UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE |
For the quarterly period ended September 30, 2003March 31, 2004
Commission File Number: 000-25291
TUT SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Delaware | 94-2958543 | |
(State or other jurisdiction of
| (I.R.S. Employer
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(Address of principal executive offices) | (Zip Code) | |
Registrant’s telephone number, including area code: (503) 594-1400 |
Registrant’s telephone number, including area code: (925) 460-3900
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes xý No ¨o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes xý No ¨o
As of October 24, 2003, 20,231,366April 30, 2004, 20,375,838 shares of the Registrant’s common stock, par value $0.001 per share, were issued and outstanding.
FORM 10-Q
INDEX
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Notes to Unaudited Condensed Consolidated Financial Statements | ||||
Management’s Discussion and Analysis of Financial Condition and Results of Operations | ||||
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Changes in Securities, | ||||
2
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
September 30, 2003 | December 31, 2002 |
| December 31, |
| March 31, |
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(unaudited) |
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ASSETS |
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Current assets: |
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Cash and cash equivalents | $ | 13,956 | $ | 25,571 |
| $ | 14,370 |
| $ | 12,270 |
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Accounts receivable, net of allowance for doubtful accounts of $40 and $10 in 2003 and 2002, respectively | 7,187 | 1,972 | |||||||||||||
Accounts receivable, net of allowance for doubtful accounts of $47 and $45 in 2003 and 2004, respectively |
| 7,062 |
| 6,083 |
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Insurance settlement receivable |
| 10,725 |
| 10,000 |
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Inventories, net | 3,822 | 3,888 |
| 4,181 |
| 3,972 |
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Prepaid expenses and other | 1,517 | 1,082 |
| 1,026 |
| 1,627 |
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Total current assets | 26,482 | 32,513 |
| 37,364 |
| 33,952 |
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Property and equipment, net | 1,579 | 1,630 |
| 1,722 |
| 2,078 |
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Intangibles and other assets | 4,099 | 5,586 |
| 3,685 |
| 3,103 |
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Total assets | $ | 32,160 | $ | 39,729 |
| $ | 42,771 |
| $ | 39,133 |
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LIABILITIES AND STOCKHOLDERS’ EQUITY |
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Current liabilities: |
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Accounts payable | $ | 2,797 | $ | 1,272 |
| $ | 3,055 |
| $ | 3,732 |
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Accrued liabilities | 1,778 | 5,924 |
| 1,516 |
| 2,097 |
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Legal settlement liability |
| 10,725 |
| 10,000 |
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Deferred revenue | 170 | 921 |
| 253 |
| 368 |
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Total current liabilities | 4,745 | 8,117 |
| 15,549 |
| 16,197 |
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Note Payable | 3,455 | 3,262 | |||||||||||||
Deferred revenue, net of current portion | — | 35 | |||||||||||||
Note payable |
| 3,523 |
| 3,603 |
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Other liabilities | 56 | 84 |
| 44 |
| 31 |
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Total liabilities | 8,256 | 11,498 |
| 19,116 |
| 19,831 |
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Commitments and contingencies (Note 7) | |||||||||||||||
Commitments and contingencies (Note 6) |
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Stockholders’ equity: |
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Common stock, $0.001 par value, 100,000 shares authorized, 20,188 and 19,796 shares issued and outstanding in 2003 and 2002, respectively | 20 | 20 | |||||||||||||
Preferred stock, $0.001 par value, 5,000 shares authorized, no shares issued and outstanding in 2003 and 2004, respectively |
| — |
| — |
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Common stock, $0.001 par value, 100,000 shares authorized, 20,274 and 20,329 shares issued and outstanding in 2003 and 2004, respectively |
| 20 |
| 20 |
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Additional paid-in capital | 305,571 | 304,888 |
| 305,777 |
| 305,865 |
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Accumulated other comprehensive loss | (153 | ) | (141 | ) |
| (89 | ) | (80 | ) | ||||||
Accumulated deficit | (281,534 | ) | (276,536 | ) |
| (282,053 | ) | (286,503 | ) | ||||||
Total stockholders’ equity | 23,904 | 28,231 |
| 23,655 |
| 19,302 |
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Total liabilities and stockholders’ equity | $ | 32,160 | $ | 39,729 |
| $ | 42,771 |
| $ | 39,133 |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
3
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)
Three Months Ended September 30, | Nine Months Ended September 30, |
| Three Months Ended |
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2003 | 2002 | 2003 | 2002 |
| 2003 |
| 2004 |
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Revenues: |
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Product | $ | 8,283 | $ | 1,840 | $ | 22,384 | $ | 6,317 |
| $ | 6,401 |
| $ | 6,159 |
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License and royalty | 239 | 195 | 604 | 590 |
| 200 |
| 18 |
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Total revenues | 8,522 | 2,035 | 22,988 | 6,907 |
| 6,601 |
| 6,177 |
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Cost of goods sold: |
| 3,259 |
| 5,129 |
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Product | 3,751 | 1,249 | 11,025 | 9,340 | |||||||||||||||||||
Total cost of goods sold | 3,751 | 1,249 | 11,025 | 9,340 | |||||||||||||||||||
Gross margin (loss) | 4,771 | 786 | 11,963 | (2,433 | ) | ||||||||||||||||||
Gross profit |
| 3,342 |
| 1,048 |
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Operating expenses: |
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Sales and marketing | 1,848 | 1,830 | 5,702 | 6,612 |
| 1,927 |
| 1,905 |
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Research and development | 1,887 | 3,172 | 6,221 | 9,959 |
| 2,086 |
| 1,822 |
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General and administrative | 1,018 | 642 | 3,325 | 3,844 |
| 1,202 |
| 1,117 |
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Restructuring Costs | 292 | 870 | 292 | 870 | |||||||||||||||||||
Impairment of intangible assets | — | — | 128 | — |
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| 202 |
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Amortization of intangible assets | 442 | 300 | 1,360 | 899 |
| 459 |
| 396 |
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Total operating expenses | 5,487 | 6,814 | 17,028 | 22,184 |
| 5,674 |
| 5,442 |
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Loss from operations | (716 | ) | (6,028 | ) | (5,065 | ) | (24,617 | ) |
| (2,332 | ) | (4,394 | ) | ||||||||||
Impairment of certain equity investments | — | — | — | (592 | ) | ||||||||||||||||||
Interest and other (expense) income, net | (26 | ) | 161 | 67 | 588 | ||||||||||||||||||
Interest and other income (expense), net |
| 101 |
| (56 | ) | ||||||||||||||||||
Net loss | $ | (742 | ) | $ | (5,867 | ) | $ | (4,998 | ) | $ | (24,621 | ) |
| $ | (2,231 | ) | $ | (4,450 | ) | ||||
Net loss per share, basic and diluted (Note 3) | $ | (0.04 | ) | $ | (0.36 | ) | $ | (0.25 | ) | $ | (1.50 | ) |
| $ | (0.11 | ) | $ | (0.22 | ) | ||||
Shares used in computing net loss per share, basic and diluted (Note 3) | 20,040 | 16,482 | 19,912 | 16,451 |
| 19,801 |
| 20,297 |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
4
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Nine Months Ended September 30, |
| Three Months Ended |
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2003 | 2002 |
| 2003 |
| 2004 |
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Cash flows from operating activities: |
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Net loss | $ | (4,998 | ) | $ | (24,621 | ) |
| $ | (2,231 | ) | $ | (4,450 | ) | ||
Adjustments to reconcile net loss to net cash used in operating activities: |
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Depreciation and other | 796 | 2,599 | |||||||||||||
Provision (recovery) for doubtful accounts | 30 | (2,035 | ) | ||||||||||||
Provision for (reduction of) excess and obsolete inventory and abandoned products | (775 | ) | 5,182 | ||||||||||||
Write off of certain equity investments | — | 592 | |||||||||||||
Depreciation |
| 235 |
| 328 |
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Noncash interest income |
| 10 |
| — |
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Provision for (recovery of) doubtful accounts |
| (15 | ) | 13 |
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Provision for excess and obsolete inventory and abandoned products |
| — |
| 974 |
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Impairment of intangible assets | 128 | — |
| — |
| 202 |
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Amortization of intangible assets | 1,360 | 899 |
| 459 |
| 396 |
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Change in operating assets and liabilities, net of businesses acquired: | |||||||||||||||
Deferred interest on note payable |
| 64 |
| 80 |
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Change in operating assets and liabilities: |
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Accounts receivable | (5,246 | ) | 1,590 |
| (185 | ) | 966 |
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Inventories | 841 | 2,482 |
| 48 |
| (765 | ) | ||||||||
Prepaid expenses and other assets | (447 | ) | 852 |
| (467 | ) | (608 | ) | |||||||
Accounts payable and accrued liabilities | (2,649 | ) | (3,427 | ) |
| (2,044 | ) | 1,245 |
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Deferred revenue | (786 | ) | (713 | ) |
| (229 | ) | 115 |
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Net cash used in operating activities | (11,746 | ) | (16,600 | ) |
| (4,355 | ) | (1,504 | ) | ||||||
Cash flows from investing activities: |
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Purchase of property and equipment | (745 | ) | (331 | ) |
| (267 | ) | (684 | ) | ||||||
Proceeds from maturities of short-term investments | — | 3,105 | |||||||||||||
Net cash (used in) provided by investing activities | (745 | ) | 2,774 | ||||||||||||
Net cash used in investing activities |
| (267 | ) | (684 | ) | ||||||||||
Cash flows from financing activities: |
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Proceeds from issuances of common stock, net | 683 | 67 |
| 11 |
| 88 |
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Deferred interest on note payable | 193 | — | |||||||||||||
Repayment of note receivable | — | 37 | |||||||||||||
Net cash provided by financing activities | 876 | 104 |
| 11 |
| 88 |
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Net decrease in cash and cash equivalents | (11,615 | ) | (13,722 | ) |
| (4,611 | ) | (2,100 | ) | ||||||
Cash and cash equivalents, beginning of period | 25,571 | 46,338 |
| 25,571 |
| 14,370 |
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Cash and cash equivalents, end of period | $ | 13,956 | $ | 32,616 |
| $ | 20,960 |
| $ | 12,270 |
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The accompanying notes are an integral part of these condensed consolidated financial statements.
5
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except per share amounts)
NOTE 1—DESCRIPTION OF BUSINESS:
Tut Systems, Inc. (the “Company”) was founded in 1983 and began operations in August 1991. The Company designs, develops, markets and sells digital video content processing systems optimizedthat enable telephony-based service providers to deliver broadcast quality digital video signals over their networks. The Company also offers video processing systems that enable private enterprise and government entities to transport video signals over satellite, fiber, radio, or copper networks for surveillance, distance learning, and TV production applications. The Company also designs, develops and markets broadband transport and service management products that enable the provisioning of public broadcast digital TVhigh speed Internet access and other broadband data services across telephone company and cable company facilities, digital video trunking systems for applications across TV broadcast, government and education facilities, and broadband transmission systems for application over existing copper networks within hotels and private campus or building facilities.
Historically, the Company derived most of the Company’sits sales were derived from its broadband data transmission systems. With the Company’stransport and service management products. In November 2002, acquisition of VideoTele.com (“VTC”), formerly a subsidiary of Tektronix, Inc., the Company extendedacquired VideoTele.com, or VTC, from Tektronix, Inc. to extend its product offerings to include digital video content processing and video trunking systems. Video-based products now represent a majority of the Company’s sales.
The Company has incurred substantial losses and negative cash flows from operations since inception. For the ninethree months ended September 30, 2003,March 31, 2004, the Company incurred a net loss of $4,998,$4,450 and negative cash flows from operating activities of $11,746,$1,504, and has an accumulated deficit of $281,534$286,503 at September 30, 2003. ToMarch 31, 2004. Management believes that the extentcash and cash equivalents as of March 31, 2004 are sufficient to fund its operating activities and capital expenditure needs for the Company’s business continues to be affected by poornext twelve months. However, in the event that general economic conditions impacting the telecommunications industry,worsen, the Company will continue tomay require additional cash to fund its operations. The Company willplans to seek additional equity funding for operations from alternative debtto provide working capital, fund potential acquisitions and equity sources if necessary to maintain reasonable operating levels.potentially redeem the VTC acquisition indebtedness. The Company cannot be assuredassure that such funding efforts will be successful. Failure to generate positive cash flow in the future could have a material adverse effectimpact on the Company’s ability to achieve its intended business objectives.
NOTE 2—SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES:
Basis of presentation
The accompanying condensed consolidated financial statements as of September 30, 2003March 31, 2004 and December 31, 20022003 and for the three and nine months ended September 30,March 31, 2003 and 20022004 are unaudited. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to present fairly the Company’s financial position as of September 30,December 31, 2003 and DecemberMarch 31, 2002,2004, its results of operations for the three and nine months ended September 30,March 31, 2003 and 20022004 and its cash flows for the ninethree months ended September 30,March 31, 2003 and 2002.2004. These condensed consolidated financial statements and the accompanying notes are unaudited and should be read in conjunction with the Company’s audited financial statements included in the Company’s Annual Report on Form 10-K,10-K/A, filed with the Securities and Exchange Commission on March 31, 2003.April 7, 2004. The balance sheet as of December 31, 20022003 was derived from audited financial statements but does not include all disclosures required by generally accepted accounting principles. The results for the three and nine months ended September 30, 2003March 31, 2004 are not necessarily indicative of the expected results for any other interim period or the year ending December 31, 2003.2004.
Revenue recognition
The Company generates revenue primarily from the sale of hardware products, including third-party products, through professional services, the licensing of its HomeRun technology and through the sale of its software products. The Company sells products through direct sales channels and through distributors. Generally, product revenue is
6
Product revenues
Product revenue is generated primarily from the sale of complete end-to-end video processing systems generally referred to as turnkey solutions. Turnkey solutions are multi-element arrangements, which consist of hardware products, software products, professional services and post-contract support. Sales of turnkey solutions are classified as product revenue in the statement of operations.
Product revenue is also generated from the sale of video processing component products and the sale of broadband transport and service management products. The Company sells these products through its own direct sales channels and also through distributors.
TUT SYSTEMS, INC.The Company’s revenue recognition policies for turnkey solutions are in accordance with SOP 97-2, Software Revenue Recognition, as amended, which is the authoritative guidance for recognizing revenue on software transactions and transactions in which software is more than incidental to the arrangement. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as hardware, software products, maintenance services, installation, training or other elements. Under SOP 97-2, the determination of fair value is based on objective evidence that is specific to the vendor. If such evidence of fair value for any undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered, subject to certain limited exceptions set forth in SOP 97-2, as amended. SOP 97-2 was amended in February 1998 by SOP 98-4, Deferral of the Effective Date of a Provision of SOP 97-2, and was amended again in December 1998 by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions. Those amendments deferred and then clarified, respectively, the specification of what was considered vendor specific objective evidence of fair value for the various elements in a multiple element arrangement.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(In the case of software arrangements which require significant production, modification or customization of software, which encompasses all of the Company’s turnkey arrangements, SOP 97-2 refers to the guidance in thousands, except per share amounts)SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts. The Company recognizes revenue for all turnkey arrangements in accordance with SOP 97-2 and SOP 81-1. Excluding the PCS element, for which the Company has established vendor specific objective evidence of fair value (as defined by SOP 97-2), revenue from turnkey solutions is generally recognized using the percentage-of-completion method, as stipulated by SOP 81-1. The percentage-of-completion method reflects the portion of the anticipated contract revenue that has been earned that is equal to the ratio of labor effort expended to date to the anticipated final labor effort, based on current estimates of total labor effort necessary to complete the project. Revenue from the PCS element of the arrangement is deferred at the point of sale and recognized over the term of the PCS period. Generally, the terms of the turnkey solution sales provide for billing of approximately 90% of the contract value of the arrangement prior to the time of delivery to the customer site, with an additional approximately 9% of the contract value billed upon substantial completion of the project and the balance upon customer acceptance. The contractual arrangements relative to turnkey solutions include customer acceptance provisions. However, such provisions are generally considered to be incidental to the arrangement in its entirety because customers are fully obligated with respect to approximately 99% of the contract value irrespective of whether acceptance occurs or not.
7
TheFor direct sales of video processing systems component products not included as part of turnkey solutions and the direct sale of broadband transport and service management products, the Company recognizes product revenue when persuasive evidence of an arrangement exists, delivery has occurred, or services have been provided, the fee is fixed or determinable, and collection is probable. reasonably assured.
Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period. The Company follows specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, the Company assesses a number of factors, including specific contract and purchase order terms, completion and timing of delivery to the common carrier,common-carrier, past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of the assessment, the Company may recognize revenue when the products are shipped or defer recognition of revenue until evidence of sell-through occurs and cash is received. Revenue from service obligations included in product revenues is deferred and recognized ratably overIn order to recognize revenue, the periodCompany must also make a judgment regarding collectibility of the obligation. arrangement fee. Management’s judgment of collectibility is applied on a customer-by-customer basis pursuant to the Company’s credit review policy. The Company sells to customers for which there is a history of successful collection and to new customers for which no similar history may exist. New customers are subject to a credit review process, which evaluates the customers’ financial position and ability to pay. New customers are typically assigned a credit limit based on a review of their financial position. Such credit limits are increased only after a successful collection history with the customer has been established. If it is determined from the outset of an arrangement that collectibility is not probable based upon the Company’s credit review process, no credit is extended and revenue is recognized on a cash-collected basis.
The Company also maintains accruals and allowances for all cooperative marketing and other programs.programs, as necessary. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized.recognized, as necessary. The Company’s products generally carry a one-yearone year warranty from the date of purchase. TheTo date, warranty accrual was not material at September 30, 2003 or December 31, 2002.costs have been insignificant to the overall financial statements taken as a whole.
Turnkey solution revenuesLicense and Royalty Revenue
Revenue on turnkey video solution sales,License and royalty revenue consists of non-refundable up-front license fees, some of which typically includemay offset initial royalty payments, and royalties received by the design, manufacture, test, integration and installationCompany for products sold by its licensees. Currently, the majority of the Company’s equipment to its customers’ specifications, or equipment acquired from third parties to be integrated with the Company’s products, is generally recognized using the percentage-of-completion method. Under the percentage-of-completion method, revenue recognized reflects the portion of the anticipated contract revenue that has been earned, equal to the ratio of labor costs expended to date, to anticipated total labor costs, based on current estimates of labor costs to complete the project. If the estimated costs to complete a project exceed the total contract amount, indicating a loss, the entire anticipated loss is recognized immediately. Generally, the terms of turnkey video solution sales provide for billing for products at the time of delivery and for services at the time of substantial completion of the project.
Licenselicense and royalty revenues
The Company has entered into non-exclusive technology agreements with various licensees. These agreements give the licensees the right to manufacture, or have manufactured, products which incorporate the Company’s proprietary technology and to receive customer support for specified periods and any changes or improvements to the technology over the term of the agreement.
Contract fees for the services provided under these licensing agreements are generallyrevenue is comprised of non-refundable license fees and non-refundable prepaid royalties that arepaid in advance. Such revenue is recognized when the proprietary technology is delivered if there are no significant vendor obligations. If the licensing agreements contain post-contract customer support, the Company recognizes the contract fees ratably over the period during which the post-contract customer support is expected to be provided. This period representsprovided or upon delivery and transfer of agreed upon technical specifications in contracts where essentially no further support obligations exist. Future license and royalty revenue is expected to consist primarily of royalties received by the estimated life of the technology. The Company begins to recognize revenue under the contract once it has delivered the implementation package that contains all information needed to use the Company’s proprietary technology in the licensee’s process. The remaining obligations are primarily to provide the licensee with any changes or improvements to the technology and technical advice on specifications, testing, debugging and enhancements.for products sold by its licensees.
The Company recognizes royalties upon notification of sale by its licensees. The terms ofShould changes in conditions cause us to determine that the royalty agreements generally require licensees to notify the Company and pay royalties within 60 days of the end of the quarter during which the sales occur.
7
TUT SYSTEMS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(in thousands, except per share amounts)
Software license and post-contract support revenues
Currently, the Company’s software revenue is derived from two separate sources, software license fees and post-contract maintenance and support fees. A software license typically grants a perpetual license to the customer. The Company generally recognizes revenue from sales of the software licenses when all criteria for revenue recognition that are similarly applicable to the Company’s hardware product sales have been met. The revenuenot met for post-contract maintenance and support fees is recognized ratably over the term of the separate support contract.
Revenue recognition- Summary
Revenue recognition in each period is dependent on the application of these accounting policies. If the Company believes that any of the conditions to recognize revenue have not been met, it will defer revenue recognition. For example, if collectibility is not reasonably assured, the Company will defercertain future transactions, revenue recognition until subsequent cash receipt. The Company’s application of percentage-of-completion accounting is subject to its estimates of labor cost to complete each turnkey solution project. In the event that actual results differ from these estimates or the Company adjusts these estimates in future periods, its operating results for a particularany reporting period could be adversely affected. Unearned revenue that has been billed but not collected at the end of the period is recorded as a reduction against the related accounts receivable balance. Unearned revenue recorded as a reduction against the related accounts receivable was $1,718 and $900 at September 30, 2003 and December 31, 2002, respectively.
8
Inventories
Inventories are stated at the lower of cost or market. Cost is computed using standard cost which approximates actual cost on a first-in, first-out basis. The Company records provisions to write down its inventory and related purchase commitments for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about the future demand and market conditions. If actual future demand or market conditions are less favorable than those estimated by the Company, additional inventory provisions may be required.
Allowance for doubtful accounts
The Company maintains an allowance for doubtful accounts for estimated losses resulting from the inability of its customers to make payments. These estimated allowances are periodically reviewed and take into account customers’ payment history and information regarding customers’ creditworthiness that is known to the Company. If the financial condition of any of its customers were to deteriorate, resulting in their inability to make payments, an additional allowance would be required.
Accounting for long-lived assets
The Company periodically assesses the impairment of long-lived assets periodically.assets. An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable.
Factors considered important which could trigger an impairment review include, but are not limited to, significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, significant negative industry or economic trends, a significant decline in the stock price for a sustained period and the Company’s market capitalization of the Company relative to its net book value.
When the Companymanagement determines that the carrying value may not be recoverable based upon the existence of one or more of the above indicators of impairment, it records anany impairment charge. Any such impairmentmeasured is calculated based on a projected discounted cash flow method using a discount rate commensurate with the risk inherent in the Company’s current business model.
8
TUT SYSTEMS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(in thousands, except per share amounts)
During the ninethree months ended September 30, 2003,March 31, 2004, the Company determined that certain of the technology acquired as part of the purchase of the ViaGateViagate Technologies, Inc. assets in September 2001 had become impaired. As a result, the Company recordedincurred a loss of $128$202 to write-off the technology.
Future events could cause the Company to conclude that impairment indicators exist. Any resulting impairment loss could have a material adverse impact on the Company’s financial condition and results of operations.
9
The Company is currently involved in certain legal proceedings as discussed in Note 7. Because of uncertainties related to both the potential amount and range of loss from the pending litigation, management is unable to make a reasonable estimate of the liability that could result if there were an unfavorable outcome in any of these legal proceedings. As additional information becomes available, the Company will re-assess the potential liability related to this pending litigation and revise its estimates accordingly. Revisions of the Company’s estimates of such potential liability could materially impact its results of operations, financial condition or cashflows.
Accounting for stock based compensation
The Company accounts for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25 (“APB No. 25”), “Accounting for Stock Issued to Employees,” Financial Accounting Standard Board Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB 25,” and complies with the disclosure provisions of Statement of Financial Accounting Standard No. 148 (“SFAS No. 148”), “Accounting for Stock-Based Compensation, Transition and Disclosure.” Under APB No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair market value of the Company’s stock and the exercise price. The Company accounts for stock issued to non-employees in accordance with the provisions of SFAS No. 148 and the Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments that are Issued to other than Employees for Acquiring, or in Conjunction with Selling Goods or Services.”
The Company amortizes stock-based compensation using the straight-line method over the remaining vesting periods of the related options, which is generally four years. Pro forma information regarding net loss and earnings per share is presented and has been determined as if the Company had accounted for employee stock options under the fair value method of SFAS No. 123, as amended by SFAS No. 148.
9
TUT SYSTEMS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(in thousands, except per share amounts)
The following table illustrates the effect on net loss and earnings per share if the Company had applied the fair value recognition provisions of SFAS No. 123, as amended by SFAS No. 148, to stock-based employee compensation:
Three Months Ended September 30, | Nine Months Ended September 30, |
| Three Months Ended |
| |||||||||||||||||||
2003 | 2002 | 2003 | 2002 |
| 2003 |
| 2004 |
| |||||||||||||||
Net loss – as reported | $ | (742 | ) | $ | (5,867 | ) | $ | (4,998 | ) | $ | (24,621 | ) |
| $ | (2,231 | ) | $ | (4,450 | ) | ||||
Adjustment: | |||||||||||||||||||||||
Total stock-based employee compensation expense determined under a fair value based method for all grants, net of related tax effects | (816 | ) | (1,063 | ) | (2,853 | ) | (3,596 | ) |
| (1,067 | ) | (812 | ) | ||||||||||
Net loss – pro forma | $ | (1,558 | ) | $ | (6,930 | ) | $ | (7,851 | ) | $ | (28,217 | ) |
| $ | (3,298 | ) | $ | (5,262 | ) | ||||
Basic and diluted net loss per share – as reported | $ | (0.04 | ) | $ | (0.36 | ) | $ | (0.25 | ) | $ | (1.50 | ) |
| $ | (0.11 | ) | $ | (0.22 | ) | ||||
Basic and diluted net loss per share – pro forma | $ | (0.08 | ) | $ | (0.42 | ) | $ | (0.39 | ) | $ | (1.72 | ) |
| $ | (0.17 | ) | $ | (0.26 | ) | ||||
The fair value of options and shares issued pursuant to the option plans and at the grant date were estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. The Company uses projected volatility rates, which are based upon historical volatility rates trended into future years. Because employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the
10
fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of options.
The effects of applying pro forma disclosures of net loss and net loss per share are not likely to be representative of the pro forma effects on net loss/income and net loss/earnings per share in the future years, as the number of future shares to be issued under these plans is not known and the assumptions used to determine the fair value can vary significantly.
Prior to the Company’s initial public offering, the fair value of each stock option was estimated using the minimum value method. Volatility and dividend yields were not factors in the Company’s minimum value calculation. Subsequent to the offering, the fair value of each stock option has been estimated on the date of grant using the Black-Scholes option pricing model. The Company has also estimated the fair value of the purchase rights issued from its employee stock purchase plan using the Black-Scholes option pricing model. The Company first issued purchase rights from the 1998 Employee Stock Purchase Plan in fiscal year 1999.
10
TUT SYSTEMS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(in thousands, except per share amounts)
Recent accounting pronouncements
In AprilJanuary 2003, the Financial Accounting Standards Board, the (“FASB”) issued SFASFASB Interpretation No. 149, “Amendment46 (FIN 46), “Consolidation of Statement 133 on Derivative Instruments and Hedging Activities.Variable Interest Entities, an Interpretation of ARB No. 51, Consolidated Financial Statements,” SFAS No. 149 amends and clarifieswhich was subsequently revised in December 2003 with the issuance of FIN46-R. This interpretation requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial accounting and reportinginterest or do not have sufficient equity at risk for derivative instruments, including certain derivative instruments embeddedthe entity to finance its activities without additional subordinated financial support from other parties. Application of this Interpretation is required in other contracts (collectively referred to as derivatives) andfinancial statements for hedging activities under FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities.” SFAS No. 149 is effective for contracts entered into or modifiedperiods ending after September 30, 2003, and for hedging relationships designated after September 30, 2003.March 15, 2004. The Company believes that the adoption of this standard willInterpretation in the period ended March 31, 2004 did not have a material impact on itsthe Company’s results of operations, financial statements.position or cash flows.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after September 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of SFAS No. 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. The Company believes that the adoption of this standard will not have a material impact on its financial statements.
Reclassifications
Certain reclassifications have been made to prior period balances in order to conform to the current period presentation.
NOTE 3—NET LOSS PER SHARE:
Basic and diluted net loss per share is computed using the weighted average number of common shares outstanding. Options were not included in the computation of diluted net loss per share because the effect would be antidilutive.
11
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(in thousands, except per share amounts)
The calculation of net loss per share follows:
Three Months Ended September 30, | Nine Months Ended September 30, |
| Three Months Ended |
| |||||||||||||||||||
2003 | 2002 | 2003 | 2002 |
| 2003 |
| 2004 |
| |||||||||||||||
Net loss per share, basic and diluted: |
|
|
|
|
| ||||||||||||||||||
Net loss | $ | (742 | ) | $ | (5,867 | ) | $ | (4,998 | ) | $ | (24,621 | ) |
| $ | (2,231 | ) | $ | (4,450 | ) | ||||
Net loss per share, basic and diluted | $ | (0.04 | ) | $ | (0.36 | ) | $ | (0.25 | ) | $ | (1.50 | ) |
| $ | (0.11 | ) | $ | (0.22 | ) | ||||
Shares used in computing net loss per share, basic and diluted | 20,040 | 16,482 | 19,912 | 16,451 |
| 19,801 |
| 20,297 |
| ||||||||||||||
Antidilutive securities not included in net loss per share calculations | 3,132 | 2,811 | 3,132 | 2,811 |
| 4,096 |
| 4,446 |
| ||||||||||||||
NOTE 4—COMPREHENSIVE LOSS:
Comprehensive loss includes net loss, unrealized gains and losses on investments, and foreign currency translation adjustments that have been previously excluded from net loss and reflected instead in stockholders’ equity. The following table sets forth the calculation of comprehensive loss:
Three Months Ended September 30, | Nine Months Ended September 30, |
| Three Months Ended |
| |||||||||||||||||||
2003 | 2002 | 2003 | 2002 |
| 2003 |
| 2004 |
| |||||||||||||||
Net loss | $ | (742 | ) | $ | (5,867 | ) | $ | (4,998 | ) | $ | (24,621 | ) |
| $ | (2,231 | ) | $ | (4,450 | ) | ||||
Unrealized gains (losses) on investments | — | (7 | ) | 12 | (62 | ) | |||||||||||||||||
Unrealized gains on investments |
| 12 |
| 16 |
| ||||||||||||||||||
Foreign currency translation adjustments | (12 | ) | (4 | ) | (24 | ) | (5 | ) |
| (5 | ) | (7 | ) | ||||||||||
Net change in other comprehensive loss | (12 | ) | (11 | ) | (12 | ) | (67 | ) |
| 7 |
| 9 |
| ||||||||||
Total comprehensive loss | $ | (754 | ) | $ | (5,878 | ) | $ | (5,010 | ) | $ | (24,688 | ) |
| $ | (2,224 | ) | $ | (4,441 | ) | ||||
12
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(in thousands, except per share amounts)
NOTE 5—BALANCE SHEET COMPONENTS:
September 30, 2003 | December 31, 2002 |
| December 31, |
| March 31, |
| |||||||||
Inventories, net: |
|
|
|
|
| ||||||||||
Finished goods | $ | 3,601 | $ | 3,667 |
| $ | 4,015 |
| $ | 4,762 |
| ||||
Raw materials | 221 | 221 |
| 391 |
| 100 |
| ||||||||
$ | 3,822 | $ | 3,888 | ||||||||||||
Allowance for excess and obsolete inventory and abandoned product |
| (225 | ) | (890 | ) | ||||||||||
| $ | 4,181 |
| $ | 3,972 |
| |||||||||
Property and equipment: |
|
|
|
|
| ||||||||||
Computers and software | $ | 1,198 | $ | 932 |
| $ | 1,328 |
| $ | 1,527 |
| ||||
Test equipment | 1,960 | 1,501 |
| 2,277 |
| 2,760 |
| ||||||||
Office equipment | 46 | 33 |
| 41 |
| 41 |
| ||||||||
| 3,646 |
| 4,328 |
| |||||||||||
3,204 | 2,466 | ||||||||||||||
Less: accumulated depreciation | (1,625 | ) | (836 | ) |
| (1,924 | ) | (2,250 | ) | ||||||
| $ | 1,722 |
| $ | 2,078 |
| |||||||||
$ | 1,579 | $ | 1,630 | ||||||||||||
Accrued liabilities: |
|
|
|
|
| ||||||||||
Provision for loss on purchase commitments | $ | — | $ | 3,700 | |||||||||||
Professional Services | 228 | 612 |
| 494 |
| 947 |
| ||||||||
Compensation | 799 | 604 |
| 652 |
| 800 |
| ||||||||
Restructuring accrual | 98 | 473 | |||||||||||||
Other | 653 | 535 |
| 370 |
| 350 |
| ||||||||
| $ | 1,516 |
| $ | 2,097 |
| |||||||||
$ | 1,778 | $ | 5,924 | ||||||||||||
As of September 30, 2003 | ||||||||||
Gross Carrying Amount | Accumulated Amortization | Net Intangibles | ||||||||
Amortized intangibles assets: | ||||||||||
Completed technology and patents | $ | 8,124 | $ | (4,623 | ) | $ | 3,501 | |||
Contract backlog | 247 | (194 | ) | 53 | ||||||
Customer lists | 86 | (11 | ) | 75 | ||||||
Maintenance contract renewals | 50 | (9 | ) | 41 | ||||||
Trademarks | 315 | (41 | ) | 274 | ||||||
$ | 8,822 | $ | (4,878 | ) | $ | 3,944 | ||||
Other non-current assets | 155 | |||||||||
$ | 4,099 | |||||||||
The Company recorded a provision for inventory within cost of goods sold totalling $974 in the three months ended March 31, 2004, related to the costs of raw materials and finished goods in excess of what the Company reasonably expected to sell in the foreseeable future as of the first quarter of 2004. The Company also reduced inventory costs to market value.
Intangible and other assets:
|
| As of December 31, 2003 |
| |||||||
|
| Gross |
| Accumulated |
| Net |
| |||
Intangible and other assets: |
|
|
|
|
|
|
| |||
Completed technology and patents |
| $ | 8,125 |
| $ | (5,003 | ) | $ | 3,122 |
|
Contract backlog |
| 247 |
| (247 | ) | — |
| |||
Customer list |
| 86 |
| (14 | ) | 72 |
| |||
Maintenance contract renewals |
| 50 |
| (12 | ) | 38 |
| |||
Trademarks |
| 315 |
| (52 | ) | 263 |
| |||
|
| $ | 8,823 |
| $ | (5,328 | ) | 3,495 |
| |
|
|
|
|
|
|
|
| |||
Other non-current assets |
|
|
|
|
| 190 |
| |||
|
|
|
|
|
| $ | 3,685 |
|
13
TUT SYSTEMS, INC.
|
| As of March 31, 2004 |
| |||||||
|
| Gross |
| Accumulated Amortization |
| Net |
| |||
Amortized intangible assets: |
|
|
|
|
|
|
| |||
Completed technology and patents |
| $ | 7,922 |
| $ | (5,382 | ) | $ | 2,540 |
|
Contract backlog |
| 247 |
| (247 | ) | — |
| |||
Customer list |
| 86 |
| (17 | ) | 69 |
| |||
Maintenance contract renewals |
| 50 |
| (14 | ) | 36 |
| |||
Trademarks |
| 315 |
| (64 | ) | 251 |
| |||
|
| $ | 8,620 |
| $ | (5,724 | ) | 2,896 |
| |
|
|
|
|
|
|
|
| |||
Other non-current assets |
|
|
|
|
| 207 |
| |||
|
|
|
|
|
| $ | 3,103 |
|
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(During the three months ended March 31, 2004, the Company determined that certain of the technology acquired as part of the purchase of the Viagate Technologies, Inc. assets in thousands, except per share amounts)September 2001 had become impaired. As a result, the Company incurred a loss of $202 to write-off the technology.
As of December 31, 2002 | |||||||||
Gross Carrying Amount | Accumulated Amortization | Net Intangibles | |||||||
Amortized intangibles assets: | |||||||||
Completed technology and patents | $ | 8,253 | (3,473 | ) | $ | 4,780 | |||
Contract backlog | 247 | (35 | ) | 212 | |||||
Customer lists | 86 | (2 | ) | 84 | |||||
Maintenance contract renewals | 50 | (2 | ) | 48 | |||||
Trademarks | 315 | (8 | ) | 307 | |||||
$ | 8,951 | (3,520 | ) | 5,431 | |||||
Other non-current assets | 155 | ||||||||
$ | 5,586 | ||||||||
The aggregate amortization expense for the three and nine months ended September 30,March 31, 2003 and 2004 was $442$459 and $1,360, respectively. The aggregate amortization expense for the three and nine months ended September 30, 2002 was $300 and $899,$396, respectively.
Minimum future amortization expense as of September 30, 2003March 31, 2004 is as follows:
Remainder of 2003 | $ | 449 | |
2004 | 1,586 | ||
2005 | 955 | ||
2006 | 485 | ||
2007 | 363 | ||
Thereafter | 106 | ||
$ | 3,944 | ||
NOTE 6—RESTRUCTURING COSTS:
In August 2003, the Company discontinued further development of one of its products. Accordingly, the Company implemented a restructuring program that included a workforce reduction and relocation. As a result of this restructuring program, the Company recorded restructuring costs of $292. The workforce reduction was approximately 11% of the Company’s employees, resulting in severance and fringe benefit expenses of approximately $192 along with relocation costs of $100. As of September 30, 2003, the Company had a remaining accrual of $100. The restructuring will be completed by December 31, 2003.
Remainder of 2004 |
| $ | 1,129 |
|
2005 |
| 875 |
| |
2006 |
| 424 |
| |
2007 |
| 363 |
| |
Thereafter |
| 105 |
| |
|
| $ | 2,896 |
|
14
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(in thousands, except per share amounts)
NOTE 7—6—COMMITMENTS AND CONTINGENCIES:
Lease obligations
The Company leases equipment and office, assembly and warehouse space under noncancelablenon-cancelable operating leases that expire from 20032004 through 2005. In connection with the acquisition of VideoTele.com (“VTC”) in November 2002, the Company assumed an operating lease that expires in July 2005.
In August 2002, the Company entered into an agreement to terminate its lease for engineering facilities in Bridgewater Township, New Jersey for $257, which consisted of forfeiture of a $116 letter of credit and a cash payment of $141. As part of its November 2002 restructuring program, the Company entered into an agreement to terminate its lease for its headquarters facility in Pleasanton, California for $2,409, which consisted of forfeiture of a $1,350 letter of credit and a cash payment of $1,059. The Company also incurred $327 in legal costs and other professional fees related to this lease termination. These amounts were paid as of March 31, 2003. In December 2002, the Company entered into a lease agreement for a facility in Pleasanton, California that expires in December 2003.
Minimum future lease payments under operating leases as of September 30, 2003March 31, 2004 are as follows:
Remainder of 2003 | $ | 275 | |||||
2004 | 806 | ||||||
Remainder of 2004 |
| $ | 694 |
| |||
2005 | 269 |
| 266 |
| |||
Thereafter | — |
| — |
| |||
| $ | 960 |
| ||||
$ | 1,350 | ||||||
Purchase commitments
The Company had noncancellablenon-cancelable commitments to purchase finished goods inventory totaling $416$1,009 and $421$364 in aggregate at September 30,December 31, 2003 and DecemberMarch 31, 2002,2004, respectively.
Contingencies
Beginning July 12, 2001, nine putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of California against the Company and certain of its current and former officers and directors. The complaints were filed on behalf of a purported class of people who purchased the Company’s stock during the period between July 20, 2000 and January 31, 2001, seeking unspecified damages. The complaints allege that the Company and certain of its current and former officers and directors made false and misleading statements about the Company’s business during the putative class period. Specifically, the complaints allege violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints have been consolidated under the name In reWhalen v. Tut Systems, Inc. Securities Litigation, Master File No. C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and lead counsel for plaintiffs have been appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on March 29, 2002. On August 15, 2002, the Court granted in part and denied in part the Motion to Dismiss. On September 23, 2002, plaintiffs filed an amended complaint. Defendants filed a Motion to Dismiss the amended complaint, and on August 6, 2003 the Court granted in part that Motion. On September 24, 2003, Defendants answered the remaining allegations of the amended complaint. Discovery has commenced. Trial is scheduled to begin on March 7, 2005. The Company believes it has meritorious defenses to the allegations in the complaint and intends to defend the case vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Company’s business, results of operations, financial condition and cash flows.et al
15
TUT SYSTEMS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(in thousands, except per share amounts)
On March 19, 2003, Chesky Lefkowitz, a shareholder of the Company, filed a derivative complaint entitled Lefkowitz v. D’Auria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of the Company’s current and former officers and directors. The complaint alleges causes of action for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment and improper insider stock trading, based on the same factual allegations contained in the Securities Litigation Action. The complaint seeks unspecified damages against the individual defendants on behalf of the Company, equitable relief, and attorneys’ fees. On May 21, 2003, the Company and the individual defendants filed separate demurrers to the complaint. The demurrers have not yet been heard by the Court, and no trial date has been established.
On October 30, 2001, the Company and certain of its current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et al., Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District Court for the Southern District of New York. An amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts that the prospectuses from the Company’s January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against the Company and certain of its current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, (the “1933 Act”) and under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, and alleges claims against certain of its current and former officers and directors under Sections 15 and 20(a) of the 1933Securities Act. The complaintscomplaint also namenames as defendants the underwriters for the Company’s initial public offering and secondary offering. Similar suits were filed in the Southern District of New York challenging over 300 other initial public offerings and secondary offerings conducted in 1999 and 2000. Therefore, for pretrial purposes, the Whalen action is being coordinated with the approximately 300 other suits before United States District Court Judge Shira Scheindlin of the Southern District of New York under the matter In Re Initial Public Offering Securities Litigation. The individual defendants in the Whalen action, namely, Nelson Caldwell, Salvatore D’Auria and Matthew Taylor, were dismissed without prejudice by an October 9, 2002 Order of the Court, has deniedapproving the parties’ October 1, 2002 Stipulation of Dismissal. On February 19, 2003, the Court issued an Opinion and Order denying the Company’s motion to dismiss. The Company’s Board recently
In June and July 2003, nearly all of the issuers named as defendants in the In Re Initial Public Offering Securities Litigation (collectively, the “issuer-defendants”), including the Company, approved a tentative settlement proposal fromthat is reflected in a memorandum of understanding. The Company’s Board of Directors approved the plaintiffs.memorandum of understanding in June 2003 on certain conditions, including the number of issuers participating in the settlement. The memorandum of understanding is not a legally
15
binding agreement. Further, any final settlement isagreement would be subject to a number of conditions, most of which would be outside of the Company’s control, including approval by the Court. The underwriter-defendants in the In Re Initial Public Offering Securities Litigation (collectively, the “underwriter-defendants”), including the underwriters in the Whalen suit, are not parties to the memorandum of understanding.
The memorandum of understanding provides that, in exchange for a release of claims against the settling issuer-defendants, the insurers of all of the settling issuer-defendants will provide a surety undertaking to guarantee plaintiffs a $1 billion recovery from the non-settling defendants, including the underwriter-defendants. The ultimate amount, if any, that may be paid on behalf of the Company will therefore depend on the final terms of the settlement agreement, including the number of issuer-defendants that ultimately approve the final settlement agreement, and the amounts, if any, recovered by the plaintiffs from the underwriter-defendants and other non-settling defendants. In the event that all or substantially all of the issuer-defendants approve the final settlement agreement, the amount that the Company would be required to pay to the plaintiffs could range from zero to approximately $3.5 million, depending on plaintiffs’ recovery from the underwriter-defendants and from other non-settling parties. If the plaintiffs recover at least $1 billion from the underwriter-defendants, the Company would have no liability for settlement payments under the proposed terms of the settlement. If the plaintiffs recover less than $1 billion, the Company believes that its insurance will likely cover some or all of its share of any payments towards satisfying plaintiffs’ $1 billion recovery deficit. Management estimates that its range of loss relative to this matter is zero to $3.5 million. Presently there is no more likely point estimate of loss within this range. As a consequence of the uncertainties described above regarding the amount the Company will ultimately be required to pay, if any, as of March 31, 2004, the Company has not accrued a liability for this matter.
In re Tut Systems, Inc. Securities Litigation, Civil Action No. C-01-2659-JCS (the “Securities Litigation Action”).
Beginning July 12, 2001, nine putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of California against the Company and certain of its current and former officers and directors. The complaints were filed on behalf of a purported class of investors who purchased the Company’s stock during the period between July 20, 2000 and January 31, 2001, seeking unspecified damages. The complaints allege that the Company and certain of its current and former officers and directors made false and misleading statements about the Company’s business during the putative class period. Specifically, the complaints allege violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints were consolidated under the name In re Tut Systems, Inc. Securities Litigation, Master File No. C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and lead counsel for plaintiffs were appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on March 29, 2002. On August 15, 2002, the Court granted in part and denied in part the Motion to Dismiss. On September 23, 2002, plaintiffs filed an amended complaint. Defendants filed a Motion to Dismiss the amended complaint, and on August 6, 2003 the Court granted in part that Motion. On September 24, 2003, defendants answered the remaining allegations of the amended complaint. Defendants reached a settlement of the Securities Litigation Action in December 2003. Subject to preliminary and final approval by the Court, the Company’s insurance carriers agreed to pay $10 million, on behalf of the Company, to settle the suit. The settlement includes a release of all defendants. The Company has recorded a liability in its financial statements for the proposed amount of the settlement. In addition, because the insurance carriers agreed to pay the entire $10 million settlement amount and, therefore, recovery from the insurance carriers was probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amounts of the settlement and the insurance recovery fully offset each other. The insurance carriers paid the settlement amount to plaintiffs’ escrow agent in January 2004. The Court preliminarily approved the settlement on February 24, 2004. The settlement amount will be paid out of escrow if and when the Court finally approves the settlement. A hearing before the Court to consider final approval of the Court. Ifterms of
16
settlement is currently scheduled for May 14, 2004. Because the settlement does not occur,is subject to Court approval, there is no guarantee the settlement will become final.
Lefkowitz v. D’Auria, et al
On March 19, 2003, Chesky Lefkowitz, a stockholder of the Company, filed a derivative complaint entitled Lefkowitz v. D’Auria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of the Company’s current and former officers and directors. The complaint alleges causes of action for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment, and improper insider stock trading based on the same factual allegations contained in the Securities Litigation Action. The complaint seeks unspecified damages against the individual defendants on behalf of the Company, equitable relief, and attorneys’ fees. On May 21, 2003, the Company and the litigation againstindividual defendants filed separate demurrers to the complaint. The Company and the individual defendants reached a settlement of the derivative action in December 2003. The settlement involves the Company’s adoption of certain corporate governance measures and payment of attorneys’ fees and expenses to the derivative plaintiff’s counsel in the amount of $722,000 and an incentive award to the derivative plaintiff in the amount of $3,000. The Company has recorded a liability in its financial statements for the proposed amount of the settlement. In addition, because the insurance carrier involved in this suit agreed to pay the entire $725,000 settlement amount and, therefore, recovery from the insurance carrier was probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amounts of the settlement and the insurance recovery fully offset each other. The settlement was approved by the Court on January 12, 2004, and, shortly thereafter, the insurance carrier paid the settlement amount to the derivative plaintiff’s counsel. Therefore, in the first quarter of 2004, the $725,000 was removed from the insurance settlement receivable and the legal settlement liability. The settlement includes a release of the Company continues,and the Company believes it has meritorious defenses to the allegations in the complaint and intends to defend the case vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Company’s business, results of operations, financial condition and cash flows.individual defendants.
The Company is subject to other legal proceedings, claims and litigation arising in the ordinary course of business. The Company’s management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company’s consolidated financial position, results of operations, or cash flows.
16
TUT SYSTEMS, INC.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)
(in thousands, except per share amounts)
NOTE 8—7—SEGMENT INFORMATION:
The Company currently targets its sales and marketing efforts to both public and private service providers and users across two related markets. Management evaluates the financial performance of theThe Company ascurrently operates in a single business segment.segment as there is only one measurement of profitability for its operations. Revenues are attributed to the following countries based on the location of customers:
Three Months September 30, | Nine Months Ended September 30, | |||||||||||
2003 | 2002 | 2003 | 2002 | |||||||||
United States | $ | 6,999 | $ | 1,283 | $ | 18,839 | $ | 3,614 | ||||
International: | ||||||||||||
Canada | 911 | 1,619 | 160 | |||||||||
Ireland | 3 | 545 | 210 | |||||||||
China | 182 | 512 | ||||||||||
Mexico | 49 | 379 | 404 | |||||||||
Japan | 136 | 357 | 372 | 1,269 | ||||||||
Great Britain | 126 | 267 | 323 | 748 | ||||||||
All other countries | 119 | 125 | 399 | 502 | ||||||||
$ | 8,522 | $ | 2,035 | $ | 22,988 | $ | 6,907 | |||||
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|
| Three Months Ended |
| ||||
|
| 2003 |
| 2004 |
| ||
United States |
| $ | 5,731 |
| $ | 5,488 |
|
International: |
|
|
|
|
| ||
Canada |
| 120 |
| 299 |
| ||
Ireland |
| 253 |
| 145 |
| ||
Japan |
| 164 |
| 123 |
| ||
All other countries |
| 333 |
| 122 |
| ||
|
| $ | 6,601 |
| $ | 6,177 |
|
It is impracticable for theTwo customers, Atlantic Telephone Membership Corporation and Home Telephone Company to compute product revenues by product type for the three and nine months ended September 30, 2003 and 2002.
No individual customer accounted for greater than 10% of the Company’s revenue for the nine months ended September 30, 2003. One customer, Oxford Networks, accounted for 15% of the Company’s revenue for the three months ended September 30, 2003. Three customers, Ingram Micro, BTN Internetworking12% and Kanematsu Computer System Ltd., accounted for 19%, 13% and 12%11%, respectively of the Company’s revenue for the three months ended September 30, 2002. Two customers, Ingram Micro and BTN Internetworking,March 31, 2003. One customer, Pioneer Long Distance Inc., accounted for 12% and 10%, respectively, of the Company’s revenue for the ninethree months ended September 30, 2002.March 31, 2004.
NOTE 9—PRO FORMA INFORMATION:Products
The Company designs, develops, and sells video processing systems and broadband transport and service management products. Video processing systems include both digital TV headend systems and video systems. The digital TV headend system enables telephony-based service providers to transport broadcast quality digital video signals across their networks and our digital video transmission systems optimize the delivery of video signals across enterprise, government and education networks. The broadband transport and service management products enable the transmission of broadband data over existing hotels and private campus networks.
In accordance with SFAS No. 141,Revenue relating to the following unaudited pro forma information is provided. The total revenues includebroadband transport and service management products was $1,658 and $1,936 for the consolidated revenues ofthree months ended March 31, 2003 and 2004, respectively. Revenue related to video processing systems was $4,943 and $4,241 for the Company as reportedthree months ended March 31, 2003 and the net revenues of VTC as if it had been acquired as of January 1, 2002. The pro forma net loss and net loss per share have been adjusted to include the additional costs of amortization of intangibles and depreciation based on the actual purchase price of VTC. The unaudited pro forma information is not necessarily indicative of what actual results would have been had the acquisition been completed by the Company at the beginning of the period.2004, respectively.
Three Months Ended September 30, 2002 | Nine Months Ended September 30, 2002 | |||||||||||||||
Actual | Pro Forma | Actual | Pro Forma | |||||||||||||
Net Revenue | $ | 2,035 | $ | 6,933 | $ | 6,907 | $ | 19,447 | ||||||||
Net Loss | $ | (5,867 | ) | $ | (5,242 | ) | $ | (24,621 | ) | $ | (26,502 | ) | ||||
Net loss per share, basic and diluted | $ | (0.36 | ) | $ | (0.27 | ) | $ | (1.50 | ) | $ | (1.34 | ) | ||||
Shares used in computing net loss per share, basic and diluted | 16,482 | 19,766 | 16,451 | 19,735 |
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ITEM 2. 2.MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” set forth below contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements include, but are not limited to, statements about (1) our expectation that our U.S. sales will continue to represent most of our aggregate sales for the remainder of 2003 and that international sales will continue to represent a significant portion of our revenue, (2) our expectation that our foreign sales will continue to be denominated primarily in U.S. dollars, (3) our expectation that we will continue to make significant expenditures on research and development activities as a percentage of overall operating expenses, (4) our expectation that our research and development activities will represent a significant percentage of our overall operating expenses during the remainder of 2003, (5) our expectation that the amount of cash used to fund operations will decrease, (6) our anticipation that our working capital expenditures on a period-to-period basis will decrease, (7) our expectation that our cash and cash equivalents will be sufficient to fund our operating activities and capital expenditure requirements for the next 12 months, (8) our expectation that we will continue to evaluate product line expansion and new product opportunities, engage in research, development and engineering activities and focus on cost-effective design of our products, (9) our expectation that we will seek additional funding for operations from alternative debt and equity sources, if necessary, to maintain reasonable operation levels, (10) our expectation that we will continue to incur losses for the remainder of fiscal year 2003, (11) our anticipation that the average selling prices for our products will continue to decrease in the near future due to increased competitive price pressures in certain geographical regions, (12) our expectation that we will make acquisitions of, or significant investments in, other companies, products or technologies, (13) our expectation that competitors will continue to market and sell inexpensive competitive products in the marketplace, (14) our anticipation that, in the future, expansion in certain areas of our business may be required to expand our customer base and exploit market opportunities, (15) our expectation that demand for our products that are based on copper telephone wires will decline, (16) our intention to introduce new products and product enhancements and (17) our revenue sources, our cash flow and cash position, our expense trends, products and standards development, and our plans, objectives, expectations and intentions and other statements contained herein that are not historical facts. When used herein, the words “anticipates,” “believes,” “continue,” “could,” “estimates,” “expects,” “intends,” “may,” “plans,” “seeks,” “should,” “will” or the negative of these terms or similar expressions are generally intended to identify forward-looking statements. BecauseWe have based these forward-looking statements involveon our current expectations and projections about future events. Such forward-looking statements are subject to various risks and uncertainties there are important factors that could cause actual results to differ materially from those expressed or implied by these forward-lookingprojected in such statements. These factors are discussed under the caption “Additional Risk Factors that Could Affect our Operating Results and the Market Price of Our Stock.” Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof. TheseThe forward-looking statements reflect current viewscontained in this quarterly report include statements about the following: (1) our belief that video products will provide most of our growth opportunities for the foreseeable future, (2) our belief that the number of telco video subscribers will grow significantly between 2004 and 2007 and that this market space will continue to become more competitive, (3) our expectation that we will compete with larger public companies as we begin to target larger telco customers, (4) our expectation that digital subscriber line or DSL technology will continue to dominate telco broadband networks for the foreseeable future, (5) our belief that new controls and procedures have addressed the conditions identified by our auditors as material weaknesses, (6) our expectation that sales related to VTC products will continue to increase in 2004 and sales relating to our broadband transport and service management products will also increase in 2004, but at a lower rate of increase, (7) our expectation that capital expenditures for research and development will decrease in 2004, (8) our expectation that capital expenditures in 2004 will be comparable to 2003 and that these capital expenditures will be funded from operations, (9) our belief that our cash and cash equivalents as of March 31, 2004 are sufficient to fund our operating activities and capital expenditure needs for the next twelve months, (10) our expectation that working capital will begin to increase in future periods, (11) our expectation that the amount of cash used to fund our operations will decrease in 2004, (12) our expectation that we will seek additional equity funding in the second quarter of 2004, (13) our expectation that future license and royalty revenue will consist primarily of royalties received by us for products sold by our licensees and that such license and royalty revenue will not constitute a substantial portion of our revenue in future periods, (14) our expectation that we will incur losses in the near future, (15) our expectation that some competitors will market some of their products for use in TV over DSL applications, (16) our anticipation that our sales and operating margins will continue to fluctuate, (17) our anticipation that we will generally continue to invoice foreign sales in U.S. dollars, (18) our intention to continue to evaluate new acquisition candidates, divesture and diversification strategies, and (19) our expectation that customers outside of the United States will represent a significant and growing portion of our revenue.
The cautionary statements contained under the caption“Additional Risk Factors that Could Affect Our Operating Results and the Market Price of Our Stock” and other similar statements contained elsewhere in this report, identify important factors with respect to future eventssuch forward-looking statements, including certain risks and are subject to these and other risks, uncertainties and assumptions. As a result,that could cause our actual results, may differ materially from theperformance or achievements expressed or implied by such forward-looking statements contained herein. All subsequent written and oral forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by this paragraph.statements.
Although we believe that the expectations reflected in such forward-looking statements are based upon reasonable assumptions, no assurance can be given that such expectations will be attained or that any deviations will not be material. We disclaim any obligation or undertaking to disseminate any updates or revision to any forward-looking statement contained herein or reflect any change in our expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.
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Overview
Our Business
We design, develop, market and sell digital video processing systems that enable telephony-based service providers to deliver broadcast quality digital video signals across their networks. We refer to these systems as digital TV headends or video content processing systems. We also offer digital video processing systems optimizedthat enable private enterprise and government entities to transport video signals across satellite, fiber, radio, or copper facilities for surveillance, distance learning, and TV production applications.
We also offer broadband transport and service management products that enable the provisioning of public broadcast digital TV services across telephone companyhigh speed Internet access and cable company facilities, digital video trunking systems for applications across TV broadcast, government and education facilities, andother broadband data transmission systems for applicationservices over existing copper networks within hotels and private campus or building facilities.
Historically,Our History
Prior to November 2002, most of our sales were derived from our broadband data transmission systems. transport and service management products. In 2000 and 2001, we acquired three companies (FreeGate Corporation, Xstreamis Limited and ActiveTelco, Inc.) and the assets from two other companies (OneWorld Systems, Inc. and ViaGate Technologies, Inc.) in order to expand our sales of broadband transport and service management products. However, the significant downturn in the world economy in general, and the telecommunications market in particular, beginning in late 2000 had a severe and sustained adverse effect on our business, financial condition and results of operations. Our sales of broadband transport and service management products decreased substantially beginning in 2001, which required us to take a number of restructuring efforts and incur significant impairment and other charges in order to realign our cost structure in light of the economic environment. For the period January 1, 2001 through December 31, 2002, we incurred an aggregate of $32.6 million in intangible asset impairment charges and $11.5 million in restructuring charges. In 2003, sales from our broadband transport and service management products stabilized, as we began to experience an improvement in sales of broadband transport and service management products to the hospitality industry.
With our November 2002 acquisition of Video Tele.com (“VTC”), formerly aTektronix’s subsidiary of Tektronix, Inc. (“Tektronix”),VTC, we extended our product offerings to includeadd video content processing systems for digital TV headends and for the transmission of video trunking systems.signals over private and government networks. The acquisition of VTC resulted in a significant changechanges in the structure, organization and priorities of the Company,our business, including: (1) changes in our organizational structure and employee staffing; (2) establishmentrelocation of our administrative offices, executive offices (as of January 2004) and a significant portion of our operations infrom Pleasanton, California to Lake Oswego, Oregon, the prior headquarters location of VTC;
18
(3) an expansion of our sales and marketing efforts to include VTC products; and (4) a reprioritization of our research and development budgetefforts to include the research and development offocus on products that we acquired by us in our acquisition of VTC. With our acquisition of VTC, sales of video processing systems now represent a majority of our total revenues and will provide most of our growth opportunities for the foreseeable future.
SalesWe earn revenue primarily by selling video content processing systems both directly and through resellers to customers outsidetelecommunications service providers. We also earn revenue by selling video transmission systems to TV broadcasters, government agencies and educational institutions, and by selling broadband transport and service management products directly and through distributors to the hospitality industry and to owners of the United States accounted for approximately 18.0%private multi-tenant campus facilities.
Prior to our acquisition of VTC, international sales represented 56.3% and 47.7%43.0% of revenue for the nine months ended September 30, 2003our total sales in 2001 and 2002, respectively. With the inclusion of the products associated with theSince our acquisition of VTC, the geographic distributioninternational sales have represented a smaller percentage of our overall business relative to prior years, though international sales has shifted significantly towardsare still a material portion of our total sales. In 2003, international sales represented 18.4% of our total sales and for the United States.three months ended March 31, 2004, international sales represented 11.2% of our total sales.
Material Trends and Uncertainties
We pay close attention to and monitor various trends and uncertainties emerging in the markets we serve. There is a growing demand by independent operating telephone companies to offer video services to
20
their customer base. According to a report released by InStat/MDR in April 2003, the number of telco video subscribers worldwide will increase from 572,000 at the end of 2003 to over 19.0 million by the end of 2007. While this growing market presents opportunities to serve a larger customer base, we are also seeing the emergence of intense competition as more companies compete to sell digital TV headend products. We expect this trendmarket space will continue to become more competitive in the future. As we begin to target larger telco customers, we expect to compete with larger public companies, including Harmonic, Motorola and Tandberg Television. Our immediate competitors in the digital TV headend markets are primarily small private companies that are focused on a more narrow product line than ours and thereby may be able to devote substantially more targeted resources to developing, marketing and selling new products than we are able to. In addition, these companies may become targets for acquisition by larger companies, in which case we would face competitors with substantially greater name recognition, and technical, financial and marketing resources than we have.
The emergence of new technologies to serve the digital TV headend market means that we must continue to invest in these new technologies to maintain our market position. Digital subscriber line (“DSL”) technologies use sophisticated modulation schemes to pack data onto copper wires. DSL technologies are sometimes referred to as “last mile” technologies because they are used only for connections from a telephone switching station to a home or office, not between switching stations. The limitations on the amount of data that can be transmitted in a fixed amount of time (“bandwidth”) and distance limitations of the copper based last mile constrain both the number of video channels that may be delivered simultaneously over a DSL network and the number of customers that are reachable from a telco central office. Emerging advancements in video compression technology will soon enable high quality video streams to be transported at lower data transfer rates or “bit rates” than currently deployed. These emerging compression advancements also introduce the possibility of delivering high-definition television over bandwidth constrained asymmetric DSL, or ADSL, lines for the first time. ADSL is a new technology that allows more data to be sent over existing copper telephone lines. Additionally, there are DSL advancements emerging that expand the available bandwidth from the telco to the subscriber thereby supporting higher DSL bit rates over longer distances. As our products continue to incorporate these new technological advancements we expect demand for our products will increase since they will enable more telcos to reach a higher percentage of their customers with a larger number of video channels.
While DSL technologies will continue to dominate telco broadband networks for the foreseeable future, telephone companies are beginning to construct fiber optic networks to their customers’ homes. Though fiber-to-the-home will eliminate bandwidth limitations on delivering higher speed data services and high-quality video offerings, telephone companies deploying fiber-to-the-home will require advanced video processing systems, such as our Astria Product line, to convert signals between multiple protocols used in their networks.
The digital media industry continues to be intensely competitive. We are continuing to focus on developing technologies and introducing new products and we expect that our research and development expenses will increase throughout the remainder of 2003. However, actual results, both geographically2004. We continue to aggressively market our new and in absolute dollars, may vary from quarterexisting products and to quarter depending on the timing of orders placed byexpand our customers. To date, all international salesmarketing efforts domestically and internationally. Nevertheless, our operations have been primarily denominated in U.S. dollars.
We expect tosubject, and will continue to evaluate product line expansionbe subject, to pressure from weakness in the overall technology sector as well as the digital media industry. During the first quarter of 2004 our sales cycle generally increased and new product opportunities, engagecustomers delayed purchasing decisions. The deferral of customer orders reduced our revenue in research, developmentthe first quarter of 2004. We believe this lengthening of the decision making process is the result of an increasing variety of other products that interface with our systems. We have been operating at a loss since inception and, engineering activities and focusbased on cost-effective design of our products. Accordingly,expected revenues, we anticipate that we will continue to make significant expendituresoperate at loss during the remainder of 2004. As we announced on researchApril 26, 2004, we expect revenues during the second quarter of 2004 to increase by 5% and development activities as a percentageour gross margin to increase to approximately 40%. However, the deferral of overall operating expenses.customer orders we experienced during the first quarter may continue, which may result in reduced revenues in the future.
In February 2000, we acquired FreeGate Corporation (“FreeGate”) for approximately $25.5 million, consistingInternal Controls and Disclosure Controls and Procedures
Our Chief Executive Officer and Chief Financial Officer carried out an evaluation of 510,931 sharesthe effectiveness of our common stock, 19,707 optionsdisclosure controls and procedures (as defined in Rule 13a-15(e) under the Exchange Act) as of March 31, 2004. This evaluation included various steps that our Chief Executive Officer and Chief Financial Officer undertook in an effort to acquire sharesensure that information required to be disclosed in our SEC reports is recorded, processed, summarized and reported within the time periods specified by the SEC and accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosure. This evaluation also included consideration of our common stock,internal controls and acquisition related expenses consisting primarilyprocedures for the preparation of investment advisory, legalour financial statements. There are inherent limitations to the effectiveness of any system of disclosure controls and other professionalprocedures, including the possibility of human error and the circumvention of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Notwithstanding these limitations, as of the end of the period covered by this report, based upon the evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures are effective.
During the three months ended March 31, 2004, we implemented the following measures:
• Perform quarterly physical inventory counts at all locations;
• Established improved inventory systems and accounting controls, hired additional qualified personnel, improved intra-company communications, implemented appropriate organizational and line of reporting changes; and
• Established improved procedures for the timely reconciliation and confirmation of accounts payable balances.
21
We implemented these measures because in connection with the completion of PricewaterhouseCoopers LLP’s audit of our financial statements for the year ended December 31, 2003, PricewaterhouseCoopers LLP advised management and the audit committee of the Board of Directors that it had identified deficiencies in our internal controls and processes relating to inventory management and reporting that it considered to be material weaknesses, as defined by Statement on Auditing Standards No. 60, “Communication of Internal Control Related Matters Noted in an Audit.” PricewaterhouseCoopers LLP identified the following two material weaknesses in our internal controls and processes:
1. Our internal controls were inadequate to properly record our inventory quantities in an accurate and timely manner; and
2. Our accounts payable process failed to adequately reconcile our accounts payable records with suppliers’ records, considering what the suppliers had shipped to us prior to period end.
Management believes its new controls and procedures have addressed the conditions identified by PricewaterhouseCoopers LLP as material weaknesses. We plan to continue to monitor the effectiveness of our internal controls and procedures on an ongoing basis and will take further action as appropriate.
Definitions for Discussion of Results of Operations
Our discussion of our results of operations focuses on the following items from our income statement: Total revenues consists of product sales, and license and royalty fees. Product revenue consists of sales of our video processing systems, which includes both digital TV headend and video transmission systems. Product revenue also consists of revenue from our broadband transport and service management products. License and royalty fees consist of non-refundable license fees and other assumed liabilities. This transaction was treated as a purchaseroyalties received by us for accounting purposes. FreeGate was located in Sunnyvale, California. FreeGate designed, developed and marketed Internet server appliances combining the functions of IP routing, firewall security, network address translation, secure remote access via VPN networking, and email and web servers on a compact, PC-based platform.
In April 2000, we acquired certain assets of OneWorld Systems, Inc. for approximately $2.4 million in cash. This transaction was treated as a purchase for accounting purposes. The acquired assets consisted of $1.0 million for acquired workforce, $1.1 million for goodwill and $0.3 million for property and equipment.
In May 2000, we acquired Xstreamis Limited (“Xstreamis”), formerly Xstreamis, PLC, for $19.6 million, consisting of 439,137 shares ofproducts sold by our common stock, 10,863 options to acquire shares of our common stock, $0.1 million in cash and $0.6 million in acquisition related expenses consisting primarily of legal and other professional fees. This transaction was treated as a purchase for accounting purposes. Xstreamis was located in the United Kingdom. Xstreamis provided policy-driven traffic management for high-performance, multimedia networking solutions including routing, switching and bridging functions.
In January 2001, we acquired ActiveTelco, Inc. (“ActiveTelco”) for approximately $4.9 million, consisting of 321,343 shares of our common stock, 18,657 options to acquire shares of our common stock, acquisition related expenses consisting primarily of legal and other professional fees, assumed ActiveTelco convertible notes in the amount of $0.7 million plus accrued interest and other assumed liabilities of approximately $1.1 million. This transaction was treated as a purchase for accounting purposes. ActiveTelco was located in Fremont, California. ActiveTelco provided an Internet telephony platform that enabled Internet and telecommunications service providers to integrate and deliver Web-based telephony applications such as unified messaging, long-distance service, voicemail and fax delivery, call forwarding, call conferencing and callback services.
In September 2001, we acquired certain assets, including some intellectual property rights, from ViaGate Technologies, Inc. (“ViaGate”) for approximately $0.6 million in cash. This transaction was treated as a purchase of assets for accounting purposes. The acquired patents and technology of ViaGate provide a highly scalable, carrier-class, full service gateway built on standards-based asynchronous transfer mode, or ATM, IP and VDSL technology.
In November 2002, we acquired VTC from Tektronix for approximately $7.2 million, consisting of 3.3 million shares of our common stock valued at $3.6 million, acquisition related expenses consisting primarily of legal and other professional fees of $0.3 million, and a note payable to Tektronix in the amount of $3.3 million. This transaction was treated as a purchase for accounting purposes. VTC was located in Lake Oswego, Oregon. VTC offers digital head-end solutions enabling home entertainment delivery via the broadband Internet.
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In connection withlicensees. Since our acquisition of VTC, a large part of our quarterly revenue has been associated with the sale of digital TV headends. Furthermore, each individual headend sale has represented a significant portion of our revenue for each quarter. If we registered on a Form S-3 pursuantwere to Rule 415(a)(1)(i) undersell even one less system than our forecasted number of headend sales per quarter, our quarterly revenue would be materially impacted. As we have not entered into any new license or royalty agreements since 2000, we expect that our license and royalty revenue will decrease in the Securities Actforeseeable future. Cost of 1933, as amended, on a continuousgoods sold, or delayed offeringCOGS, consists of costs related to raw materials, contract manufacturing, personnel, overhead, test and quality assurance for products, and the 3.3 million sharescost of common stock issuedlicensed technology included in our products. Raw materials, contract manufacturing and licensed technology are the principal elements of COGS and vary directly with product sales. Sales and marketing expense consists primarily of selling and marketing personnel costs, including sales commissions, travel, trade shows, promotions and outside services. Research and development expense consists primarily of personnel and facilities costs, contract consultants, outside testing services, and equipment and supplies associated with enhancing existing products and developing new products. General and administrative expense consists primarily of personnel costs for administrative officers and support personnel, professional services and insurance expenses. Amortization of intangible assets consists primarily of expenses associated with the amortization of technology and patents related to Tektronix, in order that Tektronix may sell such shares on or after December 1, 2003.prior years’ acquisitions.
As of September 30, 2003, our net intangible assets remaining to be amortized were $3.9 million, related to the acquisitions of the ViaGate assets, Xstreamis and VTC.
Results of Operations
The following table sets forth items from our statements of operations as a percentage of total revenues for the periods indicated:
Three Months Ended September 30, | Nine Months Ended September 30, |
| Three months ended |
| |||||||||||||
2003 | 2002 | 2003 | 2002 |
| 2003 |
| 2004 |
| |||||||||
Total revenues | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |
| 100.0 | % | 100.0 | % | ||||
Total cost of goods sold | 44.0 | 61.4 | 48.0 | 135.2 | |||||||||||||
Gross margin (loss) | 56.0 | 38.6 | 52.0 | (35.2 | ) | ||||||||||||
Cost of goods sold |
| 49.4 |
| 83.0 |
| ||||||||||||
Gross profit (loss) |
| 50.6 |
| 17.0 |
| ||||||||||||
Operating expenses: |
|
|
|
|
| ||||||||||||
Sales and marketing | 21.7 | 89.9 | 24.8 | 95.7 |
| 29.2 |
| 30.8 |
| ||||||||
Research and development | 22.2 | 155.9 | 27.0 | 144.2 |
| 31.6 |
| 29.5 |
| ||||||||
General and administrative | 11.9 | 31.5 | 14.5 | 55.7 |
| 18.2 |
| 18.1 |
| ||||||||
Restructuring Costs | 3.4 | 42.8 | 1.3 | 12.6 | |||||||||||||
Impairment of intangible assets | — | — | 0.6 | — |
| — |
| 3.3 |
| ||||||||
Amortization of intangible assets | 5.2 | 14.7 | 5.9 | 13.0 |
| 7.0 |
| 6.4 |
| ||||||||
Total operating expenses | 64.4 | 334.8 | 74.1 | 321.2 |
| 86.0 |
| 88.1 |
| ||||||||
Loss from operations | (8.4 | ) | (296.2 | ) | (22.0 | ) | (356.4 | ) |
| (35.3 | ) | (71.1 | ) | ||||
Impairment of certain equity investments | — | — | — | (8.6 | ) | ||||||||||||
Interest and other (expense) income, net | (0.3 | ) | 7.9 | 0.3 | 8.5 | ||||||||||||
Interest and other income, net |
| 1.5 |
| (0.9 | ) | ||||||||||||
Net loss | (8.7 | )% | (288.3 | )% | (21.7 | )% | (356.5 | )% |
| (33.8 | )% | (72.0 | )% | ||||
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Three and Nine Months Ended September 30,March 31, 2003 and 20022004
Revenue.Total Revenues. SinceFor the three months ended March 31, 2004, our acquisition of VTC in November 2002, we generatetotal revenues primarilydecreased by 6.4% to $6.2 million from turnkey video solutions, which are comprised of digital head-end and video trunking equipment. We also generate revenue from the sale of hardware products, which includes both our proprietary products and third-party products, and professional services through the licensing of our HomeRun technology. Our total product revenue increased to $8.3 million and $22.4$6.6 million for the three and nine months ended September 30, 2003, respectively, when comparedMarch 31, 2003. During this same period, our product revenue decreased by 3.8% to total product revenues of $1.8$6.2 million and $6.3from $6.4 million for the same periods in 2002. The increase of $6.4 million or 350.2% and $16.1 million or 254.4 % for the three and
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nine months ended September 30, 2003, respectively, compared with the same periodsMarch 31, 2003. This $0.2 million decrease in the prior year isproduct revenue was due primarily to the additional revenue resultingadverse effect of several digital TV headend sales not closing in the quarter as expected. While the market for digital TV headend sales continues to expand, we are seeing an increase in a variety of factors that is causing many prospective customers to delay their purchase decision. Sales of broadband transport and service management products increased from our sales$1.7 million in the first quarter of products acquired2003 to $1.9 million in our acquisitionthe first quarter of VTC.2004. For the ninethree months ended September 30, 2003, the increase in product revenue attributable to products acquired with the VTC acquisition offset declines in sales ofMarch 31, 2004, our other products.
Licenselicense and royalty revenue wasdecreased to $18 thousand from $0.2 million and $0.6 million for the three and nine months ended September 30, 2003, respectively, and was unchanged from license and royalty revenue for the same periods in 2002. We did not enter into any new license or royalty agreements during the first nine months of 2003 or 2002.March 31, 2003.
Cost of Goods Sold/Gross Margin.Sold. Cost of goods sold consists primarily of costs related to raw materials, contract manufacturing, personnel, overhead, test and quality assurance, andFor the cost of licensed technology included inthree months ended March 31, 2004, our products. Costcost of goods sold increased by $2.5$1.8 million to $3.8$5.1 million duringfrom $3.3 million for the three months ended September 30, 2003, from $1.2 million during the same period in 2002. Cost of goods sold during the third quarter of 2003 included a reduction of reserves for excess and obsolete inventories of $0.8 million due to sales of products for which we had set aside reserves. Excluding the effect from changes in inventory reserves, theMarch 31, 2003. The increase in cost of goods sold was primarily due to increased product sales and related costs, particularly from product sales related to our VTC acquisition. Historically, as a percentage of revenue, the VTC products generally have had a lower cost of goods sold than our other products.
For the nine months ended September 30, 2003, cost of goods sold increased by $1.7$1.0 million to $11.0 million compared with $9.3 million in 2002. Included in cost of goods sold for the nine months ended September 30, 2003, was a reduction of reserves for excess and obsolete inventories of $0.8 million due to the sales of previously fully reserved products, compared to an increase of $5.2 million in the prior year period. Excluding the effects of changes in reserves for excess and obsolete inventory, the increase in cost of goods sold was primarily due to increased product sales, particularly from product sales related to our VTC acquisition and, consequently, increased product costs.
Gross margin as a percentage of revenue increased to 56.0% and 52.0% for the three and nine months ended September 30, 2003, respectively, from 38.6% and (35.2%) for the three and nine months ended September 30, 2002, respectively, including the effect of reserves for excess and obsolete inventory. The increase in our aggregate gross margin is the resultreserves for obsolete inventory and a lower of salescost or market adjustment for certain inventory components, an increase in material costs of previously fully reserved product sales$0.2 million, direct labor and higher gross margins associated with the VTC product line. These VTC products were not included in our 2002 financials.
Sales and Marketing. Sales and marketing expense primarily consistsother direct expenses of personnel costs, including commissions and costs$0.5 million related to customer support facilities, travel, trade shows, promotions and outside services. Our sales and marketing expenses were $1.9 million and $5.7 million for the three and nine months ended September 30, 2003, respectively, compared with $1.8 million and $6.6 million for the three and nine months ended September 30, 2002, respectively. As a percentagecompletion of revenue, sales and marketing expense decreased to 21.7% and 24.8% for the three and nine months ended September 30, 2003, respectively, from 89.9% and 95.7% for the same periods in 2002. The decreases in sales and marketing expense as a percentage of revenue for the three and nine months ended September 30, 2003, compared with the same periods in 2002, were primarily due to our restructuring efforts, which have enabled us to support increasing revenue with a lower cost structure.
Research and Development. Research and development expense consists primarily of personnel and facilities costs related to engineering and technical support, contract consultants, outside testing services, equipment and supplies associated with developing new products and enhancing existing products. Research and development costs are expensed as incurred. Our research and development expense decreased to $1.9 million and $6.2 million for the three and nine months ended September 30, 2003, respectively, from $3.2 million and $10.0 million for the three and nine months ended September 30, 2002, respectively. The decreases for the three and nine months ended September 30, 2003, when compared with the same periods in 2002, of $1.3 million, or 40.5%, and $3.7 million, or 37.5%, respectively, was primarily a result of our continued focus on cost saving measures and restructurings in current and prior periods, including the reduction, postponement or abandonment of research and development efforts on certain product lines. These cost savings resulted in decreases of $0.3 million in personnel costs and $0.5 million in facilities, suppliesproject installations, and other miscellaneous expenses in the third quarter of 2003 when compared with the same periods in 2002. In addition, included in research and development expense during the third quarter
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of 2002 was $0.5 million in expenditures for prototypes of our IntelliPOP 8000 series of products. For the nine months ended September 30, 2003, personnel costs declined by $1.5 million and facilities, prototypes, supplies and other costs declined$0.1 million. Our gross profit decreased by $2.3 million. Even though our research and development costs decreased in total during the first nine months of 2003 compared with the first nine months of 2002, we expect research and development activitiesmillion to continue to represent a significant percentage of our overall operating expenses.
General and Administrative. General and administrative expense consists primarily of personnel costs for executive and administrative officers and support personnel, professional services and insurance. Our general and administrative expense increased to $1.0 million from $0.6 million for the three months ended September 30, 2003March 31, 2004 from $3.3 million for the three months ended March 31, 2003. This decrease in gross profit is due to an increase of $1.0 million in inventory reserves and 2002, respectively.a gross margin decrease of $1.5 million relating to our video content processing products. The decrease in our gross margin was partially offset by an increase of $0.2 million attributable to our broadband transport and service management products.
Sales and Marketing. For the three months ended September 30,March 31, 2004 and 2003, professional feesour sales and insurance declined $0.6 millionmarketing expenses remained consistent at $1.9 million.
Research and personnelDevelopment. For the three months ended March 31, 2004, our research and other costs declined $0.3 million compared with the same period in 2002. Included in general and administrative expense during the third quarter of 2002 was the recovery of $1.3 million of debt that we had previously classified as bad debt. General and administrativedevelopment expense decreased by 12.7% to $3.3$1.8 million from $2.1 million for the ninethree months ended September 30, 2003, from $3.8March 31, 2003. The $0.3 million decrease in our research and development expense for the nine months ended September 30, 2002. The decreasefirst quarter of $0.5 million for the nine months ended September 30, 2003,2004 when compared with the same period in 2002 included reductions2003 was due to a decrease of $1.2$0.3 million in professional feespersonnel related costs. We continued to reduce research and insurancedevelopment expenses in the first quarter of 2004 to bring them into better alignment with our current revenues. We expect that our research and reductionsdevelopment expenses will increase throughout the remainder of 2004. Our capital expenditures for research and development were $0.1 million and $0.3 million for the three months ended March 31, 2003 and 2004, respectively. We expect capital expenditures for research and development to decrease in personnel2004.
General and other costs of $1.3 million. Included inAdministrative. For the three months ended March 31, 2004, our general and administrative expense duringdecreased by 7.1% to $1.1 million from $1.2 million for the three months ended March 31, 2003. The $0.1 million decrease in our general and administrative expense for the first nine monthsquarter of 20022004 when compared with the same period in 2003 was due to decreases of $0.2 million in personnel costs from a workforce reduction in the recoverythird quarter of $2.02003 and $0.1 million in insurance expenses, partially offset by an increase of debt that we had previously classified as bad debt.$0.2 million in professional services.
Impairment of Intangibles.Intangible Assets. We recognized a lossDuring the first quarter of $0.1 million during2004, we determined that certain of the nine months ended September 30, 2003, for the impairment of certain technology acquired as part of the acquisitionpurchase of the ViaGate Technology assets of ViaGate. There were no such write-offs during the three and nine months ended September 30, 2002.
Restructuring. In August 2003,had become impaired. As a result, we implemented a restructuring program that included a workforce reduction and relocation. This restructuring program resulted in restructuring costs of $0.3 million in the third quarter of 2003. The restructuring costs consistedrecorded an impairment charge of $0.2 million in workforce reduction charges relating primarily to severance and fringe benefits and $0.1 million in relocation expenses. Inwrite off the third quarterbook value of 2002, we announced a restructuring program that included a workforce reduction, closure of our New Jersey research and development facility, and disposal of certain of our fixed assets. As a result ofthe intangible assets associated with this restructuring program, we recorded restructuring costs of $0.9 million intechnology. There was no such impairment for the third quarter of 2002. These restructuring costs consisted of $0.5 million in workforce reduction charges relating primarily to severance and fringe benefits and $0.4 million relating to closure of our New Jersey facility.three months ended March 31, 2003.
Amortization of IntangiblesIntangible Assets.. Amortization of intangiblesintangible assets is comprised of technology and patentsintangibles related to the acquisitions and is amortized over their estimated useful lives of five years. Amortization of intangibles increased to $0.4 millionXstreamis Limited in 2000, and $1.4 million for the three and nine months ended September 30, 2003, respectively, from $0.3 million and $0.9 million for the three and nine months ended September 30, 2002, respectively. The increase was primarily due to the intangibles acquired when we purchased VTC in November 2002. As of September 30, 2003, netThe remaining intangible assets of $3.9 millionsubject to amortization from these acquisitions consist primarily of completed technology and patents, which remain to be amortized.patents. For
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the three months ended March 31, 2004, amortization of Certain Equity Investments. Impairment of certain equity investmentsintangible assets decreased by 13.7% to $0.4 million from $0.5 million for the ninethree months ended September 30, 2002, consistedMarch 31, 2003. The $0.1 decrease for the first quarter of 2004 when compared with the recognition of expense related to the write-off of $0.6 million investedsame period in a privately-held company. The value of this investment2003 was impaired due to uncertainty abouta reduction in amortization expense, from an intangible asset reaching full amortization in the continued viabilityfourth quarter of the company. As of September 30, 2002, we had no remaining investments in privately held companies.2003.
Interest and Other (Expense) Income, NetNet.. Interest and other (expense) income, net consists primarily of interest income and expense and foreign currency exchange gains and losses. Our interest income and other (expense) income, net decreased duringFor the three months ended September 30, 2003 as a result ofMarch 31, 2004, our interest expense on a note payable exceeding interest income. Interest and other (expense) income, decreased to a net was $0.2expense of $0.1 million of income for the nine months ended September 30, 2003, compared withfrom a net interest and other income of $0.6$0.1 million for the ninethree months ended September 30, 2002.March 31, 2003. The decreases fordecrease in the three and nine months ended September 30,first quarter of 2004 of $0.2 million compared with the first quarter of 2003 were due towas primarily the result of lower interest rates on lower average invested cash balances and to increased interest expense associated with the long-term$3.2 million note payable to Tektronix, Inc. related to the acquisitionissued in connection with our purchase of VTC. The reductionVTC in interest and other income, net during the first nine months of 2003 was partially offset by a foreign currency exchange gain of $0.1 million.November 2002.
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Liquidity and Capital Resources
Historically, our principal source of liquidity has been through equity funding. From our inception through January 1999, we financed our operations primarily through the sale of preferred equity securities for an aggregate of $46.2 million, net of offering costs. In January 1999, we completed our initial public offering and issued 2,875,000 shares of our common stock at a price of $18.00 per share. From that January 1999 offering, we received approximately $46.9 million in cash, net of underwriting discounts, commissions and other offering costs. We also received approximately $6.7 million as a result of the exercise of a warrant to purchase 666,836 shares of Series G convertible preferred stock at a price of $10.00 per share. In March 2000, we completed our secondary offering and issued 2,500,000 shares of our common stock at a price of $60.00 per share, and we received approximately $141.7 million in cash, net of underwriting discounts, commissions and other offering costs. In the future, we cannot be certain that similar equity funding will be available to us. If we are unable to obtain additional equity financing on terms acceptable to us, our business, operating results and financial condition could be negatively impacted.
Cash and cash equivalents totaled $14.0$12.3 million at September 30, 2003, a decrease of $11.6 million, or 45.4%, fromMarch 31, 2004, compared with cash and cash equivalents of $25.6$14.4 million at December 31, 2002.
The2003, reflecting a net decreasereduction in cash and cash equivalents of $11.6 million during the nine months ended September 30, 2003, resulted primarily from our use of $11.7 million$2.1 million.
Cash used in cash for operating activities and purchase of property and equipment of $0.7 million. Included in cash used for operating activities was $1.5 million for the payment of $3.7three months ended March 31, 2004, compared with $4.4 million towards our remaining purchase commitmentsfor the three months ended March 31, 2003. The reduced cash used in operating activities was primarily due to a former vendor for raw material componentsdecrease in accounts receivable due to lower revenue levels in the first quarter of 2004 and an increase in accounts receivable of $5.2 million. Thepayable and accrued liabilities due to an increase in accounts receivable is primarily due to increased sales volume. Also includedend of quarter purchases offset by an increase in cash usedprepaid expenses. We recorded a provision for operating activities during the nine months ended September 30, 2003, were cash paymentsinventory within cost of $0.2goods sold totaling $1.0 million associated with our restructuring activities in the three months ended September 30, 2003.first quarter of 2004, related to the costs of raw materials and finished goods in excess of what we reasonably expected to sell in the foreseeable future as of the first quarter of 2004. We also reduced inventory costs to market value.
Additions to property and equipment were $0.7 million in the first quarter of 2004, compared with $0.3 million in the first quarter of 2003, primarily reflecting an increased investment in research and development assets. In future periods,2004 we generally anticipate a decrease in workingexpect capital expenditures on a period-to-period basis primarilyto be comparable to 2003. We expect these capital expenditures to be funded from operations.
The following table sets forth our contractual obligations as a result of completing substantial payments for purchase commitments for inventory and decreases in our operational costs due to our restructuring and prior workforce reductions.March 31, 2004:
|
| Payments due by period |
| |||||||||||||
Contractual |
| Total |
| Remainder |
| 2005 |
| 2007 |
| Thereafter |
| |||||
Long-Term Debt Obligations |
| $ | 3,603 |
| $ | — |
| $ | — |
| $ | 3,603 |
| $ | — |
|
Operating Lease Obligations |
| 960 |
| 694 |
| 266 |
| — |
| — |
| |||||
Purchase Obligations |
| 364 |
| 364 |
| — |
| — |
| — |
| |||||
Other Long-Term Liabilities |
| 31 |
| — |
| 31 |
| — |
| — |
| |||||
Total |
| $ | 4,958 |
| $ | 1,058 |
| $ | 297 |
| $ | 3,603 |
| $ | — |
|
We do not have entered into certain contractual obligations including inventory purchase commitments of $0.4 million at September 30, 2003, that could result in cash outflows.any off balance sheet arrangements.
Our future minimum lease payments under operating leases at September 30, 2003, are as follows:
Remainder of 2003 | $ | 275,000 | |
2004 | 806,000 | ||
2005 | 269,000 | ||
Thereafter | — | ||
$ | 1,350,000 | ||
As part of our acquisition of VTC from Tektronix in November 2002, we issued a note payable to Tektronix for $3.2 million, with repayment in ninetysixty months, or by November 2007. The interest rate on this note is 8% and is compounded annually. Through January 31, 2006, the accrued interest is added to the principal balance of the note. Thereafter, we will pay accrued interest on this note commencing on January 31, 2006 and on each April 30, July 31 and October 31 thereafter until the principal balance is paid in full. Principal and accrued interest on the note payable is $3.6 million at March 31, 2004. Accrued interest in the first quarter of 2004 was $0.1 million.
In connection with the settlement of certain legal matters in December 2003, we have recorded a liability and a receivable, each in the amount of $10.7 million, in our December 31, 2003 balance sheet. This amount will be paid by our insurance carriers, and accordingly, such liability is not reflected in the above table. The settlement amount will be reversed from our balance sheet during 2004, at such time as the settlements are formally approved by the respective courts. One of the settlements was formally approved by the courts in the first quarter of 2004, and therefore, we reversed $0.7 million relating to that settlement from the balance sheet. As of March 31, 2004, we have a receivable and liability of $10.0, respectively, on our balance sheet.
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We have incurred substantial losses and negative cash flows from operating activitiesoperations since inception. For the ninethree months ended September 30, 2003,March 31, 2004, we incurred a net loss of $5.0$4.5 million, negative cash flows from operating activities of $11.7$1.5 million, and have an accumulated deficit of $281.5$286.5 million.
We believe that the cash and cash equivalents as of September 30, 2003March 31, 2004 are sufficient to fund our operating activities and capital expenditure requirementsneeds for the next twelve months. We expectHowever, in the amount of cash necessary to fund operations to decrease throughout the remainder of 2003. However, to the extent our business
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continues to be affected by poorevent that general economic conditions impacting the telecommunications industry,worsen, we will continue tomay require additional cash to fund our operations. We willplan to seek additional equity funding for operations from alternative debtto provide working capital, fund potential acquisitions and equity sources, if necessary, to maintain reasonable operating levels.potentially redeem the VTC acquisition indebtedness. We cannot assure that such funding efforts will be successful. Failure to generate positive cash flow in the future could have a material adverse effect on our ability to achieve our intended business objectives.
Critical Accounting Policies and Estimates
TheOur discussion and analysis of our financial condition and results of operations isare based upon our unaudited condensed consolidated financial statements, which have been prepared in accordance with generally accepted accounting principles generally accepted in the United States of America.States. The preparation of these financial statements requires managementus to make estimates and judgmentsassumptions that affect the reported amounts of assets and liabilities, revenues and expenses and relatedthe disclosure of contingent assets and liabilities. On an on-going basis, we evaluateliabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting periods. We base our estimates including those related to revenue recognition, bad debts, investments, intangible assets and income taxes. Our estimates are based on historical experience and on various other assumptions we believethat are believed to be reasonable under the circumstances.circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates.estimates under different assumptions or conditions.
The accountingWe have identified the policies described below are those that most frequently require us to make estimates and judgments, and are thereforeas critical to our business operations and the understanding of our results of operations.
Revenue recognitionrecognition.
We generate revenue primarily from the sale of hardware products, including third-party products, through professional services, the licensing of our HomeRun technology and through the sale of our software products. We sell products through direct sales channels and through distributors. Generally, product revenue is generated from the sale of video processing systems and components and the sale of broadband transport and service management products. Turnkey solution revenue is principally generated by the sale of complete end-to-end video processing systems that are designed, developed and produced according to a buyer’s specifications.
Product revenue is generated primarily from the sale of complete end-to-end video processing systems generally referred to as turnkey solutions. Turnkey solutions are multi-element arrangements, which consist of hardware products, software products, professional services and post-contract support. Sales of turnkey solutions are classified as product revenue in the statement of operations.
Product revenue is also generated from the sale of video processing component products and the sale of broadband transport and service management products. We sell these products through our own direct sales channels and also through distributors.
Our revenue recognition policies for turnkey solutions are in accordance with SOP 97-2, Product revenuesSoftware Revenue Recognition, as amended, which is the authoritative guidance for recognizing revenue on software transactions and transactions in which software is more than incidental to the arrangement. SOP 97-2 requires that revenue recognized from software arrangements be allocated to each element of the arrangement based on the relative fair values of the elements, such as hardware, software products, maintenance services, installation, training or other elements. Under SOP 97-2, the determination of fair value is based on objective evidence that is specific to the vendor. If such evidence of fair value for any undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value does exist or until all elements of the arrangement are delivered, subject to certain limited exceptions set forth in SOP 97-2, as amended. SOP 97-2 was amended in February 1998 by SOP 98-4, Deferral of the Effective Date of a Provision of SOP 97-2 and was amended again in December 1998 by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, with Respect to Certain Transactions. Those amendments deferred and then clarified, respectively, the
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specification of what was considered vendor specific objective evidence of fair value for the various elements in a multiple element arrangement.
In the case of software arrangements that require significant production, modification or customization of software, which encompasses all of our turnkey arrangements, SOP 97-2 refers to the guidance in SOP 81-1, Accounting for Performance of Construction-Type and Certain Production-Type Contracts.We recognize productrevenue for all turnkey arrangements in accordance with SOP 97-2 and SOP 81-1. Excluding the PCS element of the multi-element arrangement, for which we have established vendor specific objective evidence of fair value (as defined by SOP 97-2), revenue from turnkey solutions is generally recognized using the percentage-of-completion method, as stipulated by SOP 81-1. The percentage-of-completion method reflects the portion of the anticipated contract revenue that has been earned that is equal to the ratio of labor effort expended to date to the anticipated final labor effort, based on current estimates of total labor effort necessary to complete the project. Revenue from the PCS element of the arrangement is deferred at the point of sale and recognized over the term of the PCS period. Generally, the terms of the turnkey solution sales provide for billing of approximately 90% of the contract value prior to the time of delivery to the customer site, with an additional approximately 9% of the contract value billed upon substantial completion of the project and the balance upon customer acceptance. The contractual arrangements relative to turnkey solutions include customer acceptance provisions. However, such provisions are generally considered to be incidental to the arrangement in its entirety because customers are fully obligated with respect to approximately 99% of the contract value irrespective of whether acceptance occurs or not.
For direct sales of video processing systems component products not included as part of turnkey solutions and the direct sale of broadband transport and service management products, we recognize revenue when persuasive evidence of an arrangement exists, delivery has occurred, or services have been provided, the fee is fixed or determinable, and collection is probable. reasonably assured.
Significant management judgments and estimates must be made in connection with the measurement of revenue in a given period. We follow specific and detailed guidelines for determining the timing of revenue recognition. At the time of the transaction, we assess a number of factors, including specific contract and purchase order terms, completion and timing of delivery to the common carrier,common-carrier, past transaction history with the customer, the creditworthiness of the customer, evidence of sell-through to the end user, and current payment terms. Based on the results of ourthe assessment, we may recognize revenue when the products are shipped or defer recognition of revenue until evidence of sell-through occurs and cash is received. Revenue from service obligations included in product revenues is deferred and recognized ratably over the periodIn order to recognize revenue, we must also make a judgment regarding collectibility of the obligation. arrangement fee. Management’s judgment of collectibility is applied on a customer-by-customer basis pursuant to our credit review policy. We sell to customers for which there is a history of successful collection and to new customers for which such history may not exist. New customers are subject to a credit review process, which evaluates the customers’ financial position and ability to pay. New customers are typically assigned a credit limit based on a review of their financial position. Such credit limits are only increased after a successful collection history with the customer has been established. If it is determined from the outset of an arrangement that collectibility is not probable based upon our credit review process, no credit is extended and revenue is recognized on a cash-collected basis.
We also maintain accruals and allowances for all cooperative marketing and other programs.programs, as necessary. Estimated sales returns and warranty costs are based on historical experience and are recorded at the time revenue is recognized.recognized, as necessary. Our products generally carry a one-yearone year warranty from the date of purchase. TheTo date, warranty accrual was not material at September 30, 2003 or December 31, 2002.costs have been insignificant to the overall financial statements taken as a whole.
Turnkey solution revenues
Revenue on turnkey video solution sales, which typically include the design, manufacture, test, integration and installation of our equipment to our customers’ specifications, or equipment acquired from third parties to be integrated with our products, is generally recognized using the percentage-of-completion method. Under the percentage-of-completion method, revenue recognized reflects the portion of the anticipated contract revenue that has been earned, equal to the ratio of labor costs expended to date, to anticipated total labor costs, based on current estimates of labor costs to complete the project. If the estimated costs to complete a project exceed the total contract amount, indicating a loss, the entire anticipated loss is recognized immediately. Generally, the terms of turnkey video solution sales provide for billing for products at the time of delivery and for services at the time of substantial completion of the project.
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License and royalty revenues
We have entered into non-exclusive technology agreements with variousrevenue consists of non-refundable up-front license fees, some of which may offset initial royalty payments, and royalties received by us for products sold by our licensees. These agreements provideCurrently, the licensees the right to manufacture, or have manufactured, products which incorporate the Company’s proprietary technologymajority of our license and to receive customer support for specified periods and any changes or improvement to the technology over the term of the agreement.
Contract fees for the services provided under these licensing agreements are generallyroyalty revenue is comprised of non-refundable license fees and non-refundable, prepaid royalties that arepaid in advance. Such revenue is recognized when the proprietary technology is delivered if there are no significant vendor obligations. If the licensing agreements contain post-contract customer support, we recognize the contract fees ratably over the period during which the post-contract customer support is expected to be provided. This period represents the estimated lifeprovided or upon delivery and transfer of the technology. We beginagreed upon technical specifications in contracts where essentially no further support obligations exist. Future license and royalty revenue is expected to recognize revenue under the contract once it has delivered the implementation package that contains all information needed to use our proprietary technology in the licensee’s process. The remaining obligations areconsist primarily to provide the licensee with any changes or improvements to the technology and technical advice on specifications, testing, debugging and enhancements.
We recognizeof royalties upon notification of salereceived by us for products sold by our licensees. The termsWe expect that such license and royalty revenue will not constitute a substantial portion of the royalty agreements generally require licensees to notify us and pay royalties within 60 days of the end of the quarter during which the sales occur.our revenue in future periods.
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Software license and post contract support revenuesInventories.
Currently, our software revenue is derived from two separate sources, software license fees and post-contract maintenance and support fees. A software license typically grants a perpetual license to the customer. We generally recognize revenue from the sales of software licenses when all criteria for revenue recognition that are similarly applicable to our hardware product sales have been met. The revenue for post-contract maintenance and support fees is recognized ratably over the term of the separate support contract.
Revenue recognition—Summary
Revenue recognition in each period is dependant on our application of these accounting policies. If we believe that any of the conditions to recognize revenue have not been met, we will defer revenue recognition. For example, if collectibility is not reasonably assured, we will defer revenue recognition until subsequent cash receipt. Our application of percentage-of-completion accounting is subject to our estimates of labor cost to complete each turnkey solution project. In the event that actual results differ from these estimates or we adjust these estimates in future periods, our operating results for a particular period could be adversely affected. Unearned revenue that has been billed but not collected at the end of the period is recorded as a reduction against the related accounts receivable balance. Unearned revenue recorded as a reduction against the related accounts receivable was $1.7 million and $0.9 million at September 30, 2003 and December 31, 2002, respectively.
Inventories
Inventories are stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. We record provisions to write down our inventory and related purchase commitments for estimated obsolescence or unmarketable inventory equal to the difference between the cost of the inventory and the estimated market value based upon assumptions about the future demand and market conditions. If actual future demand or market conditions are less favorable than we estimate, additional inventory provisions may be required.
Allowance for doubtful accountsaccounts.
We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make payments. These estimated allowances are periodically reviewed, and take into accountanalyzing the customers’ payment history and information regarding the customers’ creditworthiness that is known to us. If the financial condition of any of our customers were to deteriorate, resulting in their inability to make payments, an additional allowance would be required.
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Accounting for long-lived assetsassets.
We are required to periodically assess the impairment of long-lived assets periodically.assets. An impairment review is performed whenever events or changes in circumstances indicate that the carrying value may not be recoverable.
Factors considered important which could trigger an impairment review include, but are not limited to, significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of use of the acquired assets or the strategy for the overall business, significant negative industry or economic trends, a significant decline in the stock price for a sustained period, and theour market capitalization relative to net book value.
When our management determines that the carrying value may not be recoverable based upon the existence of one or more of the above indicators of impairment, any impairment measured is based on a projected discounted cash flow method using a discount rate commensurate with the risk inherent in our current business model.
No such impairment was recorded in the first quarter of 2003. During the nine months ended September 30, 2003,2004, we determined that certain of the technology acquired as part of our purchase of the ViaGateintangible long-lived assets in September 2001 had become impaired. As a result, wewere impaired and recorded a loss of $0.1$0.2 million to write off the technology.
under SFAS No. 144. Future events could cause us to conclude that impairment indicators once again exist. Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations.
Legal contingenciescontingencies.
We are currently involved in certain legal proceedings as discussed in Note 7 of our unaudited condensed consolidated financial statements.note 6. Because of uncertainties related to both the potential amount and range of loss from the pending litigation, management is unable to make a reasonable estimate of the liability that could result if there wereis an unfavorable outcome in anycertain of these legal proceedings. We recorded a liability for the In re Tut Systems, Inc. Securities Litigation matter, as well as an equal and corresponding receivable. We have not recorded a liability for the Whalen matter as a consequence of several uncertainties. As additional information becomes available, we will re-assessassess the potential liability related to this pendingthese litigation matters and may revise our estimates accordingly. Revisions of our estimates of such potential liability could materially impact our results of operations, financial condition or cashflows.
Accounting for stock based compensation
We account for stock-based employee compensation arrangements in accordance with the provisions of Accounting Principles Board Opinion No. 25 (“APB No. 25”), “Accounting for Stock Issued to Employees,” Financial Accounting Standard Board Interpretation No. 44 (“FIN 44”), “Accounting for Certain Transactions Involving Stock Compensation—an Interpretation of APB 25,” and comply with the disclosure provisions of Statement of Financial Accounting Standard No. 148 (“SFAS No. 148”), “Accounting for Stock-Based Compensation, Transition and Disclosure.” Under APB No. 25, compensation expense is based on the difference, if any, on the date of the grant, between the fair value of the Company’s stock and the exercise price. We account for stock issued to non-employees in accordance with the provisions of SFAS No. 148 and the Emerging Issues Task Force (“EITF”) Issue No. 96-18, “Accounting for Equity Instruments that are Issued to other than Employees for Acquiring, or in Conjunction with Selling Goods or Services.”
We amortize stock-based compensation using the straight-line method over the remaining vesting periods of the related options, which is generally four years. Pro forma information regarding net loss and earnings per share is required. This information is required to be determined as if we had accounted for employee stock options under the fair value method of SFAS No. 123, as amended by SFAS No. 148.
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The following table illustrates the effect on net loss and earnings per share if we had applied the fair value recognition provisions of SFAS No. 123, as amended by SFAS No. 148, to stock-based employee compensation (unaudited, in thousands except per share amounts):
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||
2003 | 2002 | 2003 | 2002 | |||||||||||||
Net loss—as reported | $ | (742 | ) | $ | (5,867 | ) | $ | (4,998 | ) | $ | (24,621 | ) | ||||
Adjustment: | ||||||||||||||||
Total stock-based employee compensation expense determined under a fair value based method for all grants, net of related tax effects | (816 | ) | (1,063 | ) | (2,853 | ) | (3,596 | ) | ||||||||
Net loss—pro forma | $ | (1,558 | ) | $ | (6,930 | ) | $ | (7,851 | ) | $ | (28,217 | ) | ||||
Basic and diluted net loss per share—as reported | $ | (0.04 | ) | $ | (0.36 | ) | $ | (0.25 | ) | $ | (1.50 | ) | ||||
Basic and diluted net loss per share—pro forma | $ | (0.08 | ) | $ | (0.42 | ) | $ | (0.39 | ) | $ | (1.72 | ) | ||||
The fair value of options and shares issued pursuant to the option plans and at the grant date were estimated using the Black-Scholes model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option-pricing models require the input of highly subjective assumptions including the expected stock price volatility. We use projected volatility rates, which are based upon historical volatility rates trended into future years. Because employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management’s opinion, the existing models do not necessarily provide a reliable single measure of the fair value of options.
The effects of applying pro forma disclosures of net loss and net loss per share are not likely to be representative of the pro forma effects on net loss/income and net loss/earnings per share in the future years, as the number of future shares to be issued under these plans is not known and the assumptions used to determine the fair value can vary significantly.
Prior to our initial public offering, the fair value of each stock option was estimated using the minimum value method. Volatility and dividend yields were not factors in the Company’s minimum value calculation. Subsequent to the offering, the fair value of each stock option has been estimated on the date of grant using the Black-Scholes option pricing model. We have also estimated the fair value of the purchase rights issued from our employee stock purchase plan using the Black-Scholes option pricing model. We first issued purchase rights from the 1998 Employee Stock Purchase Plan in fiscal year 1999.
Recent Accounting Pronouncements
In AprilJanuary 2003, the Financial Accounting Standards Board, the (“FASB”) issued SFASFASB Interpretation No. 149, “Amendment46 (FIN 46), “Consolidation of Statement 133 on Derivative InstrumentsVariable Interest Entities, an Interpretation of ARB No. 51, Consolidated Financial Statements,” and Hedging Activities.” SFAS No. 149 amends and clarifiessubsequently revised in December 2003 with the issuance of FIN 46-R. This interpretation requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial accounting and reportinginterest or do not have sufficient equity at risk for derivative instruments, including certain derivative instruments embeddedthe entity to finance its activities without additional subordinated financial support from other parties. Application of this Interpretation is required in other contracts (collectively referred to as derivatives) andfinancial statements for hedging activities under FASB Statement No. 133, “Accounting for Derivative Instruments and Hedging Activities. SFAS No. 149 is effective for contracts entered into or modifiedperiods ending after September 30, 2003, and for hedging relationships designated after September 30, 2003. We believe that theMarch 15, 2004. The adoption of this standard willInterpretation in the period ended March 31, 2004 did not have a material impact on our results of operations, financial statements.
In May 2003, the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. It requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances). Many of those instruments were previously classified as equity. SFAS No. 150 is effective for financial instruments entered intoposition or modified after May 31, 2003, and otherwise is effective atcash flows.
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the beginning of the first interim period beginning after September 15, 2003. It is to be implemented by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of SFAS No. 150 and still existing at the beginning of the interim period of adoption. Restatement is not permitted. We believe that the adoption of this standard will not have a material impact on our financial statements.
Non-Audit Services of Independent Auditors
In accordance with Section 10(A)(i)(2) of the Securities Exchange Act of 1934, as amended, as added by Section 202 of the Sarbanes-Oxley Act of 2002, we are required to disclose the non-audit services approved by our Audit Committee to be provided by PricewaterhouseCoopers LLP, our independent auditor. The Audit Committee has approved fees of $10,000 for the engagement of PricewaterhouseCoopers LLP for merger and acquisition consulting services.
ADDITIONAL RISK FACTORS THAT COULD AFFECT OUR OPERATING RESULTS AND THE MARKET PRICE OF OUR STOCK
We have a history of significant losses, and expect to continue to incur losses in the future.we may never achieve profitability.
We have incurred substantial net losses and experienced negative cash flow for each quarter since our inception. We incurred a net loss of $5.0 million for the nine months ended September 30, 2003, and a net loss of $41.6 million for the year ended December 31, 2002. As of September 30, 2003,March 31, we had an accumulated deficit of $281.5$286.5 million. We expect that we will continue to incur losses forin the remainder of fiscal year 2003.
Wenear future. Moreover, we may never achieve profitability and, if we do so, we may not be able to maintain profitability. We have spent substantial amounts of money on the development of our Expresso products, HomeRun and LongRun technology, IntelliPOP products and software products. In November 2002, we acquired VideoTele.com (“VTC”) and certain products of VTC that are generating incremental revenue beyond our Expresso, Home Run, Long Run and IntelliPOP products and that we anticipate will continue to bring us such incremental value. During fiscal years 2001, 2002 and 2003, we significantly reduced our workforce in an effort to decrease certain of our operating expenditures, including our sales and marketing, research and development and general and administrative expenditures. However, we may not be able to generate a sufficient level of revenue (even with our VTC products) to offset our current level of expenditures. Additionally, we may be unable to adjust our spending in a timely manner to respond to any unanticipated decline in revenue due to the fact thatMoreover, because our expenditures for sales and marketing, research and development, and general and administrative functions are relatively fixed in the short term. Our ability to achieve and maintain profitability in the future will primarily depend on our ability to do the following:
Our operating results may fluctuate significantly, which could cause our stock price to decline.
A number of factors could cause our quarterly and annual financial results to be worse than expected, which could result in a decline in our stock price. Our annual and quarterly operating results have fluctuated in the past and may fluctuate significantly in the future as a result of numerous factors, some of which are outside of our control. These factors include:
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We anticipate that average selling prices for our products will continue to decrease in the near future due to increased competitive price pressures in certain geographical regions. In addition, we may also experience substantial period-to-period fluctuations in future operating results and declines in gross margins as a result of the erosion of average selling prices for our VTC products, high-speed data access products and services due to a number of factors, including increased competition and rapid technological change. Decreasing the average selling prices of our products could cause us to experience decreased revenue despite an increase in the number of units sold. We may be unable to sustainadjust our gross margins, even atspending in a timely manner to respond to any unanticipated decline in revenue. If we fail to achieve profitability within the anticipated reduced levels, improve our gross marginstimeframe expected by offering new products or increased product functionality or offset future price declines with proportionate reductions in our cost structure.
As a result of these and other factors, our operating results for future periods may be below the expectations of securities analysts and investors. In that event,or investors, then the market price of our common stock would furtherwill likely decline.
We continueEach sale of our headend systems represents a significant portion of our revenue for any given quarter. Our failure to be affected by poor general economic conditions thatmeet our quarterly forecast of sales of headend systems in any given quarter could have resulted in significantly reduced sales levels and, if such adverse economic conditions continue or worsen, our business, operating results and financial condition will be further negatively impacted.
The continued poor economic conditions in the world economy, and the continued industry-wide slowdown in the telecommunications market have materially and adversely affected, and continue to materially and adversely affect, our sales. As a result, we have experienced, and will likely continue to experience, a material adverse impact on our business, operatingfinancial results and financial condition. Comparatively lower sales for eacha given quarter.
Since we acquired VTC in November 2002, a large part of our fiscal years from 2000 through 2002 have resulted in operating expenses increasing as a percentage ofquarterly revenue for 2002 and 2001 compared to 2000. Although we took actions throughout 2001, 2002 and the first nine months of 2003 to create revenue opportunities and reduce operating expenses, including our acquisition of VTC, a prolonged continuation or worsening of sales trends that we faced in 2001 and 2002 would force us to take additional actions and charges in order to reduce our operating expenses further. If we are unable to reduce operating expenses at a rate and level
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consistent with anticipated future adverse sales trends or if we continue to incur significant special chargesis associated with such expense reductions that are disproportionate to our sales, our business, operating results and financial condition will be even further negatively impacted.
We depend on a limited numberthe sale of large customers for a substantial portion of our revenue during any given period, and the loss of a key customer or loss or delay of a key order could substantially reduce our revenue in a given period.
We deriveheadend systems. Each sale represents a significant portion of our revenue infor each period from a limitedquarter. We base our operating forecast on our historical sales. Because of the high cost per unit of our headend systems, if we were to sell even one less system than our forecasted number of customers. No individual customer accounted for greater than 10% ofheadend sales per quarter, such a decrease in sales would have a material and adverse impact on our revenue for the nine months ended September 30, 2003. Two customers, Ingram Microthat quarter, and BTN Internetworking, accounted for 12%we may fail to meet investor expectations.
We operate in an intensely competitive marketplace, and 10%, respectively,many of our revenue for the nine months ended September 30, 2002. Many of our customerscompetitors have limited or, in some cases, no access to capital and continue to experience significant financial difficulties, including bankruptcy. In order to meet our revenue targets,better resources than we must continue to acquire new customers and increase sales to our existing customers. In addition, our strategy of targeting larger, more established customers may result in longer sales cycles and delayed revenue. Sales to larger accounts could also result in increased competition from larger and more established competitors. If sales to our largest customers decrease materially below current levels or if we are unable to establish a new base of customers, such decreases or failures would materially and adversely affect our business, results of operations and financial condition.do.
We haveOur primary competitors in the past and may in the future acquire other companies. If we faildigital TV headend market are small private companies that are focused on a more narrow product line than ours, thereby allowing these competitors to integrate successfully these acquisitions into our Company, our business, results of operations and financial condition could be materially harmed.
Since February 2000, we have completed six acquisitions of other companies or their assets. As a part of our business strategy, we expectdevote substantially more targeted resources to make additional acquisitions of, or significant investments in, complementary companies, products or technologies. We may need to overcome significant issues in order to realize any benefits from our past transactions, and any future acquisitions would be accompanied by similar risks. These risks include, but are not limited to:
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On November 7, 2002, we completedtarget larger telco customers for our acquisition of VTC, a leading provider of video content processing and video trunking, and we are in the process of integrating VTC into our company. We evaluate and enter into other acquisition and alliance transactions on an ongoing basis. The size and scope of the acquisition of VTC relative to our overall size increases both the scope and consequence of ongoing integration risks. We may not successfully address the integration challenges in a timely manner, or at all, and we may not fully realize all of the anticipated benefits or synergies of the VTC acquisition (which principally entail restructuring our organization through workforce reductions, identification of procurement synergies and other such operational efficiencies) or any other acquisition to the extent, or in the timeframe, anticipated. Moreover, the timeframe for achieving benefits of any such acquisition may depend partially on the actions of employees, suppliers or other third parties.
As a result of the foregoing, if we are unable to integrate successfully any completed, pending or future acquisitions, our business, operating results and financial condition could be materially harmed.
We are currently engaged in three securities lawsuits, two of which are class action lawsuits, any of which, if they were to result in an unfavorable resolution, could adversely affect our business, results of operations or financial condition.
Beginning July 12, 2001, nine putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of California against the Company and certain of its current and former officers and directors. The complaints were filed on behalf of a purported class of people who purchased the Company’s stock during the period between July 20, 2000 and January 31, 2001, seeking unspecified damages. The complaints allege that the Company and certain of its current and former officers and directors made false and misleading statements about the Company’s business during the putative class period. Specifically, the complaints allege violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints have been consolidated under the name In re Tut Systems, Inc. Securities Litigation, Master File No. C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and lead counsel for plaintiffs have been appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on March 29, 2002. On August 15, 2002, the Court granted in part and denied in part the Motion to Dismiss. On September 23, 2002, plaintiffs filed an amended complaint. Defendants filed a Motion to Dismiss the amended complaint, and on August 6, 2003 the Court granted in part that Motion. On September 24, 2003, Defendants answered the remaining allegations of the amended complaint. Discovery has commenced. Trial is scheduled to begin on March 7, 2005. The Company believes it has meritorious defenses to the allegations in the complaint and intends to defend the case vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Company’s business, results of operations, financial condition and cash flows.
On March 19, 2003, Chesky Lefkowitz, a shareholder of the Company, filed a derivative complaint entitled Lefkowitz v. D’Auria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of the Company’s current and former officers and directors. The complaint alleges causes of action for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment and improper insider stock trading, based on the same factual allegations contained in the Securities Litigation Action. The complaint seeks unspecified damages against the individual defendants on behalf of the Company, equitable relief, and attorneys’ fees. On May 21, 2003, the Company and the individual defendants filed separate demurrers to the complaint. The demurrers have not yet been heard by the Court, and no trial date has been established.
On October 30, 2001, Tut Systems and certain of its current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et al., Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District Court for the Southern District of New York. An
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amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts that the prospectuses from Tut Systems’ January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against Tut Systems and certain of its current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, (the “1933 Act”) and under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, and alleges claims against certain of its current and former officers and directors under Sections 15 and 20(a) of the 1933 Act. The complaints also name as defendants the underwriters for Tut Systems’ initial public offering and secondary offering. The Court has denied the Company’s motion to dismiss. The Company’s Board recently approved a tentative settlement proposal from the plaintiffs. The settlement is subject to a number of conditions, including approval of the Court. If the settlement does not occur, and the litigation against the Company continues, the Company believes it has meritorious defenses to the allegations in the complaint and intends to defend the case vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Company’s business, results of operations, financial condition and cash flows.
If our Expresso and IntelliPOP products do not gain broader acceptance in the market, our business, financial condition and results of operations will be further harmed.
We launched our IntelliPOP 5000 product series in the first half of 2001 and have still not been successful in generating widespread customer interest in this product. Similarly, our sales of Expresso units have been below what we had anticipated. We must devote a substantial amount of human and capital resources in order to broaden commercial acceptance of our Expresso products and to gain commercial acceptance of our IntelliPOP products and expand our offerings of these products in the multi-dwelling unit, or MDU, and the multi-tenant commercial unit, or MCU, markets. However, to date, this commitment of resources to these product lines has not generated the commercial acceptance that we have sought for these products. Historically, the majority of our Expresso products have been sold into the MDU market. Our future success depends on our ability to continue to penetrate this market and to expand our penetration into the MCU market. Our success also depends on our ability to educate existing and potential customers and end-users about the benefits of our Fast Copper and Signature Switch technologies, our LongRun and IntelliPOP products, and about the development of new products to meet changing and expanding demands of service providers, MCU owners and corporate customers, including our new product offerings based on our acquisition of VTC. The future success of our Expresso and IntelliPOP products will also depend on the ability of our service provider customers to market and sell high-speed data services to end-users. If our IntelliPOP or Expresso products do not achieve broader commercial acceptance within the MDU market, MCU market, or in any other markets we may enter, our business, financial condition and results of operations will be further materially and adversely affected.
The market in which we operate is highly competitive, and we may not be able to compete effectively.
The market for video and broadband data systems, is intensely competitive, and we expect that this market will continue to become more competitive in the future. Our immediate competitors include, or are expected to include, Cisco Systems, Inc.,competition from large public companies like Harmonic, Inc., Tandberg Television ASA, and a numberMotorola, Inc., all of which have substantially greater financial, technical and other publicresources than we do. These competitors have
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achieved success in providing headend components for cable multiple system operators and private companies. Many ofsatellite TV providers and we expect these competitors offer or mayto market some of their products for use in TV over DSL applications. For example, in the future offer technologies and servicespast, Harmonic provided video content processing systems to SaskTel, a large Canadian telephone service provider. Harmonic also recently announced that directly compete with some or all of our high-speed access products and related software products. Also, many of these competitors continueit will provide video content processing systems to announce significant changesVideo Networks Limited, a video-over-DSL provider in their business plans and operations, some of which, such as major write downs of inventory, could result in lower priced products flooding the market, which would have a negative impact on our ability to sustain our current pricing and sell our inventory. In addition, the market in which we compete is characterized by increasing consolidation, and we cannot predict with certainty how industry consolidation will affect us or our competitors.United Kingdom.
Our competitorscompetition in the market for video transmission processing products primarily comes from small private companies such as SkyStream Networks and potential competitors may have substantially greater name recognitionpublic companies such as Optibase Inc. and technical, financialTandberg Television that together offer a wide array of products with special features and marketing resources than we do,functions. Our broadband transport and we can give you no assurance that we will be ableservice management business tends to compete effectively inagainst public, private and foreign network equipment companies.
To the extent that any of these current or potential future competitors enter or expand further into our target markets. These competitors may be able to undertake more extensive marketing campaigns, adopt more aggressive pricing policiesmarkets, develop superior technology and devote substantially more resources to developing new products than we can. In addition, our HomeRun licensees may sell products based on our HomeRun technologyor offer superior prices or performance features relative to our competitors or potential competitors. This licensing may cause an erosion in the potential market for our Expresso products. We cannot assure you that we will have the financial resources, technical expertise or marketing, manufacturing, distribution and support capabilities to compete successfully. Thisproducts, such competition could result in price reductions, reduced profit marginslost sales and losssevere downward pressure on our pricing, either of market share, which could harmwould adversely affect our business, financial conditionrevenue and results of operations.profitability.
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Our copper-wire based solutions face severe competition from other technologies, and the commercialCommercial acceptance of any competing solutionstechnological solution that competes with technology based on communication over copper telephone wire could harm our ability to compete and thus materially and adversely impact demand for our business, financial conditionproducts, our revenue and results of operations.growth strategy.
The marketmarkets for video content processing, transmission and high-speed data access productssystems and services isare characterized by several competing communication technologies, including fiber optic cables, coaxial cables, satellites and other wireless facilities. These competing solutions provide fast access, high reliability and cost-effective solutions for some users. Many of our products are based on the use ofcommunication over copper telephone wire. Because there are physical limits to the speed and distance over which data can be transmitted over copper wire, our products may not be a viable solution for customers requiring service at performance levels beyond the current limits of copper telephone wire. ToOur customer base is concentrated on telephone service providers that have a large investment in copper wire technology. If these customers lose market share to their competitors who use competing technologies that are not as constrained by physical limitations as copper telephone wire, and that are able to provide faster access, greater reliability, increased cost-effectiveness or other advantages, demand for our products will decrease. Moreover, to the extent that telecommunications service providersour customers choose to install fiber optic cable or other transmission media in the last mile,as part of their infrastructure, or to the extent that homes and businesses install other transmission media within buildings, we expect that demand for our products that are based on copper telephone wires willmay decline. Commercial acceptance of any one of these competing solutions or any technological advancement or product introduction that provides faster access, greater reliability, increased cost-effectiveness or other advantages over technologies that utilize existing copper telephone wires could decrease the demand for our products and reduce average selling prices and gross margins associated with our products. The occurrence of any one or more of these events couldwould harm our business, financial condition and results of operations.
If we fail to manage our operations in light of our changing revenue base, our ability to increase our revenues and improve our results of operations could be harmed.
Our operations have changed significantly due to volatility in our business. In the past, we rapidly and significantly expanded our operations. However, in fiscal years 2001 and 2002, we reduced our workforce significantly to control overall operating expenses in response to dramatic declines in, and the expectation of continued slowing of, our sales growth. In 2003, we reduced our workforce significantly to further control operating expenses. We anticipate that, in the future, expansion in certain areas of our business may be required to expand our customer base and exploit market opportunities. In particular, we expect to face numerous challenges in the implementation of our business strategy to focus on selling our products to the larger, more established customers, such as ILECs and PTTs, in both domestic and international markets.
To exploit the marketdemand for our products, we must develop newwhich would thereby adversely affect our revenue and enhanced products while implementing and managing effective planning and operating processes. To manage our operations, we must, among other things, continue to implement and improve our operational, financial and management information systems, hire and train additional qualified personnel, continue to expand and upgrade core technologies and effectively manage multiple relationships with various customers, suppliers and other third parties. We cannot assure you that our systems, procedures or controls will be adequate to support our operations or that our management will be able to achieve the rapid execution necessary to exploit fully the market for our products or systems. If we are unable to manage our operations effectively, our business, financial condition and results of operations could be harmed.growth strategy.
We depend on international salesIf the projected growth in demand for a significant portionvideo services from telephone service providers does not materialize or if our customers find alternative methods of delivering video services, future sales of our revenue, which subjects our business to a number of risks. If we are unable to generate significant international sales, our business, financial condition and results of operations could be materially and adversely affected.video content processing systems will suffer.
Sales to customers outside of the United States accounted for approximately 18.0% and 47.7% of revenue for the nine months ended September 30, 2003 and 2002, respectively. There are a number of risks arising from the operation of our international business, including, but not limited to:
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We expect salesmanufacture video content processing systems that enable telephone service providers to offer video services to their customers. Our customers, outsidethe telephone service providers, face competition from cable companies, satellite service providers and wireless companies. For some users, these competing solutions provide fast access, high reliability and cost-effective solutions for delivering data, including video services. Telephone service providers hope to maintain their market share in their core business of voice telephony as well as increase their revenue per customer by offering their customers more services, including video services and high-speed data services. However, if the United States to continue to represent a significant portiontelephone service providers find alternative ways of our revenue. However, we cannot assure youmaintaining and growing their market share in their core business that foreign marketsdo not require that they offer video services, demand for our products will develop atdecrease substantially. Moreover, if technological advancements are developed that allow our customers to provide video services without upgrading their current system infrastructure, or that offer our customers a more cost-effective method of delivering video services, sales of our video content processing systems will suffer. Alternatively, even if the rate ortelephone service providers choose our video content processing systems, the service providers may not be successful in marketing video services to the extent currently anticipated. If we fail to generate significant internationaltheir customers, in which case our sales our business, financial condition and results of operations could be materially and adversely affected.would decrease substantially.
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Our continued low stock price means that most of our outstanding employee stock options are “under water” or priced substantially aboveoperating results fluctuate significantly from quarter to quarter, and this may cause the current market price of our common stock. Our employees maystock to decline.
Over the last 12 quarters, our sales per quarter have felt,fluctuated between $9.2 million and may continue to feel, that they are receiving inadequate compensation. Further,$2.0 million. Over the continued adverse market conditions mean thatsame periods, our stock option offerings and our stock option plans may not offer current and potential future employees sufficient incentive to work for us. If adverse market conditions persist, our stock option offerings and employee stock plans will further diminish our ability to attract and/or retain qualified personnel, which will further materially and adversely impact our business, financial condition, results ofloss from operations or cash flows.
Some of our customers have not been able to meet their financial obligations to us due to changes in the capital markets and these customers’ own precarious financial situations. If more of our customers experience similar financial difficulties, our revenue will decrease further, which would materially and adversely affect our business, operating results and financial condition.
Due to increased volatility in equity markets and tightening of lending in the credit markets, we are exposed to a significant risk that customers will not pay us the amounts that they owe us in order to conserve their capital. This would lead to increases in our outstanding accounts receivable as a percentage of revenue extended payback periodshas fluctuated between approximately 5.2% and increased risk1,274% of customer default. For example, during the latter partrevenue. We anticipate that our sales and operating margins will continue to fluctuate. We expect this fluctuation to continue for a variety of the fourth quarter of 2000, several key customers experienced a rapid deterioration in their ability to obtain additional capital to fund their businesses and eventually declared bankruptcy. As of December 31, 2002, all of these bankruptcies were finalized, and we had to write off the amounts owed to us by these customers.reasons, including:
We factor• the increased risktiming of non-payment into our assessmentcustomers’ purchase decisions, acceptance of our customers’ ability to pay,new products and possible cancellations;
• competitive pressures, including pricing pressures from our partners and competitors;
• delays or problems in some instances, these considerations will result in longer revenue deferrals than we had anticipated at the time that we booked the sales to those customers. We also believe that certainintroduction of our customersnew products;
• announcements of new products, services or technological innovations by us or our competitors; and
• management of inventory levels.
The sales cycle for video content processing systems is long and unpredictable, which requires us to incur high sales and marketing expenses with no assurance that a sale will alter their plansresult.
The sales cycle for our headend systems can be as long as 12-18 months. Additionally, with respect to deploythe sale of our products to U.S. and foreign government organizations, we may experience long sales cycles as a result of government procurement processes. As a result, while we continue to incur costs associated with a particular sale prior to payment from the customer, we may not recognize revenue from efforts to sell particular products for extended periods of time.
As a result, our quarter-to-quarter comparisons of our revenue and operating results may not be meaningful and may not provide an accurate indicator of our future performance. Our operating results in one or more future quarters may fail to meet the constraints imposed on them by changesexpectations of investment research analysts or investors, which could cause an immediate and significant decline in the capital markets. If we are not able to increase sales to other customers, or iftrading price of our sales are otherwise delayed or revenue written off, our sales will continue to decline, which would further harm our business, operating results and financial condition.common stock.
If we inaccurately estimate customerfail to accurately forecast demand for our business, results of operationsproducts, our revenue, profitability and financial conditionreputation could be harmed.
We planrely on contract manufacturers and third-party equipment manufacturers, or OEMs, to manufacture, assemble, test and package our expense levels in part basedproducts. We also depend on third-party suppliers for the materials and parts that constitute our expectations about future revenue. These expense levels are relatively fixed inproducts. Our reliance on contract manufacturers, OEMs and third-party suppliers requires us to accurately forecast the short-term. However, the number of ordersdemand for our products and coordinate our
efforts with those of our contract manufacturers, OEMs and suppliers. We often make significant up-front financial commitments with our contract manufacturers, OEMs and suppliers in order to procure the raw materials and begin manufacturing and assembly of the products. If we fail to accurately forecast demand or coordinate our efforts with our suppliers, OEMs and contract manufacturers, we may vary from
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quarterface supply, manufacturing or testing capacity constraints. These constraints could result in delays in the delivery of our products, which could lead to quarter. In some circumstances, customers may delay purchasing our current products in favorthe loss of next-generation products. In addition, our new products are generally subject to technical evaluations byexisting or potential customers that typically last 60and could thereby result in lost sales and damage to 90 days. In the case of IntelliPOP and our turnkey video solutions, those evaluations may take up to several months or longer. If orders forecasted for a specific customer for a particular quarter are delayed or cancelled,reputation, which would adversely affect our revenue for that quarter may be less than our forecast. Currently, we have minimal risk of loss associated with long-term customer commitments or penalties for delayed and/or cancelled orders. However, we may be unable to reduce our spending accordingly in the short-term if such a loss occurred, and any such revenue shortfall would have a direct and adverse impact on our results of operations for that quarter.profitability. Further, we outsource the manufacturing of our products based on forecasts of sales. If orders for our products exceed our forecasts, we may have difficulty meeting customers’ orders in a timely manner, which could damage our reputation or result in lost sales. Conversely, if our forecasts exceed the orders we actually receive and we are unable to cancel future purchase and manufacturing commitments in a timely manner, our inventory levels would increase. This could expose us to losses related to slow moving and obsolete inventory, which would have a material adverse effect on our business, operating results and financial condition.profitability.
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We do not manufacture our products. We rely on contract manufacturersIf we fail to assemble, testdevelop and package our products. We cannot assure you that these contract manufacturers and suppliers will be able to meet our future requirements for manufactured products, components and subassemblies. In addition, we believe that current market conditions have placed additional financial strain on our contract manufacturers. Any interruption in the operations of one or more of these contract manufacturers would harm our ability to meet our scheduled product deliveries to customers. We also intend to introduce new products and product enhancements, which will require that we rapidly achieve volume production by coordinating our efforts with those of our suppliers and contract manufacturers. The inability of our contract manufacturersin response to provide us with adequate supplies of high-quality products or the loss of a current contract manufacturer would cause a delay in our ability to fulfill customer orders while we obtain a replacement manufacturer and would harm our business, operating results and financial condition. In addition, we have canceled certain finished goods and component orders, which may harm our relationship with certain contract manufacturers. Moreover, if we do not accurately forecast the actual demand for our products, we may face supply, manufacturing or testing capacity constraints. These constraints could result in delaysrapid technological changes in the delivery of our products or the loss of existing or potential customers, either ofmarkets in which could harm our business, operating results or financial condition.
Based on our manufacturing specifications, several key components are purchased from single or limited source suppliers, and if our contract manufacturers fail to obtain the raw materials and component products we require in a timely mannercompete, we could lose sales. If we lose sales, our business, financial condition and results of operations would be materially and adversely affected.
We currently purchase most of our raw materials and components used in our products through our contract manufacturers. In procuring components for our products, we and our contract manufacturers rely on some suppliers that are the sole source of those components, and we are dependent upon supplies from these sources to meet our needs. We also depend on various sole source offerings from Broadcom, Metalink US, IBM and Motorola for certain of our products. Components are purchased pursuant to purchase orders based on forecasts, but neither we nor our contract manufacturers have any guaranteed supply arrangements with these suppliers. The availability of many of these components depends in part on our ability to provide our contract manufacturers and their suppliers with accurate forecasts of our future needs. If we or our manufacturers are unable to obtain a sufficient supply of key components from current sources or if there is any interruption in the supply of any of the key components currently obtained from a single or limited source, we could experience difficulties in obtaining alternative sources at reasonable prices, if at all, or in altering product designs to use alternative components. Resulting delays and reductions in product shipments could damage customer relationships, disrupt our operations and harm our business, financial condition or results of operations. In addition, any increases in component costs that are passed on to our customers could reduce demand for our products.
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We rely on third parties to test substantially all of our products. If, for any reason, these third parties were unable to or didwill not adequately assist us in controlling the quality of our products, this lack of quality control could harm our business, financial condition and results of operations.
Substantially all of our products are assembled and tested by our contract manufacturers. Although we perform random spot testing on manufactured products, we rely on our contract manufacturers for assembly and primary testing of our products. Any quality assurance problems could increase the cost of manufacturing, assembling or testing our products and could harm our business, financial condition and results of operation. Moreover, defects in products that are not discovered in the quality assurance process could damage customer relationships and result in product returns or product liability claims, each of which could harm our business, financial condition and results of operations.
Our business relies on the continued growth of the Internet and any slowdown in or reversal of the growth of Internet use could materially and adversely impact our business.
The market for high-speed data access products depends in large part on the continued use and popularity of the Internet. Issues concerning the use of the Internet, including security, lost or delayed packets, and quality of service may negatively affect the development of the market for our products, which could materially and adversely impact our business.
Our industry is characterized by rapid technological change. We must continually introduce new products that achieve broad market acceptance in order to address this change and remain competitive.
The markets for video content processing, transmission and high-speed data access productssystems are characterized by rapid technological developments, frequent enhancements to existing products and new product introductions, changes in end-user requirements and evolving industry standards. To remain competitive, we must continually improve the performance, features and reliability of our products. For example, advancements in compression technology are leading the video content processing industry to begin the transition to next generation compression standards. These advances will allow for further reductions in the bandwidth required to deliver standard definition video channels and introduce the possibility of delivering high-definition television over bandwidth constrained ADSL lines for the first time. Further advances in compression technology, or the emergence of new industry standards would require that we further redesign our products particularly in response to competitive product offerings. We must introduce products that incorporate, or areand remain compatible with, these newemerging technologies as they emerge and must do so in a timely manner. industry standards.
We cannot assure you that we will be able to respond quickly and effectively to technological change. We may have only limited time to penetrateenter certain markets, and we cannot assure you that we will be successful in achieving widespread acceptance of our products before competitors can offer products and services similar or superior to our products. Any failureIf we fail to introduce new products addressingthat address technological changes or any delayif we experience delays in our product introductions, could adversely affect our ability to compete would be adversely affected, thereby harming our revenue, profitability and cause our operating results to be below our expectations or the expectations of public market analysts or investors. In addition, when we announce new products or product enhancements that have the potential to replace or shorten the life cycle of our existing products, customers may defer purchasing our existing products. These actions could harm our business, financial condition and operating results by unexpectedly decreasing sales, increasing our inventory levels of older products and exposing us to greater risk of product obsolescence.growth strategy.
Manufacturing or design defects in our products could harm our reputation and our business, financial condition and results of operations.
Any defect or deficiency in our products could reduce the functionality, effectiveness or marketability of our products. These defects or deficiencies could cause orders for our products to be canceled or delayed, reduce our revenue, or render our product designs obsolete. In that event, we would be required to devote substantial financial and other resourcesWe depend on international sales for a significant periodportion of timeour revenue, which subjects our business to a number of risks. If we are unable to generate significant international sales, our revenue, profitability and share price could be materially and adversely affected.
Sales to customers outside of the developmentUnited States accounted for approximately 13.2% and 11.2% for the three months ended March 31, 2003 and 2004, respectively. Sales and operating activities outside of new product designs. the United States are subject to inherent risks, including fluctuations in the value of the United States dollar relative to foreign currencies; tariffs, quotas, taxes and other market barriers; political and economic instability; restrictions on the export or import of technology; potentially limited intellectual property protection; difficulties in staffing and managing international operations and potentially adverse tax consequences. Any of these factors may have a material adverse effect on our ability to grow or maintain international revenue.
We expect sales to customers outside of the United States to represent a significant and growing portion of our revenue. However, we cannot assure you that we would be successful in addressing any manufacturing or design defects in our products or in developing new product designs in a timely manner, if at all. Any of these events, individually or in the aggregate, could harm our business, financial condition, results of operations, or cash flows.
Changing industry standards may reduce the demandforeign markets for our products which would harm our business, financial condition and results of operations.
We will not be competitive unless we continually introduce new products and product enhancements that meet constantly changing industry standards. The emergence of new industry standards, whether through adoption by official standards committeesdevelop at the rate or through widespread use of such standards by
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telephone companies or other service providers, could requireto the extent that we redesignanticipate. If we fail to generate significant international sales, our products. If these standards become widespreadrevenue, profitability and our products do not comply with these standards, our customers and potential customers may not purchase our products, which would harm our business, financial condition and results of operations. The rapid development of new standards increases the risk that competitorsshare price could develop products that make our products obsolete. Any failure by us to develop and introduce new products or enhancements directed at new industry standards could harm our business, financial condition and results of operations. In addition, selection of competing technologies as standards by standards setting bodies such as the HomePNA technology could negatively affect our reputation in the market, regardless of whether our products are standards-compliant or demand for our products does not decline. This selection could be interpreted by the press and others as having a negative impact on our business, which would negatively impact our stock price.
Further, the marketplace’s anticipation of an emerging standard, such as MPEG-4, Part 10 (H.264), could delay customers from making decisions to purchase or deploy existing products that we offer, which could materially and adversely affect our sales.affected.
Fluctuations in interest and currency exchange rates may harmdecrease demand for our business.products.
A majoritySubstantially all of our foreign sales are invoiced in U.S. dollars. As a result, fluctuations in currency exchange rates could cause our products to become relatively more expensive for international customers, thereby reducing demand for our products. We anticipate that foreign saleswe will generally continue to be invoicedinvoice foreign sales in U.S. dollars. Accordingly, weWe do not currently engage in foreign currency hedging transactions. However, as we expand our current international operations, we may allow payment in foreign currencies and, as a result, our exposure to foreign currency transaction losses may increase. To reduce this exposure, we may purchase forward foreign exchange contracts or use other hedging strategies. However, we cannot assure you that any currency hedging strategy would be successful in avoiding exchange-related losses. Any such losses would adversely impact our profitability.
If our contract manufacturers, third-party OEMs and third-party suppliers fail to produce quality products or parts in a timely manner, we may not be able to meet our customers’ demands.
We do not manufacture our products. We rely on contract manufacturers and OEMs to manufacture, assemble, package and test substantially all of our products and to purchase most of the raw materials and components used in our products. Additionally, we depend on third-party suppliers to provide quality parts and materials to our contract manufacturers and OEMs, and we obtain some of the key components and sub-assemblies used in our products from a single supplier or a limited group of suppliers. Neither we nor our contract manufacturers or OEMs have any guaranteed supply arrangements with the
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suppliers. If our suppliers fail to provide a sufficient supply of key components, we could experience difficulties in obtaining alternative sources at reasonable prices, if at all, or in altering product designs to use alternative components. Moreover, if our contract manufacturers or OEMs fail to deliver quality products in a timely manner, such failure would harm our ability to meet our scheduled product deliveries to customers. Delays and reductions in product shipments could increase our production costs, damage customer relationships and harm our revenue and profitability. In addition, if our contract manufacturers and OEMs fail to perform adequate quality control and testing of our products, we would experience increased production costs for product repair and replacement, and our profitability would be harmed. Moreover, defects in products that are not discovered in the quality assurance process could damage customer relationships and result in product returns or product liability claims, each of which could harm our revenue, profitability and reputation.
Design defects in our products could harm our reputation and our revenue, profitability and reputation.
Any defect or deficiency in our products could reduce the functionality, effectiveness or marketability of our products. These defects or deficiencies could cause customers to cancel or delay their orders for our products, reduce revenue or render our product designs obsolete. In any of these events, we would be required to devote substantial financial and other resources for a significant period of time to develop new product designs. We cannot assure you that we would be successful in addressing any design defects in our products or in developing new product designs in a timely manner, if at all. Any of these events, individually or in the aggregate, could harm our revenue, profitability and reputation.
Our business depends on the integrity of our intellectual property rights. If we fail to adequately protect our intellectual property, our revenue, profitability, reputation or growth strategy could be adversely affected.
We attempt to protect our intellectual property or if others use ourand proprietary technology without our authorization, our competitive position may suffer.
Our future successthrough patents, trademarks and ability to compete depends in part on our proprietary technology. We rely on a combination of copyright, patent, trademark and trade secrets laws and nondisclosure agreements to establish and protect our proprietary technology. We currently hold 46 United States patents and have 28 United States patent applications pending. However, we cannot assure you that patents will be issued with respect to pendingcopyrights, by generally entering into confidentiality or future patent applications that we have filed or plan to file or that our patents will be upheld as valid or will prevent the development of competitive products or that any actions we have taken will adequately protect our intellectual property rights.
We generally enter into confidentialitylicense agreements with our employees, consultants, resellers,vendors, strategic partners and customers as needed, and potential customers in which we strictly limitby generally limiting access to and distribution of our softwaretrade secret technology and further limit the disclosure and useproprietary information. However, any of our pending or future patent or trademark applications may not ultimately be issued as patents or trademarks of the scope that we sought, if at all, and any of our patents, trademarks or copyrights may be invalidated, deemed unenforceable, or otherwise challenged. In addition, other parties may circumvent or design around our patents and other intellectual property rights, may misappropriate our proprietary information. Despitetechnology, or may otherwise develop similar, duplicate or superior products. Further, the intellectual property laws and our efforts toagreements may not adequately protect our proprietaryintellectual property rights unauthorized partiesand effective intellectual property protection may attemptbe unavailable or limited in certain foreign countries in which we do business or may do business in the future.
The telecommunications and data communications industries are characterized by the existence of extensive patent portfolios and frequent intellectual property litigation. From time to copytime, we have received, and may in the future receive, claims that we are infringing third parties’ intellectual property rights. Any present or otherwise obtainfuture claims, with or usewithout merit, could be time-consuming, result in costly litigation, divert management time and attention and other resources, cause product shipment delays or require us to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us. In addition, any such litigation could force us to cease selling or using certain products or services, or to redesign such products or services. Further, we may in the future initiate claims or litigation against third-parties for infringement of our intellectual property rights or to determine the scope and validity of our intellectual property rights or those of competitors. Such litigation could result in substantial costs and diversion of resources. Any of the foregoing could have an adverse effect upon our revenue, profitability, reputation or growth strategy.
If we fail to provide our customers with adequate and timely customer support, our relationships with our customers could be damaged, which would harm our revenue and profitability.
Our ability to achieve our planned sales growth and retain customers will depend in part on the quality of our customer support operations. Our customers generally require significant support and
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training with respect to our products, or technology. Our competitors may also independently develop technologies that are substantially equivalent or superiorparticularly in the initial deployment and implementation stage. As our systems and products become more complex, we believe our ability to provide adequate customer support will be increasingly important to our technology. In addition,success. We have limited experience with widespread deployment of our products to a diverse customer base, and we cannot assure you that we will have adequate personnel to provide the lawslevels of some foreign countries do not protectsupport that our proprietary rightscustomers may require during initial product deployment or on an ongoing basis. Our failure to provide sufficient support to our customers could delay or prevent the same extent as the lawssuccessful deployment of the United States.
We may be subjectour products. Failure to intellectual property infringement claims that are costly to defendprovide adequate support could also have an adverse impact on our reputation and relationship with our customers, could thereby prevent us from gaining new customers and could harm our businessrevenue and profitability.
If we fail to manage our expanding operations, our ability to compete.
Our industry is characterized by vigorous protectionincrease our revenues and pursuit of intellectual property rights. We are subject to the risk of adverse claims and litigation alleging infringement of the intellectual property rights of others. From time to time, third parties may assert infringement claims with respect toimprove our current or future products. Any such assertion, regardless of its merit, could require us to pay damages or settlement amounts and could require us to develop non-infringing technology or acquire licenses to the technology that is the subject of the asserted infringement. This litigation or potential litigation could result in product delays, increased costs or both. In addition, the cost of any litigation and the resulting distraction of our management resources to address such litigation could harm our business, results of operations orcould be harmed.
We anticipate that, in the future, we may need to expand certain areas of our business to grow our customer base and exploit market opportunities. In particular, we expect to face numerous challenges in the implementation of our business strategy to focus on selling our products to the larger, more established service providers. To manage our operations, we must, among other things, continue to implement and improve our operational, financial condition.and management information systems, hire and train additional qualified personnel, continue to expand and upgrade core technologies and effectively manage multiple relationships with various customers, suppliers and other third-parties. We also cannot assure you that any licenses of technologyour systems, procedures or controls will be adequate to support our operations or that our management will be able to achieve the rapid execution necessary to exploit fully the market for our business willproducts or systems. If we are unable to manage our operations effectively, our revenue, operations and share price could be available orharmed.
If we are unable to address the material weaknesses in our internal controls that if available, these licenses can be obtained on commercially reasonable terms. Our failureour auditors identified in the fourth quarter of fiscal 2003, such weaknesses could materially and adversely affect our ability to obtain these licensesprovide the public with timely and accurate material information about our company, which could harm our business,reputation and share price.
In January 2004, our auditors identified deficiencies in our internal controls that they considered to be material weaknesses. Based on these weaknesses, our CEO and CFO determined that, as of December 31, 2003, our disclosure controls and procedures were not sufficient to record, process, summarize and report information required to be reported within the time periods specified by the SEC. These material weaknesses related to our inventory and our accounts payable processes, both of which affect our balance sheet and may also affect our income statement reporting. (See page 20 of the Form 10-K/A for further discussion of these weaknesses.) In order for investors and the equity analyst community to make informed investment decisions and recommendations about our securities, it is important that we provide them with accurate and timely information in accordance with the Exchange Act and the rules promulgated thereunder. If we cannot do so, investors will sell our shares and industry analysts will either make incorrect recommendations about our company or else end coverage of our company altogether, any of which results of operationscould harm our reputation and financial condition.adversely impact our share price.
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We are currently engaged as a defendant in two lawsuits (i.e., In re Tut Systems, Inc. Securities Litigation and Whalen v. Tut Systems, Inc. et al.) that allege securities law violations against us and certain of our current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, and Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended. While we have reached settlements with the plaintiffs in these lawsuits, the settlements are subject to certain contingencies, including court approval of the terms of settlement. If the courts do not approve these settlements, or any other applicable contingencies are not resolved or otherwise addressed, we would be required to resume litigation in these matters. If we were to resume litigation in these matters, there is no assurance that we would prevail and, if either of the outcomes of such litigation were unfavorable to us, our reputation, profitability and share price could be adversely affected.
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If our products do not comply with complex government regulations, our products may not be sold, preventing us from increasing our revenue or achieving profitability.product sales will suffer.
We and our customers are subject to varying degrees of federal, state and local as well as foreign governmental regulation. Our products must comply with various regulations and standards defined by the Federal Communications Commission, or FCC. The FCC has issued regulations that set installation and equipment standards for communications systems. Our products are also required to meet certain safety requirements. For example, Underwriters Laboratories must certify certain of our products must be certified by Underwriters Laboratories in order to meet federal safety requirements relating to electrical appliances to be used inside the home. In addition, certain products must be Network Equipment Building Standard certified before they may be deployed by certain of our customers.customers may deploy them. Any delay in or failure to obtain these approvals could harm our business, financial condition or results of operations. Outside of the United States, our products are subject to the regulatory requirements of each country in which our products are manufactured or sold. These requirements are likely to vary widely. If we do not obtain timely domestic or foreign regulatory approvals or certificates, we would not be able to sell our products where these regulations apply, which maycould prevent us from sustainingmaintaining or growing our revenue or achieving profitability.
In addition, regulation of our customers may adversely impact our business, operating results and financial condition. For example, FCC regulatory policies affecting the availability of data and Internet services and other terms on which telecommunications companies conduct their business may impede our penetration ofentry into certain markets. In addition, the increasing demand for communications systems has exerted pressure on regulatory bodies worldwide to adopt new standards, generally following extensive investigation of competing technologies. The delays inherent in this governmental approval process may cause the cancellation, postponement or rescheduling of the installation of communications systems by our customers, which in turn may harm our sale of products to these customers.
If our customers do not receive adequate and timely customer support from us or our third-party providers, our relationships with our customers could be damaged, which would harm our business, financial condition and results of operations.
Our ability to achieve our planned sales growth and retain customers will depend in part on the quality of our customer support operations. Our customers generally require significant support and training with respect to our products, particularly in the initial deployment and implementation stage. As our systems and products become more complex, we believe our ability to provide adequate customer support will be increasingly important to our success. Moreover, we believe that our IntelliPOP products will add a significant layer of complexity to the demands placed on our customer support organizations. We have limited experience with widespread deployment of our products to a diverse customer base, and we cannot assure you that we will have adequate personnel to provide the levels of support that our customers may require during initial product deployment or on an ongoing basis. In addition, we rely on a third party for a substantial portion of our customer support functions, and therefore, we may have limited control over the level of support that is provided. Our failure to provide sufficient support to our customers could delay or prevent the successful deployment of our products. Failure to provide adequate support could also have an adverse impact on our reputation and relationship with our customers, could prevent us from gaining new customers and could harm our business, financial condition or results of operations.
If we lose key personnel or are unable to hire additional qualified personnel as necessary, we may not be able to manage our business successfully, which could materially and adversely affect our business, financial conditiongrowth strategy, reputation and results of operations.share price.
We depend on the performance of Salvatore D’Auria, our President, Chief Executive Officer and Chairman of the Board, and on other senior management and technical personnel with experience in the video and data communications, telecommunications and high-speed data access industries. The loss of any one of them could harm our ability to execute our business strategy.strategy, which could adversely affect our reputation and share price. Additionally, we do not have employment contracts with any of our executive officers. We believe that our future success will depend in large part on our continued ability to identify, hire, retain and motivate highly skilled employees who are in great demand. We cannot assure you that we will be able to do so.
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We have completed a number of acquisitions as part of our efforts to expand and diversify our business. For example, we acquired our video content processing and video transmission businesses from Tektronix in November 2002 when we purchased its subsidiary, VTC. We intend to continue to evaluate new acquisition candidates, divestiture and diversification strategies, and if we fail to manage the integration of acquired companies, it could adversely affect our operations and growth strategy. Any acquisition involves numerous risks, including difficulties in the assimilation of the acquired company’s employees, operations and products, uncertainties associated with operating in new markets and working with new customers, and the potential loss of the acquired company’s key employees. Additionally, we may incur unanticipated expenses, difficulties and other adverse consequences relating to the integration of technologies, research and development, and administrative and other functions. Any future acquisitions may also result in potentially dilutive issuances of our equity securities, acquisition or divestiture related write-offs and the assumption of debt and contingent liabilities. Any of the above factors could adversely affect our revenue, profitability, operations or growth strategy.
Our stock price has fluctuatedis volatile, and, is likely to continue to fluctuate, andif you invest in our company, you may not be ablesuffer a loss of some or all of your investment.
The market price and trading volume of our common stock has been subject to resell your shares at or above their purchase price.
Thesignificant volatility, and this trend may continue. In particular, trading volume historically has been low and the market price of our common stock has been and is likely to continue to be highly volatile. Our stock price could continue to fluctuate widely in response to many factors, including, but not limited to, the following:
In addition,increased dramatically in recent years,months. Since the stock market in general, and the Nasdaq National Market and the securitiesannouncement of Internet and technology companies in particular, have experienced extreme price and volume fluctuations with severe drops. These fluctuations have often been unrelated or disproportionate to the operating performance of these technology companies. These market and industry factors may harm our stock price, regardless of our operating results.
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Nasdaq corporate governance rules require that all shares listedour acquisition of VTC, the closing price of our common stock, as traded on the Nasdaq National Market, maintainhas fluctuated from a minimum bid price at closinglow of $1.00$1.22 to a high of $7.49 per share. Our failure to maintain such a minimum bidThe value of our common stock may decline regardless of our operating performance or prospects. Factors affecting our market price include:
• our perceived prospects;
• variations in our operating results and whether we have achieved our key business targets;
• the limited number of shares of our common stock available for a period of thirtypurchase or more consecutive trading days could resultsale in the Nasdaq governing board taking actionpublic markets;
• differences between our reported results and those expected by investors and securities analysts;
• announcements of new contracts, products or technological innovations by us or our competitors; and
• market reaction to removeany acquisitions, joint ventures or strategic investments announced by us or our shares fromcompetitors.
Recent events have caused stock prices for many companies, including ours, to fluctuate in ways unrelated or disproportionate to their operating performance. The general economic, political and stock market conditions that may affect the Nasdaq National Market. In the second half of 2002, the minimum closing bidmarket price of our common stock was consistently below $1.00 per share. On September 9, 2002, we received a Nasdaq delisting notice becauseare beyond our common stock had closed below $1.00 per share for 30 consecutive trading days. If the bidcontrol. The market price of our common stock hadat any particular time may not closed at $1.00 per share or more for a minimumremain the market price in the future. In the past, securities class action litigation has been instituted against companies following periods of 10 consecutive trading days before December 9, 2002, our stock would have been delisted fromvolatility in the Nasdaq National Market. On November 15, 2002, we received a notice from the Nasdaq that our stockmarket price had traded above $1.00 per share for the required 10 consecutive days. Since that time, our stock has not traded below the required minimum bid price at closing of $1.00 per share. However, based on the various risks noted elsewhere in this Quarterly Report on Form 10Q, we nevertheless continue to face the risk of our stock price falling below the $1.00 listing threshold, whichtheir securities. Any such litigation, if instituted against us, could result in the delistingsubstantial costs and a diversion of our stock from the Nasdaq National Market. The delistingmanagement’s attention and resources.
Future sales of shares of our common stock as well as the threat of delistingcould cause our stock price to decline.
Substantially all of our common stock may negatively impactbe sold without restriction in the valuepublic markets, subject only in the case of shares held by our officers and directors and affiliates to volume and manner of sale restrictions (other than as described in the following sentence). The approximately 3.3 million shares of common stock that we issued to Tektronix in connection with our November 2002 acquisition of VTC are restricted securities, as that term is defined in Rule 144 under the Securities Act, and therefore subject to certain restrictions. However, we are contractually obligated to file and keep effective a registration statement in order to allow Tektronix to sell these shares to the public. Likewise, Tektronix has the right (subject to certain exceptions) to include these shares in certain registration statements pursuant to which we may sell shares of our shares because shares that trade on the over-the-counter market, rather than the Nasdaq National Market, are typically less liquid and, therefore, trade with larger variations between the bid and asking price.common stock.
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Our charter, bylaws, retention and change of control plans and Delaware law contain provisions that could delay or prevent a change in control.
Certain provisions of our charter and bylaws and our retention and change of control plans, the “Plans,” may have the effect of making it more difficult for a third partythird-party to acquire, or of discouraging a third partythird-party from attempting to acquire, control of us. The provisions of the charter and bylaws and the Plans could limit the price that certain investors may be willing to pay in the future for shares of our common stock. Our charter and bylaws provide for a classified board of directors, eliminate cumulative voting in the election of directors, restrict our stockholders from acting by written consent and calling special meetings, and provide for procedures for advance notification of stockholder nominations and proposals. In addition, our board of directorsBoard has the authority to issue up to 5,000,000 shares of preferred stock and to determine the price, rights, preferences, privileges and restrictions, including voting rights, of those shares without any further
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vote or action by the stockholders. The issuance of preferred stock, while providing flexibility in connection with possible financings or acquisitions or other corporate purposes, could have the effect of making it more difficult for a third partythird-party to acquire a majority of our outstanding voting stock. The Plans provide for severance payments and accelerated stock option vesting in the event of termination of employment following a change of control. The provisions of the charter and bylaws, and the Plans, as well as Section 203 of the Delaware General Corporation Law, to which we are subject, could discourage potential acquisition proposals, delay or prevent a change of control and prevent changes in our management.
Future sales of our common stock could depress our stock price.
Sales of a substantial number of shares of our common stock in the public market, or the appearance that these shares are available for sale, could harm the market price of our common stock. Also, we may from time to time need to register shares of our common stock for resale, which registration and resale may increase the number of our shares that are publicly-traded, thereby adversely impacting the per share price of our common stock. In connection with our acquisition of VTC, in May 2003 we registered on a Form S-3 pursuant to Rule 415(a)(1)(i) under the Securities Act of 1933, as amended, on a continuous or delayed offering the 3.3 million shares of common stock issued to Tektronix, in order that Tektronix may sell such shares on or after December 1, 2003. These sales also may make it more difficult for us to sell equity securities or equity-related securities in the future at a time and price that we deem appropriate. As of September 30, 2003, we had 20,187,786 shares outstanding. Of these shares, 16,904,189 shares of our common stock are currently available for sale in the public market, some of which are subject to volume and other limitations under securities laws.
Our Pleasanton, California facility is located near known earthquake fault zones, and the occurrence of an earthquake or other natural disaster could cause damage to our facility and equipment, which could require us to curtail or cease operations.
Our Pleasanton, California facility is located in the San Francisco Bay Area near known earthquake fault zones and is vulnerable to damage from earthquakes. In October 1989, a major earthquake that caused significant property damage and a number of fatalities struck this area. We are also vulnerable to damage from other types of disasters, including fire, floods, power loss, communications failures and similar events. If any disaster were to occur, our ability to operate our business at our Pleasanton, California facility could be seriously, or completely, impaired. The insurance we maintain may not be adequate to cover our losses resulting from disasters or other business interruptions.
We rely on a continuous power supply to conduct our operations, and a statewide energy crisis could disrupt our operations and increase our expenses.
In the fourth quarter of 2000 and the first quarter of 2001, California suffered an energy crisis that could have disrupted our operations and increased our expenses. In the event of an acute power shortage which occurs when power reserves for the State of California fall below 1.5%, California has on some occasions implemented, and may in the future implement, rolling blackouts throughout the state. We currently do not have backup generators or alternate sources of power in the event of a blackout, and our current insurance does not provide coverage for any damages we or our customers may suffer as a result of any interruption in our power supply. If California were to suffer a similar energy crisis in the future and blackouts interrupt our power supply, we would be temporarily unable to continue operations at our Pleasanton, California facility. Any such interruption in our ability to continue operations at our facilities could damage our reputation, harm our ability to retain existing customers and to obtain new customers, and could result in lost revenue, any of which could substantially harm our business and results of operations.
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ITEM 3.3.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to changes in interest rates primarily from our investments in certain cash equivalents. Under our current policies, we do not use interest rate derivative instruments to manage exposure to interest rate changes. A hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of our interest-sensitive financial instruments at September 30, 2003.March 31, 2004.
We have no investments, nor are any significant sales, expenses, or other financial items denominated in foreign country currencies. All of our international sales are denominated in U.S. dollars. An increase in the value of the U.S. dollar relative to foreign currencies could make our products more expensive and, therefore, reduce the demand for our products.
ITEM 4.4.CONTROLS AND PROCEDURES
(a)Evaluation of Disclosure Controls and Procedures. The Company carried out an evaluation under the supervision and with the participation of the Company’s management, including theOur Chief Executive Officer and Chief Financial Officer carried out an evaluation of the effectiveness of the design and operation of the Company’sour disclosure controls and procedures (as such term is defined in RulesRule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)),Act) as of March 31, 2004. This evaluation included various steps that our Chief Executive Officer and Chief Financial Officer undertook in an effort to ensure that information required to be disclosed in our SEC reports is recorded, processed, summarized and reported within the endtime periods specified by the SEC and accumulated and communicated to our management, including our Chief Executive Officer and our Chief Financial Officer, to allow timely decisions regarding required disclosure. This evaluation also included consideration of our internal controls and procedures for the period covered by this report.preparation of our financial statements. There are inherent limitations to the effectiveness of any system of disclosure controls and procedures, including the possibility of human error and the circumvention or overriding of the controls and procedures. Accordingly, even effective disclosure controls and procedures can only provide reasonable assurance of achieving their control objectives. Notwithstanding these limitations, as of the end of the period covered by this report, based upon the Company’s evaluation, theour Chief Executive Officer and Chief Financial Officer concluded that theour disclosure controls and procedures are effective in all material respects to ensure that information required to be disclosed in the reports the Company files and submits under the Exchange Act is recorded, processed, summarized and reported as and when required.effective.
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(b)Changes in Internal Control Over Financial Reporting. There has not been any change in• Perform quarterly physical inventory counts at all locations;
• Established improved inventory systems and accounting controls, hired additional qualified personnel, improved intra-company communications, implemented appropriate organizational and line of reporting changes; and
• Established improved procedures for the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting that was identifiedtimely reconciliation and confirmation of accounts payable balances.
We implemented these measures because in connection with the Company’s evaluationcompletion of itsPricewaterhouseCoopers LLP’s audit of our financial statements for the year ended December 31, 2003, PricewaterhouseCoopers LLP advised management and the audit committee of the Board of Directors that it had identified deficiencies in our internal control over financial reporting.controls and processes relating to inventory management and reporting that it considered to be material weaknesses, as defined by Statement on Auditing Standards No. 60, “Communication of Internal Control Related Matters Noted in an Audit.” PricewaterhouseCoopers LLP identified the following two material weaknesses in our internal controls and processes:
1. Our internal controls were inadequate to properly record our inventory quantities in an accurate and timely manner; and
2. Our accounts payable process failed to adequately reconcile our accounts payable records with suppliers’ records, considering what the suppliers had shipped to us prior to period end.
Management believes its new controls and procedures have addressed the conditions identified by PricewaterhouseCoopers LLP as material weaknesses. We plan to continue to monitor the effectiveness of our internal controls and procedures on an ongoing basis and will take further action as appropriate.
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ITEM 1.LEGAL PROCEEDINGS
Whalen v. Tut Systems, Inc. et al
On October 30, 2001, we and certain of our current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et al., Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District Court for the Southern District of New York. An amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts that the prospectuses from our January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against us and certain of our current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, and under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, and alleges claims against certain of our current and former officers and directors under Sections 15 and 20(a) of the Securities Act. The complaint also names as defendants the underwriters for our initial public offering and secondary offering. Similar suits were filed in the Southern District of New York challenging over 300 other initial public offerings and secondary offerings conducted in 1999 and 2000. Therefore, for pretrial purposes, the Whalen action is being coordinated with the approximately 300 other suits before United States District Court Judge Shira Scheindlin of the Southern District of New York under the matter In Re Initial Public Offering Securities Litigation. The individual defendants in the Whalen action, namely, Nelson Caldwell, Salvatore D’Auria and Matthew Taylor, were dismissed without prejudice by an October 9, 2002 Order of the Court, approving the parties’ October 1, 2002 Stipulation of Dismissal. On February 19, 2003, the Court issued an Opinion and Order denying our motion to dismiss.
ITEM 1.In June and July 2003, nearly all of the issuers named as defendants in the LEGAL PROCEEDINGSIn Re Initial Public Offering Securities Litigation (collectively, the “issuer-defendants”), including our Company, approved a tentative settlement proposal that is reflected in a memorandum of understanding. Our Board of Directors approved the memorandum of understanding in June 2003 on certain conditions, including the number of issuers participating in the settlement. The memorandum of understanding is not a legally binding agreement. Further, any final settlement agreement would be subject to a number of conditions, most of which would be outside of our control, including approval by the Court. The underwriter-defendants in the In Re Initial Public Offering Securities Litigation (collectively, the “underwriter-defendants”), including the underwriters named in the Whalen suit, are not parties to the memorandum of understanding.
The memorandum of understanding provides that, in exchange for a release of claims against the settling issuer-defendants, the insurers of all of the settling issuer-defendants will provide a surety undertaking to guarantee plaintiffs a $1 billion recovery from the non-settling defendants, including the underwriter-defendants. The ultimate amount, if any, that may be paid on our behalf will therefore depend on the final terms of the settlement agreement, including the number of issuer-defendants that ultimately approve the final settlement agreement, and the amounts, if any, recovered by the plaintiffs from the underwriter-defendants and other non-settling defendants. In the event that all or substantially all of the
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issuer-defendants approve the final settlement agreement, the amount that we would be required to pay to the plaintiffs could range from zero to approximately $3.5 million, depending on plaintiffs’ recovery from the underwriter-defendants and from other non-settling parties. If the plaintiffs recover at least $1 billion from the underwriter-defendants, we would have no liability for settlement payments under the proposed terms of the settlement. If the plaintiffs recover less than $1 billion, we believe that our insurance will likely cover some or all of our share of any payments towards satisfying plaintiffs’ $1 billion recovery deficit. Management estimates that its range of loss relative to this matter is zero to $3.5 million. Presently there is no more likely point estimate of loss within this range. As a consequence of the uncertainties described above regarding the amount we will ultimately be required to pay, if any, as of March 31, 2004, we have not accrued a liability for this matter.
In re Tut Systems, Inc. Securities Litigation, Civil Action No. C-01-2659-JCS (the “Securities Litigation Action”).
Beginning July 12, 2001, nine putative stockholder class action lawsuits were filed in the United States District Court for the Northern District of California against the Companyus and certain of itsour current and former officers and directors. The complaints were filed on behalf of a purported class of peopleinvestors who purchased the Company’sour stock during the period between July 20, 2000 and January 31, 2001, seeking unspecified damages. The complaints allege that the Companywe and certain of itsour current and former officers and directors made false and misleading statements about the Company’sour business during the putative class period. Specifically, the complaints allege violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended. The complaints have beenwere consolidated under the name In re Tut Systems, Inc. Securities Litigation, Master File No. C-01-2659-CW (the “Securities Litigation Action”). Lead plaintiffs and lead counsel for plaintiffs have beenwere appointed. Plaintiffs filed a consolidated class action complaint on February 4, 2002. Defendants filed a Motion to Dismiss on March 29, 2002. On August 15, 2002, the Court granted in part and denied in part the Motion to Dismiss. On September 23, 2002, plaintiffs filed an amended complaint. Defendants filed a Motion to Dismiss the amended complaint, and on August 6, 2003 the Court granted in part that Motion. On September 24, 2003, Defendantsdefendants answered the remaining allegations of the amended complaint. Discovery has commenced. Trial is scheduledDefendants reached a settlement of the Securities Litigation Action in December 2003. Subject to beginpreliminary and final approval by the Court, our insurance carriers agreed to pay $10 million, on March 7, 2005.our behalf, to settle the suit. The settlement includes a release of all defendants. The Company believes it has meritorious defensesrecorded a liability in its financial statements for the proposed amount of the settlement. In addition, because the insurance carriers agreed to pay the entire $10 million settlement amount and, therefore, recovery from the insurance carriers was probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the allegations in the complaint and intends to defend the case vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Company’s business, resultsstatement of operations financial conditionbecause the amounts of the settlement and cash flowsthe insurance recovery fully offset each other. The insurance carriers paid the settlement amount to plaintiffs’ escrow agent in January 2004. The Court preliminarily approved the settlement on February 24, 2004. The settlement amount will be paid out of escrow if and when the Court finally approves the settlement. A hearing before the Court to consider final approval of the terms of settlement is currently scheduled for May 14, 2004. Because the settlement is subject to Court approval, there is no guarantee the settlement will become final.
Lefkowitz v. D’Auria, et al
On March 19, 2003, Chesky Lefkowitz, a shareholderone of the Company,our stockholders, filed a derivative complaint entitled Lefkowitz v. D’Auria, et al., No. RG03087467, in the Superior Court of the State of California, County of Alameda, against certain of the Company’sour current and former officers and directors. The complaint alleges causes of action for breach of fiduciary duty, gross negligence, breach of contract, unjust enrichment, and improper insider stock trading based on the same factual allegations contained in the Securities Litigation Action. The complaint seeks unspecified damages against the individual defendants on our behalf, of the Company, equitable relief, and attorneys’ fees. On May 21, 2003, the Companywe and the individual defendants filed separate demurrers to the complaint. We and the individual defendants reached a settlement of the derivative action in December 2003. The demurrerssettlement involves our adoption of certain corporate governance measures and payment of attorneys’ fees and expenses to the derivative plaintiff’s counsel in the amount of $722,000 and an incentive award to the derivative plaintiff in the amount of $3,000. We have not yet been heardrecorded a liability in our financial statements for the proposed amount of the settlement. In addition, because the insurance carrier involved in this suit agreed to pay the entire $725,000 settlement amount and, therefore, recovery from the insurance carrier was probable, a receivable was also recorded for the same amount. Accordingly, there is no impact to the statement of operations because the amounts of the settlement and the insurance recovery
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fully offset each other. The settlement was approved by the Court on January 12, 2004, and, no trial date has been established.shortly thereafter, the insurance carrier paid the settlement amount to the derivative plaintiff’s counsel. Therefore, in the first quarter of 2004, the $725,000 was removed from the insurance settlement receivable and the legal settlement liability. The settlement includes a release of our company and the individual defendants.
On October 30, 2001, the Company and certain of its current and former officers and directors were named as defendants in Whalen v. Tut Systems, Inc. et al., Case No. 01-CV-9563, a purported securities class action lawsuit filed in the United States District Court for the Southern District of New York. An amended complaint was filed on December 5, 2001. A consolidated amended complaint was filed on April 19, 2002. The consolidated amended complaint asserts that the prospectuses from the Company’s January 29, 1999 initial public offering and its March 23, 2000 secondary offering failed to disclose certain alleged actions by the underwriters for the offerings. The complaint alleges claims against the Company and certain of its current and former officers and directors under Section 11 of the Securities Act of 1933, as amended, (the “1933 Act”) and under Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934, as amended, and alleges claims against certain of its current and former officers and directors under Sections 15 and 20(a) of the 1933 Act. The complaints also name as defendants the underwriters for the Company’s initial public offering and secondary offering. The Court has denied the Company’s motion to dismiss. The Company’s Board recently approved a tentative settlement proposal from the plaintiffs. The settlement is subject to a number of conditions, including approval of the Court. If the settlement does not occur, and the litigation against the Company continues, the Company believes it has meritorious defenses to the allegations in the complaint and intends to defend the case vigorously. An unfavorable resolution of this litigation could have a material adverse effect on the Company’s business, results of operations, financial condition and cash flows.
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The Company isWe are subject to other legal proceedings, claims and litigation arising in the ordinary course of business. The Company’sOur management does not expect that the ultimate costs to resolve these matters will have a material adverse effect on the Company’sour consolidated financial position, results of operations, or cash flows.
ITEM 2.CHANGES IN SECURITIES, AND USE OF PROCEEDSAND ISSUER PURCHASES OF EQUITY SECURITIES
None
ITEM 3.DEFAULTS UPON SENIOR SECURITIES
None
None
None
None
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ITEM 6.EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
Exhibit
| Description | |||
2.1 | ||||
Agreement and Plan of Merger by and among Tut | ||||
3.1 | Second Amended and Restated Certificate of Incorporation of the Company.(1) | |||
3.2 | Bylaws of the Company, as currently in effect. | |||
4.1 | Specimen Common Stock Certificate.(1) | |||
10.1* | 1992 Stock Plan, as amended, and form of Stock Option Agreement thereunder.(1) | |||
10.2* | 1998 Stock Plan and forms of Stock Option Agreement and Stock Purchase Agreement thereunder.(1) | |||
10.3* | 1998 Employee Stock Purchase Plan, as amended.(2) | |||
10.4* | 1998 Stock Plan Inland Revenue Approved Rules for UK Employees. | |||
10.5 | American Capital Marketing, Inc. 401(k) Plan.(1) | |||
10.6 | ||||
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Form of Indemnification Agreement entered into between the Company and each director and officer.(1) |
39
Exhibit | Description | ||
10.7 | |||
Agreement and General Release between the Company and And Yet, Inc. dated July 31, 1998.(1) | |||
10.8 | |||
Home Phoneline Promoters Agreement by and between the Company and IBM Corporation, Hewlett-Packard Company, Compaq Computer Corporation, Advanced Micro Devices, Inc., Intel Corporation, Epigram, Inc., AT&T Wireless Services Inc., 3Com Corporation, Rockwell Semiconductor Systems, Inc. and Lucent Technologies Inc. dated | |||
10.9 | Master Agreement between the Company and Compaq Computer Corporation dated April 21, 1998 including supplements thereto.(1) | ||
10.10 | |||
Extension Agreement among the Company, And Yet, Inc. and Marty Graham dated December 21, 1998.(1) | |||
10.11 | |||
Commercial Office Lease between Las Positas LLC and the Company, dated March 8, 2000. | |||
10.12* | Executive Retention and Change of Control Plan. | ||
10.13* | Non-Executive Retention and Change of Control Plan and Summary Plan Description. | ||
10.14* | Non-Qualified Stock Option Agreement issued to Mark Carpenter on March 3, 2000. | ||
10.15* | 1999 Non-Statutory Stock Option | ||
Plan(7) | |||
| |||
10.16 | |||
Office Lease Agreement between Kruse Way Office Associates Limited Partnership and | |||
10.17 | Office Lease Agreement between The Richard Oppenheimer Living Trust, The Maurice Oppenheimer Living Trust, The Helene Oppenheimer Living Trust, and Tut Systems Inc. dated November 2002. | ||
10.18 | Agreement for the sale and purchase of the entire share capital of Xstreamis plc, by and among the Company, the shareholders of Xstreamis plc and Philip Corbishley.(5) | ||
11.1 | Calculation of net loss per share (contained in Note 3 of Notes to Unaudited Condensed Consolidated Financial Statements). |
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31.1 | Certification of | ||
31.2 | Certification of | ||
32.1 | Certification of | ||
32.2 | Certification of |
40
(1) Incorporated by reference to our Registration Statement on Form S-1 (File No. 333-60419) as declared effective by the Securities and Exchange Commission on January 28, 1999.
(2) Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended March 31, 1999.
(3) Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 1999.
(4) Incorporated by reference to our Registration Statement on Form S-1 (File No. 333-31446) as declared effective by the Securities and Exchange Commission on March 23, 2000.
(5) Incorporated by reference to our Current Report on Form 8-K dated May 26, 2000 as filed June 9, 2000.
(6) Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2000.
(7) Incorporated by reference to our Schedule TO (File No. 005-58093) filed May 11, 2001.
(8) Incorporated by reference to our Current Report on Form 8-K dated October 29, 2002.
(9) Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2002.
* Indicates management contracts or compensatory plans and arrangements.
(b) Reports on Form 8-K.
The Company filed the following Current ReportReports on Forms 8-K during the quarter ended September 30, 2003:March 31, 2004:
On July 31, 2003,February 2, 2004, the Company filedfurnished a Current Report on Form 8-K regarding the Company’s issuance of a press release stating its earnings for the fourth quarter and year ended June 30,December 31, 2003.
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Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
TUT | |||
| |||
By: | /s/ RANDALL K. | ||
Randall K. Gausman
| |||
Date: May 7, 2004 |
Date: October 30, 200341
47
INDEX TO EXHIBITS
Exhibit | Description | |||
2.1 | ||||
Agreement and Plan of Merger by and among Tut Systems, Inc., Tiger Acquisition Corporation, Tektronix, Inc. and VideoTele.com, Inc. dated as of October 28, 2002. | ||||
3.1 | Second Amended and Restated Certificate of Incorporation of the Company.(1) | |||
3.2 | Bylaws of the Company, as currently in effect. | |||
4.1 | Specimen Common Stock Certificate.(1) | |||
10.1* | 1992 Stock Plan, as amended, and form of Stock Option Agreement thereunder.(1) | |||
10.2* | 1998 Stock Plan and forms of Stock Option Agreement and Stock Purchase Agreement thereunder.(1) | |||
10.3* | 1998 Employee Stock Purchase Plan, as amended.(2) | |||
10.4* | 1998 Stock Plan Inland Revenue Approved Rules for UK Employees. | |||
10.5 | American Capital Marketing, Inc. 401(k) Plan.(1) | |||
10.6 |
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Form of Indemnification Agreement entered into between the Company and each director and officer.(1) | |||
10.7 | |||
Agreement and General Release between the Company and And Yet, Inc. dated July 31, 1998.(1) | |||
10.8 | |||
Home Phoneline Promoters Agreement by and between the Company and IBM Corporation, Hewlett-Packard Company, Compaq Computer Corporation, Advanced Micro Devices, Inc., Intel Corporation, Epigram, Inc., AT&T Wireless Services Inc., 3Com Corporation, Rockwell Semiconductor Systems, Inc. and Lucent Technologies Inc. dated | |||
10.9 | Master Agreement between the Company and Compaq Computer Corporation dated April 21, 1998 including supplements thereto.(1) | ||
10.10 | |||
Extension Agreement among the Company, And Yet, Inc. and Marty Graham dated December 21, 1998.(1) | |||
10.11 | |||
Commercial Office Lease between Las Positas LLC and the Company, dated March 8, 2000. | |||
10.12* | Executive Retention and Change of Control Plan. |
(6)
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10.13* | Non-Executive Retention and Change of Control Plan and Summary Plan Description. | ||
10.14* | Non-Qualified Stock Option Agreement issued to Mark Carpenter on March 3, 2000. | ||
10.15* | 1999 Non-Statutory Stock Option | ||
10.16 | |||
Office Lease Agreement between Kruse Way Office Associates Limited Partnership and | |||
10.17 | Office Lease Agreement between The Richard Oppenheimer Living Trust, The Maurice Oppenheimer Living Trust, The Helene Oppenheimer Living Trust, and Tut Systems Inc. dated November 2002. | ||
10.18 | Agreement for the sale and purchase of the entire share capital of Xstreamis plc, by and among the Company, the shareholders of Xstreamis plc and Philip Corbishley.(5) |
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Exhibit | Description | ||
11.1 | Calculation of net loss per share (contained in Note 3 of Notes to Unaudited Condensed Consolidated Financial Statements). | ||
31.1 | Certification of | ||
31.2 | Certification of | ||
32.1 | Certification of | ||
32.2 | Certification of |
50(1) Incorporated by reference to our Registration Statement on Form S-1 (File No. 333-60419) as declared effective by the Securities and Exchange Commission on January 28, 1999.
(2) Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended March 31, 1999.
(3) Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 1999.
(4) Incorporated by reference to our Registration Statement on Form S-1 (File No. 333-31446) as declared effective by the Securities and Exchange Commission on March 23, 2000.
(5) Incorporated by reference to our Current Report on Form 8-K dated May 26, 2000 as filed June 9, 2000.
(6) Incorporated by reference to our Quarterly Report on Form 10-Q for the quarter ended June 30, 2000.
(7) Incorporated by reference to our Schedule TO (File No. 005-58093) filed May 11, 2001.
(8) Incorporated by reference to our Current Report on Form 8-K dated October 29, 2002.
(9) Incorporated by reference to our Annual Report on Form 10-K for the year ended December 31, 2002.
* Indicates management contracts or compensatory plans and arrangements.
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