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, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER: 0-27877
NEXT LEVEL COMMUNICATIONS, INC.
(Exact Name of Registrant as Specified in Its Charter)
DELAWARE 94-3342408
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
6085 STATE FARM DRIVE
ROHNERT PARK, CALIFORNIA 94928
(Address of Principal Executive Offices, Including Zip Code)
Registrant's Telephone Number, Including Area Code: (707) 584-6820
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. [X] Yes [ ] No
The number of shares of our common stock, par value $0.01 per share,
outstanding as of October 31, 2001 was approximately 85,590,077.
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION
Page No.
--------
Item 1. Condensed Consolidated Financial Statements............................ 1
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations.............................................. 10
Item 3. Quantitative and Qualitative Disclosures About Market Risk............. 26
PART II. OTHER INFORMATION
Item 1. Legal Proceedings...................................................... 27
Item 6. Exhibits and Reports on Form 8-K....................................... 27
PART I. FINANCIAL INFORMATION
ITEM 1. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Next Level Communications, Inc.
Condensed Consolidated Statements of Operations
Three months and nine months ended September 30, 2001
and September 30, 2000
(In Thousands, except per share data) (Unaudited)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------------- --------------------------
2001 2000 2001 2000
--------- --------- --------- ---------
Revenues
Equipment $ 19,495 $ 47,126 $ 78,587 $ 116,155
Software 703 1,144 2,253 2,770
--------- --------- --------- ---------
Total Revenues 20,198 48,270 80,840 118,925
Cost of Revenues
Equipment 17,551 36,132 66,008 93,099
Software 18 7 127 89
Inventory charge 0 0 72,016 0
--------- --------- --------- ---------
Total Cost of Revenue 17,569 36,139 138,151 93,188
GROSS PROFIT (LOSS) 2,629 12,131 (57,311) 25,737
OPERATING EXPENSES
Research & development 11,788 13,053 38,742 40,549
Selling, general and administrative 12,931 13,705 42,279 34,235
Non-cash compensation charge 2,384
--------- --------- --------- ---------
Total operating expenses 24,719 26,758 81,021 77,168
OPERATING LOSS (22,090) (14,627) (138,332) (51,431)
INTEREST INCOME (EXPENSE), NET (5,441) 1,264 (8,525) 5,058
OTHER INCOME (EXPENSE), NET (236) (30) (5,445) (82)
--------- --------- --------- ---------
NET LOSS $ (27,767) $ (13,393) $(152,302) $ (46,455)
========= ========= ========= =========
BASIC AND DILUTED NET LOSS PER
COMMON SHARE ($0.32) ($0.16) ($1.79) ($0.57)
SHARES USED TO COMPUTE BASIC AND
DILUTED NET LOSS PER COMMON SHARE 85,473 83,483 85,115 81,164
See notes to condensed consolidated financial statements.
1
Next Level Communications, Inc.
Condensed Consolidated Balance Sheets
September 30, 2001 and December 31, 2000
(In Thousands, except share data) (Unaudited)
SEPTEMBER 30, DECEMBER 31,
2001 2000
------------- ------------
ASSETS
Current Assets:
Cash and cash equivalents $ 12,272 $ 35,863
Restricted marketable securities -- 25,000
Trade receivables, less allowance for doubtful
accounts of $1,332 and $1,332, respectively 18,311 32,993
Other receivables 5,946 4,489
Inventories, net 76,238 86,764
Prepaid expenses and other 2,286 2,123
--------- ---------
Total current assets 115,053 187,232
Property and equipment, net 49,124 53,593
Long-term investments 16,997 15,000
Goodwill, net of accumulated amortization of $11,903
and $6,879, respectively 12,790 17,813
Other assets 2,078 2,078
--------- ---------
Total Assets $ 196,042 $ 275,716
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable $ 38,508 $ 53,367
Accrued liabilities 19,210 17,609
Note payable to vendor 24,340 --
Note payable - other -- 25,000
Note payable - Motorola 4,000 --
Deferred revenue 1,939 5,661
Current portion of capital lease obligations 91 330
--------- ---------
Total current liabilities 88,088 101,967
Long-term obligations
Due to Motorola:
Note payable, net of discount 35,199 --
Tax sharing agreement liability 32,300 15,000
--------- ---------
Total long term liabilities 67,499 15,000
--------- ---------
Total Liabilities 155,587 116,967
Stockholders' Equity
Common stock - $.01 par value, 400,000,000
shares authorized, 85,559,000 and 84,443,000
shares issued and outstanding, respectively 788 776
Additional paid-in-capital 471,879 438,123
Accumulated deficit (432,212) (279,910)
Unearned compensation -- (240)
--------- ---------
Total Stockholders' Equity 40,455 158,749
--------- ---------
Total Liabilities and Stockholders' Equity $ 196,042 $ 275,716
========= =========
See notes to condensed consolidated financial statements.
2
Next Level Communications, Inc.
Condensed Consolidated Statements of Cash Flows
Nine Months Ended September 30, 2001 and September 30, 2000
(In Thousands, Unaudited)
SEPTEMBER 30,
--------------------------
2001 2000
--------- ---------
OPERATING ACTIVITIES:
Net loss $(152,302) $ (46,455)
Adjustments to reconcile net loss to net cash used in
operating activities:
Inventory charge 72,016 --
Write-down of investments and property and equipment 6,586 --
Loss on disposal of assets -- 62
Non-cash compensation charge 592 2,384
Depreciation and amortization 12,451 9,474
Amortization of discount on note payable 6,433 --
Equity in net loss of investee 536 --
Changes in assets and liabilities:
Trade receivables 14,682 (21,818)
Inventories (51,490) (33,313)
Other assets (3,139) (3,389)
Accounts payable (519) 30,649
Accrued liabilities and deferred revenue (2,121) 1,952
--------- ---------
Net cash used in operating activities (96,275) (60,454)
INVESTING ACTIVITIES:
Purchases of property and equipment (4,059) (11,093)
Proceeds from sale of marketable securities -- 3,814
Long-term investments (6,500) (10,000)
--------- ---------
Net cash used in investing activities (10,559) (17,279)
FINANCING ACTIVITIES
Issuance of common stock 2,182 5,108
Proceeds from Motorola financing 64,000 --
Proceeds from Tax Sharing Agreement 17,300 --
Proceeds from borrowings, net -- 147
Repayment of capital lease obligations (239) (482)
Initial public offering expenses, net -- (899)
--------- ---------
Net cash provided by financing activities 83,243 3,874
Net Decrease in Cash and Cash Equivalents (23,591) (73,859)
Cash and Cash equivalents, Beginning of Period 35,863 128,752
--------- ---------
Cash and Cash equivalents, End of Period $ 12,272 $ 54,893
========= =========
See notes to condensed consolidated financial statements.
3
NEXT LEVEL COMMUNICATIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
--------------------------------------------------------------------------------
1. BASIS OF PRESENTATION
Next Level Communications, Inc. (the "Company") is a leading provider
of broadband communications systems that enable telephone companies and other
emerging communications service providers to cost effectively deliver voice,
data and video services over the existing copper wire telephone infrastructure.
The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with accounting principles generally accepted
in the United States of America for interim financial information and pursuant
to the rules and regulations of the Securities and Exchange Commission. While
these financial statements reflect all adjustments (consisting of normal
recurring items, except as discussed in Notes 2 and 5) which are, in the opinion
of management, necessary to present fairly the results of the interim period,
they do not include all information and footnotes required by generally accepted
accounting principles for complete financial statements. These financial
statements and notes should be read in conjunction with the financial statements
and notes thereto, for the year ended December 31, 2000 contained in the
Company's Annual Report on Form 10-K. Certain prior period amounts have been
reclassified to conform to the current period presentation. The results of
operations for the three and nine months ended September 30, 2001 are not
necessarily indicative of the operating results for the full year.
Use of Estimates - The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and the disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenue and expenses during the year. Significant estimates include the
inventory write-down and loss on purchase commitments (see Note 2) and long-term
investment and property and equipment write-downs (see Note 5). Actual results
could differ from those estimates.
New Accounting Standard - In June 2001, the Financial Accounting
Standards Board issued Statement of Financial Accounting Standard (SFAS) No.
142, Goodwill and Other Intangible Assets. SFAS No. 142 addresses the initial
recognition and measurement of intangible assets acquired outside of a business
combination and the accounting for goodwill and other intangible assets
subsequent to their acquisition. SFAS No. 142 provides that intangible assets
with finite useful lives will be amortized and that goodwill and intangible
assets with indefinite lives will not be amortized, but rather will be tested at
least annually for impairment. At September 30, 2001, the Company's recorded
goodwill, net of accumulated amortization, was approximately $12.8 million. The
Company will adopt SFAS No. 142 for its fiscal year beginning January 1, 2002.
Upon adoption of SFAS 142, the Company will stop the amortization of goodwill
that resulted from business combinations initiated prior to the adoption of SFAS
141, Business Combinations. The Company will evaluate goodwill under the SFAS
142 transitional impairment test and has not yet determined whether or not there
will be an impairment loss. Any transitional impairment loss will be recognized
as a change in accounting principle.
4
2. SECOND QUARTER 2001 INVENTORY WRITE-DOWN AND LOSS ON PURCHASE COMMITMENTS
In the quarter ended June 30, 2001, the Company recorded a write-down of
inventory and purchase commitments for excess and obsolete quantities and lower
of cost or market adjustments related to its current generation product platform
and related communications equipment totaling $72.0 million. To meet forecasted
demand and reduce the anticipated component supply constraints that had existed
in the past, the Company increased inventory levels for certain components and
entered into purchase commitments for certain components with long lead times.
However, in the quarter ended June 30, 2001, the Company's estimates of actual
sales, as well as the Company's forecasted sales, for its current generation of
products declined significantly. As a result, the inventory charges were
required and were calculated based upon (i) the substantial completion of the
negotiation process with the Company's contract manufacturers and their
suppliers and the Company's other vendors regarding purchase commitments and
cancellations made by the Company, (ii) the inventory levels in excess of
forecasted demand and (iii) the Company's estimates of salvage or recovery value
for each raw material or finished good on an item by item basis. Such write-down
was included in cost of revenues in the nine months ended September 30, 2001 and
consisted of the following (in millions):
Excess quantities of raw materials on hand and under purchase commitments
at June 30, 2001, net of salvage $34.8
Excess quantities of finished goods on hand at June 30, 2001, net of
salvage 10.8
Obsolescence 13.2
Cancellation charges on purchase commitments 5.2
Lower of cost or market write-down on current generation product platform 8.0
-----
Total $72.0
Significant estimates included in the calculation of the inventory
write-down above include forecasted demand for the Company's products, sales
prices for residential gateways and other finished goods and estimated salvage
or recovery value for excess raw materials and finished goods. Actual results
could differ from those estimates, and therefore additional inventory
write-downs may be necessary in future periods.
3. LOAN AGREEMENT WITH MOTOROLA
On May 16, 2001 (as amended July 25, 2001), the Company entered into a
$60.0 million loan agreement with Motorola, Inc. Under the terms of the
agreement, Motorola, which currently owns approximately 75% of Next Level
Communications, Inc., made a $60.0 million loan commitment to the Company over a
two-year period, with a maturity of May 17, 2003. Interest is determined by
Motorola based on either the base rate (as defined in the agreement) plus 2% or
the Eurodollar rate plus 3 1/2%.
On September 28, 2001, the Company amended the $60.0 million loan
agreement with Motorola, Inc. to include $4.0 million of bridge financing which
was received by the Company on September 28, 2001. Under the terms of the
amended agreement, the Company was required to repay the $4.0 million subsequent
to the funding of the mortgage (see Note 10). Consequently, the Company repaid
Motorola $4.0 million on November 2, 2001. As of September 30, 2001, the
Company had an outstanding obligation under the loan agreement of $64.0 million.
5
On October 15, 2001, the Company amended the $64.0 million loan
agreement with Motorola to include an additional $3.0 million which resulted
from a revised calculation performed relative to the Tax Sharing and Allocation
Agreement between the Company and Motorola (see Note 4). As of October 15,
2001, the company had an outstanding obligation under the loan agreement of
$67.0 million.
As of November 2, 2001, subsequent to the $4.0 million repayment, the
Company had an outstanding obligation under the loan agreement of $63.0 million.
The loan agreement with Motorola has the following terms and conditions:
In the event of a debt or equity security offering or a sale of assets
in excess of $25.0 million, the first $25.0 million of proceeds may be retained
by the Company; the next $25.0 million (between $25.0 million and $50.0 million)
of such proceeds will be allocated at least one-third to repay the Company's
obligations under the Company's tax sharing agreement with Motorola (the "Tax
Sharing Agreement"), and the balance may be retained by the Company; the next
$25.0 million of such proceeds (between $50.0 million and $75.0 million) will be
allocated at least one-half to repay the Company's obligations under the Tax
Sharing Agreement and the balance may be retained by the Company; amounts of
such proceeds in excess of $75.0 million must be used 100% first to repay the
Company's obligations under the Tax Sharing Agreement (to the extent of such
obligations) and then to repay and reduce the amount owed under the loan
agreement.
The loan agreement provides for the issuance of warrants, to purchase up
to 7.5 million shares of the Company's common stock, all at an exercise price of
$7.39 per share. Warrants to purchase 4.5 million shares of the Company's common
stock were issued and exercisable at September 30, 2001. The fair value of the
warrants of $26.0 million was recorded as a discount to the note payable with a
corresponding increase to additional paid-in capital. Additional warrants become
exercisable as follows:
- 1.0 million shares become exercisable unless, prior to May 17, 2002, all
borrowings under the loan agreement have been repaid in full and it has
been terminated;
- 1.0 million shares become exercisable unless, prior to November 17, 2002
all borrowings under the loan agreement have been repaid in full and it
has been terminated; and
- 1.0 million shares become exercisable unless, prior to February 17,
2003, all borrowings under the loan agreement have been repaid in full
and it has been terminated.
Effective July 1, 2001, the Company determined that the loan agreement with
Motorola would not be repaid until its maturity date, and accordingly,
reclassified the obligation to a long-term liability. As a result, the
additional 3.0 million warrants referenced above, were recorded at the estimated
fair value of $5.3 million as a discount to the note payable with a
corresponding increase to additional paid-in capital. Such amount was determined
based upon the Black-Scholes option pricing model using expected volatility of
101%, a risk-free interest rate of 4.89% and an expected term of four years. The
estimated fair value of the additional 3.0 million warrants will be adjusted in
subsequent periods up to their respective measurement dates, to reflect changes
in the Company's stock price. As a result, at September 30, 2001, the borrowings
from Motorola with a stated value of $64.0 million were recorded at $39.2
million ($4.0 million of which is classified as a current liability) net of the
unamortized discount related to the fair value of the warrants of $24.8 million.
In the quarter and nine months ended September 30, 2001, non-cash discount
amortization of $3.8 million and $6.4 million respectively, was recorded;
non-cash
6
interest expense will be recorded through May 2003 to reflect amortization of
the remaining discount.
The loan agreement contains various covenants, including compliance with
net worth requirements, and restrictions on additional indebtedness, capital
expenditures, and dividends. As of September 30, 2001, the Company was in
compliance with all covenants.
4. TAX SHARING AND ALLOCATION AGREEMENT WITH MOTOROLA
In December 2000, the Company received a $15.0 million advance from
Motorola related to a tax sharing and allocation agreement. The Company received
an additional $17.3 million in January 2001 and the tax agreement was finalized
in February 2001. The amount advanced to the Company of $32.3 million was based
on an estimate of the present value of income tax benefits to Motorola from the
inclusion of the Company's operating losses for the period from January 6, 2000
to May 17, 2000 in Motorola's consolidated tax return. On October 10, 2001, the
Company received a revised calculation of the estimated present value of income
tax benefits to Motorola based upon actual net losses that were included in
Motorola's 2000 tax return. The revised amount was $29.3 million. Under the
original agreement, the Company was required to repay the $3.0 million
difference by October 15, 2001. On October 15, 2001, the Loan Agreement between
the Company and Motorola was amended to include such $3.0 million (see Note 3).
To the extent Motorola does not achieve the expected tax benefits by
September 30, 2006, the Company must repay any difference. In addition, should
the Company obtain certain specified levels of financing from independent third
parties, it must also repay all or a portion of the advance. The Company has
included this liability as a long term liability at September 30, 2001.
5. SECOND QUARTER 2001 LONG-TERM INVESTMENTS AND PROPERTY AND EQUIPMENT
WRITE-DOWNS/OTHER EXPENSE
The Company recorded a write-down of $4.0 million to one of its
long-term investments in the quarter ended June 30, 2001. Such amount was
measured as the amount by which the carrying amount exceeded the investment's
estimated fair value. As of September 30, 2001, the Company's long-term
investments totaled $17.0 million, consisting of $11.5 million related to
Virtual Access, $3.0 million related to Expanse Networks and $2.5 million
related to OutReach. If the estimated fair value of such investments are less
than the carrying amount, and the decline is considered other than temporary,
the carrying amount is reduced to fair value and a loss is recognized.
Additional investment write-downs may be necessary in future periods.
In addition, the Company wrote off $1.1 million of property and
equipment related to the second quarter closure of a small research and
development facility in Vietnam.
6. LEGAL PROCEEDINGS
On August 15, 2001, a complaint entitled CMC Industries, Inc., d/b/a CMC
Mississippi, Inc., d/b/a ACT Mississippi v. Next Level Communications, Inc. was
filed in the Superior Court for the State of California, County of Sonoma. The
complaint alleged that the Company was delinquent in payment relating to certain
purchase orders issued by the Company to the plaintiff, and sought damages in
the amount of $22.5 million, plus interest and attorneys' fees. On October 24,
2001, plaintiff and the Company entered into a Settlement Agreement and Mutual
Release, pursuant to which the complaint was dismissed and the Company agreed to
pay to plaintiff the total amount of
7
$21.3 million (of which amount $13.4 million had been paid as of November 12,
2001) on an agreed-upon schedule, until all amounts owed by the Company are paid
in full.
7. INVENTORIES
Inventories at September 30, 2001 and December 31, 2000 consisted of
(in millions):
September 30, December 31,
2001 2000
------------- ------------
Raw materials $ 26.8 $ 22.7
Work-in-process 2.9 2.0
Finished goods 46.5 62.1
------- -------
Total $ 76.2 $ 86.8
======= =======
8. NET LOSS PER SHARE
Basic net loss per share excludes dilution and is computed by dividing
net loss by the weighted average number of common shares outstanding for the
period. Diluted net loss per share is computed based on the weighted average
number of common shares outstanding plus the dilutive effect of outstanding
stock options and warrants. Diluted net loss per common share was the same as
basic net loss per common share for all periods presented. As of September 30,
2001 and 2000, the Company had securities outstanding that could potentially
dilute basic earnings per share in the future, but were excluded from the
computation of diluted net loss per share, as their effect would have been
anti-dilutive, given the Company's losses. Such outstanding securities consist
of the following (in millions):
September 30,
-----------------------
2001 2000
------ ------
Motorola warrants 7.5 --
Other shareholder warrants 5.6 6.0
Outstanding employee stock options 16.2 20.7
------ ------
Total 29.3 26.7
====== ======
During the quarter ended September 30, 2001, the Company implemented a
stock option exchange program in which certain employees could exchange options
with an exercise price of $40.00 or higher per share for new options to be
granted at least six months and one day from the date of cancellation at the
then fair market value. Total shares cancelled under this program were 5.5
million. Eligible employees will receive a one-for-one option re-grant on or
about February 11, 2002 at an exercise price equal to the market price on the
replacement grant date. The Company does not expect to incur any compensation
expense relative to this stock option exchange program.
8
9. COMPREHENSIVE LOSS
The following table sets forth the calculation of comprehensive loss (in
millions):
Three Months Ended Nine Months Ended
September 30, September 30,
----------------------- -----------------------
2001 2000 2001 2000
-------- -------- -------- --------
Net loss $ (27.80) $ (13.40) $(152.30) $ (46.50)
Unrealized gains (losses) on
marketable securities -- 0.03 -- (0.04)
-------- -------- -------- --------
Total comprehensive loss $ (27.80) $ (13.37) $(152.30) $ (46.54)
======== ======== ======== ========
10. SUBSEQUENT EVENTS
SALE OF TELENETWORKS
On October 11, 2001, the Company completed the sale of its software
division, Telenetworks, to Wind River Systems, Inc. for approximately $5.8
million, of which approximately $5.2 million was received in cash and
approximately $0.6 million remains in escrow. The Company expects to record a
gain on sale of approximately $2.0 million in the fourth quarter of 2001.
REDUCTION IN WORK FORCE
On October 29, 2001, the Company terminated approximately 60 employees.
Severance and related charges of approximately $0.5 million will be recognized
in the fourth quarter of 2001.
MORTGAGE FINANCING
On October 30, 2001, the Company received $20.0 million under a mortgage
loan for a Company-owned office building. The loan is amortized over a 12 year
period with a ten year term and bears interest at an annual fixed rate of 7.51%.
The entire unpaid principal balance, plus accrued interest thereon is due and
payable on November 1, 2011.
The mortgage was guaranteed by Motorola. In consideration for the
guarantee, the Company issued to Motorola warrants to purchase up to 0.4 million
shares of common stock with an exercise price of $3.82 per share. Accordingly,
the warrants were recorded at the fair value of $0.7 million as a discount to
the mortgage loan note payable with a corresponding increase to additional
paid-in capital. Such amount was determined based upon the Black-Scholes option
pricing model using expected volatility of 101%, a risk-free interest rate of
4.3% and an expected term of four years. As a result, non-cash interest expense
will be recorded through 2011 to reflect amortization of the discount.
9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Some of the statements in the following discussion and elsewhere in this
report constitute forward-looking statements. These statements relate to future
events or our future financial performance. In some cases, you can identify
forward-looking statements by terminology such as "may," "will," "should,"
"expect," "plan," "anticipate," "believe," "estimate," "predict," "potential" or
"continue" or the negative of such terms or other comparable terminology. These
statements involve known and unknown risks, uncertainties and other factors that
may cause our or our industry's actual results, levels of activity, performance
or achievements to be materially different from any future results, levels of
activity, performance or achievements expressed or implied by such
forward-looking statements. These factors include, among other things, those
listed under "Risk Factors" below and elsewhere in this report.
Although we believe that the expectations reflected in the
forward-looking statements are reasonable, we cannot guarantee future results,
levels of activity, performance or achievements.
OVERVIEW
We design and market broadband communications equipment that enables
telephone companies and other communications service providers to
cost-effectively deliver a full suite of voice, data and video services over the
existing copper wire telephone infrastructure. We commenced operations in July
1994 and recorded our first sale in September 1997. From January 1998 until
November 1999, we operated through Next Level Communications L.P., which was
formed in connection with the transfer of all of the net assets, management and
workforce of a wholly-owned subsidiary of General Instrument. In November 1999,
the business and assets of that partnership were merged into Next Level
Communications, Inc. as part of our recapitalization. In January 2000, General
Instrument was acquired by Motorola, Inc., making us an indirect subsidiary of
Motorola.
We generate our revenues primarily from sales of our equipment. A small
number of customers have accounted for a large part of our revenues to date, and
we expect this concentration to continue in the future. Qwest, formerly U S
WEST, accounted for 21% of our total revenues for the quarter ended September
30, 2001 and 47% of our total revenues for the quarter ended September 30, 2000.
Our agreements with our largest customers are cancelable by these customers on
short notice and without penalty, and do not obligate the customers to purchase
any products. In addition, our significant customer agreements generally contain
fixed-price provisions. As a result, our ability to generate a profit on these
contracts depends upon our ability to produce and market our products at costs
lower than these fixed prices.
The timing of our revenues is difficult to predict because of the length
and variability of the sales cycle for our products. Customers view the purchase
of our products as a significant and strategic decision. As a result, customers
typically undertake significant evaluation, testing and trial of our products
before deploying them. This evaluation process frequently results in a lengthy
sales cycle, typically ranging from nine months to more than a year. While our
customers are evaluating our products and before they place an order, if at all,
we may incur substantial sales and marketing expenses and expend significant
management efforts.
Revenues. Our revenues consist primarily of sales of equipment and sales of data
communications software. We recognize equipment revenues upon shipment of our
products. Software revenues consist of sales to original equipment manufacturers
that supply communications
10
software and hardware to distributors. We recognize software license revenues
when a non-cancelable license agreement has been signed, delivery has occurred,
the fees are fixed and determinable and collection is probable. The portion of
revenues from new software license agreements that relates to our obligations to
provide customer support is deferred and recognized ratably over the maintenance
period. We sold Telenetworks, our data communications software division, on
October 11, 2001 (see Note 10 to the condensed consolidated financial
statements).
Cost of revenues. Cost of equipment revenues includes direct material
and labor, depreciation and amortization expense on property and equipment,
warranty expenses, license fees and manufacturing and service overhead. Cost of
software revenues primarily includes the cost of the media the software is
shipped on, which is usually CDs. In the quarter ended June 30, 2001, we
recorded an inventory charge of $72.0 million (see Note 2 to the condensed
consolidated financial statements).
Research and development. Research and development expenses consist
principally of salaries and related personnel expenses, consultant fees,
prototype component expenses and development contracts related to the design,
development, testing and enhancement of our products. We expense all research
and development costs as incurred.
Selling, general and administrative. Selling, general and administrative
expenses consist primarily of salaries and related expenses for personnel
engaged in direct marketing and field service support functions, executive,
accounting and administrative personnel, recruiting expenses, professional fees
and other general corporate expenses.
RESULTS OF OPERATIONS
Revenues. Total revenues in the quarter ended September 30, 2001
decreased to $20.2 million from $48.3 million in the third quarter of 2000.
Total revenues in the first nine months of 2001 decreased to $80.8 million from
$118.9 million in the nine-month period ended September 30, 2000. The decrease
was primarily due to a decrease in equipment sales to Qwest. An equipment
revenue analysis by channel is detailed in the following chart. Our equipment
revenue is analyzed using three channels: Major carriers which currently include
Qwest and other North American regional bell operating companies (MAJOR
CARRIERS), independent operating companies (IOC), and other customers which
include, among others, multiple service organizations and international
customers (OTHER).
(In millions) Three Months Ended Nine Months Ended
September 30, September 30,
-------------------- --------------------
CHANNEL 2001 2000 2001 2000
-------------------------- ------- ------- ------- -------
MAJOR CARRIERS $ 4.2 $ 26.0 $ 37.6 $ 78.3
IOC 14.5 21.1 37.3 36.4
OTHER 0.8 -- 3.7 1.5
------- ------- ------- -------
TOTAL EQUIPMENT REVENUE $ 19.5 $ 47.1 $ 78.6 $ 116.2
======= ======= ======= =======
Sales to Qwest slowed in the current period due to an overall reduction
in capital spending by Qwest. Additionally, Qwest has slowed its purchases of
our equipment while it re-evaluates its plans regarding the deployment of VDSL
across its network. The re-evaluation by Qwest is
11
continuing and sales to Qwest in the future are dependent upon its decision
regarding the deployment of our product. Sales to IOC's and our other customers
slowed in the current period due to a general slowdown in the telecommunications
industry and the resulting reduction of our customers' capital expenditures.
We expect to continue to derive substantially all of our revenues from
sales of equipment to Qwest and local, foreign and independent telephone
companies for the foreseeable future. Equipment revenue levels in future
quarters will depend significantly upon Qwest's future decisions and general
economic conditions, as well as whether and how quickly our existing customers
roll out broadband services in their coverage areas and whether and how quickly
we obtain new customers.
Software revenue in the quarters ended September 30, 2001 and 2000 was
$0.7 million and $1.1 million. Software revenue was $2.3 million and $2.8
million in the nine-month periods ended September 30, 2001 and 2000. Due to the
sale of our Telenetworks software division (see Note 10 to the condensed
consolidated financial statements), we do not anticipate material software
revenue in the fourth quarter.
Cost of Revenues. Total cost of revenues decreased to $17.6 million in
the quarter ended September 30, 2001 from $36.1 million in the quarter ended
September 30, 2000 primarily because of lower sales of equipment. Total cost of
revenues in the first nine months of 2001 increased to $138.2 million from $93.2
million in the nine-month period ended September 30, 2000.
The increase in our cost of revenues in the nine-month period is
primarily attributable to a $72.0 million charge related to excess inventory,
obsolescence and lower of cost or market adjustments taken in the second quarter
of 2001. We recorded a write-down of inventory and purchase commitments for
excess and obsolete quantities and lower of cost or market adjustments related
to our current generation product platform and related communications equipment.
To meet forecasted demand and reduce the anticipated component supply
constraints that had existed in the past, we had increased inventory levels for
certain components and had entered into purchase commitments for certain
components with long lead times. However, in the quarter ended June 30, 2001,
our actual sales, as well as our estimates of forecasted sales for our current
generation of products declined significantly. As a result, the inventory
charges were required and were calculated based upon (i) the substantial
completion of the negotiation process with our contract manufacturers and their
suppliers and our other vendors regarding purchase commitments and cancellations
made by us, (ii) the inventory levels in excess of forecasted demand and (iii)
our estimates of salvage or recovery value for each raw material or finished
good on an item by item basis. Such write-down was included in costs of revenues
in the nine months ended September 30, 2001 and consisted of the following (in
millions):
Excess quantities of raw materials on hand and under purchase commitments
at June 30, 2001, net of salvage $34.8
Excess quantities of finished goods on hand at June 30, 2001, net of salvage 10.8
Obsolescence 13.2
Cancellation charges on purchase commitments 5.2
Lower of cost or market write-down on current generation product platform 8.0
-----
Total $72.0
12
Significant estimates included in the calculation of the inventory
write-down above include forecasted demand for our products, sales prices for
residential gateways and other finished goods and estimated salvage or recovery
value for excess raw materials and finished goods. Actual results could differ
from those estimates, and therefore additional inventory write-downs may be
necessary in future periods.
Our gross margin percentage decreased to 13.0% in the third quarter of
2001 from 25.1% in the third quarter of 2000. Our gross margin percentage,
excluding the $72.0 million inventory charge and $0.4 million of manufacturing
overhead charges, decreased to 18.7% in the nine-month period ended September
30, 2001 from 21.6% in the comparable 2000 period. Excluding the inventory
charges, the decline in our gross margin percentage was primarily related to
spreading the manufacturing overhead elements of product cost over reduced sales
volumes. In the future, gross margin percentage may fluctuate due to a wide
variety of factors, including customer mix, product mix, the timing and size of
orders which are received, the availability of adequate supplies of key
components and assemblies, our ability to introduce new products and
technologies on a timely basis, the timing of new product introductions or
announcements by us or our competitors, price competition and unit volume. Our
overhead reduction plans and the improved product cost attributes of our new
standards compliant product platform are intended to improve the gross margin
percentage in future periods.
Research and development. Research and development expenses decreased to
$11.8 million in the quarter ended September 30, 2001 from $13.1 million in the
quarter ended September 30, 2000. Research and development expenses in the first
nine months of 2001 and 2000 were $38.7 million and $40.5 million, respectively.
The decrease in the research and development expenses for both periods was
primarily due to cost cutting measures, including a reduction in research and
development personnel, implemented in the current year. We expense all of our
research and development costs as incurred.
Selling, general and administrative. Selling, general and administrative
expenses decreased to $12.9 million in the quarter ended September 30, 2001 from
$13.7 million in the quarter ended September 30, 2000. The decrease was
primarily due to cost-cutting measures implemented in the third quarter.
Selling, general and administrative expenses increased to $42.3 million in the
nine-month period ended September 30, 2001 from $34.2 million in the comparable
2000 period. The increase in the nine-month expenses was primarily attributable
to increased goodwill amortization arising from the purchase of SoftProse in
July 2000. In addition, we generated higher sales expenses by hiring new sales
representatives in the first half of the year in our efforts to increase the
number and size of our customer accounts. We also generated higher recruiting
and relocation expenses in the first half of the year. Subsequent to September
30, 2001, we reduced our workforce by approximately 15% and expect to achieve
related overhead cost reductions in future periods.
Non-cash compensation charge. Substantially all of our employees in 1999
were holders of contingently exercisable stock options that became options to
purchase our common stock upon our recapitalization in 1999. In addition, tandem
stock options were granted in January 1997 to some of our employees. As a
result, non-cash compensation expense was recognized upon the completion of our
initial public offering based on the difference between the exercise price of
these options and the initial public offering price of our common stock. The
non-cash compensation expense related to these option grants in the nine-month
period ended September 30, 2000 was $2.4 million. There was no such expense in
2001, and we do not expect any such expenses to be material in the future.
Interest income (expense), net. Interest expense, net in the three-month
period and nine-month period ended September 30, 2001 was $5.4 million and $8.5
million. Interest expense in the
13
current period primarily constitutes cash and non-cash interest expense related
to our loan agreement with Motorola (see Note 3 to the condensed consolidated
financial statements). Interest income, net in the quarter and nine-month period
ended September 30, 2000 was $1.3 million and $5.1 million, respectively.
Interest income earned in these periods related primarily to interest earned on
our initial public offering proceeds.
Other income (expense), net. Other expense, net in the three-month
period and nine-month period ended September 30, 2001 was $0.2 million and $5.4
million, respectively. Other expense in the nine-month period is primarily
related to the write-down of certain investments and certain property, plant and
equipment (see Note 5 in the condensed consolidated financial statements). Other
income (expense) in the prior comparable periods was not significant.
LIQUIDITY AND CAPITAL RESOURCES
Net cash used in operating activities was $96.3 million in the nine
months ended September 30, 2001 and $60.5 million in the nine months ended
September 30, 2000. In the current period, the use of cash in operating
activities was primarily due to our net losses ($152.3 million less non-cash
charges of $78.6 million) and an increase in inventory of $51.5 million
partially off-set by a reduction in accounts receivable of $14.7 million. During
the nine-month period ended September 30, 2000, the cash used in operating
activities was primarily due to net losses of $46.5 million and an increase in
inventory of $33.3 million.
Net cash used in investing activities was $10.6 million in the nine
months ended September 30, 2001 and $17.3 million in the nine months ended
September 30, 2000. The current period amount was attributable to capital
expenditures made to support our engineering and testing activities as well as
an additional $6.5 million investment in Virtual Access, a network access
company. In the prior period, the amount was primarily attributable to capital
expenditures and investments in OutReach and Expanse Networks, partially off-set
by the sale of marketable securities.
Net cash provided by financing activities was $83.2 million in the nine
months ended September 30, 2001 and $3.9 million in the nine months ended
September 30, 2000. The current period amount is primarily related to borrowings
of $64.0 million from Motorola and $17.3 million in proceeds related to our Tax
Sharing Agreement with Motorola. The prior period amount was primarily
attributable to the sale of common stock pursuant to the exercise of employee
stock options, partially off-set by the payment of expenses related to our
initial public offering.
On May 16, 2001 (as amended July 25, September 28 and October 15,
2001), we entered into a $60.0 million loan agreement with Motorola, Inc. Under
the terms of the agreement, Motorola, which currently owns approximately 75% of
the outstanding shares of our common stock, made a $60.0 million loan commitment
to us over a two-year period, with a maturity of May 17, 2003. Interest is
determined by Motorola based on either the base rate (as defined in the
agreement) plus 2% or the Eurodollar rate plus 3 1/2%.
On September 28, 2001, we amended the $60.0 million loan agreement with
Motorola, Inc. to include $4.0 million of bridge financing which was received by
us on September 28, 2001. Under the terms of the amended agreement, we were
required to repay the $4.0 million subsequent to the funding of the building
mortgage discussed below. This amount was repaid on November 2, 2001.
As of September 30, 2001, we had an outstanding obligation under the
loan agreement of $64.0 million.
14
On October 15, 2001, we amended the $64.0 million loan agreement with
Motorola to include an additional $3.0 million, which resulted from a revised
calculation performed relative to the Tax Sharing and Allocation Agreement
between us and Motorola (see Note 4 to the condensed consolidated financial
statements). As of October 15, 2001, we had an outstanding obligation under the
loan agreement of $67.0 million.
As of November 2, 2001, subsequent to the $4.0 million repayment, we
had an outstanding obligation under the loan agreement with Motorola of $63.0
million.
The loan agreement with Motorola contains various covenants, including
compliance with net worth requirements, and restrictions on additional
indebtedness, capital expenditures, and dividends. As of September 30, 2001, we
were in compliance with all of the covenants. See Note 3 to the condensed
consolidated financial statements for a discussion of other terms and conditions
of the loan agreement.
At September 30, 2001, we had $12.3 million of cash and cash equivalents
and working capital of $27.0 million. At November 7, 2001, we had $22.8 of cash
and cash equivalents. We have instituted and continue to pursue initiatives
intended to increase liquidity.
From December 2000 through November 7, 2001, we have instituted the
following measures to improve liquidity:
- Obtained on October 30, 2001 $20.0 million in financing through the
mortgage of our largest office building (see note 10 to the
condensed consolidated financial statements);
- Completed on October 11, 2001 the sale of a non-core asset for
approximately $5.8 million (see note 10 to the condensed
consolidated financial statements);
- Made a reduction in our workforce of approximately 15% on October
29, 2001, thereby reducing the number of employees from
approximately 490 at February 28, 2001 to approximately 365 at
November 8, 2001;
- Obtained $32.3 million from Motorola pursuant to the existing Tax
Sharing and Allocation Agreement;
- Obtained a $60.0 million loan from Motorola, due in May 2003; and
- Extended payment terms until May 2002 for $24.3 million of vendor
payables.
We plan to take the following actions, among others, to help sustain
our operations and seek to meet our financial obligations for the remainder of
2001 and into 2002:
- Continue our active discussions with several investors regarding
different financing alternatives;
- Continue to renegotiate payment terms under vendor payables and
purchase commitments;
- Dispose of excess inventories;
- Continue to accelerate cash collections; and
- Continue to decrease discretionary spending on general and
administrative items.
We need to obtain additional external equity or debt financing during
the first quarter of 2002 in order to maintain our current operations. We cannot
assure that we will be
15
successful in any of these initiatives or that external equity or debt financing
will be available on favorable terms, or at all.
RISK FACTORS
You should carefully consider the risk factors set forth below.
WE MAY NOT BE ABLE TO OBTAIN SUFFICIENT FINANCING TO FUND OUR BUSINESS.
We need to obtain additional external equity or debt financing during
the first quarter of 2002 in order to maintain current operations. We cannot
assure that we will be successful in any of these initiatives or that external
equity or debt financing will be available on favorable terms, or at all.
WE HAVE INCURRED NET LOSSES AND NEGATIVE CASH FLOW FOR OUR ENTIRE HISTORY, WE
EXPECT TO INCUR FUTURE LOSSES AND NEGATIVE CASH FLOW, AND WE MAY NEVER ACHIEVE
PROFITABILITY.
We incurred net losses of $152.3 million in the nine months ended
September 30, 2001 and $74.8 million in the year ended December 31, 2000. Our
ability to achieve profitability on a continuing basis will depend on the
successful design, development, testing, introduction, marketing and broad
commercial distribution of our broadband equipment products.
We expect to incur significant product development, sales and marketing,
and administrative expenses. In addition, we depend in part on cost reductions
to improve gross profit margins because the fixed-price nature of most of our
long-term customer agreements prevents us from increasing prices. As a result,
we will need to generate significant revenues and improve gross profit margins
to achieve and maintain profitability. We may not be successful in reducing our
costs or in selling our products in sufficient volumes to realize cost benefits
from our manufacturers. We cannot be certain that we can achieve sufficient
revenues or gross profit margin improvements to generate profitability.
OUR CUSTOMER BASE OF TELEPHONE COMPANIES IS EXTREMELY CONCENTRATED AND THE LOSS
OF OR REDUCTION IN BUSINESS FROM EVEN ONE OF OUR CUSTOMERS, PARTICULARLY QWEST,
COULD CAUSE OUR SALES TO FALL SIGNIFICANTLY.
A small number of customers have accounted for a large part of our
revenues to date. We expect this concentration to continue in the future. If we
lose one of our significant customers, our revenues could be significantly
reduced. Qwest accounted for 21% and 47% of total revenues in the quarters ended
September 30, 2001 and 2000. Our agreements with our customers are cancelable by
these customers on short notice, without penalty, do not obligate the customers
to purchase any products and are not exclusive. As a result of the merger
between U S WEST and Qwest, Qwest slowed its purchases of our equipment while it
re-evaluates its plans regarding the deployment of VDSL across its network.
Sales to Qwest in the future are dependent upon their decision regarding the
deployment of our product. Any continued significant reduction in purchases of
our equipment by Qwest could have a material adverse effect on us.
16
A SIGNIFICANT MARKET FOR OUR PRODUCTS MAY NOT DEVELOP IF TELEPHONE COMPANIES DO
NOT SUCCESSFULLY DEPLOY BROADBAND SERVICES SUCH AS HIGH-SPEED DATA AND VIDEO;
RECENT RELUCTANCE OF TELEPHONE COMPANIES TO MAKE SIGNIFICANT CAPITAL
EXPENDITURES MAY HEIGHTEN THIS ISSUE.
Telephone companies have just recently begun offering high-speed data
services, and most telephone companies have not offered video services at all.
Unless telephone companies make the strategic decision to enter the market for
providing broadband services, a significant market for our products may not
develop. Sales of our products largely depend on the increased use and
widespread adoption of broadband services and the ability of our customers to
market and sell broadband services, including video services, to their
customers. Certain critical issues concerning use of broadband services are
unresolved and will likely affect their use. These issues include security,
reliability, speed and volume, cost, government regulation and the ability to
operate with existing and new equipment. In addition, telephone companies have
recently been reluctant to make significant capital expenditures.
Even if telephone companies decide to deploy broadband services, this
deployment may not be successful. Our customers have delayed deployments in the
past and may delay deployments in the future. Factors that could cause telephone
companies not to deploy, to delay deployment of, or to fail to deploy
successfully the services for which our products are designed include the
following:
- industry consolidation;
- regulatory uncertainties and delays affecting telephone companies;
- varying quality of telephone companies' network infrastructure and
cost of infrastructure upgrades and maintenance;
- inexperience of telephone companies in obtaining access to video
programming content from third party providers;
- inexperience of telephone companies in providing broadband services
and the lack of sufficient technical expertise and personnel to
install products and implement services effectively;
- uncertain subscriber demand for broadband services; and
- inability of telephone companies to predict return on their
investment in broadband capable infrastructure and equipment.
Unless our products are successfully deployed and marketed by telephone
companies, we will not be able to achieve our business objectives and increase
our revenues.
OUR LIMITED OPERATING HISTORY MAKES IT DIFFICULT FOR YOU TO EVALUATE OUR
BUSINESS AND PROSPECTS.
We recorded our first sale in September 1997. As a result, we have only a
limited operating history upon which you may evaluate our business and
prospects. You should consider our prospects in light of the heightened risks
and unexpected expenses and difficulties frequently encountered by companies in
an early stage of development. These risks, expenses and difficulties, which are
described further below, apply particularly to us because the market for
equipment for
17
delivering voice, data and video services is new and rapidly evolving. Due to
our limited operating history, it will be difficult for you to evaluate whether
we will successfully address these risks.
WE EXPECT OUR QUARTERLY REVENUES AND OPERATING RESULTS TO FLUCTUATE, AND THESE
FLUCTUATIONS MAY MAKE OUR STOCK PRICE VOLATILE.
Our quarterly revenues and operating results have fluctuated in the past
and are likely to fluctuate significantly in the future. As a result, we believe
that quarter-to-quarter comparisons of our operating results may not be
meaningful. Fluctuations in our quarterly revenues or operating results may
cause volatility in the price of our stock. It is likely that in some future
quarter our operating results may be below the expectations of public market
analysts and investors, which may cause the price of our stock to fall. Factors
likely to cause variations in our quarterly revenues and operating results
include:
- delays or cancellations of any orders by Qwest, which accounted for
approximately 21% of our revenues in the quarter ended September 30,
2001, or by any other customer accounting for a significant portion
of our revenues;
- variations in the timing, mix and size of orders and shipments of our
products throughout a quarter or year;
- new product introductions by us or by our competitors;
- the timing of upgrades of telephone companies' infrastructure;
- variations in capital spending budgets of telephone companies; and
- increased expenses, whether related to sales and marketing, product
development or administration.
The amount and timing of our operating expenses generally will vary from
quarter to quarter depending on the level of actual and anticipated business
activity. Because most of our operating expenses are fixed in the short term, we
may not be able to quickly reduce spending if our revenues are lower than we had
projected and our results of operations could be harmed.
CONSOLIDATION AMONG TELEPHONE COMPANIES MAY REDUCE OUR SALES.
Consolidation in the telecommunications industry may cause delays in the
purchase of our products and cause a reexamination of strategic and purchasing
decisions by our customers. In addition, we may lose relationships with key
personnel within a customer's organization due to budget cuts, layoffs, or other
disruptions following a consolidation. For example, our sales to NYNEX,
previously one of our largest clients, have decreased significantly as a result
of a shift in focus resulting from its merger with Bell Atlantic. In addition,
as a result of the merger between U S WEST and Qwest, Qwest has slowed its
purchases of our equipment while it re-evaluates its plans regarding deployment
of VDSL across its network.
18
BECAUSE OUR SALES CYCLE IS LENGTHY AND VARIABLE, THE TIMING OF OUR REVENUE IS
DIFFICULT TO PREDICT, AND WE MAY INCUR SALES AND MARKETING EXPENSES WITH NO
GUARANTEE OF A FUTURE SALE.
Customers view the purchase of our products as a significant and
strategic decision. As a result, customers typically undertake significant
evaluation, testing and trial of our products before deployment. This evaluation
process frequently results in a lengthy sales cycle, typically ranging from nine
months to more than a year. Before a customer places an order, we may incur
substantial sales and marketing expenses and expend significant management
efforts. In addition, product purchases are frequently subject to unexpected
administrative, processing and other delays on the part of our customers. This
is particularly true for customers for whom our products represent a very small
percentage of their overall purchasing activities. As a result, sales forecasted
to be made to a specific customer for a particular quarter may not be realized
in that quarter; and this could result in lower than expected revenues.
WE INCURRED A SIGNIFICANT WRITE-DOWN OF OUR INVENTORY IN THE NINE MONTHS ENDED
SEPTEMBER 30, 2001 BASED ON ESTIMATES WHICH MAY VARY FROM ACTUAL RESULTS;
THEREFORE, ADDITIONAL INVENTORY WRITE-DOWNS MAY BE NECESSARY IN FUTURE PERIODS.
In the quarter ended June 30, 2001, we recorded an inventory write-down
(including purchase commitments) related to our current generation product
platform and related communications equipment totaling $72.0 million. To meet
forecasted demand and reduce the anticipated component supply constraints that
had existed in the past, we had increased inventory levels for certain
components and had entered into purchase commitments for certain components with
long lead times. In the quarter ended June 30, 2001, our actual sales, as well
as our estimates of forecasted sales, for our current
generation of products declined significantly. As a result, the inventory
charges were calculated based on:
- the substantial completion of the negotiation process with our
contract manufacturers and their suppliers and our other vendors
regarding purchase commitments and cancellations made by us,
- the inventory levels in excess of forecasted demand and
- our estimates of salvage or recovery value for each raw material of
finished good on an item by item basis.
Significant estimates included in the calculation of the inventory
write-down above include forecasted demand for our products, sales prices for
residential gateways and other finished goods and estimated salvage or recovery
value for excess raw materials and finished goods. Actual results could differ
from those estimates, and therefore additional inventory write-downs may be
necessary in future periods.
GOVERNMENT REGULATION OF OUR CUSTOMERS AND RELATED UNCERTAINTY COULD CAUSE OUR
CUSTOMERS TO DELAY THE PURCHASE OF OUR PRODUCTS.
The Telecommunications Act requires telephone companies, such as the
regional Bell operating companies, to offer their competitors cost-based access
to some elements of their networks, such as local "loop" or last-mile
facilities.
19
These telephone companies may not wish to make expenditures for infrastructure
and equipment required to provide broadband services if they will be forced to
allow competitors access to this infrastructure and equipment. The Federal
Communications Commission, or FCC, announced that, except in limited
circumstances, it will not require incumbent carriers to offer their competitors
access to the facilities and equipment used to provide high-speed data services.
Nevertheless, other regulatory and judicial proceedings relating to telephone
companies' obligations to provide elements of their network to competitors are
pending. The FCC also requires incumbent carriers to permit competitive carriers
to collocate certain equipment with the local switching equipment of the
incumbents. The FCC's collocation rules continue to be subject to regulatory and
judicial proceedings. The uncertainties caused by these regulatory proceedings
may cause these telephone companies to delay purchasing decisions at least until
the proceedings and any related judicial appeals are completed. The outcomes of
these regulatory proceedings, as well as other FCC regulation, may cause these
telephone companies not to deploy services for which our products are designed
or to further delay deployment. Additionally, telephone companies' deployment of
broadband services may be slowed down or stopped because of the need for
telephone companies to obtain permits from city, state or federal authorities to
implement infrastructure.
OUR CUSTOMERS AND POTENTIAL CUSTOMERS WILL NOT PURCHASE OUR PRODUCTS IF THEY DO
NOT HAVE THE INFRASTRUCTURE NECESSARY TO USE OUR PRODUCTS.
The copper wire infrastructures over which telephone companies may
deliver voice, data and video services using our products vary in quality and
reliability. As a result, some of these telephone companies may not be able to
deliver a full set of voice, data and video services to their customers, despite
their intention to do so, and this could harm our sales. Even after installation
of our products, we remain highly dependent on telephone companies to continue
to maintain their infrastructure so that our products will operate at a
consistently high performance level. Infrastructure upgrades and maintenance may
be costly, and telephone companies may not have the necessary financial
resources. This may be particularly true for our smaller customers and potential
customers such as independent telephone companies and domestic local telephone
companies. If our current and potential customers' infrastructure is inadequate,
we may not be able to generate anticipated revenues from them.
IF COMPETING TECHNOLOGIES THAT OFFER ALTERNATIVE SOLUTIONS TO OUR PRODUCTS
ACHIEVE WIDESPREAD ACCEPTANCE, THE DEMAND FOR OUR PRODUCTS MAY NOT DEVELOP.
Technologies that compete with our products include other
telecommunications-related wireline technologies, cable-based technologies,
fixed wireless technologies and satellite technologies. If these alternative
technologies are chosen by our existing and potential customers, our business,
financial condition and results of operations could be harmed. In particular,
cable operators are currently deploying products that will be capable of
delivering voice, high-speed data and video services over cable, including
products from General Instrument, our principal stockholder, and Motorola, its
parent. Our technology may not be able to compete effectively against these
technologies on price, performance or reliability.
Our customers or potential customers that also offer cable-based
services may choose to purchase cable-based technologies. Cable service
providers that offer not only data and video but also telephony over cable
systems will give subscribers the alternative of purchasing all communications
services from a single communications service provider, allowing the potential
for more favorable pricing and a single point of contact for bill payment and
customer service. If these services are implemented successfully over cable
connections, they will compete directly with the
20
services offered by telephone companies using our products. In addition, several
telephone companies have commenced the marketing of video services over direct
broadcast satellite while continuing to provide voice and data services over
their existing copper wire infrastructure. If any of these services are accepted
by consumers, the demand for our products may not develop and our ability to
generate revenues will be harmed.
WE FACE INTENSE COMPETITION IN PROVIDING EQUIPMENT FOR TELECOMMUNICATIONS
NETWORKS FROM LARGER AND MORE WELL-ESTABLISHED COMPANIES, AND WE MAY NOT BE ABLE
TO COMPETE EFFECTIVELY WITH THESE COMPANIES.
Many of our current and potential competitors have longer operating
histories, greater name recognition and significantly greater financial,
technical, marketing and distribution resources than we do. These competitors
may undertake more extensive marketing campaigns, adopt more aggressive pricing
policies and devote substantially more resources to developing new products than
we are able to, which could result in the loss of current customers and impair
our ability to attract potential customers.
Our significant current competitors include Advanced Fibre
Communications, Alcatel, Cisco Systems, Efficient Networks, Ericsson, Lucent
Technologies, Nokia, Nortel Networks, RELTEC (acquired by BAE Systems, CNI
Division, formerly GEC Marconi), Scientific Atlanta, Siemens and our largest
stockholder, General Instrument/Motorola, as well as emerging companies that are
developing new technologies. Some of these competitors have existing
relationships with our current and prospective customers. In addition, we
anticipate that other large companies, such as Matsushita Electric Industrial
which markets products under the Panasonic brand name, Microsoft, Network
Computer, Philips, Sony, STMicroelectronics and Toshiba America will likely
introduce products that compete with our N(3) Residential Gateway product in the
future. Our customer base may be attracted by the name and resources of these
large, well-known companies and may prefer to purchase products from them
instead of us.
CONSOLIDATION OF OUR COMPETITORS MAY CAUSE US TO LOSE CUSTOMERS AND NEGATIVELY
AFFECT OUR SALES.
Consolidation in the telecommunications equipment industry may
strengthen our competitors' positions in our market, cause us to lose customers
and hurt our sales. For example, as a result of the merger between U S WEST and
Qwest, Qwest has slowed its purchases of our equipment while it re-evaluates its
plans regarding the deployment of VDSL across its network. In addition, Alcatel
acquired DSC Communications, Lucent acquired Ascend Communications and BAE
Systems, CNI Division, formerly GEC Marconi, acquired RELTEC. Acquisitions such
as these may strengthen our competitors' financial, technical and marketing
resources and provide them access to regional Bell operating companies and other
potential customers. Consolidation may also allow some of our competitors to
penetrate new markets that we have targeted, such as domestic local, independent
and international telephone companies. This consolidation may negatively affect
our ability to increase revenues.
IF WE DO NOT RESPOND QUICKLY TO CHANGING CUSTOMER NEEDS AND FREQUENT NEW PRODUCT
INTRODUCTIONS BY OUR COMPETITORS, OUR PRODUCTS MAY BECOME OBSOLETE.
Our position in existing markets or potential markets could be eroded
rapidly by product advances. The life cycles of our products are difficult to
estimate. Our growth and future financial
21
performance will depend in part upon our ability to enhance existing products
and develop and introduce new products that keep pace with:
- the increasing use of the Internet;
- the growth in remote access by telecommuters;
- the increasingly diverse distribution sources for high quality
digital video; and
- other industry and technological trends.
We expect that our product development efforts will continue to require
substantial investments. We may not have sufficient resources to make the
necessary investments. If we fail to timely and cost-effectively develop new
products that respond to new technologies and customer needs, the demand for our
products may fall and we could lose revenues.
OUR EXECUTIVE OFFICERS AND CERTAIN KEY PERSONNEL ARE CRITICAL TO OUR BUSINESS
AND THE LOSS OF THEIR SERVICES COULD DISRUPT OUR OPERATIONS AND OUR CUSTOMER
RELATIONSHIPS.
None of our executive officers or key employees is bound by an
employment agreement. Many of these employees have a significant number of
options to purchase our common stock. Many of these options are currently vested
and some of our key employees may leave us once they have exercised their
options. In addition, our engineering and product development teams are critical
in developing our products and have developed important relationships with our
regional Bell operating company customers and their technical staffs. The loss
of any of these key personnel could harm our operations and customer
relationships.
OUR LIMITED ABILITY TO PROTECT OUR INTELLECTUAL PROPERTY MAY AFFECT OUR ABILITY
TO COMPETE, AND WE COULD LOSE CUSTOMERS.
We rely on a combination of patent, copyright and trademark laws, and on
trade secrets and confidentiality provisions and other contractual provisions to
protect our intellectual property. There is no guarantee that these safeguards
will protect our intellectual property and other valuable confidential
information. If our methods of protecting our intellectual property in the
United States or abroad are not adequate, our competitors may copy our
technology or independently develop similar technologies and we could lose
customers. In addition, the laws of some foreign countries do not protect our
proprietary rights as fully as do the laws of the United States. If we fail to
adequately protect our intellectual property, it would be easier for our
competitors to sell competing products, which could harm our business.
THIRD-PARTY CLAIMS REGARDING INTELLECTUAL PROPERTY MATTERS COULD CAUSE US TO
STOP SELLING OUR PRODUCTS, LICENSE ADDITIONAL TECHNOLOGY OR PAY MONETARY
DAMAGES.
From time to time, third parties, including our competitors and
customers, have asserted patent, copyright and other intellectual property
rights to technologies that are important to us. We expect that we will
increasingly be subject to infringement claims as the number of products and
competitors in our market grows and the functionality of products overlaps, and
our products may currently infringe on one or more United States or
international patents. The results of any litigation are inherently uncertain.
In the event of an adverse result in any litigation with third parties that
could arise in the future, we could be required:
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- to pay substantial damages, including paying treble damages if we are
held to have willfully infringed;
- to halt the manufacture, use and sale of infringing products;
- to expend significant resources to develop non-infringing technology;
and/or
- to obtain licenses to the infringing technology.
Licenses may not be available from any third party that asserts
intellectual property claims against us, on commercially reasonable terms, or at
all. In addition, litigation frequently involves substantial expenditures and
can require significant management attention, even if we ultimately prevail. In
addition, we indemnify our customers for patent infringement claims, and we may
be required to obtain licenses on their behalf, which could subject us to
significant additional costs.
WE DEPEND ON THIRD-PARTY MANUFACTURERS AND ANY DISRUPTION IN THEIR MANUFACTURE
OF OUR PRODUCTS WOULD HARM OUR OPERATING RESULTS.
We contract for the manufacture of all of our products and have limited
in-house manufacturing capabilities. We rely primarily on one large contract
manufacturers: SCI Systems. The efficient operation of our business will depend,
in large part, on our ability to have SCI and other companies manufacture our
products in a timely manner, cost-effectively and in sufficient volumes while
maintaining consistent quality. As our business grows, SCI and other contracted
manufacturing companies may not have the capacity to keep up with the increased
demand. Any manufacturing disruption could impair our ability to fulfill orders
and could cause us to lose customers.
WE HAVE NO LONG-TERM CONTRACTS WITH OUR MANUFACTURERS, AND WE MAY NOT BE ABLE TO
DELIVER OUR PRODUCTS ON TIME IF ANY OF THESE MANUFACTURERS STOP MAKING OUR
PRODUCTS.
We have no long-term contracts or arrangements with any of our contract
manufacturers that guarantee product availability, the continuation of
particular payment terms or the extension of credit limits. If our manufacturers
are unable or unwilling to continue manufacturing our products in required
volumes, we will have to identify acceptable alternative manufacturers, which
could take in excess of three months. It is possible that a source may not be
available to us when needed or be in a position to satisfy our production
requirements at acceptable prices and on a timely basis. If we cannot find
alternative sources for the manufacture of our products, we will not be able to
meet existing demand. As a result, we may lose existing customers, and our
ability to gain new customers may be significantly constrained.
OUR INABILITY TO PRODUCE SUFFICIENT QUANTITIES OF OUR PRODUCTS BECAUSE OF OUR
DEPENDENCE ON COMPONENTS FROM KEY SOLE SUPPLIERS COULD RESULT IN DELAYS IN THE
DELIVERY OF OUR PRODUCTS AND COULD HARM OUR REVENUES.
Some parts, components and equipment used in our products are obtained
from sole sources of supply. If our sole source suppliers or we fail to obtain
components in sufficient quantities when required, delivery of our products
could be delayed resulting in decreased revenues. Additional sole-sourced
components may be incorporated into our equipment in the future. We do not have
any long-term supply contracts to ensure sources of supply. In addition, our
suppliers may enter into exclusive arrangements with our competitors, stop
selling their products or components to
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us at commercially reasonable prices or refuse to sell their products or
components to us at any price, which could harm our operating results.
THE OCCURRENCE OF ANY DEFECTS, ERRORS OR FAILURES IN OUR PRODUCTS COULD RESULT
IN DELAYS IN INSTALLATION, PRODUCT RETURNS AND OTHER LOSSES TO US OR TO OUR
CUSTOMERS OR END-USERS.
Our products are complex and may contain undetected defects, errors or
failures. These problems have occurred in our products in the past and
additional problems may occur in our products in the future and could result in
the loss of or delay in market acceptance of our products. In addition, we have
limited experience with commercial deployment and we expect additional defects,
errors and failures as our business expands from trials to commercial deployment
at certain customers. We will have limited experience with the problems that
could arise with any new products that we introduce. Further, our customer
agreements generally include a longer warranty for defects than our
manufacturing agreements. These defects could result in a loss of sales and
additional costs and liabilities to us as well as damage to our reputation and
the loss of our customers.
WE DO NOT HAVE SIGNIFICANT EXPERIENCE IN INTERNATIONAL MARKETS AND MAY HAVE
UNEXPECTED COSTS AND DIFFICULTIES IN DEVELOPING INTERNATIONAL REVENUES.
We plan to extend the marketing and sales of our products
internationally. International operations are generally subject to inherent
risks and challenges that could harm our operating results, including:
- unexpected changes in telecommunications regulatory requirements;
- limited number of telephone companies operating internationally;
- expenses associated with developing and customizing our products for
foreign countries;
- tariffs, quotas and other import restrictions on telecommunications
equipment;
- longer sales cycles for our products; and
- compliance with international standards that differ from domestic
standards.
To the extent that we generate international sales in the future, any
negative effects on our international business could harm our business,
operating results and financial condition. In particular, fluctuating exchange
rates may contribute to fluctuations in our results of operations.
MOTOROLA MAY EXERCISE SIGNIFICANT INFLUENCE OVER OUR BUSINESS AND AFFAIRS AND
OUR STOCKHOLDER VOTES AND, FOR ITS OWN REASONS, COULD PREVENT TRANSACTIONS WHICH
OUR OTHER STOCKHOLDERS MAY VIEW AS FAVORABLE.
Motorola beneficially owns approximately 75% of the outstanding shares
of our common stock as of September 30, 2001. Motorola will be able to exercise
significant influence over all matters relating to our business and affairs,
including approval of significant corporate transactions, which could delay or
prevent someone from acquiring or merging with us and could prevent you from
receiving a premium for your shares.
24
We do not know whether Motorola's plans for our business and affairs
will be different than our existing plans and whether any changes that may be
implemented under Motorola's control will be beneficial or detrimental to our
other stockholders.
OUR PRINCIPAL STOCKHOLDER AND ITS PARENT MAY HAVE INTERESTS THAT CONFLICT WITH
THE BEST INTERESTS OF OUR OTHER STOCKHOLDERS AND US AND MAY CAUSE US TO FORGO
OPPORTUNITIES OR TAKE ACTIONS THAT DISPROPORTIONATELY BENEFIT OUR PRINCIPAL
STOCKHOLDER.
It is possible that Motorola could be in a position involving a conflict
of interest with us. In addition, individuals who are officers or directors of
Motorola and of us may have fiduciary duties to both companies. For example, a
conflict may arise if our principal stockholder were to engage in activities or
pursue corporate opportunities that may overlap with our business. These
conflicts could harm our business and operating results. Our certificate of
incorporation contains provisions intended to protect our principal stockholder
and these individuals in these situations. These provisions limit your legal
remedies.
THE PRICE OF OUR COMMON STOCK HAS BEEN AND MAY CONTINUE TO BE HIGHLY VOLATILE.
The stock markets have in general, and with respect to high technology
companies, including us, in particular, recently experienced extreme stock price
and volume volatility, often unrelated to the financial performance of
particular companies. The price at which our common stock will trade in the
future is likely to also be highly volatile and may fluctuate substantially due
to factors such as:
- actual or anticipated fluctuations in our operating results;
- changes in or our failure to meet securities analysts' expectations;
- announcements of technological innovations by us or our competitors;
- introduction of new products and services by us or our competitors;
- limited public float of our common stock;
- conditions and trends in the telecommunications and other technology
industries; and
- general economic and market conditions.
SALES OF SHARES OF OUR COMMON STOCK BY EXISTING STOCKHOLDERS COULD CAUSE THE
MARKET PRICE OF OUR COMMON STOCK TO DROP SIGNIFICANTLY.
As of November 5, 2001, Motorola owned 64.1 million shares of our common
stock and warrants to purchase an additional 4.5 million shares of our common
stock, and Kevin Kimberlin Partners, LP and its affiliates owned 2.9 million
shares of our common stock and its affiliates held warrants to purchase an
additional 4.3 million shares of our common stock; as of June 30, 2001, FMR
Corporation owned 4.8 million shares of our common stock. If Motorola, Kevin
Kimberlin Partners LP and its affiliates, FMR, or any of our other stockholders
sells substantial amounts of common stock, including shares issued upon exercise
of outstanding options and warrants, in the public market, the market price of
the common stock could fall. In addition, any distribution of shares of our
common stock by Motorola to its stockholders could also have an adverse effect
on the market price.
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Motorola and Kevin Kimberlin Partners LP and its related persons and
their transferees are entitled to registration rights pursuant to which they may
require that we register their shares under the Securities Act.
In addition, as of November 5, 2001, there were outstanding options to
purchase 15.7 million shares of our common stock. Subject to vesting provisions
and, in the case of our affiliates, volume and manner of sale restrictions, the
shares of common stock issuable upon the exercise of our outstanding employee
options will be eligible for sale into the public market at various times.
ANTI-TAKEOVER PROVISIONS IN OUR CHARTER DOCUMENTS AND DELAWARE LAW COULD PREVENT
OR DELAY A CHANGE IN CONTROL OF OUR COMPANY THAT A STOCKHOLDER MAY CONSIDER
FAVORABLE.
Several provisions of our certificate of incorporation and by-laws and
Delaware law may discourage, delay or prevent a merger or acquisition that a
stockholder may consider favorable. These provisions include:
- authorizing the issuance of preferred stock without stockholder
approval;
- providing for a classified board of directors with staggered,
three-year terms;
- prohibiting cumulative voting in the election of directors;
- restricting business combinations with interested stockholders;
- limiting the persons who may call special meetings of stockholders;
- prohibiting stockholder action by written consent;
- establishing advance notice requirements for nominations for election
to the board of directors and for proposing matters that can be acted
on by stockholders at stockholder meetings; and
- requiring super-majority voting to effect amendments to our
certificate of incorporation and by-laws.
Some of these provisions do not currently apply to Motorola and its
affiliates.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk is limited to interest rate fluctuation.
We do not engage in any hedging activities, and we do not use derivatives or
equity investments for cash investment purposes. The marketable securities
portfolio is classified as available for sale and recorded at fair value on the
balance sheet. Our portfolio consists solely of corporate bonds, commercial
paper and government securities, and therefore, our market risk is deemed
relatively low.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Securities Litigation. In July 2001 a class action complaint entitled
Zichron Yakov Menachem Inc. v. Next Level Communications, Inc., et al, was filed
in the United States District Court for the Southern District of New York,
alleging various violations of law, including alleged violations of Sections 11,
12 and 15 of the Securities Act of 1933, Section 10(b) of the Securities
Exchange Act of 1934, and Rule 10b-5 promulgated thereunder, based on alleged
excessive commissions, and agreements to engage in after-market transactions,
received by underwriters in exchange for the receipt of allocations of stock in
our initial public offering. Plaintiff seeks to represent a class comprised of
all persons who purchased our common stock during the period from November 9,
1999 through December 6, 2000. Based upon information presently known to us, we
do not believe that the ultimate resolution of these lawsuits will have a
material adverse effect on our business.
On August 15, 2001, a complaint entitled CMC Industries, Inc., d/b/a CMC
Mississippi, Inc., d/b/a ACT Mississippi v. Next Level Communications, Inc. was
filed in the Superior Court for the State of California, County of Sonoma. The
complaint alleged that the Company was delinquent in payment relating to certain
purchase orders issued by the Company to the plaintiff, and sought damages in
the amount of $22.5 million, plus interest and attorneys' fees. On October 24,
2001, plaintiff and the Company entered into a Settlement Agreement and Mutual
Release, pursuant to which the complaint was dismissed and the Company agreed to
pay to plaintiff the total amount of $21.3 million (of which amount $13.4
million had been paid as of November 12, 2001) on an agreed-upon schedule.
Other Matters. From time to time, we are a party to other actions which
arise in the normal course of business. In our opinion, the ultimate disposition
of these matters will not have a material adverse effect on our business.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a). Exhibits:
The following exhibit is included as part of this report:
Exhibit
No. Description of Exhibit
------- ----------------------
10.1 Amendment No. 2 (dated September 28, 2001) to Credit Agreement
dated as of May 16, 2001 between Next Level Communications, Inc.
and Motorola, Inc.
10.2 Amendment No. 3 (dated October 15, 2001) to Credit Agreement
dated as of May 16, 2001 between Next Level Communications, Inc.
and Motorola, Inc.
10.3 Amendment No. 1 (dated October 24, 2001) to Registration Rights
Agreement dated as of May 16, 2001 between Next Level
Communications, Inc. and Motorola, Inc.
(b) Reports on Form 8-K:
none.
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
NEXT LEVEL COMMUNICATIONS, INC.
Date: November 14, 2001 By: /s/ J. MICHAEL NORRIS
-------------------------------------
J. Michael Norris
Chief Executive Officer
and President
Date: November 14, 2001 By: /s/ JAMES F. IDE
-------------------------------------
James F. Ide
Chief Financial Officer
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EXHIBIT INDEX
Exhibit
No. Description of Exhibit
------- ----------------------
10.1 Amendment No. 2 (dated September 28, 2001) to Credit Agreement
dated as of May 16, 2001 between Next Level Communications, Inc.
and Motorola, Inc.
10.2 Amendment No. 3 (dated October 15, 2001) to Credit Agreement
dated as of May 16, 2001 between Next Level Communications, Inc.
and Motorola, Inc.
10.3 Amendment No. 1 (dated October 24, 2001) to Registration Rights
Agreement dated as of May 16, 2001 between Next Level
Communications, Inc. and Motorola, Inc.
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