10-Q 1 dzsi-6312018x10q1.htm FORM 10-Q SECOND QUARTER Document
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UNITED STATES
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 June 30, 2018
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from              to             
000-32743
(Commission File Number)
 
 
 
DASAN ZHONE SOLUTIONS, INC.
(Exact name of registrant as specified in its charter)
 
 
 
Delaware
 
22-3509099
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification Number)
 
 
 
7195 Oakport Street
Oakland, California
 
94621
(Address of principal executive offices)
 
(Zip code)
(510) 777-7000
(Registrant’s telephone number, including area code) 
 
 
 
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 has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes   x    No  ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.


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Large accelerated filer
¨
 
Accelerated filer
¨
Non-accelerated filer
¨ (Do not check if a smaller reporting company)
 
Smaller reporting company
x
 
 
 
Emerging growth company
¨
If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.    ¨ 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x
As of August 6, 2018, there were 16,497,948 shares of the registrant’s common stock outstanding.
 
 
 
    


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TABLE OF CONTENTS
 

3

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PART I. FINANCIAL INFORMATION

Item 1.    Financial Statements

4

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DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES
Unaudited Condensed Consolidated Balance Sheets
(In thousands, except par value)
 
June 30,
2018
 
December 31,
2017
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
27,308

 
$
17,475

Restricted cash
10,426

 
12,425

Accounts receivable, net
 
 
 
Trade
65,939

 
48,257

Related parties
1,224

 
13,498

Other receivables


 
 
Others
25,192

 
12,494

Related parties
65

 
164

Inventories
38,187

 
25,344

Prepaid expenses and other current assets
4,137

 
3,652

Total current assets
172,478

 
133,309

Property and equipment, net
5,432

 
5,873

Goodwill
3,977

 
3,977

Intangible assets, net
6,217

 
6,785

Non-current deferred taxes
2,925

 
2,954

Long-term restricted cash
1,136

 
1,512

Other assets
4,751

 
4,717

Total assets
$
196,916

 
$
159,127

Liabilities, Stockholders’ Equity and Non-controlling Interest
 
 

Current liabilities:
 
 
 
Accounts payable
 
 
 
Trade
$
49,414

 
$
31,441

Related parties
1,385

 
1,351

Short-term debts


 


Bank and trade facilities
39,874

 
19,790

Related parties
5,795

 

Other payables
 
 
 
Others
1,426

 
2,032

Related parties
1,449

 
1,956

Contract liabilities - current
2,600

 
3,279

Accrued and other liabilities
9,431

 
11,174

Total current liabilities
111,374

 
71,023

Long-term debts
 
 
 
Bank and trade facilities

 
2,987

Related parties
6,800

 
6,800

Contract liabilities - non-current
1,773

 
1,883

Other long-term liabilities
2,699

 
2,667

Total liabilities
122,646

 
85,360

Commitments and contingencies (Note 11)

 

Stockholders’ equity and non-controlling interest:
 
 
 
Common stock, authorized 36,000 shares, 16,450 shares and 16,410 shares outstanding as of June 30, 2018 and December 31, 2017 at $0.001 par value
16

 
16

Additional paid-in capital
91,126

 
90,198

Accumulated other comprehensive income (loss)
(399
)
 
1,871

Accumulated deficit
(16,988
)
 
(18,852
)
Total stockholders’ equity
73,755

 
73,233

Non-controlling interest
515

 
534

Total stockholders’ equity and non-controlling interest
74,270

 
73,767

Total liabilities, stockholders’ equity and non-controlling interest
$
196,916

 
$
159,127


See accompanying notes to unaudited condensed consolidated financial statements.
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DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES
Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss)
(In thousands, except per share data)
 
 
Three Months Ended
 
Six Months Ended
 
June 30,
 
June 30,
 
2018
 
2017
 
2018
 
2017
Net revenue:
 
 
 
Third parties
$
75,187

 
$
49,080

 
$
133,093

 
$
90,321

Related parties
1,070

 
10,861

 
2,668

 
21,732

Total net revenue
76,257

 
59,941

 
135,761

 
112,053

Cost of revenue:
 
 
 
 
 
 
 
Products and services - third parties
51,844

 
31,781

 
87,697

 
56,802

Products and services - related parties
1,095

 
8,574

 
2,858

 
17,282

Amortization of intangible assets
153

 
153

 
306

 
306

Total cost of revenue
53,092

 
40,508

 
90,861

 
74,390

Gross profit
23,165

 
19,433

 
44,900

 
37,663

Operating expenses:
 
 
 
 
 
 
 
Research and product development
8,714

 
9,141

 
17,691

 
18,523

Selling, marketing, general and administrative
11,712

 
10,551

 
24,106

 
21,435

Amortization of intangible assets
131

 
544

 
262

 
1,037

Total operating expenses
20,557

 
20,236

 
42,059

 
40,995

Operating income (loss)
2,608

 
(803
)
 
2,841

 
(3,332
)
Interest income
75

 
20

 
161

 
46

Interest expense
(560
)
 
(256
)
 
(883
)
 
(530
)
Other income (loss), net
(427
)
 
264

 
(287
)
 
(17
)
Income (loss) before income taxes
1,696

 
(775
)
 
1,832

 
(3,833
)
Income tax expense
341

 
99

 
336

 
539

Net income (loss)
1,355

 
(874
)
 
1,496

 
(4,372
)
Net income (loss) attributable to non-controlling interest
(61
)
 
(65
)
 
(27
)
 
184

Net income (loss) attributable to DASAN Zhone Solutions, Inc.
$
1,416

 
$
(809
)
 
$
1,523

 
$
(4,556
)
 
 
 
 
 
 
 
 
Foreign currency translation adjustments
(2,548
)
 
(824
)
 
(2,230
)
 
2,066

Comprehensive loss
(1,193
)
 
(1,698
)
 
(734
)
 
(2,306
)
Comprehensive loss attributable to non-controlling interest
(83
)
 
(64
)
 
(19
)
 
205

Comprehensive loss attributable to DASAN Zhone Solutions, Inc.
$
(1,110
)
 
$
(1,634
)
 
$
(715
)
 
$
(2,511
)
 
 
 
 
 
 
 
 
Net income (loss) per share attributable to DASAN Zhone Solutions, Inc.
 
 
 
 
 
 
 
     Basic
$
0.09

 
$
(0.05
)
 
$
0.09

 
$
(0.28
)
     Diluted
$
0.08

 
$
(0.05
)
 
$
0.09

 
$
(0.28
)
 
 
 
 
 
 
 
 
Weighted average shares outstanding used to compute basic net income (loss) per share
16,438

 
16,380

 
16,425

 
16,380

Weighted average shares outstanding used to compute diluted net income (loss) per share
16,672

 
16,380

 
16,645

 
16,380

See accompanying notes to unaudited condensed consolidated financial statements.

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DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES
Unaudited Condensed Consolidated Statements of Cash Flows
(In thousands)
 
Six Months Ended
 
June 30,
 
2018
 
2017
Cash flows from operating activities:
 
 
 
Net income (loss)
$
1,496

 
$
(4,372
)
Adjustments to reconcile net income (loss) to net cash used in operating activities:

 

Depreciation and amortization
1,381

 
2,353

Stock-based compensation
740

 
475

Valuation allowance on inventories
411

 
626

Unrealized (gain) loss on foreign currency transactions
(141
)
 
240

Deferred taxes
(82
)
 

Changes in operating assets and liabilities:

 

Accounts receivable
(18,843
)
 
(8,659
)
Inventories
(14,641
)
 
(4,346
)
Prepaid expenses and other assets
219

 
(936
)
Accounts payable
18,498

 
3,689

Accrued and other liabilities
(4,448
)
 
4,118

Net cash used in operating activities
(15,410
)
 
(6,812
)
Cash flows from investing activities:

 

Proceeds from sale of short-term investments

 
1,463

Purchase of short-term investments

 
(430
)
Proceeds from disposal of property and equipment and other assets
1

 
6

Purchase of property and equipment
(415
)
 
(663
)
Purchase of intangible asset

 
(31
)
Net cash (used in) provided by investing activities
(414
)
 
345

Cash flows from financing activities:

 

Proceeds from short-term borrowings from bank and trade facilities
44,368

 
8,679

Proceeds from long-term borrowings from related party
6,064

 

Repayments of borrowings
(26,455
)
 
(9,581
)
Proceeds from issuance of common stock
188

 
1

Net cash provided by (used in) financing activities
24,165

 
(901
)
Effect of exchange rate changes on cash and restricted cash
(883
)
 
1,067

Net increase (decrease) in cash and cash equivalents
7,458

 
(6,301
)
Cash, cash equivalents and restricted cash at beginning of period
31,412

 
24,543

Cash, cash equivalents and restricted cash at end of period
$
38,870

 
$
18,242

Reconciliation of cash, cash equivalents and restricted cash to statement of financial position
 
 
 
      Cash and equivalents
$
27,308

 
$
9,902

      Restricted cash
10,426

 
8,340

      Long-term restricted cash
1,136

 

      Cash, cash equivalents and restricted cash in statement of financial position
$
38,870

 
$
18,242

See accompanying notes to unaudited condensed consolidated financial statements.


7


Notes to Unaudited Condensed Consolidated Financial Statements
 
(1)
Organization and Summary of Significant Accounting Policies
(a)
Description of Business
DASAN Zhone Solutions, Inc. (referred to, collectively with its subsidiaries, as "DZS" or the "Company") is a global provider of network access solutions and communications equipment for service provider and enterprise networks. The Company provides a wide array of reliable, cost-effective networking technologies, including broadband access, Ethernet switching, mobile backhaul, Passive Optical LAN and software-defined networks, to a diverse customer base that includes more than 1,000 customers in more than 50 countries worldwide.
DZS was incorporated under the laws of the state of Delaware in June 1999, under the name Zhone Technologies, Inc. On September 9, 2016, the Company acquired Dasan Network Solutions, Inc. ("DNS"), a California corporation through the merger of a wholly owned subsidiary of the Company with and into DNS, with DNS surviving as a wholly owned subsidiary of the Company (the "Merger"). At the effective time of the Merger, all issued and outstanding shares of capital stock of DNS held by DASAN Networks, Inc. ("DNI") were canceled and converted into the right to receive shares of the Company's common stock in an amount equal to 57.7% of the issued and outstanding shares of the Company's common stock immediately following the Merger. In connection with the Merger, the Company changed its name from Zhone Technologies, Inc. to DASAN Zhone Solutions, Inc.
The Company is headquartered in Oakland, California and has flexible in-house production facilities in Seminole, Florida and with contract manufacturers located in China, India, Korea and Vietnam. The Company also maintains offices to provide sales and customer support at various domestic and international locations.
(b)
Risks and Uncertainties
Liquidity
The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles in the United States ("U.S. GAAP"), assuming the Company will continue as a going concern.
The Company had net income of $1.5 million for the six months ended June 30, 2018 and $1.2 million for the year ended December 31, 2017. As of June 30, 2018, the Company had an accumulated deficit of $17.0 million and working capital of $61.1 million. In addition, the Company had a net cash outflow from operations of $15.4 million for the six months ended June 30, 2018. As of June 30, 2018, the Company had $27.3 million in cash and cash equivalents, which included $12.5 million in cash balances held by its Korean subsidiary, and $52.5 million in aggregate principal debt of which $45.7 million was in current liabilities. Also, as of June 30, 2018, the Company had $3.2 million committed as security for letters of credit under its revolving credit facilities, and $8.0 million outstanding indebtedness under those facilities, leaving $5.6 million in aggregate financing availability under the facilities. On July 6, 2018, the Company repaid the $8.0 million borrowings under its Wells Fargo Bank ("WFB") Facility. The Company’s current lack of liquidity could harm it by:
increasing its vulnerability to adverse economic conditions in its industry or the economy in general;
requiring substantial amounts of cash to be used for debt servicing, rather than other purposes, including operations;
limiting its ability to plan for, or react to, changes in its business and industry; and
influencing investor and customer perceptions about its financial stability and limiting its ability to obtain financing or acquire customers.
These factors indicate that cash flows might not be sufficient for the Company to meet its obligations as they come due in the ordinary course of business for a period of 12 months from the date of this interim report on Form 10-Q.
The Company’s ability to meet its obligations as they become due in the ordinary course of business for the next 12 months will depend on its ability to achieve forecasted results and its ability to access funds approved under existing facilities. Management’s belief that it will achieve these results assumes that, among other things, the Company will continue to be successful in implementing its business strategy and that there will be no material adverse development in its business, liquidity or capital requirements. If one or more of these factors do not occur as expected, it could cause the Company to fail to meet its obligations as they come due.

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The Company plans to focus on cost management, operating efficiency and restrictions on discretionary spending. In addition, if necessary, the Company may sell assets, issue or enter into amendments of its debt or equity securities, or purchase credit insurance. The Company may also reduce the scope of its planned product development, reduce sales and marketing efforts and reduce its operations in low margin regions, including reductions in headcount. In fact, subsequent to the end of the quarter, on July 12, 2018, the Company entered into an Amended and Restated Credit and Security Agreement (the “A&R Domestic Credit Agreement”) and an Amended and Restated Credit and Security Agreement ("Ex-Im Subfacility") (the “A&R Ex-Im Credit Agreement”) with WFB, which amended and replaced the Company’s existing senior secured revolving line of credit and letter of credit facilities with WFB and revised certain reporting and compliance provisions, as described more fully in Note 7 to the unaudited condensed consolidated financial statements.
Based on the Company's current plans and current business conditions, the Company believes that these measures along with its existing cash, cash equivalents and available credit facilities will be sufficient to satisfy its anticipated cash requirements for at least the next 12 months from the date of this Quarterly Report on Form 10-Q.
Other Uncertainties
DNI owned approximately 57.7% of the outstanding shares of the Company's common stock as of June 30, 2018. For so long as DNI and its affiliates hold shares of the Company's common stock representing at least a majority of the votes, DNI will be able to freely nominate and elect all the members of the Company's board of directors, subject to the provisions of the Company's bylaws and applicable requirements under Nasdaq listing rules and applicable laws. The directors elected by DNI will have the authority to make decisions affecting the Company's capital structure, including the issuance of additional capital stock or options, the incurrence of additional indebtedness, the implementation of stock repurchase programs, and the declaration of dividends. The interests of DNI may not coincide with the interests of the Company's other stockholders or with holders of the Company's indebtedness. DNI’s ability to control all matters submitted to the Company's stockholders for approval limits the ability of other stockholders to influence corporate matters and, as a result, the Company may take actions that the Company's other stockholders or holders of the Company's indebtedness do not view as beneficial. See Notes 9 and 11 to the unaudited condensed consolidated financial statements for additional information.
(c)
Reclassifications
For the three months ended June 30, 2017, certain prior period statement of comprehensive income (loss) items have been reclassified to correctly reflect research and product development expenses and selling, marketing, general and administrative expenses of $0.1 million and $0.1 million, respectively, which were previously incorrectly classified as cost of revenue-products and services. For the six months ended June 30, 2017 certain prior period statement of comprehensive loss items have been reclassified to correctly reflect research and product development expenses and selling, marketing, general and administrative expenses of $0.3 million and $0.4 million, respectively, which were previously incorrectly classified as cost of revenue-products and services.
(d)
Basis of Presentation
For a description of what the Company believes to be the critical accounting policies and estimates used in the preparation of the Company's unaudited condensed consolidated financial statements, refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2017.
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with the U.S. GAAP for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the Company does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.
The unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary for a fair statement of the results for the interim periods presented. All intercompany transactions and balances have been eliminated in consolidation. The results of operations for the current interim period are not necessarily indicative of results to be expected for the current year or any other period. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements of the Company and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 filed with the Securities and Exchange Commission.


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(e)
Reverse Stock Split
On February 28, 2017, the Company filed a Certificate of Amendment with the Delaware Secretary of State to amend the Company's Restated Certificate of Incorporation, which amendment effected a one-for-five reverse stock split of the Company's common stock and reduced the authorized shares of the Company's common stock from 180 million to 36 million. As a result of the reverse stock split, the number of shares of the Company’s common stock then issued and outstanding was reduced from approximately 81.9 million to approximately 16.4 million. References to shares of the Company's common stock, stock options (and associated exercise price) and restricted stock units in this Quarterly Report on Form 10-Q are provided on a post-reverse stock split basis.
(f)
Concentration of Risk
The Company’s customers include competitive and incumbent local exchange carriers, competitive access providers, internet service providers, wireless carriers and resellers serving these markets. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Allowances are maintained for potential doubtful accounts.
For the three and six months ended June 30, 2018, one customer accounted for 22% and 15% of net revenue, respectively. For the three months ended June 30, 2017, two customers represented 11% and 14% (a related party) of net revenue, respectively. For the six months ended June 30, 2017, one customer represented 12% (a related party) of net revenue.
As of June 30, 2018, two customers represented 23% and 11% of net accounts receivable, respectively. As of December 31, 2017, two customers represented 20% (a related party) and 11% of net accounts receivable, respectively.
As of June 30, 2018 and December 31, 2017, receivables from customers in countries other than the United States represented 80% and 84%, respectively, of net accounts receivable.
(g)
Recent Accounting Pronouncements
Recent Accounting Pronouncements Adopted
In May 2014, the FASB issued ASU No. 2014-09 “Revenue from Contracts with Customers” (“Topic 606”), which provides a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. Topic 606 replaced most existing revenue recognition standards under U.S. GAAP, including ASC 605, Revenue Recognition ("Topic 605").
On January 1, 2018, the Company adopted Topic 606 and applied this guidance to all open contracts at the date of adoption using the modified retrospective method. The Company recognized the cumulative effect of initially applying Topic 606 as an adjustment to the balance of accumulated deficit at January 1, 2018. The comparative information has not been restated and continues to be reported under Topic 605.
The Company’s adoption of Topic 606 primarily impacted the following:
Topic 606 requires an allocation of revenue between deliverables (performance obligations) within an arrangement. Topic 605 restricted the allocation of revenue that is contingent on future deliverables to current deliverables, however, Topic 606 removes this restriction, to the extent that the future deliverables represent performance obligations that are distinct. Under Topic 606, the nature of the performance obligations identified within a contract impacts the allocation of the transaction price between deliverables.
Some of the Company’s contracts include customer acceptance terms, which provides protection to the customer by allowing it to either cancel a contract or force the Company to take corrective actions if products or services do not meet the requirements in the contract. Under Topic 606, customer acceptance that is considered a “formality”, would result in revenue recognized when control of the product or service is transferred to customer, which is typically upon shipment or delivery dependent upon the terms of the underlying contract.

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The following table summarizes the effects of Topic 606 on the Company’s unaudited condensed consolidated balance sheet at January 1, 2018 (in thousands):
 
As of January 1, 2018
 
 Balance after adoption of ASC 606
 
 Adjustments
 
 Balance without adoption of ASC 606
 Assets
 
 
 
 
 
 Accounts receivable, net
$
62,099

 
$
344

(1) 
$
61,755

 Inventories
25,239

 
(105
)
(2) 
25,344

 Liabilities
 
 
 
 


Contract liabilities - current
2,866

 
(413
)
(2) 
3,279

Accrued and other liabilities
11,518

 
344

(1) 
11,174

 Stockholders’ equity
 
 
 
 
 
 Accumulated deficit
(18,544
)
 
308

 
(18,852
)

(1) Allowance for sales returns was historically presented as a contra-asset within accounts receivable on the Company's consolidated balance sheets. Upon the adoption of Topic 606, the Company presents the allowance for sales returns in Accrued and other liabilities (current).
(2) Represents the impact of allocation of transaction price to separate performance obligations in open contracts as of the adoption date on a relative standalone selling price basis and acceleration of revenue (and related costs) for contracts for which acceptance clauses are a formality.
The following table summarizes the effects of Topic 606 on the Company’s unaudited condensed consolidated balance sheet at June 30, 2018 (in thousands): 
 
As of June 30, 2018
 
 As reported
 
 Adjustments
 
 Balance without adoption of ASC 606
 Assets
 
 
 
 
 
 Accounts receivable, net
$
67,163

 
$
512

(1) 
$
66,651

 Inventories
38,187

 
66

(2) 
38,121

 Liabilities
 
 
 
 
 
 Contract liabilities - current
2,600

 
347

(2) 
2,253

Accrued and other liabilities
9,431

 
512

(1) 
8,919

 Stockholders’ equity
 
 
 
 
 
 Accumulated deficit
(16,988
)
 
(281
)
 
(16,707
)
 
(1) Allowance for sales returns was historically presented as a contra-asset within accounts receivable on the Company's consolidated balance sheets. Upon the adoption of Topic 606, the Company presents the allowance for sales returns in Accrued and other liabilities (current).
(2) Represents the impact of allocation of transaction price to separate performance obligations in open contracts as of June 30, 2018 on a relative standalone selling price basis and acceleration of revenue (and related costs) for contracts for which acceptance clauses are a formality.
The following table summarizes the effects of Topic 606 on the Company’s unaudited condensed consolidated statement of operations for the three and six months ended June 30, 2018 (in thousands):
 
Three Months Ended June 30, 2018
 
As reported
 
Adjustments
 
Balance without adoption of ASC 606
Net revenue
$
76,257

 
$
(152
)
 
$
76,409

Cost of revenue - products and services
53,092

 
(5
)
 
53,097

Gross profit
23,165

 
(147
)
 
23,312

Provision for income taxes
(341
)
 

 
(341
)
Net income
1,355

 
(147
)
 
1,502


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Six Months Ended June 30, 2018
 
As reported
 
Adjustments
 
Balance without adoption of ASC 606
Net revenue
$
135,761

 
$
(347
)
 
$
136,108

Cost of revenue - products and services
90,861

 
(66
)
 
90,927

Gross profit
44,900

 
(281
)
 
45,181

Provision for income taxes
(336
)
 

 
(336
)
Net income
1,496

 
(281
)
 
1,777

During the three and six months ended June 30, 2018, $0.3 million and $0.6 million respectively, was recognized as revenue from the opening contract liabilities balance.
There was no impact on net revenue from related parties as a result of Topic 606.
In August 2016, FASB issued ASU 2016-15, Statement of Cash Flows, Classification of Certain Cash Receipts and Cash Payments, which addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The updated guidance became effective for the Company on January 1, 2018 and was adopted accordingly. The adoption of this standard did not have any effect on the Company's condensed consolidated statement of cash flows for the three and six months ended June 31, 2018 or 2017.
In November 2016, FASB issued ASU 2016-18, Statement of Cash Flows, Restricted Cash, which requires that a statement of cash flows to explain the change during the period in the total of cash, cash equivalents and amounts generally described as restricted cash and restricted cash equivalents. The updated guidance became effective for the Company beginning on January 1, 2018 and was adopted accordingly, using the retrospective approach. As a result, the Company no longer presents transfers between cash and cash equivalents and restricted cash in the consolidated cash flow statements. The condensed consolidated statement of cash flows for the six months ended June 30, 2017 was revised to exclude the $1.3 million change in restricted cash from net cash used in investing activities and to include $6.7 million and $8.3 million in cash, cash equivalents and restricted cash, beginning of period and cash, cash equivalents and restricted cash, end of period, respectively.  
Other Recent Accounting Pronouncements
In February 2016, the FASB issued ASU 2016-02, Leases. ASU 2016-02 requires that lease arrangements longer than 12 months result in an entity recognizing an asset and liability. The updated guidance is effective for the Company on January 1, 2019, and early adoption is permitted. The Company does not plan to early adopt this guidance. The Company expects its assets and liabilities to increase as a result of the adoption of this standard. In July 2018, the FASB issued ASU 2018-18-11, Leases (Topic 842): Targeted Improvements, ASU 2018-11 states that, separating components of a contract affect the amendments in Update 2016-02, which are not yet effective but can be early adopted. All entities, including early adopters, that elect the practical expedient related to separating components of a contract in this Update must apply the expedient, by class of underlying asset, to all existing lease transactions that qualify for the expedient at the date elected. The Company is currently assessing the potential impact of adopting this new guidance on its consolidated financial statements.
In January 2017, FASB issued ASU 2017-04, Simplifying the Test for Goodwill Impairment, which simplifies the accounting for goodwill impairment. The updated guidance is effective for the Company on January 1, 2020, and will be adopted accordingly. Early adoption is permitted. The Company is currently assessing the potential impact of adopting this new guidance on its consolidated financial statements.
In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. The amendments in this update allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act (the "Tax Act"). Consequently, the amendments eliminate the stranded tax effects resulting from the Tax Act. Because the amendments only relate to the reclassification of the income rate tax effect of the Tax Act, the underlying guidance that requires that the effect of a change in tax laws or rates be included in income from continuing operations is not affected. The amendments in this update are effective for all entities for fiscal years beginning after December 15, 2018 and interim periods in those years. The Company is not able to quantify or cannot reasonably estimate quantitative information related to the impact of the new standard on its consolidated financial statements at this time.

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In March 2018, the FASB issued ASU No. 2018-05, Income Taxes (Topic 740), Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118. The amendments add various Securities and Exchange Commission (“SEC) paragraphs pursuant to the issuance of SEC Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (“Act”) (“SAB 118”). The SEC issued SAB 118 to address concerns about reporting entities’ ability to timely comply with the accounting requirements to recognize all of the effects of the Act in the period of enactment. SAB 118 allows disclosure that timely determination of some or all of the income tax effects from the Act are incomplete by the due date of the financial statements and if possible to provide a reasonable estimate. The Company has provided a reasonable estimate of the tax reform in the notes to the consolidated financial statements.
(2)
Fair Value Measurement
The Company utilizes a fair value hierarchy that is intended to increase consistency and comparability in fair value measurements and related disclosures. The fair value hierarchy is based on inputs to valuation techniques that are used to measure fair value that are either observable or unobservable. Observable inputs reflect assumptions market participants would use in pricing an asset or liability based on market data obtained from independent sources while unobservable inputs reflect a reporting entity’s pricing based upon their own market assumptions. The fair value hierarchy consists of the following three levels:
Level 1 –
Inputs are quoted prices in active markets for identical assets or liabilities.
Level 2 –
Inputs are quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable and market-corroborated inputs which are derived principally from or corroborated by observable market data.
Level 3 –
Inputs are derived from valuation techniques in which one or more significant inputs or value drivers are unobservable.
The following financial instruments are not measured at fair value on the Company’s condensed consolidated balance sheet as of June 30, 2018 and the consolidated balance sheet as of December 31, 2017, but require disclosure of their fair values: cash and cash equivalents, short-term investments, accounts receivable, accounts payable and debt. The carrying values of financial instruments such as cash and cash equivalents, accounts receivable and accounts payable approximate their fair values based on their short-term nature. The carrying value of the Company's debt approximates their fair values based on the current rates available to the Company for debt of similar terms and maturities
To manage certain exposures to currency fluctuations, the Company started a limited hedging program during the three months ended June 30, 2018 by entering into foreign currency forward contracts with maturities of one month to hedge a portion of its net outstanding foreign currency monetary assets and liabilities. These derivatives are recorded at fair value on the condensed consolidated balance sheet under "Other Current Assets" or "Accounts Payable - Trade" with changes in the fair value being recorded in "Other income (loss), net".
These derivative contracts are entered into with a single counterparty, and are not designated as hedging instruments under applicable accounting guidance. As such, all changes in the fair value of these derivative contracts are recorded in other income (loss), net on the condensed consolidated statements of comprehensive income (loss). These derivative contracts are intended to offset the foreign currency gains or losses associated with the underlying monetary assets and liabilities, and changes in the related derivative assets and liabilities balances are classified outside of operating income (loss), consistent with the related underlying foreign currency gain or loss. 
These derivative contracts expose the Company to credit risk to the extent that the counterparty may be unable to meet the terms of the arrangement. The Company mitigates this credit risk by transacting with reputable financial institutions and entering into master netting arrangements, which permit net settlement of transactions with the same counterparty. While the contract or notional amount is often used to express the volume of foreign currency derivative contracts, the amounts potentially subject to credit risk are generally limited to the amounts, if any, by which the counterparties’ obligations under the agreements exceed the obligations of the Company to the counterparties. The Company is not required to pledge, and is not entitled to receive, cash collateral related to these derivative instruments. The Company does not enter into derivative contracts for trading or speculative purposes. 
As of June 30, 2018, the Company had derivative contracts with total notional values of $20.1 million. The Company's foreign currency contracts are classified within Level 2 because the valuation inputs are based on quoted prices and market observable data of similar instruments in active markets, such as currency spot and forward rates. The fair values of these outstanding derivative contracts as of June 30, 2018 was a $1.0 million liability, included in accounts payable - trade.


13

Table of Contents


(3)
Cash, Cash Equivalents and Restricted Cash
As of June 30, 2018 and December 31, 2017, the Company's cash and cash equivalents comprised financial deposits. Restricted cash consisted primarily of cash restricted for performance bonds, warranty bonds and collateral for borrowings. Current and long-term restricted cash was $11.6 million at June 30, 2018 and $13.9 million at December 31, 2017.
(4)
Balance Sheet Detail
Accounts Receivable
Accounts receivable, net as of June 30, 2018 and December 31, 2017 was as follows (in thousands):
 
June 30,
2018
 
December 31,
2017
Gross accounts receivable
$
67,531

 
$
63,446

Allowance for doubtful accounts
(368
)
 
(922
)
Allowance for sales returns

(1) 
(769
)
Total allowances
(368
)
 
(1,691
)
Accounts receivable, net
$
67,163

 
$
61,755

(1) Upon adoption of ASC 606, allowances for sales returns were reclassified to accrued and other liabilities as these reserve balances are considered estimated refund liabilities. Refer to footnote 1(g) for additional information about the adoption impact.
Inventories
Inventories as of June 30, 2018 and December 31, 2017 were as follows (in thousands): 
 
June 30,
2018
 
December 31,
2017
Raw materials
$
16,730

 
$
12,671

Work in process
2,030

 
2,150

Finished goods
19,427

 
10,523

Total inventories
$
38,187

 
$
25,344

Inventories provided as collateral for borrowings from Export-Import Bank of Korea amounted to $23.4 million and $11.4 million as of June 30, 2018 and December 31, 2017, respectively.

14

Table of Contents


(5)
Property and Equipment
Property and equipment as of June 30, 2018 and December 31, 2017 were as follows (in thousands): 
 
June 30,
2018
 
December 31,
2017
Furniture and fixtures
$
22,066

 
$
22,988

Machinery and equipment
5,557

 
5,455

Leasehold improvements
3,613

 
3,647

Computers and software
682

 
621

Others
975

 
1,007

 
32,893

 
33,718

Less: accumulated depreciation and amortization
(27,260
)
 
(27,584
)
Less: government grants
(201
)
 
(261
)
Property and equipment, net
$
5,432

 
$
5,873

Depreciation expense associated with property and equipment for the three and six months ended June 30, 2018 was $0.4 million and $0.8 million respectively. Depreciation expense for the three and six months ended June 30, 2017 was $0.5 million and $1.0 million, respectively.
The Company receives grants from various government entities, mainly to support capital expenditures. Such grants are deferred and are generally refundable to the extent the Company does not utilize the funds for qualifying expenditures. Once earned, the Company records the grants as a contra amount to the assets and amortizes such amount over the useful lives of the related assets as a reduction to depreciation expense.
(6)
Goodwill and Intangible Assets
Goodwill as of June 30, 2018 and December 31, 2017 was as follows (in thousands):
 
June 30,
2018
 
December 31,
2017
Beginning balance
$
3,977

 
$
3,977

Less: accumulated impairment

 

Ending balance
$
3,977

 
$
3,977

The Company did not recognize impairment loss on goodwill during the six months ended June 30, 2018 and 2017. Intangible assets as of June 30, 2018 and December 31, 2017 were as follows (in thousands):
 
June 30, 2018
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net
Developed technology
$
3,060

 
$
(1,122
)
 
$
1,938

Customer relationships
5,240

 
(961
)
 
4,279

Backlog
2,179

 
(2,179
)
 

Total intangible assets
$
10,479

 
$
(4,262
)
 
$
6,217


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December 31, 2017
 
Gross Carrying Amount
 
Accumulated Amortization
 
Net
Developed technology
$
3,060

 
$
(816
)
 
$
2,244

Customer relationships
5,240

 
(699
)
 
4,541

Backlog
2,179

 
(2,179
)
 

Total intangible assets
$
10,479

 
$
(3,694
)
 
$
6,785

Amortization expense associated with intangible assets for the three and six months ended June 30, 2018 was $0.3 million and $0.6 million, respectively. Amortization expense associated with intangible assets for the three and six months ended June 30, 2017 was $0.7 million and $1.4 million, respectively.
(7)
Debts
Wells Fargo Bank Facility
As of June 30, 2018, the Company had a $25.0 million revolving line of credit and letter of credit facility (then and as subsequently amended and replaced) with WFB, (the "WFB Facility"). Under the WFB Facility, the Company has the option of borrowing funds at agreed upon interest rates. The amount that the Company is able to borrow under the WFB Facility varies based on eligible accounts receivable and inventory, as defined in the WFB Facility, as long as the aggregate amount outstanding does not exceed $25.0 million less the amount committed as security for letters of credit. To maintain availability of funds under the WFB Facility, the Company pays a commitment fee on the unused portion. The commitment fee is 0.25% per annum and is recorded as interest expense.
As of June 30, 2018, the Company had $8.0 million in outstanding borrowings under its WFB Facility (included in short-term debts), and $2.1 million was committed as security for letters of credit. Subsequent to the end of the quarter, on July 6, 2018, the Company repaid the $8.0 million borrowings under the WFB Facility. Based on the Company's eligible accounts receivable and inventory, the Company had $2.2 million of financing availability under the WFB Facility as of June 30, 2018. The interest rate on the WFB Facility was 4.59% at June 30, 2018.
Subsequent to the end of the quarter, on July 12, 2018, the Company entered into an Amended and Restated Credit and Security Agreement (the “A&R Domestic Credit Agreement”) and an Amended and Restated Credit and Security Agreement ("Ex-Im Subfacility") (the “A&R Ex-Im Credit Agreement”) with WFB, which amended and replaced the Company’s existing senior secured revolving line of credit and letter of credit facilities with WFB and revised certain reporting and compliance provisions. The A&R Domestic Credit Agreement and the A&R Ex-Im Credit Agreement provide for a revolving line of credit of $25.0 million (including up to $5.0 million of letters of credit), with the amount that the Company is able to borrow based on eligible accounts receivable and inventory, less the amount committed as security for letters of credit. To maintain availability of funds under the A&R Domestic Credit Agreement and the A&R Ex-Im Credit Agreement, the Company will continue to pay a commitment fee of 0.25% per annum on the unused portion. The amounts borrowed under the amended WFB Facility continue to bear interest, payable monthly, at a floating rate equal to the three-month LIBOR plus a margin based on the Company's average excess availability (as calculated under the WFB Facility). The new maturity date under the WFB Facility is also extended from July 15, 2019 to July 12, 2021.
The Company’s obligations under the WFB Facility are secured by substantially all of its assets and those of its subsidiaries that guarantee the WFB Facility, including their intellectual property. The WFB Facility contains certain financial covenants, and customary affirmative and negative covenants. If the Company defaults under the WFB Facility due to a covenant breach or otherwise, WFB may be entitled to, among other things, require the immediate repayment of all outstanding amounts and sell the Company’s assets to satisfy the obligations under the WFB Facility. As of June 30, 2018, the Company was in compliance with the covenants under the WFB Facility.
Bank and Trade Facilities - Foreign Operations
Certain of the Company's foreign subsidiaries have entered into various financing arrangements with foreign banks and other lending institutions consisting primarily of revolving lines of credit, trade facilities, term loans and export development loans. These facilities are renewed as they mature and are generally secured by a security interest in certain assets of the applicable foreign subsidiaries and supported by guarantees given by DNI or third parties. Payments under such facilities are made in accordance with the given lender’s amortization schedules.
As of June 30, 2018 and December 31, 2017, the Company had an aggregate outstanding balance of $31.9 million (included in short-term debts) and $22.8 million ($19.8 million included in short-term debts), respectively, under such financing arrangements, and the interest rates per annum applicable to outstanding borrowings under these financing arrangements were as listed in the tables below (amount in thousands).
 
 
 
 
As of June 30, 2018
 
 
 
 
Interest rate (%)
 
Amount
Industrial Bank of Korea
 
Credit facility
 
3.48-4.02
 
$
4,515

Industrial Bank of Korea
 
Trade finance
 
4.47-5.25
 
2,427

Shinhan Bank
 
General loan
 
6.06
 
2,853

Shinhan Bank
 
Trade finance
 
4.16
 
1,200

NongHyup Bank
 
Credit facility
 
3.90-4.10
 
2,569

The Export-Import Bank of Korea
 
Export development loan
 
3.20-3.28
 
7,270

LGUPlus
 
General loan
 
0
 
1,782

JECC Factoring
 
AR Factoring
 
1.58
 
6,362

Shinhan Bank (India)
 
General loan
 
8.70-8.90
 
2,896

 
 
 
 
 
 
$
31,874


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Table of Contents


 
 
 
 
As of December 31, 2017
 
 
 
 
Interest rate (%)
 
Amount
Industrial Bank of Korea
 
Credit facility
 
2.89 - 3.26
 
$
2,328

Industrial Bank of Korea
 
Trade Finance
 
4.47 - 5.97
 
2,401

Shinhan Bank
 
General loan
 
5.91
 
2,987

Shinhan Bank
 
Trade finance
 
3.90 - 4.14
 
3,050

NongHyup Bank (Korea)
 
Credit facility
 
2.83 - 3.42
 
860

The Export-Import Bank of Korea
 
Export development loan
 
3.20 - 3.28
 
7,570

Mitsubishi Bank (Japan)
 
AR factoring
 
1.58
 
1,872

Shinhan Bank (India)
 
General loan
 
8.70 - 8.90
 
1,709

 
 
 
 
 
 
$
22,777

As of June 30, 2018, the Company had $7.1 million in outstanding borrowings and $1.1 million committed as security for letters of credit under the Company's $12.0 million credit facility with certain foreign banks. On June 18, 2018, the Company's Korean subsidiary received a mutual cooperation capital loan of $1.8 million from LGUPlus and provided a letter of guarantee of the same amount from Seoul Guarantee Insurance as collateral.
See Note 9 for a discussion of related-party debt.
(8)
Non-Controlling Interests
Non-controlling interests for the six months ended June 30, 2018 and 2017 were as follows (in thousands):
 
 
Six Months Ended June 30,
 
 
2018
 
2017
Beginning non-controlling interests
 
$
534

 
$
416

Net income (loss) attributable to non-controlling interests
 
(27
)
 
184

Foreign currency translation adjustments
 
8

 
21

 Ending non-controlling interests
 
$
515

 
$
621

(9)
Related-Party Transactions
Related-Party Acquisitions
On December 31, 2017, DNS acquired 100% and 99.99% of the common stock of D-Mobile Limited (“D-Mobile”) and DASAN India Private Limited ("DASAN India"), respectively, from DNI. D-Mobile and DASAN India are resellers of the Company's products in Taiwan and India, respectively. The consideration payable by the Company to DNI for the common stock of the two subsidiaries is the net book value of D-Mobile and DASAN India at December 31, 2017, subject to final adjustments. The net book value of D-Mobile and DASAN India was an aggregate of $0.8 million. These transactions were accounted for by the Company as common control transactions, with the net assets transferred recorded at historical cost. The transactions did not result in a change in reporting entity and hence were accounted for prospectively.
Related-Party Debt
In connection with the Merger, on September 9, 2016, the Company entered into a loan agreement with DNI for a $5.0 million unsecured subordinated term loan facility. Under the loan agreement, the Company was permitted to request drawdowns of one or more term loans in an aggregate principal amount not to exceed $5.0 million. As of June 30, 2018, $5.0 million in term loans was outstanding under the facility. Such term loans mature in September 2021 and are pre-payable at any time by the Company without premium or penalty. The interest rate as of June 30, 2018 under this facility was 4.6% per annum.
Also, the Company borrowed $1.8 million from DNI for capital investment in February 2016, which amount was outstanding as of June 30, 2018. This loan matures in July 2019 and bears interest at a rate of 4.6% per annum, payable annually.

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Table of Contents


On March 21, 2018, DNS borrowed KRW6.5 billion ($5.8 million) from DNI, which remained outstanding at June 30, 2018. The loan bears interest at a rate of 4.6% and matures on June 27, 2019, and is secured by certain accounts receivable of DNS Korea.
Other Related-Party Transactions
Sales and purchases, cost of revenue, research and product development, selling, marketing, general and administrative, interest expense and other expenses to and from related parties for the three and six months ended June 30, 2018 and 2017 were as follows (in thousands):
 
 
 
 
Three Months Ended June 30, 2018
Counterparty
 
DNI ownership Interest
 
Sales
 
Cost of revenue
 
Manufacturing (cost of revenue)
 
Research and product development
 
Selling, marketing,
general and administrative
 
Interest expense
 
Other expenses
DNI (Parent Company)
 
N/A
 
$
962

 
$
750

 
$

 
$

 
$
1,144

 
$
69

 
$
79

Tomato Soft Ltd.
 
100%
 

 

 
38

 

 

 

 

Tomato Soft (Xi'an) Ltd.
 
100%
 

 

 

 
123

 

 

 

Chasan Networks Co., Ltd.
 
100%
 

 

 
268

 
18

 

 

 

Dasan France
 
100%
 

 

 

 

 

 

 

Handysoft, Inc.
 
17.63%
 
108

 
39

 

 

 
2

 

 

 
 
 
 
$
1,070

 
$
789

 
$
306

 
$
141

 
$
1,146

 
$
69

 
$
79

 
 
 
 
Three Months Ended June 30, 2017
Counterparty
 
DNI ownership Interest
 
Sales
 
Cost of revenue
 
Manufacturing (cost of revenue)
 
Research and product development
 
Selling, marketing,
general and administrative
 
Other expenses
DNI (Parent Company)
 
N/A
 
$
8,480

 
$
7,095

 
$

 
$

 
$
1,326

 
$
57

Chasan Networks Co., Ltd.
 
100%
 

 

 
187

 
32

 

 

Dasan France
 
100%
 
556

 
549

 

 

 
300

 

D-Mobile
 
100%
 
1,811

 
741

 

 

 
94

 

Fine Solution
 
100%
 

 

 

 

 
1

 

HandySoft, Inc.
 
17.64%
 
14

 
2

 

 

 

 

Tomato Soft (Xi'an) Ltd.
 
100%
 

 

 

 
133

 
37

 

Solueta
 
27.21%
 

 

 

 

 

 
3

 
 
 
 
$
10,861

 
$
8,387

 
$
187

 
$
165

 
$
1,758

 
$
60

 
 
 
 
Six Months Ended June 30, 2018
Counterparty
 
DNI ownership Interest
 
Sales
 
Cost of revenue
 
Manufacturing (cost of revenue)
 
Research and product development
 
Selling, marketing,
general and administrative
 
Interest expense
 
Other expenses
DNI (Parent Company)
 
N/A
 
$
2,210

 
$
1,873

 
$

 
$

 
$
2,166

 
$
71

 
$
145

Tomato Soft Ltd.
 
100%
 

 

 
57

 

 

 

 

Tomato Soft (Xi'an) Ltd.
 
100%
 

 

 
10

 
2,777

 

 

 

Chasan Networks Co., Ltd.
 
100%
 

 

 
592

 
36

 

 

 

Dasan France
 
100%
 
202

 
177

 

 

 

 

 

HandySoft, Inc.
 
17.63%
 
256

 
149

 

 

 
2

 

 

 
 
 
 
$
2,668

 
$
2,199

 
$
659

 
$
2,813

 
$
2,168

 
$
71

 
$
145


18

Table of Contents


 
 
 
 
Six Months Ended June 30, 2017
Counterparty
 
DNI ownership Interest
 
Sales
 
Cost of revenue
 
Manufacturing (cost of revenue)
 
Research and product development
 
Selling, marketing,
general and administrative
 
Other expenses
DNI (Parent Company)
 
N/A
 
$
12,631

 
$
10,416

 
$

 
$

 
$
2,200

 
$
120

Chasan Networks Co., Ltd.
 
100
%
 

 

 
382

 
59

 

 

Dasan France
 
100
%
 
950

 
936

 

 

 
300

 

Dasan India Private Limited(1)
 
100
%
 
6,287

 
4,783

 

 

 

 

D-Mobile(1)
 
100
%
 
1,822

 
754

 

 

 
196

 

Fine Solution
 
100
%
 

 

 

 

 
4

 

HandySoft, Inc.
 
17.64
%
 
34

 
11

 

 

 

 

J-Mobile Corporation
 
68.56
%
 
8

 

 

 

 
132

 

Tomato Soft (Xi'an) Ltd.
 
100
%
 

 

 

 
304

 
37

 

Solueta
 
27.21
%
 

 

 

 

 

 
3

 
 
 
 
$
21,732

 
$
16,900

 
$
382

 
$
363

 
$
2,869

 
$
123

(1) As discussed above, on December 31, 2017 DNS acquired DASAN India and D-Mobile from DNI.            
The Company has entered into sales agreements with DNI and certain of its subsidiaries. Sales and cost of revenue to DNI and DASAN France (and with respect to the first and second quarters of 2017, DASAN India and D-Mobile) represent finished goods produced by the Company that are sold to these related parties who sell the Company's products in Korea, France, India and Taiwan, respectively.
The Company has entered into an agreement with Chasan Networks Co., Ltd. to provide manufacturing and research and development services for the Company. Under the agreement with Chasan Networks., Ltd., the Company is charged a cost plus 7% fee for the manufacturing and development of certain deliverables.

The Company has entered into an agreement with Tomato Soft Ltd., a wholly owned subsidiary of DNI, to provide manufacturing and research and development services for the Company.
The Company has entered into an agreement with Tomato Soft (Xi'an) Ltd. to provide research and development services for the Company. Under the agreement with Tomato Soft (Xi'an) Ltd., the Company is charged an expected annual fee of $0.8 million for the development of certain deliverables.
Prior to the Merger, as DNS was then a wholly owned subsidiary of DNI, DNI had sales agreements with certain customers on DNS' behalf. Since the Merger, due to these prior sales agreements, the Company has entered into an agreement with DNI in which DNI acts as a sales channel to these customers. Sales to DNI necessary for DNI to fulfill agreements with its customers are recorded net of royalty fees in related-party revenue.
The Company shares office space with DNI and certain of DNI's subsidiaries. Prior to the Merger, DNS, then a wholly owned subsidiary of DNI, shared human resources, treasury and other administrative support with DNI. As such, the Company entered into certain service sharing agreements with DNI and certain of its subsidiaries for the office space and administrative services. Expenses related to leases and administrative services are allocated and billed to the Company based on square footage occupied and headcount, respectively.
Other expenses to related parties represent payment to DNI for its guarantees relating to the Company's borrowings. The Company pays DNI a guarantee fee which is calculated as 0.9% of the guaranteed amount.
Balances of Receivables and Payables with Related Parties
Balances of receivables and payables arising from sales and purchases of goods and services with related parties as of June 30, 2018 and December 31, 2017 were as follows (in thousands):

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Table of Contents


 
 
 
 
As of June 30, 2018
 
 
Counterparty
 
DNI ownership Interest
 
Account receivables
 
Other receivables
 
Deposits for lease *
 
Short-term debt
 
Long-term debt
 
Accounts payable
 
Other Payables
DNI (parent company)
 
N/A
 
$
565

 
$

 
$
751

 
$
5,795

 
$
6,800

 
$
1,253

 
$
1,399

Tomato Soft Ltd.
 
100%
 

 

 

 

 

 

 
9

Tomato Soft (Xi'an) Ltd.
 
100%
 

 

 

 

 

 

 
41

Dasan France
 
100%
 
461

 
65

 

 

 

 

 

HandySoft, Inc.
 
17.63%
 
198

 

 

 

 

 
28

 

Chasan Networks Co., Ltd.
 
100%
 

 

 

 

 

 
104

 

 
 
 
 
$
1,224

 
$
65

 
$
751

 
$
5,795

 
$
6,800

 
$
1,385

 
$
1,449

 
 
 
 
As of December 31, 2017
 
 
Counterparty
 
DNI Ownership Interest
 
Account receivables
 
Other receivables
 
Deposits for lease *
 
Long-term debt
 
Accounts payable
 
Other Payables
 
Accrued and other liabilities**
DNI (parent company)
 
N/A
 
$
12,576

 
$
93

 
$
786

 
$
6,800

 
$
1,264

 
$
1,859

 
$
59

Tomato Soft Ltd.
 
100%
 

 

 

 

 

 
18

 

Tomato Soft (Xi'an) Ltd.
 
100%
 

 

 

 

 

 
54

 

Dasan France
 
100%
 
870

 
71

 

 

 

 

 

HandySoft, Inc.
 
17.63%
 
52

 

 

 

 

 

 

Chasan Networks Co., Ltd.
 
100%
 

 

 

 

 
87

 

 

Solueta
 
100%
 

 

 

 

 

 
25

 

 
 
 
 
$
13,498

 
$
164

 
$
786

 
$
6,800

 
$
1,351

 
$
1,956

 
$
59

* Included in other assets in the condensed consolidated balance sheets as of June 30, 2018 and December 31, 2017. 
**Included in accrued and other liabilities in the condensed consolidated balance sheets as of June 30, 2018 and December 31, 2017. 


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(10)
Net Income (Loss) Per Share Attributable to DASAN Zhone Solutions, Inc.

Basic net income (loss) per share attributable to DASAN Zhone Solutions, Inc. is computed by dividing the net income (loss) attributable to DASAN Zhone Solutions, Inc. for the period by the weighted average number of shares of common stock outstanding during the period. The calculation of diluted net income (loss) per share attributable to DASAN Zhone Solutions, Inc. gives effect to common stock equivalents; however, potential common equivalent shares are excluded if their effect is antidilutive. Potential common equivalent shares are composed of incremental shares of common equivalent shares issuable upon the exercise of stock options and the vesting of restricted stock units.

The following table is a reconciliation of the numerator and denominator in the basic and diluted net income (loss) per share calculation (in thousands, except per share data):
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2018
 
2017
 
2018
 
2017
Net income (loss) attributable to DASAN Zhone Solutions, Inc.
 
$
1,416

 
$
(809
)
 
$
1,523

 
$
(4,556
)
Weighted average number of shares outstanding:
 
 
 
 
 
 
 
 
Basic
 
16,438

 
16,380

 
16,425

 
16,380

Effect of dilutive securities:
 
 
 
 
 
 
 
 
Stock options, restricted stock units and share awards
 
234

 

 
220

 

Diluted
 
16,672

 
16,380

 
16,645

 
16,380

Net income (loss) per share attributable to DASAN Zhone Solutions, Inc.:
 
 
 
 
 
 
 
 
Basic
 
$
0.09

 
$
(0.05
)
 
$
0.09

 
$
(0.28
)
Diluted
 
$
0.08

 
$
(0.05
)
 
$
0.09

 
$
(0.28
)
 

During the three and six months ended June 30, 2018, the Company excluded 285 thousand, and 436 thousand stock options at a weighted average exercise price of $14.02, and $12.35, respectively, from diluted net income per share because their effect would have been antidilutive. 

Basic net income (loss) per share is the same as diluted net income (loss) per share for the three and six months ended June 30, 2017 because the effects of stock options and restricted stock units would have been anti-dilutive.

(11)
Commitments and Contingencies
Operating Leases
The Company has entered into operating leases for certain office space and equipment, some of which contain renewal options and escalation clauses. Estimated future lease payments under all non-cancellable operating leases with terms in excess of one year, including taxes and service fees, are as follows (in thousands):
 
Operating Leases
Year ending December 31:
 
2018 (remainder of the year)
$
2,043

2019
3,993

2020
2,998

2021
2,590

2022
2,664

Thereafter
8,423

Total minimum lease payments
$
22,711


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Warranties
The Company accrues warranty costs based on historical trends for the expected material and labor costs to provide warranty services. Warranty periods are generally one to five years from the date of shipment. The following table reconciles changes in the Company’s accrued warranties and related costs for the six months ended June 30, 2018 and 2017 (in thousands):  
 
Six Months Ended June 30,
 
2018
 
2017
Beginning balance
$
931

 
$
878

Charged to cost of revenue
728

 
239

Claims and settlements
(421
)
 
(381
)
Foreign exchange impact
9

 
15

Ending balance
$
1,247

 
$
751

Performance Bonds
In the normal course of operations, from time to time, the Company arranges for the issuance of various types of surety bonds, such as bid and performance bonds, which are agreements under which the surety company guarantees that the Company will perform in accordance with contractual or legal obligations. As of June 30, 2018, the Company had $2.9 million of surety bonds guaranteed by third parties.
Purchase Commitments
The Company has agreements with various contract manufacturers which include non-cancellable inventory purchase commitments. The Company’s inventory purchase commitments typically allow for cancellation of orders 30 days in advance of the required inventory availability date as set by the Company at time of order. The amount of non-cancellable purchase commitments outstanding, net of reserve, was $4.3 million as of June 30, 2018.
Payment Guarantees provided by Third Parties and DNI
The following table sets forth payment guarantees of the Company's indebtedness and other obligations as of June 30, 2018 (in thousands) that have been provided by third parties and DNI. DNI owns approximately 57.7% of the outstanding shares of the Company's common stock:
Guarantor
 
Amount Guaranteed (in thousands)
 
Description of Obligations Guaranteed
DNI
 
$
3,423

 
Borrowings from Shinhan Bank
DNI
 
1,712

 
Purchasing card from Shinhan Bank
DNI
 
12,355

 
Letter of credit from Industrial Bank of Korea
DNI
 
2,140

 
Purchasing Card from Industrial Bank of Korea
DNI
 
6,000

 
Letter of credit from NongHyup Bank
DNI
 
535

 
Purchasing card from NongHyup Bank
DNI
 
6,128

 
Borrowings from Export-Import Bank of Korea
DNI
 
6,000

 
Letter of credit from KookMin Bank
Industrial Bank of Korea
 
8,232

 
Letter of credit
NongHyup Bank
 
3,685

 
Letter of credit
Kookmin Bank
 
4,999

 
Letter of credit
Shinhan Bank
 
242

 
Purchasing card
Industrial Bank of Korea
 
1,556

 
Performance bonds
Industrial Bank of Korea
 
810

 
Purchasing Card
State Bank of India
 
38

 
Performance bonds
Seoul Guarantee Insurance Co.
 
3,961

 
Performance payment guarantee*
 
 
$
61,816

 
 
*The Company is responsible for the warranty liabilities generally for the period of two years regarding major product sales and has contracted surety insurance over part of the warranty liabilities. 

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Royalties
The Company has certain royalty commitments associated with the shipment and licensing of certain products. Royalty expense is generally based on a dollar amount per unit shipped or a percentage of the underlying revenue and is recorded in cost of revenue.
Legal Proceedings
The Company is subject to various legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, the Company records an accrual for legal contingencies that it has determined to be probable to the extent the amount of the loss can be reasonably estimated. The Company does not expect that the ultimate costs to resolve these matters will have a material adverse effect on its consolidated financial position or results of operations. However, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.
(12)
Stock Option and Other Benefit Plans
2018 Employee Stock Purchase Plan 
On May 22, 2018, the stockholders of the Company approved the adoption of the DASAN Zhone Solutions, Inc. 2018 Employee Stock Purchase Plan (the “ESPP”). The ESPP became effective upon stockholder approval and replaced the Company’s existing DASAN Zhone Solutions, Inc. 2002 Employee Stock Purchase Plan.
The ESPP authorizes the issuance of up to 250,000 shares of the Company’s common stock. In addition, the ESPP provides for an annual increase on the first day of each calendar year beginning on January 1, 2019 and ending on and including January 1, 2028 equal to the lesser of (1) 1% of the shares outstanding on the last day of the immediately preceding calendar year and (2) such smaller number of shares as may be determined by the Board in its sole discretion. Notwithstanding the foregoing, the number of shares of stock that may be issued or transferred pursuant to awards under the ESPP may not exceed an aggregate of 2,000,000 shares.

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(13)
Enterprise-Wide Information
The Company is a global provider of network access solutions and communications equipment for service provider and enterprise networks. There are no segment managers who are held accountable for operations, operating results and plans for levels or components below the Company unit level. Accordingly, the Company is considered to be in a single reporting segment and operating unit structure. The Company’s chief operating decision maker is the Company’s Chief Executive Officer, who reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance. The Company attributes revenue from customers to individual bill to countries. The following summarizes required disclosures about geographical concentrations and revenue by products and services (in thousands):
 
Three Months Ended
 
Six months ended
 
June 30,
 
June 30,
 
2018
 
2017
 
2018
 
2017
Revenue by geography:
 
 
 
 
 
 
 
United States
$
13,630

 
$
11,961

 
$
30,179

 
$
24,108

Canada
1,321

 
1,422

 
2,293

 
2,614

Total North America
14,951

 
13,383

 
32,472

 
26,722

Latin America
7,312

 
7,075

 
15,269

 
11,945

Europe, Middle East, Africa
9,475

 
6,253

 
16,963

 
11,756

Korea
19,111

 
32,197

 
31,235

 
48,513

Other Asia Pacific
25,408

 
1,033

 
39,822

 
13,117

Total International
61,306

 
46,558

 
103,289

 
85,331

Total
$
76,257

 
$
59,941

 
$
135,761

 
$
112,053

 
 
 
 
 

 

 
Three Months Ended
 
Six months ended
 
June 30,
 
June 30,
 
2018
 
2017
 
2018
 
2017
Revenue by classification:
 
 
 
 
 
 
 
Products
$
73,317

 
$
57,278

 
$
130,043

 
$
107,003

Services
2,940

 
2,663

 
5,718

 
5,050

Total
$
76,257

 
$
59,941

 
$
135,761

 
$
112,053

    
The Company's property and equipment, net of accumulated depreciation, were located in the following geographical areas as of June 30, 2018 and December 31, 2017 (in thousands):
 
As of June 30,
2018
 
As of December 31,
2017
United States
$
3,238

 
$
3,393

Korea
1,382

 
1,633

Other Asia Pacific
812

 
847

 
$
5,432

 
$
5,873

(14)
Income Taxes
Income tax expense for the three and six months ended June 30, 2018 was $0.3 million for each period, on pre-tax income of $1.7 million and $1.8 million, respectively. For the three and six months ended June 30, 2017, income tax expense was $0.1 million and $0.5 million, respectively, on pre-tax losses of $0.8 million and $3.8 million, respectively.
As of June 30, 2018, the income tax rate varied from the United States statutory income tax rate primarily due to valuation allowances in the United States, income attributable to foreign jurisdictions taxed at rates different from the United States federal statutory rate, and tax credits.

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Table of Contents


The total amount of unrecognized tax benefits, including interest and penalties, at June 30, 2018 was $0.5 million. The amount of tax benefits that would impact the effective income tax rate, if recognized, is $0.1 million. There were no significant changes to unrecognized tax benefits during the quarters ended June 30, 2017 and June 30, 2018. The Company does not anticipate any significant changes with respect to unrecognized tax benefits within the next 12 months.
The Company has recognized the provisional tax impacts related to the Tax Act in the Company’s consolidated financial statements for the year ended December 31, 2017. The ultimate impact may differ from provisional amounts, possibly materially, due to, among other things, additional analysis, changes in interpretations and assumptions the Company has made, additional regulatory guidance that may be issued, and actions the Company may take as a result of the Tax Act. The Company has not yet determined its policy election with respect to whether to record deferred taxes for basis differences expected to reverse as a result of the global intangible low-taxed income (“GILTI”) provisions in future periods or use the period cost method. The Company has, however, included an estimate of the current GILTI impact in its tax provision for 2018. The Company continues to evaluate the impact of the tax reform and the accounting is expected to be completed when the Company's 2017 U.S. corporate income tax return is filed in 2018.
Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This report, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933 and the Securities Exchange Act of 1934. These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. We use words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “goal,” “intend,” “may,” “plan,” “project,” “seek,” “should,” “target,” “will,” “would,” variations of such words, and similar expressions to identify forward-looking statements. In addition, statements that refer to projections of earnings, revenue, costs or other financial items as to future periods; anticipated growth and trends in our business or key markets; cost synergies, growth opportunities and other financial and operating benefits of the Merger; future growth and revenues from our products; our ability to refinance or repay our existing indebtedness prior to the applicable maturity date; future economic conditions and performance; anticipated performance of products or services; plans, objectives and strategies for future operations; and other characterizations of future events or circumstances, are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and that they are subject to risks, uncertainties and assumptions that are difficult to predict, including those identified or referenced under the heading “Risk Factors” in Part II, Item 1A, elsewhere in this report and in our other filings with the Securities and Exchange Commission (the SEC). Actual results may differ materially and adversely from those expressed in any forward-looking statements. Factors that might cause such a difference include, but are not limited to, our ability to realize the anticipated cost savings, synergies and other benefits of the Merger and any integration risks relating to the Merger, the ability to generate sufficient revenue to achieve or sustain profitability, the ability to raise additional capital to fund existing and future operations or to refinance or repay our existing indebtedness, defects or other performance problems in our products, any economic slowdown in the telecommunications industry that restricts the ability of our customers to purchase our products, commercial acceptance of our products, intense competition in the communications equipment market from large equipment companies as well as private companies with products that address the same networks needs as our products, higher than anticipated expenses that we may incur, any failure to comply with the periodic filing and other requirements of The Nasdaq Stock Market for continued listing, material weaknesses or other deficiencies in our internal control over financial reporting, the initiation of any civil litigation, regulatory proceedings, government enforcement actions or other adverse effects relating to the Audit Committee investigation or errors in the consolidated financial statements of Zhone Technologies, Inc., and other factors identified elsewhere in this report and in our most recent reports on Forms 10-K, 10-Q and 8-K. We undertake no obligation to revise or update any forward-looking statements for any reason.
OVERVIEW
We are a global provider of network access solutions and communications equipment for service provider and enterprise networks. We research, develop, test, sell, manufacture and support communications equipment in five major areas: broadband access, Ethernet switching, mobile backhaul, passive optical LAN (POLAN) and software defined networks (SDN).

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Table of Contents


CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Management’s discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles in the United States of America. The preparation of these consolidated financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities.

With the exception of the policies discussed below, there have been no material changes to our critical accounting policies and estimates from the information provided in Part II, “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies and Estimates” included in our Annual Report on Form 10-K for the year ended December 31, 2017. The policies discussed below are considered by management to be critical because changes in such estimates can materially affect the amount of our reported net income or loss. For all of these policies, management cautions that actual results may differ materially from these estimates under different assumptions or conditions.

For a description of what we believe to be the critical accounting policies and estimates used in the preparation of our unaudited condensed consolidated financial statements, refer to our Annual Report on Form 10-K for the year ended December 31, 2017.

Revenue Recognition 
Revenue from contracts with customers is recognized when control of the promised goods or services is transferred to the customers, in an amount that reflects the consideration we expect to be entitled to in exchange for those goods or services. 
We generate revenue primarily from sales of products and services, including extended warranty service and customer support. Revenue from product sales is recognized at a point in time when control of the good is transferred to the customer, generally occurring upon shipment or delivery dependent upon the terms of the underlying contract. Revenue from services is generally recognized over time on a ratable basis over the contract term, using an output measure of progress, as the contracts usually provide the customer equal benefit throughout the contract period. We typically invoice customers for support contracts in advance, for periods ranging from one to five years.
Revenue from all sales types is recognized at transaction price, which is the amount we expect to be entitled to in exchange for transferring goods and/or providing services. Transaction price is calculated as selling price net of variable consideration. Sales to certain distributors are made under arrangements which provide the distributors with volume discounts, price adjustments, and other allowances under certain circumstances. These adjustments and allowances are accounted for as variable consideration. To estimate variable consideration, we analyze historical data, channel inventory levels, current economic trends and changes in customer demand for our products, among other factors. Historically, variable consideration has not been a significant component of our contracts with customers. As of June 30, 2018, the total estimate of variable consideration was not significant.
 
Contracts with Multiple Performance Obligations 
Some of our contracts with customers contain multiple promised goods or services. For these contracts, we account for the promises separately as individual performance obligations if they are distinct. In determining whether performance obligations meet the criteria for being distinct, we consider a number of factors, including the degree of interrelation and interdependence between obligations and whether or not the good or service significantly modifies or transforms another good or service in the contract. 
After identifying the separate performance obligations, the transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. Standalone selling prices for products are determined using either an adjusted market assessment or expected cost-plus margin. For customer support and extended warranty services, standalone selling price is primarily based on the prices charged to customers. 
Remaining performance obligations represent the transaction price allocated to performance obligations that are unsatisfied or partially unsatisfied as of the end of the reporting period. Unsatisfied and partially unsatisfied performance obligations primarily consist of backlog, which are products and services for which customer purchase orders have been accepted and that are in the process of being delivered.
 

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Table of Contents


Contract Balances
Topic 606 distinguishes between a contract asset and accounts receivable based on whether receipt of the consideration is conditional on something other than passage of time. We record contract assets when we have a right to consideration and records accounts receivable when we have an “unconditional” right to consideration. Contract liabilities consist of cash payments received in advance of performance or where we have a right to consideration that is unconditional, before we transfer a good or service to a customer.
 
Warranties 
Products sold to customers include standard warranties, covering bug fixes, such as minor updates such that the product continues to function according to published technical specifications. These standard warranties are assurance type warranties and do not offer any services in addition to the assurance that the product will continue working as specified. Therefore, standard warranties are not considered separate performance obligations in the arrangement. Instead, the expected cost of warranty is accrued as expense in accordance with applicable guidance. Extended warranties are sold with certain products and include additional support services. The transaction price for extended warranties is accounted for as service revenue and recognized over the life of the contract.
 
Contract Costs 
Applying a practical expedient, we recognize the incremental costs of obtaining contracts, which primarily consist of sales commissions, as an expense when incurred if the amortization period of the assets that otherwise would have been recognized is one year or less. These costs are included in sales and marketing expenses. If the incremental direct costs of obtaining a contract relate to a service recognized over a period longer than one year, such costs are capitalized and amortized in line with the related services over the period of benefit. As of June 30, 2018, such capitalizable costs were not significant.

Financing 
Our contracts do not include a significant financing component. We apply the practical expedient not to adjust the promised amount of consideration for the effects of a financing component if we expect, at contract inception, that the period between when we transfer a good or service to the customer and when the customer pays for the good or service will be one year or less.

Shipping and Handling
We have elected to account for shipping and handling activities that occur after the customer has obtained control of a good as a fulfillment cost rather than as an additional promised service. As a result, we accrue the costs of shipping and handling when the related revenue is recognized.

Unsatisfied performance obligations
We do not disclose the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less and (ii) contracts for which we recognize revenue at the amount to which we have the right to invoice for the services performed. The majority of our performance obligations in our contracts with customers relate to contracts with a duration of less than one year and therefore transaction price allocated to unsatisfied performance obligations included in contracts with a duration of more than 12 months was not material.
 
Disaggregation of Revenue 
The disaggregation of revenue by geographical regions for the three months and six months ended June 30, 2018 is disclosed in Note 13.


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Table of Contents


RESULTS OF OPERATIONS
We list in the table below the historical condensed consolidated statement of comprehensive income (loss) as a percentage of total net revenue for the periods indicated.
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
2018
 
2017
 
2018
 
2017
Net revenue:
 
 
 
 
 
 
 
Third parties
99
 %
 
82
 %
 
98
 %
 
81
 %
Related parties
1
 %
 
18
 %
 
2
 %
 
19
 %
Total net revenue
100
 %
 
100
 %
 
100