NWK Network Equip Tech

ITEM 1.  FINANCIAL STATEMENTS

See accompanying notes to condensed consolidated financial statements

See accompanying notes to condensed consolidated financial statements

See accompanying notes to the condensed consolidated financial statements

NETWORK EQUIPMENT TECHNOLOGIES, INC.
Notes to Condensed Consolidated Financial Statements

Note 1.  Description of Business

Nature of Business:    Network Equipment Technologies, Inc. (the Company or N.E.T.) is a global provider of voice and data telecommunications equipment for multi-service networks requiring high degrees of versatility, interoperability, security and performance. N.E.T. offers an array of products purpose-built for mixed-service, multi-protocol networks; bandwidth-sensitive site communications; high-performance, security-sensitive transmissions; and converged communications. N.E.T. delivers solutions that enable seamless integration and migration of existing networks to secure internet protocol (IP)-based voice and data communications. N.E.T. was founded in 1983.

Note 2.  Summary of Significant Accounting Policies

Principles of Consolidation:    The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries. All significant intercompany balances and transactions have been eliminated.

Segments:      The Company’s management uses consolidated financial information in determining how to allocate resources and assess performance. For this reason, the Company has determined that it is engaged in a single reportable segment.

Basis of Presentation:    The unaudited condensed consolidated financial statements of the Company included herein have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Accordingly, they do not contain all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. The condensed consolidated balance sheet as of March 30, 2007 was derived from the Company’s audited consolidated financial statements.

The Company’s fiscal year ends on the last Friday in March. In most years, the fiscal year is 52 weeks, with each quarter comprised of thirteen weeks, which allows comparability of quarter over quarter results. In the opinion of management, the accompanying condensed consolidated financial statements contain all adjustments (consisting only of normal recurring adjustments) considered necessary to present fairly the financial position as of September 28, 2007, the results of operations for the three and six month periods ended September 28, 2007 and September 29, 2006, and the cash flows for the six months ended September 28, 2007 and September 29, 2006.

These financial statements should be read in conjunction with the March 30, 2007 audited consolidated financial statements and notes thereto. The results of operations for the three and six months ended September 28, 2007 are not necessarily indicative of the results to be expected for the fiscal year ending March 28, 2008 or any future period.

Revenue Recognition :    The Company recognizes product revenue when all four of the following criteria are met:

1)  the Company has a contract with its customer,
2)  the product has been shipped as required by the contract and risk of loss has passed to the customer,
3)  the price is fixed or determinable, and
4)  collection of payment is reasonably assured.

If the customer has a right of acceptance and the Company has not yet obtained acceptance, revenue is deferred until the terms of acceptance are satisfied. When product revenue is deferred, the Company also defers the associated cost of goods until the revenue is recognized. The Company recognizes service revenue upon completion of the service or, for ongoing services such as maintenance, ratably over the period of the contract. For sales arrangements that involve multiple elements to be delivered at different times, such as a sale of equipment together with post-contract support services, the Company assigns revenue to each element based on its fair value and recognizes revenue for each element as the criteria for recognition are met. Fair value for each element is determined by vendor-specific objective evidence, if available, such as the sales price charged when the same element is sold separately or otherwise by the residual method, whereby the value of delivered elements is determined by subtracting the fair value of the undelivered elements from the total value of the arrangement. If vendor-specific objective evidence of fair value of one or more undelivered elements does not exist, revenue on the entire arrangement is deferred and is recognized only upon delivery of those elements or when fair value has been established.

Financial Statement Estimates:    The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Such management estimates and assumptions include, but are not limited to:  assumptions related to contracts that have multiple elements, the allowances for sales returns and potentially uncollectible accounts receivable, the valuation of inventory, warranty costs, the valuation allowance on deferred tax assets, certain reserves and accruals, and assumptions related to stock-based compensation. Actual results could differ from those estimates.

Credit Risks:    The Company’s credit evaluation process and reasonably short collection terms help mitigate credit risk. The Company typically does not require collateral or other security to support accounts receivable. The Company performs ongoing credit evaluations of its customers’ financial condition and limits the amount of credit extended when deemed necessary. The Company maintains reserves for known recourse obligations and estimated bad debts.

Income Taxes:    Effective the beginning of fiscal 2008, the Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (FIN 48), which clarifies the accounting for uncertainty in tax positions. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. Interest and penalties related to income tax matters are recorded in income tax expense. See Note 8.

Recently Issued Accounting Standards:    In February 2007, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standard (SFAS) No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (SFAS 159), which allows entities to choose to measure certain financial instruments and certain other items at fair value (the “fair value option”). The election is made on an instrument-by-instrument basis and is irrevocable. If the fair value option is elected for an instrument, SFAS 159 specifies that all subsequent changes in fair value for that instrument shall be reported in earnings. SFAS 159 is effective for fiscal years beginning after November 15, 2007, which is the Company’s fiscal 2009. The Company will evaluate the effect on its consolidated financial statements of adopting SFAS 159.

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157), which clarifies that fair value is the amount that would be exchanged to sell an asset or transfer a liability in an orderly transaction between market participants. Further, the standard establishes a framework for measuring fair value in generally accepted accounting principles and expands certain disclosures about fair value measurements. SFAS 157 is effective for fiscal years beginning after November 15, 2007, which is the Company’s fiscal 2009, and is also effective for interim periods within the fiscal year. The Company will evaluate the effect on its consolidated financial statements of adopting SFAS 157.

The denominator for basic net income (loss) per share is the weighted average number of unrestricted common shares outstanding for the periods presented. In periods of net income, the denominator for diluted net income per share also includes potentially dilutive shares, which consist of shares issuable upon the exercise of dilutive stock options and contingently issuable shares. These shares, which are excluded from the computations of diluted net loss per share as they are anti-dilutive and reduce the loss per share, totaled 88,000 and 51,000, respectively, for the three and six months ended September 29, 2006.

There are 784,000 shares of common stock issuable upon conversion of debentures. These shares and the related effect of the accrued interest on the debentures are excluded from the calculation of diluted income (loss) per share for each period presented, as their inclusion would be anti-dilutive.

Note 5.  Restructure and Other Costs (Benefit)

The net restructure costs of $51,000 and $52,000, respectively, for the three and six months ended September 28, 2007 relate primarily to unanticipated costs to exit the Company’s former manufacturing facility. The net costs of $3,000 and $1,000, respectively, for the three and six months ended September 29, 2006, relate primarily to minor adjustments for employee separation costs from prior restructurings.

The liability for restructuring was $3.9 million at September 28, 2007, as shown in the table below. Components of accrued restructure costs and changes in accrued amounts related to restructuring during fiscal 2008 are as follows:

(1)

Consists primarily of accretion of implied interest on the remaining liability for lease and other exit costs associated with the Company’s former manufacturing facility, which the Company vacated at the end of fiscal 2007. The Company executed a sublease for a portion of the facility early in the second quarter of fiscal 2008 on financial terms consistent with prior estimates.

The balance at September 28, 2007 includes $1.6 million included in other long term liabilities for lease and other exit costs for the vacated facility for periods beyond a year, net of sublease income.

Note 6.  License and Development Agreement

In October 2005, the Company entered into a license and development agreement with a third-party technology supplier, under which the Company acquired a license to manufacture and distribute the supplier’s high-speed networking platform. In June 2007, the agreement was amended to include an additional, more advanced, platform. Under the 2005 agreement and the 2007 amendment, each party agreed to perform development and other activities to bring new products to market and the Company obtained certain rights to market these products. Under the 2005 agreement, the Company paid $3.0 million in license and development fees and capitalized the amount in other assets in the accompanying condensed consolidated balance sheets. The Company began amortizing this amount in the second half of fiscal 2007 concurrent with the sale of the initial platform. Amortization of $337,000 and $677,000, respectively, was recorded for the three and six months ended September 28, 2007.

Under the 2007 amendment, the Company has agreed to pay an additional $5.0 million in four equal installments to the supplier for the advanced platform and an extended exclusive right to market. The first installment was paid in June 2007, the second on September 29, 2007, and the remaining two will be due at separate future dates dependent upon the supplier’s delivery of future enhancements of the advanced platform. The Company has determined that the right to market, as amended, has a value separate from the prepaid license fee, and has allocated the $5.0 million between the two components, based on their fair value, with $1.7 million allocated to the right to market, and $3.3 million allocated to prepaid license fees. These amounts will be amortized over the estimable life of each component. At September 28, 2007, of the $2.5 million representing the first two installments, $800,000 for the right to market and $1.7 million for the prepaid license fee have been capitalized in other assets on the accompanying condensed consolidated balance sheets, with no amortization to date.

In addition to these payments, the Company is obligated to pay royalties on sales of the products, which began in the second half of fiscal 2007. These royalties totaled $403,000 and $620,000, respectively, for the three and six months ended September 28, 2007, and $0 for the comparable periods ended September 29, 2006.

The supplier also serves as a reseller of the platform and the parties have made occasional purchases and sales to each other of inventory components and pre-production units. In connection with these arrangements, in the three and six months ended September 28, 2007, the Company invoiced the supplier $2.4 million for sales to the supplier for resale, and in the three and six months ended September 29, 2006, the Company both invoiced the supplier $8,000 and $171,000, respectively, for sales of pre-production units, and purchased $0 and $33,000, respectively, of goods from the supplier. At September 28, 2007, the Company had outstanding invoices of $2.4 million due from the supplier and owed the supplier $395,000 for royalties.

The Company’s President and CEO served as a member of the board of directors of the supplier through March 2007.

Note 7.  Warranty Accruals

The Company generally warrants hardware product and software for twelve months. The software warranty entitles the customer to bug fixes but not software upgrades during the warranty period. The Company’s methodology is to accrue warranty expense based on historical expense trends calculated as a percentage of product sales. Actual expenses are charged against the accrual in the period they are incurred. On a quarterly basis, the warranty accrual is analyzed for adequacy based on actual trends and subsequent adjustments are made as necessary.

Components of the warranty accrual, which is included in accrued liabilities in the accompanying condensed consolidated balance sheets, were as follows:

(1)

Adjustments result from changes in warranty cost estimates related to labor costs to repair products and frequency of warranty claims.

Note 8.  Income Taxes

The Company recorded tax provisions of $101,000 and $159,000, respectively, for the three and six months ended September 28, 2007. The income tax provisions for the three and six months ended September 28, 2007 were primarily for U.S. federal alternative minimum tax as well as an increase in the Company’s unrecognized tax benefits related to tax positions in its international operations. The Company recorded tax provisions of $4,000 and $6,000, respectively, for the three and six months ended September 29, 2006. The provisions for the three and six months ended September 29, 2006 were primarily for minimum taxes in various jurisdictions as the Company incurred pre-tax losses. The Company’s effective tax rate of 6.0% and 5.3%, respectively, for the three and six months ended September 28, 2007, is lower than statutory tax rates due primarily to the effect of stock-based compensation and utilization of net operating loss carryforwards. The Company’s effective tax rate for the six months ended September 28, 2007 reflects its best current estimate of the rate expected for fiscal 2008, although relatively small changes in forecasted profitability for the remainder of the current year could significantly affect the projected annual effective rate. Accordingly, the Company’s effective tax rate for the remainder of the current fiscal year may fluctuate significantly.

Effective the beginning of fiscal 2008, the Company adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109 (FIN 48), which clarifies the accounting for uncertainty in tax positions. FIN 48 contains a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax positions for recognition by determining if the available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes if any. The second step is to measure the tax benefit as the largest amount that is more than 50% likely to be reached upon ultimate settlement. As a result of adoption, the Company recognized no change in income tax liabilities. As of the adoption date, the Company had gross unrecognized tax benefits of $8.8 million. The total amount of tax benefits, if recognized, that would affect the effective tax rate was $412,000. Consistent with the provisions of FIN 48, the Company reclassified $412,000 of current income tax liabilities resulting in a $412,000 increase to non-current income taxes payable. The gross amount of unrecognized tax benefits decreased to $8.2 million at September 28, 2007, primarily as a result of expiring federal research and development tax credits. The amount of tax benefits, if recognized, that would affect the effective tax rate at September 28, 2007 was $475,000.

Interest and penalties related to income tax matters are recorded in income tax expense. As of the date of adoption of FIN 48, the Company had accrued $74,000 for interest and penalties related to uncertain tax positions, which increased to $95,000 as of September 28, 2007.

As of the date of adoption of FIN 48 and as of September 28, 2007, tax years from 2001 in the U.S. and the Company’s primary foreign jurisdictions remain open for examination. Although the timing of resolution and closure of audits is highly uncertain, the Company does not believe it is reasonably possible that the unrecognized tax benefits would materially change in the next twelve months.

The Company has incurred tax losses in the last several fiscal years and, as of the date FIN 48 was adopted, had approximately $126.1 million of federal net operating loss carryforwards and $36.2 million of state operating loss carryforwards available expiring in the years 2013 through 2027. Currently, the Company believes that it is more likely than not that the net deferred tax asset will not be realized and therefore has recorded a valuation allowance for the entire balance. In future years, these benefits are available to reduce or eliminate taxes on future taxable income.

As of September 28, 2007, the Company had available federal research and development tax credit carryforwards of approximately $2.1 million expiring in the years 2009 through 2027 and alternative minimum tax credit carryforwards of approximately $2.5 million available indefinitely. California research and development tax credit carryforwards of approximately $9.7 million are also available indefinitely.

Note 9.  Financing Arrangements

The Company has a Business Loan Agreement and Security Agreement (Receivables) with Bank of America which provides for a $7.0 million line of credit. The line is available both for cash advances and for standby letters of credit and bears interest at the bank’s prime rate for cash advances and at prime minus 1% for letters of credit (6.75% at September 28, 2007). The line has been extended through November 30, 2007 and is secured by the Company’s accounts receivable. The agreement requires immediate repayment of all amounts outstanding if the Company’s cash balance, defined as the sum of unrestricted cash and short and long term investments, declines more than $10.0 million during a quarter or $30.0 million during the preceding twelve months. As of September 28, 2007, $415,000 and $0, respectively, in letters of credit and cash advances, were outstanding.

Note 10.  Stock-based Compensation

Stock Option and Award Plans:     The Company grants options to purchase shares of its common stock and is authorized to award restricted shares of common stock pursuant to the terms of its 1993 Stock Option Plan and 1997 Stock Option Program (collectively “option plans”). Stock options generally become exercisable ratably over a four-year period and expire after seven to ten years. Options may be granted to officers, employees, directors and independent contractors to purchase common stock at a price not less than 100% of the fair market value at the date of grant.

Restricted stock awards granted under the stock option plans are independent of option grants and are subject to restrictions. Awards issued during fiscal 2007 and 2008 are subject to forfeiture if employment or services are terminated prior to the release of restrictions, which occurs on a ratable basis over two years from the date of grant. Until the restriction is released, the shares cannot be transferred. These shares have the same cash dividend and voting rights as other common stock and are considered as issued and outstanding. The cost of the awards, determined to be the fair market value of the shares at the date of grant, is expensed ratably over the period the restrictions lapse.

Employee Stock Purchase Plan:     Under the employee stock purchase plan (ESPP), the Company’s employees, subject to certain restrictions, could purchase shares of common stock at a price equal to at least 85% of the lower of the fair market value of the Company’s common stock at the beginning of the offering period or the end of each purchase period. The Company elected to suspend indefinitely its employee stock purchase plan in fiscal 2006. The final purchase occurred on December 30, 2005.

Stock Compensation Expense:     Effective the beginning of fiscal 2007, the Company adopted the fair value recognition provisions of SFAS 123R, requiring recognition of the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of the award rather than apply intrinsic value measurement provisions of APB 25. Under SFAS 123R, the option plans and ESPP are considered compensatory plans and the Company is required to recognize compensation cost for grants made under these plans. However, since the ESPP was indefinitely suspended in fiscal 2006, no significant compensation expense has been recognized under the ESPP at or since the adoption of SFAS 123R. The Company recognizes compensation expense for all share-based payment awards granted subsequent to fiscal 2006 on a straight-line basis over the respective requisite service period of the awards. Compensation expense for share-based payment awards granted on or prior to March 31, 2006 but not vested as of March 31, 2006, is recognized on an accelerated basis.

The following table shows total stock-based compensation expense included in the Condensed Consolidated Statements of Operations as a result of adopting SFAS 123R:

There was no stock-based compensation cost capitalized as part of inventory during the three and six months ended September 28, 2007 and September 29, 2006. As required by SFAS 123R, management made an estimate of expected forfeitures and is recognizing compensation costs only for those equity awards expected to vest.

Determining Fair Value:

Valuation and amortization method:    The Company estimates the fair value of stock options granted using the Black-Scholes option-pricing formula and a single option award approach. The fair value is amortized on a straight-line basis over the requisite service periods of the awards, which is generally the vesting period.

Expected Term:    During the year ended March 30, 2007, the Company derived the expected term of options from the midpoint between the vesting and contractual term, as described in the SEC’s Staff Accounting Bulletin No. 107 (SAB 107). The use of the SAB 107 method expires in December 2007. As a result, the Company revised its method of estimating the expected term of options in fiscal 2008, using vesting periods of awards and historical data such as past experience and post vesting cancellations.

Expected Volatility:    The Company’s computation of expected volatility is based on historical volatility commensurate with the expected term of the options.

Risk-Free Interest Rate:    The risk-free interest rate used in the Black-Scholes valuation method is based on the implied yield currently available on U.S. Treasury securities with an equivalent remaining term commensurate with the expected term of the options.

Expected Dividend:    The expected dividend assumption is based on the Company’s current expectations about future dividends. The Company does not expect to pay out cash dividends in the foreseeable future.

The fair value of the Company’s stock option awards granted to employees was estimated using the following weighted-average assumptions:

At September 28, 2007, the total compensation cost related to unvested stock-based awards not yet recognized, net of estimated forfeitures, was approximately $5.6 million. The weighted-average period during which the cost will be amortized, which will be adjusted for subsequent changes in estimated forfeitures, was approximately 2.8 years.

The aggregate intrinsic value is calculated as the difference between the exercise price of the underlying awards and the quoted price of the Company’s common stock at September 28, 2007, for options outstanding as of that date.

Note 11.  Stockholders’ Rights Agreement

On July 12, 1999, the Board of Directors of the Company voted to extend the Company’s existing Stockholders’ Rights Agreement (Rights Agreement) for an additional 10 years. In addition, the Board voted to amend the Rights Agreement: 1) to adjust the exercise price to $80.00 per one-one hundredth (1/100) of a share of Series A Preferred Stock; and 2) to adopt a Three Year Independent Director Evaluation Provision or “TIDE provision” whereby a committee of independent directors of the Company will review and evaluate the Rights Agreement at least once every three years to determine if it continues to be in the best interests of the Company and its stockholders to maintain the Rights Agreement in effect. In fiscal 2006, a committee of independent directors reviewed the Rights Agreement and unanimously agreed that the maintenance of the agreement continues to be in the best interest of the Company and its stockholders, but that the committee should continue to monitor all relevant facts with regard to the exercise price. Further, the committee unanimously agreed that the Rights Agreement should be amended to delete certain “dead-hand” provisions, which the Delaware courts have ruled to be invalid. Accordingly, the Company adopted an amendment of the Rights Agreement substantially as set forth in the immediately preceding sentence above.

Under the Rights Agreement, as amended, a preferred share purchase right, or “Right”, is attached to each share of common stock. The Rights are exercisable only after a person or group acquires beneficial ownership of 15% or more of the Company’s common stock or commences a tender or exchange offer that would result in 20% or greater of common stock ownership. Each Right initially entitles a stockholder to buy one one-hundredth (1/100) of a share of a new series of participating preferred stock, the Series A Preferred Stock, at an exercise price of $80.00. If the Company is acquired in a merger or other transaction with a person or group, or sells 50% or more of its assets or earning power to such a person or group, each Right not owned by such acquiring person will entitle its holder to obtain, on exercise of the Right, a number of the acquiring company’s common shares having a market value at the time of twice the Right’s then-current exercise price. If a person or group acquires 15% or more of the Company’s outstanding common stock, each Right will entitle its holder to obtain, on exercise of the Right, a number of shares of common stock (or equivalent) having a market value of twice the Right’s then-current exercise price. After a person or group has acquired 15% of the outstanding shares of common stock but before their acquisition of 50% or more of the common stock, the Board of Directors may exchange one share of common stock or equivalent fractions of preferred stock for each Right. The Company can redeem the Rights at $.01 per Right at any time until the tenth day following the acquisition by a person or group of 15% the Company common stock. The Rights are also redeemable thereafter in certain circumstances. The Rights expire on August 24, 2009, unless earlier redeemed or exchanged.

Note 12.  Contractual Obligations and Contingencies

In the normal course of business, the Company enters into contractual commitments to purchase services, materials, components, and finished goods from suppliers, primarily the Company’s contract manufacturer. In connection with the manufacturing of final products, the contract manufacturer procures components and manufactures subassemblies based on the Company’s demand forecasts, for which the Company may also incur contractual liabilities. As of September 28, 2007, there were no such liabilities. The Company’s other contractual obligations and contingencies have not changed significantly from March 30, 2007, other than the reclassification of taxes payable related to uncertain tax positions from current to long-term liabilities as a result of our adoption of FIN 48 at the beginning of fiscal 2008 and as a result of events described in Note 13.