VERILINK CORP - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended April 1, 2005

Commission file number: 000-28562

VERILINK CORPORATION
(Exact name of registrant as specified in its charter)

Delaware		94-2857548
(State of incorporation)		(I.R.S. Employer Identification No.)

11551 E. Arapahoe Rd., Suite 150 Centennial, CO 80112-3833
(Address of principal executive offices, including zip code)

303.968.3000
(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes o No x

The number of shares outstanding of the issuer’s common stock as of April 29, 2005 was 22,945,140.

INDEX
VERILINK CORPORATION
FORM 10-Q

		Page

PART I.	FINANCIAL INFORMATION

Item 1.	Financial Statements (unaudited):

	Condensed Consolidated Statements of Operations for the three and nine months ended April 1, 2005 and April 2, 2004	3

	Condensed Consolidated Balance Sheets as of April 1, 2005 and July 2, 2004	4

	Condensed Consolidated Statements of Cash Flows for the nine months ended April 1, 2005 and April 2, 2004	5

	Notes to Condensed Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	17

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	28

Item 4.	Controls and Procedures	28

PART II.	OTHER INFORMATION

Item 6.	Exhibits	29

SIGNATURE		30

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

VERILINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited, in thousands, except per share amounts)

	Three months ended						Nine months ended

	April 1, 2005			April 2, 2004			April 1, 2005			April 2, 2004

Product sales	$	10,800		$	12,448		$	30,834		$	30,467
Service sales		3,031			1,198			8,547			1,863

Net sales		13,831			13,646			39,381			32,330

Product cost of sales		8,226			7,686			22,998			16,729
Service cost of sales		1,624			753			3,865			1,069

Total cost of sales		9,850			8,439			26,863			17,798

Gross profit		3,981			5,207			12,518			14,532

Operating expenses:
Research and development		1,796			2,149			5,792			4,981
Selling, general and administrative		4,592			3,852			13,920			8,340
Amortization of acquired intangible assets		645			265			1,901			713
Impairment charge related to goodwill		—			—			19,984			—
Restructuring charges		(42	)		400			692			400

Total operating expenses		6,991			6,666			42,289			14,434

Operating income (loss)		(3,010	)		(1,459	)		(29,771	)		98
Interest and other income, net		624			219			995			635
Interest expense		(188	)		(148	)		(428	)		(221	)

Income (loss) before provision for income taxes		(2,574	)		(1,388	)		(29,204	)		512
Provision for income taxes		—			—			—			—

Net income (loss)	$	(2,574	)	$	(1,388	)	$	(29,204	)	$	512

Earnings (loss) per share:
Basic	$	(0.11	)	$	(0.09	)	$	(1.32	)	$	0.03

Diluted	$	(0.11	)	$	(0.09	)	$	(1.32	)	$	0.03

Weighted average shares outstanding:
Basic		22,890			15,048			22,084			14,850

Diluted		22,890			15,048			22,084			16,297

The accompanying notes are an integral part of these condensed consolidated financial statements.

VERILINK CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(unaudited, in thousands, except per share data)

	April 1, 2005			July 2, 2004

ASSETS
Current assets:
Cash and cash equivalents	$	4,881		$	3,448
Restricted cash		333			—
Accounts receivable, net		10,232			7,881
Inventories, net		7,450			6,010
Other current assets		884			941

Total current assets		23,780			18,280
Property held for lease, net		6,124			6,269
Property, plant and equipment, net		1,956			1,381
Goodwill		5,464			9,887
Other intangible assets, net		16,048			9,182
Other assets		360			1,139

	$	53,732		$	46,138

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Note payable to bank	$	—		$	2,046
Current portion of long-term debt and capital lease obligations		7,688			487
Accounts payable		6,869			6,229
Accrued salaries and wages		1,710			1,473
Accrued liabilities		3,268			2,128
Deferred revenues		1,069			799
Warranty reserve		2,127			1,192
Warrants liability		1,341			—
Accrued purchase consideration		439			1,148

Total current liabilities		24,511			15,502
Long-term debt and capital lease obligations, less current portion above		5,921			6,262
Other long term liabilities		767			—

Total liabilities		31,199			21,764

Commitments and contingencies (Note 15)
Stockholders’ equity:
Preferred Stock, $0.01 par value, 1,000 shares authorized; no shares issued and outstanding		—			—
Common Stock, $0.01 par value; 40,000 shares authorized; 22,924 and 16,777 shares outstanding		229			168
Additional paid-in capital		86,322			59,532
Deferred compensation		(1	)		(520	)
Accumulated other comprehensive loss		(46	)		(39	)
Accumulated deficit		(63,971	)		(34,767	)

Total stockholders’ equity		22,533			24,374

	$	53,732		$	46,138

The accompanying notes are an integral part of these condensed consolidated financial statements.

VERILINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(unaudited, in thousands)

	Nine Months Ended

	April 1, 2005			April 2, 2004

Cash flows from operating activities:
Net income (loss)	$	(29,204	)	$	512
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		3,020			1,457
Impairment charge related to goodwill		19,984			—
Compensation expense related to stock awards		—			1,000
Amortization of deferred compensation		506			97
Forgiveness of convertible notes		(121	)		—
Accrued interest on note receivable from stockholder, net of change in reserves		—			(293	)
Loss on retirement of property, plant and equipment		1			6
Gain on revaluation of warrants		(528	)		—
Changes in assets and liabilities, net of effects of acquisitions:
Accounts receivable, net		295			(3,094	)
Inventories, net		1,776			318
Other assets		1,485			30
Accounts payable		(1,511	)		1,790
Accrued expenses		(3,565	)		1,187
Other non-current liabilities		(244	)		—

Net cash (used in) provided by operating activities		(8,106	)		3,010

Cash flows from investing activities:
Purchases of property, plant and equipment		(303	)		(540	)
Purchase of short-term investments		—			(26	)
Payments related to product line acquisitions		(709	)		(1,181	)
Cash acquired in acquisition of Larscom Incorporated, net of transaction costs		3,992			—
Acquisition of XEL Communications, Inc., net of cash acquired		—			(7,612	)
Proceeds from repayment of notes receivable		—			240

Net cash provided by (used in) investing activities		2,980			(9,119	)

Cash flows from financing activities:
Proceeds from bank borrowings and long term debt, net		10,447			—
Repayment of bank borrowings and long term debt		(3,883	)		(548	)
Repurchase of common stock		(194	)		—
Proceeds from issuance of common stock		196			1,031

Net cash used in financing activities		6,566			483

Change in other comprehensive loss		(7	)		(5	)

Net increase (decrease) in cash and cash equivalents		1,433			(5,631	)
Cash and cash equivalents at beginning of period		3,448			8,503

Cash and cash equivalents at end of period	$	4,881		$	2,872

(continued on next page)

VERILINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(continued from previous page)
(unaudited, in thousands)

	Nine Months Ended

	April 1, 2005		April 2, 2004

Supplemental disclosures:
Non-cash investing activities:
Acquisition of Larscom Incorporated for stock	$	26,559	$	—
Purchase of property, plant and equipment through capital lease obligations	$	173	$	—
Convertible notes issued in acquisition of XEL Communications, Inc.	$	—	$	10,480
Non-cash financing activities:
Repayment of notes receivable from stockholder	$	—	$	2,428

The accompanying notes are an integral part of these condensed consolidated financial statements.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 1 – Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements of Verilink Corporation have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, these statements include all adjustments, consisting of normal and recurring adjustments, considered necessary for a fair presentation of the results for the periods presented. The results of operations for the periods presented are not necessarily indicative of results which may be achieved for the entire fiscal year ending July 1, 2005. The unaudited interim condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto contained in our Annual Report on Form 10-K for the fiscal year ended July 2, 2004 as filed with the Securities and Exchange Commission. We have evaluated, and will periodically re-evaluate, our business in light of the segment reporting requirements prescribed by SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information. We have determined that we should report our operations as a single operating segment.

The accompanying financial statements have been prepared on a going concern basis which contemplates continuity of operations, realization of assets and liquidation of liabilities in the ordinary course of business and do not reflect adjustments that might result if we were not to continue as a going concern. The auditor’s report on our financial statements as of July 2, 2004 contains an explanatory paragraph, which refers to uncertain revenue streams and a low level of liquidity and notes that these matters raise substantial doubt about our ability to continue as a going concern. Sales of legacy products to Nortel Networks, our largest customer in fiscal 2004, declined from 54% of net sales in the first quarter of fiscal 2004 to 16% of net sales in the fourth quarter of fiscal 2004, and declined to less than 1% of net sales in the first nine months of fiscal 2005.

We have prepared for reduced legacy sales through acquisitions, by investment in next generation broadband access products, and the alignment of our operating costs with management’s revenue expectations in light of current conditions in the telecommunications industry. On a quarterly basis, management evaluates the revenue outlook and adjusts spending levels as necessary.

In March 2005, we entered into a securities purchase agreement for the private placement of up to $15,000,000 of senior convertible notes to six institutional investors. We issued an initial $10,000,000 of senior convertible notes, which can be converted into common stock at a fixed price per share. Proceeds received from the issuance of these notes were used to repay the line of credit with RBC Centura Bank (“RBC”), which was due to expire on April 7, 2005. We believe that our cash and cash equivalents, cash flow from operations and anticipated proceeds from the sale of the facility located at 950 Explorer Boulevard, Huntsville, Alabama will be sufficient to fund our operations through the next twelve months. However, if the facility is not sold or is sold for substantially less than the appraised value, we will need other sources of credit or financing in early calendar 2006 to repay amounts due in February 2006 under the convertible promissory notes and note payable on real estate and to provide working capital. If additional credit or other financing is not available as needed or on terms acceptable to us, we may seek to renegotiate certain of our contractual obligations.

Note 2 – Comprehensive Income (Loss)

We record gains or losses on our foreign currency translation adjustments and presents it as accumulated other comprehensive income (loss) in the accompanying condensed consolidated balance sheets. Comprehensive loss for the three months ended April 1, 2005 and April 2, 2004 totaled $2,576,000 and $1,391,000, respectively. Comprehensive loss for the three months ended April 1, 2005 consists of $2,574,000 of net loss and $2,000 of foreign currency translation adjustments, and comprehensive loss for the three months ended April 2, 2004 consists of $1,388,000 of net loss and $3,000 of foreign currency translation adjustments. Comprehensive loss for the nine months ended April 1, 2005 totaled $29,211,000 and comprehensive income for the nine months ended April 2, 2004 totaled $507,000. Comprehensive loss for the nine months ended April 1, 2005 consists of $29,204,000 of net loss and $7,000 of foreign currency translation adjustments. Comprehensive income for the nine months ended April 2, 2004 consisted of $512,000 of net income and $5,000 of foreign currency translation adjustments. As of April 1, 2005 and July 2, 2004, total accumulated other comprehensive loss was $46,000 and $39,000, respectively.

Note 3 – Earnings (Loss) Per Share

Basic earnings (loss) per share is computed by dividing net income (loss) available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted earnings (loss) per share gives effect to all dilutive potential common shares outstanding during a period. In computing diluted earnings (loss) per share, the average price of our Common Stock for the period is used in determining the number of shares assumed to be purchased from exercise of stock options and warrants. The following table sets forth the computation of basic and diluted earnings (loss) per share for the three months and nine months ended April 1, 2005 and April 2, 2004 (in thousands, except per share amounts):

	Three Months Ended						Nine Months Ended

	April 1, 2005			April 2, 2004			April 1, 2005			April 2, 2004

Net income (loss)	$	(2,574	)	$	(1,388	)	$	(29,204	)	$	512

Weighted average shares outstanding:
Basic		22,890			15,048			22,084			14,850
Effect of potential common stock from the exercise of stock options and warrants		—			—			—			1,447

Diluted		22,890			15,048			22,084			16,297

Basic earnings (loss) per share	$	(0.11	)	$	(0.09	)	$	(1.32	)	$	0.03

Diluted earnings (loss) per share	$	(0.11	)	$	(0.09	)	$	(1.32	)	$	0.03

Weighted average option shares and warrants excluded from computation of diluted earnings (loss) per share because their effect is anti-dilutive		6,227			3,872			5,733			280

Potential common shares from conversion of convertible notes as of April 1, 2005 totaling 3,863,207 shares were not included in the computation of diluted earnings (loss) per share because the inclusion of such shares would have been antidilutive.

Note 4 – Inventories

Inventories are stated at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. Inventories consist of the following (in thousands):

	April 1, 2005			July 2, 2004

Inventories:
Raw materials	$	8,951		$	5,828
Work in process		342			140
Finished goods		5,807			2,254
Miniplex inventory purchase commitment		776			1,104

		15,876			9,326
Less: inventory reserves		(8,426	)		(3,316	)

Inventories, net	$	7,450		$	6,010

Note 5 – Acquisition of Larscom Incorporated

On July 28, 2004, we completed our acquisition of Larscom Incorporated (“Larscom”) and issued approximately 5,948,652 shares of our Common Stock for all the outstanding stock of Larscom. We also assumed all outstanding stock options and warrants of Larscom. Larscom manufactures and markets high-speed network-access products for telecommunication service providers and corporate enterprise users. This acquisition reflects our strategy to pursue revenue growth, and brings a complementary customer base and product synergies. The results for the nine months ended April 1, 2005 include the results of Larscom since July 29, 2004, the first date after the closing of the acquisition.

The acquisition was recorded under the purchase method of accounting, and the purchase price was allocated based on the fair value of the assets acquired and liabilities assumed. The goodwill recorded as a result of the acquisition will not be amortized but will be included in our review of goodwill for impairment. The total purchase price of $27,852,000 consisted of (a) approximately 5,948,652 shares of Verilink common stock issued upon consummation and valued at approximately $26,043,000, using a fair value per share of $4.378, (b) approximately $516,000 of consideration for options and warrants to purchase approximately 983,306 equivalent shares of Verilink common stock assumed as part of the acquisition, and (c) direct transaction costs of approximately $1,300,000. The fair value of Verilink’s common stock issued was determined using the five-trading-day average price surrounding the date the acquisition was announced (April 29, 2004). The fair value of options and warrants assumed in the transaction was determined using the Black-Scholes option-pricing model and the following assumptions: (i) options assumed that are expected to terminate within one year following the date of closing – expected life of 0.57 years, risk-free interest rate of 1.20%, expected volatility of 85.37% and no expected dividend yield, (ii) all other options assumed – expected life of 3.06 years, risk-free interest rate of 2.99%, expected volatility of 143.10% and no expected dividend yield, and (iii) warrants assumed – remaining contractual life of 0.26 years, risk-free interest rate of 1.20% and expected volatility of 85.37%. A summary of the total purchase consideration is as follows (in thousands):

Value of common stock issued	$	26,043
Value of options and warrants assumed		516
Direct transaction costs		1,300

Total purchase consideration	$	27,859

The purchase consideration was allocated to the estimated fair values of the assets acquired and liabilities assumed. Based upon management’s estimate of fair value, which was based upon an independent valuation, the purchase price allocation is as follows (in thousands, except years):

	Purchase Price Allocation			Amortization Life

Tangible assets	$	13,163		various
Goodwill		15,561		—
Developed technology		4,566		4 – 6 years
Customer relationships		3,278		10 years
Trademarks		924		6 years
Liabilities assumed		(9,633	)	—

Total purchase price allocation	$	27,859

The acquisition was funded through the issuance of common stock and available cash.

Pro Forma Financial Information – The following unaudited pro forma summary combines our results as if the acquisition of Larscom had occurred on June 28, 2003. Certain adjustments have been made to reflect the impact of the purchase transaction. These pro forma results have been prepared for comparative purposes only and are not indicative of what would have occurred had the acquisition been made at the beginning of the respective periods, or of the results which may occur in the future (in thousands, except per share amounts).

	Three Months Ended						Nine Months Ended

	April 1, 2005			April 2, 2004			April 1, 2005			April 2, 2004

Net sales	$	13,831		$	20,335		$	40,834		$	63,669
Net loss	$	(2,574	)	$	(4,277	)	$	(32,066	)	$	(10,799	)
Earnings (loss) per share, basic	$	(0.11	)	$	(0.20	)	$	(1.41	)	$	(0.52	)
Earnings (loss) per share, diluted	$	(0.11	)	$	(0.20	)	$	(1.41	)	$	(0.52	)

Note 6 – Impairment of Goodwill

During the first quarter of fiscal 2005, we completed an interim test for impairment of goodwill due to triggering events that occurred during the quarter that we believe would more likely than not, reduce the fair value of goodwill below our carrying value. These triggering events were (a) the loss of product revenues from a significant customer, (b) the low level of liquidity noted in an explanatory paragraph included in the independent registered public accounting firm’s report on our fiscal 2004 consolidated financial statements which were filed in our Form 10-K on October 1, 2004, and (c) the low market price of our common stock following the end of the first quarter. Based on the initial impairment assessment, we determined that the fair value of our reporting unit was less than our carrying value after considering a combination of quoted market prices and discounted cash flows. In order to determine the amount of the goodwill impairment, we prepared a purchase price allocation using a discounted cash flow model utilizing the assistance of a third party valuation specialist. The projected discounted cash flow model was prepared using a discount rate commensurate with the risk inherent in our current business model. As a result, we recorded an impairment charge related to goodwill of $19,984,000.

Prior to the first quarter of fiscal 2005, our annual impairment assessment considered the carrying value of our equity to our market capitalization calculated by multiplying our outstanding shares by our current share price, disregarding anomalies in share price that we deemed were temporary in nature. Due to the changes in facts and circumstances caused by the loss of product revenues from Nortel Networks (our largest customer in fiscal 2004), the significant volatility in our share price from the end of our 2004 fiscal year through the filing of our Quarterly Report on Form 10-Q for the first quarter of fiscal 2005, and our low level of liquidity, we considered both quoted market prices and discounted cash flows as fair value models and concluded that a projected discounted cash flow model is a better indicator of our fair value, as that term is contemplated in SFAS 142, Goodwill and Other Intangibles, than the market capitalization model used historically.

Note 7 – Other Intangible Assets

Acquired other intangible assets subject to amortization are as follows (in thousands):

	April 1, 2005				July 2, 2004

	Gross Carrying Costs		Accumulated Amortization		Gross Carrying Costs		Accumulated Amortization

Customer relations	$	11,834	$	2,891	$	8,556	$	2,117
Developed technology		6,956		1,940		2,390		1,105
Trademarks		2,473		384		1,549		91

	$	21,263	$	5,215	$	12,495	$	3,313

The approximate estimated annual amortization for other intangibles for the current fiscal year, the next five fiscal years and thereafter is (in thousands):

Fiscal years ending June:

2005	$	2,547
2006	$	2,580
2007	$	2,451
2008	$	2,145
2009	$	2,054
2010	$	1,450
Thereafter	$	4,722

Note 8 – Warranty Liability

We record a warranty provision at the time of each sale. We generally warrant our products from one to five years based on product line. A reconciliation of the changes in warranty liability for the nine months ended April 1, 2005 and April 2, 2004 is (in thousands):

	Nine Months Ended

	April 1, 2005			April 2, 2004

Balance as of beginning of period	$	1,192		$	1,374
Additions:
Additions from acquisition		1,019			60
Additions charged to income		235			148
Less deductions from the reserves		(319	)		(188	)

Balance as of end of period	$	2,127		$	1,394

Note 9 – Restructuring Charges

During fiscal 2004 following the acquisition of XEL Communications, we announced plans to consolidate certain manufacturing and administrative activities in Aurora, Colorado with our operations in Madison, Alabama. We recorded pretax restructuring charges totaling $390,000 in the third and fourth quarters of fiscal 2004 and $26,000 in the first quarter of fiscal 2005 in the consolidated statement of operations in connection with these restructuring activities which include severance and other termination benefits. This restructuring resulted in a reduction in workforce of approximately 17 employees, or 10% of our total workforce. We completed these consolidation activities during the first quarter of fiscal 2005.

In September 2004, we announced plans to consolidate our engineering functions in our Madison, Alabama and Newark, California facilities. As a result of this engineering resource alignment, we closed our Santa Barbara, California office and transitioned the engineering located in Aurora, Colorado to the appropriate facility in either Madison, Alabama or Newark, California, both of which were substantially completed during the second quarter of fiscal 2005. The Aurora, Colorado facility was acquired as part of our acquisition of XEL in February 2004 and the Santa Barbara, California office was acquired as part of our acquisition of the NetEngine product line in January 2003. As part of this engineering consolidation plan, we reduced our workforce by approximately 5% and recorded restructuring charges totaling $624,000 in the nine months ended April 1, 2005, including $576,000 for one-time termination benefits for departing personnel and $48,000 for other costs associated with office and resource re-alignment. This office and resource alignment was completed in the third quarter of fiscal 2005.

In connection with our acquisition of Larscom on July 28, 2004, we assumed restructuring accruals totaling $2,811,000 recorded as restructuring charges by Larscom in periods prior to the acquisition date, which included the following items explained in more detail below: (i) real estate lease related to the closure of the Larscom facility in Durham, North Carolina, (ii) real estate lease related to the abandonment of the former Larscom headquarters in Milpitas, California, and (iii) charges related to the planned reduction in work force of certain Larscom positions in connection with our acquisition of Larscom.

During 2001, Larscom closed its facility in Durham, North Carolina, but remained financially responsible for the existing lease and recorded the remaining lease payments as a restructuring charge. Larscom entered into a sublease agreement for the entire 27,000 square foot facility with Silicon Wireless Corporation (a start-up company) that had a commencement date of February 15, 2002. Due to the uncertainty of the receipt of income under the sublease, restructuring expenses are reduced as the sublease income is received. As of July 28, 2004, the balance in the restructuring accrual totaled $1,299,000. We made monthly payments during the nine months ended April 1, 2005 totaling $248,000 which reduced the accrual. Sublease payments received during the first and second quarters of fiscal 2005 totaling $43,000 and $62,000, respectively, were recorded as a reduction in restructuring charges recorded on the condensed consolidated statement of operations. No sublease payments were received during the third quarter of fiscal 2005 as Silicon Wireless Corporation works to seek additional sources of financing. We expect the remaining lease obligation will be paid out by January 2007. No additional restructuring costs are expected to be incurred related to this lease.

During 2003, Larscom abandoned its former headquarters in Milpitas, California. As of July 28, 2004, the balance in the accrual related to this abandonment totaled $42,000, which relates to final payment of costs for the lease that expired in August 2004. We expect that the remaining balance will be paid out by the end of the current fiscal year.

In connection with the Larscom acquisition, we announced plans to eliminate redundant positions and to consolidate certain manufacturing and administrative positions in Newark, California with our operations in Madison, Alabama. We assumed a liability totaling $1,470,000 for employment termination costs as of the acquisition date recorded in accordance with EITF 95-3. We recorded additional restructuring charges in the nine months ended April 1, 2005 totaling approximately $434,000 related to additional employment termination costs. We completed these consolidation activities during the second quarter of fiscal 2005. This restructuring reserve assumed in the Larscom acquisition was reduced a total of $305,000 in the second and third quarters of fiscal 2005 due to changes in the employment status of certain employees.

The following table provides details of the activity and remaining balances for restructuring charges as of April 1, 2005 (in thousands):

	Total Charges			Real Estate and Other Costs			Employee Termination Costs

XEL Consolidation:
Balance as of July 2, 2004	$	390		$	—		$	390
Restructuring charge in the year-to-date period		26			—			26
Payments made in cash		(414	)		—			(414	)

Balance as of end of period	$	2		$	—		$	2

Engineering Consolidation:
Balance as of July 2, 2004	$	—		$	—		$	—
Restructuring charge in the year-to-date period		576			48			624
Payments made in cash		(566	)		(48	)		(614	)

Balance as of end of period	$	10		$	—		$	10

2001 Restructuring (Larscom):
Balance as of July 2, 2004	$	—		$	—		$	—
Assumed as of July 28, 2004		1,299			1,299			—
Restructuring charge in the year-to-date period		—			—			—
Payments made in cash		(248	)		(248	)		—

Balance as of end of period	$	1,051		$	1,051		$	—

2003 Restructuring (Larscom):
Balance as of July 2, 2004	$	—		$	—		$	—
Assumed as of July 28, 2004		42			42			—
Restructuring charge in the year-to-date period		—			—			—
Payments made in cash		—			—			—

Balance as of end of period	$	42		$	42		$	—

Larscom Consolidation:
Balance as of July 2, 2004	$	—		$	—		$	—
Established as of July 28, 2004		1,470			—			1,470
Restructuring charge in the year-to-date period		434			—			434
Payments made in cash		(1,568	)					(1,568	)
Adjustment to restructuring charge		(305	)		—			(305	)

Balance as of end of period	$	31		$	—		$	31

Note 10 — Note Payable to Bank

In connection with the issuance of the senior convertible notes discussed in Note 11 below, the amount outstanding under the revolving line of credit with RBC totaling $3,500,000 was repaid and the loan and security agreement terminated as of March 21, 2005. The interest on outstanding borrowings was at a rate of 250 basis points over the 30-day London inter-bank offered rate. All of our assets, other than the property subject to lease and restricted cash, were pledged as collateral securing amounts outstanding under this line.

Note 11 – Long-term Debt

Long-term debt and capital lease obligations consist of the following (in thousands):

	April 1, 2005			July 2, 2004

Senior convertible notes, 6% coupon rate, payable in $1,000,000 quarterly payments beginning in July 2005 (or sooner under certain circumstances)	$	7,177		$	—
Note payable on real estate		3,389			3,723
Convertible promissory notes		2,880			3,001
Capital lease obligations		163			25

		13,609			6,749
Less: Current portion of long-term debt and lease obligations		(7,688	)		(487	)

Long-term debt	$	5,921		$	6,262

In March 2005, we entered into a securities purchase agreement for the private placement of up to $15,000,000 of senior convertible notes to six institutional investors. We issued an initial $10,000,000 of senior convertible notes, which can be converted into common stock at an initial price of $3.01 per share. The conversion price of the senior convertible notes will be subject to weighted average anti-dilution adjustments. The senior convertible notes may not be converted into more than 20% of the number of shares or voting power of our common stock outstanding as of the closing of the financing until such conversion or exercise has been approved by our stockholders. As of April 1, 2005, a total of $10,000,000 in face value of senior convertible notes was outstanding. These senior convertible notes are recorded in the condensed consolidated balance sheet at April 1, 2005, at the discounted amount of $7,176,000. We are recording the difference between the face value and discounted amount as additional interest expense over the estimated life of the senior convertible notes. In connection with this transaction, we also issued warrants to purchase shares of our common stock as described in Note 14 – Warrants.

The senior convertible notes bear interest at a rate of six percent per annum and are repayable in ten quarterly installments beginning in July 2005, or earlier upon the occurrence of certain events. Payment of both principal and interest may be made in either cash or, provided that we have obtained stockholder approval to the extent necessary, by the delivery of shares of common stock at a price equal to the lower of (i) the conversion price of $3.01 or (ii) 90% of the weighted average sale price of our common stock for the fifteen consecutive trading days ending on the fourth trading day immediately preceding the applicable interest or installment payment date. Such issuance of common stock will not result in anti-dilution adjustments to the conversion price of the senior convertible notes. If by November 21, 2005, we have not obtained stockholder approval of the issuance of the senior convertible notes, the warrants and the shares of common stock to be issued thereunder and an increase in our authorized capital of at least 10,000,000 shares of common stock, we will be required to make at least 50% of interest and installment payments made after such date in cash. If, as of the end of each fiscal quarter during the period in which the senior convertible notes are outstanding, we fail to maintain certain minimum working capital requirements, as defined in the notes, the holders of the senior convertible notes may require us to make an additional installment payment under the senior convertible notes which shall be, at the option of each holder, such holder’s pro rata portion of one of the following: (1) the difference between (A) the unpaid principal, interest and any late charges then remaining under the senior convertible notes and (B) 60% of our working capital amount, as determined in accordance with the terms of the senior convertible notes, (2) $2,000,000 or (3) such lesser amount if reduced in accordance with the terms of the senior convertible notes. Substantially all of our assets are pledged as collateral for amounts outstanding under the senior convertible notes.

In connection with our June 2000 acquisition of a facility in Huntsville, Alabama located at 950 Explorer Boulevard, we entered into a loan agreement with Regions Bank to borrow up to $6,000,000 to finance the purchase of the property and to make improvements thereon. In December 2000, we entered into a second agreement with Regions Bank to borrow an additional $500,000 to finance further improvements to the facility. The land and building are provided as collateral for amounts outstanding under these agreements. In June 2004, the outstanding balances under the two loan agreements were combined under one note, which requires a monthly payment of $50,000. The interest is at a rate of 225 basis points over the 30 day London inter-bank offered rate, which was 4.92% at April 1, 2005. As of April 1, 2005, the amount outstanding under this note totaled $3,389,000. The final balloon payment of approximately $3,065,000 is due on February 1, 2006.

We issued two convertible promissory notes in February 2004 totaling $10,480,000 in connection with our acquisition of XEL Communications, Inc. In May 2004, the holder of the $10,000,000 convertible promissory note converted $7,250,000 of the outstanding principal amount of the note into 1,361,758 shares of our common stock. These convertible promissory notes earn interest at a rate of 7% per annum and mature February 5, 2006. The holders may convert the note in whole or in increments of at least $1,000,000 into our common stock at a conversion price of $5.324 per share. If the holders convert any portion of the convertible promissory notes, the holders must repay all interest received by them on the portion of the convertible promissory note converted before we will issue the common stock. Interest expense will be reduced by the amount of interest repaid by the holders in the period the convertible promissory note is converted into common stock. Under the terms of the $10,000,000 convertible promissory note, the note was reduced by $350,000 for payment of retention bonuses in February 2005 to certain XEL employees pursuant to retention agreements between us and the employees. As the retention bonuses were accrued and charged to compensation expense, the carrying value of the convertible promissory note was reduced and other income from the loan reduction was recorded, which totaled $8,000 and $121,000 in the three months and nine months ended April 1, 2005, respectively.

Long-term debt at April 1, 2005 also includes three capital lease obligations totaling $163,000, which currently require monthly payments totaling $6,309, including interest at rates ranging from 10% to 13.6%. These leases terminate on various dates between March 2006 and February 2010.

Note 12 – Stock Based Compensation

We account for stock-based awards to employees using the intrinsic value method in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees. Accordingly, no compensation expense has been recognized for options granted with an exercise price equal to market value at the date of grant.

Had we recorded compensation based on the estimated grant date fair value, as defined by SFAS No. 123, Accounting for Stock-Based Compensation, for awards granted under our stock option plan and stock purchase plan, our net income (loss) and earnings (loss) per share would have been reduced to the pro forma amounts below for the respective periods (in thousands, except per share amounts):

	Three Months Ended						Nine Months Ended

	April 1, 2005			April 2, 2004			April 1, 2005			April 2, 2004

Net income (loss), as reported	$	(2,574	)	$	(1,388	)	$	(29,204	)	$	512
Add: Stock-based employee compensation expense included in reported net income (loss), net of related tax effects and valuation allowance		207			11			480			49
Deduct: Stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects and valuation allowance		(738	)		(505	)		(2,125	)		(1,054	)

Pro forma net loss	$	(3,105	)	$	(1,882	)	$	(30,849	)	$	(493	)

Earnings (loss) per share:
Basic – as reported	$	(0.11	)	$	(0.09	)	$	(1.32	)	$	0.03

Basic – pro forma	$	(0.14	)	$	(0.13	)	$	(1.40	)	$	(0.03	)

Diluted – as reported	$	(0.11	)	$	(0.09	)	$	(1.32	)	$	0.03

Diluted – pro forma	$	(0.14	)	$	(0.13	)	$	(1.40	)	$	(0.03	)

In connection with the acquisition of XEL Communications, Inc., we issued 187,826 shares of restricted common stock to certain employees of XEL and recorded deferred compensation of $1,000,000, which will be charged to expense over the three year vesting period. In the event the employees who received the restricted common stock are terminated by us, or resign for good cause as defined in the restricted stock award, then the restricted shares will vest as of the termination date and the remaining deferred compensation will be charged to expense. On February 17, 2005, we accelerated the vesting of the restricted stock awards outstanding as of that date and the remaining deferred compensation was charged to expense. Total compensation expense related to these restricted shares totaled $207,000 and $476,000 for the three months and nine months ended April 1, 2005, respectively.

Note 13 – Common Stock

Restricted stock awards issued to certain employees following the XEL acquisition vested during fiscal 2005 as provided by the award and as described above in Note 12 – Stock Based Compensation. The employees elected to reduce the shares received in payment of the required tax withholdings. Therefore, we recorded 61,213 shares received as treasury stock with a value of $195,000 and remitted the required tax withholdings to the taxing authorities.

Note 14 – Warrants

On March 21, 2005, we issued warrants in connection with the issuance of the $10,000,000 senior convertible notes to purchase up to 830,563 shares of our common at a price per share of $3.41. These warrants have a term of five years and are exercisable beginning September 21, 2005.

In accordance with EITF 00-19, “Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock”, the warrants have been included as a short-term liability and were originally valued at fair value on the date of issuance. As a liability, the warrants are revalued each period until and unless the warrants are exercised. During the three months ended April 1, 2005, we recorded other income of $528,000 related to the change in fair value from the date of issuance of these warrants to April 1, 2005. This amount is included as a component of Interest and other income, net, in the accompanying condensed consolidated statement of operations. If the warrants are exercised prior to their termination, their carrying value will be transferred to equity.

Note 15 – Commitments and Contingences

We lease various sales offices, warehouse space and equipment under operating leases that expire on various dates from June 2005 through March 2010. Additionally, we assumed certain operating leases in the Larscom acquisition related principally to buildings in Newark, California and Durham, North Carolina, which have terms that expire in 2008 and 2007, respectively. Rent expense under all non-cancelable operating leases totaled $244,000 and $180,000 for the three months ended April 1, 2005 and April 2, 2004, respectively. Rent expense under all non-cancelable operating leases totaled $742,000 and $480,000 for the nine months ended April 1, 2005 and April 2, 2004, respectively. Sublease rental income was $0 and $86,000 for the three months and nine months ended April 1, 2005, respectively. Future minimum lease payments under all non-cancelable operating leases and sublease rental income as of April 1, 2005 are as follows (in thousands):

Fiscal year,	Operating Leases		Sublease Rental Income

2005 (April to June)	$	256	$	65
2006		855		268
2007		719		161
2008		567		—
2009		125		—
2010		65		—

Total minimum lease payments	$	2,587	$	494

As of April 1, 2005, we had approximately $2,984,000 of non-cancelable purchase commitments outstanding for inventory and inventory components.

We are not currently involved in any legal proceedings expected to have a material adverse effect on our financial conditions or results of operations. From time to time, however, we may be subject to claims and lawsuits arising in the normal course of business.

Note 16 – Recently Issued Accounting Pronouncements

During September 2004, the EITF released Issue 04-08, The Effect of Contingently Convertible Debt on Diluted Earnings per Share. Issue 04-08 provides guidance on when the dilutive effect of contingently convertible debt securities with a market price trigger should be included in the computation of diluted earnings per share (“EPS”). The guidance is expected to be effective as of December 31, 2004 and would be applied by retrospectively restating previously reported EPS. We anticipate that the adoption of this guidance will not have a material effect on the computation of EPS in prior periods since we did not have contingently convertible debt in those periods. In addition, the FASB is considering amending SFAS No. 128 to make it consistent with International Accounting Standard 33, and to make EPS computations comparable on a global basis. The amended standard is expected to be effective for all periods ending after December 15, 2004. We anticipate that the adoption of Issue 04-08 and the amendment to SFAS No. 128 will not have a material impact on the computation of our EPS.

In November 2004, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 151, Inventory Costs, an amendment of ARB No. 43, Chapter 4 (“FAS 151”). FAS 151 clarifies that abnormal inventory costs such as costs of idle facilities, excess freight and handling costs, and wasted materials (spoilage) are required to be recognized as current period costs. The provisions of FAS 151 are effective for our fiscal 2006. We are currently evaluating the provisions of FAS 151 and do not expect adoption will have a material impact on our financial position, results of operations, or cash flows.

In December 2004, the FASB finalized SFAS No. 123R Share-Based Payment (“FAS 123R”), amending FAS No. 123, effective beginning our first quarter of fiscal 2006. FAS 123R will require us to expense stock options based on grant date fair value in our financial statements. Further, the adoption of FAS 123R will require additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from share-based payment arrangements. In March 2005, the U.S. Securities and Exchange Commission (the “SEC”) issued Staff Accounting Bulletin (“SAB”) No. 107, which expresses views of the SEC staff regarding the interaction between FAS 123R and certain SEC rules and regulations, and provides the staff’s views regarding the valuation of share-based payment arrangements for public companies. We will consider the guidance of this SAB as we adopt FAS 123R. The effect of expensing stock options on our results of operations using a Black-Scholes option-pricing model is presented in our condensed consolidated financial statements in Note 12 — Stock Based Compensation. Under FAS 123R, we must determine the appropriate fair value model to be used for valuing share-based payments, the amortization method for compensation cost and the transition method to be used at date of adoption. The transition methods include prospective and retroactive adoption options. We have not yet determined the method of adoption or the effect of adopting FAS 123R. We are assessing the requirements of FAS 123R and expect that its adoption will have a material impact on our results of operations and earnings (loss) per share.

In December 2004, FASB issued FASB Staff Position No. FAS 109-a, Application of FAS 109 for the Tax Deduction Provided to U.S. Based Manufacturers by the American Job Creation Act of 2004, and FASB Staff Position No. FAS 109-b, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the American Jobs Creation Act of 2004. The American Jobs Creation Act of 2004 (“Act”) repeals export tax benefits, transitions in a new tax deduction for qualifying U.S. manufacturing activities and provides for the repatriation of earnings from foreign subsidiaries at reduced federal income tax rates. These two staff positions provide accounting and disclosure guidance related to the American Job Creation Act of 1004. We do not expect the Act to have an effect on our fiscal 2005 tax liability; however, we are evaluating the impact on future years.

In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions. SFAS 153 eliminates the exception from fair value measurement for nonmonetary exchanges of similar productive assets in paragraph 21(b) of APB Opinion No. 29, Accounting for Nonmonetary Transactions, and replaces it with an exception for exchanges that do not have commercial substance. SFAS 153 specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. SFAS 153 is effective for periods beginning after June 15, 2005. We do not expect that adoption of SFAS 153 will have a material effect on our consolidated financial position, consolidated results of operations, or liquidity.

In March 2005, the FASB issued FASB Interpretation (“FIN”) No. 47, Accounting for Conditional Asset Retirement Obligations, which clarifies the term conditional asset retirement obligation as used in SFAS No. 143, Accounting for Asset Retirement Obligations, as a legal obligation to perform an asset retirement activity in which the timing and/or method of settlement are conditional on a future event that may or may not be within the control of the Corporation. FIN No. 47 is effective no later than the end of fiscal years ending after December 15, 2005. We are currently evaluating the impact of adopting this interpretation.

Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Verilink is a leading provider of next-generation broadband access products and services. Our products support the delivery of voice, video and data services over converged access networks and enable the smooth migration from present time-division multiplexing (“TDM”) based networks to IP-based networking. We develop, manufacture, and market integrated access devices (“IADs”), Optical Ethernet access products and bandwidth aggregation solutions. These products are sold to service providers, enterprise customers, and original equipment manufacturer (“OEM”) partners, and are deployed worldwide as targeted solutions for applications involving voice over IP (“VoIP”), voice over ATM (“VoATM”), voice over DSL (“VoDSL”), wireless backhaul aggregation, Frame Relay service transport, point-to-point broadband services, IP/PPP multi-link access routing, service inter-working, and the migration of networks from traditional TDM based access to IP/Ethernet. Our customers include regional bell operating companies (“RBOCs”), inter-exchange carriers (“IXCs”), incumbent local exchange carriers (“ILECs”), independent operating companies, competitive local exchange carriers (“CLECs”), international post, telephone, and telegraph companies, wireless service providers, equipment vendors, Fortune 500 companies, small to mid-sized business customers, and various local, state, and federal government agencies. We were founded in California in 1982 and are incorporated as a Delaware corporation.

In fiscal 2005, we have continued our acquisition strategy to drive revenue growth, gain market share with expanded product offerings, and strengthen our position for the high-growth emerging markets in next generation broadband access including VoIP, routing and optical access. On July 28, 2004, we completed our acquisition of Larscom Incorporated (“Larscom”), a leading provider of high-speed broadband and optical Ethernet access products. The Larscom acquisition brings a broadened product line to address new market opportunities in the carrier and large enterprise markets, and includes the Orion 7400 Optical Ethernet access platform, the eLink family of TDM-based IADs and other related product lines. This acquisition also brings existing customer contracts and relationships, sales, sales engineering, customer service and support personnel, and an engineering team based in Newark, California. The results for the nine months ended April 1, 2005 include the results of Larscom since July 29, 2004, the first date after the closing of the acquisition.

We have prepared for reduced legacy sales through our recent acquisitions, by investment in next generation broadband access products, and the alignment of our operating costs with management’s revenue expectations in light of current conditions in the telecommunications equipment industry. On a quarterly basis, management evaluates revenue outlook and adjusts spending levels as necessary. Following in the end of our third fiscal quarter, we reduced headcount in certain areas and reduced operating expense targets for the fourth fiscal quarter.

In March 2005, we entered into a securities purchase agreement for the private placement of up to $15,000,000 of senior convertible notes to six institutional investors. We issued an initial $10,000,000 of senior convertible notes, which can be converted into common stock at a fixed price per share. Proceeds received from the issuance of these senior convertible notes were used to repay the line of credit with RBC Centura Bank (“RBC”), which was due to expire on April 7, 2005. We believe that our cash and cash equivalents, cash flow from operations, and anticipated proceeds from the sale of the facility located at 950 Explorer Boulevard, Huntsville, Alabama will be sufficient to fund our operations through the next twelve months. However, if the facility is not sold or is sold for substantially less than the appraised value, we will need other sources of credit or financing in early calendar 2006 to repay amounts due in February 2006 under the convertible promissory notes and note payable on real estate and to provide working capital. If additional credit or other financing is not available as needed or on terms acceptable to us, we may seek to renegotiate certain of our contractual obligations.

The information in this Item 2 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contains forward-looking statements, including, without limitation, statements relating to our revenues, expenses, margins, liquidity, capital needs and financing plans. Such forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from those anticipated in the forward-looking statements. Factors that might cause such a difference include, but are not limited to, those discussed elsewhere herein under the caption “Factors Affecting Future Results”.

RESULTS OF OPERATIONS

The following table presents the percentages of net sales represented by certain line items from the Condensed Consolidated Statements of Operations for the periods indicated.

	Three months ended						Nine months ended

	April 1, 2005			April 2, 2004			April 1, 2005			April 2, 2004

Product sales		78.1	%		91.2	%		78.3	%		94.2	%
Service sales		21.9			8.8			21.7			5.8

Net sales		100.0			100.0			100.0			100.0

Product cost of sales		59.5			56.3			58.4			51.8
Service cost of sales		11.7			5.5			9.8			3.3

Cost of sales		71.2			61.8			68.2			55.1

Gross profit		28.8			38.2			31.8			44.9

Operating expenses:
Research and development		13.0			15.8			14.7			15.4
Selling, general and administrative		33.2			28.2			35.4			25.8
Amortization of acquired intangible assets		4.7			2.0			4.8			2.2
Impairment charge related to goodwill		—			—			50.7			—
Restructuring charges		(0.3	)		2.9			1.8			1.2

Total operating expenses		50.6			48.9			107.4			44.6

Operating income (loss)		(21.8	)		(10.7	)		(75.6	)		0.3
Interest and other income, net		4.5			1.6			2.5			2.0
Interest expense		(1.3	)		(1.1	)		(1.1	)		(0.7	)

Income (loss) before provision for income taxes		(18.6	)		(10.2	)		(74.2	)		1.6
Provision for income taxes		—			—			—			—

Net income (loss)		(18.6	)%		(10.2	)%		(74.2	)%		1.6	%

Sales. Net sales for the three months ended April 1, 2005 increased 1% to $13,831,000 from $13,646,000 in the comparable period of the prior fiscal year. This increase is primarily a result of our acquisition of Larscom in July 2004, offset by the decline in sales of AS2000 products to Nortel. Net sales for the nine months ended April 1, 2005 increased 22% to $39,381,000 from $32,330,000 for the same period of the prior year. This increase is primarily a result of our acquisitions of XEL Communications, Inc. (“XEL”) in February 2004 and Larscom in July 2004, offset by the decline in sales of AS2000 products to Nortel. Net sales of carrier and carrier access products and services, which include XEL, Miniplex products and the AS2000 product family, decreased 40% to $6,270,000 in the three months ended April 1, 2005 from $10,399,000 in the comparable prior year period. Net sales of carrier and carrier access products decreased 16% in the nine months ended April 1, 2005 over the same period of the prior fiscal year. These net decreases were primarily due to the addition of the XEL products and services offset by a decline in sales of AS2000 products, which decreased from $3,963,000 in the three months ended April 2, 2004 to $258,000 in the three months ended April 1, 2005, and from $13,419,000 in the nine months ended April 2, 2004 to $704,000 for the nine months ended April 1, 2005. We expect little, if any, sales of AS2000 products to Nortel in the future. Net sales of enterprise access products and services in the three months ended April 1, 2005 increased 133% to $7,561,000 from $3,247,000 in the comparable period in the prior fiscal year. Net sales of enterprise access products and services in the nine months ended April 1, 2005 increased 108% from $9,926,000 to $20,666,000. These

increases are primarily a result of sales of Larscom products and services. Total services revenue for the three months ended April 1, 2005 increased to $3,031,000 from $1,198,000 for the three months ended April 2, 2004, and total services revenue for the nine months ended April 1, 2005 increased to $8,547,000 from $1,863,000 for the same period of the prior year. These increases as compared to the prior year are attributable to the service businesses of XEL and Larscom.

Our business continues to be characterized by a concentration of sales to a limited number of key customers. Net sales to our top five customers decreased 13% in the three months ended April 1, 2005 to $9,289,000 from $10,635,000 in the comparable period in the prior year, and increased 5% in the nine months ended April 1, 2005 to $25,427,000 from $24,318,000 in the comparable period in the prior year. Net sales to all other customers increased by 51% and 74% in the three- and nine-month periods ended April 1, 2005, respectively, from the comparable periods in the prior fiscal year. Our top five customers did not remain the same over these periods. Sales to Verizon accounted for 44% of net sales in the three months ended April 1, 2005, as compared to 43% for the same period last year and accounted for 43% of net sales in the nine months ended April 1, 2005, as compared to 22% for the same period last year. While sales to Nortel accounted for 36% of the prior year’s sales for the nine months ended April 2, 2004, net sales to them during the nine months ended April 1, 2005 were less than 1% of net sales.

Gross Profit. Gross profit decreased to 28.8% of net sales for the three months ended April 1, 2005 as compared to 38.2% for the three months ended April 2, 2004. This decrease is attributable to a number of factors, including the change in product and services sales mix between the periods, the impact of the decline in sales of AS2000 products, additional inventory reserves provided against excess inventory and decreased pricing in certain areas. Gross profit decreased to 31.8% of net sales for the nine months ended April 1, 2005 as compared to 44.9% for the nine months ended April 2, 2004. This decrease is also attributable to a number of factors, including the change in product and services sales mix between the periods, the impact of the decline in sales of AS2000 products, additional inventory reserves provided against excess inventories, and to a lesser extent, decreased pricing in certain areas effective January 1, 2005. Gross profit in the three- and nine-month periods ended April 1, 2005 were reduced by $448,000 and $1,119,000, respectively, related to additional inventory reserves provided against excess inventories. Gross profit related to service revenues increased to 46.4% for the three months ended April 1, 2005 as compared to 37.1% for the three months ended April 2, 2004, and increased to 54.8% for the nine months ended April 1, 20054 from 42.6% for the nine months ended April 2, 2004, primarily due to the impact from the XEL and Larscom acquisitions. In the fourth quarter of fiscal 2005, we have planned product cost reductions that we expect to improve gross margins.

Research and Development. Research and development expenditures for the three months ended April 1, 2005 decreased 16% to $1,796,000 from $2,149,000 for the same period in the prior year, and decreased as a percentage of sales from 15.8% to 13.0%. Research and development expenditures for the nine months ended April 1, 2005 increased 16% to $5,792,000 from $4,981,000 for the same period in the prior year, and decreased as a percentage of sales from 15.4% to 14.7%. The decrease in spending for the three months ended April 1, 2005 compared to the same quarter in the prior fiscal year is a result of the reduction in staff from the consolidation of engineering in the Santa Barbara, California and Aurora, Colorado offices into our offices in Madison, Alabama and Newark, California. The increase in spending for the nine month period ended April 1, 2005 is primarily due to the addition of staff in connection with the acquisitions of XEL and Larscom offset by a reduction in staff due to consolidation efforts. Research and development expenses for the nine month period ended April 1, 2005 includes $139,000 related to compensation charges associated with retention bonus accruals and restricted stock awards. We believe that a significant level of investment in product development is required to remain competitive and that such expenses will vary over time as a percentage of net sales. However, we continue to monitor the level of our investment in research and development activities and adjust quarterly spending levels, upward or downward, based upon anticipated sales volume.

Selling, General and Administrative. Selling, general and administrative expenses for the three months ended April 1, 2005 increased 19% to $4,592,000 from $3,852,000 in the comparable period in the prior fiscal year and increased as a percentage of sales from 28.2% to 33.2%. Selling, general and administrative expenses for the nine months ended April 1, 2005 increased 67% to $13,920,000 from $8,340,000 in the comparable period in the prior fiscal year and increased as a percentage of sales from 25.8% to 35.4%. The increase over the same period in the prior year is primarily due to increased headcount and related expenses primarily attributable to the acquisitions of XEL and Larscom. Selling, general and administrative expenses for the three- and nine- months ended April 1, 2005 includes a total of $118,000 and $594,000, respectively, related to charges associated with acquisitions, consisting of compensation charges for retention bonuses, restricted stock awards, and other direct acquisition related expenses. Based on our review of spending levels, we expect overall selling, general and administrative expenses for the fourth quarter of fiscal 2005 to decrease due to lower headcount and spending targets.

Amortization of Acquired Intangible Assets. Amortization of acquired intangible assets for the three- and nine- months ended April 1, 2005 totaled $645,000 and $1,901,000, respectively, as compared to $265,000 and $713,000 for the comparable periods of the prior fiscal year.

Impairment Charge Related to Goodwill. During the three months ended October 1, 2004, we completed an interim test for the impairment of goodwill and determined that the carrying value was impaired. Therefore, we recorded an impairment charge related to goodwill in the amount of $19,984,000. (See Note 6 to Notes to the Condensed Consolidated Financial Statements)

Restructuring Charges. During the three months ended October 1, 2004, we announced plans to consolidate our engineering functions into two locations and to consolidate certain Larscom manufacturing and administrative functions in Newark, California to our Madison, Alabama facility. These restructuring activities, along with restructuring activities announced in prior quarters, are described in more detail in Note 9 to Notes to the Condensed Consolidated Financial Statements. We recorded net charges (credits) related to restructuring activities for the three- and nine-month periods ended April 1, 2005 totaling $(42,000) and $692,000, respectively. The restructuring charge in the three months ended April 1, 2005 was reduced by $42,000 for a reduction in the restructuring accrual assumed in the Larscom consolidation to adjust severance and related costs for changes in the employment status of certain employees. These restructuring activities were substantially completed during the quarter ended December 31, 2004.

Interest and Other Income, Net. Interest and other income, net increased 185% to $624,000 for the three months ended April 1, 2005 from $219,000 and increased 57% to $995,000 for the nine months ended April 1, 2005 from $635,000 in the comparable period in the prior fiscal year due to (i) the change in fair value of warrants issued in connection with the senior convertible notes, which resulted in other income during the quarter of $528,000, (ii) offset by lower interest income on lower average investment balances during the period. Rental income, net of expenses, is included in interest and other income, net and totaled $135,000 and $406,000 in the three- and nine-month periods ended April 1, 2005 and April 2, 2004, respectively.

Interest Expense. Interest expense increased 27% to $188,000 for the three months ended April; 1, 2005 from $148,000 and increased 94% to $428,000 for the nine months ended April 1, 2005 from $221,000 in the same period in the prior fiscal year as a result of (i) interest on the convertible notes issued in connection with the acquisition of XEL in February 2004, (ii) interest paid on borrowings under our RBC line of credit from April 2004 through March 2005, which was terminated on March 21, 2005, and (iii) total interest charges related to the $10,000,000 in senior convertible notes issued on March 21, 2005.

Provision for Income Taxes. No tax provision or tax benefits were recognized for the three- or nine-month periods ended April 1, 2005 or April 2, 2004, due to the valuation allowance provided against the net change in deferred tax assets. During fiscal 2001, we established a full valuation allowance against our deferred tax assets due to the net operating loss carry forwards from prior years and the operating losses incurred in fiscal 2001.

Net Income (Loss). Net loss for the three months ended April 1, 2005 was $2,574,000 compared to $1,388,000 for the three months ended April 2, 2004. Net loss for the nine months ended April 1, 2005 was $29,204,000 compared to net income of $512,000 for the nine months ended April 2, 2004. The changes between the periods are a result of the above factors, primarily due to the impairment charge related to goodwill, the increase in selling, general and administrative expenses, the increase in amortization of acquired intangible assets and the decrease in the gross margin percentage between the periods. Net loss as a percentage of sales for the three months ended April 1, 2005 was (18.6)%, compared to (10.2)% for the three months ended April 2, 2004. Net loss as a percentage of sales for the nine months ended April 1, 2005 was (74.2)%, compared to net income as a percentage of sales of 1.6% for the nine months ended April 2, 2004.

LIQUIDITY AND CAPITAL RESOURCES

On April 1, 2005, our principal source of liquidity included $4,881,000 of unrestricted cash and cash equivalents.

Cash Flows

During the nine months ended April 1, 2005, cash used in operating activities was $8,106,000 compared to cash provided by operating activities of $3,010,000 for the nine months ended April 2, 2004. Net cash used in operating activities in the current period was primarily due to (i) the net loss before depreciation and amortization, amortization of deferred compensation and impairment charge related to goodwill, which totaled $5,694,000 and (ii) the net change of other assets and liabilities, which totaled $1,764,000. The increase of accounts receivable between the beginning and end of the period includes receivables contributed by Larscom. However, the change in accounts receivable for the current period provided cash of $295,000 in the nine months ended April 1, 2005 compared to $3,094,000 used in the comparable period in the prior fiscal year. The increase in inventories was again the result of inventory acquired in the Larscom acquisition. Otherwise, inventory provided $1,776,000 of cash in the nine months ended April 1, 2005 compared to cash provided in the same period last year of $318,000. Accounts payable and accrued expenses used $5,076,000 of cash in the nine months ended April 1, 2005 compared to providing cash of $2,947,000 in the comparable period in the prior fiscal year. The changes in accounts payable and accrued expenses for the nine months ended April 1, 2005 and the comparable prior year period were due to the timing of inventory purchases and the resulting payments to vendors, restructuring reserves, the impact of the Larscom acquisition and the increased sales volume in the current year.

Cash provided by investing activities was $2,980,000 for the nine months ended April 1, 2005 compared to cash used in investing activities of $9,119,000 for the nine months ended April 2, 2004. The funds provided in investing activities during the nine months ended April 1, 2005 are the results of net cash acquired in the Larscom acquisition of $5,292,000 offset by cash expenses relating to the acquisition of $1,300,000, current year payments related to the NetEngine and Miniplex product line acquisitions totaling $709,000, and capital expenditures of $303,000. Funds used in investing activities during the nine months ended April 2, 2004 are a result of payments related to the NetEngine and Miniplex product line acquisitions of $1,181,000, the XEL acquisition of $7,612,000, capital expenditures of $540,000 and the purchase of short-term investments of $26,000, offset by proceeds from the repayment of notes receivable of $240,000.

Cash provided by financing activities was $6,566,000 for the nine months ended April 1, 2005 and $483,000 for the nine months ended April 2, 2004. Funds provided by financing activities during the nine months ended April 1, 2005 resulted from borrowings under our line of credit and issuance of convertible notes, net of cash expenses, totaling $10,447,000 and proceeds from the issuance of common stock under our stock plans of $196,000, offset by payments on long-term debt, capital lease obligations and payoff of the line of credit with RBC totaling $3,883,000 and the purchase of treasury shares totaling $194,000 related to tax withholdings on restricted stock awards that vested during the period. Proceeds from the issuance of common stock under our stock plans provided $1,031,000 of cash and payments on long-term debt and capital lease obligations used cash of $548,000 for the nine months ended April 2, 2004.

Senior Convertible Notes

In March 2005, we entered into a securities purchase agreement for the private placement of up to $15,000,000 of senior convertible notes to six institutional investors. We issued an initial $10,000,000 of senior convertible notes, which can be converted into common stock at an initial price of $3.01 per share. The conversion price of the senior convertible notes will be subject to weighted average anti-dilution adjustments. The senior convertible notes may not be converted into more than 20% of the number of shares or voting power of our common stock outstanding as of the closing of the financing until such conversion or exercise has been approved by our stockholders. As of April 1, 2005, a total of $10,000,000 in face value of senior convertible notes was outstanding. These senior convertible notes are recorded in the condensed consolidated balance sheet at April 1, 2005, at the discounted amount of $7,176,000. As provided in the securities purchase agreement, we used $3,500,000 of the proceeds from these senior convertible notes to repay and terminate the line of credit with RBC.

issued thereunder and an increase in our authorized capital of at least 10,000,000 shares of common stock, we will be required to make at least 50% of interest and installment payments made after such date in cash. If, as of the end of each fiscal quarter during the period in which the senior convertible notes are outstanding, we fail to maintain certain minimum working capital requirements, the holders of the senior convertible notes may require us to make an additional installment payment under the senior convertible notes which shall be, at the option of each holder, such holder’s pro rata portion of one of the following: (1) the difference between (A) the unpaid principal, interest and any late charges then remaining under the senior convertible notes and (B) 60% of our working capital amount, as determined in accordance with the terms of the senior convertible notes, (2) $2,000,000 or (3) such lesser amount if reduced in accordance with the terms of the senior convertible notes. Substantially all of our assets are pledged as collateral for amounts outstanding under the senior convertible notes.

At April 1, 2005, “tested working capital”, as defined in the senior convertible notes, was $8,244,000. If we fail to maintain tested working capital of at least $8,000,000 at the end of each fiscal quarter in which amounts are outstanding under the senior convertible notes, the holders of the senior convertible notes may require us to make an additional special installment payment under these notes as described above.

Convertible Promissory Notes

In February 2004, we issued two convertible promissory notes totaling $10,480,000 in connection with our acquisition of XEL Communications, Inc. In May 2004, the holder of the $10,000,000 convertible promissory note converted $7,250,000 of the outstanding principal amount of the note into 1,361,758 shares of our common stock. These convertible promissory notes earn interest at a rate of 7% per annum and mature February 5, 2006. The holders may convert the note in whole or in increments of at least $1,000,000 into our common stock at a conversion price of $5.324 per share. As of April 1, 2005, the amount outstanding under the convertible promissory notes totaled $2,880,000.

Line of Credit

As noted above, the line of credit with RBC was repaid and the loan and security agreement terminated on March 21, 2005 in connection with the issuance of the senior convertible notes. The interest on outstanding borrowings under this line was at a rate of 250 basis points over the 30-day London inter-bank offered rate. All of our assets, other than the property subject to lease and restricted cash, were pledged as collateral securing amounts outstanding under this line.

Mortgaged Property Held for Sale

The final balloon payment of approximately $3,065,000 is due on February 1, 2006 on a note secured by our facility leased to The Boeing Company located at 950 Explorer Boulevard in Huntsville, Alabama. We continue to seek a buyer for this facility, which represents a potential source of additional cash that may be used to partially fund our commitments. We may not, however, be able to complete a sale of the property on a timely basis or on favorable terms to us.

Liquidity Generally

In connection with our acquisition of the Miniplex product line, we agreed to purchase the seller’s Miniplex related inventories totaling approximately $2,100,000 on the earlier of the date used by us or December 31, 2004. The remaining purchase commitment of $776,000 is included in inventories and accounts payable on the consolidated balance sheet as of April 1, 2005.

We believe that our cash and cash equivalents, cash flow from operations, and anticipated proceeds from the sale of the facility located at 950 Explorer Boulevard, Huntsville, Alabama will be sufficient to fund our operations through the next twelve months. However, if the facility is not sold or is sold for substantially less than the appraised value, we will need other sources of credit or financing in early calendar 2006 to repay amounts due in February 2006 under the convertible promissory notes and note payable on real estate and to provide working capital. If additional credit or other financing is not available as needed or on terms acceptable to us, we may seek to renegotiate certain of our contractual obligations.

ACQUISITION OF LARSCOM INCORPORATED

On July 28, 2004, we completed our acquisition of Larscom and issued approximately 5,948,652 shares of our Common Stock for all the outstanding stock of Larscom. Additionally, we assumed all outstanding stock options and warrants of Larscom. Larscom manufactures and markets high-speed network-access products for telecommunication service providers and corporate enterprise users. This acquisition reflects our strategy to pursue revenue growth, and brings a complementary customer base and product synergies

The acquisition was recorded under the purchase method of accounting in the first quarter of fiscal 2005, and the purchase price was allocated based on the fair value of the assets acquired and liabilities assumed. The goodwill recorded as a result of the acquisition will not be amortized but will be included in our annual review of goodwill for impairment. A summary of the total purchase consideration is as follows:

Value of common stock issued	$	26,043
Value of options and warrants assumed		516
Direct transactions costs		1,300

Total purchase consideration	$	27,859

CRITICAL ACCOUNTING POLICIES

Our financial statements and accompanying notes are prepared in accordance with generally accepted accounting principles in the United States of America. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses. We base our estimates and judgments on historical experience and on various other factors that are believed to be reasonable under the circumstances. Due to the inherent uncertainty involved in making estimates, actual results reported in future periods might be based upon amounts that differ from those estimates. The following represent what we believe are among the critical accounting policies most affected by significant management estimates and judgments:

Accounting for Acquisitions: We account for acquisitions as a purchase in accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 141, Business Combinations. As such, we report all acquired tangible and intangible assets and liabilities at fair value. We recognize the fair value of the purchased intangible assets as operating expenses over the estimated useful life of each separate intangible asset. We recognize the fair value associated with any in-process technology as an operating expense in the period an acquisition is consummated. We value any employee stock options assumed as part of the acquisition using the Black-Scholes valuation model. The value of assumed vested options and the value of assumed unvested options in excess of the intrinsic value of such unvested options are included as part of the purchase price consideration. We report the intrinsic value of any unvested options as deferred compensation and record it as an operating expense over the remaining vesting period of the options. We value our stock issued as part of the consideration using the 5-day average price surrounding the date the acquisition was announced.

Impairment of Long-Lived Assets and Goodwill. We assess the impairment of long-lived assets whenever events or changes in circumstances indicate that the carrying value may not be recoverable under the guidance prescribed by SFAS No. 144. Our long-lived assets include, but are not limited to, the property held for lease located at 950 Explorer Boulevard in Huntsville, Alabama, related furniture and equipment, software licenses, and intangible assets related to acquisitions.

We assess the impairment of goodwill at least annually or whenever events or changes in circumstances indicate that the carrying value may not be recoverable under the guidance prescribed by SFAS No. 142. Due to circumstances that occurred during the first quarter of fiscal 2005, we completed a test for impairment of goodwill. These circumstances include the loss of product revenues from a significant customer, the low level of liquidity noted in the going concern opinion issued late in the quarter on our fiscal 2004 consolidated financial statements and the low market price of our common stock following the end of the first quarter. Based on this review, we determined that the carrying value of our goodwill was impaired and recorded an impairment charge related to goodwill of $19,984,000. The impairment charge was based on a projected discounted cash flow model using a discount rate commensurate with the risk inherent in our current business model.

Prior to the first quarter of fiscal 2005, we utilized a fair value model that compared our carrying value of our equity to our market capitalization calculated by multiplying our outstanding shares by our current share price disregarding anomalies in share price that it deemed were temporary in nature. Due to the changes in facts and circumstances caused by the loss of product revenues from a significant customer, the significant volatility in our share price from the end of our 2004 fiscal year through the filing of our Quarterly Report on Form 10-Q for the first quarter of fiscal 2005, and our low level of liquidity, we evaluated the results of multiple fair value models and all available data points and concluded that the fair value calculated from a projected discounted cash flow model is a better indication of our fair value, as that term is contemplated in SFAS 142, Goodwill and Other Intangibles, than the market capitalization model used historically.

Inventories. We value inventory at the lower of cost or market. Cost is computed using standard cost, which approximates actual cost on a first-in, first-out basis. Inventory quantities on hand are reviewed on a quarterly basis and a provision for excess and obsolete inventory is recorded based primarily on our estimated forecast of product demand for the next twelve months. Management’s estimates of future product demand may prove to be inaccurate, in which case we may increase or decrease the provision required for excess and obsolete inventory in future periods. During the first three quarters of fiscal 2005, we recorded additional inventory reserves related to excess inventories, primarily due to our assumption that Nortel may not purchase additional AS2000 inventory on hand and a change in the product mix we experienced regarding the forecast for future sales of products acquired in the Larscom acquisition. Inventory reserves totaled $8,426,000 and $3,316,000 as of April 1, 2005 and July 2, 2004, respectively.

Revenue Recognition. We recognize a sale when persuasive evidence of an arrangement exists, the product has been delivered or services have been performed, the price to the purchaser is fixed or determinable, and collection of the resulting receivable is reasonably assured. A reserve for future product returns is established at the time of the sale based on historical return rates and return policies, including stock rotation for sales to distributors that stock our products. The reserve for future product returns was $560,000 and $313,000 as of April 1, 2005 and July 2, 2004, respectively. Service revenue earned from providing maintenance, installation, training or other miscellaneous services is recognized when those services are provided to the customer, if there is persuasive evidence of an arrangement, the fee is fixed and determinable and collection of the receivable is reasonably assured.

Warranty Provision. We record a warranty provision at the time of the sale based on our best estimate of the amounts necessary to settle future claims on products sold. While we believe that our warranty reserve is adequate and that the judgment applied is appropriate, actual product failure rates, material usage or other rework costs could differ from our estimates, which could result in revisions to our warranty liability that totaled $2,127,000 and $1,192,000 as of April 1, 2005 and July 2, 2004, respectively.

Allowance for Doubtful Accounts. We estimate losses resulting from the inability of our customers to make payments for amounts billed. The collectibility of outstanding invoices is continually assessed. Assumptions are made regarding the customer’s ability and intent to pay, and are based on historical trends, general economic conditions and current customer data. Should our actual experience with respect to collections differ from these assessments, there could be adjustments to our allowance for doubtful accounts, which totaled $1,300,000 and $536,000 as of April 1, 2005 and July 2, 2004, respectively.

Restructuring Reserves. Restructuring reserves are based on estimates of the salary and benefit obligations to terminated employees, amounts necessary to write off assets no longer utilized by us and for contractual payments we expect to continue to make for property no longer in use. Although we do not anticipate significant changes, the actual costs may differ from these estimates. Restructuring reserves totaled $1,136,000 and $390,000 as of April 1, 2005 and July 2, 2004, respectively.

Deferred Tax Assets. We have provided a full valuation reserve related to our deferred tax assets. In the future, if sufficient evidence of our ability to generate sufficient future taxable income in certain tax jurisdictions becomes apparent, we may be required to reduce our valuation allowances, resulting in income tax benefits in our consolidated statement of operations. Management evaluates the realizability of the deferred tax assets and assesses the need for the valuation allowance each quarter. The valuation allowance related to our deferred tax assets was $16,783,000 as of July 2, 2004.

Factors Affecting Future Results

As described by the following factors, past financial performance should not be considered to be a reliable indicator of future performance, and investors should not use historical trends to anticipate results or trends in future periods.

This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements using terminology such as “may”, “will”, “expects”, “plans”, “anticipates”, “estimates”, “potential”, or “continue”, or the negative thereof or other comparable terminology regarding beliefs, plans, expectations or intentions regarding the future. Forward-looking statements include statements regarding: the adequacy of our liquidity and capital resources for the next twelve months; the potential need to obtain credit or other financing or to renegotiate contractual obligations; the sale of our facility at 950 Explorer Boulevard in Huntsville, Alabama; satisfaction of future financial obligations, including the senior convertible notes, convertible promissory notes, and note payable on real estate; growth of our market segments; improvement in gross margins; selling, general and administrative expenses; research and development expenditures; total budgeted capital expenditures; anticipated decline in sales of legacy products; engineering consolidation plans; payment of lease obligations by our subtenants; and the impact of recently issued accounting pronouncements. These forward-looking statements involve risks and uncertainties, and it is important to note that our actual results could differ materially from those in such forward-looking statements. Among the factors that could cause actual results to differ materially are the factors detailed below and in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q, as well as the other factors set forth in Item 2 hereof. All forward-looking statements and risk factors included in this document are made as of the date hereof, based on information available to us as of the date hereof, and we assume no obligation to update any forward-looking statement or risk factor. The risk factors described herein should be read in conjunction with the risk factors more fully discussed in our Annual Report on Form 10-K and Quarterly Reports on Form 10-Q.

•	Our Indebtedness and Debt Service Obligations May Adversely Affect Our Cash Flow. Should we be unable to satisfy our interest and installment payment obligations under our outstanding convertible notes by the payment of shares of common stock, we will be required to pay those obligations in cash. If we are unable to generate sufficient cash to meet these obligations, we may have to restructure or severally limit our operations. Our indebtedness could have significant additional negative consequences, including, but not limited to: (i) requiring the dedication of a substantial portion of the our expected cash flow from operations to service the indebtedness, thereby reducing the amount of expected cash flow available for other purposes, including capital expenditures, (ii) increasing our vulnerability to general adverse economic and industry conditions, (iii) limiting our ability to obtain additional financing, (v) limiting our flexibility to plan for, or react to, changes in its business and the industry in which it competes, and (vi) placing us at a possible competitive disadvantage to competitors with less debt obligations and competitors that have better access to capital resources.

•	Issuance of the Shares of Common Stock Upon Conversion or Repayment of Senior Convertible Notes, Payment of Interest, and Exercise of Warrants Will Dilute The Ownership Interest of Existing Stockholders and Could Adversely Affect The Market Price of Our Common Stock. In connection with the securities purchase agreement, we may issue shares of common stock to the investors (i) upon conversion of some or all of the senior convertible notes (including notes issuable upon exercise of the additional investment rights), (ii) in satisfaction of our installment obligations under the notes, (iii) in satisfaction of our interest obligations under the notes, and (iv) upon exercise of the warrants. Any of these issuances will dilute the ownership interests of existing stockholders. Any sales in the public market of this common stock could adversely affect prevailing market prices of the common stock. In addition, the existence of these notes and warrants may encourage short selling by market participants.

•	The Senior Convertible Notes Provide That Upon The Occurrence of Various Events of Default and Change of Control Transactions, The Holders Would Be Entitled To Require Us To Redeem The Notes For Cash, Which Could Leave Us With Little or No Working Capital for Operations or Capital Expenditures. The senior convertible notes allow the holders to require redemption of the notes upon the occurrence of various events of default, such as the termination of

	trading of our common stock on the Nasdaq National Market, or specified change of control transactions. In such a situation, we may be required to redeem all or part of the notes, including any accrued interest and penalties, within 5 business days after receipt of a demand for such redemption. Some of the events of default include matters over which we may have some, little or no control. If an event of default or a change of control occurs, we may be unable to pay the full redemption price in cash. Even if we were able to pay the redemption price in cash, any such redemption could leave us with little or no working capital for our business. We have not established a sinking fund for payment of our obligations under the notes, nor do we anticipate doing so.

•	If We Cannot Obtain The Required Stockholder Approval To Issue Common Stock in Satisfaction of Our Interest and Installment Obligations Under The Senior Convertible Notes, We Must Satisfy at Least 50% of These Obligations In Cash. After November 21, 2005, stockholder approval will be required for us to make certain interest and installment payments under the senior convertible notes with shares of common stock. In the event that stockholder approval is not obtained by this date, we will be required to make at least 50% of such interest and installment payments in cash. Any such payments could leave us with insufficient working capital for our business.

•	The Senior Convertible Notes Are Secured by Substantially All of Our Assets. The investors in our private placement received a security interest in and a lien on substantially all of our assets, including our existing and future accounts receivable, cash, general intangibles (including intellectual property) and equipment. As a result of this security interest and lien, if we fail to meet our payment or other obligations under the notes, the investors would be entitled to foreclose on and liquidate substantially all of our assets. Under those circumstances, we may not have sufficient funds to service our day-to-day operational needs. Any foreclosure by the investors in the private placement would have a material adverse effect on our financial condition.

•	If Tested Working Capital Falls Below Certain Defined Levels, We May Be Required To Make Additional Payments To The Holders Of The Senior Convertible Notes. We may be required to make additional payments under the senior convertible notes if, as of the end of each fiscal quarter during the period in which the senior convertible notes are outstanding, we fail to maintain certain minimum working capital requirements. In that event, we must provide notice of the working capital deficiency to the noteholders on the date of our quarterly results announcement. For a period of seven business days after our notice to the noteholders, each holder may provide us a notice requiring us to pay such holder’s pro rata portion of one of the following: (1) the difference between (A) the unpaid principal, interest and any late charges then remaining under the senior convertible notes and (B) 60% of our working capital amount, as determined in accordance with the terms of the senior convertible notes, (2) $2,000,000 or (3) such lesser amount if reduced in accordance with the terms of the senior convertible notes. Our payment of these additional amounts may be in cash and/or common stock pursuant to similar terms as the payment of regular installment amounts. Any requirement that we make any such payments in cash could leave us with insufficient working capital for our business.

•	Liquidity in General and Need for Additional Financing. We may need other sources of financing or credit to repay amounts due in February 2006 under the convertible promissory notes and note payable on real estate and to provide working capital. To the extent our results of operations do not substantially meet our operating plan, or the facility located at 950 Explorer Boulevard, Huntsville, Alabama is not sold or is sold substantially below its appraised value, or additional working capital is needed to support growth, credit or other financing may be needed in greater amounts or earlier than otherwise. If additional funds are raised through the issuance of equity securities, the percentage of equity ownership of our existing stockholders will be reduced. If additional funds are raised through the issuance of debt securities, we may incur significant interest charges, and these securities would have rights, preferences and privileges senior to holders of common stock. The terms of these securities could also impose restrictions on our operations. Additional credit or other financing may not be available when needed or on terms favorable to us or at all.

•	Independent Registered Public Accounting Firm’s Report Includes a “Going Concern” Explanatory Paragraph. Our independent registered public accounting firm included in its report on our consolidated financial statements for the fiscal year ended July 2, 2004, a going concern explanatory paragraph, which states that we have uncertain revenue streams and a low level of liquidity that raise substantial doubt about our ability to continue as a going concern. Our ability to continue as a going concern is dependent upon our ability to obtain adequate financing and achieve a level of revenues and cash flow adequate to support our capital and operating requirements.

•	Evolving Regulation of Corporate Governance and Public Disclosure May Result in Additional Expenses and Continuing Uncertainty. Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and Nasdaq National Market rules are creating uncertainty for public companies. We continually evaluate and monitor developments with respect to new and proposed rules and cannot predict or estimate the amount of the additional costs we may incur or the timing of such costs. These new or changed laws, regulations and standards are subject to varying interpretations, in many cases due to their lack of specificity, and as a result, their application in practice may evolve over time as new guidance is provided by regulatory and governing bodies. This could result in continuing uncertainty regarding compliance matters and higher costs necessitated by ongoing revisions to disclosure and governance practices. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we have invested resources to comply with evolving laws, regulations and standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities. If our efforts to comply with new or changed laws, regulations and standards differ from the activities intended by regulatory or governing bodies due to ambiguities related to practice, regulatory authorities may initiate legal proceedings against us and we may be harmed.

•	When We Adopt FAS 123R Related to the Accounting for Employee Stock Option and Employee Stock Purchase Plans Using a Fair-Value Method, Our Results from Operations and Earnings Per Share Will Be Reduced Significantly. The Financial Accounting Standards Board recently issued SFAS No. 123R “Share-Based Payment” (“FAS 123R”). FAS 123R requires companies to measure all stock-based compensation awards using a fair-value method and record such expense in their consolidated financial statements. FAS 123R is effective beginning our first quarter of fiscal 2006. We are currently assessing the impact of FAS 123R on our stock-based compensation programs; however, we expect to record significant stock-based compensation expense that will reduce our net income (loss) and earnings per share. When we are required to treat all stock-based compensation as an expense, we may change both our cash and stock-based compensation practices.

•	Dependence on Legacy and Recently Introduced Products and New Product Development. In prior years, the majority of sales have been provided by our legacy products, primarily the AS2000 product line. We have planned for some time for the eventual decline in sales of legacy products. Sales of the AS2000 have significantly declined in fiscal 2005 and are expected to further decline in the future. While we believe we have positioned Verilink to offset the loss of legacy sales over the long-term, reduced legacy sales will impact our results of operations in the near-term, and sales of new products will often be at lower margins than legacy sales. Our future results of operations are dependent on market acceptance of existing and future applications for our existing products and new products in development.

•	Risks Associated With Acquisitions, Potential Acquisitions and Joint Ventures. One element of our strategy is to consider acquisition prospects and joint venture opportunities. Acquisitions of this nature by us could result in potentially dilutive issuance of equity securities, use of cash, the incurring of debt and the assumption of contingent liabilities, significant demands on management attention, and/or business risks associated with integrating other businesses into us, any of which could have a material adverse effect on our business and operating results and/or the price of our common stock.

•	Customer Concentration. A small number of customers have historically accounted for a majority of our sales, with a single customer’s orders for legacy products accounting for a majority of sales in many fiscal quarters. There can be no assurance that our current customers will continue to place orders with us, that orders by existing customers will continue at the levels of previous periods, or that we will be able to obtain orders from new customers.

•	Dependence on Key Personnel. Our future success will depend to a large extent on the continued contributions of our executive officers and key management, sales, marketing and technical personnel. In the second quarter of fiscal 2005, we implemented a temporary salary reduction program to conserve cash together with special equity incentive grants. Our current financial condition and salary reductions may make it more difficult to attract and retain key personnel.

•	Dependence on Key Suppliers and Component Availability. The loss of a key supplier, loss of a contract manufacturer, an increase in required lead times, adverse change in payment practices or other terms and conditions, an increase in prices of component parts, interruptions in the supply of any components, our inability or our third party sub-contractor to procure components from alternative sources at acceptable prices and within a reasonable time, could have a material adverse effect upon our business, financial condition and results of operations.

•	Potential Volatility of Stock Price. The trading price of our Common Stock has been and may continue to be subject to wide fluctuations in response to quarter-to-quarter variations in operating results, announcements of technological innovations or new products by us or our competitors, developments with respect to patents or proprietary rights, general conditions in the telecommunication network access and equipment industries, changes in earnings estimates by analysts, or other events or factors.

•	Competition. The market for telecommunications network access equipment addressed by our product families can be characterized as highly competitive, with intensive price pressure. Many of our current and potential competitors have substantially greater technical, financial, manufacturing and marketing resources than us, and many have long-established relationships with network service providers.

•	Rapid Technological Change. The network access and telecommunications equipment markets are characterized by rapidly changing technologies and frequent new product introductions. Our business, financial condition and results of operations would be materially adversely affected if we were to be unsuccessful, or to incur significant delays in developing and introducing new products or enhancements.

•	Compliance with Regulations and Evolving Industry Standards. The market for our products is characterized by the need to meet a significant number of communications regulations and standards, some of which are evolving as new technologies are deployed. The failure of our products to comply, or delays in compliance, with the various existing and evolving industry standards could delay introduction of our products.

•	Risks Associated With Entry into International Markets. Historically, we have little experience in International markets, but are expanding sales of our products outside of North America and expect to grow certain international markets, which will require significant management attention and financial resources. Conducting business outside of North America is subject to certain risks, including longer payment cycles, higher costs, unexpected changes in regulatory requirements and tariffs, difficulties in staffing and managing foreign operations, greater difficulty in receivables collection and potentially adverse tax consequences.

•	Risk of Third Party Claims of Infringement; Limited Protection of Intellectual Property. The network access and telecommunications equipment industries are characterized by the existence of a large number of patents and frequent litigation based on allegations of patent infringement. In the event of a successful claim against us and our failure to develop or license a substitute technology, our business, financial condition and results of operations could be materially adversely affected. We rely upon a combination of statutory and contractual restrictions to establish and protect proprietary rights in our products and technologies. There can be no assurance that these statutory and contractual arrangements will deter misappropriation of our technologies or discourage independent third-party development of similar technologies.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

We are subject to interest rate risks on the long-term debt secured by our property located at 950 Explorer Boulevard, Huntsville, Alabama. If market interest rates were to increase immediately and uniformly by 10% from levels as of April 1, 2005, the additional interest expense would not be material. We believe that the effect, if any, of reasonably possible near-term changes in interest rates on our financial position, results of operations and cash flows would not be material.

Item 4. Controls and Procedures.

(a) Evaluation of disclosure controls and procedures. Based on their evaluation as of April 1, 2005, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

(b) Changes in internal control over financial reporting. There were no significant changes in our internal control over financial reporting identified in management’s evaluation during the period covered by this Quarterly Report on Form 10-Q that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 6. Exhibits

(a)	Exhibits Index:

	Exhibit Number	Description of Exhibit

	31.1	Certification of Chief Executive Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934

	31.2	Certification of Chief Financial Officer pursuant to Rule 13a-14(a) or Rule 15d-14(a) under the Securities Exchange Act of 1934

	32.1	Certification of Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

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.

	VERILINK CORPORATION

May 10, 2005	By:	/s/ TIMOTHY R. ANDERSON

		Timothy R. Anderson
		Vice President and Chief Financial Officer
		(Principal Financial and Accounting Officer)