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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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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 APRIL 30, 2003
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)
- --------- OF THE SECURITIES EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER: 0-15810
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SORRENTO NETWORKS CORPORATION
(Exact name of Registrant as specified in charter)
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Delaware 04-3757586
(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
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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:
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
---- ----
Common Stock, $0.001 par value per share, Outstanding: 8,915,628
shares at June 6, 2003.
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.
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SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(In Thousands)
April 30, January 31,
2003 2003
---------- ---------
(Unaudited)
ASSETS
CURRENT ASSETS
Cash and equivalents................................................................ $ 3,785 $ 7,747
Accounts receivable, net............................................................ 5,000 5,576
Inventory, net...................................................................... 11,973 13,934
Prepaid expenses and other current assets........................................... 592 741
Investment in marketable securities................................................. 5,020 3,959
---------- ---------
TOTAL CURRENT ASSETS.............................................................. 26,370 31,957
---------- ---------
PROPERTY AND EQUIPMENT, NET............................................................ 15,390 17,103
---------- ---------
OTHER ASSETS
Purchased technology, net........................................................... 327 430
Investment in non-marketable securities............................................. 5,025 5,025
Other assets........................................................................ 977 1,290
---------- ---------
TOTAL OTHER ASSETS................................................................ 6,329 6,745
---------- ---------
TOTAL ASSETS........................................................................... $ 48,089 $ 55,805
========== =========
LIABILITIES AND STOCKHOLDERS' DEFICIT
CURRENT LIABILITIES
Current maturities of long term debt................................................ $ 204 $ 222
Accounts payable.................................................................... 3,595 5,135
Deferred revenue.................................................................... 373 3,700
Accrued professional fees........................................................... 3,845 4,324
Other accrued liabilities and current liabilities................................... 7,223 6,236
Due on redemption of preferred security of subsidiary............................... 48,800 48,800
---------- ---------
TOTAL CURRENT LIABILITIES......................................................... 64,040 68,417
---------- ---------
Long-term debt and capital lease obligations........................................... 3,597 3,644
Debentures payable, face amount of $32,200, net of unamortized costs and discounts..... 19,940 18,121
Dividends payable...................................................................... 99 99
---------- ---------
TOTAL LIABILITIES................................................................. 87,676 90,281
---------- ---------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value; liquidation preference $1,353...................... 1 1
Common stock, $6.00 par value; 7,500 shares authorized; 887 shares issued 886
shares outstanding at April 30, 2003; 887 shares issued 886 shares outstanding at
January 31, 2003.................................................................. 5,318 5,318
Additional paid-in capital.......................................................... 144,933 144,887
Deferred stock compensation......................................................... -- (5)
Accumulated deficit................................................................. (193,758) (187,536)
Accumulated other comprehensive loss................................................ 3,988 2,928
Treasury stock, at cost; 1 share at April 30, 2003 and January 31, 2003,
respectively...................................................................... (69) (69)
---------- ---------
TOTAL STOCKHOLDERS' DEFICIT....................................................... (39,587) (34,476)
---------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIT............................................ $ 48,089 $ 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 Ended
April 30,
--------------------
2003 2002
---------- ---------
NET SALES................................................................................ $ 7,861 $ 6,003
COST OF SALES............................................................................ 5,907 4,515
--------- ---------
GROSS PROFIT........................................................................ 1,954 1,488
--------- ---------
OPERATING EXPENSES
Selling and marketing................................................................. 2,175 3,432
Engineering, research and development................................................. 1,644 2,534
General and administrative............................................................ 1,599 1,863
Deferred stock compensation........................................................... 51 106
Other operating expenses.............................................................. 103 97
--------- ---------
TOTAL OPERATING EXPENSES............................................................ 5,572 8,032
--------- ---------
LOSS FROM OPERATIONS..................................................................... (3,618) (6,544)
--------- ---------
OTHER INCOME (EXPENSES)
Investment income..................................................................... -- 94
Interest expense...................................................................... (2,665) (1,310)
Other income (expenses)............................................................... 61 80
Gain on sale of marketable securities................................................. -- 11,656
--------- ---------
TOTAL OTHER INCOME (EXPENSES)....................................................... (2,604) 10,520
--------- ---------
NET INCOME (LOSS)........................................................................ $ (6,222) $ 3,976
========= =========
EARNINGS (LOSS) PER SHARE:
NET INCOME (LOSS) APPLICABLE TO COMMON SHARES......................................... $ (6,222) $ 3,976
BASIC WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING....................................................................... 886 716
---------- ---------
BASIC NET INCOME (LOSS) PER COMMON SHARE................................................. $ (7.02) $ 5.60
========== =========
DILUTED WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING....................................................................... 1,109 946
---------- ---------
DILUTED NET LOSS PER COMMON SHARE........................................................ $ (14.33) $ (25.20)
========== =========
COMPREHENSIVE INCOME (LOSS) AND ITS COMPONENTS CONSIST OF
THE FOLLOWING:
Net income (loss)................................................................... $ (6,222) $ 3,976
Components of other comprehensive income (loss):
Unrealized holding gains (losses) arising during the period....................... 1,060 (1,398)
Reclassification adjustment for gains included in net income...................... -- (11,656)
---------- ---------
NET COMPREHENSIVE LOSS................................................................... $ (5,162) $ (9,078)
========== =========
See accompanying notes to consolidated financial statements.
3
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
For the three months ended April 30, 2003
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In Thousands)
Preferred
Common Stock Stock Additional Deferred
------------- -------------- Paid in Stock
Shares Amount Shares Amount Capital Compensation
------ ------ ------ ------ ---------- ------------
Balance at January 31, 2003................. 886 $5,318 2 $1 $144,887 $ (5)
Unrealized losses on available for sale
securities...............................
Deferred stock compensation of subsidiary... 46 (46)
Amortization of deferred stock compensation. 51
--- ------ -- -- -------- -----
Net loss....................................
--- ------ -- -- -------- -----
Balance at April 30, 2003................... 886 $5,318 2 $1 $144,933 $ --
=== ====== == == ======== =====
Treasury
Stock Other Total
Accumulated ------------ Comprehensive Stockholders'
Deficit Shares Amount Loss Equity
----------- ------ ------ ------------- -------------
Balance at January 31, 2003.................$(187,536) 1 $(69) $2,928 $(34,476)
Unrealized losses on available for sale
securities............................... 1,060 1,060
Deferred stock compensation of subsidiary... --
Amortization of deferred stock compensation. --
-------- -- ---- ------ -------
Net loss.................................... (6,222) (6,222)
-------- -- ---- ------ -------
Balance at April 30, 2003...................$(193,758) 1 $(69) $3,988 $(39,587)
======== == ==== ====== =======
See accompanying notes to consolidated financial statements.
4
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
For the three months ended April 30, 2002
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(In Thousands)
Preferred
Common Stock Stock Additional Deferred
------------- -------------- Paid in Stock
Shares Amount Shares Amount Capital Compensation
------ ------ ------ ------ ---------- ------------
Balance at January 31, 2003................. 710 $4,263 2 $1 $143,705 $(255)
Stock option and warrant exercises.......... 1 9 (9)
Unrealized losses on available for sale
securities...............................
Realized gains on available for sale
securities...............................
Deferred stock compensation of subsidiary... 45 (45)
Expenses paid with stock issuances.......... 16 91 683
Amortization of deferred stock compensation. 106
--- ------ -- -- -------- -----
Net loss....................................
--- ------ -- -- -------- -----
Balance at April 30, 2003................... 727 $4,363 2 $1 $144,424 $(194)
=== ====== == == ======== =====
Treasury
Stock Other Total
Accumulated ------------ Comprehensive Stockholders'
Deficit Shares Amount Loss Equity
----------- ------ ------ ------------- -------------
Balance at January 31, 2003................. $(161,32) 1 $(69) $ 24,160 $(10,479)
Stock option and warrant exercises.......... --
Unrealized losses on available for sale
securities............................... (1,398) (1,398)
Realized gains on available for sale
securities............................... (11,656) (11,656)
Deferred stock compensation of subsidiary... --
Expenses paid with stock issuances.......... 744
Amortization of deferred stock compensation. 106
-------- -- ---- -------- --------
Net loss.................................... 3,976 3,976
-------- -- ---- -------- --------
Balance at April 30, 2003................... $(157,350) 1 $(69) $ 11,106 $ 2,281
======== == ==== ======== ========
See accompanying notes to consolidated financial statements.
5
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(In Thousands)
Three Months Ended
April 30,
----------------------
2003 2002
---------- ----------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss).................................................................... $ (6,222) $ 3,976
---------- ----------
Adjustments to reconcile net income (loss) to net cash used in operating
activities:
Depreciation and amortization.................................................... 1,040 1,358
Accounts receivable and inventory reserves....................................... (189) 716
Gain on sale of marketable securities............................................ -- (11,656)
Non-cash interest on debentures.................................................. 1,819 774
Deferred and other stock compensation............................................ 51 106
Changes in assets and liabilities:
(Increase) decrease in accounts receivable..................................... 754 (1,638)
Decrease in inventories........................................................ 1,972 1,061
Decrease in other current assets............................................... 149 48
Increase (decrease) in accounts payable........................................ (1,540) 1,032
Increase (decrease) in deferred revenue........................................ (3,327) 43
Increase (decrease) in accrued and other current liabilities................... 508 (28)
---------- ----------
NET CASH USED IN OPERATING ACTIVITIES.............................................. (4,985) (4,208)
---------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES:
(Purchase) disposal of property and equipment........................................ 775 (1,944)
Cash received from sale of marketable securities and other investments............... -- 13,574
Other assets......................................................................... 313 4
---------- ----------
NET CASH PROVIDED BY INVESTING ACTIVITIES.......................................... 1,088 11,634
---------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Payments of short-term debt, net..................................................... -- (153)
Repayment of long-term debt.......................................................... (65) (24)
---------- ----------
NET CASH USED IN FINANCING ACTIVITIES.............................................. (65) (177)
---------- ----------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS........................................ (3,962) 7,249
CASH AND CASH EQUIVALENTS - BEGINNING OF PERIOD......................................... 7,747 14,243
---------- ----------
CASH AND CASH EQUIVALENTS - END OF PERIOD............................................... $ 3,785 $ 21,492
========== ==========
See accompanying notes to consolidated financial statements.
6
Sorrento Networks Corporation (formerly Osicom Technologies, Inc.) (the
"Company," "We," "Our," or "Us") through its subsidiaries designs, manufactures
and markets integrated networking and bandwidth aggregation products for
enhancing the performance of data and telecommunications networks. Our products
are deployed in telephone companies, Internet Service Providers, governmental
bodies and the corporate/campus networks that make up the "enterprise" segment
of the networking marketplace. We have facilities in San Diego, California 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 ended April 30, 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 for the year ended January 31, 2003.
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 quarters ended April 30, 2003 and 2002 have been made. The
results of operations for the quarter ended April 30, 2003 are not necessarily
indicative of the operating results for the full year.
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 quarter ended April 30, 2003 were substantially higher than for the same
comparable quarter 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
predictability 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. In addition our auditors have issued a going
concern qualification to their opinion on our financial statements for the
year-ended January 31, 2003 included in our Annual Report as filed with the SEC
on form 10-K regarding the successful approval and completion of our Capital
Restructuring Plan, which closed and became effective on June 4, 2003. See the
subsequent Events Note in the financials statements included in this quarterly
report.
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
7
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
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 quarters ended April 30, 2003 and 2002 have been made.
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 stocks 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 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. The closing price of
DIGI common stock on April 30, 2003 was $4.24, and is reflected in the valuation
of our marketable securities as of that date. See Subsequent Events.
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 have 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 is
included in the
8
investment in former subsidiary and dividends payable in the accompanying
balance sheet. The aggregate distribution of our ENI shares including the shares
reserved for option and warrant holders has been accounted for at our original
cost of $5.1 million. In addition, we have 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.
The remaining 326,034 ENI shares owned by us were 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
Sorrento subsidiary granted by it to its employees; during the three months
ended April 30, 2003 and 2002 it amortized $5 thousand and $62 thousand,
respectively, of the total $2.6 million initially recorded for deferred stock
compensation.
For non-employees, we compute the fair value of stock-based compensation
in accordance with Statement of Financial Accounting Standards No. 123,
"Accounting for Stock-Based Compensation," and Emerging Issues Tax Force (EITF)
96-18, "Accounting for Equity Instruments that are Issued to Other Than
Employees for Acquiring, or in Conjunction with Selling, Goods or Services." All
such amounts relate to options to acquire common stock of our subsidiary
Sorrento Networks, Inc. ("SNI") granted by it to its consultants; during the
three months ended April 30, 2003 and 2002 it recorded $46 thousand and $44
thousand, respectively, for options granted to consultants.
Recent Accounting Pronouncements
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 June 2002, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 146, "Accounting for
Costs Associated with Exit or Disposal Activities", which addresses accounting
for restructuring and similar costs. SFAS No. 146 supersedes previous accounting
guidance, principally Emerging Issues Task Force ("EITF") Issue No. 94-3. We
have adopted the provisions of SFAS 146 for restructuring activities initiated
after December 31, 2002. SFAS 146 requires that the liability for costs
associated with an exit or disposal activity be recognized when the liability is
incurred. Under EITF No. 94-3, a liability for an exit cost was recognized at
the date of a company's commitment to an exit plan. SFAS 146 also establishes
that the liability should initially be measured and recorded at fair value.
Accordingly, SFAS 146 may affect the timing of recognizing future restructuring
costs as well as the amount recognized. Adoption of this standard did not have
any immediate effect on our consolidated financial statements.
9
In August 2001, the Financial Accounting Standards Board issued SFAS No.
143, Accounting for Asset Retirement Obligations. This Statement is effective
for fiscal years beginning after June 15, 2002. SFAS No. 143 provides accounting
requirements for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. Under the
Statement, the asset retirement obligation is recorded at fair value in the
period in which it is incurred by increasing the carrying amount of the related
long-lived asset. The liability is accreted to its present value in each
subsequent period and the capitalized cost is depreciated over the useful life
of the related asset. The adoption of SFAS 143 did not have a material effect on
our financial position or results of operations.
Balance Sheet Detail
Inventories at April 30, 2003 and January 31, 2003 consist of:
April 30, January 31,
2003 2003
----------- -------------
Raw material......................................................... $10,478 $11,306
Work in process...................................................... 2,192 2,265
Finished goods....................................................... 5,255 6,326
------- -------
17,925 19,897
Less: Valuation reserve.............................................. (5,952) (5,963)
------- -------
$11,973 $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
April 30, 2003, and January 31, 2003, marketable securities were as follows:
Unrealized Market
Cost Gains Value
---------- ------------ ---------
April 30, 2003:
Digi.................................................... $1,009 $3,920 $4,929
Entrada................................................. 22 69 91
------ ------ ------
$1,031 $3,989 $5,020
====== ====== ======
January 31, 2003:
Digi.................................................... $1,009 $2,884 $3,893
Entrada................................................. 22 44 66
------ ------ ------
$1,031 $2,928 $3,959
====== ====== ======
Intangible Assets--Under SFAS No. 142, 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, will
continue to be amortized over their useful lives.
The net carrying value of finite life intangible assets, consisting of
purchased technology, as of April 30, 2003, is $327 thousand, net of
amortization and is allocated to the Meret Optical Communications segment.
The change in the net carrying amount of finite life intangible assets
during the three months ended April 30, 2003 is due to amortization of $103
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 have a face value of $32.2 million,
10
which is convertible into our common stock at $144.20 per share. At maturity we
may elect to redeem the debentures for cash and we have the option of paying the
interest on these debentures in shares of our common stock. In addition, the
purchasers received four year warrants to acquire an additional 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 are subject to
adjustment.
In accordance with Emerging Issues Task Force ("EITF") No. 00-27 we have
accounted for the fair value of warrants issued to the purchasers and placement
agent and the fair value of the deemed beneficial conversion feature, which
results solely as a result of the required accounting, of the debenture as a
reduction to the face value of the debentures with an offsetting increase to
additional paid in capital. These amounts as well as the issuance costs paid in
cash are amortized as additional interest expense over the period the debentures
are outstanding. Interest expense during the three months ended April 30, 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. At April 30, 2003 and January 31, 2003
debentures payable consists of:
April 30, January 31,
2003 2003
----------- ------------
Face Value................................................................ $ 32,200 $ 32,200
Issuance costs............................................................ (2,451) (2,451)
Value of warrants and deemed beneficial Conversion feature................ (19,525) (19,525)
-------- --------
Debenture book value at issuance....................................... 10,224 10,224
Accumulated amortization of Issuance costs................................ 1,084 881
Value of warrants and deemed beneficial conversion feature................ 8,632 7,016
-------- --------
$ 19,940 $ 18,121
======== ========
On June 4, 2003 our debt and equity restructuring plan became effective
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. See Subsequent Events.
Stockholders' Equity
We are authorized to issue the following shares of stock:
7,500,000 shares of Common Stock ($6.00 par value)
2,000,000 shares of Preferred Stock ($.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 April 30, 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.
11
On March 22, 2001, we completed a private placement of 76,300
unregistered shares of our common stock receiving net proceeds of $9.6 million.
In addition, the purchasers received three-year warrants to acquire an
additional 19,075 shares of our common stock at $163.80 per share. For a period
of 18 months from the March 22, 2001 completion date in the event we were to
issue shares of common stock or equity securities convertible into our common
stock at a price less than $131.062 per share, the purchasers would be entitled
to receive additional shares of common stock.
During 2000, SNI completed a sale of 8,596,333 shares of its Series A
Convertible Preferred Stock receiving net proceeds of $46.6 million from a group
of investors. 1,467,891 shares were purchased by, and a finders fee of $2.0
million was paid through the issuance by Sorrento of an additional 357,799
shares of its Series A Convertible Preferred Stock to, entities in which one of
our outside directors at the time, who later in 2000 served for several months
as our Chairman and CEO, was a partner or member pursuant to a previously
contracted right of participation.
One of our current outside directors purchased 183,486 shares in this
placement. At the time of purchase, he was not one of our directors. This
individual is also a director of Liberty Media Corporation, which owns an
approximate 74% economic interest representing an approximate 94% voting
interest in United GlobalCom ("UGC"). The purchaser of 3,027,523 shares in this
placement is an indirect subsidiary of UGC. Liberty Media also holds convertible
debt in this Series A holder, which it has agreed to exchange for shares in UGC.
Each share of SNI's Series A Preferred Stock is convertible into one
share of SNI's common stock at the option of the holder, may vote on an "as
converted" basis except for election of directors, and has a liquidation
preference of $5.45 per share. The shares are automatically converted into 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 receipt of such a
request, our Sorrento subsidiary has the obligation to redeem the shares in
cash, if funds are lawfully available for such a redemption, or to redeem such
pro rata portion as to which a lesser amount of lawfully available funds do
exist. In April 2001, our Sorrento subsidiary 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.
As of April 30, 2003 and January 31, 2003, the Series A Preferred Stock
has been reclassified as a current liability since the holders have exercised
their right to request that SNI redeem the shares. The Series A liability can
only be paid through lawfully available funds that would normally be generated
from SNI profitable operations, which we do not currently have available or
foresee the availability of the near future. As of June 4, 2003, we have
consummated our restructuring transaction and have cancelled all outstanding
Series A Preferred Stock. See Subsequent Events.
Stock Option Plans
We have four stock options plans in effect: The 2000 Stock Incentive
Plan, the 1988 Stock Option Plan, the 1997 Incentive and Non-Qualified Stock
Option Plan and the 1997 Director Stock Option Plan. The stock options have been
made available to certain employees and consultants. All options are granted at
not less than fair value at the date of grant and have terms varying from 3 to
10 years. The purpose of these plans is to attract, retain, motivate and reward
our officers, directors, employees and consultants to maximize their
contribution towards our success. In addition, our shareholders approved a 2003
plan in the form described in our Apri 15, 2003 proxy statement.
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.
12
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.
For the three months ended,
April 30
---------------------------
2003 2002
------------ ----------
Net earnings (loss):
As reported.................................................... $(6,222) $ 3,976
Add: Stock-based employee compensation -- --
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards, net
of related tax effects....................................... (291) (1,467)
------- -------
Pro forma...................................................... $(6,513) $ 2,509
======= =======
Earnings (loss) per share:
Basic EPS as reported.......................................... $ (7.02) $ 5.60
======= =======
Pro forma basic EPS............................................ $ (7.35) $ 3.50
======= =======
Diluted EPS as reported........................................ $(14.33) $(25.20)
======= =======
Pro forma diluted EPS.......................................... $(14.59) $(26.79)
======= =======
Earnings Per Share Calculation
The following data show the amounts used in computing basic earnings per
share for the quarters ended April 30, 2003 and 2002.
Three Months Ended April 30,
------------------------------
2003 2002
-------- --------
Net income (loss) available to common
shareholders used in basic EPS............................... $(6,222) $ 3,976
======= =======
Average number of common shares
used in basic EPS............................................ 886,050 716,142
======= =======
We had a net loss for the quarter ended April 30, 2003. Accordingly, the
effect of dilutive securities including convertible preferred stock, vested and
non-vested stock options and warrants to acquire common stock are not included
in the calculation of EPS because their effect would be antidilutive. Our
convertible debentures create a dilutive situation even though the company had a
net loss for the quarter. The following data shows the effect on income and the
weighted average number of shares of dilutive potential common stock.
13
Three Months Ended April 30,
2003 2002
-------------- --------------
Net income (loss) available to common
shareholders used in basic EPS................................ $ (6,222) $ 3,976
Less: Convertible debt issuance costs............................ (12,260) (28,620)
Plus: Convertible debt interest.................................. 2,584 774
--------- ---------
Net loss available to common
shareholders used in diluted EPS.............................. $ (15,898) $(23,870)
========== ========
Average number of common shares
used in basic EPS............................................. 886,050 716,142
---------- --------
Effect of dilutive securities:
Convertible debentures........................................... 223,301 223,301
Warrant exercises................................................ -- 6,198
---------- --------
Average number of common shares and dilutive
potential common stock used in diluted EPS.................... 1,109,351 945,641
========== ========
Litigation
On September 10, 2001, holders of a portion of the outstanding Series A
Preferred Stock of our Sorrento subsidiary obtained a preliminary injunction
from the Delaware Court of Chancery prohibiting SNI from issuing further shares
of its Series A Preferred Stock or incurring any additional debt without the
consent of the holders of a majority of the currently outstanding shares of such
Series A Preferred Stock. On January 23, 2002, the Delaware Supreme Court
affirmed the granting of the preliminary injunction.
On October 19, 2001, an amended complaint was filed in the injunction
action, adding as named defendants, the Company, our Meret subsidiary, certain
present and former officers and directors of the Company and our subsidiaries as
well as our investment bankers. The amended complaint also added, among other
things, claims for fraud, securities fraud, breach of fiduciary duty,
conspiracy, and intentional interference with contract as well as requesting the
appointment of a receiver for our Sorrento subsidiary, all which claims are
based on alleged wrongs committed in connection with or since the Series A
placement. Our Sorrento subsidiary and the original individual defendants have
all answered this amended complaint denying all allegations of wrongdoing. The
new defendants have all moved to dismiss the amended complaint. Management
believes the allegations contained in the amended complaint are without merit.
On December 14, 2001, the plaintiffs filed motions to sequester the
common stock of our Sorrento subsidiary owned by Meret and the Sorrento Series A
preferred stock that we own, as an alternative method of obtaining jurisdiction
over us and Meret in the Delaware litigation. Management also believes that
these motions are without merit.
Currently, hearings on all pending motions have been taken off calendar
at the request of all parties. The Exchange Agreement entered into in connection
with our recently completed capital restructuring provides that this litigation
will be dismissed with 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. See Subsequent Events.
During June 2000, we entered into various agreements with Par Chadha,
our former CEO and Chairman, which, among other matters, provides for payments
of $250 thousand per year for three years of consulting services and loans by us
for the exercise of previously granted options to acquire 58,925 options at
prices varying from $140.60 to $985.00 per share. As the members of our Board of
Directors at the time of his resignation ceased to represent more than 50% of
the Board in October 2000, all payments for consulting services were accelerated
and no future consulting services are required. During October 2000, Mr. Chadha
exercised 3,556 options, applying the $500 thousand accelerated payment to the
exercise. In addition, he exercised 25,369 options for which we were
contractually obligated to loan the $5.0 million due on the exercise. Mr. Chadha
provided us with written notification dated in September 2001 that he does not
have any obligations under the agreements. We have notified him that we do not
agree with his interpretation of his repayment obligations under the terms of
the agreements.
During December 2001, we entered into an agreement whereby the
25,369-option exercise was rescinded. Mr. Chadha returned the 25,369 shares to
us for cancellation and we cancelled the receivable due from him and restored
the original option agreements. In June 2002, we filed with the Superior Court
of California, County of Los Angeles a Complaint for Declaratory Relief
regarding the interpretation of the agreement. Also in June 2002, Mr. Chadha
filed a lawsuit against us in the Superior Court of California, County of Los
Angeles, seeking declaratory
14
relief with respect to the interpretation of his separation agreement and in
addition, alleging breach of contract with respect to his option exercise rights
and fraud in connection with his rescission agreement. In February 2003, both of
these lawsuits were dismissed without prejudice to facilitate settlement
negotiations, but they can be refiled at any time. In April 2003, an agreement
in principle to settle these lawsuits was reached, subject to the execution of a
definitive agreement. While there can be no assurance that such a definitive
settlement agreement will be executed, the Company has been informed by counsel
for all parties that the agreement is acceptable and will be signed. Should the
cases be refiled, which now appears unlikely, and should Mr. Chadha prevail in
Court, in addition to any other relief that may be granted, we may be required
to issue him 58,925 shares of our stock for no consideration, which would be
valued at $292 thousand as of April 30, 2003, and/or pay him cash damages, which
he alleges to be in excess of $4 million.
In addition, claims in arbitration have been filed by two of our former
financial officers and employees who worked in our Santa Monica office, which
has now 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 filed a lawsuit against United Pan Europe Communications, N.V., one
of our customers and a related party to one of Sorrento's Series A shareholders,
in connection with a past due receivable in the amount of $1.6 million for
equipment shipped in 2000. The defendant filed for protection under the federal
bankruptcy laws, and pursuant to the Exchange Agreement entered into in
connection with our capital restructuring, we executed a definitive settlement
agreement and a stipulation of dismissal with prejudice resolving this lawsuit
in return for a payment of $350 thousand and the return of certain of the
equipment previously shipped. We have received the payment of $350 thousand from
UPC and, in accordance with the terms of the exchange agreement, have paid that
same amount to certain Series A Preferred Stock holders. The equipment has also
been returned. Accordingly, this lawsuit has been dismissed with prejudice.
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.
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.
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.
15
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 April 30, 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:
April 30, January 31,
2003 2003
-------------- --------------
Customer A............................................................. 32.9% 29.6%
Customer B............................................................. 28.5% 0.2%
Customer C............................................................. 15.5% 31.2%
Customer D............................................................. 10.8% 15.9%
Customer E............................................................. 2.0% 18.7%
The following data shows the customers accounting for more than 10% of
net consolidated sales:
April 30, April 30,
2003 2002
-------------- --------------
Customer A.............................................................. 34.7% 9.2%
Customer B.............................................................. 21.7% 26.3%
Customer C.............................................................. 11.3% 0.8%
Customer D.............................................................. 7.9% 21.9%
Segment Information
Sorrento Meret
Networks Optical Other Total
-------- ------- ------- -------
Three Months Ended April 30, 2003
Revenues from external customers.................................... $ 6,760 $1,101 -- $ 7,861
Cost of goods sold.................................................. 5,053 854 -- 5,907
------ ------ ------ -------
Gross profit...................................................... 1,707 247 -- 1,954
------ ------ ------ -------
Segment income (loss) from operations............................... (2,961) 120 (777) (3,618)
Depreciation and amortization expense............................... 887 129 24 1,040
Valuation allowance additions (reductions):.........................
Receivables and inventory....................................... (178) (11) -- (189)
Capital asset disposals, net........................................ (775) -- -- (775)
Total assets........................................................ 25,005 5,382 17,702 48,089
Three Months Ended April 30, 2002
Revenues from external customers.................................... $ 4,794 $1,209 -- $ 6,003
Cost of goods sold.................................................. 3,769 746 -- 4,515
------- ------- ------ -------
Gross profit...................................................... 1,025 463 -- 1,488
------- ------- ------ -------
Segment income (loss) from operations............................... (5,719) 22 (847) (6,544)
Depreciation and amortization expense............................... 769 133 456 1,358
Valuation allowance additions:......................................
Receivables and inventory....................................... 270 447 105 822
Capital asset additions, net........................................ 1,662 212 70 1,944
Total assets........................................................ 59,572 8,187 15,605 83,364
16
Subsequent Events
Sale of DIGI Stock
On May 7, 2003, we sold our remaining security interest in DIGI
International Inc. (Nasdaq: DGII) for $4.26 per share. The purchaser of the
stock was DIGI, itself. The proceeds from this sale, in the amount of $5.0
million, were deposited on May 7, 2003.
Restructuring Plan
The proposed capital and corporate restructuring plan outlined below, was
approved by shareholders on May 29, 2003 and was completed and became
effective on June 4, 2003.
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 contemplate 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 shares of common stock and the New Debentures to be issued in the
Exchange will represent, in the aggregate, approximately 87.5% of our common
stock on a diluted basis. This percentage takes into account the total number of
existing shares outstanding, the shares to be issued to the holders of the
Debentures and the Preferred Stock at the closing, the shares issuable upon
conversion of $12.5 million of New Debentures, and the shares issuable upon
conversion of warrants to be issued to existing shareholders. This percentage
does not take into account new employee stock options, shares issuable upon
conversion of approximately $600 thousand in New Debentures to be issued to
certain holders of the Preferred Stock to pay certain legal fees, and certain
other issuances. We issued 8,029,578 shares of common stock to the holders of
the Debentures and the Preferred Stock upon consummation of the Exchange. The
New Debentures that were issued in the Exchange (not including the New
Debentures to be issued in satisfaction of legal fees) are convertible into
approximately 19.5% of our shares of common stock, calculated on the same
diluted basis.
The Exchange Agreement states that our existing shareholders will retain
7.5% of our common stock on the same diluted basis, and will receive
non-transferable warrants to purchase approximately 5% of our common stock,
exercisable beginning one year after the closing. The exercise price of the
warrants is $5.96. The shareholders' date of record to receive warrants is May
28, 2003. The warrants will be exercisable at any time prior to August 2, 2007,
provided that any such exercise of the warrants will be subject to the
effectiveness of a registration statement with respect to the common shares to
be issued upon exercise of the warrants. We may repurchase the warrants for a
nominal price, upon 30 days prior notice, at any time after the volume-weighted
average market price of our common stock for any ten consecutive trading days
equals or exceeds 150% of the exercise price.
The New Debentures will mature on August 2, 2007 and will be convertible
at any time at the option of the holder at a conversion price of $5.42. Subject
to certain limits, interest on the New Debentures may be paid, at our option,
either in cash, additional New Debentures or our common stock.
The New Debentures include covenants restricting our ability to incur
senior or subordinated debt or preferred stock other than $5.0 million in lease
or equipment financing and a $5.0 million revolving credit facility (up to $10.0
million with certain consents), as well as other standard covenants and
protective provisions. At any time prior to the maturity date, we may redeem for
cash on a pro rata basis some or all of the New Debentures at par, plus accrued
interest.
The New Debentures are secured by substantially all of our assets and
those of our subsidiaries (with certain exceptions, including the real estate
owned by Meret Communications, Inc., and Sorrento Valley Real Estate Holdings,
LLC). No later than one year following the closing date, we must provide a
second mortgage on such real
17
estate as security for the New Debentures. When we have done so and we have
merged our subsidiaries into us, most of the remaining collateral will be
released or subordinated at our request to permit us to obtain a secured loan
from a bank.
Until one year after the closing and subject to certain exceptions,
exchanging holders of Debentures and Preferred Stock who continue to hold common
stock received in the Exchange and New Debentures will be entitled to certain
weighted average anti-dilution protection for such continued holdings with
respect to certain additional issuances of our common stock. In addition, if we
are required to issue shares of common stock upon the exercise of any right,
option or warrant to purchase common stock that was issued prior to the closing
and was not listed on the option schedule to the exchange agreement, then we
will issue additional shares of common stock to the exchanging holders, and will
adjust the conversion price of the New Debentures sufficient to offset the
dilutive impact of such issuances.
The Series A holders as a group may request that we appoint one new
director to our Board of Directors. The Debenture holders as a group may also
request that we appoint one new director to our Board of Directors. The new
director(s) would continue in office until the next regularly scheduled annual
meeting of our shareholders and shall be nominated for re-election at such
meeting.
We merged with and into a newly-formed Delaware corporation immediately
prior to the closing of the restructuring, which was formed solely for the
purpose of effecting the change in our state of incorporation from the State of
New Jersey to the State of Delaware. Promptly after the closing date of the
restructuring transaction, and in no event later than one year after the closing
date, our subsidiaries, Sorrento Networks, Inc., Meret Communications, Inc., and
Sorrento Valley Real Estate Holdings, LLC, will be merged with and into us.
The following table shows a proforma comparison of our balance sheet as of April
30, 2003. It demonstrates, among other things, our positive shareholder equity
in excess of $10.0 million, satisfying the applicable NASDAQ listing
requirement.
PROFORMA CONDENSED CONSOLIDATED BALANCE SHEET (UNAUDITED)
(In Thousands)
Historical Proforma Proforma
April 30, 2003 Adjustments April 30, 2003
-------------- ----------- --------------
ASSETS
CURRENT ASSETS
Cash and equivalents $ 3,785 $ 3,785
Accounts receivable, net 5,000 5,000
Inventory, net 11,973 11,973
Other current assets 592 592
Investment in marketable securities 5,020 5,020
- -------------------------------------------------------------------------------------------------------
TOTAL CURRENT ASSETS 26,370 -- 26,370
- -------------------------------------------------------------------------------------------------------
PROPERTY AND EQUIPMENT, NET 15,390 15,390
OTHER ASSETS 6,329 6,329
- -------------------------------------------------------------------------------------------------------
TOTAL ASSETS $48,089 $48,089
=========================================================================================================
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Current maturities of long term debt 204 204
Accounts payable 3,595 3,595
Deferred Revenue 373 373
18
Accruals and other current liabilities 11,068 11,068
Preferred Stock 48,800 (48,800)A (0)
- ----------------------------------------------------------------------------------------------------------
TOTAL CURRENT LIABILITIES 64,040 (48,800) 15,240
- ----------------------------------------------------------------------------------------------------------
Debentures payable, net of unamortized costs and discounts 19,940 (32,200)B
6,066 B
6,194 B
13,100 C 13,100
Other long-term liabilities 3,696 3,696
- ----------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES 87,676 (55,640) 32,036
- ----------------------------------------------------------------------------------------------------------
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value; liquidation preference $1,353 1 1
Common stock 5,318 43,520 D 48,838
Additional paid in capital 144,933 2,933 E
(6,066)B 141,800
Accumulated deficit (193,758) (2,933)E
(6,194)B
24,380 B (178,505)
Accumulated comprehensive loss 3,988 3,988
Treasury stock (69) (69)
- ----------------------------------------------------------------------------------------------------------
TOTAL STOCKHOLDERS' EQUITY (39,587) 55,640 16,053
- ----------------------------------------------------------------------------------------------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $48,089 -- $48,089
==========================================================================================================
Notes on the Proforma Consolidated Balance Sheet:
A To record the retirement of the Series A shares.
B To record reacquisition of the Outstanding Debentures, including the
reacquisition of the beneficial conversion option associated with the
convertible debt. An entry of $6.1 million is recorded to additional paid in
capital to reflect the estimated value of the beneficial conversion option at
the date of extinguishment. An additional $6.2 million representing the
unamortized balance of the previously issued debt costs and incremental value
of the beneficial conversion feature not reacquired will be recorded as part
of the gain on extinguishment.
C To record the issuance of the Exchange Debentures $12.5 million and the Fee
Amount Debentures $600 thousand The Fee Amount Debentures were issued to
certain exchanging holders in satisfaction of certain legal fees incurred by
them in litigation with the Company.
D To record the value of the new shares of common stock issued to holders of
the Outstanding Debentures and Series A. Amount is estimated at 8,029,578
shares at a per share price of $5.42. This is the volume-weighted average
closing price of the Company's common stock on the ten trading days ending on
the third trading day prior to the closing, which is also the conversion
price for the Exchange Debentures and the Fee Amount Debentures.
E To record the upcoming issuance of the New Warrants to existing shareholders.
The value of the New Warrants was determined using the Black Scholes option
pricing model based on the following inputs: Option price of $5.96, estimated
life of 4 years, volatility of 173%, no dividends and a risk free rate of
return of 2.3%.
NASDAQ Listing
Completion of the restructuring plan has satisfied the shareholder equity
requirement for continued listing on the NASDAQ National Market. As noted above,
as a result of the consummation of the restructuring transaction, we now have a
positive shareholders' equity in excess of $10.0 million.
19
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations.
Certain statements contained in this Quarterly Report on Form 10-Q,
including, without limitation, statements containing the words "believes",
"anticipates", "estimates", "expects", and words of similar import constitute
"forward-looking statement" within the meaning of the Private Securities
Litigation Reform Act of 1995.
Management's Discussion and Analysis of Financial Condition and Results
of Operations should be read in conjunction with the consolidated unaudited
financial statements and related notes thereto. Further reference should be made
to our Form 10-K for the year ended January 31, 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.
Results of Operations/Comparison of the Quarters ended April 30, 2003 and 2002.
Net sales. Our consolidated net sales increased $1.9 million or 31% to
$7.9 million for the quarter ended April 30, 2003 compared to net sales of $6.0
million for the quarter ended April 30, 2002. Net sales for Sorrento Networks
Inc. ("SNI"), the Company's primary operating subsidiary, increased $2.0 million
or 41% to $6.8 million for the quarter ended April 30, 2003 as compared to net
sales of $4.8 million for the quarter ended April 30, 2002. This increase is the
reflects increased domestic sales resulting from a substantial backlog at the
end of last quarter.
During the three months ended April 30, 2003 SNI shipped product to
fourteen customers of which five customers represented a combined 92% of our
revenues. During the quarter ended April 30, 2002, we shipped product to ten
customers of which five customers represented a combined 88% of our 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 $1.1 million, or by 15% for the quarter
ended April 30, 2003 from $1.2 million for the comparable quarter 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.
20
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 remained at 25% for the quarters ended
April 30, 2003 and 2002. Consolidated gross profit was $2.0 million, an increase
of 31% for the quarter ended April 30, 2003 from $1.5 million for the quarter
ended April 30, 2002.
Gross profit for SNI increased to $1.7 million the quarter ended April
30, 2003, as compared to $1.0 million in the quarter ended April 30, 2002, an
increase of 67%. The gross margin increases were primarily the result of higher
sales volume and lower fixed manufacturing overhead in our cost of shipments for
the quarter. We continue to monitor our costs of production and reduce costs
where ever possible.
For the quarter ended April 30, 2003 gross profit for Meret decreased to
$247, or by 47%, from $463 for the comparable quarter last year. Meret's gross
margins decreased to 22% for the quarter ended April 30, 2003 from 42% for the
comparable quarter last year. The gross margin decrease was primarily the result
of product mix, lower sales volume, and higher fixed manufacturing overhead in
our cost of shipments for the quarter.
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 $2.2 million or 28% of net sales, for the
quarter ended April 30, 2003 from $3.4 million, or 57% of net sales for the
quarter ended April 30, 2002. This decrease was primarily the result of cost
reduction efforts implemented and 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 $1.6 million, or 20% of net sales, for the
quarter ended April 30, 2003 from $2.5 million, or 42% of nets sales for the
quarter ended April 30, 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 $1.6 million, or 20% of net sales, for the
quarter ended April 30, 2003 from $1.9 million, or 31% of net sales, for the
quarter ended April 30, 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.
Deferred and other stock compensation. Deferred and other stock
compensation for the quarter ended April 30, 2003 includes $51 of amortization
of deferred stock compensation resulting from the amortization of the value of
stock options granted to consultants as compared with $62 of amortization of
deferred stock compensation and $44 of expenses for the comparable quarter 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 is being amortized on an accelerated basis over the vesting
period of the options.
Other income (charges). Other income (charges) from operations was a $2.6
million charge for the quarter ended April 30, 2003 compared to a $10.5 million
gain for the quarter ended April 30, 2002. The current year quarter consists
primarily of costs associated with our convertible debenture which includes
deferred 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.
The quarter ended April 30, 2002 consisted of an $11.7 million gain on the sale
of marketable securities as a result of the sale of 3,396,221 shares of
NETsilicon, Inc. common stock to Digi International, Inc. for $13.6 million in
cash. Expenses associated with our convertible debenture included interest of
$766, paid in common stock, amortization of issuance costs of $36 and
amortization of the fair value of the warrants issued to the purchasers and
placement agent and the deemed beneficial conversion feature of $398.
21
Income taxes. There was no provision for income taxes for the quarters
ended April 30, 2003 and 2002. We have carry forwards of domestic federal net
operating losses, which may be available, in part, to reduce future taxable
income in the United States. However, due to potential adjustments to the net
operating loss carry forwards as provided by the Internal Revenue Code with
respect to future ownership changes, future availability of the tax benefits is
not assured. In addition, we provided a valuation allowance in full for our
deferred tax assets, as it is our opinion that it is more likely than not that
some portion or all of the deferred tax assets will not be realized.
Liquidity and Capital Resources
We finance our operations through a combination of internal funds,
investments and debt and equity financing. At April 30, 2003, which was prior to
the consummation of our restructuring transaction which closed on June 4, 2003
and is therefore no longer applicable, our working capital was a negative $37.7
million including $5.0 million of investments in marketable securities and $3.8
million in cash and cash equivalents. See subsequent events. The primary reason
for our negative working capital condition is that $48.8 million, reflecting the
obligation due to Series A Holders obligation as a result of their right of
redemption, was classified at year end January 31, 2002, as a current liability.
The Series A liability can only be paid through lawfully available funds that
would normally be generated from SNI profitable operations, which we do not
currently have available or foresee the availability of in the near future. As
previously discussed, we have recently consummated the restructuring of both our
Senior Convertible Debentures of $32.2 million and the SNI Series A Preferred
liability of $48.8 million. See the Subsequent Events note in the financial
statements included in this quarterly report.
Operations
Our operations used cash flows of $5.0 million during the quarter ended
April 30, 2003. During the quarter ended April 30, 2002 continuing activities
used cash flows of $4.2 million. The increase in cash flows used by operations
resulted primarily from a decrease in our deferred revenue and a decrease in
accounts payable, offset by a decrease in accounts receivable and not having a
gain from the sales of marketable securities in the current quarter.
We have incurred significant losses and negative cash flows from
operations for the past two years. Sorrento Networks, Inc., 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 by the sale of securities and the
issuance of debt. There can be no assurance that similar funding will be
available in the future. In addition, after our restructuring efforts are
completed, there will be certain restrictions on us in both the amount of debt
we can incur in future periods and the types of securities that we will be able
to 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 we anticipate
that our future revenues will also be negatively impacted. As a result, our need
for additional working capital may 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 57 days of average sales days outstanding as compared to 144 days
outstanding for the same period in the prior year. Additionally, we have also
improved our inventory turnover from 1 times per year to 2 times per year when
compared to the same period in the prior year. Both the reduction in receivables
and inventory have helped to 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
22
Our investing activities during the quarter ended April 30, 2003 provided
cash flows of $1.1 million from the disposal of $775 thousand property and
equipment and a $313 thousand decrease in other assets. During the quarter ended
April 30, 2002, investing activities provided cash flows of $11.6 million. We
purchased property and equipment of $1.9 million and received $13.6 million on
the sale of marketable securities and other assets.
Financing Activities
Our financing activities during the quarter ended April 30, 2003 used
cash of $67 thousand consisting primarily of the repayment of debt. During the
quarter ended April 30, 2002, financing activities used cash flows of $177
thousand, which also consisted primarily of repayment of debt.
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.
Further, we anticipate we will need to sell our marketable securities to finance
our working capital needs for future periods. Our holdings of marketable
securities are highly volatile and do not trade in large volume. There can be no
assurance that when we need to sell our holdings in marketable securities we
will be able to obtain a market value price for the securities without
negatively impacting the price of such securities. We continue to reduce our
operating costs and have initiated activities to raise additional working
capital. 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. In addition our auditors have issued a
going concern qualification to their opinion on our financial statements for the
year-ended January 31, 2003 included in our Annual Report as filed with the SEC
on form 10-K regarding the successful approval and completion of our Capital
Restructuring Plan, which closed and became effective on June 4, 2003. See the
Subsequent Events note in the financial statements included in this quarterly
report.
Contractual Cash Obligations
The following tables quantify our future contractual obligations
and commercial commitments as of April 30, 2003 (dollars in thousands):
Contractual Obligations
Payments due in fiscal years
----------------------------------------------------------
Remainder
Total 2004 2005 2006 2007 2008 Thereafter
------- ---------- ------- ---- ---- ---- ----------
Long-term Debt.................................. $ 3,618 $ 34 $ 49 $ 54 $ 58 $63 $3,360
Capital Leases.................................. 193 138 55 -- -- -- --
Operating Leases................................ 558 209 158 131 42 18 --
7.75% convertible debentures (a)................ 32,200 -- 32,200 -- -- -- --
Series A, preferred stock put (b)............... 48,800 48,800 -- -- -- -- --
------- ------- ------- ---- ---- ---- ------
Total........................................... $85,369 $49,181 $32,462 $185 $100 $81 $3,360
======= ======= ======= ==== ==== ==== ======
(a) Maturity date, August 2, 2004
(b) The Series A has a liquidation preference, with the holders
having a right to have the outstanding shares repurchased in
the event an initial public offering did not take place at
our subsidiary, SNI, by March 1, 2001. The IPO did not take
place and a majority of Series A holders exercised their
redemption right. SNI has not repurchased those shares
because it does not have legally available funds to do so.
Applicable law prohibits a repurchase of equity securities
when the capital of the corporation is impaired or when such
repurchase would cause an impairment of the capital of the
corporation. SNI has not had funds legally available to
repurchase any of its equity securities since April 2001, and
most likely will not in the foreseeable future.
23
Note: As a result of the capital restructuring which became effective on
June 4, 2003 completing, the debt obligations to our convertible debenture
holders of $32,200 and Series A preferred stock holders of $48,800, were
eliminated and a new convertible debenture of $12,500 was issued, with a
maturity date of August 2, 2007. See the Subsequent Events note in the
financial statements included in this quarterly filing.
Securities Authorized For Issuance Under Equity Compensation Plans
The following table provides information as of April 30, 2003
regarding compensation plans (including individual compensation arrangements)
under which equity securities of Sorrento 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))
------------------------- --------------------------- -----------------------------
(a) (b) (c)
----------- ---------- -------------
Plan Category
Equity Compensation
Plans Approved by
security Holders *(FIBR) 294,277 $387.53 260,723
--------- ------- ----------
Equity Compensation
Plans not Approved by
Security Holders (SNI) 3,296,003 $ 4.93 20,000,000
--------- ------- ----------
Total 3,590,280 $ 36.29 20,260,723
--------- ------- ----------
* As adjusted for stock splits.
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
24
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 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 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
25
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 June 2002, FASB issued Statement of Financial Accounting Standards
("SFAS") No. 146, "Accounting for Costs Associated with Exit or Disposal
Activities", which addresses accounting for restructuring and similar costs.
SFAS No. 146 supersedes previous accounting guidance, principally Emerging
Issues Task Force ("EITF") Issue No. 94-3. We have adopted the provisions of
SFAS 146 for restructuring activities initiated after December 31, 2002. SFAS
146 requires that the liability for costs associated with an exit or disposal
activity be recognized when the liability is incurred. Under EITF No. 94-3, a
liability for an exit cost was recognized at the date of a company's commitment
to an exit plan. SFAS 146 also establishes that the liability should initially
be measured and recorded at fair value. Accordingly, SFAS 146 may affect the
timing of recognizing future restructuring costs as well as the amount
recognized. Adoption of this standard did not have any immediate effect on our
consolidated financial statements.
In August 2001, the Financial Accounting Standards Board issued SFAS No.
143, Accounting for Asset Retirement Obligations. This Statement is effective
for fiscal years beginning after June 15, 2002. SFAS No. 143 provides accounting
requirements for obligations associated with the retirement of tangible
long-lived assets and the associated asset retirement costs. Under the
Statement, the asset retirement obligation is recorded at fair value in the
period in which it is incurred by increasing the carrying amount of the related
long-lived asset. The liability is accreted to its present value in each
subsequent period and the capitalized cost is depreciated over the useful life
of the related asset. The adoption of SFAS 143 did not have a material effect on
our financial position or results of operations.
Effects of Inflation and Currency Exchange Rates
We believe that the relatively moderate rate of inflation in the United
States over the past few years has not had a significant impact on our sales or
operating results or on the prices of raw materials. There can be no assurance,
however, that inflation will not have a material adverse effect on our operating
results in the future.
The majority of our sales and expenses are currently denominated in U.S.
dollars and to date our business has not been significantly affected by currency
fluctuations. However, we conduct business in several different countries and
thus fluctuations in currency exchange rates could cause our products to become
relatively more expensive in particular countries, leading to a reduction in
sales in that country. In addition, inflation in such countries could increase
our expenses. In the future, we may engage in foreign currency denominated sales
or pay material amounts of expenses in foreign currencies and, in such event,
may experience gains and losses due to currency fluctuations. Our operating
results could be adversely affected by such fluctuations.
Other Matters
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
26
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.
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
We maintain disclosure controls and procedures, which we have designed to
ensure that material information related to Sorrento Networks Corporation,
including our consolidated subsidiaries, is disclosed in our public filings on a
regular basis. In response to recent legislation and proposed regulations, we
reviewed our internal control structure and our disclosure controls and
procedures. We believe our pre-existing disclosure controls and procedures are
adequate to enable us to comply with our disclosure obligations.
Within 90 days prior to the filing of this report, members of the
Company's management, including the Company's Chief Executive Officer, Phillip
Arneson, and Chief Financial Officer, Joe Armstrong, evaluated the effectiveness
of the design and operation of the company's disclosure controls and procedures.
Based upon that evaluation, Mr. Arneson and Mr. Armstrong concluded that the
Company's disclosure controls and procedures are effective in causing material
information to be recorded, processed, summarized and reported by management of
the Company on a timely basis and to ensure that the quality and timeliness of
the Company's public disclosures complies with its SEC disclosure obligations.
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.
27
PART II
OTHER INFORMATION
Item 1: Legal Proceedings
On September 10, 2001, holders of a portion of the outstanding Series A
Preferred Stock of our Sorrento subsidiary obtained a preliminary injunction
from the Delaware Court of Chancery prohibiting SNI from issuing further shares
of its Series A Preferred Stock or incurring any additional debt without the
consent of the holders of a majority of the currently outstanding shares of such
Series A Preferred Stock. On January 23, 2002, the Delaware Supreme Court
affirmed the granting of the preliminary injunction.
On October 19, 2001, an amended complaint was filed in the injunction
action, adding as named defendants, the Company, our Meret subsidiary, certain
present and former officers and directors of the Company and our subsidiaries as
well as our investment bankers. The amended complaint also added, among other
things, claims for fraud, securities fraud, breach of fiduciary duty,
conspiracy, and intentional interference with contract as well as requesting the
appointment of a receiver for our Sorrento subsidiary, all which claims are
based on alleged wrongs committed in connection with or since the Series A
placement. Our Sorrento subsidiary and the original individual defendants have
all answered this amended complaint denying all allegations of wrongdoing. The
new defendants have all moved to dismiss the amended complaint. Management
believes the allegations contained in the amended complaint are without merit.
On December 14, 2001, the plaintiffs filed motions to sequester the
common stock of our Sorrento subsidiary owned by Meret and the Sorrento Series A
preferred stock that we own, as an alternative method of obtaining jurisdiction
over us and Meret in the Delaware litigation. Management also believes that
these motions are without merit.
Currently, hearings on all pending motions have been taken off calendar
at the request of all parties. The Exchange Agreement entered into in connection
with our recently completed capital restructuring provides that this litigation
will be dismissed with 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 See Subsequent Events.
During June 2000, we entered into various agreements with Par Chadha, our
former CEO and Chairman, which, among other matters, provides for payments of
$250 per year for three years of consulting services and loans by us for the
exercise of previously granted options to acquire 58,925 options at prices
varying from $140.60 to $985.00 per share. As the members of our Board of
Directors at the time of his resignation ceased to represent more than 50% of
the Board in October 2000, all payments for consulting services were accelerated
and no future consulting services are required. During October 2000, Mr. Chadha
exercised 3,556 options, applying the $500 accelerated payment to the exercise.
In addition, he exercised 25,369 options for which we were contractually
obligated to loan the $5.0 million due on the exercise. Mr. Chadha provided us
with written notification dated in September 2001 that he does not have any
obligations under the agreements. We have notified him that we do not agree with
his interpretation of his repayment obligations under the terms of the
agreements.
During December 2001, we entered into an agreement whereby the
25,369-option exercise was rescinded. Mr. Chadha returned the 25,369 shares to
us for cancellation and we cancelled the receivable due from him and restored
the original option agreements. In June 2002, we filed with the Superior Court
of California, County of Los Angeles a Complaint for Declaratory Relief
regarding the interpretation of the agreement. Also in June 2002, Mr. Chadha
filed a lawsuit against us in the Superior Court of California, County of Los
Angeles, seeking declaratory relief with respect to the interpretation of his
separation agreement and in addition, alleging breach of contract with respect
to his option exercise rights and fraud in connection with his rescission
agreement. In February 2003, both of these lawsuits were dismissed without
prejudice to facilitate settlement negotiations, but they can be refiled at any
time. In April 2003, an agreement in principle to settle these lawsuits was
reached, subject to the execution of a definitive agreement. While there can be
no assurance that such a definitive settlement agreement will be executed, the
Company has been informed by counsel for all parties that the agreement is
acceptable and will be signed. Should the cases be refiled, which now appears
unlikely, and should Mr. Chadha prevail in Court, in addition to any other
28
relief that may be granted, we may be required to issue him 58,925 shares
of our stock for no consideration, and/or pay him cash damages, which he alleges
to be in excess of $4 million.
In addition, claims in arbitration have been filed by two of our former
financial officers and employees who worked in our Santa Monica office, which
has now 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 filed a lawsuit against United Pan Europe Communications, N.V., one of
our customers and a related party to one of Sorrento's Series A shareholders, in
connection with a past due receivable in the amount of $1.6 million for
equipment shipped in 2000. The defendant filed for protection under the federal
bankruptcy laws, and pursuant to the Exchange Agreement entered into in
connection with our capital restructuring, we executed a definitive settlement
agreement and a stipulation of dismissal with prejudice resolving this lawsuit
in return for a payment of $350 thousand and the return of certain of the
equipment previously shipped. We have received the payment of $350 thousand from
UPC and, in accordance with the terms of the exchange agreement, have paid that
same amount to certain Series A Preferred Stock holders. The equipment has also
been returned. Accordingly, this lawsuit has been dismissed with prejudice.
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
Not Applicable
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.
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,
29
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
Consolidated Financial Statements for the Quarter Ended April 30,
2003 (included in Part I, Item 1).
B. Reports on Form 8-K
March 06, 2003 Exchange Agreement and Associated Documents
April 10, 2003 FY 2003 Financial Statement, Proforma Financial
Information and Exhibits
May 07, 2003 Sale of Marketable Securities
May 09, 2003 Settlement agreement reached / Nasdaq extension
May 29, 2003 Special Meeting of Shareholders
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
30
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)
June 12, 2003 By: /s/ JOE R. ARMSTRONG
------------------------------------
Joe R. Armstrong,
Chief Financial Officer
Principal Accounting Officer
31
STATEMENT BY CHIEF EXECUTIVE OFFICER
PURSUANT TO SECTION 302
OF THE
SARBANES-OXLEY ACT
I, Phillip W. Arneson, certify that:
(1) I have reviewed this quarterly report on Form 10-Q of Sorrento
Networks Corporation (the "Company");
(2) Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state to a material fact
necessary to make the statements made, in light of the circumstances under which
such statements were made, not misleading as of the end of the period covered by
this quarterly report;
(3) Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
Company as of, and for, the periods presented in this quarterly report;
(4) The Company's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures for the Company
(as defined in Exchange Act Rules 13a-14 and 15d-14) for the Company and we
have:
(a) designed such disclosure controls and procedures to ensure
that material information relating to the Company, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
(b) evaluated the effectiveness of the Company's disclosure
controls and procedures within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date.
(5) The Company's other certifying officers and I have disclosed, based
on our most recent evaluation, to the Company's auditors and to the audit
committee of the Company's board of directors (or persons performing the
equivalent function):
(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the Company's ability to
record, process, summarize, and report financial data and have identified
for the Company's auditors any material weaknesses in internal controls;
and
(b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the Company's internal
controls; and
(6) The Company's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of their evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.
June 12, 2003 /s/ PHILLIP W. ARNESON
-----------------------------------
Phillip W. Arneson
32
STATEMENT BY CHIEF FINANCIAL OFFICER
PURSUANT TO SECTION 302
OF THE
SARBANES-OXLEY ACT
I, Joe R. Armstrong, certify that:
(1) I have reviewed this quarterly report on Form 10-Q of Sorrento
Networks Corporation (the "Company");
(2) Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state to a material fact
necessary to make the statements made, in light of the circumstances under which
such statements were made, not misleading as of the end of the period covered by
this quarterly report;
(3) Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
Company as of, and for, the periods presented in this quarterly report;
(4) The Company's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures for the Company
(as defined in Exchange Act Rules 13a-14 and 15d-14) for the Company and we
have:
(a) designed such disclosure controls and procedures to ensure
that material information relating to the Company, including its
consolidated subsidiaries, is made known to us by others within those
entities, particularly during the period in which this quarterly report
is being prepared;
(b) evaluated the effectiveness of the Company's disclosure
controls and procedures within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and
(c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date.
(5) The Company's other certifying officers and I have disclosed, based
on our most recent evaluation, to the Company's auditors and to the audit
committee of the Company's board of directors (or persons performing the
equivalent function):
(a) all significant deficiencies in the design or operation of
internal controls which could adversely affect the Company's ability to
record, process, summarize, and report financial data and have identified
for the Company's auditors any material weaknesses in internal controls;
and
(b) any fraud, whether or not material, that involves management
or other employees who have a significant role in the Company's internal
controls; and
(6) The Company's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of their evaluation, including any corrective actions
with regard to significant deficiencies and material weaknesses.
June 12, 2003 /s/ JOE R. ARMSTRONG
------------------------------------
Joe R. Armstrong
33
STATEMENT UNDER OATH FOR
CHIEF EXECUTIVE OFFICER
PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT
I, Phillip W. Arneson, certify that:
The Quarterly Report on Form 10-Q for the quarter ended April 30, 2003 of
Sorrento Networks Corporation fully complies with the requirements of section
13(a) or 15(d) of the Securities Exchange Act of 1934, and the information
contained in the Quarterly Report on Form 10-Q for the quarter ended April 30,
2003 of Sorrento Networks Corporation fairly presents, in all material respects,
the financial condition and results of operations of Sorrento Networks
Corporation.
Subscribed and sworn to
before me this 12 day of June, 2003
/s/ PHILLIP W. ARNESON /s/ ROBERT E. ANDERSON
---------------------------------- -----------------------------------
Name: Phillip W. Arneson Notary Public
Date: June 12, 2003 Seal
34
STATEMENT UNDER OATH FOR
CHIEF FINANCIAL OFFICER
PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT
I, Joe R. Armstrong, certify that:
The Quarterly Report on Form 10-Q for the quarter ended April 30, 2003 of
Sorrento Networks Corporation fully complies with the requirements of section
13(a) or 15(d) of the Securities Exchange Act of 1934, and the information
contained in the Quarterly Report on Form 10-Q for the quarter ended April 30,
2003 of Sorrento Networks Corporation fairly presents, in all material respects,
the financial condition and results of operations of Sorrento Networks
Corporation.
Subscribed and sworn to
before me this 12 day of June, 2003
/s/ JOE R. ARMSTRONG /s/ ROBERT E. ANDERSON
---------------------------------- -----------------------------------
Name: Joe R. Armstrong Notary Public
Date: June 12, 2003 Seal
35