ITEM 1. BUSINESS
Overview
We design, manufacture, sell, distribute, integrate and support communication equipment and services, and optical components. We conduct our business along three principal segments: the networking group, the optical components group and development stage enterprise group. Our networking group provides equipment used by commercial customers, governments and telecommunications service providers, and include switches, routers, physical layer products and console management products as well as specialized networking products for aerospace, defense and other applications including voice and cellular communication. Our optical components group designs, manufactures and sells optical communications components, primarily through our wholly owned subsidiary LuminentOIC, Inc. These components include fiber optic transceivers for metropolitan, access and Fiber-to-the-Premises, or FTTP, applications. Our development stage enterprise group seeks to develop new optical components, subsystems and network equipment and other products for the infrastructure of the Internet.
We market and sell our products worldwide, through a variety of channels, which include a dedicated direct sales force, manufacturers’ representatives, value-added-resellers, distributors and systems integrators. We have operations in Europe that provide network system design, integration and distribution services that include products manufactured by third-party vendors, as well as our products. We believe such specialization enhances access to customers and allows us to penetrate targeted vertical and regional markets.
We were organized in July 1988 as MRV Technologies, Inc., a California corporation and reincorporated in Delaware in April 1992, at which time we changed our name to MRV Communications, Inc.
Industry Background
Over the past decade, businesses, governments, educational institutions and other organizations have become increasingly reliant on communications networks and software applications as critical strategic assets. With the proliferation of Internet access to consumer households, communications networks have been expanded to deliver new services providing both internal and external connectivity. Productivity gains obtained by investments in network infrastructure have fueled the growth of the global economy. Increased demands for capacity in network infrastructure have resulted in greater bandwidth requirements and increased deployment of optical components and optical networks.
In the late 1990’s and through 2000, our customers deployed a large volume of networking equipment in anticipation of high network traffic growth. During this period, we experienced a period of rapid revenue growth. Subsequent to 2000 the global economy entered a recessionary period and the demand for information technology products declined as telecommunications carriers and service providers, enterprise customers and governments reduced spending on technology. In particular these enterprises cut their IT budgets for networking equipment and optical components due to overcapacity as the anticipated increase in network growth in the years 2002 through 2003 did not materialize. We believe this phenomenon adversely affected demand for our products and made it more difficult to accurately forecast demand for network equipment and optical components.
Products and Services
We provide integrated, secure network equipment and services to connect data, voice and/or video (both analog and digital), within single buildings, across private networks located in multiple buildings such as college or campus environments (“campus networks”) and in metropolitan areas. At the access point to the network, we provide standard-based products, including Ethernet connectivity over telephone wires. Access speeds (data rates) vary, scaling up to Gigabits-per-second (“Gbps”), and providing security features such as intrusion control and traffic rate control. Our products aggregate network traffic using standard protocols to interconnect high-speed networks. Additional features enable new services such as virtual private networks (“VPN”), permitting remote private network access over the Internet and quality of service (“QoS”), permitting the ability to deliver time-sensitive data, control the bandwidth, set priorities for specific network traffic and provide an appropriate level of security. For campus networks and metropolitan networks, where fiber optic cabling is not available, or cannot easily be deployed, we provide point-to-point connectivity using free-space optics (“FSO”) technology, a line-of-sight technology that uses lasers to provide optical bandwidth connections that can send and receive voice, video, and data information on invisible beams of light. These products can be deployed quickly carrying network traffic from building to building without digging up the street to install fiber optic cabling, or can be used in disaster recovery and back-up applications. We also provide wave division multiplexing (“WDM”) technology to expand the capacity of existing fiber optic infrastructure by enabling simultaneous transmission of information over multiple wavelengths on the same fiber optic strand. In addition, we provide network management systems that allow users and network administrators to control remote network elements, including network equipment, temperature and alarm sensors and power supply.
Our offerings fall into several product groups. For revenue breakdown by product group, please see Note 16, “Segment Reporting” included in the “Notes to Financial Statements” appearing elsewhere in this Form 10-K our product groups include:
Physical Layer Products - Optical Connectivity. Cabling and network transmission equipment constitute the physical infrastructure, which is essential for computer connectivity, telephony systems and video distribution. We provide a broad range of connectivity products for copper-to-fiber media conversion, signal repeating, and fiber-optimization, including WDM systems and FSO. Like fiber optic cable, FSO communications systems use lasers and light from LEDs to transmit a digital signal between two transceivers. However, unlike fiber, light is transmitted through the air (free-space) instead of through a glass strand.
We also offer both coarse wave division multiplexing (“CWDM”) and dense wave division multiplexing (“DWDM”) systems. CWDM and DWDM use a technology that puts data from different sources together on an optical fiber, with each signal carrier at the same time on its own separate light wavelength. CWDM combines up to 16 wavelengths onto a single fiber. DWDM combines up to 64 wavelengths onto a single fiber. We also provide network access technology for data and voice over standard telephone wire. This includes long range Ethernet, and voice-over-Ethernet products for converged voice and data networks.
Switches and Routers - Ethernet Connectivity. Switching and routing technologies are essential for computer networking. Switches direct the flow of data traffic between individual computers, servers and other elements on a network and routers direct the flow of data traffic between computer networks. We provide a wide range of switching and routing products that scale from small systems designed for small business applications, to very large, high capacity systems for enterprise and telecommunications carrier applications. In some cases, we also offer switches or routers manufactured by third-party vendors, supplied as part of our network system integration and distribution services.
Console Management. Our console management products allow network managers to manage, monitor and control, from a central point, the real-time elements such as temperature, humidity, electrical power and the status of other equipment that exist in the network at a remotely located network.
We also provide a network management system (“NMS”) with comprehensive management and control for our products as well as other vendors’ products. Our NMS combines complete end-to-end network viewing and performance monitoring with network configuration and fault management including automatic detection and monitoring of devices from other vendors.
Other Networking Products. We provide networking products for aerospace, defense and other applications including voice and cellular communication. Our aerospace and defense networks apply real-time data acquisition technology allowing high-speed, packet-by-packet transaction processing for flight test validation and simulation systems. These products provide in-flight parameter recording systems in military and commercial aircrafts. We also provide ground test systems as well as protocol analyzers and network performance-testing equipment. In addition, we provide networking data test equipment and a multi-service computing platform for wireless cellular telephony.
Services. Our products perform critical networking tasks and are often used in conjunction with network equipment manufactured by other vendors. We believe that pre and post-sales services ensure high-availability, reduce cost of ownership, support business goals and promote customer loyalty. Accordingly, we provide a broad range of service offerings including pre-sale network design, consultation, and site-surveys. We also provide system integration and on-site installation. Post-sales support includes in-warranty as well as out-of-warranty repair and on-site maintenance. Our services include a choice of technical support services including around-the-clock response.
Optical Components. We design, manufacture and sell optical communications components. LuminentOIC offers a broad product portfolio in transceivers, FTTP/EFM (Ethernet in the First Mile) applications, CWDM/DWDM systems, and discrete active components. Products in the transceiver product line for access to metropolitan networks support Gigabit Ethernet, SONET/SDH (an acronym for “Synchronous Optical Network/Synchronous Digital Hierarchy”) and Fibre Channel protocols, and span a complete set of data rates, power levels, and form factors. The breadth of this product line ranges from mass volume, critically low cost transceivers to small form factor pluggable (SFP) transceivers for high end metropolitan access network applications. The FTTP product line offers products for multiplexing video and bi-directional data over single fibers, providing for superior video quality with high data throughput. The FTTP/EFM products include bi-directional transceivers and integrated triplexer subsystems, integrating voice, video, and data in a single managed transceiver. Offerings in CWDM/DWDM include an extensive set of wavelengths covering a full 18-wavelength CWDM/ 64 wavelength DWDM system in a number of transceiver or discrete laser form factors.
Sales and Marketing
We employ various methods, such as public relations, advertising, and trade shows in an effort to build awareness of our products as well as establishing our brand name, MRV. We conduct our public relations activities both internally and through relationships with outside agencies. We focus on major public relations activities focused around new product introductions, corporate partnerships and other events of interest to the market. We supplement our public relations through media advertising programs, including electronic media, and attendance at various trade shows throughout the year, both in the United States and internationally.
Worldwide Sales
Our worldwide sales and marketing organization, at December 31, 2004, consisted of approximately 300 employees, including sales representatives, technical support and management. We have field sales offices in more than 20 countries and sell our products and services both directly and through channel partners with support from their sales force. Our channel partners include distributors, value-added resellers, and system integrators. We conduct international operations in branch offices located in Argentina, Belgium, Brazil, China, Denmark, Finland, France, Germany, Israel, Italy, Mexico, the Netherlands, Norway, Russia, Singapore, Spain, Sweden, Switzerland, Taiwan and the United Kingdom. Our international field offices are involved in the sales and distribution of our products and provide system installation, technical support, and follow-up services to end users of our products.
Additionally, our offices in Denmark, Finland, France, Italy, Norway, Sweden and Switzerland sell and market our products along with other products manufactured by third-party vendors, supplied as part of network system integration and distribution services. These operations provide system design, network integration and post-sales support. These services enhance our ability to penetrate targeted vertical and regional markets. We believe that partnering with successful third-party vendors in certain areas helps to provide growth opportunities beyond the limitations of our product line.
No single customer accounted for more than 10% of our revenue or accounts receivable as of December 31, 2004 or for any of the three years in the period ended December 31, 2004.
Markets Served
We primarily serve the following markets:
Enterprise Market. We provide both optical transport and Ethernet access equipment, including switching and routing for inter-building and intra-building networking through our optical and free-space optics connectivity equipment (inter-building) and our Ethernet access equipment (intra-building). We also provide data-center management services, and our console management products manage large enterprise data centers.
Telecommunication Carrier and Service Provider Markets. We provide both optical transport and Ethernet access equipment, including switching and routing to regional and national telecommunication carriers and service providers.
Vertical and Regional Markets. For certain products, we focus on vertical markets, including defense and aerospace.
Optical Components. Our optical components are designed for use by original equipment manufacturers (“OEMs”) or end-users that employ our components for optical interfaces on communications equipment. Markets served by these systems vendors include multiple building private networks, or campus networks, as well as metropolitan and access markets including the FTTP market. We also sell components to other optical components vendors.
Competition
The communications equipment and optical component industries are intensely competitive. We compete directly with a number of established and emerging networking and optical components companies.
Direct competitors in networking products, switches and routers generally include ADVA Optical Networks, Alcatel, Allied Telesyn, Ciena, Cisco Systems, Enterasys Networks, Extreme Networks, Foundry Networks, Lucent Technologies, Nortel Networks and Riverstone Networks. Our competitors in fiber optic components include Agilent Technologies, Avanex, Bookham Technology, Finisar, Fujitsu, Infineon AG, JDS Uniphase, Optical Communication Products, Sumitomo, TriQuint Semiconductor and Tyco International. Many of our competitors have significantly greater financial, technical, marketing, distribution and other resources and larger installed customer bases than we do. Several of these competitors have recently introduced or announced their intentions to introduce new competitive products. Many of our larger competitors offer customers a broader product line, which provides a more comprehensive networking solution than we provide. Accordingly, in certain regional markets we have partnered with other vendors in an effort to enhance our overall capability in providing products and services.
We believe the principal competitive factors in the markets in which we compete include:
- Product performance, features, quality and price;
- A comprehensive range of complementary products and services;
- Customer service and technical support;
- Lead and delivery times;
- Timeliness of new products introductions;
- Global presence, including distribution network;
- Conformance to standards; and
- Brand name.
Recent consolidation is likely to permit various of our competitors to devote significantly greater resources to the development and marketing of new competitive products and the marketing of existing competitive products to their larger installed customer bases. We expect that competition will increase substantially as a result of these and other industry consolidations and alliances, as well as the emergence of new competitors.
Product Development and Engineering
We believe that in order to maintain our technological competitiveness and to better serve our customers, we must enhance our existing products and continue to develop new products. Accordingly, we focus a significant amount of resources on product development and engineering.
Our product development and engineering expenses were $24.9 million, $31.0 million and $49.4 million for the years ended December 31, 2004, 2003 and 2002, respectively. Details regarding product development and engineering expenses by segments follow.
Networking Group. Product development and engineering expenses from our networking group were $16.2 million, $18.4 million and $21.0 million for the years ended December 31, 2004, 2003 and 2002, respectively. In the year ended December 31, 2003, these expenses were offset by income from recapturing accelerated deferred stock expense due to terminations that amounted to $488,000, while in years ended December 31, 2004 and 2002 these expenses include deferred stock expense totaling $79,000 and $2.1 million, respectively.
Optical Components Group. Product development and engineering expenses from our optical components group were $7.2 million, $6.9 million and $10.5 million for the years ended December 31, 2004, 2003 and 2002, respectively. These expenses include income from recapturing accelerated deferred stock expense due to terminations that amounted to $1.6 million for the year ended December 31, 2002.
Development Stage Enterprise Group. Product development and engineering expenses from our development stage enterprise group were $1.5 million, $5.7 million and $17.8 million for the years ended December 31, 2004, 2003 and 2002, respectively.
Manufacturing
We outsource our board-level assembly and on some occasions, complete turnkey production to independent contract manufacturers for our networking products, which include switches and routers, remote device management products and networking physical infrastructure equipment. Outsourcing, we believe, allows us to react more quickly to market demand, avoid the significant capital investment required to establish automated manufacturing and assembly facilities and concentrate resources on product design and development. Our in-house manufacturing operations primarily perform the functions of materials management, and, in an effort to ensure quality and reliabity, quality assurance, equipment burn-in (testing new equipment by turning the power on), as well as inspection and final testing. Our manufacturing processes and procedures are generally ISO 9000 certified and so are those of our vendors.
Our optical components are designed and manufactured in our ISO 9001 certified manufacturing and production facilities in California and Taiwan. LuminentOIC remains one of a handful of vendors in the fiber optics industry with in-house epitaxial crystal growth and device fabrication capabilities, enabling a broad portfolio of products from discrete components to managed integrated transceivers. LuminentOIC utilizes advanced metal organic chemical vapor deposition (MOCVD) laser growth process to produce high caliber distributed feedback (DFB) and fabry perot (FP) laser diodes. Vertical integration enables us to deliver high quality, advanced fiber optic components at lower cost. LuminentOIC has developed and acquired the sophisticated equipment required for evaluating and characterizing products to seek to ensure that quality levels are maintained. Comprehensive in-line quality control is incorporated throughout the mass production process. All devices produced at LuminentOIC are designed to comply with Telcordia GR-468-CORE standards. In addition, LuminentOIC has been certified under TL9000, ISO9001, ISO14001, TUV and CSA.
Components
We utilize a wide variety of components, supplies and products from a substantial number of vendors around the world. Certain of our products rely on a single or limited number of suppliers, although we seek to locate alternative sources if the need arises. The failure of delivery by our vendors in a timely manner of critical components could adversely affect our business. For a discussion of the risks associated with suppliers, please see the portion of this Form 10-K entitled “Risk Factors,” including but not limited to the risk factor entitled, “We May Lose Sales if Suppliers of Critical Components and Products Fail to Meet Our Needs.”
Intellectual Property
To date, we have relied principally on a combination of patents, copyrights and trade secrets to protect proprietary technology. Generally, we enter into confidentiality agreements with our employees and key suppliers and otherwise seek to limit access to and distribution of the source code to software and other proprietary information. These steps may not be adequate to prevent misappropriation of our technologies or a third party may independently develop technology similar or superior to any of our possesses.
Employees
As of December 31, 2004, we employed a total of approximately 1,330 full-time employees compared with approximately 1,250 at December 31, 2003. Of these 1,330 employees, approximately 675 are in manufacturing, 190 in product development and engineering and 465 in sales, marketing and general administration. Approximately 925 employees are in locations outside the United States. None of our employees are represented by a union or governed by a collective bargaining agreement, and we believe our employee relationships are satisfactory. We also believe that our long-term success depends in part on our continued ability to recruit and retain qualified personnel. The risks associated with dependence on qualified personnel are more fully discussed in the “Risk Factors” section contained in Item 1 of this Form 10-K.
Certain Risk Factors That Could Affect Future Results
You should carefully consider and evaluate all of the information in this Form 10-K, including the risk factors listed below. The risks described below are not the only ones facing our company. Additional risk not now known to us or that we currently deem immaterial may also impair our business operations.
If any of these risks actually occur, our business could be materially harmed. If our business is harmed, the trading price of our common stock could decline.
This Form 10-K also contains forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated in these forward looking statements as a result of certain factors, including the risks faced by us described below and elsewhere in this Form 10-K. We undertake no duty to update any of the forward-looking statements after the date of this Form 10-K.
Our Operating Results Could Fluctuate Significantly From Quarter To Quarter.
Our operating results for a particular quarter are extremely difficult to predict. Our revenue and operating results could fluctuate substantially from quarter to quarter and from year to year. This could result from any one or a combination of factors such as:
- the cancellation or postponement of orders;
- the timing and amount of significant orders;
- our success in developing, introducing and shipping product enhancements and new products;
- the mix of products we sell;
- software, hardware or other errors in the products we sell requiring replacements or increased warranty reserves;
- our annual reviews of goodwill and other intangibles that lead to impairment charges;
- new product introductions by our competitors;
- pricing actions by our competitors or us;
- the timing of delivery and availability of components from suppliers;
- political stability in the areas of the world we operate in;
- changes in material costs;
- currency fluctuations; and
- general economic conditions.
Moreover, the volume and timing of orders we receive during a quarter are difficult to forecast. From time to time, our customers encounter uncertain and changing demand for their products. Customers generally order based on their forecasts. If demand falls below these forecasts or if customers do not control inventories effectively, they may cancel or reschedule shipments previously ordered from us. Our expense levels during any particular period are based, in part, on expectations of future sales. If sales in a particular quarter do not meet expectations, our operating results could be materially adversely affected.
Our success is dependent, in part, on the overall growth rate of the fiber optic components and networking industry. The Internet or the industries that serve it may not continue to grow and even if it does or they do, we may not achieve increased growth. Our business, operating results or financial condition may be adversely affected by any decreases in industry growth rates. In addition, we can give no assurance that our results in any particular period will fall within the ranges for growth forecast by market researchers.
Because of these and other factors, you should not rely on quarter-to-quarter comparisons of our results of operations as an indication of our future performance. It is possible that, in future periods, our results of operations may be below the expectations of public market analysts and investors. This failure to meet expectations could cause the trading price of our common stock to decline. Similarly, the failure by our competitors or customers to meet or exceed the results expected by their analysts or investors could have a ripple effect on us and cause our stock price to decline.
Our Markets Are Subject To Rapid Technological Change, And To Compete Effectively, We Must Continually Introduce New Products That Achieve Market Acceptance.
The markets for our products are characterized by rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. We expect that new technologies will emerge as competition and the need for higher and more cost effective transmission capacity, or bandwidth, increases. Our future performance will depend on the successful development, introduction and market acceptance of new and enhanced products that address these changes as well as current and potential customer requirements. The introduction of new and enhanced products may cause our customers to defer or cancel orders for existing products. We have in the past experienced delays in product development and these delays may occur in the future. Therefore, to the extent customers defer or cancel orders in the expectation of a new product release or there is any delay in development or introduction of our new products or enhancements of our products, our operating results would suffer. We also may not be able to develop the underlying core technologies necessary to create new products and enhancements, or to license these technologies from third parties. Product development delays may result from numerous factors, including:
- changing product specifications and customer requirements;
- difficulties in hiring and retaining necessary technical personnel;
- difficulties in reallocating engineering resources and overcoming resource limitations;
- difficulties with contract manufacturers;
- changing market or competitive product requirements; and
- unanticipated engineering complexities.
The development of new, technologically advanced products is a complex and uncertain process requiring high levels of innovation and highly skilled engineering and development personnel, as well as the accurate anticipation of technological and market trends. In order to compete, we must be able to deliver products to customers that are highly reliable, operate with its existing equipment, lower the customer’s costs of acquisition, installation and maintenance, and provide an overall cost-effective solution. We may not be able to identify, develop, manufacture, market or support new or enhanced products successfully, if at all, or on a timely basis. Further, our new products may not gain market acceptance or we may not be able to respond effectively to product announcements by competitors, technological changes or emerging industry standards. Our failure to respond effectively to technological changes would significantly harm our business.
Defects In Our Products Resulting From Their Complexity Or Otherwise Could Hurt Our Financial Performance.
Complex products, such as those we offer, may contain undetected software or hardware errors when we first introduce them or when we release new versions. The occurrence of these errors in the future, and our inability to correct these errors quickly or at all, could result in the delay or loss of market acceptance of our products. It could also result in material warranty expense, diversion of engineering and other resources from our product development efforts and the loss of credibility with, and legal actions by, our customers, system integrators and end users. Any of these or other eventualities resulting from defects in our products could cause our sales to decline and have a material adverse effect on our business, operating results and financial condition.
The Long Sales Cycles For Our Products May Cause Revenues And Operating Results To Vary From Quarter To Quarter, Which Could Cause Volatility In Our Stock Price.
The timing of our revenue is difficult to predict because of the length and variability of the sales and implementation cycles for our products. We do not recognize revenue until a product has been shipped to a customer, all significant vendor obligations have been performed and collection is considered probable. Customers often view the purchase of our products as a significant and strategic decision. As a result, customers typically expend significant effort in evaluating, testing and qualifying our products and our manufacturing process. This customer evaluation and qualification process frequently results in a lengthy initial sales cycle of, depending on the products, many months or more. In addition, some of our customers require that our products be subjected to lifetime and reliability testing, which also can take months or more. While our customers are evaluating our products and before they place an order with us, we may incur substantial sales and marketing and research and development expenses to customize our products to the customer’s needs. We may also expend significant management efforts, increase manufacturing capacity and order long lead-time components or materials prior to receiving an order. Even after this evaluation process, a potential customer may not purchase our products. Even after acceptance of orders, our customers often change the scheduled delivery dates of their orders. Because of the evolving nature of the optical networking and network infrastructure markets, we cannot predict the length of these sales, development or delivery cycles. As a result, these long sales cycles may cause our net sales and operating results to vary significantly and unexpectedly from quarter-to-quarter, which could cause volatility in our stock price.
Our Business Has Been Adversely Impacted By The Worldwide Economic Slowdown And Related Uncertainties.
Weaker economic conditions worldwide, particularly in the U.S. and Europe, have contributed to the current technology industry slowdown and impacted our business resulting in:
- reduced demand for our products, particularly fiber optic components;
- increased risk of excess and obsolete inventories;
- increased price competition for our products;
- excess manufacturing capacity under current market conditions; and
- higher overhead costs, as a percentage of revenues.
We reported losses for the years ended December 31, 2004, 2003 and 2002 and have not achieved profitability for a full year since 1997. While we were profitable in the fourth quarter of the year ended December 31, 2004, we anticipate continuing to incur significant sales and marketing, product development and general and administrative expenses and, as a result, we will continue to need to contain expense levels and increase revenue levels to continue to achieve profitability in future fiscal quarters.
Cost Containment Is Critical To Achieving Positive Cash Flow From Operations And Profitability Consistently.
We are continuing efforts at strict cost containment and believe that such efforts are essential to achieving positive cash flow from operations in future quarters and maintaining profitability on a consistent basis, especially since the outlook for future quarters is subject to numerous challenges. Additional measures to contain costs and reduce expenses may be undertaken if revenues do not continue to improve. A number of factors could preclude us from consistently bringing costs and expenses in line with our revenues, such as our inability to accurately forecast business activities and the deterioration of our revenues. If we are not able to maintain an expense structure commensurate with our business activities and revenues, we may have inadequate levels of cash for operations or for capital requirements, which could significantly harm our ability to operate the business.
Our Business And Future Operating Results Are Subject To A Wide Range Of Uncertainties Arising Out Of The Continuing Threat Of Terrorist Attacks And Ongoing Military Action In The Middle East
Like other U.S. companies, our business and operating results are subject to uncertainties arising out of the continuing threat of terrorist attacks on the United States and ongoing military action in the Middle East, including the potential worsening or extension of the current global economic slowdown, the economic consequences of the war in Iraq or additional terrorist activities and associated political instability, and the impact of heightened security concerns on domestic and international travel and commerce. In particular, due to these uncertainties we are subject to:
- increased risks related to the operations of our manufacturing facilities in China;
- greater risks of disruption in the operations of our Asian contract manufacturers and more frequent instances of shipping delays; and
- the risk that future tightening of immigration controls may adversely affect the residence status of non-U.S. engineers and other key technical and other employees in our U.S. facilities or our ability to hire new non-U.S. employees in such facilities.
We Face Risks In Reselling The Products Of Other Companies.
We distribute products manufactured by other companies. To the extent we succeed in reselling the products of these companies, or products of other vendors with which we may enter into similar arrangements, we may be required by customers to assume warranty and service obligations. While these suppliers have agreed to support us with respect to those obligations, if they should be unable, for any reason, to provide the required support, we may have to expend our own resources on doing so. This risk is amplified by the fact that the equipment has been designed and manufactured by others, and is thus subject to warranty claims whose magnitude we are currently unable to fully evaluate.
The Price Of Our Shares May Continue To Be Highly Volatile.
Historically, the market price of our shares has been extremely volatile. The market price of our common stock is likely to continue to be highly volatile and could be significantly affected by factors such as:
- actual or anticipated fluctuations in our operating results;
- announcements of technological innovations or new product introductions by us or our competitors;
- changes of estimates of our future operating results by securities analysts;
- developments with respect to patents, copyrights or proprietary rights; and
- general market conditions and other factors.
In addition, the stock market has experienced extreme price and volume fluctuations that have particularly affected the market prices for shares of the common stocks of technology companies in particular, and that have been unrelated to the operating performance of these companies. These factors, as well as general economic and political conditions, may materially adversely affect the market price of our common stock in the future. Similarly, the failure by our competitors or customers to meet or exceed the results expected by their analysts or investors could have a ripple effect on us and cause our stock price to decline. Additionally, volatility or a lack of positive performance in our stock price may adversely affect our ability to retain key employees, all of whom have been granted stock options.
Our 2003 Notes Provide For Various Events Of Default That Would Entitle The Holders To Require Us To Immediately Repay The Outstanding Principal Amount, Plus Accrued And Unpaid Interest, In Cash.
On June 4, 2003, we completed the sale of $23 million principal amount of 2003 Notes to Deutsche Bank AG, London Branch in a private placement pursuant to Regulation D under the Securities Act of 1933. We will be considered in default of the 2003 Notes if any of the following events, among others, occurs:
- our default in payment of any principal amount of, interest on or other amount due under the 2003 Notes when and as due;
- the effectiveness of the registration statement, which registered for resale the shares of our common stock issuable upon conversion of the 2003 Notes, lapses for any reason or is unavailable to the holder of the 2003 Notes for resale of all of the shares issuable upon conversion, other than during allowable grace periods, for a period of five consecutive trading days or for more than an aggregate of 10 trading days in any 365-day period;
- the suspension from trading or failure of our common stock to be listed on the Nasdaq Stock Market for a period of five (5) consecutive trading days or for more than an aggregate of ten (10) trading days in any 365-day period;
- we or our transfer agent notify any holder of our intention not to issue shares of our common stock to the holder upon receipt of any conversion notice delivered in respect of a Note by the holder;
- we fail to deliver shares of our common stock to the holder within 12 business days of the conversion date specified in any conversion notice delivered in respect of a Note by the holder;
- we breach any material representation, warranty, covenant or other term or condition of the 2003 Notes or the Securities Purchase Agreement, or the Registration Rights Agreement relating to 2003 Notes and the breach, if curable, is not cured by us within 10 days;
- failure by us for 10 days after notice to comply with any other provision of the 2003 Notes in all material respects, which include abiding by our covenants not to
o incur any form of unsecured indebtedness in excess of $17.0 million, plus obligations arising from accounts receivable financing transactions with recourse through our foreign offices, in the ordinary course of business and consistent with past practices;
o repurchase our common stock for an aggregate amount in excess of $5.0 million; pursuant to a stock purchase program that was approved by our Board of Directors and publicly announced on June 13, 2002; or
o declare or pay any dividend on any of our capital stock, other than dividends of common stock with respect to our common stock;
o our common stock or securities that are convertible into or exchangeable or exercisable for shares of our common at a per share price less than the conversion price per share of the 2003 Notes then in effect, except in certain limited cases; or
o securities that are convertible into or exchangeable or exercisable for shares of our common stock at a price that varies or may vary with the market price of our common stock;
If an event of default occurs, any holder of the 2003 Notes can elect to require us to pay the outstanding principal amount, together with all accrued and unpaid interest.
Some of the events of default include matters over which we may have some, little or no control. If a default occurs and we do not pay the amounts payable under the 2003 Notes in cash (including any interest on such amounts and any applicable default interest under the 2003 Notes), the holders of the 2003 Notes may protect and enforce their rights or remedies either by suit in equity or by action at law, or both, whether for the specific performance of any covenant, agreement or other provision contained in the 2003 Notes. Any default under the 2003 Notes could have a material adverse effect on our business, operating results and financial condition or on the market price of our common stock.
In The Event Of A Change Of Control, Holders Of The 2003 Notes Have The Option To Require Immediately Repayment Of The 2003 Notes At A Premium And This Right Could Prevent A Takeover Otherwise Favored By Stockholders.
In the event of our “Change of Control,” which essentially means someone acquiring or merging with us, each holder of 2003 Notes has the right to require us to redeem the 2003 Notes in whole or in part at a redemption price of 105% of the principal amount of the 2003 Notes, plus accrued and unpaid interest or if the amount is greater, an amount equal to the number of shares issuable upon conversion of the 2003 Notes based on the conversion price at the date the holder gives us notice of redemption, multiplied by the average of the weighted average prices of our common stock during the five days immediately proceeding that date. If a Change of Control were to occur, we might not have the financial resources or be able to arrange financing on acceptable terms to pay the redemption price for all the 2003 Notes as to which the purchase right is exercised. Further, the existence of this right in favor of the holders may discourage or prevent someone from acquiring or merging with us.
Sales Of Substantial Amounts Of Our Shares By Selling Stockholders Could Cause The Market Price Of Our Shares To Decline.
Selling stockholders are offering for resale under an effective registration statement up to 9,913,914 shares of our common stock issuable upon conversion of the 2003 Notes. This represents approximately 9.5% of the outstanding shares of our common stock on February 15, 2005 (or 8.7% of the outstanding shares of our common stock on that date if pro forma effect were given to the full conversion of the 2003 Notes). Sales of substantial amounts of these shares at any one time or from time to time, or even the availability of these shares for sale, could adversely affect the market price of our shares.
Our Business Is Intensely Competitive And The Evident Trend Of Consolidations In Our Industry Could Make It More So.
The markets for fiber optic components and networking products are intensely competitive and subject to frequent product introductions with improved price/performance characteristics, rapid technological change and the continual emergence of new industry standards. We compete and will compete with numerous types of companies including companies that have been established for many years and have considerably greater financial, marketing, technical, human and other resources, as well as greater name recognition and a larger installed customer base, than we do. This may give these competitors certain advantages, including the ability to negotiate lower prices on raw materials and components than those available to us. In addition, many of our large competitors offer customers broader product lines, which provide more comprehensive solutions than our current offerings. We expect that other companies will also enter markets in which we compete.
Greater concentration of purchasing power and decreased demand for communications networking products and optical components in recent years have resulted in increased competitive pressures. We expect aggressive competitive tactics to continue, and perhaps become more severe. These tactics include:
- intense price competition in sales of new equipment, resulting in lower profit margins;
- discounting resulting from sales of used equipment or inventory that a competitor has written down or written off;
- early announcements of competing products and other extensive marketing efforts;
- customer financing assistance;
- marketing and advertising assistance; and
- intellectual property disputes.
Tactics such as those described above can be particularly effective in a concentrated base of potential customers such as communications service providers. Our service provider customers are under increasing competitive pressure to deliver their services at the lowest possible cost. This pressure may result in the pricing of communications networking equipment becoming a more important factor in customer decisions. This may favor larger competitors that can spread the effect of price discounts across a larger array of products and services and across a larger customer base than ours. If we are unable to offset any reductions in the average sales price for our products by a reduction in the cost of our products, our gross profit margins will be adversely affected. Our inability to compete successfully and maintain our gross profit margins would harm our business, financial condition and results of operations.
There has been a trend toward industry consolidation for several years. We expect this trend toward industry consolidation to continue as companies attempt to strengthen or hold their market positions in an evolving industry. We believe that industry consolidation may provide stronger competitors that are better able to compete. This could have a material adverse effect on our business, operating results and financial condition.
We Face Risks From Our International Operations.
International sales have become an increasingly important part of our operations. The following table sets forth the percentage of our total revenues from sales to customers in foreign countries for the periods identified:
We have offices in, and conduct a significant portion of our operations in and from Israel. Similarly, some of our development stage enterprises are located in Israel. We are, therefore, directly influenced by the political and economic conditions affecting Israel. Any major hostilities involving Israel, the interruption or curtailment of trade between Israel and its trading partners or a substantial downturn in the economic or financial condition of Israel could have a material adverse effect on our operations. LuminentOIC has a minority interest in a large manufacturing facility in the People’s Republic of China in which it manufactures passive fiber optic components and both LuminentOIC and we make sales of our products in the People’s Republic of China. The political tension between Taiwan and the People’s Republic of China that continues to exist, could eventually lead to hostilities. Risks we face due to international sales and the use of overseas manufacturing include:
- greater difficulty in accounts receivable collection and longer collection periods;
- the impact of recessions in economies outside the United States;
- unexpected changes in regulatory requirements;
- seasonal reductions in business activities in some parts of the world, such as during the summer months in Europe or in the winter months in Asia when the Chinese New Year is celebrated;
- difficulties in managing operations across disparate geographic areas;
- difficulties associated with enforcing agreements through foreign legal systems;
- the payment of operating expenses in local currencies, which exposes us to risks of currency fluctuations;
- higher credit risks requiring cash in advance or letters of credit;
- potentially adverse tax consequences;
- unanticipated cost increases;
- unavailability or late delivery of equipment;
- trade restrictions;
- limited protection of intellectual property rights;
- unforeseen environmental or engineering problems; and
- personnel recruitment delays.
The majority of our sales are currently denominated in U.S. dollars. As we conduct business in several different countries, we have recently benefited from sales made in currencies other than the U.S. dollar because of the weakness of the U.S. dollar in relation to the currencies in which these sales have been made. However, if this trend ceases or reverses, fluctuations in currency exchange rates could cause our products to become relatively more expensive in particular countries, leading to a reduction in sales in that country. In addition, inflation or fluctuations in currency exchange rates in these countries could increase our expenses.
To date, we have not hedged against currency exchange risks. In the future, we may engage in foreign currency denominated sales or pay material amounts of expenses in foreign currencies and, in that event, may experience gains and losses due to currency fluctuations. Our operating results could be adversely affected by currency fluctuations or as a result of inflation in particular countries where material expenses are incurred.
We Depend On Third-Party Contract Manufacturers And Therefore Could Face Delays Harming Our Sales.
We outsource the board-level assembly, test and quality control of material, components, subassemblies and systems relating to our networking products to third-party contract manufacturers. Though there are a large number of contract manufacturers that we can use for outsourcing, we have elected to use a limited number of vendors for a significant portion of our board assembly requirements in order to foster consistency in quality of the products and to achieve economies of scale. These independent third-party manufacturers also provide the same services to other companies. Risks associated with the use of independent manufacturers include unavailability of or delays in obtaining adequate supplies of products and reduced control of manufacturing quality and production costs. If our contract manufacturers failed to deliver needed components timely, we could face difficulty in obtaining adequate supplies of products from other sources in the near term. Our third party manufacturers may not provide us with adequate supplies of quality products on a timely basis, or at all. While we could outsource with other vendors, a change in vendors may require significant lead-time and may result in shipment delays and expenses. Our inability to obtain these products on a timely basis, the loss of a vendor or a change in the terms and conditions of the outsourcing would have a material adverse effect on our business, operating results and financial condition.
We May Lose Sales If Suppliers Of Other Critical Components Fail To Meet Our Needs.
Our companies currently purchase several key components used in the manufacture of our products from single or limited sources. We depend on these sources to meet our needs. Moreover, we depend on the quality of the products supplied to us over which we have limited control. We have encountered shortages and delays in obtaining components in the past and expect to encounter shortages and delays in the future. If we cannot supply products due to a lack of components, or are unable to redesign products with other components in a timely manner, our business will be significantly harmed. We have no long-term or short-term contracts for any of our components. As a result, a supplier can discontinue supplying components to us without penalty. If a supplier discontinued supplying a component, our business may be harmed by the resulting product manufacturing and delivery delays.
We May Suffer Losses As A Result Of Entering Into Fixed Price Contracts.
From time to time we enter into contracts with certain customers where the price we charge for particular products is fixed. Although our estimated production costs for these products is used to compute the fixed price for sale, if our actual production cost exceeds the estimated production cost due to our inability to obtain needed components timely or at all or for other reasons, we may incur a loss on the sale. Sales of material amounts of products on a fixed price basis where we have not accurately predicted the production costs could have a material adverse affect on our results of operations.
Our Inability To Achieve Adequate Production Yields For Certain Components We Manufacture Internally Could Result In A Loss Of Sales And Customers.
We rely heavily on our own production capability for critical semiconductor lasers and light emitting diodes used in our products. Because we manufacture these and other key components at our own facilities and these components are not readily available from other sources, any interruption of our manufacturing processes could have a material adverse effect on our operations. Furthermore, we have a limited number of employees dedicated to the operation and maintenance of our wafer fabrication equipment, the loss of any of whom could result in our inability to effectively operate and service this equipment. Wafer fabrication is sensitive to many factors, including variations and impurities in the raw materials, the fabrication process, performance of the manufacturing equipment, defects in the masks used to print circuits on the wafer and the level of contaminants in the manufacturing environment. We may not be able to maintain acceptable production yields or avoid product shipment delays. In the event adequate production yields are not achieved, resulting in product shipment delays, our business, operating results and financial condition could be materially adversely affected.
If We Fail To Adequately Protect Our Intellectual Property, We May Not Be Able To Compete.
We rely on a combination of trade secret laws and restrictions on disclosure and patents, copyrights and trademarks to protect our intellectual property rights. We cannot assure you that our pending patent applications will be approved, that any patents that may be issued will protect our intellectual property or that third parties will not challenge any issued patents. Other parties may independently develop similar or competing technology or design around any patents that may be issued to us. We cannot be certain that the steps we have taken will prevent the misappropriation of our intellectual property, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. Any of this kind of litigation, regardless of outcome, could be expensive and time consuming, and adverse determinations in any of this kind of litigation could seriously harm our business.
We Could In The Future Become Subject To Litigation Regarding Intellectual Property Rights, Which Could Be Costly And Subject Us To Significant Liability.
From time to time, third parties, including our competitors, may assert patent, copyright and other intellectual property rights to technologies that are important to us. Over the years, we have received notices from third parties alleging possible infringement of patents with respect to certain features of our products or our manufacturing processes and in connection with these notices have been involved in discussions with the claimants, including IBM, Lucent, Ortel, Nortel, Rockwell, the Lemelson Foundation and Finisar. To date, our aggregate revenues potentially subject to the foregoing claims have not been material. However, these or other companies may pursue litigation with respect to these or other claims. The results of any litigation are inherently uncertain. In the event of an adverse result in any litigation with respect to intellectual property rights relevant to our products that could arise in the future, we could be required to obtain licenses to the infringing technology, to pay substantial damages under applicable law, to cease the manufacture, use and sale of infringing products or to expend significant resources to develop non-infringing technology. Licenses may not be available from third parties either on commercially reasonable terms or at all. In addition, litigation frequently involves substantial expenditures and can require significant management attention, even if we ultimately prevail. Accordingly, any infringement claim or litigation against us could significantly harm our business, operating results and financial condition.
In The Future, We May Initiate Claims Or Litigation Against Third Parties For Infringement Of Our Proprietary Rights To Protect These Rights Or To Determine The Scope And Validity Of Our Proprietary Rights Or The Proprietary Rights Of Competitors. These Claims Could Result In Costly Litigation And The Diversion Of Our Technical And Management Personnel.
Necessary licenses of third-party technology may not be available to us or may be very expensive, which could adversely affect our ability to manufacture and sell our products. From time to time we may be required to license technology from third parties to develop new products or product enhancements. We cannot assure you that third-party licenses will be available to us on commercially reasonable terms, if at all. The inability to obtain any third-party license required to develop new products and product enhancements could require us to obtain substitute technology of lower quality or performance standards or at greater cost, either of which could seriously harm our ability to manufacture and sell our products.
We Are Dependent On Certain Members Of Our Senior Management.
We are substantially dependent upon Dr. Shlomo Margalit, our Chairman of the Board of Directors, Chief Technical Officer and Secretary, and Mr. Noam Lotan, our President and Chief Executive Officer. The loss of the services of either of these officers could have a material adverse effect on us. We have entered into employment agreements with Dr. Margalit and Mr. Lotan and are the beneficiary of key man life insurance policies in the amounts of $1.0 million each on their lives. However, we can give no assurance that the proceeds from these policies will be sufficient to compensate us in the event of the death of either of these individuals, and the policies are not applicable in the event that either of them becomes disabled or is otherwise unable to render services to us.
Our Business Requires Us To Attract And Retain Qualified Personnel.
Our ability to develop, manufacture and market our products, run our operations and our ability to compete with our current and future competitors depends, and will depend, in large part, on our ability to attract and retain qualified personnel. Competition for executives and qualified personnel in the networking and fiber optics industries is intense, and we will be required to compete for those personnel with companies having substantially greater financial and other resources than we do. To attract executives, we have had to enter into compensation arrangements, which have resulted in substantial deferred stock expense and adversely affected our results of operations. We may enter into similar arrangements in the future to attract qualified executives. If we should be unable to attract and retain qualified personnel, our business could be materially adversely affected.
Environmental Regulations Applicable To Our Manufacturing Operations Could Limit Our Ability To Expand Or Subject Us To Substantial Costs.
We are subject to a variety of environmental regulations relating to the use, storage, discharge and disposal of hazardous chemicals used during our manufacturing processes. Further, we are subject to other safety, labeling and training regulations as required by local, state and federal law. Any failure by us to comply with present and future regulations could subject us to future liabilities or the suspension of production. In addition, these kinds of regulations could restrict our ability to expand our facilities or could require us to acquire costly equipment or to incur other significant expenses to comply with environmental regulations. We cannot assure you that these legal requirements will not impose on us the need for additional capital expenditures or other requirements. If we fail to obtain required permits or otherwise fail to operate within these or future legal requirements, we may be required to pay substantial penalties, suspend our operations or make costly changes to our manufacturing processes or facilities.
Our Headquarters Are Located In Southern California, And Certain Of Our Manufacturing Facilities Are Located In Southern California And Taiwan, Where Disasters May Occur That Could Disrupt Our Operations And Harm Our Business
Our corporate headquarters are located in the San Fernando Valley of Southern California and some of our manufacturing facilities are located in Southern California and Taiwan. Historically, these regions have been vulnerable to natural disasters and other risks, such as earthquakes, fires and floods, which at times have disrupted the local economies and posed physical risks to our property.
In addition, terrorist acts or acts of war targeted at the United States, and specifically Southern California, could cause damage or disruption to us, our employees, facilities, partners, suppliers, distributors and resellers, and customers, which could have a material adverse effect on our operations and financial results.
If We Fail To Accurately Forecast Component And Material Requirements For Our Manufacturing Facilities, We Could Incur Additional Costs Or Experience Manufacturing Delays.
We use rolling forecasts based on anticipated product orders to determine our component requirements. It is very important that we accurately predict both the demand for our products and the lead times required to obtain the necessary components and materials. Lead times for components and materials that we order vary significantly and depend on factors such as specific supplier requirements, the size of the order, contract terms and current market demand for the components. For substantial increases in production levels, some suppliers may need nine months or more lead-time. If we overestimate our component and material requirements, we may have excess inventory, which would increase our costs. If we underestimate our component and material requirements, we may have inadequate inventory, which could interrupt our manufacturing and delay delivery of our products to our customers. Any of these occurrences would negatively impact our net sales.
Legislative Actions, Higher Insurance Costs And Potential New Accounting Pronouncements Are Likely To Impact Our Future Financial Position And Results Of Operations And In The Case Of FASB’s New Pronouncement Regarding The Expensing Of Stock Options Will Adversely Impact Our Financial Results.
There have been regulatory changes, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq Stock Market rules and there may be potential new accounting pronouncements or regulatory rulings, which will have an impact on our future financial position and results of operations. These regulatory changes and other legislative initiatives have increased general and administrative costs. In addition, insurers are likely to increase rates as a result of high claims rates recently and our rates for our various insurance policies are likely to increase. The Financial Accounting Standards Board’s recent change to mandate the expensing of stock options will require us to record charges to earnings for stock option grants to employees and directors and will adversely affect our financial results after we implement the new pronouncement, which we expect will be in the third quarter of 2005.
We Are At Risk Of Securities Class Action Or Other Litigation That Could Result In Substantial Costs And Divert Management’s Attention And Resources.
In the past, securities class action litigation has been brought against a company following periods of volatility in the market price of its securities. Due to the volatility and potential volatility of our stock price or the volatility of LuminentOIC’s stock price following its initial public offering, we may be the target of securities litigation in the future. Securities or other litigation could result in substantial costs and divert management’s attention and resources.
If Our Cash Flow Significantly Deteriorates In The Future, Our Liquidity And Ability To Operate Our Business Could Be Adversely Affected.
We incurred net losses in 2004, 2003 and 2002, and our combined cash and short-term investments declined in each of those years as well. Our combined cash, cash equivalents, time deposits and short-term and long-term marketable securities declined at December 31, 2004 by approximately $11.9 million, or approximately 12%, since December 31, 2003. Although we generate cash from operations, we may continue to experience negative overall cash flow in future quarters. If our cash flow significantly deteriorates in the future, our liquidity and ability to operate our business could be adversely affected. For example, our ability to raise financial capital may be hindered due to our net losses and the possibility of future negative cash flow. An inability to raise financial capital would limit our operating flexibility.
Delaware Law And Our Ability To Issue Preferred Stock May Have Anti-Takeover Effects That Could Prevent A Change In Control, Which May Cause Our Stock Price To Decline.
We are authorized to issue up to 1,000,000 shares of preferred stock. This preferred stock may be issued in one or more series, the terms of which may be determined at the time of issuance by our board of directors without further action by stockholders. The terms of any series of preferred stock may include voting rights (including the right to vote as a series on particular matters), preferences as to dividend, liquidation, conversion and redemption rights and sinking fund provisions. No preferred stock is currently outstanding. The issuance of any preferred stock could materially adversely affect the rights of the holders of our common stock, and therefore, reduce the value of our common stock. In particular, specific rights granted to future holders of preferred stock could be used to restrict our ability to merge with, or sell our assets to, a third party and thereby preserve control by the present management. We are also subject to the anti-takeover provisions of Section 203 of the Delaware General Corporation Law, which prohibit us from engaging in a business combination with an interested stockholder for a period of three years after the date of the transaction in which the person became an interested stockholder unless the business combination is approved in the manner prescribed under Section 203. These provisions of Delaware law also may discourage, delay or prevent someone from acquiring or merging with us, which may cause the market price of our common stock to decline.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Some of the information in this Form 10-K and in the documents that are incorporated by reference, including the risk factors in this section, contains forward-looking statements that involve risks and uncertainties. These statements relate to future events or our future financial performance. In many cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” or “continue,” or the negative of these terms and other comparable terminology. These statements are only predictions. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of a number of factors including the risks faced by us described above and elsewhere in this Form 10-K.
ITEM 2.
ITEM 2. PROPERTIES
Our principal administrative, sales and marketing, product development and engineering and manufacturing facility is located in Chatsworth, California. The table below lists the locations, square footage and expiration dates of our principal owned and leased facilities used for our major operations.
We believe that our existing leased and owned space is more than adequate for our current operations, and that suitable replacement and additional space will be available in the future on commercially reasonable terms.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
We have received notices from third parties alleging possible infringement of patents with respect to product features or manufacturing processes. We believe such notices are common in the communications industry because of the large number of patents that have been filed on these subjects. Our policy is to discuss these notices with the senders in an effort to demonstrate that our products and/or processes do not violate any patents. From time to time we have been involved in such discussions with IBM, Lucent, Ortel, Nortel, Rockwell, the Lemelson Foundation and Finisar. We do not believe that any of our products or processes violates any of the patents asserted by these parties and we further believe that we have meritorious defenses if any legal action is taken by any of these parties. However, if one or more of these parties was to assert a claim and gain a conclusion unfavorable to us, such claims could materially and adversely affect our business, operating results and financial condition.
We have been named as a defendant in lawsuits involving matters that we consider routine to the nature of our business. We are of the opinion that the ultimate resolution of all such matters will not have a material adverse effect on our business, operating results and financial condition.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On December 15, 2004, we held our Annual Meeting of Stockholders at which, among other things, the Company’s entire board of directors was elected. The name of each director elected at the Annual Meeting, and the number of votes cast for and against (or withheld) were as follows:
The other matter voted upon at the meeting and the number of votes cast for, against or withheld, including abstentions and broker non-votes, was as follows:
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT’S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Information and Holders
Our common stock, $0.0017 par value, is traded on the Nasdaq National Market under the symbol “MRVC.” The following table sets forth, for the periods indicated, the high and low closing prices of our common stock, as reported on the Nasdaq National Market, giving effect to all stock splits through the date hereof.
As of February 15, 2005, we had approximately 2,986 common stockholders of record.
Dividends
The payment of dividends on our common stock is within the discretion of our board of directors. Currently, we intend to retain earnings to finance the growth of our business. We have not paid cash dividends on our common stock and the board of directors does not expect to declare cash dividends on the common stock in the foreseeable future.
Securities Authorized Under Equity Compensation Plans
Information regarding securities authorized for issuance under equity compensation plans, as required pursuant to Rule 201(d) of Regulation S-K, is included in Item 12 - Equity Compensation Plan Information included elsewhere in this Annual Report on Form 10-K.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected Statement of Operations data for each of the three years in the period ended December 31, 2004 and the Balance Sheet data as of December 31, 2004 and 2003 are derived from our audited financial statements included elsewhere in this Form 10-K. The selected Statement of Operations data for each of the two years in the period ended December 31, 2001 and the Balance Sheet data as of December 31, 2002, 2001 and 2000 were derived from our audited financial statements, which are not included in this Form 10-K. The following data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and the financial statements of the Company, including the notes thereto, included elsewhere in this Form 10-K.
ITEM 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis of our financial condition and results of operations should be read in conjunction with Consolidated Condensed Financial Statements and Notes thereto included elsewhere in this Form 10-K. In addition to historical information, the discussion in this Form 10-K contains certain forward-looking statements that involve risks and uncertainties. Our actual results could differ materially from those anticipated by these forward-looking statements due to factors, including but not limited to, those set forth in the following and elsewhere in this Form 10-K. We assume no obligation to update any of the forward-looking statements after the date of this Form 10-K.
Overview
We design, manufacture, sell, distribute, integrate and support communication equipment and services, and optical components. We conduct our business along three principal segments: the networking group, the optical components group and development stage enterprise group. Our networking group provides equipment used by commercial customers, governments and telecommunications service providers, and include switches, routers, physical layer products and console management products as well as specialized networking products for aerospace, defense and other applications including voice and cellular communication. Our optical components group designs, manufactures and sells optical communications components, primarily through our wholly owned subsidiary LuminentOIC, Inc. These components include fiber optic transceivers for metropolitan, access and Fiber-to-the-Premises, or FTTP, applications. Our development stage enterprise group seeks to develop new optical components, subsystems and networks and other products for the infrastructure of the Internet.
We market and sell our products worldwide, through a variety of channels, which include a dedicated direct sales force, manufacturers’ representatives, value-added-resellers, distributors and systems integrators. We have operations in Europe that provide network system design, integration and distribution services that include products manufactured by third-party vendors, as well as our products. We believe such specialization enhances access to customers and allows us to penetrate targeted vertical and regional markets.
We were organized in July 1988 as MRV Technologies, Inc., a California corporation and reincorporated in Delaware in April 1992, at which time we changed our name to MRV Communications, Inc.
We generally recognize product revenue, net of sales discounts and allowances, when persuasive evidence of an arrangement exists, delivery has occurred and all significant contractual obligations have been satisfied, the fee is fixed or determinable and collection is considered probable. Products are generally shipped “FOB shipping point” with no right of return, except on rare occasions in which event our accounting is as described below. Sales of services and system support are deferred and recognized ratably over the contract period. Sales with contingencies, such as right of return, rotation rights, conditional acceptance provisions and price protection are rare and have historically been insignificant. We do not recognize such sales until the contingencies have been satisfied or the contingent period has lapsed. We generally warrant our products against defects in materials and workmanship for one to two year periods. The estimated costs of warranty obligations and sales returns and other allowances are recognized at the time of revenue recognition based on contract terms and prior claims experience. Gross profit is equal to our revenues less our cost of goods sold. Our cost of goods sold includes materials, direct labor and overhead. Cost of inventory is determined by the first-in, first-out method. Our operating costs and expenses generally consist of product development and engineering costs, or R&D, selling, general and administrative costs, or SG&A, and other operating related costs and expenses.
We divide and operate our business on the basis of our three principal segments. We evaluate segment performance based on the revenues and the operating expenses of each segment. We do not track segment data or evaluate segment performance on additional financial information. As such, there are no separately identifiable segment assets nor are there any separately identifiable Statement of Operations data below operating income (expense). The networking and optical components groups account for virtually all of our overall revenue.
Our business involves reliance on foreign-based entities. Several of our divisions, outside subcontractors and suppliers are located in foreign countries, including Argentina, China, Denmark, Finland, France, Germany, Israel, Italy, Japan, Korea, the Netherlands, Norway, Russia, Singapore, South Africa, Switzerland, Sweden, Taiwan and the United Kingdom. For the years ended December 31, 2004, 2003 and 2002, foreign revenues constituted 77%, 78% and 74%, respectively, of our revenues. The vast majority of our foreign sales are to customers located in the European region. The remaining foreign sales are primarily to customers in the Asia Pacific region.
Critical Accounting Policies
Our discussion and analysis of our financial condition and results of operations are based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities.
We believe that the estimates, assumptions and judgments involved in the accounting policies described below have the greatest potential impact on our financial statements, so we consider these to be our critical accounting policies. Because of the uncertainty inherent in these matters, actual results could differ from the estimates we use in applying the critical accounting policies. Certain of these critical accounting policies affect working capital account balances, including the policies for revenue recognition, allowance for doubtful accounts, inventory reserves and income taxes. These policies require that we make estimates in the preparation of our financial statements as of a given date. However, since our business cycle is relatively short, actual results related to these estimates are generally known within the six-month period following the financial statement date. Thus, these policies generally affect only the timing of reported amounts across two to three quarters.
Within the context of these critical accounting policies, we are not currently aware of any reasonably likely events or circumstances that would result in materially different amounts being reported.
Revenue Recognition. We generally recognize product revenue, net of sales discounts and allowances, when persuasive evidence of an arrangement exists, delivery has occurred and all significant contractual obligations have been satisfied, the fee is fixed or determinable and collection is considered probable. Products are generally shipped “FOB shipping point” with no right of return. Sales of services and system support are deferred and recognized ratably over the contract period. Sales with contingencies, such as right of return, rotation rights, conditional acceptance provisions and price protection are rare and insignificant and are deferred until the contingencies have been satisfied or the contingent period has lapsed. We generally warrant our products against defects in materials and workmanship for one to two year periods. The estimated costs of warranty obligations and sales returns and other allowances are recognized at the time of revenue recognition based on contract terms and prior claims experience. Our major revenue-generating products consist of: fiber optic components; switches and routers; console management products; and physical layer products.
Allowance for Doubtful Accounts. We make ongoing estimates relating to the collectability of our accounts receivable and maintain a reserve for estimated losses resulting from the inability of our customers to meet their financial obligations to us. In determining the amount of the reserve, we consider our historical level of credit losses and make judgments about the creditworthiness of significant customers based on ongoing credit evaluations. Since we cannot predict future changes in the financial stability of our customers, actual future losses from uncollectable accounts may differ from our estimates. If the financial condition of our customers were to deteriorate, resulting in their inability to make payments, a larger reserve may be required. In the event we determined that a smaller or larger reserve was appropriate, we would record a credit or a charge to selling and administrative expense in the period in which we made such a determination.
Inventory Reserves. We also make ongoing estimates relating to the market value of inventories, based upon our assumptions about future demand and market conditions. If we estimate that the net realizable value of our inventory is less than the cost of the inventory recorded on our books, we record a reserve equal to the difference between the cost of the inventory and the estimated net realizable market value. This reserve is recorded as a charge to cost of goods sold. If changes in market conditions result in reductions in the estimated market value of our inventory below our previous estimate, we would increase our reserve in the period in which we made such a determination and record a charge to cost of goods sold.
Goodwill and Other Intangibles. We adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” effective January 1, 2002. In accordance with SFAS No. 142, we no longer amortize goodwill and intangible assets with indefinite lives, but instead measure these assets for impairment at least annually, or when events indicate that impairment exists. We continue to amortize intangible assets that have definite lives over their useful lives.
Income Taxes. As part of the process of preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves us estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items, such as deferred revenue, for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our Balance Sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the Statement of Operations.
Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets. Management continually evaluates our deferred tax asset as to whether it is likely that the deferred tax assets will be realized. If management ever determined that our deferred tax asset was not likely to be realized, a write-down of that asset would be required and would be reflected in the provision for taxes in the accompanying period.
Currency Rate Fluctuations
Changes in the relative values of non-U.S. currencies to the U.S. dollar affect our results. During 2004, we conducted a significant portion of our business in foreign currencies, including the Euro, the Swedish Krona, the Swiss Franc and the Taiwan dollar. At December 31, 2004, currency changes resulted in assets, liabilities, revenues and expenses being translated into more U.S. dollars than at December 31, 2003. The U.S. dollar weakened 9% compared to the Euro and Swedish Krona, 8% compared to the Swiss Franc and 3% compared to the Taiwan dollar during the year ended December 31, 2004. The Euro, the Swedish Krona and the Swiss Franc primarily impact our networking business, while the Taiwan dollar affects our optical components business. However, because we have revenues and expenses in each of these foreign currencies, the effect on our results of operations from currency fluctuations is reduced. We do not regularly attempt to reduce our currency risks through hedging instruments, however, we may do so in the future.
Management Discussion Snapshot
The following table sets forth, for the periods indicated, certain Statement of Operations data (dollars in thousands):
NM - not meaningful
(1) Revenue information by segment includes intersegment revenue, primarily reflecting sales of fiber optic components to the networking group. No revenues were generated by the development stage enterprise group for the periods presented.
(2) Statement of Operations data express percentages as a percentage of revenue. Statement of Operations data by segment express percentages as a percentage of applicable segment revenue. No revenues or corresponding gross profit were generated by the Development stage enterprise group in 2004 or 2003.
The following management discussion and analysis refers to and analyzes our results of operations among three segments as defined by our management. These three segments are our networking group, optical components group and development stage enterprise group, which includes all start-up activities.
Year Ended December 31, 2004 (“2004”) Compared
To Year Ended December 31, 2003 (“2003”)
Revenue
(1)
Adjustments represent the elimination of intersegment revenue in order to reconcile to consolidated revenues.
(2)
Percentage information in constant currencies in the table and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results are calculated by translating the current year results at prior year average exchange rates.
Revenues for 2004 increased $32.7 million, or 14%, to $271.7 million from $239.0 million for 2003. We realized increases in revenues from sales of all of our product lines. The weakening of the U.S. dollar during the year compared with certain European currencies, in which we do business, contributed $16 million to the year-over-year increase in revenues. On a constant currency basis, revenues increased 7%. In absolute dollars, sales of our fiber optic components and switches and routers generated the strongest product line growth. Our console management products also reported strong growth with an increase of 24% year-over-year. Geographically, revenues increased 24% in the Americas. We attribute the increase in our revenues in the Americas to initial shipments of FTTP products for early deployments. FTTP networks use fiber optic cables, rather than copper cables, to deliver voice, video and high speed data to customer premises. These networks can transmit voice, data and video signals at speeds and capacities far exceeding the traditional broadband services currently offered by telecommunication providers. FTTP will allow these providers to offer superior services at very competitive prices. Shipments of FTTP products for 2004 totaled approximately $24 million ($17 million was generated in the last half of 2004). Recent announcements suggest that FTTP deployments in North America are expected to make services available to at least one million residential homes by the end of the year; however the number of actual residential homes subscribing to such services is expected to be a fraction of the total deployments. We expect sales of FTTP products to continue to grow in 2005 and beyond. However, this forward looking statement may not come to pass if the actual deployments do not meet the expectations of industry announcements, if the orders we expect to receive do not materialize, are delayed or cancelled or if we are unable to ship the products as required.
For 2004, 46% of our revenues were generated from the sale of third-party products through our system integration and distribution offices as compared to 48% of our revenues in 2003. Revenues generated from internally produced products increased $21.3 million during 2004.
Networking Group. Our networking group provides equipment used by commercial customers, governments and telecommunications service providers, which includes switches, routers, physical layer products and console management products as well as specialized networking products for defense, aerospace and other applications, including cellular communications. External revenues generated from our networking group increased $24.8 million, or 12%, to $227.2 million for 2004 as compared to $202.4 million for 2003. The increase is due to increases in sales of all of our networking products. Sales of our console management products, other networking products and switches and routers generated the largest percentage gains year-over-year. The effect of currency fluctuations contributed $15 million to the year-over-year increase in revenues. On a constant currency basis, revenues increased 5%. External revenues generated from the sales of console management products increased $3.9 million, or 24%, to $20.6 million for 2004 compared to $16.6 million for 2003. External revenues generated from the sales of our other networking products increased $6.4 million, or 20%, to $38.7 million for 2004 compared to $32.3 million for 2003. External revenues generated from the sales of our switches and routers increased $8.2 million, or 13%, to $72.2 million for 2004 compared to $64.0 million for 2003.
Optical Components Group. Our optical components group designs, manufactures and sells optical communications components and primarily consists of products manufactured by our wholly owned subsidiary, LuminentOIC. These components include fiber optic transceivers, discrete lasers and LEDs, as well as components for FTTP applications. Revenues, including intersegment revenue, generated from our optical components group increased $7.6 million, or 20%, to $46.4 million for 2004 as compared to $38.8 million for 2003. We attribute the increase in optical components revenue to initial shipments of FTTP components for North American deployments, which generated revenues totaling $24 million in 2004 ($17 million was generated in the last half of 2004). Additionally, shipments of FTTP products were the primary catalyst for our increase in sales in the Americas. The effect of currency fluctuations contributed $1 million to the year-over-year increase in revenues. On a constant currency basis, revenues increased 18%.
Development Stage Enterprise Group. No revenues were generated by these entities for 2004 and 2003.
Gross Profit
(1)
Percentage information in constant currencies in the table and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results are calculated by translating the current year results at prior year average exchange rates.
Gross profit for 2004 was $91.9 million, compared to gross profit of $74.1 million for 2003. Gross profit increased $17.8 million, or 24%, in 2004 compared to 2003. Our gross margin for 2004 improved to 34% compared to 31% for 2003, representing year-over-year improvement of $14.6 million, or 21%. The increase in gross profit is the result of the increase in revenue and the composition of product sales, primarily the increase in internally produced products. Revenues generated from internally produced products increased $21.3 million during 2004, which generate gross margins at rates higher than our company-wide averages. The effect of currency fluctuations also contributed $4 million to the year-over-year increase in gross profit. On a constant currency basis, gross profit increased 18%.
Networking Group. Gross profit for our networking group was $85.4 million for 2004 compared to $70.8 million for 2003. Gross margins improved to 38% for 2004, compared to gross margin of 35% for 2003. We attribute the improvement in gross margin during 2004 to the composition of our product revenue, specifically the increase in sales of our internally produced products. Gross margins generated from these product sales are at rates higher than our company-wide averages. The effect of currency fluctuations also contributed $4 million to the year-over-year increase in gross profit. On a constant currency basis, gross profit increased 15%.
Optical Components Group. Gross profit for 2004 was $6.5 million, compared to $3.3 million for 2003, an improvement of $3.2 million, primarily as a result of the increase in FTTP sales. Gross margins improved to 14% for 2004, compared to gross margin of 8% for 2003. The improvement in gross margin for 2004 is attributed to the increase in product sales, including the contribution from the initial shipments of FTTP products for early deployments. Gross margins are expected to continue to improve as a result of anticipated operational efficiencies and economies of scale. We continued transitioning volume manufacturing to our Taiwanese optical components facility which resulted in significant savings in direct labor in the fourth quarter of 2004 compared to the third quarter of 2004. Further, we began to realize efficiencies in material costs due to increased volumes and purchasing power. The effect of currency fluctuations did not have a significant impact on the year-over-year increase in gross profit in absolute dollars.
Development Stage Enterprise Group. As we had no sales by these entities, no gross margins were produced by these entities for 2004 and 2003.
Operating Costs and Expenses
(1)
Percentage information in constant currencies in the table and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results are calculated by translating the current year results at prior year average exchange rates.
Operating costs and expenses were $99.1 million, or 36% of revenues, for 2004, compared to $94.2 million, or 39% of revenues, for 2003. Operating costs and expenses increased $4.8 million, or 5%, in 2004 compared to 2003. For 2004, operating costs and expenses included deferred stock expense totaling $168,000, while 2003 included income from recapturing accelerated deferred stock expense due to terminations that amounted to $7.0 million . These changes in deferred stock expense (i.e., expense in 2004 compared to income reported in 2003) accounted for an increase in operating costs and expenses totaling $7.2 million. The effect of currency fluctuations contributed $3 million to the year-over-year increase in operating costs and expenses. On a constant currency basis, operating costs and expenses increased 2%. The increase in operating costs and expenses resulting from the changes in deferred stock expense and foreign currency exchange rates was offset by cost savings efforts, including head count reductions and lower spending in product development and engineering.
Networking Group. Operating costs and expenses for 2004 were $80.7 million, or 36% of revenues, compared to $73.0 million, or 36% of revenues, for 2003. Operating costs and expenses increased $7.6 million, or 10%, in 2004 compared to 2003. For 2004, operating costs and expenses included deferred stock expense totaling $141,000, while 2003 included income from recapturing accelerated deferred stock expense due to terminations that amounted to $6.7 million. Changes in deferred stock expenses accounted for an increase in our operating costs and expenses of $6.9 million. The effect of currency fluctuations contributed $3 million to the year-over-year increase in operating costs and expenses. On a constant currency basis, operating costs and expenses increased 7%. For 2004, we also experienced additional sales and marketing expenses associated with higher revenues, such as sales commissions. These increases were partially offset by reductions in our product development and engineering expenses as we continue to focus our efforts on strategic high-growth, high-return markets.
Optical Components Group. Operating costs and expenses for 2004 were $16.3 million, or 35% of revenues, compared to $14.4 million, or 37% of revenues, for 2003. Operating costs and expenses increased $2.0 million, or 14%, in 2004 compared to 2003. We attributed the increase in our operating costs and expenses to an increase in selling, general and administrative expenses in conjunction with the improvement in our optical components business. The effect of currency fluctuations did not have a significant impact on the year-over-year increase in operating costs and expenses in absolute dollars.
Development Stage Enterprise Group. Operating costs and expenses for 2004 were $2.1 million, compared to $6.8 million for 2003. Operating costs and expenses decreased $4.7 million, or 69%, in 2004 compared to 2003. We attribute the decrease in operating costs and expenses to our cost saving efforts, which mainly consisted of significant head count reductions to align these costs with current development activities.
Operating Income (Loss)
(1)
Percentage information in constant currencies in the table and in the text below excludes the effect of foreign currency translation on reported results. Constant currency results are calculated by translating the current year results at prior year average exchange rates.
We reported an operating loss of $7.2 million, or 3% of revenues, for 2004 compared to $20.1 million, or 8% of revenues, for 2003. We reduced our operating loss by $13.0 million, or 64%, in 2004 compared to 2003. This improvement is the result of our cost reduction efforts and the realignment of our costs and expenses with current operations along with our overall increase in sales and gross profit, primarily through our networking group. The effect of currency fluctuations contributed $1 million to the year-over-year improvement in our operating loss. On a constant currency basis, our operating loss improved 57%.
Networking Group. Our networking group reported operating income totaling $4.7 million, or 2% of revenues, for 2004, compared to an operating loss of $2.2 million, or 1% of revenues, for 2003, an improvement of $7.0 million. This improvement is the result of our increased sales and gross profit, partially offset by changes in deferred stock expense and increase sales and marketing expenses. The effect of currency fluctuations contributed $1 million to the year-over-year increase in our operating income.
Optical Components Group. Our optical components group reported an operating loss of $9.8 million, or 21% of revenues, for 2004, compared to $11.1 million, or 29% of revenues, for 2003. Our operating loss improved $1.3 million, or 11%, in 2004 compared to 2003. Our reduction in operating loss was the result of improved sales and gross profit, partially offset by increases in operating costs and expenses resulting. The effect of currency fluctuations did not have a significant impact on the year-over-year improvement in our operating loss in absolute dollars.
Development Stage Enterprise Group. Our development stage enterprise group reported an operating loss of $2.1 million for 2004, compared to $6.8 million for 2003. Our operating loss improved $4.7 million, or 69%, in 2004 compared to 2003. The improvement is the result of a significant reduction in spending for operating costs and expenses.
Interest Expense And Other Income (Expense), Net
Interest expense was $3.1 million and $3.2 million for 2004 and 2003, respectively. Other income (expense), net principally includes interest income on cash and investments. During 2004, other income (expense), net includes a gain on the sale of an investment totaling $2.0 million. During 2003, we retired $5.9 million principal amount of our 1998 Notes in exchange for the issuance of 4.2 million shares of our common stock to the holders of these notes. As a result of this exchange, we recognized a loss on the extinguishment of debt totaling $5.4 million, net of associated taxes.
Provision For Taxes
The provision for income taxes for 2004, principally foreign taxes, was $3.0 million, compared to $2.4 million for 2003. The increase in tax expense in 2004 versus 2003 was primarily due to increases in income in various jurisdictions where we pay income tax. During 2004, we recorded an additional valuation allowance against additional deferred income tax assets, principally domestic net operating losses and unrealized tax credits.
Year Ended December 31, 2003 (“2003”) Compared
To Year Ended December 31, 2002 (“2002”)
Revenue
Revenues for 2003 decreased $13.5 million, or 5%, to $239.0 million from $252.5 million for 2002. The decrease was due to the worldwide economic slowdown in general and specifically the downturn in telecommunications spending for optical components, partially offset by the positive impact resulting from the weakened U.S. dollar compared to our other functional currencies. Additionally, the decrease in revenues is the result of the loss of revenues from our divestiture of FOCI Fiber Optic Communications, Inc., or FOCI, and Quantum Optech, Inc., or QOI, in October 2002 that amounted to $17.0 million in 2002.
For 2003, 48% of our revenues were generated from the sale of third-party products through our system integration and distribution offices, as compared to 39% during 2002. Our revenues by segments for 2003 and 2002 were as follows (in thousands):
(1)
Adjustments represent the elimination of intersegment revenue in order to reconcile to consolidated revenues.
Networking Group. Our networking group provides equipment used by commercial customers, governments and telecommunications service providers, which includes switches, routers, network physical infrastructure equipment and remote device management equipment as well as specialized networking products for defense, aerospace and other applications, including cellular communications. External revenues generated from our networking group increased $16.7 million, or 9%, to $202.4 million for 2003 as compared to $185.7 million for 2002. The increase is due to increases in sales of switches and routers, services and other networking products. External revenues generated from sales of switches and routers increased $6.5 million, or 11%, to $64.0 million for 2003 as compared to $57.6 million for 2002. The external revenues from our networking group were also positively impacted by the effect of the weakened U.S. dollar compared to our other functional currencies, primarily the Euro. External revenues generated from sales of switches and routers are heavily dependent on our international offices. External revenues generated from sales of our remote device management products decreased $735,000, or 4%, to $16.6 million for 2003 as compared to $17.4 million for 2002. External revenues generated from sales of our network physical infrastructure products decreased by $5.1 million, or 9%, to $50.5 million for 2003 as compared to $55.6 million for 2002. External revenues from sales of our other networking products, which include defense, aerospace and other applications, including cellular communications, increased $11.8 million, or 57%, during 2003 to $32.3 million from $20.6 million for 2002. We attribute the increase in our overall external revenues to an increased number of governmental projects and improved penetration into the markets served by these products.
Optical Components Group. Our optical components group designs, manufactures and sells optical communications components and primarily consists of products manufactured by our wholly owned subsidiary, LuminentOIC. These components include fiber optic transceivers, discrete lasers and LEDs, as well as components for FTTP applications. Revenues, including intersegment revenue, generated from our optical components group decreased $28.5 million, or 42%, to $38.8 million for 2003 as compared to $67.3 million for 2002. We attribute the decrease in optical components revenue to the current slowdown in telecommunications spending for optical components. External revenues generated from optical passive components decreased $13.9 million, or 48%, to $14.9 million for 2003 as compared to $28.7 million for 2002. The decrease in revenues from sales of optical passive components is primarily due to the loss of revenues from our divestiture of FOCI and QOI in October 2002 that amounted to $17.0 million in 2002, in addition to decreases in our sales of these components through our remaining offices. External revenue generated from optical active components decreased $12.3 million, or 24%, to $39.0 million for 2003 as compared to $51.3 million for 2002. We attribute the decrease in revenues from optical active components to a sector-wide oversupply, which has adversely impacted the average selling prices of these components.
Development Stage Enterprise Group. No significant revenues were generated by these entities for 2003 and 2002.
Gross Profit
Gross profit for 2003 was $74.1 million, compared to gross profit of $83.0 million for 2002. Gross profit decreased $8.9 million, or 11%, in 2003 compared to 2002. For 2003 and 2002, gross profit includes income from recapturing accelerated deferred stock expense due to terminations that amounted to $1.1 million and $878,000, respectively. Gross profit for 2003 was also positively affected by the utilization of $1.7 million of the product credit received from the divestiture of FOCI and QOI in 2002.
Our gross margin slightly decreased to 31% for 2003, compared to gross margin of 33% for 2002. We attribute the decrease in our gross margin to a change in the composition of our product revenues. Our percentage of third-party equipment revenues increased during 2003, which generated lower gross margins. The weakened U.S. dollar compared to the Euro resulted in an increase in our cost of goods sold, particularly in lower margin business through our European offices.
Networking Group. Gross profit for 2003 was $70.8 million, compared to gross profit of $67.5 million for 2002. Gross profit increased $3.4 million, or 5%, in 2003 compared to 2002. Gross margins decreased to 35% for 2003, compared to gross margin of 36% for 2002. For 2003, our networking group’s gross profit includes income from the recapture of accelerated deferred stock expense due to terminations totaling $1.1 million, compared to deferred stock expense totaling $297,000 for 2002. Changes in deferred stock expense amounted to $1.4 million of the gross margin improvement. In addition to the decrease in deferred stock expense, we attribute the increase in gross profit during 2003 to the effects of improved operating efficiencies and cost reduction efforts.
Optical Components Group. Gross profit for 2003 was $3.3 million, compared to gross profit of $16.4 million for 2002. Gross profit decreased $13.1 million, or 80%, in 2003 compared to 2002. Gross margins decreased to 8% for 2003, compared to gross margin of 24% for 2002. For 2003 and 2002, the optical components group’s gross profit includes income from recapturing accelerated deferred stock expense due to terminations that amounted to $50,000 and $1.2 million, respectively. Changes in deferred stock expense accounted for $1.1 million of the decrease in gross profit in 2003. Gross profit decreased due to the sale of FOCI and QOI in October 2002, which contributed gross profit that amounted to $2.0 million in 2002, along with increased competition and continued market contraction resulting in lower average selling prices.
Development Stage Enterprise Group. No significant gross margins were produced by these entities for 2003 and 2002.
Operating Costs and Expenses
Operating costs and expenses were $94.2 million, or 39% of revenues, for 2003, compared to $229.3 million, or 91% of revenues, for 2002. Operating costs and expenses decreased $135.1 million, or 59%, in 2003 compared to 2002. For 2003, operating costs and expenses include income from the recapture of accelerated deferred stock expense due to terminations that amounted to $7.0 million, while 2002 includes $7.5 million in deferred stock expense. Changes in deferred stock expenses accounted for $14.5 million of the decrease in our operating costs and expenses. For 2003, operating costs and expenses include an impairment of goodwill and other intangibles that amounted to $356,000. Operating costs and expenses for 2002, includes impairment losses on goodwill and other intangibles and long-lived assets that amount to $72.7 million and $17.0 million, respectively. In addition to the income from the recapture of deferred stock expense and the substantial reduction in impairment losses on goodwill and other tangibles and long-lived assets, we attribute the decrease in operating costs and expenses during 2003 to our overall cost reduction efforts to align these costs with current operations. We reduced spending in product development and engineering and selling, general and administrative expenses.
Networking Group. Operating costs and expenses for 2003 were $73.0 million, or 36% of revenues, for 2003, compared to $126.2 million, or 68% of revenues, for 2002. Operating costs and expenses decreased $53.2 million, or 42%, in 2003 compared to 2002. For 2003, operating costs and expenses include income from recapturing accelerated deferred stock expense due to terminations that amounted to $6.7 million, while 2002 includes $6.8 million in deferred stock expense. Changes in deferred stock expenses accounted for $13.5 million of the decrease in our operating costs and expenses. For 2003, operating costs and expenses include an impairment of goodwill and other intangibles that amounted to $356,000. Operating costs and expenses for 2002, includes impairment losses on goodwill and other intangibles and long-lived assets that amount to $20.1 million and $17.0 million, respectively. In addition to the impact from income from the recapture of deferred stock expense and impairment losses, we attribute the decrease in operating costs and expenses during 2003 to our cost saving efforts, including head count reductions, to align these costs with current operations. We reduced spending in the areas of product development and engineering and general and administrative expense, while slightly increasing spending for selling and marketing efforts.
Optical Components Group. Operating costs and expenses for 2003 were $14.4 million, or 37% of revenues, for 2003, compared to $79.0 million, or 117% of revenues, for 2002. Operating costs and expenses decreased $64.6 million, or 82%, in 2003 compared to 2002. For 2003, operating costs and expenses include income from recapturing accelerated deferred stock expense due to terminations that amounted to $240,000, while 2002 includes $624,000 in deferred stock expense. Changes in deferred stock expenses accounted for $864,000 of the decrease in our operating costs and expenses. Operating costs and expenses for 2002, includes an impairment loss on goodwill and other intangibles that amounted to $51.9 million. We attributed the remaining decrease in our operating costs and expenses to our cost saving efforts, including head count reductions, to align these costs with current operations. We reduced spending in the areas of product development and engineering, selling, general and administrative expenses.
Development Stage Enterprise Group. Operating costs and expenses for 2003 were $6.8 million for 2003, compared to $24.1 million for 2002. Operating costs and expenses decreased $17.2 million, or 72%, in 2003 compared to 2002. We attribute the decrease in operating costs and expenses to our cost saving efforts, including head count reductions, to align these costs with current development activities.
Operating Loss
We reported an operating loss of $20.1 million, or 8% of revenues, for 2003 compared to $146.3 million, or 58% of revenues, for 2002. We reduced our operating loss by $126.2 million, or 86%, in 2003 compared to 2002. For 2003, our operating loss includes an impairment of goodwill and other intangibles that amounted to $356,000. Our operating loss for 2002 includes impairment losses on goodwill and other intangibles and long-lived assets that amount to $72.7 million and $17.0 million, respectively. This improvement is the result of our cost reduction efforts and the realignment of our costs and expenses with current operations along with our improvement in gross profit. Our reduction in net loss was also positively impacted by income resulting from our reversal of deferred stock expense in 2003 compared to reporting such expenses in 2002 and the substantial reduction in impairment losses on goodwill and other tangibles and long-lived assets in 2003.
Networking Group. Our networking group reported an operating loss of $2.2 million, or 1% of revenues, for 2003, compared to an operating loss of $58.8 million, or 32% of revenues, for 2002. This improvement is the result of our reduced spending for operating costs and expenses, along with the substantial reduction in impairment losses in 2003. Our results in 2003 were also positively impacted by income resulting from our reversal of deferred stock expenses in 2003 compared to reporting such expenses in 2002.
Optical Components Group. Our optical components group reported an operating loss of $11.1 million, or 29% of revenues, for 2003, compared to $62.7 million, or 93% of revenues, for 2002. Our operating loss improved $51.5 million, or 82%, in 2003 compared to 2002. Our reduction in operating loss was the result of the substantial reduction in impairment loss on goodwill and other intangibles in 2003 along with the favorable impact from our reversal of deferred stock expense in 2003 compared to reporting such expenses in 2002.
Development Stage Enterprise Group. Our development stage enterprise group reported an operating loss of $6.8 million for 2003, compared to $24.1 million for 2002. Our operating loss improved $17.2 million, or 72%, in 2003 compared to 2002. The improvement is the result of a significant reduction in spending for operating costs and expenses.
Amortization of Intangibles
During the fourth quarter of 2003, we conducted our annual review of our goodwill and intangible assets as required by SFAS 142. The review resulted in no further reduction in the carrying amount of goodwill. During 2003, we impaired $356,000 in goodwill from a foreign office that ceased operations.
We recorded a $296.4 million cumulative effect of an accounting change in 2002, as the result of our adoption of SFAS No. 142 effective January 1, 2002. As a consequence of our adoption of SFAS No. 142, we no longer amortize goodwill and intangibles with indefinite lives, but instead measure goodwill and other intangibles for impairment at least annually, or when events indicate that impairment exists. We continue to amortize intangible assets that we determine to have definite lives over their useful lives. As required by SFAS No. 142, we performed the transitional impairment test on goodwill and other intangibles, which consisted of patents and assembled work forces. Of the $296.4 million cumulative effect of an accounting change, $84.6 million was associated with our networking group and $211.8 million was associated with our optical components group.
Beginning October 1, 2002, we also performed the annual impairment review required by SFAS No. 142. As a result of the annual review, we further reduced the carrying amount of goodwill and other intangibles by recording an impairment charge of $72.7 million in the third quarter of 2002. Of the $72.7 million impairment, $20.1 million was associated with our networking group, $51.9 million was associated with our optical components group and $641,000 was associated with our development stage enterprise group.
Interest Expense and Other Income (Expense), Net
In June 2003, we completed the sale of $23.0 million principal amount of five-year 5% convertible notes due in 2008 (the “2003 Notes”), to an institutional investor, in a private placement. The 2003 Notes bear interest at 5% per annum and are convertible into our common stock at a conversion price of $2.32 per share. We are using the net proceeds from the sale of the 2003 Notes for general corporate purposes and working capital. Interest expense relating to these notes was $672,000 for 2003.
In June 1998, we issued $100.0 million principal amount of our 1998 Notes. During 2003, we retired $5.9 million principal amount of 1998 Notes in exchange for the issuance of 4.2 million shares of our common stock to the holders of these notes, resulting in a remaining outstanding balance of $26.0 million at maturity. On June 15, 2003, the balance of our outstanding 1998 Notes matured and we repaid and retired them. For 2003, we recognized a loss on the extinguishment of debt totaling $5.4 million, net of associated taxes. This loss was recognized in accordance with Emerging Issues Task Force Issue 02-15 released in September 2002. During the year ended December 31, 2002, we acquired $31.6 million in principal amount of these notes in exchange for our issuance of 12.3 million shares of our common stock to the holders of these notes. During 2002, we also purchased $21.4 million in principal amount of these notes in exchange for $19.7 million in cash. During 2002, we recognized a gain of $393,000 in connection with the extinguishment of debt. We incurred $773,000 and $3.2 million in interest expense relating to the 1998 Notes for 2003 and 2002, respectively.
During 2003, other income (expense), net totaling $3.3 million, represented our loss on the extinguishment of debt, partially offset by interest income on cash and investments. Interest expense was $3.2 million and $6.0 million for 2003 and 2002, respectively. We account for certain unconsolidated subsidiaries using the cost and equity methods. During 2002, we impaired $11.7 million on our investments in these subsidiaries along with $4.3 million from our share of losses from our equity method investments. For 2002, we recognized $3.2 million in interest expense associated with the termination of our interest rate swap.
Provision For Taxes
We record valuation allowances against our deferred tax assets, when necessary, in accordance with SFAS No. 109, “Accounting for Income Taxes.” Realization of deferred tax assets (such as net operating loss carryforwards and income tax credits) is dependent on future taxable earnings and is therefore uncertain. At least quarterly, we assess the likelihood that our deferred tax asset balance will be recovered from future taxable income. Our tax expense fluctuates primarily due to the tax jurisdictions where we currently have operating facilities and the varying tax rates in those jurisdictions.
The provision for income taxes for 2003, principally foreign taxes, was $2.4 million, compared to $13.4 million for 2002. During 2002, we recorded an additional valuation allowance, or additional tax expense, totaling $21.2 million relating to the expected realization of our deferred income tax assets based on likely future recovery. For 2003 and 2002, there was no benefit provided for net operating losses.
Recently Issued Accounting Standards
In November 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” The amendments made by SFAS No. 151 clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The pronouncement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years after November 23, 2004. The adoption of this pronouncement is not expected to have a material effect on the financial condition, the results of operations or liquidity.
On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.
SFAS No. 123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. We expect to adopt SFAS No. 123(R) on July 1, 2005, the beginning of our third quarter of 2005. We are currently evaluating the two methods of adoption allowed by SFAS No. 123(R): the modified-prospective transition method and the modified-retrospective transition method. The impact of adopting this pronouncement cannot be predicted at this time because it will depend on many factors, including the levels of share-based payments granted in the future. However, had we adopted this pronouncement in prior periods, the impact of this pronouncement would approximate the impact of SFAS No. 123 described in the disclosure of the pro forma results in Note 2, “Summary of Significant Accounting Policies - Stock-Based Compensation” in our Notes to Financial Statements included elsewhere in this Form 10-K.
Liquidity and Capital Resources
We had cash and cash equivalents of $77.2 million as of December 31, 2004, a decrease of $10.4 million from the cash and cash equivalents of $87.6 million as of December 31, 2003. The decrease in cash and cash equivalent is primarily the result of cash used in our operations, timing of cash collections from customers, cash used to procure necessary inventories, cash used to satisfy vendor obligations and net payments on short-term and long-term obligations. The following table illustrates our cash position, which we define as cash, cash equivalents, time deposits and short-term and long-term marketable securities, as it relates to our debt position, which we define as all short-term and long-term obligations including our 2003 Notes (in thousands):
(1)
Reclassified to conform with 2004 presentation.
(2)
Determined by dividing total “cash” by total “debt,” in each case as reflected in the table.
Working Capital
Current assets increased $8.6 million due to increases in all current asset categories with accounts receivables and inventory representing the largest increases, partially offset by decreases in cash and cash equivalents and short-term marketable securities. The increases were also affected by foreign currency. Fluctuations in current assets are typically due to the timing of: shipments of our products to customers, receipts of inventories from our vendors, cash used for capital expenditures and the affects of foreign currency.
Current liabilities increased $2.7 million primarily due to increases in short-term obligations and accrued liabilities. These increases were partially offset by decreases in accounts payable. These increases were also affected by foreign currency. Fluctuations in current liabilities are typically due to the timing of: payments to our vendors for raw materials, timing of payments for accrued liabilities, such as payroll related expenses and interest on our short-term and long-term obligations, changes in deferred income, income tax liabilities and the affects of foreign currency.
Cash Flow
Cash Flows Related to Operating Activities. Cash used in operating activities was $21.6 million for the year ended December 31, 2004, compared to cash used in operating activities of $17.0 million for the year ended December 31, 2003. Cash used in operating activities is a result of our net loss of $10.7 million, adjusted for non-cash items such as depreciation and amortization, additional allowances for doubtful accounts, deferred stock expense, deferred income taxes and losses on the disposition of fixed assets. Decreased accrued liabilities and deferred revenue positively affected cash used in operating activities. Cash used in operating activities was negatively affected by increases in time deposits, accounts receivable, inventories and other assets and decreases in accounts payable and other current liabilities. The increase in accounts receivables is due to a general increase in business worldwide. The increase in inventories results from an increase in FTTP products for future shipments, along with increases throughout our networking group in response to an increase in business worldwide. Decreases in accounts payable are the result of the timing of payments to our vendors. Cash used in operating activities for the prior period was the result of our net loss adjusted for non-cash items and changes in assets working capital.
Cash Flows Related to Investing Activities. Cash used in investing activities was $448,000 for the year ended December 31, 2004, compared to cash provided by investing activities totaling $3.7 million for the year ended December 31, 2003. Cash used in investing activities for the year ended December 31, 2004 was primarily the result of capital expenditures, partially offset by maturities of investments and proceeds from the sale of property and equipment. As of December 31, 2004, we had no plans for major capital expenditures. Cash flows provided by investing activities for the prior period resulted from the maturities of short-term and long-term marketable securities, partially offset by the cash used for capital expenditures and the purchase of a minority interest.
Cash Flows Related to Financing Activities. Cash flows provided by financing activities were $6.3 million for the year ended December 31, 2004, as compared to cash flows used in financing activities of $1.2 million for the year ended December 31, 2003. Cash provided by financing activities was primarily the result of our net borrowings of $4.4 million on our short-term and long-term obligations, net proceeds from the exercise of employee stock options and increases in other long-term liabilities. Cash flows used in financing activities for the prior period represent the cash paid on borrowings, our final payment on our 5% convertible subordinated notes which came due in June 2003, proceeds from the issuance of 5% convertible notes due in June 2008 and the repurchase of our common stock.
In June 1998, we issued $100.0 million principal amount of our 1998 Notes in a private placement raising net proceeds of $96.4 million. During 2003, prior to their maturity on June 15, 2003, we acquired
During the year ended December 31, 2002, we acquired $31.6 million in principal amount of these notes in exchange for our issuance of 12.3 million shares of our common stock to the holders of these notes. During 2002, we also purchased $21.4 million in principal amount of these notes in exchange for $19.7 million in cash. At maturity on June 15, 2003, we repaid in full the $26.0 million outstanding balance of our outstanding 1998 Notes using cash on-hand.
In June 2003, we completed the sale of $23.0 million principal amount of our 2003 Notes to an institutional investor in a private placement under the Securities Act of 1933. These notes have an annual interest rate of 5% and are convertible into our common stock at a conversion price of $2.32 per share. We are using the net proceeds from the sale of these notes for general corporate purposes and working capital.
During October 2003, we issued and sold 1,667,000 shares of our common stock to several institutional investors that are managed client accounts of a large investment management firm, raising net proceeds of approximately $5.0 million. These shares were taken from our shelf registration statement that was declared effective by the SEC in June 2003, which registered $20.0 million of our common stock that we may issue and sell from time to time.
Off-Balance Sheet Arrangements
We do not have transactions, arrangements and other relationships with unconsolidated entities that are reasonably likely to affect our liquidity or capital resources. We have no special purpose or limited purpose entities that provided off-balance sheet financing, liquidity or market or credit risk support, engage in leasing, hedging, research and development services, or other relationships that expose us to liability that is not reflected on the face of the financials.
Contractual Cash Obligations
The following table illustrates our total contractual cash obligations as of December 31, 2004 (in thousands):
Our total contractual cash obligations as of December 31, 2004, were $84.2 million, of which, $38.3 million are due by December 31, 2005. These total contractual cash obligations primarily consist of short-term and long-term obligations, including our 5% convertible notes due June 2008, operating leases for our equipment and facilities and unconditional purchase obligations for necessary raw materials. Historically, these obligations have been satisfied through cash generated from our operations or other avenues and we expect that this will continue to be the case.
We believe that our cash on hand and cash flows from operations will be sufficient to satisfy our current operations, capital expenditures and product development and engineering requirements for at least the next 12 months. However, we may choose to obtain additional debt or equity financing if we believe it appropriate. We are limited in the amount of debt financing we may obtain and the price per share of common stock at which we may conduct equity financings without triggering an acceleration of, or obtaining a waiver from holders of, our 5% convertible notes due June 2008. For a discussion of these limitations and other restrictions of our 5% convertible notes due June 2008, see the discussion under “Business - Certain Risk Factors That Could Affect Future Results - Our 2003 Notes Provide For Various Events Of Default That Would Entitle The Holders To Require Us To Immediately Repay The Outstanding Principal Amount, Plus Accrued And Unpaid Interest, In Cash.” Our future capital requirements will depend on many factors, including our rate of revenue growth, the timing and extent of spending to support development of new products and expansion of sales and marketing, the timing of new product introductions and enhancements to existing products and market acceptance of our products.
Internet Access to Our Financial Documents
We maintain a website at www.mrv.com. We make available free of charge, either by direct access or a link to the SEC website, our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended, as soon as reasonably practicable after such reports are electronically filed with, or furnished to, the SEC. Our reports filed with, or furnished to, the SEC are also available directly at the SEC’s website at www.sec.gov.
ITEM 7a.
ITEM 7a. QUANITITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
Market Risks
Market risk represents the risk of loss that may impact our Consolidated Financial Statements through adverse changes in financial market prices and rates and inflation. Our market risk exposure results primarily from fluctuations in foreign exchange rates. We manage our exposure to these market risks through our regular operating and financing activities and have not historically hedged these risks through the use of derivative financial instruments. The term hedge is used to mean a strategy designed to manage risks of volatility in prices or interest and foreign exchange rate movements on certain assets, liabilities or anticipated transactions and creates a relationship in which gains or losses on derivative instruments are expected to counter-balance the losses or gains on the assets, liabilities or anticipated transactions exposed to such market risks.
Interest Rates. We are exposed to interest rate fluctuations on our investments, short-term borrowings and long-term obligations. Our cash and short-term investments are subject to limited interest rate risk, and are primarily maintained in money market funds and bank deposits. Our variable-rate short-term borrowings are also subject to limited interest rate risk due to their short-term maturities. Our long-term obligations were entered into with fixed and variable interest rates. In connection with our $50.0 million variable-rate term loan due in 2003, we entered into a specific hedge, an interest rate swap, to modify the interest characteristics of this instrument. The interest rate swap was used to reduce our cost of financing and the fluctuations in the aggregate interest expense. The notional amount, interest payment and maturity dates of the swap match the principal, interest payment and maturity dates of the related debt. Accordingly, any market risk or opportunity associated with this swap is offset by the opposite market impact on the related debt. In February 2002, we paid off our $50.0 million term loan and terminated our interest rate swap for $3.2 million. To date, we have not entered into any other derivative instruments, however, as we continue to monitor our risk profile, we may enter into additional hedging instruments in the future.
Foreign Exchange Rates. We operate on an international basis with a portion of our revenues and expenses being incurred in currencies other than the U.S. dollar. Fluctuation in the value of these foreign currencies in which we conduct our business relative to the U.S. dollar affect our results and will cause U.S. dollar translation of such currencies to vary from one period to another. We cannot predict the effect of exchange rate fluctuations upon future operating results. However, because we have revenues and expenses in each of these foreign currencies, the effect on our results of operations from currency fluctuations is reduced. We do not regularly attempt to reduce our currency risks through hedging instruments, however, we may do so in the future.
During 2004, we conducted a significant portion of our business in the Euro, the Swedish Krona, the Swiss Franc and the Taiwan dollar. At December 31, 2004, currency changes resulted in assets, liabilities, revenues and expenses being translated into more U.S. dollars than at December 31, 2003. The U.S. dollar weakened 9% compared to each of the Euro and Swedish Krona, 8% compared to the Swiss Franc and 3% compared to the Taiwan dollar during the year ended December 31, 2004. The Euro, the Swedish Krona and the Swiss Franc primarily impact our networking business, while the Taiwan dollar affects our optical components business. The effect of currency fluctuations on our results is described in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included herein.
Inflation. We believe that the relatively moderate rate of inflation in the United States over the past few years has not had a significant impact on our sales or operating results or on the prices of raw materials. However, in view of our recent expansion of operations in Taiwan, Israel and other countries, which have experienced greater inflation than the United States, there can be no assurance that inflation will not have a material adverse effect on our operating results in the future.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
The Board of Directors and Stockholders of MRV Communications, Inc.
We have audited the accompanying consolidated balance sheets of MRV Communications, Inc. (and subsidiaries) as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits 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 financial statements referred to above present fairly, in all material respects, the consolidated financial position of MRV Communications, Inc. (and subsidiaries) as of December 31, 2004 and 2003, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of MRV Communication, Inc.’s (and subsidiaries) internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 25, 2005 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Woodland Hills, California
February 25, 2005
MRV Communications, Inc.
Statement of Operations
(In thousands, except per share data)
The accompanying notes are an integral part of these financial statements.
MRV Communications, Inc.
Balance Sheets
(In thousands, except par values)
MRV Communications, Inc.
Balance Sheets
(In thousands, except par values)
The accompanying notes are an integral part of these balance sheets.
MRV Communications, Inc.
Statements of Stockholders’ Equity and Comprehensive Income (Loss)
(In thousands)
MRV Communications, Inc.
Statements of Stockholders’ Equity and Comprehensive Income (Loss)
(In thousands)
The accompanying notes are an integral part of these financial statements.
MRV Communications, Inc.
Statement of Cash Flows
(In thousands)
MRV Communications, Inc.
Statement of Cash Flows
(In thousands)
The accompanying notes are an integral part of these financial statements.
MRV Communications, Inc.
Notes To Financial Statements
December 31, 2004
1. Description of Business
MRV Communications, Inc, (a Delaware corporation, “MRV” or the “Company”) designs, manufactures, sells, distributes, integrates and supports communication equipment and services, and optical components. MRV conducts its business along three principal segments: the networking group, the optical components group and development stage enterprise group. MRV’s networking group provides equipment used by commercial customers, governments and telecommunications service providers, and include switches, routers, physical layer products and console management products as well as specialized networking products for aerospace, defense and other applications including voice and cellular communication. MRV’s optical components group designs, manufactures and sells optical communications components, primarily through its wholly owned subsidiary LuminentOIC, Inc. These components include fiber optic transceivers for metropolitan, access and Fiber-to-the-Premises, or FTTP, applications. MRV’s development stage enterprise group seeks to develop new optical components, subsystems and networks and other products for the infrastructure of the Internet.
2. Summary of Significant Accounting Policies
Principles of Consolidation
The accompanying financial statements include the accounts of MRV and its wholly owned and majority owned subsidiaries. All significant intercompany transactions and accounts have been eliminated. MRV consolidates the financial results of related development stage enterprises when it has effective control, voting control or has provided the entity’s working capital. When others invest in these enterprises reducing its voting control below 50%, MRV discontinues consolidation and uses the cost or equity method of accounting for these investments unless otherwise required.
Foreign Currency
Transactions originally denominated in other currencies are converted into U.S. dollars in accordance with Statement of Financial Accounting Standards (“SFAS”) No. 52, “Foreign Currency Translation.” Increases or decreases in the resulting assets or liabilities, which are denominated in a foreign currency, are recorded as foreign currency gains and losses and are included in other income (expense) in determining net income (loss).
For foreign operations with the local currency as the functional currency, assets and liabilities are translated from the local currencies into U.S. dollars at the exchange rate prevailing at the balance sheet date. Revenues, expenses and cash flows are translated at weighted average exchange rates for the period to approximate translation at the exchange rate prevailing at the dates those elements are recognized in the financial statements. Translation adjustments resulting from the process of translating the local currency financial statements into U.S. dollars are included in determining comprehensive income (loss).
Revenue Recognition
MRV generally recognizes product revenue, net of sales discounts, returns and allowances, when persuasive evidence of an arrangement exits, delivery has occurred and all significant contractual obligations have been satisfied, the fee is fixed or determinable and collection is considered probable. Products are generally shipped “FOB shipping point” with no right of return. Sales of services and system support are deferred and recognized ratably over the contract period. Sales with contingencies, such as rights of return, rotation rights, conditional acceptance provisions and price protection, are rare and insignificant and are deferred until the contingencies have been satisfied or the contingent period has lapsed. MRV’s major revenue-generating products consist of: fiber optic components; switches and routers; console management; and physical layer products.
MRV generally warrants its products against defects in materials and workmanship for one to two year periods. The estimated cost of warranty obligations and sales returns and other allowances are recognized at the time of revenue recognition based on contract terms and prior claims experience.
Cash, Cash Equivalents and Time Deposits
MRV considers all highly liquid investments with an original maturity of 90 days or less to be cash equivalents. MRV maintains cash balances and investments in highly qualified financial institutions. At various times such amounts are in excess of insured limits. Time deposits of $1.6 million and $1.4 million as of December 31, 2004 and 2003, respectively, are restricted by short-term obligations.
Marketable Securities
MRV accounts for its marketable securities, which are available for sale, under the provisions of SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” During 2003, MRV changed its investment classification from “held-to-maturity” to “available for sale.” The original cost of MRV’s marketable securities approximated fair market value as of December 31, 2004 and 2003. As of December 31, 2004 and 2003, short-term and long-term marketable securities consisted principally of U.S. Treasury Bonds, Municipal Bonds and Corporate Bonds. Marketable securities mature at various dates through 2005. Purchase, sales and maturities of securities are presented in the accompanying Statement of Cash Flows.
Accounts Receivable
As of December 31, 2004, 2003 and 2002, the allowance for doubtful accounts totaled $9.4 million, $10.7 million and $15.0 million, respectively. Increases in the allowance for doubtful accounts totaled $1.4 million, $1.8 million and $2.2 million for the years ended December 31, 2004, 2003 and 2002, respectively. Write-offs against the allowance for doubtful accounts totaled $1.1 million, $6.1 million and $1.9 million for the years ended December 31, 2004, 2003 and 2002, respectively. During the year ended December 31, 2004, $1.6 million of the allowance for doubtful accounts was reduced based on period-end assessments of required allowances and has been included in the accompanying Statement of Operations in the period in which such determination was made. If the financial condition of MRV’s customers were to deteriorate, resulting in their inability to make payments, additional provisions would be recorded in that period.
Inventories
Inventories are stated at the lower of cost or market and consist of material, labor and overhead. Cost is determined by the first in, first out method. Inventories consisted of the following (in thousands):
Property and Equipment
Property and equipment are stated at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the related assets, ranging from three to thirty-three years. Maintenance and repairs are charged to expense as incurred and the costs of additions and betterments that increase the useful lives of the assets are capitalized. Property and equipment consisted of the following (in thousands):
Goodwill and Other Intangibles
MRV adopted SFAS No. 142, “Goodwill and Other Intangible Assets,” effective January 1, 2002. In accordance with SFAS No. 142, goodwill and intangible assets with indefinite lives will no longer be amortized, but instead will be measured for impairment at least annually, or when events indicate that impairment exists. Intangible assets that are determined to have definite lives will continue to be amortized over their useful lives (See Note 3, Goodwill and Other Intangible Assets).
Investments
MRV accounts for its investments in unconsolidated entities (see Note 2, Principles of Consolidation) under the provisions of Accounting Principles Board Opinions (“APB”) No. 18, “The Equity Method of Accounting for Investments in common stock,” and related interpretations. Unconsolidated investments, for which MRV does not have the ability to exercise significant influence over operating and financial polices, are accounted for under the cost method. Those investments, for which MRV does have the ability to exercise significant influence over operating and financial policies, are accounted for under the equity method. In general, all investments in which MRV owns greater than 20% of the voting stock, are accounted for under the equity method. Cost and equity method investments totaled $3.1 million as of December 31, 2004 and 2003.
Under the cost and equity method, a loss in value of an investment, which is deemed to be other than a temporary decline, is recognized. Evidence of a loss in value might include, but would not necessarily be limited to, absence of an ability to recover the carrying amount of the investment or inability of the investee to sustain an earnings capacity, which would justify the carrying amount of the investment. During 2004, MRV sold its remaining ownership in an equity method investment resulting in a gain on the sale totaling $2.0 million. This investment had previously been fully impaired. During the year ended December 31, 2002, MRV recognized impairment on investments totaling $11.7 million, which has been included in Other Expense, net.
Impairment of Long-Lived Assets
MRV evaluates its long-term assets, such as property and equipment and other long-term assets, for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may be impaired. MRV considers events or changes such as product discontinuance, plant closures, product dispositions and history of operating losses or other changes in circumstances to indicate that the carrying amount may not be recoverable. The carrying value of an asset is considered impaired when the anticipated undiscounted cash flow from such assets is less than its carrying value. In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair market value. Fair market value is determined using the anticipated cash flows discounted at a rate based on MRV’s weighted average costs of capital, which represents the blended after-tax costs of debt and equity.
For the year ended December 31, 2002, MRV determined that $17.0 million in long-lived assets, primarily property and equipment, were impaired. This amount was determined to be impaired using the method discussed above. The remaining carrying values of the long-lived assets were determined to be realizable. This process and analysis requires management to use significant judgment and apply assumptions regarding the future cash flows expected to result from the use of the assets and the eventual disposition of such assets. While management believes the carrying value of its assets are realizable based on its analysis, changes in the assumptions used in its models could produce significantly different results. The impairment of long-lived assets of $17.0 million for the year ended December 31, 2002 has been included in the determination of operating loss in the accompanying Statement of Operations. The vast majority of these impairments were from the optical components group. There were no impairment losses recorded for the years ended December 31, 2004 and 2003.
Fair Value of Financial Instruments
MRV’s financial instruments, including cash and cash equivalents, time deposits, short-term and long-term marketable securities, accounts receivable, accounts payable, accrued liabilities and short-term debt obligations are carried at cost, which approximates their fair market value due to the short-term nature of those instruments. The fair value of long-term debt obligations is estimated based on current interest rates available to MRV for debt instruments with similar terms, degrees of risk and remaining maturities. The carrying values of these obligations approximate their fair values.
Product Development and Engineering
Product development and engineering costs are charged to expense as incurred.
Software Development Costs
In accordance with SFAS No. 86, “Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed,” development costs related to software products are expensed as incurred until the technological feasibility of the product has been established. Technological feasibility in MRV’s circumstances occurs when a working model is completed. After technological feasibility is established, additional costs would be capitalized.
MRV believes its process for developing software is essentially completed concurrent with the establishment of technological feasibility, and, accordingly, no software development costs have been capitalized to date.
Advertising Costs
Advertising costs are charged to expense as incurred.
Income Taxes
Deferred income tax assets and liabilities are computed based on the temporary differences between the financial statement and income tax bases of assets and liabilities using the statutory marginal income tax rate in effect for the years in which the differences are expected to reverse. Deferred income tax expenses or credits are based on the changes in the deferred income tax assets or liabilities from period to period.
Earnings (Loss) Per Share
Basic earnings (loss) per share is calculated by dividing net income (loss) by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share is calculated by dividing net income (loss) by the sum of the weighted average number of common shares outstanding, plus all additional common shares that would have been outstanding if potentially dilutive securities or common stock equivalents had been issued. Stock options and warrants to purchase 11.0 million, 10.0 million and 12.6 million shares were not included in the computation of years 2004, 2003 and 2002 diluted loss per share because such stock options and warrants were considered anti-dilutive. Shares associated with MRV’s outstanding 5% Convertible Notes issued in June 2003 (“2003 Notes”) and 5% Convertible Subordinated Notes issued in June 1998 and paid in June 2003 (“1998 Notes”) were not included in the computation of loss per share as they are anti-dilutive.
Stock-Based Compensation
MRV accounts for its employee stock plan under the intrinsic value method prescribed by APB No. 25, “Accounting for Stock Issued to Employees,” and related interpretations, and has adopted the disclosure-only provisions of SFAS No. 123, “Accounting for Stock-Based Compensation” and as amended by SFAS No. 148, “Accounting for Stock-Based Compensation - Transition and Disclosure, an amendment of FASB Statement No. 123.”
SFAS No. 123, as amended by SFAS No. 148, permits companies to recognize, as expense over the vesting period, the fair value of all stock-based awards on the date of grant. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options, which have no vesting restrictions and are fully transferable. Because MRV’s stock-based compensation plans have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimate, management believes that the existing option valuation models do not necessarily provide a reliable single measure of the fair value of awards from the plan. Therefore, as permitted, MRV applies the existing accounting rules under APB No. 25 and provides pro forma net loss and pro forma loss per share disclosures for stock-based awards made during the year as if the fair value method defined in SFAS No. 123, as amended, had been applied. Net loss and net loss per share for each of the three years in the period ended December 31, 2004 would have increased to the following pro forma amounts (in thousands, except per share data):
The following assumptions were applied: (i) no expected dividend yield for all periods, (ii) expected volatility ranging from 69% to 84% for 2004, 84% for 2003 and 104% for 2002, (iii) expected lives of 4 to 6 years for all years, (iv) and risk-free interest rates ranging from 2.68% to 6.73% for all years.
MRV accounts for option and warrant grants to non-employees using the guidance prescribed by SFAS No. 123, FASB Interpretation No. (“FIN”) 44, “Accounting for Certain Transactions Involving Stock Compensation (an interpretation of APB Opinion No. 25),” and Emerging Issue Task Force (“EITF”) No. 96-18, “Accounting for Equity Instruments That Are Issued to Other Than Employees for Acquiring, or In Conjunction with Selling, Goods, or Services,” whereby the fair value of such option and warrant grants are measured using the fair value at the earlier of the date at which the non-employee’s performance is completed or a performance commitment is reached.
Deferred stock expense is being amortized using the graded vesting method over four years. Using this method, approximately 57%, 26%, 13% and 4%, respectively, of each option’s compensation expense is amortized in each of the four years following the date of grant. Deferred stock expense generated during 2001 was $7.1 million generated through acquisitions. Deferred stock expense generated during 2000 was $160.8 million of which $106.6 million was generated through acquisitions and $54.2 million was generated through stock options granted to LuminentOIC’s former President and its former Chief Financial Officer (“CFO”). There has been no deferred stock expense generated since December 31, 2001. In June 2002 and September 2001, LuminentOIC’s former CFO and its former President, respectively, resigned. As result of their resignations and as defined in their employment agreements, all outstanding stock options immediately vested and were exercisable through July 12, 2004 and September 11, 2003, respectively. MRV immediately recognized the remaining unamortized deferred stock expense of $1.7 million and $18.9 million during the years ended December 31, 2002 and 2001, respectively, as a result of their resignations. The following table presents deferred stock expense (income) recognized for the periods presented (in thousands).
During the three years in the period ended December 31, 2004, certain stock option holders ceased to be employees of MRV, either through termination or sale. Since MRV used the graded vesting method of accounting to recognize the compensation over the related employment period, MRV recognized deferred stock expense related to options that were unvested. For the years ended December 31, 2004, 2003 and 2002, MRV reversed $12,000, $11.6 million and $11.7 million, respectively, related to unvested, forfeited stock options for which compensation expense was previously recognized. Unamortized deferred stock expense totaling $1.4 million and $3.0 million for the years ended December 31, 2003 and 2002, respectively, has been reversed to additional paid-in capital relating to these employees. There was no unamortized deferred stock expense reversed to additional paid-in capital relating to these employees for the year ended December 31, 2004.
Transactions with Stock of a Subsidiary
In September 2003, MRV acquired 666,666 shares of Series A Preferred Stock, or 1.9% additional ownership interest, in Charlotte’s Networks from a minority interest in exchange for $50,000 in cash. This acquisition of a minority interest resulted in an extraordinary gain of $2.0 million for the year ended December 31, 2003. MRV’s ownership interest following this acquisition is approximately 60%. Charlotte’s Networks is included in MRV’s development stage enterprise group.
Recently Issued Accounting Standards
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs, an amendment of ARB No. 43, Chapter 4.” The amendments made by SFAS No. 151 clarify that abnormal amounts of idle facility expense, freight, handling costs and wasted materials (spoilage) should be recognized as current-period charges and require the allocation of fixed production overheads to inventory based on the normal capacity of the production facilities. The pronouncement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted for inventory costs incurred during fiscal years after November 23, 2004. The adoption of this pronouncement is not expected to have a material effect on the financial condition, the results of operations or liquidity.
On December 16, 2004, the FASB issued SFAS No. 123 (revised 2004), “Share-Based Payment,” which is a revision of SFAS No. 123, “Accounting for Stock-Based Compensation.” SFAS No. 123(R) supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees,” and amends SFAS No. 95, “Statement of Cash Flows.” Generally, the approach in SFAS No. 123(R) is similar to the approach described in SFAS No. 123. However, SFAS No. 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the income statement based on their fair values. Pro forma disclosure is no longer an alternative.
SFAS No. 123(R) must be adopted no later than July 1, 2005. Early adoption will be permitted in periods in which financial statements have not yet been issued. MRV expects to adopt SFAS No. 123(R) on July 1, 2005, the beginning of its third quarter of 2005. MRV is currently evaluating the two methods of adoption allowed by SFAS No. 123(R): the modified-prospective transition method and the modified-retrospective transition method. The impact of adopting this pronouncement cannot be predicted at this time because it will depend on many factors, including the levels of share-based payments granted in the future. However, had MRV adopted this pronouncement in prior periods, the impact would approximate the impact of SFAS No. 123 described in the disclosure of the pro forma results in Note 2, Summary of Significant Accounting Policies - Stock-Based Compensation.
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 that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Reclassifications
Certain prior year amounts have been reclassified to conform to the current year presentation. These reclassifications include the increase in accounts receivable and short-term obligations in the amount of $22.0 million and $19.0 million at December 31, 2004 and 2003, respectively, relating to the recording of accounts receivable financing transactions with recourse, which were previously recorded as sales of accounts receivable with recourse.
3. Goodwill and Other Intangible Assets
As required by SFAS No. 142, MRV performed transitional impairment tests on goodwill and other intangibles assets with indefinite lives, which consisted of patents and assembled work forces, as of January 1, 2002. As a result of the impairment tests, MRV recorded a charge of $296.4 million for the cumulative effect of an accounting change. Under SFAS No. 142, goodwill impairment exists if the net book value of a reporting unit exceeds its fair value. MRV, with the assistance of valuation experts, estimated the fair value of its reporting units using a combination of discounted cash flow analyses and comparisons with the market values of similar publicly traded companies.
Included in MRV’s $296.4 million impairment was a $247.3 million charge related to the impairment of the goodwill associated with the Foreign Optical Components and Free-Space Optics reporting units. The Foreign Optical Components reporting unit included the goodwill generated from the FOCI Fiber Optic Communications, Inc. (“FOCI”) and Quantum Optech, Inc. (“QOI”) acquisitions (see Note 5, Disposition of Assets). The optical components, active and passive, markets continued to deteriorate and had contracted significantly. As a result, MRV determined that a significant portion of the goodwill acquired had been impaired. The goodwill impairment in the Free-Space Optics reporting unit reflected the significantly lower fair value calculated on the basis of reduced operating revenues and income as a result of a depressed market for those products.
The remaining $49.1 million of impairment charge related to patents and assembled work forces associated with the Free-Space Optics reporting unit. The impairment of these patents and assembled work forces reflected the same circumstances as described above.
During the third quarter of 2002 and in addition to the transitional impairment testing, MRV reviewed its remaining goodwill and other intangible assets as required annually pursuant to SFAS No. 142. This impairment reduced the carrying value of goodwill and other intangible assets by recording an impairment charge of $72.7 million, which consisted of $70.4 million relating to goodwill and $2.3 million relating to patents. MRV has determined that the annual impairment test will be performed on October 1st of each year. MRV, with the assistance of valuation experts, estimated the fair value of its reporting units using a combination of discounted cash flow analyses and comparisons with the market values of similar publicly traded companies. During 2003, MRV impaired $356,000 in goodwill from a foreign office that ceased operations. During the fourth quarter of 2004 and 2003, MRV completed the annual review of its remaining goodwill and other intangible assets. With the assistance of valuation experts, MRV determined that no further reductions in the carrying value of its goodwill and intangible assets were necessary.
For the year ended December 31, 2004, there were no changes in the carrying amounts of goodwill. The following table summarizes MRV’s goodwill balances (in thousands):
4. Restructuring costs
During the second quarter of 2001, LuminentOIC’s management approved and implemented a restructuring plan in order to adjust operations and administration as a result of the dramatic slowdown in the communications equipment industry generally and the optical components sector in particular. Major actions primarily involved the reduction of workforce totaling $1.3 million, the abandonment of certain assets, including closed and abandoned facilities, amounting to $12.8 million and the cancellation and termination of purchase commitments totaling $6.2 million. MRV has a remaining obligation totaling $607,000 for its fulfillment of a lease obligation on an abandoned facility that it expects to pay through cash on-hand through August 2007.
5. Disposition of Assets
On October 15, 2002, MRV’s wholly owned subsidiary LuminentOIC, in a single transaction, sold (i) 53.4 million shares of the capital stock of FOCI amounting to approximately 78% of the total issued and outstanding share capital of FOCI and (ii) 19.0 million shares of the capital stock of QOI, representing approximately 100% of the total issued and outstanding share capital of QOI. The purchasers consisted of employees of FOCI, including its President. LuminentOIC continues to hold approximately 17% of the outstanding share capital of FOCI and no remaining ownership in QOI. The remaining ownership in FOCI has been recorded as a cost method investment in the accompanying Balance Sheet.
The consideration received by LuminentOIC for the sale of the FOCI and QOI shares, which was determined through arms’ length negotiations between LuminentOIC and MRV on the one hand, and the purchasers on the other, consisted of $8.0 million in cash and $2.0 million in credit against future purchases of components. These net assets have been included in MRV’s optical components group segment.
Prior to the sale of FOCI and QOI, MRV recorded an impairment loss on long-lived assets totaling $15.9 million, which was measured, based on the lower of its carrying amount or fair value less cost to sell. The fair value less cost to sell was based on the sale price described above. The adjusted carrying amounts of the major classes of assets and liabilities sold along with the consideration received as of October 15, 2002 were as follows (in thousands):
The loss on disposition of FOCI and QOI has been included in Other Expense, net in the accompanying Statement of Operations for the year ended December 31, 2002. Through December 31, 2003, MRV utilized $1.9 million of the future product credit, with the remaining $86,000 of product credit utilized during the year ended December 31, 2004.
6. Accrued Liabilities
Accrued liabilities consisted of the following (in thousands):
The provision for income taxes is as follows (in thousands):
The income tax provision differs from the amount computed by applying the federal statutory income tax rate to income before taxes as follows:
The components of deferred income taxes are as follows (in thousands):
MRV records valuation allowances against its deferred tax assets, when necessary, in accordance with SFAS No. 109, “Accounting for Income Taxes.” Realization of deferred tax assets (such as net operating loss carryforwards and income tax credits) is dependent on future taxable earnings and is therefore uncertain. At least quarterly, MRV assesses the likelihood that its deferred tax asset balance will be recovered from future taxable income. To the extent management believes that recovery is unlikely, MRV establishes a valuation allowance against its deferred tax asset, increasing its income tax expense in the period such determination is made. During 2004, MRV recorded an additional valuation allowance totaling $21.5 million against additional deferred income tax assets, principally domestic net operating losses and unrealized tax credits due to a history of domestic net losses. Although realization is not assured, management believes it is more likely than not that the net deferred tax assets will be realized.
As of December 31, 2004, MRV had federal and state net operating loss carryforwards available of $145.2 million and $148.2 million, respectively. For the year ended December 31, 2004, MRV generated additional federal and state net operating losses of $28.1 million and $5.6 million, respectively. For federal and state income tax purposes, the net operating losses are available to offset future taxable income through 2024 and 2014, respectively. Tax credits of $3.9 million and $3.2 million as of December 31, 2004 and 2003, respectively, expire at various dates through 2024. Capital loss carryforwards totaling $227.4 million and $221.8 million as of December 31, 2004 and 2003, respectively, begin to expire in 2006.
In 1995, MRV, through a subsidiary in Israel, qualified for a program under which it is eligible for a tax exemption on its income for a period of ten years from the beginning of the benefits period. This benefit is due to expire in 2006. Due to operating losses at this subsidiary, no tax benefit was received for any of the years ended December 31, 2004, 2003 and 2002.
MRV has not recorded U.S. income tax expense for foreign earnings that it has declared as indefinitely reinvested offshore, thus reducing its overall income tax expense. At December 31, 2004, MRV had approximately $17 million of accumulated but undistributed earnings at certain foreign entities. The amount of earnings designated as indefinitely reinvested offshore is based upon MRV’s expectations of the future cash needs of its foreign entities. Income tax considerations are also a factor in determining the amount of foreign earnings to be repatriated.
In the event actual cash needs of MRV’s U.S. entities exceeds its current expectations or the actual cash needs of its foreign entities are less than expected, MRV may need to repatriate foreign earnings which have been designated as indefinitely reinvested offshore. This would result in additional income tax expense being recorded.
American Jobs Creation Act of 2004-Repatriation of Foreign Earnings
In December 2004, the FASB issued FASB Staff Position No. FAS 109-2 (“FAS 109-2”), “Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creations Act of 2004” (“AJCA”). The AJCA introduces a limited time 85% dividends received deduction on the repatriation of certain foreign earnings to a U.S. taxpayer (repatriation provision), provided certain criteria are met. FAS 109-2 provides accounting and disclosure guidance for the repatriation provision. Although FAS 109-2 is effective immediately, MRV does not expect to be able to complete its evaluation of the repatriation provision until after Congress or the Treasury Department provides additional clarifying language on key elements of the provision. In January 2005, the Treasury Department began to issue the first of a series of clarifying guidance documents related to this provision. MRV expects to complete its evaluation of the effects of the repatriation provision within the second and third quarters of 2005.
8. Short-Term and Long-Term Obligations
Short-term obligations consist of secured and unsecured lines of credit, short-term loans and notes entered into with certain financial institutions. As of December 31, 2004 and 2003, these short-term obligations totaled $25.2 million and $20.6 million, respectively. Certain assets of MRV’s subsidiaries including customer accounts receivables have been pledged as collateral on these borrowings. The weighted average interest rate on these obligations was approximately 4% and 5% as of December 31, 2004 and 2003, respectively. These obligations are incurred and settled in the local currencies of the respective subsidiaries.
Long-term debt consisted of secured notes payable to financial institutions bearing interest at rates ranging from 4.7% to 9.4%. Principal and interest is payable in monthly and quarterly installments through December 2005. As of December 31, 2004 and 2003, long-term debt totaled $204,000 and $404,000, respectively. As of December 31, 2004, $92,000 of long-term debt is due during 2005 with the remaining balance of $112,000 due in 2006.
MRV entered into an interest rate swap (the “Swap”) in the second quarter of 2000 to effectively change the interest rate characteristics of its $50.0 million variable-rate term loan presented in Long-Term Debt, with the objective of fixing its overall borrowing costs. The Swap was considered to be 100% effective and was therefore recorded using the short-cut method. The Swap was designated as a cash flow hedge and changes in fair value of the debt were generally offset by changes in fair value of the related security, resulting in negligible net impact. The gain or loss from the change in fair value of the Swap as well as the offsetting change in the hedged fair value of the long-term debt were recognized in other comprehensive loss. In February 2002, MRV paid off the Long-Term Debt of $50.0 million and terminated the Swap. The realized loss on the Swap of $3.2 million has been recorded as interest expense and is included in other expense, net in the accompanying Statement of Operations for 2002.
In June 2003, MRV completed the sale of $23.0 million principal amount of five-year 5% convertible notes due in 2008, to an institutional investor, in a private placement. The 2003 Notes bear interest at 5% per annum and are convertible into shares of MRV’s common stock at a conversion price of $2.32 per share. As a condition of the 2003 Notes, MRV may not: (i) incur any form of unsecured indebtedness in excess of $17.0 million, plus obligations arising from accounts receivable financing transactions with recourse in the ordinary course of business and consistent with past practices, (ii) repurchase its common stock for an aggregate amount in excess of $5.0 million, or (iii) declare or pay any dividend on any of its capital stock, other than dividends of common stock with respect to its common stock. As of December 31, 2004, MRV was in compliance with the conditions of the 2003 Notes. MRV is using the net proceeds from the sale of the 2003 Notes for general corporate purposes and working capital. Interest Expense related to these 2003 Notes amounted to $1.2 million and $672,000 for the years ended December 31, 2004 and 2003, respectively.
In June 1998, MRV issued $100.0 million principal amount of its 1998 Notes. During 2003, MRV retired $5.9 million principal amount of 1998 Notes in exchange for the issuance of 4.2 million shares of its common stock to the holders of these notes, resulting in a remaining outstanding balance of $26.0 million at maturity. On June 15, 2003, the balance of MRV’s outstanding 1998 Notes matured and MRV repaid and retired them. For 2003, MRV recorded a loss on the extinguishment of debt totaling $5.4 million, net of associated taxes, in other expense, net in the accompanying Statement of Operations. This loss was recognized in accordance with Emerging Issues Task Force Issue 02-15 released in September 2002. During the year ended December 31, 2002, MRV acquired $53.0 million in principal amount of these notes in exchange for its issuance of 12.3 million shares of its common stock and $19.7 million in cash to the holders of these notes. During 2002, MRV recognized a gain of $393,000 in connection with the extinguishment of debt. MRV incurred $809,000 and $3.2 million in interest expense relating to the 1998 Notes for 2003 and 2002, respectively.
Lease Commitments
The Company leases all of its facilities and certain equipment under non-cancelable operating lease agreements expiring in various years through 2015. The aggregate minimum annual lease payments under leases in effect as of December 31, 2004 were as follows (in thousands):
Annual rental expense under non-cancelable operating lease agreements for the years ended December 31, 2004, 2003 and 2002, was $6.3 million, $6.0 million and $9.6 million, respectively.
Royalty Commitment
Through subsidiaries in Israel, MRV is obligated to the Office of the Chief Scientist of the Government of Israel (Chief Scientist) with respect to the government’s participation in research and development expenses for certain products. Amounts received by MRV from the participation of the Chief Scientist were offset against the related research and development expenses incurred. Accordingly, MRV’s royalty to the Chief Scientist is calculated at a rate of 2% to 5% of sales of such products developed with the participation up to the dollar amount of such participation. MRV received participation from the Chief Scientist that amounted to $31,000, $287,000 and $746,000 for the years ended December 31, 2004, 2003 and 2002, respectively. The remaining future obligation as of December 31, 2004 is approximately $1.4 million which is contingent on generating sufficient sales of this selected product line.
Litigation
MRV has received notices from third parties alleging possible infringement of patents with respect to product features or manufacturing processes. Management believes such notices are common in the communications industry because of the large number of patents that have been filed on these subjects. MRV’s policy is to discuss these notices with the senders in an effort to demonstrate that MRV’s products and/or processes do not violate any patents. From time to time, MRV has been involved in such discussions with IBM, Lucent, Ortel, Nortel, Rockwell, the Lemelson Foundation and Finisar. MRV does not believe that any of its products or processes violates any of the patents asserted by these parties and MRV further believes that it has meritorious defenses if any legal action is taken by any of these parties. However, if one or more of these parties was to assert a claim and gain a conclusion unfavorable to MRV such claims could materially and adversely affect the business, operating results and financial condition of MRV.
MRV has been named as a defendant in lawsuits involving matters that MRV considers routine to the nature of its business. Management is of the opinion that the ultimate resolution of all such matters will not have a material adverse effect on the accompanying financial statements.
Authorized Shares
On May 10, 2000, the Board of Directors and stockholders of MRV approved an increase in the authorized number of shares of its $0.0017 par value common stock from 80.0 million to 160.0 million shares relating to the two-for-one stock split distributed on May 26, 2000. MRV is authorized to issue up to 1.0 million shares of its $0.01 par value preferred stock, of which none is issued or outstanding as of December 31, 2004 and 2003.
In October 2003, MRV issued and sold 1,667,000 shares of its common stock to several institutional investors, raising net proceeds of approximately $5.0 million. These shares were taken from its shelf registration statement that was declared effective by the SEC in June 2003, which registered $20.0 million of its common stock that MRV may issue and sell from time to time.
Stock Repurchase Program
On June 13, 2002, MRV announced that its Board of Directors had approved a program to repurchase up to 7.0 million shares of its common stock. Through December 31, 2004, MRV had repurchased a total of 1.3 million shares of its common stock at a cost of $1.3 million under this program. MRV did not repurchase any of its common stock during the year ended December 31, 2004. MRV can repurchase up to 5.7 million additional shares of its common stock under this program.
Stock Options
MRV has stock option and warrant plans that provide for granting options and warrants to purchase shares of MRV’s common stock to employees, directors and non-employees performing consulting or advisory services for MRV. The plans provide for the granting of options, which meet the Internal Revenue Code requirements for qualification as incentive stock options, as well as nonstatutory options and are at the discretion of the board of directors. Under these plans, stocks option and warrant exercise prices generally equal the fair market value of MRV’s common stock at the date of grant. The options and warrants generally vest over three to five years with expiration dates ranging from six and ten years from the date of grant depending on the plan. The plans provide for the issuance of 4.8 million shares of common stock over the remaining life of the plans.
Information with respect to MRV’s stock option and warrant plans is as follows (in thousands, except per share data):
Information about MRV stock options outstanding at December 31, 2004 is summarized as follows (in thousands, except per share data and remaining contractual lives):
13. Segment Reporting and Geographical Information
MRV divides and operates its business based on three segments: the networking group, the optical components group and development stage enterprise group. The networking group designs, manufactures and distributes optical networking solutions and Internet infrastructure products. The optical components group designs, manufactures and distributes optical components and optical subsystems. The development stage enterprise group develops optical components, subsystems and networks and products for the infrastructure of the Internet. Segment information is therefore being provided on this basis.
The accounting policies of the segments are the same as those described in the summary of significant accounting polices previously described. MRV evaluates segment performance based on revenues and operating expenses of each segment. As such, there are no separately identifiable segment assets nor are there any separately identifiable Statement of Operations data below operating income.
Business segment revenues are as follows (in thousands):
Revenues by product line are as follows (in thousands):
For the years ended December 31, 2004, 2003 and 2002, MRV had no single customer that accounted for 10% or more of revenues. As of December 31, 2004 and 2003, MRV had no single customer that accounted for 10% or more of accounts receivable. MRV does not track customer revenue by region for each individual reporting segment.
A summary of external revenue by geographical region is as follows (in thousands):
A summary of long-lived assets, consisting principally of property and equipment, by geographical region is as follows (in thousands):
Business segment operating income (loss) is as follows (in thousands):
Income (loss) before provision for income taxes is as follows (in thousands):
14. 401(K) Plans
MRV has 401(K) savings plans (the Plans) at certain subsidiaries under which all eligible employees may participate. The Plans provide for MRV to make matching contributions to all eligible employees. For the years ended December 31, 2004, 2003 and 2002, approximately $575,000, $627,000 and $568,000, respectively, was charged as expense related to these plans.
15. Supplemental Statements of Cash Flow Information
Supplemental Statements of Cash Flow information for each of the years ended December 31, 2004, 2003 and 2002 is as follows (in thousands):
Other income (expense), net consisted of the following (in thousands):
ITEM 9.
ITEM 9. CHANGES IN OR DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation Of Disclosure Controls And Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the timelines specified in the Securities and Exchange Commission’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can only provide reasonable assurance of achieving the desired control objectives, and in reaching a reasonable level of assurance, management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As required by SEC Rule 13a-15(b), the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and the Company’s Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of the end of the year covered by this Report. Based on the foregoing, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level.
Management’s Report on Internal Control Over Financial Reporting
Internal control over financial reporting refers to the process designed by, or under the supervision of, our Chief Executive Officer and Chief Financial Officer, and effected by our Board of Directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with accounting principles generally accepted in the United States, and includes those policies and procedures that:
- Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of our assets:
- Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States, and that our receipts and expenditures are being made only in accordance with authorization of our management and directors; and
- Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of our assets that could have a material effect on the financial statements.
Internal control over financial reporting cannot provide absolute assurance of achieving financial reporting objectives because of its inherent limitations. Internal control over financial reporting is a process that involves human diligence and compliance and is subject to lapses in judgment and breakdowns resulting from human failures. Internal control over financial reporting also can be circumvented by collusion or improper management override. Because of such limitations, there is a risk that material misstatements may not be prevented or detected on a timely basis by internal control over financial reporting. However, these inherent limitations are known features of the financial reporting process. Therefore, it is possible to design into the process safeguards to reduce, though not eliminate, this risk. Management is responsible for establishing and maintaining adequate internal control over financial reporting for the Company.
Management has used the framework set forth in the report entitled Internal Control - Integrated Framework published by the Committee of Sponsoring Organizations of the Treadway Commission, known as COSO, to evaluate the effectiveness of the Company’s internal control over financial reporting. Management has concluded that our internal control over financial reporting was effective as of December 31, 2004. Ernst & Young LLP, our independent registered public accounting firm, has issued an attestation report on management’s assessment of our internal control over financial reporting, which is included below.
Changes in Internal Control Over Financial Reporting
There has been no change in our internal controls over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal controls over financial reporting.
Report of Independent Registered Public Accounting Firm on Internal Control Over Financial Reporting
The Board of Directors and Stockholders of MRV Communications, Inc.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control Over Financial Reporting, that MRV Communications, Inc. maintained effective internal control over financial reporting as of December 31, 2004 based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). MRV Communications, 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 MRV Communications, Inc. maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, MRV Communications, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, 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 MRV Communications, Inc. (and subsidiaries) as of December 31, 2004 and 2003, and the related consolidated statements of operations, stockholders’ equity and comprehensive income (loss), and cash flows for each of the three years in the period ended December 31, 2004 of MRV Communications, Inc. and our report dated February 25, 2005 expressed an unqualified opinion thereon.
/s/ ERNST & YOUNG LLP
Woodland Hills, California
February 25, 2005
ITEM 9B.
ITEM 9B. OTHER INFORMATION
Not applicable.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The executive officers and directors of the Registrant at February 15, 2005 are as follows:
Noam Lotan has been the President, Chief Executive Officer and a Director of the Company since May 1990 and became Chief Financial Officer of the Company in October 1993, in which position he served until June 1995. From March 1987 to January 1990, Mr. Lotan served as Managing Director of Fibronics (UK) Ltd., the United Kingdom subsidiary of Fibronics International Inc. (“Fibronics”), a manufacturer of fiber optic communication networks. The Company purchased the Fibronics business in September 1996. From January 1985 to March 1987, Mr. Lotan served as a Director of European Operations for Fibronics. Prior to such time, Mr. Lotan held a variety of sales and marketing positions with Fibronics and Hewlett-Packard. Mr. Lotan holds a Bachelor of Science degree in Electrical Engineering from the Technion, the Israel Institute of Technology, and a Masters degree in Business Administration from INSEAD (the European Institute of Business Administration, Fontainebleau, France).
Dr. Shlomo Margalit a founder of the Company, has been Chairman of the Board of Directors and Chief Technical Officer since the Company’s inception in July 1988. From May 1985 to July 1988, Dr. Margalit served as a founder and Vice President of Research and Development for LaserCom, Inc. (“LaserCom”), a manufacturer of semiconductor lasers. From 1982 to 1985, Dr. Margalit served as a Senior Research Associate at the California Institute of Technology (“Caltech”), and from 1976 to 1982, a Visiting Associate at Caltech. From 1972 to 1982, Dr. Margalit served as a faculty member and Associate Professor at the Technion. During his tenure at the Technion, Dr. Margalit was awarded the “Israel Defense” prize for his work in developing infrared detectors for heat guided missiles and the David Ben Aharon Award for Novel Applied Research. Dr. Margalit holds a Bachelor of Science degree, a Masters degree and a Ph.D. in Electrical Engineering from the Technion.
Shay Gonen became Chief Financial Officer in September 2001. Since September 1996, Mr. Gonen has served in various executive capacities for certain MRV subsidiaries, including as the Vice President of Finance, Chief Financial Officer and Secretary of Optical Access, Inc. from September 2000; as General Manager of European Activity for Fiber Driver from January 1999 to September 2000; as Chief Operating Officer of Fiber Driver Communications from September 1996 to December 1998. Mr. Gonen served as Vice President of Operations and Finance for Silver Arrow, L.P. from April 1994 to September 1996. Mr. Gonen holds a B.S. degree in industrial engineering from the Technion, and an M.B.A. degree from Bar-Ilan University in Tel Aviv.
Near Margalit, Ph.D. re-joined MRV in May 2002 as Vice President of Marketing and Business Development. From 1998 until re-joining MRV, Dr. Margalit was founder, Chairman and Chief Technology Officer for Zaffire, Inc., a DWDM Metro Platform company, which was acquired by Centerpoint in October 2001. At Zaffire, Dr. Margalit was responsible for product vision and architecture of integrating DWDM and SONET technology. Prior to founding Zaffire, Dr. Margalit was employed by MRV, both in the optical component and networking divisions. Dr. Margalit holds a B.S. in applied physics from Caltech and a Ph.D. in optoelectronics from the University of California, Santa Barbara. In February 2003, Dr. Margalit was appointed Chief Executive Officer of LuminentOIC, Inc.
Dr. Igal Shidlovsky became a Director of the Company in May 1997. Dr. Shidlovsky serves as Managing Director of Global Technologies, an investment and consulting organization, which he founded in 1994. He has extensive management and consulting experience with international companies and start up technology companies. From 1982 to 1991, Dr. Shidlovsky was a Director of Sentex Sensing Technologies. Dr. Shidlovsky held several executive positions including Vice President Corporate Development at Siemens Pacesetter, a division of Siemens AG Medical Group, Director of Strategic Planning and Technology Utilization, and Director of the Microelectronics Department at Siemens Corporate Research. From 1969 to 1982 he was with RCA Laboratories, a leading electronic R&D organization. Dr. Shidlovsky holds a Bachelor of Science degree in Chemistry from the Technion and Master and Ph.D. degrees from the Hebrew University in Israel.
Dr. Guenter Jaensch became a Director of the Company in December 1997. Dr. Jaensch serves as President of Jaensch Enterprises, a firm engaged in management and project consulting, and serves as Chairman of the Board for Biophan Technologies, Inc. For over 20 years, he held executive positions with Siemens or its subsidiaries in Europe and the United States. Among his assignments were service as President of Siemens Communications Systems, Inc.; President and Chairman of Siemens Corporate Research and Support, Inc.; Chairman and Chief Executive Officer at Siemens Pacesetter, Inc.; and head of the Cardiac Arrhythmia Division of Siemens AG Medical Group. Dr. Jaensch holds a Masters degree in Business Administration and Ph.D. degree in Business and Finance from the University of Frankfurt; he also taught business at the University of Frankfurt.
Professor Daniel Tsui is the Arthur Le Grand Doty Professor of Electrical Engineering at Princeton University and was awarded the 1998 Nobel Prize in Physics for the discovery and explanation of the fractional quantum Hall effect. Professor Tsui was a recipient of the American Physical Society 1984 Buckley Prize, the 1998 Benjamin Franklin Medal and was elected to the National Academy of Sciences. He is a fellow of the American Physical Society and the American Association for the Advancement of Science. He is currently engaged in research activity relating to properties of thin films and microstructures of semiconductors and solid-state physics. He received his Ph.D. in physics from the University of Chicago in 1967 and for 13 years was with Bell Laboratories before joining Princeton University, where he has been for more than 20 years.
Professor Baruch Fischer currently serves as a professor at the Electrical Engineering Faculty at the Technion. Professor Fischer had served as Dean of the Electrical Engineering Faculty at the Technion. Professor Fischer’s current Research Activities include solid state devices, lasers and optical amplifiers; WDM technology; fiber gratings; “all optical” networks; non-linear effect in fiber, wave mixing; and optical computing, optical data storage and optical image processing. He has authored or co-authored approximately 180 papers and holds several patents in the field of optics and opto-electronics. He received his Ph.D. from Bar-Ilan University, Israel in 1980. He subsequently became a Post-Doctorate Fellow at CalTech and joined the faculty of the Technion in 1983.
Each director is elected for a period of one year at MRV’s annual meeting of stockholders and serves until the next annual meeting and until his successor is duly elected and qualified. Officers are elected by, and serve at the discretion of, the board of directors, subject to relevant employment agreements. Except for Dr. Near Margalit, who is the son of Dr. Shlomo Margalit, none of the Directors or executive officers of MRV are related by blood, marriage or adoption to any of MRV’s Directors or executive officers.
Compliance with Section 16(a) of the Securities Exchange Act of 1934
Section 16(a) of the Securities Exchange Act of 1934 requires our directors and executive officers and persons who own more than 10% of a registered class of our equity securities, to file with the SEC initial reports of ownership and reports of changes in ownership of common stock and other equity securities of the Company. Directors, executive officers and 10% or greater stockholders are required by the SEC regulations to furnish us with copies of all Section 16(a) forms they file.
We believe, based solely on a review of the copies of such reports furnished to the Company, that each report required of the Company’s executive officers, directors and 10% or greater stockholders was duly and timely filed for the year ended December 31, 2004, except that, (a) Daniel C. Tsui, a director of MRV, inadvertently failed to report his acquisition of 215 shares of MRV common stock in connection with the short form merger of Luminent, Inc. in exchange for the cancellation of 500 shares of Luminent, Inc. having a market value of $1.85 per share, on December 28, 2001, which transaction should have been reported on Professor Tsui’s Form 5 filed February 14, 2002, and (b) Noam Lotan, a director and the President and Chief Executive Officer of MRV, due to a clerical error, incorrectly reported his beneficial ownership of MRV shares of MRV Common Stock in various Form 4s and Form 5s filed since at least 2000. Professor Tsui reported the transaction in an amendment to his Form 5 filed on February 7, 2005 and Mr. Lotan corrected the error in the number of MRV shares he beneficially owns in an amendment to his Form 5 filed on February 14, 2005.
Code of Business Conduct and Corporate Governance
We have adopted a Code of Business Conduct and Corporate Governance that applies to all of our directors, officers and employees. In compliance with the applicable rules of the SEC, special ethics obligations of our Chief Executive Officer, Chief Financial Officer, Controller and other employees who perform financial or accounting functions are set forth in the section of our Code of Business Conduct and Corporate Governance, entitled Special Ethics Obligations of Employees with Financial Reporting Responsibilities. The Code is available through our web site at www.mrv.com. Printed copies are available free of charge and may be requested by contacting our Investor Relations Department either by mail at our corporate headquarters, by telephone at (818) 886-6782 or by e-mail at if@mrv.com.
We intend to satisfy the disclosure requirements under the Securities Exchange Act of 1934, as amended, regarding an amendment to, or a waiver from, our Code of Business Conduct and Corporate Governance by posting such information on our web site at www.mrv.com.
Audit Committee Financial Expert
Our Board of Directors has determined that at least one person serving on the Audit Committee is an “audit committee financial expert” as defined under Item 401(h) of Regulation S-K and Rule 4200(a)(15) of the Nasdaq Marketplace Rules. Dr. Guenter Jaensch, the Chairman of the Audit Committee, is an “audit committee financial expert” and is independent as defined under Item 7(d)(3)(iv) of Schedule 14A of the Exchange Act.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The following table shows information regarding the total compensation paid to the Chief Executive Officer and each of its other executive officers whose total annual compensation exceeds $100,000 (collectively, the “Named Executive Officer”) for services rendered to MRV in all capacities during each of the past three fiscal years.
S U M M A R Y C O M P E N S A T I O N T A B L E
(1)
“All other Compensation” includes Company contributions to its 401(K) savings plan on behalf of the Named Executive Officer.
Option Grants in Last Fiscal Year
The following table sets forth information with respect to option grants to the Named Executive Officers during 2004:
- the number of shares of MRV common stock underlying options granted during the year;
- the percentage that such options represent of all options granted to employees during the year;
- the exercise price (which in each case was equal to the fair market value of the stock on the date of grant);
- the expiration date; and
- the hypothetical present value, as of the grant date, of the options under the option pricing model discussed below.
The hypothetical present value of the options as of their date of grant has been calculated using the Black-Scholes option pricing model, as permitted by SEC rules, based upon a set of assumptions set forth in footnote (2) to the table. It should be noted that this model is only one method of valuing options, and the Company’s use of the model should not be interpreted as an endorsement of its accuracy. The actual value of the options may be significantly different, and the value actually realized, if any, will depend upon the excess of the market value of the common stock over the option exercise price at the time of exercise.
O P T I O N G R A N T S D U R I N G F I S C A L 2 0 0 4
(1) The dollar amounts under these columns are the result of calculations assuming the price of MRV’s common stock on the date of the grant of the option increases at the hypothetical 5% and 10% rates set by the SEC for the term of the option. Neither the amounts reflected nor the rates applied are intended to forecast possible future appreciation, if any, of the Company’s stock price.
(2) The hypothetical present value at grant date of options granted during 2004 has been calculated using the Black-Scholes option pricing model, based upon the following assumptions: estimated time until exercise is four years; risk free interest rates ranging from 2.69% to 3.83%; volatility ranging from 69% to 85%; and a dividend yield of 0%. The approach used in developing the assumptions upon which the Black-Scholes valuations were calculated is consistent with the requirements of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation.” The options generally vest over four equal installments beginning on the first anniversary of the date of grant.
The table below sets forth the following information with respect to option exercises during fiscal 2004 by each of the Named Executive Officers and the status of their options at December 31, 2004:
A G G R E G A T E D O P T I O N E X E R C I S E S D U R I N G 2 0 0 4
A N D
O P T I O N V A L U E S O N D E C E M B E R 3 1, 2 0 0 4
Employment Agreements
In March 1992, MRV entered into three-year employment agreements with Mr. Lotan and Dr. Margalit. Upon expiration, these agreements automatically renew for one-year terms unless either party terminates them by giving the other three months’ notice of non-renewal prior to the expiration of the current term. Pursuant to the agreements, Mr. Lotan serves as President, Chief Executive Officer and a Director of MRV and Dr. Margalit serves as Chairman of the Board of Directors, Chief Technical Officer and Secretary. For 2005, Mr. Lotan and Dr. Margalit receive base annual salaries of $200,000 and $110,000, respectively and each is entitled to receive a bonus determined and payable at the discretion of the board of directors upon the recommendation of the Compensation Committee of the Board.
Each officer also receives employee benefits, such as vacation, sick pay and insurance, in accordance with MRV’s policies, which are applicable to all employees. MRV has obtained and is the beneficiary of, key man life insurance policies in the amount of $1,000,000 on the lives of each of Dr. Margalit and Mr. Lotan. All benefits under these policies will be payable to MRV upon the death of an insured.
Compensation of Outside Directors
Outside directors, i.e., directors who are not employees of MRV, receive cash compensation of $1,500 per month and $1,000 for each board of directors’ meeting and committee meeting attended, while serving as Directors. In March 2004, MRV granted to each outside director options to purchase 8,000 shares of its common stock at $2.80 per share. In July 2004, MRV granted to each outside director options to purchase 22,000 shares of its common stock at $3.02 per share. In December 2004, MRV granted to each audit committee member, Dr. Jaensch, Dr. Shidlovsky and Professor Tsui, options to purchase 10,000 shares of its common stock at $3.67 per share.
Board Committees
The system of governance practices followed by the Company is memorialized in the MRV Communications, Inc. Corporate Governance Guidelines and the charters of the four committees of the Board of Directors. The Governance Guidelines and charters are intended to assure that the Board will have the necessary authority and practices in place to review and evaluate the Company’s business operations and to make decisions that are independent of the Company’s management. The Governance Guidelines also are intended to align the interests of directors and management with those of MRV’s stockholders. The Governance Guidelines establish the practices the Board will follow with respect to board composition and selection, board meetings and involvement of senior management, Chief Executive Officer’s performance evaluation, board committees, and director compensation. The Board annually conducts a self-evaluation to assess compliance with the Governance Guidelines and identify opportunities to improve Board performance.
The Governance Guidelines and committee charters are reviewed periodically and updated as necessary to reflect changes in regulatory requirements and evolving oversight practices. The Governance Guidelines were most recently modified by the Board effective September 24, 2004 to, among other things, assure compliance with corporate governance requirements contained in both the Nasdaq Stock Market (“Nasdaq”) and make other enhancements to the Company’s corporate governance policies, including creating the role of lead independent director. The chair of the Nomination and Governance Committee currently serves as the lead independent director. The lead independent director is responsible for coordinating the activities of the non-management directors, coordinate with the Chairman to set the agenda for Board meetings, chairing meetings of the non-management directors, and leading the Board’s review of the Chief Executive Officer. The Board has four committees: an Audit Committee, a Compensation Committee, a Nomination and Governance Committee and an Executive Committee. The Governance Guidelines, as well as the Charter for the Audit Committee, the Compensation Committee and the Nomination and Governance Committee may be viewed at www.mrv.com/investor.
The Board of Directors, and the Audit Committee, the Compensation Committee and the Nomination and Governance Committee, hold regularly scheduled quarterly meetings. In addition to the quarterly meetings, there may be special meetings from time to time as the Board or its committees deem necessary. At each quarterly board meeting, time is set aside for the non-management directors to meet without management present. The Board of Directors met four times during the last fiscal year. All directors attended 75% or more of the Board meetings and meetings of the committees on which they served during 2004.
The table below provides current membership and information for each of the Board committees for the current year. Committee memberships changed during 2004. In September 2004, the Board of Directors established the Nomination and Governance Committee. Dr. Shidlovsky, Dr. Jaensch and Professor Tsui were appointed to the Nomination and Governance Committee. In October 2004, Professors Tsui and Fischer were appointed to the Compensation Committee, joining Dr. Shidlovsky and Dr. Jaensch on that committee.
C O M M I T T E E S
* Committee Chairperson
Below is a description of each committee of the Board of Directors. Each of the committees has authority to engage legal counsel or other experts or consultants as it deems appropriate to carry out its responsibilities. The Board of Directors has determined that each member of each committee meets the standards of independence under the Governance Guidelines and applicable Nasdaq listing standards, including that each member is free of any relationship that would interfere with his individual exercise of independent judgment.
Audit Committee: The Audit Committee assists the Board of Directors in its oversight of the quality and integrity of the accounting, auditing, and reporting practices of the Company. The Audit Committee’s role includes overseeing the work of the Company’s internal accounting and auditing processes and discussing with management the Company’s processes to manage business and financial risk, and for compliance with significant applicable legal, ethical, and regulatory requirements. The Audit Committee is responsible for the appointment, compensation, retention, and oversight of the independent auditor engaged to prepare or issue audit reports on the financial statements of the Company. The Audit Committee relies on the expertise and knowledge of management and the independent auditor in carrying out its oversight responsibilities. The Committee’s specific responsibilities are delineated in the Audit Committee Charter, which may be viewed at www.mrv.com/investor. The Board of Directors has determined that each Audit Committee member has sufficient knowledge in financial and auditing matters to serve on the Committee. In addition, the Board has determined that Dr. Guenter Jaensch is an “audit committee financial expert” as defined by Item 401(h) of Regulation S-K of Securities and Exchange Commission (“SEC”) regulations and that he is independent as that term is used in Item 7(d)(3)(iv) of Schedule 14A under the Securities Exchange Act of 1934.
Compensation Committee: The Directors who served and currently serve on the Compensation Committee are all “independent” for purposes of the rules of the Nasdaq Stock Market. The primary responsibilities of the Compensation Committee are: (a) In consultation with senior management, to make recommendations to the Board as to the Company’s general compensation philosophy and to oversee the development and implementation of compensation programs; (b) To evaluate the performance of the CEO in light of Board-approved goals and objectives, and to recommend to the Board the CEO’s compensation level based on this evaluation; (c) To make recommendations to the board regarding the compensation (including any new compensation programs) of the other executive officers, following its review of performance evaluations of the other executive officers; and (d) to review and make recommendations to the Board with respect to the Company’s incentive compensation plans and equity-based plans. The Compensation Committee’s role includes producing the report on executive compensation required by SEC rules and regulations. The specific responsibilities and functions of the Compensation Committee are delineated in the Compensation Committee Charter, which may be viewed at www.mrv.com/investor.
Nomination and Governance Committee: The principal responsibilities of the Nomination and Governance Committee are: (a)·To lead the search for qualified individuals for election as directors to ensure the Board has the right mix of skills and expertise; (b) To retain and terminate any search firm to be used to identify director candidates, as it may deem appropriate in its discretion; (c) To solicit the views of the Chief Executive Officer, other members of the Company’s senior management, and other members of the Board regarding the qualifications and suitability of candidates; (d) To establish policies and procedures for the evaluation of candidates put forth by the Company’s stockholders; (e) To review and recommend to the full Board a set of corporate governance principles and a code of business conduct and ethics applicable to the Board and the Company, and, if deemed necessary by the Board, propose from time to time any amendments to such principles and such code; (f) To oversee and evaluate compliance by the Board and management of the Company with the Company’s corporate governance principles and ethics standards and its code of conduct. The Nomination and Governance Committee’s role also includes periodically reviewing the compensation paid to non-employee directors, and making recommendations to the Board for any adjustments. In addition, the Chair of the Nomination and Governance Committee acts as the lead independent director and is responsible for leading the Board of Directors’ annual review of the chief executive officer’s performance. The specific responsibilities and functions of the Nomination and Governance Committee are delineated in the Nomination and Governance Committee Charter, which may be viewed at www.mrv.com/investor.
Nominees for the Board of Directors should be committed to enhancing long-term stockholder value and must possess a high level of personal and professional ethics, sound business judgment and integrity. The Nomination and Governance Committee annually reviews with the Board the applicable skills and characteristics required of Board nominees in the context of current Board composition and Company circumstances. In making its recommendations to the Board, the Nomination and Governance Committee considers, among other things, the qualifications of individual director candidates. The Nomination and Governance Committee works with the Board to determine the appropriate characteristics, skills, and experiences for the Board as a whole and its individual members with the objective of having a Board with business experience, diversity, and personal skills in technology, finance, marketing, international business, financial reporting and other areas that are expected to contribute to an effective Board. In evaluating the suitability of individual Board members, the Board takes into account many factors, including general understanding of marketing, finance, and other disciplines relevant to the success of a publicly traded company in today’s business environment; understanding of the Company’s business and technology; educational and professional background; and personal accomplishment. The Board evaluates each individual in the context of the Board as a whole, with the objective of recommending a group that can best perpetuate the success of the Company’s business and represent stockholder interests through the exercise of sound judgment, using its diversity of experience. In determining whether to recommend a director for re-election, the Nomination and Governance Committee also considers the director’s past attendance at meetings and participation in and contributions to the activities of the Board.
Executive Committee: The Executive Committee consists of Mr. Lotan and Dr. Margalit. The primary responsibility of the Executive Committee is to take any action that the Board is authorized to act upon, with the exception of the issuance of stock, the sale of all or substantially all of MRV’s assets and other significant corporate transactions.
Compensation Committee Interlocks And Insider Participation
No member of the Compensation Committee was, during 2004, an officer or employee of MRV or any of its subsidiaries; or was formerly an officer of MRV or any of its subsidiaries. During 2004, no executive officer of MRV served as an executive officer, director or member of the compensation committee (or other board committee performing equivalent functions, or in the absence of such committee, the entire board of directors) of another entity, one of whose executive officers served as a member of the Compensation Committee or as a director of MRV.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The following table sets forth information known to MRV with respect to beneficial ownership of MRV common stock as of February 15, 2005 for (i) each current director, (ii) MRV’s Chief Executive Officer and each of the Named Executive Officers and (iii) all executive officers and directors as a group. The table below indicates the number of shares owned by each person known to MRV to be the beneficial owner of 5% or more of the outstanding shares of MRV’s common stock.
Beneficial ownership is determined under the rules of the Securities and Exchange Commission and generally includes voting or investment power with respect to securities. Except as indicated in the footnotes to this table and pursuant to applicable community property laws, the persons named in the table below have sole voting and investment power with respect to all shares of common stock beneficially owned. The number of shares beneficially owned by each person or group as of February 15, 2005 includes shares of common stock that such person or group had the right to acquire on or within 60 days after February 15, 2005, including, but not limited to, upon the exercise of options. References to options in the footnotes of the table below include only options to purchase shares that were exercisable on or within 60 days after February 15, 2005. For each individual and group included in the table below, percentage ownership is calculated by dividing the number of shares beneficially owned by such person or group by the sum of the 104,135,290 shares of common stock outstanding on February 15, 2005 plus the number of shares of common stock that such person or group had the right to acquire on or within 60 days after February 15, 2005.
(1) Unless otherwise indicated below, each person has sole voting and investment power with respect to the shares listed. Unless otherwise indicated in the table above, the address of each person is c/o MRV Communications, Inc., 20415 Nordhoff Street, Chatsworth, California 91311.
Equity Compensation Plan Information
The table below set forth information with respect to shares of common stock that may be issued under our stock option and warrant plans as of December 31, 2004.
§ Non-Director and Non-Executive Officer Consolidated Long-Term Stock Incentive Plan
§ 1998 Nonstatutory Stock Option Plan (no securities available for future issuance);
§ 2001 MRV Communications, Inc. Stock Option Plan for Employees of Appointech, Inc. (no securities available for future issuance);
§ 2000 MRV Communications, Inc. Stock Option Plan for Employees of AstroTerra Corporation (no securities available for future issuance);
(3) See Note 15, “Stockholders’ Equity - Stock Options” to the Financial Statements included in Item 8 - Financial Statements and Supplementary Data.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Not applicable.
PART IV
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Ernst & Young LLP has audited MRV’s consolidated financial statements annually since 2002. The following is a summary of the fees billed to MRV by Ernst & Young LLP and Arthur Andersen LLP for professional services rendered for the years ended December 31, 2003 and 2002:
Audit Fees. Consists of fees billed for professional services rendered for the audits of MRV’s consolidated financial statements and internal control over financial reporting and review of the interim consolidated financial statements included in quarterly reports and services that are normally provided by Ernst & Young LLP in connection with statutory and regulatory filings or engagements.
Audit-Related Fees. Consists of fees billed for assurance and related services that are reasonably related to the performance of the audit or review of MRV’s consolidated financial statements and are not reported under “Audit Fees.” These services include employee benefit plan audits, consultations in connection with acquisitions, attest services that are not required by statute or regulation and consultation concerning financial accounting and reporting standards.
Tax Fees. Consists of fees billed for professional services for tax compliance, tax advice and tax planning. These services include assistance regarding federal, state and international tax compliance, tax audit defense and international tax planning.
All Other Fees. Consists of fees for products and services other than the services reported above.
Policy On Audit Committee Pre-Approval Of Audit And Permissible Non-Audit Services Of Independent Auditors
The Audit Committee’s policy is to pre-approve all audit and permissible non-audit related services provided by the independent audits. These services may include audit services, audit-related services, tax services and other services. Pre-approval is generally provided for up to one year and any pre-approval is detailed as to the particular service or category of services and generally subject to a specific budget. The independent auditors and management are required to periodically report to the Audit Committee regarding the extent of services provided by the independent auditors in accordance with this pre-approval, and the fees for the services performed to date. The Audit Committee may also pre-approve particular services on a case-by-case basis.
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) The financial statements and the Report of Ernst & Young LLP are included in Part II of this Form 10-K on the pages indicated:
(2) All schedules are omitted because they are not applicable or the required information is shown in the financial statements or notes thereto.
(3) Exhibits
(b) One report on Form 8-K was filed during the period covered by this Report. That Form 8-K Report, dated October 21, 2004 and filed on October 25, 2004, reported matters under Items 2.02, 8.01 and 9.01.
SIGNATURE
Pursuant to the requirements of the 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 on March 7, 2005.
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Noam Lotan, his true and lawful attorney-in-fact and agent with full power of power substitution and resubstitution, for him and in his name, place, and stead, in any and all capacities, to sign this Annual Report on Form 10-K, and to file any and all amendments to this Annual Report on Form 10-K, and to file the same, with all exhibits thereto, and all documents in connection therewith, with Securities and Exchange Commission, granting unto said attorney-in-fact and agents, full power and authority to do and perform each and every act and thing requisite and necessary to be done in and about the premises, as fully to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorney-in-fact and agent thereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Annual Report on Form 10-K has been signed below by the following persons on behalf of the Registrant in the capacity and on the dates indicated.