-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, P4Pj4JHCTJXva5jg1Rw3YfzaBjYdae3YHHElogTi8aknO9BKW1OSdB2sYT8Lcw3W W9Zd3MBwZa+H+B6D7W/feA== 0000891618-02-003804.txt : 20020813 0000891618-02-003804.hdr.sgml : 20020813 20020813162531 ACCESSION NUMBER: 0000891618-02-003804 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20020630 FILED AS OF DATE: 20020813 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ALLIANCE FIBER OPTIC PRODUCTS INC CENTRAL INDEX KEY: 0001122342 STANDARD INDUSTRIAL CLASSIFICATION: SEMICONDUCTORS & RELATED DEVICES [3674] IRS NUMBER: 770417039 STATE OF INCORPORATION: CA FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 000-31857 FILM NUMBER: 02730037 BUSINESS ADDRESS: STREET 1: 735 NORTH PASTORIA AVE. CITY: SUNNYVALE STATE: CA ZIP: 94085 BUSINESS PHONE: 408-736-69 MAIL ADDRESS: STREET 1: 735 NORTH PASTORIA AVE. CITY: SUNNYVALE STATE: CA ZIP: 94085 FORMER COMPANY: FORMER CONFORMED NAME: ALLIANCE FIBER OPTICS PRODUCTS INC DATE OF NAME CHANGE: 20000822 10-Q 1 f83724e10vq.txt FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 -------------------- FORM 10-Q (Mark One) [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended June 30, 2002 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 0-31857 ALLIANCE FIBER OPTIC PRODUCTS, INC. ------------------------------------------------------ (Exact name of registrant as specified in its charter) Delaware 77-0554122 ------------------------------- ---------------------- (State or other jurisdiction of (I.R.S. employer Incorporation or organization) identification number)
735 North Pastoria Avenue, Sunnyvale, California 94085 ----------------------------------------------------------- (Address of Principal Executive Offices) (Zip Code) Registrant's telephone number, including area code: (408) 736-6900 -------------------- 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 [ ] On August 6, 2002, 35,516,829 shares of the Registrant's Common Stock, $0.001 par value per share, were outstanding. ALLIANCE FIBER OPTIC PRODUCTS, INC. FORM 10-Q QUARTERLY PERIOD ENDED JUNE 30, 2002 INDEX
Page ---- Part I: Financial Information................................................ 1 Item 1: Financial Statements............................................. 1 Consolidated Balance Sheets at December 31, 2001 and June 1 30, 2002........................................................... Consolidated Statements of Operations for the Three and 2 Six Months Ended June 30, 2001 and 2002............................ Consolidated Statements of Cash Flows for the Six Months 3 Ended June 30, 2001 and 2002....................................... Notes to Consolidated Financial Statements............................ 4 Item 2: Management's Discussion and Analysis of Financial 7 Condition and Results of Operations................................... Item 3: Quantitative and Qualitative Disclosures About Market 23 Risk and Interest Rate Risk........................................... Part II: Other Information................................................... 24 Item 4: Submission of Matters to a Vote of Security Holders.............. 24 Item 6: Exhibits and Reports on Form 8-K................................. 24 Signatures.................................................................... 25
i PART I: FINANCIAL INFORMATION ITEM 1: FINANCIAL STATEMENTS ALLIANCE FIBER OPTIC PRODUCTS, INC. CONSOLIDATED BALANCE SHEETS (UNAUDITED, IN THOUSANDS, EXCEPT SHARE DATA)
DEC. 31, JUNE 30, 2001 2002 --------- --------- ASSETS Current assets: Cash and cash equivalents $ 16,947 $ 10,305 Short-term investments 33,118 36,049 Accounts receivable, net 2,645 1,680 Inventories, net 7,419 4,470 Prepaid expense and other current assets 1,106 1,143 --------- --------- Total current assets 61,235 53,647 Property and equipment, net 7,381 6,036 Other assets 575 411 --------- --------- Total assets $ 69,191 $ 60,094 ========= ========= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 1,425 $ 1,315 Income tax payable 153 140 Accrued expenses 1,666 1,914 --------- --------- Total current liabilities 3,244 3,369 Long-term liabilities 182 241 --------- --------- Total liabilities 3,426 3,610 --------- --------- Commitments and contingencies (Note 8) Stockholders' equity: Common stock, $0.001 par value: 250,000,000 shares authorized at December 31, 2001 and June 30, 2002; and 35,409,524 and 35,508,579 shares issued and outstanding at December 31, 2001 and June 30, 2002, respectively 35 36 Additional paid-in-capital 108,755 106,603 Receivables from stockholders (1,934) (1,730) Deferred stock-based compensation (7,261) (4,431) Accumulated deficit (33,709) (43,896) Accumulated other comprehensive loss (121) (98) --------- --------- Stockholders' equity 65,765 56,484 --------- --------- Total liabilities and stockholders' equity $ 69,191 $ 60,094 ========= =========
The accompanying notes are an integral part of these Consolidated Financial Statements. 1 ALLIANCE FIBER OPTIC PRODUCTS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED, IN THOUSANDS, EXCEPT PER SHARE DATA)
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, --------------------------- ------------------------- 2001 2002 2001 2002 ---------- ---------- ---------- --------- Revenues $ 4,568 $ 3,665 $ 11,937 $ 7,197 Cost of revenues 15,267 4,859 19,824 10,028 Stock-based compensation charge 427 (70) 912 (285) -------- -------- -------- -------- Total cost of revenues 15,694 4,789 20,736 9,743 -------- -------- -------- -------- Gross profit (loss) (11,126) (1,124) (8,799) (2,546) -------- -------- -------- -------- Operating expenses: Research and development 1,784 1,966 3,458 4,077 Stock-based compensation charge 1,275 250 2,522 520 -------- -------- -------- -------- Total research and development 3,059 2,216 5,980 4,597 Sales and marketing 733 746 1,542 1,665 Stock-based compensation charge 292 (200) 585 (129) -------- -------- -------- -------- Total sales and marketing 1,025 546 2,127 1,536 General and administrative 1,148 930 2,107 1,753 Stock-based compensation charge 755 156 1,736 532 -------- -------- -------- -------- Total general and administrative 1,903 1,086 3,843 2,285 -------- -------- -------- -------- Total operating expenses 5,987 3,848 11,950 8,418 -------- -------- -------- -------- Loss from operations (17,113) (4,972) (20,749) (10,964) Interest and other income, net 636 486 1,619 799 -------- -------- -------- -------- Loss before income taxes (16,477) (4,486) (19,130) (10,165) Income tax provision 3 10 126 22 -------- -------- -------- -------- Net loss $(16,480) $ (4,496) $(19,256) $(10,187) ======== ======== ======== ======== Net loss per share: Basic and diluted $ (0.50) $ (0.13) $ (0.59) $ (0.30) ======== ======== ======== ======== Shares used in computing net loss per share: Basic and diluted 32,987 34,546 32,809 34,455 -------- -------- -------- --------
The accompanying notes are an integral part of these Consolidated Financial Statements. 2 ALLIANCE FIBER OPTIC PRODUCTS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED, IN THOUSANDS, EXCEPT SHARE DATA)
SIX MONTHS ENDED JUNE 30, ------------------------- 2001 2002 -------- ---------- CASH FLOWS FROM OPERATING ACTIVITIES: Net loss $(19,256) $(10,187) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation 974 832 Amortization of stock-based compensation 5,755 638 Impairment/write down in property and equipment 5,200 972 Provision for inventory 6,543 3,157 Interest income receivable -- (20) Changes in assets and liabilities: Accounts receivable, net 2,423 966 Inventories, net (6,185) (168) Prepaid expenses and other assets (17) 131 Accounts payable (577) (97) Income tax payable (79) (13) Accrued expenses (133) 260 Other long-term liabilities (20) 60 -------- -------- Net cash used in operating activities (5,372) (3,469) -------- -------- CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of short-term investments (11,848) (2,988) Purchase of property and equipment (4,320) (459) -------- -------- Net cash used in investing activities (16,168) (3,447) -------- -------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from issuance of common stock under ESPP 210 151 Proceeds from the exercise of common stock options 71 28 Proceeds from the repayment of notes receivable -- 88 -------- -------- Net cash provided by financing activities 281 267 -------- -------- Effect of exchange rate changes on cash and cash equivalents 4 7 -------- -------- Net decrease in cash and cash equivalents (21,255) (6,642) Cash and cash equivalents at beginning of period 42,548 16,947 -------- -------- Cash and cash equivalents at end of period $ 21,293 $ 10,305 ======== ======== NON-CASH INVESTING AND FINANCING ACTIVITIES: Repurchase of common stocks via cancellation of notes receivable from stockholders $ -- $ 116 ======== ========
The accompanying notes are an integral part of these Consolidated Financial Statements. 3 ALLIANCE FIBER OPTIC PRODUCTS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) 1. THE COMPANY Alliance Fiber Optic Products, Inc. (the "Company") was incorporated in California on December 12, 1995 and reincorporated in Delaware on October 19, 2000. The Company designs, manufactures and markets fiber optic components for communications equipment manufacturers. The Company's headquarters is in Sunnyvale, California and it has operations in Taiwan and China. 2. BASIS OF PRESENTATION The consolidated financial information as of June 30, 2002 included herein is unaudited, has been prepared by the Company in accordance with generally accepted accounting principles in the United States of America, and reflects all adjustments, consisting only of normal recurring adjustments, which in the opinion of management are necessary to state fairly the Company's consolidated financial position, results of its consolidated operations, and consolidated cash flows for the periods presented. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates, and such differences may be material to the financial statements. These financial statements should be read in conjunction with the Company's audited Consolidated Financial Statements for the year ended December 31, 2001 included in the Company's Annual Report on Form 10-K, as filed on March 27, 2002 with the Securities and Exchange Commission ("SEC"). The results of operations for the three and six months ended June 30, 2002 are not necessarily indicative of the results to be expected for any future periods. Certain reclassifications have been made to amounts reported in prior periods, none of which affect the Company's financial position, results of operations, or cash flows. 3. INVENTORIES (IN THOUSANDS)
DEC. 31, JUNE 30, 2001 2002 -------- -------- INVENTORIES Finished goods $ 3,241 $ 2,534 Work-in-process 5,977 5,389 Raw materials 2,966 2,872 Less: Reserve for excess and obsolete inventory (4,765) (6,325) ------- ------- $ 7,419 $ 4,470 ======= =======
4. WRITE DOWN OF PROPERTY AND EQUIPMENT Certain of the Company's equipment and machinery located in Taiwan for the production of fused fiber products were determined to be non-functional or damaged. Accordingly, the Company recorded a write down charge of approximately $1 million in the three months ended June 30, 2002 for this non-functional or damaged equipment and machinery. 5. NET LOSS PER SHARE 4 Basic net loss per share is computed by dividing net loss for the period by the weighted average number of shares of common stock outstanding during the period. Diluted net loss per share is computed by dividing the net loss for the period by the weighted average number of common and potential common equivalent shares outstanding during the period. The calculation of diluted net loss per share excludes potential common shares if the effect is anti-dilutive. Potential common shares are composed of shares of common stock subject to repurchase and common stock issuable upon the exercise of stock options. As the Company is in a net loss position, diluted net loss per share is the same as basic net loss per share. The following table sets forth the computation of basic and diluted net loss per share for the periods indicated (in thousands, except per share data):
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ----------------------- ----------------------- 2001 2002 2001 2002 -------- -------- -------- -------- Numerator: Net loss $(16,480) $ (4,496) $(19,256) $(10,187) ======== ======== ======== ======== Denominator: Shares used in computing net loss per share: Weighted average of common shares outstanding 34,960 35,433 34,841 35,424 Less: Weighted average of shares subject to repurchase (1,973) (887) (2,032) (969) -------- -------- -------- -------- Basic and diluted 32,987 34,546 32,809 34,455 ======== ======== ======== ======== Net loss per share: Basic and diluted $ (0.50) $ (0.13) $ (0.59) $ (0.30) -------- -------- -------- --------
6. COMPREHENSIVE LOSS Comprehensive income (loss) is defined as the change in equity of a company during a period resulting from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners. The difference between net loss and comprehensive loss for the Company is due to foreign exchange translations adjustments and unrealized gain (loss) on available-for-sale securities. The components of comprehensive loss are as follows (in thousands):
THREE MONTHS SIX MONTHS ENDED JUNE 30, ENDED JUNE 30, ----------------------- ----------------------- 2001 2002 2001 2002 -------- -------- -------- -------- Net loss $(16,480) $ (4,496) $(19,256) $(10,187) Cumulative translation adjustments 52 91 16 78 Unrealized gain (loss) on short-term investments (94) 56 79 (57) -------- -------- -------- -------- Total comprehensive loss $(16,522) $ (4,349) $(19,161) $(10,166) ======== ======== ======== ========
7. GEOGRAPHIC SEGMENT INFORMATION The Company operates in a single industry segment. This industry segment is characterized by rapid technological change and significant competition. Revenues billed to customers outside of the United States for the six months ended June 30, 2001 and 2002 totaled were 18.3% and 9.2% of revenues, respectively. No one customer accounted for 10% or more of the Company's revenues. 5
DEC. 31, JUNE 30, 2001 2002 -------- -------- IDENTIFIABLE ASSETS United States $60,341 $51,973 Taiwan 8,554 7,394 China 481 727 ------- ------- Total $69,376 $60,094 ======= =======
8. CONTINGENCIES From time to time, the Company may be involved in litigation in the normal course of business. Management believes that the outcome of such matters to date will not have a material adverse effect on the Company's consolidated financial position, results of operations or cash flows. 9. RECENT ACCOUNTING PRONOUNCEMENTS In June 2002, the Financial Accounting Standards Board ("FASB') issued Statement of Financial Accounting Standards ("SFAS") No. 146 ("SFAS 146"), "Accounting for Exit or Disposal Activities". SFAS 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for pursuant to the guidance that the Emerging Issues Task Force (EITF) has set forth in EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). The scope of SFAS 146 also includes (1) costs related to terminating a contract that is not a capital lease and (2) termination benefits that employees who are involuntarily terminated receive under the terms of a one-time arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002. The Company is in the process of reviewing the effect the adoption of this statement will have on the Company's Financial Statements. 6 ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS When used in this discussion, the words "expects," "anticipates," "believes", "estimates," "plans," and similar expressions are intended to identify forward-looking statements. These statements, which include statements as to our critical accounting policies, our sources of revenues, anticipated revenue levels, our net losses and negative cash flow, the fluctuation of our cost of revenues as a percentage of revenues, our net losses, the amount and mix of our anticipated expenditures and expenses, including research and development, sales and marketing and general and administrative expenses, increase or decrease of our expenses or expenditures in absolute dollars or as a percentage of revenues, expansion of our sales and marketing efforts, our competitive advantage, our ability to compete, the sources of our competition, the necessary expenditures to remain competitive, our plans to expand our product development efforts, additional inventory reserves in future periods, our reliance on our OPMS products, our future growth and future revenues being dependent on our DWDM products, our plans to expand our operations domestically and internationally, our increased expenses if demand for our products increases, amortization of our deferred stock-based compensation, the adequacy of our capital resources, our plans for operations in China, the impact of recent accounting pronouncements, period-to-period comparisons of our operating results, our ability to obtain raw materials and components and maintain and develop supplier relationships, our ability to establish and maintain relationships with key customers, our success being tied to relationships with key customers, our ability to maintain appropriate inventory levels, factors that affect a customer's decision to choose a supplier, our patent applications and intellectual property, an increase in patent infringement claims, our exposure to currency rate fluctuations, adequacy of capital resources, our need for additional financing, investments of our existing cash, our exposure to interest rate risk, and the continued denomination of our international revenues in predominately United States dollars, are subject to risks and uncertainties that could cause actual results to differ materially from those projected. These risks and uncertainties include, but are not limited to, those risks discussed below, as well as competition including the impact of competitive products and pricing, timely design acceptance by our customers, our success attracting new customers, our customers adopting our new products, loss of a key customer, timely introduction of new products and technologies, our ability to ramp new products into volume production, our ability to attract and retain highly skilled personnel, industry wide shifts in supply and demand for optical components and modules, the development of the market for our DWDM products, a further decrease in spending by telecommunications companies, increased competition or consolidation in our industry, our ability to license intellectual property, industry overcapacity, financial stability in foreign markets, our continued listing on the Nasdaq National Market and the matters discussed in "Factors That May Affect Results." These forward-looking statements speak only as of the date hereof. The Company expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in the Company's expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based. This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in the Company's Annual Report on Form 10-K, its Consolidated Financial Statement and the notes thereto, for the year ended December 31, 2001. The following discussion should be read in conjunction with our Consolidated Financial Statements and Notes thereto. CRITICAL ACCOUNTING POLICIES AND ESTIMATES Management's discussion and analysis of our financial condition and results of operations are based on our Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, bad debts, 7 inventories, asset write-downs, income taxes, contingencies, and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values for assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe the following critical accounting policies affect management's more significant judgments and estimates used in the preparation of the Company's Consolidated Financial Statements: We recognize revenues upon the shipment of our products to our customers provided that we have received a purchase order, the price is fixed, and the collection of the resulting receivable is probable. Subsequent to the sale of the products, we have no obligation to provide any modification or customization, upgrades, enhancements, or post-contract customer support. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. Our inventory write-downs for estimated excess and obsolete or unmarketable inventory equal to the difference between the cost of inventory and the excess and estimated market values are based on assumptions about future demand and market conditions. If actual demand or market conditions are less favorable than those projected by management, additional inventory write-downs may be required. Based on reduced demand and revenue projections for our DWDM-related products and the rapid technological change for our OPMS products, we took net charges of $6.5 million and $0.9 million for inventory in the quarters ended June 30, 2001 and 2002, respectively. We review the valuation of long-lived assets and assess the write-down of the assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable due to significant underperformance relative to expected or historical or projected future operating results, significant changes in the manner or condition of the assets or the strategy for the overall business, and significant negative industry or economic trends. When we determine that the carrying value of long-lived assets may not be recoverable based on the existence of one or more of the above indicators of write-down, we measure any write-down based on the condition of the assets. In the quarter ended June 30, 2002, we recorded a write-down charge of $1.0 million for the property and equipment used to manufacture our fused fiber-related products, as these were determined to be non-functional or damaged. We estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our Consolidated Balance Sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the statement of operations. To date, we have recorded a full allowance against our deferred tax assets. OVERVIEW We were founded in December 1995 and commenced operations to design, manufacture and market fiber optic interconnect products, which we call our Optical Path Management Solution, or OPMS. Our OPMS product line now includes attenuators and fused fiber products, most of which were introduced between 1997 and 2000. In early 1999, we started developing our dense wavelength division multiplexing, or DWDM, and other wavelength management products, forming a new product line based in part on our proprietary technology. We started selling our DWDM devices in July 2000. Since introduction, sales of DWDM-related products have been less than expected, leading to additional inventory reserves. 8 From our inception through June 30, 2002, we derived substantially all of our revenues from our OPMS product line. Revenues from our DWDM products represented approximately 9.2% of total revenues for the year ended December 31, 2001. For the six months ended June 30, 2002, our DWDM products contributed revenues of $0.6 million, or 8.1% of total revenues. We market and sell our products predominantly through our direct sales force, which we began building in early 1998. Although we derived a significant portion of our revenues between 1996 and 1998 from overseas customers, an increasing percentage of our sales since early 1999 have been in North America. For the six months ended June 30, 2001 and 2002, revenues derived from sales outside of North America were 18.3% and 9.2%, respectively. Our cost of revenues consists of raw materials, components, direct labor, manufacturing overhead and production start-up costs. We expect that our cost of revenues as a percentage of revenues will fluctuate from period to period based on a number of factors including: - changes in manufacturing volume; - costs incurred in establishing additional manufacturing lines and facilities; - inventory write-downs and fixed asset write-downs related to manufacturing assets; - mix of products sold; - changes in our pricing and pricing from our competitors; - mix of sales channels through which our products are sold; and - mix of domestic and international sales. Research and development expenses consist primarily of salaries and related personnel expenses, fees paid to outside service providers, materials costs, test units, facilities, overhead and other expenses related to the design, development, testing and enhancement of our products. We expense our research and development costs as they are incurred. We believe that a significant level of investment for product research and development is required to remain competitive. We expect our research and development expenses, excluding stock-based compensation, to decline from second quarter levels for the remaining quarters of 2002. Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in marketing, sales and technical support functions, as well as costs associated with trade shows, promotional activities and travel expenses. We intend to expand our sales and marketing efforts, both domestically and internationally, in order to increase market awareness and to generate sales of our products. However, we cannot be certain that any increased expenditures will result in higher revenues. In addition, we believe our future success depends upon establishing successful relationships with a variety of key customers. We believe that continued investment in sales and marketing functions is critical to our success, but due to the slowdown in business, we expect these expenses, excluding stock-based compensation, to decrease slightly from second quarter levels for the remaining quarters of 2002. General and administrative expenses consist primarily of salaries and related expenses for executive, finance, administrative, accounting and human resources personnel, insurance and professional fees for legal and accounting support. We expect these expenses, excluding stock-based compensation, to remain at approximately the same level throughout the remaining quarters of 2002, as we continue to monitor the costs incurred through the growth of our business and our operations. In connection with the grant of stock options to employees and consultants, we recorded deferred stock-based compensation of approximately $24.4 million in stockholders' equity through December 31, 9 2001, representing the difference between the estimated fair market value of our common stock and the exercise price of these options at the date of grant. We amortize deferred stock-based compensation using the graded vesting method, under which each option grant is separated into portions based on its vesting terms, which results in acceleration of amortization expense for the overall award. We plan to amortize the deferred stock-based compensation balance of $4.4 million as of June 30, 2002 on an accelerated basis over the vesting periods of the option grants, which are generally four years. During the third quarter of 2002, Mr. Philip J. Rehkemper, our Chief Financial Officer, left the Company to pursue other interests. The price of our common stock has closed below the Nasdaq minimum $1.00 per share requirement for thirty consecutive trading days. Therefore, in accordance with Marketplace Rule 4450(e)(2), we have ninety calendar days, or until October 14, 2002, to regain compliance. If, at anytime before October 14, 2002, the bid price of the Company's stock has not closed at $1.00 per share or more for a minimum of ten consecutive trading days, our common stock may be delisted or we may apply to transfer our securities to The Nasdaq SmallCap Market. To transfer, the Company must satisfy the continued inclusion requirements for the SmallCap Market, which makes available an extended grace period for the minimum $1.00 bid price requirement. If the Company submits a transfer application and pays the applicable listing fees by October 14, 2002, initiation of the delisting proceedings will be stayed pending Nasdaq staff's review of the transfer application. If the transfer application is approved, the Company will be afforded the 180 calendar day Nasdaq SmallCap Market grace period, which commences on July 15, 2002, or until January 13, 2003 to regain compliance with the minimum bid requirement. The Company may also be eligible for an additional one hundred and eighty calendar day grace period provided that it meets the initial listing criteria for The Nasdaq SmallCap Market under marketplace Rule 4310(c)(2)(A). 10 RESULTS OF OPERATIONS The following table sets forth the relationship between various components of operations, stated as a percentage of revenues for the periods indicated:
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, --------------------------- ------------------------- 2001 2002 2001 2002 ---------- ----------- --------- ---------- Revenues 100.0% 100.0% 100.0% 100.0% Cost of revenues: 334.2 132.6 166.1 139.3 Stock-based compensation charge 9.3 (1.9) 7.6 (4.0) ------ ------ ------ ------ Total cost of revenues 343.6 130.7 173.7 135.4 Gross profit (loss) (243.6) (30.7) (73.7) (35.4) ------ ------ ------ ------ Operating expenses: Research and development: 39.1 53.6 29.0 56.6 Stock-based compensation charge 27.9 6.8 21.1 7.2 ------ ------ ------ ------ Total research and development 67.0 60.5 50.1 63.9 Sales and marketing: 16.0 20.4 12.9 23.1 Stock-based compensation charge 6.4 (5.5) 4.9 (1.8) ------ ------ ------ ------ Total sales and marketing 22.4 14.9 17.8 21.3 General and administrative: 25.1 25.4 17.7 24.4 Stock-based compensation charge 16.5 4.3 14.5 7.4 ------ ------ ------ ------ Total general and administrative 41.7 29.6 32.2 31.7 ------ ------ ------ ------ Total operating expenses 131.1 105.0 100.1 117.0 ------ ------ ------ ------ Loss from operations (374.6) (135.7) (173.8) (152.3) Interest and other income, net 13.9 13.3 13.6 11.1 ------ ------ ------ ------ Loss before income taxes (360.8) (122.5) (160.4) (141.3) Income tax provision 0.1 0.3 1.1 0.3 ------ ------ ------ ------ Net loss (360.9)% (122.8)% (161.4)% (141.6)% ====== ====== ====== ======
Revenues. Revenues were $4.6 million and $3.7 million for the three months ended June 30, 2001 and 2002, respectively. Revenues decreased 19.8% from June 30, 2001 to June 30, 2002 due primarily to an overall slowdown in the telecommunications industry. Revenues from our DWDM-related products were $0.2 million and $0.5 million for the three months ended June 30, 2001 and 2002, respectively. Revenues were $11.9 million and $7.2 million for the six months ended June 30, 2001 and 2002 respectively. Revenues for the six months ended June 30, 2001 and 2002 declined 39.5% due to an overall slowdown in the telecommunications industry. Gross Profit (loss). Excluding stock-based compensation expense from cost of sales, gross loss decreased from $10.7 million for the three months ended June 30, 2001, to $1.2 million for the same period in 2002. For the six month periods, gross loss decreased from $7.9 million, or (66.1%) of revenues, for the six months ended June 30, 2001, to $2.8 million, or (39.3%) of revenues, for the same period in 2002. The primary reason that gross loss decreased for the three months ended June 30, 2002 compared to the same period in 2001 was because charges for excess and obsolete inventory were lower in the three months ended June 30, 2002 than in the same period last year. 11 In the quarter ended June 30, 2002, due to the continued adverse effects of the industry slowdown and economic outlook, the Company determined that future demand for its DWDM-related products would be lower than expected and, therefore, an additional inventory reserve of $0.4 million was recorded in accordance with the Company's policy of reserving against inventory levels in excess of future demand. In addition, $0.4 million of DWDM inventory was written down due to obsolescence. An inventory reserve of $0.1 million relating to obsolete OPMS products was also recorded. We expect our gross margin as a percentage of revenues to continue to be negatively impacted in the near term due to low production volumes and unabsorbed overhead. The anticipated growth of our DWDM product sales has been significantly impacted by the overall industry slowdown. With the additional inventory reserve in the quarter ended June 30, 2002, we had approximately $1.1 million in DWDM-related net inventory on hand at June 30, 2002. Although we continue to take steps to attempt to manage future inventory levels, we may have to record additional inventory reserves in future periods if the decrease in demand continues. Research and Development Expenses. Excluding stock-based compensation expense, research and development expenses increased from $1.8 million, or 39.1% of revenues, for the three months ended June 30, 2001 to $2.0 million, or 53.6% of revenues, for the same period in 2002. Research and development expenses increased from $3.5 million, or 29.0% of revenues, for the six months ended June 30, 2001 to $4.1 million, or 56.6% of revenues, for the same period in 2002. The increase in expenses was primarily due to costs related to the development of new products and increases in the number of research and development personnel and related costs. However, we expect our quarterly research and development expenses to decline from second quarter levels for the remaining quarters of 2002. Sales and Marketing Expenses. Excluding stock-based compensation expense, sales and marketing expenses remained flat at $0.7 million for the three months ended June 30, 2002, but increased as a percentage of revenue from 16.0% for the three months ended June 30, 2001, to 20.4% for the three months ended June 30, 2002 due to decreased revenues. Sales and marketing expenses increased from $1.5 million, or 12.9% of revenues, for the six months ended June 30, 2001 to $1.7 million, or 23.1% of revenues, for the six months ended June 30, 2002. This increase was due to the continued expansion of our sales and marketing efforts including the introduction and promotion of new products in the first two quarters of 2002. However, we expect our quarterly sales and marketing expenses to decline slightly from second quarter levels for the remaining quarters of 2002. General and Administrative Expenses. Excluding stock-based compensation expense, general and administrative expenses decreased from $1.1 million, or 25.1% of revenues, for the three months ended June 30, 2001 to $0.9 million, or 25.4% of revenues, for the same period in 2002. General and administrative expenses decreased from $2.1 million, or 17.7% of revenues, for the six months ended June 30, 2001 to $1.8 million or 24.4% of revenues, for the same period in 2002. The decrease was a result of our efforts to control cost. We expect our quarterly general and administrative expenses to remain approximately at the same level throughout the remaining quarters of 2002. Stock-based compensation. Total stock-based compensation decreased from $2.7 million, or 60.1% of revenues, in the three months ended June 30, 2001, to $0.1 million, or 3.7% of revenues in the three months ended June 30, 2002. Stock-based compensation decreased from $5.8 million, or 48.1% of revenues, for the six months ended June 30, 2001 to $0.6 million, or 8.8% of revenues, for the six months ended June 30, 2002. These decreases were partially due to the Company's accounting policy, which required it to amortize a larger proportion of deferred compensation expense in earlier periods, and partially due to the reversal of compensation expense for unvested stock options of employees whose employment was terminated during the three months ended June 30, 2002. Interest and Other Income, Net. Interest and other income, net, was $0.6 million and $0.5 million for the three months ended June 30, 2001 and 2002, respectively. Interest and other income, net, was $1.6 million and $0.8 million for the six months ended June 30, 2001 and 2002, respectively. The decrease was the result of significantly lower fund balances available for investment and lower applicable interest rates. 12 Income Taxes. Income tax expense, which was relatively minor due to losses on a consolidated basis, was the result of taxable income from our Taiwan subsidiary. LIQUIDITY AND CAPITAL RESOURCES Since inception, we have financed our operations primarily through private sales of convertible preferred stock and bank debt. Additionally, in November 2000, we completed our initial public offering of common stock, raising approximately $44.4 million, net of costs and expenses. At June 30, 2002, we had cash and cash equivalents of $10.3 million and short-term investments of $36.1 million. Net cash used in operating activities was $5.4 million and $3.4 million for the six months ended June 30, 2001 and 2002, respectively. For the six months ended June 30, 2002, net cash used was primarily due to our net loss of $10.2 million, offset by non-cash adjustments, including provision for inventory of $3.2 million, write down of property and equipment of $1 million, depreciation and amortization of $1.5 million, and net changes in working capital of $1 million. For the six months ended June 30, 2001, net cash used in operating activities was due to losses of $19.3 million and an increase in net working capital of $4.5 million, offset by non-cash adjustments for inventory provision of $6.5 million, impairment of property and equipment of $5.2 million and depreciation and amortization of $6.7 million. Cash used in investing activities was $16.2 million and $3.4 million for the six months ended June 30, 2001 and 2002, respectively. In the six months ended June 30, 2001, $11.9 million was invested in high-grade, short-term investments, while $4.3 million was used to acquire property and equipment. In the six months ended June 30, 2002, $3.0 million was invested in high-grade, short-term investments, while $459,000 was used to acquire property and equipment. Cash generated by financing activities was $0.3 million and $0.06 million for the six months ended June 30, 2001 and 2002, respectively, resulting from proceeds from the exercise of options to purchase shares of our common stock and common stock issued through our employee stock purchase plan. For the six months ended June 30, 2002, cash generated also included net proceeds from the repayment of notes receivable of $0.09 million. In July 2000 and February 2001, we entered into leases for 10,500 and 10,600 square feet of space, respectively, near our existing facility in Sunnyvale, California. In Taiwan, we lease a total of approximately 38,800 square feet in one facility located in Tu-Cheng City, Taiwan. Additionally, in December 2000, the Company purchased approximately 8,200 square feet of space immediately adjacent to the leased facility for $0.8 million. As of June 30, 2002, we had a lease for a facility in the Shenzhen area totaling approximately 12,000 square feet, which will expire in December 2002. In August 2002, we entered into a new lease for a 62,000 square foot facility in the same Shenzhen area, which will expire in July 2007. We expect that our operations in China will move into the new building in August 2002. The future minimum lease payments under our operating leases are as follows (in thousands):
PERIOD ENDING AMOUNT DUE - ------------------------------------------- ----------- Six months ending December 31, 2002 $1,010 Years ending December 31,: 2003 1,970 2004 1,126 2005 55 2006 and there after 87 ------- Total $4,248 =======
We believe that our current cash, cash equivalents and short-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, our future growth, including potential acquisitions, may require additional funding. If cash generated from operations is insufficient to satisfy our long-term liquidity requirements, we may need to raise capital through additional equity or debt financings or additional credit facilities. If additional funds are raised through the issuance of securities, these securities could have rights, preferences and 13 privileges senior to holders of common stock, and the terms of any debt facility could impose restrictions on our operations. The sale of additional equity or debt securities could result in additional dilution to our stockholders, and additional financing may not be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain additional financing, we may be required to reduce the scope of our planned product development and marketing efforts, which could harm our business, financial condition and operating results. RECENT ACCOUNTING PRONOUNCEMENTS In June 2002, the Financial Accounting Standards Board ("FASB') issued Statement of Financial Accounting Standards No. 146 (SFAS 146), Accounting for Exit or Disposal Activities. SFAS 146 addresses significant issues regarding the recognition, measurement, and reporting of costs that are associated with exit and disposal activities, including restructuring activities that are currently accounted for pursuant to the guidance that the Emerging Issues Task Force (EITF) has set forth in EITF Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). The scope of SFAS 146 also includes (1) costs related to terminating a contract that is not a capital lease and (2) termination benefits that employees who are involuntarily terminated receive under the terms of a one-time arrangement that is not an ongoing benefit arrangement or an individual deferred-compensation contract. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002. The Company is in the process of reviewing the effect the adoption of this statement will have on the Company's Financial Statements. FACTORS THAT MAY AFFECT RESULTS WE HAVE A HISTORY OF LOSSES, EXPECT FUTURE LOSSES AND MAY NOT BE ABLE TO GENERATE SUFFICIENT REVENUES IN THE FUTURE TO ACHIEVE AND SUSTAIN PROFITABILITY. We incurred net losses of approximately $19.3 million and $10.2 million in the first six months of fiscal 2001 and 2002, respectively, and expect that our net losses and negative cash flows will continue for the foreseeable future as we continue to invest in our business. As of June 30, 2002, we had an accumulated deficit of approximately $43.9 million. Although we are currently experiencing decreased demand for our products, we are hopeful that demand for our products will increase in the future. If this happens, we expect we will incur significant and increasing expenses for expansion of our manufacturing operations, research and development, sales and marketing, and administration, and in developing direct sales and distribution channels. Given our early stage of development, the rate at which competition in our industry intensifies, and the significant downturn in demand for our products, we may not be able to adequately control our costs and expenses or achieve or maintain adequate operating margins. As a result, to achieve and maintain profitability, we will need to generate and sustain substantially higher revenues while maintaining reasonable cost and expense levels. We may not be able to achieve and sustain profitability on a quarterly or an annual basis. OUR QUARTERLY AND ANNUAL FINANCIAL RESULTS HAVE HISTORICALLY FLUCTUATED DUE PRIMARILY TO INTRODUCTION OF, DEMAND FOR, AND SALES OF OUR PRODUCTS, AND FUTURE FLUCTUATIONS MAY CAUSE OUR STOCK PRICE TO DECLINE. We believe that period-to-period comparisons of our operating results are not a good indication of our future performance. Our quarterly operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a number of factors. For example, the timing and expenses associated with product introductions, the timing and extent of product sales, the mix of products sold and significant decreases in the demand for our products have caused our operating results to fluctuate in the past. Because we incur operating expenses based on anticipated revenue trends, and a high percentage of our expenses are fixed in the short term, any delay in generating or recognizing revenues or any decrease in revenues could significantly harm our quarterly results of operations. Other factors, many of 14 which are more fully discussed in other risk factors below, may also cause our results to fluctuate. Many of the factors that may cause our results to fluctuate are outside of our control. If our quarterly or annual operating results do not meet the expectations of investors and securities analysts, the trading price of our common stock could significantly decline. OUR OPTICAL PATH MANAGEMENT SOLUTION (OPMS) PRODUCTS HAVE HISTORICALLY REPRESENTED SUBSTANTIALLY ALL OF OUR REVENUES, AND IF WE ARE UNSUCCESSFUL IN COMMERCIALLY SELLING OUR DWDM-RELATED PRODUCTS, OUR BUSINESS WILL BE SERIOUSLY HARMED. Sales of our OPMS products accounted for over 86% of our revenues in the quarter ended June 30, 2002, 92% of our revenues for the six months ended June 30, 2002, and substantially all of our historical revenues. We expect to substantially depend on these products for our near-term revenues. Any significant decline in the price of, or demand for, these products, or failure to increase their market acceptance, would seriously harm our business. In the quarter ended June 30, 2002, we determined that OPMS inventory of $0.1 million no longer met current customer specifications and was deemed to be obsolete. We believe that our future growth and a significant portion of our future revenues will depend on the commercial success of our DWDM-related products, which we began shipping commercially in July 2000. Demand for these products declined sharply starting in mid fiscal 2001. Based on the reduced demand and reduced revenue projections for this product line, we took a charge of $6.5 million against excess DWDM inventory in the quarter ended June 30, 2001 and charges of $1.2 million and $0.4 million against excess DWDM-related inventory in the quarters ended March 31, 2002 and June 30, 2002, respectively. If demand for these products does not increase and our target customers do not adopt and purchase our DWDM-related products, our revenues may decline further and we may have to write-off additional inventory currently on our books. WE ARE EXPERIENCING A DECREASE IN MARKET DEMAND DUE TO A RECESSION IN THE UNITED STATES AS THE SLUMPING ECONOMY IS FURTHER STYMIED BY INTERNATIONAL TERRORISM, WAR AND POLITICAL INSTABILITY. The United States economy experienced a significant slowdown in consumption and demand for fiber optic products most of 2001 as well as the first half of 2002. We may experience further decreases in the demand for our products due to a weak domestic economy as the fiber optics industry copes with the effects of international terrorism, war and political instability. Even if the general economy experiences a recovery, the activity of United States telecommunications industry may lag behind the recovery of the overall United States economy. WE MAY NOT BE ABLE TO MAINTAIN OUR LISTING ON THE NASDAQ NATIONAL MARKET AND IF WE FAIL TO DO SO, THE PRICE AND LIQUIDITY OF OUR COMMON STOCK MAY DECLINE. The Nasdaq Stock Market has quantitative maintenance criteria for the continued listing of common stock on The Nasdaq National Market. The current requirements affecting us include (i) having net tangible assets of at least $4 million and (ii) maintaining a minimum bid price per share of $1. As of June 30, 2002, our stock price closed at $0.71. The price of the Company's common stock has closed below the minimum $1.00 per share for 30 consecutive trading days since May 30, 2002. Therefore, in accordance with Marketplace Rule 4450(e)(2), the Company has 90 calendar days, or until October 14, 2002, to regain compliance with The Nasdaq National Market's revised quantitative maintenance criteria including a new minimum requirement of $10 million in stockholders' equity. There can be no assurance that we will be able to comply with the quantitative maintenance criteria or any of The Nasdaq National Market's rules in the future. If we fail to maintain continued listing on The Nasdaq National Market and must move to a market with less liquidity, our financial condition could be harmed and our stock price would likely decline. If we are delisted, it could have a material adverse effect on the market price of, and the liquidity of the trading market for, our common stock. 15 IF WE CANNOT ATTRACT MORE OPTICAL COMMUNICATIONS EQUIPMENT MANUFACTURERS TO PURCHASE OUR PRODUCTS, WE MAY NOT BE ABLE TO INCREASE OR SUSTAIN OUR REVENUES. Our future success will depend on our ability to migrate existing customers to our new products and our ability to attract additional customers. Some of our present customers are relatively new companies. The growth of our customer base could be adversely affected by: - customer unwillingness to implement our products; - any delays or difficulties that we may incur in completing the development and introduction of our planned products or product enhancements; - the success of our customers; - new product introductions by our competitors; - any failure of our products to perform as expected; or - any difficulty we may incur in meeting customers' delivery requirements or product specifications. The downturn in the economy has affected the telecommunications industry. Telecommunications companies have cut back on their capital expenditure budgets, which has decreased and may continue to further decrease demand for equipment and parts, including our products. This decrease has had and may continue to have an adverse effect on the demand for fiber optic products and negatively impact the growth of our customer base. THE MARKET FOR FIBER OPTIC COMPONENTS IS INCREASINGLY COMPETITIVE, AND IF WE ARE UNABLE TO COMPETE SUCCESSFULLY OUR REVENUES COULD DECLINE. The market for fiber optic components is intensely competitive. We believe that our principal competitors are the major manufacturers of optical components and integrated modules, including vendors selling to third parties and business divisions within communications equipment suppliers. Our principal competitors in the components market include Avanex, Corning, DiCon Fiberoptics, Gould, JDS Uniphase, Lucent, Luminent (merged into MRV Communications, Inc.), New Focus, Nortel, Oplink, Stratos Lightwave and Tyco Electronics. We believe that we primarily compete with diversified suppliers for the majority of our product line and to a lesser extent with niche companies that offer a more limited product line. Competitors in any portion of our business may also rapidly become competitors in other portions of our business. In addition, our industry has recently experienced significant consolidation, and we anticipate that further consolidation will occur. This consolidation has further increased competition. Many of our current and potential competitors have significantly greater financial, technical, marketing, purchasing, manufacturing and other resources than we do. As a result, these competitors may be able to respond more quickly to new or emerging technologies and to changes in customer requirements, to devote greater resources to the development, promotion and sale of products, to negotiate lower prices on raw materials and components, or to deliver competitive products at lower prices. Several of our existing and potential customers are also current and potential competitors of ours. These companies may develop or acquire additional competitive products or technologies in the future and subsequently reduce or cease their purchases from us. In light of the consolidation in the optical networking industry, we also believe that the size of suppliers will be an increasingly important part of a purchaser's decision-making criteria in the future. We may not be able to compete successfully with existing or new competitors, nor can we ensure that the competitive pressures we face will not result in lower prices for our products, loss of market share, or reduced gross margins, any of which could harm our business. 16 New and competing technologies are emerging due to increased competition and customer demand. The introduction of products incorporating new or competing technologies or the emergence of new industry standards could make our existing products noncompetitive. For example, there are technologies for the design of wavelength division multiplexers that compete with the technology that we incorporate in our products. If our products do not incorporate technologies demanded by customers, we could lose market share causing our business to suffer. IF WE FAIL TO EFFECTIVELY MANAGE OUR OPERATIONS, SPECIFICALLY GIVEN THE RECENT SUDDEN AND DRAMATIC DOWNTURN IN DEMAND FOR OUR PRODUCTS, OUR OPERATING RESULTS COULD BE HARMED. We rapidly expanded our operations domestically and internationally in the final two quarters of 2000. We had to carefully manage and re-evaluate this expansion given the sudden and dramatic downturn in demand for our products experienced in 2001 and that continue to date. Additionally, we implemented a reduction in force to reduce employees during the second and third quarters of 2001 to match our operations to this decreased demand for our products. As of June 30, 2002, we had a total of 110 full-time employees in Sunnyvale, California, 182 full-time employees in Taiwan, and 41 full-time employees in China. Matching the scale of our operations with the recent demand fluctuations, combined with the challenges of expanding and managing geographically dispersed operations, has placed, and will continue to place, a significant strain on our management and resources. To manage the expected fluctuations in our operations and personnel, we will be required to: - improve existing and implement new operational, financial and management controls, reporting systems and procedures; - hire, train, motivate and manage additional qualified personnel, especially if we experience a significant increase in demand for our products; - effectively expand or reduce our manufacturing capacity, attempting to adjust it to customer demand; and - effectively manage relationships with our customers, suppliers, representatives and other third parties. In addition, we will need to coordinate our domestic and international operations and establish the necessary infrastructure to implement our international strategy. If we are not able to manage our growth in an efficient and timely manner, our business will be severely harmed. Our success also depends, to a large degree, on the efficient and uninterrupted operation of our facilities. We have expanded our manufacturing facilities in Taiwan and manufacture many of our products there. We recently entered into a lease for a new facility in China, which continues through July 2007. There is significant political tension between Taiwan and China. If there is an outbreak of hostilities between Taiwan and China, our manufacturing operations may be disrupted or we may have to relocate our manufacturing operations. Tensions between Taiwan and China may also affect our training facility in China. We plan to lease additional facilities, as necessary, to support our growth. Relocating a portion of our employees could cause temporary disruptions in our operations and divert management's attention. Because of past shortages of office and manufacturing space in Northern California, we cannot assure you that we will be able to locate suitable space on acceptable terms or at all in the future. BECAUSE OF THE TIME IT TAKES TO DEVELOP FIBER OPTIC COMPONENTS, WE INCUR SUBSTANTIAL EXPENSES FOR WHICH WE MAY NOT EARN ASSOCIATED REVENUES. The development of new or enhanced fiber optic products is a complex and uncertain process. We may experience design, manufacturing, marketing and other difficulties that could delay or prevent the development, introduction or marketing of new products and enhancements. Development costs and expenses are incurred before we generate revenues from sales of products resulting from these efforts. Our total research and development expenses, excluding non-cash compensation expenses, were approximately $3.5 million and $4.1 million for the six months ended June 30, 2001 and 2002, 17 respectively. We intend to continue to invest a substantial amount of funds in our research and product development efforts, which could have a negative impact on our earnings in future periods. IF WE ARE UNABLE TO DEVELOP NEW PRODUCTS AND PRODUCT ENHANCEMENTS THAT ACHIEVE MARKET ACCEPTANCE, SALES OF OUR FIBER OPTIC COMPONENTS COULD DECLINE, WHICH COULD REDUCE OUR REVENUES. The communications industry is characterized by rapidly changing technology, frequent new product introductions, changes in customer requirements, evolving industry standards and, more recently, significant variations in customer demand. Our future success depends on our ability to anticipate market needs and develop products that address those needs. As a result, our products could quickly become obsolete if we fail to predict market needs accurately or develop new products or product enhancements in a timely manner. Our failure to predict market needs accurately or to develop new products or product enhancements in a timely manner will harm market acceptance and sales of our products. If the development or enhancement of these products or any other future products takes longer than we anticipate, or if we are unable to introduce these products to market, our sales will not increase. Even if we are able to develop and commercially introduce them, these new products may not achieve the widespread market acceptance necessary to provide an adequate return on our investment. THE OPTICAL NETWORKING COMPONENT INDUSTRY HAS IN THE PAST, IS NOW, AND MAY IN THE FUTURE EXPERIENCE DECLINING AVERAGE SELLING PRICES, WHICH COULD CAUSE OUR GROSS MARGINS TO DECLINE. The optical networking component industry has in the past experienced declining average selling prices as a result of increasing competition and greater unit volumes as communication service providers continue to deploy fiber optic networks. Average selling prices are currently decreasing and may continue to decrease in the future in response to product introductions by competitors, price pressures from significant customers, greater manufacturing efficiencies achieved through increased automation in the manufacturing process and inventory build-up due to decreased demand. Average selling price declines may contribute to a decline in our gross margins, which could harm our results of operations. WE WILL NOT ATTRACT NEW ORDERS FOR OUR FIBER OPTIC COMPONENTS UNLESS WE CAN DELIVER SUFFICIENT QUANTITIES OF OUR PRODUCTS TO OPTICAL COMMUNICATIONS EQUIPMENT MANUFACTURERS. Communications service providers and optical systems manufacturers typically require that suppliers commit to provide specified quantities of products over a given period of time. If we are unable to commit to deliver quantities of our products to satisfy a customer's anticipated needs, we will lose the order and the opportunity for significant sales to that customer for a lengthy period of time. In addition, we would be unable to fill large orders if we do not have sufficient manufacturing capacity to enable us to commit to provide customers with specified quantities of products. However, if we build our manufacturing capacity and inventory in excess of demand, as we have done in the past, we may produce excess inventory that may have to be reserved or written off. WE DEPEND ON A LIMITED NUMBER OF THIRD PARTIES TO SUPPLY KEY MATERIALS, COMPONENTS AND EQUIPMENT, SUCH AS FERRULES AND LENSES, AND IF WE ARE NOT ABLE TO OBTAIN SUFFICIENT QUANTITIES OF THESE ITEMS AT ACCEPTABLE PRICES, OUR ABILITY TO FILL ORDERS WOULD BE LIMITED AND OUR OPERATING RESULTS COULD BE HARMED. We depend on third parties to supply the raw materials and components we use to manufacture our products. To be competitive, we must obtain from our suppliers, on a timely basis, sufficient quantities of raw materials and components at acceptable prices. We obtain most of our critical raw materials and components from a single or limited number of suppliers and generally do not have long-term supply contracts with them. As a result, our suppliers could terminate the supply of a particular material or component at any time without penalty. Finding alternative sources may involve significant expense and delay, if these sources can be found at all. Difficulties in obtaining raw materials or components in the future may delay or limit our product shipments, which could result in lost orders, increase our costs, reduce our control over quality and delivery schedules and require us to redesign our products. If a supplier became unable or unwilling to continue to manufacture or ship materials or components in required volumes, we would have to identify and qualify an acceptable replacement. A 18 delay or reduction in shipments or any need to identify and qualify replacement suppliers would harm our business. All of our graded index, or GRIN, lenses, which are incorporated into substantially all of our filter-based DWDM products, are obtained from one supplier, Nippon Sheet Glass. Replacements for the GRIN lenses have been incorporated into newer products wherever practical to help mitigate this risk in the future. BECAUSE WE EXPERIENCE LONG LEAD TIMES FOR MATERIALS AND COMPONENTS, WE MAY NOT BE ABLE TO EFFECTIVELY MANAGE OUR INVENTORY LEVELS, WHICH COULD HARM OUR OPERATING RESULTS. Because we experience long lead times for materials and components and are often required to purchase significant amounts of materials and components far in advance of product shipments, we may not effectively manage our inventory levels, which could harm our operating results. We recorded significant charges for excess and obsolete inventory in the quarters ended June 30, 2001, March 31, 2002 and June 30, 2002. Alternatively, if we underestimate our raw material requirements, we may have inadequate inventory, which could result in delays in shipments and loss of customers. If we purchase raw materials and increase production in anticipation of orders that do not materialize or that shift to another quarter, we will, as we have in the past, have to carry or write off excess inventory and our gross margins will decline. Either situation could cause our results of operations to be below the expectations of investors and public market analysts, which could, in turn, cause the price of our common stock to decline. The time our customers require to incorporate our products into their own can vary significantly and generally exceeds several months, which further complicates our planning processes and reduces the predictability of our forecasts. Even if we receive these orders, the additional manufacturing capacity that we add to meet our customer's requirements may be underutilized in a subsequent quarter. WE DEPEND ON KEY PERSONNEL TO OPERATE OUR BUSINESS EFFECTIVELY IN THE RAPIDLY CHANGING FIBER OPTIC COMPONENTS MARKET, AND IF WE ARE UNABLE TO HIRE AND RETAIN APPROPRIATE MANAGEMENT AND TECHNICAL PERSONNEL, OUR ABILITY TO DEVELOP OUR BUSINESS COULD BE HARMED. Our success depends to a significant degree upon the continued contributions of the principal members of our technical sales, marketing, engineering and management personnel, many of whom perform important management functions and would be difficult to replace. We particularly depend upon the continued services of our executive officers, particularly Peter Chang, our President and Chief Executive Officer, David Hubbard, our Vice President, Sales and Marketing, and other key engineering, sales, marketing, finance, manufacturing and support personnel. In addition, we depend upon the continued services of key management personnel at our Taiwanese subsidiary. None of our officers or key employees is bound by an employment agreement for any specific term, and may terminate their employment at any time. In addition, we do not have "key person" life insurance policies covering any of our employees. In July 2002, our Chief Financial Officer resigned. Our ability to continue to attract and retain highly skilled personnel will be a critical factor in determining whether we will be successful in the future. We may have difficulty hiring skilled engineers at our manufacturing facility in Taiwan. If we are not successful in attracting, assimilating or retaining qualified personnel to fulfill our current or future needs, our business may be harmed. IF WE ARE NOT ABLE TO ACHIEVE ACCEPTABLE MANUFACTURING YIELDS AND SUFFICIENT PRODUCT RELIABILITY IN THE PRODUCTION OF OUR FIBER OPTIC COMPONENTS, WE MAY INCUR INCREASED COSTS AND DELAYS IN SHIPPING PRODUCTS TO OUR CUSTOMERS, WHICH COULD IMPAIR OUR OPERATING RESULTS. Complex and precise processes are required for the manufacture of our products. Changes in our manufacturing processes or those of our suppliers, or the inadvertent use of defective materials, could significantly reduce our manufacturing yields and product reliability. Because the majority of our manufacturing costs are relatively fixed, manufacturing yields are critical to our results of operations. Lower than expected production yields could delay product shipments and impair our operating results. We may not obtain acceptable yields in the future. In some cases, existing manufacturing techniques, which involve substantial manual labor, may not allow us to cost-effectively meet our production goals so that we maintain acceptable gross margins 19 while meeting the cost targets of our customers. We may not achieve adequate manufacturing cost efficiencies. Because we plan to introduce new products and product enhancements regularly, we must effectively transfer production information from our product development department to our manufacturing group and coordinate our efforts with those of our suppliers to rapidly achieve volume production. In our experience, our yields have been lower during the early stages of introducing new product to manufacturing. If we fail to effectively manage this process or if we experience delays, disruptions or quality control problems in our manufacturing operations, our shipments of products to our customers could be delayed. BECAUSE THE QUALIFICATION AND SALES CYCLE ASSOCIATED WITH FIBER OPTIC COMPONENTS IS LENGTHY AND VARIED, IT IS DIFFICULT TO PREDICT THE TIMING OF A SALE OR WHETHER A SALE WILL BE MADE, WHICH MAY CAUSE US TO HAVE EXCESS MANUFACTURING CAPACITY OR INVENTORY AND NEGATIVELY IMPACT OUR OPERATING RESULTS. In the communications industry, service providers and optical systems manufacturers often undertake extensive qualification processes prior to placing orders for large quantities of products such as ours, because these products must function as part of a larger system or network. This process may range from three to six months and sometimes longer. Once they decide to use a particular supplier's product or component, these potential customers design the product into their system, which is known as a design-in win. Suppliers whose products or components are not designed in are unlikely to make sales to that customer until at least the adoption of a future redesigned system. Even then, many customers may be reluctant to incorporate entirely new products into their new systems, as this could involve significant additional redesign efforts. If we fail to achieve design-in wins in our potential customers' qualification processes, we will lose the opportunity for significant sales to those customers for a lengthy period of time. In addition, some of our customers require that our products be subjected to standards-based qualification testing, which can take up to nine months or more. While our customers are evaluating our products and before they place an order with us, we may incur substantial sales and marketing and research and development expenses, expend significant management efforts, increase manufacturing capacity and order long lead-time supplies. Even after the evaluation process, it is possible a potential customer will not purchase our products. In addition, product purchases are frequently subject to unplanned processing and other delays, particularly with respect to larger customers for which our products represent a very small percentage of their overall purchase activity. Accordingly, our revenues and operating results may vary significantly and unexpectedly from quarter to quarter. IF OUR CUSTOMERS DO NOT QUALIFY OUR MANUFACTURING LINES FOR VOLUME SHIPMENTS, OUR OPTICAL NETWORKING COMPONENTS MAY BE DROPPED FROM SUPPLY PROGRAMS AND OUR REVENUES MAY DECLINE. Customers generally will not purchase any of our products, other than limited numbers of evaluation units, before they qualify our products, approve our manufacturing process and approve our quality assurance system. Our existing manufacturing lines, as well as each new manufacturing line, must pass through various levels of approval with our customers. For example, customers may require that we be registered under international quality standards. Our products may also have to be qualified to specific customer requirements. This customer approval process determines whether the manufacturing line achieves the customers' quality, performance and reliability standards. Delays in product qualification may cause a product to be dropped from a long-term supply program and result in significant lost revenue opportunity over the term of that program. OUR FIBER OPTIC COMPONENTS ARE DEPLOYED IN LARGE AND COMPLEX COMMUNICATIONS NETWORKS AND MAY CONTAIN DEFECTS THAT ARE NOT DETECTED UNTIL AFTER OUR PRODUCTS HAVE BEEN INSTALLED, WHICH COULD DAMAGE OUR REPUTATION AND CAUSE US TO LOSE CUSTOMERS. Our products are designed for deployment in large and complex optical networks. Because of the nature of these products, they can only be fully tested for reliability when deployed in networks for long 20 periods of time. Our fiber optic products may contain undetected defects when first introduced or as new versions are released, and our customers may discover defects in our products only after they have been fully deployed and operated under peak stress conditions. In addition, our products are combined with products from other vendors. As a result, should problems occur, it may be difficult to identify the source of the problem. If we are unable to fix defects or other problems, we could experience, among other things: - loss of customers; - damage to our reputation; - failure to attract new customers or achieve market acceptance; - diversion of development and engineering resources; and - legal actions by our customers. The occurrence of any one or more of the foregoing factors could cause our net loss to increase. CURRENT AND FUTURE DEMAND FOR OUR PRODUCTS DEPENDS ON THE CONTINUED GROWTH OF THE INTERNET AND THE COMMUNICATIONS INDUSTRY, WHICH IS EXPERIENCING RAPID CONSOLIDATION, REALIGNMENT, OVERSUPPLY OF PRODUCT INVENTORY AND REDUCTION IN DEMAND FOR FIBER OPTIC PRODUCTS. Our future success depends on the continued growth of the Internet as a widely used medium for communications and commerce, and the growth of optical networks to meet the increased demand for capacity to transmit data, or bandwidth. If the Internet does not continue to expand as a medium for communications and commerce, the need to significantly increase bandwidth across networks and the market for fiber optic components may not continue to develop. If this growth does not continue, sales of our products may continue to decline, which would adversely affect our revenues. Additionally, if growth in demand for our products exceeds the demand for our customers' products, our customers may experience an oversupply of inventory and decrease orders of our products. Future demand for our products is uncertain and will depend heavily on the continued growth and upgrading of optical networks, especially in the long-haul, metropolitan, last mile, and enterprise access segments of the networks. Decreased spending by telecommunications companies over the 18 months has resulted in decreased demand for our products. The rate at which communication service providers and other fiber optic network users have built new fiber optic networks or installed new systems in their existing fiber optic networks has fluctuated in the past and these fluctuations may continue in the future. These fluctuations may result in reduced demand for new or upgraded fiber optic systems that utilize our products and, therefore, may result in reduced demand for our products. Declines in the development of new networks and installation of new systems have resulted in a decrease in demand for our products, an increase in our inventory, and erosion in the average selling prices. The communications industry is experiencing rapid consolidation and realignment, as industry participants seek to capitalize on the rapidly changing competitive landscape developing around the Internet and new communications technologies such as fiber optic networks. As the communications industry consolidates and realigns to accommodate technological and other developments, our customers may consolidate or align with other entities in a manner that results in a decrease in demand for our products. THE MARKET FOR FIBER OPTIC COMPONENTS IS NEW AND UNPREDICTABLE, CHARACTERIZED BY RAPID TECHNOLOGICAL CHANGES, EVOLVING INDUSTRY STANDARDS, AND SIGNIFICANT CHANGES IN CUSTOMER DEMAND, WHICH COULD RESULT IN DECREASED DEMAND FOR OUR PRODUCTS, EROSION OF AVERAGE SELLING PRICES, AND COULD NEGATIVELY IMPACT OUR REVENUES. The market for fiber optic components is new and characterized by rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. 21 Because this market is new, it is difficult to predict its potential size or future growth rate. Widespread adoption of optical networks, especially in the long-haul, metropolitan, last mile, and enterprise access segments of the networks, is critical to our future success. Potential end-user customers who have invested substantial resources in their existing copper lines or other systems may be reluctant or slow to adopt a new approach, such as optical networks. Our success in generating revenues in this emerging market will depend on: - the education of potential end-user customers and network service providers about the benefits of optical networks; and - the continued growth of the long-haul, metropolitan, last mile, and enterprise access segments of the communications network. If we fail to address changing market conditions, sales of our products may decline, which would adversely impact our revenues. IF WE FAIL TO PROTECT OUR INTELLECTUAL PROPERTY RIGHTS, COMPETITORS MAY BE ABLE TO USE OUR TECHNOLOGIES, WHICH COULD WEAKEN OUR COMPETITIVE POSITION, REDUCE OUR REVENUES OR INCREASE OUR COSTS. The fiber optic component market is a highly competitive industry in which we, and most other participants, rely on a combination of patent, copyright, trademark and trade secret laws, confidentiality procedures and licensing arrangements to establish and protect proprietary rights. The competitive nature of our industry, rapidly changing technology, frequent new product introductions, changes in customer requirements and evolving industry standards heighten the importance of protecting proprietary technology rights. Since the United States Patent and Trademark Office keeps patent applications confidential until a patent is issued, our pending patent applications may attempt to protect proprietary technology claimed in a third party patent application. Our existing and future patents may not be sufficiently broad to protect our proprietary technologies as policing unauthorized use of our products is difficult and we cannot be certain that the steps we have taken will prevent the misappropriation or unauthorized use of our technologies, particularly in foreign countries where the laws may not protect our proprietary rights as fully as United States laws. Our competitors may independently develop similar technology, duplicate our products, or design around any of our patents or other intellectual property. If we are unable to adequately protect our proprietary technology rights, others may be able to use our proprietary technology without having to compensate us, which could reduce our revenues and negatively impact our ability to compete effectively. Litigation may be necessary to enforce our intellectual property rights or to determine the validity or scope of the proprietary rights of others. As a result of any such litigation, we could lose our proprietary rights and incur substantial unexpected operating costs. Any action we take to protect our intellectual property rights could be costly and could absorb significant management time and attention. In addition, failure to adequately protect our trademark rights could impair our brand identity and our ability to compete effectively. WE MAY BE SUBJECT TO INTELLECTUAL PROPERTY INFRINGEMENT CLAIMS THAT ARE COSTLY TO DEFEND AND COULD LIMIT OUR ABILITY TO USE SOME TECHNOLOGIES IN THE FUTURE. Our industry is very competitive and is characterized by frequent intellectual property litigation based on allegations of infringement of intellectual property rights. Numerous patents in our industry have already been issued, and as the market further develops and participants in our industry obtain additional intellectual property protection, litigation is likely to become more frequent. From time to time, third parties may assert patent, copyright, trademark and other intellectual property rights to technologies or rights that are important to our business. In addition, we may in the future enter into agreements to indemnify our customers for any expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. Any litigation arising from claims asserting that our products infringe or may infringe the proprietary rights of third parties, whether the litigation is with or without merit, could be time-consuming, resulting in significant expenses and diverting the efforts of our technical and 22 management personnel. We do not have insurance against our alleged or actual infringement of intellectual property of others. These claims could cause us to stop selling our products, which incorporate the challenged intellectual property, and could also result in product shipment delays or require us to redesign or modify our products or to enter into licensing agreements. These licensing agreements, if required, would increase our product costs and may not be available on terms acceptable to us, if at all. Although we are not aware of any intellectual property lawsuits filed against us, we may be a party to litigation regarding intellectual property in the future. We may not prevail in any such actions, given their complex technical issues and inherent uncertainties. Insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed. If there is a successful claim of infringement or we fail to develop non-infringing technology or license the proprietary rights on a timely basis, our business could be harmed. IF WE FAIL TO INCREASE SALES OF OUR PRODUCTS TO OPTICAL COMMUNICATIONS EQUIPMENT MANUFACTURERS OUTSIDE OF NORTH AMERICA, GROWTH OF OUR BUSINESS MAY BE HARMED. For the year ended December 31, 2001 and the six months ended June 30, 2002, sales to customers located outside of North America were 17.8% and 9.2% of our revenues, respectively. In order to expand our business, we must increase our sales to customers located outside of North America. We have limited experience in marketing and distributing our products internationally and in developing versions of our products that comply with local standards. Our international sales will be limited if we cannot establish relationships with international distributors, establish additional foreign operations, expand international sales channels, hire additional personnel and develop relationships with international communications equipment manufacturers. Even if we are able to successfully continue international operations, we may not be able to maintain or increase international market demand for our products. BECAUSE OUR MANUFACTURING OPERATIONS ARE LOCATED IN ACTIVE EARTHQUAKE FAULT ZONES IN CALIFORNIA AND TAIWAN, AND OUR TAIWAN LOCATION IS SUSCEPTIBLE TO THE EFFECTS OF A TYPHOON, WE FACE THE RISK THAT A NATURAL DISASTER COULD LIMIT OUR ABILITY TO SUPPLY PRODUCTS. Our primary manufacturing operations are located in Sunnyvale, California and Tu-Cheng City, Taiwan, both active earthquake fault zones. These regions have experienced large earthquakes in the past and may likely experience them in the future. In September 2001, a typhoon hit Taiwan causing businesses, including our manufacturing facility, and the financial markets to close for two days. Because the majority of our manufacturing operations are located in Taiwan, a large earthquake or typhoon in Taiwan could disrupt our manufacturing operations for an extended period of time, which would limit our ability to supply our products to our customers in sufficient quantities on a timely basis, harming our customer relationships. ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK AND INTEREST RATE RISK INTEREST RATE SENSITIVITY We currently maintain our funds primarily in money market accounts and highly liquid marketable securities. We do not have any derivative financial instruments. As of June 30, 2002, $6.4 million, or 46.5% of our investments, had maturities of less than three months. We expect we will continue to invest a significant portion of our existing cash in interest bearing, investment grade securities, with maturities of less than 12 months. We do not believe that our investments, in the aggregate, have significant exposure to interest rate risk. EXCHANGE RATE SENSITIVITY We currently have operations in the United States, Taiwan and China. The functional currency of our subsidiaries in Taiwan and China are the local currencies, and we are subject to foreign currency exchange rate fluctuations associated with the translation to United States dollars. Though some 23 expenses are incurred by our Taiwan and China operations, substantially all of our sales are made in United States dollars; hence, we have minimal exposure to foreign currency rate fluctuations relating to sales transactions. While we expect our international revenues to continue to be denominated predominately in United States dollars, an increasing portion of our international revenues may be denominated in foreign currencies in the future. In addition, we plan to continue to expand our overseas operations. As a result, our operating results may become subject to significant fluctuations based upon changes in exchange rates of certain currencies in relation to the United States dollar. We will analyze our exposure to currency fluctuations and may engage in financial hedging techniques in the future to attempt to minimize the effect of these potential fluctuations; however, exchange rate fluctuations may adversely affect our financial results in the future. PART II: OTHER INFORMATION ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS On May 17, 2002, we held our 2002 Annual Meeting of Stockholders, at which meeting our stockholders approved the following: (a) Election of Michael Tung as the Class II director:
For Withheld 20,993,988 shares 265,101 shares
(b) Ratification of the appointment of PricewaterhouseCoopers LLP as independent auditors of the Company for the current fiscal year:
For Against Abstain 21,253,153 shares 5,191 shares 745 shares
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits. Exhibit Description --------- ------------------- 10.1 Full Recourse Promissory Note between the Company and Wei-Shin Tsay dated as of May 1, 2002.
(b) Reports on Form 8-K. The Company did not file any reports on Form 8-K with the Securities and Exchange Commission during the quarter ended June 30, 2002. 24 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. Dated: August 12, 2002 ALLIANCE FIBER OPTIC PRODUCTS, INC. By /s/ Anita Ho -------------------------------------------------- Anita Ho Acting Chief Financial Officer/Corporate Controller (Principal Financial and Accounting Officer and Duly Authorized Signatory) 25 EXHIBIT INDEX
Exhibit Number Exhibit Description - -------------- ------------------- 10.1 Full Recourse Promissory Note between the Company and Wei-Shin Tsay dated as of May 1, 2002.
EX-10.1 3 f83724exv10w1.txt EXHIBIT 10.1 Exhibit 10.1 EXHIBIT D-6 FULL RECOURSE PROMISSORY NOTE $1,000,000.00 Saratoga, California May 1, 2002 FOR VALUE RECEIVED, the undersigned, Wei-Shin Tsay, promises to pay to the order of Alliance Fiber Optic Products, Inc., a Delaware Corporation (the "Company"), the principal sum of one million dollars ($1,000,000.00) with interest from the date hereof at a rate of zero percent (0.0%) per annum, payable on August 25, 2004. This Note is secured by a pledge of shares of Common Stock of the Company, and is subject to all of the terms and provisions of a Restricted Stock Purchase Agreement between the undersigned and the Company (the "Agreement"). Notwithstanding such pledge, the undersigned understands that this is a full recourse promissory note. The undersigned further agrees that, in the event that his employment by or association with the Company is terminated for any reason prior to payment in full of this Note, this Note shall be accelerated and all remaining unpaid principal shall become due and payable within 30 days after such termination. If an action is instituted for collection of this Note, the undersigned agrees to pay court costs and reasonable attorneys' fees incurred by the holder hereof. This Note may be prepaid at any time without penalty. This Note and the obligations hereunder shall be governed by and construed and enforced in accordance with the laws of the State of California. This Note, effective May 1, 2002, replaces the note between the Company and Wei-Shin Tsay signed August 25, 2000. In conjunction with the execution of this Note, Wei-Shin Tsay agrees to pay the Company one hundred twelve thousand and thirty five dollars and seven cents ($112,035.07) by July 31, 2002, satisfying the accrued interest due through April 30, 2002 on the original note dated August 25, 2000. /s/ Wei-Shin Tsay ------------------------------- Wei-Shin Tsay -----END PRIVACY-ENHANCED MESSAGE-----