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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K/A
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(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended January 31, 2004
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
Commission File number: 0-15810
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SORRENTO NETWORKS CORPORATION
(Exact name of Registrant as specified in charter)
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Delaware 04-3757589
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
9990 Mesa Rim Road
San Diego, California 92121
(Address of principal executive offices) (Zip Code)
(858) 558-3960
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, Par Value $0.001 NASDAQ
Title of each class Name of exchange on which registered
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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S is not contained herein, and will not be contained, to the best
of Registrant's knowledge, in a definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes [_] No [X]
The Registrant's revenues for its most recent fiscal year were $25,462,000
The aggregate market value of voting stock based upon the bid and asks price
held by non-affiliates of the Registrant on July 31, 2003 was $23,429,101.
Number of shares outstanding of the Registrant's only class of common stock as
of March 31, 2004 (the latest practicable date): 16,672,682.
The Company is filing 10-K/A to supplement its certifications to include the
certification set forth in section 906 of the Sarbanes-Oxley Act of 2002.
DOCUMENTS INCORPORATED BY REFERENCE:
None.
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PART I
Item 1. Business
Introduction
This Annual Report on Form 10-K may contain forward-looking statements that
involve risks and uncertainties. Such statements include, but are not limited
to, statements containing the words "believes, "anticipates," "expects,"
"estimates" and words of similar import. Our actual results could differ
materially from any forward-looking statements, which reflect, management's
opinions only as of the date of this report, as a result of such risks and
uncertainties. We undertake no obligation to revise or publicly release the
results of any revisions to these forward-looking statements. Readers should
carefully review the risk factors set forth below in "Factors That May Affect
Future Results" and in other documents the company files from time to time with
the Securities and Exchange Commission, including its quarterly reports on Form
10-Q.
We are a leading supplier of intelligent optical networking solutions for
access, metropolitan and regional applications worldwide. Our solutions enable
communication carriers and service providers to offer broadband networking
services over their existing optical fiber infrastructure. Our technologies
permit telecommunications service providers to increase fiber capacity and fiber
bandwidth utilization, reduce network costs and complexity over scalable and
efficient networking platforms. Our optical networking systems support a wide
variety of protocols, mixed speeds of traffic and accommodate changing traffic
patterns directly over optical networks.
Our product solutions include optical access, optical transport, and
network management solutions optimized for access, metro and regional markets,
and combine to create powerful, cost-effective, and easy-to-manage optical
networks. Our dense wavelength division multiplexing, or DWDM, and coarse
wavelength division multiplexing, or CWDM, platforms can be used in enterprise,
access, metropolitan and regional network applications. WDM technology allows
many optical signals to be transmitted simultaneously on the same optical fiber
by using different wavelengths of light to distinguish the signals. This
technology increases optical network capacity and flexibility.
Our comprehensive suite of optical networking interfaces and optical access
multiplexers allow us to also address video on demand, storage area networking,
data center fail-over recovery, and internet connectivity applications. Our CWDM
products provide a low cost, entry-level solution that can be used for
enterprise and carrier access applications and that complement our DWDM product
line. Multiplexing is a process that combines a number of lower speed data
streams into one high-speed data stream.
We also have two powerful network management solutions for our CWDM and
DWDM product line. Addressing all key management aspects - fault, configuration,
performance, and security - these systems conform to North American and
international standards and are simple to learn and use. We have a robust,
carrier-class management system that offers broad functionality, including
equipment/facilities management, fault management, performance monitoring,
security control, alarm filtering, and remote download. We also have an
enterprise network management solution that provides an intuitive graphical
interface and covers operations, administration, maintenance, and provisioning
functionality for our DWDM networks.
We currently have an installed base with over 20 communications service
providers and system integrators worldwide, including AT&T Broadband, now
Comcast Corporation, Deutsche Telekom, Cox Communications, Time Warner Telecom,
United Pan-Europe Communications, El Paso Global Networks and Edison Carrier
Solutions.
Understanding Our Market
Rapid Growth in Bandwidth Demand
Fueled by the growth of the Internet, the volume of data traffic
transmitted across telecommunications networks now exceeds voice traffic. The
growth of data traffic is attributable to increased Internet usage, increased
access speeds and greater use of bandwidth intensive applications. Bandwidth
means the capacity to move information down a communications channel. Bandwidth
is defined by the highest data rates that can be transmitted by that channel and
is commonly measured in bits per second.
2
Migration of Network Infrastructure
Traditional copper-based and SONET/SDH based telecommunications
infrastructures were originally designed for voice traffic. These
infrastructures do not scale effectively to provide the bandwidth needed to
support the growth in high-speed data traffic. In addition, these
infrastructures need network-wide upgrades in order to accommodate growing
traffic thus resulting in long delays for provisioning new services.
DWDM and CWDM technologies are more flexible, more efficient and more
scalable networking alternatives for meeting the growing demand for bandwidth
and new broadband services. Broadband means technologies or networks that have
the ability to transmit high data rates. DWDM is a sophisticated
opto-electronics technology that uses multiple wavelengths of light very
efficiently to greatly increase the number of video, data or voice channels of
information that can be sent on a single optical fiber. Synchronous Optical
Network, SONET, is a telecom transmission protocol for high-speed transmission
over fiber optic cable, which was introduced by Bell Communications in 1984 and
quickly accepted by American National Standards Institute. SDH stands for
Synchronous Digital Hierarchy, which is transmission protocol for high-speed
transmission over fiber optic cable published in 1988 by the Consultative
Committee for International Telegraph and Telephony. It is a transmission
protocol used outside the United States, mostly in Europe, that is similar to
SONET.
DWDM networks were first deployed in long-haul applications. However,
optical solutions specifically designed to address the challenges faced by
access and metropolitan markets have significantly lagged in deployment.
Accordingly, access and metro networks are considered to be traffic bottlenecks
in the fast and efficient transmission of data.
Enhanced Competition in the Service Provider Market
Worldwide deregulation in the telecommunications industry has led to an
increase in the number of service providers seeking to address the growing
demand for bandwidth. In the U.S. and internationally, traditional service
providers such as incumbent local exchange carriers (ILECs), inter-exchange
carriers (IXCs) and post, telephone and telegraph companies (PTTs) are seeing
new entrants in the broadband networking market seeking to capitalize on the
growing demand for bandwidth. A number of competitors to these incumbents are
building new data-centric networks to address the present bandwidth bottlenecks
in the metropolitan markets, including utilities and cable television companies
which are upgrading their current networks and are leveraging existing
investments in fiber optic infrastructure to deliver high-speed data services in
both the local and regional markets. This enhanced competition in the carrier
and service provider markets is driving increased capital expenditures on
network infrastructure that is focused on delivering scalable high-speed data
services in a cost efficient manner.
Network Topography
The following describes each of the network segments within the
optical network hierarchy:
o Long-haul networks are high capacity networks that connect
service providers and carry voice and data across large
geographic regions, typically spanning distances up to 4,000
kilometers. Long-haul networks are relatively simple networks,
built around SONET/SDH technology and are primarily designed only
to satisfy service provider long haul network capacity
requirements.
o Metropolitan core (metro-core) networks connect the central
offices of service providers in a metropolitan area and
facilitate the transport and switching of traffic within extended
metropolitan areas and between the network edge and long-haul
networks. Metropolitan core networks are typically implemented in
ring configurations and reach ring circumferences up to 300
kilometers. In order to efficiently use the optical network,
sub-rate multiplexing devices aggregate traffic into wavelengths
carrying higher speed aggregate bit rates across
telecommunications networks. Regional networks typically
transport voice and data traffic between cities across distances
of 200 to 600 kilometers or more.
o Access networks connect enterprises or traffic aggregation nodes,
in multiple locations throughout metropolitan areas, to service
providers' central offices or connect different end-user
locations to each other. In order to efficiently use the optical
network, optical access devices aggregate traffic from end users
into wavelengths or wavelength bands for transport across
3
telecommunications networks. Because access networks must support
the varying demands of end users, these networks tend to be very
complex.
Metropolitan Area Optical Network Opportunity
Although optical technologies are being deployed in long-haul networks to
relieve capacity constraints, these solutions are not specifically designed to
address the issues inherent in metropolitan and regional optical networks. Data
is normally mapped into the voice multiplexing hierarchy for transport over the
long-haul network. Metropolitan optical networks are characterized by varying
traffic patterns and protocols as well as varied topologies and end-user
requirements, making them more complex and difficult to manage than long haul
networks. As a result, service providers have only recently begun to exploit the
benefits of optical technologies in metropolitan optical networks.
The optical networking market has seen a substantial downturn. The metro
WDM market, which was expected to increase, has also experienced a slowdown as
capital spending has declined throughout the telecommunications industry.
Although we believe that the metro WDM world-wide market will grow significantly
in the years to come, such growth is not likely to occur until capital spending
resumes in the markets we serve, and we are unable to assess at present when
this might take place.
Regional Optical Network Opportunity
In addition to the metropolitan market, recent engineering enhancements
have permitted the use of DWDM networking platforms for regional optical
networking applications. This development opens up the opportunity to address a
portion of the substantial long haul market. In some regions, e.g., Europe,
regional solutions apply to the majority of the networks installed. Industry
researchers recently started looking at reclassifying the regional market
opportunity, although statistical data for this market are not available.
Specific Challenges Facing Metropolitan and Regional Optical Networks
Service providers face numerous specific challenges in addressing
metropolitan and regional optical networks:
Scalability Limitations. Originally constructed for voice
traffic, the current network infrastructure based on SONET/SDH
technology does not allow for the network efficiencies necessary
to address the shift to a predominantly data-driven network. Due
to its inherent lack of scalability, the current network
infrastructure may require service providers to undertake the
expensive and tedious process of replacing network equipment or
adding new layers of similar equipment in response to changes or
increases in bandwidth demand. Alternative approaches to WDM are
being developed by other vendors to address the scalability of
the SONET/SDH networks. These nonstandard solutions are called
next generation SONET/SDH and can minimize the wasted bandwidth
of legacy SONET/SDH. While these solutions allow carriers to
combine voice and data on the same network, such solutions do
not, however, expand the amount of bandwidth available and are,
therefore, unable to accommodate the need for large amounts of
bandwidth.
Need to Support Multiple Protocols. Metropolitan optical networks
are characterized by a wide variety of protocols. The inability
to support multiple protocols and services from a single platform
further increases the cost and complexity of the metropolitan
networks. Alternative approaches to WDM are being developed by
other vendors to address the requirement for support of multiple
services. These nonstandard solutions are called multi-service
provisioning platforms (MSPP). These solutions generally carry
out protocol conversions and are much more complex than WDM
solutions.
Market Downturn. Virtually all telecom related market segments
have suffered a decline in demand in the current economic
downturn. What was once viewed as only a long-haul decline in
market demand has now affected the regional and metropolitan
networks as both enterprise and carrier business have cut back
capital spending. Although we expect that demand in the regional
and metropolitan markets will be strong in future periods, there
are no assurances that capital spending will resume within this
sector in the near term.
4
Several Stages of Conversion. Present solutions require several
conversions to transport data through a metropolitan network. In
the access networks, aggregation of traffic often requires
protocol conversions into a common protocol before optical
transmission. In the central office, data is often demultiplexed
and converted into electrical signals for regeneration, switching
or further aggregation into higher capacity links and then
reconverted into optical signals for transmission in the
metro-core network.
Inefficient Bandwidth Utilization. Within metropolitan optical
networks, service providers must cater to end-users with varying
access speeds. Current optical access solutions do not make
efficient use of scarce wavelength resources. Service providers
must assign a full wavelength to each signal, whether or not the
end-user requires the full bandwidth potential of each
wavelength.
Difficulty of Network Management. Multiple protocols and
services, coupled with the lack of standards that exist in
metropolitan optical networks, make network management functions,
such as performance monitoring and configuration, exceedingly
difficult. Lack of a robust network management platform further
adds to the cost and complexity of metropolitan optical networks.
Need for New, Enhanced Service Offerings to Generate New Revenue
Opportunities. Service providers are searching for
next-generation solutions that will enable them to generate
additional sources of revenue from offering new or enhanced
services to their customers. Current solutions typically require
the service provider to deploy equipment that is specifically
designed for a particular service and transmission rate.
Next-generation solutions must be able to offer enhanced
features, wavelength provisioning and bandwidth-on-demand, that
end-users will increasingly request from service providers.
Our Solution
Our solutions feature products designed to specifically address the
shortcomings of legacy SONET/SDH networks and to facilitate offering new
services throughout metropolitan and regional optical networks. We enable our
customers to meet the rapidly growing demand for bandwidth by offering
end-to-end access, metropolitan and regional optical networking solutions for
the aggregation, transport and management of traffic. Our current products,
including our GigaMux'r' 6400 DWDM transport system, our EPC'TM' sub-rate
multiplexing modules, our GigaMux'r' 3200 and 1600 DWDM and CWDM transport
systems, as well as the network management product line that includes
GigaView'TM', TeraManager'TM' and TeraConfigurator'TM', are specifically
designed to meet the unique requirements of access metropolitan and regional
markets.
Our optical networking solutions offer numerous benefits including:
Cost Effective Entry-Level Access Solution. Our GigaMux'r' 3200
and 1600 DWDM and CWDM platforms allow low cost multiplexing of
up to sixteen wavelengths carrying a mix of protocols and signals
for access applications. The 3200 and 1600 products enable
customers to seamlessly and costs effectively mix CWDM and DWDM
on the same platform and on the same fiber. These products also
provide patented.
Cost effective and feature rich in wavelength management
capabilities. The 3200 and 1600 products also reduce customer
operating costs by enabling the same modules to be used across
every platform, thereby reducing sparing costs.
Scalable Architecture. We have created an optical networking
solution that simultaneously transmits voice, data, and video
over optimized fiber channels. The modular architecture of our
solution enables service providers to incrementally expand
capacity as their bandwidth needs increase. This simple,
scaleable, and functional solution solves short and long-term
service provider problems, which enhances their ability to reduce
costs and offer value-added services. For example, a service
provider can begin deployment with a single channel and later
expand up to 64 channels, providing up to 640 gigabits per
second, or Gbps, of transmission capacity without interrupting
existing traffic. A fiber channel is a serial data transfer
architecture standard conceived for new mass storage devices and
other peripheral devices that require very high bandwidth
connections. Bit rates for fiber channels are either 1.06 Gbps or
2.1 Gbps.
5
Protocol and Signal Transparency. Our suite of solutions
transports a mix of protocols and signals, including SONET/SDH,
Asynchronous Transfer Mode (ATM) over SONET, Internet Protocol
(IP) over SONET, Gigabit Ethernet, Fibre Channel and Enterprise
System Connectivity in their native formats over numerous
wavelengths in the same fiber. This transparency provides
operational simplicity in that the service provider can offer
networking connectivity without having to worry about protocol
conversions. This is particularly important in metropolitan areas
where multiple protocols are utilized and data transmission rates
change often. The transparency of our solution eliminates the
unnecessary conversions from optical to electrical and back to
optical, as well as eliminates several layers of equipment that
would otherwise be required in the transport and switching of
traffic, thus reducing network complexity and signal latency.
Protocol Aggregation. Our EPC'TM' optical access multiplexer
aggregates traffic, of varied rates utilizing a wavelength per
direction of transmission, from businesses and network points of
presence for transport throughout optical networks. This
aggregation allows better utilization of wavelengths and lowers
capital expenditures of telecom service providers by reducing
investments in excess network capacity.
Manageability. The design of our end-to-end optical networking
solution will allow service providers to perform network
management from a single platform with our TeraManager'TM'
product. This intelligent optical network element management
software platform provides fault, configuration, performance, and
security management utilizing an easy-to-use graphical user
interface that allows point and click network provisioning and
monitoring.
Regional Optical Transport. Our solution permits service
providers to expand beyond the confines of metropolitan networks
using the same platform for metropolitan and regional
applications. Regional networks can now be built using the lower
cost solutions developed for the metropolitan environment.
Our Strategy
Our objective is to become a leading supplier of intelligent optical
networking solutions for metro and regional applications worldwide. The key
elements of our strategy are to:
Enhance our optical networking solutions
We intend to continue to enhance our existing family of optical
networking products and to introduce new products that increase the
functionality of our end-to-end optical solution. We introduced
TeraManager'TM' and TeraConfigurator'TM' in our management solution
portfolio in fiscal 2002. We introduced a new 10-port Gigabit Ethernet
multiplexer in December 2003 for video on demand and large commercial
applications. The combination of our GigaMux'r' optical transport
products, with the EPC'TM' sub-rate multiplexers, and TeraManager'TM',
our carrier class network management product, creates an intelligent
all-optical transport solution.
Leverage our engineering expertise
We intend to leverage our engineering expertise in the areas of
optical, mechanical, electrical and network management design to
continue to provide leading end-to-end metropolitan and regional
optical networking systems and to expand our market share. We believe
we were the first company to commercially ship a metropolitan optical
networking product using DWDM technology. As of January 31, 2004, we
had a skilled team of 49 engineers that continually focus on
developing products for the metropolitan and regional optical
transport market. We believe that our technological expertise has been
the key to our success and will enable us to rapidly develop new
product offerings and end-to-end optical solutions for the
metropolitan and regional markets.
Allow our customers to leverage their fiber assets by offering
revenue-generating services
The majority of our existing customers and targeted customers
have a large amount of fiber assets in the metropolitan and regional
network infrastructure. We intend to continue to develop and provide
solutions that will enable our customers to leverage their existing
fiber infrastructure to deliver
6
revenue-generating services, while reducing their overall network
costs. In addition, we believe our existing customer base provides us
with an advantage when competing for new customers. We intend to
continue to work closely with our customers and invest in sales and
marketing resources to maintain our high level of customer service and
remain responsive to our customers' changing needs.
Aggressively pursue expense reduction initiatives
We continue to aggressively pursue cost reduction initiatives to
bring our expenses in line with current and future anticipated
revenues. Such reductions may affect the size of our workforce, and
may require decreasing our operating expenses and capital spending.
During the past two fiscal years we have concentrated on implementing
initiatives that have lowered our operating costs and anticipate the
need for continued cost reductions if sales volume does not increase
in the near future.
Maintain our sales, service and support organizations worldwide
We intend to continue to market our products worldwide. We
currently have sales, service and support teams in North America,
Europe and Asia. We believe that sales, service and support efforts on
a customer-by-customer basis are most effective due to the technical
evaluation and significant investments that are made by our customers.
Expand our product and customer base through careful acquisitions
We intend to expand our addressable market by adding
"best-of-breed" optical access products to our metro/regional
portfolio and enhance our edge-to-core network offerings. The recent
acquisition of LuxN, Inc., is a prime example of such expansion. LuxN
supplies optical access equipment for the network edge using CWDM and
DWDM technology. LuxN's Operations Systems Modification of Intelligent
Network Elements (OSMINE) certified products enable delivery of
high-bandwidth data, storage, video, and voice services for service
providers, cable Multiple Service Operators or MSOs, and enterprises.
Our union with LuxN broadens our 30-plus blue-chip customer base by
adding over 20 new customers including Time Warner Telecom, Hawaii
I-Net, Yipes Enterprise Services, and numerous universities.
Products
Our family of optical networking systems is designed to provide our
customers with end-to-end solutions for the metropolitan and regional optical
networking markets. Our transport, access, switching and network management
systems include the following products, some of which are still in development.
GigaMux'r' 6400 -- DWDM Optical Transport
Our GigaMux'r' 6400 optical transport product utilizes DWDM technology to
expand the capacity of new and existing fibers and enable traffic to travel
throughout metropolitan optical networks without optical to electrical to
optical conversions at each intermediate node. Our GigaMux'r' 6400 features
wavelength translation, wavelength multiplexing, optical amplification, optical
add-drop multiplexing, protection switching and performance monitoring. The
scalable and modular architecture of our GigaMux'r' 6400 product enables service
providers to easily and cost-effectively expand their existing networks as
bandwidth requirements increase. The GigaMux'r' 6400 can simultaneously
transport multiple protocols bi-directionally over one or more fibers, which
reduces the cost and complexity of the network. As part of our focus on
video-on-demand transport, we recently introduced a 10-port Gigabit Ethernet
multiplexer for GigaMux'r' 6400 metro/regional DWDM system targeted at the cable
multi-system operator community.
Our GigaMux'r' 6400 product is Network Equipment Building Standards; or
NEBS, level III certified. As of January 31, 2004, we have shipped our
GigaMux'r' product to over 20 direct carrier customers or resellers worldwide.
Our GigaMux'r' product includes the following key features:
Scalability: the system can grow from 1 to 64 protected channels
(640 Gbps/fiber) without a major upgrade or service interruption.
7
Protocol transparency: the system can aggregate and transport
SONET/SDH (OC-3/STM-1 through OC-192/STM-64 carrying voice, IP or
ATM traffic), ESCON, Fibre Channel, Fast Ethernet, Gigabit
Ethernet and video.
Modular protection: the system's modular protection system allows
redundancy to be implemented at any point in the network.
Add/drop channels: the system is equipped with add/drop modules
that allow specific channels to be added or dropped while all
other channels pass through. Our filter subsystem can add or drop
from single channels to larger wavelength bands.
Reach: Up to 600 kilometers with optical amplifiers and up to
1,000 km with the addition of dispersion compensation.
EPC'TM' - Sub-Rate Access Multiplexers
Electric Photonic Concentrator, or EPC'TM', is our sub-rate access
multiplexer product that aggregates a wide variety of traffic from businesses
and network points of presence for high-speed transport throughout optical
networks. The traffic is aggregated for transmission on a single wavelength over
the GigaMux'r' 6400. EPC'TM' is designed to lower the cost and increase the
efficiency of bandwidth delivery within optical networks.
Our EPC'TM' products aggregate the following protocols:
Ten one Gigabit Ethernet channels onto one 10 Gigabit wavelength
16 OC-3 channels or 4 OC-12 channels, or a combination thereof,
over a single OC-48 wavelength
Two one Gigabit Ethernet channels, or four fractional Gigabit
Ethernet channels, over a single OC-48 wavelength
Eight ESCON channels over a single OC-48 wavelength
GigaMux'r' 3200 and 1600 - DWDM and CWDM Optical Transport
Our GigaMux'r' 3200 and 1600 platforms feature the flexibility and value
needed for optical access and metro applications. The GM 3200 and 1600 can scale
up to 16 protected wavelengths of DWDM or 8 protected wavelengths of CWDM,
respectively, optimizing the cost of ownership for differing application needs.
The system features wavelength translation, wavelength multiplexing, optical
amplification, optical add-drop multiplexing, protection switching, and
comprehensive management and performance monitoring.
The GM 3200 and 1600 modules are supported in 4 different chassis options
(GM 3234, GM 3217, GM 1608, and GMX 128), ranging from 1 to 64 wavelengths in
capacity. All modules are common across multiple chassis allowing ease and
simplicity of sparing and flexible provisioning. Whether the CWDM/DWDM equipment
is positioned at the Central Office or customer premise, Sorrento utilizes an
industry leading form factor to keep rack space to a minimum. The operational
flexibility is extended to multi-rate software provisioning, varying methods of
protection, with DC and AC power support across all chassis. The GM 3200 and
1600 design is focused on providing simple intelligent optical access solutions
at a low cost of ownership to the carrier providing a quick ROI with ease of
implementing new revenue services.
Our GigaMux'r' 3200 and 1600 products are Network Equipment Building
Standards; or NEBS, level III certified. As of January 31, 2004, we have shipped
our GigaMux'r' 3200-1600 products to over 20 customers worldwide. Our GM 3200 -
1600 product includes the following key features:
Affordable pay-as-you-grow architecture featuring a low entry
price, modular design, and the ability to add more services
without interrupting the existing traffic.
Multi-rate, multi-protocol on the same hardware, supporting GbE,
1G & 2G Fibre Channel, ESCON, FICON, OC-3 thru OC-192, digital
video, 10 GbE LAN/WAN PHY and more.
Support for all access and metro topologies (including
point-to-point, linear add/drop, ring, and mesh) over single or
dual fibers with distances over 250 km.
8
Four different chassis options starting at 2RU in height (3.5")
and scaling from 1 to 64 wavelengths in capacity.
Cost effective In-Wavelength Management, eliminating the need for
a separate Optical Supervisory Channel.
Support for both CWDM and DWDM in the same chassis and on the
same fiber, utilizing the same form factor for all modules -
maximizing service flexibility and greatly reducing sparing and
inventory costs.
TeraManager'TM' -- Element Management System
TeraManager'TM' is our TL1-based intelligent element management software
platform that provides fault, configuration, performance and security management
for all the Sorrento networks products and for networks built with such
products. Service providers can operate our network management platform through
an easy-to-use graphical user interface, which gives users a complete network
view and enables point and click provisioning and monitoring.
Our TeraManager'TM' product includes the following features:
o Fault, configuration, security and performance management
o Carrier class performance
o Interface with higher layer operation support systems
Meret Optical Communications
Our optical networking subsidiary, Meret Communications, Inc., doing
business as Meret Optical Communications, also markets our new CWDM product, as
well as feature-rich video transport and switching, radio frequency, or RF,
transmission, and RF synthesis products.
Customers
Our target customer base includes wholesale and retail broadband service
providers, such as inter-exchange carriers, local and foreign telephone
companies, the telecom affiliates of utility companies (utilicoms), cable
television service providers, system integrators and distributors.
Our customers generally fit the following customer profiles:
o Wholesale Network Providers--these customers provide wavelength
and broadband services to communication service providers and
include telecommunication carriers, cable companies and
utilicoms.
o Managed Services Providers--these customers provide wavelength
and broadband services to enterprises and include
telecommunication carriers, cable companies, utilicoms and
Internet Service Providers.
o System Integrators--companies that specialize in providing
turnkey networking solutions for enterprise networks and
applications such as data-center connectivity and storage area
networks.
o Large Enterprises--large enterprise customers are generally large
organizations with complex networking needs, usually spanning
multiple locations and difficult types of network requirements.
Enterprise customers include industrial corporations, government
agencies, and utilities.
o Small and Medium Businesses--these customers have a need for
networks as well as connection to the Internet and/or to their
business partners. However, they generally have limited
resources. Therefore, we provide product through systems
integrators or Value Added Resellers.
Our customer base is highly concentrated. In fiscal year 2004, five
customers accounted for 48% of net sales. In fiscal year 2003, five customers
accounted for 84% of net sales, during fiscal year ended January 31, 2002 five
customers accounted for 62% of sales. We expect this customer concentration to
continue for the foreseeable future.
9
For fiscal 2004, we shipped our optical networking products to a total of 23
customers worldwide. Three customers, AT&T Broadband, now Comcast Corporation,
Cox Communications and Looking Glass Networks each represented more than 10% of
our net sales for fiscal 2004 and AT&T Broadband, now Comcast Corporation, Cox
Communications and Deutsche Telekom each represented more than 10% of our net
sales for fiscal 2003
Key Relationships
Three customers, AT&T Broadband, Cox Communications and Deutsche Telekom
each represented more than 10% of our net sales for fiscal 2002.
We have entered into long-term agreements with some of our customers,
including:
AT&T Broadband Network Solutions (Now Comcast Business Communications)
In February 2000, we entered into a strategic alliance agreement with AT&T
Broadband Network Solutions (now Comcast Business Communications), or AT&T
Broadband. Under the terms of this agreement, AT&T Broadband and we agreed to
negotiate in good faith concerning the implementation of a number of joint sales
and marketing initiatives. AT&T Broadband also agreed to help introduce our
technology to individuals at other AT&T divisions and to provide feedback
concerning our products' performance. The initial term of this agreement expired
in February 2002 and was automatically renewed for an additional one-year term
in February 2002, February 2003 and February 2004. Similar automatic renewals
will occur in each succeeding February. Either AT&T Broadband or we may
terminate the agreement for any reason upon ninety days notice. In addition, we
concurrently entered into an equipment purchase agreement. The equipment
purchase agreement expired in February 2002 and was automatically renewed for an
additional one-year term in February 2002, February 2003 and February 2004.
Similar automatic renewals will occur in each succeeding February. Either AT&T
Broadband or we may terminate the agreement for any reason upon ninety days
notice. We started shipping our products to AT&T Broadband in the second quarter
of fiscal year 2001.
In November 2002, we entered into a separate exclusive supplier agreement
with AT&T Broadband. Under this agreement, we became AT&T Broadband's exclusive
supplier, subject to certain exceptions, of dense and course wavelength division
multiplexing equipment that AT&T Broadband uses to provide UFO Communications,
Inc., a private service provider, with certain services on certain AT&T
Broadband networks. The initial term of this agreement is five years and
continues after the initial term until either party gives 90 days written notice
terminating the agreement.
Looking Glass Networks
In August 2001, we entered into an equipment purchase agreement with
Looking Glass Networks, or LGN. Under the terms of this agreement, LGN agreed to
purchase metro DWDM optical networking equipment from Sorrento as the primary
supplier. LGN also agreed to receive early adopter access to new and emerging
Sorrento technologies, and to serve as a beta tester for new and emerging
equipment and to provide feedback concerning our products' performance. The
initial term of this agreement expires in August 2004 and will be automatically
renewed for additional one-year terms. Either LGN or Sorrento may terminate the
agreement at the end of the initial or any renewal term upon ninety days notice.
We started shipping our products to LGN in the third quarter of fiscal year
2002.
Time Warner Telecom
In April 2001, we entered into an equipment purchase agreement with Time
Warner Telecom, or TWT. Under the terms of this agreement, TWT agreed to
purchase CWDM and DWDM optical networking equipment from Sorrento. The initial
term of this agreement expired in April 2003 and was automatically renewed for
an additional one-year term in April 2004. Similar automatic renewals will occur
in each succeeding April. TWT may terminate the agreement for any reason upon
thirty days notice.
Sales and Marketing
Our sales effort is currently focused on North America, Europe and Asia. As
of January 31, 2004, our sales and marketing organization included 36 employees,
including account managers, sales engineers, support personnel, product managers
and marketing personnel. In North America and Europe, we sell our products
through our direct
10
sales force as well as through system integrators. Our international direct
sales force is located in the United Kingdom, France and Germany. In Asia, we
sell our products though system integrators.
In support of our worldwide selling efforts, our marketing team targets
potential customers through in-depth market analysis. Our marketing objectives
include building market awareness and acceptance of our products as well as
expanding our customer base. Our customer acquisition strategy has focused on
targeting customers who are aggressively building network infrastructure and are
looking to leverage existing fiber assets to generate additional revenue from
broadband services. This focus has led to strategic supply agreements with
several MSOs, utilities, and CLECs. We also plan to target incumbent carriers as
they expand the development of their metropolitan and regional fiber networks.
Marketing personnel coordinate our participation in trade shows, seminars and
industry events and conduct media relation's activities with trade and general
business publications. We participate in many industry organizations responsible
for developing standards that are used in optical networks.
Customer Service and Support
Our customer service and support team provides a critical component of our
customer satisfaction initiative. This team provides support to our customers
allowing them to successfully design and implement their optical networks. All
services can be customized to meet the needs our customers. Our staff is
experienced, and has the equipment necessary to support both installation and
problem resolution. A variety of installation service packages support the
implementation from start up to upgrades and maintenance. Specialists are
available 7 days a week, 24 hours a day. We offer a Technical Assistance Center
including field services support. Multiple technical support service agreements
allow our customers to define the level of support they require. Our customer
service and support team provides installation, maintenance and training
programs addressing the product, installation and maintenance processes and can
be delivered at the customer location or at our training facility.
We currently provide service and support to our international customers on
a direct basis and are establishing service and support agreements throughout
the world. To date revenues from service and support agreements have not been
material. We intend to continue to develop our internal team to meet the needs
of our customers and will utilize strategic partners to allow us to provide
greater value when appropriate.
We provide a total service solution. Our hardware products are warranted
against defects for a period of 12 to 36 months dependent on purchase
agreements, including technical support and parts repair/replacement. We also
offer support contracts for a fee to our customer base, thereby allowing our
customers to select a service plan tailored to their own particular needs.
Engineering, Research and Development
We have assembled a team of highly skilled engineers with extensive
experience in the fields of optical, mechanical, electrical and network
management design. We believe that our success in introducing DWDM optical
technology for use in the metropolitan and regional markets was a result of our
strength in research and development. As of January 31, 2004, 49 employees were
engaged in engineering, research and development efforts. Our research and
development efforts are focused on new product development as well as enhancing
performance and reliability of our existing products. We believe that our
research and development efforts are key in maintaining technical
competitiveness, delivering innovative products, and addressing the needs of the
regional and metropolitan market.
Our engineering, research and development expenses were $8.0 million, $9.0
million and $13.7 million for the years ended January 31, 2004, 2003 and 2002,
respectively. The decrease in our engineering, research and development expenses
was primarily due to headcount and expense reduction programs initiated by the
Company as a result of decreased capital spending levels from our major telecom
customers during these periods.
Manufacturing and Quality
We outsource the manufacturing of our products. We design our products and
perform system integration, quality control, final testing and configuration at
our San Diego, California and Sunnyvale locations. Our Sunnyvale facility is ISO
9001:2000 certified and we have begun the process of upgrading our San Diego
facility from ISO 9002:1994 to ISO 9001:2000. By meeting such standards, we
assure our customers that we meet internationally recognized standards for
quality, customer care and sound management practices. We believe that
outsourcing our
11
manufacturing allows us to conserve working capital, flexibly respond to changes
in market demand and quickly deliver products to our customers.
We currently purchase products from our contract manufacturers and other
suppliers on a purchase order basis. We generally do not enter long-term
contracts with our contract manufacturers or suppliers, and they are not
obligated to perform services for us for any specific period or at any specified
price, except as may be provided in a particular purchase order. We purchase a
limited number of key components used in the manufacturing of our products from
a limited number of suppliers and some of our components are purchased
exclusively from a single supplier on a purchase order basis. Management
believes that other suppliers could be identified to provide similar components
on comparable terms. A change of suppliers, however, could cause a delay in
manufacturing and a possible loss of sales, which would affect operating results
adversely.
Patent, Trademarks and Licenses
We currently hold approximately 39 patents and have several patent
applications pending. Although we attempt to protect our intellectual property
rights through patents, trademarks, and copyrights, maintaining certain
technology as trade secrets and other measures, we cannot assure that any
patent, trademark, copyright or other intellectual property rights owned by us
will not be invalidated, circumvented or challenged, that such intellectual
property rights will provide competitive advantages to us or that any of our
pending or future patent applications will be issued with the scope of the
claims sought by us, if at all. We cannot assure that others will not develop
technologies that are similar or superior to our technology, duplicate our
technology or design around the patents that we own. In addition, effective
patent, copyright and trade secret protection may be unavailable or limited in
certain foreign countries in which we do business or intend to do business in
the future. We also have licensed and may in the future license technologies
from other companies on a non-exclusive basis. For example, one of our CWDM
products incorporates technology purchased from Entrada Networks, Inc., our
former affiliate, that we then enhanced to complete a commercially feasible
product.
We believe that the future success of our business will depend on our
ability to translate the technological expertise and innovation of our personnel
into new and enhanced products. We cannot assure that the steps taken by us will
prevent misappropriation of our technology. In the future, we may take legal
action to enforce our patents and other intellectual property rights, to protect
our trade secrets, to determine the validity and scope of the proprietary rights
of others, or to defend against claims of infringement or invalidity. Such
litigation could result in substantial costs and diversion of resources and
could harm our business and operating results.
As is common in our industry, we have from time to time received
notification from other companies of intellectual property rights held by those
companies upon which our products may infringe. Any claim or litigation, with or
without merit, could be costly, time consuming and could result in a diversion
of management's attention, which could harm our business. If we were found to be
infringing on the intellectual property rights of any third party, we could be
subject to liabilities for such infringement, which could be material, and could
be required to seek licenses from other companies or to refrain from using,
manufacturing or selling certain products or using certain processes. Although
holders of patents and other intellectual property rights often offer licenses
to their patent or other intellectual property rights, no assurance can be given
that licenses would be offered, that the terms of any offered license would be
acceptable to us or that failure to obtain a license would not cause our
operating results to suffer.
Working Capital Practices
We have historically maintained high levels of inventories to meet output
requirements of our customers and to ensure an uninterrupted flow of inputs from
suppliers. We have however, initiated active and aggressive programs to reduce
our inventories and conserve working capital resources on an ongoing basis. It
is not our standard policy to grant customers the right to return merchandise
that performs according to specifications. Typical payment terms require payment
within thirty to sixty days from the date of shipment.
We perform ongoing credit evaluations of each customer's financial
condition and extend unsecured credit related to the sales of various products.
From time to time we receive financial instruments such as letters of credit for
payments for international customers. At January 31, 2004, accounts receivable
due from Cox Communications, KLA Tencor, CNT and Time Warner Telecom accounted
for 16%, 12%, 12% and 11% respectively, of net
12
receivables. At January 31, 2003, accounts receivable due from AT&T Broadband,
Cox Communications, DeltaNet and Inoc accounted for 31%, 16%, 19% and 30%
respectively, of net receivables.
Our Backlog
At January 31, 2004, we had backlog that totaled $2.1 million compared to
$5.0 million at January 31, 2003. Our backlog consists of orders confirmed with
a purchase order for products to be shipped within twelve months to customers
with approved credit status. We do not believe that backlog, as of any
particular date, should be used as an indication of sales for any future period
for two reasons. First, orders are increasingly being booked and shipped in a
short period of time and therefore may never be calculated in the backlog amount
at the end of any particular quarter. Second, customers have and can change
delivery schedules or cancel orders without a significant penalty.
Competition
The market for optical networking equipment is extremely competitive and
subject to rapid technological change. We expect competition to continue to be
significant in the future. Our primary competitors in the DWDM market include
vendors of optical networking and infrastructure equipment such as ADVA AG
Optical Networking, CIENA Corporation, Cisco Systems, Lucent Technologies,
Fujitsu and Nortel Networks, as well as private companies that have been or will
be focusing on our target markets. Our primary competitors for our CWDM products
include ADVA AG Optical Networking and CIENA Corporation, as well as private
companies that have been or will be focusing on our target markets. Many of our
competitors have significantly greater financial resources and are able to
devote these greater resources to the development, promotion, sales and support
of their products. In addition, many of our competitors have more extensive
customer relationships than we do, including relationships with our potential
customers. We believe each of our competitors has optical networking products in
various stages of development.
We believe the principal competitive factors in the optical networking
market are:
o product performance, features, functionality and reliability;
o price/performance characteristics;
o timeliness of new product introductions;
o relationships with existing customers;
o service, support and financing; and
o financial stability and strength of company.
We believe our products compete favorably with our competition within our
marketplace.
The competitors for Meret's legacy products include Pesa, Artel, RGB
Spectrum, Utah Scientific, and many other companies.
Increased competition may result in further price reductions, reduced gross
margins and loss of market share, any of which could materially and adversely
affect our business, operating results and financial condition. There can be no
assurance that we will be able to compete successfully against current and
future competitors, or that competitive factors will not have a material adverse
effect on our business, operating results and financial condition.
Environmental Compliance
We are required to file environmental compliance reports with the Federal
Food and Drug Administration regarding the emissions levels of our laser-based
products, which are used in fiber optics communications. All of our products
comply with required safety level standards.
Employees
As of January 31, 2004, we had 132 employees, of which 49 were in
engineering, research and development, 36 in sales and marketing, and the
remainder in manufacturing and in general and administrative functions. Of the
49 employees in engineering, research and development 20 have master's degrees
and 14 have doctorate degrees.
13
We also employ a number of part-time and temporary personnel from time to time
in various departments. Our future success will depend in part on our ability to
attract, retain and motivate highly qualified technical and management
personnel, for whom competition is intense. None of our employees are covered by
a collective bargaining agreement and we believe that our relations with our
employees are good.
Forward-Looking Statements--Cautionary Statement
All statements other than statements of historical fact contained in this
Form 10-K, in our future filings with the Securities and Exchange Commission, in
our press releases and in our oral statements made with the approval of an
authorized executive officer are forward-looking statements. Words such as
"propose," "anticipate," "believe," "estimate," "expect," "intend," "may,"
"should", "could," "will" and similar expressions are intended to identify such
forward-looking statements. These forward-looking statements are made pursuant
to the safe harbor provisions of the Private Securities Litigation Reform Act of
1995. Although we believe that our expectations reflected in these
forward-looking statements are based on reasonable assumptions, such statements
involve risk and uncertainties and no assurance can be given that actual results
will be consistent with these forward-looking statements. Important factors that
could cause actual results to differ materially from those forward-looking
statements include without limitation: our ability successfully to finance our
current and future needs for working capital; our ability to keep our common
stock listed on the NASDAQ Stock Market; our ability to successfully develop,
sell and market our optical networking and other products; our expectations
concerning factors affecting the markets for our products, such as demand for
increased bandwidth; the scope and duration of the economic slowdown currently
being experienced by many of our existing and prospective customers; our ability
to compete successfully with companies who are much larger than we are and who
have much greater financial resources at their disposal; our ability, or
failure, to complete strategic alliances and strategic opportunities such as
sales or spin-offs of subsidiaries or business units on terms favorable to us
for reasons either within or outside our control; changed market conditions, new
business opportunities or other factors that might affect our decisions as to
the best interest of our shareholders; and other risks detailed from time to
time in our reports filed with the Securities and Exchange Commission.
We wish to caution readers not to place undue reliance on any such
forward-looking statements, which speak only as of the date made. Such
statements are subject to certain risks and uncertainties that could cause
actual results to differ materially from historical earnings and those presently
anticipated or projected. These risks and uncertainties are described in the
following section. We specifically decline any obligation to publicly release
the result of any revisions, which may be made to any forward-looking statements
to reflect anticipated or unanticipated events or circumstances occurring after
the date of such statements, or to update the reasons why actual results could
differ from those projected in the forward-looking statements.
Factors That May Affect Future Results
In connection with the safe harbor contained in the Private Securities
Reform Act of 1995 we are hereby identifying important factors that could cause
actual results to differ materially from those contained in any forward-looking
statements made by us or on our behalf. Any such statement is qualified by
reference to the following cautionary statements:
The telecom industry has experienced a significant downturn in the past
several years and continues to remain unpredictable as to future capital
spending level for carriers with whom we depend upon our revenues. Current world
turmoil, economic uncertainty and an equity market that is difficult to raise
new capital, could cause our future revenues to decrease. A significant downturn
in our revenues would have a negative impact upon our existing working capital
and have a negative impact on our stock price. In addition, we would be faced
with the need to raise additional working capital of which there is no certainty
that such working capital would be available.
We have substantial debt, and we may not generate sufficient cash flow to meet
our debt service obligations if revenues significantly decreased.
Our total debt consists primarily of approximately $12.4 million principal
amount of 7.5% debentures with a maturity date in August 2007, and mortgage debt
of approximately $3.6 million. The amount of our debt could have important
consequences, including:
o impairing our ability to obtain additional financing for working
capital, capital expenditures, acquisitions or general corporate
purposes;
14
o requiring us to dedicate a substantial portion of our operating
cash flow to paying principal and interest on indebtedness,
thereby reducing the funds available for operations;
o impairing our ability to adjust rapidly to changing market
conditions, invest in new or developing technologies, or take
advantage of significant business opportunities that may arise;
o placing us at a competitive disadvantage compared to our
competitors that have less debt; and
o making us more vulnerable if the current general economic
downturn continues or if our business experiences difficulties.
If we cannot generate sufficient revenues, we may not be able to meet our
debt service obligations, repay our debt when due, or comply with other
covenants in the 7.5% debentures. If we breach our obligations under the 7.5%
debentures, the holders could require repayment of all amounts owed, and we may
not have sufficient cash reserves to repay such amounts.
We may be unable to raise the funds necessary to repay or refinance our
indebtedness.
We are obligated to make interest payments on the 7.5% debentures on a
quarterly basis each year until 2007, when the 7.5% debentures mature. We have
the option to pay interest in shares of our common stock and in additional 7.5%
debentures to a certain limitation rather than cash. Upon maturity in August
2007 we may need additional capital to fund the repayment of the 7.5%
debentures. Our ability to arrange financing and the cost of financing if
necessary, to repay these debentures will depend upon many factors, including:
o our ability to deliver a good business model whereby we generate
profitable results;
o general economic and capital markets conditions generally, and in
particular the non-investment grade debt market;
o credit availability from banks or other lenders;
o investor confidence in the telecommunications industry generally
and our company specifically; and
o provisions of tax and securities law that are conducive to
raising capital.
If we need additional funds and are unable to raise them, our inability to
raise them will have an adverse effect on our operations. If we decide to raise
additional funds by incurring debt, we may become subject to additional or more
restrictive financial covenants and ratios.
A significant number of shares of our common stock issued in connection
with the restructuring transaction we undertook in June 2003, and in connection
with the December 2003 and January 2004 private placements, may be sold into the
market. This could cause the market price of our common stock to drop
significantly, even if our business is doing well.
Pursuant to the restructuring transaction we undertook in June 2003 with
the former holders of our subsidiary's Series A Preferred Stock and our then
outstanding 9.75% Senior Convertible Debentures, we registered for resale
15,000,000 shares of our common stock that were issued and are issuable or
potentially issuable in connection with the restructuring transaction. As part
of the restructuring transaction, we issued an aggregate principal amount of
$13.1 million of 7.5% convertible debentures, which are convertible into
approximately 2,416,975 shares at a conversion price of $5.42.
Additionally, in the December 2003 and January 2004 private placements, we
sold 5,061,613 shares of our common stock and issued warrants to purchase
2,530,806 shares of common stock to investors, and warrants to purchase 506,161
shares of common stock to the placement agent in the private placement.
15
Sales of a substantial number of shares of our common stock within any
narrow period of time could reduce the market price of our common stock.
Additionally, unless we achieve revenue growth and/or cost savings and other
business economies sufficient to improve our operating performance, which we
cannot assure, there could be a negative impact on our future stock price. We
have a history of losses and expect to incur future losses.
We have incurred operating losses during the years ended January 31, 2004,
2003 and 2002 of $17.6 million, $31.3 million and $37.2 million, respectively,
and as of January 31, 2004, we had an accumulated deficit of $193.8 million. We
expect that we could continue to incur losses in the future. If we do not become
profitable, the value of our stock will decrease. We have large expenses in the
areas of sales and marketing, research and development, manufacturing, and
general and administrative expenses that are not covered by our current sales
volume and resulting gross margin. Currently, the majority of revenues are from
shipments of our optical networking product lines. In order for us to become
profitable, we will need to generate and sustain higher revenue, improve our
gross margins on products while maintaining reasonable expense levels.
Our history of losses and expectation of future losses could have an impact on
our ability to finance our business and risk our ability to continue operating.
We have incurred significant losses and may incur significant losses in the
future. Such losses could cause our equity balance to fall below necessary
levels so that we are in violation of minimum listing requirements for our
publicly traded stock on the NASDAQ National Market, which could cause
significant decline in stockholder value and stock price.
Your percentage of ownership and voting power, and the price of our common stock
may decrease because we may issue a substantial number of shares of common
stock, or securities convertible or exercisable into our common stock.
We have the authority to issue up to one hundred fifty million shares of
our common stock and two million shares of our preferred stock without
stockholder approval. We have also previously issued warrants to certain of our
stockholders which will be exercisable to purchase approximately3.5 million
shares of our common stock.
In fiscal 2004, we issued 1,879,340 shares of our common stock in
connection with our acquisition of LuxN, Inc., a Delaware corporation, which we
acquired by the merger of our wholly-owned subsidiary with and into LuxN. In
addition, we issued warrants to purchase approximately 400,000 of our shares of
common stock in connection with the merger.
We may also issue additional warrants and options to purchase shares of our
common stock. These future issuances could be at values substantially below the
price paid for our common stock by current stockholders. We may conduct
additional future offerings of our common stock, preferred stock, or other
securities with rights to convert the securities into shares of our common
stock, which may result in a decrease in the value or market price of our common
stock. Further, the issuance of preferred stock could have the effect of
delaying, deferring or preventing a change of ownership without further vote or
action by the stockholders and may adversely affect the voting and other rights
of holders of common stock.
16
Our industry is highly competitive, and we may not have the resources required
to compete successfully.
The market for optical networking equipment is extremely competitive. We
expect competition to intensify in the future. Our primary sources of
competition include vendors of optical networking and infrastructure equipment
such as ADVA AG Optical Networking, CIENA Corporation, Cisco Systems, Lucent
Technologies and Nortel Networks, as well as private companies that have been or
will be focusing on our target markets. The competitors for Meret's legacy
products include Pesa, Artel, RGB Spectrum, Utah Scientific, and many other
companies. We may also face competition from a number of other companies that
have announced plans for new products to address the same network problems that
our products address. Many of our current and potential competitors have
significantly greater sales and marketing, technical, manufacturing, financial
and other resources than we do. Our competitors also may have more extensive
customer relationships than us, including relationships with our current and
potential customers. If we are unable to compete successfully against our
current and future competitors, we could experience pricing pressures, reduced
gross margins and order cancellations, any one of which could seriously harm our
business.
Our business may be seriously harmed if the market for optical networking
products in metropolitan and regional areas does not develop as we expect.
Our current and future product offerings are focused on the needs of
providers that service regional and metropolitan areas. The market for optical
networking products in regional and metropolitan areas is not yet mature, and we
cannot be certain that a feasible market for our products will develop or be
sustainable. In addition, the market has suffered a cutback in capital spending
from both enterprise and carrier customers as a result of poor economic
conditions. If this market does not develop, or develops more slowly than we
expect or continues to be impacted by the reduction in capital spending, our
business may be seriously harmed. Furthermore, the optical networking industry
is subject to rapid technological change, and newer technology or products
developed by others could render our products less competitive or obsolete. In
developing our products, we have made, and will continue to make, assumptions
about the optical networking standards that our customers and competitors may
adopt. If the standards adopted are different from those, which we have chosen
to support, market acceptance of our product would be significantly reduced and
our business will be seriously harmed.
Our future growth depends on our ability to attract new customers, and on our
customers' ability to sell additional services to their own customers.
Most of our potential customers evaluate optical networking products for
deployment in large telecommunications systems that they are installing. There
are limited number of potential customers for our products. If a potential
customer does not select us, our revenues and ability to grow our business may
seriously harmed. Similarly, much of our growth depends on our customers'
success in selling communications services based on our products and
complementary products from others. Our success will depend on our ability to
effectively anticipate and adapt to customer requirements and offer products and
services that meet customer demands. Any failure of our current or prospective
customers to purchase products from us for any reason, including a downturn in
their business, would seriously harm our ability to grow our business.
If we fail to establish and successfully maintain strategic alliances, long-term
contracts and relationships with distributors and system integrators, our
ability to grow and be profitable may be seriously harmed.
Strategic alliances and long-term contracts are an important part of our
effort to expand our sales opportunities and technological capabilities. To
date, we have entered into strategic alliances with AT&T Broadband, now Comcast
Corporation, and United Pan-Europe Communications. In addition we have long-term
contracts with Cox Communications, Looking Glass Networks and Time Warner
Telecom. We cannot be certain that our existing alliances and long-term
contracts will not be cancelled or that we will be able to enter additional
strategic alliances on terms that are favorable to us. With the exception of two
agreements we recently entered into with TCI Network Solutions, Inc., d/b/a AT&T
Broadband Network Solutions, and UFO Communications, Inc., our agreements to
date with our strategic allies are non-exclusive, and we anticipate that future
agreements will also be on a non-exclusive basis. These agreements are generally
short term, have no minimum financial commitments on either side and can be
cancelled without significant financial consequence. In addition, we cannot be
certain that our existing and any future strategic alliances will be successful.
As we expand internationally, we will increasingly depend upon distributors and
system integrators. Our ability to grow and be profitable may be seriously
harmed if
17
we fail to establish and maintain strategic alliances, long-term contracts and
relationships with distributors and system integrators.
We rely on a small number of customers for most of our revenues and any loss,
cancellation, reduction or delay in sales to, or collections from, any single
customer could seriously harm our business.
Our customer base is highly concentrated. Historically, orders from a
relatively limited number of customers accounted for most of our net sales. For
the fiscal year ending January 31, 2004, five customers accounted for 43% of net
sales, during the fiscal year ended January 31, 2003, five customers accounted
for 58% of net sales and in fiscal year 2002 five customers accounted for 70% of
our net sales. We expect that, for the foreseeable future, sales to a limited
number of customers will continue to account for a high percentage of our net
sales. We currently do not have any long-term purchase commitments with any of
our customers, and we are subject to the varying purchase cycles of our
customers. Our concentrated customer base significantly increases the credit
risks associated with slow payments or non-payments by our customers. The loss
or delay of orders or slow or non-payment from, any of our largest customers
could adversely impact our business.
Our backlog at any point may not be a good indicator of expected revenues.
Our backlog at the beginning of each quarter typically is not sufficient to
achieve expected sales for the quarter. To achieve our sales objective, we are
dependent upon obtaining orders during each quarter for shipment during that
quarter. Furthermore, our agreements with our customers typically provide that
they may change delivery schedules and cancel orders within specified times
which are typically 30 days or more prior to the scheduled shipment date,
without significant penalty. Our customers have in the past built, and may in
the future build, significant inventory in order to facilitate more rapid
deployment of anticipated major projects or for other reasons. Decisions by such
customers to reduce their inventory levels have led and could lead to reductions
in purchases from us. These reductions, in turn, have and could cause
fluctuations in our operating results and have had and could have caused an
adverse effect on our business, financial condition and results of operations in
periods in which the inventory is reduced.
Our operating results are likely to fluctuate significantly and may fail to meet
or exceed the expectations of securities analysts or investors, causing our
stock price to decline.
Our revenues and operating results may vary significantly from quarter to
quarter and year to year due to a number of factors, many of which are outside
of our control and any of which may cause our stock price to fluctuate. Some of
the factors that may affect us include changes in market demand for our optical
networking products, the cost and availability of components used in our
products, the timing and amount of customer orders, the length and
unpredictability of the sales and deployment cycles of our products, the timing
of new product introductions and enhancements by our competitors and ourselves,
changes in our pricing or the pricing of our competitors, our ability to attain
and maintain production volumes and quality levels of our products, and general
economic conditions as well as those specific to the telecommunications and
related industries.
If we are unable to comply with regulations affecting our customers' industries,
our revenues may be seriously harmed.
Our customers are involved in industries that are subject to extensive
regulation by domestic and foreign governments. If we fail to conform our
products to these regulatory requirements, we could lose sales and our business
could be seriously harmed. Additionally, any failure of our products to comply
with relevant regulations could delay their introduction and require costly and
time-consuming engineering changes.
The time that our customers and potential customers require for testing and
qualification before purchasing our products can be long and variable, and may
require us to invest significant resources without any assurances of sales,
which may cause our results of operations to be unpredictable.
Before purchasing our products, potential customers typically undertake a
lengthy evaluation, testing and product qualification process. In addition,
potential customers often require time consuming field trials of our products.
Our sales effort requires the effective demonstration of the benefits of our
products to, and significant training of, potential customers. In addition, even
after deciding to purchase our products, our customers may take several years to
deploy our products. The timing of deployment depends on many factors, including
the sophistication of a customer and the complexity and size of a customer's
networks. Our sales cycle, which is the period from the time a sales lead is
generated until the recognition of revenue, can often be longer than one year.
18
The length and variability of our sales cycle is influenced by a variety of
factors beyond our control, including our customers' build out and deployment
schedules, our customers' access to product purchase financing, our customers'
needs for functional demonstration and field trials, and the manufacturing lead
time for our products. Because our sales cycles are long and variable and may
require us to invest significant resources without any assurances of sales, our
results of operations may be unpredictable.
The GigaMux'r' 6400 and 3200 products, EPC'TM', and TeraManager'TM' are our only
currently available significant products, and if they are not commercially
successful, our revenue will not grow and we may not achieve profitability.
If our customers and potential customers do not adopt, purchase and
successfully deploy our GigaMux'r', EPC'TM', and TeraManager'TM' products in
large numbers, our revenue may not grow and our business, financial condition
and results of operations will be seriously harmed. Because the market for our
products is relatively new, future demand for our products is uncertain and will
depend on the speed of adoption of optical networking, in general, and optical
equipment in metro and regional networks, in particular.
If we are not able to develop and commercialize new or enhanced products, our
operating results and competitive position will be seriously harmed.
Our growth depends on our ability to successfully fund and develop new and
enhanced products. The development of new or enhanced products is a costly,
complex and uncertain process that requires us to anticipate accurately future
technological and market trends. Our next generation of transport and network
management products is currently under development. We cannot be sure whether
these or other new products will be successfully developed and introduced to the
market on a timely basis, or at all. We will need to complete each of the
following steps to successfully commercialize these and any other new products,
complete product development, qualify and establish component suppliers,
validate manufacturing methods, conduct extensive quality assurance and
reliability testing, complete software validation, and demonstrate systems
interoperability.
Each of these steps presents serious risks of failure, rework or delay, any
one of which could adversely affect the rate at which we are able to introduce
and market our products. If we do not develop these products in a timely manner,
our competitive position and financial condition could be adversely affected.
In addition, as we introduce new or enhanced products, we must also manage
the transition from older products to newer products. If we fail to do so, we
may disrupt customer ordering patterns or may not be able to ensure that
adequate supplies of new products can be delivered to meet anticipated customer
demand. Any failure to effectively manage this transition may cause us to lose
current and prospective customers.
If our products do not interoperate with our customers' networks, installations
will be delayed or cancelled or our products could be returned.
Many of our customers require that we design products to interoperate with
their existing networks, each of which may have different specifications and
utilize a variety of protocols. Our customers' networks contain multiple
generations of products that have been added over time as these networks have
grown and evolved. Our products must intemperate with all of the products within
these networks as well as future products in order to meet our customers'
requirements. If we are required to modify our product design to be compatible
with our customers' systems to achieve a sale, it may result in a longer sales
cycle, increased research and development expense and reduced margins on our
products. If our products do not interoperate with those of our customers'
networks, installations could be delayed, orders for our products could be
cancelled or our products could be returned, any of which could seriously harm
our business.
Our products may have errors or defects that we find only after deployment,
which could seriously harm our relationship with our customers and our
reputation.
Our customers may discover errors or defects in our products, and our
products may not operate as expected. If we are unable to fix errors or other
problems that may be identified on a timely basis, we could experience losses of
or delays in revenues and loss of market share, loss of customers, failure to
attract new customers or achieve market acceptance, diversion of engineering
resources, increased service and warranty costs, and legal actions by our
customers. Any failure of our current or planned products to operate as expected
could delay or prevent their adoption and seriously harm our relationship with
our customers and our reputation.
19
We depend upon contract manufacturers and any disruption in these relationships
may cause us to fail to meet the demands of our customers and damage our
customer relationships.
We use contract manufacturers to manufacture and assemble some of our
products in accordance with our specifications. We currently have three
U.S.-based contract manufacturers. We do not have long-term contracts with any
of them, and none of them is obligated to perform services for us for any
specific period or at any specified price, except as may be provided in a
particular purchase order. We may not be able to effectively manage our
relationships with these manufacturers and they may not meet our future
requirements for timely delivery or provide us with the quality of products that
our customers and we require.
Each of our contract manufacturers also builds products for other
companies. We cannot be certain that they will always have sufficient quantities
of inventory available to fill our orders, or that they will allocate their
internal resources to fill these orders on a timely basis. Qualifying a new
contract manufacturer and commencing volume production is expensive and time
consuming and could result in a significant interruption in the supply of our
products. If we are required to change contract manufacturers, we may suffer
delays that could lead to the loss of revenue and damage our customer
relationships.
We rely on a limited number of suppliers and single suppliers for some of our
components, and our sales and operating results may be seriously harmed if our
supply of any of these components is disrupted.
Our contract manufacturers and we currently purchase several key components
of our products from single and limited sources. We purchase each of these
components on a purchase order basis and have no long-term contracts for these
components. In the event of a disruption in supply or if we receive an
unexpectedly high level of purchase orders, we may not be able to develop an
alternate source in a timely manner or at favorable prices. Any of these events
could hurt our ability to deliver our products to our customers and negatively
affect our operating margins. In addition, our reliance on our suppliers exposes
us to potential supplier production difficulties or quality variations. Any such
disruption in supply would seriously affect our present and future sales.
We expect the average selling prices of our products to decline, which may
reduce gross margins and revenue.
Our industry has experienced erosion of average product selling prices. We
anticipate that the average selling prices of our products will decline in
response to competitive pressures, increased sales discounts, and new product
introductions by our competitors or other factors. Such reduced sales prices
require us to reduce our costs in order to maintain or improve our existing
gross margins. If we are unable to achieve sufficient cost reductions and
increases in sales volumes, the decline in average selling prices will reduce
our gross margins and revenue.
If we are unable to hire or retain highly skilled personnel, we may not be able
to operate our business successfully.
Our future success depends upon the continued services of our key
management, sales and marketing, and engineering personnel, many of whom have
significant industry experience and relationships. Many of our personnel could
be difficult to replace. We do not have "key person" life insurance policies
covering any of our personnel. The loss of the services of any of our key
personnel could delay the development and introduction of, and have a negative
impact on our ability to sell, our products. Competition for highly skilled
personnel is intense in our industry, and we may not be able to attract and
retain qualified personnel, which could seriously harm our business.
If we become subject to unfair hiring claims, we could incur substantial costs
in defending ourselves.
Companies in our industry whose employees accept positions with competitors
frequently claim that their competitors have engaged in unfair hiring practices.
We cannot assure you that we will not receive claims of this kind in the future
as we seek to hire qualified personnel or that those claims will not result in
material litigation. We could incur substantial costs in defending ourselves or
our employees against such claims, regardless of their merits. In addition,
defending ourselves from such claims could divert the attention of our
management away from our operations.
We may be unable to protect our intellectual property, which could limit our
ability to compete.
We rely on a combination of patent, copyright, trademark and trade secret
laws and restrictions on disclosure to protect our intellectual property rights.
We also enter into confidentiality or license agreements with our
20
employees, consultants and corporate partners, and control access to, and
distribution of, our software, documentation and other proprietary information.
Despite our efforts to protect our proprietary rights, unauthorized parties may
attempt to copy or otherwise obtain and use our products or technology.
Monitoring unauthorized use of our products is difficult, and we cannot be
certain that the steps we have taken will prevent unauthorized use of our
technology, particularly in foreign countries where the laws may not protect our
proprietary rights as fully as in the United States. If competitors gain access
to our technology, our ability to compete could be harmed.
We could become subject to litigation regarding intellectual property rights,
which could seriously harm our business and require us to incur significant
costs.
In recent years, there has been significant litigation in the United States
involving patents and other intellectual property rights. We may be a party to
litigation in the future to protect our intellectual property or as a result of
an allegation that we infringe upon others' intellectual property rights. Any
parties asserting that our products infringe upon their proprietary rights would
force us to defend ourselves and possibly our customers or manufacturers against
the alleged infringement. These claims and any resulting lawsuits, if
successful, could subject us to significant liability for damages and
invalidation of our proprietary rights. Additionally, any claims and lawsuits,
regardless of their merits, would likely be time-consuming and expensive to
resolve and would divert management time and attention.
Any claims of infringement on the intellectual property rights of others
could also force us to do one or more of the following: stop selling,
incorporating or using our products that use the challenged intellectual
property, obtain from the owner of the infringed intellectual property right a
license to sell or use the relevant technology, which may not be available to us
on reasonable terms, or at all, or redesign- those products that use such
technology. If we are forced to take any of the foregoing actions, our business
may be seriously harmed. However, we intend to vigorously protect our
intellectual property against all material challenges.
If necessary licenses of third-party technology are not available to us or are
very expensive, our products could become obsolete.
We have been licensing, and may be required to license, technology from
third parties to develop new products or product enhancements. We cannot assure
you that third-party licenses will be available to us on commercially reasonable
terms, if at all. If we are required to obtain any third-party licenses to
develop new products and product enhancements, we could be required to obtain
substitute technology, which could result in lower performance or greater cost,
either of which could seriously harm the competitiveness of our products.
Our international operations could subject us to risks due to currency
fluctuations and changes in foreign government regulations, which could harm our
business.
Our international operations are subject to a number of risks, including
changes in foreign government regulations and telecommunications standards,
import and export license requirements, tariffs, taxes and other trade barriers,
fluctuations in currency exchange rates, difficulty in collecting accounts
receivable, the burden of complying with a wide variety of foreign laws,
treaties and technical standards, difficulty in staffing and managing foreign
operations, and political and economic instability.
The majority of our sales and expenses have been denominated in U.S.
dollars. However, in the future a larger portion of our sales and expenses may
be denominated in non-U.S. currencies. As a result, currency fluctuations
between the U.S. dollar and the currencies in which we do business could cause
foreign currency translation gains or losses that we would recognize in the
period incurred. We cannot predict the effect of exchange rate fluctuations on
our future operating results because of the number of currencies involved, the
variability of currency exposure and the potential volatility of currency
exchange rates. We do not currently engage in foreign exchange hedging
transactions to manage our foreign currency exposure.
If we do not effectively address our financial, managerial and manufacturing
processes, we may not be able to successfully expand our business.
Our business has experienced wide fluctuations in sales volume from quarter
to quarter, which places a significant strain on our management systems and
resources. Our ability to successfully offer our products and implement our
business plan in a rapidly evolving market requires an effective planning and
management process. We will need to continue to improve our financial,
managerial and manufacturing processes and reporting systems,
21
and will need to continue to expand, train and manage our workforce worldwide.
Many of our competitors have set-up manufacturing facilities and operations
offshore into significantly less expensive labor and product markets. Our
ability to produce our products at similar favorable production costs could harm
our ability to compete in the markets we serve. If we fail to effectively
address the above requirements, our ability to pursue business opportunities and
expand our business could be harmed.
Our stock price may be volatile which may affect your ability to sell shares at
or above the offering price or result in securities litigation against us.
The stock market in general, the NASDAQ Stock Market and the stock of
optical networking companies in particular, have experienced extreme price and
volume fluctuations that have often been unrelated or disproportionate to a
company's operating performance. We expect the price of our common stock to
fluctuate. The offering price may not be indicative of the prices that will
prevail in the public market after the offering. The trading price of our common
stock could fluctuate in response to factors including those described elsewhere
in this annual report and:
o General market and economic conditions;
o Announcements of technological innovations or new products;
o Publicity regarding actual or potential results with respect to
technologies or products under development; and
o Other events or factors, many of which are beyond our control.
These broad market and industry factors may cause our stock price to
decline, regardless of our actual operating performance. In the past, following
periods of volatility in the market price of a company's securities, securities
class-action litigation has often been instituted against that company.
Securities class-action litigation, if instituted, could result in substantial
costs and a diversion of management's attention and resources, which would harm
our profitability.
Definitions
As used in this Annual Report on Form 10-K, the following terms have the
meanings indicated:
"ATM" means Asynchronous Transfer Mode, which is a type of networking technology
based on transferring data in cells or packets of a fixed size. The small,
constant cell size allows ATM equipment to transmit video, audio, and data over
the same network, and assure that no single type of data overtakes the line.
Current implementations of ATM support data transfer rates of 25 Mbps to 2.48
Gbps.
"Backbone" means a main segment of a network carrying large amounts of traffic.
Individual metro and interoffice rings are attached to the backbone.
"Bandwidth" means the capacity to move information down a communications
channel. Bandwidth is defined by the highest data rates that can be transmitted
by that channel and is commonly measured in bits per second (bps). For example,
Ethernet has a 10 Mbps bandwidth and OC-192 has 10 gigabits per second
bandwidth.
"Bridge" means a device that connects two or more networks of the same access
method (Ethernet to Ethernet or Token Ring to Token Ring) by making simple
forward/don't forward decisions on each data packet received from any of the
networks to which it is connected.
"Broadband" means technologies or networks that have the ability to transmit
high data rates.
"CLEC" means a Competitive Local Exchange Carrier.
"Concentrator" means the connection point, more sophisticated than a hub,
incorporating different types of cable connections, back-up power supply,
data-gathering capability for management purposes and possibly even bridge and
router features as well.
22
"CWDM" means Coarse Wavelength Division Multiplexing, which is a sophisticated
opto-electronics technology that uses multiple wavelengths of light spaced at
least 400 Ghz apart to increase the number of video, data or voice channels of
information that can be sent on a single optical fiber in a transmission system.
"DWDM" means Dense Wavelength Division Multiplexing, which is a sophisticated
opto-electronics technology that uses multiple wavelengths of light very
efficiently to greatly increase the number of video, data or voice channels of
information that can be sent on a single optical fiber in a transmission system.
"ESCON"--Enterprise System Connectivity--means a protocol for 200 Mbps signal
transmission speed over fiber optic cable.
"Ethernet" means a 10 Mbps speed network that runs over thick coaxial cable
(10BASE5), thin coaxial cable (10BASE2), twisted-pair (10BASE-T), and
fiber-optic cable. It is the most widely used LAN technology and the most
popular form of Ethernet is 10BASE-T. Ethernet is a network specification that
was developed at Xerox Corp's Palo Alto Research Center, and made into a network
standard by Digital, Intel, and Xerox.
"Fast Ethernet" means a 100 Mbps speed network that runs over thick coaxial,
twisted-pair, and fiber-optic cable. Fast Ethernet is 10 times faster than
Ethernet.
"FDDI" means a Fiber Distributed Data Interface and is a fiber optic network
that supports transmission speeds up to 100 Mbps.
"Fibre Channel" means a serial data transfer architecture standard conceived for
new mass storage devices and other peripheral devices that require very high
bandwidth connections. Bit rates for Fibre channel are either 1.06 Gbps or 2.1
Gbps.
"Gigabit Ethernet" means a 1000 Mbps speed network that runs fiber-optic cable
for wide area network connections.
"HDTV" means high definition television, which is a new type of television that
provides much better resolution than current television. HDTV is slowly being
implemented into the broadcast networks.
"Hub" means a central connection device to which many network tributaries are
connected.
"ILEC" means Incumbent Local Exchange Carrier and is a telephone company that
provides local services and does not offer long distance services. All the
regional operating companies after the break-up of AT&T became ILECs.
"ISDN" means an Integrated Services Digital Network and is an all-digital
communications network that provides a wide range of services on a switched
basis. Voice, data and video can be simultaneously transmitted on one line from
a source.
"ISO" means International Standards Organization. Founded in 1946, ISO is an
international organization composed of national standards bodies from over 75
countries. ISO has defined a number of important computer standards; the most
significant of which is perhaps is OSI (Open Systems Interconnection), a
standardized architecture for designing networks.
"ISP" means an Internet Service Provider.
"ITU" means International Telecommunications Union, which is an
intergovernmental organization through which private and public organizations
develop telecommunications. The ITU was founded in 1865 and became a United
Nations agency in 1947 and it is responsible for adopting international tax
treaties, regulations and standards governing telecommunications.
"IXC" means an inter-exchange carrier, a long distance telephone company or a
carrier that specializes in connecting central offices of local service
providers. This carrier typically does not offer services to end users. AT&T,
MCI and Sprint are IXCs. A carrier that provides the backbone of competitive
local exchange carriers can also be considered as an IXC. Therefore, an IXC can
provide service in both metropolitan and in long haul networks.
"LAN" means a Local Area Network and is a high-speed communications system
designed to link computers for the purpose of sharing files, programs and
various devices such as printers and high-speed modems within a small
23
geographic area such as a workgroup, department or single floor of a multi-story
building. LANs may include dedicated computers or file servers that provide a
centralized source of shared files and programs.
"MSO" means a Multiple Service Operator, which is typically a cable TV operator
that offers multiple services such as video, voice and data.
"Multiplexing" means a process that combines a number of lower speed data
transmissions into one high-speed data transmission by splitting that total
available bandwidth into narrower bands (frequency division) or by allotting a
common channel to several different transmitting devices one at a time in
sequence (time division). The opposite function of separating the data channels
into their original format is called demultiplexing.
"OC-1, OC-3, OC-12, OC-48, OC-192" means the SONET bit rates of 51.85Mbps, 155
Mbps, 622 Mbps, 2.5 Gbps and 10Gbps transmission speeds for signals over fiber
optic cables. The number in the end of the term corresponds to the equivalent
multiple of OC-1 capacity (e.g., OC-192 means equivalent to 192 times OC-1)
"OEMs" means original equipment manufacturers.
"Opto-Electro-Optical" means Optical-Electrical-Optical which describes the
conversion of optical signals to electric and back to optical. Typically,
devices performing this function in the electrical domain and the signals need
to be converted back to optical for transmission over optical fibers.
"Packet" means the "envelope" in which the network software places a message
being sent from one station to another station in a network. One of the key
features of a packet is that it contains the destination address in addition to
the data.
"POTS" means "plain old telephone service" which refers to the standard
telephone service over copper lines that most homes use. In contrast, telephone
services based on high-speed, digital communications lines, such as ISDN and
FDDI, are not POTS. The main distinction between POTS and non-POTS services is
speed and bandwidth. POTS is generally restricted to about 52Kbps.
"Protocol" means a standard developed by international standards bodies,
individual equipment vendors, and ad hoc groups of interested parties to define
how to implement a group of services in one or more layers of the OSI model. The
Open Systems Interconnect ("OSI") reference model was developed by the ISO to
define all the services a LAN should provide. Ethernet and Token Ring, for
example, are both protocols that define different ways to provide the services
called for in the Physical and Data Link Layers of the OSI model.
"PTT" means Postal, Telephone and Telegraph, and refers to a generic telephone
company outside the United States. Typically, a PTT is state owned and can
operate both local and long distance services.
"RBOC" means a Regional Bell Operating Company.
"Router" means a network translator that reads network-addressing information
within packets to provide greater selectivity in directing traffic over multiple
network segments. It is a more complex inter-networking device.
"SDH" means Synchronous Digital Hierarchy, which is transmission protocol for
high speed transmission over fiber optic cable published in 1988 by the
Consultative Committee for International Telegraph and Telephony. It a hierarchy
similar to SONET but in this case the lowest bit rate channel is STM-1 (155
Mbps).
"SONET" means a transmission protocol for high-speed transmission over fiber
optic cable, which was introduced by Bell Communications in 1984 and quickly
accepted by American National Standards Institute.
"Switch" means a device that allows the network operator to vary and select
connections between network nodes at very high speeds.
"T-1" means a dedicated phone connection supporting data rates of 1.544 Mbps. A
T-1 line actually consists of 24 individual channels, each of which supports
64Kbps and can be configured to carry voice or data traffic. T-1 lines are
sometimes referred to as DS-1 lines.
"TCP/IP" means Transmission Control Protocol/Internet Protocol, which is a suite
of protocols used for communications between two or more devices.
24
"TDM" means time division multiplexing which is a multiplexing process that
combines a number of lower speed data transmissions into one high-speed data
transmission by allotting a common channel to several different transmitting
devices one at a time in sequence.
"Token Ring" means a 4 Mbps or 16 Mbps speed network that uses different
technology than Ethernet to co-ordinate the transmission of data among nodes.
"WAN" means a Wide Area Network and is a communications network that connects
geographically dispersed users. Typically, a WAN consists of two or more LANs.
The largest WAN in existence is the Internet.
Item 2. Properties.
We are headquartered in our San Diego, California facility that we own
consisting of approximately 36,000 square feet used for offices, research and
development and manufacturing. We also own a 47,000 square foot facility in San
Diego, California adjacent to our headquarters that is used for offices,
manufacturing and customer support.
For the fiscal year 2004 we occupied an additional 40,668 square feet used
for office, research and development and manufacturing activities under lease as
detailed below:
Location Square Footage Facility Type Expiration Date
-------- -------------- -------------------- ----------------
Sunnyvale, California 35,288 Office/Manufacturing December 31, 2004
Stuttgart, Germany 5,380 Office December 31, 2005
We believe our facilities are suitable and adequate to meet our current
needs. See Note E to the Consolidated Financial Statements contained in Part II
herein for terms and amounts of mortgages on the facility we own.
Item 3. Legal Proceedings
On June 4, 2003, we consummated the exchange transaction and cancelled all
outstanding Series A Convertible Preferred Stock and 9.75% Senior Convertible
Debentures. The Exchange Agreement provides that the litigation instituted by
the former holders of Series A stock be dismissed with prejudice against the
Company, its subsidiaries, its current officers and directors, and other
defendants who execute an appropriate release, and without prejudice against all
other defendants. This dismissal will require court approval, which is in the
process of being obtained by counsel for all parties.
In addition, claims in arbitration were filed by two of our former
financial officers and employees who worked in our former Santa Monica office,
which has since been closed, alleging that their resignations in May 2002 were
for "good reason" as defined in their employment agreements, all of which were
to expire on May 22, 2002. One of the claims was settled in May 2003 for $45
thousand, approximately the value of legal fees incurred by the plaintiff. The
other claim was resolved in August 2003 by an arbitrator who ruled in our favor.
As part of the arbitration ruling, both parties were responsible for their own
legal fees.
A former officer of our SNI subsidiary brought suit alleging breach of a
consulting agreement we entered into with him in March 2002, following his
resignation "for good reason" as defined in his employment agreement. He was
seeking acceleration of consulting fees due to him under his consulting
agreement in the amount of $229 thousand. This suit was settled in January 2004
for approximately $150 thousand in full settlement and a mutual release of
claims from both parties.
From time to time, we are involved in various other legal proceedings and
claims incidental to the conduct of our business. Although it is impossible to
predict the outcome of any outstanding legal proceedings, we believe that such
legal proceedings and claims, individually and in the aggregate, are not likely
to have a material effect on our financial position, results of operations, or
cash flows.
Item 4: Submission of Matters to a Vote of Security Holders
The annual meeting of shareholders of Sorrento Networks Corporation (the
"Meeting") was held on January 8, 2004.
25
Elections of Directors
The shareholders elected each of the seven nominees for directors as listed
in the Sorrento Networks Corporation's proxy statement dated December 3, 2003.
The directors will hold office for one-year terms ending at the next Annual
Meeting or until their successors have been duly elected and qualified.
The proxies received by Sorrento Networks Corporation for the Meeting were
voted as follows:
VOTES
DIRECTOR VOTES FOR AGAINST
-------------------- --------- -------
1 Phillip W. Arneson 7,647,206 519,518
2 Donne F. Fisher 7,785,513 381,211
3 Robert L. Hibbard 7,647,206 519,518
4 Gary M. Parsons 7,785,513 381,211
5 Larry J. Matthews 7,785,513 381,211
6 Don Herzog 7,785,513 381,211
7 Tom Schilling 8,030,228 136,496
Additional Shares to LuxN Shareholders
To approve the issuance of common shares associated with the LuxN
acquisition that exceeds 20% of the current outstanding shares of the Company as
of the acquisition date. Upon approval, the cash held under restriction would be
released to the Company for general working capital purposes
VOTES VOTES
PROPOSAL VOTES FOR AGAINST ABSTAIN UNVOTED
------------------------- --------- ------- ------- ---------
Additional Shares to LuxN
Shareholders 2,224,914 144,537 22,358 5,774,915
Appointment of Auditors
The shareholders ratified the appointment of BDO Seidman, LLP as Sorrento
Networks Corporation's independent auditors. The proxies received by Sorrento
Networks Corporation for the Meeting were voted as follows:
VOTES VOTES
PROPOSAL VOTES FOR AGAINST ABSTAIN UNVOTED
----------------------- --------- ------- ------- ---------
3 BDO Seidman, Auditors 8,120,038 29,276 17,410 --
26
PART II
Item 5. Market for Company's Common Equity and Related Stockholder Matters.
Our common stock has been traded on the NASDAQ Small Cap Market under the
symbol FIBR since 1994. On December 16, 1998, we commenced trading on the NASDAQ
National Market System under the same symbol.
The following table sets forth the high and low sale prices per share of
our common stock as reported on the NASDAQ National Market for the periods
indicated. Quotations represent inter-dealer prices; they do not include retail
markups, markdowns, or commissions; and, they may not represent actual
transactions.
Fiscal
2002-2003 High Low
---------- ------ ------
Quarter from February 1, 2002 to April 30, 2002........ $73.20 $40.00
Quarter from May 1, 2002 to July 31, 2002.............. $53.00 $13.20
Quarter from August 1, 2002 to October 31, 2002........ $14.80 $ 2.40
Quarter from November 1, 2002 to January 31, 2003...... $15.07 $ 4.15
Fiscal
2003-2004
----------
Quarter from February 1, 2003 to April 30, 2003........ $ 8.30 $ 4.96
Quarter from May 1, 2003 to July 31, 2003.............. $ 5.98 $ 2.27
Quarter from August 1, 2003 to October 31, 2003........ $ 3.81 $ 2.25
Quarter from November 1, 2003 to January 31, 2004...... $ 5.35 $ 2.38
On March 31, 2004, the average of the high and low bid quotation for our
common stock was $3.13 per share. There is no assurance that a market in our
common stock will continue.
Approximate Number of Holders of Common Stock
As of March 31, 2004, there were approximately 756 holders of record,
including brokerage firms and nominees, of our common stock. We believe that the
number of beneficial owners of our common stock substantially exceeds this
number.
Dividends
We have never paid any cash dividends on our common stock. The present
policy of the Board of Directors is to retain all available funds to finance the
planned level of operations. In light of the anticipated cash needs of our
business, it is not anticipated that any cash dividends will be paid to the
holders of our common or preferred stock in the foreseeable future.
Sale of Unregistered Securities
During fiscal year 2004, we issued the following securities that were not
registered under the Securities Act of 1933:
June 04, 2003 Exchange Agreement 8,029,578 shares of common stock
June 04, 2003 Legal Settlement 54,314 shares of common stock
August 08, 2003 LuxN, Inc. Acquisition 1,879,340 shares of common stock
December 31, 2003 Private Placement 2,140,101 shares of common stock
January 26, 2004 Private Placement 2,921,512 shares of common stock
The registration statements for the above listed common stock issuances have
been filed with the Securities and Exchange Commission and have become
effective.
27
Securities Authorized For Issuance Under Equity Compensation Plans
The following table provides information as of January 31, 2004 regarding
compensation plans (including individual compensation arrangements) under which
equity securities of Sorrento are authorized for issuance.
Number of Securities To Number of Securities
Be Issued Upon Remaining Available for
Exercise Weighted-Average Exercise Future Issuance Under Equity
Of Outstanding Price of Outstanding Compensation Plans
Options, Options, (Excluding Securities
Warrants and Rights Warrants and Rights Reflected in Column (a))
----------------------- ------------------------- ----------------------------
Plan Category (a) (b) (c)
--------------------------- --------- ------ ----------
Equity Compensation
Plans Approved by
security Holders *(FIBR) 2,114,769 $19.77 556,484
--------- ------ ----------
Equity Compensation
Plans not Approved by
Security Holders (SNI) 1,887,000 $ 5.35 18,090,700
--------- ------ ----------
Total 4,001,769 $12.97 18,647,184
--------- ------ ----------
* As adjusted for stock splits.
See Note K to the Consolidated Financial Statements for information regarding
the material features of the above plans. Each of the above plans provides that
the number of shares with respect to which options may be granted, and the
number of shares of Common Stock subject to an outstanding option, shall be
proportionally adjusted in the event of a subdivision or consolidation of shares
or the payment of a stock dividend on Common Stock, and the purchase price per
share of outstanding options shall be proportionately revised.
Item 6. Selected Financial Data
The following table sets forth selected consolidated financial data with
respect to our five most recent fiscal years ended January 31. The selected
consolidated statement of operations data set forth below for each of our three
most recent fiscal years, and the selected consolidated balance sheet data set
forth at January 31, 2004 and 2003, are derived from our consolidated financial
statements which have been audited by BDO Seidman, LLP, independent certified
public accountants, as indicated in their report which is included elsewhere in
this annual report. The selected consolidated statement of operations data set
forth below for each of the two fiscal years ended January 31, 2001 and 2000,
and the consolidated balance sheet data set forth below at January 31, 2002,
2001 and 2000 are derived from our audited consolidated financial statements not
included in this annual report. The selected consolidated financial data should
be read in conjunction with our consolidated financial statements, and the notes
thereto including Note A and B which discusses our significant acquisition and
disposition
included elsewhere in this annual report, and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" in Item 7.
Fiscal Year Ended January 31,
----------------------------------------------------
2004 2003 2002 2001 2000
-------- -------- -------- -------- --------
Statement of Operations Data: (a) (b) (b) (b) (b) (b)
Net sales...................................... $ 25,462 $ 25,137 $ 40,827 $ 44,641 $ 68,372
Gross margin................................... $ 5,693 $ 3,320 $ 9,320 $ 13,171 $ 31,782
Operating loss................................. $(17,634) $(31,329) $(37,154) $(50,415) $ (9,951)
Net loss from continuing operations............ $ (6,233) $(26,210) $(43,136) $(41,905) $ (2,410)
Net income (loss) per share from continuing
operations: (c)
Basic.................................... $ (.87) $ (33.29) $ (62.00) $ (74.20) $ (3.40)
28
Diluted.................................. $ (.87) $ (33.29) $ (76.32) $ (74.20) $ (3.00)
Balance Sheet Data:
Cash and cash equivalents................ $ 17,617 $ 7,747 $ 14,243 $ 9,965 $ 13,511
Working capital (deficit)................ $ 25,806 $(36,460) $ 5,839 $ 71,993 $189,486
Total assets............................. $ 50,096 $ 55,805 $ 90,339 $113,123 $223,265
Total debt (including short-term debt
redeemable preferred stock)........... $ 16,027 $ 21,987 $ 72,122 $ 24,770 $ 20,727
Stockholders' equity (deficit)........... $ 22,994 $(34,476) $ 18,217 $ 39,733 $202,538
The Consolidated Statement of Operations and Balance Sheet data shown above
reflect the following:
(a) The results of operations for LuxN, Inc. are reflected from August 8,
2003 forward.
(b) Operating (loss) and (loss) from continuing operations includes net
capital restructuring charges of approximately $1.8 million in fiscal
year 2003 and additions to inventory reserves of $602 thousand,
$4.1 million, $4.0 million and $3.7 million, $1.6 million which
negatively affected gross margin in fiscal year 2004, 2003, 2002, 2001
and 2000, respectively.
(c) All per share data have been restated to reflect the twenty-for-one
split of our common stock that became effective on October 28, 2002.
(d) Entrada Networks, Inc. is reflected through August 31, 2000. On August
31, 2000, we completed a merger of our then subsidiary Entrada
Networks with Sync Research, Inc. ("Sync"), a NASDAQ listed company in
which we received 4,244,155 shares of the merged entity, which changed
its name to Entrada Networks, Inc. ("ENI"). We purchased 93,900 shares
of Sync in the open market during June and July 2000 for $388 thousand
and on August 31, 2000 purchased an additional 1,001,818 shares
directly from ENI for $3.3 million. After these transactions and ENI's
issuance of additional shares to outside investors in connection with
the merger we owned 49% of ENI. Accordingly, our financial statements
reflected the results of operations of ENI through August 31, 2000.
Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Certain statements contained in this Annual Report on Form 10-K, including,
without limitation, statements containing the words "believes", "anticipates",
"estimates", "expects", and words of similar import constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. Readers are referred to the "Other Risk Factors" section of this Annual
Report on Form 10-K, as well as the "Financial Risk Management" and "Future
Growth Subject to Risks" sections contained herein, which identify important
risk factors that could cause actual results to differ from those contained in
the forward-looking statements.
The results of operations reflect our activities and our wholly-owned
subsidiaries; this consolidated group is referred to individually and
collectively as "We" and "Our".
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosures of contingent assets and
liabilities. On an on-going basis, we evaluate our estimates, including those
related to our valuation of inventory and our allowance for uncollectible
accounts receivable. We base our estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may materially differ from these estimates under
different assumptions or conditions.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements:
29
o Revenue recognition. Revenue is generally recognized when the
products are shipped, all substantial contractual obligations, if
any, have been satisfied, and the collections of the resulting
receivable is reasonably assured. When title does not pass to the
customer at time of shipment, revenue is not recognized until all
contractual requirements are met and title has transferred.
During this transition period, the amount of the sale and/or
installation is shown in deferred revenue.
Revenue from installation is recognized as the services are
performed to the extent of the direct costs incurred. To date,
installation revenue has not been material. Revenue from service
obligations, if any, is deferred and recognized over the life of
the contract. Inventory or demonstration equipment shipped to
potential customers for field trials is not recorded as revenue.
We accrue for warranty costs, sales returns and other allowances
at the time of shipment. Although our products contain a software
component, the software is not sold separately and we are not
contractually obligated to provide software upgrades to our
customers.
o Inventory. Inventory is evaluated on a continual basis and
management must make estimates about the future customer demand
for our products, taking into account both the economic
conditions and growth potential of our customers. Reserve
adjustments are made based on management's estimate of future
sales value, if any, of specific inventory items. Reserve
adjustments are made for the difference between the cost of the
inventory and the estimated market value and charged to
operations in the period in which the facts that give rise to the
adjustments become known. A misinterpretation or misunderstanding
of these conditions or uncertainty in the future outlook of our
industry or the economy, or the failure to estimate correctly,
could result in inventory losses in excess of the provisions
determined to be appropriate at the time of the balance sheet.
o Accounts receivable. Accounts receivable balances are evaluated
on a continual basis and management regularly reviews the
financial stability of individual customers. This analysis
involves a judgment of the customer's current and projected
financial condition and the positive or negative effects of the
current and projected industry outlook, as well as that of the
economy in general. Allowances are provided for potentially
uncollectible accounts based on management's estimate of the
collectability and the probability of default of customer
accounts. If the financial condition of a customer were to
deteriorate, resulting in an impairment of their ability to make
payments, an additional allowance may be required. Allowance
adjustments are charged to operations in the period in which the
facts that give rise to the adjustments become known.
o Intangible assets. We currently have intangible assets that
include assets with finite lives, such as our purchased
technology. The determination of related estimated useful lives
and whether these assets are impaired involves judgments based
upon short and long-term projections of future performance. We
have no goodwill or indefinite life intangible assets. Other
intangible assets with finite lives continue to be amortized over
their useful lives.
o Legal contingencies. We are subject to proceedings, lawsuits and
other claims, including proceedings under laws and government
regulations related to securities, environmental, labor, product
and other matters. We are required to assess the likelihood of
any adverse judgments or outcomes to these matters, as well as
potential ranges of probable losses. A determination of the
amount of reserves required, if any, for the contingencies is
based on a careful analysis of each individual issue with the
assistance of outside legal counsel. Our reserves may change in
the future due to new developments in each matter or changes in
approach such as a change in settlement strategy in dealing with
these matters. For more information, see Note H to the
consolidated financial statements.
o Income taxes. We currently have no provisions for income taxes.
We have carry forward domestic federal net operating losses,
which may be available, in part, to reduce future taxable income
in the United States. However, due to potential adjustments to
the net operating loss carry forwards as provided by the Internal
Revenue Code with respect to future ownership changes, future
availability of the tax benefits is not assured. In addition, we
provided a valuation
30
allowance in full for our deferred tax assets, as it is our
opinion that it is more likely than not that some portion or all
of the deferred tax assets will not be realized.
LuxN, Inc.
On August 8, 2003, we completed our acquisition of LuxN, Inc. in which we
paid $14.8 million in cash, 1,879,347 shares of our common stock and 400,000
warrants to purchase our common stock at an exercise price of $3.05 per share.
At the effective time of the merger, our wholly-owned subsidiary, Lambda
Acquisition Corp., was merged with and into LuxN, with LuxN being the surviving
corporation in the merger. From the date of acquisition to January 31, 2004, the
results of LuxN's operations have been combined with the company in our
discussion below unless separately addressed.
Overview
Sorrento Networks was originally incorporated in New Jersey under the name
of Osicom Technologies, Inc. In fiscal 2003, we changed our name to Sorrento
Networks Corporation to better reflect the name of our primary subsidiary,
Sorrento Networks, Inc. We reincorporated in Delaware during fiscal 2004.
Presently headquartered in San Diego, California, we are a developer and
manufacturer of intelligent optical networking solutions for metropolitan and
regional applications worldwide.
Beginning in fiscal 2002, the global telecommunications market
deteriorated, reflecting a significant reduction in capital spending by
established service providers. This trend intensified during fiscal 2003 and
continued through fiscal 2004. Reasons for this reduction include the general
economic slowdown, network overcapacity, customer bankruptcies, network
build-out delays and limited capital availability. As a result, our sales and
results of operations have been and may continue to be adversely affected. The
significant slowdown in capital spending has created uncertainty as to the level
of demand in our target markets. In addition, the level of demand can change
quickly and can vary over short periods of time. As a result of the uncertainty
and variations in our markets, accurately forecasting future results, earnings
and cash flow is increasingly difficult.
As discussed in more detail throughout our MD&A:
o Our consolidated results of operations during the past three
years were adversely affected by the rapid and sustained
deterioration of the telecommunications market. After several
years of significant growth, our revenues declined during fiscal
2003 and 2002 by 38% and 9% respectively, as compared to the
respective prior year. The significant reduction in capital
spending by service providers, among other factors, contributed
to this decline. There was no significant change in fiscal 2004,
which includes $3.9 million in revenue from our newly acquired
subsidiary LuxN, Inc., when compared to the prior year. If the
revenue from LuxN is excluded for comparison purposes our revenue
declined 14% for fiscal 2004 when compared to the prior year;
o Our gross margin rates, which historically had exceeded 40%, fell
precipitously beginning in fiscal 2002. The rapid decline in
revenue from decreased market demand led to significant inventory
charges and high-unabsorbed fixed cost, which, among other
factors, adversely affected our gross margin rates;
o Management implemented a cost reduction program during fiscal
2002. As a result, total operating expenses have declined from
$63.6 million in fiscal 2001 to $23.3 million in fiscal 2004, a
reduction of over $40 million;
These were the key factors that resulted in losses from continuing
operations of $17.6 million, $31.3 million and $37.2 million respectively for
fiscal 2004, 2003 and 2002, respectively.
During 2004, we took several steps to improve our balance sheet and
strengthen our ability to compete in the marketplace, including:
o On March 6, 2003, we and our wholly-owned subsidiary Sorrento
Networks, Inc. entered into an Exchange Agreement with the
holders of our 9.75% Senior Convertible Debentures (the
"Debentures") and the Series A Convertible Preferred Stock (the
"Preferred Stock") of Sorrento Networks, Inc. The Exchange
Agreement and associated documents contemplated an exchange
31
(the "Exchange") of the Debentures and the Preferred Stock at
closing into shares of common stock and $12.5 million of our new
7.5% secured convertible debentures (the "New Debentures").
Certain holders of the Preferred Stock would also receive
additional New Debentures of approximately $600 thousand to pay
certain legal fees.
The Exchange Agreement was approved by shareholders on May 29,
2003 and was completed and became effective on June 4, 2003
pursuant to which we exchanged current outstanding debentures and
Series A Preferred Stock for common stock and an issuance of a
smaller principal amount of new debentures.
o Our acquisition of LuxN, Inc was completed on August 8, 2003. At
the effective time of the merger, our wholly-owned subsidiary,
Lambda Acquisition Corp., was merged with and into LuxN, with
LuxN being the surviving corporation in the merger. Pursuant to
the Agreement and Plan of Merger, each share of LuxN common stock
outstanding at the effective time of the merger was cancelled. As
consideration for the transaction, holders of LuxN's Series A-1
Preferred Stock with an aggregate pro-rata portion of $14.8
million of LuxN's net cash elected to receive cash at closing,
and the holders of LuxN's Series A-1 Preferred Stock with an
aggregate pro-rata portion of $3.8 million of LuxN's net cash
elected to receive our common stock at closing. We issued
1,374,194 shares of our common stock to the holders of LuxN's
Series A-1 Preferred Stock at the closing and issued an
additional 505,153 shares upon receipt of our shareholders'
approval. In addition, we issued warrants to purchase 400,000 of
our shares of common stock at an exercise price of $3.05 per
share to the holders of LuxN's Series A-1 Preferred Stock. We did
not assume or exchange any outstanding options or warrants to
purchase shares of LuxN stock.
o The first of two private placements' the Company completed in
fiscal 2004, closed on December 31, 2003. In exchange for $6.35
million in gross proceeds, Sorrento issued 2,140,101 new shares
of Sorrento common stock, and warrants to purchase 1,070,051 new
shares of Sorrento's common stock. The effective price in the
private placement was $2.97 for each unit consisting of one share
of common stock and a warrant to purchase one-half of a share of
common stock. The warrants have an exercise period of five-years
with an exercise price of $2.97 per share. The warrants are
exercisable in cash, representing a potential $2.17 million in
additional proceeds, bringing the total gross proceeds of this
offering to approximately $9.5 million upon full exercise of the
warrants.
o On January 26, 2004 the second private placement was completed
raising $10 million in gross proceeds. In connection with the
financing, Sorrento issued 2,921,512 new shares of Sorrento
common stock and warrants to purchase 1,460,756 new shares of
Sorrento's common stock. The effective price in the private
placement was $3.44 for each unit. Each unit consists of one
share of common stock and a warrant to purchase one-half of a
share of common stock. The warrants have an exercise period of
five-years and an exercise price of $3.44 per share. The warrants
are callable after one year under certain circumstances. The
warrants are exercisable in cash, representing a potential $5
million in additional proceeds, bringing the total gross proceeds
of this offering to approximately $15 million assuming the
warrants are fully exercised in cash. The warrants provide for a
cashless exercise under certain circumstances.
As we look forward to fiscal 2005, we believe that the general economic
recovery that began in 2004 will gradually take hold within the
telecommunications marketplace. Although our backlog entering fiscal 2005
remains low at slightly over $2 million; the increased level of inquiries and
quote activity from both current and potentially new customers leads us to
believe industry overcapacity has, to a large extent, been absorbed and, as
such, we anticipate gradual improvement in our business commencing in mid-fiscal
2005.
Results of Operations: Comparison of the Years Ended January 31, 2004 and
January 31, 2003
Net sales
Total revenues in 2004 were flat. Revenue in the United States increased
reflecting the acquisition of LuxN. Revenues in Europe declined 42%, as the
economic downturn, which was initially felt in the United States, more
32
severely impacted European sales in 2004. In addition, 2004 saw a revenue
increase in Asia of over 81% due to increased sales activity in Japan.
Product revenues decreased 5% while service revenues increased 111%.
Service revenues were higher due to increased product deployments, offset by
competitive pricing pressure. The contribution to revenue from the LuxN
acquisition was $3.8 million in product and service revenue from August 8, 2003
to fiscal year end January 31, 2003.
Geographic Revenues
2004 vs 2003 2003 vs 2002
For the years ended January 31, ---------------- -----------------
------------------------------- Change Change Change Change
2004 2003 2002 $ % $ %
------- ------ ------- ------- ------ -------- ------
United States $18,445 14,803 $28,341 $ 3,642 25 $(13,538) (48)
Europe 5,455 9469 10,130 (4,014) (42) (661) (7)
Asia 1,562 865 2,356 697 81 (1,491) (63)
--------------------------------------------------------------------------------------
Consolidated $25,462 25,137 $40,827 $ 325 1 $(15,690) (38)
======================================================================================
Revenues by geographic regions are based on the location of the customer.
Gross Profit
2004 vs 2003 2003 vs 2002
For the years ended January 31, ---------------- -----------------
------------------------------- Change Change Change Change
2004 2003 2002 $ % $ %
------- ------ ------- ------- ------ -------- ------
United States $3,725 $3,751 $5,996 $ (26) -- $(2,245) (37)
Europe 1,507 (487) 2,618 1,994 409 (3,105) (119)
Asia 461 -- 708 461 100 (708) (100)
--------------------------------------------------------------------------------------
Consolidated $5,693 $3,264 $9,322 $2,429 74 $(6,058) (65)
======================================================================================
Gross Profit by geographic region is based on the location of the customer.
Gross profits. Improvement in fiscal 2004 reflects improvements in U.S.
production and overhead related costs combined with the non-recurrence of
obsolescence and inventory valuation reserves taken in fiscal 2003.
Selling and marketing. Selling and marketing expenses consist primarily of
employee compensation and related costs, commissions to sales representatives,
tradeshow expenses and travel expenses. Our consolidated selling and marketing
expenses decreased to $8.4 million, or 33% of net sales, for fiscal 2004 from
$12 million, or 48% or net sales for fiscal 2003. The decline was primarily the
result of continued cost reduction efforts and a reduction in both our U.S. and
foreign sales offices.
Engineering, research and development. Engineering, research and
development expenses consist primarily of compensation related costs for
engineering personnel, facilities costs, and materials used in the design,
development and support of our technologies. All research and development costs
are expensed as incurred. We continue to manage our research and development
costs in relation to the changes in our sales volume and available capital
resources in our development efforts to enhance existing products and introduce
new products to our product offering. Our consolidated engineering, research and
development expenses decreased to $8.0 million, or 32% of net sales, for fiscal
2004 from $9.0 million, or 36% of net sales, for fiscal 2003. The decline can
primarily be attributed to decreases in product development material and
personnel related costs.
33
General and administrative. General and administrative expenses consist
primarily of employee compensation and related costs, legal and accounting fees,
public company costs, and allocable occupancy costs. Consolidated general and
administrative expenses decreased to $6.5 million, or 26% of net sales, for
fiscal 2004 compared to $12.8 million, or 51% of net sales, for fiscal 2003. The
decrease in general and administrative expenses can be attributed to a decrease
in professional fees including reduced legal fees and lower facility related
expenses.
Other operating expenses. Other operating expenses for both fiscal 2004 and
2003 included approximately $320 and $400 thousand, respectively of purchased
technology amortization expense related to acquisitions.
Other income (expenses). Other income (expenses) from continuing operations
increased to $11.4 million in income for fiscal 2004 from $5.1 million in fiscal
2003. This increase reflects a net gain on the capital restructuring of $17.6
million, combined with reduced interest expense reflecting the capital
restructuring in fiscal 2004. Partially offsetting these improvements were the
write-off of our investment in UFO Communications of approximately $5 million
together with a lower gain from the sales of DIGI stock in fiscal 2004 versus
fiscal 2003.
The Company acquired LuxN Inc. on August 8, 2003 whereby it paid $14.8
million in cash, and issued 1,879,347 shares of our common stock and 400,000
warrants to purchase our common stock at an exercise price of $3.05 per share.
Upon valuing the purchase price and allocating the price to the assets and
liabilities acquired, it was determined that net assets acquired exceeded the
purchase price by $87 thousand. This excess of net asset acquired over the
amount paid for the acquisition is reflected as a reduction to long lived
assets.
Income taxes. There was no provision for income taxes for fiscal years 2004
and 2003. We have carry forwards of domestic federal net operating losses, which
may be available, in part, to reduce future taxable income in the United States.
However, due to potential adjustments to the net operating loss carry forwards
as provided by the Internal Revenue Code with respect to future ownership
changes, future availability of the tax benefits is not assured. In addition, we
provided a valuation allowance in full for our deferred tax assets, as it is our
opinion that it is more likely than not that some portion or all of the assets
will not be realized. Our prior management did not file our tax returns for over
six years. We had losses during each of these years and do not believe there is
tax liability for any of them, other than a nominal penalty for failure to file
a return. We filed all delinquent state and federal tax returns in fiscal 2004
and are now current.
As with any purchase it is possible the net operating loss carry-forward
for taxes may be limited, possibly reduced to zero.
Sorrento Networks
Net sales. Net sales decreased to $18.7 million, or 17%, for fiscal 2004
from $22.4 million for fiscal 2003. In fiscal 2004 our top five customers
accounted for 67% of our net sales, compared to 69% net sales contributed from
the top five customers in 2003. We expect to continue experiencing significant
fluctuations in our annual revenues as a result of our long and variable sales
cycle as well as our highly concentrated customer base. Revenue was negatively
impacted by weak telecommunication industry volumes and management's
determination to not pursue low gross margin projects.
Gross profit. Gross profit was $4.2 million for fiscal 2004, an increase of
35% from $3.1 million for fiscal 2003. Gross margin increased to 22% of net
sales for fiscal 2003 from 14% for fiscal 2003. The increase was due primarily
to the cost reductions efforts started in fiscal year 2003 as well as increases
to our obsolescence and inventory value reserves in fiscal 2003.
Selling and marketing. Sales and marketing expenses declined to $7.4
million, or 39% of net sales, for fiscal 2004 from $11.7 million, or 52% of net
sales, for fiscal 2003. The decrease in sales and marketing expenses resulted
primarily from a reduction in personnel and related costs, decreased travel
expenses, trade show participation, and advertising expenses.
Engineering, research and development. Engineering, research and
development expenses decreased to $5.7 million, or 30% of net sales, for fiscal
2004 from $8.5 million, or 38% of net sales, for fiscal 2003. The decline in
engineering, research and development expenses was the result of decreased
expenditures associated with fewer engineering personnel combined with a
reduction in material related development expenses.
General and administrative. General and administrative expenses decreased
to $3.4 million, or 18% of net sales, for fiscal 2004 from $7.6 million, or 34%
of net sales, for fiscal 2003. The decline in general and
34
administrative expenses reflects the reduction of executive and administrative
personnel and reduced expense levels reflecting our continuing cost reduction
program.
Deferred and other stock compensation. Deferred and other stock
compensation for the fiscal year ended January 31, 2004 includes $51 thousand of
amortization of deferred stock compensation resulting from the value of stock
options granted to consultants compared to $433 thousand for the prior fiscal
year. In connection with the grants of stock options with exercise prices
determined to be below the fair value of our common stock on the date of grant,
SNI recorded deferred stock compensation of $2.6 million, which was fully
amortized in 2004.
Meret Optical Communications
Net sales. Net sales decreased to $2.8 million, or 10%, for fiscal 2004,
from $3.1 million for fiscal 2003. The reduction in sales volume reflects the
continued weakness in the telecommunications industry.
Gross profit. Gross profit increased to $471 thousand, or 131%, for fiscal
2004 from $204 thousand for fiscal 2003. Gross margin as a percentage of net
sales increased to 16% for fiscal 2004 compared to 7% for the comparable period
last year. The improvement was due primarily to non-recurrence of fiscal 2003
additions to our obsolescence reserves.
Selling and marketing. Sales and marketing expenses decreased to $113
thousand, or 4% of net sales, for fiscal 2004, compared to $315 thousand, or10%
of net sales, for fiscal 2003. This decline was a direct result of fewer sales
employees and reduced commissions reflecting changes in the commission structure
during 2004.
General and administrative. General and administrative expenses were
eliminated due to consolidation of operations per the exchange agreement dated
June 4, 2003, which requires Sorrento Networks Corporate subsidiaries to be
consolidated into a single entity. In preparation for combining Sorrento
Networks subsidiaries into a single entity, general and administrative,
engineering and research and development for Meret were combined with Sorrento
Networks, Inc.
Other operation expenses. Other operating expenses increased to $320
thousand, or 11% of net sales for fiscal 2004 from $421 thousand, or 14% of net
sales, for fiscal 2003. These costs represent the amortization of purchased
technology related to prior acquisitions.
Results of Operations: Comparison of the Years Ended January 31, 2003 and
January 31, 2002
Net sales. Our consolidated net sales decreased $15.7 million or 38% to
$25.1 million for fiscal 2003 when compared to net sales of $40.8 million for
fiscal 2002. Net sales for Sorrento Networks Inc., our primary operating
subsidiary, decreased $13.6 million or 38% to $22.4 million for fiscal 2003 as
compared to net sales of $36.0 million in fiscal 2002. Net sales for our Meret
Optical segment decreased $1.7 million or 35% in fiscal 2003 to $3.1 million of
which $296 thousand was inter-company sales as compared to net sales of $4.8
million in fiscal year 2002.
Gross profit. Cost of sales consists principally of the costs of
components, subcontract assembly from outside manufacturers, and in-house system
integration, quality control, final testing and configuration costs. Gross
margin percent on a consolidated basis decreased to 13% for fiscal 2003 from 23%
in fiscal 2002. Consolidated gross profit was $3.3 million, a decrease of 65%
for fiscal 2003 from $9.3 million for fiscal 2002. Gross margin percent and
gross profit were impacted negatively by increases in inventory reserves and
sales that were made at lower gross profit margins than the prior year. Gross
profit for our Sorrento subsidiary decreased to $3.1 million in fiscal 2003, as
compared to $7.7 million in fiscal 2002, a decrease of 60%. An increase in our
inventory reserves taken in the second quarter, accounted for $3.0 million of
the decrease in gross profit for SNI. The gross profit of our Meret Optical
segment decline to $204 thousand in fiscal 2003, as compared to $1.7 million in
fiscal 2002, a decrease of 88%. This decline was primarily the result of an
increase in our inventory reserve of $1.0 million, taken in the second quarter
and a decrease in revenue volume.
Selling and marketing. Selling and marketing expenses consist primarily of
employee compensation and related costs, commissions to sales representatives,
tradeshow expenses and travel expenses. Our consolidated selling and marketing
expenses decreased to $12.0 million, or 48% of net sales, for fiscal 2003 from
$16.2 million, or 40% or net sales for fiscal 2002. The decline was primarily
the result of cost reduction efforts implemented, a reduction in both our U.S.
and foreign sales offices and lower revenue volume for the year.
35
Engineering, research and development. Engineering, research and
development expenses consist primarily of compensation related costs for
engineering personnel, facilities costs, and materials used in the design,
development and support of our technologies. All research and development costs
are expensed as incurred. We continue to manage our research and development
costs in relation to the changes in our sales volume and available capital
resources in our development efforts to enhance existing products and introduce
new products to our product offering. Our consolidated engineering, research and
development expenses decreased to $9.0 million, or 36% of net sales, for fiscal
2003 from $13.7 million, or 34% of net sales, for fiscal 2002. The decrease can
primarily be attributed to decreases in product development material and
personnel related costs.
General and administrative. General and administrative expenses consist
primarily of employee compensation and related costs, legal and accounting fees,
public company costs, and allocable occupancy costs. Consolidated general and
administrative expenses remained consistent at $12.8 million, or 51% of net
sales, for fiscal 2003 compared to 31% of net sales, for fiscal 2002. The
increase in general and administrative expenses as a percentage of net sales can
be attributed to an increase in professional fees associated with the capital
restructuring partially offset by a decrease in personnel related costs.
Other operating expenses. Other operating expenses for both fiscal 2003 and
2002 included approximately $400 thousand of amortization of purchased
technology related to acquisitions included in Meret. During the fiscal year
ended January 31, 2002, we recorded a $2.7 million valuation allowance against
option receivables from our former CEO and Chairman.
Other income (expenses). Other income (expenses) from continuing operations
increased to $5.1 million in income for fiscal 2003 from $6.0 million in expense
for fiscal 2002. Investment income increased by $1.6 million during the fiscal
year ended January 31, 2003 from the comparable period last year due to
increased investments of our cash surplus in short-term investments. The
increase of $6.3 million in interest expense for the fiscal year ended January
31, 2003 from the prior fiscal year is primarily due to the interest incurred on
our convertible debentures and an adjustment relating to the amortization of
both the beneficial conversion feature of the value allocated to the issuance of
warrants on our senior convertible debentures. The $5.5 million of interest on
these debentures includes the stated 9.75% interest of $2.3 million of which
$2.0 million was paid in common stock and $292 thousand was paid in cash,
amortization of issuance costs of $259 thousand, and amortization of the fair
value of the warrants issued to the purchasers and placement agent and the
deemed beneficial conversion feature of $2.9 million. Other income increased by
$313 thousand during the fiscal year ended January 31, 2003 from the prior
fiscal year resulting primarily from favorable gains on foreign currency
exchanges. Gains on marketable securities increased by $15.5 million for the
fiscal year ended January 31, 2003 from the prior fiscal year. $11.7 million of
this increase relates to the realized gain on our sale of 3,396,221 shares of
NETsilicon, Inc. common stock to Digi International, Inc. for $13.6 million in
cash. The remaining shares of NETsilicon common stock were exchanged for Digi
International common stock and are accounted for under marketable securities. We
obtained 2,324,683 shares of Digi common stock on the exchange, of which
1,162,342 shares were later sold back to Digi for $3.6 million in cash and a
gain of $2.6 million. The remaining $1.2 million increase results from an
impairment allowance taken on our available for sale investment in Entrada and
$1.0 million in realized losses on the sale of 1,051,000 shares of Entrada in
the prior fiscal year.
Income taxes. There was no provision for income taxes for fiscal years 2003
and 2002. We have carry forwards of domestic federal net operating losses, which
may be available, in part, to reduce future taxable income in the United States.
However, due to potential adjustments to the net operating loss carry forwards
as provided by the Internal Revenue Code with respect to future ownership
changes, future availability of the tax benefits is not assured. In addition, we
provided a valuation allowance in full for our deferred tax assets, as it is our
opinion that it is more likely than not that some portion or all of the assets
will not be realized. Our prior management did not file our tax returns for over
six years. We had losses during each of these years and do not believe there is
tax liability for any of them, other than a nominal penalty for failure to file
a return. We have filed our federal returns and are in the process of preparing
and filing all our delinquent state tax returns.
Sorrento Networks
Net sales. Net sales decreased to $22.4 million, or 38%, for fiscal 2003
from $36.0 million for fiscal 2002. In fiscal 2003, eighteen customers accounted
for 92% of our net sales compared with eleven customers, which accounted for 94%
in fiscal 2002. We expect to continue experiencing significant fluctuations in
our annual revenues as a result of our long and variable sales cycle as well as
our highly concentrated customer base. Revenue
36
continues to be negatively impacted by weak telecommunication industry volumes
and management determination to not pursue low gross margin projects.
Gross profit. Gross profit was $3.1 million for fiscal 2003, a decrease of
59% from $7.7 million for fiscal 2002. Gross margin decreased to 14% of net
sales for fiscal 2003 from 21% for fiscal 2002. The declines were due primarily
to the increases in our obsolescence and inventory value reserves taken in the
second quarter and of a significantly higher fixed manufacturing overhead in our
cost of shipments for the year as a result of the lower revenue volume. We have
initiated cost cutting actions in production due to the lower revenue volume and
a continued slowdown in the capital expenditure spending throughout the telecom
industry.
Selling and marketing. Sales and marketing expenses decreased to $11.7
million, or 52% of net sales, for fiscal 2003 from $15.7 million, or 44% of net
sales, for fiscal 2002. The decrease in sales and marketing expenses resulted
primarily from a reduction in personnel and related costs, decreased travel
expenses, trade show participation, and advertising expenses. The number of
sales and marketing personnel decreased to 36 at January 31, 2003 from 38 at
January 31, 2002.
Engineering, research and development. Engineering, research and
development expenses decreased to $8.5 million, or 38% of net sales, for fiscal
2003 from $13.2 million, or 37% of net sales, for fiscal 2002. The decrease in
engineering, research and development expenses were the result of decreased
expenditures associated with the decrease in engineering personnel and related
costs and a reduction in material related development expenses. The number of
engineering personnel decreased to 29 at January 31, 2003 from 67 at January 31,
2002.
General and administrative. General and administrative expenses decreased
to $7.6 million, or 34% of net sales, for fiscal 2003 from $6.9 million, or 19%
of net sales, for fiscal 2002. The decrease in general and administrative
expenses reflects the reduction of executive and administrative personnel and
lower operating expenses. The number of general and administrative personnel
decreased to 11 at January 31, 2003 from 15 at January 31, 2002.
Deferred and other stock compensation. Deferred and other stock
compensation for the fiscal year ended January 31, 2003 includes $433 thousand
of amortization of deferred stock compensation resulting from the value of stock
options granted to consultants compared to $812 thousand for the prior fiscal
year. In connection with the grants of stock options with exercise prices
determined to be below the fair value of our common stock on the date of grant,
SNI recorded deferred stock compensation of $2.6 million, which is being
amortized on an accelerated basis over the vesting period of the options.
Meret Optical Communications
Net sales. Net sales decreased to $3.1 million, or 36%, for fiscal 2003 of
which $296 thousand was inter-company sales, from $4.8 million for fiscal 2002.
The reduction in sales volume reflects the continued weak industry volumes.
Gross profit. Gross profit decreased to $204 thousand, or 88%, for fiscal
2003 from $1.7 million for fiscal 2002. Gross margin as a percentage of net
sales decreased to 7% for fiscal 2003 compared to 35% for the comparable period
last year. These declines were due primarily to the increases in our
obsolescence reserves taken in the second quarter and a higher fixed
manufacturing overhead in our cost of shipments for the quarter as a result of
the lower revenue volume.
Selling and marketing. Sales and marketing expenses decreased to $315
thousand, or 10% of net sales, for fiscal 2003, compared to $435 thousand, or 9%
of net sales, for fiscal 2002. This decrease was a direct result of reduced
internal commissions, due primarily to lower revenue volume and changes in the
commission structure, resulting in lower commission expense for the year.
Engineering, research and development. Engineering, research and
development expenses increased to $514 thousand, or 17% of net sales compared to
$417 thousand, or 9% of net sales, for fiscal 2002. This increase results from
the addition of four engineers to support the development of new products and
the enhancement of existing products.
General and administrative. General and administrative expenses increased
to $283 thousand, or 9% of net sales during fiscal 2003 from $200 thousand, or
4% of net sales, for fiscal 2002. The increase in general and administrative
expenses during fiscal 2003 resulted primarily from additions in the
administration staff, costs
37
associated with upgrades in our business application software and costs incurred
to move the facilities to a new location.
Other operation expenses. Other operating expenses increased to $421
thousand, or 14% of net sales for fiscal 2003 from $372 thousand, or 8% of net
sales, for fiscal 2002. These costs represent the amortization of purchased
technology related to prior acquisitions. The increase represents and adjustment
made to record amortization not previously recorded on purchased technology.
Liquidity and Capital Resources
We finance our operations through a combination of internal funds,
investments and debt and equity financing. At January 31, 2004, our working
capital was $25.9 million including $17.6 million in cash and cash equivalents
and $504 thousand of investments in marketable securities.
We believe that our available cash combined with cash anticipated to be
available from future operations, will be sufficient for our working capital
requirement for the next 12 months.
Cash Flow for the Years Ended January 31, 2004, 2003 and 2002
Continuing Operations
Our operations used $15.6 million during fiscal 2004 as compared to $14.2
million in fiscal 2003. Significant items impacting the change in cash flows
used by operations are: the lower net loss in fiscal 2004, the fiscal 2004 gain
on restructuring, the realized loss on non-marketable securities, the reduced
year-to-year gain on sale of marketable securities, and decreases in accounts
payable, deferred revenue and accrued expenses. We do not anticipate the
recurrence of significant cash flow impacts due to restructuring or the
marketable/non-marketable security items in fiscal 2005.
We have incurred significant losses and negative cash flows from operations
for the past two years. Sorrento Networks, Inc., our principal operating
subsidiary has primarily been the operating entity responsible for these high
losses and negative cash flows. The losses have been generated as SNI continues
to develop its technology, marketing and sales and operations in its effort to
become a major supplier of metro and regional optical networks world-wide. In
addition, we incurred significant restructuring costs of approximately $2.8
million in 2003 associated with restructuring of our obligations under our
Senior Convertible Debentures and Series A Holders obligations.
Our standard payment terms range from net 30 to net 60 days. Receivables
from international customers have frequently taken longer to collect. In
addition, the downturn in the telecom market has impacted many of the telecom
carriers ability to purchase or pay for outstanding commitments within standard
payment terms. There can be no assurance that this continued economic
environment will not impact either current or future receivables negatively.
Investing Activities
In fiscal 2004, our investing activities provided cash flows of $9.8
million. We received $6.4 million on the sale of marketable securities and
other investments. In addition we disposed of $1.3 million in property and
equipment related to disposals and returns of demo equipment.
Our investing activities during fiscal 2003 provided cash flows of $9.1
million. We received $17.2 million from the sale of DIGI stock. Partially
offsetting were the $5 million cash investment in UFO Communications and $3.3
million of property and equipment purchases. In fiscal 2002, our investing
activities used $4.0 million. Cash used in investing activities during fiscal
2002 included purchases of property and equipment of $3.2 million and $900
thousand in other assets.
Financing Activities
Our financing activities provided net cash of $15.7 million reflecting
$15.9 million in net cash received in the private placement sale of common stock
in December 2003 and January 2004. In fiscal 2003 our financing activities used
cash of $1.4 million and consisted primarily of repayment of our line of credit
and long-term debt. Our financing activities during fiscal 2002 provided us
$40.1 million and consisted primarily of financing activities from
38
the sale of common stock in March 2001 which generated proceeds of $9.6 million
and a convertible debenture financing in August 2001 which raised $29.7 million.
Contractual Cash Obligations
The following tables quantify our future contractual obligations and
commercial commitments as of January 31, 2004 (dollars in thousands):
Contractual Obligations
Payments due in fiscal years
------------------------------------------------------------
Total 2005 2006 2007 2008 2009 Thereafter
------- ------ ---- ------- ---- ---- ----------
Long-term Debt.................... $ 3,585 $ 47 $ 54 $ 58 $ 63 $ 68 $3,295
Capital Leases.................... 54 54 -- -- -- -- --
Purchase Orders................... 1,755 1,655 100
Employment Contracts(b)........... 783 783
Operating Leases.................. 824 551 152 46 41 34 --
7.5% convertible debentures (a)... 12,338 -- -- 12,338 -- -- --
------- ------ ---- ------- ---- ---- ------
Total............................. $19,339 $3,090 $306 $12,442 $104 $102 $3,295
======= ====== ==== ======= ==== ==== ======
(a) Maturity date, August 2, 2007
(b) Reflects payments due under change of control provisions under
certain employment contracts that may be triggered by the sale of
the Company in 2005.
Contingent Liabilities
See footnote "G", under Contingent Liabilities
Effects of Inflation and Currency Exchange Rates
We believe that the relatively moderate rate of inflation in the United
States over the past few years has not had a significant impact on our sales or
operating results or on the prices of raw materials. There can be no assurance,
however, that inflation will not have a material adverse effect on our operating
results in the future.
The majority of our sales and expenses are currently denominated in U.S.
dollars and to date our business has not been significantly affected by currency
fluctuations. However, we conduct business in several different countries and
thus fluctuations in currency exchange rates could cause our products to become
relatively more expensive in particular countries, leading to a reduction in
sales in that country. In addition, inflation in such countries could increase
our expenses. In the future, we may engage in foreign currency denominated sales
or pay material amounts of expenses in foreign currencies and, in such event,
may experience gains and losses due to currency fluctuations. Our operating
results could be adversely affected by such fluctuations.
Impact of Recent Accounting Pronouncements
In January 2003, the FASB issued FASB Interpretation ("FIN") No. 46,
"Consolidation of Variable Interest Entities", and interpretation of Accounting
Research Bulletin No. 51, "Consolidated Financial Statements", FIN No. 46
explains how to identify variable interest entities and how an enterprise
assesses its interests in a variable interest entity to decide whether to
consolidate that entity. This Interpretation requires existing unconsolidated
variable interest entities to be consolidated by their primary beneficiaries if
the entities do not effectively disperse risks among parties involved. FIN No.
46 is effective immediately for variable interest entities created after January
31, 2003, and to variable interest entities in which an enterprise obtains an
interest after that date. The Interpretation applies in the first fiscal year or
interim period beginning after June 15, 2003, to variable interest entities in
which an enterprise holds a variable interest that is acquired before February
1, 2003. We adopted FIN No. 46 with no material effect on our financial position
or results of operations.
In November 2002, the FASB issued FIN 45, which expands previously issued
accounting guidance and disclosure requirements for certain guarantees. FIN 45
requires us to recognize an initial liability for the fair value of
39
an obligation assumed by issuing a guarantee. The provision for initial
recognition and measurement of the liability will be applied on a prospective
basis to guarantees issued or modified after December 31, 2002. The adoption of
FIN 45 did not materially affect our consolidated financial statements.
In August 2001, the Financial Accounting Standards Board issued SFAS No.
143, Accounting for Asset Retirement Obligations. This Statement is effective
for fiscal years beginning after June 15, 2002. SFAS 143 provides accounting
requirements for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. Under the
Statement, the asset retirement obligation is recorded at fair value in the
period in which it is incurred by increasing the carrying amount of the related
long-lived asset. The liability is accreted to its present value in each
subsequent period and the capitalized cost is depreciated over the useful life
of the related asset. The adoption of SFAS 143 did not have a material effect on
our financial position or results of operations.
In November 2002, the Emerging Issues Task Force ("EITF") reached a
consensus on Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables."
EITF Issue No. 00-21 provides guidance on how to account for arrangements that
involve the delivery or performance of multiple products, services and/or rights
to use assets. The provisions of EITF Issue No. 00-21 applied to revenue
arrangements entered into in fiscal periods beginning after June 15, 2003.
In December 2003, the SEC issued SAB 104, which supersedes SAB 101, Revenue
Recognition in Financial Statements. The primary purpose of SAB 104 is to
rescind the accounting guidance contained in SAB 101 related to multiple element
revenue arrangements, which was superseded as a result of the issuance of EITF
00-21. We adopted EITF 00-21 and SAB 104 with no material impact on our
financial statements.
Other Matters
See Item 3. "Legal Proceedings" contained herein.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to financial market risks, including changes in interest
rates and foreign currency rates. Our exposure to interest rate risk is the
result of our need for periodic additional financing for our large operating
losses and capital expenditures associated with establishing and expanding our
operations. The interest rate that we will be able to obtain on debt financing
will depend on market conditions at that time, and may differ from the rates we
have secured on our current debt.
Almost all of our sales have been denominated in U.S. dollars. A portion of
our expenses are denominated in currencies other than the U.S. dollar and in the
future a larger portion of our sales could also be denominated in non-U.S.
currencies. As a result, currency fluctuations between the U.S. dollar and the
currencies in which we do business could cause foreign currency translation
gains or losses that we would recognize in the period incurred. We cannot
predict the effect of exchange rate fluctuations on our future operating results
because of the number of currencies involved, the variability of currency
exposure and the potential volatility of currency exchange rates. We attempt to
minimize our currency exposure risk through working capital management and do
not hedge our exposure to translation gains and losses related to foreign
currency net asset exposures.
We do not hold or issue derivative, derivative commodity instruments or
other financial instruments for trading purposes. Investments held for other
than trading purposes do not impose a material market risk.
We believe that the relatively moderate rate of inflation in the United
States over the past few years and the relatively stable interest rates incurred
on short-term financing have not had a significant impact on our sales,
operating results or prices of raw materials. There can be no assurance,
however, that inflation or an upward trend in short-term interest rates will not
have a material adverse effect on our operating results in the future should we
require debt financing in the future.
A 100 basis point change in the variable interest ratewould not result in a
significant change in interest expense during fiscal 2005.
Item 8. Financial Statement and Supplementary Data.
40
The consolidated financial statement are listed in the index to the
consolidated financial statements in Part IV, item 15 (a)1.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
none
Item 9a. Controls and Procedures.Disclosure Controls and Procedures
The Company maintains controls and procedures designed to ensure that it is
able to collect the information it is required to disclose in the reports it
files with the SEC, and to process, summarize and disclose this information
within the time periods specified in the rules of the SEC. The Company's Chief
Executive and Chief Financial Officers are responsible for establishing and
maintaining these procedures, and, as required by the rules of the SEC, evaluate
their effectiveness. Based on their evaluation of the Company's disclosure
controls and procedures which took place as of a date within 90 days of the
filing date of this report, the Chief Executive and Chief Financial Officers
believe that these procedures are effective to ensure that the Company is able
to collect, process and disclose the information it is required to disclose in
the reports it files with the SEC within the required time periods.
Internal Controls
The Company maintains a system of internal controls designed to provide
reasonable assurance that; transactions are executed in accordance with
management's general or specific authorization; transactions are recorded as
necessary (1) to permit preparation of financial statements in conformity with
accounting principles generally accepted in the United States, and (2) to
maintain accountability for assets; access to assets is permitted only in
accordance with management's general or specific authorization; and the recorded
accountability for assets is compared with the existing assets at reasonable
intervals and appropriate action is taken with respect to any differences.
Since the date of the most recent evaluation of the Company's internal
controls by the Chief Executive and Chief Financial Officers, there have been no
significant changes in such controls or in other factors that could have
significantly affected those controls including any corrective actions with
regard to significant deficiencies and material weaknesses.
PART III
Item 10. Directors and Executive Officers of the Company
On March 31, 2004, our directors and executive officers were:
Name Age Position
---- --- --------
Phillip W. Arneson... 67 Chief Executive Officer, President, and Chairman
of the Board
Donne F. Fisher...... 65 Director (i), (ii)
Don Herzog........... 36 Director (i) (ii)
Robert L. Hibbard.... 51 Director (ii)
Larry J. Matthews.... 75 Director (i), (ii)
Gary M. Parsons...... 53 Director (ii)
Tom Schilling........ 41 Director (i)
Joe R. Armstrong..... 55 Chief Financial Officer
----------
(i) member of the Audit Committee
(ii) member of the Compensation Committee
41
Donne F. Fisher, with his financial management background has been
appointed as the Financial Expert on the Audit committee. The Audit committee is
enhanced with the financial expertise of Tom Schilling who has served as CFO to
Cincinnati Bell. Donne F. Fisher is independent as described in Section 14A of
the General Rules and Regulations of the Securities Exchange Act of 1934.
Our By-Laws provide that the members of the Board of Directors be elected
annually by our Shareholders for one-year terms. Each director who is not one of
our employees or our subsidiaries is paid an annual retainer of $24,000 per
year, payable at a rate of $2,000 per month. If an outside director is not
nominated for re-election or re-elected, the unpaid remainder of his $24,000
annual retainer shall be paid by the Company in a lump sum upon his departure.
In addition, each director who is not an employee of our company or our
subsidiaries receives $1,250 for each Board of Directors or committee meeting
attended. Directors who serve as the chairman of a committee receive an
additional $750 for each committee meeting attended and all other committee
members receive $500. The Board of Directors has two committees: Audit and
Compensation. There are no family relationships between any directors and
officers.
Phillip W. Arneson has been our Chairman and Chief Executive Officer of the
Company since March 2002. He previously served as our President and Chief
Operating Officer from October 2001 until his appointment as Chairman and Chief
Executive Officer. He also has served as one of our directors since October 2000
and currently serves on the Meret Communications, Inc. and Sorrento Networks,
Inc. Boards of Directors. From 1996 to 2001, Mr. Arneson held the position of
Executive Vice President for privately held Frandsen Corporation, a diversified
financial and manufacturing company where he was responsible for growing the
enterprise through acquisitions, internal growth, and strategic partnerships.
Additionally, he served as President of two of its operating companies. Mr.
Arneson has served several public and private technology companies in executive
management, holding positions as Chief Executive Officer, President and Group
Vice President as well as having extensive experience as a director of such
companies. From 1982 to 1986, he served as Executive Vice President of Allied
Signal's Electronic Sector and as Chief Executive Officer of its subsidiary,
Amphenol Corp. In 1986, Mr. Arneson's technology group garnered the prestigious
IR-100 award for the development of an integrated fiber optics phase modulator.
Mr. Arneson holds a B.S. in Electrical Engineering from the University of
Minnesota's Institute of Technology and is a veteran, U.S. Marine Corps.
Donne F. Fisher has served as one of our directors since November 2001 and
is chairman of our Audit Committee. Mr. Fisher is currently President of Fisher
Capital Partners, Ltd., a private venture capital and investment company he
founded in 1991. From 1982 to 1996, Mr. Fisher held various executive officer
positions with Tele-Communications, Inc. ("TCI") and its subsidiaries including
Executive Vice President and Treasurer. He was a TCI director from 1980 until
1999 when TCI merged into AT&T Corporation. Since his retirement in 1996, Mr.
Fisher has been a consultant to TCI (now AT&T Broadband). Mr. Fisher also serves
as a director of Liberty Media Corporation, a former subsidiary of AT&T, and
General Communications, Inc., a diversified telecommunications provider.
Robert L. Hibbard has served as one of our directors since November 2001
and is chairman of our Compensation Committee. Mr. Hibbard is an attorney and
management consultant in private practice in which he handles a wide variety of
commercial matters including technology licensing and the structuring of merger
and acquisitions transactions. From 1997 to 1999, Mr. Hibbard was Chief
Executive Officer of Kim Technologies International, Inc., a privately held
developer of electromechanical "super" capacitors for wireless applications.
From 1994 to 1997, Mr. Hibbard was Vice President and General Counsel at Allied
Signal Engines, and from 1987 to 1994, Assistant General Counsel at Allied
Signal Aerospace. Mr. Hibbard holds a bachelors degree from Gustavus Adolphus
College and a J.D. from Marquette University Law School, where he was a member
of the Marquette Law Review.
Don Herzog has served as one of our directors since October 2003. He is an
investment professional who worked most recently for the firm of Zimmer Lucas
Partners in New York City from 2001 to 2003. Prior to that, he was with the
venture capital firm Odyssey Capital from 2000 to 2001. Mr. Herzog earned his
MBA at Carnegie Mellon from 1998 to 2000. Mr. Herzog received a B. S. in
electrical engineering from Drexel University in 1990 prior to eight years as a
naval officer.
Gary M. Parsons has served on our Board of Directors since October 2000.
Since 1996, Mr. Parsons has held the position of Chairman of the Board for XM
Satellite Radio Holdings, Inc., and in October 2001 was named Chairman and Chief
Executive Officer of Mobile Satellite Ventures, LLP. From 1996 to April 2002,
Mr. Parsons served as Chairman of Motient Corporation, a wireless data firm. On
January 10, 2002, Motient filed a voluntary
42
bankruptcy petition in connection with a prearranged restructuring of its debt
and emerged from bankruptcy on May 1, 2002. From 1990 to 1996, Mr. Parsons held
a number of executive positions at MCI Communications, Inc., including Executive
Vice President, Chief Executive Officer of MCI Metro, Inc., and President of
MCI's Southern Division. From 1984 to 1990, Mr. Parsons held the
responsibilities of Executive Vice President at Telecom*USA, a fiber-optic and
long distance venture subsequently acquired by MCI. Mr. Parsons holds a B.S. in
Electrical and Computer Engineering from Clemson University and a MBA from the
University of South Carolina.
Larry J. Matthews has served on our Board of Directors since August 2002.
Mr. Matthews was a co-founder of Zytec Corporation, a manufacturer of high
performance electronics for the telecommunications and computer industries. Mr.
Matthews served as an officer and director of Zytec, which grew from a start-up
operation to a public company with revenues exceeding $250 million annually
during his tenure. In 1992, Zytec won the National Baldridge Quality Award. A
public offering of Zytec was completed in 1994. In 1997, Zytec merged with
Computer Products Corporation to form Artesyn Technologies (ATSN, NASDAQ). Mr.
Matthews currently serves on Artesyn's board as a director. He also serves on
the Board of Veritec, Inc. (VRTC.OB, OTC BB), a seller of microprocessor-based
encoding and decoding systems products. From January 1999 to June 2000, Mr.
Matthews served as Veritec's Acting President and Chief Executive Officer. Mr.
Matthews holds a Bachelor of Engineering degree from Iowa State University, and
serves on the boards of several privately held companies.
Tom Schilling has served on our Board of Directors since October 2003. He
was most recently Chief Financial Officer of Cincinnati Bell Inc. (fka Broadwing
Inc.), serving from 2002-2003. Prior to that, and from 1999, Mr. Schilling was
Senior VP and Chief Financial Officer of Broadwing Communications, a subsidiary
of Cincinnati Bell. Further, Mr. Schilling was Chief Financial Officer of
AutoTrader.com from 1998-1999, and from 1993-1998 held several management
positions with MCI Communications, Inc. He holds a B.S. in accounting from
Indiana University.
Joe R. Armstrong has served as our Chief Financial Officer since January
2001. He brings over 25 years of corporate finance, investor relations,
treasury, legal and management experience to the Company, having spent 15 years
with State Of The Art, a leading provider of accounting software. As chief
financial officer, vice president, finance and secretary of State Of The Art, he
managed two rounds of venture capital financing, the company's initial public
offering and several significant acquisitions and mergers. Prior to joining us,
Mr. Armstrong most recently served as CFO for The Bohlin Company. Previously, he
was director of marketing finance and financial planning for MAI Basic Four
Corporation and a certified public accountant for Vicenti, Lloyd and Stutzman, a
regional public accounting firm. Mr. Armstrong holds both bachelors and masters
degrees in business from Utah State University.
Our other key employees include:
Name Age Position
---- --- --------
Subrata Datta 41 Chief Technical Officer
Mary A. Lay 46 Vice President, Finance
Andrew Nguyen 44 Vice President, Engineering
Manfred Seehagen 55 Vice President, European Operations
Marc W. Thurman 54 Vice President, Operations
Mitchell R. Truelock 35 Vice President, Corporate Development
Subrata Datta has served as Chief Technical Officer since October 2003 and
previously served as our Vice President of Engineering. Mr. Datta joined
Sorrento upon our acquisition of Distributed Systems International, Inc. in
1996. From 1996 to 1999 he was responsible for all engineering development for
the LAN adapter and hub/switch products. Prior to joining us, Mr. Datta helped
develop the ANSI FDDI and FDDI-II standards and design network components and
system-level products for DSI. Prior to DSI, Mr. Datta had extensive design
experience while working at AT&T Bell Laboratories on the 3B20 Duplex computer
system, based on highly fault tolerant architectures, high-reliability and
stringent up-time requirements. Before working for AT&T Bell Laboratories, Mr.
Datta worked for IBM's Yorktown Research Center where he focused on FDDI
development for their RS6000 workstation systems. Mr. Datta holds a M.S. and
B.S. in Electrical Engineering from the Cooper Union School of Engineering.
43
Mary A. Lay has served as Vice President, Finance since July 2002 and
joined us in March 2002 as Controller. Ms. Lay brings over 20 years of corporate
finance, treasury and management experience to the Company. Ms. Lay's previous
experience includes contract and permanent position as Corporate Controller and
Chief Financial Officer at several companies including On-Point Technology
Systems, Inc., Curtis Coleman Company and Nexergy Tauber. Ms. Lay holds a B.A.
in Financial Accounting from National University, an M.B.A. from the University
of Phoenix and is a certified public accountant.
Andrew Nguyen has served as Vice President of Engineering since October
2003. Mr. Nguyen served as LuxN's Vice President, Engineering since August 2000,
during which time he was responsible for all product development including the
delivery of high-availability carrier-class optical transport platforms and
network management software products. Prior to joining LuxN, Mr. Nguyen served
as Vice President, Engineering for Allied Telesyn International (ATI), a leading
supplier of fiber transceivers/media-converter products and workgroup/enterprise
IEEE802.3 L2/L3 repeaters/switches/routers. Prior to ATI, Mr. Nguyen worked at
Motorola, Ricoh and Epson Research Center, developing and delivering successful
products to the market. Mr. Nguyen holds a B.S. in Electrical Engineering from
San Jose State University.
Manfred Seehagen has served as our Vice President of European Operations
since September 2002 and joined Sorrento Networks in March 1999 as the Director
of Sales and Marketing for our German subsidiary. He has a computer science and
electronics background as well as several years of sales and marketing
experience with ITT Telecommunications, Standard Electrik Lorenz and Alcatel.
Mr. Seehagen has also been an active member of ZVEI (Zentralverband der
Elektrotechnik und Elektronikindustrie), the German electrical and electronic
manufacturers' association where he was a representative in several
telecommunications working groups.
Marc Thurman has served as Vice President, Operations since April 2001. Mr.
Thurman oversees our manufacturing and operations, supply chain management, and
quality assurance functions. He brings to us nearly 25 years of manufacturing
operations, supply chain management and quality assurance experience on leading
edge technologies and products for the computer and telecommunication markets.
Mr. Thurman's previous experience includes service since 1971, in various
functions at Packard Bell NEC, ComCrypt Systems, IDEA Courier, Inc., Sidereal
Corporation, Intel Corporation, RTE Corporation, and Western Electric. In his
most recent position, Mr. Thurman had manufacturing responsibilities including
internal production, contract manufacturing (EMS) and third party manufacturing
(TPM), supporting revenues of $2 billion. Mr. Thurman holds a B.S. in Electrical
Engineering from Oregon State University as well as an M.B.A. degree from
University of Portland.
Mitchell R. Truelock has served as Vice President of Corporate Development
since January 2004. Prior to accepting his current position he was our Vice
President, Sales and Marketing and had responsibility for North American and
Asia Pacific sales, marketing, product management and customer support. Mr.
Truelock joined us in January 2003 as Vice President, Strategic Planning after
having consulted with us since August 2002. Prior to joining us, from February
2000 to November 2001, Mr. Truelock was a Vice President in the communications
equipment group at Banc Boston Robertson Stephens, a technology investment bank.
From June 1998 to February 2000, Mr. Truelock was a Vice President in the
technology group at Dain Rauscher Wessels, a technology investment bank. From
September 1995 to June 1998, Mr. Truelock was a corporate attorney at Cooley
Godward LLP where he focused on mergers and acquisitions, private financings and
initial public offerings for technology companies. Mr. Truelock holds a L.L.M.
in corporate securities at Georgetown University Law, a J.D. from Southern
Methodist University, and a BBA in accounting from the University of Texas at
Austin.
Item 11. Executive Compensation
The following tables set forth the annual compensation for the Company's
Chief Executive Officer ("CEO") for the fiscal year ended January 31, 2004, and
for the four most highly compensated executive officers of the Company, other
than the CEO, who were serving as executive officers at the end of our fiscal
year and whose salary and bonus exceeded $100,000.
Summary Compensation Table
Annual Compensation
------------------------------------------------------
Name and Year Salary Bonus Other All
Principal Position ($) ($)(A) Annual Other
-------------------------------- ---- ------- ------- ------------ ------------
44
Compensation Compensation
($)(B) ($)(C)(D)(E)
-------------------------------- ---- ------- ------- ------------ ------------
Phillip W. Arneson, Chairman ... 2004 265,780 185,000 -- 80,137
Chief Executive Officer ..... 2003 245,387 205,000 -- 72,066
2002 60,582 25,000 -- 12,547
-- --
Joe R. Armstrong ............... 2004 215,778 150,000 -- 27,398
Chief Financial Officer ..... 2003 191,927 165,000 -- 20,962
2002 175,011 -- -- --
Marc Thurman, VP ............... 2004 180,003 36,000 -- --
Operations .................. 2003 180,003 31,127 -- --
Subrata Datta .................. 2004 175,011 26,250 -- --
Chief Technical Officer ..... 2003 175,011 8,750 -- --
2002 175,011 --
Mitchell R. Truelock, VP ....... 2004 175,011
Corporate Development ....... 2003 13,462
(A) Bonus compensation represents performance and retention bonuses paid in
fiscal years 2004, 2003 and 2002. In fiscal year 2004, Mr. Arneson, Mr.
Armstrong, Mr. Thurman and Mr. Datta received performance bonuses of
$185,000, $150,000, $36,000 and $26,250 respectively.
In fiscal year 2003, Mr. Arneson received the final payment of $5,000 of
his $30,000 signing bonus per his employment contract, which took effect
October 2001, a performance bonus of $125,000 and a retention bonus of
$75,000. Mr. Armstrong received a performance bonus of $105,000 and a
retention bonus of $60,000.
In fiscal year 2002, Mr. Arneson received a signing bonus per his
employment contract, which took effect October 2001 of $25,000.
(B) Other compensation for Mr. Arneson for fiscal year 2004 consists of
temporary living expenses paid by the company of $6,325, vacation accrual
buy-out of $26,312 and tax and estate planning of $7,500. Other
compensation for Mr. Arneson for fiscal year 2003 consists of temporary
living expenses paid by the company of $48,930 and vacation accrual buy-out
of $23,237. In fiscal year 2002, Mr. Arneson had temporary living expenses
of $12,547.
(C) Other compensation for Mr. Armstrong represents vacation accrual buy-out.
Long-Term Incentive Plans
We have has no long-term incentive plans other than our various stock
option plans.
Option Grants--Year Ended January 31, 2004
There were no option grants exercised for the year ended January 31, 2004
for any of the Named Executive Officers.
The following table sets forth information concerning each exercise of stock
options during the year ended January 31, 2004 by each of the Named Executive
Officers and the January 31, 2004, value of unexercised options.
Aggregated Option Exercises in Fiscal Year 2004 and January 31, 2004
Option Values
Number of
Shares Securities Underlying Value of Unexercised
Acquired Value Unexercised Options In-the-Money Options
On Realized at Fiscal Year-End ($) at Fiscal Year-End (A)
Exercise ($) --------------------------- ---------------------------
45
Name (#) Exercisable Unexercisable Exercisable Unexercisable
----------------------------------- -------- -------- ----------- ------------- ----------- -------------
Phillip W. Arneson................. -- -- 454,052 60,497 $940,101 $308,532
Joe R. Armstrong................... -- -- 264,720 38,048 $553,157 $181,547
Marc Thurman....................... -- -- 6,959 51,041 $594,255 $172,545
Subrata Datta...................... -- -- 2,803 50,521 $309,188 $120,691
Mitchell R. Truelock............... -- -- 0 150,000 $ 0 $283,000
(A) Options are "in-the-money" if, on January 31, 2004, the $5.01 market price
of the Common Stock exceeded the exercise price of such options. The value
of such options is calculated by determining the difference between the
aggregate market price of the Common Stock covered by such options on
January 31, 2004, and the aggregate exercise price of such options.
Employment Agreements
On March 1, 2002 Mr. Arneson assumed the role of our Chairman, President
and Chief Executive Officer. On April 30, 2002, our Board of Directors approved
an employment agreement with Mr. Arneson regarding the terms of his employment
as Chairman, Chief Executive Officer and President, which superseded his August
2001 contract. The agreement provides for annual compensation of $250,000. The
agreement also calls for the vesting, as of March 1, 2002, of the 6,250 options
granted Mr. Arneson on September 17, 2001, and the granting of 23,750 additional
stock options (adjusted for the 1-for-20 reverse split) at a strike price equal
to the closing price of our common stock on NASDAQ on March 1, 2002, which
shares are to vest at the rate of 1,000 shares per month beginning on April 1,
2002, continuing for 12 months, when 5,000 additional shares vest, and beginning
on May 1, 2003, 1,125 shares will vest each month. The employment is at will;
however, if Mr. Arneson should be terminated without cause or resign in certain
circumstances, he would receive a lump sum severance payment of two years' base
salary and vesting of all stock options, and health and life benefits; he would
be required to provide exclusive consulting services for two years following his
termination. The agreement also calls for the reimbursement of living expenses
in San Diego at the rate of $2,750.00 per month while Mr. Arneson remains
employed. In the event of a change of control, merger or sale of our company,
Mr. Arneson is entitled to receive an immediate payment equal to two year's
salary, health and life insurance benefits for two years and vesting of all his
options. In June 2003, our Board of Directors clarified the termination section
of Mr. Arneson's contract and authorized increases in annual compensation to
$275,000, and monthly living allowance to $3,250. In June 2003, the Board of
Directors also approved an amendment to Mr. Arneson's employment agreement to
provide that in the event Mr. Arneson is terminated without cause, he shall
continue to receive his then existing health and life insurance benefits for
a period of four years.
In May 2002, we entered into an employment agreement with Mr. Armstrong,
our CFO, which provides for an annual salary of $200,000 per year plus bonus of
$20,000, which was paid in a lump-sum, in June 2002, and 10,500 options
(adjusted for the 1-for-20 reverse split) to acquire our common stock vesting
over two years. The contract is for no specified term and Mr. Armstrong is an
at-will employee such that the company or Mr. Armstrong may terminate employment
at any time, with or without cause or notice, and with or without reason,
subject to the rights and obligations as provided in the contract. However,
should Mr. Armstrong be terminated without cause he will receive a lump-sum
severance payment of one year's salary, health and life benefits for one year
and vesting of all his options. In the event of a change of control, merger or
sale of our company, Mr. Armstrong is entitled to receive an immediate payment
equal to one year's salary, health and life insurance benefits for one year and
vesting of all his options. In June 2003, our Board of Directors authorized an
increase in Mr. Armstrong's annual compensation to $225,000.
In January 2004, we entered into an employment agreement with Mr. Truelock,
our Vice President, Corporate Development, which provides for an annual salary
of $200,000 per year plus a performance bonus of up to $100,000 under certain
conditions, and 100,000 options to acquire our common stock that vest over three
years. The agreement also calls for us to reimburse Mr. Truelock up to $15,000
for relocation expenses incurred. The contract is for no specified term and Mr.
Truelock is an at-will employee which allows us to discontinue Mr. Truelock's
employment at any time, with or without cause or notice, and with or without
reason. However, should Mr. Truelock be terminated without cause prior to
certain conditions in the contract, he will receive two months salary
continuation and accelerated vesting of his outstanding options. If Mr. Truelock
is terminated by us without cause within six (6) months subsequent to a change
in control that is not a hostile takeover, he will also receive accelerated
vesting of his outstanding options.
46
Compliance with Section 16(a) of the Exchange Act
Section 16(a) of the Securities Exchange Act of 1934 (the "Exchange Act")
requires our directors and executive officers and persons who own more than ten
percent of a registered class of our equity securities to file reports of
beneficial ownership and changes in beneficial ownership with the Securities and
Exchange Commission (the "Commission"). The rules promulgated by the Commission
under Section 16(a) of the Exchange Act require those persons to furnish us with
copies of all reports filed with the Commission pursuant to Section 16(a).
During the fiscal year ended January 31, 2004, Don Herzog and Tom Schilling
received stock option grants that were not reported by the required filing date.
These directors have now filed the required forms as required under Section
16(a) of the Exchange Act.
Item 12. Security Ownership of Certain Beneficial Owners and Management
The following table sets forth certain information, as of January 31, 2004,
regarding the ownership of our common stock by (i) each of our directors; (ii)
each of the present executive officers; (iii) each person known to us to
beneficially own 5% or more of our common stock; and (iv) all of our directors
and executive officers as a group. Except as indicated, all persons named as
beneficial owners of our common stock have sole voting and investment power with
respect to the shares indicated as beneficially owned by them. All persons named
have an address at c/o Sorrento Networks Corporation, 9990 Mesa Rim Road, San
Diego, California 92121, unless otherwise indicated.
Common Stock
--------------------------
Number of Percentage of
Name of Beneficial Owner (A) Shares Outstanding(J)
---------------------------- --------- --------------
Phillip W. Arneson (B) ............................ 478,500 2.9%
Donne F. Fisher (C) ............................... 68,879 *
Robert L. Hibbard (D) ............................. 47,216 *
Gary M. Parsons (E) ............................... 44,750 *
Larry J. Matthews (F) ............................. 43,417 *
Don Herzog (G) .................................... 25,000 *
Tom Schilling (H) ................................. 25,000 *
Joe Armstrong (I) ................................. 280,221 1.7*
All Directors, and Executive
Officers as a Group ............................ 1,012,983 6.1%
Rajendra Singh (J) ................................ 873,132 5.35%
7925 Jones Branch Drive, Suite 6400
McLean, VA 22102
Belmarken Holdings, BV (K) ........................ 2,094,379 12.84%
Boeing Avenue 53
1119 PE Schiphol Rijk
The Netherlands, PF
* Less than 1%
(A) All information with respect to beneficial ownership of the shares is based
upon filings made by the respective beneficial owners with the Securities
and Exchange Commission or information provided by such beneficial owners
to us.
(B) Includes exercisable options held by Mr. Arneson to acquire 478,250 shares
of common stock, and 250 shares of common stock purchased in June 2002.
(C) Includes exercisable options to acquire 44,666 shares of common stock held
by Mr. Fisher and 24,212 shares of common stock received in distribution of
stock to our former Series A Preferred Stock holders and interest payments
on the 7.5% Convertible Debenture outstanding. Mr. Fisher is a director of
Liberty Media Corporation, which owns an approximate 74% economic interest
representing an approximate 94% voting interest in UnitedGlobalCom, Inc.
("UGC"). Belmarken Holding, B.V., an indirect subsidiary of UGC, holds
2,059,195 shares of our common stock. Liberty Media also holds convertible
debt of United Pan-Europe
47
Communications, N.V., a subsidiary of UGC, which it has agreed to exchange
for additional shares in UGC. Mr. Fisher meets all the current requirements
for an independent director.
(D) Includes exercisable options to acquire 47,166 shares of common stock held
by Mr. Hibbard and 50 shares of common stock purchased in July 2002.
(E) Represents options to acquire shares of our common stock, which were
granted to Mr. Parsons consistent with, and upon the same terms, conditions
and vesting schedules as, option grants made to other members of our Board
of Directors.
(F) Represents options to acquire shares of our common stock, which were
granted to Mr. Matthews consistent with, and upon the same terms,
conditions and vesting schedules as, option grants made to other members of
our Board of Directors
(G) Represents options to acquire shares of our common stock, which were
granted to Mr. Herzog consistent with, and upon the same terms, conditions
and vesting schedules as, option grants made to other members of our Board
of Directors
(H) Represents options to acquire shares of our common stock, which were
granted to Mr. Schilling consistent with, and upon the same terms,
conditions and vesting schedules as, option grants made to other members of
our Board of Directors
(I) Includes exercisable options to acquire 280,071 shares of common stock held
by Mr. Armstrong and 150 shares of common stock purchased in June 2002.
(J) Represents holdings reported by Rajendra Singh, Neera Singh, Cherrywood
Holdings, Inc., Telcom Ventures, L.L.C., and Telcom-SNI Investors, L.L.C.
on June 16, 2003 on Form 13-G, "General Statement of Beneficial Ownership."
Includes 647,348 shares of common stock and 225,784 shares underlying
convertible debentures held by the reporting persons.
(K) Represents holdings reported by Belmarken Holdings, BV on June 16, 2003 on
Form 13-D, "General Statement of Beneficial Ownership." Includes 1,601,723
shares of common stock and 492,656 shares underlying convertible debentures
held by the reporting person.
Item 13. Certain Relationships and Related Transactions.
Two of our customers are subsidiaries of UnitedGlobalCom, Inc ("UGC"),
which is the parent of Belmarken Holding, B.V., a holder of approximately 12.8%
of our shares of common stock, and indirect subsidiaries of UGC. During fiscal
2004, we recorded sales of $483,093, including deferred revenue, to these
customers and these customers had no outstanding receivables at January 31,
2004. As noted above, Mr. Fisher is a director of Liberty Media Corporation,
which is a shareholder of UGC and debt holder in one of its indirect
subsidiaries. Mr. Fisher was not one of our directors when we made these sales
and extended credit to these customers. However, indirect subsidiaries of UGC
continue to be among our customers, namely UPC.
In February 2003, we entered into a consulting agreement with Mr. Robert
Hibbard, to provide services to the Board of Directors and management of the
company at a consulting rate of $175 per hour and a retainer of $20,000 per
month for six months. Mr. Hibbard agrees to make himself available to the
Company for not less than 20 hours per week. This agreement supersedes his
August 2002 consulting agreement. Nearly all of Mr. Hibbard's consulting work
for us has involved matters being considered or reviewed by the board or by
committees of the board. His work has included structuring and implementing our
2003 Equity Incentive Plan for employees, participation in settlement
negotiations for pending litigation, assistance in our capital restructuring and
improving our intellectual property policies and procedures, among other
matters. In fiscal years 2004 and 2003, Mr. Hibbard was paid $204,950 and
$91,836 respectively, in consulting fees.
During July 2000, we agreed to loan $300,000 for three years at the
applicable federal rate provided for in Internal Revenue Code Section 1274 to
Mr. Jacobson in connection with accepting employment as our Senior Vice
President, Legal. This is a full recourse loan and Mr. Jacobson has pledged his
options to acquire our common stock and any options he may receive from any of
our subsidiaries as collateral. Mr. Jacobson has received $300,000 in advances
under this loan agreement for which the interest rate is 6.6%. On July 3, 2002,
a new note covering the $300,000 was incorporated in Mr. Jacobson's employment
contract. The term remained the same as the July 2000 note, with all unpaid,
accrued interest and principal due and payable on August 30, 2003. In December
2002,
48
Mr. Jacobson paid $39,330 on his loan that included payment of all prior
interest due and the remainder applied to his principal balance. Mr. Jacobson is
no longer in our employ. As of January 31, 2004, Mr. Jacobson's loan outstanding
to the Company totaled $297,961.
Item 14. Principal Accountant Fees and Services
Audit Fees
BDO Seidman, LLP billed us $299,887 and $168,441 in the aggregate, for
professional services for the audit of our annual financial statements for
fiscal 2004 and 2003 respectively, and for the review of our interim financial
statements, which are included in our Quarterly Reports on Form 10-Q for fiscal
2004.
BDO Seidman, LLP billed us $84,317 and $9,265 for other audit-related
fees for fiscal year 2004 and 2003 respectively.
Tax Fees
BDO Seidman, LLP billed us $290,650 and $193,250 for fiscal 2004 and
2003 respectively, for domestic and international tax preparation work.
Financial Information Systems Design and Implementation Fees
BDO Seidman, LLP did not provide and did not bill nor was paid any fees
for, financial information systems design and implementation services in fiscal
2004 and 2003 as described in Paragraph (C)(4)(ii) of Rule 2-01 of Regulation
S-X.
All Other Fees
BDO Seidman, LLP has billed us $50,695 in the aggregate, for
professional services rendered for all services other than those services
captioned "Audit Fees", "Tax Fees" and "Financial Information Systems Design
and Implementation Fees" in fiscal 2003. These services included consulting and
other services.
All non-audit services were reviewed with the Audit Committee, which
concluded that the provision of such services by BDO Seidman, LLP was compatible
with the maintenance of that firm's independence in the conduct of its auditing
function.
AUDIT COMMITTEE POLICY ON PRE-APPROVAL OF SERVICES PERFORMED BY THE INDEPENDENT
AUDITORS
The independence of the Company's independent auditors is critical to
ensure the integrity of the Company's financial statements. To assure that the
services performed by the independent auditors do not impair their independence,
the Audit Committee has established a policy governing pre-approval of services
to be provided by the independent auditors.
The independent auditors will submit a report, which includes an aggregate
of services in the following four categories expected to be rendered during the
year and the related range of fees, to the Audit Committee for its approval:
1. Audit services comprise the work necessary for the independent auditors to
render an opinion on the audit of the consolidated financial statements of the
Company as well as work that generally only the independent auditors can
reasonably be expected to provide, including separate audits of the Company's
subsidiaries, services associated with SEC registration statements, periodic
reports and other documents issued in connection with securities offerings.
2. Audit-related services are assurance and related services that are
reasonably related to the performance of the audit or review of the Company's
financial statements, including financial statement audits of businesses to be
divested, employee benefit plan audits, agreed-upon or expanded audit procedures
to meet certain regulatory requirements, and certain attestation services.
3. Tax services include selected non-U.S. tax compliance and limited
assistance with tax audits involving federal, state and international tax
consulting projects commenced prior to December 1, 2001.
4. Other services include attestation services required in connection with
governmental requests/reviews and other attestation services performed in
connection with nonfinancial information.
From time to time, circumstances may arise in which it will become
necessary to engage the independent auditors for additional services not
contemplated in the original pre-approval (e.g., new services or approved
services exceeding the pre-approved range of fees). In those instances, the
Audit Committee requires specific pre-approval before engaging the independent
auditors.
The Audit Committee has delegated limited pre-approval authority to the
Audit Committee Chair. Any services and associated fees approved by the Audit
Committee Chair will be reported to the Audit Committee at its next meeting.
For fiscal year 2004 no audit fees were approved after the work was
performed.
Item 15. Exhibits, Financial Statement Schedules, and Reports on Form 8-K
(a) Exhibits and Consolidated Financial Statement Schedules
1. Financial Statements: (see index to financial statements at page F-1)
Independent Certified Public Accountants' Reports
Consolidated Balance Sheets at January 31, 2004 and 2003
Consolidated Statements of Operations for the Years Ended January 31, 2004, 2003 and 2002
Consolidated Statements Comprehensive Income for the Years Ended January 31, 2004, 2003 and 2002
Consolidated Statement of Stockholders' Equity for the Years Ended January 31, 2004, 2003 and 2002
Consolidated Statements of Cash Flows for the Years Ended January 31, 2004, 2003 and 2002
Notes to Consolidated Financial Statements
2.Exhibits:
3.1 Certificate of Amendment to the Certificate of Incorporation
dated October 15, 2002 (A).
3.2 Certificate of Correction to the Certificate of Amendment to the
Certificate of Incorporation dated November 6, 2002 (A).
3.3 Certificate of Incorporation dated May 14, 2003 (J).
3.4 Amendment and Restated By-Laws of the Registrant (J).
3.5 Certificate of Amendment to the Certificate of Incorporation dated May 30, 2003 (J).
4.1 1988 Stock Option Plan (J).
4.2 Amended and restated 1997 Incentive and Non-Qualified Stock Option Plan (K).
4.3 1997 Directors Stock Option Plan (K).
4.4 2000 Stock Incentive Plan (K).
4.5 2000 Employee Stock Purchase Plan (K).
4.6 2000 Stock Option/Stock Issuance Plan of Sorrento Networks, Inc. (K).
4.7 Form of Senior Convertible 9.75% Debenture due August 2, 2004 (F).
4.8 Form of Warrant dated August 2, 2001 (F).
4.9 Form of 7.5% Convertible Debenture Due August 2, 2007 (F).
4.10 Form of Warrant, expiry date August 2, 2007 (F).
4.11 Sorrento Networks Corporation 2003 Equity Incentive Plan (K).
4.12 Series D Preferred Stock Certificate of Designation (I).
4.13 Series F Preferred Stock Certificate of Designation (I).
49
10.1 Agreement dated June 12, 2000 with Par Chadha (G).
10.2 Agreement dated May 22, 2000 with Rohit Phansalkar (G).
10.3 Agreement dated May 22, 2000 with Christopher E. Sue (G).
10.4 Agreement dated August 22, 2000 with Leonard N. Hecht (G).
10.5 Agreement dated May 22, 2000 with John A. Mason (N).
10.6 Agreement dated July 12, 2000 with Richard L. Jacobson (N).
10.7 Securities Purchase Agreement dated as of August 1, 2001 (J).
10.8 Escrow Agreement dated as of August 1, 2001 (J).
10.9 Registration Rights Agreement dated as of August 2, 2001 (J).
10.10 Agreement dated March 1, 2002, with Phillip W. Arneson (N).
10.11 Exchange Agreement dated March 6, 2003 (F).
10.12 Form of Registration Rights Agreement with Exchanging Holders (F).
10.13 Agreement dated May 17, 2002 with Joe R. Armstrong (N).
10.14 Agreement dated July 3, 2003 with Richard L. Jacobson (N).
10.15 Agreement dated February 1, 2003 with Robert L. Hibbard (N).
14.0 Code of Ethics for Senior Executive and Financial Officers
21.0 Subsidiaries of the Registrant (S).
23.0 Consent of BDO Seidman LLP--filed herewith
31.1 Certification of Phillip W. Arneson, Chief Executive Officer, pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.
31.2 Certification of Joe R. Armstrong, Chief Financial Officer, pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, filed herewith.
32.1 Certification of Phillip W. Arneson, Chief Executive Officer, pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.
32.2 Certification of Joe R. Armstrong, Chief Financial Officer, pursuant to 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, filed herewith.
----------
The foregoing are incorporated by reference from the Registrant's filings
as indicated:
(A) Form 10-QSB for the quarter ended July 31, 1996
(B) Form 10-K for the year ended January 31, 1988
(C) Form S-3 dated February 25, 1997
(D) Proxy Statement dated December 1, 1999
(E) Proxy Statement dated May 13, 1988
(F) Proxy Statement dated November 21, 1997
(G) Proxy Statement dated December 11, 2000
(H) Form 10-KSB for year ended January 31, 1996
(I) Form 10-Q for the quarter ended October 31, 2000
(J) Form 10-K for the year ended January 31, 2001
(K) Form 8-K dated August 3, 2001
(L) Form 10-K for the year ended January 31, 2002
(M) Form 8-K dated October 25, 2002
50
(N) Proxy Statement dated April 15, 2003.
(O) Registration Statement on Form S-3/A, filed with the SEC on
May 27, 2003.
(P) Proxy Statement dated December 3, 2003
----------
NOTE: Certain previously filed exhibits are no longer being incorporated by
reference (and therefore not numerically listed) as the underlying
documents have either expired or are no longer material or relevant.
(b) Reports on Form 8-K
January 24, 2002 Delaware Supreme Court ruling
November 5, 2002 Non-compliance with NASDAQ listing requirements
November 12, 2002 Five-year supply agreement
December 10, 2002 Restructuring Letter of Intent and term sheet
March 12, 2003 Exchange Agreement and associated documents
April 11, 2003 Results of Operations and Financial Condition
May 12, 2003 Sale of Marketable Securities
May 12, 2003 Settlement Agreement reached with Former Employee
May 29, 2003 Adjournment of Special Meeting of Shareholders
May 30, 2003 Special Meeting of Shareholders
June 3, 2003 Results of Operations and Financial Condition
June 9, 2003 Completion of Capital Restructuring Plan
August 5, 2003 Results of Operation and Financial Condition
October 23, 2003 Acquisition or Disposition of Assets
September 10, 2003 Results of Operations and Financial Condition
December 31, 2003 Private Placement of Common Stock
January 27, 2004 Private Placement of Common Stock
51
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Report of Independent Certified Public Accountants............... F-2
Consolidated Balance Sheets as of January 31, 2004 and 2003...... F-3
Consolidated Statements of Operations and Comprehensive Loss for
the years ended January 31, 2004, 2003 and 2002............... F-4
Consolidated Statements of Stockholders' Equity (Deficit) for the
years ended January 31, 2004, 2003 and 2002................... F-5 to F-7
Consolidated Statements of Cash Flows for the years ended
January 31, 2004, 2003 and 2002............................... F-8 to F-9
Notes to Consolidated Financial Statements....................... F-10 to F-56
F-1
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
The Shareholders of Sorrento Networks Corporation
San Diego, California
We have audited the accompanying consolidated balance sheets of Sorrento
Networks Corporation (a Delaware corporation) and subsidiaries (collectively the
"Company") as of January 31, 2004 and 2003 and the related consolidated
statements of operations and comprehensive loss, stockholders' equity (deficit)
and cash flows for each of the three years in the period ended January 31, 2004.
These consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. These standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe our audits provide a reasonable
basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of the
Company as of January 31, 2004 and 2003, and the results of their operations and
their cash flows for each of the three years in the period ended January 31,
2004 in conformity with accounting principles generally in the United States of
America.
/s/ BDO Seidman, LLP
BDO Seidman, LLP
Los Angeles, California
April 9, 2004, except for Note Q which is as of April 22, 2004.
F-2
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In Thousands)
January 31, January 31,
2004 2003
----------- -----------
ASSETS
CURRENT ASSETS
Cash and cash equivalents................................................. $ 17,617 $ 7,747
Accounts receivable, net (Notes P and S).................................. 3,754 5,576
Inventory, net (Notes B and T)............................................ 13,893 13,934
Prepaid expenses and other current assets (Note N)........................ 972 741
Investment in marketable securities (Note B).............................. 504 3,959
Notes receivable 242 --
--------- ---------
TOTAL CURRENT ASSETS................................................... 36,982 31,957
--------- ---------
PROPERTY AND EQUIPMENT, NET (Notes C and E)................................. 12,267 17,103
--------- ---------
OTHER ASSETS
Purchased technology, net (Note B)........................................ 110 430
Investment in non-marketable securities (Note B).......................... -- 5,025
Other assets (Notes A and B).............................................. 654 1,290
Notes receivable.......................................................... 83 --
--------- ---------
TOTAL OTHER ASSETS..................................................... 847 6,745
--------- ---------
TOTAL ASSETS................................................................. $ 50,096 $ 55,805
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES
Current maturities of long term debt (Note E)............................. $101 $222
Accounts payable.......................................................... 2,887 5,135
Deferred revenue.......................................................... 878 3,700
Accrued professional fees................................................. 832 4,324
Other accrued liabilities and current liabilities (Note G)................ 6,478 6,236
Due on redemption of preferred security of subsidiary (Note J)............ -- 48,800
--------- ---------
TOTAL CURRENT LIABILITIES.............................................. 11,176 68,417
--------- ---------
Long-term debt and capital lease obligations (Note E,S and G)................ 3,538 3,644
Debentures payable (Note F).................................................. 12,388 18,121
Dividends payable (Note A)................................................... -- 99
--------- ---------
TOTAL LIABILITIES...................................................... 27,102 90,281
--------- ---------
COMMITMENTS AND CONTINGENCIES (Note G)
STOCKHOLDERS' EQUITY (DEFICIT) (Note Iand J)
Preferred stock, $.01 par value; liquidation preference $1,353............ 1 1
Common stock,$0.001 par value; 150,000,000 shares authorized; 16,315,361
shares issued 16,314,917 shares outstanding at January 31, 2004;
886,494 shares issued 886,050 shares outstanding at January 31, 2003... 16 5,318
Additional paid-in capital................................................ 216,434 144,887
Deferred stock compensation............................................... -- (5)
Accumulated deficit....................................................... (193,769) (187,536)
Accumulated other comprehensive loss...................................... 381 2,928
Treasury stock, at cost; 444 shares at January 31, 2004 and January 31,
2003, respectively..................................................... (69) (69)
--------- ---------
TOTAL STOCKHOLDERS' EQUITY (DEFICIT)................................... 22,994 (34,476)
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY................................... $ 50,096 $ 55,805
========= =========
See accompanying notes to consolidated financial statements.
F-3
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(In Thousands, except per share amounts)
Twelve Months Ended
January 31
------------------------------
2004 2003 2002
-------- -------- --------
NET SALES (Notes B and S)................................................... $ 25,462 $ 25,137 $ 40,827
COST OF SALES............................................................... 19,769 21,817 31,507
-------- -------- --------
GROSS PROFIT.......................................................... 5,693 3,320 9,320
-------- -------- --------
OPERATING EXPENSES
Selling and marketing.................................................... 8,406 12,021 16,165
Engineering, research and development.................................... 8,025 8,990 13,656
General and administrative............................................... 6,525 12,779 12,770
Deferred compensation.................................................... 51 433 812
Other operating expenses................................................. 320 426 3,071
-------- -------- --------
TOTAL OPERATING EXPENSES.............................................. 23,327 34,649 46,474
-------- -------- --------
LOSS FROM OPERATIONS........................................................ (17,634) (31,329) (37,154)
-------- -------- --------
OTHER INCOME (EXPENSES)
Investment income (loss) (Note B)........................................ (5,860) 275 (1,368)
Interest expense......................................................... (4,396) (9,619) (3,311)
Other income (expenses) (Note J)......................................... 17,631 214 (99)
Gain (loss) on sale of marketable securities (Note B).................... 4,026 14,249 (1,204)
-------- -------- --------
TOTAL OTHER INCOME (EXPENSES)......................................... 11,401 5,119 (5,982)
-------- -------- --------
NET LOSS.................................................................... $ (6,233) $(26,210) $(43,136)
======== ======== ========
LOSS PER COMMON SHARE (Note M)
BASIC
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING (IN THOUSANDS)............. 7,205 787 698
-------- -------- --------
NET LOSS PER COMMON SHARE:
BASIC NET LOSS PER COMMON SHARE............................................. (0.87) $ (33.29) $ (62.00)
======== ======== ========
DILUTED
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING (IN THOUSANDS)............. 7,205 787 698
-------- -------- --------
NET LOSS PER COMMON SHARE:
DILUTED NET LOSS PER COMMON SHARE........................................... (0.87) $ (33.29) $ (76.32)
======== ======== ========
COMPREHENSIVE LOSS AND ITS COMPONENTS CONSIST OF THE FOLLOWING:
Net loss.............................................................. $ (6,233) $(26,210) $(43,136)
Components of other comprehensive loss
Foreign currency translation 208 -- --
Unrealized holding gains (losses) arising during the period........ 1,173 (6,983) (21,993)
Reclassification adjustment for gains (losses)
included in net loss............................................ (4,026) (14,249) 1,204
-------- -------- --------
NET COMPREHENSIVE LOSS...................................................... $ (8,878) $(47,442) $(63,925)
======== ======== ========
See accompanying notes to consolidated financial statements.
F-4
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
For the Year Ended January 31, 2004
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
(In Thousands)
Common Stock Preferred Stock Additional Deferred
---------------- --------------- Paid-in Stock
Shares Amount Shares Amount Capital Compensation
------ ------- ------ ------ ---------- ------------
Balance at January 31, 2003 886 $ 5,318 2 $1 $144,887 $ (5)
Common stock par value revaluation (5,317) 5,317
Warrants issued in connection with
Restructuring 436
Common stock issuance
Common stock issued in connection
with capital restructuring 8,030 8 43,512
Common stock issued in connection
with debenture principal and
interest payment 377 -- 1,215
Common stock issued in connection
with LuxN acquisition 1,879 2 4,935
Common stock issued in connection
with legal settlement 54 -- 162
Common stock issued in connection
with Pipe 1 financing 2,140 2 5,836
Common stock issued in connection
with Pipe 2 financing 2,922 3 9,139
Unrealized (losses) on available for
sale securities
Warrants issued in connection with
the LuxN acquisition 878
Reclassification adjustment for (gains)
losses realized in net loss
foreign currency translation adjustments
Deferred stock compensation of subsidiary 46 (46)
Expenses paid with stock issuances 27 71
Amortization of deferred stock
compensation 51
Net loss
Balance at January 31, 2004 16,315 $ 16- 2 $1- $216,434
Accumulated
Treasury Stock Other Stockholders
Accumulated --------------- Comprehensive Equity/
Deficit Shares Amount Loss Deficit
----------- ------ ------ ------------- ------------
Balance at January 31, 2003 $(187,536) 1 $(69) $2,928 $(34,476)
Common stock par value revaluation --
Warrants issued in connection with
Restructuring 436
Common stock issuance
Common stock issued in connection
with capital restructuring 43,520
Common stock issued in connection
with debenture principal and
interest payment 1,215
Common stock issued in connection
with LuxN acquisition 4,937
Common stock issued in connection
with legal settlement 162
Common stock issued in connection
with Pipe 1 financing 5,838
Common stock issued in connection
with Pipe 2 financing 9,142
Unrealized (losses) on available for
sale securities (2,854) (2,854)
Warrants issued in connection with
the LuxN acquisition 878
Reclassification adjustment for (gains)
losses realized in net loss 99 99
foreign currency translation adjustments 208 208
Deferred stock compensation of subsidiary
Expenses paid with stock issuances 71
Amortization of deferred stock
compensation 51
Net loss (6,233) (6,233)
Balance at January 31, 2004 $(193,769) 1 $(69) $ 381 $ 22,994
--------
F-5
See accompanying notes to consolidated financial statements.
F-6
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
For the Year Ended January 31, 2003
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
(In Thousands)
COMMON PREFERRED
STOCK STOCK ADDITIONAL NOTES DEFERRED
--------------- --------------- PAID IN RECEIVABLE STOCK
Shares Amount Shares Amount CAPITAL OPTIONS COMPENSATION
------ ------ ------ ------ ---------- ---------- ------------
Balance at January 31, 2002 ....... 710 $4,263 2 $1 $143,705 $-- $(255)
Stock option and warrant exercises
(Notes I, J and M) ............. 1 9 (9)
Unrealized losses on available for
sale securities (Note B) .......
Deferred stock compensation of
subsidiary (Note B) ............ 183 (183)
Expenses paid with stock issuances
(Note I) ....................... 175 1,046 1,008
Amortization of deferred stock
compensation (Note B) .......... 433
Net loss ..........................
--- ------ --- --- -------- --- -----
BALANCE AT JANUARY 31, 2003 ....... 886 $5,318 2 $1 $144,887 $-- $ (5)
=== ====== === === ======== === =====
TREASURY Accumulated
STOCK OTHER TOTAL
ACCUMULATED --------------- COMPREHENSIVE STOCKHOLDERS'
DEFICIT Shares Amount LOSS EQUITY(DEFICIT)
----------- ------ ------ ------------- ---------------
Balance at January 31, 2002 ....... $(161,326) 1 $(69) $ 24,160 $ 10,479
Stock option and warrant exercises
(Notes I, J and M) ............. 0
Unrealized losses on available for
sale securities (Note B) ....... (21,232) (21,232)
Deferred stock compensation of
subsidiary (Note B) ............ 0
Expenses paid with stock issuances
(Note I) ....................... 2,054
Amortization of deferred stock
compensation (Note B) .......... 433
Net loss .......................... (26,210) (26,210)
--------- --- ---- -------- --------
BALANCE AT JANUARY 31, 2003 ....... $(187,536) 1 $(69) $ 2,928 $(34,476)
========= === ==== ======== ========
See accompanying notes to consolidated financial statements.
F-7
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
For the Year Ended January 31, 2002
(Restated)
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (DEFICIT)
(In Thousands)
COMMON PREFERRED
STOCK STOCK ADDITIONAL NOTES DEFERRED
--------------- --------------- PAID IN RECEIVABLE STOCK
Shares Amount Shares Amount CAPITAL OPTIONS COMPENSATION
------ ------ ------ ------ ---------- ---------- ------------
Balance at January 31, 2001 ....... 630 $3,782 2 $1 $114,994 $(5,034) $(880)
Debentures private placement
(Notes F) ...................... 24 20,676
Stock option and warrant exercises
(Notes I, J and M) ............. (20) 23 (1,321) 5,034
Unrealized losses on available for
sale securities (Note B) .......
Deferred stock compensation of
subsidiary (Note B) ............ 187 (187)
Expenses paid with stock issuances
(Note I) ....................... (18)
Amortization of deferred stock
compensation (Note B) .......... 812
Private placement subsidiary
(Note J) ....................... 76 458 9,187
Deemed dividend (Note I) ..........
Net loss ..........................
--- ------ --- --- -------- ------- -----
BALANCE AT JANUARY 31, 2002 ....... 710 $4,263 2 $1 $143,705 $ -- $(255)
=== ====== === === ======== ======= =====
TREASURY Accumulated
STOCK OTHER TOTAL
ACCUMULATED --------------- COMPREHENSIVE STOCKHOLDERS'
DEFICIT Shares Amount LOSS EQUITY(DEFICIT)
----------- ------ ------ ------------- ---------------
Balance at January 31, 2001 ....... $(118,010) 1 $(69) $ 44,949 $(39,773)
Debentures private placement
(Notes F) ...................... 20,676
Stock option and warrant exercises
(Notes I, J and M) ............. 3,736
Unrealized losses on available for
sale securities (Note B) ....... (20,789) (20,789)
Deferred stock compensation of
subsidiary (Note B) ............
Expenses paid with stock issuances
(Note I) ....................... (18)
Amortization of deferred stock
compensation (Note B) .......... 812
Private placement subsidiary
(Note J) ....................... 9,645
Deemed dividend (Note I) .......... (180) (180)
Net loss .......................... (43,136) (43,136)
--------- --- ---- -------- --------
BALANCE AT JANUARY 31, 2002 ....... $(161,326) 1 $(69) $ 24,160 $ 10,479
========= === ==== ======== ========
See accompanying notes to consolidated financial statements.
F-8
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
Year Ended January 31,
------------------------------
2004 2003 2002
-------- -------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss................................................................... $ (6,233) $(26,210) $(43,136)
-------- -------- --------
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization........................................ 3,673 4,063 2,794
Realized loss on investment in non-marketable securities............. 5,025 -- --
Accounts receivable and inventory reserves........................... (530) (1,020) 9,309
Expenses paid through issuances of securities........................ 233 2,054 1,309
(Gain) loss on sale of marketable securities......................... (4,026) (14,249) 1,204
Non-cash interest on debentures (Note F)............................. 2,726 6,894 994
Gain on capital restructuring........................................ (13,629) -- --
Deferred and other stock compensation (Note B)....................... 51 433 812
Other non-cash....................................................... (43) -- 794
Changes in assets and liabilities net of effects of business entity
divestitures:
(Increase) decrease in accounts receivable........................ 1,891 3,020 6,360
(Increase) decrease in inventories................................ 4,719 5,381 (8,247)
(Increase) decrease in other current assets....................... 186 511 (438)
(Increase) decrease in notes receivable........................... (325) -- --
Increase (decrease) in accounts payable........................... (2,689) (440) (2,729)
Increase (decrease) in deferred revenue........................... (3,111) 3,637 --
Increase (decrease) in accrued expenses........................... (3,304) 1,681 (751)
Increase (decrease) in other current liabilities.................. (189) 55 (63)
-------- -------- --------
NET CASH USED IN OPERATING ACTIVITIES................................... (15,575) (14,190) (31,788)
CASH FLOWS FROM INVESTING ACTIVITIES:
Acquisition of business, net of cash acquired.............................. 1,506 -- --
Purchase of property and equipment......................................... 1,604 (3,333) (3,235)
Proceeds from sale of marketable securities and other investments.......... 6,360 17,178 144
Purchase of non-marketable securities...................................... -- (5,025) --
Purchase of other assets................................................... 316 280 (895)
-------- -------- --------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES..................... 9,786 9,100 (3,986)
-------- -------- --------
See accompanying notes to consolidated financial statements
F-9
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS--(Continued)
(In Thousands)
Year Ended January 31,
---------------------------
2004 2003 2002
------- ------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from short-term debt, net of repayments .......................... -- (1,043) (172)
Proceeds from long-term debt (Note E)...................................... -- -- 26
Repayment of short-term debt............................................... (36) -- --
Repayment of long-term debt (Note E)....................................... (192) (363) (39)
Proceeds from debentures (Note F).......................................... -- -- 29,749
Proceeds from common stock (Note J)........................................ 15,887 -- 9,645
Proceeds from stock option and warrant exercises (Note K )................. -- -- 861
Other...................................................................... -- -- (18)
------- ------- -------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES..................... 15,659 (1,406) 40,052
------- ------- -------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS.............................. 9,870 (6,496) 4,278
CASH AND CASH EQUIVALENTS - BEGINNING OF PERIOD............................... 7,747 14,243 9,965
------- ------- -------
CASH AND CASH EQUIVALENTS - END OF PERIOD..................................... $17,617 $ 7,747 $14,243
======= ======= =======
See accompanying notes to consolidated financial statements.
F-10
Sorrento Networks Corporation (formerly Osicom Technologies, Inc.) (the
"Company," "We," "Our," or "Us") through its subsidiaries designs, manufactures
and markets integrated networking and bandwidth aggregation products for
enhancing the performance of data and telecommunications networks. Our products
are deployed in telephone companies, Internet Service Providers, governmental
bodies and the corporate/campus networks that make up the "enterprise" segment
of the networking marketplace. We have facilities in San Diego, California and
Sunnyvale, California. In addition, we have various sales offices located in the
United States and Europe. We market and sell our products and services through a
broad array of channels including worldwide distributors, value added resellers,
local and long distance carriers and governmental agencies.
A. THE COMPANY AND BASIS OF PRESENTATION
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates that affect the reported amounts of assets,
liabilities, revenues and expenses, the disclosure of contingent assets and
liabilities. Actual results could materially differ from these estimates.
We have incurred significant losses and negative cash flows from operations
for the past several years. Sorrento Networks, Inc. ("SNI"), the Company's
principal operating subsidiary has primarily been the operating entity
responsible for these high losses and negative cash flows. The losses have been
generated as SNI continues to develop its technology, marketing and sales and
operations in its effort to become a major supplier of metro and regional
optical networks worldwide
B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation--The balance sheets and the consolidated
statement of operations for the years ended January 31, 2004, 2003 and the
consolidated statement of operations for the year ended January 31, 2002 reflect
our accounts and all subsidiaries controlled by us after the elimination of
significant intercompany transactions and balances. On August 8, 2003, we
complete the acquisition of LuxN, Inc. the results of which are reflected in
consolidation from that date forward. The consolidated group is referred to
individually and collectively as the "Company," "We," "Our," or "Us."
Use of Estimates--The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates that affect the reported amounts of
assets, liabilities, revenues and expenses, the disclosure of contingent assets
and liabilities. Actual results could materially differ from these estimates. In
the opinion of Management, all adjustments (which include normal recurring
adjustments and charges described in the notes to the financial statements)
necessary to present fairly the financial position, results of operations and
cash flows for the years ended January 31, 2004, 2003 and 2002 have been made.
Cash and Cash Equivalents--All cash on hand and in banks, certificates of
deposit and other liquid investments with original maturities of three months or
less, when purchased are considered to be cash equivalents. All such investments
are recorded at market value using the specific identification method;
unrealized gains and losses are reflected in other comprehensive income.
Accounts Receivable--In the normal course of business, we extend unsecured
credit to our customers related to the sales of various products. Typically
credit terms require payment within thirty days from the date of shipment or
upon customer acceptance for installation sales.
Allowance for Doubtful Accounts--We provide an allowance for doubtful
accounts based on our continuing evaluation of our customers' credit risk and on
specifically identified amounts that we believe to be un-collectable. We also
record additional allowance based on certain percentages of our aged
receivables, which are determined based on historical experience and our
assessment of the general financial conditions affecting our customer base. If
our actual collections experience changes, revisions to our allowance may be
required. We have a limited number of customers with individually large amounts
due at any given balance sheet date. Any unanticipated change in one of those
customer's credit worthiness or other matters affecting the collectability of
amounts due from such
F-11
customers, could have a material affect on our results of operations in the
period in which such changes or events occur. After all attempts to collect a
receivable have failed, the receivable is written off against the allowance.
Sources of Supply--The Company currently purchases important components of
its products, from a limited selection of suppliers. Although there are a
limited number of manufacturers of these components, management believes that
the other suppliers could provide similar components on comparable terms. A
change in suppliers, however, could cause a delay in manufacturing and a
possible loss of sales, which could affect operating results adversely.
Inventory--Inventory, comprised of raw materials, work in process, finished
goods and spare parts, is stated at the lower of cost (weighted average method)
or market. We periodically evaluate our on-hand stock and make appropriate
disposition of any stock deemed excess or obsolete. Inventories at January 31,
2004 and 2003 consist of:
2004 2003
-------- -------
Raw material.............................................. $ 20,744 $10,767
Work in process........................................... 3,133 2,804
Finished goods............................................ 5,416 6,326
-------- -------
29,293 19,897
Less: Valuation reserve................................... (15,400) (5,963)
-------- -------
$ 13,893 $13,934
======== =======
Marketable Securities--Marketable securities at January 31, 2004 consist of
investments in Entrada Networks, Inc ("ENI"). Our investment in ENI is
classified as available for sale and is carried at fair value, based upon quoted
market prices, with net unrealized gains reported as a separate component of
stockholders' equity until realized. Unrealized losses are recorded against
other comprehensive income when a decline in fair value is determined to be
other than temporary. At January 31, 2004, and 2003 marketable securities were
as follows:
Cost Unrealized Gains Market Value
------ ---------------- ------------
January 31, 2004:
Entrada $ 31 $ 56 $ 87
Certificate of Deposit 416 1 417
------ ------ ------
$ 447 $ 57 $ 504
====== ====== ======
January 31, 2003:
DIGI $1,009 $2,884 $3,893
Entrada 22 44 66
------ ------ ------
$1,031 $2,928 $3,959
====== ====== ======
On August 31, 2000, we completed a merger of our then subsidiary Entrada
Networks with Sync Research, Inc. ("Sync"), a NASDAQ listed company in which we
received 4,244,155 shares of the merged entity, which changed its name to
Entrada Networks, Inc. ("ENI"). We purchased 93,900 shares of Sync in the open
market during June and July 2000 for $388 and on August 31, 2000 purchased an
additional 1,001,818 shares directly from ENI for $3.3 million. After these
transactions and ENI's issuance of additional shares to outside investors in
connection with the merger we owned 49% of ENI. Accordingly, our financial
statements reflected the results of operations of ENI through August 31, 2000.
On December 9, 2002, we sold one-half of our holdings in DIGI for $3.10 per
share. The purchaser of the stock was DIGI, itself. The proceeds from this sale,
in the amount of $3.6 million, were deposited on December 13, 2002. The
remaining 1,162,341 DIGI shares were sold on May 2, 2003 for $4.26 per share.
The purchase, of the stock was again DIGI. The proceeds from this sale in the
amount of approximately $5 million, were deposited on May 7, 2003.
In accordance with a settlement agreement reached between Sorrento Networks
and our former Chairman and Founder, Par Chadha, 566,000 shares of ENI stock
were transferred to Mr. Chadha in exchange for mutual releases
F-12
by the Company and Mr. Chadha and certain of his affiliates. The stock transfer
was complete on July 1, 2003 and had a value of $88 thousand. In addition, we
transferred 128,214 shares of ENI stock to settle a dispute between a former
employee and the Company. The value of the transfer was $20 thousand and was
complete on July 16, 2003.
The remaining 458,286 ENI shares owned by us are accounted for as an
"available for sale security". Under this accounting, these shares are
marked-to-market at the end of each reporting period. The difference between our
basis and the fair maker value, as reported on NASDAQ, is a separate element of
stockholders' equity and is included in the computation of comprehensive income.
Fair Value of Financial Instruments--The fair value of financial
instruments is determined by reference to various market data and other
valuation techniques as appropriate. We believe that there are no material
differences between the recorded book values of our financial instruments and
their estimated fair value.
Property and Equipment--Property and equipment are recorded at historical
cost. Depreciation and amortization are provided over the estimated useful lives
of the individual assets or the terms of the leases if shorter using accelerated
and straight-line methods. Property and equipment are reviewed for impairment
whenever events or circumstances indicate that the asset's undiscounted expected
cash flows are not sufficient to recover its carrying amount. We measure
impairment loss by comparing the fair market value, calculated as the present
value of expected future cash flows, to its net book value. Impairment losses,
if any, are recorded currently.
Capitalized Leases--Capitalized leases are initially recorded at the
present value of the minimum payments at the inception of the contracts, with an
equivalent liability categorized as appropriate under current or non-current
liabilities. Such assets are depreciated on the same basis as described above.
Interest expense, which represents the difference between the minimum payments
and the present value of the minimum payments at the inception of the lease, is
allocated to accounting periods using a constant rate of interest over the
lease.
Purchased Technology--Technology assets were acquired in connection with
historical acquisition.These assets were analyzed during and after the close of
the acquisition. The undiscounted projected future cash flows from the purchased
technology are compared to its carrying value to indicate any impairment. No
impairment has been identified. The carrying value is $110 thousand and is
amortized over its remaining estimated economic life (7 years) using the
straight-line method. Accumulated amortization was $2.7 million and $2.4 million
at January 31, 2004 and 2003, respectively.
We assess the recoverability of purchased technology primarily by
determining whether the amortization of the net book value of purchased
technology over its remaining life can be recovered through undiscounted future
operating cash flows of the acquired operation. The amount of the impairment, if
any, of the net book value of the excess cost over net assets acquired is
measured by determining the fair value of these assets primarily based on
projected discounted future operating cash flows from the purchased technologies
using a discount rate commensurate with our cost of capital.
Research and Development--We expense research and development costs as
incurred in accordance with Statement of Financial Accounting Standards ("SFAS")
No. 2, "Accounting for Research and Development Costs." Research and development
costs are costs associated with products or processes for which technological
feasibility has not been proven and future benefits are uncertain. In-process
research and development purchased by us includes the value of products and
processes in the development stage and have not reached technological
feasibility; this amount is expensed at the date of purchase.
Other investments--Other investments in fiscal 2004, included in other
assets, include non-marketable securities held in other companies including a
privately held competitive local exchange carrier, and a broadband services
carrier, UFO Communications, Inc. ("UFO"). The investment in UFO, $5.03 million,
was written down to zero value in fiscal 2004, when a secondary round of
financing was concluded in which we chose not to participate.
Revenue Recognition--We generally recognize product revenue when the
products are shipped, all substantial contractual obligations, if any, have been
satisfied, and the collection of the resulting receivable is reasonably assured.
When title does not pass to the customer at time of shipment, revenue is not
recognized until all contractual requirements are met and title has transferred.
During this transition period, the amount of the sale and/or installation is
shown in deferred revenue.
To date, installation revenue has not been material. Revenue from service
obligations, if any, is deferred and recognized over the life of the contract.
Inventory or demonstration equipment shipped to potential customers for
F-13
field trials is not recorded as revenue. We accrue for warranty costs, sales
returns and other allowances at the time of shipment. Although our products
contain a software component, the software is not sold separately and we are not
contractually obligated to provide software upgrades to our customers.
Warranty and Customer Support--We typically warrant our products against
defects in materials and workmanship for a period of one to five years from the
date of sale and a provision for estimated future warranty and customer support
costs is recorded when revenue is recognized. To date, warranty and customer
support costs have not been material.
Income Taxes--Income taxes are accounted for in accordance with Statement
of Financial Accounting Standards No. 109 "Accounting for Income Taxes." The
statement employs an asset and liability approach for financial accounting and
reporting of deferred income taxes generally allowing for recognition of
deferred tax assets in the current period for future benefit of net operating
loss and research credit carry forwards as well as items for which expenses have
been recognized for financial statement purposes but will be deductible in
future periods. A valuation allowance is recognized, if on the weight of
available evidence it is more likely than not that some portion or all of the
deferred tax assets will not be realized. (See Note L)
Advertising--We expense advertising expenditures as incurred.
Loss Per Common Share--We compute earnings per share based on the provision
of SFAS No. 128, "Earnings Per Share." Basic income and loss per common share is
computed by dividing net income or loss available to common shareholders by the
weighted average number of common shares outstanding during each period
presented. Diluted EPS is based on the weighted average number of common shares
outstanding as well as dilutive potential common shares, which in our case
consist of convertible securities outstanding, shares issuable under stock
benefit plans, and shares issuable pursuant to warrants. In computing diluted
EPS, net income or loss available to common shareholders is adjusted for the
after-tax amount of interest expense recognized in the period associated with
convertible debt. Potential common shares are not included in the diluted loss
per share computation for the years ended January 31, 2004, 2003 and 2002 as
they would be anti-dilutive. All references in the financial statements of
common shares and per share data give effect to the 1-for-20 stock split
effective October 28, 2002. (See Note M)
Foreign Currency Translation--Our foreign operations have been translated
into U.S. dollars in accordance with the principles prescribed in SFAS No. 52,
"Foreign Currency Translation." For the periods presented the current rate
method was used whereby all assets and liabilities are translated at period end
exchange rates, and the resultant translation adjustments would have been
included as a separate component of stockholders' equity had such adjustments
been material. Revenues and expenses are translated at the average rates of
exchange prevailing throughout the period, and the resultant gains and losses
are included in net earnings.
Stock-Based Compensation--We account for employee-based stock compensation
utilizing the intrinsic value method prescribed in Accounting Principles Board
Opinion No. 25, "Accounting for Stock Issued to Employees." Accordingly,
compensation cost for stock options issued to employees is measured as the
excess, if any, of the fair market price of our common stock at the date of
grant over the amount an employee must pay to acquire the stock. The amount of
deferred stock compensation appears as a separate component of stockholders'
equity and is being amortized on an accelerated basis by charges to operations
over the vesting period of the options in accordance with the method described
in Financial Accounting Standards Board Interpretation No. 28. All such amounts
relate to options to acquire common stock of our Sorrento subsidiary granted by
it to its employees; during the fiscal years ended January 31, 2004, 2003 and
2002, we amortized $51 thousand, $250 thousand and $625 thousand of the total
$2.6 million initially recorded for deferred stock compensation.
For non-employees, we compute the fair value of stock-based compensation in
accordance with Statement of Financial Accounting Standards (SFAS) No. 123,
"Accounting for stock-Based Compensation," and Emerging Issues Task Force (EITF)
96-18, "Accounting for Equity Instruments that are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services." All
such amounts relate to options to acquire common stock of our Sorrento Networks
subsidiary granted by it to its consultants; during the fiscal years ended
January 31, 2004, 2003 and 2002, we recorded $46 thousand, $183 thousand and
$187 thousand for options granted to consultants.
Computer Software for Internal Use--Statement of Position ("SOP") 98-1,
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use," is effective for financial statements with fiscal years
F-14
beginning after December 15, 1998. The SOP provides guidance on accounting for
the costs of computer software developed or obtained for internal use. The SOP
requires that we continue to capitalize certain costs of software developed for
internal use once certain criteria are met. The adoption of SOP 98-1 had no
effect on our financial position or results of operations.
In January 2003, the FASB issued FASB Interpretation ("FIN") No. 46,
"Consolidation of Variable Interest Entities", and interpretation of Accounting
Research Bulletin No. 51, "Consolidated Financial Statements", FIN No. 46
explains how to identify variable interest entities and how an enterprise
assesses its interests in a variable interest entity to decide whether to
consolidate that entity. This Interpretation requires existing unconsolidated
variable interest entities to be consolidated by their primary beneficiaries if
the entities do not effectively disperse risks among parties involved. FIN No.
46 is effective immediately for variable interest entities created after January
31, 2003, and to variable interest entities in which an enterprise obtains an
interest after that date. The Interpretation applies in the first fiscal year or
interim period beginning after June 15, 2003, to variable interest entities in
which an enterprise holds a variable interest that is acquired before February
1, 2003. We adopted FIN No. 46 with no material effect on our financial position
or results of operations.
In November 2002, the FASB issued FIN 45, which expands previously issued
accounting guidance and disclosure requirements for certain guarantees. FIN 45
requires us to recognize an initial liability for the fair value of an
obligation assumed by issuing a guarantee. The provision for initial recognition
and measurement of the liability will be applied on a prospective basis to
guarantees issued or modified after December 31, 2002. The adoption of FIN 45
did not materially affect our consolidated financial statements.
In August 2001, the Financial Accounting Standards Board issued SFAS No.
143, Accounting for Asset Retirement Obligations. This Statement is effective
for fiscal years beginning after June 15, 2002. SFAS 143 provides accounting
requirements for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. Under the
Statement, the asset retirement obligation is recorded at fair value in the
period in which it is incurred by increasing the carrying amount of the related
long-lived asset. The liability is accreted to its present value in each
subsequent period and the capitalized cost is depreciated over the useful life
of the related asset. The adoption of SFAS 143 did not have a material effect on
our financial position or results of operations.
In November 2002, the Emerging Issues Task Force ("EITF") reached a
consensus on Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables."
EITF Issue No. 00-21 provides guidance on how to account for arrangements that
involve the delivery or performance of multiple products, services and/or rights
to use assets. The provisions of EITF Issue No. 00-21 applied to revenue
arrangements entered into in fiscal periods beginning after June 15, 2003.
In December 2003, the SEC issued SAB 104, which supersedes SAB 101, Revenue
Recognition in Financial Statements. The primary purpose of SAB 104 is to
rescind the accounting guidance contained in SAB 101 related to multiple element
revenue arrangements, which was superseded as a result of the issuance of EITF
00-21. We adopted EITF 00-21 and SAB 104 with no material impact on our
financial statements.
C. PROPERTY AND EQUIPMENT
Property and equipment of the Company consisted of the following components
as of January 31, 2004 and 2003:
2004 2003
-------- --------
Manufacturing, engineering and plant equipment and software... $ 17,397 $ 19,822
Office furniture and fixtures................................. 3,192 3,154
Land and building............................................. 6,721 6,721
Leasehold and building improvements........................... 1,294 1,294
-------- --------
Total property and equipment............................... 28,604 30,991
Less: Accumulated depreciation and amortization............... (16,337) (13,888)
-------- --------
Net book value............................................. $ 12,267 $ 17,103
======== ========
F-15
Depreciation expense for fiscal 2004, 2003 and 2002 was $ 3.3 million, $3.6
million, and $2.4 million respectively.
D. SHORT TERM DEBT
The Company has no short-term debt other than the current portion of
long-term debt.
E. LONG-TERM DEBT AND CAPITAL LEASE OBLIGATIONS
Long-term debt and capital lease obligations at January 31, 2004 and 2003
consisted of the following:
2004 2003
------ ------
Variable rate 30 year mortgage note payable (5.5% over LIBOR rate); interest
rate at January 31, 2004 and 2003 was 6.71% and 8.95% respectively......... $1,253 $1,269
Fixed rate 30 year mortgage note payable; interest rate at January 31, 2004
was 7.6%................................................................... 2,332 2,361
Obligations under capital leases (See Note G)................................. 54 237
------ ------
3,639 3,866
Less: Current portion......................................................... 101 222
------ ------
$3,538 $3,644
====== ======
On March 25, 1996, Meret completed the purchase of a 35,000 square foot
facility in San Diego, California for $1,779 in cash. On April 24, 1996, Meret
entered into a mortgage agreement with a lender in the amount of $1,331
amortized over 30 years with an adjustable interest rate of 5.5% over the LIBOR
rate, adjusted bi-annually. Monthly principal and interest payments are $11
thousand. The interest rate at January 31, 2004 was 6.71%.
In October 2000, we completed our purchase of a 41,000 square foot facility
immediately adjacent to our existing San Diego, California facility. The
purchase price was $4,805 including the assumption of existing indebtedness of
$2,417. Monthly principal and interest payments are $18 and at the end of the
30-year term on January 1, 2010 the remaining balance of $2,109 is due. The loan
has a fixed interest rate of 7.6%.
Long- term and capital lease obligations at January 31, 2004 are payable by
year as follows:
2005................................................................... $ 101
2006................................................................... 54
2007................................................................... 58
2008................................................................... 63
2009................................................................... 68
2010 and later......................................................... 3,295
------
$3,639
======
F. DEBENTURES
Debentures - During August 2001, we completed a private placement of our
9.75% convertible debentures receiving net proceeds of $29.8 million. The
debentures, due August 2, 2004 had a face value of $32.2 million, which was
convertible into our common stock at $144.20 per share. At maturity, we could
have elected to redeem the debentures for cash and we had the option of paying
the interest on these debentures in shares of our common stock. In addition, the
purchasers received four year warrants to acquire an additional 167,592 shares
of our common stock at $144.20 per share and the placement agent received five
year warrants to acquire 5,583 shares of our common stock, equity securities,
options or warrants at a price less than $144.20 per share or at a discount to
the then market price. The conversion price and warrant exercise were subject to
adjustment.
In accordance with Emerging Issues Task Force ("EITF") No. 00-27 we
accounted for the fair value of warrants issued to the purchasers and placement
agent and the fair value of the deemed beneficial conversion feature, which
resulted solely as a result of the required accounting, of the debenture as a
reduction to the face value of the
F-16
debentures with an offsetting increase to additional paid in capital. These
amounts, as well as the issuance costs paid in cash, were amortized as
additional interest expense over the period the debentures were outstanding.
On March 6, 2003, we and our wholly-owned subsidiary Sorrento Networks,
Inc. entered into an Exchange Agreement with the holders of our 9.75% Senior
Convertible Debentures (the "9.75% Debentures") and the Series A Convertible
Preferred Stock (the "Preferred Stock") of Sorrento Networks, Inc. The Exchange
Agreement and associated documents contemplated an exchange (the "Exchange") of
the 9.75% Debentures and the Preferred Stock at closing into shares of common
stock and $12.5 million of our new 7.5% Secured Convertible Debentures (the
"7.5% Debentures"). Certain holders of the Preferred Stock would also receive
additional 7.5% Debentures of approximately $600 thousand to pay certain legal
fees. With the elimination of liability from the preferred stock conversion and
the reduction in total debt relating to the debentures, offset by the value of
the common stock issuance associated with the transaction there was a net gain
on the restructuring of $13.7 million.
The Exchange Agreement was approved by shareholders on May 29, 2003 and was
completed and became effective on June 4, 2003 pursuant to which we exchanged
current outstanding debentures and Series A Preferred Stock for common stock and
an issuance of a $13.1 million principal amount of 7.5% Debentures.
Interest expense for fiscal year 2004 on the 9.75% debentures, through the
June 4, 2003 exchange date, of $3.5 million included the stated 9.75% interest
rate of $1.1 million, amortization of issuance costs of $275 thousand and
amortization of the fair value of the warrants issued to the purchasers and
placement agent and deemed beneficial conversion feature of $2.2 million.
Interest expense on the 7.5% debentures during fiscal year 2004 was $561
thousand.
The 7.5% debentures are convertible at any time at the option of the
holders into shares of common stock at a conversion price of $5.42, the fair
value on the date of the exchange. The debentures mature on August 2, 2007 and
are secured by substantially all of our assets and those of our subsidiaries
(with certain exceptions).
At January 31, 2004 and January 31, 2003 debentures payable for the 7.5%
debentures consisted of:
(thousands)
-------------------------
January 31, January 31,
2004 2003
----------- -----------
Face value of 7.5% convertible debentures..... $11,788 $--
Face value of new debentures for legal fees... 600 --
------- ---
Book value of debentures at issuance.......... $12,388 $--
======= ===
G. LEASES, OTHER COMMITMENTS AND CONTINGENCIES
Rental expense under operating leases was $763 thousand, $1.6 million, and
$1.3 million for the years ended January 31, 2004, 2003 and 2002, respectively.
The table below sets forth minimum payments under capital and operating leases
with remaining terms in excess of one year at January 31, 2004:
Capital Operating
Leases Leases
------- ---------
2005.................................................. $55 $551
2006.................................................. -- 152
2007.................................................. -- 46
2008.................................................. -- 41
2009.................................................. -- 34
2010 and thereafter................................... -- --
--- ----
55 $824
====
Less: Amount representing interest.................... (1)
---
Present value of minimum annual rentals............... $54
===
F-17
The net book value of equipment under capital leases was $495 thousand and
$657 thousand at January 31, 2004 and 2003, respectively.
Other Commitments
In March 2001, our Meret subsidiary entered into a $2.7 million supplier
agreement. The agreement requires a minimum monthly cash outlay of $50 thousand
extending over a period of fifty-four months. The remaining balance at January
31, 2004 of $853 thousand is expected to end in March 2005. The product being
acquired is a component used in a product for one of Meret's customers for which
there is a five-year sales contract.
Employment contract payments due under change of control provisions under
certain employment contracts that may be triggered by the sale of the Company in
2005 is expected to be valued at $783 thousand.
Contingent Liabilities
In the merger agreement among our predecessor corporation (Osicom
Technologies, Inc.), Entrada, and Sync Research, Inc., Osicom agreed to
indemnify and hold our former subsidiary harmless against liability arising from
the termination of a certain pension plan if the subsidiary's losses exceeded
$250 thousand, but only for such losses that exceeded $250 thousand. The pension
plan was acquired as a result of the purchase of a division of Cray
Communications in 1996 which later became Entrada.
Upon the acquisition of this former subsidiary, the seller had the right to
terminate the plan for five years following the acquisition and was responsible
for funding the plan. If the pension plan was not terminated in the five years
following the acquisition, the agreement called for the parties to agree as to a
mutually satisfactory arrangement for the termination or continuation of the
plan. In the third quarter, we were advised by the successor corporation that
the termination cost of the pension plan could total approximately $2.9 million
if the plan was terminated. Continued funding of the pension plan also remains
an unresolved issue and if funding is not kept current with regard to legal
requirements the pension plan could default. We currently hold in escrow
approximately $500 thousand in Series D Preferred Stock as a security against
possible losses resulting from this pension plan. As of this date, the parties
have not agreed to a resolution regarding the pension plan in future periods.
While we do not believe that we are liable for the continued costs
associated with future funding or a cost associated upon termination, it is
possible the pension plan could result in litigation among the parties if they
cannot agree to an acceptable resolution. The Company has reserved approximately
$1 million for possible contingencies which we believe is adequate to cover
potential claims regarding the plan.
LITIGATION
On June 4, 2003, we consummated the exchange transaction and cancelled all
outstanding Series A Convertible Preferred Stock and 9.75% Senior Convertible
Debentures. The Exchange Agreement provides that the litigation instituted by
the former holders of Series A stock be dismissed without prejudice against the
Company, its subsidiaries, its current officers and directors, and other
defendants who execute an appropriate release, and without prejudice against all
other defendants. This dismissal will require court approval, which is in the
process of being obtained by counsel for all parties.
In accordance with a settlement agreement reached between us and our former
Chairman and Founder, Par Chadha, 566,000 shares of ENI stock were transferred
to Mr. Chadha in exchange for mutual releases by the Company and Mr. Chadha and
certain of his affiliates. The stock transfer was complete on July 1, 2003 and
had a value of $88 thousand.
In addition, claims in arbitration were filed by two of our former
financial officers and employees who worked in our Santa Monica office, which
has since been closed, alleging that their resignations in May 2002 were for
"good reason" as defined in their employment agreements, all of which were to
expire on May 22, 2002. One of the claims was settled in May 2003 for $45
thousand. While the other claim was resolved by an arbitrator in August 2003 who
ruled in our favor.
A former officer of our SNI subsidiary brought suit alleging breach of a
consulting agreement we entered into with him in March 2002, following his
resignation "for good reason" as defined in his employment agreement. He
F-18
was seeking acceleration of consulting fees due to him under his consulting
agreement in the amount of $229 thousand. This suit was settled on December 1,
2003 for $15 thousand and $150 thousand of Sorrento common stock that was
distributed to him June 4, 2003.
From time to time, we are involved in various other legal proceedings and
claims incidental to the conduct of our business. Although it is impossible to
predict the outcome of any outstanding legal proceedings, we believe that such
legal proceeding and claims, individually and in the aggregate, are not likely
to have a material adverse effect on our financial position, results of
operations, or cash flows.
I. STOCKHOLDERS' EQUITY
Effective as of October 28, 2002, we implemented a one-for-twenty reverse
split of our outstanding shares of common stock. No fractional shares were
issued in connection with the reverse stock split. In lieu of fractional shares,
stockholders will receive a cash payment based on the market price, after
adjustment for the effect of the stock combination. The par value of the common
stock changed to $6.00 per share and the number of authorized shares decreased
from 150 million to 7.5 million shares of common stock. The reverse stock split
also affects options, warrants and other securities convertible into or
exchangeable for shares of the Company's common stock that were issued and
outstanding immediately prior to the effective time of the stock combination.
Preferred stock was not affected.
We are authorized to issue the following shares of stock:
150,000,000 shares of Common Stock ($0.001 par value)
2,000,000 shares of Preferred Stock ($.01 par value) of which the
following series have been designated:
3,000 shares of Preferred Stock, Series D
1,000,000 shares of Preferred Stock, Series F
We have outstanding the following shares of preferred stock:
Shares Par Liquidation
Outstanding Value Preference
----------- ----- -----------
Series D.............................. 1,353 $0.01 $1,353
----- ----- ------
1,353 $0.01 $1,353
===== ===== ======
During January 2001, we issued 86,464 shares of our common stock in
conversion of 1,500 shares of our Series D preferred stock. The remaining 1,353
shares of our non-voting, non-dividend bearing Series D preferred stock are
being held in escrow pending resolution of acquisition contingencies including
liabilities related to funding deficits related to a terminated defined benefit
pension plan of Entrada. Payments by the seller towards these liabilities will
have no effect on our financial results and payments, if any, by us will reduce
the face value of the preferred stock. Each share of Series D preferred stock is
convertible into common stock at the market value at the date of conversion and
we have the right to redeem the shares prior to conversion for 100% of their
conversion value.
J. OTHER CAPITAL STOCK TRANSACTIONS AND BUSINESS ACQUISITIONS
Stock Split--In October 2002, approval was granted for a one-for-twenty
reverse stock split effective October 28, 2002. The effect of this stock split
was reflected in the financial statements retroactively as if the stock split
occurred at the beginning of the earliest period reported.
On June 4, 2003, we consummated the Exchange Agreement and cancelled all
outstanding Series A Convertible Preferred Stock. In connection to our capital
and corporate restructuring plan, we issued 8,029,578 shares of common stock to
the holders of the 9.75% debentures and the Series A Convertible Preferred Stock
upon consummation of the Exchange. The Company's $32.2 million in convertible
debentures were converted into
F-19
common shares of the Company and a portion of $12.5 million in secured
convertible 7.5% debentures that mature in August 2007. In addition, all Series
A Convertible Preferred Stock were converted into common shares of the Company
and a portion of the $12.5 million in secured convertible debentures. The
outstanding Series A Convertible Preferred Stock "put" of $48.8 million against
SNI was withdrawn. Certain Series A Convertible Preferred stockholders also
received a total of $600 thousand in additional secured convertible 7.5%
debentures to pay certain legal fees.
There was an aggregate gain, net of tax, on the capital restructuring
transaction of $13.6 million. The conversion of the SNI Series A Convertible
Preferred Stock into common stock and a portion of the $12.5 million 7.50%
convertible debenture resulted in a net gain of $48.8 million. The gain was
off-set by the loss on the value of the warrants and beneficial conversion
feature on the $32.2 million, 9.75% convertible debentures, converted to common
stock and a portion of the 7.50% convertible debenture. The consolidated net
gain on the capital restructuring transaction was $13.8 million for the quarter
ending July 31, 2003.
On August 8, 2003, we acquired LuxN Inc. for a combination of stock,
warrants, and cash. Stockholders of LuxN were given the option of exchanging
shares of LuxN stock for either their pro-rata portion of LuxN's net cash or
shares of Sorrento's common stock. In addition to the cash or Sorrento common
stock, stockholders of LuxN have the right to receive warrants to purchase an
aggregate of 400 thousand shares of Sorrento common stock, with an exercise
price of $3.05 per share, the fair market value on the date of the acquisition.
The warrants will be held in escrow for a period of six months to satisfy any
successful indemnification claims. At closing, Sorrento issued 1,374,194 million
shares of common stock with an additional 505,146 shares of common stock issued
after shareholder approval was received in January 2004.
Private Placements-- The first of two private placements' the Company
completed in fiscal 2004, closed on December 31, 2003. In exchange for $6.35
million in gross proceeds, Sorrento issued 2,140,101 new shares of Sorrento
common stock, and warrants to purchase 1,070,051 new shares of Sorrento's common
stock. The effective price in the private placement was $2.97 for each unit
consisting of one share of common stock and a warrant to purchase one-half of a
share of common stock. The warrants have an exercise period of five-years with
an exercise price of $2.97 per share.
On January 26, 2004, the second private placement was completed raising $10
million in gross proceeds. In connection with the financing, Sorrento issued
2,921,512 new shares of Sorrento common stock and warrants to purchase 1,460,756
new shares of Sorrento's common stock. The effective price in the private
placement was $3.44 for each unit. Each unit consists of one share of common
stock and a warrant to purchase one-half of a share of common stock. The
warrants have an exercise period of five-years and an exercise price of $3.44
per share. The warrants are callable after one year under certain circumstances.
The warrants provide for a cashless exercise under certain circumstances.
Business Acquisitions-- The Company acquired LuxN Inc. on August 8, 2003.
The results of LuxN's operations have been included in the consolidated
financial statements since that date LuxN's product line supplies optical access
equipment to the network edge using coarse and dense wavelength division
multiplexing (CWDM and DWDM) technology. LuxN's OSMINE-certified products enable
delivery of high-bandwidth data, storage, video and voice services for service
providers, cable MSOs and enterprises. See the acquisition footenote R.
K. STOCK OPTION PLANS
We have five stock option plans in effect: The 2003 Equity Incentive Plan,
the 2000 Stock Incentive Plan, the 1988 Stock Option Plan, the 1997 Incentive
and Non-Qualified Stock Option Plan and the 1997 Director Stock Option Plan. The
stock options have been made available to certain employees and consultants. All
options are granted at not less than fair value at the date of grant and have
terms varying from 3 to 10 years. The purpose of these plans is to attract,
retain, motivate and reward our officers, directors, employees and consultants
to maximize their contribution towards our success. We account for these plans
under the recognition and measurement principles of APB Opinion No. 25,
Accounting for Stock Issued to Employees, and related Interpretations. No
stock-based employee compensation cost is reflected in net income, as all
options granted under these plans had an exercise price equal to the market
value of the underlying common stock on the date of grant.
The following table summarizes the activity in the plans:
F-20
Sorrento Networks Corporation (FIBR)
Number of Weighted Average
Shares Exercise Price
---------- ----------------
Shares under option at January 31, 2001......... 253,361 $618.60
Granted...................................... 43,685 $150.40
Exercised.................................... (4,913) $163.40
Canceled..................................... (61,606) $519.60
--------- -------
Shares under option at January 31, 2002......... 230,527 $566.00
Granted...................................... 112,555 $ 25.31
Canceled..................................... (48,805) $406.62
--------- -------
Shares under option at January 31, 2003......... 294,277 $387.53
Granted..................................... 1,953,734 $ 2.93
Canceled.................................... (133,242) $581.73
---------
Shares under option at January 31, 2004......... 2,114,769 $ 19.77
=========
Additional information relating to stock options outstanding and
exercisable at January 31, 2004 summarized by exercise price are as follows:
Outstanding Exercisable
----------------------------- --------------------------
Weighted Average
-----------------------------
Exercise Price Weighted Average
Per Share Shares Life (Years) Exercise Price Shares Exercise Price
--------------------------- --------- ------------ -------------- ------- ----------------
$ 2.88-- $ 19.99........ 1,998,542 9.44 3.21 870,917 3.47
$ 20.00-- $ 49.99........ 10,671 8.33 31.58 10,666 31.57
$ 50.00-- $ 99.99........ 36,868 8.10 56.57 35,067 56.85
$100.00-- $ 199.99........ 15,998 5.60 140.23 15,563 140.78
$200.00-- $ 299.99........ 4,837 3.62 255.93 4,837 255.93
$300.00-- $ 399.99........ 3,078 645 350.79 3,078 350.79
$400.00-- $ 499.99........ 13,755 6.29 448.53 13,755 448.53
$500.00-- $ 599.99........ 417 2.84 569.20 417 569.20
$600.00-- $ 699.99........ -- -- -- -- --
$700.00-- $ 799.99........ 30,503 6.29 718.37 30,503 718.37
$800.00-- $ 899.99........ -- -- -- -- --
$900.00-- $1,382.40........ 100 6.00 985.00 100 985.00
--------- -------
$ 2.88-- $1,382.40........ 2,114,769 9.30 19.77 984,903 38.86
========= =======
At January 31, 2004, the Company has five stock-based employee compensation
plans.
In order to provide more prominent and frequent disclosures about the
effects of stock-based compensation as required under SFAS 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure", the following table
summarizes the pro forma effect of stock-based compensation on net income and
earnings (loss) per share as if the optional expense recognition provisions of
SFAS 123 had been adopted.
We account for these plans under the recognition and measurement principles
of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related
Interpretations. No stock-based employee compensation cost is reflected in net
loss, as all options granted under these plans had an exercise price equal to
the market value of the underlying common stock on the date of grant. The
following table illustrates the effect on net loss and loss per share if the
company had applied the fair value recognition provisions of FASB Statement No.
123, Accounting for Stock-Based Compensation, to stock-based employee
compensation.
F-21
Years Ended January 31,
-----------------------------
2004 2003 2002
------- -------- --------
Net loss:
As reported.............................................. $(6,233) $(26,210) $(43,136)
Total stock-based employee compensation expense
determined under fair value based method for all
awards, net of related tax effects.................... (3,689) (5,581) (3,842)
------- -------- --------
Pro forma................................................ (9,922) (31,791) (46,978)
======= ======== ========
Loss per share:
Basic EPS as reported.................................... $ (0.87) $ (33.29) $ (62.00)
======= ======== ========
Pro forma basic EPS...................................... (1.38) (40.37) (67.60)
======= ======== ========
Diluted EPS as reported.................................. (0.87) (33.29) (76.32)
======= ======== ========
Pro forma diluted EPS.................................... (1.38) (40.37) (91.80)
======= ======== ========
BLACK-SCHOLES ASSUMPTIONS
For the Fiscal Year ending January 31,
------------------------------------------
2004 2003 2002
------------ ------------ ------------
Expected Life 3 years 3 years 3 years
Volatility 46% 180% 140%
Risk Free Interest Rate Range 1.29 - 2.39% 2.15 - 4.50% 2.91 - 4.50%
Dividend yield 0% 0% 0%
Fair Value Weighted Average of options issued $ 2.78 $ 22.19 $ 83.60
The fair value of stock options used to compute pro forma net loss and pro
forma loss per share disclosures is estimated using the Black-Scholes
option-pricing model, which was developed for use in estimating the fair value
of traded options that have no vesting restrictions and are fully transferable.
In addition, this model requires the input of subjective assumptions, including
the expected price volatility of the underlying stock. Projected data for
expected volatility and expected life of stock options is based upon historical
and other data. Changes in these subjective assumptions can materially affect
the fair value estimate, and therefore the existing valuation models may not
provide a reliable single measure of the fair value of the Company's employee
stock options.
Sorrento Networks Inc.
In addition SNI adopted its 2000 Stock Option/Stock Issuance Plan in
February 2000 under which it has granted options to certain of its employees,
directors and consultants. All options are generally granted at prices not less
than fair value at the date of grant and generally vest over four years.
Eligible individuals may be issued shares of common stock directly, either
through immediate purchase of the shares at fair value or as a bonus tied to
performance of services or the attainment of prescribed milestones. No
milestones were attained and, no stock has been issued under the stock issuance
program.
The option activity for this plan for the year ended January 31, 2004 is
summarized as follows:
Weighted Average
Number of Shares Exercise Price
---------------- ----------------
F-22
Shares under option at January 31, 2001... 18,735,904 $5.34
Granted................................ 1,193,064 $5.45
Exercised.............................. (22,300) $2.60
Canceled............................... (4,592,236) $5.52
-----------
Shares under option at January 31, 2002... 15,314,432 $5.30
Canceled............................... (12,018,429) $5.39
-----------
Shares under option at January 31, 2003... 3,296,003 $4.93
Canceled............................... (1,409,003) $4.40
-----------
Shares under option at January 31, 2004... 1,887,000 $5.34
===========
Additional information relating to the stock options of SNI outstanding and
exercisable at January 31, 2004 summarized by exercise price are as follows:
Outstanding Exercisable
------------------ ----------------------------
Weighted Average
------------------
Exercise Price Life Exercise Weighted Average
Per Share Shares (Years) Price Shares Exercise Price
---------------- --------- ------- -------- --------- ----------------
$2.00........... 55,000 6.05 $2.00 55,000 $2.00
$5.45........... 1,832,000 6.23 $5.45 1,829,750 $5.45
--------- ---------
$2.00 - $5.45... 1,887,000 6.22 $5.34 1,844,750 $5.34
========= =========
The holders of the options of our Sorrento subsidiary may elect to convert
all or a portion of their options into options to acquire our stock at a ratio
of 78 for one. During the year ended January 31, 2004, no shares were exchanged
for FIBR options, during 2003, 2,340,585 shares were exchanged for FIBR options
and during January 31, 2002, no options were converted.
Tender Offer
In May 2002, our Board of Directors approved an employees' stock option
exchange program. Under the program, employees holding options to purchase
Sorrento Networks Corp. common stock were given the opportunity to exchange
certain shares of their existing options, those with exercise prices above
$150.00 per share, for new options to purchase an equal number of shares of
Sorrento common stock. The new options were granted six months and one day after
the cancellation of the old options. The exercise price of the new options was
$109.00, the market price on the last reported trading price of Sorrento common
stock on their grant date. Options for 34,960 shares of Sorrento Networks Corp.
common stock were exchanged in the program. (Adjusted for 1-20 reverse split).
Options held by the company's executives and officers were not included in the
exchange program.
L. INCOME TAXES
Our provision for taxes on income for the years ended January 31, 2004,
2003 and 2002 consists of:
Year ended January 31, 2004:
Current.................... $--
Deferred................... --
---
Total...................... $--
===
Year ended January 31, 2003:
Current.................... $--
Deferred................... --
---
Total...................... $--
===
Year ended January 31, 2002:
F-23
Current.................... $--
Deferred................... --
---
Total...................... $--
===
Our domestic operations generate permanent and temporary differences for
depreciation, amortization, valuation allowances and tax attributes arising from
acquisitions. We have recorded a 100% valuation allowance against our deferred
tax assets, including net operating loss and research credit carry forwards, in
accordance with the provisions of Statement of Financial Accounting Standards
No. 109. Such allowance is recognized if, based on the weight of available
evidence, it is more likely than not that some portion or all of the deferred
tax assets will not be realized.
2004 2003
-------- --------
Deferred tax assets:
Research and development credits... $ 63 $ 63
Tax loss carry forwards............ 56,023 65,754
Purchase accounting................ 1,269 2,057
Depreciable assets................. 379 583
Other liabilities and reserves..... 8,633 5,613
Reserve for loss on investment..... 2,010
-------- --------
Gross deferred tax assets....... 68,377 74,070
Less: valuation allowance.......... (68,377) (74,070)
-------- --------
Deferred tax asset.............. $ -- $ --
======== ========
At January 31, 2004, we had federal net operating losses which may be
available to reduce future taxable income. Among potential adjustments which may
reduce available loss carry forwards, the Internal Revenue Code of 1986, as
amended, (IRC), reduces the extent to which net operating loss carry forwards
may be utilized in the event there has been an "ownership change" of a company
as defined by applicable IRC provisions. We believe that the issuances of its
equity securities and transfers of ownership of outstanding equity securities
may have resulted in one or more such ownership changes and intends to analyze
the impact of such transfers on the continued availability, for tax purposes, of
the net operating losses incurred through January 31, 2004. Further ownership
changes, as defined by the IRC, may reduce the extent to which any net operating
losses may be utilized. The NOLs were reduced under IRC section 108 by
$48,804,000 in connection with the capital restructuring. The NOL carry forwards
expire as follows:
2020..................... $ 39,483
2021..................... 36,780
2022..................... 32,508
2023..................... 19,480
2024..................... 24,367
--------
$152,618
========
The reconciliation between income tax expense and a theoretical United
States tax computed by applying a rate of 35% for the years ended January 31,
2004, 2003 and 2002, is as follows:
2004 2003 2002
-------- -------- --------
Income (loss) before income taxes....... $ (6,233) $(22,610) $(43,136)
======== ======== ========
Theoretical tax (benefit) at 35%........ (2,181) (7,914) (15,098)
Impact of non-qualified stock options... -- -- (434)
Change in Valuation Allowance........... (5,693) 10,750 16,862
Other individually immaterial items..... 1,896 (2,836) (1,330)
F-24
Impact of acquisition (5,978) --
-------- -------- --------
$ -- $ -- $ --
======== ======== ========
M. EARNINGS PER SHARE CALCULATION
The following data show the amounts used in computing basic earnings per
share. The number of shares used in the calculations for the years ended January
31, 2004, 2003 and 2002 reflect a 1-for-20 reverse stock split effective October
28, 2002.
2004 2003 2002
---------- -------- --------
Net loss ....................................................... $ (6,233) $(26,210) $(43,136)
Less: deemed dividend .......................................... -- -- (180)
---------- -------- --------
Net loss available to common shareholders used in basic EPS .... $ (6,233) $(26,210) $(43,316)
Average number of common shares used in basic EPS .............. 7,205,033 787,407 698,303
We incurred a net loss for the years ending January 31, 2004, 2003 and
2002. Accordingly, the effect of dilutive securities including convertible
debentures, convertible preferred stock, vested and non-vested stock options and
warrants to acquire common stock are not included in the calculation of EPS
because their effect would be antidilutive. The following data shows the effect
on income and the weighted average number of shares of dilutive potential common
stock.
2004 2003 2002
---------- -------- --------
Net loss available to common shareholders used in basic EPS .... $ (6,233) $(26,210) $(43,316)
Interest on convertible debt (net of tax)....................... (639) (4,826) (18,405)
Net loss available to common shareholders after assumed
conversions of dilutive securities........................... $ (5,594) $(31,036) $(61,721)
Average number of common shares used in dilutive EPS............ 7,205,033 787,407 808,740
The shares issuable upon exercise of options and warrants represents the
quarterly average of the shares issuable at exercise net of the shares assumed
to have been purchased, at the average market price for the period, with the
assumed exercise proceeds. Accordingly, options and warrants with exercise
prices in excess of the average market price for the period are excluded because
their effect would be antidilutive.
N. OTHER RELATED PARTY TRANSACTIONS
Summarized below are all material related party transactions entered into
by us and our subsidiaries during the periods presented not otherwise disclosed
in these notes.
In February 2003, we entered into a consulting agreement with Mr. Robert
Hibbard, a member of the Board of Directors, to provide services to the company
at a consulting rate of $175 per hour plus a retainer of $20 thousand per month
for six months. Mr. Hibbard agrees to make himself available to the Company for
not less than 20 hours per week. This agreement supersedes his August 2002
consulting agreement and terminated in February 2004. Nearly all of Mr.
Hibbard's consulting work for us has involved matters being considered or
reviewed by the board or by committees of the board. His work has included
structuring and implementing our 2003 Equity Incentive Plan for employees,
participation in settlement negotiations for pending litigation, assistance in
our capital restructuring and improving our intellectual property policies and
procedures, among other matters. In fiscal years 2004 and 2003 Mr. Hibbard was
paid $205 thousand and $92 thousand respectively, in consulting fees.
During fiscal 2002, we paid a total of $55 thousand to Phillip W. Arneson
as a Director of the Company. The amounts paid included $24 thousand for
consulting work performed for a special Committee of the Board, $21 thousand for
various other consulting services including outsourcing advice and
organizational matters, attendance fees of $6 thousand for Board and Committee
meetings and $5 thousand in reimbursable expenses. Consulting fees were paid at
a rate equal to normal fees for attendance at Board meetings.
F-25
During July 2000, we agreed to loan $300 thousand for three years at the
applicable federal rate provided for in Internal Revenue Code Section 1274 to
our Senior Vice President, Legal, an officer of the company, associated with his
relocation and initial employment. This is a full recourse loan and the officer
has pledged his options to acquire our common stock and any options he may
receive from any of our subsidiaries as collateral. The officer received $300
thousand in advances under this loan agreement for which the interest rate is
6.6%. On July 3, 2002 a new note covering the $300 thousand was incorporated in
his employment contract. The term remained the same as the July 2000 note, with
all unpaid, accrued interest and principal due and payable on August 30, 2003.
In December 2002, the officer paid $39 thousand on his loan that included
payment of all prior interest due and the remainder applied to his principal
balance. In August 2003, the officer left the employment of the company. As part
of his departure, the officer signed filing documents that if were to not repay
the loan, these documents could be used to obatin a default judgment in favor of
the company. As of January 31, 2004 the former officer's loan outstanding to the
Company totaled $298. Subsequent to our fiscal year end the former officer has
made, payments against the loan to keep it in good standing.
During June 2000, we entered into various agreements with Par Chadha, our
former CEO and Chairman, which, among other matters, provides for payments of
$250 thousand per year for three years of consulting services and loans by us
for the exercise of previously granted options to acquire 58,925 options at
prices varying from $140.60 to $985.00 per share. As the members of our Board of
Directors at the time of his resignation ceased to represent more than 50% of
the Board in October 2000, all payments for consulting services were accelerated
and no future consulting services are required. During October 2000, Mr. Chadha
exercised 3,556 options, applying the $500 thousand accelerated payment to the
exercise. In addition, he exercised 25,369 options for which we are
contractually obligated to loan the $5.0 million due on the exercise. During
September 2001, Mr. Chadha notified us that he does not have any obligations
under the agreements. We have notified him that we do not agree with his
interpretation of his repayment obligations under the terms of the agreements.
During December 2001, we entered into an agreement whereby the 25,369
option exercise was rescinded. Mr. Chadha returned the 25,369 shares to us for
cancellation and we cancelled the receivable due from him and restored the
original option agreements. The required non-cash expense as a result of the
rescission equal to the difference between the amount of the loan receivable and
the market value of the returned shares was recorded as a reserve of $2.7
million against the receivable during the year ended January 31, 2002 and is
included in other operating expenses in the accompanying income statement. This
rescission agreement did not resolve any underlying dispute as to the option
loan repayment obligations. In accordance with a settlement agreement reached
between us and our former Chairman and Founder, Par Chadha, 566,000 shares of
ENI stock were transferred to Mr. Chadha in exchange for mutual releases by the
Company and Mr. Chadha and certain of his affiliates. The stock transfer was
complete on July 1, 2003 and had a value of $88 thousand.
On September 30, 2001, our then Chairman and CEO executed a two year
consulting agreement with a senior officer of the company, whereby he was to to
be paid a salary at $250 thousand per year plus benefits and the vesting of all
his options to acquire our common stock. In July 2002, a dispute arose in the
agreement whereby the company stopped payment of the monthly consulting fees. In
August 2003, the dispute was resolved by the company paying $197 thousand in
full settlement and a mutual release of claims. The settlement included $15
thousand in legal costs incurred by the officer. Upon settlement, the Company
received notice from an attorney that stated he represented the officer and the
officer had refused to pay his legal fees and was notifying us that an
attorney's lien was being placed on the settlement proceeds for his portion. As
a result of the notice, $70 thousand was placed in escrow with our legal firm
pending release upon resolution with the officer and his attorney.
O. SUPPLEMENTAL CASH FLOW DISCLOSURES
Interest expense for the years ended January 31, 2004, 2003 and 2002 was
$4.4 million, $9.7 million, $3.3 million and, respectively. During fiscal 2004,
$248 thousand was paid in cash and the remaining $4.4 million neither provided
for nor used cash. For fiscal years 2003 and 2002, $9.3 million and $2.6 million
of the interest expense neither provided nor used cash.
P. CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject us to concentrations of
credit risk consist primarily of temporary cash investments and trade
receivables. As regards the former, we place our temporary cash investments with
high credit financial institutions and limits. At times such amounts may exceed
the F.D.I.C. limits. We limit the amount
F-26
of exposure with any one financial institution and believe that no significant
concentration of credit risk exists with respect to cash investments. No
accounts at a single bank accounted for more than 10% of current assets.
Although we are directly affected by the economic well being of significant
customers listed in the following tables, we do not believe that significant
credit risk exists at January 31, 2004. We perform ongoing evaluations of our
customers and require letters of credit or other collateral arrangements as
appropriate. Accordingly, trade receivable credit losses have not been
significant.
The following data shows the customers accounting for more than 10% of net
receivables at January 31 2004 and 2003:
2004 2003
---- ----
Customer A ..................................... --% 29.6%
Customer B ..................................... -- 18.7
Customer C ..................................... 10.3 --
Customer D ..................................... 10.7 15.9
Customer E ..................................... 1.1 31.2
The following data shows the customers accounting for more than 10% of net
sales during the years ended January 31, 2004, 2003 and 2002:
2004 2003 2002
---- ---- ----
Customer A...................................... 10.7% 23.0% 14.9%
Customer B...................................... 13.6 19.0 23.9
Customer C...................................... 0.4 12.2 16.3
Customer D...................................... 0.2 1.3 7.8
Customer E...................................... 6.6 0.6 6.9
Customer F...................................... 0.7 -- 5.6
Customer G...................................... 12.2 -- 0.5
As of January 31, 2004 we had the following Notes Receivable from one of
our customers:
Notes Receivable
Payments due in fiscal years
-----------------------------------------------------
Total 2005 2006 2007 2008 2009 Thereafter
----- ---- ---- ---- ---- ---- ----------
Long-term Notes Receivable 5%................ $325 $242 $83 $-- $-- $-- $--
The company holds a single note maturing April 2005.
Q. SUBSEQUENT EVENTS
On April 22, 2004, Sorrento Networks Corporation, a Delaware corporation
("Sorrento"), entered into an Agreement and Plan of Merger, dated as of April
22, 2004, with Zhone Technologies, Inc., a Delaware corporation ("Zhone") and
Selene Acquisition Corp., a Delaware corporation and wholly-owned subsidiary of
Zhone ("Merger Sub"). Pursuant to the Merger Agreement and subject to the terms
and conditions set forth therein, Merger Sub will merge with and into Sorrento,
with Sorrento surviving as a wholly-owned subsidiary of Zhone (the "Merger"). At
the effective date of the Merger, each outsatanding share of Sorrento common
stock will be exchanged for 0.9 shares of Zhone common stock, and each option,
warrant and other securities exercisable or convertible into shares subject to
the approval of the stockholders of both Zhone and Sorrento and other customary
closing conditions.
On March 8, 2004 the warrants and cash were distributed thereby resolving
all purchase price contingencies associated with the purchase of LuxN, Inc. As
part of the LuxN, Inc. purchase consideration, the Company had
F-27
placed 400,000 warrants and cash into excrow pending the expiration of an
indemnification period for the Company. The Company has reflected the resolution
of these purchase price contigencies as of January 31, 2004.
F-28
R. BUSINESS ACQUISITION
On August 8, 2003, we completed our acquisition of LuxN, Inc., pursuant to
an Agreement and Plan of Merger, dated as of June 25, 2003, between Sorrento and
LuxN. At the effective time of the merger, our wholly-owned subsidiary, Lambda
Acquisition Corp., was merged with and into LuxN, with LuxN being the surviving
corporation in the merger.
As consideration for the transaction, holders of LuxN's Series A-1
Preferred Stock with an aggregate pro-rata portion of $14.8 million of LuxN's
net cash held elected to receive cash at closing, and holders of LuxN's Series
A-1 Preferred Stock with an aggregate pro-rata portion of $3.8 million of LuxN's
net cash held elected to receive our common stock at closing. We issued
1,374,194 shares of our common stock to the holders of LuxN's Series A-1
Preferred Stock at the closing, and issued an additional 505,153 shares upon
receipt of our shareholders' approval. In addition, we issued warrants to
purchase 400,000 of our shares of common stock at an exercise price of $3.05 per
share to the holders of LuxN's Series A-1 Preferred Stock
The aggregate purchase price was $20.9 million including $14.8 million in
cash,$4.9 million of common stock, $878 thousand of warrants and $414 of related
costs. The Company issued 1,879,347 shares of common stock valued at the date of
issuance and 400,000 warrants with an exercise price of $3.05 valued on the date
of issuance.. Upon valuing the purchase price and allocating the purchase price
to the assets acquired and liabilities assumed, it was determined that the net
assets exceeded the purchase price by $87 thousand. This excess of net assets
acquired over the amount paid for the acquisition is reflected as a reduction to
long lived assets.
The following table summarizes the estimated fair values of the assets acquired
and liabilities assumed at the date of acquisition.
At August 8, 2003
(in thousands)
-----------------
Current assets $25,901
Property, plant and equipment --
Intangible assets --
-------
Total assets acquired 25,901
-------
Current liabilities (4,918)
-------
Total liabilities assumed (4,918)
-------
Net assets acquired $20,983
=======
Consolidated Pro Forma Statement of Operations as of January 31, 2004
(in thousands)
Sorrento
Networks
Consolidated LuxN, Inc Total
------------ --------- --------
Revenue $21,611 $ 5,313 $ 26,924
Net (Loss) (3,674) (7,579) (11,253)
Earnings per Share (0.51) (1.05) (1.56)
F-29
Consolidated Pro Forma Statement of Operation as of January 31, 2003
(in thousands)
Sorrento
Networks
Consolidated LuxN, Inc Total
------------ --------- --------
Revenue $ 25,137 $ 3,958 $ 29,095
Net (Loss) (26,210) (27,325) (53,535)
Earnings per Share (12.13) (12.64) (24.77)
S. SEGMENT INFORMATION
Information for the years ended January 31, 2004, 2003 and 2002 in the
table below is presented on the same basis utilized by the Company to manage its
business. The segments according to product lines are as follows: Sorrento
Networks, and LuxN are "Optical Networking", Meret, and other. Export sales and
certain income and expense items are reported in the geographic area where the
final sale to customers is made, rather than where the transaction originates.
We have no material long-term assets outside the United States. The accounting
policies of the segments are the same as the policies described in the "Summary
of Significant Accounting Policies." Each segment operates independent of one
another. The company evaluates the performance of each segment and distributes
resources to them based on earnings before income taxes, excluding corporate
charges ("Segment income (loss) from operations"). Any corporate charges that
are allocated to the segments are allocated as a percentage of revenue. These
charges, if any, are recorded under "other income (expenses)" and are eliminated
in the consolidation process. "Other income (expenses) is not shown in the
supplemental segment information contained below.
Geographical Information
The table below present external revenues based on the locations of the
customer:
2004 2003 2002
------- ------- -------
Net sales:
United States ............. $18,445 $14,803 $28,341
Asia ...................... 1,562 865 1,340
Europe .................... 5,455 9,469 10,130
Other ..................... -- -- 1,016
------- ------- -------
Total net sales ........ $25,462 $25,137 $40,827
======= ======= =======
Products and Service Revenue
The table below presents external revenues for groups of similar products
and services:
2004 2003 2002
------- ------- -------
Net sales:
Optical networking ........ $22,592 $22,373 $36,034
Switching and access ...... 2,870 2,764 4,793
------- ------- -------
Total net sales ........ $25,462 $25,137 $40,827
======= ======= =======
Supplemental Segment Information:
Optical
Networking Meret Other Consolidated
---------- ------- ------- ------------
F-30
As of January 31, 2004:
Revenues from external customers $ 22,592 $ 2,870 $ -- $ 25,462
Cost of goods sold 17,370 2,399 -- 19,769
Gross profit 5,222 471 -- 5,693
Segment income/(loss) from operations (14,862) 235 (3,007) (17,634)
Depreciation and amortization expense 3,168 410 95 3,673
Valuation allowance additions
(reductions):
Receivables and inventory (4,931) (1,822) -- (6,753)
Capital asset additions, net (1,611) 7 -- (1,604)
Total assets 35,045 4,512 20,539 50,096
Optical
Networking Meret Other Consolidated
---------- ------- ------- ------------
As of January 31, 2003:
Revenues from external customers $ 22,373 $ 2,764 $ -- $ 25,137
Cost of goods sold 19,257 2,560 -- 21,817
Gross profit 3,116 204 -- 3,320
Segment income/(loss) from operations (25,017) (1,329) (4,929) (31,329)
Depreciation and amortization expense 3,257 702 103 4,063
Valuation allowance additions:
Receivables and inventory (704) (316) -- (1,020)
Capital asset additions, net 3,201 62 70 3,333
Total assets 31,497 5,375 18,933 55,805
Optical
Networking Meret Other Consolidated
---------- ------ ------- ------------
As of January 31, 2002:
Revenues from external customers ........ $ 36,034 $4,793 $ -- $ 40,827
Cost of goods sold ...................... 28,384 3,123 -- 31,507
Gross profit ......................... 7,650 1,670 -- 9,320
Segment income/(loss) from operations ... (28,993) 246 (8,407) (37,154)
Depreciation and amortization expense ... 2,039 543 212 2,794
Valuation allowance additions:
Receivables and inventory ............ 5,328 269 987 5,597
Other ................................ 812 -- 1,788 2,600
Capital asset additions, net ............ 3,116 67 52 3,235
Total assets ............................ 36,089 7,282 46,968 90,339
T. VALUATION AND QUALIFYING ACCOUNTS
Changes in the inventory valuation reserve were as follows:
Balance at January 31, 2001 .................... $ 2,792
Additions charged to costs and expenses ..... 4,038
F-31
Amounts used during year .................... (362)
-------
Balance at January 31, 2002 .................... 6,468
Additions charged to costs and expenses ..... 4,152
Amounts used during year .................... (4,657)
-------
Balance at January 31, 2003 .................... 5,963
Balance of LuxN at August 8, 2003 ........... 14,134
Additions charged to costs and expenses ..... 692
Amounts used during year .................... (5,389)
-------
Balance at January 31, 2004 .................... $15,400
=======
F-32
Changes in the accounts receivable valuation reserve were as follows:
Balance at January 31, 2001 .................... $ 1,002
Additions charged to costs and expenses ..... 1,558
Amounts used during year .................... (821)
-------
Balance at January 31, 2002 .................... 1,739
Additions charged to costs and expenses ..... 1,531
Amounts used during year .................... (2,046)
-------
Balance at January 31, 2003 .................... 1,224
Balance of LuxN at August 8, 2004 ........... 57
Additions charged to costs and expenses ..... 333
Amounts used during year .................... (1,090)
-------
Balance at January 31, 2004 .................... $ 524
=======
U. UNAUDITED QUARTERLY FINANCIAL DATA (Unaudited)
Amounts in thousands, except per share amounts.
First Second Third Fourth
Quarter Quarter Quarter Quarter Year
------- -------- ------- -------- --------
Year ended January 31, 2004:
Net sales ........................ $ 7,861 $ 4,476 $ 6,726 $ 6,399 $ 25,462
Gross profit (loss) .............. 1,954 1,363 1,835 541 5,693
Income (loss) from operations .... (3,618) (4,093) (4,544) (5,379) (17,634)
Net income (loss) ................ (6,222) 12,514 (4,817) (7,708) (6,233)
Net income (loss) per share:
Basic ......................... (7.02) 2.13 (0.47) (0.66) (0.87)
Diluted ....................... (14.33) 1.72 (0.47) (0.66) (0.87)
Year ended January 31, 2003:
Net sales ........................ $ 6,003 $ 5,199 $ 5,525 $ 8,410 $ 25,137
Gross profit ..................... 1,488 (2,300) 962 3,170 3,320
Loss from operations ............. 3,976 (15,806) (6,922) (7,458) (26,210)
Net loss ......................... 3,976 (15,806) (6,922) (7,458) (26,210)
Net loss per share:
Basic ......................... 5.60 (21.40) (8.86) (8.42) (33.29)
Diluted ....................... (25.20) (45.20) (34.54) (32.64) (33.29)
F-33
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Company has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
SORRENTO NETWORKS CORPORATION
By: /s/ Joe R. Armstrong Date: May 7, 2004
------------------------------------
Joe R. Armstrong
Chief Financial Officer
Principal Accounting Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Company and in
the capacities and on the dates indicated.
By: /s/ Phillip W. Arneson Date: May 7, 2004
------------------------------------
Phillip W. Arneson
Chairman and Director
Chief Executive Officer
By: /s/ Donne F. Fisher Date: May 7, 2004
------------------------------------
Donne F. Fisher
Director
By: /s/ Gary M. Parsons Date: May 7, 2004
------------------------------------
Gary M. Parsons
Director
By: /s/ Robert L. Hibbard Date: May 7, 2004
------------------------------------
Robert L. Hibbard
Director
By: /s/ Larry J. Matthews Date: May 7, 2004
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Larry J. Matthews
Director
By: /s/ Tom Schilling Date: May 7, 2004
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Tom Schilling
Director
By: /s/ Don Herzog Date: May 7, 2004
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Don Herzog
Director
STATEMENT OF DIFFERENCES
The trademark symbol shall be expressed as............................... 'TM'
The registered trademark symbol shall be expressed as.................... 'r'
The service mark symbol shall be expressed as............................ 'sm'