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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, 2004
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:
Common Stock, $0.001 par value per share, Outstanding: 17,239,862 shares
at June 01, 2004.
Indicate by check mark whether the registrant is an accelerated filer as
defined in rule 12-b2 of the Securities Exchange Act of 1934. Yes No X
--- ---
This Form 10-Q, future filings of the registrant, and oral statements
made with the approval of an authorized executive officer of the Registrant may
contain forward looking statements. In connection therewith, please see the
cautionary statements and risk factors contained in Item 2. "Fluctuations in
Revenue and Operating Results" and "Forward Looking Statements -- Cautionary
Statement", which identify important factors which could cause actual results to
differ materially from those in any such forward-looking statements.
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SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(thousands)
(Unaudited)
April 30, 2004 January 31, 2004
-------------- ----------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents................................................. $ 11,008 $ 17,617
Accounts receivable, net.................................................. 5,651 3,754
Inventory, net............................................................ 11,899 13,893
Prepaid expenses and other current assets................................. 620 972
Investment in marketable securities....................................... 460 504
Notes receivable 270 242
--------- ---------
TOTAL CURRENT ASSETS.................................................... 29.908 36,982
--------- ---------
PROPERTY AND EQUIPMENT, NET.................................................. 12,938 12,267
--------- ---------
OTHER ASSETS
Purchased technology, net................................................. 100 110
Other assets.............................................................. 645 654
Notes receivable.......................................................... 55 83
--------- ---------
TOTAL OTHER ASSETS...................................................... 800 847
--------- ---------
TOTAL ASSETS................................................................. $ 43,646 $ 50,096
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Current maturities of long term debt...................................... $76 $101
Accounts payable.......................................................... 2,026 2,887
Deferred revenue.......................................................... 619 878
Accrued professional fees................................................. 395 832
Other accrued liabilities and current liabilities......................... 4,439 6,478
--------- ---------
TOTAL CURRENT LIABILITIES............................................... 7,555 11,176
--------- ---------
Long-term debt and capital lease obligations................................. 3,522 3,538
Debentures payable........................................................... 11,728 12,388
--------- ---------
TOTAL LIABILITIES....................................................... 22,805 27,102
--------- ---------
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS' EQUITY
Preferred stock, $.01 par value; liquidation preference $1,353............ 1 1
Common stock,$.001 par value; 150,000,000 shares authorized; 17,063,627
shares issued and 17,063,183 shares outstanding at April 30, 2004; and
16,314,917 shares issued and 16,315,361 shares outstanding at January 31,
2004.................................................................... 17 16
Additional paid-in capital................................................ 218,924 216,434
Accumulated deficit....................................................... (198,443) (193,769)
Accumulated other comprehensive gain...................................... 411 381
Treasury stock, at cost; 444 shares at April 30, 2004 and January 31, 2004,
respectively............................................................ (69) (69)
--------- ---------
TOTAL STOCKHOLDERS' EQUITY.............................................. 20,841 22,994
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY................................... $ 43,646 $ 50,096
========= =========
See accompanying notes to consolidated financial statements.
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
(thousands, except per share amounts)
Three Months Ended
April 30,
---------------------
2004 2003
---- ----
NET SALES ............................................... $ 6,093 $ 7,861
COST OF SALES ........................................... 3,930 5,907
-------- -------
GROSS PROFIT ....................................... 2,163 1,954
------- -------
OPERATING EXPENSES
Selling and marketing ................................ 1,985 2,175
Engineering, research and development ................ 2,352 1,644
General and administrative ........................... 2,713 1,599
Deferred stock compensation .......................... -- 51
Other operating expenses ............................. 10 103
------- -------
TOTAL OPERATING EXPENSES ........................... 7,060 5,572
------- -------
LOSS FROM OPERATIONS .................................... (4,897) (3,618)
======= =======
OTHER INCOME (EXPENSES)
Interest expense ..................................... (296) (2,665)
Other income ......................................... 519 61
------- -------
TOTAL OTHER INCOME (EXPENSES) ...................... (223) (2,604)
------- -------
NET LOSS ................................................ $(4,674) $(6,222)
LOSS PER SHARE:
NET LOSS APPLICABLE TO COMMON SHARES ................. $(4,674 ) $(6,222)
======= =======
BASIC WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING ...................................... 16,649 886
------- -------
BASIC NET LOSS PER COMMON SHARE ......................... $ (0.28) $ (7.02)
======= =======
DILUTED WEIGHTED AVERAGE COMMON SHARES
OUTSTANDING ...................................... 16,649 1,109
------- -------
DILUTED NET LOSS PER COMMON SHARE ....................... $ (0.28) $(14.33)
======= =======
COMPREHENSIVE LOSS AND ITS COMPONENTS CONSIST OF
THE FOLLOWING:
Net loss ........................................... $(4,674) $(6,222)
Components of other comprehensive income:
Unrealized holding gains arising during the period 30 1,060
------- -------
NET COMPREHENSIVE LOSS .................................. $(4,644) $(5,162)
======= =======
See accompanying notes to consolidated financial statements.
F-3
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
For the three months ended April 30, 2004
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (Unaudited)
(thousands)
Common Stock Preferred Stock Additional Deferred
---------------- ----------------- Paid in Stock
Shares Amount Shares Amount Capital Compensation
------ ------ ------ ------ ------- ------------
Balance at January 31, 2004 ............. 16,315 $16 2 $1 $216,434 $--
Common Stock Issuance ................... 748 1 2,490
Unrealized (losses) on available for sale
securities ...........................
Foreign currency translation adjustments
------ --- ------- -------- --------- ----
Net loss ................................
------ --- ------- -------- --------- ----
Balance at April 30, 2004 ............... 17,063 $17 2 $1 $218,924 $--
====== === ======= ======== ========= ====
Treasury
Stock Other Total
Accumulated ----------------------- Comprehensive Stockholders'
Deficit Shares Amount gain Equity
------- ------ ------ ---- ------
Balance at January 31, 2004 ............. $(193,769) 1 $(69) $381 $22,941
Common Stock Issuance ................... 2,491
Unrealized (losses) on available for sale
securities ........................... (9) (9)
Foreign currency translation adjustments 39 39
--------- --- ---- ---- -------
Net loss ................................ (4,674) (4,674)
--------- --- ---- ---- -------
Balance at April 30, 2004 ............... $(198,443) 1 $(69) $411 $20,841
========= === ==== ==== =======
See accompanying notes to consolidated financial statements.
F-4
SORRENTO NETWORKS CORPORATION
AND SUBSIDIARIES
For the three months ended April 30, 2003
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (Unaudited)
(thousands)
Common Stock Preferred Stock Additional Deferred
--------------- ------------- Paid In Stock Accumulated
Shares Amount Shares Amount Capital Compensation Deficit
------ ------ ------ ------ ------- ------------ -------
Balance at January 31, 2003............. 886 $5,318 2 $1 $144,887 $ (5) $(187,536)
Unrealized losses on available for sale
securities...........................
Deferred stock compensation of
subsidiary........................... 46 (46)
Amortization of deferred stock
compensation......................... 51
--- ------ - -- -------- ---- ---------
Net loss................................ (6,222)
--- ------ - -- -------- ---- ---------
Balance at April 30, 2003............... 886 $5,318 2 $1 $144,933 $ -- $(193,758)
=== ====== = == ======== ==== =========
Treasury
Stock Other Total
--------------- Comprehensive Stockholders'
Shares Amount Loss Equity
------ ------ ---- ------
Balance at January 31, 2003............. 1 $(69) $2,928 $(34,476)
Unrealized losses on available for sale 1,060 1,060
securities...........................
Deferred stock compensation of
subsidiary........................... --
Amortization of deferred stock
compensation......................... --
- ---- ------ --------
Net loss................................ (6,222)
- ---- ------ --------
Balance at April 30, 2003............... 1 $(69) $3,988 $(39,587
= ==== ====== ========
See accompanying notes to consolidated financial statements.
F-5
SORRENTO NETWORKS CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
(thousands)
Three Months Ended
April 30,
---------------------
2004 2003
------- -------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss .................................................................. $(4,674) $(6,222)
------- -------
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization ......................................... 577 1,040
Accounts receivable and inventory reserves ............................ 127 (189)
Other non cash ........................................................ 38 --
Non-cash interest on debentures ....................................... -- 1,819
Deferred and other stock compensation ................................. -- 51
Changes in assets and liabilities:
(Increase) decrease in accounts receivable .......................... (2,024) 754
Decrease in inventories ............................................. 1,757 1,972
Decrease in other current assets .................................... 352 149
Decrease in accounts payable ........................................ (861) (1,540)
Decrease in deferred revenue ........................................ (259) (3,327)
Increase (decrease) in accrued and other current liabilities ........ (1,310) 508
------- -------
NET CASH USED IN OPERATING ACTIVITIES ................................... (6,277) (4,985)
------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
(Purchase) disposal of property and equipment ............................. (990) 775
Certificate of Deposit redemption ......................................... 36 --
Other assets .............................................................. (2) 313
------- -------
NET CASH PROVIDED USED IN INVESTING ACTIVITIES .......................... (956) 1,088
------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from common stock ................................................ 665 --
Payments of short-term debt, net .......................................... (25) --
Repayment of long-term debt ............................................... (16) (65)
------- -------
NET CASH PROVIDED BY FINANCING ACTIVITIES ............................... 624 (65)
------- -------
DECREASE IN CASH AND CASH EQUIVALENTS ........................................ (6,609) (3,962)
CASH AND CASH EQUIVALENTS - BEGINNING OF PERIOD .............................. 17,617 7,747
------- -------
CASH AND CASH EQUIVALENTS - END OF PERIOD .................................... $11,008 $ 3,785
======= =======
See accompanying notes to consolidated financial statements.
F-6
The Company
Sorrento Networks Corporation (the "Company," "We," "Our," or "Us") through
its subsidiaries designs, manufactures and markets integrated networking and
bandwidth aggregation and optical access 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 and Sunnyvale,
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.
Recent Developments
In April, 2004, the Company announced its agreement to be acquired by Zhone
Technologies, Inc. (""Zhone"), Under the terms of the agreement, Zhone will
issue 0.9 of a share of Zhone common stock for each outstanding share of
Sorrento common stock and each option, warrant and other security exercisable or
convertible into Sorrento common stock will be assumed by Zhone and become
exercisable or convertible into Zhone common stock, with appropriate adjustments
based on the merger exchange ratio. The proposed stock-for-stock transaction is
intended to qualify as tax-free to the stockholders of Sorrento.
The Form S-4 Registration Statement relating to the proposed merger of
the two companies has been declared effective by the Securities and Exchange
Commission. Zhone and Sorrento also received notification of early termination
of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act.
Stockholder meeting for both Zhone and Sorrento have been scheduled for June 30,
2004, for stockholders of record as of May 25, 2004. Subject to the approval of
the stockholders of both companies, and other conditions to closing, Zhone and
Sorrento anticipate compliance with all remaining closing conditions and for
the transaction to be completed on July 1, 2004.
Summary of Significant Accounting Policies
Basis of Presentation
The accompanying financial data for the three months ended April 30, 2004
and 2003 along with financial data for January 31, 2004, 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,
2004 balance sheet was derived from audited financial statements, but does not
include all disclosures required by accounting principles generally accepted in
the United States of America. However, we believe that the disclosures we have
made are adequate to make the information presented not misleading. These
consolidated financial statements should be read in conjunction with the
financial statements and the notes thereto included in our Annual Report on Form
10-K/A for the year ended January 31, 2004.
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, 2004 and 2003 have been made. The
results of operations for the quarter ended April 30, 2004 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. Sorrento Networks, Incorporated, ("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
7
debt and equity financing. There can be no assurance that similar funding will
be available in the future. Our future capital requirements may vary materially
from those now planned including the need for additional working capital to
accommodate planned growth, hiring and infrastructure needs. There can be no
assurances that our working capital requirements will not exceed our ability to
generate sufficient cash internally to support our requirements and that
external financing will be available or that, if available, such financing can
be obtained on terms favorable to us and our shareholders.
Use of Estimates
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, 2004 and 2003 have been made.
Certain reclassifications have been made to prior year presentations to
conform to the Fiscal 2005 presentation.
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, 2004 and 2003 it amortized $0 and $5 thousand, respectively, of
the total $2.6 million initially recorded for deferred stock compensation.
For non-employees, who are not directors, 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, 2004 and 2003 it recorded
$0 and $46 thousand, respectively, for options granted to consultants.
Recent Accounting Pronouncements
In December 2003, the SEC issued SAB 104, which supersedes SAB 101, Revenue
Recognition in Financial Statements. The primary purpose of SAB 104 is to
rescind the accounting guidance contained in SAB 101 related to multiple element
revenue arrangements, which was superseded as a result of the issuance of EITF
00-21. We adopted EITF 00-21 and SAB 104 with no material impact on our
financial statements.
In January 2003, the 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 adopted FIN No. 46 with no material effect on our financial position
or results of operations.
8
In November 2002, the FASB issued FIN 45, which expands previously issued
accounting guidance and disclosure requirements for certain guarantees. FIN 45
requires us to recognize an initial liability for the fair value of an
obligation assumed by issuing a guarantee. The provision for initial recognition
and measurement of the liability will be applied on a prospective basis to
guarantees issued or modified after December 31, 2002. The adoption of FIN 45
did not materially affect our consolidated financial statements.
In November 2002, the Emerging Issues Task Force ("EITF") reached a
consensus on Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables."
EITF Issue No. 00-21 provides guidance on how to account for arrangements that
involve the delivery or performance of multiple products, services and/or rights
to use assets. The provisions of EITF Issue No. 00-21 applied to revenue
arrangements entered into in fiscal periods beginning after June 15, 2003.
Balance Sheet Detail
Inventories at April 30, 2004 and January 31, 2004 consist of:
April 30, January 31,
2004 2004
---- ----
Raw material ........................... $ 18,828 $ 20,744
Work in process ........................ 2,483 3,133
Finished goods ......................... 4,738 5,416
-------- --------
26,049 29,293
Less: Valuation reserve ................ (14,150) (15,400)
-------- --------
$ 11,899 $ 13,893
======== ========
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 investment in Entrada Network's, Inc.
("ENI") is classified as available for sale and is 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, 2004, and January 31, 2004, marketable securities were
as follows:
Unrealized Market
Cost Gains Value
---- ----- -----
April 30, 2004:
Entrada Networks ..................... $ 31 $47 $ 78
Certificate of Deposit ............... 382 -- 382
---- --- ----
$413 $47 $460
==== === ====
January 31, 2004:
Entrada Networks ..................... $31 $56 $ 87
Certificate of Deposit ............... 416 1 417
---- --- ----
$447 $57 $504
==== === ====
Intangible Assets-- Goodwill and indefinite life intangible assets are no
longer amortized but are subject to periodic impairment tests. We have no
goodwill or indefinite life intangible assets. Other intangible assets with
finite lives, such as our purchased technology, are amortized over their useful
lives.
The carrying value of finite life intangible assets, consisting of purchased
technology of our subsidiary Meret Optical, as of April 30, 2004, is $0
thousand, net of amortization. The change in the net carrying amount of finite
life intangible assets during the three months ended April 30, 2004 is due to
amortization of $20 thousand.
Debentures - During August 2001, we completed a private placement of our
9.75% convertible debentures receiving net proceeds of $29.8 million. The
debentures, due August 2, 2004 had a face value of $32.2 million, which was
convertible into our common stock at $144.20 per share. At maturity, we could
have elected to redeem
9
the debentures for cash and we had the option of paying the interest on these
debentures in shares of our common stock. In addition, the purchasers received
four year warrants to acquire an additional 167,592 shares of our common stock
at $144.20 per share and the placement agent received five year warrants to
acquire 5,583 shares of our common stock, equity securities, options or warrants
at a price less than $144.20 per share or at a discount to the then market
price. The conversion price and warrant exercise were subject to adjustment.
In accordance with Emerging Issues Task Force ("EITF") No. 00-27 we
accounted for the fair value of warrants issued to the purchasers and placement
agent and the fair value of the deemed beneficial conversion feature, which
resulted solely as a result of the required accounting, of the debenture as a
reduction to the face value of the debentures with an offsetting increase to
additional paid in capital. These amounts, as well as the issuance costs paid in
cash, were amortized as additional interest expense over the period the
debentures were outstanding.
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 "9.75% Debentures") and the Series A Convertible
Preferred Stock (the "Preferred Stock") of Sorrento Networks, Inc. The Exchange
Agreement and associated documents contemplated an exchange (the "Exchange") of
the 9.75% 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
"7.5% Debentures"). Certain holders of the Preferred Stock would also receive
additional 7.5% Debentures of approximately $600 thousand to pay certain legal
fees.
The Exchange Agreement was approved by shareholders on May 29, 2003 and was
completed and became effective on June 4, 2003 pursuant to which we exchanged
current outstanding debentures and Series A Preferred Stock for common stock and
an issuance of a smaller principal amount of 7.5% Debentures.
Interest expense on the 7.5% debentures for the three months ended April
30, 2004 was $223 thousand.
The 7.5% debentures are convertible at any time at the option of the
holders into shares of common stock at a conversion price of $5.42, the fair
value on the date of the exchange. The debentures mature on August 2, 2007 and
are secured by substantially all of our assets and those of our subsidiaries
(with certain exceptions).
In November 2003 and February 2004, we exchanged $421 thousand and $660
thousand in our senior convertible debentures for 148,988 and 155,975 shares of
common stock respectively. The exchange was made under SEC regulation 3(a)(9)
governing the exchange of such securities. At April 30, 2004 and January 31,
2004 the 7.5% debentures payable totaled $11,728 and $12,388 respectively
Stockholders' Equity
We are authorized to issue the following shares of stock:
150,000,000 shares of Common Stock ($.001 par value)
2,000,000 shares of Preferred Stock ($.01 par value) of which the
following series have been designated:
3,000 shares of Preferred Stock, Series D
1,000,000 shares of Preferred Stock, Series F
As of April 30, 2004, 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
===== ===== ======
10
In May 2004, the Company retired its Series D stock which was outstanding
as of April 30, 2004 by issuing 496,155 shares of common stock. A portion of the
common stock issued, which was subsequently sold and amounted to $500,000 is
being held in escrow under the terms of an agreement between the Company and
Anite Corporation for possible losses or claims that may arise related to a
pension plan that we acquired in 1996 upon the purchase of a division of a
company that later became Entrada Networks. Entrada was subsequently spun-off
and merged with another entity in August 2000, but as part of the spin-off, we
maintained certain obligations under the pension plan as discussed in the
section of Contingent Liabilities of this report.
Other Capital Stock Transactions
Each share of SNI's Series A Convertible Preferred Stock was convertible into
one share of SNI's common stock at the option of the holder, voted on an "as
converted" basis except for election of directors, and had a liquidation
preference of $5.45 per share. The shares were automatically convertible into
SNI's common stock upon an underwritten public offering by SNI with an aggregate
offering price of at least $50.0 million. As SNI did not complete a $50.0
million public offering by March 1, 2001, the holders of more than 50% of the
then outstanding Series A shares had the right to request in writing that SNI
redeem them at the adjusted liquidation preference. On receipt of such a
request, SNI had the obligation to redeem the shares in cash, if funds were
lawfully available for such redemption, or to redeem such pro rata portion as to
which a lesser amount of lawfully available funds existed. In April 2001, SNI
received written redemption requests from holders of a majority of the Series A
shares. The difference between the net proceeds received on the sale of these
shares and their liquidation preference of $48.8 million was recorded as a
deemed dividend during the period from issuance to March 31, 2001.
On June 4, 2003, we consummated the Exchange Agreement and cancelled all
outstanding Series A Convertible Preferred Stock.
In connection to our capital and corporate restructuring plan, we issued
8,029,578 shares of common stock to the holders of the 9.75% debentures and the
Series A Convertible Preferred Stock upon consummation of the Exchange. The
Company's $32.2 million in convertible debentures were converted into common
shares of the Company and a portion of $12.5 million in secured convertible 7.5%
debentures that mature in August 2007. In addition, all Series A Convertible
Preferred Stock were converted into common shares of the Company and a portion
of the $12.5 million in secured convertible debentures. The outstanding Series A
Convertible Preferred Stock "put" of $48.8 million against SNI was withdrawn.
Certain Series A Convertible Preferred stockholders also received a total of
$600 thousand in additional secured convertible 7.5% debentures to pay certain
legal fees.
There was an aggregate gain, net of tax, on the capital restructuring
transaction of $13.8 million. The conversion of the SNI Series A Convertible
Preferred Stock into common stock and a portion of the $12.5 million 7.50%
convertible debenture resulted in a net gain of $48.8 million. The gain was
off-set by the loss on the value of the warrants and beneficial conversion
feature on the $32.2 million, 9.75% convertible debentures, converted to common
stock and a portion of the 7.50% convertible debenture. The consolidated net
gain on the capital restructuring transaction was $13.8 million or $2.35 per
share for the quarter ending July 31, 2003.
On August 8, 2003, we acquired LuxN Inc. for a combination of stock,
warrants, and cash. Stockholders of LuxN were given the option of exchanging
shares of LuxN stock for either their pro-rata portion of LuxN's net cash or
shares of Sorrento's common stock. In addition to the cash or Sorrento common
stock, stockholders of LuxN have the right to receive warrants to purchase an
aggregate of 400 thousand shares of Sorrento common stock, with an exercise
price of $3.05 per share, the fair market value on the date of the acquisition.
At closing, Sorrento issued approximately 1.4 million shares of common stock
with the remaining approximately 500 thousand shares of common stock issued upon
stockholder approval.
Stock Option Plans
We have five stock option plans in effect: The 2003 Equity Incentive Plan,
the 2000 Stock Incentive Plan, the 1988 Stock Option Plan, the 1997 Incentive
and Non-Qualified Stock Option Plan and the 1997 Director Stock Option Plan. The
stock options have been made available to certain employees and consultants. All
options are granted at not less than fair value at the date of grant and have
terms varying from 3 to 10 years. The purpose of
11
these plans is to attract, retain, motivate and reward our officers, directors,
employees and consultants to maximize their contribution towards our success.
We account for these plans under the recognition and measurement principles
of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related
Interpretations. No stock-based employee compensation cost is reflected in net
loss, as all options granted under these plans had an exercise price equal to
the market value of the underlying common stock on the date of grant.
In order to provide more prominent and frequent disclosures about the
effects of stock-based compensation as required under SFAS 148, "Accounting for
Stock-Based Compensation - Transition and Disclosure", the following table
summarizes the pro forma effect of stock-based compensation on net loss and pro
forma loss per share as if the optional expense recognition provisions of SFAS
123 had been adopted.
The fair value of stock options used to compute pro forma net loss and pro
forma loss per share disclosures is estimated using the Black-Scholes
option-pricing model, which was developed for use in estimating the fair value
of traded options that have no vesting restrictions and are fully transferable.
In addition, this model requires the input of subjective assumptions, including
the expected price volatility of the underlying stock. Projected data for
expected volatility and expected life of stock options is based upon historical
and other data. Changes in these subjective assumptions can materially affect
the fair value estimate, and therefore the existing valuation models may not
provide a reliable single measure of the fair value of the Company's employee
stock options.
For the three months ended,
April 30
----------------------
2004 2003
------- -------
Net loss:
As reported .................................................. $(4,674) $(6,222)
Deduct: Total stock-based employee compensation expense
determined under fair value based method for all awards, net
of related tax effects ..................................... (964) (291)
------- -------
Pro forma .................................................... $(5,638) $(6,513)
======= =======
Loss per share:
Basic EPS as reported ........................................ $(0.28) $ (7.02)
======= =======
Pro forma basic EPS .......................................... $(0.34) $ (7.35)
======= =======
Diluted EPS as reported ...................................... $(0.28) $(14.33)
======= =======
Pro forma diluted EPS ........................................ $(0.34) $(14.59)
======= =======
Earnings Per Share Calculation
The following data show the amounts used in computing basic earnings per
share for the quarters ended April 30, 2004 and 2003.
Three Months Ended April 30,
----------------------------
2004 2003
---- ----
Net loss available to common
shareholders used in basic EPS............... $ (4,674) $ (6,222)
=========== ========
Average number of common shares
used in basic EPS............................ 16,648,757 886,050
=========== ========
We had a net loss for the quarter ended April 30, 2004. Accordingly, the
effect of dilutive securities including convertible preferred stock, vested and
non-vested stock options and warrants to acquire common stock are not
12
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.
Three Months Ended April 30,
2004 2003
---- ----
Net loss available to common
shareholders used in basic EPS ........... $ (4,674) $ (6,222)
Less: Convertible debt issuance costs ....... (12,260)
Plus: Convertible debt interest ............. 2,584
----------- ----------
Net loss available to common
shareholders used in diluted EPS ......... $ (4,674) $ (15,898)
=========== ==========
Average number of common shares
used in basic EPS ........................ 16,648,757 886,050
Effect of dilutive securities:
Convertible debentures ...................... -- 223,301
----------- ----------
Average number of common shares and dilutive
potential common stock used in diluted EPS 16,648,757 1,109,351
=========== ==========
Common stock options and warrants of 680,086 and 2,056,101 shares of common
stock for convertible debentures, for the three month period, are excluded from
the computation, as the effect was anti-dilutive.
Litigation
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. As of April 30, 2004, there were no outstanding
lawsuits filed against the Company.
Contingent Liabilities
In the merger agreement among our predecessor corporation (Osicom
Technologies, Inc.), Entrada, and Sync Research, Inc., Osicom agreed to
indemnify and hold our former subsidiary harmless against liability arising from
the termination of a certain pension plan if the subsidiary's losses exceeded
$250 thousand, but only for such losses that exceeded $250 thousand. The pension
plan was acquired as a result of the purchase of a division of Cray
Communications in 1996, which later became Entrada.
Upon the acquisition of this former subsidiary, the seller had the right to
terminate the plan for five years following the acquisition and was responsible
for funding the plan. If the pension plan was not terminated in the five years
following the acquisition, the agreement called for the parties to agree as to a
mutually satisfactory arrangement for the termination or continuation of the
plan. In the third quarter, we were advised by the successor corporation that
the termination cost of the pension plan could total approximately $2.9 million
if the plan was terminated. Continued funding of the pension plan also remains
an unresolved issue and if funding is not kept current with regard to legal
requirements the pension plan could default. As of April 30, 2004, we held in
escrow approximately $500 thousand in Series D Preferred Stock as a security
against possible losses resulting from this pension plan. As of this date, the
parties have not agreed to a resolution regarding the pension plan in future
periods. In May 2004, the Series D Preferred Stock was converted into common
stock and $500 thousand in cash is being held in escrow pending resolution of
the pension plan.
13
While we do not believe that we are liable for the continued costs
associated with future funding or a cost associated upon termination, it is
possible the pension plan could result in litigation among the parties if they
cannot agree to an acceptable resolution. The Company has reserved approximately
$1 million for possible contingencies which we believe is adequate to cover
potential claims regarding the plan.
Concentration Of Credit Risk
Financial instruments that potentially subject us to concentrations of
credit risk consist primarily of temporary cash investments and trade
receivables. As regards the former, we place our temporary cash investments with
high credit financial institutions. At times such amounts may exceed the
F.D.I.C. limits. We limit the amount of exposure with any one financial
institution and believe that no significant concentration of credit risk exists
with respect to cash investments.
Although we are directly affected by the economic well being of significant
customers listed in the following tables, we do not believe that significant
credit risk exists at April 30, 2004. 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,
2004 2004
-------------- --------------
Customer A............................................................. 23.0% 9.5%
Customer B............................................................. 15.6% 10.3%
Customer C............................................................. 10.9% --%
Customer D............................................................. 8.6% 10.7%
Customer E............................................................. 0.3% 10.3%
The following data shows the customers accounting for more than 10% of
net consolidated sales:
April 30, April 30,
2004 2003
-------------- --------------
Customer A.............................................................. 23.0% --%
Customer B.............................................................. 11.3% --%
Customer C.............................................................. 11.3% 0.8%
Customer D.............................................................. --% 34.7%
Customer E.............................................................. 1.1% 21.7%
Customer F.............................................................. 0.7% 11.3%
Segment Information
Optical Meret
Networking(1) Optical Other Total
------------- ------- ----- -----
Three Months Ended April 30, 2004
Revenues from external customers ....... $ 5,183 $ 910 -- $ 6,093
Cost of goods sold ..................... 3,558 372 -- 3,930
------- ------ ------- -------
Gross profit ......................... 1,625 538 -- 2,163
------- ------ ------- -------
Segment income (loss) from operations ..... (3,950) 457 (1,404) (4,897)
Depreciation and amortization expense ..... 534 23 20 577
Valuation allowance additions (reductions):
Receivables and inventory ............. (1,080) (42) -- (1,122)
Capital asset disposals, net .............. 991 -- -- 991
Total assets .............................. 23,781 5,311 14,554 43,646
14
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:
Receivables and inventory ....... (178) (11) -- (189)
Capital asset additions, net ........ (775) -- -- (775)
Total assets ........................ 25,005 5,382 17,702 48,089
(1) Optical Networking consists of subsidiaries Sorrento Networks and LuxN Inc.
Subsequent Events
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/A for the year ended January 31, 2004, 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.
15
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, 2004 and 2003.
Net sales. Our consolidated net sales decreased $1.8 million or 22% to $6.1
million for the quarter ended April 30, 2004 compared to net sales of $7.9
million for the quarter ended April 30, 2003. Sorrento Networks, Inc. and
LuxN, Inc. make up the optical networking segment. Net sales for Sorrento
Networks Inc., ("SNI") the Company's primary operating subsidiary, decreased
$3.7 million or 54% to $3.1 million for the quarter ended April 30, 2004 as
compared to net sales of $6.8 million for the quarter ended April 30, 2003.
This decrease reflects lower domestic sales resulting from a continuing
decline in the telecom market. The addition of the LuxN business accounted
for a $1.9 million increase in sales in the quarter over prior year.
During the three months ended April 30, 2004 SNI shipped product to a
broader base of customers of which seventeen customers represented a combined
94% of our revenues. During the quarter ended April 30, 2003, we shipped product
to fourteen customers of which five customers represented a combined 92% 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 concentrated customer base.
Net sales for Meret decreased to $910 thousand, or by 17% for the quarter
ended April 30, 2004 from $1.1 million for the comparable quarter last year.
This decrease is due to the continuing decline in the telecommunications market.
Gross profit. Cost of sales consists principally of the costs of
components, subcontract assembly from outside manufacturers, and in-house system
integration, quality control, final testing and configuration costs. Gross
margin percent on a consolidated basis increased to 35% in fiscal 2005 from 25%
in fiscal 2004 due to the consolidation of entities and elimination of rent
allocations to subsidiary entities.
Gross profit for the optical networking line of business decreased to $1.6
million for the quarter ended April 30, 2004, as compared to $1.7 million in the
quarter ended April 30, 2003. The gross margin decrease was primarily the result
of lower sales.
For the quarter ended April 30, 2004 gross profit for Meret increased to
$538 thousand, or by 118%, from $247 thousand for the comparable quarter last
year. Meret's gross margins increased to 59% for the quarter ended April 30,
2004 from 22% for the comparable quarter last year. The gross margin increase
was primarily the result of product mix and lower fixed manufacturing overhead.
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 $2.0 million or 33% of net sales, for the quarter ended
April 30, 2004 from $2.1 million, or 28% of net sales for the quarter ended
April 30, 2003. This decrease was primarily the result of cost reduction efforts
implemented that have resulted in 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 increased to $2.4 million, or 39% of net sales, for the
quarter ended April 30, 2004 from $1.6 million, or 21% of net sales, for the
quarter ended April 30, 2003. The increase primarily reflects the increased
personnel costs associated with projects acquired with the LuxN business
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.
16
Consolidated general and administrative expenses increased to $2.3 million, or
45% of net sales, for the quarter ended April 30, 2004 from $1.6 million, or 21%
of net sales, for the quarter ended April 30, 2003. The increase in expense was
primarily the result of increased personnel costs, legal expenses related to
fund raising activities and strategic partnership development and the
discontinuance of rent allocation to various subsidiaries.
Deferred and other stock compensation. Deferred and other stock
compensation for the quarter ended April 30, 2004 has been fully recognized,
thus there is no expense recognized in the quarter for the amortization of the
value of stock options granted to consultants. The quarter ended April 30, 2003
includes $51 thousand of amortization of deferred stock compensation resulting
from the amortization of the value of stock options granted to consultants.
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.
Other income (charges). Other income (charges) from operations was a $223
thousand for the quarter ended April 30, 2004 compared to a $2.6 million charge
for the quarter ended April 30, 2003. The current quarter consisted primarily of
interest expense associated with our convertible debentures and mortgages
partially offset with interest income from our certificates of deposit and
reversal of an over-accrual for the LuxN acquisition.
The quarter ended April 30, 2003 consisted primarily of costs associated
with our convertible debenture which includes deferred interest of $765
thousand, amortization of issuance costs of $203 thousand 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.
Income taxes. There was no provision for income taxes for the quarters
ended April 30, 2004 and 2003. 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 ownership changes made as a result of the Exchange Agreement dated
June 4, 2003, 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, 2004 our working capital
was a positive $22.4 million and included $5.7 million of accounts receivable
and $11.0 million in cash and cash equivalents. This is compared to negative
working capital in the same quarter prior year of $25.8 million. The primary
reason for the negative working capital condition last year 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 restructured the
balances of both our Senior Convertible Debentures of $32.2 million and the SNI
Series A Preferred liability of $48.8 million.
The Company is in the process of complying with certain refinancing of its
mortgages on Company owned buildings, which may have technically been required
within 12 months following the closing of the restructuring on June 4, 2003.
Due to the pending merger with Zhone we anticipate either paying off the
mortgages upon the close of the transaction or refinancing the mortgages
immediately following the close of the merger.
Operations
Our operations used cash flows of $6.3 million during the quarter ended
April 30, 2004. During the quarter ended April 30, 2003 continuing activities
used cash flows of $5.0 million. The increase in cash flows used by operations
resulted primarily as the result of the combination of increasing our accounts
receivable balances and reducing our current liabilities for the 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.
17
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. Our collection on receivables has increased to 85 days of average
sales days outstanding as compared to 57 days outstanding for the same period in
the prior year. The increase in receivables and the lack of improvement in the
inventory have contributed to increased use of operating cash. There can be no
assurance that the continued economic environment will not impact either current
or future receivables negatively or our ability to control inventory levels. We
do not provide long-term financing to customers buying our equipment.
Investing Activities
Our investing activities during the quarter ended April 30, 2004 used cash
flows of $956 thousand from the purchase of property and equipment, which was
related to demo equipment that we placed in service with both current and
potential new customers. During the quarter ended April 30, 2003, investing
activities provided cash flows of $1.1 million. We disposed of property and
equipment of $775 thousand and had a $313 thousand decrease in other assets.
Financing Activities
During the quarter ended April 30, 2004, financing activities provided cash
flows of $624 thousand, which consisted primarily of proceeds from the sale of
common stock. Our financing activities during the quarter ended April 30, 2003
used cash of $65 thousand consisting primarily of the 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.
Contractual Cash Obligations
The following tables quantify our future contractual obligations and
commercial commitments as of April 30, 2004 (dollars in thousands):
18
Contractual Obligations
Payments due in fiscal years
-------------------------------------------------------------------------------
Remainder
Total 2005 2006 2007 2008 2009 Thereafter
----- ---- ---- ---- ---- ---- ----------
Long-term Debt ................ $3,573 $37 $54 $58 $63 $68 $3,293
Capital Leases ................ 26 26 -- -- -- -- --
Operating Leases .............. 636 367 148 46 41 34 --
7.5% convertible debentures (a) 11,728 -- -- 11,728 -- -- --
------- ---- ---- ------- ---- ---- ------
Total ......................... $15,963 $430 $202 $11,832 $104 $102 $3,293
======= ==== ==== ======= ==== ==== ======
(a) Maturity date, August 2, 2007
Note: As a result of the capital restructuring which became effective on June 4,
2003, 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.
Securities Authorized For Issuance Under Equity Compensation Plans
The following table provides information as of April 30, 2004 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))
------------------- ------------------- ------------------------
Plan Category (a) (b) (c)
------------------- ------------------- ------------------------
Equity Compensation
Plans Approved by security
Holders *(FIBR) 1,132,982 $34.30 442,202
--------- ------ ----------
Equity Compensation
Plans not Approved by
Security Holders (SNI) 1,886,167 $ 5.35 20,558,153
--------- ------ ----------
Total 3,019,149 $16.21 21,000,355
--------- ------ ----------
* 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 uncollectible
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.
19
We believe the following critical accounting policies affect our more
significant judgments and estimates used in the preparation of our consolidated
financial statements:
o Revenue recognition. Revenue is generally recognized when the
products are shipped, all substantial contractual obligations, if
any, have been satisfied, and the collections of the resulting
receivable is reasonably assured. When title does not pass to the
customer at time of shipment, revenue is not recognized until all
contractual requirements are met and title has transferred.
During this transition period, the amount of the sale and/or
installation is shown in deferred revenue.
Revenue from installation is recognized as the services are
performed to the extent of the direct costs incurred. To date,
installation revenue has not been material. Revenue from service
obligations, if any, is deferred and recognized over the life of
the contract. Inventory or demonstration equipment shipped to
potential customers for field trials is not recorded as revenue.
We accrue for warranty costs, sales returns and other allowances
at the time of shipment. Although our products contain a software
component, the software is not sold separately and we are not
contractually obligated to provide software upgrades to our
customers.
o Inventory. Inventory is evaluated on a continual basis and
management must make estimates about the future customer demand
for our products, taking into account both the economic
conditions and growth potential of our customers. Reserve
adjustments are made based on management's estimate of future
sales value, if any, of specific inventory items. Reserve
adjustments are made for the difference between the cost of the
inventory and the estimated market value and charged to
operations in the period in which the facts that give rise to the
adjustments become known. A misinterpretation or misunderstanding
of these conditions or uncertainty in the future outlook of our
industry or the economy, or the failure to estimate correctly,
could result in inventory losses in excess of the provisions
determined to be appropriate at the time of the balance sheet.
o Accounts receivable. Accounts receivable balances are evaluated
on a continual basis and management regularly reviews the
financial stability of individual customers. This analysis
involves a judgment of the customers' current and projected
financial condition and the positive or negative effects of the
current and projected industry outlook, as well as that of the
economy in general. Allowances are provided for potentially
uncollectible 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.
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 ownership changes made as a result
of the Exchange Agreement dated June 4, 2003, 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.
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Impact of Recent Accounting Pronouncements
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 November 2002, the FASB issued FIN 45, which expands previously issued
accounting guidance and disclosure requirements for certain guarantees. FIN 45
requires us to recognize an initial liability for the fair value of an
obligation assumed by issuing a guarantee. The provision for initial recognition
and measurement of the liability will be applied on a prospective basis to
guarantees issued or modified after December 31, 2002. The adoption of FIN 45
did not materially affect our consolidated financial statements.
In November 2002, the Emerging Issues Task Force ("EITF") reached a
consensus on Issue No. 00-21, "Revenue Arrangements with Multiple Deliverables."
EITF Issue No. 00-21 provides guidance on how to account for arrangements that
involve the delivery or performance of multiple products, services and/or rights
to use assets. The provisions of EITF Issue No. 00-21 applied to revenue
arrangements entered into in fiscal periods beginning after June 15, 2003.
In January 2003, the 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 adopted FIN No. 46 with no material effect on our financial position
or results of operations.
In December 2003, the SEC issued SAB 104, which supersedes SAB 101, Revenue
Recognition in Financial Statements. The primary purpose of SAB 104 is to
rescind the accounting guidance contained in SAB 101 related to multiple element
revenue arrangements, which was superseded as a result of the issuance of EITF
00-21. We adopted EITF 00-21 and SAB 104 with no material impact on our
financial statements.
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.
21
Subsequent Event
In April 2004, the Company announced its agreement to be acquired by Zhone
Technologies, Inc. ("Zhone"). Under the terms of the agreement, Zhone will issue
0.9 of a share of Zhone common stock for each outstanding share of Sorrento
common stock and each option, warrant and other security exercisable or
convertible into Sorrento common stock will be assumed by Zhone and become
exercisable or convertible into Zhone common stock, with appropriate adjustments
based on the merger exchange ratio. The proposed stock-for-stock transaction is
intended to qualify as tax-free to the stockholders of Sorrento.
The Form S-4 Registration Statement relating to the proposed merger of the
two companies has been declared effective by the Securities and Exchange
Commission. Zhone and Sorrento also received notification of early termination
of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act.
Stockholder meetings for both Zhone and Sorrento have been scheduled for June
30, 2004, for stockholders of record as of May 25, 2004. Subject to the approval
of the stockholders of both companies and meeting the closing conditions as
described in the proposed merger agreement and proxy. Zhone and Sorrento
anticipate compliance with all remaining closing conditions and for the
transaction to be completed on July 1, 2004.
Fluctuations in Revenue and Operating Results
The networking and bandwidth aggregation industry is subject to fluctuation
and the declines and increases recently experienced by us are not necessarily
indicative of the operating results for any future periods. Our operating
results may fluctuate as a result of a number of factors, including the timing
of orders from, and shipments to, customers; the timing of new product
introductions and the market acceptance of those products; increased
competition; changes in manufacturing costs; availability of parts; changes in
the mix of product sales; the rate of end user adoption and carrier and private
network deployment of WAN data, video and audio communication services; factors
associated with international operations; and changes in world economic
conditions.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to financial market risks, including changes in interest
rates and foreign currency rates. Our exposure to interest rate risk is the
result of our need for periodic additional financing for our large operating
losses and capital expenditures associated with establishing and expanding our
operations. The interest rate that we will be able to obtain on debt financing
will depend on market conditions at that time, and may differ from the rates we
have secured on our current debt.
Almost all of our sales have been denominated in U.S. dollars. A portion of
our expenses are denominated in currencies other than the U.S. dollar and in the
future a larger portion of our sales could also be denominated in non-U.S.
currencies. As a result, currency fluctuations between the U.S. dollar and the
currencies in which we do business could cause foreign currency translation
gains or losses that we would recognize in the period incurred. We cannot
predict the effect of exchange rate fluctuations on our future operating results
because of the number of currencies involved, the variability of currency
exposure and the potential volatility of currency exchange rates. We attempt to
minimize our currency exposure risk through working capital management and do
not hedge our exposure to translation gains and losses related to foreign
currency net asset exposures.
We do not hold or issue derivative, derivative commodity instruments or
other financial instruments for trading purposes. Investments held for other
than trading purposes do not impose a material market risk.
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.
22
Item 4. Controls and Procedures
Evaluation of Controls and Procedures
Our chief executive officer and our chief financial officer, after
evaluating our disclosure controls and procedures (as defined in Securities
Exchange Act of 1934 (the "Exchange Act") Rules 13a-15(e) and 15d-15(e) as of
the end of the period covered by this Quarterly Report on Form 10-Q (the
"Evaluation Date") have concluded that as of the Evaluation Date, our disclosure
controls and procedures are effective to ensure that information we are required
to disclose in reports that we file or submit under the Exchange Act is
recorded, processed, summarized and reported within the time periods specified
in Securities and Exchange Commission rules and forms.
Internal Control Over Financial Reporting.
There was no significant change in our internal control over financial reporting
that occurred during the period covered by this Quarterly Report on Form 10-Q
that has materially affected, or is reasonably likely to materially affect, our
internal control over financial reporting.
23
PART II
OTHER INFORMATION
Item 1: Legal Proceedings
None
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
None
Item 5: Other Information
Not Applicable
Item 6: Exhibits and Reports on Form 8-K
A. Exhibits
Exhibit Number Description of Exhibit
-------------- ----------------------
31.1 Certification of Chief Executive Officer
pursuant to Rule 13a-14(a) or Rule 15d-14(a)
of the Securities Exchange Act of 1934 (the
"Exchange Act").
31.2 Certification of the Chief Financial Officer
pursuant to Rule 13a-14(a) or Rule 15d-14(a)
of the Exchange Act.
32.1 Certification of Chief Executive Officer
pursuant to Rule 13a-14(b) or Rule 15d-14(b)
of the Exchange Act and 18 U.S. C. Section
1350.
32.2 Certification of Chief Financial Officer
Pursuant to Rule 13a-14(b) or Rule 15d-14(b)
of the Exchange Act and 18 U.S.C. Section
1350.
B. Reports on Form 8-K
On February 17, 2004, we filed a Current Report on Form 8-K, disclosing a press
release announcing that our registration statement on Form S-3 (File No.
333-112358) was declared effective by the Securities and Exchange Commission.
The information was provided under item 5 of Form 8-K.
On April 26, 2004, we filed a Current Report on Form 8-K, disclosing
the execution of and Agreement and plan of Merger, dated as of April 22, 2004,
with Zhone Technologies, Inc., and Selene Acquisition Corp., and disclosing a
press release announcing our financial results for the fourth quarter and full
fiscal year ended January 31, 2004. The information was provided under Item 5
and Item 12, respectively, of Form 8-K.
24
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 11, 2004 By: /s/ JOE R. ARMSTRONG
-------------------------------------------
Joe R. Armstrong,
Chief Financial Officer
Principal Accounting Officer
25