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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED September 30, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ---------------TO ---------------.
COMMISSION FILE NUMBER: 000-24647
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TERAYON COMMUNICATION SYSTEMS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 77-0328533
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
2952 BUNKER HILL LANE
SANTA CLARA, CALIFORNIA 95054
(408) 727-4400
(ADDRESS, INCLUDING ZIP CODE, AND TELEPHONE NUMBER, INCLUDING AREA CODE, OF THE
REGISTRANT'S PRINCIPAL EXECUTIVE OFFICES)
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Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
As of November 12, 2001, registrant had outstanding 68,631,737 shares of
Common Stock.
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SPECIAL NOTE ON FORWARD-LOOKING STATEMENTS
This report on Form 10-Q contains forward-looking statements of Terayon
Communication Systems, Inc. within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934 which are
subject to the "safe harbor" created by those sections. The forward-looking
statements include, but are not limited to: statements related to industry
trends and future growth in the markets for our products; our strategies for
reducing the cost of our products; our product development efforts; the effect
of GAAP accounting pronouncements on our recognition of revenues; our future
research and development; the timing of our introduction of new products; the
timing and extent of deployment of our products by our customers; and future
profitability. We usually use words such as "could", "may," "will," "should,"
"expect," "plan," "anticipate," "believe," "estimate," "predict," "future,"
"intend," or "certain" or the negative of these terms or similar expressions to
identify forward-looking statements. Discussions containing such forward-looking
statements may be found throughout the document. These forward-looking
statements involve certain risks and uncertainties that could cause actual
results to differ materially from those in such forward-looking statements. We
disclaim any obligation to update these forward-looking statements as a result
of subsequent events. The business risks discussed in Part 1, Item 2 of this
Report on Form 10-Q, among other things, should be considered in evaluating our
prospects and future financial performance.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
TERAYON COMMUNICATION SYSTEMS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Consolidated Balance Sheets as of September 30, 2001 (unaudited)
and December 31, 2000................................................. 3
Consolidated Statements of Operations for the three months and
nine months ended September 30, 2001 and 2000 (unaudited)............. 4
Consolidated Statements of Cash Flows for the nine months ended
September 30, 2001 and 2000 (unaudited)............................... 5
Notes to Consolidated Financial Statements............................. 6
2
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share data)
September 30, December 31,
2001 2000
------------- ------------
ASSETS (unaudited)
Current assets:
Cash and cash equivalents ........................ $ 141,913 $ 347,015
Short-term investments ........................... 180,158 215,442
Accounts receivable, less allowance for doubtful
accounts of $5,502 in 2001 and $6,542 in 2000 ... 51,455 42,772
Accounts receivable from related parties ......... 3,054 17,454
Other current receivables ........................ 13,942 32,027
Inventory ........................................ 32,035 87,767
Other current assets ............................. 5,204 7,021
----------- -----------
Total current assets ........................... 427,761 749,498
Property and equipment, net ........................ 30,690 33,533
Intangibles and other assets ....................... 26,157 643,696
----------- -----------
Total assets ................................... $ 484,608 $ 1,426,727
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ................................. $ 48,804 $ 123,994
Accrued payroll and related expenses ............. 12,783 13,105
Deferred revenues ................................ 3,415 4,998
Warranty reserves ................................ 8,472 5,925
Accrued purchase price payable ................... -- 14,138
Other accrued liabilities ........................ 50,550 25,719
Current portion of long-term debt ................ 950 10,853
Short-term debt .................................. -- 2,697
Current portion of capital lease obligations ..... 112 131
----------- -----------
Total current liabilities ...................... 125,086 201,560
Long-term debt ..................................... 1,844 119
Long-term portion of capital lease obligations ..... 255 358
Other long-term obligations ........................ 2,523 3,444
Convertible subordinated notes ..................... 200,141 500,000
Deferred tax liability ............................. -- 18,565
Commitments and contingencies
Stockholders' equity:
Preferred stock, $.001 par value:
Authorized shares--5,000,000
Issued and outstanding shares--none ............. -- --
Common stock, $.001 par value:
Authorized shares--200,000,000
Issued and outstanding shares--68,386,264 in 2001
and 67,396,539 in 2000 .......................... 70 68
Additional paid in capital ....................... 1,044,591 1,037,891
Accumulated deficit .............................. (886,769) (329,148)
Deferred compensation ............................ (4,241) (6,788)
Stockholders' notes receivable ................... -- (3)
Accumulated other comprehensive income(loss) ..... 1,108 661
----------- -----------
Total stockholders' equity ..................... 154,759 702,681
----------- -----------
Total liabilities and stockholders' equity ..... $ 484,608 $ 1,426,727
=========== ===========
See accompanying notes.
3
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------ ------------------------
2001 2000 2001 2000
--------- --------- --------- ---------
Revenues:
Product revenues ......................... $ 71,145 $ 82,827 $ 155,152 $ 172,171
Related party product revenues ........... 8,458 42,474 44,168 104,486
--------- --------- --------- ---------
Total revenues ......................... 79,603 125,301 199,320 276,657
--------- --------- --------- ---------
Cost of goods sold:
Cost of product revenues ................. 57,292 67,130 142,095 144,318
Cost of related party product revenues ... 5,519 24,001 28,329 57,261
Special charges .......................... 6,424 -- 35,128 --
--------- --------- --------- ---------
Total cost of goods sold ............... 69,235 91,131 205,552 201,579
--------- --------- --------- ---------
Gross profit (loss) ........................ 10,368 34,170 (6,232) 75,078
Operating expenses:
Research and development ................. 20,163 19,490 61,942 46,624
Cost of product development assistance
agreement .............................. -- -- -- 9,563
In-process research and development ...... -- 5,000 -- 24,835
Sales and marketing ...................... 16,105 13,135 47,922 31,607
General and administrative ............... 8,086 8,025 24,697 17,971
Goodwill amortization .................... 149 17,594 22,953 39,244
Restructuring costs and asset write-offs . 5,301 -- 582,594 --
--------- --------- --------- ---------
Total operating expenses ............... 49,804 63,244 740,108 169,844
--------- --------- --------- ---------
Loss from operations ....................... (39,436) (29,074) (746,340) (94,766)
Interest income ............................ 3,341 7,644 14,587 10,975
Interest expense ........................... (2,351) (4,584) (12,399) (4,934)
Other expense .............................. (698) (440) (819) (487)
--------- --------- --------- ---------
Loss before extraordinary gain and
tax benefit .......................... (39,144) (26,454) (744,971) (89,212)
Income tax benefit ......................... (392) -- (14,021) --
--------- --------- --------- ---------
Loss before extraordinary gain ......... (38,752) (26,454) (730,950) (89,212)
Extraordinary gain on early retirement of
debt net of tax .......................... 51,834 -- 173,328 --
--------- --------- --------- ---------
Net income(loss) ........................... $ 13,082 $ (26,454) $(557,622) $ (89,212)
========= ========= ========= =========
Basic and diluted net loss per share before
Extraordinary gain ....................... $ (0.57) $ (0.43) $ (10.79) $ (1.50)
Extraordinary gain on early retirement of
debt ..................................... $ 0.76 -- $ 2.56 --
--------- --------- --------- ---------
Basic and diluted net income(loss) per share $ 0.19 $ (0.43) $ (8.23) $ (1.50)
========= ========= ========= =========
Shares used in computing basic and
diluted net income(loss) per share ....... 68,181 62,105 67,723 59,347
========= ========= ========= =========
See accompanying notes.
4
TERAYON COMMUNICATION SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(unaudited)
Nine Months Ended
September 30,
------------------------
2001 2000
--------- ---------
Net cash, used in operating
activities .................................... ($113,600) ($ 5,843)
--------- ---------
Investing activities:
Purchases of short-term investments ............ (280,247) (331,010)
Proceeds from sales and maturities of
short-term investments ........................ 309,531 54,190
Purchases of property and equipment ............ (10,239) (17,416)
Issuance of short-term receivable .............. -- (1,126)
Purchase of other assets ....................... -- (3,179)
Cash received from acquisitions ................ -- 8,969
Cash paid for acquisition of businesses ........ -- (4,539)
--------- ---------
Net cash provided by (used in) investing
activities .................................... 19,045 (294,111)
--------- ---------
Financing activities:
Principal payments on capital leases ........... (19) (4)
Principal payments on short-term debt .......... -- (1,078)
Proceeds from short-term borrowings ............ -- 772
Principal payments and current maturities
on long-term debt ............................. (103) (791)
Net proceeds from issuance of convertible
Subordinated debt ............................. -- 484,475
Exercise of options and warrant to purchase
common stock .................................. 3,003 11,799
Proceeds from issuance of common stock ......... -- 2,088
Retirement of debt ............................. (113,428) --
--------- ---------
Net cash (used in) provided by financing
activities .................................... (110,547) 497,261
--------- ---------
Net (decrease) increase in cash and cash
equivalents ................................... (205,102) 197,307
Cash and cash equivalents at beginning of period 347,015 32,398
--------- ---------
Cash and cash equivalents at end of period ..... $ 141,913 $ 229,705
========= =========
See accompanying notes.
5
TERAYON COMMUNICATION SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies
Description of Business
The Company develops, markets and sells broadband access systems that
enable cable operators and other providers of broadband access services to
deploy broadband services over cable, copper wire and wireless systems.
Basis of Presentation
The accompanying consolidated financial statements have been prepared in
accordance with generally accepted accounting principles for interim financial
information and in accordance with the instructions to Form 10-Q and Article 10
of Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
primarily of normal recurring accruals) necessary for a fair presentation of the
financial statements at September 30, 2001 and for the three months and nine
months ended September 30, 2001 and 2000 have been included.
The unaudited consolidated financial statements include the accounts of
the Company and its wholly owned and majority owned subsidiaries. The minority
interests in net losses of its majority owned subsidiaries were insignificant
for all periods presented. All intercompany balances and transactions have been
eliminated.
Results for the three months and nine months ended September 30, 2001
are not necessarily indicative of results for the entire fiscal year or future
periods. These financial statements should be read in conjunction with the
consolidated financial statements and the accompanying notes included in the
Company's Form 10-K405 dated April 2, 2001, as filed with the U.S. Securities
and Exchange Commission and as amended on April 30, 2001. The accompanying
balance sheet at December 31, 2000 is derived from audited financial statements
at that date.
Reclassifications
Certain amounts in the 2000 financial statements have been reclassified
to conform to the 2001 presentation.
In the third quarter of 2001, Shaw Communications Inc., one of our
related parties, has been reclassified as a non-related party due to the fact
that its employee Michael D'Avella resigned from the Company's Board of
Directors.
Cash Equivalents and Short-Term Investments
The Company invests its excess cash in money market accounts and debt
instruments and considers all highly liquid debt instruments purchased with an
original maturity of three months or less to be cash equivalents. Investments
with an original maturity at the time of purchase of over three months are
classified as short-term investments regardless of maturity date as all
investments are classified as available-for-sale and can be readily liquidated
to meet current operational needs.
The Company accounts for investments in accordance with Statement of
Financial Accounting Standards No. 115, "Accounting for Certain Investments in
Debt
6
and Equity Securities". Management determines the appropriate classification of
debt securities at the time of purchase and reevaluates such designation as of
each balance sheet date. The Company's short-term investments, which consist
primarily of commercial paper, U.S. government and U.S. government agency
obligations and fixed income corporate securities, are classified as
available-for-sale and are carried at amortized cost which approximates fair
market value. Realized gains and losses and declines in value judged to be
other-than-temporary on available-for-sale securities are included in interest
income. The cost of securities sold is based on the specific identification
method. The Company had no material investments in equity securities at either
September 30, 2001 or December 31, 2000.
Other Current Receivables
As of September 30, 2001 and December 31, 2000, other current
receivables include approximately $8.9 million and $20.1 million, respectively,
due from contract manufacturers for raw materials purchased from the Company.
Inventory
Inventory is stated at the lower of cost (first-in, first-out) or
market. The components of inventory are as follows (in thousands):
September 30, December 31,
2001 2000
------------- ------------
Finished goods ............... $15,497 $64,987
Work-in-process .............. 3,295 1,736
Raw materials ................ 13,243 21,044
------- -------
$32,035 $87,767
======= =======
Net Income(Loss) Per Share
Basic and diluted net income or loss per share were computed using the
weighted average number of common shares outstanding. Options to purchase
32,334,577 and 21,489,536 shares of common stock were outstanding at September
30, 2001 and December 31, 2000, respectively, and warrants to purchase 2,684,700
and 2,384,700 shares of common stock were outstanding at September 30, 2001 and
December 31, 2000, respectively, but were not included in the computation of
diluted net loss per share, since the effect would be antidilutive.
Comprehensive Net Income(Loss)
Accumulated other comprehensive income presented in the accompanying
consolidated balance sheets consists of net unrealized gains on short-term
investments and accumulated net translation losses. For the three months ended
September 30, 2001 the Company's comprehensive income was approximately
$13,801,000 and the Company's comprehensive loss for the three months ended
September 30, 2000 was approximately $26,539,000. For the nine months ended
September 30, 2001 and 2000 the Company's comprehensive loss was approximately
$557,175,000 and $88,931,000, respectively.
Derivative Financial Instruments
As of January 1, 2001, the Company adopted Financial Accounting
Standards Board Statement No. 133, "Accounting for Derivative Instruments and
Hedging Activities" (Statement 133). As a result of the adoption of Statement
133, the Company will recognize all derivative financial instruments, such as
foreign exchange contracts, in the consolidated financial statements at fair
value
7
regardless of the purpose or the intent for holding the instrument. Changes in
the fair value of derivative financial instruments are either recognized
periodically in income or in shareholders' equity as a component of
comprehensive income depending on whether the derivative financial instrument
qualifies for hedging accounting, and if so, whether it qualifies as a fair
value hedge or cash flow hedge. Generally, changes in fair values of derivatives
accounted for as fair value hedges are recorded in income along with the
portions of the changes in the fair values of the hedged items that relate to
the hedged risk(s). Changes in fair values of derivatives accounted for as cash
flow hedges, to the extent they are effective as hedges, are recorded in other
comprehensive income net of deferred taxes. Changes in fair value of derivatives
used as hedges of the net investment in foreign operations are reported in other
comprehensive income as part of the cumulative translation adjustment. Changes
in fair value of derivatives not qualifying as hedges are reported in income.
As the Company had no derivative financial instruments outstanding as of
September 30, 2001 or December 31, 2000, the adoption of Statement 133 had no
impact on the financial statements of the Company at September 30, 2001.
New Accounting Pronouncements
On June 29, 2001, the Financial Accounting Standards Board approved the
issuance of Statements of Financial Accounting Standards (SFAS) No. 141,
"Business Combinations" and No. 142, "Goodwill and Other Intangible Assets."
SFAS 141, which is effective for all business combinations subsequent to July 1,
2001, eliminates the pooling-of-interests method of accounting for business
combinations and includes new criteria to recognize intangible assets separately
from goodwill. Under Statement 142, goodwill and other intangible assets with
indefinite lives are no longer amortized but are reviewed at least annually for
impairment. Separable intangible assets that are deemed to have a definite life
will continue to be amortized over the estimated useful life. SFAS 142 is
effective with respect to the non-amortization of goodwill and certain
intangible assets on January 1, 2002 for amounts currently recorded on Terayon's
balance sheet and will apply to any goodwill and certain intangible assets
acquired after June 30, 2001. At September 30, 2001 goodwill approximated $2.7
million. Goodwill amortization was $0.15 million and $23.0 million for the three
and nine months ended September 30, 2001, respectively.
In August 2001, the FASB issued Statements of Financial Accounting
Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets", effective for fiscal years beginning after December 15, 2001.
The Company is currently evaluating the impact of these statements on
our operations. Any impairment resulting from our initial adoption of these
statements will be recorded as a cumulative effect of accounting change as of
January 1, 2002. The Company does not anticipate that the adoption of the new
rules will have a material impact on its earnings or financial position.
2. Segments of an Enterprise and Related Information
The Chief Executive Officer has been identified as the Chief Operating
Decision Maker (CODM) because he has final authority over resource allocation
decisions and performance assessments. The CODM allocates resources to each
segment based on their business prospects, competitive factors, revenues and
operating results.
The Company views its business as having two principal operating
segments: Cable Broadband Access Systems (Cable) and Telecom Carrier Access
Systems (Telecom). The Cable segment consists primarily of the TeraComm system,
the CherryPicker Digital Video Management Systems and the Multigate Telephony
and Data Access Systems which are sold primarily to cable operators for the
deployment of data, video and voice services over the existing cable
infrastructure. The Telecom segment consists primarily of the Miniplex DSL
Systems, the IPTL Converged Voice and Data Service System, the Highlink Router
and the Multi-serve, Function Access Platforms, which
8
are sold to providers of broadband services for the deployment of voice and data
services over the existing copper wire infrastructure.
Information on reportable segments for the three months and nine months
ended September 30, 2001 and 2000 is as follows (in thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------- --------------------------
2001 2000 2001 2000
----------- ----------- ----------- -----------
Cable Broadband Access Segment:
Revenues .............................. $ 72,223 $ 108,148 $ 174,519 $ 248,321
Operating loss ........................ (27,038) (13,962) (454,660) (66,042)
Total assets .......................... 470,114 1,171,012 470,114 1,171,012
Telecom Broadband Access Segment:
Revenues .............................. 7,380 17,153 24,801 28,336
Operating loss ........................ (12,398) (15,112) (291,680) (28,724)
Total assets .......................... 14,494 256,068 14,494 256,068
Operating income:
Operating income by reportable segments (39,436) (29,074) (746,340) (94,766)
Unallocated amounts:
Interest and other income, net ........ 292 2,620 1,369 5,554
Income tax ............................ 392 -- 14,021 --
Extraordinary gain .................... 51,834 -- 173,328 --
----------- ----------- ----------- -----------
Net gain (loss) ........................ $ 13,082 $ (26,454) $ (557,622) $ (89,212)
=========== =========== =========== ===========
Geographic areas:
Revenues:
United States ......................... $ 4,587 $ 24,828 $ 37,816 $ 57,591
Canada ................................ 41,628 42,474 77,698 104,959
Europe and Israel ..................... 18,019 22,080 35,719 51,946
Asia .................................. 15,123 27,289 47,311 47,995
South America ......................... 246 8,630 776 14,166
----------- ----------- ----------- -----------
Total ................................ $ 79,603 $ 125,301 $ 199,320 $ 276,657
=========== =========== =========== ===========
Assets:
United States ......................... $ 445,996 $ 1,072,055 $ 445,996 $ 1,072,055
Canada ................................ 27,263 25,937 27,263 25,937
Europe and Israel ..................... 174 329,088 174 329,088
Asia .................................. 681 -- 681 --
South America ......................... 10,494 -- 10,494 --
----------- ----------- ----------- -----------
Total ................................ $ 484,608 $ 1,427,080 $ 484,608 $ 1,427,080
=========== =========== =========== ===========
3. Restructuring and Asset Write-offs
The Company incurred restructuring charges in the amount of $9.1 million
and write-down of impaired assets in the amount of $1.6 million for the nine
months ended September 30, 2001. Of the total restructuring charges, $2.9
million relates to employee termination costs covering 293 technical,
production, and administrative employees. The remaining $6.2 million
restructuring charge relates to contract cancellations and costs for excess
leased facilities. As of September 30, 2001, 194 employees have been terminated
and the Company paid $0.5 million in termination costs. In addition, $1.2
million has been charged against the restructuring liability for the excess
leased facilities. For the three months ended September 30, 2001, the Company
incurred $5.1 million of restructuring costs and write-downs of impaired assets
in the amount of $0.2 million. The total includes $2.4 million of employee
termination costs and $2.7 million of contract cancellations and costs
9
for excess leased facilities. At September 30, 2001, restructuring charges of
$7.4 million remain accrued, primarily related to employee terminations and
excess facility costs. The Company anticipates that the termination costs will
be substantially paid in the fourth quarter of 2001. The Company anticipates the
remaining restructuring accrual relating to excess leased facilities will be
utilized for servicing operating lease payments or negotiated buyout of
operating lease commitments, the terms of which will expire in 2005.
Restructuring costs are summarized below (in millions):
Excess Leased
Involuntary Facilities and
Terminations cancelled contracts Total
------------ ------------------- -----
Balance at December 31, 2000 $0.0 $0.0 $0.0
Additions 0.5 2.4 2.9
Cash Payments (0.5) -- (0.5)
---- ---- ----
Balance at March 31, 2001 -- 2.4 2.4
==== ==== ====
Additions -- 1.1 1.1
Cash Payments -- -- --
---- ---- ----
Balance at June 30, 2001 -- 3.5 3.5
==== ==== ====
Additions 2.4 2.7 5.1
Cash Payments -- (1.2) (1.2)
---- ---- ----
Balance at September 30, 2001 $2.4 $5.0 $7.4
==== ==== ====
In March 2001, the Company evaluated the carrying value of certain
long-lived assets and acquired intangibles, consisting primarily of goodwill
recorded on its balance sheet. Pursuant to accounting rules, the majority of the
goodwill was recorded based on stock prices at the time acquisition agreements
were executed and announced. Goodwill and other long-lived assets are reviewed
for impairment whenever events such as product discontinuance, plant closures,
product dispositions or other changes in circumstances indicate that the
carrying amount may not be recoverable. When such events occur, the Company
compares the carrying amount of the assets to undiscounted expected future cash
flows. If this comparison indicates that there is an impairment, the amount of
the impairment is based on the fair value of the assets, typically calculated
using discounted expected future cash flows. The discount rate applied to these
cash flows is based on the Company's weighted average cost of capital, which
represents the blended after-tax costs of debt and equity.
Downturns in the broadband services and telecommunications markets
created unique circumstances with regard to the assessment of goodwill and other
intangible assets for recoverability. As a result of management's decision to
suspend certain product lines and product development efforts during the first
quarter of 2001, intangible assets totaling $165.8 million relating to certain
acquisitions were written off. Further, the aforementioned downturns in the
principal markets in which the Company operates, have negatively impacted the
forecasted revenues and cash flows from certain other businesses acquired during
fiscal 1999 and 2000. In accordance with the Company's policy, the comparison of
the discounted expected future cash flows to the carrying amount of the related
intangible assets resulted in a write-down of these assets of $405.9 million
during the first quarter of 2001.
4. Convertible Subordinated Notes
In February 2001, the Company repurchased approximately $195.6 million
of its Convertible Subordinated Notes for $68.5 million in cash, resulting in a
pretax extraordinary gain of approximately $121.5 million. In addition, in July
and August 2001, the Company repurchased approximately $104.3 million of its
Convertible
10
Subordinated Notes for $45.0 million in cash, resulting in an extraordinary gain
of approximately $51.8 million net of tax.
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with
our consolidated financial statements and notes thereto.
Overview
We develop, market and sell broadband access systems that enable cable
operators and other providers of broadband services to cost-effectively deploy
reliable voice, video and data services over cable, copper wire and satellite
systems.
Since our inception in January 1993, we have focused on the development
of our patented S-CDMA (Synchronous Code Division Multiple Access) technology,
as well as certain other core technologies, to enable broadband transmission of
data over cable networks. We began the specification and design of our first
ASIC (Application Specific Integrated Circuit) in October 1994 and produced the
first version of this ASIC in September 1996. At the same time, we developed an
end-to-end broadband access system, the TeraComm system, around the ASIC. We
commenced volume shipments of our TeraComm system in the first quarter of 1998.
We sell our products to cable operators and other providers of broadband
services through direct sales forces in North America, South America, Europe and
Asia. We also distribute our products via distributors and system integrators.
Our strategy is to supply the leading providers of broadband services worldwide.
Consistent with this strategy, our initial target market consisted of the ten
largest cable companies in each major geographic area. In most markets, a small
number of large cable operators often provide services to a majority of the
subscribers in a specific region and thus influence the purchase decisions of
smaller cable operators. In North America, two large cable operators, Rogers
Cable Inc. (formerly Rogers Cablesystems Limited)(Rodgers) and Shaw
Communications Inc. (Shaw) are using our TeraComm system. In Europe, our
TeraComm system is being used by UPC, one of Europe's largest broadband
communications companies. In the United Kingdom, our DOCSIS modems are being
used by NTL. In Asia, Sumitomo Corporation (Sumitomo, through its Crossbeam
affiliate, is our distribution partner in Japan and we sell directly to other
Asian customers such as Hong Kong Cable. In South America, GloboCabo has
implemented our S-CDMA sytem. Our Telco products are sold to major ILEC's
(Incumbent Local Exchange Carriers) in the United States, CLEC's (Competitive
Local Exchange Carriers), and IXC's (Independent Exchange Carriers. Some of our
major telco customers include ILEC's in the U.S. including Southwestern Bell
Communications, Qwest Communications and Verizon and CLEC's including Nuvox and
Century Tel. Due to the nature of the cable industry and our strategic focus, a
small number of customers have accounted for the majority of our revenues to
date, and we expect that the majority of our revenues will continue to be
generated from a small number of customers for the foreseeable future. We
anticipate that the timing and maturity of these customers' deployments of the
TeraComm system will result in variations in revenues generated from these
customers.
With the evolution of broadband, cable operators, providers of telephone
service and other service providers seek to provide a bundle of voice, data and
video services to their residential and commercial subscribers over existing and
new infrastructures. Through a series of acquisitions in 1999 and 2000, we
expanded our portfolio of broadband access products to support high-speed
delivery of voice, data and video services over cable, DSL and wireless systems.
For more information relating to the acquisitions, see Note 15,
"Business Combinations" of the Notes to Consolidated Financial Statements in our
Form 10-K405 Annual Report for the year ended December 31, 2000. All of our
acquisitions were accounted for under the purchase method of accounting and,
accordingly, this Report on Form 10-Q presents our financial results through the
entire period and combined with results from the acquired entities for the
portion of the period following the
11
date of the respective closings. As a result, the information contained herein
may not be comparable to results in previous periods.
The intensely competitive nature of the market for broadband access
systems has resulted in significant price erosion over time. We have experienced
and expect to continue to experience downward pressure on our unit ASPs (Average
Selling Price). A key component of our strategy is to decrease the cost of
manufacturing our products to offset the decline in ASP. We intend to continue
to implement cost reduction efforts, including the further integration of ASIC
components, other design changes and manufacturing efficiencies.
We sustained a net loss of $557.6 million for the nine months ended
September 30, 2001, which included an extraordinary gain of $173.3 million from
the Company's repurchase of its Convertible Subordinated Notes. We had an
accumulated deficit of $886.8 million as of September 30, 2001. Our operating
expenses are based in part on our expectations of future sales, and we expect
that a significant portion of our expenses will be committed in advance of
sales. We expect to continue to invest in technical development and sales and
marketing as we engage in activities related to product enhancement, cost
reduction and increasing market penetration. Additionally, we expect to increase
our capital expenditures and other operating expenses in order to support our
operations. We anticipate that we will spend approximately $15 million to $20
million on capital expenditures and approximately $80 million to $90 million on
research and development during the year ending December 31, 2001. Anticipated
capital expenditures consist of purchases of test equipment to support our
research and development efforts and new product introduction.
Results of Operations
Three Months and Nine Months Ended September 30, 2001 and 2000
Revenues. Revenues consist primarily of sales of broadband access
systems to new and existing customers providing broadband services over cable
and copper wire infrastructures. Our revenues decreased to $79.6 million for the
three months ended September 30, 2001 from $125.3 million in 2000 and to $199.6
million for the nine months ended September 30, 2001 from $276.7 million in
2000. The decreased revenues in 2001 are largely attributable to the economic
slowdown, which has affected and continues to affect our customers' sales and
their rebalancing of their inventory levels.
We sell our products directly to broadband service providers,
distributors and system integrators. Revenues related to product sales are
generally recognized when: (1) persuasive evidence that an arrangement exists,
(2) delivery has occurred or services have been rendered, (3) the price is fixed
or determinable and (4) collectablity is reasonably assured. A provision is made
for estimated product returns as product shipments are made. Our existing
agreements with our system integrators and distributors do not contain price
protection provisions and do not grant return rights beyond those provided by
our standard warranty.
Cost of Goods Sold. Cost of goods sold consists of direct product costs
as well as the cost of our manufacturing operations group. The cost of the
manufacturing operations group includes assembly, test and quality assurance for
products, warranty costs and associated costs of personnel and equipment. In the
three months ended September 30, 2001, we incurred cost of goods sold of $69.2
million compared to $91.1 million in 2000. In the nine months ended September
30, 2001, we incurred cost of goods sold of $205.6 million compared to $201.6
million in 2000. Cost of goods sold for the three months and nine months ended
September 30, 2001 also included approximately $.85 million and $13.3 million,
respectively, of amortization of acquired intangible assets as compared to $9.3
million and $24.1 million, respectively, for the same periods in 2000. Cost of
related party product revenues consists of direct product costs. Our cost of
goods sold decreased in the three months ended September 30, 2001, compared to
2000, due to lower demand for our products. In the three and nine months ended
September 30, 2001, the Company recorded charges of $6.4 million and $35.1
million, respectively, relating to additional inventory reserves and vendor
cancellation charges.
Gross Profit. We had a gross profit of $10.4 million and a gross loss of
$6.2 million for the three months and nine months ended September 30, 2001,
respectively,
12
compared to a gross profit of $34.2 million and $75.1 million for the same
periods in 2000. Gross profit for the three months and nine months of 2001
declined as the result of lower revenues, additional inventory reserves and
vendor cancellation charges.
Our gross profit is also influenced by the sales mix of TeraLink Master
Controllers, TeraLink Gateways and TeraPro cable modems and the maturity of
TeraComm system deployments in any quarter. TeraPro cable modems have lower
margins than the TeraLink Master Controllers and TeraLink Gateway headend
products. New deployments of TeraComm systems typically include a higher mix of
headend equipment and involve smaller quantities of product sold. Products sold
in connection with new deployments thus generally are sold at higher margins
than products associated with more mature deployments of the TeraComm system,
which generally involve larger quantities of products, primarily cable modems.
We expect that the introduction of new customers and the sales mix of revenues
generated from the sale of TeraPro cable modems to our overall revenues will
result in fluctuations in our gross profit in future periods.
Research and Development. Research and development expenses consist
primarily of personnel costs, as well as prototype material expenditures and
equipment and supplies required to develop and to enhance our products. Research
and development expenses increased to $20.2 million and $61.9 million in the
three months and nine months ended September 30, 2001, respectively, from $19.5
million and $46.6 million for the same periods in 2000. Workforce intangible
amortization in the three months and nine months accounted for approximately
$1.1 million and $4.3 million, respectively, of the increase. We believes it is
critical to continue to make significant investments in research and development
to ensure the availability of innovative technology that meets the current and
future requirements of its customers. Accordingly, we expects in future years to
continue to devote substantial resources to research and development programs.
Cost of Product Development Assistance Agreement. In March 1999, we
entered into a one-year Product Development Assistance Agreement with Rogers
(Development Agreement). Under the terms of the Development Agreement, Rogers
was obligated to assist us with the characterization and testing of our
subscriber-end and head-end voice-over-cable equipment. In addition, Rogers was
obligated to provide us with technology to assist us with our efforts to develop
high quality, field proven technology solutions that are DOCSIS-compliant and
packet cable-compliant. The Development Agreement had a term of one year. In
consideration of Rogers entering into the Development Agreement, we issued
Rogers two fully vested and non-forfeitable warrants, each to purchase 2.0
million shares of common stock on a cashless basis. One warrant had an exercise
price of $0.50 per share and one warrant had an exercise price of $18.50 per
share. The fair value of the two warrants was approximately $45.0 million and
resulted in a non-cash charge included in operating expenses over the one-year
term of the Development Agreement. As a result of the Development Agreement, our
results for the nine months ended September 30, 2000 include non-cash charges of
$9.6 million compared to none in 2001. In March 2000, Rogers purchased 3,687,618
shares of our common stock on a net exercise basis, resulting in no proceeds to
us.
In-Process Research and Development. The projects identified as
in-process will require additional effort in order to establish technological
feasibility. These projects have identifiable technological risk factors that
indicate that even though successful completion is generally expected, it is not
assured.
In-process technology acquired relating to the acquisition of Telegate
in 2000, valued at approximately $7.5 million, consisted primarily of major
additions to Telegate's core technology, which related to Telegate's planned
development of new features. The majority of the intended functionality of these
new features was not supported by Telegate's existing technology. Intended new
features include: connection on demand functionality to extend the product's
ISDN compatibility; the ability to use cordless technology for either voice or
data applications; and, a subscriber end unit that can be used in multi-dwelling
units. We have decided not to pursue the ability to use cordless technology and
multi-dwelling units.
In-process technology acquired relating to the acquisition of ANE in
2000, valued at approximately $750,000, consisted primarily of additions to
ANE's core technology, which were related to ANE's planned development of new
features. A
13
portion of the intended functionality of these new features was not supported by
ANE's existing technology. The resultant technology is intended to allow the
transmission from a 56 Kbps modem without the loss of transmission rate. This
was completed in 2001.
In-process technology acquired relating to the acquisition of Combox in
2000, valued at approximately $8.0 million consists primarily of additions to
Combox's core technology, which were related to Combox's planned development of
new features. A portion of the intended functionality of these new features was
not supported by Combox's existing technology. We have decided to discontinue
our development efforts in Combox's technology.
In-process technology acquired relating to the acquisition of Internet
Telecom in 2000, valued at approximately $2.6 million, consisted primarily of
additions to Internet Telecom's core technology, which were related to Internet
Telecom's planned development of new features. A portion of the intended
functionality of these new features was not supported by Internet Telecom's
current technology. Intended new features include network management switches
and software to enhance product performance and marketability.
In-process technology acquired relating to the acquisition of Ultracom
in 2000, valued at approximately $1.8 million, consists primarily of additions
to Ultracom's core technology, which were related to Ultracom's planned
development of new features. A portion of the intended functionality of these
new features was not supported by Ultracom's existing technology. We have
decided to discontinue our development efforts in Ultracom's technology.
In-process technology acquired relating to the acquisition of Mainsail
in 2000, valued at approximately $5.0 million, consists primarily of additions
to Mainsail's core technology, which is related to Mainsail's planned
development of new features. A portion of the intended functionality of these
new features was not supported by Mainsail's current technology. The resultant
technology is intended to provide a high capacity CPE (customer premise
equipment) and low cost gateway. This was completed in 2001.
In-process technology acquired relating to the acquisition of Digitrans,
valued at approximately $4.95 million, consists primarily of additions to
Digitrans' core technology, which is related to Digitrans' planned development
of new features. A portion of the intended functionality of these new features
was not supported by Digitrans' technology. Intended new features include a
satellite receiver that can decode up to six DigiCipher programs. This was
completed in 2001.
Except as indicated above, and notwithstanding the Company's
expectations that some of the acquired in-process technology will be
successfully developed, there remain significant technical challenges that must
be continually resolved.
Sales and Marketing. Sales and marketing expenses consist primarily of
salaries and commissions for sales personnel, marketing and support personnel
and costs related to trade shows, consulting and travel. Sales and marketing
expenses increased to $16.1 million and $47.9 million, respectively, in the
three months and nine months ended September 30, 2001 from $13.1 million and
$31.6 million for the same periods in 2000. The increase in sales and marketing
expenses was due to the associated costs from the expansion of personnel and
marketing programs. Workforce intangible amortization in the three months and
nine months accounted for approximately $1.9 million and $3.6 million,
respectively, of the increase. As a result of the economic downturn, which led
to the restructuring charges, we expect sales and marketing expenses to decrease
in the fourth quarter of 2001.
General and Administrative. General and administrative expenses
primarily consist of salary and benefits for administrative officers and support
personnel, travel expenses, legal, accounting and consulting fees. General and
administrative expenses increased to $8.1 million and $24.7 million for the
three months and nine months ended September 30, 2001, respectively, from $8.0
million and $18.0 million the same periods in 2000. During the quarter, the
expenses were flat due to the reduced requirement to invest in our
infrastructure offset by an increase in personnel costs in 2001. The
amortization of intangibles amounted to $1.1 million and $3.4 million for the
three and nine months ended. As a result of the economic
14
downturn, which led to the restructuring, we expect general and administrative
expenses to decrease in the fourth quarter of 2001.
Goodwill Amortization. The goodwill amortization significantly decreased
to $0.15 million and $23.0 million for the three and nine months ended September
30, 2001 compared to $17.6 million and $39.2 million for the same periods in
2000. This decrease was due to the impairment of goodwill in the first quarter
of 2001.
Restructuring Costs and Asset Write-offs. The Company incurred
restructuring charges in the amount of $9.1 million and write-down of impaired
assets in the amount of $1.6 million for the nine months ended September 30,
2001. Of the total restructuring charges, $2.9 million relates to employee
termination costs covering 293 technical, production, and administrative
employees. The remaining $6.2 million restructuring charge relates to contract
cancellations and costs for excess leased facilities. As of September 30, 2001,
194 employees have been terminated and the Company paid $0.5 million in
termination costs. In addition, $1.2 million has been charged against the
restructuring liability for the excess leased facilities. For the three months
ended September 30, 2001, the Company incurred $5.1 million of restructuring
costs and write-downs of impaired assets in the amount of $0.2 million. The
total includes $2.4 million of employee termination costs and $2.7 million of
contract cancellations and costs for excess leased facilities. At September 30,
2001, restructuring charges of $7.4 million remain accrued, primarily related to
employee terminations and excess facility costs. We anticipate that the
termination costs will be substantially paid in the fourth quarter of 2001. We
anticipate the remaining restructuring accrual relating to excess leased
facilities will be utilized for servicing operating lease payments or negotiated
buyout of operating lease commitments, the terms of which will expire in 2005.
In March 2001, the Company evaluated the carrying value of certain
long-lived assets and acquired intangibles, consisting primarily of goodwill
recorded on its balance sheet. Pursuant to accounting rules, the majority of the
goodwill was recorded based on stock prices at the time acquisition agreements
were executed and announced. Goodwill and other long-lived assets are reviewed
for impairment whenever events such as product discontinuance, plant closures,
product dispositions or other changes in circumstances indicate that the
carrying amount may not be recoverable. When such events occur, the Company
compares the carrying amount of the assets to undiscounted expected future cash
flows. If this comparison indicates that there is an impairment, the amount of
the impairment is based on the fair value of the assets, typically calculated
using discounted expected future cash flows. The discount rate applied to these
cash flows is based on the Company's weighted average cost of capital, which
represents the blended after-tax costs of debt and equity.
Downturns in the broadband services and telecommunications markets
created unique circumstances with regard to the assessment of goodwill and other
intangible assets for recoverability. As a result of management's decision to
suspend certain product lines and product development efforts during the first
quarter of 2001, intangible assets totaling $165.8 million relating to certain
acquisitions were deemed to be impaired and were written off. Further, the
aforementioned downturns in the principal markets in which the Company operates,
have negatively impacted the forecasted revenues and cash flows from certain
other businesses acquired during fiscal 1999 and 2000. In accordance with the
Company's policy, the comparison of the discounted expected future cash flows to
the carrying amount of the related intangible assets resulted in a write-down of
these assets of $405.9 million during the first quarter of 2001.
Interest Income and Expense. Interest income was $3.3 million and $14.6
million for the three months and nine months ended September 30, 2001,
respectively, compared to $7.6 million and $11.0 million for the same periods in
2000. Interest expense was $2.4 million and $12.4 million for the three months
and nine months ended September 30, 2001, respectively, compared to $4.6 million
and $4.9 million for the same periods in 2000. The increases to interest income
and interest expense were due to the sale in July 2000 of $500 million of 5%
Convertible Subordinate Notes due in August 2007, resulting in net proceeds to
us of approximately $484.5 million. During 2001, we repurchased approximately
$299.9 million in principal of the notes, resulting in an extraordinary gain of
approximately $173.3 million. This repurchase will reduce interest income and
expense in future periods.
15
Other Income and Expense. Other income and expense for the three months
ended September 30, 2001 consisted of approximately $0.7 million of income that
relates to the amortization of debt costs and foreign currency translation. For
the nine months ended September 30, 2001 other expense in the amount of $0.8
million was due to amortization of debt costs offset by interest received from a
foreign customer.
Income Taxes. We have generated operating losses since our inception.
For the three months ended September 30, 2001 we had a benefit from income taxes
of $0.4 million. For the nine months ended September 30, 2001, we had a benefit
of $14.0 million. There were no provisions for income taxes in the comparable
periods in 2000.
Operating Segment Information
We view our business as having two principal operating segments: Cable
Systems and Telecom Systems. The Cable segment consists primarily of the
TeraComm system, the CherryPicker Digital Video Management Systems and the
Multigate Telephony and Data Access Systems which are sold primarily to cable
operators for the deployment of data, video and voice services over the existing
cable infrastructure. The Telecom segment consists primarily of the Miniplex DSL
Systems, the IPTL Converged Voice and Data Service System, the Highlink Router
and the Multi-serve, Function Access Platforms, which are sold to providers of
broadband services for the deployment of voice and data services over the
existing copper wire infrastructure. We sell directly to providers of broadband
access services and to distributors and resellers throughout the world.
Cable. In 2001, the revenues for the cable segment were largely
attributable to continuing deployments of our TeraComm system by new and
existing customers. In addition, sales of acquired products contributed to the
revenues. Operating losses increased as a result of the write-down of the
intangibles and charges for inventory reserves and vendor cancellations.
Revenues decreased as a result of lower demand.
Telecom. Revenues and operating losses in 2001 were attributable to the
operations of Radwiz, acquired in November 1999, ANE, acquired in April 2000 and
Mainsail, acquired in September 2000. Operating losses increased as a result of
the write-down of the intangibles and charges for inventory reserves and vendor
cancellations. Revenues decreased as a result of lower demand.
Litigation
In September 1999, a group of prospective investors in Imedia
Corporation (Imedia), now our subsidiary, named Imedia as a defendant in an
action alleging that Imedia breached its term sheet with the plaintiffs when
Imedia negotiated its acquisition by us and, as a result, did not permit
plaintiffs to invest in Imedia. The plaintiffs are seeking damages in excess of
$12.0 million. The terms of the Imedia Agreement and Plan of Merger and
Reorganization provided that shares of our common stock that were to be issued
to the former shareholders of Imedia were placed in escrow to indemnify us for
any damages that are directly or indirectly suffered by us as a result
plaintiffs' claims. The value of the escrowed shares was approximately $10.0
million based on the market value of our common stock on or about the closing
date of the acquisition.
On or about September 5, 2000, the Company received an amended complaint
("Complaint") in a matter captioned Evergreen Canada Israel Management, Ltd. v.
Imedia Corporation, case no. 306185, pending in the Superior Court of the State
of California for the City and County of San Francisco. The Complaint alleges
both (i) intentional interference with contractual relations and (ii)
intentional interference with prospective economic advantage against us,
claiming that the Company formed and operated a conspiracy to deprive plaintiffs
of the opportunity to invest in Imedia. Plaintiffs argue that, prior to our
purchase of the Imedia shares, we knew of an alleged, pre-existing financing
agreement between plaintiffs and Imedia that contained a "no shop" clause,
prohibiting Imedia from seeking or obtaining financing from any other sources,
including (apparently, in plaintiffs' view) a prohibition against Imedia selling
its own stock or engaging in related transactions that preceded the acquisition.
The Company was subsequently served with the Complaint and filed a demurrer
challenging the legal sufficiency of the two causes of action. Other defendants
demurred also. The demurrer hearing was held on
16
January 16, 2001. Prior to the Court issuing a final ruling at that hearing,
Plaintiffs agreed to amend their complaint. Plaintiffs filed a second amended
complaint and, in response, we (and all other defendants) filed demurrers
challenging all the causes of action. The Company's demurrer was heard on May
22, 2001, and the Court ruled (by subsequent written decision) that three
contract claims and the tortious interference with the prospective economic
advantage claims should be dismissed. The Court also dismissed the two fraud
claims with leave to amend.
The Plaintiffs have now filed a third amended complaint, and the
defendants each have filed demurrers challenging that pleading. A hearing date
set on November on the demurrers set on the demurrers for March 18, 2002. We
have reviewed the amended allegations made by the plaintiffs, and we intend to
vigorously defend the lawsuit. We do not believe that the outcome will have a
negative impact on our financial position, results of operations or cash flows.
Beginning in April 2000, several plaintiffs filed lawsuits against us
and certain of our officers and directors in federal court. The plaintiff in
the first of these lawsuits purported to represent a class whose members
purchased our securities between February 2, 2000 and April 11, 2000. The
complaint alleged that the defendants had violated the federal securities laws
by issuing materially false and misleading statements and failing to disclose
material information regarding our technology. The allegations in the other
lawsuits were substantially the same and, on August 24, 2000, all of these
lawsuits were consolidated in the United States District Court, Northern
District of California. The consolidated lawsuit is named In re Terayon
Communication Systems, Inc. Securities Litigation, Case No. C 00-1967-MHP. The
court hearing the consolidated action has appointed lead plaintiffs and lead
plaintiffs' counsel pursuant to the Private Securities Litigation Reform Act.
On September 21, 2000, the lead plaintiffs filed a consolidated class
action complaint containing factual allegations nearly identical to those in
the original lawsuits. The consolidated class action complaint, however,
alleged claims on behalf of a class whose members purchased or otherwise
acquired our securities between November 15, 1999 and April 11, 2000. On
October 30, 2000, defendants moved to dismiss the consolidated class action
complaint. On March 14, 2001, after defendants motion had been fully briefed
and argued, the court issued an order granting in part defendants' motion and
giving plaintiffs leave to file an amended complaint. On April 13, 2001,
plaintiffs filed their first amended consolidated class action complaint. On
June 15, 2001, defendants moved to dismiss this new complaint and, as of August
24, 2001, defendants' motion is fully briefed. The motion to dismiss is
currently set for oral argument on December 17, 2001.
The lawsuit seeks an unspecified amount of damages, in addition to other
forms of relief. We consider the lawsuits to be without merit and we intend to
defend vigorously against these allegations. However, the litigation could prove
to be costly and time consuming to defend, and there can be no assurances about
the eventual outcome.
On October 16, 2000, a lawsuit was filed against the Company and the
individual defendants (Zaki Rakib, Selim Rakib, and Raymond Fritz) in the
superior court of San Luis Obispo County, California. This lawsuit is titled
Bertram v. Terayon Communications Systems, Inc., Case No. CV 000900. The Bertram
complaint contains factual allegations similar to those alleged in the federal
securities class action lawsuit. The complaint asserts causes of action under
California Business & Professions Code Sections 17200 et seq. and 17500 et seq.
for unlawful business practices, unfair and fraudulent business practices, and
false and misleading advertising. Plaintiffs purport to bring the action on
behalf of themselves and as representatives of "all persons or entities in the
State of California and such other persons or entities outside California that
have been and are adversely affected by defendants' activity, and as the Court
shall determine is not inconsistent with the exercise of the Court's
jurisdiction." Plaintiffs seek equitable and injunctive relief. Defendants filed
a motion to dismiss the complaint on January 19, 2001. A hearing on defendants'
motion was held March 26, 2001 and the court granted Defendants' motion to
dismiss the action and denied Plaintiffs' motion requesting remand. On April 5,
2001, Defendants moved for an order requiring further proceedings, if any to
take place in the Northern District of California. Plaintiffs
17
did not oppose this motion and eventually entered into a stipulation to go
forward in the Northern District. On July 9, 2001, a status conference was held
in this case before Judge Patel. Plaintiffs did not appear for the conference,
and the court requested that defendants submit an order dismissing the Bertram
action with prejudice, which the defendants have submitted to the court. The
Company believes that these allegations, as with the allegations in the federal
securities case, are without merit and intends to contest the matter vigorously.
Liquidity and Capital Resources
At September 30, 2001, we had approximately $141.9 million in cash and
cash equivalents, $180.2 million in short-term investments and a $2.5 million
revolving line of credit. There were no outstanding borrowings under the line of
credit.
In July 2000, we issued $500 million of 5% Convertible Subordinated
Notes due in August 2007, resulting in net proceeds to us of approximately
$484.5 million. The notes are our general unsecured obligation and are
subordinated in right of payment to all of our existing and future senior
indebtedness and to all of the liabilities of our subsidiaries. The Convertible
Notes are convertible into shares of our common stock at a conversion price of
$84.01 per share at any time on or after October 24, 2000 through maturity,
unless previously redeemed or repurchased. Interest is payable semiannually.
Debt issuance costs related to the notes were approximately $15.5 million.
In February 2001, we repurchased approximately $195.6 million of the
Convertible Subordinated Notes for $68.5 million in cash, resulting in a pretax
extraordinary gain of approximately $121.5 million. In addition, in July and
August 2001, we repurchased approximately $104.3 million of the Convertible
Subordinated Notes for $45.0 million in cash, resulting in an extraordinary gain
of approximately $51.8 million.
Cash used in operating activities for the nine months ended September
30, 2001 was $113.6 million compared to $5.8 million used in 2000. The increase
is primarily as a result of lowering our accounts payable by 75.2 million. Cash
provided by investing activities was $19.0 million in 2001 compared to cash used
of $294.1 million in 2000. Investing activities consisted primarily of the
purchase and sale of short-term investments in 2001 and 2000. Cash used in
financing activities was $110.5 million in 2001 compared to cash provided of
$497.3 million in 2000. In 2001, financing activities consisted primarily of
payments made to retire some of our convertible subordinated notes as well as
proceeds from the exercise of options. In 2000, financing activities consisted
primarily of proceeds from the issuance of Convertible Subordinated Notes and
the issuance of common stock as well as proceeds from the exercise of options.
As of September 30, 2001, we had provisions for $69.7 million of
purchase obligations. We anticipate that these obligations will become payable
at various times through mid-2002. We intend to make these payments out of
available working capital. In the fourth quarter of 2000 and second quarter and
third of 2001, we recorded special charges of $19.0 million and $10.3 million
for vendor cancellation fees relating to purchase obligations. In May 2001, we
entered into a $200,000 irrevocable letter of credit to fulfill our lease
obligation in one of our leased facilities to return the premises to original
condition. Furthermore, in June 2001, we established an irrevocable letter of
credit with a supplier in the amount of $20.9 million for purchase commitments.
The letter of credit will expire in November 2001.
We believe that our current cash balances will be sufficient to satisfy
our cash requirements for at least the next 12 months. This estimate is a
forward-looking statement that involves risks and uncertainties, and actual
results may vary as a result of a number of factors, including those discussed
under "Our Operating Results May Fluctuate" below and elsewhere herein. We may
need to raise additional funds in order to support more rapid expansion, develop
new or enhanced services, respond to competitive pressures, acquire
complementary businesses or technologies or respond to unanticipated
requirements. We may seek to raise additional funds through private or public
sales of securities, strategic relationships, bank debt, financing under leasing
arrangements or otherwise. If additional funds are raised
18
through the issuance of equity securities, the percentage ownership of the
stockholders of the Company will be reduced, stockholders may experience
additional dilution or such equity securities may have rights, preferences or
privileges senior to those of the holders of our common stock. There can be no
assurance that additional financing will be available on acceptable terms, if at
all. If adequate funds are not available or are not available on acceptable
terms, we may be unable to develop our products, take advantage of future
opportunities or respond to competitive pressures or unanticipated requirements,
which could have a material adverse effect on our business, financial condition
and operating results.
Recent Financial Accounting Pronouncements
On June 29, 2001, the Financial Accounting Standards Board approved the
issuance of Statements of Financial Accounting Standards (SFAS) No. 141,
"Business Combinations" and No. 142, "Goodwill and Other Intangible Assets."
SFAS 141, which is effective for all business combinations subsequent to July 1,
2001, eliminates the pooling-of-interests method of accounting for business
combinations and includes new criteria to recognize intangible assets separately
from goodwill. Under Statement 142, goodwill and other intangible assets with
indefinite lives are no longer amortized but are reviewed at least annually for
impairment. Separable intangible assets that are deemed to have a definite life
will continue to be amortized over the estimated useful life. SFAS 142 is
effective with respect to the non-amortization of goodwill and certain
intangible assets on January 1, 2002 for amounts currently recorded on Terayon's
balance sheet and will apply to any goodwill and certain intangible assets
acquired after June 30, 2001. At September 30, 2001 goodwill approximated $2.7
million. Goodwill amortization was $0.15 million and $23.0 million for the three
and nine months ended September 30, 2001, respectively.
In August 2001, the FASB issued Statements of Financial Accounting
Standards No. 144, "Accounting for the Impairment or Disposal of Long-Lived
Assets", effective for fiscal years beginning after December 15, 2001.
The Company is currently evaluating the impact of these statements on
our operations. Any impairment resulting from our initial adoption of these
statements will be recorded as a cumulative effect of accounting change as of
January 1, 2002. The Company does not anticipate that the adoption of the new
rules will have a material impact on its earnings or financial position.
In June 1998, the FASB issued Statement No. 133, "Accounting for
Derivative Instruments and Hedging Activities" (SFAS 133) which establishes
accounting and reporting standards for derivatives instruments and hedging
activities. The statement requires recognition of all derivatives at fair value
in the financial statements. FASB Statement No. 137 "Accounting for Derivative
Instruments and Hedging Activities Deferral of the Effective Date of FASB
Statement No. 133," an amendment of FASB Statement No. 133, defers
implementation of SFAS No. 133 until fiscal years beginning after June 15, 2000.
The Company has adopted the standard effective January 1, 2001. The adoption of
SFAS 133 did not affect the Company's financial condition or results of
operations.
RISK FACTORS
You should carefully consider the risks described below before making an
investment decision. The risks and uncertainties described below are not the
only ones facing our company. Additional risks and uncertainties not presently
known to us or that we currently deem immaterial also may impair our business
operations. If any of the following risks actually occur, our business could be
harmed. In such case, the trading price of our common stock could decline, and
you may lose all or part of your investment.
We Have a Limited Operating History and a History of Losses.
We have a limited operating history, and it is difficult to predict our
future operating results. We began shipping products commercially in June 1997,
and we have been shipping products in volume since the first quarter of 1998. As
of
19
September 30, 2001, we had an accumulated deficit of $886.8 million. We believe
that we will continue to experience net losses for the foreseeable future. We
generally are unable to reduce our expenses significantly in the short term to
compensate for any unexpected delay or decrease in anticipated revenues. In
addition, significant delays in our commercialization of new products may
adversely affect our business. Moreover, even though we have experienced
significant revenue growth since our inception, the profit potential of our
business remains unproven.
Our Operating Results May Fluctuate.
Our quarterly revenues are likely to fluctuate significantly in the
future due to a number of factors, many of which are outside our control.
Factors that could affect our revenues include the following:
- Variations in the timing of orders and shipments of our products;
- Variations in the size of the orders by our customers;
- New product introductions by competitors;
- Delays in our introduction of new products;
- Delays in our receipt of and cancellation of orders forecasted by
customers;
- Delays by our customers in the completion of upgrades to their cable
infrastructures;
- Variations in capital spending budgets of broadband access service
providers;
- Adoption of industry standards and the inclusion in or compatibility
of our technology with any such standards; and
A variety of factors affect our gross margin, including the following:
- The sales mix of our products;
- The volume of products manufactured;
- The type of distribution channel through which we sell our products;
- The average selling prices, or ASP, of our products; and
- The costs of manufacturing our products and the effectiveness of our
cost reduction measures.
We anticipate that unit ASPs of our products will continue to decline in
the future. This could cause a decrease in the gross margins for these products.
In addition, the gross margins we realize from the sale of our products are
affected by the mix of product sales between higher margin, lower volume headend
equipment and lower margin, higher volume consumer premise equipment (CPE). We
typically sell more headend equipment in connection with new deployments of our
cable data access systems. As deployments mature, we tend to sell more CPE into
the deployments compared to headend equipment. Sales of our CPE have
constituted, and we expect will continue to constitute, a significant portion of
our revenues for the foreseeable future.
Our expenses generally vary from quarter to quarter depending on the
level of actual and anticipated business activities. Research and development
expenses will vary as we begin development of new products and as our
development programs move to wafer fabrication and prototype development, which
results in higher engineering expenses.
We also anticipate that our operating results will be impacted by sales,
gross profit and operating expenses of any acquired companies.
20
We Are Dependent on a Small Number of Customers.
Three customers (one of which is a related party) accounted for
approximately 62% of our revenues for the three months ended September 30, 2001
and three customers (two of which are related parties) accounted for
approximately 50% of our revenues for the three months ended September 30, 2000.
Two customers accounted for approximately 46% of our revenues for the nine
months ended September 30, 2001 and three customers (two of which are related
parties) accounted for approximately 51% of our revenues for the nine months
ended September 30, 2000. We believe that a substantial majority of our revenues
will continue to be derived from sales to a relatively small number of customers
for the foreseeable future. In addition, we believe that sales to these
customers will be focused on a limited number of projects.
The cable industry is undergoing significant consolidation in North
America and internationally, and a limited number of cable operators control an
increasing number of cable systems. Currently, ten cable operators in the United
States own and operate facilities passing approximately 86% of total homes
passed. In addition, the North American DSL market is concentrated with the
major incumbent local exchange carriers (ILECs) constituting a significant
percentage of the market. As a result, our sales will continue to be largely
dependent upon product acceptance by the leading broadband service providers.
Currently, the timing and size of each customer's order is critical to
our operating results. Our major customers are likely to have significant
negotiating leverage and may attempt to change the terms, including pricing,
upon which we do business with them. These customers may decide to purchase
competitive products from other vendors at any time and can reschedule or cancel
purchase orders on short notice. When purchasing product from us, these
customers may also require longer payment terms than we anticipate, which could
require us to raise additional capital to meet our working capital requirements.
Reduced spending in the cable and telecom industries will also have a negative
impact on our operations.
Acquisitions Could Result In Dilution, Operating Difficulties and Other Adverse
Consequences.
We have acquired ten businesses since September 1999: Imedia in
September 1999; Radwiz in November 1999; Telegate in January 2000; assets of ANE
in April 2000; ComBox, Ltd. in April 2000; assets of Internet Telecom in April
2000; Ultracom in April 2000; Mainsail in September 2000; Digitrans in September
2000 and TrueChat in December 2000. The process of integrating these acquired
business into our business and operations has been risky and may create
unforeseen operating difficulties and expenditures going forward. The areas in
which we may face difficulties with these acquisitions include:
- Diversion of management time (both ours and that of the acquired
companies) for the ongoing development of our businesses, issues of
integration and future products;
- Decline in employee morale and retention issues resulting from
changes in compensation, reporting relationships, future prospects or
the direction of the business;
- The need to integrate each company's accounting, management
information, human resource and other administrative systems to
permit effective management, and the lack of control if this
integration is delayed or not implemented; and
- The need to implement controls, procedures and policies appropriate
for a larger group of public companies that prior to acquisition had
been smaller, private companies.
Future acquisitions could result in potentially dilutive issuances of
equity securities, the incurrence of additional debt, contingent liabilities or
21
amortization expenses related to goodwill and other intangible assets, any of
which could harm our business. Future acquisitions also could require us to
obtain additional equity or debt financing, which may not be available on
favorable terms or at all. Even if available, this financing may be dilutive.
The Sales Cycle for Our Products Is Lengthy.
The sales cycle for our products typically is lengthy, often lasting six
months to a year and, in some cases, even longer. Our customers typically
conduct significant technical evaluations of competing technologies prior to the
commitment of capital and other resources. In addition, purchasing decisions may
be delayed because of our customers' internal budget approval procedures. Sales
also generally are subject to customer trials, which typically last more than
three months. Because of the lengthy sales cycle and the large size of
customers' orders, if orders forecasted for a specific customer for a particular
quarter do not occur in that quarter, our revenues and operating results for
that quarter could suffer.
There Are Many Risks Associated with Our Participation in the Establishment of
Advanced Physical Layer Specifications to Be Added to DOCSIS.
In November 1998, CableLabs selected us to co-author DOCSIS 1.2 (Data
Over Cable Service Interface Specifications), an enhanced version of the DOCSIS
cable modem specification based in part on our S-CDMA technology. In September
1999, CableLabs indicated that it intended to proceed with the advanced physical
layer(PHY) work on two parallel tracks: one for the development of a prototype
based on our S-CDMA technology and one for the inclusion of Advanced TDMA
technology (Time Division Multiple Access), as proposed by other companies. In
February 2000, CableLabs expanded on the plans that it had discussed in
September 1999. CableLabs explained that four companies, including us, were
developing an advanced PHY specification based on TDMA. CableLabs also
reiterated that it was continuing to work with us on the development of a DOCSIS
specification that could include our S-CDMA technology. To that end, CableLabs
requested that we submit a prototype of a DOCSIS system that incorporated an
S-CDMA advanced physical layer capability for testing. CableLabs stated that if
the testing of this prototype revealed that the S-CDMA advanced physical layer
worked as claimed (including proper backwards compatibility and coexistence with
the other aspects of DOCSIS), and if the costs for adding S-CDMA to DOCSIS
products were in line with estimates, then it was likely, but not certain, that
S-CDMA advanced physical layer capabilities would be included in a future
version of the DOCSIS specification.
We submitted our prototype incorporating S-CDMA advanced physical layer
and Advanced TDMA technologies to CableLabs in December 2000. Subsequently , we
were asked to provide a complete system for evaluation which we delivered to
CableLabs in June 2001.
In August 2001, CableLabs announced that the efforts begun in November
1998 had culminated in a new DOCSIS standard called DOCSIS 2.0. DOCSIS 2.0
will incorporate two advanced physical layer modulation techniques, S-CDMA and
the Advanced TDMA that four companies, including us, had helped to develop.
CableLabs further announced that it would begin developing the new DOCSIS 2.0
specification immediately, a process that it expects to be completed by the end
of calendar year 2001, with the goal of certifying and qualifying DOCSIS 2.0
based products in 2002.
As part of the development of DOCSIS 2.0, CableLabs has assembled
committees consisting of manufacturers and silicon vendors, including us, to
assess and determine the final DOCSIS 2.0 specification. Neither the submission
of our prototype to CableLabs nor our involvement in the development of the
DOCSIS 2.0 specification guarantees that CableLabs will incorporate our
technology, including the technology incorporated in the prototype we submitted
to CableLabs for testing, into the final DOCSIS 2.0 specifications or any future
DOCSIS specification, which may require us to further develop our prototype.
Moreover, even if our technology is included in the final DOCSIS 2.0
specification, our products may not pass the testing required by CableLabs for
our products to be DOCSIS certified or qualified, which could affect our future
revenues and operating results.
Our future revenues and operating results are likely to suffer if, for
some reason, a modification of our existing proprietary S-CDMA technology is
included in the final DOCSIS 2.0 specifications. We also may incur substantial
additional research and development expenditures to adapt our specifications to
the version adopted by CableLabs. Delays in the establishment of a final
specification for S-
22
CDMA in DOCSIS could harm our plans to sell DOCSIS compatible modems and headend
equipment. In particular, if the final DOCSIS S-CDMA specification is not
approved prior to the time when we are ready to ship DOCSIS products with S-CDMA
features included, then we may be required to delay the introduction of those
products until the DOCSIS S-CDMA specification is released or to introduce the
S-CDMA features as proprietary enhancements to a standard DOCSIS product. Either
one of these events could harm revenues and operating results.
We have already given CableLabs assurances that we will contribute some
aspects of our current proprietary S-CDMA technology to a royalty-free
intellectual property pool to the extent that it is included in the final DOCSIS
2.0 specifications. This royalty-free pool has been established by CableLabs to
facilitate the participation of as many vendors as possible in providing
equipment that is compatible with the DOCSIS specifications. As a result, of the
inclusion of our S-CDMA technology in DOCSIS 2.0, we will contribute certain
aspects of our proprietary S-CDMA to the royalty-free technology pool based on
DOCSIS 2.0 specifications. This means that any of our competitors who join the
DOCSIS intellectual property pool would have access to some aspects of our
technology and would not be required to pay us any royalties or other
compensation for use of our technology. If a competitor is able to duplicate the
functionality and capabilities of our technology, we could lose some or all of
the time-to-market advantage we might otherwise have, which could harm our
future revenues and operating results.
We believe the addition of advanced upstream PHY capabilities to DOCSIS
will increase the overall market for DOCSIS-compatible products, and as such
will result in increased competition in the cable modem market. This competition
could come from existing competitors or from new competitors who enter the
market as a result of the enhancements to the specifications. This increased
competition is likely to result in lower ASPs of cable data access systems and
could harm revenues and gross margins. Because our competitors will be able to
incorporate some aspects of our technology into their products, our current
customers may choose alternate suppliers or choose to purchase DOCSIS-compliant
cable products with advanced PHY capabilities from multiple suppliers. We may be
unable to produce DOCSIS compliant cable products with advanced PHY capabilities
more quickly or at lower cost than our competitors. The inclusion of our
proprietary S-CDMA technology in the final DOCSIS 2.0 specifications could
result in increased competition for the services of our existing employees who
have experience with S-CDMA. The loss of these employees to one or more
competitors could harm our business.
DOCSIS standards have not yet been accepted in Europe and Asia. An
alternate standard for cable data access systems, called the EuroModem standard,
or DAVIC/DVB, has been formalized, and some European cable system operators have
embraced it. We intend to develop and sell products that comply with the
EuroModem standard and to pursue having portions of our S-CDMA technology
included in a future version of the EuroModem standard. We may be unsuccessful
in these efforts.
We Need to Develop New Products in Order to Remain Competitive.
Our future success will depend in part on our ability to develop, market
and sell new products in a timely manner. We also must respond to competitive
pressures, evolving industry standards and technological advances. To be
compliant with the DOCSIS 2.0 specification that is developed, companies must
include both S-CDMA and Advanced TDMA in their products. We are currently
developing products that incorporate S-CDMA and Advanced TDMA for testing. There
is no guarantee that our products will pass testing to be DOCSIS certified or
qualified, and if we are unable to certify or qualify our products as DOCSIS
compliant, we may lose some or all of the time to market advantage we might
otherwise have had.
Although we do sell DOCSIS systems, our S-CDMA products, which were
developed internally, are not DOCSIS compliant. We anticipate that during the
year 2001, existing or potential customers may delay or cancel purchases of our
TeraComm system in order to purchase systems that comply with the DOCSIS
standard. In addition, potential new customers could decide to purchase
DOCSIS-compliant products from one or more of our competitors rather than from
us. In order to promote sales of our current products, we may be required to
reduce our prices for sales to existing customers. This would harm our operating
results and gross margin.
Average Selling Prices of Broadband Access Equipment Typically Decrease.
23
The broadband access systems market has been characterized by erosion of
average selling prices. We expect this to continue. This erosion is due to a
number of factors, including competition, rapid technological change and price
performance enhancements. The ASPs for our products may be lower than expected
as a result of competitive pricing pressures, our promotional programs and
customers who negotiate price reductions in exchange for longer term purchase
commitments. We anticipate that ASPs and gross margins for our products will
decrease over the product life cycles. In addition, we believe that the
widespread adoption of industry standards is likely to further erode ASPs,
particularly for cable modems and other similar consumer premise equipment. It
is likely that the widespread adoption of industry standards will result in
increased retail distribution of cable modems and other similar consumer premise
equipment, which could put further price pressure on our products. Decreasing
ASPs could result in decreased revenues even if the number of units sold
increases. As a result, we may experience substantial period-to-period
fluctuations in future revenue and operating results due to ASP erosion.
Therefore, we must continue to develop and introduce on a timely basis
next-generation products with enhanced functionalities that can be sold at
higher gross margins. Our failure to do this could cause our revenues and gross
margin to decline.
We Must Achieve Cost Reductions.
Certain of our competitors currently offer products at prices lower than
ours. Market acceptance of our products will depend in part on reductions in the
unit cost of our products. We expect that as headend equipment becomes more
widely deployed, the price of cable modems and other similar consumer premise
equipment will decline. In particular, we believe that the widespread adoption
of industry standards such as DOCSIS will cause increased price competition for
consumer premise equipment. However, we may be unable to reduce the cost of our
products sufficiently to enable us to compete with other suppliers. Our cost
reduction efforts may not allow us to keep pace with competitive pricing
pressures and may not lead to gross margin improvement.
Some of our competitors are larger and manufacture products in
significantly greater quantities than we intend to for the foreseeable future.
Consequently, these competitors have more leverage in obtaining favorable
pricing from suppliers and manufacturers. In order to remain competitive, we
must significantly reduce the cost of manufacturing our cable modems through
design and engineering changes. We may not be successful in redesigning our
products. Even if we are successful, our redesign may be delayed or may contain
significant errors and product defects. In addition, any redesign may not result
in sufficient cost reductions to allow us to significantly reduce the list price
of our products or improve our gross margin. Reductions in our manufacturing
costs will require us to use more highly integrated components in future
products and may require us to enter into high volume or long-term purchase or
manufacturing agreements. Volume purchase or manufacturing agreements may not be
available on acceptable terms. We could incur expenses without related revenues
if we enter into a high volume or long-term purchase or manufacturing agreement
and then decide that we cannot use the products or services offered by the
agreement. We have incurred cancellation charges in the past and may incur such
charges in the future.
We Must Keep Pace with Rapid Technological Change to Remain Competitive.
The markets for our products are characterized by rapid technological
change, evolving industry standards, changes in end-user requirements and
frequent new product introductions and enhancements. Our future success will
depend upon our ability to enhance our existing products and to develop and
introduce new products that achieve market acceptance. Providers of broadband
access services may adopt alternative technologies or they may deploy
alternative services that are incompatible with our products.
The demand for broadband access services has resulted in the development
of several competing modulation technologies. For example, some of our cable
products utilize S-CDMA, while several of our competitors utilize TDMA (Time
Division Multiple Access) and Frequency Division Multiple Access or FDMA. Our
S-CDMA headend equipment and cable modem products currently are not
interoperable with the headend equipment and modems of other suppliers of
broadband access products. As a result, potential customers who wish to purchase
broadband access products from multiple
24
suppliers may be reluctant to purchase our products. Regardless of whether our
technology is certified or qualified under DOCSIS standards or other industry
standards, we cannot be certain that major cable operators will adopt these
standards. Major cable operators may not adopt products or technologies based on
any current or future S-CDMA technology. Further, major cable operators may
adopt products or standards technologies based on competing modulation
technologies. If competitors using other modulation technologies can incorporate
functionality and capabilities currently found in S-CDMA, the value of our
S-CDMA technology would be diminished.
Broadband Access Services Have Not Achieved Widespread Market Acceptance, and
Many Competing Technologies Exist.
Our success will depend upon the widespread commercial acceptance of
broadband access services by service providers and end users of broadband access
services. The market for these services is not fully developed. We cannot
accurately predict the future growth rate or the ultimate size of the market for
broadband access services. Potential users of our products may have concerns
regarding the security, reliability, cost, ease of installation and use and
capability of broadband access services in general.
The market for our products may be impacted by the development of other
technologies that enable the provisioning of broadband access services and the
deployment of services over other media. Widespread acceptance of other
technologies or deployment of services over media not supported by our products
could materially limit acceptance of our broadband access systems. Broadband
access services based on our products and technology may fail to gain widespread
commercial acceptance by providers of broadband access services and end users.
We may not be successful in marketing and selling these products.
We Need to Develop Additional Distribution Channels.
We presently market our products to providers of broadband services.
With changes in the industry, we may need to establish new, additional
distribution channels. For example, we believe that much of the North American
market for CPE may shift to a retail distribution model. Accordingly, we may
need to redirect our future marketing efforts to sell our CPE directly to retail
distributors and end users. This shift would require us to establish new
distribution channels for these products.
We face many challenges in establishing these new distribution channels.
- We may be unable to hire the additional personnel necessary to
establish and enhance these new distribution channels.
- To the extent that large consumer electronics companies enter the
cable modem market, their well-established retail distribution
capabilities would provide them with a significant competitive
advantage.
- Our potential customers are likely to prefer purchasing products from
established manufacturing companies that can demonstrate the
capability to supply large volumes of products on short notice.
- In addition, many of our potential customers may be reluctant to
adopt technologies that have not gained acceptance among other
providers of similar services. This reluctance could result in
lengthy product testing and acceptance cycles for our products.
Consequently, the impediments to our initial sales may be even
greater than those to later sales.
The vast majority of our sales are to larger, more established service
providers that are critical to our business. We do not have access to smaller or
geographically diverse broadband service providers. Although we intend to
establish strategic relationships with leading distributors worldwide to access
these customers, we may not succeed in establishing these relationships. Even if
we do establish these relationships, the distributors may not succeed in
marketing our products to their customers. Some of our competitors have already
established, long-standing relationships with these service providers that may
limit our and our distributors' ability to sell our products to those customers.
Even if we were to sell our products to those customers, it would likely not be
based on long-term
25
commitments, and those customers would be able to terminate their relationships
with us at any time.
We Are Dependent on Broadband Service Providers Choosing to Offer Additional
Services to Their Customers.
We depend on service providers to purchase our products. Service
providers have a limited amount of available bandwidth over which they can offer
new services, and they may choose not to provide these new services to their
customers. When service providers choose to provide these new services, we
depend upon them to market these services to their customers, to install our
equipment and to provide support to end-users. In addition, we depend on these
service providers to continue to maintain their infrastructures in a manner that
allows us to provide consistently high performance and reliable services.
Sales of Our Cable Products Are Dependent on the Cable Industry Upgrading to
Two-Way Cable Infrastructure.
Demand for our cable products will depend, to a significant degree, upon
the magnitude and timing of capital spending by cable operators for
implementation of access systems for data transmission over cable networks. This
involves the enabling of two-way transmission over existing coaxial cable
networks and the eventual upgrade to hybrid fiber coaxial (HFC) in areas of
higher penetration of data services. If service providers fail to complete these
upgrades of their cable infrastructures in a timely and satisfactory manner, the
market for our products could be limited. In addition, few businesses in the
United States currently have cable access. Service providers may not choose to
upgrade existing residential cable systems or to install new cable systems to
serve business locations.
The success and future growth of our cable business will be subject to
economic and other factors affecting the cable television industry generally,
particularly its ability to finance substantial capital expenditures. Capital
spending levels in the cable industry in the United States have fluctuated
significantly in the past, and we believe that such fluctuations will occur in
the future. We are currently experiencing reduced levels of spending in the
cable industry. The capital spending patterns of cable operators are dependent
on a variety of factors, including the following:
- The availability of financing;
- Annual budget cycles, as well as the typical reduction in upgrade
projects during the winter months;
- The status of federal, local and foreign government regulation and
deregulation of the telecommunications industry;
- Overall demand for broadband services;
- Competitive pressures (including the availability of alternative data
transmission and access technologies);
- Discretionary consumer spending patterns; and
- General economic conditions.
In recent years, the United States cable market has been characterized
by the acquisition of smaller and independent cable operators by larger service
providers. We cannot predict the effect, if any, that such consolidation will
have on overall capital spending patterns by service providers. The effect on
our business of further industry consolidation also is uncertain.
Supply of Our Products Depends On Our Ability to Forecast Demand
Accurately.
The emerging nature of the broadband access services market makes it
difficult for us to forecast accurately demand for our products. Our inability
to
26
forecast accurately the actual demand for our products may result in too much or
too little supply of product or an over/under capacity of manufacturing or
testing resources at any given point in time. The existence of any one or more
of these situations could have a negative impact on our business, operating
results or financial condition. We had purchase obligations of approximately
$69.7 million as of September 30, 2001, primarily to purchase minimum quantities
of materials and components used to manufacture our products. We must fulfill
these obligations even if demand for our products is lower than we anticipate.
Our Business May Be Affected By the Conditions In Israel.
Our operations may be affected by the conditions in Israel because a
number of our wholly owned subsidiaries are located there. Since the
establishment of the State of Israel in 1948, a number of armed conflicts have
taken place between Israel and its Arab neighbors and a state of hostility,
varying in degree and intensity, has led to security and economic problems for
Israel. Hostilities within Israel have continued to escalate over the past year,
which could disrupt some of our operations. We could be adversely affected by
any major hostilities involving Israel. As a result of the hostilities and
unrest presently occurring within Israel, the future of the peace efforts
between Israel and its Arab neighbors is uncertain. A number of our employees
based in Israel are currently obligated to perform annual reserve duty and are
subject to being called to active duty at any time under emergency
circumstances. Our business cannot assess the full impact of these requirements
on our workforce or business if conditions should change and we cannot predict
the effect on us of any expansion or reduction of these obligations.
We May Have Financial Exposure to Litigation Against Our Directors and Officers.
We are obligated to indemnify our executive officers and the members of
our Board of Directors for certain actions taken by such officers and directors
on our behalf. In order to protect ourselves against any financial exposure
resulting from the actions of our officers and directors, we purchase Directors
and Officers insurance policies every year to cover litigation expenses and
settlement awards or damage awards. We purchase our Directors and Officers
insurance in layers of varying amounts and have a different insurance company
underwrite each layer.
In October of 2001, Reliance Insurance Co. (Reliance") was liquidated by
the state of Pennsylvania. Reliance was the underwriter for the second $2.5
million layer of the first $5 million of coverage for our Directors and Officers
Insurance for the period covering the claims made against our officers in our
pending securities litigation, as well as other periods. Depending upon the
outcome of our current securities litigation and any future litigation that may
be brought against our officers and directors, we could be liable and have to
self-insure the second $2.5 million layer if the attorneys' fees and/or the
settlement or damages award exceeds the first $2.5 million layer. However, we
may be able to make a claim against the estate of Reliance for any sums we
expend within the second $2.5 million layer in litigating and settling or paying
judgments related to actions taken by our officers and directors.
We Are Dependent on Key Third-Party Suppliers.
We manufacture all of our products using components or subassemblies
procured from third-party suppliers. Some of these components are available from
a single source and others are available from limited sources. All of our sales
are from products containing one or more components that are available only from
single supply sources.
In addition, some of the components are custom parts produced to our
specifications. For example, we currently rely on Philips Semiconductors, Inc.
to supply a custom ASIC that is used in our products. Other components, such as
the radio frequency tuner and some surface acoustic wave filters, are procured
from sole source suppliers. Any interruption in the operations of vendors of
sole source parts could adversely affect our ability to meet our scheduled
product deliveries to customers. We are dependent on semiconductor manufacturers
and are affected by worldwide conditions in the semiconductor market. If we are
unable to obtain a sufficient supply of components from our current sources, we
could experience difficulties in obtaining alternative sources or in altering
product designs to use
27
alternative components. Resulting delays or reductions in product shipments
could damage customer relationships. Further, a significant increase in the
price of one or more of these components could harm our gross margin or
operating results.
We May Be Unable to Migrate to New Semiconductor Process Technologies
Successfully or on a Timely Basis.
Our future success will depend in part upon our ability to develop
products that utilize new semiconductor process technologies. These technologies
change rapidly and require us to spend significant amounts on research and
development. We continuously evaluate the benefits of redesigning our integrated
circuits using smaller geometry process technologies to improve performance and
reduce costs. The transition of our products to integrated circuits with
increasingly smaller geometries will be important to our competitive position.
Other companies have experienced difficulty in migrating to new semiconductor
processes and, consequently, have suffered reduced yields, delays in product
deliveries and increased expense levels. Moreover, we depend on our relationship
with our third-party manufacturers to migrate to smaller geometry processes
successfully.
Our Ability to Directly Control Product Delivery Schedules and Product Quality
Is Dependent on Third-Party Contract Manufacturers.
Most of our products are assembled and tested by contract manufacturers
using testing equipment that we provide. As a result of our dependence on these
contract manufacturers for assembly and testing of our products, we do not
directly control product delivery schedules or product quality. Any product
shortages or quality assurance problems could increase the costs of manufacture,
assembly or testing of our products. In addition, as manufacturing volume
increases, we will need to procure and assemble additional testing equipment and
provide it to our contract manufacturers. The production and assembly of testing
equipment typically requires significant lead times. We could experience
significant delays in the shipment of our products if we are unable to provide
this testing equipment to our contract manufacturers in a timely manner.
There Are Many Risks Associated with International Operations.
We expect sales to customers outside of the United States to continue to
represent a significant percentage of our revenues for the foreseeable future.
International sales are subject to a number of risks, including the following:
- Changes in foreign government regulations and communications
standards;
- Export license requirements, tariffs and taxes;
- Other trade barriers;
- Difficulty in protecting intellectual property;
- Difficulty in collecting accounts receivable;
- Difficulty in managing foreign operations; and
- Political and economic instability.
If our customers are affected by currency devaluations or general
economic crises, such as the recent economic crises affecting many Asian and
Latin American economies, their ability to purchase our products could be
reduced significantly. Payment cycles for international customers typically are
longer than those for customers in the United States. Foreign markets for our
products may develop more slowly than currently anticipated. Foreign countries
may decide to prohibit, terminate or delay the construction of new broadband
services infrastructures for a variety of reasons. These reasons include
environmental issues, economic downturns, the availability of favorable pricing
for other communications services or the availability and cost of related
equipment. Any action like this by foreign countries would reduce the market for
our products.
28
We anticipate that our foreign sales generally will be invoiced in U.S.
dollars, and we currently do not engage in foreign currency hedging
transactions. However, as we commence and expand our international operations,
we may be paid in foreign currencies and exposure to losses in foreign currency
transactions may increase. We may choose to limit our exposure by the purchase
of forward foreign exchange contracts or through similar hedging strategies. No
currency hedging strategy can fully protect against exchange-related losses. In
addition, if the relative value of the U.S. dollar in comparison to the currency
of our foreign customers should increase, the resulting effective price increase
of our products to those foreign customers could result in decreased sales.
We May Be Unable to Provide Adequate Customer Support.
Our ability to achieve our planned sales growth and retain current and
future customers will depend in part upon the quality of our customer support
operations. Our customers generally require significant support and training
with respect to our broadband access systems, particularly in the initial
deployment and implementation stages. To date, our sales have been concentrated
in a small number of customers. We have limited experience with widespread
deployment of our products to a diverse customer base. We may not have adequate
personnel to provide the levels of support that our customers may require during
initial product deployment or on an ongoing basis. Our inability to provide
sufficient support to our customers could delay or prevent the successful
deployment of our products. In addition, our failure to provide adequate support
could harm our reputation and relationship with our customers and could prevent
us from gaining new customers.
Our Industry Is Highly Competitive with Many Established Competitors.
The market for broadband access systems is extremely competitive and is
characterized by rapid technological change. Our direct competitors in the cable
arena include Cisco Systems, Com21, Matsushita Electric Industrial (which
markets products under the brand name "Panasonic"), Motorola, Nortel Networks,
Vyyo, Thomson Consumer Electronics (which markets products under the brand name
"RCA"), Samsung, Scientific-Atlanta, Sony, 3Com, Toshiba and Zenith Electronics.
We also compete with companies that develop integrated circuits for broadband
access products, such as Broadcom, Conexant and Texas Instruments. We also sell
products that compete with existing data access and transmission systems
utilizing the telecommunications networks, such as those of 3Com. Additionally,
our controller and headend system products face intense competition from
well-established companies such as Cisco, Nortel and 3Com. In addition, we
compete with companies in the DSL arena such as ECI, Charles Industries,
Pairgain, Copper Mountain, Accelerated Networks, Integral Access and VINA
Technologies. As standards, such as DOCSIS, are developed for broadband access
systems, other companies may enter the broadband access systems market. The
principal competitive factors in our market include the following:
- Product performance, features and reliability;
- Price;
- Size and stability of operations;
- Breadth of product line;
- Sales and distribution capability;
- Technical support and service;
- Relationships with providers of broadband access services; and
- Compliance with industry standards.
Some of these factors are outside of our control. The existing
conditions in the broadband access market could change rapidly and significantly
as a result of technological advancements. The development and market acceptance
of alternative technologies could decrease the demand for our products or render
them obsolete. Our competitors may introduce broadband access products that are
less costly, provide superior performance or achieve greater market acceptance
than our products.
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Many of our current and potential competitors have significantly greater
financial, technical, marketing, distribution, customer support and other
resources, as well as greater name recognition and access to customers than we
do. The anticipated widespread adoption of DOCSIS and other industry standards
is likely to cause increased worldwide price competition, particularly in the
North American market. The adoption of DOCSIS and these other standards also
could result in lower sales of our proprietary TeraComm system, including the
higher margin head-end products. Any increased price competition or reduction in
sales of our head-end products would result in downward pressure on our gross
margin. We cannot accurately predict how the competitive pressures that we face
will affect our business.
Our Business Is Dependent on the Internet and the Development of the Internet
Infrastructure.
Our success will depend in large part on increased use of the Internet
to increase the need for high-speed broadband access networks. Critical issues
concerning the commercial use of the Internet remain largely unresolved and are
likely to affect the development of the market for our products. These issues
include security, reliability, cost, ease of access and quality of service. Our
success also will depend on the growth of the use of the Internet by businesses,
particularly for applications that utilize multimedia content and thus require
high bandwidth. The recent growth in the use of the Internet has caused frequent
periods of performance degradation. This has required the upgrade of routers,
telecommunications links and other components forming the infrastructure of the
Internet by service providers and other organizations with links to the
Internet. Any perceived degradation in the performance of the Internet as a
whole could undermine the benefits of our products. Potentially increased
performance provided by our products and the products of others ultimately is
limited by and reliant upon the speed and reliability of the Internet backbone
itself. Consequently, the emergence and growth of the market for our products
will depend on improvements being made to the entire Internet infrastructure to
alleviate overloading and congestion.
Our Failure to Manage Growth Could Adversely Affect Us.
The growth of our business has placed, and is expected to continue to
place, a significant strain on our limited personnel, management and other
resources. Our management, personnel, systems, procedures and controls may be
inadequate to support our existing and future operations. To manage any future
growth effectively, we will need to attract, train, motivate, manage and retain
employees successfully, to integrate new employees into our overall operations
and to continue to improve our operational, financial and management systems.
We Are Dependent on Key Personnel.
Due to the specialized nature of our business, we are highly dependent on the
continued service of, and on the ability to attract and retain qualified
engineering, sales, marketing and senior management personnel. The competition
for personnel is intense. The loss of any of these individuals may harm our
business. In addition, if we are unable to hire additional qualified personnel
as needed, we may be unable to adequately manage and complete our existing sales
commitments and to bid for and execute additional sales. Further, we must train
and manage our employee base, which is likely to require increased levels of
responsibility for both existing and new management personnel. Our current
management personnel and systems may be inadequate, and we may fail to
assimilate new employees successfully.
Highly skilled employees with the education and training that we
require, especially employees with significant experience and expertise in both
data networking and radio frequency design, are in high demand. We may not be
able to continue to attract and retain the qualified personnel necessary for the
development of our business. We do not have "key person" insurance coverage for
the loss of any of our employees. Any officer or employee of our company can
terminate his or her relationship with us at any time. Our employees generally
are not bound by non-competition agreements with us.
Our Business Is Subject to the Risks of Product Returns, Product Liability and
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Product Defects.
Products as complex as ours frequently contain undetected errors or
failures, especially when first introduced or when new versions are released.
Despite testing, errors may occur. The occurrence of errors could result in
product returns and other losses to our company or our customers. This
occurrence also could result in the loss of or delay in market acceptance of our
products. We have limited experience with the problems that could arise with
each new generation of products. However, the limitation of liability provisions
contained in our terms and conditions of sale may not be effective as a result
of federal, state or local laws or ordinances or unfavorable judicial decisions
in the United States or other countries. We have not experienced any product
liability claims to date, but the sale and support of our products entails the
risk of such claims. In addition, any failure by our products to properly
perform could result in claims against us by our customers. We maintain
insurance to protect against certain claims associated with the use of our
products, but our insurance coverage may not adequately cover any claim asserted
against us. In addition, even claims that ultimately are unsuccessful could
result in our expenditure of funds in litigation and management time and
resources.
We May Be Unable to Adequately Protect or Enforce Our Intellectual Property
Rights.
We rely on a combination of patent, trade secret, copyright and
trademark laws and contractual restrictions to establish and protect proprietary
rights in our products. Our pending patent applications may not be granted. Even
if they are granted, the claims covered by the patents may be reduced from those
included in our applications. Any patent might be subject to challenge in court
and, whether or not challenged, might not be broad enough to prevent third
parties from developing equivalent technologies or products without taking a
license from us. We have entered into confidentiality and invention assignment
agreements with our employees, and we enter into non-disclosure agreements with
some of our suppliers, distributors and appropriate customers so as to limit
access to and disclosure of our proprietary information. These statutory and
contractual arrangements may not prove sufficient to prevent misappropriation of
our technology or to deter independent third-party development of similar
technologies. In addition, the laws of some foreign countries might not protect
our products or intellectual property rights to the same extent as do the laws
of the United States. Protection of our intellectual property might not be
available in every country in which our products might be manufactured, marketed
or sold.
In November 1998, CableLabs selected us to co-author DOCSIS 1.2, an
enhanced version of the DOCSIS cable modem specification based in part on our
S-CDMA technology. In September 1999, CableLabs indicated that it intended to
proceed with the advanced PHY work on two parallel tracks: one for the
development of a prototype based on our S-CDMA technology and one for the
inclusion of Advanced TDMA technology, as proposed by other companies. In
February 2000, CableLabs expanded on the plans that it had discussed in
September 1999. CableLabs explained that four companies, including us, were
developing an advanced PHY specification based on TDMA. CableLabs also
reiterated that it was continuing to work with us on the development.
In August 2001, CableLabs announced that the efforts begun in November
1998 had culminated in a new DOCSIS standard called DOCSIS 2.0. DOCSIS 2.0 will
incorporate two advanced physical layer modulation techniques, S-CDMA and the
Advanced TDMA that four companies, including us, had helped to develop.
CableLabs further announced that it would begin developing the new DOCSIS 2.0
specification immediately, a process that it expects to be completed by the end
of calendar year 2001, with the goal of certifying and qualifying DOCSIS 2.0
based products in 2002. We have already given CableLabs assurances that we will
contribute some aspects or our current proprietary S-CDMA technology to a
royalty-free intellectual property pool to the extent that it is included in the
final DOCSIS 2.0 specifications.
We would contribute our technology pursuant to a license agreement with
CableLabs that we would execute at that time, and which contains the terms that
CableLabs has established for the inclusion of any intellectual property from
any source in the final DOCSIS 2.0 specifications. Under the terms of the
proposed license agreement, we would grant to CableLabs a royalty-free license
for those aspects of our S-CDMA technology that are essential for compliance
with the DOCSIS cable modem standard. So-called "implementation know how" is not
covered by this license-only
31
those aspects of the technology that are essential to implementing a compliant
product. CableLabs would have the right to extend royalty-free sublicenses to
companies that wish to build DOCSIS-compatible products. These sublicenses would
allow participating companies to utilize and incorporate the essential portions
of the S-CDMA technology on a royalty-free basis for the limited use of making
and selling products or systems that comply with the DOCSIS cable modem
specification. We have already joined the DOCSIS intellectual property pool and,
as a result, we have a royalty-free sublicense that allows us to ship
DOCSIS-compatible products which contain intellectual property submitted by
other companies. The scope of this license would not extend to the use of the
S-CDMA technology in other areas; only for products that comply with the DOCSIS
specifications. As a result, any of our competitors who join or have joined the
DOCSIS intellectual property pool will have access to some aspects of our
technology without being required to pay us any royalties or other compensation.
If we submit S-CDMA to the DOCSIS Intellectual Property pool, we are in no way
restricted from entering into royalty-bearing license agreements with companies
that wish to use the S-CDMA technology for purposes other than implementing
DOCSIS compatible products, or that do not wish to enter into the DOCSIS
intellectual property pool. Further, some of our competitors have been
successful in reverse engineering the technology of other companies, and the
inclusion of S-CDMA in DOCSIS specification exposes some aspects of that
technology to those competitors. DOCSIS specifications are available on an open
basis once they are approved, not only to companies that are members of the
DOCSIS intellectual property Pool. If a competitor is able to duplicate the
functionality and capabilities of our technology, we could lose all or some of
the time-to-market advantage we might otherwise have. Under the terms of the
proposed license agreement, if we sue certain parties to the proposed license
agreement on claims of infringement of any copyright or patent right or
misappropriation of any trade secret, those parties may terminate our license to
the patents or copyrights they contributed to the DOCSIS intellectual property
pool. If a termination like this were to occur, we would continue to have access
to some aspects of the DOCSIS intellectual property pool, but we would not be
able to develop products that fully comply with the DOCSIS cable modem
specification. Also, even if we were to be removed from the DOCSIS intellectual
property pool, we would not be prevented from developing and selling products
that fully comply with the DOCSIS specifications, but we would not be able to do
this with the benefit of a royalty-free license, which would increase the cost
of our products, assuming we were able to obtain a license agreement for the
required technology. Because of these terms, we may find it difficult to enforce
our intellectual property rights against certain companies, even in areas that
are not directly related to DOCSIS specifications and products.
We anticipate that developers of cable modems increasingly will be
subject to infringement claims as the number of products and competitors in our
industry segment grows. We have received letters from two individuals claiming
that our technology infringes patents held by these individuals. We have
reviewed the allegations made by these individuals and, after consulting with
our patent counsel, we do not believe that our technology infringes any valid
claim of these individuals' patents. If the issues are submitted to a court, the
court could find that our products infringe these patents. In addition, these
individuals may continue to assert infringement. If we are found to have
infringed these individuals' patents, we could be subject to substantial damages
and/or an injunction preventing us from conducting our business. In addition,
other third parties may assert infringement claims against us in the future. An
infringement claim, whether meritorious or not, could be time-consuming, result
in costly litigation, cause product shipment delays or require us to enter into
royalty or licensing agreements. These royalty or licensing agreements may not
be available on terms acceptable to us or at all. Litigation also may be
necessary to enforce our intellectual property rights.
We pursue the registration of our trademarks in the United States and
foreign countries and have applications pending to register several of our
trademarks. However, the laws of certain foreign countries might not protect our
products or intellectual property rights to the same extent as the laws of the
United States. This means that effective trademark, copyright, trade secret and
patent protection might not be available in every country in which our products
might be manufactured, marketed or sold.
Our Business Is Subject to Communications Industry Regulations.
32
Our business and our customers are subject to varying degrees of
federal, state and local regulation. The jurisdiction of the Federal
Communications Commission (FCC) extends to the communications industry,
including our broadband access products. The FCC has promulgated regulations
that, among other things, set installation and equipment standards for
communications systems. Although FCC regulations and other governmental
regulations have not materially restricted our operations to date, future
regulations applicable to our business or our customers could be adopted by the
FCC or other regulatory bodies. For example, FCC regulatory policies affecting
the availability of cable services and other terms on which cable companies
conduct their business may impede our penetration of certain markets. In
addition, regulation of cable television rates may affect the speed at which
cable operators upgrade their cable infrastructures to two-way HFC. In addition,
the increasing demand for communications systems has exerted pressure on
regulatory bodies worldwide to adopt new standards for such products and
services. This process generally involves extensive investigation of and
deliberation over competing technologies. The delays inherent in this
governmental approval process have in the past, and may in the future, cause the
cancellation, postponement or rescheduling of the installation of communications
systems by our customers.
If other countries begin to regulate the broadband access services
industry more heavily or introduce standards or specifications with which our
products do not comply, we will be unable to offer products in those countries
until our products comply with those standards or specifications. In addition,
we may have to incur substantial costs to comply with those standards or
specifications. For instance, should the Digital Audio Visual Counsel (DAVIC)
standards for ATM-based digital video be established internationally, we will
need to conform our cable modems to compete. Further, many countries do not have
regulations for installation of cable modem systems or for upgrading existing
cable network systems to accommodate our products. Whether we currently operate
in a country without these regulations or enter into the market in a country
where these regulations do not exist, new regulations could be proposed at any
time. The imposition of regulations like this could place limitations on a
country's service providers' ability to upgrade to support our products. Service
providers in these countries may not be able to comply with these regulations,
and compliance with these regulations may require a long, costly process. For
example, we experienced delays in product shipments to a customer in Brazil due
to delays in certain regulatory approvals in Brazil. Similar delays could occur
in other countries in which we market or plan to market our products. In
addition, our customers in certain parts of Asia, such as Japan, are required to
obtain licenses prior to selling our products, and delays in obtaining required
licenses could harm our ability to sell products to these customers.
Our Business Is Subject to Other Regulatory Approvals and Certifications.
In the United States, in addition to complying with FCC regulations, our
products are required to meet certain safety requirements. For example, we are
required to have our products certified by Underwriters Laboratory in order to
meet federal requirements relating to electrical appliances to be used inside
the home. Outside the United States, our products are subject to the regulatory
requirements of each country in which the products are manufactured or sold.
These requirements are likely to vary widely. We may be unable to obtain on a
timely basis or at all the regulatory approvals that may be required for the
manufacture, marketing and sale of our products. In addition to regulatory
compliance, some cable industry participants may require certification of
compatibility. DOCSIS requires certification for DOCSIS modems and qualification
for DOCSIS Headend equipment.
We Are Vulnerable to Earthquakes, Power Outages and Other Unexpected Events.
The facilities housing our corporate headquarters, the majority of our
research and development activities and our in-house manufacturing operations
are located in California, an area known for seismic activity. In addition, the
operations of some of our key suppliers are also located in this area and in
other areas known for seismic activity, such as Taiwan. An earthquake, or other
significant natural disaster, could result in an interruption in our business or
that of one or more of our key suppliers. Such an interruption could harm our
operating results. In addition, during 2001, there has been a shortage of
electricity in California. As a result, many regions, including the San
Francisco
33
Bay Area, where our headquarters are located, have experienced rolling power
outages as capacity has failed to satisfy demand. Continued power shortages, a
power failure or other similar unexpected events could impair our ability to
operate our business. We may not carry sufficient business interruption
insurance to compensate for any losses that we may sustain as a result of any
natural disasters or other unexpected events.
Our Indebtedness Could Adversely Affect our Financial Condition; We May Incur
Substantially More Debt.
As of November 13, 2001, we had approximately $200.1 million of
indebtedness outstanding. Our high level of indebtedness could have important
consequences to our stockholders including the following:
- Make it more difficult for us to satisfy our obligations with respect
to our indebtedness;
- Increase our vulnerability to general adverse economic and industry
conditions;
- Limit our ability to obtain additional financing;
- Require the dedication of a substantial portion of our cash flow from
operations to the payment of principal of, and interest on, our
indebtedness, thereby reducing the availability of our cash flow to
fund our growth strategy, working capital, capital expenditures and
other general corporate purposes;
- Limit our flexibility in planning for, or reacting to, changes in our
business and the industry; and
- Place us at a competitive disadvantage relative to our competitors
with less debt.
We may incur substantial additional debt in the future. The terms of our
outstanding debt do not fully prohibit us from doing so. If new debt is added to
our current levels, the related risks described above could intensify.
Our Stock Price Has Been and Is Likely to Continue To Be Volatile.
The trading price of our common stock has been and is likely to be
highly volatile. Our stock price could be subject to wide fluctuations in
response to a variety of factors, including the following:
- Actual or anticipated variations in quarterly operating results;
- Announcements of technological innovations;
- New products or services offered by us or our competitors;
- Changes in financial estimates by securities analysts;
- Conditions or trends in the broadband access services industry;
- Changes in the economic performance and/or market valuations of
Internet, online service or broadband access service industries;
- Changes in the economic performance and/or market valuations of other
Internet, online service or broadband access service companies;
- Our announcement of significant acquisitions, strategic partnerships,
joint ventures or capital commitments;
- Adoption of industry standards and the inclusion of or compatibility
of our technology with such standards;
- Adverse or unfavorable publicity regarding us or our products;
34
- Additions or departures of key personnel;
- Sales of common stock; and
- Other events or factors that may be beyond our control.
In addition, the stock markets in general, and the Nasdaq National
Market and the market for broadband access services and technology companies in
particular, have experienced extreme price and volume volatility and a
significant cumulative decline over the last year. This volatility and decline
has affected many companies irrespective of or disproportionately to the
operating performance of these companies. Our stock price has declined
significantly in recent weeks and months and these broad market and industry
factors may materially adversely further affect the market price of our common
stock, regardless of our actual operating performance.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Interest Rate Risk.
Our exposure to market risk for changes in interest rates relates
primarily to our investment portfolio. The primary objective of our investment
activities is to preserve principal while maximizing yields without
significantly increasing risk. This is accomplished by investing in widely
diversified short-term investments, consisting primarily of investment grade
securities, substantially all of which either mature within the next twelve
months or have characteristics of short-term investments. A hypothetical 50
basis point increase in interest rates would result in an approximate $292,300
decline (less than 0.2%) in the fair value of our available-for-sale debt
securities.
Foreign Currency Risk.
A substantial majority of our revenue, expense and capital purchasing
activity are transacted in U.S. dollars. However, we do enter into transactions
in local currencies from Belgium, United Kingdom, Hong Kong, Brazil and Israel.
We have not engaged in hedging transactions to reduce our exposure to
fluctuations that may arise from changes in foreign exchange rates. An adverse
change of 10% in exchange rates would result in a decline in income before taxes
of approximately $0.5 million.
All of the potential changes noted above are based on sensitivity
analyses performed as of September 30, 2001.
PART II. OTHER INFORMATION
ITEM 3. LEGAL PROCEEDINGS
See "Litigation" under PART I, ITEM 2, MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
ITEM 5. OTHER INFORMATION
35
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Incorporated by reference to Terayon Communication Systems Form 10-K405
filed with the Commission on April 2 2001, as amended April 30, 2001.
Incorporated by reference to Terayon Communication Systems Form 10-Q
filed with the Commission on May 15, 2001.
Incorporated by reference to Terayon Communication Systems Form 10-Q
filed with the Commission on August 14, 2001.
(b) REPORTS ON FORM 8-K
None
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: November 14, 2001 TERAYON COMMUNICATION SYSTEMS, INC.
/s/ Carol Lustenader
-----------------------------------
Carol Lustenader
Chief Financial Officer
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