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| VTSS.PK > SEC Filings for VTSS.PK > Form 10-Q on 17-Feb-2009 | All Recent SEC Filings |
17-Feb-2009
Quarterly Report
Cautionary Statement
You should read the following discussion and analysis in conjunction with our Unaudited Consolidated Financial Statements and the related Notes thereto contained in Part I, Item 1 of this Report. The information contained in this Quarterly Report on Form 10-Q is not a complete description of our business or the risks associated with an investment in our common stock. We urge you to carefully review and consider the various disclosures made by us in this Report and in our Annual Report on Form 10-K for the year ended September 30, 2008, which discusses our business in greater detail, filed with the Securities and Exchange Commission, or SEC.
The section entitled "Risk Factors" contained in Part II, Item 1A of this Report, and similar discussions in our other SEC filings, describe some of the important risk factors that may affect our business, financial condition, results of operations and/or liquidity. You should carefully consider those risks, in addition to the other information in this Report and in our other filings with the SEC, before deciding to purchase, hold or sell our common stock.
This Quarterly Report contains forward-looking statements that involve risks and uncertainties. We use words such as "anticipates," "believes," "plans," "expects," "future," "intends," "may," "should," "estimates," "predicts," "potential," "continue," "becoming," "transitioning" and similar expressions to identify such forward-looking statements. Our forward-looking statements include statements as to our business outlook, revenues, margins, expenses, tax provision, capital resources sufficiency, capital expenditures, interest income, cash commitments and expenses. Forward-looking statements are not guarantees of future performance and the Company's actual results may differ significantly from the results discussed in the forward-looking statements. Factors that might cause such differences include, but are not limited to, those discussed in the subsection entitled "Risk Factors" under Part I, Item 1A of this Annual Report. The Company assumes no obligation to revise or update any forward-looking statements for any reason, except as required by law.
Overview
Over the last ten years, the proliferation of the Internet and the rapid growth in the volume of data being sent over Local Area Network ("LANs") and Wide Area Network ("WANs") has placed a tremendous strain on the existing communications infrastructure. Communication service providers have sought to increase their revenues by delivering a growing range of data services to their customers in a cost-effective manner. The resulting demand for increased bandwidth and services has created a need for faster, larger, and more complex networks. Additionally, due to increasing needs for moving, managing, and storing mission- critical data, the market for storage equipment has been growing significantly.
We are a leading supplier of high-performance integrated circuits ("ICs") principally targeted at systems manufacturers in the communications and storage industries. Within the communications industry, our products address Carrier and Enterprise networking, where they enable data to be transmitted at high-speeds and processed and switched under a variety of protocols. In Storage, our products address primarily enterprise class storage systems and blade-servers using Fibre Channel and Serial Attached SCSI ("SAS")/ Serial Attached ATA ("SATA") protocols. Our customers include leading communications and storage OEMs.
In recent years, we have focused our product development and marketing efforts on products that leverage the convergence of Carrier and Enterprise Networking onto IP-based networks. These Next-Generation Networks share the requirements of high reliability, scalability, interoperability, and low cost. Increasingly, these networks will be delivered based on Ethernet technology. We believe that
products in this emerging technology area represent the best opportunity for us to provide differentiation in the market.
In the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2008, the Company provided a chronological listing of events that occurred between April 2006 and December 2008, including, but not limited to, activities related to errors and irregularities in the disclosure of, and accounting for stock options granted by the Company to its employees and the Board. A number of these events contributed directly to the delayed filing of the prior years' Annual Reports with the SEC.
The Company filed its Annual Report on Form 10-K for the fiscal year ended September 30, 2008 on December 31, 2008, and has been current since such date with respect to its Exchange Act reporting obligations.
Our Business Product Lines
Beginning in 2008, Vitesse classified product revenues into three markets:
Carrier Networking, Enterprise Networking, and Non-Core. These classifications
reflect the major trends in our product lines and how they map into our customer
base. In addition, we have an intellectual property revenue stream that was
introduced in the last quarter of 2008.
Carrier Networking
The telecommunications Carrier Global Network, which includes networks delivering voice and data services, has grown dramatically to a complex combination of networks. These networks are often classified into groups such as WANs, Metropolitan Area Networks ("MANs"), Multi-Service Access Networks ("MSANs"), and Radio Access Networks ("RANs"). Each of these types of networks has their own set of technical and operational challenges. These evolving networks must deliver more bandwidth and provide increasing data-based capabilities to provide "quadruple play" services that integrate voice, data, and video traffic over both wired and wireless networks. To address this problem, Carriers are increasingly trying to map Ethernet services and connectivity more efficiently into their existing networks. They may even replace their legacy network with new all-IP/Ethernet-based networks. Broadly, Ethernet technology upgraded to meet these requirements is being referred to as "Carrier Ethernet." It is, in effect, an adaptation of Ethernet to provide the same features and functions that have traditionally been provided by "telecom" protocols such as Synchronous Optical Network ("SONET/SDH"), Plesiochronous Digital Hierarchy ("PDH"), etc. Because of the complexity of the Carrier networks, products sold into these applications have long design cycles, typically two to four years from design start to production, and long life cycles, typically five to ten years or more.
Vitesse provides a variety of products into Carrier networking applications.
These generally include: (i) Ethernet-over-SONET mappers, SONET framers and
switches; (ii) Optoelectronic physical media devices ("PMDs") and physical layer
devices ("PHYs") such as transceivers and Clock and Data Recovery ("CDRs");
(iii) Signal Integrity Products including backplane transceivers, CDRs, and
crosspoints switches; (iv) Ethernet Media access controllers ("EMACs") and
switches; (v) GbE Cu PHYs; and (vi) Next-Generation Optical Transport Network
("OTN") mappers.
Enterprise Networking
Enterprise Networks generally include equipment dedicated to the communication of voice and data services within large enterprise organizations. An Enterprise Network will typically be comprised of one or more LANs, computer systems including workstations and servers, as well as one or more Service Access Networks ("SANs"). Enterprise Networks will also typically include broadband connections to Carrier Networks for the broader communication of voice and/or data outside of the enterprise. Enterprise Networks are often classified into groups depending on their size and complexity. Typical categories are large Enterprise, data center switching, small-medium enterprise ("SME"), Small
Medium Business ("SMB"), and small office home office ("SOHO"). Similar to Carrier Networks, Enterprise Networks are going through an evolution to provide more bandwidth, (i.e. more data at higher speeds) and more reliability, interoperability, and scalability. Ethernet-based networks, which are already widely deployed in LANs, are becoming more prevalent in other enterprise applications such as data center switching and SANs. Enterprises are paring down their multiple networks (telephone, LAN, video conferencing, wireless, and remote mirroring/backup) to a common switched IP/Ethernet-based infrastructure. Ethernet technology that is being upgraded to meet these new requirements is generally referred to as "Converged Enhanced Ethernet." In addition, Enterprise Networks are migrating from fast 100 Mbps Ethernet to Gigabit Ethernet and from Gigabit Ethernet to 10 Gigabit Ethernet. This transition is still in the early stages and expected to accelerate over the next several years. The complexity of products within the Enterprise Networks varies dramatically based on the product application. Products at the "low-end" of the network, in SOHO, SME, and low-end SME applications typically have fast design cycles on the order of six to 12 months and short life cycles, on the order of two to four years.
Products sold into applications at the "high-end" of Enterprise such as data
center switching and high-end SME have longer design cycles, typically one to
two years from design start to production and long life cycles, typically three
to five years or more. Vitesse provides a variety of products into Enterprise
Networking applications. These generally include: (i) Ethernet MACs, switches,
and routers; (ii) GbE Cu PHYs; (iii) Integrated Cu PHY and switch products; and
(iv) Signal Integrity products including backplane transceivers, CDRs, and
crosspoint switches.
Non-Core
Products that do not substantially sell into the Carrier or Enterprise Networking markets or require little or no current or future investment have been classified as Non-Core products. Today, these products include legacy products from our Fibre Channel storage products line, our Raid-on-Chip processor line, our network processor product line, and our packet-based fabric switch product line.
Intellectual Property
In 2008, we began to leverage our substantial intellectual property portfolio into licensing opportunities with third parties. We offer a variety of intellectual property "cores" and design services in deep submicron, 130 nm and 65 nm, process technologies. To date, our primary focus has been our Gigabit Ethernet Cu PHY and switch technologies as well as high-speed PHYs and signal integrity "cores".
We anticipate being able to exploit our many years of technology development by providing this technology to systems suppliers and other semiconductor suppliers in the form of intellectual property via licensing arrangements. We believe we are in a unique position to supply such intellectual property to other Integrated Circuit ("IC") vendors as we are either the technology or low-power leader for such intellectual property, or such intellectual property is only available from IC vendors that are competing in the same markets as the companies looking for such intellectual property. As a smaller, more focused and specialized IC vendor, we are less likely to compete with those companies.
Critical Accounting Policies and Estimates
The preparation of financial statements in accordance with U.S. generally accepted accounting principles requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements, and the reported amounts of net revenue and expenses during the reporting period. We regularly evaluate our estimates and assumptions related to revenue recognition, allowance for doubtful accounts, sales returns, inventory valuation, goodwill and purchased intangible asset valuations, share-based compensation expense, and income taxes. We base
our estimates and assumptions on current facts, historical experience, and on various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities and the recording of revenues, costs, and expenses that are not apparent from other sources. The actual results experienced by us may differ materially and adversely from our estimates. To the extent there are material differences between our estimates and the actual results, our future results of operations will be affected.
We believe the following are either: (i) critical accounting policies that require us to make significant judgments and estimates in the preparation of our consolidated financial statements; or (ii) other key accounting policies that generally do not require us to make estimates or judgments but may be difficult or subjective.
Revenue Recognition, Sales Returns Reserve and Allowance for Doubtful Accounts
In accordance with SEC Staff Accounting Bulletin ("SAB") No. 101, "Revenue
Recognition in Financial Statements," as well as SAB No. 104, "Revenue
Recognition," we recognize product revenue when the following fundamental
criteria are met: (i) persuasive evidence of an arrangement exists;
(ii) delivery has occurred; (iii) the price to the customer is fixed or
determinable; and (iv) collection of the sales price is reasonably assured.
Delivery occurs when goods are shipped and title and risk of loss transfer to
the customer, in accordance with the terms specified in the arrangement with the
customer. Revenue recognition is deferred in all instances where the earnings
process is incomplete. With a few minor exceptions, we recognize revenue on
goods shipped directly to customers at the time of shipping, as that is when
title passes to the customer and all revenue recognition criteria specified
above are met.
Vitesse has a distribution network through which it sells most of its products. The Company recognizes revenue on a sell-through basis for all distributors, utilizing information provided by the distributors. These distributors maintain inventory balances, which are carried on the books of Vitesse, and are given business terms to return a portion of inventory and receive credits for changes in selling prices to end customers. At the time Vitesse ships inventory to the distributors, the magnitude of future returns and price adjustments is not known. Therefore, revenue recognition for shipments to distributors does not occur until the distributors sell inventory to end customers. Payments received from distributors for inventory shipped to them, in advance of the sale of that inventory to end-user, are shown as deferred revenue. Vitesse personnel are often involved with the sales from the distributors to end customers.
Revenues from development contracts are recognized upon attainment of specific milestones established under customer contracts. Revenues from products deliverable under development contracts, including design tools and prototype products, are recognized upon delivery. Costs related to development contracts are expensed as incurred.
We record a reserve for estimated sales returns and allowances in the same period as the related revenues are recognized. Sales returns typically occur for quality related issues and allowances are based on specific criteria such as rebate agreements. We base these estimates on our historical experience or the specific identification of an event necessitating a reserve. To the extent actual sales returns or allowances differ from our estimates; our future results of operations may be affected.
We also maintain an allowance for doubtful accounts for estimated losses resulting from customers' inability to meet their financial obligations to us. We evaluate the collectability of accounts receivable based on a combination of factors. Management reviews accounts receivable on a monthly basis to determine if any receivables will potentially be uncollected. The Company includes any accounts receivable balances that are determined to be uncollectible in the overall allowance for doubtful accounts using the specific identification method. After all attempts to collect a receivable have failed, the receivable is written off against the allowance. Management believes the allowance for doubtful accounts as of December 31, 2008 and September 30, 2008, is adequate. However, if the financial
condition of any customer were to deteriorate, resulting in an impairment of its ability to make payments, additional allowances could be required.
In accordance with SAB No. 104, "Selected Revenue Recognition Issues" ("SAB 104"), in the licensing of technology and other intangibles, delivery does not occur for revenue recognition purposes until the license term begins. Revenues should be recognized in a manner consistent with the nature of the transaction and related earnings process. Pursuant to the guidance in SAB 104, revenue related to the licensing of intellectual property is deferred until final acceptance of the contracted deliverables. Any royalties related to the licensing will be recognized when received.
Inventory Valuation
Inventories are stated at the lower of cost or market (net realizable value). Costs associated with the development of a new product are charged to engineering, research and development expense as incurred, until the product is proven through testing and acceptance by the customer. At each balance sheet date, the Company evaluates its ending inventory for excess quantities and obsolescence. This evaluation includes analyses of sales levels by product and projections of future demand.
We write down our inventory for estimated obsolete or unmarketable inventory in an amount equal to the difference between the cost of inventory and the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than our estimates, additional inventory write-downs may be required. In the event we experience unanticipated demand and are able to sell a portion of the inventory we have previously written down, our gross margins will be favorably affected.
Valuation of Goodwill, Purchased Intangible Assets, and Long-Lived Assets
Goodwill is recorded as the difference, if any, between the aggregate consideration paid for an acquisition and the fair value of the net tangible and intangible assets acquired. The amounts and useful lives assigned to intangible assets acquired, other than goodwill, impact the amount and timing of future amortization, and the amount assigned to in-process research & development is expensed immediately. The value of intangible assets, including goodwill, can be impacted by adverse changes such as declines in operating results, a decrease in stock value, changes in the worldwide economy or a specific industry or a failure to meet performance projections.
We account for goodwill and other intangible assets in accordance with the Statement of Financial Accounting Standards ("SFAS") No. 142, "Accounting for Goodwill and Other Intangible Assets" ("SFAS 142"). We evaluate these assets, including purchased intangible assets deemed to have indefinite lives, on an annual basis in the fourth quarter, or more frequently, if we believe indicators of impairment exist or changes in circumstances indicate that the carrying value may not be recoverable. Factors we consider important that could trigger an impairment review include significant underperformance to historical or projected operating results, substantial changes in our business strategy, and significant negative industry or economic trends.
If such indicators are present, we compare the fair value of the goodwill to its carrying value. Fair value of goodwill is determined by considering the Company's market capitalization, discounted cash flows, and a market approach as of the valuation date. In considering the Company's market capitalization, an estimated premium to reflect the fair value on a control basis was applied. This premium was estimated based on an evaluation of control premiums identifiable in comparable transactions.
For other intangible assets and long-lived assets, in accordance with SFAS 144, "Accounting for the Impairment or Disposal of Long-Lived Assets" ("SFAS 144"), we determine whether the sum of the estimated undiscounted cash flows attributable to each asset in question is less than its carrying value.
If less, we recognize an impairment loss based on the excess of the carrying amount of the assets over their respective fair values. Fair value of other intangible assets is determined by discounted future cash flows, appraisals, or other methods. Fair value of long-lived assets is determined based on market value. If the long-lived asset determined to be impaired is to be held and used, we recognize an impairment charge to the extent the fair value attributable to the asset is less than the asset's carrying value. The fair value of the long-lived asset then becomes the asset's new carrying value, which we amortize over the remaining estimated useful life of the asset.
These approaches use significant estimates and assumptions, including projection and timing of future cash flows, discount rates reflecting the risk inherent in future cash flows, and long-term growth rates. It is reasonably possible that the estimates and assumptions used to value these assets may be incorrect. If our actual results, or the estimates and assumptions used in future impairment analyses, are lower than the original estimates and assumptions used to assess the recoverability of these assets, we could incur additional impairment charges.
During the quarter ended December 31, 2008, we identified changes in key
factors indicating a possible impairment of the value of our goodwill. Notable
indicators were significantly depressed market conditions and industry trends,
market capitalization below book value of equity and some downward revisions to
our forecasts due to current economic conditions. Continually changing market
conditions make it difficult to project how long the current economic downturn
may last. Declining market values have negatively impacted our valuations, which
are a component of our goodwill impairment tests. Upon completion of the first
step of the impairment test for the quarter ended December 31, 2008, we
determined that additional impairment analysis was required by SFAS 142. The
second step of the goodwill impairment test compared the implied fair value of
our Company's goodwill with the carrying amount of that goodwill. Since the
carrying amount of goodwill exceeded the implied fair value of that goodwill, an
impairment loss is recognized in an amount equal to that excess. The implied
fair value of goodwill is determined in the same manner as the amount of
goodwill recognized in a business combination. The fair value was determined
through an analysis of: (i) the market capitalization; (ii) comparable public
company valuations; and (iii) the future cash flows expected to be generated by
the company. The calculated fair value is then allocated to individual assets
and liabilities (including any unrecognized intangible assets) as if the Company
had been acquired in a business combination and the fair value of the Company
was the purchase price paid to acquire the Company. In performing this
allocation, the fair values of the assets of the Company were calculated using
generally accepted valuation methodologies, including analysis of: (i) the
future cash flows expected to be generated; (ii) the estimated market value; or
(iii) the estimated cost to replace. Any variance in the assumptions used to
value the assets and liabilities could have had a significant impact on the
estimated fair value of the assets and liabilities and consequently the amount
of identified goodwill impairment. As a result of the additional analyses
performed, we recorded an impairment charge of $191.4 million for the quarter
ended December 31, 2008.
Other intangible assets, which consist primarily of technology and intellectual property, are amortized over their estimated useful lives. The remaining lives of these assets range from less than one year to three years. As required by SFAS 144, we verified our long-lived assets were not impaired as of the time of the goodwill impairment.
Valuation of Repurchase Right on Subordinated Debentures
In accordance with SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"), embedded derivatives must be bifurcated from the underlying debt instrument and valued as a separate financial instrument. Our 1.5% Convertible Subordinated Debentures due 2024 (the "2024 Debentures") include a repurchase right for 113.76% of the principal amount of the 2024 Debentures on October 1, 2009 (the "premium put"). We estimate the approximate fair value of the premium put as the difference between the estimated value of the 2024 Debentures with and without
the premium put feature. The fair value of the 2024 Debentures, both with and without the embedded premium put feature, was estimated using a convertible bond valuation model within a lattice framework. The valuation model combined expected cash outflows with market-based assumptions regarding risk-adjusted yields, stock price volatility, and recent price quotes and trading information regarding shares of our common stock into which the 2024 Debentures are convertible. Based on our analysis, we determined that the fair value of the premium put is most sensitive to the estimated amount of funds available for settlement of the liability on October 1, 2009. Any gain or loss on the fair value of the premium put is reflected in current earnings. The premium put was estimated to have no fair value as of December 31, 2008 and 2007.
Accounting for Share-Based Compensation
SFAS No. 123R "Share-Based Payments," ("SFAS 123R"), requires all share- based payments, including grants of stock options and employee stock purchase rights, to be recognized in our financial statements based on their respective grant date fair values. Under this standard, the fair value of each employee stock option and employee stock purchase right is estimated on the date of grant using an option-pricing model that meets certain requirements.
SFAS 123R requires companies to estimate the fair value of share-based payment awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense ratably over the requisite service periods. We have estimated the fair value of each award as of the date of grant or assumption using the Black-Scholes option pricing model, which was developed for use in estimating the value of traded options that have no vesting restrictions and that are freely transferable. The Black-Scholes model considers, among other factors, the expected life of the award and the expected volatility of the Company's stock . . .
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