Ikanos Communications 10-Q 2007
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington D.C. 20549
For the quarterly period ended April 1, 2007
For the Transition Period from to
Commission File Number: 0-51532
IKANOS COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)
47669 Fremont Boulevard
Fremont, CA 94538
(Address of principal executive office and zip code)
(Registrants telephone number including area code)
Indicate by check mark whether 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) had been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act (check one):
Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
The number of shares outstanding of the Registrants Common Stock, $ 0.001 par value, was 28,363,896 as of April 23, 2007.
TABLE OF CONTENTS
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands and unaudited)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data, and unaudited)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands and unaudited)
The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Ikanos and Summary of Significant Accounting Policies
Ikanos Communications, Inc. (Ikanos, or the Company) was incorporated in the State of California in April 1999 and reincorporated in the State of Delaware in September 2005. The Company is a leading global provider of high-performance silicon and software for interactive broadband. The Company develops and markets end-to-end solutions for the last mile and the digital home, which enable carriers to offer enhanced triple play services, including voice, video and data. The Companys solutions power DSLAMs, ONUs, concentrators, customer premise equipment, modems and residential gateways for leading network equipment manufacturers. The Companys products have been deployed by carriers in Asia, Europe and North America. The Company believes that it can offer advanced products by continuing to push existing limits in silicon, systems and software. The Company has developed programmable, scalable chip architectures, which form the foundation for deploying and delivering triple play services. Expertise in the creation and integration of unique DSP algorithms with advanced digital, mixed signal and analog semiconductors enables the Company to offer high-performance, high-density and low power VDSLx products. Flexible network processor architecture with wire-speed packet processing capabilities enables high-performance residential gateways for distributing advanced services in the home. These industry-leading solutions thus support carriers triple play deployment plans to the digital home while keeping their capital and operating expenditures low.
The Company outsources all of its semiconductor fabrication, assembly and test functions, which enables it to focus on design, development, sales and marketing of its products and reduces the level of its capital investment. The Companys customers consist primarily of original design manufacturers (ODMs), contract manufacturers (CMs) and original equipment manufacturers (OEMs), who in turn sell our semiconductors as part of their product solutions to carriers. The Company also sells to third-party sales representatives, who in turn sell to ODMs, CMs and OEMs.
The Companys fiscal year ends on the Sunday closest to December 31. The Companys fiscal quarters end on the Sunday closest to the end of the applicable calendar quarter, except in a 53-week fiscal year, in which case the additional week falls into the fourth quarter of that fiscal year. The balance sheet as of December 31, 2006 is derived from the audited financial statements as of that date.
Basis of Presentation
The accompanying unaudited condensed consolidated financial statements include the accounts of the Company and all of its wholly owned subsidiaries. All intercompany transactions and balances have been eliminated in consolidation.
The accompanying unaudited condensed consolidated financial statements have been prepared without audit in accordance with the rules and regulations of the Securities and Exchange Commission (the SEC). Certain information and disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (GAAP) have been condensed or omitted in accordance with these rules and regulations. The information in this report should be read in conjunction with our audited financial statements and notes thereto included in our Annual Report on Form 10-K filed with the SEC on March 7, 2007.
In the opinion of management, the accompanying unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) necessary to state fairly our financial position, results of operations and cash flows for the interim periods presented. The operating results for the three month period ended April 1, 2007 are not necessarily indicative of the results that may be expected for the year ending December 30, 2007 or for any other future period.
Use of Estimates
The preparation of the Companys consolidated financial statements in conformity with GAAP requires management to make certain estimates, judgments and assumptions. The Company believes that the estimates, judgments and assumptions upon which it relies are reasonable based upon information available to it at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements as well as the reported amounts of revenue and expenses during the periods presented. To the extent there are material differences between these estimates and actual results, the Companys financial statements would have been affected. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require managements judgment in its application. There are also areas in which managements judgment in selecting any available alternative would not produce a materially different result.
In the first quarter of 2007, the Company adopted the Financial Accounting Standards Board (FASB) Interpretation No. 48, Accounting for Uncertainty in Income TaxesAn Interpretation of FASB Statement No. 109 (FIN 48). See Note 9: Income Taxes for further discussion.
Concentration of Credit Risk
Financial instruments that potentially subject the Company to significant concentrations of credit risk consist of cash, cash equivalents, short-term investments and accounts receivable. Cash, cash equivalents and short term investments are held with a limited number of financial institutions. Deposits held with these financial institutions may exceed the amount of insurance provided on such deposits. Management believes that the financial institutions that hold the Companys investments are credit worthy and, accordingly, minimal credit risk exists with respect to those investments. Short-term investments include a diversified portfolio of commercial paper, auction rate certificates and government agency bonds. All investments are classified as available-for-sale. The Company does not hold or issue financial instruments for trading purposes.
Credit risk with respect to accounts receivable is concentrated due to the number of large orders recorded in any particular reporting period. Two customers represented 39% and 29% of accounts receivable at April 1, 2007. Three customers represented 47%, 25% and 10% of accounts receivable at December 31, 2006. Three customers accounted for 31%, 24% and 11%, respectively, of revenue for the period ended April 1, 2007. Three customers accounted for 32%, 26% and 24% of revenue for the three months ended April 2, 2006.
Concentration of Other Risk
The semiconductor industry is characterized by rapid technological change, competitive pricing pressures and cyclical market patterns. The Companys results of operations are affected by a wide variety of factors, including general economic conditions; economic conditions specific to the semiconductor industry; demand for the Companys products; the timely introduction of new products; implementation of new manufacturing technologies; manufacturing capacity; the availability of materials and supplies; competition; the ability to safeguard patents and intellectual property in a rapidly evolving market; and reliance on assembly and wafer fabrication subcontractors and on independent distributors and sales representatives. As a result, the Company may experience substantial period-to-period fluctuations in future periods due to the factors mentioned above or other factors.
Comprehensive Income (Loss)
Comprehensive income (loss) is defined as the change in equity of a business during a period from transactions and other events and circumstances from non-owner sources. The difference between the Companys net loss and its total comprehensive loss for the three months ended April 1, 2007 and April 2, 2006 was not material and related primarily to foreign currency translation and unrealized gains on marketable securities.
Net Loss Per Share
Under the provisions of the Statement of Financial Accounting Standards (SFAS) No. 128, Earnings per Share, basic net loss per share is computed using the weighted-average number of common shares outstanding during the period. Potentially dilutive securities have been excluded from the computation of diluted net loss per share if their inclusion is anti-dilutive.
The calculation of basic and diluted net loss per share is as follows (in thousands, except per share amounts):
The following potential common shares have been excluded from the calculation of diluted net loss per share as their effect would have been anti-dilutive (in thousands):
Note 2. Short-Term Investments
The following is a summary of the Companys short-term investments (in thousands):
The Companys marketable securities are classified as available-for-sale as of the balance sheet date and are reported at fair value with unrealized gains and losses reported as a separate component of accumulated other comprehensive income (loss) in stockholders equity, net of tax. Realized gains and losses and permanent declines in value, if any, on available-for-sale securities are reported in other income or expense as incurred. Estimated fair values were determined for each individual security in the investment portfolio. The declines in value of these investments are primarily related to changes in interest rates and are considered to be temporary in nature.
A significant portion of the Companys available-for-sale portfolio is composed of auction rate securities. Even though the stated maturity dates of these investments may be one year or more beyond the balance sheet dates, the Company has classified these securities as short-term investments. In accordance with Accounting Research Bulletin No. 43, Chapter 3A, Working Capital- Current Assets and Current Liabilities, the Company views its available-for-sale portfolio as available for use in its current operations. Based upon historical experience in the financial markets as well as the Companys specific experience with these investments, the Company believes there is a reasonable expectation of completing a successful auction within the subsequent twelve-month period. During its history of investing in these securities, the Company has been able to sell its holdings of these investments at its discretion. Accordingly, the Company believes that the risk of non-redemption of these investments within a year is minimal.
Note 3. Inventories
Inventories consisted of the following (in thousands):
Note 4. Property and Equipment
Property and equipment consisted of the following (in thousands):
Depreciation and amortization expense for property and equipment was $1.8 million and $1.1 million for the three months ended April 1, 2007 and April 2, 2006, respectively. Included in property and equipment are assets acquired under capital lease obligations, mostly software and machinery and equipment, with an original cost of $6.1 million as of April 1, 2007 and December 31, 2006. Related accumulated depreciation and amortization of these assets was $4.2 million and $4.0 million as of April 1, 2007 and December 31, 2006, respectively.
Note 5. Intangible Assets
The carrying amount of intangible assets as of April 1, 2007 is as follows (in thousands):
The carrying amount of intangible assets as of December 31, 2006 is as follows (in thousands):
For the three months ended April 1, 2007, and April 2, 2006, the amortization of intangible assets was $1.2 million and $1.0 million, respectively. The estimated future amortization of purchased intangible assets as of April 1, 2007 is as follows (in thousands):
Note 6. Accrued Liabilities
Accrued liabilities consisted of the following (in thousands):
Note 7. Restructuring
During the fourth quarter of 2006, the Company implemented a restructuring program of its development operations to reduce its cost structure. The restructuring plan involved reducing the Company engineering workforce by approximately 42 employees of which approximately half were from India and half were from North America. In addition, the Company closed its Canadian office and transitioned those responsibilities to the United States through a combination of relocations and hiring. The Company incurred facility related expenses in relation to the lease termination of its Canadian office. The Company expects the remaining severance and benefits and facility cost to be paid in the second quarter of 2007.
Note 8. Stock-Based Compensation Expense
Share-based compensation expense related to all stock-based compensation awards was $3.3 million and $2.0 million for the three months ended April 1, 2007 and April 2, 2006, respectively. Valuation assumptions do not differ materially with the assumptions as reported in our Annual Report on Form 10-K filed with the SEC on March 7, 2007. Stock-option grant activity was not material for the three months ended April 1, 2007.
Restricted Stock Units
A summary of our restricted stock unit activity is presented below (shares are in thousands):
The weighted average grant date fair value per restricted stock units granted was $8.22 during the three months ended April 1, 2007. The total fair values of restricted stock units that vested during the three months ended April 1, 2007 was $1 million. Our restricted stock units have vesting terms of one to four years and are scheduled to vest through 2011.
Note 9. Income Taxes
In July 2006, the FASB issued FIN 48, which clarifies the accounting for uncertainty in income taxes recognized in any entitys financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes and prescribes a recognition threshold and measurement attributes for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Under FIN 48, the impact of an uncertain income tax position on the income tax return must be recognized at the largest amount that is more-likely-than-not to be sustained upon audit by the relevant taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. Additionally, FIN 48 provides guidance on de-recognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006.
The Company has adopted the provisions of FIN 48 as of January 1, 2007. The total amount of unrecognized tax benefits as of the date of adoption was $3.1 million. As a result of the implementation of FIN 48, the Company recognized no change in the liability for unrecognized tax benefits.
Included in the balance of unrecognized tax benefits as of January 1, 2007, are tax benefits of $0.1 million that, if recognized, would affect the effective tax rate and $3.0 million of benefits that would affect deferred tax assets. No amounts were recorded to the income statement as a result of the adoption of FIN 48 because the Companys deferred tax assets have a full valuation allowance.
The Company has adopted the accounting policy that interest expense and penalties relating to income tax position are classified within the provision for income taxes. The total amount of interest and penalty recorded as of January 1, 2007 was not material.
The Company does not anticipate any significant changes within twelve months of this reporting date of its unrecognized tax benefits.
The Companys operations are subject to income and transaction taxes in the United States and in multiple foreign jurisdictions. Significant estimates and judgments are required in determining the Companys worldwide provision for income taxes. Some of these estimates are based on interpretations of existing tax laws or regulations. The ultimate amount of tax liability may be uncertain as a result.
The Company is subject to taxation in the US and various states and foreign jurisdictions. There are no ongoing examinations by taxing authorities at this time. The Companys tax years starting from 1999 to 2006 remain open in various tax jurisdictions.
Note 10. Commitments and Contingencies
The Company leases office facilities, equipment and software under non-cancelable operating and capital leases with various expiration dates through 2011. Rent expense for the three months ended April 1, 2007 and April 2, 2006 was $0.3 million and $0.2 million, respectively. The terms of the facility leases provide for rental payments on a graduated scale. The Company recognizes rent expense on a straight-line basis over the lease period, and has accrued for rent expense incurred but not paid.
Future minimum lease payments as of April 1, 2007 under non-cancelable leases with original terms in excess of one year are summarized as follows (in thousands):
The Company entered into a technology access agreement in September 2006. Under terms of the agreement, the Company agreed to pay $1.4 million for the remainder of 2007, $ 2.3 million in 2008 and $1.2 million in 2009.
As of April 1, 2007 the Company had $7.3 million of inventory purchase obligations with various suppliers.
In February 2006, the Company assumed a royalty agreement in connection with the acquisition of the network processing and ADSL assets from ADI. Under terms of the agreement, the Company agreed to pay a minimum royalty fee of $0.7 million in 2008.
Indemnities, Commitments and Guarantees
During its normal course of business, the Company has made certain indemnities, commitments and guarantees under which it may be required to make payments in relation to certain transactions. These indemnities include intellectual property indemnities to the Companys customers in connection with the sales of its products, indemnities for liabilities associated with the infringement of other parties technology based upon the Companys products, and indemnities to various lessors in connection with facility leases for certain claims arising from such facility or lease. The duration of these indemnities, commitments and guarantees varies, and in certain cases, is indefinite. The majority of these indemnities, commitments and guarantees do not provide for any limitation of the maximum potential future payments that the Company could be obligated to make. The Company believes its internal development processes and other policies and practices limit its exposure related to the indemnification provisions of the various agreements that include indemnity provisions. In addition, the Company requires its employees to sign a proprietary information and inventions agreement, which assigns the rights to its employees development work to the Company. The Company has not recorded any liability for these indemnities, commitments and guarantees in the accompanying consolidated balance sheets. The Company does, however, accrue for losses for any known contingent liability, including those that may arise from indemnification provisions, when future payment is probable and the amount of the loss can be reasonably estimated, in accordance with SFAS No. 5, Accounting for Contingencies.
In addition, the Company indemnifies its officers and directors under the terms of indemnity agreements entered into with them, as well as pursuant to its certificate of incorporation, bylaws, and applicable Delaware law. To date, the Company has not incurred any costs related to these indemnifications.
In November 2006, three putative class action lawsuits were filed in the United States District Court for the Southern District of New York against the Company, its directors, an executive officer and a former executive officer. The lawsuits were consolidated and an amended complaint was filed on April 24, 2007. The lawsuit alleges certain material misrepresentations and omissions by the Company in connection with its initial public offering in September 2005 and the follow-on offering in March 2006 concerning its business and prospects. The lawsuits seek unspecified damages. The Company cannot predict the likely outcome of these lawsuits, and an adverse result could have a material effect on its financial statements.
Additionally, the Company is a party to various legal proceedings and claims arising from the normal course of business activities. Based on current available information, the Company does not expect that the ultimate outcome of these unresolved matters, individually or in the aggregate, will have a material adverse effect on its results of operations, cash flows or financial position.
Note 11. Related Party Transactions
The Company has a consulting agreement with Texan Ventures, LLC entered into during 2001. Pursuant to the consulting agreement, G. Venkatesh, who is both the Managing Member of Texan Ventures, LLC and a member of the Companys Board of Directors provides consulting services with respect to, among other things, general business advice relating to the operation of a public company, guidance and strategic advice in analyzing acquisition opportunities, assisting in negotiations of acquisition agreements and providing assistance and guidance in the integration of acquired companies. Under the Consulting Agreement, Texan Ventures, LLC was entitled to $3,000 per month and reimbursement for reasonable expenses. In October 2006, the agreement was amended whereby Mr. Venkatesh serves as Executive Chairman of the Companys Board of Directors, expanding his advisory services to assist in tactical and operational decisions of the Company, while the Company searches for a permanent Chief Executive Officer. As a result of the amendment, the consulting fees paid to Texan Ventures increased to $18,000 per month, and Mr. Venkatesh received an option to purchase 125,000 shares of the Companys common stock. The Company paid Texan Ventures, LLC $54,000 in the three months ended April 1, 2007 and $9,000 in the three months ended April 2, 2006.
Note 12. Significant Customer Information and Segment Reporting
SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, establishes standards for the manner in which public companies report information about operating segments in annual and interim financial statements. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The method for determining the information to report is based on the way management organizes the operating segments within the Company for making operating decisions and assessing financial performance.
The Companys chief operating decision-maker is considered to be the Chief Executive Officer. The Chief Executive Officer reviews financial information presented on a consolidated basis, accompanied by disaggregated information about revenue by geographic region for purposes of making operating decisions and assessing financial performance. On this basis, the Company is organized and operates in a single segment: the design, development, marketing and sale of semiconductors.
The following table summarizes revenue by geographic region, based on the country in which the customer headquarters office is located (in thousands):
Three customers accounted for more than 10% of the Companys total revenue for three months ended April 1, 2007. Three customers accounted for more than 10% of the Companys total revenue for the three months ended April 2, 2006.
The Company divides its products into two product families: Access and Gateway. Access includes products that the Company sells on the carrier infrastructure side of the phone line while Gateway includes products that the Company sells into the residence. Revenue by product family is as follows (in thousand):
The distribution of long-lived assets (excluding goodwill, intangible assets and other assets) as of April 1, 2007 and December 31, 2006 was as follows (in thousands):
MANAGEMENTS DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
This discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. Actual results could differ materially from those projected in the forward-looking statements as a result of a number of factors, risks and uncertainties, including the risk factors set forth in this discussion, as more fully described in Part II, Item 1.A Risk Factors in this Quarterly Report on Form 10-Q. Generally, the words anticipate, expect, intend, believe and similar expressions identify forward-looking statements. These forward-looking statements include, without limitation, our expectation that a small number of OEMs will continue to account for a substantial portion of our revenue; our existing and expected cash, cash equivalents and cash flows will be sufficient to meet our anticipated cash needs for at least the next 12 months; our belief in the effectiveness of our internal controls; our expectation that significant customer concentration in a small number of OEM customers will continue for the foreseeable future; our expectation that our foreign currency exposure will increase as our operations in India and other countries expand; and future costs and expenses and financing requirements. The forward-looking statements made in this Form 10-Q are made as of the filing date with the Securities and Exchange Commission and future events or circumstances could cause results that differ significantly from the forward-looking statements included here. Accordingly, we caution readers not to place undue reliance on these statements and, except as required by law, we assume no obligation to update any such forward-looking statements.
The following discussion and analysis should be read in conjunction with the condensed financial statements and notes thereto in Part I, Item 1 above and with our financial statements and notes thereto for the year ended December 31, 2006, contained in our Annual Report on Form 10-K filed on March 7, 2006.
We are a leading global provider of high-performance silicon and software for interactive broadband. We develop and market end-to-end solutions for the last mile and the digital home, which enable carriers to offer enhanced triple play services, including voice, video and data. Our solutions power DSLAMs, ONUs, concentrators, customer premise equipment, modems and residential gateways for leading network equipment manufacturers. Our products have been deployed by carriers in Asia, Europe and North America. We believe that we can offer advanced products by continuing to push existing limits in silicon, systems and software. We have developed programmable, scalable chip architectures, which form the foundation for deploying and delivering triple play services. Expertise in the creation and integration of unique DSP algorithms with advanced digital, mixed signal and analog semiconductors enables us to offer high-performance, high-density and low power VDSLx products. Flexible network processor architecture with wire-speed packet processing capabilities enables high-performance residential gateways for distributing advanced services in the home. These industry-leading solutions thus support carriers triple play deployment plans to the digital home while keeping their capital and operating expenditures low.
We outsource all of our semiconductor fabrication, assembly and test functions, which enables us to focus on design, development, sales and marketing of our products and reduces the level of our capital investment. Our customers consist primarily of original design manufacturers, or ODMs, contract manufacturers, or CMs, and original equipment manufacturers, or OEMs, who in turn sell our semiconductors as part of their product solutions to carriers. We also sell to third-party sales representatives, who in turn sell to ODMs, CMs and OEMs.
We were incorporated in April 1999 and through December 31, 2001, we were engaged principally in research and development. We began commercial shipment of our products in the fourth quarter of 2002. Over the last three years, our revenue increased from $66.7 million in 2004 to $85.1 million in 2005 to $134.7 million in 2006, resulting from increased deployment of broadband services by carriers primarily in Japan and Korea and, in 2006, our expansion into the residential gateway market via the NPA acquisition. Our revenue, however, can fluctuate significantly, even on a quarterly basis. For instance, in the first quarter of 2005, our revenue decreased $6.2, million or 33%, from the fourth quarter of 2004, yet in the second quarter of 2005, our revenue increased $7.0 million, or 57%, from the first quarter of 2005. More recently, in the third quarter of 2006, our revenue declined by $4.5 million, or 11%, from the second quarter of 2006 and in the fourth quarter of 2006, our revenue declined by $15.7 million, or 43%, from the third quarter of 2006. Quarterly fluctuations in revenue are a characteristic of our industry. And given our concentration of revenue among a few significant customers and given their buying patterns, we have experienced, and are likely to experience again, significant quarterly fluctuations of revenue. Specifically, carriers purchase equipment based on expected deployment and OEMs may occasionally manufacture equipment at rates higher than equipment is deployed. As a result, periodically and usually without significant notice, carriers will reduce orders with OEMs for new equipment and OEMs in turn will reduce orders for our products, which will adversely impact the quarterly demand for our products, even when deployment rates may be increasing.
In September 2005, we sold 6.4 million shares of our common stock in our initial public offering at $12.00 per share. Aggregate net proceeds from our initial public offering, after deducting underwriting discounts and commissions and issuance costs, were $67.9 million. We also had 15.3 million shares of redeemable convertible preferred stock outstanding that automatically converted into the same number of shares of our common stock upon the closing of our initial public offering.
In February 2006, we acquired network processing and ADSL assets from ADI (the NPA acquisition) for $32.7 million in cash and began deriving revenue relating to network processing and ADSL products in the same quarter. This acquisition enabled us to enter the growing residential gateway semiconductor market and diversified our product offerings, allowing us to sell into new markets worldwide. As a result of the NPA acquisition, we incurred significant additional expenses related to the addition of employees and related expenses of developing and marketing products as well as non-cash acquisition-related charges.
In March 2006, we sold 2.5 million shares of our common stock in a follow-on offering at $20.75 per share. Aggregate net proceeds from the follow-on offering, after deducting underwriting discounts and commissions and issuance costs, were $48.5 million. In the follow-on offering, selling stockholders including members of our senior management sold 3.3 million shares of common stock held by them. We did not receive any proceeds from the sale of shares by the selling stockholders.
On May 8, 2007, we announced the appointment of Michael A. Ricci as our new President and Chief Executive Officer starting on June 4, 2007, at which time Daniel K. Atler will step down as our interim President and Chief Executive Officer. Mr. Atler will remain as an officer of the Company and will be responsible for driving corporate development strategy. Cory J. Sindelar, who assumed Chief Financial Officer responsibilities in October 2006, will continue as our Chief Financial Officer.
Critical Accounting Policies and Estimates
In preparing our condensed consolidated financial statements, we make assumptions, judgments, and estimates that can have a significant impact on amounts reported in our consolidated financial statements. We base our assumptions, judgments, and estimates on historical experience and various other factors that we believe to be reasonable under the circumstances. Actual results could differ materially from these estimates under different assumptions or conditions. On a regular basis, we evaluate our assumptions, judgments and estimates and make changes accordingly. We also discuss our critical accounting estimates with the Audit Committee of the Board of Directors. We believe that the assumptions, judgments and estimates involved in the accounting for revenue, cost of revenue, inventories, income taxes, impairment of goodwill, acquisitions and stock-based compensation expense have the greatest potential impact on our consolidated financial statements, so we consider these to be our critical accounting policies. Historically, our assumptions, judgments and estimates relative to our critical accounting policies have not differed materially from actual results.
The critical accounting policies are described in Item 7, Management Discussion and Analysis of Financial Condition and Results of Operations, of our Annual Report on Form 10-K for the year ended December 31, 2006, and have not changed materially as of April 1, 2007 with the exception of the following:
For accounting purposes, we are required to allocate the purchase price of acquired companies to the tangible and intangible assets acquired, liabilities assumed, as well as purchased in-process research and development (IPR&D) based on the estimated fair values. As further disclosed in Note 2 to the consolidated financial statements of our Annual Report on Form 10-K for the year ended December 31, 2006, we use various models to determine the fair values of the assets acquired and liabilities assumed. These models include the discounted cash flow (DCF), the royalty savings method and the cost savings approach. The valuation requires management to make significant estimates and assumptions, especially with respect to long-lived and intangible assets as more fully disclosed in Note 2 as previously referenced.
Critical estimates in valuing certain of the intangible assets include, but are not limited to, future expected cash flows from customer contracts, customer lists, distribution agreements and acquired developed technologies and patents; expected costs to develop the IPR&D into commercially viable products and estimating cash flows from the projects when completed; the acquired companys brand awareness and market position as well as assumptions about the period of time the brand will continue to be used in the combined companys product portfolio; and discount rates. We derive our discount rates from our internal rate of return based on our internal forecasts and we may adjust the discount rate giving consideration to specific risk factors of each asset. Managements estimates of fair value are based upon assumptions believed to be reasonable but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur.
Results of Operations
Our revenue is primarily derived from sales of our semiconductor products. Revenue from product sales is generally recognized upon shipment, net of sales returns, rebates and allowances. As is typical in our industry, the selling prices of our products generally decline over time. Therefore, our ability to increase revenue is dependent upon our ability to increase unit sales volumes of existing products and to introduce and sell new products in greater quantities. Our ability to increase unit sales volume is dependent primarily upon our ability to increase and fulfill current customer demand and obtain new customers.
Revenue decreased by $11.2 million, or 31%, to $24.7 million in three months ended April 1, 2007 from $35.8 million in the three months ended April 2, 2006. The majority of the decrease relates to a decline in the average sales price of our product, a correction in Japan as carriers slowed orders as they lowered their existing equipment levels and a transition in Korea as carriers move to our 5th generation product platform. These decreases were partially offset by an increase in carrier demand from Europe.
We generally sell our products to OEMs through a combination of our direct sales force and third-party sales representatives. Sales are generally made under short-term, non-cancelable purchase orders. We also have volume purchase agreements, and certain customers who provide us with non-binding forecasts. Although certain OEM customers may provide us with rolling forecasts, our ability to predict future sales in any given period is limited and subject to change based on demand for our OEM customers systems and their supply chain decisions.
Historically, a small number of OEM customers, the composition of which has varied over time, have accounted for a substantial portion of our revenue, and we expect that significant customer concentration will continue for the foreseeable future, but it may diversify across more carrier customers as we expect more carriers world-wide to begin deployments of Fiber Fast broadband and Gateway products. The following customers accounted for more than 10% of our revenue for the periods indicated. Sales made to OEMs is based on information that we receive at the time of ordering.
Our products generally fall within two market-focused groups Access and Gateway. Access includes products that we sell on the carrier infrastructure side, while Gateway includes product that sell into the digital home, which generally includes modems, integrated access devices (IADs) and residential gateways. Below is a table showing revenue by product family.
Revenue by Product Family as a Percentage of Total Revenue
The change in mix is primarily due to the addition of the Gateway products associated with the NPA acquisition. Also, while overall unit volume increased, units of VDSLx on the Access segment decreased while Gateway increased significantly. This mix change contributed to the revenue decrease in Japan.
Revenue by Country as a Percentage of Total Revenue
The table above reflects sales to our direct customers based on where they are headquartered. It does not necessarily reflect carrier deployment of our products as we do not sell direct to them. Revenue from France increased both in absolute dollars as well as percentage of overall revenue due to a full quarter of sales to Sagem for the three months ended April 1, 2007 as compared to the three months ended April 2, 2006 when this customer was obtained through the NPA acquisition. Revenue from the United States increased primarily as a result of an OEM building Gateway products destined for European deployment. The overall proportion of our revenue from Korea has decreased to 8% due to a delay in the receipt of follow-on orders after the initial build for product qualification for our 5th generation product.
Cost and Operating Expenses
Cost of Revenue. Our cost of revenue consists primarily of silicon wafers purchased from third-party foundries and third-party costs associated with assembling, testing, and shipping of our semiconductors. Because we do not have formal, long-term pricing agreements with our outsourcing partners, our wafer costs and services are subject to price fluctuations based on the cyclical demand for semiconductors, among other factors. In addition, after we purchase wafers from foundries, we also incur yield loss related to manufacturing these wafers into good die. Manufacturing yield is the percentage of acceptable product resulting from the manufacturing process, as identified when the product is tested. When our manufacturing yields decrease, our cost per unit increases, which could have a significant adverse impact on our cost of revenue. Cost of revenue also includes accruals for actual and estimated warranty obligations and write-downs of excess and obsolete inventories, payroll and related personnel costs, depreciation of equipment, stock-based compensation expenses and amortization of acquisition-related intangibles.
Cost of revenue decreased to $15.3 million for the three months ended April 1, 2007 as compared to $18.6 million for the three months ended April 2, 2006. The decrease is primarily due to decreased sales this quarter as compared to the same period last year. Our gross margins (which we define as revenue minus cost of revenue divided by revenue) were 38% for the three months ended April 1, 2007 as compared to 48% for the three months ended April 2, 2006. The decrease in gross margins is primarily a result of a shift in mix of product sales from Access to Gateway and the introduction of additional Gateway products in Q106 from the NPA acquisition. Our Access products generally have a higher gross margin than Gateway products, and as Gateway products represent a higher mix of our product sales, our margins have declined.
Research and development expenses. All research and development expenses are expensed as incurred and generally consist of compensation and associated costs of employees engaged in research and development; contractors; tape-out costs; reference board development; development testing, evaluation kits and tools; stock based compensation expenses; occupancy costs and depreciation expense. Before releasing new products, we incur charges for mask sets, amortization of acquisition-related intangibles, prototype wafers, mask set revisions, bring-up boards and other qualification materials, which we refer to as tape-out costs. Tape-out costs cause our research and development expenses to fluctuate because they are not incurred uniformly every quarter.
Research and development expenses decreased $1.1 million, or 8%, to $12.6 million for the three months ended April 1, 2007 as compared to $13.7 million for the three months ended April 2, 2006. The decrease was primarily due to in process research and development costs of $2.9 million in the three months ended April 2, 2006 related to the NPA acquisition that were not included in the current quarter, as well as a $1.2 million decrease in testing and tape-out costs. These decreases were partially offset by increases in intellectual property costs and design tools of $1.0 million, stock-based compensation of $0.9 million, personnel expenses of $0.7 million and depreciation expense of $0.4 million.
As of April 1, 2007, we had 168 people engaged in research and development of whom 89 were located in India and 79 were located in North America. As of April 2, 2006, we had 196 people engaged in research and development of whom 105 were located in India and 91 were located in North America. The decrease in headcount is attributed to our reorganization in the fourth quarter of 2006.
Selling, general and administrative expenses. Selling, general and administrative, or SG&A, expenses increased by $1.5 million for the three months ended April 1, 2007, or 28%, to $7.1 million as compared to $5.6 million for the three months ended April 2, 2006. The increase is primarily attributable to additional personnel costs of $1.0 million, stock-based compensation expense of $0.5 million and legal fees of $0.3 million. These increases were offset by a decrease in amortization of NPA acquisition intangibles of $0.5 million. As of April 1, 2007, SG&A headcount was 83, which compares to 61 at April 2, 2006.
Common stock offering expenses. We incurred $1.0 million of common stock offering expenses in the three months ended April 2, 2006 related to the proportionate share of expenses incurred by us on behalf of the selling stockholders in our common stock offering in March 2006.
Interest Income, Net
Interest income, net consists primarily of interest income earned on our cash, cash equivalents and short-term investments, which is partially offset by interest and other expense. Interest income, net increased to $1.3 million for the three months ended April 1, 2007 as compared to $1 million for the three months ended April 2, 2006. The increase was due to interest earned on higher average cash and investment balances during the three months ended April 1, 2007 and to a lesser extent, an increase in the yield on our investments. The higher average cash and investment balance was the result of our secondary offering that occurred in March 2006. Average cash, cash equivalents and short-term investments for the three months ended April 1, 2007 was $105.9 million compared to $104.5 million for the three months ended April 2, 2006.
Provision for Income Taxes
Income taxes are comprised of foreign, federal and state alternative minimum income taxes, and the provision for income taxes was $0.1 million for the three months ended April 1, 2007, consistent with the three months ended April 2, 2006. Our income tax provision for the remainder of 2007 may fluctuate based upon our operating results for each taxable jurisdiction in which we operate and the amount of statutory tax that we incur in each jurisdiction.
Cumulative Effect of Change in Accounting Principle
The adoption of SFAS No. 123 (revised 2004), Share Based Payment (SFAS 123(R)) in 2006 resulted in a cumulative benefit of $0.6 million, which reflects the net cumulative impact of estimating future forfeitures in the determination of period expense, rather than recording forfeitures when they occur, as previously permitted.
Net Income/Net Loss
As a result of the above factors, we had a net loss of $9.1 million for the three months ended April 1, 2007 as compared to a net loss of $1.4 million for the three months ended April 2, 2006.
Liquidity and Capital Resources
Cash, cash equivalents and short-term investments decreased by $7.5 million to $102.1 million as of April 1, 2007 as compared to $109.6 million as of December 31, 2006. This decrease was primarily due to our cash used in operating activities of $6.2 million. As of April 1, 2007, we have funded our operations primarily through cash from offerings of our common stock, cash generated from the sale of our products and proceeds from the exercise of stock options and stock purchased under our employee stock purchase plan. Our uses of cash include payroll and payroll-related expenses, manufacturing costs, purchases of equipment, tools and software and operating expenses, such as tape outs, marketing programs, travel, professional services and facilities and related costs. We have also used cash to acquire businesses and technologies to expand our product offerings. We believe there will be additional working capital requirements to fund and operate our business. We expect to finance our operations primarily through operating cash flows and existing cash and investment balances.
The following table summarizes our statement of cash flows for the three months ended April 1, 2007 and April 2, 2006:
For the three months ended April 1, 2007, we used $6.2 million in net cash from operating activities, while incurring a net loss of $9.1 million. Included in the net loss was approximately $6.4 million in various non-cash expenses and charges consisting of depreciation and amortization, stock based compensation expense and amortization of intangible assets and acquired technology. Operating cash flows also benefited from a decrease in inventory of $2.2 million and a decrease in accounts receivable of $0.8 million. The decrease in inventory was primarily due to the timing of inventory receipts and shipments as well as the acceptance of our 5th generation products in Japan. The decrease in accounts receivable was primarily due to more linearity of sales in the quarter. These sources of operating cash flows were offset by an increase in prepaid expenses and other assets of $2.1 million and a decrease in accounts payable and accrued liabilities of $4.3 million. The increase in prepaid expenses and other assets was primarily due to a non-trade receivable related to the NPA acquisition as well as prepaid rental fees. The decrease in accounts payable and accrued liabilities was primarily due to the payment of a $1.5 million settlement with a customer, restructuring payments totaling $0.6 million, decrease in payroll related accruals of $0.8 million and various other payments in the ordinary course of business.
For the three months ended April 2, 2006, we generated $7.7 million of net cash from operating activities, while incurring a net loss of $1.4 million. Included in the net loss was approximately $6.3 million in various non-cash expenses and charges consisting of depreciation and amortization, stock based compensation expense, amortization of intangible assets and acquired technology, purchased IPR&D and the cumulative effect of changes in accounting principles. Operating cash flows also benefited from an increase in accounts payable and accrued liabilities of $9.3 million. The increase in accounts payable and accrued liabilities related principally to inventory purchases required to support a broader product portfolio and the timing of our payments to our suppliers. These sources of operating cash flows were partially offset by a $4.5 million and a $2 million increase in accounts receivable and inventory, respectively. The increase in accounts receivable was caused primarily by the timing of our sales and subsequent collections. The increase in inventory was principally related to support our increased revenue.
We generated net cash from investing activities of $0.3 million for the three months ended April 1, 2007, primarily from net sale of short-term investments of $1.9 million offset by $1.6 million in purchases of property and equipment. We used net cash of $76.4 million for the three months ended April 2, 2006, which related primarily to the NPA acquisition of $32.7 million, the net purchase of short-term investments totaling $40.8 million and purchases of property and equipment of $2.9 million. We anticipate that we will continue to purchase necessary property and equipment in the normal course of our business. The amount and timing of these purchases and the related cash outflows in future periods depend on a number of factors, including the hiring of employees, the rate of change of computer hardware and software used in our business and our business outlook. We have classified our investment portfolio as available for sale, and our investment objectives are to preserve principal and provide liquidity, while maximizing yields without significantly increasing risk. We may sell an investment at any time if the quality rating of the investment declines; the yield on the investment is no longer attractive; or we are in need of cash. Because we invest only in marketable securities that are believed to be highly liquid and investment grade, we believe that the purchase, maturity or sale of our investments will have no material impact on our overall liquidity. We have used cash to acquire businesses and technologies that enhance and expand our product offerings, and we anticipate that we will continue to do so in the future. The nature of these transactions makes it difficult to predict the amount and timing of such cash requirements.
Our financing activities provided $0.2 million for the three months ended April 1, 2007, resulting from proceeds of the exercises of employee stock options as well as payments made on capital lease obligations. Financing activities provided $49.2 million for the three months ended April 2, 2006, primarily due to the completion of our secondary offering in which we raised $48.6 million of net proceeds. We have used, and continue to intend to use, the net proceeds for working capital and general corporate purposes, which may include the acquisition of businesses, products, product rights or technologies, strategic investments or purchases of common stock.
We believe that our existing cash, cash equivalents and cash flows expected to be generated from future operations, if any, will be sufficient to meet our anticipated cash needs for at least the next 12 months. Our future capital requirements will depend on many factors including our rate of revenue growth, the timing and extent of spending to support development efforts, the expansion of sales and marketing activities, the timing of introductions of new products and enhancements to existing products, the costs to ensure access to adequate manufacturing capacity and the continuing market acceptance of our products. Although we are currently not a party to any agreement with respect to potential investments in, or acquisitions of, complementary businesses, products or technologies, we may enter into these types of arrangements in the future, which could also require us to seek additional equity or debt financing. The sale of additional equity securities or convertible debt securities would result in additional dilution to our stockholders. Additional debt would result in increased interest expenses and could result in covenants that would restrict our operations. We have not made arrangements to obtain additional financing, and there is no assurance that such financing, if required, will be available in amounts or on terms acceptable to us, if at all.
Contractual Commitments and Off-Balance Sheet Arrangements
We do not use off-balance-sheet arrangements with unconsolidated entities or related parties, nor do we use other forms of off-balance-sheet arrangements such as special purpose entities and research and development arrangements. Accordingly, our liquidity and capital resources are not subject to off-balance-sheet risks from unconsolidated entities.
We lease certain office facilities, equipment and software under non-cancelable operating leases. The following table summarizes our contractual obligations as of April 1, 2007, and the effect those obligations are expected to have on our liquidity and cash flow in future periods (in millions):
For the purpose of this table, purchase obligations for the purchase of goods or services are defined as agreements that are enforceable and legally binding and that specify all significant terms, including: fixed or minimum quantities to be purchased; fixed, minimum or variable price provisions; and the approximate timing of the transaction. Our purchase orders are based on our current manufacturing needs and are fulfilled by our vendors within short time horizons. In addition, we have purchase orders that represent authorizations to purchase rather than binding agreements. We do not have significant agreements for the purchase of raw materials or other goods specifying minimum quantities or set prices that exceed our expected requirements. Access to technology represents an agreement under which we have the right to use specific technology from a third party for a period of three years. Minimum royalty obligations represent minimum royalty payments with suppliers.
In the normal course of business, we provide indemnifications of varying scope to customers against claims of intellectual property infringement made by third parties arising from the use of our products. Historically, costs related to these indemnification provisions have not been significant, and we are unable to estimate the maximum potential impact of these indemnification provisions on our future consolidated results of operations.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board (FASB) issued SFAS No. 157, Fair Value Measurements (SFAS 157), which defines fair value, provides a framework for measuring fair value, and expands the disclosures required for fair value measurements. SFAS No. 157 applies to other accounting pronouncements that require fair value measurements; it does not require any new fair value measurements. We are required to apply the provisions of SFAS No. 157 beginning in 2008. We are currently evaluating the impact of adopting SFAS 157 on our financial position, operations, or cash flows.
In February 2007, the FASB issued SFAS No. 159, the Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159), which expands the standards under SFAS 157 to provide the one-time election (Fair Value Option) to measure financial instruments and certain other items at fair value and also includes an amendment of SFAS No. 115, Accounting for Certain Investments in Debt and Equity Securities. SFAS 159 will be effective for the Company beginning in 2008. We are currently evaluating the impact of adopting SFAS 159 on our financial position, operations, or cash flows.
All market risk sensitive instruments were entered into for non-trading purposes. We do not use derivative financial instruments for speculative trading purposes. As of April 1, 2007, we did not hold derivative financial instruments.
Interest Rate Risk
Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. We do not use derivative financial instruments in our investment portfolio. The primary objective of our investment activities is to preserve principal and meet liquidity needs, while maximizing yields and without significantly increasing risk. Our investment policy specifies credit quality standards for our investments and limits the amount of credit exposure to any single issue, issuer or type of investment. Our investments consist primarily of U.S. government notes and bonds, corporate notes and bonds and auction rate securities. All investments are carried at market value, which approximates cost.
As of April 1, 2007, we had cash, cash equivalents and short term investments totaling $102.1 million. These amounts were invested primarily in money market funds and short-term investments that are held for working capital purposes. We do not enter into investments for trading or speculative purposes. If the return on our cash equivalents and short-term investments were to change by one percent, the effect would be to increase/decrease investment income by approximately $0.3 million.
Foreign Currency Risk
Our revenue and cost, including subcontractor manufacturing expenses, are predominately denominated in U.S. dollars. An increase of the U.S. dollar relative to the currencies of the countries that our customers operate in would make our products more expensive to them and increase pricing pressure or reduce demand for our products. We also incur a portion of our expenses in currencies other than the U.S. dollar, including the Japanese yen, Korean won, Indian rupee, Singapore dollar and the Euro. We do not currently enter into forward exchange contracts to hedge exposure denominated in foreign currencies or any other derivative financial instruments for trading or speculative purposes. In the future, if we feel our foreign currency exposure has increased, we may consider entering into hedging transactions to help mitigate that risk. We expect that our foreign currency exposure will increase as our operations in India and other countries expand.
Evaluation of disclosure controls and procedures.
As of the end of the period covered by this report, an evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer (collectively, our certifying officers), of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended) as required by Rules 13a-15(b) or 15d-15(b) of the Securities Exchange Act of 1934, as amended. Based on their evaluation, our certifying officers concluded that these disclosure controls and procedures were effective.
We believe that a system of internal controls, no matter how well designed and operated, is based in part upon certain assumptions about the likelihood of future events, and can be affected by limitations inherent in all internal controls systems including the realities that human judgment in decision-making can be faulty, that persons responsible for establishing controls need to consider their relative costs and benefits, that breakdowns can occur because of human failures such as simple error or mistake, and that controls can be circumvented by collusion of two or more people. Accordingly, we believe that our system of internal controls, while effective, can only provide reasonable, not absolute, assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within our company have been detected.
There was no change in our internal control over financial reporting during the quarter ended April 1, 2007, that our certifying officers concluded materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II OTHE R INFORMATION
In November 2006, three putative class action lawsuits were filed in the United States District Court for the Southern District of New York against us, our directors, an executive officer and a former executive officer. The lawsuits were consolidated and an amended complaint was filed on April 24, 2007. The lawsuit alleges certain material misrepresentations and omissions by us in connection with our initial public offering in September 2005 and the follow-on offering in March 2006 concerning our business and prospects. The lawsuits seek unspecified damages. We cannot predict the likely outcome of these lawsuits, and an adverse result could have a material effect on our financial statements.
In addition, from time to time, we are involved in legal proceedings and litigation arising in the ordinary course of business. We are not currently a party to any litigation or other legal proceedings that we believe would have a material adverse effect on our business, financial condition, results of operations and cash flows.
Investing in our common stock involves a high degree of risk. You should carefully consider the following risk factors, as well as the other information in this Quarterly Report on Form 10-Q, and in our other filings with the SEC, including our Annual Report on Form 10-K for the year ended December 31, 2006 and subsequent reports on Form 8-K, before deciding whether to invest in shares of our common stock. Additional risks and uncertainties not presently known to us may also affect our business. If any of these known or unknown risks or uncertainties actually occurs with material adverse effects on us, our business, financial condition and results of operations could be seriously harmed. In that event, the market price for our common stock will likely decline and you may lose all or part of your investment.
Risks Related to Our Business
We have a limited operating history, and our quarterly operating results have fluctuated significantly and may do so again. As a result, we may fail to meet or exceed our forecasts or the expectations of securities analysts or investors, which could cause our stock price to decline. In recent quarters, we have experienced significant fluctuations in our revenue, and revenue and operating results are likely to continue to be volatile in future periods.
We have a limited operating history, which makes it difficult to evaluate our business and financial prospects. While our operations began in 1999, we did not begin commercial shipments of our products until the fourth quarter of 2002. Since then, our quarterly revenue and operating results have varied significantly and are likely to continue to vary from quarter to quarter due to a number of factors, many of which are not within our control. For example, in the first quarter of 2005, our revenue decreased by $6.2 million, or 33%, from the preceding quarter, but then increased by $7.0 million, or 57%, in the following quarter. More recently, in the fourth quarter of 2006, our revenue declined by $15.7 million, or 43%, from the third quarter of 2006. Quarterly fluctuations in revenue are characteristic of our industry. And given our concentration of revenue among a few significant customers and given their buying patterns, we have experienced, and are likely to experience again, significant quarterly fluctuations of revenue. Specifically, carriers purchase equipment based on expected deployment and OEMs may occasionally manufacture equipment at rates higher than equipment is deployed. As a result, periodically and usually without significant notice, carriers will reduce orders with OEMs for new equipment, and OEMs in turn will reduce orders for our products, which can adversely impact the quarterly demand for our products, even when deployment rates may be increasing.
In addition, our expenses are also subject to quarterly fluctuations resulting from factors including the costs related to new product releases. If our operating results do not meet the expectations of securities analysts or investors for any quarter or other reporting period, the market price of our common stock may decline. Fluctuations in our operating results may be due to a number of factors, including, but not limited to, changes in the mix of products we develop, acquire and sell as well as those identified throughout this Risk Factors section. As a result, you should not rely on quarter to quarter comparisons of our operating results as an indicator of future performance.
We have a history of losses, and future losses may cause the market price of our common stock to decline. We may not be able to generate sufficient revenue in the future to achieve or sustain profitability.
Since inception, we have only been profitable in the third and fourth quarter of 2005. We incurred significant net losses prior to such quarters, and we incurred losses in the past five quarters. We had sequential decreases in revenue in the third and fourth quarters of 2006, and we incurred a net loss of $9.1 million in our most recent quarter and have an accumulated deficit of $118.5 million as of April 1, 2007. To achieve profitability again, we will need to generate and sustain higher revenue, while maintaining reasonable cost and expense levels. Because many of our expenses are fixed in the short term, or are incurred in advance of anticipated sales, we may not be able to decrease our costs and expenses in a timely manner to offset any revenue shortfall as occurred in the fourth quarter of 2006. We may not be able to achieve profitability again, and even if we were able to attain profitability again, we may not be able to sustain profitability on a quarterly or an annual basis in the future.
If demand for our semiconductors declines or does not grow, we will be unable to increase or sustain our revenue; and our operating results will be harmed.
We currently expect our existing semiconductors to account for substantially all of our revenue for the foreseeable future. If we are unable to develop new products or to successfully integrate acquired products and technology to meet our customers demand in a timely manner, if demand for our semiconductors declines or fails to grow, or if the VDSLx market does not materialize as expected, it would harm our business. The markets for our products are characterized by frequent introduction of new semiconductors, short product life cycles and significant price competition. If we or our OEM customers are unable to manage product transitions in a timely and cost-effective manner, our revenue would suffer. In addition, frequent technology changes and introduction of next generation products may result in inventory obsolescence, which would increase our cost of revenue and adversely affect our operating performance.
The average selling prices of our products are subject to rapid declines, which may harm our revenue and profitability.
The products we develop and sell are used for high volume applications and are subject to rapid declines in average selling prices due to competitive pressures and business objectives, including lowering average selling prices in order to increase market share. We have lowered our prices significantly at times to gain market share, and we expect that we will reduce prices again in the future. Offering reduced prices to one customer could likely impact our average selling prices to all customers. Our financial results will suffer if we are unable to offset any future reductions in our average selling prices by increasing our sales volumes, or if we are unable to reduce our cost and expenses or develop new or enhanced products on a timely basis that bear higher selling prices.
Our product mix is subject to frequent and unexpected changes, which may impact our revenue and margin. (We define margin as revenue minus cost of revenue divided by revenue.)
Our product margins vary widely by product. As a result, a change in the sales mix of our products could have an impact on the forecasted revenue and margins for the quarter. In 2006, we acquired network processor products from ADI. These products are included in our Gateway product family and generally have lower margins as compared to our Access product family. Furthermore, the product margins within our Access product line can vary based on the type and performance of deployment being used as customers typically pay higher selling prices for higher performance. In Japan, we experienced a shift from our Access products to our Gateway products during 2006 as some carriers have partially shifted from building out the infrastructure to adding subscribers. Because our Access products generally have higher margins than our Gateway products, we have seen margins decline over the past several quarters in this region. While we make estimates of what we believe the product mix will be in a given quarter, actual results can be materially different than our estimates.
Because we depend on a few significant customers for a substantial portion of our revenue, the loss of any of our key customers, our inability to continue to sell existing and new products to our key customers in significant quantities or our failure to attract new significant customers could adversely impact our revenue and harm our business.
We derive a substantial portion of our revenue from sales to a relatively small number of customers. As a result, the loss of any significant customer or a decline in business with any significant customer would materially and adversely affect our financial condition and results of operations. The following customers accounted for more than 10% of our revenue for any one of the periods indicated. We have indicated the OEM customer based on information that we receive at the time of ordering.
We expect that a small group of OEM customers, the composition of which has varied over time, will continue to account for a substantial portion of our revenue in 2007, and in the foreseeable future. Accordingly, our future operating results will continue to depend on the success of our largest OEM customers and on our ability to sell existing and new products to these customers in significant quantities. Demand for our semiconductor products is based on carrier demand for our OEM customers systems products. Accordingly, a reduction in growth of carrier deployment of product that use our semiconductors would adversely affect our product sales and business.
In addition, our relationships with some of our larger OEM customers may also deter other potential customers who compete with these customers from buying our products. To attract new customers or retain existing OEM customers, we have offered and may continue to offer certain customers favorable prices on our products. If these prices are lower than the prices paid by other existing OEM customers, we may have to offer the same lower prices to certain of these customers. In that event, our average selling prices would decline. The loss of a key customer, a reduction in sales to any major customer or our inability to attract new significant customers in the absence of any offsetting sales would harm our business.
We may be unable to attract, retain and motivate key senior management and technical personnel, which could harm our development of technology and ability to be competitive.
In October 2006, our then President and Chief Executive Officer, Rajesh Vashist, was replaced as President and Chief Executive Officer and resigned from the Board of the Directors. In May 2007, we announced the appointment of a new Chief Executive Officer, Michael Ricci, to begin in early June 2007. Our future success depends to a significant extent upon the continued service of our senior executives and key technical personnel as well as the integration of new senior executives. We do not have employment agreements with any of these executives or any other key employees that govern the length of their service. Changes in the services of senior management or technical personnel could impact our customer relationships, employee morale, our ability to operate in compliance with existing internal controls and regulations and harm our business. Furthermore, our future success depends on our ability to continue to attract, retain and motivate other senior management and qualified technical personnel, particularly software engineers, digital circuit designers, mixed-signal circuit designers and systems and algorithms engineers, and we are currently in the process of trying to hire a general manager. Competition for these employees is intense. Stock options, restricted stock units and other equity incentives generally comprise a significant portion of our compensation packages for all employees, and the expected volatility in the price of our common stock may make it more difficult for us to attract and retain key employees, which could harm our ability to provide technologically competitive products.
Because of the rapid technological development in our industry and the intense competition we face, our products tend to become outmoded or obsolete in a relatively short period of time, which requires us to provide frequent updates and/or replacements to existing products. If we do not successfully manage the transition process to next generation semiconductor products, our operating results may be harmed.
Our industry is characterized by rapid technological innovation and intense competition. Accordingly, our success depends in part on our ability to develop next generation semiconductor products in a timely and cost-effective manner. The development of new semiconductor products is expensive, complex and time consuming. If we do not rapidly develop our next generation semiconductor products ahead of our competitors, we may lose both existing and potential customers to our competitors. Further, if a competitor develops a new, less expensive
product using a different technological approach to delivering broadband services over existing networks, our products would no longer be competitive. Conversely, even if we are successful in rapidly developing new semiconductor products ahead of our competitors and we do not cost-effectively manage our inventory levels of existing products when making the transition to the new semiconductor products, our financial results may be negatively affected by high levels of obsolete inventory. If any of the foregoing were to occur, then our operating results would be harmed.
Our products include a significant amount of firmware. If we are unable to deliver the firmware in a timely manner, we may have to delay revenue recognition at the end of a quarter, which could lead to significant unplanned fluctuations in our quarterly revenue. As a result, we may fail to meet or exceed our forecasts or the expectations of securities analysts or investors, which could cause our stock price to decline.
In connection with new product introductions in a given market, we release production quality code to our OEM customers. This firmware is required for our products to function as intended. If the firmware is not released in a timely manner, we may have to defer all revenue related to the semiconductors that we may have already shipped during the quarter, and therefore, cause us to miss our revenue forecast. In addition, a customer may demand a specific future software feature as part of its order. As such, we may have to delay recognition on some or all of our revenue related to that customers order until the future software feature is delivered. Such delays or deferrals in revenue recognition could lead to significant fluctuations in our quarterly revenue and operating results and cause us to fail to meet or exceed our quarterly revenue forecasts.
We are a fabless semiconductor company and may rely on one wafer foundry and one assembly and test subcontractor to manufacture, package and test many of our products, and our failure to secure and maintain sufficient capacity with these subcontractors could impair our relationships with customers and decrease sales, which would negatively impact our market share and operating results.
We are a fabless semiconductor company in that we do not own or operate a fabrication or manufacturing facility. Currently, five wafer foundries and three outside factory subcontractors, located in Austria, Israel, Korea, Malaysia, Singapore, Taiwan and the United States, manufacture, assemble and test all of our semiconductor devices in current production. While we work with multiple suppliers, only one foundry and one assembly and test subcontractor may be used for each of our products. Accordingly, we are greatly dependent on a limited number of suppliers to deliver quality products on time.
In past periods of high demand in the semiconductor market, we have experienced delays in meeting our capacity demand and as a result were unable to deliver products to our customers on a timely basis. In addition, we have experienced similar delays due to technical and quality control problems. Furthermore, our costs for manufacturing services or components have increased from time to time without significant notice. In the future, if any of these events occur, or if the facilities of any of our subcontractors suffer any damage, power outages, financial difficulties or any other disruption due to natural disasters, terrorist acts or otherwise, we may be unable to meet our customer demand on a timely basis, or at all; and we may be required to incur additional costs and may need to successfully qualify an alternative facility in order to not disrupt our business. We typically require several months or more to qualify a new facility or process before we can begin shipping products. If we cannot accomplish this qualification in a timely manner, we would experience a significant interruption in supply of the affected products which could in turn cause our costs of revenue to increase and our overall revenue to decrease. If we are unable to secure sufficient capacity at our subcontractors existing facilities, or in the event of a closure or significant delay at any of these facilities, our relationships with our customers would be harmed and our market share and operating results would suffer as a result. In addition, we do not have formal pricing agreements with our subcontractors regarding the pricing for the products and services that they provide us. If their pricing for the products and services they provide increases and we are unable to pass along such increases to our OEM customers, our operating results would be adversely affected.
In the event we seek to use new wafer foundries to manufacture a portion of our semiconductor products, we may not be able to bring the new foundries on-line rapidly enough and may not achieve the anticipated cost reductions.
As indicated, we use five independent wafer foundries to manufacture all of our semiconductor products, which expose us to risks of delay, increased costs and customer dissatisfaction in the event that any of these foundries were unable to provide us with our semiconductor requirements. Particularly during times when semiconductor capacity is limited, we may seek to qualify additional wafer foundries to meet our requirements. In order to bring these new foundries on-line, our customers may need to qualify product from the new facility, which could take several months or more. Once qualified, these new foundries would then require an additional number of months to actually begin producing semiconductors to meet our needs, by which time our perceived need for additional capacity may have passed or the opportunities we previously identified may have been lost to our competitors. Furthermore, even if these new foundries offer better pricing than our existing manufacturers, if they prove to be less reliable than our existing manufacturers, we would not achieve some or all of our anticipated cost reductions.
If our subcontractors manufacturing facilities do not achieve satisfactory quality or yields, our relationships with our customers and our reputation will be harmed, our revenue and operating results could decline, and our cost of revenue as a percentage of revenue could increase.
Manufacturing defects may not be detected by the testing process performed by our subcontractors. If defects are discovered after we have shipped our products, we have and could continue to experience warranty and consequential damages claims from our customers. In January 2007, a significant customer notified us that they were experiencing a high defect rate on a certain product that was manufactured and shipped
in the last month of fiscal 2006. On February 8, 2007, the customer submitted a claim seeking replacement parts and specified damages. We evaluated the merits of the claim, concluded it was in our best interests to resolve the matter, and on February 26, 2007, entered into a settlement agreement releasing us of all liabilities associated with this claim in exchange for a payment and providing replacement parts. The settlement was recorded as an offset to revenue and as accrued rebates within accrued liabilities in the fourth quarter of 2006. Such claims as this one or others may have a significant adverse impact on our revenue and operating results. Furthermore, if we are unable to deliver quality products, our reputation would be harmed, which could result in the loss of, future orders and business with these OEMs. If any of these adverse risks are realized and we are not able to offset the lost opportunities, our revenue, margins and operating results would decline.
The fabrication of semiconductors is a complex and technically demanding process. Minor deviations in the manufacturing process can cause substantial decreases in yields; and in some cases, cause production to be stopped or suspended. We have experienced difficulties in achieving acceptable yields on some of our products, particularly with new products, which frequently involve newer manufacturing processes and smaller geometry features than previous generations. Maintaining high numbers of shippable die per wafer is critical to our operating results, as decreased yields can result in higher per unit cost, shipment delays and increased expenses associated with resolving yield problems. Although we work closely with our subcontractors to minimize the likelihood of reduced manufacturing yields, their facilities have from time to time experienced lower than anticipated manufacturing yields that have resulted in our inability to meet our customer demand. For instance, in the third quarter of 2006, we were unable to fulfill a certain amount of our customers orders due to difficulties in attaining acceptable yields on one of our products. While we solved the manufacturing process issue in the fourth quarter of 2006, we cannot assure you that we will be successful in improving yields on any future product or in correcting manufacturing problems with our subcontractors.
It is common for yields in semiconductor fabrication facilities to decrease in times of high demand or due to poor workmanship or operational problems at these facilities. When these events occur, especially simultaneously, as happens from time to time, we may be unable to supply our customers demand. Many of these problems are difficult to detect at an early stage of the manufacturing process and, regardless of when the problems are detected, they may be time consuming and expensive to correct. In addition, because we purchase wafers, our exposure to low wafer yields from our subcontractors wafer foundries are increased. Poor yields from the wafer foundries or defects, integration issues or other performance problems in our products could cause us significant customer relations and business reputation problems, or force us to sell our products at lower gross margins and therefore harm our financial results. Conversely, unexpected yield improvements could result in us holding excess inventory that would also increase our product cost and negatively impact our profitability.
We base orders for inventory on our forecasts of our OEM customers demand and if our forecasts are inaccurate, our financial condition and liquidity would suffer.
We place orders with our suppliers based on our forecasts of our OEM customers demand. Our forecasts are based on multiple assumptions, each of which may introduce errors into our estimates. In the past, when the demand for our OEM customers products increased significantly, we were not able to meet demand on a timely basis, and we expended a significant amount of time working with our customers to allocate limited supply and maintain positive customer relations. If we underestimate customer demand, we may forego revenue opportunities, lose market share and damage our customer relationships. Conversely, if we overestimate customer demand, we may allocate resources to manufacturing products that we may not be able to sell. As a result, we would have excess or obsolete inventory, resulting in a decline in the value of our inventory, which would increase our cost of revenue and create a drain on our liquidity. Our failure to accurately manage inventory against demand would adversely affect our financial results.
To remain competitive, we need to continue to reduce the cost of our semiconductor chips, which includes migrating to smaller geometrical process, and our failure to do so may harm our business.
We periodically evaluate the benefits, on a product-by-product basis, of migrating to smaller geometrical processes, which are measured in microns or nanometers. We have designed our products to be manufactured in 0.8 micron, 0.25 micron, 0.18 micron, 0.13 micron and 0.09 micron (or 90 nanometer) geometrical processes. We are currently migrating some of our products to even smaller 65 nanometer geometrical process technology, and over time, we are likely to migrate to even smaller geometries. The smaller geometry generally reduces our production and packaging costs, which may enable us to be competitive in our pricing. The transition to smaller geometries requires us to work with our subcontractors to modify the manufacturing processes for our products, to develop new and more complex quality assurance tests and to redesign some products. In the past, we have experienced some difficulties in shifting to smaller geometry process technologies or new manufacturing processes, which resulted in reduced manufacturing yields, delays in product deliveries and increased product costs and expenses. We may face similar difficulties, delays and expenses as we continue to transition our products to smaller geometry processes, all of which could harm our relationships with our customers, and our failure to do so would impact our ability to provide competitive prices to our customers, which would have a negative impact on our sales. Additionally, upfront expenses associated with smaller geometry process technologies such as for masks and tooling can be significantly higher than those for the processes that we currently use, and our migration to these newer process technologies can result in significantly higher research and development expenses.
We face intense competition in the semiconductor industry and the broadband communications markets, which could reduce our market share and negatively impact our revenue.
The semiconductor industry and the broadband communications markets are intensely competitive. We currently compete or expect to compete with, among others, Broadcom Corporation, Centillium Communications, Inc., Conexant Systems, Inc., Infineon Technologies A.G., Marvell Technology Group Ltd., STMicroelectronics N.V. and Texas Instruments Incorporated, which companies, we believe, have experience
in VDSLx, or VDSL-like, technology. We also expect to compete with, among others, Freescale Semiconductor, Inc., Intel Corporation, Marvell Technology Group Ltd., PMC-Sierra, Inc. and Realtek Semiconductor Corp in the network processing market. We expect competition to continue to increase. Competition has resulted and may continue to result in declining average selling prices for our products and market share.
We consider other companies that have access to Discrete Multi Tone (DMT) technology as potential competitors in the future, and we also may face competition from newly established competitors, suppliers of products based on new or emerging technologies and customers who choose to develop their own semiconductors. To remain competitive, we need to provide products that are designed to meet our customers needs. Our products must:
Many of our competitors operate their own fabrication facilities or have stronger manufacturing partner relationships than we have. In addition, many of our competitors have extensive technology libraries that could enable them to incorporate fiber-fast broadband or network processing technologies into a more attractive product line than ours. Many of them also have longer operating histories, greater name recognition, larger customer bases, and significantly greater financial, sales and marketing, manufacturing, distribution, technical and other resources than we do. These competitors may be able to adapt more quickly to new or emerging technologies and changes in customer requirements. In addition, current and potential competitors have established or may establish financial or strategic relationships among themselves or with existing or potential customers, resellers or other third parties. Accordingly, new competitors or alliances among competitors could emerge and rapidly acquire significant market share. Existing or new competitors may also develop alternative technologies that more effectively address our markets with products that offer enhanced features and functionality, lower power requirements, greater levels of semiconductor integration or lower cost. We cannot assure you that we will be able to compete successfully against current or new competitors, in which case we may lose market share in our existing markets and our revenue may fail to increase or may decline.
Other data transmission technologies and network processing technologies may compete effectively with the carrier services addressed by our products, which could adversely affect our revenue and business.
Our revenue is dependent on the increase in demand for carrier services that use VDSLx broadband technology and integrated residential gateways. Besides VDSLx and other DMT-based technologies, carriers can decide to deploy passive optical networks, which is some times also referred to as PON or fiber. In this case, fiber is used to connect directly to the residence instead of using the existing copper phone line. As such, if a carrier decides to deploy fiber-to-the-home, our VSDL solutions are not required. For example, a major carrier in Korea announced its intention to use more fiber-to-the-home deployments in the future. Such deployments of fiber may be in lieu of VDSLx solutions. If more carriers decide to use fiber-to-the-home deployments, it could harm our business.
Furthermore, residential gateways compete against a variety of different data distribution technologies, including Ethernet routers, set-top boxes provided by cable and satellite providers, wireless (WiMax) and emerging power line and multimedia over coax alliance technologies. If any of these competing technologies proves to be more reliable, faster or less expensive than, or has any other advantages over the Fiber Fast broadband technologies we provide, the demand for our products may decrease and our business would be harmed.
If we are unable to develop, introduce or to achieve market acceptance of our new semiconductor products, our operating results would be adversely affected.
Our future success depends on our ability to develop new semiconductor products and transition to new products, introduce these products in a cost-effective and timely manner and convince OEMs to select our products for design into their new systems. Our historical quarterly results have been, and we expect that our future results will continue to be, dependent on the introduction of a relatively small number of new products and the timely completion and delivery of those products to customers. The development of new semiconductor products is complex, and from time to time we have experienced delays in completing the development and introduction of new products. We have in the past invested substantial resources in emerging technologies that did not achieve the market acceptance that we had expected. Our ability to develop and deliver new semiconductor products successfully will depend on various factors, including our ability to:
If we are unable to develop and introduce new semiconductor products successfully and in a cost-effective and timely manner, we will not be able to attract new customers or retain our existing customers, which would harm our business.
Our success is dependent upon achieving design wins into commercially successful OEM systems.
Our products are generally incorporated into our OEMs customers systems at the design stage. As a result, we rely on OEMs to select our products to be designed into their systems, which we refer to as a design win. We often incur significant expenditures in obtaining a design win without any assurance that an OEM will select our product for design into its own system. Additionally, in some instances, we are dependent on third parties to obtain or provide information that we need to achieve a design win. Some of these third parties may not supply this information to us on a timely basis, if at all. Furthermore, even if an OEM designs one of our products into its system offering, we cannot be assured that its equipment will be commercially successful or that we will receive any revenue as a result of that design win. Our OEM customers are typically not obligated to purchase our products and can choose at any time to stop using our products if their own systems are not commercially successful, if they decide to pursue other systems strategies, or for any other reason. If we are unable to achieve design wins or if our OEM customers systems incorporating our products are not commercially successful, our revenue would suffer.
Acquisitions, strategic partnerships, joint ventures or investments may impair our capital and equity resources, divert our managements attention or otherwise negatively impact our operating results.
We intend to continue to actively pursue acquisitions, strategic partnerships and joint ventures that we believe may allow us to complement our growth strategy, increase market share in our current markets and expand into adjacent markets, broaden our technology and intellectual property and strengthen our relationships with carriers and OEMs. For example, in 2006, we completed the NPA and Doradus acquisitions. These transactions consumed significant management attention, added to our expenses and used $34.9 million in cash. Any future acquisition, partnership, joint venture or investment may require that we pay significant cash, issue stock, thereby diluting existing stockholders, or incur substantial debt. Acquisitions, partnerships or joint ventures may also require significant managerial attention, which may divert our focus. These capital, equity and managerial commitments may impair the operation of our business. Furthermore, acquired businesses may not be effectively integrated, may be unable to maintain key pre-acquisition business relationships, may result in the loss of key personnel, may contribute to increased fixed costs and may expose us to unanticipated liabilities and otherwise harm our operating results.
We rely on third-party sales representatives to assist in selling our products, and the failure of these representatives to perform as expected could reduce our future sales.
We sell our products to some of our OEM customers through third-party sales representatives. Our relationships with some of our third-party sales representatives have been established within the last three years, and we are unable to predict the extent to which our third-party sales representatives will be successful in marketing and selling our products. Moreover, many of our third-party sales representatives also market and sell competing products. Our third-party sales representatives may terminate their relationships with us at any time, or with short notice. Our future performance will also depend, in part, on our ability to attract additional third-party sales representatives that will be able to market and support our products effectively, especially in markets in which we have not previously distributed our products. If we cannot retain our current third-party sales representatives and recruit additional or replacement third-party sales representatives, our revenue and operating results could be harmed.
Rapidly changing standards and regulations could make our products obsolete, which would cause our revenue and operating results to suffer.
We design our products to conform to regulations established by governments and to standards set by industry standards bodies worldwide such as The American National Standards Institute and The Committee T1E1.4 in North America, European Telecommunications Standards Institute in Europe and ITU-T and the Institute of Electrical and Electronics Engineers, Inc. Because our products are designed to conform to current specific industry standards, if competing standards emerge that are preferred by our customers, we would have to make significant expenditures to develop new products. If our customers adopt new or competing industry standards with which our products are not compatible, or the industry groups adopt standards or governments issue regulations with which our products are not compatible, our existing products would become less desirable to our customers and our revenue and operating results would suffer.
If we fail to secure or protect our intellectual property rights, competitors may be able to use our technologies, which could weaken our competitive position, reduce our revenue or increase our cost.
Our success will depend, in part, on our ability to protect our intellectual property. We rely on a combination of patent, copyright, trademark and trade secret laws, confidentiality procedures and licensing arrangements to establish and protect our proprietary rights in the United States. We do not currently have any applications on file in any foreign jurisdictions with respect to our intellectual property notwithstanding the fact nearly all of our revenue is generated outside of the United States. Our pending patent applications may not result in issued patents, and our existing and future patents may not be sufficiently broad to protect our proprietary technologies or may be held invalid or unenforceable in court. While we are not currently aware of misappropriation of our existing technology, policing unauthorized use of our technology is difficult 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 we have not applied for patent protections and, even if such protections were available, the laws may not protect our proprietary rights as fully as U.S. law. The patents we have obtained or licensed, or may obtain or license in the future, may not be adequate to protect our proprietary rights. Our competitors may independently develop or may have already developed technology similar to ours, duplicate our products or design around any patents issued to us or our other intellectual property. In addition, we have been, and may be, required to license our patents as a result of our participation in various standards organizations. If competitors appropriate our technology and we are not adequately protected, our competitive position would be harmed, our legal costs would increase and our revenue would be harmed.
Third-party claims of infringement or other claims against us could adversely affect our ability to market our products, require us to redesign our products or seek licenses from third parties, and harm our business. In addition, any litigation required to defend such claims could result in significant expenses and diversion of our resources.
Companies in the semiconductor industry often aggressively protect and pursue their intellectual property rights. From time to time, we receive, and are likely to continue to receive in the future, notices that claim we have infringed upon, misappropriated or misused other parties proprietary rights. While we do not believe that we are currently infringing on the proprietary rights of third parties, we may in the future be engaged in litigation with parties who claim that we have infringed their patents or misappropriated or misused their trade secrets or who may seek to invalidate one or more of our patents, and it is possible that we would not prevail in any future lawsuits. An adverse determination in any of these types of claims could prevent us from manufacturing or selling some of our products could increase our costs of products and could expose us to significant liability. Any of these claims could harm our business. For example, in a patent or trade secret action, a court could issue a preliminary or permanent injunction that would require us to withdraw or recall certain products from the market or redesign certain products offered for sale or that are under development. In addition, we may be liable for damages for past infringement and royalties for future use of the technology and we may be liable for treble damages if infringement is found to have been willful. Even if claims against us are not valid or successfully asserted, these claims could result in significant costs and a diversion of management and personnel resources to defend.
Any potential dispute involving our patents or other intellectual property could also include our manufacturing subcontractors and OEM customers and/or carriers using our products, which could trigger our indemnification obligations to them and result in substantial expense to us.
In any potential dispute involving our patents or other intellectual property, our manufacturing subcontractors and OEM customers could also become the target of litigation. Because we often indemnify our customers for intellectual property claims made against them for products incorporating our technology, any litigation could trigger technical support and indemnification obligations in some of our license agreements, which could result in substantial expenses such as increased legal expenses, damages for past infringement or royalties for future use. In the fourth quarter of 2006, an OEM customer informed us of a potential indemnity claim against our technology. While we are still assessing the validity of the claim, it, or any future indemnity claim, could adversely affect our relationships with our OEM customers and result in substantial costs to us.
Our products typically have lengthy sales cycles, which may cause our operating results to fluctuate and result in volatility in the price of our common stock. An OEM customer or a carrier may decide to cancel or change its product plans, which could cause us to lose anticipated sales.
After we have delivered a product to an OEM customer, the OEM will usually test and evaluate our product with its carrier customer prior to the OEM completing the design of its own equipment that will incorporate our product. Our OEM customers and the carriers may need three to more than six months to test, evaluate and adopt our product and an additional three to more than nine months to begin volume production of equipment that incorporates our product. Due to this lengthy sales cycle, we may experience significant delays from the time we increase our operating expenses and make investments in inventory until the time that we generate revenue from these products. It is possible that we may never generate any revenue from these products after incurring these expenditures and investments. Even if an OEM customer selects our product to incorporate into its equipment, we have no assurances that the customer will ultimately market and sell its equipment or that such efforts by our customer will be successful. The delays inherent in our lengthy sales cycle increases the risk that an OEM customer or carrier will decide to cancel or change its product plans. From time to time, we have experienced changes and cancellations in the purchase plans of our OEM customers. A cancellation or change in plans by an OEM customer or carrier could cause us to not achieve anticipated revenue and result in volatility of the price of our common stock. In addition, our anticipated sales could be lost or substantially reduced if a significant OEM customer or carrier reduces or delays orders during our sales cycle or chooses not to release equipment that contains our products.
Changes in current or future laws or regulations or the imposition of new laws or regulations by federal or state agencies or foreign governments could impede the sale of our products or otherwise harm our business.
The effects of regulation on our customers or the industries in which they operate may materially and adversely impact our business. For example, the Federal Communications Commission (FCC) has broad jurisdiction over our target markets in the United States, and the European Union (EU) has broad jurisdiction over our target markets in Europe. Although the laws and regulations of these and other federal or state agencies are not directly applicable to our products, they do apply to much of the equipment into which our products are incorporated. Governmental regulatory agencies worldwide, including the FCC and EU, may affect the ability of telephone companies to offer certain services to their customers or other aspects of their business, which may in turn impede sales of our products.
We have historically derived a substantial amount of our revenue from Asia; and with the NPA acquisition, a majority of our network processing revenue comes from a single customer in Europe. If we fail to diversify the geographic sources and customer base of our revenue in the future, our operating results could be harmed.
A substantial portion of our revenue is derived from sales into Japan, Korea and France; and our revenue has been heavily dependent on developments in these markets. As a result, our sales are subject to economic downturns, decrease in demand and overall negative market conditions in Japan, Korea and France. For instance, a sustained slow down in growth of fiber extension over copper and broadband over copper subscribers in Asia has cause our revenue to decline, and may prevent our revenue from returning to historical levels. While part of our strategy is to continue to diversify the geographic sources and customer base of our revenue, our failure to successfully penetrate markets outside of Japan, Korea and France, and to successfully diversify our customer base could harm our business and operating results.
The complexity of our products could result in unforeseen delays or expenses and in undetected defects or bugs, which could damage our reputation with current or prospective customers and adversely affect the market acceptance of new products.
Highly complex products such as those that we offer frequently contain defects and bugs, particularly when they are first introduced or as new versions are released. In the past, we have experienced, and may in the future experience, defects and bugs in our products. If any of our products contains defects or bugs, or have reliability, quality or compatibility problems, our reputation may be damaged; and our OEM customers may be reluctant to buy our products, which could harm our ability to retain existing customers and attract new customers. In addition, these defects or bugs could interrupt or delay sales or shipment of our products to our customers.
Reductions in force could interfere with our ability to achieve our business objectives and result in additional expenses in the period in which an action is executed.
In November 2006, we reduced the number of employees and contractors in our workforce by approximately 30 people. These reductions were principally in our engineering departments and have resulted in reallocations of employee duties. Workforce reductions and job reassignments could negatively affect employee morale and make it difficult to motivate and retain the remaining employees and contractors, which would affect our ability to deliver our products in a timely fashion and otherwise negatively affect our business.
Recent changes to environmental laws and regulations applicable to manufacturers of electrical and electronic equipment are causing us to redesign our products, and may result in increases to our costs and greater exposure to liability.
The implementation of new environmental regulatory legal requirements, such as lead free initiatives, impacts our product designs and manufacturing processes. The impact of such regulations on our product designs and manufacturing processes could affect the timing of compliant product introductions as well as their commercial success. For example, a recent directive in the European Union banned the use of lead and other heavy metals in electrical and electronic equipment after July 1, 2006. As a result, some of our customers selling products in Europe are demanding product from component manufacturers that do not contain these banned substances. Because most of our existing assembly processes (as well as those of most other manufacturers) utilize a tin-lead alloy as a soldering material in the manufacturing process, we must redesign many of our products if we are to meet customer demand. This redesign may result in increased research and development and manufacturing and quality control costs. In January 2007, a customer could not get a certain number of lead free semiconductors to properly bond on the printed circuit board. We believe the lead-free substrates could have contributed to the bonding problem. In addition, given the limited experience and knowledge with the materials and processes used to manufacture lead-free parts, we may incur quality issues or production delays. Furthermore, the products that we manufacture that comply with the new regulatory standards may not perform as well as our current products. Moreover, if we are unable to successfully and timely redesign existing products and introduce new products that meet the standards set by environmental regulation and our customers, sales of our products could decline, which could materially adversely affect our business, financial condition and results of operations.
When demand for manufacturing capacity is high, we may take various actions to try to secure sufficient capacity, which may be costly and negatively impact our operating results.
The ability of each of our subcontractors manufacturing facilities to provide us with semiconductors is limited by its available capacity and existing obligations. Although we have purchase order commitments to supply specified levels of products to our OEM customers, we do not have a guaranteed level of production capacity from any of our subcontractors facilities that we depend on to produce our semiconductors. Facility capacity may not be available when we need it or at reasonable prices. We place our orders on the basis of our OEM customers purchase orders or our forecast of customer demand, and our subcontractors may not be able to meet our requirements in a timely manner. For example, in the first nine months of 2004, the second half of 2005 and in the first half of 2006, general market conditions in the semiconductor industry resulted in a significant increase in demand at these facilities. The demand for some of our OEM customers products increased significantly, and we were asked to produce significantly higher quantities than in the past and to deliver on short notice. In addition, our subcontractors have also allocated capacity to the production of other companies products and reduced deliveries to us on short notice. It is possible that our subcontractors other customers that are larger and better financed than we are, or that have long-term agreements with our subcontractors, may have induced our subcontractors to reallocate capacity to them. If this reallocation were to occur again, it would impair our ability to deliver products on a timely basis.
In order to secure sufficient manufacturing facility capacity when demand is high and mitigate the risks described in the foregoing paragraphs, we may enter into various arrangements with subcontractors that could be costly and harm our operating results, including:
We may not be able to make any such arrangements in a timely fashion or at all, and any arrangements may be costly, reduce our financial flexibility and not be on terms favorable to us. Moreover, if we are able to secure facility capacity, we may be obligated to use all of that capacity or incur penalties. These penalties and obligations may be expensive and require significant capital and could harm our business.
We rely on third-party technologies for the development of our products; and our inability to use such technologies in the future would harm our ability to remain competitive.
We rely on third parties for technologies that are integrated into some of our products, including memory cells, input/output cells and core processor logic. If we are unable to continue to use or license these technologies on reasonable terms, or if these technologies fail to operate properly, we may not be able to secure alternatives in a timely manner and our ability to remain competitive would be harmed. In addition, if we are unable to successfully license technology from third parties to develop future products, we may not be able to develop such products in a timely manner or at all.
Compliance with the requirements imposed by Section 404 of the Sarbanes-Oxley Act could harm our operating results, our ability to operate our business and our investors view of us.
If we fail to maintain the adequacy of our internal controls, as standards are modified, supplemented or amended from time to time, we may not be able to ensure that we can conclude on an ongoing basis that we have effective internal control over financial reporting in accordance with Section 404 of Sarbanes-Oxley. There is a risk that neither we, nor our independent registered public accounting firm, will be able to conclude that our internal controls over financial reporting are effective as required by Section 404 of Sarbanes-Oxley. In addition, during the course of our testing we may identify deficiencies that we may not be able to remediate in time to meet the deadline imposed by Sarbanes-Oxley for compliance with the requirements of Section 404. Effective internal controls, particularly those related to revenue recognition, valuation of inventory and warranty provisions, are necessary for us to produce reliable financial reports and are important to helping prevent financial fraud. If we cannot provide reliable financial reports or prevent fraud, our business and operating results could be harmed, investors could lose confidence in our reported financial information, and the trading price of our stock could drop significantly.
Due to the cyclical nature of the semiconductor and telecommunications industries, our operating results may fluctuate significantly, which could adversely affect the market price of our common stock.
The semiconductor industry is highly cyclical and subject to rapid change and evolving industry standards and, from time to time, has experienced significant downturns. These downturns are characterized by decreases in product demand, excess customer inventories and accelerated erosion of prices. These factors could cause substantial fluctuations in our revenue and in our operating results. Any downturns in the semiconductor or broadband communications industry may be severe and prolonged, and any failure of this industry or the broadband communications markets to fully recover from downturns could harm our business. The semiconductor industry also periodically experiences increased demand and production capacity constraints, which may affect our ability to ship products. Accordingly, our operating results may vary significantly as a result of the general conditions in the semiconductor or broadband communications industry, which could cause our stock price to decline.
In addition, the telecommunications industry from time to time has experienced and may again experience a pronounced downturn. To respond to a downturn, many carriers may be required to slow their capital expenditures, cancel or delay new developments, reduce their workforces and inventories and take a cautious approach to acquiring new equipment and technologies from OEMs, which would have a negative impact on our business. In the future, a downturn in the telecommunications industry may cause our operating results to fluctuate from year to year, which also may tend to increase the volatility of the price of our common stock and harm our business.
We are highly dependent on manufacturing, development and sales activities outside of the United States; and as our international manufacturing, development and sales operations expand, we will be increasingly exposed to various legal, business, political and economic risks associated with our international operations.
We currently obtain substantially all of our manufacturing, assembly and testing services from suppliers and subcontractors located outside the United States, and have a significant portion of our research and development team located in Bangalore and Hyderabad, India. In addition, 87% of our revenue for the three months ended April 1, 2007 and 96% of our revenue for the year ended December 31, 2006 was derived from sales to customers outside the United States. We have expanded our international business activities and may open other design and operational centers abroad. International operations are subject to many other inherent risks, including but not limited to:
Because we are currently substantially dependent on our foreign sales, research and development and operations, any of the factors described above could significantly harm our ability to produce quality products in a timely and cost effective manner, and increase or maintain our foreign sales.
Fluctuations in exchange rates between and among the Japanese yen, the Korean won, the Indian rupee, the U.S. dollar, the Singapore dollar and the Euro, as well as other currencies in which we do business, may adversely affect our operating results.
We transact business internationally. As a result, we may experience foreign exchange gains or losses due to the volatility of other currencies compared to the U.S. dollar. Our sales have been historically denominated in U.S. dollars and an increase in the U.S. dollar relative to the currencies of the countries that our customers operate in could materially affect our Asian and European customers demand for our products, thereby forcing them to reduce their orders, which would adversely affect our business. We incur a portion of our expenses in currencies other than the U.S. dollar, including the Japanese yen, Korean won, Indian rupee, Singapore dollar and the Euro. As we report our results in U.S. dollars, the difference in exchange rates in one period compared to another directly impacts period to period comparisons of our operating results. Furthermore, currency exchange rates have been especially volatile in the recent past and these currency fluctuations may make it difficult for us to predict and/or provide guidance on our results.
Currently, we have not implemented any strategies to mitigate risks related to the impact of fluctuations in currency exchange rates. Even if we were to implement hedging strategies, not every exposure is or can be hedged, and, where hedges are put in place based on expected foreign exchange exposure, they are based on forecasts which may vary or which may later prove to have been inaccurate. Failure to hedge successfully or anticipate currency risks properly could adversely affect our operating results. We cannot predict future currency exchange rate changes.
Several of the facilities that manufacture our products, most of our OEM customers and the carriers they serve, and our California facility are located in regions that are subject to earthquakes and other natural disasters.
Several of our subcontractors facilities that manufacture, assemble and test our products, and one of our subcontractors wafer foundries, are located in Taiwan, Singapore and Malaysia. Our customers are currently primarily located in Japan and Korea. The Asia-Pacific region has experienced significant earthquakes and other natural disasters in the past and could be subject to additional seismic activities. Any earthquake or other natural disaster in these areas could significantly disrupt these manufacturing facilities production capabilities and could result in our experiencing a significant delay in delivery, or substantial shortage, of wafers in particular, and possibly in higher wafer prices, and our products in general. Our headquarters in California are also located near major earthquake fault lines. If there is a major earthquake or any other natural disaster in a region where one of our facilities is located, it could significantly disrupt our operations.
Changes in our tax rates could affect our future results.
Our future effective tax rates could be favorably or unfavorably affected by the absolute amount and future geographic distribution of our pre-tax income, our ability to successfully shift our operating activities to our foreign operations and the amount and timing of inter-company payments from our foreign operations subject to U.S. income taxes related to the transfer of certain rights and functions.
Risks Related to Our Common Stock
Our stock price has been and may continue to be volatile, and you may not be able to resell shares of our common stock at or above the price you paid, or at all.
The market price of our common stock has fluctuated substantially since our initial public offering and is likely to continue to be highly volatile and subject to wide fluctuations. Fluctuations have occurred and may continue to occur in response to various factors, many of which we cannot control, including:
The closing sale price of our common stock on the Nasdaq Global Market for the period of January 1, 2006 to March 31, 2007 ranged from a low of $7.35 to a high of $24.55.
In addition, the market prices of securities of semiconductor and other technology companies have been volatile, particularly companies, like ours, with low trading volumes. This volatility has significantly affected the market prices of securities of many technology companies for reasons frequently unrelated to the operating performance of the specific companies. Accordingly, you may not be able to resell your shares of common stock at or above the price you paid.
The pending class action litigation could cause us to incur substantial costs and divert our managements attention and resources.
In November 2006, three putative class action lawsuits were filed in the United States District Court for the Southern District of New York against us, our directors, an executive officer and a former executive officer. The lawsuits were consolidated and an amended complaint was filed on April 24, 2007. The lawsuit alleges certain material misrepresentations and omissions by us in connection with our initial public offering in September 2005 and the follow-on offering in March 2006 concerning our business and prospects. The lawsuits seek unspecified damages. We cannot predict the likely outcome of these lawsuits, and an adverse result could have a material effect on our financial statements.
If we are not successful in our defense of the lawsuits, we could be forced to make significant payments to class members and their lawyers, and such payments could have a material adverse effect on our business, financial condition and results of operations, if not covered by our insurance carriers. Even if such claims are not successful, the litigation could result in substantial expenses and the diversion of managements attention, which could have an adverse effect on our business.
If securities or industry analysts do not continue to publish research or reports about our business, or if they issue an adverse opinion regarding our stock, our stock price and trading volume could decline.
The trading market for our common stock is influenced by the research and reports that industry or securities analysts publish about us or our business. If one or more of the analysts who cover us issue an adverse opinion regarding our stock, our stock price would likely decline. If one or more of these analysts cease coverage of our company or fail to regularly publish reports on us, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline.
Substantial future sales of our common stock in the public market could cause our stock price to fall.
As of April 23, 2007, we had approximately 28,363,896 million shares of common stock outstanding. Of these shares, 6.4 million were sold in our initial public offering in September 2005 and an additional 2.5 million were sold in a follow-on public offering in March 2006. All of these shares are freely tradable under federal and state securities laws without further registration under the Securities Act, except that any shares held by our affiliates (as that term is defined under Rule 144 of the Securities Act) may be sold only in compliance with the limitations under Rule 144. The remaining outstanding shares are restricted securities and generally are available for sale in the public market at various times upon qualification for exemption pursuant to Rules 144 and/or 701 of the Securities Act.
In the future, we are also likely to issue additional shares to our employees, directors or consultants, as well as in connection with corporate alliances or acquisitions, and in follow-on offerings to raise additional capital. Due to these factors, sales of a substantial number of shares of our common stock in the public market could occur at any time. These sales could reduce the market price of our common stock.
Delaware law and our corporate charter and bylaws contain anti-takeover provisions that could delay or discourage takeover attempts that stockholders may consider favorable.
Provisions in our certificate of incorporation may have the effect of delaying or preventing a change of control or changes in our management. These provisions include the following:
We are also subject to provisions of the Delaware General Corporation Law that, in general, prohibit any business combination with a beneficial owner of 15% or more of our common stock for three years after the point in time that such stockholder acquired shares constituting 15% or more of our shares, unless the holders acquisition of our stock was approved in advance by our board of directors.
An Exhibit Index has been attached as part of this Quarterly Report on Form 10-Q and is incorporated herein 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.
IKANOS COMMUNICATIONS, INC.
EXHIBITS TO FORM 10-Q QUARTERLY REPORT
For the Quarter Ended April 1, 2007