<PAGE>
===============================================================================
- -------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
-----------------------------------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED JUNE 30, 1996
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ________ TO ________
Commission file number 0-28450
FARALLON COMMUNICATIONS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 94-3033136
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
2470 MARINER SQUARE LOOP
ALAMEDA, CALIFORNIA 94501
(Address of principal executive offices, including Zip Code)
-----------------------------------------
(510) 814-5100
(Registrant's telephone number, including area code)
-----------------------------------------
Indicate by check X 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 No X
------- -------
As of August 1, 1996 there were 11,118,360 shares of the Registrant's common
stock outstanding.
- -------------------------------------------------------------------------------
===============================================================================
<PAGE>
FARALLON COMMUNICATIONS, INC.
FORM 10-Q
INDEX
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION PAGE
----
<S> <C> <C>
Item 1. Condensed Financial Statements
Condensed Condolidated Balance Sheets
At June 30, 1996 and September 30, 1995.................... 3
Condensed Consolidated Statements of Operations
For the three and nine months ended June 30, 1996 and 1995. 4
Condensed Consolidated Statements of Cash Flows
For the nine months ended June 30, 1996 and 1995........... 5
Notes to Condensed Consolidated Financial Statements....... 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations.................................. 7
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K........................... 22
SIGNATURE............................................................. 23
INDEX TO EXHIBITS..................................................... 24
</TABLE>
2
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE AMOUNTS)
<TABLE>
<CAPTION>
JUNE 30, SEPTEMBER 30,
1996 1995
----------- -------------
ASSETS (UNAUDITED)
<S> <C> <C>
Current assets:
Cash and cash equivalents....................... $37,725 $13,963
Short-term investments.......................... -- 3,680
Trade accounts receivable, net of allowances
of $1,296 and $1,254 at June 30, 1996
and September 30, 1995, respectively........... 9,760 7,724
Inventories..................................... 6,936 4,758
Deferred tax asset.............................. 1,886 -
Prepaid expenses and other current assets....... 1,242 1,005
------- -------
Total current assets...................... 57,549 31,130
Furniture, fixtures, and equipment, net........... 2,973 2,457
Deferred tax asset................................ 368 -
Other assets...................................... 370 285
------- -------
Total assets.............................. $61,260 $33,872
======= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable................................ $ 5,302 $ 6,841
Accrued compensation............................ 1,943 1,482
Accrued liabilities............................. 400 701
Deferred revenue................................ 683 168
Other current liabilities....................... 168 183
------- -------
Total current liabilities................. 8,496 9,375
------- -------
Other long-term liabilities....................... 88 218
------- -------
Total liabilities......................... 8,584 9,593
------- -------
Commitments and contigencies
Stockholders' equity:
Preferred stock: $0.001 par value, 5,000,000
shares authorized; 0 and 5,591,207 shares
issued and outstanding at June 30, 1996 and
September 30, 1995, respectively.............. - 6
Common stock: $0.001 par value, 25,000,000
shares authorized; 11,091,747 and 3,624,231
shares issued and outstanding at June 30, 1996
and September 30, 1995, respectively.......... 11 4
Additional paid-in capital...................... 49,145 23,990
Retained earnings............................... 3,520 279
------- -------
Total stockholders' equity................ 52,676 24,279
------- -------
Total liabilities and stockholders' equity...... $61,260 $33,872
======= =======
</TABLE>
See accompanying notes to Condensed Consolidated Financial Statements.
3
<PAGE>
FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA; UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
JUNE 30, JUNE 30,
------------------ -----------------
1996 1995 1996 1995
------ ------ ------ ------
<S> <C> <C> <C> <C>
Revenues:
Internet/Intranet products........... $ 4,614 $ 1,541 $11,055 $ 4,729
LAN products......................... 11,013 10,858 34,016 37,217
------- ------- ------- -------
Total revenues.................... 15,627 12,399 45,071 41,946
------- ------- ------- -------
Cost of revenues:
Internet/Intranet products........... 1,080 159 2,318 474
LAN products......................... 6,987 6,228 20,930 20,950
------- ------- ------- -------
Total cost of revenues............ 8,067 6,387 23,248 21,424
------- ------- ------- -------
Gross profit...................... 7,560 6,012 21,823 20,522
------- ------- ------- -------
Operating expenses:
Research and development............. 2,368 2,142 6,680 6,164
Selling and marketing................ 4,044 3,400 11,622 10,165
General and administrative........... 823 685 2,664 2,173
------- ------- ------- -------
Total operating expenses.......... 7,235 6,227 20,966 18,502
------- ------- ------- -------
Operating income (loss)........... 325 (215) 857 2,020
Other income, net...................... 230 246 663 570
------- ------- ------- -------
Income before income taxes........... 555 31 1,520 2,590
Income tax provision (benefit)......... 195 8 (1,721) 724
------- ------- ------- -------
Net income........................... $ 360 $ 23 $ 3,241 $ 1,866
======= ======= ======= =======
Net income per share................... $ 0.03 $ 0.00 $ 0.30 $ 0.19
======= ======= ======= =======
Shares used in per share calculation... 11,106 9,918 10,686 9,884
======= ======= ======= =======
</TABLE>
See accompanying notes to Condensed Consolidated Financial Statements.
4
<PAGE>
FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS; UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
JUNE 30,
-------------------
1996 1995
-------- --------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
- ------------------------------------
Net income.......................................... $ 3,241 $ 1,866
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization.................. 1,287 1,092
Deferred income taxes.......................... (2,254) -
Noncash compensation........................... 192 -
Changes in assets and liabilities:
Accounts receivable......................... (2,036) 622
Inventories................................. (2,178) (287)
Prepaid expenses and other assets........... (336) (222)
Accounts payable............................ (1,539) 1,084
Accrued expenses and other
current liabilities........................ 15 (567)
Deferred revenue............................ 515 (123)
-------- --------
Net cash provided by (used in)
operating activities.................... (3,093) 3,465
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of short-term investments............. (70,507) (30,370)
Proceeds from the sale of
short-term investments........................ 74,187 42,124
Acquisition of furniture, fixture
and equipment................................. (1,789) (902)
-------- --------
Net cash provided by investing
activities.............................. 1,891 10,852
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common
stock, net.................................... 24,964 118
Repayment of debt.............................. - (251)
-------- --------
Net cash provided by (used in)
financing activities.................... 24,964 (133)
-------- --------
Net increase in cash and cash equivalents........... 23,762 14,184
Cash and cash equivalents, beginning of period...... 13,963 2,746
Cash and cash equivalents, end of period............ $ 37,725 $ 16,930
======== ========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Interest paid.................................. $ 3 $ 44
======== ========
Income taxes paid.............................. $ 611 $ 988
======== ========
SUPPLEMENTAL DISCLOSURES OF NONCASH
FINANCING ACTIVITIES:
Accrual of stock option deferred compensation.. $ 90 -
======== ========
Issuance of common stock for
consulting services........................... $ 30 -
======== ========
Issuance of common stock and redeemable common
stock for rights and services................. $ 162 -
======== ========
</TABLE>
See accompanying notes to Condensed Consolidated Financial Statements.
5
<PAGE>
FARALLON COMMUNICATIONS, INC. AND SUBSIDIARY
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
----------------------
The unaudited condensed consolidated financial statements included herein
reflect all adjustments, consisting only of normal recurring adjustments which
in the opinion of management are necessary to fairly present the Company's
consolidated financial position, results of operations, and cash flows for the
periods presented. These consolidated financial statements should be read in
conjunction with the Company's consolidated financial statements as included in
the Company's Registration Statement on Form S-1 as declared effective by the
Securities and Exchange Commission on June 12, 1996 (Reg. No. 333-3868). The
consolidated results of operations for the period ended June 30, 1996 are not
necessarily indicative of the results to be expected for any subsequent quarter
or for the entire fiscal year ending September 30, 1996.
2. Initial Public Offering
------------------------
In June 1996, the Company completed its initial public offering and issued
1,750,000 shares of its common stock to the public at a price of $16.00 per
share. The Company received approximately $24.9 million of cash, net of
underwriting discounts, commissions and other offering costs. Simultaneously,
all outstanding shares of preferred stock were automatically converted on a one-
for-one basis into shares of common stock.
3. Inventories
-----------
Inventories are stated at the lower of cost or market. Cost is determined
by the first-in, first-out (FIFO) method. Inventory consisted of the following
(in thousands):
<TABLE>
<CAPTION>
JUNE 30, SEPTEMBER 30,
1996 1995
-------- -------------
<S> <C> <C>
Raw materials and work in process...... $ 3,042 $ 1,594
Finished goods......................... 3,894 3,164
------- -------
$ 6,936 $ 4,758
======= =======
</TABLE>
4. Furniture, Fixtures and Equipment, net
--------------------------------------
<TABLE>
<CAPTION>
JUNE 30, SEPTEMBER 30,
1996 1995
-------- -------------
<S> <C> <C>
Furniture, fixtures and equipment...... $11,600 $ 9,811
Accumulated depreciation and
amortization.......................... (8,627) (7,354)
------- -------
$ 2,973 $ 2,457
======= =======
</TABLE>
6
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The discussion in this Report contains forward-looking statements that involve
risks and uncertainties. The Company's actual results could differ materially
from those discussed herein. Factors that could cause or contribute to such
differences include, but are not limited to, those discussed in "Risk Factors
That May Affect Future Results" as well as those discussed in this section and
elsewhere in this Report, 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 June 12, 1996 (Reg. No.
333-3868).
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 1995 AND 1996
Revenues. The Company's total revenues are derived from the sale of
Internet/Intranet and local area networking ("LAN") connectivity products.
Internet/Intranet product revenues include license revenues for the Company's
Timbuktu Pro software, sales of the Netopia family of products and fees for
related services. LAN products revenue is derived primarily from the sale of
EtherWave, Fast Ethernet, Ethernet and LocalTalk compatible products which
include the PhoneNET system network connectivity products as well as remote
access and LAN software, of which a substantial majority have been sold to MacOS
customers. Revenue relating to the sale and licensing of hardware and software
products is recognized upon shipment of the products by the Company and service
revenues are recognized ratably over the term of the contract. Certain of the
Company's sales are made to customers under agreements permitting limited rights
of return for stock balancing. Revenue is recorded net of an estimated allowance
for returns. Any product returns or price decreases in the future that exceed
the Company's allowances will adversely affect the Company's business, operating
results and financial condition.
The Company's total revenues increased 26.0% from $12.4 million to $15.6
million for the three months ended June 30, 1995 and 1996, respectively.
Internet/Intranet products revenue increased 199.6% from $1.5 million to $4.6
million for the three months ended June 30, 1995 and 1996, respectively,
primarily due to increased volume licensing, particularly in corporate
intranets, of the Company's Timbuktu Pro collaboration software as well as the
introduction and initial market acceptance of the Netopia Router and modem. LAN
products revenue increased 1.4% from $10.9 million to $11.0 million for the
three months ended June 30, 1995 and 1996, respectively, primarily due to
increased Ethernet product sales including sales of the Company's Ethernet
PCMCIA cards and Fast Ethernet products which were not available in the three
months ended June 30, 1995, partially offset by declining sales of the Company's
EtherWave and LocalTalk products. Internet/Intranet products revenue accounted
for 12.4% and 29.5% of the Company's total revenues for the three months ended
June 30, 1995 and 1996, respectively, while LAN products revenue accounted for
87.6% and 70.5% of the Company's total revenues for the three months ended June
30, 1995 and 1996, respectively. The Company anticipates that LAN products
revenue will decline in dollar amount and will account for a decreasing
percentage of total revenues in future periods.
Revenues from distributors accounted for 67% and 57% of total revenues for the
three months ended June 30, 1995 and 1996, respectively. The decrease in the
percentage of revenues from distributors is primarily due to the increasing
percentage of sales of the Company's Internet/Intranet products sold direct by
the Company and through Internet Service Providers ("ISPs"). Revenues from
Ingram Micro ("Ingram") accounted for 14% and 17% of total revenues for the
three months ended June 30, 1995 and 1996, respectively, and revenues from
MicroWarehouse accounted for 13% and 10% of total revenues for the
7
<PAGE>
three months ended June 30, 1995 and 1996, respectively. No other customers have
accounted for 10% or more of the Company's total revenues during the three
months ended June 30, 1995 and 1996.
International revenues accounted for 31% and 28% of total revenues for the
three months ended June 30, 1995 and 1996, respectively. The decrease in the
percentage of international revenues was primarily due to increased domestic
sales of the Company's Internet/Intranet products.
Gross Margin. The Company's gross margin for Internet/Intranet and LAN
products is affected by many factors, including pricing strategies, royalties
paid to third parties, new versions of existing products and product mix. The
Company's total gross margin was 48.5% and 48.4% for the three months ended June
30, 1995 and 1996, respectively. The Company's gross margin for
Internet/Intranet products decreased from 89.6% to 76.6% for the three months
ended June 30, 1995 and 1996, respectively, primarily due to sales of the
Netopia router and modem which have lower gross margins than the Company's
Internet/Intranet software products. The Company's gross margin for LAN products
decreased from 42.6% to 36.6% for the three months ended June 30, 1995 and 1996,
respectively, primarily due to declining sales and average selling prices of the
Company's higher margin LocalTalk and EtherWave products and increased sales of
lower margin Ethernet products, including Fast Ethernet products. The Company
expects gross margins for Internet/Intranet products to decrease in future
periods reflecting increased sales of hardware products that carry lower gross
margins than software products. In addition, the Company expects gross margins
for LAN products to decrease in future periods primarily due to declining
average selling prices.
Research and Development. Research and development expenses primarily consist
of salaries and other personnel-related expenses, development-related equipment
and license expenses, occupancy costs and depreciation. Research and development
expenses increased from $2.1 million to $2.4 million for the three months ended
June 30, 1995 and 1996, respectively, primarily due to salary and other
personnel costs related to development of new Internet/Intranet products,
particularly for Windows NT versions of Timbuktu Pro collaboration software and
international versions of the Netopia router. Such expenses represented 17.3%
and 15.2% of total revenues for the three months ended June 30, 1995 and 1996,
respectively. The Company believes that it will continue to devote substantial
resources to product development and that research and development expenses will
increase in absolute dollars for the remainder of fiscal 1996 and into fiscal
1997. The Company believes its process for developing software is essentially
completed concurrent with the establishment of technological feasibility, and no
software costs have been capitalized to date.
Selling and Marketing. Selling and marketing expenses primarily consist of
personnel costs including sales commissions, as well as costs of advertising,
public relations, promotional activities, professional services and travel
expenses. Selling and marketing expenses increased from $3.4 million to $4.0
million for the three months ended June 30, 1995 and 1996, respectively,
primarily due to increased headcount and associated expenses related to the
introduction and sales of the Company's Internet/Intranet products. Such
expenses represented 27.4% and 25.9% of total revenues for the three months
ended June 30, 1995 and 1996, respectively. The Company believes that selling
and marketing expenses will increase in absolute dollars for the remainder of
fiscal 1996 and into fiscal 1997 primarily due to personnel-related expenses and
increased advertising and promotional activities.
General and Administrative. General and administrative expenses primarily
consist of personnel costs and associated expenses necessary to manage and
support the Company's operations. General and administrative expenses increased
from $700,000 to $800,000 million for the three months ended June 30, 1995 and
1996, respectively, primarily due to increased recruiting expenses and increased
utilization of
8
<PAGE>
independent contractors. Such expenses represented 5.5% and 5.3% of total
revenues for the three months ended June 30, 1995 and 1996, respectively. The
Company believes that general and administrative expenses will increase in
absolute dollars for the remainder of fiscal 1996 and into fiscal 1997 as the
Company expands its administrative staff, adds infrastructure and incurs
additional costs related to being a public company, such as expenses related to
directors' and officers' insurance, investor relations programs and increased
professional fees.
Other Income, net. Other income, net, primarily represents interest earned by
the Company on its cash, cash equivalents and short-term investments offset by
interest expense.
Provision for Income Taxes. The effective tax rates were 26% and 35% for the
three months ended June 30, 1995 and 1996, respectively. These rates differ from
the statutory rate primarily due to state income taxes and the utilization of
research and tax credit carryforwards. As of September 30, 1995, the Company had
research credit carryforwards of $515,000 and $215,000 for federal and
California purposes, respectively. If not utilized, the credits expire in years
2006 through 2010. In addition, the Company had federal alternative minimum tax
credit carryforwards of $90,000, as of September 30, 1995.
NINE MONTHS ENDED JUNE 30, 1995 AND 1996
Revenues. The Company's total revenues increased 7.5% from $41.9 million to
$45.1 million for the nine months ended June 30, 1995 and 1996, respectively.
Internet/Intranet products revenue increased 133.8% from $4.7 million to $11.1
million for the nine months ended June 30, 1995 and 1996, respectively,
primarily due to increased volume licensing, particularly in corporate
intranets, and increased sales of the Windows version of the Company's Timbuktu
Pro collaboration software, as well as the introduction and initial market
acceptance of the Netopia Router and modem. LAN products revenue decreased 8.6%
from $37.2 million to $34.0 million for the nine months ended June 30, 1995 and
1996, respectively, primarily due to declining sales of the Company's EtherWave
and MacOS LocalTalk products partially offset by increased Ethernet product
sales and the introduction of the Company's Fast Ethernet products.
Internet/Intranet products revenue accounted for 11.3% and 24.5% of the
Company's total revenues for the nine months ended June 30, 1995 and 1996,
respectively, while LAN products revenue accounted for and 88.7% and 75.5% of
the Company's total revenues for the nine months ended June 30, 1995 and 1996,
respectively.
Revenues from distributors accounted for 74% and 63% of total revenues for the
nine months ended June 30, 1995 and 1996, respectively. The decrease in the
percentage of revenues from distributors is primarily due to the increasing
percentage of sales of the Company's Internet/Intranet products sold direct by
the Company and through ISPs as well as increased volume site license sales of
the Company's Timbuktu Pro collaboration software sold direct by the Company.
Revenues from Ingram accounted for 22% and 19% of total revenues for the nine
months ended June 30, 1995 and 1996, respectively, and revenues from
MicroWarehouse accounted for 13% and 11% of total revenues for the nine months
ended June 30, 1995 and 1996, respectively. No other customers have accounted
for 10% or more of the Company's total revenues during the nine months ended
June 30, 1995 and 1996.
International revenues accounted for 30% and 32% of total revenues for the
nine months ended June 30, 1995 and 1996, respectively. The increase in
percentage of international revenues is primarily due to increasing sales in the
Pacific Rim.
Gross Margin. The Company's total gross margin was 48.9% and 48.4% for the
nine months ended June 30, 1995 and 1996, respectively. The Company's gross
margin for Internet/Intranet products
9
<PAGE>
decreased from 90.0% to 79.0% for the nine months ended June 30, 1995 and 1996,
respectively, primarily due to the introduction of the Netopia router and modem
which have lower gross margins than the Company's Internet/Intranet software
products. The Company's gross margin for LAN products decreased from 43.7% to
38.5% for the nine months ended June 30, 1995 and 1996, respectively, primarily
due to declining sales and average selling prices of the Company's higher margin
LocalTalk and EtherWave products, and increased sales of lower margin Ethernet
products including the introduction of lower margin Fast Ethernet products. The
Company expects gross margins for Internet/Intranet products to decrease in
future periods reflecting increased sales of hardware products that carry lower
gross margins than software products. In addition, the Company expects gross
margins for LAN products to decrease in future periods primarily due to
declining average selling prices.
Research and Development. Research and development expenses increased from
$6.2 million to $6.7 million for the nine months ended June 30, 1995 and 1996,
respectively, primarily due to salary and other personnel costs related to
development of the Netopia router and modem as well as international versions of
the Netopia router and Timbuktu Pro collaboration software. Such expenses
represented 14.7% and 14.8% of total revenues for the nine months ended June 30,
1995 and 1996, respectively.
Selling and Marketing. Selling and marketing expenses increased from $10.2
million to $11.6 million for the nine months ended June 30, 1995 and 1996,
respectively, primarily due to increased headcount and associated expenses as
well as increased advertising and promotional spending related to the
introduction of the new Internet/Intranet connectivity products and Internet
applets. Such expenses represented 24.2% and 25.8% of total revenues for the
nine months ended June 30, 1995 and 1996, respectively.
General and Administrative. General and administrative expenses increased
from $2.2 million to $2.7 million for the nine months ended June 30, 1995 and
1996, respectively, primarily due to consulting fees related to the acquisition
of the Netopia trademark and increased utilization of independent contractors.
Such expenses represented 5.2% and 5.9% of total revenues for the nine months
ended June 30, 1995 and 1996, respectively.
Provision for Income Taxes. The effective tax rates were 28% for the nine
months ended June 30, 1995 and 35% for the nine months ended June 30, 1996 prior
to the effect of the elimination of the valuation allowance against deferred tax
assets, as discussed below. These rates differ from the statutory rate primarily
due to state income taxes and the utilization of research and tax credit
carryforwards.
As of March 31, 1996, the Company reversed a full valuation allowance that it
had previously provided against its deferred tax assets, resulting in a non-
recurring income tax benefit of approximately $2.3 million. Prior to March 31,
1996, the Company believed that, based upon available objective evidence, there
was sufficient uncertainty regarding the realizability of its deferred tax
assets to warrant a full valuation allowance. The factors considered included
prior losses, inconsistent profits, lack of carryback potential to realize
deferred tax assets, dependence on LAN products and associated declining market
and gross margins for LAN products, dependence upon Apple, and uncertain market
acceptance of its Internet/Intranet products. As of March 31, 1996, the Company
believes that due to the demonstrated market acceptance of the new
Internet/Intranet products over the previous two quarters, the uncertainty
regarding the realizability of its deferred tax assets has diminished to the
point where it is now more likely than not that the deferred tax assets will be
realized.
10
<PAGE>
LIQUIDITY AND CAPITAL RESOURCES
In June 1996, the Company completed its initial public offering and its common
stock began trading on the Nasdaq National Market under the symbol FRLN. Through
the offering, the Company sold 1,750,000 shares of its common stock which
generated approximately $24.9 million of cash, net of underwriting discounts,
commissions and other offering costs. As of June 30, 1996, the Company had cash
and cash equivalents representing 62% of total assets, and had working capital
of $49.0 million.
The Company used cash from operating activities of $3.1 million in the nine
months ended June 30, 1996. The use of cash from operations in the nine months
ended June 30, 1996 was primarily due to: (1) increases in operating expenses
related to the introduction of Netopia products, (2) increases in accounts
receivable of $2.0 million in the nine months ended June 30, 1996, primarily due
to volume site license activity as well as other large product shipments that
were weighted to the last weeks of the Company's fiscal third quarter ended June
30, 1996 and, (3) increases in inventory of $2.2 million in the nine months
ended June 30, 1996, primarily related to Netopia and Fast Ethernet products
which represented 2% and 7% of total gross inventory as of September 30, 1995,
respectively, and 8% and 18% of total gross inventory as of June 30, 1996,
respectively.
The Company's investing activities for the nine months ended June 30, 1995 and
1996, have consisted primarily of purchases of short-term investments, and
capital equipment. Expenditures for capital equipment totaled $900,000 and $1.8
million for the nine months ended June 30, 1995 and 1996, respectively,
representing acquisitions of tooling and test equipment for new products as well
as computer equipment used predominantly in product development. The Company
expects that its capital expenditures will increase in future periods to support
new product development and production. The Company's principal commitments
consist primarily of leases on its headquarters facilities and operating
equipment.
As of June 30, 1996, the Company had a $5.0 million credit facility, bearing
interest at 8.75% and secured by the assets of the Company, which expires on
February 28, 1997. There were no borrowings under the credit facility as of June
30, 1996.
The Company believes its current cash balances, its credit facility and the
cash flows generated from operations, if any, will be sufficient to meet its
anticipated cash needs for working capital and capital expenditures for at least
the next 12 months.
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
The Company operates in a rapidly changing environment that involves a number
of risks, some of which are beyond the Company's control. The following
discussion highlights some of these risks. These risks should be read in
conjunction with 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 June 12, 1996 (Reg. No. 333-3868).
FLUCTUATIONS IN QUARTERLY RESULTS; FUTURE RESULTS OF OPERATIONS UNCERTAIN
The Company's quarterly operating results have varied significantly in the
past and are likely to vary significantly in the future, depending on factors
such as changes in networking and communications technologies, price and product
competition, usage of the Internet and developments and changes in the Internet
market, the demand for the Company's products, changes in pricing policies by
the Company or its competitors, including the grant of price protection terms
and discounts by the Company, changes in the
11
<PAGE>
mix of products sold by the Company and the resulting change in total gross
margin, changes in the mix of channels through which the Company's products are
offered, product enhancements and new product announcements by the Company and
its competitors, market acceptance of new products of the Company or its
competitors, raw material costs, write-offs of obsolete inventory, the size and
timing of distributor and end user orders and purchasing cycles, customer order
deferrals in anticipation of enhancements to the Company's or competitors'
products, customer order deferrals in anticipation of new MacOS product
offerings by Apple Computer ("Apple"), manufacturing delays, disruptions in
sources of supply, product life cycles, product quality problems, personnel
changes, changes in the Company's strategy, changes in the level of operating
expenses, the timing of research and development expenditures, the level of the
Company's international revenues, fluctuations in foreign currency exchange
rates, general economic conditions, both in the United States and abroad, and
economic conditions specific to the industries in which the Company competes,
among others. The Company's limited Internet/Intranet operating history makes
the prediction of future Internet/Intranet operating results difficult, if not
impossible. Sales orders are typically shipped shortly after receipt and,
consequently, order backlog at the beginning of any quarter has in the past
represented only a small portion of that quarter's revenues. Accordingly, the
Company's net revenues in any quarter are substantially dependent on orders
booked and shipped during that quarter. Historically, the Company has often
recognized a significant portion of its revenues in the last weeks, or even
days, of a quarter. As a result, the magnitude of quarterly fluctuations may not
become evident until late in, or after the close of, a particular quarter. In
addition, the Company recognizes revenue on products sold through distributors
upon shipment to the distributor. Although the Company maintains reserves for
projected returns and price decreases, there can be no assurance that such
reserves will be adequate. The Company's business also has experienced
seasonality in the past, largely due to customer buying patterns such as
budgeting cycles of educational institutions that purchase the Company's
products. There can be no assurance that the Company's operating results will
not be affected by seasonality in the future or that such will occur in a manner
consistent with prior periods.
The Company's expense levels are based in large part on expectations as to
future revenues and as a result are relatively fixed in the short term. If
revenues are below expectations in any given quarter, net income is likely to be
disproportionately affected. Due to all of the foregoing factors, and other
factors discussed herein, revenues and net income for any future period are not
predictable with any significant degree of certainty. Accordingly, the Company
believes that period-to-period comparisons of its results of operations are not
necessarily meaningful and should not be relied upon as indications of future
performance. There can be no assurance that the Company's business strategies
will be successful or that the Company will be able to sustain profitability on
a quarterly or annual basis in the future. It is likely that in some future
quarter the Company's operating results will be below the expectations of public
market analysts and investors. In such event, the price of the Company's Common
Stock would likely be materially and adversely affected.
DEPENDENCE ON INTERNET/INTRANET PRODUCTS
The Company's business is substantially dependent upon continued growth in the
sale of its Internet/Intranet products. Rapid growth in the use of the Internet
and Intranets is a recent phenomenon. There can be no assurance that
communication or commerce over the Internet will become widespread. In addition,
to the extent that the Internet continues to experience significant growth in
the number of users and level of use, there can be no assurance that the
Internet infrastructure will continue to be able to support the demands placed
upon it by such potential growth, or will not otherwise lose its utility due to
delays in the development or adoption of new standards and protocols required to
handle increased levels of activity, or due to increased government regulation.
Although the Company has experienced significant percentage growth in
Internet/Intranet revenues over the last four fiscal quarters, the Company does
not
12
<PAGE>
believe prior percentage growth rates are sustainable or indicative of future
operating results for these products and services. The Company's limited
Internet/Intranet operating history makes the prediction of future
Internet/Intranet operating results difficult, if not impossible. There can be
no assurance that the Company will continue to increase sales of its
Internet/Intranet products, that the Company's existing distribution channels
are appropriate for the sale of its Internet/Intranet products or that sales of
such products will reach levels significant enough to offset expected declines
in sales, average selling prices and gross margins of the Company's LAN
products. Accordingly, the failure of the Company's Internet/Intranet products
to gain market acceptance or to achieve significant sales would materially and
adversely affect the Company's business, operating results and financial
condition.
DEPENDENCE ON LAN PRODUCTS; DECLINING LAN BUSINESS
To date, the Company has derived a substantial majority of its revenues from
LAN products, which represented 100%, 91%, 89% and 76% of total revenues for
fiscal years 1993, 1994, 1995 and the nine months ended June 30, 1996,
respectively. These products have experienced variable average selling prices
and sales volumes, and declining gross margins for the past six fiscal quarters.
The Company anticipates that the average selling prices and gross margins of its
existing LAN products will continue to decline. Accordingly, to the extent the
product mix for any particular period includes a substantial proportion of LAN
products, the Company's total gross margin will be adversely affected. To date,
the Company has been able to partially reduce the decline in total gross margin
by increasing unit sales of existing LAN products, by reducing the manufacturing
cost of products and by introducing new products with higher margins. There can
be no assurance that the Company will achieve any such reductions in the future.
Although the Company's Internet/Intranet products currently carry a higher
average gross margin than its LAN products, the Company anticipates that
competitive pressures in its Internet/Intranet business may result in declining
average selling prices and gross margins in this business as well. Historically,
a substantial majority of the Company's LAN product revenues have been derived
from sales of products designed for Apple MacOS and compatible computers. Net
revenues from the Company's LAN products fluctuated on a quarterly basis during
fiscal 1995 and the nine months ended June 30, 1996, and the Company expects
that net revenues from LAN products may decline in the future as a result of
declining average selling prices of the Company's LAN products, Apple's
incorporation of built-in Ethernet connectivity into certain of its computers,
declining sales of MacOS computers and competition in the LAN products market.
In addition, as a result of technical characteristics in the MacOS environment,
Fast Ethernet products, in general, have not delivered expected performance
levels. If these technical characteristics are not addressed in the future, then
Fast Ethernet product sales in the MacOS market segment will be below the
Company's expectations, and operating results may be materially and adversely
affected. The Company is dependent upon sales and profitability of its LAN
products for the foreseeable future, and to the extent that any decline in
revenues and gross margins from LAN products is not offset by increases in
revenues from other sources, such as sales of the Company's Internet/Intranet
products, then the Company's business, operating results and financial condition
will be materially and adversely affected.
DEPENDENCE ON APPLE; COMPETITION WITH APPLE PRODUCTS
To date, the Company has derived approximately 85% to 90% of its LAN products
revenues from products designed for networking the Apple MacOS family of
personal computers. Accordingly, the Company is substantially dependent on the
market for MacOS computers and the development and sale of new Apple computers,
particularly sales of such computers into business environments. There can be no
assurance that competitive personal computers will not displace the MacOS
products or reduce sales of MacOS products. In addition, sales of the Company's
products in the past have been adversely affected by the announcement by Apple
of new products with the potential to replace existing products. The inability
of
13
<PAGE>
Apple to successfully develop, manufacture, market or sell new products, and any
decrease in the sales or market acceptance of the MacOS family of computers,
would have a material adverse effect on the Company's business, operating
results and financial condition.
The Company relies on an informal working relationship with Apple in
connection with the Company's LAN product development efforts. Although the
Company and Apple have maintained a cooperative working relationship since the
Company's founding, Apple is under no obligation to continue to share product
information or otherwise cooperate with the Company. In addition, there can be
no assurance that Apple will continue to work cooperatively with the Company in
connection with the Company's product development efforts. The absence of such
cooperation in the future, as a result of the restructuring in process at Apple
or any other factors, could have a material adverse effect on the Company's
business, operating results and financial condition. Apple currently offers
products that compete directly with certain of the Company's products. The
Company anticipates that Apple will continue to incorporate additional
connectivity technologies into more of its products in the future, which will
adversely affect sales of the Company's LAN products. Since Apple has
substantially greater financial, technical, sales, marketing and other resources
than the Company, as well as greater name recognition and a larger customer
base, Apple may be able to respond more quickly to new or emerging technologies
and changes in customer requirements or to devote greater resources to the
development, promotion and sales of its products. The Company believes that it
is likely that Apple will in the future sell separately or bundle with its
computers certain Internet access products, such as Integrated Services Digital
Network ("ISDN") terminal adapters similar to the Company's Netopia ISDN
Modem. Any such additional bundling or enhancement by Apple could have a
material adverse effect on the Company's business, operating results and
financial condition.
COMPETITION
The markets for the Company's products and services are intensely competitive,
highly fragmented and characterized by rapidly changing technology, evolving
industry standards, price competition and frequent new product introductions. A
number of companies offer products that compete with one or more of the
Company's products. The Company's current and prospective competitors include
original equipment manufacturer ("OEM") product manufacturers of Internet
access and remote LAN access equipment, manufacturers of remote control and
screen sharing software and manufacturers of LAN client access and network
systems products. In the Internet access and remote LAN access equipment market,
the Company competes primarily with Ascend, Cisco, Motorola, 3Com, U.S.
Robotics, Gandalf and several other companies. In the remote control and screen
sharing software market, the Company competes primarily with Symantec, Microcom,
Traveling Software, Stac Electronics and several other companies. In the LAN
client access and network systems product market, the Company competes primarily
with Apple, Asante, Dayna, Global Village and several other companies. The
Company has experienced and expects to continue to experience increased
competition from current and potential competitors, many of whom have
substantially greater financial, technical, sales, marketing and other
resources, as well as greater name recognition and a larger customer base, than
the Company. Accordingly, such competitors or future competitors may be able to
respond more quickly to new or emerging technologies and changes in customer
requirements or devote greater resources to the development, promotion and sales
of their products than the Company. In particular, established companies in the
personal computer industry may seek to expand their product offerings by
designing and selling products using competitive technology that could render
the Company's products obsolete or have a material adverse effect on the
Company's sales. For example, Microsoft recently announced the availability of
free, via download on the Internet, communications and collaboration software
compatible with the Microsoft Internet Explorer. This software product, which
enables real-time communication within a workgroup, as well as similar future
product offerings from Microsoft, could undermine the Company's ability to
market its Timbuktu Pro collaboration software. In
14
<PAGE>
addition, Netscape also recently announced its plan to offer software that
enables dispersed work groups to collaborate in the work environment.
Accordingly, there can be no assurance that the Company can continue to market
its collaboration software, which would have a material and adverse effect on
the Company's business, operating results and financial condition. In addition,
several of the Company's current competitors recently have introduced free
guaranteed service and support programs that appear to be similar to the
Company's Up & Running, Guaranteed! program. As a result, there can be no
assurance that the Company can continue to charge a fee for this support
program, which could have a material and adverse effect upon the Company's
business, operating results and financial condition. The markets in which the
Company competes currently are subject to intense price competition and the
Company expects additional price and product competition as other established
and emerging companies enter these markets and new products and technologies are
introduced. Increased competition may result in further price reductions,
reduced gross margins and loss of market share, any of which could materially
and adversely affect the Company's business, operating results and financial
condition. There can be no assurance that the Company will be able to compete
successfully against current and future competitors, or that competitive factors
faced by the Company will not have a material adverse effect on the Company's
business, operating results and financial condition.
NEW PRODUCT DEVELOPMENT AND RAPID TECHNOLOGICAL CHANGE; DEPENDENCE ON ISDN
TECHNOLOGY
The personal computer industry is characterized by rapidly changing
technologies, evolving industry standards, frequent new product introductions,
short product life cycles and rapidly changing customer requirements. The
introduction of products embodying new technologies and the emergence of new
industry standards can render existing products obsolete and unmarketable. The
Company's future success will depend on its ability to enhance its existing
products and to introduce new products to meet changing customer requirements
and emerging technologies. For example, the Company's Netopia products currently
operate only over ISDN telecommunication service. As other communications
technologies such as Frame Relay, Asynchronous Transfer Mode ("ATM"),
Asymmetric Digital Subscriber Line ("ADSL") and communication over cable or
wireless networks, are developed or gain market acceptance, the Company will be
required to enhance its Internet connectivity products to support such
technologies, which will be costly and time consuming. If the Company is unable
to modify its products to support new Internet access technologies, or if ISDN
does not achieve widespread customer acceptance as a result of the adoption of
alternative technologies or as result of deemphasis of ISDN by
telecommunications service providers, the Company's business, operating results
and financial condition would be materially and adversely affected. In addition,
the Company has historically derived a substantial majority of its revenues from
the sale of Ethernet connectivity products. In the event that current Ethernet
network technology is modified or replaced and the Company is unable to modify
its products to support new Ethernet technologies or alternative technologies,
the Company's business, operating results and financial condition could be
materially and adversely affected. The Company has in the past and may in the
future experience delays in new product development. There can be no assurance
that the Company will be successful in developing and marketing product
enhancements or new products that respond to technological change, evolving
industry standards and changing customer requirements, that the Company will not
experience difficulties that could delay or prevent the successful development,
introduction and marketing of these products or product enhancements, or that
its new products and product enhancements will adequately meet the requirements
of the marketplace and achieve any significant degree of market acceptance.
Failure of the Company, for technological or other reasons, to develop and
introduce new products and product enhancements in a timely and cost-effective
manner would have a material adverse effect on the Company's business, operating
results and financial condition. In addition, the future introduction or even
announcement of products by the Company or one or more of its competitors
embodying new technologies or changes in industry standards or customer
requirements could render the Company's then existing
15
<PAGE>
products obsolete or unmarketable. There can be no assurance that the
introduction or announcement of new product offerings by the Company or one of
or more of its competitors will not cause customers to defer purchase of
existing Company products. Such deferment of purchases could have a material
adverse effect on the Company's business, operating results or financial
condition.
Complex products such as those offered by the Company may contain undetected
or unresolved defects when first introduced or as new versions are released.
There can be no assurance that, despite testing by the Company, defects will not
be found in new products or new versions of products following commercial
release, resulting in loss of market share, delay in or loss of market
acceptance or product recall. Any such occurrence could have a material adverse
effect upon the Company's business, operating results or financial condition.
MANAGEMENT OF CHANGING BUSINESS
The Company has recently shifted its business strategy from providing only LAN
products to reducing its reliance on LAN products and focusing development and
management efforts on its Internet/Intranet business. This transition represents
a significant challenge for the Company and its administrative, operational and
financial resources and places increased demands on its systems and controls.
The Company's ability to manage the continuing development of its
Internet/Intranet business will require the Company to continue to change,
expand and improve its operational, management and financial systems and
controls and to expand its manufacturing capacity. This transition has resulted
in a continuing increase in the level of responsibility for both existing and
new management personnel. The Company anticipates that any growth in its
Internet/Intranet business will require it to recruit and hire a substantial
number of new engineering, sales and marketing, customer service and managerial
personnel. There can be no assurance that the Company will be successful in
hiring or retaining these personnel, if needed. If the Company is unable to
manage the transition effectively, the Company's business, operating results and
financial condition will be materially and adversely affected.
DEPENDENCE ON DISTRIBUTORS
The Company relies primarily on distributors for the sale of its
Internet/Intranet and LAN products. Revenues from distributors accounted for
81%, 76%, 73% and 63% of the Company's total revenues in fiscal 1993, 1994, 1995
and the nine months ended June 30, 1996, respectively. A substantial amount of
the Company's revenues result from a limited number of these distributors. The
Company's three largest distributors accounted for 46%, 45%, 43% and 35% of the
Company's total revenues in fiscal 1993, 1994, 1995 and the nine months ended
June 30, 1996, respectively. During fiscal 1993, 1994, 1995 and the nine months
ended June 30, 1996, revenue from Ingram accounted for 24%, 24%, 22% and 19% of
the Company's total revenues, and revenue from MicroWarehouse accounted for 12%,
12%, 13% and 11% of the Company's total revenues, respectively. Merisel
accounted for 10% of the Company's total revenues for fiscal 1993. No other
customers have accounted for 10% or more of the Company's total revenues during
fiscal 1993, 1994, 1995 and the nine months ended June 30, 1996. The
distribution of LAN products such as those offered by the Company has been
characterized by rapid change, including industry consolidations, financial
difficulties of distributors and the emergence of alternative distribution
channels. For example, Merisel has publicly announced certain financial
difficulties. There can be no assurance that Merisel will be able to pay in full
the amount currently owed to the Company or that any of the Company's other
current or future distributors will not experience financial difficulties, which
could result in a material adverse effect on the Company's business, operating
results and financial condition. There can be no assurance that Ingram,
MicroWarehouse or Merisel will continue to serve as distributors for the Company
since the Company does not currently have a written agreement regarding price or
quantity commitments with these
16
<PAGE>
or other distributors and operates with these and other distributors on a
purchase order basis. The Company's distributors generally offer products of
several different companies, including products that are competitive with the
Company's products. There can be no assurance that future sales by the Company's
distributors will continue at current levels, that the Company will be able to
retain its current distributors in the future on terms which are acceptable to
the Company, that the Company's current distributors will choose to or be able
to market the Company's products effectively, that economic conditions or
industry demand will not adversely affect these or other distributors, or that
these distributors will not devote greater resources to marketing products of
other companies. Accordingly, the loss of, or a significant reduction in revenue
from, one of the Company's distributors, including Merisel, could have a
material adverse effect on the Company's business, operating results and
financial condition.
The Company grants to its distributors limited rights to return unsold
inventories of the Company's products in exchange for new purchases and provides
price protection to its distributors. Although the Company provides allowances
for projected returns and price decreases, any product returns or price
decreases in the future that exceed the Company's allowances will materially and
adversely affect the Company's business, operating results and financial
condition. The Company also provides end users with a lifetime warranty on
certain products and permits end users to return any product for its full
purchase price if the product does not perform as warranted. To date, the
Company has not encountered material warranty claims. Nevertheless, if future
warranty claims exceed the Company's reserves, the Company's business, operating
results and financial condition could be materially and adversely affected. In
addition, the Company attempts to further limit its liability to end users
through disclaimers of special, consequential and indirect damages and similar
provisions in its end user warranty. However, no assurance can be given that
such limitations of liability will be legally enforceable.
INTERNATIONAL OPERATIONS
International revenues accounted for 25%, 25%, 29% and 32% of the Company's
total revenues in fiscal 1993, 1994, 1995 and the nine months ended June 30,
1996, respectively. The Company expects that international revenues will
continue to represent a significant portion of its total revenues. Any
significant decline in international demand for the Company's products would
have a material adverse effect on the Company's business, operating results and
financial condition. The Company believes that in order to increase sales
opportunities and profitability it will be required to expand its international
operations. The Company has committed and continues to commit significant
management attention and financial resources to developing international sales
and support channels. There can be no assurance that the Company will be able to
maintain or increase international market demand for its products. In addition,
the Company is dependent upon the international demand for Apple products. To
the extent that the Company is unable to maintain or increase international
demand for its products, or that international demand for Apple products does
not meet the Company's expectations, the Company's international sales will be
limited, and the Company's business, operating results and financial condition
would be materially and adversely affected.
The Company's international business is subject to inherent risks, including
the impact of possible recessionary environments in economies outside the United
States, costs of localizing products for foreign countries, longer receivable
collection periods and greater difficulty in accounts receivable collection,
unexpected changes in regulatory requirements, difficulties and costs of
staffing and managing foreign operations, reduced protection for intellectual
property rights in some countries, potentially adverse tax consequences and
political and economic instability. There can be no assurance that the Company
will be able to sustain or increase international revenues, or that the
foregoing factors will not have a material adverse effect on the Company's
future international revenues and its business, operating results and financial
condition. The Company's international revenues are currently denominated in
United States
17
<PAGE>
dollars, and revenues generated by the Company's distributors currently are paid
to the Company in United States dollars. If, in the future, international
revenues are denominated in local currencies, foreign currency translations may
contribute to significant fluctuations in, and could have a material adverse
effect on, the Company's business, operating results and financial condition. In
addition, the Company has a substantial portion of its products and components
manufactured by foreign suppliers. The Company's operating results are subject
to the risks inherent in international purchases, including, but not limited to,
various regulatory requirements, political and economic changes and disruptions,
transportation delays, export/import controls, tariff regulations, higher
freight rates and potentially adverse tax consequences. Duty, tariff and freight
costs can materially increase the cost of crucial components for the Company's
products.
DEPENDENCE ON STRATEGIC ALLIANCES; DEPENDENCE ON CONTRACT MANUFACTURERS AND
LIMITED SOURCE SUPPLIERS
The Company relies on a number of strategic relationships to help achieve
market acceptance of the Company's products and to leverage the Company's
development, sales and marketing resources. Although the Company views these
relationships as important factors in the development and marketing of the
Company's products and services, a majority of the Company's agreements with its
strategic partners or customers do not require future minimum commitments to
purchase the Company's products, are not exclusive and generally may be
terminated at the convenience of either party. There can be no assurance that
the Company's strategic partners regard their relationship with the Company as
strategic to their own respective businesses and operations, that they will not
reassess their commitment to the Company or its products at any time in the
future, or that they will not develop and/or market their own competitive
technology.
The Company does not manufacture any of the components used in its products
and performs only limited assembly on some products. The Company relies on
independent contractors to manufacture to specification the Company's
components, subassemblies, systems and products. The Company also relies upon
limited source suppliers for a number of components used in the Company's
products, including certain key microprocessors and integrated circuits. There
can be no assurance that these independent contractors and suppliers will be
able to timely meet the Company's future requirements for manufactured products,
components and subassemblies. The Company generally purchases limited source
components pursuant to purchase orders and has no guaranteed supply arrangements
with these suppliers. In addition, the availability of many of these components
to the Company is dependent in part on the Company's ability to provide its
suppliers with accurate forecasts of its future requirements. However, any
extended interruption in the supply of any of the key components currently
obtained from a limited source would disrupt its operations and have a material
adverse effect on the Company's business, operating results and financial
condition. In addition, the Company anticipates that it will be necessary to
establish additional strategic relationships in the future, in particular with
additional national ISPs, and there can be no assurance that the Company will be
able to establish such alliances or that such alliances will result in increased
revenues.
DEPENDENCE ON PROPRIETARY RIGHTS AND TECHNOLOGY
The Company's ability to compete is dependent in part on its proprietary
rights and technology. The Company relies primarily on a combination of patent,
copyright and trademark laws, trade secrets, confidentiality procedures and
contractual provisions to protect its proprietary rights. The Company generally
enters into confidentiality or license agreements with its employees, resellers,
distributors, customers and potential customers and limits access to the
distribution of its software, hardware designs,
18
<PAGE>
documentation and other proprietary information. There can be no assurance that
the steps taken by the Company in this regard will be adequate to prevent
misappropriation of its technology. The Company currently has nine issued United
States patents, one pending United States patent application, and one pending
application for patent in each of Canada and Australia and within the European
Patent Office. There can be no assurance that the Company's patents 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, whether or not being currently challenged
by applicable governmental patent examiners, will be issued with the scope of
the claims sought by the Company, if at all. Furthermore, there can be no
assurance that others will not develop technologies that are similar or superior
to the Company's technology or design around the patents owned by the Company.
Despite the Company's efforts to protect its proprietary rights, unauthorized
parties may attempt to copy aspects of the Company's products or to obtain and
use information that the Company regards as proprietary. Policing unauthorized
use of the Company's products is difficult, and while the Company is unable to
determine the extent to which piracy of its software products exists, software
piracy is expected to be a persistent problem. In selling its software products,
the Company relies primarily on "shrink wrap" licenses that are not signed by
licensees and, therefore, it is possible that such licenses may be unenforceable
under the laws of certain jurisdictions. In addition, the laws of some foreign
countries do not protect the Company's proprietary rights as fully as do the
laws of the United States. There can be no assurance that the Company's means of
protecting its proprietary rights in the United States or abroad will be
adequate or that competing companies will not independently develop similar
technology.
The Company relies upon certain software, firmware and hardware designs that
it licenses from third parties, including firmware that is integrated with the
Company's internally developed firmware and used in the Company's products to
perform key functions. There can be no assurance that these third-party licenses
will continue to be available to the Company on commercially reasonable terms.
The loss of, or inability to maintain, such licenses could result in shipment
delays or reductions until equivalent firmware could be developed, identified,
licensed and integrated which would materially and adversely affect the
Company's business, operating results and financial condition.
LITIGATION
From time to time, the Company has received claims of infringement of other
parties' proprietary rights. Although the Company believes that all such claims
received to date are immaterial, there can be no assurance that third parties
will not assert infringement claims in the future with respect to the Company's
current or future products. The Company expects that it will increasingly be
subject to infringement claims as the number of products and competitors in the
Company's industry segments grow and the functionality of products in different
industry segments overlaps. Any such claims, with or without merit, could be
time consuming to defend, result in costly litigation, divert management's
attention and resources, cause product shipment delays or require the Company to
enter into royalty or licensing agreements. Such royalty or licensing
agreements, if required, may not be available on terms acceptable to the
Company, if at all. In the event of a successful claim of product infringement
against the Company and failure or inability of the Company to license the
infringed or similar technology, the Company's business, operating results and
financial condition would be materially and adversely affected.
In the past, Farallon has found it necessary to file suit to protect its
proprietary rights. Such litigation has resulted in, and any litigation in the
future can be expected to result in, substantial costs to Farallon and a
diversion of efforts of Farallon's personnel. In 1993, the Company filed suit
asserting that a competitor infringed its patented technology, and filed an
International Trade Commission action asserting that products imported into the
United States infringed Farallon's patented technology. Although both actions
19
<PAGE>
were resolved favorably for the Company, there can be no assurance that future
litigation actions, if brought, will result in favorable outcomes.
From time to time, the Company may be involved in litigation or administrative
claims arising out of its operations in the normal course of business. For
example, the Company recently terminated negotiations with a manufacturer of
router products regarding a potential acquisition. Shortly thereafter, the
Company received correspondence from such manufacturer's counsel asserting that
the Company's termination of negotiations was improper and demanding that
Farallon either consummate an acquisition for cash and stock or license from
such manufacturer certain technology. The Company believes that any potential
claim by such manufacturer, if brought, would be entirely without merit and the
Company is prepared to vigorously defend any such claim.
LENGTHY SALES CYCLE
The Company's Timbuktu Pro products are often licensed to customers on a
volume license basis for use on private wide area network ("WAN") Intranets
involving thousands of nodes. These licenses often involve significant license
and maintenance fees. As a result, the license of the Company's Timbuktu Pro
products often involves a significant commitment of management attention and
resources by prospective customers. Accordingly, the Company's sales process for
these products is often subject to delays associated with long approval
processes that typically accompany significant capital expenditures. For these
and other reasons, the sales cycle associated with the license of the Timbuktu
Pro products is often lengthy and subject to a number of significant delays over
which the Company has little or no control. There can be no assurance that the
Company will not experience these and additional delays in the future on
Timbuktu Pro or other products.
TARIFF AND REGULATORY MATTERS
The Company is not currently subject to direct regulation by any government
agency, other than regulations applicable to businesses generally. However,
rates for telecommunications services are governed by tariffs of licensed
carriers that are subject to regulatory approval. Future changes in these
tariffs could have a material adverse effect on the Company's business,
operating results and financial condition. For example, if tariffs for public
switched digital services increase in the future relative to tariffs for private
leased services, then the cost-effectiveness of the Company's products would be
reduced, and its business, operating results and financial condition would be
materially and adversely affected. In addition, the Company's telecommunications
products must meet standards and receive certification for connection to public
telecommunications networks prior to their sale. In the United States, such
products must comply with Part 15(a) (industrial equipment), Part 15(b)
(residential equipment) and Part 68 (analog lines) of the Federal Communications
Commission regulations. The Company's telecommunications products also must be
certified by domestic telecommunications carriers. In foreign countries, such
products are subject to a wide variety of governmental review and certification
requirements. While certain foreign countries and the European Economic
Community regulate the importation and certification of the Company's products,
most foreign customers typically require that the Company's products receive
certification from their country's primary telecommunication carriers. Any
future inability to obtain on a timely basis or retain domestic certification or
foreign regulatory approvals could have a material adverse effect on the
Company's business, operating results and financial condition.
20
<PAGE>
DEPENDENCE ON KEY PERSONNEL
The Company's business and prospects depend to a significant degree upon the
continuing contributions of its key management, sales, marketing, product
development and administrative personnel. The Company does not have employment
contracts with its key personnel and does not maintain any key person life
insurance policies. The loss of key management or technical personnel could
materially and adversely affect the Company's business, operating results and
financial condition. The Company believes that its prospects depend in large
part upon its ability to attract and retain highly-skilled engineering,
managerial, sales and marketing, and administrative personnel. Competition for
such personnel is intense, and there can be no assurance that the Company will
be successful in attracting and retaining such personnel. Failure to attract and
retain key personnel could have a material adverse effect on the Company's
business, operating results and financial condition.
VOLATILITY OF STOCK PRICE
The market price of the shares of the Company's Common Stock is highly
volatile and may be significantly affected by factors such as actual or
anticipated fluctuations in the Company's results of operations, announcements
of technological innovations, introduction of new products by the Company or its
competitors, developments with respect to patents, copyrights or proprietary
rights, conditions and trends in the networking and other technology industries,
changes in or failure by the Company to meet securities analysts' expectations,
general market conditions and other factors. In addition, the stock market has
from time to time experienced significant price and volume fluctuations that
have particularly affected the market prices for the common stocks of technology
companies. These broad market fluctuations may adversely affect the market price
of the Company's Common Stock. In the past, following periods of volatility in
the market price of a particular company's securities, securities class action
litigation has often been brought against that company. There can be no
assurance that such litigation will not occur in the future with respect to the
Company. Such litigation could result in substantial costs and a diversion of
management's attention and resources, which could have a material adverse effect
upon the Company's business, operating results and financial condition.
21
<PAGE>
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
27.1 Financial Data Schedule
(b) Reports on Form 8-K
No Reports on Form 8-K were filed during the quarter ended June 30,
1996.
22
<PAGE>
SIGNATURE
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: August 9, 1996 FARALLON COMMUNICATIONS, INC.
(Registrant)
By: /s/ James A. Clark
--------------------------------------
James A. Clark
Vice President and Chief Financial Officer
(Duly Authorized Officer and Principal
Financial Officer)
23
<PAGE>
INDEX TO EXHIBITS
Exhibit Description
- ------- -----------
27.1 Financial Data Schedule
24
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM FARALLON
COMMUNICATIONS, INC. AND SUBSIDIARY CONSOLIDATED BALANCE SHEET AND STATEMENT OF
OPERATIONS FOR THE THREE AND NINE MONTHS ENDED JUNE 30, 1996 ON PAGES 3 AND 4 OF
THE COMPANY'S 10-Q FILING FOR THE THREE MONTHS ENDED JUNE 30, 1996 AND IS
QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C> <C>
<PERIOD-TYPE> 3-MOS 9-MOS
<FISCAL-YEAR-END> SEP-30-1996 SEP-30-1996
<PERIOD-START> APR-01-1996 OCT-01-1995
<PERIOD-END> JUN-30-1996 JUN-30-1996
<CASH> 37,725 37,725
<SECURITIES> 0 0
<RECEIVABLES> 11,056 11,056
<ALLOWANCES> 1,296 1,296
<INVENTORY> 6,936 6,936
<CURRENT-ASSETS> 57,549 57,549
<PP&E> 11,600 11,600
<DEPRECIATION> 8,627 8,627
<TOTAL-ASSETS> 61,260 61,260
<CURRENT-LIABILITIES> 8,496 8,496
<BONDS> 0 0
0 0
0 0
<COMMON> 11 11
<OTHER-SE> 52,676 52,676
<TOTAL-LIABILITY-AND-EQUITY> 61,260 61,260
<SALES> 15,627 45,071
<TOTAL-REVENUES> 15,627 45,071
<CGS> 8,067 23,248
<TOTAL-COSTS> 8,067 23,248
<OTHER-EXPENSES> 7,235 20,966
<LOSS-PROVISION> 1,296 1,296
<INTEREST-EXPENSE> 230 663
<INCOME-PRETAX> 555 1,520
<INCOME-TAX> 195 (1,721)<F1>
<INCOME-CONTINUING> 360 3,241
<DISCONTINUED> 0 0
<EXTRAORDINARY> 0 0
<CHANGES> 0 0
<NET-INCOME> 360 3,241
<EPS-PRIMARY> 0 0
<EPS-DILUTED> 0.03 0.30
<FN>
<F1>As of 3/31/96, the Company reversed a full valuation allowance that it had
previously provided against its deferred tax assets, resulting in a
non-recurring income tax benefit of approximately $2.3 million.
</FN>
</TABLE>
