10-Q 1 d10q.htm FORM 10-Q Form 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 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, 2008

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934.

For the transition period from              to             

Commission file number 000-30865

 

 

SOAPSTONE NETWORKS INC.

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

Delaware   02-0493372

(State or Other Jurisdiction

of Organization)

 

(I.R.S. Employer

Identification No.)

1 Federal Street

Billerica, Massachusetts 01821

(Address of Principal Executive Offices) (Zip Code)

Avici Systems Inc.

(Former Name of Registrant )

Registrant’s Telephone Number, Including Area Code (978) 715-2300

296 Concord Road

Billerica, Massachusetts 01821

(Former Address of Principal Executive Office)

 

 

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  ¨

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large Accelerated Filer ¨    Accelerated Filer                 x
Non-accelerated Filer    ¨ (do not check if a smaller reporting company)    Smaller reporting company ¨

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

At October 31, 2008, 14,843,813 shares of the registrant’s Common Stock, par value $0.0001 per share, were outstanding.

 

 

 


Table of Contents

SOAPSTONE NETWORKS INC.

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

  

ITEM 1.

  

Financial Statements (Unaudited)

  
  

Consolidated Balance Sheets as of September 30, 2008 and December 31, 2007

   3
  

Consolidated Statements of Operations for the three and nine months ended September 30, 2008 and 2007

   4
  

Consolidated Statements of Cash Flows for the nine months ended September 30, 2008 and 2007

   5
  

Notes to Consolidated Financial Statements

   6

ITEM 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   11

ITEM 3.

  

Quantitative and Qualitative Disclosures About Market Risk

   18

ITEM 4.

  

Controls and Procedures

   18

PART II. OTHER INFORMATION

  

ITEM 1.

  

Legal Proceedings

   19

ITEM 1A.

  

Risk Factors

   19

ITEM 6.

  

Exhibits

   20

SIGNATURE

   21

 

Page 2


Table of Contents

PART I.    FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

SOAPSTONE NETWORKS INC.

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

(unaudited)

 

     September 30,
2008
    December 31,
2007
 

ASSETS

    

Current assets:

    

Cash and cash equivalents

   $ 91,049     $ 88,903  

Marketable securities

     7,057       11,085  

Trade accounts receivable, net

     —         11,769  

Prepaid expenses and other current assets

     938       790  
                

Total current assets

     99,044       112,547  

Property and equipment, net

     3,963       3,306  

Long-term marketable securities

     —         3,000  

Prepaid rents and other non-current assets

     349       —    
                

Total assets

   $ 103,356     $ 118,853  
                

LIABILITIES AND STOCKHOLDERS’ EQUITY

    

Current liabilities:

    

Accounts payable

   $ 2,606     $ 4,167  

Accrued payroll and payroll-related costs

     1,517       4,019  

Other accrued expenses

     527       816  

Deferred revenue

     2,221       2,343  
                

Total current liabilities

     6,871       11,345  

Commitments and contingencies

    

Stockholders’ equity:

    

Preferred stock, $0.01 par value:
Authorized – 5,000,000 shares
Issued and outstanding – none

     —         —    

Common stock, $0.0001 par value:
Authorized – 250,000,000 shares
Issued – 15,417,210 shares at
September 30, 2008 and 15,347,185 shares at
December 31, 2007

     2       2  

Additional paid-in capital

     490,319       487,529  

Common stock warrants

     6,321       6,321  

Treasury stock, at cost – 573,397 shares

     (2,870 )     (2,870 )

Accumulated deficit

     (397,287 )     (383,474 )
                

Total stockholders’ equity

     96,485       107,508  
                

Total liabilities and stockholders’ equity

   $ 103,356     $ 118,853  
                

See accompanying notes.

 

Page 3


Table of Contents

SOAPSTONE NETWORKS INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

(unaudited)

 

     Three Months Ended
September 30,
    Nine Months Ended
September 30,
 
     2008     2007     2008     2007  

Revenue:

        

Product (1)

   $ —       $ 26,927     $ 1,201     $ 72,251  

Service

     2,320       2,349       7,670       7,175  
                                

Total revenue

     2,320       29,276       8,871       79,426  
                                

Cost of revenue – product

     —         6,118       —         19,433  

Cost of revenue – service (2)

     738       348       2,699       1,170  
                                

Total cost of revenue

     738       6,466       2,699       20,603  
                                

Gross margin

     1,582       22,810       6,172       58,823  
                                

Operating expenses:

        

Research and development (2)

     4,570       6,029       12,622       20,722  

Sales and marketing (2)

     1,839       752       4,590       2,052  

General and administrative (2)

     1,736       1,681       5,169       5,014  

Restructuring and impairment charges

     —         —         —         100  
                                

Total operating expenses

     8,145       8,462       22,381       27,888  
                                

(Loss) income from operations

     (6,563 )     14,348       (16,209 )     30,935  

Other income

     50       81       137       81  

Interest income, net

     624       875       2,200       2,726  
                                

(Loss) income before income taxes

     (5,889 )     15,304       (13,872 )     33,742  

Benefit from (provision for) income tax

     59       (300 )     59       (670 )
                                

Net (loss) income

   $ (5,830 )   $ 15,004     $ (13,813 )   $ 33,072  
                                

Net (loss) income per common share:

        

Basic

   $ (0.39 )   $ 1.03     $ (0.93 )   $ 2.35  
                                

Diluted

   $ (0.39 )   $ 0.97     $ (0.93 )   $ 2.23  
                                

Weighted average common shares:

        

Basic

     14,841,589       14,500,720       14,819,815       14,091,716  
                                

Diluted

     14,841,589       15,490,075       14,819,815       14,844,714  
                                

Dividends declared and paid per share

   $ —       $ —       $ —       $ 2.00  

 

(1)    Revenue deferral from prior years’ product shipments recorded as product revenue in the three months ended June 30, 2008 upon the termination of certain customer terms and conditions.

       

(2)    Includes non-cash, stock-based compensation associated with stock option grants, as follows:

      

Cost of revenue – service

   $ 44     $ —       $ 110     $ —    

Research and development

     381       381       969       1,106  

Sales and marketing

     151       79       500       129  

General and administrative

     246       256       767       944  

See accompanying notes.

 

Page 4


Table of Contents

SOAPSTONE NETWORKS INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(unaudited)

 

     Nine Months Ended
September 30,
 
     2008     2007  

Cash Flows from Operating Activities:

    

Net (loss) income

   $ (13,813 )   $ 33,072  

Adjustments to reconcile net (loss) income to net cash provided by operating activities –

    

Depreciation and amortization

     2,285       3,694  

Stock-based compensation

     2,346       2,179  

Gain on sale of fixed assets

     (87 )     —    

Tax benefit from employee stock plans

     (123 )     —    

Changes in current assets and liabilities:

    

Trade accounts receivable

     11,769       (8,976 )

Inventories

     —         4,761  

Prepaid expenses and other current assets

     (100 )     (55 )

Prepaid rents and other non-current

     (397 )     —    

Accounts payable

     (1,438 )     (86 )

Accrued payroll and payroll related

     (2,502 )     401  

Accrued restructuring expenses

     —         (2,413 )

Accrued other

     (292 )     (368 )

Deferred revenue

     (122 )     (1,306 )
                

Net cash (used in) provided by operating activities

     (2,474 )     30,903  
                

Cash Flows from Investing Activities:

    

Maturity of marketable securities

     13,113       35,195  

Purchases of marketable securities

     (6,085 )     (35,472 )

Proceeds from restricted cash

     —         1,243  

Purchases of property and equipment

     (2,942 )     (1,966 )

Proceeds from sale of fixed assets

     87       —    
                

Net cash provided by (used in) investing activities

     4,173       (1,000 )
                

Cash Flows from Financing Activities:

    

Payment of dividends to stockholders

     —         (28,339 )

Proceeds from employee stock plans

     324       4,861  

Repurchase of common stock

     —         (313 )

Tax benefit from employee stock plans

     123       —    
                

Cash provided by (used in) financing activities

     447       (23,791 )
                

Net increase in Cash and Cash Equivalents

     2,146       6,112  

Cash and Cash Equivalents, Beginning of Period

     88,903       39,679  
                

Cash and Cash Equivalents, End of Period

   $ 91,049     $ 45,791  
                

See accompanying notes.

 

Page 5


Table of Contents

SOAPSTONE NETWORKS INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

(all tabular amounts are in thousands except share and per share data)

NOTE 1. BASIS OF PRESENTATION

The unaudited financial information included herein has been prepared by Soapstone Networks Inc., pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) and includes the accounts of Soapstone Networks Inc. and subsidiaries (“Soapstone” or the “Company”). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with generally accepted accounting principles, have been condensed or omitted in accordance with such rules and regulations. In the opinion of the Company, the accompanying consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary for a fair presentation of the financial position at September 30, 2008 and December 31, 2007 and the operating results and cash flows for the periods ended September 30, 2008 and 2007. These consolidated financial statements and notes should be read in conjunction with the Company’s consolidated audited financial statements and notes thereto for the year ended December 31, 2007, which appear in the Company’s Annual Report on Form 10-K. The consolidated balance sheet at December 31, 2007 has been derived from the audited consolidated financial statements as of that date.

The results of operations for the three and nine months ended September 30, 2008 are not necessarily indicative of results that may be expected for any other interim period or for the full fiscal year ending December 31, 2008.

On March 19, 2008 the Company changed its name from Avici Systems Inc. to Soapstone Networks Inc. and changed its NASDAQ ticker symbol from “AVCI” to “SOAP”.

NOTE 2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

(a) Revenue Recognition

The Company records revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” and all related interpretations. Revenue from support and maintenance contracts is recognized ratably over the period of the related agreements, provided a purchase order has been received or a contract has been executed, the sales price is fixed or determinable and collectibility is deemed probable. For arrangements that include the delivery of multiple elements, revenue is allocated to the various elements based on vendor-specific objective evidence of fair value (VSOE) when and if achieved by the Company. The Company uses the residual method when VSOE does not exist for one of the delivered elements in an arrangement. Revenue from installation and other services is recognized as the work is performed. Amounts collected or billed prior to satisfying the above revenue recognition criteria are recorded as deferred revenue.

The Company’s remaining deferred revenue represents the deferred and unearned portion of customer maintenance and support revenue, which will be amortized into service revenue over the remaining term of the related contractual service periods, through the end of 2008.

In April 2008, the Company amended its agreement with AT&T to better reflect the Company’s existing business relationship which is to provide support for previously shipped products. The amendment also includes a noncancellable commitment on the part of both parties for support throughout 2008 and the service fee arrangement for 2008, all of which has been collected as of September 30, 2008. As a result of the amendment, certain other obligations were cancelled which resulted in the Company recording from prior years’ deferred revenue approximately $1.2 million as product revenue in the second quarter of 2008. After 2008 the Company does not expect to record any revenue resulting from the support of its router products and accordingly is expected to have completely exited all revenue generating activities associated with its router products.

 

Page 6


Table of Contents

(b) Guarantees and Product Warranties

In the normal course of business, the Company may agree to indemnify other parties, including customers, lessors and parties to other transactions with the Company, with respect to certain matters. The Company has agreed to hold these other parties harmless against losses arising from a breach of representations or covenants, or other claims made against certain parties. Historically, payments made by the Company, if any, under these agreements have not had a material impact on the Company’s operating results or financial position.

The Company establishes warranty reserves for costs expected to be incurred after the sale and delivery of product for deficiencies as required under specific product warranty provisions. The warranty reserves are determined based on the actual trend of historical charges incurred over the prior twelve-month period excluding any significant or infrequent issues, which are specifically identified and reserved for. The warranty liability is established when it is probable that customers will make claims and when a reasonable estimate of costs can be made. Warranty reserves are included in “Other accrued expenses” in the accompanying consolidated balance sheets.

 

     Three months ended     Nine months ended  
     September 30,
2008
    September 30,
2007
    September 30,
2008
    September 30,
2007
 

Beginning balance

   $ 123     $ 220     $ 299     $ 284  

Warranties issued during the period

     —         117       —         357  

Settlements made during the period

     (79 )     (131 )     (255 )     (435 )
                                

Ending balance

   $ 44     $ 206     $ 44     $ 206  
                                

(c) Cash and Cash Equivalents and Marketable Securities

The Company has classified its marketable securities as held-to-maturity and recorded them at amortized cost, which approximates market value. Funds from marketable securities designated as held-to-maturity are not available for immediate use. The Company considers all highly liquid investments with original maturities of three months or less at the date of acquisition to be cash equivalents. Cash and cash equivalents include money market funds and certificates of deposit.

Cash, cash equivalents and marketable securities consist of the following:

 

     September 30
2008
   December 31
2007

Cash and cash equivalents

   $ 91,049    $ 88,903

Marketable securities

     7,057      11,085
             

Subtotal

     98,106      99,988

Long-term marketable securities

     —        3,000
             

Total

   $ 98,106    $ 102,988
             

(d) Use of Estimates

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.

 

Page 7


Table of Contents

(e) Net Income per Share

Basic net income (loss) per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income (loss) per share is computed using the weighted-average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares primarily consist of employee stock options, common stock warrants and restricted common stock. Basic and diluted net loss per share is the same for the periods with net loss and all outstanding employee stock options, common stock warrants and unvested restricted stock have been excluded, as they are considered anti-dilutive.

Statement of Financial Accounting Standards No. 128, “Earnings per Share,” requires that employee equity share options, non-vested shares and similar equity instruments granted by the Company be treated as potential common shares outstanding in computing diluted earnings per common share. Diluted shares outstanding in the 2007 periods include the dilutive effect of in-the-money options, which is calculated based on the average share price for each fiscal period using the treasury stock method.

(f) Comprehensive Income

SFAS No. 130, “Reporting Comprehensive Income,” requires disclosure of all components of comprehensive income (loss) on an annual and interim basis. Comprehensive income (loss) is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances involving non-owner sources. During all periods presented, the Company did not have any items of comprehensive income other than its reported net income (loss).

(g) Disclosures about Segments of an Enterprise

SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for reporting information regarding operating segments and establishes standards for related disclosures about products and services and geographic areas. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or decision making group, in making decisions regarding resource allocation and assessing performance. In 2007, the Company announced its transition away from core router development and product sales to focus on its new Soapstone products. The Company completed the final shipments of its core router products in the fourth quarter of 2007 and is expected to continue to service its products through 2008. During this transition the chief operating decision maker, or decision making group commenced assessing performance and allocation of resources between its legacy core router product and service and its Soapstone product development. Accordingly, commencing from 2007 the Company operates in two operating segments – core router and the Soapstone business. Since the Soapstone business is in development, the Company has not generated revenue, and instead is currently focusing on software development and sales and marketing related to such development. Accordingly, the reported revenue and accounts receivable are attributed solely to the core router segment. The Company considers all assets to be jointly used, and accordingly does not separately identify or allocate such assets to its operating segments. Pre-tax income from operations derived from the core router segment in the three months ended September 30, 2008 and 2007 were $1.6 million and $18.5 million, respectively and in the nine months ended September 30, 2008 and 2007 were $6.2 million and $41.9 million, respectively. Pre-tax net loss from operations derived from the Soapstone business in the three months ended September 30, 2008 and 2007 were $6.4 million and $2.5 million, respectively and in the nine months ended September 30, 2008 and 2007 were $17.2 million and $6.1 million, respectively. The Company does not allocate to the operating segments its general and administrative expenses, which were $1.7 million both in the three months ended September 30, 2008 and 2007 and $5.2 million and $5.0 million for the nine months ended September 30, 2008 and 2007, respectively.

During the three and nine months ended September 30, 2008 and 2007, the Company recognized nearly all of its revenue from one customer, namely AT&T.

 

Page 8


Table of Contents

(h) Stock-Based Compensation

The Company records its share-based compensation in accordance with the provisions of Statement of Financial Accounting Standards No. 123R, (“SFAS 123R”) “Share-Based Payment,” which establishes accounting for equity instruments exchanged for employee services. Under the provisions of SFAS No. 123R, share-based compensation cost is measured at the grant date, based on the calculated fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period of the equity grant) under the accelerated attribution method.

The Company estimates the fair value of stock options using the Black-Scholes valuation model. Key input assumptions used to estimate the fair value of stock options include the exercise price of the award, the expected option term, the expected volatility of the Company’s stock over the option’s expected term, the risk-free interest rate over the option’s expected term, and the Company’s expected annual dividend yield. Expected volatilities are based on a blend of historical and implied volatilities of our common stock; the expected life represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option.

In the nine months ended September 30, 2008, the Company granted options to purchase 1,187,250 shares of common stock at a weighted average exercise price of $6.32. The weighted average fair value of these grants was $3.23 per share estimated using the Black-Scholes valuation model with the following key assumptions: Risk-free interest rate: 2.91%, Volatility: 62.73%, Expected life: 4.20 year and Expected Dividend: 0%.

(i) Recent Accounting Pronouncements

In December 2007, the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations” (“SFAS 141R”) . SFAS 141R retains the fundamental requirements in FASB Statement 141 that the acquisition method of accounting (which Statement 141 called the purchase method) be used for all business combinations and for an acquirer to be identified for each business combination. SFAS 141R requires an acquirer to recognize the assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions specified in SFAS 141R. That replaces FASB Statement 141’s cost-allocation process, which required the cost of an acquisition to be allocated to the individual assets acquired and liabilities assumed based on their estimated fair values. SFAS 141R will now require acquisition costs to be expensed as incurred; restructuring costs associated with a business combination must generally be expensed prior to the acquisition date and changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense. SFAS 141R applies prospectively to business combinations for which the acquisition date is in fiscal years beginning after December 15, 2008. Earlier adoption is prohibited. The Company will adopt this pronouncement beginning in fiscal year 2009. The adoption of the provisions of SFAS 141R is not expected to have a material impact on the Company’s financial position or results of operations.

NOTE 3. SPECIAL DIVIDENDS

On June 22, 2007, the Company distributed a special cash dividend of $2.00 per outstanding share of common stock, or $28.3 million, to shareholders of record as of June 11, 2007. As required under its equity plans, the Company made anti-dilution adjustments to reflect the impact of the special cash dividend to the total number of shares authorized under the plans, the number of shares subject to outstanding options, the number of shares available for future grant and the exercise price per share of outstanding options. Such adjustments in connection with the payment of an extraordinary dividend are intended to equitably offset the decline in stock price following the payment of such a dividend, particularly given that optionholders are not entitled to receive the cash distribution. Prior to the distribution and as approved by its shareholders at the Company’s annual meeting, the Company modified its 2000 Non-Employee Director Stock Option Plan to clarify and broaden the anti-dilution provisions, which resulted in the Company recording a charge of $0.1 million. All share and per share information with respect to options to purchase common stock have been retroactively restated to reflect the special dividend.

 

Page 9


Table of Contents

NOTE 4. FAIR VALUE MEASUREMENTS

In September 2006, the FASB issued SFAS 157, “Fair Value Measurements” (“SFAS 157”). SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy and is effective for the Company’s fiscal year beginning January 1, 2008 and for interim periods within that year. In February 2008, the FASB issued FASB Staff Position (FSP) No. 157-2, “Effective Date of FASB Statement No. 157”, which delayed for one year the effective date of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). As required, the Company adopted SFAS No. 157 for its financial assets on January 1, 2008. Adoption did not have a material impact on the Company’s financial position or results of operations. The Company has not yet determined the impact on its financial statements of the January 1, 2009 adoption of SFAS No. 157 as it pertains to non-financial assets and liabilities.

SFAS No. 157 establishes a fair value hierarchy that requires the use of observable market data, when available, and prioritizes the inputs to valuation techniques used to measure fair value in the following categories.

Level 1—Quoted unadjusted prices for identical instruments in active markets.

Level 2—Quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-derived valuations in which all observable inputs and significant value drivers are observable in active markets.

Level 3—Model derived valuations in which one or more significant inputs or significant value drivers are unobservable, including assumptions developed by the Company.

All of the fair values of the Company’s investment instruments presented in Note 2(c) were based on level 1 inputs as described above, to determine their fair values as of September 30, 2008.

NOTE 5. LITIGATION

There are no material changes to the legal proceedings described in the “Legal Proceedings section in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, as updated by the disclosures in the “Legal Proceedings” sections of our Quarterly Reports on Forms 10-Q for the fiscal quarters ended March 31, 2008 and June 30, 2008.

 

Page 10


Table of Contents
ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Except for the historical information contained herein, certain matters discussed in this Report on Form 10-Q constitute forward-looking statements that involve risks, assumptions and uncertainties. The Company’s actual results could differ materially from those stated or implied in forward-looking statements due to a number of factors, including without limitation those discussed under the caption “Risk Factors” included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2007 as filed with the Securities and Exchange Commission on March 13, 2008 and elsewhere herein. Forward-looking statements include statements regarding the future or the Company’s expectations, beliefs, intentions or strategies regarding the future and may be identified by the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will,” and “would” and similar expressions. There may be events in the future that could affect these matters.

Overview

Soapstone Networks Inc. (referred to as “Soapstone” or the “Company” or “we” or “us” or “our”) is a developer of resource and service control software. On March 19, 2008 the Company changed its name from Avici Systems Inc. to Soapstone Networks Inc.

During 2007, the Company transitioned from a provider of core router products to a developer of emerging, software-based service and control solutions for service providers’ next-generation networks. The company is now primarily focused on developing and marketing its Soapstone Provider Network Controller (PNC™) framework. Prior to its business transition, the Company developed and sold core router products to networking service providers, which together with related services accounted for substantially all of its product and service revenue since inception. The Company shipped its last router products in December 2007 and has exited the manufacturing and sale of router products and does not expect to generate future product revenue from router product sales. In addition, after 2008 the Company does not expect to record any service revenue resulting from the support of its router products and accordingly is expected to have completely exited all revenue generating activities associated with its router products.

The Company is developing resource and service control software that is designed to automate the service lifecycle for carriers and large enterprises. Unlike traditional solutions that constrain service innovation and growth, we plan to enable customers to evolve their network and service offerings independently by bringing centralized control to transport and separating services from the underlying transport technologies. The Soapstone solution is intended to accelerate service deployment and management by providing state of the art provisioning, monitoring and repair, network operations support, network fault to service correlation, Service Level Agreement (SLA) monitoring, performance, optimization, and planning software. We plan to provide a comprehensive common control framework for various technologies including Carrier Ethernet, MPLS, Optical, and Integrated Optical Ethernet. The Company is predominantly engaged in research and development activities as it continues to commercialize its Soapstone products.

Since our inception, we have incurred significant losses. As of September 30, 2008, we had an accumulated deficit of $397.3 million. Although we recorded net income in 2006 and 2007, we will not sustain this profitability in 2008 as a result of our transition away from core router development and product sales. In particular, we expect that 2008 will be a year of continued transition, as we continue to invest in Soapstone, with the objective of further product introductions in the near term. In addition we will continue to provide maintenance and other services under our existing core router customer contract only through the end of 2008. Given the early stage of our Soapstone products, we continue to expect quarterly losses and negative cash flow and there can be no assurance that we will generate meaningful revenue or achieve profitability through our Soapstone products.

Revenue

We expect that a substantial portion of our revenue in 2008 will be service revenue from our current customer AT&T. In April 2008, the Company amended its agreement with AT&T to better reflect the Company’s existing business relationship which is to provide support for previously shipped products. The amendment also includes a

 

Page 11


Table of Contents

non-cancellable commitment on the part of both parties for support throughout 2008 and the fee arrangement for 2008, all of which has been received. As a result of our decision to transition away from core router development and product sales, we no longer anticipate recording router product revenue. In the second quarter ended June 30, 2008 the Company recorded as product revenue certain revenue deferrals from prior years’ product shipments in connection with the termination of certain customer terms and conditions. After 2008 the Company does not expect to record any service revenue resulting from the support of its router products and accordingly is expected to have completely exited all revenue generating activities associated with its router products. The Company is predominantly engaged in research and development activities as it continues to commercialize its Soapstone products.

Cost of Revenue

Cost of Revenue – Service includes costs associated with providing customer support and maintenance services including labor and labor related costs, depreciation and other expenses.

Research and Development

Research and development expenses consist primarily of salaries and related employee costs, contractor costs, depreciation expense on laboratory equipment, software license and maintenance, and certain project costs. In the future we expect research and development expenses to increase from the current quarter levels, as we continue to invest in the development of our Soapstone products.

Sales and Marketing

Sales and marketing expenses have consisted primarily of salaries and related employee costs, sales commissions, tradeshows, travel, public relations and costs associated with other marketing events. In the future, we expect to increase our spending on sales and marketing primarily as a result of costs related to developing and expanding our Soapstone sales and marketing organization and additional spending on increased marketing activities and partner programs related to the introduction of our Soapstone products.

General and Administrative

General and administrative expenses consist primarily of salaries and related costs for executive, finance, legal, facilities, human resources and information technology personnel as well as professional and compliance related fees. In the future, we expect general and administrative expenses to continue at about the current levels.

Restructuring Expenses and Impairment Charges

On February 16, 2006, the Company announced a plan to restructure its business and realign its cost structure to execute a focused strategy aimed at driving the Company toward profitability and positive cash flow. The restructuring plan included a workforce reduction and employee retention plan, charges related to excess inventory and inventory related costs, asset impairment and other costs. The Company recorded total restructuring charges of approximately $11.0 million, of which $8.4 million was cash based. In 2006 the Company recorded all of these charges except $0.3 million which was recorded in the first quarter of 2007. In 2006 the Company made all cash payments except $2.7 million which was paid in the first quarter of 2007. In the future, the Company does not expect to record any additional charges associated with this restructuring.

Stock-based Compensation

The Company records share-based compensation expense under the provisions of Statement of Financial Accounting Standards No. 123R, (“SFAS 123R”) “Share-Based Payment,” which establishes accounting for equity instruments exchanged for employee services.

 

Page 12


Table of Contents

Critical Accounting Policies

The Company considers the following accounting policies related to revenue recognition, warranty liabilities, long-lived assets and stock-based compensation to be critical accounting policies due to the estimation processes and judgments involved in each. The Company bases its estimates on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.

Revenue Recognition

The Company records revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” and all related interpretations. Revenue from support and maintenance contracts is recognized ratably over the period of the related agreements, provided a purchase order has been received or a contract has been executed, the sales price is fixed or determinable and collectibility is deemed probable. For arrangements that include the delivery of multiple elements, revenue is allocated to the various elements based on vendor-specific objective evidence of fair value (VSOE) when and if achieved by the Company. The Company uses the residual method when VSOE does not exist for one of the delivered elements in an arrangement. Revenue from installation and other services is recognized as the work is performed. Amounts collected or billed prior to satisfying the above revenue recognition criteria are recorded as deferred revenue. In the event the Company is unable to meet one or all of the above criteria on a timely basis, revenue recognized for any reporting period could be adversely affected.

Warranty Liabilities

Our warranties require us to repair or replace defective products returned to us during the warranty period at no cost to the customer. We record an estimate for warranty related costs at the time of sale of a particular product based on our actual historical return rates and repair costs for that product. While our warranty costs have historically been within our expectations and the provisions established, we cannot guarantee we will continue to experience the same warranty return rates or repair costs that we have in the past. A significant increase in product return rates, or a significant increase in the costs to repair our products, could have a material adverse impact on future operating results for the period or periods in which such returns or additional costs materialize and thereafter.

Long-lived Assets

We review property, plant, and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of such an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to future undiscounted cash flows the assets are expected to generate over the remaining economic life. If such assets are considered to be impaired, the impairment to be recognized in earnings equals the amount by which the carrying value of the assets exceeds their fair market value determined by either a quoted market price, if any, or a value determined by utilizing a discounted cash flow technique. We have recognized no material impairment adjustments related to our property, plant, and equipment. Deterioration in our business in the future could lead to impairment adjustments in future periods. Evaluation of impairment of long-lived assets requires estimates of future operating results that are used in the preparation of the expected future undiscounted cash flows. Actual future operating results and the remaining economic lives of our long-lived assets could differ from the estimates used in assessing the recoverability of these assets. These differences could result in impairment charges, which could have a material adverse impact on our results of operations.

Stock-Based Compensation Expense

The Company accounts for employee stock-based compensation costs in accordance with Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”). We utilize the Black-Scholes option pricing model to estimate the fair value of employee stock based compensation at the date of grant, which requires the input of highly subjective assumptions, including expected volatility and expected life. Further, as required under SFAS 123R, we estimate forfeitures for options granted which are not expected to vest. Changes in these inputs and assumptions can materially affect the measure of estimated fair value of our stock-based compensation.

 

Page 13


Table of Contents

Results of Operations

Revenue

Total revenue decreased $27.0 million to $2.3 million in the third quarter of 2008 from $29.3 million in the third quarter of 2007. Total revenue decreased $70.5 million to $8.9 million in the first nine months of 2008 from $79.4 million for the same period in 2007. The decrease in the total revenue in the periods presented is because the Company shipped its last router products in December 2007. Deferred revenue of $1.2 million from prior years’ product shipments was recorded as product revenue in the second quarter of 2008 upon the termination of certain customer terms and conditions.

Service revenue remained unchanged at $2.3 million for the third quarter of 2008 and 2007. Service revenue increased $0.5 million to $7.7 million in the first nine months of 2008 from $7.2 million for the same period in 2007.

During the nine months ended September 30, 2008 and 2007, the Company recognized nearly all of its gross revenue from one customer, namely AT&T. We expect revenue in the fourth quarter of 2008 to be limited primarily to core router service revenue, which will continue to be highly concentrated from this one customer. In addition, after 2008 the Company does not expect to record any service revenue resulting from the support of its router products and accordingly is expected to have completely exited all revenue generating activities associated with its router products.

Cost of Revenue

Total cost of revenue decreased $5.8 million to $0.7 million in the third quarter of 2008 from $6.5 million in the third quarter of 2007. Total cost of revenue decreased $17.9 million to $2.7 million for the first nine months of 2008 from $20.6 for the same period in 2007. The decrease in the total cost of revenue is because the Company shipped its last router products in December 2007. Accordingly, the total cost of revenue in the 2008 periods did not contain any product cost of revenue.

Service cost of revenue was 32% and 15% of service revenue in the third quarter of 2008 and 2007, respectively. Service cost of revenue was 35% and 16% of service revenue in the first nine months of 2008 and 2007, respectively. The higher percentage in the 2008 period was primarily due to higher labor and labor related costs and depreciation expenses necessary for our ongoing support of our router products. The prior period related costs were lower due to favorable economies of scale achieved as a result of both product development and sales in those periods.

Research and Development

Research and development expenses decreased $1.4 million to $4.6 million for the third quarter of 2008 from $6.0 million for the third quarter of 2007. Research and development expenses decreased $8.1 million to $12.6 million in the first nine month of 2008 from $20.7 million for the same period in 2007. The decrease in the 2008 periods compared to the 2007 periods was primarily due to lower labor and labor related expenses and depreciation expenses primarily associated with the transitioning away from core router development, partially offset by an increase in labor and labor related expenses and depreciation expenses associated with the Soapstone product.

Sales and Marketing

Sales and marketing expenses increased $1.0 million to $1.8 million for the third quarter of 2008 from $0.8 million for the third quarter of 2007. Sales and marketing expenses increased $2.5 million to $4.6 million in the first nine months of 2008 from $2.1 million for the same period in 2007. The increase in the 2008 periods compared to the 2007 periods was primarily due to an increase in labor and labor related expenses associated with the Soapstone product as we continue to increase our investment in our sales and marketing efforts.

 

Page 14


Table of Contents

General and Administrative

General and administrative expenses remained unchanged at $1.7 million for the third quarter of 2008 compared to the second quarter of 2007. General and administrative expenses increased $0.2 million to $5.2 million in the first nine months of 2008 from $5.0 million for the same period in 2007.

Interest Income, Net

Interest income decreased $0.3 million to $0.6 million for the third quarter of 2008 from $0.9 million for the third quarter of 2007. Interest income decreased $0.5 million to $2.2 million in the first nine months of 2008 from $2.7 million for the same period in 2007. Interest income decreased due to lower average interest rates in 2008 partially offset by a higher invested balance in the 2008 periods.

Provision for Income Taxes

There was no provision for income taxes in the 2008 periods due to our net loss position. However, in the third quarter of 2008 the Company recorded an income tax benefit of less than $0.1 million associated with the finalization of its prior year income tax returns. In the three and nine months ended September 30, 2007 the provision of income taxes were $0.3 million and $0.7 million, respectively, representing the federal and state alternative minimum taxes.

Liquidity and Capital Resources

Since our inception, we have financed our operations through private sales of equity securities, an initial public offering in July 2000, and, to a lesser extent, from the exercise of stock options by employees. From inception through September 30, 2008, we raised approximately $427.7 million from these equity offerings. During the first nine months of 2008, we used $2.5 million in cash from operating activities, compared to generating $30.9 million in the 2007 period. The decrease in cash from operations in the 2008 period as compared to the comparable 2007 period is primarily associated with transitioning away from core router development and sales after 2007. We expect that in the future, working capital requirements will fluctuate based on the timing and magnitude of payments associated with our operating costs and future customer payment terms. In addition, we expect to invest in infrastructure costs needed to support our business, including costs associated with information technology, development tools and partner certification labs.

Purchases of capital equipment increased $0.9 million to $2.9 million for the first nine months of 2008 compared to $2.0 million for the same period in 2007. The timing and amount of future capital expenditures will depend primarily on our requirements in the Soapstone business including related infrastructure costs. We expect that capital expenditures and certain facility improvements will be between $1.5 million to $2.0 million in fourth quarter of 2008.

At September 30, 2008, we had cash and cash equivalents of $91.0 million and short-term marketable securities of $7.1 million, totaling $98.1 million. In the second quarter of 2007, the Company distributed a special cash dividend of $2.00 per outstanding share of common stock, or $28.3 million to shareholders of record. We believe that our existing cash, cash equivalents and marketable securities will meet our normal operating and capital expenditure needs beyond the next twelve months. However, we could be required, or could elect, to raise additional funds during that period and we may need to raise additional capital in the future. We may not be able to obtain additional capital on terms favorable to us or at all due to economic conditions and the early stage of the Soapstone products. The issuance of additional equity or equity-related securities would be dilutive to our stockholders. If we cannot raise funds on acceptable terms, or at all, we may not be able to develop or enhance our Soapstone products or respond appropriately to competitive pressures, which would seriously limit our ability to increase our revenue and grow our business.

 

Page 15


Table of Contents

Contractual Obligations

At September 30, 2008, our contractual obligations, which consist entirely of operating leases, were as follows (in thousands):

 

Fiscal Year

   Operating
Leases

2008 (remainder of year)

   $ 166

2009

     744

2010

     635

2011

     663

2012

     692

Thereafter

     1,400
      

Total future contractual commitments

   $ 4,300
      

In the fourth quarter of 2008 the Company relocated into a new facility to house its existing employees as well as to accommodate its anticipated future growth in headcount. Operating lease amounts reflect minimum lease payments under our non-cancellable operating leases including the new facility. Payments made under operating leases will be treated as rent expense for the facilities.

Off-Balance Sheet Arrangements

As of September 30, 2008, we did not have any off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.

 

Page 16


Table of Contents

Factors That May Affect Future Results

This Form 10-Q contains “forward-looking statements” that are subject to the safe harbors created under the Private Securities Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Any statements in this Form 10-Q that are not statements of historical fact are forward-looking statements that are subject to a number of important risks, assumptions and uncertainties that could cause actual results to differ materially from those expressed in our forward-looking statements. The Soapstone Networks business and market opportunity are at an early stage of development and accordingly estimates, projections and statements regarding our business, products, plans, objectives and expected operating results, and the assumptions upon which those statements are based, are forward-looking statements. Specifically, this Quarterly Report contains forward-looking statements relating to: technology trends and the development, size, characteristics, and growth of our markets; the Company’s position in our markets; the development, introduction and market acceptance of new products, enhancements and services; the development of a direct sales force, indirect sales channels and technology partnerships; the expansion of customer relationships; the addition of Soapstone customers; the expected operating results from our Soapstone business; our ability to manage the transition of our core router business and the expected service revenues from, and dependence on, our major core router customer; and our expectations regarding competition and technological change. For a more detailed description of the risk factors associated with the Company, please refer to our Annual Report on Form 10-K for the fiscal year ended December 31, 2007 as filed with the Securities and Exchange Commission on March 13, 2008. We do not undertake to update our forward-looking statements.

Recent Accounting Pronouncements

In December 2007, the FASB issued SFAS No. 141 (Revised 2007), “Business Combinations” (“SFAS 141R”). SFAS 141R retains the fundamental requirements in FASB Statement 141 that the acquisition method of accounting (which Statement 141 called the purchase method) be used for all business combinations and for an acquirer to be identified for each business combination. SFAS 141R requires an acquirer to recognize the assets acquired, the liabilities assumed, and any non-controlling interest in the acquiree at the acquisition date, measured at their fair values as of that date, with limited exceptions specified in SFAS 141R. That replaces FASB Statement 141’s cost-allocation process, which required the cost of an acquisition to be allocated to the individual assets acquired and liabilities assumed based on their estimated fair values. SFAS 141R will now require acquisition costs to be expensed as incurred; restructuring costs associated with a business combination must generally be expensed prior to the acquisition date and changes in deferred tax asset valuation allowances and income tax uncertainties after the acquisition date generally will affect income tax expense. SFAS 141R applies prospectively to business combinations for which the acquisition date is in fiscal years beginning after December 15, 2008. Earlier adoption is prohibited. The Company will adopt this pronouncement beginning in fiscal year 2009. The adoption of the provisions of SFAS 141R is not expected to have a material impact on the Company’s financial position or results of operations.

 

Page 17


Table of Contents
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments for speculative or trading purposes.

Interest Rate Sensitivity

We maintain an investment portfolio consisting mainly of investment grade money market funds, corporate obligations and federal agency obligations with a weighted-average maturity of less than one year. These held-to-maturity securities are subject to interest rate risk and will fall in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from the levels at September 30, 2008, the fair market value of these investments would decline by an immaterial amount. We have the ability to hold our fixed income investments until maturity. Therefore, we would not expect our operating results or cash flows to be affected to any significant degree by a sudden change in market interest rates on our securities portfolio.

Exchange Rate Sensitivity

We operate primarily in the United States, and international sales historically have been in U.S. dollars and are expected to continue in U.S. dollars. Accordingly, there has not been any material exposure to foreign currency rate fluctuations. If we expand our presence in foreign markets and consummate sales denominated in foreign currencies, our exposure to foreign currency rate fluctuations could be material in the future.

The Company has no off balance sheet concentrations such as foreign exchange contracts, option contracts or other foreign hedging arrangements.

 

ITEM 4. CONTROLS AND PROCEDURES

Evaluation of disclosure controls and procedures

The Company, under the supervision and with the participation of the Company’s management, including the principal executive officer and principal financial officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures as of the end of the period covered by this quarterly report (the “Evaluation Date”) pursuant to Rule 13a-15(b) and 15d-15(b) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on this evaluation, the Company’s principal executive officer and principal financial officer have concluded that, as of the Evaluation Date, the Company’s disclosure controls and procedures effectively ensure that information required to be disclosed in our filings and submissions under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms.

Changes in internal control over financial reporting

There were no changes in the Company’s internal control over financial reporting during the Company’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

Page 18


Table of Contents

PART II.    OTHER INFORMATION

 

ITEM 1: LEGAL PROCEEDINGS

There are no material changes to the legal proceedings described in the “Legal Proceedings section in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007, as updated by the disclosures in the “Legal Proceedings” sections of our Quarterly Reports on Forms 10-Q for the fiscal quarters ended March 31, 2008 and June 30, 2008.

 

ITEM 1A: RISK FACTORS

There are no material changes to the risk factors described in the “Risk Factors” section in our Annual Report on Form 10-K for the fiscal year ended December 31, 2007.

 

Page 19


Table of Contents
ITEM 6. EXHIBITS

 

(a) List of Exhibits

 

Exhibit No.

 

Exhibit Description

10.1

  Offer Letter, dated July 11, 2008 from the Registrant to Michael J. Cayer

10.2

  Severance Pay Agreement, dated July 14, 2008, between the Registrant and Michael J. Cayer

10.3

  Offer Letter, dated September 24, 2008 from the Registrant to Donald Wadas

10.4

  Severance Pay Agreement, dated October 16, 2008, between the Registrant and Donald Wadas

31.1

  Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2

  Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1

  Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2

  Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

Page 20


Table of Contents

SIGNATURE

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.

 

    SOAPSTONE NETWORKS INC.
Date November 5, 2008     By:  

/s/ William J. Stuart

     

William J. Stuart

Chief Financial Officer

(Duly Authorized Officer and Principal Financial Officer)

 

Page 21


Table of Contents

EXHIBIT INDEX

 

Exhibit No.

 

Exhibit Description

10.1

  Offer Letter, dated July 11, 2008 from the Registrant to Michael J. Cayer

10.2

  Severance Pay Agreement, dated July 14, 2008, between the Registrant and Michael J. Cayer

10.3

  Offer Letter, dated September 24, 2008 from the Registrant to Donald Wadas

10.4

  Severance Pay Agreement, dated October 16, 2008, between the Registrant and Donald Wadas

31.1

  Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

31.2

  Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

32.1

  Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

32.2

  Certification Pursuant to 18 U.S.C. Section 1350, As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

Page 22