| Item 1. | Business | 1 | ||
| Item 1A. | Risk Factors | 7 | ||
| Item 1B. | Unresolved Staff Comments | 16 | ||
| Item 2. | Properties | 16 | ||
| Item 3. | Legal Proceedings | 16 | ||
| Item 4. | Submission of Matters to a Vote of Security Holders | 16 | ||
| PART II | ||||
| Item 5. | 17 | |||
| Item 6. | 19 | |||
| Item 7. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
20 | ||
| Item 7A. | 30 | |||
| Item 8. | 31 | |||
| Item 9. | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure |
31 | ||
| Item 9A. | 31 | |||
| Item 9B. | 32 | |||
| PART III | ||||
| Item 10. | 33 | |||
| Item 11. | 33 | |||
| Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters |
33 | ||
| Item 13. | Certain Relationships and Related Transactions and Director Independence |
33 | ||
| Item 14. | 33 | |||
| PART IV | ||||
| Item 15. | Exhibits and Financial Statement Schedules | 34 | ||
Table of Contents
PART I
This Report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These statements relate to future events or our future financial performance. In some cases, you can identify forward-looking statements by terminology such as may, will, should, expect, plan, anticipate, believe, estimate, predict, potential or continue, the negative of terms like these or other comparable terminology. Additionally, statements concerning future matters such as the development of new products, enhancements or technologies, possible changes in legislation and other statements regarding matters that are not historical are forward-looking statements. These statements are only predictions. These statements involve known and unknown risks and uncertainties and other factors that may cause actual events or results to differ materially from the results and outcomes discussed in the forward-looking statements. All forward-looking statements included in this document are based on information available to us on the date of filing, and we assume no obligation to update any such forward-looking statements, except as required by law. In evaluating these statements, you should specifically consider various factors, including the risks outlined under the caption “Risk Factors” set forth in Item 1A and those contained from time to time in our other filings with the SEC. We caution you that our business and financial performance are subject to substantial risks and uncertainties.
| Item 1. | Business |
Recent Events
On April 4, 2008, Digital Lightwave, Inc. (the “Company”) and Optel Capital, LLC (“Optel”) entered into a Credit and Restructuring Agreement (the “Credit Agreement”) pursuant to which (a) the Company’s existing indebtedness owed to Optel, consisting of approximately $28.0 million of principal, that bore interest at 10% per annum, and accrued interest thereon of approximately $7.7 million, all of which was due and payable upon demand by Optel, was restructured and (b) Optel agreed to make a $2.5 million revolving credit facility available to the Company. Optel is controlled by Dr. Bryan J. Zwan, the Company’s largest stockholder and chairman of the board of directors. The Credit Agreement was approved by the Company’s board of directors upon the unanimous recommendation of a special committee of the board comprised solely of independent directors.
Pursuant to the Credit Agreement, the restructured indebtedness is evidenced by a new secured convertible promissory note in the principal amount of approximately $35.7 million (the “Restated Note”), and the revolving credit facility is evidenced by an additional secured convertible promissory note in the principal amount of $2.5 million (the “New Commitment Note” and, together with the Restated Note, the “Notes”). The Notes bear interest at a rate equal to London Interbank Offered Rate (“LIBOR”) plus 1.0% per annum and are secured by substantially all the Company’s assets pursuant to an amended and restated security agreement. Each of the Notes requires quarterly payments of interest commencing on June 30, 2008, and matures on March 31, 2010.
With the restructuring of the debt and the addition of the $2.5 million credit facility we plan to expand our sales force and develop new product offerings. We also expect to use the new credit facility for working capital and other general corporate purposes.
Overview
Digital Lightwave, Inc. provides the global fiber-optic communications industry with products and technology used to develop, install, maintain, monitor and manage fiber-optic communication networks. Telecommunications service providers, owners of private networks (utilities, government and large enterprises) and equipment manufacturers deploy our products to provide quality assurance and ensure optimum performance of advanced optical communications networks and network equipment. Our products are sold worldwide to telecommunications service providers, owners of private networks (utilities, government and large enterprises), telecommunications equipment manufacturers, equipment leasing companies and international distributors.
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Our revenue has been generated primarily from the sale of products from our original product line, the Network Information Computers (NIC). NICs are portable instruments used for the installation and maintenance testing of advanced, high-speed networks and transmission equipment. The NIC product family provides diagnostic capabilities for testing the performance of both optical and legacy electrical networks with an array of communications standards and transmission rates.
Our product lines also include the Network Access Agent (NAA) and the Optical Wavelength Manager (OWM). NAAs are unattended, software-controlled, performance monitoring and diagnostic systems permanently installed within optical-based networks, allowing centralized remote network monitoring and management. The OWM is a monitoring system for Dense-Wavelength Division Multiplexing (DWM) networks that remotely monitors up to eight optical fibers providing fast and highly accurate analysis of optical wavelengths for troubleshooting and predictive analysis.
For the year ended, December 31, 2007 we realized an operating profit, which was enabled by cost reductions instituted in 2006 and product improvements. We added multiple licensable features to our product, which are sold separately and provide additional margin, as well as making our products more competitive. Another highlight is the development of the NIC 40G, a portable 40/43Gb SONET/SDH/OTN test system. We improved our operations by implementing a new software system for accounting and manufacturing to provide prediction and control over our material needs.
Digital Lightwave, Inc. was incorporated in California in 1990 and reincorporated in Delaware in 1996. Unless the context indicates otherwise, the “Company,” “we,” “our,” and “Digital Lightwave,” as used in this Report, refer to Digital Lightwave, Inc., a Delaware corporation, and its predecessor entity. Our principal executive offices are located at 5775 Rio Vista Drive, Clearwater, Florida, 33760, and the telephone number is (727) 442-6677. The Digital Lightwave web site address is www.lightwave.com.
Industry
The telecommunications industry has experienced a modest stabilization after an abrupt halt of new investment and network expansion projects in 2002 through mid 2005. Consolidation, mergers and acquisitions, and business failures have resulted in fewer service providers competing for global market share, resulting in a significantly more stable market environment into which the Company sells its products and technologies. The bandwidth installed from 1997 – 2001 has been utilized and carriers are being forced to add capacity. Additionally, announcements by major local access providers in North America have provided a new catalyst for the fiber optic networking industry through the planned expansion of fiber to the home (FTTH), fiber to the premise (FTTP) as well as a variety of combined fiber build outs matched to communities’ specific existing local loop infrastructure, collectively known as (FTTx). Multi-year FTTx projects have begun in several regions of the United States. Whereas well-established network infrastructure exists in North America, leading to a slowdown in new development, aggressive network build outs in international markets are ongoing and will facilitate the use and implementation of a group of loosely related technologies known as Next Generation (NextGen) technologies. NextGen technologies facilitate efficient usage of the SONET/SDH bandwidth and though applicable in the United States, its adoption would force the upgrade of existing terminal equipment which carriers are reluctant to do. However, in certain developing international markets where there is no installed base to replace, carriers will generally opt to deploy NextGen.
The 40G market is emerging as a result of the increasing demand for bandwidth. Providing a cost-effective path to increase bandwidth without adding additional fiber, several 40G networks have been deployed throughout the world, and significant new deployments are expected in 2008 and 2009. The 40G market is expected to increase at least for the next three to five years at which time reasonably priced 100G and 100GigE products will overtake 40G. All major network equipment vendors are developing 40G transport equipment. The market for 40G test instruments includes equipment manufacturers (for research and development as well as field implementation), network providers and government.
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The Digital Lightwave Solution
Digital Lightwave provides products and technologies that are designed to support networking technologies used worldwide. The Company embraces the most advanced networking standards, and has designed its flagship product, the NIC, with a flexible architecture in anticipation of a continual upgrade path as new technologies are developed, standardized and brought to market.
The Company designs and manufactures its products in portable and embedded form factors to serve its varied customer types. Portable products are lightweight, self-contained test instruments that are used for field applications such as network diagnostics, maintenance and troubleshooting. The Company provides the same technologies in a rack-mountable product offering, designed for deployment at key points throughout the network, namely at central offices (CO), data centers, and co-location facilities. The rack-mounted equipment provides for remote monitoring from a centralized network management console residing at the service providers’ Network Operations Center (NOC). Having remotely-deployed equipment allows service providers to monitor and manage their network on a full-time basis, thereby optimizing labor resources and minimizing the time and expense of diagnosis and resolution of network emergencies and repairs.
Digital Lightwave products are also applicable to laboratory and manufacturing applications. Network equipment manufacturers use our products during the research and development phase to ensure new equipment performs to designed specifications and conforms to international standards. Service providers and private network operators use Digital Lightwave products in the laboratory environment to confirm network equipment functionality, compatibility and conformance to international standards. The Company’s products are also used to confirm functionality as part of the manufacturing process for network equipment providers throughout the world.
Products and Services
Network Installation and Maintenance Products
Consisting primarily of the Company’s original product line of Network Information Computers (NIC), our Network Installation and Maintenance Products include portable test devices used by network technicians. These devices provide a compact, lightweight, and easy-to-use product offering significant functionality.
The NIC (i) is an integrated test instrument that is capable of analyzing multiple protocols concurrently and independently; (ii) utilizes an intuitive Microsoft Windows-based Graphical User Interface (GUI) with a touch sensor display to create an easy-to-use diagnostic tool; and (iii) is a software-based solution that can be easily upgraded and customized.
These products are based on modular and scalable hardware and software platforms with a flexible architecture that allow customers to easily upgrade existing systems to accommodate new technologies and thereby preserve the value of their original investment. We are utilizing the core technology within our NIC product line to continue developing portable and embedded products that address the evolving needs of the optical networking industry. Current platforms include:
| • |
NIC 2.5G®, NIC 10G®, NIC 40G™, NIC NXG™ and NIC GigE™ are small units that accommodate two modules. They offer lightweight portability and ease of use through a 10.4” color touch-screen. NIC 2.5G® NIC 10G® and NIC 40G™ provide SONET/SDH/OTN test capability while NIC GigE™ provides Ethernet test capability. NIC NXG™ supports SONET/SDH in its standard configuration but can be upgraded with Test Options to add Ethernet and other capabilities, providing converged telecom and datacom testing in a single platform. |
| • |
NIC Plus®/NIC Plus NXG® is a larger scalable testing platform that accommodates up to five test modules. The slightly bigger platform offers a 12.1” color touch-screen with the same easy-to-use GUI as the smaller NIC platforms, but provides the space and power for multiple modules or Jitter/Wander measurement capability up to 10Gbps. |
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| • |
NIC EP® is an “embedded platform” designed for remotely operated embedded testing. It is mounted in a 19” or 23” equipment rack and accommodates up to 5 test modules. |
Available modules include:
| • | 40/43G Testing Module provides SONET/SDH/OTN test capability at 40Gbps and 43Gbps. The 40/43G Testing Module can be equipped in the small NIC chassis as a NIC 40G. Combined with other modules in the NIC Plus or NIC EP chassis, a single unit can support testing from 1.5Mbps to 43Gbps including SONET, SDH, OTN, PDH, T-Carrier and Ethernet for an all-in-one telecom and datacom solution. |
| • | Next Generation Optical Multi-rate Module provides SONET/SDH test capability from 52Mbps to 2.5Gbps, with options for 10Gbps, ATM, ODU Multiplexing, Virtual Concatenation (VCAT), Generic Framing Procedure (GFP), Link Adjustment Scheme (LCAS), Optical Transport Network (OTN), GigE, 10GigE LAN and WAN and 10GigE with Forward Error Correction (FEC). |
| • | PDH Module simultaneously and independently analyzes global electrical networks (T-carrier/PDH rates: DS0, DS1, DS3, E1, E3, E4), operating at transmission rates ranging from 1.5Mbps to 139Mbps. |
| • | PDH Jitter Module provides all of the features of the PDH Module, but adds Jitter and Wander measurement capability. |
| • | Optical Multi-rate Module provides a low-cost solution for SONET/SDH applications that do not require Next Generation features. It verifies and qualifies the performance of global high-speed optical networks, operating at transmission rates ranging from 52Mbps to 2.5Gbps. |
| • | High Density Ethernet Module provides simultaneous and independent testing for four optical GigE ports and eight electrical 10/100/1000 BaseT ports. It is available with a 10GigE LAN/WAN and Fiber Channel test options. |
| • |
2.5Gbps Jitter Module provides jitter and wander testing from 155Mbps to 2.6Gbps. It is available only in the NIC Plus® or NIC EP® platforms. |
| • |
10Gbps Jitter Module provides jitter and wander testing at the 10Gbps/10.7Gpbs rates. It is available only in the NIC Plus® or NIC EP® platforms. |
| • | Serial Interface Test Module provides testing of RS-530 and RS-232 interfaces. |
This modular approach allows the Company to support customers with specialized needs by creating custom configurations, as well as those who require a more standard configuration.
Sales of Network Installation and Maintenance Products generated approximately 74%, 68% and 68% of our net sales for the years ended December 31, 2007, 2006 and 2005, respectively.
Network Management Systems
This product category is comprised of the Company’s Network Access Agent (NAA) products and Optical Wavelength Manager (OWM) products. Using our products’ analysis capabilities, a network operator is able to monitor signal degradation, diagnose and isolate network failures, and maintain a constant view of the network. This ensures fulfillment of service-level agreements (SLA) with the operator’s customers and enables the operator to perform predictive analysis of certain situations in order to prevent potential network interruptions or failures.
The first version NAA was introduced in 1998, utilizing the core technology of the NIC platform. NAAs are software-controlled performance monitoring and diagnostic equipment that is permanently embedded at multiple access points within optical networks, providing real-time analysis and network management from a centralized location, thereby reducing truck rolls.
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The OWM is a highly sophisticated Dense Wave Division Multiplexing (DWDM) analysis system that provides more functionality and reliability than traditional optical spectrum analyzers at a significantly lower cost. The OWM is available in a compact rack-mountable form factor providing remote analysis and management via a web-enabled PC interface. The OWM remotely monitors up to eight optical fibers and provides fast and highly accurate analysis of optical wavelengths.
Customers
Since inception and through December 31, 2007, the Company sold over 6,300 NICs and over 130 NAAs to over 520 customers. The Company sold 84 OWMs since October 2002. The Company’s products are purchased and used by domestic and international customers in the following industry segments:
| • | Incumbent Local Exchange Carriers; |
| • | Inter-Exchange Carriers; |
| • | Competitive Local Exchange Carriers; |
| • | Internet Service Providers; |
| • | Communications Equipment Manufacturers; |
| • | Carriers’ Carriers; |
| • | Utility Companies; |
| • | Equipment Rental and Leasing Companies; |
| • | Wireless Service Providers; |
| • | Enterprise Network Operators; and |
| • | Government Agencies. |
The Company also sells its products to other segments of the telecommunications industry, including independent telephone companies and private network operators.
The Company involves key customers in the evaluation of products in development and continually solicits suggestions from customers regarding additional desirable features of products that we have introduced or plan to develop. The Company has generally been able to satisfy requests for additional feature sets by providing software upgrades for loading into its products in the field.
For the year ended December 31, 2007, one customer accounted for approximately 11% of net sales. For the year ended December 31, 2006, two customers accounted for, in the aggregate, approximately 27% of net sales. For the year ended December 31, 2005, three customers accounted for, in the aggregate, approximately 32% of net sales. No other customer accounted for sales of 10% or more during those years.
Sales, Marketing and Customer Support
Sales
The Company primarily sells its products in the United States through a direct sales force to telecommunications service providers and network equipment manufacturers. Sales of our products have tended to be concentrated with a few major customers, and we expect sales will continue to be concentrated with a few major customers in the future. In the third quarter of 2005, the Company opened a direct sales office in Dubai, managed by our Vice President of International Sales, to facilitate the Company’s growing market penetration of the Middle East, India and Far East markets. Our sales channels consist of a combination of direct salespeople, manufacturer representatives and distributors.
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Marketing
The Company focuses its marketing efforts on equipment manufacturers and services providers developing and deploying high-speed fiber-optic networks. The Company seeks to build awareness of its products through a variety of marketing channels and methodologies, including industry trade shows, conferences, advertising in trade publications and internet-based marketing activities to targeted customers and association groups.
Customer Support
The Company offers technical support to its customers 24 hours a day, seven days a week. The customer support organization is comprised of highly skilled employees with extensive experience across a broad range of fiber optics network equipment and technologies. All service and repair work is performed at certified facilities in Florida, Italy, Australia, Mexico, India and Thailand. The Company offers a warranty of one to three years depending on the product as well as an extended warranty program.
Production
The Company’s NIC and NAA products are currently produced in Clearwater, Florida. The Company subcontracts the manufacture of computer systems, boards, plastic molds and metal chassis and certain subassemblies and components for the NIC and NAA products. The Company performs final assembly and programs the products with our software. The Company implements strict quality control procedures throughout each stage of the manufacturing process and test the boards and subassemblies at various stages in the process, including final test and qualification of the product. The Company also obtains other equipment manufacturers’ products for resale to customers. The Company’s OWM product is manufactured by a European manufacturer according to Company specifications.
Engineering and Development
The Company has organized its engineering and development efforts into product or project teams. These teams are organized around the development of a particular product, and each team is responsible for all aspects of the development of that product and any enhanced features or upgrades.
During fiscal years 2007, 2006, and 2005, the Company spent approximately $2.0 million, $4.5 million, and $7.8 million, respectively, on engineering and development activities.
Intellectual Property
As of March 14, 2008, we had eleven issued patents, including five issued patents in the United States relating to the NIC and NAA technology, and six issued patents relating to the DWDM technology.
Seasonality
Our sales are generally seasonal with the largest portion of quarterly sales tied to telecommunications industry purchasing patterns and tend to decrease during the first calendar quarter of each year.
International
The Company sells its products in domestic and international markets. Our domestic sales represented approximately 68%, 72%, and 64% of our net sales for the years ending 2007, 2006, and 2005, respectively. The Company’s international sales represented approximately 32%, 28% and 36% total net sales for the years ended 2007, 2006, and 2005, respectively.
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Employees
As of March 14, 2008, we employed a full-time staff of 38 employees. None of the Company’s employees are represented by labor unions, and we believe our relations with our employees are good.
| Item 1A. | Risk Factors |
Our business is subject to various risks, including those described below. You should carefully consider the following risks, together with all of the other information included in this document before deciding to invest in our securities. Any of these risks could materially adversely affect our business, operating results and financial condition.
Beginning in the third quarter of 2001 and continuing through December 31, 2007, we incurred combined net losses of $166.5 million. For the years ended December 31, 2007 and 2006, we reported net losses of approximately $2.6 million and $14.5 million, respectively, and cash flows used by operations of $1.4 million and $7.9 million, respectively. We anticipate that our net operating losses may continue in fiscal year 2008. Management has taken actions to reduce operating expenses and capital expenditures, including restructuring operations to more closely align operating costs with net sales.
Our ability to meet cash and future liquidity requirements is dependent on various factors, including our ability to raise additional capital, successfully negotiate extended payment terms with certain creditors, attain our business objectives, maintain tight controls over spending and release new products and product upgrades on a timely basis. If our cash requirements cannot be satisfied from cash flows from operations and the infusion of additional capital, we may be forced to implement further expense reduction measures, including, but not limited to, workforce reductions, the sale of assets, the consolidation of operations or the delay, cancellation or reduction of certain product development, marketing, licensing, or other operational programs.
We are dependent on contract manufacturers to produce our printed circuit assemblies and rely on sole and limited source suppliers which could adversely affect our operations.
Our NIC and NAA products are currently produced in Clearwater, Florida. We subcontract the manufacturing of computer systems, boards, plastic molds and metal chassis and certain subassemblies and components for the NIC and NAA products. We perform final assembly and program the products with our software. We implement strict quality control procedures throughout each stage of the manufacturing process and test the boards and subassemblies at various stages in the process, including final test and qualification of the product. Effective as of January 31, 2005, we entered into a letter of agreement with MC Test Service, Inc. of Melbourne, Florida, to provide our subcontract manufacturing services. In the future, any failure to maintain our agreements with MC Test Service or enter into a substitute manufacturing agreement in a timely fashion could interrupt our operations and adversely impact our ability to manufacture our products, book sales and fulfill customer orders.
We currently utilize several key components in the manufacture of our products from sole-source or limited-source suppliers. Certain laser and laser amplifier components, power supplies, touch-screen sensors, single-board computers and semiconductor devices used in our NIC and the NAA products are sourced from a single or a limited number of suppliers. We purchase a controller board and an interface board from a single or limited number of suppliers for the NAA product. The loss of a supplier for any of these key components could seriously disrupt our operations.
As our technology has evolved, we rely less and less on application specific integrated circuits and more on programmable logic from major vendors. This approach has lessened our dependence on devices that may become obsolete, as well as allowing us to move the technology forward into new designs and lower cost parts. On our newer designs we have also utilized industry standard pluggable optical transponders that are available from multiple vendors. Nonetheless, we continually monitor end-of-life notices and perform last time buys or redesign as needed.
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We forecast product sales on a quarterly basis and order materials and components based on these forecasts. Lead times for materials and components that we order vary significantly and depend on factors such as the specific supplier, purchase terms and demand for a component at a given time. There may be excess or inadequate inventory of certain materials and components if actual orders vary significantly from forecasts.
In the past, there have been industry-wide shortages in some of the optical components used in our products. If such shortages occur again, suppliers may be forced to allocate available quantities among their customers and we may not be able to obtain components and material in a timely manner, if at all. These shortages could lead to delays in shipping our products to our customers, which could significantly harm our business. Additionally, if prices of these components increase significantly, the margins on our products will decrease.
Our largest stockholder has substantial influence over us as a result of his interests as our largest stockholder and principal creditor.
As of March 14, 2008, Dr. Bryan J. Zwan, our chairman of the board, beneficially owned 232,722,523 shares of our common stock, which represented approximately 91.1% of our outstanding common stock as of that date. As the beneficial holder of over 90% of the common stock of the Company, Dr. Zwan has substantial control over matters to be determined by the stockholders of the Company, which control may be exercised in a manner adverse to the interests of other stockholders of the Company.
We experience fluctuations in our operating results.
Our quarterly operating results have fluctuated in the past, and future quarterly operating results are likely to vary significantly due to a variety of factors which are outside our control. Factors that could affect our quarterly operating results include the following:
| • | fluctuations in capital expenditures and the uneven buying patterns by customers within the telecommunications industry; |
| • | pricing changes by our competitors; |
| • | the limited number of our major customers; |
| • | the product mix, volume, timing and number of orders received from our customers; |
| • | the long sales cycle for obtaining new orders; |
| • | the timing of introduction and market acceptance of new products; |
| • | our success in developing, introducing and shipping product enhancements and new products; |
| • | our ability to enter into long-term agreements or blanket purchase orders with customers; |
| • | our ability to obtain sufficient supplies of sole or limited source components for our products; |
| • | our ability to attain and maintain production volumes and quality levels for our current and future products; |
| • | changes in costs of materials, labor and overhead; and |
| • | the financial condition of our customers. |
Our operating results for any particular quarter may not be indicative of future operating results, in part because our sales often reflect orders shipped in the same quarter in which they are received, which makes our sales vulnerable to short-term fluctuations. These factors have historically been and are expected to continue to be difficult to forecast. Any unfavorable changes in these or other factors could have a material adverse effect on our business, financial condition and results of operations.
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Our net sales and operating results generally depend on the volume and timing of the orders we receive from customers and our ability to fulfill the orders received. Orders may be cancelled, modified or rescheduled after receipt. Most of our operating expenses are relatively fixed and cannot be reduced in response to decreases in net sales. The timing of orders and any subsequent cancellation, modification or rescheduling of orders have affected and will continue to affect our results of operations from quarter to quarter. The deferral of any large order from one quarter to another could have a material adverse effect on our business, financial condition and results of operations. We must obtain orders during each quarter for shipment in that quarter to achieve our net sales and profit objectives. There can be no assurance regarding the amount or timing of purchases by any customer in any future period, and business fluctuations affecting our customers have affected and will continue to affect our business.
We believe that backlog is not a meaningful indicator of future business prospects and financial results. Backlog, as we define it, generally represents cumulative outstanding orders that are scheduled for delivery within a three-month period. We have not entered into long-term agreements or blanket purchase orders for the sale of our products and, accordingly, do not carry substantial backlog from quarter-to-quarter. Our sales during a particular quarter are highly dependent upon orders placed by customers during that period. Consequently, sales may fluctuate significantly from quarter-to-quarter and year-to-year reflecting the timing and amount of our customers ordering trends. Because most of our operating expenses are relatively fixed and cannot be easily reduced in response to decreased revenues, quarterly fluctuations in sales may have a significant effect on net income.
The initiatives we have undertaken to reduce costs may have long-term adverse effects on our business.
Since 2005, we have undertaken a number of initiatives to reduce costs. These measures have included significant reductions in workforce, temporary executive salary reductions and the relocation of our headquarters to a smaller facility that better meets our needs.
There are several risks inherent in our efforts to transition to a reduced cost structure, including, but not limited to, the risk that we will not be able to sustain our cost structure at a level necessary to restore profitability, resulting in the need for further restructuring initiatives that would entail additional charges and the risk that our ability to effectively develop and market products and remain competitive in the industries in which we compete could be impaired. Our cost-cutting measures could have long-term effects on our business by reducing our pool of technical talent, decreasing or slowing improvements in our products, making it more difficult for us to respond to customers, limiting our ability to increase production quickly if the demand for our products increases, limiting our ability to maintain and update information systems and limiting our ability to hire and retain key personnel. These circumstances could have a material adverse effect on our business, financial condition and results of operations.
Changes in United States and worldwide economies and fluctuations in capital expenditures within the telecommunications industry could adversely affect us.
Our products are mainly purchased and used by telecommunications customers. Our sales are affected by the following marketplace conditions:
| • | fluctuations in the economic conditions in the United States and global markets that could result in decreased capital expenditures by telecommunication equipment manufacturers and equipment rental and leasing companies; |
| • | bankruptcies and decreased capital expenditures that could result in the telecommunications sector in the United States and global markets by competitive local exchange carriers, internet service providers and enterprise network operator segments; and |
| • | changes in the implementation of bandwidth expansion strategies by the incumbent local exchange carriers. |
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These marketplace conditions may contribute to quarterly or annual fluctuations in our operating results and could have a material adverse effect on our business, financial condition and results of operations. In addition, the threat of terrorism and war may cause further disruptions to the economy, create further uncertainties and have a material adverse effect on our business, operating results, and financial condition.
Economic, political and other risks associated with international sales and operations could adversely affect our results of operations.
Because we sell our products worldwide, our business is subject to risks associated with doing business internationally. For the fiscal year ended December 31, 2007, net sales from international customers represented approximately 32% of our total net sales for that period. We anticipate that net sales from international customers will continue to represent a significant portion of our total net sales. In addition, many of our new distributors and service and sales personnel are increasingly located outside the U.S. Accordingly, our future results could be harmed by a variety of factors, including:
| • | changes in foreign currency exchange rates; |
| • | changes in a specific country’s or region’s political, economic or other conditions; |
| • | stability and performance of new distributors, exposure to collection of receivables, sales returns and allowances; |
| • | trade protection measures and import or export licensing requirements; |
| • | negative consequences from changes in tax laws; and |
| • | difficulty in staffing and managing widespread operations. |
We may not be able to achieve sustained operating profitability.
We shipped our first product, the NIC, in February 1996, and we have shipped in excess of 6,300 units. However, we have experienced limited product shipments with respect to our NAA and OWM products. In addition, we have incurred substantial costs, including costs to:
| • | develop and enhance our technology and products; |
| • | develop our engineering, production and quality assurance operations; |
| • | recruit and train sales, marketing and customer service groups; |
| • | build administrative and operational support organizations; and |
| • | establish international sales channels and strengthen existing domestic sales channels. |
Our net losses totaled approximately $2.6 million and $14.5 million for the years ended December 31, 2007 and 2006, respectively. We anticipate that our net losses may continue in fiscal year 2008 due primarily to interest expense and costs associated with the introduction of new products and technologies.
Future changes in financial accounting standards or taxation rules may adversely affect our reported results of operations.
A change in accounting standards or a change in existing taxation rules can have a significant effect on our reported results of operations. New accounting pronouncements and taxation rules and varying interpretations of accounting pronouncements have occurred and may occur in the future. These new accounting pronouncements and taxation rules may adversely affect our reported financial results or the way we conduct our business.
On January 1, 2007, the Company adopted the provisions of the Financial Accounting Standards Board Interpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”), an interpretation of Financial
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Accounting Standards Board No. 109, Accounting for Income Taxes (“FASB 109”). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken in a tax return. The Company must determine whether it is “more-likely-than-not” that a tax position will be sustained upon examination, including resolution of any related appeals or litigation processes, based on the technical merits of the position. Once it is determined that a position meets the “more-likely-than-not” recognition threshold, the position is measured to determine the amount of benefit to recognize in the financial statements. FIN 48 applies to all tax positions related to income taxes subject to FASB 109. Based on the analysis performed, the Company did not record any unrecognized tax positions as of December 31, 2007. There is a possibility that a limitation on the Company’s net operating loss carryforwards may have come into effect under Section 382 of the Internal Revenue Code as a result of cumulative stock ownership changes. As of December 31, 2007, the impact of such a limitation has no impact on the accompanying financial statements since all net operating losses have a full valuation allowance; however, such a limitation could impact substantially the reported gross asset related to the net operating loss carryforwards.
We may engage in acquisitions, mergers, strategic alliances, joint ventures and divestitures that could result in financial results that are different than expected.
In the normal course of business, we engage in discussions with third parties relating to possible acquisitions, mergers, strategic alliances, joint ventures and divestitures. As part of our business strategy, we completed two asset acquisitions during 2002. Acquisition transactions are accompanied by a number of risks, including:
| • | use of significant amounts of cash; |
| • | incurrence of debt on potentially unfavorable terms as well as amortization expenses related to certain intangible assets; |
| • | potentially dilutive issuances of equity securities on potentially unfavorable terms; and |
| • | the possibility that we may pay too much cash or issue too much of our stock as consideration for an acquisition relative to the economic benefits that we ultimately derive from such acquisition. |
The process of integrating any acquisition may create unforeseen operating difficulties and expenditures including the following:
| • | diversion of management time during the period of negotiation through closing and further diversion of such time after closing from focus on operating the business to issues of integration and future products; |
| • | decline in employee morale and retention issues resulting from changes in compensation, reporting relationships, future prospects or the direction of the business; |
| • | the need to integrate each company’s accounting, management information, human resource and other administrative systems to permit effective management, and the lack of control if such integration is delayed or not implemented; |
| • | the need to implement controls, procedures and policies appropriate for a larger public company at companies that prior to acquisition had been smaller, private companies; |
| • | the need to incorporate acquired technology, content or rights into our products and unanticipated expenses related to such integration; and |
| • | the need to successfully develop an acquired in-process technology to achieve the value currently capitalized as intangible assets. |
From time to time, we may engage in discussions with candidates regarding the potential acquisition of our product lines, technologies and businesses. If such divestiture were to occur, there can be no assurance that our
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business, operating results and financial condition will not be materially and adversely affected. A successful divestiture depends on various factors, including our ability to:
| • | effectively transfer liabilities, contracts, facilities and employees to the purchaser; |
| • | identify and separate the intellectual property to be divested from the intellectual property that we retain; and |
| • | reduce fixed costs previously associated with the divested assets or business. |
In addition, if customers of the divested business do not receive the same level of service from the new owners, this may adversely affect our other businesses to the extent that these customers also purchase other Digital Lightwave products. All of these efforts require varying levels of management resources, which may divert attention from other business operations. Further, if market conditions or other factors lead us to change our strategic direction, we may not realize the expected value from such transactions. If we do not realize the expected benefits or synergies of such transactions, our consolidated financial position, results of operations, cash flows and stock price could be negatively affected.
We are dependent on key personnel and our ability to recruit and retain such personnel may affect our business.
Our success depends to a significant degree upon the continued contributions of key management and other personnel, some of whom could be difficult to replace. We do not currently maintain key-man life insurance covering our officers. Our success will depend on the performance of our officers, our ability to retain and motivate our officers, our ability to integrate new officers into our operations and the ability of all personnel to work together effectively as a team. We have had significant turnover of our executive officers in the past and could continue to have problems retaining and recruiting executive officers in the future. Our failure to retain and recruit officers and other key personnel could have a material adverse effect on our business, financial condition and results of operations.
We are dependent on a limited number of products and are uncertain of the market for our current products and planned new products.
The majority of our sales are from our initial product, the NIC, and we expect that sales of NIC will continue to account for a substantial portion of our sales for the foreseeable future. We are uncertain about the size and scope of the market for our current and future products, including the product lines we have acquired. Our future performance will depend on increased sales of the NIC, market penetration of the NAA and OWM product lines, and the successful development, introduction and market acceptance of other new and enhanced products.
Market acceptance of our products and our credibility with our customers might be diminished if we are delayed in introducing or producing new products or fail to detect software or hardware errors in new products (which frequently occur when new products are first introduced). Any delay in introducing or producing new products or failure to detect software or hardware errors in new products could have a material adverse effect on our business, financial condition and results of operations.
Our industry is subject to rapid technological change.
To remain competitive, we must respond to the rapid technological change in our industry by developing, manufacturing and selling new products and technology and improving our existing products and technology. The market in which we compete is characterized by the following:
| • | rapid technological change; |
| • | changes in customer requirements and preferences; |
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| • | frequent new product introductions; and |
| • | the emergence of new industry standards and practices. |
These factors could cause our sales to decrease or render our current products obsolete. Our success will depend on our ability to:
| • | create improvements on and enhancements to our existing products; |
| • | develop, manufacture and sell new products to address the increasingly sophisticated and varied needs of our current and prospective customers; |
| • | respond to technological advances and emerging industry standards and practices on a cost-effective and timely basis; and |
| • | increase market acceptance of our products. |
The failure to meet these objectives or to adapt to changing market conditions or customer requirements could have a material adverse effect on our business, financial condition and results of operations.
Our products serve an industry that is extremely competitive, and such competition may negatively affect our business.
The market for our products is intensely competitive and is subject to rapid technological change, frequent product introductions with improved performance, competitive pricing and shifting industry standards. We believe that the principal factors on which we compete include the following:
| • | product performance; |
| • | product quality; |
| • | product reliability; |
| • | value; |
| • | customer service and support; and |
| • | length of operating history, industry experience and name recognition. |
We believe that the principal competitors for our Network Installation and Maintenance Products are Anritsu, EXFO Electro-Optical Engineering, Inc., JDSU, and Sunrise Telecom. We believe the principal competitors for our Network Management System are Agilent, EXFO, and Spirent. Many of our competitors and certain prospective competitors have significantly longer operating histories, larger installed bases, greater name recognition and significantly greater technical, financial, manufacturing and marketing resources. In addition, a number of these competitors have long-established relationships with our customers and potential customers. We expect that competition will increase in the future and that new competitors will enter the market for most, if not all, of the products we currently do and will offer. Increased competition could reduce our profit margins and cause us to lose, or prevent us from gaining, market share. Any of these events could have a material adverse effect on our business, financial condition and results of operations.
We are dependent on a limited number of major customers and a decrease in orders from any major customer could decrease our net sales.
For the year ended December 31, 2007, one customer accounted for approximately 11% of net sales. For the year ended December 31, 2006, two customers accounted for, in the aggregate, approximately 27% of net sales. For the year ended December 31, 2005, three customers accounted for, in the aggregate, approximately 32% of net sales. No other customer accounted for sales of 10% or more during those years.
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Our success depends on our ability to broaden our customer base to increase the level of sales. None of our customers have a written agreement with us that obligates them to purchase additional products from us. If one or more of our major customers decide not to purchase additional products or cancels orders previously placed, our net sales could decrease which could have a material adverse effect on our business, financial condition and results of operations.
We are dependent on our products continuing to meet changing regulatory and industry standards.
Our products must meet industry standards and regulations that are evolving as new technologies are deployed. In the United States, our products must comply with various regulations promulgated by the Federal Communications Commission and Underwriters Laboratories, as well as industry standards established by the American Standards Institute and other organizations. Internationally, our products must comply with standards established by the European Union and communication authorities in other countries as well as with recommendations of the International Telecommunication Union. Some of our planned products may be required to be certified by Telcordia in order to be commercially viable. The failure of our products to comply, or delays in compliance, with the various existing and evolving regulations could prevent us from selling our products in certain markets which could have a material adverse effect on our business, financial condition and results of operations.
We are dependent on proprietary technology.
Our success and our ability to compete depend upon our proprietary technology that is protected through a combination of patent, copyright, trade secret and trademark law. As of March 14, 2008, we had eleven issued patents, including five issued patents in the United States relating to the NIC and NAA technology, and six issued patents relating to the DWDM technology. We can make no assurances the patents for which we have applied or intend to apply will be issued or that the steps that we take to protect our technology will be adequate to prevent misappropriation. Our competitors may independently develop technologies that are substantially equivalent or superior to our technology. Our business strategy includes a plan to continue the increase in net sales in international markets, and the laws of some foreign countries may not protect our proprietary rights to the same extent as do the laws of the United States. In addition, the Company may either license its proprietary rights to third parties or license certain technologies from third parties for use in the Company’s products
To further protect our proprietary information, we generally enter into non-disclosure agreements and proprietary information and invention assignment agreements with our employees and suppliers and limit access to, and distribution of, our proprietary information. It may be possible, despite these precautions, for third parties to copy or otherwise obtain and use our technology without authorization.
We may either license our proprietary rights to third parties or license certain technologies from third parties for use in our products. The telecommunications industry is characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. We believe that our technology does not infringe on the proprietary rights of others, and we have not received any notice of claimed infringements. However, third parties may assert infringement claims against us in the future that may or may not be successful. We could incur substantial costs regardless of the merits of the claims if we must defend ourselves or our customers against such claims. Parties making such claims may be able to obtain injunctive or other equitable relief that could effectively block our ability to sell our products and could obtain an award of substantial damages. We may be required to obtain one or more licenses from third parties, including our customers, in the event of a successful claim of infringement against us. Any such claim could have a material adverse effect on our business, financial condition and results of operations.
Conversely, we may be required to spend significant resources to monitor and police our intellectual property rights. We may not be able to detect infringement and our competitive position may be harmed before such detection takes place. In addition, competitors may design around our technology or develop competing technologies. Intellectual property rights may also be unavailable or limited in some foreign countries, which
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could make it easier for competitors to capture market share. Furthermore, some intellectual property rights are licensed to other companies, allowing them to compete with us using that intellectual property.
The market price of our common stock may be volatile.
The market price of our common stock has been and is likely in the future to be highly volatile. Our common stock price may fluctuate significantly in response to factors such as:
| • | quarterly variations in operating results; |
| • | announcements of technological innovations; |
| • | new product introductions by us or our competitors; |
| • | competitive activities; |
| • | changes in earnings estimates by analysts or our failure to meet such earnings estimates; |
| • | significant issuances of warrants to purchase common stock; |
| • | announcements by us regarding significant acquisitions, strategic relationships or capital expenditure commitments; |
| • |