================================================================================
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
--------------
FORM 10-Q
(Mark One) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
X OF THE SECURITIES EXCHANGE ACT OF 1934
---------
FOR THE QUARTERLY PERIOD ENDED JULY 31, 2003
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)
--------------
Delaware 04-3757589
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
9990 Mesa Rim Road 92121
San Diego, California (Zip Code)
(Address of principal executive offices)
Registrant's telephone number, including area code: (858) 558-3960
--------------
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, $0.001 par value per share, Outstanding: 10,335,800 shares
at September 5, 2003.
Indicate by check mark whether the registrant is an accelerated filer as
defined in rule 12-b2 of the Securities Exchange Act of 1934. Yes No X
----- -----
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
(In Thousands, except share information)
July 31, January 31,
2003 2003
----------- ----------
(Unaudited)
ASSETS
CURRENT ASSETS
Cash and equivalents................................................................ $ 5,075 $ 7,747
Accounts receivable, net............................................................ 3,230 5,576
Inventory, net...................................................................... 12,717 13,934
Prepaid expenses and other current assets........................................... 436 741
Investment in marketable securities................................................. 85 3,959
---------- --------
TOTAL CURRENT ASSETS.............................................................. 21,543 31,957
---------- --------
PROPERTY AND EQUIPMENT, NET............................................................ 13,849 17,103
---------- --------
OTHER ASSETS
Purchased technology, net........................................................... 225 430
Investment in non-marketable securities............................................. 5,025 5,025
Other assets........................................................................ 874 1,290
---------- --------
TOTAL OTHER ASSETS................................................................ 6,124 6,745
---------- --------
TOTAL ASSETS........................................................................... $ 41,516 $ 55,805
========== ========
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES
Current maturities of long term debt................................................ $ 176 $ 222
Accounts payable.................................................................... 2,849 5,135
Deferred revenue.................................................................... 349 3,700
Accrued professional fees........................................................... 2,921 4,324
Other accrued liabilities and current liabilities................................... 5,420 6,236
Due on redemption of preferred security of subsidiary............................... --- 48,800
---------- --------
TOTAL CURRENT LIABILITIES......................................................... 11,715 68,417
---------- --------
Long-term debt and capital lease obligations........................................... 3,563 3,644
Debentures payable..................................................................... 13,100 18,121
Dividends payable...................................................................... --- 99
---------- --------
TOTAL LIABILITIES................................................................. 28,378 90,281
---------- --------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value; liquidation preference $1,353...................... 1 1
Common stock, $.001 par value; 150,000,000 shares authorized; 8,942,849 shares
issued 8,942,405 shares outstanding at July 31, 2003; 886,494 shares issued
886,050 shares outstanding at January 31, 2003.................................... 9 5,318
Additional paid-in capital.......................................................... 194,269 144,887
Deferred stock compensation......................................................... 0 (5)
Accumulated deficit................................................................. (181,243) (187,536)
Accumulated other comprehensive income (loss) ...................................... 171 2,928
Treasury stock, at cost; 444 shares at July 31, 2003 and January 31, 2003,
respectively...................................................................... (69) (69)
---------- --------
TOTAL STOCKHOLDERS' EQUITY........................................................ 13,138 (34,476)
---------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT............................................ $ 41,516 $ 55,805
========== ========
See accompanying notes to consolidated financial statements.
2
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
(In Thousands, except per share amounts)
-------------------------------------------------------------------------------------------------------------------------
Three Months Six Months
Ended July 31, Ended July 31,
----------------------- ---------------------
2003 2002 2003 2002
-------------------------------------------------------------------------------------------------------------------------
NET SALES $ 4,476 $ 5,199 $12,337 $ 11,202
COST OF SALES 3,113 7,499 9,020 12,014
-------------------------------------------------------------------------------------------------------------------------
GROSS PROFIT 1,363 (2,300) 3,317 (812)
-------------------------------------------------------------------------------------------------------------------------
OPERATING EXPENSES
Selling and marketing 1,891 3,645 4,066 7,077
Engineering, research and development 1,550 2,339 3,194 4,873
General and administrative 1,912 5,911 3,511 7,774
Deferred stock compensation 0 109 51 215
Other operating expenses 103 93 206 190
-------------------------------------------------------------------------------------------------------------------------
TOTAL OPERATING EXPENSES 5,456 12,097 11,028 20,129
-------------------------------------------------------------------------------------------------------------------------
(LOSS) FROM OPERATIONS (4,093) (14,397) (7,711) (20,941)
-------------------------------------------------------------------------------------------------------------------------
OTHER INCOME (EXPENSES)
Investment income 8 93 8 187
Interest expense (1,139) (1,541) (3,804) (2,851)
Other income (expenses) 13,712 39 13,773 119
Gain on sale of marketable securities 4,026 - 4,026 11,656
-------------------------------------------------------------------------------------------------------------------------
TOTAL OTHER INCOME (EXPENSES) 16,607 (1,409) 14,003 9,111
-------------------------------------------------------------------------------------------------------------------------
INCOME (LOSS) FROM CONTINUING OPERATIONS
BEFORE INCOME TAX 12,514 (15,806) 6,292 (11,830)
PROVISION FOR INCOME TAXES - - - -
-------------------------------------------------------------------------------------------------------------------------
NET INCOME (LOSS) $12,514 $(15,806) $ 6,292 $(11,830)
=========================================================================================================================
EARNINGS (LOSS) PER SHARE:
BASIC WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING 5,869 740 3,419 729
-------------------------------------------------------------------------------------------------------------------------
BASIC NET INCOME (LOSS) PER COMMON SHARE $ 2.13 $ (21.35) $ 1.84 $ (16.24)
=========================================================================================================================
DILUTED WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING 7,366 964 4,180 952
-------------------------------------------------------------------------------------------------------------------------
DILUTED NET INCOME (LOSS) PER COMMON SHARE $ 1.72 $ (45.20) $ 1.54 $ (40.60)
=========================================================================================================================
COMPREHENSIVE INCOME AND ITS COMPONENTS CONSIST OF
THE FOLLOWING:
Net income (loss) $12,514 $(15,806) $ 6,292 $(11,830)
Unrealized gains(losses) from marketable securities:
Unrealized holding gains(losses) arising during the period 110 (6,812) 1,170 (8,210)
Reclassification adjustment for gains included in net income (4,026) (4,026) (11,656)
-------------------------------------------------------------------------------------------------------------------------
NET COMPREHENSIVE INCOME (LOSS) $ 8,598 $(22,618) $ 3,436 $(31,696)
=========================================================================================================================
See accompanying notes to consolidated financial statements.
3
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
For the three months ended July 31, 2003
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In Thousands)
Common Stock Preferred Stock Additional
------------------------- ------------------- Paid in
Shares Amount Shares Amount Capital
---------- -------------- -------- --------- -------------
Balance at January 31, 2003 886 $5,318 2 $1 $144,887
Common stock par value re-valuation (5,317) 5,317
Restructuring adjustment 436
Stock option and warrant exercises
Common stock issuance 8,030 8 43,512
Unrealized gaines (losses) on
available for sale securities
Realized gains on available for sale securities
Deferred stock compensation of subsidiary 46
Expenses paid with stock issuances 27 0 71
Amortization of deferred stock compensation
----- --------- ---- ----- ----------
Net income (loss)
----- --------- ---- ----- ----------
Balance at July 31, 2003 8,943 $9 2 $1 $194,269
===== ========= ==== ===== ==========
Deferred Treasury Stock Other Total
Stock Accumulated --------------- Comprehensive Stockholders'
Compensation Deficit Shares Amount Income (Loss) Equity
------------ ----------- ------ ------ -------------- -----------
Balance at January 31, 2003. $ (5) $ (187,536) 1 $(69) $2,928 $(34,476)
Common stock par value re-valuation
Restructuring adjustment 436
Stock option and warrant exercises --
Common stock issuance 43,520
Unrealized gains (losses) on
available for sale securities (2,856) (2,856)
Realized gains on available for sale
securities 99 99
Deferred stock compensation of subsidiary (46) --
Expenses paid with stock issuances 71
Amortization of deferred stock
compensation 51 51
-------- ---------- ----- -------- ---------- -------
Net income (loss) 6,293 6,293
-------- ---------- ----- -------- ---------- -------
Balance at July 31, 2003 $-- $ (181,243) 1 $(69) $171 $13,138
======== ========== ===== ======== ========== =======
See accompanying notes to consolidated financial statements.
4
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
For the three months ended July 31, 2002
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In Thousands)
Common Stock Preferred Stock Additional
-------------------- ----------------- Paid in
Shares Amount Shares Amount Capital
------ ------ ------ ------ -------
Balance at January 31, 2002 710 $4,263 2 $1 $143,705
Stock option and warrant exercises 1 9 (9)
Unrealized losses on available
for sale securities
Realized gains (loss) on available
for sale securities
Deferred stock compensation of subsidiary 91
Expenses paid with stock issuances 57 335 1,221
Amortization of deferred stock
compensation
--- ------ --- --- --------
Net loss
--- ------ --- --- --------
Balance at July 31, 2002 768 $4,607 2 $1 $145,008
=== ====== === === ========
Treasury
Deferred Accumulated Stock Other Total
Stock Deficit --------------- Comprehensive Stockholders'
Compensation Shares Amount Income (Loss) Equity
------------ ------- ------ ------ ------------- ------
Balance at January 31, 2002 $(255) $(161,326) 1 $(69) $ 24,160 $ 10,479
Stock option and warrant exercises --
Unrealized losses on available
for sale securities (8,210) (8,210)
Realized gains (loss) on available
for sale securities (11,656) (11,656)
Deferred stock compensation of subsidiary (91) --
Expenses paid with stock issuances 1,556
Amortization of deferred stock
compensation 215 215
----- --------- --- ---- -------- --------
Net loss $ (11,830) (11,830)
----- --------- --- ---- -------- --------
Balance at July 31, 2002 $(131) $(173,156) 1 $(69) $ 4,294 $(19,446)
===== ========= === ==== ======== ========
See accompanying notes to consolidated financial statements.
5
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In Thousands)
Six Months Ended
July 31,
--------------------
2003 2002
-------- --------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss).................................................................... $ 6,292 $(11,830)
-------- --------
Adjustments to reconcile net income (loss) to net cash used in
operating activities:
Depreciation and amortization.................................................... 1,969 1,890
Accounts receivable and inventory reserves....................................... (1,333) 5,537
Expenses paid through issuance of securities..................................... 71 --
Gain on sale of marketable securities............................................ (4,026) (11,656)
Non-cash interest on debentures.................................................. 2,464 2,716
Gain on restructuring............................................................ (13,629) --
Deferred and other stock compensation............................................ 51 124
Changes in assets and liabilities:
(Increase) decrease in accounts receivable..................................... 2,413 (65)
Decrease in inventories........................................................ 2,483 1,142
Decrease in other current assets............................................... 305 702
Decrease in accounts payable................................................... (2,286) (1,653)
Increase (decrease) in accrued and other current liabilities................... (4,077) 2,212
-------- --------
NET CASH USED IN OPERATING ACTIVITIES.............................................. (9,303) (10,881)
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
(Purchase) disposal of property and equipment........................................ 1,458 (1,991)
Cash received from sale of marketable securities and other investments............... 4,952 13,574
Other assets......................................................................... 349 542
-------- --------
NET CASH PROVIDED BY INVESTING ACTIVITIES.......................................... 6,759 12,125
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Payments of short-term debt, net..................................................... -- (884)
Repayment of long-term debt.......................................................... (127) (120)
Proceeds from common stock........................................................... (1) --
-------- --------
NET CASH USED IN FINANCING ACTIVITIES.............................................. (128) (1,004)
-------- --------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS........................................ (2,672) 240
CASH AND CASH EQUIVALENTS - BEGINNING OF PERIOD......................................... 7,747 14,243
-------- --------
CASH AND CASH EQUIVALENTS - END OF PERIOD............................................... $ 5,075 $ 14,483
======== ========
See accompanying notes to consolidated financial statements.
6
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
FOR THE THREE AND SIX MONTHS ENDED JULY 31, 2003 AND 2002
The Company
Sorrento Networks Corporation (the "Company," "We," "Our," or "Us")
through its subsidiaries designs, manufactures and markets integrated networking
and bandwidth aggregation products for enhancing the performance of data and
telecommunications networks. Our products are deployed in telephone companies,
Internet Service Providers, governmental bodies and the corporate/campus
networks that make up the "enterprise" segment of the networking marketplace. We
have facilities in San Diego, California and various sales offices located in
the United States and Europe. We market and sell our products and services
through a broad array of channels including worldwide distributors, value added
resellers, local and long distance carriers and governmental agencies.
Summary of Significant Accounting Policies
Basis of Presentation
The accompanying financial data for the three months and six months ended
July 31, 2003 and 2002 along with financial data for January 31, 2003, has been
prepared by us, without audit, pursuant to the rules and regulations of the
Securities and Exchange Commission. Certain information and footnote disclosures
normally included in financial statements prepared in accordance with accounting
principles generally accepted in the United States of America have been
condensed or omitted pursuant to such rules and regulations. The January 31,
2003 balance sheet was derived from audited financial statements, but does not
include all disclosures required by accounting principles generally accepted in
the United States of America. However, we believe that the disclosures we have
made are adequate to make the information presented not misleading. These
consolidated financial statements should be read in conjunction with the
financial statements and the notes thereto included in our Annual Report on Form
10-K/A for the year ended January 31, 2003.
We have incurred significant losses and negative cash flows from
operations for the past two years. SNI, our principal operating subsidiary, has
primarily been the operating entity responsible for these losses and negative
cash flows. The losses have been generated as SNI continues to develop its
technology, marketing, sales and operations in its effort to become a major
supplier of metro and regional optical networks worldwide. We fund our
operations primarily through a combination of internal funds, investments, and
debt and equity financing. There can be no assurance that similar funding will
be available in the future. Further, with the recent downturn in the economic
environment and decreases in capital spending by telecom carriers, we believe
our current and future revenues could be negatively impacted. However, orders
for the six months ended July 31, 2003 were substantially higher than for the
same comparable six months last year and as a result we believe this upward
trend could indicate a potential recovery from the lingering telecom capital
expenditure downturn. In either case, future increases in working capital will
be required to both maintain and grow our business along with a continued and
substantial focus on reducing operating expenses. Given the uncertainty and/or
unpredictability of the telecom market and the limited amount of our existing
working capital there can be no assurance that our existing financial resources
will be sufficient to cover our operational needs for the next twelve months. If
however, our revenues continue to show improvement, we implement our plans on
expense reductions and attract additional working capital through the issuance
of stock or debt, our balance sheet will be significantly improved and will
provide us with the necessary financial resources to meet our operational plans
for a period exceeding one year. Our future capital requirements may vary
materially from those now planned including the need for additional working
capital to accommodate planned growth, hiring and infrastructure needs. There
can be no assurances that our working capital requirements will not exceed our
ability to generate sufficient cash internally to support our requirements and
that external financing will be available or that, if available, such financing
can be obtained on terms favorable to us and our shareholders.
Use of Estimates
7
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates that affect the reported amounts of assets,
liabilities, revenues and expenses, the disclosure of contingent assets and
liabilities. Actual results could materially differ from these estimates. In the
opinion of Management, all adjustments (which include normal recurring
adjustments and charges described in the notes to the financial statements)
necessary to present fairly the financial position, results of operations and
cash flows for the quarter and six months ended July 31, 2003 and 2002 have been
made. The results of operations for the three and six months ended July 31, 2003
are not necessarily indicative of the operating results for the full year.
Certain reclassifications have been made to prior year presentations to
conform to the 2004 presentation.
Digi International, Inc. and NETsilicon, Inc.
Digi International, Inc. and NETsilicon, Inc. -- On September 15, 1999,
NETsilicon, Inc. ("NSI") completed an initial public offering in which 6,037,500
shares of its common stock were sold (3,537,500 shares by NSI and 2,500,000
shares by us). NSI received net proceeds of $22.3 million and we received net
proceeds of $15.4 million. In addition, NSI repaid advances due us of $5.9
million. In connection with the initial public offering by NSI, our remaining
55% interest became non-voting shares. Accordingly, our financial statements
reflected the results of operations of NSI through September 14, 1999 at which
time our remaining interest was accounted for as an "available for sale
security." Under this accounting, the 7.5 million shares of NSI held by us were
marked-to-market at the end of each reporting period with the difference between
our basis and the fair market value, as reported on NASDAQ, reported as a
separate element of stockholders' equity and included in the computation of
comprehensive loss.
In October 2000, we sold 350,000 shares of our investment in NSI for $4.2
million. The purchasers had the right to receive additional NSI shares from us
if the three-day average high for the NSI common stock, as quoted on NASDAQ, at
December 31, 2000 was less than the price paid to us by the purchasers but not
less than $8.00 per share. We issued an additional 177,344 shares of NSI to the
purchasers, reducing the price per share we received to $8.00 per share. Our
former Chairman and CEO purchased 100,000 of these shares of NSI for $1.2
million and received an additional 45,546 shares pursuant to the price
protection provision. As a result of this transaction, our remaining interest
was approximately 7.0 million shares of NSI, or 51% of the outstanding shares of
NSI as of January 31, 2002 and continued to be accounted for as a
marked-to-market security.
On February 13, 2002, NSI completed a merger with Digi International,
Inc. ("DIGI"). In connection with the merger, we exchanged our 6,972,656 shares
of NSI for 2,324,683 shares of DIGI and $13.6 million in cash. On December 9,
2002, we sold one-half of our holdings in DIGI for $3.10 per share. The
purchaser of the stock was DIGI, itself. The proceeds from this sale, in the
amount of $3.6 million, were deposited on December 13, 2002. The remaining
1,162,341 DIGI shares were sold on May 2, 2003 for $4.26 per share. The
purchaser of the stock was again DIGI. The proceeds from this sale, in the
amount of approximately $5.0 million, were deposited on May 7, 2003.
Entrada Networks, Inc.--On August 31, 2000, we completed a merger of our
then subsidiary Entrada Networks with Sync Research, Inc. ("Sync"), a NASDAQ
listed company in which we received 4,244,155 shares of the merged entity, which
changed its name to Entrada Networks, Inc. ("ENI"). We purchased 93,900 shares
of Sync in the open market during June and July 2000 for $388 and on August 31,
2000 purchased an additional 1,001,818 shares directly from ENI for $3.3
million. After these transactions and ENI's issuance of additional shares to
outside investors in connection with the merger we owned 49% of ENI.
Accordingly, our financial statements reflected the results of operations of ENI
through August 31, 2000.
Pursuant to a plan adopted by our Board of Directors prior to the merger
we distributed 3,107,155 of our ENI shares on December 1, 2000 to our
shareholders of record as of November 20, 2000. The distribution was made at the
rate of one-fourth (0.25) of an ENI share for each of our outstanding shares. At
exercise, options and warrants to acquire our common shares, which were granted
and unexercised as of November 20, 2000, would have received a similar number of
ENI shares. Prior to January 31, 2001 we distributed 20,182 of our ENI shares
upon the exercise of options and as of January 31, 2003 we reserved 826,000
shares for future exercises of options and warrants. The cost basis of these
reserved shares and related liability to the option and warrant holders was
included in the investment in former subsidiary and dividends payable in our
balance sheet. The aggregate distribution of our ENI shares including the shares
reserved for option and warrant holders was accounted for at our original cost
of $5.1
8
million. In addition, we granted options to purchase 410,000 of our ENI shares
for $3.19 per share (the merger price) to several of our then officers and
consultants. In April 2003, our Board of Directors determined that the 826,000
ENI shares should be made available for general corporate purposes, and we are
no longer reserving any for distribution to option and warrant holders.
In accordance with a settlement agreement reached between Sorrento
Networks and our former Chairman and Founder, Par Chadha, 566,000 shares of ENI
stock were transferred to Mr. Chadha in exchange for mutual releases by the
Company and Mr. Chadha and certain of his affiliates. The stock transfer was
completed on July 1, 2003 and had a value of $88 thousand. In addition, we
transferred 128,214 shares of ENI stock to settle a dispute between a former
employee and the Company. The value of the transfer was $20 thousand and was
completed on July 16, 2003.
The remaining 458,286 ENI shares owned by us are accounted for as an
"available for sale security". Under this accounting, these shares are
marked-to-market at the end of each reporting period. The difference between our
basis and the fair market value, as reported on NASDAQ, is a separate element of
stockholders' equity and is included in the computation of comprehensive income.
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
subsidiary Sorrento Networks, Inc. ("SNI") granted by it to its employees;
during the three and six months ended July 31, 2003 and 2002 it amortized $0 and
$63 thousand, and $5 thousand and $157 thousand, respectively, of the total $2.6
million initially recorded for deferred stock compensation. As of April 30, 2003
the deferred stock compensation amount of $2.6 million has been fully amortized.
For non-employees, we compute the fair value of stock-based compensation
in accordance with Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation," and Emerging Issues Tax Force (EITF)
96-18, "Accounting for Equity Instruments that are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services." All
such amounts relate to options to acquire common stock of our subsidiary
Sorrento Networks, Inc. ("SNI") granted by it to its consultants; during the
three and six months ended July 31, 2003 and 2002 it recorded $0 and $46
thousand, and $46 and $58 thousand, respectively, for options granted to
consultants. As of April 30, 2003 the deferred stock compensation for
non-employees was fully amortized.
Recent Accounting Pronouncements
In May 2003, the Financial Accounting Standards Board (FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 150. "Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and
Equity" ("SFAS 150"). SFAS 150 clarifies the accounting for certain financial
instruments with characteristics of both liabilities and equity and requires
that those instruments be classified as liabilities in the balance sheets.
Previously, many of those financial instruments were classified as equity. SFAS
150 is effective for financial instruments entered into or modified after May
31, 2003 and otherwise is effective at the beginning of the first interim period
beginning after June 15,2003. We expect this pronouncement will not have a
material impact on our results of operations and financial condition.
In April 2003, the FASB issued SFAS No. 149, "Amendment of SFAS No. 133
on Derivative Instruments and Hedging Activities"( "SFAS 149"). SFAS 149 amends
and clarifies accounting for derivative instruments, including certain
derivative instruments embedded in other contracts and for hedging activities
under SFAS No. 133 "Accounting for Derivative Instruments and Hedging
Activities" ("SFAS 133"). In particular, it (1) clarifies under what
circumstances a contract with an initial net investment meets the characteristic
of a derivative as discussed in SFAS 133, (2) clarifies when a derivative
contains a financing component, (3) amends the definition of an underlying to
conform it to the language used in FASB Interpretation No. ("FIN") 45,
"Guarantor Accounting and
9
Disclosure Requirements for Guarantees, including Indirect Guarantees of
Indebtedness of Others" ("FIN 45") and (4) amends certain other existing
pronouncements. SFAS 149 will be effective for contracts entered into or
modified after June 30, 2003, except as stated below, and for hedging
relationships designated after June 30,2003. The provisions of SFAS 149 that
relate to guidance in SFAS 133 Implementation Issues that have been effective
for fiscal quarters which began prior to June 15,2003, will continue to be
applied in accordance with their respective effective dates. In addition,
certain provisions relating to forward purchases or sales of when-issued
securities or other securities that do not yet exist, will be applied to both
existing contracts as well as new contracts entered into after June 30, 2003 We
will apply the provision of SFAS 149 on a prospective basis to contracts entered
into or modified after June 30, 2003 and expect that this pronouncement will not
have a material impact on our results of operations and financial condition.
In January 2003, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation ("FIN") No. 46, "Consolidation of Variable Interest
Entities", and interpretation of Accounting Research Bulletin No. 51,
"Consolidated Financial Statements", FIN No. 46 explains how to identify
variable interest entities and how an enterprise assesses its interests in a
variable interest entity to decide whether to consolidate that entity. This
Interpretation requires existing unconsolidated variable interest entities to be
consolidated by their primary beneficiaries if the entities do not effectively
disperse risks among parties involved. FIN No. 46 is effective immediately for
variable interest entities created after January 31, 2003, and to variable
interest entities in which an enterprise obtains an interest after that date.
The Interpretation applies in the first fiscal year or interim period beginning
after June 15, 2003, to variable interest entities in which an enterprise holds
a variable interest that is acquired before February 1, 2003. We have adopted
FIN No. 46 with no material effect on our financial position or results of
operations.
In November 2002, the FASB Emerging Issues Task Force ("EITF") reached a
consensus on Issue 00-21, "Accounting for Revenue Arrangements with Multiple
Deliverables" ("EITF 00-21"). In the absence of higher level accounting
literature, EITF 00-21 governs how to separate and allocate revenue to goods or
services or both that are to be delivered in a bundled sales arrangement. EITF
00-21 applies to revenue arrangements entered into after June 30, 2003 and
allows for either prospective application or cumulative adjustment upon
adoption. We will apply the guidance of EITF 00-21 on a prospective basis and
expect that this pronouncement will not have a material impact on our results of
operations and financial condition.
Balance Sheet Detail
Inventories at July 31, 2003 and January 31, 2003 consist of:
(thousands)
July 31, January 31,
2003 2003
----------- -------------
Raw material.................................... $9,849 $10,767
Work in process................................. 1,511 2,804
Finished goods.................................. 6,054 6,326
------- -------
17,414 19,897
Less: Valuation reserve......................... (4,697) (5,963)
------- -------
$12,717 $13,934
======= =======
Marketable Securities--Marketable securities, which consist of equity
securities that have a readily determinable fair value and do not have sale
restrictions lasting beyond one year from the balance sheet date, are classified
into categories based on our intent. Our investments in DIGI and Entrada are
classified as available for sale and are carried at fair value, based upon
quoted market prices, with net unrealized gains reported as a separate component
of stockholders' equity until realized. Unrealized losses are charged against
income when a decline in fair value is determined to be other than temporary. At
July 31, 2003, and January 31, 2003, marketable securities were as follows:
10
(thousands)
Unrealized Market
Cost Gains Value
---------- ------------ ----------
July 31, 2003:
Entrada .................... 13 72 85
------ ------ ------
$13 $72 $85
====== ====== ======
January 31, 2003:
Digi ....................... $1,009 $2,884 $3,893
Entrada .................... 22 44 66
------ ------ ------
$1,031 $2,928 $3,959
====== ====== ======
Intangible Assets--Goodwill and indefinite life intangible assets are no
longer amortized but are subject to periodic impairment tests. We have no
goodwill or indefinite life intangible assets. Other intangible assets with
finite lives, such as our purchased technology, are amortized over their useful
lives.
The carrying value of finite life intangible assets, consisting of purchased
technology of our subsidiary Meret Optical, as of July 31, 2003, is $225
thousand, net of amortization. The change in the net carrying amount of finite
life intangible assets during the six months ended July 31, 2003 is due to
amortization of $206 thousand. Annual estimated finite life intangible asset
amortization expense for each of the remaining fiscal years is expected to
approximate $40 thousand, $40 thousand, and $30 thousand.
Debentures - During August 2001, we completed a private placement of our
9.75% convertible debentures receiving net proceeds of $29.8 million. The
debentures, due August 2, 2004 had a face value of $32.2 million, which was
convertible into our common stock at $144.20 per share. At maturity, we could
have elected to redeem the debentures for cash and we had the option of paying
the interest on these debentures in shares of our common stock. In addition, the
purchasers received four year warrants to acquire an additional 167,592 shares
of our common stock at $144.20 per share and the placement agent received five
year warrants to acquire 5,583 shares of our common stock, equity securities,
options or warrants at a price less than $144.20 per share or at a discount to
the then market price. The conversion price and warrant exercise were subject to
adjustment.
In accordance with Emerging Issues Task Force ("EITF") No. 00-27 we
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
resulted 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, were amortized as additional interest expense over the period the
debentures were outstanding. Interest expense during the three and six months
ended July 31, 2003 of $2.6 million included the stated 9.75% interest of $765,
amortization of issuance costs of $203, and amortization of the fair value of
the warrants issued to the purchasers and placement agent and the deemed
beneficial conversion feature of $1.6 million.
On March 6, 2003, we and our wholly-owned subsidiary Sorrento Networks,
Inc. entered into an Exchange Agreement with the holders of our 9.75% Senior
Convertible Debentures (the "Debentures") and the Series A Convertible Preferred
Stock (the "Preferred Stock") of Sorrento Networks, Inc. The Exchange Agreement
and associated documents contemplated an exchange (the "Exchange") of the
Debentures and the Preferred Stock at closing into shares of common stock and
$12.5 million of our new 7.5% secured convertible debentures (the "New
Debentures"). Certain holders of the Preferred Stock would also receive
additional New Debentures of approximately $600 thousand to pay certain legal
fees.
The Exchange Agreement was approved by shareholders on May 29, 2003 and
was completed and became effective on June 4, 2003 pursuant to which we
exchanged current outstanding debentures and Series A Preferred Stock for common
stock and an issuance of a smaller principal amount of new debentures.
Interest expense during the three and six months ended July 31, 2003
was $1.1 million and $3.6 million, respectively.
At July 31, 2003 and January 31, 2003 debentures payable on the 9.75%
debentures consisted of:
(thousands)
July 31, January 31,
2003 2003
----------- ------------
Face value................................................................ $ -- $ 32,200
Issuance costs............................................................ -- (2,451)
Value of warrants and deemed beneficial conversion feature................ -- (19,525)
------ ---------
Debenture book value at issuance....................................... -- 10,224
Accumulated amortization of issuance costs................................ -- 881
Accumulated amortization of the value of warrants and deemed beneficial
conversion feature..................................................... -- 7,016
------ ---------
$ -- $ 18,121
====== =========
11
The $12.5 million, 7.5% debentures are convertible at any time at the
option of the holders into shares of common stock at a conversion price of
$5.42, the fair value on the date of the exchange. The debentures mature on
August 2, 2007 and are secured by substantially all of our assets and those of
our subsidiaries (with certain exceptions).
At July 31, 2003 and January 31, 2003 debentures payable on the 7.5%
debentures consisted of:
(thousands)
July 31, January 31,
2003 2003
----------- ------------
Face value of 7.5% convertible debentures................. $12,500 $ --
Face value of new debentures for legal fees............... 600 --
---------- -----
Book value of debentures at issuance $13,100 $ --
========== =====
Stockholders' Equity
We are authorized to issue the following shares of stock:
150,000,000 shares of Common Stock ($0.001 par value)
2,000,000 shares of Preferred Stock ($.01 par value) of which the
following series have been designated:
3,000 shares of Preferred Stock, Series D
1,000,000 shares of Preferred Stock, Series F
As of July 31, 2003, we had outstanding the following shares of preferred
stock:
Shares Par Liquidation
Outstanding Value Preference
------------- ------- ------------
Series D................................................... 1,353 $ 0.01 $ 1,353
------- ------- --------
1,353 $ 0.01 $ 1,353
======= ======= ========
Other Capital Stock Transactions
Stock Split - In October 2002, approval was granted for a one-for-twenty
reverse stock split effective October 28, 2002. The effect of this stock split
was reflected in the financial statements retroactively as if the stock split
occurred at the beginning of the earliest period reported.
Each share of SNI's Series A Convertible Preferred Stock was convertible
into one share of SNI's common stock at the option of the holder, voted on an
"as converted" basis except for election of directors, and had a liquidation
preference of $5.45 per share. The shares were automatically convertible into
SNI's common stock upon an underwritten public offering by SNI with an aggregate
offering price of at least $50.0 million. As SNI did not complete a $50.0
million public offering by March 1, 2001, the holders of more than 50% of the
then outstanding Series A shares had the right to request in writing that SNI
redeem them at the adjusted liquidation preference. On
12
receipt of such a request, SNI had the obligation to redeem the shares in cash,
if funds were lawfully available for such a redemption, or to redeem such pro
rata portion as to which a lesser amount of lawfully available funds existed. In
April 2001, SNI received written redemption requests from holders of a majority
of the Series A shares. The difference between the net proceeds received on the
sale of these shares and their liquidation preference of $48.8 million was
recorded as a deemed dividend during the period from issuance to March 31, 2001.
On June 4, 2003, we consummated the Exchange Agreement and cancelled all
outstanding Series A Convertible Preferred Stock.
In connection to our capital and corporate restructuring plan, we issued
8,029,578 shares of common stock to the holders of the 9.75% debentures and the
Series A Convertible Preferred Stock upon consummation of the Exchange. The
Company's $32.2 million in convertible debentures were converted into common
shares of the Company and a portion of $12.5 million in secured convertible 7.5%
debentures that mature in August 2007. In addition, all Series A Convertible
Preferred Stock were converted into common shares of the Company and a portion
of the $12.5 million in secured convertible debentures. The outstanding Series A
Convertible Preferred Stock "put" of $48.8 million against SNI was withdrawn.
Certain Series A Convertible Preferred stockholders also received a total of
$600 thousand in additional secured convertible 7.5% debentures to pay certain
legal fees.
There was an aggregate gain, net of tax, on the capital restructuring
transaction of $13.8 million. The conversion of the SNI Series A Convertible
Preferred Stock into common stock and a portion of the $12.5 million 7.50%
convertible debenture resulted in a net gain of $48.8 million. The gain was
off-set by the loss on the value of the warrants and beneficial conversion
feature on the $32.2 million, 9.75% convertible debentures, converted to common
stock and a portion of the 7.50% convertible debenture. The consolidated net
gain on the capital restructuring transaction was $13.8 million or $2.35 per
share for the quarter ending July 31, 2003.
Stock Option Plans
We have five stock option plans in effect: The 2003 Equity Incentive
Plan, the 2000 Stock Incentive Plan, the 1988 Stock Option Plan, the 1997
Incentive and Non-Qualified Stock Option Plan and the 1997 Director Stock Option
Plan. The stock options have been made available to certain employees and
consultants. All options are granted at not less than fair value at the date of
grant and have terms varying from 3 to 10 years. The purpose of these plans is
to attract, retain, motivate and reward our officers, directors, employees and
consultants to maximize their contribution towards our success. We account for
these plans under the recognition and measurement principles of APB Opinion No.
25, Accounting for Stock Issued to Employees, and related Interpretations. No
stock-based employee compensation cost is reflected in net loss, as all options
granted under these plans had an exercise price equal to the market value of the
underlying common stock on the date of grant.
In order to provide more prominent and frequent disclosures about the
effects of stock-based compensation as required under SFAS 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure", the following table
summarizes the pro forma effect of stock-based compensation on net loss and
earnings (loss) per share if the optional expense recognition provisions of SFAS
123 had been adopted.
The fair value of stock options used to compute pro forma net loss and
pro forma loss per share disclosures is estimated using the Black-Scholes
option-pricing model, which was developed for use in estimating the fair value
of traded options that have no vesting restrictions and are fully transferable.
In addition, this model requires the input of subjective assumptions, including
the expected price volatility of the underlying stock. Projected data for
expected volatility and expected life of stock options is based upon historical
and other data. Changes in these subjective assumptions can materially affect
the fair value estimate, and therefore the existing valuation models may not
provide a reliable single measure of the fair value of the Company's employee
stock options.
(thousands, except per share amounts)
Three Months Ended Six Months Ended
July 31, July 31,
------------------- --------------------
2003 2002 2003 2002
---- ---- ---- ----
Reported net income (loss):
As reported 12,514 (15,806) 6,292 (11,830)
Add: Stock-based employee compensation included in
reported net income (loss), net of related tax effect - 109 51 215
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards,
net of related tax effects (976) (1,428) (1,267) (2,895)
------- -------- ------- --------
Pro forma $11,538 $(17,125) $ 5,025 $(14,510)
------- -------- ------- --------
Earnings (loss) per share:
Basic EPS as reported $ 2.13 $ (21.35) $ 1.84 $ (16.24)
======= ======== ======= ========
Pro forma basic EPS $ 1.97 $ (23.29) $ 1.47 $ (20.20)
======= ======== ======= ========
Diluted EPS as reported $ 1.70 $ (45.20) $ 1.54 $ (40.60)
======= ======== ======= ========
Pro forma diluted EPS $ 1.57 $ (17.88) $ 1.20 $ (15.47)
======= ======== ======= ========
13
Earnings Per Share Calculation
The following data show the amounts used in computing basic earnings per
share for the three and six months ended July 31, 2003 and 2002.
(thousands, except per share amounts)
Three Months Ended July 31, Six Months Ended July 31,
----------------------------- ------------------------------
Earnings Per Share Calculation 2003 2002 2003 2002
---------- --------- ---------- --------
Net income (loss) available to common
shareholders used in basic EPS $ 12,514 $ (15,806) $ 6,292 $(11,830)
========== ========= ========== ========
Average number of common shares
used in basic EPS 5,868,756 740,457 3,418,696 728,535
========== ========= ========== ========
Basic income (loss) per common share is calculated by dividing the net
loss by the weighted average number of common shares outstanding during the
period. Diluted loss per common share is calculated by dividing the applicable
net income (loss) by the sum of the weighted average number of common shares
outstanding and all additional common shares that would have been outstanding if
potentially dilutive common shares had been issued during the period. Our
convertible debentures create a dilutive situation even though the company had a
net loss for the three and six months ended July 31, 2002. The following data
shows the effect on income and the weighted average number of shares of dilutive
potential common stock.
(thousands, except per share amounts)
Three Months Ended July 31, Six Months Ended July 31,
----------------------------- ---------------------------
2003 2002 2003 2002
--------- --------- ------- ----------
Net income (loss) available for common
shareholders used in basic EPS $ 12,514 $ (15,806) $ 6,292 $ (11,830)
Less: Convertible debt issuance costs (12,260) (28,622) (12,260) (28,622)
Plus: Convertible debt interest 420 783 1,032 1,557
--------- --------- ----------- ---------
Net loss available to common
shareholders used in diluted EPS $ 674 $ (43,645) $ (4,936) $ (38,895)
========= ========= ========== =========
Average number of common shares
used in basic EPS 5,868,756 740,457 3,418,696 728,535
--------- --------- ---------- ---------
Effect of dilutive securities:
Convertible debentures 1,497,473 223,301 761,147 223,301
--------- --------- ---------- ---------
Average number of common shares and dilutive
potential common stock used in diluted EPS 7,366,229 963,758 4,179,843 951,836
========= ========= ========== =========
Common stock options and warrants of 1,298,112 are excluded from the
computation as the effect was anti-dilutive.
Litigation
On June 4, 2003, we consummated the exchange transaction and cancelled
all outstanding Series A Convertible Preferred Stock and 9.75% Senior
Convertible Debentures. The Exchange Agreement provides that the litigation
instituted by the former holders of Series A stock be dismissed without
prejudice against the Company, its subsidiaries, its current officers and
directors, and other defendants who execute an appropriate release, and
without prejudice against all other defendants. This dismissal will require
court approval, which is in the process of being obtained by counsel for
all parties.
In accordance with a settlement agreement reached between us and our
former Chairman and Founder, Par Chadha, 566,000 shares of ENI stock were
transferred to Mr.Chadha in exchange for mutual releases by the Company and Mr.
Chadha and certain of his affiliates. The stock transfer was completed on July
1, 2003 and had a value of $88 thousand.
In addition, claims in arbitration were filed by two of our former
financial officers and employees who worked in our former Santa Monica office,
which has since been closed, alleging that their resignations in May 2002 were
for "good reason" as defined in their employment agreements, all of which were
to expire on May 22, 2002. One of the claims was settled in May 2003 for $45
thousand. The other claim was resolved by an August 2003 arbitrator ruling in
favor of the Company.
A former officer of our SNI subsidiary brought suit alleging breach of a
consulting agreement we entered into with him in March 2002, following his
resignation "for good reason" as defined in his employment agreement. He is
seeking acceleration of consulting fees due to him under his consulting
agreement in the amount of $229 thousand. We feel these claims are without merit
and are vigorously defending the claims. We have also filed counterclaims. In
May 2002, the former officer's motion for summary judgment was denied.
Currently, the matter is in discovery.
From time to time, we are involved in various other legal proceedings and
claims incidental to the conduct of our business. Although it is impossible to
predict the outcome of any outstanding legal proceedings, we believe that such
legal proceedings and claims, individually and in the aggregate, are not likely
to have a material adverse effect on our financial position, results of
operations, or cash flows.
14
Contingent Liabilities
In the merger agreement between our predecessor corporation and Sync
Research, we agreed to indemnify and hold our former subsidiary, Entrada,
harmless against any liability arising after the merger in connection with the
termination of a certain pension plan previously maintained by Entrada. In the
third quarter of 2003, we were advised by a consultant retained by us and by the
successor corporation to the entity from whom we originally purchased the
company that became Entrada that the cost of termination of the pension plan in
question is in excess of $3.0 million. While we do not believe that we are
liable for this cost, it is possible that the successor corporation, which has
been funding the pension plan since 1996, may seek a substantial contribution
from us towards this liability. We have not recorded a reserve to cover this
contingency.
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 and limits. At times such amounts may exceed
the F.D.I.C. limits. We limit the amount of exposure with any one financial
institution and believe that no significant concentration of credit risk exists
with respect to cash investments.
Although we are directly affected by the economic well being of
significant customers listed in the following tables, we do not believe that
significant credit risk exists at July 31, 2003. We perform ongoing evaluations
of our customers and require letters of credit or other collateral arrangements
as appropriate. Accordingly, trade receivable credit losses have not been
significant.
The following data shows the customers accounting for more than 10% of
net consolidated receivables:
July 31, January 31,
2003 2003
----------- -----------
Customer A...................................... 28.4% 15.9%
Customer B...................................... 25.5% 14.8%
The following data shows the customers accounting for more than 10% of
net consolidated sales:
Three Months Ended Six Months Ended
July 31, July 31,
----------------------- ---------------------------
10% of net consolidated sales: 2003 2002 2003 2002
----- ---- ------ ----
Customer A 32.7% 22.8% 16.9% 25.9%
Customer B 31.4% 0.0% 18.6% 0.0%
Customer C 5.7% 8.5% 15.9% 24.0%
Customer D 0.6% 19.7% 22.3% 9.2%
Segment Information
Sorrento Meret
Networks Optical Other Total
---------- ------- ----- -----
Three Months Ended July 31, 2003
Revenues from external customers $ 4,007 $ 469 $ $ 4,476
Cost of goods sold 2,879 234 3,113
--------- --------- ------ ----------
Gross Profit $ 1,128 $ 235 $ - $ 1,363
========= ========= ====== ==========
Segment income (loss) from operations (3,015) 192 (1,270) (4,093)
Depreciation and amortization expense 818 129 24 971
Valuation allowance additions (reductions):
Receivables and inventory (797) (459) - (1,256)
Capital asset additions (disposals), net (682) - - (682)
Total assets 22,469 5,375 13,672 41,516
Three Months Ended July 31, 2002
Net sales $ 4,547 $ 652 $ $ 5,199
Cost of sales 6,221 1,278 7,499
--------- --------- ------ ----------
Gross Profit $ (1,674) $ (626) $ - $ (2,300)
========= ========= ====== ==========
Segment income (loss) from operations (12,158) (1,044) (1,195) (14,397)
Depreciation and amortization expense 804 129 32 965
Valuation allowance additions (reductions):
Receivables and inventory 6,350 1,017 - 7,367
Capital asset additions (disposals), net (501) (155) - (656)
Total assets 29,104 6,417 25,516 61,037
Six Months Ended July 31, 2003
Net sales $ 10,768 $ 1,569 $ $ 12,337
Cost of sales 7,932 1,088 9,020
--------- --------- ------- ----------
Gross Profit $ 2,836 $ 481 $ - $ 3,317
========= ========= ======== ==========
Segment income (loss) from operations (5,976) 312 (2,047) (7,711)
Depreciation and amortization expense 1,715 258 48 2,022
Valuation allowance additions (reductions):
Receivables and inventory (797) (469) - (1,266)
Capital asset additions (disposals), net (1,458) - - (1,458)
Total assets 22,469 5,375 13,672 41,516
Six Months Ended July 31, 2002
Net sales $ 9,341 $ 1,861 $ $ 11,202
Cost of sales 9,990 2,024 12,014
--------- --------- ------- ----------
Gross Profit $ (649) $ (163) $ - $ (812)
========= ========= ======== ==========
Segment income (loss) from operations (17,877) (1,022) (2,042) (20,941)
Depreciation and amortization expense 1,573 262 55 1,890
Valuation allowance additions (reductions):
Receivables and inventory 6,620 1,464 105 8,189
Capital asset additions (disposals), net 1,161 57 70 1,288
Total assets 29,104 6,417 25,516 61,037
15
Subsequent Events
On August 8, 2003 we successfully closed the acquisition of LuxN, Inc.
LuxN supplies optical access equipment for the network edge using coarse and
dense wavelength division multiplexing (CWDM and DWDM) technology. LuxN's
OSMINE-certified products enable delivery of high-bandwidth data, storage,
video, and voice services for service providers, cable MSOs, and enterprises.
We acquired LuxN for a combination of stock, warrants, and cash
previously held by LuxN. Stockholders of LuxN were given the option of
exchanging shares of LuxN stock for either their pro-rata portion of LuxN's net
cash or shares of Sorrento's common stock. Stockholders with an aggregate
pro-rata portion of $3.8 million of LuxN's net cash elected to receive
Sorrento's common stock. In addition to the cash or Sorrento common stock,
stockholders of LuxN have the right to receive warrants to purchase an aggregate
of 400,000 shares of Sorrento common stock, with an exercise price of $3.05 per
share, the fair market value on the date of acquisition. The warrants will be
held in escrow for a period of six months to satisfy any successful
indemnification claims. At closing, Sorrento issued approximately 1.4 million
shares of common stock with the remaining approximately 500,000 shares of common
stock to be issued subject to stockholder approval.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
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/A for the year ended January 31, 2003, including the
consolidated audited financial statements and notes thereto.
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".
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," "plan", "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: (1) our ability to fund our operations
until such time that revenue and orders improve, including its ability to raise
additional equity or debt financing; (2) unanticipated technical problems
relating to our products; (3) our ability, or lack thereof, to make, market and
sell optical networking products that meet with market approval and acceptance;
(4) the greater financial, technical and other resources of our many, larger
competitors in the marketplace for optical networking products; (5) changed
market conditions, new business opportunities or other factors that might affect
our decisions as to the best interests of our shareholders; (6) other risks
detailed from time to time in our reports filed with the U.S. Securities and
Exchange Commission.
We wish to caution readers not to place undue reliance on any such
forward-looking statements, which speak only as of the date made. Such
statements are subject to certain risks and uncertainties that could cause
actual results to differ materially from historical earnings and those presently
anticipated or projected. 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.
16
Results of Operations/Comparison of the Quarters and Six Months ended July 31,
2003 and 2002.
Net sales. Our consolidated net sales decreased $723 thousand or 14% to
$4.5 million for the quarter ended July 31, 2003 compared to net sales of $5.2
million for the quarter ended July 31, 2002. Net sales for Sorrento Networks
Inc.("SNI"), the Company's primary operating subsidiary, decreased $539 thousand
or 12% to $4.0 million for the quarter ended July 31, 2003 as compared to net
sales of $4.5 million for the quarter ended July 31, 2002. This decrease is
attributable to two of SNI's major customers delaying capital expenditures due
to merger or internal restructuring. We don't expect this to be an ongoing
problem. During the six months ended July 31, 2003 our net sales increased to
$12.3 million from $11.2 million for the comparable six months ended July 21,
2002, an increase of 10%. This increase reflects higher domestic sales in the
first quarter, resulting from a substantial backlog at the end of the previous
year.
During the three months ended July 31, 2003, SNI shipped product to
twelve customers of which six customers represented a combined 88% of our
revenues. During the quarter ended July 31, 2002, we shipped product to twelve
customers of which five customers represented a combined 79% of our net sales.
During the six months ended July 31, 2003, we shipped to product to sixteen
customers of which five represented 84% of SNI's net sales. For the comparable
six months ended July 31, 2002, we shipped to twelve customers, of which five
represented 71% of net sales. We expect to continue experiencing significant
fluctuations in our quarterly revenues as a result of our long and variable
sales cycle as well as our highly concentrated customer base.
Net sales for Meret decreased to $469 thousand or by 28%, for the quarter
ended July 31, 2003 from $652 thousand for the comparable quarter last year. For
the six months ended July 31, 2003 sales decreased to $1.6 million or by 19%,
from $1.9 million in the comparable period last year. The reduction in sales
volume reflects the transfer of one of Meret's product line to SNI. This
transfer was done for conformity of products within the two segments.
Gross profit. Cost of sales consists principally of the costs of
components, subcontract assembly from outside manufacturers, and in-house system
integration, quality control, final testing and configuration costs. Gross
margin percent on a consolidated basis increased to 30% for the quarter ended
July 31, 2003 compared to a negative 44% consolidated gross margin for the
quarter ended July 31, 2002. Consolidated gross profit was $1.4 million for the
quarter ended July 31, 2003 versus a consolidated gross loss of $2.3 million for
the quarter ended July 31, 2002. During the quarter ended July 31, 2002 we took
reserves against the book value of our inventory and an adjustment to the market
prices on many of our components held in inventory, as well as the write-down of
obsolete and slow-moving inventories. A $4.0 million reserve was taken to cover
this reduction in value. The gross margin percent on a consolidated basis for
the six months ended July 31, 2003 increased to 27% compared to a negative 7%
consolidated gross margin for the six months ended July 31, 2002. Consolidated
gross profit was $ $3.3 million, an increase of $4.1 million from the comparable
six months period ended July 31, 2002. This increase reflects the obsolescence
and inventory value reserves taken in the second quarter of the prior year.
Gross profit for SNI increased to $1.1 million the quarter ended July 31,
2003, as compared to a gross loss of $1.7 million in the quarter ended July 31,
2002. For the six months ended July 31, 2003 gross profit increased $.5 million
compared to a gross loss of $650 thousand for the six months ended July 31,
2002. The gross profit increases were primarily the result of lower inventory
reserves versus the prior period and a reduction in manufacturing costs during
the current period. We continue to monitor our costs of production and reduce
costs wherever possible.
For the quarter ended July 31, 2003, gross profit for Meret was $235
thousand versus a gross loss of $626 thousand for the comparable quarter last
year. Meret's gross margins increased to 50% for the quarter ended July 31, 2003
from negative 74% for the comparable quarter last year. For the six months ended
July 31, 2003, the gross margin increased to $482 thousand compared to a gross
loss of $163 thousand in the six months ended July 31, 2002. The gross profit
increases were primarily the result of product mix and the obsolescence reserves
taken in the prior period.
Selling and marketing. Selling and marketing expenses consist primarily
of employee compensation and related costs, commissions to sales
representatives, tradeshow expenses and travel expenses. Consolidated selling
and marketing expenses decreased to $1.9 million, or 42% of net sales, for the
quarter ended July 31, 2003 from $3.6 million, or 70% of net sales, for the
quarter ended July 31, 2002. For the six months ended July 31, 2003 consolidated
selling and marketing expenses decreased to $4.1 million, or 33% of net sales,
compared to $7.1
17
million, or 63% of net sales, for the six months ended July 31, 2002. This
decrease was primarily the result of cost reduction efforts implemented and
included reductions in travel expenses, advertising expenses and personnel
costs.
Engineering, research and development. Engineering, research and
development expenses consist primarily of compensation related costs for
engineering personnel, facilities costs and materials used in the design,
development and support of our technologies. All research and development costs
are expensed as incurred. We continue to manage our research and development
cost in relation to the changes in our sales volume and available capital
resources in our development efforts to enhance existing products and introduce
new products to our product offering. Our consolidated engineering, research and
development expenses decreased to $1.5 million, or 35% of net sales, for the
quarter ended July 31, 2003, from $2.3 million, or 45% of net sales, for the
quarter ended July 31, 2002. For the six months ended July 31, 2003 our
consolidated engineering, research and development expenses decreased to $3.2
million, or 25% of net sales, compared to $4.9 million, or 44% of net sales for
the six months ended July 31, 2002. The decline can primarily be attributed to
decreases in product development material and personnel related costs reflecting
managements planned reduction in operating expense levels.
General and administrative. General and administrative expenses consist
primarily of employee compensation and related costs, legal and accounting fees,
public company costs and allocable occupancy costs. Consolidated general and
administrative expenses decreased to $1.9 million, or 43% of net sales, for the
quarter ended July 31, 2003 from $5.9 million, or 114% of net sales, for the
quarter ended July 31, 2002. The decrease was a combination of our ongoing
expense reduction plan and the finalization of our capital restructuring. For
the six months ended July 31, 2003, consolidated general and administrative
expenses decreased to $3.5 million, or 28% of net sales, compared to $7.8
million or 69.4% of net sales in the six month period ending July 31, 2002. The
decrease in general and administrative expenses can be attributed to reductions
in investment banking, professional fees and personnel related costs due to our
ongoing operating expense reduction efforts and the completion of our capital
restructuring.
Deferred stock compensation and other. Deferred and other stock
compensation for the quarter ended July 31, 2003 includes $0 of amortization of
deferred stock compensation resulting from the amortization of the value of
stock options granted to consultants as compared with $109 of amortization of
deferred stock compensation and expenses for the comparable quarter last year.
For the six months ended July 31, 2003 we recorded $51 thousand of amortization
of deferred stock compensation compared to $ 215 thousand for the comparable six
months last year. These costs were incurred in connection with the grants of
stock options with exercise prices determined to be below the fair value of
Sorrento's common stock on the date of grant, Sorrento recorded deferred stock
compensation of $2.6 million, which the amount was fully amortized at April 30,
2003.
Other operating expenses. Other operating expenses were $103 thousand for
the quarter ended July 31, 2003 as compared to $93 thousand for the same
comparable quarter last year. For the six months ended July 31, 2003, other
operating expenses were $206 as compared to $190 for the six months ended July
31, 2002. These costs represent the amortization of purchased technology related
to prior acquisitions.
Other income (charges). Other income (charges) from operations was $16.6
million in income for the quarter ended July 31, 2003 compared to $1.4 million
of expense for the quarter ended July 31, 2002. The increase was primarily
attributable to a net gain of $13.7 million on the capital restructuring that
was completed June 4, 2003 and a gain on the sale of marketable securities of
$4.0 million. This gain was partially offset by $1.1 million in interest expense
associated with the Company's convertible debentures. During the six months
ended July 31, 2003, other income was $14.0 million compared to $9.1 million for
the same period in the prior year. This increase was primarily due to the net
gain on the capital restructuring and a gain on the sale of marketable
securities. This gain was partially offset by $3.6 million in costs associated
with the Company's 9.75% convertible debentures.
Income taxes. There was no provision for income taxes for the quarters
and six months ended July 31, 2003 and 2002, respectively. 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. These carry forwards
have been adjusted due to the capital restructuring that occurred in June 2003.
However, due to potential adjustments to the net operating loss carry forwards
as provided by the Internal Revenue Code with respect to future ownership
changes, future availability of the tax benefits is not assured. In addition, we
provided a valuation allowance in full for our deferred tax assets, as it is our
opinion that it is more likely than not that some portion or all of the deferred
tax assets will not be realized.
18
Liquidity and Capital Resources
We finance our operations through a combination of internal funds,
investments and debt and equity financing. At July 31, 2003, our working capital
was $9.8 million including $5.0 million in cash and cash equivalents and $85
thousand of investments in marketable securities.
Operations
Our operations used cash flows of $9.3 million during the six months
ended July 31, 2003. During the quarter ended July 31, 2002 continuing
operations used cash flows of $10.9 million. The decrease in cash flows used by
operations resulted from a gain on the sale of marketable securities, a gain on
the capital restructuring, a decrease in accounts receivable and inventories,
partially offset by a decrease in accounts payables and accrued liabilities.
We have incurred significant losses and negative cash flows from
operations for the past two years. Sorrento Networks, Inc., ("SNI") our
principal operating subsidiary, has primarily been the operating entity
responsible for these high losses and negative cash flows. The losses have been
generated as SNI continues to develop its technology, marketing and sales and
operations in its effort to become a major supplier of metro and regional
optical networks world-wide.
We have funded our operations primarily through a combination of internal
funds, the sale of investments and debt and equity financing. There can be no
assurance that similar funding will be available in the future. In addition, now
that our capital restructuring efforts are completed, there are certain
restrictions on us in both the amount of debt we can incur in future periods and
the types of securities that we can issue to raise additional capital in future
periods. Both of these restrictions could have a negative impact on our ability
to raise the additional working capital that we will require in future periods.
Further, with the downturn in the economic environment and decreases in capital
spending by telecom carriers, our revenue has been negatively impacted and our
future revenues could also be negatively impacted. As a result, our need for
additional working capital could be accelerated in the future. If such capital
is not available, we will need to substantially decrease our operating costs and
capital spending in order to fund operations. There can be no assurance that our
available cash, future funding or reduction in operating costs will be
sufficient to fund our operations in the future.
Our standard payment terms range from net 30 to net 60 days. Receivables
from international customers have frequently taken longer to collect. In
addition, the downturn in the telecom market has impacted many of the telecom
carriers ability to purchase or pay for outstanding commitments within standard
payment terms. Despite these negative factors we have improved our collection on
receivables to 45 days of average sales days outstanding as compared to 92 days
outstanding for the same period in the prior year, helping improve our cash
flows. There can be no assurance; however, that this continued economic
environment will not impact either current or future receivables negatively, or
our ability to control inventory levels. We do not provide long-term financing
to customers buying our equipment.
Investing Activities
Our investing activities during the six months ended July 31, 2003
provided cash flows of $6.8 million from the sale of $5.0 million in marketable
securities, the disposal of $1.5 million property and equipment and a $349
thousand decrease in other assets. During the six months ended July 31, 2002,
investing activities provided cash flows of $12.1 million. We purchased property
and equipment of $1.9 million and received $13.6 million on the sale of
marketable securities and $542 thousand on the sale of other assets.
Financing Activities
Our financing activities during the six months ended July 31, 2003 used
cash of $128 thousand consisting primarily of the repayment of long-term debt.
During the comparable six months in the prior year, financing activities used
cash flows of $1.0 million, which also consisted primarily of repayment of debt.
19
We anticipate that we will need additional working capital to fulfill our
capital working requirements for the next year. While we have made significant
cost reductions to bring our losses more in line with our anticipated or
projected revenues, there is no assurance the volume of future revenues will be
sufficient to allow us to meet our financial obligations for future periods. We
continue to reduce our operating costs and have initiated activities to raise
additional working capital. If revenues do not improve from second quarter
results for future periods, we will not have sufficient working capital to
finance our operations for the next twelve months given our existing expense
base. Our future capital requirements may vary materially from those now planned
including the need for working capital to accommodate planned growth, hiring and
infrastructure needs. There can be no assurances that our working capital
requirements will not exceed our ability to generate sufficient cash internally
to support our requirements and that external financing will be available or
that, if available, such financing can be obtained on terms favorable to us and
our shareholders.
Contractual Cash Obligations
The following tables quantify our future contractual obligations
and commercial commitments as of July 31, 2003:
Contractual Obligations
Payments due in fiscal years
---------------------------------------------------------------------------------
Remainder
Total 2004 2005 2006 2007 2008 Thereafter
----- ---- ---- ---- ---- ---- ----------
Long-term Debt ............ $ 3,611 $ 27 $ 49 $ 54 $ 58 $63 $3,360
Capital Leases ............ 139 84 55 -- -- -- --
Operating Leases .......... 468 119 158 131 42 18 --
7.5% Convertible Debentures 13,100 -- -- -- 13,100 -- --
------- ---- ---- ---- ------- --- ------
Total ..................... $17,318 $230 $262 $185 $13,200 $81 $3,360
======= ==== ==== ==== ======= === ======
Securities Authorized For Issuance Under Equity Compensation Plans
The following table provides information as of July 31, 2003
regarding compensation plans (including individual compensation arrangements)
under which equity securities are authorized for issuance.
Number of Securities To Number of Securities
Be Issued Upon Remaining Available for
Exercise Weighted-Average Exercise Future Issuance Under Equity
Of Outstanding Price of Outstanding Compensation Plans
Options, Options, (Excluding Securities
Warrants and Rights Warrants and Rights Reflected in Column (a))
------------------- ------------------- ------------------------
Plan Category (a) (b) (c)
----------- ----------- -------------
Equity Compensation
Plans Approved by
security Holders *(FIBR) 1,263,011 $ 92.50 1,395,989
----------- ----------- -------------
Equity Compensation
Plans not Approved by
Security Holders (SNI) 2,737,847 $ 5.27 20,558,153
--------- --------- ----------
Total 4,000,858 $ 32.81 21,954,142
--------- --------- ----------
* As adjusted for stock splits.
20
See the Stock Option Plans note in the financial statements included in this
quarterly report for information regarding the material features of the above
plans. Each of the above plans provides that the number of shares with respect
to which options may be granted, and the number of shares of Common Stock
subject to an outstanding option, shall be proportionally adjusted in the event
of a subdivision or consolidation of shares or the payment of a stock dividend
on Common Stock, and the purchase price per share of outstanding options shall
be proportionately revised.
Critical Accounting Policies and Estimates
Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amounts of assets, liabilities,
revenues and expenses, and related disclosures of contingent assets and
liabilities. On an on-going basis, we evaluate our estimates, including those
related to our valuation of inventory and our allowance for uncollectable
accounts receivable. We base our estimates on historical experience and on
various other assumptions that are believed to be reasonable under the
circumstances, the results of which form the basis for making judgments about
the carrying values of assets and liabilities that are not readily apparent from
other sources. Actual results may differ materially from these estimates under
different assumptions or conditions.
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements:
o Revenue recognition. Revenue is generally recognized when the
products are shipped, all substantial contractual obligations, if
any, have been satisfied, and the collections of the resulting
receivable is reasonably assured. When title does not pass to the
customer at time of shipment, revenue is not recognized until all
contractual requirements are met and title has transferred.
During this transition period, the amount of the sale and/or
installation is shown in deferred revenue.
Revenue from installation is recognized as the services are
performed to the extent of the direct costs incurred. To date,
installation revenue has not been material. Revenue from service
obligations, if any, is deferred and recognized over the life of
the contract. Inventory or demonstration equipment shipped to
potential customers for field trials is not recorded as revenue.
We accrue for warranty costs, sales returns and other allowances
at the time of shipment. Although our products contain a software
component, the software is not sold separately and we are not
contractually obligated to provide software upgrades to our
customers.
o Inventory. Inventory is evaluated on a continual basis and
management must make estimates about the future customer demand
for our products, taking into account both the economic
conditions and growth potential of our customers. Reserve
adjustments are made based on management's estimate of future
sales value, if any, of specific inventory items. Reserve
adjustments are made for the difference between the cost of the
inventory and the estimated market value and charged to
operations in the period in which the facts that give rise to the
adjustments become known. A misinterpretation or misunderstanding
of these conditions or uncertainty in the future outlook of our
industry or the economy, or the failure to estimate correctly,
could result in inventory losses in excess of the provisions
determined to be appropriate at the time of the balance sheet.
o Accounts receivable. Accounts receivable balances are evaluated
on a continual basis and management regularly reviews the
financial stability of individual customers. This analysis
involves a judgment of the customers current and projected
financial condition and the positive or negative effects of the
current and projected industry outlook, as well as that of the
economy in general. Allowances are provided for potentially
uncollectable accounts based on management's estimate of the
collectability and the probability of default of customer
accounts. If the financial condition of a customer were to
deteriorate, resulting in an impairment of their ability to make
payments, an additional allowance may be required. Allowance
adjustments are charged to operations in the period in which the
facts that give rise to the adjustments become known.
o Intangible assets. We currently have intangible assets that
include assets with finite lives, such as our purchased
technology. The determination of related estimated useful lives
and whether these assets
21
are impaired involves judgments based upon short and long-term
projections of future performance. We have no goodwill or
indefinite life intangible assets. Other intangible assets with
finite lives continue to be amortized over their useful lives.
o Legal contingencies. We are subject to proceedings, lawsuits and
other claims, including proceedings under laws and government
regulations related to securities, environmental, labor, product
and other matters. We are required to assess the likelihood of
any adverse judgments or outcomes to these matters, as well as
potential ranges of probable losses. A determination of the
amount of reserves required, if any, for the contingencies is
based on a careful analysis of each individual issue with the
assistance of outside legal counsel. Our reserves may change in
the future due to new developments in each matter or changes in
approach such as a change in settlement strategy in dealing with
these matters. For more information, see Note H to the
consolidated financial statements.
o Income taxes. We currently have no provisions for income taxes.
We have carry forward domestic federal net operating losses,
which may be available, in part, to reduce future taxable income
in the United States. However, due to potential adjustments to
the net operating loss carry forwards as provided by the Internal
Revenue Code with respect to future ownership changes, future
availability of the tax benefits is not assured. In addition, we
provided a valuation allowance in full for our deferred tax
assets, as it is our opinion that it is more likely than not that
some portion or all of the deferred tax assets will not be
realized.
Impact of Recent Accounting Pronouncements
In May 2003, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 150. "Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and
Equity" ("SFAS 150"). SFAS 150 clarifies the accounting for certain financial
instruments with characteristics of both liabilities and equity and requires
that those instruments be classified as liabilities in the balance sheets.
Previously, many of those financial instruments were classified as equity. SFAS
150 is effective for financial instruments entered into or modified after May
31, 2003 and otherwise is effective at the beginning of the first interim period
beginning after June 15,2003. We expect this pronouncement will not have a
material impact on our results of operations and financial condition.
In April 2003, the FASB issued SFAS No. 149, "Amendment of SFAS No. 133
on Derivative Instruments and Hedging Activities"( "SFAS 149"). SFAS 149 amends
and clarifies accounting for derivative instruments, including certain
derivative instruments embedded in other contracts and for hedging activities
under SFAS No. 133 "Accounting for Derivative Instruments and Hedging
Activities" ("SFAS 133"). In particular, it (1) clarifies under what
circumstances a contract with an initial net investment meets the characteristic
of a derivative as discussed in SFAS 133, (2) clarifies when a derivative
contains a financing component, (3) amends the definition of an underlying to
conform it to the language used in FASB Interpretation No. ("FIN") 45,
"Guarantor Accounting and Disclosure Requirements for Guarantees, including
Indirect Guarantees of Indebtedness of Others" ("FIN 45") and (4) amends certain
other existing pronouncements. SFAS 149 will be effective for contracts entered
into or modified after June 30, 2003, except as stated below, and for hedging
relationships designated after June 30,2003. The provisions of SFAS 149 that
relate to guidance in SFAS 133 Implementation Issues that have been effective
for fiscal quarters which began prior to June 15,2003, will continue to be
applied in accordance with their respective effective dates. In addition,
certain provisions relating to forward purchases or sales of when-issued
securities or other securities that do not yet exist, will be applied to both
existing contracts as well as new contracts entered into after June 30, 2003 We
will apply the provision of SFAS 149 on a prospective basis to contracts entered
into or modified after June 30, 2003 and expect that this pronouncement will not
have a material impact on our results of operations and financial condition.
In January 2003, the Financial Accounting Standards Board ("FASB") issued
FASB Interpretation ("FIN") No. 46, "Consolidation of Variable Interest
Entities", and interpretation of Accounting Research Bulletin No. 51,
"Consolidated Financial Statements", FIN No. 46 explains how to identify
variable interest entities and how an enterprise assesses its interests in a
variable interest entity to decide whether to consolidate that entity. This
Interpretation requires existing unconsolidated variable interest entities to be
consolidated by their primary beneficiaries if the entities do not effectively
disperse risks among parties involved. FIN No. 46 is effective immediately for
variable interest entities created after January 31, 2003, and to variable
interest entities in which an enterprise obtains an interest after that date.
The Interpretation applies in the first fiscal year or interim period
22
beginning after June 15, 2003, to variable interest entities in which an
enterprise holds a variable interest that is acquired before February 1, 2003.
We have adopted FIN No. 46 with no material effect on our financial position or
results of operations.
In November 2002, the FASB Emerging Issues Task Force ("EITF") reached a
consensus on Issue 00-21, "Accounting for Revenue Arrangements with Multiple
Deliverables" ("EITF 00-21"). In the absence of higher level accounting
literature, EITF 00-21 governs how to separate and allocate revenue to goods or
services or both that are to be delivered in a bundled sales arrangement. EITF
00-21 applies to revenue arrangements entered into after June 30, 2003 and
allows for either prospective application or cumulative adjustment upon
adoption. We will apply the guidance of EITF 00-21 on a prospective basis and
expect that this pronouncement will not have a material impact on our results of
operations and financial condition.
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
See Part II, Item 1, "Other Information--Legal Proceedings".
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.
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.
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.
23
We believe that the relatively moderate rate of inflation in the United
States over the past few years and the relatively stable interest rates incurred
on short-term financing have not had a significant impact on our sales,
operating results or prices of raw materials. There can be no assurance,
however, that inflation or an upward trend in short-term interest rates will not
have a material adverse effect on our operating results in the future should we
require debt financing in the future.
Item 4. Controls and Procedures
Evaluation of Controls and Procedures
The Company maintains disclosure controls and procedures (as defined in
Exchange Act Rules 13a-15(e) and 15d-15(e)) designed to ensure that it is able
to collect the information it is required to disclose in the reports it files
with the SEC, and to process, summarize and disclose this information within the
time periods specified in the rules of the SEC. These disclosure controls and
procedures are designed and maintained by or under the supervision of the
Company's Chief Executive Officer and Chief Financial Officer, as required by
the rules of the SEC. The Company's Chief Executive Officer and Chief Financial
Officer are responsible for evaluating the effectiveness of the disclosure
controls and procedures. Based on their evaluation of the Company's disclosure
controls and procedures which took place as of the end of the period covered by
this report, the Chief Executive and Chief Financial Officers believe that these
controls and procedures are effective to ensure that the Company is able to
collect, process and disclose the information it is required to disclose in the
reports it files with the SEC within the required time periods. During the
period covered by this report, there have been no changes in the Company's
internal controls over financial reporting that have materially affected, or are
reasonably likely to materially affect, the Company's internal control over
financial reporting.
Changes in Controls and Procedures
There were no significant changes in the Company's internal controls or
in other factors that could significantly affect these internal controls after
the date of our most recent evaluation.
24
PART II
OTHER INFORMATION
Item 1: Legal Proceedings
On June 4, 2003, we consummated the exchange transaction and cancelled
all outstanding Series A Convertible Preferred Stock and 9.75% Senior
Convertible Debentures. The Exchange Agreement provides that the litigation
instituted by the former holders of Series A stock be dismissed without
prejudice against the Company, its subsidiaries, its current officers and
directors, and other defendants who execute an appropriate release, and
without prejudice against all other defendants. This dismissal will require
court approval, which is in the process of being obtained by counsel for
all parties.
In accordance with a settlement agreement reached between us and our
former Chairman and Founder, Par Chadha, 566,000 shares of ENI stock were
transferred to Mr.Chadha in exchange for mutual releases by the Company and Mr.
Chadha and certain of his affiliates. The stock transfer was completed on July
1, 2003 and had a value of $88 thousand.
In addition, claims in arbitration were filed by two of our former
financial officers and employees who worked in our Santa Monica office, which
has since been closed, alleging that their resignations in May 2002 were for
"good reason" as defined in their employment agreements, all of which were to
expire on May 22, 2002. One of the claims has been settled, and we are disputing
the other claim. The amount of the disputed claim is approximately $195 thousand
plus attorneys fees.
We have also been sued by a former officer of our Sorrento subsidiary
alleging breach of a consulting agreement we entered into with him in March
2002, following his resignation "for good reason" as defined in his employment
agreement. He is seeking acceleration of consulting fees due to him under his
consulting agreement in the amount of $229 thousand. We feel these claims are
without merit and are vigorously defending the claims. We have also filed
counterclaims. In May 2002, the former officer's motion for summary judgment was
denied. Currently, the matter is in discovery.
From time to time, we are involved in various other legal proceedings
and claims incidental to the conduct of our business. Although it is impossible
to predict the outcome of any outstanding legal proceedings, we believe that
such legal proceedings and claims, individually and in the aggregate, are not
likely to have a material adverse effect on our financial position, results of
operations, or cash flows.
Item 2: Changes in Securities and Use of Proceeds
As part of the exchange of 9.75% Debentures and Series A Preferred
Stock for shares of our common stock, we changed our state of incorporation from
New Jersey to Delaware. We provided a comparison of shareholders' rights under
the law of the states of Delaware and New Jersey in our proxy statement dated
April 15, 2003, which is incorporated herein by reference.
Item 3: Defaults Upon Senior Securities
Not Applicable
Item 4: Submission of Matters to a Vote of Security Holders
The special meeting of shareholders of Sorrento Networks Corporation
(the "Meeting") scheduled for May 19, 2003 was postponed until May 29, 2003 when
a quorum was present.
25
The shareholders approved each of the following proposals as listed in
the Sorrento Networks Corporation's proxy circular and proxy statement dated
April 15, 2003.
Proposal 01. An amendment to our certificate of incorporation to increase our
authorized common stock from 7.5 million to 30 million shares, in
order to enable us to effectuate the restructuring transaction,
and to enable us to obtain additional financing for working
capital.
Proposal 02. The issuance to the exchanging holders of the Outstanding
Debentures and Series A of an aggregate of approximately
8,269,000 shares of our common stock in the restructuring
transaction, and Exchange Debentures convertible into
approximately 2,067,000 shares of our common stock, assuming the
Exchange Debentures are convertible into 17.5% of our outstanding
common stock on a diluted basis.
Proposal 03. The reincorporation of our company from the State of New Jersey
to the State of Delaware, through the merger of our company into
a new Delaware corporation, formed solely for the purpose of
accomplishing the merger.
Proposal 04. The approval of our 2003 Equity Incentive Plan.
Proposal 05. An amendment to our certificate of incorporation to increase our
authorized common stock to a total of 150 million shares.
The proxies received by Sorrento Networks Corporation for the Meeting
were voted as follows:
Shares Voted For Shares Voted Against Shares Withhold
------------------------------------------------------------------------------------------
For Against Abstain
Proposal 01 385,631 60,416 2,783
Proposal 02. 414,879 31,013 2,938
Proposal 03 424,689 21,179 2,962
Proposal 04 392,241 51,749 4,840
Proposal 05 318,567 125,998 4,265
Item 5: Other Information
Not Applicable
Item 6: Exhibits and Reports on Form 8-K
(a). Exhibits
1. Consolidated Financial Statements for the Quarter and Six Months
Ended July 31, 2003 (included in Part I, Item 1).
26
2. Exhibits:
2.1 Agreement and Plan of Merger with LuxN, Inc. (J).
3.1 Certificate of Incorporation of the Registrant (G).
3.2 By-Laws of the Registrant (G).
3.3 Series D Preferred Stock Certificate of Designation (G).
4.1 1988 Stock Option Plan (B).
4.2 Amended and Restated 1997 Incentive and Non-Qualified Stock
Option Plan (A).
4.3 1997 Directors Stock Option Plan (C).
4.4 2000 Stock Incentive Plan (E).
4.5 2000 Employee Stock Purchase Plan (D).
4.6 2000 Stock Option/Stock Issuance Plan of Sorrento Networks,
Inc. (E).
4.7 Form of 7.5% Convertible Debenture Due August 2, 2007 (G).
4.8 Form of Warrant, expiry date August 2, 2007 (G).
4.9 Sorrento Networks Corporation 2003 Equity Incentive Plan (G).
5. Opinion of Greenbaum, Rowe, Smith, Ravin, Davis & Himmel LLP.
10.1 Agreement dated July 12, 2000 with Richard L. Jacobson (E).
10.2 Agreement dated March 1, 2002, with Phillip W. Arneson (F).
10.3 Exchange Agreement dated March 6, 2003 (G).
10.4 Form of Registration Rights Agreement with Exchanging
Holders (G).
10.5 Agreement dated May 17, 2002 with Joe R. Armstrong (H).
10.6 Agreement dated July 3, 2002 with Richard L. Jacobson (H).
10.7 Agreement dated February 1, 2003 with Robert L. Hibbard (H).
10.8 First Amendment to Exchange Agreement (I).
21. Subsidiaries of the Registrant (H).
23.1 Consent of BDO Seidman LLP - filed herewith.
-----------------
The foregoing are incorporated by reference from the Registrant's filings
indicated:
31.1 Certification of Chief Executive Officer pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002.
31.2 Certification of Principal Accounting Officer pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certifications of Chief Executive Officer and Principal
Accounting Officer pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.
27
(A) Proxy Statement dated December 1, 1999.
(B) Proxy Statement dated May 13, 1998.
(C) Proxy Statement dated November 21, 1997.
(D) Proxy Statement dated December 11, 2000.
(E) Form 10-K for the year ended January 31, 2001.
(F) Form 10-K for the year ended January 31, 2002.
(G) Proxy Statement filed with the SEC on April 16, 2003.
(H) Form 10-K for the year ended January 31, 2003.
(I) Form 8-K dated May 30, 2003.
(J) Form 8-K/A dated August 25, 2003.
NOTE: Certain previously filed exhibits are no longer being incorporated by
reference (and therefore not numerically listed) as the underlying
documents have either expired or are no longer material or relevant.
(b). Reports on Form 8-K
June 02, 2003 Q1 Results of Operations and Financial Condition
June 05, 2003 Consummation of Capital and Corporate Restructuring
Plan
June 11, 2003 Q1 Earnings Conference Call Transcript
28
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)
September 15, 2003 By: /s/ JOE R. ARMSTRONG
--------------------------------
Joe R. Armstrong,
Chief Financial Officer
Principal Accounting Officer
29
STATEMENT OF DIFFERENCES
The section symbol shall be expressed as....................................'SS'