ITEM 1A: RISK FACTORS
Our proposed merger with a
subsidiary of Corning Incorporated is subject to a number of conditions beyond
our control. Failure to complete the merger could materially and adversely
affect our future business, results of operations, financial condition and stock
price.
On April 7, 2016, we entered into an
Agreement and Plan of Merger (the Merger Agreement) with Corning Incorporated,
(Corning or Parent) a New York corporation, and Apricot Merger Company, a
Delaware corporation and a wholly-owned subsidiary of Parent (Merger Sub).
Pursuant to the Merger Agreement, Parent caused Merger Sub to commence on April
21, 2016, a tender offer (the Offer) to purchase all of the issued and
outstanding shares of our common stock and the related rights to purchase shares
of Series A Preferred Stock at a price of $18.50 per share, net to the seller in
cash without interest and subject to any required withholding taxes (the Offer
Price). Consummation of the Offer is subject to various conditions set forth in
the Merger Agreement, including, but not limited to (i) at least a majority of
Shares being tendered in the Offer and (ii) the satisfaction or waiver by Merger
Sub of certain other customary conditions and requirements set forth in the
Merger Agreement. Pursuant to the Merger Agreement, as of the effective time of
the Merger, Merger Sub will merge with and into our company, with AFOP surviving
as a wholly-owned subsidiary of Parent (the Merger).
We cannot predict whether and when the
conditions will be satisfied. If one or more of these conditions is not
satisfied, and as a result, we do not complete the Merger, or in the event the
proposed Merger is not completed or is delayed for any other reason, our
business, results of operations, financial condition and stock price may be
harmed because:
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managements and our
employees attention may be diverted from our day-to-day operations as
they focus on matters related to preparing for integration of our
operations with those of Corning;
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we could potentially lose key
employees if such employees experience uncertainty about their future
roles with us and decide to pursue other opportunities in light of the
proposed Merger;
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we could potentially lose
customers or vendors, new customer or vendor contracts could be delayed or
decreased and we may have difficulty hiring and retaining new
employees;
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we have agreed to restrictions
in the Merger Agreement that limit how we conduct our business prior to
the consummation of the Merger, including, among other things,
restrictions on our ability to make certain capital expenditures,
investments and acquisitions, sell, transfer or dispose of our assets,
enter into material contracts outside of the ordinary course of business,
amend our organizational documents and incur indebtedness. These
restrictions may not be in our best interests as an independent company
and may disrupt or otherwise adversely affect our business and our
relationships with our customers, prevent us from pursuing otherwise
attractive business opportunities, limit our ability to respond
effectively to competitive pressures, industry developments and future
opportunities, and otherwise harm our business, financial results and
operations;
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we have incurred and expect to
continue to incur expenses related to the Merger, such as legal, financial
advisory and accounting fees, and other expenses that are payable by us
whether or not the proposed Merger is
completed;
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we may be required to pay a
termination fee of approximately $10.54 million to Parent if the Merger
Agreement is terminated under certain circumstances, which would
negatively affect our financial results and liquidity;
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activities related to the
Merger and related uncertainties may lead to a loss of revenues and market
position that we may not be able to regain if the proposed Merger does not
occur; and
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the failure to, or delays in,
consummating the Merger may result in a negative impression of us with
customers, potential customers or the investment
community.
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The occurrence of these or other events
individually or in combination could have a material adverse effect on our
business, results of operations, financial condition and stock price.
In addition, our stock price may
fluctuate significantly based on announcements by us, Corning or other third
parties regarding the proposed Merger.
The Merger Agreement contains
provisions that could discourage a potential competing acquiror.
The Merger Agreement contains no
solicitation provisions that restrict our ability to solicit, initiate, or
knowingly encourage, facilitate or induce third party proposals for the
acquisition of our common stock or to pursue an unsolicited offer, subject to
certain limited expections. In addition, Parent has an opportunity to modify the
terms of the Merger in response to any competing acquisition proposals before
our Board of Directors may withdraw or change its recommendation with respect to
the Merger. Upon the termination of the Merger Agreement to pursue an
alternative transaction, including in connection with a superior proposal, we
will be required to pay $10.54 million as a termination fee. These provisions
could discourage a potential third-party acquiror from considering or proposing
an acquisition transaction, even if it were prepared to pay a higher per share
price than what would be received in the Offer and the Merger. These provisions
might also result in a potential third-party acquiror proposing to pay a lower
price per share to our stockholders than it might otherwise have proposed to pay
because of the added expense of the $10.54 million termination fee that may
become payable. If the Merger Agreement is terminated and we determine to seek
another business combination, we may not be able to negotiate a transaction with
another party on terms comparable to, or better than, the terms of the Merger.
Our executive officers and directors
have interests in the Offer and the Merger that may be different from, or in
addition to, the interests of our stockholders generally.
Our executive officers and members of
our Board of Directors may be deemed to have interests in the Offer and the
Merger that may be different from or in addition to those of our stockholders,
generally. These interests may create potential conflicts of interest. Our Board
of Directors was aware of these potentially differing interests and considered
them, among other matters, in evaluating and negotiating the Merger Agreement
and in reaching its decision to approve the Merger Agreement and the
transactions thereunder. These interests relate to or arise from, among other
things:
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the consideration to be received
in respect of options to purchase Shares and restricted stock unit awards
held by our executive officers and members of our Board of
Directors;
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the acceleration of vesting of
equity awards held by our directors and our Chief Executive Officer in
connection with the completion of the Merger; and
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the right to continued
indemnification and insurance coverage for our directors and executive
officers following the completion of the
Merger.
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We are currently subject to class action lawsuits and may be subject to additional class action lawsuits relating
to the Merger, which could materially adversely affect our business, financial condition, operating results and our ability to consummate the Merger.
Following the announcement that we had entered into the Merger Agreement with Parent and Merger Sub on April 7, 2016,
on April 22, 2016, a complaint captioned
Stephen Bushansky v. Alliance Fiber Optic Products, Inc., et al
. Case No. 16-CV-294245 was filed in the
Superior Court of California, County of Santa Clara naming as defendants our company, our Board of Directors, Corning and Merger Sub. This action purports to
be a class action brought by a stockholder alleging, among other things, that our Board of Directors breached their fiduciary duties by approving the Merger Agreement,
and that we, Corning and Merger Sub aided and abetted these alleged breaches of fiduciary duty. On April 27, 2016, a complaint captioned
Rudy Luck v. Alliance Fiber Optic Products,
Inc., et al.
, Case No. 16-CV-294413 was filed in the Superior Court of California, County of Santa Clara naming as defendants our company, our Board of Directors, Corning and Merger Sub.
Similarly to the Bushansky action, this action purports to be a class action brought by a stockholder alleging, among other things, that our Board of Directors breached their fiduciary duties
by approving the Merger Agreement, and that Corning and Merger Sub aided and abetted these alleged breaches of fiduciary duty. The complaints seek, among other things, either to
enjoin the proposed transaction or to rescind the transaction in the event it is consummated. The outcome of this litigation cannot be predicted with certainty; however, we
believe that the actions are without merit and intend to defend them vigorously.
We, our directors and officers, Corning
and Merger Sub may be subject to additional class action lawsuits relating to
the Merger and other additional lawsuits that may be filed. Such litigation is
very common in connection with acquisitions of public companies, regardless of
any merits related to the underlying acquisition. The costs of the defense of
such lawsuits and other effects of such litigation could have an adverse effect
on our business, financial condition and operating results.
In addition, one of the conditions to
consummating the Merger is that no injunction or other order prohibiting or
otherwise preventing the consummation of the Merger shall have been issued by
any governmental entity of competent jurisdiction in the United States.
Consequently, if any of the plaintiffs in these lawsuits or in any other
subsequently filed similar lawsuits are successful in obtaining an injunction
preventing the parties from consummating the Merger, such injunction may prevent
the Merger from being completed in the expected timeframe, or at all.
We have obligations under certain
circumstances to hold harmless and indemnify our directors and officers against
judgments, fines, settlements and expenses related to claims against such
directors and officers and otherwise to the fullest extent permitted under
Delaware law and our bylaws and certificate of incorporation. Such obligations
may apply to any potential litigation. However, an unfavorable outcome in any
lawsuit related to the Merger could prevent or delay the consummation of the
Merger and result in substantial costs to us.
We will incur significant costs in
connection with the Merger, whether or not it is consummated.
We will incur substantial expenses related to the Merger, whether or not it is completed, including expenses related to litigation related to the proposed Merger. Through March 31, 2015, we have incurred substantial transaction costs and we anticipate incurring additional costs and expenses until completion of the Merger. In addition, we will incur investment banking fees of $2.7 million which are payable upon consummation of the Merger. Payment of these expenses by us as a standalone entity would adversely affect our operating results and financial condition and would likely adversely affect our stock price.
We have a history of losses, may
experience future losses and may not be able to sustain profitability.
From inception through March 31, 2016,
we had an accumulated deficit of $14.3 million. We incurred a net loss of
$536,000 for the quarter ended March 31, 2016, and may incur additional losses
in the future.
We continue to experience fluctuating
demand for our products. If demand for our products declines, we may not be able
to decrease our expenses on a timely basis or at levels that offset any such
decreases. If demand for our products continues to increase in the future, we
may incur significant and increasing expenses for expansion of our manufacturing
operations, research and development, sales and marketing, and administration,
and in expanding our direct sales and distribution channels. Given the rate at
which competition in our industry intensifies and the fluctuations in demand for
our products, we may not be able to adequately control our costs and expenses or
achieve or maintain adequate operating margins. As a
result, we will need to generate and sustain substantially higher revenues while
maintaining reasonable cost and expense levels, and our failure to do so may
result in additional losses. We may not be able to achieve profitability in
future periods, or maintain profitability on a quarterly or annual basis in the
future.
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We depend on a small number of
customers for a significant portion of our revenues, and one customer accounted
for approximately 11% and 45% of our revenues for the three months ended March
31, 2016 and 2015, respectively and the loss of, or a significant reduction in
orders from, any of these customers, would significantly reduce our revenues and
harm our operating results.
In the three months ended March 31,
2016 and 2015, our 10 largest customers comprised 62.2% and 77.9% of our
revenues, respectively. One customer accounted for 10.7% and 45.1% of our
revenues for the three months ended March 31, 2016 and 2015,
respectively.
We derive a significant portion of our
revenues from a small number of customers, and we anticipate that we will
continue to do so in the foreseeable future. These customers may decide not to
purchase our products at all, to purchase fewer products than they did in the
past, to demand price concessions, or to alter their purchasing patterns in some
other way. For example, our largest customer ordered fewer products in the third
and fourth quarters of 2015 and the first quarter of 2016 than we expected,
which had an adverse effect on our operating results. The loss of any
significant customer, a significant reduction in sales we make to a customer, or
any problems collecting receivables from one or more significant customers would
likely harm our financial condition and results of operations. Changes in
purchasing by these customers may also cause our operating results to fluctuate
from period to period.
Our connectivity products have
historically represented a significant part of our revenues, and if we are
unsuccessful in selling our optical passive products, our business may be
harmed.
Sales of our connectivity products
accounted for 71.9% and 79.7% of our revenues in the quarters ended March 31,
2016 and 2015, respectively, and a majority of our historical revenues. We
expect to substantially depend on these products for the majority of our
near-term revenues. We have in the past, and may in the future experience
declines in average selling prices. Any significant decline in the price of, or
demand for, these products, or failure to increase their market acceptance,
would seriously harm our business. In addition, we believe that our future
growth and a significant portion of our future revenues will depend on the
commercial success of our optical passive products. If demand for these products
does not continue to increase and our target customers do not continue to adopt
and purchase our optical passive products, our revenues may decline.
Continuing weak general economic or
business conditions may have a negative impact on our business.
Continuing concerns over inflation,
deflation, another recession, energy costs, geopolitical issues, the
availability and cost of credit, Federal budget proposals, the Federal deficit
and credit rating, unemployment, global economic instability, slowing growth in
China and an uncertain real estate market in the U.S. have contributed to
increased volatility and diminished expectations for the global economy and
expectations of slower global economic growth. These factors, combined with low
oil prices, weak business and consumer confidence and a volatile stock market,
have resulted in an economic slowdown. If the economic climate in the U.S. and
abroad does not improve or deteriorates, our business, including our customers
and our suppliers, could be negatively affected, resulting in a negative impact
on our revenues.
Our quarterly and annual financial
results have historically fluctuated due primarily to introduction of, demand
for, and sales of our products, and future fluctuations may cause our stock
price to decline.
We believe that period-to-period
comparisons of our operating results are not a good indication of our future
performance. Our quarterly operating results have fluctuated in the past and are
likely to fluctuate significantly in the future due to a number of factors. For
example, the timing and expenses associated with product introductions and
establishing additional manufacturing lines and facilities, changes in
manufacturing volume, declining average selling prices of our products, the
timing and extent of product sales, the mix of domestic and international sales,
the mix of sales channels through which our products are sold, the mix of
products sold and significant fluctuations in demand for our products have
caused our operating results to fluctuate. Because we incur operating expenses
based on anticipated revenue levels; and a significant percentage of our
expenses are fixed in the short term, any delay in generating or recognizing
revenues or any decrease in revenues could significantly harm our quarterly
results of operations. Other factors, many of which are more fully discussed
elsewhere in this report, may also cause our results to fluctuate. Many of the
factors that may cause our results to fluctuate are
outside of our control. If our quarterly or annual operating results do not meet
the expectations of investors and securities analysts, the trading price of our
common stock could significantly decline.
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If we cannot attract more optical
communications equipment manufacturers to purchase our products, we may not be
able to increase or sustain our revenues.
Our future success will depend on our
ability to migrate existing customers to our new products and our ability to
attract additional customers. Some of our present customers are relatively new
companies. The growth of our customer base could be adversely affected
by:
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customer unwillingness to
implement our products;
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any delays or difficulties
that we may incur in completing the development and introduction of our
planned products or product enhancements;
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the success of our
customers;
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excess inventory in the
telecommunications industry;
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new product introductions by
our competitors;
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any failure of our products to
perform as expected; or
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any difficulty we may incur in
meeting customers delivery requirements or product
specifications.
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The fluctuations in the economy have
affected the telecommunications industry. Telecommunications companies have cut
back on their capital expenditure budgets, which has and may continue to further
decrease demand for equipment and parts, including our products. This decrease
has had and may continue to have an adverse effect on the demand for fiber optic
products and negatively impact the growth of our customer base.
We are exposed to risks and
increased expenses and business risk as a result of Restriction on Hazardous
Substances, or RoHS directives.
Following the lead of the European
Union, or EU, various governmental agencies have either already put into place
or are planning to introduce regulations that regulate the permissible levels of
hazardous substances in products sold in various regions of the world. For
example, the RoHS directive for EU took effect on July 1, 2006. The labeling
provisions of similar legislation in China went into effect on March 1, 2007.
Consequently, many suppliers of products sold into the EU have required their
suppliers to be
compliant with the new directive. Many of our customers have adopted this
approach and have required our full compliance. Though we have devoted a
significant amount of resources and effort planning and executing our RoHS
program, it is possible that some of our products might be incompatible with
such regulations. In such event, we could experience the following consequences:
loss of revenue, damaged reputation, diversion of resources, monetary penalties,
and legal action.
The market for fiber optic
components is increasingly competitive, and if we are unable to compete
successfully our revenues could decline.
The market for fiber optic components
is intensely competitive. We believe that our principal competitors are the
major manufacturers of optical components and integrated modules, including
vendors selling to third parties and business divisions within communications
equipment suppliers. Our principal competitors in the components market include
Oclaro Inc., JDS Uniphase Corp., Molex Inc., Senko Advanced Components and TE
Connectivity. We believe that we primarily compete with diversified suppliers
for the majority of our product line and to a lesser extent with niche companies
that offer a more limited product line. Competitors in any portion of our
business may also rapidly become competitors in other portions of our
business.
Many of our current and potential
competitors have significantly greater financial, technical, marketing,
purchasing, manufacturing and other resources than we do. As a result, these
competitors may be able to respond more quickly to new or emerging technologies
and to changes in customer requirements, to devote greater resources to the
development, promotion and sale of products, to
negotiate lower prices on raw materials and components, or to deliver
competitive products at lower prices.
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Several of our existing and potential
customers are also current and potential competitors of ours. These companies
may develop or acquire additional competitive products or technologies in the
future and subsequently reduce or cease their purchases from us. In light of the
consolidation in the optical networking industry, we also believe that the size
of suppliers will be an increasingly important part of a purchasers
decision-making criteria in the future. We may not be able to compete
successfully with existing or new competitors, and we cannot ensure that the
competitive pressures we face will not result in lower prices for our products,
loss of market share, or reduced gross margins, any of which could harm our
business.
New and competing technologies are
emerging due to increased competition and customer demand. The introduction of
products incorporating new or competing technologies or the emergence of new
industry standards could make our existing products noncompetitive. For example,
there are technologies for the design of wavelength division multiplexers that
compete with the technology that we incorporate in our products. If our products
do not incorporate technologies demanded by customers, we could lose market
share causing our business to suffer.
If we fail to effectively manage our
operations, specifically given the past history of sudden and dramatic downturn
in demand for our products, our operating results could be harmed.
As of March 31, 2016, we had 33
full-time employees in Sunnyvale, California, 376 full-time employees in Taiwan,
and 1,051 full-time employees in China. Matching the scale of our operations
with demand fluctuations, combined with the challenges of expanding and managing
geographically dispersed operations, has placed, and will continue to place, a
significant strain on our management and resources. To manage the expected
fluctuations in our operations and personnel, we will be required to:
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improve existing and implement
new operational, financial and management controls, reporting systems and
procedures;
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hire, train, motivate and
manage additional qualified personnel, especially if we experience a
significant increase in demand for our products;
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comply with numerous laws,
rules and regulations related to our business both domestically and
outside the United States;
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effectively expand or reduce
our manufacturing capacity, attempting to adjust it to customer demand;
and
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effectively manage
relationships with our customers, suppliers, representatives and other
third parties.
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In addition, we must continue to
coordinate our domestic and international operations and maintain the necessary
infrastructure to implement our international strategy. If we are not able to
manage our operations in an efficient and timely manner, our business will be
severely harmed.
Our success also depends, to a large
degree, on the efficient and uninterrupted operation of our facilities. We have
expanded our manufacturing facilities in China and manufacture many of our
products there. Our facility in Taiwan also houses a substantial portion of our
manufacturing operations. There is significant political tension between Taiwan
and China. If there is an outbreak of hostilities between Taiwan and China, our
manufacturing operations may be disrupted or we may have to relocate our
manufacturing operations. Relocating a portion of our employees could cause
temporary disruptions in our operations and divert managements
attention.
Because of the time it takes to
develop fiber optic components, we incur substantial expenses for which we may
not earn associated revenues.
The development of new or enhanced
fiber optic products is a complex and uncertain process. We may experience
design, manufacturing, marketing and other difficulties that could delay or
prevent the development, introduction or marketing of new products and
enhancements. Development costs and expenses are incurred before we generate
revenues from sales of products resulting from these efforts. Our research and
development expenses were $1.2 million and $1.1 million
for the three months ended March 31, 2016 and 2015, respectively. We intend to
continue to invest in our research and product development efforts, which could
have a negative impact on our earnings in future periods.
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If we are unable to develop new
products and product enhancements that achieve market acceptance, sales of our
fiber optic components could decline, which could reduce our revenues.
The communications industry is
characterized by rapidly changing technology, frequent new product
introductions, changes in customer requirements, evolving industry standards
and, more recently, significant variations in customer demand. Our future
success depends on our ability to anticipate market needs and develop products
that address those needs. As a result, our products could quickly become
obsolete if we fail to predict market needs accurately or develop new products
or product enhancements in a timely manner. Our failure to predict market needs
accurately or to develop new products or product enhancements in a timely manner
will harm market acceptance and sales of our products. If the development or
enhancement of these products or any other future products takes longer than we
anticipate, or if we are unable to introduce these products to market, our sales
will not increase. Even if we are able to develop and commercially introduce
them, these new products may not achieve the widespread market acceptance
necessary to provide an adequate return on our investment.
Current and future demand for our
products depends on the continued growth of the Internet and the communications
industry, which is experiencing consolidation, realignment, and fluctuating
demand for fiber optic products.
Our future success depends on the
continued growth of the Internet as a widely used medium for communications and
commerce, and the growth of optical networks to meet the increased demand for
capacity to transmit data, or bandwidth. If the Internet does not continue to
expand as a medium for communications and commerce, the need to significantly
increase bandwidth across networks and the market for fiber optic components may
not continue to develop. If this growth does not continue, sales of our products
may decline, which would adversely affect our revenues. Our customers have
experienced an oversupply of inventory due to fluctuating demand for their
products that has resulted in inconsistent demand for our products. Future
demand for our products is uncertain and will depend heavily on the continued
growth and upgrading of optical networks, especially in the metropolitan, last
mile, and enterprise access segments of the networks.
Inconsistent spending by
telecommunication companies over the past several years has resulted in
fluctuating demand for our products. The rate at which communication service
providers and other fiber optic network users have built new fiber optic
networks or installed new systems in their existing fiber optic networks has
fluctuated in the past and these fluctuations may continue in the future. These
fluctuations may result in reduced demand for new or upgraded fiber optic
systems that utilize our products and therefore, may result in reduced demand
for our products. Declines in the development of new networks and installation
of new systems have resulted in the past in a decrease in demand for our
products, an increase in our inventory, and erosion in the average selling
prices of our products.
The communications industry is
experiencing continued consolidation and realignment, as industry participants
seek to capitalize on the rapidly changing competitive landscape developing
around the Internet and new communications technologies such as fiber optic
networks. As the communications industry consolidates and realigns to
accommodate technological and other developments, our customers may consolidate
or align with other entities in a manner that results in a decrease in demand
for our products.
We have experienced fluctuations in
market demand due to overcapacity in our industry and an economy that is stymied
by current financial and economic conditions, international terrorism, war and
political instability.
The United States economy has
experienced and continues to experience significant fluctuations in consumption
and demand. We have in the past and may in the future experience decreases in
demand for our products due to a weak domestic and international economy as the
fiber optics industry copes with the effects of oversupply of products,
international terrorism, war and political and economic instability. Even if the
general economy experiences a recovery, the activity of the United States
telecommunications industry may lag behind the recovery of the overall United
States economy.
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The optical networking component
industry often experiences declining average selling prices, and declines in
average selling prices of products could cause our gross margins to decline.
The optical networking component
industry often experiences declining average selling prices as a result of
increasing competition and from pricing pressures resulting in greater unit
volume purchases as communication service providers continue to deploy fiber
optic networks. We expect that average selling prices will continue to decrease
over time in response to new product and technology introductions by us or
competitors, price pressures from significant customers, greater manufacturing
efficiencies achieved through increased automation in the manufacturing process
and inventory build-up due to decreased demand. Average selling price declines
may contribute to a decline in our gross margins which could harm our results of
operations.
We will not attract new orders for
our fiber optic components unless we can deliver sufficient quantities of our
products to optical communications equipment manufacturers.
Communications service providers and
optical systems manufacturers typically require that suppliers commit to provide
specified quantities of products over a given period of time. If we are unable
to commit to deliver quantities of our products to satisfy a customers
anticipated needs, we will lose the order and the opportunity for significant
sales to that customer for a lengthy period of time. In addition, we would be
unable to fill large orders if we do not have sufficient manufacturing capacity
to enable us to commit to provide customers with specified quantities of
products. However, if we build our manufacturing capacity and inventory in
excess of demand, as we have done in the past, we may produce excess inventory
that may have to be reserved or written off.
Because we experience long lead
times for materials and components, we may not be able to effectively manage our
inventory levels or manufacturing capacity, which could harm our operating
results.
Because we experience long lead times
for materials and components and are often required to purchase significant
amounts of materials and components far in advance of product shipments, we may
not effectively manage our inventory levels, which could harm our operating
results. Alternatively, if we underestimate our raw material requirements, we
may have inadequate inventory, which could result in delays in shipments and
loss of customers. If we purchase raw materials and increase production in
anticipation of orders that do not materialize or that shift to another quarter,
we will, as we have in the past, have to carry or write off excess inventory and
our gross margins will decline. Both situations could cause our results of
operations to be below the expectations of investors and public market analysts,
which could, in turn, cause the price of our common stock to decline. The time
our customers require to incorporate our products into their own can vary
significantly and generally exceeds several months, which further complicates
our planning processes and reduces the predictability of our forecasts. Even if
we receive these orders, the additional manufacturing capacity that we add to
meet our customers requirements may be underutilized in a subsequent quarter.
If we are unable to maintain
effective internal control over financial reporting, investors may lose
confidence in the accuracy and completeness of our reported financial
information and the market price of our common stock may be negatively affected.
As a public company, we are required to
comply with Section 404 of the Sarbanes-Oxley Act of 2002 which requires that we
evaluate and determine the effectiveness of our internal control over financial
reporting and provide a management report on our internal controls. We have
implemented an ongoing program to perform the system and process evaluation and
testing we believe to be necessary to comply with this requirement, however, we
cannot assure you that we will be successful in our efforts. If we have a
material weakness in our internal control over financial reporting, we may not
detect errors on a timely basis and our financial statements may be materially
misstated. During the evaluation and testing process, if we identify one or more
material weaknesses in our internal control over financial reporting, our
management will be unable to conclude that our internal control over financial
reporting is effective.
Our independent registered public
accounting firm is also required to issue an attestation report on the
effectiveness of our internal control over financial reporting on an annual
basis. Even if our management concludes that our internal control over financial
reporting is effective, our independent registered public accounting firm may
conclude that there are material weaknesses with respect to our internal
controls or the level at which our internal controls are documented, designed,
implemented or reviewed. If we are unable to conclude that our internal control
over financial reporting is effective or if our auditors were to express an
adverse opinion on the effectiveness of our internal control over financial
reporting because we had one or more material weaknesses, investors could lose
confidence in the accuracy and completeness of our
financial disclosures, which could cause the price of our common stock to
decline. Internal control deficiencies could also result in a restatement of our
financial results.
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We depend on key personnel to
operate our business effectively in the rapidly changing fiber optic components
market, and if we are unable to hire and retain appropriate management and
technical personnel, our ability to develop our business could be harmed.
Our success depends to a significant
degree upon the continued contributions of the principal members of our
technical sales, marketing, engineering and management personnel, many of whom
perform important management functions and would be difficult to replace. We
particularly depend upon the continued services of our executive officers,
particularly Peter Chang, our President and Chief Executive Officer; David
Hubbard, our Executive Vice President, Sales and Marketing; Anita Ho, our Acting
Chief Financial Officer; and other key engineering, sales, marketing, finance,
manufacturing and support personnel. In addition, we depend upon the continued
services of key management personnel at our Taiwanese subsidiary and at our
facility in China. None of our officers or key employees is bound by an
employment agreement for any specific term, and may terminate their employment
at any time. We do not have key person life insurance policies covering any of
our employees.
Our ability to continue to attract and
retain highly skilled personnel will be a critical factor in determining whether
we will be successful in the future. We may have difficulty hiring skilled
engineers at our manufacturing facilities in the United States, Taiwan, and
China. If we are not successful in attracting, assimilating or retaining
qualified personnel to fulfill our current or future needs, our business may be
harmed.
If we are not able to achieve
acceptable manufacturing yields and sufficient product reliability in the
production of our fiber optic components, we may incur increased costs and
delays in shipping products to our customers, which could impair our operating
results.
Complex and precise processes are
required for the manufacture of our products. Changes in our manufacturing
processes or those of our suppliers, or the inadvertent use of defective
materials, could significantly reduce our manufacturing yields and product
reliability. Because the majority of our manufacturing costs are relatively
fixed, manufacturing yields are critical to our results of operations. Lower
than expected production yields could delay product shipments, impair our
operating results and harm our reputation. We may not obtain acceptable yields
in the future.
In some cases, existing manufacturing
techniques, which involve substantial manual labor, may not allow us to
cost-effectively meet our production goals so that we maintain acceptable gross
margins while meeting the cost targets of our customers. We may not achieve
adequate manufacturing cost efficiencies.
Because we plan to introduce new
products and product enhancements, we must effectively transfer production
information from our product development department to our manufacturing group
and coordinate our efforts with our suppliers to rapidly achieve volume
production. In our experience, our yields have been lower during the early
stages of introducing new product to manufacturing. If we fail to effectively
manage this process or if we experience delays, disruptions or quality control
problems in our manufacturing operations, our shipments of products to our
customers could be delayed.
Because the qualification and sales
cycle associated with fiber optic components is lengthy and varied, it is
difficult to predict the timing of a sale or whether a sale will be made, which
may cause us to have excess manufacturing capacity or inventory and negatively
impact our operating results.
In the communications industry, service
providers and optical systems manufacturers often undertake extensive
qualification processes prior to placing orders for large quantities of products
such as ours, because these products must function as part of a larger system or
network. This process may range from three to six months and sometimes longer.
Once they decide to use a particular suppliers product or component, these
potential customers design the product into their system, which is known as a
design-in win. Suppliers whose products or components are not designed in are
unlikely to make sales to that customer until at least the adoption of a future
redesigned system. Even then, many customers may be reluctant to incorporate
entirely new products into their new systems, as this could involve significant
additional redesign efforts. If we fail to achieve design-in wins in our
potential customers qualification processes, we will lose the opportunity for
significant sales to those customers for a lengthy period of time.
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In addition, some of our customers
require that our products be subjected to standards-based qualification testing,
which can take up to nine months or more. While our customers are evaluating our
products and before they place an order with us, we may incur substantial sales
and marketing and research and development expenses, expend significant
management efforts, increase manufacturing capacity and order long lead-time
supplies. Even after the evaluation process, it is possible a potential customer
will not purchase our products. In addition, product purchases are frequently
subject to unplanned processing and other delays, particularly with respect to
larger customers for which our products represent a very small percentage of
their overall purchase activity. Accordingly, our revenues and operating results
may vary significantly and unexpectedly from quarter to quarter.
If our customers do not qualify our
manufacturing lines for volume shipments, our optical networking components may
be dropped from supply programs and our revenues may decline.
Customers generally will not purchase
any of our products, other than limited numbers of evaluation units, before they
qualify our products, approve our manufacturing process and approve our quality
assurance system. Our existing manufacturing lines, as well as each new
manufacturing line, must pass through various levels of approval with our
customers. For example, customers may require that we be registered under
international quality standards. Our products may also have to be qualified to
specific customer requirements. This customer approval process determines
whether the manufacturing line achieves the customers quality, performance and
reliability standards. Delays in product qualification may cause a product to be
dropped from a long-term supply program and result in significant lost revenue
opportunity over the term of that program.
Our fiber optic components are
deployed in large and complex communications networks and may contain defects
that are not detected until after our products have been installed, which could
damage our reputation and cause us to lose customers.
Our products are designed for
deployment in large and complex optical networks. Because of the nature of these
products, they can only be fully tested for reliability when deployed in
networks for long periods of time. Our fiber optic products may contain
undetected defects when first introduced or as new versions are released, and
our customers may discover defects in our products only after they have been
fully deployed and operated under peak stress conditions. In addition, our
products are combined with products from other vendors. As a result, should
problems occur, it may be difficult to identify the source of the problem. If we
are unable to fix defects or other problems, we could experience, among other
things:
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loss of customers;
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damage to our reputation;
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failure to attract new customers
or achieve market acceptance;
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diversion of development and
engineering resources; and
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legal actions by our customers.
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The occurrence of any one or more of
the foregoing factors could negatively impact our revenues.
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The market for fiber optic
components is unpredictable, characterized by rapid technological changes,
evolving industry standards, and significant changes in customer demand, which
could result in decreased demand for our products, erosion of average selling
prices, and could negatively impact our revenues.
The market for fiber optic components
is characterized by rapid technological change, frequent new product
introductions, changes in customer requirements and evolving industry standards.
Because this market is new, it is difficult to predict its potential size or
future growth rate. Widespread adoption of optical networks, especially in the
metropolitan, last mile, enterprise access, and datacenter segments of the
networks, is critical to our future success. Potential end-user customers who
have invested substantial resources in their existing copper lines or other
systems may be reluctant or slow to adopt a new approach, such as optical
networks. Our success in generating revenues in this market will depend on:
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the education of potential end-user customers and network
service providers about the benefits of optical networks; and
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the continued growth of the
metropolitan, last mile, and enterprise access segments of the
communications network.
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If we fail to address changing market
conditions, sales of our products may decline, which would adversely impact our
revenues.
Disclosure requirements relating to
conflict minerals could increase our costs and limit the supply of certain
metals that may be used in our products and affect our reputation with customers
and stockholders.
As required under the Dodd-Frank Wall
Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), the
Securities and Exchange Commission promulgated final rules regarding annual
disclosures by public companies of their use of certain minerals and metals,
known as conflict minerals, which are mined from the Democratic Republic of
the Congo (DRC), and adjoining countries, and their efforts to prevent the
sourcing of such conflict minerals from these countries. These rules require us
to engage in due diligence efforts to ascertain and disclose the origin of some
of the raw materials used in the production process. Annual disclosures are
required no later than May 31 of each year. We have and will continue to incur
costs associated with complying with these disclosure requirements, including
due diligence to determine the sources of conflict minerals, if any, used in our
products and other potential changes to our products, processes, or sources of
supply as a consequence of such due diligence activities. These rules and our
compliance procedures could adversely affect the supply and pricing of materials
used in our products. Not all suppliers offer conflict free conflict minerals,
so we cannot be certain that we will be able to obtain sufficient quantities of
conflict free minerals from such suppliers or at competitive prices. Also, our
reputation with our customers and stockholders could be damaged if we determine
that certain of our products contain minerals not determined to be conflict free
or if we are unable to sufficiently verify the origins of conflict minerals used
in our products through the procedures we may implement. If we cannot determine
that our products exclude conflict minerals sourced from the DRC or adjoining
countries, some of our customers may discontinue, or materially reduce,
purchases of our products, which could negatively affect our results of
operations. In addition, our customers may require us to report to them on our
conflict minerals compliance, and if we do not perform this function to a
customers satisfaction, they may cease to do business with us.
We may be unable to successfully
integrate acquired businesses or assets with our business, which may disrupt our
business, divert managements attention and slow our ability to expand the range
of our proprietary technologies and products.
To expand the range of our proprietary
technologies and products, we may acquire complementary businesses, technologies
or products, if appropriate opportunities arise. We may be unable to identify
other suitable acquisitions at reasonable prices or on reasonable terms, or
consummate future acquisitions or other investments, any of which could slow our
growth strategy. We may have difficulty integrating the acquired products,
personnel or technologies of any company or acquisition that we may make.
Similarly, we may not be able to attract or retain key management, technical or
sales personnel of any other companies that we acquire or from which we acquire
assets. These difficulties could disrupt our ongoing business, distract our
management and employees and increase our expenses.
If we fail to protect our
intellectual property rights, competitors may be able to use our technologies,
which could weaken our competitive position, reduce our revenues or increase our
costs.
The fiber optic component market is a
highly competitive industry in which we, and most other participants, rely on a
combination of patent, copyright, trademark and trade secret laws,
confidentiality procedures and licensing arrangements to establish and protect
proprietary rights. The competitive nature of our industry, rapidly changing
technology, frequent new product introductions, changes in customer requirements
and evolving industry standards heighten the importance of protecting
proprietary technology rights. Since the United States Patent and Trademark
Office keeps patent applications confidential until a patent is issued, our
pending patent applications may attempt to protect proprietary technology
claimed in a third party patent application. Our existing and future patents may
not be sufficiently broad to protect our proprietary technologies; policing the
unauthorized use of our products is difficult and we cannot be certain that the
steps we have taken will prevent the misappropriation or unauthorized use of our
technologies, particularly in foreign countries where the laws may not protect
our proprietary rights as fully as United States laws. Our competitors and
suppliers may independently develop similar technology, duplicate our products,
or design around any of our patents or other intellectual
property. If we are unable to adequately protect our proprietary
technology rights, others may be able to use our proprietary technology without
having to compensate us, which could reduce our revenues and negatively impact
our ability to compete effectively.
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Litigation may be necessary to enforce
our intellectual property rights or to determine the validity or scope of the
proprietary rights of others. As a result of any such litigation, we could lose
our proprietary rights and incur substantial unexpected operating costs. Any
action we take to protect our intellectual property rights could be costly and
could absorb significant management time and attention. In addition, failure to
adequately protect our trademark rights could impair our brand identity and our
ability to compete effectively.
We may be subject to intellectual
property infringement claims that are costly to defend and could limit our
ability to use some technologies in the future.
Our industry is very competitive and is
characterized by frequent intellectual property litigation based on allegations
of infringement of intellectual property rights. Numerous patents in our
industry have already been issued, and as the market further develops and
participants in our industry obtain additional intellectual property protection,
litigation is likely to become more frequent. From time to time, third parties
may assert patent, copyright, trademark and other intellectual property rights
to technologies or rights that are important to our business. In addition, we
have and we may continue to enter into agreements to indemnify our customers for
any expenses or liabilities resulting from claimed infringements of patents,
trademarks or copyrights of third parties. Any litigation arising from claims
asserting that our products infringe or may infringe the proprietary rights of
third parties, whether the litigation is with or without merit, could be
time-consuming, resulting in significant expenses and diverting the efforts of
our technical and management personnel. We do not have insurance against our
alleged or actual infringement of intellectual property of others. These claims
could cause us to stop selling our products, which incorporate the challenged
intellectual property, and could also result in product shipment delays or
require us to redesign or modify our products or to enter into licensing
agreements. These licensing agreements, if required, would increase our product
costs and may not be available on terms acceptable to us, if at all.
Although we are not aware of any
intellectual property lawsuits filed against us, we may be a party to litigation
regarding intellectual property in the future. We may not prevail in any such
actions, given their complex technical issues and inherent uncertainties.
Insurance may not cover potential claims of this type or may not be adequate to
indemnify us for all liability that may be imposed. If there is a successful
claim of infringement or we fail to develop non-infringing technology or license
the proprietary rights on a timely basis, our business could be harmed.
We have significant manufacturing
operations in China, which exposes us to risks inherent in doing business in
China.
A significant portion of our
manufacturing is conducted at our facilities in Shenzhen, China, and we also
conduct research and development-related activities in Shenzhen. Employee
turnover in China is high due to the intensely competitive and fluid market for
skilled labor. We will need to continue to hire appropriate personnel, obtain
and retain required legal authorization to hire such personnel, and expend time
and financial resources to hire and train such personnel. In addition, we
believe that salary inflation rates for the skilled personnel we hire and seek
to retain in China are likely to be higher than inflation rates elsewhere.
Operating in China subjects us to
political, legal and economic risks. In particular, the political, legal and
economic climate in China, both nationally and regionally, is fluid and
unpredictable. Our ability to operate in China may be adversely affected by
changes in Chinese laws and regulations such as those related to, among other
things, taxation, import and export tariffs, environmental regulations, land use
rights, intellectual property, currency controls, employee benefits and other
matters. In addition, we may not obtain or retain the requisite legal permits to
continue to operate in China, and costs or operational limitations may be
imposed in connection with obtaining and complying with such permits.
We intend to continue to export the
products manufactured at our facilities in China. Under current regulations,
upon application and approval by the relevant governmental authorities, we will
not be subject to certain Chinese taxes and will be exempt from certain duties
on imported materials that are used in the manufacturing process and
subsequently exported from China as finished products. However, Chinese trade
regulations are in a state of flux, and we may become subject to other forms of
taxation and duties in China or may be required to pay export fees in the
future. In the event that we become subject to new taxation or export fees in
China, our business and results of operations could be materially adversely
affected.
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We are subject to anti-corruption
laws in the jurisdictions in which we operate, including the U.S. Foreign
Corrupt Practices Act. Our failure to comply with these laws could result in
penalties which could harm our reputation and have a material adverse effect on
our business, results of operations and financial condition.
Because of our worldwide operations, we
are subject to risks associated with compliance with applicable anti-corruption
laws, including the U.S. Foreign Corrupt Practices Act, or FCPA, which generally
prohibits U.S. companies and their employees and intermediaries from making
payments to foreign officials for the purpose of obtaining or keeping business,
securing an advantage, or directing business to another, and requires public
companies to maintain accurate books and records and a system of internal
accounting controls. Under the FCPA, U.S. companies may be held liable for
actions taken by directors, officers, employees, agents, or other strategic or
local partners or representatives. If we or our intermediaries fail to comply
with the requirements of the FCPA or similar laws, governmental authorities in
the United States and elsewhere could seek to impose civil and criminal fines
and penalties which could have a material adverse effect on our business,
results of operations and financial condition.
We are subject to complex taxation
rules and practices, which may affect our results of operations.
As a multinational company, we are
required to comply with increasingly complex taxation rules and practices in the
U.S. and abroad. The development of our tax strategies requires expertise and
may impact how we conduct our business. Our future effective tax rates could be
unfavorably affected by changes in, or interpretations of, tax rules and
regulations in the jurisdictions in which we do business, by lapses of the
availability of the U.S. research and development tax credit or by changes in
the valuation of our deferred tax assets and liabilities. Furthermore, we
provide for certain tax liabilities that involve significant judgment. We are
subject to the examination of our tax returns by federal, state and foreign tax
authorities, which could focus on our intercompany transfer pricing methodology
as well as other matters. If our tax strategies are ineffective or we are not in
compliance with domestic and international tax laws, our financial position,
operating results and cash flows could be adversely affected.
The distribution of any earnings of
our foreign subsidiaries to the United States may be subject to United States
income taxes, thus reducing our net income.
We hold a significant amount of cash
and cash equivalents outside the United States in our foreign subsidiaries that
may not be readily available to meet certain of our cash requirements in the
United States. If we are unable to address our U.S. cash requirements through
operations, through borrowings or from other sources of cash obtained at an
acceptable cost, it may be necessary for us to consider repatriation of earnings
that are deemed permanently reinvested, and we may be required to pay additional
taxes under current tax laws, which could have a material effect on our results
of operations and financial condition. We have not recorded a deferred tax
liability of approximately $0.7 million related to U.S. federal and state income
taxes and foreign withholding taxes on approximately $26.0 million of
undistributed earnings of foreign subsidiaries indefinitely invested outside the
United States. Except as required under U.S. tax law, we do not provide for U.S.
taxes on our undistributed earnings of foreign subsidiaries that have not been
previously taxed since we intend to invest such undistributed earnings outside
of the U.S. Any such taxes would reduce our net income in the period in which
these earnings are distributed. In addition, any significant change to the tax
system in the U.S. or in other jurisdictions, including changes in the taxation
of international income, could adversely affect our financial results.
We face risks associated with
currency exchange rate fluctuations, which could adversely affect our operating
results.
We are exposed to risks associated with
the translation of Taiwan (NT) and China (RMB) denominated financial results and
accounts into U.S. dollars for financial reporting purposes. The carrying value
of the assets and liabilities held in our Taiwan and China subsidiaries will be
affected by fluctuations in the value of the U.S. dollar as compared to the NT
and RMB. Changes in the value of the U.S. dollar as compared to the NT and RMB
could have an adverse effect on our reported results of operations and financial
condition. As the net positions of our unhedged foreign currency transactions
fluctuate, our earnings might be negatively affected. In addition, the reported
carrying value of our NT and RMB denominated assets and liabilities held in our
Taiwan and China subsidiaries will be affected by fluctuations in the value of
the U.S. dollar compared to the NT and RMB. As of March 31, 2016, we had a net
asset balance, excluding intercompany payables and receivables, in our Taiwan
and China subsidiaries denominated in NT and RMB. If the NT and RMB were to
weaken 10% against the dollar, our net asset balance would decrease by
approximately $1.0 million as of this date. Although we have implemented hedging
strategies designed to mitigate foreign currency risk, these strategies may not
eliminate our exposure to foreign exchange rate
fluctuations and involve costs and risks of their own, such as ongoing
management time and expertise, external costs to implement the strategies and
potential accounting implications.
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