SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1996
Commission File Number 0-27742
CYLINK CORPORATION
(Exact name of registrant as specified in its charter)
California 95-3891600
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
910 Hermosa Court
Sunnyvale, California 94086
(Address of principal executive offices)
(408) 735-5800
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Sections 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.
(1) YES X NO
----- -----
(2) YES X NO
----- -----
As of September 30, 1996, there were 25,448,132 shares of the Registrant's
common stock outstanding.
<PAGE>
CYLINK CORPORATION
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION PAGE
----
Item 1. Financial Statements
Condensed Consolidated Balance Sheets
at September 30, 1996 and December 31, 1995 3
Condensed Consolidated Statements of Operations
for the three and nine months ended September 30 4
Condensed Consolidated Statements of Cash Flows
for the nine months ended September 30, 1996 and 1995 5
Notes to Condensed Consolidated Financial Statement 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 7
PART II. OTHER INFORMATION
Item 1. Legal Proceedings XX
Item 6. Exhibits and reports on Form 8-K XX
SIGNATURES XX
<PAGE>
<TABLE>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CYLINK CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data; unaudited)
<CAPTION>
September 30, December 31,
1996 1995
--------- ---------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 79,412 $ 3,240
Marketable securities -- 2,858
Accounts receivable, net of allowances of $671 and $483 12,541 6,013
Inventories 8,354 6,096
Deferred income taxes 1,409 1,556
Other current assets 688 483
--------- ---------
Total current assets 102,404 20,246
Property and equipment, net 3,016 2,295
Other assets 192 184
--------- ---------
$ 105,612 $ 22,725
========= =========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Bank borrowings under line of credit $ -- $ 1,000
Current portion of lease obligations 166 144
Accounts payable 3,632 1,378
Accrued liabilities 4,675 3,741
Income taxes payable 146 90
Deferred revenue 1,169 1,289
--------- ---------
Total current liabilities 9,788 7,642
--------- ---------
Lease obligations, long-term 278 291
--------- ---------
Deferred income taxes 187 187
--------- ---------
Shareholders' equity:
Preferred stock, $.01 par value; 5,000,000 shares authorized;
none issued and outstanding -- --
Common stock, $.01 par value; 40,000,000 shares authorized;
25,448,132 and 19,087,190 shares issued and outstanding 254 191
Additional paid-in capital 89,004 8,864
Notes receivable from shareholders (415) (515)
Deferred compensation related to stock options (354) --
Cumulative marketable securities valuation adjustment -- (416)
Cumulative translation adjustment (113) (135)
Retained earnings 6,983 6,616
--------- ---------
Total shareholders' equity 95,359 14,605
--------- ---------
$ 105,612 $ 22,725
========= =========
<FN>
See accompanying notes to Condensed Consolidated Financial Statements.
</FN>
</TABLE>
<PAGE>
<TABLE>
CYLINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data; unaudited)
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- --------------------
1996 1995 1996 1995
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenue $ 15,021 $ 9,258 $ 35,790 $ 25,471
Cost of revenue 6,193 3,433 15,024 9,870
-------- -------- -------- --------
Gross profit 8,828 5,825 20,766 15,601
-------- -------- -------- --------
Operating expenses:
Research and development, net 2,774 2,546 8,413 8,084
Selling and marketing 3,415 2,373 9,531 6,835
General and administrative 1,671 2,180 4,332 4,043
-------- -------- -------- --------
Total operating expenses 7,860 7,099 22,276 18,962
-------- -------- -------- --------
Income (loss) from operations 968 (1,274) (1,510) (3,361)
Other income (expense):
Interest income, net 1,003 22 2,302 85
Licensing and other income (expense), net 67 415 (237) 1,317
-------- -------- -------- --------
Income (loss) before income taxes 2,038 (837) 555 (1,959)
Provision (benefit) for income taxes 693 (346) 189 (809)
-------- -------- -------- --------
Net income (loss) $ 1,345 $ (491) $ 366 $ (1,150)
======== ======== ======== ========
Net income (loss) per share $ 0.05 $ (0.03) $ 0.01 $ (0.06)
======== ======== ======== ========
Shares used to compute net income (loss) per share 26,886 19,141 25,308 19,114
======== ======== ======== ========
<FN>
See accompanying notes to Condensed Consolidated Financial Statements.
</FN>
</TABLE>
<PAGE>
<TABLE>
CYLINK CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands; unaudited)
<CAPTION>
Nine Months Ended
September 30,
--------------------
1996 1995
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net income (loss) $ 366 $ (1,150)
Adjustments to reconcile net income (loss) to net cash
used in operating activities:
Loss on sale of securities 432 --
Depreciation and amortization 980 508
Deferred compensation related to stock options 63 --
Deferred income taxes 147 (701)
Changes in assets and liabilities:
Accounts receivable (6,528) (2,764)
Inventories (2,258) (1,311)
Other assets (196) (129)
Accounts payable 2,254 522
Accrued liabilities 934 1,071
Income taxes payable 56 73
Deferred revenue (120) 458
-------- --------
Net cash used in operating activities (3,870) (3,423)
-------- --------
Cash flows from investing activities:
Proceeds from sale of short-term investments 2,844 --
Capital expenditures (1,454) (533)
-------- --------
Net cash provided by (used in) investing activities 1,390 (533)
-------- --------
Cash flows from financing activities:
(Repayment) borrowings under bank line of credit (1,000) 1,000
Proceeds from issuance of common stock, net 79,786 83
Payment on notes receivable from shareholders 100 --
Repayment of capital lease obligations (238) --
-------- --------
Net cash provided by financing activities 78,648 1,083
-------- --------
Effect of exchange rate changes on cash and cash equivalents 4 2
-------- --------
Net increase (decrease) in cash and cash equivalents 76,172 (2,871)
Cash and cash equivalents at beginning of period 3,240 4,031
-------- --------
Cash and cash equivalents at end of period $ 79,412 1,160
======== ========
Supplemental disclosures:
Cash paid for interest $ 95 $ --
Noncash investing and financing activities:
Property and equipment acquired through capital leases $ 247 $ --
<FN>
See accompanying notes to Condensed Consolidated Financial Statements.
</FN>
</TABLE>
<PAGE>
CYLINK CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except share and per share data; unaudited)
1. Basis of Presentation
The unaudited condensed consolidated financial statements included
herein contain all adjustments, consisting only of normal recurring adjusments
which, in the opinion of management, are necessary to fairly state the Company's
consolidated financial position, results of operations, and cash flows for the
periods presented. These financial statements should be read in conjunction with
the Company's audited financial statements as included in the Company's
Registration Statement on Form S-1 as declared effective by the Securities and
Exchange Commission on February 15, 1996 (Reg. No. 33-80719). The consolidated
results of operations for the three and nine month periods ended September 30,
1996 are not necessarily indicative of the results to be expected for any
subsequent quarter or for the entire calendar year ending December 31, 1996.
2. Initial Public Offering
In February and March 1996, the Company completed its initial public
offering (the "Offering") and issued 5,750,000 shares of its common stock to the
public at a price of $15.00 per share. The Company received approximately $79.3
million of cash, net of underwriting discounts, commissons and other offering
costs.
3. Net Income (Loss) Per Share
Net income (loss) per share is computed using the weighted average
number of outstanding shares of common stock and common stock equivalents.
Common stock equivalents consist of stock options (using the treasury stock
method). Common stock equivalents are excluded from the computation if their
effect is antidilutive, except that, pursuant to the requirements of the
Securities and Exchange Commission, common stock equivalents issued subsequent
to November 30, 1994 through February 15, 1996 (using the treasury stock method
and the initial public offering price) have been included in the computation as
if they were outstanding for all periods presented through the date of the
offering.
4. Balance Sheet Details
September 30, December 31,
1996 1995
---- ----
Inventories:
Raw materials $ 4,158 $ 3,042
Work in process and subassemblies 2,862 1,773
Finished goods 1,334 1,281
-------- -------
$ 8,354 $ 6,096
======== =======
Property and equipment:
Machinery and equipment $ 6,399 $ 4,995
Furniture and fixtures 293 179
Leasehold improvements 450 267
------- -------
7,142 5,441
Less: accumulated depreciation
and amortization (4,126) (3,146)
-------- -------
$ 3,016 $ 2,295
======== =======
<PAGE>
CYLINK CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(in thousands, except share and per share data; unaudited)
4. Balance Sheet Details (Continued)
September 30, December 31,
1996 1995
---- ----
Accrued liabilities:
Accrued compensation and benefits $ 1,924 $ 1,037
Accrued professional fees 200 1,365
Other accrued liabilities 2,551 1,339
-------- -------
$ 4,675 $ 3,741
======== =======
<PAGE>
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations
The statements contained in this Report on Form 10-Q that are not
purely historical are forward looking statements within the meaning of Section
27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act
of 1934, including statements regarding the Company's expectations, hopes,
intentions, beliefs or strategies regarding the future. Forward looking
statements include Cylink's statement regarding liquidity, anticipated cash
needs and availability, and anticipated expense levels in "Management's
Discussion and Analysis of Financial Condition and Results of Operations";
expected product introductions in "Risk Factors That May Affect Future Results -
Recent Losses; Potential Fluctuations in Operating Results; Future Operating
Results Uncertain"; and expected growth in "Risk Factors That May Affect Future
Results - Management of Growth"; and expected research and development
expenditures and new product introductions in "Risk Factors That May Affect
Future Results - Rapid Technological Change." All forward looking statements
included in this document are based on information available to the Company on
the date hereof, and the Company assumes no obligation to update any such
forward looking statement. It is important to note that the Company's actual
results could differ materially from those in such forward looking statements.
Among the factors that could cause actual results to differ materially are the
factors detailed below and the risks discussed in the "Risk Factors" section
included in the Company's Registration Statement on Form S-1, as declared
effective by the Securities and Exchange Commission on February 15, 1996 (Reg.
No. 33-80719). You should also consult the risk factors listed from time to time
in the Company's Reports on Form 10-Q, 8-K, 10-K and Annual Reports to the
Stockholders.
RESULTS OF OPERATIONS
Revenue. The Company's total revenue is derived primarily from sales of
its family of commercial information security products and its medium speed
spread spectrum radio products. Fees for maintenance and support services are
<PAGE>
charged separately. Revenue from product sales is recognized upon shipment to
the customer. Concurrently, a provision is made for estimated cost to repair or
replace products under warranty arrangements. Revenue from sales to distributors
is recognized upon shipment; no right of return, stock rotation or price
protection is given. Revenue from sales to value added resellers is recognized
upon shipment and concurrently a provision for estimated returns is recorded.
The Company's revenue increased by 62% from $9.3 million for the three
months ended September 30, 1995 to $15.0 million for the three months ended
September 30, 1996, and increased by 41% from $25.5 million for the nine months
ended September 30, 1995 to $35.8 million for the nine months ended September
30, 1996. Sales of information security products increased by 32% from $5.4
million for the three months ended September 30, 1995 to $7.2 million for the
three months ended September 30, 1996, and increased 5% from $15.7 million in
the nine months ended September 30, 1995 to $16.4 for the nine months ended
September 30, 1996. The increase in revenue was primarily due to an increase in
demand for the Company's secure WAN, LAN and ACCESS encryption product line,
which is used in public and private linked networks. This increase was partially
offset over the nine month period by a decrease in demand for the Company's
CIDEC encryption product line. Sales of wireless communications products
increased 104% from $3.7 million for the three months ended September 30, 1995
to $7.5 million for the three months ended September 30, 1996, and increased
102% from $9.1 million for the nine months ended September 30, 1995 to $18.3
million for the nine months ended September 30, 1996 primarily as a result of
increased demand in international markets. Maintenance, support and other
miscellaneous revenue increased from $180,000 for the three months ended
September 30, 1995 to $374,000 for the three months ended September 30, 1996.
International product revenue was 51% of total revenue in the three
months ended September 30, 1995 and was 58% of total revenue in the three months
ended September 30, 1996. International product revenue was 45% of total revenue
in the nine months ended September 30, 1995 and was 56% of total revenue in the
nine months ended September 30, 1996. The increase in international product
revenue as a
<PAGE>
percentage of total revenue was due primarily to increased unit sales of the
Company's wireless communications products.
Gross Profit Gross profit increased 52% from $5.8 million for the three
months ended September 30, 1995 to $8.8 million for the three months ended
September 30, 1996, and increased 33% from $15.6 million for the nine months
ended September 30, 1995 to $20.8 million for the nine months ended September
30, 1996. Gross margins were 63% for the three months ended September 30, 1995
and 59% for the three months ended September 30, 1996. Gross margin in the third
quarter of 1996 was negatively affected by increased sales, as a percentage of
revenue, of wireless communications products, which generally have a lower gross
margin than information security products. Further, gross margin on information
security products declined as some of the new products have lower gross margins
than the CIDEC encryption products and represented an increased percentage of
sales. Gross margins were 61% for the nine months ended September 30, 1995 and
58% for the nine months ended September 30, 1996. Gross margin in the first nine
months of 1996 was negatively affected by the aforementioned increased sales, as
a percentage of revenue, of wireless communications products and by the decline
in gross margins on information security products. This decrease in gross margin
was partially offset by an overall increase in wireless communications product
gross margins compared to the first nine months of 1995.
Research and Development. Research and development expenses consist
primarily of salaries and other personnel-related expenses, depreciation of
development equipment, facilities and supplies. Gross research and development
expenses increased 57% from $2.8 million for the three months ended September
30, 1995 to $4.4 million for the three months ended September 30, 1996, and
increased 47% from $8.4 million for the nine months ended September 30, 1995 to
$12.3 million for the nine months ended September 30, 1996. Gross research and
development expenses as a percentage of revenue were 30% and 29% for the three
months ended September 30, 1995 and 1996, and 33% and 34% for the nine months
ended September 30, 1995 and 1996, respectively. From time to time, the Company
receives engineering funding for development projects to apply or
<PAGE>
enhance the Company's technology to a particular customer's need. The amounts
recognized under these research and development contracts are offset against
research and development expenses. Amounts recognized under non-recurring
engineering contracts totaled $242,000 for the three months ended September 30,
1995 and $1,593,000 for the three months ended September 30, 1996, and $319,000
for the nine months ended September 30, 1995 and $3,900,000 for the nine months
ended September 30, 1996.
The Company believes that a significant level of investment in product
research and development is required to remain competitive and, accordingly, the
Company anticipates that it will continue to devote substantial resources to
product research and development for at least the remainder of fiscal 1996. The
Company expects research and development expenses will increase in absolute
dollars for at least the remainder of fiscal 1996.
Selling and Marketing. Selling and marketing expenses consist primarily
of personnel costs, including sales commissions, and costs of advertising,
public relations, seminars and trade shows. Selling and marketing expenses
increased 44% from $2.4 million for the three months ended September 30, 1995 to
$3.4 million for the three months ended September 30, 1996, and increased 39%
from $6.8 million for the nine months ended September 30, 1995 to $9.5 million
for the nine months ended September 30, 1996. Selling and marketing expenses as
a percentage of revenue were 26% and 23% for the three months ended September
30, 1995 and 1996, respectively, and 27% for both the nine months ended
September 30, 1995 and 1996. The increase in dollar amount was primarily due to
expenses associated with expansion of the Company's direct sales force,
personnel increases in the marketing group, and increased costs associated with
advertising, public relations and trade shows. The Company expects selling and
marketing expenses will increase in absolute dollars for at least the remainder
of fiscal 1996.
General and Administrative. General and administrative expenses consist
primarily of personnel and related costs, recruitment expenses, information
system costs, and audit, legal and other professional service fees. General and
administrative expenses decreased from $2.2
<PAGE>
million for the three months ended September 30, 1995 to $1.7 million for the
three months ended September 30, 1996, and increased from $4.0 million for the
nine months ended September 30, 1995 to $4.3 million for the nine months ended
September 30, 1996. General and administrative expenses as a percentage of
revenue were 24% and 11% for the three months ended September 30, 1995 and 1996,
respectively, and 16% and 12% for the nine months ended September 30, 1995 and
1996, respectively. The percentage and dollar decrease for the third quarter of
1996 as compared to the comparable 1995 period are primarily a result of the
accrual of legal fees in the third quarter of 1995 associated with litigation
regarding intellectual property. Excluding this accrual, the increase in dollar
amount for the three months and nine months ended September 30, 1996 was
primarily due to increased staffing and professional fees necessary to manage
and support the Company's recent growth and provide infrastructure required for
a public company. The Company believes that its general and administrative
expenses will increase in absolute dollar amounts for at least the remainder of
fiscal 1996, due primarily to additional personnel costs as the Company
continues to expand its administrative staff and due to increased professional
fees related to reporting requirements as a public company.
Other Income (Expense), Net. Other income (expense), net, primarily
consists of royalties, interest income and interest expense. Other income
increased from $437,000 in the three months ended September 30, 1995 to
$1,070,000 in the three months ended September 30, 1996. The increase was
principally due to an increase in interest income from $22,000 in the three
months ended September 30, 1995 to $1,003,000 for the three months ended
September 30, 1996, partially offset primarily by a decrease in royalty income
from two licensees of the Company's wireless application specific integrated
circuit ("ASIC") products for cordless telephones. Other income increased from
$1,402,000 in the nine months ended September 30, 1995 to $2,065,000 for the
nine months ended September 30, 1996. The increase was principally due to an
increase in interest income from $85,000 in the nine months ended September 30,
1995 to $2,302,000 in the nine months ended September 30, 1996. The increase in
interest income was due to the funds derived from the Company's initial public
offering in February 1996. The Company sustained a decrease in royalty income
from two
<PAGE>
licensees of the Company's wireless ASIC products for cordless telephones during
the nine months ended September 30, 1996 as compared to the comparable 1995
period. Additionally, the Company wrote down its investment in marketable
securities in the first quarter of 1996 by $441,000 as management concluded the
decline in value was permanent. These marketable securities were sold during the
third quarter of 1996 at an actual loss of $432,000.
Provision (Benefit) for Income Taxes. The Company recorded a benefit
for income taxes as a percentage of income before income taxes of 41% for the
three months and nine months ended September 30, 1995 compared to a provision
for income taxes as a percentage of income before income taxes of 34% for the
three months and nine months ended September 30, 1996.
LIQUIDITY AND CAPITAL RESOURCES
In February and March 1996, the Company completed its initial public
offering (the "Offering") and its common stock began trading on the Nasdaq
National Market under the symbol CYLK. Through the Offering, the Company sold
5,750,000 shares of its common stock which generated approximately $79.3
million, net of underwriting discounts, commissions and other offering costs.
As of September 30, 1996, the Company had $79.4 million in cash and
cash equivalents. Net cash used by operating activities was $3,870,000 for the
nine months ended September 30, 1996. Cash used by operating activities
consisted primarily of increases in accounts receivable and inventories which
were partially offset by increases in accounts payable and accrued liabilities.
The Company has a credit agreement with a bank which provides a line of
credit for working capital advances of up to $5.0 million or a specified
percentage of eligible accounts receivable. Interest on borrowings under the
line of credit is set at the 30-day LIBOR plus 2.0%. At September 30, 1996, no
borrowings were outstanding under the line of credit.
<PAGE>
The Company believes that its current cash and cash equivalents and
line of credit will be sufficient to fund necessary purchases of capital
equipment and to provide working capital through at least the remainder of 1996.
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
Recent Losses; Potential Fluctuations in Operating Results; Future Operating
Results Uncertain.
Due primarily to increased research and development, sales and
marketing, and litigation expenses, the Company incurred losses in 1994 and 1995
and the first six months of 1996. There can be no assurances that the Company
will increase or maintain its revenue or be profitable on a quarterly or an
annual basis in the future.
The Company has historically experienced significant fluctuations in
its operating results on an annual and a quarterly basis and could experience
such fluctuations in the future. The Company's operating results are affected by
a number of factors, many of which are outside of the Company's control,
including: the timing of the introduction of new or enhanced products by the
Company or its competitors; market acceptance of new products of the Company,
its customers and its competitors; the timing, cancellation or delay of customer
orders, including cancellation or delay in anticipation of new product
introduction or enhancement or resulting from uncertainty relating to
intellectual property claims; competitive factors, including pricing pressures;
changes in operating expenses, including those resulting from changes in
available production capacity of independent foundries and other suppliers and
the availability of raw materials; expenses associated with obtaining, enforcing
and defending claims with respect to intellectual property rights; the mix of
products sold; changes in the percentage of products sold through the Company's
direct sales force; personnel changes; general economic conditions; and
fluctuations in foreign currency exchange rates. The Company expects to
introduce a number of new products in 1996. The failure of such new products to
achieve market acceptance at the time anticipated by the Company, or at all,
would materially and
<PAGE>
adversely affect the Company's financial condition and results of operations.
Pending Litigation
The Company is currently engaged in several litigation matters relating
to the patents that cover Public Key cryptography. Certain of the pending cases
pertain to the Company's sublicensing rights to certain patents originally
developed at Stanford University that claim the invention of Public Key
cryptography. The Public Key Cases also pertain to the rights of RSA Data
Security, Inc.("RSA DSI"), which holds a right to license a patent developed at
the Massachusetts Institute of Technology that claims a particular
implementation of Public Key cryptography using the algorithm known as "RSA".
Certain of these cases seek to invalidate the Stanford Patents. An additional
litigation matter relates to Cylink's use of a federal government standard for
sending digital signatures. An unfavorable outcome in certain of the litigation
matters in which the Company is involved could have a material adverse effect on
the Company's financial condition and results of operations. In addition, the
Company may incur significant additional legal expenses in the future with
respect to litigation.
Dependence on Key Personnel
On November 13, 1996, the Company announced Fernand B. Sarrat as
President and Chief Executive Officer. Sarrat, 45, succeeds Lewis C. Morris, 64,
who suffered a stroke in May, 1996. Dr. Jim Omura, Chief Technology Officer, had
been serving as acting Chief Executive officer. At this time, the Company is
unable to assess the potential impact resulting from the retirement of Mr.
Morris, a co-founder of the Company, and the transition to a new CEO.
The Company's future success will depend to a large extent on the
abilities of and successful transition to the new CEO, as well as continued
contributions of its executive officers and key management and technical
personnel. The failure to successfully integrate the new CEO into the Company,
loss of the services of one or more of the Company's executive officers or key
personnel or the inability to continue to attract qualified personnel could
<PAGE>
delay product development cycles or otherwise have a material adverse effect on
the Company's business and operating results.
Lengthy Sales Cycle
Sales of the Company's products generally involve a significant
commitment of capital by customers, with the attendant delays frequently
associated with large capital expenditures. For these and other reasons, the
sales cycle associated with the Company's products is typically lengthy and
subject to a number of significant risks over which the Company has little or no
control. The Company is often required to ship products shortly after it
receives orders and, consequently, order backlog at the beginning of any period
has in the past represented only a small portion of that period's expected
revenue. As a result, product revenue in any period is substantially dependent
on orders booked and shipped in that period. The Company typically plans its
production and inventory levels based on internal forecasts of customer demand,
which is highly unpredictable and can fluctuate substantially. If revenue falls
significantly below anticipated levels, the Company's financial condition and
results of operations would be materially and adversely affected. In addition,
the Company's operating expenses are based on anticipated revenue levels and a
high percentage of the Company's expenses are generally fixed in the short term.
Based on these factors a small fluctuation in the timing of sales can cause
operating results to vary significantly from period to period. In addition, it
is possible that in the future the Company's operating results will be below the
expectations of securities analysts and investors. In such an event, or in the
event that adverse conditions prevail or are perceived to prevail generally or
with respect to the Company's business, the price of the Company's Common Stock
would likely be materially adversely affected.
Dependence on Recently Introduced and New Information Security Products
The Company's future results of operations will be highly dependent on
the successful completion of the design, development, introduction, marketing
and manufacture of the SecureManager and Secure Node products, which are under
<PAGE>
development, and the SecureGate, SecureTraveler, SecurePocket Traveler,
SecureFrame and SecureDomain products, which were recently introduced. To date,
the Company has made only limited commercial shipments of certain of such
products and no commercial shipments of the remainder of such products. No
assurance can be given that any of such products will not require additional
development work, enhancement, testing or further refinement before they can be
introduced and made commercially available by the Company or that they will
achieve market acceptance. If such new and recently introduced products have
performance, reliability, quality or other shortcomings, then such products
could fail to achieve market acceptance and the Company may experience reduced
orders, higher manufacturing costs, delays in collecting accounts receivable and
additional warranty and service expenses, which in each case could have a
material adverse effect on the Company's results of operations. Failure of such
products to achieve market acceptance would have a material adverse effect on
the Company's financial condition and results of operations.
Competition
Competition is intense among providers of information security systems
and wireless communications equipment and systems, and the Company expects such
competition to increase in the future. Significant competitive factors in these
markets include the development of new products and features, product quality
and performance, the quality and experience of sales, marketing and service
organizations, product price and name recognition. Many of these factors are
beyond the Company's control.
The Company's competitors in the information security markets include
Security Dynamics, Inc., Racal-Guardata, Inc. and Information Resources
Engineering, Inc. Recently, AT&T Corp. ("AT&T"), Northern Telecom Limited,
Motorola, Inc., Digital Equipment Corporation and Sun Microsystems, Inc. have
begun to offer certain information security products as part of their overall
networking solutions. In addition, a number of significant software vendors,
including Lotus Development Corporation, Microsoft Corporation, Computer
Associates, Netscape Communications Corporation and Spyglass Inc., have embedded
security solutions in their software or announced their intention to
<PAGE>
do so. To the extent these embedded or optional security capabilities provide
all or a portion of the functionality provided by the Company's products, the
Company's products may no longer be required by customers to attain information
security.
RSA DSI licenses a method of implementing Public Key cryptography that
is different than (and incompatible with) the method of implementing Public Key
cryptography used by the Company. The Company and RSA DSI are each attempting to
establish their respective methods as industry standards. To the extent that RSA
DSI's method is adopted as a standard for implementing Public Key cryptography
in any segment of the information security market, sales of the Company's
existing and planned products in that segment may be adversely impacted, which
could have a material adverse effect on the Company's financial condition and
results of operations.
The Company competes with a large number of companies in the wireless
communications markets, including U.S. local exchange carriers and foreign
telephone companies. The most significant competition for sub-T1 rate AirLink
products in the wireless market is from telephone companies that offer leased
line data services. The Company also competes with other suppliers of wireless
products such as Digital Wireless Inc., Western Multiplex Corporation and
California Microwave Inc.
Many of the Company's competitors have substantially greater financial,
technical, marketing, distribution and other resources, greater name recognition
and longer standing relationships with customers than the Company. Competitors
with greater financial resources are better able to engage in sustained price
reductions in order to gain market share. Any period of sustained price
reductions would have a material adverse effect on the Company's financial
condition and results of operations. There can be no assurance that the Company
will be able to compete successfully in the future or that competitive pressures
will not materially and adversely affect the Company's financial condition and
results of operations.
<PAGE>
Product Liability Risks
Customers rely on the Company's information security products
to prevent unauthorized access to their networks and data transmissions. A
malfunction or the inadequate design of the Company's products could result in
tort or warranty claims. Although the Company attempts to reduce the risk of
such losses through warranty disclaimers and liability limitation clauses in its
sales agreements and by maintaining product liability insurance, there can be no
assurance that such measures will be effective in limiting the Company's
liability for any such damages. Any liability for damages resulting from
security breaches could be substantial and could have a material adverse effect
on the Company's business and results of operations. In addition, a
well-publicized actual or perceived security breach could adversely affect the
market's perception of security products in general, or the Company's products
in particular, regardless of whether such breach is attributable to the
Company's products. This could result in a decline in demand for the Company's
products, which would have a material adverse effect on the Company's financial
condition and results of operations.
Management of Growth
The Company has recently experienced and may continue to experience
substantial growth in the number of its employees and the scope of its
operations, resulting in increased responsibilities for management. To manage
growth effectively, the Company will need to continue to improve its
operational, financial and management information systems and to hire, train,
motivate and manage a growing number of employees. Competition is intense for
qualified technical, marketing and management personnel, particularly highly
skilled engineers. In particular, the current availability of qualified
engineers is quite limited, and competition among companies, academic
institutions, government entities and other organizations for skilled and
experienced engineering personnel is very intense. The Company is currently
attempting to hire a number of engineering personnel and has experienced delays
in filling such positions. The Company expects to experience continued
difficulty in filling its needs for qualified engineers and other personnel.
There can be no assurance that the Company will be able to effectively achieve
or manage any future growth, and its failure to do so could delay product
<PAGE>
development cycles or otherwise have a material adverse effect on the Company's
financial condition and results of operations.
Patents and Proprietary Rights
The Company relies on patents, trademarks, copyrights, licenses and
trade secret law to establish and preserve its intellectual property rights. The
Company owns twelve U.S. patents covering certain aspects of its product design.
The Company also has the exclusive right to sublicense the Stanford Patents,
which expire in 1997. There can be no assurance that any patent, trademark,
copyright or license owned or held by the Company will not be invalidated,
circumvented or challenged, that the rights granted thereunder will provide
competitive advantages to the Company or that any of the Company's pending or
future patent applications will be issued within the scope of the claims sought
by the Company, if at all. Further, there can be no assurance that others will
not develop technologies that are similar or superior to the Company's
technology, duplicate the Company's technology or design around the patents
owned by the Company. The Company may be subject to or may initiate interference
proceedings in the U.S. Patent Office, which can require significant financial
and management resources. In addition, the laws of certain countries in which
the Company's products are or may be developed, manufactured or sold may not
protect the Company's products and intellectual property rights to the same
extent as the laws of the United States. The inability of the Company to protect
its intellectual property adequately could have a material adverse effect on its
financial condition and results of operations.
The network information security and the wireless communications
industries in which the Company sells its products are characterized by
substantial litigation regarding patent and other intellectual property rights.
From time to time, the Company has received communications from third parties
asserting that the Company's patents or that features or content of certain of
the Company's products infringe upon the intellectual property rights held by
third parties, and the Company may receive such communications in the future.
For example, the Company has recently been notified of certain patents held by a
leading
<PAGE>
telecommunications company that apply to certain general techniques for data
scrambling and an error correction method for certain T1 transmissions. The
Company is not aware that its patents or the features or content of its products
wrongfully infringe on any valid intellectual property rights of others.
However, there can be no assurance that this telecommunications company or other
third parties will not assert claims against the Company that result in
litigation. The Company is currently engaged in several litigation matters
related to the patents that cover the practice of Public Key cryptography. Any
litigation, whether or not determined in favor of the Company, could result in
significant expense to the Company and could divert management and other
resources. In the event of an adverse ruling in any litigation involving
intellectual property, the Company might be required to discontinue the use of
certain processes, cease the manufacture, use and sale of infringing products,
expend significant resources to develop non-infringing technology or obtain
licenses to the infringing technology and may suffer significant monetary
damages, which could include treble damages. There can be no assurance that
under such circumstances a license would be available to the Company on
reasonable terms or at all. In the event of a successful claim against the
Company and the Company's failure to develop or license a substitute technology
on commercially reasonable terms, the Company's financial condition and results
of operations would be adversely affected. There can be no assurance that
existing claims or any other assertions will not materially and adversely affect
the Company's financial condition and results of operations.
Evolving Information Security Market
The market for the Company's information security products is only
beginning to emerge. This market is characterized by rapidly changing
technology, emerging industry standards, new product introductions and changes
in customer requirements and preferences. The Company's future success will
depend in part upon end users' demand for information security products in
general, and upon the Company's ability to enhance its existing products and to
develop and introduce new products and technologies that meet customer
requirements. Any significant advance in technologies for attacking
cryptographic systems could
<PAGE>
render some or all of the Company's existing and new products obsolete or
unmarketable. To the extent that a specific method other than the Company's is
adopted as the standard for implementing information security in any segment of
the information security market, sales of the Company's existing and planned
products in that market segment may be adversely impacted, which could have a
material adverse effect on the Company's financial condition and results of
operations. There can be no assurance that information security-related products
or technologies developed by others will not adversely affect the Company's
competitive position or render its products or technologies noncompetitive or
obsolete.
In addition, a portion of the sales of the Company's products will
depend upon a robust industry and infrastructure for providing access to public
switched networks, such as the Internet. There can be no assurance that the
infrastructure or complementary products necessary to make these networks into
viable commercial marketplaces will be developed, or, if developed, that these
networks will become viable commercial marketplaces.
Rapid Technological Change
The markets for the Company's products are characterized by rapidly
changing technologies, extensive research and new product introductions. The
Company believes that its future success will depend in part upon its ability to
continue to enhance its existing products and to develop, manufacture and market
new products. As a result, the Company expects to continue to make a significant
investment in engineering, research and development. There can be no assurance
that the Company will be able to develop and introduce new products or
enhancements to its existing products in a timely manner which satisfy customer
needs, achieve market acceptance or address technological changes in its target
markets. The failure of the Company to develop products and introduce them
successfully and in a timely manner could adversely affect the Company's
competitive position, financial condition and results of operations.
<PAGE>
Wireless Communications Industry Regulatory Environment
Wireless communications are subject to regulations by United States and
foreign laws and international treaties. In the United States, the Company's
wireless communications products are subject to various regulations of the
Federal Communications Commission (the "FCC"). Current FCC regulations permit
license-free operation of certain FCC certified wireless products. The future of
remote wireless communications is highly volatile, due in part to ongoing
uncertainty regarding telecommunications deregulation and the status of recent
initiatives relating to the auction of licenses for personal communications
service ("PCS") frequencies. Regulatory changes, including changes in the
allocation of available frequencies, could significantly affect the Company's
operations by diverting the Company's development efforts, making current
products obsolete or increasing the opportunity for additional competition.
There can be no assurance that new regulations will not be promulgated which
could have a material adverse effect on the Company's financial condition and
results of operations.
The Company also is subject to regulatory requirements in foreign
markets. Equipment can be marketed in a country only if permitted by suitable
frequency allocations and regulations, and only if such equipment has received
type approval by the country in question. The process of complying with new
regulations and of obtaining type approval is often complex and lengthy and can
result in significant expense and delays in the introduction of products in new
countries.
Changes in, or the failure by the Company to comply with, applicable
domestic and international regulations could have a material adverse effect on
the Company's business and operating results. There can be no assurance that the
Company will be able to comply with regulations in any particular country.
Risks Associated with International Sales; Reliance
Upon Local Partners; Restrictions on Export
International product sales represented approximately 33%, 35%, 47% and
56% of revenue in 1993, 1994, 1995 and the nine months ended September 30, 1996,
respectively. In particular, sales of the Company's wireless communications
products are currently concentrated in developing countries.
<PAGE>
The Company plans to continue to expand its foreign operations and to enter
additional international markets, both of which will require significant
management attention and financial resources. International sales are subject to
a number of risks, including unexpected changes in regulatory requirements,
tariffs and other trade barriers, political and economic instability in foreign
markets, difficulties in the staffing, management and integration of foreign
operations, longer payment cycles, greater difficulty in collecting accounts
receivable, currency fluctuations and potentially adverse tax consequences.
Since most of the Company's foreign sales are denominated in U.S. dollars, the
Company's products become less price competitive in countries in which local
currencies decline in value relative to the U.S. dollar. The uncertainty of
monetary exchange values has caused, and may in the future cause, some foreign
customers to delay new orders or delay payment for existing orders. The
long-term impact of such devaluation, including any possible effect on the
business outlook in other developing countries, cannot be predicted.
The Company's ability to compete successfully in foreign countries is
dependent in part on the Company's ability to obtain and retain reliable and
experienced in-country value added resellers ("VARs"), distributors and other
strategic partners. The Company does not have long-term relationships with any
of its VARs and distributors and, therefore, has no assurance of a continuing
relationship within a given market.
United States government regulations restrict the export of certain
cryptographic devices, including certain of the Company's information security
products. As a result, the Company may be at a disadvantage in competing for
international sales compared to companies located outside the United States that
are not subject to such restrictions.
Dependence On Component Availability, Subcontractor
Performance And Key Suppliers
The Company's ability to timely deliver its products is dependent upon
the availability of quality components and subsystems used in these products.
The Company depends in part upon subcontractors to manufacture, assemble and
<PAGE>
deliver certain items in a timely and satisfactory manner. The Company obtains
certain components and subsystems from single, or a limited number of, sources.
A significant interruption in the delivery of such items could have a material
adverse effect on the Company's financial condition and results of operations.
Part II. OTHER INFORMATION
Item 1. Legal Proceedings.
The Company is currently engaged in several litigation matters relating
to the patents that cover Public Key cryptography. Certain of the pending cases
(N.D. Cal Nos. C-94-02322 (the "MIT Patent Case"), MMC; C-94-20512 SW (the
"Third Party Case"); and C-95-03256 WHO (the "Stanford Patents Case")
(collectively "the Public Key Cases")) pertain to the patents issued to Stanford
University (U.S. Patents Nos. 4,200,770, 4,218,582, and 4,424,414) that claim
the invention of Public Key cryptography (the "Stanford Patents") and the
Company's sublicensing rights with respect to those patents. The Public Key
Cases also pertain to a patent developed at the Massachusetts Institute of
Technology that claims a particular implementation of Public Key cryptography
(U.S. Patent No. 4,405,892) using the algorithm known as RSA (the "MIT Patent")
and the rights of RSA DSI with respect to the Stanford Patents. An additional
litigation matter (D.D.C. No. CV02121) (the "DSS Case") relates to the digital
signature standard ("DSS") adopted by the National Institute of Standards and
Technology ("NIST"). The Third Party Case was brought by an individual seeking,
among other things, to invalidate the Stanford Patents and the MIT Patent.
The Public Key Cases. The Company's wholly-owned subsidiary Caro-Kann
Corporation ("Caro-Kann") holds exclusive sublicensing rights to the Stanford
Patents, and RSA DSI currently holds the exclusive sublicensing rights to the
MIT Patent. In 1990, the Company and RSA DSI formed Public Key Partners, a
California general partnership ("PKP"). The partners assigned to PKP exclusive
sublicensing rights with respect to all of their Public Key patents, including
the Stanford and the MIT Patents.
<PAGE>
Certain disputes arose between Cylink, Caro-Kann and RSA DSI in the years
following the formation of PKP. In April 1994, Cylink and Caro-Kann initiated
private arbitration proceedings against RSA DSI (the "Arbitration"). In the
Arbitration, Cylink sought relief with respect to its contractual claim to a
license for the MIT Patent and to damages resulting from RSA DSI's alleged
diversion of PKP business opportunities. RSA DSI made certain counterclaims
against Cylink for breach of fiduciary duty. The arbitrators issued a ruling in
September 1995, which determined that: (i) PKP was to be dissolved, effective as
of September 6, 1995; (ii) Cylink has an option to a patent license to the MIT
Patent, subject to certain then unspecified conditions requiring inclusion of
RSA DSI software in Cylink products covered by the MIT Patent; and (iii) RSA DSI
did not have, and never had during PKP's existence, sufficient rights to grant
to its customers the right to make copies of software incorporating the Stanford
Patents without a license under the Stanford Patents. With PKP's dissolution,
the exclusive right to sublicense the Stanford Patent was returned to Caro-Kann,
and the exclusive right to sublicense the MIT Patent was returned to RSA DSI.
The arbitrators further ruled that neither party prevailed on the material
breach issues.
Both parties submitted further with respect to their claims for damages
based on other alleged breaches of the partnership agreement and their fiduciary
duties and requested clarification to Cylink's license to the MIT Patent. On
February 1, 1996, the arbitrators issued an additional ruling, in which the
arbitrators (i) clarified that Cylink could include all or any part of RSA DSI's
software code in its products, rather than merely selected software specified by
RSA DSI, (ii) ordered RSA DSI to use its best efforts to provide Cylink with the
requirements for licensing the software and (iii) stated the royalty terms on
which such software was to be licensed to Cylink for use in stand-alone software
products as well as hardware products. In that ruling, the arbitrators further
denied the parties' claim for damages against each other and stated that each
party had the right to be indemnified by PKP for legal expenses incurred in
connection with related actions.
On May 9, 1996, the arbitrators further ruled that RSA DSI was
obligated to provide its software to the Company
<PAGE>
according to license terms commensurate with the form of license agreement it
offered to other licensees on September 6, 1995. The effect of this ruling at
this time is that the Company will be able to make, use, and sell products
incorporating RSA DSI software by modifying such software to create interfaces
and other software necessary to enable such products to operate. In return, the
Company will pay a source code fee of $50,000, and a $5.00 per copy minimum for
software products. The Company has received RSA DSI's source code and is
entitled to practice the MIT Patent if it so chooses.
In June 1994, after RSA DSI threatened to sue Cylink for patent
infringement, Cylink initiated the MIT Patent Case (N.D. Cal. No. 94-02332 MMC),
seeking a declaratory judgment that the MIT Patent is invalid or unenforceable
against Cylink. RSA DSI has counterclaimed in this action seeking unspecified
damages from Cylink for infringement of the MIT Patent with respect to products
that practice the MIT Patent technology. The Company has obtained an opinion
from its patent counsel that the MIT Patent is unenforceable. However, if the
MIT Patent is not adjudicated to be unenforceable, Cylink believes that its only
products that may rely on the MIT Patent prior to obtaining one RSA DSI source
code are the Secure X.25L and the Secure X.25H encryptor products. As a result,
the Company does not believe that an adverse determination in the MIT Patent
Case with respect to infringement will have a material adverse effect on the
Company's financial condition, liquidity or results of operations. In addition
to its claims of infringement, RSA DSI has also asserted certain claims for
breach of fiduciary duty relating to PKP and for other matters that were
addressed in the Arbitration.
In September 1995, RSA filed the Stanford Patents Case (N.D. Cal. No.
C95-03256 WHO) against Cylink seeking declaratory relief to invalidate the
Stanford Patents. The Stanford Patents Case is in the discovery phase. The
Company has obtained an opinion from its patent counsel that the two principal
Stanford Patents are valid. On April 8, 1996, the Court denied the Company's
motion for summary judgment on the res judicata effect of the Arbitration
decision dated September 6, 1995. The effect of the Court's ruling at this time
is that the Company's claims for relief
<PAGE>
may be deferred until trial. On May 16, the Court denied RSA DSI's motion for
summary judgment on the issues of patent exhaustion and implied license, and
denied the Company's motion for summary judgment on the issue of licensor
estoppel. The effect of the Court's rulings at this time is that these claims
for relief may be deferred until trial. On May 16, 1996 the Court also granted
the Company's motion for leave to supplement its counterclaims against RSA DSI
to allege direct, as well as indirect, infringement. Finally, the Court
concluded a Markman type hearing to resolve issues related to construction of
the patent claims on October 1-2, 1996 and set a trial date of February 3, 1997.
Even if the Stanford Patents were adjudicated to be invalid, Cylink has not
historically received significant royalty or license fees with respect to the
Stanford Patents, and the Stanford Patents expire in 1997. As a result, the
Company believes that the RSA DSI claims against the Stanford Patents, even if
successful, would not have a material adverse effect on the Company's financial
condition, liquidity or results of operations. Caro-Kann has cross-complained
against RSA DSI in the Stanford Patent Case for contributory infringement and
inducement of infringement of the Stanford Patents.
In July 1994, an individual filed the Third Party Case (N.D. Cal. No.
C94-20512 SW) against PKP and RSA DSI seeking, among other things, to invalidate
the Stanford Patents and the MIT Patent. Caro-Kann has been allowed to intervene
in light of the dissolution of PKP for the limited purpose of defending the
validity of the Stanford Patents. At present, there are summary judgment motions
pending in the Third Party Case as to the Stanford Patents and the MIT Patent,
and as to various business torts alleged against RSA DSI and PKP by the third
party plaintiff. In February 1996, the Stanford Patents Case and the Third Party
Case were consolidated into a single action.
The DSS Case The Company filed the DSS Case (D.D.C. No. 95-CV02121) on
November 15, 1995 to seek a declaratory judgment consistent with NIST's
previously stated position that the practice of the digital signal algorithm
("DSA") in complying with the DSS, a Federal Information Processing Standard,
does not infringe a patent owned by Dr. Claus P. Schnorr (U.S. Patent No.
4,995,082) (the "Schnorr Patent"). The Company has obtained an opinion from its
counsel that
<PAGE>
DSS is not covered by the Schnorr Patent. Based on representations by Dr.
Schnorr and his representatives, RSA DSI, that they were not threatening suit
for infringement of the Schnorr Patent by practicing DSS, the court dismissed
the DSS case on September 26, 1996. However, should it be determined in the
future that the Company's products infringe the Schnorr Patent, such a
determination could create confusion in the marketplace of DSS-based products,
require that the Company pay damages and obtain a license to the Schnorr Patent
to the extent such license is available or require the Company to redesign its
products to eliminate DSS methods. If any of such events occurs, the Company's
financial condition and results of operations could be materially and adversely
affected.
These cases involve a number of complex issues, and no assurance can be
given as to the likely outcome of the Stanford Patents Case, the RSA DSI Patent
Case, the DSS Case or the Third Party Case. The Arbitration resulted in
substantial costs and diversion of effort by the Company, and the Company may
continue to incur significant legal expenses with respect to litigation.
Item 6. Exhibits and Reports on Form 8-K
(b) No reports on Form 8-K were filed during the quarter ended
September 30, 1996.
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: November 14, 1996 CYLINK CORPORATION
(Registrant)
By: /s/ John H. Daws
------------------------------
John H. Daws
Vice President of Finance
and Administration and
Chief Financial Officer
(Duly Authorized Officer
and Principal Financial
Officer)
