| ZHONE TECHNOLOGIES INC ITEM 1A RISK FACTORS Set forth below and elsewhere in this report and in other documents we file with the SEC are risks and uncertainties that could cause actual results to differ materially from the results contemplated by the forward-looking statements contained in this report |
| Our future operating results are difficult to predict and our stock price may continue to be volatile |
| As a result of a variety of factors discussed in this report, our revenues for a particular quarter are difficult to predict |
| Our revenue and operating results may vary significantly from quarter to quarter due to a number of factors, many of which are outside of our control |
| The primary factors that may affect our results of operations include the following: • commercial acceptance of our SLMS products; • fluctuations in demand for network access products; • the timing and size of orders from customers; • the ability of our customers to finance their purchase of our products as well as their own operations; • new product introductions, enhancements or announcements by our competitors; • our ability to develop, introduce and ship new products and product enhancements that meet customer requirements in a timely manner; • changes in our pricing policies or the pricing policies of our competitors; • the ability of our company and our contract manufacturers to attain and maintain production volumes and quality levels for our products; • our ability to obtain sufficient supplies of sole or limited source components; • increases in the prices of the components we purchase, or quality problems associated with these components; • unanticipated changes in regulatory requirements which may require us to redesign portions of our products; • changes in accounting rules, such as recording expenses for employee stock option grants; • integrating and operating any acquired businesses; • our ability to achieve targeted cost reductions; • how well we execute on our strategy and operating plans; and • general economic conditions as well as those specific to the communications, internet and related industries |
| Any of the foregoing factors, or any other factors discussed elsewhere herein, could have a material adverse effect on our business, results of operations, and financial condition that could adversely affect our stock price |
| In addition, public stock markets have experienced, and may in the future experience, extreme price and trading volume volatility, particularly in the technology sectors of the market |
| This volatility has significantly affected the market prices of securities of many technology companies for reasons frequently unrelated to or disproportionately impacted by the operating performance of these companies |
| These broad market fluctuations may adversely affect the market price of our common stock |
| We may not achieve the cost savings, revenue enhancements and other benefits we expected from our acquisition of Paradyne, which may have a material adverse effect on our business, financial condition and results of operations |
| We completed our acquisition of Paradyne on September 1, 2005, with the expectation that the merger will result in cost savings, revenue enhancements, manufacturing efficiencies, and other benefits to the combined 13 ______________________________________________________________________ [40]Table of Contents company |
| However, the ability to realize these anticipated benefits of the merger will depend, in part, on our ability to integrate the business of Paradyne with the business of Zhone |
| The integration of two independent companies is a complex, costly and time-consuming process |
| It is possible that these integration efforts will not be completed as smoothly as planned or that these efforts will divert management attention for an extended period of time |
| Delays encountered in the integration process could affect customer relationships, manufacturing operations and other operational efficiencies that could have a material adverse effect on our revenues, expenses, operating results and financial condition |
| We have incurred significant losses to date and expect that we will continue to incur losses in the foreseeable future |
| If we fail to generate sufficient revenue to achieve or sustain profitability, our stock price could decline |
| We have incurred significant losses to date and expect that we will continue to incur losses in the foreseeable future |
| Our net losses for 2005 and 2004 were dlra126dtta9 million and dlra35dtta6 million, respectively, and we had an accumulated deficit of dlra758dtta3 million at December 31, 2005 |
| We have significant fixed expenses and expect that we will continue to incur substantial manufacturing, research and product development, sales and marketing, customer support, administrative and other expenses in connection with the ongoing development of our business |
| In addition, we may be required to spend more on research and product development than originally budgeted to respond to industry trends |
| We may also incur significant new costs related to acquisitions and the integration of new technologies, including our ongoing integration of Paradyne, and other acquisitions that may occur in the future |
| As a result, our ability to achieve and sustain profitability will depend on our ability to generate and sustain substantially higher revenue while maintaining reasonable cost and expense levels |
| If we fail to generate sufficient revenue to achieve or sustain profitability, we will continue to incur substantial operating losses and our stock price could decline |
| We have significant debt obligations, which could adversely affect our business, operating results and financial condition |
| As of December 31, 2005, we had approximately dlra44dtta3 million of total debt, of which dlra15dtta7 million was current and dlra28dtta6 million was long-term |
| Our debt obligations could materially and adversely affect us in a number of ways, including: • limiting our ability to obtain additional financing in the future for working capital, capital expenditures, acquisitions or general corporate purposes; • limiting our flexibility to plan for, or react to, changes in our business or market conditions; • requiring us to use a significant portion of any future cash flow from operations to repay or service the debt, thereby reducing the amount of cash available for other purposes; • making us more highly leveraged than some of our competitors, which may place us at a competitive disadvantage; and • making us more vulnerable to the impact of adverse economic and industry conditions and increases in interest rates |
| We cannot assure you that we will be able to generate sufficient cash flow in amounts sufficient to enable us to service our debt or to meet our working capital and capital expenditure requirements |
| If we are unable to generate sufficient cash flow from operations or to borrow sufficient funds to service our debt, due to borrowing base restrictions or otherwise, we may be required to sell assets, reduce capital expenditures or obtain additional financing |
| We cannot assure you that we will be able to engage in any of these actions on reasonable terms, if at all |
| 14 ______________________________________________________________________ [41]Table of Contents If we are unable to obtain additional capital to fund our existing and future operations, we may be required to reduce the scope of our planned product development, and marketing and sales efforts, which would harm our business, financial condition and results of operations |
| The development and marketing of new products, and the expansion of our direct sales operations and associated support personnel requires a significant commitment of resources |
| We may continue to incur significant operating losses or expend significant amounts of capital if: • the market for our products develops more slowly than anticipated; • we fail to establish market share or generate revenue at anticipated levels; • our capital expenditure forecasts change or prove inaccurate; or • we fail to respond to unforeseen challenges or take advantage of unanticipated opportunities |
| As a result, we may need to raise substantial additional capital |
| Additional capital, if required, may not be available on acceptable terms, or at all |
| If additional capital is raised through the issuance of debt securities, the terms of such debt could impose financial or other restrictions on our operations |
| If we are unable to obtain additional capital or are required to obtain additional capital on terms that are not favorable to us, we may be required to reduce the scope of our planned product development and sales and marketing efforts, which would harm our business, financial condition and results of operations |
| If demand for our SLMS products does not develop, then our results of operations and financial condition will be adversely affected |
| Although we expect that our SLMS product line will account for a substantial portion of our revenue in the future, to date we have generated a significant portion of our revenue from sales of products from the Legacy and Service product family |
| Our future revenue depends significantly on our ability to successfully develop, enhance and market our SLMS products to the network service provider market |
| Most network service providers have made substantial investments in their current infrastructure, and they may elect to remain with their current architectures or to adopt new architectures, such as SLMS, in limited stages or over extended periods of time |
| A decision by a customer to purchase our SLMS products will involve a significant capital investment |
| We must convince our service provider customers that they will achieve substantial benefits by deploying our products for future upgrades or expansions |
| We do not know whether a viable market for our SLMS products will develop or be sustainable |
| If this market does not develop or develops more slowly than we expect, our business, financial condition and results of operations will be seriously harmed |
| We depend upon the development of new products and enhancements to existing products, and if we fail to predict and respond to emerging technological trends and customers’ changing needs, our operating results and market share may suffer |
| The markets for our products are characterized by rapidly changing technology, evolving industry standards, changes in end-user requirements, frequent new product introductions and changes in communications offerings from network service provider customers |
| Our future success depends on our ability to anticipate or adapt to such changes and to offer, on a timely and cost-effective basis, products that meet changing customer demands and industry standards |
| We may not have sufficient resources to successfully and accurately anticipate customers’ changing needs, technological trends, manage long development cycles or develop, introduce and market new products and enhancements |
| The process of developing new technology is complex and uncertain, and if we fail to develop new products or enhancements to existing products on a timely and cost-effective basis, or if our new products or enhancements fail to achieve market acceptance, our business, financial condition and results of operations would be materially adversely affected |
| 15 ______________________________________________________________________ [42]Table of Contents Because our products are complex and are deployed in complex environments, our products may have defects that we discover only after full deployment, which could seriously harm our business |
| We produce highly complex products that incorporate leading-edge technology, including both hardware and software |
| Software typically contains defects or programming flaws that can unexpectedly interfere with expected operations |
| In addition, our products are complex and are designed to be deployed in large quantities across complex networks |
| Because of the nature of these products, they can only be fully tested when completely deployed in large networks with high amounts of traffic, and there is no assurance that our pre-shipment testing programs will be adequate to detect all defects |
| If we are unable to cure a product defect, we could experience damage to our reputation, reduced customer satisfaction, loss of existing customers and failure to attract new customers, failure to achieve market acceptance, reduced sales opportunities, loss of revenue and market share, increased service and warranty costs, diversion of development resources, legal actions by our customers, and increased insurance costs |
| Defects, integration issues or other performance problems in our products could also result in financial or other damages to our customers |
| Our customers could seek damages for related losses from us, which could seriously harm our business, financial condition and results of operations |
| A product liability claim brought against us, even if unsuccessful, would likely be time consuming and costly |
| The occurrence of any of these problems would seriously harm our business, financial condition and results of operations |
| A shortage of adequate component supply or manufacturing capacity could increase our costs or cause a delay in our ability to fulfill orders, and our failure to estimate customer demand properly may result in excess or obsolete component inventories that could adversely affect our gross margins |
| Occasionally, we may experience a supply shortage, or a delay in receiving, certain component parts as a result of strong demand for the component parts and/or capacity constraints or other problems experienced by suppliers |
| If shortages or delays persist, the price of these components may increase, or the components may not be available at all, and we may also encounter shortages if we do not accurately anticipate our needs |
| We may not be able to secure enough components at reasonable prices or of acceptable quality to build new products in a timely manner in the quantities or configurations needed |
| Accordingly, our revenue and gross margins could suffer until other sources can be developed |
| Our operating results would also be adversely affected if, anticipating greater demand than actually develops, we commit to the purchase of more components than we need |
| Furthermore, as a result of binding price or purchase commitments with suppliers, we may be obligated to purchase components at prices that are higher than those available in the current market |
| In the event that we become committed to purchase components at prices in excess of the current market price when the components are actually used, our gross margins could decrease |
| We rely on contract manufacturers for a significant portion of our manufacturing requirements |
| We rely on contract manufacturers to perform a portion of the manufacturing operations for our products |
| These contract manufacturers build product for other companies, including our competitors |
| In addition, we do not have contracts in place with some of these providers and may not be able to effectively manage those relationships |
| We cannot be certain that our contract manufacturers will be able to fill our orders in a timely manner |
| We face a number of risks associated with this dependence on contract manufacturers including reduced control over delivery schedules, the potential lack of adequate capacity during periods of excess demand, poor manufacturing yields and high costs, quality assurance, increases in prices, and the potential misappropriation of our intellectual property |
| We have experienced in the past, and may experience in the future, problems with our contract manufacturers, such as inferior quality, insufficient quantities and late delivery of products |
| We depend on sole or limited source suppliers for several key components |
| If we are unable to obtain these components on a timely basis, we will be unable to meet our customers’ product delivery requirements, which would harm our business |
| If any of our sole or limited source suppliers experience capacity constraints, work stoppages or any other reduction or 16 ______________________________________________________________________ [43]Table of Contents disruption in output, they may be unable to meet our delivery schedules |
| Our suppliers may enter into exclusive arrangements with our competitors, be acquired by our competitors, stop selling their products or components to us at commercially reasonable prices, refuse to sell their products or components to us at any price or be unable to obtain or have difficulty obtaining components for their products from their suppliers |
| If we do not receive critical components from our sole or limited source suppliers in a timely manner, we will be unable to meet our customers’ product delivery requirements |
| Any failure to meet a customer’s delivery requirements could materially adversely affect our business, operating results and financial condition and could materially damage customer relationships |
| Our target customer base is concentrated, and the loss of one or more of our customers could harm our business |
| The target customers for our products are network service providers that operate voice, data and video communications networks |
| There are a limited number of potential customers in our target market |
| During the year ended December 31, 2004, one customer accounted for 15prca of our revenue |
| Also, we expect that a significant portion of our future revenue will depend on sales of our products to a limited number of customers |
| Any failure of one or more customers to purchase products from us for any reason, including any downturn in their businesses, would seriously harm our business, financial condition and results of operations |
| Industry consolidation may lead to increased competition and may harm our operating results |
| There has been a trend toward industry consolidation in the communications equipment market for several years |
| We expect this trend to continue as companies attempt to strengthen or hold their market positions in an evolving industry and as companies are acquired or are unable to continue operations |
| We believe that industry consolidation may result in stronger competitors that are better able to compete as sole-source vendors for customers |
| This could have a material adverse effect on our business, financial condition and results of operations |
| Furthermore, rapid consolidation could result in a decrease in the number of customers we serve |
| Loss of a major customer could have a material adverse effect on our business, financial condition and results of operations |
| We are exposed to the credit risk of some of our customers and to credit exposures in weakened markets, which could result in material losses |
| Industry and economic conditions have weakened the financial position of some of our customers |
| To sell to some of these customers, we may be required to assume incremental risks of uncollectible accounts |
| While we monitor these situations carefully and attempt to take appropriate measures to protect ourselves, it is possible that we may have to defer revenue until cash is collected or write down or write off uncollectible accounts |
| Such write-downs or write-offs, if large, could have a material adverse effect on our operating results and financial condition |
| The market we serve is highly competitive and we may not be able to compete successfully |
| Competition in the communications equipment market is intense |
| This market is characterized by rapid change, converging technologies and a migration to networking solutions that offer superior advantages |
| We are aware of many companies in related markets that address particular aspects of the features and functions that our products provide |
| Currently, our primary competitors include Alcatel, Calix, Ciena, Huawei, Lucent and Tellabs, among others |
| We also may face competition from other large communications equipment companies or other companies that may enter our market in the future |
| In addition, a number of companies have introduced products that address the same network needs that our products address, both domestically and abroad |
| Many of our competitors have longer operating histories, greater name recognition, larger customer bases and greater financial, technical, sales and marketing resources than we do and may be able to undertake more extensive marketing efforts, adopt more aggressive pricing policies and provide more customer financing than we can |
| In particular, we are encountering price-focused competitors from Asia, especially China, which places pressure on us to reduce our prices |
| If our competitors offer deep discounts on certain products, we may need to lower prices 17 ______________________________________________________________________ [44]Table of Contents or offer other favorable terms in order to compete successfully |
| Moreover, our competitors may foresee the course of market developments more accurately than we do and could develop new technologies that render our products less valuable or obsolete |
| In our markets, principal competitive factors include: • product performance; • interoperability with existing products; • scalability and upgradeability; • conformance to standards; • breadth of services; • reliability; • ease of installation and use; • geographic footprints for products; • ability to provide customer financing; • price; • technical support and customer service; and • brand recognition |
| If we are unable to compete successfully against our current and future competitors, we may have difficulty obtaining or retaining customers, and we could experience price reductions, order cancellations, increased expenses and reduced gross margins, any of which could have a material adverse effect on our business, financial condition and results of operations |
| Our success largely depends on our ability to retain and recruit key personnel, and any failure to do so would harm our ability to meet key objectives |
| Our future success depends upon the continued services of our executive officers and our ability to identify, attract and retain highly skilled technical, managerial, sales and marketing personnel who have critical industry experience and relationships that we rely on to build our business, including Morteza Ejabat, our co-founder, Chairman, President and Chief Executive Officer, Kirk Misaka, our Chief Financial Officer, and Jeanette Symons, our co-founder and Chief Technology Officer |
| The loss of the services of any of our key employees, including Mr |
| Symons, could delay the development and production of our products and negatively impact our ability to maintain customer relationships, which would harm our business, financial condition and results of operations |
| Acquisitions are an important part of our strategy, and any strategic acquisitions or investments we make could disrupt our operations and harm our operating results |
| As of December 31, 2005, we had acquired twelve companies or product lines since we were founded in 1999, including our acquisition of Paradyne, which closed on September 1, 2005 |
| Further, we may acquire additional businesses, products or technologies in the future |
| On an ongoing basis, we may evaluate acquisitions of, or investments in, complementary companies, products or technologies to supplement our internal growth |
| Also, in the future, we may encounter difficulties identifying and acquiring suitable acquisition candidates on reasonable terms |
| If we do complete future acquisitions, we could: • issue stock that would dilute our current stockholders’ percentage ownership; • consume cash; 18 ______________________________________________________________________ [45]Table of Contents • incur substantial debt; • assume liabilities; • increase our ongoing operating expenses and level of fixed costs; • record goodwill and non-amortizable intangible assets that will be subject to impairment testing and potential periodic impairment charges; • incur amortization expenses related to certain intangible assets; • incur large and immediate write-offs; and • become subject to litigation |
| Any acquisitions or investments that we make in the future will involve numerous risks, including: • difficulties in integrating the operations, technologies, products and personnel of the acquired companies; • unanticipated costs; • diversion of management’s time and attention away from managing the normal daily operations of the business; • adverse effects on existing business relationships with suppliers and customers; • difficulties in entering markets in which we have no or limited prior experience; • insufficient revenues to offset increased expenses associated with acquisitions and where competitors in such markets have stronger market positions; and • potential loss of key employees, particularly those individuals employed by acquired companies |
| Mergers and acquisitions of high-technology companies are inherently risky, and we cannot be certain that our previous or future acquisitions will be successful and will not materially adversely affect our business, operating results or financial condition |
| We do not know whether we will be able to successfully integrate the businesses, products, technologies or personnel that we might acquire in the future or that any strategic investments we make will meet our financial or other investment objectives |
| Any failure to do so could seriously harm our business, financial condition and results of operations |
| We have been, and may continue to be, adversely affected by unfavorable economic and market conditions, and geopolitical uncertainties |
| Economic conditions worldwide have contributed to slowdowns in the communications industry and may impact our business |
| Our customers and potential customers continue to experience a severe economic slowdown that has led to significant decreases in their revenues |
| For most of the last decade, the markets for our equipment have been influenced by the entry into the communications services business of a substantial number of new companies |
| In the United States, this was due largely to changes in the regulatory environment, in particular those brought about by the Telecommunications Act of 1996 |
| These new companies raised significant amounts of capital, much of which they invested in new equipment, causing acceleration in the growth of the markets for communications equipment |
| More recently, there has been a reversal of this trend, including the failure of a large number of the new entrants and a sharp contraction of the availability of capital to the industry |
| This industry trend has been compounded by the weakness in the United States economy as well as the economies in virtually all of the countries in which we market our products |
| In addition, the continuing turmoil in the geopolitical environment in many parts of the world, including terrorist activities and military actions, particularly the continuing tension in and surrounding Iraq, may continue to adversely affect global economic conditions |
| If the economic and market conditions in the United States and the rest of the world do not improve, or if they deteriorate, we may experience material adverse impacts on our business, operating results and financial condition |
| 19 ______________________________________________________________________ [46]Table of Contents Sales to communications service providers are especially volatile, and weakness in sales orders from this industry may harm our operating results and financial condition |
| Sales activity in the service provider industry depends upon the stage of completion of expanding network infrastructures, the availability of funding, and the extent to which service providers are affected by regulatory, economic and business conditions in the country of operations |
| Although some service providers may be increasing capital expenditures over the depressed levels that have prevailed over the last few years, weakness in orders from this industry could have a material adverse effect on our business, operating results and financial condition |
| Slowdowns in the general economy, overcapacity, changes in the service provider market, regulatory developments and constraints on capital availability have had a material adverse effect on many of our service provider customers, with many of these customers going out of business or substantially reducing their expansion plans |
| These conditions have materially harmed our business and operating results, and we expect that some or all of these conditions may continue for the foreseeable future |
| Finally, service provider customers typically have longer implementation cycles; require a broader range of service including design services; demand that vendors take on a larger share of risks; often require acceptance provisions, which can lead to a delay in revenue recognition; and expect financing from vendors |
| All these factors can add further risk to business conducted with service providers |
| Decreased effectiveness of share-based compensation could adversely affect our ability to attract and retain employees |
| We have historically used stock options as a key component of our employee compensation program in order to align the interests of our employees with the interests of our stockholders, encourage employee retention and provide competitive compensation and benefit packages |
| In recent periods, some of our employee stock options have had exercise prices in excess of our stock price, which reduces their value to employees and could affect our ability to retain present, or attract prospective employees |
| In addition, in accordance with Financial Accounting Standards Board Statement 123R, “Share-Based Payment,” we will begin recording charges to earnings for share-based payments in the first quarter of fiscal 2006 |
| As a result, we will incur increased compensation costs associated with our share-based compensation programs |
| Moreover, difficulties relating to obtaining stockholder approval of equity compensation plans could make it harder or more expensive for us to grant share-based payments to employees in the future |
| Due to the international nature of our business, political or economic changes or other factors in a specific country or region could harm our future revenue, costs and expenses and financial condition |
| We currently have international operations consisting of sales and technical support teams in various locations around the world |
| We expect to continue expanding our international operations in the future |
| The successful management and expansion of our international operations requires significant human effort and the commitment of substantial financial resources |
| Further, our international operations may be subject to certain risks and challenges that could harm our operating results, including: • trade protection measures and other regulatory requirements which may affect our ability to import or export our products into or from various countries; • political considerations that affect service provider and government spending patterns; • differing technology standards or customer requirements; • developing and customizing our products for foreign countries; • fluctuations in currency exchange rates; • longer accounts receivable collection cycles and financial instability of customers; • difficulties and excessive costs for staffing and managing foreign operations; • potentially adverse tax consequences; and • changes in a country’s or region’s political and economic conditions |
| Any of these factors could harm our existing international operations and business or impair our ability to continue expanding into international markets |
| 20 ______________________________________________________________________ [47]Table of Contents Compliance or the failure to comply with current and future environmental regulations could cause us significant expense |
| We are subject to a variety of federal, state, local and foreign environmental regulations |
| If we fail to comply with any present and future regulations, we could be subject to future liabilities, the suspension of production or a prohibition on the sale of our products |
| In addition, such regulations could require us to incur other significant expenses to comply with environmental regulations, including expenses associated with the redesign of any non-compliant product |
| From time to time new regulations are enacted, and it is difficult to anticipate how such regulations will be implemented and enforced |
| For example, in 2003 the European Union enacted the Restriction on the Use of Certain Hazardous Substances in Electrical and Electronic Equipment Directive (RoHS) and the Waste Electrical and Electronic Equipment Directive (WEEE), for implementation in European Union member states |
| RoHS and WEEE regulate the use of certain hazardous substances in, and require the collection, reuse and recycling of waste from certain of our products |
| We are aware of similar legislation that is currently in force or is being considered in the United States, as well as other countries, such as Japan and China |
| RoHS and WEEE are in the process of being implemented by individual countries in the European Union |
| Because it is likely that each jurisdiction will interpret RoHS and WEEE differently, individual jurisdictions may impose different or additional responsibilities upon us |
| Our failure to comply with any of such regulatory requirements or contractual obligations could result in our being liable for costs, fines, penalties and third-party claims, and could jeopardize our ability to conduct business in countries in the jurisdictions where these regulations apply |
| Adverse resolution of litigation may harm our operating results or financial condition |
| We are a party to various lawsuits and claims in the normal course of our business |
| Litigation can be expensive, lengthy, and disruptive to normal business operations |
| Moreover, the results of complex legal proceedings are difficult to predict |
| An unfavorable resolution of a particular lawsuit could have a material adverse effect on our business, operating results and financial condition |
| For additional information regarding litigation in |