##### 



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
 For the three months ended September 30, 2005
 OR
 o
    
    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
(State or other jurisdiction of
incorporation or organization)
    
    52-1837515
(I.R.S. Employer Identification No.)2092 Gaither Road, Rockville, MD
(Address of principal executive offices)
    
    20850-4013
(Zip code)
  
 þ o
 þ o
 þ o




---



##### 



PART I. FINANCIAL INFORMATIONItem 1. Financial Statements:Consolidated Balance Sheets  December 31, 2004 and September 30, 2005
    
    
    3Consolidated Statements of Operations  Three and nine months ended
September 30, 2004 and 2005
    
    
    4Consolidated Statements of Cash Flows  Nine months ended September 30, 2004
and 2005
    
    
    5Notes to Consolidated Financial Statements
    
    
    6Item 2. Managements Discussion and Analysis of Financial Condition
and Results of Operations
    
    
    17Item 3. Qualitative and Quantitative Disclosures about Market Risk
    
    
    35Item 4. Controls and Procedures
    
    
    36PART II. OTHER INFORMATIONItem 1. Legal Proceedings
    
    
    37Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
    
    
    38Item 3. Defaults Upon Senior Securities
    
    
    38Item 4. Submission of Matters to a Vote of Security Holders
    
    
    38Item 5. Other Information
    
    
    38Item 6. Exhibits
    
    
    38Signatures
    
    
    39
 2




---



##### 



PART I: FINANCIAL INFORMATION
 Item 1. Financial Statements
  
 December 31,
    
    
    September 30,2004
    
    
    2005(Unaudited)AssetsCurrent assets:Cash and cash equivalents
    
    $
    11,317
    
    
    $
    10,292Accounts receivable, net of allowance of $399 and $348, respectively
    
    
    9,335
    
    
    
    7,921Inventory, net
    
    
    3,822
    
    
    
    3,000Other current assets
    
    
    940
    
    
    
    566Total current assets
    
    
    25,414
    
    
    
    21,779Property and equipment, net
    
    
    2,001
    
    
    
    1,420Total assets
    
    $
    27,415
    
    
    $
    23,199Liabilities and Stockholders EquityCurrent liabilities:Accounts payable and accrued expenses
    
    $
    9,341
    
    
    $
    8,423Deferred revenue
    
    
    3,388
    
    
    
    1,769Convertible debentures, net of unamortized debt discount of $837
    
    
    8,163
    
    
    
    Total current liabilities
    
    
    20,892
    
    
    
    10,192Long-term debt, net of unamortized debt discount of $1,813
    
    
    
    
    
    
    8,187Total Liabilities
    
    
    20,892
    
    
    
    18,379Commitments and contingencies (Note 5)Stockholders equity:Common stock, $.01 par value; 200,000,000 shares authorized, 33,981,840 and
34,676,008 shares issued and outstanding, respectively
    
    
    340
    
    
    
    346Additional paid-in capital
    
    
    477,343
    
    
    
    478,708Warrants
    
    
    2,087
    
    
    
    2,087Deferred compensation
    
    
    (143
    )
    
    
    (44
    )Accumulated deficit
    
    
    (473,104
    )
    
    
    (476,277
    )Total stockholders equity
    
    
    6,523
    
    
    
    4,820Total liabilities and stockholders equity
    
    $
    27,415
    
    
    $
    23,199
  3




---



##### 



For the
    
    
    For theThree Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2004
    
    
    2005
    
    
    2004
    
    
    2005Revenue:Hardware
    
    $
    9,021
    
    
    $
    5,337
    
    
    $
    27,642
    
    
    $
    13,835Software
    
    
    2,616
    
    
    
    4,197
    
    
    
    4,282
    
    
    
    12,739Support and services
    
    
    2,180
    
    
    
    2,038
    
    
    
    6,557
    
    
    
    6,000Total revenue
    
    
    13,817
    
    
    
    11,572
    
    
    
    38,481
    
    
    
    32,574Cost of revenue:Product
    
    
    4,001
    
    
    
    3,195
    
    
    
    10,784
    
    
    
    9,260Support and services
    
    
    283
    
    
    
    198
    
    
    
    825
    
    
    
    607Total cost of revenue
    
    
    4,284
    
    
    
    3,393
    
    
    
    11,609
    
    
    
    9,867Gross profit
    
    
    9,533
    
    
    
    8,179
    
    
    
    26,872
    
    
    
    22,707Operating expenses:Research and development
    
    
    2,378
    
    
    
    2,045
    
    
    
    7,439
    
    
    
    6,790Sales and marketing
    
    
    4,054
    
    
    
    3,982
    
    
    
    11,826
    
    
    
    11,947General and administrative
    
    
    2,560
    
    
    
    1,917
    
    
    
    7,012
    
    
    
    5,817Restructuring
    
    
    
    
    
    
    
    
    
    
    
    
    
    
    716Total operating expenses
    
    
    8,992
    
    
    
    7,944
    
    
    
    26,277
    
    
    
    25,270Income (loss) from operations
    
    
    541
    
    
    
    235
    
    
    
    595
    
    
    
    (2,563
    )Other expense
    
    
    
    
    
    
    (125
    )
    
    
    (262
    )
    
    
    (672
    )Settlement of litigation
    
    
    
    
    
    
    (725
    )
    
    
    
    
    
    
    (725
    )Gain on derivative liability
    
    
    
    
    
    
    1,931
    
    
    
    
    
    
    
    1,931Interest income
    
    
    36
    
    
    
    46
    
    
    
    98
    
    
    
    147Interest expense
    
    
    (331
    )
    
    
    (671
    )
    
    
    (1,089
    )
    
    
    (1,291
    )Net income (loss)
    
    $
    246
    
    
    $
    691
    
    
    $
    (658
    )
    
    $
    (3,173
    )Basic and diluted earnings (loss) per share
    
    $
    0.01
    
    
    $
    0.02
    
    
    $
    (0.02
    )
    
    $
    (0.09
    )Basic weighted-average shares outstanding
    
    
    33,283
    
    
    
    34,784
    
    
    
    33,160
    
    
    
    34,509Diluted weighted-average shares outstanding
    
    
    35,125
    
    
    
    35,158
    
    
    
    33,160
    
    
    
    34,509
  4




---



##### 



For theNine Months EndedSeptember 30,2004
    
    
    2005Cash Flows From Operating Activities:Net loss
    
    $
    (658
    )
    
    $
    (3,173
    )Adjustments to reconcile net loss to net cash
used in operating activities:Depreciation
    
    
    1,063
    
    
    
    968Non-cash interest expense
    
    
    718
    
    
    
    536Gain on derivative liability
    
    
    
    
    
    
    (1,931
    )Early extinguishment of debt
    
    
    262
    
    
    
    672Bad debt expense (recovery)
    
    
    52
    
    
    
    (51
    )Non-cash compensation expense
    
    
    154
    
    
    
    99Provision for excess and obsolete inventory
    
    
    492
    
    
    
    226Changes in assets and liabilities:Accounts receivable
    
    
    (4,358
    )
    
    
    1,465Inventory
    
    
    (303
    )
    
    
    596Other assets
    
    
    (587
    )
    
    
    120Accounts payable and accrued expenses
    
    
    1,297
    
    
    
    (916
    )Deferred revenue
    
    
    (1,240
    )
    
    
    (1,619
    )Net cash used in operating activities
    
    
    (3,108
    )
    
    
    (3,008
    )Cash Flows From Investing Activities:Sales of short-term investments
    
    
    1,530
    
    
    
    Expenditures for property and equipment
    
    
    (762
    )
    
    
    (387
    )Net cash provided by (used in) investing activities
    
    
    768
    
    
    
    (387
    )Cash Flows From Financing Activities:Repayment of debentures
    
    
    (1,500
    )
    
    
    (9,000
    )Proceeds from long-term debt
    
    
    
    
    
    
    10,000Exercise of stock options and issuance of common stock
under the employee stock purchase plan
    
    
    686
    
    
    
    1,370Net cash (used in) provided by financing activities
    
    
    (814
    )
    
    
    2,370Net decrease in cash and cash equivalents
    
    
    (3,154
    )
    
    
    (1,025
    )Cash and cash equivalents, beginning of period
    
    
    15,671
    
    
    
    11,317Cash and cash equivalents, end of period
    
    $
    12,517
    
    
    $
    10,292Supplemental Cash Flow Information:Cash paid for interest
    
    $
    371
    
    
    $
    755
  5




---



##### 



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




---



##### 



Principles of Consolidation
  Inventory
  December 31,
    
    
    September 30,2004
    
    
    2005(Unaudited)Raw materials
    
    $
    1,138
    
    
    $
    1,286Work-in-progress
    
    
    
    
    
    
    197Finished goods
    
    
    4,902
    
    
    
    3,329Inventory, gross
    
    
    6,040
    
    
    
    4,812Reserve for excess and
obsolete inventory
    
    
    (2,218
    )
    
    
    (1,812
    )Inventory, net
    
    $
    3,822
    
    
    $
    3,000
  2004
    
    
    2005Balance, beginning of period
    
    $
    2,811
    
    
    $
    1,829Provision for excess and obsolete inventory
    
    
    78
    
    
    
    109Sale of previously reserved inventory
    
    
    
    
    
    
    (54
    )Actual inventory scrapped
    
    
    
    
    
    
    (72
    )Balance, end of period
    
    $
    2,889
    
    
    $
    1,812
  2004
    
    
    2005Balance, beginning of period
    
    $
    3,638
    
    
    $
    2,218Provision for excess and obsolete inventory
    
    
    492
    
    
    
    226Sale of previously reserved inventory
    
    
    (66
    )
    
    
    (397
    )Actual inventory scrapped
    
    
    (1,175
    )
    
    
    (235
    )Balance, end of period
    
    $
    2,889
    
    
    $
    1,812
 Accounts Payable and Accrued Expenses
  December 31,
    
    
    September 30,2004
    
    
    2005(Unaudited)Accounts payable
    
    $
    1,940
    
    
    $
    1,524Accrued compensation
    
    
    2,108
    
    
    
    1,546Deferred rent
    
    
    434
    
    
    
    418Accrued warranty
    
    
    384
    
    
    
    384Accrued litigation settlement
    
    
    
    
    
    
    725Other accrued expenses
    
    
    4,475
    
    
    
    3,826Total
    
    $
    9,341
    
    
    $
    8,423
 7




---



##### 



Revenue Recognition
       8




---



##### 



Accrued Warranty Costs
 Select
  2004
    
    
    2005Balance, beginning of period
    
    $
    428
    
    
    $
    384Provisions for warranty
    
    
    
    
    
    
    8Settlements made
    
    
    (11
    )
    
    
    (8
    )Balance, end of period
    
    $
    417
    
    
    $
    384
  2004
    
    
    2005Balance, beginning of period
    
    $
    425
    
    
    $
    384Provisions for warranty
    
    
    52
    
    
    
    29Settlements made
    
    
    (60
    )
    
    
    (29
    )Balance, end of period
    
    $
    417
    
    
    $
    384
 9




---



##### 



Segment Reporting and Significant Customers
  Accounting for Stock Options
    10




---



##### 



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2004
    
    
    2005
    
    
    2004
    
    
    2005Net earnings (loss), as reported
    
    $
    246
    
    
    $
    691
    
    
    $
    (658
    )
    
    $
    (3,173
    )Add: Stock-based employee compensation expense
included in reported net earnings (loss)
    
    
    33
    
    
    
    33
    
    
    
    154
    
    
    
    99Deduct: Total stock-based employee compensation
expense determined under fair value based
method for all awards
    
    
    (765
    )
    
    
    (446
    )
    
    
    (3,197
    )
    
    
    (1,196
    )Pro forma net earnings (loss)
    
    $
    (486
    )
    
    $
    278
    
    
    $
    (3,701
    )
    
    $
    (4,270
    )Earnings (loss) per share:Basic and diluted: as reported
    
    $
    0.01
    
    
    $
    0.02
    
    
    $
    (0.02
    )
    
    $
    (0.09
    )Basic and diluted: pro forma
    
    $
    (0.01
    )
    
    $
    0.01
    
    
    $
    (0.11
    )
    
    $
    (0.12
    )
  Three Months Ended
    
    Nine Months EndedSeptember 30,
    
    September 30,2004
    
    2005
    
    2004
    
    2005Dividend yield
    
    None
    
    None
    
    None
    
    NoneExpected volatility
    
    
    67
    %
    
    
    52
    %
    
    
    67
    %
    
    
    65
    %Risk-free interest rate
    
    
    3.53
    %
    
    
    4.05
    %
    
    
    3.41
    %
    
    
    3.93
    %Expected term (in years)
    
    
    5
    
    
    
    5
    
    
    
    5
    
    
    
    5
  Basic and Diluted Earnings (Loss) Per Share
    11




---



##### 



Three Months Ended
    
    
    Nine Months EndedSeptember 30,
    
    
    September 30,2004
    
    
    2005
    
    
    2004
    
    
    2005Net earnings (loss)
    
    $
    246
    
    
    $
    691
    
    
    $
    (658
    )
    
    $
    (3,173
    )Basic weighted-average number of
shares of common stock outstanding
    
    
    33,283
    
    
    
    34,784
    
    
    
    33,160
    
    
    
    34,509Add: treasury stock effect of options
    
    
    1,842
    
    
    
    374
    
    
    
    
    
    
    
    Diluted weighted-average number of
shares of common stock outstanding
    
    
    35,125
    
    
    
    35,158
    
    
    
    33,160
    
    
    
    34,509Earnings (loss) per common share:Basic
    
    $
    0.01
    
    
    $
    0.02
    
    
    $
    (0.02
    )
    
    $
    (0.09
    )Diluted
    
    $
    0.01
    
    
    $
    0.02
    
    
    $
    (0.02
    )
    
    $
    (0.09
    )
 Restructuring Charges
   New Accounting Pronouncements
   2. Line of Credit:
  12




---



##### 



3. Convertible Debentures:
     13




---



##### 



4. Convertible Notes
   
    
    failure to obtain stockholder approval for the issuance of shares of common stock
issuable upon conversion of the 2005 Notes by December 6, 2005;
    
    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 the 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.
 14




---



##### 



5. Commitments and Contingencies:
     15




---



##### 



16




---



##### 



Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
  Overview
 ® ®
  Select Select Select
 17




---



##### 



Select Select
 Select Select Select Select Select
 Select
    Select
 18




---



##### 



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 September 30, 2004 compared to three months ended September 30, 2005
  Three Months EndedSeptember 30,2004
    
    
    2005UpTime:Visual UpTime
    
    $
    8,089
    
    
    $
    Visual UpTime Select
    
    
    5,321
    
    
    
    11,235IP InSight
    
    
    407
    
    
    
    324Continuing products
    
    
    13,817
    
    
    
    11,559Royalties
    
    
    
    
    
    
    13Total revenue
    
    $
    13,817
    
    
    $
    11,572
 19




---



##### 



Three Months EndedSeptember 30,2004
    
    
    2005AT&T
    
    $
    3,992
    
    
    $
    2,773Sprint
    
    
    3,896
    
    
    
    2,139MCI
    
    
    2,101
    
    
    
    2,350Interlink Communications Systems
    
    
    *
    
    
    
    1,894All other customers (each individually
less than 10%)
    
    
    3,828
    
    
    
    2,416Total revenue
    
    $
    13,817
    
    
    $
    11,572
 
 *
    
    Denotes less than 10% of total revenue for the period.
 Revenue, cost of revenue, and gross profit
  Three Months EndedSeptember 30,Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Revenue:Hardware
    
    $
    9,021
    
    
    
    65.3
    
    
    $
    5,337
    
    
    
    46.1
    
    
    $
    (3,684
    )
    
    
    (40.8
    )Software
    
    
    2,616
    
    
    
    18.9
    
    
    
    4,197
    
    
    
    36.3
    
    
    
    1,581
    
    
    
    60.4Support and services
    
    
    2,180
    
    
    
    15.8
    
    
    
    2,038
    
    
    
    17.6
    
    
    
    (142
    )
    
    
    (6.5
    )Total revenue
    
    
    13,817
    
    
    
    100.0
    
    
    
    11,572
    
    
    
    100.0
    
    
    
    (2,245
    )
    
    
    (16.2
    )Cost of revenue:Product
    
    
    4,001
    
    
    
    29.0
    
    
    
    3,195
    
    
    
    27.6
    
    
    
    (806
    )
    
    
    (20.1
    )Support and services
    
    
    283
    
    
    
    2.0
    
    
    
    198
    
    
    
    1.7
    
    
    
    (85
    )
    
    
    (30.0
    )Total cost of revenue
    
    
    4,284
    
    
    
    31.0
    
    
    
    3,393
    
    
    
    29.3
    
    
    
    (891
    )
    
    
    (20.8
    )Gross profit
    
    $
    9,533
    
    
    
    69.0
    
    
    $
    8,179
    
    
    
    70.7
    
    
    $
    (1,354
    )
    
    
    (14.2
    )
 
 *
    
    Denotes % of total revenue for the period**
    
    Denotes % change from 2004 to 2005
  Three Months EndedSeptember 30,2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    Increase
    
    
    %**Product revenue:Hardware
    
    $
    9,021
    
    
    
    77.5
    
    
    $
    5,337
    
    
    
    56.0
    
    
    $
    (3,684
    )
    
    
    (40.8
    )Software
    
    
    2,616
    
    
    
    22.5
    
    
    
    4,197
    
    
    
    44.0
    
    
    
    1,581
    
    
    
    60.4Total product revenue
    
    
    11,637
    
    
    
    100.0
    
    
    
    9,534
    
    
    
    100.0
    
    
    
    (2,103
    )
    
    
    (18.1
    )Product cost of revenue
    
    
    4,001
    
    
    
    34.4
    
    
    
    3,195
    
    
    
    33.5
    
    
    
    (806
    )
    
    
    (20.1
    )Product gross profit
    
    $
    7,636
    
    
    
    65.6
    
    
    $
    6,339
    
    
    
    66.5
    
    
    $
    (1,297
    )
    
    
    (17.0
    )
 
 *
    
    Denotes % of product revenue for the period**
    
    Denotes % change from 2004 to 2005
 20




---



##### 



Three Months EndedSeptember 30,Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Support and services
    
    $
    2,180
    
    
    
    100.0
    
    
    $
    2,038
    
    
    
    100.0
    
    
    $
    (142
    )
    
    
    (6.5
    )Support and services cost of revenue
    
    
    283
    
    
    
    13.0
    
    
    
    198
    
    
    
    9.7
    
    
    
    (85
    )
    
    
    (30.0
    )Support and services gross profit
    
    $
    1,897
    
    
    
    87.0
    
    
    $
    1,840
    
    
    
    90.3
    
    
    $
    (57
    )
    
    
    (3.0
    )
 
 *
    
    Denotes % of support and services revenue for the period**
    
    Denotes % change from 2004 to 2005
 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 Product gross profit Select
 21




---



##### 



Operating expenses
  Three Months EndedSeptember 30,Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Operating expenses:Research and development
    
    $
    2,378
    
    
    
    17.2
    
    
    $
    2,045
    
    
    
    17.7
    
    
    $
    (333
    )
    
    
    (14.0
    )Sales and marketing
    
    
    4,054
    
    
    
    29.4
    
    
    
    3,982
    
    
    
    34.4
    
    
    
    (72
    )
    
    
    (1.8
    )General and administrative
    
    
    2,560
    
    
    
    18.5
    
    
    
    1,917
    
    
    
    16.5
    
    
    
    (643
    )
    
    
    (25.1
    )Total operating expenses
    
    $
    8,992
    
    
    
    65.1
    
    
    $
    7,944
    
    
    
    68.6
    
    
    $
    (1,048
    )
    
    
    (11.7
    )
 
 *
    
    Denotes % of total revenue for the period**
    
    Denotes % change from 2004 to 2005
 Research and development general and administrative expense
 Other items
  Three Months EndedSeptember 30,Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Other expense
    
    $
    
    
    
    
    
    
    
    $
    (125
    )
    
    
    (1.1
    )
    
    $
    (125
    )
    
    
    (100.0
    )Settlement of litigation
    
    
    
    
    
    
    
    
    
    
    (725
    )
    
    
    (6.3
    )
    
    
    (725
    )
    
    
    (100.0
    )Gain on derivative liability
    
    
    
    
    
    
    
    
    
    
    1,931
    
    
    
    16.7
    
    
    
    1,931
    
    
    
    100.0Interest income
    
    
    36
    
    
    
    0.3
    
    
    
    46
    
    
    
    0.4
    
    
    
    10
    
    
    
    27.8Interest expense
    
    
    (331
    )
    
    
    (2.4
    )
    
    
    (671
    )
    
    
    (5.8
    )
    
    
    (340
    )
    
    
    (102.7
    )
 
 *
    
    Denotes % of total revenue for the period**
    
    Denotes % change from 2004 to 2005
 Other expense
 Settlement of litigation
 Gain on derivative liability
 22




---



##### 



Interest expense
 Nine months ended September 30, 2004 compared to nine months ended September 30, 2005
  Nine Months EndedSeptember 30,2004
    
    
    2005UpTime:Visual UpTime
    
    $
    28,733
    
    
    $
    936Visual UpTime Select
    
    
    7,761
    
    
    
    30,595IP InSight
    
    
    1,876
    
    
    
    1,016Continuing products
    
    
    38,370
    
    
    
    32,547Royalties
    
    
    111
    
    
    
    27Total revenue
    
    $
    38,481
    
    
    $
    32,574
  Nine Months EndedSeptember 30,2004
    
    
    2005AT&T
    
    $
    8,238
    
    
    $
    8,550SBC
    
    
    5,633
    
    
    
    *Sprint
    
    
    8,743
    
    
    
    6,368MCI
    
    
    6,889
    
    
    
    7,747All other customers (each individually
less than 10%)
    
    
    8,978
    
    
    
    9,909Total revenue
    
    $
    38,481
    
    
    $
    32,574
 
 *
    
    Denotes less than 10% of total revenue for the period.
 Revenue, cost of revenue, and gross profit
  Nine Months EndedSeptember 30,Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Revenue:Hardware
    
    $
    27,642
    
    
    
    71.9
    
    
    $
    13,835
    
    
    
    42.5
    
    
    $
    (13,807
    )
    
    
    (49.9
    )Software
    
    
    4,282
    
    
    
    11.1
    
    
    
    12,739
    
    
    
    39.1
    
    
    
    8,457
    
    
    
    197.5Support and services
    
    
    6,557
    
    
    
    17.0
    
    
    
    6,000
    
    
    
    18.4
    
    
    
    (557
    )
    
    
    (8.5
    )Total revenue
    
    
    38,481
    
    
    
    100.0
    
    
    
    32,574
    
    
    
    100.0
    
    
    
    (5,907
    )
    
    
    (15.4
    )Cost of revenue:Product
    
    
    10,784
    
    
    
    28.0
    
    
    
    9,260
    
    
    
    28.4
    
    
    
    (1,524
    )
    
    
    (14.1
    )Support and services
    
    
    825
    
    
    
    2.2
    
    
    
    607
    
    
    
    1.9
    
    
    
    (218
    )
    
    
    (26.4
    )Total cost of revenue
    
    
    11,609
    
    
    
    30.2
    
    
    
    9,867
    
    
    
    30.3
    
    
    
    (1,742
    )
    
    
    (15.0
    )Gross profit
    
    $
    26,872
    
    
    
    69.8
    
    
    $
    22,707
    
    
    
    69.7
    
    
    $
    (4,165
    )
    
    
    (15.5
    )
 
 *
    
    Denotes % of total revenue for the period.**
    
    Denotes % change from 2004 to 2005.
 23




---



##### 



Nine Months EndedSeptember 30,2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    Increase
    
    
    %**Product revenue:Hardware
    
    $
    27,642
    
    
    
    86.6
    
    
    $
    13,835
    
    
    
    52.1
    
    
    $
    (13,807
    )
    
    
    (49.9
    )Software
    
    
    4,282
    
    
    
    13.4
    
    
    
    12,739
    
    
    
    47.9
    
    
    
    8,457
    
    
    
    197.5Total product revenue
    
    
    31,924
    
    
    
    100.0
    
    
    
    26,574
    
    
    
    100.0
    
    
    
    (5,350
    )
    
    
    (16.8
    )Product cost of revenue
    
    
    10,784
    
    
    
    33.8
    
    
    
    9,260
    
    
    
    34.8
    
    
    
    (1,524
    )
    
    
    (14.1
    )Product gross profit
    
    $
    21,140
    
    
    
    66.2
    
    
    $
    17,314
    
    
    
    65.2
    
    
    $
    (3,826
    )
    
    
    (18.1
    )
 
 *
    
    Denotes % of product revenue for the period.**
    
    Denotes % change from 2004 to 2005.
  Nine Months EndedSeptember 30,Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Support and services
    
    $
    6,557
    
    
    
    100.0
    
    
    $
    6,000
    
    
    
    100.0
    
    
    $
    (557
    )
    
    
    (8.5
    )Support and services cost of revenue
    
    
    825
    
    
    
    12.6
    
    
    
    607
    
    
    
    10.1
    
    
    
    (218
    )
    
    
    (26.4
    )Support and services gross profit
    
    $
    5,732
    
    
    
    87.4
    
    
    $
    5,393
    
    
    
    89.9
    
    
    $
    (339
    )
    
    
    (5.9
    )
 
 *
    
    Denotes % of support and services revenue for the period.**
    
    Denotes % change from 2004 to 2005.
 Revenue
 Software revenue Select Select Select
 Hardware revenue Select Select
 Select Selects Select Select
 24




---



##### 



Select
 Support and services revenue Select
  Gross profit
 Gross profit on products
 Operating expenses
  Nine Months EndedSeptember 30,Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Operating expenses:Research and development
    
    $
    7,439
    
    
    
    19.3
    
    
    $
    6,790
    
    
    
    20.8
    
    
    $
    (649
    )
    
    
    (8.7
    )Sales and marketing
    
    
    11,826
    
    
    
    30.7
    
    
    
    11,947
    
    
    
    36.7
    
    
    
    121
    
    
    
    1.0General and administrative
    
    
    7,012
    
    
    
    18.3
    
    
    
    5,817
    
    
    
    17.9
    
    
    
    (1,195
    )
    
    
    (17.0
    )Restructuring
    
    
    
    
    
    
    
    
    
    
    716
    
    
    
    2.2
    
    
    
    716
    
    
    
    100.0Total operating expenses
    
    $
    26,277
    
    
    
    68.3
    
    
    $
    25,270
    
    
    
    77.6
    
    
    $
    (1,007
    )
    
    
    (3.8
    )
 
 *
    
    Denotes % of total revenue for the period.**
    
    Denotes % change from 2004 to 2005.
 Research and development general and administrative expense
 Sales and marketing expense
 Restructuring expense
 25




---



##### 



Other items
  Nine Months EndedSeptember 30,Increase2004
    
    
    %*
    
    
    2005
    
    
    %*
    
    
    (Decrease)
    
    
    %**Other expense
    
    $
    (262
    )
    
    
    (0.7
    )
    
    $
    (672
    )
    
    
    (2.1
    )
    
    $
    (410
    )
    
    
    (156.5
    )Settlement of litigation
    
    
    
    
    
    
    
    
    
    
    (725
    )
    
    
    (2.2
    )
    
    
    (725
    )
    
    
    (100.0
    )Gain on derivative liability
    
    
    
    
    
    
    
    
    
    
    1,931
    
    
    
    5.9
    
    
    
    1,931
    
    
    
    100.0Interest income
    
    
    98
    
    
    
    0.3
    
    
    
    147
    
    
    
    0.5
    
    
    
    49
    
    
    
    50.0Interest expense
    
    
    (1,089
    )
    
    
    (2.8
    )
    
    
    (1,291
    )
    
    
    (4.0
    )
    
    
    (202
    )
    
    
    (18.5
    )
 
 *
    
    Denotes % of total revenue for the period.**
    
    Denotes % change from 2004 to 2005.
 Other expense
 Settlement of litigation
 Gain on derivative liability
 Interest expense
 Liquidity and Capital Resources
 Select
  26




---



##### 




    
    failure to obtain stockholder approval for the issuance of shares of common stock
issuable upon conversion of the 2005 Notes by December 6, 2005;
    
    default by us on other indebtedness in an amount exceeding $100,000;
    
    a final, non-appealable judgment or judgments rendered against us exceeding $250,000
in the aggregate;
    
    failure to meet certain covenants as defined by the terms of the 2005 Notes;
    
    bankruptcy of the Company; and
    
    certain other failures by us to perform obligations under the 2005 Notes and/or the
related agreements.
    27




---



##### 



Debentures
    
    
    Operating Leases2005
    
    $
    201
    
    
    $
    4062006
    
    
    500
    
    
    
    1,1322007
    
    
    10,500
    
    
    
    1,1612008
    
    
    
    
    
    
    1,170Thereafter
    
    
    
    
    
    
    1,181Total minimum payments
    
    
    11,201
    
    
    $
    5,050Interest element of payments
    
    
    (1,201
    )Present value of future minimum payments
    
    
    10,000Unamortized debt discount
    
    
    (1,813
    )Total 2005 Notes
    
    $
    8,187
     Critical Accounting Policies and Estimates
  28




---



##### 



Revenue Recognition
  Reserve for Inventory Obsolescence
  Allowance for Doubtful Accounts
  Warranty
 Select
 29




---



##### 



Deferred Tax Valuation Allowance
  Risk Factors
  We are highly dependent on sales to telecommunications service providers.
 Select Select
 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
 30




---



##### 



Failure of our stockholders to approve the issuance of shares upon the conversion of the 2005
Notes or other events of default under the 2005 Notes may have an adverse effect on us.
  We rely on outsourced contract manufacturing services primarily from a new single provider.
     31




---



##### 



We may not be able to obtain critical hardware components.
  We may experience difficulties in migrating customers to Visual UpTime Select.
 Select Select
 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 $476.3 million.
  32




---



##### 



We may not be profitable in the future.
  If we are unable to recruit or retain skilled personnel, or if we lose the services of any of
our key management personnel, our business, operating results and financial condition would be
materially adversely affected
  Potential intellectual property litigation could have a significant detrimental effect on our
business.
  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.
  33




---



##### 



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.
  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.
  34




---



##### 



Select
 Errors in our products or services could discourage customers, damage our reputation and delay
product development and enhancement.
   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
  35




---



##### 



Item 4. Controls and Procedures
   36




---



##### 



PART II  OTHER INFORMATION
 Item 1. Legal Proceedings
       37




---



##### 



Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
  Item 3. Defaults Upon Senior Securities
  Item 4. Submission of Matters to a Vote of Security Holders
  Item 5. Other Information
  Item 6. Exhibits
 Exhibit Number
    
    Description4.1*
    
    Form of 5% Senior Secured Convertible Note Due December 31, 2007.10.1*
    
    Purchase Agreement dated as of August 5, 2005 by and among
Visual Networks, Inc. and the investors set forth on the
signature pages thereto.10.2*
    
    Registration Rights Agreement dated as of August 8, 2005 by and
among Visual Networks, Inc. and the investors named in the
Purchase Agreement.10.3*
    
    Pledge and Security Agreement dated August 8, 2005 by and among
Visual Networks, Inc. and the grantors named therein.10.4
    
    Services Agreement between Visual Networks Operations, Inc. and
Mahindra-British Telecom Ltd. dated as of July 30, 2004.10.4.1
    
    Statement of Work between Visual Networks Operations, Inc. and
Mahindra-British Telecom Ltd. dated as of July 30, 2004.10.4.2
    
    Amendment No. 1 to Services Agreement between Visual Networks
Operations, Inc. and Mahindra-British Telecom Ltd. dated as of
November 5, 2005.31(i).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(i).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.*
    
    Incorporated herein by reference to the Companys Registration
Statement on Form S-3 (Commission File No. 33-128145).
    
    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.
 38




---



##### 



VISUAL NETWORKS, INC.By: /s/ Lawrence S. BarkerLawrence S. BarkerPresident and Chief ExecutiveOfficerDate: November 9, 2005By: /s/ Donald E. ClarkeDonald E. ClarkeExecutive Vice President and ChiefFinancial OfficerDate: November 9, 2005
 39