Alliance Fiber Optic Products 10-Q 2010
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 2010
oTRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the trasition period from __________ to ___________
Commission File Number 0-31857
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 þ No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "accelerated filer", "large accelerated filer", and "smaller reporting company" in Rule 12b-2 of the Exchange Act). (Check one):
Large accelerated filer o Accelerated Filer o Non-accelerated filer o Smaller reporting company þ
(Do not check if a smaller reporting company)
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No þ
On August 3, 2010, 42,815,788 shares of the registrant's Common Stock, $0.001 par value per share, were outstanding.
ALLIANCE FIBER OPTIC PRODUCTS, INC.
QUARTERLY PERIOD ENDED JUNE 30, 2010
PART I: FINANCIAL INFORMATION
ITEM 1: FINANCIAL STATEMENTS
ALLIANCE FIBER OPTIC PRODUCTS, INC.
Condensed Consolidated Balance Sheets
(in thousands, except share data)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
ALLIANCE FIBER OPTIC PRODUCTS, INC.
Condensed Consolidated Statements of Income
(Unaudited, in thousands, except per share data)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
ALLIANCE FIBER OPTIC PRODUCTS, INC.
Condensed Consolidated Statements of Cash Flows
(Unaudited, in thousands)
The accompanying notes are an integral part of these Condensed Consolidated Financial Statements.
ALLIANCE FIBER OPTIC PRODUCTS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Summary of Significant Accounting Policies
Alliance Fiber Optic Products, Inc. (the "Company") was incorporated in California on December 12, 1995 and reincorporated in Delaware on October 19, 2000. The Company designs, manufactures and markets fiber optic components for communications equipment manufacturers. The Company's headquarters are located in Sunnyvale, California, and it has operations in Taiwan and China.
Basis of presentation
The accompanying condensed consolidated balance sheet as of December 31, 2009, which has been derived from audited financial statements, and the unaudited interim condensed consolidated financial statements as of June 30, 2010 have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission (the "SEC") and include the accounts of Alliance Fiber Optic Products, Inc. and its wholly-owned subsidiaries. All inter-company accounts and transactions have been eliminated. Certain information and footnote disclosures normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States of America ("U.S. GAAP") have been condensed or omitted pursuant to such rules and regulations.
These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2009 and filed with the SEC on March 19, 2010. The unaudited condensed consolidated financial statements as of June 30, 2010, and for the three and six months ended June 30, 2010 and 2009, reflect, in the opinion of management, all adjustments, consisting only of normal recurring adjustments, necessary to state fairly the financial information set forth herein. The results of operations for the interim periods are not necessarily indicative of the results to be expected for any subsequent interim period or for an entire year.
There have been no significant changes in the Company's critical accounting policies during the six months ended June 30, 2010 as compared to what was previously disclosed in the Company's Form 10-K for the fiscal year ended December 31, 2009.
The Company recognizes revenue upon shipment of its products to its customers, provided that the Company has received a purchase order, the price is fixed, collection of the resulting receivable is reasonably assured and transfer of title and risk of loss has occurred. Subsequent to the sale of its products, the Company has no obligation to provide any modification or customization upgrades, enhancements or post contract customer support.
Allowances are provided for estimated returns. A provision for estimated sales return allowances is recorded at the time revenue is recognized based on historical returns, current economic trends and changes in customer demand. Such allowances are adjusted periodically to reflect actual and anticipated experience. Such adjustments, which are recorded against revenue in the period, could be material.
Cash and Cash Equivalents
The Company considers all highly liquid instruments with a maturity of three months or less when purchased to be cash equivalents. Cash equivalents consist primarily of money market accounts, corporate bonds, and certificates of deposit that are stated at cost, which approximates fair value.
Concentrations of Risk
Our connectivity products (formerly named optical path multiplexing solution) contributed 69.8% and 58.3% of our revenues for the three months ended June 30, 2010 and 2009, respectively. Our optical passive products (formerly named dense wavelength division multiplexing) contributed 30.2% and 41.7% of our revenues for the three months ended June 30, 2010 and 2009, respectively. Our connectivity products contributed 70.8% and 57.3% of our revenues for the six months ended June 30, 2010 and 2009, respectively. Our optical passive products contributed 29.2% and 42.7% of our revenues for the six months ended June 30, 2010 and 2009, respectively.
In the three months ended June 30, 2010 and 2009, our top 10 customers comprised 71.6% and 64.6% of our revenues, respectively. For the three months ended June 30, 2010, three customers accounted for 15.8%, 14.7% and 12.8% of our total revenues, respectively. For the three months ended June 30, 2009, two customers accounted for 17.5% and 17.2% of our total revenues, respectively.
In the six months ended June 30, 2010 and 2009, our top 10 customers comprised 69.5% and 66.6% of our revenues, respectively. For the six months ended June 30, 2010, three customers accounted for 14.5%, 14.2% and 11.6% of our total revenues, respectively. For the six months ended June 30, 2009, two customers each accounted for 19.1% of our total revenues, respectively.
2. Recent Accounting Pronouncements
In January 2010, the Financial Accounting Standards Board ("FASB") issued Accounting Standards Update (ASU) No. 2010-06, Improving Disclosure about Fair Value Measurements. This ASU will add new requirements for disclosures into and out of Levels 1 and 2 fair value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. It also clarifies existing fair value disclosures about the level of disaggregation, inputs, and valuation techniques. The guidance in the ASU is effective for annual and interim reporting periods in fiscal years beginning after December 15, 2010. The Company does not anticipate the adoption of the new guidance to have any effect on the financial statements or results of operations.
In June 2009, the FASB issued ASC 105, Generally Accepted Accounting Principles, which establishes the FASB Accounting Standards Codification (the "Codification") as the source of authoritative accounting principles to be applied by nongovernmental entities in the preparation of financial statements in conformity with U.S. GAAP. Rules and interpretive releases of the SEC under authority of federal securities laws are also sources of authoritative U.S. GAAP for SEC registrants. All guidance contained in the Codification carries an equal level of authority. ASC 105 is effective for financial statements issued for interim and annual periods ending after September 15, 2009. The Codification supersedes all existing non-SEC accounting and reporting standards. All other non-grandfathered, non-SEC accounting literature not included in the Codification became non-authoritative. Following ASC 105, the FASB will not issue new standards in the form of Statements, FASB Staff Positions, or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates. The FASB will not consider Accounting Standards Updates as authoritative in their own right. Accounting Standards Updates will serve only to update the Codification, provide background information about the guidance and provide the bases for conclusions on the change(s) in the Codification. The Company adopted ASC 105 in its Form 10-K for the year ended December 31, 2009. The adoption did not have an impact on the Company's consolidated results of operations and financial condition for the quarter ended June 30, 2010.
3. Stock-based Compensation
Effective January 1, 2006, the Company adopted ASC 718, "Share-Based Payment", which establishes accounting for share-based payment ("SBP") awards exchanged for employee services and requires companies to expense the estimated fair value of these awards over the requisite employee service period.
ASC 718 requires companies to record compensation expense for stock options measured at fair value, on the date of grant, using an option-pricing model. The fair value of stock options is determined using the Binomial Lattice Model instead of the Black-Scholes Model previously utilized under ASC 718. The Company believes that the revised model represents a more likely projection of actual outcomes.
As of June 30, 2010, there was $0.01 million of total unrecognized compensation cost related to share-based compensation arrangements granted under the Company's option plans.
At June 30, 2010, the Company had two stock-based compensation plans. The (a) 1997 Stock Option Plan and (b) 2000 Stock Incentive Plan, which are described below.
(a) 1997 Stock Option Plan:
In May 1997, the Company adopted its 1997 Stock Plan under which 3,000,000 shares of common stock were reserved for issuance to eligible employees, directors and consultants upon exercise of stock options and stock purchase rights. During the year ended December 31, 2000, an additional 5,200,000 shares were reserved for issuance under the 1997 Stock Plan. Incentive stock options are granted at a price not less than 100% of the fair market value of the Company's common stock and at a price of not less than 110% of the fair market value for grants to any person who owned more than 10% of the voting power of all classes of stock on the date of grant. Nonstatutory stock options are granted at a price not less than 85% of the fair market value of the common stock and at a price not less than 110% of the fair market value for grants to a person who owned more than 10% of the voting power of all classes of stock on the date of the grant. Options granted under the 1997 Stock Plan generally vest over four years and are exercisable for not more than ten years (five years for grants to any person who owned more than 10% of the voting power of all classes of stock on the date of the grant). In November 2000, the 1997 Stock Plan was replaced by the 2000 Stock Incentive Plan.
(b) 2000 Stock Incentive Plan:
In November 2000, the Company adopted its 2000 Stock Incentive Plan under which 1,500,000 shares of common stock were reserved for issuance to eligible employees, directors and consultants upon exercise of stock options and stock purchase rights. On January 1 of each year, beginning on January 1, 2001, the number of shares available for grant will automatically increase by the lesser of: (i) 1,700,000 shares; (ii) 5% of the fully diluted outstanding shares of stock on that date; or (iii) a lesser amount as may be determined by the Board of Directors. The Board of Directors determined not to increase the number of shares available under the Plan on January 1, 2010 and 2009, respectively. Incentive stock options and nonstatutory stock options are granted at 100% of the fair market value of the Company's common stock on the date of grant.
Options granted under the 2000 Stock Incentive Plan generally vest over four years. However, most options granted in the past three years have been fully vested at the time of grant. Options are exercisable for not more than ten years.
The following information relates to the stock option activity for the six months ended June 30, 2010:
The aggregate intrinsic value in the table above represents the total pre-tax intrinsic value (the difference between the Company's closing stock price on the last trading day of the second quarter of fiscal 2010 and the exercise price, multiplied by the number of in-the-money options) that would have been received by the option holders had all option holders exercised their options on June 30, 2010. This amount changes based on the fair market value of the Company's stock. The total intrinsic value of options exercised for the three and six months ended June 30, 2010 was de minimis.
No options were granted during the three months ended June 30, 2010. The Company granted options to purchase 30,000 shares of common stock to one of the members of the Board of Directors during the three months ended June 30, 2009. The weighted average grant date fair value of options granted during the three months ended June 30, 2009 was de minimis.
Cash received from option exercises during the three and six months ended June 30, 2010 was $35,000 and $97,000, respectively, and is included within the financing activities section in the accompanying consolidated statements of cash flows.
The following table summarizes employee stock-based compensation expense resulting from stock options and the Company's employee stock purchase plan (in thousands):
4. Inventories, net (in thousands)
Basic net income per share is computed by dividing net income for the period by the weighted average number of shares of common stock outstanding during the period. Diluted net income per share is computed using the weighted-average number of shares of common stock outstanding plus the effect of all in-the-money dilutive options representing potential shares of common stock outstanding during the period.
The following table sets forth the computation of basic and diluted net income per share for the periods indicated (in thousands, except per share data):
The total number of shares excluded from the calculation of diluted net income per share is as follows (in thousands), because the effect would be anit-dilutive:
6. Comprehensive Income
Comprehensive income is defined as the change in equity of a company during a period resulting from transactions and other events and circumstances, excluding transactions resulting from investments by owners and distributions to owners. The difference between net income and comprehensive income for the Company is due to foreign exchange translations adjustments and unrealized gain (loss) on available-for-sale securities.
The components of comprehensive income are as follows (in thousands):
7. Income Taxes
The Company adopted ASC 740, Accounting for Uncertainty in Income Taxes, on January 1, 2007. It is the Company's accounting policy to record income tax interest and penalties in the income tax provision. The Company did not have any material unrecognized tax benefits or uncertain tax positions at June 30, 2010.
8. Commitments and Contingencies
From time to time, the Company may be involved in litigation in the normal course of business. As of the date of these financial statements, the Company is not aware of any material legal proceedings pending or threatened against the Company.
Indemnification and Product Warranty:
The Company indemnifies certain customers, suppliers and subcontractors for attorney fees and damages and costs awarded against these parties in certain circumstances in which products are alleged to infringe third party intellectual property rights, including patents, trade secrets, trademarks or copyrights. In all cases, there are limits on and exceptions to the potential liability for indemnification relating to intellectual property infringement claims. The Company cannot estimate the amount of potential future payments, if any, that it might be required to make as a result of these agreements. As of the date of this Report, the Company has not paid any claim or been required to defend any action related to indemnification obligations, and accordingly, the Company has not accrued any amounts for such indemnification obligations. However, the Company may record charges in the future as a result of these indemnification obligations.
The Company generally warrants products against defects in materials and workmanship and non-conformance to specifications for varying lengths of time. If there is a material increase in customer claims compared with historical experience, or if costs of servicing warranty claims are greater than expected, the Company may record a charge against cost of revenues.
The Company leases office space under long-term operating leases expiring at various dates through 2015.
The Company's aggregate future minimum facility lease payments are as follows (in thousands):
9. Bank Loans
In November 2004, the Company entered into a ten-year loan of $0.5 million in Taiwan with an interest rate of 2.3% for the first two years and 3.6% for the following years. In November 2006, the Company entered into a seven-year loan of $0.2 million in Taiwan with an interest rate of 2.8%. Both loans are secured by the Company's building in Taiwan. The net book value of the building was $0.5 million as of June 30, 2010.
In September 2007, the Company entered into a three-year equipment loan of $0.04 million and a five-year equipment loan of $0.1 million with an interest rate of 3.68% for both loans.
Payments due under our bank loans as of June 30, 2010 were as follows (in thousands):
10. Related Party Transactions
As of June 30, 2010, Foxconn Holding Limited was a holder of 18.69% of the Company's common stock, based on share ownership information set forth in a Schedule 13G filed by Foxconn Holding Limited on January 4, 2002. The Company sells products to and purchases raw materials from Hon Hai Precision Industry Company Limited, who is the parent company of Foxconn Holding Limited, in the normal course of business. These transactions were made at prices and terms consistent with those with unrelated third parties. There were no sales of products to Hon Hai Precision Industry Company Limited for the three and six months ended June 30, 2010. Purchases of raw materials from Hon Hai Precision Company Limited were $0.9 million and $1.5 million for the three and six months ended June 30, 2010, respectively. There were no amounts due from Hon Hai Precision Company Limited at June 30, 2010. Amounts due to Hon Hai Precision Company Limited were $0.9 million at June 30, 2010.
There were no sales of products to Hon Hai Precision Industry Company Limited for the three months ended June 30, 2009. Sales of products to Hon Hai Precision Industry Company Limited were $0.01 million for the six months ended June 30, 2009. Purchases of raw materials from Hon Hai Precision Company Limited were $0.5 million and $0.9 million for the three and six months ended June 30, 2009, respectively. There were no amounts due from Hon Hai Precision Company Limited at June 30, 2009. Amounts due to Hon Hai Precision Company Limited were $0.5 million at June 30, 2009.
11. Fair Value of Financial instruments
Effective January 1, 2008, the Company adopted ASC 820 which provides a definition of fair value, establishes a hierarchy for measuring fair value under generally accepted accounting principles, and requires certain disclosures about fair values used in the financial statements. ASC 820 does not extend the use of fair value beyond what is currently required by other pronouncements, and it does not pertain to stock-based compensation under ASC 718, Share-Based Payments or to leases under ASC 840, Accounting for Leases.
In February 2008, FASB ASC 820 was issued. This FSP provides a one year deferral of the effective date of ASC 820 for non-financial assets and non-financial liabilities, except those that are recognized or disclosed in the financial statements at fair value at least annually. Therefore, the Company has adopted the provisions of ASC 820 with respect to financial assets and liabilities only.
ASC 820 defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. Valuation techniques used to measure fair value under ASC 820 must maximize the use of observable inputs and minimize the use of unobservable inputs. The standard describes a fair value hierarchy based on three levels of inputs, of which the first two are considered observable and the last unobservable, that may be used to measure fair value, which are the following:
The Company measures the following financial assets at fair value on a recurring basis. The fair value of these financial assets at June 30, 2010 (in thousands) are as follows:
As of June 30, 2010, the Company held investments in corporate bonds, certificates of deposit, money market securities, and auction rate securities ("ARS"). The Company's cash and cash equivalents are comprised of investments with original maturities of 90 days or less from the date of purchase and these investment instruments are classified within Level 1 of the fair value hierarchy because they are valued based on quoted market prices in active markets. The Company's short-term investments are comprised of corporate bonds, certificates of deposit and ARS with original maturities of 91 days or more from the date of purchase. These investment instruments are classified within Level 1 of the fair value hierarchy because they are valued based on quoted market prices in active markets with the exception of corporate bonds which are classified as Level 2 and ARS which are classified as Level 3.
As of June 30, 2010, the Company held investments in ARS that are required to be measured at fair value on a recurring basis. Since February 2008, all ARS investments in the Company's portfolio have experienced failed auctions. The Company's ARS investments have been classified within Level 3 as their valuation requires substantial judgment and estimation of factors that are not currently observable in the market due to the lack of trading. This valuation may be revised in future periods as market conditions evolve. The Company estimated the fair value of its ARS based on estimates contained in broker statements that were compiled utilizing Level 3 inputs including, but not limited to factors such as tax status, credit quality, duration, insurance wraps and the portfolio composition of The Federal Family Education Loan Program loans.
As of June 30, 2010, the Pennsylvania Higher Education Assistance Agency completed six partial calls of the ARS at par and the Company received settlement of $250,000 in total.
In November 2008, the Company accepted an offer from UBS, the Company's investment advisor, granting the Company the right to require UBS to purchase the Company's ARS at their par value of $16.3 million anytime during the two-year period beginning June 30, 2010 ("Right"). As of June 30, 2010, UBS had exercised the Rights for the settlement of $9.5 million in total. Subsequent to quarter-end, UBS exercised the Rights for the remaining balance and the full cash value of the Company's ARS was redeemed on July 1, 2010.
In conjunction with the adoption of ASC 825, the Company elected the fair value option for its ARS and the Right. Since the Right is directly related to the Company's ARS investments, the Company elected the fair value option for these financial assets and they have been classified within Level 3 as ARS investments. In conjunction with the adoption of ASC 825, the Company elected a one-time transfer of ARS subject to settlements from available-for-sale to the trading category. As of June 30, 2010, the Company has recognized the Right as other current assets on the balance sheet and recorded a loss of $1.2 million as other expense.
The following table provides a reconciliation of the beginning and ending balance for the assets measured at fair value using significant unobservable inputs (Level 3) (in thousands):
12. Geographic Segment Information
The Company operates in a single industry segment. This industry segment is characterized by rapid technological change and significant competition.
The following is a summary of the Company's revenues generated by geographic segments, revenues generated by product lines and identifiable assets located in these segments (in thousands):
ITEM 2: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
When used in this Report, the words "expects," "anticipates," "believes", "estimates," "plans," "intends," "could," "will," "may" and similar expressions are intended to identify forward-looking statements. These are statements that relate to future periods and include statements as to our operating results, revenues, sources of revenues, cost of revenues, gross profit, profitability, the amount and mix of anticipated investments, expenditures and expenses, our liquidity and the adequacy of our capital resources, our auction rate securities and associated rights, exposure to interest rate or currency fluctuation, anticipated working capital and capital expenditures, reliance on our connectivity products, our cash flow, trends in average selling prices, our reliance on the commercial success of our optical passive products, plans for future products and enhancements of existing products, features, benefits and uses of our products, demand for our products, our success being tied to relationships with key customers, industry trends and market demand, our efforts to protect our intellectual property, potential indemnification agreements, increases in the number of possible license offers and patent infringement claims, our competitive position, sources of competition, consolidation in our industry, our international strategy, inventory management, our employee relations, the adequacy of our internal controls, the effect of recent or future accounting pronouncements and our critical accounting policies, estimates, models and assumptions. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from those projected. These risks and uncertainties include, but are not limited to, those risks discussed in Item 1A and elsewhere in this report, as well as risks related to the development of the metropolitan, last mile access, and enterprise networks, customer acceptance of our products, our ability to retain and obtain customers, industry-wide overcapacity and shifts in supply and demand for optical components and modules, our ability to meet customer demand and manage inventory, fluctuations in demand for our products, declines in average selling prices, development of new products by us and our competitors, increased competition, inability to obtain sufficient quantities of a raw material product, loss of a key supplier, integration of acquired businesses or technologies, financial stability in foreign markets, foreign currency exchange rates, interest rates, costs associated with being a public company, delisting from the Nasdaq Capital Market, failure to meet customer requirements, our ability to license intellectual property on commercially reasonable terms, economic stability, and the risks set forth below under Part II, Item 1A, "Risk Factors." These forward-looking statements speak only as of the date hereof. The Company expressly disclaims any obligation or undertaking to release publicly any updates or revisions to any forward-looking statements contained herein to reflect any change in the Company's expectations with regard thereto or any change in events, conditions or circumstances on which any such statement is based.
The following discussion should be read in conjunction with our Condensed Consolidated Financial Statements and Notes thereto.
Critical Accounting Policies and Estimates
Stock-based Compensation Expense
On January 1, 2006, we adopted ASC718, which requires the measurement and recognition of compensation expense for all share-based payment awards made to our employees and directors including employee stock options and employee stock purchases pursuant to our Employee Stock Purchase Plan ("ESPP") based on estimated fair values. We adopted ASC 718 using the modified prospective transition method, which requires the application of the accounting standard as of January 1, 2006, the first day of our 2006 fiscal year.
Stock-based compensation expense recognized under ASC 718 was $0.05 million and $0.08 million for the three and six months ended June 30, 2010, respectively, as determined by the Binomial Lattice valuation model, and represents stock-based compensation expense related to share based compensation arrangements under our stock option plan and our ESPP.
Management's discussion and analysis of financial condition and results of operations is based on our Condensed Consolidated Financial Statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. 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 disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, bad debts, inventories, asset impairments, income taxes, contingencies, and litigation. 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 for assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
For additional information regarding our critical accounting policies and estimates, see the section entitled "Management's Discussion and Analysis of Financial Condition and Results of Operations" in our Annual Report on Form 10-K for the year ended December 31, 2009.
We were founded in December 1995 and commenced operations to design, manufacture and market fiber optic interconnect products, which we call our connectivity products. We started selling our optical passive products in July 2000. Since introduction, sales of optical passive products have fluctuated with the overall market for these products.
Our connectivity products contributed revenues of $8.4 million, or 69.8% and $4.5 million, or 58.3% for the three months ended June 30, 2010 and 2009, respectively. Our optical passive products contributed revenues of $3.6 million, or 30.2% and $3.2 million, or 41.7% for the three months ended June 30, 2010 and 2009, respectively.
Our connectivity products contributed revenues of $14.5 million, or 70.8% and $8.8 million, or 57.3% for the six months ended June 30, 2010 and 2009, respectively. Our optical passive products contributed revenues of $6.0 million, or 29.2% and $6.6 million, or 42.7% for the six months ended June 30, 2010 and 2009, respectively.
In the three months ended June 30, 2010 and 2009, our top 10 customers comprised 71.6% and 64.6% of our revenues, respectively. For the three months ended June 30, 2010, three customers accounted for 15.8%, 14.7% and 12.7% of our total revenues. For the three months ended June 30, 2009, two customers accounted for 17.5% and 17.2% of our total revenues. We market and sell our products predominantly through our direct sales force.
In the six months ended June 30, 2010 and 2009, our top 10 customers comprised 69.5% and 66.6% of our revenues, respectively. For the six months ended June 30, 2010, three customers accounted for 14.5%, 14.2% and 11.6% of our total revenues, respectively. For the six months ended June 30, 2009, two customers each accounted for 19.1% of our total revenues.
Our cost of revenues consists of raw materials, components, direct labor, manufacturing overhead and production start-up costs. We expect that our cost of revenues as a percentage of revenues will fluctuate from period to period based on a number of factors including:
Research and development expenses consist primarily of salaries and related personnel expenses, fees paid to outside service providers, materials costs, test units, facilities, overhead and other expenses related to the design, development, testing and enhancement of our products. We expense our research and development costs as they are incurred. We believe that a significant level of investment for product research and development is required to remain competitive.
Sales and marketing expenses consist primarily of salaries, commissions and related expenses for personnel engaged in marketing, sales and technical support functions, as well as costs associated with trade shows, promotional activities and travel expenses. We intend to continue to invest in our sales and marketing efforts, both domestically and internationally, in order to increase market awareness and to generate sales of our products. However, we cannot be certain that our expenditures will result in higher revenues. In addition, we believe that our future success depends upon establishing successful relationships with a variety of key customers.
General and administrative expenses consist primarily of salaries and related expenses for executive, finance, administrative, accounting and human resources personnel, insurance and professional fees for legal and accounting support.
Results of Operations
The following table sets forth the relationship between various components of operations, stated as a percentage of revenues for the periods indicated:
Revenues. Revenues were $12.1 million and $7.7 million for the three months ended June 30, 2010 and 2009, respectively. Revenues increased 56.5% in the three months ended June 30, 2010 from the same period in 2009. Revenues were $20.5 million and $15.4 million for the six months ended June 30, 2010 and 2009, respectively. Revenues increased 33.4% in the six months ended June 30, 2010 from the same period in 2009. The increase for the three and six months ended June 30, 2010 was mainly due to increased orders from our existing customers and higher volume shipments of telecom and datacom applications related products.
Cost of Revenues. Cost of revenues was $8.0 million and $5.3 million for the three months ended June 30, 2010 and 2009, respectively. Cost of revenues as a percentage of revenues decreased to 66.5% for the three months ended June 30, 2010 from 68.9% for the three months ended June 30, 2009. Cost of revenues was $13.7 million and $10.7 million for the six months ended June 30, 2010 and 2009, respectively. Cost of revenues as a percentage of revenues decreased to 67.1% for the six months ended June 30, 2010 from 69.4% for the six months ended June 30, 2009. The lower percentage cost of revenues for the three and six months ended June 30, 2010 resulted from increased factory utilization due to higher revenues.
Gross Profit. Gross profit increased in dollars to $4.1 million, or 33.5% of revenues, for the three months ended June 30, 2010 from $2.4 million, or 31.1% of revenues, for the same period in 2009. Gross profit increased to $6.7 million, or 32.9% of revenues, for the six months ended June 30, 2010 from $4.7 million, or 30.6% of revenues, for the same period in 2009. For the three and six months ended June 30, 2010, the higher gross profit was due to the higher utilization of our factories as a result of increased volume shipments to our customers. We expect our gross profit as a percentage of revenues to continue to improve with higher production volumes, which we anticipate will result in improved absorption of overhead expenses. However, decreasing average selling prices will negatively impact our gross profit and may offset any benefits from improved absorption.
Research and Development Expenses. Research and development expenses increased to $0.9 million for the three months ended June 30, 2010 from $0.8 million for the same period in 2009. Research and development expenses increased to $1.6 million for the six months ended June 30, 2010 from $1.5 million for the same period in 2009. The higher research and development expenses were due to capital investments for new product development.
As a percentage of revenues, research and development expenses decreased to 7.2% in the three months ended June 30, 2010 from 9.8% for the same period in 2009. As a percentage of revenues, research and development expenses decreased to 7.7% in the six months ended June 30, 2010 from 9.7% for the same period in 2009. The lower research and development expenses as a percentage of revenues were mainly due to increased revenue levels. We expect research and development expenses will remain relatively flat in the next two quarters.
Sales and Marketing Expenses. Sales and marketing expenses remained at $0.6 million for the three months ended June 30, 2010 and 2009, respectively. Sales and marketing expenses remained at $1.2 million for the six months ended June 30, 2010 and 2009.
As a percentage of revenues, sales and marketing expenses decreased to 5.3% in the three months ended June 30, 2010 from 7.5% for the same period in 2009. As a percentage of revenues, sales and marketing expenses decreased to 5.8% in the six months ended June 30, 2010 from 7.9% for the same period in 2009. The lower sales and marketing expenses as a percentage of revenues was mainly due to increased revenue levels. We expect sales and marketing expenses will remain relatively flat in the next two quarters.
General and Administrative Expenses. General and administrative expenses increased to $1.0 million for the three months ended June 30, 2010 from $0.8 million for the same period in 2009. General and administrative expenses increased to $1.9 million for the six months ended June 30, 2010 from $1.6 million for the same period in 2009. The higher expenses were due to higher franchise and property taxes and employee profit sharing.
As a percentage of revenues, general and administrative expenses decreased to 8.0% in the three months ended June 30, 2010 from 10.0% for the same period in 2009. As a percentage of revenues, general and administrative expenses decreased to 9.3% in the six months ended June 30, 2010 from 10.5% for the same period in 2009. The lower general and administrative expenses as a percentage of revenue was mainly due to increased revenue levels. We expect general and administrative expenses will remain relatively flat in the next two quarters.
Stock-Based Compensation. Total stock-based compensation increased to approximately $51,000 for the three months ended June 30, 2010 from approximately $22,000 for the same period in 2009. Total stock-based compensation increased to approximately $84,000 for the six months ended June 30, 2010 from approximately $50,000 for the same period in 2009. This increase was due to the higher price of our common stock as of June 30, 2010, which resulted in higher stock based compensation cost related to our stock option plan.
Interest and Other Income, Net. Interest and other income, net, was $0.1 million and $0.2 million for the three months ended June 30, 2010 and 2009, respectively. Interest and other income, net, was $0.3 million and $0.4 million for the six months ended June 30, 2010 and 2009, respectively. These amounts consisted primarily of interest income which fluctuated based on cash balances and changes in interest rates.
Income Tax Expense. Income tax expense was approximately $0.07 million and $0.03 million for the three months ended June 30, 2010 and 2009, respectively. Income tax expense was approximately $0.08 million and $0.04 million for the six months ended June 30, 2010 and 2009, respectively.
Liquidity and Capital Resources
At June 30, 2010, we had cash and cash equivalents of $7.6 million and short-term investments of $33.4 million, which includes our ARS of $5.7 million. We also held $0.6 million of ARS Rights in other current assets.
Net cash provided by operating activities was $0.8 million for the six months ended June 30, 2010. Net cash provided by operating activities was primarily due to net income of $2.2 million, an increase in accounts payable of $3.0 million, and contribution from adjustment for non-cash charges, including depreciation and stock based compensation of $0.6 million. These were offset by a $2.8 million increase in accounts receivable and a $1.8 million increase in inventory. Net cash provided by operating activities was $0.7 million for the six months ended June 30, 2009. The increase in net cash provided by operating activities was primarily due to net income of $0.7 million. Additionally, cash used for accounts payable of $0.6 million, accounts receivable of $0.4 million, prepaid expenses of $0.2 million, and accrued liabilities of $0.2 million, offset cash provided by decreases in inventory of $0.9 million, and depreciation and amortization of $0.5 million.
Cash used in investing activities was $2.1 million for the six months ended June 30, 2010. This resulted from $0.2 million in net purchases of short-term investments and $1.8 million spending on equipment purchases. Cash used in investing activities was $5.5 million for the six months ended June 30, 2009. This resulted from $5.2 million in net purchases of short-term investments and reclassification of long-term investments to short-term investments. We also used $0.3 million cash on equipment purchases.
Cash provided by financing activities was $0.2 million and $0.05 million for the six months ended June 30, 2010 and 2009, respectively. Net cash provided by financing activities was primarily due to proceeds from the exercise of options to purchase our common stock and the sale of our common stock through our Employee Stock Purchase Plan, which was offset in part by repayment of bank borrowings.
We believe that our current cash, cash equivalents and short-term investments will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for at least the next 12 months. However, our future growth, including any potential acquisitions, may require additional funding. If cash generated from operations is insufficient to satisfy our long-term liquidity requirements, we may need to raise capital through additional equity or debt financings, additional credit facilities, strategic relationships or other arrangements. If additional funds are raised through the issuance of securities, these securities could have rights, preferences and privileges senior to holders of common stock, and the terms of any debt facility could impose restrictions on our operations. The sale of additional equity or debt securities could result in additional dilution to our stockholders, and additional financing may not be available in amounts or on terms acceptable to us, if at all. If we are unable to obtain additional financing, we may be required to reduce the scope of our planned product development and marketing efforts. Strategic arrangements, if necessary to raise additional funds, may require us to relinquish our rights to certain of our technologies or products. Our failure to raise capital when needed could harm our business, financial condition and operating results.
Off Balance Sheet Arrangements
We did not have any off-balance sheet arrangements at June 30, 2010.
Our long-term debt obligations are for principal and interest on mortgage and equipment loans from financial institutions in Taiwan.
In July 2004, we moved into our corporate headquarters in Sunnyvale, California. The lease has a six-year term commencing on July 22, 2004. In June 2010, we renewed the lease for a 18,088 square foot facility in the same building, which lease will expire in January 2016.
In Taiwan, we lease a total of approximately 38,800 square feet in one facility located in Tu-Cheng City, Taiwan. This lease expires at various times from December 2010 to December 2011. In December 2000, we purchased approximately 8,200 square feet of space immediately adjacent to the leased facility for $0.8 million, bringing the total square footage to approximately 47,000 square feet.
In August 2009, we moved into a 132,993 square foot facility in Shenzhen, China, This lease will expire in October 2014.
Recent Accounting Pronouncements
See Note 2 of our Notes to Unaudited Condensed Consolidated Financial Statements included with this Quarterly Report on Form 10-Q for information on recent accounting pronouncements.
ITEM 4T: CONTROLS AND PROCEDURES
(a) Evaluation of disclosure controls and procedures. We maintain "disclosure controls and procedures," as such term is defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the "Exchange Act"), that are designed to ensure that information required to be disclosed by us 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, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Acting Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, management recognized that disclosure controls and procedures, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the disclosure controls and procedures are met. Our disclosure controls and procedures have been designed to meet reasonable assurance standards. Additionally, in designing disclosure controls and procedures, our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible disclosure controls and procedures. The design of any disclosure controls and procedures also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Chief Executive Officer and Acting Chief Financial Officer have concluded that, as of such date, our disclosure controls and procedures were effective to ensure that material information relating to us, including our consolidated subsidiaries, is made known to them by others within those entities, particularly during the period in which this Quarterly Report on Form 10-Q was being prepared.
(b) Changes in internal controls. There was no change in our internal control over financial reporting (as defined in Rule 13a-15(f) under the Exchange Act) identified in connection with the evaluation described in Item 4(a) above that occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II: OTHER INFORMATION
ITEM 1A: RISK FACTORS
We have a history of losses, may experience future losses and may not be able to generate sufficient revenues in the future to sustain profitability.
We had net income of approximately $1.6 million and $0.4 million in the second quarter of fiscal 2010 and 2009, respectively. Although we generated a profit in the second quarter of fiscal 2010 and 2009, we may not be able to sustain profitability in the future. Although our cash and cash equivalents increased in the second quarter of fiscal 2010, our cash flows may be negative again in the future as we continue to invest in our business. As of June 30, 2010, we had an accumulated deficit of approximately $61.5 million.
We continue to experience fluctuating demand for our products. If demand for our products increases in the future, we expect to incur significant and increasing expenses for expansion of our manufacturing operations, research and development, sales and marketing, and administration, and in expanding direct sales and distribution channels. Given the rate at which competition in our industry intensifies and the fluctuations in demand for our products, we may not be able to adequately control our costs and expenses or achieve or maintain adequate operating margins. As a result, to maintain profitability, we will need to generate and sustain substantially higher revenues while maintaining reasonable cost and expense levels. We may not be able to sustain profitability on a quarterly or an annual basis.
Our connectivity products have historically represented a significant part of our revenues, and if we are unsuccessful in commercially selling our optical passive products, our business will be seriously harmed.
Sales of our connectivity products accounted for over 69.8% of our revenues in the quarter ended June 30, 2010 and a majority of our historical revenues. We expect to substantially depend on these products for the majority of our near-term revenues. Any significant decline in the price of, or demand for, these products, or failure to increase their market acceptance, would seriously harm our business. In addition, we believe that our future growth and a significant portion of our future revenues will depend on the commercial success of our optical passive products, which we began shipping commercially in July 2000. Demand for these products has fluctuated over the past few years, declining sharply starting in mid fiscal 2001 and then increasing beginning in 2003. If demand for these products does not continue to increase and our target customers do not continue to adopt and purchase our optical passive products, our revenues may decline and we may have to write-off additional inventory that is currently on our books.
Continuing weak general economic or business conditions may have a negative impact on our business.
Continuing concerns over inflation, deflation, energy costs, geopolitical issues, the availability and cost of credit, the Federal stimulus package and budget process, the U.S. mortgage market and a declining real estate market in the U.S. have contributed to increased volatility and diminished expectations for the global economy and expectations of slower global economic growth going forward. These factors, combined with volatile oil prices, declining business and consumer confidence, a volatile stock market and increased unemployment, have precipitated an economic slowdown and recession. If the economic climate in the U.S. and abroad does not improve or continues to deteriorate, our business, including our customers and our suppliers, could be negatively affected, resulting in a negative impact on our revenues.
We depend on a small number of customers for a significant portion of our total revenues and the loss of, or a significant reduction in orders from, any of these customers, would significantly reduce our revenues and harm our operating results.
In the quarters ended June 30, 2010 and 2009, our top 10 customers comprised 71.6 and 64.6% of our revenues, respectively. Three customers accounted for 15.8%, 14.7% and 12.7% of our total revenues for the three months ended June 30, 2010. Three customers accounted for 14.5%, 14.2% and 11.6% of our total revenues for the six months ended June 30, 2010.
We derive a significant portion of our revenues from a small number of customers, and we anticipate that we will continue to do so in the foreseeable future. These customers may decide not to purchase our products at all, to purchase fewer products than they did in the past, or to alter their purchasing patterns in some other way. The loss of any significant customer, a significant reduction in sales we make to them, or any problems collecting receivables from them would likely harm our financial condition and results of operations.
Our quarterly and annual financial results have historically fluctuated due primarily to introduction of, demand for, and sales of our products, and future fluctuations may cause our stock price to decline.
We believe that period-to-period comparisons of our operating results are not a good indication of our future performance. Our quarterly operating results have fluctuated in the past and are likely to fluctuate significantly in the future due to a number of factors. For example, the timing and expenses associated with product introductions and establishing additional manufacturing lines and facilities, changes in manufacturing volume, declining average selling prices of our products, the timing and extent of product sales, the mix of domestic and international sales, the mix of sales channels through which our products are sold, the mix of products sold and significant fluctuations in the demand for our products have caused our operating results to fluctuate in the past. Because we incur operating expenses based on anticipated revenue trends, and a high percentage of our expenses are fixed in the short term, any delay in generating or recognizing revenues or any decrease in revenues could significantly harm our quarterly results of operations. Other factors, many of which are more fully discussed in other risk factors, may also cause our results to fluctuate. Many of the factors that may cause our results to fluctuate are outside of our control. If our quarterly or annual operating results do not meet the expectations of investors and securities analysts, the trading price of our common stock could significantly decline.
If we cannot attract more optical communications equipment manufacturers to purchase our products, we may not be able to increase or sustain our revenues.
Our future success will depend on our ability to migrate existing customers to our new products and our ability to attract additional customers. Some of our present customers are relatively new companies. The growth of our customer base could be adversely affected by:
The fluctuations in the economy have affected the telecommunications industry. Telecommunications companies have cut back on their capital expenditure budgets, which has and may continue to further decrease demand for equipment and parts, including our products. This decrease has had and may continue to have an adverse effect on the demand for fiber optic products and negatively impact the growth of our customer base.
We are exposed to risks and increased expenses and business risk as a result of new Restriction on Hazardous Substances, or RoHS directives.>
Following the lead of the European Union, or EU, various governmental agencies have either already put into place or are planning to introduce regulations that regulate the permissible levels of hazardous substances in products sold in various regions of the world. For example, the RoHS directive for EU took effect on July 1, 2006. The labeling provisions of similar legislation in China went into effect on March 1, 2007. Consequently, many suppliers of products sold into the EU have required their suppliers to be compliant with the new directive. Many of our customers have adopted this approach and have required our full compliance. Though we have devoted a significant amount of resources and effort planning and executing our RoHS program, it is possible that some of our products might be incompatible with such regulations. In such event, we could experience the following consequences: loss of revenue, damaged reputation, diversion of resources, monetary penalties, and legal action.
The market for fiber optic components is increasingly competitive, and if we are unable to compete successfully our revenues could decline.
The market for fiber optic components is intensely competitive. We believe that our principal competitors are the major manufacturers of optical components and integrated modules, including vendors selling to third parties and business divisions within communications equipment suppliers. Our principal competitors in the components market include Oclaro Corp., DiCon Fiberoptics, Inc., JDS Uniphase Corp., Oplink Communications Inc., Senko Advanced Components and Tyco Electronics Corporation. We believe that we primarily compete with diversified suppliers for the majority of our product line and to a lesser extent with niche companies that offer a more limited product line. Competitors in any portion of our business may also rapidly become competitors in other portions of our business.
Many of our current and potential competitors have significantly greater financial, technical, marketing, purchasing, manufacturing and other resources than we do. As a result, these competitors may be able to respond more quickly to new or emerging technologies and to changes in customer requirements, to devote more resources to the development, promotion and sale of products, to negotiate lower prices on raw materials and components, or to deliver competitive products at lower prices.
Several of our existing and potential customers are also current and potential competitors of ours. These companies may develop or acquire additional competitive products or technologies in the future and subsequently reduce or cease their purchases from us. In light of the consolidation in the optical networking industry, we also believe that the size of suppliers will be an increasingly important part of a purchaser's decision-making criteria in the future. We may not be able to compete successfully with existing or new competitors, and we cannot ensure that the competitive pressures we face will not result in lower prices for our products, loss of market share, or reduced gross margins, any of which could harm our business.
New and competing technologies are emerging due to increased competition and customer demand. The introduction of products incorporating new or competing technologies or the emergence of new industry standards could make our existing products noncompetitive. For example, there are technologies for the design of wavelength division multiplexers that compete with the technology that we incorporate in our products. If our products do not incorporate technologies demanded by customers, we could lose market share causing our business to suffer.
If we fail to effectively manage our operations, specifically given the past history of sudden and dramatic downturn in demand for our products, our operating results could be harmed.
As of June 30, 2010, we had a total of 37 full-time employees in Sunnyvale, California, 307 full-time employees in Taiwan, and 736 full-time employees in China. Matching the scale of our operations with demand fluctuations, combined with the challenges of expanding and managing geographically dispersed operations, has placed, and will continue to place, a significant strain on our management and resources. To manage the expected fluctuations in our operations and personnel, we will be required to:
In addition, we will need to coordinate our domestic and international operations and establish the necessary infrastructure to implement our international strategy. If we are not able to manage our operations in an efficient and timely manner, our business will be severely harmed.
Our success also depends, to a large degree, on the efficient and uninterrupted operation of our facilities. We have expanded our manufacturing facilities in Taiwan and manufacture many of our products there. Our facility in China also houses a substantial portion of our manufacturing operations. There is significant political tension between Taiwan and China. If there is an outbreak of hostilities between Taiwan and China, our manufacturing operations may be disrupted or we may have to relocate our manufacturing operations. Tensions between Taiwan and China may also affect our facility in China. Relocating a portion of our employees could cause temporary disruptions in our operations and divert management's attention.
Because of the time it takes to develop fiber optic components, we incur substantial expenses for which we may not earn associated revenues.
The development of new or enhanced fiber optic products is a complex and uncertain process. We may experience difficulties in design, manufacturing, marketing and other areas that could delay or prevent the development, introduction or marketing of new products and enhancements. Development costs and expenses are incurred before we generate revenues from sales of products resulting from these efforts. Our total research and development expenses were approximately $0.9 million and $0.8 million for the three months ended June 30, 2010 and 2009, respectively. Our total research and development expenses were approximately $1.6 million and $1.5 million for the six months ended June 30, 2010 and 2009, respectively. We expect that our research and development expense will remain relatively flat in the second half of 2010.
If we are unable to develop new products and product enhancements that achieve market acceptance, sales of our fiber optic components could decline, which could reduce our revenues.
The communications industry is characterized by continued changing technology, frequent new product introductions, changes in customer requirements, evolving industry standards and, more recently, significant variations in customer demand. Our future success depends on our ability to anticipate market needs and develop products that address those needs. As a result, our products could quickly become obsolete if we fail to predict market needs accurately or develop new products or product enhancements in a timely manner. Our failure to predict market needs accurately or to develop new products or product enhancements in a timely manner will harm market acceptance and sales of our products. If the development or enhancement of these products or any other future products takes longer than we anticipate, or if we are unable to introduce these products to market, our sales will not increase. Even if we are able to develop and commercially introduce them, these new products may not achieve the widespread market acceptance necessary to provide an adequate return on our investment.
Current and future demand for our products depends on the continued growth of the Internet and the communications industry, which is experiencing consolidation, realignment, oversupply of product inventory and fluctuating demand for fiber optic products.
Our future success depends on the continued growth of the Internet as a widely used medium for communications and commerce, and the growth of optical networks to meet the increased demand for capacity to transmit data, or bandwidth. If the Internet does not continue to expand as a medium for communications and commerce, the need to significantly increase bandwidth across networks and the market for fiber optic components may not continue to develop. If this growth does not continue, sales of our products may decline, which would adversely affect our revenues. Our customers have experienced an oversupply of inventory due to fluctuating demand for their products that has resulted in inconsistent demand for our products. Future demand for our products is uncertain and will depend heavily on the continued growth and upgrading of optical networks, especially in the metropolitan, last mile, and enterprise access segments of the networks.
Inconsistent spending by telecommunication companies over the past several years has resulted in fluctuating demand for our products. The rate at which communication service providers and other fiber optic network users have built new fiber optic networks or installed new systems in their existing fiber optic networks has fluctuated in the past and these fluctuations may continue in the future. These fluctuations may result in reduced demand for new or upgraded fiber optic systems that utilize our products and therefore, may result in reduced demand for our products. Declines in the development of new networks and installation of new systems have resulted in the past in a decrease in demand for our products, an increase in our inventory, and erosion in the average selling prices of our products.
The communications industry is experiencing consolidation and realignment, as industry participants seek to capitalize on the rapidly changing competitive landscape developing around the Internet and new communications technologies such as fiber optic networks. As the communications industry consolidates and realigns to accommodate technological and other developments, our customers may consolidate or align with other entities in a manner that results in a decrease in demand for our products.
We are experiencing fluctuations in market demand due to overcapacity in our industry and an economy that is stymied by international terrorism, war and political instability.
The United States economy has experienced and continues to experience significant fluctuations in consumption and demand. During the past several years, telecommunication companies have mostly decreased their spending, which has resulted in excess inventory, overcapacity and a decrease in demand for our products. We may experience further decreases in the demand for our products due to a weak domestic and international economy as the fiber optics industry copes with the effects of oversupply of products, international terrorism, war and political instability. Even if the general economy experiences a recovery, the activity of the United States telecommunications industry may lag behind the recovery of the overall United States economy.
The optical networking component industry has in the past, is now, and may in the future experience declining average selling prices, which could cause our gross margins to decline.
The optical networking component industry has in the past experienced declining average selling prices as a result of increasing competition and greater unit volumes as communication service providers continue to deploy fiber optic networks. We expect that average selling prices may decrease in the future in response to new product and technology introductions by competitors, price pressures from significant customers, greater manufacturing efficiencies achieved through increased automation in the manufacturing process and inventory build-up due to decreased demand. Average selling price declines may contribute to a decline in our gross margins, which could harm our results of operations.
We will not attract new orders for our fiber optic components unless we can deliver sufficient quantities of our products to optical communications equipment manufacturers.
Communications service providers and optical systems manufacturers typically require that suppliers commit to provide specified quantities of products over a given period of time. If we are unable to commit to deliver quantities of our products to satisfy a customer's anticipated needs, we will lose the order and the opportunity for significant sales to that customer for a lengthy period of time. In addition, we would be unable to fill large orders if we do not have sufficient manufacturing capacity to enable us to commit to provide customers with specified quantities of products. However, if we build our manufacturing capacity and inventory in excess of demand, as we have done in the past, we may produce excess inventory that may have to be reserved or written off.
We depend on a limited number of third parties to supply key materials, components and equipment, such as ferrules, optical filters and lenses, and if we are not able to obtain sufficient quantities of these items at acceptable prices, our ability to fill orders would be limited and our operating results could be harmed.
We depend on third parties to supply the raw materials and components we use to manufacture our products. To be competitive, we must obtain from our suppliers, on a timely basis, sufficient quantities of raw materials and components at acceptable prices. We obtain most of our critical raw materials and components from a single or limited number of suppliers and generally do not have long-term supply contracts with them. As a result, our suppliers could terminate the supply of a particular material or component at any time without penalty. Finding alternative sources may involve significant expense and delay, if these sources can be found at all. One component, GRIN lenses, is only available from one supplier. Difficulties in obtaining raw materials or components in the future may delay or limit our product shipments, which could result in lost orders, increase our costs, reduce our control over quality and delivery schedules and require us to redesign our products. If a supplier became unable or unwilling to continue to manufacture or ship materials or components in required volumes, we would have to identify and qualify an acceptable replacement. A delay or reduction in shipments or any need to identify and qualify replacement suppliers would harm our business.
Because we experience long lead times for materials and components, we may not be able to effectively manage our inventory levels and manufacturing capacity, which could harm our operating results.
Because we experience long lead times for materials and components and are often required to purchase significant amounts of materials and components far in advance of product shipments, we may not effectively manage our inventory levels, which could harm our operating results. Alternatively, if we underestimate our raw material requirements, we may have inadequate inventory, which could result in delays in shipments and loss of customers. If we purchase raw materials and increase production in anticipation of orders that do not materialize or that shift to another quarter, we will, as we have in the past, have to carry or write off excess inventory and our gross margins will decline. Both situations could cause our results of operations to be below the expectations of investors and public market analysts, which could, in turn, cause the price of our common stock to decline. The time our customers require to incorporate our products into their own can vary significantly and generally exceeds several months, which further complicates our planning processes and reduces the predictability of our forecasts. Even if we receive these orders, the additional manufacturing capacity that we add to meet our customer's requirements may be underutilized in a subsequent quarter.
We are exposed to risks and increased expenses as a result of legislation requiring companies to evaluate internal controls over financial reporting.>
Although we will not have to comply with the auditor attestation requirements of Section 404(b) of the Sarbanes-Oxley Act of 2002 until we become an accelerated filer, we are still required to perform an assessment of our internal control over financial reporting and to disclose management's assessment of the same under Section 404(a) of Sarbanes-Oxley. We have implemented an ongoing program to perform the system and process evaluation and testing we believe to be necessary to comply with this requirement, however, we cannot assure you that we will be successful in our efforts. In the event that our chief executive officer, acting chief financial officer or, when applicable, our independent registered public accounting firm, determines that our internal controls over financial reporting are not effective as defined under Section 404(a), investor perceptions of our company may be negatively affected and this could cause a decline in our stock price.
We depend on key personnel to operate our business effectively in the rapidly changing fiber optic components market, and if we are unable to hire and retain appropriate management and technical personnel, our ability to develop our business could be harmed.
Our success depends to a significant degree upon the continued contributions of the principal members of our technical sales, marketing, engineering and management personnel, many of whom perform important management functions and would be difficult to replace. We particularly depend upon the continued services of our executive officers, particularly Peter Chang, our President and Chief Executive Officer; David Hubbard, our Vice President, Sales and Marketing; Wei-shin Tsay, our senior Vice President of Product Development; Anita Ho, our Acting Chief Financial Officer and Corporate Controller; and other key engineering, sales, marketing, finance, manufacturing and support personnel. In addition, we depend upon the continued services of key management personnel at our Taiwanese subsidiary and at our facility in China. None of our officers or key employees is bound by an employment agreement for any specific term, and may terminate their employment at any time. In addition, we do not have "key person" life insurance policies covering any of our employees.
Our ability to continue to attract and retain highly skilled personnel will be a critical factor in determining whether we will be successful in the future. We may have difficulty hiring skilled engineers at our manufacturing facilities in the United States, Taiwan, and China. If we are not successful in attracting, assimilating or retaining qualified personnel to fulfill our current or future needs, our business may be harmed.
If we are not able to achieve acceptable manufacturing yields and sufficient product reliability in the production of our fiber optic components, we may incur increased costs and delays in shipping products to our customers, which could impair our operating results.
Complex and precise processes are required for the manufacture of our products. Changes in our manufacturing processes or those of our suppliers, or the inadvertent use of defective materials, could significantly reduce our manufacturing yields and product reliability. Because the majority of our manufacturing costs are relatively fixed, manufacturing yields are critical to our results of operations. Lower than expected production yields could delay product shipments and impair our operating results. We may not obtain acceptable yields in the future.
In some cases, existing manufacturing techniques, which involve substantial manual labor, may not allow us to cost-effectively meet our production goals so that we maintain acceptable gross margins while meeting the cost targets of our customers. We may not achieve adequate manufacturing cost efficiencies.
Because we plan to introduce new products and product enhancements, we must effectively transfer production information from our product development department to our manufacturing group and coordinate our efforts with our suppliers to rapidly achieve volume production. In our experience, our yields have been lower during the early stages of introducing new product to manufacturing. If we fail to effectively manage this process or if we experience delays, disruptions or quality control problems in our manufacturing operations, our shipments of products to our customers could be delayed.
Because the qualification and sales cycle associated with fiber optic components is lengthy and varied, it is difficult to predict the timing of a sale or whether a sale will be made, which may cause us to have excess manufacturing capacity or inventory and negatively impact our operating results.
In the communications industry, service providers and optical systems manufacturers often undertake extensive qualification processes prior to placing orders for large quantities of products such as ours, because these products must function as part of a larger system or network. This process may range from three to six months and sometimes longer. Once they decide to use a particular supplier's product or component, these potential customers design the product into their system, which is known as a design-in win. Suppliers whose products or components are not designed in are unlikely to make sales to that customer until at least the adoption of a future redesigned system. Even then, many customers may be reluctant to incorporate entirely new products into their new systems, as this could involve significant additional redesign efforts. If we fail to achieve design-in wins in our potential customers' qualification processes, we will lose the opportunity for significant sales to those customers for a lengthy period of time.
In addition, some of our customers require that our products be subjected to standards-based qualification testing, which can take up to nine months or more. While our customers are evaluating our products and before they place an order with us, we may incur substantial sales and marketing and research and development expenses, expend significant management efforts, increase manufacturing capacity and order long lead-time supplies. Even after the evaluation process, it is possible a potential customer will not purchase our products. In addition, product purchases are frequently subject to unplanned processing and other delays, particularly with respect to larger customers for which our products represent a very small percentage of their overall purchase activity. Accordingly, our revenues and operating results may vary significantly and unexpectedly from quarter to quarter.
If our customers do not qualify our manufacturing lines for volume shipments, our optical networking components may be dropped from supply programs and our revenues may decline.
Customers generally will not purchase any of our products, other than limited numbers of evaluation units, before they qualify our products, approve our manufacturing process and approve our quality assurance system. Our existing manufacturing lines, as well as each new manufacturing line, must pass through various levels of approval with our customers. For example, customers may require that we be registered under international quality standards. Our products may also have to be qualified to specific customer requirements. This customer approval process determines whether the manufacturing line achieves the customers' quality, performance and reliability standards. Delays in product qualification may cause a product to be dropped from a long-term supply program and result in significant lost revenue opportunity over the term of that program.
Our fiber optic components are deployed in large and complex communications networks and may contain defects that are not detected until after our products have been installed, which could damage our reputation and cause us to lose customers.
Our products are designed for deployment in large and complex optical networks. Because of the nature of these products, they can only be fully tested for reliability when deployed in networks for long periods of time. Our fiber optic products may contain undetected defects when first introduced or as new versions are released, and our customers may discover defects in our products only after they have been fully deployed and operated under peak stress conditions. In addition, our products are combined with products from other vendors. As a result, should problems occur, it may be difficult to identify the source of the problem. If we are unable to fix defects or other problems, we could experience, among other things:
The occurrence of any one or more of the foregoing factors could negatively impact our revenues.
The market for fiber optic components is new and unpredictable, characterized by rapid technological changes, evolving industry standards, and significant changes in customer demand, which could result in decreased demand for our products, erosion of average selling prices, and could negatively impact our revenues.
The market for fiber optic components is new and characterized by rapid technological change, frequent new product introductions, changes in customer requirements and evolving industry standards. Because this market is new, it is difficult to predict its potential size or future growth rate. Widespread adoption of optical networks, especially in the metropolitan, last mile, and enterprise access segments of the networks, is critical to our future success. Potential end-user customers who have invested substantial resources in their existing copper lines or other systems may be reluctant or slow to adopt a new approach, such as optical networks. Our success in generating revenues in this market will depend on:
If we fail to address changing market conditions, sales of our products may decline, which would adversely impact our revenues.
We may be unable to successfully integrate acquired businesses or assets with our business, which may disrupt our business, divert management's attention and slow our ability to expand the range of our proprietary technologies and products.
To expand the range of our proprietary technologies and products, we may acquire complementary businesses, technologies or products, if appropriate opportunities arise. We may be unable to identify other suitable acquisitions at reasonable prices or on reasonable terms, or consummate future acquisitions or other investments, any of which could slow our growth strategy. We may have difficulty integrating the acquired products, personnel or technologies of any company or acquisition that we may make. Similarly, we may not be able to attract or retain key management, technical or sales personnel of any other companies that we acquire or from which we acquire assets. These difficulties could disrupt our ongoing business, distract our management and employees and increase our expenses.
If our common stock is not relisted on the Nasdaq Global Market, we will be subject to certain provisions of the California General Corporation Law that may affect our charter documents and result in additional expenses.
Beginning at the commencement of trading on November 8, 2002, the listing of our common stock was transferred from the Nasdaq Global Market to the Nasdaq Capital Market. As a result, we may become subject to certain sections of the California General Corporation Law that will affect our charter documents if our common stock is not returned to being listed on the Nasdaq Global Market. A recent Delaware decision has called into question the applicability of the California General Corporation Law to Delaware corporations. However, if the California General Corporation Law applies to our Company, we will not be able to continue to have a classified board or continue to eliminate cumulative voting by our stockholders. In addition, certain provisions of our Certificate of Incorporation that call for supermajority voting may need to be approved by stockholders every two years or be eliminated. Also, in the event of a reorganization, stockholders will have dissenting stockholder rights under both California and Delaware law. Any of these changes will result in additional expense as we will have to comply with certain provisions of the California General Corporation Law as well as the Delaware General Corporation Law. We included these provisions in our charter documents in order to delay or discourage a change of control or changes in our management. Because of the California General Corporation Law, we may not be able to avail ourselves of these provisions.
If we are unable to maintain our listing on the Nasdaq Capital Market, the price and liquidity of our common stock may decline.
There can be no assurance that we will be able to satisfy all of the quantitative maintenance criteria for continued listing on the Nasdaq Capital Market, including a requirement that we maintain a continued minimum bid price of $1.00 per share. Accordingly, if the closing bid price of our common stock falls and remains below $1.00 for 30 consecutive trading days, as it has for significant periods of time in the past, our common stock may not remain listed on the Nasdaq Capital Market. If we fail to maintain continued listing on the Nasdaq Capital Market and must move to a market with less liquidity, our financial condition could be harmed and our stock price would likely decline. If we are delisted, it could have a material adverse effect on the market price of our common stock as well as the liquidity of the trading market for our common stock.
Many companies that face delisting as a result of closing bid prices that are below the Nasdaq Capital Market's continued listing standards seek to maintain the listing of their securities by effecting reverse stock splits. However, reverse stock splits do not always result in a sustained closing bid price per share. We may consider the merits of implementing a reverse split and evaluate other courses of action as we believe may be appropriate.
If we fail to protect our intellectual property rights, competitors may be able to use our technologies, which could weaken our competitive position, reduce our revenues or increase our costs.
The fiber optic component market is a highly competitive industry in which we, and most other participants, rely on a combination of patent, copyright, trademark and trade secret laws, confidentiality procedures and licensing arrangements to establish and protect proprietary rights. The competitive nature of our industry, rapidly changing technology, frequent new product introductions, changes in customer requirements and evolving industry standards heighten the importance of protecting proprietary technology rights. Since the United States Patent and Trademark Office keeps patent applications confidential until a patent is issued, our pending patent applications may attempt to protect proprietary technology claimed in a third party patent application. Our existing and future patents may not be sufficiently broad to protect our proprietary technologies as it is difficult to police the unauthorized use of our products and we cannot be certain that the steps we have taken will prevent the misappropriation or unauthorized use of our technologies, particularly in foreign countries where the laws may not protect our proprietary rights as fully as United States laws. Our competitors and suppliers may independently develop similar technology, duplicate our products, or design around any of our patents or other intellectual property. If we are unable to adequately protect our proprietary technology rights, others may be able to use our proprietary technology without having to compensate us, which could reduce our revenues and negatively impact our ability to compete effectively.
Litigation may be necessary to enforce our intellectual property rights or to determine the validity or scope of the proprietary rights of others. As a result of any such litigation, we could lose our proprietary rights and incur substantial unexpected operating costs. Any action we take to protect our intellectual property rights could be costly and could absorb significant management time and attention. In addition, failure to adequately protect our trademark rights could impair our brand identity and our ability to compete effectively.
We may be subject to intellectual property infringement claims that are costly to defend and could limit our ability to use some technologies in the future.
Our industry is very competitive and is characterized by frequent intellectual property litigation based on allegations of infringement of intellectual property rights. Numerous patents in our industry have already been issued, and as the market further develops and participants in our industry obtain additional intellectual property protection, litigation is likely to become more frequent. From time to time, third parties may assert patent, copyright, trademark and other intellectual property rights to technologies or rights that are important to our business. In addition, we have and we may continue to enter into agreements to indemnify our customers for any expenses or liabilities resulting from claimed infringements of patents, trademarks or copyrights of third parties. Any litigation arising from claims asserting that our products infringe or may infringe the proprietary rights of third parties, whether the litigation is with or without merit, could be time-consuming, resulting in significant expenses and diverting the efforts of our technical and management personnel. We do not have insurance against our alleged or actual infringement of intellectual property of others. These claims could cause us to stop selling our products, which incorporate the challenged intellectual property, and could also result in product shipment delays or require us to redesign or modify our products or to enter into licensing agreements. These licensing agreements, if required, would increase our product costs and may not be available on terms acceptable to us, if at all.
Although we are not aware of any intellectual property lawsuits filed against us, we may be a party to litigation regarding intellectual property in the future. We may not prevail in any such actions, given their complex technical issues and inherent uncertainties. Insurance may not cover potential claims of this type or may not be adequate to indemnify us for all liability that may be imposed. If there is a successful claim of infringement or we fail to develop non-infringing technology or license the proprietary rights on a timely basis, our business could be harmed.
Because our manufacturing operations are located in active earthquake fault zones in Taiwan, and our Taiwan location is susceptible to the effects of a typhoon, we face the risk that a natural disaster could limit our ability to supply products.
Our primary manufacturing operations are located in Tu-Cheng City, Taiwan, an active earthquake fault zone. This region has experienced large earthquakes in the past and may likely experience them in the future. In September 2001, a typhoon hit Taiwan causing businesses, including our manufacturing facility, and the financial markets to close for two days. A large earthquake or typhoon in Taiwan could disrupt our manufacturing operations in Taiwan for an extended period of time, which would limit our ability to supply our products to our customers in sufficient quantities on a timely basis, harming our customer relationships.
ITEM 6: EXHIBITS
# Indicates management contract or compensatory plan or arrangement.
* In accordance with Item 601(b)(32)(ii) of Regulation S-K and SEC Release No. 34-47986, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed "filed" for purposes of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.
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.
Dated: August 12, 2010
ALLIANCE FIBER OPTIC PRODUCTS, INC.
By /s/ Anita K. Ho
Anita K. Ho
Acting Chief Financial Officer
(Principal Financial and Accounting Officer and Duly
Alliance Fiber Optic Products, Inc.
# Indicates management contract or compensatory plan or arrangement.
* In accordance with Item 601(b)(32)(ii) of Regulation S-K and SEC Release No. 34-47986, the certifications furnished in Exhibits 32.1 and 32.2 hereto are deemed to accompany this Form 10-Q and will not be deemed "filed" for purposes of Section 18 of the Exchange Act. Such certifications will not be deemed to be incorporated by reference into any filing under the Securities Act or the Exchange Act, except to the extent that the registrant specifically incorporates it by reference.