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 September 30, 2001. OR [_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from to . Commission File Number: 0-30757 --------------- Sunrise Telecom Incorporated (Exact name of Registrant as specified in its charter) --------------- Delaware 77-0291197 (State or other jurisdiction of (IRS Employer Identification No.) incorporation or organization) 302 Enzo Drive, San Jose, California 95138 (Address of principal executive offices, including zip code) Registrant's telephone number, including area code: (408) 363-8000 22 Great Oaks Blvd., San Jose, California 95119 (Former address of principal executive offices, including zip code) --------------- Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [_] As of November 2, 2001, there were 50,429,000 shares of the Registrant's Common Stock outstanding, par value $0.001. 1 SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES TABLE OF CONTENTS
Page PART I. Financial Information Number --------------------- ------ Item 1 Financial Statements (unaudited) Condensed Consolidated Balance Sheets as of September 30, 2001 and December 31, 2000................................................................ 3 Condensed Consolidated Statements of Operations for the three and nine months ended September 30, 2001 and 2000........................................ 4 Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2001 and 2000............................................. 5 Notes to Condensed Consolidated Financial Statements................................. 6 Item 2 Management's Discussion and Analysis of Financial Condition and Results of Operations ................................................ 10 Item 3 Quantitative and Qualitative Disclosures about Market Risk........................... 25 PART II. Other Information ----------------- Item 1 Legal Proceedings .................................................................. 26 Item 2 Changes in Securities and Use of Proceeds .......................................... 26 Item 3 Defaults Upon Senior Securities .................................................... 26 Item 4 Submission of Matters to a Vote of Security Holders ................................ 26 Item 5 Other Information .................................................................. 26 Item 6 Exhibits and Reports on Form 8-K ................................................... 26 Signatures ...................................................................................... 27
2 PART I. Financial Information ITEM 1. SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except share data, unaudited)
September 30, December 31, 2001 2000 ---- ---- ASSETS Current assets: Cash and cash equivalents $ 33,888 $ 56,298 Investment in marketable securities 8,248 6,300 Accounts receivable, net 14,702 18,419 Inventories 10,207 13,330 Prepaid expenses and other current assets 763 1,748 Deferred tax assets 2,806 4,245 -------------- --------------- Total current assets 70,614 100,340 Property and equipment, net 29,185 8,580 Intangible assets, net 18,140 11,725 Deferred tax assets 1,433 799 Investment in marketable securities 5,483 - Other assets 1,437 4,112 -------------- --------------- Total assets $ 126,292 $ 125,556 ============== =============== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 1,523 $ 2,578 Short-term borrowings and current portion of notes payable 474 780 Other accrued expenses 11,199 12,581 Income taxes payable 659 1,888 Deferred revenue 233 546 -------------- --------------- Total current liabilities 14,088 18,373 -------------- --------------- Notes payable, less current portion 636 1,047 Other liabilities 800 492 Stockholders' equity: Common stock, $0.001 par value per share; 175,000,000 shares 50 50 authorized; 50,436,000 and 49,941,000 shares issued and outstanding, respectively. Additional paid-in capital 69,723 68,317 Deferred stock-based compensation (4,941) (6,611) Retained earnings 46,005 43,961 Accumulated other comprehensive loss (69) (73) -------------- --------------- Total stockholders' equity 110,768 105,644 -------------- --------------- Total liabilities and stockholders' equity $ 126,292 $ 125,556 ============== ===============
The accompanying notes are an integral part of these condensed consolidated financial statements. 3 SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share data, unaudited)
Three Months Nine Months Ended September 30, Ended September 30, 2001 2000 2001 2000 ---- ---- ---- ---- Net sales $ 17,952 $ 35,085 $ 61,483 $ 82,361 Cost of sales 5,952 10,034 20,185 23,604 -------- --------- --------- --------- Gross profit 12,000 25,051 41,298 58,757 -------- --------- --------- --------- Operating expenses: Research and development 4,320 5,283 13,904 13,121 Selling and marketing 4,640 6,157 15,820 16,611 General and administrative 3,383 2,619 10,715 6,367 -------- --------- --------- --------- Total operating expenses 12,343 14,059 40,439 36,099 -------- --------- --------- --------- Income (loss) from operations (343) 10,992 859 22,658 Other income, net 472 635 2,061 632 -------- --------- --------- --------- Income before income taxes 129 11,627 2,920 23,290 Income tax expense 39 4,302 876 8,617 -------- --------- --------- --------- Net income $ 90 $ 7,325 $ 2,044 $ 14,673 ======== ========= ========= ========= Earnings per share: Basic $ 0.00 $ 0.15 $ 0.04 $ 0.32 ======== ========= ========= ========= Diluted $ 0.00 $ 0.14 $ 0.04 $ 0.30 ======== ========= ========= ========= Shares used in per share computation: Basic 50,351 49,178 50,124 46,572 ======== ========= ========= ========= Diluted 51,319 51,855 51,394 48,849 ======== ========= ========= =========
The accompanying notes are an integral part of these condensed consolidated financial statements. 4 SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands, unaudited)
Nine Months Ended September 30, 2001 2000 ----------- ----------- Cash flows from operating activities: Net income $ 2,044 $ 14,673 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization 6,202 2,995 Amortization of deferred stock-based compensation 1,634 1,405 Loss on the sale of property and equipment 48 48 Deferred income taxes 739 (2,370) Change in operating assets and liabilities (net of acquisition balances): Accounts receivable 4,480 (12,119) Inventories 3,668 (6,197) Prepaid expenses and other assets 101 (871) Accounts payable and accrued expenses (3,132) 7,512 Income taxes payable (1,043) 348 Deferred revenue (37) 302 -------- -------- Net cash provided by operating activities 14,704 5,726 -------- -------- Cash flows from investing activities: Capital expenditures (18,714) (4,104) Purchases of marketable securities (17,846) (4,544) Sales of marketable securities 10,458 -- Acquisitions, net of cash acquired (11,275) (4,717) -------- -------- Net cash used in investing activities (37,377) (13,365) -------- -------- Cash flows from financing activities: Net payments of short-term borrowings (192) -- Payments on notes payable (558) (1,412) Proceeds from issuance of common stock 742 51,608 Proceeds from exercise of stock options 310 759 -------- -------- Net cash provided by financing activities 302 50,955 -------- -------- Effect of exchange rate changes on cash (39) (122) -------- -------- Net increase (decrease) in cash and cash equivalents (22,410) 43,194 Cash and cash equivalents at the beginning of the period 56,298 8,615 -------- -------- Cash and cash equivalents at the end of the period $ 33,888 $ 51,809 ======== ======== Supplemental cash flow disclosures: Cash paid during the period: Interest $ 40 $ 113 ======== ======== Income taxes $ 865 $ 8,635 ======== ======== Noncash investing and financing activities: Promissory note issued in connection with acquisition $ -- $ 1,000 ======== ======== Stock issued for acquisition of Pro.Tel $ -- $ 5,000 ======== ======== Unrealized gain (loss) on marketable securities $ 42 $ (3) ======== ======== Deferred stock-based compensation $ -- $ 6,500 ======== ========
The accompanying notes are an integral part of these condensed consolidated financial statements. 5 SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (1) Basis of Presentation Sunrise Telecom Incorporated and subsidiaries (collectively, "the Company") manufacture and market service verification equipment to pre-qualify, verify, and diagnose telecommunications, cable TV, and Internet networks. The Company markets and distributes its products on six continents through a worldwide network of manufacturers, sales representatives, distributors, and direct sales people. The Company has wholly owned subsidiaries in Norcross, Georgia; Taipei, Taiwan; Modena, Italy; Tokyo, Japan; Seoul, Korea; and Anjou, Canada. It also has a representative liaison office in Beijing, China and a foreign sales corporation in Barbados. These condensed consolidated financial statements, including the notes to the condensed consolidated financial statements included herein, have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission ("SEC"). In the opinion of management, the accompanying condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary for their fair presentation. These financial statements and notes should be read in conjunction with the Company's audited financial statements and notes thereto, included in the Company's Annual Report on Form 10-K for the year ended December 31, 2000 filed with the SEC. The interim results presented are not necessarily indicative of results that may be expected for any subsequent interim period or for the full fiscal year ending December 31, 2001. (2) Earnings Per Share Basic earnings per share ("EPS") is computed using the weighted-average number of common shares outstanding during the period. Diluted EPS is computed using the weighted-average number of common and dilutive common equivalent shares outstanding during the period. Dilutive common equivalent shares consisted of common stock issued in the Pro.Tel acquisition and common stock issuable upon exercise of stock options using the treasury stock method. The following is a reconciliation of the shares used in the computation of basic and diluted EPS (in thousands):
Three Months Nine Months Ended September 30, Ended September 30, 2001 2000 2001 2000 ------ ------ ------ ------ Basic EPS-weighted-average number of common shares outstanding.............................................. 50,351 49,178 50,124 46,572 Effect of dilutive common equivalent shares: Stock options outstanding................................ 968 2,677 1,270 2,110 Stock issued in acquisition subject to put arrangement... - - - 167 ------ ------ ------ ------ Diluted EPS-weighted-average number of common shares outstanding.............................................. 51,319 51,855 51,394 48,849 ====== ====== ====== ======
6 (3) Comprehensive Income Comprehensive income comprises net income and other comprehensive income. Other comprehensive income includes certain changes in the equity of the Company that are excluded from net income. The components of comprehensive income, net of tax, are as follows (in thousands):
Three Months Ended Nine Months Ended September 30, September 30, 2001 2000 2001 2000 ---- ---- ---- ---- Net income................................... $ 90 $7,325 $2,044 $14,673 Change in unrealized gain (loss) on available-for-sale investments............ 91 (3) 42 (3) Cumulative translation adjustment............ 52 (86) (39) (122) ---- ------ ------ ------- Total comprehensive income................... $233 $7,236 $2,047 $14,548 ==== ====== ====== =======
(4) Recent Accounting Pronouncements In July 2001, the Financial Accounting Standards Board ("FASB") issued two new pronouncements: Statement of Financial Accounting Standards ("SFAS") No. 141, "Business Combinations", and SFAS No. 142, "Goodwill and Other Intangible Assets". SFAS No. 141, which is required to be adopted immediately, prohibits the use of the pooling-of-interest method for business combinations initiated after June 30, 2001 and also applies to all business combinations accounted for by the purchase method that are completed after June 30, 2001. There are also transitional provisions that apply to business combinations completed before July 1, 2001, which were accounted for by the purchase method. SFAS No. 142 is effective for fiscal years beginning after December 15, 2001 and applies to all goodwill and other intangible assets recognized in an entity's balance sheet at that date, regardless of when those assets were initially recognized. The Company's adoption of SFAS No. 141 did not have a significant impact on its financial position and results of operations. The Company is currently evaluating the provisions of SFAS No. 142 and the effect of this statement on the Company's financial statements. In October 2001, FASB issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets", which is effective for financial statements issued for fiscal years beginning after December 15, 2001. SFAS No. 144 develops one accounting model for long-lived assets that are to be disposed of by sale, and requires that these assets be measured at the lower of book value or fair value less costs to sell. Additionally, SFAS No. 144 expands the scope of discontinued operations to include all components of an entity with operations that (1) can be distinguished from the rest of the entity, and (2) will be eliminated from the ongoing operations of the entity in a disposal transaction. The Company is currently evaluating the provisions of SFAS No. 144 and the effect of this statement on the Company's financial statements. (5) Inventories Inventories consisted of the following (in thousands):
September 30, December 31, 2001 2000 ---- ---- Raw materials.................................... $ 5,570 $ 8,987 Work-in-process.................................. 1,934 2,070 Finished goods................................... 2,703 2,273 ----------- ---------- $ 10,207 $ 13,330 =========== ==========
(6) Notes Payable and Line of Credit The Company has a $9,000,000 revolving line of credit with a financial institution that expires on August 1, 2002, bearing interest at the bank's prime rate less 0.25% (5.75% as of September 30, 2001). The agreement, which is collateralized by the receivables and inventories of the Company, contains certain financial covenants and restrictions. As of September 30, 2001, there were no balances outstanding under the line of credit. The Company also had borrowings from various Italian financial institutions, which bear interest at variable rates, ranging from 7.375% to 7.625% at September 30, 2001, based on the ABI prime rate. At September 30, 2001, 7 approximately $42,000 had been drawn down under these facilities. Generally, these foreign credit lines do not require commitment fees or compensating balances and are cancelable at the option of the Company or the financial institutions. In connection with various acquisitions completed during 1999 and 2000, the Company has three non-interest bearing notes payable outstanding at September 30, 2001. Amounts to be repaid under these notes total $59,000 for October through December 2001 and $413,000, $384,000, and $175,000 for fiscal years 2002, 2003, and 2004, respectively. The remaining notes payable balance consists of equipment leases payable. (7) Acquisitions On February 22, 2000, the Company acquired all the outstanding shares of Pro. Tel. S.r.l. and subsidiaries ("Pro. Tel"), an Italian manufacturer of distributed network signaling analysis equipment. On January 8, 2001, the Company acquired all the outstanding shares of Avantron Technologies Inc. ("Avantron"), a Canadian company that specializes in the design and manufacture of Cable TV / modem spectrum analyzers and performance monitoring systems. The following summary is prepared on an unaudited pro forma basis and reflects the condensed consolidated results of operations for the three and nine-month periods ended September 30, 2001 and 2000, assuming Pro.Tel and Avantron had been acquired at the beginning of the periods presented (in thousands, except per share data):
Three Months Ended Nine Months Ended September 30, September 30, 2001 2000 2001 2000 ---- ---- ---- ---- Net sales............................................ $17,952 $36,502 $61,483 $87,194 Net income........................................... $ 57 $ 6,962 $ 1,917 $12,949 Basic earnings per share............................. $ 0.00 $ 0.14 $ 0.04 $ 0.28 Shares used in pro forma per share computation....... 50,351 49,178 50,124 46,850
The pro forma results are not necessarily indicative of what would have occurred if the acquisitions had been in effect for the periods presented. In addition, they are not intended to be a projection of future results and do not reflect the synergies that might be achieved from combined operations. (8) Segment Information SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information", sets forth standards for the manner in which public companies report information about operating segments, products, services, geographic areas, and major customers in annual and interim financial statements. The method of determining what information to report is based on the way that management organizes the operating segments within the enterprise for making operating decisions and assessing financial performance. The Company's chief operating decision-maker is considered to be the Chief Executive Officer (CEO). The CEO reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenue by geographic region for purposes of making operating decisions and assessing financial performance. The consolidated financial information reviewed by the CEO is the same as the information presented in the accompanying condensed consolidated statements of operations. As the Company's assets are primarily located in its corporate offices in the United States and not allocated to any specific segment, the Company does not produce reports for or measure the performance of its segments based on any asset-based metrics. Therefore, the Company operates in a single operating segment which incorporates the design, manufacture, and sale of digital test equipment for telecommunications, transmission, cable, and signaling applications. 8 Revenue information regarding operations in the different geographic regions is as follows (in thousands):
Three Months Ended Nine Months Ended September 30, September 30, 2001 2000 2001 2000 ---- ---- ---- ---- North America.................................. $12,243 $28,213 $41,656 $65,581 Europe/Africa/Middle East...................... 2,618 2,910 7,840 7,621 Asia/Pacific................................... 2,463 3,052 9,583 6,600 Latin America.................................. 628 910 2,404 2,559 ------- ------- ------- ------- $17,952 $35,085 $61,483 $82,361 ======= ======= ======= =======
Revenue information by product category is as follows (in thousands):
Three Months Ended Nine Months Ended September 30, September 30, 2001 2000 2001 2000 ---- ---- ---- ---- Wire line access (including DSL)............... $10,377 $27,160 $39,346 $67,021 Cable TV....................................... 2,912 1,655 8,579 2,630 Fiber optics................................... 3,877 4,733 10,750 9,696 Signaling...................................... 786 1,537 2,808 3,014 ------- ------- ------- ------- $17,952 $35,085 $61,483 $82,361 ======= ======= ======= =======
9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS In addition to the other information in this report, certain statements in the following Management's Discussion and Analysis of Financial Condition and Results of Operation (MD&A) are forward-looking statements. When used in this report, the word "expects," "anticipates," "estimates," and similar expressions are intended to identify forward-looking statements. Such statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. Such risks and uncertainties are set forth below under "Factors Affecting Future Operating Results." The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements and notes thereto included elsewhere in this report. Overview We manufacture and market service verification equipment to pre-qualify, verify, and diagnose telecommunications, cable, and Internet networks. We design our products to maximize technicians' effectiveness in the field and to provide realistic network simulations for equipment manufacturers to test their products. Our customers include incumbent local exchange carriers, competitive local exchange carriers, other service providers, and network infrastructure suppliers and installers throughout North America, Latin America, Europe, Africa, the Middle East, and the Asia/Pacific region. Sources of Net Sales We sell our products predominantly to large telecommunications and cable TV service providers. These prospective customers generally commit significant resources to an evaluation of our and our competitors' products and require each vendor to expend substantial time, effort, and money educating the prospective customer about the value of the proposed solutions. Delays associated with potential customers' internal approval and contracting procedures, procurement practices, and testing and acceptance processes are common and may cause potential sales to be delayed or foregone. As a result of these and related factors, the sales cycle of new products for large customers typically ranges from 6 to 24 months. In recent months, we have observed a slowing of growth as well as a decline in capital spending in the telecommunications industry, which may lengthen the sales cycle further. Substantially all of our sales are made on the basis of purchase orders rather than long-term agreements or requirements contracts. As a result, we commit resources to the development and production of products without having received advance or long-term purchase commitments from customers. Historically, a significant portion of our net sales have resulted from a small number of relatively large orders from a limited number of customers. Sales to SBC Communications affiliates have decreased to less than 6% of net sales in the first nine months of 2001, from $16.2 million or 20% of net sales for the same period in 2000, primarily due to the slowing of DSL deployment and the decline in the telecommunications industry capital equipment spending levels. Additionally, in the first nine months of 2001, $6.3 million or 10% of our net sales were generated from an OEM product sold to both Lucent Technologies and to Solectron, a contract manufacturer for Lucent Technologies, as compared to $13.9 million or 17% for the same period in 2000. Solectron integrated this OEM product into the Stinger DSLAM product that it manufactures for Lucent Technologies. No customers comprised more than 10% of our sales during the third quarter of 2001. We anticipate that our operating results for any given period will continue to be dependent to a significant extent on large purchase orders, which can be delayed or cancelled by our customers without penalty. In addition, we anticipate that our operating results for a given period will continue to be dependent on a small number of customers. Currently, competition in the telecommunications and cable equipment market is intense and is characterized by declining prices due to increased competition and new products. Due to competition and potential pricing pressures from large customers in the future, we expect that the average selling price for our products will decline over time. If we fail to reduce our production costs accordingly, our gross margins will correspondingly decline. See "Factors Affecting Future Operating Results--Competition and --Risks of the Telecommunications Industry." During the last three years, a substantial portion of our net sales have come from customers located outside of the United States, and we believe that continued growth will require expansion of our sales in international markets. Currently, we maintain a procurement support and manufacturing facility in Taipei, Taiwan; manufacturing, research, development, and sales facilities in Modena, Italy; and research, development, and sales facilities in Anjou, Canada. We also have a representative liaison office in Beijing, China, a foreign sales corporation in Barbados, and sales offices in Tokyo, Japan and Seoul, Korea, and we may establish additional international sales and other offices in the future. 10 Prior to our acquisition of Pro.Tel in February 2000, international sales were denominated solely in U.S. dollars and, accordingly, we have not historically been exposed to fluctuations in non-U.S. currency exchange rates related to these sales activities. Since our acquisitions of Pro.Tel in February 2000 and then Avantron in January 2001, we have had a small amount of sales denominated in Euros and Canadian dollars, respectively, and have at certain times used derivative financial instruments to hedge our foreign exchange risks. As of September 30, 2001, we had no financial derivative instruments. To date, foreign exchange exposure from sales has not been material to our operations. We have also been exposed to fluctuations in non-U.S. currency exchange rates related to our procurement activities in Taiwan. In the future, we expect that a growing portion of international sales may be denominated in currencies other than U.S. dollars, thereby exposing us to gains and losses on non-U.S. currency transactions. We may choose to limit such exposure by using hedging strategies. See "Factors Affecting Future Operating Results--Risks of International Operations." We recognize product sales at the time of shipment unless we have future obligations or customer acceptance is required, in which case revenue is recognized when these obligations have been met or the customer accepts the product. We offer a three-year warranty covering parts and labor on our wire line access (including DSL) products and fiber optic products sold in the United States and generally offer a one-year warranty covering parts and labor for our products sold overseas, with a two-year extended warranty option at time of sale. Our cable TV and signaling products are covered by a one-year warranty. Revenue from sales of extended warranties is deferred and recognized over the extended warranty term, which is generally two years. We charge estimated warranty costs to cost of sales when the related sales are recognized. We recognize revenue for out-of-warranty repair when we ship the repaired product. Cost of Sales Our cost of sales consist primarily of the following: . direct material costs of product components, manuals, product documentation, and product accessories; . production wages, taxes, and benefits; . production allocated overhead costs; . warranty costs; . the costs of board level assembly by third party contract manufacturers; and . scrapped material used in the production process. We recognize direct cost of sales, wages, taxes, benefits, and allocated overhead costs as we ship product. We expense scrapped materials as incurred. Our industry is characterized by limited supply chains and long lead times for the materials and components that we use in the manufacture of our products. If we underestimate our requirements, we may have inadequate inventory, resulting in additional product costs for expediting delivery of long lead-time components. An increase in the cost of components could result in lower margins. Additionally, these long lead times have in the past, and may in the future, cause us to purchase large quantities of some parts, increasing our investment in inventory and the risk of the parts' obsolescence. Any subsequent write-off of inventory could also result in lower margins. See "Factors Affecting Future Operating Results--Dependence on Sole and Single Source Suppliers". 11 Operating Costs We classify our operating expenses into three general categories: selling and marketing, research and development, and general and administrative. Our operating expenses include stock-based compensation and amortization of goodwill and other intangible assets. We classify charges to the selling and marketing, research and development, and general and administrative expense categories based on the nature of the expenditures. Although each of these three categories includes expenses that are unique to the category type, there are commonly recurring expenditures that typically appear in all of these categories, such as salaries, amortization of stock-based compensation, employee benefits, travel and entertainment costs, allocated communication costs, rent and facilities costs, and third party professional service fees. The selling and marketing category of operating expenses also includes expenditures specific to the selling and marketing group, such as commissions, public relations and advertising, trade shows, and marketing materials. We allocate the total cost of overhead and facilities to each of the functional areas that use overhead and facilities based upon the square footage of facilities used by each of these areas or the headcount in each of these areas. These allocated charges include facility rent and utilities for the corporate office, communications charges, and depreciation expenses for our building and for office furniture and equipment. In the first nine months of 2001, we recorded amortization of deferred stock-based compensation expense of $1,634,000 related to the grant of pre-IPO options to purchase our common stock at exercise prices subsequently deemed to be below fair market value. Total compensation expense related to these options, which were granted in 1999 and the first quarter of 2000, will be amortized on a straight-line basis, over the respective four-year vesting periods of the options, to the departments of the employees who received these below market option grants. In the first nine months of 2001 and 2000, we allocated amortization of deferred stock-based compensation expense of $223,000 and $189,000, respectively, to cost of sales, $633,000 and $560,000, respectively, to research and development expense, $496,000 and $420,000, respectively, to selling and marketing expense, and $282,000 and $236,000, respectively, to general and administrative expense. Also, we recorded amortization of goodwill and other intangible assets of $3,825,000 and $1,723,000, respectively, in general and administrative expense. At September 30, 2001, $4,941,000 of deferred stock-based compensation expense remained to be amortized, at a rate not exceeding $545,000 per quarter. Acquisitions In February 2000, we acquired Pro.Tel, an Italian manufacturer of distributed network signaling analysis equipment, its U.S. affiliate, and the assets of an unrelated U.S. distributor. We accounted for this acquisition using the purchase method and, accordingly, recorded goodwill of $8.9 million, to be amortized on a straight-line basis over its original estimated useful life of two to five years, until the end of 2001. Beginning January 1, 2002, we will implement SFAS No. 142, and accordingly, we will no longer amortize goodwill resulting from the Pro. Tel. Acquisition. At December 31, 2001, we expect to have $5.6million in unamortized goodwill remaining from the Pro. Tel. Acquisition. We will periodically review this asset for impairment, as required by SFAS No. 142. In addition, we recorded deferred stock-based compensation for stock options granted to employees of Pro.Tel in the first quarter of 2000 in the amount of $6.5 million, to be amortized on a straight-line basis over their four-year vesting period and non-compete amortization of $0.5 million to be amortized on a straight-line basis over the next two to five years, based on the expected life of the underlying assets. In January 2001, we acquired Avantron, a Canadian company that specializes in the design and manufacture of cable TV/modem spectrum analyzers and performance monitoring systems. The purchase price was Cdn. $17.6 million (U.S. $11.9 million) in cash and short-term notes payable. We accounted for this acquisition using the purchase method, and, accordingly, recorded goodwill of $10.3 million, to be amortized on a straight-line basis over its original estimated useful life of two to five years, until the end of 2001. Beginning January 1, 2002, we will implement SFAS No. 142, and accordingly, we will no longer amortize goodwill resulting from the Avantron acquisition. At December 31, 2001, we expect to have $8.2 million in unamortized goodwill remaining from the Avantron acquisition. We will periodically review this asset for impairment, as required by SFAS No. 142. We believe that acquisitions and joint ventures may be an important part of our growth and competitive strategy. See "Factors Affecting Future Operating Results--Acquisitions." 12 Salary Reductions In response to a slowdown in our customers' telecom spending patterns and softening demand for telecom equipment generally, we implemented a salary reduction across the company ranging from 5% at the lowest paid employee level up to 25% at the founder executive management level. This reduction commenced during the second quarter of 2001. A salary freeze was also implemented along with this base salary reduction. Results of Operations Comparison of Three and Nine-Month Periods Ended September 30, 2001 and 2000 Net Sales. Net sales decreased 49% to $18.0 million in the third quarter of 2001, from $35.1 million for the same quarter in 2000. Net sales decreased 25% to $61.5 million in the first nine months of 2001, from $82.4 million for the same period in 2000. The decrease for the third quarter of 2001 consisted of a sales decrease of $16.8 million in our wire line access products, including DSL products, a sales decrease of $0.9 million in our fiber optics products, and a sales decrease of $0.8 million in our signaling products, which were partially offset by a $1.3 million increase in sales of our cable TV products. The decrease for the first nine months of 2001 consisted of a sales decrease of $27.7 million in our wire line access products, including DSL products, and a sales decrease of $0.2 million in our signaling product lines, which were partially offset by $5.9 million and $1.1 million increases in sales of our cable TV and fiber optics products, respectively. The increase in cable TV is primarily due to revenues gained by the acquisition of Avantron in January 2001. Sales in the third quarter of 2001 as compared to the same period in 2000 decreased $16.0 million or 57% in North America, $0.3 million or 10% in Europe/Africa/Middle East, $0.6 million or 19% in Asia Pacific, and $0.3 million or 33% in Latin America. Sales in the first nine months of 2001 as compared to the same period in 2000 decreased $23.9 million or 36% in North America and $0.2 million or 8% in Latin America, which were offset with an increase of $0.2 million or 3% in Europe/Africa/Middle East and $3.0 million or 45% in Asia Pacific. The decrease in North American sales during the third quarter and the first nine months of 2001, over the same periods in 2000 is primarily due to a $13.5 million and a $24.8 million decrease, respectively, in sales of our wire line access products, including DSL products. We anticipate that demand for our wire line access products in North America may continue to decline in the fourth quarter of 2001 due to an overall slowdown in the telecommunications equipment market. Factors contributing to the decrease in sales of wire line access products, including DSL, include the decrease in sales to Lucent for the copper loop test head, which sales are not expected to be material for the remainder of the year. Sales to Lucent for the copper loop test head were $0 and $8.9 million for the third quarter of 2001 and 2000 respectively, and $6.3 million and $13.9 million for the first nine months of 2001 and 2000 respectively. In addition, over the past year some DSL providers have encouraged customer self-installation and have reported that up to 90% of their customers perform self-installation. If the self-installation procedure reduces the need for technicians to test for DSL service, demand for our DSL wire line access products may decline further as our equipment may be used primarily for troubleshooting rather than installation. International sales, including North American sales to Canada, decreased to $6.5 million, or 36% of net sales in the third quarter of 2001, from $9.3 million, or 26% of net sales in the same quarter in 2000. International sales, including Canada, increased to $22.1 million, or 36% of net sales in the first nine months of 2001, from $20.0 million, or 24% of net sales in the same period in 2000. The decrease in international sales is primarily due to decreased sales of our wire line access products, including DSL. Cost of Sales. Cost of sales consists primarily of direct material, warranty, and personnel costs related to the manufacturing of our products and allocated overhead. Cost of sales decreased 41% to $6.0 million in the third quarter of 2001, from $10.0 million in the same quarter in 2000. The decrease is primarily due to the decrease in net sales for the third quarter of 2001. Cost of sales decreased 14% to $20.2 million in the first nine months of 2001, from $23.6 million in the same period in 2000. Cost of sales represented 33% and 29% of net sales in the third quarter of 2001 and 2000, respectively, and 33% and 29% of net sales in the first nine months of 2001 and 2000, respectively. The increase as a percentage of net sales resulted primarily from a shift in our sales mix toward higher sales volume of light chassis DSL products, which have lower average selling prices than full chassis DSL products, and increased sales of our cable TV products, which generated lower gross margins than the mix of products sold during the prior year, as well as the cost of sales associated with the negotiated completion of our original Lucent OEM orders. We expect that cost of sales may continue to increase as a percentage of sales for the foreseeable future 13 if our light chassis DSL products and cable TV products increase as a percentage of our overall product mix, if international sales continue to grow as a percentage, or if pricing pressures increase. Research and Development. Research and development expenses consist primarily of the costs of payroll and benefits for engineers, equipment, and consulting services. Research and development expenses decreased 18% to $4.3 million in the third quarter of 2001, from $5.3 million for the same quarter in 2000. Research and development expenses increased 6% to $13.9 million in the first nine months of 2001, from $13.1 million for the same period in 2000. Research and development expenses represented 24% and 15% of net sales during the third quarters of 2001 and 2000, respectively, and 23% and 16% of net sales during the first nine months of 2001 and 2000, respectively. The decrease in absolute dollars was primarily due to cost cutting measures implemented during the period. Research and development expenses may increase in absolute dollars as we continue to invest in product development and expand our product lines. Selling and marketing. Selling and marketing expenses consist primarily of the costs of payroll and benefits for selling and marketing personnel, manufacturers' representatives and direct sales commissions, travel, facilities expenses related to selling and marketing, and trade show and advertising expenses. Selling and marketing expenses decreased 25% to $4.6 million in the third quarter of 2001, from $6.2 million in the same quarter in 2000. Selling and marketing expenses decreased 5% to $15.8 million in the first nine months of 2001, from $16.6 million in the same period in 2000. Selling and marketing expenses represented 26% and 18% of net sales during the third quarters of 2001 and 2000, respectively, and 26% and 20% of net sales during the first nine months of 2001 and 2000, respectively. The decrease in absolute dollars in 2001 was primarily related to cost cutting measures implemented during the period. Selling and marketing expenses may increase in absolute dollars as we continue to invest in our selling and marketing capabilities. General and Administrative. General and administrative expenses consist primarily of payroll and benefits, facilities, other costs of our finance and administrative departments, legal and accounting expenses, and amortization expenses for goodwill and other intangible assets related to our business acquisitions. General and administrative expenses increased 29% to $3.4 million in the third quarter of 2001, from $2.6 million in the same quarter in 2000. General and administrative expenses increased 68% to $10.7 million in the first nine months of 2001, from $6.4 million in the same period in 2000. General and administrative expenses represented 19% and 7% of net sales during the third quarters of 2001 and 2000, respectively, and 17% and 8% of net sales during the first nine months of 2001 and 2000, respectively. The increase in absolute dollars and as a percentage of net sales was primarily due to amortization of goodwill and other intangible assets related to the recent business acquisitions, amortization of deferred stock-based compensation, increased staffing and occupancy costs associated with the growth of our business, increased professional fees for accounting and legal. General and administrative expenses may increase in absolute dollars to accommodate the growth of our business, to add related infrastructure, and to pursue our acquisition strategy. Other Income, Net. Other income, net primarily represents interest earned on cash and investment balances net of interest expense on notes payable and short-term borrowings under our line of credit. Other income, net decreased to $0.5 million in the third quarter of 2001, from $0.6 million for the same quarter in 2000, and increased to $2.1 million in the first nine months of 2001, from $0.6 million for the same period in 2000. The increase resulted primarily from interest income earned on the net proceeds received from our initial public offering in July 2000 and miscellaneous income of $0.2 million relating to proceeds from a litigation settlement. Income Tax Expense. Income tax expense consists of federal, state, and international income taxes. We recorded income tax expense of $39,000 in the third quarter of 2001 and a $4.3 million expense in the same quarter in 2000. We recorded income tax expense of $0.9 million in the first nine months of 2001 and $8.6 million in the same period in 2000. Our effective income tax rates were 30% for the third quarter and first nine months of 2001 and 37% for the same periods in 2000. Income tax expense and the effective income tax rates are lower in 2001 than in 2000 primarily due to lower levels of income. Seasonality Our sales have been seasonal in nature and tied to the buying patterns of our customers. In years prior to 2000, the largest quarterly sales have usually been during the last calendar quarter of the year, as customers spent the unused portions of their annual budgets. In 2000, there was a change in this fourth quarter seasonality with no significant remaining unused budget dollars available for an increase in the fourth quarter seasonal sales. There has been no indication that the fourth quarter 2001 will return to historical seasonal trends. We expect that our quarterly operating results may fluctuate significantly and will be difficult to predict given the nature of our business. Many 14 factors could cause our operating results to fluctuate from quarter to quarter in the future, including the lengthy and unpredictable buying patterns of our customers, the degree to which our customers allocate and spend their yearly budgets, and the timing of our customers' budget processes. Liquidity and Capital Resources Historically, we have financed our operations and satisfied our capital expenditure requirements primarily through cash flow from operations and borrowings under our line of credit. Additionally, in July of 2000, we received net proceeds totaling $51.6 million from our initial public offering. As of December 31, 2000 and September 30, 2001, we had working capital of $82.0 million and $56.5 million, respectively, and cash and cash equivalents of $56.3 million and $33.9 million, respectively. As of September 30, 2001, we also had $13.7 million in investments in marketable securities. During the nine months ended September 30, 2001, we generated $14.7 million in cash flow from operating activities, compared to $5.7 million during the same period in 2000. Operating cash flow increased primarily as a result of collections of accounts receivable and a reduction in inventory purchases. Also, the amount of non-cash charges against net income increased significantly in the nine months ended September 30, 2001 from the same period in 2000. Therefore, the decline in the net income over these respective periods was not associated with a proportional decline in operating cash flow. The factors increasing operating cash flow were partially offset by decreases in accounts payable and accrued expenses and income taxes payable. During the nine months ended September 30, 2001, we used $37.4 million in cash flow for investing activities, as compared to $13.4 million during the same period in 2000. For the first nine months of 2001, cash used in investing activities included $18.7 million for capital expenditures, including our new facility, $11.3 million for acquisitions, and $17.8 million for purchases of marketable securities. Cash provided by investing activities was $10.5 million from the sale of marketable securities. During the first nine months of 2000, cash used in investing activities was $4.7 million for acquisitions, $4.6 million for purchases of marketable securities, and $4.1 million for capital expenditures. Cash used for capital expenditures increased during the first nine months of 2001 over the same period in 2000 primarily due to the completion of our new facility in San Jose, California. Cash outlays for the facility during the first nine months of 2001 were $8.8 million for the land and $5.6 million for construction. Cash used for capital expenditures during the first nine months of 2001 also included research and development laboratory equipment, general office equipment to support the new facility, and demonstration equipment to support our selling and marketing programs. During the nine months ended September 30, 2001, we generated $0.3 million in cash flow from financing activities, compared to $51.0 million generated during the same period in 2000. For the first nine months of 2001, proceeds from stock options exercised were $0.3 million, and proceeds from common stock issued were $0.7 million. This was offset by $0.6 million used to repay notes payable and $0.2 million to repay short-term borrowings. During the first nine months of 2000, cash provided by financing activities consisted of net proceeds of approximately $51.6 million from our initial public offering in July 2000 and $0.8 million from stock options exercised, which were partially offset by $1.4 million used to repay notes payable. Currently, we have a line of credit from Bank of America, N.A. for up to $9.0 million in borrowings at the bank's prime rate less 0.25% (5.75% at September 30, 2001). The line of credit expires on August 1, 2002. At December 31, 2000 and September 30, 2001, there were no balances outstanding under the line of credit. Borrowings under the line of credit are secured by our inventory and accounts receivable. The agreement governing the line of credit contains covenants, with which we were in compliance at December 31, 2000 and at September 30, 2001, that, among other things: . require us to maintain various financial covenants, including profitability and current ratios; . limit capital expenditures; . restrict the payment of dividends on our common stock to dividends payable in common stock and to $1.0 million payable in any one fiscal year; and . restrict our ability to redeem our common stock beyond 20% of our net income for the prior fiscal year. 15 We also have credit facilities from various Italian financial institutions ranging from $0.2 million up to $1.0 million, which bear interest at variable rates ranging from 7.375% to 7.625% at September 30, 2001 based on the ABI prime rate. At September 30, 2001 there was approximately $42,000 outstanding under these facilities. We believe that the net proceeds received by us from our initial public offering, together with current cash balances, cash flows from operations, and available borrowings under our line of credit will be sufficient to meet our anticipated cash needs for working capital, capital expenditures, and other activities for at least the next 12 months. After that, if current sources are not sufficient to meet our needs, we may seek additional equity or debt financing. In addition, any material acquisition of complementary businesses, products or technologies, or material joint ventures could require us to obtain additional equity or debt financing. We cannot assure you that such additional financing would be available on acceptable terms, if at all. Factors Affecting Future Operating Results Quarterly Fluctuations--Because our quarterly operating results have fluctuated significantly in the past and are likely to fluctuate significantly in the future, our stock price may decline and may be volatile. In the past, we have experienced significant fluctuations in our quarterly results due to a number of factors beyond our control. In the future, our quarterly operating results may fluctuate significantly and may be difficult to predict given the nature of our business. Many factors could cause our operating results to fluctuate from quarter to quarter in the future, including the following: . the size and timing of orders from our customers, which may be exacerbated by our customers' buying patterns lengthening and being more unpredictable, and our ability to ship these orders on a timely basis; . the impact of the September 11/th/ terrorist attacks on the United States and the resulting economic slowdown on our customers' purchasing decisions; . the degree to which our customers have allocated and spent their yearly budgets; . the uneven pace of technological innovation, the development of products responding to these technological innovations by us and our competitors, and customer acceptance of these products and innovations; . the varied degree of price, product, technology competition, and our customers' and competitors' responses to these changes; . the relative percentages of our products sold domestically and internationally; . the mix of the products we sell and the varied margins associated with these products; and . the timing of our customers' budget processes. The factors listed above may affect our business and stock price in several ways. Given the high fixed costs related to overhead, research and development, and advertising and marketing, among others, if our net sales are below our expectations in any quarter, we may not be able to adjust spending accordingly. As a result of the above, our stock price may decline and may be volatile, particularly if public market analysts and investors perceive these factors to exist, whether or not that perception is accurate. Furthermore, the above factors, taken together may make it more difficult for us to issue additional equity in the future or raise debt financing to fund future acquisitions and accelerate growth. These risks may be exacerbated by, or may be in addition to, the risk of a general economic slowdown that affects the economy as a whole or the telecommunications industry in particular. Dependence on DSL--The majority of our sales have been from our DSL products. Demand for our DSL products has recently declined and may decline further. In fiscal 2000 and the first nine months of 2001, sales of our DSL and other wire line access products represented approximately 81% and 64% of our net sales, respectively. Currently, our DSL products are primarily used by a limited number of incumbent local exchange carriers, including the regional Bell operating companies, 16 and competitive local exchange carriers, who offer DSL services. A competitive local exchange carrier is a company that, following the Telecommunications Act of 1996, is authorized to compete in a local communications services market. These parties, and other Internet service providers and users, are continuously evaluating alternative high-speed data access technologies, including cable modems, fiber optics, wireless technology, and satellite technologies, and may at any time adopt these competing technologies. These competing technologies may ultimately prove to be superior to DSL services and reduce or eliminate the demand for our DSL products. In addition, the availability and quality of DSL service may be impaired by technical limitations and problems of the existing copper wire network on which DSL service runs, such as: . the distance of end users from the central office of the incumbent local exchange carrier, which is typically limited to between 12,000 and 18,000 feet; . the quality and degree of interference within the copper wire network; . the configuration of the copper wire network, which may degrade or prevent DSL service; . the ability of DSL networks and operational support systems of service providers to connect and manage a substantial number of online end users at high speeds, while achieving reliable and high quality service; and . the vulnerability of the copper wire network to physical damage from natural disasters and other unanticipated telecommunications failures and problems. During 2001, the business prospects of many competitive local exchange carriers have declined. Some competitive local exchange carriers have filed for the protection of the bankruptcy court or gone out of business. Due to these and other factors, we have seen a slowing in the growth of DSL deployment and a softening in the demand for our DSL products. If DSL deployment rates decrease or remain flat, demand for our DSL products may decline further. It is not possible to predict whether any decline would be temporary or sustained. Accordingly, our future success is substantially dependent upon whether DSL technology continues to gain growing and widespread market acceptance by exchange carriers, end users of their services, and other Internet service providers and users. In the past, our customers have deployed DSL equipment, including our products, in substantially larger volumes than their subscriber count. In addition, the inability of our current or future customers to acquire and retain subscribers as planned, or to respond to competition for their services or reduced demand for their services, could cause them to reduce or eliminate their DSL deployment plans. If our customers are forced to curtail their DSL deployment plans, our sales to them will likely decline. Risks of the Telecommunications Industry--We face several risks regarding the telecommunications industry, including the possible effects of its unpredictable growth or decline, the possible effects of consolidation among our principal customers, and the risk that deregulation will slow. Since the passage of the Telecommunications Act of 1996, the telecommunications industry has experienced rapid growth. The growth has led to great innovations in technology, intense competition, short product life cycles, and, to some extent, regulatory uncertainty inside and outside the United States. The course of the development of the telecommunications industry is, however, difficult to predict. Companies operating in this industry have a difficult time forecasting future trends and developments and forecasting customer acceptance of competing technologies. One possible effect of this uncertainty is that there is, and may continue to be, a delay or a reduction in these companies' investment in their business and purchase of related equipment, such as our products, and a reduction in their and our access to capital. In addition, deregulation may result in a delay or a reduction in the procurement cycle because of the general uncertainty involved with the transition period of businesses. The growth that has occurred since the passage of the Telecommunications Act of 1996 has slowed, and it is unknown whether or when it will resume. This slowdown includes reduced investment in the telecommunications industry in general and delayed purchase orders for service verification equipment such as our products in particular. It is not possible to predict whether this slowdown will be temporary, or sustained. In addition, the telecommunications industry has been experiencing consolidation among its primary participants, such as incumbent local exchange carriers and competitive local exchange carriers, several of whom are our primary customers. For example, in recent years, SBC Communications Inc. acquired Pacific Bell Telephone 17 Company and Ameritech Corporation, both of which were customers of ours. Continued consolidation may cause delay or cancellation of orders for our products. The consolidation of our customers will likely provide them with greater negotiating leverage with us and may lead them to pressure us to lower the prices of our products. In the United States, there is litigation pending that challenges the validity of the Telecommunications Act of 1996 and the local telephone competition rules adopted by the Federal Communications Commission to implement that act. If deregulation in international markets or in the United States were to slow or to take an unanticipated course, the telecommunications industry might suffer, among other effects, the following: . a general slowdown in economic activity relating to the telecommunications industry and a consequent multiplier effect on the general economy; . reduced investment in the telecommunications industry in general, and in DSL technology in particular, due to increased uncertainty regarding the future of the industry and this technology; . greater consolidation of providers of high-speed access technologies, which may not favor the development of DSL technology and which might provide these companies with greater negotiating leverage regarding the prices and other terms of the DSL products and services they purchase; . uncertainty regarding judicial and administrative proceedings, which may affect the pace at which investment and deregulation continue to occur; and . delay in purchase orders of service verification equipment, such as our products, if customers were to reduce their investment in new high-speed access technologies. Customer Concentration--A limited number of customers account for a high percentage of our net sales, and any adverse factor affecting these customers or our relationship with these customers could cause our net sales to decrease. Our customer base is highly concentrated, and a relatively small number of companies have accounted for a large percentage of our net sales. Net sales from our top five customers in the United States represented approximately 16% of net sales in 1998, 49% in 1999, 42% in 2000 and 25% in the first nine months of 2001. Our largest customers over this period have been affiliates of SBC Communications Inc., which include Pacific Bell Telephone Company, Southwestern Bell Telephone Company, Ameritech Corporation, Nevada Bell, Advanced Solutions, Inc., and Southern New England Telephone and which in total accounted for approximately 16% of net sales in fiscal 2000, but less than 6% in the first nine months of 2001. Additionally, sales to both Lucent Technologies and Solectron, a contract manufacturer for Lucent Technologies' Stinger DSLAM products, represented approximately 17% of sales in 2000 and 10% in the first nine months of 2001. As of the end of the second quarter of 2001, our initial contract orders from Lucent Technologies for the Copper Loop Test Head came to a negotiated completion. In general, our customers are not obligated to purchase a specific amount of products or to provide us with binding forecasts of purchases for any period. We expect that we will continue to depend upon SBC's affiliates and upon other major customers for a significant portion of our net sales. As a result of the general slowdown in the United States economy, our net sales including those to SBC's affiliates have declined and anticipate that future sales may continue to decline from our fiscal 2000 net sales. Our future sales to Lucent Technologies and Solectron may be immaterial. Sales of DSL related equipment, in particular, have declined and may continue to decline in 2001 compared to 2000. The loss of a major customer or the reduction, delay, or cancellation of orders from one or more of our significant customers could cause our net sales and, therefore, profits to decline. In addition, many of our customers are able to exert substantial negotiating leverage over us. As a result, they may cause us to lower our prices and to negotiate other terms and provisions that may negatively affect our business and profits. Use of Field Technicians--If service providers reduce their use of field technicians and continue successful implementation of a self-service installation model, demand for our products could decrease. To ensure quality service, our major service provider customers have historically sent a technician, who uses our products, into the field to verify service for installations. SBC Communications, Qwest Communications, Bell South Corporation and Verizon Communications encourage customers to install DSL themselves. Over the past year, some DSL providers have reported that up to 90% of their customers perform self-installation. Additionally, AT&T has begun a self- installation program for cable modem devices. By encouraging customers to install DSL and cable access themselves, these companies intend to reduce their expenses and expedite installation for their customers. To encourage self-installation, these companies offer financial incentives. If service providers continue successful 18 implementation of these plans or choose to send technicians into the field only after a problem has been reported, or if alternative methods of verification become available, such as remote verification, the need for field technicians and the need for our products would decrease. Product Development--If we are unable to enhance our existing products and to manage successfully the development of new products, our future success may be threatened. The market for our products is characterized by rapid technological advances, changes in customer requirements and preferences, evolving industry and customer-specific protocol standards, and frequent new product enhancements and introductions. Our existing products and our products currently under development could be rendered obsolete by the introduction of products involving competing technologies, by the evolution of alternative technologies or new industry protocol standards, or by rival products by our competitors. These market conditions are more complex and challenging because of the introduction of the high degree to which the telecommunications industry is fragmented. We believe our future success will depend, in part, upon our ability, on a timely and cost-effective basis, to continue to do the following: . anticipate and respond to varied and rapidly changing customer preferences and requirements, a process made more challenging by our customers' buying patterns; . anticipate and develop new products and solutions for networks based on emerging technologies, such as the asynchronous transfer mode protocol that packs digital information into cells to be routed across a network, and Internet telephony, which comprises voice, video, image, and data across the Internet, that are likely to be characterized by continuing technological developments, evolving industry standards, and changing customer requirements; . invest in research and development to enhance our existing products and to introduce new verification and diagnostic products for the telecommunications, Internet, cable network, and other markets; and . support our products by investing in effective advertising, marketing, and customer support. We cannot ensure that we will accomplish these objectives, and our failure to do so could have a material adverse impact on our market share, business and financial results. SalesImplementation Cycles--The length and unpredictability of the sales and implementation cycles for our products makes it difficult to forecast revenues. Sales of our products often entail an extended decision-making process on the part of prospective customers. We frequently experience delays following initial contact with a prospective customer and expend substantial funds and management effort pursuing these sales. Our ability to forecast the timing and amount of specific sales is therefore limited. As a result, the uneven buying patterns of our customers may cause fluctuations in our operating results, which could cause our stock price to decline. Other sources of delays that lead to long sales cycles, or even a sales loss, include current and potential customers' internal budgeting procedures, internal approval and contracting procedures, procurement practices, and testing and acceptance processes. Recently our customers' budgeting procedures have lengthened. The sales cycle for larger deployment now typically ranges from 6 to 24 months and up to six or more months. The deferral or loss of one or more significant sales could significantly affect operating results in a particular quarter, especially if there are significant selling and marketing expenses associated with the deferred or lost sales. Electrical Blackouts in California--Possible shutdowns in our manufacturing operations could occur. Beginning in 2000 and continuing into 2001, California has experienced restricted supplies of electrical power. These restricted supplies have resulted in blackouts and higher electricity costs. Since we do not have back up generators, should we experience blackouts, our business will be negatively affected by slowed production, slowed research and development, slowed marketing, slowed sales efforts, and a general loss of productivity. In addition, increased electrical rates will increase our costs and lower our margins. 19 Managing Growth and Slowdowns--We may have difficulty managing our expanding operations, which could reduce our chances of maintaining our profitability. We have experienced rapid growth in revenues and in our business in 1999 and 2000 and a slowdown in 2001 that has placed, and may continue to place, a significant strain on our management and operations. For example, our revenues have increased from approximately $61.5 million in 1999 to $113.5 million in 2000. Yet revenues have slowed to $61.5 million for the first nine months of 2001 from $82.4 million in the first nine months of 2000, and our number of employees has increased from 118 at December 31, 1998 to 383 at September 30, 2001. To date, we have acquired three significant companies: Hukk Engineering in July 1999, Pro.Tel. S.r.l. and subsidiaries in February 2000, and Avantron Technologies Inc. in January 2001. As a result of our historical growth and future growth, or slowdowns, we face several risks, including the following: . the need to improve our operational, financial, management, informational, and control systems; . the need to hire, train, and retain highly skilled personnel in a market in which there may be severe shortages of these kinds of personnel, as we discuss below; . the possibility that our management's attention will be diverted from running our business to the needs of managing a public company; and . the challenge to manage expense reductions as rapidly as revenue slowdowns without impacting development strategies. We cannot ensure that we will be able to manage growth or slowdowns profitably. Acquisitions--We have acquired three significant companies and intend to pursue further acquisitions in the future. These activities involve numerous risks, including the use of cash, amortization of goodwill, and the diversion of management attention. As discussed in the previous section, we have acquired three significant companies to date: Hukk Engineering, Pro.Tel S.r.l., and Avantron Technologies Inc. As a result of these and other smaller acquisitions, we face numerous risks, including the following: . integrating the existing management, sales force, technicians, and other personnel into one culture and business; . integrating manufacturing, administrative, and management information and other control systems into our existing systems; . developing and implementing an integrated business strategy over what had previously been three independent companies; and . developing compatible or complementary products and technologies from previously independent operations. The risks stated above will be made more difficult because Hukk Engineering is located in Norcross, Georgia; Avantron is located in Anjou, Canada; and Pro.Tel is located in Modena, Italy. In addition, if we make future acquisitions, these risks will be exacerbated by the need to integrate additional operations at a time when we may not have fully integrated all of our previous acquisitions. If we pursue further acquisitions, we will face similar risks as those above and additional risks, including the following: . the diversion of our management's attention and the expense of identifying and pursuing suitable acquisition candidates, whether or not consummated; . negotiating and closing these transactions; 20 . the potential need to fund these acquisitions by dilutive issuances of equity securities and by incurring debt; and . the potential negative effect on our financial statements from the increase in goodwill and other intangibles, the write-off of research and development costs, and the high cost and expenses of completing acquisitions. We cannot ensure that we will locate suitable acquisition candidates or that, if we do, we will be able to acquire them and then integrate them successfully and efficiently into our business. Competition--Competition could reduce our market share and decrease our net sales. The market for our products is fragmented and intensely competitive, both inside and outside the United States, and is subject to rapid technological change, evolving industry standards, regulatory developments, and varied and changing customer preferences and requirements. We compete with a number of United States and international suppliers that vary in size and in the scope and breadth of the products and services offered. The following table sets forth our principal competitors in each of our product categories.
Product Category Principal Competitors ---------------- --------------------- Wire Line Access (including DSL) Acterna Corporation; Agilent Technologies, Inc.; Tollgrade Communications, Inc.; Turnstone Systems, Inc. Fiber Optics SONET/SDH Digital Lightwave, Inc.; Acterna Corporation ; Agilent Technologies, Inc. Cable TV Acterna Corporation; Agilent Technologies, Inc. Signaling Inet Technologies, Inc.; GN Nettest
Many of these competitors have longer operating histories, larger installed customer bases, longer relationships with customers, wider name recognition and product offerings, and greater financial, technical, marketing, customer service, and other resources than we have. We expect that, as our industry and markets evolve, new competitors or alliances among competitors with existing and new technologies may emerge and acquire significant market share. We anticipate that competition in our markets will increase, and we will face greater threats to our market share, price pressure on our products, and the likelihood that, over time, our profitability may decrease. Over the past year, we have recorded lower revenue and gross margin. In addition, it is difficult to assess accurately the market share of our products or of Sunrise overall because of the high degree of fragmentation in the market for DSL service verification equipment, in particular, and for high-speed data access technology, in general. As a result, it may be difficult for us to forecast accurately trends in the markets, which of our products will be the most competitive over the longer term and, thus, what is the best use of our human and other forms of capital. We cannot ensure that we will be able to compete effectively. Dependence on Key Employees--If one or more of our senior managers were to leave, we could experience difficulties in replacing them and our operating results could suffer. Our success depends to a significant extent upon the continued service and performance of a relatively small number of key senior management, technical, sales, and marketing personnel. In particular, the loss of either of two of our founders, Paul Ker-Chin Chang and Paul A. Marshall, would likely harm our business. Neither of these individuals is bound by an employment agreement with us, and we do not carry key man life insurance on them. In addition, competition for senior level personnel with telecommunications knowledge and experience is intense. If any of our senior managers were to leave Sunrise, we would need to devote substantial resources and management attention to replace them. As a result, management attention may be diverted from managing our business, and we may need to pay higher compensation to replace these employees. 21 Dependence on Sole and Single Source Suppliers--Because we depend on a limited number of suppliers and some sole and single source suppliers that are not contractually bound in the long-term, our future supply of parts is uncertain. We purchase many key products, such as microprocessors, field programmable gate arrays, bus interface chips, optical components, and oscillators, from a single source or sole suppliers, and we license certain software from third parties. We rely exclusively on third-party subcontractors to manufacture some sub-assemblies, and we have retained, from time to time, third party design services in the development of our products. We do not have long-term supply agreements with these vendors. In general, we make advance purchases of some products and components to ensure an adequate supply, particularly for products that require lead times of up to nine months to manufacture. In the past, we have experienced supply problems as a result of financial or operational difficulties of our suppliers, shortages, and discontinuations resulting from component obsolescence or other shortages or allocations by suppliers. Our reliance on these third parties involves a number of risks, including the following: . the unavailability of critical products and components on a timely basis, on commercially reasonable terms, or at all; . the unavailability of products or software licenses, resulting in the need to qualify new or alternative products or develop or license new software for our use and/or to reconfigure our products and manufacturing process, each of which could be lengthy and expensive; . the likelihood that, if these products are not available, we would suffer an interruption in the manufacture and shipment of our products until the products or alternatives become available; . reduced control over product quality and cost, risks that are exacerbated by the need to respond, at times, to unanticipated changes and increases in customer orders; and . the unavailability of, or interruption in, access to some process technologies. In addition, the purchase of these components on a sole source basis subjects us to risks of price increases and potential quality assurance problems. This dependence magnifies the risk that we may not be able to ship our products on a timely basis to satisfy customers' orders. We cannot ensure that one or more of these factors will not cause delays or reductions in product shipments or increases in product costs, which in turn could have a material adverse effect on our business. Risksof International Operations--Our plan to expand sales in international markets could lead to higher operating expenses and may subject us to unpredictable regulatory and political systems. Sales to customers located outside of the United States represented 42% of our net sales in 1998, 20% in 1999, 26% in 2000, and 36% in the first nine months of 2001, and we expect international revenues to continue to account for a significant percentage of net sales for the foreseeable future. In addition, an important part of our strategy calls for further expansion into international markets. As a result, we will face various risks relating to our international operations, including the following: . potentially higher operating expenses, resulting from the establishment of international offices, the hiring of additional personnel, and the localization and marketing of products for particular countries' technologies; . the need to establish relationships with government-owned or subsidized telecommunications providers and with additional distributors; . fluctuations in foreign currency exchange rates and the risks of using hedging strategies to minimize our exposure to these fluctuations, which have been heightened by our recent acquisition of Pro.Tel and Avantron, whose revenues have been and are likely to continue to be in Italian lira and Canadian dollars, respectively; and . potentially adverse tax consequences related to acquisitions and operations, including the ability to claim goodwill deductions and a foreign tax credit against U.S. federal income taxes, especially since Italy has a higher tax rate. 22 We cannot ensure that one or more of these factors will not materially and adversely affect our ability to expand into international markets or our revenues and profits. In addition, the Asia/Pacific and Latin America regions have experienced instability in many of its economies and significant devaluations in local currencies. 11% of our sales in 1999, 13% in 2000 and 19% of our sales in the first nine months of 2001 were derived from customers located in these regions. These instabilities may continue or worsen, which could have a materially adverse effect on our results of operations. If international revenues are not adequate to offset the additional expense of expanding international operations, our future growth and profitability could suffer. Concentration of Control--Our executive officers and directors retain significant control over us, which allows them to decide the outcome of matters submitted to stockholders for approval. This influence may not be beneficial to all stockholders. As of September 30, 2001, Paul Ker-Chin Chang, Paul A. Marshall, and Robert C. Pfeiffer beneficially owned 26%, 24%, and 13%, respectively, of our outstanding shares of common stock. Consequently, these three individuals, acting together, are able to control the election of our directors and the approval of significant corporate transactions that must be submitted to a vote of stockholders. In addition, Mr. Chang, Mr. Marshall, and Mr. Pfeiffer constitute three of the six members of the board of directors and have significant influence in directing the actions taken by the directors. The interests of these persons may conflict with the interests of other stockholders, and the actions they take or approve may be contrary to those desired by other stockholders. This concentration of ownership and control of the management and affairs of our company may also have the effect of delaying or preventing a change in control of our company that stockholders may consider desirable. Potential Product Liability--Our products are complex, and our failure to detect errors and defects may subject us to costly repairs and product returns under warranty and product liability litigation. Our products are complex and may contain undetected defects or errors when first introduced or as enhancements are released. These errors may occur despite our testing and may not be discovered until after a product has been shipped and used by our customers. Many of the products that we ship contain known imperfections that we consider to be insignificant at the time of shipment. We may misjudge the seriousness of a product imperfection and allow it to be shipped to our customers. These risks are compounded by the fact that we offer many products, with multiple hardware and software modifications, which makes it more difficult to ensure high standards of quality control in our manufacturing process. The existence of these errors or defects could result in costly repairs and/or returns of products under warranty and, more generally, in delayed market acceptance of the product or damage to our reputation and business. In addition, the terms of our customer agreements and purchase orders, which provide us with protection against unwarranted claims of product defect and error, may not protect us adequately from unwarranted claims against us, unfair verdicts if a claim were to go to trial, settlement of these kinds of claims, or future regulation or laws regarding our products. Our defense against these claims in the future, regardless of their merit, could result in substantial expense to us, diversion of management time and attention, and damage to our business reputation and our ability to retain existing customers or attract new customers. Need For Highly Trained Personnel--We may not be able to retain the R&D, manufacturing, sales, and marketing personnel we need to support our business. Our business requires engineers, technicians, and other highly trained and experienced personnel. In particular, because our products require a sophisticated selling effort targeted at several key people within our prospective customers' organizations, we have a special need for experienced sales personnel. In addition, the complexity of our products and the difficulty of configuring and maintaining them require highly trained customer service and support personnel. Although competition for such persons has decreased recently, it remains strong, especially in the San Francisco Bay Area. Therefore, we may not be successful in retaining these individuals. Our failure to keep these kinds of employees could impair our ability to grow or maintain profitability. Reliance On Non-U.S. Workers--If U.S. immigration policies prevent us from hiring or retaining the workers we need, our growth may be limited. In the past we have filled a significant portion of our new personnel needs, particularly for our engineers, with non-U.S. citizens holding temporary work visas that allow these people to work in the United States for a limited 23 period of time. We rely on these non-U.S. workers because of the shortage of engineers, technicians, and other highly skilled and experienced workers in the telecommunications industry in the United States, in general, and in the San Francisco Bay Area, in particular. Regulations of the Immigration and Naturalization Service permit non-U.S. workers a limited number of extensions for their visas and also set quotas regarding the number of non-U.S. workers U.S. companies may hire. As a result, we face the risk that a portion of our existing employees may not be able to continue to work for us, thereby disrupting our operations, and that we may not be able to hire the number of engineers, technicians, and other highly skilled and experienced workers that we need to grow our business. Furthermore, changes in these regulations could exacerbate these risks. Intellectual Property Risks--Policing any unauthorized use of our intellectual property by third parties and defending any intellectual property infringement claims against us could be expensive and disrupt our business. Our intellectual property and proprietary technology is an important part of our business, and we depend on the development and use of various forms of intellectual property and proprietary technology. As a result, we are subject to several related risks, including the risks of unauthorized use of our intellectual property and the costs of protecting our intellectual property. Much of our intellectual property and proprietary technology is not protected by patents. If unauthorized persons were to copy, obtain, or otherwise misappropriate our intellectual property or proprietary technology without our approval, the value of our investment in research and development would decline, our reputation and brand could be diminished, and we would likely suffer a decline in revenue. We believe these risks, which are present in any business in which intellectual property and proprietary technology play an important role, are exacerbated by the difficulty in finding unauthorized use of intellectual property in our business, the increasing incidence of patent infringement in our industry in general, and the difficulty of enforcing intellectual property rights in some foreign countries. In addition, litigation has in the past been, and may in the future be, necessary to enforce our intellectual property rights. This kind of litigation is time-consuming and expensive to prosecute or resolve, and results in substantial diversion of management resources. We cannot ensure that we will be successful in that litigation, that our intellectual property rights will be held valid and enforceable in any litigation or that we will otherwise be able to protect our intellectual property and proprietary technology. Anti-takeover Provisions--Anti-takeover provisions in our charter documents could prevent or delay a change of control and, as a result, negatively impact our stockholders. Some provisions of our certificate of incorporation and bylaws may have the effect of discouraging, delaying, or preventing a change in control of our company or unsolicited acquisition proposals that you, as a stockholder, may consider favorable. These provisions provide for: . authorizing the issuance of "blank check" preferred stock; . a classified board of directors with staggered, three-year terms; . prohibiting cumulative voting in the election of directors; . requiring super-majority voting to effect certain amendments to our certificate of incorporation and by-laws; . limiting the persons who may call special meetings of stockholders; . prohibiting stockholder action by written consent; and . establishing advance notice requirements for nominations for election to the board of directors or for proposing matters that can be acted upon at stockholders meetings. Some provisions of Delaware law and our stock incentive plans may also have the effect of discouraging, delaying, or preventing a change in control of our company or unsolicited acquisition proposals. These provisions also could limit the price that some investors might be willing to pay in the future for shares of our common stock. 24 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK We sell our products in North America, Asia, Latin America, Africa, the Middle East, and Europe. As a result, our financial results could be affected by factors such as changes in foreign currency exchange rates. Prior to our acquisition of Pro.Tel, international sales had been denominated solely in U.S. dollars and, accordingly, we had not historically been exposed to fluctuations in non-U.S. currency exchange rates related to these sales activities. Since our acquisitions of Pro.Tel in February 2000 and Avantron in January 2001, we now have a small amount of sales denominated in Euros and Canadian dollars, and we have used derivative instruments to hedge our foreign exchange risks. As of September 30, 2001, we had no derivative instruments. To date, foreign exchange risks from these sales have not been material to our operations. We are exposed to the impact of interest rate changes and changes in the market values of our investments. Our exposure to market rate risk for changes in interest rates relates primarily to our investment portfolio. We have not used derivative financial instruments in our investment portfolio. We invest our excess cash in debt instruments of the U.S. Government and its agencies and in high-quality corporate issuers, and, by policy, we limit the amount of credit exposure to any one issuer. We protect and preserve our invested funds by limiting default, market, and reinvestment risk. As of September 30, 2001, we have invested $5.5 million in long-term marketable securities to take advantage of prevailing interest rates. These marketable securities range in maturity from July 1, 2002 to December 1, 2002. Investments in both fixed rate and floating rate interest earning instruments carry a degree of interest rate risk. Fixed rate securities may have their fair market value adversely impacted due to a rise in interest rates, while floating rate securities may produce less income than expected if interest rates fall. Due in part to these factors, our future investment income may fall short of expectations due to changes in interest rates, or we may suffer losses in principal if forced to sell securities that have declined in market value due to changes in interest rates. Due to the nature of our investments, we anticipate no material market risk exposure. 25 PART II - OTHER INFORMATION --------------------------- ITEM 1. LEGAL PROCEEDINGS. We are not currently a party to any material legal proceedings. ITEM 2. CHANGES IN SECURITIES and USE OF PROCEEDS. Our registration statement (Registration No. 333-32070) under the Securities Act of 1933, as amended, for our initial public offering became effective on July 12, 2000. Offering proceeds, net of aggregate expenses to us of $1.6 million, were $51.6 million. None of the net proceeds from the offering were paid directly or indirectly to any director, officer, general partner of the Company or its associates, persons owning 10 percent or more of any class of equity securities of the Company, or an affiliate of the Company. We used $2.4 million of the net proceeds from the offering to repay amounts drawn under our line of credit and $979,000 to repay notes payable. In the first quarter 2001, we used $11.9 million of the net proceeds for the acquisition of Avantron Technologies. Since the offering, we have used $14.4 million for the construction of our new facility. Funds that have not been used have been invested in money market funds, auction rate securities, and marketable debt securities. We intend to use the remaining net proceeds of the offering for working capital and general corporate purposes and capital expenditures made in the ordinary course of our business. We may also apply a portion of the proceeds of the offering to acquire businesses or products and technologies that are complementary to our business and product offerings. ITEM 3. DEFAULTS UPON SENIOR SECURITIES. None. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. None. ITEM 5. OTHER INFORMATION. None. ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K. (a) Exhibits (b) Reports on Form 8-K There were no Reports on Form 8-K filed during the three-month period ended September 30, 2001. 26 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. SUNRISE TELECOM INCORPORATED (Registrant) Date: November 13, 2001 By: /s/ Paul Ker-Chin Chang -------------------------------------- Paul Ker-Chin Chang President and Chief Executive Officer (Principal Executive Officer) By: /s/ Peter L. Eidelman -------------------------------------- Peter L. Eidelman Chief Financial Officer (Principal Accounting Officer) 27