ITEM 1. BUSINESS
Some of the information in this Form 10-K contains forward-looking statements that involve substantial risks and uncertainties. You can identify these statements by forward-looking words such as “may,” “will,” “should,” “expect,” “anticipate,” “potential,” “believe,” “estimate,” “intends” and “continue” or similar words. You should read statements that contain these words carefully because they: (i) discuss our expectations about our future performance; (ii) contain projections of our future operating results or of our future financial condition; or (iii) state other “forward-looking” information. There will be events in the future that we are not able to predict or over which we have no control, which may adversely affect our future results of operations, financial condition or stock price. The risk factors described in this Form 10-K, as well as any cautionary language in this Form 10-K, provide examples of risks, uncertainties and events that may cause our actual results to differ materially from the expectations we described in our forward-looking statements. You should be aware that the occurrence of any of the risks, uncertainties, or events described in this Form 10-K could seriously harm our business and that, upon the occurrence of any of these events, the price of our common stock could decline. All forward-looking statements included in this Form 10-K are based on information available to us on the date hereof. We assume no obligation to update any such forward-looking statements.
Overview
We are a developer and provider of high performance broadband customer premises networking equipment and carrier-class software for the remote management of broadband services and equipment. We also develop and provide broadband enabled services and remote management software for enterprises technical support, help-desks and personal computers.
Our broadband equipment includes modems, routers and gateways, and related accessories for use at the premises. Our equipment enables broadband access and services. Our line of equipment includes gateways for advanced high-speed broadband access. DSL technologies and standards used to transmit data over copper lines, including integrated wireless (or Wi-Fi) access, are a technology focus for our equipment. The largest customers for our equipment are telecommunications carriers. These customers deploy our equipment at their broadband customers’ premises, including residences and distributed businesses.
Our management software enables carriers to remotely manage our gateways, as well as gateways from third party suppliers, and to deploy new broadband services. Our software enables broadband service providers and enterprises to remotely respond to service problems and calls and to automate the maintenance of the gateways and broadband services. Our solution also provides for the efficient delivery of value added services. NBBS or Netopia Broadband Server software is the brand name for our remote management software, which we license on both a server license and hosted basis.
We also license and host software for remotely managing networks of personal computers. This software is licensed under the brand names Timbuktu and eCare. eCare is a solution designed for enterprise technical service support and help desks. Our solutions enable remote problem solving and management of distributed desktop or personal computers.
We sell Web site services, including Web site hosting, development, and tools for Web site development. We offer a Hot-Spot solution and service for distributed enterprises, such as restaurants, hotels and other venues that offer wireless Internet access to their customers. We offer a Parental Controls service that provides content filtering and other controls over access to the Internet.
Our broadband equipment is manufactured by outsourcing partners in manufacturing facilities in Thailand, China and Mexico. The components included in our equipment are high-quality industry standard components
provided by leading vendors. We work closely with the providers of silicon chips, circuits and switches, antennae and other high-technology components in the development of our products. We develop and maintain the embedded software called firmware included in our equipment.
The markets in which we compete are highly competitive. We continuously strive to make advances and compete based on forward-looking technology and service innovations, superior performance and quality, and by identifying solutions and opportunities for our customers to attract and retain customers, improve productivity, reduce costs, and achieve competitive advantage.
For the fiscal year ended September 30, 2005, we had revenues of $106 million, employed approximately 300 employees and conducted most of our business in North America and Europe.
We make significant ongoing investments in research and development and marketing of broadband equipment, remote management software and broadband enabled services. In addition, over the years we have completed acquisitions, acquiring other companies for technology and customers that we viewed as important to growing our business. We made no acquisitions in fiscal year 2005.
We were incorporated in California in 1986 as Farallon Computing, Inc. In 1996, we were reincorporated in Delaware as Farallon Communications, Inc. In November 1997, we changed our name to Netopia, Inc.
Our Internet address is http://www.netopia.com. Our most recent annual report on Form 10-K and our other filings with the Securities and Exchange Commission (“SEC”) are available in PDF format through the Investor Relations section of our website. These filings are also available on the SEC website at http://www.sec.gov. The contents of these websites are not intended to be incorporated by reference into this report or in any report or document we file, and our references to these websites are intended to be inactive textual references only.
Our principal executive offices are located at 6001 Shellmound Street, 4th Floor, Emeryville, California 94608, and our telephone number is (510) 420-7400.
Evolving Opportunities and Industry Background
Demand for Broadband Services
The growth and evolution of the Internet, the proliferation of advanced digital media and the advancement of communications infrastructure have fundamentally changed the way people work, shop, entertain and communicate. The number of online households worldwide is in the hundreds of millions and growing. Of these households, over one hundred million are accessing the Internet through broadband connections. As the Internet has evolved and content rich applications have been developed, consumers and businesses are increasingly opting for access that provides advanced digital media, video, communications and interactive broadband applications, including:
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Broadcast and high definition television;
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Internet Protocol television, or IPTV;
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Video on demand, or VOD;
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Interactive television;
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Peer-to-peer file sharing;
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Sending and receiving advanced digital media such as music, photos and video;
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Video conferencing;
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Video surveillance;
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Streaming video and audio;
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Online gaming and game hosting;
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Point of sale services;
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Business applications including secure virtual private networks, or VPM, for telecommmuters; and
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Voice over Internet Protocol, or VoIP.
Additionally, users are increasingly creating, interacting with and transmitting advanced digital media. As a result, the ability to send information upstream has become increasingly important along with the ability to receive information downstream. For example, applications such as peer-to-peer file sharing or online gaming have the same high bandwidth requirements for both upstream and downstream transmissions. As data and media files increase in size, we believe users will become increasingly dissatisfied with their existing dial-up connections and first generation broadband technology, which do not maintain sufficient transmission rates for satisfactory delivery of these advanced digital media, video, communications and interactive broadband applications.
The Service Provider Market Opportunity for High-Speed Broadband Services
Historically, telecommunication carriers have used their copper lines primarily for providing basic voice services, commonly referred to as POTS, or plain old telephone service. These telecommunication carriers’ legacy voice revenue is under pressure due to increased competition from cell phone providers, cable operators and other alternative service providers.
Anticipating a significant increase in advanced communications traffic, carriers upgraded their core and metro area networks with millions of miles of high-capacity optical fiber in the 1990s and this upgrade process has continued to the present. However, broadly deploying fiber directly to the end user on the access network to provide high-speed broadband has proven costly and time consuming. As a result, there is disparity between bandwidth in the fiber network and the bandwidth available to the end user. Most Internet users are connected to carriers’ copper lines, a practical means available to the carriers for delivering high-speed broadband services is to utilize their existing copper lines.
In an attempt to meet the growth in demand for Internet access and to supplement their legacy voice revenue, telecommunication service providers have been deploying various generations of broadband technologies in the form of DSL solutions over copper lines. Earlier generations of DSL typically offer transmission rates that are becoming inadequate for providing the bandwidth necessary for advanced digital media, video and communications applications.
In addition, telecommunication carriers and Internet service providers are seeking to offer interactive broadband, including the combination of data, voice and video, or “Triple Play,” services to their subscribers. Interactive broadband provides a richer user experience through the combination of higher upstream and downstream transmission rates, which, together with customizable applications, such as interactive television, provides more personalized services than broadcast-oriented networks. Moreover, more advanced high-speed broadband equipment enables service providers to offer Triple Play and interactive services that may effectively compete with the services currently provided by cable operators.
Telecommunications Market Evolution and Opportunity For Broadband Equipment and Software Providers
We expect that the telecommunications market will continue to evolve quickly in future years as enhanced high-speed broadband technology is deployed and offered to users. This change will require new broadband equipment to be deployed, including new broadband customer premises equipment designed for high-speed broadband services. Service providers also need to manage and support distributed networks of gateways and services. Our goal is to be a leading provider of the customer premises equipment and remote management software required to deploy and manage distributed residential and business networks with high-speed broadband connectivity.
Carriers are responding to competitive challenges in their core voice business, particularly from the cable television network operators, which are beginning to use a bundle of voice, video and high-speed data to gain market share. We expect that carriers will add digital video and other services to their offerings, which already includes voice and high-speed data. Examples of other services include streaming live video, music and pictures.
The strategies that carriers are pursuing to modernize their networks include the deployment of all fiber networks and hybrid fiber/copper networks without end-to-end fiber connection by leveraging advanced digital subscriber line technology.
The all fiber network strategy is often referred to as fiber to the premises (“FTTP”). FTTP provides fiber’s high reliability, ease of service provisioning, and almost unlimited bandwidth. The hybrid fiber/copper network strategy is often referred to as fiber to the neighborhood (“FTTN”) or fiber to the curb. FTTN provides sufficient bandwidth to meet the needs of digital video and other applications. FTTN requires the use of very-high-speed digital subscriber line, or VDSL, a new high performance version of DSL for the connection to the premises. The three largest domestic local exchange carriers, AT&T Corporation (formerly SBC Communications Inc.), Verizon Communications Inc. and BellSouth Corporation, all have announced that they are making substantial investments in the expansion of their fiber optic networks to, or closer to, residences. The fiber lines enable the providers to offer voice, video and high-speed data over one connection. Our gateways and remote management software can be deployed as part of providing and managing these new services.
All these changes will impact the gateway and gateway software management markets in which we compete. For example, as carriers implement FTTP or FTTN and deploy new residential home networking solutions, we may have the opportunity to compete against incumbent suppliers so that carriers achieve the cost and performance requirements for gateways in the modernized network. We are positioning and marketing our products for this evolving market and we expect to compete vigorously to win new and retain existing telecommunication and Internet service provider customers. Attracting new or expanding existing customer relationships could positively benefit our operating performance. Conversely, if we are unable to compete effectively, we could lose existing customer relationships, which could negatively harm our operating performance. Given this evolution and change, we expect the next few years and calendar year 2006 in particular to be a period of intense competition among broadband equipment and remote management software providers with both significant opportunities for growth as well as risk of failure.
Our Strategy
Our objective is to be a leading developer and provider of high performing broadband customer premises networking equipment and remote management software. Our objective is also to be a leading developer and provider broadband enabled services and remote management software for enterprises technical support, help-desks and personal computers.
The principal elements of our strategy are:
Leverage our market and technology positions. We believe we have achieved a major position in the higher performance broadband customer premises equipment market. Our remote management software has recently been implemented for deployment at BellSouth Corporation. We have a long history of providing remote management solutions for networks of personal computers. Our equipment and software has been deployed by many leading telecommunication carriers, Internet service providers, and business enterprises in the United States and Europe.
We are a proven technology leader. We have shipped millions of gateways, including 1.1 million units shipped in the fiscal year ended September 30, 2005. Our equipment is deployed or being tested by many leading carriers and service providers worldwide. Our five largest customers are BellSouth Corporation, AT&T Corporation (formerly SBC Communications Inc.), Swisscom AG, eircom Group plc and Covad
Communications Group, Inc. Our customers conduct extensive system-level testing and field qualification of gateways over many months to ensure that the gateways meet performance, standards compliance and stability requirements before approval for mass deployment.
We intend to leverage our incumbent position to more broadly meet our customers’ gateway and network management requirements, including their upcoming deployments of higher-speed broadband services using newer technologies such as VDSL2 and ADSL2+ bonding for the management and deployment of triple-play services, such as video on demand. We believe that our close relationships with carriers and service providers provide us with a deep understanding of their needs and enable us to continue to develop customized technology and solutions to meet their requirements. We believe that we have extensive experience in delivering gateways with advanced firmware features, such as quality of service, or QoS, for triple play services, for this class of customers. In addition, we have long standing enterprise relationships for remote management software and we intend to maintain and build upon these relationships. We also intend to try to attract new customers worldwide for our broadband equipment and remote management software.
Pursue strategic relationships. We may pursue opportunities for strategic relationships that may allow us to accelerate or complement our growth strategy, increase market share in our current markets, broaden our technology and intellectual property and strengthen our customer relationships.
Leverage our technology capabilities to pursue new market opportunities. We have developed expertise in technologies that are key to high-speed broadband, remote management and broadband related services. We plan to further extend our technology expertise by devoting engineering resources to research and development of our products and solutions as well as by exploring potential technology acquisition opportunities. We intend to use our core technologies and expertise to develop new complementary products that incorporate additional functionality in our gateways, remote management software and broadband enabled services to expand our addressable market.
Gain penetration in broadband enabled services. As residences and distributed businesses increasingly gain high-speed broadband access, we intend to sell other broadband enabled services, including Hot Spot services; business services, such as point-of-sale solutions; website services, including selling website fulfillment (which is creating websites, hosting websites, and selling tools for individuals and enterprises to build websites) and other new applications.
Expand our geographic presence. We have a significant United States and European presence. We are adding sales personnel and field engineers in Europe and the United States. We intend to continue to expand our sales team and technical support organization to broaden our customer reach on a global basis, with particular focus on Europe and North and South America. We believe that geographic expansion provides significant potential for additional long-term growth for our company.
Capitalize on our outsourced manufacturing model. We intend to continue to outsource our manufacturing to multiple reliable outsource manufacturing partners, which minimizes our need for capital investment in manufacturing. We also intend to continue working closely with our third-party outsourcing partners to achieve higher performance and lower cost for our gateways.
Products and Services
Our broadband solutions include broadband equipment, remote management software and broadband enabled services. For the fiscal years ended September 30, 2005 and 2004, revenues from the sale of our broadband equipment accounted for 89% and 85%, respectively, of our total revenues; the balance of revenues was from the sale of software and services.
Our broadband equipment includes modems, routers and gateways for homes and distributed businesses, collectively referred to as gateways. This networking equipment is commonly referred to as customer premises equipment or “CPE” because it resides in the local area network (“LAN”) or the premises side of a telecommunications network. Gateways connect the premises to a communication service provider’s wide area networks (“WAN”). Once connected, our equipment provides various types of connectivity, wired and wireless (“Wi-Fi”) to various types of equipment attached to the gateway, which together form the LAN. Services and attached equipment that pass through and are connected to the gateway might include many combinations, such as data service through an Internet connection to a personal computer, voice service to an Internet Protocol (“IP”) phone, or video service to a digital television. The quality-of-service, commonly referred to as “QoS” is delivered through the firmware imbedded in our equipment.
Our remote management software permits remote management of the broadband equipment and the devices connected at a customer’s premises. Remote management enables a service provider to efficiently and effectively provision services and provide help-desk support to their end-users. The types of services that can be provisioned might include data, voice and video as well as other services that can be delivered through broadband.
We provide remote management software on a licensed or hosted basis. Licensed software is installed by the carrier customer in its own environment. Hosted customers obtain secure access to the software residing in our server network environment.
Broadband Equipment
We offer multiple broadband equipment product lines that are designed to address different segments of the broadband market, from entry-level broadband modems through feature rich high-speed broadband gateways. Service providers can choose from our multiple products based upon the services to be delivered to their customer.
Our gateways connect to carrier lines and enable the transport of broadband, high-speed data over carrier networks including the local copper wires (often referred to as “loop”) and new deployments of fiber-optic networks. We have developed gateways that are designed to achieve the optimal transfer rate that is available from fiber extension over copper network systems based on VDSL2 technology. Our gateways will enable carriers to exploit the benefits of fiber networks using existing copper lines by delivering transmission rates of up to 100 Mbps downstream and 50 Mbps upstream. Our gateways are designed to address this market are branded as MiAVo and utilizes silicon chips designed by Ikanos Communications, Analog Devices, Inc. and Conexant Systems, Inc.
We are introducing gateways that will provide the highest transmission rates achievable over copper telephone lines. These transmission rates enable carriers to deliver advanced digital media, video, communications and interactive broadband applications such as broadcast television, HDTV, IPTV, VOD, interactive television, peer-to-peer file sharing, sending and receiving advanced digital media, video conferencing, video surveillance, streaming audio and video, online gaming and game hosting and VoIP, as well as traditional telephony services.
Our gateways serve many carrier network interfaces, including many digital subscriber line standards (ADSL, ADSL2+, Bonded ADSL and VDSL2), Ethernet, and T1. For users’ devices on the LAN-side of our gateways, our products support both wireless and Ethernet network connectivity. We are developing products using emerging new technology standards such as multimedia over coaxial cable (MoCA and HPNA3).
As carrier-class gateways, our products are designed to deliver high performance, quality of service, excellent reliability, scalability, and affordability, and to be a platform from which carrier and service providers can offer their customers additional broadband services and applications, especially triple play voice, video and data services.
We believe that our key competitive advantages include our broadband equipment expertise, the high quality and high-performance of our firmware, our technology leadership and experience working directly with carriers in mass deployment of this DSL technology as well as the many vendors that provide systems and equipment for provider systems. Our gateways are deployed by many leading telecommunication and Internet service providers and are also being evaluated by other leading service providers.
Key attributes of our broadband equipment include:
Telecommunications carrier class quality and performance. Because the performance of gateway is critical to the quality of the experience of the end-user and customer retention, our gateways undergo extensive testing in carrier laboratories prior to deployment. We have a long history of achieving the quality and performance requirements and subsequent deployment to end-users customers of major telecommunication carriers.
High performing, high quality firmware. We develop and deploy advanced broadband equipment firmware that optimizes many performance characteristics, including:
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Wired and wireless data throughput or data transfer rate;
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Wireless reach, which refers to the distance between the gateway and attached devices, such as a personal computer with continuous access and service;
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Quality of service, or QoS, which is the segmentation of throughput when more than one service is being accessed simultaneously, for example simultaneous data, voice and video services;
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Security, including advanced virtual private networking, or VPN, which allow secure communication over the Internet; encryption; and firewall protection; and
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Standards that enable remote management.
Our firmware can be remotely downloaded into our gateways. This capability allows service providers to upgrade their existing systems without having to replace the gateway, thereby enabling providers to protect their investments and reduce costs. In addition, we provide application software that can be used by our customers to facilitate the remote management and updating of gateways.
Broadband gateway offerings:
Residential Gateways
Our residential modems, routers and gateways are designed to allow service providers to deliver revenue-enhancing services to residential subscribers, from high-speed data services alone to “triple play” combined voice, video, and data services.
MiAVo Series Gateways
Designed explicitly for the “triple play” of bandwidth-intensive, quality-sensitive voice, video, and data services, the MiAVo Series consists of VDSL2 gateways for IP and ATM networks, and bonded ADSL2+ gateways that allow providers to bond ADSL2+ lines for double the throughput of standard ADSL2+ networks.
3300 Series Modems and Gateways
The 3300 Series includes gateways with WAN connections that include ADSL, ADSL2+, and Ethernet for use with cable modems or other WAN devices. LAN interfaces include USB, Ethernet, and 3-D Reach Wi-Fi. The 3300-VGx models feature Netopia’s QoS technology to enable delivery of quality-sensitive voice services for “double play” offering of voice and high-speed Internet, while the 3342 Pocket Modem gives providers a highly cost-effective means to provide low-cost high-speed Internet to single-PC households.
2200 Series ADSL2+ Gateways
The 2200 Series ADSL2+ residential gateways enable lower-cost deployments of data or data and voice services, with robust features for diverse LAN connectivity, ease of use, and security. Models include one to four LAN ports with USB and Ethernet connections, and optional 802.11g Wi-Fi.
The following table summarizes our residential gateways:
Business Routers and Gateways
Our portfolio of business-class broadband equipment has a combination of routing, security, and management features that service providers can use to meet the requirements of small and medium business subscribers and distributed enterprises.
3300 Business Series Routers
The 3300-ENT Series business-class routers are designed for deployment of cable or ADSL/ADSL2+ broadband connectivity in distributed enterprises, while the 3300-VGx routers offer user-friendly features for small-business subscribers. The 3300 Series enables business service providers and enterprises to deliver business-class functionality for small branch office and home office environments.
4500 Series Routers
The 4500 Series business-class routers are designed for cost-effective broadband connectivity using a variety of WAN options, including ADSL, SDSL, IDSL and T1.
4600 Series Routers
The 4600 Series business-class routers combine hardware-based VPN acceleration, built-in software VPN features, an Ethernet switch, and routing and management tools in a single device. Designed for the needs of small, medium, and distributed enterprises, the 4600 Series offers the WAN options of SDSL, IDSL, and T1.
R-Series Routers
The R-Series routers have modular architecture, enabling cost effective upgrades to different WAN connections such as Ethernet or T1. The R-Series is designed to support a wide range of networking options, from analog to Ethernet to T1.
The following table summarizes our business routers and gateways:
Accessories
Designed to make Wi-Fi connectivity simple for laptops and desktops, we also sell Wi-Fi PC cards and USB adapters.
Remote Management Software and Broadband Enabled Services
Our remote management software and broadband enabled solutions include remote device management, help desk software, network management, and eCommerce solutions. Our remote control and help desk products were designed to increase the capacity of support organizations with virtual hands-on tools in order to reduce call time and the need for on-site service calls.
We offer two principal remote management software solutions: NBBS (Netopia Broadband Server software) and Timbuktu.
Netopia Broadband Server
Our Netopia Broadband Server, or NBBS, software solution enables carrier-to-customer remote support and management of installed broadband gateways and centralized service delivery (provisioning) for value-added broadband services such as voice, video and data. Utilizing the TR-069 protocol standard adopted by the DSL Forum as well as other standard methodologies, this solution allows carriers and broadband service providers to provision services and provides support to their customers on a remote basis, which can lower the cost of installation and broadband service provisioning over the lifetime of the relationship with their customers. NBBS can manage both Netopia gateways and other third party devices.
Timbuktu
Timbuktu Pro software provides remote control and computing individual-to-individual and help desk-to-users, for secure remote control of both Mac and Windows personal computers. This solution serves enterprise help desk customers and IT organizations, allowing help desks to provide support and configuration on a remote basis when computer users experience problems or require additional software upgrades for desktop or laptop computers. Remote control of distant computers can use connections over the Internet, local network, or modem-to-modem. The software enables other users to view all, or part of a computer’s screen, file sharing, secure encrypted connections and communication by voice intercom, text chat, or instant message. The remote control can be from Mac to PC, or PC to Mac, or across like platforms.
Broadband Enabled Services
Our broadband enabled service offerings (including Web site, help desk, Hot Spot, and parental controls solutions) are designed for enterprises and distributed businesses and are designed to provide carriers and service providers a selection of value-added services capable of generating incremental monthly service revenue opportunities.
Web site and Web Store Hosting
Our eCommerce solutions provide “no assembly required” Web sites and online stores that we call eSites and eStores, and include a wide variety of vertical market content packages to suit many business needs, from franchisees to sole proprietors.
eCare-Remote Control Hosting
Designed for help desks, technical support, customer service and call centers, we offer a hosted remote control solution that uses the remote control technology of Timbuktu. Marketed as eCare, this hosted service enables customer support agents to support their customers over the Internet with Web-enabled desktop remote control, screen sharing, chat as well as trouble ticketing, tracking and diagnostic services. This solution is designed to allow support personnel to provide virtual hands-on support.
Parental Controls
We offer a gateway-based parental controls service that enables gateways to block adult content and supervise Internet access. This solution enables control of the home Internet network and is designed to monitor access to the Internet by user profile at the gateway, regardless of which Internet-capable device is used.
Support Services
Our products and services are complemented by a set of support services and managed services that assist our customers in rapidly deploying our solutions.
Technical Support. We provide technical support to our customers, including telephone support, and online access to our support personnel and internal technical databases.
Managed Services. We offer managed services associated with our remote management software and broadband enable services. These services provide customers flexibility in deploying and running their Netopia solutions by offering various levels of hosting, complete solution outsourcing or remote management of our solutions. Our data centers feature dedicated staff and scalable advanced technology infrastructure, high system availability, proactive monitoring and disaster recovery capabilities necessary to operate mission-critical services. Our managed services alternatives allow our customers to realize the benefits of our solution with reduced project risk, complexity and time to market, while simultaneously achieving increased operational efficiency, service and maintenance levels.
Creative Services. We offer custom website design services for customers who prefer to outsource website design and maintenance, but who want a more cost-effective alternative to traditional web design firms.
Customers
Our largest customers are telecommunications carriers and service providers. They include regional, national, and international telecommunications carriers, as well as Internet Service Providers.
Three customers accounted for 10% or more of revenues in fiscal years 2005 and 2004. Sales to BellSouth Telecommunications, Inc. were approximately 20% and 10% of revenues in fiscal years 2005 and 2004, respectively. Sales to Swisscom AG were approximately 18% and 19% of revenues in fiscal years 2005 and 2004, respectively. Sales to eircom Group plc were approximately 10% of revenues in fiscal year 2005 and less than 10% of revenues in fiscal year 2004. Sales to AT&T Corporation (formerly SBC Communications Inc.) were less than 10% of revenues in fiscal year 2005 and approximately 10% of revenues in fiscal year 2004.
Sales to our top 5 customers accounted for 64% and 53% of revenues in fiscal years 2005 and 2004, respectively.
Sales and Marketing
Our Sales and Marketing organization has primary responsibility for our field sales, relationships with carriers, Internet Service Providers, distributors and resellers, technical sales support, technical services, product management, and marketing. Our field sales force is geographically disbursed within the United States and Europe.
We sell our products to customers in the United States, and other parts of the world, primarily in Europe. Sales to customers in the United States accounted for 64% and 61% of revenues in fiscal years 2005 and 2004, respectively. Sales to customers in Europe accounted for 33% and 36% in fiscal years 2005 and 2004, respectively.
Sales to our largest customers have fluctuated in the past and could fluctuate significantly from quarter to quarter and year to year. Typically customers provide us with purchase orders for units on an as-needed basis. Because our largest customers are significantly larger than, and are able to exert a high degree of influence over, us, they may be able to reschedule or cancel orders without significant penalty. Prior to selling our products to large service providers and organizations, we must undergo lengthy evaluation, approval, and purchase processes.
Backlog
Our backlog at September 30, 2005, the last day of fiscal year 2005 was approximately $7.2 million, compared with backlog of approximately $13.6 million at September 30, 2004. Backlog includes orders confirmed with a purchase order for products scheduled for shipment within 90 days to customers with approved credit status. Because of the generally short cycle between order and shipment and occasional customer changes in delivery schedules or cancellation of orders (which are made without significant penalty), we do not believe that our backlog at any particular date is necessary indicative of actual revenues for any future period.
Research and Development
Our research and development efforts are focused on the development of advanced broadband equipment, related software and remote management software, and other broadband enabled services. We have experienced engineers who have expertise in advanced broadband networking equipment hardware, firmware and systems and remote management software. In addition, we work closely with the research and development teams of our vendors and customers. During fiscal years 2005 and 2004, research and development expense was $13.4 million and $15.8 million, respectively. All of our expenditures for research and development costs in fiscal years 2005 and 2004 have been expensed as incurred. We expect to continue to devote substantial resources to product and technological development.
Many of our products are standards based, particularly broadband equipment and remote management software for broadband equipment. We seek to confirm with industry wide standardization organizations, which include the DSL Forum, the American National Standards Institute in the United States and the European Telecommunications Standards Institute, which are responsible for specifying transmission standards for telecommunications technologies. We incorporate these standards into the design of our products and purchase components based on these standards. Our broadband equipment products depend on semiconductor chips that function according to these standards. Accordingly, our broadband equipment business depends on the availability of semiconductor chips at competitive prices.
The industry in which we compete is subject to rapid technology developments, evolving standards, changes in customer requirements, and new competitor product introductions and enhancements with increasingly higher levels of performance, reliability, and systems compatibility. As a result, the future of our business depends in part upon our ability, on a cost-effective and timely basis, to continue to enhance our existing products, to develop or acquire new functionality and features, and to introduce new products that improve performance, enable new services and reduce total cost of ownership. We continuously evaluate changing market needs to provide customers with new broadband equipment and services incorporating new technologies, standards and functionality. In order to achieve these objectives, our management and engineering personnel work with customers to identify and respond to customer needs, as well as with vendors and other corporations on strategic product development. We intend to continue developing products that meet key industry standards and to enable evolving communication service opportunities, particularly Internet protocol services. There can be no assurance that we will be able to successfully develop products to address new customer requirements and technological changes or that our products will achieve market acceptance.
Manufacturing
We primarily employ an outsourced manufacturing strategy that relies on third-party outsourcing manufacturers for manufacturing services. Our third-party outsourcing manufacturers produce our hardware products in factories primarily located in Thailand, China and Mexico. They produce the circuit boards for our broadband equipment and in certain circumstances assemble, package and ship our products directly to our customers. We presently rely on a three outsourcing manufacturers and on many vendors that sell components. The manufacturing processes and procedures are ISO 9001 certified. We have not entered into any significant long terms contracts with any outsourcing manufacturer. The arrangements with our outsourcing manufacturers generally do not commit us to purchase any particular amount or quantities beyond certain amounts covered by orders that we submit covering discrete periods of time. Reliance on third-party subcontractors involves several risks, including the potential absence of adequate capacity, delivery schedules, manufacturing yields and product quality, and cost.
Competition
The markets in which we compete are characterized by rapid technological change, converging technologies, evolving industry standards, evolving customer requirements, price competition and frequent new product introductions. We face significant to intense competition in all areas of our business. Most of our revenues are from the sale of broadband communications equipment and the competition in that market is intense. We must continually anticipate market trends and develop new products that meet the requirements of our customers.
We compete with numerous vendors in each product category. The competition in the broadband equipment market has become increasingly global. Reference designs for customer premises equipment from semiconductor manufacturers have lowered barriers to entry from low-cost manufacturers. As a result, we are seeing more price- focused competitors from Asia, and we anticipate this will continue. However, because of the high standards and exhaustive lab tests performed by major telecommunication carriers, this class of competitor has not been successful to date in selling to our largest customers.
Increased competition may result in price reductions, reduced gross margins and loss of market share, any one of which could harm our business.
In the market for broadband equipment and services, we primarily compete with 2Wire, Inc.; Actiontec Electronics, Inc.; Siemens AG; Thomson Corporation; Westell Technologies, Inc.; and ZyXEL Communications Co., among others.
In the market for our remote management software for broadband services and equipment, we compete primarily with 2Wire, Inc.; Fine Point Technologies, Inc.; Siemens AG; SupportSoft, Inc. and Motive, Inc., among others.
In the market for remote management software for enterprises technical support, help-desks and personal computers, we compete primarily with Altiris, Inc.; Axeda Systems; CrossTec Corporation; Citrix Systems Inc.; LANDesk Software, Inc.; Microsoft Corporation; SupportSoft, Inc.; Symantec Corporation; WebEx and open source software initiatives.
The market for Web site services is highly fragmented with a large number of competitors. Some of the prominent competitors include Interland, Inc.; Hostopia; United Online, Inc; Website Pros, Inc.; and Affinity Internet, Inc.
Many of our competitors in each product area have significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger base of customers than we do. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of these industries. In the past, we have lost potential customers to competitors in each product area for various reasons, including lower prices and other incentives that we did not match. Furthermore, new competitors or alliances among competitors may emerge and rapidly acquire significant market share. The worldwide telecommunications industry has and is experiencing consolidation, such as the merger of SBC Communications Inc. and AT&T Corporation, and we cannot predict the impact of this consolidation on competition in our markets.
We believe that the principal competitive factors in our markets are:
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Product feature, functionality and reliability;
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Proven customer results;
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Customer service and support;
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Price and performance;
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User experience, including ease of installation and use;
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The ability to timely introduce new products, including products with price-performance advantages and products that respond to customer requirements;
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The ability to provide value-added features;
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The ability to reduce product costs;
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Conformance to standards;
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Breadth of product line;
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The loyalty of customers to incumbent suppliers;
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Brand name recognition; and
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Strategic alliances.
We cannot provide assurance that we will be able to compete successfully in the future. An inability to successfully compete would seriously harm our business.
We also face competition from customers to whom we sell or with whom we collaborate. For example, our management software manages customer premises equipment manufactured by other vendors, and as a result we
must cooperate and at the same time compete with many companies. Balancing cooperation and competition is inherently challenging. Any inability to effectively manage these complicated relationships with customers and strategic partners could have a material adverse effect on our business, operating results, and financial condition and according affect our chances of success.
Intellectual Property and Other Proprietary Rights
Our ability to compete is dependent in part on our proprietary rights and technology. We rely primarily on a combination of patent, copyright, trademark and trade secret laws, confidentiality procedures and contractual provisions to protect our proprietary rights. We presently have one United States patent issued that relates to the remote control technology in our eCare and Timbuktu software. The term of this patent is through August 2010. We also have filed patent applications relating to the design of our broadband equipment. We generally enter into confidentiality or license agreements with our employees, consultants, resellers, distributors, customers and potential customers and limit access to the distribution of our software, hardware designs, documentation and other proprietary information. However, in some instances, we may find it necessary to release our source code to certain parties.
Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult, and there is no guarantee the safeguards we employ will protect our intellectual property and other valuable competitive information. In addition, the laws of some foreign countries where our products are or may be manufactured or sold, particularly developing countries including various countries in Asia, do not protect our proprietary rights as fully as do the laws of the United States. We rely upon certain software, firmware and hardware designs that we license from third parties, including firmware that is integrated with our internally developed firmware and used in our products to perform key functions. We cannot be certain that these third-party licenses will continue to be available to us on commercially reasonable terms. The loss of, or inability to maintain, such licenses could result in shipment delays or reductions until equivalent firmware is developed or licensed, and integrated into our products, which would seriously harm our business.
There has been a substantial amount of litigation in the software and Internet industries regarding intellectual property rights. Although we have not been party to any such litigation, in the future, third parties may claim that our current or potential future products or we infringe their intellectual property. The evaluation and defense of any such claims, with or without merit, could be time-consuming and expensive. Furthermore, such claims could cause product shipment delays or require us to enter into royalty or licensing agreements on financially unattractive terms, which could seriously harm our business.
Employees
As of November 30, 2005, we employed 297 persons, including 113 in research and development, 60 in sales and marketing, 33 in professional services, 27 in customer service and support, 33 in manufacturing operations, and 31 in general and administrative functions. None of our employees is represented by a collective bargaining agreement, nor have we experienced any work stoppage. We consider our relations with our employees to be positive.
We depend on key employees and in general our employees are vital to our future performance. Our key management, engineering and other employees are difficult to replace. We do not generally have employment agreement with our employees in the United States. On December 9, 2005, we entered into an employment agreement effective as of October 1, 2005 with Alan B. Lefkof, our President and Chief Executive Officer. We do not carry key person life insurance. The loss of the services of one or more of our key personnel could seriously harm our business. Competition for qualified personnel in our industry and geographic location is intense. We believe that our future success depends in part on our continued ability hire, assimilate, and retain qualified personnel. During fiscal year 2005, we believe that we have been successful in recruiting qualified employees, but there can be no assurance that we will continue to be successful in the future.
ITEM 2.
ITEM 2. PROPERTIES
The facilities we occupy are generally leased for a term of one to five years. We believe that our existing facilities are adequate for our current needs and that additional space sufficient to meet our needs for the foreseeable future will be available on reasonable terms. Since our California facilities are located near major earthquake fault lines in the San Francisco Bay area, our business could be seriously harmed in the event of a major earthquake. The following table sets forth our facilities and their related lease terms as of September 30, 2005:
(a) Other office space in Paris, France and Alexandria, Virginia used primarily for sales and marketing activities.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
On December 3, 2004, the United States District Court for the Northern District of California issued an order consolidating previously filed purported class action cases under the name In re Netopia, Inc. Securities Litigation, and appointing lead plaintiffs and plaintiffs’ counsel. On June 29, 2005, the lead plaintiffs filed their consolidated amended complaint. The consolidated amended complaint alleges violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The consolidated amended complaint alleges that during the purported class period, November 6, 2003 through August 16, 2004, we made false and misleading statements or failed to disclose material facts, and that the market price of our common stock was artificially inflated as a result of such alleged conduct. We believe that we have strong defenses to the claims asserted in the consolidated amended complaint. We intend to defend the case vigorously. We currently cannot estimate the extent of the potential damages in this dispute.
In August 2004, the first of four purported derivative actions, Freeport Partners, LLC, Derivatively on Behalf of Nominal Defendant Netopia, Inc., v. Alan B. Lefkof, William D. Baker, Reese M. Jones, Harold S. Wills, Robert Lee and Netopia, Inc., was filed in the United States District Court for the Northern District of California. Two purported derivative actions are pending in the United States District Court for the Northern District of California, and two related purported derivative actions are pending in the Superior Court of California for the County of Alameda. These actions make claims against our officers and directors arising out of the alleged misstatements described above in connection with the purported class action described above. In November 2004, the derivative plaintiffs agreed to coordinate the four derivative actions. The parties have agreed to a stay of the federal derivative actions, which was ordered by the court in January 2005. The state actions have been consolidated under the name In re Netopia, Inc. Derivative Litigation. The plaintiffs have not filed their consolidated amended complaint. We believe that we have strong defenses to the claims asserted in the complaints as initially filed. We intend to defend the cases vigorously. We currently cannot estimate the extent of the potential damages in this dispute.
On October 29, 2004, we were advised by the United States Securities and Exchange Commission (“SEC”) that an informal inquiry previously commenced by the SEC had become the subject of a formal order of investigation. This investigation is to determine whether the federal securities laws have been violated. We cooperated fully with the informal inquiry, and we have been cooperating fully with the formal investigation.
On July 22, 2005, we announced that following discussions with the SEC staff, we had made a settlement offer to the SEC to resolve the investigation into our disclosures and accounting practices, primarily related to our restatement of financial statements for the fiscal years ended September 30, 2003 and 2002. Without admitting or denying any wrongdoing, we offered to consent to the entry of an order with respect to violations of Sections 13(a) and 13(b)(2)(A)-(B) of the Exchange Act, and Rules 12b-20, 13a-1, 13a-11 and 13a-13 promulgated thereunder. The SEC staff has agreed to recommend that the SEC approve the offer of settlement. The proposed settlement is subject to completion of mutually agreeable settlement language and final approval by the SEC.
On July 22, 2005, we also announced that we had learned that the SEC staff has agreed to recommend that the SEC approve an offer of settlement with Alan B. Lefkof, our President and Chief Executive Officer. Mr. Lefkof, without admitting or denying any wrongdoing, offered to consent to the entry of an order with respect to violations of Sections 17(a)(2)-(3) of the Securities Act of 1933, as amended, and Rule 13b2-1 promulgated under the Exchange Act, and aiding and abetting our violations of Sections 13(a) and 13(b)(2)(A)-(B) of the Exchange Act, and Rules 12b-20 and 13a-11 promulgated thereunder, in connection with a Report on Form 8-K and exhibit furnished to the SEC on July 6, 2004. The proposed settlement with Mr. Lefkof contemplates a monetary payment. The proposed settlement is subject to completion of mutually agreeable settlement language and final approval by the SEC.
Responding to the formal order of investigation of the SEC has required significant attention and resources of management. Our proposed settlement described above is subject to final approval by the SEC. In addition,
even though we have announced the proposed settlement with the SEC, the investigation by the SEC is ongoing, and may continue to require significant attention and resources. If either we and/or Mr. Lefkof are unable to complete the proposed settlements and the SEC elects to pursue an enforcement action against us and/or Mr. Lefkof, the defense could be costly and require additional management resources. If we were unsuccessful in defending against this or other investigations or proceedings, we could face civil or criminal penalties that would seriously harm our business and results of operations.
In April 2005, we learned that the United States Attorney for the Northern District of California has opened an investigation following a referral by the SEC. We do not know the scope or focus of the investigation.
In January 2005, we were notified by the Occupational Health and Safety Administration (“OSHA”) that we were named in an administrative complaint filed by two former employees alleging violations of Section 806 of the Corporate and Criminal Fraud Accountability Act of 2002, 18 U.S.C. § 1514A, also known as the Sarbanes-Oxley Act. The former employees alleged that we terminated them in retaliation for their participation in the internal accounting review conducted by the audit committee in 2004. On May 11, 2005, following its investigation, OSHA advised us that the complaint was determined to have no merit. On August 31, 2005, the two former employees refiled these claims in the United States District Court for the Northern District of Texas in an action entitled Frankl v. Netopia et al. The complaint names the Company and certain current and former officers and directors as defendants. The plaintiffs will be filing a motion to stay this action. We believe that our defenses to this action are strong and intend to defend it vigorously. We currently cannot estimate the extent of the potential damages in this dispute.
In February 2005, these same two former employees filed a complaint in the United States District Court for the Northern District of Texas, Dallas Division. The complaint named the Company and Alan Lefkof as defendants, and asserted claims for defamation and breach of contract. The plaintiffs have voluntarily dismissed this action.
Defending against the government investigations, the private securities class action, the derivative actions and other litigation matters described above will likely require significant attention and resources of management and, regardless of the outcome, result in significant legal expense. If our defenses ultimately are unsuccessful, or if we are unable to achieve a favorable settlement, we could be liable for large damage awards that could seriously harm our business and results of operation. While we have provided notice of the government investigations and the litigation matters described above to our directors and officers liability insurance carriers, the insurance carriers have raised certain coverage issues and to date have not reimbursed us for all legal expenses incurred, and may not agree that they are responsible to pay any damages that ultimately could be awarded to the plaintiffs. Furthermore, we have only a limited amount of insurance, and even if our insurers agree to make payments under the policies, the legal expenses and damage awards or settlements may be greater than the amount of insurance, and we would in all cases be liable for any amounts in excess of our insurance policy limits.
We are named as a defendant in an action pending in the United States Bankruptcy Court for the Northern District of California entitled E. Lynn Schoenmann, trustee of NorthPoint Communications, Inc. v. Netopia. In this action commenced on January 11, 2003, the trustee of the bankruptcy estate of NorthPoint Communications, Inc. (“NorthPoint”) is seeking to recover approximately $1.2 million that NorthPoint paid to us within the 90-day preference period before NorthPoint filed for bankruptcy in January 2001. NorthPoint’s trustee is claiming that NorthPoint was insolvent at the time it made these payments, and that therefore the payments are recoverable preferences within the meaning of the Bankruptcy Code. We believe that we have defenses to the claims asserted by NorthPoint’s trustee, and we intend to continue to defend ourselves vigorously. We do not believe that the outcome of this lawsuit is likely to harm our business seriously. We currently cannot estimate the extent of the potential damages in this dispute.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
There were no matters submitted to a vote of our security holders during the fiscal fourth quarter ended September 30, 2005.
ITEM 4A. Executive Officers of the Registrant
Our executive officers, and their ages as of December 14, 2005, are as follows:
Name
Age
Position
Alan B. Lefkof
President, Chief Executive Officer and Director
Charles Constanti
Vice President and Chief Financial Officer
Brooke A. Hauch
Senior Vice President, Professional Services
David A. Kadish
Senior Vice President, General Counsel and Secretary
Bao T. Nguyen
Vice President of Software Engineering
Dano Ybarra
Senior Vice President, Sales and Marketing
Alan B. Lefkof. Mr. Lefkof, President, Chief Executive Officer and Director, joined Netopia as President and a member of the Board of Directors in August 1991 and has been Chief Executive Officer since November 1994. Mr. Lefkof received a B.S. in computer science from the Massachusetts Institute of Technology in 1975 and a M.B.A. from Harvard Business School in 1977.
Charles Constanti. Mr. Constanti was appointed Chief Finance Officer effective May 16, 2005. From May 2001 to April 2005, Mr. Constanti served as Vice President of Finance and Corporate Controller of Quantum Corporation, for which he earlier served in different accounting and finance positions since January 1997. Mr. Constanti is a certified public accountant and earned a B.S. in Accounting from Binghamton University in 1985.
Brooke A. Hauch. Ms. Hauch, Senior Vice President, Professional Services, joined Netopia in October 1991 as Director, MIS. Ms. Hauch was appointed Vice President and Chief Information Officer in May 1997, and became Senior Vice President in October 2000. Ms. Hauch received a bachelor’s degree in business from Arizona State University.
David A. Kadish. Mr. Kadish, Senior Vice President, General Counsel and Secretary, joined Netopia in June 1999. Mr. Kadish provided legal services to Netopia as a consultant from September 1996 to June 1999. Mr. Kadish received a B.A. in American history from University of California at Santa Cruz in 1973, a M.A. in American history from Brandeis University in 1974 and a J.D. from Yale University in 1979.
Bao T. Nguyen. Mr. Nguyen joined Netopia in June 2004 as Vice President of Software Engineering. Prior to joining Netopia, Mr. Nguyen served as Vice President of Software Engineering at 2Wire, Inc. from 2002 to 2004, Vice President of Software Engineering at TCSI, Inc. in 2001, and Vice President of Research & Development at GVN Technologies, Inc. in 2000. Mr. Nguyen received a BSEE degree (Bachelor of Science in Electrical Engineering) from the University of Minnesota in 1987, and a M.B.A. from the University of St. Thomas in 1990.
Dano Ybarra. Mr. Ybarra, Senior Vice President, Sales and Marketing, joined Netopia in July 2003 as Vice President of Business Development, was named Vice President of Marketing in January 2004, and took on his current role in September 2004. Prior to joining Netopia, he served as a Vice President and General Manager, Business Solutions Division of the Siemens Subscriber Networks, Inc. subsidiary of Siemens AG, formerly Efficient Networks, from 1997 to 2003. Mr. Ybarra received a B.S. in Computer Science from Portland State University in 1984.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Following our initial public offering in June 1996, our common stock traded on the NASDAQ Stock Market. Effective October 20, 2004, our stock was delisted because we had failed as of that date to file our Quarterly Report on Form 10-Q for the fiscal quarter ended June 30, 2004, due to an internal accounting review.
From October 20, 2004 to November 8, 2005, our common stock traded on the National Daily Quotations Journal, often referred to as the “pink sheets,” where subscribing dealers can submit bid and ask prices on a daily basis. On November 9, 2005, our common stock was listed for quotation on the OTC Bulletin Board (OTCBB) System under the symbol NTPA. The OTCBB is a regulated quotation service that displays real-time quotes, last-sale prices, and volume information in over-the-counter (OTC) equity securities.
The following table sets forth the range of quarterly intra-day high and low sale prices of our common stock for the last two fiscal years ended September 30, 2005 and 2004.
On December 12, 2005, we had 146 stockholders of record and 25,430,320 shares of common stock outstanding. The closing price of our common stock as reported on the OTCBB was $2.58 per share. Historically, we have neither declared nor paid cash dividends on our common stock, and we expect this trend to continue. We maintain stock option plans under which we grant options to purchase our common stock and an Employee Stock Purchase Plan under which our common stock is sold to employees participating in such plans. Additional information with respect to these plans can be found in Note 8 of Notes to Consolidated Financial Statements, which is incorporated herein by reference. We did not repurchase any of our shares of common stock in the fiscal quarter ended September 30, 2005.
The market price of our common stock may fluctuate significantly in response to a number of factors, including the following, some of which are beyond our control:
•
Variations in our quarterly operating results;
•
Changes in securities analysts’ estimates of our financial performance;
•
Changes in market valuations of similar companies;
•
Announcements by us or our competitors of technological innovations, new products or enhancements, significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments;
•
Losses of major customers, major projects with major customers or the failure to complete significant licensing transactions;
•
Additions or departures of key personnel;
•
Developments in ongoing litigation matters and the SEC investigation of us;
•
Our ability to have our common stock listed again on the Nasdaq National Market;
•
Volatility generally of securities of companies in our industry;
•
General conditions in the broadband communications industry, in particular the DSL market, or the domestic and worldwide economies;
•
Decreases or delays in purchases by significant customers;
•
A shortfall in revenues or earnings from securities analysts’ expectations or other announcements by securities analysts;
•
Our ability to protect and exploit our intellectual property or defend against the intellectual property rights of others; and
•
Developments in our relationships with customers, distributors and suppliers.
In recent years the stock market in general, and the market for shares of high technology stocks in particular, have experienced extreme price fluctuations, which often have been unrelated to the operating performance of affected companies. There can be no assurance that the market price of our common stock will not experience significant fluctuations in the future, including fluctuations that are unrelated to our performance.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data should be read in conjunction with “Item 7.
ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion and analysis should be read in conjunction with our Consolidated Financials Statements and related Notes included elsewhere in this Annual Report on Form 10-K.
Changes to Previously Announced Fourth Fiscal Quarter and Fiscal Year 2005 Results
Subsequent to the November 10, 2005 announcement of our preliminary financial results for fiscal year 2005, we have made certain adjustments to these reported preliminary results. These adjustments resulted in an increase in inventory and accrued liabilities in the amount of $722,000 relating to inventory in-transit to us from one of our outsourcing manufacturing partners. These adjustments had no impact on our Consolidated Statements of Operations.
Overview
We are a developer and provider of high performance broadband customer premises networking equipment and carrier-class software for the remote management of broadband services and equipment. We also develop and provide broadband enabled services and remote management software for enterprises technical support, help-desks and personal computers.
The growth of our revenues to $106 million in fiscal year 2005 from $101 million in the prior fiscal year resulted from increased sales of broadband equipment to our existing customers. In fiscal year 2005, we retained our key broadband equipment customers. We have experienced a decline in our software and service sales, mostly from a decline in license revenue for Timbuktu, our remote management software for personal computers. The decline in the sales of Timbuktu reflected turnover in our software sales group. In the fourth fiscal quarter of fiscal year 2005, we licensed Netopia Broadband Server (NBBS), to BellSouth Telecommunications, Inc. This license of NBBS to BellSouth was part of a multiple element arrangement, and some of the elements of this arrangement were undelivered as of September 30, 2005. As a result, the license revenue was deferred as of September 30, 2005 because not all revenue recognition criteria under generally accepted accounting principles (GAAP) had been satisfied for the undelivered elements.
In fiscal year 2006, we will focus on revenue growth for both our broadband networking equipment and our software and services. Our objective is to increase sales to existing customers and to attract new customers. Our goal is to leverage our strengths in DSL technologies to meet market requirements for higher bandwidth services being provided by telecommunications and Internet service providers. This focus includes achieving design wins for higher performance gateways utilizing new technologies, including VDSL2 and ADSL2+ Bonded technologies as well as other innovations. Software and services revenue growth is largely dependent on sales and revenue from our NBBS remote management software.
In fiscal year 2005, continued to have geographic and customer revenue balance. Of our five largest customers that made up 64% of sales in fiscal year 2005, three are in the United States and two are in Europe. Revenue from the United States was 64% of revenues in fiscal year 2005 and international revenue, mostly from Europe, was 36% of revenues. We had three customers that each comprised greater than 10% of revenues: BellSouth Telecommunications, Inc. was 20% of revenues; Swisscom AG was 18% of revenues; and eircom Group plc was 10% of revenues.
During fiscal year 2005, 89% of our revenues were from the sale of broadband equipment, compared to 85% in the prior fiscal year. The balance of revenues was from the sale of software and services.
Our net loss in fiscal year 2005 was $7.1 million or a diluted $0.28 loss per share, compared with a net loss of $8.8 million or a diluted $0.37 loss per share in fiscal year 2004.
We ended fiscal year 2005 with $22.2 million of cash and cash equivalents and no long-term debt. Cash was down from $24.0 million in fiscal year 2004. Legal spending was the primary cause of the decline in cash. Legal costs were $2.6 million and $2.8 million in fiscal years 2005 and 2004, respectively. We believe we have adequate cash, cash equivalents and borrowing capacity to meet our anticipated capital needs for at least the next twelve months.
Critical Accounting Policies and Estimates
Management’s discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. We review the accounting policies used in reporting our financial results on a regular basis. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our processes used to develop estimates, including those related to revenues, accounts receivable, inventories, investments, intangible assets and goodwill. We base our estimates on historical experience, expectations of future results, and on various other assumptions that are believed to be reasonable for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates due to actual outcomes being different from those on which we based our assumptions. These estimates and judgments are reviewed by management on an ongoing basis. The Audit Committee reviews any changes in our methodology for arriving at our estimates, and discusses the appropriateness of any such changes with management and our independent auditors on a quarterly basis. We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our consolidated financial statements.
Revenue Recognition. Our products are integrated with software that is essential to the functionality of the equipment. Accordingly, we account for revenues in accordance with Statement of Position (“SOP”) No. 97-2, “Software Revenue Recognition,” and all related interpretations. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. Determining whether and when some of these criteria have been satisfied often involve assumptions and judgments that can have significant impact on the timing and amount of revenues we report. At the date of shipment, assuming that the revenue recognition criteria specified above is met, we provide for an estimate of returns and warranty expense based on historical experience of returns of similar products and warranty costs incurred, respectively.
We recognize software revenue in accordance with SOP 97-2, as amended by SOP 98-9, and SEC Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition”. We have multiple element arrangements, including perpetual software licenses and maintenance. We allocate and defer revenue for the undelivered items based on vendor-specific objective evidence, or VSOE, of fair value of the undelivered elements, and recognize the difference between the total arrangement fee and the amount deferred for the undelivered items as revenue. VSOE of each element is based on the price for which the undelivered element is sold separately. We determine fair value of the undelivered elements based on historical evidence of our stand-alone sales of these elements to third parties. Software license revenue is recognized when a non-cancelable license agreement has been signed or a properly authorized firm purchase order is received and the customer acknowledges an unconditional obligation to pay, the software product has been delivered, there are no uncertainties surrounding product acceptance, the fees are fixed and determinable, and collection is considered probable. Maintenance revenue, including revenue included in multiple element arrangements, is deferred and recognized ratably over the related contract period, generally twelve months.
We apply the provisions of Emerging Issues Task Force (“EITF”) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, to arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. Our enhanced web site services generally involve the delivery of multiple services. We allocate a portion of the arrangement fee to the undelivered element, generally web site hosting,
based on the residual method utilizing VSOE for the undelivered elements, regardless of any separate prices stated within the contract for each element. VSOE for hosting is based on the price the customer would pay when sold separately. Fair value for the delivered elements, primarily fulfillment services, is based on the residual amount of the total arrangement fees after deducting the VSOE for the undelivered elements. Fulfillment revenue is recognized when a properly authorized firm purchase order is received and the customer acknowledges an unconditional obligation to pay, there are no uncertainties surrounding product acceptance, the fees are fixed and determinable, collection is considered probable and the fulfillment has been completed. Hosting revenue is deferred and recognized ratably over the related service period, generally twelve months. We have adopted the provisions of EITF 01-09, Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products), for the accounting treatment of marketing incentive programs that have resulted in the provision of rebates, credits and discounts given to our customers directly or indirectly. We presume such incentive programs and rebates, credits and discounts to be a reduction of the selling prices of the our products and/or services and, therefore, are characterized as a reduction of revenue when recognized in our Consolidated Financial Statements.
Goodwill. We perform goodwill impairment tests on an annual basis in our fiscal fourth quarter. For additional information about goodwill, see Note 3 to the Consolidated Financial Statements.
Long-Lived Assets, Including Other Intangible Assets. We evaluate our long-lived assets, including other intangible assets and test our long-lived assets and other intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future net cash flows expected to be generated by the asset group that represents the lowest level for which identifiable cash flows exist. If an asset group is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount exceeds the fair value of the assets and is allocated to the long-lived assets of the asset group on a pro rata basis. Fair value is estimated using the discounted cash flow method. Assets to be disposed of are reported at the lower of carrying values or fair values, less costs of disposal.
Allowance for Doubtful Accounts. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments that are deemed uncollectible. Management specifically analyzes the aging of accounts receivable and also analyzes historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customer payment terms, when evaluating the adequacy of the allowance for doubtful accounts in any accounting period. We will continue to monitor our customers’ ability to pay throughout the term of the applicable arrangement and will adjust the provision for bad debt allowance or defer revenue recognition, as appropriate. If the financial condition of our customers or channel partners were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.
Allowance for Sales Returns. We maintain allowances for sales returns from distributors and resellers. Management specifically analyzes historical trends and current information when evaluating the adequacy of the sales return allowance.
Service Accrual. We expense costs to provide future complimentary, technical phone support for hardware and software customers. This is telephone support that is not paid for by the customer pursuant to the terms of a contractual agreement. Effective in the fourth fiscal quarter of 2005, the Company changed the policy of providing hardware customers complimentary phone support, generally reducing the complimentary time period. Once the complimentary period lapses, no further phone support is offered unless the customer purchases a customer care contract.
Product Warranty. We generally provide a one-year warranty to domestic purchasers and a two-year warranty to European purchasers. We generally do not offer a warranty on broadband software and services products. We accrue for estimated product warranty costs at the time of shipment, based upon the our historical experience.
Excess and Obsolete Inventory. We assess the need for reserves on excess and obsolete inventory based upon monthly forward projections of sales of products. Inventories are recorded at the lower of cost or net realizable value. Cost is computed using standard costs, which approximate actual costs on a first-in, first-out basis. Cost includes material costs and applicable manufacturing overhead. The provision for potentially obsolete or slow moving inventory is made based upon management’s analysis of inventory levels, forecasted sales, expected product life cycles and market conditions. Once inventory is reserved, the reserve can only be relieved by the subsequent sale or scrapping of the inventory.
Liquidity and Capital Resources
The following sections discuss the effects of changes in our balance sheets, cash flows and commitments on our liquidity and capital resources. As of September 30, 2005, our principal source of liquidity included cash and cash equivalents in the amount of $22.2 million and a credit facility with a maximum borrowing capacity of up to $10.0 million from which we had no outstanding borrowings.
Cash and Cash Equivalents. The following table sets forth our cash and cash equivalents as of the fiscal years ended September 30, 2005, 2004 and 2003.
For the fiscal year ended September 30, 2005, cash and cash equivalents decreased primarily as a result of cash used in our operating activities, particularly legal costs, and capital equipment purchases offset by proceeds we received from issuance of common stock. We did not have any off-balance sheet transactions at September 30, 2005, 2004 or 2003.
Operating Activities
During the fiscal year 2005, our operating activities used approximately $1.8 million of cash. Excluding the changes in operating assets and liabilities, our operating activities used $3.4 million of cash primarily due to our net loss, partially offset by depreciation and amortization. Changes in our operating assets and liabilities provided $1.6 million of cash primarily as a result of decreased accounts receivable and increased deferred revenues and accounts payable, partially offset by increased inventory as a result of lower sales in the fourth quarter. The increase in deferred revenues reflected a license of our remote management software in the fourth quarter ended September 30, 2005.
Investing Activities
During the fiscal year 2005, we purchased of approximately $1.7 million of capital equipment and software. This was our only investing activity.
Financing Activities
Our financing activities provided $1.7 million in fiscal year 2005, primarily from the proceeds from the exercise of stock options and the issuance of common stock under the Employee Stock Purchase Plan. We used $0.1 million for the repayment of term loans.
We amended our credit facility agreement with Silicon Valley Bank, effective June 27, 2005. Under the amended credit facility, the credit limit is $10 million, the interest rate is Silicon Valley Bank’s prime rate, the term or maturity date is June 27, 2007. The amended credit facility contains financial covenants related to our
liquidity and net worth as well as other nonfinancial covenants. Covenants require that we maintain an adjusted quick ratio (described below) of 1.25 and the credit facility will be subject to formula based credit limits if the adjusted quick ratio falls below 1.50. Covenants included in a subsequent amendment effective September 30, 2005 also require us to maintain a minimum tangible net worth of $28 million for September 2005, subsequently the minimum declines every few months to $24 million for September 2006 and thereafter, unless reset. The facility is secured by substantially all of our assets. The adjusted quick ratio is the ratio of (i) Netopia’s unrestricted cash, cash equivalents and investments maintained at Silicon Valley Bank plus net receivables to (ii) the Netopia’s current liabilities plus the outstanding principal amount of any borrowings under the facility less deferred revenues. We may borrow under the credit facility in order to finance working capital requirements for new products and customers, and otherwise for general corporate purposes in the normal course of business. As of September 30, 2005, we had no outstanding borrowings, approximately $500,000 of outstanding letters of credit, and approximately $9.5 million available under the credit facility, and we were in compliance with the covenants.
The credit facility contains events of default that, include among other things, non-payment of principal, interest or fees, violation of covenants, inaccuracy of representations and warranties, bankruptcy and insolvency events and changes of control. The occurrence of an event of default could result in the acceleration of any outstanding obligations under the agreement and foreclosure on the collateral securing any outstanding obligation.
As of September 30, 2005, we had no material commitments for capital expenditures. We believe we have adequate cash, cash equivalents and borrowing capacity to fund our operating activities for at least the next twelve months. For our long-term sustainability and cash preservation, we must continue to improve margins and reduce costs. If we issue additional stock to raise capital, our existing stockholders’ percentage ownership in Netopia would be reduced.
Commitments
Operating Lease Commitments. The Company conducts its operations in leased facilities under operating lease agreements expiring at various dates through 2014. The following is a summary of future minimum rental payments required under these leases that have initial or remaining non-cancelable lease terms in excess of one year:
Purchase Commitments with Outsourcing Manufacturers and Suppliers. The Company has purchase commitments with its outsourcing manufacturers. Our outsourcing manufacturers procure component inventory on our behalf based on our production orders. The Company is obligated to purchase component inventory that the outsourcing manufacturer procures in accordance with the orders, unless cancellation is given within applicable lead times. These commitments are reflected in our financial statements as a liability once goods or services have been received or payments related to the obligations become due. At September 30, 2005, purchase commitments totaled $14.0 million.
Results of Operations for Fiscal Years Ended September 30, 2005, 2004 and 2003
This data has been derived from the Consolidated Financial Statements included elsewhere in this Form 10-K. The operating results for any period should not be considered indicative of results for any future period. This information should be read in conjunction with the Consolidated Financial Statements and Notes thereto included elsewhere in this Form 10-K.
REVENUES
2005 Revenues Compared to 2004 Revenues; 2004 Revenues Compared to 2003 Revenues
Total revenues increased for fiscal year 2005 by 4% to $105.8 million from $101.3 for fiscal year 2004. The increase resulted from increased sales of our broadband equipment partially offset by reduced revenues from sale of our broadband software and services. Our unit sale increase was partially offset by a decline in average selling prices (“ASP’s”) resulting from competitive pressures. Total revenues increased for fiscal year 2004 from fiscal year 2003 by 19% from $84.9 million primarily due to increased revenue from the sale of our broadband equipment products, partially offset by reduced revenue from the sale of our broadband software and services.
Broadband Equipment. Broadband equipment revenue increased for fiscal year 2005 by 10% to $94.4 million from $85.7 million for fiscal year 2004. The increase was primarily due to increased sales volumes to BellSouth and increased sales of our accessories both in the United States and Europe.
For fiscal year 2004, sales increased by 27% to $85.7 million compared to $67.4 million in fiscal 2003 primarily as a result of increased sales volume of our broadband equipment, the introduction of our Wi-Fi products and increased sales of our accessories both in the United States and Europe.
Volumes and ASP’s, excluding accessories, of our broadband equipment products are summarized in the table below. The decline in average selling prices resulted from increased sales of lower price residential class products as compared to higher price business class products, as well as competitive market conditions generally. We expect that average selling prices will continue to decline for the same reasons.
Broadband Software and Services. Our broadband software and services revenues decreased in fiscal year 2005 by 27% to $11.4 million compared to $15.6 million in fiscal year 2004 as a result of lower license sales of our system management software, Timbutku and netOctopus Enterprise.
Broadband software and services revenues decreased in fiscal year 2004 by 11% to $15.6 million compared to $17.5 million in fiscal year 2003. The decrease resulted from a reduction in our recurring revenue of our eSites and eStores hosting solutions in addition to decreased software license sales of Timbutku and netOctopus Enterprise.
In fiscal year 2006, we expect that revenue, including recognition of deferred revenue, from sales of our NBBS remote control software will increase software and services revenues.
Customer Information
Our largest customers are telecommunication carriers and Internet service providers. The customers that accounted for 10% or more of our revenues in each year of the three years reported, are shown in the table below:
Geographic Information
The following table summarizes revenues by region:
The increase in our sales to customers in the United States in fiscal year 2005 reflected increased sales to large telecommunication carriers, particularly sales to BellSouth. The decrease in our sales to customers in Europe in fiscal year 2005 reflected declines in average unit prices to our larger carrier customers and generally lower sales to smaller European service providers. The increase in our sales to customers in Europe in fiscal year 2004 reflected increased volume shipments to our key customers.
GROSS MARGIN
Our total gross margin decreased to 32% in 2005 from 35% in 2004 due primarily to a decrease in higher gross margin software and service sales. Software and service sales generate higher gross margins than sales of broadband equipment. Fiscal year 2005 broadband equipment margins of 25% were comparable with fiscal year 2004 margins of 25%. In fiscal year 2005, we increased our accrual for the estimated cost to provide customer support by approximately $700,000. These estimated costs are related to our practice of providing ongoing customer support services through our call centers, almost all of which was related to our broadband equipment.
Gross margin decreased to 35% for fiscal year 2004 from 39% for fiscal year 2003 primarily due to increased sales of lower margin ADSL broadband equipment and a lower percentage of higher gross margin broadband software and services revenues in the total revenues mix.
RESEARCH AND DEVELOPMENT
Research and development expenses include employee related expenses, depreciation and amortization, development related expenses such as product prototyping, design and testing, and overhead. Our research and development expenses for fiscal year 2005 decreased by 16% to $13.4 million from fiscal 2004 expenses primarily due to cost reductions that resulted from the closure of research and development activities in Germany. For fiscal year 2004, our research and development expenses increased by 2% to $15.8 million.
We expect to continue to devote substantial resources to product and technological development. In fiscal year 2006, we expect to increase research and development expenses in absolute dollars in order to expand the breadth and depth of our product offerings. We believe our process for developing software is essentially completed concurrently with the establishment of technological feasibility. We capitalized no development costs in fiscal years 2005 or 2004.
SELLING AND MARKETING
Selling and marketing expenses include salary and commission expense for our sales force, travel and entertainment, advertising and promotional expenses, product marketing, customer service and support costs. Our selling and marketing expenses decreased in fiscal year 2005 by 9% to $18.7 million compared to $20.5 million in fiscal year 2004. The reduction resulted primarily from an increase in the allocation of technical support expense to cost of sales, and to a lesser extent from cost containment. For fiscal year 2004, selling and marketing expenses increased by 2% to $20.5 million compared to $20.1 million in fiscal year 2003. The increase in fiscal year 2004 from fiscal year 2003 was primarily related to increased commission expense as a result of increased revenues in addition to increased marketing and advertising expenses related to new product offerings introduced in fiscal year 2004.
In fiscal 2006, we expect selling and marketing expenses to increase as a result of increased salary and commission costs.
GENERAL AND ADMINISTRATIVE
General and administrative expenses include employee related expenses, provisions for doubtful accounts and legal, accounting and insurance costs. General and administrative expense increased in fiscal year 2005 by 18% to $8.4 million compared to $7.1 million in fiscal year 2004 due to increased audit costs and the cost related to the implementation of Section 404 of the Sarbanes-Oxley Act, which required our management to assess the effectiveness of our internal controls over financial reporting, as well as legal expenses related to the SEC investigation and private securities litigation. General and administrative expenses increased in fiscal year 2004 by 51% to $7.1 million compared to $4.7 million in fiscal 2003 due to increased professional and legal expenses related to an internal accounting review.
AMORTIZATION OF INTANGIBLE ASSETS
For fiscal years 2005, 2004 and 2003, these amounts represented the amortization of intangible assets with identifiable lives related to our acquisitions. We did not complete an acquisition in fiscal year 2005. See Notes 2 and 3 of Notes to Consolidated Financial Statements for more information.
RESTRUCTURING COSTS
For fiscal year 2005, the Company recorded a net restructuring charge of $40,000, primarily consisting of employee termination costs, wind down costs associated with the closure of a sales office in the Netherlands and additional wind down costs associated with the prior closure of the Germany office in 2004.
For fiscal year 2004, the Company implemented plans and took steps to reduce costs. These steps resulted in a restructuring charge of approximately $0.5 million primarily related to severance and related benefit charges for the closure of our German software research and development facility.
For fiscal year 2003, we recorded a net restructuring charge of $0.4 million. This net charge consisted primarily of $0.6 million of employee severance benefits related to reductions in our workforce during fiscal year 2003 and facility closure costs related to the closure of a sales office in Hong Kong as well as a reversal of $0.2 million of liabilities we had accrued in connection with our restructurings during fiscal year 2002.
IMPAIRMENT OF GOODWILL
For fiscal years 2005 and 2003, the Company did not record any impairment of goodwill. For fiscal year 2004, the Company recorded $465,000 of goodwill impairment relating to the closure of the Germany software development office.
OTHER INCOME (LOSS), NET
Other income (loss), net includes interest income earned on our cash and cash equivalents, interest expense, realized and unrealized gains and losses on foreign currency transactions as well as losses on impaired securities that we deem other than temporary.
Loss on Impaired Securities. For fiscal year 2003, the approximately $0.5 million loss represented the impairment of our remaining carry value of our investment in Everdream Corporation as result of valuations used in subsequent financing rounds.
Other Income (Expense), Net. Other income (expense), net includes interest expense and fees related to our credit facility, interest income and gains or losses on foreign currency transactions. Other income, net increased for fiscal year 2005 when compared to fiscal year 2004 due primarily to increased interest income offset by foreign currency transaction losses. For fiscal year 2004 compared to 2003, other income, net increased due primarily to increased interest income and foreign currency transaction gains.
Risk Factors
The following risk factors discussed below should be considered carefully in evaluating our business because such factors may have a significant impact on our business, operating results and financial condition. As a result of these risk factors and other risks discussed elsewhere in this Annual Report on Form 10-K, and the risks discussed in our other filings with the United States Securities and Exchange Commission, our actual results could differ materially from those projected in any forward-looking statements. You should carefully consider all these risks and other information in this report before investing in Netopia. The fact that certain risks are endemic to our industry does not lessen the significance of the risk.
We have a history of losses and negative cash flow. We may incur losses and negative cash flow in the future, which could significantly harm our business.
During the fiscal years ended September 30, 2005 and 2004, we incurred net losses of $7.1 million and $8.8 million, respectively, and used approximately $1.8 million and $5.2 million, respectively, of cash for operating activities. Our cash and cash equivalents totaled $22.2 million at September 30, 2005. We may not be able to reach, sustain or increase profitability or generate cash on a quarterly or annual basis, which could significantly harm our business.
We may find it difficult to raise needed capital in the future, which could delay or prevent introduction of new products or services, require us to reduce our business operations or otherwise significantly harm our business.
We must continue to enhance and expand our product and service offerings in order to maintain our competitive position and to increase our market share. As a result, and due to any future net losses and use of cash, the continuing operations of our business may require capital infusions. Whether or when we can achieve cash flow levels sufficient to support our operations cannot be accurately predicted. Unless such cash flow levels are achieved, we may require additional borrowings or the sale of debt or equity securities, sale of non-strategic assets, or some combination thereof, to provide funding for our operations. We believe we have cash, cash equivalents and borrowing capacity adequate to meet our anticipated capital needs for the next twelve months. However, if we are unable to obtain additional funds to finance our operations when needed, our financial condition and operating results would be materially and adversely affected and we would not be able to operate our business.
If we are unable to resolve pending the government investigations, the private securities action, the derivative actions and other litigation related to and arising out of the restatements of our consolidated financial statements for prior periods in a timely and economic manner, our business could be significantly harmed.
We currently are named as a defendant in a consolidated private securities action brought as a purported class action. In addition, there are purported derivative actions pending in state and federal court in California. We also are the subject of a formal order of investigation by the SEC to determine whether the federal securities laws have been violated. We also have learned that the United States Attorney for the Northern District of California has opened an investigation following a referral by the SEC. We do not know the scope or focus of the investigation by the United States Attorney’s office. Responding to the formal order of investigation of the SEC has required significant attention and resources of management. Although we have announced a proposed settlement with the SEC, this settlement is subject to final approval by the SEC. In addition, even though we have announced proposed settlements with the SEC and us and Alan B. Lefkof, our President and Chief Executive Officer, the investigation by the SEC is ongoing, and may continue to require significant attention and resources. If we and/or Mr. Lefkof are unable to complete the proposed settlements and the SEC elects to pursue an enforcement action against us and/or Mr. Lefkof, the defense could be costly and require additional management resources. If we were unsuccessful in defending against this or other investigations or proceedings, we could face
civil or criminal penalties that would seriously harm our business and results of operations. Defending against the government investigations, the private securities class action, the derivative actions and other litigation matters related to the restatements also will likely require significant attention and resources of management and, regardless of the outcome, result in significant legal expense. If our defenses ultimately are unsuccessful, or if we are unable to achieve a favorable settlement, we could be liable for large damage awards that could seriously harm our business and results of operations. While we have provided notice of the government investigations and the other litigation matters to our directors and officers liability insurance carriers, the insurance carriers have raised certain coverage issues and have not reimbursed us for all legal expenses incurred, and may not agree that they are responsible to pay any damages that ultimately could be awarded to the plaintiffs. Furthermore, we have only a limited amount of insurance, and even if our insurers agree to make payments under the policies, the legal expenses and damage awards or settlements may be greater than the amount of insurance, and we would in all cases be liable for any amounts in excess of our insurance policy limits.
Substantial sales of our broadband equipment will not occur unless telecommunications carriers and service providers continue to expand their deployments of DSL and other broadband services, and without continued expansion our revenues may decline, which could significantly harm our business.
The success of our broadband equipment depends upon the extent to which telecommunications carriers and service providers continue to expand their deployments of DSL and other broadband services. Factors that have impacted such deployments include:
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Lengthy approval processes followed by carriers and service providers, including laboratory tests, technical trials, marketing trials, initial commercial deployment and full commercial deployment;
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Improved business opportunities provided by deployment of broadband services by our ILEC and other customers;
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Lack of compatibility of DSL equipment that is supplied by different manufacturers;
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Rapidly changing industry standards for DSL and other broadband technologies; and
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Government regulations.
We offer to carriers and service providers the opportunity to bundle basic DSL connectivity with value-added features that enable the provider to bundle differentiated features and services that we believe can justify higher recurring revenues from end users. These features and services include dial backup, VPNs, remote management and configuration using our NBBS software platform, a parental controls service, and hosting of eSites and eStores. We can offer no assurance that our strategy of enabling bundled service offerings will be widely accepted. If telecommunications carriers and service providers do not continue to expand their deployments of DSL and other broadband services, our revenues could decline and our business could be significantly harmed.
We expect our revenues to be increasingly dependent on our ability to sell our broadband equipment to Independent Local Exchange Carriers (ILECs), and we may incur losses if we cannot successfully market and sell our products through ILEC channels.
ILECs have been aggressively marketing DSL services principally focusing on residential services. We have committed resources to expand our sales in the ILEC channel both domestically and internationally. There continue to be barriers associated with such sales including, but not limited to, lengthy product evaluation cycles, the difficulty in dislodging competitors whose products are currently being utilized, long-term product deployment cycles and intense price competition. ILECs currently obtain equipment from our competitors, which include 2Wire, Inc., Westell Technologies, Inc., Siemens AG (through its Siemens Subscriber Networks, Inc. subsidiary, formerly known as Efficient Networks), Thomson Corporation and ZyXEL Communications Co., which have proven to be strong competitors. All of these competitors are larger than us and may have greater
financial resources. There is no guarantee we will be successful in expanding our presence in the ILEC market. If we fail to further penetrate the ILEC market for our products and services, our business may be materially and adversely affected.
We expect our revenues to be increasingly dependent on our ability to develop and sell our broadband equipment into the residential broadband gateway market.
Prior to our acquisition of Cayman in October 2001, we developed, marketed and sold broadband equipment products primarily to CLECs and ISPs serving the small business market for DSL Internet connectivity. With our current products and technology, we now are competing for sales of broadband equipment to ILECs serving the residential market. There are numerous risks associated with the residential broadband gateway market including, but not limited to:
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The ability to design and develop products that meet the needs of the residential market;
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The ability to market these products successfully to ILECs and to dislodge competitors that are currently supplying residential-class broadband gateways; and
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Intense price pressure.
If we are unable to increase our sales into the residential broadband gateway market, our business will be materially and adversely affected.
The loss of, or decline in, purchases by one or more of our key customers would result in a significant decline in our revenues and harm our business.
We rely on a small number of customers for a large portion of our revenues. For the fiscal years ended September 30, 2005 and September 30, 2004, there were three customers that each individually represented at least 10% of our revenues and in the aggregate, accounted for 48% and 39%, respectively, of our total revenues. Our revenues will decline and our business may be significantly harmed if one or more of our significant customers stop buying our products, or reduce or delay purchases of our products.
Substantial portions of our revenues are derived from sales to international customers, and currency fluctuations can adversely impact our operations.
A substantial portion of our revenues is derived from sales to international customers, mainly in Europe. For the fiscal years ended September 30, 2005 and September 30, 2004, our international sales represented 36% and 39%, respectively, of our total revenues. We expect sales to international customers to continue to comprise a significant portion of our revenues. Sales of broadband equipment products to certain of our European customers are denominated in Euros. For our international sales that continue to be denominated in United States dollars, fluctuations in currency exchange rates could cause our products and services to become relatively more expensive to our foreign customers, which could result in decreased sales of our products and services. In addition, changes in the value of the Euro relative to the United States dollar could adversely affect our operating results to the extent we do not adequately hedge sales denominated in Euros.
Additional risks associated with international operations could adversely affect our sales and operating results.
Our international operations, which principally are in Europe, are subject to a number of difficulties and special costs, including, but not limited to:
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Costs of customizing products for foreign countries;
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Laws and business practices favoring local competitors;
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Compliance with multiple, conflicting and changing governmental laws and regulations;
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Greater difficulty in collecting accounts receivable;
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Import and export restrictions and tariffs;
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Difficulties staffing and managing foreign operations; and
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Multiple conflicting tax laws and regulations.
In addition, if we establish more significant operations overseas, we may incur additional costs that would be difficult to reduce quickly because of employee-related laws and practices in those countries.
Because the markets for our products and services are intensely competitive and some of our competitors are larger, better established and have more cash resources, we may not be able to compete successfully against current and future competitors.
We sell products and services in markets that are highly competitive. We expect competition to intensify as current competitors expand their product and service offerings and new competitors enter the market. Increased competition is likely to result in price reductions, reduced gross margins and could cause loss of market share, any one of which could seriously harm our business. Competitors vary in size, scope and breadth of the products and services offered.
In the market for broadband equipment, we primarily compete with 2Wire, Inc., Westell Technologies, Inc., Siemens AG (through its Siemens Subscriber Networks, Inc. subsidiary, formerly known as Efficient Networks), Thomson Corporation and ZyXEL Communications Co. In the market for our broadband software and services products, we primarily compete with Motive, Inc., 2Wire, Inc., Altiris, Inc., Computer Associates International, Inc., CrossTec Corporation, Expertcity, Inc., LANDesk Software, Inc., Microsoft Corporation and Symantec Corporation.
Many of our current and potential competitors in all product areas have longer operating histories, significantly greater financial, technical, marketing and other resources, significantly greater name recognition and a larger base of customers than ours. In addition, many of our competitors have well-established relationships with our current and potential customers and have extensive knowledge of these industries. In the past, we have lost potential customers to competitors in all product areas for various reasons, including lower prices and other incentives not matched by us. In addition, current and potential competitors have established or may establish cooperative relationships among themselves or with third parties to increase the ability of their products and services to address customer needs. Accordingly, new competitors or alliances among competitors may emerge and rapidly acquire significant market share. We also expect that competition will increase as a result of industry consolidation.
Our quarterly operating results are likely to fluctuate because of many factors and may cause our stock price to fluctuate.
Our revenues and operating results have varied in the past and are likely to vary in the future from quarter to quarter. For example, during the past eight quarters ended September 30, 2005, our revenues have ranged from $21.8 million to $29.3 million, and our net results have ranged from $1.2 million of income to a loss of $6.1 million. As a result, we believe that period-to-period comparisons of our operating results are not necessarily meaningful. Investors should not rely on the results of any one quarter or series of quarters as an indication of our future performance.
In the quarter ended September 30, 2005 and in certain quarters in the past, our operating results were below the expectations of securities analysts. It is likely that in some future quarter, quarters or year, our operating results again will be below the expectations of securities analysts or investors. When our operating results are below such expectations, the market price of our common stock may decline significantly. In addition to the uncertainties and risks described elsewhere under this “Risk Factors” heading, variations in our operating results will likely be caused by factors related to the operation of our business, including, but not limited to:
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Variations in the timing and size of orders for our broadband equipment products;
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Increased price competition for our broadband equipment products;
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Our ability to license, and the timing of licenses, of our broadband software and services;
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The mix of products and services and the gross margins associated with such products and services, including the impact of our increased sales of lower margin broadband equipment as a percentage of our total revenues and increased sales of lower margin residential-class ADSL products within our family of broadband equipment;
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The price and availability of components for our broadband equipment;
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Foreign currency fluctuations; and
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The timing and size of expenses, including operating expenses and expenses of developing new products and product enhancements.
Other technologies for the broadband gateway market compete with DSL services.
DSL services compete with a variety of different broadband services, including cable, satellite and other wireless technologies. Many of these technologies compete effectively with DSL services. If any technology competing with DSL technology is more reliable, faster, less expensive, reaches more customers or has other advantages over DSL technology, then the demand for our DSL products and services and our revenues and gross margins will decrease. We cannot guarantee that we will be able to develop and introduce products for these competing technologies.
We purchase the semiconductor chips for our broadband equipment from a limited number of suppliers, and the inability to obtain in a timely manner a sufficient quantity of chips at an economic price would adversely affect our business.
All of our broadband equipment products rely on special semiconductor chips that we purchase from fewer than five suppliers. We do not have volume purchase contracts with any of our suppliers and they could cease selling to us at any time. In addition, our suppliers change their selling prices frequently in response to market trends, which may include increased demand industry-wide. Because we generally have been unable to pass component price increases along to our customers, our gross margins and operating results have been harmed as a result of component price increases. If we are unable to obtain a sufficient quantity of these semiconductor chips in a timely manner for any reason, sales of our broadband equipment products could be delayed or halted. Further, we could also be forced to redesign our broadband equipment products and qualify new suppliers of semiconductor chip sets. The resulting stoppage or delay in selling our products and the expense of redesigning our products would adversely affect our business.
If we were unable to obtain components and manufacturing services for our broadband equipment from independent contractors and specialized suppliers, our business would be harmed.
We do not manufacture any of the components used in our products and perform only limited assembly on some products. All of our broadband equipment relies on components that are supplied by independent contractors and specialized suppliers. Furthermore, substantially all of our broadband equipment includes printed circuit boards that are manufactured by fewer than five contract manufacturers that assemble and package our products. We do not have guaranteed supply arrangements with these third parties and they could cease selling components to us at any time. Moreover, the ability of independent contractors and specialized suppliers to provide us with sufficient components for our broadband equipment also depends on our ability to accurately forecast our future requirements. If we are unable to obtain a sufficient quantity of components from independent contractors or specialized suppliers in a timely manner for any reason, sales of our broadband equipment could be delayed or halted. Similarly, if supplies of circuit boards or products from our contract manufacturers are interrupted for any reason, we will incur significant losses until we arrange for alternative sources. In addition, we may be required to pay premiums for components purchased from other vendors should our regular
independent contractors and specialized suppliers be unable to timely provide us with sufficient quantity of components. To the extent we pay any premiums, our gross margins and operating results would be harmed. Further, we could also be forced to redesign our broadband equipment and qualify new suppliers of components. The resulting stoppage or delay in selling our products and the expense of redesigning our broadband equipment would seriously harm our reputation and business.
Failure to develop, introduce and market new and enhanced products and services in a timely manner could harm our competitive position and operating results.
We compete in markets characterized by continuing technological advancement, changes in customer requirements and evolving industry standards. To compete successfully, we must design, develop, manufacture and sell new or enhanced products and services that provide increasingly higher levels of performance, reliability, compatibility, and cost savings for our customers. We will need to continue to integrate our DSL modem and router technology with the architectures of leading central office equipment providers in order to enhance the reliability, ease-of-use and management functions of our broadband equipment.
Our Netopia Broadband Server (NBBS) software platform enables network operations centers of broadband service providers the ability to remotely manage, support, and troubleshoot installed broadband gateways, thereby providing the potential for reducing support costs. We believe that NBBS can assist us in differentiating our products and services from those of our competitors. However, NBBS is a relatively new product that has required and is expected to continue to require significant investment of development resources and to date has not generated significant revenues, and we cannot provide any assurance that NBBS will be widely adopted by the customers to whom we are marketing it. In addition, we cannot provide any assurance that when and if deployed in mass scale, NBBS will perform as expected or that it has no hidden bugs or defects.
We may not be able to develop, introduce, enhance or market successfully these or other products and services necessary to our future success. In addition, any delay in developing, introducing or marketing these or other products would seriously harm our business. Many of our broadband equipment products and services are relatively new. You should consider our prospects in light of the difficulties we may encounter because these products are at an early stage of development in a rapidly evolving and intensely competitive market. For example, we may not correctly anticipate market requirements, or introduce rapidly new products that meet such requirements for performance, price, features and compatibility with other broadband equipment. Failure to continue to develop and market competitive products would harm our competitive position and operating results.
We may experience declining gross margins due to price competition and an increase in sales of lower margin broadband equipment as a percentage of our total revenues.
We expect that sales of our broadband equipment may account for a larger percentage of our total revenues in future periods. Because our broadband equipment products are sold at lower gross margins than our broadband software and services products, and sales volumes of our lower margin residential-class DSL products are increasing, our overall gross margin rate will likely decrease. Further, we expect that the market for broadband equipment will remain highly competitive and as a result, we will continue to lower the prices we charge for our broadband equipment. If the average selling price of our broadband equipment continues to decline faster than our ability to realize lower manufacturing and product costs, our gross margins related to such products, as well as our overall gross margins, are likely to decline.
We may incur greater losses if we cannot successfully sell our broadband software and services products. We derive a substantial portion of the recurring revenues from our broadband software and services products from a small number of large customers.
The majority of our broadband software and services revenues are derived from the sale of higher margin software products for corporate help desks, mostly Timbuktu. For the years ended September 30, 2005 and
September 30, 2004, revenue from help desk applications were approximately 60% and 70%, respectively, of total revenues for our broadband software and services products. We anticipate that the market for Timbuktu may continue to decline or grow more slowly than the market for our other broadband software products and services. We also have not generated significant revenue to date from the NBBS software platform in which we have made and expect to continue to make a significant investment of development resources. In addition, we rely on a small number of licensees to promote the use of our broadband software and services for building web sites and stores. We derive the majority of the recurring revenues from our broadband software and services products from fewer than five customers. The extent and nature of the promotions by licensees of our broadband software and services are outside of our control. If licensees of our eSite and eStore software do not successfully promote web sites and stores to their customers, our recurring revenues may decrease. If these customers were to choose a competitive platform, our recurring revenues would decline and adversely impact our results.
If hosting services for our broadband software and services perform poorly, our revenue may decline and we could be sued.
We depend on our servers, networking hardware and software infrastructure, and third-party service and maintenance of these items to provide reliable, high-performance hosting for eSite and eStore customers and subscribers to our parental controls service. In addition, our servers are located at third-party facilities. Failure or poor performance by third parties with which we contract for maintenance services could also lead to interruption or deterioration of our parental controls, eSite and eStore hosting services. Additionally, a slowdown or failure of our systems for any reason could also lead to interruption or deterioration of our parental controls, eSite and eStore hosting services. In such a circumstance, our hosting and subscription revenues may decline. In addition, if our parental controls, eSite and eStore hosting services are interrupted, perform poorly, or are unreliable, we are at risk of litigation from our customers, the outcome of which could harm our business.
Failure to attract or retain key personnel could harm our business.
Our future performance depends on the continued service of our senior management, product development and sales personnel. The loss of the services of one or more of our key personnel could seriously harm our business. Competition for qualified personnel in our industry and geographic location is intense. Although we believe our personnel turnover rate is consistent with industry norms, our future success depends on our continuing ability to attract, hire, train and retain highly skilled managerial, technical, sales, marketing and customer support personnel. In addition, new hires frequently require extensive training before they achieve desired levels of productivity.
Our intellectual property may not be adequately protected, and our products may infringe upon the intellectual property rights of third parties, which may adversely impact our competitive position and require us to engage in costly litigation.
We depend on our ability to develop and maintain the proprietary aspects of our technology. To protect our proprietary technology, we rely primarily on a combination of contractual provisions, confidentiality procedures, trade secrets, and patent, copyright and trademark law. We presently have one United States patent issued that relates to our remote control technology incorporated in most of our software products. The term of this patent is through August 2010. We also have filed patent applications relating to the design of our Wi-Fi gateways. Despite our efforts to protect our proprietary rights, unauthorized parties may attempt to copy aspects of our products or obtain and use information that we regard as proprietary. Policing unauthorized use of our products is difficult, and there is no guarantee that the safeguards that we employ will protect our intellectual property and other valuable competitive information.
There has been a substantial amount of litigation in the software and Internet industries regarding intellectual property rights. Although we have not been party to any such litigation, in the future third parties may claim that our current or potential future products infringe their intellectual property. The evaluation and defense
of any such claims, with or without merit, could be time-consuming and expensive. Furthermore, such claims could cause product shipment delays or require us to enter into royalty or licensing agreements on financially unattractive terms, which could seriously harm our business.
If we are unable to license necessary software, firmware and hardware designs from third parties, our business could be harmed.
We rely upon certain software, firmware and hardware designs that we license from third parties, including firmware that is integrated with our internally developed firmware and used in our products. We cannot be certain that these third-party licenses will continue to be available to us on commercially reasonable terms. The loss of, or inability to maintain, such licenses could result in product shipment delays until equivalent firmware is developed or licensed, and integrated into our products, which would seriously harm our business.
Our products are complex and may contain undetected or unresolved defects.
Our products are complex and may contain undetected or unresolved defects when first introduced or as new versions are released. Although we historically have not experienced material problems with product defects, if our products do contain undetected or unresolved defects, we may lose market share, experience delays in or losses of market acceptance or be required to issue a product recall. Similarly, although we have not experienced material warranty claims, if warranty claims exceed our reserves for such claims, our business would be seriously harmed. In addition, we would be at risk of product liability litigation because of defects in our products. Although we attempt to limit our liability to end users through disclaimers of special, consequential and indirect damages and similar provisions, we cannot assure you that such limitations of liability will be legally enforceable.
Our industry may become subject to changes in regulations, which could harm our business.
Our industry and industries on which our business depends may be affected by changes in regulations. For example, we depend on telecommunications service providers for sales of our broadband equipment, and companies in the telecommunications industry must comply with numerous regulations. If our industry or industries on which we depend become subject to regulatory changes that increase the cost of doing business or doing business with us, our revenues could decline and our business could be harmed. For example, if a regulatory agency imposed restrictions on DSL service that were not also imposed on other forms of high-speed Internet access, our business could be harmed.
Business interruptions that prevent our ability to deliver products and services to our customers could adversely affect our business.
Our operations are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, terrorist attacks, labor disputes by transportation providers, and other events beyond our control. In particular, our headquarters are located near earthquake fault lines in the San Francisco Bay area and may be susceptible to the risk of earthquakes. If there is an earthquake in the region, our business could be seriously harmed. We do not have a detailed disaster recovery plan. In addition, our business interruption insurance may not be sufficient to compensate us fully for losses that may occur and any losses or damages incurred by us in the event we are unable to deliver products and services to our customers could have a material adverse effect on our business.
Our stock price may be volatile, which may result in substantial losses for our stockholders.
The market price of our common stock may fluctuate significantly in response to many factors, some of which are beyond our control, including the following:
•
Our ability to meet the listing standards and to obtain a relisting of our common stock on The NASDAQ Stock Market or a listing on The NASDAQ SmallCap Market;
•
Variations in our quarterly operating results, including shortfalls in revenues or earnings from securities analysts’ expectations;
•
Changes in securities analysts’ estimates of our financial performance;
•
Changes in market valuations and volatility generally of securities of other companies in our industry;
•
Announcements by us or our competitors of technological innovations, new products or enhancements, significant contracts, acquisitions, strategic partnerships, joint ventures or capital commitments; and
•
General conditions in the broadband communications industry.
In recent years the stock market in general, and the market for shares of high technology stocks in particular, have experienced extreme price fluctuations, which often have been unrelated to the operating performance of affected companies. There can be no assurance that the market price of our common stock will not experience significant fluctuations in the future as it has in the past, including fluctuations that are unrelated to our performance. Securities class action litigation has often been brought against a company following periods of volatility in market price of its securities. We currently are and may in the future be the target of securities litigation. Securities litigation has resulted and is expected to continue to result in substantial costs and diversion of management’s attention and resources, which could seriously harm our business.
A third party may have difficulty acquiring us, even if doing so would be beneficial to our stockholders.
Provisions of our Amended and Restated Certificate of Incorporation, our Bylaws and Delaware law could make it difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders.
Changes in the accounting treatment of stock options will adversely affect our results of operations.
In December 2004, the FASB issued SFAS 123R, which is a revision of SFAS 123. SFAS 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values and does not permit pro forma disclosure as an alternative to financial statement recognition. SFAS 123R is scheduled to be effective for us beginning in the first quarter of fiscal 2006. The adoption of the SFAS 123R fair value method will have a significant adverse impact on our reported results of operations because the stock-based compensation expense will be charged directly against our reported earnings. The impact of our adoption of SFAS 123R cannot be quantified at this time because it will depend on the future fair values and number of share-based payments granted in the future. However, had we adopted SFAS 123 in prior periods, the magnitude of the impact of that standard would have approximated the impact of SFAS 123R assuming the application of the Black-Scholes model as described in the disclosure of pro forma net loss and pro forma loss per share presented under Note 1. to our Consolidated Financial Statements.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our exposure to market risk for changes in interest rates relates primarily to our cash equivalents. Our exposure to foreign exchange risk relates primarily to sales made to international customers denominated in Euros and our employee related expenses in European Union countries. We do not use derivative financial instruments for speculative or trading purposes. We place our cash equivalents in instruments that meet high credit quality standards. We do not expect any material loss with respect to our cash equivalents.
In order to reduce our exposure resulting from currency fluctuations, we have entered into currency exchange forward contracts. These contracts guarantee a predetermined exchange rate at the time the contract is purchased. We do not enter into currency exchange contracts for speculative or trading purposes. All currency exchange contracts have a maturity of less than one year.
Interest Rate Risk
The table below presents the market value and related weighted-average interest rates for our cash equivalents at September 30, 2005 and 2004. All of our investments mature within 90 days.
Our market interest rate risk for our cash equivalents relates primarily to changes in the United States short-term prime interest rate. Our market interest rate risk for borrowings under our credit facility, from which we had no borrowings at September 30, 2005, relates primarily to the rate we could be charged by Silicon Valley Bank for borrowings under our credit facility. The credit facility bears interest at a rate equal to the prime rate (the rate announced by Silicon Valley Bank as its “prime rate”). To the extent we borrow heavily against the credit facility and Silicon Valley Bank were to increase its prime rate, it would cost us more to borrow and our interest expense would increase.
Foreign Currency Exchange Risk
The table below presents the carrying value, in United States dollars, of our accounts receivable denominated in Euros at September 30, 2005 and 2004. The accounts receivable at September 30, 2005 are valued at the United States/Euro exchange rate as of September 30, 2005 and the accounts receivable at September 30, 2004 are valued at the United States/Euro exchange rate as of September 30, 2004. The carrying value approximates fair value at September 30, 2005 and 2004.
The table below presents the carrying value of our currency exchange forward contracts, in United States dollars, at September 30, 2005 and 2004. The carrying value approximates fair value at September 30, 2004 and 2003.
Our foreign currency exchange risk relates to changes in the value of the Euro relative to the United States dollar. We manage this risk by entering into currency exchange forward contracts. These contracts guarantee a predetermined exchange rate at the time the contract is purchased.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The following financial statements are filed as part of this Report on Form 10-K:
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of Netopia, Inc.:
We have audited the accompanying consolidated balance sheets of Netopia, Inc. and its subsidiaries (the “Company”) as of September 30, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity and cash flows for the each of the years in the three year period ended September 30, 2005. In connection with our audits of the consolidated financial statements, we have also audited the financial statement schedule-valuation and qualifying accounts. These consolidated financial statements and financial statement schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audits to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Netopia, Inc. and its subsidiaries as of September 30, 2005 and 2004, and the results of their operations and their cash flows for each of the years in the three year period ended September 30, 2005, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic consolidated financial statements taken as a whole, presents fairly, in all material respects, the information set forth therein.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Netopia, Inc.’s internal control over financial reporting as of September 30, 2005, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated December 14, 2005 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
/s/ Burr, Pilger & Mayer LLP
San Francisco, California
December 14, 2005
Report of Independent Registered Public Accounting Firm
To the Board of Directors and Stockholders of Netopia, Inc.:
We have audited management’s assessment, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting included in Item 9A, that Netopia, Inc. and its subsidiaries (the “Company”) maintained effective internal control over financial reporting as of September 30, 2005, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). The Company’s management is responsible for maintaining effective 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 including 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 Netopia, Inc. and its subsidiaries maintained effective internal control over financial reporting as of September 30, 2005, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, Netopia, Inc. and its subsidiaries maintained, in all material respects, effective internal control over financial reporting as of September 30, 2005, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Netopia, Inc. and its subsidiaries as of September 30, 2005 and 2004, and the related consolidated statements of operations, stockholders’ equity and cash flows for the each of years in the three year period ended September 30, 2005, and the related financial statement schedule and our report dated December 14, 2005 expressed an unqualified opinion on those consolidated financial statements and the related financial statement schedule.
/s/ Burr, Pilger & Mayer LLP
San Francisco, California
December 14, 2005
Netopia, Inc.
Consolidated Balance Sheets
(in thousands, except share and per share amounts)
See accompanying notes.
Netopia, Inc.
Consolidated Statements of Operations
(in thousands, except per share amounts)
See accompanying notes.
Netopia, Inc.
Consolidated Statements of Stockholders’ Equity and Comprehensive Loss
(in thousands, except share amounts)
See accompanying notes.
Netopia, Inc.
Consolidated Statements of Cash Flows
(in thousands)
See accompanying notes.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Nature of Business and Summary of Significant Accounting Policies
Description of Business. Netopia, Inc. (the “Company”) develops and markets broadband customer premises networking equipment and remote management software for the management of broadband services and equipment. The Company also develops and provides broadband enabled services and remote management software for enterprises technical support, help-desks and personal computers.
Fiscal Year. The Company’s fiscal year is the 12-months ended September 30.
Principles of Consolidation. The Consolidated Financial Statements include the accounts of Netopia, Inc. and its wholly owned foreign subsidiaries. All significant intercompany balances and transactions have been eliminated.
Cash and Cash Equivalents. Cash and cash equivalents consist of money market funds with original maturities of 90 days or less from the time of purchase. Cash equivalents are recorded at cost, which approximates fair value. Cash equivalents as of September 30, 2005 and 2004, consisted of the following:
Revenue Recognition. Our broadband products are integrated with software that is essential to the functionality of the equipment. Accordingly, we account for revenues in accordance with Statement of Position (“SOP”) No. 97-2, “Software Revenue Recognition,” and all related interpretations. Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred, the fee is fixed or determinable, and collectibility is reasonably assured. Determining whether and when some of these criteria have been satisfied often involve assumptions and judgments that can have significant impact on the timing and amount of revenues we report. At the date of shipment, assuming that the revenue recognition criteria specified above is met, we provide for an estimate of returns and warranty expense based on historical experience of returns of similar products and warranty costs incurred, respectively.
The Company’s sales to our distributors and resellers are generally recognized at the time title to our product passes to the distributor or reseller, provided all other criteria for revenue recognition are met. This policy is predicated on the Company’s ability to estimate sales returns. The Company is also required to evaluate whether our distributors and resellers have the ability to honor their commitment to make fixed and determinable payments, regardless of whether they collect cash from their customers. If we were to change any of these assumptions or judgments, it could cause a material increase or decrease in the amount of revenues that we report in a particular period.
We recognize software revenue in accordance with SOP 97-2, as amended by SOP 98-9, and SEC Staff Accounting Bulletin (SAB) No. 104, “Revenue Recognition”. We have multiple element arrangements, including perpetual software licenses and maintenance. We allocate and defer revenue for the undelivered items based on vendor-specific objective evidence, or VSOE, of fair value of the undelivered elements, and recognize the difference between the total arrangement fee and the amount deferred for the undelivered items as revenue. VSOE of each element is based on the price for which the undelivered element is sold separately. We determine fair value of the undelivered elements based on historical evidence of our stand-alone sales of these elements to third parties. Software license revenue is recognized when a non-cancelable license agreement has been signed or a properly authorized firm purchase order is received and the customer acknowledges an unconditional obligation to pay, the software product has been delivered, there are no uncertainties surrounding product acceptance, the fees are fixed and determinable, and collection is considered probable. Maintenance revenue, including revenue included in multiple element arrangements, is deferred and recognized ratably over the related contract period, generally twelve months.
The Company applies the provisions of Emerging Issues Task Force (EITF) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables, to arrangements that involve the delivery or performance of multiple products, services and/or rights to use assets. The Company’s enhanced web site services generally involve the delivery of multiple services. The Company allocates a portion of the arrangement fee to the undelivered element, generally web site hosting, based on the residual method utilizing VSOE for the undelivered elements, regardless of any separate prices stated within the contract for each element. VSOE for hosting is based on the price the customer would pay when sold separately. Fair value for the delivered elements, primarily fulfillment services, is based on the residual amount of the total arrangement fees after deducting the VSOE for the undelivered elements. Fulfillment revenue is recognized when a properly authorized firm purchase order is received and the customer acknowledges an unconditional obligation to pay, there are no uncertainties surrounding product acceptance, the fees are fixed and determinable, collection is considered probable and the fulfillment has been completed. Hosting revenue is deferred and recognized ratably over the related service period, generally twelve months.
Concentrations of Credit Risk and Allowance for Doubtful Accounts. Financial instruments that potentially expose the Company to concentrations of credit risk principally consist of cash, cash equivalents and accounts receivable. The Company’s accounts receivable are mostly derived from sales to telecommunication service providers, resellers and distributors in the United States and Europe. The Company performs ongoing credit evaluations of its customers’ financial condition and limits the amount of credit extended when deemed necessary, but generally requires no collateral. In addition, allowances are maintained for potential credit losses associated with potential problem accounts receivable. The Company maintains most of its cash investments with one financial institution. Although such investments exceed the $0.1 million amount subject to Federal Deposit Insurance, management believes the financial risks associated with such investments are minimal.
During fiscal year 2005 and 2004, the Company did not experience significant losses on trade receivables from any particular customer, industry, or geographic region. During fiscal year 2003, the Company fully reserved $0.6 million of outstanding accounts receivable primarily owed by certain carrier customers. The allowance for doubtful accounts is based on the Company’s assessment of the collectibility of customer accounts. The Company regularly reviews the allowance by considering factors such as historical experience, credit quality, the age of the accounts receivable balance, and current economic conditions that may affect a customer’s ability to pay.
Inventories. Inventories are recorded at the lower of cost or market (net realizable value). Cost is computed using standard cost, which approximates actual cost, on a first-in, first-out basis. Cost includes material costs, labor and applicable manufacturing overhead. The Company evaluates ending inventories for estimated excess quantities and obsolescence. This evaluation includes analysis of sales levels by product and projections of future demand within specific time horizons (generally six months or less). Inventories in excess of future demand are reserved. In addition, the Company considers the impact of changing technology on our inventory-on-hand and writes-off inventories that are considered obsolete. At the point of loss recognition, a new, lower-cost basis for that inventory is established, and subsequent changes in facts and circumstances do not result in the restoration or increase in the newly established cost basis.
Property and Equipment. Property and equipment are stated at cost less accumulated depreciation. Depreciation is computed using the straight-line method over the shorter of estimated useful life or the lease term. Upon retirement or sale, the cost and related accumulated depreciation are removed from the accounts and any related gain or loss is reflected in operations. Maintenance and repairs are charged to operations as incurred. The following table sets forth the depreciable lives generally used by major class of asset:
Major class of asset
Depreciable life (years)
Manufacturing tooling
Computers
Machinery and equipment
Furniture and fixtures
Leasehold improvements
Shorter of estimated useful life or remaining term of lease (five years or less)
Research and Development Costs. Research and development costs required to be capitalized pursuant to SFAS No. 86, Accounting for the Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed have not been material in fiscal years 2005 and 2004. The Company capitalized approximately $100,000 of costs in fiscal year 2003. Capitalized development costs are amortized over the estimated economic life of the product, which is generally three years. In fiscal year 2005, the Company fully expensed certain product development costs it had earlier capitalized because the Company decided not to incorporate the technology into its products. Software development costs for internal use required to be capitalized pursuant to Statement of Position No. 98-1, “Accounting for the Costs of Computer Software Developed or Obtained for Internal Use,” have not been material.
Goodwill. Goodwill represents the excess of price and related costs over the value assigned to the net tangible and intangible assets of the business acquired. Goodwill is tested for impairment on an annual basis and between annual tests if indicators of potential impairment exist, using a fair-value-based approach generally based on projected cash flows. No impairment of goodwill was identified during fiscal years 2005 and 2003. During fiscal year 2004, the Company concluded that due to the planned closure of its German subsidiary in the first quarter of fiscal 2005, the goodwill associated with that entity of $0.5 million was impaired and was written-off.
Long-Lived Assets, Including Other Intangible Assets. We evaluate our long-lived assets, including other intangible assets and test our long-lived assets and other intangible assets for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to the estimated undiscounted future net cash flows expected to be generated by the asset group that represents the lowest level for which identifiable cash flows exist. If an asset group is considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount exceeds the fair value of the assets and is allocated to the long-lived assets of the asset group on a pro rata basis. Fair value is estimated using the discounted cash flow method. Assets to be disposed of are reported at the lower of carrying values or fair values, less costs of disposal. No impairment of intangible assets was identified during fiscal years 2005, 2004 and 2003. Intangible assets are amortized using the straight-line method over their estimated period of benefit, ranging from 3 to 6 years.
Advertising Costs. The Company expenses advertising costs as incurred. Advertising expenses were $0.7 million, $0.7 million and $0.5 million for fiscal years 2005, 2004 and 2003, respectively.
Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years that those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. A valuation allowance is provided to the extent such deferred tax assets may not be realized.
Equity Investment. The Company has a carrying value associated with one investment in a privately held company. The Company monitors the investment for impairment and makes appropriate reductions in carrying values if the Company determines that an impairment charge is required based primarily on the financial condition and near-term prospects of the company.
Stock-Based Compensation. Beginning in fiscal 2006, the Company will be required to adopt Statement of Financial Accounting Standards No. 123(R) “Share-Based Payments” (“SFAS 123(R)”), which requires all share-based payments to employees, including stock options and stock issued under certain employee stock purchase plans, to be recognized in the Company’s financial statements at their fair value. SFAS 123(R) will require the Company to estimate future forfeitures of stock based compensation, while the current pro forma
disclosure includes only those options that have been forfeited during the current period. The Company has continued to use the Black-Scholes option pricing model to determine fair value of options under SFAS 123(R) and will use the modified-prospective transition method. Therefore, prior period financial statements will not be restated but disclosure of the pro forma net loss calculation will be included in the footnotes to the financial statements for periods prior to fiscal year 2006 and the adoption of SFAS 123(R). The impact of adopting SFAS 123(R) cannot be accurately estimated at this time because the calculation depends on the market value and amount of share based awards granted in future periods.
Pro Forma Disclosure-Compensatory Stock Arrangements. If the Company had elected to recognize compensation cost based on the fair value of the options granted at grant date and the fair value of shares purchased under the plan as prescribed by SFAS No. 123, the pro-forma stock-based incentive expense would have impacted our net loss and net loss per share. The following table illustrates the effect on our net loss and net loss per share if we had applied the fair value recognition provisions of SFAS 123:
The fiscal years 2005, 2004 and 2003 pro forma amounts are not necessarily indicative of future period pro forma amounts.
Service Accrual. The Company expenses cost to provide future complimentary, technical phone support for hardware and software customers. This is telephone support that is not paid for by the customer pursuant to the terms of a contractual agreement. Effective in the fourth fiscal quarter of 2005, the Company changed the policy of providing hardware customers complimentary phone support, generally reducing the complimentary time period. Once the complimentary period lapses, no further phone support is offered unless the customer purchases a customer care contract.
Use of Estimates. The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and judgments that affect the amounts reported in the Consolidated Financial Statements and accompanying notes. Estimates are used for revenue recognition, allowance for doubtful accounts and sales returns, reserves for excess and obsolete inventory, warranty costs, investment impairments, income taxes, service costs, and loss contingencies, among others. The actual results experienced by the Company may differ materially from management’s estimates.
Per Share Calculations. Basic net loss per share is computed by dividing the net loss for the period by the weighted-average number of common shares outstanding during the period. Diluted net loss per share is computed using the weighted-average number of common shares and excludes dilutive potential common shares outstanding, as their effect is antidilutive. Dilutive potential common shares consist of employee stock options, which in the aggregate were approximately 5.7 million options outstanding at September 30, 2005.
Business Segments. The Company operates two business segments. The Company develops and markets broadband customer premises equipment and remote management software for the management of broadband services and equipment. The Company also develops and provides broadband enabled services and remote management software for enterprises technical support, help-desks and personal computers. Our organization is structured in a functional manner. The President and Chief Executive Officer was identified as the Company’s
Chief Operating Decision Maker as defined by SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information. SFAS No. 131 establishes standards for the reporting by public business enterprises of information about operating segments, products and services, geographic areas, and major customers. The methodology for determining the information reported is based on the organization of operating segments and the related information that the Chief Operating Decision Maker uses for operational decisions and assessing financial performance. The Company’s Chief Operating Decision Maker managed Netopia based primarily on broad functional categories of manufacturing costs, sales and marketing, product development and engineering, administrative. For purposes of making operating decisions and assessing financial performance, the Company’s Chief Operating Decision Maker reviews financial information presented on a consolidated basis accompanied by disaggregated information for revenues and gross margins by product group as well as revenues by geographic region and by major customer. Operating expenses, assets, and cash flows are not segregated by product group for purposes assessing financial performance.
Foreign Currency Translation. Assets and liabilities of the Company’s non-U.S. subsidiaries that operate in a local currency environment, where the local currency is the functional currency, are translated to U.S. dollars at exchange rates in effect at the balance sheet date, with the resulting translation adjustments directly recorded to a separate component of accumulated other comprehensive income. Income and expense accounts are translated at the weighted average exchange rates during the year. Translation adjustments are recorded in other income (loss), net, where the U.S. dollar is the functional currency.
Derivative Instruments-Foreign Currency Forward Contracts. The Company has entered into foreign currency forward contracts to hedge foreign currency receivables. Forward contracts involve agreements to sell foreign currencies at specific rates at future dates. The Company does not hold or issue derivative financial instruments for speculative trading purposes. These contracts are designed to hedge, or reduce the potential foreign currency losses and gains on the foreign currency denominated receivables. The forward contracts are not designated as accounting hedges and the carrying amount of the forward contracts is the fair value, which is determined by obtaining quoted market prices, and recognized as either assets or liabilities. Changes in fair value of forward contracts are recognized in other income (loss), net at the end of each period.
Reclassifications. Certain reclassifications have been made to prior year balances in order to conform to the current year’s presentation.
Fair Value of Financial Instruments. The fair value of cash and cash equivalents, accounts receivable and accounts payable for all periods presented approximates their respective carrying amounts because of the short maturity of these financial instruments.
Recent Accounting Pronouncements.
In July 2005, the Financial Accounting Standards Board (FASB) issued an Exposure Draft of a proposed Interpretation “Accounting for Uncertain Tax Positions-an interpretation of FASB Statement No. 109.” Under the proposed Interpretation, a company would recognize in its financial statements its best estimate of the benefit of a tax position, only if the tax position is considered probable of being sustained on audit based solely on the technical merits of the tax position. In evaluating whether the probable recognition threshold has been met, the proposed Interpretation would require the presumption that the tax position will be evaluated during an audit by taxing authorities. The proposed Interpretation would be effective as of the end of the first fiscal year ending after December 15, 2005, with a cumulative effect of a change in accounting principle to be recorded upon the initial adoption. The proposed Interpretation would apply to all tax positions and only benefits from tax positions that meet the probable recognition threshold at or after the effective date would be recognized. The Company does not believe that the proposed interpretation has had nor will have a material impact on our Consolidated Financial Statements.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error Corrections, a replacement of APB No. 20 and FASB Statement No. 3 (“SFAS No. 154”). SFAS No. 154 requires retrospective application to
prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable. APB Opinion No. 20 “Accounting Changes,” previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. This statement is effective for our Company as of January 1, 2006. The Company does not believe that the adoption of SFAS No. 154 has had nor will have a material impact on our Consolidated Financial Statements.
In December 2004, the FASB issued SFAS No. 123 (revised 2004), Share-Based Payment (“SFAS No. 123R”), which replaces SFAS No. 123 Accounting for Stock-Based Compensation and supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123R requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statements based on their fair values. The pro forma disclosures previously permitted under SFAS No. 123 no longer will be an alternative to financial statement recognition. We are required to adopt SFAS No. 123R in the first quarter of fiscal year 2006, beginning October 1, 2005. We are evaluating the requirements of SFAS No. 123R and expect that the adoption of SFAS No. 123R will have a material impact on our consolidated results of operations and earnings per share. We have not yet determined the effect of adopting SFAS No. 123R, and we have not determined whether the adoption will result in amounts that are similar to the current pro forma disclosures under SFAS No. 123.
In March 2005, the SEC issued Staff Accounting Bulletin (“SAB”) No. 107, which expresses the views of the SEC regarding the interaction between SFAS No. 123R and certain SEC rules and regulations. SAB No. 107 provides guidance related to the valuation of share-based payment arrangements for public companies, including assumptions such as guidance related to share-based payment transactions with non-employees, expected volatility, expected term and the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS No. 123R. The Company will apply the principles of SAB 107 in conjunction with its adoption of SFAS No. 123R.
In March 2004, the FASB ratified the recognition and measurement guidance and certain disclosure requirements for impaired securities as described in Emerging Issues Task Force (EITF) Issue No. 03-1, The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF Issue No. 03-1 provides new guidance for determining and recording impairment for both debt and equity securities. It also requires additional disclosure for declines in investments that are deemed to be temporary under the standard. In September 2004, the FASB approved the issuance of a FASB Staff Position to delay certain measurement and recognition guidance contained in EITF Issue No. 03-1. We do not expect that the adoption of the recognition and measurement provisions will have a material impact on our consolidated balance sheet or statement of operations. The disclosure requirements are effective for fiscal years ending after June 15, 2004, and are required only for annual periods.
In November 2004, the FASB issued SFAS No. 151, “Inventory Costs-an amendment of ARB No. 43, Chapter 4.” This statement clarifies the accounting for abnormal amounts of facility expense, freight, handling costs and wasted materials (spoilage) to require them to be recognized as current-period charges. This statement is effective for inventory costs incurred during fiscal years beginning after June 15, 2005. Earlier application is permitted. The adoption of this standard is not expected to have a material impact on the Company’s Consolidated Balance Sheet or Statement of Operations.
(2) Acquisitions
In fiscal year 2004, the Company acquired JadeSail Systems, Inc, as described below. The Company did not complete an acquisition in fiscal years 2005 or 2003.
In October 2003, the Company acquired JadeSail, a provider of Internet Protocol services management and network equipment provisioning software. JadeSail survived as a wholly owned subsidiary of Netopia and was later merged into Netopia. Netopia has incorporated the JadeSail technology into its NBBS remote management software platform.
Under the terms of the merger agreement, the Company issued shares of its common stock in exchange for all the outstanding common stock of JadeSail. The aggregate purchase price was approximately $1.4 million and consisted of (a) 160,000 shares of the Company’s common stock, which were valued using the average of the closing price of the Company’s common stock for the 5 day period beginning two days prior to and ending two days after the closing date, and (b) other transaction related expenses of approximately $0.2 million. The Company accounted for the transaction using the purchase method.
The allocation of the purchase price was based upon the Company’s estimate of the fair value of the tangible and intangible assets acquired as summarized below:
Developed product technology is being amortized to expense based on an estimated useful life of 5 years.
(3) Goodwill and Purchased Intangible Assets
The Company’s goodwill was allocated to the broadband software and services segment. The table below presents the changes in goodwill during fiscal 2004 and 2005 (in thousands).
During fiscal year 2004, the Company concluded that due to the planned closure of its German subsidiary in the first quarter of fiscal 2005, the goodwill associated with that entity of $0.5 million was impaired and written-off.
At September 30, 2005, the Company’s purchased intangible assets consisted of developed product technology, acquired customer relationships and a marketing agreement. The table below presents details of the Company’s purchased intangible assets.
The acquisition related amortization of acquired customer relationships was $345,000 in each of fiscal years 2005, 2004 and 2003.
The Company’s purchased intangible assets are estimated to be almost fully amortized by the end of fiscal 2007, with estimated future amortization of $1,300,000; $1,020,000 and $49,000, in fiscal years 2006, 2007 and 2008, respectively
(4) Inventories
At September 30, 2005 and 2004, inventories consisted of the following:
(5) Property and Equipment
At September 30, 2005 and 2004, property and equipment consisted of the following:
(6) Warranty Liability
Warranty liability is recorded as a component of accrued liabilities on the Company’s Consolidated Balance Sheets. For the Company’s broadband equipment products, the Company generally provides a one-year warranty to domestic purchasers and a two-year warranty to European purchasers. The Company generally does not offer a warranty on its broadband software and services products. The Company accrues for its estimated product warranty costs at the time of shipment. Product warranty costs are estimated based upon the Company’s historical experience.
The following table summarizes the activity related to the product warranty liability (in thousands):
(7) Income Taxes
For financial reporting purposes, the Company’s net loss prior to the provision for income taxes included the following:
Income tax expense consisted of the following:
Income tax expense (benefit) differs from the amounts computed by applying the statutory income tax rate of 34% for 2005, 2004 and 2003 to pretax loss as a result of the following:
The tax effects of temporary differences that gave rise to significant portions of the deferred tax assets and liabilities were as follows:
The net change in the total valuation allowance for the years ended September 30, 2005 and 2004 was an increase of $0.8 million and $12.8 million, respectively.
At September 30, 2005, the Company believed that based upon available evidence, there was sufficient uncertainty regarding the ability to realize its deferred tax assets to warrant a full valuation allowance. The factors considered included the relative shorter life cycles in the high technology industry and the uncertainty of longer-term taxable income estimates.
At September 30, 2005, the Company had net operating loss carry-forwards of approximately $114.1 million for federal tax purposes and $59.3 million for state tax purposes. If not earlier utilized, the federal net operating loss carryforwards will expire in various years from 2018 through 2025 and the state net operating loss carryforwards will expire in various years from 2005 through 2016.
At September 30, 2005, the Company also had research credit carry-forwards of approximately $4.7 million for federal tax purposes and $2.9 million for state tax purposes. If not earlier utilized, the federal research credit carry-forwards will expire in various years beginning 2006 through 2025. The state research credit carries forward indefinitely until utilized. The Company has California manufacturing credit carry-forwards of approximately $0.2 million, which expire in various years beginning 2006 through 2008.
At September 30, 2005, the Company also had minimum tax credit carry-forwards of approximately $0.1 million for federal tax purposes and $0.2 million for state tax purposes. These credits carry forward until utilized.
Federal and California tax laws impose substantial restrictions on the utilization of net operating loss carry-forwards in the event of an “ownership change” for tax purposes, as defined in section 382 of the Internal Revenue Code. The Company has not yet determined if an ownership change has occurred. If such ownership change has occurred, utilization of the net operating losses could be subject to annual limitation in future years.
(8) Stockholders’ Equity and Stock Option Plans
Common Stock. The holders of common stock are entitled to one vote per share on all matters to be voted upon by the stockholders. Subject to preferences that may be applicable to any outstanding preferred stock, the holders of common stock are entitled to receive ratably such dividends, if any, as may be declared from time to time by the Board of Directors out of funds legally available. In the event of a liquidation, dissolution or winding up of the Company, the holders of common stock are entitled to share ratably in all assets remaining after payment of liabilities, subject to prior distribution rights of preferred stock, if any, then outstanding. The common stock has no preemptive or conversion rights or other subscription rights.
Stock Option Plans
The Company has three plans under which it grants options.
1996 Stock Option Plan. In April 1996, the Company adopted the 1996 Stock Option Plan (the 1996 Plan) providing for the issuance of incentive or non-statutory options to directors, employees, and non-employee consultants. Options are granted at the discretion of the Board of Directors or the Compensation Committee of the Board of Directors. Incentive stock options may be granted at not less than 100% of the fair market value per share and non-statutory stock options may be granted at not less than 85% of the fair market value per share at the date of grant as determined by the Board of Directors or the Compensation Committee, except for options granted to a person owning greater than 10% of the total combined voting power of all classes of stock of the Company, for which the exercise price of the options must be not less than 110% of the fair market value. Included in the 1996 Plan is a provision for the automatic grant of non-statutory options to non-employee directors of the Company. The current provisions relating to the automatic grant of options to directors are described below.
2000 Stock Incentive Plan. In October 2000, the Company adopted the 2000 Stock Incentive Plan (the 2000 Plan) providing for issuance of non-statutory options and restricted stock to employees, officers, directors, consultants, independent contractors and advisors of the Company or any subsidiary of the Company. Options and restricted stock awards granted under the 2000 Plan are granted at the discretion of the Board of Directors or the Compensation Committee of the Board of Directors. The 2000 Plan is not a stockholder approved stock option plan and is intended to comply with the exception for broadly based option plans in which a majority of the participants are rank and file employees not officers or directors, and a majority of the grants are made to such employees. Only nonqualified stock options that do not qualify as incentive stock options within the
meaning of Section 422(b) of the Code may be granted under this Plan. The Board of Directors or the Compensation Committee will determine the exercise price of an option when the option is granted and may be not less than the par value of the shares on the date of grant. Officers and directors will not receive any additional awards under the 2000 Plan. A restricted stock award is an offer by the Company to sell to an eligible person shares that are subject to restrictions. The purchase price of shares sold pursuant to a restricted stock award will be determined by the Compensation Committee on the date the restricted stock award is granted and may be not less than the par value of the shares on the date of grant. Restricted stock awards shall be subject to such restrictions as the Board of Directors or the Compensation Committee may impose. As of September 30, 2005, there were no restricted stock awards granted under the 2000 Plan.
Equity Incentive Plan. In December 2001, the Company adopted the 2002 Equity Incentive Plan (the 2002 Plan) providing for the issuance of incentive or non-statutory options, stock awards and other equity awards to directors, employees, and non-employee consultants. The Company’s stockholders approved the 2002 Plan at the Annual Stockholder Meeting in January 2002. The 2002 Plan is a successor to the 1996 Plan. Options and other awards are granted at the discretion of the Board of Directors or the Compensation Committee of the Board of Directors. Incentive stock options may be granted at not less than 100% of the fair market value per share and non-statutory stock options may be granted at not less than 85% of the fair market value per share at the date of grant as determined by the Board of Directors or the Compensation Committee. Included in the 2002 Plan is a provision for the automatic grant of non-statutory options to non-employee directors of the Company. The current provisions relating to the automatic grant of options to directors are described below. The automatic grant provisions of the 2002 Plan take effect only at such time as there are not sufficient shares available under the existing automatic grant program in the 1996 Plan.
The initial number of shares of common stock available for issuance under the 2002 Plan was 750,000 shares. The number of shares of common stock available for issuance under the 2002 Plan automatically increases on the first trading day of each calendar year beginning 2003 by an amount equal to four and three-quarter percent (4.75%) of the shares of common stock outstanding on December 31 of the immediately preceding calendar year, provided, however, that no such automatic annual increase may exceed 1,000,000 shares. As a result of this automatic increase provision, an additional 1,000,000, 1,000,000 and 898,081 shares of common stock became available on January 3, 2005, January 2, 2004 and January 2, 2003, respectively, for issuance under the 2002 Plan.
Amendments to Automatic Option Grant Programs in Stock Option Plans. Amendments to the Company’s Automatic Option Grant Programs that are included in the 1996 Stock Option Plan and 2002 Equity Incentive Plan to increase the number of options granted to non-employee directors of the Company were approved at the Company’s Annual Meeting of Stockholders in January 2003. As amended, the Automatic Option Grant Programs provide that each non-employee director who is first elected or appointed on or after the date of the 2003 Annual Meeting of Stockholders will receive the grant of an option to purchase 50,000 shares of common stock. The Automatic Option Grant Programs also provide for the grant on the date of each annual stockholder meeting beginning with the 2003 Annual Meeting of Stockholders of (a) an option to purchase 15,000 shares of common stock to each non-employee director, and (b) an additional option to purchase 5,000 shares of common stock to each non-employee director who is a member of the Audit Committee of the Company’s Board of Directors.
As of September 30, 2005, the Company had 5,709,856 shares subject to outstanding options and 2,043,721 shares available for grant.
The following table summarizes activity under the Company’s stock option plans:
The fair value, based upon the Black-Scholes option valuation model, of the options granted during fiscal years 2005, 2004 and 2003 were $3.15, $6.73 and $3.15, respectively.
The following table summarizes information with respect to the Company’s stock options outstanding at September 30, 2005:
1996 Employee Stock Purchase Plan. In April 1996, the Board of Directors adopted the 1996 Employee Stock Purchase Plan (the 1996 Purchase Plan). A total of 3,500,000 shares of common stock were approved for issuance under the 1996 Purchase Plan, and a total of 3,499,920 shares of common stock were issued under the 1996 Purchase Plan as of the final purchase date in March 2005. Employees purchased shares of common stock at a price per share that is 85% of the lesser of the fair market value as of the beginning or the end of the semi-annual option period.
Shares issued under the 1996 Purchase Plan totaled 261,651 in fiscal year 2005, 1,141,324 in fiscal year 2004 and 756,190 in fiscal year 2003.
2005 Employee Stock Purchase Plan. The Board of Directors adopted the 2005 Employee Stock Purchase Plan (the 2005 Purchase Plan) effective as of January 2005. The Company’s stockholders approved the 2005 Purchase Plan at the annual stockholder meeting in March 2005. The 2005 Purchase Plan supersedes and replaces the 1996 Purchase Plan. A total of 1,225,000 shares of common stock have been approved for issuance under the 2005 Purchase Plan. Employees may purchase shares of common stock at a price per share that is 85% of the lesser of the fair market value as of the beginning or the end of the semi-annual option period. Shares issued under the 2005 Purchase Plan totaled 180,981 in fiscal year 2005. As of September 30, 2005, 1,044,019 shares were reserved for future issuance under the 2005 Purchase Plan.
Statement of Financial Accounting Standard No. 123R
Information regarding net income and net income per share, as adjusted, is required by SFAS 123R, which requires that the information be determined as if the Company had accounted for its employee stock options granted under the fair value method. 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 while the Company’s employee stock options have characteristics significantly different from those of traded options. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. The per share weighted average estimated fair value for employee stock options granted during fiscal years 2005, 2004 and 2003 was $3.15, $6.73 and $3.15, respectively.
The following are the estimates used to value employee stock options in the Black-Scholes option-pricing model:
The weighted average estimated fair value of shares issued under the employee stock purchase plan was $3.32 per share during fiscal year 2005, $2.36 during fiscal 2004 and $2.51 during fiscal 2003. These were estimated using the Black-Scholes option-pricing model, based on the following assumptions:
The Company recognizes as an expense, using the Black-Scholes option valuation model, the fair value of options and other equity instruments granted to non-employees.
(9) Commitments and Contingencies
Operating Lease Commitments. The Company conducts its operations in leased facilities under operating lease agreements expiring at various dates through 2014. The following is a summary of future minimum rental payments required under these leases that have initial or remaining non-cancelable lease terms in excess of one year:
Total rental expense for all operating leases amounted to $1.2 million, $1.4 million and $1.6 million for fiscal years 2005, 2004 and 2003, respectively.
Purchase Commitments with Outsourcing Manufacturers and Suppliers. The Company has purchase commitments with its outsourcing manufacturers. Our outsourcing manufacturers procure component inventory on our behalf based on our production orders. The Company is obligated to purchase component inventory that the outsourcing manufacturer procures in accordance with the orders, unless cancellation is given within applicable lead times. These commitments are reflected in our financial statements as a liability once goods or services have been received or payments related to the obligations become due. At September 30, 2005, purchase commitments totaled $14.0 million.
Litigation. On December 3, 2004, the United States District Court for the Northern District of California issued an order consolidating previously filed purported class action cases under the name In re Netopia, Inc. Securities Litigation, and appointing lead plaintiffs and plaintiffs’ counsel. On June 29, 2005, the lead plaintiffs filed their consolidated amended complaint. The consolidated amended complaint alleges violations of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The consolidated amended complaint alleges that during the purported class period, November 6, 2003 through August 16, 2004, we made false and misleading statements or failed to disclose material facts, and that the market price of our common stock was artificially inflated as a result of such alleged conduct. We believe that we have strong defenses to the claims asserted in the consolidated amended complaint. We intend to defend the case vigorously. We currently cannot estimate the extent of the potential damages in this dispute.
In August 2004, the first of four purported derivative actions, Freeport Partners, LLC, Derivatively on Behalf of Nominal Defendant Netopia, Inc., v. Alan B. Lefkof, William D. Baker, Reese M. Jones, Harold S. Wills, Robert Lee and Netopia, Inc., was filed in the United States District Court for the Northern District of California. Two purported derivative actions are pending in the United States District Court for the Northern District of California, and two related purported derivative actions are pending in the Superior Court of California for the County of Alameda. These actions make claims against our officers and directors arising out of the alleged misstatements described above in connection with the purported class action described above. In November 2004, the derivative plaintiffs agreed to coordinate the four derivative actions. The parties have agreed to a stay of the federal derivative actions, which was ordered by the court in January 2005. The state actions have been consolidated under the name In re Netopia, Inc. Derivative Litigation. The plaintiffs have not filed their consolidated amended complaint. We believe that we have strong defenses to the claims asserted in the complaints as initially filed. We intend to defend the cases vigorously. We currently cannot estimate the extent of the potential damages in this dispute.
On October 29, 2004, we were advised by the United States Securities and Exchange Commission (“SEC”) that an informal inquiry previously commenced by the SEC had become the subject of a formal order of investigation. This investigation is to determine whether the federal securities laws have been violated. We cooperated fully with the informal inquiry, and we have been cooperating fully with the formal investigation.
On July 22, 2005, we announced that following discussions with the SEC staff, we had made a settlement offer to the SEC to resolve the investigation into our disclosures and accounting practices, primarily related to our restatement of financial statements for the fiscal years ended September 30, 2003 and 2002. Without admitting or denying any wrongdoing, we offered to consent to the entry of an order with respect to violations of Sections 13(a) and 13(b)(2)(A)-(B) of the Exchange Act, and Rules 12b-20, 13a-1, 13a-11 and 13a-13 promulgated thereunder. The SEC staff has agreed to recommend that the SEC approve the offer of settlement. The proposed settlement is subject to completion of mutually agreeable settlement language and final approval by the SEC.
On July 22, 2005, we also announced that we had learned that the SEC staff has agreed to recommend that the SEC approve an offer of settlement with Alan B. Lefkof, our President and Chief Executive Officer.
Mr. Lefkof, without admitting or denying any wrongdoing, offered to consent to the entry of an order with respect to violations of Sections 17(a)(2)-(3) of the Securities Act of 1933, as amended, and Rule 13b2-1 promulgated under the Exchange Act, and aiding and abetting our violations of Sections 13(a) and 13(b)(2)(A)-(B) of the Exchange Act, and Rules 12b-20 and 13a-11 promulgated thereunder, in connection with a Report on Form 8-K and exhibit furnished to the SEC on July 6, 2004. The proposed settlement with Mr. Lefkof contemplates a monetary payment. The proposed settlement is subject to completion of mutually agreeable settlement language and final approval by the SEC.
Responding to the formal order of investigation of the SEC has required significant attention and resources of management. Our proposed settlement described above is subject to final approval by the SEC. In addition, even though we have announced the proposed settlement with the SEC, the investigation by the SEC is ongoing, and may continue to require significant attention and resources. If either we and/or Mr. Lefkof are unable to complete the proposed settlements and the SEC elects to pursue an enforcement action against us and/or Mr. Lefkof, the defense could be costly and require additional management resources. If we were unsuccessful in defending against this or other investigations or proceedings, we could face civil or criminal penalties that would seriously harm our business and results of operations.
In April 2005, we learned that the United States Attorney for the Northern District of California has opened an investigation following a referral by the SEC. We do not know the scope or focus of the investigation.
In January 2005, we were notified by the Occupational Health and Safety Administration (“OSHA”) that we were named in an administrative complaint filed by two former employees alleging violations of Section 806 of the Corporate and Criminal Fraud Accountability Act of 2002, 18 U.S.C. § 1514A, also known as the Sarbanes-Oxley Act. The former employees alleged that we terminated them in retaliation for their participation in the internal accounting review conducted by the audit committee in 2004. On May 11, 2005, following its investigation, OSHA advised us that the complaint was determined to have no merit. On August 31, 2005, the two former employees refiled these claims in the United States District Court for the Northern District of Texas in an action entitled Frankl v. Netopia et al. The complaint names the Company and certain current and former officers and directors as defendants. The plaintiffs will be filing a motion to stay this action. We believe that our defenses to this action are strong and intend to defend it vigorously. We currently cannot estimate the extent of the potential damages in this dispute.
In February 2005, these same two former employees filed a complaint in the United States District Court for the Northern District of Texas, Dallas Division. The complaint named the Company and Alan Lefkof as defendants, and asserted claims for defamation and breach of contract. The plaintiffs have voluntarily dismissed this action.
Defending against the government investigations, the private securities class action, the derivative actions and other litigation matters described above will likely require significant attention and resources of management and, regardless of the outcome, result in significant legal expense. If our defenses ultimately are unsuccessful, or if we are unable to achieve a favorable settlement, we could be liable for large damage awards that could seriously harm our business and results of operation. While we have provided notice of the government investigations and the litigation matters described above to our directors and officers liability insurance carriers, the insurance carriers have raised certain coverage issues and to date have not reimbursed us for all legal expenses incurred, and may not agree that they are responsible to pay any damages that ultimately could be awarded to the plaintiffs. Furthermore, we have only a limited amount of insurance, and even if our insurers agree to make payments under the policies, the legal expenses and damage awards or settlements may be greater than the amount of insurance, and we would in all cases be liable for any amounts in excess of our insurance policy limits.
We are named as a defendant in an action pending in the United States Bankruptcy Court for the Northern District of California entitled E. Lynn Schoenmann, trustee of NorthPoint Communications, Inc. v. Netopia. In
this action commenced on January 11, 2003, the trustee of the bankruptcy estate of NorthPoint Communications, Inc. (“NorthPoint”) is seeking to recover approximately $1.2 million that NorthPoint paid to us within the 90 day preference period before NorthPoint filed for bankruptcy in January 2001. NorthPoint’s trustee is claiming that NorthPoint was insolvent at the time it made these payments, and that therefore the payments are recoverable preferences within the meaning of the Bankruptcy Code. We believe that we have defenses to the claims asserted by NorthPoint’s trustee, and we intend to continue to defend ourselves vigorously. We do not believe that the outcome of this lawsuit is likely to harm our business seriously. We currently cannot estimate the extent of the potential damages in this dispute.
In addition to the lawsuits described above, from time to time we are involved in other litigation or disputes that are incidental to the conduct of our business. We are not party to any such other incidental litigation or dispute that in our opinion is likely to seriously harm our business. Legal fees are expensed as incurred.
(10) Segment, Geographic and Major Customer Information
The Company develops and markets broadband customer premises equipment and remote management software for the management of broadband services and equipment. The Company also develops and provides broadband enabled services and remote management software for enterprises’ technical support, help-desks and personal computers. Our organization is structured in a functional manner. The President and Chief Executive Officer was identified as the Company’s Chief Operating Decision Maker as defined by SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information. SFAS No. 131 establishes standards for the reporting by public business enterprises of information about operating segments, products and services, geographic areas, and major customers. The methodology for determining the information reported is based on the organization of operating segments and the related information that the Chief Operating Decision Maker uses for operational decisions and assessing financial performance. The Company’s Chief Operating Decision Maker managed Netopia based primarily on broad functional categories of manufacturing costs, sales and marketing, product development and engineering, administrative. For purposes of making operating decisions and assessing financial performance, the Company’s Chief Operating Decision Maker reviews financial information presented on a consolidated basis accompanied by disaggregated information for revenues and gross margins by product group as well as revenues by geographic region and by major customer. Operating expenses, assets, and cash flows are not segregated by product group for purposes assessing financial performance.
The Company generates revenues from two primary groups, (i) broadband equipment and (ii) broadband software and services. Financial information regarding the operating segments was as follows:
Geographic Information.
The Company sells most of its products through its field sales organization, with a small portion of sales through distributors and resellers. Most of the Company’s sales are to telecommunications carriers and service providers in the United States and Europe through our field sales force. Our field sales force is geographically disbursed within the United States and Europe and we have a sales office in Paris, France. Most of our sales in Europe are to customers in Switzerland and Ireland.
Sales outside of the United States are primarily export sales denominated in United States dollars or Euros. Information regarding the Company’s revenues by geographic region follows:
The Company has no material operating assets outside the United States.
Customer Information.
The Company’s largest customers are service providers. They include regional, national, and international telecommunications carriers, as well as Internet Service Providers.
Three customers accounted for 10% or more of revenues in fiscal years 2005, 2004 and 2003. Sales to BellSouth Telecommunications, Inc. were approximately 20% and 10% of revenues in fiscal years 2005 and 2004, respectively. Sales to Swisscom AG were approximately 18%, 19%, and 16% of revenues in fiscal years 2005, 2004 and 2003, respectively. Sales to eircom Group plc were approximately 10% of revenues in fiscal year 2005. Sales to AT&T Corporation (formerly SBC Communications Inc.) were approximately 10% and 11% of revenues in fiscal years 2004 and 2003, respectively. Sales to Covad Communication Group, Inc. were approximately 15% of revenues in fiscal year 2003.
The following tables sets forth 2005 and 2004 customer balances accounting for 10% or more of accounts receivable along with such data expressed as a percentage of total accounts receivable:
(11) Long-Term Investments
In fiscal year 2001, the Company purchased $2.0 million of Series D Preferred stock in MegaPath Networks Inc. (MegaPath). In fiscal year 2002, the Company purchased $0.4 million of Series E Preferred Stock in MegaPath. In fiscal year 2003, MegaPath completed an additional round of financing in which the Company invested $26,000. The Company owns approximately 2.4% of MegaPath. MegaPath offers high-speed DSL access and eCommerce and Web hosting services to small and medium size businesses. During fiscal year 2005, Megapath purchased $0.1 million of the Company’s products directly from the Company. Most of Megapath’s purchases of the Company’s products during 2005 were through an independent distributor. In fiscal years 2004 and 2003, MegaPath purchased $1.3 million and $1.3 million, respectively, of the Company’s products. In fiscal year 2002, the Company recorded a $1.4 million impairment write-down to the carry value of its investment in MegaPath. Although there is no public market for MegaPath’s stock, management of the Company believes that the market value of its investment in MegaPath is not less than the Company’s approximately $1.0 million carrying value at September 30, 2005.
In fiscal year 2000, the Company purchased $2.0 million of Series C Preferred Stock in Everdream Corporation (Everdream). Everdream provides outsourced information technology expertise, products and services that enable small and medium size businesses to focus on their core competencies. In fiscal year 2002, the Company recorded a $1.5 million impairment write-down to the carry value of its investment in Everdream. In fiscal year 2003, the Company recorded a $0.5 million impairment write-down, fully writing-off the remaining carry value of the Company’s investment in Everdream.
(12) Restructuring Costs
During the year ended September 30, 2005, the Company recorded a restructuring charge of $40,000, primarily consisting of employee termination costs, wind down costs associated with the closure of a sales office in the Netherlands and additional wind down costs associated with the closure of the software research and development facility in Germany in the quarter ended September 30, 2004.
During the year ended September 30, 2004, the Company recorded a restructuring charge of approximately $500,000, primarily consisting of employee termination costs, wind down costs associated with the closure of the German facility.
During the year ended September 30, 2003, the Company recorded a restructuring charge of $0.4 million, primarily consisting of employee severance benefits resulting from a reduction in the Company’s workforce.
The restructuring accrual activity is summarized below:
(13) Credit Facility
The Company amended its credit facility agreement with Silicon Valley Bank, effective June 27, 2005. Under the amended credit facility, the credit limit is $10 million, the interest rate is Silicon Valley Bank’s prime rate, the term or maturity date is June 27, 2007. The amended credit facility contains financial covenants related to liquidity and net worth as well as other nonfinancial covenants. Covenants require that the Company maintain an adjusted quick ratio (described below) of 1.25 and the credit facility will be subject to formula based credit limits if the adjusted quick ratio falls below 1.50. Covenants included in an a subsequent amendment effective September 30, 2005 also require the Company to maintain a minimum tangible net worth of $28 million for September 2005, subsequently the minimum declines every few months to $24 million for September 2006 and thereafter, unless reset. The facility is secured by substantially all of the assets of the Company. The adjusted quick ratio is the ratio of (i) the Company’s unrestricted cash, cash equivalents and investments maintained at Silicon Valley Bank plus net receivables to (ii) the Company’s current liabilities plus the outstanding principal amount of any borrowings under the facility less deferred revenues. The Company may borrow under the credit facility in order to finance working capital requirements for new products and customers, and otherwise for general corporate purposes in the normal course of business. As of September 30, 2005, the Company was in compliance with the covenants and had access to approximately $9.5 million of the credit facility, and had no outstanding borrowings and approximately $500,000 of outstanding letters of credit.
On February 25, 2003, Silicon Valley Bank made two term loans to the Company with a combined original principal amount of $0.5 million. The principal was payable in twenty-four equal monthly payments of principal in the amount of $20,833 per month, commencing on March 1, 2003 and continuing until paid in full. As of September 30, 2004 the remaining balance of $104,167 was recorded as a current liability on the Company’s Consolidated Balance Sheet. The loans were fully repaid in fiscal year 2005.
(14) Other Income (Loss), Net
Other income (loss), net consists of interest income the Company earns on its cash, cash equivalents and short-term investments, interest expense related to the Company’s borrowing under its credit facility, and realized and unrealized gains and losses on foreign currency transactions. The following table summarizes the Company’s other income (loss), net:
(15) Subsequent Event
In December 2005, the Company received from a directors’ and officers’ liability insurance policy approximately $0.3 million for reimbursement of legal expenses incurred. The reimbursement was recorded as a reduction of general and administrative expense in the period received in accordance with the Company’s accounting policy.
(16) Quarterly Financial Information
The following table sets forth certain unaudited quarterly results of operations data for the twelve quarters ended September 30, 2005. This data has been derived from our unaudited interim Consolidated Financial Statements that, in our opinion, include all adjustments necessary for a fair presentation of such information.
When reading this information, you also should read Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and the Consolidated Financial Statements and related Notes thereto included elsewhere in this Form 10-K.
Schedule-Valuation and Qualifying Accounts
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None
ITEM 9A.
ITEM 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
We carried out an evaluation, under the supervision and with the participation of our management, including our President and Chief Executive Officer and Vice President and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based upon this evaluation, our President and Chief Executive Officer and our Vice President and Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by the Company in reports it files under the Securities Exchange Act of 1934, as amended, and regulations promulgated thereunder, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
Management’s Report on Internal Control Over Financial Reporting
Our management, including our President and Chief Executive Officer and Vice President and Chief Financial Officer, is responsible for establishing and maintaining adequate internal control over our financial reporting. 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.
There are inherent limitations in the effectiveness of any system of internal control, including the possibility of human error and the circumvention or overriding of controls. Accordingly, even effective internal controls can provide only reasonable assurances with respect to financial statement preparation. Further, because of changes in conditions, the effectiveness of internal control may vary over time.
Our management assessed the effectiveness of our internal control over financial reporting as of September 30, 2005. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations (COSO) of the Treadway Commission in Internal Control-Internal Framework. Based on its assessment using those criteria, our management concluded that, as of September 30, 2005, our internal control over financial reporting is effective.
Management’s assessment of the effectiveness of our internal control over financial reporting as of September 30, 2005 has been audited by Burr, Pilger & Mayer LLP, an independent registered public accounting firm, as stated in their report that appears under “Item 8. Financial Statements and Supplementary Data”.
Changes in Internal Controls over Financial Reporting
During the fourth quarter of fiscal year 2005, in connection with our ongoing review of our internal control over financial reporting, we implemented changes to strengthen access controls to sensitive financial systems, subsystems and data, to improve our documentation of significant transactions and to improve our documentation of testing of financial application changes. Other than these changes, there has been no change in our internal control over financial reporting identified in connection with our evaluation of our internal control over financial reporting that occurred during the fourth quarter of fiscal year 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B.
ITEM 9B. OTHER INFORMATION
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Directors and Executive Officers
The information required by this item relating to our directors and nominees is included under the caption “Proposal No. 1: Election of Directors” in our Proxy Statement to be filed with the United States Securities and Exchange Commission within 120 days after the end of our fiscal year ended September 30, 2005.
Pursuant to General Instruction G(3) of Form 10-K, the information required by this item relating to our executive officers is included under the caption “Executive Officers of the Registrant” in Part I of this report.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Exchange Act of 1934 requires the Company’s executive officers, directors and persons who beneficially own more than 10% of the Company’s Common Stock to file initial reports of ownership and reports of changes in ownership with SEC. Such persons are required by SEC regulations to furnish the Company with copies of all Section 16(a) forms filed by such persons. Based solely on the Company’s review of such forms furnished to the Company and written representations from certain reporting persons, the Company believes that all filing requirements applicable to the Company’s executive officers, directors and more than 10% stockholders were complied with during fiscal year 2005.
Code of Ethics
We have adopted a code of business conduct and ethics applies to all directors, officers and employees, and certain additional portions of the policy apply to all executive and senior financial officers. A copy of the Company’s Code of Business Conduct and Ethics has been filed as Exhibit 14.1 to the Company’s annual report on Form 10-K for the fiscal year ended September 30, 2003. In addition, the Company’s Code of Business Conduct and Ethics is publicly available on the Company’s website at http://media.corporate-ir.net/media_files/nsd/ntpa/corpgov/codeofethics0703.pdf.
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 of Form 10-K is incorporated by reference to the information contained in the section captioned “Executive Compensation and Other Matters” in our Proxy Statement to be filed with the United States Securities and Exchange Commission within 120 days after the end of our fiscal year ended September 30, 2005.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
The information required by Item 12 of Form 10-K is incorporated by reference to the information contained in the section captioned “Security Ownership of Certain Beneficial Owners and Management” in our Proxy Statement to be filed with the United States Securities and Exchange Commission within 120 days after the end of our fiscal year ended September 30, 2005.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Pursuant to the indemnification provisions of our By-Laws and our Amended and Restated Certificate of Incorporation, as well as indemnification agreements entered into between us and our officers and directors, we have been paying the legal fees and expenses of certain officers and directors that have been incurred in connection with the SEC investigation and related class action lawsuits, subject to undertakings by each
individual to reimburse such amounts in the event it is ultimately determined that such individual not entitled to indemnification under such provisions and agreements. The following is a list of the Company’s officers and directors that have received advancement of their legal fees in excess of $60,000 for the fiscal year ended September 30, 2005 and the amount advanced as of such date: (a) Director, President and Chief Executive Officer Alan B. Lefkof: $265,625; (b) Senior Vice President, General Counsel and Secretary David A. Kadish: $356,514; (c) Directors Harold S. Wills and Howard T. Slayen, jointly: $196,514. These amounts were included in the legal costs in our general and administrative expenses for the fiscal year ended September 30, 2005.
ITEM 14.
ITEM 14. PRINCIPAL ACCOUNTING FEES AND SERVICES
The information required by Item 14 of Form 10-K is incorporated by reference to the information contained in the section captioned “Audit Fees” in our Proxy Statement to be filed with the United States Securities and Exchange Commission within 120 days after the end of our fiscal year ended September 30, 2005.
PART IV
ITEM 15.
ITEM 15. EXHIBITS, FINANCIAL SCHEDULES AND REPORTS ON FORM 8-K
(a) See Item 8 in Part II of this Annual Report on Form 10-K, Financial Statements and Supplementary Data, for an index to the consolidated financial statements and supplementary financial information filed on this Form 10-K.
(b) During the three months ended September 30, 2005, we filed the following reports on Form 8-K:
•
On July 26, 2005, we filed a Current Report on Form 8-K, reporting Items 2 and 9.01, reporting our financial results for the third fiscal quarter ended June 30, 2004, as well as certain other information.
•
On July 22, 2004, we filed a Current Report on Form 8-K, reporting Items 8.01 and 9.01, reporting our announcement that we submitted an offer of settlement to the staff of the Division of Enforcement of the Securities and Exchange Commission to resolve a pending, previously-disclosed investigation into the Company’s disclosures and accounting practices, as well as certain other information.
(c) Exhibits have been filed separately with the United States Securities and Exchange Commission in connection with the Annual Report on Form 10-K or have been incorporated into the report by reference. You may obtain copies of such exhibits directly from us upon request.
(a) Incorporated by reference to our Registration Statement on Form S-1 (No. 333-3868).
(b) Incorporated by reference to our Form S-8 as filed on February 25, 2004.
(c) Incorporated by reference to our Form 10-K for the fiscal year ended September 30, 1997.
(d) Incorporated by reference to our Form S-8 as filed on December 8, 2000.
(e) Incorporated by reference to our Form 8-K as filed on October 17, 2001.
(f) Incorporated by reference to our Form S-8 as filed on May 2, 2003.
(g) Incorporated by reference to our Form 10-Q as filed on August 14, 2002.
(h) Incorporated by reference to our Form 10-K for the fiscal year ended September 30, 2002.
(i) Incorporated by reference to our Form 10-Q as filed on August 1, 2003.
(j) Incorporated by reference to our Form 10-Q as filed on February 17, 2004.
(k) Incorporated by reference to our Form 10-Q as filed on February 9, 2005.
(l) Incorporated by reference to our Form S-8 as filed on March 18, 2005.
(m) Incorporated by reference to our Form 10-Q as filed on August 9, 2005.
(n) Incorporated by reference to our Form 10-K for the fiscal year ended September 30, 2003.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities indicated, in the City of Emeryville, State of California on this 16th day of December 2005.
By:
/s/ Alan B. Lefkof
Alan B. Lefkof
President and Chief Executive Officer
By:
/s/ Charles Constanti
Charles Constanti
Vice President and Chief Financial Officer (Principal Accounting Officer)
Dated: December 16, 2005
POWER OF ATTORNEY
By signing this Form 10-K below, I hereby appoint each of Alan B. Lefkof and Charles Constanti as my attorney-in-fact to sign all amendments to this Form 10-K on my behalf, and to file this Form 10-K (including all exhibits and other documents related to the form 10-K) with the United States Securities and Exchange Commission. I authorize each of my attorneys-in-fact to (1) appoint a substitute attorney-in-fact for himself and (2) perform any actions that he believes are necessary or appropriate to carry out the intention and purpose of this Power of Attorney. I ratify and confirm all lawful actions taken directly or indirectly by my attorneys-in-fact and by any properly appointed substitute attorneys-in-fact.
Pursuant to the requirements of the Securities Exchange Act of 1934, the following persons on behalf of the Registrant and in the capacities and on the dates indicated have signed this report.