Riverstone Networks Inc. (Nasdaq: RSTN)took a hit this morning after reporting its fiscal fourth-quarter earnings today (see Riverstone Reports Q4). While the company saw improvement in revenue, its gross margins were well below expectations, leaving many wondering what happened.

At midday, the company’s stock was trading down $0.14 (9.27%) to $1.37.

The company reported that fourth-quarter revenues increased 9.7 percent to $15.1 million from $13.8 million the prior quarter, in line with most analysts' estimates (see Riverstone Slapped in Face of Good News). A year ago, the company reported $51.3 million for its fourth quarter. According to Generally Accepted Accounting Principles (GAAP), net loss for the quarter was $40.6 million or $0.33 per share, compared to $34.1 million or $0.28 per share in the third quarter. Last year, the fourth-quarter net loss was $28.2 million or $0.23 per share.

The biggest news was the company’s plummeting gross margins, which fell below zero when calculated using GAAP figures. Much of this can be blamed on a slew of non-recurring charges the company took in the fourth quarter, some of which adversely affected its gross margins. These included: a $5.1 million charge for inventory associated with discontinued and excess products; $100,000 related to amortized stock compensation; and about $600,000 for the amortization of intangibles related to the purchase of Pipal Systems Inc. (see Oil Refiner Drills SANs Together).

Because these charges are not expected to reoccur, analysts have taken them out of their investment models. But even with the pro forma numbers, margins still fell about 7.5 percent from the previous quarter. Several analysts following the company calculated that the company’s pro forma gross margins were about 28.5 percent, compared to about 36 percent in the third quarter.

“The initial read on the margins is that they are considerably lower that what we were anticipating,” says Pacific Growth Equities Inc. analyst Erik Suppiger.

During the conference call this morning, Robert Stanton, Riverstone's CFO, said he expects margins to improve to just over 30 percent in the current first quarter of fiscal 2004. This is still much lower than analysts were hoping. It’s this bleak outlook that has some analysts concerned and scrambling to figure out exactly what happened.

Part of the problem is that Riverstone’s revenues are so small. Any sort, of special charge, change in product mix, or a deal that generates lower than expected margins can have a serious impact on the overall gross margin for the quarter.

Riverstone executives claim that the falling margins resulted from a higher percentage of lower-margin product sales in the fourth quarter. While the company doesn't expect that trend to continue, executives say they are being cautious with their guidance.

Whatever the cause, the sagging gross margins spell big trouble for Riverstone, which has seen its annual revenues fall 67 percent from the previous year. In order for the company to even come close to break-even, it will need to generate over $40 million per quarter and raise gross margins above 50 percent, say analysts. This is certainly no easy assignment.Company executives are trying to stay positive. Romulus Pereira, president and CEO of the company, said Riverstone is set to announce several new products this year that should help improve its outlook.

“We will continue to aggressively target new markets including 10-Gbit/s Ethernet,” he said. “We think these new products and our focus on enterprise and service provider customers will position us well for long-term success.”

Even with new products, there's a long road ahead for the company. The service provider market is not expected to improve much this year. Enterprise spending is also expected to be weak through the first half. And while 10-Gbit/s Ethernet will soon become a required product for any company in this market, it is not expected to generate much revenue in 2003.

— Marguerite Reardon, Senior Editor, Light Reading