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FORM 10
GENERAL FORM FOR REGISTRATION OF SECURITIES
Pursuant to Section 12(b) or (g) of The Securities Exchange Act of 1934
Sorrento Networks Corporation
(Exact name of registration as specified in its charter)
DELAWARE 04-3757586
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
9990 Mesa Rim Road, San Diego, CA 92121
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (858) 909-3960
Copies to:
Phillip W. Arneson W. Raymond Felton, Esq.
Chief Executive Officer Greenbaum, Rowe, Smith, Ravin, Davis &
Sorrento Networks Corporation Himmel LLP
9990 Mesa Rim Road Metro Corporate Campus I
San Diego, California Post Office Box 5600
(858) 558-3960 Woodbridge, New Jersey 07095
(732) 549-5600
Securities to be registered pursuant to Section 12(b) of the Act: None
Securities to be registered pursuant to Section 12(g) of the Act:
Warrants (Expiration Date August 2, 2007)
(Title of class)
TABLE OF CONTENTS
Page No.
--------
Item 1 Business................................................................2
Item 2. Financial Information..................................................17
Item 3 Properties.............................................................40
Item 4. Security Ownership of Certain Beneficial Owners and Management.........40
Item 5. Directors and Executive Officers.......................................43
Item 6. Executive Compensation.................................................48
Item 7. Certain Relationships and Related Transactions.........................55
Item 8. Legal Proceedings......................................................57
Item 9. Market Price of and Dividends on the Registrant's Common
Equity and Related Stockholder Matters.................................59
Item 10. Recent Sales of Unregistered Securities................................60
Item 11. Description of Registrant's Securities to be Registered................60
Item 12. Indemnification of Directors and Officers..............................61
Item 13. Financial Statements and Supplementary Data............................62
Item 14. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure....................................62
Item 15. Financial Statements and Exhibits......................................63
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INTRODUCTION
In connection with our financial restructuring and exchange of our debt
securities and our subsidiary's preferred stock for shares of our common stock
and a lesser principal amount of debt securities, we propose to issue warrants
to each of our shareholders of record as of May 28, 2003. The warrants will
be issued as of the closing date of the restructuring transaction, which
occurred on June 4, 2003.
We are filing this registration statement on Form 10 to register the
warrants to be issued to our shareholders. The warrants are, with certain
limited exceptions, non-transferable, are exercisable for approximately 591,000
shares of our common stock in the aggregate, and may be exercised at any time
after the first anniversary date of the restructuring transaction and before
August 2, 2007. We have the right to repurchase the warrants upon 30 days prior
notice, for $0.01 per warrant share, at any time after the volume-weighted
average market price of our common stock for any ten consecutive trading days
equals or exceeds 150% of the exercise price. In accordance with the terms of
the Exchange Agreement we have entered into in connection with the restructuring
transaction, the exercise price of the warrants is $5.96.
ITEM 1. BUSINESS
Introduction
We are a leading supplier of intelligent optical networking solutions for
metropolitan and regional applications worldwide. Our solutions enable
communication carriers and service providers to offer broadband networking
services over optical fibers for metropolitan and regional applications. Our
technologies permit telecommunications service providers to increase fiber
capacity and fiber bandwidth utilization, reduce network costs and complexity
over scalable and efficient networking platforms. Our optical networking systems
support a wide variety of protocols, mixed speeds of traffic and accommodate
changing traffic patterns directly over optical networks.
Our product solutions include optical transport, optical access, and
network management solutions optimized for metro and regional markets, and
combine to create powerful, cost-effective, and easy-to-manage optical networks.
Our dense wavelength division multiplexing, or DWDM, and course wavelength
division multiplexing, or CWDM, platforms can be used in both metropolitan and
regional network applications. DWDM and CWDM technology allows many optical
signals to be transmitted simultaneously on the same optical fiber by using
different wavelengths of light to distinguish the signals. This technology
increases optical network capacity and flexibility.
Our comprehensive suite of optical networking interfaces and optical access
multiplexers allow us to also address broadband applications in the optical
access market including data center fail-over recovery, storage area networking
and internet connectivity applications. In addition,
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our CWDM product is a lower cost, entry level solution that can be used for
enterprise and carrier customer access that complements our DWDM product line.
Multiplexing is a process that combines a number of lower speed data
transmissions into one high-speed data transmission.
We also have two powerful network management solutions for our DWDM product
line. Addressing all key management aspects - fault, configuration, performance,
and security - these systems conform to North American and international
standards and are simple to learn and use. We have a robust, carrier-class
management system that offers broad functionality, including
equipment/facilities management, fault management, performance monitoring,
security control, alarm filtering, and remote download. We also have an
enterprise network management solution that provides an intuitive graphical
interface and covers operations, administration, maintenance, and provisioning
functionality for our DWDM networks.
We currently have an installed base with over 20 communications service
providers and system integrators worldwide, including AT&T Broadband, now
Comcast Corporation, Deutsche Telekom, Cox Communications, United Pan-Europe
Communications, El Paso Global Networks and Edison Carrier Solutions.
Understanding Our Market
Rapid Growth in Bandwidth Demand
Fueled by the growth of the Internet, the volume of data traffic
transmitted across telecommunications networks now exceeds voice traffic. The
growth of data traffic is attributable to increased Internet usage, increased
access speeds and greater use of bandwidth intensive applications. Bandwidth
means the capacity to move information down a communications channel. Bandwidth
is defined by the highest data rates that can be transmitted by that channel and
is commonly measured in bits per second. According to Ryan, Hankin & Kent,
Industry Analysts, Internet traffic is projected to increase at a rate exceeding
40% per year for the next five years.
Migration of Network Infrastructure
Traditional copper-based and SONET/SDH based telecommunications
infrastructures were originally designed for voice traffic. These
infrastructures do not scale effectively to provide the bandwidth needed to
support the growth in high-speed data traffic. In addition, these
infrastructures need network-wide upgrades in order to accommodate growing
traffic thus resulting in long delays for provisioning new services.
DWDM and CWDM technologies are more flexible, more efficient and more
scalable networking alternatives for meeting the growing demand for bandwidth
and new broadband services. Broadband means technologies or networks that have
the ability to transmit high data rates. DWDM means dense wavelength division
multiplexing, which is a sophisticated opto-electronics technology that uses
multiple wavelengths of light very efficiently to greatly increase the number of
video, data or voice channels of information that can be sent on a single
optical fiber. SONET means a transmission protocol for high-speed transmission
over fiber optic cable, which was introduced by Bell Communications in 1984 and
quickly accepted by American National Standards Institute. SDH means Synchronous
Digital Hierarchy, which is transmission protocol for high-speed transmission
over fiber optic cable published in 1988 by the Consultative
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Committee for International Telegraph and Telephony. It is a transmission
protocol used outside the United States that is similar to SONET.
DWDM networks for long-haul applications were the first to be deployed, and
optical solutions specifically designed to address the challenges faced by
metropolitan markets have significantly lagged in deployment. Accordingly, metro
networks are considered to be traffic bottlenecks in the fast and efficient
transmission of data.
Enhanced Competition in the Service Provider Market
Worldwide deregulation in the telecommunications industry has led to an
increase in the number of service providers seeking to address the growing
demand for bandwidth. In America and internationally, traditional service
providers such as incumbent local exchange carriers (ILECs), inter-exchange
carriers (IXCs) and post, telephone and telegraph companies (PTTs) are seeing
new entrants in the broadband networking market seeking to capitalize on the
growing demand for bandwidth. A number of competitors to these incumbents are
building new data-centric networks to address the present bandwidth bottlenecks
in the metropolitan markets, including utilities and cable television companies
which are upgrading their current networks and are leveraging existing
investments in fiber optic infrastructure to deliver high-speed data services in
both the local and regional markets. This enhanced competition in the carrier
and service provider markets is driving increased capital expenditures on
network infrastructure that is focused on delivering scalable high-speed data
services in a cost efficient manner.
Network Topography
The following describes each of the network segments within the optical
network hierarchy:
o Long-haul networks are high capacity networks that connect service
providers and carry voice and data across large geographic regions,
typically spanning distances up to 4,000 kilometers. Long-haul
networks are relatively simple networks, built around SONET/SDH
technology and are primarily designed only to satisfy service provider
long haul network capacity requirements.
o Metropolitan core (metro-core) networks connect the central offices of
service providers in a metropolitan area and facilitate the transport
and switching of traffic within extended metropolitan areas and
between the network edge and long-haul networks. Metropolitan core
networks are typically implemented in ring configurations and reach
ring circumferences up to 300 kilometers. In order to efficiently use
the optical network, sub-rate multiplexing devices aggregate traffic
into wavelengths carrying higher speed aggregate bit rates across
telecommunications networks. Regional networks typically transport
voice and data traffic between cities across distances of 200 to 600
kilometers or more.
o Access networks connect enterprises or traffic aggregation nodes, in
multiple locations throughout metropolitan areas, to service
providers' central offices or connect different end-user locations to
each other. In order to efficiently use the optical network, optical
access devices aggregate traffic from end users into wavelengths or
wavelength bands for transport across telecommunications networks.
4
Because access networks must support the varying demands of end users,
these networks tend to be very complex.
Metropolitan area optical network opportunity
Although optical technologies are being deployed in long-haul networks to
relieve capacity constraints, these solutions are not specifically designed to
address the issues inherent in metropolitan and regional optical networks. Data
is normally mapped into the voice multiplexing hierarchy for transport over the
long-haul network. Metropolitan optical networks are characterized by varying
traffic patterns and protocols as well as varied topologies and end-user
requirements, making them more complex and difficult to manage than long haul
networks. As a result, service providers have only recently begun to exploit the
benefits of optical technologies in metropolitan optical networks.
The optical networking market saw a substantial downturn in 2002 from 2001
levels. The metro WDM market, which was expected to increase, has also
experienced a slowdown as capital spending has declined throughout the
telecommunications industry. While we believe that the metro WDM world-wide
market will grow significantly in the years to come, such growth is not likely
to occur until capital spending resumes in the markets we serve, and we are
unable to assess at present when this might take place. According to industry
analysts, including Ryan, Hankin and Kent and others, the metro WDM market in
2001 was about $1.2 billion worldwide and is expected to grow to $3.6 billion by
2005.
Regional optical network opportunity
In addition to the metropolitan market, recent engineering enhancements
have permitted the use of DWDM networking platforms for regional optical
networking applications. This development opens up the opportunity to address a
portion of the substantial long haul market. In some regions, e.g., Europe,
regional solutions apply to the majority of the networks installed. Industry
researchers recently started looking at reclassifying the regional market
opportunity, although statistical data for this market are not available.
Specific challenges facing metropolitan optical networks
Service providers face numerous specific challenges in addressing
metropolitan and regional optical networks:
o Scalability Limitations. Originally constructed for voice traffic, the
current network infrastructure based on SONET/SDH technology does not
allow for the network efficiencies necessary to address the shift to a
predominantly data-driven network. Due to its inherent lack of
scalability, the current network infrastructure may require service
providers to undertake the expensive and tedious process of replacing
network equipment or adding new layers of similar equipment in
response to changes or increases in bandwidth demand. Alternative
approaches to WDM are being developed by other vendors to address the
scalability of the SONET/SDH networks. These nonstandard solutions are
called next generation SONET/SDH and can minimize the wasted bandwidth
of legacy SONET/SDH. While these solutions allow carriers to combine
voice and data on the same network, such solutions do not, however,
expand the amount of bandwidth available and are, therefore, unable to
accommodate the need for large amounts of bandwidth.
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o Need to Support Multiple Protocols. Metropolitan optical networks are
characterized by a wide variety of protocols. The inability to support
multiple protocols and services from a single platform further
increases the cost and complexity of the metropolitan networks.
Alternative approaches to WDM are being developed by other vendors to
address the requirement for support of multiple services. These
nonstandard solutions are called multi-service provisioning platforms.
These solutions generally carry out protocol conversions and are much
more complex than WDM solutions.
o Market Downturn. Virtually all telecom related market segments have
suffered a decline in demand in the current economic downturn. What
was once viewed as only a long-haul decline in market demand has now
affected the regional and metropolitan networks as both enterprise and
carrier business have cut back capital spending. Although we expect
that demand in the regional and metropolitan markets will be strong in
future periods, there are no assurances that capital spending will
resume within this sector in the near term.
o Several Stages of Conversion. Present solutions require several
conversions to transport data through a metropolitan network. In the
access networks, aggregation of traffic often requires protocol
conversions into a common protocol before optical transmission. In the
central office, data is often demultiplexed and converted into
electrical signals for regeneration, switching or further aggregation
into higher capacity links and then reconverted into optical signals
for transmission in the metro-core network.
o Inefficient Bandwidth Utilization. Within metropolitan optical
networks, service providers must cater to end-users with varying
access speeds. Current optical access solutions do not make efficient
use of scarce wavelength resources. Service providers must assign a
full wavelength to each signal, whether or not the end-user requires
the full bandwidth potential of each wavelength.
o Difficulty of Network Management. Multiple protocols and services,
coupled with the lack of standards that exist in metropolitan optical
networks, make network management functions, such as performance
monitoring and configuration, exceedingly difficult. Lack of a robust
network management platform further adds to the cost and complexity of
metropolitan optical networks.
o Need for New, Enhanced Service Offerings to Generate New Revenue
Opportunities. Service providers are searching for next-generation
solutions that will enable them to generate additional sources of
revenue from offering new or enhanced services to their customers.
Current solutions typically require the service provider to deploy
equipment that is specifically designed for a particular service and
transmission rate. Next-generation solutions must be able to offer
enhanced features, wavelength provisioning and bandwidth-on-demand,
that end-users will increasingly request from service providers.
Our Solutions
Our solutions feature products designed to specifically address the
shortcomings of legacy SONET/SDH networks and to facilitate offering new
services throughout metropolitan and regional optical networks. We enable our
customers to meet the rapidly growing demand for
6
bandwidth by offering end-to-end metropolitan and regional optical networking
solutions for the aggregation, transport and management of traffic. Our current
products, including our GigaMux'r' DWDM transport system, our EPC'TM' sub-rate
multiplexing modules, our JumpStart'TM' CWDM transport system, as well as the
network management product line that includes GigaView, TeraManager'TM' and
TeraConfigurator'TM', are specifically designed to meet the unique requirements
of the metropolitan and regional markets.
Our optical networking solutions offer numerous benefits including:
o Cost Effective Entry-Level Access Solution. Our Jumpstart CWDM
platform allows low cost multiplexing of up to four wavelengths
carrying a mix of protocols and signals for access applications. CWDM
means course wavelength division multiplexing, which is a
sophisticated opto-electronics technology that uses multiple
wavelengths of light to increase the number of video, data or voice
channels of information that can be sent on a single optical fiber.
o Scalable Architecture. We have created an optical networking solution
that simultaneously transmits voice, data, and video over optimized
fiber channels. The modular architecture of our solution enables
service providers to incrementally expand capacity as their bandwidth
needs increase. This simple, scalable, and functional solution solves
short and long-term service provider problems, which enhances their
ability to reduce costs and offer value-added services. For example, a
service provider can begin deployment with a single channel and later
expand up to 64 channels, providing up to 640 gigabits per second, or
Gbps, of transmission capacity without interrupting existing traffic.
A fiber channel is a serial data transfer architecture standard
conceived for new mass storage devices and other peripheral devices
that require very high bandwidth connections. Bit rates for fiber
channels are either 1.06 Gbps or 2.1 Gbps.
o Protocol and Signal Transparency. Our suite of solutions transports a
mix of protocols and signals, including SONET/SDH, Asynchronous
Transfer Mode (ATM) over SONET, Internet Protocol (IP) over SONET,
Gigabit Ethernet, Fibre Channel and Enterprise System Connectivity in
their native formats over numerous wavelengths in the same fiber. This
transparency provides operational simplicity in that the service
provider can offer networking connectivity without having to worry
about protocol conversions. This is particularly important in
metropolitan areas where multiple protocols are utilized and data
transmission rates change often. The transparency of our solution
eliminates the unnecessary conversions from optical to electrical and
back to optical, as well as eliminates several layers of equipment
that would otherwise be required in the transport and switching of
traffic, thus reducing network complexity and signal latency.
o Protocol Aggregation. Our EPC'TM' optical access multiplexer
aggregates traffic, of varied rates utilizing a wavelength per
direction of transmission, from businesses and network points of
presence for transport throughout optical networks. This aggregation
allows better utilization of wavelengths and lowers capital
expenditures of telecom service providers by reducing investments in
excess network capacity.
o Manageability. The design of our end-to-end optical networking
solution will allow service providers to perform network management
from a single platform with our
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TeraManager'TM' product. This intelligent optical network element
management software platform provides fault, configuration,
performance, and security management utilizing an easy-to-use
graphical user interface that allows point and click network
provisioning and monitoring.
o Regional optical transport. Our solution permits service providers to
expand beyond the confines of metropolitan networks using the same
platform for metropolitan and regional applications. Regional networks
can now be built using the lower cost solutions developed for the
metropolitan environment
Our Strategy
Our objective is to become a leading supplier of intelligent optical
networking solutions for metro and regional applications worldwide. The key
elements of our strategy are to:
o Enhance and complete our metropolitan/regional optical networking
solutions
We intend to continue to enhance our existing family of metropolitan and
regional optical networking products and to introduce new products that increase
the functionality of our end-to-end optical solution. We introduced
TeraManager'TM' and TeraConfigurator'TM' in our management solution portfolio in
fiscal 2003. We also introduced JumpStart'TM', our CWDM solution, in fiscal year
2002. The combination of our GigaMux'r' optical transport products, with the
EPC'TM' sub-rate multiplexer, the JumpStart'TM' CWDM, and TeraManager'TM', our
carrier class network management product, creates an intelligent all-optical
transport solution.
o Leverage our engineering leadership
We intend to leverage our engineering expertise in the areas of optical,
mechanical, electrical and network management design to continue to provide
leading end-to-end metropolitan and regional optical networking systems and to
expand our market share. We believe we were the first company to commercially
ship a metropolitan optical networking product using DWDM technology. As of
January 31, 2003, we had a skilled team of 29 engineers that continually focus
on developing products for the metropolitan and regional optical transport
market. We believe that our technological leadership has been the key to our
success and will enable us to rapidly develop new product offerings and
end-to-end optical solutions for the metropolitan and regional markets.
o Allow our customers to leverage their fiber assets by offering
revenue-generating services
The majority of our existing customers and targeted customers have a large
amount of fiber assets in the metropolitan and regional network infrastructure.
We intend to continue to develop and provide solutions that will enable our
customers to leverage their existing fiber infrastructure to deliver
revenue-generating services, while reducing their overall network costs. In
addition, we believe our existing customer base provides us with an advantage
when competing for new customers. We intend to continue to work closely with our
customers and invest in sales and marketing resources to maintain our high level
of customer service and remain responsive to our customers' changing needs.
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o Continue our aggressive pursuit of expense reduction initiatives
We plan to continue to aggressively pursue cost reduction initiatives to
control our expenses in line with current and future anticipated revenues. Such
reductions may affect the size of our workforce, and may require decreasing our
operating expenses and capital spending. During the past two fiscal years we
have concentrated on implementing initiatives that have lowered our operating
costs and anticipate the need for continued cost reductions if sales volume does
not increase in the near future.
o Maintain our sales, service and support organizations worldwide
We intend to continue to market our products worldwide. We currently have
sales, service and support teams in North America, Europe and Asia. We believe
that sales, service and support efforts on a customer-by-customer basis are most
effective due to the technical evaluation and significant investments that are
made by our customers.
Products
Our family of optical networking systems is designed to provide our
customers with end-to-end solutions for the metropolitan and regional optical
networking markets. Our transport, access, switching and network management
systems include the following products, some of which are still in development:
GigaMux'r'--DWDM Optical Transport
Our GigaMux'r' optical transport product uses DWDM technology to expand the
capacity of new and existing fibers and enable traffic to travel throughout
metropolitan optical networks without optical to electrical to optical
conversions at each intermediate node. GigaMux'r' features wavelength
translation, wavelength multiplexing, optical amplification, optical add-drop
multiplexing, protection switching and performance monitoring. The scalable and
modular architecture of our GigaMux'r' product enables service providers to
easily and cost effectively expand their existing networks as bandwidth
requirements increase. GigaMux'r' can simultaneously transport multiple
protocols bi-directionally over one or more fibers, which reduces the cost and
complexity of the network.
Our GigaMux'r' product is Network Equipment Building Standards, or NEBS,
level III certified. As of January 31, 2003, we had shipped our GigaMux'r'
product to over 20 direct carrier customers or resellers worldwide. Our
GigaMux'r' product includes the following key features:
o Scalability: the system can grow from 1 to 64 protected channels (640
Gbps/fiber) without a major upgrade or service interruption.
o Protocol transparency: the system can aggregate and transport
SONET/SDH (OC-3/STM-1 through OC-192/STM-64 carrying voice, IP or ATM
traffic), ESCON, Fibre Channel, Fast Ethernet, Gigabit Ethernet and
video.
o Modular protection: the system's modular protection system allows
redundancy to be implemented at any point in the network.
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o Add/drop channels: the system is equipped with add/drop modules that
allow specific channels to be added or dropped while all other
channels pass through. Our filter subsystem can add or drop from
single channels to larger wavelength bands.
o Reach: Up to 600 kilometers with optical amplifiers and up to 1,000 km
with the addition of dispersion compensation.
EPC'TM'--Sub-Rate Access Multiplexer
Electric Photonic Concentrator, or EPC'TM', is our sub-rate access
multiplexer product that aggregates a wide variety of traffic from businesses
and network points of presence for high-speed transport throughout optical
networks. The traffic is aggregated and effectively shares a wavelength per
direction of transmission and can be ported directly into the DWDM stage of our
GigaMux'r'. EPC'TM' is designed to lower the cost and increase the efficiency of
bandwidth delivery within optical networks.
Our EPC'TM' products include the following key features:
o Support for asynchronous or synchronous (SONET/SDH) time division
multiplexing of data
o Provisionable bit rates and protocol and overhead transparency
JumpStart'TM'--CWDM Transport
JumpStart is our entry level solution for multiplexing up to 4
bi-directional data channels using coarse wavelength division multiplexing
technology on a single fiber. The product is very compact and can be stacked to
provide additional capacity -- 4 channels per fiber.
TeraManager'TM'--Element Management System
TeraManager'TM' is our TL1-based intelligent element management software
platform that provides fault, configuration, performance and security management
for all our products and for networks built with such products. Service
providers can operate our network management platform through an easy-to-use
graphical user interface, which gives users a complete network view and enables
point and click provisioning and monitoring.
Our TeraManager'TM' product includes the following features:
o Fault, configuration, security and performance management
o Carrier class performance
o Interface with higher layer operation support systems
Customers
Our target customer base includes wholesale and retail broadband service
providers, such as inter-exchange carriers, local and foreign telephone
companies, the telecom affiliates of utility companies (utilicoms), cable
television service providers, system integrators and distributors.
Our customers generally fit the following customer profiles:
10
o Wholesale Network Providers--these customers provide wavelength and
broadband services to communication service providers and include
telecommunication carriers, cable companies and utilicoms.
o Managed Services Providers--these customers provide wavelength and
broadband services to enterprises and include telecommunication
carriers, cable companies, utilicoms and Internet Service Providers.
o System Integrators--companies that specialize in providing turn key
networking solutions for enterprise networks and applications such as
data-center connectivity and storage area networks.
o Major Enterprises--major enterprise customers are generally large
organizations with complex networking needs, usually spanning multiple
locations and difficult types of network requirements. Enterprise
customers include industrial corporations, government agencies, and
utilities.
o Small and Medium Businesses--these customers have a need for networks
as well as connection to the Internet and/or to their business
partners. However, they generally have limited resources. Therefore,
we provide product through systems integrators or Value Added
Resellers.
During fiscal 2003, the majority of our sales were to relatively few
customers, and we expect this customer concentration to continue for the
foreseeable future. For fiscal 2003, we shipped our optical networking products
to a total of 23 customers worldwide. Three customers, AT&T Broadband Network
Solutions (now Comcast Business Communications), Cox Communications and Deutsche
Telekom each represented more than 10% of our net sales for fiscal 2003 and for
fiscal 2002.
Key Relationships
We have entered into long-term agreements with some of our customers and
strategic allies, including:
AT&T Broadband Network Solutions (Now Comcast Business Communications)
In February 2000, we entered into a strategic alliance agreement with AT&T
Broadband Network Solutions (now Comcast Business Communications or AT&T
Broadband). Under the terms of this agreement, we and AT&T Broadband agreed to
negotiate in good faith concerning the implementation of a number of joint sales
and marketing initiatives. AT&T Broadband also agreed to help introduce our
technology to individuals at other AT&T divisions and to provide feedback
concerning our products' performance. The initial term of this agreement expired
in February 2002 and was automatically renewed for an additional one-year term
in February 2002 and in February 2003. Similar automatic renewals will occur in
each succeeding February unless we or AT&T Broadband terminate the agreement for
any reason upon ninety days notice. In addition, we concurrently entered into an
equipment purchase agreement. The equipment purchase agreement expired in
February 2002 and was automatically renewed for an additional one-year term in
February 2002 and in February 2003. Similar automatic renewals will occur in
each succeeding February unless we or AT&T Broadband terminate the agreement for
any reason upon ninety days notice. We started shipping our products to AT&T
Broadband in the second quarter of fiscal year 2001.
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In November 2002, we entered into a separate exclusive supplier agreement
with AT&T Broadband. Under this agreement, we become AT&T Broadband's exclusive
supplier, subject to certain exceptions, of dense and course wavelength division
multiplexing equipment that AT&T Broadband uses to provide UFO Communications,
Inc., a private service provider, with certain services on certain AT&T
Broadband networks. The initial term of this agreement is five years and
continues after the initial term until either party gives 90 days written notice
terminating the agreement.
UFO Communications, Inc.
In November 2002, we entered into an exclusive supplier agreement with UFO
Communications, Inc., or UFO. Under this agreement, we become UFO's exclusive
supplier of dense and course wavelength division multiplexing equipment, subject
to certain exceptions, for networks owned, leased or operated by UFO. The
initial term of this agreement is five years and can be renewed at any time by
the written agreement of both parties for additional terms of one year or
longer.
Looking Glass Networks
In August 2001, we entered into an equipment purchase agreement with
Looking Glass Networks, or LGN. Under the terms of this agreement, LGN agreed to
purchase metro DWDM optical networking equipment from us as its primary
supplier. LGN also agreed to receive early adopter access to our new and
emerging technologies, to serve as a beta tester for new and emerging equipment
and to provide feedback concerning our products' performance. The initial term
of this agreement expires in August 2004 and will be automatically renewed for
additional one-year terms unless LGN or we terminate the agreement at the end of
the initial or any renewal term upon ninety days notice. We started shipping our
products to LGN in the third quarter of fiscal year 2002.
Sales and Marketing
Our sales effort is currently focused on North America, Europe and Asia. As
of January 31, 2003, our sales and marketing organization included 39 employees,
including account managers, sales engineers, support personnel, product managers
and marketing personnel. In North America, Europe and Asia, we sell our products
through our direct sales force as well as through system integrators. Our
international direct sales force is located in the United Kingdom, France,
Belgium, Germany, Singapore and China.
In support of our worldwide selling efforts, our marketing team targets
potential customers through in-depth market analysis. Our marketing objectives
include building market awareness and acceptance of our products as well as
expanding our customer base. Our customer acquisition strategy has focused on
targeting customers who are aggressively building network infrastructure and are
looking to leverage existing fiber assets to generate additional revenue from
broadband services. This focus has led to strategic supply agreements with
several multiple service operators, utilities, and to a lesser extent
competitive local exchange carriers. We also plan to target incumbent carriers
as they expand the development of their metropolitan and regional fiber
networks. Marketing personnel coordinate our participation in trade shows,
seminars and industry events and conduct media relation's activities with trade
and general
12
business publications. We participate in many industry organizations responsible
for developing standards that are used in optical networks.
Customer Service and Support
Our customer service and support team are a critical component of our
customer satisfaction initiative. This team provides support to our customers
allowing them to successfully design and implement their optical networks. All
services can be customized to meet the needs our customers. Our staff is
experienced, and has the equipment necessary to support both installation and
problem resolution. A variety of installation service packages supports the
implementation from start-up to upgrades and maintenance. Specialists are
available 7 days a week, 24 hours a day. We offer a Technical Assistance Center
as well as field services support. Multiple technical support service agreements
allow our customers to define the level of support they require. Our customer
service and support team provides installation, maintenance and training
programs addressing the product, installation and maintenance processes and can
be delivered at the customer location or at our training facility.
We currently provide service and support to our international customers on
a direct basis and are establishing service and support agreements throughout
the world. To date revenues from service and support agreements have not been
material. We intend to continue to develop our internal team to meet the needs
of our customers and will utilize strategic partners to allow us to provide
greater value when appropriate.
We provide a total service solution. Our hardware products are warranted
against defects for a period of 12 to 36 months dependent on purchase
agreements, including technical support and parts repair/replacement. We also
offer support contracts for a fee to our customer base, thereby allowing our
customers to select a service plan tailored to their own particular needs.
Engineering, Research and Development
We have assembled a team of highly skilled engineers with extensive
experience in the fields of optical, mechanical, electrical and network
management design. We believe that our success in introducing DWDM optical
technology for use in the metropolitan and regional markets was a result of our
strength in research and development. As of January 31, 2003, 29 employees were
engaged in engineering, research and development efforts. Our research and
development efforts are focused on new product development as well as enhancing
performance and reliability of our existing products. We believe that our
research and development efforts are key in maintaining technical
competitiveness, delivering innovative products, and addressing the needs of the
regional and metropolitan market.
Our engineering, research and development expenses were $9.0 million, $13.7
million and $23.9 million for the years ended January 31, 2003, 2002 and 2001,
respectively. The decrease in our engineering, research and development expenses
was primarily due to headcount reduction and product rationalizations under our
cost reduction program.
Manufacturing and Quality
We outsource the manufacturing of our products. We design our products and
perform system integration, quality control, final testing and configuration at
our San Diego, California location. Our San Diego facility is ISO-9002 certified
and we have begun the process of
13
becoming ISO9000/2000. By meeting such standards, we assure our customers that
we meet internationally recognized standards for quality, customer care and
sound management practices. We believe that outsourcing our manufacturing allows
us to conserve working capital, flexibly respond to changes in market demand and
more quickly deliver products to our customers.
We currently purchase products from our contract manufacturers and other
suppliers on a purchase order basis. We generally do not enter long-term
contracts with our contract manufacturers or suppliers, and they are not
obligated to perform services for us for any specific period or at any specified
price, except as may be provided in a particular purchase order. We purchase a
limited number of key components used in the manufacturing of our products from
a limited number of suppliers and some of our components are purchased
exclusively from a single supplier on a purchase order basis.
Patent, Trademarks and Licenses
We currently hold approximately 36 patents and have several patent
applications pending. Although we attempt to protect our intellectual property
rights through patents, trademarks, and copyrights, maintaining certain
technology as trade secrets and other measures, we cannot assure readers that
any patent, trademark, copyright or other intellectual property rights owned by
us will not be invalidated, circumvented or challenged, that such intellectual
property rights will provide competitive advantages to us or that any of our
pending or future patent applications will be issued with the scope of the
claims sought by us, if at all. We cannot assure readers that others will not
develop technologies that are similar or superior to our technology, duplicate
our technology or design around the patents that we own. In addition, effective
patent, copyright and trade secret protection may be unavailable or limited in
certain foreign countries in which we do business or intend to do business in
the future. We also have licensed and may in the future license technologies
from other companies on a non-exclusive basis. For example, our CWDM product
incorporates technology purchased from Entrada Networks, Inc., our former
affiliate, which we then enhanced to complete a commercially feasible product.
We believe that the future success of our business will depend on our
ability to translate the technological expertise and innovation of our personnel
into new and enhanced products. We cannot assure readers that the steps taken by
us will prevent misappropriation of our technology. In the future, we may take
legal action to enforce our patents and other intellectual property rights, to
protect our trade secrets, to determine the validity and scope of the
proprietary rights of others, or to defend against claims of infringement or
invalidity. Such litigation could result in substantial costs and diversion of
resources and could harm our business and operating results.
As is common in our industry, we have from time to time received
notification from other companies of intellectual property rights held by those
companies upon which our products may infringe. Any claim or litigation, with or
without merit, could be costly, time consuming and could result in a diversion
of management's attention, which could harm our business. If we were found to be
infringing on the intellectual property rights of any third party, we could be
subject to liabilities for such infringement, which could be material, and could
be required to seek licenses from other companies or to refrain from using,
manufacturing or selling certain products or using certain processes. Although
holders of patents and other intellectual property rights often offer licenses
to their patent or other intellectual property rights, no assurance can be given
that licenses would be offered, that the terms of any offered license would be
acceptable to us or that failure to obtain a license would not cause our
operating results to suffer.
14
Working Capital Practices
We have historically maintained high levels of inventories to meet output
requirements of our customers and to ensure an uninterrupted flow of inputs from
suppliers. It is not our standard policy to grant customers the right to return
merchandise that performs according to specifications. Typical payment terms
require payment within thirty to sixty days from the date of shipment.
We perform ongoing credit evaluations of each customer's financial
condition and extend unsecured credit related to the sales of various products.
From time to time we receive financial instruments such as letters of credit for
payments for international customers. At January 31, 2003, accounts receivable
due from AT&T Broadband, Cox Communications, DeltaNet and iNOC accounted for
31%, 16%, 19% and 30% respectively, of net receivables.
Our Backlog
At January 31, 2003, we had backlog that totaled over $5.0 million compared
to slightly over $200,000 at January 31, 2002. Our backlog consists of orders
confirmed with a purchase order for products to be shipped within twelve months
to customers with approved credit status. We do not believe that backlog, as of
any particular date, should be used as an indication of sales for any future
period for two reasons. First, orders are increasingly being booked and shipped
in a short period of time and therefore may never be calculated in the backlog
amount at the end of any particular quarter. Second, customers have and can
change delivery schedules or cancel orders without a significant penalty.
Competition
The market for optical networking equipment is extremely competitive and
subject to rapid technological change. We expect competition to continue to be
significant in the future. Our primary competitors in the DWDM market include
vendors of optical networking and infrastructure equipment such as Nortel
Networks, CIENA Corporation, Cisco Systems, and Lucent Technologies, as well as
private companies that have been or will be focusing on our target markets. Our
primary competitors for our CWDM products include Adva AG Optical Networking,
and CIENA Corporation. Many of our competitors have significantly greater
financial resources and are able to devote those greater resources to the
development, promotion, sales and support of their products. In addition, many
of our competitors have more extensive customer relationships than we do,
including relationships with our potential customers. We believe each of our
competitors has optical networking products in various stages of development.
We believe the principal competitive factors in the optical networking
market are:
o product performance, features, functionality and reliability;
o price/performance characteristics;
o timeliness of new product introductions;
o relationships with existing customers;
o service, support and financing; and
o financial stability and strength of company.
15
We believe our products compete favorably with our competition within our
marketplace.
The competitors for the legacy products of our subsidiary, Meret Optical
Communications, include Pesa, Artel, RGB Spectrum, Utah Scientific, and many
other companies.
Increased competition may result in further price reductions, reduced gross
margins and loss of market share, any of which could materially and adversely
affect our business, operating results and financial condition. There can be no
assurance that we will be able to compete successfully against current and
future competitors, or that competitive factors will not have a material adverse
effect on our business, operating results and financial condition.
Environmental Compliance
We are required to file environmental compliance reports with the Federal
Food and Drug Administration regarding the emissions levels of our laser-based
products, which are used in fiber optics communications. All of our products
comply with required safety level standards.
Employees
As of January 31, 2003, we had 115 employees, 29 of whom were in
engineering, research and development, 39 in sales and marketing, and the
remainder in manufacturing and in general and administrative functions. Of the
29 employees in research and development, 15 have masters degrees and 11 have
doctorate degrees. We also employ a number of part-time and temporary personnel
from time to time in various departments. Our future success will depend in part
on our ability to attract, retain and motivate highly qualified technical and
management personnel, for whom competition is intense. None of our employees is
covered by a collective bargaining agreement and we believe that our relations
with our employees are good.
Forward-Looking Statements--Cautionary Statement
All statements other than statements of historical fact contained in this
registration statement on Form 10, in our future filings with the Securities and
Exchange Commission, in our press releases and in our oral statements made with
the approval of an authorized executive officer are forward-looking statements.
Words such as "propose," "anticipate," "believe," "estimate," "expect,"
"intend," "may," "should", "could," "will" and similar expressions are intended
to identify such forward-looking statements. These forward-looking statements
are made pursuant to the safe harbor provisions of the Private Securities
Litigation Reform Act of 1995. Although we believe that our expectations
reflected in these forward-looking statements are based on reasonable
assumptions, such statements involve risk and uncertainties and no assurance can
be given that actual results will be consistent with these forward-looking
statements. Important factors that could cause actual results to differ
materially from those forward-looking statements include without limitation: our
ability to consummate our proposed capital restructuring; our ability
successfully to finance our current and future needs for working capital; our
ability to keep our common stock listed on the Nasdaq Stock Market; our ability
to successfully develop, sell and market our optical networking and other
products; our expectations concerning factors affecting the markets for our
products, such as demand for increased bandwidth; the scope and duration of the
economic slowdown currently being experienced by many of our existing and
prospective customers; our ability to compete successfully with companies who
are much larger than we are and who have much greater financial resources at
their disposal; our ability, or failure, to complete strategic alliances and
16
strategic opportunities such as sales or spin-offs of subsidiaries or business
units on terms favorable to us for reasons either within or outside our control;
changed market conditions, new business opportunities or other factors that
might affect our decisions as to the best interest of our shareholders; and
other risks detailed from time to time in our reports filed with the Securities
and Exchange Commission.
We wish to caution readers not to place undue reliance on any such
forward-looking statements, which speak only as of the date made. Such
statements are subject to certain risks and uncertainties that could cause
actual results to differ materially from historical earnings and those presently
anticipated or projected. These risks and uncertainties are described in the
following section. We specifically decline any obligation to publicly release
the result of any revisions which may be made to any forward-looking statements
to reflect anticipated or unanticipated events or circumstances occurring after
the date of such statements, or to update the reasons why actual results could
differ from those projected in the forward-looking statements.
Item 2. Financial Information
(a) Selected Financial Data.
The following table sets forth selected consolidated financial data with
respect to our five most recent fiscal years ended January 31. The selected
consolidated statement of operations data set forth below for each of our three
most recent fiscal years, and the selected consolidated balance sheet data set
forth at January 31, 2003 and 2002, together with the selected consolidated
statement of operations data set forth below for each of the two fiscal years
ended January 31, 2000 and 1999, and the consolidated balance sheet data set
forth below at January 31, 2001, 2000 and 1999 are derived from our audited
consolidated financial statements, which have been audited by BDO Seidman, LLP,
independent certified public accountants. The selected consolidated financial
data should be read in conjunction with our consolidated financial statements,
and the notes thereto including Note A which discusses our significant
acquisitions, dispositions and discontinued operations, included elsewhere in
this Form 10, and "Management's Discussion and Analysis of Financial
Condition and Results of Operations" below.
17
Fiscal Year Ended January 31,
----------------------------------------------------
2003 2002 2001 2000 1999
-------- -------- -------- -------- --------
Statement of Operations Data: (a) (a) (b) (a) (b)
Net sales..................................... $ 25,137 $ 40,827 $ 44,641 $ 68,372 $ 58,362
Gross margin.................................. $ 3,320 $ 9,320 $ 13,171 $ 31,782 $ 25,885
Operating loss................................ $(31,329) $(37,154) $(50,415) $ (9,951) $(10,060)
Net income (loss) from continuing operations.. $(26,210) $(43,136) $(41,905) $ 2,410 $(11,069)
Net income (loss) per share from continuing
operations:
Basic...................................... $ (33.29) $ (62.00) $ (74.20) $ 3.40 $ (33.80)
Diluted.................................... $ (33.29) $ (76.32) $ (74.20) $ 3.00 $ (33.80)
Balance Sheet Data:
Cash and cash equivalents.................. $ 7,747 $ 14,243 $ 9,965 $ 13,511 $ 3,480
Total assets............................... $ 55,805 $ 90,339 $113,123 $223,265 $ 66,796
Total liabilities.......................... $ 90,281 $ 79,860 $ 24,770 $ 20,727 $ 27,938
Stockholders' equity (deficit)............. $(34,376) $ 10,479 $ 39,733 $202,538 $ 38,858
The Consolidated Statement of Operations and Balance Sheet data shown above
include financial results from the following subsidiaries which have since been
disposed of:
(a) Entrada Networks, Inc. is reflected through August 31, 2001.
(b) NETsilicon is reflected through September 14, 1999.
(b) Management's Discussion and Analysis of Financial Condition and Results of
Operations
The results of operations reflect our activities and our wholly-owned
subsidiaries; this consolidated group is referred to individually and
collectively as "We" and "Our".
Overview
Beginning in fiscal 2002, the global telecommunications market
deteriorated, reflecting a significant reduction in capital spending by
established service providers. This trend intensified during fiscal 2003.
Reasons for this reduction include the general economic slowdown, network
overcapacity, customer bankruptcies, network build-out delays and limited
capital availability. As a result, our sales and results of operations have been
and may continue to be adversely affected. The significant slowdown in capital
spending has created uncertainty as to the level of demand in our target
markets. In addition, the level of demand can change quickly and can vary over
short periods of time. As a result of the uncertainty and variations in our
markets, accurately forecasting future results, earnings and cash flow is
increasingly difficult.
As discussed in more detail throughout our management's discussion and
analysis:
o Our consolidated results of operations during the past two years were
adversely affected by the rapid and sustained deterioration of the
telecommunications market.
18
After several years of significant growth, our revenues declined
during fiscal 2003 and 2002 by 38% and 8.5% respectively, as compared
to the respective prior year. The significant reduction in capital
spending by service providers, among other factors, contributed to
this decline;
o Our gross margin rates, which historically had been at least 40%,
declined to 13% and 23% during fiscal 2003 and 2002, respectively. The
significant and rapid decline in revenue from decreased market demand
led to significant inventory charges and high-unabsorbed fixed cost,
which, among other factors, adversely affected our gross margin rates;
o We were able to reduce our operating expenses during fiscal 2003 and
2002 by 25% and 27%, respectively as a result of a cost reduction plan
implemented. The reduction in operating expenses for fiscal 2003 were
partially off-set by legal and professional fees of $2.8 million
associated with our capital restructuring plan;
o We recorded significant provisions for bad debts of $1.5 million and
$1.6 million during fiscal 2003 and 2002, respectively, as a result of
the significant deterioration of the financial health or bankruptcy of
certain customers.
These factors contributed significantly to our loss from continuing
operations of $31.3 million and $37.1 million for fiscal 2003 and 2002,
respectively.
During this prolonged market downturn, we have worked closely with our
customers to position the full breadth of our products and services and
significantly reduced our cost structure. If capital investment levels continue
to decline, or if the telecommunications market does not improve or improves at
a slower pace than we anticipate, our revenues and profitability will continue
to be adversely affected. However, we believe our results could improve by
realizing higher gross margin rates and lower operating expenses resulting from
improved product mix, cost reductions relating to our capital restructuring plan
and reduced operating expenses, lower inventory-related charges and lower
provisions for bad debts.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosures of contingent assets and
liabilities. On an on-going basis, we evaluate our estimates, including those
related to our valuation of inventory and our allowance for uncollectable
accounts receivable. We base our estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ from these estimates under different
assumptions or conditions.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements:
o Revenue recognition. Revenue is generally recognized when the products
are shipped, all substantial contractual obligations, if any, have
been satisfied, and the collections
19
of the resulting receivable is reasonably assured. When title does
not pass to the customer at time of shipment, revenue is not
recognized until all contractual requirements are met and title has
transferred. During this transition period, the amount of the sale
and/or installation is shown in deferred revenue. Revenue from
installation is recognized as the services are performed to the extent
of the direct costs incurred. To date, installation revenue has not
been material. Revenue from service obligations, if any, is deferred
and recognized over the life of the contract. Inventory or
demonstration equipment shipped to potential customers for field
trials is not recorded as revenue. We accrue for warranty costs, sales
returns and other allowances at the time of shipment. Although our
products contain a software component, the software is not sold
separately and we are not contractually obligated to provide software
upgrades to our customers.
o Inventory. Inventory is evaluated on a continual basis and management
must make estimates about the future customer demand for our products,
taking into account both the economic conditions and growth potential
of our customers. Reserve adjustments are made based on management's
estimate of future sales value, if any, of specific inventory items.
Reserve adjustments are made for the difference between the cost of
the inventory and the estimated market value and charged to operations
in the period in which the facts that give rise to the adjustments
become known. A misinterpretation or misunderstanding of these
conditions or uncertainty in the future outlook of our industry or the
economy, or the failure to estimate correctly, could result in
inventory losses in excess of the provisions determined to be
appropriate at the time of the balance sheet.
o Accounts receivable. Accounts receivable balances are evaluated on a
continual basis and management regularly reviews the financial
stability of individual customers. This analysis involves a judgment
of the customers current and projected financial condition and the
positive or negative effects of the current and projected industry
outlook, as well as that of the economy in general. Allowances are
provided for potentially uncollectable accounts based on management's
estimate of the collectability and the probability of default of
customer accounts. If the financial condition of a customer were to
deteriorate, resulting in an impairment of their ability to make
payments, an additional allowance may be required. Allowance
adjustments are charged to operations in the period in which the facts
that give rise to the adjustments become known.
o Intangible assets. We currently have intangible assets that include
assets with finite lives, such as our purchased technology. The
determination of related estimated useful lives and whether these
assets are impaired involves judgments based upon short and long-term
projections of future performance. We have no goodwill or indefinite
life intangible assets. Other intangible assets with finite lives
continue to be amortized over their useful lives.
o Legal contingencies. We are subject to proceedings, lawsuits and other
claims, including proceedings under laws and government regulations
related to securities, environmental, labor, product and other
matters. We are required to assess the likelihood of any adverse
judgments or outcomes to these matters, as well as potential ranges of
probable losses. A determination of the amount of reserves required,
if any, for the contingencies is based on a careful analysis of each
individual issue with the assistance of outside legal counsel. Our
reserves may change in the future due to new developments in each
matter or changes in approach such as a change in settlement
20
strategy in dealing with these matters. For more information, see Note
H to the consolidated financial statements.
o Income taxes. We currently have no provisions for income taxes. We
have carry- forward domestic federal net operating losses, which may
be available, in part, to reduce future taxable income in the United
States. However, due to potential adjustments to the net operating
loss carry-forwards as provided by the Internal Revenue Code with
respect to future ownership changes, future availability of the tax
benefits is not assured. In addition, we provided a valuation
allowance in full for our deferred tax assets, as it is our opinion
that it is more likely than not that some portion or all of the
deferred tax assets will not be realized.
Entrada Networks
On August 31, 2000, we completed a merger of our then subsidiary Entrada
Networks with Sync Research, Inc. ("Sync"), a NASDAQ listed company. We received
4,244,155 shares of the merged entity, which changed its name to Entrada
Networks, Inc. We purchased 93,900 shares of Sync in the open market during June
and July 2000 for $388,000 and on August 31, 2000 purchased an additional
1,001,818 shares directly from Entrada for $3.3 million. After these
transactions and Entrada's issuance of additional shares to outside investors in
connection with the merger we owned 49% of Entrada. Accordingly, our financial
statements reflected the results of operations of Entrada through August 31,
2000.
Results of Operations: Comparison of the Years Ended January 31, 2003 and
January 31, 2002
Net sales. Our consolidated net sales decreased $15.7 million or 38% to
$25.1 million for fiscal 2003 when compared to net sales of $40.8 million for
fiscal 2002. Net sales for Sorrento Networks, Inc., our primary operating
subsidiary, decreased $13.6 million or 38% to $22.4 million for fiscal 2003 as
compared to net sales of $36.0 million in fiscal 2002. Net sales for our Meret
Optical subsidiary decreased $1.7 million or 35% in fiscal 2003 to $3.1 million
of which $296 thousand was intercompany sales as compared to net sales of $4.8
million in fiscal year 2002.
Gross profit. Cost of sales consists principally of the costs of
components, subcontract assembly from outside manufacturers, and in-house system
integration, quality control, final testing and configuration costs. Gross
margin percent on a consolidated basis decreased to 13% for fiscal 2003 from 23%
in fiscal 2002. Consolidated gross profit was $3.3 million, a decrease of 65%
for fiscal 2003 from $9.3 million for fiscal 2002. Gross margin percent and
gross profit were impacted negatively by increases in inventory reserves and
sales that were made at lower gross profit margins than the prior year. Gross
profit for our Sorrento Networks, Inc. subsidiary decreased to $3.1 million in
fiscal 2003, as compared to $7.7 million in fiscal 2002, a decrease of 60%. An
increase in our inventory reserves taken in the second quarter, accounted for
$3.0 million of the decrease in gross profit for SNI. The gross profit of our
Meret Optical subsidiary declined to $204 thousand in fiscal 2003, as compared
to $1.7 million in fiscal 2002, a decrease of 88%. This decline was primarily
the result of an increase in our inventory reserve of $1.0 million, taken in
the second quarter and a decrease in revenue volume.
Selling and marketing. Selling and marketing expenses consist primarily of
employee compensation and related costs, commissions to sales representatives,
tradeshow expenses and
21
travel expenses. Our consolidated selling and marketing expenses decreased to
$12.0 million, or 48% of net sales, for fiscal 2003 from $16.2 million, or 40%
or net sales for fiscal 2002. The decline was primarily the result of cost
reduction efforts implemented, a reduction in both our U.S. and foreign sales
offices and lower revenue volume for the year.
Engineering, research and development. Engineering, research and
development expenses consist primarily of compensation related costs for
engineering personnel, facilities costs, and materials used in the design,
development and support of our technologies. All research and development costs
are expensed as incurred. We continue to manage our research and development
costs in relation to the changes in our sales volume and available capital
resources in our development efforts to enhance existing products and introduce
new products to our product offering. Our consolidated engineering, research and
development expenses decreased to $9.0 million, or 36% of net sales, for fiscal
2003 from $13.7 million, or 34% of net sales, for fiscal 2002. The decrease can
primarily be attributed to decreases in product development material and
personnel related costs.
General and administrative. General and administrative expenses consist
primarily of employee compensation and related costs, legal and accounting fees,
public company costs, and allocable occupancy costs. Consolidated general and
administrative expenses remained consistent at $12.8 million, or 51% of net
sales, for fiscal 2003 compared to 31% of net sales, for fiscal 2002. The
increase in general and administrative expenses as a percentage of net sales can
be attributed to an increase in professional fees associated with the capital
restructuring partially offset by a decrease in personnel related costs.
Other operating expenses. Other operating expenses for both fiscal 2003 and
2002 included approximately $400 thousand of amortization of purchased
technology related to acquisitions included in Meret. During the fiscal year
ended January 31, 2002, we recorded a $2.7 million valuation allowance against
option receivables from our former CEO and Chairman.
Other income (expenses). Other income (expenses) from continuing operations
increased to $5.1 million in income for fiscal 2003 from $6.0 million in expense
for fiscal 2002. Investment income increased by $1.6 million during the fiscal
year ended January 31, 2003 from the comparable period last year due to
increased investments of our cash surplus in short-term investments. The
increase of $6.3 million in interest expense for the fiscal year ended January
31, 2003 from the prior fiscal year is primarily due to the interest incurred on
our convertible debentures and an adjustment relating to the amortization of
both the beneficial conversion feature of the value allocated to the issuance of
warrants on our senior convertible debentures. The $5.5 million of interest on
these debentures includes the stated 9.75% interest of $2.3 million of which
$2.0 million was paid in common stock and $292 thousand was paid in cash,
amortization of issuance costs of $259 thousand, and amortization of the fair
value of the warrants issued to the purchasers and placement agent and the
deemed beneficial conversion feature of $2.9 million. Other income increased by
$313 thousand during the fiscal year ended January 31, 2003 from the prior
fiscal year resulting primarily from favorable gains on foreign currency
exchanges. Gains on marketable securities increased by $15.5 million for the
fiscal year ended January 31, 2003 from the prior fiscal year. $11.7 million of
this increase relates to the realized gain on our sale of 3,396,221 shares of
NETsilicon, Inc. common stock to Digi International, Inc. for $13.6 million in
cash. The remaining shares of NETsilicon common stock were exchanged for Digi
International common stock and are accounted for under marketable securities. We
obtained 2,324,683 shares of Digi common stock on the exchange, of which
22
1,162,342 shares were later sold back to Digi for $3.6 million in cash and a
gain of $2.6 million. The remaining $1.2 million increase results from an
impairment allowance taken on our available for sale investment in Entrada and
$1.0 million in realized losses on the sale of 1,051,000 shares of Entrada in
the prior fiscal year.
Income taxes. There was no provision for income taxes for fiscal years 2003
and 2002. We have carry forwards of domestic federal net operating losses, which
may be available, in part, to reduce future taxable income in the United States.
However, due to potential adjustments to the net operating loss carry forwards
as provided by the Internal Revenue Code with respect to future ownership
changes, future availability of the tax benefits is not assured. In addition, we
provided a valuation allowance in full for our deferred tax assets, as it is our
opinion that it is more likely than not that some portion or all of the assets
will not be realized. Our prior management did not file our tax returns for over
six years. We had losses during each of these years and do not believe there is
tax liability for any of them, other than a nominal penalty for failure to file
a return. We have filed our federal returns and are in the process of preparing
and filing all our delinquent state tax returns.
Sorrento Networks I, Inc. (SNI) f/k/a Sorrento Networks, Inc.
Net sales. Net sales decreased to $22.4 million, or 38%, for fiscal 2003
from $36.0 million for fiscal 2002. In fiscal 2003, 18 customers accounted for
92% of net sales compared with eleven customers, which accounted for 94% in
fiscal 2002. We expect to continue experiencing significant fluctuations in
annual revenues as a result of our long and variable sales cycle as well as our
highly concentrated customer base. Revenue continues to be negatively impacted
by weak telecommunication industry volumes and management determination to not
pursue low gross margin projects.
Gross profit. Gross profit was $3.1 million for fiscal 2003, a decrease of
59% from $7.7 million for fiscal 2002. Gross margin decreased to 14% of net
sales for fiscal 2003 from 21% for fiscal 2002. The declines were due primarily
to the increases in our obsolescence and inventory value reserves taken in the
second quarter and of a significantly higher fixed manufacturing overhead in our
cost of shipments for the year as a result of the lower revenue volume. We have
initiated cost cutting actions in production due to the lower revenue volume and
a continued slowdown in the capital expenditure spending throughout the telecom
industry.
Selling and marketing. Sales and marketing expenses decreased to $11.7
million, or 52% of net sales, for fiscal 2003 from $15.7 million, or 44% of net
sales, for fiscal 2002. The decrease in sales and marketing expenses resulted
primarily from a reduction in personnel and related costs, decreased travel
expenses, trade show participation, and advertising expenses. The number of
sales and marketing personnel decreased to 36 at January 31, 2003 from 38 at
January 31, 2002.
Engineering, research and development. Engineering, research and
development expenses decreased to $8.5 million, or 38% of net sales, for fiscal
2003 from $13.2 million, or 37% of net sales, for fiscal 2002. The decrease in
engineering, research and development expenses was the result of decreased
expenditures associated with the decrease in engineering personnel and related
costs and a reduction in material related development expenses. The number of
engineering personnel decreased to 29 at January 31, 2003 from 67 at January 31,
2002.
General and administrative. General and administrative expenses decreased
to $7.6 million, or 34% of net sales, for fiscal 2003 from $6.9 million, or 19%
of net sales, for fiscal
23
2002. The decrease in general and administrative expenses reflects the reduction
of executive and administrative personnel and lower operating expenses. The
number of general and administrative personnel decreased to 11 at January 31,
2003 from 15 at January 31, 2002.
Deferred and other stock compensation. Deferred and other stock
compensation for the fiscal year ended January 31, 2003 includes $433 thousand
of amortization of deferred stock compensation resulting from the value of stock
options granted to consultants compared to $812 thousand for the prior fiscal
year. In connection with the grants of stock options with exercise prices
determined to be below the fair value of our common stock on the date of grant,
SNI recorded deferred stock compensation of $2.6 million, which is being
amortized on an accelerated basis over the vesting period of the options.
Meret Communications, Inc. d/b/a Meret Optical Communications
Net sales. Net sales decreased to $3.1 million, or 36%, for fiscal 2003 of
which $296 thousand was inter-company sales, from $4.8 million for fiscal 2002.
The reduction in sales volume reflects the continued weak industry volumes.
Gross profit. Gross profit decreased to $204 thousand, or 88%, for fiscal
2003 from $1.7 million for fiscal 2002. Gross margin as a percentage of net
sales decreased to 7% for fiscal 2003 compared to 35% for the comparable period
last year. These declines were due primarily to the increases in our
obsolescence reserves taken in the second quarter and a higher fixed
manufacturing overhead in our cost of shipments for the quarter as a result of
the lower revenue volume.
Selling and marketing. Sales and marketing expenses decreased to $315
thousand, or 10% of net sales, for fiscal 2003, compared to $435 thousand, or 9%
of net sales, for fiscal 2002. This decrease was a direct result of reduced
internal commissions, due primarily to lower revenue volume and changes in the
commission structure, resulting in lower commission expense for the year.
Engineering, research and development. Engineering, research and
development expenses increased to $514 thousand, or 17% of net sales compared to
$417 thousand, or 9% of net sales, for fiscal 2002. This increase results from
the addition of four engineers to support the development of new products and
the enhancement of existing products.
General and administrative. General and administrative expenses increased
to $283 thousand, or 9% of net sales during fiscal 2003 from $200 thousand, or
4% of net sales, for fiscal 2002. The increase in general and administrative
expenses during fiscal 2003 resulted primarily from addition in the
administration staff, costs associated with upgrades in our business application
software and costs incurred to move the facilities to a new location.
Other operating expenses. Other operating expenses increased to $421
thousand, or 14% of net sales for fiscal 2003 from $372 thousand, or 8% of net
sales, for fiscal 2002. These costs represent the amortization of purchased
technology related to prior acquisitions. The increase represents and adjustment
made to record amortization not previously recorded on purchased technology.
24
Results of Operations: Comparison of the Years Ended January 31, 2002 and
January 31, 2001.
Net sales. Our consolidated net sales decreased $3.8 million or 9% to $40.8
million for fiscal 2002 when compared to net sales of $44.6 million for fiscal
2001. Net sales of SNI, increased $9.6 million or 36% to $36.0 million for
fiscal 2002 as compared to net sales of $26.4 million in fiscal 2001. Net sales
for Meret Optical decreased $1.5 million or 24% in fiscal 2002 to $4.8 million
as compared to net sales of $6.3 million in fiscal year 2001. Entrada Networks,
an operating subsidiary which we spun-off in August 2000, had revenues of $11.9
million in fiscal 2001 whereas no revenues were reported for Entrada Networks in
fiscal year 2002.
Gross profit. Cost of sales consists principally of the costs of
components, subcontract assembly from outside manufacturers, and in-house system
integration, quality control, final testing and configuration costs. Gross
margin percent on a consolidated basis decreased to 23% for fiscal 2002 from 30%
in fiscal 2001. Consolidated gross profit was $9.3 million, a decrease of 29%
for fiscal 2002 from $13.2 million for fiscal 2001. Gross margin percent and
gross profit were impacted negatively by increases in inventory reserves and
sales that were made at lower gross profit than the prior year. Gross profit of
SNI decreased to $7.7 million in fiscal 2002 from $9.1 million in fiscal 2001, a
decrease of 16%. An increase in inventory reserves accounts for $3.7 million of
the decrease in gross profit. The gross profit of our Meret Optical segment
decreased by $941 thousand from the prior fiscal year and was primarily the
result of the revenue volume decrease. The remaining change in gross profit
related to Entrada Networks.
Selling and marketing. Selling and marketing expenses consist primarily of
employee compensation and related costs, commissions to sales representatives,
tradeshow expenses and travel expenses. We continue to manage our expenditures
for sales and marketing in relation with the expansion of our domestic and
international sales channels and the establishment of strategic relationships.
Our consolidated selling and marketing expenses decreased to $16.2 million, or
40% of net sales, for fiscal 2002 from $17.2 million, or 39% or net sales for
fiscal 2001.
Engineering, research and development. Engineering, research and
development expenses consist primarily of compensation related costs for
engineering personnel, facilities costs, and materials used in the design,
development and support of our technologies. All research and development costs
are expensed as incurred. We continue to manage our research and development
costs in relation to the changes in our sales volume and available capital
resources in our development efforts to enhance existing products and introduce
new products to our product offering. Our consolidated engineering, research and
development expenses decreased to $13.7 million, or 33% of net sales, for fiscal
2002 from $23.9 million, or 54% of net sales, for fiscal 2001. The decrease can
primarily be attributed to decreases in product development material and
personnel related costs.
General and administrative. General and administrative expenses consist
primarily of employee compensation and related costs, legal and accounting fees,
public company costs, and allocable occupancy costs. Consolidated general and
administrative expenses decreased to $12.7 million, or 31% of net sales, for
fiscal 2002 from $18.1 million, or 41% of net sales, for fiscal 2001. The
decrease in general and administrative expenses can be attributed to reductions
in investment banking, professional fees and personnel related costs.
25
Other operating expenses. Other operating expenses for both fiscal 2002 and
2001 included approximately $400 thousand of amortization of purchased
technology related to acquisitions included in Meret. During the fiscal year
ended January 31, 2002, we recorded a $2.7 million valuation allowance against
option receivables from our former CEO and Chairman. During the fiscal year
ended January 31, 2001, approximately $2.1 million of these costs were
attributable to the closure of one of Entrada's facilities and valuation
reserves recorded against distributor receivables and capitalized software costs
of Entrada.
Other income (expenses). Other income (expenses) from continuing operations
decreased to $6.0 million charges for fiscal 2002 from $8.5 million income for
fiscal 2001. Investment income declined by $6.9 million during the fiscal year
ended January 31, 2002 from the comparable period last year due to reduced
investments of our cash surplus in short-term investments, lower interest rates
as well as reduced interest received on customer financing receivables. The
increase of $2.4 million in interest expense for the fiscal year ended January
31, 2002 from the prior fiscal year is primarily due to the interest incurred on
our newly issued convertible debentures which was partially offset by a decline
in our short term borrowings. The $2.6 million of interest on these debentures
included the stated 9.75% interest of $1.6 million which was paid in common
stock, amortization of issuance costs of $82 thousand and amortization of the
fair value of the warrants issued to the purchasers and placement agent and the
deemed beneficial conversion feature of $911 thousand. Other expenses increased
by $99 thousand during the fiscal year ended January 31, 2002 from the prior
fiscal year resulting primarily from unfavorable losses on foreign currency
exchanges. Gains on marketable securities decreased by $5.1 million for the
fiscal year ended January 31, 2002 from the prior fiscal year. Approximately
$4.0 million of this decrease relates to the gain on our sale of Netsilicon
shares during the prior fiscal year. The remaining $1.1 million decrease results
from an impairment allowance of $178 thousand on our available for sale
investment in Entrada and $1.0 million in realized losses on the sale of
1,051,000 shares of Entrada.
Income taxes. There was no provision for income taxes for fiscal years 2002
and 2001. We have carry forwards of domestic federal net operating losses, which
may be available, in part, to reduce future taxable income in the United States.
However, due to potential adjustments to the net operating loss carry forwards
as provided by the Internal Revenue Code with respect to future ownership
changes, future availability of the tax benefits is not assured. In addition, we
provided a valuation allowance in full for our deferred tax assets, as it is our
opinion that it is more likely than not that some portion or all of the assets
will not be realized.
Sorrento Networks I, Inc.
Net sales. Net sales increased to $36.0 million, or 36%, for fiscal 2002
from $26.5 million for fiscal 2001. The increase in net sales was primarily due
to an increase in the number of deployments of systems to both new and existing
customers. In fiscal 2002, eleven customers accounted for 94% of our net sales
compared with seven customers which accounted for 91% in fiscal 2001. In
addition to the number of new customer and existing customer orders achieved in
fiscal year 2002, we continued to increase its product offering by enhancements
to existing products and the introduction of new products which also contributed
to the increase in net sales in fiscal year 2002. We plan to continue to enhance
our existing product line and develop new products to increase sales. Our
ability to achieve this goal will depend on continued sales and available
working capital that can be allocated to our development efforts.
26
Gross profit. Gross profit was $7.7 million for fiscal 2002, a decrease of
16% from $9.1 million for fiscal 2001. Gross margin decreased to 21% of net
sales for fiscal 2002 from 34% for fiscal 2001. The gross margin percentage
decrease resulted from the shipment of lower margin products to multiple
customers with long-term purchase commitments or strategic alliance agreements
in fiscal 2002 as well as an increase in the valuation allowance recorded
against inventory of $4.0 million.
Selling and marketing. Sales and marketing expenses increased to $15.7
million, or 44% of net sales, for fiscal 2002 from $14.0 million, or 53% of net
sales, for fiscal 2001. The increase in sales and marketing expenses resulted
from increased travel expenses, trade show participation, and advertising
expenses. The number of sales and marketing personnel decreased to 38 at January
31, 2002 from 65 at January 31, 2001.
Engineering, research and development. Engineering, research and
development expenses decreased to $13.2 million, or 37% of net sales, for fiscal
2002 from $20.4 million, or 77% of net sales, for fiscal 2001. The decrease in
engineering, research and development expenses was the result of decreased
expenditures associated with the decrease in engineering personnel and decreases
in employee relocation and recruiting expenses and reduction in material related
development expenses. The number of engineering personnel decreased to 67 at
January 31, 2002 from 91 at January 31, 2001.
General and administrative. General and administrative expenses decreased
to $6.9 million, or 19% of net sales, for fiscal 2002 from $9.0 million, or 34%
of net sales, for fiscal 2001. The decrease in general and administrative
expenses reflects the reduction of executive and administrative personnel and
lower operating expenses. The number of general and administrative personnel
decreased to 15 at January 31, 2002 from 32 at January 31, 2001.
Deferred and other stock compensation. Deferred and other stock
compensation for the fiscal year ended January 31, 2002 includes $812 thousand
of amortization of deferred stock compensation resulting from the value of stock
options granted to consultants compared to $1.9 million for the prior fiscal
year. In connection with the grants of stock options with exercise prices
determined to be below the fair value of our common stock on the date of grant,
deferred stock compensation of $2.6 million was recorded, which is being
amortized on an accelerated basis over the vesting period of the options.
Meret Communications, Inc., d/b/a Meret Optical Communications
Net sales. Net sales decreased to $4.8 million, or 24%, for fiscal 2002
from $6.3 million for fiscal 2001. The decrease in net sales was primarily due
to changes in product demand in the RF Synthesis product family. The majority of
this decrease was recognized in the fourth quarter of this year.
Gross profit. Gross profit decreased to $1.7 million, or 35%, for fiscal
2002 from $2.6 million for fiscal 2001. Gross margin as a percentage of net
sales decreased to 35% for fiscal 2002 compared to 42% for the comparable period
last year. The decrease in the gross margin percentage from the prior year
resulted from the reduction in RF Synthesis sales which generates a higher gross
margin.
Selling and marketing. Sales and marketing expenses remained basically
unchanged at $435 thousand, or 9% of net sales, for fiscal 2002, compared to
$437 thousand, or 7% of net
27
sales, for fiscal 2001. Major expense changes by category within the sales and
marketing function included an increase in commissions to external sales
representatives that was offset by reduced personnel costs as a result of
reductions in the sales force.
Engineering, research and development. Meret incurred engineering expenses
during fiscal 2002 of $417 thousand, or 9% of net sales compared to $177
thousand, or 3% for the comparable period last year. The increase for the fiscal
year ended January 31, 2002 relates to the addition of three engineers to
support our development of our new coarse wavelength division multiplexing
products and the enhancement of existing products.
General and administrative. General and administrative expenses decreased
to $200 thousand, or 4% of net sales during fiscal 2002 from $595 thousand, or
9% of net sales for the comparable period last year. The decrease in general and
administrative expenses during fiscal 2002 resulted from reductions in bad debt
allowances and bank fees.
Liquidity and Capital Resources
We finance our operations through a combination of internal funds,
investments and debt and equity financing. At January 31, 2003, our working
capital was a negative $36.5 million including $4.0 million of investments in
marketable securities and $7.7 million in cash and cash equivalents. The primary
reason for our negative working capital condition is that $48.8 million,
reflecting the obligation due to holders of SNI's Series A Preferred Stock as a
result of their right of redemption, was classified at year end January 31, 2003
and January 31, 2002, as a current liability. This obligation had been
classified as mezzanine in our liability and owner's equity for the period ended
January 31, 2001. The Series A Preferred Stock liability can only be paid
through lawfully available funds that would normally be generated from SNI
profitable operations, which we do not currently have available or foresee the
availability of in the near future. As previously discussed, we are in the
process of restructuring both our Senior Convertible Debentures of $32.2 million
and the SNI Series A Preferred stock liability of $48.8 million.
Cash Flow for the Years Ended January 31, 2003, 2002 and 2001
Continuing Operations
Our operations used cash flows of $14.2 million during fiscal 2003 as
compared to $31.8 million in fiscal 2002. The decrease in cash flows used by
operations in fiscal 2003 was primarily the result of lower accounts receivable
and inventories, combined with the increase in reserves for inventory and
accounts receivable, the use of stock for the payment of interest on debentures
and the gain on sale of marketable securities. This favorable impact on cash
used for operations was partially offset by the negative cash impact of our
larger net operating loss and the use of cash to decrease our accounts payable.
In addition to the foregoing there were less significant changes associated with
changes in amortization and depreciation and other current liabilities.
We have incurred significant losses and negative cash flows from operations
for the past two years. Sorrento Networks, Inc., (SNI) our principal operating
subsidiary, has primarily been the operating entity responsible for these high
losses and negative cash flows. The losses have been generated as SNI continues
to develop its technology, marketing and sales and operations in its effort to
become a major supplier of metro and regional optical networks world-wide. In
28
addition, we have incurred significant restructuring costs of approximately $2.8
million in 2003 associated with restructuring of our obligations under our 9.75%
Senior Convertible Debentures and Series A Preferred Stock. Although we feel
these restructuring costs are beneficial to our long-term survival in a
depressed telecom market, there is no certainty the restructuring will be
approved by the shareholders or will close even with shareholder approval.
We have funded our operations primarily by the sale of securities and the
issuance of debt. There can be no assurance that similar funding will be
available in the future. In addition, if our restructuring efforts are
successful, there will be certain restrictions on us in both the amount of debt
we can incur in future periods and the types of securities that we will be able
to issue to raise additional capital in future periods. Both of these
restrictions could have a negative impact on our ability to raise the additional
working capital that we will require in future periods. Further, with the
downturn in the economic environment and decreases in capital spending by
telecom carriers, our revenue has been negatively impacted and we anticipate
that our future revenues will also be negatively impacted. As a result, our need
for additional working capital may be accelerated in the future. If such capital
is not available, we will need to substantially decrease our operating costs and
capital spending in order to fund operations. There can be no assurance that our
available cash, future funding or reduction in operating costs will be
sufficient to fund our operations in the future.
Our standard payment terms range from net 30 to net 60 days. Receivables
from international customers have frequently taken longer to collect. In
addition, the downturn in the telecom market has impacted many of the telecom
carriers ability to purchase or pay for outstanding commitments within standard
payment terms. There can be no assurance that this continued economic
environment will not impact either current or future receivables negatively. We
do not provide long-term financing to customers buying our equipment.
Investing Activities
Our investing activities during fiscal 2003 provided for cash flows of $9.1
million. Cash used in investing activities during fiscal year 2003 included
purchases of property and equipment of $3.3 million and $280 thousand in
purchases of other assets. We also made a $5.0 million investment in UFO
Communications, Inc. a private service provider, as part of a strategic
relationship. This was offset by $17.2 million of cash received from the sale of
marketable securities and other investments. In fiscal 2002 our investing
activities used $4.0 million. Cash used in investing activities during fiscal
2002 included purchases of property and equipment of $3.2 million and $900
thousand in other assets, which was offset by $144 thousand of cash received
from the sale of marketable securities and other investments.
In fiscal 2001 we used cash flows in investing activities of $12.5 million
including $7.0 million in cash balances at Entrada as of August 31, 2000 when it
ceased to be a subsidiary following the merger with Sync Research. We purchased
property and equipment of $14.4 million, invested $3.3 million in Entrada and
$3.2 million in one of SNI's customers. During fiscal 2001, we received $4.2
million from the sale of 350,000 of our Netsilicon shares and $819 thousand from
the purchasers of our discontinued operations. We received $9.2 million offset
by our investment of $3.2 million from the investment in one of SNI's customers
and payment of $1.8 million on a note receivable.
29
Financing Activities
In fiscal 2003 our financing activities used cash of $1.4 million and
consisted primarily of repayment of our line of credit and long-term debt. Our
financing activities during fiscal 2002 provided us $40.1 million and consisted
primarily of financing activities from the sale of common stock in March, 2001
of 76,300 shares which generated proceeds of $9.6 million and a convertible
debenture financing in August, 2001 which raised $29.7 million. As previously
mentioned, we have restructured both our 9.75% convertible debenture financing
completed in August, 2001 and the SNI Series A Preferred Stock obligation of
$48.8 million. In addition to the sale of common stock and convertible
debentures, we received $1.1 million from proceeds of stock option and warrant
exercises of $900 thousand and long term debt of $20 thousand. Offsetting these
amounts were repayments of short-term and long-term debt of $300 thousand.
In fiscal 2001 our financing activities provided cash flows of $60.6
million which consisted primarily of $46.6 million in net proceeds from a
private placement by SNI of its convertible preferred stock, $7.9 million in net
proceeds from a private placement by Entrada of its common stock, $3.9 million
in proceeds from option and warrant exercises, $2.4 million in proceeds from
long term debt offset by repayments of short and long term debt.
During March 2000, SNI completed a private placement of 8,596,333 shares of
its Series A Convertible Preferred Stock to a group of investors receiving net
proceeds of approximately $46.6 million. Each share of the SNI Series A
Preferred Stock was, prior to the closing of our capital restructuring on
June 4, 2003, convertible into one share of SNI common stock at the option
of the holder and could vote on an "as converted" basis except for election of
directors, and had a liquidation preference of $5.45 per share.
On August 31, 2000, we completed a merger of Entrada with Sync Research,
Inc., a Nasdaq listed company in which we received 4,244,155 shares of the
merged entity, which changed its name to Entrada Networks, Inc. and changed its
symbol to ESAN. We purchased 93,900 shares of Sync in the open market during
June and July, 2000 for $388 and on August 31, 2000 purchased an additional
1,001,818 shares directly from Entrada for $3,306. After these transactions we
owned 48.9% of Entrada Networks and we have accounted for our interest on our
balance sheet at cost as of January 31, 2001.
On December 1, 2000, we distributed 3,107,155 of our Entrada shares to our
shareholders of record as of November 20, 2000. The distribution was made at the
rate of one-fourth (0.25) of an Entrada share for each of our outstanding
shares. At exercise, options and warrants to acquire our common shares which
were granted and unexercised as of November 20, 2000 will receive a
30
similar number of Entrada shares. Prior to January 31, 2001 we distributed
20,182 of our Entrada shares upon the exercise of options and as of January 31,
2001 have reserved 1,080,283 shares for future exercises of options and
warrants. The cost basis of these reserved shares and related liability to the
option and warrant holders is included in the investment in former subsidiary
and dividends payable in the accompanying balance sheet. The aggregate
distribution of our Entrada shares including the shares reserved for option and
warrant holders has been accounted for at our original cost of $5.1 million. In
addition we have granted options to purchase 410,000 of our Entrada shares for
$3.19 per share (the merger price) to several of our then officers and
consultants. In April 2003 our Board of Directors determined that our Entrada
shares should be made available for general corporate purposes, and we are no
longer reserving any for distribution to option and warrant holders as of
November 20, 2000.
We anticipate that we will need additional working capital to fulfill our
capital working requirements for the next year. While we have made significant
cost reductions to bring our losses more in line with our anticipated or
projected revenues, there is no assurance the volume of future revenues will be
sufficient to allow us to meet our financial obligations for future periods.
Further, we anticipate we will need to sell our marketable securities to finance
our working capital needs for future periods. Our holdings of marketable
securities are highly volatile and do not trade in large volume. There can be no
assurance that when we need to sell our holdings in marketable securities we
will be able to obtain a market value price for the securities without
negatively impacting the price of such securities. We continue to reduce our
operating costs and have initiated activities to raise additional working
capital. Our future capital requirements may vary materially from those now
planned including the need for working capital to accommodate planned growth,
hiring and infrastructure needs. There can be no assurances that our working
capital requirements will not exceed our ability to generate sufficient cash
internally to support our requirements and that external financing will be
available or that, if available, such financing can be obtained on terms
favorable to us and our shareholders. In addition our auditors have issued a
going concern qualification to their opinion regarding the successful approval
and completion of our capital restructuring plan, which closed on June 4, 2003.
Contractual Cash Obligations
The following tables quantify our future contractual obligations and
commercial commitments as of January 31, 2003 (dollars in thousands):
Contractual Obligations
Payments due in fiscal years
-------------------------------------------------------------
Total 2004 2005 2006 2007 2008 Thereafter
------- ------- ------- ---- ---- ---- ----------
Long-term Debt.......................... $ 3,630 $ 38 $ 57 $ 54 $ 58 $63 $3,360
Capital Leases.......................... 253 198 55 -- -- -- --
Operating Leases........................ 650 301 158 131 42 18 --
9.75% convertible debentures (a)........ 32,200 -- 32,200 -- -- -- --
Series A, preferred stock put (b)....... 48,800 48,800 -- -- -- -- --
------- ------- ------- ---- ---- --- ------
Total................................... $85,533 $49,337 $32,470 $185 $100 $81 $3,360
======= ======= ======= ==== ==== === ======
31
(a) Maturity date, August 2, 2004
(b) The Series A had a liquidation preference, and the holders had the right to
have the outstanding shares repurchased in the event an initial public
offering of SNI did not take place by March 1, 2001. The initial public
offering did not take place and a majority of Series A holders exercised
their redemption right. SNI has not repurchased those shares because it
does not have legally available funds to do so. Applicable law prohibits a
repurchase of equity securities when the capital of the corporation is
impaired or when such repurchase would cause an impairment of the capital
of the corporation. SNI has not had funds legally available to repurchase
any of its equity securities since April 2001, and most likely will not in
the foreseeable future.
Note: As a result of the consummation of the capital restructuring, the debt
obligations to our 9.75% convertible debenture holders of $32.2 million and
Series A Preferred Stock holders of $48.8 million were eliminated and new 7.5%
convertible debentures of $12.5 million have become effective, which have a
maturity date of August 2, 2007.
Results of Operations/Comparison of the Quarters ended April 30, 2003 and 2002.
Net sales. Our consolidated net sales increased $1.9 million or 31% to $7.9
million for the quarter ended April 30, 2003 compared to net sales of $6.0
million for the quarter ended April 30, 2002. Net sales for Sorrento Networks
Inc.("SNI"), our primary operating subsidiary, increased $2.0 million or 41% to
$6.8 million for the quarter ended April 30, 2003 as compared to net sales of
$4.8 million for the quarter ended April 30, 2002. This increase is the reflects
increased domestic sales resulting from a substantial backlog at the end of last
quarter.
During the three months ended April 30, 2003 SNI shipped product to
fourteen customers of which five customers represented a combined 92% of our
revenues. During the quarter ended April 30, 2002, we shipped product to ten
customers of which five customers represented a combined 88% of our net sales.
We expect to continue experiencing significant fluctuations in our quarterly
revenues as a result of our long and variable sales cycle as well as our highly
concentrated customer base.
Net sales for Meret decreased to $1.1 million, or by 15% for the quarter
ended April 30, 2003 from $1.2 million for the comparable quarter last year. The
reduction in sales volume reflects the transfer of one of Meret's product line
to SNI. This transfer was done for conformity of products within the two
segments.
Gross profit. Cost of sales consists principally of the costs of
components, subcontract assembly from outside manufacturers, and in-house system
integration, quality control, final testing and configuration costs. Gross
margin percent on a consolidated basis remained at 25% for the quarters ended
April 30, 2003 and 2002. Consolidated gross profit was $2.0 million, an increase
of 31% for the quarter ended April 30, 2003 from $1.5 million for the quarter
ended April 30, 2002.
Gross profit for SNI increased to $1.7 million the quarter ended April 30,
2003, as compared to $1.0 million in the quarter ended April 30, 2002, an
increase of 67%. The gross margin increases were primarily the result of higher
sales volume and lower fixed manufacturing overhead in our cost of shipments for
the quarter. We continue to monitor our costs of production and reduce costs
where ever possible.
For the quarter ended April 30, 2003 gross profit for Meret decreased to
$247, or by 47%, from $463 for the comparable quarter last year. Meret's gross
margins decreased to 22% for the quarter ended April 30, 2003 from 42% for the
comparable quarter last year. The gross margin decrease was primarily the result
of product mix, lower sales volume, and higher fixed manufacturing overhead in
our cost of shipments for the quarter.
Selling and marketing. Selling and marketing expenses consist primarily of
employee compensation and related costs, commissions to sales representatives,
tradeshow expenses and travel expenses. Consolidated selling and marketing
expenses decreased to $2.2 million or 28% of net sales, for the quarter ended
April 30, 2003 from $3.4 million, or 57% of net sales for the quarter ended
April 30, 2002. This decrease was primarily the result of cost reduction efforts
implemented and reductions in travel expenses, advertising expenses and
personnel costs.
Engineering, research and development. Engineering, research and
development expenses consist primarily of compensation related costs for
engineering personnel, facilities costs and
32
materials used in the design, development and support of our technologies. All
research and development costs are expensed as incurred. We continue to manage
our research and development cost in relation to the changes in our sales
volume and available capital resources in our development efforts to enhance
existing products and introduce new products to our product offering. Our
consolidated engineering, research and development expenses decreased to $1.6
million, or 20% of net sales, for the quarter ended April 30, 2003 from $2.5
million, or 42% of net sales for the quarter ended April 30, 2002. The decline
can primarily be attributed to decreases in product development material and
personnel related costs reflecting managements planned reduction in operating
expense levels.
General and administrative. General and administrative expenses consist
primarily of employee compensation and related costs, legal and accounting fees,
public company costs and allocable occupancy costs. Consolidated general and
administrative expenses decreased to $1.6 million, or 20% of net sales, for the
quarter ended April 30, 2003 from $1.9 million, or 31% of net sales, for the
quarter ended April 30, 2002. The decrease in general and administrative
expenses can be attributed to reductions in investment banking, professional
fees and personnel related costs due to our ongoing operating expense reduction
efforts.
Deferred and other stock compensation. Deferred and other stock
compensation for the quarter ended April 30, 2003 includes $51 of amortization
of deferred stock compensation resulting from the amortization of the value of
stock options granted to consultants as compared with $62 of amortization of
deferred stock compensation and $44 of expenses for the comparable quarter last
year. These costs were incurred in connection with the grants of stock options
with exercise prices determined to be below the fair value of our common stock
on the date of grant, we recorded deferred stock compensation of $2.6 million,
which is being amortized on an accelerated basis over the vesting period of the
options.
Other income (charges). Other income (charges) from operations was a $2.6
million charge for the quarter ended April 30, 2003 compared to a $10.5 million
gain for the quarter ended April 30, 2002. The current year quarter consists
primarily of costs associated with our convertible debenture which includes
deferred interest of $765, amortization of issuance costs of $203 and
amortization of the fair value of the warrants issued to the purchasers and
placement agent and the deemed beneficial conversion feature of $1.6 million.
The quarter ended April 30, 2002 consisted of an $11.7 million gain on the sale
of marketable securities as a result of the sale of 3,396,221 shares of
NETsilicon, Inc. common stock to Digi International, Inc. for $13.6 million in
cash. Expenses associated with our convertible debenture included interest of
$766, paid in common stock, amortization of issuance costs of $36 and
amortization of the fair value of the warrants issued to the purchasers and
placement agent and the deemed beneficial conversion feature of $398.
Income taxes. There was no provision for income taxes for the quarters
ended April 30, 2003 and 2002. We have carry forwards of domestic federal net
operating losses, which may be available, in part, to reduce future taxable
income in the United States. However, due to potential adjustments to the net
operating loss carry forwards as provided by the Internal Revenue Code with
respect to future ownership changes, future availability of the tax benefits is
not assured. In addition, we provided a valuation allowance in full for our
deferred tax assets, as it is our opinion that it is more likely than not that
some portion or all of the deferred tax assets will not be realized.
33
Liquidity and Capital Resources
We finance our operations through a combination of internal funds,
investments and debt and equity financing. At April 30, 2003, which was prior to
the consummation of our restructuring transaction which closed on June 4, 2003
and is therefore no longer applicable, our working capital was a negative $37.7
million including $5.0 million of investments in marketable securities and $3.8
million in cash and cash equivalents. The primary reason for our negative
working capital condition was that $48.8 million, reflecting the obligation due
to Series A Holders obligation as a result of their right of redemption, was
classified at year end January 31, 2003, as a current liability. The Series A
liability could only be paid through lawfully available funds that would
normally be generated from SNI profitable operations, which we did not then have
available and did not then foresee the availability of in the near future. As
previously discussed, we have recently consummated the restructuring of both our
Senior Convertible Debentures of $32.2 million and the SNI Series A Preferred
liability of $48.8 million.
Operations
Our operations used cash flows of $5.0 million during the quarter ended
April 30, 2003. During the quarter ended April 30, 2002 continuing activities
used cash flows of $4.2 million. The increase in cash flows used by operations
resulted primarily from a decrease in our deferred revenue and a decrease in
accounts payable, offset by a decrease in accounts receivable and not having a
gain from the sales of marketable securities in the current quarter.
We have incurred significant losses and negative cash flows from operations
for the past two years. SNI has primarily been the operating entity responsible
for these high losses and negative cash flows. The losses have been generated as
SNI continues to develop its technology, marketing and sales and operations in
its effort to become a major supplier of metro and regional optical networks
world-wide.
We have funded our operations primarily by the sale of securities and the
issuance of debt. There can be no assurance that similar funding will be
available in the future. In addition, after our restructuring efforts are
completed, there will be certain restrictions on us in both the amount of debt
we can incur in future periods and the types of securities that we will be able
to issue to raise additional capital in future periods. Both of these
restrictions could have a negative impact on our ability to raise the additional
working capital that we will require in future periods. Further, with the
downturn in the economic environment and decreases in capital spending by
telecom carriers, our revenue has been negatively impacted and we anticipate
that our future revenues will also be negatively impacted. As a result, our need
for additional working capital may be accelerated in the future. If such capital
is not available, we will need to substantially decrease our operating costs and
capital spending in order to fund operations. There can be no assurance that our
available cash, future funding or reduction in operating costs will be
sufficient to fund our operations in the future.
Our standard payment terms range from net 30 to net 60 days. Receivables
from international customers have frequently taken longer to collect. In
addition, the downturn in the telecom market has impacted many of the telecom
carriers ability to purchase or pay for outstanding commitments within standard
payment terms. Despite these negative factors we have improved our collection on
receivables to 57 days of average sales days outstanding as
34
compared to 144 days outstanding for the same period in the prior year.
Additionally, we have also improved our inventory turnover from 1 times per
year to 2 times per year when compared to the same period in the prior year.
Both the reduction in receivables and inventory have helped to improve our
cash flows. There can be no assurance however, that this continued economic
environment will not impact either current or future receivables negatively
or our ability to control inventory levels. We do not provide long-term
financing to customers buying our equipment.
Investing Activities
Our investing activities during the quarter ended April 30, 2003 provided
cash flows of $1.1 million from the disposal of $775 thousand property and
equipment and a $313 thousand decrease in other assets. During the quarter ended
April 30, 2002, investing activities provided cash flows of $11.6 million. We
purchased property and equipment of $1.9 million and received $13.6 million on
the sale of marketable securities and other assets.
Financing Activities
Our financing activities during the quarter ended April 30, 2003 used cash
of $67 thousand consisting primarily of the repayment of debt. During the
quarter ended April 30, 2002, financing activities used cash flows of $177
thousand, which also consisted primarily of repayment of debt.
We anticipate that we will need additional working capital to fulfill our
capital working requirements for the next year. Although we have made
significant cost reductions to bring our losses more in line with our
anticipated or projected revenues, there is no assurance the volume of future
revenues will be sufficient to allow us to meet our financial obligations for
future periods. Further, we anticipate we will need to sell our marketable
securities to finance our working capital needs for future periods. Our holdings
of marketable securities are highly volatile and do not trade in large volume.
There can be no assurance that when we need to sell our holdings in marketable
securities we will be able to obtain a market value price for the securities
without negatively impacting the price of such securities. We continue to reduce
our operating costs and have initiated activities to raise additional working
capital. Our future capital requirements may vary materially from those now
planned including the need for working capital to accommodate planned growth,
hiring and infrastructure needs. There can be no assurances that our working
capital requirements will not exceed our ability to generate sufficient cash
internally to support our requirements and that external financing will be
available or that, if available, such financing can be obtained on terms
favorable to us and our shareholders. In addition our auditors have issued a
going concern qualification to their opinion on our financial statements for the
year ended January 31, 2003 included in our Annual Report as filed with the SEC
on Form 10-K, as amended, regarding the successful approval and completion of
our Capital Restructuring Plan, which closed on June 4, 2003.
Contractual Cash Obligations
The following tables quantify our future contractual obligations and
commercial commitments as of April 30, 2003 (dollars in thousands):
35
Contractual Obligations
Payments due in fiscal years
-------------------------------------------------------------------
Remainder
Total 2004 2005 2006 2007 2008 Thereafter
-------------------------------------------------------------------
Long-term Debt .................................... $ 3,618 $ 34 $ 49 $ 54 $ 58 $63 $3,360
Capital Leases .................................... 193 138 55 -- -- -- --
Operating Leases .................................. 558 209 158 131 42 18 --
9.75% convertible debentures (a) .................. 32,200 -- 32,200 -- -- -- --
Series A, preferred stock put (b) ................. 48,800 48,800 -- -- -- -- --
------- ------- ------- ---- ---- --- ------
Total ............................................. $85,369 $49,181 $32,462 $185 $100 $81 $3,360
======= ======= ======= ==== ==== === ======
(a) Maturity date, August 2, 2004
(b) The Series A has a liquidation preference, with the holders
having a right to have the outstanding shares repurchased in the
event an initial public offering did not take place at our
subsidiary, SNI, by March 1, 2001. The IPO did not take place and
a majority of Series A holders exercised their redemption right.
SNI did not repurchased those shares because it did not have
legally available funds to do so. Applicable law prohibits a
repurchase of equity securities when the capital of the
corporation is impaired or when such repurchase would cause an
impairment of the capital of the corporation. SNI did not have
funds legally available to repurchase any of its equity
securities since April 2001.
Note: As a result of the capital restructuring that was consummated on June 4,
2003 completing the capital restructuring, the debt obligations to our
convertible debenture holders of $32,200 and Series A preferred stock holders of
$48,800 have been eliminated and new convertible debentures in the aggregate
principal amount of $12,500 have become effective, with a maturity date of
August 2, 2007.
Securities Authorized For Issuance Under Equity Compensation Plans
The following table provides information as of April 30, 2003 regarding
compensation plans (including individual compensation arrangements) under which
equity securities of Sorrento are authorized for issuance.
36
Number of
Securities To Number of Securities
Be Issued Upon Remaining Available for
Exercise Weighted-Average Future Issuance Under
Of Outstanding Exercise Equity
Options, Price of Outstanding Compensation Plans
Warrants and Options, (Excluding Securities
Rights Warrants and Rights Reflected in Column(a))
-------------------------------------------------------------------
Plan Category (a) (b) (c)
------- ------- -------
Equity Compensation
Plans Approved by
security Holders
*(FIBR) 294,277 $387.53 260,723
-------- ------- ---------
Equity Compensation
Plans not Approved by
Security Holders
(SNI) 3,296,003 $ 4.93 20,000,000
--------- ------- ----------
Total 3,590,280 $ 36.29 20,260,723
--------- ------- ----------
* As adjusted for stock splits.
See the Stock Option Plans note in the financial statements included in this
registration statement for information regarding the material features of the
above plans. Each of the above plans provides that the number of shares with
respect to which options may be granted, and the number of shares of common
stock subject to an outstanding option, shall be proportionally adjusted in the
event of a subdivision or consolidation of shares or the payment of a stock
dividend on common stock, and the purchase price per share of outstanding
options shall be proportionately revised.
Contingent Liabilities
One of our component suppliers is contending that our efforts to reschedule
shipments of certain components constitutes an anticipatory breach of the
purchase order by which the components were ordered, and has informed us that
they believe they are entitled to damages approximately $950,000, despite the
fact none of the goods have as yet been shipped. We do not believe that our
supplier can support the amount of the alleged cancellation fee. Our supplier
has threatened litigation if the dispute is not satisfactorily resolved and
while we believe that our defenses to both liability and damages are strong, we
can give no assurance that our position in such litigation would prevail. In the
merger agreement between our predecessor corporation and Sync Research, we
agreed to indemnify and hold our former subsidiary, Entrada, harmless against
any liability arising after the merger in connection with the termination of a
certain pension plan previously maintained by Entrada. In the third quarter, we
were advised by a consultant retained by us and by the successor corporation to
the entity from whom we originally purchased the company that became Entrada
that the cost of termination of the pension plan in question is in excess of $3
million. While we do not believe that we are liable for this cost, it is
possible that the successor corporation, which has been funding the pension plan
since 1996, may seek a substantial contribution from us towards this liability.
Effects of Inflation and Currency Exchange Rates
We believe that the relatively moderate rate of inflation in the United
States over the past few years has not had a significant impact on our sales or
operating results or on the prices of raw materials. There can be no assurance,
however, that inflation will not have a material adverse effect on our operating
results in the future.
The majority of our sales and expenses are currently denominated in U.S.
dollars and to date our business has not been significantly affected by currency
fluctuations. However, we conduct business in several different countries and
thus fluctuations in currency exchange rates could cause our products to become
relatively more expensive in particular countries, leading to a reduction in
sales in that country. In addition, inflation in such countries could increase
our expenses. In the future, we may engage in foreign currency denominated sales
or pay material
37
amounts of expenses in foreign currencies and, in such event, may experience
gains and losses due to currency fluctuations. Our operating results could be
adversely affected by such fluctuations.
Impact of Recent Accounting Pronouncements
In January 2003, the FASB issued FASB Interpretation ("FIN") No. 46,
"Consolidation of Variable Interest Entities", and interpretation of Accounting
Research Bulletin No. 51, "Consolidated Financial Statements", FIN No. 46
explains how to identify variable interest entities and how an enterprise
assesses its interests in a variable interest entity to decide whether to
consolidate that entity. This Interpretation requires existing unconsolidated
variable interest entities to be consolidated by their primary beneficiaries if
the entities do not effectively disperse risks among parties involved. FIN No.
46 is effective immediately for variable interest entities created after January
31, 2003, and to variable interest entities in which an enterprise obtains an
interest after that date. The Interpretation applies in the first fiscal year or
interim period beginning after June 15, 2003, to variable interest entities in
which an enterprise holds a variable interest that is acquired before February
1, 2003. We do not anticipate that the adoption of FIN No. 46 will have a
material effect on our financial position or results of operations.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure," which amended SFAS No. 123,
"Accounting for Stock-Based Compensation." The new standard proves alternative
methods of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation. Additionally, the statement
amends the disclosure requirements of SFAS No. 123 to require prominent
disclosures in the annual and interim financial statements about the method of
accounting for stock-based employee compensation and the effect of the method
used on reported results. This statement is effective for financial statements
for fiscal years ending after December 15, 2002. In compliance with SFAS No.
148, we have elected to continue to follow the intrinsic value method in
accounting for its stock-based employee compensation arrangement as defined by
Accounting Principles Board Opinion ("APB") No. 25, Accounting for Stock Issued
to Employees, and has made the applicable disclosures in note K to the
consolidated financial statements.
In November 2002, the FASB issued FIN 45, which expands previously issued
accounting guidance and disclosure requirements for certain guarantees. FIN 45
requires us to recognize an initial liability for the fair value of an
obligation assumed by issuing a guarantee. The provision for initial recognition
and measurement of the liability will be applied on a prospective basis to
guarantees issued or modified after December 31, 2002. The adoption of FIN 45 is
not expected to materially affect our consolidated financial statements.
In June 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 146, "Accounting for
Costs Associated with Exit or Disposal Activities", which addresses accounting
for restructuring and similar costs. SFAS No. 146 supersedes previous accounting
guidance, principally Emerging Issues Task Force ("EITF") Issue No. 94-3. We
will adopt the provisions of SFAS 146 for restructuring activities initiated
after December 31, 2002. SFAS 146 requires that the liability for costs
associated with an exit or disposal activity be recognized when the liability is
incurred. Under EITF No. 94-3, a liability for an exit cost was recognized at
the date of a company's commitment to an exit plan. SFAS 146 also establishes
that the liability should initially be measured and recorded at fair
38
value. Accordingly, SFAS 146 may affect the timing of recognizing future
restructuring costs as well as the amount recognized. Adoption of this standard
will not have any immediate effect on our consolidated financial statements. We
will apply this guidance prospectively.
In April 2002, the Financial Accounting Standards Board issued SFAS No.
145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections". This statement eliminates the
current requirement that gains and losses on debt extinguishment must be
classified as extraordinary items in the income statement. Instead, such gains
and losses will be classified as extraordinary items only if they are deemed to
be unusual and infrequent, in accordance with the current GAAP criteria for
extraordinary classification. In addition, SFAS 145 eliminates an inconsistency
in lease accounting by requiring that modifications of capital leases that
result in reclassification as operating leases be accounted for consistent with
sale-leaseback accounting rules. The statement also contains other
nonsubstantive corrections to authoritative accounting literature. The changes
related to debt extinguishment will be effective for fiscal years beginning
after May 15, 2002, and the changes related to lease accounting will be
effective for transactions occurring after May 15, 2002. Adoption of this
standard will not have any immediate effect on our consolidated financial
statements. We will apply this guidance prospectively.
In August 2001, the Financial Accounting Standards Board issued SFAS No.
143, Accounting for Asset Retirement Obligations. This Statement is effective
for fiscal years beginning after June 15, 2002. SFAS 143 provides accounting
requirements for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. Under the
Statement, the asset retirement obligation is recorded at fair value in the
period in which it is incurred by increasing the carrying amount of the related
long-lived asset. The liability is accreted to its present value in each
subsequent period and the capitalized cost is depreciated over the useful life
of the related asset. We do not believe the adoption of SFAS 143 will have a
material effect, if any, on our financial position or results of operations.
(c) Quantitative and Qualitative Disclosures About Market Risk
We are exposed to financial market risks, including changes in interest
rates and foreign currency rates. Our exposure to interest rate risk is the
result of our need for periodic additional financing for our large operating
losses and capital expenditures associated with establishing and expanding our
operations. The interest rate that we will be able to obtain on debt financing
will depend on market conditions at that time, and may differ from the rates we
have secured on our current debt.
Almost all of our sales have been denominated in U.S. dollars. A portion of
our expenses are denominated in currencies other than the U.S. dollar and in the
future a larger portion of our sales could also be denominated in non-U.S.
currencies. As a result, currency fluctuations between the U.S. dollar and the
currencies in which we do business could cause foreign currency translation
gains or losses that we would recognize in the period incurred. We cannot
predict the effect of exchange rate fluctuations on our future operating results
because of the number of currencies involved, the variability of currency
exposure and the potential volatility of currency exchange rates. We attempt to
minimize our currency exposure risk through working capital management and do
not hedge our exposure to translation gains and losses related to foreign
currency net asset exposures.
39
We do not hold or issue derivative, derivative commodity instruments or
other financial instruments for trading purposes. Investments held for other
than trading purposes do not impose a material market risk.
We believe that the relatively moderate rate of inflation in the United
States over the past few years and the relatively stable interest rates incurred
on short-term financing have not had a significant impact on our sales,
operating results or prices of raw materials. There can be no assurance,
however, that inflation or an upward trend in short-term interest rates will not
have a material adverse effect on our operating results in the future should we
require debt financing in the future.
Item 3. Properties
We recently moved our headquarters to the San Diego, California facility
that we own, which consists of approximately 36,000 square feet used for
offices, research and development and manufacturing. We also own a 47,000 square
foot facility in San Diego, California adjacent to our headquarters that is used
for offices, manufacturing and customer support.
For fiscal year 2003 we occupied an additional 19,240 square feet used for
office, research and development and manufacturing activities under lease as
detailed below:
Square
Location Footage Facility Type Expiration Date
-------- ------- -------------------- ------------------
Santa Monica, California... 6,000 Office April 30, 2003
Fremont, California........ 5,000 Office/Manufacturing July 31, 2003
Richardson, Texas.......... 2,860 Office September 30, 2003
Stuttgart, Germany......... 5,380 Office December 31, 2005
As we move to bring our expenses in line with our revenue, we have
completed, or are in the process of completing, the relocation of the Santa
Monica, California, Fremont, California and Richardson, Texas offices to our San
Diego, California facility. In addition, we have closed down our overseas
facilities in The Netherlands, Belgium, China and Singapore.
We believe our facilities are suitable and adequate to meet our current
needs. See Note E to the Consolidated Financial Statements for terms and amounts
of mortgages on the facility we own.
Item 4. Security Ownership of Certain Beneficial Owners and Management
The following table sets forth certain information as of January 31, 2003,
and as of the date of issuance of the warrants being registered hereunder,
June 4, 2003, regarding the ownership of our common stock by (i) each of our
directors; (ii) each of our present executive officers; (iii) each person
known to us to beneficially own 5% or more of our common stock; and (iv) all
our directors and executive officers as a group. Except as indicated, all
persons named as beneficial owners of common stock have sole voting and
investment power with respect to the shares indicated as beneficially
owned by them. All persons named have an
40
address at c/o Sorrento Networks Corporation, 9990 Mesa Rim Road, San Diego,
California 92121, unless otherwise indicated. All numbers give effect to our
1-for-20 reverse stock split, which took effect on October 28, 2002.
Common Stock Beneficially Owned Common Stock Owned as of Date
as of January 31, 2003** of Issuance of Warrants***
-------------------------------------------------------------------------------------------
% of % of
Name of Beneficial Number of Outstanding Number of Outstanding
Owner (A) Shares (J) Shares (J)
-------------------------------------------------------------------------------------------
Phillip W. Arneson (B) 19,083 2.1% 19,083 *
-------------------------------------------------------------------------------------------
Donne F. Fisher (C) 1,750 * 1,750 *
-------------------------------------------------------------------------------------------
Robert L. Hibbard (D) 4,300 * 4,300 *
-------------------------------------------------------------------------------------------
Gary M. Parsons (E) 1,834 * 1,834 *
-------------------------------------------------------------------------------------------
Larry J. Matthews (F) 1,750 * 1,750 *
-------------------------------------------------------------------------------------------
Joe R. Armstrong (G) 10,138 1.1% 10,138 *
-------------------------------------------------------------------------------------------
Richard L. Jacobson (H) 11,788 1.3% 11,788 *
-------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------
All Directors, Nominees
and Executive Officers
as a Group 48,892 5.4% 48,892 *
-------------------------------------------------------------------------------------------
Qila, LLC(I)
15332 Antioch Street
Pacific Palisades, CA
90272 55,369 6.3% 55,369 *
-------------------------------------------------------------------------------------------
Deutsche Bank (M) 0 0 1,023,155 11.2
-------------------------------------------------------------------------------------------
ZLP Master Technology 0 0 682,103 7.5
Fund (N)
-------------------------------------------------------------------------------------------
Belmarken Holding B-V (O) 0 0 2,053,738 21.1
-------------------------------------------------------------------------------------------
Societe Generale (P) 0 0 545,682 6.0
-------------------------------------------------------------------------------------------
Sorrento Holdings LLC (Q) 0 0 791,604 8.7
-------------------------------------------------------------------------------------------
* Less than 1%
** Based on 886,050 shares outstanding
*** Based on 8,915,628 shares outstanding
(A) All information with respect to beneficial ownership of the shares is based
upon filings made by the respective beneficial owners with the Securities
and Exchange Commission or information provided by such beneficial owners
to us.
(B) Includes exercisable options held by Mr. Arneson to acquire 18,833 shares
of common stock, and 250 shares of common stock purchased in June
2002.
(C) Includes options to acquire 1,750 shares of common stock. On March 7, 2000,
Mr. Fisher was granted options to acquire 100,000 shares of SNI's common
stock at $5.45 under its option plan for his services as an advisor to it.
Pursuant to an outstanding conversion offer, Mr. Fisher may elect to
convert the SNI options into options to acquire
41
our common stock at a ratio of 78 for 1. Mr. Fisher is President of Fisher
Capital Partners which holds 183,486 shares of Series A. Mr. Fisher is a
director of Liberty Media Corporation which owns an approximate 74%
economic interest representing an approximate 94% voting interest in
UnitedGlobalCom, Inc. ("UGC"). Belmarken Holding, B.V., an indirect
subsidiary of UGC, holds 3,027,523 shares of the Series A. Liberty Media
also holds convertible debt of United Pan-Europe Communications, N.V., a
subsidiary of UGC, which it has agreed to exchange for additional shares in
UGC.
(D) Includes exercisable options held by Mr. Hibbard to acquire 4,250 shares of
common stock and 50 shares of common stock purchased in July 2002.
(E) Includes exercisable options held by Mr. Parsons to acquire 1,834 shares of
common stock.
(F) Mr. Matthews was granted options to acquire 1,750 shares of our common
stock upon his election to our board of directors. Under the terms,
conditions and vesting schedules as option grants made to other members of
our board of directors, the options vest upon completion of one year of
service measured from the grant date.
(G) Includes exercisable options held by Mr. Armstrong to acquire 9,988 shares
of common stock, and 150 shares of common stock purchased in June 2002.
(H) Includes exercisable options held by Mr. Jacobson to acquire 11,354 shares
of common stock, and 434 shares of common stock held in a 401K
plan.
(I) Represents holdings reported by Qila, LLC and RII Partners, Inc. on
September 20, 2002 on Form 13-D, "General Statement of Beneficial
Ownership". Represents exercisable options to acquire 55,370 shares of
common stock held by RT Investments, Inc. Mr. and Mrs. Chadha disclaim
ownership in all these shares.
(J) For each beneficial owner, the "Percentage of Outstanding" equals each
owner's actual holdings of shares plus shares represented by vested,
unexercised options and warrants or other securities convertible into
our common stock held, divided by our total shares outstanding at
January 31, 2003 plus the unexercised options and warrants or
other securities convertible into our common stock detailed
above of the referenced holder only. In other words, individual
percentages of the listed holders will not add to the group total because
the calculations are made separately for each holder.
42
(L) "Diluted basis" is a concept that is used in the Exchange Agreement we have
entered into in connection with our proposed restructuring transaction, and
means the total number of shares of our common stock issued and outstanding
immediately after the closing of the restructuring transaction, after
giving effect to (i) the issuance of shares of common stock as part of the
restructuring transaction, (ii) shares of our common stock issuable upon
conversion of $12.5 million principal amount of our new 7.5% convertible
debentures being issued, and (iii) shares of our common stock issuable upon
exercise of the new warrants being registered hereunder. "Diluted basis"
does not give effect to (i) the shares of our common stock issuable under
our new 2003 Equity Incentive Plan, (ii) shares of common stock issuable
upon conversion of $600,000 principal amount of new 7.5% convertible
debentures that we are issuing to certain holders of Series A Preferred
Stock as part of ourthe restructuring transaction in payment of certain
legal fees incurred by them, (iii) shares of our common stock issuable upon
conversion of our currently outstanding Series D Preferred Stock, and (v)
shares of our common stock issuable upon exercise of existing options or
warrants.
(M) Includes 228,300 shares underlying convertible debentures held by
Deutsche Bank AG, London Branch.
(N) Includes 152,200 shares underlying convertible debentures held by
ZLP Master Technology Fund, Ltd.
(O) Includes 448,376 shares underlying convertible debentures held by
Belmarken Holding B.V.
(P) Includes 121,760 shares underlying convertible debentures held by
Societe Generale.
(Q) Includes 176,633 shares underlying convertible debentures held by
Sorrento Holdings, L.L.C.
Item 5. Directors and Executive Officers
On May 31, 2003, our directors and executive officers were:
Name Age Position
---- --- --------
Phillip W. Arneson............ 66 Chief Executive Officer, President, and
Chairman of the Board (ii)
Donne F. Fisher............... 64 Director (i), (ii)
Robert L. Hibbard............. 50 Director (ii)
Larry J. Matthews............. 75 Director (i)
Gary M. Parsons............... 53 Director (i)
Joe R. Armstrong.............. 54 Chief Financial Officer
Richard L. Jacobson........... 60 Sr. Vice President, Legal and Secretary
----------
(i) member of the Audit Committee
(ii) member of the Compensation Committee
Our by-laws provide that the members of the Board of Directors will be
elected annually by our shareholders for one-year terms. Each director who is
not an employee of our company or our subsidiaries receives $1,000 for each
Board of Directors or committee meeting attended. Directors who serve as the
chairman of a committee receive an additional $500 for each committee meeting
attended. The Board of Directors has two committees: Audit and Compensation.
There are no family relationships between any directors and officers.
Phillip W. Arneson, has been our Chairman and Chief Executive Officer since
March 2002. He previously served as our President and Chief Operating Officer
from October 2001 until his appointment as Chairman and Chief Executive Officer.
He also has served as one of our directors since October 2000 and currently
serves on the Meret Communications, Inc. and Sorrento Networks, Inc. Boards of
Directors. From 1996 to 2001, Mr. Arneson held the position of
43
Executive Vice President for the privately held Frandsen Corporation, a
diversified financial and manufacturing company where he was responsible for
growing the enterprise through acquisitions, internal growth, and strategic
partnerships. Additionally, he served as President of two of its operating
companies. Mr. Arneson has served several public and private technology
companies in executive management, holding positions as Chief Executive Officer,
President and Group Vice President as well as having extensive experience as a
director of such companies. From 1982 to 1986, he served as Executive Vice
President of Allied Signal's Electronic Sector and as Chief Executive Officer of
its subsidiary, Amphenol Corp. In 1986, Mr. Arneson's technology group garnered
the prestigious IR-100 award for the development of an integrated fiber optics
phase modulator. Mr. Arneson holds a B.S. in Electrical Engineering from the
University of Minnesota's Institute of Technology and is a veteran, U.S. Marine
Corps.
Donne F. Fisher, has served as one of our directors since November 2001 and
is chairman of our Audit Committee. Mr. Fisher is currently President of Fisher
Capital Partners, Ltd., a private venture capital and investment company he
founded in 1991. From 1982 to 1996, Mr. Fisher held various executive officer
positions with Tele-Communications, Inc. ("TCI") and its subsidiaries including
Executive Vice President and Treasurer. He was a TCI director from 1980 until
1999 when TCI merged into AT&T Corporation. Since his retirement in 1996, Mr.
Fisher has been a consultant to TCI (now AT&T Broadband). Mr. Fisher also serves
as a director of Liberty Media Corporation, a former subsidiary of AT&T, and
General Communications, Inc., a diversified telecommunications provider.
Robert L. Hibbard, has served as one of our directors since November 2001
and is chairman of our Compensation Committee. Mr. Hibbard is an attorney and
management consultant in private practice, in which he handles a wide variety of
commercial matters including technology licensing and the structuring of merger
and acquisitions transactions. From 1997 to 1999, Mr. Hibbard was Chief
Executive Officer of Kim Technologies International, Inc., a privately held
developer of electromechanical "super" capacitors for wireless applications.
From 1994 to 1997, Mr. Hibbard was Vice President and General Counsel at Allied
Signal Engines, and from 1987 to 1994, Assistant General Counsel at Allied
Signal Aerospace. Mr. Hibbard holds a bachelors degree from Gustavus Adolphus
College and a J.D. from Marquette University Law School, where he was a member
of the Marquette Law Review.
Gary M. Parsons, has served on our Board of Directors since October 2000.
Since 1996, Mr. Parsons has held the position of Chairman of the Board for XM
Satellite Radio Holdings, Inc., and in October 2001 was named Chairman and Chief
Executive Officer of Mobile Satellite Ventures, LLP. From 1996 to April 2002,
Mr. Parsons served as Chairman of Motient Corporation, a wireless data firm. On
January 10, 2002, Motient filed a voluntary bankruptcy petition in connection
with a prearranged restructuring of its debt and emerged from bankruptcy on May
1, 2002. From 1990 to 1996, Mr. Parsons held a number of executive positions at
MCI Communications, Inc., including Executive Vice President, Chief Executive
Officer of MCI Metro, Inc., and President of MCI's Southern Division. From 1984
to 1990, Mr. Parsons held the responsibilities of Executive Vice President at
Telecom USA, a fiber-optic and long distance venture subsequently acquired by
MCI. Mr. Parsons holds a B.S. in Electrical and Computer Engineering from
Clemson University and a MBA from the University of South Carolina.
Larry J. Matthews, has served on our Board of Directors since August 2002.
Mr. Matthews was a co-founder of Zytec Corporation, a manufacturer of high
performance electronics for the telecommunications and computer industries. Mr.
Matthews served as an officer and director of
44
Zytec which grew from a start-up operation to a public company with revenues
exceeding $250 million annually during his tenure. In 1992, Zytec won the
National Baldridge Quality Award. A public offering of Zytec was completed in
1994. In 1997, Zytec merged with Computer Products Corporation to form Artesyn
Technologies (ATSN, NASDAQ). Mr. Matthews currently serves on Artesyn's board as
a director. He also serves on the Board of Veritec, Inc. (VRTC.OB, OTC BB), a
seller of microprocessor-based encoding and decoding systems products. From
January 1999 to June 2000, Mr. Matthews served as Veritec's Acting President and
Chief Executive Officer. Mr. Matthews holds a Bachelor of Engineering degree
from Iowa State University, and serves on the boards of several privately held
companies.
Joe R. Armstrong, has served as our Chief Financial Officer since January
2001. He brings over 25 years of corporate finance, investor relations,
treasury, legal and management experience to our company, having spent 15 years
with State Of The Art, a leading provider of accounting software. As chief
financial officer, vice president, finance and secretary of State Of The Art, he
managed two rounds of venture capital financing, the company's initial public
offering and several significant acquisitions and mergers. Prior to joining us,
Mr. Armstrong most recently served as CFO for The Bohlin Company. Previously, he
was director of marketing finance and financial planning for MAI Basic Four
Corporation and a certified public accountant for Vicenti, Lloyd and Stutzman, a
regional public accounting firm. Mr. Armstrong holds both bachelors and masters
degrees in business from Utah State University.
Richard L. Jacobson, has been our Senior Vice President, Legal and
Secretary since July 2000. Mr. Jacobson was a partner with the law firm of
Fulbright & Jaworski, LLP from 1990 to 2000 where his practice consisted
primarily of securities litigation and SEC enforcement matters. Prior to joining
Fulbright in 1988 he was in private practice in Palo Alto, California, from 1986
to 1988, and in Washington, D.C., from 1980 to 1986. From 1977 to 1979, Mr.
Jacobson worked for the SEC, where he was a member of the Trial Unit in the
Enforcement Division and served as Special Counsel to the Chairman. He served as
a law clerk for Ninth Circuit Judge Walter Ely from 1970 to 1971 and then
clerked for Associate United States Supreme Court Justice William O. Douglas
from 1971 to 1972. Mr. Jacobson holds a J.D. from the University of Southern
California and a S.B. from the University of Chicago.
Our other key employees include:
Name Age Position
---- --- --------
Darin L. Clause............... 34 Vice President, Strategic Sales
Subrata Datta................. 40 Vice President, Engineering
Demetri Elias, Ph.D........... 59 Vice President, Marketing
Mary A. Lay................... 46 Vice President, Finance
Jeff S. Phillips.............. 33 Vice President, Corporate Development
Mark W. Thurman............... 53 Vice President, Operations
Mitchell R. Truelock.......... 34 Vice President, Sales & Marketing
Li-Ran Wu..................... 50 Vice President, Management Software
45
Darin L. Clause has served as Vice President, Strategic Sales since
September 2000 and joined us in December 1999 as Director, Sales Development.
Prior to joining us, Mr. Clause was employed with Pirelli as a Senior Product
Manager from 1996 to 1999, where he was responsible for implementation of indoor
cabling and connectivity business lines for the CATV, CLEC, Utility and IXC
markets and multiple channels. From 1994 to 1996, Mr. Clause was a Project and
Sales Engineer for Sumitomo Electric Lightwave, where he was responsible for
fiber optic passive component sales. Mr. Clause holds a B.S. in Mechanical
Engineering from Clemson University.
Subrata Datta has served as Vice President, Engineering since November 2000
and joined upon our acquisition of Distributed Systems International, Inc. in
1996. From 1996 to 1999 he was responsible for all engineering development for
the LAN adapter and hub/switch products. Prior to joining, Mr. Datta helped
develop the ANSI FDDI and FDDI-II standards and design network components and
system-level products for DSI. Prior to DSI, Mr. Datta had extensive design
experience while working at AT&T Bell Laboratories on the 3B20 Duplex computer
system, based on highly fault tolerant architectures, high-reliability and
stringent up-time requirements. Before working for AT&T Bell Laboratories, Mr.
Datta worked for IBM's Yorktown Research Center where he focused on FDDI
development for their RS6000 workstation systems. Mr. Datta holds a M.S. and
B.S. in Electrical Engineering from the Cooper Union School of Engineering.
Demetri Elias, Ph.D. has served as Vice President, Marketing since October
2000 and joined us in April 2000 as Director, Product Line Management. Prior to
joining us, Sorrento, Dr. Elias was with Nortel Networks, a leading optical
equipment developer, for over 22 years holding positions in research and
development, consulting, product management and marketing. In his most recent
Nortel Networks assignments he served as Director, Product Line Management and
Director, Strategic Marketing on optical networking products. Dr. Elias holds a
Ph.D. in Electrical Engineering from McGill University, Montreal, Canada.
Mary A. Lay has served as Vice President, Finance since July 2002 and
joined us in March 2002 as Controller. Ms. Lay has also served as Meret's Chief
Financial Officer since July 2002. Prior to joining, Ms. Lay brings over 20
years of corporate finance, treasury and management experience to the Company.
Ms. Lay's previous experience includes contract and permanent position as
Corporate Controller and Chief Financial Officer at several companies including
On-Point Technology Systems, Inc., Curtis Coleman Company and Nexergy Tauber.
Ms. Lay holds a B.A. in Financial Accounting from National University, an M.B.A
from the University of Phoenix and is a certified public accountant.
Jeff S. Phillips has served as Vice President, Corporate Development since
January 2001. From 1995 to 2000, Mr. Phillips was a Vice President at US Bancorp
where he focused on financing for telecom related technology concerns and
advisory assignments. Prior to joining US Bancorp, Mr. Phillips was a financial
analyst/strategist with Hillebrand GmbH, a European investment group. Mr.
Phillips began his career as a floor trader at the London International
Financial and Futures and Options Exchange where he focused on Deutsche Mark
denominated financial derivatives. Mr. Phillips holds a B.A. in Economics from
the University of California at Berkeley.
Marc W. Thurman has served as Vice President, Operations since April 2001.
Mr. Thurman oversees our manufacturing and operations, supply chain management,
and quality assurance
46
functions. He brings to us nearly 25 years of manufacturing operations, supply
chain management and quality assurance experience on leading edge technologies
and products for the computer and telecommunication markets. Mr. Thurman's
previous experience includes service since 1971, in various functions at Packard
Bell NEC, ComCrypt Systems, IDEA Courier, Inc., Sidereal Corporation, Intel
Corporation, RTE Corporation, and Western Electric. In his most recent position,
Mr. Thurman had manufacturing responsibilities including internal production,
contract manufacturing (EMS) and third party manufacturing (TPM), supporting
revenues of $2 billion. Mr. Thurman holds a B.S. in Electrical Engineering from
Oregon State University as well as an M.B.A. degree from University of Portland.
Mitchell R. Truelock, has served as Vice President, Sales and Marketing
since February 2003 and is responsible for North American and Asia Pacific
sales, marketing, product management and customer support. Mr. Truelock joined
us in January 2003 as Vice President, Strategic Planning after having consulted
with us since August 2002. Prior to working with us, from February 2000 to
November 2001, Mr. Truelock was a Vice President in the communications equipment
group at Robertson Stephens, a technology investment bank. From June 1998 to
February 2000, Mr. Truelock was a Vice President in the technology group at Dain
Rauscher Wessels, a technology investment bank. From September 1995 to June
1998, Mr. Truelock was a corporate attorney at Cooley Godward LLP where he
focused on mergers and acquisitions, private financings and initial public
offerings for technology companies. Mr. Truelock holds an L.L.M. in corporate
securities at Georgetown University Law, a J.D. from Southern Methodist
University, and a BBA in accounting from the University of Texas at Austin.
Li-Ran Wu has served as Vice President, Management Software since November
2000 and joined us in October 1999. Before joining us, Mr. Wu was a senior
consultant and Lead Systems Engineer at Hitachi Telecom where he developed
second-generation SONET equipment to complement WDM and OXC products within the
OTN. He also developed the WDM information model that was published in 1998.
Prior to working at Hitachi, Mr. Wu was with Nortel Networks, Racal Datacom and
Taiwan Telecom. While at Nortel he developed a SONET UPSR-based communication
messaging protocol. Mr. Wu holds an M.S. in Electrical Engineering from North
Carolina State University and a B.S. in Computer Science from Chiao Tung
University. He has also completed work on his doctoral thesis at the Georgia
Institute of Technology.
47
Item 6. Executive Compensation
The following tables set forth the annual compensation for our Chief
Executive Officer ("CEO") for the fiscal year ended January 31, 2003, and for
our four most highly compensated executive officers (the "Named Executive
Officers"), other than the CEO, who were serving as executive officers at the
end of our fiscal year and whose salary and bonus exceeded $100,000.
Summary Compensation Table
Annual Compensation
--------------------------------------- All
Other Other
Annual Compensation
Salary Bonus Compensation ($) (B) (C) (D)
Name and Principal Position Year ($) ($) (A) ($) (E) (F)
--------------------------- ---- ------- ------- ------------ ---------------
Phillip W. Arneson, Chairman, Chief Executive
Officer......................................... 2003 245,387 205,000 -- 72,066
2002 60,582 25,000 -- 12,547
2001 -- -- -- --
Joe R. Armstrong, Chief Financial Officer.......... 2003 191,927 165,000 -- 20,962
2002 175,011 -- -- --
2001 -- -- -- --
Richard L. Jacobson, Sr. VP Legal and Secretary.... 2003 250,000 150,000 -- 19,231
2002 251,802 -- -- --
2001 140,850 -- -- 42,746
Jeff S. Phillips, VP Corporate Development......... 2003 170,019 68,000 -- 37,918
2002 170,019 10,000 62,339
2001 -- -- -- --
Darin L. Clause, VP Strategic Sales................ 2003 160,014 -- 79,393 8,400
2002 160,014 -- 158,399 77,211
2001 145,181 -- 51,101 51,740
(A) Bonus compensation represents performance and retention bonuses paid in
fiscal year 2003 and 2002. In fiscal year 2003 Mr. Arneson received the
final payment of $5,000 of his $30,000 signing bonus per his employment
contract which took effect October 2001, a performance bonus of $125,000
and a retention bonus of $75,000. Mr. Armstrong received a performance
bonus of $105,000 and a retention bonus of $60,000. Mr. Jacobson received a
$75,000 performance bonus and a $75,000 retention bonus. Mr. Phillips
received a $51,000 performance bonus and a $17,000 retention bonus.
In fiscal year 2002, Mr. Arneson received a signing bonus per his
employment contract which took effect October 2001 of $25,000 and Mr.
Phillips received a $10,000 performance bonus.
48
(B) Other compensation for Mr. Arneson for fiscal year 2003 consists of
temporary living expenses paid by the company of $48,930 and vacation
accrual buy-out of $23,237. In fiscal year 2002 Mr. Arneson had temporary
living expenses of $12,547.
(C) Other compensation for Mr. Armstrong represents vacation accrual buy-out.
(D) Other compensation for Mr. Jacobson represents vacation accrual buy-out in
fiscal year 2003 and relocation related expenses reimbursed by us in fiscal
year 2001.
(E) Other compensation for Mr. Phillips represents living expenses of $37,918
and $55,800 for fiscal years 2003 and 2002 respectively, and vacation
accrual buy-out of $6,539 in fiscal year 2002.
(F) Other compensation for Mr. Clause represents car allowance of $8,400,
$7,200 and $2,400 for fiscal years 2003, 2002 and 2001 respectively. Mr.
Clause had relocation expenses reimbursed by us of $70,011 and $49,340 for
fiscal years 2002 and 2001 respectively.
Key Employee Retention and Incentive Plan:
In November 2002, our Board of Directors, acting on a recommendation of the
Compensation Committee and in consultation with Towers Perrin, a national
executive compensation accounting firm, approved our "Key Employee Retention and
Incentive Plan." The purpose of this plan is to provide a means whereby we can
achieve the ongoing retention of certain key employees and certain management
personnel. In addition, the plan also provides for granting incentive based
awards for the achievement of our goals and objectives along with recognition
for the participant's continued contributions to our company. In the past we had
no such formal plan.
A portion of the retention plan approved by our Board provides for certain
economic benefits to be paid to participants upon a change of control or merger
of our company. Management participants in the retention plan include our Chief
Executive Officer, Chief Financial Officer and Senior Legal Counsel, each of
whom have waived their rights to compensation benefits that could or would be
triggered under this plan related to our upcoming capital restructuring efforts.
Long-Term Incentive Plans
We have no long-term incentive plans other than our various stock option
plans.
Option Grants -- Year Ended January 31, 2003
There were no option grants exercised for the year ended January 31, 2003
for any of the Named Executive Officers.
Aggregated Option/SAR Exercises
The following table sets forth information concerning each exercise of
stock options during the year ended January 31, 2003 by each of the Named
Executive Officers and the January 31, 2003 value of unexercised options.
49
Aggregated Option Exercises in Fiscal Year 2003 and January 31, 2003
Option Values
Number of
Securities Underlying Value of Unexercised
Shares Unexercised Options In-the-Money Options
Acquired On Value at Fiscal Year-End ($) at Fiscal Year-End (#) (A)
Exercise Realized --------------------------- ---------------------------
Name (#) ($) Exercisable Unexercisable Exercisable Unexercisable
---- ----------- -------- ----------- ------------- ----------- -------------
Phillip W. Arneson.......... -- -- 16,833 3,750 -- --
Joe R. Armstrong............ -- -- 8,875 9,125 -- --
Richard L. Jacobson......... -- -- 10,760 5,940 -- --
Jeff S. Phillips............ -- -- 4,805 2,695 -- --
Darin L. Clause............. -- -- 2,021 2,021 -- --
(A) Options are "in-the-money" if, on January 31, 2003, the market price of our
common stock ($6.33) exceeded the exercise price of such options. The value
of such options is calculated by determining the difference between the
aggregate market price of our common stock covered by such options on
January 31, 2003, and the aggregate exercise price of such options. As of
January 31, 2003 there were no options held by executive officers or
management that were exercisable at $6.33 or less.
Employment Agreements
On March 1, 2002 Mr. Arneson assumed the role as our Chairman, President
and Chief Executive Officer. On April 30, 2002, our Board of Directors approved
an employment agreement with Mr. Arneson regarding the terms of his employment
as Chairman, Chief Executive Officer and President and which superseded his
August 2002 contract. The agreement provides for an annual compensation of
$250,000. The agreement also calls for the vesting, as of March 1, 2002, of the
6,250 options granted Mr. Arneson on September 17, 2001, and the granting of
23,750 additional stock options (adjusted for the 1-for-20 reverse split) at a
strike price equal to the closing price of our common stock on Nasdaq on March
1, 2002, which shares are to vest at the rate of 1,000 shares per month
beginning on April 1, 2002, continuing for 12 months, when 5,000 additional
shares vest, and beginning on May 1, 2003, 1,125 shares will vest each month.
The employment is at will; however, if Mr. Arneson should be terminated without
cause or resign in certain circumstances, he would receive a lump sum severance
payment of two years' base salary and vesting of all stock options, and health
and life benefits; he would be required to provide exclusive consulting services
for two years following his termination. The agreement also calls for the
reimbursement of living expenses in San Diego at the rate of $2,750.00 per month
while Mr. Arneson remains employed.
50
In May 2002, we entered into an employment agreement with Mr. Armstrong,
our Chief Financial Officer, which provides for an annual salary of $200,000 per
year plus bonus of $20,000 to paid in lump-sum in June 2002, and 10,500 options
(adjusted for the 1-for-20 reverse split) to acquire our common stock, which
vest over two years. The contract is for no specified term and Mr. Armstrong is
an at-will employee such that we or Mr. Armstrong may terminate employment at
any time, with or without cause or notice, and with or without reason, subject
to the rights and obligations as provided in the contract. However, should Mr.
Armstrong be terminated without cause he will receive a lump-sum severance
payment of one year's salary, health and life benefits for one year and vesting
of all his options. In the event of a change of control, merger or sale of our
company, Mr. Armstrong is entitled to receive an immediate payment equal to one
year's salary, health and life benefits for one year and vesting of all his
options.
In July 2002, we entered into an employment agreement with Mr. Jacobson
which provides for an annual salary of $250,000 per year and 9,000 options
(adjusted for the 1-for-20 reverse split) to acquire our common stock, which
vest over two years. The contract is for no specified term and Mr. Jacobson is
an at-will employee such that either we or Mr. Jacobson may terminate employment
at any time, with or without cause or notice, and with or without reason,
subject to the rights and obligations as provided in the contract. However,
should Mr. Jacobson be terminated without cause he will receive a lump-sum
severance payment of six month's salary and vesting of all his options. In the
event of a change of control, merger or sale of our company, Mr. Jacobson is
entitled to receive an immediate payment equal to six month's salary and vesting
of all his options.
On January 25, 2002, the then Directors of Meret Optical Communications,
Mr. Cheng and Mr. Sue, approved an employment agreement with Mr. Rajadhyksha
appointing him President of Meret and raising his annual salary to $210,000 per
year. In addition to the increase in salary there were provisions for severance
benefits based upon termination without cause or change in control of Company.
Severance benefits for termination without cause or change in control provisions
allow Mr. Rajadhyksha to receive a lump sum payment of up to one year's salary
and the vesting of all his options to acquire our common stock. As of August 27,
2002 Mr. Rajadhyksha was no longer with our company and he was paid severance
benefits of $28,270 in full settlement.
Our then Board of Directors approved a two-year employment contract with
Mr. Mason ending May 2002, which provided for a base salary of $130,900 per year
and vesting of all his options to acquire our common stock granted prior to
February 1, 2000. This contract could be terminated for cause. However, were Mr.
Mason to be terminated without cause or resign in certain circumstances prior to
the end of the contract term he was entitled to receive a continuation of his
base salary and benefits for two years, vesting of all his options to acquire
our common stock, and he would be contractually required to provide consulting
services to us during the two years following his termination. In March 2002 Mr.
Mason notified us that he was resigning with cause, relying on an agreement
between Mr. Mason and Dr. Cheng in April 2001 that allowed him to resign for
cause at any time prior to the expiration of his employment agreement as a
result of having been relocated more than 35 miles from his prior employment
location. Mr. Mason's resignation under these circumstances entitled him to
receive two year salary and benefit continuation and immediate stock vesting
which agreed to provide on the condition that Mr. Mason sign our standard
employee confidentially, proprietary and invention
51
agreement. Mr. Mason refused to sign the confidentiality agreement and also
refused to return valuable company property in his possession. As a result we
stopped payments to Mr. Mason and have sought recovery of sums already paid to
Mr. Mason under his consulting agreement. Mr. Mason is seeking acceleration of
his extended employment benefits.
Our then Board of Directors approved a two-year employment contract with
Mr. Sue ending May 2002, which provided for a salary of $168,500 per year and
the vesting of all his options to acquire our common stock granted prior to
February 1, 2000. This contract could be terminated for cause. However, were Mr.
Sue to be terminated without cause or resign in certain circumstances prior to
the end of the contract term he was entitled to receive a continuation of his
salary and benefits for two years, vesting of all his options to acquire our
common stock and could be contractually required to provide consulting services
to us during that period. On May 8, 2002 Mr. Sue resigned from his position
effective May 17, 2002 alleging entitlement to the foregoing salary continuation
and other benefits. We do not believe Mr. Sue is entitled to any such benefits.
In June, 2002 Mr. Sue filed a complaint in arbitration against us to seek
entitlement to his salary continuation. We are opposing the complaint and have
filed counter claims against Mr. Sue for certain breaches of his duties as an
officer and employee of the company.
Our then Board of Directors entered into a two-year employment contract
with Mr. Nimrod Johnson, Corporate Controller, ending May 22, 2002, which
provided for a salary of $97,307 per year and the vesting of all his options to
acquire our common stock. This contract could be terminated for cause. However,
were Mr. Johnson to be terminated without cause or resign in certain
circumstances prior to the end of the contract term he was entitled to receive a
continuation of his salary and benefits for two years, vesting of all his
options to acquire our common stock and could be contractually required to
provide consulting services to us during that period. On May 9, 2002 Mr. Johnson
resigned from his position effective May 17, 2002 alleging entitlement to the
foregoing salary continuation and other benefits. We do not believe Mr. Johnson
is entitled to any such benefits. In June, 2002 Mr. Johnson filed a complaint in
arbitration against seeking entitlement to his salary continuation and benefits.
Compensation Committee Report
The following report shall not be deemed incorporated by reference by any
general statement incorporating by reference this registration statement on Form
10 into any filing under the Securities Act of 1933 or under the Securities
Exchange Act of 1934, except to the extent we specifically incorporate this
information by reference, and shall not otherwise be deemed filed under such
Acts.
The Compensation Committee currently consists of Donne F. Fisher, Robert L.
Hibbard and Phillip W. Arneson. The Compensation Committee reviews, recommends
and approves changes to our compensation and benefits policies and programs,
makes recommendations to the Board for options granted under our plans and is
responsible for reviewing and approving the compensation for our executive
officers and certain of our senior management. A majority of the Committee is
neither our employees nor our former employees nor are they eligible to
participate in any of our executive compensation programs. Mr. Arneson does not
participate in meetings of the Committee concerning his compensation.
52
We have developed and are developing compensation programs designed to
reflect our performance and to be competitive in the marketplace. In designing
compensation programs, we attempt to reflect both value created for shareholders
while supporting our strategic goals. The goals of our short-term and long-term
compensation programs are to:
Attract, retain and motivate a high caliber executive leadership team and
employee group;
Provide competitive base salaries in keeping with a philosophy of career
continuity;
Align executive compensation with shareholder interests;
Support our short-term and long-term strategic goal and objectives;
Promote our value and reward individuals for outstanding contributions to
our success.
The nature of our business requires a technologically innovative personnel
team to make a long-term commitment to our growth. Accordingly, we grant
incentive awards primarily in the form of stock options with view towards
long-term corporate performance. These awards may not fluctuate as much as
year-to-year financial results. Under our programs, a substantial portion of
senior executives' potential compensation depends on increases in shareholder
value.
We pay for performance on the basis of an individual's level of
responsibility. For this purpose, performance means both individual and
corporate performance. Individual performance includes the ability to put our
business plans into effect and to react to unanticipated events. We base
compensation decisions for all employees, including the executive officers on
these criteria.
Our executive compensation is based upon three components, base salary,
short-term incentive awards and long-term incentives, which are intended to meet
our compensation program goals.
Base Salary
In keeping with the long-term and highly technical nature of our business,
we take a long-term approach to management development. This career-oriented
philosophy requires a competitive base salary. We base our salary structure on
competitive positioning (comparing our salary structure with salaries paid by
comparable companies), our own business performance, and general economic
factors, and increases in the individual's responsibilities, whether through
promotions or otherwise. Specific weights are not given to these factors, but
competitive positioning is the most important factor. Within the comparable
salary ranges, we determine individual senior management salaries based on
individual performance, level of responsibility, and experience.
Short-Term Incentive Awards
Our short-term incentive awards are discretionary. When deemed appropriate,
they are designed to reflect the officer's contribution to the overall success
of the organization and also consider the long-range impact of near-term
decisions and contributions. Any award an
53
executive receives depends on his/her individual performance and level of
responsibility. Both objective and subjective measures are considered. These
include, but are not limited to: sales, profit margins, operating expense, net
income, working capital, individual initiative, business judgment, technical
expertise and operational excellence.
Long-Term Incentive Awards
Long-term incentive awards are intended to develop and retain strong
management through share ownership and incentive awards that recognize future
performance. At present, stock options are the only long term incentive granted
to executive officers and all our employees. The Committee believes that a
significant portion of senior management's compensation should depend on value
created for the shareholders. Options are an excellent way to accomplish this
because they tie management's interests directly to the shareholders' interests.
The number of options granted to senior management is based on individual
performance and level of responsibility. For this purpose, the Committee
measures performance the same way as described above for short-term awards.
Option grants must be sufficient in size to provide a strong incentive for
executives to work for long-term business interests and become significant
owners of our company.
Compensation of the Chief Executive Officer
For fiscal year 2002, Mr. Arneson earned a base salary pursuant to the
terms of his employment agreement, outlined above. In addition, he was paid the
final payment of $5,000 of his $30,000 signing bonus per his employment contract
which took effect October 2001, a performance bonus of $125,000 and a retention
bonus of $75,000.
Stock Option Exchange Offer
To address the needs of our employees, to retain talented employees, and to
keep our employees motivated, the Compensation Committee approved a stock option
exchange program. The stock option exchange offer was a voluntary program that
allowed eligible employees to exchange some or all of their eligible underwater
stock options that had an exercise price greater than or equal to $7.50 per
share (before giving effect to our 1-for-20 reverse stock split in October 2002)
for our FIBR shares and all options granted by our subsidiary Sorrento Networks,
Inc., options regardless of exercise price, for the opportunity to receive an
option for a smaller number of shares at a current market price. Eligible
employees were required to declare their election to participate in the program
before May 17, 2002, at which time the options they elected to exchange were
cancelled. In order for the company to avoid adverse accounting treatment, the
new grant was awarded after the expiration of six months and one day following
the day the exchanged options were cancelled.
All new options granted in the stock option exchange program were vested to
the same degree that the cancelled options would have been vested on the
replacement grant date, with the remaining unvested portion of each new option
grant vesting after the replacement grant date in accordance with the vesting
schedule of the cancelled options for which the new grant was exchanged.
54
Our then current and former directors and executive officers, and key
management were not eligible to participate in the stock option exchange
program.
We believe the actions we have taken over the past fiscal year have aligned
with our objectives and were appropriate to attract, retain and motivate the
talent we need to execute our restructuring plan and restore value to our
shareowners.
Phillip W. Arneson
Robert L. Hibbard
Donne F. Fisher
Item 7. Certain Relationships and Related Transactions
In February 2003 we entered into a consulting agreement with Mr. Robert
Hibbard, to provide services to the Board of Directors and management of our
company at a consulting rate of $175 per hour and a retainer of $20,000 per
month for six months. Mr. Hibbard agrees to make himself available to us for not
less than 20 hours per week. The term of this agreement is for twelve months,
but may be terminated after six months by either party, with or without cause,
upon 5 days written notice. This agreement supersedes his August 2002 consulting
agreement. Nearly all of Mr. Hibbard's consulting work for us has involved
matters being considered or reviewed by the Board or by committees of the Board.
His work has included structuring and implementing our 2003 Equity Incentive
Plan, participation in settlement negotiations for pending litigation,
assistance in our capital restructuring and improving our intellectual property
policies and procedures, among other matters. In fiscal year 2003 Mr. Hibbard
was paid $91,836 in consulting fees.
During July 2000 we agreed to loan $300,000 for three years at the
applicable federal rate provided for in Internal Revenue Code Section 1274 to
Mr. Jacobson in connection with accepting employment as our Senior Vice
President, Legal. This is a full recourse loan and Mr. Jacobson has pledged his
options to acquire our common stock and any options he may receive from any of
our subsidiaries as collateral. Mr. Jacobson has received $300,000 in advances
under this loan agreement for which the interest rate is 6.6%. On July 3, 2002 a
new note covering the $300,000 was incorporated in Mr. Jacobson's employment
contract. The term remained the same as the July 2000 note, with all unpaid,
accrued interest and principal due and payable on August 30, 2003. In December
2002, Mr. Jacobson paid $39,330 on his loan that included payment of all prior
interest due and the remainder applied to his principal balance. As of January
31, 2003 Mr. Jacobson's loan outstanding to our company totaled $297,961.
During June 2000, we entered into various agreements with Par Chadha, our
former CEO and Chairman, which, among other matters, provided for payments of
$250,000 per year for three years of consulting services and loans by us for the
exercise of previously granted options to acquire 58,925 options at prices
varying from $140.60 to $985.00 per share. As the members of our Board of
Directors at the time of his resignation ceased to represent more than 50% of
the Board in October 2000, all payments for consulting services were accelerated
and no future consulting services are required. During October 2000, Mr. Chadha
exercised 3,556 options, applying the $500,000 accelerated payment to the
exercise. In addition, he exercised 25,369 options for which we were
contractually obligated to loan the $5.0 million due on their exercise.
55
Mr. Chadha provided us with written notification dated in September 2001 that he
does not have any obligations under the agreements. We have notified him that we
do not agree with his interpretation of his repayment obligations under the
terms of the agreements.
During December 2001, we entered into an agreement whereby the 25,369
option exercise was rescinded. Mr. Chadha returned the 25,369 shares to us for
cancellation and we cancelled the receivable due from him and restored the
original option agreements. In June 2002, we filed with the Superior Court of
California, County of Los Angeles a Complaint for Declaratory Relief regarding
the interpretation of the agreement. Also in June 2002, Mr. Chadha filed a
lawsuit against us in the Superior Court of California, County of Los Angeles,
seeking declaratory relief with respect to the interpretation of his separation
agreement and in addition, alleging breach of contract with respect to his
option exercise rights and fraud in connection with his rescission agreement. In
February 2003, both of these lawsuits were dismissed without prejudice to
facilitate settlement negotiations, but they can be refiled at any time. In
April 2003, an agreement in principle to settle these lawsuits was reached,
subject to the execution of a definitive agreement. There can be no assurance
that such a definitive settlement agreement will be executed. Should the cases
be refiled, and should Mr. Chadha prevail in court, in addition to any other
relief that may be granted, we may be required to issue him 58,925 shares of our
stock for no consideration, and/or pay him cash damages, which he alleges to be
in excess of $4 million.
In November 2001, we acquired in a like kind exchange furniture having an
approximate current value of $8,000 from Digital Boardwalk, Inc. ("DBI") which
is an affiliate of Par Chadha, our former Chairman and CEO. Also, during the
fourth quarter of fiscal 2002, our Meret subsidiary retained DBI to consult on
various matters, for which DBI charged a consulting fee of approximately
$49,000, and our Sorrento Networks, Inc.subsidiary retained DBI to consult on a
matter for which DBI charged a consulting fee of approximately $7,000.
On September 30, 2001, our then Chairman and CEO executed a two year
consulting agreement with Leonard Hecht whereby Mr. Hecht was to be paid a
salary at $250,000 per year plus benefits and the vesting of all his options to
acquire our common stock. We have since stopped making payments under this
agreement, and have been notified by Mr. Hecht that he believes we have thereby
breached this agreement.
In September 2000, our then Board of Directors approved a two year
consulting agreement with Rohit Phansalkar whereby he is paid a salary of
$250,000 per year plus benefits and the vesting of all his options to acquire
our common stock. This contract was amended July 21, 2001.
During fiscal 2002, we paid a total of $55,218 to Phillip W. Arneson as one
of our directors. The amounts paid included $23,500 for consulting work
performed for a special Committee of the Board, $20,760 for various other
consulting services including outsourcing advice and organizational matters,
attendance fees of $6,000 for Board and Committee meetings and $4,958 in
reimbursable expenses. Consulting fees were paid at a rate equal to normal fees
for attendance at Board meetings.
During fiscal 2001, we entered into employment agreements with Mr. Hecht,
Mr. Phansalkar, Mr. Sue, and Mr. Jacobson which provide for loans to the
employees to exercise stock options to acquire our common stock and the stock of
our subsidiaries including any
56
required tax withholdings due upon exercise. The loans are for a period not to
exceed two years at the applicable federal rate, are full recourse and require
the pledge of shares issued upon exercise. Currently, no such loans are
outstanding.
Item 8. Legal Proceedings
On September 10, 2001, holders of a portion of the outstanding Series A
Preferred Stock of our Sorrento Networks, Inc. ("SNI") subsidiary obtained a
preliminary injunction from the Delaware Court of Chancery prohibiting it from
issuing further shares of its Series A Preferred Stock or incurring any
additional debt without the consent of the holders of a majority of the
outstanding shares of such Series A Preferred Stock. On January 23, 2002, the
Delaware Supreme Court affirmed the granting of the preliminary injunction.
On October 19, 2001, an amended complaint was filed in the injunction
action adding as named defendants, our company, our Meret subsidiary, certain of
our present and former officers and directors and of our subsidiaries as well as
our investment bankers. The amended complaint also added, among other things,
claims for fraud, securities fraud, breach of fiduciary duty, conspiracy, and
intentional interference with contract as well as requesting the appointment of
a receiver for our SNI, all of which claims are based on alleged wrongs
committed in connection with or since the Series A placement. SNI and the
original individual defendants have all answered this amended complaint denying
all allegations of wrongdoing. The new defendants have all moved to dismiss the
amended complaint. Management believes the allegations contained in the amended
complaint are without merit.
On December 14, 2001, plaintiffs filed motions to sequester the common
stock of SNI that are owned by Meret, and the Sorrento Series A Preferred Stock
that we own, as an alternative method of obtaining jurisdiction over us and
Meret in the Delaware litigation. Management also believes that these motions
are without merit.
Currently, hearings on all pending motions have been taken off calendar at
the request of all parties, pending the resolution of ongoing settlement
discussions between our company and the plaintiffs. Section 8.3 of the Exchange
Agreement, as amended, entered into in connection with our proposed capital
restructuring provides that this litigation will be dismissed with prejudice
against our company, our subsidiaries, and our current officers and directors
and any other defendants who execute and deliver a release, and without
prejudice against all other defendants, following the closing of the
restructuring transaction.
During June 2000, we entered into various agreements with Par Chadha, our
former CEO and Chairman, which, among other matters, provides for payments of
$250,000 per year for three years of consulting services and loans by us for the
exercise of previously granted options to acquire 58,925 options at prices
varying from $140.60 to $985.00 per share. As the members of our Board of
Directors at the time of his resignation ceased to represent more than 50% of
the Board in October 2000, all payments for consulting services were accelerated
and no future consulting services are required. During October 2000, Mr. Chadha
exercised 3,556 options, applying the $500,000 accelerated payment to the
exercise. In addition, he exercised 25,369 options for which we were
contractually obligated to loan the $5.0 million due on the exercise. Mr. Chadha
provided us with written notification dated in September 2001 that he does not
have any obligations under the agreements. We notified him that we do not agree
with his interpretation of his repayment obligations under the terms of the
agreements.
57
During December 2001, we entered into an agreement whereby the 25,369
option exercise was rescinded. Mr. Chadha returned the 25,369 shares to us for
cancellation and we cancelled the receivable due from him and restored the
original option agreements. In June 2002, we filed with the Superior Court of
California, County of Los Angeles a Complaint for Declaratory Relief regarding
the interpretation of the agreement. Also in June 2002, Mr. Chadha filed a
lawsuit against us in the Superior Court of California, County of Los Angeles,
seeking declaratory relief with respect to the interpretation of his separation
agreement and in addition, alleging breach of contract with respect to his
option exercise rights and fraud in connection with his rescission agreement. In
February 2003, both of these lawsuits were dismissed without prejudice to
facilitate settlement negotiations, but they can be refiled at any time. In
April 2003, an agreement in principle to settle these lawsuits was reached,
subject to the execution of a definitive agreement. There can be no assurance
that such a definitive settlement agreement will be executed. Should the cases
be refiled, and should Mr. Chadha prevail in court, in addition to any other
relief that may be granted, we may be required to issue him 58,925 shares of our
stock for no consideration, and/or pay him cash damages, which he alleges to be
in excess of $4 million.
In April 2002, our former Chairman and Chief Executive Officer, Dr. Xin
Cheng, who was terminated without cause, filed a claim in arbitration seeking,
among other things, payment of $500,000 and acceleration of the vesting of
options pursuant to alleged contractual obligations of SNI. The arbitrator has
issued a decision favorable to Dr. Cheng, and having exhausted our legal
remedies, we have paid Dr. Cheng $610,000 in full satisfaction of the
arbitration award.
In addition, claims in arbitration have been filed by two of our former
financial officers and employees who worked in our Santa Monica office, which
has now been closed, alleging that their resignations in May 8, 2002 were for
"good reason" as defined in their employment agreements, all of which were to
expire on May 22, 2002. We are disputing these claims, and have filed
counterclaims in one of the arbitrations. The aggregate amount of these claims
is in excess of $490,000.
We filed a lawsuit against United Pan Europe Communications, N.V., one of
our customers and a related party to one of SNI's Series A shareholders, in
connection with a past due receivable in the amount of $1.6 million for
equipment shipped in 2000. The defendant has filed for protection under the
federal bankruptcy laws, and pursuant to the Exchange Agreement entered into in
connection with our capital restructuring, we have executed a definitive
settlement agreement and a stipulation of dismissal with prejudice resolving
this lawsuit in return for a payment of $350,000 and the return of certain of
the equipment previously shipped. We have received the payment of $350,000 from
UPC and, in accordance with the terms of the Exchange Agreement, have paid that
same amount to certain Series A Preferred Stock holders to defray legal costs
incurred by them. The equipment has also been returned.
We have been sued by a former officer of SNI alleging breach of a
consulting agreement we entered into with him in March 2002, following his
resignation "for good reason" as defined in his employment agreement. Our
execution of the consulting agreement, upon resignation "for a good reason" was
required by the employment agreement, which had been approved by our then Board
of Directors in the summer of 2000. The former officer is seeking acceleration
of consulting fees due to him under his consulting agreement in the amount of
$229,000. We feel these claims are without merit and are vigorously defending
the claims. We have also filed counterclaims. Currently, the matter is in the
early stages of discovery.
58
From time to time, we are involved in various other legal proceedings and
claims incidental to the conduct of our business. Although it is impossible to
predict the outcome of any outstanding legal proceedings, we believe that such
legal proceedings and claims, individually and in the aggregate, are not likely
to have a material effect on our financial position, results of operations, or
cash flows.
Item 9. Market Price of and Dividends on the Registrant's Common Equity and
Related Stockholder Matters
Our common stock traded on the Nasdaq SmallCap Market under the symbol FIBR
since 1994. On December 16, 1998, we commenced trading on the Nasdaq National
Market System under the same symbol.
Effective October 28, 2002 we implemented a one-for-twenty reverse split of
our outstanding shares of common stock. No fractional shares were issued in
connection with the reverse stock split. In lieu of fractional shares,
shareholders received a cash payment based on the market price, after adjustment
for the effect of the stock combination. The par value of the common stock
changed to $6.00 per share and the number of authorized shares decreased from
150 million to 7.5 million shares of common stock. The reverse stock split also
affects options, warrants and other securities convertible into or exchangeable
for shares of our common stock that were issued and outstanding immediately
prior to the effective time of the stock combination. Preferred stock was not
affected.
The following table sets forth the high and low closing bid prices for our
common stock in the over-the-counter market from February 1, 2001 to January 31,
2003, based upon information obtained from Nasdaq. Quotations represent
inter-dealer prices; they do not include retail markups, markdowns, or
commissions; and they may not represent actual transactions.
Fiscal 2001-2002 High Low
---------------- ------- -------
Quarter from February 1, 2001 to April 30, 2001......... $510.00 $ 78.20
Quarter from May 1, 2001 to July 31, 2001............... $323.80 $110.60
Quarter from August 1, 2001 to October 31, 2001......... $160.40 $ 33.40
Quarter from November 1, 2001 to January 31, 2002....... $101.20 $ 64.20
Fiscal 2002-2003
----------------
Quarter from February 1, 2002 to April 30, 2002......... $ 73.20 $ 40.00
Quarter from May 1, 2002 to July 31, 2002............... $ 53.00 $ 13.20
Quarter from August 1, 2002 to October 31, 2002......... $ 14.80 $ 2.40
Quarter from November 1, 2002 to January 31, 2003....... $ 15.07 $ 4.15
On March 31, 2003, the average of the high and low bid quotation for our
common stock was $7.00 per share. There is no assurance that a market in our
common stock will continue.
Approximate Number of Holders of Common Stock
As of May 31, 2003, (the latest practicable date) there were
approximately 756 shareholders of record, including brokerage firms and
nominees, of our common stock.
59
Dividends
We have never paid any cash dividends on our common stock. The present
policy of our Board of Directors is to retain all available funds to finance the
planned level of operations. In light of the anticipated cash needs of our
business, it is not anticipated that any cash dividends will be paid to the
holders of our common or preferred stock in the foreseeable future.
Securities Authorized For Issuance Under Equity Compensation Plans
The following table provides information as of January 31, 2003 regarding
compensation plans (including individual compensation arrangements) under which
our equity securities and those of SNI are authorized for issuance.
Number of
Securities To Number of Securities
Be Issued Upon Remaining Available for
Exercise Weighted-Average Future Issuance Under
Of Outstanding Exercise Equity
Options, Price of Outstanding Compensation Plans
Warrants and Options, (Excluding Securities
Rights Warrants and Rights Reflected in Column (a))
-------------- -------------------- ------------------------
Plan Category (a) (b) (c)
Equity Compensation Plans
Approved by security
Holders * (FIBR)............ 294,277 $387.53 260,723
Equity Compensation Plans not
Approved by Security
Holders (SNI)............... 3,296,003 $ 4.93 20,000,000
Total.......................... 3,590,280 $ 36.29 20,260,723
* As adjusted for stock splits.
See Note K to the Consolidated Financial Statements for information regarding
the material features of the above plans. Each of the above plans provides that
the number of shares with respect to which options may be granted, and the
number of shares of common stock subject to an outstanding option, shall be
proportionally adjusted in the event of a subdivision or consolidation of shares
or the payment of a stock dividend on common stock, and the purchase price per
share of outstanding options shall be proportionately revised.
Item 10. Recent Sales of Unregistered Securities
During fiscal year 2003 we did not issue any shares of our common stock
that were not registered under the Securities Act of 1933. See Item 2,
Financial Information for previous years.
Item 11. Description of Registrant's Securities to be Registered.
We are registering hereunder warrants to purchase approximately 591,000
shares of our common stock, which have a par value of $0.001 per share. We
expect to issue the warrants to our shareholders of record on May 28,
60
2003. The warrants will be issued as of the closing date of our upcoming
restructuring transaction, June 4, 2003. The exercise price of the warrants
is $5.96.
The warrants are non-transferable, and may be exercised at any time after
the first anniversary date of the restructuring transaction and before August 2,
2007. We have the right to repurchase the warrants upon 30 days prior notice,
for $0.01 per warrant share, at any time after the volume-weighted average
market price of our common stock for any ten consecutive trading days equals or
exceeds 150% of the exercise price. Exercise of the warrants is subject to the
effectiveness of a registration statement with respect to the shares of our
common stock to be issued upon exercise of the warrants. We anticipate filing a
registration statement registering the shares of our common stock for which the
warrants are exercisable prior to the first year anniversary of the closing date
of the restructuring transaction.
Item 12. Indemnification of Directors and Officers
Our Certificate of Incorporation permits indemnification to the
fullest extent permitted by Delaware law. Our bylaws require us to
indemnify any person who was or is a party or is threatened to be
made a party to any proceeding, by reason of the fact that such
person was or is our director or officer or that, being or having been
such a director or officer, such person is or was serving at our request as
a director, officer, employee or agent of another business entity, against
expenses, judgments, penalties, fines and amounts paid in settlement actually
and reasonably incurred by such person in connection with such proceeding
if such person acted in good faith and in a manner such person reasonably
believed to be in, or not opposed to, our best interests and, with respect
to any criminal third party proceeding (including any action or investigation
which could or does lead to a criminal third party proceeding) had no
reasonable cause to believe such conduct was unlawful. We may also
indemnify any person who was or is our authorized representative and who
was or is a party or is threatened to be made a party to any proceeding by
reason of the fact that such person was or is an authorized representative,
against expenses actually and reasonably incurred by such person in connection
with the defense or settlement of such proceeding if such person acted in good
faith and in a manner reasonably believed to be in, or not opposed to, our best
interests, except that no indemnification shall be made in respect of any claim,
issue or matter as to which such person shall have been adjudged to be liable to
us unless and only to the extent that the court in which such corporate
proceeding was pending shall determine upon application that, despite the
adjudication of liability but in view of all the circumstances of the case, such
authorized representative is fairly and reasonably entitled to indemnity for
such expenses which the court shall deem proper. Such indemnification is
mandatory under the our by-laws as to expenses actually and reasonably incurred
to the extent that our authorized representative has been successful on the
merits or otherwise in defense of any third party or corporate proceeding or in
defense of any claim, issue or matter therein. The determination of whether an
individual is
61
entitled to indemnification may be made by a majority of disinterested
directors, independent legal counsel in a written legal opinion or the
shareholders.
The Delaware General Corporation Law authorizes a corporation to indemnify
directors, officers, employees or agents of the corporation if such party acted
in good faith and in a manner he or she reasonably believed to be in or not
opposed to the best interest of the corporation and, with respect to any
criminal action or proceeding, had no reason to believe his or her conduct was
unlawful, as determined in accordance with Delaware General Corporation Law.
Delaware law further provides that indemnification shall be provided if the
party in question is successful on the merits otherwise. In addition, Delaware
General Corporation Law does not permit indemnification in an action or suit
by or in the right of the corporation, where such person has been adjudged
liable to the corporation, unless, and only to the extent that, a court
determines that such person fairly and reasonably is entitled to indemnity for
costs the court deems proper in light of liability adjudication. Indemnity is
mandatory to the extent a claim, issue or matter has been successfully defended.
We currently maintain a directors and officers liability insurance policy.
Item 13. Financial Statements and Supplementary Data
Unaudited Quarterly Financial Data (Unaudited)
(Amounts in thousands, except per share amounts.)
First Second Third Fourth
Quarter Quarter Quarter Quarter Year
------- -------- -------- -------- --------
Year ended January 31, 2004:
Net sales.......................... $ 7,861
Gross profit (loss)................ 1,954
Income (loss) from operations...... (3,618)
Net income (loss).................. (6,222)
Net income (loss) per share:
Basic........................... (7.02)
Diluted......................... (14.33)
Year ended January 31, 2003:
Net sales.......................... $ 6,003 $ 5,199 $ 5,525 $ 8,410 $ 25,137
Gross profit (loss)................ 1,488 (2,300) 962 3,170 3,320
Income (loss) from operations...... 3,976 (15,806) (6,922) (7,458) (26,210)
Net income (loss).................. 3,976 (15,806) (6,922) (7,458) (26,210)
Net income (loss) per share:
Basic........................... 5.60 (21.40) (8.86) (8.42) (33.29)
Diluted......................... (25.20) (45.20) (34.54) (32.64) (33.29)
Year ended January 31, 2002:
Net sales.......................... $14,497 $ 7,998 $ 10,066 $ 8,266 $ 40,827
Gross profit....................... 4,929 1,296 1,321 1,774 9,320
Loss from operations............... (5,768) (10,961) (15,924) (10,483) (43,136)
Net loss........................... (5,768) (10,961) (15,924) (10,483) (43,136)
Net loss per share:
Basic........................... (9.00) (15.40) (22.24) (14.80) (62.00)
Diluted......................... (9.00) (15.40) (22.24) (14.80) (76.32)
Item 14. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
62
None.
Item 15. Financial Statements and Exhibits.
Exhibits and Consolidated Financial Statement Schedules
1. Financial Statements: (see index to financial statements at page F-1)
Independent Certified Public Accountants' Reports
Consolidated Balance Sheets at January 31, 2003 and 2002, April 30,
2003
Consolidated Statements of Operations for the Years Ended January 31,
2003, 2002 and 2001, and 3 months ended April 30, 2003
Consolidated Statements Comprehensive Income for the Years Ended
January 31, 2003, 2002 and 2001
Consolidated Statement of Stockholders' Equity for the Years Ended
January 31, 2003, 2002 and 2001, and 3 momths ended April 30, 2003
Consolidated Statements of Cash Flows for the Years Ended January 31,
2003, 2002 and 2001, and 3 momths ended April 30, 2003
Notes to Consolidated Financial Statements
2. Exhibits:
3.1 Certificate of Incorporation of the Registrant (G).
3.2 By-Laws of the Registrant (G).
3.3 Series D Preferred Stock Certificate of Designation (G).
4.1 1988 Stock Option Plan (B).
4.2 Amended and restated 1997 Incentive and Non-Qualified Stock Option
Plan (A).
4.3 1997 Directors Stock Option Plan (C).
4.4 2000 Stock Incentive Plan (E).
4.5 2000 Employee Stock Purchase Plan (D).
4.6 2000 Stock Option/Stock Issuance Plan of Sorrento Networks, Inc. (E).
4.7 Form of 7.5% Convertible Debenture due August 2, 2007 (G).
63
4.8 Form of Warrant, expiry date August 2, 2007 (G).
4.9 Sorrento Networks Corporation 2003 Equity Incentive Plan (G).
10.1 Agreement dated July 12, 2000 with Richard L. Jacobson (E).
10.2 Agreement dated March 1, 2002, with Phillip W. Arneson (F).
10.3 Exchange Agreement dated March 6, 2003 (G).
10.4 Registration Rights Agreement with Exchanging Holders (G).
10.5 Agreement dated May 17, 2002 with Joe R. Armstrong (H).
10.6 Agreement dated July 3, 2002 with Richard L. Jacobson (H).
10.7 Agreement dated February 1, 2003 with Robert L. Hibbard (H).
10.8 First Amendment to Exchange Agreement (I).
21.0 Subsidiaries of the Registrant (H).
----------
The foregoing are incorporated by reference from the Registrant's
filings as indicated:
(A) Proxy Statement dated December 1, 1999
(B) Proxy Statement dated May 13, 1988
(C) Proxy Statement dated November 21, 1997
(D) Proxy Statement dated December 11, 2000
64
(E) Form 10-K for the year ended January 31, 2001
(F) Form 10-K for the year ended January 31, 2002
(G) Proxy Statement dated April 15, 2003.
(H) Form 10-K for the year ended January 31, 2003, as amended.
(I) Form 8-K dated May 30, 2003.
----------
NOTE: Certain previously filed exhibits are no longer being incorporated by
reference (and therefore not numerically listed) as the underlying
documents have either expired or are no longer material or relevant.
65
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
----
Report of Independent Certified Public Accountants................................................ F-2
Consolidated Balance Sheets as of January 31, 2003 and 2002....................................... F-3
Consolidated Statements of Operations and Comprehensive Loss for the years ended January 31,
2003, 2002 and 2001............................................................................. F-4
Consolidated Statements of Shareholders' Equity (Deficit) for the years ended January 31, 2003,
2002 and 2001................................................................................... F-5 to F-7
Consolidated Statements of Cash Flows for the years ended January 31, 2003, 2002 and 2001......... F-8 to F-9
Notes to Consolidated Financial Statements........................................................ F-10 TO F-35
Consolidated Balance Sheets as of April 30, 2003 and January 31, 2003............................. F-36
Consolidated Statements of Operations for the Quarter ended April 30, 2003 and 2002............... F-37
Consolidated Statement of Stockholders Equity for Quarter ended April 30, 2003 and 2002........... F-38
Consolidated Statements of Cash Flows for Quarter ended April 30, 2003 and 2002................... F-40
Notes to Consolidated Financial Statements........................................................ F-41
F-1
REPORT OF INDEPENDENT CERTIFIED PUBLIC ACCOUNTANTS
The Shareholders of Sorrento Networks Corporation
9990 Mesa Rim Road
San Diego, CA 92121
We have audited the accompanying consolidated balance sheets of Sorrento
Networks Corporation (a New Jersey corporation) and subsidiaries (collectively
the "Company") as of January 31, 2003 and 2002 and the related consolidated
statements of operations and comprehensive loss, stockholders' equity (deficit)
and cash flows for each of the three years in the period ended January 31, 2003.
These consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. These standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe our audits provide a reasonable
basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of the
Company as of January 31, 2003 and 2002, and the results of their operations and
their cash flows for each of the three years in the period ended January 31,
2003 in conformity with accounting principles generally in the United States of
America.
The accompanying consolidated financial statements have been prepared assuming
the Company will continue as a going concern. As discussed in the Note R, the
Company is in the process of completing a restructuring plan that is subject to
shareholder approval. If the Company is not successful in the restructuring it
will be delisted from Nasdaq, this delisting would constitute a triggering event
that would allow their debenture holders to request accelerated payment of their
debentures at 125% of the face value, this condition gives rise to substantial
doubt about the Company's ability to continue as a going concern. The
consolidated financial statements do not include any adjustments that might
arise from this uncertainty.
As discussed in Note F, the 2002 Financial Statements have been restated to
reflect a change in the calculation of the beneficial conversion feature of the
Company's debentures.
/s/ BDO Seidman, LLP
BDO Seidman, LLP
Los Angeles, California
April 11, 2003
F-2
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In Thousands)
January 31, 2003 January 31, 2002
---------------- -----------------
ASSETS
CURRENT ASSETS
Cash and equivalents ................................................ $ 7,747 $ 14,243
Accounts receivable, net (Notes D, J and S) ......................... 5,576 8,081
Inventory, net (Notes B, D and S) ................................... 13,934 18,810
Prepaid expenses and other current assets (Note N) .................. 741 1,252
Investment in marketable securities (Note B) ........................ 3,959 28,120
--------- ---------
TOTAL CURRENT ASSETS .............................................. 31,957 70,506
--------- ---------
PROPERTY AND EQUIPMENT, NET (Notes C, D and E) ......................... 17,103 17,411
--------- ---------
OTHER ASSETS
Purchased technology, net (Note B) .................................. 430 852
Investment in non-marketable securities (Note B) .................... 5,025 --
Other assets (Notes A, B and N) ..................................... 1,290 1,471
Investment in former subsidiary (Note A) ............................ -- 99
--------- ---------
TOTAL OTHER ASSETS ................................................ 6,745 2,422
--------- ---------
TOTAL ASSETS ........................................................... $ 55,805 $ 90,339
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
CURRENT LIABILITIES
Short-term debt (Note D) ............................................ $ -- $ 1,043
Current maturities of long term debt (Note E) ....................... 222 362
Accounts payable .................................................... 5,135 5,575
Deferred revenue .................................................... 3,700 63
Accrued professional fees ........................................... 4,324 2,103
Other accrued liabilities and current liabilities ................... 6,236 6,721
Due on redemption of preferred security of subsidiary (Note J) ...... 48,800 48,800
--------- ---------
TOTAL CURRENT LIABILITIES ......................................... 68,417 64,667
--------- ---------
Long-term debt and capital lease obligations (Note E) .................. 3,644 3,867
Debentures payable, face amount of $32,200, net of unamortized costs and
discounts (Note F) .................................................. 18,121 11,227
Dividends payable (Note A) ............................................. 99 99
--------- ---------
TOTAL LIABILITIES ................................................. 90,281 79,860
--------- ---------
COMMITMENTS AND CONTINGENCIES (Notes F, G and H)
STOCKHOLDERS' EQUITY (DEFICIT) (Note I)
Preferred stock, $.01 par value; liquidation preference $1,353 ...... 1 1
Common stock, $6.00 par value; 7,500 shares authorized; 887 shares
issued and 886 shares outstanding at January 31, 2003; 711 shares
issued and 710 shares outstanding at January 31, 2002 ............. 5,318 4,263
Additional paid-in capital .......................................... 144,887 143,705
Deferred stock compensation ......................................... (5) (255)
Accumulated deficit ................................................. (187,536) (161,326)
Accumulated other comprehensive loss ................................ 2,928 24,160
Treasury stock, at cost; 1 share at January 31, 2003 and January 31,
2002, respectively ................................................ (69) (69)
--------- ---------
TOTAL STOCKHOLDERS' EQUITY (DEFICIT) .............................. (34,476) 10,479
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ............................. $ 55,805 $ 90,339
========= =========
See accompanying notes to consolidated financial statements.
F-3
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(In Thousands, except per share amounts)
Twelve Months Ended
January 31
----------------------------------------
2003 2002 2001
----------- ------------ -------------
NET SALES (Notes B and J)................................................. $ 25,137 $ 40,827 $ 44,641
COST OF SALES............................................................. 21,817 31,507 31,470
----------- ------------ -------------
GROSS PROFIT......................................................... 3,320 9,320 13,171
----------- ------------ -------------
OPERATING EXPENSES
Selling and marketing.................................................. 12,021 16,165 17,200
Engineering, research and development.................................. 8,990 13,656 23,928
General and administrative............................................. 12,779 12,770 18,110
Deferred compensation.................................................. 433 812 1,908
Other operating expenses............................................... 426 3,071 2,440
----------- ------------ -------------
TOTAL OPERATING EXPENSES............................................. 34,649 46,474 63,586
----------- ------------ -------------
LOSS FROM OPERATIONS...................................................... (31,329) (37,154) (50,415)
----------- ------------ -------------
OTHER INCOME (EXPENSES)
Investment income (loss)............................................... 275 (1,368) 5,507
Interest expense....................................................... (9,619) (3,311) (918)
Other income (expenses)................................................ 214 (99) --
Gain (loss) on sale of marketable securities (Note A).................. 14,249 (1,204) 3,921
----------- ------------ -------------
TOTAL OTHER INCOME (EXPENSES)........................................ 5,119 (5,982) 8,510
----------- ------------ -------------
NET LOSS.................................................................. $ (26,210) $ (43,136) $ (41,905)
=========== ============ =============
LOSS PER COMMON SHARE (Note M)
BASIC
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING (IN THOUSANDS)............ 787 698 593
NET LOSS PER COMMON SHARE:
----------- ------------ -------------
BASIC NET LOSS PER COMMON SHARE........................................... (33.29) $ (62.00) $ (74.20)
=========== ============ =============
DILUTED
WEIGHTED AVERAGE COMMON SHARES OUTSTANDING (IN THOUSANDS)............ 787 809 593
NET LOSS PER COMMON SHARE:
----------- ------------ -------------
DILUTED NET LOSS PER COMMON SHARE......................................... (33.29) $ (76.32) $ (74.20)
=========== ============ =============
COMPREHENSIVE LOSS AND ITS COMPONENTS CONSIST OF THE FOLLOWING:
Net loss............................................................. $ (26,210) $ (43,136) $ (41,905)
Unrealized gains (losses) from marketable securities:
Unrealized holding losses arising during the period................ (6,983) (21,993) (123,486)
Reclassification adjustment for gains (losses) included in net loss (14,249) 1,204 3,921
----------- ------------ -------------
NET COMPREHENSIVE LOSS.................................................... $ (47,442) $ (63,925) $ (161,470)
=========== ============ =============
See accompanying notes to consolidated financial statements.
F-4
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
For the Year Ended January 31, 2003
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In Thousands)
COMMON PREFERRED
STOCK STOCK ADDITIONAL NOTES DEFERRED
---------------- --------------- PAID IN RECEIVABLE STOCK
Shares Amount Shares Amount CAPITAL OPTIONS COMPENSATION
------ ------ ------ ------ ---------- ---------- ------------
Balance at
January 31, 2002.... 710 $4,263 2 $1 $143,705 $ -- $(255)
Stock option and
warrant exercises
(Notes I, J and M).. 1 9 (9)
Unrealized losses on
available for sale
securities (Note B).
Deferred stock
compensation
of subsidiary
(Note B)............ 183 (183)
Expenses paid with
stock issuances
(Note I)............ 175 1,046 1,008
Amortization of
deferred stock
compensation
(Note B)............ 433
------ ------ ------ ------ ---------- ---------- ------------
Net loss..............
------ ------ ------ ------ ---------- ---------- ------------
BALANCE AT
JANUARY 31, 2003.... 886 $5,318 2 $1 $144,887 $ -- $ (5)
====== ====== ====== ====== ========== ========== ============
TREASURY
STOCK OTHER TOTAL
ACCUMULATED --------------- COMPREHENSIVE STOCKHOLDERS'
DEFICIT Shares Amount LOSS EQUITY
----------- ------ ------ ------------- -------------
Balance at
January 31, 2002..... $(161,326) 1 $(69) $24,160 $10,479
Stock option and
warrant exercises
(Notes I, J and M)... 0
Unrealized losses on
available for sale
securities (Note B).. (21,232) (21,232)
Deferred stock
compensation
of subsidiary
(Note B)............. 0
Expenses paid with
stock issuances
(Note I)............. 2,054
Amortization of
deferred stock
compensation
(Note B)............. 433
conversion amount
related to debentures
(Note F).............
----------- ------ ------ ----------- ------------
Net loss............... (26,210) (26,210)
----------- ------ ------ ----------- ------------
BALANCE AT
JANUARY 31, 2003.... $(187,536) 1 $(69) $2,928 $(34,476)
=========== ====== ====== =========== ============
See accompanying notes to consolidated financial statements.
F-5
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
For the Year Ended January 31, 2002
(Restated)
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In Thousands)
COMMON PREFERRED
STOCK STOCK ADDITIONAL NOTES DEFERRED
---------------- ---------------- PAID IN RECEIVABLE STOCK
Shares Amount Shares Amount CAPITAL OPTIONS COMPENSATION
------ ------ ------ ------ ---------- ---------- ------------
Balance at
January 31, 2001...... 630 $3,782 2 $1 $114,994 $(5,034) $(880)
Debentures
private placement
(Notes F)............. 24 20,676
Stock option and
warrant exercises
(Notes I, J and M).... (20) 23 (1,321) 5,034
Unrealized losses on
available for sale
securities (Note B)...
Deferred stock
compensation
of subsidiary
(Note B).............. 187 (187)
Expenses paid with
stock issuances
(Note I).............. (18)
Amortization of
deferred stock
compensation
(Note B).............. 812
Private placement
subsidiary (Note J)... 76 458 9,187
Deemed dividend
(Note I)..............
Net loss................
------ ------ ------ ------ ---------- ---------- ------------
BALANCE AT
JANUARY 31, 2002...... 710 $4,263 2 $1 $143,705 $-- $(255)
====== ====== ====== ====== ========== ========== ============
TREASURY
STOCK OTHER TOTAL
ACCUMULATED --------------- COMPREHENSIVE STOCKHOLDERS'
DEFICIT Shares Amount LOSS EQUITY
----------- ------ ------ ------------- ------------
Balance at
January 31, 2001...... $(118,010) 1 $(69) $44,949 (39,773)
Debentures
private placement
(Notes F)............. $20,676
Stock option and
warrant exercises
(Notes I, J and M).... 3,736
Unrealized losses on
available for sale
securities (Note B)... (20,789) (20,789)
Deferred stock
compensation
of subsidiary
(Note B)..............
Expenses paid with
stock issuances
(Note I).............. (18)
Amortization of
deferred stock
compensation
(Note B).............. 812
Private placement
subsidiary (Note J)... 9,645
Deemed dividend
(Note I).............. (180) (180)
Net loss................ (43,136) (43,136)
----------- ------ ------ ----------- ------------
BALANCE AT
JANUARY 31, 2002...... $(161,326) 1 $(69) $24,160 $(69,027)
=========== ====== ====== =========== ============
See accompanying notes to consolidated financial statements.
F-6
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
For the Year Ended January 31, 2001
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In Thousands)
COMMON PREFERRED
STOCK STOCK ADDITIONAL NOTES DEFERRED
----------------- ------------------ PAID IN RECEIVABLE STOCK
Shares Amount Shares Amount CAPITAL OPTIONS COMPENSATION
----------------- ------------------ ---------- ----------- --------------
Balance at
January 31, 2000 574 $3,445 5 $1 $102,418 $-- $--
Preferred stock
conversions
(Note I)............ 8 50 (3) -- (50)
Stock option and
warrant exercises
(Notes J, K and M).. 46 276 8,619 (5,034)
Unrealized losses on
available for sale
securities
(Note B)............
Deferred stock
compensation
of subsidiary
(Note B)............ 2,788 (2,788)
Amortization of
deferred stock
compensation
(Note B)............ -- 1,908
Distribution of
shares of
subsidiary
(Note A)............
Deemed dividend
(Note J)............
Dividends paid
(Note I)............ 2 11 1,219
Net loss..............
--- ------ --- ---- -------- ------- -----
BALANCE AT
JANUARY 31, 2001..... 630 $3,782 2 $ 1 $114,994 $(5,034) $(880)
=== ====== === ==== ======== ======= =====
TREASURY
STOCK OTHER TOTAL
ACCUMULATED ---------------------------- COMPREHENSIVE STOCKHOLDERS'
DEFICIT Shares Amount LOSS EQUITY
----------- ------------ ------------ ------------- ------------
Balance at
January 31, 2000.... $(67,771) 1 $(69) $164,514 $202,538
Preferred stock
conversions
(Note I)............ --
Stock option and
warrant exercises
(Notes J, K and M).. 3,861
Unrealized losses on
available for sale
securities
(Note B)............ (119,565) (119,565)
Deferred stock
compensation
of subsidiary
(Note B)............ --
Amortization of
deferred stock
compensation
(Note B)............ 1,908
Distribution of
shares of
subsidiary
(Note A)............ (5,122) (5,122)
Deemed dividend
(Note J)............ (1,982) (1,982)
Dividends paid
(Note I)............ (1,230) --
Net loss.............. (41,905) (41,905)
--------- --- ---- ------- -------
BALANCE AT
JANUARY 31, 2001...... $(118,010) 1 $(69) $44,949 $39,733
========= === ==== ======= =======
See accompanying notes to consolidated financial statements.
F-7
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In Thousands)
Year Ended January 31,
----------------------------------
2003 2002 2001
----------- --------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss............................................................... $ (26,210) $(43,136) $(41,905)
----------- --------- -----------
Adjustments to reconcile net loss to net cash used in operating activities:
Intangible assets valuation allowances (Note B).................... -- -- 435
Depreciation and amortization...................................... 4,063 2,794 4,386
Accounts receivable, option receivables and inventory reserves
(recoveries)................................................... (1,020) 9,309 6,347
Expenses paid through issuances of securities...................... 2,054 1,309 --
(Gain) loss on sale of marketable securities....................... (14,249) 1,204 (7,622)
Non-cash interest on debentures (Note F)........................... 6,894 994 --
Deferred and other stock compensation (Note B)..................... 433 812 1,908
Other non-cash..................................................... -- 794 --
Changes in assets and liabilities net of effects of business entity
divestitures:
(Increase) decrease in accounts receivable....................... 3,020 6,360 (15,597)
(Increase) decrease in inventories............................... 5,381 (8,247) (11,201)
(Increase) decrease in other current assets...................... 511 (438) 1,191
Increase (decrease) in accounts payable.......................... (440) (2,729) 4,951
Increase (decrease) in deferred revenue.......................... 3,637 -- --
Increase (decrease) in accrued expenses.......................... 1,681 (751) 5,303
Increase (decrease) in other current liabilities................. 55 (63) 122
----------- --------- ---------
NET CASH USED IN OPERATING ACTIVITIES................................ (14,190) (31,788) (51,682)
----------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment..................................... (3,333) (3,235) (14,413)
Cash received from sale of marketable securities and other investments
(Notes A and B) 17,178 144 13,393
Expenditures for investments........................................... (5,025) -- (7,111)
Purchase of other assets (Note B)...................................... 280 (895) --
Other receivables (Note M)............................................. -- -- 2,621
Cash of former subsidiary (Note A)..................................... -- -- (6,961)
----------- --------- ---------
NET CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES.................. 9,100 (3,986) (12,471)
----------- --------- ---------
F-8
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS -- (Continued)
(In Thousands)
Year Ended January 31,
--------------------------------------
2003 2002 2001
------------ ----------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from short-term debt, net of repayments (Note D)............ (1,043) (172) (56)
Proceeds from long-term debt (Note E)................................ -- 26 2,412
Repayment of long-term debt (Note E)................................. (363) (39) (99)
Proceeds from debentures (Note F).................................... -- 29,749 --
Proceeds from convertible preferred stock issued by subsidiary
(Note J)........................................................... -- -- 46,638
Proceeds from common stock issued by subsidiary (Note I)............. -- -- 7,851
Proceeds from common stock (Note I).................................. -- 9,645 --
Proceeds from stock option and warrant exercises (Notes I, J and K).. -- 861 3,861
Other................................................................ -- (18) --
------------ ----------- -----------
NET CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES.................. (1,406) 40,052 60,607
------------ ----------- -----------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS........................ (6,496) 4,278 (3,546)
CASH AND CASH EQUIVALENTS - BEGINNING OF PERIOD......................... 14,243 9,965 13,511
------------ ----------- -----------
CASH AND CASH EQUIVALENTS - END OF PERIOD............................... $ 7,747 $ 14,243 $ 9,965
============ =========== ===========
See accompanying notes to consolidated financial statements.
F-9
Sorrento Networks Corporation (formerly Osicom Technologies, Inc.) (the
"Company," "We," "Our," or "Us") through its subsidiaries designs, manufactures
and markets integrated networking and bandwidth aggregation products for
enhancing the performance of data and telecommunications networks. Our products
are deployed in telephone companies, Internet Service Providers, governmental
bodies and the corporate/campus networks that make up the "enterprise" segment
of the networking marketplace. We have facilities in San Diego, California and
Fremont, California. In addition, we have various sales offices located in the
United States and Europe. We market and sell our products and services through a
broad array of channels including worldwide distributors, value added resellers,
local and long distance carriers and governmental agencies.
A. THE COMPANY AND BASIS OF PRESENTATION
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates that affect the reported amounts of assets,
liabilities, revenues and expenses, the disclosure of contingent assets and
liabilities. Actual results could materially differ from these estimates.
We have incurred significant losses and negative cash flows from
operations for the past two years. Sorrento Networks, Inc. ("SNI"), the
Company's principal operating subsidiary has primarily been the operating entity
responsible for these high losses and negative cash flows. The losses have been
generated as SNI continues to develop its technology, marketing and sales and
operations in its effort to become a major supplier of metro and regional
optical networks world-wide. In addition, we have incurred significant
restructuring costs of approximately $2.8 million in 2003 associated with
restructuring of our obligations under our Senior Convertible Debentures and
Series A Preferred Stock Holders obligations. While we feel these restructuring
costs are beneficial to our long-term survival in a depressed telecom market,
there is no certainty the restructuring will be approved by the shareholders or
will close with our Series A Holders and Senior Convertible Debenture Holders
even with Shareholder approval.
Even if our debenture repayment obligations are not accelerated, our
future capital requirements may vary materially from those now planned including
the need for additional working capital to accommodate planned growth, hiring
and infrastructure needs. There can be no assurances that our working capital
requirements will not exceed our ability to generate sufficient cash internally
to support our requirements and that external financing will be available or
that, if available, such financing can be obtained on terms favorable to us and
our shareholders.
Digi International, Inc. and NETsilicon, Inc. -- On September 15, 1999,
NETsilicon, Inc. ("NSI") completed an initial public offering in which 6,037,500
shares of its common stocks were sold (3,537,500 shares by NSI and 2,500,000
shares by us). NSI received net proceeds of $22.3 million and we received net
proceeds of $15.4 million. In addition, NSI repaid advances due us of $5.9
million. In connection with the initial public offering by NSI, our remaining
55% interest became non-voting shares. Accordingly, our financial statements
reflected the results of operations of NSI through September 14, 1999 at which
time our remaining interest was accounted for as an "available for sale
security." Under this accounting, the 7.5 million shares of NSI held by us were
marked-to-market at the end of each reporting period with the difference between
our basis and the fair market value, as reported on NASDAQ, reported as a
separate element of stockholders' equity and included in the computation of
comprehensive loss.
In October 2000, we sold 350,000 shares of our investment in NSI for $4.2
million. The purchasers had the right to receive additional NSI shares from us
if the three-day average high for the NSI common stock, as quoted on NASDAQ, at
December 31, 2000 was less than the price paid to us by the purchasers but not
less than $8.00 per share. We issued an additional 177,344 shares of NSI to the
purchasers, reducing the price per share we received to $8.00 per share. Our
former Chairman and CEO purchased 100,000 of these shares of NSI for $1.2
million and received an additional 45,546 shares pursuant to the price
protection provision. As a result of this transaction, our remaining interest
was approximately 7.0 million shares of NSI, or 51% of the outstanding shares of
NSI as of January 31, 2002 and continued to be accounted for as a
marked-to-market security.
On February 13, 2002, NSI completed a merger with Digi International,
Inc. ("DIGI"). In connection with the merger, we exchanged our 6,972,656 shares
of NSI for 2,324,683 shares of DIGI and $13.6 million in cash. One December 9,
2002, we sold one-half of our holdings in DIGI for $3.10 per share. The
purchaser of the stock was
F-10
DIGI, itself. The proceeds from this sale, in the amount of $3.6 million, were
deposited on December 13, 2002. The remaining 1,162,341 DIGI shares owned by us
are accounted for as an "available for sale security". Under this accounting,
these shares are marked-to-market at the end of each reporting period. The
difference between our basis and the fair market value, as reported on NASDAQ,
is a separate element of stockholders' equity and is included in the computation
of comprehensive income. The closing price of DIGI common stock on January 31,
2003 was $3.35, and is reflected in the valuation of our marketable securities
as of that date.
Entrada Networks, Inc. -- On August 31, 2000, we completed a merger of
our then subsidiary Entrada Networks with Sync Research, Inc. ("Sync"), a NASDAQ
listed company in which we received 4,244,155 shares of the merged entity, which
changed its name to Entrada Networks, Inc. ("ENI"). We purchased 93,900 shares
of Sync in the open market during June and July 2000 for $388 and on August 31,
2000 purchased an additional 1,001,818 shares directly from ENI for $3.3
million. After these transactions and ENI's issuance of additional shares to
outside investors in connection with the merger we owned 49% of ENI.
Accordingly, our financial statements reflected the results of operations of ENI
through August 31, 2000.
Pursuant to a plan adopted by our Board of Directors prior to the merger
we distributed 3,107,155 of our ENI shares on December 1, 2000 to our
shareholders of record as of November 20, 2000. The distribution was made at the
rate of one-fourth (0.25) of an ENI share for each of our outstanding shares. At
exercise, options and warrants to acquire our common shares, which were granted
and unexercised as of November 20, 2000, would have received a similar number of
ENI shares. Prior to January 31, 2001 we distributed 20,182 of our ENI shares
upon the exercise of options and as of January 31, 2003 we have reserved 826,000
shares for future exercises of options and warrants. The cost basis of these
reserved shares and related liability to the option and warrant holders is
included in the investment in former subsidiary and dividends payable in the
accompanying balance sheet. The aggregate distribution of our ENI shares
including the shares reserved for option and warrant holders has been accounted
for at our original cost of $5.1 million. In addition, we have granted options
to purchase 410,000 of our ENI shares for $3.19 per share (the merger price) to
several of our then officers and consultants. In April 2003 our Board of
Directors determined that our ENI should be made available for general corporate
purposes, and we are no longer reserving any for distribution to option and
warrant holders as of November 20, 2000.
The remaining 326,034 ENI shares owned by us were accounted for as of
July 31, 2003 an "available for sale security". Under this accounting, these
shares are marked-to-market at the end of each reporting period. The difference
between our basis and the fair market value, as reported on NASDAQ, is a
separate element of stockholders' equity and is included in the computation of
comprehensive income.
B. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Principles of Consolidation -- The balance sheets and the consolidated
statement of operations for the years ended January 31, 2003 and 2002 and the
consolidated statement of operations for the year ended January 31, 2001 reflect
our accounts and all subsidiaries controlled by us after the elimination of
significant intercompany transactions and balances. The consolidated statement
of operations for the year ended January 31, 2001 includes the results of
Entrada through August 31, 2000 after which date we no longer controlled
Entrada. The consolidated group is referred to individually and collectively as
the "Company," "We," "Our," or "Us."
Use of Estimates --The preparation of financial statements in conformity
with accounting principles generally accepted in the United States of America
requires management to make estimates that affect the reported amounts of
assets, liabilities, revenues and expenses, the disclosure of contingent assets
and liabilities. Actual results could materially differ from these estimates. In
the opinion of Management, all adjustments (which include normal recurring
adjustments and charges described in the notes to the financial statements)
necessary to present fairly the financial position, results of operations and
cash flows for the years ended January 31, 2003, 2002 and 2001 have been made.
Cash and Cash Equivalents -- All cash on hand and in banks, certificates
of deposit and other highly-liquid investments with original maturities of three
months or less, when purchased are considered to be cash equivalents.
F-11
Accounts and Notes Receivable -- In the normal course of business, we
extend unsecured credit to our customers related to the sales of various
products. Typically credit terms require payment within thirty days from the
date of shipment.
Allowance for Doubtful Accounts -- We provide an allowance for doubtful
accounts based on our continuing evaluation of our customers' credit risk. We
generally do not require collateral from our customers.
Inventory -- Inventory, comprised of raw materials, work in process,
finished goods and spare parts, are stated at the lower of cost (first-in,
first-out method) or market. We periodically evaluate our on-hand stock and make
appropriate disposition of any stock deemed excess or obsolete. Inventories at
January 31, 2003 and 2002 consist of:
2003 2002
---------- ----------
Raw material................................................................ $10,767 $14,593
Work in process............................................................. 2,804 879
Finished goods.............................................................. 6,326 9,806
-------- --------
19,897 25,278
Less: Valuation reserve..................................................... (5,963) (6,468)
-------- --------
$13,934 $18,810
======== ========
Marketable Securities -- Marketable securities, which consist of equity
securities that have a readily determinable fair value and do not have sale
restrictions lasting beyond one year from the balance sheet date, are classified
into categories based on our intent. Investments not classified as held to
maturity, those for which we have the intent and ability to hold, are classified
as available for sale. Our investments in DIGI and ENI are classified as
available for sale and are carried at fair value, based upon quoted market
prices, with net unrealized gains reported as a separate component of
stockholders' equity until realized. Unrealized losses are charged against
income when a decline in fair value is determined to be other than temporary. At
January 31, 2003, and 2002 marketable securities were as follows:
Cost Unrealized Gains Market Value
-------- ---------------- --------------
January 31, 2003:
DIGI.................................................. $ 1,009 $2,884 $3,893
Entrada............................................... 22 44 66
-------- ---------------- -------------
$ 1,031 $2,928 $3,959
======== ================ =============
January 31, 2002:
NETsilicon............................................ $ 3,938 $24,142 $28,080
Entrada............................................... 22 18 40
-------- ---------------- -------------
$ 3,960 $24,160 $28,120
======== ================ =============
Fair Value of Financial Instruments -- The fair value of financial
instruments is determined by reference to various market data and other
valuation techniques as appropriate. We believe that there are no material
differences between the recorded book values of our financial instruments and
their estimated fair value.
Property and Equipment -- Property and equipment are recorded at
historical cost. Depreciation and amortization are provided over the estimated
useful lives of the individual assets or the terms of the leases if shorter
using accelerated and straight-line methods. Property and equipment are reviewed
for impairment whenever events or circumstances indicate that the asset's
undiscounted expected cash flows are not sufficient to recover its carrying
amount. We measure impairment loss by comparing the fair market value,
calculated as the present value of expected future cash flows, to its net book
value. Impairment losses, if any, are recorded currently.
Capitalized leases - Capitalized leases are initially recorded at the
present value of the minimum payments at the inception of the contracts, with an
equivalent liability categorized as appropriate under current or non-current
liabilities. Such assets are depreciated on the same basis as described above.
Interest expense, which represents the
F-12
difference between the minimum payments and the present value of the minimum
payments at the inception of the lease, is allocated to accounting periods using
a constant rate of interest over the lease.
Software Development -- Software development costs where technological
feasibility has not been established, are expensed in the period in which they
occurred, otherwise, development costs that will become an integral part of our
products are deferred in accordance with Statement of Financial Accounting
Standards Nos. 2 and 86. The deferred costs are amortized using the
straight-line method over the remaining estimated economic life of the product
or the ratio that current revenues for the product bear to the total of current
and anticipated future revenues for that product. Amortization expense for the
years ended January 31, 2003, 2002 and 2001 was $0, $0, and $1,046,
respectively, over 3 to 5 years. Accumulated amortization was $398 as of January
31, 2003 and 2002, bringing the net book value to zero as of January 31, 2003
and 2002.
Purchased Technology -- Technology assets were acquired in connection
with the acquisition of Sciteq. These assets were analyzed during and after the
close of the acquisition. The discounted projected future cash flow from proven
technology and software are capitalized and amortized over their remaining
estimated economic life (7 years) using the straight-line method. Accumulated
amortization was $2,415 and $1,994 at January 31, 2003 and 2002, respectively.
We assess the recoverability of purchased technology primarily by
determining whether the amortization of the net book value of purchased
technology over its remaining life can be recovered through undiscounted future
operating cash flows of the acquired operation. The amount of the impairment, if
any, of the net book value of the excess cost over net assets acquired is
measured by determining the fair value of these assets primarily based on
projected discounted future operating cash flows from the purchased technologies
using a discount rate commensurate with our cost of capital.
Research and Development -- We expense research and development costs as
incurred in accordance with Statement of Financial Accounting Standards ("SFAS")
No. 2, "Accounting for Research and Development Costs." Research and development
costs are costs associated with products or processes for which technological
feasibility has not been proven and future benefits are uncertain. In-process
research and development purchased by us includes the value of products and
processes in the development stage and have not reached technological
feasibility; this amount is expensed at the date of purchase.
Other investments -- Other investments, included in other assets, include
non-marketable securities held in other companies including a privately held
competitive local exchange carrier, and a broadband services carrier, UFO
Communications, Inc. ("UFO").
In November 2000, we sold all our shares in this local exchange carrier
for $9,937 and $320 in accumulated, unpaid dividends. Of the total $10,257 due
from the purchaser, approximately 7.7% or $787 was held in a segregated escrow
account for one year. The gain of $3,701 on the sale of the shares is included
in investment income in the accompanying income statement. Due to a dispute, a
$787 reserve against the remaining escrow balance was recorded during the fiscal
year ended January 31, 2002.
During the year ended January 31, 2001, we made sales of $5,746, to this
local exchange carrier under a long-term equipment financing agreement. The
purchase agreement with this customer provides for invoiced installation and
other deployment expenses not to exceed 10% of the equipment cost. The terms of
the financing agreement provide that the customer may convert any balances
outstanding longer than 90 days into a level 35-month term note at 11% per annum
interest. We financed $5,971, including deployment expenses of $210, during
fiscal 2001 for this customer, which was paid in full including accrued interest
during January 2001. We financed $3,328 of receivables, including deployment
expenses of $120, during fiscal 2000 for this customer and $3,000 of the then
unpaid note was exchanged for our equity interest in the customer. The remaining
balance of the note and accrued interest of $344 was paid in cash.
On November 12, 2002, as part of a strategic relationship, we purchased
$5 million of UFO Communications, Inc. Series B preferred stock. UFO provides
enterprise broadband optical communications services in major metropolitan
areas. UFO currently operates metropolitan optical networks in San Francisco and
Chicago. We have already supplied optical networking equipment for these
markets.
F-13
Revenue Recognition -- We generally recognize product revenue when the
products are shipped, all substantial contractual obligations, if any, have been
satisfied, and the collection of the resulting receivable is reasonably assured.
When title does not pass to the customer at time of shipment, revenue is not
recognized until all contractual requirements are met and title has
transferred. During this transition period, the amount of the sale and/or
installation is shown in deferred revenue. Revenue from installation is
recognized as the services are performed to the extent of the direct
costs incurred. To date, installation revenue has not been material.
Revenue from service obligations, if any, is deferred and recognized
over the life of the contract. Inventory or demonstration equipment shipped to
potential customers for field trials is not recorded as revenue. We accrue for
warranty costs, sales returns and other allowances at the time of shipment.
Although our products contain a software component, the software is not sold
separately and we are not contractually obligated to provide software upgrades
to our customers.
Warranty and Customer Support -- We typically warrant our products
against defects in materials and workmanship for a period of one to five years
from the date of sale and a provision for estimated future warranty and customer
support costs is recorded when revenue is recognized. To date, warranty and
customer support costs have not been material.
Income Taxes -- Income taxes are accounted for in accordance with
Statement of Financial Accounting Standards No. 109 "Accounting for Income
Taxes." The statement employs an asset and liability approach for financial
accounting and reporting of deferred income taxes generally allowing for
recognition of deferred tax assets in the current period for future benefit of
net operating loss and research credit carry forwards as well as items for which
expenses have been recognized for financial statement purposes but will be
deductible in future periods. A valuation allowance is recognized, if on the
weight of available evidence it is more likely than not that some portion or all
of the deferred tax assets will not be realized. (See Note L).
Advertising -- We expense advertising expenditures as incurred.
Loss Per Common Share -- We compute earnings per share based on the
provision of SFAS No. 128, "Earnings Per Share." Basic income and loss per
common share is computed by dividing net income or loss available to common
shareholders by the weighted average number of common shares outstanding during
each period presented. Diluted EPS is based on the weighted average number of
common shares outstanding as well as dilutive potential common shares, which in
our case consist of convertible securities outstanding, shares issuable under
stock benefit plans, and shares issuable pursuant to warrants. In computing
diluted EPS, net income or loss available to common shareholders is adjusted for
the after-tax amount of interest expense recognized in the period associated
with convertible debt. Potential common shares are not included in the diluted
loss per share computation for the years ended January 31, 2003, 2002 and 2001
as they would be anti-dilutive. All references in the financial statements of
common shares and per share data give effect to the 1-for-20 stock split
effective October 28, 2002. (See Note M).
Foreign Currency Translation -- Our foreign operations have been
translated into U.S. dollars in accordance with the principles prescribed in
SFAS No. 52, "Foreign Currency Translation." For the periods presented the
current rate method was used whereby all assets and liabilities are translated
at period end exchange rates, and the resultant translation adjustments would
have been included as a separate component of stockholders' equity had such
adjustments been material. Revenues and expenses are translated at the average
rates of exchange prevailing throughout the period, and the resultant gains and
losses are included in net earnings.
Stock-Based Compensation -- We account for employee-based stock
compensation utilizing the intrinsic value method prescribed in Accounting
Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees."
Accordingly, compensation cost for stock options issued to employees is measured
as the excess, if any, of the fair market price of our common stock at the date
of grant over the amount an employee must pay to acquire the stock. The amount
of deferred stock compensation appears as a separate component of stockholders'
equity and is being amortized on an accelerated basis by charges to operations
over the vesting period of the options in accordance with the method described
in Financial Accounting Standards Board Interpretation No. 28. All such amounts
relate to options to acquire common stock of our Sorrento subsidiary granted by
it to its employees; during the fiscal years ended January 31, 2003 and 2002, we
amortized $250 and $625 of the total $2,604 initially recorded for deferred
stock compensation. (See Note J).
For non-employees, we compute the fair value of stock-based compensation
in accordance with Statement of Financial Accounting Standards (SFAS) No. 123,
"Accounting for stock-Based Compensation," and Emerging
F-14
Issues Task Force (EITF) 96-18, "Accounting for Equity Instruments that are
Issued to Other Than Employees for Acquiring, or in Conjunction with Selling,
Goods or Services." All such amounts relate to options to acquire common stock
of our Sorrento Networks subsidiary granted by it to its consultants; during the
fiscal years ended January 31, 2003 and 2002, we recorded $183 and $187 for
options granted to consultants. (See Note J).
The FASB issued Interpretation (FIN) No. 44, "Accounting for Certain
Transactions involving Stock Compensation," an Interpretation of APB Opinion No.
25. FIN 44 clarifies the application of Opinion No. 25 for (a) the definition of
an employee for purposes of applying Opinion No. 25, (b) the criteria for
determining whether a plan qualifies as a non-compensatory plan, (c) the
accounting consequences of various modifications to the terms of a previously
fixed stock option award, and (d) the accounting for an exchange of stock
compensation awards in a business combination. FIN 44 was effective July 2,
2000, but certain conclusions cover specific events that occur after either
December 15, 1998, or January 12, 2000. The adoption of this standard had no
material effect on our financial position or results of operations.
In December 2002, the FASB issued SFAS No. 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure," which amended SFAS No.
123, "Accounting for Stock-Based Compensation." The new standard proves
alternative methods of transition for a voluntary change to the fair value based
method of accounting for stock-based employee compensation. Additionally, the
statement amends the disclosure requirements of SFAS No. 123 to require
prominent disclosures in the annual and interim financial statements about the
method of accounting for stock-based employee compensation and the effect of the
method used on reported results. This statement is effective for financial
statements for fiscal years ending after December 15, 2002. In compliance with
SFAS No. 148, Sorrento has elected to continue to follow the intrinsic value
method in accounting for its stock-based employee compensation arrangement as
defined by Accounting Principles Board Opinion ("APB") No. 25, Accounting for
Stock Issued to Employees, and has made the applicable disclosures in Note K to
the consolidated financial statements.
Computer Software for Internal Use -- Statement of Position ("SOP") 98-1,
"Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use," is effective for financial statements with fiscal years beginning
after December 15, 1998. The SOP provides guidance on accounting for the costs
of computer software developed or obtained for internal use. The SOP requires
that we continue to capitalize certain costs of software developed for internal
use once certain criteria are met. The adoption of SOP 98-1 had no effect on our
financial position or results of operations.
New Accounting Standards -- In January 2003, the FASB issued
Interpretation No. 46, "Consolidation of Variable Interest Entities", an
interpretation of Accounting Research Bulletin No. 51,"Consolidated Financial
Statements." This Interpretation addresses the consolidation by business
enterprises of variable interest entities as defined in the Interpretation. The
Interpretation applies immediately to variable interests in variable interest
entities created after January 31, 2003, and to variable interests in variable
interest entities obtained after January 31, 2003. We have no variable interest
entities and thus this Interpretation is not expected to have a material impact
on our financials statements.
In December 2002, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 148, "Accounting for Stock-Based Compensation - Transition and
Disclosure." This pronouncement amends SFAS No. 123, "Accounting for Stock-Based
Compensation" to provide alternative methods of transition for a voluntary
change to the fair value based method of accounting for stock-based employee
compensation. In addition, this statement also amends the disclosure
requirements of SFAS No. 123 to require prominent disclosures in both annual and
interim financial statements. Certain of the disclosure modifications are
required for fiscal years ending after December 15, 2002 and are included in the
notes to these consolidated financial statements.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs
Associated with Exit or Disposal Activities." SFAS No. 146 applies to costs
associated with an exit activity (including restructuring) or with a disposal of
long-lived assets. Those activities can include eliminating or reducing product
lines, terminating employees and contracts, and relocating plant facilities or
personnel. Under SFAS No. 146, a company will record a liability for a cost
associated with an exit or disposal activity when that liability is incurred and
can be measured at
F-15
fair value. Under current rules, companies can record a liability for
restructuring costs when a commitment to a plan of action is made. SFAS No. 146
will require a company to disclose information about its exit and disposal
activities, the related costs, and changes in those costs in the notes to the
interim and annual financial statements that include the period in which an exit
activity is initiated and in any subsequent period until the activity is
completed. SFAS No. 146 is effective prospectively for exit or disposal
activities initiated after December 31, 2002, with earlier adoption encouraged.
Under SFAS No. 146, a company may not restate its previously issued financial
statements, and the new statement grandfathers the accounting for liabilities
that a company had previously recorded under Emerging Issues Task Force Issue
94-3. We do not believe the adoption of this statement will have a material
impact on our consolidated financial statements. We will apply this guidance
prospectively.
In April 2002, the Financial Accounting Standards Board issued SFAS No.
145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB
Statement No. 13, and Technical Corrections". This statement eliminates the
current requirement that gains and losses on debt extinguishment must be
classified as extraordinary items in the income statement. Instead, such gains
and losses will be classified as extraordinary items only if they are deemed to
be unusual and infrequent, in accordance with the current GAAP criteria for
extraordinary classification. In addition, SFAS 145 eliminates an inconsistency
in lease accounting by requiring that modifications of capital leases that
result in reclassification as operating leases be accounted for consistent with
sale-leaseback accounting rules. The statement also contains other
nonsubstantive corrections to authoritative accounting literature. The changes
related to debt extinguishment will be effective for fiscal years beginning
after May 15, 2002, and the changes related to lease accounting will be
effective for transactions occurring after May 15, 2002. Adoption of this
standard will not have any immediate effect on our consolidated financial
statements. We will apply this guidance prospectively.
In August 2001, the Financial Accounting Standards Board issued SFAS No.
143, Accounting for Asset Retirement Obligations. This Statement is effective
for fiscal years beginning after June 15, 2002. SFAS No. 143 provides accounting
requirements for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. Under the
Statement, the asset retirement obligation is recorded at fair value in the
period in which it is incurred by increasing the carrying amount of the related
long-lived asset. The liability is accreted to its present value in each
subsequent period and the capitalized cost is depreciated over the useful life
of the related asset. We do not believe the adoption of SFAS 143 will have a
material effect, if any, on our financial position or results of operations.
In June 2001, the Financial Accounting Standards Board finalized SFAS
141, "Business Combinations," and SFAS 142, "Goodwill and Other Intangible
Assets." SFAS 141 requires the use of the purchase method of accounting and
prohibits the use of the pooling-of-interests method of accounting for business
combinations initiated after June 30, 2001. SFAS 141 also requires that we
recognize acquired intangible assets apart from goodwill if the acquired
intangible assets meet certain criteria. SFAS 141 applies to all business
combinations initiated after June 30, 2001 and for purchase business
combinations completed on or after July 1, 2001. Upon adoption of SFAS 142, it
requires that we reclassify the carrying amounts of intangible assets and
goodwill based on the criteria in SFAS 141.
SFAS 142 requires, among other things, that companies no longer amortize
goodwill, but instead test goodwill for impairment at least annually. In
addition, SFAS 142 requires that we identify reporting units for the purposes of
assessing potential future impairments of goodwill, reassess the useful lives of
other existing recognized intangible assets, and cease amortization of
intangible assets with an indefinite useful life. An intangible asset with an
indefinite useful life should be tested for impairment in accordance with the
guidance in SFAS 142. SFAS 142 is required to be applied in fiscal years
beginning after December 15, 2001 to all goodwill and other intangible assets
recognized at that date, regardless of when those assets were initially
recognized. SFAS 142 requires us to complete a transitional goodwill impairment
test nine months from the date of adoption. We are also required to reassess the
useful lives of other intangible assets within the first interim quarter after
adoption of SFAS 142. We adopted both SFAS 141 and 142 on February 1, 2002, and
there was no impact to our financial statements.
C. PROPERTY AND EQUIPMENT
Property and equipment of the Company consisted of the following
components as of January 31, 2003 and 2002:
F-16
2003 2002
---------- ---------
Manufacturing, engineering and plant equipment and software............... $ 19,822 $ 15,354
Office furniture and fixtures............................................. 3,154 4,359
Land and building......................................................... 6,721 6,650
Leasehold and building improvements....................................... 1,294 1,294
--------- ---------
Total property and equipment........................................... 30,991 27,657
Less: Accumulated depreciation............................................ (13,888) (10,246)
--------- ---------
Net book value......................................................... $ 17,103 $ 17,411
========= =========
Depreciation expense for fiscal 2003, 2002 and 2001 was $3,642, $2,422,
and $3,404 and respectively.
D. SHORT TERM DEBT
Short term debt at January 31, 2003 and 2002 consisted of the following:
2003 2002
---------- ---------
Floating interest rate loan (2.5% over Coast's prime rate) secured by all $ - $ 1,043
the tangible assets of Meret:...........................................
========== =========
Meret had a line of credit of $2,000 from Coast Business Credit
("Coast"); the line of credit that was collateralized by substantially all the
assets of Meret including accounts receivable, inventory and property and
equipment. We guaranteed this line to the extent of $1,000. This line of credit
provided for interest at 2.5% over the bank's prime rate but not less than 8%
(8.75% at May 30, 2002) with a minimum monthly interest of $8. Advances were
limited to 80% of eligible accounts receivable and 40% of eligible inventory
limited to $740; this line also provides for a $500 letter of credit sub-line.
Subsequent to January 31, 2002, the Loan and Security Agreement was amended
reducing the line of credit to $1,000, adjusting the advance rate for eligible
inventory to 20%, limited to $370, eliminating minimum monthly interest with an
expiration date of July 1, 2002. The highest amount outstanding was $999 and
$1,259 during fiscal years 2003 and 2002 respectively. The average amount
outstanding was $300 and $1,419 during fiscal years 2003 and 2002, respectively.
The line of credit with Coast Business Credit was terminated in May 2002.
E. LONG TERM DEBT
Long term debt at January 31, 2003 and 2002 consisted of the following:
2003 2002
-------- ---------
Variable rate 30 year mortgage note payable (5.5% over LIBOR rate); interest $ 1,269 $ 1,283
rate at January 31, 2003 was 8.95%.........................................
Fixed rate 30 year mortgage note payable; interest rate at January 31, 2003
was 7.6%................................................................... 2,361 2,385
Obligations under finance leases (See Note G)................................. 237 561
-------- ---------
3,867 4,229
Less: Current portion......................................................... 223 362
-------- ---------
$3,644 $3,867
======== =========
On March 25, 1996, Meret completed the purchase of a 35,000 square foot
facility in San Diego, California for $1,779 in cash. On April 24, 1996, Meret
entered into a mortgage agreement with a lender in the amount of
F-17
$1,331 amortized over 30 years with an adjustable interest rate of 5.5% over the
LIBOR rate, adjusted bi-annually. Monthly principal and interest payments are
$11. The interest rate at January 31, 2003 was 8.95%.
In October 2000, we completed our purchase of a 41,000 square foot
facility immediately adjacent to our existing San Diego, California facility.
The purchase price was $4,805 including the assumption of existing indebtedness
of $2,417. Monthly principal and interest payments are $18 and at the end of the
30 year term on January 1, 2010 the remaining balance of $2,109 is due. The loan
has a fixed interest rate of 7.6%.
Long term debt including capitalized leases at January 31, 2003 is
payable by year as follows:
2004................................................................................... $ 223
2005................................................................................... 109
2006................................................................................... 54
2007................................................................................... 58
2008................................................................................... 63
2009 and later......................................................................... 3,360
---------
$3,867
=========
F. DEBENTURES
Debentures - During August 2001, we completed a private placement of our
9.75% convertible debentures receiving net proceeds of $29.8 million. The
debentures, due August 2, 2004 have a face value of $32.2 million, which is
convertible into our common stock at $144.20 per share. At maturity we may elect
to redeem the debentures for cash and we have the option of paying the interest
on these debentures in shares of our common stock. In addition, the purchasers
received four year warrants to acquire an additional 167,592 shares of our
common stock at $144.20 per share and the placement agent received five year
warrants to acquire 5,583 shares of our common stock, equity securities, options
or warrants at a price less than $144.20 per share or at a discount to the then
market price. The conversion price and warrant exercise are subject to
adjustment.
In accordance with Emerging Issues Task Force ("EITF") No. 00-27 we have
accounted for the fair value of warrants issued to the purchasers and placement
agent and the fair value of the deemed beneficial conversion feature, which
results solely as a result of the required accounting, of the debenture as a
reduction to the face value of the debentures with an offsetting increase to
additional paid in capital. These amounts as well as the issuance costs paid in
cash are amortized as additional interest expense over the period the debentures
are outstanding. Interest expense during the year ended January 31, 2003 of $9.6
million included the stated 9.75% interest of $2.3 million which was paid in
174,863 shares of common stock and $292 in cash, amortization of issuance costs
of $770, and amortization of the fair value of the warrants issued to the
purchasers and placement agent and the deemed beneficial conversion feature of
$6,134. The fiscal 2002 financial statements have been restated to reflect a
change in the beneficial conversion feature. The revision had the impact of
decreasing additional paid in capital and unamortized debenture discount by
approximately $7.7 million. At January 31, 2003 and 2002 debentures payable
consists of:
2003 2002
----------- -----------
Face Value...................................................................... $ 32,200 $ 32,200
Issuance costs.................................................................. (2,451) (2,451)
Value of warrants and deemed beneficial
Conversion feature....................................................... (19,525) (19,525)
----------- -----------
Debenture book value at issuance..................................... 10,224 10,224
Accumulated amortization of
Issuance costs........................................................... 881 92
Value of warrants and deemed beneficial conversion feature............... 7,016 911
----------- -----------
$ 18,121 $ 11,227
=========== ===========
F-18
We are in the process of a debt and equity restructuring plan that would
exchange current outstanding debentures and Series A Preferred stock for common
stock and an issuance of a smaller new debenture. See Note R for further
information.
G. LEASES, OTHER COMMITMENTS AND CONTINGENCIES
Leases
Rental expense under operating leases was $1.6 million, $1.3 million, and
$1.3 million for the years ended January 31, 2003, 2002 and 2001, respectively.
The table below sets forth minimum payments under capital and operating leases
with remaining terms in excess of one year, at January 31, 2003:
Capital Operating
Leases Leases
---------- -----------
2004.................................................................... 198 301
2005.................................................................... 55 158
2006.................................................................... -- 131
2007.................................................................... -- 42
2008 -- 18
---------- -----------
253 650
===========
Less: Amount representing interest...................................... (16)
-----------
Present value of minimum annual rentals................................. 237
===========
The net book value of equipment under capital leases was $657 and $1,071
at January 31, 2003 and 2002, respectively.
Other Commitments
We previously reimbursed Entrada on a prorata basis for space in its San
Diego facility utilized by Meret. During the twelve months ended January 31,
2003 and 2002, we paid $54 and $48 to Entrada under this month to month
agreement.
In March 2001, our Meret subsidiary entered into a $2.7 million supplier
agreement. The agreement requires a minimum monthly cash outlay of $50 extending
over a period of fifty-four months. The remaining balance at January 31, 2003 of
$1.5 million is expected to end in March 2005. The product being acquired is a
component used in a product for one of Meret's customers for which there is a
five year sales contract.
Contingent Liabilities
One of our component suppliers is contending that our efforts to
reschedule shipments of certain components constitutes an anticipatory breach of
the purchase order by which the components were ordered, and has informed us
that they believe they are entitled to damages in the approximate amount of
$900, despite the fact the goods in question have not as yet been shipped. We
do not believe that our supplier can support the amount of the alleged
cancellation fee, and we are trying to work out a business solution to the
dispute. Our supplier has threatened litigation if the dispute is not
satisfactorily resolved and while we believe that our defenses to both
liability and damages are strong, we can give no assurance that our position in
such litigation would prevail.
In the merger agreement between our predecessor corporation and Sync
Research, we agreed to indemnify and hold our former subsidiary, Entrada,
harmless against any liability arising after the merger in connection with the
termination of a certain pension plan previously maintained by Entrada. In the
third quarter, we were advised by a consultant retained by us and by the
successor corporation to the entity from whom we originally purchased the
company that became Entrada that the cost of termination of the pension plan in
question is in excess of $3 million.
F-19
While we do not believe that we are liable for this cost, it is possible that
the successor corporation, which has been funding the pension plan since 1996,
may seek a substantial contribution from us towards this liability.
H. LITIGATION
On September 10, 2001, holders of a portion of the outstanding Series A
Preferred Stock of our Sorrento subsidiary obtained a preliminary injunction
from the Delaware Court of Chancery prohibiting SNI from issuing further shares
of its Series A Preferred Stock or incurring any additional debt without the
consent of the holders of a majority of the currently outstanding shares of such
Series A Preferred Stock. On January 23, 2002, the Delaware Supreme Court
affirmed the granting of the preliminary injunction.
On October 19, 2001, an amended complaint was filed in the injunction
action, adding as named defendants, the Company, our Meret subsidiary, certain
present and former officers and directors of the Company and our subsidiaries as
well as our investment bankers. The amended complaint also added, among other
things, claims for fraud, securities fraud, breach of fiduciary duty,
conspiracy, and intentional interference with contract as well as requesting the
appointment of a receiver for our Sorrento subsidiary, all which claims are
based on alleged wrongs committed in connection with or since the Series A
placement. Our Sorrento subsidiary and the original individual defendants have
all answered this amended complaint denying all allegations of wrongdoing. The
new defendants have all moved to dismiss the amended complaint. Management
believes the allegations contained in the amended complaint are without merit.
On December 14, 2001, the plaintiffs filed motions to sequester the
common stock of our Sorrento subsidiary owned by Meret and the Sorrento Series A
preferred stock that we own, as an alternative method of obtaining jurisdiction
over us and Meret in the Delaware litigation. Management also believes that
these motions are without merit.
Currently, hearings on all pending motions have been taken off calendar
at the request of all parties, pending the resolution of ongoing settlement
discussions between the Company and the plaintiffs. The Exchange Agreement
entered into in connection with our proposed capital restructuring provides that
this litigation will be dismissed with prejudice against the Company, its
subsidiaries, and its current officers and directors, and without prejudice
against all other defendants, at the closing of the Agreement. (See Note R).
During June 2000, we entered into various agreements with Par Chadha, our
former CEO and Chairman, which, among other matters, provides for payments of
$250 per year for three years of consulting services and loans by us for the
exercise of previously granted options to acquire 58,925 options at prices
varying from $140.60 to $985.00 per share. As the members of our Board of
Directors at the time of his resignation ceased to represent more than 50% of
the Board in October 2000, all payments for consulting services were accelerated
and no future consulting services are required. During October 2000, Mr. Chadha
exercised 3,556 options, applying the $500 accelerated payment to the exercise.
In addition, he exercised 25,369 options for which we were contractually
obligated to loan the $5.0 million due on the exercise. Mr. Chadha provided us
with written notification dated in September 2001 that he does not have any
obligations under the agreements. We have notified him that we do not agree with
his interpretation of his repayment obligations under the terms of the
agreements.
During December 2001, we entered into an agreement whereby the
25,369-option exercise was rescinded. Mr. Chadha returned the 25,369 shares to
us for cancellation and we cancelled the receivable due from him and restored
the original option agreements. In June 2002, we filed with the Superior Court
of California, County of Los Angeles a Complaint for Declaratory Relief
regarding the interpretation of the agreement. Also in June 2002, Mr. Chadha
filed a lawsuit against us in the Superior Court of California, County of Los
Angeles, seeking declaratory relief with respect to the interpretation of his
separation agreement and in addition, alleging breach of contract with respect
to his option exercise rights and fraud in connection with his rescission
agreement. In February 2003, both of these lawsuits were dismissed without
prejudice to facilitate settlement negotiations, but they can be refiled at any
time. In April 2003, an agreement in principle to settle these lawsuits was
reached, subject to the execution of a definitive agreement. There can be no
assurance that such a definitive settlement agreement will be executed. Should
the cases be refiled, and should Mr. Chadha prevail in Court, in addition to
any other relief that may be granted, we may be required to issue him 58,925
shares of our stock for no consideration, and/or pay him cash damages, which he
alleges to be in excess of $4 million.
F-20
In April 2002, our former Chairman and CEO, Dr. Xin Cheng, filed a claim
in arbitration seeking, among other things, payment of $500 and acceleration of
the vesting of options pursuant to alleged contractual obligations of our
Sorrento subsidiary. The arbitrator has issued a decision favorable to Dr.
Cheng, and having exhausted our legal remedies, we have paid Dr. Cheng $610 in
full satisfaction of the arbitration award.
In addition, claims in arbitration have been filed by two of our former
financial officers and employees who worked in our Santa Monica office, which
has now been closed, alleging that their resignations in May 2002 were for "good
reason" as defined in their employment agreements, all of which were to expire
on May 22, 2002. We are disputing these claims, and have filed counterclaims in
one of the arbitrations. The aggregate amount of these claims is in excess of
$490.
We have also filed a lawsuit against United Pan Europe Communications,
N.V., one of our customers and a related party to one of Sorrento's Series A
shareholders, in connection with a past due receivable in the amount of $1.6
million for equipment shipped in 2000. The defendant has filed for protection
under the federal bankruptcy laws, and pursuant to the Exchange Agreement
entered into in connection with our capital restructuring, we have executed a
definitive settlement agreement and a stipulation of dismissal with prejudice
resolving this lawsuit in return for a payment of $350 and the return of certain
of the equipment previously shipped. We have received the payment of $350 from
UPC and, in accordance with the terms of the exchange agreement, have paid that
same amount to certain Series A Preferred Stock holders. The equipment has
also been returned.
We have also been sued by a former officer of our Sorrento subsidiary
alleging breach of a consulting agreement we entered into with him in March
2002, following his resignation "for good reason" as defined in his employment
agreement. He is seeking acceleration of consulting fees due to him under his
consulting agreement in the amount of $229. We feel these claims are without
merit and are vigorously defending the claims. We have also filed counterclaims.
Currently, the matter is in the early stages of discovery.
From time to time, we are involved in various other legal proceedings and
claims incidental to the conduct of our business. Although it is impossible to
predict the outcome of any outstanding legal proceedings, we believe that such
legal proceedings and claims, individually and in the aggregate, are not likely
to have a material effect on our financial position, results of operations, or
cash flows.
I. STOCKHOLDERS' EQUITY
Effective as of October 28, 2002 we implemented a one-for-twenty reverse
split of our outstanding shares of common stock. No fractional shares were
issued in connection with the reverse stock split. In lieu of fractional shares,
stockholders will receive a cash payment based on the market price, after
adjustment for the effect of the stock combination. The par value of the common
stock changed to $6.00 per share and the number of authorized shares decreased
from 150 million to 7.5 million shares of common stock. The reverse stock split
also affects options, warrants and other securities convertible into or
exchangeable for shares of the Company's common stock that were issued and
outstanding immediately prior to the effective time of the stock combination.
Preferred stock was not affected.
We are authorized to issue the following shares of stock:
7,500,000 shares of Common Stock ($6.00 par value)
2,000,000 shares of Preferred Stock ($.01 par value) of which the
following series have been designated:
3,000 shares of Preferred Stock, Series D
1,000,000 shares of Preferred Stock, Series F
F-21
We have outstanding the following shares of preferred stock:
Shares Par Liquidation
Outstanding Value Preference
----------- ----- ----------
Series D................................................. 1,353 $0.01 $ 1,353
----------- ----- -----------
1,353 $0.01 $ 1,353
=========== ===== ===========
During January 2001, we issued 86,464 shares of our common stock in
conversion of 1,500 shares of our Series D preferred stock. The remaining 1,353
shares of our non-voting, non-dividend bearing Series D preferred stock are
being held in escrow pending resolution of acquisition contingencies including
liabilities related to funding deficits related to a terminated defined benefit
pension plan of Entrada. Payments by the seller towards these liabilities will
have no effect on our financial results and payments, if any, by us will reduce
the face value of the preferred stock. Each share of Series D preferred stock is
convertible into common stock at the market value at the date of conversion and
we have the right to redeem the shares prior to conversion for 100% of their
conversion value.
J. OTHER CAPITAL STOCK TRANSACTIONS AND BUSINESS ACQUISITIONS
Stock Split - In October, 2002, approval was granted for a one-for-twenty
reverse stock split effective October 28, 2002. The effect of this stock split
was reflected in the financial statements retroactively as if the stock split
occurred at the beginning of the earliest period reported.
Private Placements - Immediately prior to its merger with Sync Research
our Entrada subsidiary completed a private placement of 2,431,818 of its common
shares receiving net proceeds of $7,851. We purchased 1,001,818 of these shares
for $3,306. (See Note A).
On March 22, 2001, we completed a private placement of 76,300
unregistered shares of our common stock receiving net proceeds of $9.6 million.
In addition, the purchasers received three-year warrants to acquire an
additional 19,075 shares of our common stock at $163.80 per share. For a period
of 18 months from the March 22, 2001 completion date in the event we were to
issue shares of common stock or equity securities convertible into our common
stock at a price less than $131.062 per share, the purchasers would be entitled
to receive additional shares of common stock.
During 2000, SNI completed a sale of 8,596,333 shares of its Series A
Convertible Preferred Stock receiving net proceeds of $46.6 million from a group
of investors. 1,467,891 shares were purchased by, and a finders fee of $2.0
million was paid through the issuance by Sorrento of an additional 357,799
shares of its Series A Convertible Preferred Stock to, entities in which one of
our outside directors at the time, who later in 2000 served for several months
as our Chairman and CEO, was a partner or member pursuant to a previously
contracted right of participation.
One of our current outside directors purchased 183,486 shares in this
placement. At the time of purchase, he was not one of our directors. This
individual is also a director of Liberty Media Corporation, which owns an
approximate 74% economic interest representing an approximate 94% voting
interest in United GlobalCom ("UGC"). The purchaser of 3,027,523 shares in this
placement is an indirect subsidiary of UGC. Liberty Media also holds convertible
debt in this Series A holder, which it has agreed to exchange for shares in UGC.
Each share of SNI's Series A Preferred Stock is convertible into one
share of SNI's common stock at the option of the holder, may vote on an "as
converted" basis except for election of directors, and has a liquidation
preference of $5.45 per share. The shares are automatically converted into SNI's
common stock upon an underwritten public offering by SNI with an aggregate
offering price of at least $50.0 million. As SNI did not complete a $50.0
million public offering by March 1, 2001, the holders of more than 50% of the
then outstanding Series A shares had the right to request in writing that SNI
redeem them at the adjusted liquidation preference. On receipt of such a
request, our Sorrento subsidiary has the obligation to redeem the shares in
cash, if funds are lawfully available for such a redemption, or to redeem such
pro rata portion as to which a lesser amount of lawfully available funds do
exist. In April 2001, our Sorrento subsidiary received written redemption
requests from holders of a majority of the Series A shares. The difference
between the net proceeds received on the sale of these shares
F-22
and their liquidation preference of $48.8 million was recorded as a deemed
dividend during the period from issuance to March 31, 2001. During the year
ended January 31, 2003 and 2002, we recorded a deemed dividend of $0 and $180
with respect to the SNI Series A shares.
As of January 31, 2003 and 2002, the Series A Preferred Stock has been
reclassified as a current liability since the holders have exercised their right
to request that SNI redeem the shares. The Series A liability can only be paid
through lawfully available funds that would normally be generated from SNI
profitable operations, which we do not currently have available or foresee the
availability of the near future.
We made sales of products to affiliates of two of the purchasers of
Sorrento's Series A Preferred Stock. During the years ended January 31, 2003 and
2002, we made sales of $29 and $2,076 to the subsidiaries of the purchaser of
33.8% of the shares of which $29 and $1,601 was outstanding at January 31, 2003
and 2002 under 180 days terms. During the fiscal years ended January 31, 2003
and 2002, we made sales of $568 and $2,553 to the subsidiaries of the purchaser
of 6.2% of the shares of which $324 and $2 was outstanding at January 31, 2003
and 2002 respectively.
Warrants - During the year ended January 31, 2001, we issued 13,009
shares of our common stock upon the cashless exercise by our lender of 16,668
warrants with exercise prices ranging from $10.02 to $15.94. (See Note D).
K. STOCK OPTION PLANS
We have four stock options plans in effect: The 2000 Stock Incentive
Plan, the 1988 Stock Option Plan, the 1997 Incentive and Non-Qualified Stock
Option Plan and the 1997 Director Stock Option Plan. The stock options have been
made available to certain employees and consultants. All options are granted at
not less than fair value at the date of grant and have terms varying from 3 to
10 years. The purpose of these plans is to attract, retain, motivate and reward
our officers, directors, employees and consultants to maximize their
contribution towards our success.
We account for these plans under the recognition and measurement
principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and
related Interpretations. No stock-based employee compensation cost is reflected
in net loss, as all options granted under these plans had an exercise price
equal to the market value of the underlying common stock on the date of grant.
The following table illustrates the effect on net loss and loss per share if the
company had applied the fair value recognition provisions of FASB Statement No.
123, Accounting for Stock-Based Compensation, to stock-based employee
compensation.
The following table summarizes the activity in the plans:
Sorrento Networks Corporation (FIBR)
Weighted Average
Number of Shares Exercise Price
---------------- ----------------
Shares under option at January 31, 2000..................... 109,403 $236.60
Granted.................................................. 193,903 $748.40
Exercised................................................ (44,545) $200.20
Canceled................................................. (5,400) $246.20
----------------
Shares under option at January 31, 2001..................... 253,361 $618.60
Granted.................................................. 43,685 $150.40
Exercised................................................ (4,913) $163.40
Canceled................................................. (61,606) $519.60
----------------
Shares under option at January 31, 2002..................... 230,527 $566.00
Granted.................................................. 112,555 $ 25.31
Exercised................................................ -- --
Canceled................................................. (48,805) $406.62
----------------
Shares under option at January 31, 2003..................... 294,277 $387.53
F-23
Additional information relating to stock options outstanding and
exercisable at January 31, 2003 summarized by exercise price are as follows:
Outstanding Exercisable
---------------------------- -------------------------
Weighted Average
Exercise Price ---------------------------- Weighted Average
Per Share Shares Life (Years) Exercise Price Shares Exercise Price
-------------- ------- ------------ -------------- ------- ----------------
$ 4.20 -- $ 19.99...... 73,044 9.61 $ 15.67 43,794 $ 14.95
$ 20.00 -- $ 49.99...... 10,789 9.33 $ 31.70 4,203 $ 31.84
$ 50.00 -- $ 99.99...... 37,694 8.23 $ 57.03 20,837 $ 60.88
$100.00 -- $ 199.99...... 36,021 6.26 $ 142.31 33,879 $ 143.69
$200.00 -- $ 299.99...... 13,612 3.87 $ 243.94 13,612 $ 243.94
$300.00 -- $ 399.99...... 5,746 7.43 $ 355.47 5,746 $ 355.47
$400.00 -- $ 499.99...... 25,359 7.00 $ 447.27 21,194 $ 448.69
$500.00 -- $ 599.99...... 417 3.84 $ 569.20 417 $ 69.20
$600.00 -- $ 699.99...... 8 7.75 $ 623.60 8 $ 623.60
$700.00 -- $ 799.99...... 32,254 7.29 $ 717.91 32,254 $ 717.91
$800.00 -- $ 899.99...... -- -- -- -- --
$900.00 -- $1,382.40...... 59,333 7.34 $1,098.45 59,333 $1,098.45
------- -------
$ 4.20 -- $1,382.40...... 294,277 7.76 $ 387.53 235,277 $ 469.11
======= =======
At January 31, 2003, the Company has four stock-based employee
compensation plans.
Years Ended January 31,
-------------------------------
2003 2002 2001
--------- --------- ---------
Net loss:
As reported.............................................. $(26,210) $(43,136) $ (41,905)
Total stock-based employee compensation expense
determined under fair value based method for all
awards, net of related tax effects..................... (5,581) (3,842) (61,225)
-------------------------------
Pro forma ............................................... (31,791) (46,978) (103,130)
===============================
Loss per share:
Basic EPS as reported.................................... $ (33.29) $ (62.00) $ (74.20)
===============================
Pro forma basic EPS...................................... (40.37) (67.60) (177.40)
===============================
Diluted EPS as reported.................................. (33.29) (76.32) (74.20)
===============================
Pro forma diluted EPS.................................... (40.37) (91.80) (177.40)
===============================
The fair value of option grants is estimated on the date of grant
utilizing the Black-Scholes option-pricing model with the following weighted
average assumptions for grants during the year ended January 31, 2003: expected
life of option 3 years, expected volatility of 180%, risk free interest rate of
2.15% to 4.50% based upon the date of grant and a 0% dividend yield. The fair
value, at date of grant, using these assumptions range from $3.70 to $62.20 and
the weighted average was $22.19. The assumptions for the year ended January 31,
2002 were expected life of option 3 years, expected volatility of 140%, risk
free interest rate of 2.91% to 4.50% and a 0% dividend yield. The fair value, at
date of grant, using these assumptions range from $46.00 to $112.60 and the
weighted average was $83.60. The assumptions for the year ended January 31,
2001 were expected life of option 3 to 5 years, expected volatility of 85%, risk
free interest rate of 4.89 to 6.75% and a 0% dividend yield. The fair value, at
date of grant, using these assumptions range from $179.40 to $801.80 and the
weighted average was $443.40.
F-24
Sorrento Networks Inc.
In addition SNI adopted its 2000 Stock Option/Stock Issuance Plan in
February 2000 under which it has granted options to certain of its employees,
directors and consultants. All options are generally granted at prices not less
than fair value at the date of grant and generally vest over four years.
Eligible individuals may be issued shares of common stock directly, either
through immediate purchase of the shares at fair value or as a bonus tied to
performance of services or the attainment of prescribed milestones. No
milestones were attained and, no stock has been issued under the stock issuance
program.
The option activity for this plan for the year ended January 31, 2003 is
summarized as follows:
Weighted Average
Number of Shares Exercise Price
----------------- ----------------
Shares under option at January 31, 2001................... 18,735,904 $5.34
Granted................................................ 1,193,064 $5.45
Exercised.............................................. (22,300) $2.60
Canceled............................................... (4,592,236) $5.52
-----------
Shares under option at January 31, 2002................... 15,314,432 $5.30
Granted................................................ --
Exercised.............................................. --
Canceled............................................... (12,018,429) $5.39
-----------
Shares under option at January 31, 2003................... 3,296,003 $4.93
Additional information relating to the stock options of SNI outstanding
and exercisable at January 31, 2003 summarized by exercise price are as follows:
Outstanding Exercisable
---------------------------- -------------------------
Weighted Average
Exercise Price ---------------------------- Weighted Average
Per Share Shares Life (Years) Exercise Price Shares Exercise Price
-------------- ------- ------------ -------------- ------- ----------------
$2.00.................... 485,211 7.05 $2.00 482,461 $2.00
$5.45.................... 2,810,792 7.26 $5.45 2,679,826 $5.45
--------- ---------
$2.00 - $5.45............ 3,296,003 7.22 $4.93 3,162,287 $4.93
========= =========
The holders of the options of our Sorrento subsidiary may elect to
convert all or a portion of their options into options to acquire our stock at a
ratio of 78 for one. During the year ended January 31, 2003, 2,340,585 shares
were exchanged for FIBR options and during January 31, 2002, no options were
converted.
Tender Offer
In May 2002 our Board of Directors approved an employees' stock option
exchange program. Under the program, employees holding options to purchase
Sorrento Networks Corp. common stock were given the opportunity to exchange
certain shares of their existing options, those with exercise prices above
$150.00 per share, for new options to purchase an equal number of shares of
Sorrento common stock. The new options were granted six months and one day after
the cancellation of the old options. The exercise price of the new options was
$109.00, the market price on the last reported trading price of Sorrento common
stock on their grant date. Options for 34,960 shares of Sorrento Networks Corp.
common stock were exchanged in the program. (Adjusted for 1-20 reverse split).
Options held by the company's executives and officers were not included in the
exchange program.
F-25
L. INCOME TAXES
Our provision for taxes on income for the years ended January 31, 2003,
2002 and 2001 consists of:
Year ended January 31, 2003:
Current......................................................... $ --
Deferred........................................................ --
--------
Total........................................................... $ --
========
Year ended January 31, 2002:
Current......................................................... $ --
Deferred........................................................ --
--------
Total........................................................... $ --
========
Year ended January 31, 2001:
Current......................................................... $ --
Deferred........................................................ --
--------
Total........................................................... $ --
========
Our domestic operations generate permanent and temporary differences for
depreciation, amortization, valuation allowances and tax attributes arising from
acquisitions. We have recorded a 100% valuation allowance against its deferred
tax assets, including net operating loss and research credit carry forwards, in
accordance with the provisions of Statement of Financial Accounting Standards
No. 109. Such allowance is recognized if, based on the weight of available
evidence, it is more likely than not that some portion or all of the deferred
tax assets will not be realized.
2003 2002
-------- --------
Deferred tax assets:
Valuation allowances.................................................... $ 2,875 $ 3,283
Research and development credits........................................ 63 63
Tax loss carry forwards................................................. 65,754 55,004
Purchase accounting..................................................... 2,057 2,057
Depreciable assets...................................................... 583 583
Other liabilities and reserves.......................................... 2,738 2,334
-------- --------
Gross deferred tax assets............................................. 74,070 63,324
Less: valuation allowance............................................... (74,070) (63,324)
-------- --------
Deferred tax asset.................................................... $ -- $ --
======== ========
At January 31, 2003, we had federal net operating losses which may be
available to reduce future taxable income. Among potential adjustments which may
reduce available loss carry forwards, the Internal Revenue Code of 1986, as
amended, (IRC), reduces the extent to which net operating loss carry forwards
may be utilized in the event there has been an "ownership change" of a company
as defined by applicable IRC provisions. We believe that the issuances of its
equity securities and transfers of ownership of outstanding equity securities
may have resulted in one or more such ownership changes and intends to analyze
the impact of such transfers on the continued availability, for tax purposes, of
the net operating losses incurred through January 31, 2003. Further ownership
changes, such as the pending restructuring agreement, in the future, as defined
by the IRC, may reduce the extent to which any net operating losses may be
utilized. These NOL carry forwards expire as follows:
F-26
2007................................................... $2,327
2008................................................... 1,209
2009................................................... 394
2010................................................... 3,588
2011................................................... 2,819
2012................................................... 4,707
2018................................................... 8,200
2019................................................... 3,963
2020................................................... 45,420
2021................................................... 36,780
2022................................................... 32,508
2023................................................... 22,472
--------
$164,387
========
The reconciliation between income tax expense and a theoretical United
States tax computed by applying a rate of 35% for the years ended January 31,
2003, 2002 and 2001, is as follows:
2003 2001 2001
-------- -------- --------
Income (loss) before income taxes.............................. $(22,610) $(43,136) $(41,905)
======== ======== ========
Theoretical tax (benefit) at 35%............................... (7,914) (15,098) (14,667)
Impact of purchase accounting.................................. -- -- 101
Impact of non-qualified stock options.......................... -- (434) (3,978)
Change in valuation allowance.................................. 10,750 16,862 18,499
Other individually immaterial items............................ (2,836) (1,330) 45
-------- -------- --------
$ -- $ -- $ --
======== ======== ========
M. EARNINGS PER SHARE CALCULATION
The following data show the amounts used in computing basic earnings per
share. The number of shares used in the calculations for the years ended January
31, 2003, 2002 and 2001 reflect a 1-for-20 reverse stock split effective October
28, 2002.
2003 2002 2001
-------- -------- --------
Net loss.................................................. $(26,210) $(43,136) $(41,905)
Less: deemed dividend..................................... -- (180) (1,982)
Less: preferred dividends paid............................ -- -- --
Less: accrued, unpaid preferred dividends................. -- -- (118)
-------- -------- --------
Net loss available to common shareholders used in basic
EPS.................................................... $(26,210) $(43,316) $(44,005)
======== ======== ========
Average number of common shares used in basic EPS......... 787,407 698,303 593,742
======== ======== ========
We incurred a net loss for the years ending January 31, 2003, 2002 and
2001. Accordingly, the effect of dilutive securities including convertible
debentures, convertible preferred stock, vested and nonvested stock options and
warrants to acquire common stock are not included in the calculation of EPS
because their effect would be antidilutive. The following data shows the effect
on income and the weighted average number of shares of dilutive potential common
stock.
F-27
2003 2002 2001
---------- -------- --------
Net loss available to common shareholders used in basic
EPS................................................... $ (26,210) $(43,316) $(44,005)
Interest on convertible debt (net of tax)................ (4,826) (18,405) --
---------- -------- --------
Net loss available to common shareholders after
Assumed conversions of dilutive securities............ $ (31,036) $(61,721) $(44,005)
========== ======== ========
Average number of common shares used in basic EPS........ 787,407 698,303 592,742
Effect of dilutive securities:
Convertible preferred stock........................... -- -- 1,102
Stock benefit plans................................... -- -- 81,413
Stock benefit plan of SNI............................. -- -- --
Warrants.............................................. -- -- 4,670
Convertible debentures................................ 223,301 110,437 --
---------- -------- --------
Average number of common shares and dilutive potential
common stock used in diluted EPS...................... 1,010,708 808,740 679,927
========== ======== ========
The shares issuable upon exercise of options and warrants represents the
quarterly average of the shares issuable at exercise net of the shares assumed
to have been purchased, at the average market price for the period, with the
assumed exercise proceeds. Accordingly, options and warrants with exercise
prices in excess of the average market price for the period are excluded because
their effect would be antidilutive.
N. OTHER RELATED PARTY TRANSACTIONS
Summarized below are all material related party transactions entered into
by us and our subsidiaries during the periods presented not otherwise disclosed
in these notes.
In February 2003 we entered into a consulting agreement with Mr. Robert
Hibbard, a member of the Board of Directors, to provide services to the company
at a consulting rate of $175 per hour plus a retainer of $20 thousand per month
for six months. Mr. Hibbard agrees to make himself available to the Company for
not less than 20 hours per week. The term of this agreement is for twelve
months, but may be terminated after six months by either party, with or without
cause, upon 5 days written notice. This agreement supersedes his August 2002
consulting agreement. Nearly all of Mr. Hibbard's consulting work for us has
involved matters being considered or reviewed by the board or by committees of
the board. His work has included structuring and implementing our 2003 Equity
Incentive Plan for employees, participation in settlement negotiations for
pending litigation, assistance in our capital restructuring and improving our
intellectual property policies and procedures, among other matters. In fiscal
year 2003 Mr. Hibbard was paid $92 thousand in consulting fees.
During fiscal 2002, we paid a total of $55 thousand to Phillip W. Arneson
as a Director of the Company. The amounts paid included $24 thousand for
consulting work performed for a special Committee of the Board, $21 thousand for
various other consulting services including outsourcing advice and
organizational matters, attendance fees of $6 thousand for Board and Committee
meetings and $5 thousand in reimbursable expenses. Consulting fees were paid at
a rate equal to normal fees for attendance at Board meetings.
During July 2000 we agreed to loan $300 thousand for three years at the
applicable federal rate provided for in Internal Revenue Code Section 1274 to
Mr. Jacobson in connection with accepting employment as our Senior Vice
President, Legal. This is a full recourse loan and Mr. Jacobson has pledged his
options to acquire our common stock and any options he may receive from any of
our subsidiaries as collateral. Mr. Jacobson has received $300 thousand in
advances under this loan agreement for which the interest rate is 6.6%. On July
3, 2002 a new note covering the $300 thousand was incorporated in Mr. Jacobson's
employment contract. The term remained the same as the July 2000 note, with all
unpaid, accrued interest and principal due and payable on August 30, 2003. In
December 2002, Mr. Jacobson paid $39 thousand on his loan that included payment
of all prior interest due and the remainder applied to his principal balance. As
of January 31, 2003 Mr. Jacobson's loan outstanding to the Company totaled $298
thousand.
F-28
During June 2000, we entered into various agreements with Par Chadha, our
former CEO and Chairman, which, among other matters, provides for payments of
$250 thousand per year for three years of consulting services and loans by us
for the exercise of previously granted options to acquire 58,925 options at
prices varying from $140.60 to $985.00 per share. As the members of our Board of
Directors at the time of his resignation ceased to represent more than 50% of
the Board in October 2000, all payments for consulting services were accelerated
and no future consulting services are required. During October 2000, Mr. Chadha
exercised 3,556 options, applying the $500 thousand accelerated payment to the
exercise. In addition, he exercised 25,369 options for which we are
contractually obligated to loan the $5.0 million due on the exercise. During
September 2001, Mr. Chadha notified us that he does not have any obligations
under the agreements. We have notified him that we do not agree with his
interpretation of his repayment obligations under the terms of the agreements.
During December 2001, we entered into an agreement whereby the 25,369
option exercise was rescinded. Mr. Chadha returned the 25,369 shares to us for
cancellation and we cancelled the receivable due from him and restored the
original option agreements. The required non-cash expense as a result of the
rescission equal to the difference between the amount of the loan receivable and
the market value of the returned shares was recorded as a reserve of $2.7
million against the receivable during the year ended January 31, 2002 and is
included in other operating expenses in the accompanying income statement. This
rescission agreement did not resolve any underlying dispute as to the option
loan repayment obligations. An agreement in principle to resolve this dispute
has been reached, see details in Note H.
On September 30, 2001, our then Chairman and CEO executed a two year
consulting agreement with Leonard Hecht, A FORMER EMPLOYEE OF THE COMPANY,
whereby Mr. Hecht is to be paid a salary at $250 thousand per year plus benefits
and the vesting of all his options to acquire our common stock. We have since
stopped making payments under this agreement, and have been notified by Mr.
Hecht that he believes we have thereby breached this agreement.
In September 2000, our then Board of Directors approved a two year
consulting agreement with Rohit Phansalkar, A FORMER EMPLOYEE OF THE COMPANY,
whereby he is paid a salary of $250 thousand per year plus benefits and the
vesting of all his options to acquire our commons stock. This agreement was
amended in July 2001.
O. SUPPLEMENTAL CASH FLOW DISCLOSURES
Interest expense for the years ended January 31, 2003, 2002 and 2001 was
$9,619, $3,311 and $918, respectively. During fiscal 2003, $292 was paid in cash
and the remaining $9,327 neither provided for nor used cash. For fiscal years
2002 and 2001, the interest expense neither provided nor used cash.
P. CONCENTRATIONS OF CREDIT RISK
Financial instruments that potentially subject us to concentrations of
credit risk consist primarily of temporary cash investments and trade
receivables. As regards the former, we place our temporary cash investments with
high credit financial institutions and limits. At times such amounts may exceed
the F.D.I.C. limits. We limit the amount of exposure with any one financial
institution and believe that no significant concentration of credit risk exists
with respect to cash investments. No accounts at a single bank accounted for
more than 10% of current assets.
Although we are directly affected by the economic well being of
significant customers listed in the following tables, we do not believe that
significant credit risk exists at January 31, 2003. We perform ongoing
evaluations of our customers and require letters of credit or other collateral
arrangements as appropriate. Accordingly, trade receivable credit losses have
not been significant.
The following data shows the customers accounting for more than 10% of
net receivables at January 31 2003 and 2002:
F-29
2003 2002
---- ----
Customer A..................................................... 29.6% 20.4%
Customer B..................................................... 18.7 --
Customer C..................................................... -- 19.8
Customer D..................................................... 15.9 13.9
Customer E..................................................... -- 24.7
Customer F..................................................... 31.2 3.9
The following data shows the customers accounting for more than 10% of
net sales during the years ended January 31, 2003, 2002 and 2001:
2003 2002 2001
---- ---- ----
Customer A..................................................... 23.0% 14.9% 8.2%
Customer B..................................................... 19.0 23.9 15.7
Customer C..................................................... 12.2 16.3 2.8
Customer D..................................................... 1.3 7.8 21.7
Customer E..................................................... 0.6 6.9 10.9
Customer F..................................................... -- 5.6 12.2
Q. SUBSEQUENT EVENTS
Litigation resolution
On March 4, 2003, SNI and UPC executed a Settlement Agreement resolving
the litigation between SNI and UPC, exchanging mutual releases, and dismissing
the litigation against UPC with prejudice, in exchange for the return of certain
equipment by UPC and the payment of $350 thousand. We have received the payment
of $350 from UPC and, in accordance with the terms of the Exchange Agreement,
have paid that same amount to certain Series A Preferred Stock holders to defray
legal costs incurred by them. The equipment has also been returned.
In April 2003, an agreement in principle was reached to settle our
dispute with Par Chadha and the other parties to our dispute with Mr. Chadha,
subject to the execution of a definitive agreement. There can be no assurance
that such a definitive agreement will be executed.
Nasdaq
On March 6, 2003 we presented before the Nasdaq Panel our reasons for
the request for an extension of time to complete our restructuring plans. On
April 4, 2003, the Panel issued a decision extending until May 16, 2003, our
time to demonstrate compliance with the minimum shareholder equity standard. As
our current plan is to close the capital restructuring, subject to shareholder
approval, on or about May 21, 2003, we are asking the Panel for a short
extension on the May 16 deadline. While there can be no assurance that the Panel
will grant this extension, our understanding is that Panels customarily grant
such short extensions under circumstances such as these.
If our stock is delisted from Nasdaq, the ability of holders of our
common stock to sell our stock could be adversely affected, our ability to
secure future funding might be severely impacted, and there could be a material
adverse effect on our financial condition.
R. RESTRUCTURING AGREEMENT IN PRINCIPLE
On March 6, 2003, we and our wholly-owned subsidiary Sorrento Networks,
Inc. entered into an Exchange Agreement with the holders of our 9.75% Senior
Convertible Debentures (the "Debentures") and the Series A Convertible Preferred
Stock (the "Preferred Stock") of Sorrento Networks, Inc. The Exchange Agreement
and associated documents contemplate an exchange (the "Exchange") of the
Debentures and the Preferred Stock at a closing into shares of common stock and
$12.5 million of our new 7.5% secured convertible debentures (the "New
F-30
Debentures"). Certain holders of the Preferred Stock would also receive
additional New Debentures of approximately $600,000 to pay certain legal fees.
The shares of common stock and the New Debentures to be issued in the
Exchange will represent, in the aggregate, approximately 87.5% of our common
stock on a diluted basis. This percentage takes into account the total number of
existing shares outstanding, the shares to be issued to the holders of the
Debentures and the Preferred Stock at the closing, the shares issuable upon
conversion of $12.5 million of New Debentures, and the shares issuable upon
conversion of warrants to be issued to existing shareholders. This percentage
does not take into account new employee stock options, shares issuable upon
conversion of approximately $600,000 in New Debentures to be issued to certain
holders of the Preferred Stock to pay certain legal fees, and certain other
issuances. The exact number of shares of common stock that will be issued to the
holders of the Debentures and the Preferred Stock upon consummation of the
Exchange will depend on the conversion price of the New Debentures, which will
not be known until shortly before closing. The New Debentures that will be
issued in the Exchange (not including the New Debentures to be issued in
satisfaction of legal fees) will be convertible into not less than 8.75%, or
more than 26.25%, of our shares of common stock, calculated on the same diluted
basis.
The Exchange Agreement contemplates that our existing shareholders will
retain 7.5% of our common stock on the same diluted basis, and will receive
non-transferable warrants to purchase approximately 5% of our common stock,
exercisable beginning one year after the closing at a 10% premium over an
average closing price of our stock prior to the closing of the Exchange. We will
establish a record date not more than ten business days prior to the closing to
determine the specific holders of our common stock who will be entitled to
receive the warrants. The warrants will be exercisable at any time prior to
August 2, 2007, provided that any such exercise of the warrants will be subject
to the effectiveness of a registration statement with respect to the common
shares to be issued upon exercise of the warrants. We may repurchase the
warrants for a nominal price, upon 30 days prior notice, at any time after the
volume-weighted average market price of our common stock for any ten consecutive
trading days equals or exceeds 150% of the exercise price.
The New Debentures will mature on August 2, 2007 and will be
convertible at any time at the option of the holder at a conversion price equal
to the reference price into shares of our common stock. However, the number of
shares issuable upon conversion of the New Debentures on a diluted basis as of
the closing cannot represent less than 8.75%, or more than 26.25%, of our shares
of common stock. Subject to certain limits, interest on the new debentures may
be paid, at our option, either in cash, additional new debentures or our common
stock.
The new debentures would include covenants restricting our ability to
incur senior or subordinated debt or preferred stock other than $5 million in
lease or equipment financing and a $5 million revolving credit facility (up to
$10 million with certain consents), as well as other standard covenants and
protective provisions. At any time prior to the maturity date, we may redeem for
cash on a pro rata basis some or all of the new debentures at par, plus accrued
interest.
At the closing of the restructuring transaction, the New Debentures
will be secured by substantially all of our assets and those of our subsidiaries
(with certain exceptions, including the real estate owned by Meret
Communications, Inc., and Sorrento Valley Real Estate Holdings, LLC). No later
than one year following the closing date, we must provide a second mortgage on
such real estate as security for the New Debentures. When we have done so and we
have merged our subsidiaries into us, most of the remaining collateral will be
released or subordinated at our request to permit us to obtain a secured loan
from a bank.
Until one year after the closing and subject to certain exceptions,
exchanging holders of debentures and Series A preferred stock who continue to
hold common stock received in the exchange and new debentures will be entitled
to certain weighted average anti-dilution protection for such continued holdings
with respect to certain additional issuances of our common stock. In addition,
if we are required to issue shares of common stock upon the exercise of any
right, option or warrant to purchase common stock that was issued prior to the
closing and was not listed on the option schedule to the exchange agreement,
then we will issue additional shares of common stock to the exchanging holders,
and will adjust the conversion price of the new debentures sufficient to offset
the dilutive impact of such issuances.
F-31
The Series A holders as a group may request, on or before the closing,
that we appoint one new director to our Board of Directors. The debenture
holders as a group may also request, on or before the closing, that we appoint
one new director to our Board of Directors. The new director(s) would continue
in office until the next regularly scheduled annual meeting of our shareholders
and shall be nominated for re-election at such meeting.
No later than the day before the closing date of the restructuring
transaction, we will merge with and into a to-be-formed Delaware corporation,
which will be formed solely for the purpose of effecting the change in our state
of incorporation from the State of New Jersey to the State of Delaware. Promptly
after the closing date of the restructuring transaction, and in no event later
than one year after the closing date, our subsidiaries, Sorrento Networks, Inc.,
Meret Communications, Inc., and Sorrento Valley Real Estate Holdings, LLC, will
be merged with and into us.
While we are working to complete the restructuring plan and consummate
the exchange, our ability to do so is not certain, and depends on many factors,
including but not limited to our ability to satisfy or obtain waivers with
regard to the conditions in the definitive agreement, obtain the requisite
consents from the debenture holders and Series A shareholders, pay the
substantial legal costs associated with the restructuring from existing capital
resources, and raise additional capital in a timely manner. If we are not able
to carry out the restructuring plan embodied in the letter of intent, we will
have to explore other alternatives on an expedited basis. There can be no
assurance, however, that we will be able to find an acceptable alternative.
If we are not successful in the restructuring we will be delisted from
Nasdaq, this delisting would constitute a triggering event that would allow our
debenture holders to request accelerated payment of their debentures at 125% of
the face value, this condition gives rise to substantial doubt about the
Company's ability to continue as a going concern. If such an event were to
occur, we would not have the financial resources to repay such a request, thus
resulting in a default under the debenture agreement.
S. SEGMENT INFORMATION
Information for the years ended January 31, 2003, 2002 and 2001 in the
table below is presented on the same basis utilized by the Company to manage its
business. The segments according to product lines are as follows; Sorrento
Networks, Meret Optical and other. Export sales and certain income and expense
items are reported in the geographic area where the final sale to customers is
made, rather than where the transaction originates. We have no material long
term assets outside the United States. The accounting policies of the segments
are the same as the policies described in the "Summary of Significant Accounting
Policies." Each segment operates independent of one another. The company
evaluates the performance of each segment and distributes resources to them
based on earnings before income taxes, excluding corporate charges ("Segment
income Class) from operations"). Any corporate changes that are allocated to
the segments are allocated as a percentage of revenue. These charges, if any,
are recorded under "other income (expenses)" and are eliminated in the
consolidation process. "Other income (expenses)" is not shown in the
supplemental segment information contained below.
Geographical Information
The table below present external revenues based on the locations of the
customer:
2003 2002 2001
------- ------- -------
Net sales:
United States.......................................................... $14,803 $28,341 $36,923
Asia................................................................... 865 1,340 247
Europe................................................................. 9,469 10,130 7,285
Other.................................................................. -- 1,016 186
-------- ------- -------
Total net sales...................................................... $25,137 $40,827 $44,641
======= ======= =======
Products and Service Revenue
The table below presents external revenues for groups of similar
products and services:
F-32
2003 2002 2001
------- ------- -------
Net sales:
Optical networking .................................................... $22,373 $36,034 $38,369
Switching and access................................................... 2,764 4,793 6,272
------- ------- -------
Total net sales...................................................... $25,137 $40,827 $44,641
======= ======= =======
Supplemental Segment Information:
Sorrento Meret
Networks Optical Other Consolidated
-------- ------- ------- -----------
As of January 31, 2003:
Revenues from external customers...................... $ 22,373 $ 2,764 $ -- $ 25,137
Cost of goods sold.................................... 19,257 2,560 -- 21,817
Gross profit....................................... 3,116 204 -- 3,320
Segment income/(loss) from operations................. (25,017) (1,329) (4,929) (31,275)
Depreciation and amortization expense................. 3,257 702 103 4,062
Valuation allowance additions (reductions):
Receivables and inventory.......................... (704) (316) -- (1,020)
Capital asset additions, net.......................... 3,201 62 70 3,333
Total assets.......................................... 31,497 5,375 18,933 55,805
Sorrento Meret
Networks Optical Other Consolidated
-------- ------- ------- -----------
As of January 31, 2002:
Revenues from external customers.................... $ 36,034 $4,793 $ -- $ 40,827
Cost of goods sold.................................. 28,384 3,123 -- 31,507
Gross profit..................................... 7,650 1,670 -- 9,320
Operating income/(loss) from operations............. (28,993) 246 (8,407) (37,154)
Depreciation and amortization expense............... 2,039 543 212 2,794
Valuation allowance additions:
Receivables and inventory........................ 5,328 269 987 5,596
Other............................................ 812 -- 1,788 2,600
Capital asset additions, net........................ 3,116 67 52 3,235
Total assets........................................ 36,089 7,282 46,968 90,339
Sorrento Meret Entrada
Networks Optical Networks Other Consolidated
--------- ------- -------- ------- ------------
As of January 31, 2001 except for Entrada
which is as of August 31, 2000:
Revenues from external customers.......... $ 26,477 $6,272 $11,892 $ -- $ 44,641
Cost of goods sold........................ 17,344 3,661 10,465 -- 31,470
Gross profit......................... 9,133 2,611 1,427 -- 13,171
F-33
Sorrento Meret Entrada
Networks Optical Networks Other Consolidated
--------- ------- -------- ------- ------------
Operating income/(loss) from continuing
operations........................... (36,147) 1,031 (7,859) (7,440) (50,415)
Depreciation and amortization expense... 2,593 515 1,024 254 4,386
Valuation allowance additions:
Receivables and inventory.......... 642 678 4,327 700 6,347
Other.............................. 1,979 -- 434 -- 2,413
Capital asset additions, net............ 8,320 157 444 5,492 14,413
Total assets........................... 36,524 9,088 n/a 67,511 113,123
T. VALUATION AND QUALIFYING ACCOUNTS
Changes in the inventory valuation reserve were as follows:
Balance at January 31, 2000............................................. $ 4,070
Additions charged to costs and expenses............................... 3,689
Amounts used during year.............................................. (55)
Balance of Entrada at August 31, 2000................................. (4,912)
Balance at January 31, 2001............................................. 2,792
Additions charged to costs and expenses............................... 4,038
Amounts used during year.............................................. (362)
Balance at January 31, 2002............................................. 6,468
Additions charged to costs and expenses............................... 4,152
Amounts used during year.............................................. (4,657)
Balance at January 31, 2003............................................. $ 5,963
=======
Changes in the accounts receivable valuation reserve were as follows:
Balance at January 31, 2000............................................. $ 1,203
Additions charged to costs and expenses............................... 1,958
Amounts used during year.............................................. (570)
Balance of Entrada at August 31, 2000................................. (1,589)
Balance at January 31, 2001............................................. 1,002
Additions charged to costs and expenses............................... 1,558
Amounts used during year.............................................. (821)
Balance at January 31, 2002............................................. 1,739
Additions charged to costs and expenses............................... 1,531
Amounts used during year.............................................. (2,046)
Balance at January 31, 2003............................................. $ 1,224
=======
U. UNAUDITED QUARTERLY FINANCIAL DATA (Unaudited)
Amounts in thousands, except per share amounts.
F-34
First Second Third Fourth
Quarter Quarter Quarter Quarter Year
------- -------- -------- -------- --------
Year ended January 31, 2003:
Net sales......................................... $ 6,003 $ 5,199 $ 5,525 $ 8,410 $ 25,137
Gross profit (loss)............................... 1,488 (2,300) 962 3,170 3,320
Income (loss) from operations..................... 3,976 (15,806) (6,922) (7,458) (26,210)
Net income (loss)................................. 3,976 (15,806) (6,922) (7,458) (26,210)
Net income (loss) per share:
Basic........................................... 5.60 (21.40) (8.86) (8.42) (33.29)
Diluted......................................... (25.20) (45.20) (34.54) (32.64) (33.29)
Year ended January 31, 2002:
Net sales......................................... $14,497 $ 7,998 $ 10,066 $ 8,266 $ 40,827
Gross profit...................................... 4,929 1,296 1,321 1,774 9,320
Loss from operations.............................. (5,768) (10,961) (15,924) (10,483) (43,136)
Net loss.......................................... (5,768) (10,961) (15,924) (10,483) (43,136)
Net loss per share:
Basic........................................... (9.00) (15.40) (22.24) (14.80) (62.00)
Diluted......................................... (9.00) (15.40) (22.24) (14.80) (76.32)
F-35
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In Thousands)
April 30, January 31,
2003 2003
--------- ---------
(Unaudited)
ASSETS
CURRENT ASSETS
Cash and equivalents .............................................................. $ 3,785 $ 7,747
Accounts receivable, net .......................................................... 5,000 5,576
Inventory, net .................................................................... 11,973 13,934
Prepaid expenses and other current assets ......................................... 592 741
Investment in marketable securities ............................................... 5,020 3,959
--------- ---------
TOTAL CURRENT ASSETS ............................................................ 26,370 31,957
--------- ---------
PROPERTY AND EQUIPMENT, NET .......................................................... 15,390 17,103
--------- ---------
OTHER ASSETS
Purchased technology, net ......................................................... 327 430
Investment in non-marketable securities ........................................... 5,025 5,025
Other assets ...................................................................... 977 1,290
--------- ---------
TOTAL OTHER ASSETS .............................................................. 6,329 6,745
--------- ---------
TOTAL ASSETS ......................................................................... $ 48,089 $ 55,805
========= =========
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES
Current maturities of long term debt .............................................. $ 204 $ 222
Accounts payable .................................................................. 3,595 5,135
Deferred revenue .................................................................. 373 3,700
Accrued professional fees ......................................................... 3,845 4,324
Other accrued liabilities and current liabilities ................................. 7,223 6,236
Due on redemption of preferred security of subsidiary ............................. 48,800 48,800
--------- ---------
TOTAL CURRENT LIABILITIES ....................................................... 64,040 68,417
--------- ---------
Long-term debt and capital lease obligations ......................................... 3,597 3,644
Debentures payable, face amount of $32,200, net of unamortized costs and discounts ... 19,940 18,121
Dividends payable .................................................................... 99 99
--------- ---------
TOTAL LIABILITIES ............................................................... 87,676 90,281
--------- ---------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value; liquidation preference $1,353 .................... 1 1
Common stock, $6.00 par value; 7,500 shares authorized; 887 shares issued 886
shares outstanding at April 30, 2003; 887 shares issued 886 shares outstanding at
January 31, 2003 ................................................................ 5,318 5,318
Additional paid-in capital ........................................................ 144,933 144,887
Deferred stock compensation ....................................................... -- (5)
Accumulated deficit ............................................................... (193,758) (187,536)
Accumulated other comprehensive loss .............................................. 3,988 2,928
Treasury stock, at cost; 1 share at April 30, 2003 and January 31, 2003,
respectively .................................................................... (69) (69)
--------- ---------
TOTAL STOCKHOLDERS' DEFICIT ..................................................... (39,587) (34,476)
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT .......................................... $ 48,089 $ 55,805
========= =========
See accompanying notes to consolidated financial statements.
F-36
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
(In Thousands, except per share amounts)
Three Months Ended
April 30,
---------------------
2003 2002
------- --------
NET SALES ......................................................... $ 7,861 $ 6,003
COST OF SALES ..................................................... 5,907 4,515
------- --------
GROSS PROFIT ................................................. 1,954 1,488
------- --------
OPERATING EXPENSES
Selling and marketing .......................................... 2,175 3,432
Engineering, research and development .......................... 1,644 2,534
General and administrative ..................................... 1,599 1,863
Deferred stock compensation .................................... 51 106
Other operating expenses ....................................... 103 97
------- --------
TOTAL OPERATING EXPENSES ..................................... 5,572 8,032
------- --------
LOSS FROM OPERATIONS .............................................. (3,618) (6,544)
------- --------
OTHER INCOME (EXPENSES)
Investment income .............................................. -- 94
Interest expense ............................................... (2,665) (1,310)
Other income (expenses) ........................................ 61 80
Gain on sale of marketable securities .......................... -- 11,656
------- --------
TOTAL OTHER INCOME (EXPENSES) ................................ (2,604) 10,520
------- --------
NET INCOME (LOSS) ................................................. $(6,222) $ 3,976
======= ========
EARNINGS (LOSS) PER SHARE:
NET INCOME (LOSS) APPLICABLE TO COMMON SHARES .................. $(6,222) $ 3,976
BASIC WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING ................................................ 886 716
------- --------
BASIC NET INCOME (LOSS) PER COMMON SHARE .......................... $(7.02) $5.60
======= ========
DILUTED WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING ................................................ 1,109 946
------- --------
DILUTED NET LOSS PER COMMON SHARE ................................. $(14.33) $ (25.20)
======= ========
COMPREHENSIVE INCOME (LOSS) AND ITS COMPONENTS CONSIST OF
THE FOLLOWING:
Net income (loss) ............................................ $(6,222) $3,976
Components of other comprehensive income (loss):
Unrealized holding gains (losses) arising during the period 1,060 (1,398)
Reclassification adjustment for gains included in net income -- (11,656)
------- --------
NET COMPREHENSIVE LOSS ............................................ $(5,162) $ (9,078)
======= ========
See accompanying notes to consolidated financial statements.
F-37
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
For the three months ended April 30, 2003
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In Thousands)
Common Stock Preferred Stock Additional Deferred
------------ --------------- Paid in Stock
Shares Amount Shares Amount Capital Compensation
------ ------ ------ ------ ------- ------------
Balance at January 31, 2003................. 886 $5,318 2 $1 $144,887 $ (5)
Unrealized losses on available for sale
securities...............................
Deferred stock compensation of subsidiary... 46 (46)
Amortization of deferred stock compensation. 51
--- ------ - -- -------- --
Net loss....................................
--- ------ - -- -------- --
Balance at April 30, 2003................... 886 $5,318 2 $1 $144,933 $ --
=== ====== = == ======== ====
Treasury
Stock Other Total
Accumulated ------------- Comprehensive Stockholders'
Deficit Shares Amount Loss Equity
------- ------ ------ ---- ------
Balance at January 31, 2003................. $(187,536) 1 $(69) $2,928 $(34,476)
Unrealized losses on available for sale
securities............................... 1,060 1,060
Deferred stock compensation of subsidiary... --
Amortization of deferred stock compensation. --
-------- - ---- ------ --------
Net loss.................................... (6,222) (6,222)
-------- - ---- ------ --------
Balance at April 30, 2003................... $(193,758) 1 $(69) $3,988 $(39,587)
========= = ==== ====== =========
See accompanying notes to consolidated financial statements.
F-38
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
For the three months ended April 30, 2002
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In Thousands)
Common Stock Preferred Additional Deferred
--------------- ------------- Paid in Stock
Shares Amount Shares Amount Capital Compensation
------ ------ ------ ------ ------- ------------
Balance at January 31, 2002................. 710 $4,263 2 $1 $143,705 $(255)
Stock option and warrant exercises.......... 1 9 (9)
Unrealized losses on available for sale
securities...............................
Realized gains on available for sale
securities...............................
Deferred stock compensation of subsidiary... 45 (45)
Expenses paid with stock issuances.......... 16 91 683
Amortization of deferred stock compensation. 106
--- ------ - -- -------- -----
Net loss....................................
--- ------ - -- -------- -----
Balance at April 30, 2002................... 727 $4,363 2 $1 $144,424 $(194)
=== ====== = == ======== =====
Treasury
Stock Other Total
Accumulated ------------- Comprehensive Stockholders'
Deficit Shares Amount Loss Equity
------- ------ ------ ---- ------
Balance at January 31, 2002................. $(161,326) 1 $(69) $ 24,160 $10,479
Stock option and warrant exercises.......... --
Unrealized losses on available for sale
securities............................... (1,398) (1,398)
Realized gains on available for sale
securities............................... (11,656) (11,656)
Deferred stock compensation of subsidiary... --
Expenses paid with stock issuances.......... 744
Amortization of deferred stock compensation. 106
--------- - ---- -------- ---------
Net loss.................................... 3,976 3,976
--------- - ---- -------- ---------
Balance at April 30, 2002................... $(157,350) 1 $(69) $ 11,106 $ 2,251
========= = ==== ======== =========
See accompanying notes to consolidated financial statements.
F-39
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In Thousands)
Three Months Ended
April 30,
---------------------
2003 2002
------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) ...................................................... $(6,222) $ $3,976
------- --------
Adjustments to reconcile net income (loss) to net cash used in operating
activities:
Depreciation and amortization ...................................... 1,040 1,358
Accounts receivable and inventory reserves ......................... (189) 716
Gain on sale of marketable securities .............................. -- (11,656)
Non-cash interest on debentures .................................... 1,819 774
Deferred and other stock compensation .............................. 51 106
Changes in assets and liabilities:
(Increase) decrease in accounts receivable ....................... 754 (1,638)
Decrease in inventories .......................................... 1,972 1,061
Decrease in other current assets ................................. 149 48
Increase (decrease) in accounts payable .......................... (1,540) 1,032
Increase (decrease) in deferred revenue .......................... (3,327) 43
Increase (decrease) in accrued and other current liabilities ..... 508 (28)
------- --------
NET CASH USED IN OPERATING ACTIVITIES ................................ (4,985) (4,208)
------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
(Purchase) disposal of property and equipment .......................... 775 (1,944)
Cash received from sale of marketable securities and other investments . -- 13,574
Other assets ........................................................... 313 4
------- --------
NET CASH PROVIDED BY INVESTING ACTIVITIES ............................ 1,088 11,634
------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Payments of short-term debt, net ....................................... -- (153)
Repayment of long-term debt ............................................ (65) (24)
------- --------
NET CASH USED IN FINANCING ACTIVITIES ................................ (65) (177)
------- --------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS .......................... (3,962) 7,249
CASH AND CASH EQUIVALENTS - BEGINNING OF PERIOD ........................... 7,747 14,243
------- --------
CASH AND CASH EQUIVALENTS - END OF PERIOD ................................. $ 3,785 $ 21,492
======= ========
See accompanying notes to consolidated financial statements.
F-40
Sorrento Networks Corporation (formerly Osicom Technologies, Inc.) (the
"Company," "We," "Our," or "Us") through its subsidiaries designs, manufactures
and markets integrated networking and bandwidth aggregation products for
enhancing the performance of data and telecommunications networks. Our products
are deployed in telephone companies, Internet Service Providers, governmental
bodies and the corporate/campus networks that make up the "enterprise" segment
of the networking marketplace. We have facilities in San Diego, California and
various sales offices located in the United States and Europe. We market and
sell our products and services through a broad array of channels including
worldwide distributors, value added resellers, local and long distance carriers
and governmental agencies.
Summary of Significant Accounting Policies
Basis of Presentation
The accompanying financial data for the three months ended April 30,
2003 and 2002 along with financial data for January 31, 2003, has been prepared
by us, without audit, pursuant to the rules and regulations of the Securities
and Exchange Commission. Certain information and footnote disclosures normally
included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America have been
condensed or omitted pursuant to such rules and regulations. The January 31,
2003 balance sheet was derived from audited financial statements, but does not
include all disclosures required by accounting principles generally accepted in
the United States of America. However, we believe that the disclosures we have
made are adequate to make the information presented not misleading. These
consolidated financial statements should be read in conjunction with the
financial statements and the notes thereto included in our Annual Report on Form
10-K for the year ended January 31, 2003.
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates that affect the reported amounts of assets,
liabilities, revenues and expenses, the disclosure of contingent assets and
liabilities. Actual results could materially differ from these estimates. In the
opinion of Management, all adjustments (which include normal recurring
adjustments and charges described in the notes to the financial statements)
necessary to present fairly the financial position, results of operations and
cash flows for the quarters ended April 30, 2003 and 2002 have been made. The
results of operations for the quarter ended April 30, 2003 are not necessarily
indicative of the operating results for the full year.
We have incurred significant losses and negative cash flows from
operations for the past two years. SNI, our principal operating subsidiary, has
primarily been the operating entity responsible for these losses and negative
cash flows. The losses have been generated as SNI continues to develop its
technology, marketing, sales and operations in its effort to become a major
supplier of metro and regional optical networks worldwide. We fund our
operations primarily through a combination of internal funds, investments, and
debt and equity financing. There can be no assurance that similar funding will
be available in the future. Further, with the recent downturn in the economic
environment and decreases in capital spending by telecom carriers, we believe
our current and future revenues could be negatively impacted. However, orders
for the quarter ended April 30, 2003 were substantially higher than for the same
comparable quarter last year and as a result we believe this upward trend could
indicate a potential recovery from the lingering telecom capital expenditure
downturn. In either case, future increases in working capital will be required
to both maintain and grow our business along with a continued and substantial
focus on reducing operating expenses. Given the uncertainty and/or
predictability of the telecom market and the limited amount of our existing
working capital there can be no assurance that our existing financial resources
will be sufficient to cover our operational needs for the next twelve months. If
however, our revenues continue to show improvement, we implement our plans on
expense reductions and attract additional working capital through the issuance
of stock or debt, our balance sheet will be significantly improved and will
provide us with the necessary financial resources to meet our operational plans
for a period exceeding one year. In addition our auditors have issued a going
concern qualification to their opinion regarding the successful approval and
completion of our Capital Restructuring Plan, which closed on June 4, 2003.
Our future capital requirements may vary materially from those now
planned including the need for additional working capital to accommodate planned
growth, hiring and infrastructure needs. There can be no assurances that our
working capital requirements will not exceed our ability to generate sufficient
cash internally to
F-41
support our requirements and that external financing will be available or that,
if available, such financing can be obtained on terms favorable to us and our
shareholders.
Use of Estimates
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates that affect the reported amounts of assets,
liabilities, revenues and expenses, the disclosure of contingent assets and
liabilities. Actual results could materially differ from these estimates. In the
opinion of Management, all adjustments (which include normal recurring
adjustments and charges described in the notes to the financial statements)
necessary to present fairly the financial position, results of operations and
cash flows for the quarters ended April 30, 2003 and 2002 have been made.
Certain reclassifications have been made to prior year presentations to
conform to the 2004 presentation.
Digi International, Inc. and NETsilicon, Inc.
Digi International, Inc. and NETsilicon, Inc. -- On September 15, 1999,
NETsilicon, Inc. ("NSI") completed an initial public offering in which 6,037,500
shares of its common stocks were sold (3,537,500 shares by NSI and 2,500,000
shares by us). NSI received net proceeds of $22.3 million and we received net
proceeds of $15.4 million. In addition, NSI repaid advances due us of $5.9
million. In connection with the initial public offering by NSI, our remaining
55% interest became non-voting shares. Accordingly, our financial statements
reflected the results of operations of NSI through September 14, 1999 at which
time our remaining interest was accounted for as an "available for sale
security." Under this accounting, the 7.5 million shares of NSI held by us were
marked-to-market at the end of each reporting period with the difference between
our basis and the fair market value, as reported on NASDAQ, reported as a
separate element of stockholders' equity and included in the computation of
comprehensive loss.
In October 2000, we sold 350,000 shares of our investment in NSI for
$4.2 million. The purchasers had the right to receive additional NSI shares from
us if the three-day average high for the NSI common stock, as quoted on NASDAQ,
at December 31, 2000 was less than the price paid to us by the purchasers but
not less than $8.00 per share. We issued an additional 177,344 shares of NSI to
the purchasers, reducing the price per share we received to $8.00 per share. Our
former Chairman and CEO purchased 100,000 of these shares of NSI for $1.2
million and received an additional 45,546 shares pursuant to the price
protection provision. As a result of this transaction, our remaining interest
was approximately 7.0 million shares of NSI, or 51% of the outstanding shares of
NSI as of January 31, 2002 and continued to be accounted for as a
marked-to-market security.
On February 13, 2002, NSI completed a merger with Digi International,
Inc. ("DIGI"). In connection with the merger, we exchanged our 6,972,656 shares
of NSI for 2,324,683 shares of DIGI and $13.6 million in cash. On December 9,
2002, we sold one-half of our holdings in DIGI for $3.10 per share. The
purchaser of the stock was DIGI, itself. The proceeds from this sale, in the
amount of $3.6 million, were deposited on December 13, 2002. The remaining
1,162,341 DIGI shares owned by us are accounted for as an "available for sale
security". Under this accounting, these shares are marked-to-market at the end
of each reporting period. The difference between our basis and the fair market
value, as reported on NASDAQ, is a separate element of stockholders' equity and
is included in the computation of comprehensive income. The closing price of
DIGI common stock on April 30, 2003 was $4.24, and is reflected in the valuation
of our marketable securities as of that date. See Subsequent Events.
Entrada Networks, Inc. -- On August 31, 2000, we completed a merger of
our then subsidiary Entrada Networks with Sync Research, Inc. ("Sync"), a NASDAQ
listed company in which we received 4,244,155 shares of the merged entity, which
changed its name to Entrada Networks, Inc. ("ENI"). We purchased 93,900 shares
of Sync in the open market during June and July 2000 for $388 and on August 31,
2000 purchased an additional 1,001,818 shares directly from ENI for $3.3
million. After these transactions and ENI's issuance of additional shares to
outside investors in connection with the merger we owned 49% of ENI.
Accordingly, our financial statements reflected the results of operations of ENI
through August 31, 2000.
Pursuant to a plan adopted by our Board of Directors prior to the
merger we distributed 3,107,155 of our ENI shares on December 1, 2000 to our
shareholders of record as of November 20, 2000. The distribution was made at the
rate of one-fourth (0.25) of an ENI share for each of our outstanding shares. At
exercise, options and warrants to acquire our common shares, which were granted
and unexercised as of November 20, 2000, would have received a similar number of
ENI shares. Prior to January 31, 2001 we distributed 20,182 of our ENI shares
upon the exercise
F-42
of options and as of January 31, 2003 we have reserved 826,000 shares for future
exercises of options and warrants. The cost basis of these reserved shares and
related liability to the option and warrant holders is included in the
investment in former subsidiary and dividends payable in the accompanying
balance sheet. The aggregate distribution of our ENI shares including the shares
reserved for option and warrant holders has been accounted for at our original
cost of $5.1 million. In addition, we have granted options to purchase 410,000
of our ENI shares for $3.19 per share (the merger price) to several of our then
officers and consultants. In April 2003, our Board of Directors determined that
the 826,000 ENI shares should be made available for general corporate purposes,
and we are no longer reserving any for distribution to option and warrant
holders.
The remaining 326,034 ENI shares owned by us were accounted for as an
"available for sale security". Under this accounting, these shares are
marked-to-market at the end of each reporting period. The difference between our
basis and the fair market value, as reported on NASDAQ, is a separate element of
stockholders' equity and is included in the computation of comprehensive income.
Deferred Stock Compensation
We account for employee-based stock compensation utilizing the
intrinsic value method prescribed in Accounting Principles Board Opinion No. 25,
"Accounting for Stock Issued to Employees." Accordingly, compensation cost for
stock options issued to employees is measured as the excess, if any, of the fair
market price of our common stock at the date of grant over the amount an
employee must pay to acquire the stock. This amount appears as a separate
component of stockholders' equity and is being amortized on an accelerated basis
by charges to operations over the vesting period of the options in accordance
with the method described in Financial Accounting Standards Board Interpretation
No. 28. All such amounts relate to options to acquire common stock of our
Sorrento subsidiary granted by it to its employees; during the three months
ended April 30, 2003 and 2002 it amortized $5 thousand and $62 thousand,
respectively, of the total $2.6 million initially recorded for deferred stock
compensation.
For non-employees, we compute the fair value of stock-based
compensation in accordance with Statement of Financial Accounting Standards No.
123, "Accounting for Stock-Based Compensation," and Emerging Issues Tax Force
(EITF) 96-18, "Accounting for Equity Instruments that are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services." All
such amounts relate to options to acquire common stock of our subsidiary
Sorrento Networks, Inc. ("SNI") granted by it to its consultants; during the
three months ended April 30, 2003 and 2002 it recorded $46 thousand and $44
thousand, respectively, for options granted to consultants.
Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board ("FASB")
issued FASB Interpretation ("FIN") No. 46, "Consolidation of Variable Interest
Entities", and interpretation of Accounting Research Bulletin No. 51,
"Consolidated Financial Statements", FIN No. 46 explains how to identify
variable interest entities and how an enterprise assesses its interests in a
variable interest entity to decide whether to consolidate that entity. This
Interpretation requires existing unconsolidated variable interest entities to be
consolidated by their primary beneficiaries if the entities do not effectively
disperse risks among parties involved. FIN No. 46 is effective immediately for
variable interest entities created after January 31, 2003, and to variable
interest entities in which an enterprise obtains an interest after that date.
The Interpretation applies in the first fiscal year or interim period beginning
after June 15, 2003, to variable interest entities in which an enterprise holds
a variable interest that is acquired before February 1, 2003. We have adopted
FIN No. 46 with no material effect on our financial position or results of
operations.
In June 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 146, "Accounting for
Costs Associated with Exit or Disposal Activities", which addresses accounting
for restructuring and similar costs. SFAS No. 146 supersedes previous accounting
guidance, principally Emerging Issues Task Force ("EITF") Issue No. 94-3. We
have adopted the provisions of SFAS 146 for restructuring activities initiated
after December 31, 2002. SFAS 146 requires that the liability for costs
associated with an exit or disposal activity be recognized when the liability is
incurred. Under EITF No. 94-3, a liability for an exit cost was recognized at
the date of a company's commitment to an exit plan. SFAS 146 also establishes
that the liability should initially be measured and recorded at fair value.
Accordingly, SFAS 146 may affect the timing of recognizing future restructuring
costs as well as the amount recognized. Adoption of this standard did not have
any immediate effect on our consolidated financial statements.
F-43
In August 2001, the Financial Accounting Standards Board issued SFAS
No. 143, Accounting for Asset Retirement Obligations. This Statement is
effective for fiscal years beginning after June 15, 2002. SFAS No. 143 provides
accounting requirements for obligations associated with the retirement of
tangible long-lived assets and the associated asset retirement costs. Under the
Statement, the asset retirement obligation is recorded at fair value in the
period in which it is incurred by increasing the carrying amount of the related
long-lived asset. The liability is accreted to its present value in each
subsequent period and the capitalized cost is depreciated over the useful life
of the related asset. The adoption of SFAS 143 did not have a material effect on
our financial position or results of operations.
Balance Sheet Detail
Inventories at April 30, 2003 and January 31, 2003 consist of:
April 30, January 31,
2003 2003
------- -------
Raw material......................................................... $10,478 $11,306
Work in process...................................................... 2,192 2,265
Finished goods....................................................... 5,255 6,326
------- -------
17,925 19,897
Less: Valuation reserve.............................................. (5,952) (5,963)
------- -------
$11,973 $13,934
======= =======
Marketable Securities--Marketable securities, which consist of equity
securities that have a readily determinable fair value and do not have sale
restrictions lasting beyond one year from the balance sheet date, are classified
into categories based on our intent. Our investments in DIGI and Entrada are
classified as available for sale and are carried at fair value, based upon
quoted market prices, with net unrealized gains reported as a separate component
of stockholders' equity until realized. Unrealized losses are charged against
income when a decline in fair value is determined to be other than temporary. At
April 30, 2003, and January 31, 2003, marketable securities were as follows:
Unrealized Market
Cost Gains Value
---- ----- -----
April 30, 2003:
Digi ........................ $1,009 $3,920 $4,929
Entrada ..................... 22 69 91
------ ------ ------
$1,031 $3,989 $5,020
====== ====== ======
January 31, 2003:
Digi ........................ $1,009 $2,884 $3,893
Entrada ..................... 22 44 66
------ ------ ------
$1,031 $2,928 $3,959
====== ====== ======
Intangible Assets--Under SFAS No. 142, goodwill and indefinite life
intangible assets are no longer amortized but are subject to periodic impairment
tests. We have no goodwill or indefinite life intangible assets. Other
intangible assets with finite lives, such as our purchased technology, will
continue to be amortized over their useful lives.
The net carrying value of finite life intangible assets, consisting of
purchased technology, as of April 30, 2003, is $327 thousand, net of
amortization and is allocated to the Meret Optical Communications segment.
The change in the net carrying amount of finite life intangible assets
during the three months ended April 30, 2003 is due to amortization of $103
thousand. Annual estimated finite life intangible asset amortization expense for
each of the remaining fiscal years is expected to approximate $40 thousand, $40
thousand, and $30 thousand.
F-44
Debentures - During August 2001, we completed a private placement of
our 9.75% convertible debentures receiving net proceeds of $29.8 million. The
debentures, due August 2, 2004 have a face value of $32.2 million, which is
convertible into our common stock at $144.20 per share. At maturity we may elect
to redeem the debentures for cash and we have the option of paying the interest
on these debentures in shares of our common stock. In addition, the purchasers
received four year warrants to acquire an additional 167,592 shares of our
common stock at $144.20 per share and the placement agent received five year
warrants to acquire 5,583 shares of our common stock, equity securities, options
or warrants at a price less than $144.20 per share or at a discount to the then
market price. The conversion price and warrant exercise are subject to
adjustment.
In accordance with Emerging Issues Task Force ("EITF") No. 00-27 we
have accounted for the fair value of warrants issued to the purchasers and
placement agent and the fair value of the deemed beneficial conversion feature,
which results solely as a result of the required accounting, of the debenture as
a reduction to the face value of the debentures with an offsetting increase to
additional paid in capital. These amounts as well as the issuance costs paid in
cash are amortized as additional interest expense over the period the debentures
are outstanding. Interest expense during the three months ended April 30, 2003
of $2.6 million included the stated 9.75% interest of $765, amortization of
issuance costs of $203, and amortization of the fair value of the warrants
issued to the purchasers and placement agent and the deemed beneficial
conversion feature of $1.6 million. At April 30, 2003 and January 31, 2003
debentures payable consists of:
April 30, January 31,
2003 2003
----------- ------------
Face Value................................................................ $ 32,200 $ 32,200
Issuance costs............................................................ (2,451) (2,451)
Value of warrants and deemed beneficial Conversion feature................ (19,525) (19,525)
-------- --------
Debenture book value at issuance....................................... 10,224 10,224
Accumulated amortization of Issuance costs................................ 1,084 881
Value of warrants and deemed beneficial conversion feature................ 8,632 7,016
-------- --------
$ 19,940 $ 18,121
======== ========
We are in the process of a debt and equity restructuring plan that
would exchange current outstanding debentures and Series A Preferred Stock for
common stock and an issuance of a smaller principal amount of new debentures.
See Subsequent Events.
Stockholders' Equity
We are authorized to issue the following shares of stock:
7,500,000 shares of Common Stock ($6.00 par value)
2,000,000 shares of Preferred Stock ($.01 par value) of which the
following series have been designated:
3,000 shares of Preferred Stock, Series D
1,000,000 shares of Preferred Stock, Series F
We have outstanding the following shares of preferred stock:
Shares Par Liquidation
Outstanding Value Preference
----------- ----- ----------
Series D................................................... 1,353 $0.01 $1,353
----- ----- ------
1,353 $0.01 $1,353
===== ===== ======
F-45
Other Capital Stock Transactions
Stock Split - In October, 2002, approval was granted for a
one-for-twenty reverse stock split effective October 28, 2002. The effect of
this stock split was reflected in the financial statements retroactively as if
the stock split occurred at the beginning of the earliest period reported.
On March 22, 2001, we completed a private placement of 76,300
unregistered shares of our common stock receiving net proceeds of $9.6 million.
In addition, the purchasers received three-year warrants to acquire an
additional 19,075 shares of our common stock at $163.80 per share. For a period
of 18 months from the March 22, 2001 completion date in the event we were to
issue shares of common stock or equity securities convertible into our common
stock at a price less than $131.062 per share, the purchasers would be entitled
to receive additional shares of common stock.
During 2000, SNI completed a sale of 8,596,333 shares of its Series A
Convertible Preferred Stock receiving net proceeds of $46.6 million from a group
of investors. 1,467,891 shares were purchased by, and a finders fee of $2.0
million was paid through the issuance by Sorrento of an additional 357,799
shares of its Series A Convertible Preferred Stock to, entities in which one of
our outside directors at the time, who later in 2000 served for several months
as our Chairman and CEO, was a partner or member pursuant to a previously
contracted right of participation.
One of our current outside directors purchased 183,486 shares in this
placement. At the time of purchase, he was not one of our directors. This
individual is also a director of Liberty Media Corporation, which owns an
approximate 74% economic interest representing an approximate 94% voting
interest in United GlobalCom ("UGC"). The purchaser of 3,027,523 shares in this
placement is an indirect subsidiary of UGC. Liberty Media also holds convertible
debt in this Series A holder, which it has agreed to exchange for shares in UGC.
Each share of SNI's Series A Preferred Stock is convertible into one
share of SNI's common stock at the option of the holder, may vote on an "as
converted" basis except for election of directors, and has a liquidation
preference of $5.45 per share. The shares are automatically converted into SNI's
common stock upon an underwritten public offering by SNI with an aggregate
offering price of at least $50.0 million. As SNI did not complete a $50.0
million public offering by March 1, 2001, the holders of more than 50% of the
then outstanding Series A shares had the right to request in writing that SNI
redeem them at the adjusted liquidation preference. On receipt of such a
request, our Sorrento subsidiary has the obligation to redeem the shares in
cash, if funds are lawfully available for such a redemption, or to redeem such
pro rata portion as to which a lesser amount of lawfully available funds do
exist. In April 2001, our Sorrento subsidiary received written redemption
requests from holders of a majority of the Series A shares. The difference
between the net proceeds received on the sale of these shares and their
liquidation preference of $48.8 million was recorded as a deemed dividend during
the period from issuance to March 31, 2001.
As of April 30, 2003 and January 31, 2003, the Series A Preferred Stock
has been reclassified as a current liability since the holders have exercised
their right to request that SNI redeem the shares. The Series A liability can
only be paid through lawfully available funds that would normally be generated
from SNI profitable operations, which we do not currently have available or
foresee the availability of the near future. As of June 4, 2003, we have
consummated our restructuring transaction and have cancelled all outstanding
Series A Preferred Stock. See Subsequent Events.
Stock Option Plans
We have four stock options plans in effect: The 2000 Stock Incentive
Plan, the 1988 Stock Option Plan, the 1997 Incentive and Non-Qualified Stock
Option Plan and the 1997 Director Stock Option Plan. The stock options have been
made available to certain employees and consultants. All options are granted at
not less than fair value at the date of grant and have terms varying from 3 to
10 years. The purpose of these plans is to attract, retain, motivate and reward
our officers, directors, employees and consultants to maximize their
contribution towards our success.
We account for these plans under the recognition and measurement
principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and
related Interpretations. No stock-based employee compensation cost is reflected
in net loss, as all options granted under these plans had an exercise price
equal to the market value of the underlying common stock on the date of grant.
F-46
In order to provide more prominent and frequent disclosures about the
effects of stock-based compensation as required under SFAS 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure", the following table
summarizes the pro forma effect of stock-based compensation on net loss and
earnings (loss) per share if the optional expense recognition provisions of SFAS
123 had been adopted.
The fair value of stock options used to compute pro forma net loss and
pro forma loss per share disclosures is estimated using the Black-Scholes
option-pricing model, which was developed for use in estimating the fair value
of traded options that have no vesting restrictions and are fully transferable.
In addition, this model requires the input of subjective assumptions, including
the expected price volatility of the underlying stock. Projected data for
expected volatility and expected life of stock options is based upon historical
and other data. Changes in these subjective assumptions can materially affect
the fair value estimate, and therefore the existing valuation models may not
provide a reliable single measure of the fair value of the Company's employee
stock options.
For the three months ended,
April 30
----------------------
2003 2002
------- -------
Net earnings (loss):
As reported .................................................. $(6,222) $ 3,976
Add: Stock-based employee compensation ....................... -- --
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards, net
of related tax effects ..................................... (291) (1,467)
------- -------
Pro forma .................................................... $(6,513) $ 2,509
======= =======
Earnings (loss) per share:
Basic EPS as reported ........................................ $ (7.02) $ 5.60
======= =======
Pro forma basic EPS .......................................... $ (7.35) $ 3.50
======= =======
Diluted EPS as reported ...................................... $(14.33) $(25.20)
======= =======
Pro forma diluted EPS ........................................ $(14.59) $(26.79)
======= =======
Earnings Per Share Calculation
The following data show the amounts used in computing basic earnings
per share for the quarters ended April 30, 2003 and 2002.
Three Months Ended April 30,
------------------------------
2003 2002
-------- --------
Net income (loss) available to common
shareholders used in basic EPS............................... $ (6,222) $ 3,976
======== ========
Average number of common shares
used in basic EPS............................................ 886,050 716,142
======== =========
We had a net loss for the quarter ended April 30, 2003. Accordingly,
the effect of dilutive securities including convertible preferred stock, vested
and non-vested stock options and warrants to acquire common stock are not
included in the calculation of EPS because their effect would be antidilutive.
Our convertible debentures create a dilutive situation even though the company
had a net loss for the quarter. The following data shows the effect on income
and the weighted average number of shares of dilutive potential common stock.
F-47
Three Months Ended April 30,
2003 2002
---------- ---------
Net income (loss) available to common
shareholders used in basic EPS ............ $ (6,222) $ 3,976
Less: Convertible debt issuance costs ........ (12,260) (28,620)
Plus: Convertible debt interest .............. 2,584 774
---------- ---------
Net loss available to common
shareholders used in diluted EPS .......... $(15,898) $(23,870)
========= =========
Average number of common shares
used in basic EPS ......................... 886,050 716,142
---------- ---------
Effect of dilutive securities:
Convertible debentures ....................... 223,301 223,301
Warrant exercises ............................ -- 6,198
---------- ---------
Average number of common shares and dilutive
potential common stock used in diluted EPS 1,109,351 945,641
========= =========
Litigation
On September 10, 2001, holders of a portion of the outstanding Series A
Preferred Stock of our Sorrento subsidiary obtained a preliminary injunction
from the Delaware Court of Chancery prohibiting SNI from issuing further shares
of its Series A Preferred Stock or incurring any additional debt without the
consent of the holders of a majority of the currently outstanding shares of such
Series A Preferred Stock. On January 23, 2002, the Delaware Supreme Court
affirmed the granting of the preliminary injunction.
On October 19, 2001, an amended complaint was filed in the injunction
action, adding as named defendants, the Company, our Meret subsidiary, certain
present and former officers and directors of the Company and our subsidiaries as
well as our investment bankers. The amended complaint also added, among other
things, claims for fraud, securities fraud, breach of fiduciary duty,
conspiracy, and intentional interference with contract as well as requesting the
appointment of a receiver for our Sorrento subsidiary, all which claims are
based on alleged wrongs committed in connection with or since the Series A
placement. Our Sorrento subsidiary and the original individual defendants have
all answered this amended complaint denying all allegations of wrongdoing. The
new defendants have all moved to dismiss the amended complaint. Management
believes the allegations contained in the amended complaint are without merit.
On December 14, 2001, the plaintiffs filed motions to sequester the
common stock of our Sorrento subsidiary owned by Meret and the Sorrento Series A
preferred stock that we own, as an alternative method of obtaining jurisdiction
over us and Meret in the Delaware litigation. Management also believes that
these motions are without merit.
Currently, hearings on all pending motions have been taken off calendar
at the request of all parties. The Exchange Agreement entered into in connection
with our recently completed capital restructuring provides that this litigation
will be dismissed with prejudice against the Company, its subsidiaries, its
current officers and directors, and other defendants who execute an appropriate
release, and without prejudice against all other defendants. This dismissal will
require court approval, which is in the process of being obtained by counsel for
all parties. See Subsequent Events.
During June 2000, we entered into various agreements with Par Chadha,
our former CEO and Chairman, which, among other matters, provides for payments
of $250 thousand per year for three years of consulting services and loans by us
for the exercise of previously granted options to acquire 58,925 options at
prices varying from $140.60 to $985.00 per share. As the members of our Board of
Directors at the time of his resignation ceased to represent more than 50% of
the Board in October 2000, all payments for consulting services were accelerated
and no future consulting services are required. During October 2000, Mr. Chadha
exercised 3,556 options, applying the $500 thousand accelerated payment to the
exercise. In addition, he exercised 25,369 options for which we were
contractually obligated to loan the $5.0 million due on the exercise. Mr. Chadha
provided us with written notification dated in September 2001 that he does not
have any obligations under the agreements. We have notified him that we do not
agree with his interpretation of his repayment obligations under the terms of
the agreements.
F-48
During December 2001, we entered into an agreement whereby the
25,369-option exercise was rescinded. Mr. Chadha returned the 25,369 shares to
us for cancellation and we cancelled the receivable due from him and restored
the original option agreements. In June 2002, we filed with the Superior Court
of California, County of Los Angeles a Complaint for Declaratory Relief
regarding the interpretation of the agreement. Also in June 2002, Mr. Chadha
filed a lawsuit against us in the Superior Court of California, County of Los
Angeles, seeking declaratory relief with respect to the interpretation of his
separation agreement and in addition, alleging breach of contract with respect
to his option exercise rights and fraud in connection with his rescission
agreement. In February 2003, both of these lawsuits were dismissed without
prejudice to facilitate settlement negotiations, but they can be refiled at any
time. In April 2003, an agreement in principle to settle these lawsuits was
reached, subject to the execution of a definitive agreement. While there can be
no assurance that such a definitive settlement agreement will be executed, the
Company has been informed by counsel for all parties that the agreement is
acceptable and will be signed. Should the cases be refiled, which now appears
unlikely, and should Mr. Chadha prevail in Court, in addition to any other
relief that may be granted, we may be required to issue him 58,925 shares of our
stock for no consideration, which would be valued at $292 thousand as of April
30, 2003, and/or pay him cash damages, which he alleges to be in excess of $4
million.
In addition, claims in arbitration have been filed by two of our former
financial officers and employees who worked in our Santa Monica office, which
has now been closed, alleging that their resignations in May 2002 were for "good
reason" as defined in their employment agreements, all of which were to expire
on May 22, 2002. One of the claims has been settled, and we are disputing the
other claims. The amount of the disputed claim is approximately $195 thousand
plus attorneys fees.
We filed a lawsuit against United Pan Europe Communications, N.V., one
of our customers and a related party to one of Sorrento's Series A shareholders,
in connection with a past due receivable in the amount of $1.6 million for
equipment shipped in 2000. The defendant filed for protection under the federal
bankruptcy laws, and pursuant to the Exchange Agreement entered into in
connection with our capital restructuring, we executed a definitive settlement
agreement and a stipulation of dismissal with prejudice resolving this lawsuit
in return for a payment of $350 thousand and the return of certain of the
equipment previously shipped. We have received the payment of $350 thousand from
UPC and, in accordance with the terms of the exchange agreement, have paid that
same amount to certain Series A Preferred Stock holders. The equipment has also
been returned. Accordingly, this lawsuit has been dismissed with prejudice.
We have also been sued by a former officer of our Sorrento subsidiary
alleging breach of a consulting agreement we entered into with him in March
2002, following his resignation "for good reason" as defined in his employment
agreement. He is seeking acceleration of consulting fees due to him under his
consulting agreement in the amount of $229 thousand. We feel these claims are
without merit and are vigorously defending the claims. We have also filed
counterclaims. In May 2002, the former officer's motion for summary judgment was
denied. Currently, the matter is in discovery.
From time to time, we are involved in various other legal proceedings
and claims incidental to the conduct of our business. Although it is impossible
to predict the outcome of any outstanding legal proceedings, we believe that
such legal proceedings and claims, individually and in the aggregate, are not
likely to have a material adverse effect on our financial position, results of
operations, or cash flows.
Contingent Liabilities
In the merger agreement between our predecessor corporation and Sync
Research, we agreed to indemnify and hold our former subsidiary, Entrada,
harmless against any liability arising after the merger in connection with the
termination of a certain pension plan previously maintained by Entrada. In the
third quarter of 2003, we were advised by a consultant retained by us and by the
successor corporation to the entity from whom we originally purchased the
company that became Entrada that the cost of termination of the pension plan in
question is in excess of $3.0 million. While we do not believe that we are
liable for this cost, it is possible that the successor corporation, which has
been funding the pension plan since 1996, may seek a substantial contribution
from us towards this liability.
Concentration Of Credit Risk
Financial instruments that potentially subject us to concentrations of
credit risk consist primarily of temporary cash investments and trade
receivables. As regards the former, we place our temporary cash investments with
high
F-49
credit financial institutions and limits. At times such amounts may exceed the
F.D.I.C. limits. We limit the amount of exposure with any one financial
institution and believe that no significant concentration of credit risk exists
with respect to cash investments.
Although we are directly affected by the economic well being of
significant customers listed in the following tables, we do not believe that
significant credit risk exists at April 30, 2003. We perform ongoing evaluations
of our customers and require letters of credit or other collateral arrangements
as appropriate. Accordingly, trade receivable credit losses have not been
significant.
The following data shows the customers accounting for more than 10% of
net consolidated receivables:
April 30, January 31,
2003 2003
-------------- --------------
Customer A............................................................. 32.9 % 29.6 %
Customer B............................................................. 28.5 % 0.2 %
Customer C............................................................. 15.5 % 31.2 %
Customer D............................................................. 10.8 % 15.9 %
Customer E............................................................. 2.0 % 18.7 %
The following data shows the customers accounting for more than 10% of
net consolidated sales:
April 30, April 30,
2003 2002
-------------- --------------
Customer A.............................................................. 34.7 % 9.2 %
Customer B.............................................................. 21.7 % 26.3 %
Customer C.............................................................. 11.3 % 0.8 %
Customer D.............................................................. 7.9 % 21.9 %
Segment Information
Sorrento Meret
Networks Optical Other Total
------- ------ ------- -------
Three Months Ended April 30, 2003
Revenues from external customers .......... $ 6,760 $1,101 -- $ 7,861
Cost of goods sold ........................ 5,053 854 -- 5,907
------- ------ ------- -------
Gross profit ............................ 1,707 247 -- 1,954
------- ------ ------- -------
Segment income (loss) from operations ..... (2,961) 120 (777) (3,618)
Depreciation and amortization expense ..... 887 129 24 1,040
Valuation allowance additions (reductions):
Receivables and inventory ............. (178) (11) -- (189)
Capital asset disposals, net .............. (775) -- -- (775)
Total assets .............................. 25,005 5,382 17,702 48,089
Three Months Ended April 30, 2002
Revenues from external customers .......... $ 4,794 $1,209 -- $ 6,003
Cost of goods sold ........................ 3,769 746 -- 4,515
-------- -------- -------- --------
Gross profit ............................ 1,025 463 -- 1,488
------- ------ ------- -------
Segment income (loss) from operations ..... (5,719) 22 (847) (6,544)
F-50
Depreciation and amortization expense ..... 769 133 456 1,358
Valuation allowance additions:
Receivables and inventory ............. 270 447 105 822
Capital asset additions, net .............. 1,662 212 70 1,944
Total assets .............................. 59,572 8,187 15,605 83,364
Subsequent Events
Sale of DIGI Stock
On May 7, 2003, we sold our remaining security interest in DIGI
International Inc. (Nasdaq: DGII) for $4.26 per share. The purchaser of the
stock was DIGI, itself. The proceeds from this sale, in the amount of $5.0
million, were deposited on May 7, 2003.
Restructuring Plan
The proposed capital and corporate restructuring plan outlined below, was
approved by shareholders on May 29, 2003 and was completed after the market
closed on June 4, 2003.
On March 6, 2003, we and our wholly-owned subsidiary Sorrento Networks,
Inc. entered into an Exchange Agreement with the holders of our 9.75% Senior
Convertible Debentures (the "Debentures") and the Series A Convertible Preferred
Stock (the "Preferred Stock") of Sorrento Networks, Inc. The Exchange Agreement
and associated documents contemplate an exchange (the "Exchange") of the
Debentures and the Preferred Stock at closing into shares of common stock and
$12.5 million of our new 7.5% secured convertible debentures (the "New
Debentures"). Certain holders of the Preferred Stock would also receive
additional New Debentures of approximately $600 thousand to pay certain legal
fees.
The shares of common stock and the New Debentures to be issued in the
Exchange will represent, in the aggregate, approximately 87.5% of our common
stock on a diluted basis. This percentage takes into account the total number of
existing shares outstanding, the shares to be issued to the holders of the
Debentures and the Preferred Stock at the closing, the shares issuable upon
conversion of $12.5 million of New Debentures, and the shares issuable upon
conversion of warrants to be issued to existing shareholders. This percentage
does not take into account new employee stock options, shares issuable upon
conversion of approximately $600 thousand in New Debentures to be issued to
certain holders of the Preferred Stock to pay certain legal fees, and certain
other issuances. We issued 8,029,578 shares of common stock to the holders of
the Debentures and the Preferred Stock upon consummation of the Exchange. The
New Debentures that were issued in the Exchange (not including the New
Debentures to be issued in satisfaction of legal fees) are convertible into
approximately 19.5% of our shares of common stock, calculated on the same
diluted basis.
The Exchange Agreement states that our existing shareholders will
retain 7.5% of our common stock on the same diluted basis, and will receive
non-transferable warrants to purchase approximately 5% of our common stock,
exercisable beginning one year after the closing. The exercise price of the
warrants is $5.96. The shareholders' date of record to receive warrants is May
28, 2003. The warrants will be exercisable at any time prior to August 2, 2007,
provided that any such exercise of the warrants will be subject to the
effectiveness of a registration statement with respect to the common shares to
be issued upon exercise of the warrants. We may repurchase the warrants for a
nominal price, upon 30 days prior notice, at any time after the volume-weighted
average market price of our common stock for any ten consecutive trading days
equals or exceeds 150% of the exercise price.
The New Debentures will mature on August 2, 2007 and will be
convertible at any time at the option of the holder at a conversion price of
$5.42. Subject to certain limits, interest on the New Debentures may be paid, at
our option, either in cash, additional New Debentures or our common stock.
The New Debentures include covenants restricting our ability to incur
senior or subordinated debt or preferred stock other than $5.0 million in lease
or equipment financing and a $5.0 million revolving credit facility (up to $10.0
million with certain consents), as well as other standard covenants and
protective provisions. At any time prior to the
F-51
maturity date, we may redeem for cash on a pro rata basis some or all of the New
Debentures at par, plus accrued interest.
The New Debentures are secured by substantially all of our assets and
those of our subsidiaries (with certain exceptions, including the real estate
owned by Meret Communications, Inc., and Sorrento Valley Real Estate Holdings,
LLC). No later than one year following the closing date, we must provide a
second mortgage on such real estate as security for the New Debentures. When we
have done so and we have merged our subsidiaries into us, most of the remaining
collateral will be released or subordinated at our request to permit us to
obtain a secured loan from a bank.
Until one year after the closing and subject to certain exceptions,
exchanging holders of Debentures and Preferred Stock who continue to hold common
stock received in the Exchange and New Debentures will be entitled to certain
weighted average anti-dilution protection for such continued holdings with
respect to certain additional issuances of our common stock. In addition, if we
are required to issue shares of common stock upon the exercise of any right,
option or warrant to purchase common stock that was issued prior to the closing
and was not listed on the option schedule to the exchange agreement, then we
will issue additional shares of common stock to the exchanging holders, and will
adjust the conversion price of the New Debentures sufficient to offset the
dilutive impact of such issuances.
The Series A holders as a group may request that we appoint one new
director to our Board of Directors. The Debenture holders as a group may also
request that we appoint one new director to our Board of Directors. The new
director(s) would continue in office until the next regularly scheduled annual
meeting of our shareholders and shall be nominated for re-election at such
meeting.
We merged with and into a newly-formed Delaware corporation immediately
prior to the closing of the restructuring, which was formed solely for the
purpose of effecting the change in our state of incorporation from the State of
New Jersey to the State of Delaware. Promptly after the closing date of the
restructuring transaction, and in no event later than one year after the closing
date, our subsidiaries, Sorrento Networks, Inc., Meret Communications, Inc., and
Sorrento Valley Real Estate Holdings, LLC, will be merged with and into us.
The following table shows a proforma comparison of our balance sheet as of April
30, 2003. It demonstrates, among other things, our positive shareholder equity
in excess of $10.0 million, satisfying the applicable NASDAQ listing
requirement.
PROFORMA CONDENSED CONSOLIDATED BALANCE SHEET (UNAUDITED)
(In Thousands)
Historical Proforma Proforma
April 30, 2003 Adjustments April 30, 2003
-------------- ----------- --------------
ASSETS
CURRENT ASSETS
Cash and equivalents $ 3,785 $ 3,785
Accounts receivable, net 5,000 5,000
Inventory, net 11,973 11,973
Other current assets 592 592
Investment in marketable securities 5,020 5,020
------------------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 26,370 - 26,370
------------------------------------------------------------------------------------------------------------
PROPERTY AND EQUIPMENT, NET 15,390 15,390
OTHER ASSETS 6,329 6,329
------------------------------------------------------------------------------------------------------------
TOTAL ASSETS $48,089 $48,089
============================================================================================================
F-52
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Current maturities of long term debt 204 204
Accounts payable 3,595 3,595
Deferred Revenue 373 373
Accruals and other current liabilities 11,068 11,068
Preferred Stock 48,800 (48,800) A (0)
------------------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 64,040 (48,800) 15,240
------------------------------------------------------------------------------------------------------------
Debentures payable, net of unamortized costs and discounts 19,940 (32,200) B
6,066 B
6,194 B
13,100 C 13,100
Other long-term liabilities 3,696 3,696
------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 87,676 (55,640) 32,036
------------------------------------------------------------------------------------------------------------
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value; liquidation preference $1,353 1 1
Common stock 5,318 43,520 D 48,838
Additional paid in capital 144,933 2,933 E
(6,066) B 141,800
Accumulated deficit (193,758) (2,933) E
(6,194) B
24,380 B (178,505)
Accumulated comprehensive loss 3,988 3,988
Treasury stock (69) (69)
------------------------------------------------------------------------------------------------------------
TOTAL STOCKHOLDERS' EQUITY (39,587) 55,640 16,053
------------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 48,089 - $ 48,089
============================================================================================================
Notes on the Proforma Consolidated Balance Sheet:
A To record the retirement of the Series A shares.
B To record reacquisition of the Outstanding Debentures, including the
reacquisition of the beneficial conversion option associated with the
convertible debt. An entry of $6.1 million is recorded to additional paid
in capital to reflect the estimated value of the beneficial conversion
option at the date of extinguishment. An additional $6.2 million
representing the unamortized balance of the previously issued debt costs
and incremental value of the beneficial conversion feature not reacquired
will be recorded as part of the gain on extinguishment.
C To record the issuance of the Exchange Debentures $12.5 million and the Fee
Amount Debentures $600 thousand. The Fee Amount Debentures were issued to
certain exchanging holders in satisfaction of certain legal fees incurred
by them in litigation with the Company.
D To record the value of the new shares of common stock issued to holders of
the Outstanding Debentures and Series A. Amount is estimated at 8,029,578
shares at a per share price of $5.42. This is the volume-weighted average
closing price of the Company's common stock on the ten trading days ending
on the third trading day prior to the closing, which is also the conversion
price for the Exchange Debentures and the Fee Amount Debentures.
E To record the upcoming issuance of the New Warrants to existing
shareholders. The value of the New Warrants was determined using the Black
Scholes option pricing model based on the following inputs: Option price of
$5.96, estimated life of 4 years, volatility of 173%, no dividends and a
risk free rate of return of 2.3%.
F-53
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Company has duly caused this Form 10 to be signed on its behalf
by the undersigned, thereunto duly authorized.
SORRENTO NETWORKS CORPORATION
By: /s/ Joe R. Armstrong Date: June 30, 2003
----------------------------
Joe R. Armstrong
Chief Financial Officer
Principal Accounting Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the Company and in
the capacities and on the dates indicated.
By: /s/ Phillip W. Arneson Date: June 30, 2003
-------------------------------------
Phillip W. Arneson
Chairman and Director
Chief Executive Officer
By: /s/ Donne F. Fisher Date: June 30, 2003
-------------------------------------
Donne F. Fisher
Director
By: /s/ Gary M. Parsons Date: June 30, 2003
-------------------------------------
Gary M. Parsons
Director
By: /s/ Robert L. Hibbard Date: June 30, 2003
-------------------------------------
Robert L. Hibbard
Director
By:
-------------------------------------
Larry J. Matthews
Director
F-54
STATEMENT OF DIFFERENCES
The trademark symbol shall be expressed as..................................'TM'
The registered trademark symbol shall be expressed as........................'r'