10-Q 1 d10q.txt FORM 10-Q 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 January 31, 2002, or [_] Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 for the Transition Period from _________ to ___________ Commission file number 0-30869 STRATOS LIGHTWAVE, INC. (Exact name of Registrant as specified in its charter) ---------- Delaware 36-4360035 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 7444 West Wilson Avenue Chicago, Illinois 60706 (708) 867-9600 (Address, including zip code, and telephone number, including area code, of Registrant's principal executive offices) ---------- Not Applicable -------------- (Former name, former address and former fiscal year, if changed since last report) Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No____ - As of March 11, 2002 there were 67,268,094 shares of the Registrant's common stock outstanding. STRATOS LIGHTWAVE, INC. INDEX -----
Page ---- PART I FINANCIAL INFORMATION Item 1. Financial Statements Condensed Consolidated Balance Sheets as of April 30, 2001 and January 31, 2002 (unaudited) ................................................................. 2 Condensed Consolidated Statements of Operations (unaudited) for the three and nine months ended January 31, 2001 and 2002 ........................................ 3 Condensed Consolidated Statements of Cash Flows (unaudited) for the nine months ended January 31, 2001 and 2002 .................................................. 4 Notes to Condensed Consolidated Financial Statements (unaudited) January 31, 2002 ............................................................................. 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations ........ 10 Item 3. Quantitative and Qualitative Disclosures About Market Risk ................................... 28 PART II. OTHER INFORMATION Item 1. Legal Proceedings ............................................................................ 29 Item 2. Changes in Securities and Use of Proceeds .................................................... 30 Item 6. Exhibits and Reports on Form 8-K ............................................................. 30 SIGNATURES ..................................................................................................... 32 INDEX TO EXHIBITS .............................................................................................. 33
-1- PART I FINANCIAL INFORMATION Item 1. Financial Statements. STRATOS LIGHTWAVE, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands)
April 30, January 31, 2001 2002 --------- ----------- (unaudited) ASSETS Current assets: Cash and cash equivalents ......................................................... $125,438 $ 64,747 Short-term investments ............................................................ 20,400 32,500 Accounts receivable, less allowance ............................................... 24,646 10,693 Inventories: Finished products ................................................................. 1,551 1,087 Work in process ................................................................... 2,281 2,000 Materials ......................................................................... 23,430 16,888 ----------- -------- 27,262 19,975 Deferred income taxes ............................................................... 2,624 3,255 Prepaid expenses .................................................................... 1,012 1,862 ----------- -------- Total current assets ............................................................ 201,382 133,032 Other assets: Goodwill, less accumulated amortization ........................................... 13,472 20,218 Other ............................................................................. 534 4,648 ----------- -------- 14,006 24,866 Property, plant and equipment ....................................................... 85,181 114,894 Less allowances for depreciation .................................................. 20,121 29,002 ----------- -------- 65,060 85,892 ----------- -------- Total assets .................................................................... $280,448 $243,790 =========== ======== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable .................................................................. $12,993 $ 6,317 Other current liabilities ......................................................... 9,875 6,219 ----------- -------- Total current liabilities ........................................................ 22,868 12,536 Long term debt ...................................................................... -- 6,736 Deferred income taxes ............................................................... 2,205 3,256 Minority interest ................................................................... 476 488 Stockholders' equity: Preferred stock ................................................................... -- -- Common stock ...................................................................... 641 641 Additional paid-in capital ........................................................ 245,538 245,538 Retained earnings (deficit) ....................................................... 9,075 (25,138) Foreign currency translation adjustment ........................................... (355) (267) ----------- -------- Total stockholders' equity ....................................................... 254,899 220,774 ----------- -------- Total liabilities and stockholders' equity ..................................... $280,448 $243,790 =========== ========
See notes to condensed consolidated financial statements. -2- STRATOS LIGHTWAVE, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) (in thousands, except per share amounts)
Three Months Ended Nine Months Ended January 31, January 31, ------------------- ----------------------- 2001 2002 2001 2002 ------- -------- -------- -------- Revenue: Net sales ........................................ $40,339 $12,524 $100,734 $ 42,234 License fees and royalties ....................... 226 390 1,103 1,837 ------- -------- -------- -------- Total .......................................... 40,565 12,914 101,837 44,071 Costs and expenses: Cost of sales .................................... 25,514 11,554 65,686 45,650 Research and development ......................... 3,661 5,589 9,898 21,173 Sales and marketing .............................. 2,670 1,695 6,911 5,792 General and administrative ....................... 3,679 3,133 8,562 11,370 ------- -------- --------- -------- Total costs and expenses ........................ 35,524 21,971 91,057 83,985 ------- -------- --------- -------- Income (loss) from operations ...................... 5,041 (9,057) 10,780 (39,914) Interest income, net ............................... 2,365 834 5,930 3,119 ------- -------- --------- -------- Income (loss) before income taxes .................. 7,406 (8,223) 16,710 (36,795) Provision for income taxes (credit) ................ 2,590 -- 5,850 (2,581) ------- -------- --------- -------- Net income (loss) .................................. $4,816 (8,223) $10,860 $(34,214) ======= ======== ========= ======== Net income (loss) per share, basic ................. $0.08 $ (0.13) $0.18 $(0.53) ======= ======== ========= ======== Net income (loss) per share, diluted ............... $0.08 $ (0.13) $0.17 $(0.53) ======= ======== ========= ======== Weighted average number of common shares outstanding: Basic ............................................ 64,092 64,092 61,916 64,092 ======= ======== ========= ======== Diluted .......................................... 65,095 64,092 62,376 64,092 ======= ======== ========= ========
See notes to condensed consolidated financial statements. -3- STRATOS LIGHTWAVE, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited) (in thousands)
Nine Months Ended January 31, -------------------------- 2001 2002 ---------- --------- Operating activities: Net income (loss) ............................................................... $ 10,860 $(34,213) Adjustments to reconcile net income (loss) to net cash used in operating activities: Provision for depreciation and amortization .................................... 5,100 9,929 Provision for deferred taxes ................................................... -- 421 Provision for losses on accounts receivable .................................... -- 152 Change in operating assets and liabilities ..................................... (19,722) 8,532 -------- --------- Net cash used in operating activities ............................................. (3,762) (15,179) Investing activities: Purchases of property, plant and equipment ...................................... (31,594) (21,447) Purchases of short-term investments ............................................. -- (34,700) Sales of short-term investments ................................................. -- 22,600 Acquisitions .................................................................... (752) (8,117) Additional purchase price of prior period acquisition ........................... (2,957) -- Other ........................................................................... (12) (77) -------- --------- Net cash used in investing activities ............................................. (35,315) (41,741) Financing activities: Net proceeds from initial public offering ....................................... 195,465 -- Loan to Affiliate ............................................................... -- (3,771) Payment of note related to prior period acquisition ............................. (333) -- Net cash transfers to Methode Electronics, Inc. ................................. (1,179) -- -------- --------- Net cash provided by (used in) financing activities ............................. 193,953 (3,771) -------- --------- Net increase (decrease) in cash and cash equivalents ............................ 154,876 (60,691) Cash and cash equivalents at beginning of period ................................ 537 125,438 -------- --------- Cash and cash equivalents at end of period ...................................... $155,413 $64,747 ======== ========= 2001 2002 -------- --------- Supplemental schedule of non cash investing and financing activities: Proceeds of long-term debt (including current portion) to purchase software and equipment for information technology system ............ -- $9,084
See notes to condensed consolidated financial statements. -4- STRATOS LIGHTWAVE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) January 31, 2002 1. Basis of Presentation The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the three-month and nine-month periods ended January 31, 2002 are not necessarily indicative of the results that may be expected for the year ending April 30, 2002. This unaudited quarterly information should be read in conjunction with the audited consolidated financial statements and related notes for the fiscal year ended April 30, 2001 included in the Company's Annual Report on Form 10-K, filed with the Securities and Exchange Commission. As of May 28, 2000, Methode Electronics, Inc. ("Methode") contributed and transferred to the Company all of the capital stock and equity interests held by Methode in subsidiaries and other entities that conducted a majority of its optical products business, pursuant to a master separation agreement. The capital stock and equity interests contributed and transferred to the Company were Bandwidth Semiconductor, LLC, Methode Communications Modules, Inc. (now Stratos Lightwave-Florida, Inc.), Stratos Lightwave, LLC, Methode's sixty percent interest in MP Optical Communications, LLC and Stratos Limited. Prior to its transfer of Stratos Lightwave, LLC to the Company, Methode transferred all of the assets and liabilities of its optoelectronics and fiber optic divisions, the properties associated with its optoelectronics research center and Methode's corporate facilities occupied by these divisions to Stratos Lightwave, LLC. In July 2000, the Company completed the sales of 10,062,500 shares of common stock in its initial public offering at a price of $21 per share. The net proceeds from the offering, after deducting the underwriting discount and the offering expenses paid by the Company, were approximately $195.5 million. After completion of the Company's initial public offering, Methode owned 54,029,807 shares of the Company's common stock, representing approximately 84.3% of the outstanding shares. After receiving a favorable letter ruling from the Internal Revenue Service in March 2001, and in accordance with its previously announced intentions, on April 28, 2001, Methode distributed all of the shares of the Company's common stock owned by Methode to Methode's stockholders in a distribution intended to be tax free for U.S. federal income tax purposes. The Company's condensed consolidated financial statements for the periods ended on or prior to May 28, 2000, have been carved out from the consolidated financial statements of Methode, using the historical results of operations and cash flows and historical basis of the assets and liabilities of the business. The condensed consolidated financial statements for the periods ended on or prior to May 28, 2000, also include allocations to the Company of Methode's corporate expenses, including centralized accounting, treasury, information technology, human resources, sales and marketing, legal, real estate and other corporate service and infrastructure costs. The Company considers the expense allocations to be reasonable reflections of the utilization of the services provided to it or the benefits received by it. The -5- condensed consolidated financial statements after May 28, 2000 reflect the operations, cash flows and assets and liabilities of the Company on a stand-alone basis. For purposes of governing certain of the ongoing relationships between the Company and Methode after the separation and to provide for an orderly transition, the Company and Methode have entered into various agreements to provide similar services as those described above. The agreements govern individual transitional services as requested by Methode or the Company, of the other party. These services are to be provided in accordance with the policies, procedures and practices in effect before the transfer date. The term of each agreement is one year (provision for extension exists) unless earlier terminated. The Company's expenses under its transitional service arrangements with Methode do not differ significantly from the costs historically allocated to it by Methode for similar arrangements. The need for services under these agreements have been substantially reduced at the close of fiscal 2001. Shared services have continued in fiscal 2002 only in the areas of legal and quality control. The allocation of Methode corporate expenses was discontinued on May 28, 2000. Subsequent to this date, the Company incurred these corporate expenses either directly in its operations or indirectly under its transitional services agreement with Methode. Charges to the Company from Methode for allocations in the nine months ended January 31, 2001 were classified as follows:
in thousands ------------ Cost of sales....................... $106 Research and development............ 5 Sales and marketing................. 188 General and administrative.......... 376 ---- Total............................. $675 ====
In addition, the Company incurred charges of approximately $54,000 and $333,000 in the three and nine months ended January 31, 2001 and a $4,000 credit and $27,000 credit in the three and nine months ended January 31, 2002 under its transitional service agreements with Methode. Short-term investments represent short-term corporate debt that is held to maturity. Cost represents estimated fair value at the balance sheet date and there is no gross unrealized gains or losses. Interest payments are included in investment income. Comprehensive income (loss) consists of net income (loss) and foreign currency translation adjustments and totaled $4,879,000 and ($8,340,000) for the third quarters of fiscal 2001 and 2002, and $10,734,000 and ($34,125,000) for the nine months ended January 31, 2001 and 2002. Recent Accounting Pronouncements In June 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, Business Combinations, and No. 142, Goodwill and Other Intangible Assets, effective for fiscal years beginning after December 15, 2001. Under the new rules, goodwill and intangible assets deemed to have indefinite lives will no longer be amortized but will be subject to annual impairment tests in accordance with the Statements. Other intangible assets will continue to be amortized over their useful lives. -6- The Company will apply the new rules on accounting for goodwill and other intangible assets beginning in the first quarter of fiscal year 2003. Application of the nonamortization provisions of the Statement is expected to result in an increase in net income of approximately $535,000 ($0.01 per share) per year. During fiscal year 2003, the Company will perform the first of the required impairment tests of goodwill and indefinite lived intangible assets as of May 1, 2002 and has not yet determined what the effect of these tests will be on the earnings and financial position of the Company. In August 2001, the FASB issued SFAS 144, Accounting for the Impairment/Disposal of Long Lived Assets. The Company will adopt this standard on May 1, 2002. The Company does not expect that the adoption of this statement will have a material effect on the Company's financial statements. 2. Acquisitions On May 31, 2001, the Company purchased, for approximately $8,117,000 in cash including costs of acquisition, substantially all of the net assets of the Optical Flexcircuits division of Advanced Interconnection Technology, Inc. The allocation of the purchase price to the net assets acquired was as follows:
Asset acquired: Inventories............................... $ 559,000 Property, plant and equipment............. 318,000 Other..................................... 50,000 ---------- Total assets............................ 927,000 Liabilities assumed: Accrued expenses.......................... 180,000 ---------- Total liabilities......................... 180,000 ---------- Net assets acquired....................... 747,000 Excess purchase price..................... 7,370,000 ---------- Purchase price............................ $8,117,000 ==========
On November 22, 2000, the Company purchased, for approximately $752,000 in cash including costs of acquisition, substantially all of the net assets of B&H Mold, Inc., a tool manufacturer in Libertyville, Illinois. Effective February 23, 2000, the Company entered into an amendment to the Asset Purchase Agreement with Rockledge Microelectronics, Inc. (formerly Polycore Technologies, Inc.) which provided that in the event the Company is part of an initial public offering of shares to be accomplished not later than November 15, 2000, the sum of $2.957 million will become payable to the seller within 30 days following the initial public offering in full satisfaction of such additional contingent consideration. This amount was paid in July 2000 and has been accounted for as additional purchase price. The above described acquisitions were accounted for using the purchase method of accounting. If these acquisitions had been made as of the beginning of fiscal 2001, the impact on the Company's operating results would not have been significant. -7- 3. Income Taxes The tax benefit recognized in the nine months ended January 31, 2002 represents the benefit of tax loss carrybacks available to the Company. The Company determined the need for a valuation allowance in the second quarter of fiscal 2002, against the carrying value of deferred tax assets primarily associated with tax loss carry forwards based on the significant reduction in business levels experienced during the quarter and revised estimates of taxable earnings for the remainder of the fiscal year. As a result, a $13.8 million valuation allowance has been recorded which eliminated the tax benefit attributable to the net losses incurred in the second and third quarters of fiscal 2002 (approximately $9.5 million), eliminated approximately $3.9 million of tax benefits recorded in the quarter ended July 31, 2001, and reserved for approximately $400,000 of deferred tax assets recorded as of April 30, 2001. 4. Long Term Debt Long term debt consists of two notes payable for the purchase of computer software and hardware in connection with the implementation of a new information technology system. Information relating to these notes is as follows:
Note 1 Note 2 ---------- ---------- Current portion.................... $1,088,000 $1,260,000 Long-term.......................... 1,754,000 4,982,000 ---------- ---------- $2,842,000 $6,242,000 ========== ========== Interest rate..................... 3.52% 5.50% Payment terms.................... Quarterly Monthly Payment amount................... $300,587 $107,476 Maturity......................... 7/31/04 10/01/05
5. Earnings Per Share The following table sets forth the computation of basic and diluted earnings per share.
Three Months Ended Nine Months Ended January 31, January 31, ------------------------ ---------------------- 2001 2002 2001 2002 ------- -------- ------- -------- Numerator - net income (loss)............................. $ 4,816 $ (8,223) $10,860 $(34,214) Denominator: Denominator for basic earnings (loss) per share- weighted-average shares outstanding..................... 64,092 64,092 61,916 64,092 Dilutive potential common shares- employee stock options.................................. 3 -- 460 -- ------- -------- ------- -------- Denominator for diluted earnings (loss) per shares-adjusted weighted-average shares and assumed conversions..................................... 64,095 64,092 62,376 64,092 ======= ======== ======== ======== Basic earnings (loss) per share......................... $ 0.08 $ (0.13) $ 0.18 $ (0.53) ======= ======== ======== ======== Diluted earnings (loss) per share....................... $ 0.08 $ (0.13) $ 0.17 $ (0.53) ======= ======== ======== ========
-8- 6. Discontinuance of Development Program In November 2001, management decided to discontinue the vertical cavity surface emitting laser (VCSEL) development program at its Bandwidth Semiconductor LLC subsidiary located in Bedford, MA. The Company has incurred or will incur charges of approximately $1.1 million related to the discontinuation of this program for employee severance pay, losses on abandonment of fixed assets and costs to sublease the manufacturing facility. These charges were recorded in the third quarter of the current fiscal year. 7. Subsequent Event On February 4, 2002 the Company acquired all of the outstanding common stock of Tsunami Optics, Inc. in exchange for approximately 3.2 million shares of its common stock. In addition, the Company assumed approximately $5.9 million of debt, plus certain expenses in connection with the transaction, including a loan of approximately $3.8 million made by the Company to Tsunami prior to the acquisition. The purchase agreement includes additional contingent consideration of up to $18.0 million in Stratos Common Stock that may become due based upon the attainment of certain performance targets. The transaction will be accounted for using the purchase method of accounting. -9- Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations. The following discussion of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and related notes thereto included elsewhere in this Form 10-Q. The following discussion contains forward-looking statements that involve risks and uncertainties. Our actual results could differ substantially from those anticipated in these forward-looking statements as a result of several factors, including those set forth under "Factors That May Affect Our Future Results." Overview We develop, manufacture and sell optical subsystems and components for high data rate networking, data storage and telecommunication applications. These optical subsystems are designed for use in local area networks (LANs), storage area networks (SANs), metropolitan area networks (MANs), wide area networks (WANs) and in the telecommunication markets. Our optical subsystems are compatible with the advanced transmission protocols used in these networks, including Gigabit Ethernet, Fast Ethernet, Fibre Channel, and synchronous optical network (SONET). We also design, manufacture and sell a full line of optical components and cable assemblies for use in these networks. On February 23, 2000, Methode Electronics, Inc. ("Methode") announced plans to create a separate company comprised of its optical products businesses. Accordingly, we were incorporated in Delaware in April 2000 as a wholly owned subsidiary of Methode. In June 2000 we launched our initial public offering of 10,062,500 shares of common stock at $21.00 per share. After the completion of our public offering, Methode owned approximately 84.3% of our outstanding common stock. On March 23, 2001, Methode announced that its board of directors had declared a stock dividend of all of Methode's shares in us. The dividend was distributed on April 28, 2001 to Methode stockholders of record as of April 5, 2001. The distribution was made on the basis of 1.5113 shares of Stratos stock for each share of Methode Class A and Class B common stock held. Our net sales are derived principally from the sale of optical subsystems and components to optical communication original equipment manufacturers (OEMs). Our net sales have fluctuated from period to period based on customer demand for our products, the size and timing of customer orders, particularly from our largest customers, and based on any canceled, delayed or rescheduled orders in the relevant period. We determine reserves for rapid technological change on a product by product basis. While it is likely that obsolescence due to rapid technological change will continue, the timing and amount of this obsolescence cannot be predicted with certainty. The average unit prices of our products generally decrease as the products mature in response to factors such as increased competition, the introduction of new products and increased unit volumes. We anticipate that average selling prices will continue to decline in future periods, although the timing and degree of the declines cannot be predicted with any certainty. We must continue to develop and introduce on a timely basis new products that incorporate features that can be sold at higher average selling prices. License fees and royalties represent payments received from licensees of our patented technology, which is also used by us in our optical subsystems. These license agreements generally provide for up-front payments and/or future fixed payments or ongoing royalty payments based on a percentage of sales of the licensed products. The timing and amounts of these payments is beyond our control. Accordingly, the amount received in any given period is expected to vary significantly. The duration of all of these license agreements extends until the expiration of the licensed patents. We will -10- consider entering into similar agreements in the future, however, we are not able to predict whether we will enter into any additional licenses in the future and, if so, the amount of any license fees or royalties. Our cost of sales consists of materials, salaries and related expenses for manufacturing personnel and manufacturing overhead. We purchase several key components used in the manufacture of our products from a limited number of suppliers. We have periodically experienced shortages and delivery delays for these materials. In some circumstances, we maintain an inventory of limited source components to decrease the risk of shortage. If we overestimate our requirements, we may have excess inventory of these components. Substantially all of our products are designed and manufactured in our own facilities. Accordingly, a significant portion of our cost of sales is fixed over the near term. In order to remain competitive, we must continually reduce our manufacturing costs through design and engineering innovations and increases in manufacturing efficiencies. There can be no assurance that we will be able to reduce our manufacturing costs or introduce new products to offset anticipated decreases in the average selling prices of our products. It is our policy to reserve 100% of the value of inventory we specifically identify and consider obsolete or excessive to fulfill future sales estimates. We define obsolete inventory as inventory that will no longer be used in the manufacturing process or items that have potential quality problems. Excess inventory is defined as inventory in excess of one year's projected usage. Excess inventory is determined using our best estimate of future demand at the time, based upon information then available to us. In general, our policy is to scrap inventory determined to be obsolete shortly after the determination is made and to keep excess inventory for a reasonable amount of time before it is discarded. Reserves associated with obsolete or excessive inventory are written-off as obsolete or excessive inventory is scraped or discarded. Occasionally, changed circumstances in the marketplace present us with an opportunity to sell inventory that was previously determined to be excessive and reserved for. If this occurs, we intend to vigorously pursue such opportunities. Research and development expenses consist primarily of salaries and related expenses for design engineers, scientists and other technical personnel, depreciation of test and prototyping equipment, and tooling. Research and development expenses also consist of materials and overhead costs related to major product development projects. Prior to May 28, 2000, research and development expenses have included allocations from Methode Electronics, Inc. ("Methode") of expenses for salaries and related expenses for research and development personnel. We charge all research and development expenses to operations as incurred. We believe that continued investment in research and development is critical to our long-term business success. We intend to continue to invest in research and development programs in future periods for the purpose of enhancing or reducing the cost of current optical subsystems and components, and developing new optical subsystems and components. We market and sell our products domestically and internationally through our direct sales force, local resellers and manufacturers' representatives. Sales and marketing expenses consist primarily of personnel costs, including sales commissions and product marketing and promotion costs. Prior to May 28, 2000, expenses have included allocations from Methode of expenses for the salaries and related expenses for sales and marketing personnel. We expect to continue to make significant expenditures for sales and marketing services. General and administrative expenses consist primarily of personnel costs for our administrative and financial groups, as well as legal, accounting and other professional fees. General and administrative expenses also include the amortization of goodwill resulting from the excess of the purchase price over net assets of the acquired companies. Prior to May 28, 2000, expenses have included allocations from Methode for the salaries and related expenses for administrative, finance and human resources personnel; -11- professional fees; information technology and other corporate expenses. We expect to continue to make significant expenditures for general and administrative services. Basis of Presentation Our historical consolidated financial statements for periods ending on or prior to May 28, 2000 have been carved out from the consolidated financial statements of Methode using the historical results of operations and cash flows and historical basis of the assets and liabilities of our business. The historical consolidated financial statements also include allocations to us of Methode's corporate expenses, including centralized accounting, treasury, information technology, human resources, sales and marketing, legal, real estate and other corporate services and infrastructure costs. We consider the expense allocations to be reasonable reflections of the utilization of the services provided to us or the benefits received by us. The consolidated financial statements after May 28, 2000 reflect the operations, cash flows and assets and liabilities of the Company on a stand-alone basis. Our historical financial information for periods ending on or prior to May 28, 2000, is not indicative of our financial position, results of operation or cash flows in the future, nor is it necessarily indicative of what our financial position, results of operations or cash flows would have been were we a separate, stand-alone entity for the periods presented. Our consolidated financial information for periods ending on or prior to May 28, 2000 does not reflect additional expenses which we may incur as a result of being a stand-alone public company. Results of Operations The following table sets forth certain statement of operations data as a percentage of net sales for the periods indicated:
Three Months Ended Nine Months Ended January 31, January 31, ---------------------- --------------------- 2001 2002 2001 2002 ----- ----- ----- ----- Revenue: Net sales............................................... 100.0% 100.0% 100.0% 100.0% License fees and royalties.............................. 0.6 3.1 1.1 4.3 ----- ----- ----- ----- Total.................................................. 100.6% 103.1% 101.1% 104.3% Costs and expenses: Cost of sales........................................... 63.2 92.3 65.2 108.1 Research and development................................ 9.1 44.6 9.8 50.1 Sales and marketing..................................... 6.7 13.5 6.9 13.7 General and administrative.............................. 9.1 25.0 8.5 26.9 ----- ----- ----- ----- Total costs and expenses............................... 88.1 175.4 90.4 198.8 ----- ----- ----- ----- Income (loss) from operations............................. 12.5 (72.3) 10.7 (94.5) Interest income, net...................................... 5.9 6.6 5.9 7.4 ----- ----- ----- ----- Income (loss) before income taxes......................... 18.4 (65.7) 16.6 (87.1) Provision for income taxes (credit)....................... 6.4 -- 5.8 (6.1) ----- ----- ----- ----- Net income (loss)......................................... 12.0% (65.7)% 10.8% (81.0)% ===== ===== ===== =====
-12- Three and Nine Months Ended January 31, 2002 and 2001 Net Sales. Net sales for the third quarter of fiscal 2002 decreased to $12.5 million from $40.3 million in the same period a year ago. Of the $27.8 million decrease in the third quarter, $18.0 million is from a decrease in net sales of optical subsystems and $9.8 million is from a decrease in net sales of optical components. Net sales for the nine month period ended January 31, 2002 decreased 58% over the same period a year ago to $42.2 million from $100.7 million. Net sales of optical subsystems and optical components decreased $38.2 million and $20.3 million, respectively, in the nine months ended January 31, 2002 over the comparable period last year. The decrease in net sales during the three and nine month periods ended January 31, 2002 of our optical subsystems was primarily due to a decrease in sales of our embedded and removable transceivers. The decrease in sales of our optical components was primarily due to a decrease in sales of our optical backplane connectors and cable assemblies. The overall decrease in sales was primarily due to lower customer demand due to the current economic climate and reduced capital spending for optical networking equipment. Sales were also negatively impacted by declines in average unit prices for our products resulting from pricing pressure and changes in product mix. Our total sales order backlog decreased to $9.9 million as of January 31, 2002 from $34.2 million as of April 30, 2001. Of this $24.3 million decrease in backlog, $17.2 million was due to a decrease in orders for our optical subsystems, and $7.1 million was due to a decrease in orders for our optical components. These decreases reflect lower customer demand for our products, customer push-outs and cancellation of orders, due in part to delays in the launch of new product programs by our customers. License Fees and Royalties. License fees increased to $390,000 in the three months ended January 31, 2002 from $226,000 in the three months ended January 31, 2001. License fees increased to $1,837,000 in the nine months ended January 31, 2002 from $1,103,000 in the comparable period last year. These increases are primarily from the addition of two new licensees in the fourth quarter of fiscal 2001, offset in part by generally lower sales of optical subsystems and components among licensees, consistent with general economic conditions in the optical networking market. License fees consist of both fixed schedule payments and contingent payments based on sales volumes of licensed products. Cost of Sales and Gross Margins. Cost of sales decreased to $11.5 million in the three months ended January 31, 2002 from $25.5 million in the three months ended January 31, 2001 and to $45.6 million for the nine months ended January 31, 2002 compared to $65.7 million in the nine months ended January 31, 2001. Gross profit as a percentage of net sales, or gross margin, decreased to 7.7% in the three months ended January 31, 2002 from 36.8% in the three months ended January 31, 2001. Approximately 17.0 percentage points of the 29.1 percentage point decrease in gross margin was due to the decline in sales, 6.9 percentage points was due to the expenses related to the discontinuance of the VCSEL development program at our Bandwidth Semiconductor subsidiary and 9.6 percentage points was due to a charge for obsolete and slow moving inventory. These factors were offset by the sale of approximately $555,000 million of inventory that was previously considered excess and fully reserved against its cost in the fourth quarter of fiscal year 2001. The sale of this inventory favorably impacted gross margin by 4.4 percentage points. The gross margin decreased to negative (8.1)% for the nine months ended January 31, 2002 from 34.8% in the comparable period last year. Approximately 22.9 percentage points of the 42.9 percentage point decrease in gross margin was due to charges for obsolete and slow moving inventory, 16.0 percentage points of the decrease in gross margin was a result of the decline in sales, 2.1 percentage points was due to the expenses related to the discontinuance of the VCSEL development program at our Bandwidth Semiconductor subsidiary, 2.5 percentage points was due to customer returns of unusable -13- inventory and approximately 3.0 percentage points was due to a decline in the average unit selling price for our products due primarily to pricing pressures and product mix. These factors were offset by the sale of approximately $1.5 million of inventory that was previously considered excess and fully reserved against its cost in the fourth quarter of fiscal year 2001. The sale of this inventory favorably impacted gross margin by 3.6 percentage points. Cost of sales was charged approximately $1.2 million and $9.7 million in the three and nine months ended January 31, 2002 to increase the reserve for obsolete and excess inventory. The reserve was decreased by approximately $723,000 and $2.8 million in the three and nine months ended January 31, 2002 to account for the disposal of obsolete and excess inventory. Research and Development. Research and development expenses increased to $5.6 million in the three months ended January 31, 2002 from $3.6 million in the three months ended January 31, 2001. This increase of $2.0 million was due primarily to $1.0 million in material and overhead costs related to major product development projects (including $150,000 related to the discontinuance of the VCSEL development program at our Bandwidth Semiconductor subsidiary), $500,000 of additional personnel costs dedicated to research and development and $500,000 for new and expanded research and development facilities in Chicago, IL and Hudson, New Hampshire. Research and development expenses increased to $21.2 million in the nine months ended January 31, 2002 from $9.9 million in the nine months ended January 31, 2001. This increase of $11.3 million was due primarily to $6.2 million in material and overhead costs related to major product development projects (including $150,000 related to the discontinuance of the VCSEL development program at our Bandwidth Semiconductor subsidiary), and $1.9 million of material costs related to scrap experienced in increasing the performance specifications of our products to exceed the current product requirements of our customers, $3.6 million of additional personnel costs dedicated to research and development, and $1.5 million for new and expanded research and development facilities in Chicago, Illinois and Hudson, New Hampshire. Sales and Marketing. Sales and marketing expenses decreased to $1.7 million in the three months ended January 31, 2002 from $2.7 million in the three months ended January 31, 2001. This $1.0 million decrease was due to a decrease of $450,000 in sales and marketing salaries, fringe benefits, bonuses and commissions, and $550,000 in field sales operating costs supporting our sales volume. Sales and marketing expenses decreased to $5.8 million in the nine months ended January 31, 2002 from $6.9 million in the comparable period last year. This $1.1 million decrease was due both to a decrease of $500,000 in sales and marketing salaries, fringe benefits, bonuses and commissions, and $600,000 in field sales operating costs supporting our sales volume. General and Administrative. General and administrative expenses decreased to $3.1 million in the three months ended January 31, 2002 from $3.7 million in the three months ended January 31, 2001. This $600,000 decrease was primarily due to the reduction in corporate management costs after the effect of costs ($75,000) related to the discontinuance of the VCSEL development program at our Bandwidth Semiconductor subsidiary. General and administrative expenses increased to $11.4 million in the nine months ended January 31, 2002 from $8.6 million in the comparable period last year. This $2.8 million increase was primarily due to a $2.1 million increase in the allowance for doubtful accounts, and $700,000 of additional corporate management and legal costs including $75,000 related to the discontinuance of the -14- VCSEL development program at our Bandwidth Semiconductor subsidiary and approximately $285,000 of costs associated with corporate development activities. We operate in markets that are currently experiencing a severe economic downturn that began late in the third quarter of fiscal 2001 and escalated during the first quarter of fiscal 2002. As a result, many of our customers began to stretch their payment terms and our days sales in accounts receivable increased to 85 days at April 30, 2001. Days sales in accounts receivable improved to 77 days at January 31, 2002. During the first quarter of fiscal year 2002, we identified customers that we considered to be high risk relative to the collection of accounts receivable. Based upon this review, we recorded a $2.1 million provision for doubtful accounts in the first quarter of fiscal year 2002. Investment Income, Net. Investment income, net of investment expense, decreased to $834,000 in the three months ended January 31, 2002 from $2.4 million in the three months ended January 31, 2001 and decreased to $3.1 million in the nine months ended January 31, 2002 from $5.9 million in the comparable period last year. Investment income consists of earnings on the short-term investment of excess cash balances and the decreases of this income in the three and nine month periods ended January 31, 2002 reflect the reduction of excess cash balances as well as lower interest rates throughout the market place during these periods. Income Taxes. The tax benefit recognized in the nine months ended January 31, 2002 represents the benefit of tax loss carrybacks available to the Company. We determined the need for a valuation allowance in the second quarter of fiscal 2002, against the carrying value of deferred tax assets primarily associated with tax loss carry forwards based on the significant reduction in business levels experienced during the quarter and our revised estimated of taxable earnings for the remainder of the fiscal year. As a result, a $13.8 million valuation allowance has been recorded which eliminated the tax benefit attributable to the net losses incurred in the second and third quarters of fiscal 2002 (approximately $9.5 million), eliminated approximately $3.9 million of tax benefits recorded in the quarter ended July 31, 2001, and reserved for approximately $400,000 of deferred tax assets recorded as of April 30, 2001. Liquidity and Capital Resources Net cash used in operating activities totaled $15.2 million for the nine months ended January 31, 2002. The use of cash in operating activities resulted primarily from a net loss and the decrease in accounts payable and accrued expenses offset in part by decreases in accounts receivable and inventories. Net cash used in operating activities was $3.8 million for the nine months ended January 31, 2001. Cash used in operating activities resulted primarily from increases in accounts receivable and inventories offset in part by net income and increases in accounts payable and accrued expenses. Net cash used in investing activities totaled $41.7 million in the nine months ended January 31, 2002, including $21.5 million for the purchase of equipment and facilities, a $12.1 million net increase in short-term investments and $8.1 million for the acquisition of the Optical Flexcircuits division of Advanced Interconnection Technology, Inc. Net cash used in investing activities totaled $35.3 million in the nine months ended January 31, 2001, including $31.6 million for the purchase of equipment and facilities, $3.0 million for additional purchase price related to the acquisition of our Stratos Lightwave-Florida facility, and $752,000 for the acquisition of substantially all of the assets of B&H Mold, Inc. Cash used in financing activities in the nine months ended January 31, 2002 represents an advance of $3,771,000 to Tsunami Optics, Inc. Net cash provided by financing activities in the nine months ended January 31, 2001, consisted primarily of net proceeds of $196.0 million, after related expenses, from our initial public offering, and $1.5 million in advances from a subsidiary of Methode, -15- offset in part by the repayment of $2.7 million of advances from a Methode subsidiary, and $333,000 for repayment of a note assumed in connection with the acquisition of our Stratos Ltd. Subsidiary. We sold 10,062,500 shares of common stock, including the underwriters' exercise of their overallocation option, at $21 per share in our initial public offering. As of January 31, 2002, our principal source of liquidity was approximately $97.2 million in cash, cash equivalents and short-term investments. Our future capital requirements will depend on a number of factors, including our future net sales and the timing and rate of expansion of our business. We believe that our current cash balances will be sufficient to meet our cash needs for working capital and capital expenditures for the next 12 months. Factors That May Affect Our Future Results Risks Relating to Our Business We have recently incurred significant net losses, primarily due to the current economic downturn. Unless we are able to increase our sales or further reduce our costs, we will continue to incur net losses. The current economic downturn has resulted in reduced capital spending for optical networking products. As a result, many of our customers have significantly reduced, cancelled or rescheduled orders for our products and expressed uncertainty as to their future requirements. We experienced a decrease in net sales of 58% and incurred a net loss of $34.2 million during the first nine months of fiscal 2002. We expect difficult industry conditions to continue for at least the next three to six months and may continue for a longer period. Any continued or further decline in demand for our customers' products or in general economic conditions would likely result in further reduction in demand for our products and our business, operating results and financial condition would suffer. Although we have implemented personnel reductions and other cost reduction programs, many of our costs are fixed in the near term and we expect to continue to incur significant manufacturing, research and development, sales and marketing and administrative expenses. Consequently, we will need to generate higher revenues while containing costs and operating expenses if we are to return to profitability. If our efforts to increase our revenues and contain our costs are not successful, we will continue to incur net losses. Our net sales and operating results vary significantly from quarter to quarter, and our stock price may fall if our quarterly performance does not meet analysts' or investors' expectations. Our quarterly net sales and operating results have varied significantly in the past and are likely to vary significantly in the future, which makes it difficult to predict our future operating results. Accordingly, we believe that quarter-to-quarter comparisons of our net sales and operating results are not meaningful and should not be relied upon as an indicator of our future performance. Some of the factors which cause our net sales and operating results to vary include: . the timing of customer orders, particularly from our largest customers; . the level of demand for our customers' products; . the cancellation or postponement of orders; -16- . our ability to manufacture and ship our products on a timely basis; . changes in our product mix; . competitive pressures resulting in lower prices; . our ability to control costs and expenses; . the introduction of new products or technologies by us or our competitors; . the timing of our receipt of license fees and royalty payments relating to our intellectual property; and . general economic factors. Our net sales and operating results have been and in one or more future quarters will likely be below the expectations of public market analysts and investors. If this occurs, the price of our common stock would likely decline. Our success depends on the long-term growth of communication networks and their use of optical communication technologies. If these events do not occur, our net sales may decline and our business would likely be significantly harmed. Our optical subsystems and components are used primarily in enterprise, metropolitan area, wide area and telecommunication networks. These markets are rapidly evolving and it is difficult to predict their potential size or future growth rate. In addition, there is uncertainty as to the extent to which optical communication technologies will be used throughout these markets. Our success in generating revenue in these markets will depend on the long-term growth of these markets and their use of optical communication technologies. If these markets do not grow, or if the use of optical communication technologies in these markets does not expand, our net sales may decline and our business would likely be significantly harmed. We must develop new products and technology as well as enhancements to existing products and technology in order to remain competitive. If we fail to do so, our products will no longer be competitive and our net sales will decline. The market for our products and technology is characterized by rapid technological change, new and improved product introductions, changes in customer requirements and evolving industry standards. Our future success will depend to a substantial extent on our ability to develop, introduce and support new products and technology on a successful and timely basis. If we fail to develop and deploy new products and technologies or enhancements of existing products on a successful and timely basis or we experience delays in the development, introduction or enhancement of our products and technologies, our products will no longer be competitive and our net sales will decline. The introduction of new and enhanced products may cause our customers to defer or cancel orders for existing products. In addition, a slowdown in demand for existing products ahead of a new product introduction could result in a write down in the value of inventory on hand relating to existing products. The development of new, technologically advanced products is a complex and uncertain process requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. We cannot assure you that we will be able -17- to identify, develop, manufacture, market or support new or enhanced products successfully, if at all, or on a timely basis. Further, we cannot assure you that our new products will gain market acceptance or that we will be able to respond effectively to product announcements by competitors, technological changes or emerging industry standards. Any failure to respond to technological change would significantly harm our business. Our products are incorporated into larger systems which must comply with various domestic and international government regulations. If the performance of our products contributes to our customers' inability to comply with these requirements, we may lose these customers and our net sales will decline. In the United States, our products are incorporated into larger systems which must comply with various regulations and standards defined by the Federal Communications Commission and Underwriters Laboratories. Internationally, our products are incorporated into larger systems which must also comply with standards established by local authorities in various countries which may vary considerably. If the performance of our products contributes to our customers' inability to comply with existing or evolving standards established by regulatory authorities or to obtain timely domestic or foreign regulatory approvals we may lose these customers and our net sales will decline. If our products fail to comply with evolving industry standards or alternative technologies in our markets, we may be required to make significant expenditures to redesign our products. Our products comprise only a part of an entire networking system and must comply with evolving industry standards in order to gain market acceptance. In many cases, we introduce a product before an industry standard has become widely accepted and we depend on the companies that provide other components to support industry standards as they evolve. Because industry standards do not exist in some cases at the time we are developing new products, we may develop products that do not comply with the eventual industry standard. If this occurs, we would need to redesign our products to comply with adopted industry standards. In addition, if alternative technologies are adopted as an industry standard within our target markets, we would have to dedicate significant time and resources to redesign our products to meet this new industry standard. If we are required to redesign our products, we may incur significant expenses and losses due to lack of customer demand, unusable purchased components for these products and the diversion of our engineers from future product development efforts. If we are not successful in redesigning our products or developing new products to meet new standards or any other standard that may emerge, our net sales will decline. We derive a significant portion of our net sales from a few large customers, and our net sales may decline significantly if any of these customers cancels, reduces, returns or delays purchases of our products. Our success will depend on our continued ability to develop and manage relationships with significant customers. For the nine months ended January 31, 2002, our two largest customers and their respective contract manufacturers accounted for 28% of our net sales, with McData Corporation and Con-Tech Systems Inc. accounting for 24% and 4% of our net sales, respectively. For the 2001 fiscal year, our three largest customers and their respective contract manufacturers accounted for 32% of our net sales, with McData Corporation, Alcatel Network Systems and Cisco Systems accounting for 11%, 11% and 10% of our net sales, respectively. We expect our dependence on sales to a small number of large customers to continue. -18- The markets in which we sell our products are dominated by a relatively small number of systems manufacturers, thereby limiting the number of our potential customers. As a result, our relationships with these customers are critically important to our business. We cannot assure you that we will be able to retain our largest customers, that we will be able to attract additional customers or that our customers will be successful in selling their products which incorporate our products. Our customers have in the past sought price concessions from us and will continue to do so in the future. Also, many of our customers have canceled, reduced, returned or delayed purchases of our products. Further, some of our customers may in the future shift their purchases of products from us to our competitors or to joint ventures between these customers and our competitors. The loss of or a significant reduction in orders from one or more of our largest customers, our inability to successfully develop relationships with additional customers or future price concessions that we may make could cause our net sales to significantly decline. Our sales cycle runs from our customers' initial design to production for commercial sale. This cycle is long and unpredictable and may cause our net sales to decline or increase our operating expenses. We cannot predict the timing of our sales accurately because of the length of our sales cycles. As a result, if sales forecasts from specific customers are not realized, we may be unable to compensate for the sales shortfall and our net sales may decline. The period of time between our initial contact with a customer and the receipt of a purchase order may span up to a year or more, and varies by product and customer. During this time, customers may perform, or require us to perform, extensive evaluation and qualification testing of our products. Generally, they consider a wide range of issues before committing to purchase our products, including ability to interoperate with other subsystems and components, product performance and reliability. We may incur substantial sales and marketing expenses and expend significant management effort while our potential customers are qualifying our products. Even after incurring these costs, we ultimately may not sell any or only small amounts of our products to these potential customers. Consequently, if new sales do not result from our efforts to qualify our products, our operating expenses will increase. Our customers may cease purchasing our products at any time and may cancel or defer purchases on short notice, which may cause our net sales to decline or increase our operating expenses. We generally do not have long-term contracts with our customers. Sales are typically made pursuant to individual purchase orders, often with extremely short lead times, that may be canceled or deferred by customers on short notice without significant penalty. Our customers base their orders for our products on the forecasted sales and manufacturing schedules for their own products. Our customers have in the past significantly accelerated, canceled or delayed orders for our products in response to unanticipated changes in the manufacturing schedules for their own products, and will likely do so again in the future. During the last twelve months, our customers have cancelled a significant number of orders. The reduction, cancellation or delay of individual customer purchase orders has caused and could continue to cause our net sales to decline. Moreover, these uncertainties complicate our ability to accurately plan our manufacturing schedule and may increase our operating expenses. If we do not decrease our manufacturing costs or increase sales of higher margin products as the average unit price of our existing products decreases, our gross margins will decline. The average unit price of our products generally decrease as the products mature in response to increased competition, the introduction of new products and increased unit volumes. Substantially all of our products are designed and manufactured in our own facilities. Accordingly, a significant portion of our cost of sales is fixed over the near term. In order to remain competitive, we must continually reduce -19- our manufacturing costs through design and engineering changes and increases in manufacturing efficiencies. We must also continue to develop and introduce on a timely basis new products that incorporate features that can be sold at higher average selling prices. Our inability to reduce manufacturing costs or introduce new products with higher average selling prices will cause our gross margins to decline, which would significantly harm our operating results. The market for optical subsystems and components is highly competitive, which may result in lost sales or lower gross margins. The markets for optical subsystems and components are highly competitive and are expected to intensify in the future. For optical subsystems, we compete primarily with Agilent Technologies, Inc., Finisar Corporation, Infineon Technologies Corp., JDS Uniphase Corporation and Optical Communications Products, Inc. For optical components, we compete primarily with Infineon Technologies Corp, Lucent Technologies Inc., Molex, Inc. and Tyco International, Ltd. and numerous other smaller companies. Many of these companies have substantially greater financial, technical, marketing and distribution resources and brand name recognition than we have. As a result, these competitors are able to devote greater resources than we can to the development, promotion, sale and support of their products. In addition, several of our competitors have large market capitalizations or cash reserves and are much better positioned than we are to acquire other companies in our consolidating industry in order to gain new technologies or products. Many of our competitors have much greater name recognition, more extensive customer bases, better-developed distribution channels and broader product offerings. These companies can leverage their customer bases and broader product offerings and adopt aggressive pricing policies to gain market share. In addition, companies with diversified product offerings can better sustain an economic downturn. We expect that more companies, including some of our customers, will enter the markets for our products. We may not be able to compete successfully against either current or future competitors. Competitive pressures, combined with weakening demand, may result in further price reductions, lower margins and loss of market share. In addition, some of our current and potential customers are attempting to integrate their operations by producing their own optical subsystems or components or acquiring one or more of our competitors which may eliminate the need to purchase our products. Furthermore, larger companies in other related industries are developing and acquiring technologies and applying their significant resources, including their distribution channels and brand name recognition, in an effort to capture significant market share. While this trend has not historically impacted our competitive position, it may result in future decreases in our net sales. We depend on suppliers for several key components. If we underestimate or overestimate our requirements for these components, our business could be significantly harmed. We purchase several key components that are incorporated into our products from a limited number of suppliers. We have experienced shortages and delays in obtaining key components in the past and expect to experience shortages and delays in the future. These shortages and delays have typically occurred when demand within the industry has increased rapidly and exceeds the capacity of suppliers of key components in the short term. Delays and shortages also often occur in the early stages of a product's life cycle. The length of shortages and delays in the past has varied from several days to a month. We are unable to predict the length of any future shortages or delays. The inability to obtain sufficient quantities of these components that meet our quality requirements may interrupt and delay the manufacturing of our products or result in the cancellation of orders for our products. In addition, our suppliers could discontinue the manufacture or supply of these -20- components at any time. We may not be able to identify and integrate alternative sources of supply in a timely fashion, or at all. Any transition to alternative suppliers may result in delays in shipment and increased expenses and may limit our ability to deliver products to our customers. Furthermore, if we are unable to identify an alternative source of supply, we may have to redesign or modify our products, which may cause delays in shipments, increased design and manufacturing costs and increased prices for our products. We make forecasts for our component requirements based on anticipated product orders. Although we enter into long-term agreements for the purchase of key components from time to time, our purchases of key components are generally made on a purchase order basis. We may also maintain an inventory of limited source components to limit the potential impact of a component shortage. We may not accurately predict the demand for our products and the lead-time required to obtain key components. If we overestimate our requirements, we may have excess inventory, which may become obsolete and would increase our costs. If we underestimate our requirements, we may have inadequate inventory, which could interrupt our manufacturing and delay delivery of our products to our customers. Either of these occurrences would significantly harm our business. If we are unable to manage our growth effectively, we will incur additional operating expenses and our operating results will suffer. We have significantly expanded our operations over the last several years. This growth has placed a strain on our management systems and operational resources. As demand for our products grows, we will need to expand our design and manufacturing capabilities, as well as our sales, marketing and technical support. We will also need to improve our financial and managerial controls, reporting systems and procedures. The technical complexities of our products and the rapidly evolving markets we serve will require a high level of management effectiveness in managing the expansion of our operations. Our key management personnel have limited experience in managing this type of growth. If we are unable to manage our growth effectively, we will incur additional expenses which will cause our operating results to suffer. Our success depends on our ability to hire and retain qualified technical personnel, and if we are unable to do so, our product development efforts and customer relations will suffer. Our products require sophisticated manufacturing, research and development, marketing and sales, and technical support. Our success depends on our ability to attract, train and retain qualified technical personnel in each of these areas. Competition for personnel in all of these areas is intense and we may not be able to hire or retain sufficient personnel to achieve our goals or support the anticipated growth in our business. The market for the highly-trained personnel we require is very competitive, due to the limited number of people available with the necessary technical skills and understanding of our products and technology. If we fail to hire and retain qualified personnel, our product development efforts and customer relations will suffer. Our products may contain defects which may cause us to incur significant costs, divert our attention from product development efforts and result in a loss of customers. Our products are complex and may contain defects, particularly when first introduced or as new versions are released. Our customers integrate our subsystems and components into systems and products that they develop themselves or acquire from other vendors. As a result, when problems occur in equipment or a system into which our products have been incorporated, it may be difficult to identify the source of the problem. We may be subject to liability claims for damages related to product defects or -21- experience manufacturing delays as a result of these defects in the future, any or all of which could be substantial. The length of any future manufacturing delays in connection with a product defect will depend on the nature of the defect and whether we or one of our component suppliers was the source of the defect. Moreover, the occurrence of defects, whether caused by our products or technology or the products of another vendor, may result in significant customer relations problems and injury to our reputation and may impair the market acceptance of our products and technology. We are subject to environmental laws and other legal requirements that have the potential to subject us to substantial liability and increase our costs of doing business. Our properties and business operations are subject to a wide variety of federal, state, and local environmental, health and safety laws and other legal requirements, including those relating to the storage, use, discharge and disposal of toxic, volatile or otherwise hazardous substances used in our manufacturing processes. We cannot assure you that these legal requirements will not impose on us the need for additional capital expenditures or other requirements. If we fail to obtain required permits or otherwise fail to operate within these or future legal requirements, we may be required to pay substantial penalties, suspend our operations or make costly changes to our manufacturing processes or facilities. Although we believe that we are in compliance and have complied with all applicable legal requirements, we may also be required to incur additional costs to comply with current or future legal requirements. Economic, political and regulatory risks associated with international operations may limit our sales and increase our costs of doing business abroad. A portion of our sales are generated from customers located outside the United States, principally in Europe. We also operate manufacturing facilities in China and the United Kingdom. Sales to customers located outside of the United States were approximately 28.3% of our net sales during the nine months ended January 31, 2002 and approximately 19.8% of our net sales in fiscal 2001. Our international operations are subject to a number of risks and uncertainties, including: . difficulties in managing operations in different locations; . changes in foreign currency rates; . longer accounts receivable collection cycles; . difficulties associated with enforcing agreements through foreign legal systems; . seasonal reductions in business activities in some parts of the world, such as during the summer months in Europe; . trade protection measures and import and export licensing requirements; . changes in a specific country's or region's political or economic conditions; . potentially adverse tax consequences; . the potential difficulty in enforcing intellectual property rights in some foreign countries; and . acts of terrorism directed against the United States or U.S. affiliated targets. -22- These factors could adversely impact our international sales or increase our costs of doing business abroad or impair our ability to expand into international markets, and therefore could significantly harm our business. We intend to pursue additional acquisitions. If we are unable to successfully integrate any businesses or technologies that we acquire in the future or are unable to realize the intended benefits of any future acquisitions, our business will be harmed. As part of our strategy, we intend to pursue opportunities to buy other businesses or technologies that would complement our current products, expand our markets or enhance our technical capabilities, or that may otherwise offer growth opportunities. Our experience in acquiring other businesses and technologies is limited. Acquisitions could result in a number of financial consequences, including: . use of significant amounts of cash; . the incurrence of debt and contingent liabilities; . potentially dilutive issuances of equity securities; . large one-time write-offs; and . amortization expenses related to goodwill and other intangible assets. Acquisitions also involve numerous operational risks, including: . difficulties in integrating operations, products, technologies and personnel; . unanticipated costs or write-offs associated with the acquisition; . diversion of management's attention from other business concerns; . diversion of capital and other resources from our existing businesses; and . potential loss of key employees of purchased organizations. If we are unable to successfully integrate these businesses or any other businesses or technologies that we may acquire in the future or are unable to realize the intended benefits of any future acquisitions, our business will be harmed. Our recent acquisitions have not generated significant sales and require significant amounts of capital. If these businesses do not become profitable, our operating results could be seriously harmed. In May 2001, we acquired substantially all of the assets of Advanced Interconnection Technology, Inc. In February 2002, we acquired all of the capital stock of Tsunami Optics, Inc. The integration of these businesses into our company is not complete. These businesses are expected to focus on the development and introduction of new products and have not generated significant revenues to date. In addition, these businesses have or will require significant amounts of capital to support their product development activities, and we expect to continue to invest substantial amounts of capital in these businesses for the foreseeable future. If these businesses do not become profitable, our operating results could be seriously harmed. -23- Our inability to protect our intellectual property rights would significantly impair their value and our competitive position. We rely on a combination of patent, copyright, trademark and trade secret laws, as well as confidentiality agreements and licensing arrangements, to establish and protect our proprietary rights. Although we have numerous issued patents and pending patent applications, we cannot assure you that any patents will issue as a result of our pending patent applications or, if issued, that any patent claim allowed will be sufficiently broad to protect our technology. In addition, we cannot assure you that any existing or future patents will not be challenged, invalidated or circumvented, or that any right granted thereunder would provide us with meaningful protection of our technology. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy or otherwise obtain and use our products or technology. We may be unable to detect the unauthorized use of our intellectual property or to take appropriate steps to enforce our intellectual property rights. Policing unauthorized use of our products and technology is difficult. In addition, the laws of some foreign countries do not protect our proprietary rights to the same extent as do the laws of the United States. Further, enforcing our intellectual property rights could result in the expenditure of significant financial and managerial resources and the success of these efforts cannot be predicted with certainty. Litigation has been necessary and may continue to be necessary in the future to enforce our intellectual property rights. This litigation could be costly and its outcome cannot be predicted with certainty. Our inability to adequately protect against unauthorized use of our intellectual property would significantly impair its value and our competitive position. We are currently involved in pending patent litigation which, if decided against us, could impair our ability to prevent others from using our technology, result in the loss of future royalty income and require us to pay significant monetary damages. Methode and Stratos are plaintiffs in several lawsuits relating to our intellectual property rights. The defendants in these lawsuits include Infineon Technologies Corp., Optical Communications Products, Inc. and E20, Inc. In these actions, Stratos alleges that optoelectronic products sold by the defendants infringe upon certain Stratos patents. The defendants in these lawsuits have filed various affirmative defenses. As part of our separation from Methode, the Methode patents which are the subject of these lawsuits and Methode's rights in these lawsuits have been contributed to us and we have agreed to indemnify Methode against all costs, expenses and liabilities associated with these lawsuits. These lawsuits are in the preliminary stage, and we cannot predict their outcome with certainty. If one or more of these patents were found to be invalid or unenforceable, we would lose the ability to prevent others from using the technologies covered by the invalidated patents. This could result in significant decreases in our sales and gross margins for our products that use these technologies. In addition, we would lose the future royalty payments from our current licensees of these patents. We could also be required to pay significant monetary damages to one or more of the defendants or be required to reimburse them for their legal fees. Accordingly, if one or more of these patents were found to be invalid or unenforceable, our business would be significantly harmed. Claims that we infringe third-party intellectual property rights could result in significant monetary damages and expenses or restrictions on our ability to sell our products. In recent years, there has been significant litigation in the United States involving patents and other intellectual property rights. From time to time, third parties may assert patent, copyright and other intellectual property rights to technologies used in our business. In addition, our rights to use our name or other trademarks are subject to challenge by others. Any claims, with or without merit, could be time- -24- consuming, result in costly litigation, and divert the efforts of our technical and management personnel. If we are unsuccessful in defending ourselves against these types of claims, we could be subject to significant monetary damages and may be required to do one or more of the following: . stop using the challenged trademarks or selling our products that use or incorporate the relevant technology; . attempt to obtain a license to sell or use the challenged intellectual property, which license may not be available on reasonable terms or at all; or . redesign those products that use the relevant technology. In the event a claim against us was successful and we could not obtain a license to the relevant technology on acceptable terms or license a substitute technology or redesign our products to avoid infringement, our business would be significantly harmed. We are currently defending several class action lawsuits which could subject us to significant money damages, cause us to incur significant costs or otherwise harm our business. We and certain of our executive officers are defendants in certain purported class action lawsuits filed in the United States District Court, Southern District of New York. Although we believe these lawsuits are without merit, an adverse result in these lawsuits could subject us to significant money damages. This litigation may also require us to incur significant costs in defense of these lawsuits, could require significant involvement of our senior management and may divert management's attention from our business and operations, any of which could have a material adverse affect on our business, results of operation or financial condition. Risks Relating to Our Separation from Methode Electronics Our historical financial information may not be representative of our results as a separate company. Our historical financial information for periods ending on or prior to April 30, 2000 may not reflect what our results of operation, financial position and cash flows would have been had we been a stand-alone company for the periods presented. Methode did not account for us as, and we were not operated as, a stand-alone company during these periods. In addition, our historical financial information is not necessarily indicative of what our results of operations, financial position and cash flows will be in the future. We have not made adjustments to reflect many significant changes that occurred in our cost structure, funding and operations as a result of our separation from Methode, including changes in our management structure and employee benefit plans and the increased costs associated with being a public, stand-alone company. One of our directors may have conflicts of interest because he is also a director of Methode. One member of our board of directors is also a director of Methode. This director will have obligations to both companies and may have conflicts of interest with respect to matters potentially or actually involving or affecting us. In addition, this director's family owns significant amounts of Methode's stock. This ownership could create, or appear to create, potential conflicts of interest when this director is faced with decisions that could have different implications for Methode and us. -25- We may have potential business conflicts of interest with Methode with respect to our past and ongoing relationships, the resolution of which may not be as favorable to us as if we were dealing with an unaffiliated party. We currently have various interim and ongoing agreements with Methode. As a result, conflicts of interest may arise between Methode and us in a number of areas relating to our past and ongoing relationships, including: . the nature, quality and pricing of the interim services Methode has agreed to provide to us; . litigation, labor, tax, employee benefits and other matters arising from our separation from Methode; and . major business combinations involving us. We cannot assure you that we will be able to resolve any conflicts we may have with Methode or, if we are able to do so, that the resolution will be as favorable as if we were dealing with an unaffiliated party. We have agreed to contractual limitations under our separation agreements with Methode which could limit the conduct of our business and our ability to pursue our business objectives. We have agreed to contractual limitations under our separation agreements with Methode which place restrictions on our ability to conduct our business. Under our tax sharing and indemnification agreement with Methode, we have agreed to limit our ability to complete acquisitions and divestitures and issue capital stock. The purpose of these provisions is to preserve Methode's tax-free treatment of the spin-off. These restrictions in the tax sharing and indemnification agreement generally expire two years after the completion of the spin-off. Under our master separation agreement with Methode, we and our affiliates have agreed not to engage in: . the manufacture or sale, other than to our current customers as of the contribution date, of standard cable assemblies and specified cable management cabinets and value-added cable assemblies for local area networks, data centre, telecom and other project installation driven applications in Europe; . the manufacture or sale of electronic interconnect devices anywhere in the world; and/or . the sale of standard cable assembly or cable management cabinets in combination with system integration or system installation services to end-user clients in the United States and Europe. Any of these restrictions could materially limit the way in which we conduct our business and our ability to pursue our business objectives. -26- If the spin-off is not tax-free, we could be liable to Methode for the resulting taxes, which would significantly harm our business. We have agreed to indemnify Methode in the event the spin-off is not tax-free to Methode for reasons including actions taken by or with respect to us or our failure to take various actions, all as set forth in our tax sharing agreement with Methode. We may not be able to control some of the events that could trigger this liability. In particular, any acquisition of us by a third party within two years of the spin-off could result in the spin-off becoming a taxable transaction and give rise to our obligation to indemnify Methode for any resulting tax or other liability. If we were to become obligated to indemnify Methode for this liability, our financial condition and business would be significantly harmed. Risks Relating to the Securities Markets and Ownership of Our Common Stock The market prices for securities of technology related companies have been volatile in recent years and our stock price could fluctuate significantly. Our common stock has been publicly traded only since June 27, 2000. The market price of our common stock has been subject to significant fluctuations since the date of our initial public offering. These fluctuations could continue. Factors that could affect our stock price include: . economic and stock market conditions generally and specifically as they may impact participants in the communication industry; . earnings and other announcements by, and changes in market evaluations of, participants in the optical communication industry; . changes in financial estimates and recommendations by securities analysts following our stock; . announcements or implementation by us or our competitors of technical innovations or new products; and . strategic moves by us or our competitors, such as acquisitions. In addition, the securities of many companies have experienced extreme price and volume fluctuations in recent years, often unrelated to the companies' operating performance. Specifically, market prices for securities of technology related companies have frequently reached elevated levels, often following their initial public offerings. These levels may not be sustainable and may not bear any relationship to these companies' operating performances. Provisions in our charter documents and Delaware law may delay or prevent an acquisition of our company, which could decrease the value of your shares. Our restated certificate of incorporation and bylaws and Delaware law contain provisions that could make it more difficult for a third party to acquire us without the consent of our board of directors. These provisions include a classified board of directors and limitations on actions by our stockholders by written consent. In addition, our board of directors has the right to issue preferred stock without stockholder approval, which could be used to dilute the stock ownership of a potential hostile acquiror. Delaware law also imposes some restrictions on mergers and business combinations between us and any -27- holder of 15% or more of our outstanding common stock. These provisions apply even if the offer may be considered beneficial by some stockholders. We recently adopted a shareholder rights plan which has anti-takeover effects. We recently entered into a shareholder rights plan. The plan has the anti-takeover effect of causing substantial dilution to a person or group that attempts to acquire us on terms not approved by our board of directors. The existence of the plan could limit the price that certain investors might be willing to pay in the future for shares of our common stock and could discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. Item 3. Quantitative and Qualitative Disclosures About Market Risk Although certain of the Company's subsidiaries enter into transactions in currencies other than their functional currency, foreign currency exposures arising from these transactions are not material to the Company. The primary foreign currency exposure arises from the translation of the Company's net equity investment in its foreign subsidiaries to U.S. dollars. The Company generally views as long-term its investments in foreign subsidiaries with functional currencies other than the U.S. dollar. The primary currencies to which the Company is exposed are the pound sterling and the Chinese renmimbi. -28- PART II OTHER INFORMATION ----------------- Item 1. Legal Proceedings. Pending Litigation From time to time, we become involved in various lawsuits and legal proceedings that arise in the normal course of business. Litigation is subject to inherent uncertainties and an adverse result in a lawsuit may harm our business, financial condition or results of operation. The Company's management is of the opinion that the resolution of these lawsuits and legal proceedings will not have a significant effect on the Company's business, financial condition or results of operation. The Company and certain of its directors and executive officers have been named as defendants in purported class action lawsuits filed in the United States District Court, Southern District of New York. The first of these lawsuits, filed on July 25, 2001, is captioned Kucera v. Stratos Lightwave, Inc. et. al., No. 01 CV 6821. Three other similar lawsuits have also been filed against the Company and certain of its directors and executive officers. The complaints also name as defendants the underwriters for the Company's initial public offering. The complaints are substantially identical to numerous other complaints filed against other companies that went public over the last several years. The complaints generally allege, among other things, that the registration statement and prospectus from the Company's June 26, 2000 initial public offering failed to disclose certain alleged actions by the underwriters for the offering. The complaints charge the Company and two or three of its directors and executive officers with violations of Sections 11 and 15 of the Securities Act of 1933, as amended, and/or Sections 10(b) and Section 20(a) of the Securities Exchange Act of 1934, as amended. The complaints also allege claims solely against the underwriting defendants under Section 12(a)(2) of the Securities Act of 1933, as amended. The Company believes that these lawsuits are without merit and intends to defend them vigorously. Methode and Stratos are plaintiffs in several lawsuits relating to our intellectual property rights. The defendants in these lawsuits include Infineon Technologies Corp. and Optical Communications Products, Inc. in the U.S. District Court for the Northern District of California and E2O, Inc. in the District Court for the District of Delaware. In these actions, Stratos alleges that optoelectronic products sold by the defendants infringe upon up to nine of our patents. We are seeking monetary damages and injunctive relief. The defendants in these lawsuits have filed various affirmative defenses and contend that the patents are invalid, unenforceable and/or not infringed by the products sold by the defendants and, if successful, are seeking attorneys' fees and costs in connection with the lawsuits. As part of our separation from Methode, the Methode patents which are the subject of these lawsuits and Methode's rights in this litigation have been contributed to us and we have agreed to indemnify Methode against all costs, expenses and liabilities associated with these lawsuits. We intend to pursue these lawsuits and defend against these counterclaims vigorously. These lawsuits are in the preliminary stage, and we cannot predict their outcome with certainty. Patent litigation is particularly complex and can extend for a protracted time, which can substantially increase the cost of such litigation. If one or more of these patents were found to be invalid or unenforceable, we would lose the ability to prevent others from using the technologies covered by the invalidated patents. This could result in significant decreases in our sales and gross margins for our products that use these technologies. In addition, we would lose the future royalty payments from our current licensees of these patents. We could also be required to pay significant monetary damages to one or more of the defendants and/or be -29- required to reimburse them for their legal fees. Accordingly, if one or more of these patents were found to be invalid or unenforceable, our business would be significantly harmed. Settled Litigation Stratos was previously a plaintiff in a lawsuit against Finisar Corporation pending in the United States District Court for the Northern District of California. In this action, Stratos alleged that optoelectronic products sold by Finisar infringed upon certain Stratos' patents. Finisar had filed various affirmative defenses and counterclaims against Stratos, including claims that Finisar invented and was the rightful owner or co-owner of the subject patents. In February 2002, Methode, Stratos and Finisar entered into an agreement under which they dismissed their claims against one another and released each other from claims pending prior to the agreement, including Finisar's claims of ownership and inventorship and Stratos' claims of patent infringement and damages. However, neither party believes that the agreement will have a material adverse effect on its business or financial condition. Item 2. Changes in Securities and Use of Proceeds. Stratos Lightwave's registration statement on Form S-1 filed under the Securities Act of 1933, Commission File No. 333-34864, was declared effective by the Commission on June 26, 2000. A total of 10,062,500 shares of our common stock were registered pursuant to this registration statement. The managing underwriters for the offering were Lehman Brothers, CIBC World Markets, U.S. Bancorp Piper Jaffray, Robert W. Baird & Co., Tucker Anthony Cleary Gull, and Fidelity Capital Markets, a division of National Financial Services Corporation. The offering commenced on June 26, 2000 and has been completed. All 10,062,500 registered shares, including 1,312,500 shares sold upon exercise of the underwriters' over allotment option, were sold by Stratos Lightwave at an initial public offering price of $21.00 per share. The aggregate underwriting discount paid in connection with the offering was $14,791,875. The net proceeds from the offering, after deducting the underwriting discount and the estimated offering expenses to be paid by Stratos Lightwave, were approximately $195 million. Uses of proceeds to date include $68.7 million for general corporate purposes and the purchase of equipment and facilities, payments of $11.8 million in connection with various acquisitions, $3.8 million for a loan to Tsunami Optics, Inc., repayment of $2.7 million of advances from a Methode subsidiary, and $333,000 for repayment of a note assumed in connection with the acquisition of our Stratos Ltd. subsidiary. The remainder of the proceeds will be used for general corporate purposes, including working capital, capital expenditures, and research and development. Pending these uses, the remaining net proceeds have been invested in short-term interest bearing, investment grade marketable securities. Other than the repayment of advances from a Methode subsidiary described above and the payment of the additional purchase price described above in connection with our Stratos Lightwave-Florida acquisition which was paid to two of our officers (and the payment of salaries and expense reimbursements to employees in the ordinary course of business), none of the net proceeds of the offering have been paid, directly or indirectly, to any Stratos Lightwave director or officer or any of their associates, to any persons owing 10 percent or more of our common stock, or to any Stratos Lightwave affiliate. Item 6. Exhibits and Reports on Form 8-K. (a) Exhibits. Please see the Exhibit Index following the signature page. -------- -30- (b) Reports on Form 8-K. No Current Reports on Form 8-K were filed by the Registrant in the three months ended January 31, 2002. The Registrant filed a Current Report on Form 8-K on February 15, 2002 to report the acquisition of Tsunami Optics, Inc. -31- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Dated: March 12, 2002 Stratos Lightwave, Inc. By: /s/ James W. McGinley ------------------------------------------ James W. McGinley President and Chief Executive Officer By: /s/ David A. Slack ------------------------------------------- David A. Slack Chief Financial Officer (Principal Financial and Accounting Officer) -32- EXHIBIT INDEX Exhibit Number Description of Document ------- ----------------------- 3.1 Certificate of Incorporation of Registrant (1) 3.2 Restated Certificate of Incorporation of Registrant (1) 3.3 Bylaws of Registrant (1) 3.4 Certificate of Designation of Series A Junior Participating Preferred Stock, included as Exhibit A to Exhibit 4.2 4.1 Specimen certificate representing the common stock (1) 4.2 Rights Agreement, dated as of March 23, 2001, between Stratos Lightwave, Inc. and Mellon Investor Services LLC (2) 10.1 Master Separation Agreement between Methode Electronics, Inc. and Registrant (1) 10.2 Initial Public Offering and Distribution Agreement between Methode Electronics, Inc. and Registrant (3) 10.3 Tax Sharing and Indemnification Agreement between Methode Electronics, Inc. and Registrant (3) 10.4 Master Transitional Services Agreement between Methode Electronics, Inc. and Registrant (1) 10.5 Employee Matters Agreement between Methode Electronics, Inc. and Registrant (1) 10.6 Registration Rights Agreement between Methode Electronics, Inc. and Registrant (3) 10.7 General Assignment and Assumption Agreement between Methode Electronics, Inc. and Stratos Lightwave, LLC (1) 10.8 Form of Indemnity Agreement between Registrant and Registrant's directors and officers (1) 10.9 Stratos Lightwave, Inc. 2000 Stock Plan, as amended and restated (4) 10.10 Promissory Note of the Registrant payable to Methode Development Company (1) 10.11 Agreement and Plan of Reorganization, dated January 22, 2002, by and among the Registrant, Tundra Acquisition Corp. and Tsunami Optics, Inc. (5) 10.12 Stratos Lightwave, Inc. 2002 Stock Plan for Acquired Companies (6) ------------------------- (1) Incorporated by reference to the Registrant's Registration Statement on Form S-1 effective June 26, 2000. (2) Incorporated by reference to the Registrant's Form 8-K dated March 22, 2001. (3) Incorporated by reference to the Registrant's Quarterly Report on Form 10-Q for the quarter ended July 31, 2000. (4) Incorporated by reference to the Registrant's Annual Report on Form 10-K for the year ended April 30, 2001. (5) Incorporated by reference to the Registrant's Form 8-K dated February 15, 2002. (6) Incorporated by reference to the Registrant's Registration Statement on Form S-8 dated January 31, 2002. -33-