ITEM 1. BUSINESS
Overview
Avici Systems Inc. (referred to as Avici, we, our and the company) provides high-speed core Internet infrastructure equipment that enables networking service providers to transmit large volumes of data, voice and video, across their networks. Our high-performance routing solutions are designed and built to deliver the scalability, reliability, and performance that carriers need to support a wide range of applications while lowering the total cost of building and operating their core data networks.
The Avici core routing product family consists of three chassis platforms and several line cards to provide carriers with flexibility in selecting a product that best fits their needs. We offer customers three different equipment configurations, the Terabit Switch Router (TSR™), the Stackable Switch Router (SSR™), and the Quarter-rack Scalable Router (QSR™), and each chassis is configured with our line cards and proprietary software to support a range of speeds, protocols, and carrier services. All three chassis use the same line cards and software to enable carriers of every size to take advantage of Avici’s proprietary carrier-class technology. Our core routers are designed to provide our customers:
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Carrier-class reliability;
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In-service modular scalability to enable non-disruptive incremental capacity additions to the network;
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Stability and interoperability;
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Advanced security features; and
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High performance across very large IP-based core networks.
Our current strategy is primarily to pursue direct sales of our legacy core routing products principally to our largest customer, AT&T Inc. (“AT&T”), maximize the near-term financial returns from our core routing business, and pursue new market initiatives and product development. Our principal customer is, and has been, AT&T. In the past, we utilized a direct sales force to sell and market our products to incumbent local exchange carriers, inter-exchange carriers, postal telephone and telegraph operators, internet service providers and other service providers globally. In February 2006, we announced a corporate restructuring aimed at driving Avici toward profitability and positive cash flow.
Avici was incorporated in Delaware in 1996 and held its initial public offering in July 2000. We are headquartered in North Billerica, Massachusetts. At December 31, 2006, we had 104 full time employees. In February 2006, we announced a corporate restructuring aimed at driving Avici toward profitability and positive cash flow. Our corporate restructuring resulted in reduction in both full time and contract labor by approximately 45%, with the majority of this reduction occurring at the time of the announcement.
In February 2007, we announced the launch of a new product initiative, Soapstone Networks (“Soapstone”). The positive cash flow that Avici has been able to generate will enable us to fund the development of Soapstone.
Industry Background
Traditional carrier networks were primarily built on technologies to support voice services. These legacy voice networks used circuit switches, which dedicate an individual connection, or part of the network, for the duration of a call even while there are pauses in the conversation. As the amount of data traffic carried over the network infrastructure increased, carriers sought to increase the efficiency of data transmission through their networks by adopting packet switching technologies, such as Asynchronous Transfer Mode (ATM) and Frame Relay. Packet switching technologies enabled carriers to send data from multiple sources on the same connection, substantially reducing the network bandwidth wasted using traditional circuit switch technology.
Internet, telecom, and media networks are converging and carrier IP networks are now expected to support critical services such as voice, video, IPTV, Virtual Private Networks (VPNs), online gaming, security, storage, and other business and residential applications. These types of services are required for carriers to increase revenue and profits. In addition, these applications require significantly high levels of reliability, scale, QoS, and performance.
Today, a maturing Internet has placed new demands on routers. As IP is increasingly used to support more diverse and demanding applications, carriers require routing platforms purpose built for the carrier network. Carriers recognize that they cannot cost effectively support multiple networks-one for landline voice, another for IP traffic, another for wireless, and many more for separate data network. Carriers envision a converged IP network where voice, data, video and wireless services are supported over a single reliable and cost effective network. This vision requires upgrading existing best effort IP networks to a new-real time IP network powered by carrier-grade IP routers to improve the economics of the IP network.
Carrier Requirements for an IP Network
The boundaries that exist between Internet, telecom, and media networks are blurring and the core routers that run carrier networks today must evolve and support a new model of system availability, scale in service to extend network longevity, keep pace with new traffic requirements, and deliver the levels of service and performance to converge these networks over a common IP core. As a result, carriers are demanding solutions with the following attributes:
Carrier-Class Reliability. The equipment that carriers deploy within their networks must offer the highest level of up time and redundancy.
Reduced Network Cost and Complexity. Carriers are demanding modular solutions that scale in service to accommodate new capacity requirements, reduce the number of devices needed and, consequently, reduce the forecasting uncertainty, complexity, and costs of operating large capacity networks.
Faster Service Provisioning. Networks and service demands are changing constantly, and carriers require a cost-effective means of increasing capacity and offering new services on a continual basis.
High Performance. As carriers consolidate existing legacy networks and deliver new services on an IP backbone, they must provide Quality of Service, or the ability to prioritize different traffic types in order to meet customers’ service level agreements for premium services.
Interoperability. Due to economic constraints associated with upgrading an entire network to accommodate new technologies, it is critical that new network equipment support the protocols and devices already deployed in carrier networks.
Industry Segments
Avici has conducted its operations in one industry segment. Please see our financial statements attached hereto in Item 8 for financial information related to our segment.
The Avici Core Router Solution
Products and Technology
Our high-performance core routing family is engineered to provide a carrier network solution that addresses a wide range of network applications across a carrier’s core IP network. Avici routers are designed to deliver scalability, reliability, and performance to IP networks using carrier-proven principles of redundancy, in-service upgradeability, multi-generational investment protection, and quality assurance.
Avici has developed a modular network architecture that eliminates many of the constraints of traditional routers. Our core routing platforms support traffic expansion by scaling, in-service, from gigabits to terabits of capacity through the non-disruptive addition of line cards and chassis. Unlike traditional routers, every port can be used to support customer traffic, and no ports or external switching hubs are needed for interconnection or scaling. Our routing platforms provide carriers with a stable, scalable, and reliable foundation to support traffic growth and lower cost requirements. Our routers can also perform both the core and aggregation/hub functions in a single platform, thereby eliminating the need for a separate aggregation layer. Our routing technologies provide internal hardware and software redundancy to deliver carrier-grade 99.999+% system availability to support SLAs on services such as IPTV, video, VPNs and Voice over IP (VoIP). Because Avici products can deliver such high levels of reliability, carriers are able to remove duplicate routers and simplify their Points of Presence (PoP). Avici routers also enable the IP network to recover quickly from service disruptions, a critical requirement for supporting real time services.
Our products provide these benefits through our proprietary technologies, including our application-specific integrated circuits, or ASICs, Velociti™ switch fabric and distributed system design, IPriori™ system software, Composite Links™, and Non Stop Routing (NSR™) technologies. We incorporate all of these proprietary technologies into each of our three available product platforms-the Terabit Switch Router (TSR), Stackable Switch Router (SSR), and Quarter-rack Scalable Router (QSR). The TSR, SSR, and QSR offer customers differing combinations of speed, capacities and numbers of available ports in order to allow them to tailor their network infrastructure to meet their traffic needs.
ASIC-based Packet Routing Technology
We have consolidated all data-flow and control processes, including packet input and output framing, forwarding, scheduling, and switching into our application specific integrated circuits, or ASICs. We utilize a distributed routing architecture. Each line card has its own ASICs, and, accordingly, the addition of each line card increases the overall capacity of our product.
Velociti Switch Fabric
Our Velociti switch fabric is the mechanism that transfers data from an input line card to specific output cards in our products. This direct communication provides high-speed data transfer and, as additional capacity is needed, enables cost-effective addition of line cards. The Velociti switch fabric also gives our products a high level of reliability by creating multiple connections between pairs of input and output line cards.
IPriori Carrier System Control Software
Avici’s IPriori system software has been developed to optimize and control switching and routing in all of our products. IPriori is built on a distributed model, which uses multiple processor units to provide increased levels of reliability and scalability, and is specifically designed to address the system requirements arising from scaling to a large number of ports.
Composite Links for Seamless Capacity Additions and Cost-Effective Link Protection
Avici’s proprietary Composite Links technology enables carriers to seamlessly expand capacity in the PoP by enabling multiple physical links or fiber interfaces between two Avici routers to be grouped into a single logical connection. This technology provides greater flexibility to carriers in migrating to higher-speed backbones that leverage multiple generations of fiber infrastructure and speeds. Hardware upgrades can be done without costly downtime by adding or removing router modules without disruption to packet ordering, routing tables or traffic flows. Composite Links also provide carriers with cost-effective link protection through the ability to recover from failures on individual member-link interfaces.
Non-Stop Routing (NSR) Technology
Our products have been designed and manufactured to be highly reliable in the core of carrier networks. Avici’s NSR technology provides nodal reliability by protecting against failure of the route controller, the brain of the router, thus enabling carriers to achieve 99.999+% system availability in a single router. This functionality is achieved by having a second route controller take over routing functions in the event the primary controller fails. Many of today’s IP networks also use two core routers within a POP to increase reliability. Avici NSR can provide potential cost savings by enabling carriers to end the costly practice of deploying redundant routers to increase router reliability.
Strategy
In February 2006, we announced a plan to restructure the business and realign our cost structure to execute a focused strategy aimed at driving Avici toward profitability and positive cash flow.
In February 2007, we announced the launch of Soapstone, a new product initiative.
The Soapstone software-based solution we are developing is designed to manage the complexities between carrier service offerings and applications, and the underlying transport equipment and technologies. Soapstone’s mission is to enable carriers to bring orderly, predicable, business-driven behavior to their IP networks, regardless of vendor or technology composition.
The Soapstone solution is based on key industry standards such as service-oriented architecture (SOA), telemanagement forum (TMF), international telecommunications union (ITU) and next generation networks (NGN) among others, and utilizes open application programming interfaces (APIs) between the network and operational support systems (OSS). It maps the abstract service needs expressed by the business plane into a simple configuration command set that can be applied to an array of technologies and equipment. With this capability, even the simplest network devices can provide support for complex service provisioning and SLA management.
The key elements of our strategy are to:
Focus on Major Customer. We restructured the core routing business to focus on becoming profitable and cash flow positive by pursuing direct sales principally to our major customer, AT&T. We are focused on dynamically responding to our customer’s volume and service requirements, given changing dynamics in a multi-network, multi-vendor environment and limited visibility into future volume requirements.
Develop and Market Soapstone Solution. Carrier networks are undergoing unprecedented transformations as they migrate to the NGN (Next Generation Network) model. In order to increase their service offerings and grow revenues, they will have to support multiple access networks and devices at the lowest cost possible. The complexity of today’s networks creates a need for a product that will form a common control framework for over-IP, IP, over-Ethernet and optical technologies and allow for seamless service migration among them. We are developing the Soapstone solution to deliver a network abstraction layer that decouples the services from the network infrastructure.
Selectively Pursue Indirect Sales Channels for Soapstone. The Soapstone solution will be targeted to the service provider market. We will seek distribution partners to capture new carrier opportunities.
Sales, Marketing, and Customer Service and Support
Historically, we sold and marketed our products through our direct sales force, sales agents, systems integrators, and distribution partners. Subsequent to our restructuring, announced in February 2006, we have primarily sold and marketed our core router products through a downsized domestic sales force.
In the past, we also marketed, sold, and supported our products through systems integrators, sales agents, and distribution partners, including Nortel Networks and Huawei Technologies. In May 2003, we entered into a strategic relationship with Huawei Technologies for sales and support of our products in Greater China. The term of the agreement was two years and expired during 2005. In January 2004, we entered into a worldwide three-year strategic agreement with Nortel Networks to market, sell, and support our products. The term of the agreement is three years and expired in January 2007. During 2005, we entered into a Supply Agreement with Alcatel Teletas to provide Turk Telekom with Avici equipment for its IP/MPLS network. The Alcatel Teletas arrangement was terminated in October 2006.
In the future, we plan to market our Soapstone solution both directly and through strategic indirect channel partners.
Customers
AT&T is our primary customer. Our agreement with AT&T has no minimum purchase commitment level and remains in effect until December 31, 2009. The agreement describes the conditions under which AT&T may purchase equipment and services from us. AT&T has deployed our TSR product in sixteen locations within its North American IP backbone network.
AT&T accounted for 94%, 94% and 60% of our gross revenue in 2006, 2005 and 2004 respectively. In 2004, Huawei and Nortel accounted for 27% and 12%, respectively, of our gross revenue.
Research and Development
We have a team of skilled engineers responsible for product design and development, quality assurance, and documentation. Our engineers have significant experience in optical networking, hardware and software. As part of the restructuring of the business announced in February 2006, our development resources were reduced and partially redeployed to focus on the Soapstone initiative. We have also utilized offshore and outsourced development resources. We have made, and will continue to make, although at a reduced level, substantial investments in research and development. Research and development expenses were $30.1 million, $36.2 million, $32.4 million, and $46.5 million for the years ended December 31, 2006, 2005, 2004, and 2003, respectively.
Competition
The market for data networking equipment is intensely competitive, subject to rapid technological change and significantly affected by new product introductions and other market activities of industry participants. This market historically has been dominated by Cisco Systems, which as a result of its leadership position in the market has been able to develop and promote a broad product line of routers. We also compete with other established companies such as Juniper Networks. For new technology initiatives such as our Soapstone product, we will face competition from large equipment and software companies, as our product will serve as an abstraction layer that will bridge IT/OSS and network centric domains. We may experience reluctance by our prospective customers to replace or expand their current solutions, which may be supplied by competitors, with our products. Competitors have significantly broader product lines and market presence than we do and may bundle their products with other products that we do not offer. In addition, we have faced significant competition and pricing pressure in the core router market.
In order for our Soapstone solution to compete effectively, we must deliver a technologically advanced product that is superior in meeting the needs of carriers, namely a product which:
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hides complexity of transport elements from services, control functions, and OSS;
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provides common API for specifying resources and their SLAs;
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interoperates with existing solutions and equipment vendors;
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enables seamless migration of legacy services onto NGN while supporting new NGN-based service offerings;
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mediates between resource requests from services/control and OSS and available resources of the IP network; and
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creates a cost-effective solution for our target customers.
In addition, we will be required to leverage our Soapstone differentiators to extend customer acceptance.
Many of our current and potential competitors have greater selling and marketing, technical, manufacturing, financial and other resources, more customers, greater market recognition, and more established relationships and alliances in the industry. As a result, these competitors may be able to develop, enhance and expand their product offerings more quickly, adapt more swiftly to new or emerging technologies and changes in customer demands, devote greater resources to the marketing and sale of their offerings, pursue acquisitions and other opportunities more readily, and adopt more aggressive pricing policies than us.
Intellectual Property
We presently have 20 patents granted in the United States and over 50 United States and foreign patent applications pending. Our success and ability to compete are dependent on our ability to develop and maintain the proprietary aspects of our technology and operate without infringing on the proprietary rights of others. We rely on a combination of patent protection, copyrights, trademarks, trade secret laws, contractual restrictions on disclosure, and other methods to protect the proprietary aspects of our technology. These legal protections afford only limited protection for our technology. We cannot be certain that patents will be granted based on our pending or any other applications, or that, even if issued, the patents will adequately protect our technology. We seek to protect our source code for our software, documentation and other written materials under trade secret and copyright laws, and we seek to limit disclosure of our intellectual property by requiring employees, consultants, and any third-party with access to our proprietary information to execute confidentiality agreements with us.
While we rely on patent, copyright, trade secret and trademark law to protect our technology, we also believe that factors such as the technological and creative skills of our personnel, new product developments and enhancements, and reliable product maintenance are essential to establishing and maintaining a technology leadership position. We cannot assure you that others will not develop technologies that are similar or superior to our technology.
Our success will depend upon our ability to obtain necessary intellectual property rights and protect our intellectual property rights. We cannot be certain that we will be able to obtain the necessary intellectual property rights or that other parties will not contest our intellectual property rights.
Manufacturing
We outsource the manufacture and assembly of our products to contract manufacturers. We primarily use Celestica Corporation and Sanmina-SCI Corporation, both of which provide comprehensive manufacturing services, including assembly, test and control and procurement of material, on our behalf. We design product tests that are conducted using our test equipment by the contract manufacturer. We believe that the outsourcing of our manufacturing enables us to conserve the working capital that would be required to purchase capital equipment, allows us to adjust manufacturing volumes to meet changes in demand and enables us to more quickly deliver products. Because we outsource our manufacturing, compliance with U.S. federal, state and local environmental laws has not had a material effect on our results or costs.
Employees
As of December 31, 2006, we had 104 full time employees. Our future success will depend in part on our ability to attract, retain and motivate highly qualified personnel, for whom competition is intense. Our employees are not represented by any labor union. We believe our relations with our employees are good. Additionally, as of December 31, 2006, we utilized on-shore and off-shore contract labor, approximating 66 full time equivalent employees.
Financial Information about Geographic Areas
See section (m) of Note 1 to Consolidated Financial Statements at Item 8 incorporated herein by reference.
Additional Information
Our Internet address is www.avici.com. On our Investor Relations web site, located at www.avici.com, we post the following filings as soon as reasonably practicable after they are electronically filed with or furnished to the Securities and Exchange Commission: our annual report on Form 10-K, our quarterly reports on Form 10-Q, our current reports on Form 8-K, our proxy statement on Form 14A related to our annual stockholders’ meeting and any amendments to those reports or statements filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. All such filings on our Investor Relations web site are available free of charge.
ITEM 1A.
ITEM 1A. RISK FACTORS
Our company, business and operations are subject to a number of risks and uncertainties. We discuss material risks and uncertainties below. To the extent any of these risks and uncertainties materialize, our business, results of operation and financial condition would suffer. You should carefully consider these risk factors in evaluating our company.
We are reliant on our major customer AT&T, from which we derive substantially all of our revenue, and if AT&T does not continue to select our legacy router products to be deployed in its networks, our revenue and cash flow would be adversely affected.
We have adjusted our corporate strategy to focus our efforts on a limited target customer base, particularly AT&T, and core product functionalities. As a result, we have grown increasingly reliant on the revenues generated by the sale of our legacy router products to AT&T, which accounted for 94%, 94% and 60% of our gross revenue in 2006, 2005 and 2004, respectively. In 2004, Huawei and Nortel accounted for 27% and 12%, respectively, of our gross revenue. We expect that in the next twelve months substantially all of our revenue will continue to depend on sales of our products to our major customer AT&T. Our products compete in a multi-vendor environment for use in AT&T’s networks and our agreement with AT&T does not require AT&T to purchase any minimum level of product from us. We generally have limited ability to forecast the volume, mix or timing of orders from AT&T beyond the current quarter due to, among other things, supply chain dynamics as well as limited visibility on the network traffic and capacity demands on our customer. In addition, our business will be affected by shifts in the nature and architecture of our customers’ networks, including multi-vendor environments. Shifts by AT&T to networks or architectures less reliant on our core router products, as a result of technological changes in the industry, adoption of competitive or alternative products or solutions, or otherwise, would adversely affect our legacy core router business. While we continue to invest in targeted product development required by AT&T, we have limited the development of new products and features for our core routers, and as a result our legacy router products may not continue to meet AT&T’s technical requirements. The loss of or reduction in business from AT&T would materially reduce our revenue and cash flow, and adversely affect our ability to achieve and maintain profitability.
In November 2005, AT&T completed its merger with SBC Communications and in December 2006, AT&T completed its acquisition of BellSouth and Cingular. These developments give rise to new risks and challenges for our business as our major customer experiences changes associated with integrating new businesses and networks and as we face additional incumbent vendors. We will face additional competitive challenges in maintaining our position despite our established customer relationship.
We compete in the rapidly changing telecommunications industry and, as a result, our products could become obsolete.
The market for high-speed core router products has been and is likely to continue to be characterized by rapid technological change, evolving industry standards, and frequent new product introductions. New products and technologies will emerge and existing products and technologies will further develop. These new products and technologies may reduce the prices for our core product functionalities or they may be superior to, and render obsolete, the legacy core products and services we offer and the technologies we use, and may consequently reduce the revenues generated by our products and services. It may be very expensive for us to enhance or upgrade our products and technology in order to continue to compete effectively, and we do not currently plan to significantly invest in new router development that has not been requested by our major customer.
We currently depend on a limited number of products offered in the core routing market segment and our future revenues depend on enhancements to these products and their commercial success.
We depend on the commercial success of our TSR, SSR and QSR products, from which we have historically derived all of our revenue and which are the only products that we currently offer. We offer these products in the core routing market. We must continue to enhance the features and functionality of our products to meet customer requirements. In addition, the failure of these planned product enhancements to operate as expected could delay or prevent future sales of our products.
Our plan to restructure our business and realign our cost structure may not continue to produce the revenue or profitability results that we achieved in 2006, and, accordingly, our future results from operations may decline.
We have restructured our legacy core router business to focus our efforts on our major customer, AT&T. We cannot predict the volume or sustainability of business from AT&T. We will monitor and adjust our operating expenses in our core router business in the future in line with our expectations of business volumes. In addition, the restructuring resulted in significant charges and a reduction in our staff and capabilities in key areas such as sales and marketing, product development and engineering and international operations, and as a result has limited our operational flexibility. Further, in connection with the restructuring we continue to evaluate our commercial relationships with certain of our existing customers, distributors and vendors, and the outcome of any such evaluation could have a negative impact on our business, financial position and results of operations. In connection with this evaluation we may face claims, costs or expenses beyond our current restructuring charges.
New technology initiatives require a substantial commitment of resources and are not certain of ultimate success.
New technology initiatives require significant capital expenditures, management attention and resources. Our commitment of resources and capital to a new technological concept means that those resources and capital are unavailable for other activities and operations. Our decision to launch a new initiative is based on our assessment that a significant opportunity exists in the marketplace; however, investments in new technology are inherently speculative and the market is unproven. Commercial success depends on many factors including innovativeness and accurate anticipation of technological and market trends, developer support and effective distribution and marketing. For example, our ability to realize revenue from the Soapstone initiative depends on, among other things, our timely release of the product. Product development delays may result from numerous factors, including:
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unanticipated engineering complexities;
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claims of infringement of third-party intellectual property;
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difficulties in hiring and reallocating existing engineering resources and overcoming resource limitations;
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changing market or competitive product requirements; and
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the timing and level of research and development and prototype expenses.
There are no assurances that our new technology will receive sufficient consumer acceptance and if our new technology initiative does not develop and grow substantially and achieve profitability, it could have a material adverse effect on our growth, operating results, margins and profitability. Further, even if our products initially obtain market acceptance, we may not be able to effectively support the product or successfully respond on a timely basis to products introduced into the marketplace by our competitors. In order for our Soapstone solution to compete effectively, we must: deliver a technologically advanced product that is superior in meeting the needs of carriers; promote the market for that solution; and effectively market and sell that product to carriers and indirect channel partners, against established and emerging competitive vendors.
We have reduced our sales capability as a result of our 2006 restructuring and, accordingly, we may face difficulties in appropriately marketing new technology initiatives such as our Soapstone product to our target customer base.
Our products require a sophisticated and in depth sales effort targeted at key individuals within worldwide target end user customer organizations. Our future success in penetrating our target customer base is highly dependent upon establishing and maintaining successful relationships with a variety of indirect distribution channels. Our inability to develop and manage our distribution channels could affect sales of our products. We expect that a significant amount of revenue from new technology initiatives will be through indirect channel sales. By relying on indirect channels, we may have little or no contact with the ultimate users of our products, thereby making it more difficult for us to establish brand awareness, service ongoing customer requirements and respond to evolving customer needs.
Recruiting and training qualified channel partners for our technology offerings requires significant time and resources. In order to develop and expand our distribution channel, we must scale our sales, marketing, and service organizations and the processes and procedures that support indirect channel relationships.
Our failure to compete effectively in the core router business, particularly against Cisco Systems, Juniper Networks, and other established participants with greater financial and other resources than ours, could result in order cancellations, lost customer opportunities and price and volume reductions.
The competition in the network infrastructure equipment market is intense. This market historically has been dominated by Cisco Systems, although we also compete with other companies such as Juniper Networks. Further, many of our competitors have greater selling and marketing, technical, manufacturing, financial and other resources, more customers, greater market recognition and more established relationships and alliances in the industry. As a result, these competitors may be able to develop, enhance and expand their product offerings more quickly, adapt more swiftly to new or emerging technologies and changes in customer demands, devote greater resources to the marketing and sale of their offerings, pursue acquisitions and other opportunities more readily and adopt more aggressive pricing policies. In addition, established or emerging network equipment vendors may also focus on our target market, thereby further intensifying competition. Accordingly, we may not be able to compete effectively with these competitors.
In addition, we believe that understanding the infrastructure requirements of telecommunications carriers and other service providers, experience in working with these providers to develop new services for their customers and an ability to provide vendor-sponsored financing are important competitive factors in our market. We have limited experience in working with telecommunications carriers and other service providers. In addition, we do not currently anticipate an ability to provide vendor-sponsored financing and this may influence the purchasing decision of prospective customers, which may decide to purchase products from one of our competitors that offer such financing.
If we are unable to compete successfully against our current and future competitors, we could experience order cancellations, lost customer opportunities and price and volume reductions. If this occurs, our revenues may decline, our gross margins could decrease and we could experience additional material losses.
Our failure to stabilize our revenues and manage our costs would prevent us from achieving and maintaining profitability.
Although we recorded net income in 2006, we had prior to 2006, incurred significant losses in each quarterly and annual period since inception. As of December 31, 2006, we had an accumulated deficit of $417.4 million. Although historically we have derived all of our revenue from our legacy core router products, we cannot be certain that we will increase or maintain our revenues or that we will generate sufficient revenues to sustain profitability. We plan to focus product development on our recent Soapstone product initiative, which is at an early stage and unproven. These efforts will continue to require significant expenditures, a substantial portion of which we will make long before any significant revenue related to these expenditures may be realized. We do not expect to recognize material revenue from Soapstone in the next twelve months. Accordingly, we will not likely maintain profitability unless our new product line achieves commercial success that outpaces a relative decline in our core router business.
Our operating expenses are based largely on anticipated revenue trends and a significant portion of our expenses, such as personnel and real estate facilities costs, is fixed. As a result, we will need to generate significant revenues and manage ongoing costs to maintain profitability. If we fail to achieve such revenue levels, material operating losses could result. In the future we may never achieve sustained profitability or consistently generate positive cash flows from operations.
We have had and may continue to experience difficulties identifying, analyzing and consummating strategic alternatives, and any such alternatives may not lead to the achievement of desired results.
In connection with our February 2006 restructuring, we are in an ongoing process of examining strategic alternatives to enhance shareholder value. The strategic options we may consider could include a variety of different business arrangements including, but not limited to: combinations with or a sale to another entity; the sale or spin off of certain assets; strategic partnerships and joint ventures; the acquisition of complementary businesses, technologies or product lines; investments in new businesses; recapitalization, dividend or distribution alternatives; equity or debt financings; or other alternatives. Any strategic decision will involve risks and uncertainties and present challenges in implementation and integration. As a result, any such business arrangement may not lead to increased shareholder value. In addition, any strategic decision could lead to non-recurring or other charges.
We rely on single or limited source suppliers for several key components. If we are unable to purchase these components for any reason or on a timely basis, we will not be able to deliver our products to our customers within the timeframes required and we may experience order cancellations.
We currently specify and purchase through our contract manufacturers several key components from single or limited sources such as ASICs, optical components, field programmable gate arrays and other miscellaneous components. At times some of these components are subject to end of life notices, allocation and/or lead-times far in excess of 12 weeks. We do not have a long-term, fixed price or minimum volume of supply agreements with component vendors. Although we believe that there are alternative sources for many of these components, in the event of a disruption in supply, we may not be able to develop an alternate source in a timely manner or at favorable prices.
We typically specify for purchase through our contract manufacturers all of our components, including our ASICs. From time to time and in end of life purchases, Avici may directly place purchase orders for stocking inventory. We otherwise do not generally carry significant inventories of components and have no guaranteed
supply arrangements with our vendors. If we are unable to purchase our critical components, or to provide for the production of our ASICs, at times and in volumes as our business requirements necessitate, we will not be able to manufacture and deliver our products to our customers in accordance with their volume and schedule requirements. If we are not able to satisfy the delivery requirements of our customers, which are difficult to forecast, they may reduce any future orders or eliminate our status as a vendor.
We have worked with LSI Logic for many years to develop and manufacture several of our key proprietary application specific integrated circuits, or ASICs, which are custom designed integrated circuits built to perform a specific function more rapidly than a general purpose microprocessor. These proprietary ASICs are very complex and LSI Logic is the sole source supplier for them. LSI Logic announced the discontinuation of a product technology used in several of Avici’s ASIC designs. In the second quarter of 2006, Avici executed an end of life purchase for these items to meet its anticipated production requirements for the foreseeable future. Changes in demand for our product in the future may render our inventory stocking purchases to be in excess or short of future requirements, and in the event we require additional supplies we may be unable to transition to an alternative vendor on a timely or cost effective basis.
We depend upon contract manufacturers and any disruption in these relationships may cause us to fail to meet the demands of our customers and damage our customer relationships.
We do not have internal manufacturing capabilities. We rely on a small number of contract manufacturers to manufacture our products in accordance with our specifications and to fill orders on a timely basis. These contract manufacturers procure material on our behalf and provide comprehensive manufacturing services, including assembly, test and control. We have historically been dependent on two contract manufacturers, Sanmina-SCI Corporation and Celestica Corporation. We may not be able to effectively manage our relationships with these contract manufacturers, they may not meet our future requirements for timely delivery and quality, and our business terms, such as pricing and credit terms, may change in a manner not favorable to us. If we experience changing demand for our products, the challenges we face in managing our relationships with these manufacturers will be increased. Each of our contract manufacturers also builds products for other companies, and we cannot be certain that they will always have sufficient quantities of inventory available to fill orders placed by our customers, or that they will allocate their internal resources to fill these orders on a timely basis. Qualifying a new contract manufacturer and commencing volume production is expensive and time consuming and could result in a significant interruption in the supply of our product. If we are required or choose to change one or both of our contract manufacturers, we could experience a material loss in our revenue and significant damage to our customer relationships.
If we fail to accurately predict our manufacturing requirements, we could incur additional inventory costs or experience manufacturing delays.
Our contract manufacturers are not obligated to supply products to us for any specific period, in any specific quantity or at any certain price, except as may be provided in a particular purchase order. We generally provide forecasts of our demand to these manufacturers up to 12 months prior to scheduled delivery of product to our customers. If we overestimate our requirements, we may purchase excess inventory, which would consume cash by increasing our costs and may require us to take additional charges for excess and obsolete inventory. If we underestimate our requirements, we may have an inadequate amount of inventory, which could result in delays in delivery to our customers and in recognition of revenue or in increased costs incurred to expedite product delivery. In addition, the lead times for materials and components we order vary significantly and depend on factors such as the specific supplier, contract terms and demand for each component at a given time. We also may experience shortages of other components from time to time, which also could delay the manufacturing of our products and delay our recognition of revenue.
In addition, we may be subject to regulatory requirements which could affect our ability to manufacture and deliver product on a timely and cost-effective basis.
Our complex products may have errors or defects or may not interoperate within the networks of our customers, which could result in reduced demand for our products or costly litigation against us.
Our products are technologically sophisticated and are designed to be deployed in complex networks. Accordingly, our products can only be fully tested when completely deployed in these types of networks. Despite deployment and internal testing, our customers may discover errors or defects in the hardware or the software, or the product may not operate as expected even after it has been fully deployed. In addition, our customers will require that our products be designed to interface with their existing networks, each of which may have different specifications. Our products must interface with many of the products within these networks as well as future products in order to meet the requirements of our customers. Because our products are critical to the networks of our customers, any significant interruption in their service as a result of defects in our product or the failure of our product to interoperate within our customers’ networks could result in lost profits or damage to these customers. These problems could cause us to incur significant service and warranty costs, divert engineering personnel from product development efforts and significantly impair our ability to maintain existing customer relations and attract new customers. Although our existing and future customer contracts will generally contain provisions designed to limit our exposure to potential product liability claims, such as disclaimers of warranties and limitations on liability for special, consequential and incidental damages, a court might not enforce a limitation on our liability, which could expose us to additional financial loss. In addition, a product liability claim, whether successful or not, would likely be time consuming and expensive to resolve and would divert management time and attention. Further, if we are unable to fix the errors or other problems that may be identified in full deployment, we would likely experience loss of or delay in revenues and loss of market share and our business and prospects would suffer.
The unpredictability of our quarterly results of operations may adversely affect the trading price of our common stock.
Our quarterly operating results are likely to vary significantly in the future based on a number of factors related to our industry, the markets for our products and how we manage our business. We have little or no control over many of these factors and any of these factors could cause the price of our common stock to fluctuate significantly. In addition to the risks discussed elsewhere in this section, the following may also adversely affect the trading price of our common stock:
•
fluctuations and uncertainties in core router product and service demands from our major customer AT&T;
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the sustainability of demand for the existing capabilities of our core router products;
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our ability to manufacture and deliver product within short order timeframes;
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the timing and size of customer orders for our products or cancellations of orders;
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the timing and extent of product acceptance by customers;
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the timing and level of research and development and prototype expenses;
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the timing of new product launches;
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the distribution channels through which we sell our products;
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the timing and impact of special charges such as the restructuring program enacted in February 2006;
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general economic conditions; and
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conditions specific to the telecommunications industry, including uncertainty related to consolidation.
We plan to invest in research and development and, in the future, sales and marketing and customer support related to new product initiatives, as well as research and development in selective enhancements to our legacy core router products. Our operating expenses will largely be based on revenue trends and a high percentage of
our expenses are, and will continue to be, fixed in the short term. As a result, if revenue for a particular quarter is below our expectations for any of the reasons set forth above, or for any other reason, we may not be able to proportionately reduce operating expenses for that quarter. Accordingly, this revenue shortfall would have a disproportionate effect on our expected operating results and could result in material operating losses for that quarter, which could result in significant variations in our operating results from quarter to quarter.
Due to the foregoing factors, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance. You should not rely on our results or growth for any single quarter as an indication of our future performance. It is likely that in some future quarters, our operating results may be below the expectations of public market analysts and investors. In this event, the price of our common stock may decline.
A vendor’s leadership position in our market may allow that vendor to set de facto industry standards, which could create technical challenges to our ability to sell our products.
In developing our products, we have made, and will continue to make, assumptions about the standards that may be adopted by our customers and competitors. If the standards adopted are different from those that we have chosen to support, market acceptance of our products would likely be significantly reduced and our business will be seriously harmed.
Customer requirements are likely to evolve, and we will not retain our target customer base or attract new customers if we do not anticipate and meet specific customer requirements.
Our future success will depend upon our ability to develop and manage key customer relationships in order to develop Soapstone products and product enhancements that address the increasingly sophisticated needs of our target base of customers. Our current customers may require product features and capabilities that our core legacy products do not have. We must effectively anticipate and adapt on a timely basis to customer requirements and offer products that meet those demands in a timely manner. Our long-term strategy is to focus on Soapstone which we believe is well positioned to take advantage of opportunities in the market. Our failure to develop products that satisfy customer requirements would seriously harm our ability to achieve market acceptance for our products. In addition, we may experience design, engineering, manufacturing, marketing and other difficulties that could delay or prevent our development or introduction of new products and enhancements. Material delays in introducing new products may cause customers to forego purchases of our products and purchase those of our competitors, which could seriously harm our business.
Our ability to develop, market and support products depends on retaining our management team and attracting and retaining highly qualified individuals in our industry.
Our future success depends on the continued services of our management team, which has significant experience with the data communications, telecommunications and Internet infrastructure markets, in addition to relationships with many of the communications service providers and business partners that we currently or may in the future rely on in implementing our business plan. The loss of the services of our management team or any key executive could have a significant detrimental effect on our ability to execute our business strategy.
Our future success also depends on our continuing ability to selectively identify, hire as needed, train, assimilate and retain highly qualified engineering, sales and marketing, managerial, support and other personnel. The demand and competition for qualified personnel is high, and we have from time to time experienced, and we expect to continue to experience in the future, difficulty in hiring and retaining highly skilled employees with appropriate qualifications. In particular, we have experienced difficulty in hiring qualified engineering personnel. The loss of the services of any of our key employees, the inability to attract or retain qualified personnel in the future or delays in hiring required personnel, particularly engineers, could delay product development, particularly with respect to new product initiatives and negatively impact our ability to sell our products.
Our office lease expires in 2007 and, as a result, we will incur costs associated with negotiating a new or renewed lease, as well as possible relocation costs.
We lease office space, used as our headquarters and primary business location, at 101 Billerica Avenue, North Billerica, Massachusetts. Our current lease expires in the second half of 2007. As a result, we have engaged a real estate agent to assist us in considering our options. We anticipate that we will lease a new facility in the same general vicinity as our current location, but which will nevertheless require us to relocate our operations and incur relocation costs. The process of evaluating our options, negotiating a new or renewed lease, and managing a relocation will require expense, time and attention from members of management. Further, if we elect to lease a new facility, we will incur related expenses and will encounter disruption of operations related to the move, all of which could have a material adverse effect on our financial condition and results of operations.
We face risks associated with international sales and operations that could impair our ability to grow our revenues abroad.
International activities involve risks that we do not have to address in the domestic market, such as difficulties in managing foreign operations, different regulatory requirements and different technology standards. We currently do not have significant foreign operations or sales capabilities. Any future international sales will be subject to, among other things, currency exchange rate fluctuation risks. As a result, increases in the value of the United States dollar relative to foreign currencies would cause our products to become less competitive in international markets and could result in limited, if any, sales and profitability. To the extent that we denominate sales in foreign currencies or incur significant operating expenses denominated in local currencies, we will be exposed to increased risks of currency exchange rate fluctuations.
We may experience difficulty in identifying, acquiring and integrating acquisition candidates.
We may acquire complementary businesses, technologies or product lines. We may not be able to identify and acquire suitable candidates on reasonable terms. We compete for acquisition candidates with other companies that have substantially greater financial, management and other resources than we do. If we do complete an acquisition, then we may face numerous business risks. These risks include difficulties in assimilating the acquired operations, technologies, personnel and products, difficulties in managing geographically dispersed and international operations; difficulties in assimilating diverse financial reporting and management information systems; the diversion of management’s attention from other business concerns; the potential disruption of our business; and the potential loss of key employees, customers, distributors or suppliers. We may finance acquisitions by issuing shares of our common stock, which could dilute our existing stockholders. We may also use cash or incur additional debt to pay for these acquisitions. In addition, we may be required to expend substantial funds to develop acquired technologies. We may also be required to amortize significant intangible assets in connection with future acquisitions, which could adversely affect our operating results.
Our intellectual property protection may be inadequate to protect our proprietary rights, and we may be subject to infringement claims that could subject us to significant liability and divert the time and attention of our management.
We regard our products and technology as proprietary. We attempt to protect them through a combination of patent protection, copyrights, trademarks, trade secret laws, contractual restrictions on disclosure and other methods. These methods may not be sufficient to protect our proprietary rights. We presently have 20 patents granted in the United States and over 50 United States and foreign patent applications pending. We cannot be certain that patents will be granted based on these or any other applications, or that, even if issued, the patents will adequately protect our technology. We also generally enter into confidentiality agreements with our employees, consultants and customers, and generally control access to and distribution of our documentation and other proprietary information. Despite these precautions, it may be possible for a third party to copy or otherwise misappropriate and use our products or technology without authorization, particularly in foreign countries where
the laws may not protect our proprietary rights to the same extent as do the laws of the United States, or to develop similar technology independently. We may need to resort to litigation in the future to enforce our intellectual property rights, to protect our trade secrets or to determine the validity and scope of the proprietary rights of others. This litigation could result in substantial costs and diversion of resources and could harm our business.
We also license technologies from third parties, some of which we license without indemnification from the licensor for infringement of third party intellectual property rights. We are continuing to develop and acquire additional intellectual property. Although we have not been involved in any litigation relating to our intellectual property, including intellectual property that we license from third parties, we expect that participants in our markets will be increasingly subject to infringement claims. Third parties may try to claim our products infringe their intellectual property. Any claim, whether meritorious or not, could be time consuming, result in costly litigation and/or require us to enter into royalty or licensing agreements. Although we carry general liability insurance, our insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed. In addition, any royalty or licensing agreements might not be available on terms acceptable to us or at all, in which case we would have to cease selling, incorporating or using the products that incorporate the challenged intellectual property and expend substantial amounts of resources to redesign our products. If we are forced to enter into unacceptable royalty or licensing agreements or to redesign our products, our business and prospects would suffer.
We are uncertain of our ability to obtain additional financing for our future capital needs.
We expect our current cash, cash equivalents and marketable securities will meet our normal working capital and capital expenditure needs for at least the next twelve months. We may need to raise additional funding at that time or earlier if we decide to undertake more rapid expansion, including acquisitions of complementary products or technologies, or if we increase our research and development or other efforts, or in connection with any strategic alternative. We cannot be certain that we will be able to obtain additional financing on favorable terms, if at all. We may obtain additional financing by issuing shares of our common stock, which could dilute our existing stockholders, or through the incurrence of debt, which could affect our cash flows and flexibility with respect to future operations, financings and acquisitions. If we cannot raise needed funds on acceptable terms, or at all, we may not be able to develop or enhance our products or respond appropriately to competitive pressures, which would seriously harm our business.
The market price of our common stock may be materially adversely affected by market volatility.
The price at which our common stock trades is highly volatile and fluctuates substantially. Given the limited volume of our product sales and our limited number of customers, the announcement of any significant customer developments, awards or losses or of any significant partnerships or acquisitions by us or our competitors could have a material adverse effect on our stock price. In addition, the stock market in general has, and technology companies in particular have, from time to time experienced extreme price and volume fluctuations that have often been unrelated or disproportionate to the operating performance or prospects of such companies.
In the past, securities class action litigation has often been brought against companies following periods of volatility in the market price of their securities. Those companies, like us, that are involved in rapidly changing technology markets are particularly subject to this risk. Securities class action lawsuits have been filed against us in the United States District Court for the Southern District of New York. The consolidated amended complaint generally alleges that our offering documents failed to disclose certain underwriting fees and commissions and underwriter tie-ins and other arrangements with certain customers of the underwriters that impacted the price of our common stock in the after-market. The plaintiffs are seeking unspecified damages. We believe that the claims in this case against us lack merit, and we have defended the litigation vigorously.
We can provide no assurance as to the outcome of this securities litigation. Any conclusion of this litigation in a manner adverse to us could have a material adverse effect on our business, financial condition, results of
operations and cash flows. In addition, the cost to us of defending the litigation, even if resolved in our favor, could be substantial. Such litigation could also substantially divert the attention of our management and our resources in general. Uncertainties resulting from the initiation and continuation of this litigation could harm our ability to compete in the marketplace. Because the price of our common stock has been, and may continue to be, volatile, we can provide no assurance that additional securities litigation will not be filed against us in the future.
The market price of our common stock might decline due to future non-cash charges to earnings.
As of January 1, 2006, we account for employee stock-based compensation costs in accordance with Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”). Our adoption of this SFAS 123R resulted in material non-cash charges to our earnings and we expect such non-cash charges to continue to have a material impact on future earnings. It may not be possible to calculate the future impact with respect to stock-based grants as the amount of these charges to earnings fluctuates with the price of our common stock and other factors. It is possible that some investors might consider this impact on operating results to be material, which could result in a decline in the price of our common stock.
Our estimates and judgments related to critical accounting policies could be inaccurate.
We consider accounting policies related to revenue recognition, inventory valuation, warranty liabilities, long-lived assets, restructuring and impairment charges and stock-based compensation to be critical in fully understanding and evaluating our financial results. Management makes certain significant accounting judgments and estimates related to these policies. Our business, operating results and financial condition could be materially and adversely impacted in future periods if our accounting judgments and estimates related to these critical accounting policies prove to be inadequate.
Any failure to maintain effective internal information systems or to implement effective internal controls over financial reporting could adversely impact our business.
We must continue to maintain our internal information systems in order to manage our business operations. We must also maintain internal controls over financial reporting in accordance with The Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”). Our disclosure controls and procedures and internal controls over financial reporting may not prevent all errors and intentional misrepresentations. Any system of internal control can only provide reasonable assurance that all control objectives are met. Some of the potential risks involved could include but are not limited to management judgments, simple errors or mistakes, willful misconduct regarding controls or misinterpretation. There is no guarantee that existing controls will prevent or detect all material issues or that existing controls will be effective in future conditions, which could materially and adversely impact our financial results. Under Sarbanes-Oxley, we are required to evaluate and determine the effectiveness of our internal controls over financial reporting. Compliance with this legislation will require management’s attention and resources and will cause us to continue to incur significant expense. Management’s assessment of our internal controls over financial reporting may identify weaknesses that need to be addressed in our internal controls over financial reporting or other matters that may raise concerns for investors. Should we determine that we have material weaknesses in our internal controls over financial reporting, our results of operations or financial condition may be materially adversely affected or the price of our common stock may decline.
Our charter documents, Shareholder Rights Plan, and Delaware law could inhibit a takeover that some stockholders may consider favorable.
There are provisions of Delaware law and our charter, by-laws, and Shareholder Rights Plan that could make it more difficult for a third party to acquire us, even if doing so would be beneficial to some of our stockholders by providing them the opportunity to sell their shares at a premium over the market price. If a change of control or change in management is delayed or prevented, the market price of our common stock could be affected.
ITEM 1B.
ITEM 1B. UNRESOLVED STAFF COMMENTS
None.
ITEM 2.
ITEM 2. PROPERTIES
Our headquarters is currently located in a leased facility in North Billerica, Massachusetts, consisting of approximately 81,000 square feet under a lease expiring in the second half of 2007.
We anticipate that we will lease a new facility in the same general vicinity as our current location, particularly to house employees associated with the Soapstone initiative, which will require us to relocate operations and incur relocation costs. The commercial real estate market in the Boston area is unpredictable in terms of available space, rental and occupancy rates and preferred locations.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
In addition to claims in the normal course of business, twelve purported securities class action lawsuits were filed against Avici and one or more of Avici’s underwriters in Avici’s initial public offering, and certain officers and directors of Avici. The lawsuits alleged violations of the federal securities laws and were docketed in the U.S. District Court for the Southern District of New York (the “Court”) as: Felzen, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3363; Lefkowitz, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3541; Lewis, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3698; Mandel, et. al v. Avici Systems Inc., et al., C.A. No. 01-CV-3713; Minai, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3870; Steinberg, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3983; Pelissier, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-4204; Esther, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-4352; Zhous, et al. v. Avici Systems Inc. et al., C.A. No. 01-CV-4494; Mammen, et al. v. Avici Systems Inc., et. al., C.A. No. 01-CV-5722; Lin, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-5674; and Shives, et al. v. Banc of America Securities, et al., C.A. No. 01-CV-4956. On April 19, 2002, a consolidated amended class action complaint (the “Complaint”), which superseded these twelve purported securities class action lawsuits, was filed in the Court. The Complaint is captioned “In re Avici Systems, Inc. Initial Public Offering Securities Litigation” (21 MC 92, 01 Civ. 3363 (SAS)) and names as defendants Avici, certain of the underwriters of Avici’s initial public offering, and certain of Avici’s officers and directors. The Complaint, which seeks unspecified damages, alleges violations of the federal securities laws, including among other things, that the underwriters of Avici’s initial public offering (“IPO”) improperly required their customers to pay the underwriters excessive commissions and to agree to buy additional shares of Avici’s stock in the aftermarket as conditions of receiving shares in Avici’s IPO. The Complaint further claims that these supposed practices of the underwriters should have been disclosed in Avici’s IPO prospectus and registration statement. In addition to the Complaint against Avici, various other plaintiffs have filed other substantially similar class action cases against approximately 300 other publicly traded companies and their IPO underwriters in New York City, which along with the case against Avici have all been transferred to a single federal district judge for purposes of case management. Avici and its officers and directors believe that the claims against Avici lack merit, and have defended the litigation vigorously. In that regard, on July 15, 2002, Avici, together with the other issuers named as defendants in these coordinated proceedings, filed a collective motion to dismiss the consolidated amended complaints against them on various legal grounds common to all or most of the issuer defendants.
On October 9, 2002, the Court dismissed without prejudice all claims against the individual current and former officers and directors who were named as defendants in our litigation, and they are no longer parties to the lawsuit. On February 19, 2003, the Court issued its ruling on the motions to dismiss filed by the issuer defendants and separate motions to dismiss filed by the underwriter defendants. In that ruling, the Court granted in part and denied in part those motions. As to the claims brought against Avici under the antifraud provisions of the securities laws, the Court dismissed all of these claims with prejudice, and refused to allow the plaintiffs an opportunity to re-plead these claims against Avici. As to the claims brought under the registration provisions of
the securities laws, which do not require that intent to defraud be pleaded, the Court denied the motion to dismiss these claims as to Avici and as to substantially all of the other issuer defendants as well. The Court also denied the underwriter defendants’ motion to dismiss in all respects.
In June 2003, Avici elected to participate in a proposed settlement agreement with the plaintiffs in this litigation. If ultimately approved by the Court, this proposed settlement would result in the dismissal, with prejudice, of all claims in the litigation against Avici and against any of the other issuer defendants who elect to participate in the proposed settlement, together with the current or former officers and directors of participating issuers who were named as individual defendants. The proposed settlement does not provide for the resolution of any claims against the underwriter defendants, and the litigation as against those defendants is continuing. The proposed settlement provides that the class members in the class action cases brought against the participating issuer defendants will be guaranteed a recovery of $1 billion by insurers of the participating issuer defendants. If recoveries totaling $1 billion or more are obtained by the class members from the underwriter defendants, however, the monetary obligations to the class members under the proposed settlement will be satisfied. In addition, Avici and any other participating issuer defendants will be required to assign to the class members certain claims that they may have against the underwriters of their IPOs.
The proposed settlement contemplates that any amounts necessary to fund the settlement or settlement-related expenses would come from participating issuers’ directors and officers liability insurance policy proceeds as opposed to funds of the participating issuer defendants themselves. A participating issuer defendant could be required to contribute to the costs of the settlement if that issuer’s insurance coverage were insufficient to pay that issuer’s allocable share of the settlement costs. Avici expects that its insurance proceeds will be sufficient for these purposes and that it will not otherwise be required to contribute to the proposed settlement.
Consummation of the proposed settlement is conditioned upon obtaining approval by the Court. On September 1, 2005, the Court preliminarily approved the proposed settlement and directed that notice of the terms of the proposed settlement be provided to class members. Thereafter, the Court held a fairness hearing on April 24, 2006, at which objections to the proposed settlement were heard. After the fairness hearing, the Court took under advisement whether to grant final approval to the proposed settlement.
On December 5, 2006, the U.S. Court of Appeals for the Second Circuit issued a decision that six purported class action lawsuits containing allegations substantially similar to those asserted against the Company may not be certified as class actions due, in part, to the Appeals Court’s determination that individual issues of reliance and knowledge would predominate over issues common to the proposed classes. On January 8, 2007, the plaintiffs filed a petition seeking rehearing en banc of this ruling. U.S. District Court has ordered that all proceedings in the consolidated cases brought against the Company and against the roughly 300 other issuers sued in substantially similar cases (including proceedings relating to the proposed settlement) will be stayed pending the ruling by the Court of Appeals on whether to entertain that petition for rehearing. As a result, in part, of that filing, the impact, if any, of the Court of Appeals’ ruling on the viability of the proposed settlement cannot yet be determined.
If the proposed settlement described above is not consummated, Avici intends to continue to defend the litigation vigorously. Moreover, if the proposed settlement is not consummated, Avici believes that the underwriters may have an obligation to indemnify Avici for the legal fees and other costs of defending this suit and that Avici’s directors’ and officers’ liability insurance policies would also cover the defense and potential exposure in the suit. While Avici can make no promises or guarantees as to the outcome of these proceedings, Avici believes that the final result of these actions will have no material effect on Avici’s consolidated financial condition, results of operations or cash flows.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
During the quarter ended December 31, 2006, no matters were submitted to a vote of security holders through the solicitation of proxies or otherwise.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Price Range of Common Stock
Our common stock has been traded on the NASDAQ National Market under the symbol “AVCI” since July 28, 2000. The following table sets forth, for the periods indicated, the high and low sale prices as reported on the NASDAQ National Market.
As of March 9, 2007, there were approximately 395 stockholders of record.
Stock Performance Graph
The following graph shows the five-year cumulative total stockholder return on the Company’s Common Stock during the period from December 31, 2001 through December 31, 2006, with the cumulative total return on the Nasdaq Stock Market (U.S.) Index and the Nasdaq Telecommunications Index. The comparison assumes $100 was invested on December 31, 2001 in the Company’s Common Stock and in each of the foregoing indices and assumes reinvestment of dividends, if any.
COMPARISON OF 5 YEAR CUMULATIVE TOTAL RETURN *
AMONG AVICI SYSTEMS, INC., THE NASDAQ STOCK MARKET (U.S.) INDEX
AND THE NASDAQ TELECOMMUNICATIONS INDEX
* $100 invested on 12/31/01 in stock or index-including reinvestment of dividends.
Fiscal year ending December 31.
Notes:
A. The lines represent monthly index levels derived from compounded daily returns that include all dividends.
B. If the monthly interval, based on the fiscal year-end, is not a trading day, the preceding trading day is used.
C. The Index level for all series was set to 100.00 on December 31, 2001.
Dividend Policy
We have never paid or declared any cash dividends on our common stock or other securities. Any future determination to pay cash dividends will be at the discretion of the Board of Directors and will be dependent upon our financial condition, results of operations, capital requirements, general business condition and such other factors as the Board of Directors may deem relevant.
Information concerning our equity compensation plans is set forth in our Definitive Proxy Statement with respect to our 2006 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year, under the heading of “Equity Compensation Plan Information,” which is incorporated herein by reference.
ITEM 6.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
The following selected consolidated financial data should be read in conjunction with the consolidated financial statements and notes thereto and with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and other financial data included elsewhere in this report. The statement of operations data for the years ended December 31, 2006, 2005 and 2004, and the balance sheet data as of December 31, 2006 and 2005 are derived from our audited consolidated financial statements, which are included elsewhere in this report. The statement of operations data for the years ended December 31, 2003 and 2002 and the balance sheet data as of December 31, 2004, 2003 and 2002 are derived from our audited consolidated financial statements, which are not included in this report. The historical results are not necessarily indicative of results to be expected for any future period.
* Relates to assignment of a claim in bankruptcy in 2005, customer credits that expired unused in 2003 and a gain from an insurance settlement in 2002.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with “Selected Consolidated Financial Data” and the accompanying consolidated financial statements and related notes included elsewhere in this Form 10-K. This report contains forward-looking statements, which involve risks and uncertainties. We make such forward-looking statements under the provision of the “Safe Harbor” section of the Private Securities Litigation Reform Act of 1995. Any forward-looking statements should be considered in light of the factors described above in Item 1A under “Risk Factors.” Actual results may vary materially from those projected, anticipated or indicated in any forward-looking statements. Forward-looking statements include statements regarding the future or Avici’s expectations, beliefs, intentions or strategies regarding the future and may be identified by the words “anticipate,” “believe,” “could,” “estimate,” “expect,” “intend,” “may,” “should,” “will,” and “would” and similar expressions.
Overview
Avici Systems provides high-speed data networking equipment that enables networking service providers to transmit high volumes of information across their networks.
The Avici Terabit Switch Router (TSR™), which was introduced in 1999, is purpose-built for the stresses of carrier core routing in large IP networks, and has been deployed at AT&T Corp. (AT&T) since 1999. During 2001, we introduced the Avici Stackable Switch Router (SSR™), a rack-mountable scalable router for service providers with smaller core networks. During the fourth quarter of 2002, we introduced the Avici Quarter-rack Scalable Router (QSR™), which provides customers with one of the smallest footprint, highest density routers commercially available.
On February 16, 2006, Avici announced a plan to restructure its business and realign its cost structure to execute a focused strategy aimed at driving Avici toward profitability and positive cash flow. The restructuring plan included a workforce reduction and employee retention plan, charges related to excess inventory and inventory related costs, asset impairment and other costs. Through March 31, 2007, the Company expects to record total restructuring charges of approximately $10.8 million, of which $8.2 million is cash based. In 2006 Avici recorded $10.7 million of these charges, and expects to record the remaining $0.1 million, all of which are workforce related and cash based in the first quarter of 2007. In connection with this announcement in February 2006, Avici also indicated that, in consultation with its investment bankers, it would evaluate strategic alternatives that may include a further restructuring of the business.
In February 2007 we announced our decision to launch a new product initiative (“Soapstone”) that leverages our deep knowledge of carrier-world transport elements and our leadership role in industry forums. The product initiative is designed to enable carriers to bring orderly, predictable, business-driven behavior to their networks, regardless of vendor or technology composition.
Since our inception, we have incurred significant losses. As of December 31, 2006, we had an accumulated deficit of $417.4 million. Although we recorded our first net income in 2006 and strive to continue such profitability, there is no certainty that profitability will continue.
Revenues
We expect that substantially all of our revenue in the next twelve months will continue to depend on product sales and service revenue from our current customers, primarily AT&T. Under existing procurement agreements, our customers are not committed to purchase any minimum quantities of products from us. In September 2004, we amended our original procurement agreement with AT&T to extend through December 31, 2009. The agreement describes the conditions under which AT&T may purchase equipment and services from us and provides AT&T with the ability, but not the obligation to purchase equipment and services from us. The agreement has no minimum purchase commitment. We do not anticipate recording any material revenue in the next twelve months associated with Soapstone.
Prior to our restructuring, we sought to increase our worldwide presence through indirect sales channels established through agreements with system integrators and distribution partners. In April 2003, we entered into a strategic relationship with Huawei. The agreement had no minimum purchase commitment and expired in April 2005. In January 2004, we entered into a worldwide three-year strategic agreement with Nortel Networks (“Nortel”) to market, sell and support Avici’s carrier-class core routers as part of its converged network solutions based on Internet Protocol (IP) technology. The agreement has no minimum purchase commitment and expired in January 2007. The relationships with Nortel and Huawei did not produce the results we anticipated when entering into these relationships. Our current strategy does not include the development of and investment in distribution channels in the core router business.
Common Stock Warrant Discount-Product
In January 2004, in connection with a three-year strategic OEM agreement with Nortel, Avici issued a warrant to purchase 800,000 shares of Avici common stock at an exercise price of $8.03 per share. The agreement provides Nortel with the ability, but not the obligation, to purchase equipment and services from Avici for its own use or for resale. The warrant is nonforfeitable and has a term of approximately seven years from the date of issuance and is exercisable after seven years. The right to exercise the warrant may be accelerated if Nortel achieves certain performance milestones or at the discretion of Avici, upon a change in control. The fair value of the warrant was calculated to be approximately $6.3 million using the Black-Scholes valuation model, and was being recorded as a reduction of revenue on a straight-line basis over three years. The unamortized balance was deemed impaired and was fully written off in the first quarter of 2006, as further described below under Restructuring and Impairment Charges. The unamortized balance of $2.1 million at December 31, 2005 is recorded as a Contract Distribution Right in the accompanying balance sheet.
Cost of Revenue
Cost of Revenue-Product includes material cost, provision for warranty, rework, depreciation, provision for excess and obsolete inventory and, in first and third quarters of 2006, charges of $1.4 million and $1.7 million, respectively, directly associated with Avici’s restructuring. We outsource our manufacturing operations to contract manufacturers that assemble and test our products in accordance with our specifications. Accordingly, a significant portion of our product cost is material cost paid to these entities. Avici’s cost of revenue also includes overhead costs, primarily for material procurement associated with our manufacturing. Warranty costs and inventory provisions are expensed as cost of revenue-product.
Cost of Revenue-Service includes costs associated with providing customer support and maintenance services.
Research and Development
Research and development expenses consist primarily of salaries and related employee costs, depreciation expense on laboratory equipment and project costs, namely, prototype equipment, materials costs and third-party costs and fees related to the development and prototyping of our proprietary technology. Project costs may vary from period to period depending upon the timing and extent of applicable initiatives. In the future, we expect research and development expenses to decline, resulting from the full-year benefit from the restructuring and re-alignment of Avici’s cost structure, partially offset by additional development related to Soapstone.
Sales and Marketing
Sales and marketing expenses have consisted primarily of salaries and related employee costs, sales commissions, travel, public relations, training and other costs associated with marketing material and tradeshows. In the future, we expect sales and marketing expenses to decline, resulting from the full-year benefit from the restructuring and re-alignment of Avici’s cost structure, partially offset by additional expenses related to Soapstone.
General and Administrative
General and administrative expenses consist primarily of salaries and related costs for executive, finance, legal, facilities, human resources and information technology personnel as well as professional and compliance related fees. In the future, we expect general and administrative expenses to decline, resulting from the full-year benefit from the restructuring and re-alignment of Avici’s cost structure.
Restructuring and Impairment Charges
On February 16, 2006, Avici announced a plan to restructure its business and realign its cost structure to execute a focused strategy aimed at driving Avici toward profitability and positive cash flow. The restructuring plan included a workforce reduction and employee retention plan (“workforce restructuring”), charges related to excess inventory and inventory related costs, asset impairment and other costs.
The Company expects to record total restructuring charges of approximately $10.8 million, of which $8.2 million is cash based. In 2006 Avici recorded $10.7 million of these charges.
Workforce restructuring
The restructuring plan resulted in the reduction of approximately 45% of the employee base of full-time and contract employees across all business functions and geographic regions. Avici expects to record $5.5 million of employee related charges, all of which are cash based. In 2006, Avici recorded $5.4 million of these charges. Avici expects to pay approximately $1.6 million in the first quarter of 2007.
Inventory and inventory related costs
Due to Avici’s strategic decision to focus on a select customer base, certain inventories and related purchase commitments were determined to be in excess of foreseeable usage. In the first quarter of 2006 Avici recorded a $1.4 million charge to cost of revenue-product to write-down the value of such excess inventory ($1.1 million) and accrue the cost of the non-cancelable inventory purchase commitments ($0.3 million).
In connection with its restructuring, Avici also evaluated certain of its customer relationships and the outcome of this evaluation resulted in Avici agreeing to terminate one of its customer contracts. Avici has not recorded any revenue under this customer contract since all revenue recognition criteria were not met. Under the terms of the termination agreement, the customer will return Avici’s product after a transition period during which Avici will provide product support estimated to cost $0.3 million. In addition, Avici unwound the financial arrangements, reversing remaining accounts receivable and deferred revenue balances and committing to pay $1.4 million. Avici paid $0.7 million in 2006 and will pay the balance upon return of the inventory, scheduled for the third quarter of 2007. Avici has assessed the inventory expected to be received from this customer for recoverability and has adjusted the carrying value accordingly. In 2006 Avici recorded a net charge of $1.7 million in cost of revenue-product as a result of the adjustments relating to this termination agreement. Avici amended the termination agreement in January 2007 and provided incentives to this customer to return the inventory earlier than originally scheduled. Upon such earlier return an additional payment will be made. Avici will record such costs, when it becomes probable an additional loss will be incurred.
Asset impairment
In January 2004, in connection with a three-year strategic OEM agreement with Nortel, Avici issued a warrant to purchase 800,000 shares of Avici common stock as further described in Common Stock Warrant Discount-Product above. The fair value of the warrant was capitalized as contract distribution rights and was being amortized as a reduction of revenue on a straight-line basis over three years. As a result of Avici’s implementation of a revised customer strategy and public announcements by the channel partner of a strategic shift away from wire line data, Avici anticipated minimal future revenue under this agreement. As a result, Avici determined that the unamortized balance of such contract distribution rights ($1.6 million) was impaired and wrote off such balance in the first quarter of 2006.
Other costs
Avici also recorded in 2006, $0.7 million of other restructuring costs relating primarily to certain contract cancellations, legal and administrative expenses.
The restructuring charges recorded in 2006 and the reserve activity are summarized as follows:
Stock-based Compensation
Through December 31, 2001, Avici had recorded cumulative non-cash deferred compensation, relating to pre-IPO stock option grants, as an element of stockholders’ equity, representing the aggregate difference between the deemed fair value of Avici’s common stock and the exercise price of stock options and restricted stock granted and the selling price of stock sold. The deferred compensation was recognized as an expense over the vesting period of the stock options and restricted stock and was fully expensed by the third quarter of 2004. During the year ended December 31, 2004, Avici recorded approximately $0.3 million of non-cash compensation expense associated with these grants.
In 2004, 2005 and 2006, Avici granted 120,000, 172,000 and 92,500 shares, respectively, of performance-based restricted stock to certain key employees of the Company. The shares vest no later than five years from the grant date. Vesting may be accelerated upon the achievement of certain pre-defined performance milestones. The value of the shares at the dates of grant was $1.3 million, $0.8 million and $0.6 million for 2004, 2005 and 2006, respectively, and is being charged to sales and marketing, general and administrative and research and development expenses on a straight-line basis over the shorter of the expected performance period or the five year vesting period. The performance criteria for the 2004 grants were met in 2006 and accordingly all unamortized expenses associated with such grant were expensed.
Effective January 1, 2006, Avici adopted the provisions of Statement of Financial Accounting Standards No. 123R, (“SFAS 123R”) “Share-Based Payment,” which establishes accounting for equity instruments exchanged for employee services. The adoption of SFAS 123R resulted in a non-cash expense of $0.8 million in the year ended December 31, 2006.
Critical Accounting Policies
Avici considers the following accounting policies related to revenue recognition, inventory valuation, warranty liabilities, long-lived assets, restructuring and impairment charges and stock-based compensation to be critical accounting policies due to the estimation processes and judgments involved in each. Avici bases its estimates on historical experience and various other factors that are believed to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions.
Revenue Recognition
Consistent with Statement of Position No. 97-2, Avici recognizes revenue from product sales upon shipment or delivery to customers, including resellers, provided that a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed or determinable and collectibility is deemed probable. If uncertainties regarding customer acceptance exist, Avici recognizes revenue when those uncertainties are resolved. For arrangements that include the delivery of multiple elements, revenue is allocated to the various elements based on vendor-specific objective evidence of fair value (VSOE). Avici uses the residual method when VSOE does not exist for one of the delivered elements in an arrangement. We also generate revenue from support and maintenance as well as installation and service. We defer revenue from support and maintenance contracts and recognize it ratably over the period of the related agreements. We recognize revenue from installation and other services as the work is performed. Amounts collected or billed prior to satisfying the above revenue recognition criteria are recorded as deferred revenue. In the event the Company is unable to meet one or all of the above criteria on a timely basis, revenue recognized for any reporting period could be adversely affected.
Inventory Valuation
We value our inventory at the lower of the actual cost to purchase or the current estimated market value. We regularly review inventory quantities on hand and at customer sites and inventory commitments with suppliers and record a provision for potentially excess and obsolete inventory based primarily on our estimated forecast of product demand for up to the next twelve months. When we place end-of-life orders we review the recovery of such components against the expected future revenue over several years. Demand for our products can fluctuate suddenly and significantly due to changes in economic and business conditions. A significant increase in demand for our products could result in a short-term increase in the cost of inventory purchases while a significant decrease in demand or change in strategy could result in an increase in the amount of excess inventory on hand and at suppliers. In addition, our industry is characterized by rapid technological change, frequent new product development, and rapid product obsolescence that could result in an increase in the amount of obsolete inventory on hand and at suppliers. Therefore, although we endeavor to ensure the accuracy of our forecasts of future product demand, any significant unanticipated changes in demand or technological developments could result in additional reserves in future periods for the existing inventories and hence could have a significant impact on the value of our inventory and our reported operating results.
Warranty Liabilities
Our warranties require us to repair or replace defective products returned to us during the warranty period at no cost to the customer. We record an estimate for warranty related costs at the time of sale based on our actual historical return rates and repair costs. While our warranty costs have historically been within our expectations and the provisions established, we cannot guarantee we will continue to experience the same warranty return rates or repair costs that we have in the past. A significant increase in product return rates, or a significant increase in the costs to repair our products, could have a material adverse impact on future operating results for the period or periods in which such returns or additional costs materialize and thereafter.
Long-lived Assets
We review property, plant, and equipment for impairment whenever events or changes in circumstances indicate that the carrying amount of such an asset may not be recoverable. Recoverability of these assets is measured by comparison of their carrying amount to future undiscounted cash flows the assets are expected to generate over the remaining economic life. If such assets are considered to be impaired, the impairment to be recognized in earnings equals the amount by which the carrying value of the assets exceeds their fair market value determined by either a quoted market price, if any, or a value determined by utilizing a discounted cash flow technique. We have recognized no material impairment adjustments related to our property, plant, and equipment. In the first quarter of 2006 we recorded a $1.6 million impairment charge against contract distribution
rights in conjunction with restructuring actions. Deterioration in our business in the future could lead to additional impairment adjustments in future periods. Evaluation of impairment of long-lived assets requires estimates of future operating results that are used in the preparation of the expected future undiscounted cash flows. Actual future operating results and the remaining economic lives of our long-lived assets could differ from the estimates used in assessing the recoverability of these assets. These differences could result in impairment charges, which could have a material adverse impact on our results of operations.
Restructuring and Impairment Charges
During the first quarter of fiscal 2006, Avici restructured its business and realigned its cost structure and expects to record total restructuring charges of approximately $10.8 million, of which $10.7 million was recorded in 2006. The restructuring charges included a workforce reduction, charges related to excess inventory and inventory related costs, asset impairment and other costs. These restructuring activities required us to make numerous assumptions and estimates, including future employee retention rate, future revenue levels, product and customer mix, ability to sell used equipment, lab deployment needs and recoverability of intangible assets. The estimates and assumptions relating to the restructuring activities are continually monitored and evaluated, and if these estimates and assumptions change, we may be required to record additional charges or credits against the reserves previously recorded for these restructuring activities.
Stock-Based Compensation Expense
As of January 1, 2006, we account for employee stock-based compensation costs in accordance with Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“SFAS 123R”). We utilize the Black-Scholes option pricing model to estimate the fair value of employee stock based compensation at the date of grant, which requires the input of highly subjective assumptions, including expected volatility and expected life. Further, as required under SFAS 123R, we now estimate forfeitures for options granted, which are not expected to vest. Changes in these inputs and assumptions can materially affect the measure of estimated fair value of our share-based compensation.
Results of Operations
Fiscal Year Ended December 31, 2006 Compared to Fiscal Year Ended December 31, 2005
Revenue
Total gross revenue increased $45.6 million to $82.8 million in 2006 from $37.2 million in 2005. Gross product revenue increased $44.0 million to $76.4 million in 2006 from $32.4 million in 2005. Net product revenue, after warrant amortization of $0.5 million, increased $45.5 million to $75.8 million in 2006 from $30.3 million in 2005. The increase in gross and net product revenue in 2006 was primarily due to a significant increase in the volume of product ordered from AT&T as compared to 2005.
We cannot predict future revenue volumes, however we do not believe that the revenue volumes experienced during 2006 will be sustainable and we are planning the business at reduced revenue volumes.
Service revenue increased $1.6 million to $6.4 million in 2006 from $4.8 million in 2005. The increase in service revenue was primarily due to a larger installed base of products.
One customer, namely AT&T accounted for 94% of the gross revenue in 2006 and 2005. We anticipate future core router product revenue to continue to be highly concentrated from this one customer.
Cost of Revenue
Total cost of revenue increased $14.8 million to $28.1 million in 2006 from $13.3 million in 2005. Excluding the impact of inventory and inventory related charges of $3.1 million associated with restructuring
expenses in 2006, product cost of revenue was 31% and 37% of gross product revenue in 2006 and 2005, respectively. The lower product cost of revenue as a percentage of gross product revenue, excluding the impact of inventory and inventory related charges associated with restructuring expenses, in the 2006 as compared to the 2005 was primarily due to spreading certain fixed costs over a significantly higher product volume in 2006, favorable product mix, and higher direct sales.
We expect future product costs as a percent of gross revenue will continue to be affected by changes in the mix of products sold, discounts and related pricing, changes in material costs, excess inventory and obsolescence charges and credits, warranty liability, changes in volume and pricing competition.
Service cost of revenue was 28% and 44% of service revenue in 2006 and 2005, respectively. The lower percentage in 2006 was due to lower depreciation and labor costs and higher revenue in 2006.
Research and Development
Research and development expenses decreased $5.6 million to $30.6 million in 2006 from $36.2 million in 2005. The decrease in 2006 as compared to 2005 was primarily due to a decrease in labor and labor related expenses of $5.1 million due to the workforce reductions associated with the restructuring.
Sales and Marketing
Sales and marketing expenses decreased $4.9 million to $4.2 million in 2006 from $9.1 million in 2005. The decrease in 2006 was primarily due to lower labor and labor related expenses and lower travel expenses as a result of the significant workforce reductions associated with the restructuring plan.
General and Administrative
General and administrative expenses increased $1.1 million to $5.8 million in 2006 from $4.7 million in 2005. The increase in 2006 was due to higher labor and labor related expenses primarily due to stock-based compensation expense associated with stock grants and due to the adoption of SFAS 123R.
Interest Income
Interest income increased $0.8 million to $2.6 million in 2006 from $1.8 million in 2005. The increase in 2006 was primarily due to increased investment yields available in the market as well as a higher invested cash balance.
Other Income
Other income was $1.8 million in 2005. During the second quarter of 2005, the Company reached an agreement with an independent third party to assign to the third party a claim in bankruptcy held by the Company in consideration for $1.3 million which was received in the second quarter of 2005. Other income in 2005 also includes the reversal of approximately $0.5 million of credits previously established in connection with this claim.
Provision for Income Taxes
In 2006, Avici provided for federal and state income taxes of approximately $0.2 million after giving benefit to the utilization of net operating loss carryforwards. Avici has incurred net operating losses from inception through December 31, 2005, thus, no provision for federal or state income taxes were recorded for those periods. As of December 31, 2006, Avici had net operating loss carryforwards for federal and state income tax purposes of approximately $349.9 million and $155.7 million, respectively. Approximately $15.2 million of Avici’s net operating loss carryforwards relate to deductions associated with Avici’s stock option plans, which will be
benefited through stockholders’ equity if realized. The federal and state net operating loss carryforwards begin to expire in 2012 and 2007, respectively. As of December 31, 2006 Avici also has gross federal and state research tax credit carryforwards of approximately $11.8 million and $9.0 million respectively, which will begin to expire in 2012. The utilization of the net operating loss carryforwards may be subject to annual limitations as a result of changes in the ownership of the Company.
Fiscal Year Ended December 31, 2005 Compared to Fiscal Year Ended December 31, 2004
Revenue
Total gross revenue increased $10.6 million to $37.2 million in 2005 from $26.6 million in 2004. Gross product revenue increased $11.2 million to $32.4 million in 2005 from $21.2 million in 2004. The increase in gross product revenue was primarily due to an increase in our product volume and also due to a change in our customer mix since 2004 included a higher proportion of sales through channel partners at discounts higher than in direct sales. Net product revenue, after warrant amortization of $2.1 million, increased $11.3 million to $30.3 million in 2005 from $19.0 million in 2004. Service revenue decreased $0.7 million to $4.8 million in 2005 from $5.5 million in 2004. The decrease in service revenue was primarily due to lower pricing partially offset by higher installed base of products.
One customer, namely AT&T accounted for 94% of the gross revenue in 2005. In 2004, three customers, namely AT&T, Huawei and Nortel accounted for 60%, 27% and 12%, respectively, of gross revenue.
Cost of Revenue
Total cost of revenue increased $1.2 million to $13.3 million in 2005 from $12.1 million in 2004. Product cost of revenue was 37% and 52% of product net revenue in 2005 and 2004, respectively. Product cost of revenue is net of credits for the utilization of inventory previously reserved in 2001 resulting from a downturn in industry demand. Such credits were $0.3 million and $0.8 million in 2005 and 2004, respectively. The lower product cost of revenue as a percentage of product net revenue in 2005 as compared 2004 was primarily due to change in customer mix since 2004 included a higher proportion of sales through channel partners at discounts higher than in direct sales.
Service cost of revenue was 44% and 42% of service revenue in 2005 and 2004, respectively. The higher percentage in 2005 was primarily due to lower service pricing partially offset by lower depreciation costs in 2005.
Research and Development
Research and development expenses increased $3.6 million to $36.2 million in 2005 from $32.6 million in 2004. The increase in 2005 from 2004 was primarily due to an increase in labor and labor related expenses of $5.5 million. Such increase was due to deployment of additional resources primarily on a contract basis to support product innovation for existing and future products, and realignment of the Company’s compensation program including management incentive costs as performance targets for the first six months in 2005 were achieved. The increase in 2005 was partially offset by lower depreciation and project related expenses of $2.0 million and $0.4 million, respectively.
Sales and Marketing
Sales and marketing expenses decreased $1.7 million to $9.1 million in 2005 from $10.8 million in 2004. The decrease in 2005 was primarily due to lower spending on marketing programs and travel related expenses. Also contributing to the decrease was higher sales incentive costs and recruiting costs in 2004.
General and Administrative
General and administrative expenses decreased $1.1 million to $4.7 million in 2005 from $5.8 million in 2004. The decrease in 2005 was primarily due to lower costs associated with labor, depreciation and insurance.
Stock-Based Compensation
Stock-based compensation, associated with pre-IPO stock option grants, was $0.3 million in 2004. All costs related to such grants were fully amortized and expensed by the third quarter of 2004.
Interest Income
Interest income increased $0.4 million to $1.8 million in 2005 from $1.4 million in 2004. The increase in 2005 was primarily due to increased investment yields available in the market partially offset by lower invested cash balance.
Interest Expense
Interest expense was eliminated in 2004 due to the expiration of equipment-based capital leases.
Other Income
Other income was $1.8 million in 2005. During the second quarter of 2005, the Company reached an agreement with an independent third party to assign to the third party a claim in bankruptcy held by the Company in consideration for $1.3 million which was received in the second quarter of 2005. Other income also includes the reversal of approximately $0.5 million of credits previously established in connection with this claim.
Provision for Income Taxes
As Avici has incurred net operating losses since inception, no provision for federal or state income taxes has been recorded. As of December 31, 2005, Avici had net operating loss carryforwards for federal and state income tax purposes of approximately $360.1 million and $222.6 million, respectively. Approximately $18.5 million of Avici’s net operating loss carryforwards relate to deductions associated with Avici’s stock option plans, which will be benefited through stockholders’ equity if realized. The federal and state net operating loss carryforwards begin to expire in 2012 and 2006, respectively. As of December 31, 2005 Avici also has gross federal and state research tax credit carryforwards of approximately $11.0 million and $8.3 million respectively, which will begin to expire in 2012. The utilization of the net operating loss carryforwards may be subject to annual limitations as a result of changes in the ownership of the Company.
Liquidity and Capital Resources
Since our inception, we have financed our operations through private sales of equity securities, an initial public offering in July 2000, and, to a lesser extent, from the exercise of stock options by employees. From inception through December 31, 2006, we raised approximately $422.2 million from these equity offerings. In 2006, we gained $17.7 million in cash from operating activities, compared to $11.3 million used in 2005 and $24.2 million used in 2004. The significant change in our cash from operating activities in 2006 as compared to 2005 and 2004 was primarily a result of net income before non cash items such as depreciation, warrant amortization and stock compensation expenses. We expect that in the future, working capital requirements will fluctuate based on the timing of payments associated with remaining restructuring costs, the timing of customer orders, the related need to build inventory in anticipation of orders and actual shipment dates. In addition, we expect to selectively invest in infrastructure costs needed to support the scale of operations.
Purchases of property and equipment were $2.1 million in 2006, compared to $7.8 million in 2005, and $6.9 million in 2004. Purchases of property and equipment decreased in 2006 as compared to 2004 and 2003 primarily due to a focused spending level to match our expected development requirements under our restructured
business. The timing and amount of future capital expenditures will depend primarily on our future growth. We expect that capital expenditures will be approximately $2.0 million to $3.0 million in 2007. We expect that capital expenditure requirements may increase if product sales increase, creating a need for increased levels of test and management information systems equipment.
At December 31, 2006, we had cash and cash equivalents of $39.7 million, current marketable securities of $20.4 million, and long-term marketable securities of $8.5 million, totaling $68.6 million. In addition, we had $1.0 million of restricted cash collateralized towards a letter of credit; this letter of credit expired and the cash became unrestricted in February of 2007 and the remaining $0.2 million of restricted cash is held as deposits for facility related obligations. We believe that our existing cash, cash equivalents and marketable securities will meet our normal operating and capital expenditure needs for the next twelve months. However, we could be required, or could elect, to raise additional funds during that period and we may need to raise additional capital in the future. We may also be required to enter into revised terms with key vendors, some of which could be less favorable to us. We may not be able to obtain additional capital on terms favorable to us or at all. The issuance of additional equity or equity-related securities would be dilutive to our stockholders. If we cannot raise funds on acceptable terms, or at all, we may not be able to develop or enhance our products or respond appropriately to competitive pressures, which would seriously limit our ability to increase our revenue and grow our business.
On February 16, 2006, Avici announced a plan to restructure its business which included a workforce reduction and employee retention plan, charges related to excess inventory and inventory related costs, asset impairment and other costs. Related to this restructuring initiative, Avici recorded $10.7 million in 2006 and expects to record the remaining $0.1 million in the first quarter of 2007. The cash based charge is $8.2 million, of which the remaining $2.5 million will be paid in 2007.
Off-Balance Sheet Arrangements
As of December 31, 2006, we did not have any off-balance-sheet arrangements, as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Contractual Obligations
At December 31, 2006, our contractual obligations, which consist entirely of contractual commitments for the restructuring plan, operating leases and inventory purchase commitments, were as follows (in thousands):
Payments made under operating leases, which expires in the second half of 2007, will be treated as rent expense for the facilities. We outsource the manufacture and assembly of our products. During the normal course of business, in order to maintain competitive lead times for customers and adequate supply of components, we enter into agreements with certain suppliers to procure inventory based upon criteria defined by us.
Recent Accounting Pronouncements
In June 2006, the FASB issued Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and provides guidance on derecognition, classification, interest and penalties,
accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. Avici will adopt this pronouncement beginning in fiscal year 2007. The adoption of the provisions of SFAS No. 154 is not expected to have a material impact on Avici’s financial position or results of operations.
In September 2006, the FASB issued FAS 157, “Fair Value Measurements” (“FAS 157”). SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years, with early adoption permitted. The Company has not yet determined the effect, if any, that the implementation of FAS 157 will have on the financial position or results of operations of the Company.
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for the Company’s fiscal year ending December 31, 2007. We do not expect SAB 108 to have a material impact on the financial position or results of operations of the Company.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to market risk related to changes in interest rates and, to a lesser extent, foreign currency exchange rates. We do not use derivative financial instruments for speculative or trading purposes.
Interest Rate Sensitivity
We maintain an investment portfolio consisting mainly of investment grade money market funds, corporate obligations, federal agency obligations, state and municipal bonds including auction rate securities with a weighted-average maturity ranging from less than one year to over 10 years. These securities are subject to interest rate risk and will fall in value if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from levels at December 31, 2006, the fair market value of these investments would decline by an immaterial amount. Except for auction rate securities, we have the ability to hold our other fixed income investments until maturity. Therefore, we would not expect our operating results or cash flows to be affected to any significant degree by a sudden change in market interest rates on our securities portfolio. The following table provides information about our investment portfolio. For investment securities, the table presents principal cash flows and related weighted average interest rates by expected maturity dates.
Exchange Rate Sensitivity
We operate primarily in the United States, and all sales to date have been made in U.S. dollars. Accordingly, there has not been any material exposure to foreign currency rate fluctuations. If we expand our presence in international markets and consummate sales denominated in foreign currencies, our exposure to foreign currency rate fluctuations could be material in the future.
Avici has no off-balance sheet concentrations such as foreign exchange contracts, option contracts, or other foreign hedging arrangements.
ITEM 8.
ITEM 8. CONSOLIDATED FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
AVICI SYSTEMS INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Ernst & Young LLP, Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statements of Stockholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
REPORT OF ERNST & YOUNG LLP, INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders
Avici Systems Inc.
We have audited the accompanying consolidated balance sheets of Avici Systems Inc. as of December 31, 2006 and 2005 and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed in the Index at Item 15. These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those 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 that 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 Avici Systems Inc. as of December 31, 2006 and 2005, and the result of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment.”
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) the effectiveness of Avici Systems Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 12, 2007, expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Boston, Massachusetts
March 12, 2007
AVICI SYSTEMS INC.
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
AVICI SYSTEMS INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
The accompanying notes are an integral part of these consolidated financial statements.
AVICI SYSTEMS INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
The accompanying notes are an integral part of these consolidated financial statements.
AVICI SYSTEMS INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 2006
(all tabular amounts in thousands except share and per share data)
(1) OPERATIONS AND SIGNIFICANT ACCOUNTING POLICIES
Avici Systems Inc. and subsidiaries (Avici or the Company) was incorporated in the State of Delaware on November 12, 1996 and was organized to design and develop high-speed data networking equipment for the carrier market. Avici’s Terabit Switch Router product (TSR), Stackable Switch Router (SSR) and Quarter-rack Switch Router (QSR) are designed to cost-effectively provide high-speed/high-volume capacity, carrier-class reliability and in-service scalability, or the ability to incrementally add capacity to the network without disrupting network performance.
Avici is subject to a number of risks and challenges similar to other companies in a similar stage of development. These risks include, but are not limited to, dependence on few customers, dependence on key individuals, dependence on contract manufacturers and key suppliers of integral components, the need to develop and market commercially usable products, the ability to obtain adequate financing to support growth and product development and competition from substitute products and larger companies with greater financial, technical, management and marketing resources.
Avici posted a net income of approximately $8.3 million for the year ended December 31,2006 and net losses of approximately $24.7 million, and $35.4 million, for the years ended December 31, 2005 and 2004, respectively. At December 31, 2006, Avici had an accumulated deficit of approximately $417.4 million and has funded those losses primarily through the sale of redeemable convertible preferred stock, the proceeds from the sale of its common stock and certain capital leases. Avici is dependent on one major customer and the proceeds of these financings to meet its future working capital and research and development needs.
The accompanying consolidated financial statements reflect the application of certain significant accounting policies as described in this note and elsewhere in these notes to consolidated financial statements.
(a) Revenue Recognition
Avici records revenue in accordance with Statement of Position No. 97-2, “Software Revenue Recognition,” and all related interpretations. Avici recognizes revenue from product sales upon shipment or delivery to customers, including resellers, provided that a purchase order has been received or a contract has been executed, there are no uncertainties regarding customer acceptance, the sales price is fixed or determinable and collectibility is deemed probable. If uncertainties regarding customer acceptance exist, Avici recognizes revenue when those uncertainties are resolved. For arrangements that include the delivery of multiple elements, revenue is allocated to the various elements based on vendor-specific objective evidence of fair value (VSOE). Avici uses the residual method when VSOE does not exist for one of the delivered elements in an arrangement. Revenue from support and maintenance contracts is recognized ratably over the period of the related agreements. Revenue from installation and other services is recognized as the work is performed. Amounts collected or billed prior to satisfying the above revenue recognition criteria are recorded as deferred revenue.
(b) Cash and Cash Equivalents and Marketable Securities
Avici follows the provisions of Statement of Financial Accounting Standards (SFAS) No. 115, Accounting for Certain Investments in Debt and Equity Securities. Avici has classified its marketable securities, except auction rate certificates, which are available for sale, as held-to-maturity and recorded them at amortized cost, which approximates market value. Unrealized losses are primarily due to rising interest rates and are considered temporary in nature. Avici considers all highly liquid investments with original maturities of three months or less at the date of acquisition to be cash equivalents. Cash and cash equivalents include money markets, certificates of deposit and commercial paper.
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
As of December 31, 2006, cash, cash equivalents and marketable securities consisted of the following:
As of December 31, 2005, cash, cash equivalents and marketable securities consisted of the following:
(c) Use of Estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions, including certain allocations of costs, that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ from those estimates.
(d) Inventories
Inventories are stated at the lower of cost (first-in, first-out) or market and consist of the following:
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
Inventories consist of finished goods and raw materials. Finished goods inventory includes product on hand or product at customer sites, as well as deferred costs associated with shipments for which revenue has been deferred. Raw materials include component parts and chips on hand. Avici regularly reviews inventory quantities on hand and inventory commitments with suppliers and records a provision for excess and obsolete inventory based primarily on the estimated forecast of product demand for up to the next twelve months. Purchase commitments accrued at December 31, 2006 and 2005 were $0.4 million and $0.7 million, respectively.
(e) Depreciation, Amortization and Impairment
Property and equipment are stated at cost, net of accumulated depreciation and amortization. Expenditures for maintenance and repairs are charged to expense as incurred, whereas major betterments are capitalized as additions to property and equipment. Avici provides for depreciation and amortization on the straight-line basis and charges to operations amounts that allocate the cost of the assets over their estimated useful lives as follows:
Asset Classification
Estimated
Useful
Life
Computer equipment
3 years
Laboratory and test equipment
2-3 years
Leasehold improvements
3 years
Furniture and fixtures
5 years
Accumulated amortization expense and amortization expense on equipment under capital leases is included in accumulated depreciation and depreciation expense, respectively. Depreciation and amortization expense was $6.3 million, $6.7 million, and $9.3 million for the years ended December 31, 2006, 2005, and 2004, respectively.
(f) Concentrations of Credit and Other Risks
SFAS No. 105, Disclosure of Information about Financial Instruments with Off-Balance Sheet Risk and Financial Instruments with Concentrations of Credit Risk, requires disclosure of any significant off-balance sheet and credit risk concentrations. Avici’s principal credit risk relates to its cash, cash equivalents, marketable securities and accounts receivable. Avici invests its excess cash, cash equivalents and marketable securities primarily in deposits with commercial banks and high-quality corporate securities. One customer accounted for 100% of trade receivables at December 31, 2006. Two customers accounted for 100% of trade receivables at December 31, 2005. One customer accounted for 94% of gross revenue in 2006 and 2005. Three customers accounted for 99% of the gross revenue in 2004.
Avici has no off-balance sheet concentrations such as foreign exchange contracts, option contracts, or other foreign hedging arrangements.
Certain key components used in Avici’s products are procured from single or limited source suppliers, and Avici relies on single or limited contract manufacturers for the assembly of its products. The failure of a supplier, including a contract manufacturer, to deliver on schedule could delay or interrupt Avici’s delivery of products and thereby adversely affect Avici’s revenues and operating results.
(g) Fair Value of Financial Instruments
Avici’s financial instruments mainly consist of cash and cash equivalents and marketable securities. The carrying amounts of these instruments approximate their fair value based on their short-term maturity or quoted market prices.
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
(h) Research and Development and Software-Development Costs
The costs of the development of hardware products and enhancements to existing hardware products are expensed as incurred. Avici accounts for its software development costs in accordance with SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased or Otherwise Marketed. Accordingly, the costs for the development of new software that are included in the hardware products and substantial enhancements to such existing software are expensed as incurred until technological feasibility has been established, at which time any additional costs would be capitalized. Avici determines technological feasibility has been established at the time at which a working model of the software has been completed. Because Avici believes its current process for developing software is essentially completed concurrently with the establishment of technological feasibility, no costs have been capitalized to date.
(i) Net Loss per Share and Pro Forma Net Loss per Share
Basic net income per share is computed using the weighted-average number of common shares outstanding during the period. Diluted net income per share is computed using the weighted-average number of common shares and dilutive potential common shares outstanding during the period. Dilutive potential common shares primarily consist of employee stock options and restricted common stock. Basic and diluted net loss per share is the same for periods with net loss and all outstanding employee stock options and unvested restricted stock have been excluded, as they are considered antidilutive. All outstanding common stock warrants have been excluded for all periods presented as they are considered antidilutive.
Options to purchase a total of 2,847,293 shares and 2,694,701 shares have been excluded from the computation of diluted weighted average shares outstanding for the years ended December 31, 2005 and 2004, respectively. In addition, 239,500 shares and 99,604 shares of unvested restricted common stock have been excluded from the computation of diluted weighted average shares outstanding for the years ended December 31, 2005 and 2004, respectively. Warrants to purchase 800,000 shares of common stock have been excluded from the computation of diluted weighted average shares outstanding for the three years in the period ended December 31, 2006.
Statement of Financial Accounting Standards No. 128, “Earnings per Share,” requires that employee equity share options, nonvested shares and similar equity instruments granted by the Company be treated as potential common shares outstanding in computing diluted earnings per common share. Diluted shares outstanding include the dilutive effect of in-the-money options, which is calculated, based on the average share price for each fiscal period using the treasury stock method.
(j) Comprehensive Income (Loss)
SFAS No. 130, “Reporting Comprehensive Income,” requires disclosure of all components of comprehensive income on an annual and interim basis. Comprehensive income is defined as the change in equity of a business enterprise during a period from transactions and other events and circumstances involving non-owner sources. During all periods presented, Avici did not have any items of comprehensive income (loss) other than its reported net income/(loss).
(k) Stock-Based Compensation
Effective January 1, 2006, Avici adopted the provisions of Statement of Financial Accounting Standards No. 123R, (“SFAS 123R”) “Share-Based Payment,” which establishes accounting for equity instruments exchanged for employee services. Under the provisions of SFAS No. 123R, share-based compensation cost is
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
measured at the grant date, based on the calculated fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period of the equity grant). Prior to 2006, the Company accounted for share-based compensation to employees in accordance with Accounting Principles Board Opinion No. 25, (“APB 25”) “Accounting for Stock Issued to Employees,” and related interpretations. Avici also followed the disclosure requirements of SFAS No. 123, “Accounting for Stock-Based Compensation”, as amended by SFAS 148, “Accounting for Stock-Based Compensation-Transition and Disclosure”. Avici elected to adopt the modified prospective transition method as provided by SFAS No. 123R and, accordingly, financial statement amounts for the prior years presented have not been restated to reflect the fair value method of expensing share-based compensation.
Avici estimates the fair value of stock options using the Black-Scholes valuation model. Key input assumptions used to estimate the fair value of stock options include the exercise price of the award, the expected option term, the expected volatility of Avici’s stock over the option’s expected term, the risk-free interest rate over the option’s expected term, and Avici’s expected annual dividend yield. Expected volatilities are based on historical volatilities of our common stock; the expected life represents the weighted average period of time that options granted are expected to be outstanding giving consideration to vesting schedules and our historical exercise patterns; and the risk-free rate is based on the U.S. Treasury yield curve in effect at the time of grant for periods corresponding with the expected life of the option. The fair value of each option grant was estimated on the grant date using the Black-Scholes option-pricing model with the following assumptions:
The fair value of grants made under the employee stock purchase plan in 2006 was calculated using the following assumptions: risk-free interest rate of 4.49%, expected lives of 0.5 years and expected volatility of 82.8%.
Avici did not recognize compensation expense under APB 25 for employee stock options in 2005 and 2004, since the exercise price of the Avici’s employee stock option awards equaled the market price of the underlying stock on the dates of grant. The following table illustrates the effects on net loss and net loss per share for the years ended December 31, 2005 and 2004 as if the Company had applied the fair value recognition provisions of SFAS 123 to share-based employee awards.
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
The fair value of each option grant in 2005 and 2004 included in the above table was estimated on the grant date using the Black-Scholes option-pricing model with the following assumptions:
Through December 31, 2001, Avici had recorded cumulative non-cash deferred compensation, relating to pre-IPO stock option grants, as an element of stockholders’ equity, representing the aggregate difference between the deemed fair value of Avici’s common stock and the exercise price of stock options and restricted stock granted and the selling price of stock sold. The deferred compensation was recognized as an expense over the vesting period of the stock options and restricted stock and was fully expensed by the third quarter of 2004. During the year ended December 31, 2004, Avici recorded approximately $0.3 million of non-cash compensation expense associated with these grants.
(l) Disclosures about Segments of an Enterprise
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for reporting information regarding operating segments and establishes standards for related disclosures about products and services and geographic areas. Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision maker, or decision making group, in making decisions regarding resource allocation and assessing performance. Avici has conducted its operations in one segment. For the year ended December 31, 2006, the geographic distribution of gross revenue was as follows: North America 95%, Europe 5%. For the year ended December 31, 2005, the geographic distribution of gross revenue was as follows: North America: 95%, Europe: 3%, Asia: 2%. For the year ended December 31, 2004, the geographic distribution of gross revenue was as follows: North America: 73%, Asia (predominantly China): 27%.
(m) Principles of Consolidation
The consolidated financial statements include the accounts of Avici Systems Inc. and all of its wholly owned subsidiaries after elimination of intercompany accounts and transactions.
(n) Recent Accounting Pronouncements
In June 2006, the FASB issued Interpretation No. 48 (“FIN 48”), Accounting for Uncertainty in Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN 48 also prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return and provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006. Avici will adopt this pronouncement beginning in fiscal year 2007. The adoption of the provisions of SFAS No. 154 is not expected to have a material impact on Avici’s financial position or results of operations.
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
In September 2006, the FASB issued FAS 157, “Fair Value Measurements” (“FAS 157”). SFAS 157 clarifies the principle that fair value should be based on the assumptions market participants would use when pricing an asset or liability and establishes a fair value hierarchy that prioritizes the information used to develop those assumptions. Under the standard, fair value measurements would be separately disclosed by level within the fair value hierarchy. FAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007 and interim periods within those fiscal years, with early adoption permitted. The Company has not yet determined the effect, if any, that the implementation of FAS 157 will have on the financial position or results of operations of the Company.
In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”). SAB 108 provides interpretive guidance on how the effects of the carryover or reversal of prior year misstatements should be considered in quantifying a current year misstatement. The SEC staff believes that registrants should quantify errors using both a balance sheet and an income statement approach and evaluate whether either approach results in quantifying a misstatement that, when all relevant quantitative and qualitative factors are considered, is material. SAB 108 is effective for the Company’s fiscal year ending December 31, 2007. We do not expect SAB 108 to have a material impact on the financial position or results of operations of the Company.
(2) STOCKHOLDERS’ EQUITY
(a) Share Repurchase Program
During the third quarter of 2002, the Board of Directors authorized a share repurchase program, in effect for a one year period, to acquire up to 1.5 million shares of Avici’s common stock in the open market at times and prices considered appropriate by Avici. The share buyback program was initiated during the fourth quarter of 2002, and during the program Avici purchased 482,308 shares at an aggregate cost of approximately $2.1 million. The share repurchase program terminated during the third quarter of 2003.
(b) Common Stock Warrants
In January 2004, in connection with a three-year strategic OEM agreement with a channel partner, Avici issued a warrant to purchase 800,000 shares of Avici common stock at an exercise price of $8.03 per share. The agreement provides the channel partner with the ability, but not the obligation, to purchase equipment and services from Avici for its own use or for resale. The warrant is nonforfeitable and has a term of approximately seven years from the date of issuance and is exercisable after seven years. The right to exercise the warrant may be accelerated if certain performance milestones are achieved or at the discretion of Avici, upon a change in control. The fair value of the warrant was calculated to be approximately $6.3 million using the Black-Scholes valuation model, and was being recorded as a reduction of revenue on a straight-line basis over three years. The unamortized balance was deemed impaired and was fully written off in the first quarter of 2006, as further described in Note 3.
During 2000, Avici issued two warrants to purchase an aggregate of 237,500 shares of Avici’s common stock at per-share exercise prices of $124.00 and $110.92. The fair value of the warrants was calculated to be $12.2 million using the Black-Scholes valuation model, and was accounted for as elements of expense and Stockholders’ Equity. The warrants were fully amortized in the Consolidated Statements of Operations in accordance with the terms of the applicable agreements. The warrants, which were non-forfeitable and fully
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
exercisable, expired in 2005. Accordingly, the $12.2 million previously identified in Stockholders’ Equity as “Common Stock Warrants” was reclassified to “Additional Paid-In-Capital” within Stockholders’ Equity in 2005. The reclassification had no effect on the Avici’s financial condition at December 31, 2005 or on its results of operations for the year then ended.
(c) Equity-Based Compensation Plans
Avici currently has two primary stock incentive plans: the 1997 Stock Incentive Plan (the “1997 Plan”) and the 2000 Stock Option and Incentive Plan (the “2000 Plan”). A total of approximately 3.5 million shares of common stock have been reserved for issuance under these plans. The 2000 Plan is the only one of the two primary plans under which new awards are currently being issued. The maximum number of shares with respect to which awards may be granted to any employee under the 2000 Plan shall not exceed 500,000 shares of common stock during any calendar year. In addition, any shares not yet issued under the 1997 Plan on or before the date of Avici’s initial public offering or shares subject to options outstanding on the date of Avici’s initial public offering which are forfeited or terminated are available for issuance under the 2000 Plan.
The Plans provide for the grant of stock-based awards to Avici’s employees, officers, directors, consultants and advisors. Under the Plans, Avici may grant options that are intended to qualify as incentive stock options within the meaning of Section 422 of the Internal Revenue Code, options not intended to qualify as incentive stock options, restricted stock and other stock-based awards. Incentive stock options may be granted only to employees of Avici.
(d) 2000 Nonemployee Director Stock Option Plan
In May 2000, the Board of Directors approved the 2000 Nonemployee Director Stock Option Plan (the “Director Plan”). A total of 100,000 shares of common stock have been authorized for issuance under the Director Plan. On January 1 of each year, commencing with January 1, 2001, the aggregate number of shares available for grant under the plan will automatically increase by the number of shares necessary to cause the total number of shares then available for grant to be 100,000 shares.
The Director Plan is administered by the compensation committee. Under the Director Plan, each nonemployee director who becomes a member of the Board of Directors will be automatically granted on the date first elected to the Board of Directors an option to purchase 8,750 shares of common stock, which will vest in four equal installments over four years. In addition, provided that the director continues to serve as a member of the Board of Directors, each nonemployee director will be automatically granted on the date of each annual meeting of stockholders following his or her initial option grant date an option to purchase 3,750 shares of common stock, 1,250 shares of which will vest immediately and 2,500 shares of which will vest in four equal installments over four years. Avici granted a total of 50,000 options to its nonemployee directors at the time of Avici’s initial public offering. Such options vested in four equal installments over four years.
As of December 31, 2006, 100,000 shares were available for future grant under the Director Plan.
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
(e) Option Grants
Option activity under all stock option plans is as follows:
The following table summarizes information relating to currently outstanding and exercisable stock options as of December 31, 2006:
The aggregate intrinsic value of outstanding options as of December 31, 2006 was $2.9 million, of which $1.2 million were vested. The intrinsic value of options exercised in 2006 was $1.9 million.
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
As of December 31, 2006, total unrecognized compensation cost was approximately $1.8 million related to unvested stock-based compensation arrangements granted under the Company’s stock plans and is expected to be recognized over a weighted-average period of less than one year.
(f) Restricted Stock Grants
In 2004, 2005 and 2006, Avici granted 120,000, 172,000 and 92,500 shares, respectively, of performance-based restricted stock to certain key employees of the Company. The shares vest no later than five years from the grant date. Vesting may be accelerated upon the achievement of certain pre-defined performance milestones. The value of the shares at the dates of grant was $1.3 million, $0.8 million and $0.6 million for 2004, 2005 and 2006, respectively, and is being charged to sales and marketing, general and administrative and research and development expenses on a straight-line basis over the shorter of the expected performance period or the five year vesting period. The performance criteria for the 2004 grants were met in 2006 and accordingly all unamortized expenses associated with such grant were expensed.
The following table summarizes Avici’s nonvested restricted stock activity for the year ended December 31, 2006:
(g) 2000 Employee Stock Purchase Plan
A total of 187,500 shares of common stock have been reserved for issuance under the 2000 Employee Stock Purchase Plan. The plan contains consecutive, overlapping, 24-month offering periods. Each offering period includes four consecutive six-month purchase periods. Eligible employees may purchase common stock at a price equal to 85% of the lower of the fair market value of the common stock (i) at the beginning of the offering period or (ii) at the end of the purchase period, whichever is lower, with the option price at the beginning of the first offering period equal to 85% of the initial public offering price. Participation is limited to 10% of the employee’s eligible compensation, not to exceed $25,000 per calendar year or amounts allowed by the Internal Revenue Code. On January 1 of each year, commencing with January 1, 2001, the aggregate number of shares of common stock available for purchase under the 2000 Employee Stock Purchase Plan will automatically increase by the number of shares necessary to cause the total number of shares then available for purchase to be 187,500 shares. During the years ended December 31, 2006, 2005 and 2004, Avici sold 31,700 shares, 46,396 shares and 56,708 shares, respectively, to employees under the 2000 Employee Stock Purchase Plan.
(h) Shareholder Rights Agreement
On December 5, 2001, the Board of Directors enacted a stockholder rights agreement and declared a dividend of one preferred share purchase right for each outstanding share of common stock outstanding at the close of business on December 17, 2001 to the stockholders of record on that date. Each stockholder of record as
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
of December 17, 2001 received a summary of the rights and any new stock certificates issued after the record date contain a legend describing the rights. Each preferred share purchase right entitles the registered holder to purchase from Avici one two-hundred fiftieth of a share of Series A Junior Participating Preferred Stock, par value $0.01 per share, at a price of $40.00 per one two-hundred fiftieth of a Preferred Share, subject to adjustment, upon the occurrence of certain triggering events, including the purchase of 15% or more of Avici’s outstanding common stock by a third party. Until a triggering event occurs, the common stockholders have no right to purchase shares under the stockholder rights agreement. If the right to purchase the preferred stock is triggered, the common stockholders will have the ability to purchase sufficient stock to significantly dilute the 15% or greater holder.
(3) RESTRUCTURING AND IMPAIRMENT CHARGES
On February 16, 2006, Avici announced a plan to restructure its business and realign its cost structure to execute a focused strategy aimed at driving Avici toward profitability and positive cash flow. The restructuring plan included a workforce reduction and employee retention plan (“workforce restructuring”), charges related to excess inventory and inventory related costs, asset impairment and other costs.
The Company expects to record total restructuring charges of approximately $10.8 million, of which $8.2 million is cash based. In 2006 Avici recorded $10.7 million of these charges.
Workforce restructuring
The restructuring plan resulted in the reduction of approximately 45% of the employee base of full-time and contract employees across all business functions and geographic regions. Avici expects to record $5.5 million of employee related charges, all of which are cash based. In 2006 Avici recorded $5.4 million of these charges. Avici expects to pay approximately $1.6 million in the first quarter of 2007.
Inventory and inventory related costs
Due to Avici’s strategic decision to focus on a select customer base, certain inventories and related purchase commitments were determined to be in excess of foreseeable usage. In the first quarter of 2006 Avici recorded a $1.4 million charge to cost of revenue-product to write-down the value of such excess inventory ($1.1 million) and accrue the cost of the non-cancelable inventory purchase commitments ($0.3 million).
In connection with its restructuring, Avici also evaluated certain of its customer relationships and the outcome of this evaluation resulted in Avici agreeing to terminate one of its customer contracts. Avici has not recorded any revenue under this customer contract since all revenue recognition criteria were not met. Under the terms of the termination agreement, the customer will return Avici’s product after a transition period during which Avici will provide product support estimated to cost $0.3 million. In addition, Avici unwound the financial arrangements, reversing remaining accounts receivable and deferred revenue balances and committing to pay $1.4 million. Avici paid $0.7 million in 2006 and will pay the balance upon return of the inventory, scheduled for the third quarter of 2007. Avici has assessed the inventory expected to be received from this customer for recoverability and has adjusted the carrying value accordingly. In 2006 Avici recorded a net charge of $1.7 million in cost of revenue - product as a result of the adjustments relating to this termination agreement. Avici amended the termination agreement in January 2007 and provided incentives to this customer to return the inventory earlier than originally scheduled. Upon such earlier return an additional payment will be made. Avici will record such costs, when it becomes probable an additional loss will be incurred.
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
Asset impairment
In January 2004, in connection with a three-year strategic OEM agreement with Nortel, Avici issued a warrant to purchase 800,000 shares of Avici common stock as further described in Common Stock Warrant Discount-Product above. The fair value of the warrant was capitalized as contract distribution rights and was being amortized as a reduction of revenue on a straight-line basis over three years. As a result of Avici’s implementation of a revised customer strategy and public announcements by the channel partner of a strategic shift away from wire line data, Avici anticipated minimal future revenue under this agreement. As a result, Avici determined that the unamortized balance of such contract distribution rights ($1.6 million) was impaired and wrote off such balance in the first quarter of 2006.
Other costs
Avici also recorded $0.7 million of other restructuring costs relating primarily to certain contract cancellations, legal and administrative expenses.
The restructuring charges recorded in 2006 and the reserve activity are summarized as follows:
(4) INCOME TAXES
Avici accounts for income taxes in accordance with SFAS No. 109, Accounting for Income Taxes. Under SFAS No. 109, deferred tax assets or liabilities are computed based on the difference between the financial statement and income tax basis of assets and liabilities using currently enacted tax rates. Deferred income tax expense or credits are based on changes in the asset or liability from period to period.
In 2006, Avici provided for federal and state income taxes of approximately $0.2 million after giving benefit to the utilization of net operating loss carryforwards. Avici has incurred net operating losses from inception through December 31, 2005, thus, no provision for federal or state income taxes were recorded for those periods. As of December 31, 2006, Avici had net operating loss carryforwards for federal and state income tax purposes of approximately $349.9 million and $155.7 million, respectively. Approximately $15.2 million of Avici’s net operating loss carryforwards relate to deductions associated with Avici’s stock option plans, which will be benefited through stockholders’ equity if realized. The federal and state net operating loss carryforwards begin to expire in 2012 and 2007, respectively. As of December 31, 2006 Avici also has gross federal and state research tax credit carryforwards of approximately $11.8 million and $9.0 million respectively, which will begin to expire in 2012. The utilization of the net operating loss carryforwards may be subject to annual limitations as a result of changes in the ownership of the Company.
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
The approximate income tax effects of each type of temporary differences and carryforwards are as follows:
Due to the uncertainty surrounding the realization of the deferred tax assets, Avici has provided a full valuation allowance against these amounts at December 31, 2006 and 2005. The reduction of the valuation allowance in 2006 is due to the utilization of net operating loss carryforwards.
(5) EMPLOYEE BENEFIT PLAN
Avici has a 401(k) Plan that provides for eligible employees to make contributions on a tax-deferred basis. All employees on the first day of the month following their date of employment are eligible to participate in the 401(k) Plan. Contributions are limited to 15% of their annual compensation, as defined, subject to certain IRS limitations. Avici may contribute to the Plan at its discretion. Employer contributions to the Plan were $0.3 million and $0.4 million at December 31, 2006 and December 31, 2005, respectively.
(6) COMMITMENTS AND CONTINGENCIES
(a) Leases
Future minimum payments due under lease agreements at December 31, 2006 are as follows:
Rent expense from operating leases included in the accompanying consolidated statements of operations was approximately $1.2 million, $1.3 million, and $1.2 million for the years ended December 31, 2006, 2005, and 2004, respectively. In connection with its facilities leases, Avici provided letters of credit to the lessor. The letters of credit are fully collateralized by cash of $0.2 million as of December 31, 2006 and 2005, and are recorded as restricted cash in the accompanying consolidated balance sheets. The lease for Avici’s current facility expires in the second half of 2007.
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
(b) Commitments
Avici outsources the manufacture and assembly of its products. During the normal course of business, in order to maintain competitive lead times for customers and adequate components supply, Avici enters into agreements with certain suppliers to procure inventory based upon criteria as defined by Avici. As of December 31, 2006, Avici is committed to purchase approximately $4.6 million of inventory over the next 12 months.
(c) Guarantees and Product Warranties
The Financial Accounting Standards Board issued Interpretation No. 45 (FIN 45), “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others,” requires certain guarantees to be recorded at fair value as opposed to the current practice of recording a liability only when a loss is probable and reasonably estimable and also requires a guarantor to make significant new guaranty disclosures, even when the likelihood of making any payments under the guarantee is remote. The following is a summary of agreements that Avici has determined to be within the scope of FIN 45.
In the normal course of business, Avici may agree to indemnify other parties, including customers, lessors and parties to other transactions with Avici, with respect to certain matters. Avici has agreed to hold these other parties harmless against losses arising from a breach of representations or covenants, or other claims made against certain parties. Historically, payments made by Avici, if any, under these agreements have not had a material impact on Avici’s operating results or financial position.
Avici establishes warranty reserves for costs expected to be incurred after the sale and delivery of product for deficiencies as required under specific product warranty provisions. The warranty reserves are determined based on the actual trend of historical charges incurred over the prior twelve-month period excluding any significant or infrequent issues, which are specifically identified and reserved for. The warranty liability is established when it is probable that customers will make claims and when a reasonable estimate of costs can be made. Warranty reserves are included in “Accrued other” in the accompanying consolidated balance sheets.
(d) Litigation
In addition to claims in the normal course of business, twelve purported securities class action lawsuits were filed against Avici and one or more of Avici’s underwriters in Avici’s initial public offering, and certain officers and directors of Avici. The lawsuits alleged violations of the federal securities laws and were docketed in the U.S. District Court for the Southern District of New York (the “Court”) as: Felzen, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3363; Lefkowitz, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3541; Lewis, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3698; Mandel, et. al v. Avici Systems Inc., et al., C.A. No. 01-CV-3713; Minai, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-3870; Steinberg, et al. v. Avici
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
Systems Inc., et al., C.A. No. 01-CV-3983; Pelissier, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-4204; Esther, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-4352; Zhous, et al. v. Avici Systems Inc. et al., C.A. No. 01-CV-4494; Mammen, et al. v. Avici Systems Inc., et. al., C.A. No. 01-CV-5722; Lin, et al. v. Avici Systems Inc., et al., C.A. No. 01-CV-5674; and Shives, et al. v. Banc of America Securities, et al., C.A. No. 01-CV-4956. On April 19, 2002, a consolidated amended class action complaint (the “Complaint”), which superseded these twelve purported securities class action lawsuits, was filed in the Court. The Complaint is captioned “In re Avici Systems, Inc. Initial Public Offering Securities Litigation” (21 MC 92, 01 Civ. 3363 (SAS)) and names as defendants Avici, certain of the underwriters of Avici’s initial public offering, and certain of Avici’s officers and directors. The Complaint, which seeks unspecified damages, alleges violations of the federal securities laws, including among other things, that the underwriters of Avici’s initial public offering (“IPO”) improperly required their customers to pay the underwriters excessive commissions and to agree to buy additional shares of Avici’s stock in the aftermarket as conditions of receiving shares in Avici’s IPO. The Complaint further claims that these supposed practices of the underwriters should have been disclosed in Avici’s IPO prospectus and registration statement. In addition to the Complaint against Avici, various other plaintiffs have filed other substantially similar class action cases against approximately 300 other publicly traded companies and their IPO underwriters in New York City, which along with the case against Avici have all been transferred to a single federal district judge for purposes of case management. Avici and its officers and directors believe that the claims against Avici lack merit, and have defended the litigation vigorously. In that regard, on July 15, 2002, Avici, together with the other issuers named as defendants in these coordinated proceedings, filed a collective motion to dismiss the consolidated amended complaints against them on various legal grounds common to all or most of the issuer defendants.
On October 9, 2002, the Court dismissed without prejudice all claims against the individual current and former officers and directors who were named as defendants in our litigation, and they are no longer parties to the lawsuit. On February 19, 2003, the Court issued its ruling on the motions to dismiss filed by the issuer defendants and separate motions to dismiss filed by the underwriter defendants. In that ruling, the Court granted in part and denied in part those motions. As to the claims brought against Avici under the antifraud provisions of the securities laws, the Court dismissed all of these claims with prejudice, and refused to allow the plaintiffs an opportunity to re-plead these claims against Avici. As to the claims brought under the registration provisions of the securities laws, which do not require that intent to defraud be pleaded, the Court denied the motion to dismiss these claims as to Avici and as to substantially all of the other issuer defendants as well. The Court also denied the underwriter defendants’ motion to dismiss in all respects.
In June 2003, Avici elected to participate in a proposed settlement agreement with the plaintiffs in this litigation. If ultimately approved by the Court, this proposed settlement would result in the dismissal, with prejudice, of all claims in the litigation against Avici and against any of the other issuer defendants who elect to participate in the proposed settlement, together with the current or former officers and directors of participating issuers who were named as individual defendants. The proposed settlement does not provide for the resolution of any claims against the underwriter defendants, and the litigation as against those defendants is continuing. The proposed settlement provides that the class members in the class action cases brought against the participating issuer defendants will be guaranteed a recovery of $1 billion by insurers of the participating issuer defendants. If recoveries totaling $1 billion or more are obtained by the class members from the underwriter defendants, however, the monetary obligations to the class members under the proposed settlement will be satisfied. In addition, Avici and any other participating issuer defendants will be required to assign to the class members certain claims that they may have against the underwriters of their IPOs.
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
The proposed settlement contemplates that any amounts necessary to fund the settlement or settlement-related expenses would come from participating issuers’ directors and officers liability insurance policy proceeds as opposed to funds of the participating issuer defendants themselves. A participating issuer defendant could be required to contribute to the costs of the settlement if that issuer’s insurance coverage were insufficient to pay that issuer’s allocable share of the settlement costs. Avici expects that its insurance proceeds will be sufficient for these purposes and that it will not otherwise be required to contribute to the proposed settlement.
Consummation of the proposed settlement is conditioned upon obtaining approval by the Court. On September 1, 2005, the Court preliminarily approved the proposed settlement and directed that notice of the terms of the proposed settlement be provided to class members. Thereafter, the Court held a fairness hearing on April 24, 2006, at which objections to the proposed settlement were heard. After the fairness hearing, the Court took under advisement whether to grant final approval to the proposed settlement.
On December 5, 2006, the U.S. Court of Appeals for the Second Circuit issued a decision that six purported class action lawsuits containing allegations substantially similar to those asserted against the Company may not be certified as class actions due, in part, to the Appeals Court’s determination that individual issues of reliance and knowledge would predominate over issues common to the proposed classes. On January 8, 2007, the plaintiffs filed a petition seeking rehearing en banc of this ruling. U.S. District Court has ordered that all proceedings in the consolidated cases brought against the Company and against the roughly 300 other issuers sued in substantially similar cases (including proceedings relating to the proposed settlement) will be stayed pending the ruling by the Court of Appeals on whether to entertain that petition for rehearing. As a result, in part, of that filing, the impact, if any, of the Court of Appeals’ ruling on the viability of the proposed settlement cannot yet be determined.
If the proposed settlement described above is not consummated, Avici intends to continue to defend the litigation vigorously. Moreover, if the proposed settlement is not consummated, Avici believes that the underwriters may have an obligation to indemnify Avici for the legal fees and other costs of defending this suit and that Avici’s directors’ and officers’ liability insurance policies would also cover the defense and potential exposure in the suit. While Avici can make no promises or guarantees as to the outcome of these proceedings, Avici believes that the final result of these actions will have no material effect on Avici’s consolidated financial condition, results of operations or cash flows.
(7) OTHER INCOME:
In 2005, the Company reached an agreement with an independent third party to assign to the third party a claim in bankruptcy held by the Company in consideration for $1.3 million which was received in the second quarter of 2005. Other income also includes the reversal of approximately $0.5 million of credits previously established in connection with this claim.
AVICI SYSTEMS INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS-(Continued)
December 31,
(all tabular amounts in thousands except share and per share data)
(8) SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Consolidated Statement of Operations Data:
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of disclosure controls and procedures
Avici, under the supervision and with the participation of Avici’s management, including the principal executive officer and principal financial officer, evaluated the effectiveness of Avici’s disclosure controls and procedures as of the end of the period covered by this annual report (the “Evaluation Date”) pursuant to Rule 13a-15(b) and 15d-15(b) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Based on this evaluation, Avici’s principal executive officer and principal financial officer have concluded, that, as of the Evaluation Date, Avici’s disclosure controls and procedures effectively ensure that information required to be disclosed in our filings and submissions under the Exchange Act is recorded, processed, summarized, and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms, including ensuring that such information is accumulated and communicated to Avici’s management, including Avici’s principal executive officer and principal financial officer, as appropriate, to allow timely decisions regarding required disclosure.
Changes in internal control over financial reporting
The Company has continued to make enhancements to its internal controls over financial reporting to meet its compliance requirements pursuant to Section 404 of Sarbanes-Oxley.
There were no changes in Avici’s internal control over financial reporting during Avici’s last fiscal quarter that have materially affected, or are reasonably likely to materially affect Avici’s internal control over financial reporting.
Management’s Report on Internal Control Over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting, as such term is defined in Exchange Act Rules 13a-15(f) and 15(d)-15(f). Under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, we conducted an assessment of the effectiveness of our internal control over financial reporting based on the framework in “Internal Control-Integrated Framework” issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on our assessment under the framework in “Internal Control-Integrated Framework”. The assessment did not identify any material weaknesses in our internal control over financial reporting and our management concluded that our internal control over financial reporting was effective as of December 31, 2006.
Management’s assessment of the effectiveness of our internal control over financial reporting as of December 31, 2006 has been audited by Ernst & Young LLP, an independent registered public accounting firm, as stated in their report which is included in this item 9A under the heading “Report of Independent Registered Public Accounting Firm.”
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of Avici Systems Inc.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that Avici Systems Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Avici Systems Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that Avici Systems Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Avici Systems Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2005, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Avici Systems Inc. as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006 and our report dated March 12, 2007 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Boston, Massachusetts
March 12, 2007
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by this Item 10 is incorporated herein by reference to our Definitive Proxy Statement with respect to our 2007 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year ended December 31, 2006.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by this Item 11 is incorporated herein by reference to our Definitive Proxy Statement with respect to our 2007 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year ended December 31, 2006.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by this Item 12 is incorporated herein by reference to our Definitive Proxy Statement with respect to our 2007 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year ended December 31, 2006, under the heading of “Ownership of Management and Directors” and “Equity Compensation Plan Information.”
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item 13 is incorporated herein by reference to our Definitive Proxy Statement with respect to our 2007 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission not later than 120 days after the end of the fiscal year ended December 31, 2006.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES.
The information required by this Item 14 is incorporated herein by reference to our Definitive Proxy Statement with respect to our 2007 Annual Meeting of Stockholders to be filed with the Securities and Exchange Commission no later than 120 days after the end of the fiscal year ended December 31, 2006.
ITEM 15.
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES.
(a) The following documents are filed as a part of this Form 10-K:
1. All Financial Statements. (see “Consolidated Financial Statements and Supplementary Data” at Item 8 and incorporated herein by reference).
2. Financial Statement Schedules. (see “Schedule II - Valuation and Qualifying Accounts,” which is included herein by reference)
3. Exhibits
The following exhibits are filed as part of and incorporated by reference into this Form 10-K:
* Indicates a management contract or any compensatory plan, contract or arrangement
 Confidential treatment granted for certain portions of this Exhibit pursuant to Rule 406 promulgated under the Securities Act, which portions are omitted and filed separately with the Securities and Exchange Commission
+ Confidential treatment requested for certain portions of this Exhibit pursuant to Rule 24b-2 promulgated under the Securities and Exchange Act, which portions are omitted and filed separately with the Securities and Exchange Commission
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
AVICI SYSTEMS INC.
By:
/s/ WILLIAM J. STUART
William J. Stuart
Chief Financial Officer, Treasurer, Secretary and
Senior Vice President of Finance
Date: March 15, 2007
POWER OF ATTORNEY AND SIGNATURES
We, the undersigned officers and directors of Avici Systems Inc., hereby severally constitute and appoint William J. Stuart, our true and lawful attorney, with full power to him, to sign for us in our names in the capacities indicated below, any amendments to this Annual Report on Form 10-K (including post-effective amendments), and to file the same, with all exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, and generally to do all things in our names and on our behalf in our capacities as officers and directors to enable Avici Systems Inc., to comply with the provisions of the Securities Act of 1933, as amended, hereby ratifying and confirming our signatures as they may be signed by our said attorneys, or any of them, to said Annual Report and all amendments thereto.
Pursuant to the requirements of the Securities Act of 1933, this Annual Report on Form 10-K has been signed by the following persons in the capacities and on the date indicated.
AVICI SYSTEMS INC.
SCHEDULE II-VALUATION AND QUALIFYING ACCOUNTS
In thousands
EXHIBIT INDEX
* Indicates a management contract or any compensatory plan, contract or arrangement
 Confidential treatment granted for certain portions of this Exhibit pursuant to Rule 406 promulgated under the Securities Act, which portions are omitted and filed separately with the Securities and Exchange Commission
+ Confidential treatment requested for certain portions of this Exhibit pursuant to Rule 24b-2 promulgated under the Securities and Exchange Act, which portions are omitted and filed separately with the Securities and Exchange Commission