-----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, J8UT4OnV2Hu//A/J/8lIbqE6Ggi2tjnVqGMbpZJQEaNWTkKT7Jso8D79oOz9XPf4 0yo7OUor8t1jll1qMtSy1Q== 0000891618-97-003950.txt : 19970930 0000891618-97-003950.hdr.sgml : 19970930 ACCESSION NUMBER: 0000891618-97-003950 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 5 CONFORMED PERIOD OF REPORT: 19970629 FILED AS OF DATE: 19970929 SROS: NASD FILER: COMPANY DATA: COMPANY CONFORMED NAME: VERILINK CORP CENTRAL INDEX KEY: 0000774937 STANDARD INDUSTRIAL CLASSIFICATION: TELEPHONE & TELEGRAPH APPARATUS [3661] IRS NUMBER: 942857548 STATE OF INCORPORATION: DE FISCAL YEAR END: 0630 FILING VALUES: FORM TYPE: 10-K SEC ACT: SEC FILE NUMBER: 000-28562 FILM NUMBER: 97687783 BUSINESS ADDRESS: STREET 1: 145 BAYTECH DR CITY: SAN JOSE STATE: CA ZIP: 95134 BUSINESS PHONE: 4089451199 MAIL ADDRESS: STREET 1: 145 BAYTECH DR CITY: SAN JOSE STATE: CA ZIP: 95134 10-K 1 FORM 10-K 1 ================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 ------------------------ FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED JUNE 29, 1997 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 COMMISSION FILE NUMBER: 0-28562 VERILINK CORPORATION (EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER) DELAWARE 94-2857548 (STATE OR OTHER JURISDICTION OF (IRS EMPLOYER INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)
145 BAYTECH DRIVE, SAN JOSE, CALIFORNIA SAN JOSE, CALIFORNIA 95134 (ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (408) 945-1199 REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT: COMMON STOCK, PAR VALUE $.01 PER SHARE (TITLE OF CLASS) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendments to this Form 10-K. [ ] The aggregate market value of the voting stock held by non-affiliates of the Registrant, based on the closing sale price of the Common Stock on September 19, 1997, as reported by the Nasdaq National Market was $67,096,642. Shares of Common Stock held by each officer and director and by each person who owns 5% or more of the outstanding Common Stock have been excluded from this computation in that such persons may be deemed to be affiliates. This determination of affiliate status is not a conclusive determination for other purposes. As of September 19, 1997 the registrant had outstanding 13,673,137 shares of Common Stock. DOCUMENTS INCORPORATED BY REFERENCE Parts of the following document are incorporated by reference in this Annual Report on Form 10-K: the Proxy Statement for the Registrant's Annual Meeting of Stockholders to be held November 13, 1997 (the "Proxy Statement"), (Part III). ================================================================================ 2 PART I ITEM 1. BUSINESS INTRODUCTION Verilink Corporation develops, manufactures and markets access products for telecommunications network service providers and corporate end users. Verilink designed the Access System 2000 with modular hardware and the Company's software-based Advanced Programmable Architecture(TM) to enable its customers to access increased network capacity and to adopt new communications services in a cost-effective manner. The Access System 2000 provides integrated access to narrowband transmission facilities including fractional or full T1/E1, and to multiple T1/E1 facilities, up to broadband (T3) transmission speeds. The AS2000 enables carriers to seamlessly connect their service networks to support the full range of these transmission rates. The AS2000 may be deployed to support a broad range of services including ISDN, Frame Relay, and Internet Protocol (IP). Verilink's integrated network access products are used in corporate networks and by network service providers such as interexchange and local exchange carriers, and providers of Internet, personal communications and cellular services. The Company also sells single purpose network access devices for selected applications. The Company's largest customers include NORTEL, MCI Communications Corp., CompuServe Corp., and QUALCOMM Incorporated. INDUSTRY BACKGROUND Corporate and consumer demand for data, voice and video transmission services is expanding worldwide, creating a need for both increased bandwidth and new communication services. At the same time, the competitive landscape faced by providers of high bandwidth transmission capacity is evolving rapidly due to developments including the migration of corporations from private networks to public networks, the proliferation of the Internet, the continuing deregulation of the telecommunications industry and the introduction of new services. In response to these developments, network service providers ("NSPs"), including interexchange and local exchange carriers, and providers of Internet, personal communications and cellular services, are offering a variety of new communications services, each of which traditionally required a separate single purpose network access device. The limitations of single purpose network access devices in high-density deployment have created the need for flexible integrated network access equipment that will allow NSPs to provide corporate users access to a variety of communications services in a cost-effective manner. Demand for Increased Bandwidth Businesses increasingly depend on the flow of data, voice and video traffic through their communication networks, driving demand for additional bandwidth. Corporate employees increasingly travel, telecommute and work in geographically dispersed teams, creating a need for remote connections to corporate local area networks ("LANs"). Corporations are also deploying wide area networks ("WANs") to connect LANs located in local and remote locations. In addition, the type of information transmitted over networks increasingly requires high transmission rates. For example, video conferencing and multimedia applications require substantially more bandwidth than needed for traditional data file transfers. This continued growth in demand for bandwidth has caused corporations to seek network access solutions from NSPs and equipment suppliers that accommodate both current and future bandwidth requirements. Migration from Private to Public Networks Since the mid-1980s, corporations have relied on private data networks using dedicated digital circuits leased from communications carriers. Corporations now increasingly use public network services offered by NSPs as an alternative to the high cost of corporate private networks. These public network services allow users to access end-to-end digital circuits on an as-needed basis. This migration resulted from cost-effective and reliable new communication services offered by NSPs, the trend to outsource non-core corporate functions, and the growth in the cost and complexity of maintaining private networks. In order to provide 1 3 competitive service to these corporations, NSPs need flexible network access equipment that facilitates cost-effective provision of a variety of communications services. Growth of Corporate Use of the Internet The Internet was originally used by academic and governmental organizations for applications such as e-mail and file transfer. Increasingly, corporations and individuals are using the Internet for more bandwidth-intensive applications that use sound, images and video, and to provide interconnectivity within the enterprise. Internet users now face transmission delays as backbone capacity lags the growth in the number of users and as use of high-bandwidth applications increases. In response to this transmission bottleneck, NSPs are upgrading the Internet's communications backbone, which may encourage corporations to continue increasing activity on the Internet. Deregulation and Increased Competition The market for providing communication services to larger organizations has become increasingly competitive since the 1984 divestiture of AT&T. This environment has led to the development and introduction of new services by a broader range of NSPs, including long distance companies (such as AT&T, MCI and Sprint), local exchange carriers (such as regional Bell operating companies ("RBOCs") and GTE) and competitive access providers (such as MFS Communications Company, Inc. and Teleport Communications Group, Inc.). The deregulation effected by the Telecommunications Act of 1996 is expected to further increase competition among NSPs, as long distance and local exchange carriers enter each others' business and new entrants emerge, including cable TV operators, wireless carriers, Competitive Local Exchange Carriers ("CLECs"), and Internet/on-line service providers. To compete successfully, this growing group of NSPs must offer customers access to new services at a low cost and with high reliability. Wide Range of New Communications Services and Technologies Over the past several years, NSPs have introduced a variety of new, high-bandwidth switched services as alternatives to historical dedicated leased line services. For example, ISDN service allows users to exchange data, voice and video on a "dial-up" basis. In the United States, ISDN service is currently offered by NSPs at transmission rates from 64 Kbps to 1.544 Mbps. Furthermore, NSPs have introduced packet and cell-based switching services such as frame relay and ATM. Frame relay is a data service which provides corporate users with dedicated access to the NSP's frame relay network at transmission speeds of 56 Kbps to 45 Mbps ("T3"). ATM provides high speed transmission and low latency which allows effective transmission of data, voice and video traffic, in a single, shared network. Wireless telecommunications services are becoming more widespread due to advances in technology, regulatory encouragement and increased demand. The Company expects that personal communication services ("PCS"), digital cellular and other emerging services will make wireless service cheaper, easier to use and more compatible with existing information delivery systems. LIMITATIONS OF SINGLE PURPOSE NETWORK ACCESS SOLUTIONS Traditionally, a dedicated single purpose access device has been deployed for each type of network communications service. For example, one device is used for Frame Relay service and another entirely separate device is used to provide voice service. The use of single purpose devices to access the expanding variety of communications services has become increasingly costly and inefficient for several reasons: - Limited Ability to Accommodate Emerging Technologies and Services. As new technologies and services such as ATM or Digital Subscriber Line ("DSL") are deployed, the need to have a flexible and cost-effective migration path to such technologies is critical, as few companies can afford to replace large portions of their network access equipment. Single purpose network access devices typically cannot provide such a migration path. 2 4 - Limited Ability to Accommodate Multiple Services. The migration of network users from dedicated private to switched public networks has placed NSPs in the position of having to be "everything to everyone" because NSPs must offer network access compatible with the various communications services chosen by their customers. Expenditures for numerous single purpose access devices that each support a single service offering can be an inefficient use of NSP's financial resources. - Limited Scalability. The rapid expansion of networks has increased demand for upgraded network access which is difficult to meet efficiently by simply purchasing more non-scalable single purpose network access devices. Furthermore, growing bandwidth requirements often necessitate the adoption of new and faster technologies, thereby requiring additional outlays for new access equipment. - Difficulty of Maintenance and Support. Use of numerous single purpose network access devices built to different standards and requiring separate management systems can complicate operating procedures and result in multiple potential failure points. The increasing importance of network applications to end users has resulted in new focus on the importance of investing in network access equipment that is reliable and easy to manage, repair and upgrade. THE VERILINK SOLUTION Verilink's Access System 2000 is a flexible network access and management solution that provides cost-effective integrated access to a broad range of network services. The Access System 2000 uses a modular hardware architecture and the Company's software-based Advanced Programmable Architecture ("APA") to provide a scalable, adaptable platform for a flexible network migration path to new communications services. In addition, the Access System 2000 was designed to simplify network management and to provide reliable service. The benefits of the Access System 2000 include: - Flexible Access to Multiple Services. The integrated Access System 2000 is designed to allow NSPs to rely on a single, flexible equipment platform that they can adapt to meet the current and emerging service needs of multiple customers. The Access System 2000 currently enables NSPs to support data transmission over fractional T1/E1, T1/E1, multiple T1/E1, and T3 for access to services such as private lines, ISDN, ATM, frame relay and Internet Protocol ("IP") in an integrated platform. Verilink expects to offer voice and DSL functionality on the Access System 2000 platform during fiscal 1998. As these service needs change, the Access System 2000's modular hardware architecture and APA allows NSPs to use the same platform to provide access to multiple services. - Migration Path to New Technologies and Services. The Access System 2000 architecture was designed to allow NSPs and corporate customers to add new technologies and services incrementally. The Access System 2000 allows the customer access to increased network capacity or access to additional service offerings by adding circuit cards. The end-user can also vary certain system features simply by downloading new software. - Scalable Growth. The Access System 2000's scalable design enables it to be expanded to meet customer demands for access to increased network capacity by adding additional circuit cards often at lower incremental cost, compared to the cost of buying, installing and maintaining multiple new dedicated single-purpose access devices. - Ease of Network Management. The Access System 2000 can also be monitored remotely using the Company's proprietary management system, the Access Manager 2000, or using industry standard simple network management protocol ("SNMP") tools. The Company's APA technology allows the product to be configured, upgraded and serviced remotely. - Reliable Performance. Verilink's Access System 2000 is designed to be highly reliable, and its ability to provide access to multiple services from one integrated device lowers the number of potential failure points. In addition, the Company believes its product reliability is enhanced by its commitment to high quality standards and its formal program of total quality management. See "-- Manufacturing and Quality." 3 5 VERILINK STRATEGY The Company's objective is to become the leading provider of integrated network access equipment for use by NSPs and large corporate customers. Key elements of the Company's strategy include: - Expand Relationships with Key Customers. The Company has developed close relationships with MCI, CompuServe, NORTEL and QUALCOMM, leaders in traditional or emerging telecommunications markets. The Company believes that these relationships have allowed it to gain an in-depth knowledge of several networking technologies, which today are deployed in different markets. As its key customers adopt new technologies to expand the range of services they offer and enter new markets, the Company intends to leverage its expertise in each of these technologies by selling additional types of products to these customers. - Expand Customer Base. The Company believes that a direct sales organization that understands and can solve complex network access problems is necessary to sell its products to NSPs and large corporations. During fiscal 1997, the Company invested significantly to enlarge this sales and support organization. The Company intends to continue to invest in this sales and support organization as well as in other distribution channels in order to expand its customer base. - Offer Broad Array of Network Access Solutions. The Company's product strategy is to offer multiple network access technologies on a single integrated platform, as well as complimentary single-function access devices. Verilink designed the modular and scalable architecture of the Access System 2000 to provide a migration path to new network services, enabling customers to provide additional services without entirely replacing network access equipment. The Company is currently developing voice, M1-3 multiplexing and DSL applications for the Access System 2000 product line. - Focus on Emerging International Markets. The Company believes that the markets for network access solutions in developing countries present significant opportunities. The Company intends to address these opportunities by partnering with NSPs and telecommunications equipment providers active in these markets and by forming an international distribution channel. To date the Company's Access System 2000 product for E1 access has been selected by Avantel for deployment in Mexico, by CompuServe and Concert for deployment in Europe. - Provide Highly Reliable Products. The Company's customers operate in an environment in which transmission reliability and availability are increasingly mission critical factors. The Company has adopted a formal total quality management process that integrates new product specifications, development, manufacturing, repair and service, which is intended to achieve high reliability of its products and services. The Company has been ISO 9001 certified since 1993. PRODUCTS Access System 2000 Verilink's Access System 2000 is a flexible network access and management solution that provides cost-effective integrated access to a broad range of network services. Access System 2000 products are designed for installation at the origination and termination points at which NSPs provide communications services to their corporate customers. A key element of the flexibility and adaptability of the Access System 2000 is its modular architecture which allows customers to access new services or expanded network capacity by installing new circuit cards. In addition, its Advanced Programmable Architecture allows certain functions of 4 6 the Access System 2000's hardware to be configured through software downloads. The table below summarizes the Access System 2000 product line: VERILINK ACCESS SYSTEM 2000 PRODUCT LINE
APPLICATION DESCRIPTION AND GENERAL FEATURES - ----------------------- ------------------------------------------------------------ CSU Accesses T1 lines for PBX, multiplexer and D4 channel banks Provides ESF performance monitoring capabilities Supports TDM applications DSU/CSU Integrated DSU/CSU to connect standard serial ports such as V.35 to T1 and fractional T1 facilities Supports data applications at low speeds and at multiples of 56 Kbps/64 Kbps rates T1/E1 Multiplexing Aggregates multiple lower speed data ports onto a single T1/E1 line Supports V.35, RS449, E1A530 and other interfaces and provides drop-and-insert capability Subrate Multiplexing Aggregates up to five RS-232 subrate data channels into a single DSO. Supports DS0A/DS0B formats. Supports synchronous/asynchronous modes from 300 bps to 19.2 Kbps DACS Supports 13 T1/E1 lines Non-blocking 0-1 cross connect Inverse Multiplexing Provides bit-based inverse multiplexing for high-speed data Supports up to eight T1/E1s DS3 Provides DS3 access for high-speed data applications Supports a single or dual port High-Speed Serial Interface Automatic Protection Provides T1 transmission facility protection switching Switching User-defined protection groups Automatic or manual switching ISDN Provides ISDN-PRI access for bandwidth on demand protection switching. ATM* Provides ATM WAN access for data applications Supports T1/E1 and T3/E3 and NxT1/E1 Internetworking functions for frame relay to ATM M13* Supports channelized access to DS3 or Fractional DS3 transmission. HDSL* Supports 8 HDSL modems supporting 4 T1 lines Analog Voice* FXO, FXS, and 2 and 4 wire E&M for legacy analog voice applications.
- --------------- * Currently under development. See "Factors Affecting Future Results -- Dependence on Recently Introduced Products and Products Under Development." The Access System 2000 is accessed and controlled by the Access Manager 2000, a full-network monitoring system. The Access Manager 2000 facilitates remote configuration of node equipment and provides integral performance monitoring, diagnostics, test and maintenance capabilities for the entire network. Software downloads for product upgrades and modifications can be implemented remotely using the Access Manager 2000 or SNMP tools. Access System 2000 Applications NSPs use the Access System 2000 in a number of applications. The following are brief descriptions of some of the uses of the Access System 2000: Interexchange Carrier Frame Relay Network. In an interexchange carrier ("IXC") frame relay network, the Access System 2000 is located at the IXC's point of presence and is used to terminate T1, fractional T1, mulitiple T1 or T3 circuits from frame relay subscribers. In this application, the Access System 2000 is used to concentrate frame relay traffic from multiple users, providing more efficient use of 5 7 network ports on the carrier's frame relay switches or nodal processors. As a result, the carrier can achieve increased circuit utilization and decreased transmission costs. Internet Service Provider Network. In an Internet service provider ("ISP") network, the Access System 2000 is located at the ISP's network access point and provides access to high-speed transmission between the ISP's regional centers and its network operation center. The Access System 2000 provides high-bandwidth connections between router serial ports and transmission systems such as T3 and multiple T1/E1 circuits. The Access System 2000 provides physical transmission management, bandwidth sharing, and inverse multiplexing functions. Personal Communications Service Network. In a new personal communication service ("PCS") network based on Code Division Multiple Access (CDMA), the Access System 2000 is being used to provide wireline access and termination. The Access System 2000, with its integrated access technology, is designed to be used by the service provider to connect to carrier-provided services, while providing channel grooming, performance monitoring and drop-and-insert functions at their mobile switching sites. Other Products and Services Dedicated single purpose access devices are designed to support a specific type of network communications service. For example, one device may be used to support a Frame Relay service while another entirely separate device may be used to support voice service. Low cost single purpose devices can be a good choice for remote sites with limited application requirements and where customers prefer an end-to-end solution from a single equipment vendor. In response to this need, Verilink offers the following other products and services: ConnecT DSU/CSU Products. The Company's ConnecT DSU/CSU line of products integrates the capabilities of T1 data service units ("DSUs") and channel service units ("CSUs"). They are designed to provide economical solutions for connecting LANs and geographically separated digital devices, including video teleconferencing equipment, mainframe computers, computer aided design and manufacturing (CAD/CAM) workstations and imaging systems. Verilink's ConnecT DSU/CSU products include the ConnecT1, a dual-port device with integrated DSU/CSU functions that allow users to interconnect digital applications operating at data rates from 56Kbps to T1, via the carrier network, and the ConnecT FT1, a costeffective, single-port device that provides access to T1 and fractional T1 services. Extended Superframe ("ESF") Products. The Company's ESF CSU products interface data terminal equipment to a network facility and offer the full benefit of ESF performance measurement. The ESF CSU products can be controlled and monitored locally or remotely and are offered in a variety of configurations, ranging from a single T1 circuit to a multiline shelf accommodating up to 10 ESF CSUs. C-Series Products. The Company's C-Series line of products are ultra-compact integrated CSU/DSUs that support digital voice and data services over T1/E1 or fractional T1/E1, and data only applications over 56K/64K digital access lines. They come equipped with fully embedded SNMP management to provide an interface to industry-standard management platforms. They are designed to provide low cost point-to-point service in small offices or satellite locations. Services. The Company offers its customers the option of purchasing extended services in addition to those provided under its standard product warranty. These extended services include product upgrades, software and on-site hardware maintenance and installation services, extended telephone support, on-site training and advanced equipment exchange. 6 8 CUSTOMERS The market for the Company's products is comprised of NSPs and large corporations with private networks. The following table sets forth a representative list of Verilink's NSP and corporate end user customers, and its resellers, in these markets. Alamo Rent A Car N.E.T Alltel Supply Nynex Ameritech Pacific Bell Anixter QUALCOMM Bell South Rockwell International Compuserve Source EDS Southwestern Bell First Data Corp. Sungard Graybar The Travelers Group MCI Worldcom NORTEL
The Company's products are sold to a limited number of customers. See "Factors Affecting Future Results -- Customer Concentration." SALES AND MARKETING The Company sells its products primarily to NSPs and their large corporate end user customers through a direct sales force and through a number of non-exclusive resellers, including OEMs, VARs and distributors. The Company has focused its marketing strategy on leveraging existing, and developing new, key customer relationships in specific telecommunications market segments, including the WAN and remote LAN access, Internet access, and wireless access segments. An important element of the Company's marketing strategy of targeting key customer relationships is its direct sales efforts to such customers. Approximately 82% of the Company's sales during fiscal 1997 were derived through direct sales to such customers. A direct sales effort, supported by sales engineers who provide customers with pre- and post-sale technical and strategic assistance, allows the Company to gain a more in-depth knowledge of customers' network access requirements. The Company believes this knowledge helps it to build long-term relationships and alliances with key customers. The Company increased the size of its direct sales and support organization in fiscal 1997, and intends to expand further its direct sales and support organization in fiscal 1998. The Company has eleven offices located in major U.S. metropolitan areas. Verilink's service and support program includes: a five-year product warranty; formal customer training programs; on-site installation and maintenance; free telephone support; complete repair, refurbishment and upgrade services with a committed ten-day turnaround; and local applications engineering support. In addition to its direct sales, the Company sells its products through VARs and distributors such as Alltel Supply, Anixter, Graybar and Kent Electronics. Approximately 18% of the Company's sales during fiscal 1997 were made to VARs and distributors. The Company's VARs and distributors have primarily sold the Company's single purpose network access products. To date, the Company has had minimal direct sales to international customers. The Company believes that the international market for network access solutions will experience increasing growth in the future. The Company's strategy is to increase and diversify its international sales through corporate relationships and by establishing international distributors. The Company's Access System 2000 product has been designed to meet international telecommunications standards. See "Factors Affecting Future Results -- Risks Associated With Entry into International Markets." COMPETITION The market for network access and telecommunications equipment is highly competitive, and the Company expects competition to increase in the future. This market is subject to rapid technological change, 7 9 regulatory developments and emerging industry standards. The Company faces different competitive environments for its Access System 2000 products than for its single purpose network access products. The market for integrated access devices such as the Company's Access System 2000 is newly emerging and is subject to rapid change. The Company believes that the primary competitive factors in this market are the development and rapid introduction of new product features, price/performance, support for multiple types of communications services, network management, reliability and safety, and quality of customer support. There can be no assurance that the Company's products and products under development will be able to compete successfully with respect to these or other factors. The Company's principal competition to date for its current Access System 2000 products has been from Digital Link Corporation, Kentrox, a division of ADC Telecommunications (both in Kentrox's own products and products supplied by Premisys Communications, Inc.) and Larscom, Inc., a subsidiary of Axel Johnson. To the extent that the Company develops new products for the Access System 2000 line, the Company expects to increasingly compete with Premisys. The Company expects additional competition from companies that are currently competitors in the markets for the Company's single purpose network access products, as such companies develop new products. In addition, the Company expects substantial competition from companies in the computer networking market and other related markets such as Newbridge Networks Corporation, Telco Systems, Inc., and Ascend Communications, Inc. To the extent that current or potential competitors can expand their current offerings to include products that have functionality similar to the Company's products and planned products, the Company's business, financial condition and results of operations could be materially adversely affected. The Company believes that the market for its single purpose network access products is mature. The Company believes that the principal competitive factors in this market are price, installed base and quality of customer support. In this market, the Company primarily competes with Adtran, Inc., Digital Link, Kentrox and Larscom. There can be no assurance that such companies or other competitors will not introduce new products that provide greater functionality and/or at a lower price than the Company's single purpose network access products. In addition, the Company anticipates that competitors and customers may develop products that could be used for selected applications for which the Company's products are currently provided. Successful, timely development of such products could reduce the level of demand for the Company's products. There can be no assurance that the Company's single purpose network access products will be competitive in the future. AT&T Paradyne Corporation, a company that had been a major customer in fiscal 1993, developed a product for use in applications addressed by one of the Company's single purpose network access products and subsequently substantially reduced orders for the Company's products. Many of the Company's current and potential competitors have substantially greater technical, financial, manufacturing and marketing resources than the Company. In addition, many of the Company's competitors have long-established relationships with network service providers. There can be no assurance that the Company will have the financial resources, technical expertise, manufacturing, marketing, distribution and support capabilities to compete successfully in the future. See "Factors Affecting Future Results -- Competition." RESEARCH AND DEVELOPMENT The Company's research and development efforts are focused on developing new products, core technologies and enhancements to existing products. For the past several years, product development activities have emphasized expansion of features and functionality for the Access System 2000 product family. The Company's product development strategy has focused on the development of modular software and hardware products that can be integrated and adapted to the changing standards and requirements of the communications and internetworking industries. During fiscal 1997, 1996 and 1995, total research and development expenditures were $9.4 million, $7.3 million and $6.6 million, respectively. All research and development expenses are charged to expense as incurred. The Company expects that it will continue to expend significant resources for product development of specific applications such as voice and DSL as well as to respond to market demand and new service offerings 8 10 from network service providers. See "Factors Affecting Future Results -- Dependence on Recently Introduced Products and Products Under Development." The network access and telecommunications equipment markets are characterized by rapidly changing technologies and frequent new product introductions. The rapid development of new technologies increases the risk that current or new competitors could develop products that would reduce the competitiveness of the Company's products. The Company's future results will depend to a substantial degree upon its ability to respond to changes in technology and customer requirements. This will require the timely selection, development and marketing of new products and enhancements on a cost-effective basis. The development of new, technologically advanced products is a complex and uncertain process, requiring high levels of innovation. The development of new products for the integrated access market requires competence in the general areas of telephony, data networking, network management and wireless telephony as well as specific technologies such as DSL, IP, ISDN, and ATM. Further, the communications industry is characterized by the need to design products which meet industry standards for safety, emissions and network interconnection. With new and emerging technologies and service offerings from network service providers, such standards are often changing or unavailable. As a result, there is a potential for product development delay due to the need for compliance with new or modified standards. The introduction of new and enhanced products also requires that the Company manage transitions from older products in order to minimize disruptions in customer orders, avoid excess inventory of old products and ensure that adequate supplies of new products can be delivered to meet customer orders. There can be no assurance that the Company will be successful in developing, introducing or managing the transition to new or enhanced products or that any such products will be responsive to technological changes or will gain market acceptance. The Company's business, financial condition and results of operations would be materially adversely affected if the Company were to be unsuccessful, or to incur significant delays, in developing and introducing such new products or enhancements. MANUFACTURING AND QUALITY The Company's manufacturing operations consist primarily of material requirements planning, materials procurement and final assembly, test and quality control of subassemblies and systems. The Company performs virtually all aspects of its manufacturing process at its San Jose facility, with the exception of printed circuit board assembly. A local contract manufacturer performs printed circuit board assembly with parts sourced by Verilink. This control of the manufacturing process enables the Company to implement quality control and continuous process improvement techniques and methods, including failure mode analysis, statistical process control and the use of quality improvement teams. In addition, the Company has extended these quality control techniques to certain suppliers by teaching and assisting them to implement such techniques as statistical process control and just-in-time parts delivery. The Company has been ISO 9001 certified since 1993. ISO 9000 is an international quality certification process, developed in the European Common Market and adopted by the United States as the method by which companies can demonstrate the functionality of their quality system. Verilink obtained such certification through an independent third party, with ongoing audits on a semi-annual basis. On-time delivery of the Company's products is dependent upon the availability of quality components and subsystems used in its products. The Company depends upon a subcontractor to assemble printed circuit boards used in its products in a timely and satisfactory manner. The Company obtains several components, and licenses certain embedded software, from single sources. Although the Company believes that, in each case, either an alternative supplier is available or the product can be redesigned to incorporate a different component, significant interruption in the delivery of any such item could have a material adverse effect on the Company's business, financial condition and results of operations. In particular, the Company's orders frequently require delivery quickly after placement of the order. Because the Company does not maintain significant component inventories, delay in shipment by a supplier could lead to lost sales. See "Factors Affecting Future Results -- Dependence on Component Availability and Key Suppliers." 9 11 INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS The Company relies upon a combination of patent, trade secret, copyright and trademark laws and contractual restrictions to establish and protect proprietary rights in its products and technologies. The Company has been issued certain U.S. and Canadian patents with respect to limited aspects of its single purpose network access technology. The Company has not obtained significant patent protection for its Access System 2000 technology. The Company is not currently aware of any material past infringement on its technology by third parties. There can be no assurance that third parties have not or will not develop equivalent technologies or products without infringing the Company's patents or that the Company's patents would be held valid and enforceable by a court having jurisdiction over a dispute involving such patents. The Company has also entered into confidentiality and invention assignment agreements with its employees, and enters into non-disclosure agreements with its suppliers, distributors and appropriate customers so as to limit access to and disclosure of its proprietary information. There can be no assurance that these statutory and contractual arrangements will deter misappropriation of the Company's technologies or discourage independent third-party development of similar technologies. In the event such arrangements are insufficient, the Company's business, financial condition and results of operations could be materially adversely affected. The laws of certain foreign countries in which the Company's products are or may be developed, manufactured or sold may not protect the Company's products or intellectual property rights to the same extent as do the laws of the United States and thus make the possibility of misappropriation of the Company's technology and products more likely. See "Factors Affecting Future Results -- Limited Protection of Intellectual Property." The network access and telecommunications equipment industries are characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. From time to time, third parties may assert exclusive patent, copyright, trademark and other intellectual property rights to technologies that are important to the Company. The Company has not conducted a formal patent search relating to the technology used in its products, due in part to the high cost and limited benefits of a formal search. In addition, since patent applications in the United States are not publicly disclosed until the patent issues and foreign patent applications generally are not publicly disclosed for at least a portion of the time that they are pending, applications may have been filed which, if issued as patents, would relate to the Company's products. Software comprises a substantial portion of the technology in the Company's products. The scope of protection accorded to patents covering software-related inventions is evolving and is subject to a degree of uncertainty which may increase the risk and cost to the Company if the Company discovers third party patents related to its software products or if such patents are asserted against the Company in the future. Patents have been granted recently on fundamental technologies in software, and patents may issue which relate to fundamental technologies incorporated into the Company's products. The Company may receive communications from third parties in the future asserting that the Company's products infringe or may infringe the proprietary rights of third parties. In its distribution agreements, the Company typically agrees to indemnify its customers for all expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. In the event of litigation to determine the validity of any third-party claims, such litigation, whether or not determined in favor of the Company, could result in significant expense to the Company and divert the efforts of the Company's technical and management personnel from productive tasks. In the event of an adverse ruling in such litigation, the Company might be required to discontinue the use and sale of infringing products, expend significant resources to develop non-infringing technology or obtain licenses from third parties. There can be no assurance that licenses from third parties would be available on acceptable terms, if at all. In the event of a successful claim against the Company and the failure of the Company to develop or license a substitute technology, the Company's business, financial condition and results of operations would be materially adversely affected. See "Factors Affecting Future Results -- Risk of Third Party Claims Infringement." EMPLOYEES As of June 29, 1997, the Company had approximately 219 employees worldwide. Management believes that the future success of Verilink will depend in part on its ability to attract and retain qualified employees, including management, technical, and design personnel. In particular, the Company currently has numerous 10 12 open positions, specifically in the engineering arena. Any lengthy delays in filling these positions will lead to delays in the introduction of various products currently being developed, a well as the research and development associated with potential new products. See "Factors Affecting Future Results -- Dependence on Key Personnel," and "Factors Affecting Future Results -- Need to Expand Sales Organization and Channels of Distribution." BACKLOG Orders for the Company's products are usually placed by customers on an as-needed basis and the Company has typically been able to ship these products within 30 days after the customer submits a firm purchase order. Because of the possibility of customer changes in delivery schedules or cancellation of orders, the Company's backlog as of any particular date may not be indicative of sales in any future period. ITEM 2. PROPERTIES The Company's headquarters and principal administrative and engineering facility is located in a building containing approximately 55,000 square feet located in San Jose, California. During 1997, the Company moved its manufacturing operations into a new 24,000 square foot facility located nearby its headquarters building in San Jose, California. The Company leases these buildings through April 2001 and November 2001, respectively, from a partnership which is comprised of Leigh S. Belden and Steven C. Taylor. Under the terms of the leases the Company must lease an additional 45,800 square feet no later than December 1, 1998. The Company believes these leases were made on terms that are no less favorable to the Company than would have been obtained from unaffiliated third parties. In addition, the Company has eleven sales offices located in the U.S These properties are occupied under operating leases that expire on various dates through 2002 with options to renew in most instances. The Company believes its current facilities are suitable for and adequate to support its present level of operations and believes that future growth can be accommodated by leasing additional space near these facilities. ITEM 3. LEGAL PROCEEDINGS The Company is not currently involved in any material legal actions. From time to time, however, the Company may be subject to claims and lawsuits arising in the normal course of business. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS No matters were submitted to a vote of the security holders of the Company during the fourth quarter of fiscal 1997, which ended June 29, 1997. EXECUTIVE OFFICERS OF THE COMPANY Information concerning executive officers of the Company is set forth below: Mr. Leigh S. Belden, age 48, co-founded the Company and has served as its President, Chief Executive Officer and Director since its inception in December 1982. From 1980 to 1982, Mr. Belden was Vice President of Marketing for Cushman Electronics, a manufacturer of telephone central office and two-way radio test equipment. Previously, he held various international and domestic sales and marketing management positions for California Microwave. Mr. Belden received a B.S. in Electrical Engineering from the University of California at Berkeley and an M.B.A. from Santa Clara University. Mr. Steven C. Taylor, age 51, co-founded the Company and has served as its Chief Technical Officer since its inception in December 1982. In addition, Mr. Taylor served as Chairman of the Board of Directors from the Company's inception until January 1996, at which time he became the Vice Chairman of the Board of Directors. Previously, Mr. Taylor served as Chief Engineer of Digital Products for Culbertson Industries 11 13 and California Microwave. In 1980, Mr. Taylor formed Telecommunications Consultants, Inc., a consulting firm engaged in the design and support of digital and analog communications equipment. Mr. John C. Batty, age 42, joined the Company in May 1997 as Vice President, Finance and Chief Financial Officer. From December 1992 until joining Verilink, Mr. Batty was Vice President and Treasurer for VLSI Technology, Inc., a semiconductor manufacturer. From April 1991 to December 1992, Mr. Batty was Director Corporate Financial Planning for VLSI. Mr. Batty received a B.A. in Economics from the University of New Hampshire, and an M.B.A. from the University of Chicago. Mr. Robert F. Griffith, age 53, joined the Company in June 1996 as Vice President of Sales. From February 1994 until joining Verilink, Mr. Griffith was Vice President of Sales of Network Equipment Technologies, a telecommunications equipment manufacturer. From November 1989 to February 1994, Mr. Griffith was Director of Sales for NORTEL, Inc Mr. Griffith received a B.A. in Business Administration and an M.B.A. from Pepperdine University. Mr. Michael Harmon, age 38, joined the Company in May 1997 as Vice President, Engineering. From March 1996 until joining Verilink, Mr. Harmon was Director, Wave Engineering for Madge Networks Inc., a telecommunications and LAN equipment manufacturer. From July 1987 to February 1996 Mr. Harmon was Vice President of Engineering and Director of Development at Teleos Communications, Inc., a telecommunications equipment manufacturer. Mr. Harmon received a M.S. in Electrical Engineering from the California Institute of Technology. Ms. Andrea Potts, age 48, joined the Company in April 1997 as Vice President, Human Resources. From June 1994 until joining Verilink, Ms. Potts was Director, Human Resources, for the Western Region of Sony Electronics, Inc. From June 1984 until January 1991, Ms. Potts was Manager of Human Resources for Fujitsu Microelectronics, Inc., a semiconductor manufacturer. Ms. Potts received a B.S. in Business Administration from San Jose State University. Mr. Henry L. Tinker, age 65, joined the Company in May 1991 as Vice President, Operations. From May 1990 until joining Verilink, Mr. Tinker served as an Operations Consultant to the Company. From May 1984 to May 1990, Mr. Tinker was Vice President of a business group of Cipher Data Products, a tape drive manufacturer. Mr. Tinker received a B.S. in Business Administration from the University of California at Los Angeles. Other than Henry L. Tinker, who is the father-in-law of Leigh S. Belden, there are no family relationships among any of the directors or executive officers of the Company. PART II ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
FISCAL 1997 -- QUARTER ENDED JUNE 29 MARCH 30 DECEMBER 29 SEPTEMBER 29 - --------------------------------------------------- ---------- -------- ----------- ------------ Market Price:(1) High.............................. $11.25 $33.25 $ 37.00 $30.00 Low............................. $ 5.50 $ 5.69 $ 24.50 $21.25
FISCAL 1996 -- QUARTER ENDED JUNE 30(2) MARCH 31 DECEMBER 31 OCTOBER 1 - --------------------------------------------------- ---------- -------- ----------- ------------ Market Price:(1) High.............................. $26.25 -- -- -- Low............................. $18.50 -- -- --
- --------------- (1) The Company's Common Stock is traded on the Nasdaq National Market under the symbol VRLK. The market prices per share represent the highest and lowest closing prices for Verilink's Common Stock on the Nasdaq national market during each quarter. As of September 19, 1997 the Company had approximately 224 stockholders of record. The Company has never declared or paid dividends on its capital stock and does not intend to pay dividends in the foreseeable future. (2) Beginning June 10, 1996. 12 14 ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA FINANCIAL INFORMATION BY YEAR (UNAUDITED) (THOUSANDS, EXCEPT PER SHARE AMOUNTS AND NUMBER OF EMPLOYEES)
1997 1996 1995 1994 1993 ------- ------- ------- ------- ------- Sales.................................... $57,170 $41,608 $31,447 $36,533 $28,007 Gross Profit............................. 28,845 21,453 14,755 17,647 11,887 Income (loss) from operations............ 4,832 3,232 347 2,869 (955) Net Income (loss)........................ 4,194 2,716 448 2,263 (1,390) Net Income per share..................... $ 0.29 $ 0.24 $ 0.04 $ 0.23 $ (0.16) Shares used to compute net income per share.................................. 14,293 11,367 10,676 9,900 8,579 Research and development as a percentage of sales............................... 16.4% 17.5% 21.0% 16.4% 19.6% Capital expenditures..................... $ 6,471 $ 958 $ 782 861 491 Cash and cash equivalents and short-term investments............................ $39,050 $40,542 $ 3,243 $ 6,161 $ 931 Working capital.......................... $46,217 $45,015 $ 5,695 $ 5,358 $ 3,082 Stockholders' equity..................... $53,767 $47,234 $ 7,433 $ 6,988 $ 4,737 Total assets............................. $60,687 $55,218 $12,617 $15,029 $10,891 Employees................................ 219 182 152 147 132
FINANCIAL INFORMATION BY QUARTER (UNAUDITED) (THOUSANDS, EXCEPT PER SHARE AMOUNTS)
FISCAL 1997 JUNE 29 MARCH 30 DECEMBER 29 SEPTEMBER 29 ------- -------- ----------- ------------ Sales......................................... $12,448 $13,760 $16,286 $ 14,676 Gross Profit.................................. $ 5,979 $ 6,817 $ 8,495 $ 7,554 Income (loss) from operations................. $ (248) $ 875 $ 2,301 $ 1,904 Net Income.................................... $ 169 $ 865 $ 1,712 $ 1,448 Net Income per share.......................... $ 0.01 $ 0.06 $ 0.12 $ 0.10 Shares used to compute net income per share... 14,150 14,312 14,360 14,350
FISCAL 1996 JUNE 30 MARCH 31 DECEMBER 31 OCTOBER 1 ------- -------- ----------- ------------ Sales......................................... $12,931 $10,533 $ 8,640 $ 9,505 Gross Profit.................................. $ 6,567 $ 5,427 $ 4,284 $ 4,897 Income from operations........................ $ 1,479 $ 711 $ 293 $ 750 Net Income.................................... $ 952 $ 1,105 $ 196 $ 463 Net Income per share.......................... $ 0.08 $ 0.10 $ 0.02 $ 0.04 Shares used to compute net income per share... 12,122 11,496 11,011 10,837
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Management's Discussion and Analysis of Financial Condition and Results of Operations ("MDA") should be read in conjunction with the 1997 Consolidated Financial Statements and Notes thereto. This MDA contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of the risk factors set forth herein, including those set forth in "Factors Affecting Future Results" below. 13 15 The Company's fiscal year ends on the Sunday nearest June 30. Fiscal years 1997, 1996, and 1995 ended June 29, June 30, and July 2 respectively, and consisted of 52 weeks. References to 1997, 1996, and 1995 shall be to the respective fiscal year unless otherwise stated or the context otherwise requires. OVERVIEW Verilink Corporation (the "Company") develops, manufactures and markets integrated access products for telecommunications network service providers ("NSPs") and corporate end users. Verilink's integrated network access products are used by network service providers such as interexchange and local exchange carriers, and providers of Internet, personal communications and cellular services to provide seamless connectivity and interconnect for multiple traffic types on wide area networks ("WANs"). Verilink's Access System 2000 product line continued to be well received in the marketplace and generated the majority of 1997 sales. Verilink designed the Access System 2000 with modular hardware and software to enable its customers to access increased network capacity and to adopt new communications services in a cost-effective manner. The Access System 2000 provides integrated access to low speed services, fractional T1/E1 services, and T1, E1, T3, and frame relay services. The Company has other products under development that are intended to expand the number of services the Access System 2000 platform supports. The Company also sells single purpose network access devices for selected applications. The Company believes that period-to-period comparisons of its financial results are not necessarily meaningful and should not be relied upon as an indication of future performance. In addition, the Company's results of operations may fluctuate from period to period in the future. RESULTS OF OPERATIONS SALES
(THOUSANDS) 1997 1996 1995 ------- ------- ------- Sales......................................................... $57,170 $41,608 $31,447 Percentage change from preceding year......................... 37% 32% -14%
Sales for 1997 increased 37% to $57.2 million as compared to $41.6 million in 1996, which increased 32% from $31.4 million in 1995. The growth in sales during 1997 and 1996 was attributable primarily to an increase in unit shipments as a result of market acceptance of the Company's Access System 2000 product line. The increase in unit shipments for the Access System 2000 product line was primarily attributable to the growth in the business targeted at wireless communications service applications which accounted for approximately 31% of sales in 1997 as compared to 13% and 4% in 1996 and 1995 respectively. The Access System 2000 product line in total accounted for approximately 80% of sales in 1997 as compared to approximately 70% in 1996 and approximately 53% in 1995. The Company's business is characterized by the concentration of sales to a limited number of customers. Sales to the Company's top five customers accounted for 67%, 64% and 47% of sales in 1997, 1996, and 1995, respectively. The Company's largest customers include NORTEL, Inc., MCI Communications Corp., CompuServe Corp., and QUALCOMM Incorporated. See Note 1 of "Notes to Consolidated Financial Statements," and "Factors Affecting Future Results -- Customer Concentration." The Company sells its products primarily in the United States to NSPs through a direct sales force and through a variety of resellers, including original equipment manufacturers (OEMs), value added resellers (VARs) and distributors. Sales to VARs and distributors accounted for approximately 18% of sales in 1997 as compared to approximately 14% in 1996, and 24% in 1995. To date, international sales have not been significant. The Company intends to expand the marketing of its products generally and particularly to markets outside the United States. 14 16 GROSS PROFIT
(THOUSANDS) 1997 1996 1995 ------- ------- ------- Gross Profit.................................................. $28,845 $21,453 $14,755 Percentage of Sales........................................... 50.5% 51.6% 46.9%
Gross profit as a percentage of sales in 1997 was 50.5% as compared to 51.6% in 1996. The decrease in gross profit margin was primarily the result of higher fixed overhead costs associated with the addition of a new manufacturing facility in 1997, and lower sales volume in the second half of the year. Gross profit as a percentage of sales in 1996 increased to 51.6% from 46.9% in 1995 due to manufacturing efficiencies attributable to higher volume production and lower component costs. In future periods, the Company's gross profit will vary depending upon a number of factors, including the channels of distribution, the price of products sold, discounting practices, the mix of products sold, price competition, increases in material costs, and changes in other components of cost of sales. As the Company introduces new products, it is possible that such products may have lower gross profit than other established products in high volume production. Accordingly, gross profit as a percentage of sales may vary. RESEARCH AND DEVELOPMENT
(THOUSANDS) 1997 1996 1995 ------ ------ ------ Research and development......................................... $9,373 $7,283 $6,619 Percentage of Sales.............................................. 16.4% 17.5% 21.0%
Research and development expenses increased to $9.4 million or 16.4% of sales in 1997, compared to $7.3 million and $6.6 million or 17.5% and 21.0% of sales for 1996 and 1995, respectively. The expense increase was due principally to the addition of personnel, use of outside consultants, depreciation of capital expenditures and prototype development, design, and testing. The Company considers product development expenditures to be critical to future sales and expects to increase spending in absolute dollars, while such expenditures as a percentage of sales may vary. There can be no assurance that the Company's research and development efforts will result in commercially successful new technology and products in the future, and those efforts may be affected by other factors as noted below. SELLING, GENERAL AND ADMINISTRATIVE
(THOUSANDS) 1997 1996 1995 ------- ------- ------- Selling, general, and administrative.......................... $14,640 $10,938 $ 7,789 Percentage of Sales........................................... 25.6% 26.3% 24.8%
The Company's selling, general and administrative expenses increased to $14.6 million in 1997 compared to $10.9 million in 1996 and $7.8 million in 1995. The increase in dollars spent was due to the addition of personnel, the expansion of domestic sales offices, and incentive compensation, including commissions associated with sales growth. These expenses decreased as a percentage of sales to 25.6% in 1997 from 26.3% in 1996 primarily due to increased sales. The Company expects to increase sales and marketing spending in fiscal 1998 as a part of its effort to increase international sales and expand the markets for its products. In addition, the Company expects to increase administrative, legal, and information technology costs necessary to support expanded operations. The Company expects that selling, general, and administrative expenses may vary as a percentage of sales. INTEREST AND OTHER INCOME, NET Interest income increased to $2.0 million in 1997 compared to $147,000 in 1996 and $141,000 in 1995. The increase in interest income during 1997 is due primarily to the investment of proceeds from the Company's initial public offering of its common stock, completed in June 1996. 15 17 PROVISION FOR INCOME TAXES The provision for income taxes for 1997 was $2.7 million, an effective tax rate of 39%, compared to an effective tax rate of 20% and 8.2% for 1996 and 1995 respectively. The 1997 effective tax rate of 39% approximates the combined federal and state statutory rates. The effective tax rate in 1996 was less than the combined federal and state statutory rates primarily due to the recognition of previously reserved deferred tax assets based on carryback capacity and, to a lesser extent, expectations of future income in 1997. The provision for income taxes of $40,000 in fiscal 1995 represented minimum state income and franchise taxes. LIQUIDITY AND CAPITAL RESOURCES On June 29, 1997, the Company's principal sources of liquidity included $39.1 million of cash and cash equivalents, and short-term investments. The Company had a secured $2.0 million revolving line of credit which expired on August 15, 1997. There was no borrowing under the line of credit in 1997. The Company is currently investigating the possibility of establishing a new unsecured credit facility on more favorable terms. There can be no assurance that the Company will be able to establish such facility on more favorable terms, or at all. During 1997, the Company generated $2.8 million of net cash from operating activities, a 68% increase over the $1.7 million generated in 1996. During 1995, net cash used in operating activities was $2.0 million, primarily due to the payment of accrued compensation expense. Accounts receivable remained constant in 1997 as compared to 1996 at $2.3 million while increasing from 1995 levels of $1.4 million. Inventory levels declined $499,000 from 1996 reflecting the shipment of product that had accumulated in anticipation of higher sales in early 1997. Accounts payable decreased by $941,000 in 1997 reflecting lower year-end volume with outside subcontractors and suppliers. Net cash used for investing activities was $8.9 million in 1997, as compared to $958,000 and $782,000 in 1996 and 1995 respectively. Verilink invested $6.5 million in property, and equipment during 1997 compared to $958,000 in 1996 and $782,000 in 1995. The 1997 investments in property and equipment were primarily for leasehold improvements for its new 24,000 square foot manufacturing facility, and computer and test equipment. The Company estimates that total budgeted capital expenditures for 1998 will approximate $6.0 million and will include expenditures for test equipment, design tools, and new manufacturing capability. The Company expects current facilities will be adequate through 1998. Net cash provided from financing activities was $2.1 million in 1997 compared to $36.6 million in 1996 . The Company raised $36.9 million through its initial public offering of common stock in June 1996. Prior to the offering, the primary source of financing for the Company had been cash flow from operations. In addition, the Company had used proceeds from the private sale of equity securities and bank borrowings to support its operations, acquire capital equipment and finance inventory and accounts receivable growth. The Company believes that its cash and investment balances and anticipated cash flow from operations, will be adequate to finance current operations, anticipated investments and capital expenditures for at least the next twelve months. However, there can be no assurance that future events will not require the Company to seek additional capital sooner, or if so required, that adequate capital will be available on terms acceptable to the Company, or at all. FACTORS AFFECTING FUTURE RESULTS As described by the following factors, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods. Forward-looking Statements. This Report on Form 10-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Such forward-looking statements include the Company's plans to introduce Voice and DSL functionality on the Access System 2000 platform and the timing of such introduction, the Company's expectation that the percentage of its sales represented by Access System 2000 products will increase, and the Company's plans 16 18 to develop new products, expand its sales force, expand its customer base and enter international markets, and the Company's plans to increase levels of spending on research and development and capital equipment. Such forward-looking statements also include the Company's expectations concerning factors affecting the markets for its products, such as demand for increased bandwidth, the migration from private to public networks, growth in the corporate use of the Internet, deregulation and increased competition, the introduction of a wide range of new communication services and technologies (including the potential deployment of ATM and DSL and product and service developments) and growth in the international market for network access solutions. Actual results could differ from those projected in any forward-looking statements for the reasons detailed below and in the other sections of this Annual Report on Form 10-K. The forward-looking statements are made as of the date of this Annual Report on Form 10-K, and the Company assumes no obligation to update the forward-looking statements, or to update the reasons why actual results could differ from those projected in the forward-looking statements. You should consult the risk factors listed from time to time in the Company's Reports on Form 10-Q, 8-K, 10-K and Annual Report to Stockholders. Customer Concentration. A small number of customers have accounted for a majority of the Company's sales in each of the past several fiscal years. In fiscal 1997, NORTEL, MCI, and CompuServe accounted for 22%, 20%, and 11% of the Company's sales, respectively, and sales to the Company's top five customers accounted for 67% of the Company's sales. In fiscal 1996, NORTEL, MCI, and CompuServe accounted for 7%, 29% and 18% of the Company's sales, respectively, and the Company's top five customers accounted for 64% of the Company's sales. In fiscal 1995, MCI and CompuServe each accounted for 14% of the Company's sales and the Company's top five customers accounted for 47% of sales. Other than NORTEL, MCI and CompuServe, no customer accounted for more than 10% of the Company's revenue in fiscal 1997, fiscal 1996, or fiscal 1995. There can be no assurance that the Company's current customers will continue to place orders with the Company, that orders by existing customers will continue at the levels of previous periods, or that the Company will be able to obtain orders from new customers. The Company's customers are typically not contractually obligated to purchase any quantity of products in any particular period. Product sales to major customers have varied widely from year to year. In some cases, major customers have abruptly terminated purchases of the Company's products. For example, sales of the Company's single purpose network access products to AT&T Paradyne represented 24% of sales in fiscal 1993, but declined to 11% and 2% of sales in fiscal 1994 and 1995, respectively, due to the decision by AT&T Paradyne to focus its sales efforts on competing products developed within the AT&T organization. In addition, sales to Stratacom, Inc. for provision of network management capabilities in a system sold to another AT&T business unit accounted for 9% of the Company's sales during fiscal 1995. Sales to Stratacom ceased during the second half of fiscal 1995 due to the decision by such AT&T business unit to internally provide such management functionality in its system. Loss of, or a material reduction in orders by, one or more of the Company's major customers would materially adversely affect the Company's business, financial condition and results of operations. See "Competition." Fluctuations in Quarterly Operating Results. The Company's sales are subject to quarterly and annual fluctuations due to a number of factors. Most of the Company's sales are in the form of large orders with short delivery times. The Company's ability to affect and judge the timing of individual customer orders is limited. The Company has experienced large fluctuations in sales from quarter to quarter due to a wide variety of factors, such as delay, cancellation or acceleration of customer projects, and other factors discussed below. The Company's sales for a given quarter may depend to a significant degree upon planned product shipments to a single customer, often related to specific equipment deployment projects. The Company has experienced both acceleration and slowdown in orders related to such projects, causing changes in the sales level of a given quarter relative to both the preceding and subsequent quarters. Sales to individual current customers have varied by as much as $2.0 million between consecutive quarters. Delays or lost sales can be caused by other factors beyond the Company's control, including late deliveries by other vendors of components in a customer's system, changes in implementation priorities, slower than anticipated growth in demand for the services that the Company's products support and delays in obtaining regulatory approvals for new services. Delays and lost sales have occurred in the past and may occur in the future. Operating results in recent periods have been adversely affected by delays in receipt of significant 17 19 purchase orders from customers. In addition, the Company has in the past experienced delays as a result of the need to modify its products to comply with unique customer specifications. These and similar delays or lost sales could materially adversely affect the Company's business, financial condition and results of operations. See "Customer Concentration," and "Dependence on Component Availability and Key Suppliers." The Company's backlog at the beginning of each quarter typically is not sufficient to achieve expected sales for that quarter. To achieve its sales objective, the Company is dependent upon obtaining orders in a quarter for shipment in that quarter. Furthermore, the Company's agreements with its customers typically provide that they may change delivery schedules and cancel orders within specified timeframes, typically up to 30 days prior to the scheduled shipment date, without significant penalty. The Company's customers have in the past built, and may in the future build, significant inventory in order to facilitate more rapid deployment of anticipated major projects or for other reasons. Decisions by such customers to reduce their inventory levels could lead to reductions in purchases from the Company. These reductions, in turn, could cause fluctuations in the Company's operating results and could have an adverse effect on the Company's business, financial condition and results of operations in the periods in which the inventory is reduced. The Company's industry is characterized by declining prices of existing products, therefore continual improvement of manufacturing efficiencies and introduction of new products and enhancements to existing products are required to maintain gross margins. In response to customer demands or competitive pressures, or to pursue new product or market opportunities, the Company may take certain pricing or marketing actions, such as price reductions, volume discounts, or provision of services at below-market rates. These actions could materially and adversely affect the Company's operating results. Operating results may also fluctuate due to factors such as the timing of new product announcements and introductions by the Company, its major customers or its competitors, delays in new product introductions by the Company, market acceptance of new or enhanced versions of the Company's products, changes in the product or customer mix of sales, changes in the level of operating expenses, competitive pricing pressures, the gain or loss of significant customers, increased research and development and sales and marketing expenses associated with new product introductions, and general economic conditions. All of the above factors are difficult for the Company to forecast, and these or other factors can materially adversely affect the Company's business, financial condition and results of operations for one quarter or a series of quarters. The Company's expense levels are based in part on its expectations regarding future sales and are fixed in the short term to a large extent. Therefore, the Company may be unable to adjust spending in a timely manner to compensate for any unexpected shortfall in sales. Any significant decline in demand relative to the Company's expectations or any material delay of customer orders could have a material adverse effect on the Company's business, financial condition and results of operations. There can be no assurance that the Company will be able to sustain profitability on a quarterly or annual basis. In addition, the Company has had, and in some future quarter may have operating results below the expectations of public market analysts and investors. In such event the price of the Company's Common Stock would likely be materially and adversely affected. See "Potential Volatility of Stock Price." Potential Volatility of Stock Price. The trading price of the Company's Common Stock could be subject to wide fluctuations in response to quarter to quarter variations in operating results, announcements of technological innovations or new products by the Company or its competitors, developments with respect to patents or proprietary rights, general conditions in the telecommunication network access and equipment industries, changes in earnings estimates by analysts, or other events or factors. In addition, the stock market has experienced extreme price and volume fluctuations, which have particularly affected the market prices of many technology companies and which have often been unrelated to the operating performance of such companies. These Company-specific factors or broad market fluctuations may materially adversely affect the market price of the Company's Common Stock. The Company has experienced significant fluctuations in its stock price and share trading volume since its initial public offering in June 1996. There is no assurance that such fluctuations will not continue. Dependence on Recently Introduced Products and Products Under Development. The Company's future results of operations are highly dependent on market acceptance of existing and future applications for the 18 20 Company's Access System 2000 product line. The Access System 2000 product line represented approximately 80% of sales in fiscal 1997 and 70% of sales in fiscal 1996. Increased market acceptance of the Company's Access System 2000 products is dependent on a number of factors, not all of which are in the Company's control, including the continued growth in the use of bandwidth intensive applications, continued deployment of new telecommunications services, market acceptance of integrated access devices in general, the availability and price of competing products and technologies, and the success of the Company's sales efforts. Failure of the Company's products to achieve increased market acceptance would have a material adverse effect on the Company's business, financial condition and results of operations. Failure to introduce new products in a timely manner could cause companies to purchase products from competitors and have a material adverse effect on the Company's business, financial condition and results of operations. Due to a variety of factors, the Company may experience delays in developing its planned products. New products may require additional development work, enhancement, testing or further refinement before they can be made commercially available by the Company. The Company has in the past experienced delays in the introduction of Access System 2000 product applications and enhancements due to a variety of internal factors, such as reallocation of priorities, difficulty in hiring sufficient numbers of qualified personnel and unforeseen technical obstacles, as well as to changes in customer requirements. Although the Company does not believe that such delays have had a material adverse effect on its customer relationships, such delays have deferred the receipt of revenue from the products involved. If the Company's Access System 2000 products have performance, reliability or quality shortcomings, then the Company may experience reduced orders, higher manufacturing costs, delays in collecting accounts receivable and additional warranty and service expenses. Need to Expand Sales Organization and Channels of Distribution. Currently the Company sells its products to a small number of customers through a relatively small sales force. The Company's strategy is to distribute its products to a broader customer base, which will require the Company to significantly expand its sales force and other channels of distribution. There can be no assurance that the Company will be able to recruit, train, motivate and manage additional qualified sales personnel with the requisite experience and knowledge, or attract additional qualified distributors. Availability of qualified sales personnel is limited, and competition for experienced sales personnel in the network access and telecommunications equipment industries is intense. The failure to timely expand the Company's sales force and expand its channels of distribution could have a material adverse effect on the Company's business, financial condition and results of operations. See "Customer Concentration," "Management of Growth" and "Dependence on Key Personnel." Dependence on Component Availability and Key Suppliers. On-time delivery of the Company's products depends upon the availability of components and subsystems used in its products. The Company depends in part upon suppliers to manufacture, assemble and deliver components in a timely and satisfactory manner. The Company obtains several components and licenses certain embedded software from single sources. There can be no assurance that these suppliers will continue to be able and willing to meet the Company's requirements for any such components. The Company generally does not have any long-term contracts with such suppliers, other than software vendors. Any significant interruption in the supply of, or degradation in the quality of, any such item could have a material adverse effect on the Company's results of operations. The Company has no current plans to significantly expand its supplier base. Purchase orders from the Company's customers frequently require delivery quickly after placement of the order. Because the Company does not maintain significant component inventories, delay in shipment by a supplier could lead to lost sales. The Company uses internal forecasts to determine its general materials and components requirements. Lead times for materials and components may vary significantly, and depend on factors such as specific supplier performance, contract terms and general market demand for components. If orders vary from forecasts, the Company may experience excess or inadequate inventory of certain materials and components. From time to time, the Company has experienced shortages and allocations of certain components, resulting in delays in fulfillment of customer orders. Such shortages and allocations could have a material adverse effect on the Company's business, financial condition and results of operations. See "Fluctuations in Quarterly Operating Results." Competition. The market for network access and telecommunications equipment is highly competitive, and the Company expects competition to increase in the future. This market is subject to rapid technological 19 21 change, regulatory developments and emerging industry standards. The Company faces different competitive environments for its Access System 2000 products than for its single purpose network access products. The market for integrated access devices such as the Company's Access System 2000 is newly emerging and is subject to rapid change. The Company believes that the primary competitive factors in this market are the development and rapid introduction of new product features, price/performance, support for multiple types of communications services, network management, reliability and safety, and quality of customer support. There can be no assurance that the Company's new products and products under development will be able to compete successfully with respect to these or other factors. The Company's principal competition to date for its current Access System 2000 products has been from Digital Link Corporation, Kentrox, a division of ADC Telecommunications (both in Kentrox's own products and products supplied to Kentrox by Premisys Communications, Inc.), and Larscom, Inc. As the Company develops new products for the Access System 2000 line, the Company expects to increasingly compete with Premisys. The Company expects additional competition from companies that are currently competitors in the market for the Company's single purpose network access products, as such companies develop new products. In addition, the Company expects competition from companies in the computer networking market and other related markets such as Newbridge Networks Corporation, Telco Systems, Inc. and Ascend Communications, Inc. To the extent that current or potential competitors can expand their current offerings to include products that have functionality similar to the Company's products and planned products, the Company's business, financial condition and results of operations could be materially adversely affected. The Company believes that the market for its single purpose network access products is mature. The Company believes that the principal competitive factors in this market are price, installed base and quality of customer support. In this market, the Company primarily competes with Adtran, Inc., Digital Link, Kentrox and Larscom. There can be no assurance that such companies or other competitors will not introduce new products at a lower price and/or that provide greater functionality than the Company's single purpose network access products. In addition, the Company anticipates that competitors and customers may develop products that could be used for selected applications for which the Company's products are currently provided. Successful, timely development of such products could reduce the level of demand for the Company's products. The Company does not expect to spend significant resources, if any, on research and development of its single purpose network access products. There can be no assurance that the Company's single purpose network access products will be competitive in the future. Many of the Company's current and potential competitors have substantially greater technical, financial, manufacturing and marketing resources than the Company. In addition, many of the Company's competitors have long-established relationships with network service providers. There can be no assurance that the Company will have the financial resources, technical expertise, manufacturing, marketing, distribution and support capabilities to compete successfully in the future. Rapid Technological Change. The network access and telecommunications equipment markets are characterized by rapidly changing technologies and frequent new product introductions. The rapid development of new technologies increases the risk that current or new competitors could develop products that would reduce the competitiveness of the Company's products. The Company's success will depend to a substantial degree upon its ability to respond to changes in technology and customer requirements. This will require the timely selection, development and marketing of new products and enhancements on a cost-effective basis. The development of new, technologically advanced products is a complex and uncertain process, requiring high levels of innovation. The development of new products for the integrated access market requires competence in the general areas of telephony, data networking, network management and wireless telephony as well as specific technologies such as DSL, IP, ISDN and ATM. Furthermore, the communications industry is characterized by the need to design products which meet industry standards for safety, emissions and network interconnection. With new and emerging technologies and service offerings from network service providers, such standards are often changing or unavailable. As a result, there is a potential for product development delay due to the need for compliance with new or modified standards. The introduction of new and enhanced products also requires that the Company manage transitions from older products in order to minimize disruptions in customer orders, avoid excess inventory of old products and ensure that adequate supplies of 20 22 new products can be delivered to meet customer orders. There can be no assurance that the Company will be successful in developing, introducing or managing the transition to new or enhanced products or that any such products will be responsive to technological changes or will gain market acceptance. The Company's business, financial condition and results of operations would be materially adversely affected if the Company were to be unsuccessful, or to incur significant delays, in developing and introducing such new products or enhancements. See "Dependence on Recently Introduced Products and Products under Development." Management of Growth. The Company has recently experienced and may continue to experience growth in the number of its employees and the scope of its operations. In particular, the Company intends to increase its sales, marketing and support staff. These increases will result in increased responsibilities for management. To manage potential future growth effectively, the Company must improve its operational, financial and management information systems and must hire, train, motivate and manage a growing number of employees. The future success of the Company also will depend on its ability to increase its customer support capability and to attract and retain qualified technical, sales, marketing and management personnel, for whom competition is intense. In particular, the current availability of qualified sales and engineering personnel is quite limited, and competition among companies for such personnel is intense. The Company is currently attempting to hire a number of sales and engineering personnel and has experienced delays in filling such positions. During strong business cycles, the Company expects to experience continued difficulty in filling its needs for qualified sales, engineering and other personnel. There can be no assurance that the Company will be able to effectively achieve or manage any such growth, and failure to do so could delay product development cycles or otherwise have a material adverse effect on the Company's business, financial condition and results of operations. See "Need to Expand Sales Organization and Channels of Distribution," "Dependence on Key Personnel." Compliance with Regulations and Evolving Industry Standards. The market for the Company's products is characterized by the need to meet a significant number of communications regulations and standards, some of which are evolving as new technologies are deployed. In the United States, the Company's products must comply with various regulations defined by the Federal Communications Commission and standards established by Underwriters Laboratories and Bell Communications Research. For some public carrier services, installed equipment does not fully comply with current industry standards, and this noncompliance must be addressed in the design of the Company's products. Standards for new services such as frame relay and ATM are still evolving. As these standards evolve, the Company will be required to modify its products or develop and support new versions of its products. The failure of the Company's products to comply, or delays in compliance, with the various existing and evolving industry standards could delay introduction of the Company's products, which could have a material adverse effect on the Company's business, financial condition and results of operations. Government regulatory policies are likely to continue to have a major impact on the pricing of existing as well as new public network services and therefore are expected to affect demand for such services and the telecommunications products that support such services. Tariff rates, whether determined by network service providers or in response to regulatory directives, may affect the cost effectiveness of deploying communication services. Such policies also affect demand for telecommunications equipment, including the Company's products. Risks Associated With Entry into International Markets. The Company has had minimal direct sales to international customers to date. The Company has little experience in international markets, but intends to expand sales of its products outside of the United States and to enter certain international markets, which will require significant management attention and financial resources. Conducting business outside of the United States is subject to certain risks, including longer payment cycles, unexpected changes in regulatory requirements and tariffs, difficulties in staffing and managing foreign operations, greater difficulty in accounts receivable collection and potentially adverse tax consequences. To the extent any Company sales are denominated in foreign currency, the Company's sales and results of operations may also be directly affected by fluctuations in foreign currency exchange rates. In order to sell its products internationally, the Company must meet standards established by telecommunications authorities in various countries, as well as recommendations of the Consultative Committee on International Telegraph and Telephony. A delay in obtaining, or the 21 23 failure to obtain, certification of its products in countries outside the United States could delay or preclude the Company's marketing and sales efforts in such countries, which could have a material adverse effect on the Company's business, financial condition and results of operations. Risk of Third Party Claims of Infringement. The network access and telecommunications equipment industries are characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. From time to time, third parties may assert exclusive patent, copyright, trademark and other intellectual property rights to technologies that are important to the Company. The Company has not conducted a formal patent search relating to the technology used in its products, due in part to the high cost and limited benefits of a formal search. In addition, since patent applications in the United States are not publicly disclosed until the patent issues and foreign patent applications generally are not publicly disclosed for at least a portion of the time that they are pending, applications may have been filed which, if issued as patents, would relate to the Company's products. Software comprises a substantial portion of the technology in the Company's products. The scope of protection accorded to patents covering software-related inventions is evolving and is subject to a degree of uncertainty which may increase the risk and cost to the Company if the Company discovers third party patents related to its software products or if such patents are asserted against the Company in the future. Patents have been granted recently on fundamental technologies in software, and patents may issue which relate to fundamental technologies incorporated into the Company's products. The Company may receive communications from third parties in the future asserting that the Company's products infringe or may infringe the proprietary rights of third parties. In its distribution agreements, the Company typically agrees to indemnify its customers for any expenses or liabilities, generally without limitation, resulting from claimed infringements of patents, trademarks or copyrights of third parties. In the event of litigation to determine the validity of any third-party claims, such litigation, whether or not determined in favor of the Company, could result in significant expense to the Company and divert the efforts of the Company's technical and management personnel from productive tasks. In the event of an adverse ruling in such litigation, the Company might be required to discontinue the use and sale of infringing products, expend significant resources to develop non-infringing technology or obtain licenses from third parties. There can be no assurance that licenses from third parties would be available on acceptable terms, if at all. In the event of a successful claim against the Company and the failure of the Company to develop or license a substitute technology, the Company's business, financial condition and results of operations would be materially adversely affected. Limited Protection of Intellectual Property. The Company relies upon a combination of patent, trade secret, copyright and trademark laws and contractual restrictions to establish and protect proprietary rights in its products and technologies. The Company has been issued certain U.S. and Canadian patents with respect to limited aspects of its single purpose network access technology. The Company has not obtained significant patent protection for its Access System 2000 technology. There can be no assurance that third parties have not or will not develop equivalent technologies or products without infringing the Company's patents or that the Company's patents would be held valid and enforceable by a court having jurisdiction over a dispute involving such patents. The Company has also entered into confidentiality and invention assignment agreements with its employees, and enters into non-disclosure agreements with its suppliers, distributors and appropriate customers so as to limit access to and disclosure of its proprietary information. There can be no assurance that these statutory and contractual arrangements will deter misappropriation of the Company's technologies or discourage independent third-party development of similar technologies. In the event such arrangements are insufficient, the Company's business, financial condition and results of operations could be materially adversely affected. The laws of certain foreign countries in which the Company's products are or may be developed, manufactured or sold may not protect the Company's products or intellectual property rights to the same extent as do the laws of the United States and thus make the possibility of misappropriation of the Company's technology and products more likely. Dependence on Key Personnel. The Company's future success will depend to a large extent on the continued contributions of its executive officers and key management, sales and technical personnel, including Leigh S. Belden, the Company's President and Chief Executive Officer, and Steven C. Taylor, the Company's Chief Technical Officer. Except for employment agreements with Mr. Belden and Mr. Taylor, the Company 22 24 does not have employment agreements with any other of such persons. Each of the Company's executive officers, and key management, sales and technical personnel would be difficult to replace. The loss of the services of one or more of the Company's executive officers or key personnel, or the inability to continue to attract qualified personnel could delay product development cycles or otherwise have a material adverse effect on the Company's business, financial condition and results of operations. See "Management of Growth." Control of the Company; Antitakeover Effects of Certain Charter Provisions. The current officers, directors and holders of five percent or more of the Company's Common Stock own approximately 36% of the outstanding Common Stock. Accordingly, these stockholders, if they were to act as a group, would effectively be able to elect all of the Company's directors, increase the authorized capital and otherwise control the policies of the Company. The Company's Board of Directors has the authority to issue up to 1,000,000 shares of Preferred Stock and to determine the price, rights, preferences and privileges of those shares without any further vote or action by the stockholders. The rights of the holders of Common Stock will be subject to, and may be adversely affected by, the rights of the holders of any Preferred Stock that may be issued in the future. The issuance of shares of Preferred Stock, while potentially providing desirable flexibility in connection with possible acquisitions and other corporate purposes, could have the effect of making it more difficult for a third party to acquire a majority of the outstanding voting stock of the Company. The Company has no present intention to issue shares of Preferred Stock. In addition, the Company is subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which will prohibit the Company from engaging in a "business combination" with an "interested stockholder" for a period of three years after the date of the transaction in which the person became an interested stockholder, unless the business combination is approved in a prescribed manner. The application of Section 203 also could have the effect of delaying or preventing a change of control of the Company. Furthermore, certain provisions of the Company's Amended and Restated Certificate of Incorporation, including provisions that provide for the Board of Directors to be divided into three classes to serve for staggered three-year terms, may have the effect of delaying or preventing a change of control of the Company, which could adversely affect the market price of the Company's Common Stock. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The chart entitled "Financial Information by Quarter (Unaudited)" contained in Item 5 of Part II hereof is hereby incorporated by reference into this Item 8 of Part II of this form 10-K. 23 25 VERILINK CORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENTS AND FINANCIAL STATEMENT SCHEDULE Consolidated Financial Statements Included in Item 8:
PAGE ---- Report of Price Waterhouse LLP, Independent Accountants............................... 25 Consolidated Balance Sheets as of June 29, 1997 and June 30, 1996..................... 26 Consolidated Statements of Operations for each of the three years in the period ended June 29, 1997....................................................................... 27 Consolidated Statements of Cash Flows for each of the three years in the period ended June 29, 1997....................................................................... 28 Consolidated Statements of Stockholders' Equity for each of the three years in the period ended June 29, 1997.......................................................... 29 Notes to Consolidated Financial Statements............................................ 30 Schedule for each of the three years in the period ended June 29, 1997 included in Item 14(a): II -- Valuation and Qualifying Accounts and Reserves................................ 44
Schedules other than those listed above have been omitted since the required information is not present or not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements or the notes thereto. 24 26 REPORT OF INDEPENDENT ACCOUNTANTS To the Board of Directors and Stockholders of Verilink Corporation In our opinion, the consolidated financial statements listed in the accompanying index present fairly, in all material respects, the financial position of Verilink Corporation and its subsidiary at June 29, 1997 and June 30, 1996, and the results of their operations and their cash flows for each of the three years in the period ended June 29, 1997, in conformity with generally accepted accounting principles. These financial statements are the responsibility of the Company's management; our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits of these statements in accordance with generally accepted auditing standards which require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for the opinion expressed above. /s/ PRICE WATERHOUSE LLP -------------------------------------- PRICE WATERHOUSE LLP San Jose, California July 23, 1997 25 27 VERILINK CORPORATION CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA) ASSETS
JUNE 29, JUNE 30, 1997 1996 -------- -------- Current assets: Cash and cash equivalents.............................................. $ 36,596 $ 40,542 Short-term investments................................................. 2,454 -- Accounts receivable, net of allowance of $76 at each date.............. 8,462 6,182 Inventories............................................................ 4,453 4,952 Deferred tax assets.................................................... 957 815 Other current assets................................................... 215 508 ------- ------- Total current assets........................................... 53,137 52,999 Property and equipment, net.............................................. 6,607 1,530 Deferred tax assets...................................................... 616 613 Other assets............................................................. 327 76 ------- ------- $ 60,687 $ 55,218 ======= ======= LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable....................................................... $ 1,258 $ 2,199 Accrued expenses....................................................... 5,080 4,945 Income taxes payable................................................... 582 840 ------- ------- Total liabilities.............................................. 6,920 7,984 Commitments (Note 10) Stockholders' equity: Preferred Stock, $0.01 par value, 1,000,000 shares authorized; no shares issued and outstanding....................................... -- -- Common Stock, $0.01 par value; 40,000,000 shares authorized; 13,586,286 and 13,122,833 shares issued and outstanding........................ 136 131 Additional paid-in capital............................................. 43,941 42,432 Notes receivable from stockholders..................................... (1,086) (1,445) Treasury stock; 3,352,710 shares of Common Stock at cost at each date................................................................ (7,320) (7,320) Deferred compensation related to stock options......................... (350) (816) Retained earnings...................................................... 18,446 14,252 ------- ------- Total stockholders' equity..................................... 53,767 47,234 ------- ------- $ 60,687 $ 55,218 ======= =======
The accompanying notes are an integral part of this consolidated financial statements. 26 28 VERILINK CORPORATION CONSOLIDATED STATEMENTS OF OPERATIONS (DOLLARS AND SHARES IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE YEARS ENDED JUNE 29, 1997 ------------------------------- 1997 1996 1995 ------- ------- ------- Sales......................................................... $57,170 $41,608 $31,447 Cost of sales................................................. 28,325 20,155 16,692 ------- ------- ------- Gross profit.................................................. 28,845 21,453 14,755 ------- ------- ------- Operating expenses: Research and development.................................... 9,373 7,283 6,619 Selling, general and administrative......................... 14,640 10,938 7,789 ------- ------- ------- Total operating expenses...................................... 24,013 18,221 14,408 ------- ------- ------- Income from operations........................................ 4,832 3,232 347 Interest and other income, net................................ 2,043 147 141 ------- ------- ------- Income before income taxes.................................... 6,875 3,379 488 Provision for income taxes.................................... 2,681 663 40 ------- ------- ------- Net income.................................................... $ 4,194 $ 2,716 $ 448 ======= ======= ======= Net income per share.......................................... $ 0.29 $ 0.24 $ 0.04 ======= ======= ======= Shares used to compute net income per share................... 14,293 11,367 10,676 ======= ======= =======
The accompanying notes are an integral part of these consolidated financial statements. 27 29 VERILINK CORPORATION CONSOLIDATED STATEMENTS OF CASH FLOWS (DOLLARS IN THOUSANDS)
THREE YEARS ENDED JUNE 29, 1997 --------------------------- 1997 1996 1995 ------- ------- ------- Cash flows from operating activities: Net income...................................................... $ 4,194 $ 2,716 $ 448 Adjustments to reconcile net income to net cash provided by (used in) operating activities: Depreciation and amortization................................ 1,394 846 977 Deferred income taxes........................................ (145) (769) -- Deferred compensation related to stock options............... 261 357 -- Accrued interest on notes receivable from stockholders....... (71) (18) -- Changes in assets and liabilities: Accounts receivable........................................ (2,280) (2,269) (1,381) Inventories................................................ 499 (2,232) 409 Other assets............................................... 42 80 271 Accounts payable........................................... (941) 896 (236) Accrued expenses........................................... 135 1,505 (2,645) Income taxes payable....................................... (258) 571 182 ------- ------- ------- Net cash provided by (used in) operating activities..... 2,830 1,683 (1,975) ------- ------- ------- Cash flows from investing activities: Purchases of property and equipment............................. (6,471) (958) (782) Purchase of short-term investments.............................. (2,454) -- -- ------- ------- ------- Net cash used in investing activities................... (8,925) (958) (782) ------- ------- ------- Cash flows from financing activities: Proceeds from issuance of Common Stock, net..................... 797 36,872 5 Repurchase of Common Stock...................................... -- (183) (8) Proceeds from repayments of notes receivable from stockholders................................................. 455 -- -- Repayment of long-term debt..................................... -- (172) (158) Tax benefit from exercise of stock options...................... 897 57 -- Net cash provided by (used in) financing activities..... 2,149 36,574 (161) ------- ------- ------- Net (decrease) increase in cash and cash equivalents.............. (3,946) 37,299 (2,918) Cash and cash equivalents at beginning of year.................... 40,542 3,243 6,161 ------- ------- ------- Cash and cash equivalents at end of year.......................... $36,596 $40,542 $ 3,243 ======= ======= ======= Supplemental disclosures: Cash paid for interest.......................................... $ -- $ 8 $ 29 Cash paid (refund) for income taxes............................. $ 2,042 $ 805 $ (142) Supplemental disclosure of noncash financing activities: Common stock issued for notes receivable........................ $ 25 $ 577 $ --
The accompanying notes are an integral part of these consolidated financial statements. 28 30 VERILINK CORPORATION CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
DEFERRED NOTES COMPENSATION COMMON STOCK ADDITIONAL RECEIVABLE RELATED TO ------------------- PAID-IN FROM TREASURY STOCK RETAINED SHARES AMOUNT CAPITAL STOCKHOLDERS STOCK OPTIONS EARNINGS TOTAL ---------- ------ ---------- ------------ -------- ------------ -------- ------- Balance at July 3, 1994.......... 9,518,952 $ 95 $ 3,894 $ (850) $(7,320) $ -- $11,169 $ 6,988 Issuance of Common Stock under stock plans.................... 10,162 -- 5 -- -- -- -- 5 Repurchase and retirement of shares of Common Stock......... (9,602) -- (5) -- -- -- (3) (8) Net income....................... -- -- -- -- -- -- 448 448 ---------- ---- ------- ------- ------- ------- ------- ------- Balance at July 2, 1995.......... 9,519,512 95 3,894 (850) (7,320) -- 11,614 7,433 Issuance of Common Stock in initial public offering, net... 2,555,000 25 36,742 -- -- -- -- 36,767 Issuance of Common Stock under stock plans.................... 1,258,711 13 669 (577) -- -- -- 105 Repurchase and retirement of shares of Common Stock......... (210,390) (2) (103) -- -- -- (78) (183) Deferred compensation related to stock options.................. -- -- 1,173 -- -- (1,173) -- -- Amortization of deferred compensation................... -- -- -- -- -- 357 -- 357 Accrued interest on notes receivable from stockholders... -- -- -- (18) -- -- -- (18) Tax benefit of stock options..... -- -- 57 -- -- -- -- 57 Net income....................... -- -- -- -- -- -- 2,716 2,716 ---------- ---- ------- ------- ------- ------- ------- ------- Balance at June 30, 1996......... 13,122,833 131 42,432 (1,445) (7,320) (816) 14,252 47,234 Issuance of Common Stock under stock plans.................... 463,453 5 817 (25) -- -- -- 797 Amortization of deferred compensation................... -- -- -- -- -- 261 -- 261 Reversal of deferred compensation related to forfeited stock options........................ -- -- (205) -- -- 205 -- -- Accrued interest on notes receivable from stockholders... -- -- -- (71) -- -- -- (71) Repayment of notes receivable from stockholders.............. -- -- -- 455 -- -- -- 455 Tax benefit of stock options..... -- -- 897 -- -- -- -- 897 Net income....................... -- -- -- -- -- -- 4,194 4,194 ---------- ---- ------- ------- ------- ------- ------- ------- Balance at June 29, 1997......... 13,586,286 $136 $ 43,941 $ (1,086) $(7,320) $ (350) $18,446 $53,767 ========== ==== ======= ======= ======= ======= ======= =======
The accompanying notes are an integral part of these consolidated financial statements. 29 31 VERILINK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS THREE YEARS ENDED JUNE 29, 1997 NOTE 1 -- THE COMPANY AND A SUMMARY OF ITS SIGNIFICANT ACCOUNTING POLICIES: The Company Verilink Corporation (the "Company"), a Delaware Corporation, was incorporated in 1982 to manufacture and market equipment for use by telecommunication network service providers and their corporate customers. Certain equity transactions In April 1996, the Company's Board of Directors approved a two-for-one stock split of the Company's Common Stock. All applicable share and per share amounts of Common Stock have been retroactively adjusted to reflect the stock split. Management estimates and assumptions The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Basis of presentation The consolidated financial statements include the accounts of the Company and its wholly owned subsidiary in the United Kingdom. All significant intercompany accounts and transactions have been eliminated. The Company's fiscal year ends on the Sunday nearest June 30. Fiscal 1997, 1996 and 1995 ended June 29, June 30, and July 2 respectively, and consisted of 52 weeks. References to 1997, 1996, and 1995 shall be to the respective fiscal year unless otherwise stated or the context otherwise requires. Foreign currency The functional currency of the Company's foreign subsidiary is the local currency. The balance sheet accounts are translated into United States dollars at the exchange rate prevailing at the balance sheet date. Revenues, costs and expenses are translated into United States dollars at average rates for the period. Gains and losses resulting from translation are accumulated as a component of stockholders' equity and to date have not been material. Net gains and losses resulting from foreign exchange transactions are included in the consolidated statements of operations and were not significant during any of the periods presented. Cash and cash equivalents The Company considers all highly liquid instruments with a maturity of three months or less when purchased to be cash equivalents. Short-term investments The Company classifies its investment securities as available for sale. Realized gains or losses are determined on the specific identification method and are reflected in income. Net unrealized gains or losses are recorded directly in stockholders' equity except those unrealized losses which are deemed to be other than temporary which are reflected in the consolidated statements of operations. No such losses were recorded during any of the periods presented. 30 32 VERILINK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED JUNE 29, 1997 Inventories Inventories are stated at the lower of cost, determined using the first-in, first-out method, or market. Property and equipment Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, generally two to five years. Leasehold improvements are amortized using the straight-line method over the lesser of the estimated useful lives of the assets or the remaining lease term. Revenue recognition Revenues from the sale of products are recognized upon shipment to customers. The following table summarizes the percentage of total sales for customers accounting for more than 10% of the Company's sales:
THREE YEARS ENDED JUNE 29, 1997 -------------------------- 1997 1996 1995 ---- ---- ---- NORTEL...................................... 22% -- -- MCI Communications Corporation.............. 20% 29% 14% CompuServe Corporation...................... 11% 18% 14%
Concentrations of credit risk Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of cash and cash equivalents, short-term investments and accounts receivable. The Company limits the amount of investment exposure to any one financial institution and financial instrument. The Company's trade accounts receivable are derived from sales to customers primarily in the United States. The Company performs credit evaluations of its customers' financial condition and, generally, requires no collateral from its customers. The Company maintains reserves for potential credit losses and historically such losses have been immaterial. Research and development costs Research and development costs are expensed as incurred. Software development costs Software development costs are included in research and development and are expensed as incurred. Statement of Financial Accounting Standards No. 86 requires the capitalization of certain software development costs incurred subsequent to the date technological feasibility is established, which the Company defines as the completion of a working model, and prior to the date the product is generally available for sale. The capitalized cost is then amortized on a straight-line basis over the estimated product life, or on the ratio of current sales to total projected product sales, whichever is greater. To date, the period between achieving technological feasibility and the general availability of such software has been short and software development costs qualifying for capitalization have been insignificant. Accordingly, the Company has not capitalized any software development costs. Warranty The estimated costs of fulfilling product warranties are accrued at the time the related sale is recorded. 31 33 VERILINK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED JUNE 29, 1997 Income taxes A deferred income tax liability or asset, net of valuation allowance, is established for the expected future tax consequences resulting from the differences between the financial reporting and income tax bases of the Company's assets and liabilities and from tax credit carryforwards. Net income per share Net income per share is computed using the weighted average number of common and common equivalent shares outstanding during the period. Common equivalent shares consist of stock options (using the treasury stock method). Common equivalent shares are excluded from the computation if their effect is antidilutive, except that, pursuant to the requirements of the Securities and Exchange Commission, common equivalent shares (using the treasury stock method and the initial public offering price) issued subsequent to March 31, 1995 through June 10, 1996 have been included in the computation as if they were outstanding for all periods through the effective date of the Company's initial public offering. Recently issued accounting pronouncements In February 1997, the Financial Accounting Standards Board ("FASB") issued Statement of Financial Accounting Standards No. 128, "Earnings per Share" ("FAS 128"). This statement redefines earnings per share under generally accepted accounting principles. Under the new standard, primary earnings per share is replaced by basic earnings per share and fully diluted earnings per share is replaced by diluted earnings per share. The Company is required to adopt the new standard in the second quarter of fiscal 1998. The following table sets forth net income per share as reported and unaudited pro forma basic and diluted net income per share assuming FAS 128 had been applied during the periods presented:
THREE YEARS ENDED JUNE 29, 1997 --------------------------- 1997 1996 1995 ----- ----- ----- Net income per share as reported.......... $0.29 $0.24 $0.04 Pro forma basic net income per share...... 0.31 0.25 0.04 Pro forma diluted net income per share.... 0.29 0.24 0.04
In June 1997, the FASB issued Statement No. 130, "Reporting Comprehensive Income" (FAS 130). FAS 130 establishes standards for reporting comprehensive income and its components in a financial statement that is displayed with the same prominence as other financial statements. Comprehensive income as defined includes all changes in equity (net assets) during a period from nonowner sources. Examples of items to be included in comprehensive income, which are excluded from net income, include foreign currency translation adjustments and unrealized gain/loss on available-for-sale securities. The disclosure prescribed by FAS 130 must be made beginning with fiscal 1999. In June 1997, the FASB issued Statement No. 131, "Disclosures About Segments of an Enterprise and Related Information" (FAS 131). This statement establishes standards for the way companies report information about operating segments in annual financial statements. It also establishes standards for related disclosures about products and services, geographic areas, and major customers. The Company has not yet determined the impact, if any, of adopting this new standard. The disclosures prescribed by FAS 131 are effective for fiscal 1999. Reclassifications Certain prior-year amounts have been reclassified to conform to the fiscal 1997 financial statement presentation. 32 34 VERILINK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED JUNE 29, 1997 NOTE 2 -- INITIAL PUBLIC OFFERING In June 1996, the Company completed an initial public offering and issued 2,555,000 shares of its Common Stock to the public at a price of $16.00 per share. The Company realized proceeds of approximately $36.8 million, net of underwriting discounts, commissions and other offering costs. NOTE 3 -- DETAILS OF BALANCE SHEET COMPONENTS
JUNE 29, JUNE 30, 1997 1996 -------- -------- (IN THOUSANDS) Inventories: Raw materials.................................. $ 3,228 $ 2,999 Work-in-process................................ 973 831 Finished goods................................. 1,175 1,780 ------- ------- 5,376 5,610 Less inventory reserves........................ (923) (658) ------- ------- $ 4,453 $ 4,952 ======= ======= Property and equipment: Furniture, fixtures and office equipment....... $ 7,494 $ 5,179 Machinery and equipment........................ 3,650 2,513 Leasehold improvements......................... 2,556 533 ------- ------- 13,700 8,225 Less accumulated depreciation and amortization................................ (7,093) (6,695) ------- ------- $ 6,607 $ 1,530 ======= ======= Accrued expenses: Compensation and related benefits.............. $ 1,664 $ 1,673 Warranty....................................... 491 743 Commissions.................................... 478 435 Other.......................................... 2,447 2,094 ------- ------- $ 5,080 $ 4,945 ======= =======
NOTE 4 -- SHORT-TERM INVESTMENTS The Company's short-term investments consist primarily of municipal and corporate bonds, and auction rate preferred stock. As of June 29, 1997, approximately $1.7 million of such investments had maturities of greater than one year. However, all such investments mature within two years. As of June 29, 1997, the cost of these short-term investments approximated fair value. NOTE 5 -- LINE OF CREDIT In April 1996, the Company entered into a line-of-credit agreement with a bank which provides for borrowings of up to $2,000,000. Borrowings under the agreement are limited to a specified percentage of eligible accounts receivable. Interest on borrowings is set at the bank's prime rate (8.5% at June 29, 1997). Borrowings under the line of credit are secured by substantially all of the Company's assets. Among other provisions, the Company is required to maintain certain financial covenants and annual profitability. In addition, payment of cash dividends is prohibited without the bank's consent. The line-of-credit agreement 33 35 VERILINK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED JUNE 29, 1997 was extended in May 1997 and expired on August 15, 1997. At June 29, 1997, no borrowings were outstanding under the line-of-credit agreement. NOTE 6 -- COMMON STOCK During fiscal 1996 and 1995, the Company repurchased and retired 210,390 and 9,602 shares of Common Stock, respectively, at prices ranging from $0.50 to $2.17 per share. During the period of November 1995 through February 1996, the Company made loans totaling $577,000 to certain executives, employees and directors pursuant to the Company's 1993 Stock Option Plan. During fiscal 1997, a total of $405,000 of such loans were repaid. The remaining loans outstanding are secured by 264,000 shares of the Company's Common Stock, have a five-year term and bear interest at 5% per annum. Principal plus accrued interest is repayable at maturity. In September 1993, the Company issued 1,600,000 shares of Common Stock to one of its principal stockholders and 100,000 shares to one of its officers in exchange for notes totaling $800,000 and $50,000, respectively. During fiscal 1997, the $50,000 note was repaid. The remaining $800,000 note bears interest at 5% per annum and is due in September 1998. The note is secured by 130,398 shares of the Company's Common Stock. NOTE 7 -- INCOME TAXES The provision for income taxes consists of the following (in thousands):
THREE YEARS ENDED JUNE 29, 1997 ---------------------------- 1997 1996 1995 ------ ------ ---- Current: Federal................................ $2,528 $1,350 $-- State.................................. 298 82 40 ------ ------ -- 2,826 1,432 40 ------ ------ -- Deferred: Federal................................ (200) (240) -- State.................................. 55 (529) -- ------ ------ -- (145) (769) -- ------ ------ -- $2,681 $ 663 $40 ====== ====== ==
The tax provision reconciles to the amount computed by multiplying income before tax by the U.S. federal statutory rate of 34% as follows:
THREE YEARS ENDED JUNE 29, 1997 ---------------------------- 1997 1996 1995 ---- ----- ----- Provision at statutory rate.............. 34.0% 34.0% 34.0% State taxes, net of federal benefit...... 5.1 5.8 5.3 Change in valuation allowance............ -- (30.8) (22.5) Credits.................................. (2.6) Disallowance of research and development credits................................ -- 5.4 -- Other.................................... 2.5 5.2 (8.6) ---- ----- ----- 39.0% 19.6% 8.2% ==== ===== =====
34 36 VERILINK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED JUNE 29, 1997 Deferred tax assets comprise the following (in thousands):
JUNE 29, JUNE 30, 1997 1996 -------- -------- Credit carryforwards.............................. $ 125 $ 179 Inventory reserves................................ 386 282 Warranty.......................................... 171 190 Other reserves and accruals....................... 230 210 Depreciation...................................... 439 424 Other............................................. 222 143 ------ ------ Total deferred tax assets......................... 1,573 1,428 Valuation allowance............................... -- -- Net deferred tax assets........................... $1,573 $1,428 ====== ======
At June 29, 1997, the Company had credit carryforwards of $125,000 available to offset future income; such carryforwards expire in 2005. NOTE 8 -- EMPLOYEE BENEFIT PLANS The 1993 Stock Option Plan (the "1993 Plan") was approved by the Board of Directors in March 1993. During fiscal 1996, the 1989 Directors Stock Option Plan (the "1989 Plan") was terminated and all options outstanding and available for grant under the 1989 Plan were incorporated into the 1993 Plan. As of June 29, 1997, a total of 4,050,000 shares of Common Stock had been reserved for issuance under the 1993 Plan to eligible employees, officers, directors, independent contractors and consultants upon the exercise of incentive stock options ("ISOs") and nonqualified stock options ("NSOs"). Options granted under the 1993 Plan are for periods not to exceed ten years and must be issued at prices not less than 100% and 85% for ISOs and NSOs, respectively, of the fair market value of the stock on the date of grant. Options granted under the 1993 Plan are exercisable immediately and generally vest 25% after one year and 1/48th of the total grant monthly thereafter, provided that the optionee remains continuously employed by the Company. Upon cessation of employment for any reason, the Company has the option to repurchase all unvested shares of Common Stock issued upon exercise of an option at a repurchase price equal to the exercise price of such shares. Options granted to stockholders who own greater than 10% of the outstanding stock are for periods not to exceed five years and must be issued at prices not less than 110% of the fair market value of the stock on the date of grant as determined by the Board. 35 37 VERILINK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED JUNE 29, 1997 The following summarizes stock option activity under the Company's 1993 Plan:
WEIGHTED SHARES AVERAGE AVAILABLE OPTIONS EXERCISE FOR GRANT OUTSTANDING PRICE ---------- ----------- ---------- BALANCE AT JULY 3, 1994............ 1,252,500 1,546,000 $ 0.50 Granted at market price............ (279,000) 279,000 0.72 Exercised.......................... -- (10,162) 0.50 Canceled........................... 137,854 (137,854) 51 ---------- ---------- ---------- BALANCE AT JULY 2, 1995............ 1,111,354 1,676,984 0.54 Approved........................... 500,000 -- Granted at market price............ (563,800) 563,800 3.78 Granted below market price......... (493,800) 493,800 0.88 Exercised.......................... -- (1,258,711) 0.54 Canceled........................... 147,997 (147,997) 0.85 ---------- ---------- ---------- BALANCE AT JUNE 30, 1996........... 701,751 1,327,876 2.00 Approved........................... 750,000 -- Granted at market price............ (1,450,913) 1,450,913 17.01 Exercised.......................... -- (429,698) 0.67 Canceled........................... 777,415 (777,415) 20.68 ---------- ---------- ---------- BALANCE AT JUNE 29, 1997........... 778,253 1,571,676 $ 6.98 ========== ==========
On June 11, 1997, the Company canceled options to purchase 346,000 shares of Common Stock with exercise prices ranging from $16.13 to $36.13 previously granted to employees, and reissued all such options at an exercise price of $10.38, the fair market value of the stock on June 11, 1997. The reissued options have a ten year term and vest over four years from the date of reissuance. The following table summarizes information concerning outstanding and vested stock options as of June 29, 1997:
OPTIONS OUTSTANDING OPTIONS VESTED ----------------------------------------------------- ---------------------------- WEIGHTED AVERAGE WEIGHTED AVERAGE WEIGHTED AVERAGE RANGE OF NUMBER REMAINING EXERCISE NUMBER EXERCISE EXERCISE PRICES OUTSTANDING CONTRACTUAL LIFE PRICE VESTED PRICE - ---------------------- ----------- ---------------- ---------------- ------- ---------------- $ 0.50 - $ 0.88 488,063 8.03 $ 0.81 197,831 $ 0.76 5.00 - 6.00 487,363 9.66 5.77 22,681 5.24 6.88 - 10.38 495,750 9.60 9.36 103,310 9.17 29.50 - 31.00 100,500 9.55 30.99 0 0.00 --------- ------- $ 0.50 - $31.00 1,571,676 9.13 $ 6.98 323,822 $ 3.76 ========= =======
1996 Employee Stock Purchase Plan In April 1996, the Company adopted an Employee Stock Purchase Plan (the "Purchase Plan") under which 300,000 shares of Common Stock have been reserved for issuance. The Purchase Plan permits eligible employees to purchase Common Stock through periodic payroll deductions of up to 10% of their annual compensation. The Purchase Plan provides for two six month offering periods during each calendar year with the first offering period beginning on January 1 and ending on June 30, and the second offering period beginning on July 1 and ending on December 31. The initial offering period commenced upon the effectiveness of the Company's initial public offering. The price at which Common Stock is purchased under the Purchase 36 38 VERILINK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED JUNE 29, 1997 Plan is equal to 85% of the lower of the fair value of the Common Stock at the beginning or end of each offering period. During fiscal 1997, a total of 33,755 shares of Common Stock were issued under the Purchase Plan at an aggregate purchase price of $12.65. Estimated fair value awards under the Company's stock plans The weighted average estimated grant date fair value, as defined by SFAS 123, of options granted during fiscal 1996 at market price and below market price under the Company's stock option plan was $1.82 and $2.49, respectively. The weighted average estimated grant date fair value, as defined by SFAS 123, of options granted during fiscal 1997 at market price under the Company's stock option plan was $6.17. The weighted average estimated grant date fair value of Common Stock issued pursuant to the Company's employee stock purchase plan during fiscal 1997 and 1996 was $3.89 and $4.88, respectively. The estimated grant date fair values disclosed by the Company are calculated using the Black-Scholes model. The Black-Scholes model, as well as other currently accepted option valuation models, was developed to estimate the fair value of freely tradable, fully transferable options without vesting restrictions, which significantly differ from the Company's stock option awards. These models also require highly subjective assumptions, including future stock price volatility and expected time until exercise, which greatly affect the calculated grant date fair value. The following weighted average assumptions are included in the estimated grant date fair value calculations for the Company's stock option and purchase awards:
1997 1996 ---- ---- Stock option plan: Expected dividend yield.............................. 0.0% 0.0% Expected stock price volatility...................... 61% 61% Risk free interest rate.............................. 6.07% 5.69% Expected life (years)................................ 2.55 2.55 Stock purchase plan: Expected dividend yield.............................. 0.0% 0.0% Expected stock price volatility...................... 61% 61% Risk free interest rate.............................. 5.36% 5.33% Expected life (years)................................ 0.50 0.50
Pro forma net income and net income per share Had the Company recorded compensation based on the estimated grant date fair value, as defined by SFAS 123, for awards granted under its stock option plan and stock purchase plan, the Company's net income and net income per share would have been reduced to the pro forma amounts below for the years ended June 29, 1997 and June 30, 1996 (in thousands, except per share amounts):
1997 1996 ------ ------ Net income as reported............................. $4,194 $2,716 Pro forma net income............................... $2,657 $2,529 Net income per share as reported................... $ 0.29 $ 0.24 Pro forma net income per share..................... $ 0.19 $ 0.22
The pro forma effect on net income and net income per share for fiscal 1997 and 1996 is not representative of the pro forma effect on net income in future years because it does not take into consideration pro forma compensation expense related to grants made prior to fiscal 1996. 37 39 VERILINK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED JUNE 29, 1997 The Company has recorded compensation expense for the difference between the grant price and deemed fair market value of the Company's Common Stock for options granted in January and February 1996. Such compensation expense was $261,000 and $357,000 for fiscal 1997 and 1996, respectively, and will aggregate approximately $968,000 over the vesting period of four years. Awards under the Company's profit sharing plan are at the discretion of the Board of Directors and are based on achieving targeted levels of profitability. The Company provided for awards of $517,000 for fiscal 1996. No expense under the profit sharing plan was incurred in fiscal 1997 or 1995. NOTE 9 -- RELATED PARTY TRANSACTIONS The Company leases its principal headquarters facility and its manufacturing facility from Baytech Associates ("Baytech") under operating leases which expire in April 2001, and November 2001, respectively. Baytech is owned by two stockholders who hold an aggregate of 34% of the Company's Common Stock and who are also officers and directors of the Company. During fiscal 1997, 1996 and 1995, rent expense totaled $428,000, $826,000 and $816,000, respectively. During fiscal 1997, the Company entered into an agreement with RISC Communication Network Systems ("RISC") which provides for the performance of research and development services by RISC on behalf of the Company. The Company also consented to an equity investment of $450,000 in RISC by Baytech and one of the directors of the Company. During fiscal 1997, the Company paid $98,000 to RISC for research and development services. Included in other current assets as of June 29, 1997 and June 30, 1996, are advances of $170,000 and $325,000, respectively, due from certain officers of the Company. These advances are non-interest bearing and are due on demand. During fiscal 1997, the Company advanced $220,000 to one of its officers in exchange for a note receivable. The note bears interest at 5% per annum and is due in June 2002. The note is included in other assets as of June 29, 1997. The Company paid approximately $110,000 and $120,000 for consulting services to an outside director during fiscal 1997 and 1996, respectively, and approximately $149,000 for consulting services to two of its outside directors during fiscal 1995. NOTE 10 -- COMMITMENTS The Company leases its facilities under noncancelable operating lease agreements which expire through fiscal 2002. The Company's principal facility lease (see Note 9) provides for lease payments based on the fair market value of comparable facilities commencing in May 1999 through expiration of the lease in April 2001. The future minimum lease payments set forth below assume that the monthly lease payment for the Company's principal facility from May 1999 through April 2001 will not vary significantly from the present monthly lease payment. 38 40 VERILINK CORPORATION NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED) THREE YEARS ENDED JUNE 29, 1997 Future minimum lease payments under all noncancelable operating leases with terms in excess of one year are as follows (in thousands): Fiscal year, 1998.............................................. $ 874 1999.............................................. 1,086 2000.............................................. 1,092 2001.............................................. 1,012 2002.............................................. 252 ------ Total minimum lease payments.............. $4,316 ======
Rent expense under all noncancelable operating leases totaled $797,000, $906,000 and $897,000 for fiscal 1997, 1996 and 1995, respectively. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not Applicable. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT Information regarding directors appearing under the caption "Election of Directors" in the Proxy Statement is hereby incorporated by reference. Information regarding executive officers is incorporated herein by reference from Part I hereof under the heading "Executive Officers of the Company" immediately following Item 4 in Part I hereof. Information regarding compliance with Section 16(a) of the Securities Act of 1934, as amended, is hereby incorporated by reference to the Company's Proxy Statement. ITEM 11. EXECUTIVE COMPENSATION The information required by this item is incorporated by reference to the Company's Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by this item is incorporated by reference to the Company's Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by this item is incorporated by reference to the Company's Proxy Statement. PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) 1. FINANCIAL STATEMENTS The financial statements (including the notes thereto) listed in the Index to Consolidated Financial Statements and Financial Statement Schedule (set forth in Item 8 of Part II of this Form 10-K) are filed within this Annual Report on Form 10-K. 39 41 2. FINANCIAL STATEMENT SCHEDULE The financial statement schedule listed in the Index to Consolidated Financial Statements and Financial Statement Schedule (set forth in Item 8 of Part II of this Form 10-K) is filed as part of this Annual Report on Form 10-K. 3. EXHIBITS The exhibits listed under Item 14(c) hereof are filed as part of this Annual Report on Form 10-K. (b) REPORTS ON FORM 8-K No reports on form 8-K were filed during the quarter ended June 29, 1997. (c) EXHIBITS
EXHIBIT NUMBER DESCRIPTION - ------ ---------------------------------------------------------------------------------- 3.1 Registrant's Amended and Restated Certificate of Incorporation.(1) 3.2 Registrant's Amended and Restated Bylaws.(1) 4.1 Reference is made to Exhibits 3.1 and 3.2. 10.1 Common Stock and Option Purchase Agreement, dated as of June 27, 1985 between the Registrant and the stockholders set forth herein, and Standstill Agreement dated as of November 15, 1989 between the Registrant, TA Associates, and the stockholders set forth therein.(1) 10.2 Form of Indemnification Agreement between the Registrant and each of its executive officers and directors.(1) 10.3* Employment Agreement between the Registrant and Leigh S. Belden dated as of April 16, 1986.(1) 10.4* Employment Agreement between the Registrant and Steven C. Taylor dated as of April 16, 1986.(1) 10.5* Executive Incentive Compensation Agreement between the Registrant and Timothy G. Conley dated as of July 1, 1995.(1) 10.6* Executive Incentive Compensation Agreement between the Registrant and James G. Regel dated as of July 1, 1995.(1) 10.7 Common Stock Purchase Agreement and Promissory Note between the Registrant and Leigh S. Belden each dated as of September 16, 1993.(1) 10.8 Promissory Notes of Timothy G. Conley in favor of the Registrant dated as of November 16, 1995 and January 2, 1996.(1) 10.9 Promissory Note of James G. Regel in favor of the Registrant dated as of January 1, 1996.(1) 10.10 Promissory Note of Henry L. Tinker in favor of the Registrant dated as of November 16, 1995.(1) 10.11 Promissory Note of Howard Oringer in favor of the Registrant dated as of January 2, 1996.(1) 10.12 Lease Agreement between the Registrant and Baytech Associates, a California general partnership, dated February 27, 1986, and Memorandum of Lease Modification dated January 22, 1987.(1) 10.13+ Software License Agreement between the Registrant and Integrated Systems, Inc. dated January 27, 1993, as amended.(1) 10.14* Registrant's Amended and Restated 1993 Stock Option Plan, including forms of agreements thereunder.(1) 10.15* Form of Registrant's 1996 Employee Stock Purchase Plan, including forms of agreements thereunder.(1)
40 42
EXHIBIT NUMBER DESCRIPTION - ------ ---------------------------------------------------------------------------------- 10.16* Promissory Note of Robert F. Griffith in favor of the Registrant dated as of August 27, 1997. 11.1 Statement regarding calculation of net income per share. 23.1 Consent of Price Waterhouse LLP. 27.1 Financial Data Schedule.
- --------------- (1) Incorporated by reference to identically numbered Exhibit to the Company's Registration Statement on Form S-1 (Commission File No. 333-4010), which became effective on June 10, 1996. * Management contracts or compensatory plans or arrangements. + Confidential treatment granted as to portions of this exhibit. (d) FINANCIAL STATEMENT SCHEDULES See Item 14(a) (2) above. 41 43 SCHEDULE II -- VALUATION AND QUALIFYING ACCOUNTS AND RESERVES (IN THOUSANDS)
BALANCE AT ADDITIONS DEDUCTIONS BALANCE AT BEGINNING CHARGED FROM END OF YEAR TO INCOME RESERVES OF YEAR ---------- --------- ---------- ---------- Inventory Reserves Year ended June 29, 1997....... $658 $ 265 $ -- $923 Year ended June 30, 1996....... $819 $ -- $ (161) $658 Year ended July 2, 1995........ $814 $ 5 $ -- $819
42 44 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) 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. VERILINK CORPORATION September 26, 1997 By: /s/ LEIGH S. BELDEN ------------------------------------ Leigh S. Belden President, Chief Executive Officer and Director Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE - --------------------------------------------- ---------------------------- ------------------- /s/ LEIGH S. BELDEN President, Chief Executive September 26, 1997 - --------------------------------------------- Officer and Director Leigh S. Belden (Principal Executive Officer) /s/ JOHN C. BATTY Vice President, Finance and September 26, 1997 - --------------------------------------------- Chief Financial Officer John C. Batty (Principal Financial and Accounting Officer) /s/ HOWARD ORINGER Chairman of the Board of September 26, 1997 - --------------------------------------------- Directors Howard Oringer /s/ STEVEN C. TAYLOR Chief Technical Officer, September 26, 1997 - --------------------------------------------- Vice Chairman of the Board Steven C. Taylor of Directors /s/ DAVID L. LYON Director September 26, 1997 - --------------------------------------------- David L. Lyon
43 45 INDEX OF EXHIBITS
EXHIBIT NUMBER DESCRIPTION ------ ----------- 3.1 Registrant's Amended and Restated Certificate of Incorporation. (1) 3.2 Registrant's Amended and Restated Bylaws. (1) 4.1 Reference is made to Exhibits 3.1 and 3.2. 10.1 Common Stock and Option Purchase Agreement, dated as of June 27, 1985 between the Registrant and the stockholders set forth herein, and Standstill Agreement dated as of November 15, 1989 between the Registrant, TA Associates, and the stockholders set forth therein. (1) 10.2 Form of Indemnification Agreement between the Registrant and each of its executive officers and directors. (1) 10.3* Employment Agreement between the Registrant and Leigh S. Belden dated as of April 16, 1986. (1) 10.4* Employment Agreement between the Registrant and Steven C. Taylor dated as of April 16, 1986. (1) 10.5* Executive Incentive Compensation Agreement between the Registrant and Timothy G. Conley dated as of July 1, 1995. (1) 10.6* Executive Incentive Compensation Agreement between the Registrant and James G. Regel dated as of July 1, 1995. (1) 10.7 Common Stock Purchase Agreement and Promissory Note between the Registrant and Leigh S. Belden each dated as of September 16, 1993. (1) 10.8 Promissory Notes of Timothy G. Conley in favor of the Registrant dated as of November 16, 1995 and January 2, 1996. (1) 10.9 Promissory Note of James G. Regel in favor of the Registrant dated as of January 1, 1996. (1) 10.10 Promissory Note of Henry L. Tinker in favor of the Registrant dated as of November 16, 1995. (1) 10.11 Promissory Note of Howard Oringer in favor of the Registrant dated as of January 2, 1996. (1) 10.12 Lease Agreement between the Registrant and Baytech Associates, a California general partnership, dated February 27, 1986, and Memorandum of Lease Modification dated January 22, 1987. (1) 10.13+ Software License Agreement between the Registrant and Integrated Systems, Inc. dated January 27, 1993, as amended. (1) 10.14* Registrant's Amended and Restated 1993 Stock Option Plan, including forms of agreements thereunder. (1) 10.15* Form of Registrant's 1996 Employee Stock Purchase Plan, including forms of agreements thereunder. (1) 10.16* Promissory Note of Robert F. Griffith in favor of the Registrant dated as of August 27, 1997. 11.1 Statement regarding calculation of net income per share. 23.1 Consent of Price Waterhouse LLP. 27.1 Financial Data Schedule. - --------------
(1) Incorporated by reference to identically numbered Exhibit to the Company's Registration Statement on Form S-1 (Commission File No. 333-4010), which became effective on June 10, 1996. * Management contracts or compensatory plans or arrangements. + Confidential treatment granted as to portions of this exhibit. EX-10.16 2 PROMISSORY NOTE 1 EXHIBIT 10.16 PROMISSORY NOTE Amount: $220,000 Dated: August 27, 1997 FOR VALUE RECEIVED, the undersigned hereby promises to pay to Verilink Corporation ("Lender") at San Jose, California, the sum of Two Hundred Twenty Thousand Dollars ($220,000). Principal shall be paid in full on or before July 1, 2002. Lender will include on the undersigned's W-2 form income equal to interest imputed on this Note pursuant to Internal Revenue Service Regulations. Interest shall accrue from the date of the advances to the undersigned by Lender. If the undersigned ceases to be employed by Lender prior to July 1, 2001, this Note and interest accrued after the date of termination of employment at the rate of eight percent (8%) per annum shall be due on the earlier of July 1, 2002 or 36 months after the date of termination of employment. If the undersigned ceases to be employed by Lender after July 1, 2001, this Note and interest accrued after the date of termination of employment at the rate of eight percent (8%) per annum shall be due six (6) months from the date of termination of employment; provided, however, that if the undersigned's employment terminates by reason of the undersigned's death, this Note and accrued interest shall be due twelve (12) months thereafter. Upon the occurrence of any such of the following events, the undersigned shall be deemed to be in default hereunder: (a) commencement of any bankruptcy, insolvency arrangement, reorganization or other debtor-relief proceedings by or against the undersigned; or (b) failure of the undersigned to pay principal hereunder when due. Upon a default, Lender may, at its election and without demand or notice of any kind, which are hereby waived, declare the unpaid principal and accrued interest due under this Note immediately due and payable, proceed to collect the same, and exercise any and all other rights, powers and remedies given it by this Note or by law. This Note supersedes any prior promissory notes payable by the undersigned to Lender. In the event of any proceeding to enforce the undersigned's obligations hereunder, the prevailing party shall be entitled to recover its attorney's fees and costs. This Note shall be governed by the laws of the State of California. ------------------------------ Robert F. Griffith EX-11.1 3 STATEMENT RE CALCULATION OF NET INCOME PER SHARE 1 EXHIBIT 11.1 STATEMENT REGARDING CALCULATION OF NET INCOME PER SHARE (1) (in thousands, except per share date)
Three years ended June 29, 1997 ------------------------------- 1997 1996 1995 ------- ------- ------- Net income $ 4,194 $ 2,716 $ 448 ======= ======= ======= Weighted average shares outstanding: Common stock .............................. 13,327 10,180 9,520 Common stock issuable upon exercise of stock options ........................... 966 513 443 Common stock issuable upon exercise of stock options granted from March 31, 1995 through June 10, 1996 (2) .......... -- 674 713 ------- ------- ------- Weighted average common shares and equivalents ............................... 14,293 11,367 10,676 ======= ======= ======= Net income per share ......................... $ 0.29 $ 0.24 $ 0.04 ======= ======= =======
- ---------- (1) This exhibit should be read in conjunction with Note 1 of Notes to Consolidated Financial Statements. (2) Stock options granted (using the treasury stock method and the initial public offering price) have been included in the calculation of common equivalent shares as if they were outstanding for all periods presented through June 10, 1996. EX-23.1 4 CONSENT OF PRICE WATERHOUSE LLP 1 EXHIBIT 23.1 CONSENT OF INDEPENDENT ACCOUNTANTS We hereby consent to the incorporation by reference in the Registration Statement on Form S-8 (No. 333-05651) of Verilink Corporation of our report dated July 23, 1997 appearing in Form 10-K. We also consent to the application of such report to the Financial Statement Schedule for the three years ended June 29, 1997 listed under Item 14(a) 2 of this Form 10-K when such schedule is read in conjunction with the financial statements referred to in our report. The audits referred to in such report also included this schedule. PRICE WATERHOUSE LLP San Jose, California September 26, 1997 EX-27.1 5 FINANCIAL DATA SCHEDULE
5 THIS FINANCIAL SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE FINANCIAL STATEMENTS CONTAINED IN THE FORM 10-K OF VERILINK CORPORATION FOR THE FISCAL YEAR ENDED JUNE 29, 1997 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000 YEAR JUN-29-1997 JUL-01-1996 JUN-29-1997 36,596 2,454 8,538 76 4,453 53,137 13,700 7,093 60,687 6,920 0 136 0 0 53,631 60,687 57,170 57,170 28,325 28,325 24,013 0 0 6,875 2,681 4,194 0 0 0 4,194 .29 .29
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