##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
 Washington, D.C. 20549-0001
 
 FORM 10-Q
  þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
   o
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
  
 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)
  
 þ o
 þ o




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##### 



PART I. FINANCIAL INFORMATIONItem 1. Financial Statements:Consolidated Balance Sheets  December 31, 2004 and June 30, 2005
    
    
    3Consolidated Statements of Operations  Three and six months ended
June 30, 2004 and 2005
    
    
    4Consolidated Statements of Cash Flows  Six months ended June 30, 2004
and 2005
    
    
    5Notes to Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    16Item 3. Qualitative and Quantitative Disclosures about Market Risk
    
    
    33Item 4. Controls and Procedures
    
    
    33PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    34Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    34Item 3. Defaults Upon Senior Securities
    
    
    34Item 4. Submission of Matters to a Vote of Security Holders
    
    
    35Item 5. Other Information
    
    
    35Item 6. Exhibits
    
    
    35Signatures
    
    
    36
 2




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##### 



PART I: FINANCIAL INFORMATION
 Item 1. Financial Statements
  
 December 31,
    
    
    June 30,2004
    
    
    2005(Unaudited)AssetsCurrent assets:Cash and cash equivalents
    
    $
    11,317
    
    
    $
    4,294Accounts receivable, net of allowance of $399 and $409, respectively
    
    
    9,335
    
    
    
    9,098Inventory, net
    
    
    3,822
    
    
    
    3,331Other current assets
    
    
    940
    
    
    
    1,017Total current assets
    
    
    25,414
    
    
    
    17,740Property and equipment, net
    
    
    2,001
    
    
    
    1,583Total assets
    
    $
    27,415
    
    
    $
    19,323Liabilities and Stockholders EquityCurrent liabilities:Accounts payable and accrued expenses
    
    $
    9,341
    
    
    $
    7,022Deferred revenue
    
    
    3,388
    
    
    
    2,340Short-term debt
    
    
    
    
    
    
    4,000Convertible debentures, net of unamortized debt discount of $837 and $112,
respectively
    
    
    8,163
    
    
    
    1,888Total current liabilities
    
    
    20,892
    
    
    
    15,250Commitments and contingencies (Note 4)Stockholders equity:Common stock, $.01 par value; 200,000,000 shares authorized, 33,981,840 and
34,655,691 shares issued and outstanding, respectively
    
    
    340
    
    
    
    346Additional paid-in capital
    
    
    477,343
    
    
    
    478,685Warrants
    
    
    2,087
    
    
    
    2,087Deferred compensation
    
    
    (143
    )
    
    
    (77
    )Accumulated deficit
    
    
    (473,104
    )
    
    
    (476,968
    )Total stockholders equity
    
    
    6,523
    
    
    
    4,073Total liabilities and stockholders equity
    
    $
    27,415
    
    
    $
    19,323
  3




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##### 



For the
    
    
    For theThree Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2004
    
    
    2005
    
    
    2004
    
    
    2005Revenue:Hardware
    
    $
    9,091
    
    
    $
    3,990
    
    
    $
    18,621
    
    
    $
    8,498Software
    
    
    1,514
    
    
    
    5,413
    
    
    
    1,666
    
    
    
    8,542Support and services
    
    
    2,218
    
    
    
    2,035
    
    
    
    4,377
    
    
    
    3,962Total revenue
    
    
    12,823
    
    
    
    11,438
    
    
    
    24,664
    
    
    
    21,002Cost of revenue:Product
    
    
    3,745
    
    
    
    2,880
    
    
    
    6,783
    
    
    
    6,065Support and services
    
    
    257
    
    
    
    195
    
    
    
    542
    
    
    
    409Total cost of revenue
    
    
    4,002
    
    
    
    3,075
    
    
    
    7,325
    
    
    
    6,474Gross profit
    
    
    8,821
    
    
    
    8,363
    
    
    
    17,339
    
    
    
    14,528Operating expenses:Research and development
    
    
    2,391
    
    
    
    2,198
    
    
    
    5,061
    
    
    
    4,745Sales and marketing
    
    
    3,968
    
    
    
    4,298
    
    
    
    7,772
    
    
    
    7,965General and administrative
    
    
    2,278
    
    
    
    1,528
    
    
    
    4,452
    
    
    
    3,900Restructuring
    
    
    
    
    
    
    716
    
    
    
    
    
    
    
    716Total operating expenses
    
    
    8,637
    
    
    
    8,740
    
    
    
    17,285
    
    
    
    17,326Income (loss) from operations
    
    
    184
    
    
    
    (377
    )
    
    
    54
    
    
    
    (2,798
    )Other expense
    
    
    (262
    )
    
    
    (547
    )
    
    
    (262
    )
    
    
    (547
    )Interest income
    
    
    35
    
    
    
    46
    
    
    
    62
    
    
    
    101Interest expense
    
    
    (371
    )
    
    
    (291
    )
    
    
    (758
    )
    
    
    (620
    )Net loss
    
    $
    (414
    )
    
    $
    (1,169
    )
    
    $
    (904
    )
    
    $
    (3,864
    )Basic and diluted loss per share
    
    $
    (0.01
    )
    
    $
    (0.03
    )
    
    $
    (0.03
    )
    
    $
    (0.11
    )Basic and diluted weighted-average shares outstanding
    
    
    33,185
    
    
    
    34,607
    
    
    
    33,098
    
    
    
    34,425
  4




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##### 



For theSix Months EndedJune 30,2004
    
    
    2005Cash Flows From Operating Activities:Net loss
    
    $
    (904
    )
    
    $
    (3,864
    )Adjustments to reconcile net loss to net cash
used in operating activities:Depreciation
    
    
    744
    
    
    
    671Non-cash interest expense
    
    
    500
    
    
    
    397Early extinguishment of debt
    
    
    262
    
    
    
    547Bad debt expense (recovery)
    
    
    (6
    )
    
    
    10Non-cash compensation expense
    
    
    121
    
    
    
    66Provision for excess and obsolete inventory
    
    
    24
    
    
    
    Changes in assets and liabilities:Accounts receivable
    
    
    (2,304
    )
    
    
    227Inventory
    
    
    1,317
    
    
    
    491Other assets
    
    
    (628
    )
    
    
    (297
    )Accounts payable and accrued expenses
    
    
    164
    
    
    
    (2,317
    )Deferred revenue
    
    
    (1,031
    )
    
    
    (1,048
    )Net cash used in operating activities
    
    
    (1,741
    )
    
    
    (5,117
    )Cash Flows From Investing Activities:Sales of short-term investments
    
    
    1,002
    
    
    
    Expenditures for property and equipment
    
    
    (422
    )
    
    
    (253
    )Net cash provided by (used in) investing activities
    
    
    580
    
    
    
    (253
    )Cash Flows From Financing Activities:Repayment of debentures
    
    
    (1,500
    )
    
    
    (7,000
    )Proceeds from issuance of short-term debt
    
    
    
    
    
    
    4,000Exercise of stock options and issuance of common stock
under the employee stock purchase plan
    
    
    545
    
    
    
    1,347Net cash provided by (used in) financing activities
    
    
    (955
    )
    
    
    (1,653
    )Net decrease in cash and cash equivalents
    
    
    (2,116
    )
    
    
    (7,023
    )Cash and cash equivalents, beginning of period
    
    
    15,671
    
    
    
    11,317Cash and cash equivalents, end of period
    
    $
    13,555
    
    
    $
    4,294Supplemental Cash Flow Information:Cash paid for interest
    
    $
    258
    
    
    $
    223
  5




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##### 



1.
    
    Nature of Operations and Significant Accounting Policies:
  Risk Factors
 Select
  Financial Statement Presentation
   6




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##### 



Principles of Consolidation
  Inventory
  December 31,
    
    
    June 30,2004
    
    
    2005(Unaudited)Raw materials
    
    $
    1,138
    
    
    $
    1,085Work-in-progress
    
    
    
    
    
    
    Finished goods
    
    
    4,902
    
    
    
    4,075Inventory, gross
    
    $
    6,040
    
    
    
    5,160Reserve for excess and
obsolete inventory
    
    
    (2,218
    )
    
    
    (1,829
    )Inventory, net
    
    $
    3,822
    
    
    $
    3,331
  2004
    
    
    2005Balance, beginning of period
    
    $
    3,593
    
    
    $
    2,021Provision for excess and obsolete inventory
    
    
    24
    
    
    
    Sale of previously reserved inventory
    
    
    
    
    
    
    (157
    )Actual inventory scrapped
    
    
    (806
    )
    
    
    (35
    )Balance, end of period
    
    $
    2,811
    
    
    $
    1,829
  2004
    
    
    2005Balance, beginning of period
    
    $
    3,638
    
    
    $
    2,218Provision for excess and obsolete inventory
    
    
    414
    
    
    
    117Sale of previously reserved inventory
    
    
    (66
    )
    
    
    (343
    )Actual inventory scrapped
    
    
    (1,175
    )
    
    
    (163
    )Balance, end of period
    
    $
    2,811
    
    
    $
    1,829
 Accounts Payable and Accrued Expenses
  December 31,
    
    
    June 30,2004
    
    
    2005(Unaudited)Accounts payable
    
    $
    1,940
    
    
    $
    896Accrued compensation
    
    
    2,108
    
    
    
    1,283Accrued warranty
    
    
    384
    
    
    
    384Deferred rent
    
    
    434
    
    
    
    423Other accrued expenses
    
    
    4,475
    
    
    
    4,036Total
    
    $
    9,341
    
    
    $
    7,022
 7




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##### 



Revenue Recognition
       8




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##### 



Accrued Warranty Costs
 Select
  2004
    
    
    2005Balance, beginning of period
    
    $
    428
    
    
    $
    384Provisions for warranty
    
    
    30
    
    
    
    14Settlements made
    
    
    (30
    )
    
    
    (14
    )Balance, end of period
    
    $
    428
    
    
    $
    384
  2004
    
    
    2005Balance, beginning of period
    
    $
    425
    
    
    $
    384Provisions for warranty
    
    
    52
    
    
    
    21Settlements made
    
    
    (49
    )
    
    
    (21
    )Balance, end of period
    
    $
    428
    
    
    $
    384
 Segment Reporting and Significant Customers
  9




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##### 



Accounting for Stock Options
    Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2004
    
    
    2005
    
    
    2004
    
    
    2005Net loss, as reported
    
    $
    (414
    )
    
    $
    (1,169
    )
    
    $
    (904
    )
    
    $
    (3,864
    )Add: Stock-based employee compensation expense
included in reported net loss
    
    
    33
    
    
    
    33
    
    
    
    121
    
    
    
    66Deduct: Total stock-based employee compensation
expense determined under fair value based
method for all awards
    
    
    (1,101
    )
    
    
    (420
    )
    
    
    (2,432
    )
    
    
    (836
    )Pro forma net loss
    
    $
    (1,482
    )
    
    $
    (1,556
    )
    
    $
    (3,215
    )
    
    $
    (4,634
    )Loss per share:Basic and diluted: as reported
    
    $
    (0.01
    )
    
    $
    (0.03
    )
    
    $
    (0.03
    )
    
    $
    (0.11
    )Basic and diluted: pro forma
    
    $
    (0.04
    )
    
    $
    (0.04
    )
    
    $
    (0.10
    )
    
    $
    (0.13
    )
 10




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##### 



Three Months Ended
    
    
    Six Months EndedJune 30,
    
    
    June 30,2004
    
    
    2005
    
    
    2004
    
    
    2005Dividend yield
    
    None
    
    None
    
    None
    
    NoneExpected volatility
    
    
    67
    %
    
    
    98
    %
    
    
    67
    %
    
    
    98
    %Risk-free interest rate.
    
    
    3.72
    %
    
    
    4.00
    %
    
    
    3.36
    %
    
    
    3.88
    %Expected term (in years)
    
    
    5
    
    
    
    5
    
    
    
    5
    
    
    
    5
  Basic and Diluted Earnings (Loss) Per Share
    Restructuring Charges
   New Accounting Pronouncements
  11




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##### 



2.
    
    Line of Credit:
   3.
    
    Convertible Debentures:
  12




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##### 




    
    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 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.
  13




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##### 



4.
    
    Commitments and Contingencies:
     14




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##### 



5.
    
    Subsequent Events:
   
    
    default by the Company on other indebtedness in an amount exceeding $100,000;
    
    a final, non-appealable judgment or judgments rendered against the Company
exceeding $250,000 in aggregate;
    
    failure to meet certain covenants as defined by the terms of the 2005 Notes;
    
    bankruptcy of the Company; and
    
    certain other failures by the Company to perform obligations under the 2005 Notes
and/or the related agreements.
   15




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##### 



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
  Overview
   Select Select Select Select Select
 16




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##### 



Select Select Select Select Select
 Select
    Select
 17




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##### 



Results of Operations
  Revenue. Select Select
 Cost of revenue and gross profit.
 Operating expenses.
 Research and development expense.
 Sales and marketing expense.
 General and administrative expense.
 Three months ended June 30, 2004 compared to three months ended June 30, 2005
  Three Months EndedJune 30,2004
    
    
    2005(unaudited, in thousands)UpTime:Visual UpTime
    
    $
    9,588
    
    
    $
    53Visual UpTime Select
    
    
    2,440
    
    
    
    11,022IP InSight
    
    
    741
    
    
    
    354Continuing products
    
    
    12,769
    
    
    
    11,429Royalties
    
    
    54
    
    
    
    9Total revenue
    
    $
    12,823
    
    
    $
    11,438
 18




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##### 



Three Months EndedJune 30,2004
    
    
    2005(unaudited, in thousands)AT&T
    
    $
    3,056
    
    
    $
    2,663Sprint
    
    
    3,019
    
    
    
    2,661MCI
    
    
    2,925
    
    
    
    4,076All other customers (each individually
less than 10%)
    
    
    3,823
    
    
    
    2,038Total revenue
    
    $
    12,823
    
    
    $
    11,438
 Revenue, cost of revenue, and gross profit
  Three Months EndedJune 30,(unaudited, in thousands, except percentage data)Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Revenue:Hardware
    
    $
    9,091
    
    
    
    70.9
    %
    
    $
    3,990
    
    
    
    34.9
    %
    
    $
    (5,101
    )
    
    
    (56.1
    )%Software
    
    
    1,514
    
    
    
    11.8
    
    
    
    5,413
    
    
    
    47.3
    
    
    
    3,899
    
    
    
    257.5Support and services
    
    
    2,218
    
    
    
    17.3
    
    
    
    2,035
    
    
    
    17.8
    
    
    
    (183
    )
    
    
    (8.3
    )Total revenue
    
    
    12,823
    
    
    
    100.0
    
    
    
    11,438
    
    
    
    100.0
    
    
    
    (1,385
    )
    
    
    (10.8
    )Cost of revenue:Product
    
    
    3,745
    
    
    
    29.2
    
    
    
    2,880
    
    
    
    25.2
    
    
    
    (865
    )
    
    
    (23.1
    )Support and services
    
    
    257
    
    
    
    2.0
    
    
    
    195
    
    
    
    1.7
    
    
    
    (62
    )
    
    
    (24.1
    )Total cost of revenue
    
    
    4,002
    
    
    
    31.2
    
    
    
    3,075
    
    
    
    26.9
    
    
    
    (927
    )
    
    
    (23.2
    )Gross profit
    
    $
    8,821
    
    
    
    68.8
    %
    
    $
    8,363
    
    
    
    73.1
    %
    
    $
    (458
    )
    
    
    (5.2
    )%
    Three Months EndedJune 30,(unaudited, in thousands, except percentage data)2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    Increase
    
    
    %**Product revenue:Hardware
    
    $
    9,091
    
    
    
    85.7
    %
    
    $
    3,990
    
    
    
    42.4
    %
    
    $
    (5,101
    )
    
    
    (56.1
    )%Software
    
    
    1,514
    
    
    
    14.3
    
    
    
    5,413
    
    
    
    57.6
    
    
    
    3,899
    
    
    
    257.5Total product revenue
    
    
    10,605
    
    
    
    100.0
    
    
    
    9,403
    
    
    
    100.0
    
    
    
    (1,202
    )
    
    
    (11.3
    )Product cost of revenue
    
    
    3,745
    
    
    
    35.3
    
    
    
    2,880
    
    
    
    30.6
    
    
    
    (865
    )
    
    
    (23.1
    )Product gross profit
    
    $
    6,860
    
    
    
    64.7
    %
    
    $
    6,523
    
    
    
    69.4
    %
    
    $
    (337
    )
    
    
    (4.9
    )%
   19




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##### 



Three Months EndedJune 30,(unaudited, in thousands, except percentage data)Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Support and services
    
    $
    2,218
    
    
    
    100.0
    %
    
    
    2,035
    
    
    
    100.0
    
    
    
    (183
    )
    
    
    (8.3
    )Support and services cost of revenue
    
    
    257
    
    
    
    11.6
    
    
    
    195
    
    
    
    9.6
    
    
    
    (62
    )
    
    
    (24.1
    )Support and services gross profit
    
    $
    1,961
    
    
    
    88.4
    %
    
    $
    1,840
    
    
    
    90.4
    %
    
    $
    (121
    )
    
    
    (6.2
    )%
   Revenue
 Software revenue Select Select Select
 Hardware revenue Select Select
 Select Selects Select Select
 Select
 Support and services revenue Select
  Gross profit
 Gross profit Gross profit on products Select
 20




---



##### 



Operating expenses
  Three Months EndedJune 30,(unaudited, in thousands, except percentage data)Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Operating expenses:Research and development
    
    $
    2,391
    
    
    
    18.7
    %
    
    $
    2,198
    
    
    
    19.2
    %
    
    $
    (193
    )
    
    
    (8.1
    )%Sales and marketing
    
    
    3,968
    
    
    
    30.9
    
    
    
    4,298
    
    
    
    37.5
    
    
    
    330
    
    
    
    8.3General and administrative
    
    
    2,278
    
    
    
    17.8
    
    
    
    1,528
    
    
    
    13.4
    
    
    
    (750
    )
    
    
    (32.9
    )Restructuring
    
    
    
    
    
    
    
    
    
    
    716
    
    
    
    6.3
    
    
    
    716
    
    
    
    100.0Total operating expenses
    
    $
    8,637
    
    
    
    67.4
    %
    
    $
    8,740
    
    
    
    76.4
    %
    
    $
    103
    
    
    
    1.2
    %
 
 Research and development general and administrative expense
 Sales and marketing expense
 Other items
  Three Months EndedJune 30,(unaudited, in thousands, except percentage data)Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Other expense
    
    $
    (262
    )
    
    
    (2.0
    )%
    
    $
    (547
    )
    
    
    (4.8
    )%
    
    $
    285
    
    
    
    108.8
    %Interest income
    
    
    35
    
    
    
    0.3
    
    
    
    46
    
    
    
    0.4
    
    
    
    11
    
    
    
    31.4Interest expense
    
    
    (371
    )
    
    
    (2.9
    )
    
    
    (291
    )
    
    
    (2.5
    )
    
    
    (80
    )
    
    
    (21.6
    )
   Other expense
 Interest expense
 21




---



##### 



Six months ended June 30, 2004 compared to six months ended June 30, 2005
  Six Months EndedJune 30,2004
    
    
    2005(unaudited, in thousands)UpTime:Visual UpTime
    
    $
    20,644
    
    
    $
    936Visual UpTime Select
    
    
    2,440
    
    
    
    19,360IP InSight
    
    
    1,469
    
    
    
    692Continuing products
    
    
    24,553
    
    
    
    20,988Royalties
    
    
    111
    
    
    
    14Total revenue
    
    $
    24,664
    
    
    $
    21,002
  Six Months EndedJune 30,2004
    
    
    2005(unaudited, in thousands)AT&T
    
    $
    4,246
    
    
    $
    5,777SBC
    
    
    5,119
    
    
    
    *Sprint
    
    
    4,847
    
    
    
    4,229MCI
    
    
    4,788
    
    
    
    5,397All other customers (each individually
less than 10%)
    
    
    7,664
    
    
    
    5,599Total revenue
    
    $
    26,664
    
    
    $
    21,002
  Revenue, cost of revenue, and gross profit
  Six Months EndedJune 30,(unaudited, in thousands, except percentage data)Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Revenue:Hardware
    
    $
    18,621
    
    
    
    75.5
    %
    
    $
    8,498
    
    
    
    40.5
    %
    
    $
    (10,123
    )
    
    
    (54.4
    )%Software
    
    
    1,666
    
    
    
    6.8
    
    
    
    8,542
    
    
    
    40.6
    
    
    
    6,876
    
    
    
    412.7Support and services
    
    
    4,377
    
    
    
    17.7
    
    
    
    3,962
    
    
    
    18.9
    
    
    
    (415
    )
    
    
    (9.5
    )Total revenue
    
    
    24,664
    
    
    
    100.0
    
    
    
    21,002
    
    
    
    100.0
    
    
    
    (3,662
    )
    
    
    (14.8
    )Cost of revenue:Product
    
    
    6,783
    
    
    
    27.5
    
    
    
    6,065
    
    
    
    28.9
    
    
    
    (718
    )
    
    
    (10.6
    )Support and services
    
    
    542
    
    
    
    2.2
    
    
    
    409
    
    
    
    1.9
    
    
    
    (133
    )
    
    
    (24.5
    )Total cost of revenue
    
    
    7,325
    
    
    
    29.7
    
    
    
    6,474
    
    
    
    30.8
    
    
    
    (851
    )
    
    
    (11.6
    )Gross profit
    
    $
    17,339
    
    
    
    70.3
    %
    
    $
    14,528
    
    
    
    69.2
    %
    
    $
    (2,811
    )
    
    
    (16.2
    )%
   22




---



##### 



Six Months EndedJune 30,(unaudited, in thousands, except percentage data)2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    Increase
    
    
    %**Product revenue:Hardware
    
    $
    18,621
    
    
    
    91.8
    %
    
    $
    8,498
    
    
    
    49.9
    %
    
    $
    (10,123
    )
    
    
    (54.4
    )%Software
    
    
    1,666
    
    
    
    8.2
    
    
    
    8,542
    
    
    
    50.1
    
    
    
    6,876
    
    
    
    412.7Total product revenue
    
    
    20,287
    
    
    
    100.0
    
    
    
    17,040
    
    
    
    100.0
    
    
    
    (3,247
    )
    
    
    (16.0
    )Product cost of revenue
    
    
    6,783
    
    
    
    33.4
    
    
    
    6,065
    
    
    
    35.6
    
    
    
    (718
    )
    
    
    (10.6
    )Product gross profit
    
    $
    13,504
    
    
    
    66.6
    %
    
    $
    10,975
    
    
    
    64.4
    %
    
    $
    (2,529
    )
    
    
    (18.7
    )%
    Six Months EndedJune 30,(unaudited, in thousands, except percentage data)Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Support and services
    
    $
    4,377
    
    
    
    100.0
    %
    
    
    3,962
    
    
    
    100.0
    
    
    
    (415
    )
    
    
    (9.5
    )Support and services cost of revenue
    
    
    542
    
    
    
    12.4
    
    
    
    409
    
    
    
    10.3
    
    
    
    (133
    )
    
    
    (24.5
    )Support and services gross profit
    
    $
    3,835
    
    
    
    87.6
    %
    
    $
    3,553
    
    
    
    89.7
    %
    
    $
    (282
    )
    
    
    (7.4
    )%
   Revenue
 Software revenue Select Select Select
  Hardware revenue Select Select
 23




---



##### 



Select Selects Select Select
 Select
 Support and services revenue Select
  Gross profit
 Gross profit Gross profit on products
 Operating expenses
  Six Months EndedJune 30,(unaudited, in thousands, except percentage data)Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Operating expenses:Research and development
    
    
    5,061
    
    
    
    20.5
    %
    
    
    4,745
    
    
    
    22.6
    %
    
    $
    (316
    )
    
    
    (6.2
    )%Sales and marketing
    
    
    7,772
    
    
    
    31.5
    
    
    
    7,965
    
    
    
    37.9
    
    
    
    193
    
    
    
    2.5General and administrative
    
    
    4,452
    
    
    
    18.1
    
    
    
    3,900
    
    
    
    18.6
    
    
    
    (552
    )
    
    
    (12.4
    )Restructuring
    
    
    
    
    
    
    
    
    
    
    716
    
    
    
    3.4
    
    
    
    716
    
    
    
    100.0Total operating expenses
    
    $
    17,285
    
    
    
    70.1
    %
    
    $
    17,326
    
    
    
    82.5
    %
    
    $
    41
    
    
    
    0.2
    %
   Research and development general and administrative expense
 Sales and marketing expense
 24




---



##### 



Other items
  Six Months EndedJune 30,(unaudited, in thousands, except percentage data)Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Other expense
    
    $
    (262
    )
    
    
    (1.1
    )%
    
    $
    (547
    )
    
    
    (2.6
    )%
    
    $
    285
    
    
    
    108.8
    %Interest income
    
    
    62
    
    
    
    0.3
    
    
    
    101
    
    
    
    0.5
    
    
    
    39
    
    
    
    62.9Interest expense
    
    
    (758
    )
    
    
    (3.1
    )
    
    
    (620
    )
    
    
    (3.0
    )
    
    
    (138
    )
    
    
    (18.2
    )
   Other expense
 Interest expense
 Liquidity and Capital Resources
 Select
     25




---



##### 




    
    default by the Company on other indebtedness in an amount exceeding $100,000;
    
    a final, non-appealable judgment or judgments rendered against the Company
exceeding $250,000 in aggregate;
    
    failure to meet certain covenants as defined by the terms of the 2005 Notes;
    
    bankruptcy of the Company; and
    
    certain other failures by the Company to perform obligations under the 2005 Notes
and/or the related agreements.
    Debentures
    
    
    Operating Leases2005
    
    
    50
    
    
    
    8162006
    
    
    2,023
    
    
    
    1,1322007
    
    
    
    
    
    
    1,1612008
    
    
    
    
    
    
    1,170Thereafter
    
    
    
    
    
    
    1,181Total minimum payments
    
    
    2,073
    
    
    $
    5,460Interest element of payments
    
    
    (73
    )Present value of future minimum payments
    
    
    2,000Unamortized debt discount
    
    
    (112
    )Total Debentures
    
    $
    1,888
     26




---



##### 



Critical Accounting Policies and Estimates
  Revenue Recognition
  Reserve for Inventory Obsolescence
  Allowance for Doubtful Accounts
  27




---



##### 



Warranty
 Select
 Deferred Tax Valuation Allowance
  Risk Factors
  We are highly dependent on sales to telecommunications service providers.
 Select Select
 28




---



##### 



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 which may not be available or available on terms that are reasonable or acceptable to us.
 Select
 The ongoing patent litigation between us and Paradyne, and any other potential intellectual
property litigation, could have a significant detrimental effect on our business.
   29




---



##### 



We rely on outsourced contract manufacturing services and primarily from a new single
provider.
     We may not be able to obtain critical hardware components.
  We may experience difficulties in migrating customers to Visual UpTime Select.
 Select Select
 30




---



##### 



Substantial dilution to our common stockholders could result if the holders of our
financing instruments convert the instruments into common stock.
   We have an accumulated deficit of $477.0 million.
  We may not be profitable in the future.
  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.
  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.
  31




---



##### 



Failure to adapt to rapid technological change could adversely affect our ability to compete
effectively.
  We face growing competition from several market segments that could make it difficult for us
to acquire and retain customers.
 Select
 Errors in our products or services could discourage customers, damage our reputation and delay
product development and enhancement.
   32




---



##### 



We have anti-takeover protections that may delay or prevent a change in control that could
benefit our stockholders.
  
    
    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.
 Item 3. Qualitative and Quantitative Disclosures About Market Risk
   Item 4. Controls and Procedures
   33




---



##### 



PART II  OTHER INFORMATION
 Item 1. Legal Proceedings
       Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
  Item 3. Defaults Upon Senior Securities
  34




---



##### 



Item 4. Submission of Matters to a Vote of Security Holders
  Proposal I. Three directors were elected to serve for a term of three years, and until their
successors are elected and duly qualified, with 88% of the eligible voting shares voting as
follows:
 For
    
    
    WithheldEdward L. Glotzbach
    
    
    30,207,121
    
    
    
    332,699Edward H. Kennedy
    
    
    30,159,183
    
    
    
    380,637Peter J. Minihane
    
    
    28,731,735
    
    
    
    1,808,085
 Proposal II. The selection of Grant Thornton LLP as our independent accountants for the fiscal
year ending December 31, 2005 was ratified with 88% of the eligible voting shares voting as
follows:
 For
    
    Against
    
    Abstain30,334,619
    
    177,644
    
    27,557
 Item 5. Other Information
   
    
    default by the Company on other indebtedness in an amount exceeding $100,000;
    
    a final, non-appealable judgment or judgments rendered against the Company
exceeding $250,000 in aggregate;
    
    failure to meet certain covenants as defined by the terms of the 2005 Notes;
    
    bankruptcy of the Company; and
    
    certain other failures by the Company to perform obligations under the 2005 Notes
and/or the related agreements.
   Item 6. Exhibits
 Exhibit Number
    
    Description4.1
    
    Revolving Promissory Note of Visual Networks, Inc.
and subsidiaries, dated June 17, 2005.10.1
    
    Loan and Security Agreement, dated June 17, 2005, by
and among Visual Networks, Inc. and subsidiaries and
Silicon Valley Bank. *10.2
    
    Amendment to Employment Agreement,
dated April 21, 2005, by and between Visual Networks Operations, Inc.
and Lawrence S. Barker.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.
 *
    Confidential treatment requested for
certain portions of this Exhibit pursuant to Rule 24b-2 of the Securities Exchange Act of 1934,
as amended, which portions are omitted and filed separately with the Securities and Exchange Commission.
 35




---



##### 



VISUAL NETWORKS, INC.By:
    /s/ Lawrence S. BarkerLawrence S. BarkerPresident and Chief Executive Officer  By:
    /s/ Donald E. ClarkeDonald E. ClarkeExecutive Vice President and Chief Financial Officer  36