<PAGE>
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
________________
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 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: 0-30757
_______________
Sunrise Telecom Incorporated
(Exact name of Registrant as specified in its charter)
_______________
Delaware 77-0291197
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
22 Great Oaks Blvd., San Jose, California 95119
(Address of principal executive offices, including zip code)
Registrant's telephone number, including area code: (408) 363-8000
_______________
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 [_]
As of November 6, 2000, there were 49,892,779 shares of the Registrant's Common
Stock outstanding, par value $0.001.
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SUNRISE TELECOM INCORPORATED
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
PART I. Financial Information Number
--------------------- ------
<S> <C> <C>
Item 1 Financial Statements (unaudited)
Condensed Consolidated Balance Sheets as of September 30, 2000
and December 31, 1999................................................. 3
Condensed Consolidated Statements of Operations for the three and nine
month periods ended September 30, 2000 and 1999....................... 4
Condensed Consolidated Statements of Cash Flows for the nine month
periods ended September 30, 2000 and 1999............................. 5
Notes to Condensed Consolidated 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............ 24
PART II. Other Information
-----------------
Item 1 Legal Proceedings..................................................... 26
Item 2 Changes in Securities................................................. 26
Item 3 Defaults Upon Senior Securities....................................... 26
Item 4 Submission of Matters to a Vote of Security Holders................... 26
Item 5 Other Information..................................................... 26
Item 6 Exhibits and Reports on Form 8-K...................................... 26
Signatures.......................................................................... 28
</TABLE>
2
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PART I. Financial Information
ITEM 1.
SUNRISE TELECOM INCORPORATED
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share data, unaudited)
<TABLE>
<CAPTION>
September 30, December 31,
2000 1999
------------- -------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 51,809 $ 8,615
Investment in marketable debt securities 4,300 -
Accounts receivable, net 22,333 9,524
Inventories 13,880 7,612
Prepaid expenses and other assets 1,136 214
Deferred tax assets 3,752 2,050
------------- -------------
Total current assets 97,210 28,015
Property and equipment, net 7,542 4,417
Intangible assets, net 12,656 2,324
Deferred tax assets 479 -
Other assets 3,852 3,510
------------- -------------
Total assets $121,739 $38,266
============= =============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 3,844 1,701
Current portion of notes payable 1,079 219
Other accrued expenses 12,683 6,688
Income taxes payable 3,212 2,814
Deferred revenue 431 233
------------- -------------
Total current liabilities 21,249 11,655
------------- -------------
Deferred tax liability - 171
Notes payable, less current portion 1,181 638
Other liabilities 518 331
Stockholders' equity:
Common stock, $0.001 par value per share; 175,000,000 shares 50 45
authorized; 49,876,000 and 44,913,000 shares issued and
outstanding, respectively.
Additional paid-in capital 67,777 3,915
Deferred stock-based compensation (7,160) (2,065)
Retained earnings 38,249 23,576
Accumulated other comprehensive loss (125) -
------------- ------------
Total stockholders' equity 98,791 25,471
------------- ------------
Total liabilities and stockholders' equity $121,739 $38,266
============= ============
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
3
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SUNRISE TELECOM INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data, unaudited)
<TABLE>
<CAPTION>
Three Months Nine Months
Ended September 30, Ended September 30,
2000 1999 2000 1999
---------- -------- ------- --------
<S> <C> <C> <C> <C>
Net sales $ 35,085 $ 14,511 $ 82,361 $ 39,011
Cost of sales 10,034 3,463 23,604 9,745
--------- -------- -------- --------
Gross profit 25,051 11,048 58,757 29,266
--------- -------- -------- --------
Operating expenses:
Research and development 5,283 2,793 13,121 7,312
Selling and marketing 6,157 3,645 16,611 9,932
General and administrative 2,619 1,100 6,367 2,662
--------- -------- -------- --------
Total operating expenses 14,059 7,538 36,099 19,906
--------- -------- -------- --------
Income from operations 10,992 3,510 22,658 9,360
Other income, net 635 99 632 209
--------- -------- -------- --------
Income before income taxes 11,627 3,609 23,290 9,569
Income taxes 4,302 1,149 8,617 3,029
--------- -------- -------- --------
Net income $ 7,325 $ 2,460 $ 14,673 $ 6,540
========= ======== ======== ========
Earnings per share:
Basic $ 0.15 $ 0.05 $ 0.32 $ 0.15
========= ======== ======== ========
Diluted $ 0.14 $ 0.05 $ 0.30 $ 0.14
========= ======== ======== ========
Shares used in per share computation:
Basic 49,178 44,728 46,572 44,607
========= ======== ======== ========
Diluted 51,855 45,963 48,849 45,696
========= ======== ======== ========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
4
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SUNRISE TELECOM INCORPORATED
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands, unaudited)
<TABLE>
<CAPTION>
Nine Months
Ended September 30,
2000 1999
---------- ----------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 14,673 $ 6,540
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 2,995 847
Amortization of deferred stock-based compensation 1,405 64
Loss on the sale of property and equipment 48 -
Deferred income taxes (2,370) -
Change in operating assets and liabilities (net of acquisition balances):
Accounts receivable (12,119) (2,681)
Inventories (6,197) (2,367)
Prepaid expenses and other assets (871) (125)
Other accrued expenses 7,512 6,150
Deferred revenue 302 (78)
Income taxes payable 348 610
---------- ----------
Net cash provided by operating activities 5,726 8,960
---------- ----------
Cash flows used in investing activities:
Capital expenditures (4,104) (1,530)
Purchases of marketable equity securities (4,303) -
Purchase of long-term investment (241) -
Acquisition of Pro. Tel and Hukk, net of cash acquired (4,717) (781)
---------- ----------
Net cash used in investing activities (13,365) (2,311)
---------- ----------
Cash flows provided by (used in) financing activities:
Payments on notes payable (1,412) -
Repurchase of common stock - (202)
Cash dividends - (223)
Net proceeds from issuance of common stock 51,608 -
Proceeds from exercise of stock options 759 113
---------- ----------
Net cash provided by (used in) financing activities 50,955 (312)
---------- ----------
Effect of exchange rate changes on cash (122) -
---------- ----------
Net increase in cash and cash equivalents 43,194 6,337
Cash and cash equivalents at the beginning of the period 8,615 5,030
---------- ----------
Cash and cash equivalents at the end of the period $ 51,809 $ 11,367
========== ==========
Supplemental cash flow disclosures:
Cash paid during the period:
Interest $ 113 $ -
========== ==========
Income taxes $ 8,635 $ 2,562
========== ==========
Noncash investing and financing activities:
Unrealized loss on marketable securities and investments $ 3 $ -
========== ==========
Promissory note issued in connection with acquisition $ 1,000 $ -
========== ==========
Stock issued in acquisition $ 5,000 $ 1,000
========== ==========
Deferred stock-based compensation $ 6,500 $ 646
========== ==========
</TABLE>
The accompanying notes are an integral part of these condensed consolidated
financial statements.
5
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SUNRISE TELECOM INCORPORATED
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(1) Basis of Presentation
Sunrise Telecom Incorporated and subsidiaries was originally incorporated
as Sunrise Telecom, Inc. in California in October 1991. In July 2000, the
Company reincorporated in Delaware and changed its name to Sunrise Telecom
Incorporated ("the Company") (see Note 11. Capital Stock). The Company
manufactures and markets service verification equipment to pre-qualify, verify
and diagnose telecommunications and Internet networks. The Company markets and
distributes its products via a worldwide network of manufacturers, sales
representatives, distributors, and a direct sales force throughout six
continents. The Company has wholly owned subsidiaries in Norcross, Georgia;
Taipei, Taiwan; Modena, Italy; Tokyo, Japan; a representative liaison office in
Beijing, China; and a foreign sales corporation in Barbados.
These accompanying unaudited condensed consolidated financial statements
have been prepared under the same basis as the audited consolidated financial
statements, and in the opinion of management, reflect all adjustments
(consisting only of normal recurring adjustments) necessary for their fair
presentation. Certain amounts in the prior year financial statements have been
reclassified, where appropriate, to conform to the current year financial
statement presentation. 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 interim results presented are not necessarily indicative of results
that may be expected for any subsequent interim period or for the full fiscal
year ending December 31, 2000.
(2) Completion of Initial Public Offering
On July 12, 2000, the Company completed its initial public offering of 4.6
million shares at $15 per share, including 600,000 over-allotment shares, of
which 782,572 shares were sold by selling stockholders. Net proceeds to the
Company from the offering after underwriter's fees and expenses of approximately
$5.7 million totaled approximately $51.6 million.
(3) Revenue Recognition
Revenue is recognized when earned. 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 extended warranty programs is deferred
and recognized on a straight-line basis over the warranty period. Deferred
revenue represents amounts received from customers in advance of services and
support to be provided or prior to customer acceptance. Provisions are recorded
at the time of sale for estimated product returns, standard warranty and
customer support.
(4) Earnings Per Share
Basic earnings per share ("EPS") is computed using the weighted-average
number of common shares outstanding during the period. Diluted EPS is computed
using the weighted-average number of common and dilutive common equivalent
shares outstanding during the period. Dilutive common equivalent shares consist
of common stock issued in the Pro.Tel acquisition and common stock issuable upon
exercise of stock options using the treasury stock method.
The following is a reconciliation of the shares used in the computation of
basic and diluted EPS (in thousands):
<TABLE>
<CAPTION>
Three Months Nine Months
Ended September 30, Ended September 30,
2000 1999 2000 1999
------- -------- -------- --------
<S> <C> <C> <C> <C>
Basic EPS- weighted-average number of common
shares outstanding............................ 49,178 44,728 46,572 44,607
Effect of dilutive common equivalent shares:
Stock options outstanding..................... 2,677 1,235 2,110 1,089
Stock issued in acquisition subject to put
arrangement............................... - - 167 -
------ ------ ------ ------
Diluted EPS- weighted-average number of common
shares outstanding............................ 51,855 45,963 48,849 45,696
======= ====== ====== ======
</TABLE>
6
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(5) Other Comprehensive Income
Comprehensive income comprises net income and other comprehensive income.
Other comprehensive income includes certain changes in equity of the Company
that are excluded from net income, including foreign currency translation
adjustments. The following table presents the calculation of comprehensive
income as required by Statement of Financial Accounting Standards ("SFAS") No.
130. The components of comprehensive income, net of tax, are as follows (in
thousands):
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
2000 1999 2000 1999
------ ------ ------- ------
<S> <C> <C> <C> <C>
Net income.............................. $7,325 $2,460 $14,673 $6,540
Change in unrealized loss on
available-for-sale investments......... (3) - (3) -
Cumulative translation adjustment....... (86) - (122) -
------ ------ ------- ------
Total comprehensive income.............. $7,236 $2,460 $14,548 $6,540
====== ====== ======= ======
</TABLE>
(6) Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued SFAS No.
133, "Accounting for Derivative Instruments and Hedging Activities". SFAS No.
133 establishes accounting and reporting standards, requiring that every
derivative instrument be recorded in the balance sheet as either an asset or
liability measured at its fair value. SFAS No. 133, as recently amended, is
effective for fiscal years beginning after June 30, 2000. Management believes
the adoption of SFAS No. 133 will not have a material effect on the Company's
financial position or results of operations.
In December 1999, the Securities and Exchange Commission issued Staff
Accounting Bulletin No. 101 "Revenue Recognition in Financial Statements." The
staff accounting bulletin, as amended, is effective no later than the fourth
quarter of 2000. The Company is in the process of determining the impact that
adoption will have on its consolidated financial statements.
Effective July 1, 2000, the Company adopted Financial Accounting Standards
Board Interpretation No. 44 ("FIN 44") "Accounting for Certain Transactions
involving Stock Compensation - - an Interpretation of Accounting Principles
Board ("APB") Opinion No. 25." FIN 44 clarifies the application of APB Opinion
No. 25. The adoption of FIN 44 has not had a material effect on the Company's
financial position or results of operations.
(7) 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
September 30, 2000 and December 31, 1999 consist primarily of cash on deposit
with banks, money market funds, auction rate securities and marketable debt
securities. The Company has adopted SFAS No. 115, "Accounting for Certain
Investments in Debt and Equity Securities". The Company determines the
appropriate classification of debt and equity securities at the time of purchase
and reevaluates such designation as of each balance sheet date. Investments
classified as available for sale are reported at market value, with the
unrealized gains and losses, net of tax, reported as a separate component of
other comprehensive income
7
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(loss) in stockholders' equity. Realized gains and losses on sales of
investments and declines in value determined to be other than temporary are
included in other income (expense).
(8) Financial Statement Details
Inventories consisted of the following (in thousands):
September 30, December 31,
2000 1999
------------ ------------
Raw materials.......................... $ 7,920 $ 2,553
Work-in-process........................ 3,826 2,704
Finished goods......................... 2,134 2,355
------------ ------------
$ 13,880 $ 7,612
============ =============
(9) Minority Investment
During 1998, the Company acquired 1,666,667 shares (approximately 16.4%)
of the common stock of Top Union Electronics (Top Union), a Taiwan R.O.C.
corporation, for a purchase price of $606,612. Top Union is a subcontractor
manufacturer utilized by the Company for the manufacture of certain products.
During 1999 and 2000, the Company invested an additional $39,000 and $241,000,
respectively, in Top Union as part of two of three external rounds of third-
party financing obtained by Top Union. This investment by the Company was less
than 16.4% of the total financing raised by Top Union and, thus, diluted the
Company's ownership of Top Union to 13.7%. The Company accounts for this
investment using the cost method of accounting. The Company evaluates the fair
value of its investment based on the valuation associated with third party
external rounds of financing. To date no impairment charges have been
recognized.
(10) Notes Payable and Line of Credit
The Company has a $9,000,000 revolving line of credit with a financial
institution that expires on May 1, 2001, bearing interest at the bank's prime
rate less 0.25% (9.25% as of September 30, 2000). The agreement, which is
collateralized by the receivables and inventories of the Company, contains
certain financial covenants and restrictions. As of September 30, 2000, there
were no balances outstanding under the line of credit. In addition, on June 30,
2000, the Company issued a short-term note payable in the amount of $1.0 million
in connection with an acquisition and repaid $400,000 in August 2000, with the
remainder due in monthly installments of $100,000 per month beginning in
November 2000 through April 2001.
(11) Capital Stock
Recapitalization
On July 12, 2000, the Company was reincorporated into Delaware with the
authorization of 175,000,000 shares of $0.001 par value per share common stock
and 10,000,000 shares of $0.001 par value preferred stock.
(12) Acquisitions
The following summary prepared on an unaudited pro forma basis reflects
the condensed consolidated results of operations for the year ended December 31,
1999 and the nine month period ended September 30, 2000, assuming Hukk
Engineering ("Hukk") and Pro.Tel. Srl ("Pro.Tel") had been acquired at the
beginning of the periods presented (in thousands, except per share data):
Nine Months Year
Ended Ended
September 30, December 31,
2000 1999
------------- ------------
Net sales....................................... $ 82,605 $ 63,716
Net income...................................... $ 14,113 $ 7,885
Basic net income per share...................... $ 0.30 $ 0.17
Shares used in pro forma per share computation.. 46,850 45,317
8
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(13) Segment Information
SFAS No. 131, "Disclosure About Segments of an Enterprise and Related
Information", establishes standards for the manner in which public companies
report information about operating segments, products, services, geographic
areas, and major customers in annual and interim financial statements. The
method of determining what information to report is based on the way that
management organizes the operating segments within the enterprise for making
operating decisions and assessing financial performance.
The Company's chief operating decision-maker is considered to be the
Company's Chief Executive Officer (CEO). The CEO reviews financial information
presented on a consolidated basis accompanied by disaggregated information about
revenue by geographic region for purposes of making operating decisions and
assessing financial performance. The consolidated financial information reviewed
by the CEO is the same as the information presented in the accompanying
condensed consolidated statements of operations. In addition, as the Company's
assets are primarily located in its corporate offices in the United States and
not allocated to any specific segment, the Company does not produce reports for
or measure the performance of its segments based on any asset-based metrics.
Therefore, the Company operates in a single operating segment; the design,
manufacture, and sale of digital test equipment for telecommunications,
transmission, and signaling applications.
Revenue information regarding operations in the different geographic regions
is as follows (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
2000 1999 2000 1999
------- -------- ------- -------
North America............. $28,213 $11,519 $65,581 $31,359
Europe.................... 2,910 833 7,621 2,603
Asia/Pacific.............. 3,052 1,728 6,600 4,215
Latin America............. 910 431 2,559 834
------- ------- ------- -------
$35,085 $14,511 $82,361 $39,011
======= ======= ======= =======
Revenue information by product category is as follows (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
2000 1999 2000 1999
------- ------- ------- -------
Digital subscriber line... $27,160 $13,953 $67,021 $38,453
Cable TV.................. 1,655 558 2,630 558
Fiber optics.............. 4,733 - 9,696 -
Signaling................. 1,537 - 3,014 -
------- ------- ------- -------
$35,085 $14,511 $82,361 $39,011
======= ======= ======= =======
9
<PAGE>
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 Operation (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 Consolidated Financial Statements and
notes thereto included elsewhere in this report.
Overview
We manufacture and market service verification equipment to pre-qualify,
verify and diagnose telecommunications and Internet networks. We design our
products to maximize technicians' effectiveness in the field and to provide
realistic network simulations for equipment manufacturers to test their
products. Our customers include incumbent local exchange carriers, competitive
local exchange carriers, and other service providers, network infrastructure
suppliers and installers throughout North America, Latin America, Europe and the
Asia/Pacific region.
Sources of Net Sales
We sell our products predominantly to large telecommunications service
providers. These prospective customers generally commit significant resources to
an evaluation of our and our competitors' products and require each vendor to
expend substantial time, effort and money educating the prospective customer
about the value of the proposed solutions. Delays associated with potential
customers' internal approval and contracting procedures, procurement practices,
testing and acceptance processes are common and may cause potential sales to be
delayed or foregone. As a result of these and related factors, the sales cycle
of new products for large customers typically ranges from six to 24 months.
Substantially all of our sales are made on the basis of purchase orders rather
than long-term agreements or requirements contracts. As a result, we commit
resources to the development and production of products without having received
advance or long-term purchase commitments from customers.
To date, a significant portion of our net sales has resulted from a small
number of relatively large orders from a limited number of customers. In the
first nine months of 2000 and 1999, we sold approximately $16.2 million and
$14.9 million, respectively, of our products to affiliates of SBC
Communications, which represented approximately 20% and 38%, respectively, of
our net sales. Sales to SBC Communications affiliates have decreased to
approximately $3.1 million, or 9% of net sales in the third quarter of 2000 from
approximately $4.4 million or 30% of net sales for the same period in 1999,
primarily due to a higher sales volume of light chassis DSL products which have
lower average selling prices than full chassis DSL products. As a percentage of
sales, sales to SBC Communications affiliates have decreased due to our
expanding customer base and the growth of our business as well as a change in
the product mix purchased. Additionally, in the first nine months of 2000,
approximately $13.9 million or 17% of our net sales were generated from an OEM
product sold to Solectron, a new customer who integrates this product into the
Stinger DSLAM that it manufactures for Lucent Technologies. 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.
Currently, competition in the telecommunications equipment market is intense
and 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
reduce our production costs accordingly, our gross margins will correspondingly
decline. See "Factors Affecting Future Operating Results--Competition and --
Risks of the Telecommunications Industry."
During the last three years, a substantial portion of our net sales were
derived from customers located outside of the United States, and we believe that
continued growth will require expansion of our sales in international markets.
Currently, we maintain a procurement support and manufacturing facility in
Taipei, Taiwan, a representative liaison office in Beijing, China, a foreign
sales corporation in Barbados and manufacturing, research and development and
sales facilities in Modena, Italy, a sales office in Tokyo, Japan and expect to
establish additional international sales and other offices in the future. Prior
to our acquisition of Pro.Tel, international sales
10
<PAGE>
have been denominated solely in U.S. dollars and, accordingly, we have not
historically been exposed to fluctuations in non-U.S. currency exchange rates
related to these sales activities. Since our acquisition of Pro.Tel in February
2000, we now have a small amount of sales denominated in Euro and have begun to
use derivative instruments to hedge our foreign exchange risks. To date, foreign
exchange risks from these sales have not been material to our operations. We
have also been exposed to fluctuations in non-U.S. currency exchange rates
related to our procurement activities in Taiwan. In the future, we expect that a
growing portion of international sales may be denominated in currencies other
than U.S. dollars, thereby exposing us to gains and losses on non-U.S. currency
transactions. We may choose to limit such exposure by entering into various
hedging strategies. See "Factors Affecting Future Operating Results--Risks
Relating to Our Business--Risks of International Operations."
We recognize product sales 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. We offer a three-year warranty covering parts and labor on our DSL and
fiber optic products sold in the United States and a one-year warranty covering
parts and labor for those products sold overseas with a two-year extended
warranty option at time of sale. Our cable TV and signaling products are covered
by a one-year warranty. Sales of extended warranties are deferred and recognized
over the extended warranty term, which is generally two years. We charge
estimated warranty costs to cost of sales when the related sales are recognized.
We recognize revenue for out-of-warranty repair when we ship the repaired
product.
Cost of Sales
Our cost of sales consist primarily of:
. direct material costs of product components, manuals, product documentation
and product accessories sold;
. production wages, taxes and benefits;
. production allocated occupancy costs;
. warranty costs;
. the costs of board level assembly by third party contract
manufacturers; and
. scrapped material used in the production process.
Our industry is characterized by limited supply chains and long lead times
for materials and components we use in the manufacture of our products. If we
underestimate our requirements, we may have inadequate inventory, resulting in
additional costs to our products to expedite delivery of certain long lead time
components. An increase in the cost of components could result in lower margins.
Additionally, these long lead times have in the past, and may in the
future, cause us to attempt to mitigate these lead times by purchasing larger
quantities of some parts, increasing our investment in inventory and the risk of
the parts' obsolescence. Any subsequent write-off of inventory could also result
in lower margins. See "Factors Affecting Future Operating Results--Risks
Relating to Our Business--Dependence on Sole and Single Source Suppliers".
We recognize direct cost of sales as we ship product. We expense scrapped
materials, wages, taxes, benefits and allocated occupancy costs as incurred.
Operating Costs
We classify our operating expenses into three general operational
categories: sales and marketing, research and development and general and
administrative. Our operating expenses also include stock-based compensation and
amortization of goodwill and other intangible assets. We classify all charges to
the sales and marketing, research and development and general and administrative
expense categories based on the nature of the expenditures. Although each of
these three categories includes expenses that are unique to the category type,
there are commonly recurring expenditures that are typically included in these
categories, such as salaries, amortization of stock-based
11
<PAGE>
compensation, employee benefits, travel and entertainment costs, allocated
communication, rent and facilities costs and third party professional service
fees. The sales and marketing category of operating expenses also includes
expenditures specific to the sales and marketing group, such as those relating
to commissions, public relations and advertising, trade shows and marketing
materials.
We allocate the total cost of overhead and facilities to each of the
functional areas that use overhead and facilities based upon the facilities
square footage used by each of these areas. These allocated charges include
facility rent and utilities for the corporate office, communications charges and
depreciation expense for office furniture and equipment.
In the first nine months of 2000, we recorded amortization of deferred
stock-based compensation expense of approximately $1,405,000 related to the
grant of options to purchase our common stock at exercise prices subsequently
deemed to be below fair market value. Total compensation expense related to
options granted in 1999 and the first quarter of 2000 will be amortized on a
straight-line basis to the departments in which the employees received these
below market option grants over the respective four-year vesting periods of the
options. In the first nine months of 2000 and 1999, we allocated amortization of
deferred stock-based compensation expense of $189,000 and $5,000, respectively,
to cost of sales, $560,000 and $42,000, respectively, to research and
development expense, $420,000 and $12,000, respectively, to sales and marketing
expense and $236,000 and $5,000, respectively, to general and administrative
expense. At September 30, 2000, approximately $7,160,000 of deferred stock-based
compensation expense remained to be amortized at a rate not exceeding $549,000
per quarter.
Acquisitions
In July 1999, we acquired Hukk Engineering ("Hukk"), a manufacturer of
digital cable testing equipment. We accounted for the Hukk Engineering
acquisition as a purchase and recorded goodwill and other intangibles of
approximately $2.5 million to be amortized on a straight-line basis over the
next five years. In February 2000, we acquired Pro.Tel. S.r.l. ("Pro.Tel"), an
Italian manufacturer of distributed network signaling analysis equipment, and
its U.S. affiliate and the assets of an unrelated U.S. distributor. We accounted
for the Pro.Tel acquisition as a purchase and recorded goodwill and other
intangibles of approximately $9.4 million to be amortized on a straight-line
basis over the next two to five years, based on the expected life of the
underlying assets. In addition, we recorded stock-based compensation for stock
options granted to employees of Pro.Tel in the first quarter of 2000 in the
amount of approximately $6.5 million to be amortized on a straight-line basis
over their four year vesting period. We believe that acquisitions and joint
ventures may be an important part of our growth and competitive strategy.
"Factors Affecting Future Operating Results--Risks Relating to Our Business--
Acquisitions."
Results of Operations
Comparison of Three and Nine Month Periods Ended September 30, 2000 and 1999
Net Sales. Net sales increased approximately 142% to $35.1 million in the
third quarter of 2000 from $14.5 million for the comparable quarter in 1999. Net
sales increased approximately 111% to $82.4 million in the first nine months of
2000 from $39.0 million for the comparable period in 1999.
For the third quarter of 2000, sales of our DSL products accounted for
approximately $13.2 million of the net sales increase, our new fiber optics
products accounted for approximately $4.7 million of the net sales increase, our
new signaling products accounted for approximately $1.5 million of the net sales
increase, and our cable TV products accounted for approximately $1.1 million of
the net sales increase over the comparable quarter in the prior year. For the
first nine months of 2000, sales of our DSL products accounted for approximately
$28.7 million of the net sales increase, our new fiber optics products accounted
for approximately $9.7 million of the net sales increase, our new signaling
products accounted for approximately $3.0 million of the net sales increase and
our cable TV products accounted for approximately $2.1 million of the net sales
increase over the comparable period in the prior year.
Sales in the third quarter of 2000 grew $16.7 million or 145% in North
America, $2.1 million or 249% in Europe, $1.3 million or 77% in Asia and
$479,000 or 111% in Latin America as compared to the same period in 1999. Sales
for the first nine months of 2000 grew $34.2 million or 109% in North America,
$5.0 million or 193% in Europe, $2.4 million or 57% in Asia and $1.7 million or
207% in Latin America as compared to the same period in 1999.
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The strong increase in North American sales is primarily due to sales of our DSL
products which accounted for approximately $9.9 million and approximately $20.8
million of the increase in North American sales for the third quarter and for
the nine month period, respectively, in part due to sales of our new customized
Copper Loop Test Head for Lucent Technologies' Stinger DSLAM, which totaled
approximately $8.9 million or 26% of net sales for the third quarter and
approximately $13.9 million or 17% of net sales for the first nine months of
2000. In the fourth quarter of 2000, we expect that sales of our new customized
Copper Loop Test Head will moderate to a more sustainable rate of 10% to 20% of
net sales. Sales of our new fiber optics products accounted for approximately
$4.2 million and $8.6 million of the increase in North American sales for the
third quarter and for the first nine months of 2000, respectively. Our new
signaling products accounted for approximately $1.5 million and $2.7 million of
the increase in North American sales for the third quarter and for the first
nine months of 2000, respectively, and sales of our cable TV products which were
acquired in July of 1999, accounted for approximately $1.1 million and $2.1
million of the increase in North American sales for the third quarter and for
the first nine months of 2000, respectively.
International sales increased to approximately $9.3 million, or 26% of net
sales in the third quarter of 2000 from approximately $3.4 million or 24% of net
sales in the same period in 1999. International sales increased to approximately
$20.0 million, or 24% of net sales in the first nine months of 2000 from
approximately $8.8 million or 22% of net sales in the same period in 1999. The
increase in international sales is primarily due to increased sales of our DSL
product line and our expanded international operations.
Cost of Sales. Cost of sales consists primarily of direct material,
warranty and personnel costs related to the manufacturing of our products and
allocated overhead. Cost of sales increased approximately 190% to $10.0 million
in the third quarter of 2000 from $3.5 million in the same period in 1999. Cost
of sales increased approximately 142% to $23.6 million in the first nine months
of 2000 from $9.7 million in the same period in 1999. The increase in absolute
dollars is primarily due to the increase in net sales. Cost of sales represented
approximately 29% and 24% of net sales in the third quarter of 2000 and 1999,
respectively, and 29% and 25% of net sales in the first nine months of 2000 and
1999, respectively. The increase as a percentage of net sales resulted primarily
from a higher sales volume of light chassis DSL products which have lower
average selling prices than full chassis DSL products and the introduction of
our new fiber optics and cable TV product lines which generated lower gross
margins than the mix of products sold during the prior year. We expect that cost
of sales expenses will continue to increase as a percentage of sales for the
foreseeable future as our OEM relationships expand and our light chassis DSL and
cable TV products increase as a percentage of our overall product mix.
Research and Development. Research and development expenses consist
primarily of the costs of payroll and benefits for engineers, equipment and
consulting services. Research and development expenses increased approximately
89% to $5.3 million in the third quarter of 2000 from $2.8 million for the same
period in 1999. Research and development expenses increased approximately 79% to
$13.1 million in the first nine months of 2000 from $7.3 million for the same
period in 1999. The increase in absolute dollars was primarily due to costs
associated with increased staffing dedicated to research and development
activities. These research and development expenses represented approximately
15% and 19% of net sales during the third quarter of 2000 and 1999,
respectively, and approximately 16% and 19% of net sales in the first nine
months of 2000 and 1999, respectively. The decrease as a percentage of net sales
in 2000 was primarily attributable to increased product sales relative to
research and development expenditures. We expect that research and development
expenses will increase in absolute dollars for the foreseeable future as we
intend to continue to invest in product development.
Sales and Marketing. Sales and marketing expenses consist primarily of
manufacturers' representatives and direct sales commissions, personnel, travel
and facilities expenses related to sales and marketing, and trade show and
advertising expenses. Sales and marketing expenses increased approximately 69%
to $6.2 million in the third quarter of 2000 from $3.6 million in the same
period in 1999. Sales and marketing expenses increased approximately 67% to
$16.6 million in the first nine months of 2000 from $9.9 million in the same
period in 1999. The increase in absolute dollars in 2000 was primarily related
to increased staffing to support expanded product offerings and increased
marketing and promotional activities. These sales and marketing expenses
represented approximately 18% and 25% of net sales during the third quarter of
2000 and 1999, respectively, and approximately 20% and 25% of net sales in the
first nine months of 2000 and 1999, respectively. The decrease as a percentage
of net sales was primarily due to increased OEM sales which have led to lower
commission, occupancy, and salary and related expenses as a percentage of sales.
We expect that sales and marketing expenses will increase in absolute dollars
for the foreseeable future as we intend to continue to invest in our sales and
marketing capabilities.
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<PAGE>
General and Administrative. General and administrative expenses consist
primarily of personnel, facilities and other costs of our finance and
administrative departments as well as legal and accounting expenses. General and
administrative expenses increased approximately 138% to $2.6 million in the
third quarter of 2000 from $1.1 million in the same period in 1999. General and
administrative expenses increased approximately 139% to $6.4 million in the
first nine months of 2000 from $2.7 million in the same period in 1999. These
general and administrative expenses represented approximately 7% and 8% of net
sales during the third quarter of 2000 and 1999, respectively, and approximately
8% and 7% of net sales in the first nine months of 2000 and 1999, respectively.
The increase in absolute dollars was primarily related to increased staffing and
related costs associated with the growth of our business, amortization of
goodwill and other intangible assets related to recent business acquisitions and
amortization of deferred stock-based compensation. We anticipate that general
and administrative expenses will continue to increase in absolute dollars for
the foreseeable future as we accommodate our growth, add related infrastructure
and incur expenses related to being a public company.
Other Income, Net. Other income, net represents primarily interest earned
on cash and investment balances net of interest expense on notes payable and
short-term borrowings under our line of credit. Other income, net increased to
approximately $635,000 in the third quarter of 2000 from approximately $99,000
for the same period in 1999. Other income, net increased to approximately
$632,000 in the first nine months of 2000 from approximately $209,000 for the
same period in 1999. The increase resulted primarily from interest income earned
on the net proceeds received from our initial public offering in July 2000.
Income Taxes. Income taxes consist of federal, state and international
income taxes. We recorded income tax expense of approximately $4.3 million in
the third quarter of 2000 and approximately $1.1 million in the same period in
1999. We recorded income tax expense of approximately $8.6 million in the first
nine months of 2000 and approximately $3.0 million in the same period in 1999.
Our effective income tax rates were 37% for the first nine months of 2000 and
32% in 1999. The effective income tax rate is higher in 2000 than in 1999
primarily due to higher levels of income, charges from non-cash amortization of
goodwill and deferred stock-based compensation, and an increased concentration
of sales in local jurisdictions with higher tax rates.
Seasonality
Our sales have been seasonal in nature with the largest portion of
quarterly sales tied to the buying patterns of our customers which, in past
years, have usually increased during the last calendar quarter of the year as
customers spent the unused portion of their yearly budget. As a result, in the
past, our first quarter sales tended to decrease from the prior quarter. In the
future, we expect that our quarterly operating results may fluctuate
significantly and will be difficult to predict given the nature of our business.
Many factors could cause our operating results to fluctuate from quarter to
quarter in the future, including the lengthy and unpredictable buying patterns
of our customers, and the degree to which our customers allocate and spend their
yearly budgets.
Liquidity and Capital Resources
Historically, we have financed our operations and satisfied our capital
expenditure requirements primarily through cash flow from operations and
borrowings under our line of credit. Additionally, in July of 2000, we received
net proceeds totaling approximately $51.6 million from our initial public
offering. As of December 31, 1999 and September 30, 2000, we had working capital
of approximately $16.3 million and $76.0 million, respectively, and cash and
cash equivalents of approximately $8.6 million and $51.8 million, respectively.
During the nine months ended September 30, 2000, we generated approximately
$5.7 million in cash flow from operating activities as compared to the same
period in 1999 when we generated approximately $9.0 million. Operating cash
flows decreased during the first nine months of 2000 as compared with the same
period in the prior year as a result of increases in accounts receivable,
increases in inventory required to meet our expected future sales targets,
increases in prepaid expenses and other assets for deposits related to both our
new building and our increased marketing activities, and an increase in deferred
income taxes. These uses of cash were partially offset by positive cash flow
generated from increased levels of income from operations, increased non-cash
charges for depreciation and amortization and amortization of deferred stock-
based compensation, and an increase in accounts and commissions payable and
accrued compensation and related benefits.
Cash used in investing activities was approximately $13.4 million and $2.3
million for the nine months ended September 30, 2000 and 1999, respectively. For
the first nine months of 2000, cash used in investing
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activities included approximately $4.7 million for acquisitions, $4.3 million
for purchases of marketable equity securities, $4.1 million for capital
expenditures and $241,000 for the purchase of a long-term investment. For the
same period in 1999, cash used in investing activities totaled approximately
$1.5 million for capital expenditures and $781,000 for acquisitions. Cash used
for capital expenditures increased in the first nine months of 2000 primarily as
a result of purchases of general office equipment to support our growth,
research and development laboratory equipment and demonstration equipment
required for the introduction of new products and an increase in the number of
our distribution channels. We believe that capital expenditures in the first
quarter 2001 will include approximately $18.0 million relating to the
construction of our new facility in San Jose, California, which we are building
to accommodate our need for an increase in manufacturing capacity and employees,
and approximately $3.0 million for equipment, furniture and fixtures relating to
the new facility. In addition, due to anticipated growth in our operations and
the increased capacity afforded by our new facility, we believe that capital
expenditures for the acquisition of property and equipment relating to our
ongoing business activities will increase to a total of approximately $6.0
million for the year 2000.
During the nine months ended September 30, 2000, we generated approximately
$51.0 million in financing activities as compared to the same period in 1999
where we used approximately $312,000. For the nine months ended September 30,
2000, cash provided by financing activities was primarily due to net proceeds of
approximately $51.6 million from our initial public offering in July 2000 and
$759,000 received from the exercise of stock options, partially offset by $1.4
million used for repayments of notes payable. Our use of cash in financing
activities for the same period in 1999 was primarily related to the repurchase
of approximately $202,000 of our common stock and cash dividends of $223,000,
offset by proceeds of $113,000 from the exercise of stock options.
Currently, we have a line of credit from Bank of America, N.A. for up to
$9.0 million in borrowings at the bank's prime rate less 0.25% which expires on
May 1, 2001. At December 31, 1999 and September 30, 2000 there were no balances
outstanding under the line of credit. Borrowings under the line of credit are
secured by our inventory and accounts receivable. The agreement governing the
line of credit contains covenants, which we were in compliance with at December
31, 1999 and at September 30, 2000, that, among other things:
. requires us to maintain various financial covenants, including
profitability and current ratios;
. limits capital expenditures;
. restricts the payment of dividends on our common stock to dividends payable
in common stock and to $1.0 million payable in any one fiscal year; and
. restricts our ability to redeem our common stock beyond 20% of our net
income for the prior fiscal year.
In July 2000, we completed our initial public offering of 4.6 million shares at
$15 per share, including 600,000 over-allotment shares, of which 782,572 shares
were sold by selling stockholders. Net proceeds to us from the offering after
underwriter's fees and expenses of approximately $5.7 million totaled
approximately $51.6 million. We believe that the net proceeds received by us
from our initial public offering, together with current cash balances, cash
flows from operations and available borrowings under our line of credit will be
sufficient to meet our anticipated cash needs for working capital, capital
expenditures and other activities for at least the next 12 months. After that,
if current sources are not sufficient to meet our needs, we may seek additional
equity or debt financing. In addition, any material acquisition of complementary
businesses, products or technologies or material joint venture could require us
to obtain additional equity or debt financing. We cannot assure you that such
additional financing would be available on acceptable terms, if at all.
Factors Affecting Future Operating Results
Quarterly Fluctuations--Because our quarterly operating results have fluctuated
significantly in the past and are likely to fluctuate significantly in the
future, our stock price may decline and may be volatile.
In the past, we have experienced significant fluctuations in our quarterly
results due to a number of factors beyond our control. In the future, we expect
that our quarterly operating results may fluctuate significantly and will be
difficult to predict given the nature of our business. Many factors could cause
our operating results to fluctuate from quarter to quarter in the future,
including the following:
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. the size and timing of orders from our customers, in each case
exacerbated by the lengthy and unpredictable buying patterns of our
customers, and our ability to ship these orders on a timely basis;
. the degree to which our customers have allocated and spent their
yearly budgets, which has, in some cases, resulted in higher net sales
in our fourth quarter;
. the uneven pace of technology innovation, the development of products
responding to these technology innovations by us and our competitors
and customer acceptance of these products and innovations;
. the varied degree of price, product and technology competition, which
has been buffeted by the rapid changes in the telecommunications
industry and our customers' and competitors' responses to these
changes;
. the relative percentages of our products sold domestically and
internationally; and
. the mix of the products we sell and the varied margins associated with
these products.
The factors listed above may affect our business and stock price in
several ways, including the following:
. Given the high fixed costs relating to overhead, research and
development, and advertising and marketing, among others, if our net
sales are below our expectations in any quarter, the negative effect
may be magnified by our inability to adjust spending in a timely
manner.
. As a result of the above, our stock price may decline and may be
volatile, particularly if public market analysts and investors
perceive these factors to exist, whether or not that perception is
accurate.
. Finally, the above factors, taken together may make it more difficult
for us to issue additional equity in the future or raise debt
financing to fund future acquisitions and accelerate growth.
Customer Concentration--A limited number of customers account for a high
percentage of our net sales, and any adverse factor affecting these customers
or our relationship with these customers could cause our net sales to
decrease.
Our customer base is highly concentrated, and a relatively small
number of companies have accounted for a large percentage of our net sales. Net
sales from our top five customers in the United States represented approximately
16% of net sales in 1997, 16% in 1998 and 49% in 1999 and 45% in the first nine
months of 2000. Our largest customers over this period have been affiliates of
SBC Communications Inc., which include Pacific Bell Telephone Company,
Southwestern Bell Telephone Company, Ameritech Corporation, Nevada Bell and
Southern New England Telephone and which in total accounted for approximately
41% of net sales in fiscal 1999 and 20% in the first nine months of 2000.
Additionally, sales to a new customer in 2000, Solectron, a contract
manufacturer for Lucent Technologies' Stinger DSLAM, represented approximately
17% of sales in the first nine months of 2000. No customer is presently
obligated to purchase a specific amount of products or to provide us with
binding forecasts of purchases for any period. We expect that we will continue
to depend upon SBC Communications' affiliates and other major customers for a
substantial portion of our net sales in future periods. We cannot guarantee that
our future net sales, including those from SBC Communications' affiliates, will
be comparable to our fiscal 1999 net sales. The loss of a major customer or the
reduction, delay or cancellation of orders from one or more of our significant
customers could cause our net sales and, therefore, profits to decline. In
addition, many of our customers are able to exert substantial negotiating
leverage over us. As a result, they may cause us to lower our prices and
negotiate other forms and provisions that may negatively affect our business and
profits.
Dependence on DSL--Substantially all of our sales have been from our DSL
products. If the market for DSL services does not continue to grow as we
anticipate, our net sales could decline.
In 1999 and the first nine months of 2000, sales of our DSL products
represented approximately 98% and 81% of our net sales, respectively. Currently,
our DSL products are primarily used by a limited number of incumbent local
exchange carriers, including the regional Bell operating companies, and
competitive local exchange carriers, who offer DSL services. A competitive local
exchange carrier is a company that, following the Telecommunications Act of
1996, is authorized to compete in a local communications services market. These
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parties, and other Internet service providers and users, are continuously
evaluating alternative high-speed data access technologies, including cable
modems, fiber optics, wireless technology and satellite technologies, and may at
any time adopt these competing technologies. These competing technologies may
ultimately prove to be superior to DSL services and reduce or eliminate the
demand for our DSL products.
In addition, the availability and quality of DSL service may be impaired by
technical limitations and problems of the existing copper wire network on which
DSL service runs, such as:
. the distance of end users from the central office of the incumbent local
exchange carrier, which is typically limited to between 12,000 and 18,000
feet;
. the quality and degree of interference with the copper wire network;
. the configuration of the copper wire network, which may degrade or prevent
DSL service;
. the ability of DSL networks and operational support systems of service
providers to connect and manage a substantial number of online end users at
high speeds, while achieving reliable and high quality service; and
. the vulnerability of the copper wire network to physical damage from
natural disasters and other unanticipated telecommunications failures and
problems.
Accordingly, our future success is substantially dependent upon whether DSL
technology gains widespread market acceptance by these companies, end users of
their services and other Internet service providers and users.
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 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. If our customers are forced to reduce or eliminate their DSL deployment
plans, our sales to them will decline.
Use of Field Technicians--If service providers reduce their use of field
technicians and successfully implement a self-service installation model,
demand for our products could decrease.
To ensure quality service, our major service provider customers, including
SBC Communications, historically sent a technician who uses our product into the
field to verify service for installations. However, SBC Communications has
recently announced plans to encourage their customers to install their own DSL
service. U.S. West and Bell Atlantic already encourage customers to install DSL
themselves. By encouraging customers to install DSL themselves, these phone
companies intend to reduce their expenses and expedite installation for their
customers. To encourage self-installation, these companies offer financial
incentives. Additionally, SBC Communications has created a subsidiary, Advanced
Solutions, Inc., to provide installation services which further reduces the need
for the local telephone company technician to carry a test set that can emulate
both a DSL modem and find DSL physical layers problems. If SBC Communications
and other service providers successfully implement these plans or choose to send
technicians into the field only after a problem has been reported, or if
alternative methods of verification become available, such as remote
verification, the need for field technicians and the need for our products could
decrease.
Sales Implementation Cycles--The length and unpredictability of the sales and
implementation cycles for our products makes it difficult to forecast
quarterly revenues.
Sales of our products often entail an extended decision-making process on
the part of prospective customers. We frequently experience delays following
initial contact with a prospective customer and expend substantial funds and
management effort pursuing these sales. Our ability to forecast the timing and
amount of specific sales is therefore limited. As a result, the uneven buying
patterns of our customers may cause fluctuations in our quarterly operating
results, which could cause our stock price to decline.
Other sources of delays that lead to long sales cycles, or even a sales
loss, include: potential customers' internal approval and contracting
procedures, procurement practices, and testing and acceptance processes. As a
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result, the sales cycle for larger deployment of selected products typically
ranges from six to 24 months for new deployment of selected product sales, and
up to six months for occasional large selected product sales. The deferral or
loss of one or more significant sales could significantly affect operating
results in a particular quarter, especially if there are significant sales and
marketing expenses associated with the deferred or lost sales.
Product Enhancements--If we are unable to enhance our existing products and
successfully manage the development of new products, our future success may be
threatened.
The market for our products is characterized by rapid technological
advances, changes in customer requirements and preferences, evolving industry
and customer-specific protocol standards and frequent new product enhancements
and introductions. Our existing products and our products currently under
development could be rendered obsolete by the introduction of products for
telecommunications networks involving competing technologies, by the evolution
of alternative technologies or new industry protocol standards and by rival
products introduced by our competitors. These market conditions are made more
complex and challenging by the high degree to which the telecommunications
industry is fragmented.
We believe our future success will depend, in part, upon our ability, on a
timely and cost-effective basis, to continue to:
. anticipate and respond to varied and rapidly changing customer preferences
and requirements, a process made more challenging by our customers' buying
patterns;
. anticipate and develop new products and solutions for networks based on
emerging technologies, such as the asynchronous transfer mode protocol that
packs digital information into cells to be routed across a network, and
Internet telephony, which comprises voice, video, image and data across the
Internet, that are likely to be characterized by continuing technological
developments, evolving industry standards and changing customer
requirements;
. invest in research and development to enhance our existing products and to
introduce new verification and diagnostic products for the
telecommunications, Internet, cable network and other markets; and
. support our products by investing in effective advertising, marketing and
customer support.
We cannot assure you that we will accomplish these objectives, and our failure
to do so could have a material adverse impact on our market share, business and
financial results.
Potential Product Liability--Our products are complex, and our failure to detect
errors and defects may subject us to costly repairs, product returns under
warranty and product liability litigation.
Our products are complex and may contain undetected defects or errors when
first introduced or as enhancements are released. These errors may occur despite
our testing and may not be discovered until after a product has been shipped and
used by our customers. This risk is compounded by the fact that we offer over 20
products, with multiple hardware and software modifications, which makes it more
difficult to ensure high standards of quality control in our manufacturing
process. The existence of these errors or defects could result in costly repairs
and/or returns of products under warranty and, more generally, in delayed market
acceptance of the product or damage to our reputation and business.
In addition, the terms of our customer agreements and purchase orders,
which provide us with protection against unwarranted claims of product defect
and error, may not protect us adequately from unwarranted claims against us,
unfair verdicts if a claim were to go to trial, settlement of these kinds of
claims or future regulation or laws regarding our products. Our defense against
these claims in the future, regardless of their merit, could result in
substantial expense to us, diversion of management time and attention, damage to
our business reputation and hurt our ability to retain existing customers or
attract new customers.
Managing Growth--We may have difficulties managing our expanding operations,
which could reduce our chances of maintaining our profitability.
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We have recently experienced rapid growth in revenues and in our business
generally that has placed, and we expect will continue to place, a significant
strain on our management and operations. For example, our revenues have
increased from approximately $28.5 million in 1998 to $61.5 million in 1999 and
to $82.4 million for the first nine months of 2000, our number of employees has
increased from 118 at December 31, 1998 to 338 at September 30, 2000, and we
have made two significant acquisitions, that of Hukk Engineering and Pro.Tel. As
a result of our historical and expected growth, we face several risks,
including:
. the need to improve our operational, financial, management, informational
and control systems;
. the need to hire, train and retain highly skilled personnel in a market
where there are already severe shortages of these kinds of personnel, as we
discuss below; and
. the possibility that our management's attention will be diverted from
running our business to the needs of managing a public company.
We cannot assure you that we will be able to manage this growth profitably.
Competition--Competition could reduce our market share and decrease our net
sales.
The market for our products is fragmented and intensely competitive both in
and outside the United States, and is subject to rapid technological change,
evolving industry standards, regulatory developments and varied and changing
customer preferences and requirements. We compete with a number of United States
and international suppliers that vary in size and in the scope and breadth of
the products and services offered. The following table sets forth our principal
competitors in each of our product categories.
<TABLE>
<CAPTION>
Product Category Principal Competitors
---------------- ---------------------
<S> <C>
Digital Subscriber Line Acterna Corporation (formerly TTC, a division of Dynatech
Corporation), Agilent Technologies, Inc., Tollgrade
Communications, Inc. and Turnstone Systems, Inc.
Fiber Optics SONET/SDH Digital Lightwave, Inc., Acterna Corporation (formerly TTC, a
division of Dynatech Corporation) and Agilent Technologies, Inc.
Cable TV Acterna Corporation (formerly Dynatech Corporation, formerly
Wavetek Wandel Golterman, Inc. prior to their merger with
Dynatech Corporation on May 23, 2000) and Agilent Technologies,
Inc.
Signaling Inet Technologies, Inc. and GN Nettest
</TABLE>
Many of these competitors have longer operating histories, larger installed
customer bases, longer relationships with customers, wider name recognition and
product offerings and greater financial, technical, marketing, customer service
and other resources than we do.
We expect that, as our industry and market evolves, new competitors or
alliances among competitors with existing and new technologies could emerge and
acquire significant market share. We anticipate that competition in our market
will increase and we will face greater threats to our market share, price
pressure on our products and the likelihood that, over time, our profitability
may decrease. In addition, it is difficult to assess accurately the market share
of our products or of Sunrise overall because of the high degree of
fragmentation in the market for DSL service verification equipment, in
particular, and for high-speed data access technology, in general. As a result,
it may be difficult for us to forecast accurately trends in the market, which of
our products will be the most competitive over the longer term and, thus, what
is the best use of our human and other forms of capital. We cannot assure you
that we will be able to compete effectively.
Need for New Personnel--If we cannot hire and train the R&D, manufacturing,
sales, and marketing personnel we need to support our anticipated growth, our
plans for continued expansion will be hampered.
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Our business requires engineers, technicians and other highly trained and
experienced personnel. In particular, since our products require a sophisticated
selling effort targeted at several key people within our prospective customers'
organizations, we have a special need for experienced sales personnel as well as
specialized engineers. In addition, the complexity of our products and the
difficulty of configuring and maintaining them require highly trained customer
service and support personnel. If we continue to grow, we will need to hire a
significant number of engineering, sales, marketing and customer service and
support personnel in the future, in and outside the United States. Given that
competition for such persons is intense, especially in the San Francisco Bay
Area, we may not be successful in attracting and retaining these individuals.
Our failure to hire, train and keep these kinds of employees could impair our
ability to grow profitably. In addition, if we do hire new personnel, the
addition of significant numbers of new personnel will require us to incur
significant start-up expenses, including procurement of office space and
equipment, initial training costs, and may result in low productivity rates of
these new personnel. These start-up expenses may adversely affect our future
operating results.
Reliance On Non-U.S. Workers--If U.S. immigration policies prevent us from
hiring or retaining the workers we need, our growth may be limited.
In the past we have filled a significant portion of our new personnel
needs, particularly for our engineers, with non-U.S. citizens holding temporary
work visas that allow these persons to work in the United States for a limited
period of time. We rely on these non-U.S. workers because of the shortage of
engineers, technicians and other highly skilled and experienced workers in the
telecommunications industry in the United States, in general, and in the San
Francisco Bay Area, in particular. Regulations of the Immigration and
Naturalization Service permit non-U.S. workers a limited number of extensions
for their visas and also set quotas regarding the number of non-U.S. workers
U.S. companies may hire. As a result, we face the risk that a portion of our
existing employees may not be able to continue to work for us, thereby
disrupting our operations, and that we may not be able to hire the number of
engineers, technicians and other highly skilled and experienced workers that we
need to grow our business. Furthermore, changes in these regulations could
exacerbate these risks.
Dependence on Key Employees--If one or more of our senior managers were to
leave, we could experience difficulties in replacing them and our operating
results could suffer.
Our success depends to a significant extent upon the continued service and
performance of a relatively small number of key senior management, technical,
sales and marketing personnel. The loss of any of our three founders, Paul Ker-
Chin Chang, Paul A. Marshall and Robert C. Pfeiffer, in particular, would likely
harm our business. None of these individuals is bound by an employment agreement
with us, and we do not carry key man life insurance on them. In addition,
competition for senior level personnel with telecommunications knowledge and
experience is intense. If any of our senior managers were to leave Sunrise, we
would need to devote substantial resources and management attention to replace
them. As a result, management attention may be diverted from managing our
business and we may need to pay higher compensation to replace these employees.
Risks of International Operations--Our plan to expand sales in international
markets could lead to higher operating expenses and may subject us to
unpredictable regulatory and political systems.
Sales to customers located outside of the United States represented 46% of
our net sales in 1997, 42% in 1998, 20% in 1999 and 24% in the first nine months
of 2000, and we expect international revenues to continue to account for a
significant percentage of net sales for the foreseeable future. In addition, an
important part of our strategy calls for further expansion into international
markets. As a result, we will face various risks relating to our international
operations, including:
. potentially higher operating expenses, resulting from the establishment of
international offices, the hiring of additional personnel and the
localization and marketing of products for particular countries'
technologies;
. the need to establish relationships with government-owned or subsidized
telecommunications providers as well as additional distributors;
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. fluctuations in foreign currency exchange rates and the risks of using
hedging strategies to minimize our exposure to these fluctuations, which
have been heightened by our recent acquisition of Pro.Tel, whose revenues
have been and are likely to continue to be in Italian lira; and
. potentially adverse tax consequences related to acquisitions and
operations, including the ability to claim goodwill deductions and a
foreign tax credit against U.S. federal income taxes, especially since
Italy has a higher tax rate.
We cannot assure you that one or more of these factors will not materially and
adversely affect our ability to expand into international markets, our revenues
and profits.
In addition, since the last nine months of 1997, the Asia/Pacific region
has experienced instability in many of its economies and significant
devaluations in local currencies. Approximately 20% of our sales in 1998, 9% of
our sales in 1999 and 8% of our sales in the first nine months of 2000 were
derived from customers located in this region. These instabilities may continue
or worsen, which could have a materially adverse effect on our results of
operations. If international revenues are not adequate to offset the additional
expense of expanding international operations, our future growth and
profitability could suffer.
Dependence on Sole and Single Source Suppliers--Because we depend on a limited
number of suppliers and some sole and single source suppliers that are not
contractually bound in the long-term, our future supply of product components
is uncertain. This could lead to manufacturing difficulties.
In our manufacturing process, we purchase many key products, such as
microprocessors, bus interface chips, optical components and oscillators, from a
single source or sole supplier and we license certain software from third
parties. We rely exclusively on third-party subcontractors to manufacture some
sub-assemblies, and we have retained, from time to time, third party design
services in the development of our products. We do not have long-term supply
agreements with these vendors. In general, we make advance purchases of some
products and components to ensure an adequate supply, particularly for products
that require lead times of up to nine months to manufacture. In the past, we
have experienced supply problems as a result of financial or operational
difficulties of our suppliers, shortages, discontinuations resulting from
component obsolescence or other shortages or allocations of supplies. Our
reliance on these third parties involves a number of risks, including:
. the unavailability of critical products and components on a timely basis,
on commercially reasonable terms or at all;
. if products or software licenses were to become unavailable, the need to
qualify new or alternative products or develop or license new software for
our use and/or to reconfigure our products and manufacturing process, each
of which could be lengthy and expensive;
. the likelihood that, if these products are not available, we would suffer
an interruption in the manufacture and shipment of our products until the
products or alternatives become available;
. reduced control over product quality and cost, risks exacerbated by the
need to respond, at times, to unanticipated changes and increases in
customer orders; and
. the unavailability of, or interruption in, access to some process
technologies.
In addition, the purchase of these components on a sole source basis subjects us
to risks of price increases and potential quality assurance problems. This
dependence magnifies the risk that we may not be able to ship our products on a
timely basis to satisfy customers' orders. We cannot assure you that one or more
of these factors will not cause delays or reductions in product shipments or
increases in product costs, which in turn could have a material adverse effect
on our business.
Manufacturing Capacity--If demand for our products exceeds our manufacturing
capacity, our revenues may suffer.
Demand for our products has put increased pressure on our manufacturing
capacity. If we are not able to increase our manufacturing capacity in the time
necessary to meet demand, if we experience difficulty in obtaining parts or
components needed for manufacturing, or if demand exceeds our expectations, we
may experience
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insufficient manufacturing capacity. If our manufacturing capacity does not keep
pace with product demand, we will not be able to fulfill orders in a timely
manner which in turn could have a material adverse effect on our revenues and on
our overall business.
Acquisitions--We have acquired two significant companies and intend to pursue
further acquisitions in the future. These activities involve numerous risks,
including the use of cash, amortization of goodwill and the diversion of
management attention.
Recently, we acquired two companies, Hukk Engineering in July 1999, and
Pro.Tel in February 2000. As a result of these and other smaller acquisitions,
we face numerous risks, including:
. integrating the existing management, sales force, technicians and other
personnel into one existing culture and business;
. combining manufacturing, administrative and management information and
other control systems into our corresponding systems;
. developing and implementing an integrated business strategy from what had
been previously three independent companies; and
. developing compatible or complementary products and technologies from
previously independent operations. For Hukk Engineering, this means
addressing the convergence of telephony and cable products.
The risks stated above will be made more difficult because Hukk Engineering is
located in Norcross, Georgia and Pro.Tel is located in Modena, Italy and
Springfield, Virginia. In addition, if we make future acquisitions, these risks
will be exacerbated by the need to integrate additional operations at a time
when we may not have fully integrated Hukk Engineering and Pro.Tel.
If we pursue further acquisitions, we will face similar risks as those
above and additional risks, including:
. the diversion of our management's attention and the expense of identifying
and pursuing suitable acquisition candidates, whether or not consummated;
. negotiating and closing these transactions;
. the potential need to fund these acquisitions by dilutive issuances of
equity securities and by incurring debt; and
. the potential negative effect on our financial statements from the increase
in goodwill and other intangibles, the write-off of research and
development costs and the high cost and expenses of completing
acquisitions.
We cannot assure you that we will locate suitable acquisition candidates or
that, if we do, we will be able to acquire them and then integrate them
successfully and efficiently into our business.
Risks of the Telecommunications Industry--We face several risks regarding the
telecommunications industry, including the possible effects of its rapid and
unpredictable growth, the possible effects of consolidation among our
principal customers and the risk that deregulation will slow.
Since the passage of the Telecommunication Act of 1996, the
telecommunications industry has experienced rapid growth. This has and will
likely continue to lead to great innovations in technology, intense competition,
short product life cycles and, to some extent, regulatory uncertainty in and
outside the United States. The course of the development of the
telecommunications industry is, however, difficult to predict. As a result,
companies who operate in this industry have a difficult time forecasting future
trends and developments and the acceptance of competing technologies. One
possible effect of this uncertainty is that there may be, in the future, a delay
or a reduction in these companies' investment in their business and purchase of
related equipment, such as our products, and a reduction in their and our access
to capital. Moreover, in the short-term, deregulation may result in a delay or a
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reduction in the procurement cycle because of the general uncertainty involved
with the transition period of businesses.
The telecommunications industry has been experiencing consolidation among
its primary participants, such as incumbent local exchange carriers and
competitive local exchange carriers, several of whom are our primary customers.
For example, in recent years, SBC acquired Pacific Bell and Ameritech, both of
which were customers of ours. Continued consolidation may cause delay or cause
cancellation of orders for our products. In addition, the consolidation of our
customers will likely provide them with greater negotiating leverage with us and
may lead them to pressure us to lower the prices of our products.
Because the market for our products has grown with the deregulation of
portions of the telecommunications industry, we face the risk that these trends
may slow or may be reversed. For example, in the United States, there is
litigation pending that challenges the validity of the Telecommunications Act of
1996 and the local telephone competition rules adopted by the Federal
Communications Commission to implement that act. If deregulation in
international markets and in the United States were to slow or to take an
unanticipated course, the telecommunications industry might suffer the following
effects:
. greater consolidation of providers of high-speed access technologies, which
may not favor the development of DSL technology and which might provide
these companies with greater negotiating leverage regarding the prices and
other terms of the DSL products and services they purchase;
. uncertainty regarding judicial and administrative proceedings, which may
affect the pace at which investment and deregulation continue to occur;
. a general slowdown in economic activity relating to the telecommunications
industry and a consequent multiplier effect on the general economy;
. reduced investment in the telecommunications industry in general and in DSL
technology in particular due to increased uncertainty regarding the future
of the industry and this technology; and
. delay in purchase orders of service verification equipment, such as our
products, if they were to reduce their investment in new high-speed access
technologies.
Intellectual Property Risks--Policing any unauthorized use of our intellectual
property by third parties and defending any intellectual property infringement
claims against us could be expensive and disrupt our business.
Our intellectual property and proprietary technology is an important part
of our business, and we depend on the development and use of various forms of
intellectual property and proprietary technology. As a result, we are subject to
several related risks, including the risks of unauthorized use of our
intellectual property and the costs of protecting our intellectual property.
Much of our intellectual property and proprietary technology is not
protected by patents. If unauthorized persons were to copy, obtain or otherwise
misappropriate our intellectual property or proprietary technology without our
approval, the value of our investment in research and development would decline,
our reputation and brand could be diminished and we would likely suffer a
decline in revenue. We believe these risks, which are present in any business in
which intellectual property and proprietary technology play an important role,
are exacerbated by the difficulty in finding unauthorized use of intellectual
property in our business, the increasing incidence of patent infringement in our
industry in general and the difficulty of enforcing intellectual property rights
in some foreign countries.
In addition, litigation has in the past been, and may in the future be,
necessary to enforce our intellectual property rights. This kind of litigation
is time-consuming and expensive to prosecute or resolve, and results in
substantial diversion of management resources. We cannot assure you that we will
be successful in that litigation, that our intellectual property rights will be
held valid and enforceable in any litigation or that we will otherwise be able
to protect our intellectual property and proprietary technology.
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Concentration of Control--Our executive officers and directors retain
significant control over us, which allows them to decide the outcome of
matters submitted to stockholders for approval. This influence may not be
beneficial to all stockholders.
Mr. Chang, Mr. Marshall and Mr. Pfeiffer beneficially own approximately
26%, 24% and 13% of our outstanding shares of common stock. Consequently, these
three individuals, acting together, are able to control the election of our
directors and the approval of significant corporate transactions that must be
submitted to a vote of stockholders. In addition, Mr. Chang, Mr. Marshall and
Mr. Pfeiffer constitute three of the six members of the board of directors and
have significant influence in directing the actions taken by the directors. The
interests of these persons may conflict with your interests as stockholders, and
the actions they take or approve may be contrary to those desired by other
stockholders. This concentration of ownership and control of the management and
affairs of our company may also have the effect of delaying or preventing a
change in control of our company that stockholders may consider desirable.
Anti-takeover Provisions--Anti-takeover provisions in our charter documents
could prevent or delay a change of control, and as a result, negatively impact
our stockholders.
Some provisions of our certificate of incorporation and bylaws may have the
effect of discouraging, delaying or preventing a change in control of our
company or unsolicited acquisition proposals that you, as a stockholder, may
consider favorable. These provisions provide for:
. authorizing the issuance of "blank check" preferred stock;
. a classified board of directors with staggered, three-year terms;
. prohibiting cumulative voting in the election of directors;
. requiring super-majority voting to effect certain amendments to our
certificate of incorporation and by-laws;
. limiting the persons who may call special meetings of stockholders;
. prohibiting stockholder action by written consent; and
. establishing advance notice requirements for nominations for election to
the board of directors or for proposing matters that can be acted upon at
stockholders meetings.
Some provisions of Delaware law and our stock incentive plans may also have the
effect of discouraging, delaying or preventing a change in control of our
company or unsolicited acquisition proposals. These provisions also could limit
the price that some investors might be willing to pay in the future for shares
of our common stock.
ITEM 3. QUALITATIVE AND QUANTITATIVE DISCLOSURE ABOUT MARKET RISK
We sell our products in North America, Asia, Latin America and Europe. As a
result, our financial results could be affected by factors such as changes in
foreign currency exchange rates. Prior to our acquisition of Pro.Tel,
international sales had been denominated solely in U.S. dollars and,
accordingly, we had not historically been exposed to fluctuations in non-U.S.
currency exchange rates related to these sales activities. Since our acquisition
of Pro.Tel in February 2000, we now have a small amount of sales denominated in
Euro and have begun to use derivative instruments to hedge our foreign exchange
risks. To date, foreign exchange risks from these sales have not been material
to our operations.
We are exposed to the impact of interest rate changes and changes in the
market values of our investments. Our exposure to market rate risk for changes
in interest rates relates primarily to our investment portfolio. We have not
used derivative financial instruments in our investment portfolio. We invest
our excess cash in debt instruments of the U.S. Government and its agencies, and
in high-quality corporate issuers and, by policy, limit the amount of credit
exposure to any one issuer. We protect and preserve our invested funds by
limiting default, market and reinvestment risk.
Investments in both fixed rate and floating rate interest earning
instruments carry a degree of interest rate risk. Fixed rate securities may
have their fair market value adversely impacted due to a rise in interest rates,
while
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floating rate securities may produce less income than expected if interest rates
fall. Due in part to these factors, our future investment income may fall short
of expectations due to changes in interest rates or we may suffer losses in
principal if forced to sell securities which have declined in market value due
to changes in interest rates. Due to the nature of our investments, we
anticipate no material market risk exposure.
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PART II - OTHER INFORMATION
---------------------------
ITEM 1. LEGAL PROCEEDINGS.
In September 1999, the United States District Court for the Northern
District of California entered final judgment against Electrodata, Inc. stating
that it had literally infringed our U.S. Patent No. 5,619,489, entitled Handheld
Communications Tester. The court also entered judgment against Electrodata that
the patent claims at issue were valid and the patent was enforceable.
Electrodata has filed a notice of appeal with the United States Court of Appeals
for the Federal Circuit. The parties have briefed the issues, and the Federal
Circuit has indicated that it will most likely hear oral argument in January
2001. We do not believe that the outcome of this appeal will materially impact
our business.
ITEM 2. CHANGES IN SECURITIES and USE OF PROCEEDS.
From July 1 through September 30, 2000, we issued approximately 110,550
shares of our common stock to employees pursuant to exercises of stock options
(with an average exercise price of approximately $1.45 per share) under our 1993
stock option plan. These issuances were deemed exempt from registration under
Section 5 of the Securities Act of 1933 in reliance upon Rule 701 thereunder.
Our registration statement (Registration No. 333-32070) under the
Securities Act of 1933, as amended, for our initial public offering became
effective on July 12, 2000. A total of 4,600,000 shares of common stock were
registered and 3,817,428 shares of our common stock were sold to an underwriting
syndicate. Chase H&Q, CIBC World Markets and U.S. Bancorp Piper Jaffray were
the managing underwriters of the offering. An additional 782,572 shares of
common stock were sold on behalf of selling stockholders as part of the same
offering. All shares were sold to the public at a price of $15.00 per share.
In connection with the offering, we paid approximately $4.0 million in
underwriting discounts and commissions to the underwriters. Offering proceeds,
net of aggregate expenses to us of approximately $1.6 million, were
approximately $51.6 million. None of the net proceeds from 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.
We have used $2.4 million of the net proceeds from the offering to repay
amounts drawn under our line of credit and $779,000 to repay notes payable.
Funds that have not been used have been invested in money market funds, auction
rate securities and marketable debt securities. 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.
We intend to use the remaining net proceeds of the offering for working
capital and general corporate purposes, including the construction of our new
facility and capital expenditures made in the ordinary course of our business.
We may also apply a portion of the proceeds of the offering to acquire
businesses or products and technologies that are complementary to our business
and product offerings.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None.
ITEM 5. OTHER INFORMATION. None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits
27.1 Financial Data Schedule.
(b) Reports on Form 8-K
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There were no reports on form 8-K filed during the three-month period
ended September 30, 2000.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf
by the undersigned thereunto duly authorized.
SUNRISE TELECOM INCORPORATED
(Registrant)
Date: November 8, 2000
By: /s/ Paul Ker-Chin Chang
-----------------------
Paul Ker-Chin Chang
President and Chief Executive Officer
(Principal Executive Officer)
By: /s/ Peter L. Eidelman
---------------------
Peter L. Eidelman
Chief Financial Officer
(Principal Accounting Officer)
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EXHIBIT INDEX
Exhibit No.
----------
27.1 Financial Data Schedule.
29
