________________________________________________________________________________
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-------------------
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED OCTOBER 31, 2001
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER: 0-15810
SORRENTO NETWORKS CORPORATION
(EXACT NAME OF REGISTRANT AS SPECIFIED IN CHARTER)
NEW JERSEY 22-2367234
(STATE OR OTHER JURISDICTION OF INCORPORATION (IRS EMPLOYER IDENTIFICATION NUMBER)
OR ORGANIZATION)
9990 MESA RIM ROAD
SAN DIEGO, CALIFORNIA 92121
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(858) 558-3960
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
-------------------
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes __X__ No _____
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
Common Stock, $.30 par value per share, Outstanding: 13,989,037 shares at
December 12, 2001.
This Form 10-Q, future filings of the registrant, and oral statements made
with the approval of an authorized executive officer of the Registrant may
contain forward looking statements. In connection therewith, please see the
cautionary statements and risk factors contained in Item 2. 'Fluctuations in
Revenue and Operating Results' and 'Forward Looking Statements -- Cautionary
Statement', which identify important factors which could cause actual results to
differ materially from those in any such forward-looking statements.
________________________________________________________________________________
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
OCTOBER 31, JANUARY 31,
2001 2001
---- ----
(Unaudited)
(In thousands)
ASSETS
CURRENT ASSETS
Cash and equivalents.................................... $ 13,329 $ 9,965
Restricted cash......................................... 10,314 --
Accounts receivable, net................................ 10,691 16,000
Inventory, net.......................................... 19,576 14,601
Prepaid expenses and other current assets............... 1,629 813
Investment in marketable securities..................... 20,464 50,258
--------- ---------
TOTAL CURRENT ASSETS................................ 76,003 91,637
--------- ---------
PROPERTY AND EQUIPMENT, NET................................. 18,106 16,600
--------- ---------
OTHER ASSETS
Purchased technology, net............................... 745 1,023
Other assets............................................ 2,465 2,556
Investment in former subsidiary......................... 1,061 1,307
--------- ---------
TOTAL OTHER ASSETS.................................. 4,271 4,886
--------- ---------
TOTAL ASSETS................................................ $ 98,380 $ 113,123
--------- ---------
--------- ---------
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Short-term debt......................................... $ 1,239 $ 1,342
Current maturities of long term debt.................... 32 422
Accounts payable........................................ 10,061 8,382
Accrued and other current liabilities................... 8,344 9,498
--------- ---------
TOTAL CURRENT LIABILITIES........................... 19,676 19,644
--------- ---------
Long-term debt and capital lease obligations................ 3,938 3,819
Debentures payable.......................................... 4,963 --
Dividend payable............................................ 1,061 1,307
--------- ---------
TOTAL LIABILITIES................................... 29,638 24,770
--------- ---------
COMMITMENTS AND CONTINGENCIES
MINORITY INTEREST
Preferred stock of subsidiary; 8,954 shares issued and
outstanding; subsidiary liquidation preference
$48,800............................................... 48,800 48,620
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value; cumulative dividends;
liquidation preference $1,353 including accumulated
dividends............................................. 1 1
Common stock, $.30 par value; 16,667 shares authorized;
14,505 shares issued and 14,496 shares outstanding at
October 31, 2001; 12,608 shares issued and 12,599
shares outstanding at January 31, 2001................ 4,351 3,782
Additional paid-in capital.............................. 152,826 114,994
Receivable from option exercises........................ (2,334) (5,034)
Deferred stock compensation............................. (412) (880)
Accumulated deficit..................................... (150,843) (118,010)
Accumulated unrealized gain on marketable securities.... 16,422 44,949
Treasury stock, at cost; 9 shares and 9 shares at
October 31, 2001 and January 31, 2001, respectively... (69) (69)
--------- ---------
TOTAL STOCKHOLDERS' EQUITY.......................... 19,942 39,733
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY.................. $ 98,380 $ 113,123
--------- ---------
--------- ---------
See accompanying notes to consolidated financial statements.
2
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
OCTOBER 31 OCTOBER 31
--------------------- ---------------------
2001 2000 2001 2000
--------- --------- --------- ---------
(In thousands, except per share amounts)
NET SALES........................................ $ 10,066 $ 10,849 $ 32,561 $ 32,273
COST OF SALES.................................... 8,745 7,340 25,015 23,067
-------- --------- -------- ---------
GROSS PROFIT................................. 1,321 3,509 7,546 9,206
-------- --------- -------- ---------
OPERATING EXPENSES
Selling and marketing 4,099 4,335 12,248 13,561
Engineering, research and development........ 3,511 5,707 10,237 18,093
General and administrative................... 3,361 4,186 9,404 12,386
Deferred compensation........................ 203 400 609 1,236
Other operating expenses..................... 2,793 93 2,979 2,348
-------- --------- -------- ---------
TOTAL OPERATING EXPENSES................. 13,967 14,721 35,477 47,624
-------- --------- -------- ---------
LOSS FROM OPERATIONS............................. (12,646) (11,212) (27,931) (38,418)
-------- --------- -------- ---------
OTHER INCOME (CHARGES)
Investment income............................ 186 494 329 1,855
Interest expense............................. (3,500) (234) (3,834) (746)
Other income (charges)....................... 83 -- (34) (4)
Gains (losses) on marketable securities...... (47) 4,049 (1,183) 4,049
-------- --------- -------- ---------
TOTAL OTHER INCOME (CHARGES)............. (3,278) 4,309 (4,722) 5,154
-------- --------- -------- ---------
LOSS BEFORE INCOME TAXES......................... (15,924) (6,903) (32,653) (33,264)
Provision for Income Taxes....................... -- -- -- --
-------- --------- -------- ---------
NET LOSS......................................... $(15,924) $ (6,903) $(32,653) $ (33,264)
-------- --------- -------- ---------
-------- --------- -------- ---------
INCOME (LOSS) PER COMMON SHARE:
PREFERRED STOCK DIVIDENDS.................... -- 579 180 1,555
NET LOSS APPLICABLE TO COMMON SHARES......... $(15,924) $ (7,482) $(32,833) $ (34,819)
-------- --------- -------- ---------
-------- --------- -------- ---------
BASIC
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING (IN THOUSANDS)............. 14,316 11,845 13,891 11,658
NET LOSS PER COMMON SHARE................ $ (1.11) $ (0.63) $ (2.36) $ (2.99)
-------- --------- -------- ---------
-------- --------- -------- ---------
DILUTED
WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING (IN THOUSANDS)............. 14,316 11,845 13,891 11,658
NET LOSS PER COMMON SHARE................ $ (1.11) $ (0.63) $ (2.36) $ (2.99)
-------- --------- -------- ---------
-------- --------- -------- ---------
COMPREHENSIVE INCOME AND ITS COMPONENTS CONSIST
OF THE FOLLOWING:
Net loss..................................... $(15,924) $ (6,903) $(32,653) $ (33,264)
Unrealized gains (losses) from marketable
securities:
Unrealized holding losses arising during
the period............................. (5,276) (100,082) (29,710) (66,623)
Reclassification adjustment for (gains)
losses included in net income.......... 47 -- 1,183 (4,049)
-------- --------- -------- ---------
COMPREHENSIVE INCOME (LOSS).......... $(21,153) $(106,985) $(61,180) $(103,936)
-------- --------- -------- ---------
-------- --------- -------- ---------
See accompanying notes to consolidated financial statements.
3
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
NINE MONTHS ENDED
OCTOBER 31
-------------------
2001 2000
-------- --------
(In thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss from operations................................ $(32,653) $(33,264)
-------- --------
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization....................... 1,910 3,345
Accounts receivable, option receivables and
inventory reserves................................ 8,201 5,416
Expense paid through issuances of securities........ 516 --
(Gains) losses on marketable securities............. 1,183 (4,049)
Non-cash interest on debentures..................... 2,466 --
Deferred and other stock compensation............... 609 1,236
Changes in assets and liabilities net of effects of
business entity divestures:
Increase in restricted cash......................... (10,314) --
Decrease (increase) in accounts receivable.......... 3,921 (12,127)
Increase in inventories............................. (8,587) (6,732)
(Increase) decrease in other current assets......... (335) 491
Increase in accounts payable........................ 1,716 1,061
Increase (decrease) in accrued and other current
liabilities....................................... (1,603) 5,987
-------- --------
NET CASH USED IN OPERATING ACTIVITIES........... (32,970) (38,636)
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment...................... (3,138) (12,473)
Cash received from sale of marketable securities........ 82 4,219
Other receivables....................................... (285) 808
Other assets............................................ (603) (343)
Expenditures for investments............................ -- (6,929)
Cash of former subsidiary............................... -- (6,961)
-------- --------
NET CASH USED IN INVESTING ACTIVITIES........... (3,944) (21,679)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from short-term debt, net of repayments........ (103) (211)
Proceeds from long-term debt............................ 167 2,417
Repayment of long-term debt............................. (26) (402)
Proceeds from debentures................................ 29,749 --
Proceeds from preferred stock issued by subsidiary...... -- 46,638
Proceeds from common stock issued by former
subsidiary............................................ -- 7,851
Proceeds from common stock.............................. 9,630 --
Proceeds from stock option exercises.................... 861 3,246
-------- --------
NET CASH PROVIDED BY FINANCING ACTIVITIES....... 40,278 59,539
-------- --------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS............ 3,364 (776)
CASH AND CASH EQUIVALENTS -- BEGINNING OF PERIOD............ 9,965 13,511
-------- --------
CASH AND CASH EQUIVALENTS -- END OF PERIOD.................. $ 13,329 $ 12,735
-------- --------
-------- --------
See accompanying notes to consolidated financial statements.
4
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
(In Thousands, except share and per share amounts)
Sorrento Networks Corporation (formerly Osicom Technologies, Inc.) (the
'Company,' 'We,' 'Our,' or 'Us') through its subsidiaries designs, manufactures
and markets integrated networking and bandwidth aggregation products for
enhancing the performance of data and telecommunications networks. Our products
are deployed in telephone companies, Internet Service Providers, governmental
bodies and the corporate/campus networks that make up the 'enterprise' segment
of the networking marketplace. We have facilities in San Diego, California,
Santa Monica, California and Fremont, California. In addition, we have various
sales offices located in the United States, Europe and Asia. Our former
subsidiary, Entrada Networks is located in Irvine, California. We market and
sell our products and services through a broad array of channels including
worldwide distributors, value added resellers, local and long distance carriers
and governmental agencies.
SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS OF PRESENTATION
The accompanying financial data as of October 31, 2001 and January 31, 2001,
for the three and nine months ended October 31, 2001 and 2000, have been
prepared by us, without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with generally
accepted accounting principles have been condensed or omitted pursuant to such
rules and regulations. The January 31, 2001 balance sheet was derived from
audited financial statements, but does not include all disclosures required by
generally accepted accounting principles. However, we believe that the
disclosures we have made are adequate to make the information presented not
misleading. These consolidated financial statements should be read in
conjunction with the financial statements and the notes thereto included in our
Annual Report on Form 10-K for the year ended January 31, 2001.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates that affect
the reported amounts of assets, liabilities, revenues and expenses, the
disclosure of contingent assets and liabilities. Actual results could differ
from these estimates. In the opinion of Management, all adjustments (which
include only normal recurring adjustments) necessary to present fairly the
financial position, results of operations and cash flows as of October 31, 2001
and for the three and nine months ended October 31, 2000, have been made. The
results of operations for the three and nine months ended October 31, 2001 are
not necessarily indicative of the operating results for the full year.
On August 31, 2000, we completed a merger of Entrada Networks with Sync
Research, Inc. ('Sync'), a Nasdaq listed company in which we received 4,244,155
shares of the merged entity which changed its name to Entrada Networks, Inc. and
changed its symbol to ESAN. We purchased 93,900 shares of Sync in the open
market during June and July, 2000 for $388 and on August 31, 2000 purchased an
additional 1,001,818 shares directly from Entrada for $3,306. After these
transactions and Entrada's issuance of shares to outside investors in connection
with the merger we owned 48.9% of Entrada Networks. Accordingly, the
accompanying financial statements reflect the results of Entrada through
August 31, 2000.
Pursuant to a plan adopted by our Board of Directors prior to the merger we
distributed 3,107,155 of our Entrada shares on December 1, 2000 to our
shareholders of record as of November 20, 2000. The distribution was made at the
rate of one-fourth (0.25) of an Entrada share for each of our outstanding
shares. At exercise, options and warrants to acquire our common shares which
were granted and unexercised as of November 20, 2000 will receive a similar
number of Entrada shares. Prior to October 31, 2001 we distributed 29,533 of our
Entrada shares upon the exercise of options and as of October 31, 2001 have
reserved 877,218 shares for future exercises of options and warrants. The cost
basis of these reserved shares and related
5
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(In Thousands, except share and per share amounts)
liability to the option and warrant holders is included in the investment in
former subsidiary and dividends payable in the accompanying balance sheet. The
aggregate distribution of our Entrada shares including the shares reserved for
option and warrant holders has been accounted for at our original cost of
$5,122. In addition we have granted options to purchase 410,000 of our Entrada
shares for $3.19 per share (the merger price) to several of our then officers
and consultants.
The remaining 695,478 Entrada shares owned by us, which includes 193,714
shares attributable to eligible options which lapsed unexercised, are accounted
for as an 'available for sale security'. Under this accounting, these shares are
marked-to-market at the end of each reporting period. The difference between our
basis and the fair market value, as reported on Nasdaq, is a separate element of
stockholders' equity and is included in the computation of comprehensive income.
In July 2001 we recorded an impairment allowance of $1,087 to reflect the
decline in the market value of our Entrada shares. More information concerning
Entrada is available in its public filings with the Securities and Exchange
Commission.
NETSILICON, INC.
On September 15, 1999 NETsilicon, Inc. ('NSI') completed an initial public
offering in which we sold 2,000,000 of our shares in NSI and in which our
remaining 55.4% interest became non-voting shares until sold to a non-affiliate.
Accordingly, the accompanying financial statements reflect the results of
operations of NSI through September 14, 1999 at which time our remaining
interest is accounted for as an 'available for sale security.' Under this
accounting, the 7.5 million shares of NSI held by us are marked-to-market at the
end of each reporting period with the difference between our basis and the fair
market value, as reported on Nasdaq, reported as a separate element of
stockholders' equity and is included in the computation of comprehensive income.
After our sale in October 2000 of 527,344 of our shares in NSI we own
6,972,656 shares of NSI, or 49.6% as of October 31, 2001. More information
concerning NSI is available in its public filings with the Securities and
Exchange Commission.
DEFERRED STOCK COMPENSATION
We account for employee-based stock compensation utilizing the intrinsic
value method prescribed in Accounting Principles Board Opinion No. 25,
'Accounting for Stock Issued to Employees.' Accordingly, compensation cost for
stock options issued to employees is measured as the excess, if any, of the fair
market price of our common stock at the date of grant over the amount an
employee must pay to acquire the stock. This amount appears as a separate
component of stockholders' equity and is being amortized on an accelerated basis
by charges to operations over the vesting period of the options in accordance
with the method described in Financial Accounting Standards Board Interpretation
No. 28. All such amounts relate to options to acquire common stock of our
Sorrento subsidiary granted by it to its employees. During the quarters ended
October 31, 2001 and 2000, and the nine months ended October 31, 2001 and 2000,
our subsidiary Sorrento Networks ('Sorrento') amortized $157, $303, $468 and
$981 respectively of the total $2,604 initially recorded for deferred stock
compensation.
For non-employees, we compute the fair value of stock-based compensation in
accordance with Statement of Financial Accounting Standards No. 123, 'Accounting
for stock-Based Compensation,' and Emerging Issues Tax Force (EITF) 96-18,
'Accounting for Equity Instruments that are Issued to Other Than Employees for
Acquiring, or in Conjunction with Selling, Goods or Services.' All such amounts
relate to options to acquire common stock of our Sorrento subsidiary granted by
it to its consultants. During the quarters ended October 31, 2001 and 2000, and
the nine months ended October 31, 2001 and 2000 Sorrento recorded $46, $97, $141
and $255, respectively, for options granted to consultants.
6
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(In Thousands, except share and per share amounts)
RECENT ACCOUNTING PRONOUNCEMENTS
In October 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards ('SFAS') No. 144, 'Accounting for the
Impairment or Disposal of Long-Lived Assets' effective for financial statements
issued for fiscal years beginning after December 15, 2001, and interim periods
within those fiscal years. Restatements of previously issued annual financial
statements is not permitted, however, comparative financial information for
earlier periods shall reflect required reclassifications in presentation. SFAS
144 requires long-lived assets of continuing and discontinued operations be
measured at the lesser of carrying amount or fair value less estimated selling
costs. The assets and liabilities of discontinued operations shall be presented
separately in the asset and liability sections of the balance rather than shown
as net realizable value. We do not believe the adoption of SFAS 144 will have a
material effect on our financial position or results of operations.
In August 2001, the Financial Accounting Standards Board issued SFAS 143,
'Accounting for Asset Retirement Obligations' effective for fiscal years
beginning after June 15, 2002. SFAS 143 requires the recognition of the fair
value of liabilities for asset retirement obligations to be recognized in the
period in which it is incurred if a reasonable estimate of fair value can be
made. The associated asset retirement costs are capitalized as part of the
carrying amount of the long-lived asset. We do not believe the adoption of SFAS
143 will have a material effect, if any, on our financial position or results of
operations.
In June 2001, the Financial Accounting Standards Board finalized SFAS 141,
'Business Combinations', and SFAS 142, 'Goodwill and Other Intangible Assets'.
SFAS 141 requires the use of the purchase method of accounting and prohibits the
use of the pooling-of-interests method of accounting for business combinations
initiated after June 30, 2001. SFAS 141 also requires that we recognize acquired
intangible assets apart from goodwill if the acquired intangible assets meet
certain criteria. SFAS 141 applies to all business combinations initiated after
June 30, 2001 and for purchase business combinations completed on or after
July 1, 2001. Upon adoption of SFAS 142, it requires that we reclassify the
carrying amounts of intangible assets and goodwill based on the criteria in
SFAS 141.
SFAS 142 requires, among other things, that companies no longer amortize
goodwill, but instead test goodwill for impairment at least annually. In
addition, SFAS 142 requires that we identify reporting units for the purposes of
assessing potential future impairments of goodwill, reassess the useful lives of
other existing recognized intangible assets, and cease amortization of
intangible assets with an indefinite useful life. An intangible asset with an
indefinite useful life should be tested for impairment in accordance with the
guidance in SFAS 142. SFAS 142 is required to be applied in fiscal years
beginning after December 15, 2001 to all goodwill and other intangible assets
recognized at that date, regardless of when those assets were initially
recognized. SFAS 142 requires us to complete a transitional goodwill impairment
test nine months from the date of adoption. We are also required to reassess the
useful lives of other intangible assets within the first interim quarter after
adoption of SFAS 142.
During the fiscal years ended January 31, 1997 we completed several business
combinations which were accounted for using the purchase method. As of
October 31, 2001, the net carrying amount of intangible assets is $745 all of
which pertain to our Meret Optical business segment. Amortization expense during
the quarters ended October 31, 2001 and 2000 was $93 and during the nine months
ended October 31, 2001 and 2000 was $279. We are currently evaluating the
effect, if any, the adoption of SFAS 141 and 142 will have on our financial
position and results of operations.
7
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(In Thousands, except share and per share amounts)
SFAS 133, as amended by SFAS 137 and 138, 'Accounting for Derivative
Instruments and Hedging Activities,' is effective for financial statements with
fiscal quarters of all fiscal years beginning after June 15, 2000. The
Accounting Standards Executive Committee issued Statement of Position ('SOP')
98-1, 'Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use,' and SOP 98-5, 'Reporting on the Costs of Start-up Activities,'
effective in the current or future periods. The adoption or future adoption of
these standards has had or will have no material effects, if any, on our
financial position or results of operations.
The Financial Accounting Standards Board issued Interpretation ('FIN')
No. 44, 'Accounting for Certain Transactions involving Stock Compensation,' an
Interpretation of APB Opinion No. 25. FIN 44 clarifies the application of
Opinion No. 25 for (a) the definition of an employee for purposes of applying
Opinion No. 25, (b) the criteria for determining whether a plan qualifies as a
non-compensatory plan, (c) the accounting consequences of various modifications
to the terms of a previously fixed stock option award, and (d) the accounting
for an exchange of stock compensation awards in a business combination. FIN 44
is effective July 2, 2000, but certain conclusions cover specific events that
occur after either December 15, 1998, or January 12, 2000. The adoption of this
standard had no material effect, if any, on our financial position or results of
operations.
The Securities and Exchange Commission issued Staff Accounting Bulletin No.
101, Revenue Recognition ('SAB 101') which broadly addresses how companies
report revenues in their financial statements effective the fourth fiscal
quarter of years beginning after December 31, 1999. The adoption of this policy
had no effect on our financial position or results of operations.
BALANCE SHEET DETAIL
Inventories at October 31, 2001 and January 31, 2001 consist of:
OCTOBER 31, 2001 JANUARY 31, 2001
---------------- ----------------
Raw material.................................. $12,926 $10,201
Work in process............................... 5,053 4,310
Finished goods................................ 8,304 2,882
------- -------
26,283 17,393
Less: Valuation reserve....................... (6,707) (2,792)
------- -------
$19,576 $14,601
------- -------
------- -------
Marketable Securities -- Marketable securities, which consist of equity
securities that have a readily determinable fair value and do not have sale
restrictions lasting beyond one year from the balance sheet date, are classified
into categories based on our intent. Investments not classified as held to
maturity, those for which we have the intent and ability to hold, are classified
as available for sale. Our investments in NETsilicon and Entrada are classified
as available for sale and are carried at fair value, based upon quoted market
prices, with net unrealized gains reported as a separate component of
stockholders' equity until realized. Unrealized losses are charged against
income when a decline in fair value is determined to be other than temporary and
during the quarter ended July 31, 2001 we recorded an impairment loss of $1,087
against our investment in Entrada. During the quarter ended October 31, 2001 we
incurred losses of $47 on the sale of 579,686 shares of Entrada. During the nine
months ended October 31, 2001 we incurred losses of $96 on sales of 630,486
shares of Entrada. At October 31, 2001 and January 31, 2000 marketable
securities were as follows:
8
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(In Thousands, except share and per share amounts)
UNREALIZED
COST GAINS MARKET VALUE
------ ----- ------------
October 31, 2001:
NETsilicon............................... $3,938 $16,422 $20,360
Entrada.................................. 104 -- 104
------ ------- -------
$4,042 $16,422 $20,464
------ ------- -------
------ ------- -------
January 31, 2001:
NETsilicon............................... $3,938 $42,303 $46,241
Entrada.................................. 1,371 2,646 4,017
------ ------- -------
$5,309 $44,949 $50,258
------ ------- -------
------ ------- -------
Debentures -- During August 2001, we completed a private placement of our
9.75% convertible debentures receiving net proceeds of $29,749. The debentures,
due August 2, 2004, have a face value of $32,200 which is convertible into our
common stock at $7.21 per share. At maturity we may elect to redeem the
debentures for cash and we have the option of paying the interest on these
debentures in shares of our common stock. In addition the purchasers received
four year warrants to acquire an additional 3,351,840 shares of our common stock
at $7.21 per share and the placement agent received five year warrants to
acquire 111,651 shares of our common stock at $7.21 per share. Subject to
certain exceptions, if we issue shares of our common stock, equity securities,
options or warrants at a price less than $7.21 per share or at a discount to the
then market price the conversion price and warrant exercise price are subject to
adjustment.
In accordance with Emerging Issues Task Force ('EITF') No. 00-27 we have
accounted for the fair value of warrants issued to the purchasers and placement
agent and the fair value of the deemed beneficial conversion feature, which
results solely as a result of the required accounting, of the debenture as a
reduction to the face value of the debentures with an offsetting increase to
additional paid in capital. These amounts as well as the issuance costs paid in
cash will be amortized as additional interest expense over the period the
debentures are outstanding. Interest expense during the three and nine months
ended October 31, 2001 of $3,249 included the stated 9.75% interest of $783
which is paid in common stock, amortization of issuance costs of $203 and
amortization of the fair value of the warrants issued to the purchasers and
placement agent and the deemed beneficial conversion feature of $2,263. We
issued 267,399 shares of our common stock in payment of $516 interest. At
October 31, 2001 debentures payable consists of:
Face Value.................................................. $ 32,200
Issuance costs.............................................. (2,451)
Value of warrants and deemed beneficial
Conversion feature........................................ (27,252)
--------
Debenture book value at issuance.................... 2,497
Accumulated amortization of
Issuance costs............................................ 203
Value of warrants and deemed beneficial conversion
feature............................................... 2,263
--------
$ 4,963
--------
--------
9
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(In Thousands, except share and per share amounts)
STOCKHOLDERS' EQUITY
We are authorized to issue the following shares of stock:
150,000,000 shares of Common Stock ($.30 par value)
2,000,000 shares of Preferred Stock ($.01 par value) of which the
following series have been designated:
2,500 shares of Preferred Stock, Series A
1,000 shares of Preferred Stock, Series B
100,000 shares of Preferred Stock, Series C
3,000 shares of Preferred Stock, Series D
1,000,000 shares of Preferred Stock, Series E
1,000,000 shares of Preferred Stock, Series F
We have outstanding the following shares of preferred stock:
SHARES PAR LIQUIDATION
OUTSTANDING VALUE PREFERENCE
----------- ----- ----------
Series D........................................ 1,353 $1 $1,353
----- -- ------
----- -- ------
Preferred stock dividends during the three and nine months ended
October 31, 2001 and 2000 consist of:
THREE MONTHS NINE MONTHS
ENDED OCTOBER 31, ENDED OCTOBER 31,
----------------- -------------------
2001 2000 2001 2000
---- ---- ---- ----
Accrued, unpaid dividends (Series A)..... $ -- $ 38 $ -- $ 113
Deemed dividends (Sorrento Series A)..... -- 541 180 1,442
---- ---- ---- ------
$ -- $579 $180 $1,555
---- ---- ---- ------
---- ---- ---- ------
OTHER CAPITAL STOCK TRANSACTIONS
In March 2001, we completed a private placement of 1,525,995 unregistered
shares of our common stock receiving net proceeds of $9,645. In addition the
purchasers received three year warrants to acquire an additional 381,499 shares
of our common stock at $8.19 per share. If we issue shares of our common stock
or equity securities convertible into our common stock at a price less than
$6.5531 per share for an aggregate purchase price of $10,000, the purchasers are
entitled to receive additional shares of common stock. If we issue common stock
or equivalents at a price less than the warrant exercise price the warrant
exercise price is subject to adjustment. During October 2001 the warrant
exercise price was reduced to $1.93 per share.
During 2000, our Sorrento subsidiary ('Sorrento') completed a sale of
8,596,333 shares of its Series A Convertible Preferred Stock receiving net
proceeds of $46,638 from a group of investors. 1,467,891 shares were purchased
by entities in which our immediate past Chairman and CEO, who was an outside
director at that time, was a partner or member pursuant to a previously
contracted right of participation. In addition, Sorrento paid a finders fee of
$1,950 through the issuance by Sorrento of an additional 357,799 shares of its
Series A Convertible Preferred Stock to an entity in which our immediate past
Chairman and CEO, who was an outside director at that time, was a partner. One
of our then outside directors purchased 45,872 shares and a then director of
Sorrento purchased 91,744 shares in this placement. One of our present outside
directors, who was not a director at that time, purchased 183,486 shares in this
placement. In addition, he is a director of Liberty Media Corporation which
owns an 11% economic interest representing a 37% voting interest in UGC. The
purchaser of 3,027,523 shares in this placement is an indirect subsidiary of
UGC. Liberty Media also holds convertible debt in this Series A holder which
debt it has agreed to exchange for shares in UGC.
Each share of Sorrento's Series A Preferred Stock is convertible into one
share of Sorrento's common stock at the option of the holder, may vote on an 'as
converted' basis except for
10
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(In Thousands, except share and per share amounts)
election of directors, and has a liquidation preference of $5.45 per share. The
shares are automatically converted into Sorrento's common stock upon an
underwritten public offering by Sorrento with an aggregate offering price of at
least $50,000. Since Sorrento did not complete a $50,000 public offering by
March 1, 2001, the holders of more than 50% of the then outstanding Series A
shares may request a redemption at the current liquidation preference of $48.8
million and Sorrento has received such written notices. The requested redemption
can only be made from specified categories of funds, and our Sorrento subsidiary
cannot legally redeem any of the Series A shares at this time. We have engaged
an investment banking firm to assist in structuring an agreement between
Sorrento and the Series A shareholders regarding their redemption request. The
net proceeds from the issuance of these shares has been classified as a minority
interest in the accompanying financial statements. The difference between the
net proceeds received on the sale of these shares and their liquidation
preference of $48,800 has been recorded as a deemed dividend during the period
from issuance to March 31, 2001. During the nine months ended October 31, 2001
and the quarter and nine months ended October 31, 2000, we recorded a deemed
dividend of $180, $541 and $1,442, respectively, with respect to the Sorrento
Series A shares.
We made sales of products to affiliates of two of the purchasers of
Sorrento's Series A Preferred Stock. During the three and nine months ended
October 31, 2001 we made sales of $292 and $1,884, respectively, to
affiliates of the purchaser of 33.8% of the shares and these customers had
outstanding receivables of $818 at October 31, 2001 under 180 days terms. One of
our present outside directors is also a director of Liberty Media which is
shareholder of the parent of these customers and is debt holder of a subsidiary
of these purchasers as more fully described above. During the three and nine
months ended October 31, 2001 we made sales of $4 and $2,296, respectively, to
the subsidiaries of the purchaser of 6.2% of the shares and those customers had
outstanding receivables of $0 at October 31, 2001.
STOCK OPTION PLANS
We have four stock options plans in effect: The 2000 Stock Incentive Plan,
the 1988 Stock Option Plan, the 1997 Incentive and Non-Qualified Stock Option
Plan and the 1997 Director Stock Option Plan. The stock options have been made
available to certain employees and consultants. All options are granted at not
less than fair value at the date of grant and have terms varying from 3 to 10
years. The purpose of these plans is to attract, retain, motivate and reward our
officers, directors, employees and consultants to maximize their contribution
towards our success. At October 31, 2001 there were 4,408,962 shares under
option at prices varying from $2.93 to $69.13 per share.
In addition Sorrento adopted its 2000 Stock Option/Stock Issuance Plan under
which it has granted options to certain of its employees, directors at prices
not less than fair value at the date of grant and generally vest over four
years. Eligible individuals may be issued shares of common stock directly, when
through immediate purchase of the shares at fair value or as a bonus tied to
performance milestones. No stock has been issued under the stock issuance
program and at October 31, 2001 there were 16,143,381 Sorrento shares under
option at prices varying from $2.00 to $6.85 per share. The holders of these
options may elect to convert all or a portion of their options into options to
acquire our stock at a ratio of 3.9 for one. During the nine months ended
October 31, 2001 we issued options to acquire 5,718 of our common stock
exercisable at $7.80 to $21.55 per share upon conversions of Sorrento options.
EARNINGS PER SHARE CALCULATION
The following data show the amounts used in computing basic earnings per
share for the three and nine months ended October 31, 2001 and 2000.
11
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(In Thousands, except share and per share amounts)
THREE MONTHS ENDED NINE MONTHS ENDED
OCTOBER 31, OCTOBER 31,
--------------------------- ---------------------------
2001 2000 2001 2000
---- ---- ---- ----
Net loss............................... $ (15,924) $ (6,903) $ (32,653) $ (33,264)
Less: preferred dividends.............. -- (579) (180) (1,555)
---------- ---------- ---------- ----------
Net loss available to common
shareholders used in basic EPS....... $ (15,924) $ (7,482) $ (32,833) $ (34,819)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Average number of common shares used in
basic EPS............................ 14,316,221 11,844,816 13,891,207 11,657,679
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
We had a net loss for the three and nine months ended October 31, 2001 and
2000. Accordingly, the effect of dilutive securities including convertible
preferred stock, vested and nonvested stock options and warrants to acquire
common stock are not included in the calculation of EPS because their effect
would be antidilutive. The following data shows the effect on income and the
weighted average number of shares of dilutive potential common stock.
THREE MONTHS ENDED NINE MONTHS ENDED
OCTOBER 31, OCTOBER 31,
--------------------------- ---------------------------
2001 2000 2001 2000
---- ---- ---- ----
Net loss available to common
shareholders used in basic EPS....... $ (15,924) $ (7,482) $ (32,833) $ (34,819)
Interest on convertible debt (net of
tax)................................. 3,249 -- -- --
---------- ---------- ---------- ----------
Net loss available to common
shareholders used in diluted EPS..... $ (12,675) $ (7,482) $ (32,833) $ (34,819)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Average number of common shares used in
basic EPS............................ 14,316,221 11,844,816 13,891,207 11,657,679
Effect of dilutive securities:
Convertible preferred stock........ -- 31,623 -- 10,541
Stock benefit plans................ 1,275 1,574,748 159,906 1,954,255
Stock benefit plan of Sorrento..... -- -- 31,880 --
Warrants........................... 33,472 87,522 32,470 108,101
Convertible debentures............. 4,368,934 -- 1,456,311 --
---------- ---------- ---------- ----------
Average number of common shares and
dilutive potential common stock used
in diluted EPS....................... 18,719,902 13,538,709 15,571,774 13,730,576
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
The shares issuable upon exercise of options and warrants represents the
quarterly average of the shares issuable at exercise net of the shares assumed
to have been purchased, at the average market price for the period, with the
assumed exercise proceeds. Accordingly, options and warrants to acquire
12,465,211 of our common stock with exercise prices in excess of the average
market price during the quarter ended October 31, 2001 are excluded because
their effect would be antidilutive.
RELATED PARTY TRANSACTIONS
During the year ended January 31, 2001 we made a 6.6% three year loan in the
amount of $300 to an officer in connection with his accepting employment as our
Senior Vice President, Legal. This is a full recourse loan and the officer has
pledged all his options to acquire our common stock and any options he may
receive from any of our subsidiaries as collateral. Accrued unpaid interest on
this loan at October 31, 2001 was $11.
During June 2000, we entered into various agreements with our former CEO and
Chairman which, among other matters, provides for payments of $250 per year for
three years of consulting services and loans by us for the exercise of
previously granted options to acquire 1,178,500 options
12
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(In Thousands, except share and per share amounts)
at prices varying from $7.03 to $49.25 per share. As the members of our Board of
Directors at the time of his resignation ceased to represent more than 50% of
the Board in October 2000, all payments for consulting services were accelerated
and no future consulting services are required. During October 2000, he
exercised 71,112 options, applying the $500 accelerated payment to the exercise.
In addition, he exercised 507,388 options for which we are contractually
obligated to loan the $5,034 due on the exercise. During September 2001, he
notified us that he does not have any obligations under the agreements. We have
notified him that we do not agree with his interpretation of his repayment
obligations under the terms of his agreements.
During December 2001, we entered into an agreement whereby the 507,388
option exercise was rescinded. Our former CEO and Chairman returned the 507,388
shares to us for cancellation and we cancelled the receivable due from him and
restored the original option agreements. The required non-cash expense as a
result of the rescission equal to the difference between the amount of the loan
receivable and the market value of the returned shares was recorded as a reserve
of $2,700 against the receivable during the quarter ended October 31, 2001 and
is included in other operating expenses in the accompanying income statement.
This rescission agreement did not resolve any underlying dispute as to the
option loan repayment obligations.
CONCENTRATION OF CREDIT RISK
Financial instruments that potentially subject us to concentrations of
credit risk consist primarily of temporary cash investments and trade
receivables. As regards the former, we place our temporary cash investments with
high credit financial institutions. At times such amounts may exceed the
F.D.I.C. limits. We limit the amount of credit exposure with any one financial
institution and believe that no significant concentration of credit exists with
respect to cash investments. No accounts at a single bank accounted for more
than 10% of our current assets.
Although we are directly affected by the economic well being of significant
customers listed in the following tables, management does not believe that
significant credit risk exist at October 31, 2001. We perform ongoing
evaluations of our customers and require letters of credit or other collateral
arrangements as appropriate. Accordingly, trade credit losses have not been
significant.
The following data shows the customers accounting for more than 10% of net
receivables:
OCTOBER 31, 2001 JANUARY 31, 2001
---------------- ----------------
Customer A.................................... 26.9% 20.6%
Customer B.................................... 5.5 14.1
Customer C.................................... -- 15.6
Customer D.................................... 0.3 2.4
Customer E.................................... 10.0 --
Customer F.................................... 1.5 12.0
Customer G.................................... 8.1 20.5
Customer H.................................... 13.0 --
The following data shows the customers accounting for more than 10% of net
sales:
THREE MONTHS ENDED NINE MONTHS ENDED
OCTOBER 31, OCTOBER 31,
------------------- -------------------
2001 2000 2001 2000
---- ---- ---- ----
Customer A........................... 32.5% 19.8% 19.3% 12.9%
Customer B........................... 7.8 -- 15.2 2.3
Customer C........................... -- 9.0 7.1 14.8
Customer D........................... 13.2 14.4 6.9 17.8
Customer E........................... -- -- 2.1 --
Customer F........................... 3.5 -- 12.1 6.8
Customer G........................... 2.9 10.9 5.8 10.0
Customer H........................... 16.3 -- 5.0 --
13
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(In Thousands, except share and per share amounts)
SEGMENT INFORMATION
SORRENTO MERET ENTRADA
NETWORKS OPTICAL NETWORKS OTHER TOTAL
-------- ------- -------- ----- -----
Three months ended October 31, 2001:
Net sales to external customers........... $ 8,707 $1,359 $ -- $ -- $ 10,066
Intersegment sales........................ -- -- -- -- --
------- ------ ------- -------- --------
Total net sales....................... 8,707 1,359 -- -- 10,066
Cost of goods sold........................ 7,959 786 -- -- 8,745
------- ------ ------- -------- --------
Gross profit.......................... 748 573 -- -- 1,321
------- ------ ------- -------- --------
Operating income (loss) from operations... (8,831) 170 -- (3,985) (12,646)
Depreciation & amortization expense....... 101 135 -- 26 262
Valuation allowance additions............. 2,613 82 -- 2,700 5,395
Capital asset additions................... 312 5 -- -- 317
Total assets.............................. 46,470 7,733 n/a 44,177 98,380
Three months ended October 31, 2000:
Net sales to external customers........... $ 7,157 $1,551 $ 2,141 $ -- $ 10,849
Intersegment sales........................ -- -- -- -- --
------- ------ ------- -------- --------
Total net sales....................... 7,157 1,551 2,141 -- 10,849
Cost of goods sold........................ 4,951 1,017 1,372 -- 7,340
------- ------ ------- -------- --------
Gross profit.......................... 2,206 534 769 -- 3,509
------- ------ ------- -------- --------
Operating income (loss) from continuing
operations.............................. (8,139) 31 (266) (2,838) (11,212)
Depreciation & amortization expense....... 578 126 143 137 984
Valuation allowance additions............. (397) 4 8 -- (385)
Capital asset additions................... 1,889 78 260 5,449 7,676
Total assets.............................. 26,200 9,114 n/a 134,221 169,535
Nine Months ended October 31, 2001:
Net sales to external customers........... $28,593 $3,968 $ -- $ -- $ 32,561
Intersegment sales........................ -- -- -- -- --
------- ------ ------- -------- --------
Total net sales....................... 28,593 3,968 -- -- 32,561
Cost of goods sold........................ 22,570 2,445 -- -- 25,015
------- ------ ------- -------- --------
Gross profit.......................... 6,023 1,523 -- -- 7,546
------- ------ ------- -------- --------
Operating income (loss) from continuing
operations.............................. (22,401) 417 -- (5,947) (27,931)
Depreciation & amortization expense....... 1,314 407 -- 189 1,910
Valuation allowance additions............. 4,672 329 -- 3,200 8,201
Capital asset additions................... 3,061 16 -- 61 3,138
Total assets.............................. 46,470 7,733 n/a 44,177 98,380
Nine months ended October 31, 2000:
Net sales to external customers........... $15,392 $4,989 $11,892 $ -- $ 32,273
Intersegment sales........................ -- -- -- -- --
------- ------ ------- -------- --------
Total net sales....................... 15,392 4,989 11,892 -- 32,273
Cost of goods sold........................ 9,813 2,789 10,465 -- 23,067
------- ------ ------- -------- --------
Gross profit.......................... 5,579 2,200 1,427 -- 9,206
------- ------ ------- -------- --------
(table continued on next page)
14
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED) (CONTINUED)
(In Thousands, except share and per share amounts)
(table continued from previous page)
SORRENTO MERET ENTRADA
NETWORKS OPTICAL NETWORKS OTHER TOTAL
-------- ------- -------- ----- -----
Operating income (loss) from continuing
operations.............................. (26,565) 1,003 (7,859) (4,997) (38,418)
Depreciation & amortization expense....... 1,810 372 1,024 139 3,345
Valuation allowance additions............. 351 304 4,761 -- 5,416
Capital asset additions................... 6,433 129 444 5,467 12,473
Total assets.............................. 26,200 9,114 n/a 134,221 169,535
15
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Certain statements contained in this Quarterly Report on Form 10-Q,
including, without limitation, statements containing the words 'believes',
'anticipates', 'estimates', 'expects', and words of similar import constitute
'forward-looking statements' within the meaning of the Private Securities
Litigation Reform Act of 1995. Readers are referred to the 'Other Risk Factors'
section of our Annual Report on Form 10-K, as well as the 'Financial Risk
Management' and 'Future Growth Subject to Risks' sections contained therein,
which identify important risk factors that could cause actual results to differ
from those contained in the forward-looking statements.
Management's Discussion and Analysis of Financial Condition and Results of
Operations should be read in conjunction with the consolidated unaudited
financial statements and related notes thereto. Further reference should be made
to our Form 10-K for the year ended January 31, 2001.
The results of operations reflect our activities and our wholly-owned
subsidiaries; this consolidated group is referred to individually and
collectively as 'We' and 'Our'.
ENTRADA NETWORKS
On August 31, 2000, we completed a merger of our Entrada subsidiary with
Sync Research, Inc. a Nasdaq listed company. After the merger, our purchase of
Sync shares prior to the merger and our purchase of shares for cash from Entrada
we owned 48.9% of the merged entity which changed its name to Entrada Networks.
Pursuant to our plans adopted prior to the merger, we distributed one-fourth
shares of an Entrada share for each of our outstanding shares and reserved a
similar number for each unexercised option and warrant to acquire our common
stock outstanding on the record date. After the distribution and reserve for
options and warrants we own approximately 6.3% of Entrada and account for this
remaining interest as an 'available for sale security' which is marked to market
at the end of each period.
The amounts included in our fiscal 2002 year are not comparable to our
fiscal 2000 year due to the inclusion of Entrada Networks only through the
August 31, 2000 merger. Additional information regarding the Entrada is
available from its various filings with the Securities and Exchange Commission
which are available online at www.freeedgar.com and www.sec.gov or from the
Securities and Exchange Commission.
RESULTS OF OPERATIONS/COMPARISON OF THE QUARTERS AND NINE MONTHS ENDED
OCTOBER 31, 2001 AND 2000
Net sales. Our consolidated net sales were $10.1 million for the quarter
ended October 31, 2001 compared to $10.8 million for the three months ended
October 31, 2000, a decrease of 6.5%. This decrease in net sales reflects an
increase of $1.6 million at our subsidiary Sorrento Networks ('Sorrento') and a
decrease of $192,000 at Meret Optical Communications ('Meret'). The remaining
decline was related to Entrada Networks. During the nine months ended
October 31, 2001 our net sales increased to $32.6 million from $32.3 million for
the comparable nine months ended October 31, 2000. This increase in net sales
reflects a $13.2 million increase at Sorrento, and an $1.0 million decrease at
Meret. The remaining decline was related to Entrada.
Gross profit. Cost of sales consists principally of the costs of components,
subcontract assembly from outside manufacturers, and in-house system
integration, quality control, final testing and configuration costs.
Consolidated gross profit decreased to $1.3 million for the quarter ended
October 31, 2001 from $3.5 million for the comparable quarter last year.
Sorrento's gross profit decreased by $1.5 million however this decrease includes
an increase in the valuation allowance recorded against inventory at Sorrento of
$2.4 million. Gross profit increased by $39,000 for Meret during the quarter
ended October 31, 2001 from the comparable quarter last year. The remaining
decline was related to Entrada. Consolidated gross profit decreased to $7.5
million, or by 18.5%, for the nine months ended October 31, 2001 from $9.2
million for the nine months ended October 31, 2000. This decrease reflects a
$2.4 million increase at Sorrento exclusive of the $2.0 million valuation
allowance against inventory at Sorrento during the nine months ended
16
October 31, 2001. Gross profit decreased by $700,000 for Meret for the nine
months ended October 31, 2001 from the comparable nine months last year. The
remaining decline was related to Entrada.
Selling and marketing. Selling and marketing expenses consist primarily of
employee compensation and related costs, commissions to sales representatives,
tradeshow expenses, facilities costs, and travel expenses. We will continue to
manage our expenditures for sales and marketing in relation with the expansion
of our domestic and international sales channels and the establishment of
strategic relationships. Our consolidated selling and marketing expenses
decreased to $4.1 million, or 40.6% of net sales, for quarter ended October 31,
2001 from $4.3 million, or 39.8% of net sales for the comparable quarter last
year. Selling expenses for Sorrento and Meret increased by approximately
$110,000 and $83,000 respectively during the quarter ended October 31, 2001 from
the comparable quarter last year, offset by the decrease related to Entrada. Our
selling and marketing expenses decreased to $12.2 million, or 37.4% of net
sales, during the nine months ended October 31, 2001 from $13.6 million, or
42.1% of net sales, for the comparable nine month period last year. Sorrento's
selling expenses increased by $1.5 million for the nine months ended
October 31, 2001 and Meret remained relatively unchanged from the comparable
nine month period last year. These increases were offset by the decrease related
to Entrada.
Engineering, research and development. Engineering, research and development
expenses consist primarily of compensation related costs for engineering
personnel, facilities costs, and materials used in the design, development and
support of our technologies. All research and development costs are expensed as
incurred. We will continue to manage our research and development costs in
relation to the changes in our sales volumes. Our consolidated engineering,
research and development expenses decreased to $3.5 million, or 34.7% of net
sales, for the quarter ended October 31, 2001 from $5.7 million, or 52.8% of net
sales, for the comparable period last year. Sorrento accounted for $1.8 million
of this decrease and the remaining decrease was related to Entrada. During the
nine months ended October 31, 2001, our consolidated engineering, research and
development expenses decreased to $10.2 million, or 31.3% of net sales, from
$18.1 million, or 56.0% of net sales, for the comparable nine month period last
year. Sorrento's engineering, research and development expenses decreased by
$4.6 million for the nine months ended October 31, 2001 from the comparable nine
month period last year. The remaining decrease was related to Entrada.
General and administrative. General and administrative expenses consist
primarily of employee compensation and related costs, legal and accounting fees,
public company costs, and allocable occupancy costs. Our consolidated general
and administrative expenses decreased to $3.4 million, or 33.7% of net sales,
for the quarter ended October 31, 2001 from $4.2 million, or 38.9% of net sales,
for the comparable quarter last year. During the quarter, Sorrento reflected an
increase of approximately $1.1 million while Meret had a decrease of
approximately $221,000 from the comparable quarter last year. We had a decrease
of approximately $1.6 million in our corporate headquarters expenses relating
primarily to decreases in legal, financial advisor and professional fees,
employee compensation and relocation costs. The remaining decrease related to
Entrada. Our consolidated general and administrative expenses decreased to $9.4
million, or 28.8% of net sales, for the nine months ended October 31, 2001 from
$12.4 million, or 38.4% of net sales, for the comparable period last year.
Sorrento expenses remained relatively unchanged while Meret and corporate
headquarters accounted for $230,000 and $3.0 million, respectively, of the
decrease with the remaining decrease related to Entrada.
Other operating expenses. Other operating expenses for the quarter and nine
months ended October 31, 2001 and 2000 include $93,000 and $279,000,
respectively, of amortization of purchased technology related to acquisitions
included in Meret. During the quarter and nine months ended October 31, 2001 we
recorded a $2.7 million valuation allowance against option receivables from our
former CEO and Chairman. During the nine months ended October 31, 2000,
approximately $2.1 million of these costs were attributable to the closure of
one of Entrada's facilities and valuation reserves recorded against distributor
receivables and capitalized software costs of Entrada.
17
Other income (charges). Other income (charges) decreased to $3.3 million
charges for the quarter ended October 31, 2001 from $4.3 million income for the
comparable period last year. Investment income declined by $308,000 during the
quarter ended October 31, 2001 from the comparable period last year due to
reduced investments of our cash surplus in short-term investments, lower
interest rates as well as reduced interest received on customer financing
receivables. The increase of $3.3 million in interest expense for the quarter
ended October 31, 2001 from the comparable quarter last year is primarily due to
the interest incurred on our convertible debentures. The $3.2 million of
interest on these debentures included the stated 9.75% interest of $783,000
which is paid in common stock, amortization of issuance costs of $203,000, and
amortization of the fair value of the warrants issued to the purchasers and
placement agent and the deemed beneficial conversion feature of $2.3 million.
Other charges increased by $83,000 during the quarter ended October 31, 2001
from the comparable period last year resulting primarily from favorable gains on
foreign currency exchanges. We incurred losses of $47,000 on the sale of 579,686
shares of Entrada during the quarter ended October 31, 2001. During the nine
months ended October 31, 2001 other income (charges) decreased to $4.7 million
charges from $5.1 million income for the comparable nine months last year. The
decrease reflects a $1.5 million reduction of investment income resulting from
reduced investments of surplus cash in short term investments, lower interest
rates as well as reduced interest received on customer financing receivables.
Our interest expense increased by $3.1 million for the nine months ended
October 31, 2001 from the comparable nine months last year due to the interest
incurred on our newly issued convertible debentures which was partially offset
by a decline in our short term borrowings. Other charges increased by $30,000
during the nine months ended October 31, 2001 from the comparable period last
year primarily as the result of foreign currency exchanges. Gains on marketable
securities decreased by $5.2 million for the nine months ended October 31, 2001
from the comparable nine months last year. Approximately $4.0 million of this
decrease relates to the gain on our sale of NSI shares during the comparable
nine month period last year. The remaining $1.2 million decrease is results from
an impairment allowance of $1.1 million on our available for sale investment in
Entrada and $100,000 in realized losses on the sale of 630,486 shares of
Entrada.
Income taxes. There was no provision for income taxes for quarters and nine
months ended October 31, 2001 and 2000. We have carry forwards of domestic
federal net operating losses, which may be available, in part, to reduce future
taxable income in the United States. However, due to potential adjustments to
the net operating loss carry forwards as provided by the Internal Revenue Code
with respect to future ownership changes, future availability of the tax
benefits is not assured. In addition, we provided a valuation allowance in full
for our deferred tax assets as it is our opinion that it is more likely than not
that some portion or all of the assets will not be realized.
SORRENTO NETWORKS
Net sales. Net sales increased 20.8% to $8.7 million for the three months
ended October 31, 2001 from $7.2 million for the comparable quarter last year.
During the three months ended October 31, 2001, we shipped product to fourteen
customers of which four customers represented 79.6% of our net sales. During the
quarter ended October 31, 2000, we shipped product to eight customers of which
five customers represented 92.0% of our net sales. Net sales increased by 85.7%
to $28.6 million for the nine months ended October 31, 2001 from $15.4 million
for the comparable period last year. During the nine months ended October 31,
2001, we shipped product to eighteen customers of which four customers
represented over 59.7% of our net sales. During the nine months ended
October 31, 2000, we shipped product to twelve customers of which four customers
represented 77.7% of our net sales. Sales to our international customers
decreased to 14.8% of our net sales during the quarter ended October 31, 2001
from 30.2% during the comparable quarter last year. For the nine months ended
October 31, 2001 sales to international customers increased to 35.9% of our net
sales from 27.3% during the comparable period last year. We expect to continue
experiencing significant fluctuations in our quarterly revenues as a result of
our long and variable sales cycle as well as our highly concentrated customer
base.
18
Gross profit. Gross profit decreased by 66% to $748,000 for the quarter
ended October 31, 2001 from $2.2 million for the comparable quarter last year.
This decrease includes a $2.4 million reserve recorded against Sorrento's
inventory. Our gross margin decreased to 8.6% of net sales for the quarter ended
October 31, 2001 from 30.8% of net sales for the comparable quarter last year.
Absent the inventory valuation reserve our gross margin on sales during the
quarter ended October 31, 2001 would have been significantly higher. Gross
profit for the nine months ended October 31, 2001 increased by 7.1% to $6.0
million from $5.6 million for the comparable period last year. Our gross margin
for the nine months ended October 31, 2001 decreased to 21.1% of net sales from
36.2% for the comparable period last year. The decline in gross margin for the
quarter and nine months ended October 31, 2001 is the result of a $2.0 million
inventory valuation allowance and changes in our product mix.
Selling and marketing. Selling and marketing expenses increased to $4.0
million, or 46.0% of net sales, for the quarter ended October 31, 2001 from $3.8
million, or 53.5% of net sales for the comparable quarter last year. For the
nine month period ended October 31, 2001 selling and marketing expenses
increased to $11.9 million, or 41.6% of net sales from $10.4 million, or 67.5%
of net sales. The increase in sales and marketing expenses for the three months
ended October 31, 2001 is primarily the result of increases in advertising and
promotional expenses. The increase in sales and marketing expenses for the nine
months ended October 31, 2001 is primarily the result of increased operating
expenses related to opening three foreign sales offices located in Beijing,
Singapore and the Netherlands, and increased field service and promotional
expenses. We increased our sales and marketing personnel to 71 at October 31,
2001, from 53 at October 31, 2000. We are continually evaluating our resource
requirements and will plan accordingly for any additions necessary to expand our
domestic and international sales force and marketing efforts.
Engineering, research and development. Engineering, research and development
expenses decreased to $3.4 million, or 39.1% of net sales, for the quarter ended
October 31, 2001 from $5.2 million, or 73.2% of net sales, for the comparable
quarter last year. For the nine months ended October 31, 2001 engineering,
research and development expenses decreased to $10.0 million, or 35.0% of net
sales from $14.6 million, or 94.8% of net sales. The decreases were primarily
due to the completion of existing projects and reduced payroll and payroll
related costs, consulting and travel expenses. We decreased our research and
development personnel to 83 at October 31, 2001 from 96 at October 31, 2000.
General and administrative. General and administrative expenses increased to
$2.0 million, or 23.0% of net sales, for the quarter ended October 31, 2001 from
$858,000, or 12.0% of net sales, for the comparable quarter last year. For the
nine months ended October 31, 2001 general and administrative expenses increased
to $6.0 million, or 21.0% of net sales from $5.9 million, or 38.3% of net sales.
During the three and nine month periods, our legal and professional expenses
decreased in comparison to last year where substantially higher expenses were
incurred in anticipation of a public offering. This decrease was offset by
increases to our bad debt allowance, purchase cancellation fees and costs
associated with our personnel reductions. We have decreased our general and
administrative personnel to 23 at October 31, 2001 from 24 at October 31, 2000.
Deferred and other stock compensation. Deferred and other stock compensation
for the quarter and nine months ended October 31, 2001 includes $157,000 and
$468,000 of amortization of deferred stock compensation and $46,000 and $141,000
of amortization of the value of stock options granted to consultants,
respectively. In connection with the grants of stock options with exercise
prices determined to be below the fair value of Sorrento's common stock on the
date of grant, Sorrento recorded deferred stock compensation of $2.6 million,
which is being amortized on an accelerated basis over the vesting period of the
options.
MERET OPTICAL COMMUNICATIONS
Net sales. Net sales for Meret decreased to $1.4 million, or by 12.5%, for
the quarter ended October 31, 2001 from $1.6 million for the comparable quarter
last year. During the nine months ended October 31, 2001 net sales decreased to
$4.0 million, or by 20.0%, from $5.0 million for the
19
comparable nine months last year. The decline in net sales results from
decreased in product demand for the legacy product family.
Gross Profit. Gross profit increased to $573,000, or by 7.3%, for the
quarter ended October 31, 2001 from $534,000 for the comparable quarter last
year. Meret's gross margins increased to 41.0% for the quarter ended
October 31, 2001 from 33.4% for the comparable quarter last year. During the
nine months ended October 31, 2001 Meret's gross profit decreased to $1.5
million, or by 31.8%, from $2.2 million for the nine months ended October 31,
2000. Meret's gross margins decreased to 37.5% for the nine months ended
October 31, 2001 from 44.0% for the nine months ended October 31, 2000. The
comparative changes in gross margin resulted from sales volume fluctuations and
shifts in Meret's product mix.
Selling and Marketing. Selling and marketing expenses increased to $145,000
or 10.4% of net sales, for the quarter ended October 31, 2001 from $62,000, or
3.9% of net sales, for the comparable period last year. The increase during the
quarter ended October 31, 2001 compared to the same three month period last year
resulted from higher internal commissions due to increases in commissionable
sales, severance costs related to personnel reduction, and increases in
commissions to external sales representatives. For the nine months ended
October 31, 2001, selling and marketing expenses increased slightly to $365,000,
or 9.1% of net sales, from $347,000, or 6.9% of net sales, for the nine months
ended October 31, 2000. The increase results primarily from severance costs
related to personnel reductions.
Engineering, Research and Development. Engineering, research and development
expenses increased to $86,000 or 6.1% of net sales, for the quarter ended
October 31, 2001 from $47,000 or 2.9% of net sales for the comparable quarter
last year. During the nine months ended October 31, 2001 engineering expenses
increased to $255,000 or 6.4% of net sales, from $134,000 for 2.7% of net sales
for the comparable nine months last year. The increase for both the three and
nine months ended October 31, 2001 relate to the addition of three engineers to
support our development of our new coarse wavelength division multiplexing
products and the enhancement of existing products.
General and Administrative. General and administrative expenses decreased to
$79,000 or 5.6% of net sales for the quarter ended October 31, 2001 from
$300,000 or 18.8% of net sales for the comparable quarter last year. During the
nine months ended October 31, 2001, general and administrative expenses
decreased to $208,000 or 5.2% of net sales from $438,000 or 8.8% of net sales
for the comparable nine months last year. The decreases for the three and nine
months ended October 31, 2001 results from reductions in bad debt allowances and
bank fees.
Other operating expenses. Other operating expenses of $93,000 and $279,000
for the quarter and nine months ended October 31, 2001 remained unchanged
compared to the comparable quarter and nine months last year. These costs
represent the amortization of purchased technology related to prior
acquisitions.
LIQUIDITY AND CAPITAL RESOURCES
We finance our operations through a combination of debt and equity
financing. At October 31, 2001, our working capital was $56.3 million including
$13.3 million in cash and cash equivalents as well as $10.3 million of
restricted cash from our August 2001 debenture placement which was released to
us subsequent to October 31, 2001.
The amounts included in our statement of cash flows for the nine months
ended October 31, 2001 are not comparable to our nine months ended October 31,
2000 amounts due to the inclusion of Entrada for only the seven months ended
August 31, 2000. Readers should refer to Entrada's quarterly reports on
Form 10-Q for information concerning Entrada.
Our operating activities used cash flows of $33.0 million during the nine
months ended October 31, 2001. During the nine months ended October 31, 2000 our
operating activities used cash flows of $38.6 million. The decreases in cash
flows used by operations results primarily from the temporary increase in
restricted cash of $10.3 million, decreases in our accounts receivable,
20
increases in accounts payable partially offset by increases in inventory and
other current assets as well as decreases in accrued and other current
liabilities.
Our standard payment terms range from net 30 to net 90 days. Receivables
from international customers have frequently taken longer to collect. For some
of the Sorrento customers, payment is required within 180 days from the date of
shipment.
Our investing activities during the nine months ended October 31, 2001 used
cash flows of $3.9 million. We purchased property and equipment of $3.1 million
and other assets of $603,000, other receivables increased by $285,000 and we
received $82,000 proceeds from the sale of shares of Entrada. During the nine
months ended October 31, 2000 the investing activities used cash flows of $21.7
million including $7.0 million in cash balances at Entrada on August 31, 2000
when it ceased to be a subsidiary. We purchased capital equipment $12.5 million,
invested $3.3 million in Entrada and $3.2 million in a Sorrento customer. During
the nine months ended October 31, 2000, we received $4.2 million from the sale
of a portion of our shares in NSI and $808 from the purchasers of our
discontinued operations.
Our financing activities during the nine months ended October 31, 2001
provided cash flows of $40.3 million which consisted of $29.7 million in net
proceeds from the private placement of our 9.75% convertible debentures, $9.6
million in proceeds from issuance of common stock, $861,000 in proceeds from
option and warrant exercises offset by repayments of short and long term debt.
During the nine months ended October 31, 2000 the financing activities provided
cash flows of $59.5 million which consisted of $46.6 million in net proceeds
from a private placement by Sorrento of its convertible preferred stock, $7.9
million in net proceeds from a private placement by Entrada of it's common
stock, $3.2 million from option and warrant exercises and $2.4 million in
proceeds from long-term debt offset by repayments of short and long term debt.
We have a line of credit of $8.0 million. Outstanding borrowings against
this line of credit was $1.2 million at October 31, 2001. Our credit line is
collateralized by accounts receivable, inventory and equipment.
During March 2000, our Sorrento subsidiary completed a private placement of
8,596,333 shares of its Series A Convertible Preferred Stock to a group of
investors receiving net proceeds of approximately $46.6 million. Each share of
our Sorrento subsidiary's Series A Preferred Stock is convertible into one share
of its common stock at the option of the holder, may vote on an 'as converted'
basis except for election of directors, and has a liquidation preference of
$5.45 per share. The shares are automatically converted into Sorrento's common
stock upon an underwritten public offering by Sorrento with an aggregate
offering price of at least $50 million. Since our Sorrento subsidiary did not
complete a $50 million public offering by March 1, 2001, the holders of more
than 50% of the then outstanding Series A shares may request to be redeemed at
the shares then adjusted liquidation preference. Our Sorrento subsidiary has
received notice from the holders of more than 50% of its Series A Preferred
Stock requesting that Sorrento redeem the Series A Preferred Stock which has a
liquidation preference of $48.8 million. The requested redemption can only be
made from specified categories of funds, and our Sorrento subsidiary cannot
legally redeem any of the Series A Preferred Stock at this time. We have engaged
an investment banking firm to assist in structuring an agreement between our
Sorrento subsidiary and the Series A Preferred Shareholders regarding their
redemption request.
During August 2001, we completed a private placement of our 9.75% senior
convertible debentures receiving net proceeds of $29.7 million. The debentures,
due August 2, 2004, have a face value of $32.2 million which is convertible into
our common stock at $7.21 per share. At maturity we may elect to redeem the
debentures for cash and we have the option of paying the interest on these
debentures in shares of our common stock or cash. In addition the purchasers
received four year warrants to acquire an additional 3,351,840 shares of our
common stock at $7.21 per share. Subject to certain exceptions, if we issue
shares of our common stock, equity securities, options or warrants at a price
less than $7.21 per share or at a discount to the then market price the
conversion price and warrant exercise price are subject to adjustment.
21
We anticipate that our available working capital, together with additional
financings including a line of credit at our Sorrento subsidiary, will be
sufficient to meet our presently anticipated capital requirements for the next
year. Nonetheless, our future capital requirements may vary materially from
those now planned including the need for additional working capital to
accommodate our future growth, hiring and infrastructure needs. There can be no
assurances that our working capital requirements will not exceed our ability to
generate sufficient cash internally to support our requirements and that
external financing will be available or that, if available, such financing can
be obtained on terms favorable to us and our shareholders.
IMPACT OF RECENT ACCOUNTING PRONOUNCEMENTS
In October 2001, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards ('SFAS') No. 144, 'Accounting for the
Impairment or Disposal of Long-Lived Assets' effective for financial statements
issued for fiscal years beginning after December 15, 2001, and interim periods
within those fiscal years. Restatements of previously issued annual financial
statements is not permitted, however, comparative financial information for
earlier periods shall reflect required reclassifications in presentation. SFAS
144 requires long-lived assets of continuing and discontinued operations be
measured at the lesser of carrying amount or fair value less estimated selling
costs. The assets and liabilities of discontinued operations shall be presented
separately in the asset and liability sections of the balance rather than shown
as net realizable value. We do not believe the adoption of SFAS 144 will have a
material effect on our financial position or results of operations.
In August 2001, the Financial Accounting Standards Board issued SFAS 143,
'Accounting for Asset Retirement Obligations' effective for fiscal years
beginning after June 15, 2002. SFAS 143 requires the recognition of the fair
value of liabilities for asset retirement obligations to be recognized in the
period in which it is incurred if a reasonable estimate of fair value can be
made. The associated asset retirement costs are capitalized as part of the
carrying amount of the long-lived asset. We do not believe the adoption of SFAS
143 will have a material effect, if any, on our financial position or results of
operations.
In June 2001, the Financial Accounting Standards Board finalized SFAS 141,
'Business Combinations', and SFAS 142, 'Goodwill and Other Intangible Assets'.
SFAS 141 requires the use of the purchase method of accounting and prohibits the
use of the pooling-of-interests method of accounting for business combinations
initiated after June 30, 2001. SFAS 141 also requires that we recognize acquired
intangible assets apart from goodwill if the acquired intangible assets meet
certain criteria. SFAS 141 applies to all business combinations initiated after
June 30, 2001 and for purchase business combinations completed on or after
July 1, 2001. Upon adoption of SFAS 142, it requires that we reclassify the
carrying amounts of intangible assets and goodwill based on the criteria in
SFAS 141.
SFAS 142 requires, among other things, that companies no longer amortize
goodwill, but instead test goodwill for impairment at least annually. In
addition, SFAS 142 requires that we identify reporting units for the purposes of
assessing potential future impairments of goodwill, reassess the useful lives of
other existing recognized intangible assets, and cease amortization of
intangible assets with an indefinite useful life. An intangible asset with an
indefinite useful life should be tested for impairment in accordance with the
guidance in SFAS 142. SFAS 142 is required to be applied in fiscal years
beginning after December 15, 2001 to all goodwill and other intangible assets
recognized at that date, regardless of when those assets were initially
recognized. SFAS 142 requires us to complete a transitional goodwill impairment
test nine months from the date of adoption. The Company is also required to
reassess the useful lives of other intangible assets within the first interim
quarter after adoption of SFAS 142.
During the fiscal years ended January 31, 1997 we completed several business
combinations which were accounted for using the purchase method. As of
October 31, 2001, the net carrying amount of intangible assets is $837 all of
which pertain to our Meret Optical business segment. Amortization expense during
the quarters ended October 31, 2001 and 2000 was $93 and during
22
the nine months ended October 31, 2001 and 2000 was $279. We are currently
evaluating the effect, if any, the adoption of SFAS 141 and 142 will have on our
financial position and results of operations.
SFAS 133, as amended by SFAS 137 and 138, 'Accounting for Derivative
Instruments and Hedging Activities,' is effective for financial statements with
fiscal quarters of all fiscal years beginning after June 15, 2000. The
Accounting Standards Executive Committee issued Statement of Position ('SOP')
98-1, 'Accounting for the Costs of Computer Software Developed or Obtained for
Internal Use,' and SOP 98-5, 'Reporting on the Costs of Start-up Activities,'
effective in the current or future periods. The adoption or future adoption of
these standards has had or will have no material effects, if any, on our
financial position or results of operations.
The Financial Accounting Standards Board issued Interpretation ('FIN')
No. 44, 'Accounting for Certain Transactions involving Stock Compensation,' an
Interpretation of APB Opinion No. 25. FIN 44 clarifies the application of
Opinion No. 25 for (a) the definition of an employee for purposes of applying
Opinion No. 25, (b) the criteria for determining whether a plan qualifies as a
non-compensatory plan, (c) the accounting consequences of various modifications
to the terms of a previously fixed stock option award, and (d) the accounting
for an exchange of stock compensation awards in a business combination. FIN 44
is effective July 2, 2000, but certain conclusions cover specific events that
occur after either December 15, 1998, or January 12, 2000. The adoption of this
standard had no material effect, if any, on our financial position or results of
operations.
The Securities and Exchange Commission issued Staff Accounting Bulletin
No. 101, Revenue Recognition ('SAB 101') which broadly addresses how companies
report revenues in their financial statements effective the fourth fiscal
quarter of years beginning after December 31, 1999. The adoption of this policy
had no effect on our financial position or results of operations.
EFFECTS OF INFLATION AND CURRENCY EXCHANGE RATES
We believe that the relatively moderate rate of inflation in the United
States over the past few years has not had a significant impact on our sales or
operating results or on the prices of raw materials. There can be no assurance,
however, that inflation will not have a material adverse effect on our operating
results in the future.
The majority of our sales and expenses are currently denominated in U.S.
dollars and to date our business has not been significantly affected by currency
fluctuations. However, we conduct business in several different countries and
thus fluctuations in currency exchange rates could cause our products to become
relatively more expensive in particular countries, leading to a reduction in
sales in that country. In addition, inflation in such countries could increase
our expenses. In the future, we may engage in foreign currency denominated sales
or pay material amounts of expenses in foreign currencies and, in such event,
may experience gains and losses due to currency fluctuations. Our operating
results could be adversely affected by such fluctuations.
OTHER MATTERS
Our Sorrento subsidiary has received notice from the holders of more than
50% of its Series A Preferred Stock requesting that Sorrento redeem the
Series A Preferred Stock. One of our present outside directors, who was not a
director at that time, owns 2% of the Series A Preferred stock and he is a
director of the majority shareholder of the holder of 33.8% of the Series A
Preferred Stock. The requested redemption can only be made from specified
categories of funds, and our Sorrento subsidiary cannot legally redeem any of
the Series A Preferred Stock at this time. We have engaged an investment banking
firm to assist in structuring an agreement between our Sorrento subsidiary and
the Series A Preferred Shareholders regarding their redemption request.
On September 10, 2001, holders of a portion of the outstanding Series A
Preferred Stock of our Sorrento subsidiary obtained a preliminary injunction
prohibiting it from issuing further shares of its Series A Preferred Stock or
incurring any additional debt without the consent of the holders of a majority
of the currently outstanding shares of such Series A Preferred Stock.
Subsequently,
23
the Delaware Supreme Court accepted our appeal of the preliminary injunction
ruling. The appeal has been briefed and oral argument is currently scheduled to
take place on January 8, 2002. Neither the preliminary injunction nor the
original Series A documents prevent us from making capital contributions to, or
buying the common stock of Sorrento in the best business judgment of our board
of directors.
On October 19, 2001, an amended complaint was filed in the injunction
action, adding as named defendants, the Company, our Meret subsidiary, certain
present and former officers and directors of the Company and our subsidiaries as
well as our investment bankers. The amended complaint also added, among other
things, claims for fraud, securities fraud, breach of fiduciary duty,
conspiracy, and intentional interference with contract as well as requesting the
appointment of a receiver for our Sorrento subsidiary all which are based on
alleged wrongs committed in connection with or since the Series A placement. Our
Sorrento subsidiary and the original individual defendants have all answered
this amended complaint denying all allegations of wrongdoing. The new defendants
have all moved to dismiss the amended complaint. Management believes the
allegations contained in the amended complaint are without merit. The Company
and all other defendants intend to vigorously litigate this matter.
On December 14, 2001, plaintiffs filed motions to sequester the common
stock of our Sorrento subsidiary owned by Meret and the Sorrento Series A
preferred stock that we own, as an alternative method of obtaining jurisdiction
over us and Meret in the Delaware litigation. Management believes that these
motions are without merit and intends vigorously to contest them.
FLUCTUATIONS IN REVENUE AND OPERATING RESULTS
The networking and bandwidth aggregation industry is subject to fluctuation
and the declines and increases recently experienced by us are not necessarily
indicative of the operating results for any future periods. Our operating
results may fluctuate as a result of a number of factors, including the timing
of orders from, and shipments to, customers; the timing of new product
introductions and the market acceptance of those products; increased
competition; changes in manufacturing costs; availability of parts; changes in
the mix of product sales; the rate of end user adoption and carrier and private
network deployment of WAN data, video and audio communication services; factors
associated with international operations; and changes in world economic
conditions.
FORWARD-LOOKING STATEMENTS -- CAUTIONARY STATEMENT
All statements other than statements of historical fact contained in this
Form 10-Q, in our future filings with the Securities and Exchange Commission, in
our press releases and in our oral statements made with the approval of an
authorized executive officer are forward-looking statements. Words such as
'propose,' 'anticipate,' 'believe,' 'estimate,' 'expect,' 'intend,' 'may,'
'should', 'could,' 'will' and similar expressions are intended to identify such
forward-looking statements. These forward-looking statements are made pursuant
to the safe harbor provisions of the Private Securities Litigation Reform Act of
1995. Although we believe that our expectations reflected in these
forward-looking statements are based on reasonable assumptions, such statements
involve risk and uncertainties and no assurance can be given that actual results
will be consistent with these forward-looking statements. Important factors that
could cause actual results to differ materially from those forward-looking
statements include without limitation: our ability to successfully develop, sell
and market our optical networking and other products; our expectations
concerning factors affecting the markets for our products, such as demand for
increased bandwidth; the scope and duration of the economic slowdown currently
being experienced by many of our existing and prospective customers; our ability
to compete successfully with companies who are much larger than we are and who
have much greater financial resources at their disposal; our ability, or
failure, to complete strategic alliances and strategic opportunities such as
sales or spin-offs of subsidiaries or business units on terms favorable to us
for reasons either within or outside our control; our ability successfully to
finance our current and future needs for working capital; changed market
conditions, new business opportunities or other factors that might affect our
decisions as to the best interest of our shareholders; our ability to resolve a
dispute with our former CEO and Chairman with respect to his option exercise
loan obligations; the impact of recent terrorist activities and potential
activities as described more fully below; and other risks detailed from time to
time in our reports filed with the Securities and Exchange Commission.
24
Our business depends upon the free flow of products and services through the
channels of commerce. Recently, in response to terrorists' activities and
threats aimed at the United States, transportation, mail, financial and other
services have been slowed or stopped altogether. Further delays or stoppages in
transportation, mail, financial or other services could have a material adverse
effect on our business, results of operations and financial condition.
Furthermore, we may experience an increase in operating costs, such as costs for
transportation, insurance and security as a result of the activities and
potential activities. We may also experience delays in receiving payments from
payers that have been affected by the terrorist activities and potential
activities. Our customers and potential customers may delay or cancel orders for
our products. The U.S. and global economy in general is being adversely affected
by the terrorist activities and potential activities and any economic downturn
could adversely impact our results of operations, impair our ability to raise
capital or otherwise adversely affect our ability to grow our business.
We wish to caution readers not to place undue reliance on any such
forward-looking statements, which speak only as of the date made. Such
statements are subject to certain risks and uncertainties that could cause
actual results to differ materially from historical earnings and those presently
anticipated or projected. These risks and uncertainties are described above and
in our report on Form 10-K for the year ended January 31, 2001. We specifically
decline any obligation to publicly release the result of any revisions which may
be made to any forward-looking statements to reflect anticipated or
unanticipated events or circumstances occurring after the date of such
statements, or to update the reasons why actual results could differ from those
projected in the forward-looking statements.
ITEM 3: QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We are exposed to financial market risks, including changes in interest
rates and foreign currency rates. Our exposure to interest rate risk is the
result of our need for periodic additional financing for our large operating
losses and capital expenditures associated with establishing and expanding our
operations. The interest rate that we will be able to obtain on debt financing
will depend on market conditions at that time, and may differ from the rates we
have secured on our current debt. Additionally, the interest rates charged by
our present lenders adjust on the basis of the lenders' prime rate.
Almost all of our sales have been denominated in U.S. dollars. A portion of
our expenses are denominated in currencies other than the U.S. dollar and in the
future a larger portion of our sales could also be denominated in non-U.S.
currencies. As a result, currency fluctuations between the U.S. dollar and the
currencies in which we do business could cause foreign currency translation
gains or losses that we would recognize in the period incurred. We cannot
predict the effect of exchange rate fluctuations on our future operating results
because of the number of currencies involved, the variability of currency
exposure and the potential volatility of currency exchange rates. We attempt to
minimize our currency exposure risk through working capital management and do
not hedge our exposure to translation gains and losses related to foreign
currency net asset exposures.
We do not hold or issue derivative, derivative commodity instruments or
other financial instruments for trading purposes. Investments held for other
than trading purposes do not impose a material market risk.
We believe that the relatively moderate rate of inflation in the United
States over the past few years and the relatively stable interest rates incurred
on short-term financing have not had a significant impact on our sales,
operating results or prices of raw materials. There can be no assurance,
however, that inflation or an upward trend in short-term interest rates will not
have a material adverse effect on our operating results in the future should we
require debt financing in the future.
25
PART II
OTHER INFORMATION
ITEM 1: LEGAL PROCEEDINGS
On September 10, 2001, holders of a portion of the outstanding Series A
Preferred Stock of our Sorrento subsidiary obtained a preliminary injunction
prohibiting it from issuing further shares of its Series A Preferred Stock or
incurring any additional debt without the consent of the holders of a majority
of the currently outstanding shares of such Series A Preferred Stock.
Subsequently, the Delaware Supreme Court accepted our appeal of the preliminary
injunction ruling. The appeal has been briefed and oral argument is currently
scheduled to take place on January 8, 2002. Neither the preliminary injunction
nor the original Series A documents prevent us from making capital contributions
to, or buying the common stock of Sorrento in the best business judgment of our
board of directors.
On October 19, 2001, an amended complaint was filed in the injunction
action, adding as named defendants, the Company, our Meret subsidiary, certain
present and former officers and directors of the Company and our subsidiaries as
well as our investment bankers. The amended complaint also added, among other
things, claims for fraud, securities fraud, breach of fiduciary duty,
conspiracy, and intentional interference with contract as well as requesting the
appointment of a receiver for our Sorrento subsidiary all which are based on
alleged wrongs committed in connection with or since the Series A placement. Our
Sorrento subsidiary and the original individual defendants have all answered
this amended complaint denying all allegations of wrongdoing. The new defendants
have all moved to dismiss the amended complaint. Management believes the
allegations contained in the amended complaint are without merit. The Company
and all other defendants intend to vigorously litigate this matter.
On December 14, 2001, plaintiffs filed motions to sequester the common
stock of our Sorrento subsidiary owned by Meret and the Sorrento Series A
preferred stock that we own, as an alternative method of obtaining jurisdiction
over us and Meret in the Delaware litigation. Management believes that these
motions are without merit and intends vigorously to contest them.
From time to time, we are involved in various legal proceedings and claims
incidental to the conduct of our business. Although it is impossible to predict
the outcome of any outstanding legal proceedings, we believe that such legal
proceedings and claims, individually and in the aggregate, are not likely to
have a material effect on our financial position or results of operations or
cash flows.
ITEM 2: CHANGES IN SECURITIES AND USE OF PROCEEDS
On August 2, 2001 we issued $32,200,000 of our 9.75% convertible debentures
to a group of eleven private institutional investors, receiving $29,700,000 in
net proceeds to be used for working capital purposes. The debentures, due
August 2, 2004, are convertible into our common stock at $7.21 per share. At
maturity we may elect to redeem the debentures for cash and we have the option
of paying the interest in shares of our common stock. There were no underwriters
in the transaction; however, we paid of fee of $2,093,000 to a placement agent.
In addition the purchasers received four year warrants to acquire an additional
3,351,840 shares of our common stock at $7.21 per share and the placement agent
received a five year warrant to acquire 111,651 shares of our common stock at
$7.21 per share. Subject to certain exceptions, if we issue shares of our common
stock, equity securities or warrants at a price less than $7.21 per share the
conversion price and warrant exercise price are subject to adjustment.
This sale was made without general solicitation or advertising and no
underwriters received fees in connection with this security sale. The purchasers
were accredited and sophisticated investors with access to all relevant
information necessary. The shares were issued pursuant to exemptions from
registration under Rule 506 of Regulation D and Section 4(2) of the Securities
Act of 1933 as a transaction not involving any public offering. We have filed a
Registration Statement on Form S-3 covering the resale of these shares.
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ITEM 3: DEFAULTS UPON SENIOR SECURITIES
Not Applicable
ITEM 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable
ITEM 5: OTHER INFORMATION
Not Applicable
ITEM 6: EXHIBITS AND REPORTS ON FORM 8-K
A. Exhibits
20 Consolidated Financial Statements for the Quarter Ended October 31, 2001 (included
in Part I, Item 1)
B. Reports on Form 8-K
August 3, 2001 Convertible Debentures Placement
September 5, 2001 Sorrento Networks, Inc. (our Sorrento subsidiary)
legal matters
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
SORRENTO NETWORKS CORPORATION
(Registrant)
Date: December 17, 2001 By: /s/ JOE R. ARMSTRONG
.........................................
JOE R. ARMSTRONG,
CHIEF FINANCIAL OFFICER
PRINCIPAL ACCOUNTING OFFICER
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