UTStarcom 10-K 2005
Documents found in this filing:
WASHINGTON, D. C. 20549
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 2004
¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number: 000-29661
(Exact name of registrant as specified in its charter)
(Registrants telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common stock, $0.00125 par value
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes x No o
The aggregate market value of the voting stock held by non-affiliates of the registrant as of the last business day of the registrants most recently completed second fiscal quarter was approximately $2,777,913,977 based upon the closing price of $30.25 reported for such date on The Nasdaq National Market. For purposes of this disclosure, shares of Common Stock held by persons who hold more than 10% of the outstanding shares of Common Stock and shares held by officers and directors of the registrant, have been excluded in that such persons may be deemed to be affiliates. This determination is not necessarily conclusive for other purposes.
As of March 31, 2005 the registrant had 114,841,976 outstanding shares of Common Stock.
Portions of the Proxy Statement for the Annual Meeting of Shareholders to be held on May 13, 2005 are incorporated herein by reference in Part III.
TABLE OF CONTENTS
UTStarcom (which may be referred to as the Company, we, us, or our) means UTStarcom, Inc. or UTStarcom, Inc. and its subsidiaries, as the context requires. The name UTStarcom is a registered trademark of UTStarcom, Inc.
In this Annual Report on Form 10-K, references to and statements regarding China refer to mainland China, references to U.S. dollars or $ are to United States Dollars, and references to Renminbi are to Renminbi, the legal currency of China.
Unless specifically stated, information in this Annual Report on Form 10-K assumes an exchange rate of 8.2775 Renminbi for one U.S. dollar, the exchange rate in effect as of December 31, 2004.
Throughout this Annual Report on Form 10-K we incorporate by reference certain information from other documents filed with the Securities and Exchange Commission (the SEC). Please refer to such information at www.sec.gov.
UTStarcoms public filings, including our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K, and any amendments to such reports, are available free of charge at our website, www.utstar.com. The information contained on our website is not being incorporated herein.
This Annual Report on Form 10-K contains forward-looking statements. Beginning on page 60, we discuss some of the risk factors that could cause actual our results to differ materially from those provided in the forward-looking statements.
We design, manufacture and sell telecommunications equipment and provide services associated with their installation, operation, and maintenance. Our products are deployed and installed primarily by telecommunications service providers. We sell an extensive range of products that are designed to enable voice, data and video services for our customers around the world. While historically, the vast majority of our sales have been to service providers in China, the Company has expanded its focus to build a global presence and currently sells its products to several other emerging and established growth markets, which include North America, Japan, India, Central and Latin America, Europe, the Middle East and Africa and southeastern and northern Asia.
UTStarcom was incorporated in Delaware in 1991. Our headquarters are based in Alameda, California, with research and design operations in the United States, Canada, China, India and Korea. Our primary mailing address is 1275 Harbor Bay Parkway, Alameda, California, 94502. We can be reached by telephone at (510) 864-8800, and our website address is www.utstar.com. All of our SEC filings can be found under the Investor Relations section of our website, and are available free of charge.
Our objective is to be a leading global provider of end-to-end Internet Protocol (IP)-based communications products and services. We seek to differentiate ourselves by developing innovative products that are designed to allow for additional revenue-generating services; integrate multiple functionalities; reduce network complexity, and enable a migration to a new generation of network technologies. Our technology and products are designed to make carrier deployments, maintenance and upgrades both economical and efficient, allowing operators to earn a high return on their investment.
Our strategy is built upon the following key concepts:
· driving product innovation to offer our customers an increased number of features and enhanced functionality;
· reducing overall operational and deployment costs of our customers networks, enabling them to meet the demands of a greater number of consumers by expanding their addressable markets; and
· providing custom tailored products and services to suit customers unique needs.
Our key strengths in the implementation of our strategy include the following factors:
A History of Technology Innovation
Since our inception, we have focused on the development of new innovative and disruptive communications technologies and products that are designed to differentiate us from our peers and create new market opportunities for our carrier customers. For example, we helped create a new market for wireless telephony in China based upon the development of our Personal Access Service and IP-based Personal Access Service (collectively PAS) solutions offering a low power, low cost alternative to prevailing mobile telephony. We believe PAS became successful with traditional fixed wireline carriers because it enabled them to leverage their fixed-line networks to offer their consumers wireless mobile services. This service, while limited in range to each specific city or region in which it was offered, afforded a low-cost alternative to more expensive traditional cellular services. The rapid rate of adoption for PAS positioned us as one of the leading wireless infrastructure and handset providers in China and to date over 35 million subscribers are using services supported by our technology. In addition, we believe it has provided a springboard for our development of other similarly disruptive technologies such as IP-based wireless, broadband and switching.
A Significant Customer Base and Leverage in China
Over the course of several years, we have built an extensive administrative, research and development, manufacturing, and sales and support infrastructure in China. We believe this infrastructure allows us to quickly identify our customers needs and to focus our engineering, product development and sales and marketing efforts to address those needs. In addition, the low-cost research and development and manufacturing capabilities in China allow us to be competitive on a cost and pricing basis for our products. Finally, by virtue of its large population and low teledensity, or the number of telephones per person in a region, and our significant customer deployments, the China market provides a highly conducive platform for us to deploy our most advanced technology in substantial volume. We believe that our infrastructure, cost efficiencies and research and development advances in China provide a significant platform and strategic advantage for our global success.
A Commitment to Carrier Value
We believe we have been able to develop strong relationships with our customers by delivering end-to-end solutions that are designed to enable carriers to capitalize on economies of scale and to easily customize and extend their service portfolios. To ensure our products deliver the most value, the UTStarcom product architecture is designed to allow carriers to offer a full range of services over multiple access networks, whether wireless or wireline. Our wireless products support a broad range of frequencies for cost-effective deployment worldwide, and our broadband products support both copper- and fiber-based access. To help ensure we offer high value solutions at a low cost, we leverage our extensive design, development, and manufacturing facilities in China.
A Focused Global Market Diversification Initiative
In 2004, we continued to focus on the diversification of our global customer base and market penetration. Our diversification strategy involves a combination of internal efforts and strategic acquisitions. In order to better address new markets outside of China we introduced a number of new products and completed a number of acquisitions, including the acquisition of the selected assets of the Audiovox Communications Corporation (ACC), the wireless handset division of Audiovox Corporation in November of 2004. We believe these efforts have significantly enhanced our ability to gain access to the largest and most stable operators worldwide. We intend to seek additional acquisitions and use partnerships to solidify our market position and expand our technology portfolio and sales channels in new markets.
In addition to the large telecommunications service providers in well-established markets, we also target carriers in emerging markets, such as Softbank Group, Vonage in the United States and Reliance Infocomm Ltd. in India, which have focused their network deployments on IP-based voice, data and video services.
We believe emerging markets beyond China present significant opportunities for growth. We believe that many developing regions see a correlation between increased teledensity and improved economic growth, recognizing the need to invest in a telecommunications infrastructure in order to compete globally and overcome economic disparities. Our strategy is to develop products and design services specifically tailored to the needs and level of affordability of these emerging-market service providers and their customers. In addition, we recognize that to be successful in these emerging markets, it is often important to commit to establishing a local presence in areas such as research and development, manufacturing, sales and support. We continue to explore major growth potential in global markets outside of China and believe that many of these markets are ideal candidates for our products and services as well as operations.
TECHNOLOGY AND PRODUCTS
Our technology focus centers on an IP-based softswitch core network architecture that creates a single platform for delivering multiple services to the end user of the telecommunications network. Softswitch is a technological approach to telephony networking where all the service intelligence for the delivery of telephone services resides in easily adaptable IP-based software. A Softswitch is designed to reduce the cost of long distance and local exchange switching and to create new differentiated voice, data and video services. In contrast, legacy networks are based on the delivery of a single service, such as voice or data. If a service provider operating a traditional network wanted to offer multiple services, it would have to build, run and maintain a separate network for each service, including separate billing, network management and support functionalities, adding significant costs to the carriers operating model. An IP-based core network is designed so that all services can be converged onto one platform with one billing, network management and support function for all services. In addition, because it is largely software-based, an IP network is by design more cost-effective to run and maintain than traditional infrastructure technologies. All of our products are interoperable and can be integrated into a single IP-based network. We intend to continue to support our IP-based wireless and broadband services and enhance their functionality for deployment in all global markets. We also intend to continue our research and development efforts on future IP-based access services.
Our IP-based, multi-service softswitch architecture (mSwitch), is a diverse assembly of software and hardware-based networking elements designed to replace traditional central office telephone switches. Our IP-based softswitch platform enables the delivery of a common set of value-added end-to-end services over a variety of access networks, whether wireless or wireline. Our architecture is designed to support a comprehensive set of services, including broadband and narrowband access, call control of telephone and data communications and delivery of next generation features not offered by the traditional fixed line switching infrastructure, including IP-based television (IPTV).
Our mSwitch platform enables a next-generation core network for all of our wireless, wireline and broadband networks with the exception of CDMA2000, which is supported by its own Softswitch that we expect to integrate into our existing platform in the future. The mSwitch has been extensively deployed in our Personal Access Systems networks in various networks around the globe. In addition, the mSwitch provides the softswitch functionality for various other UTStarcom solutions including, but not limited to, Voice over Broadband (VoBB), Time Division-Code Division Multiple Access (TD-CDMA), Wideband Code Division Multiple Access (WCDMA) and Television over IP (TVoIP).
Our mSwitch platform is designed to reliably transport and route packets as well as to handle signaling, network control, and information management. The architecture includes operations support systems for associated billing, provisioning, and service management.
Key Product Families
Our key product families fall into three major categories:
· Wireless Infrastructure: technologies and products that enable end users, or subscribers, to send and receive voice and data communication in either a fixed or mobile environment by using wireless devices;
· Broadband Infrastructure: technologies and products that enable end users to access high-speed, cost effective fixed data and voice and media communication; and
· Handsets and Customer Premise Equipment: consumer devices that allow customers to access wireless and broadband services.
Our products within each of these categories include multiple hardware and software subsystems that can be offered in various combinations to suit individual carrier needs. Our system technologies and products are based on widely adopted global communications standards and are designed to allow service providers to quickly and cost-efficiently integrate our systems into their existing networks and deploy our systems in new broadband, IP and wireless network rollouts. Our system technologies are also designed to allow timely and cost efficient transition to future next-generation network technologies, enabling our service provider customers to protect their initial infrastructure investments. See Item 7, Managements Discussion and Analysis of Financial Condition and Results of OperationsNet Sales, for a discussion of our net sales by product lines.
Wireless networking is one of our core technologies that refers to communications networks that enable end users to send and receive voice and data while mobile by using wireless devices such as cellular telephones, personal computers, personal digital assistants and other wireless communications devices. Wireless networks require the use of customized equipment that enables an end user or subscriber to be connected and identified when not in a fixed location within a network. We offer a broad range of wireless infrastructure products and services, from service platforms to core infrastructure systems for large carriers that can support millions of subscribers.
We provide wireless networking infrastructure products based on a variety of leading global mobile interface standards, including: Personal Handyphone System (PHS), Code Division Multiple Access (CDMA), WCDMA, and TD-CDMA. All of our wireless products are designed to offer a full suite of integrated, customizable, voice and value-added services, including short-message services, web browsing, e-mail, voice mail, and Internet access.
PHS Wireless Mobile Phone Systems
Personal Access System (PAS)/ IP-based Personal Access System (iPAS)
Our globally deployed PAS, a family of wireless core infrastructure equipment, based on the Personal Handyphone System (PHS) standards developed by The Association of Radio Industries and Telecommunication Technology Committee in Japan, is designed to help our customers create new revenue opportunities with high quality wireless voice and data services.
Our PAS wireless access system employs micro-cellular radio technology that is designed to enable service providers to offer subscribers both mobile and fixed access to telephone services. In China, the PAS architecture is designed to allow service providers to transition their network capabilities from wireline to wireless, allowing them to offer both mobile wireless voice and data services within a city or community. Using our products, service providers can offer new wireless services, including citywide mobility, e-mail, mobile Internet access, and short message services.
We designed our PAS equipment to meet the needs of subscribers that do not require all of the features offered by traditional cellular technology, but want more than the features offered by standard fixed-line technology, including regional mobility, a more cost-effective tariff plan, and access to value-added data services. When compared to other traditional macro-cellular wireless systems, PAS offers lower deployment costs, easier radio frequency planning, higher traffic capacity, better voice quality, faster data transmission speeds, lighter handsets with lower power requirements, and better support of advanced information services.
In comparison to traditional macro-cellular systems, PAS base stations are small and are normally installed on existing utility poles or buildings rather than on large towers. Mounting small transmitters this way greatly reduces the cost and complexity of installation as there is neither need for a major tower
construction project nor any significant tower lease fees. Additionally, mounting a small PAS base station close to its antenna and connecting it to the network using standard telephone wire is far simpler and more cost effective than the traditional cellular approach of installing a large transmitter on the ground and running heavy coaxial cables up a tower to the antennas. PAS base station installation takes a few hours, compared to the several days required to install, power, and commission a traditional wireless cell station. Because PAS uses dynamic frequency allocation, a process where each cell listens to all available radio channels before selecting one for each call, the overall radio planning and engineering for PAS is very simple. While adding cells to handle more calls in a traditional cellular network requires considerable frequency planning and balancing, adding cells to a PAS network is less difficult because PAS cells can automatically determine what channels to use. This capability, combined with the low cost per cell, allows a carrier to start with a very small system serving only hundreds of subscribers and grow that system to serve millions, simply by adding small cells.
CDMA, TD-CDMA, WCDMA and TD-SCDMA Wireless Mobile Systems
We have developed a suite of products and services for third-generation (3G) wireless networks that support the open 3G wireless standards CDMA, WCDMA, TD-CDMA and TD-SCDMA defined under 3GPP, the international standardization body, and the standards of TIA/EIA, the United States Standardization body.
MovingMedia 2000 Wireless Voice and Data Product (CDMA/CDMA 2000)
In the fall of 2004, we introduced our MovingMedia 2000 All-IP CDMA/CDMA 2000 infrastructure solution. The MovingMedia 2000 product line is the first IP-based infrastructure solution in the world for CDMA 2000. It provides for the communication of data and voice over IP and offers mobile operators savings on infrastructure and transmission costs. It also allows incumbent CDMA operators to transition smoothly and efficiently to an all-IP network and to offer new value-add services not provided by legacy CDMA networks. We believe these attributes make MovingMedia 2000 an ideal solution for both incumbent and greenfield CDMA operators.
Our CDMA/CDMA 2000 wireless infrastructure product family includes IP base stations, intelligent media gateways, signaling gateways, and packet data server nodes (PDSN).
Our MovingMedia 2000 solution employs an advanced next-generation network voice and data over IP architecture that distributes all of the components of a CDMA system throughout the network, rather than in one centralized location. With a distributed architecture, a wireless service provider can deploy various elements of the solution in different citiesNew York, Dallas, and San Francisco, for exampleand they would operate as one system transparently to the operator, reducing the size and cost of its infrastructure.
MovingMedia 2000 is designed to be compatible with all wireless equipment designed to internationally defined standards, giving service providers enormous flexibility when designing and developing their networks. In addition, our open, standards-based architecture is designed to provide the scalability and flexibility required by service providers for easy deployment of services and applications.
MovingMedia 6000 Wireless Data Product (TDCDMA)
In the fall of 2004, we introduced our MovingMedia 6000 wireless broadband data solution. The MovingMedia 6000 wireless broadband solution is based on the Universal Mobile Telecommunications System Time Division Duplexing (UMTS TDD) standard for 3G mobile networks, which utilizes TD-CDMA technology. We have an established relationship with IPWireless, Inc., which provides the core technology for our TD-CDMA portfolio. Our MovingMedia 6000 turns a range of low-cost licensed frequency bands1900-1920MHz, 2010-2025MHz, 2500-2700MHz, and 3400-3600MHzinto valuable
assets that we believe will provide a rapid return on operator investment. Mobile and wireless broadband service providers worldwide can deploy the solution today to offer high-value data services of up to 3Mbps per subscriber, enabling subscribers to access the network from home, work, or any other location. We anticipate that, in the near future, operators will be able to use our MovingMedia 6000 solution to offer wireless Voice over IP (VoIP) in addition to the high-mobility data services available today.
Our TD-CDMA wireless infrastructure product family includes base stations, radio network controllers, Gateway GPRS Support Nodes, which ensure a secure connection between the packet core network and the IP network, and Serving GPRS Support Nodes that provide session management, traffic processing and mobility management.
MovingMedia 8000 Wireless Voice and Data Product (WCDMA)
We expect to launch our MovingMedia 8000 WCDMA solution to the market in the second half of 2005. In November 2004, we successfully completed the Phase II field trials of our MovingMedia 8000 with China Netcom Corporation in China. These trials were conducted in conjunction with the Ministry of Information Industry in China.
TD-SCDMA Wireless Voice and Data Product
We are developing and testing a suite of products and services for 3G wireless networks that support the time division-synchronous code division multiple access standard, (TD-SCDMA) the emerging China-developed 3G standard. As a TD-SCDMA Forum council member, we have been working closely with Datang Telecom Technology on the development of certain elements for a TD-SCDMA product that would use the same core network as the MovingMedia 6000 and 8000 series.
Our broadband infrastructure products are designed to satisfy customer demand for high speed and cost effective data, voice and multimedia transport. Our wireline technology enables high-speed voice, video and data transmissions over broadband IP-based networks.
Broadband Access Solutions
Broadband Access Network Solutions reside on the network edge enabling the deployment of IP-based, high-speed Internet, voice, data and multimedia services over wireline networks. Digital subscriber line (DSL) technology allows high-speed data and content transfer while providing simultaneous telephone communications over the same fixed copper line. Our IP-based DSL Access Multiplexers (IP-DSLAMs) incorporate the latest DSL technologies combined with a range of form factors to enable high-speed access and deliver services to residential and commercial subscribers using broadband networks.
IP-Based Digital Subscriber Line Access Multiplexer (IP-DSLAM) (AN-2000)
Our AN-2000 platform represents a new generation of DSLAM products that are based on IP technology. We believe the AN-2000 platform is economical to deploy as it has been designed to eliminate the need for more expensive legacy infrastructure, which we believe will result in an accelerated return on investment. We have designed our AN-2000 platform to serve a variety of commercial and residential customer applications.
Our AN-2000 IP DSLAMs convert customer traffic from legacy infrastructure into IP at the edge of the network, simplifying the delivery of multiple, high-speed services such as VoIP and TVoIP, in addition to traditional broadband data services. An all-IP network also simplifies the process of video streaming,
incorporating technologies such as IP multicast and IP Quality of Service (QoS). To date, we have deployed more than five million IP DSLAM lines globally.
Multi-Service Access Node (iAN-8000)
Our iAN-8000 Multi-Service Access Node (iAN-8000) platform is an integrated broadband access platform that delivers a mix of broadband, traditional voice and data services, and media gateway functionality via copper, fiber, or wireless transmission. The iAN-8000 platform integrates the functionality of our AN-2000 IP DSLAM with a VoIP Media Gateway platform and a traditional digital loop carrier (DLC). By consolidating traditionally standalone access devices into one standards-based platform, the iAN-8000 provides operators the maximum amount of service flexibility and allows them to add services and applications efficiently, without incurring additional infrastructure expenses.
Service providers can deploy the iAN-8000 throughout their networks, which allows them to bring new VoIP and broadband applications to the widest possible service area. The iAN-8000 is designed to enable providers to offer multiple services from one platform, including traditional voice, VoIP, and high-speed data access using the latest DSL technologies. Because the platform incorporates a DLC, service providers can also deploy it in remote locations to extend their voice service reach beyond the area served by the central office. The media gateway function allows providers to aggregate VoIP calls from enterprise networks and transport them over one line to the central office.
Optical Multi-Service Transport and Access
Our optical products include scalable, cost-effective transport solutions based upon internationally defined optical transmission standards and access solutions based upon Gigabit Ethernet Passive Optical Networking (GEPON). They support transmission speeds ranging from 155 Megabits per second to 10 Gigabits per second that enable multi-speed integrated transport for both traditional voice and high-speed data and video services. The product platform supports various complex network topologies and includes a sophisticated multi-service management system. Our optical solutions are also designed to enable providers to easily transition from legacy products to next-generation networks.
Gigabit Ethernet Passive Optical Network (GEPON)Optical Access System
In June 2004, we introduced our BBS 1000 GEPON solution, which is designed to enable service providers to offer Fiber To The Premises (FTTP) broadband access to their subscribers at high speeds. Our GEPON platform is designed to provide high subscriber density and low cost of entry, making it a compelling alternative to legacy, last-mile access solutions.
Our BBS 1000 family includes both central office and customer premises equipment, providing the end-to-end optical last mile, with up to one Gigabit per second of bandwidth to residential and business customers. By integrating more functionality into the product, we have eliminated the need for carriers to deploy additional switching and routing equipment, making the BBS 1000 an optimal transport platform for support of bandwidth-intensive voice, data and video services.
NetRingOptical Transport System
We introduced our NetRing Multi-Service Transport Product (MSTP) optical product line in December 2003. Our NetRing products are designed to provide a broad range of functions for carriers to manage voice, data and video traffic. NetRing provides network management functions previously available only on multiple independent platforms. The NetRing family is designed to satisfy high-end, mid-range, and entry-level application needs in global carrier networks. Our NetRing 600 products provide voice and data services for multi-tenant unit buildings (MTUs), office buildings, and enterprise campus applications. Our mid-range NetRing 2500 products offer voice and data transport when more
bandwidth and greater capacity is required. Our high-end NetRing 10000 products provide service for regional transport applications, when maximum bandwidth and capacity is required. NetRing provides the availability and reliability of optical transport platforms that support full redundancy, multiple protection options, and in-service upgrades.
Television over IP System (TvoIP)
Our TVoIP system, mVision, is a complete end-to-end solution for delivering television and multimedia over carrier networks based on IP Protocol technology.
Our mVision family is a suite of carrier-class products and services that enable a service provider to deliver broadcast television and on-demand video services to residential and commercial premises over a switched network architecture. It is a carrier-class product that is designed to scale to support millions of users and hundreds of thousands of content hours. We believe mVision is the first solution designed to enable carriers to deploy very-large-scale streaming video content over a switched network architecture.
The mVision product family includes a streaming and storage server system (MediaSwitch); a device (Content Engine) for assimilating disparate video signals onto a unified distribution system; a media console set-top-box that resides in the end-user premise and provides Internet access, broadcast TV, video on demand and video conferencing services to the subscribers; and a network management system that enables non-stop, system-wide operation.
mVision is designed to allow carriers to offer new, revenue-generating television and multi-media services. The system is also designed to help providers capture customers of cable and satellite operators by offering a more comprehensive and interactive suite of services.
Handsets and Customer Premise Equipment (CPE)
We also design and sell a variety of handsets and CPE targeted at multiple customer segments for our wireless and broadband products. These handsets range from basic, low-cost units to high-functionality, higher-cost models that offer rich functionality and excellent value. Today we feature single, dual and multimode handsets with cameras, video recorders and players, high resolution color displays, multiple ring tones, bilingual short message service (SMS) and High Speed Internet access and email capability. We believe our strategy of designing handsets in-house, licensing, manufacturing, and direct-sourcing components gives us the flexibility to meet demand while offering the broadest line of handsets to our customers.
We currently offer more than 20 different PAS handset models from high-end, data-capable and feature-rich models to low-cost value models. According to a November 2004 report by the industry research firm GfK Ltd., we are the market leader for PAS handsets in China, which is the largest handset market in the world according to its Ministry of Information Industry. We shipped more than 14.6 million PAS handsets in 2004.
CDMA/GSM/WiFi and Multi-Mode Handsets
In 2004, we announced our entry into the CDMA, Global System for Mobile Communications (GSM) and Wireless Fidelity (WiFi) handset markets. We offer carriers a wide selection of price ranges and handset features by providing a broad range of models supporting each of these technologies.
Our product portfolio also includes dual-mode and multi-mode models and includes a comprehensive roadmap to include third generation WCDMA and TD-CDMA handsets in the future.
Our acquisition of selected assets of the Audiovox Communications Corporation (ACC) in November 2004 marked our entry into the North and South American handset markets. With existing carrier relationships of more than 20 years, ACC has been a leading wireless handset provider to the regions largest operators in the U.S., Canada, and South America, including Verizon Wireless, Verizon International, Sprint PCS, ALLTEL, US Cellular, Bell Mobility, Telus, BellSouth International, Telefonica, Virgin Mobile, MetroPCS, T-Mobile and others. By combining ACCs channel assets with our existing handset design and high-volume manufacturing capabilities, we believe we will be able to realize significant economies of scale from manufacturing, component sourcing, and development.
Customer Premise Equipment
Our CPE product line is comprised of various single and multi-port DSL modems, set-top boxes and VoIP Analog Telephone Adapters (ATAs) that allow residential and business customers to access voice, data and video services. Our products are designed to be rich in functionality, simple to set-up, easy to install and easy to manage. The diversity and flexibility in the product offering enables them to work with both our own infrastructure equipment as well as with other vendors infrastructure equipment. The comprehensive line of CPE products enables carriers to deliver end-to-end services across an array of access technologies including, ADSL2/2+, WiFi/802.11 and GEPON.
For the year ended December 31, 2003 and for the first three quarters of 2004, we managed our business as a single operating segment. For the fourth quarter 2004, we determined that our chief operating decision makers were evaluating performance, making operating decisions and allocating resources based on two operating segments: (i) China and (ii) International, consisting of all regions outside of China. In addition, a third operating segment, the Personal Communications Division was formed as a result of our acquisition of the selected assets of Audiovox Communication Corporation in November 2004.
The China segment was comprised of discrete administrative, research and development, manufacturing and sales and support infrastructure for China. International was comprised of operations for all other geographic areas including non-China Asia, Europe, the Middle East, Africa and North and South America. The Personal Communications Division focused on the North and South American handset markets.
For additional information on our reportable segments as of December 31, 2004 see Item 7Managements Discussion and Analysis of Financial Condition and Results of OperationsSegment Disclosures and Note 2 to the Companys consolidated financial statements for the year ended December 31, 2004.
Effective in the first quarter of 2005, we realigned our business into four units, namely Broadband Infrastructure, Wireless Infrastructure, Terminal Products (which will be reported as Handsets and our Personal Communication Division), and Global Service Solutions. Each unit will represent its own reporting segment, with the exception of Terminal Products, which will consist of two reporting segments.
MARKETS AND CUSTOMERS
Our products and services are being deployed and implemented in regions throughout the world in markets including China, Japan, India, Central and Latin America, Europe, Middle East and Africa, North America, and southeastern and northern Asia. China continues to be our largest market, representing
approximately 79% of our overall revenue for the year ended December 31, 2004, 86% for the year ended December 31, 2003 and 84% for the year ended December 31, 2002. However our focus on geographic diversification and extensive work in new technology innovation is beginning to change the percentage of revenue attributed to various regions globally. Worldwide adoption of our technology and key customer wins in Europe and Africa, North America, Japan, India and the Central and Latin American regions have resulted in a shift in revenue with international (i.e., non-China regions) contributing 53% of total revenues for the fourth quarter and 21% of total revenues for the year ended December 31, 2004. Total revenue attributed to the United States totaled approximately 13%, 2%, and less than 1% of total revenues for the years ended December 31, 2004, 2003, and 2002, respectively.
Our customers, telecommunications service providers, enable delivery of wireless and broadband access services including data, voice, and/or video communication services to their subscribers. They include but are not limited to, local, regional, national and international telecommunications carriers, including broadband, cable, Internet, and wireline and wireless providers. Telecommunications service providers typically require extensive proposal review, product certification, test and evaluation as well as network design, and, in most cases, are associated with long sales cycles. Our service provider customers networking requirements are influenced by numerous variables, including their size, the number and types of subscribers that they serve, the relative teledensity of the served geography and their subscriber demand for wireless and wireline communications and access services in the served geography. In 2004, the Guangdong and Jiangsu provinces accounted for 12% and 10% of our net sales, respectively. In 2003, the Hei Long Jiang province accounted for 11% of net sales; and in 2002, sales to the Zhejiang province accounted for 18% and sales to Softbank BB Corporation, an affiliate of SOFTBANK America Inc., a related party, accounted for 13% of net sales.
Global Sales and Service
Our worldwide sales organization consists of managers, sales representatives, network consultants and technical support personnel. We have field sales offices in several locations including China, Japan, India, the Central and Latin American region, the North American, European, Middle Eastern and African regions, and Southeast and North Asia regions. The majority of our products and services are sold and serviced by our direct sales and support staff.
In addition to our product offerings, we provide a broad range of service offerings, including technical support services. Our service offerings complement our products with a range of consulting, technical, project, quality and maintenance support-level services including 24-hour support through technical assistance centers. Technical support services are designed to help ensure that our products operate efficiently, remain highly available, and benefit from the most up-to-date system software. These services enable customers to protect their network investments and minimize downtime for systems running mission-critical applications.
China is currently our largest market and we believe that it will continue to be an important market for our current and future technologies and product development for the foreseeable future. To support this large and growing market, we have sales offices, manufacturing facilities and research and development centers throughout China that enable us to react and respond to our customers needs in an expeditious manner.
We believe that China continues to be one of the fastest-growing, largest communications markets in the world, and the Chinese government has committed to developing a powerful communications
infrastructure in order to support demand for communications services in support of economic growth in the region. According to Chinas State Statistics Bureau, Chinas gross domestic product (GDP) grew 9.5% in 2004, and the GDP per capita surpassed $1,265 in 2004. The bureau also estimates that Chinas GDP will grow by approximately 8.1% through 2006. We believe that China will continue to focus on its telecommunications infrastructure for the foreseeable future. Please refer to the table below for information, provided by Chinas Ministry of Information Industry (the MII), regarding the increasing telecommunications spending in China:
Despite the increased teledensity rate of Chinas fixed-line and cellular telephony to 25% and 26%, respectively, in 2004, the teledensity remains relatively low in comparison to that of developed countries. In contrast, fixed-line teledensity rates for the United Kingdom, France, Japan and the United States were 59%, 57%, 56%, and 62% respectively, according to a report published by the International Telecommunication Union in May 2004. We believe that Chinas low teledensity will continue to drive the growth in its telecommunications market.
Although voice services predominantly drive Chinas communications market growth, the increasing demand for broadband data and multi-media services also presents a growing opportunity in China. According to data provided by the MII, Internet users in China reached 94.0 million by the end of 2004, an increase of 18% from 2003. In order to support this growth in data traffic, service providers in China must continue to expand their networks. In 2004, Chinas broadband users increased from 11.9 million at the beginning of the year to approximately 23.9 million at the close of 2004.
The following chart presents relevant historical and estimated data related to the development of Chinas telecommunications, based on information provided by the MII:
We have continued to offer our products in growing communications markets outside of mainland China (our International Sales), leveraging global sales operations in the Southeast and North Asia region, the Central and Latin American region, the European, Middle Eastern and African region, and the North American region. We continue to increase our penetration of these markets in several ways:
· through direct sales offices located in key market regions;
· by licensing our technology to local manufacturers where import taxation is favorable;
· by developing local sales agency and distributor relationships within specific market regions; and
· by establishing sales relationships with original equipment manufacturers.
Our International Sales division has continued to aggressively build regional in-country sales offices and local direct sales staff in order to provide support for our expanding global operations.
With the completion of the acquisition of ACC in November 2004, North America became our second largest market in sales for 2004. Sales in North America are derived primarily from the CDMA handset product portfolio but also include both our broadband and wireless infrastructure products. We expect the North American market will continue to be our second largest market going forward.
We supply handsets and infrastructure solutions to some of the leading wireless carriers in North America including Verizon, Sprint, Cingular, T-Mobile, Bell Mobility and Metro PCS amongst others. In 2004, we also gained new customers amongst the emerging North American providers such as Vonage whose service is designed to enable anyone to make and receive phone callsworldwidewith a touch-tone telephone using a high-speed Internet connection.
Japan was our third largest market in 2004 and also represents our largest market for broadband products. One of our key customers in Japan is Softbank Group (SBB), which is a related party to UTStarcom. SBB is a parent company to several of our key service provider customers in Japan, including Yahoo! BB and Japan Telecom. According to the Japan Ministry of Public Management, Yahoo! BB is the leading provider of broadband service in Japan with over 4.5 million IP-based ADSL lines as of December 31, 2004, representing over 35% of the total market in Japan. Yahoo! BB continues to expand and deploy our AN-2000 IP-DSLAM and iAN-8000 MSAN and mSwitch equipment in support of their Voice over Broadband and 8, 12, 26, 45 and 50 Mbps ADSL services.
In the fall of 2004, Yahoo! BB also launched its PON, or Passive Optical Network, fiber-based Hikari Service, which will enable the delivery of high-speed broadband voice, data and multi-media services over a single optical connection to the customer. We are providing both the network infrastructure and customer premise elements to support this GEPON service.
SBB Acquired Japan Telecom, LTD in July 2004, and has deployed our iAN-8000 Multi-service access node which is designed to enable Japan Telecom to offer the combination of the capabilities of a DLC, a next-generation VoIP Media Gateway and an IP DSLAM in a single multi-service access platform.
We continue to see growth opportunities in India for both our broadband and wireless products given its large population and low teledensity. According to the Telecom Regulatory Authority of India
(TRAI) as of December 31, 2004, India had a population of 1.07 billion and a low fixed line teledensity of approximately 4.4%.
We currently offer our AN-2000 Multi-Service Broadband Access, NetRing Optical Solutions and CDMA Wireless Access products and services in India. With over one million access lines deployed today, we anticipate that we will continue to implement and deploy our products and conduct trials with several operators, including Reliance Infocomm Ltd. and Bharat Sanchar Nigam Ltd.
We continue to focus on both customer development as well as the development of our research and development initiatives in India. We have research and development at our facilities in the New Delhi area, Guargan and Bangalore. We have also established local manufacturing of our AN-2000 technology in association with Himachal Futuristic Communications Limited.
Central and Latin America Region
We have established sales and service operations in support of the Central and Latin American region, and anticipate growth in this market in fiscal year 2005.
Our target markets in Central and Latin America include, but are not limited to, countries like Brazil, Mexico, Panama, Haiti, Honduras and Guatemala. We have shipped our AN-2000 Multi-Service Broadband Access and PAS wireless equipment to service providers and continue to perform extensive testing and certification for telecommunications carriers within these regions. In 2004, key customers in Central and Latin America included Telefonos de Mexico, S.A. in Mexico, Telefonica del Sur in Chile and Multifon in Honduras.
European, Middle Eastern and African Region
We continued to expand our presence in the European, Middle Eastern and African (EMEA) region in 2004, with both new customer wins and additional sales and service operations.
We offer our AN-2000, PAS, MovingMedia 2000 and MovingMedia 6000 products and services in each of these markets. We expect to continue to supply our products and conduct trials within this region in 2005.
Specifically, we have seen increased demand for our wireless data products as a result of increased consumer demand for faster and more comprehensive data services and proliferation of camera phones, advanced wireless handheld devices and other high data content products.
In 2004, new customers in EMEA included Versatel Nederland BV in the Netherlands, Tiscali S.P.A. in Italy and UK Broadband, a subsidiary of PCCW.
Southeast and North Asia Region
Southeast and North Asia is another region with a large population base and relatively low teledensity rate. We have established business operations as well as a sales and service presence to support various countries in this region including, but not limited to, Vietnam, Thailand and Taiwan. At the close of fiscal year 2004, our customers had approximately one million PAS subscribers in Vietnam and Taiwan utilizing our network infrastructure.
Key customers in the region include FITEL and Chunghwa Telecom Co. Ltd. in Taiwan, and Vietnam Post and Telecommunications Corporation in Vietnam.
We compete in the telecommunications equipment market, providing products and services for transporting data, voice and video traffic across traditional and IP based networks.
As we expand into new markets, we will face competition from both existing and new competitors, including existing companies with strong technological, marketing and sales positions in those markets.
We believe our competitive strengths are derived from three main tenets: our early entry and commitment to the development of all IP-based communications technologies; our experience in high-volume, low-cost manufacturing and large-scale technology deployments in China; and our commitment to developing comprehensive, end-to-end solutions for our carrier customers that allow them to capitalize on economies of scale and differentiate their service offerings.
By contrast, our competitive disadvantages include our relatively smaller size in terms of revenues and number of employees as compared to many of our competitors, our lack of history and experience in selling to many of the largest carriers in well-established markets and our lack of consumer visibility and brand recognition in markets outside of Asia.
Our principal competitors within our current product categories include the following:
PAS systems: Lucent Technologies, Inc. and Zhongxing Telecommunications Equipment Corporation.
CDMA and WCDMA Systems: Alcatel; LM Ericsson Telephone Company; Huawei Technology Co., Ltd.; Lucent Technologies, Inc.; Motorola, Inc.; Nokia Corporation; Nortel Networks Corporation; Samsung Electronics Co. Ltd.; Siemens AG and Zhongxing Telecommunications Equipment Corporation.
TD-CDMA Systems: InterDigital Communications Corp.
mSwitch: Alcatel; Cisco Systems, Inc.; Clarent Corporation; LM Ericsson Telephone Co.; Huawei Technology Co., Ltd.; Lucent Technologies, Inc.; Motorola, Inc.; Nokia Corporation; Nortel Networks Corporation; Nuera Communications, Inc.; Siemens AG; Sonus Networks, Inc. and Zhongxing Telecommunications Equipment Corporation.
iAN-8000/MSAN and AN-2000/IP DSLAM: Alcatel; Datang Telecom Technology Co. Ltd.; Huawei Technology Co., Ltd.; Lucent Technologies, Inc.; Tellabs, Inc. and Zhongxing Telecommunications Equipment Corporation.
HANDSETS AND CUSTOMER PREMISE EQUIPMENT
PAS handsets: China PTIC Information Industry Corporation; Zhongxing Telecommunications Equipment Corporation; Lucent Technologies, Inc.; Amoi Electronics Company, Ltd.; Huawei Technologies Co, Ltd; Kyocera Corporation; Nippon Electric Corporation and Sanyo Electric Company, Ltd.
CDMA handsets: LG Electronics, Inc.; Motorola, Inc.; Nokia Corporation; Samsung Electronics Co. Ltd. and Sanyo Electric Company, Ltd.
As of December 31, 2004, we employed a total of approximately 8,200 full-time employees. We also from time to time employ part-time employees and hire contractors. Of the total number of full-time employees at December 31, 2004, approximately 3,600 were in research and development, approximately 700 were in manufacturing, approximately 3,400 were in marketing, sales and support, and approximately 500 were in administration. We had approximately 6,500 employees located in China, approximately 1,100 employees located in the United States, and approximately 600 employees in other countries. Our employees are not represented by any collective bargaining agreement, and we have never experienced a work stoppage. We believe that we have good employee relations.
We pursue a direct sales and marketing strategy in China, targeting sales to telecommunication operators and equipment distributors with closely associated customers. We maintain sales and customer support sites in all major cities in China. Our customer service operation in Hangzhou, China, serves as both a technical resource and liaison to our product development organization. In China, customer service technicians are distributed in the regional sales and customer support sites to provide a local presence.
Our sales efforts in markets outside of China combine direct sales, original equipment manufacturers, distributors, resellers, agents and licensees. We maintain 48 sales and customer support offices in 29 countries covering the U.S., Canada, Latin America, the Caribbean, Europe, the Middle East, Africa, India, and the Asia-Pacific region.
To capture business opportunities in the growing telecommunication service market and further improve our customer service on a global basis, we plan to combine our China and International service operation teams to leverage the strengths from both teams. The new service organization is structured to provide traditional services such as Build, Operate, Turnover and System Maintenance, as well as to work closely with customers and research and development to develop and deliver value-added customized service solutions.
We manufacture or engage in the final assembly and testing of our mSwitch, PAS systems, handsets and AN-2000 products at our manufacturing facility in the Chinese province of Zhejiang. The manufacturing operations consist of circuit board assembly, final system assembly, software installation and testing. We assemble circuit boards primarily using surface mount technology. Assembled boards are individually tested prior to final assembly and tested again at the system level prior to system shipment. We use internally developed functional and parametric tests for quality management and process control and have developed an internal system to track quality statistics at a serial number level.
Our manufacturing facility is ISO 9001-2000 certified. ISO 9001-2000 certification requires that the certified entity establish, maintain and follow an auditable quality process including documentation requirements, development, training, testing and continuous improvement which is periodically audited by an independent outside auditor.
We contract with third parties in China to undertake high volume assembly and manufacturing of our handsets and some high volume single boards for AN-2000, PAS and mSwitch system and we conduct final assembly, testing and packaging at our own facilities. In addition, we generally use third parties for high volume assembly of circuit boards.
We have also contracted with various suppliers to provide PAS wireless base station components for distribution under the UTStarcom label. In China, we undertake final assembly and test our wireless infrastructure products at our own facilities and have begun to manufacture some of these products ourselves.
We believe that continued and timely development and introduction of new and enhanced products are essential if we are to maintain our competitive position. While we use competitive analyses and technology trends as factors in our product development plans, the primary input for new products and product enhancements comes from soliciting and analyzing information about service providers needs. Our relationships with Chinas MII and Telecommunications Administration and individual telecommunications bureaus and our full-service post-sale customer support in China provide our research and development organization with insight into trends and developments in the marketplace. The insight provided from these relationships allows us to develop market-driven products such as PAS, mSwitch and IP-DSLAM. We maintain a strong relationship between our research centers in the U.S. and China. We rotate engineers between the U.S. and China to further integrate our research and development operations. We have been able to cost-effectively hire highly skilled technical employees from a large pool of qualified candidates in China. We also have a development center in India to take advantage of the talent pool available there, and to support our operations in India. Our research and development centers are ISO 9001-2000 certified.
In the past we have made, and expect to continue to make, significant investments in research and development. Our research and development expenditures totaled $219.0 million in 2004, $155.3 million in 2003, and $86.2 million in 2002.
Our ability to compete is dependent in part on our proprietary technology. We rely on a combination of patent, copyright, trademark and trade secret laws, as well as confidentiality agreements and licensing arrangements, to establish and protect our proprietary rights. We hold U.S. and foreign patents for our existing products expiring between 2014 and 2023, and have patents pending in both the U.S. and in foreign countries. In addition, we have, from time to time, chosen to abandon previously filed applications. Patents may not be issued and any patents issued may not cover the scope of the claims sought in the applications. Additionally, issued patents may be found to be invalid or unenforceable in the courts of those countries where we hold or have filed for patents. Our U.S. patents do not afford any intellectual property protection in China or other international jurisdictions. Additionally, patents that we hold in countries other than the United States do not afford any intellectual property protection in the United States. Please refer to the discussion of risks associated with our intellectual property in the section entitled Managements Discussion and Analysis of Financial Statement Results of OperationsFactors Affecting Future Operating Results.
See Item 7. Managements Discussion and Analysis of Financial Condition and Results of OperationsResults of Operations for a discussion of the impact of seasonality on our business.
We lease properties in the United States, China and globally totaling approximately 1,372,000 square feet. These properties are used for corporate headquarters, sales and support offices, research and development and manufacturing purposes.
In North America, we have approximately 492,000 square feet of leased property used for the following purposes: approximately 63,000 square feet for our corporate headquarters in Alameda, 210,000 square feet for research and development, 88,000 square feet for sales and services, and 131,000 square feet for our new Personal Communications Division including 5,000 square feet of retail space.
We lease approximately 730,000 square feet of property in China. Approximately 85,000 square feet are for corporate offices in Beijing, approximately 200,000 square feet are for sales and support offices, approximately 230,000 square feet are used for manufacturing, and approximately 215,000 square feet are used for research and development.
In 2001, we purchased the rights to use 49 acres of land located in Zhejiang Science and Technology Industry Garden of Hangzhou Hi-tech Industry Development Zone. As of December 31, 2004, we have substantially completed the construction of a 1,150,000 square foot manufacturing facility at this location which was put in use in October 2004. The facility houses our manufacturing operations and administrative offices. We anticipate the completion of the remaining construction by the second quarter 2005.
We believe our existing facilities and equipment are well maintained and in good operating condition, and we believe our facilities are sufficient to meet our needs for the foreseeable future.
Securities Class Action Litigation
On October 26, 2004, an alleged former shareholder of the Company filed a class action complaint in the United States District Court for the District of Idaho against us and two of our directors and/or officers, purporting to assert claims under the federal securities laws on behalf of a class of purchasers of the Companys publicly traded securities in the period from April 16, 2003 through September 20, 2004. Among other things, the complaint refers to our disclosures as to significant control deficiencies related to revenue recognition and as to the deferral of revenue recognition on a particular transaction and the related lowering of our financial guidance. The complaint further alleges that the defendants previously made positive statements regarding our business and financial performance that were false and misleading because such statements, among other things, failed to disclose problems with our internal controls and revenue recognition policies and procedures and failed to disclose that the revenue on the transaction at issue would need to be deferred, which allegedly caused the price of our publicly traded securities to be artificially inflated. The complaint claims that the plaintiff and other class members were damaged as a result thereof, and seeks monetary recovery in their favor in an unspecified amount.
Four similar class action complaints were later filed in the United States District Court for the Northern District of California against us and several of our directors and officers. In both the Idaho court and the California court, competing motions were filed for appointment of lead plaintiff and approval of lead plaintiffs counsel, and in the California court various motions for consolidation of actions were filed as well. On March 15 and 16, 2005, the California court entered orders consolidating the cases pending in that court, appointing the lead plaintiff and approving the lead plaintiffs counsel. Pursuant to those orders, a consolidated complaint is to be filed in that court within 60 days thereafter. On April 6, 2005, the Idaho court entered an order appointing the lead plaintiff and approving the lead plaintiffs counsel.
This class action litigation is in its preliminary stages, and we cannot predict its outcome, as the litigation process is inherently uncertain. However, we believe that the allegations and claims in this litigation are without merit and that we have valid defenses, and we intend to contest such allegations and claims and defend ourself vigorously. If the outcome of the litigation is adverse to us and if, in addition, we are required to pay significant monetary damages, our business would be significantly harmed. At a minimum, this litigation could result in substantial costs and divert our managements attention and resources, which could seriously harm our business. As of December 31, 2004, no loss amount has been accrued because a loss is not considered probable or estimable.
On August 31 and September 2, 2004, respectively, two shareholder derivative actions were filed in the Superior Court of California, Alameda County, by alleged shareholders of the Company purporting to assert, on our behalf, claims of breach of fiduciary duty against certain of our current and former directors and officers, and also naming us as a nominal defendant. The complaints in these actions refer to our disclosures as to an Audit Committee investigation into revenue recognition issues and as to significant control deficiencies related to revenue recognition. The complaints further allege that the individual defendants ignored problems with our accounting and internal control practices and procedures and breached their fiduciary duties by failing to maintain adequate internal accounting controls or to make good faith efforts to do so. Plaintiffs claim that such alleged breaches damaged the Company, and they seek monetary recovery against the individual defendants and in favor of the Company, as well as equitable relief. In addition, plaintiffs claim that they should be excused from pre-suit demand requirements based on allegations that our Board of Directors could not have fairly evaluated such pre-suit demand, and thus that such demand would have been futile. On November 22, 2004, the Court entered an order consolidating the two actions and appointing lead plaintiffs counsel.
On November 23 and December 2, 2004, two related shareholder derivative actions were filed in the same court. On January 13, 2005, the Court consolidated these two newer cases with the previously consolidated actions, and directed plaintiffs to prepare and file an amended consolidated complaint, which plaintiffs filed on January 31, 2005. On March 17, 2005, we filed a motion, joined by other defendants, seeking dismissal of the consolidated complaint for failure to adequately plead futility of the pre-suit demand.
This derivative litigation is in its preliminary stages, and we cannot predict its outcome, as the litigation process is inherently uncertain. However, we believe that plaintiffs allegations of demand futility are without merit, and we intend to contest those allegations vigorously. At a minimum, this derivative litigation could result in substantial costs and divert our managements attention and resources, which could seriously harm our business. As of December 31, 2004, no loss amount has been accrued because a loss is not considered probable or estimable.
On October 31, 2001, a complaint was filed in United States District Court for the Southern District of New York against us, some of our directors and officers and various underwriters for our initial public offering. Substantially similar actions were filed concerning the initial public offerings for more than 300 different issuers, and the cases were coordinated as In re Initial Public Offering Securities Litigation, 21 MC 92. In April 2002, a consolidated amended complaint was filed in the matter against us, captioned In re UTStarcom, Initial Public Offering Securities Litigation, Civil Action No. 01-CV-9604. Plaintiffs allege violations of the Securities Act of 1933 and the Securities Exchange Act of 1934 through undisclosed improper underwriting practices concerning the allocation of IPO shares in exchange for excessive brokerage commissions, agreements to purchase shares at higher prices in the aftermarket and misleading analyst reports. Plaintiffs seek unspecified damages on behalf of a purported class of purchasers of our common stock between March 2, 2000 and December 6, 2000. Our directors and officers have been dismissed without prejudice pursuant to a stipulation. On February 19, 2003, the Court granted in part and denied in part a motion to dismiss brought by defendants including us. The order dismisses all claims against us except for a claim brought under Section 11 of the Securities Act of 1933, which alleges that the registration statement filed in accordance with the IPO was misleading. In June 2004, a stipulation of settlement and release of claims against the issuer defendants, including us, was submitted to the court for approval. The terms of the settlement, if approved, would dismiss and release all claims against the participating defendants (including us). In exchange for this dismissal, D&O insurance carriers would agree to guarantee a recovery by the plaintiffs from the underwriter defendants of at least $1 billion, and
the issuer defendants would agree to an assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. The settlement is subject to a number of conditions, including court approval. If the settlement does not occur, and litigation against us continues, we believe we have valid defenses and we intend to defend the case vigorously. The total amount of the loss associated with the above litigation is not determinable at this time. Therefore we are unable to currently estimate the loss, if any, associated with the litigation.
We have sued Starent Networks Corporation (Starent) for patent infringement in the U.S. District Court for the Northern District of California. On March 22, 2004, we filed our Complaint. On June 3, 2004, we served our Complaint on Starent. On July 30, 2004, Starent filed and served its answer and counterclaims. On August 30, 2004, we served and filed our Amended Complaint. In our Amended Complaint, we assert that Starent infringes a UTStarcom patent through the manufacture, use, offer for sale, and sale of Starents ST-16 Intelligent Mobile Gateway. We seek, inter alia, compensatory damages and injunctive relief. Starent filed its answer to the Amended Complaint and counterclaims on September 17, 2004. In its answer and counterclaims, Starent denies our allegations and seeks a declaration that the patent-in-suit is not infringed, is invalid and is unenforceable. The Court held an initial case management conference on November 2, 2004 and scheduled a hearing to construe the claims of the patent-in-suit for June 30, 2005. At that time the Court will hold an additional case management conference to schedule a date for trial. On February 17, 2005, we filed a motion for a preliminary injunction against Starents use, sale, and offer for sale of products having the infringing feature. A hearing on our motion is set for May 11, 2005. Although we cannot reliably predict the outcome of this litigation, we believe that any adverse judgment on Starents counterclaims will not have a material adverse effect on the business, financial condition, or results of our operations.
On January 6, 2005, Fenner Investments, Ltd. filed suit against us and co-defendants Juniper Networks, Inc., Nokia, Inc., Nortel Networks Corp., Lucent Technologies, Inc., and Cisco Systems, Inc. in the U.S. District Court for the Eastern District of Texas. The suit alleges that unspecified products and services infringe two Fenner patents and seeks compensatory and injunctive relief. On March 1, 2005, we filed a motion to dismiss the complaint due to improper venue; no hearing is yet scheduled for this motion. This lawsuit is in its initial stage and it is not possible to reliably predict the outcome or any relief that could be awarded, as the litigation process is inherently uncertain. We intend to contest the allegations and claims and defend ourselves vigorously. If the outcome of the litigation is adverse to us and if, in addition, we are enjoined or required to pay significant monetary damages, our business may be harmed. At a minimum, this litigation could result in substantial costs and divert our managements attention and resources, which could harm our business.
On August 19, 2004, we received a letter from the new management team of Hyundai Syscomm, Inc. (HSI) stating that they consider the Asset Purchase Agreement, dated as of February 26, 2004, among HSI, UTSI, Dr. Seong-Ik Jang and 3R Inc. (the APA), and the various ancillary agreements entered into in connection with the closing related to the APA on April 27, 2004, to be null and void due to unfulfillment of condition precedents and material breach of terms of such agreements. Such condition precedents and material breach of terms were not specified in such letter from HSI. In addition, HSI has made allegations and arguments before Korean governmental agencies and to the Korean press alleging that the technology that was purchased by us pursuant to the APA has been exported outside of Korea. We believe none of such technology has been exported by us from Korea to any foreign country. In addition,
we believe that we have materially complied with all provisions of the APA and the ancillary agreements and HSI cannot void or nullify such agreements. We have taken, and will continue to take, appropriate legal actions to fully enforce our rights under the APA and the ancillary agreements. We believe that this dispute with HSI would not have a material adverse effect on our financial condition, results of operations or cash flow.
We are a party to other litigation matters and claims that are normal in the course of operations, and while the results of such litigation matters and claims cannot be predicted with certainty, we believe that the final outcome of such matters will not have a material adverse impact on our financial position or results of operations.
In the future we may subject to other lawsuits. Any litigation, even if not successful against us, could result in substantial costs and divert managements attention and other resources away from our business operations.
Our common stock has been traded on The Nasdaq National Market (NASDAQ) under the symbol UTSI since our initial public offering on March 3, 2000. The preceding table sets forth the high and low closing sales prices per share of our common stock as reported on NASDAQ for the periods indicated. As of March 31, 2005, we had approximately 194 stockholders of record.
To date, we have not paid any cash dividends on our common stock. We currently anticipate that we will retain any available funds to finance the growth and operation of our business and we do not anticipate paying any cash dividends in the foreseeable future. Certain present or future agreements may limit or prevent the payment of dividends on our common stock. For example, our convertible debt requires that we have to provide notice of our intent to pay certain dividends. Additionally, our cash held in foreign countries may be subject to certain control limitations or repatriation requirements, limiting our ability to use this cash to pay dividends.
The following table sets forth information, as of December 31, 2004, about equity awards under our equity compensation plans:
(1) See Note 15 of our Notes to Consolidated Financial Statements for a description of our equity compensation plans.
(2) Includes the 1997 Stock Plan which provides for an annual increase in the number of shares available for issuance under the plan equal to (i) 4% of the outstanding Shares on such date, (ii) 6,000,000
shares or (iii) a lesser amount determined by the Board, and the 2000 Employee Stock Purchase Plan, which provides for an annual increase in the number of shares available for issuance under the plan equal to (i) 2% of the outstanding shares on such date, (ii) 2,000,000 shares or (iii) a lesser amount determined by the Board.
(3) Includes shares of common stock to be issued upon exercise of options granted under our 1995 Stock Plan, 1997 Stock Plan and 2001 Director Option Plan.
(4) Includes 2,826,910 shares of common stock available for issuance under our 2000 Employee Stock Purchase Plan, 2,479,577 shares of common stock available for issuance under our 1997 Stock Plan and 880,000 shares of common stock available for issuance under our 2001 Director Option Plan. There are no shares available for issuance under the 1995 Stock Plan.
(5) Includes 1,274,287 options outstanding under the 2003 Non-Statutory Stock Option Plan, a maximum of 49,030 performance shares outstanding under the Advanced Communication Devices Corporation Incentive Program and a maximum of 17,942 performance shares outstanding under the Issanni Communications, Inc. Incentive Program. Does not include 11,453 shares and 8,580 shares of common stock subject to outstanding options with a weighted-average exercise price of $2.69 that were assumed in our acquisitions of Advanced Communication Devices Corporation, and RollingStreams Systems, Ltd., respectively.
(6) Represents the average weighted exercise price of 1,274,287 options outstanding under the 2003 Non-Statutory Stock Option Plan. Excludes performance shares outstanding under the Advanced Communication Devices Corporation Incentive Program and the Issanni Communications, Inc. Incentive Program because performance shares do not have an exercise price.
(7) Includes 217,763 shares of common stock available for issuance under our 2003 Non-Statutory Stock Option Plan.
You should read the selected consolidated financial data set forth below in conjunction with Managements Discussion and Analysis of Financial Condition and Results of Operations and our Consolidated Financial Statements and the Notes thereto included elsewhere in this report. Historical results are not necessarily indicative of results that may be expected for any future period. The Company filed an Amendment to its Annual Report on Form 10-K for the year ended December 31, 2003 to reflect the restatement of its consolidated financial statements for the year ended December 31, 2003. See Note 2 to the Consolidated Financial Statements.
(1) On November 1, 2004, the Company completed its acquisition of Audiovox Communication Corporation. Revenue for the two months ended December 31, 2004 from this acquisition was $277.4 million.
(2) Operating income for the year ended December 31, 2004 included an $11.5 million charge associated with the impairment of various assets, including $7.0 million of goodwill, related to the substantially abandoned operations of Hyundai Syscomm, Inc. See Note 10 to the Consolidated Financial Statements. Operating income for the year ended December 31, 2003 included a charge of $10.7 million for in-process research and development associated with various acquisitions.
(3) Working capital is equal to current assets less current liabilities.
This Annual Report on Form 10-K contains forward-looking statements within the meaning of the federal securities laws. These statements are based on information that is currently available to management. We intend such forward-looking statements to be covered by the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, and we are including this statement for purposes of complying with those provisions. The forward-looking statements include, without limitation, those concerning the following: our expectations as to the nature of possible trends; our expectations regarding continued growth in our business and operations; our expectation that there will be fluctuations in our overall gross profit, gross margin, product mix, quarter to quarter results, customer base and selling prices; our plans for expanding the direct sales organization and our selling and marketing campaigns and activities; our expectation that we may use our cash, debt or securities to acquire or invest in complementary businesses, technologies or product offerings; our expectation that there will be increases in selling, marketing, research and development, and general and administrative expenses; our expectations regarding future growth of our business and operations; our expectation that we will continue to invest significantly in research and development; our expectations regarding the status of products under development; our expectations regarding our future investments; our expectations regarding our future levels of cash and cash equivalents, as well as our expectation that existing cash and cash equivalents will be sufficient to finance our operations for the foreseeable future; our expectations regarding licensing requirements and our ability to receive licenses in China for our PAS system and other products; our expectations regarding the development of a 3G network in China; our expectations regarding the impact of a reorganization of China telecommunication companies; our expectations regarding the growth of Chinas telecom markets; our expectation that our business will continue to be significantly influenced by the political, economic and legal environment in China, as well as expectations about the nature of political, economic and legal reform in China and other international markets; our expectations regarding market share percentages for our products; our expectations regarding the future allocation of net sales by product group; our expectations regarding efficiencies we hope to achieve in supply chain capability; and our expectations regarding our expansion into new markets around the world. Additional forward-looking statements may be identified by the words, anticipate, expect, believe, intend, will and similar expressions, as they relate to us or our management. Investors are cautioned that these forward-looking statements are inherently uncertain. These statements are subject to risks and uncertainties that may cause actual results and events to differ materially. For a detailed discussion of these risks and uncertainties, see the Factors Affecting Future Operating Results section of this Form 10-K. We do not guarantee future results and undertake no obligation to update the forward-looking statements to reflect events or circumstances occurring after the date of this Form 10-K.
We filed the Amendment No. 1 to our Annual Report on Form 10-K for the year ended December 31, 2003 to reflect the restatement of our consolidated financial statements for the year ended December 31, 2003 and the quarters ended March 31, 2003, June 30, 2003 and September 30, 2003 and certain corresponding changes described below.
As part of the financial closing process for the year ended December 31, 2004, we identified certain errors resulting in a restatement which decreased the provision for income taxes and increased net income by $20.7 million for the year ended December 31, 2003. In addition, as a result of the correction of the tax provision, retained earnings was increased by $20.7 million, additional paid-in capital was increased $0.9 million, income taxes payable was decreased by $2.5 million, other long-term assets were increased by
$21.6 million, prepaids were increased by $2.8 million and other current assets were reduced by $5.3 million. There was no net effect on cash provided from operating activities as a result of this error.
During the evaluation of the errors related to the income tax provision, we determined that an additional reclassification of reported 2003 results was required. Specifically, cost of sales and other income both increased by $3.5 million for the year ended December 31, 2003 to properly classify certain incentive payments received for exports and value-added taxes in China.
In addition to the errors in the 2003 tax provision, we did not correctly identify a related party that is deemed a variable interest entity and for whom we are considered the primary beneficiary in accordance with FASB Interpretation No. 46 (FIN 46). We have corrected our 2003 financial statements to reflect the consolidation of this variable interest entity, MDC Holding Limited (MDC Holding) and its affiliated entities (MDC Holding and such affiliated entities are referred to, collectively, as MDC). At December 31, 2003, this consolidation resulted in a $5.5 million increase in total assets and a $0.7 million increase in total liabilities. There was no effect on net income as a result of this consolidation.
Furthermore, an impairment charge of $7.4 million, net of taxes of $1.3 million, was recorded to reflect an impairment of MDC equipment subject to a revenue sharing arrangement. Due to the uncertainties surrounding the customers subscriber income and ability to pay under this arrangement, we determined that an impairment charge should have been recorded in 2003 when these conditions should have been identified. Accordingly, an impairment charge of $7.4 million, net of tax, was recorded, which decreased both total assets and equity by $7.4 million at December 31, 2003.
In addition, we identified the following revisions in classification during the preparation of the restated consolidated financial statements:
(1) Cost of sales for related party revenue transactions is presented separately from cost of sales for non-related party revenue transactions for all years presented;
(2) Certain other long-term assets increased and intangible assets decreased by $1.7 million at December 31, 2003;
(3) Changes in restricted cash had been incorrectly categorized as a part of operating cash flows instead of investing cash flows in accordance with Statement of Financial Accounting Standards No. 95, Statement of Cash Flows, (SFAS 95). Accordingly, we have reflected this change in categorization in the Consolidated Statement of Cash Flows for each of the three years in the period ended December 31, 2003. The change for 2003 and 2002 is an increase in cash flows from operating activities and a decrease in cash flows from investing activities of $3.2 million and $21.3 million, respectively, and there was no change for 2001; and
(4) A related party which is 31% owned by an individual related to a member of our Board of Directors and associated transactions have been identified. See Note 22 to the Consolidated Financial Statements.
We design, manufacture and sell telecommunications equipment and products and provide services associated with their installation, operation and maintenance. Our products are deployed and installed primarily by telecommunications wireless and wireline service providers. We provide an extensive range of products for transportation of voice, data and video traffic for service providers around the world. Our business is conducted globally in China, Japan, India, the Central and Latin American region, North America, the European, Middle Eastern and African region, and southeastern and northern Asia. Our objective is to be a leading global provider of Internet Protocol (IP) networking products and services. We differentiate ourselves with products designed, developed and commercialized to reduce network
complexity, integrate high performance capabilities and that allow a simple transition to next generation networks. This results in deployments, maintenance and upgrades that are both economical and efficient, and that we believe allow operators to earn a high return on their investment. Our technologies and products fall into three major categories:
· Wireless Infrastructure: technologies and products that enable end users, or subscribers, to send and receive voice and data communication in either a fixed or mobile environment using wireless devices;
· Broadband Infrastructure: technologies and products that enable end users to access high-speed, cost effective fixed data, voice and media communication; and
· Handsets and Customer Premise Equipment: consumer devices that allow customers to access wireless and broadband networks.
Our products within each of these categories include multiple hardware and software subsystems that can be offered in various combinations to suit individual subscriber needs. Our system technologies and products are based on widely adopted global communications standards and are designed to allow service providers to quickly and cost-efficiently integrate our systems into their existing networks and deploy our systems in new broadband, IP and wireless network rollouts. Our system technologies are also designed to allow timely and cost-efficient transition to future next-generation network technologies, enabling our service provider customers to protect their initial infrastructure investments.
In 2004, we had approximately $2.7 billion of revenue, a 38% increase over 2003, with cost of sales of $2.1 billion, which increased by 57% compared to 2003. The growth in revenue was driven by our globalization efforts in gaining sales revenue outside of China as well as $277.4 million of incremental revenue from our acquisition of ACC in November 2004. We believe China remains one of the fastest growing telecommunications markets in the world. China continued its growth in fixed-line, mobile telephone and internet subscribership, with approximately 647.2 million subscribers in 2004, a 6% increase from 2003, according to a report published in January 2005 by Chinas MII. We believe this subscriber growth continued to support the demand for our PAS services and handsets. We use subscriber growth statistics to gauge future inventory purchasing requirements, as well as to forecast our anticipated revenue growth.
Historically, substantially all of our sales have been to service providers in China. We derived 79% of our sales for the year ended December 31, 2004 from China in comparison to 86% in 2003. In 2004, we earned 13% of our sales from North America. North America replaced Japan as our second largest market in 2004 as a result of our global expansion efforts and the ACC acquisition. We continued expanding our sales efforts to include other communications markets, such as markets in the Central and Latin American region, the European, Middle Eastern and African region, the North American region, and the Southeast and North Asia region. We intend to penetrate these markets through direct sales offices located in key market regions, by licensing our technology to local manufacturers where import taxation is favorable, by developing local sales agency and distributor relationships within specific market regions, and by establishing sales relationships with original equipment manufacturers. Our sales division has continued to establish regional offices and local direct sales representative offices to provide support for our expanding global sales operations.
The following table summarizes our net sales by geographic region:
The number of competitors for communications access and switching systems and handsets in China grew in 2004 in line with Chinas growing telecommunications market. This growth led to competitive pricing pressure, causing our average selling prices to decrease by 10% to 20% in 2004 relative to 2003 levels. We continued to develop products with more advanced features and to enhance the features of our existing products in 2004, which we believe will enable us to offer our customers a more advanced product at a higher average selling price in future periods. In addition, we intend to continue to work to reduce the cost of manufacturing our products by streamlining our design and engineering functions.
In an effort to penetrate new markets around the world, support our growing business and expand our product offerings, we continued to invest resources in our selling, administrative and research and development groups in 2004. These costs are expected to increase in the near future as we proceed with our expansion into other markets. Operating costs as a percentage of revenue were 20% in 2004 compared to 18% in 2003.
In 2004, we had negative net cash flow from operating activities, mainly due to increases in accounts receivable and inventory balances. Our accounts receivable and inventory balances increased at December 31, 2004, as compared to 2003, and can be attributed to our global expansion efforts including the sales generated by our Personal Communications Division (PCD), our new division formed in connection with the ACC acquisition.
KEY ACQUISITIONS AND OTHER TRANSACTIONS
Since our incorporation, we have focused our resources on developing products for the global communications market. In particular, we have made several key strategic acquisitions to acquire additional resources to further this development in recent years. These acquisitions were accounted for as purchases, and the results of operations of the acquired companies have been included in our consolidated financial statements from the closing dates of the acquisitions.
Our acquisitions often result in a one-time charge to operating expenses related to products under development that have not yet reached technological feasibility, or in-process research and development (IPR&D). A project is classified as IPR&D if there are significant risks associated with completing the development of the acquired technology including both technological and commercial risks. When assessing IPR&D projects, we consider the key project characteristics as well as its future prospects, the rate at which technology changes in the telecommunications equipment industry, product life cycles and the products development stage.
In connection with acquisitions, we often issue stock-based incentives that vest according to terms established in the acquisition agreement. Historically, our stock-based incentives have vested based upon the achievement of product development milestones, the meeting of revenue targets or the duration of employment.
On October 29, 2004, UTStarcom CDMA Technologies Korea Limited, a limited liability company organized under the laws of Korea and our wholly owned subsidiary (UTStarcom Korea), entered into an Asset Purchase Agreement with Giga Telecom, Inc. (Giga), a Korean corporation that develops and manufactures wireless handsets. Pursuant to the Asset Purchase Agreement and related ancillary agreements, UTStarcom Korea will pay $18.6 million for certain assets relating to the research and development of CDMA wireless products, of which (i) $13.0 million will be paid in cash at the closing, (ii) $1.6 million pursuant to a separate arrangement in respect of certain services rendered by Giga relating to the design of wireless handsets for UTStarcom Korea, is to be applied against the purchase price, and (iii) $4.0 million is to be paid in three separate installments tied to certain product design and production milestones. We completed the acquisition on January 4, 2005, and at the closing, $13.0 million in cash was paid and an additional $2.0 million was paid into an escrow account that will be held by us for a period of six months.
On November 1, 2004, we completed our acquisition of ACC, the wireless handset division of Audiovox Corporation, and acquired select assets and liabilities, including inventories, prepaids, payables, accrued expenses and the right to hire approximately 250 employees for $165.1 million in cash. We acquired ACCs sales, service and support infrastructure, its CDMA handset brand, access to supply-chain channels, product marketing expertise and key relationships with CDMA operators in North and South America.
In consummating this acquisition, we obtain access to ACCs distribution channel into the CDMA handset market particularly in North America. We believe this distribution channel strengthens our position in the handset market by providing additional volume to benefit economies of scale in manufacturing, sourcing and development. We also plan to improve gross margins on the sale of ACCs CDMA handsets by supplying products we manufacture to ACC.
Based in part on an independent valuation, the allocation of the purchase price to intangible assets is comprised of customer/dealer relationships of $24.4 million, supplier relationships of $5.3 million, non-compete agreement of $10.8 million, backlog of $3.2 million, trade name of $4.0 million, and goodwill of $74.1 million. No amount was allocated to IPR&D.
On May 19, 2004, we completed our acquisition of substantially all of the assets and certain liabilities of TELOS Technology, Inc. and its subsidiaries (TELOS). TELOS is a provider of mobile switching products and services for voice and data communication networks to developing rural, enterprise and emerging wireless markets. The total consideration for the acquisition, funded from cash on hand, was approximately $30.0 million. We paid $29.0 million in cash, in addition to $1.0 million of acquisition-related transaction costs. Within one year of the acquisition date, additional payments totaling a maximum of $19.0 million may become payable based upon revenue recognized from the sale of TELOS products. In the event these revenue milestones are met, the original purchase price will be adjusted for the amount of the contingent payment in accordance with Statement of Financial Accounting Standards No. 141 (SFAS 141), Business Combinations. As of December 31, 2004, no additional payments or accruals were required.
The existing technology acquired included the entire TELOS product family of CDMA softswitch technology products, supporting servers and operations maintenance centers. CDMA technology is the common platform on which second and third-generation wireless data services and applications are built. By assigning unique codes to each communication to differentiate it from others in the same spectrum,
CDMA technology allows many users to occupy the same time and frequency allocations in a given band or space. The amount of the purchase price allocated to existing technology was $15.9 million. The TELOS product line will be integrated with our suite of CDMA products, strengthening our existing CDMA product portfolio.
In addition to developed product technology, we acquired fixed assets, IPR&D, an assembled workforce of approximately 60 employees, customer relationships and recorded goodwill. The amount of the purchase price allocated to IPR&D of $1.4 million was charged to our results of operations, as no alternative future uses existed at the acquisition date. In assessing TELOS IPR&D projects, we considered key product characteristics including the products development stage at the acquisition date, the products life cycle and the products future prospects. We also considered the rate at which technology changes in the telecommunications equipment industry, the industrys competitive environment and the economic outlook for both local and global markets. We recorded $6.4 million of goodwill related to this acquisition.
As of the acquisition date, TELOS had two projects under development that qualified for IPR&D: the Sonata SE product family and the iCell product. The objective of both projects is to enhance the functionality of products designed to comply with the CDMA2000 technology standard. Specifically, the objective of the Sonata SE product family is to provide additional features to operation maintenance center products. The objective of the iCell product is to enhance iCell base station features. The projects under development are enhancements to existing products that do not affect the functionality of those existing products.
As of December 31, 2004, one project was completed and for the other project, the estimated completion date is June 2005, with estimated remaining costs to complete of $0.6 million.
On April 27, 2004, we completed our acquisition of the assets, substantially all of the intellectual property, certain employees and certain contracts related to HSIs CDMA infrastructure business for markets outside of Korea. Subject to the attainment of certain milestones and the transfer of certain know-how, the total consideration for this transaction was approximately $12.3 million excluding transaction costs of $1.8 million. Approximately $7.3 million in cash was paid at the closing date and an additional $3.0 million in cash is payable one year from the closing date. The remaining purchase price was comprised of $2.0 million to be paid by us upon the completion of HSIs training of our manufacturing employees in China under the terms of a Training Services Agreement. Not included in the purchase price was $2.0 million payable upon the completion of certain revenue milestones. In the event these revenue milestones are met, the original purchase price will be adjusted for the amount of the contingent payment in accordance with SFAS 141. In conjunction with this transaction, we loaned HSI $3.2 million at an effective interest rate of 12% per annum, which was used by HSI to satisfy outstanding debt obligations. The principal amount of the loan is due in April 2005. We may offset HSIs payment obligations against the outstanding $3.0 million of the purchase price and any other liabilities.
Under the terms of the transaction with HSI, we acquired existing technologies and entered into non-compete and licensing agreements. The existing technologies acquired were the base transceiver station (BTS) and base station controller (BSC) product lines. BTS is the antenna and radio equipment that enables wireless devices to communicate with a land-based transmission network in a given range. BSC performs radio signal management functions for BTS, managing functions such as frequency assignment and handoff. As part of the asset purchase agreement, we entered into a training services agreement with HSI, whereby HSI employees were to provide technical training to our manufacturing staff in China for the ninth-month period subsequent to the acquisition. This technology and technological know-how will strengthen our existing CDMA product portfolio and the development of future CDMA technology.
In addition to acquiring existing technology, we entered non-compete and licensing agreements with HSI. The non-compete agreement prohibits HSI from competing against us in all countries except Korea for four years from the valuation date. The licensing agreement requires that HSI pay us 1% of revenue as a royalty for the usage of the intellectual property that we acquired under the terms of the acquisition for fifteen years subsequent to the valuation date. There were no IPR&D projects acquired.
We initially recorded goodwill of $6.8 million in connection with the acquisition and subsequently increased the amount of goodwill by $0.2 million upon the completion of the purchase price allocation. We encountered difficulties integrating the HSI operations into our operations after the acquisition. In the fourth quarter of 2004, we decided to wind-down the legacy operations and transfer employees and tangible assets to support our handset engineering operations in Korea during the first quarter of 2005. The decision to abandon the operations occurred within nine months of the acquisition and before the HSI operations were integrated into our Company. Therefore, in accordance with SFAS 142, we have written off the entire goodwill of $7.0 million associated with this acquisition. We have also written off all of the remaining values of the intangible assets associated with this acquisition including $3.1 million of purchased technologies, $0.6 million related to non-compete agreements, and $0.8 million related to a license agreement with HSI. At December 31, 2004, we believed we would utilize most of HSIs tangible assets to support our new handset design center. If any assets will not be utilized in support of the handset design center, the net book value of those assets will be written off. We expect to complete the evaluation and decision during the second quarter of 2005.
On May 23, 2003, we completed our acquisition from 3Com Corporation, a Delaware corporation, (3Com) of selected assets and liabilities from 3Coms CommWorks division (CommWorks). We funded the consideration for the acquisition from cash on hand, and paid $100.0 million in cash and incurred transaction and other related costs of $9.3 million.
Selected assets acquired included CommWorks portfolio of carrier-focused voice and data networking products and customer support and professional services. In addition, we acquired or licensed all of the 3Com intellectual property used by CommWorks. CommWorks develops and deploys carrier-class, IP-based multi-service access and service-creation platforms for telecommunications service providers.
Based on an independent valuation, $1.3 million of the purchase price was allocated to IPR&D and was charged to our results of operations, as no alternative future uses existed at the acquisition date.
As of the date of the acquisition, CommWorks had two projects under development that qualified for IPR&D, SLAP and High Density Voice (HDV) 2.0. SLAP is an IPR&D project in the Wireless division of CommWorks. It is an interface that connects our products with radio switch manufacturers products in China in order to connect a cellular network to the Internet. HDV 2.0 is an IPR&D project in the Broadband infrastructure product line of CommWorks. HDV 2.0 utilizes software technology to increase data capacity for VoIP solutions. Both the SLAP and HDV 2.0 projects were completed and commercialized in 2004.
On June 30, 2003, we completed the acquisition of RollingStreams Systems, Ltd. (RollingStreams), a development-stage company, pursuant to a share exchange agreement. RollingStreams designs streaming, end-to-end TVoIP products and services for telecommunications operators and broadband service providers. Our investment in RollingStreams was $0.4 million prior to the acquisition. The purchase consideration for all of the outstanding shares of RollingStreams, other than those already held by us prior to the acquisition, was 301,074 shares of our common stock. In addition, we assumed all
outstanding RollingStreams options, which became options to purchase an aggregate of 12,742 shares of our common stock, valued at $0.5 million. Of the 301,074 shares, 164,115 shares valued at $5.8 million, were issued at the closing, 28,696 of which are held in escrow for any undisclosed liabilities or contingencies incurred by RollingStreams prior to the closing or for any breach of the share exchange agreement. The 28,696 shares held in escrow were released and issued in 2004. Up to 136,959 of the 301,074 shares will be payable in the form of an earnout after an earnout period expiring 18 months after the closing, subject to the achievement of certain revenue milestones during such earnout period. No shares have been issued pursuant to the earnout as of March 31, 2005.
The amount of the purchase price allocated to IPR&D was $6.2 million, based on an independent valuation. This amount was charged to our results of operations, as no alternative future uses existed at the acquisition date.
As of the date of the acquisition, RollingStreams had one project under development that qualified for IPR&D, MediaSwitch. MediaSwitch is an end-to-end solution designed for telecom operators and broadband service providers to deliver broadcast quality TV and on-demand entertainment services over Internet Protocol networks.
MediaSwitch is considered an IPR&D project because there are significant risks associated with the development of this technology. These risks include technological and commercial risks. The technological risks stem from the fact that the technology was 70% complete at December 31, 2003. As of December 31, 2004, the project was completed and no further cost is anticipated.
On October 16, 2002, we acquired the assets and intellectual property of Shanghai Yi Yun Telecom Technology Co. Ltd. (Shanghai Yi Yun), a provider of synchronous digital hierarchy equipment. Consideration was $0.2 million of cash and 342,854 shares of restricted stock valued at $6.0 million. In connection with the acquisition, Shanghai Yi Yun and each of the stockholders that received the 342,854 shares of restricted stock executed an indemnity escrow agreement in our favor and such shares of restricted stock were placed in escrow. In addition, we issued 514,290 shares of restricted stock valued at that time at $9.0 million to the Shanghai Yi Yun employees that were hired by one of our subsidiaries. Such shares of restricted stock vest over five years, with accelerated vesting upon the achievement of specified milestones. We have treated these 514,290 shares of restricted stock as deferred compensation.
On January 14, 2004, we sold 12.1 million shares of common stock at $39.25 per share in a privately negotiated transaction to an institution, for net proceeds of approximately $474.6 million. The net proceeds are intended to fund strategic and general corporate activities, including, but not limited to, acquisitions, investments, working capital or capital expenditures. During the first and second quarters of 2004, we used a portion of the capital raised to repurchase a total of 3.6 million shares of our common stock, at an average price of $30.25 per share and a total cost of $107.6 million, including transaction fees.
On April 5, 2003, we repurchased 8.0 million shares of common stock beneficially owned by SOFTBANK America Inc., at a purchase price of $17.385 per share. The total cost of the repurchase was $139.6 million including transaction fees. In connection with this repurchase transaction, SOFTBANK America Inc. entered into an agreement with us not to offer, sell or otherwise dispose of our common stock for a period of one year, subject to a number of exceptions.
On March 12, 2003, we completed an offering of $402.5 million of convertible subordinated notes due March 1, 2008 to qualified institutional buyers pursuant to Rule 144A under the Securities Act of 1933. The notes bear interest at a rate of 7/8% per annum and are convertible into our common stock at a conversion price of $23.79 per share and are subordinated to all of our present and future senior debt. Holders of the notes may convert their notes only if: (i) the price of our common stock issuable upon conversion of a note reaches a specified threshold, (ii) specified corporate transactions occur, or (iii) the trading price for the notes falls below certain thresholds. At the initial conversion price, each $1,000 principal amount of notes will be convertible into approximately 42.0345 shares of common stock.
Concurrent with the issuance of the convertible notes, we entered into a convertible bond hedge and a call option transaction with respect to our common stock. Both the bond hedge and call option transactions may be settled at our option either in cash or net shares and expire on March 1, 2008. The convertible bond hedge and call option transactions are expected to reduce the potential dilution from the conversion of the notes. The options have been included in stockholders equity in accordance with the guidance in Emerging Issues Task Force Issue No. 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Companys Own Stock.
Our net sales consist of product and service sales within three broad telecommunications product lines; wireless infrastructure, broadband infrastructure and handsets and customer premise equipment. Wireless infrastructure is primarily comprised of the PAS and CDMA products. Broadband infrastructure is primarily comprised of the AN-2000, iAN-8000, IP-DSLAM, GEPON, NetRing and other wireline products. The handsets and customer premise equipment products include PAS handsets, CPE and CDMA handsets that were introduced in the fourth quarter of 2004. With many of our product sales, we provide installation services. Additionally, we provide maintenance services for some of our products. For each of the years ended December 31, 2004, 2003 and 2002, total services sales accounted for less than 10% of net sales.
Approximately 79%, 86% and 84% of our net sales for the years ended December 31, 2004, 2003 and 2002, respectively, were in China. Accordingly, our business, financial condition and results of operations are likely to be influenced by the political, economic and legal environment in China, and by the general state of Chinas economy for the foreseeable future. For example, we experienced lower demand for our products in China in the fourth quarter of 2004 resulting from the slowdown in Chinas economy as well as from the maturation of the PAS market. Our results may be adversely affected by, among other things, changes in the political, economic, competitive and social conditions in China, including changes in governmental policies with respect to laws and regulations, changes in the telecommunications industry and regulatory rules and policies, anti-inflationary measures, currency conversion and remittance abroad, and rates and methods of taxation. We extend credit to our customers in China without requiring collateral. We monitor our exposure for credit losses and maintain allowances for doubtful accounts. Business activity in China and many other countries in Asia decline considerably during the first quarter of each year in observance of the Lunar New Year. As a result, sales during the first quarter of our fiscal year have typically been lower than sales during the fourth quarter of the preceding year, and we expect this trend to continue.
Cost of sales consists primarily of materials costs, fees to agents, costs associated with manufacturing, assembly and testing of products, costs associated with installation and customer training and overhead and warranty costs. Cost of sales also includes import taxes and tariffs on components and assemblies. Some components and materials used in our products are purchased from a single supplier or a limited group of suppliers and, in some cases, are subject to our obtaining Chinese import permits and approvals. We also rely on third party manufacturers to manufacture and assemble most of our handsets.
Our gross profit has been affected by product mix, average selling prices and material costs. Our gross profit, as a percentage of net sales, varies among our product families. We expect that our overall gross profit, as a percentage of net sales, will fluctuate from period to period as a result of shifts in product mix, anticipated decreases in average selling prices and our ability to reduce cost of sales.
Selling, general and administrative expenses include compensation and benefits, professional fees, sales commissions, provision for doubtful accounts receivable and travel and entertainment costs. A large percentage of our costs are fixed and are difficult to quickly reduce in periods of reduced sales. We intend to pursue aggressive selling and marketing campaigns and to expand our direct sales organization, and, as a result, our sales and marketing expenses will increase in future periods. We also expect that in support of our continued growth, general and administrative expenses will continue to increase in the foreseeable future.
Research and development expenses consist primarily of salaries and related costs of employees engaged in research, design and development activities, the cost of parts for prototypes, equipment depreciation and third party development expenses. A large percentage of our costs are fixed and are difficult to quickly reduce in periods of lower sales. We believe that continued investment in research and development is critical to our long-term success. Accordingly, we expect that our research and development expenses will increase in future periods.
Income tax expense is based upon a blended effective tax rate based upon our expectation of the amount of income to be earned in each tax jurisdiction. The primary drivers for income tax expense include both the total amount and geographic source of the income earned. We use credits and other tax incentives to minimize our income tax expense. Income tax expense as a percentage of income before taxes will increase if relatively more income is earned in higher tax jurisdictions.
The following table summarizes our net sales by product line:
The 38% increase in sales from $2.0 billion in 2003 to $2.7 billion in 2004 was primarily attributable to increased demand for our products and services and results of our geographic expansion into other markets. Our new customer wins in prior years continued to contribute to the increased demand for our products and services. In addition, our recent acquisitions also attributed to our growth in sales. For example, our PCD division contributed $277.4 million in sales since the acquisition on November 1, 2004.
Net sales growth, excluding PCD, was primarily due to an increase in subscribers, requiring telecommunication providers to expand their telecommunication infrastructures. Wireless infrastructure revenues are generally affected by the timing of customer acceptance. In 2004, the percentage of total sales for our wireless product line increased from 37% to 52% generally as a result of our international customers who undertook a number of wireless infrastructure expansion projects including the broadband fiber-to-the-home projects in Japan. While we experienced an increase in our wireless infrastructure revenue between 2004 and 2003, our handset revenue remained relatively flat as a result of a combination of factors. For one, our handset revenue in China decreased by approximately $225.9 million due primarily to lower average selling prices resulting from increased competition by 10% to 20%, depending on products, while units of shipment remained at the same level as last year. Secondly, the decline in China handset revenue was offset by $277.4 million in handset revenue recognized in the fourth quarter of 2004 by PCD. We believe that in 2005 we will maintain approximately 55% to 60% percent market share in China for PAS wireless infrastructure and 50% to 55% percent market share for PAS handsets as smaller competitive handset vendors exit the market. Additionally, we expect that with the addition of PCD, total handset revenue will represent 50% to 60% of our net sales in 2005. Sales to related parties decreased from 9.4% in 2003 to 5.4% in 2004 of total net sales. See Related Parties for further discussion.
Most Chinese carriers have three levels of operations; the central headquarters level, the provincial level and the local city/county level. Both central and provincial levels are independent legal entities and have their own corporate mandate. The purchasing decision making process may take various forms for different projects and may also differ significantly from carrier to carrier. We group all of our China customers together by province and treat each province as one customer since that is the level at which purchasing decisions are made. At December 31, 2004, and 2003, we had 31 customers in China. In 2004, the Guangdong and Jiangsu provinces accounted for 12% and 10% of our net sales, respectively. In 2003, the Hei Long Jiang province accounted for 11% of our net sales.
In the case of PAS systems, all China Netcom contracts are negotiated and entered into between the provincial operators and the Company. However, thecentral headquarters of China Telecom recently began exerting more influence in the purchasing decision-making process by negotiating contractual terms, such as purchase price, payment terms, and acceptance clauses at the central level. The provincial operator then further negotiates the contract based on the guidelines provided by the headquarters. Final contracts are entered into between the provincial operator and the Company. However, if this trend of centralized decision-making expands to unified purchasing, resulting in the negotiation and execution of contracts at the central headquarter level, there may be a concentration of customers which could have a significant impact on our business.
Three months ended December 31, 2004 and 2003
In the fourth quarter 2004, net sales increased by $103 million or 16% over the fourth quarter of 2003. This increase was driven by the PCD division, which contributed $277.4 million in sales in the fourth quarter 2004. Excluding the impact of the PCD acquisition, our sales declined in the fourth quarter 2004 by 27 % compared to the prior year. The revenue from our Wireless products experienced a decline in the fourth quarter of 2004 primarily due to the delay of revenue recognition for our PAS infrastructure products due to extended period for product acceptance due to certain new contract terms. In addition, our revenue growth continued to be impacted negatively by the maturity of PAS market infrastructure.
The percentage of revenue generated outside of China exceeded 53% of total sales in the fourth quarter 2004 versus 13% of total sales in the fourth quarter 2003. Excluding PCD, there was a 37% increase in sales from $83 million in the fourth quarter 2003 to $114 million in the fourth quarter 2004. This was primarily due to telecommunication providers expanding their infrastructure requirements. In addition, there was an increase in our Broadband product sales due to the introduction of our GEPON and NetRing products.
Fiscal 2003 vs. 2002
The 100% increase in sales from $981.8 million in 2002 to $1,965.2 million in 2003 was primarily attributable to increased demand for our products and services, the continued strength of our sales in China, as well as an increase in our global sales. Net sales growth was due to an increase in subscribers, which required telecommunication providers to expand their telecommunication infrastructures. As a result, we had more sales to customers that were expanding their existing networks in 2003. Approximately 30% of our sales in 2003 were attributable to new customers compared to 54% of sales to new customers in 2002. In addition to increasing the amount of infrastructure sales, this increase in subscribers also led to an increase in customer demand for handsets. Sales to related parties decreased from 13% in 2002 to 9% in 2003 of total net sales. See Related Parties for further discussion.
During 2003, the China provincial-level telecommunications service entities continued to consolidate telecommunications purchasing decisions by province. As a result of this consolidation trend, we grouped all of our China customers together by province, and treat each province as one customer. At December 31, 2003 and 2002, we had approximately 31 such customers. Giving effect to this consolidation, in 2003, the Hei Long Jiang province accounted for 11% of our net sales. In 2002, sales to the Zhejiang province accounted for 18% and sales to SBBC accounted for 13% of our net sales.
The following table summarizes our gross profit:
Fiscal 2004 vs. 2003
Our gross profit varies across our different product lines and is affected by product mix, average selling prices and the cost of materials. Gross profit percentage declined by approximately 10% due to several factors. The International segment experienced the largest drop in gross profit, declining from 58% for 2003 to 34% for 2004. Most of this decrease was driven by the decline in our broadband product, which experienced a shift in product mix from our more traditional DSLAM product to newer optical broadband products. These broadband products have experienced lower initial margins upon product introduction. In addition, the gross profit percentage recognized on handset sales made through the PCD business is approximately 4% which is significantly lower than those realized on handset sales related to our PAS systems. PCD was acquired in November 2004 and contributed $11.9 million in gross profit. The lower PCD gross margin resulted in a decrease in consolidated gross margin of 2.1%. The China segment also experienced a decline in gross margin percentage, declining from 27% to 23%, primarily attributable to our handset products, which have experienced increased competitive market pricing pressure. We expect that there will be continued competitive market pricing pressures on our products in line with current trends in the industry.
In addition, our gross profit was negatively impacted by a $39 million increase in our provision for inventory reserves.
Three months ended December 31, 2004 and 2003
Gross profit for the three months ended December 31, 2004 was $112.2 million or 15% of sales compared to $188.1 million or 29%. The most significant factor related to this decline is the inclusion of
two months of PCD sales at approximately 4% gross profit. The lower PCD gross profit percentage decreased the consolidated gross profit by 6% in the three months ended December 31, 2004.
The majority of the remaining decline in gross profit is related to the International segment. During the fourth quarter of 2004, the International segment sold more of its newer optical broadband products, which has a lower margin than the DSLAM product. In addition, the fourth quarter gross profit was negatively impacted by provision for inventory and warranty reserves of $34.4 million compared to $12.6 million in the fourth quarter of 2003.
Fiscal 2003 vs. 2002
The decrease in gross profit as a percentage of net sales in 2003 from 2002 was attributable to increased competitive market pricing pressures and lower margins on our PAS systems as well as to our having a higher volume of sales of our lower margin handset products. The telecommunications market experienced continued pricing pressures in 2003. Our gross profit decreased in 2003 also due to an increased cost of sales from foreign exchange losses resulting from our purchasing significant amounts of inventory denominated in Japanese Yen.
The following table summarizes our operating expenses:
Selling, general and administrative
Fiscal 2004 vs. 2003
Selling, general and administrative expenses increased by $127.4 million, or 2% as a percentage of net sales, compared to 2003. The increase from 2003 to 2004 was primarily due to the hiring of additional personnel to support our increased business activities both in China and globally. Selling, general and administrative headcount increased approximately 49% from an average of 2,033 employees for 2003 to an average of 3,038 employees for 2004. Additionally, our professional services fees increased by approximately $31.7 million in 2004 from 2003 due to expansion of our overall global activities and also driven in part by expenses of approximately $13.3 million related to systems implementations, Sarbanes-Oxley compliance and supply chain management consulting fees in 2004. The allowance for doubtful accounts increased from $31.2 million at December 31, 2003, to $51.2 million at December 31, 2004, due primarily to the increased size of our receivable balances in China. The net increase in allowance for doubtful accounts was partially offset by a refinement in our estimation methodology and assumptions in the fourth quarter of 2004. The revision to our allowance for doubtful accounts assumptions reflect the changing 2004 collection experience and further analysis of collectibility trends within the China accounts receivable balances. Throughout 2004, we experienced slower collections cycles. This slowdown has been attributed to a variety of reasons but principally to changes in customers business practices surrounding payment and, to a lesser degree, to maturation of the telecommunications sector. However, we do not believe that the lengthening of the collections cycle will coincide with a reduction in the overall
recoverability of the associated receivables. This lengthening of the collection cycle caused us to reevaluate our provisioning methodology. The change in estimation resulted in a $10.1 million lower provision for doubtful accounts than would have been provided under the previous assumptions. Finally, we incurred an asset impairment charge of approximately $11.5 million relating to goodwill and intangible assets impairment of our HSI acquisition.
Fiscal 2003 vs. 2002
The increase in selling, general and administrative expenses was due to the expansion of our overall business activities both in China and globally. To support our expanding global business, we hired approximately 1,150 additional selling, general and administrative employees in 2003, which also contributed to the increased selling, general and administrative expenses. The decrease in selling, general and administrative expenses as a percentage of net sales was primarily due to economies of scale associated with the significant increase in net sales.
Research and development
Fiscal 2004 vs. 2003
Research and development expense remained at 8% of total net sales for 2004 as compared to 2003. The research and development expenses increased by $63.8 million primarily due to hiring additional technical personnel to support both product enhancements and new product development. Research and development headcount increased approximately 52% from an average of 1,809 employees for 2003 to an average of 2,757 employees for 2004. The significant majority of the increase in research and development expenses from 2003 to 2004 was attributable to higher payroll and payroll-related costs resulting from the continued expansion of our research and development teams in China, from a full year of salaries for CommWorks personnel as compared to seven months salaries in the same period in the prior year and from approximately 100 employees hired in conjunction with the acquisitions of TELOS and HSI in 2004.
Fiscal 2003 vs. 2002
The increase in absolute dollars of research and development expenses was primarily due to the hiring of approximately 950 additional technical personnel in 2003 to support our increased business levels. The decrease of research and development expenses as a percentage of net sales was due to the majority of the new personnel being hired in China, where labor costs are less expensive than in the United States, as well as to increased economies of scale associated with increased business levels.
In-process research and development expenses
Fiscal 2004 vs. 2003
The IPR&D charge of $1.4 million for 2004 resulted from our acquisition of TELOS and was based, in part, on an independent valuation.
Please see Acquisitions and Other Key Transactions for details on our IPR&D expenses incurred in 2004.
Fiscal 2003 vs. 2002
The IPR&D charge for 2003 resulted from our acquisition of CommWorks and three smaller acquisitions: RollingStreams, Xebeo and Shanghai Yi Yun Telecom Technology Co. Ltd., which accounted for $1.3 million, $6.2 million, $1.9 million and $1.3 million, respectively, and were based on independent valuations. The charge for 2002 arose from our acquisition of Issanni Communications, Inc. on April 19, 2002 and was based on an independent valuation.
Amortization of intangible assets
Fiscal 2004 vs. 2003
Amortization of intangible assets increased by $7.2 million in 2004 primarily due to the addition of $68.6 million of intangible assets recorded upon our acquisitions of selected assets of ACC and TELOS in 2004. Estimated amortization expenses for the next five years, beginning with the year ended December 31, 2005, are $23.1 million, $18.9 million, $16.0 million, $12.7 million, and $6.9 million, respectively.
Fiscal 2003 vs. 2002
The increase in amortization of intangible assets was primarily due to an additional $44.9 million of intangibles recorded upon our acquisition of CommWorks in May 2003. The estimated useful lives of these purchased intangibles range from one to ten years.
Interest income (expense), net
Fiscal 2004 vs. 2003
Interest income was $6.2 million in 2004 compared to interest income of $3.2 million in 2003. Interest income increased due to higher average cash balances in 2004 compared to 2003 primarily due to cash generated from financing activities.
Interest expense was $6.9 million in 2004 compared to $4.7 million in 2003. The increase of $2.2 million in interest expense was in part attributable to the interest associated with our convertible debt issued in March 2003, which accrues at a rate of approximately $1.4 million per quarter. In addition, in 2004 we incurred interest expense relating to short-term borrowings in China. These increases in interest expense were offset by an increase in capitalized interest of approximately $0.8 million relating to the construction of our new manufacturing facility in Hangzhou, China.
Fiscal 2003 vs. 2002
Interest income was $3.2 million in 2003 compared to interest income of $5.5 million in 2002. Interest income decreased due to lower average cash and short-term investment balances of $319.2 million in 2003 compared to $372.5 million in 2002, as well as due to a reduction in interest rates on deposits.
Interest expense was $4.7 million in 2003 compared to $1.3 million in 2002. The increase of $3.4 million in interest expense was primarily attributable to the interest associated with our convertible debt issued in March 2003. We capitalized $0.6 million of interest in 2003.
Other income (expense), net
Fiscal 2004 vs. 2003
Net other income was $15.4 million in 2004, compared to $4.9 million in 2003. Net other income in 2004 primarily consisted of $10.3 million in financial subsidies received from the local Chinese government
during the first two quarters of 2004. We do not expect to receive any additional financial subsidies or payments in the near future. These subsidies were to encourage our investment in local research and development and manufacturing activities. Net other income also included Japanese consumption tax refunds of approximately $5.3 million and net investment gains and dividends of approximately $0.9 million offset by foreign exchange losses of approximately $0.7 million.
Fiscal 2003 vs. 2002
Net other income was $4.9 million in 2003, compared to net other expense of $9.9 million in 2002. Net other income in 2003 primarily consisted of a reinvestment incentive payment received in China of $3.9 million, an incentives payment for exports and value added taxes in China of $6.1 million, government incentives related to our operations in Japan of $6.2 million, offset by foreign exchange losses of approximately $8.7 million and expenses attributable to selling or transferring of notes receivable of $2.3 million.
Equity in net loss of affiliated companies
Fiscal 2004 vs. 2003
Consolidated equity in net loss of affiliated companies was $1.3 million in 2004 compared to $5.3 million in 2003. The equity loss for 2004 primarily consisted of our share of losses relating to our joint venture with Matsushita Communications Industrial Co., Ltd. and Matsushita Electric Industrial Co., Ltd. to jointly develop, manufacture and sell telecommunications products. We have a 49% ownership interest in the joint venture. The equity losses for fiscal 2003 were related to losses from the same joint venture.
Consolidated equity in net loss of affiliated companies was $5.3 million in 2003 and $4.1 million in 2002. The equity loss for 2003 primarily consisted of our share of losses relating to our joint venture with Matsushita Communications Industrial Co., Ltd. and Matsushita Electric Industrial Co., Ltd. The equity loss for 2002 was related to losses relating to our interests in investment funds and to our share of losses generated by GUTS prior to our acquisition of the remaining 49% ownership interest in this entity.
Income tax benefit (expense)
Fiscal 2004 vs. 2003
We recorded an income tax benefit of $9.8 million in 2004 and an expense of $45.4 million in 2003. We have a negative 15% effective income tax rate for 2004. There are three principal reasons for the negative income tax rate for 2004.
The first reason relates to the mix in income or loss between income tax jurisdictions. In the United States (a 35% tax jurisdiction), we incurred a loss of $19.7 million before taxes. Therefore, we recorded a tax benefit of approximately $6.9 million related to our 2004 domestic losses. In international jurisdictions, we recognized approximately $83.0 million of income in 2004. However, our net statutory tax rate for our international locations, principally China, was substantially lower than the 35% U.S. statutory rate.
Secondly, the Company experienced a significant tax benefit resulting from the increase in the tax rate applied to the temporary differences within our China companies. In 2003, the Company recorded most deferred tax assets for the China jurisdiction at a 15% rate based upon our location within a high tech zone. When we moved into our new facility in China in the fourth quarter of 2004, we no longer qualified for the lower rate and consequently, the rate applied to our deferred tax assets and liabilities increased to 24%. The resulting benefit from the higher rate applied to our deferred tax assets is $19.6 million. We are currently re-applying for the high tech zone certification. However, there can be no assurance that we
will receive the certification. If we were to receive the approval and our 15% tax rate were to be re-instated, the tax benefit would be reversed.
The third reason for the income tax benefit was the utilization of tax credits, primarily within the United States. This resulted in a reduction in the effective income tax rate by approximately 9%.
Income tax expense was $45.4 million in 2003 and $27.3 million in 2002. The primary reason for the increase in income tax expense was that our income increased 91% in 2003 from 2002. Our effective tax rate was 17% in 2003 compared to 20% in 2002.
Minority interest in (losses) earnings of consolidated subsidiaries
Fiscal 2004 vs. 2003
Minority interest in losses of consolidated subsidiaries was ($0.3) million in 2004 and ($1.0) million in 2003. Minority interest in the losses of our consolidated subsidiaries represents the minority interest in losses of MDC Holding Limited (MDC Holding) and its affiliated entities (MDC Holding and such affiliated entities are referred to, collectively, as MDC), a variable interest entity consolidated in accordance with Financial Accounting Standards Board (FASB) Interpretation 46, net of the 10% share of earnings of our Chongqing manufacturing joint venture UTStarcom Co., Ltd. (CUTS) attributable to our joint venture partner.
Fiscal 2003 vs. 2002
Minority interest in (losses) earnings of consolidated subsidiaries was ($1.0) million in 2003 and $1.2 million in 2002. The change was due primarily to the minority interest in losses in 2003 of MDC, a variable interest entity included in our consolidated financials in the fourth quarter of 2003, and to the acquisition of the remaining 12% ownership interest in our Zhejiang manufacturing joint venture, UTStarcom Telecom Co., Ltd. (HUTS) during 2002. Minority interest in losses of consolidated subsidiaries for 2003 represented the minority interest in losses of MDC, net of the 10% share of earnings of CUTS attributable to our joint venture partner. Minority interest in earnings of consolidated subsidiaries for 2002 represented the share of earnings in HUTS attributable to our joint venture partner, prior to our acquisition of the remaining 12% ownership interest in HUTS in May 2002. HUTS is now a wholly-owned subsidiary.
We recognized revenue of $143.7 million, $184.4 million, and $123.0 million during the years ended December 31, 2004, 2003, and 2002, respectively, with respect to sales of telecommunications equipment to Softbank BB Corporation (SBBC), an affiliate of SOFTBANK CORP. and SOFTBANK America Inc., a significant stockholder of the Company. SBBC offers asynchronous digital subscriber line (ADSL) coverage throughout Japan, which is marketed under the name YAHOO! BB. In addition, we support SBBCs new fiber-to-the-home service through sales of its carrier class Gigabit Ethernet Passive Optical Network (GEPON) product as well as its multi-service optical transport product (NetRing). Revenue recognized for the GEPON and NetRing products for the twelve months ended December 31, 2004 was $93.4 million. Both the GEPON and NetRing contracts were obtained through a form of auction. Included in accounts receivable at December 31, 2004 and 2003, were $86.8 million and $43.9 million, respectively, related to these contracts.
During 2000, we invested $10.0 million in Softbank China, an investment fund established by SOFTBANK CORP. focused on investments in Internet companies in China. This investment permits us to participate in the anticipated growth of Internet-related businesses in China. Our investment constitutes 10% of the funding for Softbank China, with SOFTBANK CORP. contributing the remaining 90%. The fund has a separate management team, and none of our employees are employed by the fund. Many of the funds investments are and will be in privately held companies, many of which are still in the start-up or development stages. These investments are inherently risky as the market for the technologies or products the companies have under development are typically in the early stages and may never materialize. We account for this investment under the cost method and recorded insignificant losses in 2004 and losses of $0.2 million, and $2.8 million due to an other-than-temporary decline in the carrying value of this investment in 2003, and 2002, respectively. The balance in this investment was $5.3 million at December 31, 2004.
During the first quarter of fiscal 2002, we invested $2.0 million in Restructuring Fund No. 1, a venture capital investment limited partnership established by SOFTBANK INVESTMENT CORP., an affiliate of SOFTBANK CORP. The fund focuses on leveraged buyout investments in companies in Asia undergoing restructuring or bankruptcy proceedings. The total fund offering is expected to be between approximately $150.0 million and $226.0 million, with each investor contributing a minimum of $0.8 million. The fund has a separate management team, and none of our employees are employed by the fund. We account for this investment under the equity method of accounting. We recorded immaterial equity losses during the years ended December 31, 2004 and 2003. The balance in this investment was $1.8 million at December 31, 2004.
On August 29, 2002, we completed the repurchase of 6.0 million shares of our common stock for $72.9 million from SOFTBANK America Inc.
On April 5, 2003, we repurchased 8.0 million shares of our common stock beneficially owned by SOFTBANK America Inc., at a purchase price of $17.385 per share. The total cost of the repurchase was $139.6 million, including transaction fees. In connection with this repurchase transaction, SOFTBANK America Inc. entered into an agreement with us not to offer, sell or otherwise dispose of our common stock for a period of one year, subject to a number of exceptions. As of December 31, 2004 and 2003, SOFTBANK America Inc. beneficially owned approximately 12.8% and 14.1% respectively, of our outstanding stock.
On July 17, 2003, we entered into a Mezzanine Loan Agreement with BB Modem Rental PLC (BB Modem), an affiliate of SOFTBANK CORP. Under the terms of the agreement, we loaned BB Modem $10.1 million, for the purpose of investing in a portfolio of ADSL modems and associated modem rental agreements, from SOFTBANK BB CORP., formerly BB Technologies, an affiliate of SOFTBANK CORP. SOFTBANK BB CORP. will continue to service such modems and modem rental agreements. Our loan is subordinated to certain senior lenders of BB Modem, and repayments are payable to us over a 42-month period through January 31, 2007, with a substantial portion of the principal amount of the loan schedule to be repaid during the last 16 months of this period. Our recourse for nonpayment of the loan is limited to the assets of BB Modem, the account into which subscriber payments are made and its rights under the securitization transaction documents. The value of BB Modems modems that serve as collateral for the loan may decrease over time and may not be sufficient upon sale to pay the outstanding amounts on the loans. We assess the loan for impairment whenever events or changes in circumstances indicate that the carrying amount may not be recoverable. We periodically review the underlying quality of the asset pool securing the loan to assess whether impairment has incurred and needs to be recorded. We recorded $1.3 million and $0.5 million in interest income in respect to this loan in 2004, and 2003, respectively. The loan receivable at December 31, 2004 and 2003, were approximately $11.8 million and $11.2 million respectively.
During August 2004, we entered into several agreements with Japan Telecom Co., Ltd (JT), a wholly owned subsidiary of SOFTBANK Corp., related to the sale of telecommunication equipment and promotional services. The nature of these agreements contemplate the sale of iAN-8000 equipment with specified value and delivery dates, as well as an oral agreement, which subsequently converted into specific service contracts to manage a sales promotional program for JT. We have determined that the service activities revenue should be recorded net of expected promotional spending. Because we have not provided these activities in the past and cannot estimate the fair value of these services, we have determined under guidance of SAB 104, that all revenue related to these agreements will be deferred and included in customer advance until the above-mentioned promotional activities are complete. We delivered the majority of the equipment during the third and fourth quarters of 2004.
The promotional services discussed above involve contracting with third party promotional vendors, who in turn, facilitate the marketing and subscriber recruitment for the JT fiber-to-the-home program. During the fourth quarter of 2004, we determined that we would end our involvement with the JT promotional program after completion of the contract discussed above. Accordingly, late in the fourth quarter of 2004 and the end of the first quarter of 2005, we have either cancelled or assigned to another party, all third party contracts with promotional vendors related to the JT contract. We now expect to satisfy all equipment and promotional obligations by the end of the first quarter of 2005.
The terms of these agreements specify that JT was to remit 50 percent of the contract value in cash to us within one month of the execution of the contract, which was August 20, 2004. The remaining 50 percent is due shortly after delivery of the equipment. As of December 31, 2004, approximately 73% of the total expected cash had been received. All cash received from JT in advance of revenue recognition has been accounted for as a customer advance. As we spend cash for promotional activities, such spending is accounted for as a reduction of customer advance. As of December 31, 2004, there was $217.5 million included in customer advance related to these agreements.
We also entered into an agreement during the third quarter in 2004 with JT to supply chassis equipment with an approximate value of $75 million. Although some of the equipment was shipped to the customer during the third quarter, it is considered linked to the iAN-8000 sale noted above and as such, the revenue from this contract will be deferred until the completion of the above-mentioned promotional activities.
In September 2001, we invested $2.0 million in Cellon International Holdings Corporation (Cellon). Cellon designs wireless terminals and related technology for handset manufacturers and private distributors. We invested an additional $3.0 million each in April and December 2002. As of December 31, 2004, we had a 9% ownership interest in Cellon. In October 2002, we entered into a license and a royalty agreement with Cellon International Holding Corporation (Cellon). We paid $0.8 million to license certain technology for the development of certain handset products in China. Per the terms of the royalty agreement, we are required to pay Cellon $3 per unit shipped for a minimum of 0.1 million units. This agreement is not material to the overall financial results of Cellon.
In September 2002, we invested $2.0 million in Fiberxon Inc. (Fiberxon), a company that develops and sells optical modules and related systems. In March 2004, we invested an additional $1.0 million in Fiberxon. We have an outstanding purchase commitment with Fiberxon, in which we have an 11% ownership interest, to purchase component parts for optical networking products. In addition, we provided a letter of credit for $5.0 million to purchase raw materials for the manufacture of these component parts. This commitment should be fulfilled without adverse consequences material to our operations or financial
condition. Purchases from Fiberxon totaled $15.1 million in 2004 and we had $13.3 million in accounts payable to Fiberxon at December 31, 2004.
We recognized revenue of $1.0 million for the year ending December 31, 2004 with MELCO, an affiliated member of Mitsubishi, which is an insignificant shareholder of the Company. We have purchased from Mitsubishi components associated with base station units used to produce our PAS products totaling approximately $97.4 million in 2004, $363.1 million in 2003, and $157.2 million in 2002. In addition we had $6.4 million in accounts payable to Mitsubishi at December 31, 2004 and $12.7 million at December 31, 2003.
Starcom Products, Inc.
We obtain engineering consulting and employee placement services from Starcom Products, Inc. (Starcom), which is 31% owned by an individual related to a member of our Board of Directors. We paid to Starcom $1.1 million in 2004, $1.4 million in 2003, and $0.7 million in 2002 for engineering consulting and employee placement services provided by Starcom.
During 2004, we continued to expand our focus on markets and operations outside of China. Effective with the fourth quarter of 2004, it was determined that our chief operating decision makers, in accordance with SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information, were evaluating performance, making operating decisions and allocating resources based on two operating segments, i) China and ii) all other regions referred to as International (International).
On November 1, 2004, we acquired selected assets of ACC, the wireless handset division of Audiovox Corporation. The acquired business has been integrated into the Company as a separate and distinct operating division referred to as the Personal Communications Division. As we determined to evaluate performance and allocate resources to this division, it was considered a third operating segment.
As a result, as of December 31, 2004, we were organized in three operating segments, China, International and PCD, and each segment consisted of one reporting unit. For the year ended December 31, 2003 and for the first three quarters of 2004, we managed our business as a single reportable segment.
We evaluate operating performance of and allocate resources to the operating segments based on segment gross profit. Certain corporate headquarters expenses are not allocated but rather are included in the International segment. In addition, none of the non-operating items are allocated to a segment.
The following table sets forth certain financial information for each of our operating segments described above:
(1) Adjustments reflect elimination of inter-segment transactions and investments in subsidiaries.
Effective in the first quarter of 2005, we realigned our business into four units, namely Broadband Infrastructure, Wireless Infrastructure, Terminal Products (which will be reported as Handsets and PCD), and Global Service Solutions. Each unit will represent its own reporting segment, with the exception of Terminal Products, which will consist of two reporting segments.
Fiscal 2004 vs. 2003
Revenues from external customers in the China segment increased from $1.7 billion in 2003 to $2.1 billion in 2004. For most of 2004, we continued to benefit from the increased demand due to the expansion of wireless infrastructure in China. Revenues from external customers in the International segment increased slightly from 2003 to 2004. Revenues from external customers in the PCD segment increased by $277.4 million in 2004, due to the acquisition of ACC and the creation of the PCD segment in 2004.
Gross profit percentage declined by 10% due to several factors. The International segment experienced the largest drop in gross profit declining from 58% for 2003 to 34% for 2004. Most of this decrease was driven by the decline in our broadband product, which experienced a shift in product mix from our more traditional DSLAM product to newer optical broadband products. We typically experience lower margins in the early stages of a product life cycle. In addition, the gross profit percentage recognized on handset sales made through the PCD business is approximately 4% which is significantly lower than that realized on handset sales related to our PAS systems. PCD was acquired in November 2004 and contributed $11.9 million in gross profit. The China segment also experienced a 4% decline in gross margin percentage primarily attributable to our handset products, which have experienced increased competitive market pricing pressure. In addition, our gross profit was negatively impacted by a $39.0 million increase in our provision for inventory reserves.
Fiscal 2003 vs. 2002
Revenues from external customers in the China segment increased from $822.3 million in 2002 to $1,680.8 million in 2003 is attributable to the increased demand of our products resulting from the strong growth in the China telecommunication market. Revenues from external customers in the International segment increased from $159.5 million in 2002 to $284.4 million in 2003 and can primarily be attributed to sales growth in Japan.
Gross profit from the China segment increased from $301.8 million in 2002 to $460.4 million in 2003. The increased sales contributed to the increase in gross profit. Gross profit from the International segment increased from $43.7 million in 2002 to $164.0 million in 2003.
Net cash used in operating activities for the year ended December 31, 2004 was $95.0 million. Operating cash was affected by changes in accounts receivable, inventory and customer advances offset by changes in accounts payable and deferred costs/inventories at customer sites under contract.
The $455.9 million increase in accounts receivable was attributable to increased sales, and longer collection periods experienced during 2004. The increase in accounts receivable was, in part, due to the addition of ACC sales revenue. Approximately 14.4% of the accounts receivable balance outstanding at December 31, 2004 was attributable to PCD. Inventory increased by $197.6 million in 2004 and includes $156.0 million of inventory for PCD. Customer advances decreased by $134.2 million for the year ended December 31, 2004. Customer advances represent cash deposits we have received from our customers for orders that have not yet received final acceptance. Upon receipt of final acceptances, customer advance is reduced and revenue and cost of sales is recorded. The reduction of customer advances and deferred costs for inventory at customer sites in 2004 is largely a result of our customers in China transitioning from new system installations to system expansions, which generally requires a shorter period between customer advance and acceptance. Our working capital of $1.1 billion increased in proportion to the growth of our business in addition to the $175.0 million increase associated with our acquisition of ACC.
Offsetting the activity that decreased operating cash for the period were net income and non-cash charges including a $12.7 million provision for asset impairment and write-downs, $76.2 million in depreciation and amortization, a $39.0 million inventory provision, and a $21.3 million provision for doubtful accounts. Accounts payable increased by $98.3 million, consistent with increased inventory purchasing. Inventories at customer sites under contracts awaiting final acceptance are classified as deferred costs, separate from what was historically considered inventory. The title and risk of loss of this inventory is transferred to the customer. Revenue and costs of sales are recorded when final acceptance is received from the customer. Deferred costs/Inventories at customer sites under contracts decreased by $299.9 million from December 31, 2003 to December 31, 2004. The decrease in deferred costs resulted from a greater number of customer acceptances, corresponding to the decrease in customer advances.
Net cash provided by operating activities for the year ended December 31, 2003 was $45.2 million. Operating cash was affected by changes in accounts receivable, inventory, accounts payable, other assets and offset by changes in deferred revenue. The $151.9 million increase in our accounts receivable balance, attributable to a 100% increase in sales in 2003, reduced our net cash provided by operations. In 2003, we sold $298.8 million of our notes receivable with associated expenses of $2.3 million. Cash provided by operating activities was also reduced by an $81.6 million and $301.1 million increase in inventory and
deferred costs, respectively. Operating cash also decreased due to a $5.9 million decrease in accounts payable. The decrease in operating cash in 2003 was offset by an increase in customer advances and deferred revenue of $294.2 million and $27.4 million, respectively. We collected approximately $2.5 billion in cash from our customers in 2003.
Net cash provided by operating activities in fiscal 2002 was $178.6 million. Net cash provided by operations was mainly due to a $170.5 million and $87.8 million increase in accounts payable and customer advances, respectively, offset by increases in inventories, deferred costs, accounts receivable and other assets of $76.1 million, $137.8 million, $34.2 million and $24.6 million, respectively.
Net cash used in investing activities was $468.0 million for the year ended December 31, 2004. The most significant components of our investing activities are business acquisitions, additions to property, plant and equipment and the net investment in short-term securities. Cash used for business acquisitions totaled $217.8 million during 2004, including approximately $178.3 million for selected assets of ACC; $30.0 million for substantially all assets and liabilities of TELOS, and $9.1 million for HSI. Cash used for the purchase of property, plant and equipment, including $57.1 million for the construction of our Hangzhou facility, totaled $135.6 million. Net cash used for the purchase of short-term investments was $82.8 million.
Net cash used in investing activities was $176.5 million for the year ended December 31, 2003. This change was mainly due to $123.2 million of property, plant and equipment purchases, $106.7 million of business acquisitions and offset by $69.6 million of net proceeds from the sale of short-term investments.
Net cash used in investing activities in fiscal 2002 was $165.4 million. This was mainly due to $75.3 million of property, plant and equipment purchases, $17.7 million of business acquisitions, primarily attributable to our purchase of the remaining interest in HUTS and $28.9 million of investments in affiliates, which primarily comprised investments in public and private technology companies, offset by $22.4 million of net purchases of short-term investments.
Net cash provided by financing activities was $742.7 million for the year ended December 31, 2004. This was primarily due to proceeds raised from the sale of 12.1 million shares of common stock at $39.25 per share to Banc of America Securities, LLC, in January 2004 for net proceeds of approximately $474.6 million. In addition, we incurred net borrowing of $350.0 million during the year from existing lines of credit in China to fund our operations needs in China. We also received $25.7 million for the issuance of common stock through stock option and warrant exercises. Offsetting cash provided by financing activities, during the first and second quarter of 2004, we used a portion of the capital raised to repurchase a total of 3.6 million shares of our common stock at an average price of $30.25 per share for a total cost of $107.6 million, including transaction fees.
Net cash provided by financing activities was $275.3 million for the year ended December 31, 2003. This was primarily due to the $58.9 million in proceeds from the issuance of common stock through ESPP and stock option exercises, and $399.6 million proceeds from net borrowing, and offset by the repurchase of our shares and related transaction costs of $139.6 million and the purchase of a convertible bond hedge and a call option totaling $43.8 million.
Net cash used in financing activities in fiscal 2002 was $102.4 million. This was primarily due to the repurchase of our shares and related transaction costs of $72.9 million and net payments of $70.5 million on borrowings under our lines of credit. This was offset by $40.9 million in proceeds from the underwritten sale of common stock at the same time SOFTBANK America, Inc. sold 10.0 million shares of our common stock through an underwriter and the issuance of common stock through stock option exercises.
Our working capital was $1,117.5 million and $883.3 million at December 31, 2004 and 2003, respectively. This increase in working capital is due to increased cash on hand. Cash on hand increased from $377.7 million in cash and cash equivalents and $48.6 million of short-term investments, in 2003 to $562.5 million in cash and cash equivalents and $136.3 million of short-term investments in 2004. Our working capital also increased due to larger accounts receivable and inventory balances, which were offset by increases in accounts payable and notes payable balances.
We believe that our existing credit facilities and cash and cash equivalents, short-term investments and cash from operations will be sufficient to finance our operations through at least the next 12 months. As of December 31, 2004, we had cash, short-term restricted cash and investments of $732.2 million. We also had credit facilities, excluding the $8.2 million bank loan resulting from the consolidation of MDC, totaling $780.4 million of which $388.0 million remained available for future borrowings. Of the $388.0 million available credit facilities, $380.8 million expires in 2005 and $7.2 million expires in 2010. We are proceeding with the extension or renewal of these credit facilities, however, such renewal is not certain. Interest rates for borrowings under these credit facilities range from approximately 2.58% to 6.21%. We have not guaranteed any debt that is not included in the consolidated balance sheet.
Of our total cash and short-term investment balance, $342.6 million is held in China where currency exchange controls exist. As a result, our ability to make payments in other jurisdictions could be limited by our ability to transfer money from China to other jurisdictions.
In the event that our current cash balances, future cash flows from operations and current credit facilities are not sufficient to meet our obligations or strategic needs or in the event that market conditions are favorable, we would consider raising additional funds in the capital or equity markets. Due to the delinquent filing of our Annual Report on Form 10-K for the year ended December 31, 2004, we are not eligible to register equity securities using Form S-3, which could have an impact on our ability to raise additional funds. If additional financing is needed, there can be no assurance that such financing will be available to us on commercially reasonable terms, or at all. In addition, the delayed filing has resulted in a technical default of the Companys 7¤8% Convertible Subordinated Notes due in 2008. Upon filing of this Form 10-K, the technical default will be cured.
Certain subsidiaries and joint ventures located in China enjoy tax benefits in China which are generally available to foreign investment enterprises, including full exemption from national enterprise
income tax for two years starting from the first profit-making year and/or a 50% reduction in national income tax rate for the following three years. In addition, local enterprise income tax is often waived or reduced during this tax holiday/incentive period. Under current regulations in China, foreign investment enterprises that have been accredited as technologically advanced enterprises are entitled to additional tax incentives. These tax incentives vary in different locales and could include preferential national enterprise income tax treatment at 50% of the usual rates for different periods of time. The tax holidays discussed above are applicable or potentially applicable to CUTS, HUTS, Hangzhou UTStarcom Telecom Co., Ltd. (HSTC) and UTStarcom China Co., Ltd. (UTSC), our active subsidiaries in China, as those entities may qualify as accredited technologically advanced enterprises. HSTC and CUTS were exempt from income tax for the year ended December 31, 2004.
We are currently in the process of applying for a Knowledge Intensive, Technology Intensive Certificate (Certificate) for our new Hangzhou manufacturing facility. If we are not granted the Certificate, HUTS will continue to be subject to a 24% tax rate and, HSTC and CUTS will then be subject to a 12% tax rate for the year ending December 31, 2005. If we are granted the Certificate, HUTS will then be subject to a 15% tax rate. In addition, HSTC and CUTS will be subject to a 7.5% tax rate, which will expire on December 31, 2007.
UTSC currently enjoys a 10% holiday tax rate that expires on December 31, 2005, at which point it will be subject to a 15% tax rate provided they remain as an advanced and high-tech enterprise and the Government does not change the tax laws.
We are working to implement a research and development cost sharing arrangement among our key worldwide entities. The purpose of cost sharing is to enable its participants to jointly develop and own intangibles. Under research and development cost sharing, the total research and development expense is paid by cost-sharing participants in proportion to each participants future sales. The benefit is that there is greater certainty with respect to transfer pricing and defined ownership of IP. Cost sharing in China is a new concept and we are working closely with the China Tax and Regulatory Authorities to gain approval for cost sharing.
Under the definition contained in Item 303(a)(4)(iii) of Regulation S-K, we do not have any off balance sheet arrangements.
Contractual obligations and other commercial commitments
Our obligations under contractual obligations and commercial commitments are primarily with regard to leasing arrangements and standby letters of credit and are as follows:
Certain sales contracts include provisions under which customers would be indemnified by us in the event of, among other things, a third-party claim against the customer for intellectual property rights infringement related to our products. There are no limitations on the maximum potential future payments under these guarantees. We have not accrued any amounts in relation to these provisions as no such claims have been made and we believe we have valid enforceable rights to the intellectual property embedded in our products.
Occasionally, we issue short-term notes payable to our vendors in lieu of trade accounts payable. The payment terms are normally three to nine months and are typically non-interest bearing.
At December 31, 2004, we had loans with various banks totaling $350.0 million with interest rates ranging from 2.58% to 6.21% per annum. These bank loans mature during 2005 and are included in short-term debt.
The Company has a bank loan in connection with an equipment purchase resulting from the consolidation of MDC. On January 10, 2003, a third party established a bank loan with Shanghai Pudong Development Bank for the purchase of the equipment. The obligations of the bank loan and related equipment were assumed by the Company on January 23, 2003, and were subsequently transferred to MDC on January 31, 2003. The bank loan of $8.2 million bears interest at a rate of 4.94% per annum, and expires on January 10, 2006. The Company does not serve as legal obligor for the loan.
Our $402.5 million of convertible subordinated notes, due March 1, 2008, bear interest at a rate of 7¤8% per annum, payable semiannually on May 1 and September 1, are convertible into our common stock at a conversion price of $23.79 per share and are subordinated to all present and future senior debt of the Company. The principal is due only at maturity of the notes.
We lease certain facilities under non-cancelable operating leases that expire at various dates through 2023.
We issue standby letters of credit primarily to support international sales activities outside of China. When we submit a bid for a sale, often the potential customer will require that we issue a bid bond or a standby letter of credit to demonstrate our commitment through the bid process. In addition, we may be required to issue standby letters of credit as guarantees for advance customer payments upon contract signing or performance guarantees. The standby letters of credit usually expire six to nine months from date of issuance without being drawn by the beneficiary thereof.
We are obligated to purchase raw materials and work-in-process inventory under various orders from our suppliers, all of which are expected to be fulfilled, with no adverse consequences material to our operations or financial condition. As of December 31, 2004, total open commitments under these purchase orders were approximately $578.3 million.
We have entered into various earnout agreements related to certain acquisitions, which are subject to the completion of performance milestones. See Note 5 to the Consolidated Financial Statements.
Accounts receivable transferred to notes receivable
We accept commercial notes receivable from our customers in China in the normal course of business. The notes are typically non-interest bearing, with maturity dates between three and six months. Notes receivable available for sale were $27.0 million and $11.4 million at December 31, 2004 and December 31, 2003, respectively. We may discount these notes with banking institutions in China. A sale of these notes is reflected as a reduction of notes receivable and the proceeds of the settlement of these notes are included in cash flows from operating activities in the consolidated statement of cash flows. There were no notes receivable sold during the year ended December 31, 2004 and there were $298.8 million of notes receivable sold during the year ended December 31, 2003. Any notes that have been sold are not included in our consolidated balance sheets as the criteria for sale treatment established by Statement of Financial Accounting Standards No. 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities, (SFAS 140) has been met. The costs of settling or transferring these notes receivable were $2.3 million for the years ended December 31, 2003, and were included in other income (expense), net in the consolidated statements of operations.
As of December 31, 2004, we had invested a total of $2.0 million in Global Asia Partners L.P. that is recorded as a long-term investment. The fund size is anticipated to be $100 million and the fund was formed to make private equity investments in private or pre-IPO technology and telecommunications companies in Asia. We have a commitment to invest up to a maximum of $5.0 million. The remaining amount is due at such times and in such amounts as shall be specified in one or more future capital calls to be issued by the general partner.
Pursuant to the joint venture agreement with Matsushita Communications Industrial Co., Ltd. and Matsushita Electric Industrial Co., Ltd., we are jointly liable for the losses incurred in the operations of the joint venture up to the maximum of our investment in the entity. At December 31, 2004, and 2003, we recorded losses of $1.3 million and $4.8 million, respectively. In the fourth quarter of 2004, we made an additional capital contribution of $9.3 million.
Certain sales contracts include provisions under which customers would be indemnified by us in the event of, among other things, a third-party claim against the customer for intellectual property rights infringement related to our products. There are no limitations on the maximum potential future payments under these guarantees. We have not accrued any amounts in relation to these provisions as no such claims have been made and we believe we have valid enforceable rights to the intellectual property embedded in our products.
Our financial condition and results of operations are based on certain critical accounting policies and estimates, which include judgments, estimates, and assumptions on the part of management. Estimates are based on historical experience, knowledge of economic and market factors and various other assumptions that management believes to be reasonable under the circumstances. Actual results may differ from those estimates. The following summary of critical accounting policies and estimates highlights those areas of significant judgment in the application of our accounting policies that affect our financial condition and results of operations.
Revenues from sales of telecommunications equipment and handsets are recognized when persuasive evidence of an arrangement exists, delivery of the product has occurred, customer acceptance has been obtained, the fee is fixed or determinable and collectability is reasonably assured. If the payment due from the customer is not fixed or determinable due to extended payment terms, revenue is recognized as payments become due from the customer, assuming all other criteria for revenue recognition are met. Any payments received prior to revenue recognition are recorded as customer advances. Normal payment terms differ for various reasons amongst different customer regions, depending upon common business practices for customers within a region. Shipping and handling costs are recorded as revenues and costs of revenues. Any expected losses on contracts are recognized when identified.
Sales may be generated from complex contractual arrangements that require significant revenue recognition judgments, particularly in the areas of multiple element arrangements. Where multiple elements exist in an arrangement, the arrangement fee is allocated to the different elements based upon verifiable objective evidence of the fair value of the elements, as governed under Emerging Issues Task Force Issue (EITF) No. 00-21, and SAB 104. Multiple element arrangements primarily involve the sale of PAS, a family of wireless access handsets, wireless consumer products and core infrastructure equipment or Internet Protocol-based PAS (iPAS), wireless access systems that employ micro cell radio technology and specialized handsets, allowing service providers to offer subscribers both mobile and fixed access to telephone services. These multiple element arrangements include the sale of PAS or iPAS equipment with handsets, installation and training and the provision of such equipment to different locations for the same customer. Revenue is recognized as each element is earned, namely upon installation and acceptance of equipment or delivery of handsets, provided that the fair value of the undelivered element(s) has been determined, the delivered element(s) has stand-alone value, there is no
right of return on delivered element, and we are in control of the undelivered element(s). For arrangements that include service elements, including promotional support and installation, for which verifiable objective evidence of fair value does not exist, revenue is deferred until such services are deemed complete.
Final acceptance is required for revenue recognition when installation services are not considered perfunctory. Final acceptance indicates that the customer has fully accepted delivery of equipment and we are entitled to the full payment. We will not recognize revenue before final acceptance is granted by the customer if acceptance is considered substantive to the transaction. Additionally, we do not recognize revenue when cash payments are received from customers for transactions that do not have the customers final acceptance. We record these cash receipts as customer advances, and defer revenue recognition until final acceptance is received.
Where multiple elements exist in an arrangement that includes software, and the software is considered more than incidental to the equipment or services in the arrangement, software and software related elements are recognized under the provisions of Statement of Position 97-2, as amended, and EITF No. 03-05. We allocate revenues to each element of software arrangements based on vendor specific objective evidence (VSOE). VSOE of each element is based on the price charged when the same element is sold separately. We use the residual method to recognize revenue when an arrangement includes one or more elements to be delivered at a future date and VSOE of the fair value of all the undelivered elements exists. Under the residual method, the fair value of the undelivered elements is deferred and the remaining portion of the arrangement fee is recognized as revenue. If evidence of fair value of one or more undelivered elements does not exist, revenue is deferred and recognized when delivery of those elements occurs or when fair value can be established.
We recognize revenue for system integration, installation and training upon completion of performance and if all other revenue recognition criteria are met. Other service revenue, such as that related to maintenance and support contracts, is recognized ratably over the contract term. Revenues from services were less than 10% of revenues for all years.
We also sell products through resellers. Revenue is generally recognized when the standard price protection period, which ranges from 30 to 90 days, has lapsed. If collectability cannot be reasonably assured in a reseller arrangement, revenue is recognized upon sell-through to the end customer and receipt of cash. There may be additional obligations in reseller arrangements such as inventory rotation, or stock exchange rights on the product. As such, revenue is recognized in accordance with Statement of Financial Accounting Standards No. 48, Revenue Recognition When Right of Return Exists, (SFAS 48). We have developed reasonable estimates for stock exchanges. Estimates are derived based on historical experience with similar types of sales of similar products.
We have sales agreements with certain wireless customers that provide for a rebate of the selling price to such customers if the particular product is subsequently sold at a lower price to such customers or to a different customer. The rebate period extends for a relatively short period of time. Historically, the amounts of such rebates paid to customers have not been material. We estimate the amount of the rebate based upon the terms of each individual arrangement, historical experience and future expectations of price reductions, and we record our estimate of the rebate amount at the time of the sale. We also enter into sales incentive programs, such as co-marketing arrangements, with certain wireless and handset customers. We record the incurred costs related to the incentive as a reduction of revenue when the sales revenue is recognized.
The assessment of collectability is also a factor in determining whether revenue should be recognized. We assess collectability based on a number of factors, including payment history and the credit worthiness of the customer. We do not request collateral from our customers. In international sales, we often require letters of credit from our customers that can be drawn on demand if the customer defaults on its payment.
If we determine that collection of a payment is not reasonably assured, we recognize revenue at the time collection becomes reasonably assured, which is generally upon receipt of cash. Occasionally, we enter into revenue sharing arrangements. Under these arrangements, we collect revenues only after our customer, the telecommunications service provider, collects service revenues. When we enter a revenue sharing arrangement, we do not recognize revenue until collection is reasonably assured.
Because of the nature of doing business in China and other emerging markets, our billings and/or customer payments may not correlate with the contractual payment terms and we generally do not enforce contractual payment terms prior to final acceptance. Accordingly, accounts receivable are not booked until we recognize the related customer revenue. Advances from customers are recognized when we have collected cash from the customer, prior to recognizing revenue. Deferred revenue is recorded if there are undelivered elements after final acceptance has been obtained.
We provide a warranty on our equipment and handset sales for a period generally ranging from one to three years from the time of final acceptance. Very rarely, we have entered into arrangements to provide limited warranty services for periods longer than three years. The longest such warranty period is ten years. We provide for the expected cost of product warranties at the time that revenue is recognized based on an assessment of past warranty experience.
Variable Interest Entities
The Financial Accounting Standards Board, (FASB) issued FASB Interpretation No. 46, (FIN 46). FIN 46 requires that if an entity is the primary beneficiary of a variable interest entity, (VIE), the assets, liabilities, and results of operations of the VIE should be included in the consolidated financial statements of the entity. We have adopted FIN 46 in the quarter ended December 31, 2003, and consolidated a related party deemed a VIE and for whom we are the primary beneficiary.
We accept bank notes and commercial notes from our customers in China in the normal course of business and estimate the collectability of our trade receivables and notes receivable. The notes are typically non-interest bearing, with maturity dates between three and six months. We provide an allowance for doubtful accounts for the estimated losses on the trade receivables and notes receivable when collection may no longer be reasonably assured. We assess collectability of the receivable by determining whether the creditworthiness of the customer has deteriorated and could result in an inability to collect payment; if collectability is doubtful, we record an allowance against the receivable. If the financial condition of our customers was to deteriorate and their ability to make payments suffers as a result, we may need to increase our allowances for our receivables. With the greater concentration of accounts receivable with certain customers, the financial condition of any specific or individual customer may result in increased concentration risk exposure. Although we evaluate customer creditworthiness prior to a sale, we generally assess the collectibility of an individual receivable balance based upon the length of time a receivable has remained outstanding.
We periodically reassess our evaluation methodologies based upon changes in facts and circumstances. For example, our experience in China throughout 2004 caused us to review our estimates. Throughout 2004, we experienced a lengthening of the collection cycle for our China based receivables; however, this lengthening did not necessarily coincide with a change in the overall estimate of recoverability of an individual receivable balance. As a result, we revised our estimates to reflect the changed environment. The incremental amount provided under the new estimate was $10.1 million lower than would have been provided using historical estimates in the fourth quarter of 2004. The lengthened
collection cycle has been attributed to a number of factors, but principally to changes in customers business practices surrounding payment and to a lesser degree to the maturation of the telecommunications sector. Although these factors did not result in a reduction of the overall collectibility of individual receivables in 2004, the lengthening payment cycle could result in a reduction of the overall collectibility of our receivable balances in the future. If we were to observe a deterioration of the actual collectibility of our receivables, our allowance for doubtful accounts would increase resulting in additional bad debt expense.
Inventories consist of inventories held at our manufacturing facility, warehouses or at customer sites prior to signing of contracts. We may ship inventory to existing customers that require additional equipment to expand their existing networks prior to the signing of an expansion contract. Our inventories are stated at the lower of cost or net realizable value, net of write-downs for excess, slow moving and obsolete inventory. Inventory is written down for estimated obsolescence or unmarketable inventory equal to the difference between inventory cost and the estimated market value. Write-downs are based on our assumptions about future market conditions and customer demand, including projected changes in average selling prices resulting from competitive pricing pressures. We continually monitor inventory valuation for potential losses and obsolete inventory at our manufacturing facilities as well as at customer sites.
Deferred costs/Inventories at customer sites under contracts
Inventories at customer sites under contracts awaiting final acceptance are classified as deferred costs. Title associated with this inventory has transferred to the customer who has assumed the risk of physical loss. Deferred costs also include labor related to third party integrators and freight. All deferred costs are stated at cost. We periodically assesses the recoverability of deferred costs and provide reserves against deferred cost balances when recovery of deferred costs is not probable. Recoverability is evaluated based on various factors including length of time inventory has been held at the customer site, the viability of payment, including assessment of product demand if a revenue sharing arrangement exists. Revenue and cost of sales are recorded when final acceptance is received from the customer. With greater concentration of inventory at customer sites under contract with specific or individual customer, the financial conditions of any specific or individual customer may result in increased concentration risk exposure for our inventory.
Research and Development and Capitalized Software Development Costs
Our research and development costs are charged to expense as incurred. We capitalize software development costs, incurred in the development of software that will ultimately be sold, between the time technological feasibility has been attained and the related product is ready for general release. Management judgment is required in assessing technological feasibility, expected future revenues, estimated product lives and changes in product technologies, and the ultimate recoverability of our capitalized software development costs.
Deferred Income Taxes
We recognize deferred income taxes as the difference between the tax bases of assets and liabilities and their financial statement amounts based on enacted tax rates. Management judgment is required in the assessment of the recoverability of our deferred tax assets based on our assessment of projected taxable income. Numerous factors could affect our results of operations in the future. If there was a significant decline in our future operating results, our assessment of the recoverability of our deferred tax assets would need to be revised, and any such adjustment to our deferred tax assets would be charged to income
in that period. If necessary, we record a valuation allowance to reduce deferred tax assets to an amount management believes is more likely than not to be realized.
Goodwill and Intangible Assets
We have recorded goodwill and intangible assets in connection with our business acquisitions. Management judgment is required in the assessment of the related useful lives, assumptions regarding our ability to successfully develop and ultimately commercialize acquired technology, and assumptions regarding the fair value and the recoverability of these assets. We perform our annual goodwill impairment review in the fourth quarter of each year or when changes in circumstances indicate a potential impairment exists. During the fourth quarter of 2004, with the consummation of the acquisition of ACC, we evaluated our management operation and reporting and determined that we operated as three operating segments for the fourth quarter of 2004. Those segments were the Personal Communications Division (PCD), China and International. PCD includes the legacy activities of the ACC selected assets acquisition. The China segment represents our activities within our China companies and the International segment includes all other non-China and non-PCD operations. Management has determined that each segment is its own reporting unit as there are no management or reporting structures below this segment reporting level. We have reallocated our goodwill between our segments and each have a single reporting unit. We have performed goodwill impairment analysis at the reporting unit level. When assessing potential impairment to goodwill, we compare our book value to our fair market value. Fair market value is determined based on the present value of estimated future cash flows.
We have invested in a fund focused on investments in Internet companies in China and a fund focused on investments in companies in Asia undergoing restructuring or bankruptcy procedures. We have also invested directly in a number of private technology-based companies in the early stages of development and in publicly listed technology companies traded on NASDAQ and the New York Stock Exchange. While quoted market prices are readily available to determine the fair value of our investments in these publicly traded companies, management judgment is required to determine when losses are other than temporary. Furthermore, management judgment is required in evaluating the carrying value of our private company investments for possible impairment. For our private technology company investments, we assess impairment based on an evaluation of the achievement of business objectives and milestones, the financial condition and prospects of these companies and other relevant factors. We continually monitor these investments for impairment, and charge to income any impairment amounts in the period such a determination is made.
In December 2004, the Financial Accounting Standards Board, FASB, issued SFAS No. 123 (revised 2004), Share-Based Payment, (SFAS 123(R)). SFAS 123(R) will require us to measure all employee stock-based compensation awards using a fair value method and record such expense in its consolidated financial statements. In addition, the adoption of SFAS 123(R) will require additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from share-based payment arrangements. We do not currently have any plans to modify our existing compensation programs.
In March 2005, the SEC issued Staff Accounting Bulletin No. 107 (SAB 107) which provides guidance regarding the application of SFAS 123(R). SAB 107 expresses views of the staff regarding the interaction between SFAS No. 123(R), Share-Based Payment, and certain SEC rules and regulations and provides the staffs views regarding the valuation of share-based payment arrangements for public companies. In particular, SAB 107 provides guidance related to share-based payment transactions with
nonemployees, the transition from nonpublic to public entity status, valuation methods (including assumptions such as expected volatility and expected term), the accounting for certain redeemable financial instruments issued under share-based payment arrangements, the classification of compensation expense, non-GAAP financial measures, first-time adoption of SFAS 123(R) in an interim period, capitalization of compensation cost related to share-based payment arrangements, the accounting for income tax effects of share-based payment arrangements upon adoption of SFAS 123(R), the modification of employee share options prior to adoption of SFAS 123(R) and disclosures in Managements Discussion and Analysis (MD&A) subsequent to adoption of SFAS 123(R).
On April 14, 2005, the SEC approved a new rule that delays the effective date for SFAS 123(R) to annual periods beginning after June 15, 2005. The adoption of SFAS 123(R) on January 1, 2006 is expected to have a material impact on the Companys consolidated results of operations, financial position and statement of cash flows. The Company is evaluating the transition method and pricing model alternatives upon adoption.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Non-monetary Assets, an amendment of APB Opinion No. 29, (SFAS 153). SFAS 153 addresses the measurement of exchanges of non-monetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS 153 is effective for non-monetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. The adoption of SFAS 153 is not expected to have a material effect on our consolidated financial position or results of operations.
In November 2004, the FASB issued SFAS 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4, (SFAS 151). SFAS 151 clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as current period charges. The provisions of SFAS 151 are effective for the fiscal year beginning after June 15, 2005. The adoption of SFAS 151 is not expected to have a material impact on our consolidated financial position, results of operations and cash flows.
In December 2004, the FASB issued FASB Staff Position No. FAS 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004, (FSP FAS 109-2). The American Jobs Creation Act of 2004 provides a one-time 85% dividends received deduction for certain foreign earnings that are repatriated under a plan for reinvestment in the United States, provided certain criteria are met. FSP FAS 109-2 is effective immediately and provides accounting and disclosure guidance for the repatriation provision. FSP FAS 109-2 allows companies additional time to evaluate the effects of the law on its unremitted earnings for the purpose of applying the indefinite reversal criteria under APB Opinion No. 23, Accounting for Income TaxesSpecial Areas, and requires explanatory disclosures from companies that have not yet completed the evaluation. We are currently evaluating the effects of the repatriation provision and their impact on our consolidated financial statements. We do not expect to complete this evaluation before the end of 2006. The range of possible amounts of unremitted earnings that is being considered for repatriation under this provision is between zero and $541 million and the related potential range of income tax is between zero and $28 million.
Our future product sales are unpredictable and, as a result, our operating results are likely to fluctuate from quarter to quarter.
Our quarterly and annual operating results have fluctuated in the past and are likely to fluctuate in the future due to a variety of factors, some of which are outside of our control. Factors that may affect our future operating results, in addition to those described below, include:
· the timing and size of the orders for our products;
· changes in our customers subscriber growth rate;
· the lengthy and unpredictable sales cycles associated with sales of our products;
· cancellation, deferment or delay in implementation of large contracts;
· issues that might arise from the integration of acquired entities or the inability to achieve expected results from such acquisitions;
· revenue recognition, which is based on acceptance, is unpredictable;
· a seasonal reoccurrence of an outbreak of severe acute respiratory syndrome (SARS) or other illnesses;
· the decline in business activity we typically experience during the Lunar New Year, which leads to decreased sales during our first fiscal quarter;
· changes in accounting rules, such as recording expenses related to employee stock option compensation plans;
· shift in our product mix or market focus; and
· quality issues resulting from the design or manufacture of the products, or from the software used in the product.
As a result of these and other factors, period-to-period comparisons of our operating results are not necessarily meaningful or indicative of future performance. In addition, the factors noted above may make it difficult for us to forecast and provide in a timely manner public guidance (including updates to prior guidance) related to our projected financial performance of the Company. Furthermore, it is possible that in some future quarters our operating results will fall below the expectations of securities analysts or investors. If this occurs, the trading price of our common stock could decline.
Competition in our markets may lead to reduced prices, revenues and market share.
We have experienced intense competition in the past years, and we believe that we will continue to face intense competition from both domestic and international companies in our target markets, many of which may operate under lower cost structures or may be given preferential treatment by applicable governmental regulators and policies and have much larger sales forces than we do. Additionally, other companies not presently offering competing products may also enter our target markets. Many of our competitors have significantly greater financial, technical, product development, sales, marketing and other resources than we do. As a result, our competitors may be able to respond more quickly to new or emerging technologies and changes in service provider requirements. Our competitors may also be able to devote greater resources than we can to the development, promotion and sale of new products. These competitors may be able to offer significant financing arrangements to service providers, which may give them a competitive advantage in selling systems to service providers with limited financial and currency
resources. In many of the developing markets in which we operate or intend to operate, relationships with local governmental telecommunications agencies are important to establish and maintain. In many such markets, our competitors may have or be able to establish better relationships with local governmental telecommunications agencies than we have, which could result in their ability to influence governmental policy formation and interpretation to their advantage. Additionally, our competitors might have better relationships with their third party suppliers and obtain component parts at a reduced rate, allowing them to offer their end products at reduced prices. Moreover, the telecommunications and cable industries have experienced significant consolidation, and we expect this trend to continue. If we have fewer significant customers, we may be more reliant on such large customers and our bargaining position and profit margins may suffer. Increased competition is likely to result in price reductions, reduced gross profit as a percentage of net sales and loss of market share, any one of which could materially harm our business, financial condition, cash flows, and results of operations.
If we seek to secure additional financing and are not able to do so, our ability to expand strategically may be limited. If we are able to secure additional financing, our stockholders may experience dilution of their ownership interest, or we may be subject to limitations on our operations and increased leverage.
We currently anticipate that our available cash resources, which include existing cash and cash equivalents, short-term investments and cash from operations, will be sufficient to meet our anticipated needs for working capital and capital expenditures for the foreseeable future. If we are unable to generate sufficient cash flows from operations, we may need to raise additional funds to develop new or enhanced products, respond to competitive pressures, take advantage of acquisition opportunities or raise capital for strategic purposes. If we raise additional funds through the issuance of equity securities, our stockholders will experience dilution of their ownership interest, and the newly issued securities may have rights superior to those of common stock. If we raise additional funds by issuing debt, we may be subject to limitations on our operations and increase our leverage. For example, in connection with the sale of convertible debt securities in March 2003, we incurred $402.5 million of indebtedness. As a result of this indebtedness, our principal and interest payment obligations have increased substantially. The degree to which we are leveraged could materially and adversely affect our ability to obtain financing for working capital, acquisitions or other purposes and could make us more vulnerable to industry downturns and competitive pressures. Our ability to meet our debt service obligations will be dependent upon our future performance, which will be subject to financial, business and other factors affecting our operations, many of which are beyond our control. Finally, we are not certain that we can maintain our existing unsecured credit line available to our China operations or additional sources of financing may not be available on reasonable terms or at all if and when we require it, which could harm our business.
The average selling prices of our products may decrease, which may reduce our revenues and our gross profit. As a result, we must introduce new products and reduce our costs in order to maintain profitability.
The average selling prices for communications access and switching systems and handsets have historically declined as a result of a number of factors, including:
· increased competition;
· aggressive price reductions by competitors;
· rapid technological change; and
· constant change in customer buying behavior and market trends.
The average selling prices of our products may continue to decrease in the future in response to product introductions by us or our competitors or other factors, including price pressures from customers. Certain of our products, including wireless handsets, have historically had low gross profit margins, and any
further deterioration of our profit margins on such products could result in losses with respect to such products. Therefore, we must continue to develop and introduce new products and enhancements to existing products that incorporate features that can be sold at higher average selling prices. Failure to do so could cause our revenues and gross profit to decline.
Our cost reduction efforts may not allow us to keep pace with competitive pricing pressures or lead to improved gross profit, as a percentage of net sales. In order to be competitive, we must continually reduce the cost of manufacturing our products through design and engineering changes. We may not be successful in these efforts or in delivering our products to market in a timely manner. In addition, any redesign may not result in sufficient cost reductions to allow us to reduce the prices of our products to remain competitive or to improve or maintain our gross profit, as a percentage of net sales, which would cause our financial results to suffer.
Sales in China have accounted for most of our total sales, and our business, financial condition and results of operations are to a significant degree subject to economic, political and social events in China.
Approximately $2.1 billion, or 79%, and $1.7 billion, or 86%, of our net sales in the years ended December 31, 2004 and 2003, respectively, occurred in China. While we anticipate expansion into other markets, a significant portion of our net sales will be derived from China for the foreseeable future. In addition, we plan to continue to make further investments in China in the future. Therefore, our business, financial condition and results of operations are to a significant degree subject to economic, political, legal and social developments and other events in China. Please read the risks detailed below under the heading Risks Related to Conducting Business in China for additional information about the risks we face in connection with our China operations.
Our market is subject to rapid technological change, and to compete effectively, we must continually introduce new products and product enhancements that achieve market acceptance.
The market for communications equipment is characterized by rapid technological developments, frequent new product introductions and evolving industry and regulatory standards. Our success will depend in large part on our ability to enhance our network and broadband access and switching technologies and develop and introduce new products and product enhancements that anticipate changing service provider requirements and technological developments. We may need to make substantial capital expenditures and incur significant research and development costs to develop and introduce new products and enhancements. If we fail to develop and introduce new products or enhancements to existing products that effectively respond to technological change on a timely basis, our business, financial condition and results of operations could be materially adversely affected. Certain of our products, including wireless handsets, have a short product life. Moreover, from time to time, our competitors or we may announce new products or product enhancements, technologies or services that have the potential to replace or shorten the life cycles of our products and that may cause customers to defer purchasing our existing products, resulting in inventory reserve due to obsolescence. Future technological advances in the communications industry may diminish or inhibit market acceptance of our existing or future products or render our products obsolete.
Even if we are able to develop and introduce new products, they may not gain market acceptance. Market acceptance of our products will depend on various factors, including:
· our ability to obtain necessary approvals from regulatory organizations within the countries in which we operate and for any new technologies that we introduce;
· the length of time it takes service providers to evaluate our products, causing the timing of purchases to be unpredictable;
· our products being compatible with legacy technologies and standards existing in previously deployed network equipment;
· our ability to attract customers who may have preexisting relationships with our competitors;
· product cost relative to performance;
· the level of customer service available to support new products; and
· the timing of new product introductions meeting demand patterns.
If our products fail to obtain market acceptance in a timely manner, our business and results of operations could suffer.
We depend on some sole source and other key suppliers, as well as international sources, for handsets, base stations, components and materials used in our products. If we cannot obtain adequate supplies of high quality products at competitive prices or in a timely manner from these suppliers or sources, or if the suppliers successfully market their products directly to our customers, our competitive position, reputation and business could be harmed.
We have contracts with a single supplier or with a limited group of suppliers to purchase some components and materials used in our products. If any supplier is unwilling or unable to provide us with high-quality components and materials in the quantities required and at the costs specified by us, we may not be able to find alternative sources on favorable terms, in a timely manner, or at all. Further, a supplier could market its products directly to our customers. In particular, our PCD division is highly dependent on a single supplier for our handset devices. The possibility of a supplier marketing its own products would create direct competition and may affect our ability to obtain adequate supplies. Our inability to obtain or to develop alternative sources if and as required could result in delays or reductions in manufacturing or product shipments. From time to time, there could be shortages of different products or components. Moreover, our suppliers may supply us with inferior quality products. If an inferior product supplied by a third party is embedded in our end product and causes a problem, it might be difficult to identify the source of the problem as being due to the component parts. If any of these events occur, our competitive position, reputation and business could suffer.
Our ability to source a sufficient quantity of high-quality, cost-effective components used in our products may also be limited by import restrictions and duties in the foreign countries in which we manufacture our products. We require a significant number of imported components to manufacture our products, and imported electronic components and other imported goods used in the operation of our business may be limited by a variety of permit requirements, approval procedures, import duties and registration requirements. Moreover, import duties on such components increase the cost of our products and may make them less competitive.
Product defects or performance quality issues could cause us to lose customers and revenue or to incur unexpected expenses.
Many of our products are highly complex and may have quality issues resulting from the design or manufacture of such product, or from the software used in the product. Often these issues are identified prior to the shipment of the products and may cause delays in market acceptance of our products, delays in shipping products to customers, or the cancellation of orders. In other cases, we may identify the quality issues after the shipment of products. In such cases, we may incur unexpected expenses and diversion of resources to replace defective products or correct problems. Such pre-shipment and post-shipment quality issues could result in delays in the recognition of revenue, loss of revenue or future orders, and damage to our reputation and customer relationships. In addition, we may be required to pay damages for failed performance under certain customer contracts.
Our recent growth has strained our resources, and if we are unable to manage and sustain our growth, our operating results will be negatively affected.
We have recently experienced a period of rapid growth and anticipate that we must continue to expand our operations to address potential market opportunities. Our expansion has placed and will continue to place a significant strain on our management, operational, financial and other resources. To manage our growth effectively, we will need to take various actions, including:
· enhancing management information systems, including forecasting procedures;
· further developing our operating, administrative, financial and accounting systems and controls;
· managing our working capital and sources of financing to fund our expansion;
· maintaining close coordination among our engineering, accounting, finance, marketing, sales and operations organizations;
· expanding, training and managing our employee base;
· enhancing human resource operations and improving employee hiring and training programs;
· reorganizing our business structure to more effectively allocate and utilize our internal resources;
· improving and sustaining our supply chain capability;
· managing the expansion of both our direct and indirect sales channels in a cost-efficient and competitive manner; and
· fully reviewing our new customers credit histories to ensure their financial stability before finalizing contracts.
If we fail to implement or improve systems or controls or to manage any future growth and expansion effectively, our business could suffer.
Our success is dependent on continuing to hire and retain qualified personnel, and if we are not successful in attracting and retaining these personnel, our business will suffer.
The success of our business depends in significant part upon the continued contributions of key technical and senior management personnel, many of whom would be difficult to replace. In particular, our success depends in large part on the knowledge, expertise and services of Hong Liang Lu, our Chairman of the Board, President and Chief Executive Officer, Ying Wu, our Chairman and Chief Executive Officer of China Operations, and Philip Christopher, President and Chief Executive Officer of our PCD. The loss of any key employee, the failure of any key employee to perform satisfactorily in his or her current position or our failure to attract and retain other key technical and senior management employees could have a significant negative impact on our operations.
To effectively manage our recent growth as well as any future growth, we will need to recruit, train, assimilate, motivate and retain qualified employees both locally and internationally. Competition for qualified employees is intense, and the process of recruiting personnel in all fields, including technology, research and development, sales and marketing, administration and managerial personnel with the combination of skills and attributes required to execute our business strategy can be difficult, time-consuming and expensive. As we grow globally, we must implement hiring and training processes that are capable of quickly deploying qualified local residents to knowledgeably support our products and services. Alternatively, if there is an insufficient number of qualified local residents available, we might incur substantial costs importing expatriates to service new global markets. For example, we have historically experienced difficulty finding qualified accounting personnel knowledgeable in both U.S. and
Chinese accounting standards who are Chinese residents. If we fail to attract, hire, assimilate or retain qualified personnel, our business would be harmed.
Competitors and others have in the past, and may in the future, attempt to recruit our employees. In addition, companies in the telecommunications industry whose employees accept positions with competitors frequently claim that the competitors have engaged in unfair hiring practices. We may be the subject of these types of claims in the future as we seek to hire qualified personnel. Some of these claims may result in material litigation and disruption to our operations. We could incur substantial costs in defending ourselves against these claims, regardless of their merit.
Any acquisitions that we undertake could be difficult to integrate, disrupt our business, dilute our stockholders and harm our operating results.
We have acquired other businesses, products and technologies. For example, during the second quarter of 2004, we completed our acquisitions of TELOS and HSI for $30.0 million and $14.1 million, respectively. On November 1, 2004, we completed our selected asset acquisition of ACC for $165.1 million. Additionally, in October 2004, we entered into an asset purchase agreement with Giga Telecom, Inc. to acquire certain assets related to the research and development of various products. Any anticipated benefits of these acquisitions may not be realized. We have in the past and will continue to evaluate acquisition prospects that would complement our existing product offerings, augment our market coverage, enhance our technological capabilities, or that may otherwise offer growth opportunities. Acquisitions may result in dilutive issuances of equity securities, use of our cash resources, the incurrence of debt and the amortization of expenses related to intangible assets. In addition, acquisitions involve numerous risks, including difficulties in the assimilation of operations, technologies, products and personnel of the acquired company, diversion of managements attention from other business concerns, risks of entering markets in which we have no direct or limited prior experience, the potential loss of key employees of the acquired company, unanticipated costs and, in the case of the acquisition of financially troubled businesses, challenges as to the validity of such acquisitions from third party creditors of such businesses. For example, in the fourth quarter 2004, we encountered difficulties in integrating HSIs legacy operations into our operations and determined to abandon HSIs legacy operations. As a result, in the fourth quarter 2004, we wrote off the entire goodwill and intangibles associated with HSI. In addition, the acquisitions of businesses involved in the manufacturing or sales of handset products could introduce specific litigation risk from the potential harmful effects of electric and magnetic fields (EMF).
We may be unable to adequately protect the loss or misappropriation of our intellectual property, which could substantially harm our business.
We rely on a combination of patents, copyrights, trademarks, trade secret laws and contractual obligations to protect our technology. We have applied for patents in the United States and internationally. Additional patents may not be issued from our pending patent applications, and our issued patents may not be upheld. In addition, we have, from time to time, chosen to abandon previously filed applications. Moreover, we may face difficulties in registering our existing trademarks in new jurisdictions in which we operate. We cannot guarantee that the intellectual property protection measures that we have taken will be sufficient to prevent misappropriation of our technology or trademarks or that our competitors will not independently develop technologies that are substantially equivalent or superior to ours. In addition, the legal systems of many foreign countries do not protect or honor intellectual property rights to the same extent as the legal system of the United States. For example, in China, the legal system in general, and the intellectual property regime in particular, are still in the development stage. It may be very difficult, time-consuming and costly for us to attempt to enforce our intellectual property rights in these jurisdictions.
We may be subject to claims that we infringe the intellectual property rights of others, which could substantially harm our business.
The industry in which we compete is moving towards aggressive assertion, licensing, and litigation of patents and other intellectual property rights. From time to time, we have become aware of the possibility or have been notified that we may be infringing certain patents or other intellectual property rights of others. Regardless of their merit, responding to such claims could be time consuming, divert managements attention and resources and cause us to incur significant expenses. In addition, although some of our supplier contracts provide for indemnification from the supplier with respect to losses or expenses incurred in connection with any infringement claim, certain contracts with our key suppliers do not provide for such protection. Moreover, certain of our sales contracts provide that we must indemnify our customers against claims by third parties for intellectual property rights infringement related to our products. There are no limitations on the maximum potential future payments under these guarantees. Therefore, we may incur substantial costs related to any infringement claim, which may substantially harm our results of operations and financial condition.
We may, in the future, become subject to litigation to defend against claimed infringements of the rights of others or to determine the scope and validity of the proprietary rights of others. Future litigation may also be necessary to enforce and protect our trade secrets and other intellectual property rights. Any intellectual property litigation or threatened intellectual property litigation could be costly, and adverse determinations or settlements could result in the loss of our proprietary rights, subject us to significant liabilities, require us to seek licenses from or pay royalties to third parties which may not be available on commercially reasonable terms, if at all, and/or prevent us from manufacturing or selling our products, which could cause disruptions to our operations.
In the event that there is a successful claim of infringement against us and we fail to develop non-infringing technology or license the propriety rights on commercially reasonable terms and conditions, our business, results of operations or financial condition could be materially and adversely impacted.
Our multinational operations subject us to various economic, political, regulatory and legal risks.
We market and sell our products globally, with the majority of our sales made in China. The expansion of our existing multinational operations and entry into new markets will require significant management attention and financial resources. Multinational operations are subject to a variety of risks, such as:
· the burden of complying with a variety of foreign laws and regulations;
· the burden of complying with United States laws and regulations for foreign operations, including the Foreign Corrupt Practices Act;
· difficulty complying with continually evolving and changing global product and communications standards and regulations for both our end products and their component technology;
· market acceptance of our new products, including longer product acceptance periods in new markets into which we enter;
· reliance on local original equipment manufacturers (OEMs), third party distributors and agents to effectively market and sell our products;
· unusual contract terms required by customers in developing markets;
· changes in local governmental control or influence over our customers;
· changes to import and export regulations, including quotas, tariffs, licensing restrictions and other trade barriers;
· evolving and unpredictable nature of the economic, regulatory, competitive and political environments;
· reduced protection for intellectual property rights in some countries;
· longer accounts receivable collection periods; and
· difficulties and costs of staffing and managing multinational operations, including but not limited to internal controls and compliance.
We do business in markets that are not fully developed, which subjects us to various economic, political, regulatory and legal risks unique to developing economies.
Less developed markets present additional risks, such as the following:
· customers that may be unable to pay for our products in a timely manner or at all;
· new and unproven markets for our products and the telecommunications services that our products enable;
· inconsistent infrastructure support;
· lack of a large, highly trained workforce;
· difficulty in controlling local operations from our headquarters;
· variable ethical standards and an increased potential for fraud;
· unstable political and economic environments; and
· a lack of a secure environment for our personnel, facilities and equipment.
In particular, these factors create the potential for physical loss of inventory and operating assets. We have in the past experienced cases of vandalism and armed theft of our equipment that had been or was being installed in the field. If disruptions for any of these reasons become too severe in any particular market, it may become necessary for us to terminate contracts and withdraw from that market and suffer the associated costs and lost revenue.
We are subject to claims of possible health risks from wireless handsets.
There have been claims made alleging a link between the use of wireless handsets and the development or aggravation of certain cancers, including brain cancer. The scientific community is divided on whether there is a risk from wireless handset use, and if so, the magnitude of the risk. Even if there is no link established between wireless handset use and cancer, the negative publicity and possible litigation could have a material adverse effect on our business.
In the past, several plaintiffs groups have brought class actions against wireless handset manufacturers and distributors, alleging that wireless handsets have caused cancer. To date, we have not been named in any of these actions and none of these actions has been successful. In the future we could incur substantial costs in defending ourselves against similar claims, regardless of their merit. Also, claims may be successful in the future and have a material adverse effect on our business.
We are subject to risks relating to currency rate fluctuations and exchange controls.
Because most of our sales are made in foreign countries, we are exposed to market risk for changes in foreign exchange rates on our foreign currency denominated accounts and notes receivable balances. Historically, the majority of our sales have been made in China and denominated in Renminbi; as such, the impact of currency fluctuations of Renminbi thus far has been insignificant as it is fixed to the U.S. dollar.
However, in the future, China could choose to revalue the Renminbi versus the U.S. dollar, or the Renminbi-U.S. dollar exchange rate could float, and the Renminbi could depreciate relative to the U.S. dollar. Additionally, during 2004, we made significant sales in both Japanese Yen and in Euros. Fluctuations in currency exchange rates in the future may have a material adverse effect on our results of operations.
We enter into transactions that may expose us to foreign currency rate fluctuation risk. Historically, the largest component of our foreign currency exchange loss has resulted from our purchasing inventory denominated in foreign currencies. If we continue to purchase inventory in foreign currencies, we may incur additional foreign currency exchange losses, causing our operating results to suffer.
We may, from time to time, enter into foreign exchange forward contracts to hedge certain translation exposures, due to fluctuation of the U.S. dollar to the Japanese Yen, resulting from Japanese Yen-dominated balance sheet accounts. However, our management has had limited prior experience in engaging in these types of transactions, and the hedging may not be effective in limiting our exposure to a decline in operating results.
Moreover, some of the foreign countries in which we do business might impose currency restriction that may limit the ability of our subsidiaries and joint ventures in such countries to obtain and remit foreign currency necessary for the purchase of imported components and may limit our ability to obtain and remit foreign currency in exchange for foreign earnings. For example, China employs currency controls restricting Renminbi conversion, limiting our ability to engage in currency hedging activities in China. Various foreign exchange controls may also make it difficult for us to repatriate earnings, which could have a material adverse effect on our ability to conduct business globally.
Business interruptions could adversely affect our business.
Our operations are vulnerable to interruption by fire, earthquake, power loss, telecommunications failure, external interference with our information technology systems, incidents of terrorism and other events beyond our control. For example, our Hangzhou manufacturing facilitys ability to produce sufficient products is dependent upon a continuous power supply. However, the Hangzhou facility has in the past been subject to power shortages, which has affected our ability to produce and ship sufficient products. We do not have a detailed disaster recovery plan, and the occurrence of any events like these that disrupt our business could harm our operating results.
We may suffer losses with respect to equipment held at customer sites, which could harm our business.
We face the risk of loss relating to our equipment held at customer sites. In some cases, our equipment held at customer sites is under contract, pending final acceptance by the customer. We generally do not hold title or risk of loss on such equipment, as title and risk of loss are typically transferred to the customer upon delivery of our equipment. However, we do not recognize revenue and accounts receivable with respect to the sale of such equipment until we obtain acceptance from the customer. If we do not obtain final acceptance, we may not be able to collect the contract price and recover this equipment or its associated costs. In other cases, particularly in China, where governmental approval is required to finalize certain contracts, inventory not under contract may be held at customer sites. We hold title and risk of loss on this inventory until the contracts are finalized and, as such, are subject to any losses incurred resulting from any damage to or loss of this inventory. If our contract negotiations fail or if the government of China otherwise delays approving contracts, we may not recover or receive payment for this inventory. Moreover, our insurance may not cover all losses incurred if our inventory at customer sites not under contracts is damaged prior to contract finalization. If we incur a loss relating to inventory for any of the above reasons, our financial condition, cash flows, and operating results could be harmed.
We have been named as a defendant in securities litigation and other lawsuits, as well as lawsuits in the ordinary course of business.
We are currently a defendant in several securities litigation class actions and other lawsuits, as well as lawsuits in the ordinary course of our business. In the future, we may be subject to similar litigation. The defense of these lawsuits may divert our managements attention, and we may incur significant expenses in defending these lawsuits (including substantial fees of lawyers and other professional advisors and potential obligations to indemnify officers and directors who may be parties to such actions). In addition, we may be required to pay judgments or settlements that could have a material adverse effect on our results of operations, financial condition and liquidity.
Restrictions on the use of handsets while driving could affect our future growth.
Several foreign governments and U.S. state and local governments have adopted or are considering legislation that would restrict or prohibit the use of wireless handsets while driving. Widespread legislation that restricts or prohibits the use of wireless handsets while driving could negatively affect our future growth.
Failure to achieve and maintain effective internal controls in accordance with Section 404 of the Sarbanes-Oxley Act of 2002 could have a material adverse effect on our business and stock price.
Section 404 of the Sarbanes-Oxley Act of 2002 (the Sarbanes-Oxley Act) requires that we establish and maintain an adequate internal control structure and procedures for financial reporting and include a report of management on our internal control over financial reporting in our annual report on Form 10-K. That report must contain an assessment by management of the effectiveness of our internal control over financial reporting and must include disclosure of any material weaknesses in internal control over financial reporting that we have identified. In addition, our independent registered public accounting firm must attest to and report on managements assessment of the effectiveness of our internal control over financial reporting. These requirements first apply to this Annual Report.
We have identified material weaknesses in our internal controls over financial reporting. See Item 9AControls and ProceduresManagements Report on Internal Control Over Financial Reporting for a discussion of these material weaknesses. As of the date of this Annual Report on Form 10-K, we are still in the process of implementing remedial measures related to the material weaknesses identified as discussed at Item 9AControls and ProceduresManagements Report on Internal Control Over Financial Reporting. If our efforts to remedy the weaknesses we identified are not successful, our business and operating results could be harmed and the reliability of our financial statements could be impaired, which could adversely affect our stock price. The requirements of Section 404 of the Sarbanes-Oxley Act are ongoing and also apply to future years. In addition, during 2005, we will apply the requirements of the Sarbanes-Oxley Act to our November 2004 acquisition of ACC, which was exempted from our 2004 assessment as permitted under the Sarbanes-Oxley Act. We expect that our internal controls over financial reporting will continue to evolve as we continue in our efforts to grow and expand our business in the future. Although we are committed to continue to improve our internal control processes and we will continue to diligently and vigorously review our internal controls over financial reporting in order to ensure compliance with the Section 404 requirements, any control system, regardless of how well designed, operated and evaluated, can provide only reasonable, not absolute, assurance that its objectives will be met. Therefore, we cannot assure you that in the future additional material weaknesses or significant deficiencies will not exist or otherwise be discovered.
Recently enacted and proposed changes in securities laws and regulations are likely to increase our costs.
The Sarbanes-Oxley Act , has required and will continue to require changes in some of our corporate governance and securities disclosure or compliance practices. The Sarbanes-Oxley Act also requires the SEC to promulgate new rules on a variety of subjects, in addition to rule proposals already made, and NASDAQ has revised its requirements for companies that are quoted on it. These developments (i) have required and may continue to require us to devote additional resources to our operational, financial and management information systems procedures and controls to ensure our continued compliance with current and future laws and regulations, (ii) will make it more difficult and more expensive for us to obtain director and officer liability insurance, and we may be required to accept reduced coverage, increase our level of self-insurance, or incur substantially higher costs to obtain coverage, and (iii) could make it more difficult for us to attract and retain qualified members on our board of directors, or qualified executive officers. To ensure our compliance with Section 404 of the Sarbanes-Oxley Act and other related security rules, we incurred costs of approximately $4.6 million in 2004 relating to the implementation of plans designed to ensure our compliance. We continue to evaluate and monitor regulatory developments and cannot estimate the timing or magnitude of additional costs that we may incur as a result of such developments.
Changes in accounting rules.
We prepare our financial statements in conformity with accounting principles generally accepted in the United States of America. These principles are subject to interpretation by the SEC and various bodies formed to interpret and create appropriate accounting policies. A change in these policies can have a significant effect on our reported results and may even retroactively affect previously reported transactions. For example, there have been recent changes to FASB guidelines relating to accounting for stock-based compensation that will increase our compensation expense, could make our net income less predictable in any given reporting period and could change the way we compensate our employees or cause other changes in the way we conduct our business.
Chinas governmental and regulatory reforms may impact our ability to do business in China.
Since 1978, the Chinese government has been in a state of evolution and reform. The reforms have resulted in and are expected to continue to result in significant economic and social development in China. Many of the reforms are unprecedented or experimental and may be subject to change or readjustment due to a variety of political, economic and social factors. Multiple government bodies are involved in regulating and administrating affairs in the telecommunications industry, among which the MII, the National Development and Reform Commission (NDRC) and the State Asset Supervisory Administrative Commission (SASAC) play the leading roles. These government agencies have broad discretion and authority over all aspects of the telecommunications and information technology industry in China, including but not limited to, setting the telecommunications tariff structure, granting carrier licenses and frequencies, approving equipment and products, granting product licenses, specifying technological standards as well as appointing carrier executives, all of which may impact our ability to do business in China.
While we anticipate that the basic principles underlying the reforms will remain unchanged, any of the following changes in Chinas political and economic conditions and governmental policies could have a substantial impact on our business:
· the promulgation of new laws and regulations and the interpretation of those laws and regulations;
· inconsistent enforcement and application of the telecommunications industrys rules and regulations by the Chinese government between foreign and domestic companies;
· the restructuring of telecommunications carriers in China;
· the introduction of measures to control inflation or stimulate growth;
· the introduction of new guidelines for tariffs and service rates, which affect our ability to competitively price our products and services;
· changes in the rate or method of taxation;
· the imposition of additional restrictions on currency conversion and remittances abroad; or
· any actions that limit our ability to develop, manufacture, import or sell our products in China, or to finance and operate our business in China.
For example, on November 1, 2004, as a continuation of the restructuring of telecom carriers relating to the initial public offering of China Netcom in 2004, SASAC decided to swap the senior executives of China Mobile, China Unicom, China Telecom and China Netcom in an effort to ease competition among carriers. This led to business interruption between China Telecom and China Netcom, which had an adverse impact of delaying revenue recognition in the fourth quarter of 2004. Moreover, we are not certain whether there may be additional government interference, including government imposed mergers or spin-offs of the existing carriers.
In addition to modifying the existing telecommunications regulatory framework, the Chinese government is currently preparing a draft of a standard, national telecommunications law (the Telecommunications Law) to provide a uniform regulatory framework for the telecommunications industry. We do not yet know the final nature or scope of the regulations that would be created if the Telecommunications Law is passed. Accordingly, we cannot predict whether it will have a positive or negative effect on us or on some or all aspects of our business.
Under Chinas current regulatory structure, the communications products that we offer in China must meet government and industry standards. In addition, a network access license for the equipment must be obtained. Without a license, telecommunications equipment is not allowed to be connected to public telecommunications networks or sold in China. Moreover, we must ensure that the quality of the telecommunications equipment for which we have obtained a network access license is stable and reliable, and will not negatively affect the quality or performance of other installed licensed products.
The product quality supervision department of the China State Council, in concert with the MII, performs spot checks to track and supervise the quality of licensed telecommunications equipment and publishes the results of such spot checks.
Chinas changing economic environment may impact our ability to do business in China.
Since 1978, the Chinese government has been reforming the economic system in China to increase the emphasis placed on decentralization and the utilization of market forces in the development of Chinas economy. These reforms have resulted in significant economic growth. However, any economic reform policies or measures in China may from time to time be modified or revised by the Chinese government. While we may be able to benefit from the effects of some of these policies, these policies and other measures taken by the Chinese government to regulate the economy could also have a significant negative impact on economic conditions in China, which would result in a negative impact on our business. Chinas economic environment has been changing as a result of Chinas entry, in December of 2001, into the World Trade Organization (the WTO). Entry into the WTO requires that China reduce tariffs and eliminate non-tariff barriers, including quotas, licenses and other restrictions by early 2005 at the latest,
and we cannot predict the impact of these changes on Chinas economy. Moreover, although Chinas entry into the WTO and the related relaxation of trade restrictions may lead to increased foreign investment, it may also lead to increased competition in Chinas markets from other foreign companies. If Chinas entry into the WTO results in increased competition or has a negative impact on Chinas economy, our business could suffer. In addition, although China is increasingly according foreign companies and foreign investment enterprises established in China the same rights and privileges as Chinese domestic companies as a result of its admission into the WTO, special laws, administrative rules and regulations governing foreign companies and foreign investment enterprises in China may still place foreign companies at a disadvantage in relation to Chinese domestic companies and may adversely affect our competitive position.
Uncertainties with respect to the Chinese legal system may adversely affect us.
We conduct our business in China primarily through our wholly owned subsidiaries incorporated in China. Our subsidiaries are generally subject to laws and regulations applicable to foreign investment in China. Accordingly, our business might be affected by Chinas developing legal system. Since 1978, many new laws and regulations covering general economic matters have been promulgated in China, and government policies and internal rules promulgated by governmental agencies may not be published in time, or at all. As a result, we may operate our business in violation of new rules and policies without having any knowledge of their existence. In addition, there are uncertainties regarding the interpretation and enforcement of laws, rules and policies in China. The Chinese legal system is based on written statutes, and prior court decisions have limited precedential value. Because many laws and regulations are relatively new and the Chinese legal system is still evolving, the interpretations of many laws, regulations and rules are not always uniform. Moreover, the relative inexperience of Chinas judiciary in many cases creates additional uncertainty as to the outcome of any litigation, and the interpretation of statutes and regulations may be subject to government policies reflecting domestic political changes. Finally, enforcement of existing laws or contracts based on existing law may be uncertain and sporadic, and it may be difficult to obtain swift and equitable enforcement, or to obtain enforcement of a judgment by a court of another jurisdiction. Any litigation in China may be protracted and result in substantial costs and diversion of resources and managements attention.
If tax benefits available to our subsidiaries located in China are reduced or repealed, our business could suffer.
The Chinese government is considering the imposition of a unified corporate income tax that would phase out, over time, the preferential tax treatment to which foreign investment enterprises, such as our Company, are currently entitled. While it is not certain whether the government will implement such a unified tax structure or whether our Company will be grandfathered under into any new tax structure, if a new tax structure is implemented, a new tax structure may adversely affect our financial condition. Moreover, certain of our subsidiaries and joint ventures located in China enjoy tax benefits in China that are generally available to foreign investment enterprises. If these tax benefits are reduced or repealed due to changes in tax laws, our business could suffer.
Our ability to continue successful deployment of PAS system and sales of PAS handsets are limited by certain factors, including the following:
Maturing PAS market and increased competition in handsets and tariffs.
The market for PAS exceeded 66 million users as of the end of fiscal year 2004 and is present throughout China. As the PAS market has matured, we believe that it may level off in the near future. In addition, the increase in handset competitors entering the market during 2004 has resulted in decreased average selling prices and margins. If additional handset competitors enter the market or if competitors decide to further reduce pricing, our sales of PAS handsets may be adversely impacted.
Furthermore, competition from mobile operators, such as China Mobile and China Unicom, has increased in cities where PAS is deployed. Mobile operators offering special promotional pricing or incentives to customers, such as free incoming calls or free mobile-to-mobile calls, have harmed the ability of our customers, China Telecom and China Netcom, to compete effectively. The continued use of such incentive programs by mobile operators may adversely impact China Telecom and China Netcoms ability to increase PAS subscriptions. Due to our relationships with China Telecom and China Netcom, reduced subscription growth at these carriers may have a material adverse effect on our pricing and harm our business or results of operations.
Our PAS system and handsets sales may experience a sharp decline if China Telecom or China Netcom obtain licenses allowing them to deliver mobile services.
Chinas media sources have widely reported that the MII may grant 3G mobile licenses to China Telecom or China Netcom, or to both during 2005. If China Telecom or China Netcom obtain 3G mobile licenses, they may re-allocate capital expenditures to construct 3G networks, and as a consequence, may significantly reduce capital expenditures relating to PAS networks that utilize our existing products. In addition, it is possible that current PAS frequency bands utilized by PAS networks may be reallocated for use by 3G networks, resulting in the restriction of or shutting down of PAS networks. If this were to occur, we could lose current and potential future customers of our products, and our financial condition and results of operations could be significantly harmed.
We only have trial licenses for the PAS system and handsets in China.
We only have trial licenses for our PAS systems and handsets. We have applied for, but have not yet received, a final official network access license for our PAS systems and handsets. Based upon conversations with the MII, we understand that our PAS systems and handsets are considered to still be in the trial period and that sales of our PAS systems and handsets may continue to be made by us during this trial period, but that licenses will ultimately be required. If we fail to obtain the required licenses, we could be prohibited from making further sales of the unlicensed products, including our PAS systems and handsets, in China, which would substantially harm our business, financial condition and results of operations. The regulations implementing these requirements are not very detailed, have not been applied by a court and may be interpreted and enforced by regulatory authorities in a number of different ways. Our legal counsel in China has advised us that Chinas governmental authorities may interpret or apply the regulations with respect to which licenses are required and the ability to sell a product while a product is in the trial period in a manner that is inconsistent with the information received by our legal counsel in China, and either of these conditions could have a material adverse effect on our business, financial condition and results of operations.
Increasing centralization of purchasing decision-making by carriers may lead to customer concentration and affect the results of our business.
Most Chinese carriers have three levels of operations; the central headquarters level, the provincial level and the local city/county level. Both central and provincial levels are independent legal persons and have their own corporate mandate. The purchasing decision making process may take various forms for different projects and may also differ significantly from carrier to carrier.
In the case of PAS systems, all China Netcom contracts are negotiated and entered into between the provincial operators and the Company. However, the central headquarters of China Telecom recently began exerting more influence in the purchasing decision-making process by negotiating contractual terms, such as purchase price, payment terms, and acceptance clauses at the central level. The provincial operator then further negotiates the contract based on the guidelines provided by the headquarters. Final contracts are entered into between the provincial operator and the Company. However, if this trend of centralized
decision-making expands to unified purchasing, resulting in the negotiation and execution of contracts at the central headquarter level, there may be a concentration of customers which could have a significant impact on our business.
Our stock price is highly volatile.
The trading price of our common stock has fluctuated significantly since our initial public offering in March of 2000. Our stock price could be subject to wide fluctuations in the future in response to many events or factors, including those discussed in the preceding risk factors relating to our operations, as well as:
· actual or anticipated fluctuations in operating results, actual or anticipated gross profit as a percentage of net sales, levels of inventory, our actual or anticipated rate of growth and our actual or anticipated earnings per share;
· changes in expectations as to future financial performance or changes in financial estimates or buy/sell recommendations of securities analysts;
· changes in governmental regulations or policies in China;
· our, or a competitors, announcement of new products, services or technological innovations;
· the operating and stock price performance of other comparable companies; and
· news and commentary emanating from the media, securities analysts or government bodies in China relating to us and to the industry in general.
General market conditions and domestic or international macroeconomic factors unrelated to our performance may also affect our stock price. For these reasons, investors should not rely on recent trends to predict future stock prices or financial results. In addition, following periods of volatility in a companys securities, securities class action litigation against a company is sometimes instituted. This type of litigation could result in substantial costs and the diversion of managements time and resources.
In addition, public announcements by China Telecom, China Netcom, China Mobile, and China Unicom each of which exert significant influence over many of our major customers in China, may contribute to volatility in the price of our stock. The price of our stock may react to such announcements.
SOFTBANK CORP. and its related entities, including SOFTBANK America Inc., have significant influence over our management and affairs, which it could exercise against the best interests of our stockholders.
SOFTBANK CORP. and its related entities, including SOFTBANK America Inc. (collectively, SOFTBANK), beneficially owned approximately 12.8% of our outstanding stock as of December 31, 2004. As a result, SOFTBANK has the ability to influence all matters submitted to our stockholders for approval, as well as our management and affairs. Matters that could require stockholder approval include:
· election and removal of directors;
· merger or consolidation of our Company; and
· sale of all or substantially all of our assets.
This concentration of ownership may delay or prevent a change of control or discourage a potential acquirer from making a tender offer or otherwise attempting to obtain control of our Company, which could decrease the market price of our common stock.
Delaware law and our charter documents contain provisions that could discourage or prevent a potential takeover, even if the transaction would benefit our stockholders.
Other companies may seek to acquire or merge with us. An acquisition or merger of our Company could result in benefits to our stockholders, including an increase in the value of our common stock. Some provisions of our Certificate of Incorporation and Bylaws, as well as provisions of Delaware law, may discourage, delay or prevent a merger or acquisition that a stockholder may consider favorable. These provisions include:
· authorizing the board of directors to issue additional preferred stock;
· prohibiting cumulative voting in the election of directors;
· limiting the persons who may call special meetings of stockholders;
· prohibiting stockholder action by written consent;
· creating a classified board of directors pursuant to which our directors are elected for staggered three year terms; and
· establishing advance notice requirements for nominations for election to the board of directors and for proposing matters that can be acted on by stockholders at stockholder meetings.
Together with the holders of our convertible subordinated notes due in 2008, we face a variety of risks related to the notes.
Holders of our convertible subordinated notes due in 2008 (the Notes) and we face a variety of risks with respect to the Notes, including the following:
· we may be limited in our ability to purchase the Notes in the event of a change in control, either for cash or stock, which could result in our defaulting on the Notes at the time of the change in control and purchases for stock would be subject to market risk;
· an event of default under our senior debt, including one of our subsidiaries, could restrict our ability to purchase or pay any or all amounts due on Notes, and after paying our senior debt in full, we may not have sufficient assets remaining to pay any or all amounts due on the Notes;
· there is no listed trading market for the Notes, which could have a negative impact on the market price of the Notes;
· we have significantly increased our leverage as a result of the sale of the Notes which could have an adverse impact on our ability to obtain additional financing for working capital;
· hedging transactions related to the Notes and our common stock and other transactions, as well as changes in interest rates and our creditworthiness, may affect the value of the Notes and of our common stock; and
· the Notes might not be rated or may receive a lower rating than anticipated by investors, ultimately having a negative affect on the price of the Notes and of our common stock.
· In addition, we are subject to various covenants and obligations pursuant to the terms of the indenture governing the Notes (the Indenture). Should we default on certain of these obligations, then all unpaid principal and accrued interest on the Notes then outstanding could become immediately due and payable. For example, as of April 1, 2005, we were in technical noncompliance under the Indenture due to the untimely filing of our Annual Report on Form 10-K for the year ended December 31, 2004. If we had failed to file this Annual Report within 60 days of written notice being provided to us be either the trustee under the Indenture or the holders of at least 25%
in aggregate principal amount of the Notes then outstanding, an event of default under the Indenture would have occured. If an event of default under the Indenture occurs and if payment of principal and accrued interest on the Notes is accelerated, our business could be seriously harmed.
Nasdaq has informed us that our common stock may be delisted, which could materially impair the ability of investors to trade in our common stock and could have a material adverse effect on our stock price.
On April 5, 2005, we received a notice from the staff of Nasdaq, indicating that we failed to comply with Marketplace Rule 4310(c)(14), due to the fact that we did not file this Annual Report on Form 10-K with the SEC by March 31, 2005. Beginning at the opening of business on April 7, 2005, Nasdaq appended the fifth character E to the trading symbol for our common stock. We have requested a hearing before a Nasdaq Listing Qualifications Panel, (the Panel), to review the Nasdaq staffs determination. The hearing request has stayed the delisting of our common stock pending the Panels decision. There can be no assurance that the Panel will grant our request for continued listing. In the event that the Panel denies our request for continued listing and our common stock is delisted from Nasdaq, the ability of our investors to buy and sell shares of our common stock could be materially impaired. In addition, the delisting of our common stock from Nasdaq could have a material adverse effect on our stock price.
We are exposed to the impact of interest rate changes, changes in foreign currency exchange rates and changes in the stock market.
Interest Rate Risk:
Our exposure to market risk for changes in interest rates relates primarily to our investment portfolio. The fair value of our investment portfolio would not be significantly affected by either a 10% increase or decrease in interest rates due mainly to the short-term nature of most of our investment portfolio. However, our interest income can be sensitive to changes in the general level of U.S. interest rates since the majority of our funds are invested in instruments with maturities of less than one year. Our policy is to limit the risk of principal loss and to ensure the safety of invested funds by generally attempting to limit market risk. Funds in excess of current operating requirements are mostly invested in government-backed notes, commercial paper, floating rate corporate bonds, fixed income corporate bonds and tax-exempt instruments. In accordance with our investment policy, all short-term investments are invested in investment grade rated securities with minimum A or better ratings. Currently, most of our short-term investments have AA or better ratings.
The table below represents carrying amounts and related weighted-average interest rates of our investment portfolio at December 31, 2004 and 2003: