FORM 10-Q UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 _______________________ [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended September 28, 2002 [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from_______________ to ___________________ Commission file number 0-12751 Corvis Corporation (Exact name of registrant as specified in its charter) Delaware 52-2041343 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 7015 Albert Einstein Drive, Columbia, Maryland 21046-9400 (Address of principal executive offices) (Zip Code) (443) 259-4000 (Registrant's telephone number, including area code) ____________________________________________________________________________ (Former name, former address and former fiscal year, if changed since last report) 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 ___X____ No_______ Number of shares of Common Stock, $0.01 par value, outstanding at October 26, 2002: 412,290,812 TABLE OF CONTENTS Page ---- Part I - Financial Information Item 1. Financial Statements Unaudited condensed consolidated balance sheets as of December 29, 2001 and September 28, 2002 .............................................................. 2 Unaudited condensed consolidated statements of operations for the three and nine months ended September 29, 2001 and September 28, 2002 ..................... 3 Unaudited condensed consolidated statements of cash flows for the nine months ended September 29, 2001 and September 28, 2002 .............................. 4 Notes to unaudited condensed consolidated financial statements ...................... 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations .............................................................................. 15 Item 3. Quantitative and Qualitative Disclosures About Market Risk .............................. 26 Item 4. Controls and Procedures ................................................................. 27 Part II - Other Information Item 1. Legal Proceedings ....................................................................... 28 Item 2. Changes in Securities and Use of Proceeds ............................................... 29 Item 3. Defaults upon Senior Securities. ........................................................ 29 Item 4. Submission of Matters to a Vote of Security Holders. .................................... 29 Item 5. Other Information ....................................................................... 30 Item 6. Exhibits and Reports on Form 8-K ........................................................ 30 PART I - Financial Information Item 1. Financial Statements. CORVIS CORPORATION AND SUBSIDIARIES UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS (In thousands, except share and per share amounts) December 29, September 28, 2001 2002 ------------- -------------- ASSETS ------ Current assets: Cash and cash equivalents ......................................... $ 638,872 $ 510,729 Short-term investments ............................................ 21,907 38,014 Trade accounts receivable ......................................... 33,676 6,021 Inventory, net .................................................... 96,426 74,472 Other current assets .............................................. 17,486 12,544 ------------ ------------- Total current assets ..................................... 808,367 641,780 Restricted cash, long-term ................................................. 2,417 2,396 Property and equipment, net ................................................ 134,393 104,852 Goodwill and other intangible assets, net .................................. 21,429 58,593 Other long-term assets, net ................................................ 12,219 2,811 ------------ ------------- Total assets ............................................. $ 978,825 $ 810,432 ============ ============= LIABILITIES AND STOCKHOLDERS' EQUITY ------------------------------------ Current liabilities: Notes payable, current portion .................................... $ 126 $ 105 Capital lease obligations, current portion ........................ 6,796 3,866 Accounts payable .................................................. 14,488 16,000 Accrued expenses and other liabilities ............................ 36,402 41,629 Provision for restructuring and other charges ..................... 24,050 19,696 ------------ ------------- Total current liabilities ................................ 81,862 81,296 Noncurrent liabilities: Notes payable, net of current portion ............................. 2,959 2,587 Capital lease obligations, net of current portion ................. 1,743 167 Deferred lease liability and other ................................ 3,408 2,871 ------------ ------------- Total liabilities ........................................ 89,972 86,921 Commitments and contingencies Stockholders' equity: Common stock--$0.01 par value; 1,900,000,000 shares authorized; 362,687,909 shares issued and outstanding as of December 29, 2001; 412,288,312 shares issued and outstanding as of September 28, 2002 ....................................... 3,621 4,117 Additional paid-in capital ........................................ 2,648,955 2,798,275 Shareholder notes receivable ...................................... -- (32) Accumulated other comprehensive loss: Foreign currency translation adjustment .................. (10,796) (8,377) Accumulated deficit ...................................... (1,752,927) (2,070,472) ------------ ------------- Total stockholders' equity ............................... 888,853 723,511 ------------ ------------- Total liabilities and stockholders' equity ............... $ 978,825 $ 810,432 ============ ============= See accompanying notes to unaudited condensed consolidated financial statements. 2 CORVIS CORPORATION AND SUBSIDIARIES UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (In thousands, except per share amounts) Three Months Ended Nine Months Ended ----------------------------- ------------------------------ September 29, September 28, September 29, September 28, 2001 2002 2001 2002 ------------- ------------- ------------- ------------- Revenue .............................................. $ 24,157 $ 1,353 $ 173,203 $ 13,092 Costs of Revenue: Product sales ............................... 15,554 757 108,999 9,478 Inventory write-downs and other charges .................................. -- 24,278 99,166 30,324 ------------ ------------- ------------ ------------ Gross profit (loss) ......................... 8,603 (23,682) (34,962) (26,710) Operating expenses: Research and development, exclusive of equity-based expense ..................... 34,827 32,980 117,751 95,123 Sales and marketing, exclusive of equity-based expense ..................... 12,672 10,954 43,185 36,147 General and administrative, exclusive of equity-based expense ..................... 7,652 7,231 27,163 24,407 Equity-based expense: Research and development ................. 10,940 7,152 36,368 22,209 Sales and marketing ...................... 8,265 2,954 15,560 9,092 General and administrative ............... 8,997 7,601 27,346 23,383 Amortization of intangible assets ........... 12,014 5,658 113,890 12,833 Purchased research and development .......... -- -- -- 34,580 Restructuring, impairment and other charges .................................. 131 31,313 606,866 35,664 ------------ ------------- ------------ ------------ Total operating expenses ........... 95,498 105,843 988,129 293,438 ------------ ------------- ------------ ------------ Operating loss ..................... (86,895) (129,525) (1,023,091) (320,148) Interest income and other, net ....................... 6,269 2,127 19,804 2,603 ------------ ------------- ------------ ------------ Net loss ........................... $ (80,626) $ (127,398) $ (1,003,287) $ (317,545) ============ ============= ============ ============ Other comprehensive income (loss)-- foreign currency translation adjustment ................. 11,949 (128) (68,726) 2,419 ------------ ------------- ------------ ------------ Comprehensive loss .......................... $ (68,677) $ (127,756) $ (1,072,013) $ (315,126) ============ ============= ============ ============ Basic and diluted net loss per common share .......... $ (0.23) $ (0.31) $ (2.87) $ (0.82) ============ ============= ============ ============ Weighted average number of common shares outstanding ..................................... 352,335 410,323 349,490 385,643 See accompanying notes to unaudited condensed consolidated financial statements. 3 CORVIS CORPORATION AND SUBSIDIARIES UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (In thousands) Nine Months Ended --------------------------- September 29, September 28, 2001 2002 ------------- ------------- Cash flows from operating activities: Net loss .......................................................................... $(1,003,287) $ (317,545) Adjustments to reconcile net loss to net cash used in operating activities: Depreciation and amortization ................................................. 148,245 38,807 Equity-based expense .......................................................... 79,274 54,684 Purchased research and development ............................................ -- 34,580 Restructuring, impairment and other charges ................................... 672,162 48,716 Changes in operating assets and liabilities: Decrease (increase) in accounts receivable ................................. (41,020) 27,655 Decrease (increase) in inventory, net ...................................... (30,756) 686 Decrease (increase) in other assets ........................................ (4,940) 10,191 Increase (decrease) in accounts payable and accrued expenses ................................................................... (20,603) 4,918 ----------- ---------- Net cash used in operating activities ......................................... (200,925) (97,308) ----------- ---------- Cash flows from investing activities: Purchase of property and equipment ............................................ (93,634) (15,150) Cash acquired in business combination ......................................... -- 6,013 Purchases and sales of short-term investments, net ............................ -- (16,107) Decrease (increase) in deposits and other ................................. non-current assets ............................................................ (15,150) 21 ----------- ---------- Net cash used in investing activities ......................................... (108,784) (25,223) ----------- ---------- Cash flows from financing activities: Payments on note payable and capital leases ................................... (3,609) (4,899) Proceeds from the issuance of stock ........................................... 5,420 941 ----------- ---------- Net cash provided by (used in) financing activities ........................... 1,811 (3,958) Effect of exchange rate changes on cash and cash equivalents ................................................................... (1,884) (1,654) ----------- ---------- Net decrease in cash and cash equivalents .................................... (309,782) (128,143) ----------- ---------- Cash and cash equivalents--beginning .............................................. 1,024,758 638,872 ----------- ---------- Cash and cash equivalents--ending ................................................. $ 714,976 $ 510,729 =========== ========== Supplemental disclosure of cash flow information: Interest paid ................................................................. $ 2,866 $ 754 =========== ========== Supplemental disclosure of noncash activities: Obligations under capital lease ............................................... $ 3,299 $ -- Purchase business combinations consideration paid with common stock ............................................................... -- 91,818 See accompanying notes to unaudited condensed consolidated financial statements. 4 CORVIS CORPORATION AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (1) Summary of Significant Accounting Policies and Practices (a) Basis of Presentation The unaudited condensed consolidated financial statements included herein for Corvis Corporation and subsidiaries (the "Company") have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. In the opinion of management, the condensed consolidated financial statements included in this report reflect all normal recurring adjustments which the Company considers necessary for the fair presentation of the results of operations for the interim periods. Certain information and footnote disclosures normally included in the annual consolidated financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. However, the Company believes that the disclosures are adequate to understand the information presented. The operating results for interim periods are not necessarily indicative of the operating results for the entire year. These financial statements should be read in conjunction with the Company's December 29, 2001 audited consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K filed on March 21, 2002. (b) Revenue and Costs of Revenue Revenue from product sales is recognized upon execution of a contract and the completion of all delivery obligations provided that there are no uncertainties regarding customer acceptance and collectibility is deemed probable. If uncertainties exist, revenue is recognized when such uncertainties are resolved. Revenue from installation services is recognized as the services are performed unless the terms of the supply contract combine product acceptance with installation, in which case revenues for installation services are recognized when the terms of acceptance are satisfied and installation is completed. Revenues from installation service fixed price contracts are recognized on the percentage-of-completion method, measured by the percentage of costs incurred to date compared to estimated total costs for each contract. Amounts received in excess of revenue recognized are included as deferred revenue in the accompanying condensed consolidated balance sheets. Revenue from annual maintenance agreements is recognized on a straight-line basis over the service period. Costs of revenue include the costs of manufacturing the Company's products and other costs associated with warranty and other contractual obligations, inventory obsolescence costs and overhead related to the Company's manufacturing, engineering, finishing and installation. Warranty reserves are determined based upon actual warranty cost experience, estimates of component failure rates and management's industry experience. 5 CORVIS CORPORATION AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (c) Uses of Estimates The preparation of consolidated 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, the disclosure of contingent assets and liabilities at the date of the consolidated financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. (2) Inventory Inventories are comprised of the following: December September 29, 28, 2001 2002 --------- --------- Raw materials ............................................................... $ 197,549 $ 197,931 Work-in-process ............................................................. 17,037 5,913 Finished goods .............................................................. 52,268 40,063 Less: reserve for excess inventory and obsolescence ........................ (170,428) (169,435) --------- --------- Inventory, net ..................................................... $ 96,426 $ 74,472 ========= ========= (3) Inventory Write-downs, Restructuring and Other Charges During 2001 and 2002, unfavorable economic conditions resulted in reduced capital expenditures by telecommunications service providers causing a decline in the demand for the Company's products. In response to these conditions, in the second, third and fourth quarters of 2001, the Company implemented restructuring plans designed to decrease the Company's operating expenses and to align resources for long-term growth opportunities. These plans included the closure of the Company's Canadian operations. Additionally, the Company evaluated the recoverability of the carrying value of its inventory and long-lived assets in light of the economic environment, the delay of customer network build-outs and projected sales. As a result, the Company recorded charges of approximately $1.0 billion in the year ended December 29, 2001. These charges were comprised of $216.5 million in cost of revenue charges associated with inventory write downs; $77.7 million associated with consolidation of excess facilities, write-downs of idle equipment and workforce reductions; $711.5 million associated with the write-down of goodwill generated in the acquisition of Algety Telecom S.A.; and $12.3 million associated with permanent impairment charges on strategic equity investments carried at cost. During the nine months ended September 28, 2002, the Company continued to develop and implement restructuring plans designed to further align resources for long-term growth opportunities. 6 CORVIS CORPORATION AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Restructuring efforts included the completion of a multi-year manufacturing outsourcing agreement with Celestica, a world leader in electronics manufacturing services, in an effort to improve overall manufacturing flexibility and reduce costs. Under the agreement, the Company will transition all of its manufacturing capabilities to Celestica with the exception of final assembly, system integration and testing capabilities. The full transition of affected manufacturing capabilities is expected to be complete in the second quarter of 2003. In September 2002, the Company completed plans for the reorganization of its French subsidiary, Corvis Algety. The reorganization will result in the elimination of jobs as well as the consolidation of facilities and equipment. These actions will result in staff reductions totaling approximately 165 employees or 80 percent of the local workforce over the next six months. In light of these activities as well as the continued contraction within the telecommunications sector, the Company continued to evaluate the carrying value of its inventory and other assets. These events and analysis have resulted in the following inventory write-downs, restructuring, impairment and other special charges: 7 CORVIS CORPORATION AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Interest Income and Cost of Revenue Restructuring Other Charges Other --------------- --------------------------------------------------- ----------- Special Charges, Inventory Write- downs, Contract Total Losses and Restructuring Impairment Purchase Workforce Facility Asset and Other of Commitments Reduction Consolidation Impairments Charges Investments Total ---------------- ----------- ------------- ----------- ------------- ------------- --------- (In thousands) Restructuring liability as of December 29, 2001 ......... $ 15,313 $ 1,146 $ 7,591 -- $ 8,737 -- $ 24,050 Quarter ended March 30, 2002: Restructuring and other charges ................ 4,307 2,599 -- -- 2,599 -- 6,906 Non-cash charges ............. (4,307) (775) -- -- (775) -- (5,082) Cash payments ................ (5,002) (2,034) (151) -- (2,185) -- (7,187) Quarter ended June 29, 2002: Restructuring and other charges ................ 6,895 4,232 500 -- 4,732 4,771 16,398 Non-cash charges ............. (6,895) (1,847) -- -- (1,847) (4,771) (13,513) Cash payments ................ (2,396) (1,394) (176) -- (1,570) -- (3,966) Accretion of interest ........ -- -- 127 -- 127 -- 127 Adjustments of prior estimates .................... (5,155) -- (2,980) -- (2,980) -- (8,135) Quarter ended September 28, 2002: Restructuring and other charges ................ 24,278 12,516 -- 18,832 31,348 -- 55,626 Non-cash charges ............. (23,841) -- -- (18,832) (18,832) -- (42,673) Cash payments ................ (908) (1,576) (388) -- (1,964) -- (2,872) Accretion of interest ........ -- -- (81) -- (81) -- (81) Effect of international exchange rates ........................ 132 -- -- -- -- -- 132 Adjustments of prior estimates .................... -- -- (34) -- (34) -- (34) -------- -------- -------- -------- -------- -------- -------- Restructuring liability as of September 28, 2002 ........ $ 2,421 $ 12,867 $ 4,408 -- $ 17,275 -- $ 19,696 ======== ======== ======== ======== ======== ======== ======== (4) Basic and Diluted Net Loss Per Share Basic and diluted net loss per share are computed as follows (in thousands, except per share data): 8 CORVIS CORPORATION AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Three Months Ended ---------------------------- September 29, September 28, 2001 2002 ------------ ------------ Net loss .......................................................................$ (80,626) $ (127,398) Basic and diluted weighted average common shares ............................... 352,335 410,323 Basic and diluted net loss per common share ....................................$ (0.23) $ (0.31) Nine Months Ended ---------------------------- September 29, September 28, 2001 2002 ------------ ------------ Net loss .......................................................................$(1,003,287) $ (317,545) Basic and diluted weighted average common shares ............................... 349,490 385,643 Basic and diluted net loss per common share ....................................$ (2.87) $ (0.82) Options and warrants outstanding as of September 28, 2002 to purchase 52.3 million and 7.6 million shares of common stock, respectively, and 1.1 million unvested shares acquired through the exercise of options were not included in the computation of diluted loss per share for the three and nine months period ended September 28, 2002 as their inclusion would be anti-dilutive. Options and warrants outstanding as of September 29, 2001 to purchase 59.2 million and 7.6 million shares of common stock, respectively, and 6.4 million unvested shares acquired through the exercise of options were not included in the computation of diluted loss per share for the three and nine months ended September 29, 2001 as their inclusion would be anti-dilutive. (5) Dorsal Acquisition On May 16, 2002, the Company completed its acquisition of Dorsal Networks, Inc., a privately held provider of next-generation transoceanic and regional undersea optical network solutions for 41.8 million shares of common stock valued at approximately $91.8 million. The acquisition was accounted for under the "purchase" method of accounting. Under the purchase method, the purchase price of Dorsal was allocated to identifiable assets and liabilities acquired from Dorsal, with the excess being treated as goodwill. The following table summarizes the estimated fair value of the assets acquired and liabilities assumed at the date of acquisition which is based on an independent valuation. 9 CORVIS CORPORATION AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS Current assets ..................................... $ 6,632 Property and equipment ............................. 5,506 Other assets ....................................... 577 Patents ............................................ 30,799 In-process research and development ................ 34,580 Goodwill ........................................... 19,089 ----------- Total assets acquired ........................ 97,183 ----------- Current liabilities ................................ (5,365) ----------- Total liabilities assumed .................... (5,365) ----------- Net assets acquired .......................... $ 91,818 =========== Acquired patents will be amortized over an estimated life of five years. Goodwill will have an indefinite life, but will be subject to periodic impairment tests. In process research and development was expensed during the nine months ended September 28, 2002. Dr. David R. Huber, the Company's Chairman and Chief Executive Officer, owned, directly or indirectly, approximately 31 percent of the outstanding stock of Dorsal. The following unaudited pro forma data summarizes the results of operations for the period indicated as if the Dorsal acquisition had been completed as of the beginning of each period presented. The unaudited pro forma data gives effect to actual operating results prior to the acquisition, adjusted to include the pro forma effect of amortization of intangibles. These pro forma amounts do not purport to be indicative of the results that would have actually been obtained if the acquisition occurred as of the beginning of the periods presented or that may be obtained in the future. Three Months Ended ------------------------------- September 29, September 28, 2001 2002 -------------- ------------- Revenues .................................... $ 24,157 $ 1,353 Net Loss .................................... (99,443) (127,398) Basic and diluted net loss per share ........ $ (0.28) $ (0.31) Nine Months Ended ------------------------------- September 29, September 28, 2001 2002 -------------- ------------- Revenues .................................... $ 173,203 $ 13,092 Net Loss .................................... (1,059,294) (329,111) Basic and diluted net loss per share ........ $ (3.03) $ (0.85) 10 CORVIS CORPORATION AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Amounts in thousands, except per share data) (6) Legal Matters In July 2000, Ciena Corporation ("Ciena") informed the Company of its belief that there is significant correspondence between products that the Company offers and several U.S. patents held by Ciena relating to optical networking systems and related dense wavelength division multiplexing communications systems technologies. On July 19, 2000, Ciena filed a lawsuit in the United States District Court for the District of Delaware alleging that the Company is willfully infringing three of Ciena's patents. Ciena is seeking injunctive relief, monetary damages including treble damages, as well as costs of the lawsuit, including attorneys' fees. On September 8, 2000, the Company filed an answer to the complaint, as well as counter-claims alleging, among other things, invalidity and/or unenforceability of the three patents in question. On March 5, 2001, a motion was granted, allowing Ciena to amend its complaint to include allegations that the Company is willfully infringing two additional patents. Although a trial date has not been set, we believe that a trial will commence in the first quarter of 2003. Based on the status of the litigation, the Company cannot reasonably predict the likelihood of any potential outcome. Between May 7, 2001 and June 15, 2001, nine class action lawsuits were filed in the United States District Court for the Southern District of New York relating to the Company's IPO on behalf of all persons who purchased Company stock between July 28, 2000 and the filing of the complaints. Each of the complaints names as defendants: the Company, its directors and officers who signed the registration statement in connection with the Company's IPO, and certain of the underwriters that participated in the Company's IPO. Our directors and officers have since been dismissed from the case, without prejudice. The complaints allege that the registration statement and prospectus relating to the Company's IPO contained material misrepresentations and/or omissions in that those documents did not disclose (1) that certain of the underwriters had solicited and received undisclosed fees and commissions and other economic benefits from some investors in connection with the distribution of the Company's common stock in the IPO and (2) that certain of the underwriters had entered into arrangements with some investors that were designed to distort and/or inflate the market price for the Company's common stock in the aftermarket following the IPO. The complaints ask the court to award to members of the class the right to rescind their purchases of Corvis common stock (or to be awarded rescissory damages if the class member has sold its Corvis stock) and prejudgment and post-judgment interest, reasonable attorneys' and experts witness' fees and other costs. By order dated October 12, 2001, the court appointed an executive committee of six plaintiffs' law firms to coordinate their claims and function as lead counsel. Lead plaintiffs have been appointed in almost all of the IPO allocation actions including the Corvis action. On October 17, 2001, a group of underwriter defendants moved for the judge's recusal. The judge denied that application. On December 13, 2001, the moving underwriter defendants filed a petition for writ of mandamus seeking the disqualification of the judge in the United States Court of Appeals for the Second Circuit. On April 1, 2002, the Second Circuit denied the moving underwriter defendants' application for a writ of mandamus seeking the judge's recusal from this 11 CORVIS CORPORATION AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Amounts in thousands, except per share data) action. On April 19, 2002, plaintiffs filed amended complaints in each of the IPO allocation actions, including the Corvis action. On May 23, 2002, a conference was held at which the court set a briefing schedule for the filing of motions to dismiss the amended complaints. On July 1, 2002, the underwriter defendants filed their motion to dismiss the amended complaints. On July 15, 2002, the issuer defendants filed their motion to dismiss the amended complaints. The briefing on the motions to dismiss has recently been completed, and the judge heard oral arguments on the motions on November 1, 2002. No discovery has occurred. It is the position of Company management that, at this time, it is not possible to estimate the amount of a probable loss, if any, that might result from this matter. Accordingly, no provision for this matter has been made in the Company's consolidated financial statements. (7) Concentrations The Company has relied on four customers for all of its revenue: Wiltel Communications Group, Inc. (formally Williams Communications, LLC), Broadwing Communications Services, Inc., Telefonica de Espana S.A.U. and France Telecom. The Company expects that a significant portion of its future revenue will continue to be generated by a limited number of customers. The loss of any one of these customers or any substantial reduction in orders by any one of these customers could materially adversely affect the Company's financial condition or operating results. (8) Recent Accounting Pronouncements The Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards No. 143 (SFAS 143), "Accounting for Asset Retirement Obligations," in August 2001. SFAS 143 requires companies to record the fair value of a liability for an asset retirement obligation in the period in which it is incurred, and capitalize the cost by increasing the carrying amount of the related long-lived asset. The Company is required to adopt SFAS 143 on January 1, 2003. The adoption of this standard will not have a material effect on the company's results of operations. The FASB issued SFAS 145, "Rescission of FASB Statements No. 4, 44 and 64, Amendment of FASB Statement No. 13, and Technical Corrections" in April 2002. SFAS 145 clarifies guidance related to the reporting of gains and losses from extinguishment of debt and resolves inconsistencies related to the required accounting treatment of certain lease modifications. The provisions of this statement relating to the extinguishment of debt are effective for financial statements issued for fiscal years beginning after May 15, 2002. The provisions of this statement relating to lease modifications are effective for transactions occurring after May 15, 2002. The Company does not believe this standard will have a material impact on its results of operations. 12 CORVIS CORPORATION AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Amounts in thousands, except per share data) The FASB issued SFAS 146, "Accounting for Costs Associated with Exit or Disposal Activities" in June 2002. SFAS 146 nullifies previous guidance on this issue and requires a liability for a cost associated with an exit or disposal activity to be recognized and measured at its fair value in the period in which the liability is incurred. The Company is required to adopt the provisions of this statement for exit or disposal activities initiated after December 31, 2002. The Company is assessing the impact that the adoption of this standard will have on the Company's results of operations. In July 2001, the FASB issued SFAS No. 141, "Business Combinations", and SFAS No. 142, "Goodwill and Other Intangible Assets." SFAS No. 141 addresses the accounting for acquisitions of businesses and is effective for acquisitions occurring on or after July 1, 2001. SFAS No. 142 addresses the method of identifying and measuring goodwill and other intangible assets acquired in a business combination, eliminates further amortization of goodwill, provides for classification of workforce intangibles as goodwill and requires periodic evaluations of impairment of goodwill balances. SFAS No. 141 and 142 are effective January 1, 2002, except for acquisitions occurring on or after July 1, 2001, for which the provisions of SFAS No. 141 and 142 are applicable. Accordingly, through December 29, 2001, the Company continued to amortize goodwill. Had the amortization provisions of SFAS No. 142 been applied as of January 1, 2001, for all of the Company's acquisitions, the Company's income (loss) and earnings (loss) per share would have been as follows: Three Months Ended ----------------------------- September 29, September 28, 2001 2002 ------------- -------------- Net loss, as reported .......................... $ (80,626) $ (127,398) Goodwill amortization .......................... 8,982 -- Workforce in place amortization ................ 110 -- ------------- -------------- Net loss, as adjusted .......................... $ 71,534 $ 127,398 ============= ============== Basic and diluted per share data: Net loss per common share, as reported ....... $ (0.23) $ (0.31) Goodwill and workforce in place amortization per common share ........................... 0.03 -- ------------- -------------- Net loss per common share, as adjusted ....... $ (0.20) $ (0.31) ============= ============== Nine Months Ended ------------------------------ September 29, September 28, 2001 2002 -------------- ------------- Net loss, as reported .......................... $ (1,003,287) $ (317,545) Goodwill amortization .......................... 104,790 -- Workforce in place amortization ................ 334 -- ------------- ------------ Net loss, as adjusted .......................... $ (898,163) $ (317,545) ============= ============ 13 CORVIS CORPORATION AND SUBSIDIARIES NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Amounts in thousands, except per share data) Nine Months Ended -------------------------------------- Basic and diluted per share data: September 29, 2001 September 28, 2002 Net loss per common share, as reported ... $ (2.87) $ (0.82) Goodwill and workforce in place amortization per common share ......... 0.30 -- ----------------- ------------------ Net loss per common share, as adjusted ... $ (2.57) $ (0.82) ================= ================== As of January 1, 2002, the Company reclassified approximately $0.7 million of intangible assets associated with an acquired employee workforce from intangible assets to goodwill, which in accordance with SFAS No. 142, are no longer separately identifiable from goodwill. As of September 28, 2002, the Company had approximately $87.9 million of intangible assets ($38.6 million net of accumulated amortization) related to patents and intellectual property, which are being amortized straight-line over a period of three years. The Company incurred amortization expense of $12.8 million during the nine months ended September 28, 2002 and anticipates amortization expense to be the following for the next five years: Estimated Amortization Expense: For the year ended 12/28/02: $18,492 For the year ended 12/27/03: $17,771 For the year ended 12/25/04: $10,966 For the year ended 12/24/05: $ 4,141 For the year ended 12/23/06: $ - In August 2001, the Financial Accounting Standard Board issued SFAS No. 144, "Accounting for the Impairment or Disposal of Long-Lived Assets". This statement addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This statement supersedes FASB Statement No. 121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to be Disposed of", and the accounting and reporting provisions of APB Opinion No. 30, "Reporting the Results of Operations, Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and infrequently Occurring Events and Transactions", for the disposal of segments of a business (as previously defined in that opinion). The adoption of SFAS No. 144 did not have any effect on the Company's results of operations. 14 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations You should read the following discussion and analysis along with our unaudited condensed consolidated financial statements and the notes to those statements included elsewhere in this report and in conjunction with our Form 10-K for the year ended December 29, 2001 filed on March 21, 2002 with the Securities and Exchange Commission. Overview We design, manufacture and sell high performance all-optical and electrical/optical terrestrial and undersea communications systems that we believe accelerate carrier revenue opportunities and lower the overall cost of network ownership for carriers. Our optical products have enabled a fundamental shift in network design and efficiency by allowing for the transmission, switching and management of communications traffic entirely in the optical domain. By deploying our products, carriers eliminate the need for expensive and bandwidth limiting electrical regeneration and switching equipment, significantly reducing costs, increasing network capacity and allowing them to provide new services more quickly and efficiently. Our products also open new market opportunities for carriers by enabling a flexible, in-service migration path from existing point-to-point and ring electrical/optical networks to all-optical mesh networks. Customers We currently have six customers, including Broadwing Communications Services, Inc., Wiltel Communications Group, Inc. (formally Williams Communications, LLC), Qwest Communications Corporation, Telefonica de Espana S.A.U., France Telecom and the U.S. Federal Government. Broadwing has agreed to purchase at least $200 million of our products and services as part of a multi-year purchase agreement. Since successfully completing field trials in July 2000, Broadwing has deployed a wide range of our optically optimized networking products, including the all-optical switch, to create a national all-optical network that has been in service for over a year. Sales to Broadwing continue as part of network expansions and maintenance. Cumulative sales to Broadwing through September 28, 2002 totaled $191.6 million. In 2001, Wiltel accepted a field trial system and agreed to purchase up to $300 million of our products and services as part of a multi-year purchase agreement. Firm commitments totaling approximately $85.0 million must be purchased prior to December 31, 2003. Wiltel has deployed our switching and transport equipment to create a national all-optical network, which is currently in service carrying commercial traffic. Cumulative sales to Wiltel through September 28, 2002 total $77.5 million. On April 22, 2002, we reached an agreement with Qwest Communications Corporation modifying the terms of our previous purchase agreement. Under the terms of the new agreement, Qwest agreed to purchase up to $150 million of our products and services over a multi-year period. Firm commitments totaling $7.0 million must be purchased in 2002 and $5.0 million must be purchased in 2003 subject to certain acceptance criteria. In addition, we have agreed 15 with Qwest to enter into two field trials of Corvis ON transport and switching equipment as well as our Corvis Optical Convergence Switch (OCS). The field trials began in the third quarter of 2002. During the first quarter of 2002, we completed the first sales of our XF repeaterless link product to Telefonica de Espana, which was deployed between the island of Mallorca and Telefonica's backbone network in Spain. In April 2002, we sold a XF repeaterless link to France Telecom to upgrade its link between the European mainland and the island of Corsica. The relationships with Telefonica and France Telecom are in early stages and the agreements do not include significant purchase commitment levels, however, we hope to develop these arrangements into long-term business relationships. In the third quarter of 2002, we created a wholly owned subsidiary, Corvis Government Solutions, Inc. (CGSI), to provide optical networking solutions and services to the Federal marketplace. During the third quarter, CGSI secured its first contract and purchase order from the U.S. Federal Government. We have also entered into lab trials and discussions regarding laboratory and field trials with other carriers for our ON, OCS and transoceanic subsea products. Upon successful completion of these field trials, we hope to enter into agreements for commercial deployment with new customers. Starting in 2001 and continuing in 2002, conditions within the general economy and the telecommunications sector have resulted in reduced capital expenditures by carriers and a reduced demand for telecommunications networking systems. As a response to these conditions, we implemented restructuring plans designed to decrease our business expenses and to align resources for long-term growth opportunities. Additionally, we evaluated the carrying value of our inventory and long-term assets. As a result of these steps, we recorded charges totaling approximately $1.0 billion in the second, third and fourth quarters of 2001. These charges were comprised of $216.5 million in cost of revenue charges associated with inventory write-downs and losses on open purchase commitment cancellations; $24.5 million associated with workforce reductions; $53.2 million associated with consolidation of excess facilities and write-downs of idle equipment; $711.5 million associated with the write-down of goodwill; and $12.3 million associated with permanent impairment charges on strategic equity investments. During the nine months ended September 28, 2002, we continued to develop and implement additional restructuring plans designed to further align resources for long-term growth opportunities. Restructuring efforts included the execution of a multi-year manufacturing outsourcing agreement with Celestica, a world leader in electronics manufacturing services in an effort to improve overall manufacturing flexibility and reduce costs. Under the agreement, we will transition all of our manufacturing capabilities to Celestica with the exception of final assembly, system integration and test capabilities. The full transition of affected manufacturing capabilities is expected to be complete in the second quarter of 2003. 16 In September 2002, we completed plans for the reorganization of our French subsidiary, Corvis Algety. The reorganization will result in the elimination of jobs as well as the consolidation of facilities and equipment. These actions will result in total staff reductions of approximately 165 employees or 80 percent of the local workforce over the next six months. In light of these activities as well as continued contraction within the telecommunications sector, we continued to evaluate the carrying value of our inventory and other assets. These events and analysis have resulted in the following inventory write-downs, restructuring, impairment and other special charges: Interest Income and Cost of Revenue Restructuring and Other Charges Other ------------------ --------------------------------------------------------- -------------- Special Charges, Inventory Write-downs, Total Contract Losses Restructuring Impairment and Purchase Workforce Facility Assets and Other of Commitments Reduction Consolidation Impairments Charges Investments Total ------------------ ----------- --------------- ------------- ------------- -------------- -------- (In thousands) Restructuring liability as of December 29, 2001 ..... $15,313 $1,146 $7,591 -- $8,737 -- $24,050 Quarter ended March 30, 2002: -- Restructuring and other charges ........... 4,307 2,599 -- -- 2,599 -- 6,906 Non-cash charges ......... (4,307) (775) -- -- (775) -- (5,082) Cash payments ............ (5,002) (2,034) (151) -- (2,185) -- (7,187) Quarter ended June 29, 2002: Restructuring and other charges ........... 6,895 4,232 500 -- 4,732 4,771 16,398 Non-cash charges ......... (6,895) (1,847) -- -- (1,847) (4,771) (13,513) Cash payments ............ (2,396) (1,394) (176) -- (1,570) -- (3,966) Accretion of interest .... -- -- 127 -- 127 -- 127 Adjustments of prior estimates ................ (5,155) -- (2,980) -- (2,980) -- (8,135) Quarter ended September 28, 2002: Restructuring and other charges ........... 24,278 12,516 -- 18,832 31,348 -- 55,626 Non-cash charges ......... (23,841) -- -- (18,832) (18,832) -- (42,673) Cash payments ............ (908) (1,576) (388) -- (1,964) -- (2,872) Accretion of interest .... -- -- (81) -- (81) -- (81) Effect of international exchange rates ........... 132 -- -- -- -- -- 132 Adjustments of prior estimates ................ -- -- (34) -- (34) -- (34) --------- -------- ------- --------- -------- -------- ------- Restructuring liability as of September 28, 2002 .... $ 2,421 $ 12,867 $ 4,408 -- $ 17,275 -- $19,696 ========= ======== ======= ========= ======== ======== ======= 17 We continue to monitor our financial position and will make strategic decisions as necessary to position us for long-term success, which may result in additional restructuring charges. These initiatives could lead to further reductions in our facility and fixed asset needs, resulting in associated asset impairment and write-down charges. Critical Accounting Policies and Estimates We have identified the following critical accounting policies that affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. The preparation of our financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and judgments that affect our reported amounts of assets and liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to asset impairment, revenue recognition, product warranty liabilities, allowance for doubtful accounts, and contingencies and litigation. We stated these accounting policies in the notes to our 2001 annual consolidated financial statements and at relevant sections in this discussion and analysis. These estimates are based on the information that is currently available to us and on various other assumptions that we believe to be reasonable under the circumstances. Actual results could vary from those estimates under different assumptions or conditions. We believe that the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements. Revenue. Revenue from product sales is recognized upon execution of a contract and the completion of all delivery obligations provided that there are no uncertainties regarding customer acceptance and collectibility is deemed probable. If uncertainties exist, revenue is recognized when such uncertainties are resolved. Customer contracts generally include extensive lab and field trial testing and some include other acceptance criteria. Our products can be installed by our customers, third party service providers or by us. Revenue from installation services is recognized as the services are performed unless the terms of the supply contract combine product acceptance with installation, in which case revenues for installation services are recognized when the terms of acceptance are satisfied and installation is completed. To the extent customer contracts include both product sales and installation services, revenues are recognized based on their respective fair values. Revenues from installation service fixed price contracts are recognized on the percentage-of-completion method, measured by the percentage of costs incurred to date compared to estimated total costs for each installation contract. Amounts received in excess of revenue recognized are included as deferred revenue in our condensed consolidated balance sheet. Revenue from annual maintenance agreements is recognized on a straight-line basis over the service period. Costs of Revenue. Costs of revenue include the costs of manufacturing our products and other costs associated with warranty and other contractual obligations, inventory obsolescence costs and overhead related to our manufacturing, engineering, finishing and installation operations. Warranty reserves are determined based upon actual warranty cost experience, estimates of component failure rates and management's industry experience. Inventory 18 obsolescence costs are estimated using certain assumptions, including projected sales and sales mix. Actual results may differ from those estimates. We continually monitor component failures, technical changes, and levels of on-hand inventory and adjust our estimates accordingly. If, however, actual results vary significantly from our estimates, we will adjust the assumptions utilized in our methodologies and reduce or provide for additional accruals as appropriate. Allowance for Bad Debt. To date, we have relied on four customers for all of our revenues. We expect that a significant portion of our future revenue will continue to be generated by a limited number of customers. We monitor the financial conditions of these customers closely and have concluded that no allowance for bad debt was appropriate as of September 28, 2002. Restructuring and Other Charges. Reflecting continued unfavorable economic conditions and continued lack of expected customer wins and product sales, our Board of Directors approved plans for the reduction of operations including the consolidation of facilities, reduction of employees and the outsourcing of a majority of our manufacturing capabilities. In addition, we evaluated the recoverability of the carrying value of our inventory and long-lived assets. As a result, we recorded charges associated with estimated excess inventory and open purchase commitments based on projected sales volumes, sales mix and estimated selling prices. Facility consolidation costs are based on assumed exit costs and timetables. Asset impairment charges are based on estimated salvage values and recoverability estimates. Goodwill impairment charges are based on estimated discounted future cash flows. If actual results differ significantly from our estimates and assumptions, we will adjust our reserves and allowances accordingly. Goodwill and Other Intangible Assets. We have recorded goodwill and intangibles resulting from our acquisitions. Through December 29, 2001, goodwill and intangibles have been amortized on a straight-line basis over their respective lives of between 3 and 5 years. Upon the adoption of SFAS No. 142 on December 30, 2001, we ceased amortizing goodwill and will perform an annual impairment analysis to assess the recoverability of the goodwill, in accordance with the provisions of SFAS No. 142. Our annual impairment analysis will take place in the fourth quarter. If we are required to record an impairment charge in the future, it would have an adverse impact on our results of operations. Litigation. In July 2000, Ciena Corporation ("Ciena") informed us of its belief that there is significant correspondence between products that we offer and several U.S. patents held by Ciena relating to optical networking systems and related dense wavelength division multiplexing communications systems technologies. On July 19, 2000, Ciena filed a lawsuit in the United States District Court for the District of Delaware alleging that we are willfully infringing three of Ciena's patents. Ciena is seeking injunctive relief, monetary damages including treble damages, as well as costs of the lawsuit, including attorneys' fees. On September 8, 2000, we filed an answer to the complaint, as well as counter-claims alleging, among other things, invalidity and/or unenforceability of the three patents in question. On March 5, 2001, a motion was granted, allowing Ciena to amend its complaint to include allegations that we are willfully infringing two additional patents. Although a trial date has not been set, we believe that a trial will commence in the first quarter of 2003. Based on the status of the litigation, we cannot reasonably predict the likelihood of any potential outcome. 19 Between May 7, 2001 and June 15, 2001, nine class action lawsuits were filed in the United States District Court for the Southern District of New York relating to our initial public offering on behalf of all persons who purchased our stock between July 28, 2000 and the filing of the complaints. Each of the complaints names as defendants: Corvis, our directors and officers who signed the registration statement in connection with our initial public offering, and certain of the underwriters that participated in our initial public offering. The complaints allege that the registration statement and prospectus relating to our initial public offering contained material misrepresentations and/or omissions in that those documents did not disclose (1) that certain of the underwriters had solicited and received undisclosed fees and commissions and other economic benefits from some investors in connection with the distribution of our common stock in the initial public offering and (2) that certain of the underwriters had entered into arrangements with some investors that were designed to distort and/or inflate the market price for our common stock in the aftermarket following the initial public offering. The complaints ask the court to award to members of the class the right to rescind their purchases of Corvis common stock (or to be awarded rescissory damages if the class member has sold its Corvis stock) and prejudgment and post-judgment interest, reasonable attorneys' and experts witness' fees and other costs. By order October 12, 2001, the court appointed an executive committee of six plaintiffs' law firms to coordinate their claims and function as lead counsel. Lead plaintiffs have been appointed in almost all of the IPO allocation actions, including the Corvis action. On October 17, 2001, a group of underwriter defendants moved for the judge's recusal. The judge denied that application. On December 13, 2001, the moving underwriter defendants filed a petition for writ of mandamus seeking the disqualification of the judge in the United States Court of Appeals for the Second Circuit. On April 1, 2002, the Second Circuit denied the moving underwriter defendants' application for a writ of mandamus seeking the judge's recusal from this action. On April 19, 2002, plaintiffs filed amended complaints in each of the IPO allocation actions, including the Corvis action. On May 23, 2002, a conference was held at which the court set a briefing schedule for the filing of motions to dismiss the amended complaints. On July 1, 2002, the underwriter defendants filed their motion to dismiss the amended complaints. On July 15, 2002, the issuer defendants filed their motion to dismiss the amended complaints. The briefing on the motions to dismiss has recently been completed, and the judge heard oral arguments on the motions on November 1, 2002. No discovery has occurred. Based on the status of the litigation, we cannot reasonably predict the likelihood of any potential outcome. We continue to monitor the status of the litigation, however we can give no assurances that an unfavorable outcome will not result in future charges. Results of Operations Three months ended September 28, 2002 compared to three months ended September 29, 2001 Revenue. Revenue decreased to $1.35 million for the three months ended September 28, 2002 from $24.2 million for the three months ended September 29, 2001. This decrease in revenue is primarily due to a reduction in capital spending by telecommunications carriers resulting in a decline in demand for telecommunications equipment, including our products. Revenue for the three months ended September 28, 2002 was attributable to two customers. 20 Service revenues, including maintenance, training and support totaled approximately $0.9 million. Gross Profit (loss). Costs of revenue consists of component costs, direct compensation costs, warranty and other contractual obligations, inventory obsolescence costs and overhead related to our manufacturing and engineering, finishing and installation operations. In addition, cost of revenue includes charges associated with our restructuring plans and excess inventories. Gross profit (loss) decreased to $(23.7) million for the three months ended September 28, 2002 from $8.6 million for the three months ended September 29, 2001. Negative gross margins are attributable to inventory write-downs of $24.3 million recorded in the three months ended September 28, 2002. Excluding inventory write-downs and other charges, gross profit and gross margin were $0.6 million and 44% for the three months ended September 28, 2002 and $8.6 million and 36% for the three months ended September 29, 2001. The increase in gross margin is primarily due to an increase in the relative proportion of service revenue compared to product revenues as well as the recognition of certain product revenues which had been deferred pending final acceptance. We expect that gross margin, excluding inventory write-downs and other charges, will decrease in the coming quarters as a result of an increase in the relative proportion of product revenues. Research and Development, Excluding Equity-Based Expense. Research and development expense, excluding equity-based expense consists primarily of salaries and related personnel costs, test and prototype expenses related to the design of our hardware and software products, laboratory costs and facilities costs. All costs related to product development, both hardware and software, are recorded as expenses in the period in which they are incurred. Due to the timing and nature of the expenses associated with research and development, significant quarterly fluctuations may result. We believe that research and development is critical to achieving current and future strategic product objectives. Research and development expenses, excluding equity-based expense decreased to $33.0 million for the three months ended September 28, 2002 from $34.8 million for the three months ended September 29, 2001. The decrease in expenses was primarily due to lower prototype and lab materials expense, offset in part by higher labor costs associated with the Dorsal acquisition. Sales and Marketing, Excluding Equity-Based Expense. Sales and marketing expense, excluding equity-based expense, consists primarily of salaries and related personnel costs, laboratory trial systems provided to customers, trade shows, other marketing programs and travel expenses. Sales and marketing expense, excluding equity-based expense, decreased to $11.0 million for the three months ended September 28, 2002 from $12.7 million for the three months ended September 29, 2001. The decrease in expenses was primarily attributable to the effects of cost saving initiatives including staff reductions and the curtailment of certain discretionary spending. General and Administrative, Excluding Equity-Based Expense. General and administrative expense, excluding equity-based expense, consists primarily of salaries and related personnel costs, information systems support, recruitment expenses and facility demands 21 associated with establishing the proper infrastructure to support our organization. This infrastructure consists of executive, financial, legal, information systems and other administrative responsibilities. General and administrative expenses, excluding equity-based expense, decreased to $7.2 million for the three months ended September 28, 2002 from $7.7 million for the three months ended September 29, 2001. The decrease in expenses was primarily attributable to staff reductions and professional service fees. Equity-based Expense. Equity-based expense consists primarily of charges associated with employee options granted at below fair market value prior to our initial public offering. Equity-based expense related to research and development, sales and marketing and general and administrative functions for the three months ended September 28, 2002 decreased to $17.7 million from $28.2 million for the three months ended September 29, 2001. The decrease in equity-based expense resulted from a decrease in employee headcount. Amortization of Intangible Assets. Amortization of intangible assets relates to the amortization of certain intangible assets with finite lives. As a result of the issuance of SFAS No. 142, we no longer record amortization of goodwill, rather goodwill will be tested at least annually for impairment. There may be more volatility in reported income (loss) than previous standards because impairment losses are likely to occur irregularly and in varying amounts. Amortization of intangible assets expenses decreased to $5.7 million for the three months ended September 28, 2002 from $12.0 million for the three months ended September 29, 2001. The decrease was primarily attributable to the discontinuation of amortization of goodwill resulting from the acquisition of Algety Telecom S.A. that was being amortized over five years. Interest Income, Net. Interest income, net of interest expense, decreased to $2.1 million for the three months ended September 28, 2002 from $6.3 million of net interest income for the three months ended September 29, 2001. The decrease was primarily attributed to lower average invested cash balances and lower average returns on investments. Nine months ended September 28, 2002 compared to nine months ended September 29, 2001 Revenue. Revenue decreased to $13.1 million for the nine months ended September 28, 2002 from $173.2 million for the nine months ended September 29, 2001. This decrease in revenue is due to a reduction in capital spending by telecommunications carriers resulting in a sharp decline in demand for telecommunications equipment, including for our products. Revenue for the nine months ended September 28, 2002 was attributable to four customers. Service revenues, including maintenance, training and support totaled $4.3 million. Gross Profit (loss). Costs of revenue consists of component costs, direct compensation costs, warranty and other contractual obligations, inventory obsolescence costs and overhead related to our manufacturing and engineering, finishing and installation operations. In addition, cost of revenue includes charges associated with our restructuring plans and excess inventories. 22 Gross loss decreased to $(26.7) million for the nine months ended September 28, 2002 from $(35.0) million for the nine months ended September 29, 2001. Negative gross margins are primarily attributable to inventory write-downs of $30.3 million in the nine months ended September 28, 2002 and $99.2 million recorded in the nine months ended September 29, 2001. Excluding inventory write-downs and other charges, gross profit and gross margin were $3.7 million or 28% in the nine months ended September 28, 2002 and $64.2 million or 37% in the nine months ended September 29, 2001. Due to current competitive and economic pressures, we expect that gross margin, excluding inventory write-downs and other charges, may continue to decrease in the coming quarters. Research and Development, Excluding Equity-Based Expense. Research and development expense, excluding equity-based expense, consists primarily of salaries and related personnel costs, test and prototype expenses related to the design of our hardware and software products, laboratory costs and facilities costs. All costs related to product development, both hardware and software, are recorded as expenses in the period in which they are incurred. Due to the timing and nature of the expenses associated with research and development, significant quarterly fluctuations may result. We believe that research and development is critical to achieving current and future strategic product objectives. Research and development expenses, excluding equity-based expense, decreased to $95.1 million for the nine months ended September 28, 2002 from $117.8 million for the nine months ended September 29, 2001. The decrease in expenses was primarily attributable to the reduction in prototype and lab material expenses. Sales and Marketing, Excluding Equity-Based Expense. Sales and marketing expense, excluding equity-based expense, consists primarily of salaries and related personnel costs, laboratory trial systems provided to customers, trade shows, other marketing programs and travel expenses. Sales and marketing expense, excluding equity-based expense, decreased to $36.1 million for the nine months ended September 28, 2002 from $43.2 million for the nine months ended September 29, 2001. The decrease in expenses was primarily attributable to the effects of staff reductions and decreases in professional service fees and transportation expenses. General and Administrative, Excluding Equity-Based Expense. General and administrative expense, excluding equity-based expense consists primarily of salaries and related personnel costs, information systems support, recruitment expenses and facility demands associated with establishing the proper infrastructure to support our organization. This infrastructure consists of executive, financial, legal, information systems and other administrative responsibilities. General and administrative expenses, excluding equity-based expense, decreased to $24.4 million for the nine months ended September 28, 2002 from $27.2 million for the nine months ended September 29, 2001. The decrease in expenses was primarily attributable to the effects of cost saving initiatives including staff reductions, facility consolidations and the curtailment of certain discretionary spending, offset, in part, by increases in professional service fees. 23 Equity-based Expense. Equity-based expense consists primarily of charges associated with employee options granted at below fair market value prior to our initial public offering. Equity-based expense related to research and development, sales and marketing and general and administrative functions for the nine months ended September 28, 2002 decreased to $54.7 million from $79.3 million for the nine months ended September 29, 2001. The decrease in equity-based expense resulted from decreases in employee headcount. Amortization of Intangible Assets. Amortization of intangible assets relates to the amortization of certain intangible assets with finite lives. As a result of the issuance of SFAS No. 142, we no longer record amortization of goodwill on a straight-line basis, rather goodwill will be tested at least annually for impairment. There may be more volatility in reported income (loss) than previous standards because impairment losses are likely to occur irregularly and in varying amounts. Amortization of intangible assets expenses decreased to $12.8 million for the nine months ended September 28, 2002 from $113.9 million for the nine months ended September 29, 2001. The decrease was primarily attributable to the discontinuation of amortization of goodwill resulting from the acquisition of Algety Telecom S.A. that was being amortized over five years. Interest Income, Net. Interest income, net of interest expense, decreased to $2.6 million for the nine months ended September 28, 2002 from $19.8 million of net interest income for the nine months ended September 29, 2001. The decrease was primarily attributable to lower average invested cash balances, lower average returns on investments and the write down of certain strategic investments. Liquidity and Capital Resources Since inception through September 28, 2002 we have financed our operations, capital expenditures and working capital primarily through public and private sales of our capital stock, borrowings under credit and lease facilities and cash generated from product sales. At September 28, 2002, our cash and cash equivalents and short-term investments totaled $548.8 million. Net cash used in operating activities was $97.3 million for the nine months ended September 28, 2002 and $200.9 million for the nine months ended September 29, 2001. Cash used in operating activities for the nine months ended September 28, 2002 was primarily attributable to a net loss of $317.5 million, offset in part by non-cash charges including depreciation and amortization of $38.8 million, equity-based expense of $54.7 million and purchased research and development expense of $34.6 million associated with our acquisition of Dorsal Networks in May 2002 and certain non-cash restructuring charges of $48.7 million. Cash flows from operating activities were further offset by changes in operating assets and liabilities of $43.7 million, principally a change in accounts receivable of $27.7 million. Net cash used in investing activities was $25.2 million for the nine months ended September 28, 2002 and $108.8 million for the nine months ended September 29, 2001. The decrease in net cash used in investing activities for the nine months ended September 28, 2002 24 was primarily attributable to reductions in capital expenditures offset in part with cash acquired through our purchase of Dorsal Networks. Net cash used in financing activities for the nine months ended September 28, 2002 was $4.0 million, primarily attributable to the repayment of principal on notes and capital leases. Net cash provided by financing activities for the nine months ended September 29, 2001 was $1.8 million, primarily attributable to proceeds from the exercise of warrants and employee stock options off-set in part by proceeds from the issuance of common stock. As of September 28, 2002 long-term restricted cash totaled $2.4 million associated with outstanding irrevocable letters of credit relating to lease obligations for various manufacturing and office facilities and other business arrangements. These letters of credit are collateralized by funds in our operating account. Various portions of the letters of credit expire at the end of each respective lease term or agreement term. On October 24, 2002, we announced that our Board of Directors has authorized a share repurchase program under which we can acquire up to $25 million of our common stock in the open market. The purchases will be executed at times and prices considered appropriate by us during the next two years. The share repurchase program may be implemented at such future date as we may determine and may be suspended at any time and from time-to-time without prior notice. The repurchase program will be funded using our existing cash balances and the repurchases shares may be used for corporate purposes in compliance with applicable law. Due to current economic conditions, we have and may be required to sell our product to future customers at lower margins or be required to provide customers with financing which could result in reduced gross margins, extended payment terms or delayed revenue recognition, all of which could have a negative impact on our liquidity, capital resources and results of operations. Our liquidity will also be dependent on our ability to manufacture and sell our products. Changes in the timing and extent of the sale of our products will affect our liquidity, capital resources and results of operations. We currently have a limited number of customers that could provide substantially all of our revenues for the near future and these customers are operating in a troubled economic environment. The loss of any of these customers, any substantial reduction in current or anticipated orders or an inability to attract new customers, could materially adversely affect our liquidity and results of operations. We plan to diversify our customer base by seeking new customers both domestically and internationally. If we experience delays or disruptions in manufacturing output or we are unable to successfully manufacture our products and to develop alternative manufacturing sources in a timely manner, our sales, financial position and results of operations would be adversely affected. We believe that our current cash and cash equivalents, short-term investments and cash generated from product sales will satisfy our expected working capital, capital expenditure and investment requirements through at least the next twelve months. 25 If cash on hand and cash generated from operations is insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or debt securities. To the extent that we raise additional capital through the sale of equity or debt securities, the issuance of such securities could result in dilution to our existing shareholders. If additional funds are raised through the issuance of debt securities, the terms of such debt could impose additional restrictions on our operations. Additional capital, if required, may not be available on acceptable terms, or at all. If we are unable to obtain additional financing, we may be required to reduce the scope of our planned product development and sales and marketing efforts, which could harm our business, financial condition and operating results. Increasingly, as a result of the financial demands of major network deployments, carriers are looking to their suppliers for financing assistance. From time to time, we have and may continue to provide or commit to extend credit or credit support to our customers as we consider appropriate in the course of our business. Dorsal Networks On May 16, 2002, we completed our acquisition of Dorsal Networks, Inc., a privately held provider of next-generation transoceanic and regional undersea optical network solutions for 41.8 million shares of common stock valued at approximately $91.8 million. The acquisition was accounted for under the "purchase" method of accounting. Under the purchase method, the purchase price of Dorsal was allocated to identifiable assets and liabilities acquired from Dorsal, with the excess being treated as goodwill. The acquisition resulted in an in-process research and development charge of approximately $34.6 million as well as the recognition of certain intangible assets of $30.2 million, which will be amortized over an estimated life of five years. In addition, the acquisition will result in goodwill of approximately $19.1 million, which will have an indefinite life, but will be subject to periodic impairment tests. Dr. David R. Huber, our Chairman and Chief Executive Officer, owned, directly or indirectly, approximately 31 percent of the outstanding stock of Dorsal. Item 3. Quantitative and Qualitative Disclosures About Market Risk The following discussion about our market risk disclosures involves forward-looking statements. Actual results could differ materially from those projected in forward-looking statements. We maintain instruments subject to interest rate and foreign currency exchange rate risk. We categorize all of our market risk sensitive instruments as non-trading or other instruments. Interest Rate Sensitivity We maintain a portfolio of cash equivalents and short-term investments in a variety of securities including: commercial paper, certificates of deposit, money market funds and government and non-government debt securities. Substantially all amounts are in money market funds as well as high grade, short-term commercial paper and certificates of deposit, the value of which is generally not subject to interest rate changes. We believe that a 10% increase or decline in interest rates would not be material to our investment income or cash flows. Our long-term debt obligations bear fixed interest rates. As such, we have minimal cash flow exposure due to general interest rate changes associated with our long-term debt obligations. 26 Foreign Rate Sensitivity We primarily operate in the United States; however, we have expanded operations to include research and development and sales offices in various European countries. As a result, we may have sales in foreign currencies exposing us to foreign currency rate fluctuations. For the nine months ended September 28, 2002, we recorded limited sales in a foreign currency. We are exposed to the impact of foreign currency changes, associated with the Euro, for financial instruments held by our European subsidiaries. These instruments are limited to cash and cash equivalents and trade receivables. It is the policy of management to fund foreign operations on a monthly basis, thus minimizing average cash and overnight investments in the Euro. At September 28, 2002, our European subsidiaries maintained cash and cash equivalents and trade accounts receivable of approximately (Euro) 6.2 million. We believe that a 10% increase or decline in the Euro exchange ratio would not be material to cash and cash equivalent balances, interest income, or cash flows from consolidated operations. Item 4. Controls and Procedures Pursuant to Section 302 of the Sarbanes-Oxley Act and Rule 13a-14 of the Securities Exchange Act of 1923 ("Exchange Act") promulgated thereunder, our chief executive officer and chief financial officer have evaluated the effectiveness of our disclosure controls and procedures as of a date within 90 days prior to the date of the filing of this report (the "Evaluation Date") with the Securities and Exchange Commission. Based on such evaluation, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures were effective as of the Evaluation Date to ensure that information required to be disclosed in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms. In addition, a Disclosure Committee has been established consisting of key legal, financial and business unit leaders to review the Company's public filings and to insure accurate and timely disclosure of required information. Except for the establishment of a Disclosure Committee, there have been no significant changes in the internal controls or in other factors that could significantly affect our internal controls subsequent to the date of their most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. 27 PART II - OTHER INFORMATION Item 1. Legal Proceedings By letter dated July 10, 2000, Ciena Corporation ("Ciena") informed us of its belief that there is significant correspondence between products that we offer and several U.S. patents held by Ciena relating to optical networking systems and related dense wavelength division multiplexing communications systems technologies. On July 19, 2000, Ciena filed a lawsuit in the United States District Court for the District of Delaware alleging that we are willfully infringing three of Ciena's patents. Ciena is seeking injunctive relief, monetary damages including treble damages, as well as costs of the lawsuit, including attorneys' fees. On September 8, 2000, we filed an answer to the complaint, as well as counter-claims alleging, among other things, invalidity and/or unenforceability of the three patents in question. On March 5, 2001, a motion was granted, allowing Ciena to amend its complaint to include allegations that we are willfully infringing two additional patents. Although a trial date has not been set, we believe that a trial will commence in the first quarter of 2003. We have designed our products in an effort to respect the intellectual property rights of others. We intend to defend ourselves vigorously against these claims and we believe that we will prevail in this litigation. However, there can be no assurance that we will be successful in the defense of the litigation, and an adverse determination in the litigation could result from a finding of infringement of only one claim of a single patent. We may consider settlement due to the costs and uncertainties associated with litigation in general, and patent infringement litigation in particular, and due to the fact that an adverse determination in the litigation could preclude us from producing some of our products until we were able to implement a non-infringing alternative design to any portion of our products to which such a determination applied. Even if we consider settlement, there can be no assurance that we will be able to reach a settlement with Ciena. An adverse determination in, or settlement of, the Ciena litigation could involve the payment of significant amounts by us, or could include terms in addition to payments, such as a redesign of some of our products, which could have a material adverse effect on our business, financial condition and results of operations. We believe that defense of the lawsuit may be costly and may divert the time and attention of some members of our management. Further, Ciena and other competitors may use the existence of the Ciena lawsuit to raise questions in customers' and potential customers' minds as to our ability to manufacture and deliver our products. There can be no assurance that questions raised by Ciena and others will not disrupt our existing and prospective customer relationships. Between May 7, 2001 and June 15, 2001, nine class action lawsuits were filed in the United States District Court for the Southern District of New York relating to our initial public offering on behalf of all persons who purchased our stock between July 28, 2000 and the filing of the complaints. Each of the complaints names as defendants: Corvis, our directors and officers who signed the registration statement in connection with our initial public offering, and certain of the underwriters that participated in our initial public offering. Our directors and officers have since been dismissed from the case, without prejudice. The complaints allege that the registration statement and prospectus relating to our initial public offering contained material 28 misrepresentations and/or omissions in that those documents did not disclose (1) that certain of the underwriters had solicited and received undisclosed fees and commissions and other economic benefits from some investors in connection with the distribution of our common stock in the initial public offering and (2) that certain of the underwriters had entered into arrangements with some investors that were designed to distort and/or inflate the market price for our common stock in the aftermarket following the initial public offering. The complaints ask the court to award to members of the class the right to rescind their purchases of Corvis common stock (or to be awarded rescissory damages if the class member has sold its Corvis stock) and prejudgment and post-judgment interest, reasonable attorneys' and experts witness' fees and other costs. By order dated October 12, 2001, the court appointed an executive committee of six plaintiffs' law firms to coordinate their claims and function as lead counsel. Lead plaintiffs have been appointed in almost all of the IPO allocation actions, including the Corvis action. On October 17, 2001, a group of underwriter defendants moved for Judge Scheindlin's recusal. Judge Scheindlin denied that application. On December 13, 2001, the moving underwriter defendants filed a petition for writ of mandamus seeking the disqualification of Judge Scheindlin in the United States Court of Appeals for the Second Circuit. On April 1, 2002, the Second Circuit denied the moving underwriter defendants' application for a writ of mandamus seeking Judge Scheindlin's recusal from this action. On April 19, 2002, plaintiffs filed amended complaints in each of the actions, including the Corvis action. On May 23, 2002, a conference was held at which the court set a briefing schedule for the filing of motions to dismiss the amended complaints. On July 1, 2002, the underwriter defendants filed their motion to dismiss the amended complaints. On July 15, 2002, the issuer defendants filed their motion to dismiss the amended complaints. The briefing on the motions to dismiss has recently been completed, and the judge heard oral arguments on the motions on November 1, 2002. No discovery has occurred. We intend to vigorously defend ourselves. Item 2. Changes in Securities and Use of Proceeds (a) None. (b) None. (c) None. (d) Not applicable. Item 3. Defaults upon Senior Securities. None. Item 4. Submission of Matters to a Vote of Security Holders. (a) None. (b) None. 29 (c) None. (d) None. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K (a) Certification under Section 906 of the Sarbanes-Oxley Act of 2002. (b) On August 13, 2002, we filed a Current Report on Form 8-K dated August 13, 2002 containing the certification required by Section 906 of the Sarbanes-Oxley Act of 2002. 30 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. CORVIS CORPORATION Date: November 12, 2002 /s/ Lynn D. Anderson ---------------------------------------- Lynn D. Anderson Senior Vice President, Chief Financial Officer and Treasurer Date: November 12, 2002 /s/ Timothy C. Dec ---------------------------------------- Timothy C. Dec Vice President and Chief Accounting Officer 31 CERTIFICATE I, David R. Huber, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Corvis Corporation; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent 32 evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: November 12, 2002 --------------------- /s/ David R. Huber --------------------------------------- Name: David R. Huber Title: Chairman and Chief Executive Officer 33 CERTIFICATE I, Lynn D. Anderson, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Corvis Corporation; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent 34 evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: /s/ November 12, 2002 ----------------------- /s/ Lynn D. Anderson --------------------------------------- Name: Lynn D. Anderson Title: Senior Vice President, Chief Financial Officer and Treasurer 35 EXHIBIT INDEX Exhibit No. Description ------- ----------- 99.1 Certificate of the Chief Executive Officer and the Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 36