##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549-0001
   FORM 10-Q (MARK ONE) þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934For the three months ended March 31, 2005ORo
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
 Commission File Number 000-23699   VISUAL NETWORKS, INC.  Delaware
    
    52-1837515(State or other jurisdiction of
    
    (I.R.S. Employer Identification No.)incorporation or organization)2092 Gaither Road, Rockville, MD
    
    20850-4013(Address of principal executive offices)
    
    (Zip code)
 Registrants telephone number, including area code: (301) 296-2300   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 the filing requirements for the past 90 days. Yes þ No o Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes þ No o The number of outstanding shares of the Registrants Common Stock, par value $.01 per share,
as of May 4, 2005 was 34,535,341 shares.




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VISUAL NETWORKS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED
March 31, 2005 TABLE OF CONTENTS PART I. FINANCIAL INFORMATIONItem 1. Financial Statements:Consolidated Balance Sheets  December 31, 2004 and March 31, 2005
    
    
    3Consolidated Statements of Operations  Three months ended
March 31, 2004 and 2005
    
    
    4Consolidated Statements of Cash Flows  Three months ended
March 31, 2004 and 2005
    
    
    5Notes to Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    15Item 3. Qualitative and Quantitative Disclosures about Market Risk
    
    
    29Item 4. Controls and Procedures
    
    
    30PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    31Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    31Item 3. Defaults Upon Senior Securities
    
    
    32Item 4. Submission of Matters to a Vote of Security Holders
    
    
    32Item 5. Other Information
    
    
    32Item 6. Exhibits
    
    
    32Signatures
    
    
    33
 2




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PART I: FINANCIAL INFORMATION Item 1. Financial Statements VISUAL NETWORKS, INC. CONSOLIDATED BALANCE SHEETS
(In thousands, except share data) December 31,
    
    March 31,2004
    
    
    2005(Unaudited)AssetsAssetsCurrent assets:Cash and cash equivalents
    
    $
    11,317
    
    
    $
    10,799Accounts receivable, net of allowance of $399 and $303, respectively
    
    
    9,335
    
    
    
    6,356Inventory, net
    
    
    3,822
    
    
    
    4,024Other current assets
    
    
    940
    
    
    
    1,075Total current assets
    
    
    25,414
    
    
    
    22,254Property and equipment, net
    
    
    2,001
    
    
    
    1,877Total assets
    
    $
    27,415
    
    
    $
    24,131Liabilities and Stockholders EquityCurrent liabilities:Accounts payable and accrued expenses
    
    $
    9,341
    
    
    $
    7,868Deferred revenue
    
    
    3,388
    
    
    
    2,924Convertible debentures, net of unamortized debt discount of $837 and
$669, respectively
    
    
    8,163
    
    
    
    8,331Total current liabilities
    
    
    20,892
    
    
    
    19,123Commitments and contingencies (Note 4)Stockholders equity:Common stock, $.01 par value; 200,000,000 shares authorized,
33,981,840 and 34,492,396 shares issued and outstanding,
respectively
    
    
    340
    
    
    
    344Additional paid-in capital
    
    
    477,343
    
    
    
    478,486Warrants
    
    
    2,087
    
    
    
    2,087Deferred compensation
    
    
    (143
    )
    
    
    (110
    )Accumulated deficit
    
    
    (473,104
    )
    
    
    (475,799
    )Total stockholders equity
    
    
    6,523
    
    
    
    5,008Total liabilities and stockholders equity
    
    $
    27,415
    
    
    $
    24,131
 The accompanying notes are an integral part of these consolidated financial statements. 3




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VISUAL NETWORKS, INC. CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
(In thousands, except per share data) For theThree Months EndedMarch 31,2004
    
    
    2005Revenue:Hardware
    
    $
    9,530
    
    
    $
    4,508Software
    
    
    152
    
    
    
    3,129Support and services
    
    
    2,159
    
    
    
    1,927Total revenue
    
    
    11,841
    
    
    
    9,564Cost of revenue:Product
    
    
    3,038
    
    
    
    3,185Support and services
    
    
    285
    
    
    
    214Total cost of revenue
    
    
    3,323
    
    
    
    3,399Gross profit
    
    
    8,518
    
    
    
    6,165Operating expenses:Research and development
    
    
    2,670
    
    
    
    2,547Sales and marketing
    
    
    3,804
    
    
    
    3,667General and administrative
    
    
    2,174
    
    
    
    2,372Total operating expenses
    
    
    8,648
    
    
    
    8,586Loss from operations
    
    
    (130
    )
    
    
    (2,421
    )Interest income
    
    
    27
    
    
    
    55Interest expense
    
    
    (387
    )
    
    
    (329
    )Net loss
    
    $
    (490
    )
    
    $
    (2,695
    )Basic and diluted loss per share
    
    $
    (0.01
    )
    
    $
    (0.08
    )Basic and diluted weighted-average shares outstanding
    
    
    33,011
    
    
    
    34,241
 The accompanying notes are an integral part of these consolidated financial statements. 4




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VISUAL NETWORKS, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(In thousands) For theThree Months EndedMarch 31,2004
    
    
    2005Cash Flows From Operating Activities:Net loss
    
    $
    (490
    )
    
    $
    (2,695
    )Adjustments to reconcile net loss to net cash
used in operating activities:Depreciation
    
    
    422
    
    

    
    336Non-cash interest expense
    
    
    254
    
    
    
    218Bad debt expense (recovery)
    
    
    76
    
    
    
    (96
    )Non-cash compensation expense
    
    
    88
    
    
    
    33Provision for excess and obsolete inventory
    
    
    390
    
    
    
    117Changes in assets and liabilities:Accounts receivable
    
    
    (356
    )
    
    
    3,075Inventory
    
    
    133
    
    
    
    (319
    )Other assets
    
    
    (412
    )
    
    
    (186
    )Accounts payable and accrued expenses
    
    
    (748
    )
    
    
    (1,471
    )Deferred revenue
    
    
    617
    
    
    
    (464
    )Net cash used in operating activities
    
    
    (26
    )
    
    
    (1,452
    )Cash Flows From Investing Activities:Sales of short-term investments
    
    
    1,002
    
    
    
    Expenditures for property and equipment
    
    
    (258
    )
    
    
    (212
    )Net cash provided by (used in) investing activities
    
    
    744
    
    
    
    (212
    )Cash Flows From Financing Activities:Exercise of stock options and issuance of common
stock under the employee stock purchase plan
    
    
    358
    
    
    
    1,146Net cash provided by financing activities
    
    
    358
    
    
    
    1,146Net increase (decrease) in cash and cash equivalents
    
    
    1,076
    
    
    
    (518
    )Cash and cash equivalents, beginning of period
    
    
    15,671
    
    
    
    11,317Cash and cash equivalents, end of period
    
    
    16,747
    
    
    $
    10,799Supplemental Cash Flow Information:Cash paid for interest
    
    $
    132
    
    
    $
    111
 The accompanying notes are an integral part of these consolidated financial statements. 5




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VISUAL NETWORKS, INC. NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 2005
(Unaudited) 1. Nature of Operations and Significant Accounting Policies: Visual Networks, Inc. (the Company) is a leading provider of network and application
performance management solutions. Risk Factors The Company is subject to certain risks and uncertainties which could affect its ability to
continue as a going concern. These risks and uncertainties include, but are not limited to: the
timing and nature of repayment of the outstanding debentures (see Note 3), expenses and an
uncertain outcome associated with the Paradyne litigation (see Note 4), customer migration to
UpTime Select, availability of hardware components, reliance on two subcontract manufacturers,
limited access to the line of credit (see Note 2), substantial dilution if the Company is required
to raise capital through the sale of equity, the Companys history of losses and the size of its
accumulated deficit, uncertainty about future profitability, dependence on a limited number of
major service provider customers for the majority of its revenue, long sales cycles, rapidly
changing technology, competition from several market segments, potential errors in the Companys
products or services, and anti-takeover protections that may delay or prevent a change in control
that could benefit stockholders. The future success of the Company will depend upon its ability to generate adequate cash for
operating and capital needs. The Company is relying on its existing balance of cash and cash
equivalents ($10.8 million at March 31, 2005), together with future sales and the collection of
related accounts receivable to meet its future operating cash requirements. If cash provided by
these sources is inadequate and the line of credit is not available or is not sufficient to fund
future operations, the Company will be required to further reduce its expenditures for operations
or to seek additional capital through other means that may include additional borrowings, the sale
of equity securities or the sale of assets. Under those circumstances, there can be no assurances
that additional capital would be available under reasonable or acceptable terms, particularly in
light of the Companys history of losses and accumulated deficit position. Financial Statement Presentation The preparation of financial statements in conformity with generally accepted accounting
principles in the United States of America requires management to make estimates and assumptions
that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of revenue and
expenses during the reporting periods. Actual results could differ from those estimates. These financial statements are unaudited and have been prepared by the Company pursuant to the
rules and regulations of the Securities and Exchange Commission regarding interim financial
reporting. Accordingly, they do not include all of the information and footnotes required by
generally accepted accounting principles for complete financial statements, and it is suggested
that these financial statements be read in conjunction with the financial statements, and notes
thereto, included in the Companys Annual Report on Form 10-K for the year ended December 31, 2004.
In the opinion of management, the comparative financial statements for the periods presented herein
include all adjustments that are normal and recurring which are necessary for a fair presentation
of results for the interim periods. The results of operations for the three months ended March 31,
2005 6




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are not necessarily indicative of the results that will be achieved for the year ended
December 31, 2005. Principles of Consolidation The consolidated financial statements include the accounts of Visual Networks, Inc. and its
wholly owned subsidiaries. All intercompany account balances and transactions have been eliminated
in consolidation. Inventory Inventory, stated at the lower of cost or market, with costs determined on the first-in,
first-out basis, consists of the following (in thousands): December 31,
    
    
    March 31,2004
    
    
    2005(Unaudited)Raw materials
    
    $
    1,138
    
    
    $
    1,274Work-in-progress
    
    
    
    
    
    
    73Finished goods
    
    
    4,902
    
    
    
    4,698Inventory, gross
    
    $
    6,040
    
    
    
    6,045Reserve for excess and
obsolete inventory
    
    
    (2,218
    )
    
    
    (2,021
    )Inventory, net
    
    $
    3,822
    
    
    $
    4,024
 The Company writes down its inventory to the lower of cost or market value based on
assumptions about future demand and market conditions. The following table summarizes the activity
in the Companys reserve for excess and obsolete inventory during the three months ended March 31,
2004 and 2005 (in thousands): 2004
    
    
    2005Balance, beginning of period
    
    $
    3,638
    
    
    $
    2,218Provision for excess and obsolete inventory
    
    
    390
    
    
    
    117Sale of previously reserved inventory
    
    
    (66
    )
    
    
    (186
    )Actual inventory scrapped
    
    
    (369
    )
    
    
    (128
    )Balance, end of period
    
    $
    3,593
    
    
    $
    2,021
 Accounts Payable and Accrued Expenses Accounts payable and accrued expenses consist of the following (in thousands): December 31,
    
    
    March 31,2004
    
    
    2005(Unaudited)Accounts payable
    
    $
    1,940
    
    
    $
    1,808Accrued compensation
    
    
    2,108
    
    
    
    1,034Accrued warranty
    
    
    384
    
    
    
    384Deferred rent
    
    
    434
    
    
    
    429Other accrued expenses
    
    
    4,475
    
    
    
    4,213Total
    
    $
    9,341
    
    
    $
    7,868
 Revenue Recognition The Companys products and services include hardware, software, professional services and
technical support. The Company sells its products directly to service providers, through resellers
(indirect channels) and, occasionally, to end-user customers. Professional services and technical
support revenues are included in support and services revenue in the accompanying consolidated
statements of operations. The Company recognizes revenue from software licensing in accordance with
the American Institute of Certified 7




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Public Accountants Statement of Position (SOP) No. 97-2, Software Revenue Recognition. The Company recognizes revenue from the sale of hardware in
accordance with SEC Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition, which
summarizes existing accounting literature and requires that four criteria be met prior to the recognition
of revenue. The Companys accounting policies regarding revenue recognition comply with the
following criteria: 1) persuasive evidence of an arrangement exists; 2) delivery has occurred; 3)
the fee is fixed or determinable; and 4) collectibility is probable. To determine if a fee is fixed or determinable, the Company evaluates rights of return,
customer acceptance rights (if applicable), extended payment terms (if any), and multiple-element
arrangements of products and services to determine the impact on revenue recognition. Certain reseller agreements include stock rotation rights. If an agreement provides for a
right of return, the Company recognizes revenue when the right has expired or a specific end-user
customer has been identified by the reseller as evidenced with a letter of acceptance or
documentation provided by the reseller. If the Company has sufficient historical information to
allow it to make an estimate of returns in accordance with the Financial Accounting Standards Board
(FASB) Statement of Financial Accounting Standards (SFAS) No. 48, Revenue Recognition When
Right of Return Exists, the Company defers revenue based on an estimate for such returns. If an
agreement calls for a right of return and sufficient historical return information does not exist,
the Company defers revenue for the entire agreement until the right of return expires. If an agreement provides for evaluation or customer acceptance, the Company recognizes revenue
upon the completion of the evaluation process, acceptance of the product by the customer and
completion of all other criteria. The Companys normal payment terms are between 30 and 45 days. Any payment terms beyond those
normal terms are considered to be extended payment terms. The Company examines the specific facts
and circumstances of all sales arrangements with extended payment terms to make a determination of
whether the sales price is fixed or determinable and whether collectibility is probable. Payment
terms are not tied to milestone deliverables or customer acceptance. The evaluation of the impact
on revenue recognition, if any, includes the Companys history with the particular customer and the
specific facts of each arrangement. Historically, the Company has not provided any concessions or
written off any accounts receivable related to extended payment term arrangements. Many of the Companys sales are multiple element arrangements and include hardware, software,
and technical support. The Companys software sales may include professional services for
installation, but these services are not a significant source of revenue. The Company does not
perform professional services to customize the product. Training is also offered but is not a
significant source of revenue. Revenue from multiple element arrangements is recognized using the
residual method, as prescribed in SOP No. 98-9, Modification of SOP 97-2, Software Revenue
Recognition, With Respect to Certain Transactions, whereby the fair value of any undelivered
elements, such as customer support and services, is deferred and any residual value is allocated to
the software and recognized as revenue upon delivery provided all other basic revenue recognition
criteria have been met. The fair value of any undelivered elements, typically professional
services, technical support and training, have been determined based on the Companys specific
objective evidence of fair value, which is based on the price that the Company charges customers
when the element is sold separately. Should the Company introduce new multiple element arrangements
into its sales channels, a determination of the objective evidence of the fair value of the
undelivered elements will be necessary and an inability to provide objective evidence could impact
the Companys ability to recognize revenue. The Company recognizes revenue from services, such as installation and training, when the
services are performed. The Companys technical support contracts require it to provide technical
support and unspecified software updates to customers on a when and if available basis. The Company
recognizes customer support revenue, including support 8




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revenue that is bundled with product sales, ratably over the term of the contract period, which typically ranges from one to three years. The Company has agreements with certain service providers that provide price protection in the event that more favorable prices and terms are granted to any other
similarly situated customer. When required, reserves for estimated price protection credits are
established by the Company concurrently with the recognition of revenue. The Company monitors the
factors that influence the pricing of its products and service provider inventory levels and makes
adjustments to these reserves when management believes that actual price protection credits may
differ from established estimates. Accrued Warranty Costs The Company warrants Visual UpTime hardware for a period of up to five years. The Company
warrants Visual UpTime Selecthardware for one year. The Company estimates its warranty obligation
at the end of each period and records changes in the liability to cost of revenue in the respective
period. Such estimates are based in part on historical warranty cost experience and expectations of
future claims under warranty. The following is a summary of the change in the Companys accrued warranty costs during the
three months ended March 31, 2004 and 2005 (in thousands): 2004
    
    
    2005Balance, beginning of period
    
    $
    425
    
    
    $
    384Provisions for warranty
    
    
    22
    
    
    
    7Settlements made
    
    
    (19
    )
    
    
    (7
    )Balance, end of period
    
    $
    428
    
    
    $
    384
 Segment Reporting and Significant Customers SFAS No. 131, Disclosure about Segments of an Enterprise and Related Information,
establishes standards for the way that public business enterprises report information about
operating segments in annual financial statements and requires that these enterprises report
selected information about operating segments in interim financial reports. Management has
concluded that the Companys operations occur in one segment only based upon the information used
by management in evaluating the performance of the business. SFAS No. 131 also establishes
standards for related disclosures about products and services, geographic areas and major
customers. The revenue and assets of the Companys foreign subsidiaries were less than 10% of
consolidated revenue and assets. Regarding significant customers, four customers individually
represented 39%, 16%, 15% and 10% of revenue for the three months ended March 31, 2004. Three
customers individually represented 33%, 16%, and 13% of revenue for the three months ended March
31, 2005. The Companys major service provider customers include, among others: AT&T, BellSouth,
Earthlink, Equant, MCI, SBC, Sprint and Verizon. The revenue generated from sales to service
providers was 90% and 80% of the Companys consolidated revenue for the three months ended March
31, 2004 and 2005, respectively. The agreements with the Companys significant customers do not
obligate these customers to make any minimum purchases from the Company. Accounting for Stock Options During the three months ended March 31, 2004, the Company granted non-qualified stock options
to purchase 465,213 shares of common stock to employees under the 1997 Non-Qualified Stock Option
Plan at an issuance price that was less than the fair market value of the Companys common stock
and recorded deferred compensation of $330,000. The deferred compensation is being amortized over
the vesting period of the stock options, which is 20% as of the grant date and the remaining
portion over 24 equal monthly installments after the grant date. As a result, the Company recorded
deferred compensation expense of approximately $88,000 and $33,000 during the three months ended 9




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March 31, 2004 and 2005, respectively. The Company accounts for its stock-based compensation under the recognition and measurement
principles of Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations. APB Opinion No. 25 provides that compensation expense relative to a companys employee stock options is measured based on
the intrinsic value of the stock options at the measurement date. If compensation expense had been determined based on the fair value of the options at the
grant dates consistent with the method of accounting under SFAS No. 123, Accounting for Certain
Transactions Involving Stock Compensation, as amended by SFAS No. 148, Accounting for Stock-Based
Compensation-Transition and Disclosure, the Companys net loss per share would have changed to the
pro forma amounts for the three months ended March 31, 2004 and 2005 as indicated below (in
thousands, except per share amounts): 2004
    
    
    2005Net loss, as reported
    
    $
    (490
    )
    
    $
    (2,695
    )Add: Stock-based employee compensation expense
included in reported net loss
    
    
    88
    
    
    
    33Deduct: Total stock-based employee compensation
expense determined under fair value based method for all
awards
    
    
    (1,331
    )
    
    
    (411
    )Pro forma net loss
    
    $
    (1,733
    )
    
    $
    (3,073
    )Loss per share:Basic and diluted: as reported
    
    $
    (0.01
    )
    
    $
    (0.08
    )Basic and diluted: pro forma
    
    $
    (0.05
    )
    
    $
    (0.09
    )
 The fair value of each option is estimated on the date of grant using the Black-Scholes
option-pricing model with the following assumptions used for grants during the three months ended
March 31, 2004 and 2005: 2004
    
    
    2005Dividend yield
    
    None
    
    NoneExpected volatility
    
    
    67
    %
    
    
    87
    %Risk-free interest rate
    
    
    3.41
    %
    
    
    3.65
    %Expected term (in years)
    
    
    5
    
    
    
    5
 The weighted-average grant-date fair value per share of options granted was $1.53 and
$3.28 during the three months ended March 31, 2004 and 2005, respectively. Basic and Diluted Earnings (Loss) Per Share SFAS No. 128, Earnings Per Share, requires dual presentation of basic and diluted income
(loss) per share. Basic income (loss) per share includes no dilution and is computed by dividing
net income (loss) available to common stockholders by the weighted-average number of common shares
outstanding for the period. Diluted income (loss) per share includes the potential dilution that could occur if securities
or other contracts to issue common stock were exercised or converted into common stock. Options and warrants to purchase 10,039,837 and 8,834,233 shares of common stock outstanding
at March 31, 2004 and 2005, respectively, were not included in the computation of diluted loss per
share as their effect would be anti-dilutive. The effect of the convertible debentures issued in
March 2002 (see Note 3) that were convertible into 2,986,093 and 2,559,509 shares of common stock
at March 31, 2004 and 2005, 10




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respectively, has not been included in the computation of diluted income per share for the three months ended March 31, 2004 and 2005 as their effect would be
anti-dilutive. Restructuring Charges SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities,
addresses financial accounting and reporting for costs associated with exit or disposal activities
and requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred and establishes that fair value is the
objective for initial measurement of the liability. On April 6, 2005, the Company announced a plan to realign its cost structure with an adjusted
business model which reflects procurement changes within the Companys channels and the related
effect on the Companys anticipated future revenue stream. The reorganization included a workforce reduction
of approximately 25 employees throughout the Company. In connection with this plan, the Company
will record a restructuring charge in the second quarter of 2005 that will consist primarily of
employee termination costs, including severance and other benefits. New Accounting Pronouncements In December 2004, the FASB issued SFAS No. 123
(revised 2004), Share-Based Payment (SFAS No. 123R), which replaces SFAS No. 123 and supersedes
APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123R requires all
share-based payments to employees, including grants of employee stock options, to be recognized in
the financial statements based on their fair values. The pro forma disclosures previously permitted
under SFAS No. 123 no longer will be an alternative to financial statement recognition. In
accordance with a recently-issued Securities and Exchange Commission rule, companies will be
allowed to implement SFAS No. 123R as of the beginning of the first interim or annual period that
begins after June 15, 2005. The company currently expects that it will adopt SFAS No. 123R on
January 1, 2006. Under SFAS No. 123R, the company 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 permitted transition methods include either
retrospective or prospective adoption. Under the retrospective method, prior periods may be
restated either as of the beginning of the year of adoption or for all periods presented. The
prospective method requires that compensation expense be recorded for all unvested stock options at
the beginning of the first quarter of adoption of SFAS No. 123R, while the retrospective methods
would record compensation expense for all unvested stock options beginning with the first period
presented. The company is currently evaluating the requirements of SFAS No. 123R and expects that
adoption of SFAS No. 123R will have a material impact on the companys consolidated financial
position and consolidated results of operations. The company has not yet determined the method of
adoption or the effect of adopting SFAS No. 123R, and it has not determined whether the adoption
will result in amounts that are similar to the current pro forma disclosures under SFAS No. 123. 2. Line of Credit: In July 2004, the Company and Silicon Valley Bank (SVB) entered into a $6.0 million line of
credit agreement. Borrowings under the line of credit are available once the convertible debentures
(see Note 3) have been fully repaid. The Company entered into this line of credit agreement
primarily to provide additional capital in the event that the debenture holders exercise their
right to require the Company to repay the Debentures in full prior to their due date, and the
Company makes all or a substantial portion of the repayment in cash. No amounts were outstanding
under this line of credit at December 31, 2004 or March 31, 2005. The line of credit agreement with SVB expires on July 22, 2005, at which time any outstanding
advances under the agreement are immediately payable. Under the agreement, the Company would be
able to borrow amounts not exceeding the lesser of (i) $6.0 million 11




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or (ii) a borrowing base which is 80% of eligible accounts receivable as defined in the agreement. Interest would be payable
monthly at the greater of (i) SVBs prime rate plus 1.25% per annum or (ii) 5.25% per annum.
Collateral under the agreement consists of the Companys right, title and interest in and to
substantially all of its assets other than its intellectual property. Once the convertible
debentures are repaid, the agreement subjects the Company to certain financial and other covenants.  3.
    Convertible Debentures: In March 2002, the Company issued senior secured convertible debentures (the Debentures) in
the aggregate amount of $10.5 million in a private placement transaction. The Debentures, now due
on demand but no later than March 25, 2006, are payable in cash or common stock at the Companys
option provided certain conditions are satisfied, which are currently satisfied. The Debentures
bear interest at an annual rate of 5% payable quarterly in cash or common stock, at the Companys
option, provided certain conditions are satisfied, which are currently satisfied. To date, all
quarterly interest payments under the Debentures have been made in cash. The conversion price of
the Debentures will adjust if the Company issues additional equity or instruments convertible into
equity at a price that is less than the then-effective conversion price of the Debentures. The
Company has the right to require the holders to convert their Debenture holdings into common stock
if the weighted average price of the Companys common stock exceeds 175% of the conversion price
for 20 consecutive trading days. The remaining Debentures totaling $9.0 million are convertible
currently into 2,559,509 shares of common stock at March 31, 2005 at a price of $3.5163 per share. In connection with the issuance of the Debentures, the Company issued to the holders warrants
to purchase 828,861 shares of its common stock at an exercise price of $4.2755 per share. If the
Company issues additional equity or instruments convertible into equity at a lower price than the
then-effective exercise price, the exercise price would be adjusted downward on a weighted average
basis. The warrants expire on March 25, 2007. The holders of the Debentures also received the right to purchase shares of to-be-created
Series A preferred stock and equity participation rights, which have now expired unexercised. The
Debenture holders were also granted registration rights. Because the Company did not meet the 2003 earnings target set forth in the Debentures, the
Debenture holders may require that the Company repay, in whole or in part, at any time and from
time to time, the outstanding principal amount of their Debenture holdings, plus accrued interest.
Accordingly, the Debentures, net of unamortized debt discount, are classified as current
liabilities in the accompanying consolidated balance sheets. Under the terms of the Debentures: (i)
a Debenture holder electing payment for some portion of the Debentures must notify the Company of
this election; (ii) the Company, in turn, must notify the Debenture holder of the manner in which
it intends to repay that Debenture holder (either all cash or all common stock); and (iii) the
notifying Debenture holder then notifies the Company of the amount to be paid in that form at that
time. The redemption of each Debenture may be made in cash or common stock, at the Companys
option, provided certain conditions are satisfied, which the Company currently satisfies. During
2004, the Company elected to repay $1.5 million of the outstanding Debentures in cash subsequent to
a repayment request from a Debenture holder. In addition, under the terms of the Debentures, a number of events could trigger the Debenture
holders right to force early repayment of 115% of the outstanding principal plus accrued and
unpaid interest owed under the Debentures. Events constituting a triggering event include:  
    default by the Company on other indebtedness or obligations under any other
debenture, mortgage, credit agreement or other facility, indenture agreement, factoring
agreement or other instrument under which there may be issued, or by which there may be
secured or evidenced, any indebtedness for borrowed money or money due under any long
term leasing or factoring arrangement in an amount 12




---



##### 



exceeding $500,000;
    failure by the Company to have its common stock listed on an eligible market;
    failure to have an effective registration statement covering the shares of common
stock issuable upon conversion of the Debentures or exercise of the warrants;
    bankruptcy of the Company;
    engagement by the Company in certain change in control, sale
of assets or redemption transactions; and
    certain other failures by the Company to perform obligations under the Debenture
agreement and/or the related agreements. The aggregate amounts of the Debentures are reflected in the accompanying balance sheets as a
current liability of $9.0 million, net of unamortized debt discount of $0.8 million and $0.7
million, as of December 31, 2004 and March 31, 2005, respectively. The net amount reflects the fair
market value on the date of issuance after allocating the proceeds to the various additional
components of the debt. $2.1 million in proceeds from the Debentures was allocated to the value of
the warrants. Approximately $0.3 million in proceeds from the Debentures was allocated to
additional paid-in capital to recognize the value of the rights of the holders to purchase shares
of preferred stock, which expired in 2002, as determined by an appraisal. On the date of issuance
of the Debentures, the effective conversion price of the Debentures was less than the quoted market
price of the Companys common stock. Accordingly, $0.7 million in proceeds from the Debentures was
allocated to additional paid-in capital to recognize this beneficial conversion feature. The
discount on the Debentures resulting from the allocation of proceeds to the value of the warrants,
preferred stock rights and beneficial conversion feature is being amortized as a charge to interest
expense over the four-year period until the Debentures become due in March 2006. Debt issuance
costs of $0.9 million were deferred and are being amortized over the term of the Debentures.
Because of the early repayment of $1.5 million of the outstanding Debentures in June 2004, a
proportionate amount of the unamortized discount and debt issuance costs associated with this $1.5
million repayment was expensed. The related charge of $0.3 million was included in other expense in
the statement of operations for the three months ended June 30, 2004. Subsequent to March 31, 2005, the Company received a definitive, binding notice from a
Debenture holder requesting the repayment in full of an aggregate of $3.0 million of the Companys
$9.0 million outstanding Debentures. The Company plans to pay in cash such amounts and any interest
due thereon no later than May 23, 2005, pursuant to the terms of the Debentures. 4. Commitments and Contingencies: In January 2004, the Company received notice that a lawsuit had been filed by Paradyne
Networks, Inc. (Paradyne Networks) of Largo, Florida, in the United States District Court for the
Middle District of Florida, Tampa Division (the Florida Court) against the Company, seeking
damages, and injunctive and declaratory relief, for the Companys alleged infringement of patents
owned by Paradyne Corporation (Paradyne), a subsidiary of Paradyne Networks. On May 14, 2004, the Florida Court granted the Companys motion to dismiss the case for lack
of subject matter jurisdiction and denied Paradyne Networks motion for leave to amend its
complaint and its motion for preliminary injunction. Paradyne Networks did not appeal the decision. In a related matter, one of the Companys subsidiaries, Visual Networks Operations, Inc.
(VNO), filed a lawsuit in United States District Court for the District of Maryland, Southern
Division (the Maryland Court), against Paradyne. This lawsuit requests declaratory judgment that
Visual UpTime and Visual IP InSight do not infringe 13




---



##### 



upon certain patents owned by Paradyne and that those patents are invalid and unenforceable and alleges that Paradynes assertion of its patents
against the Company is baseless and has been for the sole purpose of obtaining an unfair
competitive advantage, and that Paradyne has infringed upon certain patents owned by the Company.
Paradyne filed counterclaims alleging that VNO infringes upon its patents, mirroring the Florida
claims. On October 15, 2004, Paradyne filed amended counterclaims, adding allegations of willful
patent infringement and unenforceability of two of the Companys patents in the lawsuit. The
Maryland lawsuit presently is in the fact discovery phase of the litigation. The Maryland Court
conducted a hearing concerning patent claim construction on February 7, 2005 and has not yet ruled
on that hearing. The fact discovery phase of the Maryland lawsuit was recently completed and a
trial date has not yet been scheduled. Pursuant to the terms of a confidential settlement agreement entered into on March 11, 2005
between Paradyne and VNO, Paradyne has agreed to dismiss its patent claims against Visual IP
Insight. VNO has agreed to dismiss its unfair competition claim against Paradyne with respect to
Visual IP Insight and pay royalties to Paradyne through the remaining life of Paradynes patents in
the amount of 1% of revenue recognized by the Company from the licensing and distribution of Visual
IP Insight. On March 15, 2005, the Maryland Court approved a Stipulation of Partial Dismissal
submitted by the parties concerning the patent claims against Visual IP InSight and the unfair
competition claim against Paradyne. Despite the Companys belief that its products do not infringe upon Paradynes patents and
that Paradynes claims are frivolous and without merit, the defense of these claims is expensive
and may divert the Companys resources from other activities, which could have a material adverse
effect on the Companys business and results of operations. At this point in the litigation, the
likelihood of any outcome cannot be determined and the adverse effect, if any, cannot be estimated. The Company is periodically a party to disputes arising from normal business activities
including various employee-related matters. In the opinion of management, resolution of these
various employee-related matters will not have a material adverse effect upon the Companys
financial position or future operating results. Litigation costs are expensed as incurred. 14




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##### 



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations This Managements Discussion and Analysis of Financial Condition and Results of Operations may
contain forward-looking statements that involve risks and uncertainties. Under the section Risk
Factors, we have described what we believe to be some of the major risks related to these
forward-looking statements, as well as the general outlook for our business. Investors should
review these risk factors and the rest of this Quarterly Report on Form 10-Q in combination with
the more detailed description of our business in our 2004 Annual Report on Form 10-K for a more
complete understanding of the risks associated with an investment in our common stock. Overview We design and sell products that allow enterprises and network service providers to measure
the performance of their networks and identify and monitor software applications that operate on
the network. Our solutions correlate traditional network performance information with application
data collected from various network locations to provide the network manager with the ability to
understand the health and performance of the network and the applications traversing that network -
the primary objective is to reduce or avoid expensive network and application downtime. Currently,
we offer two product lines to our customers, Visual UpTime and Visual IP InSight. Most of our
revenue is derived from the sales and licenses of Visual UpTime products, which sales represented
93% and 96% of our total revenue for the three months ended March 31, 2004 and 2005, respectively. We market our products to enterprises, service providers and Value Added Resellers (VARs).
We sell our products through indirect sales channels. An enterprise which desires our technology
generally acquires the solution from either a service provider or a VAR. Many of our service
provider channel partners have incorporated our products into their value added service offerings
to enterprises. Consequently, an enterprise can choose either to utilize our solutions as part of
a monthly service offered by the service providers or to purchase our solution. Enterprises that
want to host their own systems may procure our solutions through a service provider resale program
or through a VAR. Pursuant to agreements with us, our service provider customers purchase our
products for internal use, for resale to their customers or to serve as the basis for a value-added
service offering. Our major service provider customers include, among others: AT&T, BellSouth,
Earthlink, Equant, MCI, SBC, Sprint and Verizon. The revenue generated from sales to service
providers was 90% and 80% of the Companys consolidated revenue for the three months ended March
31, 2004 and 2005, respectively. We intend to increase our efforts in the VAR channel in order to
grow this distribution channel. We also intend to expand our international focus, and, during the
fourth quarter of 2004, announced the opening of our European headquarters outside of London,
England. With the appointment of Lawrence Barker as our President and Chief Executive Officer in April
2003, we began to restructure our senior management team and launch new corporate initiatives. The
most important initiative involved fundamental changes to our flagship product, Visual UpTime, and
which ultimately became known as Visual UpTime Select. Visual UpTime Selectbuilt upon the strength
of the original Visual UpTime product. Where Visual UpTime was focused solely on performance
monitoring of private data networks and was sold only one way  fully loaded as a highly
intelligent and capable hardware appliance, Visual UpTime Selectrepresents a modular software
approach with expanded capabilities beyond traditional performance monitoring. Visual UpTime Select
is a re-architected solution which unbundled our hardware from our software and aggregated our
software into its logical modules with the idea of delivering additional capabilities over time
through the release of additional software modules. Now customers can purchase only those aspects
of our solutions they require while preserving the capability of adding incremental features at a
later date. This modular approach has made our solutions more economical for new customers when
compared to the original Visual UpTime. Also, this modular approach allows us to sell additional
capabilities to our installed base of 15




---



##### 



end user customers, a capability not possible under the
original Visual UpTime. We
announced Visual UpTime Selectin October 2003, began shipping in April 2004 and by year end
2004 had essentially completed the transition from Visual UpTime to Visual UpTime Select. We expect to release one to two new Visual UpTime Selectsoftware modules each year for the
next few years. Our first new Visual UpTime Selectmodules were released during the third quarter
2004  SelectAppFlows and SelectAppSummary. These two modules are focused on application
discovery, monitoring and reporting. Our next module will significantly enhance our existing voice
over internet protocol (VoIP) capabilities and is scheduled to be released during the second
quarter of 2005. We reported net income of $3.4 million in 2002 and incurred net losses in 2003 and in the
first two quarters of 2004. However, we returned to profitability in the third and fourth quarters
of 2004. We reported net income of $15,000 in 2004, compared with a net loss of $4.3 million in
2003. These improvements can be attributed to both initial success in launching Visual UpTime
Selectand improvement in the economy. However, during the first three months of 2005, we reported
a net loss of $2.7 million. In 2005, Uptime and UpTime Selecthardware sales to our service
provider channels decreased primarily due to tighter inventory control and reduced capital
expenditures resulting from pending consolidation in the telecommunications industry. Sales cycles
have increased to accommodate for the increased response time to customer requests from our service
provider channels and the extended approval process within the service provider channel. There can
be no assurance that we will return to profitability. On April 6, 2005, we announced a plan to realign our cost structure with an adjusted business
model which reflects the changes within our channels and the anticipated future revenue stream.
The reorganization included a workforce reduction of approximately 25 employees throughout the
Company. In connection with this plan, we will record a restructuring charge in the second quarter
of 2005 that will consist of employee termination costs, including severance and other benefits. Based on our current cost structure, our ability to generate net income in the future is, in
large part, dependent on our success in achieving quarterly revenue of at least $11.5 million to
$12.0 million, achieving quarterly gross margins of 70% to 75% and maintaining or further reducing
operating expenses. Due to market conditions, competitive pressures, and other factors beyond our
control, there can be no assurances that we will be able to meet these goals. In the event that
the anticipated revenue goals are not met, we may not be profitable and we may be required to
further reduce our cost structure. The market for solutions related to applications delivery infrastructure management is
intensely competitive. Increased competition may result in price reductions, reduced profit
margins, reduced profitability, and the loss of market share, any of which would have a material
adverse effect on our business, financial condition, and results of operations. Current
competitors continue to include, among others, Paradyne, Packeteer, Concord Communications and
NetScout. If we are successful in the applications management marketplace, we may compete more
frequently with significantly larger software companies like IBM, BMC and Computer Associates.
Also, consolidations in our traditional service provider channels continue in 2005 and the impact
of these consolidations on our business is uncertain. We are continuously enhancing Visual UpTime Selectwith new features and capabilities to
expand our value, address new network service requirements, and support new applications. We expect
to package many of these enhancements as additional, optional software modules that will be
separately licensed. To compete successfully, we must be able to deliver our new product offerings
through our channels to enterprise end-users. To assure demand for our products, we intend to
continue to strengthen our direct relationships with enterprise end-user customers and cultivate
mature alternative channels for bringing our products to market. 16




---



##### 



Results of Operations The primary statements of operations components are: Revenue.Our revenue consists of three types: hardware, software, and support and services.
The fees we receive associated with the licensing of our software products are classified as
software revenue. The sale of the hardware component of the Visual UpTime and Visual UpTime Select
platforms, the analysis service element (ASE), is classified as hardware. Visual UpTime sales are
primarily hardware. In contrast, Visual UpTime Selectsales have unbundled hardware and software
components and such sales are classified under hardware and/or software as appropriate. Revenue
associated with the licensing of Visual IP Insight is primarily classified as software. Sales of
technical support, professional services and training for all products are classified as support
and services revenue. Cost of revenue and gross profit.Cost of revenue includes both hardware and software cost of
revenue. Cost of revenue related to software sales has not been significant. Cost of revenue
consists primarily of the direct costs of hardware purchased from contract manufacturing firms,
shipping and warehouse costs, warranty repair costs and overhead expenses related to manufacturing
operations. Support and services cost of revenue primarily consists of outsourced depot repair and
costs associated with the employees who provide technical assistance, training and professional
services. Operating expenses. Research and development expense.Research and development expense consists primarily of
research and development staff compensation, outsourced development, testing services and prototype
materials. Sales and marketing expense.Sales and marketing expense consists primarily of sales and
marketing compensation, commissions, travel and entertainment costs and the costs of trade shows
and other marketing programs. General and administrative expense.General and administrative expense consists primarily of
those costs associated with executive management, finance, accounting, legal, information
technology and other administrative activities. Three months ended March 31, 2004 compared to three months ended March 31, 2005 The following table presents revenue by product line: Three Months EndedMarch 31,2004
    
    
    2005(unaudited, in thousands)UpTime:Visual UpTime
    
    $
    11,056
    
    
    $
    883Visual UpTime Select
    
    
    
    
    
    
    8,338IP InSight
    
    
    728
    
    
    
    338Continuing products
    
    
    11,784
    
    
    
    9,559Royalties
    
    
    57
    
    
    
    5Total revenue
    
    $
    11,841
    
    
    $
    9,564
 The following table presents the hardware, software, and support and services revenue
attributable to customers that individually represented more than 10% of our total revenue for each
period presented: 17




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##### 



Three Months EndedMarch 31,2004
    
    
    2005(unaudited, in thousands)AT&T
    
    $
    1,190
    
    
    $
    3,114Sprint
    
    
    1,828
    
    
    
    1,533SBC
    
    
    4,561
    
    
    
    *MCI
    
    
    1,863
    
    
    
    1,233All other customers (each individually
less than 10%)
    
    
    2,399
    
    
    
    3,684Total revenue
    
    $
    11,841
    
    
    $
    9,564
   *
    
    Less than 10% Revenue, cost of revenue, and gross profit The table below sets forth the changes in total revenue, cost of revenue and gross profit: Three Months EndedMarch 31,(unaudited, in thousands, except percentage data)Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Revenue:Hardware
    
    $
    9,530
    
    
    
    80.5
    %
    
    $
    4,508
    
    
    
    47.1
    %
    
    $
    (5,022
    )
    
    
    (52.7
    )%Software
    
    
    152
    
    
    
    1.3
    
    
    
    3,129
    
    
    
    32.7
    
    
    
    2,977
    
    
    
    1,958.6Support and services
    
    
    2,159
    
    
    
    18.2
    
    
    
    1,927
    
    
    
    20.2
    
    
    
    (232
    )
    
    
    (10.7
    )Total revenue
    
    
    11,841
    
    
    
    100.0
    
    
    
    9,564
    
    
    
    100.0
    
    
    
    (2,277
    )
    
    
    (19.2
    )Cost of
revenue:Product
    
    
    3,038
    
    
    
    25.7
    
    
    
    3,185
    
    
    
    33.3
    
    
    
    147
    
    
    
    4.8Support and services
    
    
    285
    
    
    
    2.4
    
    
    
    214
    
    
    
    2.2
    
    
    
    (71
    )
    
    
    (24.9
    )Total cost of revenue
    
    
    3,323
    
    
    
    28.1
    
    
    
    3,399
    
    
    
    35.5
    
    
    
    76
    
    
    
    2.3Gross profit
    
    $
    8,518
    
    
    
    71.9
    %
    
    $
    6,165
    
    
    
    64.5
    %
    
    $
    (2,353
    )
    
    
    (27.6
    )%
   *
    
    Denotes % of total revenue for the period**
    
    Denotes % change from 2004 to 2005 The table below sets forth the changes in product revenue, product cost of revenue and product
gross profit: Three Months EndedMarch 31,(unaudited, in thousands, except percentage data)2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    Increase
    
    
    %**Product
revenue:Hardware
    
    $
    9,530
    
    
    
    98.4
    %
    
    $
    4,508
    
    
    
    59.0
    %
    
    $
    (5,022
    )
    
    
    (52.7
    )%Software
    
    
    152
    
    
    
    1.6
    
    
    
    3,129
    
    
    
    41.0
    
    
    
    2,977
    
    
    
    1,958.6Total product revenue
    
    
    9,682
    
    
    
    100.0
    
    
    
    7,637
    
    
    
    100.0
    
    
    
    (2,045
    )
    
    
    (21.1
    )Product cost of revenue
    
    
    3,038
    
    
    
    31.4
    
    
    
    3,185
    
    
    
    41.7
    
    
    
    147
    
    
    
    4.8Product gross profit
    
    $
    6,644
    
    
    
    68.6
    %
    
    $
    4,452
    
    
    
    58.3
    %
    
    $
    (2,192
    )
    
    
    (33.0
    )%
   *
    
    Denotes % of product revenue for the period**
    
    Denotes % change from 2004 to 2005 The table below sets forth the changes in service revenue, service cost of revenue and service
gross profit: 18




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##### 



Three Months EndedMarch 31,(unaudited, in thousands, except percentage data)Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Support and
services revenue
    
    
    2,159
    
    
    
    100.0
    
    
    
    1,927
    
    
    
    100.0
    
    
    
    (232
    )
    
    
    (10.7
    )Support and services cost of revenue
    
    
    285
    
    
    
    13.2
    
    
    
    214
    
    
    
    11.1
    
    
    
    (71
    )
    
    
    (24.9
    )Support and services gross profit
    
    $
    1,874
    
    
    
    86.8
    %
    
    $
    1,713
    
    
    
    88.9
    %
    
    $
    (161
    )
    
    
    (8.6
    )%
   *
    
    Denotes % of support and services revenue for the period**
    
    Denotes % change from 2004 to 2005 Revenue Hardware revenuedecreased from period to period due to decreased Uptime and UpTime Select
hardware sales to SBC, Sprint and MCI primarily due to changes in procurement practices and
inventory investment possibly as a result of pending consolidation in the telecommunications
industry. During 2005, sales cycles increased to accommodate increased response time to customer
requests from our service provider channels and the extended approval process within the service
provider channel. Revenue related to Visual UpTime hardware was $9.5 million and $0.9 million
during the first quarter of 2004 and 2005, respectively. No revenue related to Visual UpTime Select
hardware was recorded during the first quarter of 2004 as Visual UpTime Selectwas not available
until April 2004. Revenue related to Visual UpTime Selecthardware was $3.6 million during the
first quarter of 2005. The average price of a Visual UpTime SelectASE is lower than the average price of a Visual
UpTime ASE. This is due to Visual UpTime Selectsunbundled hardware and software components. When
viewed on a comparable basis, the effective average price (hardware plus separately licensed
software) of a Visual UpTime SelectASE approximated the effective average price of a Visual UpTime
ASE. We are unable to predict how future Visual UpTime Selectpricing will compare with historical
Visual UpTime pricing on a comparable basis. We expect that hardware revenue will decrease as a percentage of revenue in the future as we
have largely transitioned to Visual UpTime Select, which has unbundled hardware and software
components. This trend may be particularly true throughout 2005, where the full-year effect of
Visual UpTime Selectsales will be reflected in our operating results. Software revenueincreased from period to period as we have largely transitioned to Visual
UpTime Select, which has unbundled hardware and software components. This trend may be particularly
true throughout 2005, where the full-year effect of Visual UpTime Selectsales will be reflected in
our operating results. Revenue related to Visual UpTime software was $0.2 million during the first
quarter of 2004. No revenue related to Visual UpTime software was recorded during the first quarter
of 2005. Revenue related to Visual UpTime Selectsoftware was $3.0 million during the first quarter
of 2005. No revenue related to Visual UpTime Selectsoftware was recorded during the first quarter
of 2004. Insignificant revenue related to Visual IP Insight software was recorded during the first
quarter of 2004. Revenue related to Visual IP Insight software was $0.1 million during the first
quarter of 2005. Visual IP Insight revenue often fluctuates due to the uncertain timing of orders. Support and services revenuedecreased from period to period due to decreased Visual IP
Insight maintenance revenue of $0.5 million, down from $0.7 million during the first quarter of
2004 to $0.2 million during the first quarter of 2005, due to technical support contracts which
were not renewed. Visual UpTime and Visual UpTime Selectservices were $1.4 million and $1.7
million during the first quarter of 2004 and 2005, respectively. We expect that support and services revenue will follow the same trend as product revenue in
the future. 19




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##### 



Gross profit Gross profitand Gross profit on productsas a percentage of revenue decreased from period to
period as fixed overhead costs remained constant while revenue levels decreased. Operating expenses The table below sets forth the changes in operating expenses: Three Months EndedMarch 31,(unaudited, in thousands, except percentage data)Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Operating
expenses:Research and development
    
    $
    2,670
    
    
    
    22.5
    %
    
    $
    2,547
    
    
    
    26.7
    %
    
    $
    (123
    )
    
    
    (4.6
    )%Sales and marketing
    
    
    3,804
    
    
    
    32.1
    
    
    
    3,667
    
    
    
    38.3
    
    
    
    (137
    )
    
    
    (3.6
    )General and administrative
    
    
    2,174
    
    
    
    18.4
    
    
    
    2,372
    
    
    
    24.8
    
    
    
    198
    
    
    
    9.1Total operating expenses
    
    $
    8,648
    
    
    
    73.0
    %
    
    $
    8,586
    
    
    
    89.8
    %
    
    $
    (62
    )
    
    
    (0.7
    )%
   *
    
    Denotes % of total revenue for the period**
    
    Denotes % change from 2004 to 2005 Research and developmentand Sales and Marketing expensesdecreased from period to period
primarily due to reduced incentive compensation. General and administrative expenseincreased from period to period primarily due to a $0.4
million increase in legal costs arising from the Paradyne litigation and other legal matters offset
by a $0.2 million decrease in incentive compensation costs. Other items The table below sets forth the changes in other items: Three Months EndedMarch 31,(unaudited, in thousands, except percentage data)2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    Increase
    
    
    %**Interest income
    
    $
    27
    
    
    
    0.2
    %
    
    $
    55
    
    
    
    0.6
    %
    
    $
    28
    
    
    
    103.7
    %Interest expense
    
    
    (387
    )
    
    
    (3.3
    )
    
    
    (329
    )
    
    
    (3.4
    )
    
    
    58
    
    
    
    15.0
   *
    
    Denotes % of total revenue for the period**
    
    Denotes % change from 2004 to 2005 Interest expensedecreased from period to period due to reduced interest expense associated
with the lower outstanding Debentures balance, which were $10.5 million and $9.0 million at March
31, 2004 and 2005, respectively. Liquidity and Capital Resources We require substantial working capital to fund our business, particularly to finance
inventories, accounts receivable, research and development activities, operating expenses and
capital expenditures. To date, we have financed our operations and capital expenditures primarily
with the proceeds from our initial public offering (completed in February 1998), cash provided by
operating activities, bank borrowings, and the proceeds from the issuance of the Debentures. Our
future capital requirements will depend on many factors, including the timing and nature of
repayment of the $9.0 million in outstanding Debentures, the rate of future revenue growth, if any,
and the acceptance of our Visual
UpTime Selectproduct suite by our customers. If cash provided by currently available sources
is not sufficient, we will be required to further reduce our expenditures for operations and/or to
seek additional capital through other means that may include additional borrowings and/or the sale
of equity securities or the sale of assets. Our 20




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access to the SVB line of credit, unavailable until
the Debentures are fully repaid, may be limited if we have an insufficient borrowing base or if we
cannot meet the financial and other covenants required under the line of credit agreement. Under
those circumstances, there can be no assurance that additional capital will be available, or
available on terms that are reasonable or acceptable to us, and our business and financial
condition may be materially and adversely affected. Based on our cash balance and our revenue and
expense expectations, we believe that we will have sufficient cash to operate for at least the next
twelve months. On April 6, 2005, we announced a plan to realign our cost structure with an adjusted business
model which reflects procurement changes within our channels and the related effect on our
anticipated future revenue stream. The reorganization included a workforce reduction of
approximately 25 employees throughout the Company. In connection with this plan, we will record a
restructuring charge in the second quarter of 2005 that will consist of employee termination costs,
including severance and other benefits. At March 31, 2005, our principal source of liquidity was our existing balance of cash and cash
equivalents of $10.8 million. Our operating activities consumed $1.5 million in cash and cash equivalents for the three
months ended March 31, 2005. The primary use of cash affecting operating activities was the $2.7
million net loss. Accounts payable decreased $1.5 million primarily due to payments made in 2005
for bonus and commissions earned in 2004 as well as other payments for operations. These uses were
partially offset by the $3.1 million decrease in accounts receivable which was primarily due to
decreased revenue in the quarter. Our financing activities provided cash and cash equivalents of $1.1 million for the three
months ended March 31, 2005 related to the receipt of cash for the exercise of stock options and
issuance of common stock under the employee stock purchase plan. Future minimum payments, assuming no additional early Debenture repayments, at March 31, 2005
under the Debentures and non-cancelable operating leases are as follows (in thousands): Debentures
    
    
    Operating Leases2005
    
    
    338
    
    
    
    1,2322006
    
    
    9,113
    
    
    
    1,1322007
    
    
    
    
    
    
    1,1612008
    
    
    
    
    
    
    1,170Thereafter
    
    
    
    
    
    
    1,181Total minimum payments
    
    
    9,451
    
    
    $
    5,876Interest element of payments
    
    
    (451
    )Present value of future minimum payments
    
    
    9,000Unamortized debt discount
    
    
    (669
    )Total Debentures
    
    $
    8,331
 We have a subtenant occupying a portion of our office space under a sublease that expires
in December 2005. This sublease runs co-terminus with our lease on that office space. Future
minimum lease payments due from the sublessee are $0.2 million as of March 31, 2005. The Debentures, now due on demand but no later than March 2006, were issued in March 2002 in
the aggregate amount of $10.5 million in a private placement transaction (see Note 3 of Notes to
Consolidated Financial Statements). The terms of the Debentures provide for a number of events that
could trigger the debenture holders right to a repayment of 115% of the outstanding principal plus
accrued and unpaid interest. The redemption of each Debenture may be made in cash or common stock,
at our option, provided certain conditions are satisfied, which we currently satisfy. If we choose
to issue common stock to repay the debt, our stockholders could be subject to significant dilution. Subsequent to March 31, 2005, we received a definitive, binding notice from a Debenture holder
requesting the repayment in full of an aggregate of $3.0 million of our 21




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$9.0 million outstanding
Debentures. We plan to pay in cash such amounts and any interest due thereon no later than May 23,
2005, pursuant to the terms of the Debentures. Should we receive any additional Debenture repayment requests, we intend to carefully evaluate
and balance liquidity concerns against dilution considerations and make each determination of
whether to repay in cash or common stock on a case-by-case basis. If we choose to repay a Debenture
holder with shares of our common stock and the per share issuance price of the stock is less than
$3.5163, the conversion price of any outstanding Debentures would be adjusted downward to the
issuance price of such stock. In addition, under the terms of the warrants held by the debenture
holders, an issuance of shares below the exercise price of the warrants would cause the exercise
price to be adjusted on a weighted-average basis. The following table outlines the number of shares into which the outstanding Debentures would
be convertible if we were to issue additional equity (including for repayment of the Debentures) at
the prices specified, as well as the total percent of the outstanding shares of common stock of the
Company that such shares would represent upon conversion, calculated using the number of shares
outstanding as of May 4, 2005: Issuance
    
    
    DebentureDecline
    
    Price
    
    
    Shares(1)
    
    
    % of CompanyNone
    
    $
    3.5163
    
    
    
    2,559,509
    
    
    6.9%25%
    
    $
    2.6372
    
    
    
    3,412,679
    
    
    9.0%50%
    
    $
    1.7582
    
    
    
    5,119,018
    
    
    12.9%75%
    
    $
    0.8791
    
    
    
    10,238,036
    
    
    22.9%
   (1)
    
    These numbers and percentages reflect our repayment in cash of $1.5 million of the Debentures
in June 2004. The warrants are subject to weighted average anti-dilution protection which would
decrease the exercise price and increase the number of shares issuable under the warrants. These
changes would be determined once the total investment amount and price per share of any future
equity issuance were known. In order to provide us with additional capital resources in the event that the Debentures are
repaid in full, we entered into a $6.0 million asset-based line of credit agreement with SVB.
Borrowings under the line of credit would be available only after the Debentures are fully repaid
(see Note 2 of Notes to Consolidated Financial Statements). We are involved in a lawsuit in which we are claiming that (i) our products do not infringe
upon patents owned by a competitor, which patents we are arguing are invalid and unenforceable, and
(ii) the competitor has infringed upon certain patents owned by us. The competitor has filed
counterclaims alleging our infringement of its patents and unenforceability of two of our patents
in the lawsuit. Despite our belief that our products do not infringe upon the competitors patents and that
the competitors claims are frivolous and without merit, the defense of these claims is expensive
and may divert our resources from other activities, which could have a material adverse effect on
our business and results of operations. At this point in the litigation, the likelihood of any
outcome cannot be determined and the adverse effect, if any, cannot be estimated. We have commitments related to inventory purchased by certain suppliers on our behalf. If such
inventory is not used within a specified period of time or we discontinue a product for which the
suppliers have made purchases or we terminate a relationship with the supplier for which we have
set minimum inventory requirements, we are required to purchase the excess inventory from the
suppliers. Additionally, if we cancel a purchase order placed with a supplier, we may be subject to
certain costs and fees. At March 31, 2005, anticipated demand exceeds the supply of inventory. As
such, we do not have a liability recorded at March 31, 2005 for inventory purchase commitments. We do not engage in any off-balance sheet financing arrangements. In particular, we 22




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do not
have any so-called limited purpose entities, which include special purpose entities and structured
finance entities. Critical Accounting Policies and Estimates The preparation of consolidated financial statements requires us to make estimates and
judgments that affect the reported amounts of assets, liabilities, revenues, expenses and related
disclosure of contingent assets and liabilities. Those policies are described in our 2004 Annual
Report on Form 10-K. On an ongoing basis, we re-evaluate our estimates, including those related to
bad debts, inventory, investment, income taxes, warranty obligations, and contingencies and
litigation. We base our estimates on historical experience and on various other assumptions that we
believe to be reasonable under the circumstances. Among other things, these estimates form the
basis for judgments about the carrying values of assets and liabilities that are not readily
apparent from other sources. Actual results may differ from these estimates under different
assumptions or conditions. We consider our critical accounting policies to be the following: Revenue Recognition We recognize revenue from the sale of hardware, the licensing of software and the provision of
support and other services. Our revenue recognition policies follow the American Institute of
Certified Public Accountants Statement of Position (SOP) No. 97-2, Software Revenue Recognition
and SEC Staff Accounting Bulletin (SAB) No. 104, Revenue Recognition, which summarizes existing
accounting literature and requires that four criteria be met prior to the recognition of revenue.
Our accounting policies regarding revenue recognition comply with the following required criteria
(see Note 1 of Notes to Consolidated Financial Statements): 1) persuasive evidence of an
arrangement exists; 2) delivery has occurred; 3) the fee is fixed or determinable; and 4)
collectibility is probable. The third and fourth criteria may require us to make significant
judgments or estimates, including the determination of the fair value of the undelivered elements
of a sale. Historically, the revenue reserves that we have established relating to estimated
returns associated with customer acceptance rights and price protection credits have been adequate.
We have not provided any concessions or written off any accounts receivable relating to extended
payment term arrangements. If we were to use new multiple element arrangements in our future sales
efforts, a determination of the objective evidence of the fair value of the undelivered elements
will be necessary and an inability to provide objective evidence could impact our ability to
recognize revenue. Reserve for Inventory Obsolescence Because of the lead times required to obtain manufactured proprietary hardware, we must
maintain sufficient quantities of inventory for all of our products to meet expected demand. If
actual demand is lower than forecasted, we may not be able to dispose of our inventory at prices
exceeding its cost. In addition, hardware model upgrades may result in excess quantities of
obsolete models. It is our practice to write down the value of excess and obsolete inventory to the
lower of cost or market value based on the number of items that we expect to sell within a one-year
period. We review the adequacy of our inventory reserves based on current quantities of hardware in
stock, historical sales trends, sales forecasts and certain customer demand and make appropriate
inventory valuation adjustments. If future demand is lower than currently estimated, additional
valuation adjustments to our inventory may be required. Historically, we have not been required to
record significant inventory write-offs of amounts in excess of our reserves. Allowance for Doubtful Accounts We grant credit terms without collateral to our customers. Other than in 2002, we have not
experienced any significant credit related losses. During 2002, we wrote off $0.7 million in
accounts receivable from MCI, following MCIs bankruptcy filing, against the allowance for doubtful
accounts. During 2003, we sold those MCI receivables to an unrelated third party and recovered $0.3
million. The accounts receivable balance 23




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reflects an allowance to state the balance at its estimated net realizable value that is based
on assessments of the collectibility of certain problem accounts and a review of historical
write-off trends at the end of each reporting period. If future events occur that negatively impact
our customers, additional accounts receivable write-downs may be required. As our sales expansion
strategies include the identification of alternative North America sales channels and international
sales opportunities, we expect that the allowance for doubtful accounts will increase in the
future. Warranty We provide for the estimated cost of product warranties at the time revenue is recognized. We
utilize extensive product quality programs and processes including the active monitoring and
evaluation of the quality of our component suppliers and contract manufacturers. Our warranty
obligation calculation is based on historical product failure rates and material usage and services
delivery costs incurred in correcting a product failure. Should actual product failure rates,
material usage, or service costs differ from our estimates, revisions to the estimated warranty
liability would be required. Our standard warranty term of one year for Visual UpTime Select
hardware has been reduced from our historical warranty terms. Our warranty obligation should
decrease over time as the warranty terms for older hardware units expire. We account for and
disclose our obligations for warranties in accordance with Financial Accounting Standards Board
(FASB) Interpretation No. 45 (FIN 45), Guarantors Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN 45 requires the
accounting for and disclosure of guarantees and clarifies the requirements of FASB No. 5,
Accounting for Contingencies. Deferred Tax Valuation Allowance We calculate the deferred tax valuation allowance in accordance with the provisions of
Statement of Financial Accounting Standard No. 109, Accounting for Income Taxes (SFAS No. 109)
which requires an assessment of both positive and negative evidence when measuring the need for a
valuation allowance. Recent evidence, such as operating results during recent years, is given more
weight when assessing whether the level of future profitability needed to recognize the deferred
assets will be achieved. Our cumulative loss in the last five years represents sufficient negative
evidence to require a full valuation allowance under the provisions of SFAS No. 109. We intend to
maintain a full valuation allowance until sufficient positive evidence exists to support the
reversal of any portion of the allowance. Risk Factors Investing in our securities involves a high degree of risk. In addition to the other
information contained in this Quarterly Report on Form 10-Q, you should consider the following
factors before investing in our securities. We are highly dependent on sales to telecommunications service providers. Our primary sales and marketing strategy has predominantly revolved around sales to
telecommunications service providers. We expect that a significant portion of future revenue will
be attributable to sales of Visual UpTime Selectto service providers. The loss of any one of our
service provider customers, which together have historically provided a majority of our revenue,
could result in a substantial loss of revenue that could have a material adverse effect on our
business and results of operations. Business combinations, such as the prospective MCI-Verizon and
AT&T-SBC mergers, would represent significant reductions in the number of our service provider
channels. The impact that these combinations may have on our revenue is uncertain. Existing service
provider customers are not easily replaced because of the relatively few participants in that
market. High barriers to entry due to extraordinary capital requirements and the possibility that
existing service providers may merge or fail may further reduce their numbers. Furthermore, the
small number of network service providers means that the reduction, delay or cancellation of orders
or a delay in shipment of our products to any one service provider customer could have a material
adverse effect on our revenue in any 24




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given quarter. Our anticipated dependence on sizable orders from a limited number of service
provider customers will make the relationship between us and each service provider critically
important to our business. Further, because our agreements do not contain minimum purchase
requirements, there can be no assurance of significant business with our service provider customers
on an ongoing basis. With the introduction of Visual UpTime Select, we anticipate that we will see
growth in revenue from our value added reseller channel, although there can be no assurance that
such growth will occur. Our Debenture holders now have the right to demand repayment of any or all of our Debentures
at any time and from time to time. Because we did not meet the financial targets for 2003 under our Debentures, the
Debenture holders may require that we repay any or all of the outstanding principal amount of their
Debentures plus accrued interest at any time and from time to time. The choice of whether to repay
all common stock or all cash is in our absolute discretion provided we meet certain criteria
specified in the Debentures, which we currently meet. If we choose to repay any such demand with
common stock, such issuance would have a dilutive effect on our common stockholders. If the
issuance price of such shares is below the then-current conversion price of the Debentures, the
conversion price of the Debentures is immediately reset to such lower price and the exercise price
of the warrants and the number of shares issuable upon exercise would be adjusted upwards on a
weighted-average basis. If we choose to repay any such demand with cash, and we do not have sufficient cash to both
repay amounts and to fund ongoing operations, we may be required to seek additional capital through
a sale of assets, sale of additional securities or through additional borrowings, none of which may
be available on terms acceptable to us. Our business and financial condition could be materially
and adversely affected. As of the date of this filing, Debentures totaling $4.5 million of the original Debentures
face amount of $10.5 million has been presented for payment prior to the original due date of March
25, 2006. Debentures totaling $1.5 million were presented for payment and paid in the second
quarter of 2004 and Debentures totaling $3.0 million were presented for payment and will be paid in
the second quarter of 2005. The remaining Debentures, totaling $6.0 million, can be presented at
any time. Our access to the SVB line of credit may be limited. Our access to the SVB line of credit, unavailable until the Debentures are fully repaid, may
be limited if we have an insufficient borrowing base or if we cannot meet the financial and other
covenants required by the facility. Under those circumstances, there can be no assurance that
additional capital will be available, or available on terms that are reasonable or acceptable to
us, and our business and financial condition may be materially and adversely affected. Substantial dilution to our common stockholders could result if we are required to raise
additional capital through the sale of equity below certain price thresholds. Debentures outstanding of $9.0 million are convertible into 2,559,509 shares of our common
stock at the rate of $3.5163 per share and the associated warrants are exercisable for 828,861
shares of our common stock at a price of $4.2755 per share. The Debentures contain full ratchet
anti-dilution price protection, meaning that if we issue additional shares of common stock in
connection with a financing or under other circumstances at a price lower than $3.5163 per share,
the Debentures would become convertible into a greater number of shares of common stock than they
are today. Issuances of common stock that do not trigger this anti-dilution protection include:
issuances as part of an acquisition or strategic investment, issuances under our stock incentive
plan or employee stock purchase plan, or issuances as part of a public offering of more than $30.0
million. 25




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The warrants are subject to weighted average anti-dilution protection which would decrease the
exercise price and increase the number of shares issuable under the
warrants. These changes would be determined once the total investment amount and price per
share of any future equity issuance were known. The ongoing patent litigation between us and Paradyne, and any other potential intellectual
property litigation, could have a significant detrimental effect on our business. Despite our belief that our products do not infringe upon Paradynes patents and that
Paradynes claims are frivolous and without merit, the conduct of this litigation is expensive and
may divert our resources from other productive activities, which could have a material adverse
effect on our business and results of operations. At this point in the litigation, the likelihood
of any outcome cannot be determined and the adverse effect of any finding cannot be estimated. Additionally, if others claim that our products infringe upon their intellectual property
rights, whether the claims are valid or not, we may be forced to incur significant litigation
expense, pay damages, delay product shipments, re-engineer our products or acquire licenses to the
claimants intellectual property. We may be unable to develop non-infringing technology or to
obtain licenses on commercially reasonable terms. We expect that these claims may become more
common as the number of products in the network management industry increases and the functionality
of these products further overlaps. If a claimant is successful in a lawsuit arising from such a
claim, it could have a material adverse effect on our business. Adverse publicity related to any
intellectual property litigation also could harm (i) the sale of our products and damage our
competitive position; (ii) the market for our common stock; and (iii) our ability to obtain
additional capital, lines of credit or other borrowings on terms acceptable to us. We rely on two firms for contract manufacturing services and one of these firms has sent us a
notice of termination. We have outsourced the manufacture of our hardware components to two contract manufacturing
firms. We derive a substantial portion of our revenue from the sale of our hardware components. A
contract manufacturer could decide to tighten or eliminate our credit terms due to concerns about
our perceived financial condition or to suspend or cease the shipment of products due to our
failure to meet volume expectations. On March 25, 2005, Visual Networks Operations, Inc. (VNO), a wholly-owned operating
subsidiary, received written notice from Celestica Corporation (Celestica) that Celestica has
exercised its right to terminate the Agreement for Electronic Manufacturing Services dated March 1,
2000, between VNO and Celestica (the Services Agreement). The notice states that the effective
date of termination of the Services Agreement will be October 17, 2005. Pursuant to the Services
Agreement, Celestica has served as our primary manufacturer of electronic products. We are exploring alternative electronic product manufacturers and expect to have a new
manufacturer in place prior to termination of the Services Agreement. Furthermore, Celestica has
indicated that it will manufacture electronic products for us pursuant to the Services Agreement
through September 2005. However, there can be no assurance that an agreement with a new
manufacturer will be reached on acceptable terms prior to termination of the Services Agreement. We
could experience substantial production delays and may be required to pay substantially higher
prices in order to complete delivery of customers orders, having a material adverse effect on our
revenue and gross profit. In addition, we could experience an increase in inventory levels during
the transition from Celestica which could negatively affect our liquidity. We may not be able to obtain critical hardware components. Our contract manufacturers purchase a number of critical components from vendors for which
alternative sources are not currently available. Delays or interruptions in the 26




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supply of these
components could result in delays or reductions in product shipments. The purchase of these
components from outside suppliers on a sole source basis subjects us to risks, including the
continued availability of supplies, price increases and potential
quality assurance problems. While alternative suppliers may be available, these suppliers must
be identified and qualified. We cannot be certain that any such suppliers will meet our required
qualifications or that alternative suppliers can be identified in a timely fashion, if at all. Our
contract manufacturers may not be able to obtain sufficient quantities of these components on the
same or substantially the same terms. Consolidations involving suppliers could further reduce the
number of component alternatives and affect the cost of such supplies. An increase in the cost of
such supplies could make our products less competitive. Production delays, lower margins or less
competitive product pricing could have a material adverse effect on our business and results of
operations. We may experience difficulties in migrating customers to Visual UpTime Select. Visual UpTime Selectis based on a new licensing model and includes significant new
technological innovations. We have sales and technical obstacles to overcome related to upgrading
Visual UpTime customers to Visual UpTime Select. These obstacles may delay new orders, slow product
deployment or result in other unforeseen challenges with otherwise negative impacts. We have an accumulated deficit of $475.8 million. Our net losses since 2000 have resulted in an accumulated deficit of $475.8 million at March
31, 2005. This accumulated deficit could affect our ability to raise equity financing, arrange bank
financing or arrange credit from suppliers on reasonable or acceptable terms. We may not be profitable in the future. Our ability to generate operating income in the future is dependent on our success in growing
revenue and managing operating expenses. Market conditions, competitive pressures, and other
factors beyond our control, may adversely affect our ability to adequately sustain revenue in the
future. In particular, our ability to sustain revenue may be negatively affected by our dependence
on our service provider customers. Pressure on capital expenditures and the decline of the
telecommunications industry may delay the roll-out of new services based on our products offered by
our service provider customers. Any potential reduction in demand for value added services or
products, which our products support, from the service providers customers, directly impacts the
purchase volume of our products and may impact our ability to sustain revenue. We may be required
to further reduce operating expenses if future revenue projections fall short of expectations. Our
operating expenses include substantial fixed components which cannot be reduced quickly. If
anticipated revenue levels are below expectations, operating results are likely to be materially
and adversely affected because we may not be able to reduce operating expenses on a timely basis. Our current stock compensation expense negatively impacts our earnings, and when we are
required to report the fair value of employee stock options as an expense in conjunction with a new
accounting standard, our reported financial performance will be adversely affected, which may cause
our stock price to decline. Under our current accounting practice for stock options granted to employees, stock
compensation expense is recorded to the extent the current market price of the underlying stock
exceeds the exercise price on the date of grant. In December 2004, the Financial Accounting
Standards Board issued SFAS No. 123R, Share-Based Payment. SFAS No. 123R establishes standards
for the accounting for transactions in which an entity exchanges its equity instruments for goods
or services. This statement focuses primarily on accounting for transactions in which an entity
obtains employee services in share-based payment transactions. SFAS No. 123R requires that the fair
value of such equity 27




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instruments be recognized as an expense in the historical financial statements
as services are performed. Prior to SFAS No. 123R, only certain pro forma disclosures of fair value
were required. In accordance with a recently-issued Securities and Exchange Commission rule,
companies will be allowed to implement SFAS No. 123R as of the beginning
of the first interim or annual period that begins after June 15, 2005. We currently expect to
adopt SFAS No. 123R on January 1, 2006. The adoption of SFAS No. 123R is expected to have a
material effect on our financial statements by depressing net income, possibly causing our stock
price to decline. Our long sales cycle, which has had a median length of approximately five to six months,
requires us to expend significant resources on potential sales opportunities that may never be
consummated. Our sales cycles are relatively long because large enterprises, our target end-user market,
frequently experience delays in making significant capital expenditures on complicated systems. For
enterprise customers, our historical sales cycle has a median of approximately five to six months.
This extended cycle increases the risk that a potential customer might lower its capital
expenditures or change product functionality requirements during the sales process. Because we are
required to commit substantial sales and marketing resources during this extended time period
without any assurance of consummating an eventual sale, we risk incurring significant expense
without generating any associated revenue. Failure to adapt to rapid technological change could adversely affect our ability to compete
effectively. The market for our products is characterized by rapid changes, including continuing advances
in technology, frequent new product introductions, changes in customer requirements and preferences
and changes in industry standards. If we are unable to develop and introduce new products and
product enhancements in a timely fashion that accommodate future changes, we will likely lose
customers and business which could have a material adverse effect on our business, financial
condition and results of operations. The introduction of new technologies, advances in techniques
for network services, the integration of service level management functionality into other network
hardware components and improvements to the infrastructure of the Internet could render our
products obsolete or unmarketable. There can be no assurance that (i) there will continue to be a
need for our products; (ii) our existing products will continue to compete successfully; (iii) our
future product offerings will keep pace with the technological changes implemented by our
competitors; (iv) our products will satisfy evolving industry standards or preferences of existing
or prospective customers; or (v) we will be successful in developing and marketing products for any
future technology. We face growing competition from several market segments that could make it difficult for us
to acquire and retain customers. We face competition from several market segments whose functionality our products
integrate. We expect competition in each of these market segments to intensify in the future. In
addition, consolidation between competitors in various market segments (such as Concord-Computer
Associates) could intensify competition. Our primary current competitors include, or in the future
may include, the following: Adtran, Brix, Concord, Kentrox, Lucent Technologies, NetScout,
Packeteer, and Paradyne. Our competitors vary in size and in the scope and breadth of the products
and services that they offer. While we intend to compete by offering superior features,
performance, reliability and flexibility at competitive prices and on the strength of our
relationships with service providers, many of these competitors have greater financial, technical,
marketing and other resources than us, and some have well-established relationships with our
current and potential customers. As a result, these competitors may be able to respond to new or
emerging technologies and changes in customer requirements more effectively than us, or devote
greater resources than us to the development, promotion and sale of products. In addition, we
believe that competitors from one or more of our market segments could partner with each other to
offer products that supply functionality approaching that 28




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provided by Visual UpTime Select.
Increased competition may result in price reductions, reduced profitability and loss of market
share, any of which could have a material adverse effect on our business and results of operations. Errors in our products or services could discourage customers, damage our reputation and delay
product development and enhancement. Products and services as complex as those which we offer may contain undetected errors or
failures when first introduced or as new versions are released. There can be no assurance that,
despite testing by us and by current and potential customers, errors will not be found in new
products and services until commercial shipments have commenced. Such errors can substantially
delay the time until we are able to generate revenue from new product releases and could force us
to divert additional development resources to correct the errors. If such errors are detected after
shipments have been made, then our reputation may be damaged, and we may incur substantial costs
covering warranty claims. In our research and development spending plan, we plan for a certain level of engineering
activity associated with sustaining issues. Sustaining issues include fixing problems in
released products that were not identified in the development and testing cycle. During any period,
if more sustaining issues arise than anticipated, we may have to divert resources away from
scheduled product development and enhancement activities. A delay in product development and
enhancement activities could have a material adverse effect on our future revenue and operating
results. We have anti-takeover protections that may delay or prevent a change in control that could
benefit our stockholders. Terms of our certificate of incorporation and bylaws make it more difficult for another
individual or company to acquire control of our company, even if a change of control would benefit
our stockholders. These terms include:  
    our board of directors, without stockholder approval, may issue up to 5,000,000 shares
of preferred stock on terms that they determine, including terms that delay or prevent
the change in control of our company, make removal of management more difficult or
depress the price of our stock;
    certain provisions of our certificate of incorporation and bylaws and of Delaware law
could delay or make more difficult a merger, tender offer or proxy contest;
    we are subject to the anti-takeover provisions of Section 203 of the Delaware General
Corporation Law which prohibits a publicly held Delaware corporation from engaging in a
business combination with an interested stockholder for a period of three years after
the date of the transaction in which the person became an interested stockholder, unless
the business combination is approved in a prescribed manner;
    our board of directors is staggered so that only a portion of its members are
elected each year;
    only our board of directors, our chairman of the board, our president, or stockholders
holding a majority of our stock can call special stockholder meetings; and
    special procedures must be followed in order for stockholders to present proposals at
stockholder meetings. In addition, the outstanding Debentures may become immediately due and payable upon a change
of control, which could have the effect of discouraging an acquisition that might otherwise benefit
our stockholders. Item 3. Qualitative and Quantitative Disclosures About Market Risk During 2002, we issued long-term debt in the form of the convertible debentures discussed in
Note 3 of Notes to Consolidated Financial Statements. The convertible debentures bear interest at a
fixed annual rate of 5%. Our investment policy restricts us 29




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to investing only in investment-grade securities, and we may be exposed to market risk from
interest rate changes. A failure of these investment securities to perform at their historical
levels could reduce the interest income realized by us. While substantially all of our product sales to date have been made to customers in the United
States, we plan to sell our products to international customers at prices denominated in United
States dollars. However, if we commence selling material volumes of product to such customers at
prices not denominated in United States dollars, we intend to adopt a strategy to hedge against
fluctuations in foreign currency. Item 4. Controls and Procedures Our management, including our principal executive and principal financial officers, has
evaluated the effectiveness of our disclosure controls and procedures as of March 31, 2005. Our
disclosure controls and procedures are designed to provide reasonable assurance that the
information required to be disclosed in this Quarterly Report on Form 10-Q has been appropriately
recorded, processed, summarized and reported. Based on that evaluation, our principal executive and
principal financial officers have concluded that our disclosure controls and procedures are
effective at the reasonable assurance level. Our management, including our principal executive and principal financial officers, has
evaluated any changes in our internal control over financial reporting that occurred during the
quarterly period ended March 31, 2005, and has concluded that there was no change that occurred
during the quarterly period ended March 31, 2005 that has materially affected, or is reasonably
likely to materially affect, our internal control over financial reporting. 30




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PART II  OTHER INFORMATION Item 1. Legal Proceedings In January 2004, we received notice that a lawsuit had been filed by Paradyne Networks, Inc.
(Paradyne Networks), of Largo, Florida, in the United States District Court for the Middle
District of Florida, Tampa Division (the Florida Court) against us, seeking damages, and
injunctive and declaratory relief, for our alleged infringement of patents owned by Paradyne
Corporation (Paradyne), a subsidiary of Paradyne Networks. On May 14, 2004, the Florida Court granted our motion to dismiss the case for lack of subject
matter jurisdiction and denied Paradyne Networks motion for leave to amend its complaint and its
motion for preliminary injunction. Paradyne Networks did not appeal the decision. In a related matter, one of our subsidiaries, Visual Networks Operations, Inc. (VNO), filed
a lawsuit in United States District Court for the District of Maryland, Southern Division (the
Maryland Court), against Paradyne. This lawsuit requests declaratory judgment that Visual UpTime
and Visual IP InSight do not infringe upon certain patents owned by Paradyne and that those patents
are invalid and unenforceable. The lawsuit further alleges that Paradynes assertion of its patents
against us is baseless and has been for the sole purpose of obtaining an unfair competitive
advantage, and that Paradyne has infringed upon certain patents own by us. Paradyne filed
counterclaims alleging that VNO infringes upon its patents, mirroring the Florida claims. On
October 15, 2004, Paradyne filed amended counterclaims, adding allegations of willful patent
infringement and unenforceability of two of our patents in the lawsuit. The Maryland lawsuit
presently is in the fact discovery phase of the litigation. The Maryland Court conducted a hearing
concerning patent claim construction on February 7, 2005 and has not yet ruled on that hearing. The
fact discovery phase of the Maryland lawsuit was recently completed and a trial date has not yet
been scheduled. Pursuant to the terms of a confidential settlement agreement entered into on March 11, 2005
between Paradyne and VNO, Paradyne has agreed to dismiss its patent claims against Visual IP
Insight. VNO has agreed to dismiss its unfair competition claim against Paradyne with respect to
Visual IP Insight and pay royalties to Paradyne through the remaining life of Paradynes patents in
the amount of 1% of revenue recognized by us from the licensing and distribution of Visual IP
Insight. On March 15, 2005, the Maryland Court approved a Stipulation of Partial Dismissal
submitted by the parties concerning the patent claims against Visual IP InSight and the unfair
competition claim against Paradyne. Despite managements belief that our products do not infringe upon Paradynes patents and that
Paradynes claims are frivolous and without merit, the defense of these claims is expensive and may
divert our resources from other activities, which could have a material adverse effect on our
business and results of operations. At this point in the litigation, the likelihood of any outcome
cannot be determined and the adverse effect, if any, cannot be estimated. We are periodically a party to disputes arising from normal business activities including
various employee-related matters. In the opinion of our management, resolution of these matters
will not have a material adverse effect upon our financial position or future operating results. Item 2. Unregistered Sales of Equity Securities and Use of Proceeds On March 11, 2005, Mark B. Skurla was granted options to purchase 100,000 shares of common
stock with 25% of the options vesting on March 11, 2006 and the remainder vesting in equal monthly
installments over the following 36 months. 100% of the options vest upon a change in control. The
options expire on March 11, 2015. 31




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Item 3. Defaults Upon Senior Securities None. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. Item 6. Exhibits Exhibit Number
    
    Description10.1
    
    Fourth Amendment, dated March 21, 2005, to the
Reseller/Integration Agreement between the Company
and MCI Telecommunications Corporation.10.2
    
    Nonstatutory Stock Option Grant Agreement, dated
March 11, 2005, by and between the Company and Mark
B. Skurla.31.1
    
    Certification of Chief Executive Officer Pursuant to
Rule 13a-14(a) under the Securities Exchange Act of
1934 as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.31.2
    
    Certification of Chief Financial Officer Pursuant to
Rule 13a-14(a) under the Securities Exchange Act of
1934 as Adopted Pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.32.1
    
    Certification of Chief Executive Officer Pursuant to
18 U.S.C. Section 1350 as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.32.2
    
    Certification of Chief Financial Officer Pursuant to
18 U.S.C. Section 1350 as Adopted Pursuant to Section
906 of the Sarbanes-Oxley Act of 2002.
 32




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SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly
caused this report to be signed on its behalf by the undersigned thereunto duly authorized. VISUAL NETWORKS, INC.By: /s/ Lawrence S. BarkerLawrence S. BarkerPresident and Chief Executive Officer
 Date: May 6, 2005 By: /s/ Donald E. ClarkeDonald E. ClarkeExecutive Vice President and Chief Financial Officer
 Date: May 6, 2005 33