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ZHNE > SEC Filings for ZHNE > Form 10-Q on 14-May-2014All Recent SEC Filings

Show all filings for ZHONE TECHNOLOGIES INC

Form 10-Q for ZHONE TECHNOLOGIES INC


14-May-2014

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Statements
This report, including "Management's Discussion and Analysis of Financial Condition and Results of Operations," contains forward-looking statements regarding future events and our future results that are subject to the safe harbors created under the Securities Act of 1933 and the Securities Exchange Act of 1934. These statements are based on current expectations, estimates, forecasts, and projections about the industries in which we operate and the beliefs and assumptions of our management. We use words such as "anticipate," "believe," "continue," "could," "estimate," "expect," "goal," "intend," "may," "plan," "project," "seek," "should," "target," "will," "would," variations of such words, and similar expressions to identify forward-looking statements. In addition, statements that refer to projections of earnings, revenue, costs or other financial items; anticipated growth and trends in our business or key markets; future growth and revenues from our Single Line Multi-Service (SLMS) products; our ability to refinance or repay our existing indebtedness prior to the applicable maturity date; future economic conditions and performance; anticipated performance of products or services; plans, objectives and strategies for future operations; and other characterizations of future events or circumstances, are forward-looking statements. Readers are cautioned that these forward-looking statements are only predictions and are subject to risks, uncertainties and assumptions that are difficult to predict, including those identified under the heading "Risk Factors" in Part II, Item 1A, elsewhere in this report and our other filings with the Securities and Exchange Commission (the SEC). Therefore, actual results may differ materially and adversely from those expressed in any forward-looking statements. Factors that might cause such a difference include, but are not limited to, the ability to generate sufficient revenue to achieve or sustain profitability, the ability to raise additional capital to fund existing and future operations or to refinance or repay our existing indebtedness, defects or other performance problems in our products, the economic slowdown in the telecommunications industry that has restricted the ability of our customers to purchase our products, commercial acceptance of our SLMS products, intense competition in the communications equipment market from large equipment companies as well as private companies with products that address the same networks needs as our products, higher than anticipated expenses that we may incur, and other factors identified elsewhere in this report and in our most recent reports on Forms 10-K, 10-Q and 8-K. We undertake no obligation to revise or update any forward-looking statements for any reason.
OVERVIEW
We believe that we are the first company dedicated solely to developing the full spectrum of next-generation access network solutions to cost-effectively deliver high bandwidth services while simultaneously preserving the investment in today's networks. Our next-generation solutions are based upon our SLMS architecture. From its inception, this SLMS architecture was specifically designed for the delivery of multiple classes of subscriber services (such as voice, data and video distribution), rather than being based on a particular protocol or media. In other words, our SLMS products are built to support the migration from legacy circuit to packet technologies and from copper to fiber technologies. This flexibility and versatility allows our products to adapt to future technologies while allowing service providers to focus on


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the delivery of additional high bandwidth services. Because this SLMS architecture is designed to interoperate with existing legacy equipment, service providers can leverage their existing networks to deliver a combination of voice, data and video services today, while they migrate, either simultaneously or at a future date, from legacy equipment to next-generation equipment with minimal interruption. We believe that our SLMS solution provides an evolutionary path for service providers from their existing infrastructures, as well as gives newer service providers the capability to deploy cost-effective, multi-service networks that can support voice, data and video.
Our global customer base includes regional, national and international telecommunications carriers. To date, our products are deployed by over 750 network service providers on six continents worldwide. We believe that we have assembled the employee base, technological breadth and market presence to provide a simple yet comprehensive set of next-generation solutions to the bandwidth bottleneck in the access network and the other problems encountered by network service providers when delivering communications services to subscribers.
Although we generated net income of $4.3 million for the year ended December 31, 2013 and net income of $0.3 million for the quarter ended March 31, 2014, we have incurred net losses in prior years and there can be no assurance that we will continue to generate net income or have positive cash flows from operations in any future period. We had an accumulated deficit of $1,036.5 million as of March 31, 2014. If we are unable to access or raise the capital needed to meet liquidity needs and finance capital expenditures and working capital, or if the economic, market and geopolitical conditions in the United States and the rest of the world deteriorate, we may experience material adverse impacts on our business, operating results and financial condition. During the past four years, we have continued our focus on cost control and operating efficiency along with restrictions on discretionary spending.
Going forward, our key financial objectives include the following:
Increasing revenue while continuing to carefully control costs;

          Continued investments in strategic research and product development
           activities that will provide the maximum potential return on
           investment; and

Minimizing consumption of our cash and cash equivalents.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES
There have been no material changes to our critical accounting policies and estimates from the information provided in Part II, "Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations - Critical Accounting Policies and Estimates" included in our Annual Report on Form 10-K for the year ended December 31, 2013.


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RESULTS OF OPERATIONS
We list in the table below the historical condensed consolidated statement of
comprehensive income data as a percentage of net revenue for the periods
indicated.

                                   Three Months Ended
                                       March 31,
                                   2014         2013
Net revenue                         100 %        100 %
Cost of revenue                      62 %         63 %
Gross profit                         38 %         37 %
Operating expenses:
Research and product development     15 %         13 %
Sales and marketing                  16 %         17 %
General and administrative            6 %          6 %
Total operating expenses             37 %         36 %
Operating income                      1 %          1 %
Interest expense                      0 %          0 %
Other income, net                     0 %          0 %
Income before income taxes            1 %          1 %
Income tax provision                  0 %          0 %
Net income                            1 %          1 %
Other comprehensive loss              0 %          0 %
Comprehensive income                  1 %          1 %

Net Revenue
Information about our net revenue for products and services for the three months
ended March 31, 2014 and 2013 is summarized below (in millions):
                           Three Months Ended
                               March 31,
          2014      2013      Increase/ (Decrease)    % change
Products $ 26.8    $ 26.3    $             0.5           1.9  %
Services    1.8       2.1                 (0.3 )       (14.3 )%
Total    $ 28.6    $ 28.4    $             0.2           0.7  %


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Information about our net revenue for North America and international markets for the three months ended March 31, 2014 and 2013 is summarized below (in millions):

                                         Three Months Ended
                                             March 31,
                                                  Increase
                             2014      2013      (Decrease)    % change
Revenue by geography:
United States               $  9.4    $  9.2    $     0.2         2.2  %
Canada                         0.6       0.7         (0.1 )     (14.3 )%
Total North America           10.0       9.9          0.1         1.0  %
Latin America                  5.0       4.7          0.3         6.4  %
Europe, Middle East, Africa   13.0      13.2         (0.2 )      (1.5 )%
Asia Pacific                   0.6       0.6            -           -  %
Total International           18.6      18.5          0.1         0.5  %
Total                       $ 28.6    $ 28.4    $     0.2         0.7  %

For the three months ended March 31, 2014, net revenue increased 1% or $0.2 million to $28.6 million from $28.4 million for the same period last year. For the three months ended March 31, 2014, product revenue increased 2% or $0.5 million to $26.8 million, compared to $26.3 million for the same period last year. The increases in net revenue and product revenue were primarily due to increased sales of our MXK products. International net revenue remained relatively flat at $18.6 million compared to $18.5 million for the same period last year, and represented 65% of total net revenue for each of the three months ended March 31, 2014 and 2013.
Service revenue represents revenue from maintenance and other services associated with product shipments. The decrease in service revenue for the three months ended March 31, 2014 of 14% or $0.3 million was primarily due to decreased sales of installation services due to the completion of a large broadband development project in 2013.
For the three months ended March 31, 2014 and 2013, two customers represented 31% and 32% of net revenue, respectively. We anticipate that our results of operations in any given period may depend to a large extent on sales to a small number of large accounts. As a result, our revenue for any quarter may be subject to significant volatility based upon changes in orders from one or a small number of key customers.
Cost of Revenue and Gross Profit
Total cost of revenue, including stock-based compensation, decreased $0.2 million or 1% to $17.7 million for the three months ended March 31, 2014 compared to $17.9 million for the same period last year. The decrease in cost of revenue for the three months ended March 31, 2014 was primarily due to changes in product mix and an improved pricing environment. Gross margin increased due primarily to greater sales of products with higher gross margin, such as MXK products.
We expect that in the future our cost of revenue as a percentage of net revenue will vary depending on the mix and average selling prices of products sold. In addition, continued competitive and economic pressures could cause us to reduce our prices, adjust the carrying values of our inventory, or record inventory charges relating to discontinued products and excess or obsolete inventory. Research and Product Development Expenses Research and product development expenses increased 13% or $0.4 million to $4.1 million for the three months ended March 31, 2014 compared to $3.7 million for the three months ended March 31, 2013. The increase in the three months ended March 31, 2014 was primarily due to $0.1 million of higher personnel-related expenses resulting from a higher headcount in 2014 compared to 2013, as well as $0.3 million in higher health benefit expenses due to a credit recorded in 2013. We recorded a $0.6 million credit to our statement of comprehensive income in the quarter ended March 31, 2013 as a result of a vendor refund received in 2013 which related to overpayments for health benefits made in 2012. We allocated $0.3 million of the credit to research and product development expenses. There was no similar credit in the current period. We intend to continue to invest in research and product development to attain our strategic product development objectives while seeking to manage the associated costs through expense controls.


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Sales and Marketing Expenses
Sales and marketing expenses decreased 3% or $0.1 million to $4.7 million for the three months ended March 31, 2014 compared to $4.8 million for the three months ended March 31, 2013. The decrease in the three months ended March 31, 2014 was primarily due to $0.3 million decrease in consulting expenses, which was offset by $0.1 million in higher commissions and $0.1 million in higher health benefit expenses due to a credit recorded in 2013. We recorded a $0.6 million credit to our statement of comprehensive income in the quarter ended March 31, 2013 as a result of a vendor refund received in 2013 which related to overpayments for health benefits made in 2012. We allocated $0.1 million of the credit to sales and marketing expenses. There was no similar credit in the current period.
General and Administrative Expenses
General and administrative expenses remained flat at $1.7 million for both the three months ended March 31, 2014 and three months ended March 31, 2013. In the three months ended March 31, 2014, a $0.1 million increase in personnel related expenses and a $0.1 million increase in property taxes were offset by a $0.1 million decrease in stock compensation expense and a $0.1 million decrease in bonus expense.
Income Tax Provision
During the three months ended March 31, 2014 and 2013, no material provision or benefit for income taxes was recorded, due to our previous operating losses and the significant uncertainty regarding the realization of our net deferred tax assets, against which we have continued to record a full valuation allowance.

OTHER PERFORMANCE MEASURES
In managing our business and assessing our financial performance, we supplement the information provided by our GAAP results with adjusted earnings before stock-based compensation, interest, taxes, and depreciation, or Adjusted EBITDA, a non-GAAP financial measure. We define Adjusted EBITDA as net income (loss) plus (i) interest expense, (ii) provision (benefit) for taxes,
(iii) depreciation and amortization, (iv) non-cash equity-based compensation expense, and (v) material non-recurring non-cash transactions, such as gain
(loss) on sale of assets or impairment of fixed assets. We believe that the presentation of Adjusted EBITDA enhances the usefulness of our financial information by presenting a measure that management uses internally to monitor and evaluate our operating performance and to evaluate the effectiveness of our business strategies. We believe Adjusted EBITDA also assists investors and analysts in comparing our performance across reporting periods on a consistent basis because it excludes the impact of items that we do not believe reflect our core operating performance. Adjusted EBITDA has limitations as an analytical tool. Some of these limitations are:

          Adjusted EBITDA does not reflect our cash expenditures, or future
           requirements, for capital expenditures or contractual requirements;


          Adjusted EBITDA does not reflect changes in, or cash requirements for,
           our working capital needs;


          Adjusted EBITDA does not reflect the interest expense, or the cash
           requirements necessary to service interest or principal payments, on
           our debts;


          although depreciation and amortization are non-cash charges, the
           assets being depreciated and amortized will often have to be replaced
           in the future, and Adjusted EBITDA does not reflect any cash
           requirements for such replacements;


          non-cash compensation is and will remain a key element of our overall
           long-term incentive compensation package, although we exclude it as an
           expense when evaluating our ongoing operating performance for a
           particular period; and


          other companies in our industry may calculate Adjusted EBITDA and
           similar measures differently than we do, limiting its usefulness as a
           comparative measure.

Because of these limitations, Adjusted EBITDA should not be considered in isolation or as a substitute for net income (loss) or any other performance measures calculated in accordance with GAAP or as a measure of liquidity. Management understands these limitations and compensates for these limitations by relying primarily on our GAAP results and using Adjusted EBITDA only supplementally.


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Set forth below is a reconciliation of net income to Adjusted EBITDA, which we consider to be the most directly comparable GAAP financial measure to Adjusted EBITDA (in thousands):

                                                Three Months Ended
                                                    March 31,
                                                  2014            2013
Net income                                 $     302             $ 230
Add:
Interest expense                                  16                39
Provision for taxes                               43                32
Depreciation and amortization                     90                82
Non-cash equity-based compensation expense        59               178
Adjusted EBITDA                            $     510             $ 561

LIQUIDITY AND CAPITAL RESOURCES
Our operations are financed through a combination of our existing cash, cash equivalents, available credit facilities, and sales of equity and debt instruments, based on our operating requirements and market conditions. At March 31, 2014, cash and cash equivalents were $15.6 million compared to $15.7 million at December 31, 2013. The $0.1 million decrease in cash and cash equivalents was attributable to net cash used in operating and investing activities totaling $0.2 million, partially offset by net cash provided by financing activities of $0.1 million.
Operating Activities
Net cash used in operating activities for the three months ended March 31, 2014 consisted of net income of $0.3 million, adjusted for non-cash credits totaling $0.1 million and offset by an increase in net operating assets totaling $0.4 million. The most significant components of the changes in net operating assets were a decrease of $4.3 million in accounts payable offset by decreases in accounts receivable of $2.9 million and inventory of $1.7 million. The decrease in accounts receivable was primarily the result of significant cash collections from several large customers in the current year period which caused a decrease in accounts payable as more cash was available to apply to vendor invoices. The decrease in inventory was due to better inventory management and a buildup of inventory in prior periods.

Net cash provided by operating activities for the three months ended March 31, 2013 consisted of net income of $0.2 million, adjusted for non-cash charges totaling $0.9 million and an increase in net operating assets totaling $0.4 million. The most significant components of the changes in net operating assets were a decrease of $2.2 million in accounts payable, offset by a decrease of $0.9 million in accounts receivable. The decrease in accounts receivable was primarily the result of significant cash collections from several large customers which caused a corresponding decrease in accounts payable as more cash was available to apply to vendor invoices. Investing Activities
Net cash used in investing activities for the three months ended March 31, 2014 and 2013 consisted of purchases of property and equipment. Financing Activities
Net cash provided by financing activities for the three months ended March 31, 2014 was $0.1 million, which consisted of proceeds related to exercises of stock options. Net cash provided by financing activities for the three months ended March 31, 2013 was immaterial and consisted of proceeds related to exercises of stock options and purchases under our 2002 Employee Stock Purchase Plan (ESPP). Cash Management
Our primary source of liquidity comes from our cash and cash equivalents which totaled $15.6 million at March 31, 2014, and our $25.0 million revolving line of credit and letter of credit facility with WFB. At current revenue levels, we anticipate that some portion of our existing cash and cash equivalents may be consumed by operations.


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As of March 31, 2014, we had a $25.0 million revolving line of credit and letter of credit facility with WFB to provide liquidity and working capital through March 31, 2016. The amount that we are able to borrow under the WFB Facility varies based on eligible accounts receivable and inventory, as defined in the agreement, as long as the aggregate principal amount outstanding does not exceed $25.0 million less the amount committed as security for letters of credit. In addition, under the WFB Facility, we are able to utilize the facility as security for letters of credit. At March 31, 2014, our borrowing base was $20.3 million. To maintain availability of funds under the WFB Facility, we pay a commitment fee on the unused portion. The commitment fee is 0.25% and is recorded as interest expense.

We had $10.0 million outstanding at March 31, 2014 under the WFB Facility. We had $7.1 million of borrowing availability under the WFB Facility as of March 31, 2014. The amounts borrowed under the WFB Facility bear interest, payable monthly, at a floating rate equal to the three-month LIBOR plus a margin of 3.0%. The interest rate on the WFB Facility was 3.23% at March 31, 2014. Our obligations under the WFB Facility are secured by substantially all of our personal property assets and those of our subsidiaries that guarantee the WFB Facility, including our intellectual property. The WFB Facility contains certain financial covenants, and customary affirmative covenants and negative covenants. If we default under the WFB Facility due to a covenant breach or otherwise, WFB may be entitled to, among other things, require the immediate repayment of all outstanding amounts and sell our assets to satisfy the obligations under the WFB Facility. As of March 31, 2014, we were in compliance with these covenants. We make no assurances that we will be in compliance with these covenants in the future.
Future Requirements and Funding Sources
Our fixed commitments for cash expenditures consist primarily of payments under operating leases, inventory purchase commitments, and payments of principal and interest for debt obligations. Our operating lease commitments include $1.7 million of future minimum lease payments spread over the three-year lease term under the lease agreement we entered into in July 2013 for our manufacturing facility in Largo, Florida. In addition, we have $1.0 million of future minimum lease payments spread over the five-year lease term under the lease agreement we entered into in September 2010 with respect to our Oakland, California campus following the sale of our campus in a sale-leaseback transaction.
From time to time, we may provide or commit to extend credit or credit support to our customers. This financing may include extending the terms for product payments to customers. Any extension of financing to our customers will limit the capital that we have available for other uses.
Our accounts receivable, while not considered a primary source of liquidity, represent a concentration of credit risk because a significant portion of the accounts receivable balance at any point in time typically consists of a relatively small number of customer account balances. As of March 31, 2014, three customers accounted for 50% of net accounts receivable and receivables from customers in countries other than the United States of America represented 81% of net accounts receivable. We do not currently have any material commitments for capital expenditures, or any other material commitments aside from operating leases for our facilities, inventory purchase commitments and debt.

Although we generated net income of $4.3 million for the year ended December 31, 2013 and net income of $0.3 million for the quarter ended March 31, 2014, we have incurred net losses in prior years and there can be no assurance that we will continue to generate net income or have positive cash flows from operations in any future period. In order to meet our liquidity needs and finance our capital expenditures and working capital needs for our business, we may be required to sell assets, issue debt or equity securities or borrow on potentially unfavorable terms. In addition, we may be required to reduce our operations in low margin regions, including reductions in headcount. We may be unable to sell assets, issue securities or access additional financing to meet these needs on favorable terms, or at all. If additional capital is raised through the issuance of debt securities or other debt financing, the terms of such debt may include covenants, restrictions and financial ratios that may restrict our ability to operate our business. Likewise, any equity financing could result in additional dilution of our stockholders. If we are unable to obtain additional capital or are required to obtain additional capital on terms that are not favorable to us, we may be required to reduce the scope of our planned product development and sales and marketing efforts beyond the reductions we have previously taken. In addition, we may be required to reduce our operations in low margin regions, including reductions in headcount.Based on our current plans and business conditions, we believe that our existing cash, cash equivalents and available credit facilities will be sufficient to satisfy our anticipated cash requirements for at least the next twelve months.


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Contractual Commitments and Off-Balance Sheet Arrangements At March 31, 2014, our future contractual commitments by fiscal year were as follows (in thousands):

                                                                  Payments due by period
                          Total         2014          2015          2016           2017        2018 and  thereafter
Operating leases       $   2,945     $   1,239     $   1,290     $     403     $       13     $                   -
. . .
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