<PAGE>
================================================================================
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
------------------
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 : 0-23023
MMC NETWORKS, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 77-0319809
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
1134 E. ARQUES AVENUE
SUNNYVALE, CA 94086
(ADDRESS OF PRINCIPAL OFFICES)
(ZIP CODE)
(408) 731-1600
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED
TO BE FILED BY SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING
THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS
REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING
REQUIREMENTS FOR THE PAST 90 DAYS.
YES [X] NO __
THE NUMBER OF SHARES OUTSTANDING OF THE ISSUER'S COMMON STOCK AS OF NOVEMBER 5,
1998 WAS 30,049,028.
================================================================================
<PAGE>
MMC NETWORKS, INC.
QUARTERLY REPORT ON FORM 10-Q
INDEX
<TABLE>
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Balance Sheets at September 30, 1998 and December 31, 1997...................... 3
Condensed Statements of Operations for the three and nine months
ended September 30, 1998 and 1997................................................. 4
Condensed Statements of Cash Flows for the nine months
months ended September 30, 1998 and 1997.......................................... 5
Notes to the Condensed Financial Statements............................................... 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of
Operations........................................................................ 8
PART II. OTHER INFORMATION
Item 1. Legal Proceedings......................................................................... 16
Item 2. Changes in Securities..................................................................... 16
Item 3. Defaults Upon Senior Notes................................................................ 16
Item 4. Submission of Matters to a Vote of Security Holders....................................... 16
Item 5. Other Information......................................................................... 16
Item 6. Exhibits and Reports on Form 8-K.......................................................... 16
SIGNATURES................................................................................................... 17
</TABLE>
2
<PAGE>
MMC NETWORKS, INC.
CONDENSED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents........................................................................ $40,943 $45,401
Short-term investments........................................................................... 9,140 -
Accounts receivable, net of allowance of $172 and $181........................................... 7,704 4,526
Finished goods inventories....................................................................... 725 570
Prepaid expenses and other current assets........................................................ 2,098 382
------- -------
Total current assets................................................................. 60,610 50,879
Property and equipment, net........................................................................... 5,224 3,631
Other assets.......................................................................................... 209 213
------- -------
$66,043 $54,723
======= =======
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable................................................................................. $ 3,370 $ 2,626
Accrued expenses................................................................................. 3,221 1,744
Current portion of capital lease obligations..................................................... 304 350
------- -------
Total current liabilites............................................................. 6,895 4,720
------- -------
Capital lease obligations, net of current portion..................................................... 63 286
------- -------
Stockholders' equity:
Series A Convertible Preferred Stock: $0.001 par value; 0 and 9,378 shares
authorized; no shares issued or outstanding................................................. - -
Series B Convertible Preferred Stock: $0.001 par value; 0 and 4,121 shares
authorized; no shares issued or outstanding................................................. - -
Preferred Stock: $0.001 par value; 10,000 and 0 shares authorized; no
shares issued or outstanding................................................................ - -
Common Stock: $0.001 par value; 100,000 shares authorized; 29,943
and 29,198 shares issued and outstanding.................................................... 26 25
Additional paid-in capital....................................................................... 54,550 50,778
Notes receivable from stockholders............................................................... (116) (181)
Retained earnings (Accumulated deficit).......................................................... 4,625 (905)
------- -------
Total stockholders' equity........................................................... 59,085 49,717
------- -------
$66,043 $54,723
======= =======
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONDENSED FINANCIAL
STATEMENTS.
3
<PAGE>
<TABLE>
<CAPTION>
MMC NETWORKS, INC.
CONDENSED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA)
(UNAUDITED)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
--------------------------------- ------------------------------
1998 1997 1998 1997
---------------- ------------ ------------- ------------
<S> <C> <C> <C> <C>
Revenues...................................................... $ 14,015 $ 6,095 $35,655 $14,296
Cost of revenues.............................................. 4,036 1,746 10,462 4,281
------------- ------------ ------------ ------------
Gross profit........................................ 9,979 4,349 25,193 10,015
------------- ------------ ------------ ------------
Operating expenses:
Research and development, net............................ 3,872 2,659 10,670 5,410
Selling, general and administrative...................... 2,406 1,582 6,758 4,141
Litigation settlement.................................... - - 1,250 -
------------- ------------ ------------ ------------
Total operating expenses............................ 6,278 4,241 18,678 9,551
------------- ------------ ------------ ------------
Operating income.............................................. 3,701 108 6,515 464
------------- ------------ ------------ ------------
Other income (expense):
Interest income.......................................... 567 57 1,591 212
Interest expense......................................... (11) (33) (46) (101)
------------- ------------ ------------ -----------
Total other income.................................. 556 24 1,545 111
------------- ------------ ------------ -----------
Income before income taxes.................................... 4,257 132 8,060 575
Provision for income taxes.................................... 1,275 9 2,530 18
------------ ------------ ------------ -----------
Net income.................................................... $ 2,982 $ 123 $ 5,530 $ 557
============ ============ ============ ===========
Basic income per share........................................ $ 0.10 $ 0.01 $ 0.19 $ 0.05
============ ============ ============ ===========
Shares used to compute basic income per share................. 29,854 11,664 29,561 11,456
============ ============ ============ ===========
Diluted income per share...................................... $ 0.09 $ 0.00 $ 0.16 $ 0.02
============ ============ ============ ===========
Shares used to compute diluted income per share............... 33,723 28,946 33,745 28,061
============ ============ ============ ===========
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONDENSED FINANCIAL
STATEMENTS.
4
<PAGE>
MMC NETWORKS, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
---------------------
1998 1997
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net income.................................................................................. $ 5,530 $ 557
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization...................................................... 1,562 695
Issuance of Common Stock in exchange for services.................................. - 30
Tax benefit from the exercise of stock options..................................... 2,434 -
Changes in assets and liabilities:
Accounts receivable............................................................. (3,178) (2,002)
Inventories..................................................................... (155) 142
Prepaid expenses and other assets............................................... (1,712) (542)
Accounts payable................................................................ 744 2,169
Accrued expenses................................................................ 1,477 618
Deferred revenue and customer deposits.......................................... - (100)
-------- --------
Net cash provided by operating activites..................................... 6,702 1,567
-------- --------
Cash flows from investing activities:
Purchase of short-term investments.......................................................... (9,140) (666)
Acquisition of property and equipment....................................................... (3,155) (2,321)
-------- --------
Net cash used in investing activities........................................ (12,295) (2,987)
-------- --------
Cash flows from financing activities:
Proceeds from exercise of stock options and other........................................... 1,339 167
Proceeds from the repayment of notes receivable from stockholders........................... 65 -
Principal payments on capital lease obligations............................................. (269) (315)
-------- --------
Net cash provided by (used in) financing activitIes.......................... 1,135 (148)
-------- --------
Net decrease in cash and cash equivalents........................................................ (4,458) (1,568)
Cash and cash equivalents at beginning of period................................................. 45,401 4,809
-------- --------
Cash and cash equivalents at end of period....................................................... $ 40,943 $ 3,241
======== ========
SUPPLEMENTAL DISCLOSURE:
Cash paid for interest...................................................................... $ 46 101
Cash paid for income taxes.................................................................. $ - $ 2
</TABLE>
THE ACCOMPANYING NOTES ARE AN INTEGRAL PART OF THESE CONDENSED FINANCIAL
STATEMENTS.
5
<PAGE>
MMC NETWORKS, INC.
NOTES TO THE CONDENSED FINANCIAL STATEMENTS
NOTE 1 - BASIS OF PRESENTATION
In the opinion of management, the accompanying unaudited financial information
reflects all adjustments, including only normal recurring adjustments, necessary
for the fair presentation of the financial position, results of operations and
cash flows for MMC Networks, Inc. (the "Company") for the periods presented.
Certain information and footnote disclosures normally included in financial
statements prepared in accordance with generally accepted accounting principles
have been omitted pursuant to the rules and regulations of the Securities and
Exchange Commission. These financial statements should be read in conjunction
with the audited financial statements and notes thereto included in the
Company's Annual Report on Form 10-K filed with the Securities and Exchange
Commission for the year ended December 31, 1997. Results for the interim periods
are not necessarily indicative of results for the entire year.
NOTE 2 - EARNINGS PER SHARE
The following table reconciles the numerator and denominator of the basic and
diluted EPS computations for the three and nine month periods ended September
30, 1998 and 1997:
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
------------------------------------- ------------------------------------
SEPTEMBER 30, SEPTEMBER 30,
1998 1997 1998 1997
--------------- --------------- -------------- ----------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
Net income available to
common stockholders.................... $ 2,982 $ 123 $ 5,530 $ 557
=============== =============== ============== ================
Shares used to compute basic income
per share.............................. 29,854 11,664 29,561 11,456
Effect of dilutive securities:
Convertible Preferred Stock............ - 13,342 - 13,342
Warrants............................... 31 141 31 128
Stock options.......................... 3,838 3,799 4,153 3,135
--------------- --------------- -------------- ----------------
Shares used to compute diluted income
per share.............................. 33,723 28,946 33,745 28,061
=============== =============== ============== ================
Basic income per share...................... $ 0.10 $ 0.01 $ 0.19 $ 0.05
=============== =============== ============== ================
Diluted income per share.................... $ 0.09 $ 0.00 $ 0.16 $ 0.02
=============== =============== ============== ================
</TABLE>
NOTE 3 - EQUITY
On January 13, 1998, the Company amended its Certificate of Incorporation to
authorize 10,000,000 shares of undesignated Preferred Stock. The Board of
Directors has the authority to issue the undesignated Preferred Stock in one or
more series and to fix the rights, preferences, privileges and restrictions
thereof.
On September 18, 1998 the Board of Directors offered to the employees, other
than members of the Board of Directors and officers of the Company, holding
outstanding options to purchase Common Stock of the Company the opportunity to
reprice such options with grant dates subsequent to October 28, 1997 to an
exercise price equal to $16.38, the closing sales price of the Company's Common
Stock on September 25, 1998. No other terms or conditions of the original option
agreements were changed except that the repriced option is not exercisable for a
period of six months from the effective date of the repricing, except in the
event of a change of control of the Company or termination of the optionee's
employment with the Company due to involuntary termination, disability, or
death. A total of 424,000 options with original exercise prices ranging from
$16.75 to $32.13 were repriced.
6
<PAGE>
MMC NETWORKS, INC.
NOTES TO THE CONDENSED FINANCIAL STATEMENTS
NOTE 4 - RECENT ACCOUNTING PRONOUNCEMENTS
The Company adopted Statement of Financial Accounting Standards No. 130,
"Reporting Comprehensive Income" ("SFAS 130") in the first quarter of 1998. SFAS
130 establishes standards for the reporting of comprehensive income and its
components in a financial statement that is displayed with the same prominence
as other financial statements. Comprehensive income, as defined, includes all
changes in equity (net assets) during a period from non-owner sources. Examples
of items to be included in comprehensive income, which are excluded from net
income, include foreign currency translation adjustments and unrealized
gain/loss on available-for-sale securities. For the three and nine month periods
ended September 30, 1998 and 1997, comprehensive income approximated net income.
The Company adopted Statement of Financial Accounting Standards No. 131,
"Disclosures About Segments of an Enterprise and Related Information" ("SFAS
131") in the first quarter of 1998. This statement establishes standards for the
way companies report information about operating segments in financial
statements. It also establishes standards for related disclosures about products
and services, geographic areas and major customers. The adoption of SFAS 131 has
not resulted in a change in the way the Company reports information and related
disclosures.
In June 1998, the FASB issued Statement of Financial Accounting Standards No.
133 "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133").
SFAS 133 requires that all derivatives be recognized in the statement of
financial position as either assets or liabilities and be measured at fair
value. In addition, all hedging relationships must be designated, reassessed and
documented pursuant to the provisions of SFAS 133. The accounting prescribed by
SFAS 133 is effective beginning with the first quarter of 2000. The adoption of
SFAS 133 in 2000 is not expected to have a material impact on the Company's
financial position or results of operations.
NOTE 5 - FINANCING AGREEMENTS
As of December 31, 1997, the Company had two lines of credit, a $5.0 million
revolving bank credit facility under which borrowings accrued interest at the
bank's prime rate and a $3.0 million bank lease line under which borrowings
accrued interest at the bank's prime rate plus 0.5%. The Company never utilized
either of these lines of credit which expired in April 1998.
During the first half of 1998, the Company established two credit facilities
with a bank pursuant to a loan agreement and a non-recourse receivables purchase
agreement. The loan agreement, which expires in May 1999, allows the Company to
borrow up to $8.0 million. Borrowings under the loan agreement bear interest at
the bank's prime rate. The agreement requires that the Company comply with
certain financial covenants. In the event of default, all outstanding borrowings
will accrue interest at a rate of five percentage points above the rate
effective immediately prior to any such default. The non-recourse receivables
purchase agreement, which expires in February 1999, allows the Company to sell
up to $2.0 million of its accounts receivable to the bank at a discount rate
equal to the bank's prime rate plus 1.0% per annum, less an administrative fee
equal to 0.20% of the total purchased receivables balance. The receivables
purchase agreement also provides for the Company to grant to the bank a
continuing lien on and security interest in all purchased receivables and
related property. To date, the Company has not utilized either credit facility.
NOTE 6 - LITIGATION SETTLEMENT
During the fourth quarter of 1997, FORE Systems, Inc. ("FORE") filed complaints
alleging patent infringement and trade secret misappropriation against MMC
Networks, Inc. The Company entered into a settlement agreement with FORE in June
1998. In accordance with the settlement, the Company agreed to pay a settlement
fee and entered into a patent cross-licensing agreement pursuant to which the
Company and FORE granted each other perpetual, with certain exceptions, and
fully-paid licenses to certain patents held by them. The settlement fee and
related legal expenses totaling approximately $1.3 million were charged to
operating income in the quarter ended June 30, 1998.
7
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following information should be read in conjunction with the interim
condensed financial statements and the notes thereto included in Part I, Item 1
of this Quarterly Report on Form 10-Q and the financial statements and notes
thereto contained in the Company's Annual Report on Form 10-K for the year ended
December 31, 1997.
This Management's Discussion and Analysis of Financial Condition and Results of
Operations contains forward-looking statements which reflect the Company's
current views with respect to future events which may impact the Company's
results of operations and financial condition. In this report, the words
"anticipates", "believes", "expects", "intends" and similar expressions identify
forward-looking statements. These forward-looking statements are subject to
risks and uncertainties and other factors, including those set forth below under
the captions "Factors Affecting Future Results" and "Impact of the Year 2000
Issue", which could cause the actual future results to differ materially from
historical results or those described in the forward-looking statements. Readers
are urged to carefully review the disclosures made by the Company in this Report
and in the section entitled "Management's Discussion and Analysis of Condition
and Results of Operations - Factors Affecting Future Results" of the Company's
Annual Report on Form 10-K for the year ended December 31, 1997 that describe
certain risks and factors that may affect the Company's business, and not to
place undue reliance on these forward-looking statements, which speak only of
management's expectations as of the date hereof.
BACKGROUND
The Company is a leading developer and supplier of network
processors--high-performance, open-architecture, software-programmable
integrated circuits optimized for network applications. The Company's network
processors form the core silicon "engines" of LAN and WAN switches and routers
and are designed to allow network equipment vendors to rapidly develop
high-performance, feature-rich, cost-effective products supporting a broad range
of networking functions. MMC Networks' customers employ the Company's network
processors to develop and market multi-gigabit, wire-speed switches and routers
with advanced features such as Layer 3 switching, internetworking of LANs and
WANs, security, class of service, quality of service and network management.
The Company's current products, the PS1000, ATMS2000 and AF5000 families of
network processors, provide the core functionality of high-performance Fast
Ethernet and Asynchronous Transfer Mode ("ATM") networking equipment. The
Company believes that network equipment vendors are able to reduce design and
development costs and accelerate product development cycles for high-performance
routers and switches by using the Company's products. All of the Company's
products are based on the Company's proprietary ViX(TM) architecture, which
enables network equipment vendors to easily and cost-effectively implement
high-performance, value-added features in their switch and router products.
The Company was incorporated in California in September 1992 and reincorporated
in Delaware in October 1997.
8
<PAGE>
RESULTS OF OPERATIONS
The following table sets forth certain statement of operations data expressed as
a percentage of the Company's revenues for the interim periods presented.
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------- -----------------------
1998 1997 1998 1997
------------ ------------ --------- ---------
<S> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues........................................................ 100.0% 100.0% 100.0% 100.0%
Cost of revenues................................................ 28.8% 28.6% 29.3% 29.9%
--------- -------- ------- ------
Gross profit.......................... 71.2% 71.4% 70.7% 70.1%
--------- -------- ------- ------
Operating expenses:
Research and development, net......................... 27.6% 43.6% 29.9% 37.9%
Selling, general and administrative................... 17.2% 26.0% 19.0% 29.0%
Litigation settlement................................. 0.0% 0.0% 3.5% 0.0%
--------- -------- ------- ------
Total operating expenses.............. 44.8% 69.6% 52.4% 66.9%
--------- -------- ------- ------
Operating income................................................ 26.4% 1.8% 18.3% 3.2%
Interest income, net.................................. 4.0% 0.4% 4.3% 0.8%
--------- -------- ------- ------
Income before income taxes...................................... 30.4% 2.2% 22.6% 4.0%
Provision for income taxes...................................... 9.1% 0.2% 7.1% 0.1%
--------- -------- ------- ------
Net income...................................................... 21.3% 2.0% 15.5% 3.9%
--------- -------- ------- ------
</TABLE>
Revenues
Revenues increased by 16.6% to $14.0 million in the third quarter of 1998 from
$12.0 million in the second quarter of 1998 and increased by 129.9% as compared
to $6.1 million for the same quarter of the previous year. The revenue growth
from the second quarter to the third quarter of 1998 was due to increased sales
of the Company's AnyFlow5000 product family to new and existing customers
partially offset by a decline in sales of the ATMS2000 and the PS1000 product
families during the same period. The AnyFlow5000 and ATMS2000 product families
comprise the majority of the Company's total revenues and sales of the PS1000
product family continue to constitute a relatively small percentage of total
revenues. Revenues for the nine months ended September 30, 1998 increased by
149.4% to $35.7 million from $14.3 million for the same period in the previous
year. This increase is a result of increased sales to new and existing customers
across all of the Company's products lines. Given the economic downturn in Japan
and Asia in general, coupled with the lower than anticipated demand for the
Company's PS1000 product family, the Company expects fourth quarter revenues to
remain relatively flat. However, there can be no assurance that changes in the
demand for the network equipment products of the Company's customers, changes in
the timing and amount of orders from the Company's network equipment vendor
customers, cancellations or delays of customer product orders or new product
introductions by the Company or its competitors, a worsening of the economic
climate in Asia, in addition to a number of other uncertainties described
elsewhere in this report, will not cause actual results to differ from the
Company's expectations.
Cost of revenues; Gross profit
Cost of revenues increased to $4.0 million in the third quarter of 1998 from
$3.5 million in the second quarter of 1998 and increased $2.3 million from $1.7
million in the same quarter of the previous year. The increase in cost of
revenues primarily reflects the increased volume of shipments from period to
period and, accordingly, gross profit as a percentage of total revenues stayed
relatively constant: 71.2%, 71.0% and 71.4% for the three months ended September
30, 1998, June 30, 1998 and September 30, 1997, respectively. The cost of
revenues and related gross profit for the nine months ended September 30, 1998
were $10.5 million and 70.7%, respectively, as compared to $4.3 million and
70.1%, respectively, for the same period in the previous year.
9
<PAGE>
Research and development expenses, net
Research and development expenses, net, increased by 6.0% to $3.9 million in the
third quarter of 1998 from $3.7 million in the second quarter of 1998 and
increased by 45.6% from $2.7 million for the same quarter of the previous year.
Research and development expenses decreased as a percentage of total revenues to
27.6% in the third quarter of 1998 compared to 30.4% in the second quarter of
1998 and 43.6% in the same quarter of the previous year. Research and
development expenses as a percentage of total revenues were significantly higher
in the third quarter of 1997 due to unusually high contract engineering and
pre-production charges associated with the launch of the AnyFlow5000 products
during that period. Research and development expenses, net, include expenses
incurred under a number of contracts with customers whereby the Company receives
partial or complete reimbursement for expenses incurred. These reimbursements
are recorded as an offset against research and development expenses. The
increase in research and development expenses, net during the third quarter was
due in part to a headcount increase at MMC Networks Israel Ltd. ("MMCIL"), which
has grown to 7 employees since its establishment during the second quarter of
1998 and it is expected to continue to grow in headcount in future periods.
Research and development expenses for the nine months ended September 30, 1998
were $10.7 million or 29.9% of revenues, as compared to $5.4 million or 37.9% of
revenues for the nine months ended September 30, 1997. The increase in research
and development expenses from period to period was due to increased expenditures
for the development of new products and additional personnel. The Company
expects quarterly research and development expenses, net, to remain relatively
constant in absolute dollars in the fourth quarter of 1998.
Selling, general and administrative expenses
Selling, general and administrative expenses increased by 6.7% to $2.4 million
in the third quarter of 1998 from $2.3 million in the second quarter of 1998 and
increased by 52.1% as compared to $1.6 million for the same quarter of the
previous year. The increase in selling, general and administrative expenses from
period to period consisted of increased sales commissions resulting from higher
revenues and increased selling and marketing expenses associated with new
products and additional personnel. Selling, general and administrative expenses
decreased as a percentage of revenues to 17.2% in the third quarter of 1998
compared to 18.8% in the second quarter of 1998 and 26.0% in the same quarter of
the previous year. Selling, general and administrative expenses for the nine
months ended September 30, 1998 were $6.8 million or 19.0% as compared to $4.1
million or 29.0% for the nine months ended September 30, 1997. Selling, general
and administrative expenses have continued to decrease as a percentage of
revenue from period to period as revenue growth outpaced the increase in
selling, general and administrative expenses required to support that growth.
The Company expects quarterly selling, general and administrative expenses to
remain relatively constant in absolute dollars in the fourth quarter of 1998.
Litigation settlement
During the fourth quarter of 1997, FORE Systems, Inc. ("FORE") filed complaints
alleging patent infringement and trade secret misappropriation against MMC
Networks, Inc. The Company entered into a settlement agreement with FORE in June
1998. In accordance with the settlement, the Company agreed to pay a settlement
fee and entered into a patent cross-licensing agreement pursuant to which the
Company and FORE granted each other perpetual, with certain exceptions, and
fully-paid licenses to certain patents held by them. The settlement fee and
related legal expenses totaling approximately $1.3 million were charged to
operating income in the quarter ended June 30, 1998.
Interest income, net
The increase in net interest income for the three and nine months ended
September 30, 1998 as compared to the same periods of the previous year is due
to increased cash and investment balances from period to period due primarily to
the proceeds of the Company's initial public offering in October 1997 and cash
flow from operations.
Provision for income taxes
The provision for income taxes increased to $1.3 million in the third quarter of
1998 from $0.5 million in the second quarter of 1998. This increase is directly
related to the increase in operating income from period
10
<PAGE>
to period as there was no change in the effective tax rate from the second
quarter to the third quarter of 1998. The Company expects the effective tax rate
to remain at 30% for the remainder of 1998.
LIQUIDITY AND CAPITAL RESOURCES
As of September 30, 1998, the Company's cash, cash equivalents and short-term
investments totaled $50.1 million, and the Company's working capital was $53.7
million. Net cash totaling $6.7 million was provided by operating activities
during the nine months ended September 30, 1998. This increase was primarily due
to net income adjusted for depreciation and amortization and the tax benefit
from the exercise of stock options for a total of $9.5 million and an increase
in accrued expenses of $1.5 million offset by an increases in accounts
receivable and prepaid expenses and other assets of $3.2 million and $1.7
million, respectively. Cash used in investing activities of $12.3 million for
the nine months ended September 30, 1998 consisted of the purchase of short-term
investments of $9.1 million and the acquisition of property and equipment of
$3.2 million. Net cash of $1.1 million was provided by financing activities
during the nine months ended September 30, 1998 and was primarily due to cash of
$1.3 million provided by the proceeds from the exercise of stock options and
other.
As of December 31, 1997, the Company had two lines of credit, a $5.0 million
revolving bank credit facility under which borrowings accrued interest at the
bank's prime rate and a $3.0 million bank lease line under which borrowings
accrued interest at the bank's prime rate plus 0.5%. These lines of credit
expired in April 1998. During the first half of 1998 the Company established two
credit facilities with a bank pursuant to a loan agreement which allows the
Company to borrow up to $8.0 million and a non-recourse receivables purchase
agreement which allows the Company to sell up to $2.0 million of its accounts
receivables. To date, the Company has not utilized any of the credit facilities.
See Note 5 - Financing Agreements.
The Company believes that its existing cash balances together with the borrowing
capacity under its two credit facilities and cash flow from future operations
will be sufficient to meet the Company's capital requirements through the next
twelve months, although the Company could be required, or could elect, to seek
to raise additional capital before such time. This is a forward-looking
statement and the actual period of time for which the Company's resources will
be sufficient will depend on many factors, including the rate of revenue growth,
if any, the timing and extent of spending to support product development efforts
and the expansion of sales and marketing efforts, the timing and size of
business or technology acquisitions, the timing of introductions of new products
and enhancements to existing products and market acceptance of the Company's
products. There can be no assurance that additional equity or debt financing, if
required, will be available on acceptable terms or at all.
IMPACT OF THE YEAR 2000 ISSUE
The Year 2000 Issue is the result of computer programs being written using two
digits rather than four to define the applicable year. Any computer programs
that have date-sensitive software may recognize a date using "00" as the year
1900 rather than the year 2000. This could result in a system failure or
miscalculations causing disruptions of operations, including among other things
a temporary inability to process transactions, send invoices or engage in
similar normal business activities.
The Company is pursuing a plan to identify and address Year 2000 issues. One
component of the Plan is designed to identify and assess the risks associated
with its information technology ("IT") systems, non-IT systems and products.
This component of the Plan is composed of three phases: (1) identification and
assessment of risks (2) implementation and (3) testing. Based on documentation
supplied by the computer hardware and software vendors, phase 1 and 2 have been
completed with respects to the Company's critical IT systems and phase 3 is
expected to be completed by June 1999. With respect to non-critical IT systems,
phase 1 has been completed and phases 2 and 3 are expected to be completed by
January and June of 1999, respectively. Non-IT systems such as facilities and
laboratory test equipment are currently in phase 1 which is expected to be
completed by January 1999 and phases 2 and 3 are expected to be completed by
March and June of 1999, respectively. The Company has completed testing its
products, including semiconductors, software, and reference design systems, and
believes them to be Year 2000 compliant. However, there is no assurance that
errors will not be discovered in the future. The Company does not intend to
create a contingency plan, but will reassess the need for a contingency plan as
each major phase of
11
<PAGE>
the Plan is completed.
The second component of the Plan is designed to identify and assess the risks
associated with the Year 2000 readiness of the Company's suppliers. The Company
believes this to be its greatest potential risk associated with preparing for
the Year 2000 given the degree of reliance which must be placed upon the
supplier's ability to adequately resolve potential Year 2000 issues on a timely
basis. This component of the Plan is composed of three phases: (1)
identification and assessment of risks (2) survey significant or critical
suppliers regarding their Year 2000 preparedness and (3) contingency planning.
Phase 1 and 2 are expected to be completed by January and March of 1999,
respectively. Phase 3 is expected to be completed by June 1999. As part of the
contingency planning, the Company may be required to find alternative suppliers
to replace suppliers identified as having Year 2000 compliance issues or
suppliers whose published reports and or response to the Company's survey are
not timely, accurate or complete. There can be no assurance that the Company
will be able to adequately address Year 2000 compliance of its vendors, to find
suitable alternate suppliers and contract with them on terms reasonable to the
Company, or at all, and that such inability will not have a material adverse
effect on the Company's business, financial condition and results of operations.
Based on the status of the Company's Year 2000 efforts to date, the Company does
not anticipate total expenses, which are expensed as incurred, to exceed
$50,000, excluding expenses related to internal IT staff. However, the Company
may discover additional Year 2000 problems, may not be able to develop,
implement, or test contingency plans, or may find that the expenses associated
with these activities exceed current expectations. In many cases, the Company is
relying on assurances from suppliers and vendors that new and upgraded IT
systems and other products will be Year 2000 compliant. The Company cannot be
sure that its tests of third-party products will be adequate or that, if
problems are identified, they will be adequately addressed by the third party on
a timely basis. Because the Company uses a variety of IT systems and has
additional systems embedded in its infrastructure, it can not be sure that all
of its systems will work together in a Year 2000-compliant fashion. Furthermore,
the Company cannot be sure that it will not suffer business interruptions,
either because of its own Year 2000 problems or those of its customers or
suppliers whose Year 2000 problems may make it difficult or impossible for them
to fulfill their commitments to the Company. If the Company fails to
satisfactorily resolve Year 2000 issues in a timely manner it could also be
exposed to liability to third parties.
FACTORS AFFECTING FUTURE RESULTS
Past financial performance should not be considered a reliable indicator of
future performance and investors should not use historical trends to anticipate
results or trends in future periods. The Company operates in a rapidly changing
environment that involves a number of risks and uncertainties, some of which are
beyond the Company's control. In addition to the uncertainties describes
elsewhere in this report, these include:
Fluctuations in operating results
Fluctuations in the Company's revenues, operating expenses and operating income
have occurred in the past and are likely to occur in the future due to a variety
of factors, any of which may have a material adverse effect on the Company's
operating results. In addition, the Company's quarterly results of operations
may vary significantly due to general business conditions in the networking
equipment and semiconductor industries, changes in demand for the network
equipment products of the Company's customers, the timing and amount of orders
from the Company's network equipment vendor customers, cancellations or delays
of customer product orders, new product introductions by the Company or its
competitors, cancellations, changes or delays of deliveries of products to the
Company by its suppliers, increases in the costs of products from the Company's
suppliers, fluctuations in product life cycles, price erosion, competition,
changes in the mix of products sold by the Company, availability of
semiconductor foundry capacity, variances in the timing and amount of
nonrecurring engineering funding and operating expenses, seasonal fluctuations
in demand, intellectual property disputes and general economic conditions.
In addition, in the past the Company has recognized a substantial portion of its
revenues in the last month of a quarter. Since a large portion of the Company's
operating expenses, including rent, salaries and capital lease expenses, is
fixed and difficult to reduce or modify, if revenue does not meet the Company's
12
<PAGE>
expectations, the material adverse effect of any revenue shortfall will be
magnified by the fixed nature of these operating expenses. All of the above
factors are difficult for the Company to forecast, and these and other factors
could have a material adverse effect on the Company's business, financial
condition and results of operations.
Customer Concentration
The percentage of total revenues accounted for by the Company's significant
customers (significant customers are those customers accounting for more than
10% of the Company's total revenues) for the periods presented are as follows:
for the three months ended September 30, 1998 a single customer, Cisco Systems,
Inc. ("Cisco") accounted for 56% of total revenues; for the three months ended
September 30, 1997, Cisco, Mitsui Comtek Corp., a non-stocking sales
representative for Japan ("Mitsui"), and the U.S. Computer Division of Hitachi
("Hitachi") accounted for 39%, 17% and 14% of total revenues, respectively; for
the nine months ended September 30, 1998, Cisco and Mitsui accounted for 48% and
14% of total revenues, respectively; for the nine months ended September 30,
1997, Cisco, Mitsui and Hitachi accounted for 30%, 20% and 17% of total
revenues, respectively.
The Company's customer base is highly concentrated. A relatively small number of
customers has accounted for a significant portion of the Company's revenues to
date, and the Company expects that this trend will continue for the foreseeable
future. Each of the Company's network equipment vendor customers, including
Cisco, Mitsui and Hitachi, can cease incorporating the Company's products with
limited notice to the Company and with little or no penalty. The Company has no
minimum purchase agreements with its customers.
The Company's future operating results are currently substantially dependent on
Cisco's competitive position in the networking equipment market. The loss of one
or more of the Company's customers in general and Cisco in particular, the
possibility that the introduction of the customer's product may not be
successful, the possibility that design wins with customers do not result in
significant production levels or the inability of the Company to successfully
develop relationships with additional significant network equipment vendors
could have a material adverse effect on the Company's business, financial
condition and results of operations.
New Product Development and Technological Change
The data networking and semiconductor industries are characterized by rapidly
changing technology, frequent product introductions, rapid erosion of average
selling prices and evolving industry standards. Accordingly, the Company's
future performance depends on a number of factors, including the acceptance of
network processors as an alternative to Application-Specific Integrated Circuit
("ASIC") components and general purpose processors and the acceptance by the
Company's customers of third party sourcing for network processors as an
alternative to in-house development as well as the Company's ability to identify
emerging technological trends in its target markets, develop and maintain
competitive products, enhance its products by adding innovative features that
differentiate its products from those of competitors, bring products to market
on a timely basis at competitive prices, properly identify target markets and
respond effectively to technological changes or new product announcements by
others. Products as complex as those offered by the Company frequently contain
errors, defects and bugs when first introduced or as new versions are released.
The Company has in the past experienced such errors, defects and bugs. Delivery
of products with production defects or reliability, quality or compatibility
problems could significantly delay or hinder market acceptance of such products,
which could damage the Company's reputation and adversely affect the Company's
ability to retain its existing customers and to attract new customers. In
addition, the Company must generally incur substantial research and development
costs before the technical feasibility and commercial viability of a product
line can be ascertained. There can be no assurance that revenues from future
products or product enhancements will be sufficient to recover the development
costs associated with such products or enhancements, or that the Company will be
able to secure the financial resources necessary to fund future development. The
inability of the Company and its products to achieve market acceptance from
network equipment vendors and to adequately address any of the factors discussed
above could have a material adverse effect on the Company's business, financial
condition and results of operations.
13
<PAGE>
Dependence on Independent Manufacturers
Currently, the Company outsources all manufacturing, assembly and testing of its
network processors. The Company purchases both fully assembled and tested
products on a turnkey basis and wafers which it then consigns to subcontract
assembly and test providers. For products purchased in wafer form, the Company
assumes the risk of yield loss in subsequent manufacturing steps. Only one of
the Company's products is currently manufactured by more than one supplier. The
Company depends on its suppliers to deliver sufficient quantities of finished
product to the Company in a timely manner. Since the Company places its orders
on a purchase order basis and does not have a long-term volume purchase
agreement with any of its existing suppliers, these suppliers may allocate, and
in the past have allocated, capacity to the production of other products while
reducing deliveries to the Company on short notice. Given that the Company must
place orders approximately 8 to 12 weeks in advance of expected delivery, any
sudden increase in customer demand not anticipated by the Company in advance
could result in the inability to deliver product on a timely basis and, as such,
may reduce the Company's product revenues or increase the Company's cost of
revenues and could have a material adverse effect on the Company's business,
financial condition and results of operations. In addition, the Company places
orders based on forecast demand to ensure enough lead time to be able to meet
anticipated customer orders. Any sudden decrease in the anticipated customer
demand could have a material adverse effect on the Company's business, financial
condition and results of operations.
Competition
The data networking and semiconductor industries are intensely competitive and
are characterized by constant technological change, rapid rates of product
obsolescence and price erosion. The Company's PS1000, ATMS2000 and AF5000
product families compete with products from companies such as Texas Instruments
Incorporated, Lucent Technologies, Inc., PMC-Sierra Inc./Integrated Technology
Ltd., Galileo Technology Ltd. and I-Cube, Inc. In addition, the Company expects
significant competition in the future from major domestic and international
semiconductor suppliers. The Company also may face competition from suppliers of
products based on new or emerging technologies. Moreover, several established
electronics and semiconductor suppliers have recently entered or indicated an
intent to enter the switching and routing equipment market. In addition, many of
the Company's existing and potential customers internally develop ASICs, general
purpose processors, network processors and other devices which attempt to
perform all or a portion of the functions performed by the Company's products.
Many of the Company's current and prospective competitors offer broader product
lines and have significantly greater financial, technical, manufacturing and
marketing resources than the Company. Failure of the Company to compete
successfully could have a material adverse effect on its operating results.
Protection of Intellectual Property
The Company relies primarily on a combination of nondisclosure agreements and
other contractual provisions as well as patent, trademark, trade secret and
copyright law to protect its proprietary rights. There can be no assurance that
any patents will issue pursuant to the Company's current or future patent
applications or that patents issued pursuant to such applications will not be
invalidated, circumvented, challenged or licensed to others. In addition, there
can be no assurance that the rights granted under any such patents will provide
competitive advantages to the Company or be adequate to safeguard and maintain
the Company's proprietary rights. From time to time, third parties, including
competitors of the Company, may assert patent, copyright and other intellectual
property rights to technologies that are important to the Company. There can be
no assurance that third parties will not assert infringement claims against the
Company in the future, that assertions by third parties will not result in
costly litigation or that the Company would prevail in any such litigation or be
able to license any valid and infringed patents from third parties on
commercially reasonable terms, if at all. Failure of the Company to enforce and
protect its intellectual property rights could have a material adverse effect on
the Company's business, financial condition and results of operations.
During the fourth quarter of 1997, FORE Systems, Inc. ("FORE") filed complaints
alleging patent infringement and trade secret misappropriation against MMC
Networks, Inc. The Company entered into a settlement agreement with FORE in June
1998. In accordance with the settlement, the Company agreed to pay a settlement
fee and entered into a patent cross-licensing agreement pursuant to which the
Company and
14
<PAGE>
FORE granted each other perpetual, with certain exceptions, and fully-paid
licenses to certain patents held by them. The settlement fee and related legal
expenses totaling approximately $1.3 million were charged to operating income in
the quarter ended June 30, 1998
Risks Associated with Expansion of International Business Activities
The Company is subject to additional risks inherent in international operations.
All of the Company's international sales to date are U.S. dollar-denominated. As
a result, an increase in the value of the U.S. dollar relative to foreign
currencies could make the Company's products less competitive in international
markets. In addition, the Company procures a most of its manufacturing, assembly
and test services from suppliers located outside the United States.
International business activities may be limited or disrupted by the imposition
of governmental controls, export license requirements, restrictions on the
export of critical technology, currency exchange fluctuations, political
instability, trade restrictions and changes in tariffs. Demand for the Company's
products could also be adversely affected by seasonality of international sales
and economic conditions in the Company's primary overseas markets. These
international factors could have a material adverse effect on future sales of
the Company's products to international customers and, consequently, on the
Company's business, financial condition and results of operations. As a
percentage of total revenues, sales to Mitsui have declined over the last four
quarters to less than 10% and may remain at this lower level or decline further
due to the economic downturn in Japan and Asia in general, and could have an
adverse effect on the Company's revenues in the future.
Expected Volatility of Stock Price.
In recent years the stock market in general, and the market for shares of high
technology, data networking and semiconductor companies in particular, have
experienced extreme price fluctuations, which have often been unrelated to the
operating performance of affected companies. The trading price of the Company's
Common Stock is expected to be subject to extreme fluctuations in response to
both business-related issues, such as quarterly variations in operating results,
announcements of new products by the Company or its competitors and the gain or
loss of significant network equipment vendor customers, and stock market-related
influences, such as changes in analysts' estimates, the presence or absence of
short-selling of the Company's Common Stock or events affecting other companies
that the market deems to be comparable to the Company. In addition, technology
stocks have from time to time experienced extreme price and volume fluctuations
that often have been unrelated or disproportionate to the operating performance
of these companies.
15
<PAGE>
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Not Applicable.
ITEM 2. CHANGES IN SECURITIES
Not Applicable.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not Applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
Not Applicable.
ITEM 5. OTHER INFORMATION
Not Applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
Exhibit No. Description of Exhibit
----------- ----------------------
27.1 Financial Data Schedule as of September 30,
1998 and for the nine months then ended.
(b) Reports on Form 8-K
The Company filed no reports on Form 8-K during the three months
ended September 30, 1998.
16
<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.
Dated: November 12, 1998 MMC NETWORKS, INC.
By: /s/ AMOS WILNAI
----------------------------------------
Interim Chief Executive Officer and
Chairman of the Board
By: /s/ UDAY BELLARY
----------------------------------------
Uday Bellary
Vice President, Finance,
Chief Financial Officer and
Assistant Secretary
(Principal Financial and
Accounting Officer)
17
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