers and
- cause us to lose sales to existing and future customers.
In addition, the purchase of these components on a sole source basis subjects
us to risks of price increases and potential quality assurance problems.
Our contract manufacturer currently purchases key components for which there
are currently no substitutes available from approximately 11 suppliers. All of
these components are critical to the production of our products, and competition
exists with other manufacturers for these key components. We might not be able
to qualify or identify alternative suppliers in a timely fashion, or at all.
Consolidations involving suppliers could further reduce the number of
alternatives
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<PAGE> 20
for us and affect the cost of components. An increase in the cost of components
could make our products less competitive and result in lower margins.
BECAUSE OUR PRODUCTS ARE DEPLOYED IN COMPLEX ENVIRONMENTS, THEY MAY HAVE ERRORS
OR DEFECTS THAT ARE FOUND ONLY AFTER FULL DEPLOYMENT, WHICH COULD RESULT IN
LIABILITY CLAIMS AGAINST US.
Errors or other problems in our CX100 or other products could result in:
- loss of or delay in revenues and loss of customers or market share;
- failure to achieve market acceptance;
- diversion of development resources;
- increased service and warranty costs;
- legal actions by our customers; and
- increased insurance costs.
Because our products are designed to provide critical services, if errors,
defects or failures are discovered in our current or future products, or as new
versions are released, we may be exposed to significant legal claims. Any
claims, whether or not successful, could damage our reputation and our business,
increase our expenses and impair our operating results. Although we maintain
product liability insurance covering some damages arising from implementation
and use of our products, our insurance may not fully cover claims sought against
us. Liability claims could require us to spend significant time and money in
litigation or to pay significant damages.
The CX100 is designed for large and complex networks. The CX100 was only
recently introduced and, to date, has been deployed on a limited basis.
Consequently, our customers may discover errors or defects in our hardware or
software only after it has been fully deployed and operated as part of their
infrastructure in connection with products from other vendors, especially DSL
access multiplexers and DSL modems.
WE MAY NOT BE ABLE TO GROW OUR BUSINESS IF WE FAIL TO DEVELOP AND MAINTAIN
RELATIONSHIPS WITH THIRD PARTIES TO MARKET AND SELL OUR PRODUCTS.
Our growth will largely be dependent upon relationships with third parties
who market and sell our products. In particular, we have entered an original
equipment manufacturer agreement with Lucent Technologies under which we have
agreed to co-brand and sell our products to Lucent. If Lucent reduces its
purchases of our products or breaches or terminates the agreement, our business
will be harmed. Our agreement does not require Lucent to sell specified volumes
of our products. In addition to our CX100 products, Lucent resells products
manufactured by Tollgrade, a competitor. Lucent has also announced plans to
produce DSL access multiplexer products that will include some of the same
features and functions as our CX100 product. Lucent may choose to sell Tollgrade
or other competing products instead of our products.
IF WE CANNOT ATTRACT EXPERIENCED SALES PERSONNEL, SPECIALIZED ENGINEERS AND
HIGHLY-TRAINED CUSTOMER SERVICE PERSONNEL, WE WILL NOT BE ABLE TO SELL AND
SUPPORT OUR PRODUCTS.
Our products and services require a sophisticated selling effort targeted at
several key people within our prospective customers' organizations. This process
requires the efforts of experienced sales personnel as well as specialized
systems and consulting engineers. In addition, the complexity of our products
and the difficulty of configuring and maintaining them require highly trained
customer service and support personnel. We intend to hire a significant number
of engineering, sales, marketing and customer service and support personnel in
the future. We believe our success depends,
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<PAGE> 21
in large part, upon our ability to attract and retain these key employees.
Competition for such persons is intense, especially in the San Francisco Bay
area. We may not be successful in attracting and retaining these individuals.
WE DEPEND ON A SINGLE APPLICATION SERVICE PROVIDER FOR INFORMATION SYSTEMS AND
SERVICES. IF THOSE SERVICES ARE INTERRUPTED, OUR ABILITY TO PROCESS TRANSACTIONS
WILL BE IMPAIRED.
We rely on a single application service provider, AristaSoft Corporation, to
provide accounting and operations software and support. If AristaSoft is unable
to provide the level and quality of service we currently anticipate, our ability
to process orders, ship products, prepare invoices and manage our day-to-day
financial transactions will be impaired. Locating and educating a new
application service provider would be time consuming and would put further
strain on our management personnel. In addition, the terms of our arrangement
with an alternative provider could be less advantageous, which could increase
our expenses. AristaSoft began providing information systems and services to us
on a regular basis in August 1999, at which time we were their only customer. In
December 1999, we entered into a three year agreement with AristaSoft for access
to financial, logistics and manufacturing software. In order for us to realize
our business goals, AristaSoft must be able to provide and manage a scalable and
reliable information technology infrastructure to support the growth of our
business. If AristaSoft is unable to meet our expectations, we may be unable to
obtain alternative services on a timely or economical basis.
IF WE FAIL TO MANAGE EXPANSION EFFECTIVELY, THIS WILL PLACE SIGNIFICANT STRAIN
ON OUR MANAGEMENT AND OPERATIONAL RESOURCES.
We have expanded our operations rapidly since our inception and intend to
continue to expand in order to pursue existing and potential market
opportunities. Our planned rapid growth places a significant strain on
management and operational resources. Our customer relationships could be
strained if we are unable to devote sufficient resources to them as a result of
our growth.
Also due to our rapid growth, we expect to require additional office space
within the next 12 months. We may be unable to locate necessary office space on
commercially reasonable terms or in a timely manner. Failure to do so would
disrupt our business and place additional strain on our management.
RAPID TECHNOLOGICAL CHANGE IN THE TELECOMMUNICATIONS INDUSTRY COULD RENDER OUR
PRODUCTS OBSOLETE.
The markets for high-speed telecommunications products are characterized by
rapid technological developments, frequent enhancements to existing products and
new product introductions, changes in customer requirements and evolving
industry standards. Intense competition among numerous high-speed access
technologies has further driven innovation and increasingly complex product
requirements. We may be unable to improve the performance and features of our
products as needed to respond to these developments. The introduction or market
acceptance of products incorporating superior technologies or the emergence of
alternative technologies or new industry standards could render our existing or
potential future products less economical, obsolete and unmarketable. For
example, if semiconductor, robotic or other technologies become effective
alternatives for our product architecture, our products may become obsolete.
WE COULD LOSE OUR COMPETITIVE ADVANTAGE IF WE ARE UNABLE TO PROTECT OUR
INTELLECTUAL PROPERTY.
If we fail to adequately protect our proprietary rights, our competitors
could offer similar products relying on technologies developed by us,
potentially harming our competitive position and decreasing our revenues. We
have filed three patent applications to date. Our existing and future patent
applications, if any, may not be approved, any issued patents may not protect
our intellectual property and any issued patents could be challenged by third
parties. Furthermore, other parties may independently develop similar or
competing technology or design around any patents that may be issued to us.
Attempts may be made to copy aspects of our products or to obtain and use
information that we regard as proprietary. We attempt to protect our
intellectual property rights by limiting access to the distribution of our
software, documentation and other proprietary information and by relying on a
combination of copyright, trademark and
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<PAGE> 22
trade secret laws. In addition, we enter into confidentiality agreements with
our employees and certain customers, vendors and strategic partners. These steps
may fail to prevent the misappropriation of our intellectual property,
particularly in foreign countries where the laws may not protect our proprietary
rights as fully as in the United States.
IF WE BECOME INVOLVED IN A PROTRACTED INTELLECTUAL PROPERTY DISPUTE, OR ONE WITH
A SIGNIFICANT DAMAGES AWARD, OR WHICH REQUIRES US TO CEASE SELLING OUR PRODUCTS,
WE COULD BE SUBJECT TO SIGNIFICANT LIABILITY AND THE TIME AND ATTENTION OF OUR
MANAGEMENT COULD BE DIVERTED.
In recent years, there has been significant litigation in the United States
involving patents and other intellectual property rights, including among
companies in telecommunications and Internet industries. Intellectual property
claims against us and any resulting lawsuit, if successful, could subject us to
significant liability for damages and invalidate our proprietary rights. These
lawsuits, regardless of their success, would likely be time-consuming and
expensive to resolve and would divert management time and attention. Any
potential intellectual property litigation also could force us to do one or more
of the following:
- cease selling, incorporating or using products or services that
incorporate the infringed intellectual property;
- obtain from the holder of the infringed intellectual property right a
license to sell or use the relevant technology, which license may not be
available on acceptable terms, if at all; or
- redesign those products or services that incorporate the disputed
technology.
If we are subject to a successful claim of infringement against us and fail
to develop non-infringing technology or license the infringed technology on
acceptable terms and on a timely basis, our revenues may decline or our expenses
may increase.
We may in the future initiate claims or litigation against third parties for
infringement of our proprietary rights or to determine the scope and validity of
our proprietary rights or the proprietary rights of competitors. These claims
could result in costly litigation and the diversion of our technical and
management personnel.
CONTROL BY OUR EXISTING STOCKHOLDERS MAY LIMIT YOUR ABILITY TO INFLUENCE MATTERS
REQUIRING STOCKHOLDER APPROVAL AND COULD DELAY OR PREVENT A CHANGE IN CONTROL,
WHICH COULD PREVENT YOU FROM REALIZING A PREMIUM IN THE MARKET PRICE OF OUR
COMMON STOCK.
The concentration of ownership of our common stock by existing stockholders
could delay or prevent a change in our control or discourage a potential
acquirer from attempting to obtain control of us, which could cause the market
price of our common stock to fall or prevent our stockholders from realizing a
premium in the market price associated with an acquisition. As of June 30, 2000,
our executive officers, directors and principal stockholders and their
affiliates beneficially owned 43,577,428 shares or approximately 71.7% of the
outstanding shares of common stock. These stockholders, if acting together,
would be able to significantly influence all matters requiring approval by our
stockholders, including the election of directors and the approval of mergers or
other business combination transactions.
WE EXPECT TO EXPERIENCE VOLATILITY IN OUR STOCK PRICE WHICH COULD NEGATIVELY
AFFECT YOUR INVESTMENT.
Prior to February 2000, you could not buy or sell our common stock publicly.
An active public market for our common stock may not be sustained in the future.
The market for technology stocks has been extremely volatile. The following
factors could cause the market price of our common stock to fluctuate
significantly:
- announcements by us or our competitors of significant contracts, new
products or technological innovations, acquisitions, strategic
relationships, joint ventures or capital commitments;
- changes in financial estimates by securities analysts;
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<PAGE> 23
- release of lock-up or the transfer restrictions on our outstanding shares
of common stock or sales of additional shares of common stock;
- changes in market valuations of networking and telecommunications
companies; and
- fluctuations in stock market prices and volumes.
SHOULD OUR STOCKHOLDERS SELL A SUBSTANTIAL NUMBER OF SHARES OF OUR COMMON STOCK
IN THE PUBLIC MARKET, THE PRICE OF OUR COMMON STOCK COULD FALL.
Our executive officers, directors and principal stockholders and their
affiliates hold a substantial number of shares, which they will be able to sell
in the public market in the near future. Sales of a substantial number of shares
of our common stock that have not previously been available for sale in the
public market could reduce the trading price of our common stock. In addition,
the sale of these shares could impair our ability to raise capital through the
sale of additional equity securities.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The primary objective of the Company's investment activities is to preserve
principal while at the same time maximizing the income it receives from its
investments without significantly increasing risk. Some of the securities that
the Company has invested in may be subject to market risk. This means that a
change in prevailing interest rates may cause the principal amount of the
investment to fluctuate. For example, if the Company holds a security that was
issued with a fixed interest rate at the then-prevailing rate and the prevailing
interest rate later rises, the principal amount of the investment will probably
decline. To minimize this risk, the Company maintains its portfolio of cash
equivalents and short-term investments in a variety of securities, including
money market funds, commercial paper and government and non-government debt
securities. In general, money market funds are not subject to market risk
because the interest paid on such funds fluctuates with the prevailing interest
rate. In addition, the Company invests in relatively short-term securities.
The following table (in thousands, except interest rates) presents the amounts
of cash equivalents and short-term investment that are subject to market risk by
range of expected maturity and weighted average interest rates as of June 30,
2000 and December 31, 1999. This table does not include money market funds
because those funds are not subject to market risk.
<TABLE>
<CAPTION>
MATURING
BETWEEN
MATURING IN THREE
THREE MONTHS MONTHS AND
AT JUNE 30, 2000 OR LESS ONE YEAR TOTALS
------------------------------------------
<S> <C> <C> <C>
Included in cash and cash equivalents $ 45,290 -- $ 45,290
Weighted average interest rate 5.03% -- 5.03%
Included in short-term investments $ 9,523 $ 39,986 $ 49,509
Weighted average interest rate 6.70% 6.29% 6.37%
Total portfolio $ 54,813 $ 39,986 $ 94,799
Weighted average interest rate 5.32% 6.29% 5.73%
</TABLE>
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<PAGE> 24
<TABLE>
<CAPTION>
MATURING
BETWEEN
MATURING IN THREE
THREE MONTHS MONTHS AND
AT DECEMBER 31, 1999 OR LESS ONE YEAR TOTALS
------------------------------------------
<S> <C> <C> <C>
Included in cash and cash equivalents $ 2,750 -- $ 2,750
Weighted average interest rate 6.76% -- 6.76%
</TABLE>
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Not applicable.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
(a) Changes in Securities
In July 2000, the Board of Directors approved a two-for-one stock split
of our common stock, to be effected in the form of a stock dividend. The stock
split will be effected on or about August 23, 2000 by distribution to each
stockholder of record as of August 9, 2000 of one share of common stock for each
share of common stock held.
(b) Use of Proceeds
In February 2000, the Company completed the initial public offering of
3,450,000 shares of its common stock (including 450,000 shares sold in
connection with the exercise of the underwriters' over-allotment option)
registered under the Securities Act of 1933, as amended, on a Registration
Statement on Form S-1 (No. 333-91427). The managing underwriters in the offering
were Goldman, Sachs & Co., Dain Rauscher Wessels and Robertson Stephens. The
offering commenced on January 31, 2000 and terminated on February 4, 2000 when
we sold all of the 3,450,000 shares of common stock. The Securities and Exchange
Commission declared the Registration Statement effective on February 1, 2000.
The initial public offering price was $29.00 per share for an aggregate initial
public offering of $100.1 million.
We paid a total of $7.0 million in underwriting discounts and
commissions and $947,000 for costs and expenses associated with the offering.
None of the costs and expenses related to the offering were paid directly or
indirectly to any director, officer, general partner of the Company or its
associates, persons owning 10 percent or more of any class of equity securities
of the Company or an affiliate of the Company.
After deducting the underwriting discounts and commissions and the
offering expenses, the net proceeds to the Company of the offering were
approximately $92.1 million. The net offering proceeds have been used for
general corporate purposes, including to provide working capital to develop
products and to expand the Company's operations. Funds that have not been used
have been invested in money market funds, certificate of deposits and other
investment grade securities. We may also use a portion of the net proceeds to
acquire or invest in businesses, technologies, products or services.
The information in the above paragraphs in this Item 2(b) does not give
effect to the two-for-one stock split authorized by the Board of Directors in
July 2000.
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<PAGE> 25
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS
The Company held its annual meeting of stockholders in Mountain View,
California on May 10, 2000. Of the 30,155,210 shares outstanding as of the
record date, 24,091,807 shares were present or represented by proxy at the
meeting on May 10, 2000 and 24,105,357 shares were present or represented by
proxy at the adjourned meeting on May 25, 2000. At these meetings the following
actions were voted upon:
a. To elect the following two Class I directors to serve for a term
ending upon the 2003 Annual Meeting of Stockholders or until their
successors are elected and qualified:
<TABLE>
<CAPTION>
FOR AGAINST ABSTAIN
----------------------------------------
<S> <C> <C> <C>
Richard N. Tinsley 24,093,678 11,679 0
P. Kingston Duffie 24,093,633 11,724 0
</TABLE>
b. To approve our 2000 Stock Plan for a total of 5,287,876 shares of
common stock reserved for issuance, including 287,876 shares available for grant
under the 1998 Stock Plan that were transferred to the 2000 Stock Plan. An
annual increase in the share reserve will be added on the first day of our
fiscal year, beginning in 2001, equal to the lesser of (i). 5,000,000 shares;
(ii). 6% of the outstanding shares on that date; or (iii). a lesser amount
determined by the Board of Directors. Our 2000 Stock Plan had been approved by
our Board of Directors and stockholders prior to our initial public offering,
and had become effective January 31, 2000:
<TABLE>
<CAPTION>
FOR AGAINST ABSTAIN
----------------------------------------
<S> <C> <C> <C>
21,784,453 765,994 1,554,910
</TABLE>
c. To ratify the appointment of KPMG LLP as the Company's independent
public accountants for the year ending December 31, 2000:
<TABLE>
<CAPTION>
FOR AGAINST ABSTAIN
----------------------------------------
<S> <C> <C> <C>
24,100,506 2,980 1,871
</TABLE>
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<PAGE> 26
ITEM 5. OTHER INFORMATION
Not applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
27.1 Financial Data Schedule
(b) Reports on Form 8-K
There were no reports on Form 8-K filed during the three month
period ended June 30, 2000.
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<PAGE> 27
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this Report to be signed on its behalf by the
undersigned, thereunto duly authorized.
TURNSTONE SYSTEMS, INC.
Date: August 7, 2000 By: /s/ Richard N. Tinsley
------------------------------------
Richard N. Tinsley
President, Chief Executive
Officer and Director
(Principal Executive Officer)
Date: August 7, 2000 By: /s/ Terrence J. Schmid
------------------------------------
Terrence J. Schmid
Chief Financial Officer
(Principal Financial and Accounting
Officer)
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<PAGE> 28
INDEX TO EXHIBITS
27.1 FINANCIAL DATA SCHEDULE
