Loading...
Docoh

DZS (DZSI)

Filed: 8 Nov 18, 4:43pm
Table of Contents


   
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
   
FORM 10-Q 
   
(Mark One)
xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2018
OR
¨TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period from             to             
000-32743
(Commission File Number)
   
DASAN ZHONE SOLUTIONS, INC.
(Exact name of registrant as specified in its charter)
   
Delaware 22-3509099
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification Number)
   
7195 Oakport Street
Oakland, California
 94621
(Address of principal executive offices) (Zip code)
(510) 777-7000
(Registrant’s telephone number, including area code) 
   
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).     Yes   x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and "emerging growth company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer¨ Accelerated filer¨
Non-accelerated filer
¨ 
 Smaller reporting companyx
   Emerging growth company¨


Table of Contents


If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.  ¨ 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
  Yes  ¨    No  x
As of November 5, 2018, there were 16,575,229 shares of the registrant’s common stock outstanding.
   
    


Table of Contents


TABLE OF CONTENTS
 

3

Table of Contents


PART I. FINANCIAL INFORMATION

Item 1.    Financial Statements

4

Table of Contents


DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES
Unaudited Condensed Consolidated Balance Sheets
(In thousands, except par value)
 September 30,
2018
 December 31,
2017
Assets   
Current assets:   
Cash and cash equivalents$20,028
 $17,475
Restricted cash7,825
 12,425
Accounts receivable - trade, net   
Third parties58,880
 48,257
Related parties2,139
 13,498
Other receivables

  
Suppliers and others28,097
 12,494
Related parties91
 164
Inventories45,457
 25,344
Prepaid expenses and other current assets12,256
 3,652
Total current assets174,773
 133,309
Property and equipment, net5,374
 5,873
Goodwill3,977
 3,977
Intangible assets, net5,933
 6,785
Non-current deferred taxes2,895
 2,954
Long-term restricted cash847
 1,512
Other assets1,400
 4,717
Total assets$195,199
 $159,127
Liabilities, Stockholders’ Equity and Non-controlling Interest  
Current liabilities:   
Accounts payable - trade   
Third parties$52,943
 $31,441
Related parties1,302
 1,351
Short-term debts

 

Bank and trade facilities34,171
 19,790
Related party3,148
 
Other payables   
Third parties1,769
 2,032
Related parties1,859
 1,956
Contract liabilities - current2,394
 3,279
Accrued and other liabilities10,315
 11,174
Total current liabilities107,901
 71,023
Long-term debts   
Bank and trade facilities
 2,987
Related parties5,000
 6,800
Contract liabilities - non-current1,851
 1,883
Other long-term liabilities2,677
 2,667
Total liabilities117,429
 85,360
Commitments and contingencies (Note 11)
 
Stockholders’ equity and non-controlling interest:   
Common stock, authorized 36,000 shares, 16,566 shares and 16,410 shares outstanding as of September 30, 2018 and December 31, 2017 at $0.001 par value16
 16
Additional paid-in capital92,408
 90,198
Accumulated other comprehensive income5
 1,871
Accumulated deficit(15,190) (18,852)
Total stockholders’ equity77,239
 73,233
Non-controlling interest531
 534
Total stockholders’ equity and non-controlling interest77,770
 73,767
Total liabilities, stockholders’ equity and non-controlling interest$195,199
 $159,127

See accompanying notes to unaudited condensed consolidated financial statements.
5



Table of Contents


DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES
Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss)
(In thousands, except per share data)
 
 Three Months Ended Nine Months Ended
 September 30, September 30,
 2018 2017 2018 2017
Net revenue:   
Third parties$70,227
 $60,513
 $203,317
 $150,834
Related parties1,687
 5,925
 4,358
 27,657
Total net revenue71,914
 66,438
 207,675
 178,491
Cost of revenue:       
Products and services - third parties46,565
 38,301
 134,234
 95,103
Products and services - related parties1,765
 5,569
 4,651
 22,851
Amortization of intangible assets153
 153
 459
 459
Total cost of revenue48,483
 44,023
 139,344
 118,413
Gross profit23,431
 22,415
 68,331
 60,078
Operating expenses:       
Research and product development8,655
 8,939
 26,346
 27,462
Selling, marketing, general and administrative11,106
 11,661
 35,212
 33,096
Amortization of intangible assets131
 154
 393
 1,191
Total operating expenses19,892
 20,754
 61,951
 61,749
Operating income (loss)3,539
 1,661
 6,380
 (1,671)
Interest income42
 36
 203
 82
Interest expense(447) (263) (1,330) (793)
Other income (expense), net(572) 60
 (859) 43
Income (loss) before income taxes2,562
 1,494
 4,394
 (2,339)
Income tax expense735
 107
 1,071
 646
Net income (loss)1,827
 1,387
 3,323
 (2,985)
Net income (loss) attributable to non-controlling interest29
 (12) 2
 172
Net income (loss) attributable to DASAN Zhone Solutions, Inc.$1,798
 $1,399
 $3,321
 $(3,157)
        
Foreign currency translation adjustments391
 (284) (1,839) 1,782
Comprehensive income (loss)2,218
 1,103
 1,484
 (1,203)
Comprehensive income (loss) attributable to non-controlling interest16
 (14) (3) 191
Comprehensive income (loss) attributable to DASAN Zhone Solutions, Inc.$2,202
 $1,117
 $1,487
 $(1,394)
        
Net income (loss) per share attributable to DASAN Zhone Solutions, Inc.       
     Basic$0.11
 $0.09
 $0.20
 $(0.19)
     Diluted$0.11
 $0.09
 $0.20
 $(0.19)
        
Weighted average shares outstanding used to compute basic net income (loss) per share16,683
 16,382
 16,425
 16,380
Weighted average shares outstanding used to compute diluted net income (loss) per share16,891
 16,382
 16,640
 16,380
See accompanying notes to unaudited condensed consolidated financial statements.

6

Table of Contents


DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES
Unaudited Condensed Consolidated Statements of Cash Flows
(In thousands)
 Nine Months Ended
 September 30,
 2018 2017
Cash flows from operating activities:   
Net income (loss)$3,323
 $(2,985)
Adjustments to reconcile net income (loss) to net cash used in operating activities:
 
Depreciation and amortization2,033
 3,105
Stock-based compensation1,357
 670
Valuation allowance on inventories753
 1,003
Unrealized loss (gain) on foreign currency transactions226
 (185)
Deferred taxes(56) 
Changes in operating assets and liabilities:
 
Accounts receivable(14,536) (2,948)
Inventories(21,967) (1,581)
Prepaid expenses and other assets(7,942) (101)
Accounts payable24,790
 6,713
Accrued and other liabilities(3,695) (4,314)
Net cash used in operating activities(15,714) (623)
Cash flows from investing activities:
 
Proceeds from sale of short-term investments
 1,463
Purchase of short-term investments
 (430)
Proceeds from disposal of property and equipment and other assets1
 6
Purchase of property and equipment(753) (840)
Purchase of intangible asset
 (72)
Net cash (used in) provided by investing activities(752) 127
Cash flows from financing activities:
 
Proceeds from short-term borrowings from bank and trade facilities61,419
 13,778
Proceeds from short-term borrowings from related party6,098
 
Repayments of borrowings from bank and trade facilities(48,739) (15,627)
Repayments of borrowings related party(4,460) 
Proceeds from issuance of common stock853
 28
Net cash provided by (used in) financing activities15,171
 (1,821)
Effect of exchange rate changes on cash and restricted cash(1,417) 977
Net decrease in cash and cash equivalents(2,712) (1,340)
Cash, cash equivalents and restricted cash at beginning of period31,412
 24,543
Cash, cash equivalents and restricted cash at end of period$28,700
 $23,203
Reconciliation of cash, cash equivalents and restricted cash to statement of financial position   
      Cash and equivalents$20,028
 $10,145
      Restricted cash7,825
 13,058
      Long-term restricted cash847
 
      Cash, cash equivalents and restricted cash in statement of financial position$28,700
 $23,203
See accompanying notes to unaudited condensed consolidated financial statements.


7


Notes to Unaudited Condensed Consolidated Financial Statements
 
(1)    Organization and Summary of Significant Accounting Policies
(a)Description of Business
DASAN Zhone Solutions, Inc. (referred to, collectively with its subsidiaries, as "DZS" or the "Company") is a global provider of network access solutions and communications equipment for service provider and enterprise networks. The Company provides a wide array of reliable, cost-effective networking technologies, including broadband access, Ethernet switching, mobile backhaul, Passive Optical LAN and software-defined networks, to a diverse customer base that includes more than 1,000 customers in more than 50 countries worldwide.
DZS was incorporated under the laws of the state of Delaware in June 1999, under the name Zhone Technologies, Inc. On September 9, 2016, the Company acquired Dasan Network Solutions, Inc., a California corporation ("DNS") through the merger of a wholly owned subsidiary of the Company with and into DNS, with DNS surviving as a wholly owned subsidiary of the Company (the "Merger"). At the effective time of the Merger, all issued and outstanding shares of capital stock of DNS held by DASAN Networks, Inc. ("DNI") were canceled and converted into the right to receive shares of the Company's common stock in an amount equal to 57.3% of the issued and outstanding shares of the Company's common stock immediately following the Merger. In connection with the Merger, the Company changed its name from Zhone Technologies, Inc. to DASAN Zhone Solutions, Inc.
The Company is headquartered in Oakland, California with flexible in-house production facilities in Seminole, Florida and contract manufacturers located in China, India, Korea and Vietnam. The Company also maintains offices to provide sales and customer support at various domestic and international locations.
(b)Risks and Uncertainties
Liquidity
The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles in the United States ("U.S. GAAP"), assuming the Company will continue as a going concern.
The Company had net income of $3.3 million for the nine months ended September 30, 2018, and $1.2 million for the year ended December 31, 2017. As of September 30, 2018, the Company had an accumulated deficit of $15.2 million and working capital of $66.9 million. In addition, the Company had a net cash outflow from operations of $15.7 million for the nine months ended September 30, 2018. As of September 30, 2018, the Company had $20.0 million in cash and cash equivalents, which included $6.0 million in cash balances held by its international subsidiaries, and $42.3 million in aggregate principal debt of which $37.3 million was in current liabilities. Also, as of September 30, 2018, the Company had $6.4 million committed as cash collateral for letters of credit under its revolving credit facilities, and $12.9 million outstanding indebtedness under those facilities, leaving $21.3 million in aggregate financing availability under the facilities. Subsequent to the end of the quarter, the Company repaid $6.0 million in borrowings to Wells Fargo Bank ("WFB"), which constituted all of the outstanding balance under its Wells Fargo Bank Facility (the “WFB Facility”). On July 12, 2018, the Company amended the WFB Facility by entering into an Amended and Restated Credit and Security Agreement (the “A&R Domestic Credit Agreement”) and an Amended and Restated Credit and Security Agreement (the “A&R Ex-Im Credit Agreement”) with WFB which amended and replaced the Company’s existing senior secured revolving line of credit and letter of credit facilities with WFB and revised certain reporting and compliance provisions. The A&R Domestic Credit Agreement and the A&R Ex-Im Credit Agreement (together, the “Amended WFB Facility") is described more fully in Note 7 to the unaudited condensed consolidated financial statements. On October 22, 2018, the Company borrowed $3.0 million under the Amended WFB Facility. On October 31, 2018, the Company repaid the $3.0 million in full.
The Company’s current lack of liquidity could harm it by:
increasing its vulnerability to adverse economic conditions in its industry or the economy in general;
requiring substantial amounts of cash to be used for debt servicing, rather than other purposes, including operations;
limiting its ability to plan for, or react to, changes in its business and industry;
limiting its ability to complete the Keymile acquisition; and

8

Table of Contents


influencing investor and customer perceptions about its financial stability and limiting its ability to obtain financing or acquire customers.
These factors indicate that cash flows might not be sufficient for the Company to meet its obligations as they come due in the ordinary course of business for a period of 12 months from the date of this Quarterly Report on Form 10-Q.
The Company’s ability to meet its obligations as they become due in the ordinary course of business for the next 12 months will depend on its ability (i) to achieve forecasted results, (ii) access funds approved under existing or new credit facilities and/or raise additional capital through sales of the Company’s common stock to the public and (iii) effectively manage inventory procurement. If the Company cannot raise additional funds when it needs or wants them, its operations and prospects could be negatively affected. Management’s belief that it will achieve forecasted results assumes that, among other things, the Company will continue to be successful in implementing its business strategy and that there will be no material adverse development in its business, liquidity or capital requirements. If one or more of these factors do not occur as expected, it could cause the Company to fail to meet its obligations as they come due.
The Company plans to focus on capital raising, cost management, operating efficiency and restrictions on discretionary spending. In addition, if necessary, the Company may sell assets, issue or enter into amendments of its debt or equity securities, or purchase credit insurance. The Company may also reduce the scope of its planned product development, reduce sales and marketing efforts and reduce its operations in low margin regions, including reductions in headcount.
Based on the Company's current plans and current business conditions, the Company believes that these measures along with its existing cash, cash equivalents and available credit facilities will be sufficient to satisfy its anticipated cash requirements for at least the next 12 months from the date of this Quarterly Report on Form 10-Q.
Other Uncertainties
DNI owned approximately 57.3% of the outstanding shares of the Company's common stock as of September 30, 2018. For so long as DNI and its affiliates hold shares of the Company's common stock representing at least a majority of the votes, DNI will be able to freely nominate and elect all the members of the Company's board of directors, subject to the provisions of the Company's bylaws and applicable requirements under Nasdaq listing rules and applicable laws. The directors elected by DNI will have the authority to make decisions affecting the Company's capital structure, including the issuance of additional capital stock or options, the incurrence of additional indebtedness, the implementation of stock repurchase programs, and the declaration of dividends. The interests of DNI may not coincide with the interests of the Company's other stockholders or with holders of the Company's indebtedness. DNI’s ability to control all matters submitted to the Company's stockholders for approval limits the ability of other stockholders to influence corporate matters and, as a result, the Company may take actions that the Company's other stockholders or holders of the Company's indebtedness do not view as beneficial. See Notes 9 and 11 to the unaudited condensed consolidated financial statements for additional information.
(c)Reclassifications
For the three months ended September 30, 2017, certain statement of comprehensive income (loss) items have been reclassified to correctly reflect research and product development expenses and selling, marketing, general and administrative expenses of $0.1 million and $0.2 million, respectively, which were previously incorrectly classified as cost of revenue-products and services. For the nine months ended September 30, 2017 certain prior period statement of comprehensive loss items have been reclassified to correctly reflect research and product development expenses and selling, marketing, general and administrative expenses of $0.4 million and $0.6 million, respectively, which were incorrectly classified as cost of revenue-products and services.
(d)Basis of Presentation
For a description of what the Company believes to be the critical accounting policies and estimates used in the preparation of the Company's unaudited condensed consolidated financial statements, refer to the Company's Annual Report on Form 10-K for the year ended December 31, 2017.
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. GAAP for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the Company does not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

9

Table of Contents


The unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary for a fair statement of the results for the interim periods presented. All intercompany transactions and balances have been eliminated in consolidation. The results of operations for the current interim period are not necessarily indicative of results to be expected for the current year or any other period. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements of the Company and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017 filed with the Securities and Exchange Commission ("SEC").
(e)Reverse Stock Split
On February 28, 2017, the Company filed a Certificate of Amendment with the Delaware Secretary of State to amend the Company's Restated Certificate of Incorporation, which amendment effected a one-for-five reverse stock split of the Company's common stock and reduced the authorized shares of the Company's common stock from 180 million to 36 million. As a result of the reverse stock split, the number of shares of the Company’s common stock then issued and outstanding was reduced from approximately 81.9 million to approximately 16.4 million. References to shares of the Company's common stock, stock options (and associated exercise price) and restricted stock units in this Quarterly Report on Form 10-Q are provided on a post-reverse stock split basis.
(f)Concentration of Risk
The Company’s customers include competitive and incumbent local exchange carriers, competitive access providers, internet service providers, wireless carriers and resellers serving these markets. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Allowances are maintained for potential doubtful accounts.
For the three and nine months ended September 30, 2018, one customer each accounted for 11% of net revenue, respectively. For the three months ended September 30, 2017, two customers represented 10% and 9% (a related party) of net revenue, respectively. For the nine months ended September 30, 2017, two customers each represented 9% of net revenue (one of which was a related party).
As of September 30, 2018, one customer represented 12% of net accounts receivable. As of December 31, 2017, two customers represented 20% (a related party) and 11% of net accounts receivable, respectively.
As of September 30, 2018 and December 31, 2017, receivables from customers in countries other than the United States represented 89% and 84%, of net accounts receivable, respectively.
(g)Recent Accounting Pronouncements
Recent Accounting Pronouncements Adopted
In May 2014, the FASB issued ASU No. 2014-09 “Revenue from Contracts with Customers” (“Topic 606”), which provides a single comprehensive model for entities to use in accounting for revenue arising from contracts with customers. Topic 606 replaced most existing revenue recognition standards under U.S. GAAP, including ASC 605, Revenue Recognition ("Topic 605").
On January 1, 2018, the Company adopted Topic 606 and applied this guidance to all open contracts at the date of adoption using the modified retrospective method. The Company recognized the cumulative effect of initially applying Topic 606 as an adjustment to the balance of accumulated deficit at January 1, 2018. The comparative information has not been restated and continues to be reported under Topic 605.
The Company’s adoption of Topic 606 primarily impacted the following:
Topic 606 requires an allocation of revenue to performance obligations identified within an arrangement. Topic 605 restricted the allocation of revenue that is contingent on future deliverables to current deliverables, however, Topic 606 removes this restriction, to the extent that the future deliverables represent performance obligations that are distinct. Under Topic 606, the nature of the performance obligations identified within a contract impacts the allocation of the transaction price between deliverables.
Some of the Company’s contracts include customer acceptance terms, which provide protection to the customer by allowing it to either cancel a contract or force the Company to take corrective actions if products or services do not meet the requirements in the contract. Under Topic 606, customer acceptance that is considered a “formality”, would result in revenue recognized when control of the product or service

10

Table of Contents


is transferred to customer, which is typically upon shipment or delivery dependent upon the terms of the underlying contract.
The following table summarizes the effects of Topic 606 on the Company’s unaudited condensed consolidated balance sheet at January 1, 2018 (in thousands):
 As of January 1, 2018
  Balance after adoption of ASC 606  Adjustments  Balance without adoption of ASC 606
 Assets     
 Accounts receivable, net$62,099
 $344
(1) 
$61,755
 Inventories25,239
 (105)
(2) 
25,344
 Liabilities    

 Contract liabilities - current3,038
 (241)
(2) 
3,279
 Accrued and other liabilities11,518
 344
(1) 
11,174
 Contract liabilities - non-current1,711
 (172)
(2) 
1,883
 Stockholders’ equity     
 Accumulated deficit(18,544) 308
 (18,852)

(1) Allowance for sales returns was historically presented as a contra-asset within accounts receivable on the Company's consolidated balance sheets. Upon the adoption of Topic 606, the Company presents the allowance for sales returns in Accrued and other liabilities (current).
(2) Represents the impact of allocation of transaction price to separate performance obligations in open contracts as of the adoption date on a relative standalone selling price basis and acceleration of revenue (and related costs) for contracts for which acceptance clauses are a formality.
The following table summarizes the effects of Topic 606 on the Company’s unaudited condensed consolidated balance sheet as of September 30, 2018 (in thousands): 
 As of September 30, 2018
  As reported  Adjustments   Balance without adoption of ASC 606
 Assets      
 Accounts receivable, net$61,019
 $(5,356)
(1) 
(3) 
$66,375
 Inventories45,457
 62
(2) 
 45,395
 Prepaid expenses and other current assets12,256
 5,984
(3) 
 6,272
 Liabilities      
 Contract liabilities - current2,394
 (75)
(2) 
 2,469
 Accrued and other liabilities10,315
 628
(1) 
 9,687
 Contract liabilities - non-current1,851
 36
(2) 
 1,815
 Stockholders’ equity      
 Accumulated deficit(15,190) 101
  (15,291)
 
(1) Allowance for sales returns was historically presented as a contra-asset within accounts receivable on the Company's consolidated balance sheets. Upon the adoption of Topic 606, the Company presents the allowance for sales returns in Accrued and other liabilities (current).
(2) Represents the impact of allocation of transaction price to separate performance obligations in open contracts as of September 30, 2018 on a relative standalone selling price basis and acceleration of revenue (and related costs) for contracts for which acceptance clauses are a formality.
(3) Represents conditional rights to consideration as of September 30, 2018.


11

Table of Contents


The following table summarizes the effects of Topic 606 on the Company’s unaudited condensed consolidated statement of operations for the three and nine months ended September 30, 2018 (in thousands):
 Three Months Ended September 30, 2018
 As reported Adjustments Balance without adoption of ASC 606
Net revenue$71,914
 $386
 $71,528
Cost of revenue - products and services48,483
 5
 48,478
Gross profit23,431
 381
 23,050
Income tax expense(735) 
 (735)
Net income1,827
 381
 1,446
 Nine Months Ended September 30, 2018
 As reported Adjustments Balance without adoption of ASC 606
Net revenue$207,675
 $39
 $207,636
Cost of revenue - products and services139,344
 (62) 139,406
Gross profit68,331
 101
 68,230
Income tax expense(1,071) 
 (1,071)
Net income3,323
 101
 3,222
There was no impact on net revenue from related parties as a result of Topic 606.
Revenue Recognition Accounting Policy
Revenue Recognition
Revenue from contracts with customers is recognized when control of the promised goods or services is transferred to the customers, in an amount that reflects the consideration the Company expects to be entitled to in exchange for those goods or services.
The Company generates revenue primarily from sales of products and services, including, extended warranty service and customer support. Revenue from product sales is recognized at a point in time when control of the goods is transferred to the customer, generally occurring upon shipment or delivery dependent upon the terms of the underlying contract. Revenue from services is generally recognized over time on a ratable basis over the contract term, using an output measure of progress, as the contracts usually provide the customer equal benefit throughout the contract period. The Company typically invoices customers for support contracts in advance, for periods ranging from one to five years.
Revenue from all sales types is recognized at the transaction price, which is the amount the Company expects to be entitled to in exchange for transferring goods and/or providing services. Transaction price is calculated as selling price net of variable consideration. Sales to certain distributors are made under arrangements which provide the distributors with volume discounts, price adjustments, and other allowances under certain circumstances. These adjustments and allowances are accounted for as variable consideration. To estimate variable consideration, the Company analyzes historical data, channel inventory levels, current economic trends and changes in customer demand for the Company's products, among other factors. Historically, variable consideration has not been a significant component of the Company’s contracts with customers. As of September 30, 2018, the total estimate of variable consideration was not significant.
Contracts with Multiple Performance Obligations
Some of the Company's contracts with customers contain multiple promised goods or services. For these contracts, the Company accounts for the promises separately as individual performance obligations if they are distinct. In determining whether performance obligations meet the criteria for being distinct, the Company considers a number of factors, including the degree of interrelation and interdependence between obligations and whether or not the good or service significantly modifies or transforms another good or service in the contract. After identifying the separate performance obligations, the transaction price is allocated to the separate performance obligations on a relative standalone selling price basis. Standalone selling prices for

12

Table of Contents


products are determined using either an adjusted market assessment or expected cost-plus margin. For customer support and extended warranty services, standalone selling price is primarily based on the prices charged to customers. Remaining performance obligations represent the transaction price allocated to performance obligations that are unsatisfied or partially unsatisfied as of the end of the reporting period. Unsatisfied and partially unsatisfied performance obligations primarily consist of backlog, which are products and services for which customer purchase orders have been accepted and that are in the process of being delivered.
Contract Balances
Topic 606 distinguishes between contract assets and accounts receivable based on whether receipt of the consideration is conditional on something other than the passage of time. The Company records contract assets when it has a right to consideration and records accounts receivable when it has an “unconditional” right to consideration. Contract liabilities consist of cash payments received (or unconditional rights to receive cash) in advance of fulfilling performance obligations.
The following table reflects the changes in contract balances for the nine months ended September 30, 2018 (in thousands):
Item Balance Sheet Location September 30,
2018
 January 1,
2018
 $ change % change
Contract assets Prepaid expenses and other current assets $5,984
 $
 $5,984
 
Contract liabilities - current Contract liabilities - current 2,394
 3,038
 (644) (21)%
Contract liabilities - non-current Contract liabilities - non-current 1,851
 1,711
 140
 8 %
During the nine months ended September 30, 2018, contract liabilities - non-current increased and contract liabilities - current decreased primarily as a result of changes in open contracts containing multiple performance obligations. As of September 30, 2018, contract assets increased as a result of the timing of certain events for the right to consideration to become unconditional. There were no significant changes in estimates during the nine months ended September 30, 2018 that would affect the contract assets and liabilities balances.
During the three and nine months ended September 30, 2018, $0.4 million and $2.7 million, respectively, was recognized as revenue from the opening contract liabilities balance.
Warranties
Products sold to customers include standard warranties, covering bug fixes, minor updates such that the product continues to function according to published technical specifications. These standard warranties are assurance type warranties and do not offer any services in addition to the assurance that the product will continue working as specified. Therefore, standard warranties are not considered separate performance obligations in the arrangement. Instead, the expected cost of warranty is accrued as expense in accordance with applicable guidance. Extended warranties are sold with certain products and include additional support services. The transaction price for extended warranties is accounted for as service revenue and recognized ratably over the life of the contract.
Contract Costs
Applying a practical expedient, the Company recognizes the incremental costs of obtaining contracts, which primarily consist of sales commissions, as an expense when incurred if the amortization period of the assets that otherwise would have been recognized is one year or less. These costs are included in sales and marketing expenses. If the incremental direct costs of obtaining a contract relate to a service recognized over a period longer than one year, such costs are capitalized and amortized in line with the related services over the period of benefit. As of September 30, 2018, such capitalizable costs were not significant.

13

Table of Contents


Financing
The Company's contracts do not include a significant financing component. The Company applies the practical expedient not to adjust the promised amount of consideration for the effects of a financing component if the Company expects, at contract inception, that the period between when the Company transfers a good or service to the customer and when the customer pays for the good or service will be one year or less.
Shipping and Handling
The Company has elected to account for shipping and handling activities that occur after the customer has obtained control of a good as a fulfillment cost rather than as an additional promised service. As a result, the Company accrues the costs of shipping and handling when the related revenue is recognized.
Unsatisfied performance obligations
The Company does not disclose the value of unsatisfied performance obligations for (i) contracts with an original expected length of one year or less and (ii) contracts for which the Company recognizes revenue at the amount to which the Company has the right to invoice for the services performed. The majority of the Company's performance obligations in its contracts with customers relate to contracts with duration of less than one year and therefore transaction price allocated to unsatisfied performance obligations included in contracts with duration of more than 12 months was not material.
Disaggregation of Revenue
The disaggregation of revenue by geographical regions for the three and nine months ended September 30, 2018 is disclosed in Note 12.

In August 2016, FASB issued ASU 2016-15, Statement of Cash Flows, Classification of Certain Cash Receipts and Cash Payments, which addresses eight specific cash flow issues with the objective of reducing the existing diversity in practice. The updated guidance became effective for the Company on January 1, 2018 and was adopted accordingly. The adoption of this standard did not have any effect on the Company's condensed consolidated statement of cash flows for the three and nine months ended September 30, 2018 or 2017.
In November 2016, FASB issued ASU 2016-18, Statement of Cash Flows, Restricted Cash, which requires that a statement of cash flows to explain the change during the period in the total of cash, cash equivalents and amounts generally described as restricted cash and restricted cash equivalents. The updated guidance became effective for the Company beginning on January 1, 2018 and was adopted accordingly, using the retrospective approach. As a result, the Company no longer presents transfers between cash and cash equivalents and restricted cash in the consolidated cash flow statements. The condensed consolidated statement of cash flows for the nine months ended September 30, 2017 was revised to exclude the $6.1 million change in restricted cash from net cash used in investing activities and to include $6.7 million in cash, cash equivalents and restricted cash, beginning of period and $13.1 million in cash, cash equivalents and restricted cash, end of period.  
Other Recent Accounting Pronouncements
In February 2016, the FASB issued ASU 2016-02, Leases. ASU 2016-02 requires that lease arrangements longer than 12 months result in an entity recognizing an asset and liability. The updated guidance is effective for the Company on January 1, 2019, and early adoption is permitted. The Company does not plan to early adopt this guidance. The Company expects its assets and liabilities to increase as a result of the adoption of this standard. In July 2018, the FASB issued ASU 2018-18-11, Leases (Topic 842): Targeted Improvements, ASU 2018-11 states that, separating components of a contract affect the amendments in Update 2016-02, which are not yet effective but can be early adopted. All entities, including early adopters that elect the practical expedient related to separating components of a contract in this Update 2016-02 must apply the expedient, by class of underlying asset, to all existing lease transactions that qualify for the expedient at the date elected. The Company is currently assessing the potential impact of adopting this new guidance on its consolidated financial statements.
In January 2017, FASB issued ASU 2017-04, Simplifying the Test for Goodwill Impairment, which simplifies the accounting for goodwill impairment. The updated guidance is effective for the Company on January 1, 2020, and will be adopted accordingly. Early adoption is permitted. The Company is currently assessing the potential impact of adopting this new guidance on its consolidated financial statements.

14

Table of Contents


In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. The amendments in this update allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act (the "Tax Act"). Consequently, the amendments eliminate the stranded tax effects resulting from the Tax Act. Because the amendments only relate to the reclassification of the income rate tax effect of the Tax Act, the underlying guidance that requires that the effect of a change in tax laws or rates be included in income from continuing operations is not affected. The amendments in this update are effective for all entities for fiscal years beginning after December 15, 2018 and interim periods in those years. The Company does not expect the impact of the new standard to have a material impact on its consolidated financial statements.
In March 2018, the FASB issued ASU No. 2018-05, Income Taxes (Topic 740), Amendments to SEC Paragraphs Pursuant to SEC Staff Accounting Bulletin No. 118. The amendments add various Securities and Exchange Commission (“SEC) paragraphs pursuant to the issuance of SEC Accounting Bulletin No. 118, Income Tax Accounting Implications of the Tax Cuts and Jobs Act (“Act”) (“SAB 118”). The SEC issued SAB 118 to address concerns about reporting entities’ ability to timely comply with the accounting requirements to recognize all of the effects of the Act in the period of enactment. SAB 118 allows disclosure that timely determination of some or all of the income tax effects from the Act are incomplete by the due date of the financial statements and if possible to provide a reasonable estimate. The Company has provided a reasonable estimate of the tax reform in the notes to the consolidated financial statements.
On July 30, 2018, the FASB issued ASU No. 2018-11, Leases (Topic 842), to provide entities with relief from the costs of implementing certain aspects of the new leasing standard, ASU 2016-0210 (codified as ASC 842). Specifically, under the amendments in ASU 2018-11, entities may elect not to recast the comparative periods presented when transitioning to ASC 842, and lessors may elect not to separate lease and nonlease components when certain conditions are met. The Company is currently assessing the potential impact of adopting this new guidance on its consolidated financial statements.
On August 28, 2018, the FASB issued ASU No. 2018-13, Fair Value Measurement (Topic 820), which removes, modifies, and adds certain disclosure requirements related to fair value measurements in ASC 820. The Company is currently assessing the potential impact of adopting this new guidance on its consolidated financial statements.
(2)Fair Value Measurement
The Company utilizes a fair value hierarchy that is intended to increase consistency and comparability in fair value measurements and related disclosures. The fair value hierarchy is based on inputs to valuation techniques that are used to measure fair value that are either observable or unobservable. Observable inputs reflect assumptions market participants would use in pricing an asset or liability based on market data obtained from independent sources while unobservable inputs reflect a reporting entity’s pricing based upon their own market assumptions. The fair value hierarchy consists of the following three levels:
Level 1 –Inputs are quoted prices in active markets for identical assets or liabilities.
Level 2 –Inputs are quoted prices for similar assets or liabilities in an active market, quoted prices for identical or similar assets or liabilities in markets that are not active, inputs other than quoted prices that are observable and market-corroborated inputs which are derived principally from or corroborated by observable market data.
Level 3 –Inputs are derived from valuation techniques in which one or more significant inputs or value drivers are unobservable.
The following financial instruments are not measured at fair value on the Company’s condensed consolidated balance sheet as of September 30, 2018 and the consolidated balance sheet as of December 31, 2017, but require disclosure of their fair values: cash and cash equivalents, accounts receivable, accounts payable and debt. The carrying values of financial instruments such as cash and cash equivalents, accounts receivable and accounts payable approximate their fair values based on their short-term nature. The carrying value of the Company's debt approximates their fair values based on the current rates available to the Company for debt of similar terms and maturities.
To manage certain exposures to currency fluctuations, the Company started a limited hedging program by entering into foreign currency forward contracts with maturities of one month to hedge a portion of its net outstanding foreign currency monetary assets and liabilities. These derivatives are recorded at fair value on the condensed consolidated balance sheet under "Other Current Assets" or "Accounts Payable - Trade" with changes in the fair value being recorded in "Other income (loss), net".

15

Table of Contents


These derivative contracts are entered into with a single counterparty, and are not designated as hedging instruments under applicable accounting guidance. As such, all changes in the fair value of these derivative contracts are recorded in other income (loss), net on the condensed consolidated statements of comprehensive income (loss). These derivative contracts are intended to offset the foreign currency gains or losses associated with the underlying monetary assets and liabilities, and changes in the related derivative assets and liabilities balances are classified outside of operating income (loss), consistent with the related underlying foreign currency gain or loss. 
These derivative contracts expose the Company to credit risk to the extent that the counterparty may be unable to meet the terms of the arrangement. The Company mitigates this credit risk by transacting with reputable financial institutions and entering into master netting arrangements, which permit net settlement of transactions with the same counterparty. While the contract or notional amount is often used to express the volume of foreign currency derivative contracts, the amounts potentially subject to credit risk are generally limited to the amounts, if any, by which the counterparties’ obligations under the agreements exceed the obligations of the Company to the counterparties. The Company is not required to pledge, and is not entitled to receive, cash collateral related to these derivative instruments. The Company does not enter into derivative contracts for trading or speculative purposes. The Company's foreign currency contracts are classified within Level 2 because the valuation inputs are based on quoted prices and market observable data of similar instruments in active markets, such as currency spot and forward rates.
As of September 30, 2018, the Company had no derivative contracts, and no liability was included in accounts payable - trade.
(3)Cash, Cash Equivalents and Restricted Cash
As of September 30, 2018 and December 31, 2017, the Company's cash and cash equivalents comprised financial deposits. Restricted cash consisted primarily of cash restricted for performance bonds, warranty bonds and collateral for borrowings. Current and long-term restricted cash was $8.7 million at September 30, 2018 and $13.9 million at December 31, 2017.
Reconciliation of cash, cash equivalents and restricted cash to statement of financial position as of September 30, 2018 and December 31, 2017 were as follows (in thousands):
 September 30,
2018
 December 31,
2017
Cash and cash equivalents$20,028
 $17,475
Restricted cash7,825
 12,425
Long-term restricted cash847
 1,512
Cash, cash equivalents and restricted cash$28,700
 $31,412

(4)Balance Sheet Detail
Accounts Receivable - Trade
Accounts receivable - trade, net as of September 30, 2018 and December 31, 2017 was as follows (in thousands):
 September 30,
2018
 December 31,
2017
Gross accounts receivable$61,324
 $63,446
Allowance for doubtful accounts(305) (922)
Allowance for sales returns
(1) 
(769)
Total allowances(305) (1,691)
Accounts receivable - trade, net$61,019
 $61,755
(1) Upon adoption of ASC 606, allowances for sales returns were reclassified to accrued and other liabilities as these reserve balances are considered estimated refund liabilities. Refer to footnote 1(g) for additional information about the adoption impact.

16

Table of Contents


Inventories
Inventories as of September 30, 2018 and December 31, 2017 were as follows (in thousands): 
 September 30,
2018
 December 31,
2017
Raw materials$19,227
 $12,671
Work in process3,474
 2,150
Finished goods22,756
 10,523
Total inventories$45,457
 $25,344
Inventories provided as collateral for borrowings from Export-Import Bank of Korea amounted to $9.5 million and $11.4 million as of September 30, 2018 and December 31, 2017, respectively.
(5)Property and Equipment
Property and equipment as of September 30, 2018 and December 31, 2017 were as follows (in thousands): 
 September 30,
2018
 December 31,
2017
Furniture and fixtures$22,495
 $22,988
Machinery and equipment5,577
 5,455
Leasehold improvements3,619
 3,647
Computers and software728
 621
Others1,034
 1,007
 33,453
 33,718
Less: accumulated depreciation and amortization(27,872) (27,584)
Less: government grants(207) (261)
Property and equipment, net$5,374
 $5,873
Depreciation expense associated with property and equipment for the three and nine months ended September 30, 2018 was $0.4 million and $1.2 million respectively. Depreciation expense for the three and nine months ended September 30, 2017 was $0.5 million and $1.4 million, respectively.
The Company receives grants from various government entities, mainly to support capital expenditures. Such grants are deferred and are generally refundable to the extent the Company does not utilize the funds for qualifying expenditures. Once earned, the Company records the grants as a contra amount to the assets and amortizes such amount over the useful lives of the related assets as a reduction to depreciation expense.
(6)Goodwill and Intangible Assets
Goodwill as of September 30, 2018 and December 31, 2017 was as follows (in thousands):
 September 30,
2018
 December 31,
2017
Beginning balance$3,977
 $3,977
Less: accumulated impairment
 
Ending balance$3,977
 $3,977
The Company did not recognize impairment loss on goodwill during the nine months ended September 30, 2018 and 2017.

17

Table of Contents


Intangible assets as of September 30, 2018 and December 31, 2017 were as follows (in thousands):
 September 30, 2018
 Gross Carrying Amount Accumulated Amortization Net
Developed technology$3,060
 $(1,276) $1,784
Customer relationships5,240
 (1,091) 4,149
Backlog2,179
 (2,179) 
Total intangible assets$10,479
 $(4,546) $5,933
 December 31, 2017
 Gross Carrying Amount Accumulated Amortization Net
Developed technology$3,060
 $(816) $2,244
Customer relationships5,240
 (699) 4,541
Backlog2,179
 (2,179) 
Total intangible assets$10,479
 $(3,694) $6,785
Amortization expense associated with intangible assets for the three and nine months ended September 30, 2018 was $0.3 million and $0.9 million, respectively. Amortization expense associated with intangible assets for the three and nine months ended September 30, 2017 was $0.3 million and $1.7 million, respectively.
(7)Debts
Wells Fargo Bank Facility
On July 12, 2018, the Company entered into the A&R Domestic Credit Agreement and the A&R Ex-Im Credit Agreement with WFB, which amended and replaced the Company’s existing senior secured revolving line of credit and letter of credit facilities with WFB and revised certain reporting and compliance provisions. The Amended WFB Facility provides for a revolving line of credit of $25.0 million (including up to $5.0 million of letters of credit), with the amount that the Company is able to borrow based on eligible accounts receivable and inventory, less the amount committed as cash collateral for letters of credit. The amounts borrowed under the Amended WFB Facility bears interest, payable monthly, at a floating rate equal to the three-month LIBOR plus a margin based on the Company's average excess availability (as calculated under the WFB Facility). To maintain availability of funds under the Amended WFB Facility, the Company pays a commitment fee on the unused portion. The commitment fee is 0.25% per annum and is recorded as interest expense. The maturity date of the Amended WFB Facility is July 12, 2021.
As of September 30, 2018, the Company had $6.0 million in outstanding borrowings under its Amended WFB Facility (included in short-term debts), and $2.1 million was committed as cash collateral for letters of credit. Subsequent to the end of the quarter, the Company repaid $6.0 million in borrowings under the WFB Facility.
Based on the Company's eligible accounts receivable and inventory, the Company had $6.5 million of financing availability under the Amended WFB Facility as of September 30, 2018. The interest rate on the Amended WFB Facility was 4.4% at September 30, 2018.
The Company’s obligations under the Amended WFB Facility are secured by substantially all of its assets and those of its subsidiaries that guarantee the Amended WFB Facility, including their intellectual property. The Amended WFB Facility contains certain financial covenants, and customary affirmative and negative covenants. If the Company defaults under the Amended WFB Facility due to a covenant breach or otherwise, WFB may, after the lapse of any applicable grace periods, be entitled to, among other things, require the immediate repayment of all outstanding amounts and sell the Company’s assets to satisfy the obligations under the Amended WFB Facility. As of September 30, 2018, the Company was in compliance with the covenants under the WFB Facility. On October 22, 2018, the Company borrowed $3.0 million under the Amended WFB Facility. On October 31, 2018, the Company repaid the $3.0 million in full.

18

Table of Contents


Bank and Trade Facilities - Foreign Operations
Certain of the Company's foreign subsidiaries have entered into various financing arrangements with foreign banks and other lending institutions consisting primarily of revolving lines of credit, trade facilities, term loans and export development loans. These facilities are renewed as they mature and are generally secured by a security interest in certain assets of the applicable foreign subsidiaries and supported by guarantees given by DNI or third parties. Payments under such facilities are made in accordance with the given lender’s amortization schedules.
As of September 30, 2018 and December 31, 2017, the Company had an aggregate outstanding balance of $28.2 million (included in short-term debts) and $22.8 million ($19.8 million included in short-term debts), respectively, under such financing arrangements, and the interest rates per annum applicable to outstanding borrowings under these financing arrangements were as listed in the tables below (amount in thousands).
    As of September 30, 2018
    Maturity DateDenominationInterest rate (%) Amount
Industrial Bank of Korea Credit facility 10/2/2018 - 2/4/2019USD3.81~4.03 $4,229
Industrial Bank of Korea Credit facility 10/10/2018 - 11/12/2018USD3.81~3.84 1,834
Industrial Bank of Korea Trade finance 10/15/2018USD6.82 651
Shinhan Bank General loan 3/30/2019KRW6.06 2,876
NongHyup Bank Credit facility 11/19/2018 - 3/4/2019USD3.95~4.17 852
The Export-Import Bank of Korea Export development loan 12/29/2018KRW3.28 6,471
The Export-Import Bank of Korea Import development loan 11/14/2018USD4.02 850
Korea Development Bank General loan 8/8/2019KRW3.48 4,494
LGUPlus General loan 6/17/2019KRW0 1,797
JECC Factoring AR Factoring 10/26/2018 - 12/25/2018JPY1.58 3,236
Shoko Chukin Bank General loan 6/28/2019JPY1.33 881
        $28,171
    As of December 31, 2017
    Maturity DateDenominationInterest rate (%) Amount
Industrial Bank of Korea Credit facility 1/2/2018 - 5/2/2018USD2.89 - 3.26 $2,328
Industrial Bank of Korea Trade Finance 1/2/2018 - 5/23/2018USD4.47 - 5.97 2,401
Shinhan Bank General loan 3/30/2019KRW5.91 2,987
Shinhan Bank Trade finance 2/19/2018- 3/26/2018KRW3.90 - 4.14 3,050
NongHyup Bank (Korea) Credit facility 1/8/2018- 6/18/2018USD2.83 - 3.42 860
The Export-Import Bank of Korea Export development loan 2/13/2018 & 6/29/2018KRW3.20 - 3.28 7,570
Mitsubishi Bank (Japan) AR factoring 1/31/2018 - 5/31/2018JPY1.58 1,872
Shinhan Bank (India) General loan 4/24/2018 - 11/12/2018INR8.70 - 8.90 1,709
        $22,777

19

Table of Contents


As of September 30, 2018, the Company had $6.9 million in outstanding borrowings and $4.3 million committed as cash collateral for letters of credit under the Company's $25.9 million credit facility with certain foreign banks. On June 18, 2018, the Company's Korean subsidiary received a mutual cooperation capital loan of $1.8 million from LGUPlus and provided a letter of guarantee of the same amount from Seoul Guarantee Insurance as collateral.
See Note 9 for a discussion of related-party debt.
(8)Non-Controlling Interests
Non-controlling interests for the nine months ended September 30, 2018 and 2017 were as follows (in thousands):
  Nine Months Ended September 30,
  2018 2017
Beginning non-controlling interests $534
 $416
Net income (loss) attributable to non-controlling interests 2
 172
Foreign currency translation adjustments (5) 19
 Ending non-controlling interests $531
 $607
(9)Related-Party Transactions
Related-Party Acquisitions
On December 31, 2017, DNS acquired 100% and 99.99% of the common stock of D-Mobile Limited (“D-Mobile”) and DASAN India Private Limited ("DASAN India"), respectively, from DNI. D-Mobile and DASAN India are resellers of the Company's products in Taiwan and India, respectively. The consideration payable by the Company to DNI for the common stock of the two subsidiaries is the net book value of D-Mobile and DASAN India at December 31, 2017, subject to final adjustments. The net book value of D-Mobile and DASAN India was an aggregate of $0.8 million. These transactions were accounted for by the Company as common control transactions, with the net assets transferred recorded at historical cost. The transactions did not result in a change in reporting entity and hence were accounted for prospectively.
Related-Party Debt
In connection with the Merger, on September 9, 2016, the Company entered into a loan agreement with DNI for a $5.0 million unsecured subordinated term loan facility. Under the loan agreement, the Company was permitted to request drawdowns of one or more term loans in an aggregate principal amount not to exceed $5.0 million. As of September 30, 2018, $5.0 million in term loans was outstanding under the facility. Such term loans mature in September 2021 and are pre-payable at any time by the Company without premium or penalty. The interest rate as of September 30, 2018 under this facility was 4.6% per annum.
In February 2016, the Company borrowed $1.8 million from DNI for capital investment, which was outstanding as of September 30, 2018. This loan matures in July 2019 and bears interest at a rate of 4.6% per annum, payable annually.
On March 21, 2018, DNS borrowed $5.8 million from DNI, of which $4.5 million was repaid on August 8, 2018. As of September 30, 2018, $1.3 million remained outstanding. The loan bears interest at a rate of 4.6% and matures on June 27, 2019, and is secured by certain accounts receivable of DNS Korea.
Other Related-Party Transactions
Sales and purchases, cost of revenue, research and product development, selling, marketing, general and administrative, interest expense and other expenses to and from related parties for the three and nine months ended September 30, 2018 and 2017 were as follows (in thousands):

20

Table of Contents


    Three Months Ended September 30, 2018
Counterparty DNI ownership Interest Sales Cost of revenue Research and product development 
Selling, marketing,
general and administrative
 Interest expense Other expenses
DNI (Parent Company) N/A $1,472
 $1,270
 $
 $784
 $112
 $89
Tomato Soft Ltd. 100% 
 27
 
 
 
 
Tomato Soft (Xi'an) Ltd. 100% 
 
 119
 
 
 
Chasan Networks Co., Ltd. 100% 
 260
 21
 
 
 
Handysoft, Inc. 17.63% 215
 208
 
 2
 
 
    $1,687
 $1,765
 $140
 $786
 $112
 $89
    Three Months Ended September 30, 2017
Counterparty DNI ownership Interest Sales Cost of revenue Research and product development Selling, marketing,
general and administrative
 Other expenses
DNI (Parent Company) N/A $3,976
 $3,604
 $
 $1,291
 $51
Chasan Networks Co., Ltd. 100% 
 257
 20
 
 
Dasan France 100% 662
 576
 
 83
 
Dasan India Private Limited 100% 
 
 
 30
 
D-Mobile 100% 1,233
 1,077
 
 122
 
HandySoft, Inc. 17.64% 54
 12
 
 6
 4
Tomato Soft Ltd. 100% 
 43
 108
 
 
Tomato Soft (Xi'an) Ltd. 100% 
 
 144
 
 
    $5,925
 $5,569
 $272
 $1,532
 $55
    
    Nine Months Ended September 30, 2018
Counterparty DNI ownership Interest Sales Cost of revenue Research and product development 
Selling, marketing,
general and administrative
 Interest expense Other expenses
DNI (Parent Company) N/A $3,683
 $3,143
 $
 $2,950
 $338
 $234
Tomato Soft Ltd. 100% 
 84
 
 
 
 
Tomato Soft (Xi'an) Ltd. 100% 
 10
 396
 
 
 
Chasan Networks Co., Ltd. 100% 
 880
 57
 
 
 
Dasan France 100% 202
 177
 
 
 
 
HandySoft, Inc. 17.63% 473
 357
 
 4
 
 
    $4,358
 $4,651
 $453
 $2,954
 $338
 $234

21

Table of Contents


    Nine Months Ended September 30, 2017
Counterparty DNI ownership Interest Sales Cost of revenue Research and product development Selling, marketing,
general and administrative
 Other expenses
DNI (Parent Company) N/A $16,608
 $14,020
 $
 $3,491
 $171
Chasan Networks Co., Ltd. 100% 
 578
 79
 
 
Dasan France 100% 1,612
 1,512
 
 383
 
Dasan India Private Limited(1)
 100% 6,287
 4,783
 
 30
 
D-Mobile(1)
 100% 3,054
 1,831
 
 318
 
Fine Solution 100% 
 
 
 4
 
HandySoft, Inc. 17.64% 88
 23
 
 6
 4
J-Mobile Corporation 90.47% 8
 
 
 132
 
Tomato Soft Ltd. 100% 
 104
 108
 
 
Tomato Soft (Xi'an) Ltd. 100% 
 
 448
 37
 
Solueta 27.21% 
 
 
 
 3
    $27,657
 $22,851
 $635
 $4,401
 $178
(1) As discussed above, on December 31, 2017 DNS acquired DASAN India and D-Mobile from DNI.            
The Company has entered into sales agreements with DNI and certain of its subsidiaries. Sales and cost of revenue to DNI and DASAN France (and with respect to the first three quarters of 2017, DASAN India and D-Mobile) represent finished goods produced by the Company that are sold to these related parties who sell the Company's products in Korea, France, India and Taiwan, respectively.
The Company has entered into an agreement with Chasan Networks Co., Ltd. to provide manufacturing and research and development services for the Company. Under the agreement with Chasan Networks., Ltd., the Company is charged a cost plus 7% fee for the manufacturing and development of certain deliverables.

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

22

Table of Contents


    As of September 30, 2018   
Counterparty DNI ownership Interest Account receivables Other receivables Deposits for lease * Loans Payable Accounts payable Other PayablesAccrued and other liabilities**
DNI (parent company) N/A $1,679
 $26
 $738
 $8,148
 $1,000
 $1,810
$157
Tomato Soft Ltd. 100% 
 
 
 
 
 9

Tomato Soft (Xi'an) Ltd. 100% 
 
 
 
 
 40

Dasan France 100% 285
 65
 
 
 
 

HandySoft, Inc. 17.63% 175
 
 
 
 216
 

Chasan Networks Co., Ltd. 100% 
 
 
 
 86
 

    $2,139
 $91
 $738
 $8,148
 $1,302
 $1,859
$157
    As of December 31, 2017    
Counterparty DNI Ownership Interest Account receivables Other receivables Deposits for lease * Long-term debt Accounts payable Other Payables Accrued and other liabilities**
DNI (parent company) N/A $12,576
 $93
 $786
 $6,800
 $1,264
 $1,859
 $59
Tomato Soft Ltd. 100% 
 
 
 
 
 18
 
Tomato Soft (Xi'an) Ltd. 100% 
 
 
 
 
 54
 
Dasan France 100% 870
 71
 
 
 
 
 
HandySoft, Inc. 17.63% 52
 
 
 
 
 
 
Chasan Networks Co., Ltd. 100% 
 
 
 
 87
 
 
Solueta 100% 
 
 
 
 
 25
 
    $13,498
 $164
 $786
 $6,800
 $1,351
 $1,956
 $59
* Included in other assets in the condensed consolidated balance sheets as of September 30, 2018 and December 31, 2017. 
**Included in accrued and other liabilities in the condensed consolidated balance sheet as of September 30, 2018 and December 31, 2017. 


23

Table of Contents


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

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

The following table is a reconciliation of the numerator and denominator in the basic and diluted net income (loss) per share calculation (in thousands, except per share data):
  Three Months Ended September 30, Nine Months Ended September 30,
  2018 2017 2018 2017
Net income (loss) attributable to DASAN Zhone Solutions, Inc. $1,798
 $1,399
 $3,321
 $(3,157)
Weighted average number of shares outstanding:        
Basic 16,683
 16,382
 16,425
 16,380
Effect of dilutive securities:        
Stock options, restricted stock units and share awards 208
 
 215
 
Diluted 16,891
 16,382
 16,640
 16,380
Net income (loss) per share attributable to DASAN Zhone Solutions, Inc.:        
Basic $0.11
 $0.09
 $0.20
 $(0.19)
Diluted $0.11
 $0.09
 $0.20
 $(0.19)
 

During the three and nine months ended September 30, 2018, the Company excluded 1.0 million, and 26 thousand stock options at a weighted average exercise price of $10.89, and $14.73, respectively, from diluted net income per share because their effect would have been antidilutive. 

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

(11)Commitments and Contingencies
Operating Leases
The Company has entered into operating leases for certain office space and equipment, some of which contain renewal options and escalation clauses. Estimated future lease payments under all non-cancellable operating leases with terms in excess of one year, including taxes and service fees, are as follows (in thousands):
 Operating Leases
Year ending December 31: 
2018 (remainder of the year)$1,053
20194,088
20202,998
20212,590
20222,664
Thereafter8,423
Total minimum lease payments$21,816

24

Table of Contents


Warranties
The Company accrues warranty costs based on historical trends for the expected material and labor costs to provide warranty services. Warranty periods are generally one to five years from the date of shipment. The following table reconciles changes in the Company’s accrued warranties and related costs for the nine months ended September 30, 2018 and 2017 (in thousands):  
 Nine Months Ended September 30,
 2018 2017
Beginning balance$931
 $878
Charged to cost of revenue1,022
 126
Claims and settlements(598) (195)
Foreign exchange impact6
 14
Ending balance$1,361
 $823
Performance Bonds
In the normal course of operations, from time to time, the Company arranges for the issuance of various types of surety bonds, such as bid and performance bonds, which are agreements under which the surety company guarantees that the Company will perform in accordance with contractual or legal obligations. As of September 30, 2018, and 2017, the Company had $2.9 million and $1.0 million of surety bonds guaranteed by third parties, respectively.
Purchase Commitments
The Company has agreements with various contract manufacturers which include non-cancellable inventory purchase commitments. The Company’s inventory purchase commitments typically allow for cancellation of orders 30 days in advance of the required inventory availability date as set by the Company at time of order. The amount of non-cancellable purchase commitments outstanding, net of reserve, was $2.4 million as of September 30, 2018.
Payment Guarantees provided by Third Parties and DNI
The following table sets forth payment guarantees of the Company's indebtedness and other obligations as of September 30, 2018 (in thousands) that have been provided by third parties and DNI. DNI owns approximately 57.3% of the outstanding shares of the Company's common stock:
Guarantor Amount Guaranteed (in thousands) Description of Obligations Guaranteed
DNI $3,451
 Borrowings from Shinhan Bank
DNI 1,726
 Purchasing Card from Shinhan Bank
DNI 10,730
 LC from Industrial Bank of Korea
DNI 2,157
 Purchasing Card from Industrial Bank of Korea
DNI 6,000
 LC from NongHyup Bank
DNI 6,170
 Borrowings from Export-Import Bank of Korea
DNI 6,000
 LC from KookMin Bank
DNI 5,392
 Borrowings from Korea Development Bank
DNI
8,400

LC from Korea Development Bank
Industrial Bank of Korea 6,486
 Borrowings and letter of credit
NongHyup Bank 3,497
 Borrowings and letter of credit
Kookmin Bank 304
 Letter of credit
Korea Development Bank 894
 Letter of credit
Shinhan Bank 933
 Purchasing Card
Industrial Bank of Korea 4,075
 Performance bonds
State Bank of India 34
 Performance bonds
Seoul Guarantee Insurance Co. 4,232
 Performance payment guarantee*
  $70,481
  
*The Company is responsible for the warranty liabilities generally for the period of two years on major product sales and has contracted surety insurance to cover part of the warranty liabilities. 

25

Table of Contents


Royalties
The Company has certain royalty commitments associated with the shipment and licensing of certain products. Royalty expense is generally based on a dollar amount per unit shipped or a percentage of the underlying revenue and is recorded in cost of revenue.
Legal Proceedings
The Company is subject to various legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, the Company records an accrual for legal contingencies that it has determined to be probable to the extent the amount of the loss can be reasonably estimated. The Company does not expect that the ultimate costs to resolve these matters will have a material adverse effect on its consolidated financial position or results of operations. However, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. If an unfavorable ruling were to occur, there exists the possibility of a material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.
(12)Stock Option and Other Benefit Plans
2018 Employee Stock Purchase Plan 
On May 22, 2018, the stockholders of the Company approved the adoption of the DASAN Zhone Solutions, Inc. 2018 Employee Stock Purchase Plan (the “ESPP”). The ESPP became effective upon stockholder approval and replaced the Company’s existing DASAN Zhone Solutions, Inc. 2002 Employee Stock Purchase Plan.
The ESPP authorizes the issuance of up to 250,000 shares of the Company’s common stock. In addition, the ESPP provides for an annual increase on the first day of each calendar year beginning on January 1, 2019 and ending on and including January 1, 2028 equal to the lesser of (i) 1% of the shares outstanding on the last day of the immediately preceding calendar year and (ii) such smaller number of shares as may be determined by the Board in its sole discretion. Notwithstanding the foregoing, the number of shares of stock that may be issued or transferred pursuant to awards under the ESPP may not exceed an aggregate of 2,000,000 shares. These 2,000,000 shares have been registered pursuant to a registration statement on Form S-8 filed with the SEC on November 8, 2018.

26

Table of Contents



(13)Enterprise-Wide Information
The Company is a global provider of network access solutions and communications equipment for service provider and enterprise networks. There are no segment managers who are held accountable for operations, operating results and plans for levels or components below the Company unit level. Accordingly, the Company is considered to be in a single reporting segment and operating unit structure. The Company’s chief operating decision maker is the Company’s Chief Executive Officer, who reviews financial information presented on a consolidated basis accompanied by disaggregated information about revenues by geographic region for purposes of making operating decisions and assessing financial performance. The Company attributes revenue from customers to individual bill to countries. The following summarizes required disclosures about geographical concentrations and revenue by products and services (in thousands):
 Three Months Ended Nine months ended
 September 30, September 30,
 2018 2017 2018 2017
Revenue by geography:       
United States$11,125
 $13,068
 $41,373
 $37,176
Canada1,131
 1,498
 3,344
 4,112
Total North America12,256
 14,566
 44,717
 41,288
Latin America6,841
 7,480
 21,713
 19,425
Europe, Middle East, Africa10,425
 7,378
 27,264
 19,134
Korea19,609
 20,520
 50,844
 69,032
Other Asia Pacific22,783
 16,494
 63,137
 29,612
Total International59,658
 51,872
 162,958
 137,203
Total$71,914
 $66,438
 $207,675
 $178,491
     
 
 Three Months Ended Nine months ended
 September 30, September 30,
 2018 2017 2018 2017
Revenue by classification:       
Products$68,787
 $63,257
 $198,830
 $169,831
Services3,127
 3,181
 8,845
 8,660
Total$71,914
 $66,438
 $207,675
 $178,491
    
The Company's property and equipment, net of accumulated depreciation, were located in the following geographical areas as of September 30, 2018 and December 31, 2017 (in thousands):
 
As of September 30,
2018
 
As of December 31,
2017
United States$3,131
 $3,393
Korea1,441
 1,633
Other Asia Pacific802
 847
 $5,374
 $5,873
(14)Income Taxes
Income tax expense for the three and nine months ended September 30, 2018 was $0.7 million and $1.1 million, respectively, on pre-tax income of $2.6 million and $4.4 million, respectively. For the three and nine months ended September 30, 2017, income tax expense was $0.1 million and $0.6 million, respectively, on pre-tax income (loss) of $1.5 million and $(2.3) million, respectively.
As of September 30, 2018, the income tax rate varied from the United States statutory income tax rate primarily due to valuation allowances in the United States and taxable income generated by the Company’s wholly-owned foreign subsidiaries.

27

Table of Contents


The total amount of unrecognized tax benefits, including interest and penalties, at September 30, 2018 was $0.5 million. The amount of tax benefits that would impact the effective income tax rate, if recognized, is $0.1 million. There were no significant changes to unrecognized tax benefits during the quarters ended September 30, 2018 and 2017. The Company does not anticipate any significant changes with respect to unrecognized tax benefits within the next 12 months.
The Company has recognized the provisional tax impacts related to the Tax Act in the Company’s consolidated financial statements for the year ended December 31, 2017. The ultimate impact may differ from provisional amounts, possibly materially, due to, among other things, additional analysis, changes in interpretations and assumptions the Company has made, additional regulatory guidance that may be issued, and actions the Company may take as a result of the Tax Act. The Company has not yet determined its policy election with respect to whether to record deferred taxes for basis differences expected to reverse as a result of the global intangible low-taxed income (“GILTI”) provisions in future periods or use the period cost method. The Company has, however, included an estimate of the current GILTI impact in its tax provision for 2018. The Company continues to evaluate the impact of the tax reform and the accounting is expected to be completed before the end of the measurement period in the fourth quarter of 2018.
(15)Subsequent Events
Keymile Acquisition / Share Purchase Agreement
On October 5, 2018, ZTI Merger Subsidiary III, Inc., a Delaware corporation, and wholly owned subsidiary of the Company (the “Purchaser”) and Riverside KM Beteiligung GmbH, a limited liability company organized under the laws of Germany (the “Seller”) entered into a Share Purchase Agreement (the “Purchase Agreement”) whereby the Purchaser agreed to purchase from the Seller all shares in Keymile GmbH (“Keymile”), a limited liability company organized under the laws of Germany, and certain of its subsidiaries, for an aggregate cash purchase price of EUR 10.25 million ($11.9 million) (the “Keymile Acquisition��). The purchase price is to be paid at closing and is subject to customary regulatory approval and satisfaction of certain closing conditions. Certain liabilities including unfunded pension liabilities are to be assumed by the Purchaser.
Keymile offers a series of multi-service access platforms for FTTx network architectures, including ultra-fast broadband copper access based on VDSL/Vectoring & G. Fast technology. The Company has pursued the acquisition to enable the strengthening of its global broadband access service market.
The Company has $42,000 of outstanding receivables and $59,000 of sales to Keymile as of and for the nine months period ended September 30, 2018.
Guarantee Agreement and Working Capital Facility
In connection with the Keymile Acquisition and the Purchase Agreement, the Company has also entered into a guarantee agreement with the Seller, dated October 5, 2018, which guarantees the purchase price of EUR 10.25 million ($11.9 million) and guarantees a working capital facility of EUR 4.0 million ($4.6 million). Both the guarantee agreement and the working capital facility are to be provided at closing of the Keymile Acquisition, which is expected to be completed in the fourth quarter of 2018.
The foregoing description of the Keymile Acquisition and the Purchase Agreement, which includes the Guarantee Agreement and Working Capital Facility as exhibits, is not complete and is qualified in its entirety by reference to the full text of the Purchase Agreement, which will be filed by the Company when the Keymile Acquisition closes on a Form 8-K.
Wells Fargo Bank Facility
On October 22, 2018, the Company borrowed $3.0 million under the Amended WFB Facility. On October 31, 2018, the Company repaid the $3.0 million in full.

Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations
Forward-Looking Statements
This report, including “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933 and the Securities Exchange Act of 1934. These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. We use

28

Table of Contents


words such as “anticipate,” “believe,” “continue,” “could,” “estimate,” “expect,” “goal,” “intend,” “may,” “plan,” “project,” “seek,” “should,” “target,” “will,” “would,” variations of such words, and similar expressions to identify forward-looking statements. In addition, statements that refer to projections of earnings, revenue, costs or other financial items as to future periods; anticipated growth and trends in our business or key markets; cost synergies, growth opportunities and other financial and operating benefits of the Merger; future growth and revenues from our products; our ability to refinance or repay our existing indebtedness prior to the applicable maturity date; future economic conditions and performance; anticipated performance of products or services; plans, objectives and strategies for future operations; and other characterizations of future events or circumstances, are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and that they are subject to risks, uncertainties and assumptions that are difficult to predict, including those identified or referenced under the heading “Risk Factors” in Part II, Item 1A, elsewhere in this report and in our other filings with the Securities and Exchange Commission (the SEC). Actual results may differ materially and adversely from those expressed in any forward-looking statements. Factors that might cause such a difference include, but are not limited to, the ability to generate sufficient revenue to achieve or sustain profitability, the ability to raise additional capital to fund existing and future operations or to refinance or repay our existing indebtedness, defects or other performance problems in our products, any economic slowdown in the telecommunications industry that restricts the ability of our customers to purchase our products, commercial acceptance of our products, intense competition in the communications equipment market from large equipment companies as well as private companies with products that address the same networks needs as our products, higher than anticipated expenses that we may incur, any failure to comply with the periodic filing and other requirements of The Nasdaq Stock Market for continued listing, material weaknesses or other deficiencies in our internal control over financial reporting, the initiation of any civil litigation, regulatory proceedings, government enforcement actions or other adverse effects relating to errors in the consolidated financial statements of Zhone Technologies, Inc., and other factors identified elsewhere in this report and in our most recent reports on Forms 10-K, 10-Q and 8-K. We undertake no obligation to revise or update any forward-looking statements for any reason.
OVERVIEW
We are a global provider of network access solutions and communications equipment for service provider and enterprise networks. We research, develop, test, sell, manufacture and support communications equipment in five major areas: broadband access, Ethernet switching, mobile backhaul, passive optical LAN (POLAN) and software defined networks (SDN).
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
For a complete description of what we believe to be the critical accounting policies and estimates used in the preparation of our Unaudited Condensed Consolidated Financial Statements, refer to our Annual Report on Form 10-K for the year ended December 31, 2017. Refer to Note 1 (g) Recent Accounting Pronouncements in the Notes to Unaudited Condensed Consolidated Balance Sheets in Item 1 of Part I of this Quarterly Report on Form 10-Q, for the updated accounting policy of revenue recognition upon the adoption of ASU 2014-09, "Revenue from Contracts with Customers" (Topic 606) as of January 1, 2018.

29

Table of Contents


RESULTS OF OPERATIONS
We list in the table below the historical condensed consolidated statement of income (loss) as a percentage of total net revenue for the periods indicated.
 Three Months Ended September 30, Nine Months Ended September 30,
 2018 2017 2018 2017
Net revenue:       
Third parties98 % 91 % 98 % 85 %
Related parties2 % 9 % 2 % 15 %
Total net revenue100 % 100 % 100 % 100 %
Cost of revenue:       
Products and services - third parties65 % 58 % 65 % 53 %
Products and services - related parties2 % 8 % 2 % 13 %
Amortization of intangible assets %  %  %  %
Total cost of revenue67 % 66 % 67 % 66 %
Gross profit33 % 34 % 33 % 34 %
Operating expenses:       
Research and product development12 % 13 % 13 % 15 %
Selling, marketing, general and administrative16 % 18 % 17 % 19 %
Amortization of intangible assets %  %  % 1 %
Total operating expenses28 % 31 % 30 % 35 %
Operating income (loss)5 % 3 % 3 % (1)%
Interest income %  %  %  %
Interest expense % (1)%  %  %
Other income, net(1)%  %  %  %
Income (loss) before income taxes4 % 2 % 3 % (1)%
Income tax provision1 %  % 1 %  %
Net income (loss)3 % 2 % 2 % (1)%
Net Revenue
Information about our net revenue for products and services for the nine months ended September 30, 2018 and 2017 is summarized below (in millions):
 Three Months Ended September 30, Nine Months Ended September 30, 
 2018 2017 Increase/ (decrease) % change 2018 2017 Increase % change 
Products$68.8
 $63.2
 $5.6
 9 % $198.8
 $169.8
 $29.0
 17% 
Services3.1
 3.2
 (0.1) (3)% 8.9
 8.7
 0.2
 2% 
Total$71.9
 $66.4
 $5.5
 8 % $207.7
 $178.5
 $29.2
 16% 


30

Table of Contents


Information about our net revenue for North America and international markets for the three and nine months ended September 30, 2018 and 2017 is summarized below (in millions):
 Three Months Ended September 30, Nine Months Ended September 30,
 2018 2017 Increase/(decrease) % change 2018 2017 Increase/(decrease) % change
Revenue by geography:               
United States$11.2
 $13.1
 $(1.9) (15)% $41.4
 $37.2
 $4.2
 11 %
Canada1.1
 1.5
 (0.4) (27)% 3.3
 4.1
 (0.8) (20)%
Total North America12.3
 14.6
 (2.3) (16)% 44.7
 41.3
 3.4
 8 %
Latin America6.8
 7.5
 (0.7) (9)% 21.7
 19.5
 2.2
 11 %
Europe, Middle East, Africa (EMEA)10.4
 7.4
 3.0
 41 % 27.3
 19.1
 8.2
 43 %
Korea19.6
 20.4
 (0.8) (4)% 50.9
 69.0
 (18.1) (26)%
Other Asia Pacific22.8
 16.5
 6.3
 38 % 63.1
 29.6
 33.5
 113 %
Total International59.6
 51.8
 7.8
 15 % 163.0
 137.2
 25.8
 19 %
Total$71.9
 $66.4
 $5.5
 8 % $207.7
 $178.5
 $29.2
 16 %

For the three months ended September 30, 2018, net revenue increased 8% or $5.5 million to $71.9 million from $66.4 million for the same period last year. For the nine months ended September 30, 2018, net revenue increased 16% or $29.2 million to $207.7 million from $178.5 million for the same period of last year. For the three months ended September 30, 2018, product revenue increased 9% or $5.6 million to $68.8 million from $63.2 million for the same period last year. For the nine months ended September 30, 2018, product revenue increased 17% or $29.0 million to $198.8 million from $169.8 million for the same period last year. The increase in net revenue for both the three and nine month periods ended September 30, 2018 was primarily due to increased products sales in the Europe, Middle East and Africa ("EMEA") and Other Asia Pacific, primarily in India, offset by decreased product sales in Korea. We also added customers in late 2017, which contributed to the revenue increase during the first three quarters this year as compared to the same periods last year.

Service revenue represents revenue from maintenance and other services associated with product shipments. For the three months ended September 30, 2018, service revenue decreased 3% or $0.1 million to $3.1 million from $3.2 million for the same period last year. For the nine months ended September 30, 2018, service revenue increased 2% or $0.2 million to $8.9 million from $8.7 million for the same period last year. The increase in service revenue was primarily related to a greater number of products under contract for maintenance and extended warranty.

International net revenue increased 15% or $7.8 million to $59.6 million for the three months ended September 30, 2018 from $51.8 million for the same period last year, and represented 83% of total net revenue compared with 78% during the same period of 2017. International net revenue increased 19% or $25.8 million to $163.0 million for the nine months ended September 30, 2018, from $137.2 million for the same period last year, and represented 78% of total net revenue compared with 77% during the same period last year. The increases in international net revenue were primarily related to increased product sales in Other Asia Pacific, primarily in India.

For both the three and nine months ended September 30, 2018, one customer each accounted for 11% of net revenue. For the three months ended September 30, 2017, two customers represented 10% and 9% (a related party) of net revenue, respectively. For the nine months ended September 30, 2017, two customers represented 9% of net revenue (one of which was a related party).     

We anticipate that our results of operations in any given period may depend to a large extent on sales to a small number of large accounts. As a result, our revenue for any quarter may be subject to significant volatility based upon changes in orders from one or a small number of key customers.

31

Table of Contents


Cost of Revenue and Gross Profit
Total cost of revenue increased 10% or $4.5 million to $48.5 million for the three months ended September 30, 2018, compared to $44.0 million for the three months ended September 30, 2017. Total cost of revenue was 67% of net revenue for the three months ended September 30, 2018, compared to 66% for the three months ended September 30, 2017. Total cost of revenue increased 18% or $20.9 million to $139.3 million for the nine months ended September 30, 2018, from $118.4 million for the nine months ended September 30, 2017. Total cost of revenue was 67% of net revenue for the nine months ended September 30, 2018 compared to 66% for the nine months ended September 30, 2017. The increase in total cost of revenue, as a percentage of sales, was primarily due to an increase in revenues in the EMEA and certain Other Asia Pacific customers.
We expect that in the future our cost of revenue as a percentage of net revenue will vary depending on the mix and average selling prices of products sold. In addition, continued competitive and economic pressures could cause us to reduce our prices, adjust the carrying values of our inventory, or record inventory expenses relating to discontinued products and excess or obsolete inventory.
Research and Product Development Expenses
Research and product development expenses decreased 3% or $0.2 million to $8.7 million for the three months ended September 30, 2018 compared to $8.9 million for the three months ended September 30, 2017. As a percentage of sales, research and product development expenses were 12% for the three months ended September 30, 2018, compared to 13% for the three months ended September 30, 2017. Research and product development expenses decreased 4% or $1.1 million to $26.3 million for the nine months ended September 30, 2018 compared to $27.5 million for the nine months ended September 30, 2017. As a percentage of sales, research and product development expenses were 13% for the nine months ended September 30, 2018, compared to 15% for the nine months ended September 30, 2017. The decrease in research and product development expenses was primarily due to cost containment initiatives and more focused product development activities. We intend to continue to invest in research and product development to attain our strategic product development objectives, while seeking to manage the associated costs through expense controls.
Selling, Marketing, General and Administrative Expenses
Selling, marketing, general and administrative expenses decreased 5% or $0.6 million to $11.1 million for the three months ended September 30, 2018, compared to $11.7 million for the three months ended September 30, 2017. As a percentage of sales, selling, marketing, general and administrative expenses were 16% for the three months ended September 30, 2018, compared to 18% for the three months ended September 30, 2017. Selling, marketing, general and administrative expenses increased 6% or $2.1 million to $35.2 million for the nine months ended September 30, 2018, compared to $33.1 million for the nine months ended September 30, 2017. As a percentage of sales, selling, marketing, general and administrative expenses were 17% for the nine months ended September 30, 2018, compared to 19% for the nine months ended September 30, 2017. The decrease in selling, marketing, general and administrative expenses for the three months ended September 30, 2018 was primarily related to a continued focus on our cost containment initiatives. The increase in selling, marketing, general and administrative expenses for the nine months ended September 30, 2018 was primarily related to higher personnel expenses due to increased headcount, as well as increased legal and outside service fees.
Income Tax Provision
Income tax expense for the three and nine months ended September 30, 2018 was $0.7 million and $1.1 million, respectively, on pre-tax income of $2.6 million and $4.4 million, respectively. For the three and nine months ended September 30, 2017, income tax expense was $0.1 million and $0.6 million, respectively, on pre-tax income (loss) of $1.5 million and $(2.3) million, respectively. As of September 30, 2018, the income tax rate varied from the United States statutory income tax rate primarily due to valuation allowances in the United States and taxable income generated by our wholly-owned foreign subsidiaries.


OTHER PERFORMANCE MEASURES
In managing our business and assessing our financial performance, we supplement the information provided by our U.S. GAAP results with adjusted earnings before stock-based compensation, interest, taxes, and depreciation, or Adjusted EBITDA, a non-GAAP financial measure. We define Adjusted EBITDA as net income (loss) plus (i) interest expense, net, (ii) provision (benefit) for taxes, (iii) depreciation and amortization, (iv) stock-based compensation expenses, and (v) material non-recurring transactions or events, such as merger and acquisition transaction costs or a gain (loss) on sale of assets or impairment of fixed assets. We believe that the presentation of Adjusted EBITDA enhances the usefulness of our financial information by presenting a measure that management uses internally to monitor and evaluate our operating performance and to evaluate the effectiveness of our core operating business strategies. We believe Adjusted EBITDA also assists investors and analysts in

32

Table of Contents


comparing our performance across reporting periods on a consistent basis because it excludes the impact of items that we do not believe reflect our core operating performance.
Adjusted EBITDA has limitations as an analytical tool. Some of these limitations are:
Adjusted EBITDA does not reflect our cash expenditures, or future requirements, for capital expenditures or contractual requirements;
Adjusted EBITDA does not reflect changes in, or cash requirements for, our working capital needs;
Adjusted EBITDA does not reflect the interest expense, or the cash requirements necessary to service interest or principal payments, on our debts;
although depreciation and amortization are non-cash expenses, the assets being depreciated and amortized will often have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements;
non-cash compensation is and will remain a key element of our overall long-term incentive compensation programs and packages, although we exclude it as an expense when evaluating our ongoing operating performance for a particular period; and
other companies in our industry may calculate Adjusted EBITDA and similar measures differently than we do, potentially limiting its usefulness as a comparative measure.
Because of these limitations, Adjusted EBITDA should not be considered in isolation or as a substitute for net income (loss) or any other performance measures calculated in accordance with U.S. GAAP or as a measure of liquidity. Management understands these limitations and compensates for these limitations by relying primarily on our U.S. GAAP results and using Adjusted EBITDA only supplementally.
Set forth below is a reconciliation of net income (loss) to Adjusted EBITDA, which we consider to be the most directly comparable U.S. GAAP financial measure to Adjusted EBITDA (in thousands):
 Three Months Ended September 30, Nine Months Ended September 30,
 2018 2017 2018 2017
Net income (loss)$1,827
 $1,387
 $3,323
 $(2,985)
Add:       
Interest expense, net405
 227
 1,127
 711
Income tax expense735
 107
 1,071
 646
Depreciation and amortization652
 752
 2,033
 3,105
Stock-based compensation617
 195
 1,357
 670
Non-recurring merger and acquisition costs139
 
 139
 
Adjusted EBITDA$4,375
 $2,668
 $9,050
 $2,147
LIQUIDITY AND CAPITAL RESOURCES
Our operations are financed through a combination of our existing cash, cash equivalents, available credit facilities, and sales of equity and debt instruments, based on our operating requirements and market conditions.
We had a net income of $3.3 million for the nine months ended September 30, 2018, and $1.2 million for the year ended December 31, 2017. As of September 30, 2018, we had an accumulated deficit of $15.2 million and working capital of $66.9 million. In addition, we had a net cash outflow from operations of $15.7 million for the nine months ended September 30, 2018. As of September 30, 2018, we had $20.0 million in cash and cash equivalents, which included $6.0 million in cash balances held by our international subsidiaries and $42.3 million in aggregate principal debt of which $37.3 million was in current liabilities. In addition, as of September 30, 2018 we had $6.4 million committed as cash collateral for letters of credit under our revolving credit facilities, leaving $21.3 million in aggregate financing availability under these facilities. Our current lack of liquidity could harm us by:
increasing our vulnerability to adverse economic conditions in our industry or the economy in general;
requiring substantial amounts of cash to be used for debt servicing, rather than other purposes, including operations;
limiting our ability to plan for, or react to, changes in our business and industry;
limiting its ability to complete Keymile acquisition; and

33

Table of Contents


influencing investor and customer perceptions about our financial stability and limiting our ability to obtain financing or acquire customers.

These factors indicate that cash flows might not be sufficient for us to meet our obligations as they come due in the ordinary course of business for a period of 12 months from the date of this Quarterly Report on Form 10-Q.

Our ability to meet our obligations as they become due in the ordinary course of business for the next 12 months will depend on our ability to (i) achieve forecasted results, (ii) access funds approved under existing or new credit facilities and/or to raise additional capital through sales of our common stock to the public and (iii) effectively manage inventory procurement. If we cannot raise additional funds when we need or want them, our operations and prospects could be negatively affected. Management’s belief that we will achieve these results assumes that, among other things, we will continue to be successful in implementing our business strategy and that there will be no material adverse development in our business, liquidity or capital requirements. If one or more of these factors do not occur as expected, it could cause us to fail to meet our obligations as they come due.
We plan to focus on capital raising, cost management, operating efficiency and restrictions on discretionary spending. In addition, if necessary, we may sell assets, issue or enter into amendments of our debt or equity securities, or purchase credit insurance. We may also reduce the scope of our planned product development, reduce sales and marketing efforts and reduce our operations in low margin regions, including reductions in headcount. On July 12, 2018, we entered into the A&R Domestic Credit Agreement and the A&R Ex-Im Credit Agreement with WFB, which amended and replaced our existing senior secured revolving line of credit and letter of credit facilities with WFB and revised certain reporting and compliance provisions, as described more fully in Note 7 to the unaudited condensed consolidated financial statements.
Based on our current plans and current business conditions, we believe that these measures along with our existing cash, cash equivalents and available credit facilities will be sufficient to satisfy our anticipated cash requirements for at least the next 12 months from the date of this Quarterly Report on Form 10-Q.
Operating Activities

Net cash used in operating activities was $15.7 million for the nine months ended September 30, 2018, compared with net cash used of $0.6 million for the nine months ended September 30, 2017. This increase was primarily due to changes in operating assets and liabilities, resulting in using $23.4 million of cash for nine months ended September 30, 2018, compared to using $2.2 million of cash for the nine months ended September 30, 2017.

Investing Activities

Net cash used in investing activities was $0.8 million for the nine months ended September 30, 2018 compared to net cash provided by investing activities of $0.1 million for the nine months ended September 30, 2017.

Financing Activities

Net cash provided by financing activities was $15.2 million for the nine months ended September 30, 2018 compared to net cash used in financing activities of $1.8 million for the nine months ended September 30, 2017. This change was primarily due to the proceeds from short-term borrowings of $67.5 million, offset by repayments of short-term borrowings of $53.2 million.

Cash Management

Our primary source of liquidity comes from our cash and cash equivalents, which totaled $20.0 million at September 30, 2018, as well as our credit facilities, under which we had aggregate financing availability of $21.3 million as of September 30, 2018, and under which $6.4 million was committed as cash collateral for letters of credit as of September 30, 2018. Our cash and cash equivalents as of September 30, 2018 included $6.0 million in cash balances held by our international subsidiaries.




34

Table of Contents


WFB Facility

Wells Fargo Bank Facility
On July 12, 2018, we entered into the A&R Domestic Credit Agreement and the A&R Ex-Im Credit Agreement with WFB, which amended and replaced our existing senior secured revolving line of credit and letter of credit facilities with WFB and revised certain reporting and compliance provisions. The Amended WFB Facility provides for a revolving line of credit of $25.0 million (including up to $5.0 million of letters of credit), with the amount that we are able to borrow based on eligible accounts receivable and inventory, less the amount committed as cash collateral for letters of credit. The amounts borrowed under the Amended WFB Facility bears interest, payable monthly, at a floating rate equal to the three-month LIBOR plus a margin based on our average excess availability (as calculated under the WFB Facility). To maintain availability of funds under the Amended WFB Facility, we pay a commitment fee on the unused portion. The commitment fee is 0.25% per annum and is recorded as interest expense. The maturity date of the Amended WFB Facility is July 12, 2021.
As of September 30, 2018, we had $6.0 million in outstanding borrowings under its WFB Facility, and 2.1 million was committed as cash collateral for letters of credit. Subsequent to the end of the quarter, we repaid $6.0 million in borrowings under the WFB Facility. Based on our eligible accounts receivable and inventory, we had $6.5 million of financing availability under the WFB Facility as of September 30, 2018. The interest rate on the WFB Facility was 4.4% at September 30, 2018.
Our obligations under the Amended WFB Facility are secured by substantially all of our assets and those of our subsidiaries that guarantee the Amended WFB Facility, including their intellectual property. The Amended WFB Facility contains certain financial covenants, and customary affirmative and negative covenants. If we default under the Amended WFB Facility due to a covenant breach or otherwise, after any applicable grace periods. WFB may be entitled to, among other things, require the immediate repayment of all outstanding amounts and sell our assets to satisfy the obligations under the Amended WFB Facility. As of September 30, 2018, we were in compliance with the covenants under the Amended WFB Facility.
On October 22, 2018, we borrowed $3.0 million under the Amended WFB Facility. On October 31, 2018, we repaid $3.0 million in full.
Bank and Trade Facilities - Foreign Operations
Certain of our foreign subsidiaries have entered into various financing arrangements with foreign banks and other lending institutions consisting primarily of revolving lines of credit, trade facilities, term loans and export development loans. These facilities are renewed on an annual basis and are generally secured by a security interest in certain assets of the applicable foreign subsidiaries and supported by guarantees given by DNI or third parties. Payments under such facilities are made in accordance with the given lender’s amortization schedules. As of September 30, 2018 and December 31, 2017, we had an aggregate outstanding balance of $28.2 million and $22.8 million, respectively, under such financing arrangements, and the interest rate per annum applicable to outstanding borrowings under these financing arrangements ranged from 1.3% to 6.82% as of September 30, 2018, 1.58% to 8.90% and December 31, 2017.
Related-Party Debt
In connection with the Merger, on September 9, 2016, we entered into a loan agreement with DNI for a $5.0 million unsecured subordinated term loan facility. Under the loan agreement, we were permitted to request drawdowns of one or more term loans in an aggregate principal amount not to exceed $5.0 million. As of September 30, 2018, $5.0 million in term loans was outstanding under the facility. Such term loans mature in September 2021 and are pre-payable at any time by us without premium or penalty. The interest rate as of September 30, 2018 under this facility was 4.6% per annum.
Also, we borrowed $1.8 million from DNI for capital investment in February 2016, which amount was outstanding as of September 30, 2018. This loan matures in July 2019 and bears interest at a rate of 4.6% per annum, payable annually.
On March 21, 2018, DNS borrowed $5.8 million from DNI, of which $4.5 million was repaid on August 8, 2018. As of September 30, 2018, $1.3 million remained outstanding. The loan bears interest at a rate of 4.6% and matures on June 27, 2019, and is secured by certain accounts receivable of DNS Korea.
Interest expense on these related-party borrowings was $0.1 million and $0.3 million in the three and nine months ended September 30, 2018.

35

Table of Contents


Future Requirements and Funding Sources
Our fixed commitments for cash expenditures consist primarily of payments under operating leases, inventory purchase commitments, and payments of principal and interest for debt obligations.
From time to time, we may provide or commit to extend credit or credit support to our customers. This financing may include extending the terms for product payments to customers. Any extension of financing to our customers will limit the capital that we have available for other uses.
Our accounts receivable, while not considered a primary source of liquidity, represent a concentration of credit risk because a significant portion of the accounts receivable balance at any point in time typically consists of a relatively small number of customer account balances. As of September 30, 2018, one customer represented 12% of net accounts receivable, respectively, and receivables from customers in countries other than the United States represented 89% of net accounts receivable. Additionally, Dasan Networks Japan has factoring arrangements in relation to certain accounts receivable with certain financial institutions as of September 30, 2018. We do not currently have any material commitments for capital expenditures, or any other material commitments aside from operating leases for our facilities, inventory purchase commitments and debt.

Contractual Commitments and Off-Balance Sheet Arrangements
At September 30, 2018, our future contractual commitments by fiscal year were as follows (in thousands):
 
   Payments due by period
 Total 2018 2019 2020 2021 2022 Thereafter
Operating leases$21,816
 $1,053
 $4,088
 $2,998
 $2,590
 $2,664
 $8,423
Purchase commitments2,403
 2,403
 
 
 
 
 
Short-term debt - bank and trade facilities34,171
 34,171
 
 
 
 
 
Short-term debt - related party3,148
 3,148
 


 
 
 
Long-term debt -related party5,000
 
   
 5,000
 
 
Other payable - related party1,859
 1,859
 
 
 
 
 
Royalty obligations250
 250
 
 
 
 
 
Total future contractual commitments$68,647
 $42,884
 $4,088
 $2,998
 $7,590
 $2,664
 $8,423
Operating Leases
The operating lease amounts shown above represent primarily off-balance sheet arrangements. For operating lease commitments, a liability is generally not recorded on our balance sheet unless the facility represents an excess facility for which an estimate of the facility exit costs has been recorded on our balance sheet, net of estimated sublease income. For operating leases that include contractual commitments for operating expenses and maintenance, estimates of such amounts are included based on current rates. Payments made under operating leases are treated as rent expense for the facilities currently being utilized.
Purchase Commitments
The purchase commitments shown above represent non-cancellable inventory purchase commitments as of September 30, 2018.
Short-term Debt
Our short-term debt obligations have been recorded as liabilities on our balance sheet, and are comprised of $28.2 million in outstanding borrowings under the credit facilities of our foreign subsidiaries and $6.0 million in outstanding borrowings under the WFB Facility as of September 30, 2018. The amount shown above represents scheduled principal repayments under the facilities, but not the associated interest payments which may vary based on changes in market interest rates. Subsequent to the end of the quarter, we repaid $6.0 million in borrowings under our WFB Facility. At September 30, 2018, the interest rate per annum applicable to outstanding borrowings under the trade facilities of our foreign subsidiaries ranged from 1.3% to 6.8% and was 4.4% under the WFB Facility. See above under "Cash Management" for further information about these facilities.

36

Table of Contents


Related-Party Debt
As of September 30, 2018, we had borrowed an aggregate of $8.1 million from DNI, which consisted of a $5.0 million unsecured subordinated term loan facility which matures in September 2021, a $1.8 million loan for capital investment which matures in July 2019 and a secured loan outstanding of $1.3 million which matures in June 27, 2019. All three loans bear interest at a rate of 4.6% per annum.
See above under “Cash Management” for further information about our related-party debt.
RECENT ACCOUNTING PRONOUNCEMENTS

Please refer to Note 1(g) to the unaudited condensed consolidated financial statements included in part 1, Item 1 of this report.

Item 3.    Quantitative and Qualitative Disclosures about Market Risk
Concentration of Credit Risk
Financial instruments which potentially subject us to concentrations of credit risk consist primarily of cash and cash equivalents, and accounts receivable. Cash and cash equivalents consist principally of financial deposit and money market accounts. Cash and cash equivalents are principally held with various domestic financial institutions with high credit standing. We perform ongoing credit evaluations of our customers and generally do not require collateral. Allowances are maintained for potential doubtful accounts.

We anticipate that our results of operations in any given period may depend to a large extent on sales to a small number of large accounts. As a result, our revenue for any quarter may be subject to significant volatility based upon changes in orders from one or a small number of key customers.
For the three and nine months ended September 30, 2018, one customer each accounted for 11% of net revenue, respectively. For the three months ended September 30, 2017, two customers represented 10% and 9% (a related party) of net revenue, respectively. For the nine months ended September 30, 2017, two customers each represented 9% of net revenue (one of which was a related party).
As of September 30, 2018, one customer represented 12% of net accounts receivable. As of December 31, 2017, two customers represented 20% (a related party) and 11% of net accounts receivable, respectively.
As of September 30, 2018 and December 31, 2017, receivables from customers in countries other than the United States represented 89% and 84%, of net accounts receivable, respectively.
Interest Rate Risk
Our exposure to market risk for changes in interest rates relates primarily to our variable rate outstanding debt. As of September 30, 2018, our outstanding short-term debt balance was $37.3 million, which consisted of principal amount of borrowings under the short-term credit facilities of our foreign subsidiaries, DNI and the WFB Facility (all of which bear interest at a variable rate). Amounts borrowed under our short-term credit facilities bore interest ranging from 1.3% to 6.82% as of September 30, 2018 and amounts borrowed under the WFB Facility bore interest at 4.4%. Assuming the outstanding balance on our variable rate debt remains constant over a year, a 1% increase in the interest rate would decrease pre-tax income and cash flow by approximately $0.3 million. As of September 30, 2018, our outstanding long-term debt balance was $5.0 million and consisted of loans from DNI and its affiliates (which bear interest at fixed rates).
Foreign Currency Risk
We transact business in various foreign countries, and a significant portion of our assets is located in Korea. We have sales operations throughout Asia, Europe the Middle East and Latin America. We are exposed to foreign currency exchange rate risk associated with foreign currency denominated assets and liabilities, primarily intercompany receivables and payables. Accordingly, our operating results are exposed to changes in exchange rates between the U.S. dollar and those currencies.
We have performed a sensitivity analysis as of September 30, 2018 using a modeling technique that measures the impact on the balance sheet arising from a hypothetical 10% adverse movement in the levels of foreign currency exchange rates relative to the U.S. dollar, with all other variables held constant. The sensitivity analysis indicated that a hypothetical 10% adverse movement in foreign currency exchange rates would result in a foreign exchange loss of approximately $3.0 million at September 30, 2018. This sensitivity analysis assumes a parallel adverse shift in foreign currency exchange rates, which do not always move in the same direction. Actual results may differ materially.

37

Table of Contents


Item 4.    Controls and Procedures

Disclosure Controls and Procedures
We maintain disclosure controls and procedures designed to provide reasonable assurance of achieving the objective that information required to be disclosed in our reports filed or submitted pursuant to the Securities Exchange Act of 1934 (the Exchange Act) is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow for timely decisions regarding required disclosures. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by Rule 13a-15(b) under the Exchange Act, we conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of September 30, 2018, the end of the period covered by this report. The evaluation was done under the supervision and with the participation of management, including our Chief Executive Officer and our Chief Financial Officer. Based upon this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, because of the material weaknesses in our internal control over financial reporting that existed as of December 31, 2017 and that have not yet been fully remediated, as described below, our disclosure controls and procedures were not effective as of September 30, 2018.
A material weakness is a deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility that a material misstatement of the registrant’s annual or interim financial statements will not be prevented or detected on a timely basis. Based on the results of the independent investigation and due to the incorrect application of generally accepted accounting principles that resulted in material misstatements and a restatement of our unaudited condensed consolidated financial statements for the three and nine months ended September 30, 2016, management identified material weaknesses in our internal control over financial reporting as of December 31, 2016 which continued to exist at December 31, 2017. Specifically, we did not maintain an effective control environment as there was an insufficient complement of personnel with appropriate accounting knowledge, experience and competence, resulting in incorrect application of generally accepted accounting principles. This material weakness contributed to the following material weaknesses. We did not maintain effective controls over our financial close process. Also, we did not design and maintain effective controls over the review of supporting information to determine the completeness and accuracy of the accounting for complex transactions, specifically related to the business combination that occurred on September 9, 2016, which resulted in an incorrect application of generally accepted accounting principles that resulted in material misstatements and a restatement of our unaudited condensed consolidated financial statements for the three and nine months period ended September 30, 2016. Additionally, these material weaknesses could result in a misstatement in the financial statements that would result in a material misstatement in the annual or interim consolidated financial statements that would not be prevented or detected.
In light of the material weakness described above and based on the criteria set forth in Internal Control —Integrated Framework (2013) issued by the Committee Sponsoring Organizations of the Treadway Commission (COSO), our management concluded that our internal control over financial reporting was not effective as of December 31, 2017.
As of the date of this report, we are continuing to re-assess the design of our internal controls over financial reporting and to modify processes related to the accounting for significant and unusual transactions, as well as enhancing monitoring and oversight controls in the application of relevant accounting guidance related to such transactions. In connection therewith, we have hired various accounting, operational and financial planning and analysis resources, we have begun designing and implementing additional processes and controls and we are in the early stages of formalizing our project plan and updating the documentation of our business process flows and related internal control over financial reporting. We anticipate that we will continue to hire additional accounting personnel with relevant skills, training and experience, and conduct further training of accounting and finance personnel.
Changes in Internal Control over Financial Reporting

Except as described above, there were no changes in our internal control over financial reporting that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting. Merger-related integration activities may lead us to modify certain internal controls in future periods.


38

Table of Contents


Inherent Limitations on Effectiveness of Controls
Our management, including our Chief Executive Officer and Chief Financial Officer, does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent or detect all errors and all fraud. A control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control system’s objectives will be met. The design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Further, because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that misstatements due to error or fraud will not occur or that all control issues and instances of fraud, if any, within our company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty and that breakdowns can occur because of simple error or mistake. Controls can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Projections of any evaluation of controls effectiveness to future periods are subject to risks. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.


39

Table of Contents


PART II. OTHER INFORMATION

Item 1.    Legal Proceedings

We are subject to various legal proceedings, claims and litigation arising in the ordinary course of business. While the outcome of these matters is currently not determinable, we do not expect that the ultimate costs to resolve these matters will have a material adverse effect on our consolidated financial position or results of operations. However, litigation is subject to inherent uncertainties, and unfavorable rulings could occur. If an unfavorable ruling were to occur, there exists the possibility of material adverse impact on the results of operations of the period in which the ruling occurs, or future periods.

Item 1A. Risk Factors

In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, "Item 1A, Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2017, which could materially affect our business, financial condition or future results. Except as set forth below, there have been no material changes to the risk factors we previously disclosed in our filings, including the Form 10-K filed for the year ended December 31, 2017 with the SEC. The risks described in our Annual Report on Form 10-K, however, are not the only risks facing our company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.
We may need or want to raise or access additional funds to fund our ongoing operations and to complete the Keymile acquisition and these funds may not be available to us when we need them. If we cannot raise additional funds when we need or want them, our operations and prospects could be negatively affected.
We need sufficient capital to fund our ongoing operations and to complete the Keymile acquisition. Our ability to meet our obligations will depend on our ability to access funds approved under existing or new credit facilities and or our ability to raise additional capital through sales of our common stock to the public. We cannot be certain that additional funds will be available to us on favorable terms when required, or at all. If we cannot raise additional funds when we need them, our financial condition, results of operations, business and prospects could be materially and adversely affected.
We face exposure to foreign currency exchange rate fluctuations.
We currently operate a limited hedging program to mitigate the impact of foreign currency exchange rate fluctuations. The use of such hedging activities may not offset any or more than a portion of the adverse financial effects of unfavorable movements in foreign currency exchange rates over the limited time the hedges are in place. Moreover, the use of hedging instruments may introduce additional risks if we are unable to structure effective hedges with such instruments, which could adversely affect our financial condition and operating results.

Item 6.    Exhibits




40

Table of Contents


EXHIBIT INDEX
 
Exhibit
Number
Description
  
  
31.1
31.2
32.1
101.INSXBRL Instance Document
101.SCHXBRL Taxonomy Extension Schema
101.CALXBRL Taxonomy Extension Calculation Linkbase
101.DEFXBRL Taxonomy Extension Definition Linkbase
101.LABXBRL Taxonomy Extension Labels Linkbase
101.PREXBRL Taxonomy Extension Presentation Linkbase
  
 



41

Table of Contents


SIGNATURES
Pursuant to the retirements 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.
 
 DASAN ZHONE SOLUTIONS, INC.
   
Date: November 8, 2018   
 By: /s/ IL YUNG KIM
 Name: Il Yung Kim
 Title: President and Chief Executive Officer
   
    
 By: /s/ MICHAEL GOLOMB
 Name: Michael Golomb
 Title: Chief Financial Officer, Corporate Treasurer and Secretary
    


42