10-K 1 d10k.htm FORM 10-K Form 10-K
Table of Contents

United States

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

 

FORM 10-K

 

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the fiscal year ended December 31, 2006

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                     

 

Commission File Number: 000-30757

 

 

 

Sunrise Telecom Incorporated

(Exact name of Registrant as specified in its charter)

 

Delaware   77-0291197

(State or other jurisdiction of

incorporation or organization)

  (IRS Employer Identification No.)

 

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

 

 

 

Securities registered pursuant to Section 12(b) of the Act:

 

None

 

Securities registered pursuant to Section 12(g) of the Act:

 

Common Stock, par value $0.001 per share

(Title of class)

 

Indicate by check mark whether the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.

 

    Yes ¨    No x

 

Indicate by check mark whether the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.

 

    Yes ¨    No x

 

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 (“Exchange Act”) 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 ¨    No x

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check One):

 

Large Accelerated Filer    ¨  

Accelerated Filer    ¨

 

Non-accelerated Filer    x

 

Smaller reporting company    ¨

   

      (Do not check if a

      smaller reporting company)

 

 

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act).

 

    Yes ¨    No x

 

As of June 30, 2006, the aggregate market value of the Common Stock of the Registrant held by non-affiliates was $46,144,818 based upon the last sale price for that date reported for such sale on the NASDAQ National Market.

 

As of March 1, 2008, there were 51,349,058 shares of the Registrant’s Common Stock outstanding, par value $0.001 per share.


Table of Contents

SUNRISE TELECOM INCORPORATED

 

Index to Annual Report on Form 10-K

 

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2006

 

          Page
Number
   Part I.   
Item 1.   

Business

   3
Item 1A.   

Risk Factors

   14
Item 1B.   

Unresolved Staff Comments

   27
Item 2.   

Properties

   28
Item 3.   

Legal Proceedings

   28
Item 4.   

Submission of Matters to a Vote of Security Holders

   28
   Part II.   
Item 5.   

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

   29
Item 6.   

Selected Financial Data

   30
Item 7.   

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

   31
Item 7A.   

Quantitative and Qualitative Disclosures About Market Risk

   44
Item 8.   

Financial Statements and Supplementary Data

   46
Item 9.   

Changes in and Disagreements with Accountants On Accounting and Financial Disclosure

   77
Item 9A.   

Controls and Procedures

   77
Item 9B.   

Other Information

   79
   Part III.   
Item 10.   

Directors, Executive Officers and Corporate Governance

   80
Item 11.   

Executive Compensation

   86
Item 12.   

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

   104
Item 13.   

Certain Relationships and Related Transactions, and Director Independence

   106
Item 14.   

Principal Accountant Fees and Services

   106
   Part IV.   
Item 15.   

Exhibits, Financial Statement Schedules

   108

 

“3GMaster”, “FTT”, “HTT”, “RealWORX” “Sunrise Telecom,” “SunSet”, “SunLite”, “STT”, “Sunset MTT”, “Oculist”, “NeTracker”, “Ghepardo”, “CaLan”, and “Lantrend” are trademarks of Sunrise Telecom Incorporated. This Annual Report on Form 10-K also includes references to registered service marks and trademarks of other entities.

 

2


Table of Contents

Forward-Looking Statements

 

This Annual Report on Form 10-K contains forward-looking statements, such as: statements concerning projected revenues, costs and expenses and gross margin; accounting estimates; assumptions and judgments; statements about our pending litigation; expected demand for our products; the effect that seasonality and volume will have on our quarterly operating results; our dependence on a few key customers for a substantial portion of our revenue; our ability to scale our operations in response to changes in demand for existing products and services or the demand for new products requested by our customers; the competitive nature of, and anticipated growth in, our markets; manufacturing, assembly and test capacity; our potential needs for additional capital; and inventory and accounts receivable levels. These forward-looking statements are based on our current expectations, estimates and projections about our industry and business, and certain assumptions we have made, all of which may be subject to change. Forward-looking statements can often be identified by words such as “anticipates,” “expects,” “intends,” “plans,” “predicts,” “believes,” “seeks,” “estimates,” “may,” “will,” “should,” “would,” “could,” “potential,” “continue,” “ongoing,” similar expressions, and variations or negatives of these words. These statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of many factors, including those listed under the section “Risk Factors” contained in Part I, Item 1A of this report. These forward-looking statements speak only as of the date of this report. We undertake no obligation to revise or update any forward-looking statement for any reason, except as otherwise required by law.

 

Part I.

 

ITEM 1.    BUSINESS

 

OVERVIEW

 

Sunrise Telecom designs, manufactures, and markets service verification equipment that enables service providers to pre-qualify facilities for services, verify newly installed services, and diagnose problems relating to telecommunications, cable broadband, internet access, and wireless networks. In addition, our products continuously monitor in-service cable, telecom and wireless networks to assist operators in improving network quality and to provide traffic data to assist network operations. Customers include telephone companies, incumbent local exchange carriers, cable companies, competitive local exchange carriers, mobile operators, and network infrastructure suppliers throughout North America, Latin America, Europe, Africa, the Middle East, and the Asia/Pacific region.

 

In October 1991, we were incorporated in California as Sunrise Telecom, Inc. In July 2000, we reincorporated in Delaware, changed our name to Sunrise Telecom Incorporated and listed our common stock on the NASDAQ Stock Market for public trading.

 

INDUSTRY BACKGROUND

 

Data traffic in the United States and Canada has surpassed the amount of voice traffic carried on the existing telephone network. Consumers are seeking higher-speed access to bandwidth intensive content and services, such as multi-media rich websites, music, video, and software downloads. As an increasing number of subscribers access this bandwidth intensive content, the ability to connect to and receive data from the Internet at high speeds has become, and will continue to become, more important.

 

A primary area of investment by our customers is the redesign of their networks to support higher speed broadband access to subscribers, and to enable new multimedia services such as Voice-over IP networks (VoIP) and IP-TV. This involves upgrading the “last mile” portion of the network to a higher capacity, by deploying fiber and

 

3


Table of Contents

electronics deeper into the last mile. This may also include the deployment of new technologies such as VDSL (Very high bit-rate DSL) and sophisticated customer premises equipment to deliver these new services. As the capacity of the last mile is increased, the capacity of the long-haul networks must also be increased to handle the demand. In addition, the signaling portion of the network is being upgraded to integrate and converge the new multimedia services into the existing infrastructure.

 

In the last few years, the nature of competition between various service provider segments also has changed. Cable companies now routinely offer voice services, and telephone companies are now providing television programming to their subscribers. These once separate segments of the market are now competing fiercely for new customers, and are seeking to minimize the loss of their customers. This makes the economics of service installation and repair, and the quality of the service delivered to the subscriber extremely important to the competitive outcome. Due to this competition, comprehensive testing and monitoring of the network is becoming a competitive necessity for today’s carriers.

 

KEY PRODUCT CATEGORIES

 

Our key product application technology areas are described below:

 

Wireline Access Technology.    Wireline access technology includes technologies such as “Plain Old Telephone Service”, T-carrier, E-carrier, ISDN, and most recently, digital subscriber line technology. Digital subscriber line technology, commonly known as DSL, transmits data up to fifty times faster than older dial-up modems using the existing copper telephone wires. Various implementations of DSL are being developed and deployed, including asymmetric DSL, known as ADSL, symmetric DSL, known as SDSL, high bit-rate DSL, known as HDSL, very high bit-rate DSL, known as VDSL, and others. Service providers deploying DSL technology include local exchange carriers, such as AT&T, Inc. (formerly SBC Communications Inc.), British Telecom, France Telecom PLC, and Verizon Communications Inc.

 

Cable Broadband Networks.    Cable broadband operators use a hybrid fiber coax last mile infrastructure, cable modems installed in the home, cable modem termination systems installed at major cable concentration points, and network headend equipment designed to connect their cable broadband networks to video feeds and other networks. Most cable companies are currently offering analog and digital video, high-speed Internet access services, and VoIP, including Comcast Corporation, Charter Communications, Inc., Cox Communications, Inc., TimeWarner Cable, Inc., and Virgin Media Inc. (formerly NTL+Telewest), among others.

 

Fiber Optics.    Fiber optic cables use pulses of light to transmit digital information and offer very high bandwidth capacity. Due to their high capacity, fiber optic cables are being used increasingly in the service provider networks in telecommunications, cable broadband, and mobile network applications. Today, fiber optic cables carry higher bandwidths by increasing the wavelength modulation speed or by carrying multiple wavelengths on a single fiber. Common wavelength multiplexing schemes include Coarse Wavelength Division Multiplexing (CWDM) and Dense Wavelength Division Multiplexing (DWDM). Several service providers, such as Verizon Communications, Inc., are now deploying fiber optic cables directly to the subscriber’s residence, using a WDM technology called Passive Optical Network (PON).

 

Signaling.    Traditional telephone systems require a signaling mechanism to set up and tear down phone calls. These signals serve functions such as supervising or monitoring the status of a line or circuit to see if it is busy, idle, or requesting service; alerting or indicating the arrival of an incoming call; and addressing or transmitting routing and destination signals over the network. Signaling System 7 (“SS7”), is the base signaling system used by traditional telecom networks worldwide. In addition, new network services such as VoIP, IP-TV, text messaging, multimedia messaging, roaming, and cell-phone web access place entirely new demands on the signaling system. As a result, signaling standards are evolving, and network operators face increasing complexity in monitoring and troubleshooting their signaling networks.

 

4


Table of Contents

THE NEED FOR SERVICE VERIFICATION EQUIPMENT

 

In order to successfully deploy and maintain broadband networks, service providers rely on sophisticated service verification equipment. This equipment allows service providers to pre-qualify facilities for services, verify proper operation of newly installed services, and diagnose problems. In addition, equipment manufacturers use service verification equipment to test simulated networks during equipment development and verify the successful production of equipment. Service verification equipment can be grouped into the following three types: field verification; remote testing; and alarm and surveillance.

 

Field Verification Equipment.    Field verification equipment is used by service providers to probe the actual wires, cables, or airwaves to verify that a service is functioning properly. In the case of a service malfunction, a field technician can use the equipment to locate the exact fault so that repairs can be made. Research and development labs, manufacturing departments, and central office technicians also use field verification equipment in their day-to-day operations. Service providers have found field verification to be an effective method to ensure that the lines operate properly at installation or after repair.

 

Remote Test Equipment.    Remote test equipment can help verify services and identify certain types of service malfunctions from a centralized location. The equipment is typically controlled by a centralized test system that automates much of the remote testing process. It is commonly used to determine which section has malfunctioned and to diagnose quickly the nature of a customer’s complaint. Due to its centralized and automated nature, remote test equipment is an efficient way to complement field test equipment in the deployment and maintenance of broadband networks.

 

Alarm and Surveillance Equipment.    Alarm and surveillance equipment constantly monitors the telephone network, searching for facility or service degradations, including outages. When a problem is noticed, a report may be sent immediately to an automated trouble diagnostic system or to a human operator who interprets the message and decides what further action is required. Corrective action typically involves field verification or remote test equipment to identify and correct specific problems. This equipment may also collect data on network operation and forward the information to a system for developing statistics on network quality or other attributes of interest.

 

Because the competition is intense for subscribers for high-speed bandwidth access, the quality and reliability of network service has become critical to service providers. These service providers cannot afford the loss of customers, loss of revenue, and negative publicity resulting from poor service. Service verification equipment, such as the products provided by Sunrise Telecom, allows service providers to verify and repair service problems effectively and, thus, increase the quality and reliability of their networks.

 

THE SUNRISE TELECOM SOLUTION

 

We design and manufacture service verification equipment, physical layer diagnostic equipment, and monitoring systems that enable service providers to pre-qualify facilities for services, verify newly installed services, monitor the performance of video and signaling networks, and diagnose problems relating to copper twisted pair, coaxial cable, and optical fibers. Our products also enable equipment manufacturers to test simulated networks during equipment development, verify the successful production of equipment, and help their field service teams diagnose problems. Our products offer the following features:

 

   

Design Flexibility.    We design our products to be flexible and to evolve as customer needs change. Our CM 1000, STT and SunSet MTT product lines, for example, allow field technicians the ability to upgrade their equipment easily through a variety of plug-in hardware modules. This flexible design allows the customer to adapt the test set to new services and applications as network standards evolve.

 

5


Table of Contents
   

Customer Driven Features.    Each of our products is tailored to our customers’ needs. Our product marketing team interacts with our customers during the design process to ensure that our products are the best available solution for them. Our Traffic Analysis & Measurement System (TAMS), through such interactions, has been architected to offer unique economic benefits to customers, providing scalability from a standalone protocol analyzer to a distributed system, and visibility of signaling issues in near real time.

 

   

Handheld Modular Design.    We use handheld designs for many of our products that are to be used in the field. The compact, lightweight design of these products enhances the field technicians’ ability to easily carry these devices with them to diagnose problems and verify line operation. The SunSet MTT product family, for example, offers over thirty different test modules, in a lightweight portable unit.

 

Because of the design and functionality of our products, we provide the following benefits to our customers:

 

   

Rapid and Cost-Efficient Deployment.    Our products allow customers to test facilities and services rapidly and efficiently to ensure that they are properly installed and that they can deliver the speed and features as ordered by the subscriber. In a single device, our products can be used to pre-qualify facilities for services, identify the source of problems, and verify the proper operation of newly installed service before delivering service to end-user customers.

 

   

Improved Network Quality and Reliability.    Our products diagnose and locate a variety of problems and degradations in established broadband networks allowing service providers to identify and repair problems and to restore service efficiently. Our products allow service providers to monitor their network quality and ensure customer satisfaction.

 

PRODUCTS

 

Our major products are segmented into the following categories:

 

WIRELINE ACCESS PRODUCTS

   
SunSet MTT    ·    The Modular Test Toolkit is a full-featured handheld test set for access network service, installation, and maintenance. It features a variety of handheld SunSet chassis configurations with support for over thirty different test modules to fit applications ranging from DSL, IP-TV, VoIP, Ethernet, copper diagnostics, T1 (1.544 mbps) and E1 (2 mbps) transmission, analog Voice Frequency circuits, and SONET/SDH. The SunSet MTT’s modularity allows field technicians to use a single unit to test a broad variety of services found in today’s access network, and protects the customer’s capital investment. The unit identifies problems with the physical transmission media, verifies proper signal transmission, verifies proper performance of the service to the customer, and identifies other problems on a troubled circuit.
   

SunSet ISDN,

SunLite BRI

   ·    These products support analysis and service verification for the Integrated Services Digital Network, known as ISDN. ISDN is a digital network that offers more bandwidth than the traditional analog telephone network, but less bandwidth than DSL, T1, Ethernet, cable modems and other newer technologies.
   
SunLite E1    ·    This pocket-sized unit supports transmission testing for E1.
   
SunSet E20    ·    This handheld unit supports transmission testing for E1 and service verification for data, voice, mobile, and other signaling protocols.

 

6


Table of Contents

CABLE BROADBAND PRODUCTS

   

CM2000

CM1000

CM750

   ·    These handheld units are used for cable modem installation and field testing for cable television and telephone companies. Different configurations support installation and test of current (Video on Demand, Digital Television and High Speed Data) as well as next generation IP services such as VoIP networks. The CM Series provides an economic growth strategy by providing a simple upgrade path for evolving network installation and test needs.
   
3010H    ·    A rack-mounted headend analyzer and sweep generator that provides the capabilities required to keep cable networks operating reliably and delivering quality, distortion-free signals. It supports up to ten field technicians using remote 3010R products for return path maintenance and, as a forward sweep transmitter, it supports an unlimited number of technicians for maintaining the forward path.
   
3010R    ·    A rugged field unit that includes both forward and return sweep plus Signal Level Meter (“SLM”) capabilities for maintaining the entire cable network. The 3010R can also function as a headend unit for troubleshooting intermittent problems in specific network segments for added flexibility.
   
AT2500R Series    ·    A lightweight, full-featured Spectrum Analyzer designed for Cable TV (“CATV”) headend and field portable applications. It combines high performance CATV, quadrature amplitude modulation (“QAM”), and video analysis in one instrument to verify and maintain analog TV signals, as well as premium digital services.
   
AT2500H Series    ·    Rack-mounted headend Spectrum Analyzer providing remote visibility into headend and plant performance. It performs remote headend testing of both analog and digital downstream and upstream signals from 1 MHz to 1.5 GHz. It can also monitor maximum, minimum, and average ingress levels to be stored for historical reference and trend analysis.
   
realWORX    ·    Fully automated broadband performance verification system that monitors upstream and downstream signal quality on a continuous basis from a headend or hub site. It verifies the quality of downstream QAM and Analog CATV channels and ensures that the Return Path Ingress levels are within acceptable limits. realWORX integrates with the AT2500H Spectrum Analyzers and the optional CM Series test units for remote real-time ingress levels.

FIBER OPTIC PRODUCTS

   
Scalable Test Toolkit (STT)    ·    A portable, modular unit designed to test the core and metro optical networks of today and tomorrow. The STT supports SONET, SDH, OTN, GFP, LCAS, C/DWDM (Coarse/Dense Wavelength Division Multiplexing), OTDR (Optical Time Domain Reflectometer), loss test set, and Ethernet/Gigabit Ethernet testing through a family of stackable test modules. The unit also features a Multi Services Analyzer (MSA) module which offers similar test functionality to our 3GMaster and NeTracker products. The STT offers advanced analysis and diagnostic tools for exchange, central office and laboratory applications.

 

7


Table of Contents

FIBER OPTIC PRODUCTS

   
SunSet 10G+    ·    A compact handheld unit that supports transmission testing for metropolitan and core optical networks. It supports both SONET and SDH networks, including both electrical and optical signal testing in a small package for testing from 1.5 Mbps to ten gigabits per second bit rates.
   
SunSet SDH    ·    A handheld unit that supports international SDH and digital transmission types found throughout metropolitan and access networks worldwide. The SunSet SDH includes both electrical and optical signal testing and performs advanced service verification for various applications like ATM, mobile, ISDN, and voice.
   
SunSet OCx    ·    A handheld unit that supports North American SONET and digital transmission types found throughout metropolitan and access networks worldwide. The SunSet OCx includes both electrical and optical signal testing and performs advanced service verification for various applications like ATM, mobile, ISDN, and voice.
   
SunSet MTT    ·    The Modular Test Toolkit (MTT) offers physical layer fiber optic testing modules and characterization for fiber optic links through an OTDR, loss test set, power meter, and light source, as well as gigabit Ethernet testing on fiber optic links and an SDH/SONET testing.

SIGNALING TESTING PRODUCTS

   
3GMaster    ·    A network analyzer used to monitor Second and Third Generation Mobile networks. Applications include regular network maintenance, billing verification, network traffic statistics, quality of service testing, and troubleshooting complex problems like roaming and internetworking.
   
NeTracker    ·    An advanced analyzer for testing the multiple protocols and data rates found in next-generation VoIP. Applications include service verification, protocol analysis, voice quality testing, and stress testing for the VoIP environment.
   
STT-MSA    ·    The STT Multi-Service Analyzer (MSA) simulates, monitors, and analyzes different signaling protocols on SS7, ISDN, and IP-based next-generation networks, and analyzes telecommunication environments such as 2G, 2.5G (including GSM, GPRS and EDGE), and 3G (UMTS, IMS and CDMA 2000). Advanced analysis tools capture, decode, and report on both the access network (wireless and wireline) and the core network, simultaneously.
   
TAMS    ·    Traffic Analysis & Measurement System (TAMS) is a distributed system for VoIP, wireline, and wireless networks. It features the Data Collector System (DCS) that gathers, stores, and processes network-wide data, and a centralized server. TAMS monitors in real-time the network traffic and the services provided by the operator, offering detailed reports, statistics and alarms as well as troubleshooting capabilities.

 

8


Table of Contents

The percentage of our total revenue contributed by each class of products was as follows:

 

     Year ended December 31,
     2006    2005    2004

Wireline Access

   36%    34%    43%

Cable Broadband

   31%    30%    26%

Fiber Optics

   25%    28%    22%

Signaling

   8%    8%    9%

 

CUSTOMERS

 

Our customers include telecommunications service providers, cable network operators, network infrastructure suppliers and installers, technicians, and engineers in North America, Latin America, Europe, Africa, the Middle East, and the Asia/Pacific region. We generally sell through distributors internationally and sell direct in the United States. Our international sales offices may also sell directly. The following is a selected list of some of our largest customers in 2006:

 

Adelphia Communications Corporation

AT&T, Inc. (formerly SBC Communications Inc.)

BellSouth Telecom, Inc. (now AT&T, Inc.)

British Telecom PLC

Cablevision Systems Corporation

Comcast Corporation

Cox Communications, Inc.

Deutsche TeleKom, AG

  

NTT

Siemens AG

Sprint Corporation

Telecom Italia Mobile

Telkom SA Ltd.

Time Warner Cable, Inc.

United States Department of Defense

Verizon Communications, Inc.

 

Since our inception, we have sold versions of our products to over 2,000 customers in over sixty countries. Verizon Communications, Inc. accounted for 11% of our net sales in 2006. No individual end customer or distributor accounted for 10% or more of our net sales in 2005 or in 2004. See Item 1A, “Risk Factors—Customer Concentration.”

 

SALES, MARKETING AND CUSTOMER SERVICE

 

Sales.    We sell our products to telecommunications service providers, cable network operators, network infrastructure suppliers and installers, technicians, and engineers through manufacturers’ representatives, independent distributor organizations, and our direct sales force.

 

In the United States, we sell our products through manufacturers’ representatives who are supported by our in-house direct sales force. Manufacturers’ representatives are paid on a commission basis and have exclusive rights in their respective regions. Our manufacturers’ representatives or direct sales people solicit orders from the customer and we ship our products directly to the customer. We pay commissions once we have received payment from the customer. Our direct sales force includes a team of regional sales managers who direct the sales efforts of our manufacturers’ representatives and regional account managers who focus on specific accounts within a region.

 

Outside the United States, we sell our products through a mix of our own sales offices and independent distributors, which are directed by our country managers and our regional directors of marketing and sales. In general, we sell our products to the distributor at a discount from the end user price, and the distributor or sales office then resells the products to the end user. International sales were $47.4 million, or 48% of total net sales in 2006, $33.3 million, or 49% of total net sales in 2005, and $29.2 million, or 47% of total net sales in 2004. We expect that international sales will continue to account for a significant portion of our net sales in future periods. In addition to our

 

9


Table of Contents

network of international distributors, we have sales offices based in Anjou, Canada; Beijing, Guangzhou, and Shanghai, China; Tokyo, Japan; Seoul, Korea; Milan, Italy; Paris, France; Mexico City, Mexico; and Gomaringen, Germany. As part of our restructuring announced in February 2008, we have made a decision to close our facility in Anjou, Canada. See Item 1A, “Risk Factors—Risks of International Operations.”

 

We sell our products predominantly to large telecommunications and cable service providers. These types of customers generally commit significant resources to evaluate our and our competitors’ products and require each vendor to expend substantial funds, time, and effort educating them about the value of the vendor’s solutions. Consequently, sales to this type of customer generally require an extensive sales effort throughout the prospective customer’s organization and final acceptance of our products by an executive officer or other senior level employee. The result is lengthy sales and implementation cycles that make sales forecasting difficult. In addition, even after a large service provider has approved our product for purchase, future purchases are uncertain because we generally do not enter into long-term supply agreements or requirements contracts. Delays associated with 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 our large customers typically ranges from six to twenty-four months.

 

We generally do not sell our products with rights of return. On the few occasions when we have agreed to provide customers with rights of return, we have deferred recognition of sales revenue until the rights of return have lapsed. We generally do not provide extended payment terms to our customers. Our normal terms are typically thirty days for North America and up to sixty days in other markets.

 

Marketing.    We market and promote sales of our products by the following activities:

 

   

Our sales groups bring new product ideas to our product marketing group;

 

   

Our product marketing group researches new opportunities, prepares product definitions with our research and development group, and defines new features to create new products;

 

   

The overall marketing group hosts a variety of seminars several times a year in the United States, Asia, Europe, and Latin America to improve the sales effectiveness of our manufacturers’ representatives and international distributors;

 

   

Our product marketing engineers, regional sales managers, and account managers travel extensively with our sales engineers, manufacturers’ representatives, and international distributors to develop new product opportunities with customers and to support their presentations;

 

   

The marketing communications group maintains a public website, publishes brochures and specification sheets, and generates press releases and publicity to increase our recognition in the telecommunications industry; and

 

   

Our technical publications group prepares user’s manuals, field manuals, quick reference guides, and product operation videos to serve the needs of our users.

 

Customer Service.    We believe that customer service following the sale of our products is a critical ingredient to our success. We provide customer service in numerous ways, including the following:

 

   

providing rapid instrument repair services;

 

   

operating a telephone support line to help customers who are having difficulty using our products in their particular application;

 

10


Table of Contents
   

maintaining a proprietary website containing online, up-to-the-minute product repair information for our distributors’ international repair centers, with a factory-certified technician training program for our distributors’ international repair center technicians; and

 

   

measuring the satisfaction of our customers and communicating this information internally for corrective action.

 

SEASONALITY

 

Our sales have traditionally been seasonal in nature and tied to the buying patterns of our customers. The largest volume of quarterly sales has typically been during the last calendar quarter of the year. In 2006, sales during the fourth quarter rose to $36.7 million or 37% of annual sales. Our 2005 and 2004 fourth quarter sales were $21.7 million, or 32% of annual sales, and $20.1 million, or 33% of annual sales, respectively. We expect that our quarterly operating results may fluctuate significantly and will be difficult to predict due to 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. See Item 1A, “Risk Factors—Quarterly Fluctuations.”

 

BACKLOG

 

Our backlog of customer orders, as of December 31, 2006, was approximately $8.0 million, compared to approximately $7.6 million as of December 31, 2005. Variations in the size and delivery schedules of purchase orders that we receive, as well as changes in customers’ delivery requirements, may result in substantial fluctuations in the amount of backlog orders for our products from quarter to quarter.

 

RESEARCH AND DEVELOPMENT

 

We have assembled a team of highly skilled engineering professionals who are experienced at designing telecommunications service verification test equipment. Our engineering personnel have expertise in a number of fields, including interfacing test equipment with digital loop carriers, voice and data switching technology, local loop equipment, and operations support systems. We spent approximately $21.1 million on research and development in 2006, $18.4 million in 2005, and $16.6 million in 2004. Research and development represents our largest direct employment expense. As of December 31, 2006, we had a total of 150 permanent and temporary employees engaged in research and development in: San Jose, California; Norcross, Georgia; Anjou, Canada; Modena, Italy; Taipei County, Taiwan; Beijing, China; and Geneva, Switzerland. We had a total of 139 permanent and temporary employees engaged in research and development as of March 1, 2008.

 

We believe that our continued success depends on our ability to anticipate and respond to changes in the telecommunications industry and anticipate and satisfy our customers’ preferences and requirements. Accordingly, we

continually review and evaluate competitive dynamics, as well as technological and regulatory changes affecting the converging telecommunications and cable broadband industries, and seek to offer products and capabilities that solve our customers’ operational challenges and improve their efficiency. In general, we spend from six months to four years developing a new product.

 

REGULATIONS AND INDUSTRY STANDARDS

 

Our products are designed to comply with a significant number of industry standards and regulations, some of which are evolving as new technologies are deployed. In the United States, our products must comply with various regulations defined by the Federal Communications Commission and Underwriters Laboratories, as well as industry standards established by Telcordia Technologies, Inc. (formerly Bellcore), the American National Standards Institute, the Internet Engineering Task Force, and various industry interest groups. Internationally, our products must comply

 

11


Table of Contents

with standards established by the European Committee for Electrotechnical Standardization, the European Committee for Standardization, the European Telecommunications Standards Institute, telecommunications authorities in various countries, and with recommendations of the International Telecommunications Union. The Company must also comply with recent directives by the European Union, including the Reduction of Hazardous Substance Directive which restricts the use of six hazardous materials in the manufacture of various types of electronic and electrical equipment, and the Waste Electrical and Electronics Equipment Directive which sets collection, recycling, and recovery targets for electrical goods. The failure of our products to comply, or delays in compliance, with the various existing and evolving standards could negatively impact our ability to sell our products.

 

MANUFACTURING AND SOURCES OF SUPPLY

 

Our production process consists of planning, procurement, fabrication, rework, system assembly, system final test, software option customization, and shipping. We purchase substantially all parts, including resistors, integrated circuit boards, LCDs, and printed circuit boards, from distributors and manufacturers worldwide. We package these parts into kits and either send them to local contract manufacturers to assemble into printed circuit boards or we assemble them ourselves at our Taiwan facility. We perform substantially all remaining manufacturing operations. We maintain sourcing and manufacturing operations in San Jose, California; Anjou, Canada; Taipei County, Taiwan; Geneva, Switzerland; and Modena, Italy, with the Taipei County facility being our largest manufacturing center. Our San Jose, Taipei County, and Modena operations are ISO 9001 certified. As part of our restructuring announced in February 2008, we have made a decision to close our facility in Anjou, Canada.

 

In our manufacturing process, we purchase many key products, such as microprocessors, bus interface chips, optical components, and oscillators, from a single source or from that source’s sole supplier. We rely exclusively on third-party subcontractors to manufacture certain 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 purchases of some products and components in advance to ensure an adequate supply, particularly for products that require lead times of up to nine months to manufacture. See Item 1A, “Risk Factors—Dependence on Sole and Single Source Suppliers.”

 

COMPETITION

 

The market for field verification test equipment 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

Wireline Access    JDS Uniphase Corporation; Exfo Electro-Optical Engineering, Inc.; Danaher Corporation (Fluke and Fluke Networks); 3M Corporation; Trend Communications, Ltd.
Fiber Optics SONET/SDH    JDS Uniphase Corporation; Exfo Electro-Optical Engineering, Inc.; Anritsu Corporation; Trend Communications Ltd.
Cable Broadband    JDS Uniphase Corporation; Trilithic, Inc
Signaling   

Agilent Technologies, Inc.; Danaher Corporation (Tektronix);

Radcom Ltd.

 

We expect that, as our industry and market evolve, new competitors or alliances among competitors could emerge and acquire significant market share. Competition in our markets could increase which would result in greater threats to our market share, price pressure on our products, and the potential of decreasing profitability.

 

12


Table of Contents

We believe that the principal competitive factors in our market include the following:

 

   

continued high level of investment in research and development and marketing;

 

   

speed of new product development and introductions to market;

 

   

depth of product functionality;

 

   

ease of installation, integration, and use;

 

   

system reliability and performance;

 

   

price and financing terms;

 

   

technical support and customer service;

 

   

size and stability of the vendor’s operations; and

 

   

compliance with government and industry standards.

 

INTELLECTUAL PROPERTY AND PROPRIETARY TECHNOLOGY

 

Our intellectual property, including our proprietary technology, processes and know-how, trade secrets, patents, trademarks, and copyrights, is important to our business and to our continued success. As of January 1, 2008, we had twenty issued U.S. patents relating to communications testers that expire between 2015 and 2024. We have filed several applications for additional patents with the U.S. Patent and Trademark Office and with foreign patent offices. Our research and development and manufacturing process typically involves the use and development of a variety of forms of intellectual property and proprietary technology, although no one particular form of this intellectual property and proprietary technology is material to our business. In addition, we incorporate software, some of which we may license from third party sources. These licenses generally renew automatically on an annual basis. We believe that alternative technologies for this licensed software are available both domestically and internationally.

 

We protect our proprietary technology by the following means:

 

   

relying on intellectual property law, including patent, trade secret, copyright, and trademark law and by initiating litigation when necessary to enforce our rights;

 

   

limiting access to our software, documentation, and other proprietary information; and

 

   

entering into confidentiality agreements with our employees.

 

EMPLOYEES

 

At December 31, 2006, we had a total of 610 full-time employees, consisting of 240 in the United States, 186 in Taiwan, 45 in Italy, 44 in Canada, 6 in Korea, 9 in Switzerland, 57 in China, 5 in Japan, 6 in Germany, 5 in France, 3 in Spain, and 4 in Mexico. We also had 18 temporary employees at December 31, 2006. Of the total full-time employees, 146 were engaged in research and development, 132 were engaged in sales, marketing and customer support, 262 were engaged in operations, and 70 were engaged in administration and finance.

 

At March 1, 2008, we had a total of 533 full-time employees, consisting of 204 in the United States, 148 in Taiwan, 47 in Italy, 35 in Canada, 4 in Korea, 10 in Switzerland, 62 in China, 5 in Japan, 4 in Germany, 5 in France, 3 in Spain, and 6 in Mexico. We also had 18 temporary employees at February 29, 2008. Of the total full-time employees, 135 were engaged in research and development, 133 were engaged in sales, marketing and customer support, 193 were engaged in operations, and 72 were engaged in administration and finance.

 

None of our employees are subject to a collective bargaining agreement. Our employees worldwide are protected by a multitude of labor laws enacted by the countries in which we operate. We believe that our relations with our employees are good. See Item 1A “Risk Factors—Dependence on Key Employees.”

 

13


Table of Contents

ITEM 1A.    RISK FACTORS

 

In addition to other information in this Annual Report on Form 10-K, the following risk factors should be carefully considered in evaluating us and our business because these factors may have a significant impact on our business, prospects, operating results or financial condition. Actual results could differ materially from those projected in the forward-looking statements contained in this report as a result of the risk factors discussed below and elsewhere in this report.

 

Stock Option Granting Practices—Our investigation of our historical stock option granting practices and resulting financial statement restatements and litigation have had, and may continue to have, a material adverse effect on our business, financial condition and results of operations.

 

Based on our investigation of our historical stock option granting practices, we concluded that we had improperly accounted for options to purchase an aggregate of 1,377,970 shares of our common stock that were awarded in January 2001 and June 2002. As a result, we recorded a total of $5.5 million in additional stock-based compensation expense for the years 2001 through 2004, net of forfeitures related to employee terminations. These expenses had the effect of decreasing income from operations, net income and net income per share (basic and diluted) in the affected periods in which we reported a profit, and increasing loss from operations, net loss and net loss per share in the affected periods in which we reported a loss. As a result, in connection with our Annual Report on Form 10-K for the year ended December 31, 2005, which we filed November 2, 2007, we have restated our consolidated balance sheet as of December 31, 2004 and the consolidated statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the two-year period ended December 31, 2004, each of the quarters of 2004 and the first two quarters of 2005 as well as our financial statements for fiscal 2001 and 2002 presented in selected financial data in Part II, Item 6, “Selected Financial Data” presented in our 2005 Annual Report on Form 10-K filed.

 

Our senior management and our Board of Directors have devoted a significant amount of time on matters relating to the restatement, our outstanding periodic reports, remedial efforts and related litigation. In addition, some members of our senior management and our Board of Directors are named defendants in a lawsuit alleging violations of federal securities laws related to the restatement. Defending these actions may require significant time and attention from members of our current senior management and our Board of Directors. If our senior management is unable to devote a significant amount of time in the future developing and attaining our strategic business initiatives and running ongoing business operations, there may be a material adverse effect on our business, financial condition and results of operations.

 

We may face challenges in hiring and retaining qualified personnel due to the restatement, the related internal investigations and the delisting from NASDAQ. We depend on our employees and on our ability to attract and retain highly qualified personnel. Given the lengthy restatement process, the related internal investigations and the delisting of our common stock from NASDAQ, it may become more difficult to retain key personnel, including members of our finance team. In addition, we began to experience a higher attrition rate in the second quarter of 2006, which continued through the first six months of 2007. Our inability to hire qualified personnel and retain existing key personnel has disrupted, and may continue to disrupt, our ability to effectively manage our business and to complete our outstanding periodic reports. In addition, the loss of the services of any of our key employees, the inability to attract or retain qualified personnel in the future, or delays in hiring required personnel, particularly engineers and sales personnel, could delay the development and introduction of, and negatively affect our ability to sell, our products.

 

We likely will not apply to relist our common stock on a national securities exchange until we have filed all reports required to be filed with the SEC. There can be no assurance that we will be able to obtain listing of our common stock on a national securities exchange.

 

14


Table of Contents

Stock Option Issuance and Exercise of Existing Options—We have not issued option grants since August 2005 and option holders have not been permitted to exercise options since December 2005.

 

Because we are not current with our SEC filings, the Compensation Committee has not approved any new grants of options since August 2005, and existing option holders have not been able to exercise stock options since December 2005. Some options that would otherwise be exercisable have expired unexercised and purchases under the Employee Stock Purchase Plan have been suspended.

 

The purpose of our various share-based compensation plans is to attract, motivate, retain, and reward employees, directors, and consultants by enabling them to acquire or increase their proprietary interest in our common stock in order to strengthen the mutuality of interests between such persons and our stockholders and to provide such persons with annual and long-term performance incentives to focus their best efforts in the creation of stockholder value. As long as these equity compensation plans are not available to us, we have more limited means of compensating and providing incentives to employees, directors and consultants, which may harm our business and financial results. The failure to meet employee expectations could harm our ability to hire, retain and motivate our employees.

 

In addition, current and former employees who were unable to exercise in-the-money vested stock options before the options expired may have claims against the Company. We may be required to provide compensation to those employees for the value of their expired unexercised options.

 

Material Weaknesses in Internal Control over Financial Reporting—We have identified material weaknesses in our internal control over financial reporting in the past and cannot assure you that additional material weaknesses will not be identified in the future. If our internal controls or disclosure controls and procedures are not effective, there may be material errors in our financial statements that are not identified in a timely manner and that could require restatement, or our filings may not be timely, and investors may lose confidence in our reported financial information, any of which could lead to a decline in our stock price.

 

Management concluded that there were material weaknesses in our internal control over financial reporting as of December 31, 2006. We identified a material weakness in our internal control over financial reporting associated with our accounting for deferred income taxes, as well as deficiencies in our staffing requirements and policy regarding the timely filling of key financial positions impacting the preparation of our consolidated financial statements.

 

We do not expect that our internal control over financial reporting will prevent all error and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. Controls can be circumvented by the individual acts of some persons, by the collusion of two or more people, or by management override of the controls. Over time, controls may become inadequate because changes in conditions or deterioration in the degree of compliance with policies or procedures may occur. In addition, misstatements due to error or fraud may occur and not be detected because of the inherent limitations in a cost-effective control system. As a result, significant deficiencies or material weaknesses in our internal controls may be identified in the future. Any failure to maintain or implement required new or improved controls, or any difficulties we encounter in their implementation, could result in significant deficiencies or material weaknesses, cause us to fail to timely meet our periodic reporting obligations, result in material misstatements in our financial statements and/or cause investors to lose confidence in our reported financial information, all of which could lead to a decline in our stock price. Any such failure could also adversely affect the results of periodic management evaluations and annual auditor attestation reports regarding disclosure controls and the effectiveness of our internal control over financial reporting.

 

15


Table of Contents

Stockholder Litigation—We have been named as a party to a stockholder derivative action lawsuit arising from our investigation of our historical stock option granting practices and the subsequent restatement of our financial statements and may be named as a party to additional lawsuits, which could require significant management time and attention and result in significant legal expenses, which could have a material adverse effect on our business, financial condition, results of operations and cash flows.

 

We are currently engaged in civil litigation with a party that claims, among other allegations, that certain of our current and former officers and directors improperly dated stock option grants to enhance their own profits on the exercise of such options or for other improper purposes, and we may become the subject of additional private lawsuits based on our historical stock option granting practices and the subsequent restatement of our financial statements. The expense of defending such litigation may be significant. We have entered into indemnification agreements with each of our present and former officers and directors and if we incur indemnification obligations in connection with the pending stockholder derivative litigation or otherwise, this could affect adversely our financial condition. Moreover, the amount of time to resolve such litigation and potential additional lawsuits is unpredictable and defending the lawsuit may divert management’s attention from the day-to-day operations of our business, which could harm our business, results of operations and cash flows. In addition, an unfavorable outcome in such lawsuits, such as a court judgment against us resulting in monetary damages or penalties, could have a material adverse effect on our business, results of operations and cash flows.

 

Foreign Corrupt Practices Act—Our international operations are subject to anti-corruption laws, such as the U.S. Foreign Corrupt Practices Act, and any violations could lead to sanctions against us that could harm our business and our financial condition.

 

Our operations are subject to the Foreign Corrupt Practices Act (“FCPA”) and similar anti-corruption laws of other countries. The FCPA generally prohibits U.S. companies and their intermediaries from making payments to foreign officials for the purpose of obtaining or maintaining business or otherwise obtaining favorable treatment. The FCPA also requires companies to maintain adequate record-keeping and internal accounting practices to accurately reflect the transactions of the companies. Under the FCPA, U.S. companies may be held liable for actions taken by their strategic or local partners or representatives. The FCPA and similar laws in other countries can impose civil and criminal penalties for violations.

 

If we do not properly implement practices and controls with respect to compliance with the FCPA and similar laws, or if we fail to enforce those practices and controls properly, we may be subject to regulatory sanctions. For example, the SEC and the U.S. Department of Justice (the “DOJ”) may assert that we have violated the FCPA, which could lead to fines against us and other penalties or remedies, such as appointment of a monitor or suspension of our ability to contract with U. S. or foreign governmental agencies. Investigations or sanctions by the SEC and DOJ in connection with FCPA enforcement, and internal investigations into whether or not violations have occurred, can be expensive and time-consuming for us. Any of these outcomes may have an adverse effect on our business, and could adversely affect our financial results and financial condition.

 

Delisting from NASDAQ and Compliance with SEC Reporting Requirements—Our common stock was delisted from the NASDAQ Stock Market, which could adversely affect the price of our stock and the ability of our stockholders to trade in our stock. We have not been in compliance with SEC reporting requirements since November 2005 and if we are unable to regain and remain in compliance with SEC reporting requirements, there may be a material adverse effect on us and our stock price.

 

Due to our Audit Committee investigation of our business practices, the independent investigation of our historical stock option granting practices, and the restatement activities as a result of the stock option investigation we were unable to timely file our periodic reports with the SEC. As a result, we were not in compliance with the filing requirements for continued listing on the NASDAQ Stock Market and, consequently, our common stock was delisted

 

16


Table of Contents

from the NASDAQ Stock Market in December 2005 and subsequently began trading on the Pink Sheets under the symbol “SRTI.PK.” To the extent that we attempt to relist our common stock on NASDAQ or another exchange, it would be uncertain when, if ever, our common stock would be relisted. In addition, as a result of our delay in filing periodic reports on a timely basis, we will not be eligible to use a registration statement on Form S-3 to register offers and sales of our securities until all periodic reports have been timely filed for at least twelve months after we have filed all required reports.

 

We have been unable to remain current with the filing of our periodic reports with the SEC, and our efforts to become current may require substantial management time and attention as well as additional accounting and legal expense. As a result of our restatement, we experienced significant delays in the filing of our periodic reports. In addition, if we are unable to become current with our filings with the SEC, we may face several adverse consequences. If we are unable to become and remain current with our filings with the SEC, investors in our securities will not have information regarding our business and financial condition with which to make decisions regarding investment in our securities. In addition, we will not be able to have a registration statement under the Securities Act of 1933, covering a public offering of securities, declared effective by the SEC, and will not be able to make offerings pursuant to existing registration statements pursuant to certain “private placement” rules of the SEC under Regulation D to any purchasers not qualifying as “accredited investors.” These restrictions could adversely affect our business, financial condition and results of operations.

 

Change in SEC Guidance and Disclosure Requirements—Judgments and estimates utilized by us in determining stock option grant dates and related adjustments in connection with the restatement of our consolidated financial statements may be subject to change due to subsequent SEC guidance or other disclosure requirements.

 

In determining the financial restatement adjustments in connection with our investigation of our historical stock option granting practices, we used all reasonably available relevant information to form conclusions we believe are appropriate as to the most likely option granting actions that occurred, the dates when such actions occurred, and the determination of grant dates for financial accounting purposes based on when the requirements of the accounting standards were met. We considered various alternatives throughout the course of our investigation and the restatement of our financial statements, and we believe the approaches used were appropriate, and the choices of measurement dates used in our investigation of stock option grant accounting and restatement of our financial statements were reasonable and appropriate in our circumstances. Nevertheless, the issues surrounding our historical stock option granting practices are complex and the regulatory guidelines or requirements continue to evolve. There can be no assurance that the SEC will not issue additional guidance on disclosure requirements related to the financial impact of past stock option grant measurement date errors and that we will not be required to further amend this report or other filings with the SEC to provide additional disclosures pursuant to such additional guidance. Any such circumstance could also lead to future delays in filing our subsequent SEC reports. Furthermore, if we are subject to adverse findings in any of these matters, we could be required to pay damages or penalties or have other remedies imposed upon us which could harm our business, financial condition, results of operations and cash flows.

 

Costs of Being a Small Public Company—As a public company we are required to comply with many financial accounting, disclosure and governance rules that impose significant financial and management burdens on us.

 

As a small public company we are subject to many financial accounting, disclosure and governance requirements, with disproportionately high associated compliance costs relative to our size. For example, we must have our annual financial statements audited and our quarterly statements reviewed by an independent registered public accounting firm, and we must prepare, review and file annual, quarterly and current reports with the SEC. Costs of these and other compliance activities are particularly significant to us because of our small size and our financial position. We have reviewed proposals to make the Company more successful with its current capital structure and with alternative ones. The process of evaluating different alternatives and proposals is time consuming, expensive, and distracts management

 

17


Table of Contents

attention from the operations of the Company. Moreover, so long as we are not current with our SEC filings, our opportunities are more limited. If we are not able to file all the delinquent reports, our financial condition and stockholder confidence in our company may be harmed. Even if we do file all our delinquent reports, we may not be able to comply with all the requirements of being a public company on a regular basis in the future, or we may be unable to reduce the costs of compliance or increase our revenue or profitability sufficiently to cover those costs.

 

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 be volatile.

 

We have experienced significant fluctuations in our quarterly results and we expect that our quarterly operating results will fluctuate significantly and unpredictably. Many factors could cause our operating results to fluctuate from quarter to quarter, including the following:

 

   

the size and timing of orders from our customers, and limitations on our ability to ship these orders on a timely basis;

 

   

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 variety of price, product, and technology competition;

 

   

the proportion of our sales that is domestic or international;

 

   

the mix of the products we sell and the varied margins associated with these products;

 

   

developments relating to our ongoing litigation; and

 

   

economic downturns reducing demand for telecommunication and cable equipment and services.

 

The factors listed above may affect our business and stock price in several ways. Given our high fixed costs from overhead, research and development, and selling and marketing, and other activities necessary to run our business, if our net sales are below our expectations in any quarter, we may not be able to adjust spending accordingly. Our stock price may decline and may be volatile, particularly if public market analysts and investors perceive that the factors listed above may contribute to unfavorable changes in operating results. 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.

 

Consolidation and Other Risks Within the Telecommunications Industry—Our operating results and financial condition could be adversely affected by consolidation among our principal customers, the uncertainty of end-user demand for the telecommunication services they provide, and the risk of regulatory changes in the telecommunications industry.

 

In recent years, the telecommunications industry has experienced rapid growth. This growth led to technology innovation, intense competition, short product life cycles, and regulatory uncertainty worldwide. It is difficult for companies operating in this industry to forecast future trends and developments, particularly forecasting customer acceptance of competing technologies. Moreover, the continued growth of end-user demand for telecommunications services is uncertain and difficult to predict. Such uncertainties may lead telecommunications companies to postpone investments in their businesses and purchases of related equipment, such as our products.

 

The telecommunications industry has also experienced consolidation, such as among incumbent local exchange carriers and competitive local exchange carriers, some of which are major customers. For example, GTE and Bell Atlantic, both of which were customers of ours, merged to create Verizon Communications Inc. Southwestern Bell, Pacific Bell, Ameritech, Bell South, and AT&T have consolidated and now operate as AT&T, Inc. Continued

 

18


Table of Contents

consolidation in the telecommunications industry may cause delay or cancellation of orders for our products. Additionally, 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.

 

Long-term Impact of Cost Controls—The actions we have taken and may take in response to the slowdowns in demand for our products and services could have long-term adverse effects on our business.

 

From time to time, our business experiences lower revenues due to decreased or cancelled customer orders. To scale back our operations and to reduce our expenses in response to decreased demand for our products and services and lower revenue, we have in the past reduced our workforce, restricted hiring, reduced salaries, restricted pay increases, reduced discretionary spending, and closed or relocated some of our operations abroad.

 

On February 6, 2008, we announced a restructuring plan intended to reduce costs and improve operating efficiencies. The plan included a 12% reduction in our worldwide workforce, across all functional areas, and a shut-down of certain international offices. We may be unable to reduce expenditures quickly enough, and sustain them at a level necessary to restore profitability, and we may have to undertake further restructuring initiatives that would entail additional charges. Cost-cutting initiatives may impair our future ability to develop and market products effectively, to manage and control our business, and to remain competitive. Moreover, cost reducing measures are time-consuming, can be costly to implement and can lead to a diminished quality of our products. Each of the above measures could have long-term effects on our business by reducing our pool of employee talent, decreasing or slowing improvements in our products, making it more difficult for us to respond to customers, limiting our ability to increase production quickly if, and when, the demand for our products increases, and limiting our ability to hire and retain key personnel. These circumstances could cause our growth and our earnings to be lower than they otherwise might be.

 

Dependence on Wireline Access Products—A significant portion of our sales has been from our wireline access products, which makes our future sales and overall business vulnerable to product obsolescence and technological change in the wireline field.

 

Sales of our DSL and other wireline access products represented approximately 36% of our net sales during 2006 and 34% during 2005. Currently, our DSL products are primarily used by a limited number of incumbent local exchange carriers, including the regional Bell operating companies, and competitive local exchange carriers who offer DSL services. 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.

 

Cable Broadband Industry Health—Many companies in the cable broadband industry have incurred significant amounts of debt and operating losses, and face increasing competition from direct broadcast satellite and telecom service providers, which may negatively impact our cable equipment sales.

 

The cable broadband industry has taken on significant debt as companies aggressively consolidate and build new digital networks to allow them to provide better picture quality, internet access, and voice telephony. As a result, cable companies may reduce their capital expenditures and hiring, either of which could adversely impact our cable business more than we currently anticipate.

 

19


Table of Contents

Customer Concentration—Our customers are concentrated in the telecommunications and cable broadband industries, which makes our future success dependent on the buying patterns of these customers and their continued demand for our products. In addition, a limited number of customers account for a high percentage of our net sales, and any adverse effect on these customers or our relationship with these customers could cause our net sales to decrease.

 

Our customers are concentrated in the telecommunications and cable broadband industries. Accordingly, our future success depends on the buying patterns of these customers and the continued demand by these customers for our products. Additionally, the market is characterized by rapidly changing technology, evolving industry standards, changes in end-user requirements and frequent new product introductions and enhancements. See “Risk Factors—Consolidation and Other Risks Within the Telecommunications Industry” for a discussion of risks associated with the telecommunications industry. Our continued success will depend upon our ability to enhance existing products and to develop and introduce, on a timely basis, new products and features that keep pace with technological developments and emerging standards.

 

Moreover, a relatively small number of customers account for a large percentage of our net sales. Net sales from our top five customers represented approximately 28% of total net sales in 2006, 22% in 2005, and 26% in 2004. In general, our customers are not subject to long-term supply contracts with us and are not obligated to purchase a specific amount of products from us or to provide us with binding forecasts of purchases for any period.

 

Historically, a significant portion of our net sales have come from a small number of relatively large orders from a limited number of large customers. We anticipate that our operating results for a given period will be dependent on a limited number of customers.

 

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 pressure us to lower our prices to them, and they may successfully negotiate other terms and provisions that may adversely affect our business and profits.

 

Product Development—If we are unable to develop new products successfully and enhance our existing 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 or otherwise abandoned because of the introduction of products involving competing technologies, by the evolution of alternative technologies or new industry protocol standards, by rival products of our competitors, market timing, or product design flaws. These market conditions are even more complex and challenging because 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;

 

20


Table of Contents
   

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.

 

Furthermore, our expenditures devoted to research and development may be considered high for our level of sales. If these efforts do not result in the development of products that generate strong sales for us or if we do not reduce these expenditures, our profit levels will not return to desired levels. If we reduce this spending, we may not be able to develop needed new products, which could negatively impact our sources of new revenues.

 

Sales Implementation Cycles—The length and unpredictability of the sales and implementation cycles for our products make 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 contacts. 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 to 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 deployments now typically ranges from six to twenty-four months. The deferral or loss of one or more significant sales could significantly affect our operating results, especially if there are significant selling and marketing expenses associated with deferred or lost sales.

 

Managing Growth and Slowdowns—We may have difficulty managing expansions and contractions in our operations, which could reduce our chances of maintaining or restoring our profitability.

 

We experienced rapid growth in revenues and in our business during 1999 and 2000 followed by significant slowdowns in 2001 and 2002, which were then followed by sales increases in subsequent years. In particular, we experienced rapid growth in revenues during 2006. These periods of expansion and contraction in our revenues and operations have placed, and may continue to place, a significant strain on our management and operations. As a result of our historical growth and potential 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; and

 

   

the challenge to manage expense reductions without impacting development strategies or our long-term goals.

 

We cannot ensure that we will be able to manage growth or slowdowns successfully, or that we will be able to achieve or sustain profitability.

 

Manufacturing Capacity—If demand for our products does not match our manufacturing capacity, our earnings may suffer.

 

We cannot immediately adapt our production capacity and related cost structures to rapidly changing demand for our products. When demand does not meet our expectations or manufacturing capacity exceeds our production

 

21


Table of Contents

requirements, profitability may decline. Conversely, if during a market upturn we cannot increase our manufacturing capacity to meet product demand, we will not be able to fulfill orders in a timely manner, which in turn may have a negative effect on our earnings and overall 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 of 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. 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 continued challenges to our market share and price pressure on our products. Also, over time, our profitability, if any, may decrease. In addition, it is difficult to assess accurately the market share of each of our products and lines of products because of the high degree of fragmentation in the market for service verification equipment. As a result, it may be difficult for us to forecast accurately trends in the market and which of our products will be the most competitive over the longer term, and therefore, what is the best use of our cash, personnel and other forms of resources.

 

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 bound by long-term contracts, our future supply of parts is uncertain.

 

We purchase many key parts, such as microprocessors, field programmable gate arrays, bus interface chips, optical components, and oscillators, from single source or sole suppliers, and we license certain software from third parties. We rely exclusively on third-party subcontractors to manufacture certain 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 help ensure an adequate supply. We may experience supply problems as a result of financial or operating 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, 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;

 

   

the unavailability of, or interruption in, access to some process technologies; and

 

   

exposure to the financial problems and stability of our suppliers.

 

22


Table of Contents

In addition, the purchase of these components on a sole source basis subjects us to risks of price increases and potential quality assurance problems. Long lead-times for delivery of certain sole-sourced components may impact our ability to respond to changes in production demand in a timely fashion to satisfy customers’ orders and we may not be able to ensure customer satisfaction. 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.

 

Risks of 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 approximately 48% of our net sales in 2006, 49% in 2005 and 47% in 2004. 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 local 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;

 

   

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; and

 

   

possible disruptions to our customers, sales channels, sources of supply, or production facilities due to wars, terrorist acts, acts of protest or civil disobedience, or other conflicts between or within various nations and due to variations in crime rates and the rule of law between nations.

 

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, both high-growth emerging markets for telecommunications equipment, have experienced instability in many of their economies and significant devaluations in local currencies. 22% of our sales in 2006 and 2005 and 24% of our sales in 2004 were from customers located in these regions. These economic instabilities may continue or worsen, which could have a material 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.

 

Operations in Taiwan—We rely on our subsidiary in Taiwan to manufacture a substantial portion of our products, and our reputation and results of operations could be adversely affected if this subsidiary does not perform as we expect.

 

We produce a substantial portion of our products at our subsidiary in Taiwan and plan to concentrate more of our production there in the future. We depend on our Taiwan subsidiary to produce a sufficient volume of our products in a timely fashion and at satisfactory quality levels. If we fail to manage our subsidiary so that it produces quality products on time and in sufficient quantities, our reputation and results of operations could suffer. In addition, we rely on our Taiwan subsidiary to place orders with suppliers for the components they need to manufacture our products. If our subsidiary in Taiwan fails to place timely and sufficient orders with its suppliers, our results of operations could suffer.

 

23


Table of Contents

The cost, quality, and availability of our Taiwan operations are essential to the successful production and sale of our products. Our increasing reliance on this foreign subsidiary for manufacturing exposes us to risks that are not under our immediate control and which could negatively impact our results of operations. In addition, transportation delays and interruptions, political and economic regulations, and natural disasters could also adversely impact our Taiwan operations and negatively impact our results of operations. See “Risk Factors—Dependence on Sole and Single Source Suppliers” and, “—Risks of International Operations” for a discussion of risks associated with concentrating production activities at one facility that is outside the United States.

 

Concentration of Control—Our Chief Executive Officer and certain directors retain significant control over us, which may allow them to decide the outcome of matters submitted to stockholders for approval. This influence may not be beneficial to all stockholders.

 

As of February 29, 2008, Paul A. Marshall, our President and Chief Executive Officer and a member of our Board, and Robert C. Pfeiffer, a member of our Board, beneficially owned approximately 23% and 12%, respectively, of our outstanding shares of common stock. Consequently, these two individuals together control approximately 35% of our outstanding shares of common stock and, to the extent that they act together, may be able to control the election of our directors and the approval of significant corporate transactions that must be submitted to a vote of the stockholders. In addition, Messrs. Marshall and Pfeiffer constitute two of the five members of our Board and have significant influence in directing the actions taken by the Board. Further, to our knowledge, as of February 26, 2008, Paul Ker-Chin Chang, our former Chief Executive Officer, President and Chairman of the Board, continued to hold approximately 10% of our outstanding shares of common stock. To the extent that Mr. Chang acts together with Messrs. Marshall and Pfeiffer, the three individuals together control approximately 45% of our outstanding shares. 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 us may also delay or prevent a change in control of us that other stockholders may consider desirable. In addition, conflict among the controlling stockholders may adversely impact their ability to take joint actions in the best interests of us and our other stockholders.

 

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 imperfections that we consider to be insignificant at the time of shipment. We may misjudge the seriousness of a product imperfection and allow the product 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 defects and errors 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 regulations or laws regarding our products. Our defense against such 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.

 

24


Table of Contents

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 are 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 risks associated with our intellectual property assets, including the risks of unauthorized use of our intellectual property and the costs of protecting our intellectual property.

 

Most of our intellectual property and proprietary technology is not protected by patents, and as a result our intellectual property may not be adequately protected. If unauthorized persons were to copy, obtain, or otherwise misappropriate our intellectual property or proprietary technology, 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 revenues. 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 monitoring and detecting the 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.

 

Although our employees are subject to confidentiality obligations, this protection may be inadequate to deter or prevent the misappropriation of our intellectual property or proprietary technology. Our inability to protect our intellectual property or proprietary technology may adversely affect our competitive business position.

 

Litigation has in the past been, and may in the future be, necessary to enforce our intellectual property rights and/or defend against the accusations of others. This kind of litigation is time-consuming and expensive to prosecute and resolve and results in a substantial diversion of management resources. We cannot assure you that we will be successful in this type of 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.

 

In the future, we may receive notices from holders of patents that raise issues as to possible infringement by our products. As the number of telecommunications test, measurement, and network management products increases and the functionality of these products further overlap, we believe that we may become subject to allegations of infringement given the nature of the telecommunications industry and the high incidence of these kinds of claims. Questions of infringement and the validity of patents in the field of telecommunications technologies involve highly technical and subjective analyses. These kinds of proceedings are time consuming and expensive to defend or resolve, result in a substantial diversion of management resources, cause product shipment delays, and could force us to enter into royalty or license agreements rather than dispute the merits of the proceedings initiated against us.

 

Acquisitions—We have in the past acquired multiple companies and lines of business, and we may pursue additional acquisitions in the future. These activities involve numerous risks, including the use of cash, acquired intangible assets, and the diversion of management attention.

 

We have acquired multiple companies and lines of business in the past. As a result of these 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 independent companies;

 

25


Table of Contents
   

developing compatible or complementary products and technologies from previously independent operations; and

 

   

pre-acquisition liabilities associated with the companies or intellectual property acquired, or both.

 

The risks stated above are increased by the fact that most of the companies and assets that we have acquired are located outside of the United States, which makes integration more difficult and costly. 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 additional acquisitions, we will face similar risks as those outlined 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 an acquisition is consummated;

 

   

negotiating and closing these transactions;

 

   

the possible need to fund these acquisitions by dilutive issuances of equity securities or by incurring debt; and

 

   

the potential negative effect on our financial statements from an increase in other intangibles, write-off of research and development costs, and high costs and expenses from 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 effectively, efficiently, and successfully into our business.

 

Goodwill Valuation—Our financial results could be materially and adversely affected if it is determined that the book value of goodwill is higher than the fair value.

 

Our balance sheet at December 31, 2006 included an amount designated as “Goodwill” of $12.6 million. Goodwill arises when an acquirer pays more for a business than the fair value of the acquired tangible and separately measurable intangible net assets. Under accounting pronouncement SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), beginning in January 2002, the amortization of goodwill has been replaced with an “impairment test,” which requires that we compare the fair value of goodwill to its book value at least annually, and more frequently, if circumstances indicate a possible impairment.

 

Our impairment test is based on a market capitalization analysis. Accordingly, if our market capitalization were to diminish significantly, the book value of goodwill could be higher than the fair value, and we would need to record a non-cash impairment charge for the difference, which could materially and adversely affect our net income or loss.

 

Dependence on Key Employees—If one or more of our senior managers were to leave, we could experience difficulty 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. If any of our senior managers were to leave us, 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. We do not have employment contracts with, or key person life insurance for, any of our personnel. During 2006, following the loss of a number of key employees, we announced the adoption of a retention bonus program and other inducements to reward long-term employees who remained employed with us. Competition for skilled employees is intense, especially in the San Francisco Bay Area where our main operations are located, and there can be no assurance that we will be able to recruit and retain such personnel.

 

26


Table of Contents

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 a stockholder may consider favorable. These provisions provide for the following:

 

   

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 could also limit the price that some investors might be willing to pay in the future for shares of our common stock.

 

Effectiveness of Internal Controls—We will be required to evaluate our system of internal control over financial reporting as of December 31, 2007 and our independent auditor will be required to attest to the effectiveness of our internal controls as of December 31, 2008. Any deficiencies found in our internal control over financial reporting or the inability of our independent auditor to conclude on the effectiveness could negatively impact our stock price.

 

Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. We will be required, beginning with our 2007 Form 10-K, to include in our annual report our management assessment of the effectiveness of our internal control over financial reporting as of December 31, 2007. Furthermore, our independent auditor will be required to report on whether it believes we maintained, in all material respects, effective internal control over financial reporting as of December 31, 2008. If we determine that our internal controls have significant deficiencies or material weaknesses, our ability to report financial results reliably could be questioned and investors might lose confidence in our reports. In addition, inadequate internal controls could cause us to fail to meet our regulatory reporting obligations. Any of these failures could adversely affect the price of our common stock.

 

AVAILABLE INFORMATION

 

Our website is http://www.sunrisetelecom.com. We make available free of charge, on or through our website, our annual, quarterly and current reports, and any amendments to those reports, as soon as reasonably practicable after electronically filing such reports with the SEC. Information contained on our website is not part of this report.

 

ITEM 1B.     UNRESOLVED STAFF COMMENTS

 

None.

 

27


Table of Contents

ITEM 2.    PROPERTIES

 

We own our headquarters, manufacturing and research, and development facility, which we built during 2001 on property that we acquired that year. The facility is 91,700 square feet and is located in San Jose, California. As of January 1, 2008, we also leased 10,000 square feet of office and manufacturing space in Anjou, Canada; 16,500 square feet of office and manufacturing space in Norcross, Georgia; 10,000 square feet of office and manufacturing space in Modena, Italy; 127,300 square feet of office and manufacturing space in Taipei County, Taiwan; and 2,000 square feet of office and manufacturing space in Geneva, Switzerland. We lease sales offices in Beijing, Guangzhou, and Shanghai, China; Seoul, Korea; Tokyo, Japan; Gomaringen, Germany; Milan, Italy; Paris, France; and Mexico City, Mexico. As part of our restructuring announced in February 2008, we have made a decision to close our facility in Anjou, Canada.

 

We believe that our existing facilities are adequate for our needs for the foreseeable future.

 

ITEM 3.    LEGAL PROCEEDINGS

 

As of December 31, 2006, we were involved in the following material legal proceeding:

 

On December 13, 2006, a stockholder derivative lawsuit was filed in the Superior Court of the State of California on behalf of Chris Stovall, a purported stockholder of ours, against certain of our current and former officers, directors, and employees and naming us as a nominal defendant. The complaint asserts claims for breach of fiduciary duty, waste, unjust enrichment and other statutory claims arising out of our stock option grant practices, which plaintiff claims included the “backdating” of stock option grants. We disclosed an internal review of such practices in November 2006 and described the results of that review in our Annual Report on Form 10-K for 2005, filed on November 2, 2007. The court has twice granted our motions to dismiss the claims based on the insufficiency of the complaint.

 

On November 21, 2007, Stovall filed a second amended complaint alleging similar legal claims arising primarily out of the historic stock option grant practices as described in our 2005 Form 10-K. The second amended complaint seeks money damages from the individual defendants, restitution, disgorgement of profits, attorneys’ fees, and various corporate governance reforms.

 

In February 2008, the parties attempted to resolve the litigation through mediation, but were unsuccessful. The parties may continue with their mediation efforts in the future. The Company intends to continue to assert all available defenses.

 

From time to time, the Company may be involved in litigation or other legal proceedings, including those noted above, relating to claims arising out of its day-to-day operations or otherwise. Litigation is inherently uncertain, and the Company could experience unfavorable rulings. Should the Company experience an unfavorable ruling, there exists the possibility of a material adverse impact on its financial condition, results of operations, cash flows or on its business for the period in which the ruling occurs and/or future periods.

 

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

During the quarter ended December 31, 2006, there were no matters submitted to a vote of the security holders, through the solicitation of proxies or otherwise.

 

28


Table of Contents

Part II.

 

ITEM 5.    MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

INFORMATION ABOUT OUR COMMON STOCK

 

Our common stock was traded on the NASDAQ Stock Market under the symbol “SRTI” since our initial public offering on July 13, 2000 through December 15, 2005, when our common stock was delisted and began trading on the Pink Sheets under the symbol “SRTI.PK”. Since December 15, 2005 there has been no established public trading market for our common stock.

 

The following table sets forth, for the periods indicated from January 1, 2005 through December 15, 2005 the highest and lowest sale prices for our common stock, as reported by the NASDAQ Stock Market, and for the period from December 16, 2005 through December 31, 2006, the highest and lowest sale prices for our common stock, as reported by the Pink Sheets.

 

2006

   High    Low   

2005

   High    Low

First Quarter

   $ 2.25    $ 1.30    First Quarter    $ 3.50    $ 2.58

Second Quarter

   $ 2.35    $ 1.85    Second Quarter    $ 2.70    $ 1.12

Third Quarter

   $ 2.35    $ 1.80    Third Quarter    $ 2.39    $ 1.82

Fourth Quarter

   $ 2.35    $ 1.85    Fourth Quarter    $ 2.36    $ 1.00

 

Number of Holders

 

As of March 1, 2008, we had approximately 62 stockholders of record of our common stock. We estimate that as of March 1, 2008, there were approximately 1,486 beneficial owners of our common stock.

 

Dividend Policy

 

We did not declare or pay any cash dividend in 2006. In February 2005, our board of directors declared a cash dividend for 2005 in the aggregate amount of approximately $2.5 million. We paid this dividend in March 2005. In February 2004, we declared and paid a cash dividend of approximately $2.5 million. Our Board of Directors will determine the amount of any future dividends based on our future financial condition and results of operations. Our secured revolving credit arrangement with Silicon Valley Bank limits our ability to pay future dividends. See Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Liquidity and Capital Resources.”

 

Unregistered Sales of Equity Securities

 

We did not sell any unregistered shares of our common stock during 2006, 2005, or 2004.

 

Purchases of Equity Securities by the Issuer and Affiliated Purchasers

 

Neither we nor any affiliated purchaser repurchased any of our equity securities in the fourth quarter of 2006.

 

29


Table of Contents

ITEM 6.    SELECTED FINANCIAL DATA

 

The table below sets forth summary consolidated financial information for the periods indicated. It is important that you read this information together with the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our audited consolidated financial statements and the notes thereto included elsewhere in this report.

 

     Years Ended December 31,  
     2006    2005     2004     2003     2002  

Consolidated Statements of Operations Data:
(in thousands, except per share data)

           

Net sales

   $ 99,880    $ 68,514     $ 61,669     $ 54,949     $ 54,333  

Cost of sales

     34,504      22,874       18,966       19,752       18,687  
                                       

Gross profit

     65,376      45,640       42,703       35,197       35,646  
                                       

Operating expenses:

           

Research and development

     21,068      18,402       16,623       16,612       18,044  

Selling and marketing

     27,688      23,462       18,067       17,431       17,678  

General and administrative

     16,586      14,795       10,154       10,111       11,959  

Gain from legal settlement

     —        (1,500 )     —         —         —    
                                       

Total operating expenses

     65,342      55,159       44,844       44,154       47,681  
                                       

Income (loss) from operations

     34      (9,519 )     (2,141 )     (8,957 )     (12,035 )

Other income, net

     2,174      472       899       875       895  
                                       

Income (loss) before income taxes

     2,208      (9,047 )     (1,242 )     (8,082 )     (11,140 )

Income tax expense (benefit)

     1,694      1,193       10,464       (2,487 )     (4,335 )
                                       

Net income (loss)

   $ 514    $ (10,240 )   $ (11,706 )   $ (5,595 )   $ (6,805 )
                                       

Dividends per share

   $ —      $ 0.05     $ 0.05     $ 0.04     $ —    
                                       

Net income (loss) per share: (1)

           

Basic

   $ 0.01    $ (0.20 )   $ (0.23 )   $ (0.11 )   $ (0.14 )
                                       

Diluted

   $ 0.01    $ (0.20 )   $ (0.23 )   $ (0.11 )   $ (0.14 )
                                       

Shares used in computing net income (loss) per share: (1)

           

Basic

     51,349      51,006       50,426       49,750       49,854  
                                       

Diluted

     51,580      51,006       50,426       49,750       49,854  
                                       
     December 31,  
     2006    2005     2004     2003     2002  

Consolidated Balance Sheet Data (in thousands):

           

Cash, cash equivalents and short-term investments

   $ 22,015    $ 24,956     $ 33,871     $ 39,885     $ 37,463  

Working capital

     40,694      40,134       50,500       56,535       54,876  

Total assets

     107,658      99,780       109,661       119,671       122,989  

Notes payable, less current portion

     528      602       882       1,095       1,177  

Total stockholders’ equity

     82,736      80,849       93,486       104,626       107,310  

 

(1)   See Note 1(p) of the Notes to Consolidated Financial Statements for a detailed explanation of the determination of the number of shares used to compute basic and diluted net income (loss) per share.

 

30


Table of Contents

ITEM 7.    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 Operations (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 above under Part I, Item 1A, “Risk Factors.” The following discussion should be read in conjunction with our consolidated financial statements and notes thereto included elsewhere in this report.

 

OVERVIEW

 

We manufacture and market service verification equipment that enables service providers to pre-qualify facilities for services, verify newly installed services, and diagnose problems relating to telecommunications, cable broadband, and internet networks. Our products offer broad functionality, leading edge technology, and compact size to test broadband services. These include wireline access services (including DSL), fiber optics, cable broadband networks, and signaling networks. We design our products to provide rapid answers for technicians in centralized network operations centers. Our customers include incumbent local exchange carriers, cable companies, competitive local exchange carriers, and other service providers, network infrastructure suppliers, and installers throughout North America, Latin America, Europe, Africa, the Middle East, and the Asia/Pacific region.

 

We assess the overall success of our business primarily through the use of financial metrics. Management considers several factors to be particularly important when assessing past business success and projecting future performance. The first such factor is the maintenance of high levels of working capital and low levels of debt. See “Liquidity and Capital Resources.”

 

This first factor is enabled by the second factor: the generation of cash flows from our operating activities. Ultimately, the ability to consistently generate substantial positive cash flows is the primary indicator of our business success and is imperative for our business survival. See “Liquidity and Capital Resources.”

 

The third factor is profitability. In general, profitability indicates our success in generating present and future cash flows from our operating activities. The key components of our profitability are net sales, cost of sales, and operating expenses. See the discussion directly below and “Comparison of Years Ended December 31, 2006 and 2005” and “Comparison of the Years Ended December 31, 2005 and 2004.”

 

Sources of Net Sales

 

We generate our cash flows primarily from selling telecommunications and broadband cable network testing equipment, and our future cash flows are largely dependent on our continuing ability to sell our products and collect cash for the sales to our customers. Our sales largely depend upon our ability to provide products that test most types of telecommunications network technologies, including those related to twisted-pair copper, cable broadband, and fiber optics networks. Within these technologies, we provide products that test the entire length of the network, from the point of installation in a building or residence through system back-offices and trunk lines, including the signaling processes that set up and tear down phone calls and transmit packets. We consider investment in research and development and selling and marketing activities to be critical to our ability to generate strong sales volume in the future. To that end, we continually offer new products, and update existing products, to meet customer needs.

 

We sell our products predominantly to large telecommunications service providers. These types of customers generally commit significant resources to the evaluation of our and our competitors’ products and require each vendor to expend substantial time, effort, and cost educating them about the value of the proposed solutions. Delays associated

 

31


Table of Contents

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 six to twenty-four months. 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. We anticipate that our operating results for any given period will continue to be dependent, to a significant extent, on purchase orders, which can be delayed or cancelled by our customers.

 

Historically, a significant portion of our net sales have come from a small number of relatively large orders from a limited number of customers. Verizon Communications, Inc. accounted for 11% of our net sales in 2006. No customers comprised more than 10% of our net sales in 2005 or 2004. Overall, we anticipate that our operating results for a given period will be dependent on a small number of customers.

 

Currently, competition in the telecommunications equipment market is intense and is characterized by declining prices due to increased competition and new products and due to declining customer demand. Because of these market conditions 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, or fail to introduce higher margin new products, there will be a corresponding decline in our gross margin percentage. See Part I, Item 1A, “Risk Factors—Competition” and “—Risks of the Telecommunications Industry.”

 

We have increasing sales denominated in Euros, as well as small amounts in the Canadian dollar, Japanese yen, Korean won and other currencies, and have, in prior years, used derivative financial instruments to hedge our foreign exchange risks. We record the impact of changes in the current value of such forward contracts as other income or expense. Foreign exchange exposure from sales is increasingly material to our operations and had a material effect on our operations in fiscal 2006. We have also been exposed to fluctuations in non-U.S. currency exchange rates related to our manufacturing activities in Taiwan. In the future, we expect that a growing portion of our 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. See Part I, Item 1A, “Risk Factors—Risks of International Operations.”

 

Cost of Sales

 

Our cost of sales consists primarily of the following:

 

   

direct material costs of product components, manuals, product documentation, and product accessories;

 

   

production wages, taxes, and benefits;

 

   

allocated production overhead costs;

 

   

warranty costs;

 

   

the costs of board level assembly by third party contract manufacturers; and

 

   

scrapped and reserved material purchased for use in the production process.

 

We recognize direct cost of sales, wages, taxes, benefits, and allocated overhead costs at the same time that we recognize revenue for products sold. We expense scrapped materials as incurred.

 

Our industry is characterized by limited sources and long lead times for the materials and components that we use to manufacture 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. These long lead times have caused in the past, and may in the future, cause us to

 

32


Table of Contents

purchase larger quantities of some parts, increasing our investment in inventory and the risk of the parts’ obsolescence. Additionally, initiatives to remove lead and other hazardous substances may require redesign of our products and could result in higher rates of obsolescence for components currently on hand. Any subsequent write-off of inventory could result in lower margins. See Part I, Item 1A, “Risk Factors—Dependence on Sole and Single Source Suppliers.”

 

Operating Costs

 

We classify our operating expenses into three general categories: research and development, selling and marketing, and general and administrative. Our operating expenses include stock-based compensation expense and amortization of certain intangible assets. We classify charges to the research and development, selling and marketing, and general and administrative expense categories based on the nature of these expenses. Although each of these three categories includes expenses that are unique to the category type, each category also includes commonly recurring expenses that typically relate to all of these categories, such as salaries, amortization of stock-based compensation, employee benefits, travel and entertainment costs, communications 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. The research and development category of operating expenses includes expenditures specific to the research and development group, such as design and prototyping costs. The general and administrative category of operating expenses includes expenses specific to the general and administrative group, such as legal and professional fees and amortization of identifiable intangible assets, such as patents and licenses.

 

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 or the headcount in each of these areas. These allocated charges include facility rent, utilities, communications charges, and depreciation expenses for our building, equipment, and office furniture.

 

We adopted SFAS 123R effective January 1, 2006, using the modified-prospective method of recognition of compensation expense related to share-based payments. Our condensed consolidated statements of operations for the twelve months ended December 31, 2006 reflect the impact of adopting SFAS 123R. In accordance with the modified prospective transition method, our condensed consolidated statements of operations for prior periods have not been restated to reflect, and do not include, the impact of SFAS 123R.

 

SFAS 123R requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense ratably over the requisite service periods. We have estimated the fair value of each award as of the date of grant or assumption using the Black-Scholes option pricing model. In 2006, we recorded stock-based compensation of $1.0 million.

 

In 2005 and 2004, we recorded amortization of the deferred stock-based compensation expense of $51,000 and $1.5 million, respectively, related to options to purchase our common stock granted prior to our initial public offering and in 2001 and 2002 at exercise prices that were subsequently deemed to be below fair market value. Total compensation expense related to the options granted prior to our initial public offering, which were granted in 1999 and the first quarter of 2000, and the options granted at below fair market value in the first quarter of 2001 and the second quarter of 2002, were 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. The 1999 options were fully amortized by the end of 2003, the 2000 options were fully amortized by the end of 2004, the 2001 options were fully amortized by the end of 2005, and the 2002 options were fully amortized by the end of 2006.

 

33


Table of Contents

Also, during 2006, 2005, and 2004, we charged $0.8 million, $1.8 million, and $2.7 million, respectively, to general and administrative expense for amortization of intangible assets obtained through various business acquisitions, such as developed technology and non-compete agreements.

 

On February 6, 2008, we announced a restructuring plan intended to reduce costs and improve operating efficiencies. The plan included a 12% reduction in our worldwide workforce, across all functional areas, and a shut-down of certain international offices. The cost reduction program, when fully implemented, is expected to save approximately $10-12 million per year on a pre-tax basis. We will recognize a one-time charge of approximately $1.4 million associated with employee severance payments, lease terminations, and other miscellaneous charges during the first quarter of fiscal 2008. The restructuring and impairment costs include employee severance and benefit costs, costs related to leased facilities to be abandoned or subleased, and impairment of owned equipment that will be disposed.

 

RESULTS OF OPERATIONS

 

The following table sets forth certain operating data as a percentage of net sales for the periods indicated:

 

     Percentage of Net Sales  
     Years Ended December 31,  
     2006     2005     2004  

Net sales

   100.0 %   100.0 %   100.0 %

Cost of sales

   34.5     33.4     30.8  
                  

Gross profit

   65.5     66.6     69.2  
                  

Operating expenses:

      

Research and development

   21.1     26.9     27.0  

Selling and marketing

   27.7     34.2     29.3  

General and administrative

   16.6     21.6     16.4  

Gain from legal settlement

   —       (2.2 )   —    
                  

Total operating expenses

   65.4     80.5     72.7  
                  

Income (loss) from operations

   0.1     (13.9 )   (3.5 )

Other income, net

   2.2     0.7     1.5  
                  

Income (loss) before income taxes

   2.3     (13.2 )   (2.0 )

Income tax expense

   1.8     1.7     17.0  
                  

Net income (loss)

   0.5 %   (14.9 )%   (19.0 )%
                  

 

COMPARISON OF YEARS ENDED DECEMBER 31, 2006 AND 2005

 

Net Sales.    Net sales increased 46% to $99.9 million in 2006 from $68.5 million in 2005. During 2006, sales of our wireline access products increased 56% or $12.8 million, sales of our fiber optics products increased 29% or $5.7 million, sales of our cable broadband products increased 51% or $10.6 million, and sales of our signaling products increased 39% or $2.2 million. The sales increases in fiber optics and cable broadband products were generally due to increased demand for our products resulting from our continuing penetration of diverse geographic markets with product lines that we continue to enhance in terms of breadth, functionality, and performance. The increase in wireline access products is primarily the result of the expected transition to new technologies. During the years ended December 31, 2006, 2005, and 2004, our sales were not significantly affected by changes in prices.

 

During 2006, sales increased $16.8 million or 45% in North America, increased $8.1 million or 49% in Europe/Africa/Middle East, increased $1.2 million or 62% in Latin America, and increased $5.2 million or 40% in Asia/Pacific

 

34


Table of Contents

compared to 2005. The increase in North American sales was primarily the result of increased sales of wireline access products and cable broadband products. Our growth in Europe/Africa/Middle East reflected the results of our ongoing development of distribution channels in these regions. International sales increased to $47.4 million, or 48% of net sales, in 2006, from $33.3 million, or 49% of net sales, in 2005.

 

Cost of Sales.    Cost of sales increased 51%, to $34.5 million in 2006 from $22.9 million in 2005. Cost of sales represented 35% of net sales in 2006 and 33% of net sales in 2005. This increase in cost of sales was primarily the result of increased sales and increases in the overall cost of materials and increased warranty costs relative to 2005, and the impact of product mix. This percentage is susceptible to change from variations in our product mix, changes in the proportion of our sales to international customers, and pricing pressures. Gross margins are expected to be under continued pressure through 2007 as product mix, new product introductions and regulatory impact on components adversely impact margins. Margins are expected to return to historic levels of approximately 65% in 2008.

 

Research and Development.    Research and development expenses increased to $21.1 million in 2006 compared to $18.4 million in 2005, and represented 21% of net sales in 2006 as compared to 27% in 2005. The increase in expense was primarily due to increased salaries and wages of $1.0 million associated with increased staffing in Canada and our Beijing research laboratory and retention bonus payments, increased parts and prototyping costs of $0.4 million, and increased stock-based compensation expense of $0.5 million associated with the adoption of SFAS 123R. Research and development expenses tend to fluctuate from period to period, depending on requirements at the various stages of our product development cycles. Through our research and development activities, we have attempted to control costs and to develop products that address customer needs in a rapidly changing and competitive market so that we can increase share in new markets and grow our sales. Research and development expenses are expected to remain at the current levels, or increase slightly as a result of expanded product development activity.

 

Selling and Marketing.    Selling and marketing expenses increased 18% to $27.7 million in 2006 from $23.5 million in 2005. Selling and marketing expenses represented 28% of net sales in 2006 and 34% of net sales in 2005. The increase in expense was primarily due to increased salaries and wages of $1.5 million primarily associated with increased headcount and retention bonus payments, increased commission expense of $1.7 million associated with increased sales, and increased stock-based compensation expense of $0.4 million associated with the adoption of SFAS 123R. The commission expenses included in selling and marketing can fluctuate both with changes in sales volume and with changes in the channels through which the sales flow. We use different distribution methods to supply our products to different geographical regions and different customers, and the commission rates we incur can vary among these channels. International sales to distributors are generally made at substantial discounts but without commission, resulting in both lower sales prices and lower marketing expenses than equivalent sales made domestically directly to the end customer.

 

General and Administrative.    General and administrative expenses increased 12% to $16.6 million in 2006 from $14.8 million in 2005. This increase was primarily due to increased salaries and wages of $1.7 million primarily associated with increased headcount and retention bonus payments, increased legal expense of $0.6 million related to special investigations, increased audit related expense of $0.7 million due to expanded procedures as a result of the investigation and restatement, offset in part by lower amortization expense related to intangible assets of $1.0 million and lower legal fees of $0.2 million due to the settlement of litigation with Acterna in August 2005. General and administrative expenses represented 17% of net sales in 2006 and 22% of net sales in 2005. During 2006, we experienced substantial costs related to a special investigation undertaken by the Audit Committee. Excluding this item, general and administrative expense in 2006 was essentially flat as compared to 2005. General and administrative expenses are expected to continue at similar levels through the first half of 2008 as decreased legal expenses are offset by increased costs of compliance with Sarbanes-Oxley and continuing significant accounting and audit related expenses.

 

35


Table of Contents

Gain from Legal Settlement.    A one-time settlement of $1.5 million was received as a result of the settlement of all litigation between us and Acterna in August 2005. This is considered an unusual item and reported separately on the consolidated statement of operations as a component of operating expenses for the year ended December 31, 2005.

 

Other Income, Net.    Other income, net primarily represents interest earned on cash and investment balances and gains and/or losses on assets, liabilities, and transactions denominated in foreign currencies. Other income, net increased 361% to $2.2 million in 2006 from $0.5 million in 2005 reflecting a $1.3 million increase in exchange gains due to the impact of the declining dollar on our investments in foreign subsidiaries, increased gains of $0.3 million from the sale of marketable securities, and other income of $0.1 million.

 

Income Tax Expense.    Income tax expense consists of federal, state, and foreign income taxes. Income tax expense increased to $1.7 million in 2006 from $1.2 million in 2005 and reflects the higher levels of taxable income generated in 2006, primarily in certain of the Company’s foreign subsidiaries.

 

COMPARISON OF YEARS ENDED DECEMBER 31, 2005 AND 2004

 

Net Sales.    Net sales increased 11% to $68.5 million in 2005 from $61.7 million in 2004. During 2005, sales of our wireline access products decreased by $3.8 million or 14%, sales of our fiber optics products increased by $5.6 million or 41%, sales of our broadband products increased by $5.1 million or 32%, and sales of our signaling products remained substantially flat. The sales increases in fiber optics and broadband products were generally due to increased demand for our products resulting from our continuing penetration of diverse geographic markets with product lines that we continue to enhance in terms of breadth, functionality, and performance. The decline in wireline access products is primarily the result of the expected transition to new technologies. Overall sales growth is primarily due to increased unit sales and not changes in average selling price.

 

During 2005, sales increased $3.7 million or 11% in North America, increased $3.1 million or 23% in Europe/Africa/Middle East, increased $0.7 million or 53% in Latin America and decreased $0.6 million or 5% in Asia/Pacific compared to 2004. The increase in North American sales was primarily the result of increased sales of cable broadband products. Our growth in Europe/Africa/Middle East reflected the results of our ongoing development of distribution channels in these regions. International sales increased to $33.3 million, or 49% of net sales in 2005, from $29.2 million, or 47% of net sales in 2004.

 

Cost of Sales.    Cost of sales increased 21% to $22.9 million in 2005 from $19.0 million in 2004. Cost of sales represented 33% and 31% of net sales in 2005 and 2004, respectively. This increase in cost of sales was primarily the result of increased sales and increases in the overall cost of materials relative to 2004 and the impact of product mix. Although cost of sales has increased as a percentage of sales in 2005 relative to 2004, the gross margin percentage in 2005 was consistent with historic margins. This percentage is susceptible to change from variations in our product mix, changes in the proportion of our sales going to international customers, and pricing pressures.

 

Research and Development.    Research and development expenses increased 11% to $18.4 million in 2005 compared to $16.6 million in 2004. Research and development expenses represented 27% of net sales in both 2005 and 2004. Research and development expenses tend to fluctuate from period to period, depending on requirements at the various stages of our product development cycles. Through our research and development activities, we have attempted to balance two conflicting strategic priorities. The first is to tightly control costs in response to sales volume that has significantly increased since 2002. The second is to continue to develop products that address customer needs in a rapidly changing and very competitive market so that we can increase our share in new markets. We opened a Chinese research facility in 2004, which lowered the average cost per man-hour of engineering during 2005 relative to 2004.

 

36


Table of Contents

Selling and Marketing.    Selling and marketing expenses increased 30% to $23.5 million in 2005 from $18.1 million in 2004. Selling and marketing expenses represented 34% of net sales in 2005 and 29% of net sales in 2004. During 2005, we invested heavily in our sales channels to better penetrate large accounts and regions where we believed substantial future growth is possible. In particular, the consolidation of the North American sales channel and the establishment of sales offices in France, Mexico, Spain, Italy, and China increased sales expenses in the near term but is expected to result in increased sales in the future. The commission expenses included in selling and marketing can fluctuate both with changes in sales volume and with changes in the channels through which the sales flow. We use different distribution methods to supply our products to different geographical regions and different customers, and the commission rates we incur can vary among these channels.

 

General and Administrative.    General and administrative expenses increased 45% to $14.8 million in 2005 from $10.2 million in 2004. General and administrative expenses represented 22% of net sales in 2005 and 16% of net sales in 2004. During 2005, we experienced costs aggregating $3.2 million related to litigation to protect our intellectual property rights and $0.8 million associated with a special investigation undertaken by the Audit Committee. Excluding these items, general and administrative expense for 2005 was substantially flat compared to 2004.

 

Gain from Legal Settlement.    A legal settlement of $1.5 million was received during 2005 relating to patent litigation. This item represents 2% of net sales in 2005. This is considered an unusual item and reported separately on the consolidated statements of operations as a component of operating expenses.

 

Other Income, Net.    Other income, net primarily represents interest earned on cash and investment balances and, to a lesser extent, gains and/or losses on assets, liabilities, and transactions denominated in foreign currencies. Other income, net decreased 44% to $0.5 million in 2005 from $0.9 million in 2004 reflecting decreased interest earned due to lower investment balances and the impact of currency fluctuations.

 

Income Tax Expense.    Income tax expense consists of federal, state, and foreign income taxes. Income tax expense decreased to $1.2 million in 2005 from $10.5 million in 2004. During the three months ended March 31, 2004, we reevaluated our need for a valuation allowance in light of forecast industry conditions. As a result of this assessment, the consideration of cumulative losses in prior periods, uncertain industry conditions and the inability to predict future earnings, we recorded a valuation allowance against our deferred tax assets in most jurisdictions aggregating $9.0 million during the first quarter of 2004.

 

LIQUIDITY AND CAPITAL RESOURCES

 

Cash Requirements and Capital Resources

 

As of December 31, 2006 and 2005, we had working capital of $40.7 million and $40.1 million, respectively, and cash, cash equivalents and short-term investments of $22.0 million and $25.0 million, respectively.

 

In 2001, we obtained a loan from the Italian government, which bears interest at 2% a year. At December 31, 2006, the outstanding balance on this loan was $0.7 million, which is to be repaid by semi-annual principal payments over an eight-year period which began in July 2003. As of December 31, 2006, we also have short-term notes and other borrowings, with an aggregate amount due of less than $0.1 million.

 

On August 13, 2007, we entered into a $10 million secured revolving credit arrangement, as well as a letter of credit facility, with Silicon Valley Bank. We may borrow, repay and reborrow under the line of credit facility at any time. The line of credit facility bears interest at the bank’s prime rate (5.25% at March 18, 2008). Our line of credit is collateralized by substantially all of our assets and requires us to comply with customary affirmative and negative covenants principally relating to use and disposition of assets, tangible net worth and the satisfaction of a quick ratio test. In addition, the credit arrangement contains customary events of default. Upon the occurrence of an uncured

 

37


Table of Contents

event of default, among other things, the bank may declare that all amounts owing under the credit arrangement are due and payable. The line of credit and facility expire on August 13, 2008. As of the date of this report, there is no amount outstanding under this revolving credit arrangement.

 

On February 6, 2008, we announced a restructuring plan intended to reduce costs and improve operating efficiencies. The plan included a 12% reduction in our worldwide workforce, across all functional areas, and the closure of certain international offices. The cost reduction program, when fully implemented, is expected to save approximately $10-12 million per year on a pre-tax basis. We will recognize a one-time charge of approximately $1.4 million associated with employee severance payments, lease terminations, and other miscellaneous charges in the first quarter of fiscal 2008. The restructuring and impairment costs include employee severance and benefit costs, costs related to leased facilities to be abandoned or subleased, and impairment of owned equipment that will be disposed.

 

As of March 1, 2008, we believe that our current cash balances, future cash flows from operations, and line of credit arrangement will be sufficient to meet our anticipated cash needs for our operations, complete needed business projects, achieve our plans and objectives, meet financial commitments, meet working capital requirements, make capital expenditures, and fund other activities beyond the next twelve months.

 

Sources and Uses of Cash

 

Cash provided by operating activities was $2.7 million in 2006. Cash used in operating activities was $4.0 million in 2005 and $1.5 million in 2004. Cash provided by operating activities increased during 2006 compared to 2005 primarily due to net income in 2006, increased income taxes payable and deferred revenue. These increases were partially offset by increased inventories and accounts receivable in response to higher sales volume. Cash used in operating activities increased during 2005 compared to 2004 primarily due to the increase in operating loss in 2005. In general, our ability to continue to generate positive cash flows from operations will depend on our ability to generate and collect cash from future sales, while maintaining a cost structure lower than those sales amounts. Therefore, sales volume is the most significant uncertainty in our ability to continue to generate positive cash flows from operations.

 

Cash used in investing activities was $2.9 million in 2006, cash provided by investing activities was $6.2 million in 2005, and cash used in investing activities was $2.5 million in 2004. The $9.1 million decrease in net cash provided by investing activities during 2006 compared to 2005 was primarily due to an increase in capital expenditures associated primarily with the relocation of our manufacturing facility in Taiwan and a decrease in proceeds received from the sale of short-term investments, net of purchases. The $8.7 million increase in net cash provided by investing activities during 2005 compared to 2004 was primarily due to a decrease in capital expenditures and an increase in proceeds received from the sale of short-term investments, net of purchases. As of December 31, 2006, we do not anticipate large capital expenditures outside the usual course of those needed for our ongoing production, research and development, and selling and marketing activities.

 

Cash used in financing activities was $0.5 million in 2006, $1.4 million in 2005, and $1.9 million in 2004. The decrease in cash used in financing activities during 2006 compared to 2005 is primarily due to the Board of Directors not declaring a cash dividend to be paid in 2006, offset by an increase in restricted cash and a decrease in proceeds from common stock issued under our Employee Stock Purchase Plan and exercise of stock options. No purchases of stock under the Stock Purchase Plan or exercises of stock options have been permitted subsequent to December 2005 due to restrictions on our ability to issue stock as a result of not being current with our SEC filings. The decrease in cash used in financing activities during 2005 compared to 2004 is primarily due to a decrease in restricted cash and an increase in proceeds from common stock issued under our Employee Stock Purchase Plan and exercise of stock options.

 

38


Table of Contents

Debt Instruments, Guarantees, and Related Covenants

 

Our outstanding debt at December 31, 2006 consisted primarily of a $0.7 million loan from the Italian government for research and development that is payable over a period of eight years through semi-annual payments ending in 2011. We have not used off-balance sheet financing arrangements, issued or purchased derivative instruments linked to our stock, or used our stock as a form of liquidity. We do not believe that there are any known or reasonably likely changes in credit ratings or ratings outlook or an inability to achieve such changes which would have any significant impact on our operations. We are not subject to any debt covenants that we believe might have a material impact on our business.

 

On August 13, 2007, we entered into a $10 million revolving credit arrangement and line of credit facility with Silicon Valley Bank. It is collateralized by substantially all of our assets. As of the date of this report, there is no amount outstanding under this revolving credit arrangement and we are in compliance with all operating and financial covenants.

 

CRITICAL ACCOUNTING POLICIES

 

The preparation of financial statements in accordance with United States generally accepted accounting principles requires us to make estimates, assumptions, and judgments that affect the amounts reported in our consolidated financial statements and the accompanying notes. We base our estimates on historical experience and various other assumptions that we believe to be reasonable. Although these estimates are based on our present best knowledge of the future impact that current events and actions will have on us, actual results may differ from these estimates, assumptions, and judgments.

 

We consider “critical” those accounting policies that require our most subjective or complex judgments, which often result from a need to make estimates about the effect of matters that are inherently uncertain, and that are among the most important of our accounting policies to the portrayal of our financial condition and results of operations. These critical accounting policies are the determination of our allowance for doubtful accounts receivable, valuation of excess and obsolete inventory, valuation of goodwill and other intangible assets, accounting for the liability of product warranty, deferred income tax assets and liabilities, revenue recognition, and accounting for stock-based compensation.

 

Allowance for Doubtful Accounts Receivable

 

We determine our allowance for doubtful accounts receivable by making our best estimate considering our historical accounts receivable collection experience and the information that we have about the current status of our accounts receivable balances. If future conditions cause our collection experience to change or if we later obtain different information about the status of any or all of our accounts receivable, additional allowances for doubtful accounts receivable may be required. We charge provisions for doubtful accounts receivable to general and administrative expenses on our statements of operations.

 

Valuation of Excess and Obsolete Inventory

 

We determine the valuation of excess and obsolete inventory by making our best estimate considering the current quantities of inventory on hand and our forecast of the need for this inventory to support future sales of our products. We often have limited information on which to base our forecasts, and if future sales differ from these forecasts, the valuation of excess and obsolete inventory may change. We charge provisions for excess and obsolete inventory to cost of sales on our statement of operations.

 

39


Table of Contents

Valuation of Goodwill and Other Intangible Assets

 

We evaluate the valuation of goodwill in the manner prescribed by SFAS 142. As required by SFAS 142, we test goodwill for impairment annually, during our fourth fiscal quarter. We would also test goodwill for impairment if certain events or changes in circumstances stipulated by SFAS 142 were to occur. SFAS 142 prescribes a two-phase process for the impairment testing of goodwill. The first screens for impairment by comparing the fair value of our reporting unit, which we consider to be the market capitalization of our entire telecommunications testing equipment business, to its carrying value. If the carrying value were to exceed the fair value, the second phase of the process would occur. In the second phase, we would recognize an impairment for the excess of the carrying value, if any, of our goodwill over its implied fair value. The implied fair value of our goodwill is the excess of our reporting unit’s total fair value over the combined net fair values of its individual assets and liabilities. Based on the annual test for impairment performed during the fourth fiscal quarter of 2006, goodwill was determined not to be impaired, and no subsequent indicators of impairment have been noted. Our market capitalization has consistently exceeded our net asset value, although the margin is narrow and has generally been declining in recent periods.

 

We evaluate the valuation of intangible assets other than goodwill in the manner prescribed by SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets. As required by that standard, we monitor events and changes in circumstances that could indicate that the carrying amount of an intangible asset may not be recoverable. These events and circumstances include a significant change in how we use the asset, significant changes in legal factors or the business climate that could affect the asset’s value, and current period operating or cash flow losses combined with a history of such losses or a forecast of continuing losses associated with the use of the asset. If such an event or change in circumstances were to occur we would assess the recoverability of the intangible asset by determining whether its carrying value would be recovered through undiscounted expected future cash flows. If the carrying value of the asset were to exceed the undiscounted expected future cash flows, we would recognize an impairment for the excess of the carrying value over the asset’s fair value.

 

Product Warranties

 

Our wireline access products and fiber optic products sold in the United States are covered by a three-year warranty covering parts and labor, with an option to purchase a two-year extended warranty. Our cable broadband and signaling products are covered by a one to three year warranty, with an option to purchase a two-year extended warranty. Our products sold in all other countries generally are sold with a one-year warranty, with the option to purchase a two-year extended warranty. We defer revenue from services and support provided under our extended warranty programs and recognize it on a straight-line basis over the warranty period. We are also subject to laws and regulations in the various countries in which we sell regarding vendor obligations to ensure product performance. At the time we recognize revenue from a product’s sale, we determine the reserve for the future cost of meeting our obligations under the standard warranties and product performance laws and regulations by considering our historical experience with the costs of meeting such obligations. If the future costs of meeting these obligations differ from our historical experience, additional reserves for warranty obligations may be required. We charge provisions for future warranty costs to cost of sales in our statements of operations.

 

Deferred Income Tax Assets and Liabilities

 

We account for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for the future tax consequences attributable to operating loss and tax credit carryforwards. In assessing the recoverability of deferred tax assets, we consider whether it is more likely than not that all or some portion of the deferred tax assets will be realized. The ultimate realization of certain deferred tax assets is dependent upon the generation of future taxable income during

 

40


Table of Contents

the periods in which the related temporary differences become deductible. If we obtain information that causes our forecast of future taxable income to change or if taxable income differs from our forecast, we may have to revise the carrying value of our deferred tax assets, which would affect our net income in the period in which the change occurs. The ultimate realization of certain other deferred tax assets is dependent on our ability to carry forward or back operating losses and tax credits. If changes in the tax laws occur that inhibit our ability to carry forward or back operating losses or tax credits, we will recognize the effect on our deferred tax assets in the results of operations of the period that includes the enactment date of the change. Furthermore, we measure our deferred tax assets and liabilities using the enacted tax laws expected to apply to taxable income in the years in which temporary differences are expected to be recovered or settled. If tax laws change, we will recognize the effect on our deferred tax assets and liabilities in the results of operations in the period that includes the enactment date of the change.

 

During the first quarter of 2004, we recorded a valuation allowance against all of our net deferred tax assets in the United States and most of the foreign jurisdictions in the amount of $9.0 million. We evaluated all significant available positive and negative evidence, including the existence of cumulative net losses in recent periods, benefits that could be realized from available tax strategies, and forecasts of future taxable income, in determining the need for a valuation allowance on our deferred tax assets. The cumulative net losses in recent periods represented sufficient negative evidence that was difficult for positive evidence to overcome under the evaluation guidance of SFAS No. 109, Accounting for Income Taxes (“SFAS 109”). Accordingly, a valuation allowance was recorded. We intend to maintain this valuation allowance until sufficient positive evidence, such as the resumption of a consistent earnings pattern, exists to support our reversal in accordance with SFAS 109. The expense for recording the valuation allowance is a non-cash item, and the recording of this expense does not imply that we owe additional income taxes.

 

Revenue Recognition

 

We recognize revenue from a customer order when all of the following criteria are met: persuasive evidence of an arrangement exists; delivery has occurred; the price is fixed or determinable; and collectability is reasonably assured. For product sales, we consider delivery to have occurred when title and risk of loss have been transferred to the customer, which is usually when the product has been received by a common carrier. For services, we consider delivery to have occurred once the service has been provided. We use objective evidence of fair value to allocate revenue to elements in multiple element arrangements and recognize revenue when the criteria for revenue recognition has been met for each element. In the absence of objective evidence of fair value of a delivered element, we allocate revenue to the fair value of the undelivered elements and the residual revenue to the delivered elements. The price charged when an element is sold separately generally determines its fair value.

 

When the arrangement with the customer includes future obligations or customer acceptance, we recognize revenue when those obligations have been met or customer acceptance has been received. We defer revenue from services and support provided under our extended warranty programs, and recognize it over the warranty period. Deferred revenue represents amounts received from customers in advance of services and support to be provided and amounts received for product sales that are subject to customer acceptance. Provisions are recorded at the time of sale for estimated product returns, standard warranty obligations, and customer support.

 

Stock-based Compensation

 

In December 2004, the FASB issued the revised SFAS No. 123R, Share-Based Payment (“SFAS 123R”), which addresses the accounting for share-based payment transactions in which we obtain employee services in exchange for (a) equity instruments of the Company or (b) liabilities that are based on the fair value of our equity instruments or that may be settled by the issuance of such equity instruments. This statement eliminates the ability to account for employee share-based payment transactions using Accounting Principles Board (“APB”) 25, Accounting for Stock Issued to Employees, and requires instead that such transactions be accounted for using the grant-date fair value based method. We implemented SFAS 123R effective January 1, 2006 using the modified-prospective method of recognition of stock-based compensation expense.

 

41


Table of Contents

SFAS 123R requires all share-based payments, including grants of stock options and employee stock purchase rights, to be recognized in our financial statements based on their respective grant date fair values. Under this standard, the fair value of each employee stock option and employee stock purchase right is estimated on the date of grant using an option pricing model that meets certain requirements. We currently use the Black-Scholes option pricing model to estimate the fair value of our share-based payments. The Black-Scholes model meets the requirements of SFAS 123R but the fair values generated by the model may not be indicative of the actual fair values of our stock-based awards as it does not consider certain factors important to stock-based awards, such as continued employment and periodic vesting requirements and limited transferability. The determination of the fair value of share-based payment awards utilizing the Black-Scholes model is affected by our stock price and a number of assumptions, including expected volatility, expected life, risk-free interest rate and expected dividends. We use the actual historic volatility of our stock as the expected volatility assumption required in the Black-Scholes model.

 

The expected life of the stock options is based on historical data trended into the future. The risk-free interest rate assumption is based on observed interest rates appropriate for the terms of our stock options and stock purchase rights. The dividend yield assumption is based on our history and expectation of dividend payouts. Stock-based compensation expense recognized in our financial statements in 2006 and thereafter is based on awards that are ultimately expected to vest. The amount of stock-based compensation expense in 2006 and thereafter will be reduced for estimated forfeitures based on historical experience. Forfeitures are required to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We will evaluate the assumptions used to value stock awards on a quarterly basis. If factors change and we employ different assumptions, stock-based compensation expense may differ significantly from what we have recorded in the past. If there are any modifications or cancellations of the underlying unvested securities, we may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense. To the extent that we grant additional equity securities to employees or we assume unvested securities in connection with any acquisitions, our stock-based compensation expense will be increased by the additional unearned compensation resulting from those additional grants or acquisitions. If we had adopted SFAS 123R in prior periods, the magnitude of the impact of that standard on our results of operations would have approximated the impact of SFAS 123, assuming the application of the Black-Scholes option pricing model as described in the disclosure of pro forma net income (loss) and pro forma net income (loss) per share in Note 12 of our Notes to Consolidated Financial Statements.

 

OFF-BALANCE SHEET ARRANGEMENTS

 

As of December 31, 2006, we did not have any off-balance sheet arrangements that have or are reasonably likely to have a material effect on our current or future financial condition, revenues or expenses, results of operations, liquidity, capital expenditures, or capital resources.

 

CONTRACTUAL OBLIGATIONS

 

The following table summarizes, as of December 31, 2006, the timing of future cash payments due under certain contractual obligations (in thousands):

 

     Payments Due In
     Total    Less than
1 year
   1-3
years
   4-5
years
   More than
5 years

Borrowings and notes payable

   $709    $181    $302    $226    $—  

Interest expense associated with borrowings and notes payable

   33    14    15    4    —  

Operating lease obligations

   4,627    1,247    1,922    1,406    52

Purchase obligations*

   3,882    3,882    —      —      —  
                        

Total

   $9,251    $5,324    $2,239    $1,636    $52
                        

 

42


Table of Contents

 

*   Represents our outstanding purchase orders for goods and services. While the amount above represents our purchase agreements as of December 31, 2006, the actual amounts to be paid may be less in the event that any agreements are renegotiated, cancelled, or terminated.

 

RECENT ACCOUNTING PRONOUNCEMENTS

 

On July 13, 2006, the FASB issued Interpretation 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement 109 (“FIN 48”), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold that a tax position must reach before financial statement recognition. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. We do not expect that the adoption of FIN 48 will have a significant impact on our consolidated financial statements.

 

On September 15, 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 does not expand the use of fair value in any new circumstances. SFAS 157 is effective for fiscal years beginning after November 15, 2007 for financial assets and liabilities and for fiscal years beginning after November 15, 2008 for non-financial assets and liabilities. We do not expect that the adoption of SFAS 157 will have a significant impact on our consolidated financial statements.

 

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides guidance on how prior year misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 does not change the guidance in SAB No. 99, Materiality, when evaluating the materiality of misstatements. SAB 108 is effective for fiscal years ending after November 15, 2006. Upon initial application, SAB 108 permits a one-time cumulative effect adjustment to beginning retained earnings. We do not expect that the adoption of SAB 108 will have a significant impact on our consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact of the adoption of SFAS 159 on our consolidated financial statements.

 

In June 2007, the FASB ratified the consensus on Emerging Issues Task Force (“EITF”) Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards (“EITF 06-11”). EITF 06-11 requires companies to recognize the income tax benefit realized from dividends or dividend equivalents that are charged to retained earnings and paid to employees for non-vested equity-classified employee share-based payment awards as an increase to additional paid-in capital. EITF 06-11 is effective for fiscal years beginning after September 15, 2007, which will be our fiscal year 2008. We do not expect that the adoption of EITF 06-11 will have a significant impact on our consolidated financial statements.

 

In June 2007, the FASB ratified the consensus reached on EITF Issue No. 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities (“EITF 07-3”), which requires that nonrefundable advance payments for goods or services that will be used or rendered for future

 

43


Table of Contents

research and development activities be deferred and amortized over the period that the goods are delivered or the related services are performed, subject to an assessment of recoverability. EITF 07-3 will be effective for fiscal years beginning after December 15, 2007, which will be our fiscal year 2008. We do not expect that the adoption of EITF 07-3 will have a significant impact on our consolidated financial statements.

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS 141R”), which replaces SFAS 141. SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired. SFAS 141R also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for fiscal years beginning after December 15, 2008. We will be required to adopt SFAS 141R in our fiscal year 2009 commencing January 1, 2009.

 

ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

Foreign Currency Risk

 

We sell our products in North America, the Asia/Pacific region, Latin America, Africa, the Middle East, and Europe and maintain operations in several different countries. Changes in currency exchange rates affect the valuation in our financial statements of the assets and liabilities of these operations. We also have increasing amounts of sales denominated in euros, the Canadian dollar, Japanese yen, Korean won, and other currencies, which are also affected by changes in currency exchange rates. To hedge these risks, we have, at certain times, used derivative financial instruments. As of December 31, 2006, we had no material derivative financial instruments or other foreign exchange risk hedging devices. With or without hedges, our financial results could be affected by changes in foreign currency exchange rates. Foreign exchange risks are increasingly material to our operations and had a material effect on our operations in fiscal 2006.

 

Interest Rate Risk

 

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 held derivative financial instruments in our investment portfolio. We invest our excess cash in depository accounts with financial institutions, in debt instruments of United States governmental agencies, and in debt instruments of 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 through portfolio diversification and review of the financial stability of the institutions with which we deposit funds and from whom we purchase debt instruments.

 

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. Because our investment policy restricts us to conservative, interest-bearing investments and because our business strategy does not rely on generating material returns from our investment portfolio, we do not expect our market risk exposure on our investment portfolio to be material.

 

44


Table of Contents

Equity Price Risk

 

As of December 31, 2006, we owned 1,883,000 shares of the common stock of Top Union Electronics Corp. (“Top Union”), a Taiwan R.O.C. corporation, which we acquired as a strategic investment primarily during the years 1998 through 2000. The Company sold 1,426,020 shares of Top Union stock and realized gains of $341,000 during the fiscal year ended December 31, 2006. We consider the Top Union stock to be “available-for-sale,” as that term is defined in SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, and accordingly we carry our holdings of Top Union stock at fair value on our balance sheet, with the unrealized gain or loss deferred as a component of stockholders’ equity. Because our holding is large relative to the normal trading volume in Top Union stock, we do not consider this to be a liquid investment, and therefore, we classify the investment in Top Union as a non-current asset. The carrying amount of this investment as of December 31, 2006 was $861,000 and on December 31, 2005 was $818,000. The carrying amount may be affected by an adverse movement of equity market prices in Taiwan and internationally and would be affected by adverse movement in exchange rates. As of December 31, 2006, we did not have any hedging arrangements to protect our Top Union investment against adverse movements in equity prices or exchange rates.

 

45


Table of Contents

ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

 

Index to Financial Statements

 

     Page

Audited Consolidated Financial Statements of Sunrise Telecom Incorporated

  

Report of Independent Registered Public Accounting Firm

   47

Consolidated Balance Sheets as of December 31, 2006 and 2005

   48

Consolidated Statements of Operations for the Years Ended December 31, 2006, 2005, and 2004

   49

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss) for the Years Ended December 31, 2006, 2005, and 2004

   50

Consolidated Statements of Cash Flows for the Years Ended December 31, 2006, 2005, and 2004

   51

Notes to Consolidated Financial Statements

   52

 

46


Table of Contents

Report of Independent Registered Public Accounting Firm

 

The Board of Directors and Stockholders

Sunrise Telecom Incorporated:

 

We have audited the accompanying consolidated balance sheets of Sunrise Telecom Incorporated and subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

 

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

 

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Sunrise Telecom Incorporated and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.

 

As discussed in Note 1 to the consolidated financial statements, the Company adopted SFAS 123(R), Share-Based Payment, applying the modified prospective method at the beginning of fiscal year 2006.

 

/s/ KPMG LLP

 

Mountain View, California

April 8, 2008

 

47


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Consolidated Balance Sheets

 

(in thousands, except share and per share data)

 

     December 31,  
      2006    2005  
ASSETS      

Current assets:

     

Cash and cash equivalents

   $ 17,450    $ 18,324  

Short-term investments

     4,565      6,632  

Accounts receivable, net of allowance of $281 and $428, respectively

     22,079      17,725  

Inventories

     17,639      13,298  

Prepaid expenses and other assets

     1,674      1,185  

Deferred tax assets

     417      155  
               

Total current assets

     63,824      57,319  

Property and equipment, net

     28,064      26,681  

Restricted cash

     300      17  

Marketable securities

     861      818  

Goodwill

     12,608      12,493  

Intangible assets, net

     1,084      1,564  

Other assets

     917      888  
               

Total assets

   $ 107,658    $ 99,780  
               
LIABILITIES AND STOCKHOLDERS’ EQUITY      

Current liabilities:

     

Short-term borrowings and current portion of notes payable

   $ 181    $ 243  

Accounts payable

     2,453      2,446  

Other accrued expenses

     14,518      11,796  

Income taxes payable

     3,562      1,858  

Deferred revenue

     2,416      842  
               

Total current liabilities

     23,130      17,185  

Notes payable, less current portion

     528      602  

Deferred revenue

     25      9  

Deferred tax liabilities

     1,239      1,135  
               

Total liabilities

     24,922      18,931  
               

Commitments

     

Stockholders’ equity:

     

Preferred stock, $0.001 par value per share; 10,000,000 shares authorized; none issued and outstanding

     —        —    

Common stock, $0.001 par value per share; 175,000,000 shares authorized; 51,349,058 shares issued and outstanding as of December 31, 2006 and 2005

     51      51  

Additional paid-in capital

     77,426      76,392  

Deferred stock-based compensation

     —        (8 )

Retained earnings

     3,764      3,250  

Accumulated other comprehensive income

     1,495      1,164  
               

Total stockholders’ equity

     82,736      80,849  
               

Total liabilities and stockholders’ equity

   $ 107,658    $ 99,780  
               

 

See accompanying notes to consolidated financial statements.

 

48


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Consolidated Statements of Operations

 

(in thousands, except per share data)

 

     Years Ended December 31,  
     2006    2005     2004  

Net sales

   $ 99,880    $ 68,514     $ 61,669  

Cost of sales

     34,504      22,874       18,966  
                       

Gross profit

     65,376      45,640       42,703  
                       

Operating expenses:

       

Research and development

     21,068      18,402       16,623  

Selling and marketing

     27,688      23,462       18,067  

General and administrative

     16,586      14,795       10,154  

Gain from legal settlement

     —        (1,500 )     —    
                       

Total operating expenses

     65,342      55,159       44,844  
                       

Income (loss) from operations

     34      (9,519 )     (2,141 )

Other income, net

     2,174      472       899  
                       

Income (loss) before income taxes

     2,208      (9,047 )     (1,242 )

Income tax expense

     1,694      1,193       10,464  
                       

Net income (loss)

   $ 514    $ (10,240 )   $ (11,706 )
                       

Net income (loss) per share:

       

Basic and diluted

   $ 0.01    $ (0.20 )   $ (0.23 )
                       

Shares used in computing net income (loss) per share:

       

Basic

     51,349      51,006       50,426  
                       

Diluted

     51,580      51,006       50,426  
                       

 

See accompanying notes to consolidated financial statements.

 

49


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Consolidated Statements of Stockholders’ Equity and Comprehensive Income (Loss)

 

(in thousands)

 

    Common Stock   Additional
Paid-in

Capital
    Deferred
Stock-based

Compensation
    Retained
Earnings
    Accumulated
Other
Comprehensive

Income (Loss)
    Total
Stockholders’

Equity
    Comprehensive
Income (Loss)
 
    Shares   Amount            

Balances, December 31, 2003

  50,076   $ 50   $ 74,561     $ (1,608 )   $ 30,242     $ 1,381     $ 104,626    

Exercise of common stock options

  299     —       232       —         —         —         232    

Common stock issued under Employee Stock Purchase Plan

  328     1     662       —         —         —         663    

Deferred stock-based compensation

  —       —       (43 )     1,548       —         —         1,505    

Cash dividend of $0.05 per share

  —       —       —         —         (2,507 )     —         (2,507 )  

Change in unrealized gain on available-for-sale investments

  —       —       —         —         —         (38 )     (38 )   $ (38 )

Cumulative translation adjustment

  —       —       —         —         —         711       711       711  

Net loss

  —       —       —         —         (11,706 )     —         (11,706 )     (11,706 )
                                                         

Comprehensive loss

                $ (11,033 )
                     

Balances, December 31, 2004

  50,703     51     75,412       (60 )     16,029       2,054       93,486    
                                                   

Exercise of common stock options

  166     —       270       —         —         —         270    

Common stock issued under Employee Stock Purchase Plan

  480     —       711       —         —         —         711    

Deferred stock-based compensation

  —       —       (1 )     52       —         —         51    

Cash dividend of $0.05 per share

  —       —       —         —         (2,539 )     —         (2,539 )  

Change in unrealized gain on available-for-sale investments

  —       —       —         —         —         (613 )     (613 )   $ (613 )

Cumulative translation adjustment

  —       —       —         —         —         (277 )     (277 )     (277 )

Net loss

  —       —       —         —         (10,240 )     —         (10,240 )     (10,240 )
                                                         

Comprehensive loss

                $ (11,130 )
                     

Balances, December 31, 2005

  51,349     51     76,392       (8 )     3,250       1,164       80,849    
                                                   

Reversal of deferred stock-based compensation

  —       —       (8 )     8       —         —         —      

Stock-based compensation expense

  —       —       1,042       —         —         —         1,042    

Change in unrealized gain on available-for-sale investments

  —       —       —         —         —         352       352     $ 352  

Cumulative translation adjustment

  —       —       —         —         —         (21 )     (21 )     (21 )

Net income

  —       —       —         —         514       —         514       514  
                                                         

Comprehensive income

                $ 845  
                     

Balances, December 31, 2006

  51,349   $ 51   $ 77,426     $ —       $ 3,764     $ 1,495     $ 82,736    
                                                   

 

See accompanying notes to consolidated financial statements.

 

50


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Condensed Consolidated Statements of Cash Flows

 

(in thousands)

 

     Years Ended December 31,  
     2006     2005     2004  

Cash flows from operating activities:

      

Cash received from customers

   $ 96,840     $ 65,984     $ 59,860  

Cash paid to suppliers and employees

     (95,983 )     (71,711 )     (62,612 )

Income taxes refunded (paid)

     (146 )     (403 )     596  

Interest and other receipts, net

     1,957       2,142       614  
                        

Net cash provided by (used in) operating activities

     2,668       (3,988 )     (1,542 )
                        

Cash flows from investing activities:

      

Purchases of short-term investments

     (4,510 )     (6,819 )     (20,000 )

Proceeds from sales of short-term investments

     6,577       16,300       20,693  

Proceeds from sales of marketable securities

     657       3       794  

Capital expenditures

     (5,401 )     (3,281 )     (3,945 )

Acquisition of intangible assets

     (236 )     —         —    
                        

Net cash provided by (used) in investing activities

     (2,913 )     6,203       (2,458 )
                        

Cash flows from financing activities:

      

Decrease (increase) in restricted cash

     (283 )     288       (199 )

Proceeds from notes payable

     27       64       161  

Payments on notes payable

     (240 )     (194 )     (251 )

Dividends paid

     —         (2,539 )     (2,507 )

Net proceeds from issuance of common stock

     —         711       663  

Proceeds from exercise of stock options

     —         270       232  
                        

Net cash used in financing activities

     (496 )     (1,400 )     (1,901 )
                        

Effect of exchange rate changes on cash and cash equivalents

     (133 )     (249 )     580  
                        

Net increase (decrease) in cash and cash equivalents

     (874 )     566       (5,321 )

Cash and cash equivalents, beginning of year

     18,324       17,758       23,079  
                        

Cash and cash equivalents, end of year

   $ 17,450     $ 18,324     $ 17,758  
                        

Reconciliation of net income (loss) to net cash provided by (used in) operating activities:

      

Net income (loss)

   $ 514     $ (10,240 )   $ (11,706 )
                        

Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:

      

Depreciation and amortization

     5,186       6,576       7,510  

Stock-based compensation

     1,042       51       1,505  

Provision for (recoveries of) losses on accounts receivable

     271       (80 )     (250 )

Loss on disposal of property and equipment

     111       156       66  

Gain on sale of marketable securities

     (341 )     (2 )     (574 )

Deferred income taxes

     (158 )     642       9,306  

Changes in operating assets and liabilities:

      

Accounts receivable

     (4,625 )     (2,530 )     (1,809 )

Inventories

     (4,837 )     (2,025 )     (6,607 )

Prepaid expenses and other assets

     (518 )     (226 )     (880 )

Accounts payable and accrued expenses

     2,729       3,279       174  

Income taxes receivable and payable

     1,704       148       1,974  

Deferred revenue

     1,590       263       (251 )
                        

Total adjustments

     2,154       6,252       10,164  
                        

Net cash provided by (used in) operating activities

   $ 2,668     $ (3,988 )   $ (1,542 )
                        

Supplemental Disclosures

      

Cash paid for interest

   $ 23     $ 18     $ 20  
                        

 

See accompanying notes to consolidated financial statements.

 

51


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements

 

(1)    Business and Significant Accounting Policies

 

(a)    Business

 

Sunrise Telecom Incorporated (the “Company”) was incorporated as Sunrise Telecom, Inc. in California in October 1991. In July 2000, the Company reincorporated in Delaware and changed its name to Sunrise Telecom Incorporated. The Company develops, manufactures, and markets service verification equipment that enables service providers to pre-qualify facilities for services, verify newly installed services, and diagnose problems relating to telecommunications, cable broadband, and Internet networks. The Company sells its products on six continents through a worldwide network of manufacturers, sales representatives, distributors, and direct sales people. Due to its international operations, the Company has wholly-owned subsidiaries located outside of the United States in Canada, Italy, Taiwan, Switzerland, South Korea, Japan, China, Germany, France, Spain, and Mexico.

 

(b)    Basis of Presentation

 

The accompanying consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries. All significant intercompany transactions have been eliminated.

 

(c)    Revenue Recognition

 

The Company recognizes revenue when all of the following criteria are met: persuasive evidence of an arrangement exists, delivery has occurred, the price is fixed or determinable, and collectability is reasonably assured. For product sales, the Company considers delivery to have occurred when title and risk of loss have been transferred to the customer, which is usually at the time that the product has been picked up by a common carrier. For services, the Company considers delivery to have occurred once the service has been provided. The Company uses objective evidence of fair value to allocate revenue to elements in multiple element arrangements and recognize revenue when the criteria for revenue recognition have been met for each element. In the absence of objective evidence of fair value of a delivered element, the Company allocates revenue to the fair value of the undelivered elements and the residual revenue to the delivered elements. The price charged when an element is sold separately generally determines fair value.

 

The Company generally does not sell its products with rights of return. On the few occasions when the Company has agreed to provide customers with rights of return, it has deferred recognition of sales revenue until the rights of return have lapsed. The Company generally does not provide extended payment terms to its customers. The normal terms are typically thirty days for North America and up to sixty days in other markets. Outside the United States, the Company sells its products through a mix of its own sales offices and independent distributors.

 

When the arrangement with the customer includes future obligations or obtaining customer acceptance, the Company recognizes revenue when those obligations have been met or customer acceptance has been received. The Company defers revenue from services and support provided under its extended warranty programs and recognizes it on a straight-line basis over the warranty period. Deferred revenue represents amounts received from customers in advance of services and support to be provided and amounts received prior to customer acceptance.

 

(d)    Warranty Cost

 

The Company’s products are covered by standard warranties of one to three years to its customers depending on the specific product and terms of the customer purchase agreement. The Company’s standard warranties require it to repair or replace defective products during the warranty period at no cost to the customer. At the time that product revenue is recognized, the Company records a liability for estimated costs under its standard warranties. The costs are

 

52


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

estimated based on historical experience. The Company periodically assesses the adequacy of its recorded liability for product warranties and adjusts the amount as necessary.

 

(e)    Research and Development

 

Costs incurred in the research and development of new products and enhancements to existing products are expensed as incurred until the product has been completed and tested and is ready for commercial manufacturing. To date, software development projects have been completed concurrently with the establishment of technological feasibility in the form of a working model. Accordingly, development costs have been expensed as incurred, and no research and development costs have been capitalized.

 

(f)    Fair Value of Financial Instruments

 

For financial instruments consisting of cash and cash equivalents, accounts receivable, accounts payable and accrued expenses included in the Company’s financial statements, the carrying amounts are reasonable estimates of fair value due to their short maturities. Estimated fair values for investment securities, which are separately disclosed elsewhere, are based on quoted market prices for the same or similar instruments. Based on borrowing rates currently available to the Company, the carrying value of the notes payable approximates fair value as of December 31, 2006.

 

(g)    Cash Equivalents and Short-Term Investments

 

The Company considers all highly liquid investments with an original maturity of 90 days or less when acquired to be cash equivalents. Cash equivalents as of December 31, 2006 and 2005 consisted primarily of cash on deposit with banks and money market funds. The Company determines the appropriate classification of debt and equity securities at the time of purchase. Investments classified as available for sale are reported at market value, with the unrealized gains and losses, net of tax, reported as a separate component of other comprehensive income or loss in stockholders’ equity. Realized gains and losses on sales of investments and declines in value determined to be other than temporary are included in other income (expense).

 

Short-term investments as of December 31, 2006 and 2005 consisted primarily of market auction rate notes that reset every seven to 90 days, but have an underlying maturity that extends beyond ninety days. The fair value of the short-term investments approximated cost as of December 31, 2006 and 2005.

 

(h) Restricted Cash

 

Restricted cash is cash held in certificates of deposit by a financial institution that collateralize standby letters of credit issued by the financial institution on the Company’s behalf (See Note 16).

 

(i) Allowance for Doubtful Accounts

 

The Company determines its allowance for doubtful accounts receivable by making its best estimate considering its historical accounts receivable collection experience and the information that it has about the current status of the accounts receivable balances. If future conditions cause the collection experience to change or if the Company later obtains different information about the status of any or all of its accounts receivable, additional allowances for doubtful accounts receivable may be required. The Company charges provisions for doubtful accounts receivable to general and administrative expenses in its statements of operations.

 

53


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

(j) Inventories

 

Inventories are stated at the lower of cost or market. Cost is determined using the weighted-average method.

 

(k) Property and Equipment

 

Property and equipment are carried at cost. Depreciation and amortization is computed using the straight-line method over the shorter of the estimated useful life of the asset or the lease term. Useful lives range from fifteen to thirty-nine years for buildings, five to seven years for improvements, and three to five years for equipment, furniture and fixtures.

 

(l) Goodwill and Other Intangible Assets

 

The Company initially records acquired intangible assets at their fair values. The Company amortizes those acquired intangible assets with estimable useful lives over those lives in proportion to the economic benefits consumed. The Company has determined that straight-line amortization over two to ten years reasonably approximates the consumption of these economic benefits. The Company capitalizes the legal and other costs of registering patents on technology developed by its own research and development activities. Legal and other costs of registering patents capitalized were $236,000, $27,000, and $14,000 during 2006, 2005 and 2004, respectively. The Company amortizes the capitalized costs of issued or acquired patents over the estimated useful life or legal life of the patent, whichever is shorter.

 

The Company assesses the recoverability of the carrying value of its goodwill as of November 30 of each fiscal year, or whenever events or changes in circumstances indicate that the carrying amount of the asset may not be fully recoverable. Recoverability of goodwill is determined at the reporting unit level, with the Company as a single reporting unit, using a two-step approach. First, the carrying amount of the entire reporting unit is compared to its fair value, as determined by the market value of the Company’s outstanding common stock. If the carrying value of the entire reporting unit exceeds its fair value, the second step is performed. In this step, an impairment loss is recognized for the excess, if any, of the carrying amount of goodwill over its implied fair value. The implied fair value of the reporting unit’s goodwill is the amount by which the fair value of the entire reporting unit exceeds the sum of the individual fair values of its assets, except goodwill, less the sum of the individual fair values of its liabilities. The fair values of individual assets and liabilities may be estimated as the amount at which they could be bought or sold in a current transaction between willing parties. If this information is not available, fair value is determined based on the best information available under the circumstances. This often involves the use of valuation techniques, such as the present value of expected future cash flows, discounted at a rate commensurate to the risk involved, or other acceptable valuation techniques.

 

(m) Long-Lived Assets

 

Long-lived assets, including property and equipment and identifiable intangible assets, are evaluated for impairment whenever events or changes in circumstances indicate that such assets may be impaired, or that the estimated useful lives are no longer appropriate. In accordance with Statement of Financial Accounting Standard (“SFAS”) No. 144, Accounting for the Impairment of Long Lived Assets (“SFAS 144”), the impairment evaluation is performed based on asset groups, which represent the lowest level for which identifiable cash flows are largely independent of the cash flows of other groups of assets and liabilities. The Company reviews its long-lived assets for impairment based on estimated future undiscounted cash flows attributable to the assets. In the event that such cash flows are not expected to be sufficient to recover the recorded value of the assets, the assets are written down to their estimated fair values using discounted estimates of future cash flows.

 

54


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

(n) Income Taxes

 

The Company accounts for income taxes using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using the enacted tax laws expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax laws is recognized in the results of operations in the period that includes the enactment date.

 

SFAS No. 109, Accounting for Income Taxes (“SFAS 109”), requires that the Company weigh both positive and negative evidence in order to ascertain whether it is likely that deferred tax assets will be realized. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis and for the future tax consequences attributable to operating losses and tax credit carry-forwards.

 

(o) Business and Concentrations of Credit Risk

 

Financial instruments that potentially subject the Company to concentrations of credit risk consist primarily of cash equivalents and accounts receivable. The Company’s cash equivalents consist primarily of cash on deposit with banks and money market funds. The Company believes no significant concentrations of credit exist with respect to these financial instruments.

 

Concentrations of credit risk with respect to trade receivables are limited as the majority of the Company’s sales are derived from large telephone operating companies, large cable television system operators, and other established telecommunication companies with relatively good credit histories located throughout the world. The Company performs ongoing credit evaluations of its customers. Based on management’s evaluation of potential credit losses, the Company believes its allowances for doubtful accounts are adequate.

 

The Company’s customers are concentrated in the telecommunications and cable broadband industries. Accordingly, the Company’s future success depends on the buying patterns of these customers and the continued demand by these customers for the Company’s products. Additionally, the market is characterized by rapidly changing technology, evolving industry standards, changes in end-user requirements, and frequent new product introductions and enhancements. The Company’s continued success will depend upon its ability to enhance existing products and to develop and introduce, on a timely basis, new products and features that keep pace with technological developments and emerging standards. As a result of its international sales, the Company’s operations are subject to risks of doing business abroad, including, but not limited to, fluctuations in the relative values of currencies, longer payment cycles, and greater difficulty in collecting accounts receivable. Verizon Communications, Inc. accounted for 11% of our net sales in 2006. No individual end customer or distributor accounted for 10% or more of our net sales in 2005 or 2004.

 

The Company purchases many key products, such as microprocessors, bus interface chips, optical components, and oscillators, from a single source or from that source’s sole supplier and relies exclusively on third-party subcontractors to manufacture certain sub-assemblies. The Company may also retain third party design services in the development of our products. The Company does not have long-term supply agreements with these vendors. As a result of its reliance on single-source vendors, the Company’s operations are subject to risks including, but not limited to, interruption of supply of key components, delays in product manufacture and delivery, product development delays,

 

55


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

price fluctuations, and exposure to quality related issues. Long lead-times for delivery of certain sole-sourced components may impact the ability of the Company to respond to changes in production demand in a timely fashion.

 

(p) Earnings (loss) per Share

 

Basic earnings (loss) 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 potential common equivalent shares outstanding during the period. Potential common equivalent shares consist of common stock issuable upon exercise of stock options using the treasury stock method. For the years ended December 31, 2006, 2005, and 2004, potential common equivalent shares from weighted average outstanding stock options of 4,402,434, 4,835,859, and 4,564,332, respectively, were excluded from the calculation of diluted EPS presented in the consolidated statements of operations because their effect would have been anti-dilutive.

 

The following is a reconciliation of the shares used in the computation of basic and diluted EPS (in thousands):

 

     Years Ended December 31,
     2006    2005    2004

Basic EPS—weighted-average number of common shares outstanding

   51,349    51,006    50,426

Effect of dilutive common equivalent shares:

        

Stock options outstanding

   231    —      —  
              

Diluted EPS—weighted-average number of common shares and common equivalent shares outstanding

   51,580    51,006    50,426
              

 

(q) Stock-Based Compensation

 

The Company has in effect stock incentive plans under which incentive stock options have been granted to employees and non-qualified stock options have been granted to employees and non-employee members of the Board of Directors. The Company also has an employee stock purchase plan for all eligible employees. Effective January 1, 2006, the Company adopted SFAS No. 123R, Share-Based Payment (“SFAS 123R”), which requires all share-based payments to employees, including grants of employee stock options and employee stock purchase rights, to be recognized in the financial statements based on their respective grant date fair values and does not allow the previously permitted pro forma disclosure-only method as an alternative to financial statement recognition. SFAS 123R supersedes Accounting Principles Board Opinion (“APB”) No. 25, Accounting for Stock Issued to Employees (“APB 25”), and related interpretations and amends SFAS No. 95, Statement of Cash Flows. SFAS 123R also requires the benefits of tax deductions in excess of recognized compensation cost be reported as a financing cash flow, rather than as an operating cash flow as required under previous literature. In March 2005, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulleting (“SAB”) No. 107, Share-Based Payment (“SAB 107”), which provides guidance regarding the interaction of SFAS 123R and certain SEC rules and regulations. The Company has applied the provisions of SAB 107 in its adoption of SFAS 123R.

 

The Company adopted SFAS 123R using the modified-prospective method of recognition of compensation expense related to share-based payments effective January 1, 2006. The Company’s consolidated statements of operations for the year ended December 31, 2006 reflect the impact of adopting SFAS 123R. In accordance with the modified prospective transition method, the Company’s consolidated statements of operations for prior periods have not been

 

56


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

restated to reflect, and do not include, the impact of SFAS 123R. See Note 12 for the pro forma illustration of the effect on net loss and net loss per share information for the years ended December 31, 2005 and 2004, computed as if the Company had valued stock-based awards to employees using the Black-Scholes option pricing model instead of applying the guidelines provided by APB 25.

 

SFAS 123R requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense ratably over the requisite service periods. The Company has estimated the fair value of each award as of the date of grant using the Black-Scholes option pricing model. See Note 12 for further disclosures regarding the adoption of SFAS 123R.

 

(r) Use of Estimates

 

The preparation of financial statements in accordance with United States generally accepted accounting principles requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. The Company revises estimates as additional information becomes available.

 

(s) Foreign Currency Translation

 

The functional currency for the Company’s foreign subsidiaries located in Taiwan and Canada is the U.S. dollar. Accordingly, the Company remeasures the monetary assets and liabilities of these foreign subsidiaries to the U.S. dollar at year-end exchange rates and remeasures the nonmonetary assets and liabilities to the U.S. dollar at historical rates. Income and expense amounts related to monetary assets and liabilities are remeasured to the U.S. dollar at the weighted average exchange rates in effect during the year, and income and expense accounts related to nonmonetary assets and liabilities are remeasured to the U.S. dollar at historical exchange rates. Remeasurement gains and losses are recognized as income, or expense, in the year of occurrence.

 

The functional currencies for the Company’s other foreign subsidiaries are the local currencies. Accordingly, the Company applies the period end exchange rate to translate each subsidiary’s assets and liabilities and the weighted average exchange rate for the period to translate the subsidiary’s revenues, expenses, gains, and losses into U.S. Dollars. Translation adjustments are included as a separate component of accumulated other comprehensive income (loss) within stockholders’ equity.

 

(t) Advertising Cost

 

The Company expenses advertising costs as incurred. Such costs are included in selling and marketing expense and totaled approximately $417,000, $743,000, and $243,000 during the years ended December 31, 2006, 2005, and 2004, respectively.

 

(u) Recent Accounting Pronouncements

 

On July 13, 2006, the Financial Accounting Standards Board (“FASB”) issued Interpretation 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS 109 (“FIN 48”), to create a single model to address accounting for uncertainty in tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition

 

57


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

threshold that a tax position must reach before financial statement recognition. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006, which is the Company’s fiscal year 2007. The Company does not expect that the adoption of FIN 48 will have a significant impact on the Company’s consolidated financial statements.

 

On September 15, 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”). SFAS 157 defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles, and expands disclosures about fair value measurements. SFAS 157 does not expand the use of fair value in any new circumstances. SFAS 157 is effective for fiscal years beginning after November 15, 2007, which is the Company’s fiscal year 2008, for financial assets and liabilities and for fiscal years beginning after November 15, 2008, which is the Company’s fiscal year 2009, for non-financial assets and liabilities. The Company does not expect that the adoption of SFAS 157 will have a significant impact on the Company’s consolidated financial statements.

 

In September 2006, the SEC issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides guidance on how prior year misstatements should be considered when quantifying misstatements in the current year financial statements. SAB 108 requires registrants to quantify misstatements using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 does not change the guidance in SAB No. 99, Materiality, when evaluating the materiality of misstatements. SAB 108 is effective for fiscal years ending after November 15, 2006. Upon initial application, SAB 108 permits a one-time cumulative effect adjustment to beginning retained earnings. The Company adopted SAB 108 in the fourth quarter of fiscal year 2006. The adoption did not have any impact on its consolidated financial statements.

 

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (“SFAS 159”). SFAS 159 permits entities to choose to measure many financial assets and financial liabilities at fair value. Unrealized gains and losses on items for which the fair value option has been elected are reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007, which is the Company’s fiscal year 2008. The Company is currently assessing the impact of the adoption of SFAS 159 on its consolidated financial statements.

 

In June 2007, the FASB ratified the consensus on Emerging Issues Task Force (“EITF”) Issue No. 06-11, Accounting for Income Tax Benefits of Dividends on Share-Based Payment Awards (“EITF 06-11”). EITF 06-11 requires companies to recognize the income tax benefit realized from dividends or dividend equivalents that are charged to retained earnings and paid to employees for non-vested equity-classified employee share-based payment awards as an increase to additional paid-in capital. EITF 06-11 is effective for fiscal years beginning after September 15, 2007, which will be the Company’s fiscal year 2008. The Company does not expect that the adoption of EITF 06-11 will have a significant impact on the Company’s consolidated financial statements.

 

In June 2007, the FASB ratified the consensus reached on EITF Issue No. 07-3, Accounting for Nonrefundable Advance Payments for Goods or Services Received for Use in Future Research and Development Activities (“EITF 07-3”), which requires that nonrefundable advance payments for goods or services that will be used or rendered for future research and development activities be deferred and amortized over the period that the goods are delivered or the related services are performed, subject to an assessment of recoverability. EITF 07-3 will be effective for fiscal years beginning after December 15, 2007, which is the Company’s fiscal year 2008. The Company does not expect that the adoption of EITF 07-3 will have a significant impact on the Company’s consolidated financial statements.

 

58


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

In December 2007, the FASB issued SFAS No. 141 (revised 2007), Business Combinations (“SFAS 141R”), which replaces SFAS 141. SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any non-controlling interest in the acquiree and the goodwill acquired. SFAS 141R also establishes disclosure requirements which will enable users to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for fiscal years beginning after December 15, 2008. The Company will be required to adopt SFAS 141R in its fiscal year 2009 commencing January 1, 2009.

 

(v) Business Enterprise Segments

 

The Company operates in one reportable operating segment: the design, manufacture, and sale of equipment for testing wireline access, cable broadband, fiber optics and signaling. SFAS No. 131, Disclosure About Segments of an Enterprise and Related Information (“SFAS 131”), establishes standards for the way public business enterprises report information about operating segments in annual consolidated financial statements and requires that those enterprises report selected information about operating segments in interim financial reports. SFAS 131 also establishes standards for related disclosures about products and services, geographic areas, and major customers.

 

(2)    Related Party Transactions

 

On February 7, 2006, Paul Chang resigned his positions as President and Chief Executive Officer and Chairman and member of the Board of Directors. On that same day, the Company entered into an employment agreement with Mr. Chang, pursuant to which the Company employed Mr. Chang as its Technology Advisor at an annual salary of $400,000. Under the terms of the agreement, if Mr. Chang’s employment was terminated by the Company without cause and Mr. Chang executed a general release of claims, the Company agreed to provide him with certain severance benefits at the time of termination of employment less applicable withholdings. On March 14, 2006, the Company entered into a separation agreement with Mr. Chang and provided Mr. Chang a severance payment of $300,000, less applicable taxes as well as payment of outstanding salary and benefits.

 

Paul Chang is the owner of Telecom Research Center (“TRC”). During 2006, 2005, and 2004, the Company purchased equipment used in its manufacturing process totaling $83,000, $67,000, and $40,000, respectively, from TRC. The Company had no accounts payable to TRC at December 31, 2006 and 2005. The terms of the Company’s transactions with TRC are similar to those with unrelated parties. The Company’s business relationship with TRC was reviewed and approved by the Company’s Board of Directors and Audit Committee.

 

(3)    Financial Statement Details

 

Inventories

 

Inventories consisted of the following (in thousands):

 

     December 31,
     2006    2005

Raw materials

   $ 11,323    $ 5,317

Work in process

     2,732      4,402

Finished goods

     3,584      3,579
             
   $ 17,639    $ 13,298
             

 

59


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

Property and Equipment

 

Property and equipment consisted of the following (in thousands):

 

     December 31,
     2006    2005

Land

   $ 8,821    $ 8,821

Building

     9,872      9,864

Equipment

     32,428      28,020

Furniture and fixtures

     2,584      2,364

Leasehold improvements

     1,420      617
             
     55,125      49,686

Less accumulated depreciation and amortization

     27,061      23,005
             
   $ 28,064    $ 26,681
             

 

Depreciation expense for the years ended December 31, 2006, 2005 and 2004 was $4.4 million, $4.8 million and $4.8 million, respectively.

 

Other Accrued Expenses

 

Other accrued expenses consisted of the following (in thousands):

 

     December 31,
     2006    2005

Accrued compensation and other related benefits

   $ 4,822    $ 3,973

Commissions payable

     1,807      1,364

Sales tax payable

     931      855

Accrued warranty (see Note 8)

     1,656      834

Accrued inventory receipts

     1,536      1,059

Legal accrual

     372      1,673

Other accrued expenses

     3,394      2,038
             
   $ 14,518    $ 11,796
             

 

Other Income, net

 

Other income, net consisted of the following (in thousands):

 

     Years Ended
December 31,
 
     2006     2005     2004  

Interest income

   $ 650     $ 676     $ 475  

Foreign exchange gain (loss)

     1,028       (272 )     148  

Gain on sale of marketable securities

     335       2       538  

Interest expense

     (60 )     (57 )     (53 )

Other income (expense), net

     221       123       (209 )
                        
   $ 2,174     $ 472     $ 899  
                        

 

60


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

(4)    Valuation and Qualifying Accounts

 

A summary of valuation and qualifying accounts is as follows (in thousands):

 

     Balance at
Beginning
of Year
   Charged to
Expenses
   Write Offs     Reversals
and
Recoveries
    Balance
at End
of Year

Allowance for doubtful accounts:

            

2006

   $ 428    $ 66    $ (213 )   $ —       $ 281

2005

   $ 799    $ 67    $ (291 )   $ (147 )   $ 428

2004

   $ 1,380    $ 9    $ (331 )   $ (259 )   $ 799

 

(5)    Marketable Securities

 

The Company determines the appropriate classification of debt and equity securities at the time of purchase and reevaluates this designation at each balance sheet date. Investments classified as available-for-sale are reported at market value, with unrealized gains and losses, net of tax, reported as a separate component of other comprehensive income (loss) in stockholders’ equity. Realized gains and losses on sales of investments and declines in value determined to be other than temporary are included in other income, net in the consolidated statements of operations. Investment securities available for current operations are classified as current assets, and all other investment securities are classified as non-current assets.

 

Non-current marketable securities, at December 31, 2006 and December 31, 2005, consisted entirely of common stock of Top Union Electronics Corp. (“Top Union”), a Taiwan R.O.C. corporation. The Company has classified this investment as an available-for-sale security, which is stated at fair value with the unrealized gain presented as a separate component of stockholders’ equity. The market for these securities is limited and the Company believes it may be difficult to sell a substantial number of shares in any given period. For this reason it is not classified as a current asset. During the twelve months ended December 31, 2006, the Company sold 1,426,020 shares of Top Union stock, realizing gross proceeds of approximately $657,000 and realizing gains of $341,000. At December 31, 2006, the Company held 1,883,000 shares of Top Union stock with a fair value of $861,000. At December 31, 2006, the cumulative unrealized gain on this investment was $407,000.

 

(6)    Goodwill and Other Intangible Assets

 

On January 1, 2002, the Company adopted SFAS 142. In accordance with SFAS 142, the Company no longer amortizes goodwill from business acquisitions.

 

Acquired intangible assets consisted of the following (in thousands):

 

     As of December 31, 2006
   Gross
Carrying
Amount
   Accumulated
Amortization
    Net
Carrying
Amount

Developed technology

   $ 6,878    $ (6,697 )   $ 181

Non-compete

     230      (204 )     26

Licenses

     637      (554 )     83

Patents and trademarks

     925      (131 )     794
                     
   $ 8,670    $ (7,586 )   $ 1,084
                     

 

61


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

     As of December 31, 2005
   Gross
Carrying
Amount
   Accumulated
Amortization
    Net
Carrying
Amount

Developed technology

   $ 6,871    $ (6,096 )   $ 775

Non-compete

     213      (152 )     61

Licenses

     637      (500 )     137

Patents and trademarks

     686      (95 )     591
                     
   $ 8,407    $ (6,843 )   $ 1,564
                     

 

Aggregate amortization expense for the years ended December 31, 2006, 2005, and 2004 was $0.8 million, $1.8 million, and $2.7 million, respectively.

 

Estimated future aggregate annual amortization expense for intangible assets is as follows (in thousands):

 

Year ending December 31,   

2007

   $ 241

2008

     32

2009

     32

2010

     32

2011

     32

Thereafter

     715
      
   $ 1,084
      

 

The changes in the carrying amount of goodwill during the year ended December 31, 2006 were as follows (in thousands):

 

Balance as of January 1, 2006

   $ 12,493

Effect of foreign currency translation

     115
      

Balance as of December 31, 2006

   $ 12,608
      

 

The Company completed its impairment tests of goodwill during the quarters ended December 31, 2006 and 2005, as required under SFAS 142. The Company bases its impairment testing on a market capitalization analysis and considers itself to be a single reporting unit for purposes of this test.

 

(7)    Other Assets

 

Other assets consisted of the following (in thousands):

 

     December 31,
   2006    2005

Insurance deposits

   $ 494    $ 313

Rental deposits

     324      200

Other deposits

     99      375
             
   $ 917    $ 888
             

 

62


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

(8)    Liability for Product Warranties

 

Changes in the Company’s liability for product warranties during the years ended December 31, 2006, 2005, and 2004, are as follows (in thousands):

 

     Balance at
Beginning
of Year
   Warranty
Expense
   Warranty
Cost
    Balance
at End
of Year

2006

   $ 834    $ 1,836    $ (1,014 )   $ 1,656

2005

   $ 811    $ 839    $ (816 )   $ 834

2004

   $ 1,038    $ 539    $ (766 )   $ 811

 

(9)    Short-term Borrowings and Notes Payable

 

As a result of various acquisitions completed prior to 2004, the Company assumed three non-interest bearing notes payable. The aggregate outstanding balance on these notes at December 31, 2006 was $37,000. In addition, the Company obtained a loan from the Italian government in 2001, which bears interest at 2% a year. At December 31, 2006, the outstanding balance on this loan was $672,000, which is to be repaid by semi-annual principal payments over an eight-year period which began in July 2003.

 

Annual amounts to be repaid under all of these notes are as follows (in thousands):

 

Year ending December 31,   

2007

   $ 181

2008

     151

2009

     151

2010

     151

2011

     75
      
   $ 709
      

 

Short-term borrowings and notes payable are reported on the accompanying consolidated balance sheets as follows (in thousands):

 

     December 31,
         2006            2005    

Short-term borrowings and current portion of notes payable

   $ 181    $ 243

Notes payable, less current portion

     528      602
             

Total short-term borrowings and notes payable

   $ 709    $ 845
             

 

63


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

(10)    Leases

 

The Company leases all of its facilities, other than its U.S. headquarters which is owned by the Company, under several operating lease agreements through 2012. Future minimum lease payments, under these agreements, as of December 31, 2006, are as follows (in thousands):

 

Year ending December 31,   

2007

   $ 1,247

2008

     981

2009

     941

2010

     939

2011

     467

Thereafter

     52
      
   $ 4,627
      

 

Rent expense for the years ended December 31, 2006, 2005, and 2004 was approximately $1.8 million, $1.3 million, and $1.1 million, respectively.

 

(11)    Capital Stock

 

The Company’s Board of Directors declared dividends of $0.05 per share in 2004 and 2005, but no dividends were declared for 2006.

 

Shares reserved for future issuance are as follows:

 

Employee Stock Purchase Plan

   702,887

Stock Option Plan

   10,905,145
    
   11,608,032
    

 

(12)    Share-Based Compensation Plans

 

The purpose of the Company’s various share-based compensation plans is to attract, motivate, retain, and reward high-quality employees, directors, and consultants by enabling such persons to acquire or increase their proprietary interest in the Company’s common stock in order to strengthen the mutuality of interests between such persons and its stockholders and to provide such persons with annual and long-term performance incentives to focus their best efforts in the creation of stockholder value. Consequently, share-based compensatory awards issued subsequent to the initial award to the Company’s employees and consultants are determined primarily on the basis of individual performance. The Company’s share-based compensation plans with outstanding awards consist of its 1993 Stock Option Plan, its 2000 Stock Plan, and its 2000 Employee Stock Purchase Plan.

 

The Company utilizes the Black-Scholes option pricing model to estimate the grant-date fair value of certain employee share-based compensatory awards, which requires the input of highly subjective assumptions, including expected volatility and expected life. Historical volatilities were used in estimating the fair value of the Company’s share-based awards, while the expected life of options was estimated based on historical trends since the Company’s initial

 

64


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

public offering. Changes in these inputs and assumptions can materially affect the measure of estimated fair value of the Company’s share-based compensation expense. Further, as required under SFAS 123R, the Company estimates forfeitures for share-based awards that are not expected to vest. The Company charges the estimated fair value less estimated forfeitures to earnings on a straight-line basis over the vesting period of the underlying awards, which is generally four years for its stock option grants and up to two years for its employee stock purchase plan. While the Company’s estimate of fair value and the associated charge to earnings materially affects its results of operations, it has no impact on its cash position.

 

In accordance with SFAS 123R, the Company recognizes tax benefits upon expensing certain share-based awards associated with its share-based compensation plans, including nonqualified stock options and awards, but under current accounting standards the Company cannot recognize tax benefits concurrent with the recognition of share-based compensation expenses associated with incentive stock options and employee stock purchase plan shares (qualified stock options). For qualified stock options that vested after the adoption of SFAS 123R, the Company recognizes tax benefits only in the period when disqualifying dispositions of the underlying stock occur, which may be up to several years after vesting and in a period when the stock price substantially increases. For qualified stock options that vested prior to the adoption of SFAS 123R, the tax benefit is recorded directly to additional paid-in capital to the extent the Company is able to reduce taxes payable.

 

On November 10, 2005, the FASB issued FASB Staff Position No. SFAS 123R-3, Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards (“FSP 123R-3”). The Company has elected to adopt the alternative transition method provided in FSP 123R-3 for calculating the tax effects of stock-based compensation pursuant to SFAS 123R. The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee stock-based compensation expense, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee stock-based compensation awards that are outstanding upon adoption of SFAS 123R. Under SFAS 123R, tax benefits associated with excess tax deductions normally creditable to additional paid-in capital are not recognized until the deduction reduces taxes payable. Accordingly, no tax benefit related to excess tax deductions from qualified stock options was recognized during the fiscal year ended December 31, 2006.

 

Share-based compensation expense recognized in the Company’s consolidated statements of operations for the fiscal year ended December 31, 2006 as a result of the adoption of SFAS 123R was as follows (in thousands):

 

     Year Ended
December 31,
2006

Cost of sales

   $ 56

Research and development

     458

Selling and marketing

     375

General and administrative

     153
      

Total

   $ 1,042
      

 

The impact of adopting SFAS 123R resulted in a decrease to the Company’s income before income taxes, net income and net income per share of $1,042,000, $1,042,000 and $0.02, respectively for the fiscal year ended December 31, 2006. Application of SFAS 123R had no impact on the Company’s cash position or cash flows from operations.

 

65


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

The Company has historically issued new shares upon the exercise of stock options or employee stock purchase plan purchases.

 

Employee Stock Purchase Plan

 

The Company’s 2000 Employee Stock Purchase Plan (the “Purchase Plan”) became effective in April 2000. The Purchase Plan allows employees to designate up to 15% of their base compensation, subject to legal restrictions and limitations, to purchase shares of common stock at 85% of the lesser of the fair market value (“FMV”) at the beginning of the offering period or the exercise date. The offering period extends for up to two years and includes four exercise dates occurring at six month intervals. Under the terms of the plan, if the FMV at an exercise date is less than the FMV at the beginning of the offering period, the current offering period will terminate and a new offering period of up to two years will commence.

 

In February 2006, the Company’s Board of Directors approved a 300,000 share reserve increase for the Purchase Plan pursuant to the automatic adjustment provisions of the Purchase Plan. As of December 31, 2006, 2,350,000 shares of common stock had been reserved for issuance under the Purchase Plan with 1,647,113 shares issued, leaving 702,887 shares remaining for future issuance. During 2006, no shares were issued under the Purchase Plan. During 2005 and 2004, the Company issued 480,432 and 328,078 shares, respectively, under the Purchase Plan.

 

No purchases have been permitted subsequent to November 10, 2005 due to restrictions on the Company’s ability to issue stock as a result of not being current with its SEC filings. There were no purchases under the Purchase Plan during 2006 and employee contributions were terminated during the quarter ended June 30, 2006. The termination of future contributions and extension of the purchase date were treated as modifications to the two year offering period which began May 10, 2005. The fair value associated with these modifications was calculated using the Black-Scholes option pricing model.

 

The assumptions used to value the Purchase Plan are as described in the table below:

 

    

2006

  

2005

  

2004

Dividend yield

      2.0%    1.5%

Expected Term

   1 Year    1.25 Years    1.25 Years

Risk-free interest rate

   5.01%    4.11%    3.46%

Volatility rate

   0.8173    0.6836    0.6987

 

The following table summarizes cash received and the aggregate intrinsic value for purchases under the Purchase Plan during the fiscal years ended December 31 2006, 2005 and 2004 (in thousands):

 

     2006    2005    2004

Cash received

   $ —      $ 711    $ 663

Aggregate intrinsic value

   $ —      $ 289    $ 274

 

Stock Option Plan

 

In April 2000, the Company’s Board of Directors approved the adoption of the 2000 Stock Plan (the “Stock Plan”). The Stock Plan became effective upon the Company’s initial public offering in July 2000. The total number of shares reserved for issuance under the Stock Plan equaled 7,750,000 shares of common stock, plus 5,250,000 shares of common stock that remained reserved for issuance under the 1993 stock option plan as of the date the Stock Plan

 

66


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

became effective, for a total of 12,800,000 shares. In February 2006, the Company’s Board approved a 200,000 share reserve increase for the Stock Plan which increased the total number of shares to 13,000,000. All outstanding options under the 1993 stock option plan are administered under the 2000 Stock Plan but will continue to be governed by their existing terms. As of December 31, 2006, the Company had granted options to purchase 9,846,346 shares of its common stock to its employees, directors, and consultants and 3,907,511 options were canceled and returned to the Stock Plan, leaving 7,061,165 shares available for future grants.

 

Options may be granted as incentive stock options or nonstatutory stock options at the fair market value of such shares on the date of grant as determined by the Board of Directors. Options granted subsequent to 1996 vest over a four-year period, and expire 10 years from the date of grant, or sooner, upon termination of employment or if the stock plan is terminated by the Board of Directors. Approximately 571,000 shares associated with options granted in prior periods vested in the fiscal year ended December 31, 2006.

 

The options granted under the 1993 stock option plan include a provision whereby the option holder may elect at any time to exercise the option prior to its vesting. Unvested shares so purchased are subject to a repurchase right by the Company at the original purchase price. Such right lapses at a rate equivalent to the vesting period of the original option. As of December 31, 2006, there were no shares issued and subject to repurchase.

 

The following table summarizes stock option activity and weighted-average exercise prices for the year ended December 31, 2006, and for options outstanding and options exercisable, the weighted-average exercise prices and the aggregate intrinsic value as of December 31, 2006. The aggregate intrinsic value is based on the closing price of the Company’s common stock on December 29, 2006 of $2.20. Outstanding in the money options represented 1,397,805 shares, of which 1,385,720 were exercisable as of December 31, 2006.

 

     Options
Available
for

Grant
   Options
Outstanding
    Weighted-
Average
Exercise
Price
   Weighted-Average
Remaining
Contractual Life
(in years)
   Aggregate
Intrinsic
Value (000’s)

Balance at December 31, 2005

   5,822,664    4,882,481     $ 3.62      

Additional shares

   200,000           

Granted

   —      —       $ —        

Exercised

   —      —       $ —        

Forfeited

   1,038,501    (1,038,501 )   $ 4.05      
                   

Balance at December 31, 2006

   7,061,165    3,843,980     $ 3.51    4.89    $ 609
                   

Exercisable

      3,419,474     $ 3.55    4.54    $ 605
                 

Exercisable and expected to vest

      3,789,551     $ 3.51    4.80    $ 608
                 

 

The Company has not issued stock options since August 2005 due to the Company not being current in its SEC filings. As of December 31, 2006, management has committed to present to the Compensation Committee of the Board of Directors proposed new-hire grants totaling 259,000 shares upon the Company becoming current in its filings with the SEC. These proposed grants are not included in the above table because the proposed grants have not yet been approved by the Board of Directors.

 

67


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

The following table summarizes cash received and the aggregate intrinsic value for stock options exercised under the Stock Plan during the fiscal years ended December 31 2006, 2005 and 2004 (in thousands):

 

     2006    2005    2004

Cash received

   $—      $270    $232

Aggregate intrinsic value

   $—      $51    $675

 

Information regarding stock options outstanding as of December 31, 2006, is summarized in the following table:

 

Range of

Exercise Prices

   Options Outstanding    Exercisable Options
   Number
Outstanding
   Weighted-
Average
Remaining
Contractual
Life (years)
   Weighted-
Average
Exercise
Price
   Number
Exercisable
   Weighted-
Average
Exercise
Price
$1.00-1.58    500,150    2.83    $ 1.47    500,150    $ 1.47
1.67-1.76    243,557    5.44    $ 1.74    243,557    $ 1.74
1.91    403,072    5.39    $ 1.91    393,278    $ 1.91
1.96-2.57    528,331    5.31    $ 2.35    415,945    $ 2.29
2.60-3.15    89,859    5.20    $ 2.95    89,859    $ 2.95
3.20    481,311    7.86    $ 3.20    234,940    $ 3.20
3.26-3.91    27,484    7.89    $ 3.41    16,254    $ 3.44
3.98    605,800    4.37    $ 3.98    605,800    $ 3.98
4.09-4.93    217,972    6.08    $ 4.11    173,247    $ 4.12
4.94-20.38    746,444    3.48    $ 6.81    746,444    $ 6.81
                  
   3,843,980       $ 3.51    3,419,474    $ 3.55
                  

 

The adoption of SFAS 123R will continue to have a significant adverse impact on the Company’s reported results of operations, although it should not have any impact on its overall financial position. The amount of unearned stock-based compensation expense currently estimated to be recorded in the period 2007 through 2009 related to unvested share-based payment awards at December 31, 2006 is $571,000. Of this amount, $352,000, $202,000, and $17,000 are currently estimated to be recorded in 2007, 2008, and 2009, respectively. The weighted-average period over which the unearned stock-based compensation expense is expected to be recognized is approximately 1.3 years. If there are any modifications or cancellations of the underlying unvested securities, the Company may be required to accelerate, increase or cancel any remaining unearned stock-based compensation expense.

 

Prior to the adoption of SFAS 123R, the Company accounted for stock-based compensation expense in accordance with APB 25 and related interpretations, and had adopted the disclosure-only alternative of SFAS 123 and SFAS No. 148, Accounting for Stock-Based Compensation — Transition and Disclosure. In accordance with APB 25 and related interpretations, stock-based compensation expense was not recorded in connection with share-based payment awards granted with exercise prices equal to or greater than the fair market value of the Company’s common stock on the date of grant, unless certain modifications were subsequently made. The Company recorded deferred compensation in connection with stock options granted with exercise prices less than the fair market value of the common stock on the date of grant. Recorded deferred stock-based compensation was recognized as stock-based compensation expense ratably over the applicable vesting periods, which are generally deemed to be the applicable service periods. Upon the adoption of SFAS 123R effective January 1, 2006, the Company reversed unrecognized deferred stock-based compensation of $8,000 as of December 31, 2005 and reduced additional paid-in capital by the same amount.

 

68


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

If compensation expense for the Company’s stock-based compensation plans had been determined in a manner consistent with the fair value approach described in SFAS 123 as amended by SFAS 148, the Company’s net loss and loss per share, as reported, would have been reduced to the pro forma amounts indicated below (in thousands, except per share data):

 

     Years ended December 31,  
          2005               2004       

Net loss, as reported

   $ (10,240 )   $ (11,706 )

Add: Stock-based employee compensation expense included in reported net loss, net of related tax effects

     51       1,505  

Deduct: Total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects

     (1,698 )     (3,181 )
                

Pro forma net loss

   $ (11,887 )   $ (13,382 )
                

Loss per share, as reported:

    

Basic and diluted

   $ (0.20 )   $ (0.23 )
                

Loss per share, pro forma:

    

Basic and diluted

   $ (0.23 )   $ (0.27 )
                

 

The Company made no new grants of stock options or other share-based awards during the fiscal year ended December 31, 2006; however, the Company did extend for two additional years 76 outstanding fully vested option grants representing 295,094 shares in the fiscal year ended December 31, 2006 that could not be exercised due to the Company not being current in its SEC filings and that would have otherwise expired. These extensions were treated as modifications to the original grants and the incremental fair value associated with these modifications of $0.2 million was calculated using the Black-Scholes option pricing model. For the purposes of computing stock-based compensation expense for the fiscal year ended December 31, 2006 under SFAS 123R for stock options that were modified and for purposes of computing pro forma net loss for the fiscal years ended December 31, 2005 and 2004 under SFAS 123, the fair value of each option grant or modification is estimated on the date of grant or modification using the Black-Scholes option pricing model. The assumptions used to value the option grants are as follows:

 

    

Years ended December 31,

    

2006

  

2005

  

2004

Dividend yield

      2.0%    1.5%

Expected Term

   2 Years    5 Years    5 Years

Risk-free interest rate

   4.83%    4.11%    3.46%

Volatility rate

   0.7801    0.6836    0.6987

 

(13)    401(k) Plan

 

In 1996, the Company adopted a 401(k) Plan (the “Plan”). Participation in the Plan is available to all full-time employees. Each participant may elect to contribute up to 15% of his or her annual salary, but not to exceed the statutory limit as prescribed by the Internal Revenue Code. The Company may make discretionary contributions to the Plan, which vests over a six-year period beginning on the employee’s date of hire. The Plan does not provide participants with an election to use their contributions to purchase the Company’s stock. The Company made no contributions to the Plan during 2006, 2005 or 2004.

 

69


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

(14)    Income Taxes

 

Income (loss) before income taxes consisted of the following (in thousands):

 

     Years Ended December 31,  
   2006     2005     2004  

U.S

   $ (106 )   $ (6,755 )   $ (957 )

Foreign.

     2,314       (2,292 )     (285 )
                        

Total

   $ 2,208     $ (9,047 )   $ (1,242 )
                        

 

The provision for income taxes consisted of the following (in thousands):

 

     Years Ended December 31,  
   2006     2005    2004  

Current expense:

       

Federal

   $ 173     $ —      $ —    

State

     17       —        94  

Foreign

     1,663       551      1,064  
                       
     1,853       551      1,158  
                       

Deferred expense (benefit):

       

Federal

     249       222      6,920  

State

     20       42      2,456  

Foreign

     (428 )     378      (70 )
                       
     (159 )     642      9,306  
                       
   $ 1,694     $ 1,193    $ 10,464  
                       

 

Income tax expense differed from the amounts computed by applying the U.S. federal income tax rate of 34% for the years ended December 31, 2006, 2005 and 2004 to pretax income (loss), as a result of the following (in thousands):

 

     Years Ended December 31,  
   2006     2005     2004  

Computed tax

   $ 750     $ (3,076 )   $ (422 )

State taxes, net of federal income tax benefit

     25       28       94  

Nondeductible stock-based compensation

     —         —         31  

Nondeductible goodwill amortization

     —         104       406  

Nondeductible meals and entertainment

     52       42       34  

Losses and other items not benefited

     847       3,956       9,376  

Foreign tax rate differential

     (379 )     355       264  

Other, net

     399       (216 )     681  
                        
   $ 1,694     $ 1,193     $ 10,464  
                        

 

On October 22, 2004, the President of the United States signed the American Jobs Creation Act of 2004 (the “Jobs Act”). Among other provisions, the Jobs Act contains a deduction for income from qualified domestic production activities, phased in from 2005 through 2010, and a temporary incentive for U.S. corporations to repatriate

 

70


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

accumulated income earned abroad. During 2006, the Company did not have a deduction from domestic production activities and the Company did not repatriate earnings under the Jobs Act.

 

The types of temporary differences that give rise to significant portions of the Company’s deferred tax assets and liabilities are set out below (in thousands):

 

     December 31,  
   2006     2005  

Deferred tax assets:

    

Inventory reserves and additional costs capitalized

   $ 1,162     $ 999  

Accrued compensation and vacation

     930       524  

Allowance for doubtful accounts

     162       164  

Other accruals and reserves

     3,620       1,766  

Net operating losses

     2,994       4,231  

Tax credits

     2,678       1,382  

Accumulated amortization of intangible assets

     4,834       5,416  
                

Total deferred tax assets

     16,380       14,482  

Valuation allowance

     (13,728 )     (12,881 )
                

Available deferred tax assets

     2,652       1,601  
                

Deferred tax liabilities:

    

Property and equipment

     (813 )     (666 )

State deferred tax liabilities, net of federal benefit

     (782 )     (860 )

Goodwill amortization

     (1,337 )     (1,055 )

Foreign deferred taxes

     (542 )     —    
                

Total deferred tax liabilities

     (3,474 )     (2,581 )
                

Net deferred tax liabilities

   $ (822 )   $ (980 )
                

 

Net deferred tax liabilities are reported on the accompanying consolidated balance sheets as follows (in thousands):

 

     December 31,  
   2006     2005  

Current deferred tax assets

   $ 417     $ 155  

Long-term deferred tax liabilities

     (1,239 )     (1,135 )
                

Net deferred tax liabilities

   $ (822 )   $ (980 )
                

 

During 2006 and 2005, the Company recorded a valuation allowance against all of the Company’s net deferred tax assets in the United States and most of the foreign jurisdictions in the amount of $13.8 million and $12.9 million, respectively. The expense for recording the valuation allowance is a non-cash item, and the recording of this expense does not imply that the Company owes additional income taxes.

 

As of December 31, 2006, deferred tax assets of approximately $177,000 consisting of certain net operating losses resulting from the exercise of employee stock options had not been recognized in the financial statements. When utilized, the tax benefit of these losses will be accounted for as a credit to additional paid-in capital.

 

71


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

The Company determined the valuation allowance on deferred tax assets in accordance with the provisions of SFAS 109 which requires that the Company weigh both positive and negative evidence in order to ascertain whether it is more likely than not that deferred tax assets will be realized. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to temporary differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and for the future tax consequences attributable to operating losses and tax credit carryforwards. The ultimate realization of deferred tax assets is dependent on the generation of future taxable income during the periods in which the related temporary differences become deductible. The Company evaluated all significant available positive and negative evidence, including the existence of cumulative net losses in recent periods, benefits that could be realized from available tax strategies, and forecasts of future taxable income, in determining the need for a valuation allowance on its deferred tax assets. Cumulative net losses in recent periods represented sufficient negative evidence that was difficult for positive evidence to overcome under the evaluation guidance of SFAS 109 and, accordingly, a valuation allowance was recorded against all of the Company’s net deferred tax assets in the United States and most of the foreign jurisdictions. The Company intends to maintain this valuation allowance until sufficient positive evidence, such as the resumption of a consistent earnings pattern, exists to support its reversal in accordance with SFAS 109.

 

As of December 31, 2006, the Company has net operating losses for federal and state income tax purposes of approximately $6.3 million and $16.9 million, respectively, that it expects to carry forward to reduce future income subject to income taxes. The federal net operating loss will expire, if not used, in 2023 and the state net operating loss carryforwards will begin to expire in 2013.

 

As of December 31, 2006, unused research and development tax credits of approximately $527,000 and $562,000 are available to reduce future federal and California income taxes, respectively. The federal research credit carryforward will begin to expire in 2022, and the state development credits will carry forward indefinitely.

 

Utilization of the Company’s operating loss and tax credit carryforwards may be subject to substantial annual limitations due to ownership change limitations provided by the Internal Revenue Code and similar state provisions. Any such annual limitation could result in the expiration of net operating loss and tax credit carryforwards before utilization.

 

Cumulative undistributed earnings of the Company’s international subsidiaries as of December 31, 2006 are intended to be permanently reinvested. A deferred income tax liability would have resulted had such earnings been repatriated, which would have been absorbed by a corresponding reversal in valuation allowance.

 

(15)    Segment Information

 

Net sales information regarding operations in the different geographic regions is as follows (in thousands):

 

     Years Ended December 31,
   2006    2005    2004

United States

   $ 52,433    $ 35,195    $ 32,457

Canada

     1,340      1,797      831

Asia/Pacific

     18,313      13,071      13,687

Europe/Africa/Middle East

     24,540      16,440      13,378

Latin America

     3,254      2,011      1,316
                    
   $ 99,880    $ 68,514    $ 61,669
                    

 

72


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

Long-lived assets, excluding financial instruments, deferred tax assets, and intangible assets, were located in the following geographic regions (in thousands):

 

     As of December 31,
   2006    2005

United States

   $ 22,451    $ 23,036

Canada

     1,523      1,157

Taiwan and other Asia/Pacific

     2,659      1,339

Europe/Africa/Middle East

     1,431      1,149
             
   $ 28,064    $ 26,681
             

 

Net sales information by product category is as follows (in thousands):

 

     Years Ended December 31,
   2006    2005    2004

Wireline access

   $ 35,618    $ 22,778    $ 26,615

Cable broadband

     31,306      20,704      15,638

Fiber optics

     24,969      19,285      13,670

Signaling

     7,987      5,747      5,746
                    
   $ 99,880    $ 68,514    $ 61,669
                    

 

(16)    Commitments and Contingencies

 

Stock Options

 

Certain current and former employees have expired unexercised options, that, but for the Company’s inability to issue stock, may have realized gains from the exercise of those options. The Company may decide, or be required, to provide compensation for the intrinsic value of those expired unexercised options. The Company could elect, or be required, to make cash payments, issue stock, or provide replacement share-based compensation to these option holders to compensate them for the lost intrinsic value from these expired unexercised options. There exists the possibility of a material adverse impact on the Company’s results of operations as a result of the resolution of this matter.

 

Letters of Credit

 

At December 31, 2006, the Company had four standby letters of credit with a maximum potential future payment amount of $300,000. These standby letters of credit secure an equal number of performance bonds that were issued by financial institutions to our customers.

 

Gain from Legal Settlement

 

The Company was engaged in litigation beginning March 31, 2004 and continuing through August 30, 2005 with Acterna, LLC (“Acterna”) involving claims of patent infringement by Acterna against the Company. Acterna was subsequently acquired by JDS Uniphase Corporation (“JDSU”). During the course of this litigation, the Company subsequently alleged that Acterna violated certain of its patents.

 

73


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

On August 30, 2005, the Company entered into a Confidential Settlement agreement with Acterna and JDSU pursuant to which all of the outstanding litigation was terminated and the parties entered into mutual covenants not to initiate new patent litigation between the Company and Acterna or JDSU for a specified period of time. As part of this agreement, the Company realized a gain from legal settlement of $1.5 million in the third quarter of 2005.

 

Stockholder Litigation

 

On December 13, 2006, a stockholder derivative lawsuit was filed in the Superior Court of the State of California on behalf of Chris Stovall, a purported stockholder of the Company, against certain of the Company’s current and former officers, directors, and employees and naming the Company as a nominal defendant. The complaint asserts claims for breach of fiduciary duty, waste, unjust enrichment and other statutory claims arising out of the Company’s stock option grant practices, which plaintiff claims included the “backdating” of stock option grants. The court has twice granted the Company’s motions to dismiss the claims based on the insufficiency of the complaint.

 

On November 21, 2007, Stovall filed a second amended complaint alleging similar legal claims arising primarily out of the historic stock option grant practices. The second amended complaint seeks monetary damages from the individual defendants, restitution, disgorgement of profits, attorneys’ fees, and various corporate governance reforms.

 

In February 2008, the parties attempted to resolve the litigation through mediation, but were unsuccessful. The parties may continue with their mediation efforts in the future. The Company intends to continue to assert all available defenses. The outcome of this litigation is uncertain and should the Company experience an unfavorable ruling, there exists the possibility of a material adverse impact on its financial condition, results of operations and cash flows for the period in which the ruling occurs. No amount has been accrued for this contingency as of December 31, 2006.

 

Other Legal Contingencies

 

From time to time, the Company may be involved in litigation or other legal proceedings, including those noted above, related to claims arising out of its day-to-day operations or otherwise. Litigation is inherently uncertain, and the Company could experience unfavorable rulings. Should the Company experience an unfavorable ruling, there exists the possibility of a material adverse impact on its financial condition, results of operations, cash flows or on its business for the period in which the ruling occurs and/or future periods.

 

(17)    Subsequent Events

 

Litigation Against VeEx, Inc.

 

On January 22, 2007, the Company filed a complaint in the Superior Court of the State of California against VeEx Inc. (the “VeEx Action”) and certain of its former employees, including its former Chief Executive Officer, Paul Chang. The VeEx Action alleged misappropriation of trade secrets, conversion, breach of good faith and fair dealing, intentional interference with contractual relationships, intentional interference with prospective economic advantage, and violation of Section 502(c) of the California Penal Code by the defendants.

 

On March 2, 2007, VeEx filed a cross-complaint against the Company alleging intentional interference with prospective economic advantage and unfair competition under California Business and Professions Code Section 17200.

 

74


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

On September 27, 2007, the Company reached a settlement with VeEx which terminated all outstanding litigation. The settlement did not have a material impact on the Company’s consolidated financial statements.

 

B.T.T. Communications Technologies Ltd.

 

On February 14, 2007, B.T.T. Communications Technologies Ltd. (“BTT”) filed a lawsuit against the Company and RDT Equipment and Systems (1993) Ltd. (“RDT”) in Tel-Aviv Jaffa District Court in Israel. BTT alleged that the Company unlawfully terminated that certain Distribution Agreement by and between the Company and BTT dated December 1, 2000. BTT further alleged that the Company misappropriated BTT’s proprietary and quasi-proprietary rights with respect to certain trade secrets including, but not limited to, customer lists, projects and certain rights of distribution. BTT sought injunctive relief to prohibit the Company from distributing products in Israel through another distributor, namely RDT. On December 31, 2007, the Company reached a settlement with BTT which terminated all outstanding litigation between the parties. The settlement did not have a material impact on the Company’s consolidated financial statements.

 

Revolving Credit Arrangement

 

On August 13, 2007, the Company entered into a $10 million secured revolving credit arrangement, as well as a letter of credit facility, with Silicon Valley Bank to improve liquidity and working capital for the Company. The Company may borrow, repay and reborrow under the line of credit facility at any time. The line of credit facility bears interest at the bank’s prime rate (5.25% at March 31, 2008). This line of credit is collateralized by substantially all of the Company’s assets and requires the Company to comply with customary affirmative and negative covenants principally relating to use and disposition of assets, tangible net worth and the satisfaction of a quick ratio test. In addition, the credit arrangement contains customary events of default. Upon the occurrence of an uncured event of default, among other things, the bank may declare that all amounts owed under the credit arrangement are due and payable. The line of credit and facility expires on August 13, 2008. As of December 28, 2007, the revolving credit arrangement was amended to reduce the Company’s tangible net worth requirement from $57 million to $50 million. As of the date of this report, there are no amounts outstanding under this revolving credit arrangement.

 

Restructuring

 

On February 6, 2008, the Company announced a restructuring plan intended to reduce costs and improve operating efficiencies. The plan included a reduction in the Company’s worldwide workforce, across all functional areas, and a closure of certain international offices. The restructuring charge is estimated to be approximately $1.4 million and includes employee severance and benefit costs, costs related to leased facilities to be abandoned or subleased, and impairment of owned equipment that will be disposed, and will be recorded during the first quarter of fiscal year 2008.

 

75


Table of Contents

SUNRISE TELECOM INCORPORATED AND SUBSIDIARIES

 

Notes to Consolidated Financial Statements—(Continued)

 

(18)    Quarterly Financial Data (unaudited) (in thousands, except per share data)

 

     Mar. 31,
2006
    June 30,
2006
    Sept. 30,
2006
   Dec. 31,
2006
   Mar. 31,
2005
    June 30,
2005
    Sept. 30,
2005
    Dec. 31,
2005
 

Net sales

   $ 16,389     $ 21,978     $ 24,843    $ 36,670    $ 11,718     $ 18,330     $ 16,784     $ 21,682  

Gross profit

   $ 10,327     $ 14,936     $ 16,409    $ 23,704    $ 7,678     $ 11,551     $ 11,276     $ 15,135  

Income (loss) from operations

   $ (5,114 )   $ (747 )   $ 895    $ 5,000    $ (4,923 )   $ (3,141 )   $ (1,492 )   $ 37  

Net income (loss)

   $ (5,182 )   $ 70     $ 1,058    $ 4,568    $ (4,958 )   $ (3,374 )   $ (1,283 )   $ (625 )

Earnings (loss) per share:

                  

Basic and diluted

   $ (0.10 )   $ 0.00     $ 0.02    $ 0.09    $ (0.10 )   $ (0.07 )   $ (0.03 )   $ (0.01 )

Shares used in per share computation:

                  

Basic

     51,349       51,349       51,349      51,349      50,758       50,965       51,068       51,233  

Diluted

     51,349       51,607       51,486      51,569      50,758       50,965       51,068       51,233  

 

During the fourth quarter of 2005, the Company corrected for a prior period error in the translation of its inventories located in Taiwan from local currency into U.S. dollars. The error resulted in an understatement of previously reported inventories by $203,000 as of December 31, 2004.

 

76


Table of Contents

ITEM 9.    CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE

 

None.

 

ITEM 9A.    CONTROLS AND PROCEDURES

 

EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

 

Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, as of the end of the period covered in this report, evaluated the effectiveness of our disclosure controls and procedures, as that term is defined in Rules 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and determined that, as a result of the material weaknesses in internal control over financial reporting described below, as of December 31, 2006, our disclosure controls and procedures were not effective to ensure that information required to be disclosed by us in reports that we file or submitted under the Exchange Act was recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.

 

The Public Company Accounting Oversight Board’s Auditing Standard No. 2, An Audit of Internal Control Over Financial Reporting Performed in Conjunction with An Audit of Financial Statements (“AS 2”), defines a material weakness as a significant deficiency, or combination of significant deficiencies, that results in more than a remote likelihood that a material misstatement of the annual or interim financial statements will not be prevented or detected.

 

During the course of our external audits for fiscal 2005 and 2006, we noted several adjustments identified by our external auditors associated with one of our operating divisions. We identified deficiencies in our staffing requirements and policy regarding the timely replacement of key financial personnel. We have taken actions to remediate this material weakness during 2007, but it remained a material weakness as of December 31, 2006.

 

In September 2007, we identified a material weakness in our internal control over financial reporting relating to the calculation of our tax provision. We identified failures to properly document the tax impact of SFAS 142 relating to goodwill amortization at the time of adoption on January 1, 2002 and the failure to recognize the impact of indefinite lived deferred tax liabilities during the first quarter of 2004 on our deferred tax balances and tax expense. Controls over the calculation of income tax were inadequate to ensure that intangible assets were appropriately identified and tracked, and that indeterminate lived deferred tax liabilities resulting from timing differences relating to goodwill were clearly identified and not offset against determinate lived deferred tax assets. In September 2007, we took action designed to remediate this material weakness, but it remained a material weakness as of December 31, 2006.

 

Controls at division level

 

During the course of our external audits for fiscal 2005 and 2006, we noted several adjustments identified by our external auditors associated with one of our operating divisions. In addition, revenue classification errors associated with this division caused a material error in the financial results for the first quarter of 2007 provided in our first quarter 2007 earnings release. We believe the reasons for these errors were inadequate levels of training of divisional finance and accounting personnel, and inadequate staffing due to employee promotion and turnover. These errors resulted from a material weakness which consisted of deficiencies in our staffing requirements and policy regarding the timely replacement of key financial personnel. We consider these control deficiencies to be significant and in aggregate led to a material weakness in our internal control over financial reporting as of December 31, 2006. We have taken the following actions during 2007 to remediate this material weakness:

 

   

We have hired an experienced senior financial manager with an appropriate professional accounting certification as division controller.

 

   

We have filled all open positions in the division’s finance organization with personnel with adequate competence to ensure compliance with finance policies and procedures.

 

77


Table of Contents
   

We have refined the job requirements for the division’s finance staff to emphasize familiarity with U.S. generally accepted accounting principles.

 

   

We now require division finance staff to notify corporate finance staff of any leaves of absence or job vacancies that might impact the accuracy and timeliness of financial reporting.

 

   

We have hired corporate finance staff to perform site reviews of finance staff at our various locations to review local financial reporting, evaluate the effectiveness of the local internal control systems and staff performance, and initiate prompt corrective action.

 

Controls over tax provision calculation

 

During the course of preparing our 2006 federal tax provisions, we identified incomplete information in the supporting schedules for deferred tax assets and liabilities that revealed an error in the calculation of our tax provision for 2004. This represented a material error in our previously reported financial results for 2004 which continued through December 31, 2005. When we adopted SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”), on January 1, 2002, we failed to create proper documentation detailing the impact of SFAS 142 on deferred tax liabilities. This failure to properly document the impact of the adoption of SFAS 142 had no financial statement impact until 2004. In March 2004, as a result of employee turnover combined with this lack of appropriate documentation, we failed to recognize the impact the adoption of SFAS 142 would have on the Company’s income tax provision once a full valuation allowance was recorded against the net deferred tax assets, as was required under SFAS 109 due to the uncertainty of the realization of such assets. Consequently, we improperly offset the indeterminate-lived deferred tax liability associated with goodwill against definite-lived deferred tax assets.

 

In accordance with SFAS 142, we ceased amortizing goodwill from business acquisitions for financial reporting purposes. Goodwill continues to be amortized for income tax reporting, creating a temporary book to tax difference. SFAS No. 109, Accounting for Income Taxes, requires that we recognize a deferred tax liability for this temporary book to tax difference. The temporary difference created by amortization of goodwill is classified as a long-term deferred tax liability as the timing of any ultimate recognition of expense from the impairment or disposal of these assets is indeterminate.

 

In addition, the ultimate realization of deferred tax assets is dependent on the generation of future taxable income during the periods in which the related temporary differences become deductible. In the first quarter of 2004, a valuation allowance was recorded against all of our net deferred tax assets in most jurisdictions, the realization of these deferred tax assets was uncertain due to our recent operating losses. At the time this valuation allowance was recorded, we improperly offset the deferred tax liability associated with the temporary difference in the amortization of goodwill against other deferred tax assets and as a result, understated our valuation allowance.

 

We have taken the following actions during 2006 which helped us identify this material weakness:

 

   

We have retained outside tax consultants to assist with the analysis and preparation of all tax related entries.

 

   

We have retained a new director of taxation.

 

In addition, in September 2007, we have taken the following actions to remediate this material weakness:

 

   

We created appropriate schedules detailing book to tax differences relating to goodwill and the associated tax impact have been created and are utilized in calculating the tax provision.

 

   

We analyze all deferred tax items no less than once each quarter in connection with the preparation of our tax provision.

 

We will continue to assess whether additional actions or controls will be needed to remediate this material weakness.

 

78


Table of Contents

CHANGES IN INTERNAL CONTROL

 

During the last fiscal quarter of 2006, we implemented the following controls over the calculation of excess and obsolete inventory:

 

   

System generated demand is compared to inventory on hand to identify inventory that is potentially excess or obsolete.

 

   

System generated excess and obsolete inventory is compared to prior period reserves to identify any reductions in quantities reserved at the item level. All reductions to quantities previously reserved are evaluated to confirm the change is due to the use or disposal of that item.

 

   

Price calculations are reviewed to confirm the system generated values are appropriately calculated.

 

   

Newly reserved items are manually reviewed by production planning to ensure calculated reserves are appropriate and consistent with known requirements.

 

   

Items released from reserve due to the system calculation methodology that are not the result of disposal or use of the items in the manufacturing process are added back to reserves.

 

There were no other changes in internal control over financial reporting during the last fiscal quarter of 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

 

INHERENT LIMITATIONS ON INTERNAL CONTROL

 

A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, have been detected. These inherent limitations include the realities that judgments in decision making can be faulty, and that breakdowns can occur because of simple errors or mistakes. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls is also based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

 

ITEM 9B.    OTHER INFORMATION

 

None.

 

79


Table of Contents

Part III.

 

ITEM 10.    DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE

 

Set forth below are the names, ages and positions of each of our directors and executive officers, as of March 1, 2008:

 

Name

   Age   

Position

Patrick Peng-Koon Ang

   48    Director

Henry P. Huff

   64    Chairman of the Board

Robert C. Pfeiffer

   45    Vice Chairman

Jennifer J. Walt

   51    Director

Paul A. Marshall

   50    Director, Chief Executive Officer, President

Richard D. Kent

   51    Chief Financial Officer

Gerhard Beenen

   52    President and General Manager—Telecom Products Group

Robert Heintz

   51    Vice President—Worldwide Sales and Marketing

Kirk O. Williams

   38    Chief Legal and Compliance Officer, Secretary

 

The following are brief biographies of each of our current directors and executive officers. There are no family relationships among our directors and executive officers.

 

•     Patrick Peng-Koon Ang

Mr. Ang has served as a Director of Sunrise Telecom since March 2000. Mr. Ang has served as the Chair of the Corporate Governance/Nominating Committee since February 2006 and also serves as a member of the Audit Committee and the Compensation Committee. Since November 1, 2007, Mr. Ang has served as Vice President—Marketing of UniRAM Technology, Inc., developer of high performance memory solutions. From July 2006 to November 2007, Mr. Ang managed his personal investments. Mr. Ang served as the Chief Executive Officer of PicoNetics, Inc., a developer of low power IC technology, from January 2005 to July 2006. Mr. Ang served as Executive Vice President and Chief Operating Officer of ESS Technology, Inc., a developer of highly integrated, mixed-signal semiconductor, hardware, software and system solutions from December 2001 to October 2004. Mr. Ang holds a B.S. in Electrical Engineering from the National University of Singapore.

 

•     Henry P. Huff

Mr. Huff has served as a Director of Sunrise Telecom since March 2000 and has served as the Chairman of the Audit Committee since that time. Mr. Huff has served as Chairman of the Board since February 2006. Mr. Huff also serves as a member of the Compensation Committee and the Corporate Governance/Nominating Committee. Since May 2000,

 

80


Table of Contents
 

Mr. Huff has served as the part-time Chief Financial Officer of Cambrian Ventures, a venture capital fund, and as a part-time Financial Advisor to Corticon Technologies, Inc., an enterprise software company. Mr. Huff was Vice President, Finance and Chief Financial Officer of NorthPoint Communications Group Inc., a provider of DSL service from June 1998 until his retirement in May 2000. Mr. Huff holds a B.S. in Business Administration from the University of California at Berkeley and is a Certified Public Accountant in the State of California.

 

•     Robert C. Pfeiffer

Mr. Pfeiffer co-founded Sunrise Telecom in October 1991 and has served as a Director since that time. Mr. Pfeiffer also serves as the Vice-Chairman of the Board. Mr. Pfeiffer served as interim Vice President of Engineering from April 2006 to November 2006 and as Vice President of Engineering from October 1991 to December 1999 and as our Chief Technology Officer from December 1999 until March 2001. Mr. Pfeiffer served as our Secretary from October 1991 to July 2000. Mr. Pfeiffer holds an M.B.A. and a B.S. in Electrical Engineering from Santa Clara University.

 

•     Jennifer J. Walt

Ms. Walt has served as a Director of Sunrise Telecom and as the Chair of its Compensation Committee since March 2000. Ms. Walt serves as the Chair of the Compliance Subcommittee of the Audit Committee and as a member of the Audit Committee and the Corporate Governance/Nominating Committee. Ms. Walt has been an attorney with the law firm of Littler Mendelson, P.C. since 1983 and is a shareholder of that firm. Ms. Walt holds a J.D. from the University of California, Hastings College of the Law and a B.A. in History from Stanford University.

 

•     Paul A. Marshall

Mr. Marshall co-founded Sunrise Telecom in October 1991 and has served as Chief Executive Officer since February 2006. Mr. Marshall served as Chief Operating Officer from December 1999 to February 2006, as Vice President of Marketing from March 1992 to February 2006, and as a Director since October 1991. Mr. Marshall also served as Chief Financial Officer of Sunrise from March 1992 until December 1999 and Acting Chief Financial Officer from October 2002 to February 2005. Mr. Marshall holds an M.B.A. from the Harvard Business School and a B.S. in Mechanical Engineering from the University of California at Davis.

 

81


Table of Contents

•     Richard D. Kent

Mr. Kent joined Sunrise Telecom as Chief Financial Officer in February 2005. Mr. Kent was Vice-President of Finance from February 2003 to January 2005 at Natural Selection Foods, LLC, a producer of organic fruits and vegetables. Prior to his employment with Natural Selection Foods, he was Managing Director from June 2002 to February 2003 at RAMP Partners, an accounting and financial management firm. Mr. Kent served as Chief Financial Officer, Chief Operating Officer and Corporate Secretary from January 1997 to January 2002 at Cidco Incorporated, a publicly-traded producer of telecommunications products and personal Internet communications products and services. Mr. Kent holds a B.S. in Business Administration with an emphasis in Finance and Accounting from the University of California at Berkeley. Mr. Kent is a Certified Public Accountant and a member of the American Institute of Certified Public Accountants.

 

•     Gerhard J. Beenen

Mr. Beenen joined Sunrise Telecom as President and General Manager—Telecom Products Group in August 2006. Prior to joining the Company, Mr. Beenen served as Vice President of Engineering at Steridian, Inc., a developer of micro-display technology, from July 2005 to March 2006. From June 2004 to July 2005, Mr. Beenen managed his personal investments. From September 2000 to June 2004, Mr. Beenen served as Vice President/General Manager of Network Elements, Inc., a telecommunications equipment provider. Mr. Beenen holds a Ph.D. in Analytical Chemistry from Oregon State University and a BS in Chemistry from the University of Wisconsin.

 

•     Robert G. Heintz

Mr. Heintz joined Sunrise Telecom as Vice President—North American Sales and served in that capacity from June 2004 through August 2006, at which time he was appointed Vice President of Worldwide Sales and Marketing. Prior to Sunrise Telecom, Mr. Heintz was founder and Chairman of Axcelerant, a managed security services provider, which was founded in January 2001, and sold to GRIC Communications in December 2003. Mr. Heintz holds a B.S. in Electrical Engineering from Stanford University.

 

•     Kirk O. Williams

Mr. Williams joined Sunrise Telecom in December 2002 and has served as its Chief Legal and Compliance Officer, Secretary since February 2007.

 

82


Table of Contents

Mr. Williams served as the Company’s Vice President, General Counsel and Secretary from December 2004 to February 2007, and as General Counsel and Secretary from January 2003 to December 2004. Prior to joining the Company, Mr. Williams served in positions of increasing responsibility in the Legal Department of Exodus Communications, Inc., an internet hosting company, from October 1999 through March 2002, with his final position being Vice President, Legal and Corporate Affairs, and Assistant General Counsel. Mr. Williams holds a JD from New York University School of Law and dual B.A. in Economics and Political Science from Stanford University.

 

For a description of material proceedings to which our directors or officers are a party, see Part I, Item 3, “Legal Proceedings.”

 

Section 16(a) Beneficial Ownership Reporting Compliance

 

Section 16(a) of the Securities Exchange Act requires our officers and directors and persons who own more than 10% of a registered class of our equity securities to file certain reports regarding ownership of, and transactions in, our securities with the SEC. Such officers, directors and 10% stockholders are also required by SEC rules to furnish us with copies of all Section 16(a) forms that they file.

 

Based solely on our review of such forms furnished to us and written representations from certain reporting persons, we believe that all filing requirements applicable to our executive officers, directors and more than 10% stockholders were complied with during the fiscal year ended December 31, 2006.

 

Code of Business Conduct and Ethics

 

In May 2003, the Corporate Governance/Nominating Committee and our Board adopted our Code of Business Conduct and Ethics that applies to all of our employees, officers, directors, and independent contractors (including our principal executive officer, principal financial officer, principal accounting officer, controller, and senior financial officers). Our Code of Business Conduct and Ethics is posted on our website and can be accessed electronically at http://www.sunrisetelecom.com/ig/sunrise_code_business_conduct_ethics.pdf. We will post amendments to or waivers from a provision of the Code of Business Conduct and Ethics on our website at http://www.sunrisetelecom.com/ig/amendments_and_waivers.shtml under Investors/Governance—Corporate Governance—“Code of Business Conduct and Ethics and Amendments and Waivers.” Stockholders may request free printed copies of our Code of Business Conduct and Ethics from: Sunrise Telecom Incorporated, Attn: Investor Relations, 302 Enzo Drive, San Jose, California 95138.

 

STOCKHOLDER DIRECTOR NOMINATIONS

 

. The Corporate Governance/Nominating Committee will consider director candidates properly submitted by stockholders in accordance with the procedures set forth in our Bylaws.

 

Audit Committee and Audit Committee Financial Expert

 

The Audit Committee is currently composed of Messrs. Huff and Ang and Ms. Walt. Mr. Huff serves as the Chairman of the Audit Committee. Our Board has determined that all members of the Audit Committee are

 

83


Table of Contents

“independent” as required by the applicable listing standards of the NASDAQ Stock Market. In addition, the Board has determined that Mr. Huff qualifies as the Company’s audit committee financial expert as defined in the rules of the SEC.

 

BOARD OF DIRECTORS MEETINGS AND COMMITTEES

 

Board of Directors

 

The Board is currently composed of five members: Messrs. Ang, Huff, Marshall, and Pfeiffer and Ms. Walt. Mr. Huff serves as Chairman of the Board and Mr. Pfeiffer serves as Vice Chairman of the Board.

 

During 2006, the Board consisted of Messrs. Ang, Chang, Huff, Marshall, and Pfeiffer and Ms. Walt. Mr. Chang served as the Chairman of the Board. On February 7, 2006, Mr. Chang resigned as the Company’s Chief Executive Officer, President, Chairman and member of the Board.

 

The Board held eight meetings during fiscal year 2006, four of which were regularly scheduled meetings and four of which were special meetings. The Board also acted one time by unanimous written consent. Each Director attended at least 75% of the aggregate of all of our Board meetings and committee meetings on which such Director served during fiscal year 2006 and was eligible to attend.

 

The Board has an Audit Committee, a Compensation Committee, and a Corporate Governance/Nominating Committee. Each committee operates under a charter that has been approved by the Board. Copies of the charters are posted in the Investor/Governance section of our website at www.sunrisetelecom.com.

 

Audit Committee

 

The Audit Committee is currently composed of Messrs. Huff and Ang and Ms. Walt. Mr. Huff serves as the Chairman of the Audit Committee. The Audit Committee held eight meetings during fiscal year 2006, four of which were regularly scheduled meetings and four of which were special meetings.

 

The responsibilities of the Audit Committee include:

 

   

Reviewing Sunrise Telecom’s audit and related services at least annually;

 

   

Appointing, determining funding for and overseeing Sunrise Telecom’s auditors and ensuring their independence, including pre-approving all audit services and permissible non-audit services provided by the auditors;

 

   

Reviewing Sunrise Telecom’s annual and interim financial statements;

 

   

Reviewing and actively discussing with Sunrise Telecom’s auditors the results of the annual audit of Sunrise Telecom’s financial statements and all significant issues, transactions and changes;

 

   

Reviewing and actively discussing with Sunrise Telecom’s auditors the results of the SAS 100 review of Sunrise Telecom’s financial statements and all significant issues, transactions and changes;

 

   

Overseeing the adequacy of Sunrise Telecom’s system of internal accounting controls, including obtaining from the auditors management letters or summaries on such internal accounting controls;

 

   

Reviewing and establishing procedures for the receipt, retention and treatment of complaints received by Sunrise Telecom regarding accounting, internal controls or any auditing matters; and

 

   

Overseeing Sunrise Telecom’s finance function and compliance with SEC requirements, and reviewing the status of any legal matters that could have a significant impact on Sunrise Telecom’s financial statements.

 

84


Table of Contents

Compliance Subcommittee of the Audit Committee

 

The Compliance Subcommittee of the Audit Committee is currently composed of one member, Ms. Walt, who serves as its Chair. The Subcommittee did not hold any formal meetings during fiscal year 2006. However, the Subcommittee worked closely with management on its compliance initiatives.

 

Compensation Committee

 

The Compensation Committee is currently composed of Ms. Walt and Messrs. Huff and Ang. Ms. Walt serves as Chairwoman of the Compensation Committee. During 2006, the Compensation Committee held eight meetings, of which four were regularly scheduled meetings and four were special meetings.

 

The responsibilities of the Compensation Committee include:

 

   

Establishing and reviewing Sunrise Telecom’s general compensation policies and compensation levels applicable to Sunrise Telecom’s Chief Executive Officer and President, and other executive officers;

 

   

Establishing and reviewing Sunrise Telecom’s general compensation policies applicable to all Sunrise Telecom employees;

 

   

Reviewing and advising the Board concerning the performance of Sunrise Telecom’s Chief Executive Officer and President, and other executive officers; and

 

   

Overseeing the administration of the stock compensation plans that Sunrise Telecom may adopt from time to time, including the determination of employees and other parties who are to receive grants of stock or stock options, and the terms of such grants or options.

 

Corporate Governance/Nominating Committee

 

The Corporate Governance/Nominating Committee is currently composed of Messrs. Huff and Ang and Ms. Walt. Mr. Ang serves as the Chairman of the Corporate Governance/Nominating Committee.

 

During 2006, the Corporate Governance/Nominating Committee consisted of Ms. Walt and Messrs. Pfeiffer, Huff, and Ang. Mr. Pfeiffer served as the Chairman of the Corporate Governance/Nominating Committee from March 20, 2004 until April 5, 2006, at which time Mr. Pfeiffer resigned from the Committee to work with the Company as its Acting Vice President of Engineering to manage and oversee its research and development efforts in San Jose and China. The Corporate Governance/Nominating Committee held five meetings during fiscal year 2006, four of which were regularly scheduled meetings and one of which was a special meeting.

 

The responsibilities of the Corporate Governance/Nominating Committee include:

 

   

Evaluating periodically and recommending to the Board any changes in the size and composition of the Board;

 

   

Reviewing and evaluating director nominees to the Board, including incumbent directors;

 

   

Evaluating the performance and operations of the Board and the performance of the individual directors;

 

   

Evaluating the performance, operations, composition, authority and charter of each of the Board committees and the performance of the individual committee members; and

 

   

Reviewing and recommending to the Board any changes in corporate governance policy, including any changes suggested or recommended by our stockholders.

 

85


Table of Contents

The Corporate Governance/Nominating Committee recommends nominees for election to the Board of Directors. In evaluating director nominees, the Corporate Governance/Nominating Committee considers the following factors:

 

   

The appropriate size of the Board of Directors;

 

   

The changing needs of Sunrise Telecom;

 

   

The character and integrity of the candidate;

 

   

The candidate’s knowledge of Sunrise Telecom and its industry;

 

   

The candidate’s desire to represent the best interests of the stockholders as a whole;

 

   

The value of the candidate’s experience as a director of Sunrise Telecom;

 

   

The availability of new director candidates who may offer unique contributions;

 

   

The knowledge, skills and experience of the candidate, including experience in technology, business, finance, administration or public service;

 

   

Any potential conflicts of interest; and

 

   

The candidate’s commitment to dedicate the necessary time and attention to Sunrise Telecom.

 

The Corporate Governance/Nominating Committee considers each new director candidate and each incumbent director carefully, including considering other factors as it may deem are in the best interests of Sunrise Telecom and its stockholders. The Corporate Governance/Nominating Committee will consider director candidates properly submitted by stockholders in accordance with the procedures set forth in the Sunrise Telecom Bylaws. The Board has determined that each of the members of the Corporate Governance/Nominating Committee is an “independent director” as defined in Rule 4200 of the Marketplace Rules of the National Association of Securities Dealers, Inc.

 

ITEM 11.    EXECUTIVE COMPENSATION

 

COMPENSATION DISCUSSION AND ANALYSIS

 

This Compensation Discussion and Analysis contains a discussion of the principles underlying our executive compensation policies and decisions and material elements of executive compensation awarded to the named executive officers listed in the Summary Compensation Table—Fiscal 2006 below. The discussion below should be read in conjunction with the tables and related disclosures set forth below in this section. The terms of our separation agreement with Mr. Chang, who was our Chief Executive Officer and during 2006 until February 5, 2006, are summarized in the section below entitled “Separation Agreement with Paul Ker-Chin Chang.”

 

GENERAL OBJECTIVES AND POLICIES

 

We believe that the telecommunications test equipment industry is a highly competitive business environment and that it is important to develop an executive compensation program that attracts, motivates and retains qualified executives by rewarding excellence, leadership and long-term company performance. Accordingly, our compensation strategy is generally market and performance oriented and designed to link executive compensation to our strategic business objectives, specific financial performance objectives and the enhancement of stockholder returns. However, during fiscal 2006 we determined that the compensation of many of our named executive officers, like the compensation of other employees, was significantly below prevailing market rates, and many unexpected challenges required the Compensation Committee temporarily to set aside performance-oriented objectives and to develop compensation arrangements that promoted the retention of key employees, including our named executive officers.

 

86


Table of Contents

As described in more detail below, the material elements of our executive compensation program for our named executive officers during fiscal year 2006 were as follows:

 

Element

   Form of
Compensation
  

Purpose

Base Salary

   Cash    Fixed compensation to attract and retain exceptional executive talent.

Retention Bonus

   Cash    Incentive to remain employed with the Company through specified dates.

Discretionary Bonus

   Cash    Recognize individual contributions.

Change of Control Severance Plan

   Cash    Motivate executive officers to continue employment with the Company until the completion of a change of control transaction and to provide compensation in the event a named executive officer is terminated as a result of a change of control transaction.

 

How We Determine Compensation

 

The Compensation Committee meets regularly during the year and is responsible for the determination of all executive compensation matters. The Compensation Committee conducts an annual review of executive compensation, typically in the first quarter of the year, at which it reviews the elements of executive compensation for each named executive officer and makes compensation decisions for the year, including setting any performance targets for incentive compensation plans. In developing these decisions, the Committee receives and considers recommendations from the Chief Executive Officer. In its annual review, the Compensation Committee considers many factors, including:

 

   

the relationship between executive compensation and corporate performance and returns to stockholders;

 

   

the qualitative or quantitative measures of corporate performance to be used in the determination of executive compensation;

 

   

the roles, responsibilities and performance of individual executives;

 

   

the relative compensation of different executives and the long-term value of each executive; and

 

   

market data of executive compensation at comparable companies, for the purpose of assessing the Company’s competitive position relative to these companies.

 

The Compensation Committee reviewed each element of executive compensation for 2006 for our named executive officers.

 

Role of Compensation Consultant

 

The Company and the Compensation Committee did not retain the services of an independent compensation consultant in connection with our determination of executive compensation. The Company and the Compensation Committee used only their own internal resources, the Radford compensation surveys, and published public company compensation information from selected comparable companies.

 

87


Table of Contents

Role of Executive Officers in Determining 2006 Compensation

 

Our management provides background information relevant to the Compensation Committee’s deliberations on executive compensation matters, and our Chief Executive Officer recommends compensation for other named executive officers but does not participate in the consideration of his own compensation by the Compensation Committee. In March 2006, our Chief Executive Officer provided the Compensation Committee recommended base salaries for all named executive officers other than the Chief Executive Officer, to be in effect for fiscal year 2006. The Compensation Committee has the authority to accept, reject or modify these recommendations, and it accepted them with minor adjustments. The Chief Executive Officer made no recommendations with respect to equity compensation in 2006 because the Company was not current with its periodic SEC reporting requirements and was unable to issue any equity compensation under a registration statement on Form S-8.

 

In making his recommendations to the Compensation Committee, the Chief Executive Officer reviewed the scope of each named executive officer’s responsibilities, the executive’s background, training and experience, the Company’s ability to find a replacement for the individual and internal pay equity considerations. He also reviewed the performance of the individual executives. He referred to the 2006 Radford Executive Survey. This survey contains market data and compensation alternatives to consider in making compensation decisions for our named executive officers. We believe that this survey is a commonly-used resource for technology companies in our geographic area. We reviewed the amounts reported in the Radford survey for telecommunications companies with average revenue ranging between $50 million and $199 million, to match our industry and company size. To gain additional perspective, our management also evaluated aspects of compensation reported by a group of public companies in the telecommunications industry with which we compete for business and executive talent. The companies surveyed for this purpose change from time to time, but for 2006 we reviewed information from the following companies:

 

•    IXIA

  

•    EXFO

•    Tektronix

  

•    Agilent

•    Catapault

  

•    Acterna

•    Tollgrade

  

 

We do not consider these companies a “peer group” for executive compensation benchmarking purposes, but refer to their compensation practices for additional perspective.

 

ELEMENTS OF COMPENSATION

 

Base Salary

 

Our goal is to pay base salaries to our executive officers that are competitive with the base salaries paid to similar executives of companies with which we believe we compete to attract and retain executives. We generally target executive officer base salaries at approximately the 50th percentile of the Radford Executive Survey. The Compensation Committee reviewed the base salaries for each named executive officer in the first quarter of 2006 in light of the Radford data as well as the additional information from the companies identified above. Executive officer base salaries were also evaluated as part of the total compensation package for each named executive officer, with a general target that total compensation should be approximately the 50th percentile of the relevant Radford data. The weight given to different compensation elements may differ from individual to individual, as the Compensation Committee deems appropriate, based on each executive officer’s position and relative experience. We may adjust base salary during the year as warranted to address retention issues or to reflect promotions or other changes in the scope or breadth of an executive’s role or responsibilities.

 

We determined 2006 base salaries for each named executive officer based on the 2006 Radford Executive Survey. Our Chief Executive Officer, who is also one of our principal stockholders, took a reduction in salary when he was appointed CEO to better reflect the results of the Radford Executive Survey.

 

88


Table of Contents

Retention Incentive Bonus Program

 

In April 2006, the Compensation Committee determined that the base salaries of our named executive officers, other than our Chief Executive Officer, like the salaries of other employees, were lower than the 50th percentile for 2006, making our base salaries significantly non-competitive. As a result of several years in which we had paid little or no bonuses to our executives, continuing below market salaries, and our continuing internal problems, the Compensation Committee realized that we were in a period of increased risk of substantial employee turnover. The Compensation Committee believed that the Company needed to motivate and retain our executives to continue working for the Company while the Audit Committee completed its special investigation and we worked through accounting and reporting challenges associated with that activity. As a result, the Compensation Committee met to determine what incentive compensation programs would be appropriate, and our executive officers offered their suggestions for retention incentives. Ultimately the Compensation Committee authorized a retention incentive program for Company employees, including the named executive officers.

 

The Compensation Committee approved the Retention Incentive Bonus Program, pursuant to which each employee was eligible to receive a bonus equivalent to up to three months of his or her base salary. Our named executive officers were compensated on the same basis as other salaried employees in San Jose, California under this program. Each bonus payment was in an amount equal to one month of the employee’s current annual salary as of April 27, 2006. We agreed to pay bonuses in three equal installments to eligible employees who remained employed as of July 28, 2006, December 1, 2006 and May 4, 2007. The retention incentives paid to our named executive officers for 2006 and the totals paid under this plan, are set forth in the following table:

 

Named Executive Officer

   2006
Retention
Bonus
   Total
Retention
Bonus

Paul Marshall

   $ —      $ —  

Robert G. Heintz

   $ 30,167    $ 45,251

Jeungeun Joo

   $ 28,333    $ 42,500

Richard D. Kent

   $ 34,500    $ 51,750

Kirk O. Williams

   $ 31,250    $ 46,875

 

Heintz 2006 Bonus/Commission Structure

 

Mr. Heintz received commissions based on revenue and sales margin targets, with a commission target of $125,000 based on Corporate North American sales margin and Company revenue and margin targets, calculated and paid monthly.

 

Discretionary Bonus

 

In December 2006, the Compensation Committee awarded discretionary bonuses to Messrs. Marshall, Kent and Williams in the amounts of $65,000, $25,000 and $10,000, respectively. In determining the amounts of the discretionary bonuses, the Compensation Committee considered (i) the additional duties assumed by each recipient in 2006 that went beyond his normal job responsibilities as a result of the Audit Committee’s special investigation discussed elsewhere in this report, (ii) the 46% increase in revenues in 2006 over 2005, (iii) the $10.8 million increase in net income in 2006 over 2005, and (iv) whether or not the recipient participated in the Company’s Retention Incentive Bonus Program.

 

Change of Control Severance Plan

 

In June 2006, the Compensation Committee approved and adopted a Change of Control Severance Plan to promote our executive compensation objectives to motivate and retain qualified executives by offering severance

 

89


Table of Contents

arrangements designed to provide reasonable compensation to departing executives under certain circumstances. Because many change of control transactions involve significant management turnover, we believe that the potential for a change of control transaction involving the Company creates uncertainty among our executives about their continued employment and might lead to unwanted turnover. The Change of Control Severance Plan allows named executives to remain focused on Company business.

 

In order to encourage our executive officers to remain employed with the Company during an important time when their prospects of continued employment following a change in control transaction are uncertain, we provide Messrs. Kent and Williams with severance benefits pursuant to our Change of Control Severance Plan. As a principal stockholder, our Chief Executive Officer, Paul Marshall, did not participate in the Change of Control Severance Plan or any other severance agreement. At the time of the adoption of the Change of Control Severance Plan, neither Mr. Heintz nor Mr. Joo was eligible to participate, and Mr. Beenen was not yet employed by the Company. When Mr. Beenen joined the Company in August 2006, he was offered change of control severance terms substantially similar to those offered to other executives under the plan. Mr. Heintz also was added to the plan in December 2007. The Company may amend the plan at any time.

 

Please see the section below titled “Potential Payments Upon Termination or Change of Control” for a description of the potential payments that may be made to our named executive officers in connection with their termination of employment in connection with a change of control.

 

Perquisites and Other Benefits

 

Our executive officers receive the same benefits package that is available to other regular full time employees of the Company. In general, our executive officers do not receive any special perquisites or other benefits solely by virtue of the fact that they are executive officers.

 

EXECUTIVE COMPENSATION FOR 2007

 

Relationship with Independent Compensation Consultant

 

In late 2006, we retained the services of an independent compensation consultant, to assess the Company’s overall employee compensation program. The consultant was also engaged to provide executive level support for our new Chief Executive Officer. We subsequently expanded the consultant’s scope of services specifically to include a review of our executive compensation strategies. The consultant was engaged by and reported to Company management, but regularly interacted with the Compensation Committee, and attended its meetings, both with and without management present. The consultant advised the Compensation Committee on the practical aspects of the Company’s executive compensation program and evolving best practices, and provided market information and analysis regarding the competitiveness of the Company’s compensation program.

 

90


Table of Contents

2007 Executive Compensation Components

 

The Compensation Committee made all decisions regarding the 2007 compensation of our named executive officers, with participation of Company executives substantially as described above relative to 2006 executive compensation. Our 2007 executive compensation program for our named executive officers included the following elements:

 

Element

  

Form of Compensation

  

Purpose

Base Salary    Cash    Fixed compensation to attract and retain exceptional executive talent.
Retention Incentive Bonus Plan    Cash    Incentive to remain employed by the Company through specified dates.
Management Objective Plan    Cash    Incentive to achieve individual and overall Company performance.
Discretionary Bonus    Cash    Recognize individual contributions.
Equity-Based Compensation    Stock options and/or restricted stock units    Create a strong financial incentive for achieving or exceeding long-term performance goals and encourage a significant equity stake in our Company.
Change of Control Severance Plan    Cash    Compensation in the event of termination as a result of a change of control transaction.

 

2007 Allocation of Compensation

 

The Compensation Committee seeks to allocate total compensation in a manner that is competitive with our peer group. The Compensation Committee believes that this is appropriate because the peer group is the group of companies with which we compete for executive talent. The Compensation Committee also believes that the allocations that result from this approach are effective in motivating our named executive officers to maximize stockholder value. The allocations that apply with respect to 2007 appear in the chart below, where we have included our President and General Manager—Telecom Products Group, Mr. Gerhard Beenen, who we expect to be one of our named executive officers for 2007. The retention incentive bonus payments listed below were the final payment of a bonus program that began in early 2006 and terminated in early 2007.

 

Name Executive Officer

   2007
Annual
Base
Salary
   Percent of
Total
Compensation
    Target
Annual
Incentive
   Percent of
Total
Compensation
    Retention
Bonus
   Percent of
Total
Compensation
    Total Annual
Planned
Compensation

Paul Marshall

   $ 355,000    77 %   $ 106,500    23 %     —      —       $ 461,500

Richard Kent

   $ 230,000    73 %   $ 69,000    22 %   $ 17,250    5 %   $ 316,250

Gerhard Beenen

   $ 235,000    72 %   $ 70,500    22 %   $ 19,167    6 %   $ 324,667

Robert Heintz

   $ 200,000    57 %   $ 135,000    39 %   $ 15,000    4 %   $ 350,000

Kirk Williams

   $ 200,000    73 %   $ 60,000    22 %   $ 15,625    5 %   $ 275,625

 

91


Table of Contents

2007 Management by Objective Plan

 

In February 2007, based on the advice of our compensation consultant, the Compensation Committee approved the 2007 Management by Objective Plan (“MBO Plan”), which is a non-equity incentive plan. Under the MBO Plan, incentive bonuses are paid based upon performance relative to: (1) individual performance objectives; (2) a company revenue target for 2007; and (3) a company net income target for 2007. The target bonus was 30% of annual base salary. In lieu of participation in the MBO Plan, Mr. Heintz received commissions based on margins and sales, with a 2007 commission target of $135,000, calculated and paid monthly. In addition, the Compensation Committee in its discretion may award him an extra bonus based on Company performance, not to exceed two times his annual base salary.

 

Half of the MBO Plan target bonus is payable if individual performance objectives are achieved, regardless of Company performance. The other half of the target bonus is payable upon achievement of Company metrics for the year determined by the Compensation Committee. The Compensation Committee decided that the Company metrics for 2007 should be revenue and net income because they are key components of the Company’s business strategy for 2007. Because of their importance, the Compensation Committee weighted the Company metrics to equal 50% of the target bonus, allocating 25% to each metric, but also wanted to motivate each named executive officer to improve their respective functional areas through their individual performance target of 50%. Mr. Beenen’s Company performance metrics also included business unit performance targets. Individual performance goals were based on certain Company metrics for the respective functional area of each named executive officer. The goals of Mr. Marshall were determined and approved by the Compensation Committee. The goals of Messrs. Kent, Beenen and Williams were approved by our Chief Executive Officer shortly after the adoption of the MBO Plan.

 

If the Company achieved 75% of its revenue target under the MBO Plan, half of the revenue target bonus was payable, with graduated payments up to 100% of this component at 100% achievement of our annual revenue target. If the Company achieved break even results, half of the net income target bonus was payable, with graduated payments up to 100% of this component at 100% achievement of our net income target. In addition, the Compensation Committee may award discretionary bonuses, not to exceed three times each named executive officer’s base salary, if our revenue and net income targets were exceeded. Conversely, the Compensation Committee reserved the discretion to reduce or eliminate bonuses if the Company’s revenue and net income targets were not achieved.

 

Equity-Based Incentive Awards

 

We believe that our named executive officers’ equity-based compensation should be directly linked to the value provided to our stockholders. However, due to the internal investigation concerning our business practices, the investigation of our historical stock option granting practices, the restatement activities relating to the stock option investigation and the other errors in our historical accounting practices, we were unable to timely file periodic reports with the SEC. As a result, we were not in compliance with the filing requirements for continued listing on the NASDAQ Stock Market as set forth in Marketplace Rule 4310(c)(14), our common stock was delisted from the NASDAQ Stock Market in December 2005 and subsequently began trading on the Pink Sheets under the symbol “SRTI.PK” and we do not have an effective registration statement on Form S-8 on file with the SEC. Therefore, our Compensation Committee has not granted stock option awards since 2005.

 

At the first Compensation Committee meeting following the date on which we are deemed current with our SEC periodic reporting requirements and therefore are able to issue equity-based compensation, we intend to award stock option grants to our employees, including our named executive officers, with an exercise price equal to the closing sale price of our common stock on the date of the grant. Like many technology companies, our common stock price is highly volatile, which creates uncertainty about the value of current equity awards. A stock option is an instrument more directly tied to stock market risk and will have no value if the exercise price is higher than the market price of our

 

92


Table of Contents

common stock on the exercise date. Thus, the named executive officers will only realize value on their stock options if our stockholders realize value on their shares.

 

We believe that stock options also function as a retention incentive for our named executives as they vest over a four year period following the grant date in accordance with the following schedule: 25% vest on the first anniversary of the date of the grant and the remaining 75% vest in equal monthly installments of approximately 2% per month thereafter. We typically make initial equity awards of stock options to new executives at the first regularly scheduled Compensation Committee meeting held following the new executive’s date of hire and annual equity award grants to our current executives at the first regularly scheduled Compensation Committee meeting of each year. The number of shares of the Company’s common stock subject to each annual award is intended to create a meaningful opportunity for stock ownership in light of the named executive officer’s current position with the Company, the size of comparable awards to comparable executives at comparable companies, the individual’s potential for increased responsibility and promotion over the award term, the individual’s personal performance and contributions in recent periods and the individual’s anticipated contribution to meeting the Company’s long term strategic performance goals. The Compensation Committee also takes into account the number of unvested equity awards held by the named executive officer in order to maintain an appropriate level of retention incentive for that individual. However, the Compensation Committee does not adhere to any specific guidelines as to the relative equity award holdings of the Company’s named executive officers.

 

COMPLIANCE WITH INTERNAL REVENUE CODE SECTION 162(M)

 

Section 162(m) of the Internal Revenue Code of 1986, as amended, which we refer to herein as the “Code,” generally disallows a tax deduction to public companies for certain compensation in excess of $1 million paid to the named executive officers. Certain compensation, including qualified performance-based compensation, will not be subject to the deduction limit if certain requirements are met. The Compensation Committee reviews the potential effect of Section 162(m) periodically and generally seeks to structure the long-term incentive compensation granted to its executive officers in a manner that is intended to avoid disallowance of deductions under Section 162(m). Nevertheless, there can be no assurance that compensation attributable to long-term incentive awards will be treated as qualified performance-based compensation under Section 162(m). In addition, the Compensation Committee reserves the right to use its judgment to authorize compensation payments that may be subject to the limit when the Compensation Committee believes such payments are appropriate and in our and our stockholders’ best interests, after taking into consideration changing business conditions and the performance of its employees.

 

COMPENSATION OF THE NAMED EXECUTIVE OFFICERS

 

The Summary Compensation Table below quantifies the value of the different forms of compensation earned by, or awarded to, our named executive officers in 2006. The primary elements of each named executive officer’s total compensation reported in the table are base salary and bonuses. The Summary Compensation Table should be read in conjunction with the tables and narrative descriptions that follow. A description of the material terms of each named executive officer’s base salary and annual bonus is provided immediately following the Summary Compensation Table. There were no equity or non-equity incentive awards in 2006. The Outstanding Equity Awards at Fiscal Year-End 2006 and Option Exercises and Stock Vested—Fiscal 2006 tables provide further information on the named executive officers’ potential realizable value and actual value realized with respect to their equity awards. The discussion of the potential payments due upon a termination of employment resulting from a change in control that follows is intended to further explain the potential future payments that are, or may become, payable to our named executive officers under certain circumstances.

 

93


Table of Contents

Summary Compensation Table—Fiscal 2006

 

The following table summarizes the compensation of our Chief Executive Officer, our Chief Financial Officer, and our other three most highly compensated executive officers during the year ended December 31, 2006. We refer to these individuals as the “named executive officers” elsewhere in this report.

 

Name and Principal Position

  Year   Salary
($)
  Bonus
($) (5)
    Option
Awards
($)
  All Other
Compensation
($)(7)
  Total
($)

Paul Ker-Chin Chang (1) (6)

  2006   157,688   —       —     300,698   $ 458,386

Former Chief Executive Officer, President and Chairman of the Board; Technology Advisor