Dasan Zhone Solutions Earnings 2019-03-31

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended March 31, 2019

OR

For the transition period from              to

000-32743

(Commission File Number)

DASAN ZHONE SOLUTIONS, INC.

(Exact name of registrant as specified in its charter)

(510) 777-7000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  ☒    No  ☐

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files).     Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company”, and “emerging growth company” in rule 12b-2 of the Exchange Act.

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes☐ No ☒

Securities registered pursuant to Section 12(b) of the Act:

TABLE OF CONTENTS

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DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Balance Sheets

(In thousands, except par value)

See accompanying notes to unaudited condensed consolidated financial statements.

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DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Comprehensive Income (Loss)

(In thousands, except per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Stockholders' Equity and Non-Controlling Interest

(In thousands, except per share data)

See accompanying notes to unaudited condensed consolidated financial statements.

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DASAN ZHONE SOLUTIONS, INC. AND SUBSIDIARIES

Unaudited Condensed Consolidated Statements of Cash Flows

(In thousands)

See accompanying notes to unaudited condensed consolidated financial statements.

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Notes to Unaudited Condensed Consolidated Financial Statements

DASAN Zhone Solutions, Inc. (referred to, collectively with its subsidiaries, as “DZS” or the “Company”) is a global provider of ultra-broadband network access solutions and communications platforms deployed by advanced Tier 1, 2 and 3 service providers and enterprise customers. The Company provides a wide array of reliable, cost-effective networking technologies, including broadband access, Ethernet switching, mobile backhaul, Passive Optical LAN and software-defined networks, to a diverse customer base that includes more than 900 customers in more than 80 countries worldwide.

DZS was incorporated under the laws of the state of Delaware in June 1999, under the name Zhone Technologies, Inc. On September 9, 2016, the Company acquired Dasan Network Solutions, Inc., a California corporation (“DNS”), through the merger of a wholly owned subsidiary of the Company with and into DNS, with DNS surviving as a wholly owned subsidiary of the Company (the “Merger”). At the effective time of the Merger, all issued and outstanding shares of capital stock of DNS held by DASAN Networks, Inc. (“DNI”) were canceled and converted into the right to receive shares of the Company's common stock in an amount equal to 58% of the issued and outstanding shares of the Company's common stock immediately following the Merger. In connection with the Merger, the Company changed its name from Zhone Technologies, Inc. to DASAN Zhone Solutions, Inc.

The Company is headquartered in Oakland, California with flexible in-house production facilities in Seminole, Florida and Hanover, Germany (acquired as part of the Keymile Acquisition in January 2019), and contract manufacturers located in China, India, Korea and Vietnam. The Company also maintains offices to provide sales and customer support at global locations.

The accompanying consolidated financial statements have been prepared in conformity with generally accepted accounting principles in the United States (“U.S. GAAP”), assuming the Company will continue as a going concern.

Although the Company had net income of $2.8 million and $1.2 million for the years ended December 31, 2018 and 2017, the Company had a net loss of $1.5 million for the quarter ended March 31, 2019 and has incurred significant losses in prior years.  As of March 31, 2019, the Company had an accumulated deficit of $17.4 million and working capital of $86.5 million.  As of March 31, 2019, the Company had $20.9 million in cash and cash equivalents, which included $12.2 million in cash balances held by its international subsidiaries, and $57.5 million in aggregate principal amount of short-term debt obligations, other long-term debt and long-term related-party borrowings. In addition, as of March 31, 2019, the Company had $12.3 million committed as security for letters of credit under its revolving credit facilities, leaving $21.7 million in aggregate borrowing availability under these facilities.

The Company’s current lack of liquidity could harm the Company by:

The Company’s ability to meet its obligations as they become due in the ordinary course of business for the next twelve (12) months will depend on its ability to (i) achieve forecasted results, (ii) access capital under its existing or new credit facilities and/or raise additional capital through debt or equity financing from public and/or private capital markets and (iii) effectively manage inventory procurement. If the Company cannot access or raise additional capital when needed, its operations and prospects could be negatively affected. Management’s belief that the Company will be able to achieve forecasted results assumes that, among other things, the Company will continue to be successful in implementing its business strategy and that there will be no material adverse development in its business, liquidity or capital requirements. If one or more of these factors do not occur as expected, it could cause the Company to fail to meet its obligations as they come due.

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Based on the Company's current plans and current business conditions, the Company believes that its existing cash, cash equivalents and available credit facilities will be sufficient to satisfy its anticipated cash requirements for at least the next twelve (12) months.

DNI owned approximately 57.2% of the outstanding shares of the Company's common stock as of March 31, 2019. As long as DNI and its affiliates hold shares of the Company's common stock representing at least a majority of the votes, DNI will be able to freely nominate and elect all the members of the Company's board of directors, subject to applicable requirements under Nasdaq listing rules and applicable laws. The directors elected by DNI will have the authority to make decisions affecting the Company's capital structure, including the issuance of additional capital stock or options, the incurrence of additional indebtedness, the implementation of stock repurchase programs, and the declaration of dividends. The interests of DNI may not coincide with the interests of the Company's other stockholders or with holders of the Company's indebtedness. DNI’s ability to control all matters submitted to the Company's stockholders for approval limits the ability of other stockholders to influence corporate matters and, as a result, the Company may take actions that the Company's other stockholders or holders of the Company's indebtedness do not view as beneficial.  See Note 11 and Note 14 to the unaudited condensed consolidated financial statements for additional information.

For a complete description of what the Company believes to be the critical accounting policies and estimates used in the preparation of its unaudited condensed consolidated financial statements, refer to the Company’s Annual Report on Form 10-K for the year ended December 31, 2018.

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. GAAP for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements.

The unaudited condensed consolidated financial statements reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary for a fair presentation of the results for the interim periods presented.  All intercompany transactions and balances have been eliminated in consolidation. The results of operations for the current interim period are not necessarily indicative of results to be expected for the current year or any other period. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements of the Company and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2018 filed with the Securities and Exchange Commission.

The preparation of the condensed consolidated financial statements in conformity with U.S. GAAP 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 consolidated financial statements and the reported amounts of revenue and expenses during the reporting period. Actual results could differ materially from those estimates.

The following table presents the revenues by source (in thousand):

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The following summarizes required disclosures about geographical concentrations and revenue by products and services (in thousands):

Financial instruments, which potentially subject the Company to concentrations of credit risk, consist primarily of cash and cash equivalents which totaled $20.9 million at March 31, 2019, as well as the Company’s PNC Facility (defined below), under which the Company had aggregate borrowing availability of $15.0 million as of March 31, 2019. Cash and cash equivalents consist principally of financial deposits and money market accounts. Cash and cash equivalents are principally held with various domestic and international financial institutions with high credit standing.

The Company’s customers include competitive and incumbent local exchange carriers, competitive access providers, internet service providers, wireless carriers and resellers serving these markets. The Company performs ongoing credit evaluations of its customers and generally does not require collateral. Allowances are maintained for potential doubtful accounts.  

For the three months ended March 31, 2019 and 2018, no single customer accounted for 10% or more of net revenue.

As of March 31, 2019, no single customer represented 10% or more of net accounts receivable. As of December 31, 2018, two (2) customers represented 11% and 10% of net accounts receivable, respectively.

As of March 31, 2019 and December 31, 2018, receivables from customers in countries other than the United States represented 92% and 88%, respectively, of net accounts receivable.

The Company allocates the fair value of purchase consideration to the tangible assets acquired, liabilities assumed and intangible assets acquired based on their estimated fair values. The excess of the fair value of purchase consideration over the fair values of these identifiable assets and liabilities is recorded as goodwill. When determining the fair values of assets acquired and liabilities assumed, management makes significant estimates and assumptions, especially with respect to intangible assets and certain tangible assets such as inventory.

Critical estimates in valuing certain tangible and intangible assets include but are not limited to future expected cash flows from the underlying assets and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable and, as a result, actual results may differ from estimates.

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The Company provides certain defined benefit pension plans to employees in Germany. Pension accounting is intended to reflect the recognition of future benefit costs over the employees' average expected future service to the Company based on the terms of the plans and investment and funding decisions. To estimate the impact of these future payments and the Company’s decisions concerning funding of these obligations, the Company is required to make assumptions using actuarial concepts within the framework of U.S. GAAP. Two critical assumptions are the discount rate and the expected long-term return on plan assets. Other important assumptions include expected future salary increases, expected future increases to benefit payments, expected retirement dates, employee turnover, retiree mortality rates and portfolio composition. The Company evaluates these assumptions at least annually.

Recent Accounting Pronouncements Adopted

Leases

In February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2016-02, Leases as modified subsequently by ASUs 2018-01, 2018-10, 2018-11, 2018-20 and 2019-01 (“ASC 842”), which introduces the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under previous guidance. ASU 2016-02 requires that lease arrangements longer than 12 months’ result in an entity recognizing an asset and liability, among other changes.

The Company adopted the new standard on January 1, 2019, the first day of fiscal 2019 using the modified retrospective approach whereby the cumulative effect of adoption was recognized on the adoption date and prior periods were not restated. There was no net cumulative effect adjustment to retained earnings as of January 1, 2019 as a result of this adoption. ASC 842 sets out the principles for the recognition, measurement, presentation and disclosure of leases.

The Company has elected a certain package of practical expedients permitted under the transition guidance within ASC 842. Those practical expedients are as follows:

The Company applies significant judgment in considering all relevant factors that create an economic benefit (e.g., contract-based, asset-based, entity-based, and market-based, among others) as of the commencement date in determining the initial lease term and future lease payments. For example, the Company exercises judgment in determining whether renewal periods will be exercised during the initial measurement process. If the Company believes it will exercise the renewal option, and the lease payments associated with the renewal periods are known or calculable, such renewal lease payments would be included in the initial measurement of the lease liability. Otherwise, even if the Company believes that it will exercise the renewal period, if the renewal payments are unknown or not calculable, they would not be included until they become known or calculable at which time the Company would remeasure the remaining lease payments similar to a lease modification.

Adoption of the standard resulted in the balance sheet recognition of right of use assets and lease liabilities of approximately $21.2 million and $22.4 million, respectively as of January 1, 2019. Adoption of the standard did not materially impact the Company’s unaudited condensed consolidated statements of comprehensive income (loss) and cash flows. See Note 13 in the notes to unaudited condensed consolidated financial statements.

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Income Tax Effects within Accumulated Other Comprehensive Income

In February 2018, the FASB issued ASU 2018-02, Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income. The amendments in this update allow a reclassification from accumulated other comprehensive income to retained earnings for stranded tax effects resulting from the Tax Cuts and Jobs Act (the “Tax Act”). The adoption of this standard on January 1, 2019 did not have a material impact on the Company’s condensed consolidated financial statements, since the Company did not elect to reclassify the income tax effects of 2017 Tax Act from accumulated other comprehensive income to retained earnings.  

Improving the Presentation of Net Periodic Pension Cost and Net Periodic Post-Retirement Benefit Cost

In March 2017, the FASB issued ASU 2017-07, Improving the Presentation of Net Periodic Pension Cost and Net Periodic Post-Retirement Benefit Cost. The ASU requires the Company to disaggregate the service cost component from the other components of net periodic benefit costs and requires the Company to present the other components of net periodic benefit cost in other income, net. The standard is effective for annual and interim periods beginning after December 31, 2017, and retrospective application is required. The Company adopted this guidance during the first quarter of 2019 without any retrospective adjustments since the underlying pension obligations were acquired through Keymile Acquisition in 2019. The interest cost, which is the only component of net period post-retirement cost, is recognized in Other income (loss), net in the condensed consolidated statement of comprehensive income (loss).

Other Recent Accounting Pronouncements Not Yet Adopted

In January 2017, FASB issued ASU 2017-04, Simplifying the Test for Goodwill Impairment, which simplifies the accounting for goodwill impairment. The updated guidance is effective for the Company on January 1, 2020, and will be adopted accordingly. Early adoption is permitted. The Company is currently assessing the potential impact of adopting this new guidance on its consolidated financial statements.

On August 28, 2018, the FASB issued ASU 2018-13, Fair Value Measurement (Topic 820), which removes, modifies, and adds certain disclosure requirements related to fair value measurements in ASC 820. The Company is currently assessing the potential impact of adopting this new guidance on its consolidated financial statements.

In August 2018, the FASB issued ASU 2018-14, Disclosure Framework-Changes to the Disclosure Requirements for Defined Benefit Plans, which amends ASC 715 to add, remove, and clarify disclosure requirements related to defined benefit pension and other postretirement plans. The updated guidance is effective for the Company on January 1, 2021, with early adoption permitted. The Company is currently assessing the potential impact of adopting this new guidance on its consolidated financial statements.

Keymile Acquisition

On January 3, 2019, ZTI Merger Subsidiary III Inc., a Delaware corporation and a wholly owned subsidiary of the Company (“ZTI”), acquired all of the outstanding shares of Keymile GmbH (“Keymile”), a limited liability company organized under the laws of Germany, from Riverside KM Beteiligung GmbH (“Riverside”), a limited liability company organized under the laws of Germany, pursuant to a share purchase agreement (the “Keymile Acquisition”).

The allocation of the purchase price was based upon a preliminary valuation, and the Company’s estimates and assumptions are subject to refinement, within the measurement period (up to one year from the Acquisition Date). Measurement period adjustments, with the corresponding adjustment to the bargain purchase, will be recorded in the reporting period in which the adjustment to the provisional amounts are determined.

The aggregate cash purchase price paid for all of the shares of Keymile and certain of its subsidiaries, was €10,250,000 (approximately $11.8 million). The Company also assumed pension obligations of approximately $12.7 million, net of pension assets of $3.5 million. Following the closing of the Keymile Acquisition, Keymile became the Company’s wholly owned subsidiary. The Keymile Acquisition agreement also provides for a lockbox mechanism such that normal operations are observed by Keymile management and any excess cash flows generated from operating activities for the period from October 1, 2018 to December 31, 2018 remains with Keymile, with the Company as the beneficiary, as the purchaser of Keymile. At December 31, 2018, cash received from the lockbox mechanism amounted to $2.5 million.

On October 1, 2018, as a condition for the Keymile Acquisition, Riverside extended a €4.0 million ($4.6 million, which represents the cash and cash equivalents and short-term debt, in the table below) as working capital loan to Keymile. The working capital loan bears interest at a rate of 3.5% per annum and is scheduled for repayment in two equal installments in April and November 2019.

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Keymile is a leading solution provider and manufacturer of telecommunication systems for broadband access. The Company believes Keymile strengthens its portfolio of broadband access solutions, which now includes a series of multi-service access platforms for FTTx network architectures, including ultra-fast broadband copper access based on VDSL/Vectoring and G. Fast technology.

A summary of the preliminary estimated purchase price allocation to the fair value of assets acquired and liabilities assumed is as follows (in thousands):

The following summarizes the preliminary estimated fair values of the assets acquired and liabilities assumed at the date of acquisition for the acquisition consummated during the three-month period ended March 31, 2019 (in thousands):

The purchase price allocation resulted in the recognition of a gain on bargain purchase of approximately $0.3 million, which was included in the unaudited condensed consolidated statements of comprehensive income (loss) for the quarter ended March 31, 2019. The gain on bargain purchase was the result of the fair value of the identifiable net assets acquired exceeding the purchase price paid for the Keymile Acquisition which was reduced by the lockbox mechanism.

The estimated weighted average useful lives of the acquired property, plant and equipment is 5 years. Depreciation is calculated using straight-line method.

The following table represents the preliminary estimated fair value and useful lives of identifiable intangible assets acquired:

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The Company valued the customer relationships using the Income Approach, specifically the Multi-Period Excess Earnings Method (“MPEEM”). As of the valuation date, there was value attributable to Keymile’s existing customer relationships. Keymile’s key customer base is made up of independent telecommunication service providers and network operators, a base of customers that have seen growth since 2012. Keymile is seen as a market leader and historically has had low customer attrition. In addition, switching costs are considered to be high due to the disruption of switching platforms as well as the additional training necessary.

The Company utilized the Relief from Royalty Method (“RFRM”) to value the tradename and developed technology. The RFRM assumes that the value of the asset equals the amount a third party would pay to use the asset and capitalize on the related benefits of the asset. Therefore, a revenue stream for the asset is estimated, and then an appropriate royalty rate is applied to the forecasted revenue to estimate the pre-tax income associated with the asset. The pre-tax income is then tax-effected to estimate the after-tax net income associated with the asset. Finally, the after tax net income is discounted to the present value using an appropriate rate of return that considers both the risk of the asset and the associated cash flow estimates.

Pro Forma Financial Information

The unaudited pro forma information for the periods set forth below gives effect to the Keymile Acquisition as if it had occurred as of January 1, 2018.  The unaudited pro forma financial information has been prepared by management for illustrative purposes only and does not purport to represent what the results of operations, financial condition or other financial information of the Company would have been if the Keymile Acquisition had occurred on January 1, 2018 or what such results or financial condition will be for any future periods. The unaudited pro forma financial information is based on estimates and assumptions and on the information available at the time of the preparation thereof. These estimates and assumptions may change, be revised or prove to be materially different, and the estimates and assumptions may not be representative of facts existing at the time of the Keymile Acquisition. The pro forma adjustments primarily relate to acquisition related costs, amortization of acquired intangibles and interest expense related to financing arrangements. Below is the pro forma financial information (in thousands):

The Company utilizes a fair value hierarchy that is intended to increase consistency and comparability in fair value measurements and related disclosures. The fair value hierarchy is based on inputs to valuation techniques that are used to measure fair value that are either observable or unobservable. Observable inputs reflect assumptions market participants would use in pricing an asset or liability based on market data obtained from independent sources while unobservable inputs reflect a reporting entity’s pricing based upon their own market assumptions. The fair value hierarchy consists of the following three levels:

The following financial instruments are not measured at fair value on the Company’s condensed consolidated balance sheet as of March 31, 2019 and the consolidated balance sheet as of December 31, 2018, but require disclosure of their fair values: cash and cash equivalents, short-term investments, accounts receivable, accounts payable and debt.  The carrying values of financial instruments (Level 3) such as cash and cash equivalents, short-term investments, accounts receivable and accounts payable approximate their fair values based on their short-term nature. The carrying value of the Company's debt (Level 3) approximates their fair values based on the current rates available to the Company for debt of similar terms and maturities.

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As of March 31, 2019 and December 31, 2018, the Company's cash and cash equivalents comprised financial deposits. Restricted cash consisted primarily of cash restricted for performance bonds, warranty bonds and collateral for borrowings.

Accounts receivable, net as of March 31, 2019 and December 31, 2018 was as follows (in thousands):

Inventories as of March 31, 2019 and December 31, 2018 were as follows (in thousands):