UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

 

 

 

Form 10-K

 

FOR ANNUAL AND TRANSITION REPORTS

PURSUANT TO SECTIONS 13 OR 15(d) OF THE

SECURITIES EXCHANGE ACT OF 1934

 

 

Commission file number 000-30684

 

Bookham, Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

 

Registrant’s telephone number, including area code:

408-383-1400

 

Securities registered pursuant to Section 12(b) of the Act:

 

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the Registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes o     No þ

 

Indicate by check mark if the Registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes o     No þ

 

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

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  þ

 

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

Large accelerated filer  o     Accelerated filer  þ     Non-accelerated filer  o

 

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).  Yes o     No þ

 

The aggregate market value of the common stock held by non-affiliates of the registrant was $175,610,528 based on the last reported sale price of the registrant’s common stock on September 1, 2006 as reported by the NASDAQ Global Market ($3.09 per share) (reference is made to Part II, Item 5 herein for a Statement of Assumptions upon which this calculation is based). As of September 1, 2006, there were 57,978,908 shares of common stock outstanding.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

The registrant intends to file a proxy statement pursuant to Regulation 14A within 120 days of the end of the fiscal year ended July 1, 2006. Portions of the proxy statement are incorporated herein by reference into Part III of this Annual Report on Form 10-K.

 

 

ANNUAL REPORT ON FORM 10-K

 

FOR THE FISCAL YEAR ENDED JULY 1, 2006

 

TABLE OF CONTENTS

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

 

This Annual Report on Form 10-K and the documents incorporated herein by reference contain forward-looking statements, within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended, about our plans, objectives, expectations and intentions. You can identify these statements by words such as “expect,” “anticipate,” “intend,” “objective,” “plan,” “goal”, “attempt,” “believe,” “seek,” “estimate,” “may,” “will” and “continue” or similar words or phrases. You should read statements that contain these words or phrases carefully. They discuss our future expectations, contain projections of our future results of operations or our financial condition or state other forward-looking information, and may involve known and unknown risks over which we have limited or no control. Our actual results could differ significantly from results discussed in these forward-looking statements. You should not place undue reliance on forward-looking statements. We cannot guarantee any future results, levels of activity, performance or achievements. Moreover, we assume no obligation to update forward-looking statements or update the reasons actual results could differ materially from those anticipated in forward-looking statements. Several of the important factors that may cause our actual results to differ materially from the expectations we describe in our forward-looking statements are identified in the sections captioned “Business,” “Risk Factors,” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Annual Report on Form 10-K and the documents incorporated herein by reference.

 

We design, manufacture and market optical components, modules and subsystems that generate, detect, amplify, combine and separate light signals principally for use in high-performance fiber optics communications networks. Due to its advantages of higher capacity and transmission speed, optical transmission has become the predominant technology for large scale communications networks. We believe we are the second largest vendor of optical components used for fiber optic telecommunications networks applications, on the basis of revenue.

 

Innovation at the component level has been a primary enabler of optical networking, facilitating increased transmission capacity, improving signal quality and lowering cost. For this reason, optical communications equipment vendors initially developed and manufactured their own optical components. Due to a variety of industry-related reasons, the majority of optical equipment vendors have sold, eliminated or outsourced their internal component capabilities and now rely on third-party sources for their optical component needs. In the absence of significant internal component technology expertise or manufacturing capability, communications equipment vendors have become more demanding of their component suppliers, seeking companies with broad technology portfolios, component innovation expertise, advanced manufacturing capabilities, the ability to provide more integrated solutions and financial strength.

 

We believe we offer one of the most comprehensive end-to-end portfolios of optical component solutions to the telecommunications market, enabling us to deliver more of the components our customers require. Our product portfolio includes several leading products (on the basis of our market share), such as our 10 gigabit per second, or Gb/s, discrete transmitters, receivers and optical amplifiers. We intend to maintain our leadership position for these products, as well as develop new solutions that leverage the knowledge and capital invested in our current generation of offerings.

 

We believe our advanced component design and manufacturing facilities, which would be prohibitively expensive to replicate in the current market environment, are a significant competitive advantage. On-chip, or monolithic, integration of functionality is more difficult to achieve without access to the production process, and requires advanced process know-how and equipment. Although the market for optical integrated circuits is still in its early stages, it shares many characteristics with the semiconductor market, including the positive relationship between the number of features integrated on a chip, the wafer size and the cost and sophistication of the fabrication equipment. For this reason, we believe our 3-inch wafer indium phosphide semiconductor fabrication facility in Caswell, U.K. provides us a competitive advantage as it allows us to increase the complexity of the circuits that we design and manufacture.

We intend to draw upon our internal development and manufacturing capability to continue to create innovative solutions for our customers, such as our pluggable telecommunications transceiver products and our small form factor 10 Gb/s transmitter. One example of a monolithically integrated component we make is our LMC10 transmitter, which integrates a 10 Gb/s modulator and a transmit laser on two single indium phosphide chips in a single package. On-chip integration enables us to fit the device inside a package identical in size to current, slow speed lasers, making it easier for our customers to upgrade their equipment for 10 Gb/s transmission. We believe the LMC10 transmitter is the only transmitter of its kind on the market today, and it is currently sole-sourced to a number of customers.

 

Through our acquisition and integration of seven optical components companies and businesses including those of Nortel Networks Corporation, which we refer to as Nortel Networks, and Marconi Optical Components Limited, which we refer to as Marconi, we significantly increased our product portfolio and manufacturing expertise, and we believe we enhanced established relationships with leading optical systems vendors. As part of the process of integrating acquired businesses and companies, we have taken significant steps to rationalize production capacity, adjust headcount and restructure resources to reduce manufacturing and operating overhead.

 

We acquired the optical components business of Nortel Networks in 2002 in a transaction financed in part through promissory notes issued to Nortel Networks having an aggregate principal amount of $50 million. In connection with the acquisition, Nortel Networks entered into a supply agreement with us which specified a minimum amount of products to be purchased from us. This supply agreement has since been amended three times, most recently by the third addendum to the supply agreement in January 2006. Under the second addendum, which we entered into in May 2005, Nortel Networks agreed to purchase approximately $100 million of products from us, equally divided into two categories of products: those we will discontinue manufacturing following fulfillment of the Nortel Networks orders, which we call “last-time buy” products, and products that we will continue to manufacture. In addition, pursuant to this second addendum, the price of certain products covered by the supply agreement were increased. The third addendum to the supply agreement, among other things, (i) extended the term of the supply agreement to the end of calendar 2006, and (ii) requires Nortel Networks to purchase approximately $72 million of products from us. Remaining obligations of approximately $30 million under the supply agreement, as amended, are expected to be fulfilled by the end of the December 2006 quarter. As of July 1, 2006, substantially all of Nortel Network’s “last-time buy” obligations have been fulfilled. Non-“last-time buy” purchases will be transacted at the then current market prices and not at the increased prices which were agreed to in the second addendum. In January 2006, in connection with a series of transactions, we paid all outstanding principal and interest on the promissory notes we issued to Nortel Networks, and the security agreements and related security interests securing our obligations under the notes and the supply agreement were terminated.

 

Nortel Networks has been our largest customer over the past three fiscal years, and accounted for 48% of our revenue for the fiscal year ended July 1, 2006. Over the past two quarters, revenues from Nortel Networks have been decreasing as its “last-time buy” obligations under supply agreements, as amended, have been fulfilled. We expect quarterly revenues from Nortel Networks to remain flat or decline through the remainder of calendar 2006. During the quarters ended April 1, 2006 and July 1, 2006, our quarterly revenues from all customers other than Nortel Networks have increased by 11% and 25%, respectively. One of our key strategic objectives is to continue diversifying our customer and revenue base by increasing revenues from customers other than Nortel Networks.

 

Bookham, Inc., a Delaware corporation, was incorporated on June 29, 2004. On September 10, 2004, pursuant to a scheme of arrangement under the laws of the United Kingdom, Bookham, Inc. became the publicly traded parent company of the Bookham Technology plc group of companies, including Bookham Technology plc, a public limited company incorporated under the laws of England and Wales whose stock was previously traded on the London Stock Exchange and the NASDAQ National Market. Our common stock is traded on the NASDAQ Global Market under the symbol “BKHM.”

 

We maintain a Web site with the address www.bookham.com. Our Web site includes links to our Code of Business Conduct and Ethics, and our Audit Committee, Compensation Committee, and Nominating and Corporate Governance Committee charters. We are not including the information contained in our Web site as part of, or incorporating it by reference into, this Annual Report on Form 10-K. We make available free of charge, through our Web site, our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, and Current Reports on Form 8-K,

and amendments to these reports, as soon as reasonably practical after such material is electronically filed with, or furnished to, the Securities and Exchange Commission.

 

Industry Background

 

In the 1990s, telecommunications network vendors and data communications vendors increasingly incorporated optical systems into communications infrastructures, taking advantage of the ability of fiber optic systems to support dramatically greater bandwidths than traditional copper networks. Widespread adoption of fiber optic systems has significantly improved the ability of these networks to transmit and manage the high volume of voice, video and data traffic generated in recent years by the growth of the Internet and other innovative communications technologies. The build-out of fiber optic networks requires optical components that generate, detect, amplify, combine and separate light signals as they are transmitted.

 

During the late 1990s, demand for telecommunications equipment, and the components that went into that equipment, grew dramatically. This demand was driven in part by bandwidth demands resulting from the rise of the Internet and in part by regulatory changes in the U.S. that opened the telecommunications markets to new network service providers. Many of these new networking companies elected to draw upon optical networking technology and to build their own networks in response to forecasts for exponential network traffic growth and supported by ready availability of capital.

 

The business climate for telecommunications companies became less favorable in late 2000, as network service providers began to experience significant financial difficulties. Unable to obtain financing for continued growth, and with actual network utilization below expectations due to an overbuilt infrastructure network, service providers stopped buying new equipment. In turn, many equipment providers stopped buying components, which severely affected optical component manufacturers, who were left with significant inventories, excess production capacity and cost structures not aligned with industry demand levels. In response, optical component suppliers have reduced manufacturing and operating cost overheads dramatically in order to sustain their businesses during a period of reduced demand and to achieve cost efficiencies required to meet their customers’ pricing objectives.

 

As the market for optical systems declined, optical systems vendors were exposed to many of the same inefficiencies confronting independent optical component companies. These challenges, as well as the prioritization on optical systems design manufacturing, resulted in the divestiture or closure of many captive optical component businesses. As a result, during the last three years, optical systems vendors have been seeking component suppliers with (i) a depth of technology expertise and breadth of product portfolio that no longer exists within their own organizations, and (ii) the manufacturing capabilities that they have sold, outsourced or eliminated.

 

Fewer customers, each demanding more complete solutions and requiring continued innovation at reduced cost, have led to significant consolidation among optical component suppliers. We have played an active role in this consolidation, acquiring the optical components businesses of Nortel Networks and Marconi, among others. We believe that the trend toward consolidation will continue, providing companies positioned as consolidators with the opportunity to capture increased market share and to improve profitability through increased capacity utilization and other operating efficiencies.

 

The market for optical components, modules and subsystems continues to evolve. Telecommunications network vendors are requiring optical component suppliers to take advantage of developments in product integration and miniaturization to provide solutions incorporating multiple optical components on a single subsystem or module, thereby reducing the need for component assembly and additional testing by the vendor. Accordingly, optical component suppliers who are able to offer more integrated, technologically-advanced modules and subsystems have an advantage over suppliers who can only offer discrete optical components. In addition, optical component suppliers have increasingly had to address the requirements of both the telecommunications and data communications markets. Historically, telecommunications products were characterized by high performance, high cost and significant product customization, while data communications products were characterized by high volume, low cost and standard product specifications. This distinction is becoming blurred as technologies evolve that cost-effectively address both sets of applications at attractive price points, creating an opportunity to leverage technologies that meet the broader demands of the two markets. In addition, optical technologies originally

developed for the communications industry, such as high-power lasers, are also being deployed in industrial, automotive, aerospace and military applications. These technologies offer optical component suppliers the opportunity to achieve improved margins and leverage embedded research and development expertise in new applications that are less dependent on the cycles of the telecommunications industry.

 

In early 2004, the optical components market showed signs of recovery, driven by customers and service providers with stronger balance sheets, a growing economy and regulatory changes that spurred competition among providers of voice, video and data services. Certain signs of recovery in the industry have been continuing. We believe that there are three primary drivers of this market: (i) the continued recovery of spending by telecommunications networking equipment companies, (ii) the introduction of new, more cost-effective product technologies, such as 10 Gb/s pluggable transceivers, and (iii) the expansion of optical networking in the metro space, driven by the build out of broadband access networks such as fiber-to-the-home initiatives. In addition, the growing competition among cable network operators offering voice, video and data services and traditional telephony service providers is resulting in increased utilization of optical networking technologies as communications networks converge.

 

To succeed in such a challenging and evolving market, we believe that an optical component supplier must:

 

 

Our Solution

 

We are a leading supplier of optical component solutions for the telecommunications market. Through a focused acquisition strategy, we have significantly increased our product portfolio and manufacturing expertise, and enhanced established relationships with leading optical systems vendors. We believe we are well-positioned to succeed as an optical component vendor for the following reasons:

 

 

 

We continue to evaluate further means of enhancing our financial position through various forms of financing, which could include the sale of certain assets.

 

Our Strategy

 

Our goal is to maintain and enhance our position as a leading provider of optical components, module and subsystem solutions for telecommunications providers and broaden our leadership into new markets by:

 

 

 

Our Product Offerings

 

We design, manufacture and market optical components, modules and subsystems that generate, detect, amplify, combine and separate light signals with primary application in fiber optic telecommunications networks. We have significant expertise in technology such as III-V optoelectronic semiconductors utilizing indium phosphide and gallium arsenide substrates, thin film filters and micro-optic assembly and packaging technology. In addition to these technologies, we also have electronics design, firmware and software capabilities to produce transceivers, transponders, optical amplifiers and other value-added subsystems.

 

We believe that our acquisitions of the optical component businesses of Nortel Networks and Marconi, as well as our acquisitions of Ignis Optics, New Focus, Avalon and Onetta and the assets of Cierra Photonics, Inc., which we refer to as Cierra Photonics, have significantly enhanced our product portfolio. We believe our enhanced portfolio will enable us to provide optical systems suppliers with subsystems and modules based on our components. This ability to offer a more comprehensive array of products addresses our customers’ goals of reducing the number of suppliers from whom they purchase.

 

Our products provide functionality for the various elements within the optical networking system from transmitting to receiving light signals, and include products that generate, detect, amplify, combine and separate light signals. Our product offerings that are principally aimed at the telecommunications marketplace include:

 

 

 

The optical technology originally developed for the telecommunications industry is also increasingly being deployed in other markets, such as industrial, consumer display and life sciences, in addition to the test and measurement market where it has been deployed for some time. Advancements in laser technology have improved the cost, size and power of devices, making them more suitable for non-telecommunications applications. We believe that we are positioned to benefit from the increased use of lasers in new markets as a leading provider of such technology, including advanced pump laser technology for industrial applications. Optical thin film filter technology is already widely deployed outside of telecommunications; we are focusing our efforts on developing applications for life sciences, biotechnology and consumer display industries.

 

Through our New Focus division, we develop photonics and microwave solutions for diversified markets such as research, semiconductor capital equipment and the military. We sell two primary families of products in the area of photonics and microwave solutions: advanced photonic tools principally used for generating, measuring, moving, manipulating, modulating and detecting optical signals, and tunable lasers for test and measurement applications. We sell our products to the research market primarily via an extensive catalog, and believe we benefit from the broad market awareness of our New Focus brand in this market. We pursue a direct sales approach for the semiconductor capital equipment and military markets, and currently sell to several of the leading companies in the semiconductor capital equipment market.

 

Customers, Sales and Marketing

 

We principally sell our optical component products to telecommunications systems vendors as well as to customers in the data communications, military, aerospace, industrial and manufacturing industries. Customers for our photonics and microwave product portfolio include academic and governmental research institutions that engage in advanced research and development activities, and semiconductor capital equipment manufacturers.

 

We operate in two business segments: (i) optics and (ii) research and industrial. Optics relates to the design, development, manufacture, marketing and sale of optical solutions for telecommunications and industrial applications. Research and industrial relates to the design, manufacture, marketing and sale of photonics and microwave solutions.

The following table sets forth our revenues by segment for the periods indicated:

 

Revenues by Segment

 

 

For additional information on the optics and research and industrial segments, see Note 12 — “Segments of an Enterprise and Related Information” — to our consolidated financial statements appearing elsewhere herein.

 

Nortel Networks accounted for 48% of our total revenue in the year ended July 1, 2006 (or fiscal 2006), 45% in the year ended July 2, 2005, 46% in the six-month period ended July 3, 2004, and 59% in the year ended December 31, 2003, respectively. Marconi accounted for 13% of our total revenue in the year ended December 31, 2003. In addition to our efforts to rationalize and streamline our operations, we have also undertaken efforts to realign our relationship with our largest customer, Nortel Networks, with whom we have entered into several agreements. In connection with our purchase of Nortel Networks’ optical components business in 2002, Nortel Networks agreed to a long-term supply agreement which, among other things, required Nortel Networks to purchase a specified level of products from us, and they obtained certain rights from us. We financed the acquisition of the optical components business in part through the issuance of two promissory notes having an initial aggregate principal amount of $50 million, which were settled in full in January 2006, at which time the security agreements we entered into with Nortel Networks and related security interests securing our obligations under the promissory notes and the supply agreement were terminated. Pursuant to the third addendum to the supply agreement, Nortel Networks is obligated to purchase $72 million of product from us through the end of calendar 2006.

 

During the past three years, Nortel Networks has been our largest customer. In the process of completing the delivery of a majority of the “last-time buys” required under the second addendum to the Nortel Networks supply agreement, our revenues from Nortel Networks decreased in the third and fourth quarters of fiscal 2006, from $34.3 million in the second quarter of fiscal 2006, to $24.1 million in the third quarter of fiscal 2006, to $18.5 million in this fourth quarter of fiscal 2006. Under the third addendum to the Nortel Networks supply agreement, we anticipate our quarterly revenues from Nortel Networks will continue to drop through the remaining two quarters of calendar 2006, which are the first two quarters of our fiscal 2007, and potentially decline further in future quarters.

 

General

 

We believe it is essential to maintain a comprehensive and capable direct sales and marketing organization. As of July 1, 2006, we had an established direct sales and marketing force of 91 people for all of our products sold in the U.K., China, France, Germany, Switzerland, Canada, Italy and the U.S. In addition to our direct sales and marketing force, we also sell and market our products through international sales representatives and resellers that extend our commercial reach to smaller geographic locations and customers that are not currently covered by our direct sales and marketing force. Our products targeted at research and industrial applications are sold through catalogs.

 

Our products typically have a long sales cycle. The period of time between our initial contact with a customer to the receipt of an actual purchase order is frequently a year or more. In addition, many customers perform, and require us to perform, extensive process and product evaluation and testing of components before entering into purchase arrangements.

 

In certain instances, support services for our products include customer service and technical support. Customer service representatives assist customers with orders, warranty returns and other administrative functions. Technical support engineers provide customers with answers to technical and product-related questions. Technical support engineers also provide application support to customers who have incorporated our products into custom applications.

The following table sets forth our revenues by geographic region for the periods, determined based on the country shipped to, indicated:

 

Revenues by Geographic Region

 

 

We are subject to risks related to operating in foreign countries. These risks include, among others: currency fluctuations; difficulty in accounts receivable collection and longer collection periods; difficulty in enforcing or adequately protecting our intellectual property; foreign taxes; political, legal and economic instability in foreign markets; and foreign regulations. Any of these risks, or any other risks related to our foreign operations, could materially adversely affect our business, financial condition and results of operations and could result in increased operating expenses and reduced revenues.

 

Intellectual Property

 

We believe that our proprietary technology provides us with a competitive advantage, and we intend to continue to protect our technology, as appropriate, including design, process and assembly aspects. We believe that our intellectual property portfolio is a strategic asset that we can use to develop our own sophisticated solutions and applications, or in conjunction with the technologies of the companies with whom we collaborate, for use in optical networking. Our intellectual property portfolio is supplemented by our expertise and application and process engineering know-how developed by our personnel, including personnel who joined us from Nortel Networks, Marconi, Cierra Photonics, Ignis Optics, New Focus, Avalon and Onetta. We believe that the future success of our business will depend on our ability to translate our intellectual property portfolio and the technological expertise and innovation of our personnel into new and enhanced products.

 

As of August 1, 2006, we held 292 U.S. patents and 173 non-U.S. patents, and we had approximately 295 patent applications pending in various countries. The patents we currently hold expire between 2006 and 2025. We maintain an active program to identify technology appropriate for patent protection. We require employees and consultants to execute non-disclosure and proprietary rights agreements upon commencement of employment or consulting arrangements. These agreements acknowledge our exclusive ownership of all intellectual property developed by the individuals during their work for us and require that all proprietary information disclosed will remain confidential. While such agreements may be binding, we may not be able to enforce them in all jurisdictions.

 

Although we continue to take steps to identify and protect our patentable technology and to obtain and protect proprietary rights to our technology, we cannot be certain the steps we have taken will prevent misappropriation of our technology. We may, as appropriate, take legal action to enforce our patents and trademarks and otherwise to protect our intellectual property rights, including our trade secrets. In the future, situations may arise in which we may decide to grant licenses to certain of our proprietary technology.

Research and Development

 

Since the inception of Bookham Technology plc in 1988, we have been committed to our research and development activities. We spent $42.6 million during the year ended July 1, 2006, $44.8 million during the year ended July 2, 2005, $26.9 million during the six-month period ended July 3, 2004, and $50.4 million during the year ended December 31, 2003 on our research and development programs. We believe that continued focus on the development of our technology is critical to our future competitive success and our goal is to expand and develop our line of telecommunications products, particularly in the area of subsystems, expand and develop our line of non-telecommunications products and technologies for use in a variety of different applications, enhance our manufacturing processes to reduce production costs, provide increased device performance and reduce product time to market. We also believe it is critical to focus our resources on those technologies where our strengths as a company may translate into the most significant potential for product demand and profitability. Accordingly, in connection with our most recent cost reduction plan announced in May 2006, we are rationalizing our product development portfolio to focus on such programs. As of July 1, 2006, our research and development organization comprised 352 people.

 

Our research and development facilities in Paignton, U.K., Santa Rosa and San Jose, California, and Ottawa, Canada, include computer-aided design stations, modern laboratories and automated test equipment. Our research and development organization has optical and electronic integration expertise that facilitates meeting customer-specific requirements as they arise.

 

Manufacturing

 

Our manufacturing capabilities include fabrication processing for indium phosphide, gallium arsenide and TTFs, including clean room facilities for each of these fabrication processes, along with assembly and test capability and reliability/quality testing. We utilize sophisticated semiconductor processing equipment, such as epitaxy reactors, metal deposition systems, and photolithography, etching, analytical measurement and control equipment. Our assembly and test facilities include specialized automated assembly equipment, temperature and humidity control and reliability and testing facilities.

 

We lease an advanced 3-inch wafer indium phosphide semiconductor fabrication facility, which we believe is one of our key competitive differentiators, in Caswell U.K. under a 20 year lease with an option to extend an additional 5 years after the initial 20 year period and for additional 2 year increments indefinitely after the initial 25 year period. We previously owned this facility, but in March 2006 we sold it to a subsidiary of Scarborough Development as a part of a sale-leaseback arrangement. For additional information about the sale-leaseback arrangement of the Caswell facility, see Note 5 — “Commitments and Contingencies” to our consolidated financial statement, appearing herein. We also have assembly and test facilities in Shenzhen, China and San Jose, California, and an assembly and test facility in Paignton U.K. a substantial portion of the manufacturing related activities at the Paignton U.K. facility has been transferred to Shenzhen, and the remainder are expected to be transferred no later than the end of the December 2006 quarter. We have a wafer fabrication facility in Zurich, Switzerland, and a TTF manufacturing facility in Santa Rosa, California. We previously had manufacturing facilities in Abingdon, Harlow and Swindon, U.K.; Columbia, Maryland; Poughkeepsie, New York; and Ottawa, Canada, all of which are now closed. During 2003, we consolidated our Ottawa manufacturing equipment and activities into our existing Caswell facility and consolidated our optical amplifier assembly and test operations and chip-on-carrier operations into our Paignton site. In 2003, we substantially underutilized our existing manufacturing capacity. In 2004, we implemented a restructuring plan which included a reduction in our excess manufacturing floor space to 700,000 square feet and the transfer of a majority of our assembly and test operations from Paignton to Shenzhen in order to take advantage of the comparatively low manufacturing costs in China. In the quarter ended October 2, 2004, we commenced assembly and test operations in Shenzhen. Revenues shipped from our Shenzhen facility have increased from $3.1 million in the quarter ended March 31, 2005 to $36.8 million in the quarter ended July 1, 2006. The transfer of assembly and test operations from our Paignton facility was substantially complete by the end of the quarter ended April 1, 2006, except for a remaining assembly process expected to transition to Shenzhen by the end of December 2006. In May 2006, we announced plans to transition all remaining supply chain and manufacturing overhead support from Paignton to Shenzhen.

The following table sets forth our long-lived tangible assets by geographic region as of the dates indicated:

 

Long-Lived Tangible Assets

 

 

The following table sets forth our total assets by geographic region as of the dates indicated:

 

Total Assets

 

 

Competition

 

The market for our products is highly competitive. We believe we compete favorably with respect to the following factors:

 

 

With respect to our telecommunications products, we also believe we compete favorably on the basis of our historical customer relationships and the breadth of our product lines.

 

Although we believe that we compete favorably with respect to these factors, there can be no assurance that we will continue to do so. We encounter substantial competition in most of our markets, although no one competitor competes with us across all product lines or markets.

 

We believe that our principal competitors in telecommunications are the major suppliers of optical components and modules, including both vendors selling to third parties and components companies owned by large telecommunications equipment manufacturers. Specifically, we believe that we compete against two main categories of competitors in telecommunications:

 

 

In addition, as we integrate and expand our offerings into new markets, we may compete against market leaders, such as Agilent, Finisar and Marvell, which acquired Intel’s communications business, in industries such as semiconductor and data communications, who may have significantly more resources than we do.

 

In the area of photonics and microwave solutions, we compete with a number of companies including Melles Griot, Newport, Thermo Oriel (a unit of the Thermo Photonics Division of Thermo Electron Corporation), Thorlabs, Miteq and Aeroflex.

 

Employees

 

As of July 1, 2006, we employed 2,123 persons, including 352 in research and development, 1,571 in manufacturing, 90 in sales and marketing, and 110 in finance and administration. None of our employees are subject to collective bargaining agreements. We believe that our relations with our employees are good.

 

Investing in our securities involves a high degree of risk. You should carefully consider the risks and uncertainties described below in addition to the other information included or incorporated by reference in this Annual Report on Form 10-K. If any of the following risks actually occur, our business, financial condition or results of operations would likely suffer. In that case, the trading price of our common stock could fall.

 

Risks Related to Our Business

 

We have a history of large operating losses and we expect to generate losses in the future unless we achieve further cost reductions and revenue increases.

 

We have never been profitable. We have incurred losses and negative cash flow from operations since our inception. As of July 1, 2006, we had an accumulated deficit of $954 million.

 

Our net loss for the year ended July 1, 2006 was $87.5 million, which included an $18.8 million loss on conversion of convertible debt and early extinguishment of debt, a $11.7 million tax gain, and an aggregate of $11.2 million of restructuring charges. For the year ended July 2, 2005 our net loss was $248 million, which included goodwill and intangibles impairment charges of $114.2 million and restructuring charges of $20.9 million.

 

Even though we generated positive gross margins in each of the past five fiscal quarters, we have a history of negative gross margins. In the quarter ended April 1, 2006, we experienced a decrease in margins when compared with the prior fiscal quarter, which is the result of a shift to lower margin products as we transition to new products, underutilization of our semiconductor facility located in Caswell, U.K. as a result of the changing product mix, and costs associated with the shutdown of certain production lines in our Paignton assembly and test facility. We may not be able to maintain positive gross margins if we do not address these issues, continue to reduce our costs, improve our product mix and generate sufficient revenues from new and existing customers to offset the revenues we will lose after Nortel Networks completes its “last-time-buy” purchases and its other purchases pursuant to the supply agreement, as amended.

 

In order to continue as a going concern, we will need capital in excess of our current cash resources.

 

Based on our cash balances, and given our continuing and expected losses for the foreseeable future, if we fail to meet management’s current cash flow forecasts, or we are unable to draw sufficient amounts under the three year $25 million senior secured revolving credit agreement with Wells Fargo Foothill, Inc. and other lenders, which was entered into in August 2006, for any reason, we will need to raise additional funding of at least $10 million to $20 million through external sources prior to July 2007 in order to maintain sufficient financial resources in order to operate as a going concern through the end of fiscal 2007. If necessary, we will attempt to raise additional funds by any one or a combination of the following: (i) completing the sale of certain assets; (ii) issuing equity, debt or convertible debt (iii) selling certain non core businesses. There can be no assurance of our ability to raise sufficient capital through the above, or any other efforts.

We remain highly dependent on sales to Nortel Networks and we expect revenues from Nortel Networks to decrease at least through calendar 2006.

 

Historically, Nortel Networks has been our largest customer. In the fiscal year ended July 1, 2006 and in the fiscal year ended July 2, 2005, we sold $110.5 million and $89.5 million of products and services to Nortel Networks, or 48% and 45% of our total revenues, respectively.

 

In connection with the third addendum to the supply agreement with Nortel Networks we entered into on January 13, 2006, Nortel Networks is obligated to purchase $72 million of our products through calendar year 2006. There can be no assurance Nortel Networks will continue to buy any of our products after the supply agreement, as amended, is completed, or if Nortel Networks does not continue to buy at its current level, that we can replace the loss of revenue from Nortel Networks with revenue from other customers. To the extent that we may rely on Nortel Networks for revenues in the future, Nortel Networks has experienced significant losses in the past and any future adverse change in Nortel Networks’ financial condition could adversely affect their demand for our products.

 

Our success will depend on our ability to anticipate and respond to evolving technologies and customer requirements.

 

The market for telecommunications equipment is characterized by substantial capital investment and diverse and evolving technologies. For example, the market for optical components is currently characterized by a trend toward the adoption of “pluggable” components and tunable transmitters that do not require the customized interconnections of traditional fixed wave length “gold box” devices and the increased integration of components on subsystems. Our ability to anticipate and respond to these and other changes in technology, industry standards, customer requirements and product offerings and to develop and introduce new and enhanced products will be significant factors in our ability to succeed. We expect that new technologies will continue to emerge as competition in the telecommunications industry increases and the need for higher and more cost efficient bandwidth expands. The introduction of new products embodying new technologies or the emergence of new industry standards could render our existing products uncompetitive from a pricing standpoint, obsolete or unmarketable.

 

We may encounter unexpected costs or delays in transferring our assembly and test operations from the United Kingdom to Shenzhen, China.

 

A key element of our restructuring and cost reduction efforts is the successful transfer of substantially all of our assembly and test operations from Paignton, U.K. to Shenzhen, China. Accordingly, we expect that our ability to transfer manufacturing capabilities to, and to operate effectively in, China is critical to the overall success of our business. We began to implement the transfer of our assembly and test operations from Paignton to Shenzhen in the fall of 2004. The substantial portion of the manufacturing transfer has been completed as of July 1, 2006. In November 2005, we announced that our chip-on-carrier assembly will also be transferred from Paignton to Shenzhen. We expect that the transfer of chip-on-carrier assembly operation to Shenzhen will continue at least into the quarter ended December 31, 2006. In May 2006, we announced that substantially all remaining manufacturing and supply chain management and related activities in Paignton would also be transferred to Shenzhen, and that transfer will also continue at least into the quarter ended December 31, 2006. Our business and results of operations would be materially adversely affected if we experience delays in, increased costs related to, or if we are ultimately unable to:

 

 

During the year ended July 1, 2006, we recorded significant unanticipated costs related to the wind-down of manufacturing activities in Paignton, and the transfer of the related activities to Shenzhen, and we may continue to do so in the future. If we continue to incur these unanticipated costs in connection with transferring certain operations to our Shenzhen facility, our business and results of operations will be adversely affected.

 

The market for optical components continues to be characterized by excess capacity and intense price competition which has had, and will continue to have, a material adverse affect on our results of operations.

 

By 2002, actual demand for optical communications equipment and components was dramatically less than that forecasted by leading market researchers only two years before. Even though the market for optical components has been recovering recently, particularly in the metro market segment, there continues to be excess capacity, intense price competition among optical component manufacturers and continued consolidation of the industry. As a result of this excess capacity, and other industry factors, pricing pressure remains intense. The continued uncertainties in the telecommunications industry and the global economy make it difficult for us to anticipate revenue levels and therefore to make appropriate estimates and plans relating to cost management. Continued uncertain demand for optical components has had, and will continue to have, a material adverse effect on our results of operations.

 

A default under our supply agreement with Nortel Networks would have an adverse impact on our ability to conduct our business.

 

We are party to a supply agreement with Nortel Networks that has been amended three times, most recently in January 2006. The supply agreement, as amended, requires that we grant a license for the assembly, test, post-processing and test intellectual property (but excluding wafer technology) of certain critical products to Nortel Networks and to any designated alternative supplier, if at any time, we: are unable to manufacture critical products for Nortel Networks in any material respect for a continuous period of not less than six weeks, or are subject to an insolvency event, such as a petition or assignment in bankruptcy, appointment of a trustee, custodian or receiver, or entrance into an arrangement for the general benefit of creditors. In addition, if there is an insolvency event, Nortel Networks will have the right to buy all Nortel Networks inventory we hold, and we will be obligated to grant a license to Nortel Networks or any alternative supplier for the manufacture of all products covered by the first addendum to the supply agreement. Our revenues and business would be substantially harmed if we were required to license this assembly, test, post-processing and test intellectual property to Nortel Networks or any supplier they were to designate.

 

We and our customers are each dependent upon a limited number of customers.

 

Historically, we have generated most of our revenues from a limited number of customers. Sales to one customer, Nortel Networks, accounted for 48% and 45% of our revenues for the year ended July 1, 2006 and the year ended July 2, 2005, respectively. In addition to the reduced outlook for revenue from Nortel Networks after the purchase orders under the supply agreement, as amended, are filled, we expect that revenue from our other major customers may decline or fluctuate significantly during the remainder of calendar year 2006 and beyond. We may not be able to offset any such decline in revenues from our existing major customers with revenues from new customers.

 

Our dependence on a limited number of customers is due to the fact that the optical telecommunications systems industry is dominated by a small number of large companies. Similarly, our customers depend primarily on a limited number of major telecommunications carrier customers to purchase their products that incorporate our optical components. Many major telecommunication systems companies and telecommunication carriers are experiencing losses from operations. The further consolidation of the industry, coupled with declining revenues from our major customers, may have a material adverse impact on our business.

As a result of our global operations, our business is subject to currency fluctuations that have adversely affected our results of operations in recent quarters and may continue to do so in the future.

 

Our financial results have been materially impacted by foreign currency fluctuations and our future financial results may also be materially impacted by foreign currency fluctuations. At certain times in our history, declines in the value of the U.S. dollar versus the U.K. pound sterling have had a major negative effect on our profit margins and our cash flow. Despite our change in domicile from the United Kingdom to the United States and the implementation of our restructuring program to move all assembly and test operations from Paignton, U.K. to Shenzhen, China, the majority of our expenses are still denominated in U.K. pounds sterling and substantially all of our revenues are denominated in U.S. dollars. Fluctuations in the exchange rate between these two currencies and, to a lesser extent, other currencies in which we collect revenues and pay expenses will continue to have a material affect on our operating results. Additional exposure could result should the exchange rate between the U.S. dollar and the Chinese Yuan vary more significantly than it has to date.

 

We engage in currency transactions in an effort to cover any exposure to such fluctuations, and we may be required to convert currencies to meet our obligations. Under certain circumstances, these transactions can have an adverse effect on our financial condition.

 

We are increasing manufacturing operations in China, which exposes us to risks inherent in doing business in China.

 

We are taking advantage of the comparatively low manufacturing costs in China by transferring substantially all of our assembly and test operations, chip-on-carrier operations and manufacturing and supply chain management operations to our facility in Shenzhen, China. Operations in China are subject to greater political, legal and economic risks than our operations in other countries. In order to operate the facility, we must obtain and retain required legal authorization and train and hire a workforce. In particular, the political, legal and economic climate in China, both nationally and regionally, is fluid and unpredictable. Our ability to operate in China may be adversely affected by changes in Chinese laws and regulations such as those related to taxation, import and export tariffs, environmental regulations, land use rights, intellectual property and other matters. In addition, we may not obtain or retain the requisite legal permits to continue to operate in China and costs or operational limitations may be imposed in connection with obtaining and complying with such permits.

 

We have been advised that power may be rationed in the location of our Shenzhen facility, and were power rationing to be implemented, it could either have an adverse impact on our ability to complete manufacturing commitments on a timely basis or, alternatively, could require significant investment in generating capacity to sustain uninterrupted operations at the facility. Our ability to transfer chip-on-carrier operations and manufacturing and supply chain management operations from our facilities in the U.K. to China would be hindered by a power rationing. We may also be required to expend greater amounts than we currently anticipate in connection with increasing production at the facility. Any one of these factors, or a combination of them, could result in unanticipated costs, which could materially and adversely affect our business.

 

We intend to export the majority of the products manufactured at our Shenzhen facility. Under current regulations, upon application and approval by the relevant governmental authorities, we will not be subject to certain Chinese taxes and will be exempt from certain duties on imported materials that are used in the manufacturing process and subsequently exported from China as finished products. However, Chinese trade regulations are in a state of flux, and we may become subject to other forms of taxation and duties in China or may be required to pay export fees in the future. In the event that we become subject to new forms of taxation in China, our business and results of operation could be materially adversely affected.

 

Fluctuations in operating results could adversely affect the market price of our common stock.

 

Our revenues and operating results are likely to fluctuate significantly in the future. The timing of order placement, size of orders and satisfaction of contractual customer acceptance criteria, as well as order or shipment delays or deferrals, with respect to our products, may cause material fluctuations in revenues. Our lengthy sales cycle, which may extend to more than one year, may cause our revenues and operating results to vary from period to period and it may be difficult to predict the timing and amount of any variation. Delays or deferrals in purchasing

decisions may increase as we develop new or enhanced products for new markets, including data communications, aerospace, industrial and military markets. Our current and anticipated future dependence on a small number of customers increases the revenue impact of each customer’s decision to delay or defer purchases from us. Our expense levels in the future will be based, in large part, on our expectations regarding future revenue sources and, as a result, net income for any quarterly period in which material orders fail to occur, or are delayed or deferred could vary significantly.

 

Because of these and other factors, quarter-to-quarter comparisons of our results of operations may not be an indication of future performance. In future periods, results of operations may differ from the estimates of public market analysts and investors. Such a discrepancy could cause the market price of our common stock to decline.

 

We may incur additional significant restructuring charges that will adversely affect our results of operations.

 

Over the past five years, we have enacted a series of restructuring plans and cost reduction plans designed to reduce our manufacturing overhead and our operating expenses. In 2001, we reduced manufacturing overhead and our operating expenses in response to the initial decline in demand in the optics components industry. In connection with our acquisitions of Nortel Networks’ optical components business in November 2002 and New Focus in March 2004, we enacted restructuring plans related to the consolidation of our operations, which we expanded in September 2004 to include the transfer of our main corporate functions, including consolidated accounting, financial reporting, tax and treasury, from Abingdon, U.K. to our new U.S headquarters in San Jose, California.

 

In May and November of 2004, we adopted additional restructuring plans, which included the transfer of our assembly and test operations from Paignton, U.K. to Shenzhen, China, a process that commenced in the quarter ended October 2, 2004. This transition was substantially complete by the end of March 2006, except for a chip-on-carrier assembly process we added to the transition plan in November 2005, and which we expect to be completed by the end of December 2006. In May 2006, we announced our latest cost reduction plans, which included transitioning all remaining manufacturing support and supply chain management, along with pilot line production and production planning, from Paignton to Shenzhen, also by the end of December, 2006.

 

With respect to the transfer of the operations described in the previous paragraph, some of which are still in the process of being transferred, we have spent $22.6 million as of July 1, 2006, and we anticipate spending a total of approximately $30 million to $37 million, including $6.0 million to $7.0 million on the cost reduction plan announced in May 2006. The substantial portion of the remaining spending relates to personnel and personnel related costs. We expect the cost reduction plan announced in May 2006 to reduce our costs by between $5.5 million and $6.5 million a quarter, when compared to the expenses incurred in the quarter ended April 1, 2006, with the cost savings expected to be realized in the March 2007 quarter.

 

We may incur charges in excess of amounts currently estimated for these restructuring and cost reduction plans. We may incur additional charges in the future in connection with future restructurings and cost reduction plans. These charges, along with any other charges, have adversely affected, and will continue to adversely affect, our results of operations for the periods in which such charges have been, or will be, incurred.

 

Our results of operations may suffer if we do not effectively manage our inventory, and we may incur inventory-related charges.

 

We need to manage our inventory of component parts and finished goods effectively to meet changing customer requirements. The ability to accurately forecast customers’ product needs is difficult. Some of our products and supplies have in the past, and may in the future, become obsolete while in inventory due to rapidly changing customer specifications or a decrease in customer demand. If we are not able to manage our inventory effectively, we may need to write down the value of some of our existing inventory or write off unsaleable or obsolete inventory, which would adversely affect our results of operations. We have from time to time incurred significant inventory-related charges. During the year ended July 1, 2006, we incurred significant costs for inventory production variances associated with unanticipated shifts in the mix of our customers’ product orders. Any such charges we incur in future periods could significantly adversely affect our results of operations.

Charges to earnings resulting from the application of the purchase method of accounting may adversely affect the market value of our common stock.

 

We account for our acquisitions, including the acquisition of New Focus, using the purchase method of accounting. In accordance with GAAP, we allocate the total estimated purchase price to the acquired company’s net tangible assets, amortizable intangible assets, and in-process research and development based on their fair values as of the date of announcement of the transaction, and record the excess of the purchase price over those fair values as goodwill. With respect to our acquisition of New Focus, we expensed the portion of the estimated purchase price allocated to in-process research and development in the third quarter of fiscal 2004. We will incur an increase in the amount of amortization expense over the estimated useful lives of certain of the intangible assets acquired in connection with the acquisition on an annual basis. To the extent the value of goodwill or intangible assets with indefinite lives becomes impaired, we may be required to incur material charges relating to the impairment of those assets. In the year ended July 2, 2005, following a triggering event in the third quarter and in accordance with our policy of evaluating long-lived assets for impairment in the fourth quarter, we recorded charges totaling $114.2 million related to the impairment of goodwill and purchased intangible assets. In addition, in the past, after the completion of a transaction, we have amended the provisional values of assets and liabilities we obtained as part of transactions, specifically the acquisition of the optical components business of Nortel Networks. This amendment resulted in the value of our inventory being increased by $20.2 million, current liabilities being increased by approximately $1.3 million, intangible assets being decreased by approximately $9.1 million and property, plant and equipment being increased by $9.8 million. In March 2006, we acquired Avalon Photonics AG, and recorded $2.5 million as the value of goodwill and $2.2 million as the value of purchased intangible assets, both of which will be subject to reviews for impairment of value in the future. We cannot assure you that we will not incur charges in the future as a result of any such transaction, which charges may have an adverse effect on our earnings.

 

Bookham Technology plc may not be able to utilize tax losses and other tax attributes against the receivables that arise as a result of its transaction with Deutsche Bank.

 

On August 10, 2005, Bookham Technology plc purchased all of the issued share capital of City Leasing (Creekside) Limited, a subsidiary of Deutsche Bank. Creekside is entitled to receivables of £73.8 million (approximately $135.8 million, based on an exchange rate of £1.00 to $1.8403, the noon buying rate on September 2, 2005 for cable transfers in foreign currencies as certified by the Federal Reserve Bank of New York) from Deutsche Bank in connection with certain aircraft subleases and will in turn apply those payments over a two-year term to obligations of £73.1 million (approximately $134.5 million based on an exchange rate of £1.00 to $1.8403) owed to Deutsche Bank. As a result of these transactions, Bookham Technology plc will have available through Creekside cash of approximately £6.63 million (approximately $12.2 million based on an exchange rate of £1.00 to $1.8405). We expect Bookham Technology plc to utilize certain expected tax losses and other tax attributes to reduce the taxes that might otherwise be due by Creekside as the receivables are paid. In the event that Bookham Technology plc is not able to utilize these tax losses and other tax attributes when U.K. tax returns are filed for the relevant periods (or these tax losses and other tax attributes do not arise), Creekside may have to pay taxes, reducing the cash available from Creekside. In the event there is a future change in applicable U.K. tax law, Creekside, and in turn Bookham Technology plc, would be responsible for any resulting tax liabilities, which amounts could be material to our financial condition or operating results.

 

Our products are complex, may take longer to develop than anticipated and we may not recognize revenues from new products until after long field testing and customer acceptance periods.

 

Many of our new products must be tailored to customer specifications. As a result, we are constantly developing new products and using new technologies in those products. For example, while we currently manufacture and sell “discrete gold box” technology, we expect that many of our sales of gold box technology will soon be replaced by pluggable modules. New products or modification to existing products often take many quarters to develop because of their complexity and because customer specifications sometimes change during the development cycle. We often incur substantial costs associated with the research and development and sales and marketing activities in connection with products that may be purchased long after we have incurred the costs associated with designing, creating and selling such products. In addition, due to the rapid technological changes in

our market, a customer may cancel or modify a design project before we begin large-scale manufacture of the product and receive revenue from the customer. It is unlikely that we would be able to recover the expenses for cancelled or unutilized design projects. It is difficult to predict with any certainty, particularly in the present economic climate, the frequency with which customers will cancel or modify their projects, or the effect that any cancellation or modification would have on our results of operations.

 

If our customers do not qualify our manufacturing lines or the manufacturing lines of our subcontractors for volume shipments, our operating results could suffer.

 

Most of our customers do not purchase products, other than limited numbers of evaluation units, prior to qualification of the manufacturing line for volume production. Our existing manufacturing lines, as well as each new manufacturing line, must pass through varying levels of qualification with our customers. Our manufacturing lines have passed our qualification standards, as well as our technical standards. However, our customers may also require that we pass their specific qualification standards and that we, and any subcontractors that we may use, be registered under international quality standards. In addition, we have in the past, and may in the future, encounter quality control issues as a result of relocating our manufacturing lines or introducing new products to fill production. We may be unable to obtain customer qualification of our manufacturing lines or we may experience delays in obtaining customer qualification of our manufacturing lines. Such delays would harm our operating results and customer relationships.

 

Delays, disruptions or quality control problems in manufacturing could result in delays in product shipments to customers and could adversely affect our business.

 

We may experience delays, disruptions or quality control problems in our manufacturing operations or the manufacturing operations of our subcontractors. As a result, we could incur additional costs that would adversely affect gross margins, and product shipments to our customers could be delayed beyond the shipment schedules requested by our customers, which would negatively affect our revenues, competitive position and reputation. Furthermore, even if we are able to deliver products to our customers on a timely basis, we may be unable to recognize revenues at the time of delivery based on our revenue recognition policies.

 

We may experience low manufacturing yields.

 

Manufacturing yields depend on a number of factors, including the volume of production due to customer demand and the nature and extent of changes in specifications required by customers for which we perform design-in work. Higher volumes due to demand for a fixed, rather than continually changing, design generally result in higher manufacturing yields, whereas lower volume production generally results in lower yields. In addition, lower yields may result, and have in the past resulted, from commercial shipments of products prior to full manufacturing qualification to the applicable specifications. Changes in manufacturing processes required as a result of changes in product specifications, changing customer needs and the introduction of new product lines have historically caused, and may in the future cause, significantly reduced manufacturing yields, resulting in low or negative margins on those products. Moreover, an increase in the rejection rate of products during the quality control process, either before, during or after manufacture, results in lower yields and margins. Finally, manufacturing yields and margins can also be lower if we receive or inadvertently use defective or contaminated materials from our suppliers.

 

We depend on a number of suppliers who could disrupt our business if they stopped, decreased or delayed shipments.

 

We depend on a number of suppliers of raw materials and equipment used to manufacture our products. Some of these suppliers are sole sources. We typically have not entered into long-term agreements with our suppliers and, therefore, these suppliers generally may stop supplying materials and equipment at any time. The reliance on a sole supplier or limited number of suppliers could result in delivery problems, reduced control over product pricing and quality, and an inability to identify and qualify another supplier in a timely manner. Any supply deficiencies relating to the quality or quantities of materials or equipment we use to manufacture our products could adversely affect our ability to fulfill customer orders or our financial results of operations.

Our intellectual property rights may not be adequately protected.

 

Our future success will depend, in large part, upon our intellectual property rights, including patents, design rights, trade secrets, trademarks, know-how and continuing technological innovation. We maintain an active program of identifying technology appropriate for patent protection. Our practice is to require employees and consultants to execute non-disclosure and proprietary rights agreements upon commencement of employment or consulting arrangements. These agreements acknowledge our exclusive ownership of all intellectual property developed by the individuals during their work for us and require that all proprietary information disclosed will remain confidential. Although such agreements may be binding, they may not be enforceable in all jurisdictions and any breach of a confidentiality obligation could have a very serious effect on our business and the remedy for such breach may be limited.

 

Our intellectual property portfolio is an important corporate asset. The steps we have taken and may take in the future to protect our intellectual property may not adequately prevent misappropriation or ensure that others will not develop competitive technologies or products. We cannot assure investors that our competitors will not successfully challenge the validity of our patents or design products that avoid infringement of our proprietary rights with respect to our technology. There can be no assurance that other companies are not investigating or developing other similar technologies, that any patents will be issued from any application pending or filed by us or that, if patents are issued, the claims allowed will be sufficiently broad to deter or prohibit others from marketing similar products. In addition, we cannot assure investors that any patents issued to us will not be challenged, invalidated or circumvented, or that the rights under those patents will provide a competitive advantage to us. Further, the laws of certain regions in which our products are or may be developed, manufactured or sold, including Asia-Pacific, Southeast Asia and Latin America, may not protect our products and intellectual property rights to the same extent as the laws of the United States, the U.K. and continental European countries. This is especially relevant as we transfer of our assembly and test operations and chip-on-carrier operations from our facilities in the U.K. to Shenzhen, China and as our competitors establish manufacturing operations in China to take advantage of comparatively low manufacturing costs.

 

Our products may infringe the intellectual property rights of others which could result in expensive litigation, require us to obtain a license to use the technology from third parties, or we may be prohibited from selling certain products in the future.

 

Companies in the industry in which we operate frequently receive claims of patent infringement or infringement of other intellectual property rights. In this regard, third parties may in the future assert claims against us concerning our existing products or with respect to future products under development. We have entered into and may in the future enter into indemnification obligations in favor of some customers that could be triggered upon an allegation or finding that we are infringing other parties’ proprietary rights. If we do infringe a third party’s rights, we may need to negotiate with holders of patents relevant to our business. We have from time to time received notices from third parties alleging infringement of their intellectual property and where appropriate have entered into license agreements with those third parties with respect to that intellectual property. We may not in all cases be able to resolve allegations of infringement through licensing arrangements, settlement, alternative designs or otherwise. We may take legal action to determine the validity and scope of the third-party rights or to defend against any allegations of infringement. In the course of pursuing any of these means or defending against any lawsuits filed against us, we could incur significant costs and diversion of our resources. Due to the competitive nature of our industry, it is unlikely that we could increase our prices to cover such costs. In addition, such claims could result in significant penalties or injunctions that could prevent us from selling some of our products in certain markets or result in settlements that require payment of significant royalties that could adversely affect our ability to price our products profitably.

 

If we fail to obtain the right to use the intellectual property rights of others necessary to operate our business, our ability to succeed will be adversely affected.

 

Certain companies in the telecommunications and optical components markets in which we sell our products have experienced frequent litigation regarding patent and other intellectual property rights. Numerous patents in these industries are held by others, including academic institutions and our competitors. Optical component

suppliers may seek to gain a competitive advantage or other third parties may seek an economic return on their intellectual property portfolios by making infringement claims against us. In the future, we may need to obtain license rights to patents or other intellectual property held by others to the extent necessary for our business. Unless we are able to obtain such licenses on commercially reasonable terms, patents or other intellectual property held by others could inhibit our development of new products for our markets. Licenses granting us the right to use third-party technology may not be available on commercially reasonable terms, if at all. Generally, a license, if granted, would include payments of up-front fees, ongoing royalties or both. These payments or other terms could have a significant adverse impact on our operating results. Our larger competitors may be able to obtain licenses or cross-license their technology on better terms than we can, which could put us at a competitive disadvantage.

 

The markets in which we operate are highly competitive, which could result in lost sales and lower revenues.

 

The market for fiber optic components is highly competitive and such competition could result in our existing customers moving their orders to competitors. Certain of our competitors may be able more quickly and effectively to:

 

 

Many of our current competitors, as well as a number of our potential competitors, have longer operating histories, greater name recognition, broader customer relationships and industry alliances and substantially greater financial, technical and marketing resources than we do. In addition, market leaders in industries such as semiconductor and data communications, who may also have significantly more resources than we do, may in the future enter our market with competing products. All of these risks may be increased if the market were to further consolidate through mergers or other business combinations between competitors.

 

We cannot assure investors that we will be able to compete successfully with our competitors or that aggressive competition in the market will not result in lower prices for our products or decreased gross profit margins. Any such development would have a material adverse effect on our business, financial condition and results of operations.

 

We generate a significant portion of our revenues internationally and therefore are subject to additional risks associated with the extent of our international operations.

 

For the year ended July 1, 2006, the year ended July 2, 2005, the six months ended July 3, 2004, and the year ended December 31, 2003, 21%, 28%, 26%, and 9% of our revenues, respectively, were derived in the United States and 79%, 72%, 74%, and 91%, respectively, were derived outside the United States. We are subject to additional risks related to operating in foreign countries, including:

 

 

Any of these risks, or any other risks related to our foreign operations, could materially adversely affect our business, financial condition and results of operations.

Our business will be adversely affected if we cannot manage the significant changes in the number of our employees and the size of our operations.

 

We have significantly reduced the number of employees and scope of our operations because of declining demand for certain of our products and continue to reduce our headcount in connection with our on-going restructuring and cost reduction efforts. There is a risk that, during periods of growth or decline, management will not sufficiently coordinate the roles of individuals to ensure that all areas of our operations receive appropriate focus and attention. If we are unable to manage our headcount, manufacturing capacity and scope of operations effectively, the cost and quality of our products may suffer, we may be unable to attract and retain key personnel and we may be unable to market and develop new products. Further, the inability to successfully manage the substantially larger and geographically more diverse organization, or any significant delay in achieving successful management, could have a material adverse effect on us and, as a result, on the market price of our common stock.

 

We may be faced with product liability claims.

 

Despite quality assurance measures, there remains a risk that defects may occur in our products. The occurrence of any defects in our products could give rise to liability for damages caused by such defects and for consequential damages. They could, moreover, impair the market’s acceptance of our products. Both could have a material adverse effect on our business and financial condition. In addition, we may assume product warranty liabilities related to companies we acquire which could have a material adverse effect on our business and financial condition. In order to mitigate the risk of liability for damages, we carry product liability insurance with a $26 million aggregate annual limit and errors and omissions insurance with a $5 million annual limit. We cannot assure investors that this insurance could adequately cover our costs arising from defects in our products or otherwise.

 

If we fail to attract and retain key personnel, our business could suffer.

 

Our future depends, in part, on our ability to attract and retain key personnel. Competition for highly skilled technical people is extremely intense and we continue to face difficulty identifying and hiring qualified engineers in many areas of our business. We may not be able to hire and retain such personnel at compensation levels consistent with our existing compensation and salary structure. Our future also depends on the continued contributions of our executive management team and other key management and technical personnel, each of whom would be difficult to replace. The loss of services of these or other executive officers or key personnel or the inability to continue to attract qualified personnel could have a material adverse effect on our business.

 

Similar to other technology companies, we rely upon our ability to use stock options and other forms of equity-based compensation as key components of our executive and employee compensation structure. Historically, these components have been critical to our ability to retain important personnel and offer competitive compensation packages. Without these components, we would be required to significantly increase cash compensation levels (or develop alternative compensation structures) in order to retain our key employees. Accounting rules relating to the expensing of equity compensation may cause us to substantially reduce, modify, or even eliminate, all or portions of our equity compensation programs.

 

Our business and future operating results may be adversely affected by events outside of our control.

 

Our business and operating results are vulnerable to interruption by events outside of our control, such as earthquakes, fire, power loss, telecommunications failures, political instability, military conflict and uncertainties arising out of terrorist attacks, including a global economic slowdown, the economic consequences of additional military action or additional terrorist activities and associated political instability, and the effect of heightened security concerns on domestic and international travel and commerce.

Risks Related to Regulatory Compliance and Litigation

 

If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results, which may cause stockholders to lose confidence in the accuracy of our financial statements.

 

Effective internal controls are necessary for us to provide reliable financial reports and effectively prevent fraud. If we cannot provide reliable financial reports or prevent fraud, our brand and operating results could be harmed. In addition, compliance with the internal control requirements, as well as other financial reporting standards applicable to a public company, including the Sarbanes-Oxley Act of 2002, has in the past and will in the future continue to involve substantial cost and investment of our management’s time.

 

Included in this Annual Report on Form 10-K is management’s report on our internal controls over our financial reporting (See Item 9A.b) and Ernst & Young LLP’s attestation audit report thereon (See Item 9A.c), both of which identify a material weakness in our internal controls over financial reporting as of July 1, 2006 related to the inconsistent classification of intercompany loan translation between two subsidiaries which led to an adjustment to translation gain/loss and to cumulative translation adjustment. As of July 2, 2005, we also reported on four additional material weaknesses in our systems of internal control over financial reporting. While we have implemented procedures to remediate these four material weaknesses, we are currently undertaking efforts to remediate the material weakness related to the inconsistent classification of the intercompany loan translation.

 

In fiscal 2007, and beyond, we will continue to spend significant time and incur significant costs to assess and report on the effectiveness of internal controls over financial reporting as required by Section 404 of the Sarbanes-Oxley Act. Discovering additional material weaknesses in the future could make it more difficult for us to attract and retain qualified persons to serve on our board of directors or as executive officers, which could harm our business. In addition, if we discover future material weaknesses, disclosure of that fact could reduce the market’s confidence in our financial statements, which could harm our stock price and our ability to raise capital.

 

Our business involves the use of hazardous materials, and environmental laws and regulations may expose us to liability and increase our costs.

 

We historically handled small amounts of hazardous materials as part of our manufacturing activities and now handle more and different hazardous materials as a result of the manufacturing processes related to New Focus, the optical components business acquired from Nortel Networks and the product lines we acquired from Marconi. Consequently, our operations are subject to environmental laws and regulations governing, among other things, the use and handling of hazardous substances and waste disposal. We may be required to incur environmental costs to comply with current or future environmental laws. As with other companies engaged in manufacturing activities that involve hazardous materials, a risk of environmental liability is inherent in our manufacturing activities, as is the risk that our facilities will be shut down in the event of a release of hazardous waste. The costs associated with environmental compliance or remediation efforts or other environmental liabilities could adversely affect our business. In addition, under applicable EU regulations, we, along with other electronics component manufacturers, are prohibited from using lead and certain other hazardous materials in our products. We have incurred unanticipated expenses in connection with the related reconfiguration of our products, and could lose business or face product returns if we failed to implement these requirements properly or on a timely basis.

 

Litigation regarding Bookham Technology plc’s initial public offering and follow-on offering and any other litigation in which we become involved, including as a result of acquisitions, may substantially increase our costs and harm our business.

 

On June 26, 2001, a putative securities class action captioned Lanter v. New Focus, Inc. et al., Civil Action No. 01-CV-5822, was filed against New Focus, Inc. and several of its officers and directors, or the New Focus Individual Defendants, in the United States District Court for the Southern District of New York. Also named as defendants were Credit Suisse First Boston Corporation, Chase Securities, Inc., U.S. Bancorp Piper Jaffray, Inc. and CIBC World Markets Corp., or the Underwriter Defendants, the underwriters in New Focus’s initial public offering. Three subsequent lawsuits were filed containing substantially similar allegations. These complaints have been

consolidated. On April 19, 2002, plaintiffs filed an amended class action complaint, described below, naming as defendants the New Focus Individual Defendants and the Underwriter Defendants.

 

On November 7, 2001, a class action complaint was filed against Bookham Technology plc and others in the United States District Court for the Southern District of New York. On April 19, 2002, plaintiffs filed an amended complaint, or the Amended Complaint. The Amended Complaint names as defendants Bookham Technology plc, Goldman, Sachs & Co. and FleetBoston Robertson Stephens, Inc., two of the underwriters of Bookham Technology plc’s initial public offering in April 2000, and Andrew G. Rickman, Stephen J. Cockrell and David Simpson, or the Bookham Individual Defendants, each of whom was an officer and/or director at the time of the initial public offering.

 

The Amended Complaint asserts claims under certain provisions of the securities laws of the United States. It alleges, among other things, that the prospectuses for Bookham Technology plc’s and New Focus’s initial public offerings were materially false and misleading in describing the compensation to be earned by the underwriters in connection with the offerings, and in not disclosing certain alleged arrangements among the underwriters and initial purchasers of ordinary shares, in the case of Bookham Technology plc, or common stock, in the case of New Focus, from the underwriters. The Amended Complaint seeks unspecified damages (or in the alternative rescission for those class members who no longer hold our or New Focus common stock), costs, attorneys’ fees, experts’ fees, interest and other expenses. In October 2002, the New Focus Individual Defendants and the Bookham Individual Defendants were dismissed, without prejudice, from the action. In July 2002, all defendants filed motions to dismiss the Amended Complaint. The motion was denied as to Bookham Technology plc and New Focus in February 2003. Special committees of the board of directors authorized the companies to negotiate a settlement of pending claims substantially consistent with a memorandum of understanding negotiated among class plaintiffs, all issuer defendants and their insurers.

 

Plaintiffs and most of the issuer defendants and their insurers have entered into a stipulation of settlement for the claims against the issuer defendants, including Bookham and New Focus. Under the stipulation of settlement, the plaintiffs will dismiss and release all claims against participating defendants in exchange for a payment guaranty by the insurance companies collectively responsible for insuring the issuers in the related cases, and the assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. On February 15, 2005, the court issued an Opinion and Order preliminarily approving the settlement provided that the defendants and plaintiffs agree to a modification narrowing the scope of the bar order set forth in the original settlement agreement. The parties agreed to the modification narrowing the scope of the bar order, and on August 31, 2005, the court issued an order preliminarily approving the settlement and setting a public hearing on its fairness which took place on April 24, 2006. The judge has yet to issue a decision on this hearing.

 

Litigation is subject to inherent uncertainties, and an adverse result in these or other matters that may arise from time to time could have a material adverse effect on our business, results of operations and financial condition. Any litigation to which we are subject may be costly and, further, could require significant involvement of our senior management and may divert management’s attention from our business and operations.

 

A variety of factors could cause the trading price of our common stock to be volatile or decline.

 

The market price of our common stock has been, and is likely to continue to be, highly volatile due to causes in addition to publication of our business results, such as:

 

 

Since Bookham Technology plc’s initial public offering in April 2000, Bookham Technology plc’s ADSs and ordinary shares, our shares of common stock and the shares of our customers and competitors have experienced substantial price and volume fluctuations, in many cases without any direct relationship to the affected company’s

operating performance. An outgrowth of this market volatility is the significant vulnerability of our stock price and the stock prices of our customers and competitors to any actual or perceived fluctuation in the strength of the markets we serve, regardless of the actual consequence of such fluctuations. As a result, the market prices for these companies are highly volatile. These broad market and industry factors caused the market price of Bookham Technology plc’s ADSs and ordinary shares, and our common stock to fluctuate, and may in the future cause the market price of our common stock to fluctuate, regardless of our actual operating performance or the operating performance of our customers.

 

The future sale of substantial amounts of our common stock could adversely affect the price of our common stock.

 

As of July 1, 2006, affiliates of Nortel Networks held 3,999,999 shares of our common stock. Other stockholders or groups of stockholders also hold significant percentages of our shares of common stock. In January and March 2006, pursuant to a series of transactions we issued an aggregate of 10,507,158 shares of common stock and warrants to purchase an aggregate of 1,086,001 shares of common stock in connection with the payment and subsequent cancellation of the promissory notes we issued to Nortel Networks and the conversion and subsequent cancellation of $25.5 million aggregate principle amount of convertible debentures. On September 1, 2006, we entered into an agreement to sell 8,696,000 shares of our common stock and warrants to purchase 2,174,00 shares of our common stock, in a private placement. In connection with that private placement certain institutional investors have the right to purchase, on or before September 19, 2006, up to an additional 2,898,667 shares of common stock and additional warrants to purchase up to 724,667 shares of common stock at the same purchase price sold to the initial purchasers in the private placement. Sales by Nortel Networks or other holders of substantial amounts of shares of our common stock in the public or private market could adversely affect the market price of our common stock by increasing the supply of shares available for sale compared to the demand in the public and private markets to buy our common stock. These sales may also make it more difficult for us to sell equity securities in the future at a time and price that we deem appropriate to meet our capital needs.

 

Some anti-takeover provisions contained in our charter and under Delaware laws could hinder a takeover attempt.

 

We are subject to the provisions of Section 203 of the General Corporation Law of the State of Delaware prohibiting, under some circumstances, publicly-held Delaware corporations from engaging in business combinations with some stockholders for a specified period of time without the approval of the holders of substantially all of our outstanding voting stock. Such provisions could delay or impede the removal of incumbent directors and could make more difficult a merger, tender offer or proxy contest involving us, even if such events could be beneficial, in the short-term, to the interests of the stockholders. In addition, such provisions could limit the price that some investors might be willing to pay in the future for shares of our common stock. Our certificate of incorporation and bylaws contain provisions relating to the limitations of liability and indemnification of our directors and officers, dividing our board of directors into three classes of directors serving three-year terms and providing that our stockholders can take action only at a duly called annual or special meeting of stockholders. These provisions also may have the effect of deterring hostile takeovers or delaying changes in control or management of us.

 

None.

 

We lease our corporate headquarters in San Jose, California, which has approximately 52,000 square feet, and includes manufacturing, research and development and office space, under a lease agreement that will expire at the end of March, 2007. We also lease a facility of approximately 20,000 square feet in Abingdon, U.K., under a lease that will expire at the end of June 2007. We also lease our wafer fabricating facility in Zurich, Switzerland, which is approximately 124,000 square feet, under a lease that will expire in 2007. We lease a second facility in Zurich, which houses our Avalon subsidiary, and is approximately 17,000 square feet, under leases that will expire in

December 2007 and September 2008. We lease a thin film manufacturing facility in Santa Rosa, California, which has approximately 33,000 square feet, under a lease that expires on December 31, 2011. We lease a 183,000 square foot facility in Caswell, U.K., which includes wafer fabricating, assembly and test capabilities, manufacturing support functions and research and development capabilities and office space, under a lease that expires in March 2026, with options to extend an additional 5 years immediately after 2026 and for 2 year increments indefinitely after 2031. We own our facility in Paignton, U.K., which is approximately 240,000 square feet, comprising manufacturing space including clean rooms, assembly and test capabilities and supporting laboratories, office and storage space. Having recently transitioned most of the manufacturing activities from Paignton to Shenzhen, we have begun efforts to sell this facility. We anticipate moving all remaining personnel who are currently at our Paignton facility, primarily research and development and support related employees, to a smaller leased site, as yet not identified, of approximately 25,000 to 35,000 square feet early in calendar 2007. We also own our facility in Shenzhen, China, which is approximately 247,000 square feet comprising manufacturing space, including clean rooms, assembly and test capabilities, packaging, storage and office space. All of these properties are used by our optics segment. Our corporate headquarters in San Jose, California, is also used by our research and industrial segment. We also lease a facility of approximately 20,000 square feet in Abingdon, U.K., under a lease that will expire in 2007. In addition, we lease approximately 275,000 square feet of facilities in San Jose and Ventura Country California, of which 130,000 square feet expires in 2007, and 145,000 square feet expires in April 2011, both of which we currently do not utilize.

 

Settlement of Yue Litigation

 

On April 3, 2006, we entered into a definitive settlement agreement, or the Settlement Agreement, with Mr. Howard Yue, or the Plaintiff, relating to the lawsuit the Plaintiff filed against New Focus, Inc., which is one of our subsidiaries, and several of its officers and directors in Santa Clara County Superior Court. The lawsuit, which was originally filed on February 13, 2002, is captioned Howard Yue v. New Focus, Inc. et al, Case No. CV808031, or the Yue Litigation, and relates to events that occurred prior to our acquisition of New Focus, Inc.

 

The terms of the Settlement Agreement provided that we would issue to the Plaintiff a $7.5 million promissory note, or the Note, payable on or before April 10, 2006, of which $5.0 million could be satisfied by the issuance of shares of our common stock.

 

Pursuant to the Settlement Agreement, we issued the Note on April 3, 2006 and paid the Note in full by issuing to the Plaintiff 537,635 shares of common stock valued at $5.0 million and paying $2.5 million in cash. The Plaintiff filed dismissal papers in the Yue Litigation on April 6, 2006.

 

The defense fees for the Yue Litigation have been paid by the insurers under the applicable New Focus directors and officers insurance policy. In addition, we have demanded that the relevant insurers fully fund the amounts paid pursuant to this settlement within policy limits. At this time, certain of the insurers have not confirmed to us their definitive coverage position on this matter.

 

We recorded $5.0 million, net of insurance recoveries, in other operating expense in our results of operations during the year ended July 1, 2006 in connection with the Settlement Agreement. If and when additional insurers confirm their definitive coverage position, we will record the additional amounts paid by insurers as recoveries against operating expenses in the corresponding future periods. There can be no guarantee that these additional insurers will pay any such amounts.

 

From time to time, we are involved in litigation relating to claims arising out of our operations in the normal course of business. We believe that such claims will not have a material adverse effect on our results of operations, cash flows or financial position.

 

Other Litigation

 

On June 26, 2001, a putative securities class action captioned Lanter v. New Focus, Inc. et al., Civil Action No. 01-CV-5822, was filed against New Focus, Inc. and several of its officers and directors, or the Individual Defendants, in the United States District Court for the Southern District of New York. Also named as defendants

were Credit Suisse First Boston Corporation, Chase Securities, Inc., U.S. Bancorp Piper Jaffray, Inc. and CIBC World Markets Corp., or the Underwriter Defendants, the underwriters in New Focus’s initial public offering. Three subsequent lawsuits were filed containing substantially similar allegations. These complaints have been consolidated. On April 19, 2002, plaintiffs filed an amended class action complaint, described below, naming as defendants the Individual Defendants and the Underwriter Defendants.

 

On November 7, 2001, a class action complaint was filed against Bookham Technology plc and others in the United States District Court for the Southern District of New York. On April 19, 2002, plaintiffs filed an Amended Complaint or, the Amended Complaint. The Amended Complaint names as defendants Bookham Technology plc, Goldman, Sachs & Co. and FleetBoston Robertson Stephens, Inc., two of the underwriters of Bookham Technology plc’s initial public offering in April 2000, and Andrew G. Rickman, Stephen J. Cockrell and David Simpson, each of whom was an officer and/or director at the time of Bookham Technology plc’s initial public offering.

 

The Amended Complaint asserts claims under certain provisions of the securities laws of the United States. It alleges, among other things, that the prospectuses for Bookham Technology plc’s and New Focus’s initial public offerings were materially false and misleading in describing the compensation to be earned by the underwriters in connection with the offerings, and in not disclosing certain alleged arrangements among the underwriters and initial purchasers of ordinary shares, in the case of Bookham Technology plc, or common stock, in the case of New Focus, from the underwriters. The Amended Complaint seeks unspecified damages (or in the alternative rescission for those class members who no longer hold our or New Focus common stock), costs, attorneys’ fees, experts’ fees, interest and other expenses. In October 2002, the individual defendants were dismissed, without prejudice, from the action. In July 2002, all defendants filed motions to dismiss the Amended Complaint. The motion was denied as to Bookham Technology plc and New Focus in February 2003. Special committees of the board of directors authorized the companies to negotiate a settlement of pending claims substantially consistent with a memorandum of understanding negotiated among class plaintiffs, all issuer defendants and their insurers.

 

Plaintiffs and most of the issuer defendants and their insurers have entered into a stipulation of settlement for the claims against the issuer defendants, including us. Under the stipulation of settlement, the plaintiffs will dismiss and release all claims against participating defendants in exchange for a payment guaranty by the insurance companies collectively responsible for insuring the issuers in the related cases, and the assignment or surrender to the plaintiffs of certain claims the issuer defendants may have against the underwriters. On February 15, 2005, the court issued an Opinion and Order preliminarily approving the settlement provided that the defendants and plaintiffs agree to a modification narrowing the scope of the bar order set forth in the original settlement agreement. The parties agreed to the modification narrowing the scope of the bar order, and on August 31, 2005, the court issued an order preliminarily approving the settlement and setting a public hearing on its fairness which took place on April 24, 2006. The judge has yet to enter a decision on this hearing. We believe that both Bookham Technology plc and New Focus have meritorious defenses to the claims made in the Amended Complaint and therefore believes that such claims will not have a material effect on our financial position, results of operations or cash flows.

 

No matters were submitted to a vote of our security holders in the fourth quarter of fiscal 2006.

 

Market Information and Holders

 

Our common stock began trading on the NASDAQ National Market under the symbol “BKHM” on September 10, 2004. Prior to that date, there was no established public trading market for our common stock. From April 11, 2000 through September 10, 2004, the date of the closing of the scheme of arrangement pursuant to which Bookham Technology plc became our wholly-owned subsidiary, Bookham Technology plc’s ordinary shares were quoted on the Official List of the United Kingdom Listing Authority under the symbol “BHM” and its

American Depository Shares, or ADSs, were quoted on the NASDAQ National Market under the symbol “BKHM”. Each ADS represented one ordinary share. In connection with the scheme of arrangement, every ten ordinary shares, and every ten ADSs, of Bookham Technology plc were exchanged for one share of our common stock. The closing price of our common stock on September 1, 2006 was $3.09.

 

The following table sets forth the range of high and low sale prices of (i) Bookham Technology plc’s ordinary shares and ADSs for the periods indicated through September 9, 2004 and (ii) our common stock beginning on September 10, 2004 through the periods indicated (the sales prices for periods prior to September 10, 2004 have been adjusted to reflect the exchange ratio in the scheme of arrangement):

 

 

As of September 1, 2006, there were 44,620 holders of record of our common stock. This number does not include stockholders who hold their shares in “street name” or through broker or nominee accounts.

 

Dividends

 

We have never paid cash dividends on our common stock or ordinary shares. To the extent we generate earnings, we intend to retain them for use in our business and, therefore, do not anticipate paying any cash dividends on our common stock in the foreseeable future.

 

The selected financial data set forth below should be read in conjunction with our consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing elsewhere in this Annual Report on Form 10-K. Prior to June 2004, Bookham Technology plc reported on a December 31 fiscal year end basis. In June 2004, Bookham Technology plc approved a change in its fiscal year end from December 31 to the Saturday closest to June 30 which matches the fiscal year end of Bookham Inc. Pursuant to a scheme of arrangement under the laws of the United Kingdom, Bookham Inc. assumed the financial reporting history of Bookham Technology plc effective September 10, 2004. In addition, in connection with the scheme of arrangement, Bookham changed its corporate domicile from the United Kingdom to the United States and changed its reporting currency from the U.K. pound sterling to the U.S. dollar effective September 10, 2004. Subsequent to the scheme of arrangement, our common stock is traded only on the NASDAQ Global Market whereas, previously, our ordinary shares had been traded on the London Stock Exchange and our ADSs had been traded on the NASDAQ National Market, which is the former name of the NASDAQ Global Market.

 

The selected financial data set forth below at July 1, 2006 and July 2, 2005, and for the years ended July 1, 2006 and July 2, 2005, the twelve months ended July 3, 2004, and the year ended December 31, 2003 are derived from our consolidated financial statements included elsewhere in this report. The selected financial data at July 3, 2004, December 31, 2003 and 2002 and 2001 and for the years ended December 31, 2002 and 2001 are derived from our transitional report on Form 10-K, as amended, for the six months ended July 3, 2004. The selected financial data at

December 31, 2001 are derived from our annual report on Form 20-F and have been translated into U.S. dollars using the historical exchange rate at each corresponding period end for balance sheet data and a corresponding simple average rate for statement of operations data.

 

Consolidated Statements of Operations Data

 

 

Consolidated Balance Sheet Data

 

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Risk Factors” appearing in Item 1A of this Annual Report on 10-K, “Selected Financial Data” appearing in Item 6 of this Annual Report on Form 10-K and our consolidated financial statements and related notes appearing elsewhere in this Annual Report on Form 10-K, including Note 1 to such financial statements, in which we discuss our need for additional financing to continue as a going concern. This discussion and analysis contains forward-looking statements that involve risks and uncertainties. Our actual results may differ materially from those anticipated by the forward-looking statements due to, among other things, our critical accounting estimates discussed below and important other factors set forth in this Annual Report on Form 10-K.

 

Overview

 

We design, manufacture and market optical components, modules and subsystems that generate, detect, amplify, combine and separate light signals principally for use in high-performance fiber optics communications networks. We principally sell our optical component products to optical systems vendors as well as to customers in the data communications, military, aerospace, industrial and manufacturing industries. Customers for our photonics and microwave product portfolio include semiconductor equipment manufacturers, academic and governmental research institutions that engage in advanced research and development activities. Our products typically have a long sales cycle. The period of time between our initial contact with a customer to the receipt of a purchase order is frequently a year or more. In addition, many customers perform, and require us to perform, extensive process and product evaluation and testing of components before entering into purchase arrangements.

 

We operate in two business segments: (i) optics and (ii) research and industrial. Optics relates to the design, development, manufacture, marketing and sale of optical solutions for telecommunications and industrial applications. Research and industrial relates to the design, manufacture, marketing and sale of photonics and microwave solutions.

Effective September 10, 2004, we changed our corporate domicile from the United Kingdom to the United States and our reporting currency from U.K. pounds sterling to U.S. dollars. In contemplation of the scheme of arrangement, Bookham Technology plc changed its fiscal year end from December 31 to the Saturday closest to June 30, which matches the fiscal year end of Bookham, Inc. Accordingly, our financial statements have been prepared based on a fifty-two/fifty-three week cycles going forward, including for the years ended July 1, 2006 and July 2, 2005 and the six-month period ended July 3, 2004, which are included in this Form 10-K. Our consolidated financial statements for the periods up to and including December 31, 2003, were reported in U.K. pounds sterling prior to the scheme of arrangement, and have been translated to U.S. dollars using the historical exchange rate at each corresponding period end for balance sheet accounts and a corresponding simple average rate for statement of operations accounts.

 

In view of the change in our fiscal year, this Management’s Discussion and Analysis of Financial Condition and Results of Operations compares the financial position and results of operations as of and for the fiscal year ended July 1, 2006 with the fiscal year ended July 2, 2005, the financial position and results of operations as of and for the fiscal year ended July 2, 2005 with the unaudited twelve-month period ended July 3, 2004, and the results of operations for the unaudited twelve-month period ended July 3, 2004 with the results of operations for the fiscal year ended December 31, 2003. All data as of and for the twelve-month period ended July 3, 2004 have been derived from unaudited consolidated financial information disclosed in our consolidated financial statements, including Note 18 to our consolidated financial statements.

 

Since the beginning of 2002, we have acquired a total of eight companies and businesses. In 2002, we acquired the optical components businesses of Nortel Networks and Marconi. In 2003, we purchased substantially all of the assets of Cierra Photonics and acquired all of the outstanding capital stock of Ignis Optics, Inc. During 2004, we acquired New Focus, Inc., and Onetta, Inc. In fiscal 2006, we acquired Avalon Photonics AG and City Leasing (Creekside) Limited, or Creekside.

 

Over the past five years, we have enacted a series of restructuring plans and cost reduction plans designed to reduce our manufacturing overhead and our operating expenses. In 2001, we reduced manufacturing overhead and our operating expenses in response to the initial decline in demand in the optics components industry. In connection with our acquisitions of Nortel Networks’ optical components business in November 2002 and New Focus in March 2004, we enacted restructuring plans related to the consolidation of our operations, and which we expanded in September 2004 to include the transfer of our main corporate functions, including consolidated accounting, financial reporting, tax and treasury, from Abingdon, U.K. to our new U.S headquarters in San Jose, California.

 

In May and November of 2004, we adopted additional restructuring plans, which included the transfer of our assembly and test operations from Paignton, U.K. to Shenzhen, China, a process that commenced in the quarter ended October 2, 2004. This transition was substantially complete by the end of March 2006, except for a chip-on-carrier assembly process we added to the transition plan in November 2005, and which we expect to be completed by the end of December 2006. In May 2006, we announced our latest cost reduction plans, which included transitioning all remaining manufacturing support and supply chain management, along with pilot line production and production planning, from Paignton to Shenzhen, also by the end of December, 2006.

 

With respect to the transfer of the operations described in the previous paragraph, some of which are still in the process of being transferred, we have spent $22.6 million as of July 1, 2006, and we anticipate spending a total of approximately $30 million to $37 million, including $6 million to $7 million on the cost reduction plan announced in May 2006. The substantial portion of the remaining spending relates to personnel and personnel related costs. We expect the cost reduction plan announced in May 2006 to reduce our costs by between $5.5 million and $6.5 million a quarter, when compared to the expenses incurred in the quarter ended April 1, 2006, with the cost savings expected to be realized in the March 2007 quarter.

 

A substantial portion of our revenues are, and have been, denominated in U.S. dollars, while the majority of our costs have been incurred in U.K. pounds sterling, and we anticipate that a substantial portion of our cash will continue to be incurred in U.K. pounds sterling for the forseeable future. Declines in the value of the U.S. dollar in comparison with the U.K. pound sterling have resulted, and we expect will continue to result in, pressure on our cash flow, margins and operating results, even though moving assembly and testing to our facility in Shenzhen, China will help mitigate our exposure to these fluctuations, but may expose us, to a limited extent , to changes in

value of the U.S. dollar in comparison with the Chinese Yuan. We also attempt to mitigate our currency exposure using foreign exchange contracts as we consider appropriate. Regardless, any weakness in the U.S. dollar versus the U.K. pounds sterling will make it more difficult for us to achieve improvements in our margins in the short term.

 

Recent Developments

 

Credit Facility

 

On August 2, 2006, we, with Bookham Technology plc, New Focus and Bookham (US) Inc., each a wholly-owned subsidiary, which we collectively refer to as the Borrowers, entered into a credit agreement, or Credit Agreement, with Wells Fargo Foothill, Inc. and other lenders regarding a three-year $25,000,000 senior secured revolving credit facility. Advances are available under the Credit Agreement based on a percentage of accounts receivable at the time the advance is requested.

 

The obligations of the Borrowers under the Credit Agreement are guaranteed by us, Onetta, Focused Research, Inc., Globe Y. Technology, Inc., Ignis Optics, Inc., Bookham (Canada) Inc., Bookham Nominees Limited and Bookham International Ltd., each also a wholly-owned subsidiary, (which we refer to collectively as the Guarantors and together with the Borrowers, as the Obligors), and are secured pursuant to a security agreement, or the Security Agreement, by the assets of the Obligors, including a pledge of the capital stock holdings of the Obligors in some of their direct subsidiaries. Any new direct subsidiary of the Obligors is required to execute a guaranty agreement in substantially the same form and join in the Security Agreement.

 

Pursuant to the terms of the Credit Agreement, borrowings made under the Credit Agreement bear interest at a rate based on either the London Interbank Offered Rate (LIBOR) plus 2.75 percentage points or the prime rate plus 1.25 percentage points. In the absence of an event of default, any amounts outstanding under the Credit Agreement may be repaid and reborrowed anytime until maturity, which is August 2, 2009. A termination of the commitment line anytime prior to August 2, 2008 will subject the Borrowers to a prepayment premium of 1.0% of the maximum revolver amount.

 

The obligations of the Borrowers under the Credit Agreement may be accelerated upon the occurrence of an event of default under the Credit Agreement, which includes customary events of default, including payment defaults, defaults in the performance of affirmative and negative covenants, the inaccuracy of representations or warranties, a cross-default related to indebtedness in an aggregate amount of $1,000,000 or more, bankruptcy and insolvency related defaults, defaults relating to such matters as ERISA, judgments, and a change of control default. The Credit Agreement contains negative covenants applicable to the Borrowers and their subsidiaries, including financial covenants requiring the Borrowers to maintain a minimum level of EBITDA (if the Borrowers have not maintained specified levels of liquidity), as well as restrictions on liens, capital expenditures, investments, indebtedness, fundamental changes to the Borrower’s business, dispositions of property, making certain restricted payments (including restrictions on dividends and stock repurchases), entering into new lines of business, and transactions with affiliates.

 

In connection with the Credit Agreement, we agreed to pay a monthly servicing fee of $3,000 and an unused line fee equal to 0.375% per annum, payable monthly on the unused amount of revolving credit commitments. To the extent there are letters of credit outstanding under the Credit Agreement, the Borrowers will pay to the administrative agent a letter of credit fee at a rate equal to 2.75% per annum.

 

Private Placement

 

On August 31, 2006, we entered into definitive agreement for a private placement pursuant to which we issued, on September 1, 2006, 8,696,000 shares of common stock, which we refer to as the Shares, and warrants to purchase up to 2,174,000 shares of common stock, which we refer to as the Warrants, with certain institutional accredited investors for gross proceeds of approximately $23.5 million. The Warrants are exercisable for a five year period beginning on March 2, 2007 at an exercise price of $4.00 per share. We have agreed to file a registration statement relating to the resale of the Shares and the shares of common stock issued upon the exercise of the Warrants. Up to an additional 2,898,667 shares of common stock and warrants to purchase 724,667 shares of common stock may be issued and sold to additional institutional accredited investors at a subsequent closing pursuant to a right of

participation under the Exchange Agreement, dated January 13, 2006, by and among us, Bookham Technology plc and the investors.

 

Recent Accounting Pronouncements

 

In June 2005, the Financial Accounting Standards Board, or FASB, issued Statement of Financial Accounting Standards, or SFAS, No. 154, “Accounting Changes and Error Corrections” (“SFAS 154”), which replaces Accounting Principles Board, or APB, Opinion No. 20 (“APB 20”) and Statement of Financial Accounting Standards No. 3, “Reporting Accounting Changes in Interim Financial Statements.” SFAS 154 applies to all voluntary changes in accounting principle, and changes the requirements for accounting for and reporting of a change in accounting principle. APB 20 previously required that most voluntary changes in accounting principle be recognized by including in net income of the period of change a cumulative effect of changing to the new accounting principle, whereas SFAS 154 requires retrospective application to prior periods’ financial statements of a voluntary change in accounting principle unless it is impracticable. SFAS 154 is intended to enhance the consistency of financial information between periods. SFAS 154 is effective for fiscal years beginning after December 15, 2005, and we are required to adopt it in the first quarter of fiscal 2007.

 

In November 2005, the FASB issued FASB Staff Position, or FSP, Nos. FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments”. FSP Nos. FAS 115-1 and FAS 124-1 amend SFAS No. 115, “Accounting for Certain Investments in Debt and Equity Securities”. This guidance nullifies certain requirements of Emerging Issues Task Force, or EITF, 03-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments”. FSP Nos. FAS 115-1 and FAS 124-1 include guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. FSP Nos. FAS 115-1 and FAS 124-1 also require other-than-temporary impaired debt securities to be written down to impaired value, which becomes the new cost basis. FSP Nos. FAS 115-1 and FAS 124-1 are effective for fiscal years beginning after December 15, 2005. We do not believe that adoption of FSP Nos. FAS 115-1 and FAS 124-1 on July 2, 2006 will have a material impact on our financial position, results of operations or cash flows.

 

In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments,” which amends SFAS 133 and SFAS 140. SFAS 155 permits hybrid financial instruments that contain an embedded derivative that would otherwise require bifurcation to irrevocably be accounted for at fair value, with changes in fair value recognized in the statement of income. The fair value election may be applied on an instrument-by-instrument basis. SFAS 155 also eliminates a restriction on the passive derivative instruments that a qualifying special purpose entity may hold. SFAS 155 is effective for those financial instruments acquired or issued after December 1, 2006. At adoption, any difference between the total carrying amount of the individual components of the existing bifurcated hybrid financial instrument and the fair value of the combined hybrid financial instrument will be recognized as a cumulative-effect adjustment to beginning retained earnings. We are currently evaluating the potential impact of adopting SFAS 155.

 

In July 2006, the FASB issued Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes — an interpretation of SFAS No. 109”. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS 109 and prescribes a recognition threshold and measurement attribute for financial statement disclosure of tax positions taken or expected to be taken on a tax return. Additionally, FIN 48 provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 is effective for fiscal years beginning after December 15, 2006, with early adoption permitted. We will adopt FIN 48 in fiscal 2007 and are currently evaluating whether the adoption of FIN 48 will have a material effect on our consolidated financial position, results of operations or cash flows.

 

Application of Critical Accounting Policies

 

The discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements contained elsewhere in this Annual Report on Form 10-K, which have been prepared in accordance with GAAP. The preparation of our financial statements requires us to make estimates and judgments

that affect our reported assets and liabilities, revenues and expenses and other financial information. Actual results may differ significantly from those based on our estimates or could be materially different if we used using different assumptions, estimates or conditions. In addition, our reported financial condition and results of operations could vary due to a change in the application of a particular accounting standard.

 

We regard an accounting estimate or assumption underlying our financial statements as a “critical accounting estimate” where:

 

 

Our significant accounting policies are more fully described in Note 1 to our consolidated financial statements included elsewhere in this Annual Report on Form 10-K. Not all of these significant accounting policies, however, require that we make estimates and assumptions that we believe are “critical accounting estimates.” We have discussed our accounting policies with the audit committee of our board of directors, and we believe that the policies described below involve critical accounting estimates.

 

Revenue Recognition and Sales Returns

 

Revenue represents the amounts, excluding sales taxes, derived from the provision of goods and services to third-party customers during a given period. Our revenue recognition policy follows Securities and Exchange Commission Staff Accounting Bulletin, or SAB, No. 104, “Revenue Recognition in Financial Statements”. Specifically, we recognize product revenue when persuasive evidence of an arrangement exists, the product has been shipped, title has transferred, collectibility is reasonably assured, fees are fixed or determinable and there are no uncertainties with respect to customer acceptance. For certain sales, we are required to determine, in particular, whether the delivery has occurred, whether items will be returned and whether we will be paid under normal commercial terms. For certain products sold to customers, we specify delivery terms in the agreement under which the sale was made and assess each shipment against those terms, and only recognize revenue when we are certain that the delivery terms have been met. For shipments to new customers and evaluation units, including initial shipments of new products, where the customer has the right of return through the end of the evaluation period, we recognize revenue on these shipments at the end of an evaluation period, if not returned, and when collection is reasonably assured. We record a provision for estimated sales returns in the same period as the related revenues are recorded which is netted against revenue. These estimates are based on historical sales returns, other known factors and our return policy. Before accepting a new customer, we review publicly available information and credit rating databases to provide ourselves with reasonable assurance that the new customer will pay all outstanding amounts in accordance with our standard terms. For existing customers, we monitor historic payment patterns to assess whether we can expect payment in accordance with the terms set forth in the agreement under which the sale was made.

 

We recognize royalty revenue when it is earned and collectibility is reasonably assured.

 

Inventory Valuation

 

In general, our inventory is valued at the cost to acquire or manufacture our products, less write-offs of inventory we believe could prove to be unsaleable. Manufacturing costs include the cost of the components purchased to produce our products and related labor and overhead. We review our inventory on a monthly basis to determine if it is saleable. Products may be unsaleable because they are technically obsolete due to substitute products, specification changes or excess inventory relative to customer forecasts. We currently reserve for inventory using methods that take those factors into account. In addition, if we find that the cost of inventory is greater than the current market price, we will write the inventory down to the selling price, less the cost to complete and sell the product.

 

During 2002, in connection with the acquisition of the optical components business of Nortel Networks, we recorded the fair value of the inventory that was acquired. In accordance with SFAS No. 141, or SFAS 141 “Business Combinations”, an adjustment was made in the 2003 accounts for amendments to those provisional

values. During 2003, a larger amount of acquired inventory was sold than was expected at the time of the acquisition. As a consequence, we increased the value of our inventory by $20.2 million, increased current liabilities by approximately $1.3 million, decreased intangible assets by $9.1 million and increased property, plant and equipment by $9.8 million.

 

Accounting for Acquisitions and Goodwill

 

We account for acquisitions using the purchase accounting method in accordance with SFAS No. 142 or SFAS 142, “Goodwill and Other Intangible Assets.” SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually or sooner whenever events or changes in circumstances indicate they may be impaired. Circumstances which could trigger an impairment test include, but are not limited to, significant decreases in the market price of the asset, significant adverse changes to the business climate or legal factors, current period cash flow or operating losses or a forecast of continuing losses associated with the use of the asset and a current expectation that the asset will more likely than not be sold or disposed of significantly below carrying value before the end of its estimated useful life. Under this method, the total consideration paid, excluding the contingent consideration that has not been earned, is allocated over the fair value of the net assets acquired, including in-process research and development, with any excess allocated to goodwill (defined as the excess of the purchase price over the fair value allocated to the net assets). Our judgments as to fair value of the assets will, therefore, affect the amount of goodwill that we record. These judgments include estimating the useful lives over which periods the fair values will be amortized to expense. For tangible assets acquired in any acquisition, such as plant and equipment, we estimate useful lives by considering comparable lives of similar assets, past history, the intended use of the assets and their condition. In estimating the useful life of the acquired intangible assets with definite lives, we consider the industry environment and unique factors relating to each product relative to our business strategy and the likelihood of technological obsolescence. Acquired intangible assets primarily include core and current technology, patents, supply agreements, capitalized licenses and customer contracts. We are currently amortizing our acquired intangible assets with definite lives over periods generally ranging from three to six years and, in the case of one specific customer contract, sixteen years.

 

Impairment of Goodwill and Other Intangible Assets

 

Under SFAS 142, goodwill is tested annually for impairment, in our case during the fourth quarter of each fiscal year, or more often if an event or circumstance suggests impairment has occurred. In addition, we review identifiable intangibles, excluding goodwill, for impairment whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable. Circumstances which could trigger an impairment test include, but are not limited to, significant decreases in the market price of the asset, significant adverse changes to the business climate or legal factors, current period cash flow or operating losses or a forecast of continuing losses associated with the use of the asset and a current expectation that the asset will more likely than not be sold or disposed of significantly below carrying value before the end of its estimated useful life.

 

SFAS 142 requires that the first phase of testing goodwill for impairment be based on a business unit’s “fair value,” which is generally determined through market prices. In certain cases, due to the absence of market prices for a particular element of our business, and as permitted by SFAS 142, we have elected to base our testing on discounted future expected cash flows. Although the discount rates and other input variables may differ, the model we use in this process is the same model we use to evaluate the fair value of acquisition candidates and the fairness of offers to purchase businesses that we are considering for divestiture. The forecasted cash flows we use are derived from the annual long-range planning process that we perform and present to our board of directors. In this process, each business unit is required to develop reasonable sales, earnings and cash flow forecasts for the next three to seven years based on current and forecasted economic conditions. For purposes of testing for impairment, the cash flow forecasts are adjusted as needed to reflect information that becomes available concerning changes in business levels and general economic trends. The discount rates used for determining discounted future cash flows are generally based on our weighted average cost of capital and are then adjusted for “plan risk” (the risk that a business will fail to achieve its forecasted results) and “country risk” (the risk that economic or political instability in the countries in which we operate will cause a business unit’s projections to be inaccurate). Finally, a growth factor beyond the three to seven-year period for which cash flows are planned is selected based on expectations of future

economic conditions. Virtually all of the assumptions used in our models are susceptible to change due to global and regional economic conditions as well as competitive factors in the industry in which we operate. In recent years, many of our cash flow forecasts have not been achieved due in large part to the unexpected length and depth of the downturn in our industry. Unanticipated changes in discount rates from one year to the next can also have a significant effect on the results of the calculations. While we believe the estimates and assumptions we use are reasonable in these circumstances, various economic factors could cause the results of our goodwill testing to vary significantly.

 

In the year ended July 1, 2006, our annual impairment review of goodwill and other intangible assets led to the recording of an impairment charge of $760,000 due to the impairment of intangible assets of Ignis Optics. This charge was entirely related to the optics segment.

 

In the year ended July 2, 2005, a continued decline in our share price, and therefore market capitalization, combined with continuing net losses and a history of not meeting revenue and profitability targets, suggested that the goodwill related to certain of our acquisitions may have been impaired as of the third quarter of that fiscal year. As a result of these triggering events, we performed a preliminary evaluation of the related goodwill balances at that time. In the fourth quarter, we finalized this evaluation during our annual evaluation of goodwill, and also performed our annual evaluation of acquired intangible assets. In total, in the year ended July 2, 2005, we recorded impairment charges of approximately $114,226,000, approximately $113,592,000 related to goodwill associated with New Focus, Ignis and Onetta, and approximately $634,000 related to intangibles of New Focus, including patents and other technology, for the year ended July 2, 2005. Approximately, $83,326,000 of these charges related to the research and industrial segment, and approximately $30,900,000 related to the optics segment.

 

Accounting for Acquired In-Process Research and Development

 

In the year ended July 1, 2006, in connection with the acquisition of Avalon Photonics AG, or Avalon, we recorded a charge of $118,000 for in-process research and development. In the six-month period ended July 3, 2004, in connection with the acquisition of New Focus, we recorded a charge of $5.9 million for in-process research and development. In the year ended December 31, 2003, in connection with the acquisition of Ignis Optics, we recorded a charge of $1.9 million for in-process research and development. In the year ended December 31, 2002, in connection with the acquisition of the optical components businesses of Marconi and Nortel Networks, we recorded charges of $5.9 million and $7.3 million, respectively, for in-process research and development. There were no charges for in-process research and development related to the Cierra Photonics and Onetta acquisitions. During the year ended December 31, 2003, following the required review of the purchase price allocation for the acquisition of the optical components business of Nortel Networks, a credit of $1.7 million was made related to the in-process research and development expensed as part of an overall reallocation of the purchase price. Management is responsible for estimating the fair values of in-process research and development.

 

As of the dates of each in-process research and development valuation, the projects assessed had not yet demonstrated technological or commercial feasibility, and the technology did not have an alternative future use. Therefore, the fair values were expensed at the relevant date of acquisition. Expenses related to development projects which, when using the technology contribution approach, are deemed to have positive net present value, are assigned a fair value, capitalized and amortized over the expected useful lives.

 

For each acquisition, allocations of consideration were based on the estimated fair values derived from calculating the discounted cash flows required to develop each incomplete research and development project into a commercially viable product, taking into account the anticipated future revenues and the remaining costs of completion. Consideration was also given to the direct expenses incurred, contribution from other assets, the implications of various jurisdictions of corporate tax, the degrees of completion and the relative risks attributable to each project. All forecasted future operating cash flows were discounted at appropriate rates. The revenue estimates assumed that the development and marketing of the projects would be successful, and that their commercialization would correlate to management’s forecasts as of the date of the analysis, and that forecasted sales would decline over each product’s expected economic life as new versions were introduced either by us or competitors.

 

In identifying the research and development programs to be valued, we distinguish between two main areas of research and development. Pure research of a given technology application is referred to as technology research, or

TR. New product introduction, or NPI, follows from this stage, and is the development of a known technology from initial identification of an application with a market opportunity, through design and testing, to implementation and delivery of products to a customer.

 

Acquisition of the Optical Components Business of Marconi Optical Components Limited

 

In connection with the acquisition of the optical components business of Marconi in February 2002, $5.9 million of the $29.9 million total consideration was allocated to in-process research and development projects.

 

At the time of the acquisition the remaining projects under development at the acquisition date were expected to result in a portfolio addressing tunability, bandwidth, integration, amplification, and managed optical networks.

 

At the time of the acquisition, the expected dates of release of these projects ranged from seven to seventeen months from the date of acquisition. We acquired three main programs in the NPI stage of development. All estimated costs to complete were to be funded from our current cash reserves. The current status of each category is given below:

 

 

Acquisition of the Optical Components Business of Nortel Networks

 

Of the total $119.0 million consideration for the optical components business of Nortel Networks in November 2002, the initial allocation to acquired in-process research and development was $7.3 million. This initial allocation was subsequently adjusted following the required review of the purchase price allocation during the second half of 2003, resulting in a reduction of the allocated in-process research and development by $1.7 million, which was recognized as a credit in 2003.

 

At the time of the acquisition the projects remaining under development at the acquisition date were expected to result in a portfolio addressing tunability, bandwidth, integration, amplification, and managed optical networks. These projects were split into two distinct categories: NPI and TR. The TR projects, which met the criteria for recognition as in-process research and development, were assessed as requiring between one and one and a half years before attaining NPI status. All estimated costs to complete were to be funded from our current cash reserves. The current status of each category is given below.

 

NPI

 

 

TR

 

 

Acquisition of Ignis Optics

 

In connection with the acquisition of Ignis Optics in October 2003, $1.9 million of the $18 million total consideration was allocated to in-process research and development projects. The NPI projects under development at the acquisition date were expected to result in small form factor pluggable optical transceivers or component elements to these products and address quality and reliability requirements. Commercial shipments of the products began during the second half of fiscal 2005, and to a large degree were discontinued in fiscal 2006. There were no TR projects at the time of acquisition.

 

Acquisition of New Focus

 

In connection with the acquisition of New Focus in March 2004, $5.9 million of the $211.0 million of total consideration was allocated to in-process research and development projects. The NPI projects at the acquisition date were expected to result in the development of products to support the New Focus OEM and catalog business. Catalog related programs were focused on increasing the wavelength spectrum over which modulator products can operate and developing detectors to operate at higher frequency with lower noise over a broader wavelength, with their first incorporation in shipments in December 2004. Of the OEM related products, two have been completed, namely a super luminous diode light source for use in subsystems and a laser for use in high precision/high stability labs. The final program for development of a small form factor laser for use in fiber sensing applications continues but has been slowed due to lower than expected emergence of market opportunities. There were no TR programs at the time of acquisition.

 

Acquisition of Avalon

 

In connection with the acquisition of Avalon in March 2006, $118,000 of the $6.7 million total consideration was allocated to in-process research and development projects.

 

Accounting for Share-Based Payments

 

In December 2004, the FASB issued SFAS No. 123R, “Share-Based Payment”, or SFAS 123R, which requires companies to recognize in their statement of operations all share-based payments to employees, including grants of employee stock options, based on their fair values. We adopted SFAS 123R on July 3, 2005, using the modified-prospective-transition method. Accounting for share-based compensation transactions using the intrinsic method supplemented by pro forma disclosures in the financial statement footnotes is no longer permissible. The application of SFAS 123R involves significant amounts of judgment in the determination of inputs into the Black-Scholes-Merton valuation model which we use to determine the fair value of share-based awards. These inputs are based upon highly subjective assumptions as to the volatility of the underlying stock, risk free interest rates and the expected life of the options. As a result of adopting SFAS 123R, our income before income taxes and net income for the year ended July 1, 2006 are $8.2 million lower and basic and diluted earnings per share are $0.17 per share lower than they would have been had we not adopted SFAS 123R. Judgement is also required in estimating the number of share based awards that are expected to be forfeited. If actual results or future changes in

estimates differ significantly from our current estimates, stock-based compensation expense and our consolidated results of operations could be materially impacted. During the year ended July 1, 2006, we recognized $8.2 million of stock compensation expense, of which $1.7 million relates to certain performance based options for which the related performance targets were met and recognized in the three months ended October 2, 2005.

 

Results of Operations

 

Revenues

 

 

Year ended July 1, 2006 versus year ended July 2, 2005

 

Revenues for the year ended July 1, 2006 increased by $31.3 million, or 16%, compared to the year ended July 2, 2005. $21.0 million of this increase is due to revenues from Nortel Networks, which increased to $110.5 million in the year ended July 1, 2006 from $89.5 million in the year ended July 2, 2005. This increase in revenues from Nortel Networks was due to the amended terms of our supply agreement with Nortel Networks. The second addendum to the supply agreement, which we entered into in May 2005, provided for, among other things, Nortel Networks’ obligation to purchase certain products from us, an increase in the price of those products above those previously charged to Nortel Networks, our grant to Nortel Networks of a security interest on certain of our assets, and a waiver of certain prepayment conditions. Under the second addendum, Nortel Networks agreed to purchase approximately $100 million of products from us, equally divided into two categories of products: “last-time buy” products, and products that we will continue to manufacture. The third addendum to the supply agreement, among other things, (i) extends the term of the supply agreement to the end of calendar 2006, and (ii) requires Nortel Networks to purchase approximately $72 million of products from us. Remaining obligations of approximately $30 million under the supply agreement, as amended, are expected to be fulfilled by the end of the December 2006 quarter. As of July 1, 2006, substantially all of Nortel Network’s “last-time buy” obligations have been fulfilled. Non-“last-time buy” purchases will be transacted at the then current market prices and not at the increased prices which were agreed to in the second addendum to the supply agreement. Our revenues from Nortel Networks decreased in the quarter ended March 31, 2006 from the quarter ended December 31, 2005, and decreased again in the quarter ended July 1, 2006 from the quarter ended March 31, 2006. We expect our revenues from Nortel Networks may continue to decrease through the first two quarters of our year ended June 30, 2007, and to potentially decline further in future quarters, although we do expect Nortel Networks to continue as a major customer for the foreseeable future beyond that time.

 

Overall the revenues from our optics segment, which designs, manufactures, markets and sells optical solutions for telecommunications and industrial applications, increased by $29.6 million, or by 17%, to $206.1 million in the year ended July 1, 2006 from $176.5 million in the year ended July 2, 2005. The increase in revenues, excluding amounts related to Nortel Networks, was spread across a large number of customers, none of which exceeded 10% of total revenues in either year. From a products point of view, the increases in optics segment revenues in the year ended July 1, 2006 from the year ended July 2, 2005 was derived from most major product categories, except for TOA/ROA which were generally sold to Nortel Networks as part of the “last-time buy” products and which decreased by $10.0 million.

 

Our research and industrial segment, which designs, manufactures, markets and sells photonic and microwave solutions, primarily comprises the products and services of New Focus. Revenues from the research and industrial segment increased to $25.6 million in the year ended July 1, 2006 from $23.7 million in the year ended July 2, 2005 as a result of increased sales during the period.

Year ended July 2, 2005 versus twelve months ended July 3, 2004

 

Revenues for the year ended July 2, 2005 increased by $42.1 million, or 27%, as compared to the twelve months ended July 3, 2004. The increase was primarily due to the inclusion of a full year of revenue from New Focus and Onetta, which we acquired during the twelve months ended July 3, 2004. Revenues from products and services acquired as part of these acquisitions were $30.4 million for the year ended July 2, 2005 compared to $8.7 million in revenues for the twelve months ended July 3, 2004, which included only approximately three months of revenues from New Focus and one month of revenues from Onetta. In addition, sales of products and services to customers other than Nortel Networks and Marconi increased to $88.9 million in fiscal 2005 from $52.2 million in the twelve months ended July 3, 2004.

 

Revenues from our optics segment increased to $176.6 million in fiscal 2005 from $147.8 million in the twelve months ended July 3, 2004, primarily as a result of increased sales of products and services. Revenues from the research and industrial segment increased to $23.7 million in fiscal 2005 from $10.4 million in the twelve months ended July 3, 2004, primarily as a result of these products and services contributing sales for the entire year as a result of a full year of revenue from New Focus.

 

Our largest customer for the year ended July 2, 2005 and the twelve months ended July 3, 2004 was Nortel Networks. Sales of products and services to Nortel Networks were $89.5 million in fiscal 2005 compared to $81.4 million in the twelve months ended July 3, 2004, representing 45% and 52% of our revenues in the respective years. The increase in revenue from the twelve months ended July 3, 2004 to fiscal 2005 was due to revisions to our supply agreement with Nortel Networks in March 2005. Pursuant to the terms of the supply agreement with Nortel Networks, Nortel Networks issued non-cancelable purchase orders and “last-time buys” totaling approximately $100 million, based on revised pricing terms, to be delivered through March 2006. Through July 2, 2005, we delivered products pursuant to these purchase orders having an aggregate price of approximately $34 million.

 

Twelve months ended July 3, 2004 versus year ended December 31, 2003

 

Revenues for the twelve months ended July 3, 2004 increased by $12.0 million, to $158.2 million from $146.2 million in the year ended December 31, 2003. Revenues from New Focus, which we acquired in March 2004, accounted for $10.4 million of this increase. The remaining increase was the result of increased sales across our customer base, consistent with our strategy of expanding revenues across a broader customer base, offsetting reductions under supply agreements with Nortel Networks, for which revenues decreased to $81.4 million from $85.5 million in the twelve months ended July 3, 2004 as compared to the year ended December 31, 2003, respectively, and Marconi, for which revenues decreased to $16.6 million from $18.1 million in the twelve months ended July 3, 2004 compared to the year ended December 31, 2003, respectively.

 

Cost of Revenues

 

 

Our cost of revenues consists of the costs associated with manufacturing our products, and includes the purchase of raw materials, labor costs and related overhead, including stock compensation expenses. It also includes the costs associated with under-utilized production facilities and resources, as well as the charges for the write-down of impaired manufacturing assets or restructuring related costs, which are categorized as “Net Charges.” Charges for inventory obsolescence, the cost of product returns and warranty costs are also included in cost of revenues. Costs and expenses related to our manufacturing resources, which relate to the development of new products, are included in research and development.

Year ended July 1, 2006 versus year ended July 2, 2005

 

Our cost of revenues for the year ended July 1, 2006 decreased compared to the year ended July 2, 2005 primarily due to the transition of our assembly and test facilities from Paignton, U.K. to Shenzhen, China, which has a lower cost base. The substantial portion of this transition was completed by the end of March 2006. We expect to transfer the one remaining assembly process before the end of December 2006, along all of the manufacturing planning, supply chain management and related activities. In addition, headcount reductions that were implemented at our Paignton facility during the quarters ended March 31, 2006 and July 1, 2006 were also responsible for the overall decrease in cost of revenues. In May 2006, we announced our latest cost reduction plan to reduce our total costs and expenses by $5.5 million to $6.5 million a quarter, compared to the quarter ended April 1, 2006, largely related to the transition of the remaining Paignton manufacturing activities to Shenzhen, along with cost reductions in our Caswell U.K. wafer fabrication facility, which in total are expected to result in cost of revenues reductions of approximately $4.0 million per quarter, which we expect to begin fully realizing in the March 2007 quarter.

 

During the year ended July 1, 2006, the reductions in our cost of revenues were partially offset by $1.9 million of stock based compensation expense recorded under SFAS 123R, which we adopted on July 3, 2005. The year ended July 2, 2005 included $14,000 of stock based compensation expense recorded under previous accounting pronouncements.

 

Year ended July 2, 2005 versus twelve months ended July 3, 2004

 

Our cost of revenues for the year ended July 2, 2005 increased compared to the prior year primarily due to the inclusion of a full year of manufacturing costs associated with the products of the New Focus and Onetta businesses which we acquired in March and June of 2004, respectively.

 

Our cost of revenues for the year ended July 2, 2005 also increased because cost of revenues for the year ended July 3, 2004 included the impact of adverse movements in foreign exchange rates. A substantial portion of our cost of revenues during the period were incurred in U.K. pounds sterling due to the manufacturing expenses associated with our facilities in the United Kingdom. Relative to U.K. pounds sterling, the U.S. dollar declined significantly during the year ended July 2, 2005, with the rates moving from an average rate of 1.736 dollars per U.K. pound sterling for the twelve months ended July 3, 2004 to 1.856 dollars per U.K. pound sterling for the year ended July 2, 2005, reaching a peak of 1.926 dollars per U.K. pound sterling on December 31, 2004, and ending at a rate of 1.792 dollars per U.K. pound sterling on July 2, 2005.

 

Our cost of revenues also increased during the period due to the costs of ramping up our manufacturing facility in Shenzhen, China while transferring most of our assembly and test operations from Paignton, U.K. to this facility in order to take advantage of lower costs of production. Although we began shipping products out of our Shenzhen facility during the quarter ended October 2, 2004, we continued to operate both the Paignton and Shenzhen facilities during the ramp up of Shenzhen, and also to fulfill purchase orders and “last-time buys” required pursuant to the Nortel Networks supply agreement, as amended.

 

Twelve months ended July 3, 2004 versus year ended December 31, 2003

 

Our cost of revenues for the twelve months ended July 3, 2004 as compared to the year ended December 31, 2003 increased by $3.5 million. As part of the acquisition of the optical components business of Nortel Networks, we undertook a comprehensive restructuring plan, which involved closing facilities, consolidating manufacturing operations and workforce reductions. This plan began immediately after the acquisition was completed on November 8, 2002 and was substantially complete by the end of 2003. As a result of this restructuring plan, following the acquisition, fixed overhead was substantially lower for the twelve month period ended July 3, 2004 compared with the year ended December 31, 2003. However, cost of revenues increased in the twelve month period ended July 3, 2004 compared with the year ended December 31, 2003 principally because of higher variable production costs, including direct material and labor costs related to increased revenues, which more than offset the lower fixed manufacturing overhead.

Gross Margin/(Loss)

 

 

Gross profit/(loss) is calculated as revenues less cost of revenues. Gross margin/(loss) rate is gross profit/(loss) reflected as a percentage of revenue.

 

Year ended July 1, 2006 versus year ended July 2, 2005

 

For the year ended July 1, 2006, our gross margins improved because of the positive impact of higher revenues spread across our fixed costs, the lower cost base of our Shenzhen facility compared to our Paignton U.K. facility, and favorable pricing terms under the second amendment to our supply agreement with Nortel Networks. We expect our gross margins for the year ended June 30, 2007 to benefit from the additional cost reductions and related cost savings under the cost reduction plan announced in May 2006, which are expected to be fully realized in the third quarter of fiscal 2007.

 

During the year ended July 1, 2006, we had revenues of $9.5 million related to, and recognized profits on, inventory that had been carried on our books at zero value. The inventory had originally been acquired in connection with our purchase of the optical components business of Nortel Networks. While this inventory is on our books at zero value, and its sale generates higher margins than most of our new products, we incur additional costs to complete the manufacturing of these products prior to sale. We believe revenues from this zero value inventory will be negligible in the year ended June 30, 2007.

 

During the year ended July 1, 2006, the improvements in our gross margins were partially offset by $1.9 million of stock based compensation expense recorded to cost of revenues under SFAS 123R, which we adopted on July 2, 2005. Only $14,000 of stock based compensation expense was recorded to cost of revenues in the year ended July 2, 2005, under previous accounting pronouncements.

 

Year ended July 2, 2005 versus twelve months ended July 3, 2004

 

Our gross margin rate improved in fiscal 2005 compared to the twelve months ended July 3, 2004 primarily because of the positive impact of higher revenues spread across our fixed costs, despite the fact that we experienced a difficult competitive environment which was exacerbated in fiscal 2005 by the negative impact of currency fluctuations, and certain costs of maintaining assembly and test facilities in both Paignton and Shenzhen during the transition of these operations to Shenzhen.

 

During fiscal 2005, we had revenues of $19.5 million related to our zero value inventory. While this inventory is on our books at zero value, and its sale generated higher margins than most of our new products during the period, we incurred additional costs to complete the manufacturing of these products prior to sale.

 

Twelve months ended July 3, 2004 versus year ended December 31, 2003

 

The improved gross loss and gross loss rate improvement for the twelve month period ended July 3, 2004 compared with the year ended December 31, 2003 was principally the result of the lower fixed overhead costs in the twelve month period ended July 3, 2004 and, to a lesser degree, the higher revenue during the same twelve month period when compared to the year ended December 31, 2003.

Research and Development Expenses

 

 

Research and development expense consists primarily of salaries and related costs of employees engaged in research and design activities, including stock compensation charges related to those employees, costs of design tools and computer hardware, and costs related to prototyping.

 

Year ended July 1, 2006 versus year ended July 2, 2005

 

Research and development expense decreased in the year ended July 1, 2006 compared to the year ended July 2, 2005 primarily due to the cost savings efforts implemented in fiscal 2005, under our 2004 restructuring plan, being in effect for the full year. In May 2006, we announced a cost reduction plan, which we expect will be fully implemented by the March 2007 quarter, that we expect will further reduce quarterly research and development expenditures.

 

In the year ended July 1, 2006 decreases in research and development expense were partially offset by $1.9 million of stock based compensation expense recorded under SFAS 123R, which we adopted on July 2, 2005. $8,000 of stock based compensation expense was recorded in the year ended July 2, 2005, as a research and development expense under previous accounting pronouncements.

 

Year ended July 2, 2005 versus twelve months ended July 3, 2004

 

Research and development expenses decreased in fiscal 2005 compared to the twelve months ended July 3, 2004 as a result of the significant reductions made in connection with our 2004 restructuring plan, offsetting the increase in research and development spending that resulted from acquiring New Focus and Onetta and the negative effects of the weakness in the U.S. dollar relative to the U.K. pound sterling and other currencies in which we operate.

 

Twelve months ended July 3, 2004 versus year ended December 31, 2003

 

Research and development expenses rose by 1% in the twelve months ended July 3, 2004 compared to the year ended December 31, 2003 due to increased spending of approximately $7.2 million that resulted from our acquisition of New Focus and Ignis Optics, which was partially offset by cost-cutting measures implemented in 2003 that included the discontinuance of our research and development of the ASOC product line.

 

Selling, General and Administrative Expenses

 

 

Selling, general and administrative expenses consist primarily of personnel-related expenses, including stock compensation charges related to employees engaged in sales, general and administrative functions, legal and professional fees, facilities expenses, insurance expenses and certain information technology costs.

Year ended July 1, 2006 versus year ended July 2, 2005

 

Our selling, general and administrative expenses decreased in fiscal 2006 compared to fiscal 2005, primarily due to cost reductions implemented in fiscal 2005, which were in effect for the full year ended July 1, 2006, reductions in the costs associated with our compliance with the Sarbanes-Oxley Act of 2002, no replication of costs incurred in connection with our moving administrative activities to a newly established corporate headquarters in San Jose, California which were incurred during fiscal 2005, and reductions in certain insurance premiums.

 

In the year ended July 1, 2006 decreases in our selling, general and administrative expenses were partially offset by $4.4 million of stock based compensation expense recorded under SFAS 123R, which we adopted on July 2, 2005. $742,000 of stock based compensation expense was recorded as a selling, general and administrative expense in the year ended July 2, 2005, under previous accounting pronouncements.

 

Year ended July 2, 2005 versus twelve months ended July 3, 2004

 

Selling, general and administrative expenses increased by $15.7 million in fiscal 2005 compared to the twelve months ended July 3, 2004. The increase was due to higher selling costs to support revenue growth, the inclusion of the operations of New Focus and Onetta for an entire year, the negative impact of the weakness in the U.S. dollar relative to the U.K. pound sterling, costs associated with compliance with the Sarbanes-Oxley Act of 2002 and costs associated with moving administrative activities to the newly established U.S. headquarters in San Jose, California in the second quarter of fiscal 2005. In total, these costs more than offset the cost reductions attained in connection with the 2004 restructuring plan.

 

Twelve months ended July 3, 2004 versus year ended December 31, 2003

 

The increase of $10.8 million in selling, general and administrative expense in the twelve month period ended July 3, 2004 compared with the year ended December 31, 2003 resulted from the inclusion of the operations of New Focus for only three months in the twelve month period ended July 3, 2004 and, to a lesser extent, the inclusion of the business acquired from Cierra Photonics, combined with higher legal and professional fees relating to various corporate development activities.

 

Restructuring

 

 

Over the past five years, we have enacted a series of restructuring plans and cost reduction plans designed to reduce our manufacturing overhead and our operating expenses. In 2001, we reduced manufacturing overhead and our operating expenses in response to the initial decline in demand in the optics components industry. In connection with our acquisitions of Nortel Networks’ optical components business in November 2002 and New Focus in March 2004, we enacted restructuring plans related to the consolidation of our operations, and which we expanded in September 2004 to include the transfer of our main corporate functions, including consolidated accounting, financial reporting, tax and treasury, from Abingdon, U.K. to our new U.S headquarters in San Jose, California.

 

In May and November of 2004, we adopted additional restructuring plans, which included the transfer of our assembly and test operations from Paignton, U.K. to Shenzhen, China, a process that commenced in the quarter ended October 2, 2004. This transition was substantially complete by the end of March 2006, except for a chip-on-carrier assembly process we added to the transition plan in November 2005, and which we expect to be

completed by the end of December 2006. In May 2006, we announced our latest cost reduction plans, which included transitioning all remaining manufacturing support and supply chain management, along with pilot line production and production planning, from Paignton to Shenzhen, also by the end of December, 2006.

 

With respect to the transfer of the operations described in the previous paragraph, some of which are still in the process of being transferred, we have spent $22.6 million as of July 1, 2006, and we anticipate spending a total of approximately $30 million to $37 million, including $6 million to $7 million on the cost reduction plan announced in May 2006. The substantial portion of the remaining spending relates to personnel and personnel related costs. We expect the cost reduction plan announced in May 2006 to reduce our costs by between $5.5 million and $6.5 million a quarter, when compared to the expenses incurred in the quarter ended April 1, 2006, with the cost savings expected to be realized in the March 2007 quarter.

 

Year ended July 1, 2006

 

The restructuring charges of $11.2 million in the year ended July 1, 2006 were primarily associated with those employees in our assembly and test operations in Paignton identified for termination and retained until the completion of the transfer of the operations from Paignton, U.K. to Shenzhen, China. Costs of their severance and retention were accrued over their remaining service period. Restructuring charges in fiscal 2006 also included $1.9 million of additional accruals related to revised assumptions as to subleases and final costs associated with lease facilities exited. $1.5 million of these addition lease accruals were incurred in our research and industrial segment and all other restructuring charges in fiscal 2006 were incurred in our optics sector.

 

Year ended July 2, 2005

 

The restructuring charges in the year ended July 2, 2005 were primarily associated with manufacturing, research and development, and selling, general and administrative employees identified for termination under the restructuring plans referred to above, including the consolidation of operations, the transfer of our main corporate functions to the U.S. and the initial stages of the Paignton to Shenzhen transition. Costs of the employee’s severance and retention were accrued over their remaining service period. Restructuring charges in fiscal 2005 also include $2.6 million for costs associated with lease facilities exited, and $2.2 million of additional accruals related to revised assumptions as to subleases and final costs associated with lease facilities exited.

 

Twelve months ended July 3, 2004

 

The restructuring charges in the twelve months ended July 3, 2004 were primarily associated with employees identified for termination under plans that included the closure of a semiconductor fabrication facility in Ottawa, Canada and the transfer of related fabrication capabilities to Caswell, U.K. We also closed a few smaller manufacturing-related sites in Milton, U.K., Harlow, U.K. and Poughkeepsie, New York, and consolidated certain production processes into new locations. The transfer was completed in August 2003. In connection with this transfer, certain products and research projects were discontinued. Subsequent to its completion, we achieved annualized cost savings in excess of $25 million related to this plan. During the twelve months ended July 3, 2004, we also assumed $16.8 million of restructuring charges related to facility commitments previously entered into by companies we acquired during that period, the substantial portion of which represents lease commitments in the research and industrial segment.

 

Year ended December 31, 2003

 

In the year ended December 31, 2003, we recorded restructuring charges primarily related to the closure of a semiconductor fabrication facility in Ottawa, Canada and the transfer of related fabrication capabilities to Caswell, U.K. We also closed a few smaller manufacturing-related sites in Milton, U.K., Harlow, U.K. and Poughkeepsie, New York, and consolidated certain production processes into new locations. The transfer was completed in August 2003. In connection with this transfer, certain products and research projects were discontinued. All charges recorded in the year ended December 31, 2003 related to the optics segment.

Amortization of Other Intangible Assets

 

 

Since 2001, we have acquired six optical components companies and businesses, and one photonics and microwave company, and amortization tends to increase in connection with the addition of intangible assets purchased in connection with these acquisitions. In the year ended December 31, 2002, we acquired the optical components businesses of Nortel Networks and Marconi. In the year ended December 31, 2003, amortization of purchased intangible assets increased when compared to the prior year due to the effect of including the results of the optical components businesses of Nortel Networks and Marconi for the full year, and of our acquisition of Ignis Optics and the business of Cierra Photonics during the year. Amortization of purchased intangible assets increased in the twelve months ended June 3, 2004 compared to the year ended December 31, 2003, due to our acquisition of New Focus in March 2004 and Onetta in June 2004, and increased again in the year ended July 2, 2005 as compared to the twelve months ended July 3, 2004 due to the effect of amortizing the purchased intangible assets of New Focus and Onetta for the full year. In the year ended July 1, 2006, amortization of purchased intangible assets decreased because purchased intangible assets associated with our earliest acquisitions became fully amortized, and because the additional amortization related to our March 2006 acquisition of Avalon was not significant enough to offset these reductions.

 

Impairment of Goodwill and Other Intangible Assets

 

SFAS 142 requires that goodwill and intangible assets with indefinite useful lives no longer be amortized, but instead be tested for impairment at least annually, or sooner whenever events or changes in circumstances indicate that they may be impaired. In the fourth quarter of the year ended July 1, 2006, in connection with our annual review for impairment, we recorded $760,000 of impairment charges related to purchased intangible assets associated with our acquisition of Ignis Optics. In the third quarter of the year ended July 2, 2005, the decline in our stock price, and therefore market capitalization, combined with continuing net losses and a history of not meeting revenue and profitability targets, suggested that the goodwill related to certain of our acquisitions may have been impaired at such time. As a result of these triggering events, we performed a preliminary evaluation of the related goodwill balances. In the fourth quarter of fiscal 2005, we finalized this evaluation during our annual evaluation of goodwill, and also performed our annual evaluation of acquired intangible assets. As a result, for the year ended July 2, 2005, we recorded charges of $114.2 million, primarily related to the impairment of goodwill related to the acquisitions of New Focus, Ignis Optics and Onetta, including $0.6 million related to the impairment of certain intangible assets related to the acquisition of New Focus. We recorded no charges for the impairment of goodwill or intangible assets during any of the other periods presented herein.

 

Impairment/(Recovery) of Other Long-Lived Assets

 

In September 2005, we sold a parcel of land in Swindon, U.K., which had previously been accounted for as held for sale, and for which the recorded book value had previously been written down as impaired. The proceeds from the sale of this parcel of land were $15.5 million, resulting in a recovery of previous impairment of $1.3 million, net of transaction costs. In the fourth quarter of fiscal 2006, in connection with a review of our long-lived assets for impairment, we recorded $433,000 of impairment charges, which offset the recovery related to this land sale.

 

Legal Settlement

 

On April 3, 2006, we entered into a settlement agreement with Mr. Howard Yue relating to the lawsuit Mr. Yue filed against New Focus, Inc., one of our subsidiaries, and several of its officers and directors in Santa Clara County Superior Court. This lawsuit was filed by Mr. Yue prior to our acquisition of New Focus. The terms of the settlement provided that we would issue to Mr. Yue a $7.5 million promissory note, payable on or before April 10, 2006, of

which $5.0 million could be satisfied at our option through the issuance of shares of common stock. In connection with this settlement, we recorded $7.2 million ($7.5 million, net of insurance recoveries expected as of that time) as an other operating expense. In the fourth quarter of fiscal 2006, we settled the promissory note for $2.5 million in cash and $5.0 million of common stock valued on the date of the payment. We also received $2.2 million from certain insurance carriers in connection with this settlement, which reduced our net expense for this settlement to $5.0 million. If and when additional insurers confirm their definitive coverage position, we may record the amounts of this coverage as recoveries against operating expenses in the corresponding future periods.

 

Loss on Conversion and Early Extinguishment of Debt

 

On January 13, 2006, we entered into a series of transactions to (i) retire $45.9 million aggregate principal amount of outstanding notes payable to Nortel Networks UK Limited and (ii) convert $25.5 million in outstanding convertible debentures which were issued in December 2004. In connection with the satisfaction of these debt obligations and conversion of these convertible debentures we issued approximately 10.5 million shares of common stock, warrants to purchase approximately 1.1 million shares of common stock, paid approximately $22.2 million in cash, and recorded a charge of $18.8 million in the fiscal year ended July 1, 2006 for loss on conversion and early extinguishment of debt. See Note 17 - Debt to our consolidated financial statements appearing elsewhere herein for additional disclosures regarding the conversion of the convertible debentures and early extinguishment of debt.

 

Interest Income, Interest Expense, Other Income/(Expense) net, Gain/(Loss) on Foreign Exchange

 

 

Other income/(expense), net in the year ended July 2, 2005 included a one-time gain of $1.1 million arising from the release of an acquisition provision related to the closure of the Bookham (Switzerland) AG pension arrangement.

 

Interest income decreased in the year ended July 1, 2006 from the year ended July 2, 2005 by $800,000, in the year ended July 2, 2005 from the twelve months ended July 3, 2004 by $4.9 million, and in the twelve months ended July 3, 2004 from the year ended December 31, 2003 interest expense decreased by $3.4 million, due to corresponding reductions in balances of cash and short-term investments across those periods.

 

Interest expense in the years ended July 1, 2006 and July 2, 2005 included interest on notes payable to Nortel Networks and the amortization of interest costs related to the issuance of $25.5 million of convertible notes in December 2004. Interest expense decreased in fiscal 2006 from fiscal 2005 by $1.1 million due to the conversion and extinguishment of the convertible notes and payment of the promissory notes issued to Nortel Networks pursuant to a series of agreements entered into in January 2006. Interest expense in the twelve months ended July 3, 2004 and in the year ended December 31, 2003 was primarily related to the promissory notes payable to Nortel Networks.

 

Gain/(loss) on foreign exchange includes the net impact of translation of intercompany balances, translation of U.S. dollar denominated monetary accounts in non-U.S. dollar functional currency subsidiaries, realized gains or losses on foreign currency contracts designated as hedges, and realized and unrealized gains or losses on foreign currency contracts not designated as hedges. The net results are largely a function of exchange rate changes between the U.S dollar and the U.K. pound sterling. The $7.3 million gain and $4.4 million loss on foreign exchange in the twelve months ended July 3, 2004 and in the year ended 2003, respectively, were primarily due to translation of these balances and results which had been previously reported in U.K. pounds sterling, restated for comparative

period disclosure in U.S. dollars subsequent to our September 2004 redomicile in the U.S., as described more fully in the introduction to Item 6. Selected Financial Data.

 

Income Tax Benefit/(Provision)

 

 

We have incurred substantial losses to date and expect to incur additional losses in the future. Based upon the weight of available evidence, which includes our historical operating performance and the recorded cumulative net losses in all prior fiscal periods, we have provided a full valuation allowance against our net deferred tax assets of $316.4 million at July 1, 2006 and $330.4 million at July 2, 2005.

 

During fiscal 2006, in connection with our acquisition of Creekside in August 2005, we recorded a one time tax gain of $11.8 million related to our anticipated use of tax attributes to offset deferred tax liabilities assumed. In the twelve month period ended July 3, 2004, and in the year ended December 31, 2003, we recognized a credit of $3.7 million related to a payment received in 2002 from the U.K. Inland Revenue as compensation for certain research and development expenditures. As our business develops globally, we may incur local tax charges which we will not be able to offset.

 

Liquidity, Capital Resources and Contractual Obligations

 

Liquidity and Capital Resources

 

Operating activities

 

In the past five years, we have funded our operations from several sources, including through public and private offerings of equity, issuance of debt and convertible debentures, sale of assets and net cash obtained in connection with recent acquisitions. As of July 1, 2006, we held $43.3 million in cash and cash equivalents (including restricted cash of $5.5 million). On August 3, 2006, we entered into a three year senior secured revolving credit facility for $25 million with advances available based on a percentage of accounts receivable at the time the advance is requested. On September 1, 2006, we entered into an agreement for the private placement of 8,696,000 shares of common stock at $2.70 per share, and warrants to purchase 2,174,000 shares of common stock, with selected institutional investors, for gross proceeds of approximately $23.5 million. The warrants, which have a term of five years and will become exercisable after March 1, 2007, have an exercise price of $4.00 per share. Certain additional institutional investors will have the right to purchase, on or before September 19, 2006, up to 2,898,667 shares of common stock and warrants to purchase up to 724,667 shares of common stock at the same purchase price as the initial institutional investors.

 

Based on our cash balances, and given our continuing and expected losses for the foreseeable future, if we fail to meet management’s current cash flow forecasts, or we are unable to draw sufficient amounts under the three year $25 million senior secured revolving credit agreement with Wells Fargo Foothill, Inc. and other lenders, which was entered into in August 2006, for any reason, we will need to raise additional funding of at least $10 million to $20 million through external sources prior to July 2007 in order to maintain sufficient financial resources in order to operate as a going concern through the end of fiscal 2007. If necessary we will attempt to raise additional funds by any one or a combination of the following: (i) completing the sale of certain assets; (ii) issuing equity, debt or convertible debt; (iii) selling certain non core businesses. There can be no assurance of our ability to raise sufficient capital through the above, or any other efforts.

 

Year ended July 1, 2006

 

Net cash used in operating activities for the year ended July 1, 2006 was $55.6 million, primarily resulting from the net loss of $87.5 million, offset by non-cash accounting charges of $49.8 million, primarily consisting of an $18.8 million loss on conversion and early retirement of debt, $8.2 million of expense related to stock based compensation, $5.0 million of common stock issued to settle a legal claim brought by Howard Yue, and $30.2 million related to depreciation and amortization of certain assets, net of an $11.8 million tax gain. Increases in working capital of $17.9 million also contributed to the use of cash, primarily due to decreases in accounts payables and accrued expenses and other liabilities and an increase in accounts receivable offset by a decrease in prepaid expenses and other assets.

 

Year ended July 2, 2005

 

Net cash used in operating activities for the year ended July 2, 2005 was $98.8 million, primarily resulting from the net loss of $248.0 million, offset by non-cash accounting charges of $151.3 million, which includes $114.2 million for the impairment of goodwill and certain intangibles recorded in connection with past acquisitions, primarily New Focus, and $32.2 million related to the depreciation and amortization of certain assets. The increase in working capital also resulted in a reduction in cash in the amount of $2.1 million, primarily related to higher levels of inventory required to support our increasing level of sales through the period, and our expected sales in the first quarter of fiscal 2006.

 

Six months ended July 3, 2004

 

Net cash used in operating activities for the six-month period ended July 3, 2004 was $50.2 million, primarily resulting from the net loss of $67.4 million, offset by non-cash accounting charges of $14.2 million, mainly related to depreciation and amortization and a $3.0 million decrease in working capital. The decrease in working capital was the result of a reduction in inventory, primarily through the sale of inventory purchased as part of the acquisition of the optical components business from Nortel Networks.

Year ended December 31, 2003

 

Net cash used in operating activities in 2003 was $98.0 million, primarily resulting from the net loss of $125.8 million, offset by non-cash accounting charges of $14.7 million primarily for depreciation and amortization and an $18.9 million decrease in working capital. The decrease in working capital was the result of a reduction in inventory, primarily through the sale of inventory purchased as part of the acquisition of the optical components business from Nortel Networks.

 

Return/(Loss) on Investments

 

Return/(loss) on investments represents net interest, which is the difference between interest received on our cash and interest paid on our debts. Loss on investments were $4.0 million in the year ended July 1, 2006, $4.3 million in the year ended July 2, 2005, $5.8 million in the twelve months ended July 3, 2004, and $6.3 million in the year ended December 31, 2003. From the year ended December 31, 2003 to the twelve months ended July 3, 2004, and from the twelve months ended July 3, 2004 to the year ended July 2, 2005, decreasing returns on investment and the loss on investment have been due to lower interest income earned on declining cash balances, interest on balances outstanding from the $50 million of notes issued to Nortel Networks in November 2002 and the amortization of interest, costs and warrants associated with our issuance of $25.5 million of convertible debt in December 2004, prior to converting such convertible debt into common stock in January and March 2006. The reduction in loss on investment in the year ended July 1, 2006 compared to the year ended July 2, 2005 is due to the payment and retirements of notes issued to Nortel Networks and the conversion of $25.5 million of convertible debt into common stock both pursuant to a series of agreements entered into on January 13, 2006.

 

Investing Activities

 

We generated net cash of $42.7 million from investing activities in the year ended July 1, 2006, primarily from $14.7 million in proceeds, net of costs, from the sale of a parcel of land in Swindon U.K. (as described further below), $9.6 million of cash assumed in connection with the two acquisitions completed during the year, $23.4 million from the sale of land and building in Caswell pursuant to a sale-leaseback transaction, and $2.4 million in proceeds from the sale of property and equipment. These sources of cash were partially offset by $10.1 million in capital expenditures. A substantial portion of the capital spending during this period was incurred in connection with the ramp up of our Shenzhen assembly and test operations.

 

In the year ended July 2, 2005, we used $2.3 million of cash in investing activities, primarily relating to $16.0 million of capital expenditures, along with a $1.7 million transfer of funds to restricted cash, partially offset by proceeds of $7.0 million from the sale of marketable securities, proceeds of $5.7 million from the disposal of certain of our subsidiaries, net of costs, proceeds of $1.4 million from the sale of property and equipment, and proceeds of $1.2 million received from the settlement of a loan note issued by a former New Focus executive officer. A substantial portion of the capital spending during this period was incurred in connection with the ramp up of our Shenzhen assembly and test operations.

 

In the six months ended July 3, 2004, we generated $87.4 million of cash, primarily consisting of $88.6 million assumed in connection with our acquisitions of New Focus and Onetta, along with $5.2 million in proceeds from the sale of property and equipment, partially offset by purchases of property and equipment of $6.6 million.

 

In the year ended December 31, 2003, we used $12.0 million of cash in financing activities, primarily the result of purchasing $19.2 million of property and equipment, partially offset by $7.1 million received in connection with the sale of property and equipment. The principal area of capital spending in 2003 was to upgrade the Caswell, U.K. wafer fabrication site to a capability required to produce products transferred from Ottawa, Canada.

 

Caswell Sale-Leaseback

 

On March 10, 2006, Bookham Technology plc, our wholly-owned subsidiary, entered into multiple agreements with a subsidiary of Scarborough Development, which we refer to as Scarborough, for the sale and leaseback of the land and facilities located at our Caswell, United Kingdom, manufacturing site. The sale transaction, which closed on March 30, 2006, resulted in proceeds to Bookham Technology plc of £13.75 million (approximately

U.S. $24.0 million using an exchange rate of £1.00 to $1.7455). Under these agreements, Bookham Technology plc leases back the Caswell site for an initial term of 20 years, with options is renew the lease term for 5 years following the initial term and for rolling 2 year terms thereafter. Annual rent is £1.1 million during the first 5 years of the lease, approximately £1.2 million during the next 5 years of the lease, approximately £1.4 million during the next 5 years of the lease and approximately £1.6 million during the next 5 years of the lease. Rent during the renewal terms will be determined according to the then market rent for the site. We have guaranteed the obligations of Bookham Technology plc under these agreements. In addition, Scarborough, Bookham Technology plc and Bookham, Inc. entered into a pre-emption agreement under which Bookham Technology plc, within the next 20 years, has a right to purchase of the Caswell site in whole or in part on terms acceptable to Scarborough if Scarborough agrees to terms with or receives an offer from a third party to purchase the Caswell facility.

 

Acquisition of Creekside

 

On August 10, 2005, Bookham Technology plc, our wholly owned subsidiary, entered into a share purchase agreement pursuant to which Bookham Technology plc purchased all of the issued share capital of City Leasing (Creekside) Limited, a subsidiary of Deutsche Bank, for consideration of £1.00, plus professional fees of approximately £455,000 (approximately $837,000, based on an exchange rate of £1 to $1.8403). The parties to the share purchase agreement are Bookham Technology plc, Deutsche Bank and London Industrial Leasing Limited, a subsidiary of Deutsche Bank, which we refer to as London Industrial. Creekside was utilized by Deutsche Bank in connection with the leasing of four aircraft to a third party. The leasing arrangement is structured as follows: Phoebus Leasing Limited, a subsidiary of Deutsche Bank, which we refer to as Phoebus, leases the four aircraft to Creekside under the primary leases and Creekside in turn sub-leases the aircraft to a third party. Under the sub-lease arrangement, the third party lessee who utilizes the aircraft, whom we refer to as the Sub-Lessee, makes sublease payments to Creekside, who in turn must make lease payments to Phoebus under the primary leases. To insulate Creekside from any risk that the Sub-Lessee will fail to make payments under the sub-lease arrangement, prior to the execution of the share purchase agreement, Creekside assigned its interest in the Sub-Lessee payments to Deutsche Bank in return for predetermined deferred consideration amounts, which we refer to as Deferred Consideration, which are paid directly from Deutsche Bank. Additionally, on closing the transaction, Deutsche Bank loaned Creekside funds to (i) pay substantially all of the rentals under the primary lease with Phoebus, excluding an amount equal to £400,000 (approximately $736,000), and (ii) repay an existing loan made by another wholly owned subsidiary of Deutsche Bank to Creekside. The obligation of Creekside to repay the Deutsche Bank loans may be fully offset against the obligation of Deutsche Bank to pay the Deferred Consideration to Creekside.

 

As a result of these transactions, Bookham Technology plc will have available through Creekside cash of approximately £6.63 million (approximately $12.2 million, based on an exchange rate of £1.00 to $1.8403). Under the terms of the agreement, Bookham Technology plc received £4.2 million (approximately $7.5 million) of available cash when the transaction closed on August 10, 2005. An additional £1 million (approximately $1.8 million) has since been received on October 14, 2005, £1 million (approximately $1.8 million) was received on July 14, 2006 and the balance of approximately £431,000 (approximately $793,000) is expected to be available on July 16, 2007.

 

At the closing of this transaction, Creekside had receivables (including services and interest charges) of £73.8 million (approximately $135.8 million) due from Deutsche Bank in connection with certain aircraft subleases of Creekside and cash of £4.7 million (approximately $8.6 million), of which £4.2 million was immediately available. The assignment was made in exchange for the receivables, which are to be paid by Deutsche Bank to Creekside in three installments, with the last payment being made on July 16, 2007. We have recorded these receivables and payables as net assets on our balance sheet as of July 1, 2006, which is included elsewhere in this Annual Report on Form 10-K.

 

Creekside and Deutsche Bank entered into two facility agreements relating to a loan in the principal amount of £18.3 million (approximately $33.7 million) and a loan in the principal amount of £42.5 million including interest (approximately $78.2 million), which together will accrue approximately £3.6 million (approximately $6.6 million) in interest during the term of these loans. At the closing, Creekside used the loans to repay amounts outstanding under a loan dated April 12, 2005 between Creekside, as borrower, and City Leasing (Donside) Limited, a subsidiary of Deutsche Bank, as lender, and to pay part of Creekside’s rental obligations under the lease agreements.

At August 10, 2005, Creekside had long-term liabilities to Deutsche Bank under the loans, an agreement to pay Deutsche Bank £8.3 million (approximately $15.3 million, including principal and interest) to cover settlement of current Creekside tax liabilities and £0.4 million (approximately $0.7 million) of outstanding payments due to Deutsche Bank under the lease agreements; we refer to these collectively as the Obligations.

 

Creekside will use the Deferred Consideration to pay off the Obligations over a period of two years, or the Term, such that the Obligations will be offset in full by the receivables and result in Bookham Technology plc having excess cash of approximately £6.63 million (approximately $12.2 million) available to it during the Term. Bookham Technology plc expects to surrender certain of its tax losses against any U.K. taxable income that may arise as a result of the Deferred Consideration, to reduce any U.K. taxes that would otherwise be due from Creekside.

 

The loans issued by Deutsche Bank may be prepaid in whole at any time with 30 days’ prior written notice to Deutsche Bank. The loan for £18.3 million plus interest was repaid by Creekside on October 14, 2005, and the loan for £42.5 million is repayable by Creekside in installments: the first installment of £23.5 million (approximately $43.2 million) was paid on July 14, 2006; and the second installment of £22.5 million (approximately $41.4 million) is payable on July 16, 2007. The remaining loan accrues interest a rate of 5.68% per year. Events of default under the loan includes failure by Creekside to pay amounts under the loans when due, material breach by Creekside of the terms of the lease agreements and related documentation, a judgment or order made against Creekside that is not stayed or complied with within seven days or an attachment by creditors that is not discharged within seven days, insolvency of Creekside or failure by Creekside to make payments with respect to all or any class of its debts, presentation of a petition for the winding up of Creekside, and appointment of any administrative or other receiver with respect to Creekside or any material part of Creekside’s assets. While Deutsche Bank may accelerate repayment under the facility agreements upon an event of default, the loan will be fully offset against the receivables, as described above.

 

Pursuant to the terms of the agreements governing this transaction, we believe that we have not assumed any material credit risk in connection with these arrangements. The material cash flow obligations associated with Creekside are directly related to Deutsche Bank’s obligations to pay Creekside the Deferred Consideration, and Creekside’s obligation to repay the loans to Deutsche Bank. The obligations of Creekside to repay the Deutsche Bank loan can be fully offset against Deutsche Bank’s obligation to pay the Deferred Consideration. Any Sub-Lessee default has no impact on Deutsche Bank’s obligation to pay Creekside the Deferred Consideration. Regarding the primary leases between Phoebus and Creekside, all but £400,000 has been paid. For these reasons, we believe we do not bear a material risk and have no substantial continuing payments or obligations.

 

Under the share purchase agreement and related documents, London Industrial and Deutsche Bank have indemnified us, Bookham Technology plc and Creekside with respect to contractual obligations and liabilities entered into by Creekside prior to the closing of the transaction and certain tax liabilities of Creekside that may arise in taxable periods both prior to and after the closing.

 

Pursuant to an administration agreement between Creekside, City Leasing Limited, a subsidiary of Deutsche Bank, and Deutsche Bank, Creekside is to be administered during the Term by City Leasing Limited to ensure Creekside complies with its obligations under the lease agreements.

 

In accordance with the terms of the primary leases and the sub-leases, Phoebus is ultimately entitled to the four aircraft in the event of default by the Sub-Lessee. An event of default will not impact the payment obligations described above.

 

Sale of Real Property

 

In September 2005, our Bookham Technology plc subsidiary entered into a contract with Abbeymeads LLP to sell a parcel of land in Swindon, U.K., which had previously been accounted for as held for sale, and for which the recorded book value had previously been written down as impaired. Net proceeds from the sale were $14.7 million, and we recorded a recovery of previous impairment of $1.3 million in the first quarter of fiscal 2006.

Financing Activities

 

In the year ended July 1, 2006, we generated $25.2 million of cash from financing activities, primarily consisting of $49.3 million of net proceeds from a public offering of our common stock in October 2005, as described below, offset by $24.3 million used in connection with the early retirement of two promissory notes originally issued to Nortel Networks in connection with our acquisition of their optical components business and the payment of certain amounts in connection with the conversion of our convertible debentures which were issued in December 2004.

 

In the year ended July 2, 2005, we generated $14.9 million of cash from financing activities. This primarily consisted of net proceeds of $24.2 million from the issuance of convertible debentures and warrants to purchase common stock, offset by the repayment of $4.2 million due to Nortel Networks under a promissory note and payments of $5.1 million related to capital lease obligations assumed primarily in connection with the Onetta acquisition.

 

In the six months ended July 3, 2004 and in the year ended December 31, 2003, we generated $1.7 million and $1.1 million, respectively, from financing activities, primarily resulting from the issuance of common stock.

 

On January 13, 2006, we entered into a series of transactions to (i) retire $45.9 million aggregate principal amount of outstanding notes payable to Nortel Networks UK Limited and (ii) convert $25.5 million in outstanding convertible debentures which were issued in December 2004. In connection with the satisfaction of these debt obligations and conversion of these convertible debentures we issued approximately 10.5 million shares of common stock, warrants to purchase approximately 1.1 million shares of common stock, paid approximately $22.2 million in cash, and recorded a charge of $18.8 million in the fiscal year ended July 1, 2006 for loss on conversion and early extinguishment of debt. See Note 17 - Debt to our consolidated financial statements appearing elsewhere herein for additional disclosures regarding the conversion of the convertible debentures and early extinguishment of debt.

 

On October 17, 2005, we completed a public offering of our common stock, issuing a total of 11,250,000 shares at a price per share to the public of $4.75, resulting in proceeds of $53.4 million, of which we received $49.3 million net of commissions to the underwriters and the payment of offering costs and expenses.

 

Sources of Cash

 

In the past five years, we have funded our operations from several sources, including through public offerings of equity, issuance of debt and convertible debt, sale of assets and net cash from acquisitions. As of July 1, 2006, we held $43.3 million in cash and cash equivalents (including restricted cash of $5.5 million). On August 3, 2006, we entered into a $25 million revolving credit line facility with availability based on 80% of our accounts receivable. On September 1, 2006, we entered into a definitive agreement for the private placement of 8,696,000 shares of common stock at $2.70 per share, and warrants to purchase 2,174,000 shares of common stock, with selected institutional investors, for proceeds of approximately $23.5 million. The warrants, which have a term of five years and will become exercisable after March 1, 2007, have an exercise price of $4.00 per share. Certain additional institutional investors will have the right to purchase, on or before September 19, 2006, up to 2,898,667 shares of common stock and warrants to purchase up to 724,667 shares of common stock at the same purchase price as the initial investors.

 

Future Cash Requirements

 

Based on our cash balances, and given our continuing and expected losses for the foreseeable future, if we fail to meet management’s current cash flow forecasts, or we are unable to draw sufficient funds under the three year $25 million senior secured revolving credit agreement with Wells Fargo Foothill, Inc. and other lenders, which was entered into in August 2006, for any reason, we will need to raise additional funding of at least $10 million to $20 million through external sources prior to July 2007 in order to maintain sufficient financial resources in order to operate as a going concern through the end of fiscal 2007. If necessary we will attempt to raise additional funds by any one or combination of the following: (i) completing the sale of certain assets; (ii) issuing equity, debt or convertible debt; (iii) selling certain non core businesses. There can be no assurance of our ability to raise sufficient capital through the above, or any other efforts.

From time to time, we have engaged in discussions with third parties concerning potential acquisitions of product lines, technologies and businesses. We continue to consider potential acquisition candidates. Any of these transactions could involve the issuance of a significant number of new equity securities, debt, and/or cash consideration. We may also be required to raise additional funds to complete any such acquisition, through either the issuance of equity securities or borrowings. If we raise additional funds or acquire businesses or technologies through the issuance of equity securities, our existing stockholders may experience significant dilution.

 

Risk Management — Foreign Currency Risk

 

We are exposed to fluctuations in foreign currency exchange rates and interest rates. As our business has grown and become increasing multinational in scope, we have become increasingly subject to fluctuations based upon changes in the exchange rates between the currencies in which we collect revenues and pay expenses. Despite our change in domicile from the United Kingdom to the United States, in the future we expect that a substantial portion of our revenues will be denominated in U.S. dollars, while a substantial portion of our expenses will continue to be denominated in U.K. pounds sterling. Fluctuations in the exchange rate between the U.S. dollar and the U.K. pound sterling and, to a lesser extent, other currencies in which we collect revenues and pay expenses, could affect our operating results. This includes the Chinese Yuan, now that our Shenzhen, China facility is fully operational, in which we pay local expenses. To the extent the exchange rate between the U.S. dollar and the Chinese Yuan were to begin to fluctuate more significantly than experienced to date, our exposure would increase. We enter into foreign currency forward exchange contracts in an effort to mitigate our exposure to such fluctuations between the U.S. dollar and the U.K. pound, and we may be required to convert currencies to meet our obligations. Under certain circumstances, foreign currency forward exchange contracts can have an adverse effect on our financial condition. As of July 1, 2006, we held nine foreign currency forward exchange contracts with a nominal value of $19.5 million which include put and call options which expire, or expired, at various dates from August 2006 to June 2007. During the year ended July 1, 2006, we recorded a net gain of $0.8 million in our statement of operations in connection with foreign exchange contracts. As of July 1, 2006, the fair value of our outstanding foreign currency forward exchange contracts was an asset of $0.6 million and we recorded the unrealized gain of $0.6 million to other comprehensive income in connection with marking these contracts to fair value.

 

Contractual Obligations

 

Our contractual obligations at July 1, 2006, by nature of the obligation and amount due over certain periods of time, are set out in the table below: