<PAGE>
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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
----------------
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 2000
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934
For the transition period from to
Commission file number: 000-24360
COBALT NETWORKS, INC.
(Exact name of registrant as specified in its charter)
<TABLE>
<S> <C>
Delaware 77-0440751
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
</TABLE>
555 Ellis Street, Mountain View, CA 94043
(Address of Principal Executive Offices) (Zip Code)
Registrant's telephone number, including area code: (650) 623-2500
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 and Exchange Act
of 1934 during the preceding 12 months (or for 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 [_]
As of March 31, 2000, 28,324,000 shares of common stock of the Registrant
were outstanding.
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<PAGE>
COBALT NETWORKS, INC.
<TABLE>
<S> <C>
PART I--FINANCIAL INFORMATION............................................... 3
ITEM 1. FINANCIAL STATEMENTS (unaudited).................................. 3
CONDENSED CONSOLIDATED BALANCE SHEETS................................... 3
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS.......................... 4
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS.......................... 5
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS.................... 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS...................................... 9
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT
MARKET RISK.............................................................. 27
PART II--OTHER INFORMATION.................................................. 28
ITEM 1. LEGAL PROCEEDINGS................................................. 28
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS......................... 28
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.................................. 28
</TABLE>
2
<PAGE>
PART I--FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
March 31, December 31,
2000 1999(1)
--------- ------------
<S> <C> <C>
ASSETS
------
Current assets:
Cash and cash equivalents............................. $ 85,059 $141,777
Short-term investments................................ 50,194 --
Accounts receivable, net of allowance................. 7,229 6,187
Inventories........................................... 682 714
Other current assets.................................. 2,787 1,494
-------- --------
Total current assets................................ 145,951 150,172
Property and equipment, net............................. 1,825 1,685
-------- --------
Total assets........................................ $147,776 $151,857
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Current liabilities:
Notes payable, current................................ $ 45 $ 44
Accounts payable...................................... 9,836 15,101
Accrued liabilities................................... 6,913 4,611
Deferred margin on distributor inventory.............. 1,513 1,305
-------- --------
Total current liabilities........................... 18,307 21,061
Notes payable........................................... 29 40
-------- --------
Total liabilities................................... 18,336 21,101
-------- --------
Stockholders' equity:
Preferred Stock....................................... -- --
Common Stock.......................................... 28 28
Additional paid-in capital............................ 174,500 174,462
Unearned stock compensation........................... (5,209) (6,444)
Notes receivable from stockholders.................... (456) (450)
Accumulated deficit................................... (39,423) (36,840)
-------- --------
Total stockholders' equity.......................... 129,440 130,756
-------- --------
Total liabilities and stockholders' equity.......... $147,776 $151,857
======== ========
</TABLE>
(1) The information in this column was derived from the Company's audited
financial statements for the fiscal year ended December 31, 1999.
See Notes to Condensed Consolidated Financial Statements
3
<PAGE>
COBALT NETWORKS, INC.
CONDENSED CONSOLIDATED STATEMENT OF OPERATIONS
(in thousands, except per share amounts)
(unaudited)
<TABLE>
<CAPTION>
Three months
ended
-----------------
March 31, April
2000 2, 1999
--------- -------
<S> <C> <C>
Net revenues................................................ $12,033 $ 2,634
Cost of revenues............................................ 6,716 2,002
------- -------
Gross profit............................................ 5,317 632
------- -------
Operating expenses:
Research and development.................................. 1,630 1,397
Sales and marketing....................................... 5,222 2,753
General and administrative................................ 1,578 621
Amortization of stock compensation........................ 1,235 140
------- -------
Total operating expenses................................ 9,665 4,911
------- -------
Loss from operations........................................ (4,348) (4,279)
Interest income (expense), net.............................. 1,765 (128)
------- -------
Net loss.................................................... (2,583) (4,407)
Accretion of Preferred Stock to Redemption Value............ -- (799)
------- -------
Net loss attributable to holders of Common Stock............ $(2,583) $(5,206)
======= =======
Net loss attributable to holders of Common Stock per share:
Basic and diluted......................................... $ (0.09) $ (1.62)
======= =======
Basic and diluted weighted average shares outstanding....... 27,464 3,206
======= =======
</TABLE>
See Notes to Condensed Consolidated Financial Statements
4
<PAGE>
COBALT NETWORKS, INC.
CONDENSED CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands)
(unaudited)
<TABLE>
<CAPTION>
Three months ended
-------------------
March 31, April 2,
2000 1999
--------- --------
<S> <C> <C>
Cash flows from operating activities:
Net loss.................................................. $ (2,583) $(4,407)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation.......................................... 180 165
Amortization of stock compensation.................... 1,235 140
Non-cash interest (income) expense.................... (6) 77
Changes in assets and liabilities:
Accounts receivable................................. (1,042) (236)
Inventories......................................... 32 (78)
Other current assets................................ (93) (57)
Accounts payable.................................... (5,265) (178)
Accrued liabilities................................. 2,302 717
Deferred margin on distributor inventory............ 208 161
-------- -------
Net cash used in operating activities............. (5,032) (3,696)
-------- -------
Cash flows used in investing activities:
Acquisition of property and equipment..................... (320) (184)
Advances made to Chili!Soft, Inc.......................... (1,200) --
Purchases of short-term investments....................... (50,194) --
-------- -------
Net cash used in investing activities............. (51,714) (184)
-------- -------
Cash flows from financing activities:
Proceeds from exercise of stock options................... 38 --
Principal payments on notes payable....................... (10) (12)
Proceeds from borrowings under convertible promissory
notes.................................................... -- 3,741
-------- -------
Net cash provided by financing activities......... 28 3,729
-------- -------
Net decrease in cash and cash equivalents................. (56,718) (151)
Cash and cash equivalents at beginning of period.......... 141,777 2,090
-------- -------
Cash and cash equivalents at end of period................ $ 85,059 $ 1,939
======== =======
</TABLE>
See Notes to Condensed Consolidated Financial Statements
5
<PAGE>
COBALT NETWORKS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Interim Results
The interim unaudited financial information of Cobalt Networks, Inc. (the
"Company") is prepared in conformity with generally accepted accounting
principles and such principles are applied on a basis consistent with the
audited financial information contained in the Annual Report on Form 10-K
filed with the Securities and Exchange Commission on March 30, 2000. The
financial information included herein has been prepared by management, without
audit by independent accountants who do not express an opinion thereon, and
should be read in conjunction with the audited financial statements contained
in the Company's Annual Report on Form 10-K for the fiscal year ended December
31, 1999. The condensed consolidated balance sheet as of December 31, 1999,
has been derived from, but does not include all the disclosures contained in,
the audited financial statements for the year ended December 31, 1999. The
information furnished includes all adjustments and accruals consisting only of
normal recurring accrual adjustments that are, in the opinion of management,
necessary for a fair presentation of results for the interim periods. Certain
information or footnote disclosure normally included in financial statements
prepared in accordance with generally accepted accounting principles has been
condensed or omitted pursuant to the rules and regulations of the Securities
and Exchange Commission.
The interim results are not necessarily indicative of the results of
operations for the full fiscal year ending December 29, 2000.
2. Balance Sheet Components (in thousands):
<TABLE>
<CAPTION>
March 31, December 31,
2000 1999
--------- ------------
<S> <C> <C>
Inventories:
Finished goods....................................... $ 668 $ 517
Raw materials........................................ 14 197
------ -------
Total.............................................. $ 682 $ 714
====== =======
Property and equipment:
Computer equipment................................. $1,432 $ 1,337
Office equipment and fixtures...................... 669 619
Leasehold improvements............................. 635 485
------ -------
2,736 2,441
Less: Accumulated depreciation..................... (911) (756)
------ -------
$1,825 $ 1,685
====== =======
Accrued liabilities:
Employee benefits.................................. $2,314 $ 1,539
Reserve for sales returns.......................... 2,663 1,817
Warranty........................................... 1,079 885
Other.............................................. 857 370
------ -------
$6,913 $ 4,611
====== =======
</TABLE>
3. Net Loss Per Share
The Company computes net loss per share in accordance with Statement of
Financial Accounting Standards ("SFAS") No. 128, "Earnings per Share" and SEC
Staff Accounting Bulletin ("SAB") No. 98. Under the provisions of SFAS No. 128
and SAB 98, basic net loss per share is computed by dividing the net loss
available to holders of Common Stock for the period by the weighted average
number of shares of Common Stock outstanding during the period. Weighted
average shares exclude shares of Common Stock subject to repurchase by the
Company ("restricted shares"). Diluted net loss per share is computed by
dividing the net loss available to holders of Common Stock for the period by
the weighted average number of shares of Common Stock and
6
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COBALT NETWORKS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Potential Common Stock outstanding during the period, if dilutive. Because the
inclusion of Potential Common Stock would be anti-dilutive, diluted net loss
per share is the same as basic net loss per share. Potential Common Stock
includes unvested restricted shares of Common Stock and incremental shares of
Common Stock issuable upon the exercise of stock options and warrants and upon
conversion of Series A and B Mandatorily Redeemable Convertible Preferred
Stock (with respect to the three months ended April 2, 1999).
The following table sets forth the computation of basic and diluted net loss
per share for the periods indicated (in thousands, except per share data):
<TABLE>
<CAPTION>
March 31, April 2,
2000 1999
--------- --------
<S> <C> <C>
Numerator:
Net loss attributable to holders of Common Stock...... $(2,583) $(5,206)
======= =======
Denominator:
Weighted average shares outstanding................... 28,352 4,798
Weighted average shares of Common Stock subject to
repurchase........................................... (888) (1,592)
------- -------
Denominator for basic and diluted calculation......... 27,464 3,206
======= =======
Basic and diluted net loss per share attributable to
holders of Common Stock.............................. $ (0.09) $ (1.62)
======= =======
</TABLE>
The effects of options to purchase 4,106,000 and 1,764,000 shares of Common
Stock at an average exercise price of $8.50 and $0.34 per share at March 31,
2000 and April 2, 1999, respectively, and warrants to purchase 243,000 shares
of Common Stock at $3.70 per share at March 31, 2000 and warrants to purchase
204,000 shares of Preferred Stock at an average exercise price of $1.24; and
7,271,000 shares of Mandatorily Redeemable Convertible Preferred Stock at
April 2, 1999, have not been included in the computation of diluted net loss
per share as their effect would have been anti-dilutive.
4. New Accounting Pronouncements
In December 1999, the staff of the Securities and Exchange Commission issued
Staff Accounting Bulletin ("SAB") 101, "Revenue Recognition," which outlines
the basic criteria that must be met to recognize revenue and provides guidance
for presentation of revenue and for disclosure related to revenue recognition
policies in financial statements filed with Securities and Exchange
Commission. The effective date of this pronouncement is the second quarter of
the fiscal year beginning after December 15, 1999. We believe that adopting
SAB 101 will not have a material impact on our financial position and results
of operations.
In March 2000 the Financial Accounting Standards Board ("FASB") issued FASB
Interpretation No. 44 ("FIN 44") Accounting for Certain Transactions involving
Stock Compensation an interpretation of APB Opinion No. 25. FIN 44 clarifies
the application of Opinion 25 for (a) the definition of employee for purposes
of applying Opinion 25, (b) the criteria for determining whether a plan
qualifies as a noncompensatory plan, (c) the accounting consequence of various
modifications to the terms of a previously fixed stock option or award, and
(d) the accounting for an exchange of stock compensation awards in a business
combination.
FIN 44 is effective July 1, 2000, but certain conclusions cover specific
events that occur after either December 15, 1998 or January 12, 2000.
Management believes that the impact of FIN 44 will not have a material effect
on the financial position or results of operations of the Company.
7
<PAGE>
COBALT NETWORKS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS --(Continued)
In June 1998, the FASB issued SFAS No. 133 "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 establishes methods of
accounting for derivative financial instruments and hedging activities related
to those instruments as well as other hedging activities. In July 1999, the
FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging
Activities--Deferral of the Effective Date of FASB Statement No. 133." SFAS
No. 137 deferred the effect of SFAS No. 133 until fiscal year beginning after
June 15, 2000. We will adopt SFAS No. 133 in 2001. To date, we have not
engaged in derivative or hedging activities. We are unable to predict the
impact of adopting SFAS No 133 if we were to engage in derivative and hedging
activities in the future.
5. Litigation and Other Events
In December 1998, CUBE Computer Corporation filed a lawsuit against the
Company in the United States District Court for the Southern District of New
York for trademark infringement. CUBE, an original equipment manufacturer of
personal computers, argued that this alleged infringement resulted from the
Company's use of "Qube" in connection with its products. In December 1999, the
Company entered into a settlement agreement with Cube Computer. We acquired
certain trademark rights for a one-time payment of $4.1 million, not including
related legal costs.
6. Segment information
During each period presented, the Company operated in a single business
segment, primarily in the United States, Japan and Europe.
7. Comprehensive Income
To date, the Company has not had any transactions that are required to be
reported in comprehensive income (loss) as compared to its reported net loss.
8. Acquisition of Chili!Soft Inc.
On March 22, 2000, Cobalt entered into a definitive agreement to acquire
Chili!Soft, Inc., a provider of web page development technology. Cobalt will
acquire all outstanding stock and assume all stock options of Chili!Soft in
exchange for 1,150,000 shares of Cobalt's common stock. The transaction is
expected to be accounted for as a purchase business combination and is
expected to close during the three months ended June 30, 2000. In conjunction
with this agreement, the Company has advanced $1.2 million to Chili!Soft, Inc.
8
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Certain statements in this "Management's Discussion and Analysis of
Financial Condition and Results of Operations" are forward looking statements.
These statements relate to future events or our future financial performance
and involve known and unknown risks, uncertainties and other factors that may
cause our or our industry's actual results, levels of activity, performance or
achievements to be materially different from any future results, levels of
activity, performance or achievements expressed or implied by the forward-
looking statements. These risks and other factors include those listed under
"Factors Affecting Future Operating Results" and elsewhere in this quarterly
report on Form 10-Q. In some cases, you can identify forward-looking
statements by terminology such as "may", "will", "should", "expects", "plans",
"anticipates", "believes", "estimates", "predicts", "potential", "continue" or
the negative of these terms or other comparable terminology. These statements
are only predictions. Actual events or results may differ materially. In
evaluating these statements, you should specifically consider various factors,
including the risks outlined under "Factors Affecting Future Operating
Results". These factors may cause our actual results to differ materially from
any forward-looking statement.
Overview
Since our inception in 1996, we have incurred substantial costs to develop
our technology and products, to recruit and train personnel for our
engineering, sales and marketing and technical support departments, and to
establish an administrative organization. As a result, we had an accumulated
deficit of $39.4 million as of March 31, 2000. We anticipate that our
operating expenses will increase substantially in the future as we increase
our sales and marketing operations, develop new channels, fund greater levels
of research and development, broaden our technical support and improve our
operational and financial systems. Accordingly, we will need to generate
significant revenues to achieve profitability. In addition, our limited
operating history makes it difficult for us to predict future operating
results and, accordingly, there can be no assurance that we will sustain
revenue growth or achieve profitability in future quarters.
We currently derive substantially all of our net revenues from sales of a
limited number of products. In the three months ended March 31, 2000 and April
2, 1999, respectively, 93% and 86% of our net revenues were derived from sales
of our Cobalt Qube and Cobalt RaQ products. Although we began selling our
Cobalt Cache products in 1998 and Cobalt NAS products in 1999, we expect that
a substantial majority of our revenues in 2000 will continue to be generated
from sales of our Cobalt Qube and Cobalt RaQ products.
We sell our products directly through our sales force and indirectly through
channel partners that include distributors, resellers and system integrators.
Indirect sales are a majority of our total sales and account for substantially
all of our sales outside of the United States. In the three months ended March
31, 2000 and April 2, 1999, respectively, 31% and 19% of our net revenues were
from direct sales. The increase in direct sales as a percentage of net
revenues is due to focused efforts by our direct sales force. Direct sales in
absolute dollars rose to $3.7 million in the three months ended March 31, 2000
from $501,000 in the three months ended April 2, 1999.
Indirect sales were 69% and 81% of our net revenues in the three months
ended March 31, 2000 and April 2, 1999, respectively. In the three months
ended March 31, 2000, sales to two of our distributors, Nissho Electronics and
Tech Data, accounted for 15% and 11% of our net revenues, respectively. In the
three months ended April 2, 1999, approximately 15% of our net revenues came
from sales to Nissho Electronics. While we are seeking to diversify our
customer base and expand the portion of our net revenues which is derived from
sales through various channels, we anticipate that our operating results will
continue to depend on volume sales to a relatively small number of channel
partners.
For direct sales and sales to resellers and system integrators, we record
revenues upon shipment. We recognize revenues on sales to distributors at the
time products are sold through to end-users. As a result, we defer recognition
of gross profit, captioned on our balance sheet as "deferred margin on
distributor inventory"
9
<PAGE>
until we record the revenues and cost of revenues on a sell-through basis.
Revenues from service obligations are deferred and recognized on a straight-
line basis over the contractual period.
Our customers and distributors are generally able to cancel their orders at
any time prior to shipment without penalty. In addition, Cobalt is typically
able to fulfill a majority of orders in less than seven days. Consequently,
backlog measured on any given day is not a meaningful predictor of our
prospects in the ensuing weeks and months.
We provide allowances for estimated sales returns and warranty costs at the
time of revenue recognition based on our historical results. To date, our
actual sales returns and warranty expenditures have each been less than 5% of
net revenues in any quarter. However, our past product return and warranty
experience may not be indicative of future product return rates and warranty
costs.
Although we enter into general sales contracts with our channel partners,
none of our channel partners is obligated to purchase any amount of our
products pursuant to these contracts. We rely on our channel partners to
submit purchase orders for specific quantities of our products.
Our gross profit is affected by:
. fluctuations in demand for our products;
. the mix of products sold;
. the mix of sales channels through which our products are sold;
. the mix of sales within and outside North America;
. the timing and size of customer orders;
. new product introductions by us and our competitors;
. changes in our pricing policies;
. changes in component costs; and
. the volume manufacturing prices we are able to obtain from our contract
manufacturers.
We recorded unearned stock compensation on our balance sheet of $8.9 million
in connection with stock options granted to our employees between July 1, 1998
and October 1, 1999. We are amortizing this stock compensation over the
vesting period of the related options. During the three months ended March 31,
2000, we amortized $1.2 million of stock compensation. During the remainder of
2000, we expect to amortize stock compensation of:
<TABLE>
<CAPTION>
Expected
Amortization
of Stock
Compensation
------------
(in
thousands)
<S> <C>
First Quarter Ended
June 30, 2000................................................... $1,280
September 29, 2000.............................................. $ 940
December 29, 2000............................................... $ 690
</TABLE>
We then expect aggregate per quarter stock compensation amortization of
between $533,000 and $318,000 during 2001, between $262,000 and $116,000
during 2002 and between $78,000 and $10,000 during 2003. The amount of stock
compensation expense to be recorded in future periods could decrease in the
event of the forfeiture of options for which accrued but unvested compensation
has been recorded.
10
<PAGE>
Prior to April 26, 1999, our net loss attributable to holders of common
stock includes accretion charges to increase over time the carrying amount of
our mandatorily redeemable convertible preferred stock to the amount we would
be required to pay if the preferred stock were to be redeemed. As of April 26,
1999, we ceased recording these charges because we changed the terms of the
preferred stock to limit the redemption amount to its original issue price
plus accrued dividends.
We had 162 employees as of March 31, 2000, a substantial increase from 77
employees as of April 2, 1999. This rapid growth has placed significant
demands on our management and operational resources. In order to manage our
growth effectively, we must implement and improve our operational systems,
procedures and controls on a timely basis. We could experience a decline in
our revenues and operating results if:
. our total revenues do not increase relative to our operating expenses;
. our management systems do not expand to meet increasing demands;
. we fail to attract, assimilate and retain qualified personnel, or
. our management otherwise fails to manage our expansion effectively.
Until January 1, 1999, we operated on calendar fiscal quarters and a fiscal
year ended December 31. Beginning in 1999, we began to operate on thirteen
week fiscal quarters ending on a Friday. Therefore, in 2000 our fiscal
quarters end on March 31, June 30, September 29 and December 29.
Results of Operations--Three Months Ended March 31, 2000 and April 2, 1999
Net Revenues
Net revenues increased to $12.0 million in the three months ended March 31,
2000 from $2.6 million in the three months ended April 2, 1999. The 362%
increase in net revenues was primarily the result of an increase in sales to
new and existing customers of our Cobalt Qube and Cobalt RaQ product lines,
which together represented 93% and 86% of net revenue in the three months
ended March 31, 2000 and April 2, 1999, respectively. We expect that the
majority of our revenues in the future may continue to be generated from sales
of our Cobalt Qube and Cobalt RaQ products.
Net revenues from sales to international customers increased to $6.2
million, or 52% of net revenues, in the three months ended March 31, 2000 from
$1.5 million, or 59% of net revenues in the three months ended April 2, 1999.
The increase in international revenues absolute dollars was due to expansion
of our operations in Japan, Europe and other countries. One factor relating to
the increase in net revenues from sales outside the United States was our
introduction of various local language user interfaces including Japanese,
German, French and Chinese. Our net revenues from sales outside the United
States were primarily denominated in U.S. dollars. The effect of foreign
exchange fluctuations did not have a significant impact on our results.
Revenues in past periods may not be indicative of future revenues, which may
be affected by those factors discussed in "Factors Affecting Future Operating
Results", as well as other factors.
Cost of Revenues and Gross Profit
Cost of revenues includes technology license fees, manufacturing costs,
manufacturing personnel expenses, packaging and shipping costs and warranty
expenses. We have outsourced our manufacturing and repair operations.
Accordingly, in the three months ended March 31, 2000 approximately 77% and in
the three months ended April 2, 1999 approximately 56% of our cost of revenues
consists of payments to our contract manufacturers. Cost of revenues increased
to $6.7 million in the three months ended March 31, 2000 from $2.0 million in
the three months ended April 2, 1999. The increase in cost of revenues was
primarily due to increased sales volume and the introduction of new products.
We believe that our cost of revenues will increase in absolute dollars in
future periods but may continue to fluctuate as a percentage of net revenues
due to factors including changes in product mix, and material and labor costs.
11
<PAGE>
Gross profit increased to $5.3 million in the three months ended March 31,
2000 from $632,000 in the three months ended April 2, 1999. Gross profit as a
percentage of net revenues increased to 44% in the three months ended March
31, 2000 from 24% in the three months ended April 2, 1999. The increase in
gross profit was primarily due to increased sales volume and the introduction
of new products. We believe that the rate of growth of the increase in gross
profit will not be sustainable in future quarters.
Research and Development
Research and development expenses consist primarily of salaries and related
expenses for personnel engaged in research and development including the
development of application and server management software, material costs for
prototype and test units and other expenses related to the design,
development, testing and enhancements of our products. We expense all of our
research and development costs as they are incurred. Research and development
expenses increased to $1.6 million in the three months ended March 31, 2000
from $1.4 million in the three months ended April 2, 1999. The increase
resulted from the hiring of additional research and development personnel. As
net revenues increased, research and development expenses declined as a
percentage of net revenues to 14% in the three months ended March 31, 2000
from 53% in the three months ended April 2, 1999. We believe that a
significant level of investment in product research and development is
required to remain competitive. Accordingly, we expect to continue to devote
substantial resources to product research and development such that research
and development expenses will increase in absolute dollars but may continue to
fluctuate as a percentage of net revenues.
Sales and Marketing
Sales and marketing expenses consist primarily of salaries, commissions and
related expenses for personnel engaged in marketing, sales and customer
support functions, as well as costs associated with trade shows, promotional
activities, advertising and public relations. Sales and marketing expenses
increased to $5.2 million in the three months ended March 31, 2000 from $2.8
million in the three months ended April 2, 1999. The increase in sales and
marketing expenses was due to the expansion of our sales and marketing
efforts, our branding campaign, advertising and tradeshows, and the hiring of
additional sales and marketing personnel. As net revenues increased, sales and
marketing expenses declined as a percentage of net revenues to 43% in the
three months ended March 31, 2000 from 105% in the three months ended April 2,
1999. We intend to expand our sales and marketing operations and efforts
substantially, both domestically and internationally, in order to increase
market awareness and to generate sales of our products. Accordingly, we expect
our sales and marketing expenses to increase in absolute dollars but may
continue to fluctuate as a percentage of net revenues.
General and Administrative
General and administrative expenses consist primarily of salaries and
related expenses for executive, finance, accounting, information technology,
facilities and human resources personnel, recruiting expenses, professional
fees and costs associated with expanding our information systems. General and
administrative expenses increased to $1.6 million in the three months ended
March 31, 2000 from $621,000 in the three months ended April 2, 1999. The
increase was due to hiring of additional administrative personnel and
increased rent. As net revenues increased, general and administrative expenses
declined as a percentage of net revenues to 13% in the three months ended
March 31, 2000 from 24% in the three months ended April 2, 1999. We expect
these expenses to increase in absolute dollars but may continue to fluctuate
as a percentage of net revenues as we add personnel and incur additional costs
related to the growth of our business, expansion of our information
infrastructure and our operation as a public company.
Amortization of Stock Compensation
In connection with the grant of stock options to employees for the period
from July 1, 1998 to October 1, 1999, we recorded unearned stock compensation
within stockholders' equity of approximately $8.9 million, representing the
difference between the estimated fair value of the common stock for accounting
purposes and
12
<PAGE>
the option exercise price of these options at the date of grant. We recorded
$1.2 million of stock compensation amortization during the three months ended
March 31, 2000 and $140,000 of stock compensation amortization in the three
months ended April 2, 1999. The amount of stock compensation expense to be
recorded in future periods could decrease if options for which accrued but
unvested compensation has been recorded are forfeited. During the three months
ended March 31, 2000, no unearned stock compensation costs were reversed upon
the cancellation of options.
Interest Income (Expense), Net
Interest income (expense), net includes income from our cash investments net
of expenses related to our debt and lease financing obligations. We had net
interest income of $1.8 million in the three months ended March 31, 2000 and
net interest expense of $128,000 in the three months ended April 2, 1999. The
growth in net interest income from the three months ended March 31, 2000 was
primarily due to an increase in interest income earned on proceeds from our
initial public offering of common stock.
Liquidity and Capital Resources
Since inception, we have financed our operations primarily through private
sales of mandatorily redeemable convertible preferred stock, proceeds from our
initial public offering of common stock, the issuance of convertible notes,
equipment financings and net revenues generated from product sales. As of
March 31, 2000, we had cash and cash equivalents of $85.0 million, short-term
investments of $50.2 million, an accumulated deficit of $39.4 million and
working capital of $127.6 million.
Our operating activities used cash of $5.0 million in the three months ended
March 31, 2000 and $3.7 million in the three months ended April 2, 1999. Cash
used in operating activities during the three months ended March 31, 2000 was
attributable to a net loss of $2.6 million, and increases in accounts
receivable of $1.0 million and a decrease in accounts payable of $5.3 million,
but was offset in part by increases in accrued liabilities of $2.3 million,
deferred margin on distributor inventory of $208,000, depreciation,
amortization of stock compensation and other non-cash expenses aggregating
$1.4 million. Cash used in operating activities for the three months ended
April 2, 1999 was primarily attributable to net losses of $4.4 million. In the
three months ended April 2, 1999, cash used in operating activities was also
attributable to increases in accounts receivable, inventories and accounts
payable of $236,000, $78,000 and 178,000, respectively, offset in part by
increases in accrued expenses of $717,000.
Our investing activities used cash of $51.7 million in the three months
ended March 31, 2000 and $184,000 in the three months ended April 2, 1999.
Cash used in investing activities for the three months ended March 31, 2000
was primarily attributable to purchases of short-term investments and advances
to Chili!Soft, Inc. for working capital. The decreases in the three months
ended April 2, 1999 reflect purchases of computer equipment and other fixed
assets.
Our financing activities provided cash of $28,000 in the three months ended
March 31, 2000 and $3.7 million in the three months ended April 2, 1999. The
increases in the three months ended March 31, 2000 resulted primarily from the
net proceeds from the issuances of common stock to our employees upon the
exercise of stock options. The increases in the three months ended April 2,
1999 resulted from the proceeds from the issuance of convertible notes.
From inception, we have made capital expenditures of $3.2 million to support
our research and development, sales and marketing and administrative
activities. We expect to have capital expenditures of approximately $1.8
million for the next twelve months. We also anticipate that our capital
expenditures will increase over the next several years as we expand our
facilities and acquire equipment to support expansion of our sales and
marketing and research and development activities.
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In September 1998, we entered into an equipment lease financing agreement
with available borrowings of up to $1.0 million at an interest rate of 10.95%
per annum secured by our equipment, machinery and fixtures. We are required to
repay advances under the line in 34 equal installments. As of March 31, 2000
and April 2, 1999, respectively, we had outstanding borrowings of $74,000 and
$114,000 under this lease line.
We intend to continue to invest heavily in the development of new products
and enhancements to our existing products. Our future liquidity and capital
requirements will depend upon numerous factors, including:
. the costs and timing of expansion of sales and marketing activities;
. the costs and timing of expansion of product development efforts and the
success of these development efforts;
. the extent to which our existing and new products gain market
acceptance;
. the level and timing of license revenues;
. the costs involved in maintaining and enforcing intellectual property
rights;
. market developments;
. available borrowings under line of credit arrangements; and
. other factors.
We believe that our current cash and investment balances and any cash
generated from operations and future debt financing, will be sufficient to
meet our operating and capital requirements for at least the next 12 months.
However, it is possible that we may require additional financing within this
period. We have no current plans, and we are not currently negotiating, to
obtain additional financing. The factors described above will affect our
future capital requirements and the adequacy of our available funds. In
addition, even if we raise sufficient funds to meet our anticipated cash needs
during the next 12 months, we may need to raise additional funds beyond this
time. We may be required to raise those funds through public or private
financings, strategic relationships or other arrangements. We cannot assure
you that such funding, if needed, will be available on terms attractive to us,
or at all. Furthermore, any additional equity financing may be dilutive to
stockholders, and debt financing, if available, may involve restrictive
covenants. If we fail to raise capital when needed, our failure could have a
negative impact on our ability to pursue our business strategy and achieve and
maintain profitability.
Recent Accounting Pronouncements
In December 1999, the staff of the Securities and Exchange Commission issued
Staff Accounting Bulletin ("SAB") 101, "Revenue Recognition," which outlines
the basic criteria that must be met to recognize revenue and provides guidance
for presentation of revenue and for disclosure related to revenue recognition
policies in financial statements filed with Securities and Exchange
Commission. The effective date of this pronouncement is the second quarter of
the fiscal year beginning after December 15, 1999. We believe that adopting
SAB 101 will not have a material impact on our financial position and results
of operations.
In March 2000 the Financial Accounting Standards Board ("FASB") issued FASB
Interpretation No. 44 ("FIN 44") Accounting for Certain Transactions involving
Stock Compensation an interpretation of APB Opinion No. 25. FIN 44 clarifies
the application of Opinion 25 for (a) the definition of employee for purposes
of applying Opinion 25, (b) the criteria for determining whether a plan
qualified as a noncompensatory plan, (c) the accounting consequence of various
modifications to the terms of a previously fixed stock option or award, and
(d) the accounting for an exchange of stock compensation awards in a business
combination.
FIN 44 is effective July 1, 2000, but certain conclusions cover specific
events that occur after December 15, 1998, or January 12, 2000. Management
believes that the impact of FIN 44 will not have a material effect on the
financial position or results of operations of the Company.
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In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133 "Accounting for
Derivative Instruments and Hedging Activities." SFAS No. 133 establishes
methods of accounting for derivative financial instruments and hedging
activities related to those instruments as well as other hedging activities.
In July 1999, the FASB issued SFAS No. 137, "Accounting for Derivative
Instruments and Hedging Activities--Deferral of the Effective Date of FASB
Statement No. 133." SFAS No. 137 deferred the effect of SFAS No. 133 until
fiscal year beginning after June 15, 2000. We will adopt SFAS No. 133 in 2001.
To date, we have not engaged in derivative or hedging activities. We are
unable to predict the impact of adopting SFAS No 133 if we were to engage in
derivative and hedging activities in the future.
Factors That May Affect Future Operating Results
We only began selling our products in March of 1998 and, as a result, you may
have difficulty evaluating our business and operating results.
Our company was founded in October 1996, and we did not begin selling our
products until March 1998. You should consider the risks and difficulties we
may encounter as an early stage company in the new and rapidly evolving server
appliance market. Our limited historical financial performance may make it
difficult for you to evaluate the success of our business to date and to
assess its future viability. We cannot be certain that our business strategy
will be successful.
We have a history of losses and may experience losses in the future, which
could result in the market price of our common stock declining.
Since our inception, we have incurred significant net losses including net
losses of $2.6 million in the three months ended March 31, 2000 and $5.2
million in the three months ended April 2, 1999. In addition, we had an
accumulated deficit of $39.4 million as of March 31, 2000.
We expect to continue to incur significant product development, sales and
marketing and administrative expenses. As a result, we will need to generate
significant revenues to achieve profitability. We cannot be certain that we
will achieve profitability in the future or, if we achieve profitability, to
sustain it. If we do not achieve and maintain profitability, the market price
for our common stock may decline, perhaps substantially.
We anticipate that our expenses will increase substantially in the next 12
months as we:
. increase our direct sales and marketing activities, particularly by
expanding our direct sales forces;
. develop our technology, expand our existing product lines and create and
market additional server appliance products;
. make additional investments to develop our brand;
. expand our distribution and reseller channels;
. pursue original equipment manufacturing relationships; and
. implement additional internal systems, develop additional infrastructure
and hire additional management to keep pace with our growth.
Any failure to significantly increase our revenues as we implement our
product and distribution strategies would also harm our ability to achieve and
maintain profitability and could negatively impact the market price of our
common stock.
We may not be able to sustain our current revenue growth rates, which could
cause our stock price to decline.
Although our revenues grew rapidly in the three months ended March 31, 2000
and April 2, 1999, we do not believe that we will maintain this rate of
revenue growth because we started from a small base of revenue, and it is
difficult to maintain high percentage increases over a larger revenue base. In
addition, growing
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competition, the incremental manner in which customers implement server
appliances and our inexperience in selling our products to small- to medium-
sized organizations could also affect our revenue growth. Any significant
decrease in our rate of revenue growth would likely result in a decrease in
our stock price.
Because our ability to accurately forecast our quarterly sales is limited,
our costs are relatively fixed in the short term and we expect our business
to be affected by seasonality, our quarterly operating results and our stock
price may fluctuate.
Because of our limited operating history and the new and rapidly evolving
market for our server appliances, our ability to accurately forecast our
quarterly sales is limited, which makes it difficult to predict the quarterly
revenues that we will recognize. In addition, we cannot forecast operating
expenses based on historical results, and most of our costs are for personnel
and facilities, which are relatively fixed in the short term. If we have a
shortfall in revenues in relation to our expenses, we may be unable to reduce
our expenses quickly enough to avoid lower quarterly operating results. We do
not know whether our business will grow rapidly enough to absorb the costs of
these employees and facilities. As a result, our quarterly operating results
could fluctuate, and such fluctuation could adversely affect the market price
of our common stock.
In addition, we expect to experience seasonality in the sales of our
products. For example, we expect that sales may decline during summer months,
particularly in Asian and European markets. We generally anticipate sales to
be lower in our first fiscal quarter due to patterns in the capital budgeting
and purchasing cycles of our current and prospective customers. These seasonal
variations in our sales may lead to fluctuations in our quarterly operating
results. It is difficult for us to evaluate the degree to which this
seasonality may affect our business because our growth may have largely
overshadowed this seasonality in recent periods.
We have relied and expect to continue to rely on sales of our Cobalt Qube and
Cobalt RaQ products for our revenues, and a decline in sales of these
products could cause our revenues to fall.
Historically, we have derived substantially all of our revenues from sales
of our Cobalt Qube and Cobalt RaQ products. During the three months ended
March 31, 2000 and April 2, 1999, sales of Cobalt Qube and Cobalt RaQ products
accounted for approximately 93% and 86% of our total revenues. We expect that
these products will continue to account for a large portion of our total
revenues for at least the next two fiscal years. Any factors adversely
affecting the pricing of or demand for our Cobalt Qube and Cobalt RaQ
products, including competition or technological change, could cause our
revenues to decline and our business to suffer. Factors that may affect the
market acceptance of our products, some of which are beyond our control,
include the following:
. the growth and changing requirements of the server appliance market;
. the performance, quality, price and total cost of ownership of our
products;
. the availability, price, quality and performance of competing products
and technologies; and
. the successful development of our relationships with original equipment
manufacturer customers and existing and potential channel partners.
We may not succeed in developing and marketing new server appliance products,
and our operating results may decline as a result.
We are developing additional server appliance products that use the Linux
operating system, particularly for use by web hosting and application service
providers. Developing new products that meet the needs of web hosting and
application service providers requires significant additional expenses and
development resources. If we fail to successfully develop and market new
products, our operating results will decline.
We introduced our caching products in July 1998 and network attached storage
products in May 1999. To date, these products have accounted for only a
limited portion of our revenues. However, our future growth and profitability
could be affected by our ability to increase sales of our caching and network
attached storage products.
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If we experience any increase in the length of our sales cycle, our quarterly
operating results could become more unpredictable and our stock price may
decline as a result.
We experience sales cycles ranging from three weeks to four months for our
products depending on the identity of the end user and whether the sale is
direct or indirect. If we experience any increase in the length of our sales
cycle, our quarterly operating results could become more unpredictable and our
stock price could decline as a result. Sales of our Cobalt Qube products are
generally limited to one unit per end user and do not involve a lengthy
evaluation cycle, if any. We rely heavily for sales of this product on
indirect selling, where our product is recommended by a reseller or
distributor. If the sales cycle for our Cobalt Qube products becomes longer,
our revenues could become less predictable. Our Cobalt RaQ and Cobalt Cache
products are generally sold to customers who evaluate the products before
committing to purchase them. In addition, for these products, a typical
customer may purchase a small number of units and then incrementally increase
the size of the installation over time. If customers were to implement
enterprise-wide evaluation programs or purchase products for the entire
organization at once, our sales cycle could lengthen and our revenues could be
erratic from quarter to quarter. We do not have enough historical experience
selling our Cobalt NAS products to determine how the sales cycle for these
products will affect our revenues.
If we cannot increase our sales volumes, reduce our costs or introduce higher
margin products to offset anticipated reductions in the average unit price of
our products, our operating results may suffer.
We have not experienced an overall decrease in the average selling prices of
our products. However, we anticipate that as products in the server appliance
market become more commoditized, the average unit price of our products may
decrease in the future. The average unit price of our products may also
decrease in response to changes in product mix, competitive pricing pressures,
new product introductions by us or our competitors or other factors. If we are
unable to offset the anticipated decrease in our average selling prices by
increasing our sales volumes, our revenues will decline. Changes in the mix of
our sales, including the mix between higher margin Cobalt RaQ products and
somewhat lower margin Cobalt Qube products, could adversely affect our
operating results for future quarters. In addition, our margins could be
affected if we invest additional resources in our lower margin Cobalt NAS
products. To maintain our gross margins, we also must continue to reduce the
manufacturing cost of our products. Further, as average unit prices of our
current products decline, we must develop and introduce new products and
product enhancements that sell at higher margins.
Our business is dependent on the adoption of server appliances to perform
discrete tasks for corporate and internet-based computer networks and a
decrease in their rates of adoption could cause the market price for our
common stock to decline as a result of lower revenues or more limited
investor expectations of the size of the market for our products.
We expect that substantially all of our revenues will continue to come from
sales of our server appliance products. As a result, we depend on the growing
use of server appliances to perform discrete tasks for corporate and internet-
based networks. If the role of server appliances does not increase as we
anticipate, or if it in any way decreases, our revenues would decline. We
believe that our expectations for the growth of the server appliance market
may not be fulfilled if customers continue to use general purpose servers. The
role of our server appliances could, for example, be limited if general
purpose servers become better at performing the functions currently being
performed by our server appliances or are offered at a lower cost. This could
force us to lower the prices of our products or result in fewer sales of our
products. In addition, if corporate information technology organizations do
not accept Linux-based operating systems, or if there is a wide acceptance of
alternative operating systems that provide enhanced capabilities, the market
price of our stock could decline due to our lower operating results or
investors' assessment that the growth potential for sales of our products is
limited.
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The server appliance market for web hosting and application service providers
in which we compete is new and unpredictable, and if this market does not
develop and expand as we anticipate, our revenues may not grow. In addition,
consolidation in this market could result in our clients being absorbed into
larger organizations which might not be as receptive to our products.
The market for server appliance products, particularly those for use
primarily by web hosting and application service providers--companies that
provide internet, intranet, extranet and application hosting services to
others--has only recently begun to develop and is evolving rapidly. Because
this market is new, we cannot predict its potential size or future growth
rate. Our revenues may not continue to grow and the market price for our
common stock could decline if the server appliance market does not grow
rapidly over a number of years.
Our Cobalt RaQ products are used primarily by web hosting and application
service providers. Recently, consolidation has begun to occur in the web
hosting and application service provider market, and many large web hosting
and application service providers are acquiring the smaller and the regional
companies. For example, Verio, Inc. acquired our customer, DigitalNATION in
1999. Large web hosting and application service providers that provide hosting
services may not be as receptive to our products, because their buying
programs are more likely to be based on established, proprietary operating
systems and general purpose servers. In addition, we expect that internet
service providers that specialize in providing internet access and non-hosting
services to consumers will not be substantial purchasers of our products.
Small- to medium-sized organizations may not accept server appliances
because they are less likely to be early adopters of new technologies due to
their need for minimal service disruptions. As a result, we believe the rates
of adoption of server appliances for small- to medium-sized organizations are
unpredictable. Our success in generating net revenues in this emerging market
will depend on, among other things, our ability to:
. educate potential end users, original equipment manufacturers and
channel partners about the benefits of server appliances;
. establish and maintain relationships with leading original equipment
manufacturers and maintain and enhance our relationships with our other
channel partners; and
. predict and base our products on technology that ultimately becomes
industry standard.
Because our products use Linux as their operating system, the failure of
Linux developers to enhance and develop the Linux kernel could impair our
ability to release major product upgrades and maintain market share.
We may not be able to release major upgrades of our Cobalt Qube, Cobalt RaQ,
Cobalt Cache and Cobalt NAS products on a timely basis because our products
use Linux as their operating system. The heart of Linux, the Linux kernel, is
maintained by third parties. Linus Torvalds, the original developer of the
Linux kernel, and a small group of independent engineers are primarily
responsible for the development and evolution of the Linux kernel. If this
group of developers fails to further develop the Linux kernel or if Mr.
Torvalds or other prominent Linux developers were to no longer work on the
Linux kernel, we would have to either rely on another party to further develop
the kernel or develop it ourselves. To date we have optimized our Linux-based
operating system based on a version of Red Hat Linux, which we have licensed
for a nominal price. If we were unable to access Red Hat Linux, or Red Hat
Linux were to become substantially more expensive to obtain, we would be
required to spend additional time to obtain a tested, recognized version of
the Linux kernel from another source or develop our own operating system
internally. We cannot predict whether enhancements to the kernel would be
available from reliable alternative sources. We could be forced to rely to a
greater extent on our own development efforts, which would increase our
development expenses and might delay our product release and upgrade
schedules. In addition, any failure on the part of the kernel developers to
further develop and enhance the kernel could stifle the development of
additional Linux-based applications for use with our products.
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We may not succeed if Linux fragments, and application developers do not
develop software for our products.
Our products utilize a version of the Red Hat Linux operating system that we
have optimized for our server appliances. If Linux becomes a proprietary
operating system model, like UNIX or Windows NT, and our products do not use
the predominant Linux operating system, we may not be able to encourage third
party developers to write software applications for use with our products. If
this were to occur, our sales might be limited and our revenues could suffer.
We may be unable to manufacture the targeted volume of our products, or any
products at all, if our outside manufacturers are unable to meet our
manufacturing needs because we have no internal manufacturing capacity.
We rely on contract manufacturers to produce our products. In the future, we
may need to find a new outside manufacturer that can manufacture our products
in higher volume and at lower costs. We may not find a outside manufacturer
that meets our needs. Additionally, qualifying a new outside manufacturer and
commencing volume production is expensive and time consuming. If we are
required or choose to change outside manufacturers, we may lose sales and our
customer relationships may suffer.
We may experience transitional problems if we switched outside manufacturers,
including delays and quality control issues that could cause us to lose sales
and impair our ability to achieve profitability.
Prior to August 1999, almost all of our products were manufactured for us by
a single manufacturer that also provided supply chain management for our
products' components. We experienced problems getting our products
manufactured by this contractor in a timely fashion due in part to the
increase in our volume requirements. In response to these problems, in August
1999 we switched the majority of our manufacturing to SMTC Corp. Although we
believe that SMTC will be capable of satisfying our manufacturing needs in
2000, we cannot be certain that we will not face similar problems in the
future. If we face similar problems in the future, we could lose sales and may
not achieve profitability. If SMTC does not meet our volume and quality
requirements, we may experience increased costs or lose sales to other
vendors.
SMTC is only obligated to supply products to us until August 2000 and only
up to a quantity based on our forecasts. If SMTC experiences delays,
disruptions, capacity constraints or quality control problems in its
manufacturing operations, then product shipments to our customers could be
delayed, which would negatively impact our net revenues, competitive position
and reputation.
We may experience production delays or disruptions if we relocate our
manufacturing to offshore facilities, which could result in lost revenues.
We anticipate that we may relocate our manufacturing operations for sales
outside North America to one of SMTC's offshore manufacturing facilities
during 2000. Additionally, we may consider moving our manufacturing to other
locations or to a different contract manufacturer. We could experience
difficulties and disruptions in the manufacture of our products while we
transition to a new facility. Manufacturing disruption could prevent us from
achieving timely delivery of products and could result in lost revenues.
Because we depend on sole source and limited source suppliers for key
components, we are susceptible to supply shortages that could prevent us from
shipping customer orders on time, if at all, and result in lost sales.
We depend upon single source suppliers for our industry standard processors
and power supplies and our custom printed circuit boards, chassis and sheet
metal parts. We also depend on limited sources to supply several other
industry standard components. We have in the past experienced and may in the
future experience shortages of, or difficulties in acquiring, these
components. If we are unable to buy these components, we will not be able to
manufacture our products on a timely basis or deliver our products to our
customers.
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Because we order components and materials based on rolling forecasts, we may
overestimate or underestimate our component and material requirements, which
could increase our costs or prevent us from meeting customer demand.
We use rolling forecasts based on anticipated product orders to determine
our component requirements. Lead times for materials and components that we
order vary significantly and depend on factors including specific supplier
requirements, contract terms and current market demand for those components.
As a result, our component requirement forecasts may not be accurate. If we
overestimate our component requirements, we may have excess inventory, which
would increase our costs. If we underestimate our component requirements, we
may have inadequate inventory, which could interrupt our manufacturing and
delay delivery of our products to our customers. Any of these occurrences
would negatively impact our business and operating results.
Because we rely on channel partners to sell a majority of our products, our
revenues could decline substantially if our existing channel partners do not
continue to purchase products from us.
We rely on our channel partners who are distributors, such as Ingram Micro,
Merisel and Tech Data, resellers and system integrators to sell a majority of
our products in the United States. A substantial majority of our sales outside
of the United States are through other channel partners, and we rely on Nissho
Electronics to sell a majority of our products in Japan. Sales to distributors
accounted for 69% of our net revenues in the three months ended March 31, 2000
and 81% of our net revenues in the three months ended April 2, 1999. If we
fail to sell our products through our existing channel partners, we would
experience a material decline in revenues. Even if we are successful in
selling our products through new channel partners, the rate of growth of our
net revenues could be materially and adversely affected if our existing
channel partners do not continue to sell a substantial number of our products.
We cannot be certain that we will be able to attract channel partners that
market our products effectively or provide timely and cost-effective customer
support and service. None of our current channel partners are obligated to
continue selling our products. We cannot be certain that any channel partner
will continue to represent our products or that our channel partners will
devote a sufficient amount of effort and resources to selling our products in
their territories.
We may incur significant costs to promote our brand that may not result in
the desired brand recognition by customers or increased sales.
We believe that we need a strong brand to compete successfully. In order to
attract and retain customers, we believe that our brand must be recognized and
viewed favorably by end user customers. Although we intend to advertise and
promote our brand, we cannot be certain that these strategies will be
successful. If we are unable to design and implement effective marketing
campaigns or otherwise fail to promote and maintain our brand, our sales could
decline. Our business may also suffer if we incur excessive expenses in an
attempt to promote and maintain our brand without a corresponding increase in
revenues.
We need to expand our direct and indirect sales channels, and if we fail to
do so, our growth could be limited.
In order to increase market awareness and sales of our products, we will
need to substantially expand our direct and indirect sales operations, both
domestically and internationally. If we fail in this endeavor, our growth will
be limited. To date, we have relied primarily on our direct sales force to
generate demand for our products by regional and national web hosting and
application service providers. Our products require a sophisticated sales
effort targeted at our prospective customers' information technology
departments. We have recently expanded our direct sales force and plan to hire
additional sales personnel. Competition for qualified sales people is intense,
and we might not be able to hire the quality and number of sales people we
require.
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Our expansion to international markets will result in higher personnel costs
and could reduce our operating margins due to the higher costs of
international sales.
We must expand the number of channel partners who sell our products or our
direct international sales presence to significantly increase our
international sales. We may incur higher personnel costs by hiring direct
sales staff that may not result in an increase in our revenues. We may not
realize corresponding increases in operating margins from increases in
international sales, due to the higher costs of these sales. Our sales outside
of the United States represented 52% of our total revenues in the three months
ended March 31, 2000 and 59% of our total revenues in the three months ended
April 2, 1999. To date, we have relied primarily on international channel
partners and have only recently begun to employ direct sales staff outside of
the United States. Even if we are able to successfully expand our direct and
indirect international selling efforts, we cannot be certain that we will be
able to create or increase international market demand for our products.
If we are unable to expand our customer service and support organization, we
may not be able to retain our existing customers and attract new customers.
We currently have a small customer service and support organization and will
need to increase our staff to support new customers and the expanding needs of
our existing customers. If we are unable to expand our customer service and
support organization, we may not be able to retain our existing customers and
attract new customers. Hiring customer service and support personnel is very
competitive in our industry due to the limited number of people available with
the necessary technical skills and understanding of the Linux operating
environment.
We do not have a consulting staff, and our revenues may suffer if customers
demand extensive consulting or other support services.
Our products are designed to require little or no support from us and to be
deployed quickly and easily by our customers. Many of our competitors offer
extensive consulting services in addition to server appliance products. If we
introduced a product that required extensive consulting services for
installation and use or if our customers wanted to purchase from a single
vendor a menu of items that included extensive consulting services, we would
be required to change our business model. We would be required to hire and
train consultants, outsource the consulting services or enter into a joint
venture with another company that could provide those services. If these
events were to occur, our future profits would likely suffer because customers
would choose another vendor or we would incur the added expense of hiring and
retaining consulting personnel.
We may not be able to effectively compete against providers of general
purpose servers or limited purpose servers as a result of their greater
financial resources and brand awareness.
In the market for server appliances, we face significant competition from
larger companies who market general purpose servers or limited purpose servers
and have greater financial resources and name recognition than we do. We
believe that Compaq, Dell, Gateway, Hewlett-Packard, IBM, Sun Microsystems, VA
Linux or other server manufacturers, each of which is also currently competing
with us by manufacturing and selling general purpose servers or limited
purpose servers, could also introduce server products that include the
functionality that we currently provide in our products at lower prices. If
these vendors provide lower cost server appliances that perform comparable
functions to our products coupled with the broader applications of their
existing product lines, our products could become obsolete. Even if the
functionality of the standard features of these products is equivalent to
ours, we face a substantial risk that a significant number of customers would
elect to pay a premium for similar functionality rather than purchase products
from a less well-known vendor.
We may face competition in the future from established companies that have
only recently entered the server appliance market, such as Intel, Novell or
Oracle or from emerging software companies. Barriers to entry in the server
appliance market are relatively low. Increased competition may negatively
affect our business and future operating results by leading to price
reductions, higher selling expenses or a reduction in our market share.
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Our revenues could be reduced if general purpose server manufacturers make
acquisitions in order to join their extensive distribution capabilities with
our smaller competitors' products.
Compaq, Dell, Gateway, Hewlett-Packard, IBM, Sun Microsystems, VA Linux, and
other server manufacturers may not only develop their own server appliance
solutions, but they may also acquire or establish cooperative relationships
with our other current competitors, including smaller private companies.
Because general purpose server manufacturers have significant financial and
organizational resources available, they may be able to quickly penetrate the
server appliance market by leveraging the technology and expertise of smaller
companies and utilizing their own extensive distribution channels. We expect
that the server appliance industry will continue to consolidate. For example,
Whistle Communications was acquired by IBM. It is possible that new
competitors or alliances among competitors may emerge and rapidly acquire
significant market share.
We may sell fewer products if other vendors' products are no longer
compatible with ours or other vendors bundle their products with those of our
competitors and sell them at lower prices.
Our ability to sell our products depends in part on the compatibility of our
products with other vendors' software and hardware products. Developers of
these products may change their products so that they will no longer be
compatible with our products. These other vendors may also decide to bundle
their products with other server appliances for promotional purposes and
discount the sales price of the bundle. If that were to happen, our business
and future operating results could suffer if we were no longer able to offer
commercially viable products.
Server appliance products are subject to rapid technological change due to
changing operating system software and network hardware and software
configurations, and our products could be rendered obsolete by new
technologies.
The server appliance market is characterized by rapid technological change,
frequent new product introductions and enhancements, uncertain product life
cycles, changes in customer demands and evolving industry standards. Our
products could be rendered obsolete if products based on new technologies are
introduced or new industry standards emerge. For example, sales of our
products may be limited if customers widely adopt Windows 2000-based server
appliances, and our products, which do not currently operate on the Windows
2000 platform, fail to provide comparable functionality.
Computer networks in which servers perform functions for other computers,
such as a personal computer on an employee's desk, are inherently complex. As
a result, we cannot accurately estimate the life cycles of our server
appliance products. New products and product enhancements can require long
development and testing periods, which requires us to hire and retain
increasingly scarce, technically competent personnel. Significant delays in
new product releases or significant problems in installing or implementing new
products could seriously damage our business. We have, on occasion,
experienced delays in the scheduled introduction of new and enhanced products
and cannot be certain that we will avoid similar delays in the future.
Our future success depends upon our ability to enhance existing products,
develop and introduce new products, satisfy customer requirements and achieve
market acceptance. We cannot be certain that we will successfully identify new
product opportunities and develop and bring new products to market in a timely
and cost-effective manner.
We may not be able to preserve the value of our products' intellectual
property because we do not have any patents and other vendors could challenge
our other intellectual property rights.
Our products are differentiated from those of our competitors by our
internally developed technology that is incorporated into our products. If we
fail to protect our intellectual property, other vendors could sell products
with features similar to ours, and this could reduce demand for our products.
We protect our intellectual property through a combination of copyright, trade
secret and trademark laws. We have only recently commenced a patent
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program and to date have only filed one patent application. We generally enter
into confidentiality or license agreements with our employees, consultants and
corporate partners, and generally control access to our intellectual property
and the distribution of our server appliances, integrated software,
documentation and other proprietary information. We believe that such measures
afford only limited protection. Others may develop technologies that are
similar or superior to our technology or design around the copyrights and
trade secrets we own. Despite our efforts to protect our proprietary rights,
unauthorized parties may attempt to copy or otherwise obtain and use our
products or technology. Policing unauthorized use of our products is
difficult, and we cannot be certain that the steps we have taken will prevent
misappropriation of our technology, particularly in foreign countries where
the laws may not protect our proprietary rights as fully as those in the
United States. Our means of protecting our proprietary rights may be
inadequate.
We have invested substantial resources in developing our products and our
brand, and our operating results would suffer if we were subject to a
protracted infringement claim or one with a significant damages award.
Substantial litigation regarding intellectual property rights and brand
names exists in our industry. We expect that server appliance products may be
increasingly subject to third-party infringement claims as the number of
competitors in our industry segment grows and the functionality of products in
different industry segments overlaps. We are not aware that our products
employ technology that infringes any proprietary rights of third parties.
However, third parties may claim that we infringe their intellectual property
rights. Any claims, with or without merit, could:
. be time consuming to defend;
. result in costly litigation;
. divert our management's attention and resources;
. cause product shipment delays; or
. require us to enter into royalty or licensing agreements.
These royalty or licensing agreements may not be available on terms
acceptable to us, if at all. A successful claim of product infringement
against us or our failure or inability to license the infringed or similar
technology could adversely affect our business because we would not be able to
sell the impacted product without redeveloping it or incurring significant
additional expenses.
If we were named in a trademark infringement suit in the future, we could be
forced to pay significant monetary damages, a royalty for continuing use of a
trademark or be barred from using certain product names altogether. This could
result in us losing brand equity.
Our recent growth has placed a significant strain on our management systems
and resources and we may be unable to effectively control our costs and
implement our business strategies as a result.
We continue to increase the scope of our operations and have grown our
headcount substantially. As of March 31, 2000 we had a total of 162 employees,
and as of April 2, 1999, we had a total of 77 employees. Our productivity and
the quality of our products may be adversely affected if we do not integrate
and train our new employees quickly and effectively. We also cannot be sure
that our revenues will continue to grow at a sufficient rate to absorb the
costs associated with a larger overall headcount, as well as recruiting-
related expenses.
This growth has placed, and we expect that any future growth we experience
will continue to place, a significant strain on our management, systems and
resources. To manage the anticipated growth of our operations, we may be
required to:
. improve existing and implement new operational, financial and management
information controls, reporting systems and procedures;
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. hire, train and manage additional qualified personnel; and
. establish relationships with additional suppliers and partners while
maintaining our existing relationships.
Because our strategy to expand our international operations is subject to
uncertainties, we may not be able to enter new international markets or
generate a significant level of revenues from those markets outside of the
United States in which we currently operate.
Customers outside of the United States accounted for $6.2 million of our net
revenues in the three months ended March 31, 2000 and $1.5 million of our net
revenues in the three months ended April 2, 1999. Although international sales
represented a majority of our sales in the three months ended March 31, 2000,
the absolute dollar amount of our international sales was relatively small and
must grow substantially in order for us to achieve and maintain profitability.
We plan to increase our international sales activities, but we have limited
experience in developing foreign language translations of our products and
little direct experience marketing and distributing our products
internationally.
We conduct direct sales activities in Japan, the United Kingdom, Germany and
the Netherlands and indirect sales activities in Asia, elsewhere in Europe and
Mexico. Our international operations are subject to other inherent risks,
including:
. the impact of recessions in economies outside the United States;
. greater difficulty in accounts receivable collection and longer
collection periods;
. 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.
Latent Year 2000 problems could have an uncertain impact on our internal
systems or products.
Many currently installed computer systems and software products are coded to
accept only two digit entries in the date code field. As a result, software
that records only the last two digits of the calendar year may not be able to
determine whether "00" means 1900 or 2000. This may result in software
failures or the creation of erroneous results.
Computer industry experts and US government officials were particularly
concerned that electronic systems would demonstrate unpredictable behavior
when internal electronic clocks rolled over to January 1, 2000. Since the New
Year has arrived with minimal date related problems in electronic systems
worldwide, the risk of Year 2000 errors appears to have largely passed.
However, a risk of latent Year 2000 related problems continues to exist that
applies to both our internal systems and our products.
We are not aware of any Year 2000 related problems with its internal
computer and electronics related systems on or since January 1 of this year,
but Year 2000 related problems in installed equipment could potentially still
transpire. We are unable to predict to what extent our core business functions
may be affected if our internal systems or software experience a material Year
2000 failure.
In December 1999, we learned that Year 2000 errors existed in the InfoPlace
Document Organizer, a third-party program included under license in the
standard software configuration of the Cobalt Qube 2 product. InfoPlace
developed a patch to resolve the problem, which we provide to users from our
website at no cost. This patch enables the InfoPlace Document Organizer to
display dates correctly after January 1, 2000. It also fixes the
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"Find Document" interface to allow searches with the year specified as "00."
We notified user groups for our product of the error and the patch via
electronic mail in December. Since December 1999, the software correction has
been part of the standard software configuration of the Cobalt Qube 2.
To date, we have not received complaints or comments from customers
concerning Year 2000 problems with the InfoPlace Document Organizer or any of
our products. Nonetheless, our server appliance products operate in complex
system environments and directly and indirectly interact with a number of
other hardware and software systems. Despite the investigation and testing by
us and our partners, our server appliance products and the underlying systems
and protocols running our products may contain latent errors or defects
associated with Year 2000 date functions. We are unable to predict to what
extent our business may be affected if our software or the systems that
operate in conjunction with our software experience a material Year 2000
failure. Known or unknown errors or defects that affect the operation of our
server appliances could result in:
. delay or loss of revenues;
. cancellation of customer contracts;
. diversion of development resources;
. damage to our reputation;
. increased maintenance and warranty costs; or
. litigation costs;
any of which could adversely affect our business, financial condition and
results of operations.
We rely on the services of our founders and other key personnel, and those
persons' knowledge of our business and technical expertise would be difficult
to replace.
Our products and technologies are complex and we are substantially dependent
upon the continued service of our existing engineering personnel, and
especially Stephen DeWitt, our President and Chief Executive Officer, and
Vivek Mehra, our Chief Technology Officer and one of our founders. The loss of
any of our key employees could adversely affect our business and slow our
product development processes. Although we maintain key person life insurance
policies on our key employees, the amount of this insurance may be inadequate
to compensate us for their loss.
Errors in our products or the failure of our products to conform to
specifications could result in our customers demanding refunds from us or
asserting claims for damages against us.
Because our server appliance products are complex, they could contain errors
or bugs that can be detected at any point in a product's life cycle. In the
past we have discovered errors in some of our products and have experienced
delays in the shipment of our products during the period required to correct
these errors. These delays have principally related to new product releases.
To date none of these delays has materially affected our business. While we
continually test our products for errors and work with customers through our
customer support services to identify and correct bugs in our software and
other product problems, errors in our products may be found in the future.
Although many of these errors may prove to be immaterial, any of these errors
could be significant. Detection of any significant errors may result in:
. the loss of or delay in market acceptance and sales of our products;
. diversion of development resources;
. injury to our reputation; or
. increased maintenance and warranty costs.
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These problems could harm our business and future operating results. Product
errors or delays could be material, including any product errors or delays
associated with the introduction of new products or the versions of our
products that support operating systems other than Linux. Occasionally, we
have warranted that our products will operate in accordance with specified
customer requirements. If our products fail to conform to these
specifications, customers could demand a refund for the purchase price or
assert claims for damages.
Moreover, because our products are used in connection with critical
distributed computing systems services, we may receive significant liability
claims if our products do not work properly. Our agreements with customers
typically contain provisions intended to limit our exposure to liability
claims. However, these limitations may not preclude all potential claims.
Liability claims could require us to spend significant time and money in
litigation or to pay significant damages. Any such claims, whether or not
successful, could seriously damage our reputation and our business.
Our stock has been and will likely continue to be subject to substantial
price and volume fluctuations due to a number of factors, many of which will
be beyond our control, that may prevent our stockholders from reselling our
common stock at a profit.
The securities markets have experienced significant price and volume
fluctuations in the past and the market prices of the securities of technology
companies have been especially volatile. This market volatility, as well as
general economic, market or political conditions, could reduce the market
price of our common stock in spite of our operating performance. In addition,
our operating results could be below the expectations of public market
analysts and investors, and in response the market price of our common stock
could decrease significantly. The market price of our common stock ranged from
a low of $22 to a high of $172 during the period from November 5, 1999 to
March 31, 2000. Investors may be unable to resell their shares of our common
stock for a profit. In the past, companies that have experienced volatility in
the market price of their stock have been the object of securities class
action litigation. If we were the object of securities class action
litigation, it could result in substantial costs and a diversion of
management's attention and resources.
The provisions of our charter documents may inhibit potential acquisition
bids that a stockholder may believe are desirable, and the market price of
our common stock may be lower as a result.
Our board of directors has the authority to issue up to 10,000,000 shares of
preferred stock at any time. The board of directors can fix the price, rights,
preferences, privileges and restrictions of the preferred stock without any
further vote or action by our stockholders. The issuance of shares of
preferred stock may delay or prevent a change in control transaction. As a
result, the market price of our common stock and the voting and other rights
of our stockholders may be adversely affected. The issuance of preferred stock
may result in the loss of voting control to other stockholders. We have no
current plans to issue any shares of preferred stock.
Our charter documents contain anti-takeover devices including:
. only one of the three classes of directors is elected each year;
. the ability of our stockholders to remove directors without cause is
limited;
. the right of stockholders to act by written consent has been eliminated;
. the right of stockholders to call a special meeting of stockholders has
been eliminated; and
. a requirement of advance notice to nominate directors or submit
proposals for consideration at stockholder meetings.
These provisions could discourage potential acquisition proposals and could
delay or prevent a change in control transaction. They could also have the
effect of discouraging others from making tender offers for our common stock.
As a result, these provisions may prevent the market price of our common stock
from increasing substantially in response to actual or rumored takeover
attempts. These provisions may also prevent changes in our management.
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Delaware law may inhibit potential acquisition bids; this may adversely
affect the market price of our common stock, discourage merger offers and
prevent changes in our management.
Section 203 of the Delaware General Corporation Law may inhibit potential
acquisition bids for our company. We are subject to the antitakeover provision
of the Delaware General Corporation Law, which regulates corporate
acquisitions. Under Delaware law, a corporation may opt out of the
antitakeover provisions. We have not and do not intend to opt out of the
antitakeover provisions of Delaware Law.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
We do not engage in any foreign currency hedging transactions and therefore,
do not believe we are subject to exchange rate risk. Our exposure to market
risk for changes in interest rates relates primarily to our cash and cash
equivalents. We are subject to fluctuating interest rates that may impact,
adversely or otherwise, our results of operations or cash flows for our cash
and cash equivalents.
As of March 31, 2000, we had short-term investments of $50.2 million. These
short-term investments consist of highly liquid investments with original
maturities at the date of purchase between three and nine months. These
investments are subject to interest rate risk and will decrease in value if
market interest rates increase. An immediate 10% change in interest rates
would be immaterial to our financial condition or results of operations.
Because we have the ability to hold these investments until maturity we would
not expect any significant decline in value of our investments caused by
market interest rate changes. Declines in interest rates over time will,
however, reduce our interest income.
27
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PART II--OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
In December 1998, CUBE Computer Corporation filed a lawsuit against the
Company in the United States District Court for the Southern District of New
York for trademark infringement. CUBE, an original equipment manufacturer of
personal computers, argued that this alleged infringement resulted from the
Company's use of "Qube" in connection with its products. In December 1999, the
Company entered into a settlement agreement with Cube Computer. We acquired
certain trademark rights for a one-time payment of $4.1 million, not including
related legal costs.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS.
With respect to the requirements of Item 701(f) of Regulation S-K regarding
the reporting of use of proceeds, pursuant to the information required to be
reported by Item 701(f)(4)(viii), Cobalt used net proceeds in the amounts
noted for the stated purposes since its December 31, 1999 Annual Report on
Form 10-K: purchase and installation of machinery and equipment--$320,000 and
working capital--$127.6 million.
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 three
months ended March 31, 2000.
28
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, as
amended, the Registrant has duly caused this report to be signed on its behalf
by the undersigned, thereunto duly authorized.
COBALT NETWORKS, INC.
Date May 12, 2000
/s/ Stephen W. DeWitt
_____________________________________
Stephen W. DeWitt
President and Chief Executive
Officer
(Principal Executive Officer)
/s/ Kenton D. Chow
_____________________________________
Kenton D. Chow
Vice President of Finance and Chief
Financial Officer (Principal
Financial and Accounting Officer)
29
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THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE ISSUER'S
ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1999 AND IS QUALIFIED
IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
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