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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(MARK ONE)
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 [FEE REQUIRED]
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
FOR THE TRANSITION PERIOD
FROM ________________________ TO ________________________.
COMMISSION FILE NUMBER 0-20191
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ODS NETWORKS, INC.
(Exact name of registrant as specified in its charter)
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DELAWARE 75-1911917
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
1101 EAST ARAPAHO ROAD
RICHARDSON, TEXAS 75081
(Address of principal executive offices) (Zip Code)
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Registrant's telephone number, including area code: (972) 234-6400
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.01 par value
(Title of class)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes_X No__
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
As of March 2, 1999, the aggregate market value of the Registrant's voting
stock held by non-affiliates of the Registrant was approximately $44,147,128
(affiliates being, for these purposes only, directors, executive officers and
holders of more than 5% of Registrant's Common Stock). As of March 2, 1999,
18,535,528 shares of the Registrant's Common Stock were outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement filed in connection
with the Registrant's 1999 Annual Meeting of Stockholders are incorporated by
reference into Part III of this Form 10-K.
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PART I
ITEM 1. BUSINESS.
In addition to the historical information contained herein, the discussion
in this Form 10-K contains certain forward-looking statements, within the
meaning of Section 27A of the Securities Act of 1933 and Section 21E of the
Securities Exchange Act of 1934, that involve risks and uncertainties, such as
statements concerning: growth and future operating results, developments in the
Company's markets and strategic focus; new products and product enhancements;
potential acquisitions and the integration of acquired businesses, products and
technologies, strategic relationships and future economic and business
conditions. The cautionary statements made in this Form 10-K should be read as
being applicable to all related forward-looking statements whenever they appear
in this Form 10-K. The Company's actual results could differ materially from the
results discussed in the forward-looking statements. Factors that could cause or
contribute to such differences include, but are not limited to, those discussed
under the section captioned "Factors That May Affect Future Results of
Operations" in Item 1 of this Form 10-K as well as those cautionary statements
and other factors set forth elsewhere herein.
GENERAL
ODS Networks, Inc. ("ODS", the "Company" or the "Registrant") develops,
markets and supports switches, network management and security software and
related products that securely link computer networks. The Company's products
enable customers to connect computers and supercomputers to form clusters,
workgroups and local area networks ("LANs"), to build backbones for
enterprise-wide networks, and to create networks that are protected from access,
theft and damage by unauthorized network users and protected from misuse by
curious or disgruntled employees, contractors and other authorized users.
The Company markets and distributes its products primarily through a direct
sales force to end-users and by numerous domestic and international system
integrators, service providers and value-added resellers. The Company's end-user
customers include manufacturing, telecommunications, retail, transportation,
health care, insurance, entertainment, utilities and energy companies;
government agencies; financial institutions; and academic institutions.
The Company was organized in Texas in September 1983 and reincorporated in
Delaware in October 1995. The Company changed its name in April 1997 from
Optical Data Systems, Inc. to ODS Networks, Inc. The Company's principal
executive offices are located at 1101 E. Arapaho Road, Richardson, Texas 75081,
and its telephone number is (972) 234-6400.
INDUSTRY BACKGROUND
The power of personal computers ("PCs"), workstations and network servers
has increased dramatically during the past decade. The rapid proliferation of
these devices has created a demand for an effective method to enable users to
communicate with each other to access common databases, software and peripheral
devices. The LAN industry evolved to provide a means by which computers and
related devices ("nodes") located within a limited geographical area, such as a
single office building or a campus, can be interconnected by means of a common
cabling system to permit communication and the sharing of data and resources.
These LANs can then be interconnected into wide area networks ("WANs") that
enable all of the client and server devices in an enterprise to communicate with
each other.
In the past, LAN technologies such as Ethernet and Token Ring have required
networked devices to take turns communicating on a singe LAN. Such technologies
are often referred to as shared-media or shared-bandwidth technologies because
they require computers to contend for the total capacity or "bandwidth" of a
LAN. The performance of these shared-bandwidth LANs has declined in recent years
due to the increased processor speeds of computers, increased size of LANs and
higher bandwidth
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requirements of software applications such as document image processing, medical
imaging, video and the World Wide Web.
In recent years, a new generation of LAN technology has emerged utilizing
"switching" to relieve the performance issues experienced in shared-bandwidth
LANs. Some switches have been designed to enhance the performance of existing
shared-bandwidth LANs by reducing the number of devices taking turns and sharing
the capacity of a single LAN Ethernet segment or token ring. More recently,
switches such as the Company's InfiniteSwitch and LANBlazer product lines have
been designed to replace the traditional hub and router architecture. In a
totally switched network, each PC, workstation and server has its own dedicated
network connection; thus, networked devices do not experience the performance
constraints of taking turns transmitting information over the LAN.
In addition, high-end workstations, servers and supercomputers are
increasingly being networked to form solutions for manipulating 3D models for
computer-aided design, calculating complex formulas for chemistry and geographic
information systems applications, video editing, animation rendering, technical
publishing, World Wide Web and intranet authoring and serving, and software
development. The Company's acquisition of Essential Communication Corporation in
May of 1998 established ODS as a leader in providing high performance networking
switches and network interface cards ("NICs") to create clusters and workgroups
of such high-end workstations, servers and supercomputers.
The migration of data from tightly controlled mainframe computers onto LANs,
workstations and personal computers and connectivity of an organization's
network to the Internet have created security issues. In the past, an
organization could rely on tight mainframe access controls to restrict access to
sensitive data. However, many networks now contain proprietary, intellectual
property and other sensitive data being carried by insecure network protocols.
Today, firewalls represent the most common form of network security, forming
barriers to entry into an organization's network. However, the hacker community
has developed innovative techniques for circumventing firewalls. Furthermore,
firewalls do not adequately address the security issues related to disgruntled
employees or those who would commit corporate espionage. Thus, a need has
evolved for the implementation of comprehensive monitoring of installed networks
and real-time response to security violations. The Company's acquisition of
certain products and technologies, including the Computer Misuse Detection
System ("CMDS") product line from Science Applications International Corporation
("SAIC") in September of 1998 significantly enhanced ODS' ability to create
trusted networks that are protected from access, theft and damage by
unauthorized network users and protected from misuse by curious or disgruntled
employees, contractors and other authorized users.
ODS PRODUCTS
NETWORK SECURITY SOFTWARE. ODS' CMDS software permits information security
administrators to monitor an organization's network for suspicious events,
unauthorized activity and misuse of the computer network. CMDS profiles user
behavior and usage patterns across multiple statistical categories. Variations
from a usage pattern can indicate a variety of potential computer misuses and
intrusions. Using a graphical user interface, a security administrator can
define rules and desired reactions to unauthorized events on an organization's
network. CMDS analyzes audit log files from UNIX-Registered Trademark-, Windows
NT-Registered Trademark- and numerous other sources of audit log data. CMDS
monitors for overt intrusion signatures such as failed login attempts, attempted
root access, system configuration modifications, unauthorized software
installations and attempts to subvert security systems. CMDS can alert the
security administrator of deviations from defined rules, intrusion signatures
and deviations from normal, authorized computer user behavior.
ODS' PROTOCOP is a network investigative software tool which offers a
proactive model for analyzing, filtering and viewing network management data.
ProtoCop monitors for physical or logical changes to a network infrastructure,
unusual TCP/IP port activity and workstation misconfigurations, modem back
doors, over-utilized segments and servers, and suspicious network conversations.
With ProtoCop, network
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managers and security administrators can better plan and secure their network
from outside invaders, internal configuration and performance problems and track
against performance-based service level agreements.
NETWORK SECURITY APPLIANCES. ODS' SECURECOM product family is designed to
provide comprehensive security solutions through network security appliances
that are easy to implement and manage. ODS believes that its integrated approach
to networks and security products provides a more comprehensive security
solution than the single product offerings marketed by many of its competitors.
The SecureCom products are modular solutions offering simultaneous connections
to multiple network segments, integrated firewalls, network based and host based
intrusion detection systems (including ProtoCop), ODS' CMDS computer misuse
detection system, ODS' CRYPTOWATCH virtual private network systems for
authenticated, encrypted transmission of information, and other security
applications.
HIGH PERFORMANCE NETWORK SWITCHES AND NICS. ODS' ESSENTIAL switches and
NICs enable high performance computing systems to be implemented using high-end
workstations, servers and supercomputers from market leaders including Compaq,
Hewlett Packard, Silicon Graphics and Sun Microsystems. The Essential Gigabyte
System Network ("GSN") and High Performance Parallel Interface ("HIPPI")
switches and NICs are based on industry standards and provide industry leading
performance of up to 10 gigabits per second per port data streams and an
aggregate bandwidth of up to 512 gigabits per second. The Essential switches and
NICs enable the creation of high performance solutions for manipulating 3D
models for computer-aided design, calculating complex formulas for chemistry and
geographic information systems applications, video editing, animation rendering,
technical publishing, World Wide Web and intranet authoring and serving, and
software development.
ODS' LANBLAZER 7000 gigabit Ethernet and Fast Ethernet switches are designed
for high bandwidth server farms, corporate backbone switching and high-end
applications at the individual user level. The LANBlazer 7000 includes a modular
7-slot chassis that supports over 45 gigabits per second of bandwidth and
connects up to 24 separate Gigabit Ethernet ports or up to 120 Fast Ethernet
ports. One implementation of the LANBlazer 7000 is as a backbone network for
users of ODS' InfiniteSwitches, high density Ethernet switches. Additional
features of the LANBlazer include high-speed Layer 3 switching, VLAN management
and flexible network management capabilities. In 1999, the Company expects to
offer ATM and HIPPI uplinks in the LANBlazer 7000 chassis to integrate Ethernet
architectures with other high performance network architectures.
The ODS INFINITESWITCH product family comprises flexible switched Ethernet
connectivity while providing high-speed ATM, Fast Ethernet and Gigabit Ethernet
uplinks that fully integrate each LAN device into more complex, enterprise
networks. The ODS InfiniteSwitch product family includes modular chassis, switch
and uplink modules, and network management software. The modular chassis are
available with 12, 7, 4 and 2 slots. Each switch, uplink and management module
is re-deployable across these modular chassis platforms, including the Company's
prior generation Infinity intelligent hub chassis, thereby reducing the
operating costs associated with spare units and enabling a cost-effective
migration from shared-bandwidth network architectures and small work groups to
large switched networks.
THIRD-PARTY PRODUCTS. The Company believes that it is beneficial to work
with third parties with complementary technologies to provide integrated
solutions to its customers. As the Company also competes with these technology
partners in certain segments of the market, there can be no assurance that the
Company will have access to all of the third-party products which may be
desirable in order to offer fully integrated solutions to ODS customers.
CUSTOMER SERVICES. In addition to manufacturing broad lines of secure
networking products, the Company also offers a wide range of services, including
consulting, design and configuration, project planning and management,
performance analysis and installation and maintenance.
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PRODUCT DEVELOPMENT
The networking industry is characterized by rapidly changing technology,
standards and customer demands. Management believes that the Company's future
success depends in large part upon the timely enhancement of existing products
as well as the development of technologically advanced new products which meet
industry standards, perform successfully and achieve market acceptance. The
Company is currently developing and marketing next-generation data security and
switching products. The Company is also investing in the development of products
which comply with emerging industry standards and is continuously engaged in
testing to ensure that the Company's products interoperate with other
manufacturers' products which comply with industry standards.
During 1998, 1997 and 1996, the Company's research and development
expenditures were $12.2 million, $10.8 million and $10.4 million, respectively.
All of the Company's expenditures for hardware and software research and
development costs have been expensed as incurred. At December 31, 1998, the
Company had 68 employees engaged in research and product development.
MANUFACTURING AND SUPPLIERS
The Company's manufacturing operations consist primarily of final assembly,
testing and quality control of subassemblies and finished units. Materials used
by the Company in its manufacturing processes include semiconductors such as
microprocessors, memory chips and application specific integrated circuits
("ASICs"), printed circuit boards, power supplies and enclosures.
The Company's operational strategy relies on outsourcing of printed circuit
board assembly and certain other operations to reduce fixed costs and to provide
flexibility in meeting market demand. The Company inserts the printed circuit
board-based modules, assembled by a variety of domestic third-party contract
assembly companies, into product enclosures in combination with power supplies,
ODS software and other components to configure systems to meet the needs of
end-user customers.
INTELLECTUAL PROPERTY AND LICENSES
The Company's success and its ability to compete is dependent, in part, upon
its proprietary technology. While the company has applied for certain patents,
the Company does not hold any issued patents and currently relies on a
combination of contractual rights, trade secrets and copyright laws to establish
and protect its proprietary rights in its products. The Company has also entered
into confidentiality agreements with its employees and enters into
non-disclosure agreements with its suppliers, resellers and certain customers to
limit access to and disclosure of proprietary information. There can be no
assurance that the steps taken by the Company to protect its intellectual
property will be adequate to prevent misappropriation of its technology or that
the Company's competitors will not independently develop technologies that are
substantially equivalent or superior to the Company's technology.
The Company has entered into several software and product license
agreements. These license agreements provide the Company with additional
software and hardware components that add value to its data security, switch and
network management products. These license agreements do not provide proprietary
rights which are unique or exclusive to the Company and are generally available
to other parties on the same or similar terms and conditions, subject to payment
of applicable license fees and royalties.
SALES, MARKETING AND CUSTOMERS
The Company markets and distributes its products primarily through a direct
sales force to end users supplemented by several domestic and international
system integrators and value added resellers. The Company's direct sales and
marketing organization currently consists of 100 individuals, including
managers, sales representatives, marketing personnel and technical support
personnel.
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FIELD SALES FORCE. The Company's direct sales organization focuses on major
account sales, promotes the Company's products to current and potential
customers, and monitors evolving customer requirements. The field sales and
technical support force provides training and technical support to the Company's
resellers and end users and assists ODS customers to design secure data
networking solutions.
The Company currently conducts its direct sales and marketing efforts from
its principal office in Richardson (Dallas), Texas; through domestic field
offices located in the following metropolitan areas: Albuquerque, Chicago,
Denver, Los Angeles, Minneapolis, San Diego, San Francisco and Washington, D.C.;
and through its foreign sales offices located in the following regions: Canada,
England, France, Germany, Malaysia, Singapore, South Korea and Taiwan.
RESELLERS. Domestic and international system integrators and value added
resellers (collectively, "resellers") sell ODS products as stand-alone solutions
to end users and integrate ODS products with products sold by other vendors into
networking and data security systems that are sold to end users. The Company's
field sales force and technical support organization provide support to these
resellers. The Company's agreements with resellers are non-exclusive, and the
Company's resellers generally sell other products which may compete with ODS
products. Resellers may place higher priority on products of other suppliers who
are larger than and have more name recognition than ODS, and there can be no
assurance that resellers will continue to sell and support the Company's
products.
FOREIGN SALES. The Company believes that rapidly evolving international
markets are important sources of future net sales for the Company. The Company's
export sales are currently being made through a direct sales force supplemented
by international resellers in Europe, Asia, Latin America and Canada. Export
sales accounted for approximately 20.0%, 27.2% and 14.4% of net sales in 1998,
1997 and 1996, respectively. See Management's Discussion and Analysis of
Financial Condition and Results of Operations included in this report for a
geographic breakdown of the Company's product revenue 1998, 1997 and 1996. Sales
to foreign customers and resellers generally have been made in United States
dollars.
MARKETING. The Company has implemented several methods to market its
products, including regular participation in trade shows and seminars,
advertisement in trade journals, telemarketing, distribution of sales literature
and product specifications and ongoing communications with its resellers and
installed base of end-user customers.
CUSTOMERS. The Company's end-user customers include manufacturing,
telecommunications, retail, transportation, health care, insurance, utilities
and energy companies; government agencies; financial institutions; and academic
institutions. Sales to certain customers and groups of customers can be impacted
by seasonal capital expenditure approval cycles, and sales to customers within
certain geographic regions can be subject to seasonal fluctuations in demand.
Although the Company sells its products to many customers, direct sales to
three such resellers and end-user customers, Electronic Data Systems Corporation
("EDS"), AT&T Corp. ("AT&T") and various agencies of the U. S. Government
(aggregated as one), have each accounted for 10% or more of the Company's net
sales in at least one of the past three fiscal years as indicated in the
following schedule.
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CUSTOMER PERCENTAGE OF NET SALES
1998 1997 1996
EDS 7.0% 16.1% 19.4%
AT&T 2.9 1.6 12.1
U. S. GOVERNMENT 13.2 11.7 13.5
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A large portion of the products sold to EDS during the periods shown were
integrated with other products or services and sold to end-users by EDS. No
other customer accounted for 10% or more of the Company's net sales in 1998,
1997 or 1996, respectively. The loss of any of these customers could have a
material adverse effect on the Company and its operating results if not
replaced.
Most of the Company's business with the U.S. Government is on a fixed-price
basis. Government contracts customarily include provisions which provide for
cancellation at the convenience of the Government. In addition, upon
cancellation by the Government, the Company generally would be entitled to
reimbursement of costs incurred, plus a pro rata share of profit. The Company
has never received a cancellation of a material government contract and has no
reason to anticipate any such cancellation. The products sold, characteristics
and business risks associated with the Company's sales to U.S. Government
agencies do not differ materially from those associated with sales of the
Company's products to commercial customers.
BACKLOG. The Company believes that only a small portion of its order
backlog is noncancelable and that the dollar amount associated with the
noncancelable portion is immaterial. The Company manufactures its products based
upon its forecast of customers' demand and maintains inventories of
sub-assemblies and finished products in advance of receiving firm orders from
customers. Orders are generally fulfilled by the Company within one to four
weeks following receipt of an order. Because of the generally short cycle
between order and shipment and occasional customer-initiated changes in delivery
schedules or cancellation of orders which are made without significant penalty,
the Company does not believe that its backlog as of any particular date is
indicative of future net sales.
CUSTOMER SUPPORT, SERVICE AND WARRANTY. The Company services, repairs and
provides technical support for its products. The ODS field sales and technical
support force work closely with resellers and end-user customers on-site and by
telephone to assist with pre- and post-sales support services such as network
design, system installation and technical consulting. By working closely with
the Company's customers, ODS employees gain a thorough understanding of end-user
requirements and provide input to the product development process.
The Company warrants all its products against defects in materials and
workmanship for periods ranging from 90 days to 12 months. Before and after
expiration of the product warranty period, the Company offers both on-site and
factory-based support, parts replacement and repair services. Extended warranty
services are separately invoiced on a time and materials basis or on an annual
maintenance contract.
COMPETITION
The market for network switches and data security solutions is intensely
competitive and subject to frequent product introductions with improved
price/performance characteristics. Industry suppliers compete in areas such as
conformity to existing and emerging industry standards, interoperability with
other networking products, network management and security capabilities,
performance, price, ease of use, scalability, reliability, flexibility, product
features and technical support. The Company believes that its solutions-oriented
approach to networking (combining network design services, ODS products and
third-party products to provide superior, secure networking systems to
customers) provides the Company a competitive advantage with large organizations
with complex networking requirements.
There are numerous companies competing in various segments of the data
security and network switch markets. The Company's principal competitors include
Cisco Systems, Inc. ("Cisco"), Cabletron Systems, Inc. ("Cabletron"), Lucent
Technologies ("Lucent"), Nortel Networks ("Nortel"), 3Com Corporation ("3Com"),
FORE Systems, Inc. ("FORE Systems"), Xylan Corporation ("Xylan"), International
Business Machines Corporation ("IBM"), Axent Technologies, Inc. ("Axent"),
Security Dynamics Technologies, Inc. ("Security Dynamics"), Internet Security
Systems, Inc. ("ISS"), and Network Associates, Inc. Several of the Company's
competitors have substantially greater financial, technical, sales and marketing
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resources, better name recognition and a larger customer base than the Company.
In addition, many of the Company's competitors offer customers a broader product
line which provides a more comprehensive networking and security solution than
the Company currently offers. Even if the Company does introduce advanced
products which meet evolving customer requirements in a timely manner, there can
be no assurance that the new Company products will gain market acceptance.
Certain companies in the networking and security industry have expanded
their product lines or technologies in recent years as a result of acquisitions.
Further, more companies have developed products which conform to existing and
emerging industry standards and have sought to compete on the basis of price.
The Company anticipates increased competition from large telecommunication
equipment vendors which are expanding their capabilities in the data networking
market. For example, Lucent and Nortel have acquired several networking
companies to enhance their capabilities in data networking. Further the Company
anticipates increased competition from private "start-up" companies that have
developed or are developing advanced network switching and security products.
Increased competition in the networking and security industry could result in
significant price competition, reduced profit margins or loss of market share,
any of which could have a material adverse effect on the Company's business,
operating results and financial condition.
There can be no assurance that the Company will be able to compete
successfully in the future with current or new competitors.
EMPLOYEES
As of December 31, 1998, the Company employed a total of 265 persons,
including 100 in sales, marketing and technical support, 74 in manufacturing and
operations, 68 in research and product development, and 23 in administration and
finance. The number of people employed by the Company declined by 31% compared
to December 31, 1997 as the Company (1) out sourced more of its manufacturing
operations and (2) restructured to integrate the companies acquired in 1998 and
to improve performance.
None of the Company's employees are represented by a labor organization, and
the Company is not a party to any collective bargaining agreement. The Company
has not experienced any work stoppages and considers its relations with its
employees to be good.
Competition in the recruiting of personnel in the networking and data
security industry is intense. The Company believes that its future success will
depend in part on its continued ability to hire, motivate and retain qualified
management, sales and marketing, and technical personnel. To date, the Company
has not experienced significant difficulties in attracting and retaining
qualified employees.
FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS
In addition to the other information in this Form 10-K, the following
factors should be considered in evaluating the Company and its business.
TECHNOLOGICAL CHANGES. The market for the Company's products is
characterized by frequent product introductions, rapidly changing technology and
continued evolution of new industry standards. The market for network
intelligent hubs, switches, management and security products requires the
Company's products to be compatible and interoperable with products and
architectures offered by various vendors, including other networking products,
workstation and personal computer architectures and computer and network
operating systems. The Company's success will depend to a substantial degree
upon its ability to develop and introduce in a timely manner new products and
enhancements to its existing products that meet changing customer requirements
and evolving industry standards. The development of technologically advanced
products is a complex and uncertain process requiring high levels of innovation
as well as the accurate anticipation of technological and market trends. There
can be no assurance that the Company will
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be able to identify, develop, manufacture, market and support new or enhanced
products successfully in a timely manner. Further, the Company or its
competitors may introduce new products or product enhancements that shorten the
life cycle of or obsolete the Company's existing product lines which could have
a material adverse effect on the Company's business, operating results and
financial condition.
MARKET ACCEPTANCE. The Company is pursuing a strategy to increase the
percentage of its revenue generated through indirect sales channels including
value added resellers, system integrators, original equipment manufacturers and
network service providers. There can be no assurance that the Company's products
will gain market acceptance in these indirect sales channels. Further,
competition among networking and security companies to sell products through
these indirect sales channels could result in significant price competition and
reduced profit margins.
The Company is also pursuing a strategy to broaden and further differentiate
its product line by introducing complementary network switching, management and
security products and incorporating new technologies into its existing product
line. There can be no assurance that the Company will successfully introduce
these products or that such products will gain market acceptance. The Company
anticipates competition from networking companies, network security companies
and others in each of its product lines. The Company anticipates that profit
margins will vary among its product lines and that product mix fluctuations
could have an adverse effect on the Company's overall profit margins.
ACQUISITIONS. Cisco, Cabletron, FORE Systems, Lucent, Nortel and other
competitors have recently acquired several networking and security companies
with complementary technologies, and the Company anticipates that such
acquisitions will continue in the future. These acquisitions may permit such
competitors to accelerate the development and commercialization of broader
product lines and more comprehensive networking solutions than the Company
currently offers. In the past, the Company has relied upon a combination of
internal product development and partnerships with other networking and security
vendors to provide competitive solutions to customers. Certain of the recent and
future acquisitions by the Company's competitors may have the effect of limiting
the Company's access to commercially significant technologies. Further, the
business combinations and acquisitions in the networking and security industry
are creating companies with larger market shares, customer bases, sales forces,
product offerings and technology and marketing expertise. There can be no
assurance that the Company will be able to compete successfully in such an
environment.
In March 1998, the Company invested $1.25 million in Blue Ridge Networks
("Blue Ridge"), Inc., a private corporation which provides secure remote access
products for local and wide area networks. In December 1998 the Company wrote
off all remaining unamortized investments in Blue Ridge, resulting in a total
charge to expense of approximately $1.1 million due to the Company's
restructuring plan, ongoing losses by Blue Ridge and the uncertainty of
obtaining additional outside financing. On May 7, 1998, the Company acquired
Essential Communication Corporation, a privately held company based in
Albuquerque, New Mexico. Essential designs and manufactures high-speed computer
network equipment. In September 1998, the Company completed an acquisition of
certain assets of the Computer Misuse and Detection System ("CMDS") Division
from Science Applications International Corporation ("SAIC"), a privately held
company in San Diego, California. The Company may, in the future, acquire or
invest in additional companies, business units, product lines, or technologies
to accelerate the development of products and sales channels complementary to
the Company's existing products and sales channels. Acquisitions involve
numerous risks, including difficulties in assimilation of operations,
technologies, and products of the acquired companies; risks of entering markets
in which the Company has no or limited direct prior experience and where
competitors in such markets have stronger market positions; the potential loss
of key employees of the acquired company; and the diversion of management's
attention from normal daily operation of the Company's business. There can be no
assurance that any potential acquisition or investment will be consummated or
that such acquisition or investment will be realized.
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PRODUCT TRANSITIONS. Once current networking and security products have
been in the market place for a period of time and begin to be replaced by higher
performance products (whether of the Company's or a competitor's design), the
Company expects the net sales of such products to decrease. In order to achieve
revenue growth in the future, the Company will be required to design, develop
and successfully commercialize higher performance products in a timely manner.
For example, the market for shared bandwidth intelligent hubs, sales of which
represented the majority of the Company's net sales over the past several years,
decreased in 1998 and may continue to decrease as switching products with
enhanced price/performance characteristics gain market acceptance. There can be
no assurance that the Company will be able to introduce new products and gain
market acceptance quickly enough to avoid adverse revenue transition patterns
during current or future product transitions. Nor can there be any assurance
that the Company will be able to respond effectively to technological changes or
new product announcements by competitors, which could render portions of the
Company's inventory obsolete.
The Company's sales of commodity LAN switches and hubs have declined over
the past two years as certain of the Company's large competitors gained market
share. The Company's goal is to transition an increasing proportion of its
revenues to growing markets in which the Company offers differentiated products,
such as data security solutions and high performance switches. The Company's
ability to achieve its revenue objectives over the next several quarters will
largely depend upon the extent to which growth in these differentiated product
lines compensates for the expected decline in the commodity LAN switch and hub
product lines.
MANUFACTURING AND SUPPLIERS. All of the materials used in the Company's
products are purchased under contracts or purchase orders with third parties.
While the Company believes that many of the materials used in the production of
its products are generally readily available from a variety of sources, certain
components such as microprocessors and ASICs are available from one or a limited
number of suppliers. The lead times for delivery of components vary
significantly and exceed twelve weeks for certain components. If the Company
should fail to forecast its requirements accurately for components, it may
experience excess inventory or shortages of certain components which could have
an adverse effect on the Company's business and operating results. Further, any
interruption in the supply of any of these components, or the inability of the
Company to procure these components from alternative sources at acceptable
prices within a reasonable time, could have an adverse effect on the Company's
business and operating results.
The Company's operational strategy relies on outsourcing of product assembly
and certain other operations. There can be no assurance that the Company will
effectively manage its third-party contractors or that these contractors will
meet the Company's future requirements for timely delivery of products of
sufficient quality and quantity. Further, the Company intends to introduce a
number of new products and product enhancements in 1999 which will require that
the Company rapidly achieve volume production of those new products by
coordinating its efforts with those of its suppliers and contractors. The
inability of the third-party contractors to provide ODS with adequate supplies
of high-quality products could cause a delay in the Company's ability to fulfill
orders and could have an adverse effect on the Company's business and operating
results.
INTELLECTUAL PROPERTY AND LICENSES. There are many patents held by
companies which relate to the design and manufacture of data security and
networking systems. Potential claims of infringement could be asserted by the
holders of those patents. The Company could incur substantial costs in defending
itself and its customers against any such claim regardless of the merits of such
claims. In the event of a successful claim of infringement, the Company may be
required to obtain one or more licenses from third parties. There can be no
assurance that the Company could obtain the necessary licenses on reasonable
terms.
THIRD-PARTY PRODUCTS. The Company believes that it is beneficial to work
with third parties with complementary technologies to broaden the appeal of the
Company's switches and network security products. These alliances allow ODS to
provide integrated solutions to its customers, combining ODS
10
<PAGE>
developed technology with third-party products. As the Company also competes
with these technology partners in certain segments of the market, there can be
no assurance that the Company will have access to all of the third-party
products which may be desirable to offer fully integrated solutions to ODS
customers.
DEPENDENCE ON KEY CUSTOMERS. A relatively small number of customers have
accounted for a significant portion of the Company's revenue. U.S. Government
agencies and strategic network integrators are expected to continue to account
for a substantial portion of the Company's net revenue. The Company continuously
faces competition from Cisco, Cabletron, Lucent, Nortel, FORE Systems, Xylan,
3Com, Axent, Security Dynamics, ISS and others for U.S. Government networking
and security projects and corporate networking and security installations. Any
reduction or delay in sales of the Company's products to these customers could
have a material adverse effect on the Company's operating results.
INTERNATIONAL OPERATIONS. The Company's international operations may be
affected by changes in demand resulting from fluctuations in currency exchange
rates and local purchasing practices, including seasonal fluctuations in demand,
as well as by risks such as increases in duty rates, difficulties in
distribution, regulatory approvals and other constraints upon international
trade. For example, the fluctuation in currency exchange rates and adverse
economic developments in Malaysia, South Korea and certain other countries
adversely affected demand for the Company's products in those countries in 1998
and may continue to adversely affect demand for the Company's products in those
countries in 1999. The Company's sales to foreign customers are subject to
export regulations. In particular, certain sales of the Company's high
performance networking and data security products require clearance and export
licenses from the U.S. Department of Commerce under these regulations. Any
inability to obtain such clearances or any required foreign regulatory approvals
on a timely basis could have a material adverse effect on the Company's
operating results.
IMPACT OF GOVERNMENT CUSTOMERS. A significant portion of the Company's
revenue is derived from sales to the U.S. government, either directly by the
Company or through system integrators and other resellers. Sales to the
government present risks in addition to those involved in sales to commercial
customers, including potential disruptions due to appropriation and spending
patterns and the government's reservation of the right to cancel contracts and
purchase orders for its convenience.
EXPENSE REDUCTION PROGRAM. During 1998, the Company announced and
implemented a restructuring program aimed at bringing its expenses more in line
with current revenue levels and restoring long-term profitability to the
Company. The Company is seeking to reduce its 1999 operating expenses
significantly below the level of 1998 operating expenses. As part of this
effort, the Company reduced its number of employees from 415 as of September 30,
1998 to 265 as of December 31, 1998. These steps, and generally tighter expense
controls, are part of an overall program to reduce the Company's expense
structure. While the Company's objective is to reduce its costs in ways that
will not have a material impact on revenue levels, there can be no assurance
that this will be achieved.
YEAR 2000. Significant uncertainty still exists as to the global
implications of the Year 2000 issue. Costs of defending and resolving Year 2000
related disputes, reductions in product development programs by customers or the
failure of the Company to adequately resolve internal Year 2000 compliance
issues could result in a material adverse effect on the Company's business,
operating results and financial condition.
GENERAL. Sales of networking products fluctuate, from time to time, based
on numerous factors, including customers' capital spending levels and general
economic conditions. While certain industry analysts believe that there is a
significant market for network switches, management and security products, there
can be no assurance as to the rate or extent of the growth of such market or the
potential adoption of alternative technologies. Future declines in networking
and security product sales as a result of general economic conditions, adoption
of alternative technologies or any other reason could have a material adverse
effect on the Company's business, operating results and financial condition.
11
<PAGE>
Due to the factors noted above and elsewhere in Management's Discussion and
Analysis of Financial Condition and Results of Operations, the Company's future
earnings and stock price may be subject to significant volatility, particularly
on a quarterly basis. Past financial performance should not be considered a
reliable indicator of future performance and investors should not use historical
trends to anticipate results or trends in future periods. Any shortfall in
revenue and earnings from the levels anticipated by securities analysts could
have an immediate and significant effect on the trading price of the Company's
common stock in any given period. Also, the Company participates in a highly
dynamic industry which often results in volatility of the Company's common stock
price.
ITEM 2. PROPERTIES.
The Company's headquarters is located in a modern, two-story building in
Richardson, Texas, with an aggregate of approximately 95,000 square feet of
floor space. This facility includes the Company's corporate administration,
manufacturing, marketing, sales and technical support personnel. The Company
occupies this facility under a lease, the base term of which expires in February
2005, with two seven-year options to extend the lease term, subject to
compliance with certain conditions. The Company owns a one-story building
consisting of approximately 50,000 square feet of floor space adjacent to the
Company's headquarters. As part of the Company's restructuring and cost
reduction program, the Company is planning to sell this 50,000 square foot
building in the future and relocate the research and development personnel from
such building to the adjacent headquarters facility. The Company also leases a
separate warehouse facility consisting of approximately 8,000 square feet
adjacent to its headquarters under a lease that expires in June 2000.
In 1998, the Company leased a 12,000 square foot building in Albuquerque,
New Mexico for its Essential division. This lease was not renewed in 1999, and
the Essential division personnel moved to a 15,120 square foot leased property
in February 1999. This property is also located in Albuquerque and the lease
term will expire in February 2009. Research and development, administrative,
manufacturing, marketing and sales personnel occupy this property.
In 1998, the Company's security software research and development staff in
San Diego was located in a building owned by Science Applications International
Corporation. In March 1999, the Company's security software research and
development staff relocated to an 11,400 square foot leased building in San
Diego. The lease will expire in September 2002. Research and development, sales
and administrative personnel occupy this facility.
In addition, the Company and its subsidiaries lease small amounts of office
space for sales and technical support personnel domestically in California,
Colorado, Georgia, Illinois, Massachusetts, Texas, Virginia and Washington, and
internationally in Canada, England, France, Germany, Malaysia, Singapore, South
Korea and Taiwan R.O.C. The Company believes that these existing facilities will
be adequate to meet its requirements through 1999. See Note 8 of Notes to
Consolidated Financial Statements for additional information regarding the
Company's obligations under leases.
ITEM 3. LEGAL PROCEEDINGS.
The company is not a party to any material litigation and is not aware of
any threatened litigation which would have a material adverse effect on the
Company, its operating results or its financial position.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
There were no matters submitted to a vote of security holders of the Company
during the fourth quarter of 1998.
12
<PAGE>
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's common stock is traded on The Nasdaq Stock Market (National
Market System) under the symbol ODSI. As of March 2, 1999, there were
approximately 500 holders of record of the common stock. The following table
sets forth, for the periods indicated, the high and low sales prices for the
common stock, as reported by The Nasdaq Stock Market.
<TABLE>
<CAPTION>
1998 1997 1996
-------------- ------------ -------------
HIGH LOW HIGH LOW HIGH LOW
------ ----- ------ --- ------- ---
<S> <C> <C> <C> <C> <C> <C>
First Quarter $715/16 $513/16 $181/4 $115/16 $283/4 $171/4
Second Quarter 9 53/8 163/8 113/8 273/8 191/4
Third Quarter 73/4 33/16 133/4 101/64 231/4 167/8
Fourth Quarter 41/16 21/4 13 51/2 165/8 113/8
</TABLE>
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA.
The following selected consolidated financial data should be read in
conjunction with "Management's Discussion and Analysis of Financial Condition
and Results of Operations" in Item 7 of this Form 10-K and the consolidated
statements and notes thereto included in Item 14 of this Form 10-K.
(IN THOUSANDS, EXCEPT PER SHARE DATA)
INCOME STATEMENT DATA:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------------------------
1998 1997 1996 1995 1994
---------- --------- ---------- ---------- ---------
<S> <C> <C> <C> <C> <C>
Net sales $ 74,610 $ 92,327 $ 117,864 $ 111,450 $ 86,608
Cost of sales 50,230(1) 55,795 60,737 55,499 46,804
---------- --------- ---------- ---------- ---------
Gross profit 24,380 36,532 57,127 55,951 39,804
Operating expenses:
Sales and marketing 29,378 30,390 25,969 22,555 15,965
Research and development 12,244 10,810 10,417 8,021 7,503
In process research and development 3,347(2) -- -- -- --
General and administrative 4,882 4,912 3,844 4,215 3,046
Amortization of intangibles 968 -- -- -- --
Restructuring charge 3,932(3) -- -- -- --
---------- --------- ---------- ---------- ---------
Operating income (loss) (30,371) (9,580) 16,897 21,160 13,290
Interest income, net 1,398 1,639 944 938 546
Other expense (1,122) -- -- -- --
---------- --------- ---------- ---------- ---------
Income (loss) before income taxes (30,095) (7,941) 17,841 22,098 13,836
Income taxes (benefit) (4,345) (3,004) 6,790 8,420 5,274
---------- --------- ---------- ---------- ---------
Net income (loss) $ (25,750) $ (4,937) $ 11,051 $ 13,678 $ 8,562
---------- --------- ---------- ---------- ---------
---------- --------- ---------- ---------- ---------
Diluted earnings (loss) per share $ (1.50) $ (0.30) $ 0.66 $ 0.81 $ 0.52
Weighted average shares outstanding assuming dilution 17,190 16,437 16,825 16,876 16,424
---------- --------- ---------- ---------- ---------
</TABLE>
- ------------------------
(1) In connection with the Company's restructuring plan, cost of sales in fiscal
1998 includes a $6.7 million charge to write-down the value of inventory
with reduced utility, generally associated with older technologies.
13
<PAGE>
(2) The write-off of acquired in-process research and development in the year
ending December 31, 1998, is comprised of $2.3 million (as restated for the
required new SEC's "Exclusion" method) resulting from the Company's
acquisition of Essential Communication Corporation and approximately $1.0
million resulting from the Company's acquisition of Computer Misuse and
Detection System assets from Science Applications International Corporation.
(3) In connection with the Company's restructuring plan the Company recorded a
$3.5 million charge to write off the value of certain fixed assets which are
no longer in use and to be disposed of and incurred approximately $0.4
million in severance costs resulting from the Company's reduction in
workforce.
BALANCE SHEET DATA:
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------------------------------------
1998 1997 1996 1995 1994
--------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
Working capital $ 31,763 $ 51,847 $ 54,529 $ 49,645 $ 38,242
Total assets 61,710 77,178 81,935 71,685 52,551
Total liabilities 12,204 10,799 10,997 12,987 9,190
Total stockholders' equity 49,506 66,379 70,938 58,698 43,361
</TABLE>
See Management's Discussion and Analysis of Financial Condition and Results
of Operations and Notes to Consolidated Financial Statements.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
"SAFE HARBOR" STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF
1995
This Annual Report, other than historical information, may include
forward-looking statements, including statements with respect to financial
results, product introductions, market demand, sales channels, industry trends,
sufficiency of cash resources and certain other matters. These statements are
made under the "safe harbor" provisions of the Private Securities Litigation
Reform Act of 1995 and involve risks and uncertainties which could cause actual
results to differ materially from those in the forward-looking statements,
including those discussed in the section entitled "Factors That May Affect
Future Results of Operations" in Item 1 and elsewhere in this Annual Report on
Form 10-K and other filings with the Securities and Exchange Commission.
14
<PAGE>
RESULTS OF OPERATIONS
The following tables set forth, for the periods indicated, certain financial
data as a percentage of net sales.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Net sales 100.0% 100.0% 100.0%
Cost of sales 67.3 60.4 51.5
--------- --------- ---------
Gross profit 32.7 39.6 48.5
Operating expenses:
Sales and marketing 39.4 32.9 22.0
Research and development 16.4 11.7 8.8
In process research and development 4.5 -- --
General and administrative 6.5 5.3 3.3
Amortization of intangibles 1.3 -- --
Restructuring charge 5.3 -- --
--------- --------- ---------
Operating income (loss) (40.7) (10.3) 14.4
Interest income, net 1.9 1.7 0.8
Other expense (1.5) -- --
--------- --------- ---------
Income (loss) before income taxes (40.3) (8.6) 15.2
Income taxes (benefit) (5.8) (3.3) 5.8
--------- --------- ---------
Net income (loss) (34.5)% (5.3)% 9.4%
--------- --------- ---------
--------- --------- ---------
</TABLE>
<TABLE>
<CAPTION>
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Switching product sales 50.7% 37.7% 13.4%
Shared bandwidth hub sales 39.2 54.4 80.5
Security, service and other sales 10.1 7.9 6.1
--------- --------- ---------
Net sales 100.0% 100.0% 100.0%
--------- --------- ---------
--------- --------- ---------
</TABLE>
<TABLE>
<CAPTION>
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Domestic sales 80.0% 72.8% 85.6%
Export sales to:
Europe 12.2 9.6 7.9
Canada 3.0 3.6 2.9
Asia 3.8 11.6 2.9
Latin America 1.0 2.4 0.7
--------- --------- ---------
Net sales 100.0% 100.0% 100.0%
--------- --------- ---------
--------- --------- ---------
</TABLE>
1998 COMPARED WITH 1997
NET SALES
Net sales in 1998 decreased to $74.6 million from $92.3 million in 1997 as
sales of the Company's new network switching and security products did not
increase quickly enough to offset the decrease in sales of its prior generation
shared bandwidth intelligent hubs. The Company's goal is to transition an
increasing proportion of its net sales to data security and high performance
switching solutions in 1999.
15
<PAGE>
Export sales in 1998 decreased to $14.9 million, or 20.0% of net sales,
compared to $25.1 million, or 27.2% of net sales in 1997 primarily due to
adverse economic developments in Malaysia and South Korea. Adverse economic
conditions in certain foreign countries may continue to adversely affect demand
for the Company's products in those countries in 1999.
Direct net sales to various agencies of the U.S. Government (aggregated as
one) were 13.2% and 11.7%, respectively of net sales in 1998 and 1997. Sales to
Electronic Data Systems Corporation ("EDS") in 1998 and 1997 were 7.0% and
16.1%, respectively of net sales. In addition, a portion of the Company's sales
to EDS and other corporations were resold by those organizations to various
agencies of the U.S. Government.
GROSS PROFIT
Gross profit decreased to $24.4 million or 32.7% of net sales in 1998
compared to $36.5 million or 39.6% of net sales in 1997. Gross profit as a
percentage of net sales in 1998 was impacted by several factors, including the
Company's restructuring plan, an increase in reserves for slow-moving inventory
of such prior generation products, product mix and lower sales volumes. In
connection with the change of the Company's product focus under the Company's
restructuring plan, the company recorded a $6.7 million charge to cost of sales
to write down the value of inventory with reduced utility, generally associated
with older technologies. In the fourth quarter of 1998, the Company implemented
a more extensive manufacturing outsourcing and vendor consolidation program and
reduced its headcount of manufacturing operations staff by approximately 72
positions as part of a restructuring plan designed to improve performance. Gross
profit margins in future periods may be affected by several factors such as
continued product transition, declining market demand for prior generation
products, obsolescence or surplus of inventory, shifts in product mix, changes
in channels of distribution, sales volume, fluctuation in manufacturing costs,
pricing strategies of the Company and its competitors and fluctuations in sales
of integrated third-party products. Gross profit margins are typically lower on
sales of integrated third-party products.
SALES AND MARKETING
Sales and marketing expenses decreased to $29.4 million in 1998 from $30.4
million in 1997. As a percentage of net sales, sales and marketing expenses
increased to 39.4% in 1998 from 32.9% in 1997. The Company expects sales and
marketing expenses to decrease in 1999 compared to 1998 based on its
restructuring and expense reduction programs. Sales and marketing expenses may
vary as a percentage of net sales in the future.
RESEARCH AND DEVELOPMENT
Research and development expenses, excluding the one-time charges for
in-process research and development, increased to $12.2 million or 16.4% of net
sales in 1998 compared to $10.8 million or 11.7% of net sales in 1997. The
Company's research and development costs are expensed in the period incurred.
The increase in research and development expenses was primarily due to an
increase in the number of development personnel and increased costs related to
the acquisition of Essential's engineering personnel in May of 1998 and the
hiring of certain CMDS research and development personnel in September 1998. The
Company expects research and development expenses to decrease in 1999 compared
to 1998 based on the Company's restructuring and expense reduction programs
implemented in the fourth quarter of 1998.
IN-PROCESS RESEARCH AND DEVELOPMENT
The Company incurred one-time charges associated with the acquisition of
Essential and the acquisition of certain assets of SAIC of $3.3 million in 1998
to expense the purchased in-process research and development that had not
reached technological feasibility.
16
<PAGE>
GENERAL AND ADMINISTRATIVE
General and administrative expenses, excluding amortization expenses,
remained constant at $4.9 million in 1998 and 1997. General and administrative
expenses increased as a percentage of net sales to 6.5% in 1998 from 5.3% of net
sales in 1997. General and administrative expenses may vary as a percentage of
net sales in the future.
AMORTIZATION
The Company incurred $1.0 million of amortization expense in 1998 primarily
associated with the amortization of intangible assets related to the acquisition
of Essential and the acquisition of certain assets of SAIC. The Company expects
amortization expense to increase in 1999 compared to 1998 as such expenses were
incurred for only a portion of the year in 1998. Amortization expenses may vary
as a percentage of net sales in the future.
RESTRUCTURING CHARGE
On December 31, 1998, the Company's management with the approval of the
Board of Directors committed to and implemented a series of measures to refocus
the Company's efforts on long term strategic objectives. The restructuring plans
are designed to focus the Company's efforts on high-performance network and data
security solutions while reducing the Company's cost structure and improving its
responsiveness to customers, operating efficiencies, and return on assets. The
necessity of restructuring to focus on key growth opportunities was required due
to the Company's performance levels resulting from declining markets for modular
shared media hubs and intense competition in the rapidly consolidating local
area network market.
The restructuring plan included (i) writing down the value of inventory
associated with older technologies, (ii) the write off of certain fixed assets,
(iii) preparation for closure of one of the two facilities in Richardson, Texas,
(iv) the reorganization and/or closure of certain sales offices, (v)
streamlining of research, product development and other functional activities
and (vi) workforce reductions.
The Company also recorded a $3.5 million restructuring charge to write off
the value of certain fixed assets which are no longer in use and are to be
disposed of.
Implementation of the plan in the fourth quarter of 1998 resulted in
workforce reductions of approximately 45 professional staff positions and
approximately 72 manufacturing operations positions. Overall employment at the
Company has decreased, predominately due to the restructuring, from
approximately 415 employees in September 1998 to approximately 265 employees as
of December 31, 1998, a decrease of 150 employees. In connection with these cost
reduction actions, the Company incurred approximately $0.4 million of severance
costs. The Company recognized a liability and expense for the cost of the
involuntary termination benefits in fiscal 1998 as the Company's management
approved the plan of termination during fiscal 1998 and terminations were
complete as of December 31, 1998.
NET INTEREST INCOME
Net interest income decreased to $1.4 million in 1998 compared to $1.6
million in 1997 primarily due to a decrease in the Company's average cash and
investment balances during 1998. Net interest income may vary in the future
based on the Company's cash flow and rate of return on investments.
INCOME TAXES
The Company's effective income tax rate decreased to 14.4% in 1998 compared
to 37.8% in 1997. The Company's income tax benefit for 1998 primarily reflects
the amount that the Company expects to recover as a refund of income taxes paid
by the Company in prior years. The Company did not record an income tax benefit
as of December 31, 1998 related to the net operating losses which can be carried
forward to offset taxable income in future years. See Note 10 of Notes to
Consolidated Financial Statements.
17
<PAGE>
1997 COMPARED WITH 1996
NET SALES
Net sales in 1997 decreased to $92.3 million from $117.9 million in 1996 as
sales of the Company's new network switching products did not increase quickly
enough to offset the decrease in sales of its prior generation shared bandwidth
intelligent hubs.
Export sales in 1997 increased to $25.1 million, or 27.2% of net sales,
compared to $17.1 million, or 14.4% of net sales in 1996 primarily due to growth
in export sales to customers in Malaysia and South Korea. Sales to customers in
Malaysia and South Korea declined in the fourth quarter of 1997 compared to the
preceding quarters in 1997.
Sales to Electronic Data Systems Corporation ("EDS") in 1997 and 1996 were
16.1% and 19.4%, respectively of net sales. Sales to AT&T Corp. ("AT&T") in 1997
and 1996 were 1.6% and 12.1%, respectively, of net sales in 1997 and 1996.
Direct net sales to various agencies of the U.S. Government (aggregated as one)
were 11.7% and 13.5%, respectively, of net sales in 1997 and 1996. In addition,
a portion of the Company's sales to EDS, AT&T and other corporations were resold
by those organizations to various agencies of the U.S. Government.
GROSS PROFIT
Gross profit decreased to $36.5 million or 39.6% of net sales in 1997
compared to $57.1 million or 48.5% of net sales in 1996. Gross profit as a
percentage of net sales in 1997 was impacted by several factors, including a
decline in the net realizable value of certain prior generation products, an
increase in reserves for slow-moving inventory of such prior generation
products, product mix and lower sales volumes.
SALES AND MARKETING
Sales and marketing expenses increased to $30.4 million or 32.9% of net
sales in 1997 from $26.0 million or 22.0% of net sales in 1996. The increase in
sales and marketing expenses was primarily due to higher levels of staffing in
sales, marketing and technical support and associated costs.
RESEARCH AND DEVELOPMENT
Research and development expenses increased to $10.8 million or 11.7% of net
sales in 1997 compared to $10.4 million or 8.8% of net sales in 1996. The
increase in research and development expenses was primarily due to an increase
in the number of development personnel and increased costs related to the
development and testing of switching products, network management products and
network security products.
GENERAL AND ADMINISTRATIVE
General and administrative expenses increased to $4.9 million or 5.3% of net
sales in 1997 from $3.8 million or 3.3% of net sales in 1996. The increase in
general and administrative expenses was primarily due to an increase in
personnel and associated costs.
NET INTEREST INCOME
Net interest income increased to $1.6 million in 1997 compared to $0.9
million in 1996 primarily due to an increase in the Company's average cash and
investment balances during 1997.
18
<PAGE>
INCOME TAXES
The Company's effective income tax rate decreased to 37.8% in 1997 compared
to 38.1% in 1996. See Note 10 of Notes to Consolidated Financial Statements.
LIQUIDITY AND CAPITAL RESOURCES
The Company's principal sources of liquidity at December 31, 1998 were $16.8
million of cash and cash equivalents and $4.8 million of short-term investments.
As of December 31, 1998, working capital was $31.8 million compared to $51.8
million as of December 31, 1997.
Cash flows used in operations in 1998 were $5.3 million, primarily due to a
net loss for the year partially offset by a decrease in inventory and accounts
receivable balances. Future fluctuation in accounts receivable and inventory
balances will be dependent upon several factors, including but not limited to
quarterly sales, ability to collect accounts receivable timely, and the accuracy
of the Company's forecasts of product demand and component requirements.
Cash provided by investing activities in 1998 was $3.9 million which
consisted of $13.1 million of net maturities of investments partially offset by
$5.6 million of payments for corporate acquisitions (net of cash acquired), a
$1.3 million equity investment in Blue Ridge Networks and purchases of property
and equipment of $2.3 million.
Cash provided by financing activities in 1998 was $0.3 million which
consisted of the issuance of $1.5 million of common stock relating to the
acquisition of certain assets of Science Applications International Corporation
and $0.4 million related to the exercise of certain employee stock options
partially offset by a loan to a stockholder of $1.2 million and a $0.4 million
repayment of a line of credit associated with the acquisition of Essential by
the Company in 1998.
During 1998, the Company funded its operations solely through cash flow from
operations.
The Company believes that its cash, cash equivalents and investment balances
will provide sufficient cash resources to finance its operations and currently
projected capital expenditures through 1999. However, there can be no assurance
the Company's cash resources will be sufficient for 1999.
The Company intends to explore the possible acquisitions of businesses,
products and technologies that are complementary to those of the Company. The
Company is continuing to identify and prioritize additional networking and
security technologies which it may wish to develop, either internally or through
the licensing or acquisition of products from third parties. While the Company
engages from time to time in discussions with respect to potential acquisitions,
there can be no assurances that any such acquisitions will be made or that the
Company will be able to successfully integrate any acquired business. In order
to finance such acquisitions, it may be necessary for the Company to raise
additional funds through public or private financings. Any equity or debt
financings, if available at all, may be on terms which are not favorable to the
Company and, in the case of equity financings, may result in dilution to the
Company's stockholders.
GENERAL DESCRIPTION OF THE YEAR 2000 ISSUE AND THE NATURE AND EFFECTS OF THE
YEAR 2000 ON INFORMATION TECHNOLOGY (IT) AND NON-IT SYSTEMS
The Year 2000 Issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Any of the Company's
computer programs or hardware that have date-sensitive software or embedded
chips may recognize a date using "00" as the year 1900 rather than the year
2000. This could result in a system failure or miscalculations causing
disruptions of operations, including, among other things, a temporary inability
to process transactions, send invoices, or engage in similar normal business
activities.
19
<PAGE>
Based on assessments, the Company determined that it was necessary to
implement upgrades to financial information systems software so that such
systems will properly utilize dates beyond December 31, 1999. The Company
presently believes that the necessary upgrades and related modifications of
existing software are complete and that the Year 2000 Issue has been mitigated.
However, if such modifications and replacements are not complete, the Year 2000
Issue could have a material impact on the operations of the Company.
The Company's plan to resolve the Year 2000 Issue involves the following
four phases: assessment, remediation, testing, and implementation. The Company
further classified all information technology systems as mission critical and
non-mission critical based on the potential for the Company's operations to be
significantly impacted by a IT systems ability to process Year 2000 dates
properly. The completed assessment indicated that most of the Company's
significant information technology systems could be affected, particularly the
general ledger, billing, payroll, and inventory systems. That assessment also
indicated that software and hardware (embedded chips) used in production and
manufacturing systems (hereafter also referred to as operating equipment) also
are at risk. Based on a review of its product line, the Company has determined
that most of the products it has sold and will continue to sell do not require
remediation to be Year 2000 compliant. Accordingly, the Company does not believe
that the Year 2000 presents a material exposure as it relates to the Company's
products. In addition, the Company has gathered and continues to gather
information about the Year 2000 compliance status of its significant suppliers
and subcontractors and continues to monitor their compliance.
STATUS OF PROGRESS IN BECOMING YEAR 2000 COMPLIANT
For its information technology exposures, to date the Company is 100%
complete on all phases with respect to all mission critical systems that could
be significantly affected by the Year 2000. The assessment phase on non-mission
critical systems are 100% complete with 35% of non-mission critical systems
through the remediation phase. The implementation phase for all non-mission
critical systems is expected to be complete in the second quarter of 1999. If
the completed and planned modifications for mission critical and non-mission
critical IT systems are inadequate, the Year 2000 Issue could have a material
impact on the operations of the Company.
The assessment phase on the Company's products did not identify any
significant use of any real time clocks that would be affected by the Year 2000
Issue. Therefore, the Company's Year 2000 activities with respect to the
Company's products are 100% complete. If management's assessment with respect to
the Company's products is incorrect, the Company may not be able to manufacture
and ship products, fill customer orders, or comply with contractual obligations.
Management believes based on its assessment that the Company is not at
significant risk with respect to the Company's products.
For operating equipment, generally considered non-critical to the Company's
operations, the Company is 65%, 60% and 60% complete in the remediation,
testing, and implementation phases, respectively. The Company expects to
complete its remediation efforts by end of the third quarter of 1999. Testing
and implementation of affected equipment is expected to be complete by the third
quarter of 1999.
NATURE AND LEVEL OF IMPORTANCE OF THIRD PARTIES AND THEIR EXPOSURE TO THE YEAR
2000
The Company's payroll application is processed directly by a third party
vendor. The Company has obtained and evaluated representations from the third
party vendor to ensure that the Company's outsourced payroll application is Year
2000 compliant.
There are no significant third party vendors that interface directly with
the Company's information systems. The Company has started but not completed
queries of its significant customers, suppliers and subcontractors that do not
share information systems with the Company (external agents). To date, the
Company is not aware of any external agent with a Year 2000 issue that would
materially impact the Company's results of operations, liquidity, or capital
resources. However, the Company has no means of
20
<PAGE>
ensuring that external agents will be Year 2000 ready. The inability of external
agents to complete their Year 2000 resolution process in a timely fashion could
materially impact the Company. The effect of non-compliance by external agents
is not determinable.
COSTS
The Company utilizes both internal and external resources to reprogram, or
replace, test, and implement the software and operating equipment for Year 2000
modifications. The total cost of the Year 2000 project is estimated at $0.3 to
$0.4 million and has been funded through operating cash flows and working
capital. To date, the Company has expensed approximately $0.25 million related
to all phases of the Year 2000 project. The remaining $0.05 to $0.15 million
relates to completing assessment, remediation, testing, and implementation with
respect to non-critical operating equipment and ongoing evaluation of third
party representations of Year 2000 readiness. The remaining Year 2000 Issue
costs will be expensed as incurred.
The costs of the project and the date on which the Company believes it will
complete the Year 2000 modifications are based on management's best estimates,
which were derived utilizing numerous assumptions of future events, including
the continuous availability of certain resources and other factors. However,
there can be no guarantee that these estimates will be achieved and actual
results could differ materially from those anticipated. Specific factors that
might cause such material differences include, but are not limited to, the
availability and cost of personnel trained in this area, the ability to locate
and correct all relevant computer codes, and similar uncertainties.
RISKS
Management of the Company believes it has an effective program in place to
resolve the Year 2000 issue in a timely manner. As noted above, the Company has
completed all necessary phases of the Year 2000 program with respect to mission
critical information technology and the Company's products. Further, as noted
above, the Company continues the assessment, remediation, testing, and
implementation phases with respect to non-mission critical IT systems and
operating equipment, and continues to gather and evaluate representations from
other third parties. In the event that the Company has not fully completed all
phases with respect to each category of Year 2000 exposure, the Company could be
unable to take customer orders, manufacture and ship products, invoice customers
or collect payments. In addition, disruptions in the economy generally resulting
from Year 2000 issues could also materially adversely affect the Company. The
Company could be subject to litigation for computer systems product failure, for
example, equipment shutdown or failure to properly date business records. The
amount of potential liability and lost revenue cannot be reasonably estimated at
this time.
The Company has contingency plans for certain critical applications and is
working on such plans for others. These contingency plans involve, among other
actions, manual workarounds, increasing inventories, adjusting staffing
strategies and restoring systems with backup copies of Company software and data
and backdating operating systems until Year 2000 issues are resolved.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Foreign Exchange. The Company's revenue originating outside the U.S. in
1998, 1997 and 1996 was 20.0%, 27.2% and 14.4% of total revenues, respectively.
Revenues generated from the European region in 1998, 1997 and 1996 was 12.2%,
9.6% and 7.9% of total revenues, respectively. International sales are made
mostly from the Company's foreign sales subsidiaries in the local countries and
are typically denominated in U.S. dollars. These subsidiaries incur most of
their expenses in the local currency.
The Company's international business is subject to risks typical of an
international business, including, but not limited to: differing economic
conditions, changes in political climate, differing tax structures, other
regulations and restrictions, and foreign exchange rate volatility. Accordingly,
the Company's future
21
<PAGE>
results could be materially adversely impacted by changes in these or other
factors. The effect of foreign exchange rate fluctuations on the Company in
1998, 1997 and 1996 was not material.
Interest Rates. The Company invests its cash in a variety of financial
instruments, including bank time deposits, fixed rate obligations of
corporations, municipalities, and state and national governmental entities and
agencies. These investments are denominated in U.S. dollars. Cash balances in
foreign currencies overseas are operating balances and are invested in
short-term time deposits of the local operating bank.
Interest income on the Company's investments is carried in "Interest income,
net." The Company accounts for its investment instruments in accordance with
Statement of Financial Accounting Standards No. 115, "Accounting for Certain
Investments in Debt and Equity Securities" ("SFAS 115"). All of the cash
equivalents and short-term investments are treated as available-for-sale under
SFAS 115.
Investments in fixed rate interest earning instruments carry a degree of
interest rate risk. Fixed rate securities may have their fair market value
adversely impacted due to a rise in interest rates. Due in part to these
factors, the Company's future investment income may fall short of expectations
due to changes in interest rates or the Company may suffer losses in principal
if forced to sell securities which have seen a decline in market value due to
changes in interest rates. The Company's investment securities are held for
purposes other than trading. Certain of the investment securities had maturities
in excess of one year. The weighted-average interest rate on investment
securities at December 31, 1998 was 5.3%. The fair value of investments held at
December 31, 1998 approximated amortized cost.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The information required by this item is included in Part IV Item 14(a)(1
and 2).
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not applicable.
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND OFFICERS OF THE REGISTRANT.
DIRECTORS
The information regarding Directors of the Company appearing under the
captions "Election of Directors" and "Compliance with Section 16 Reporting
Requirements" contained in the Company's definitive Proxy Statement filed in
connection with the Company's 1999 Annual Meeting of Stockholders is
incorporated herein by reference.
22
<PAGE>
EXECUTIVE OFFICERS AND OFFICERS
The following table sets forth the names and ages of all executive officers
and officers of the Company, their respective positions with the Company, and
the period during which each has served as an officer.
<TABLE>
<CAPTION>
SERVED AS
NAME AGE POSITION(S) OFFICER SINCE
- ------------------------ --- ----------------------------------------------- ---------------
<S> <C> <C> <C>
G. Ward Paxton 63 Chairman of the Board of Directors, President 1983
and Chief Executive Officer
T. Joe Head 42 Executive Vice President and Director 1983
Timothy W. Kinnear 35 Executive Vice President, Chief Operating 1996
Officer, Chief Financial Officer, Corporate
Secretary, Treasurer and Director
Billie J. Cottongim 68 Vice President--Manufacturing Engineering 1987
David L. Drake 42 Vice President--Engineering, Security Products 1998
Eric H. Gore 45 Vice President--Strategic Business Development 1994
Garry L. Hemphill 50 Vice President--Operations 1987
John W. Howland 39 Vice President--North American Sales 1998
Michael McGowen 45 Vice President--Engineering, Chief Technical 1998
Officer
Jerry W. Pate 46 Vice President--Chief Engineer 1987
Timothy E. Woods 38 Vice President--Technical Customer Services 1992
</TABLE>
G. WARD PAXTON is a co-founder of the Company and has served as Chairman of
the Board of Directors, President and Chief Executive Officer since the
Company's inception in September 1983 and served as Chief Financial Officer from
1983 until 1994. Prior to founding the Company, Mr. Paxton was Vice President of
Honeywell Optoelectronics, a division of Honeywell, Inc., from 1978 to 1983.
From 1969 to 1978, Mr. Paxton was Chairman of the Board of Directors, President,
Chief Executive Officer and founder of Spectronics, Inc., which was acquired by
Honeywell, Inc. in 1978. Prior to founding Spectronics, Inc., Mr. Paxton held
various managerial and technical positions at Texas Instruments Incorporated
from 1959 to 1969. Mr. Paxton holds Ph.D., M.S. and B.S. degrees in Physics from
the University of Oklahoma.
T. JOE HEAD is co-founder of the Company and has served as Executive Vice
President since 1998 and a Senior Vice President and a director since the
Company's inception in September 1983. Prior to co-founding the Company, Mr.
Head held the positions of Product Marketing Manager and Marketing Engineer at
Honeywell Optoelectronics from 1980 to 1983. Mr. Head holds a B.S. degree in
Electrical Engineering from Texas A & M University.
TIMOTHY W. KINNEAR has served as a director of the Company since November
1998. Mr. Kinnear is currently Executive Vice President, Chief Operating
Officer, Chief Financial Officer, Corporate Secretary and Treasurer. Mr. Kinnear
was Vice President and Chief Financial Officer of the Company since September of
1996. Prior to joining the Company, Mr. Kinnear held various managerial
positions,
23
<PAGE>
including Vice President of Finance, at Cyrix Corporation from 1992 to 1996.
Prior to joining Cyrix Corporation, Mr. Kinnear held various positions,
including Audit Manager, at Ernst & Young LLP from 1986 to 1992. Mr. Kinnear
holds a B.B.A. degree in Accounting from Texas Tech University.
BILLIE J. COTTONGIM has served as Vice President--Manufacturing Engineering
of the Company since 1987 and previously served as its Director of Manufacturing
Engineering from 1983 to 1987. Prior to joining the Company, Mr. Cottongim held
the position of Senior Engineer at Honeywell Optoelectronics from 1982 to 1983.
DAVID L. DRAKE has served the Company as Vice President--Engineering,
Security Products since October 1998. Prior to joining the Company, Mr. Drake
held various positions, including Chief Scientist, Center for Information
Security Technology, at Science Applications International Corporation from 1992
to 1998.
ERIC H. GORE has served the Company as Vice President--Strategic Business
Development since February 1994. Mr. Gore previously held positions with the
Company as Director of Strategic Business Development from 1992 to 1994, Area
Sales Manager from 1989 to 1992 and Regional Sales Manager from 1984 to 1989.
Prior to joining the Company, Mr. Gore served Texas Instruments Incorporated as
Marketing Manager--Eastern United States from 1982 to 1983 and Product Marketing
Representative from 1979 to 1982.
GARRY L. HEMPHILL has served the Company as Vice President--Operations since
1987 and previously served as its Manager of Operations from 1984 to 1987. Prior
to joining the Company, Mr. Hemphill held the position of Supervisor of Military
Products at Honeywell Optoelectronics from 1979 to 1983.
JOHN W. HOWLAND has served the Company as Vice President--North American
Sales since October 1998. Mr. Howland previously held positions with the Company
as Director of Federal Sales from 1995 to 1998, Regional Sales Manager from 1993
to 1995 and Account Manager from 1991 to 1993. Prior to joining the Company, Mr.
Howland held the position of Program Manager for American Systems, Corporation
from 1986 to 1991 and Design Engineer for Media General Cable from 1981 to 1986.
MICHAEL MCGOWEN has served the Company as Chief Technical Officer and Vice
President of Engineering since August 1998. Mr. McGowen previously held the
positions of Chief Technical Officer from 1992 to 1997 and Chief Executive
Officer from 1997 to 1998 for Essential Communication Corporation. Essential
Communication Corporation was acquired in May 1998 by the Company.
JERRY W. PATE has served the Company as Vice President--Chief Engineer since
February 1992 and previously served as its Vice President from 1987 to February
1992 and Director of Engineering from 1983 to 1987. Prior to joining the
Company, Mr. Pate served as an independent consultant for Honeywell
Optoelectronics and Siemens AG from 1980 to 1983.
TIMOTHY E. WOODS has served the Company as Vice President--Customer
Technical Services since February 1992 and previously held positions with the
Company as Manager of Technical Support and Product Support Engineer from 1990
to 1991. Prior to joining the Company, Mr. Woods held the position of Systems
Design Engineer at Jaycor Technical Services, Incorporated from 1987 to 1990.
Neither the Company nor any of its subsidiaries has employment agreements
with any of its executives.
All executive officers of the Company are elected annually by the Board of
Directors and serve at the discretion of the Board. There are no other family
relationships between any director or executive officer and any other such
person.
24
<PAGE>
ITEM 11. EXECUTIVE COMPENSATION.
The information set forth under the caption "Executive Compensation"
contained in the Company's definitive Proxy Statement filed in connection with
the 1999 Annual Meeting of Stockholders is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information set forth under the caption "Security Ownership of Certain
Beneficial Owners and Management" contained in the Company's definitive Proxy
Statement filed in connection with the 1999 Annual Meeting of Stockholders is
incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information set forth under the caption "Certain Transactions" contained
in the Company's definitive Proxy Statement filed in connection with the 1999
Annual Meeting of Stockholders is incorporated herein by reference.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
<TABLE>
<S> <C> <C>
(a) 1. CONSOLIDATED FINANCIAL STATEMENTS.
The following consolidated financial statements of ODS Networks, Inc. and
subsidiaries, are submitted as a separate section of this report (See F pages), and
are incorporated by reference in Item 8:
<CAPTION>
PAGE NO.
-----------
<S> <C> <C>
Report of Independent Auditors F-1
Consolidated Balance Sheets at December 31, 1998 and 1997 F-2
Consolidated Statements of Income for the years ended December 31, 1998,
1997 and 1996 F-3
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1998, 1997 and 1996 F-4
Consolidated Statements of Cash Flows for the years ended December 31,
1998, 1997 and 1996 F-5
Notes to Consolidated Financial Statements F-6
2. FINANCIAL STATEMENT SCHEDULES.
<CAPTION>
PAGE NO.
-----------
<S> <C> <C>
SCHEDULE II--Valuation and Qualifying Accounts S-1
</TABLE>
All other schedules are omitted because they are either not required or not
applicable or the required information is shown in the Consolidated Financial
Statements or Notes thereto.
25
<PAGE>
(b) REPORTS ON FORM 8-K.
On October 13, 1998, the Company filed a Current Report on Form 8-K (Item 5)
in order to report the acquisition of certain assets from Science Applications
International Corporation during the quarter ended September 30, 1998.
(c) EXHIBITS.
The following Exhibits are filed herewith pursuant to Item 601 of Regulation
S-K or are incorporated herein by reference to previous filings as noted:
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
- --------- ---------------------------------------------------------------------------------------------------
<C> <S> <C>
3.1(1) Certificate of Incorporation of the Registrant.
3.2(1) Bylaws of the Registrant.
4.1(2) Specimen of Common Stock Certificate.
10.1(3) Lease Agreement, dated September 12, 1989, between G.D.A.F. Associates and the Registrant for the
Registrant's headquarters and executive office building.
10.2(3) 1983 Incentive Stock Option Plan of ODS Networks, Inc. (formerly Optical Data Systems, Inc.), as
amended.
10.3(3) 1987 Incentive Stock Option Plan of ODS Networks, Inc. (formerly Optical Data Systems, Inc.), as
amended.
10.4(3) Copy of Stock Option granted to Robert Anderson.
10.5(3) Form of Indemnification Agreement.
10.6(7) Amended and Restated ODS 401(k) Savings Plan, effective April 1, 1997.
10.7(7) Amendment to the ODS 401(K) Savings Plan, effective November 1, 1997.
10.8(4) 1995 Stock Option Plan of ODS Networks, Inc. (formerly Optical Data Systems, Inc.)
10.9(4) 1995 Non-Employee Directors Stock Option Plan of ODS Networks, Inc. (formerly Optical Data Systems,
Inc.)
10.11(5) Supplemental Lease Agreement, dated March 7, 1995, between G.D.A.F. Associates, subsequently
assigned to CIIF Associates II Limited Partnership, Landlord, and the Registrant, as Tenant,
relative to the Registrant's headquarters and executive office building.
10.12(6) 1997 Employee Stock Purchase Plan of ODS Networks, Inc. (formerly Optical Data Systems, Inc.)
10.13(10) Amendment to the ODS 401(K) Savings Plan, effective May 29, 1998.
10.14(10) Amendment to the ODS 401(K) Savings Plan, effective October 1, 1998.
10.15(8) Asset and Securities Purchase Agreement, dated as of September 25, 1998, by and among the
Registrant and Science Applications International Corporation.
10.16(8) Registration Rights Agreement, dated as of September 25, 1998, by and between the Registrant and
Science Applications International Corporation.
10.17(8) $8.00 Warrant to Purchase Common Stock of the Registrant, dated September 25, 1998, issued to
Science Applications International Corporation.
10.18(8) $10.50 Warrant to Purchase Common Stock of the Registrant, dated September 25, 1998, issued to
Science Applications International Corporation.
10.19(8) Stockholder and Voting Agreement, dated as of September 25, 1998, by and among Science Applications
International Corporation, the Registrant and certain stockholders of the Registrant.
</TABLE>
26
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
- --------- ---------------------------------------------------------------------------------------------------
<C> <S> <C>
10.20(8) Strategic Alliance Agreement, dated as of September 25, 1998, by and between Science Applications
International Corporation and the Registrant.
10.21(8) Software Royalty, Grant Back and Improvements License Agreement, dated as of September 25, 1998, by
and between Science Applications International Corporation and the Registrant.
10.22(8) PartnersPlus Agreement, dated September 25, 1998, by and between the Registrant and Science
Applications International Corporation.
10.23(9) Agreement and Plan of Merger, dated April 30, 1998, by and among the Registrant, ECC Acquisition
Corp., and Essential Communication Corporation.
21(10) Subsidiaries of the Registrant.
23(10) Consent of Independent Auditors.
27(10) Financial Data Schedule.
</TABLE>
- ------------------------
(1) Filed as an Exhibit in the Registrant's Current Report on Form 8-K dated
November 6, 1995 (Date of Earliest Event Reported: October 31, 1995;
Commission File No. 0-20191), which Exhibit is incorporated herein by
reference.
(2) Filed as an Exhibit in the Registrant's Current Report on Form 8-K dated
May 7, 1997 (Date of Earliest Event Reported: April 24, 1997; Commission
File No. 0-20191), which Exhibit is incorporated herein by reference.
(3) Filed as an Exhibit in the Registrant's Registration Statement on Form S-1,
as amended (File No. 33-6899) which was declared effective on May 21, 1992,
by the Securities and Exchange Commission, which Exhibit is incorporated
herein by reference.
(4) Filed as an Exhibit to the Registrant's definitive Proxy Statement in
connection with the solicitation of proxies for its 1995 Annual Meeting of
Stockholders (File No. 0-20191), which Exhibit is incorporated herein by
reference.
(5) Filed as an Exhibit in the Registrant's Annual Report on Form 10-K, for the
fiscal year ended December 31, 1995 (File No. 0-20191), which Exhibit is
incorporated herein by reference.
(6) Filed as an Exhibit in the Registrant's definitive Proxy Statement filed in
connection with the solicitation of proxies for its 1997 Annual Meeting of
Stockholders (File No. 0-20191), which Exhibit is incorporated herein by
reference.
(7) Filed as an Exhibit in the Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1997 (File No. 0-20191), which Exhibit is
incorporated herein by reference.
(8) Filed as an Exhibit in the Registrant's Current Report on Form 8-K (Item
5), dated October 13, 1998 (File No. 0-20191), which Exhibit is
incorporated herein by reference.
(9) Filed as an Exhibit in the Registrant's Current Report on Form 8-K (Item
2), dated May 21, 1998 (File No. 0-20191), which Exhibit is incorporated
herein by reference.
(10) Filed herewith.
27
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
ODS NETWORKS, INC.
Dated: March 20, 1999 (Registrant)
By: /s/ G. WARD PAXTON
-----------------------------------------
G. Ward Paxton
CHAIRMAN OF THE BOARD OF DIRECTORS,
PRESIDENT AND CHIEF EXECUTIVE OFFICER
(PRINCIPAL EXECUTIVE OFFICER)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
- ------------------------------ -------------------------- -------------------
Chairman of the Board of
/s/ G. WARD PAXTON Directors, President and
- ------------------------------ Chief Executive Officer March 20, 1999
G. Ward Paxton (Principal Executive
Officer)
Executive Vice President,
Chief Operating Officer,
/s/ TIMOTHY W. KINNEAR Chief Financial Officer,
- ------------------------------ Corporate Secretary, March 20, 1999
Timothy W. Kinnear Treasurer and Director
(Principal Financial and
Accounting Officer)
/s/ T. JOE HEAD
- ------------------------------ Executive Vice President March 20, 1999
T. Joe Head and Director
/s/ ROBERT ANDERSON
- ------------------------------ Director March 20, 1999
Robert Anderson
/s/ J. FRED BUCY
- ------------------------------ Director March 20, 1999
J. Fred Bucy
/s/ DONALD M. JOHNSTON
- ------------------------------ Director March 20, 1999
Donald M. Johnston
/s/ WILLIAM A. ROPER, JR.
- ------------------------------ Director March 20, 1999
William A. Roper, Jr.
/s/ DOUGLAS M. SCHRIER
- ------------------------------ Director March 20, 1999
Douglas M. Schrier
28
<PAGE>
ANNUAL REPORT ON FORM 10-K
ITEM 14(a)(1)
LIST OF FINANCIAL STATEMENTS
YEAR ENDED DECEMBER 31, 1998
ODS NETWORKS, INC.
RICHARDSON, TEXAS
<PAGE>
REPORT OF INDEPENDENT AUDITORS
The Board of Directors and Stockholders,
ODS Networks, Inc.
We have audited the accompanying consolidated balance sheets of ODS
Networks, Inc., and subsidiaries (the Company) as of December 31, 1998, and
1997, and the related consolidated statements of operations, stockholders'
equity, and cash flows for each of the three years in the period ended December
31, 1998. These financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free from
material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit
also includes assessing the accounting principles used and significant estimates
made by management, as well as evaluating the overall financial statement
presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of ODS Networks,
Inc., and subsidiaries at December 31, 1998 and 1997, and the consolidated
results of their operations and their cash flows for each of the three years in
the period ended December 31, 1998, in conformity with generally accepted
accounting principles.
[SIG]
Dallas, Texas
January 22, 1999
F-1
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PAR VALUE AMOUNTS)
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
--------- ---------
<S> <C> <C>
ASSETS
Current Assets:
Cash and cash equivalents $ 16,791 $ 17,911
Short-term investments 4,760 14,667
Accounts receivable, net of allowance for doubtful accounts
and returns of $880 in 1998 and $758 in 1997 6,265 8,668
Income taxes receivable 4,749 3,159
Inventories, net (Note 6) 9,262 14,671
Deferred tax assets (Note 10) -- 1,721
Other assets 759 1,221
--------- ---------
Total current assets 42,586 62,018
Property and Equipment:
Land 602 600
Building and building improvements 2,511 2,492
Machinery and equipment 8,760 20,649
Furniture and fixtures 1,294 1,048
Leasehold improvements 970 1,068
--------- ---------
14,137 25,857
Accumulated depreciation (6,510) (14,021)
--------- ---------
7,627 11,836
Long-term investments -- 3,168
Equity investments 700 --
Goodwill and intangible assets, net (Note 6) 10,614 --
Other assets 183 156
--------- ---------
TOTAL ASSETS $ 61,710 $ 77,178
--------- ---------
--------- ---------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current Liabilities:
Accounts payable and accrued expenses (Note 6) $ 7,700 $ 8,709
Deferred revenue 3,123 1,462
--------- ---------
Total current liabilities 10,823 10,171
Deferred tax liabilities (Note 10) 1,361 628
Capital lease obligation 20 --
Stockholders' Equity (Note 11):
Preferred stock, $.01 par value:
Authorized shares--5,000
No shares issued and outstanding -- --
Common stock, $.01 par value:
Authorized shares--80,000
Issued and outstanding shares--18,513 in 1998 and 16,486 in 1997 185 165
Additional paid-in capital 29,551 19,488
Retained earnings 21,282 47,032
Note receivable from stockholder (1,189) --
Foreign currency translation adjustments (323) (306)
--------- ---------
Total stockholders' equity 49,506 66,379
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 61,710 $ 77,178
--------- ---------
--------- ---------
</TABLE>
See accompanying notes.
F-2
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------------
1998 1997 1996
---------- --------- ----------
<S> <C> <C> <C>
Net sales $ 74,610 $ 92,327 $ 117,864
Cost of sales 50,230 55,795 60,737
---------- --------- ----------
Gross profit 24,380 36,532 57,127
Operating expenses:
Sales and marketing 29,378 30,390 25,969
Research and development 12,244 10,810 10,417
In process research and development 3,347 -- --
General and administrative 4,882 4,912 3,844
Amortization of intangibles 968 -- --
Restructuring charge 3,932 -- --
---------- --------- ----------
54,751 46,112 40,230
---------- --------- ----------
Operating income (loss) (30,371) (9,580) 16,897
Interest income, net 1,398 1,639 944
Other expense (1,122) -- --
---------- --------- ----------
Income (loss) before provision for income taxes (30,095) (7,941) 17,841
Provision (benefit) for income taxes (4,345) (3,004) 6,790
---------- --------- ----------
Net income (loss) $ (25,750) $ (4,937) $ 11,051
---------- --------- ----------
---------- --------- ----------
Basic earnings (loss) per share $ (1.50) $ (0.30) $ 0.68
---------- --------- ----------
---------- --------- ----------
Diluted earnings (loss) per share $ (1.50) $ (0.30) $ 0.66
---------- --------- ----------
---------- --------- ----------
Weighted average common shares outstanding 17,190 16,437 16,261
---------- --------- ----------
---------- --------- ----------
Weighted average shares outstanding assuming dilution 17,190 16,437 16,825
---------- --------- ----------
---------- --------- ----------
</TABLE>
See accompanying notes.
F-3
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)
<TABLE>
<CAPTION>
NOTE FOREIGN
ADDITIONAL RECEIVABLE CURRENCY
NUMBER OF COMMON PAID-IN RETAINED FROM TRANSLATION STOCKHOLDERS'
SHARES STOCK CAPITAL EARNINGS STOCKHOLDER ADJUSTMENT EQUITY
----------- ----------- ----------- ----------- --------------- ------------- -------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31,
1995 16,150 $ 162 $ 17,729 $ 40,918 -- $ (111) $ 58,698
Foreign currency
translation adjustment -- -- -- -- -- (9) (9)
Exercise of stock warrants 5 -- 22 -- -- -- 22
Issuance of common stock
under stock option and
purchase plans 173 1 614 -- -- -- 615
Tax benefit derived from
the exercise of employee
stock options -- -- 543 543
Net income for 1996 -- -- -- 11,051 -- -- 11,051
----------- ----- ----------- ----------- ------- ------ -------------
Balance at December 31,
1996 16,328 163 18,908 51,969 -- (102) 70,938
Foreign currency
translation adjustment -- -- -- -- -- (204) (204)
Exercise of stock warrants 59 1 266 -- -- -- 267
Issuance of common stock
under stock option and
purchase plans 99 1 287 -- -- -- 288
Tax benefit derived from
the exercise of employee
stock options -- -- 27 -- -- -- 27
Net loss for 1997 -- -- -- (4,937) -- -- (4,937)
----------- ----- ----------- ----------- ------- ------ -------------
Balance at December 31,
1997 16,486 165 19,488 47,032 -- (306) 66,379
FOREIGN CURRENCY
TRANSLATION ADJUSTMENT -- -- -- -- -- (17) (17)
ISSUANCE OF COMMON STOCK
FOR ESSENTIAL
COMMUNICATION
CORPORATION ACQUISITION 306 3 2,941 -- -- -- 2,944
ISSUANCE OF COMMON STOCK
FOR SAIC TRANSACTION 1,600 16 6,704 -- -- -- 6,720
ISSUANCE OF COMMON STOCK
UNDER STOCK OPTION AND
PURCHASE PLANS 121 1 383 -- -- -- 384
TAX BENEFIT DERIVED FROM
THE EXERCISE OF EMPLOYEE
STOCK OPTIONS -- -- 35 -- -- -- 35
NOTE RECEIVABLE FROM
STOCKHOLDER -- -- -- -- (1,189) -- (1,189)
NET LOSS FOR 1998 -- -- -- (25,750) -- -- (25,750)
----------- ----- ----------- ----------- ------- ------ -------------
BALANCE AT DECEMBER 31,
1998 18,513 $ 185 $ 29,551 $ 21,282 $ (1,189) $ (323) $ 49,506
----------- ----- ----------- ----------- ------- ------ -------------
----------- ----- ----------- ----------- ------- ------ -------------
</TABLE>
See accompanying notes.
F-4
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------
1998 1997 1996
---------- --------- ---------
<S> <C> <C> <C>
Operating Activities:
Net income (loss) $ (25,750) $ (4,937) $ 11,051
Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activities:
Depreciation and amortization 4,601 3,285 2,618
In process research and development 3,347 -- --
Impaired investment in affiliate 1,122 -- --
Non-cash restructuring charge 3,460 -- --
Provision for deferred income taxes 979 (195) (455)
Provision for doubtful accounts and returns 147 86 227
Changes in operating assets and liabilities:
Accounts receivable 3,115 7,819 (1,562)
Income tax receivable (1,555) (3,047) (154)
Inventories 5,755 10,902 (6,199)
Other assets 349 (316) (122)
Accounts payable and accrued expenses (1,924) 26 (1,787)
Deferred revenue 1,061 (251) 316
Capital lease obligation 7 -- --
---------- --------- ---------
Net cash provided by (used in) operating activities (5,286) 13,372 3,933
Investing Activities:
Equity investment in affiliate (1,250) -- --
Payments for corporate acquisition (net of cash required) (5,604) -- --
Purchases of short-term investments (2,437) (17,967) (23,707)
Maturities of short-term investments 17,107 24,616 25,245
Purchases of long-term investments (1,606) (5,665) (5,050)
Maturities of long-term investments 11 21 --
Purchases of property and equipment (2,333) (3,382) (4,899)
---------- --------- ---------
Net cash provided by (used in) investing activities 3,888 (2,377) (8,411)
Financing Activities:
Issuance of common stock and warrants 1,500 -- --
Note receivable secured by company's common stock (1,189) -- --
Repayment of line of credit (400) -- --
Exercise of warrants -- 267 22
Exercise of employee stock options 384 288 615
---------- --------- ---------
Net cash provided by financing activities 295 555 637
---------- --------- ---------
Effect of foreign currency translation adjustment on cash and cash equivalents (17) (204) 9
Net (decrease) increase in cash and cash equivalents (1,120) 11,346 (3,832)
Cash and cash equivalents at beginning of period 17,911 6,565 10,397
---------- --------- ---------
Cash and cash equivalents at end of period $ 16,791 $ 17,911 $ 6,565
---------- --------- ---------
---------- --------- ---------
</TABLE>
See accompanying notes.
F-5
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. DESCRIPTION OF BUSINESS
ODS Networks, Inc. ("ODS", the "Company" or the "Registrant") develops,
markets and supports switches, network management and security software and
related products that securely link computer networks. The Company's products
enable customers to connect computers and supercomputers to form clusters,
workgroups and local area networks ("LANs"), to build backbones for
enterprise-wide networks, and to create networks that are protected from access,
theft and damage by unauthorized network users and protected from misuse by
curious or disgruntled employees, contractors and other authorized users.
The Company markets and distributes its products primarily through a direct
sales force to end-users and by numerous domestic and international system
integrators, service providers and value-added resellers. The Company's end-user
customers include manufacturing, telecommunications, retail, transportation,
health care, insurance, entertainment, utilities and energy companies,
government agencies, financial institutions, and academic institutions.
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of ODS Networks,
Inc. and its wholly-owned subsidiaries. Intercompany balances and transactions
have been eliminated in consolidation.
CASH EQUIVALENTS
The Company considers cash and all highly liquid investments purchased with
an original or remaining maturity of less than three months at the date of
purchase to be cash equivalents.
SHORT-TERM INVESTMENTS
The Company's short-term investments consist of U.S. government obligations,
government agencies, and corporate securities with maximum maturities of one
year. Short-term investments are classified as available for sale. These
investments are valued at market value, which approximates amortized cost. The
difference between fair value and amortized cost is not material.
RISK CONCENTRATION
Financial instruments which potentially subject the Company to
concentrations of credit risk are primarily cash and cash-equivalents,
investments and accounts receivable. The Company places its investments in U.S.
government obligations, corporate securities and money market funds.
Substantially all of the Company's cash, cash equivalents and investments are
maintained with one major financial institution.
The Company sells its products to customers in diversified industries
worldwide, primarily in North America, Europe, Asia and Latin America.
Fluctuations in currency exchange rates and adverse economic developments in
Malaysia, South Korea and certain other countries could adversely effect the
Company's operating results. The Company performs ongoing credit evaluations of
its customers' financial condition and generally requires no collateral. The
Company maintains reserves for potential credit losses and such losses, in the
aggregate, have not exceeded management expectations.
While the Company believes that many of the materials used in the production
of its products are generally readily available from a variety of sources,
certain components are available from one or a
F-6
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
limited number of suppliers. The inability of any supplier or manufacturer to
fulfill supply requirements of the Company could impact future results.
INVENTORIES
Inventories are stated at the lower of cost or market. Cost is computed
using standard cost, which approximates actual cost on a first-in, first-out
basis. Management estimates the allowance required to state inventory at the
lower of cost or market. There is a risk that the Company will forecast demand
for its products and market conditions incorrectly and produce excess
inventories. Therefore, there can be no assurance that the Company will not
produce excess inventory and incur inventory lower of cost or market charges in
the future.
PROPERTY AND EQUIPMENT
Property and equipment is stated at cost and depreciated on a straight-line
basis over the estimated useful lives of the assets. Such lives vary from 3 to
20 years. Leasehold improvements are amortized over the shorter of their useful
lives or the terms of the leases. Repair and maintenance costs are expensed as
incurred.
LONG-TERM INVESTMENTS
Long-term investments consist of U.S. government obligations and corporate
obligations with maturities which range up to two years. Long-term investments
are classified as available for sale. These investments are valued at market
value, which approximates amortized cost. The difference between fair value and
amortized cost is not material
EQUITY INVESTMENTS
The Company uses the equity method to account for investments in common
stock of affiliated companies where the Company has the ability to exercise
significant influence over operating and financial policies of the affiliated
company, generally where the Company owns between 20% and 50% of an affiliated
company's common stock. The Company's carrying amount of the investment is
adjusted to reflect the Company's share of income, loss or dividends of the
affiliated company and the Company's share of income or loss of the affiliated
company is reported in the income statement of the Company.
GOODWILL AND OTHER INTANGIBLE ASSETS
Goodwill represents the excess of purchase price and related direct costs
over the value assigned to the net tangible and specifically identifiable
intangible assets of businesses acquired. Goodwill is being amortized using the
straight-line method over 7 years. Intangibles generally relate to software and
developed technology acquired in a purchase business combination or an
acquisition of assets. Intangibles are being amortized over their estimated
useful lives, generally estimated at 7 years. Annual amortization expense and
accumulated amortization related to goodwill and other intangible assets as of
and for the year ended December 31, 1998 was $968,000.
The Company assesses whether its goodwill and other intangible assets are
impaired as required by SFAS No. 121, ACCOUNTING FOR THE IMPAIRMENT OF
LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF, based on the
evaluation of undiscounted projected cash flows through the remaining
amortization
F-7
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
period. If an impairment exists, the amount of such impairment is calculated
based on the estimated fair value of the asset.
FOREIGN CURRENCY TRANSLATION
The Company's international subsidiaries use their local currencies as their
functional currencies. Assets and liabilities are translated at the exchange
rate in effect at the balance sheet date, and income and expense accounts at
average exchange rates during the year. Resulting translation adjustments are
recorded directly to a separate component of stockholders' equity.
ACCOUNTING FOR STOCK OPTIONS
The Company has elected to continue to follow APB Opinion No. 25, ACCOUNTING
FOR STOCK ISSUED TO EMPLOYEES, (APB 25) and related interpretations in
accounting for its employee stock options. Under APB 25, if the exercise price
of an employee's stock option equals or exceeds the market price of the
underlying stock on the date of grant, no compensation expense is recognized.
The Financial Accounting Standards Board (FASB) has issued Statement of
Financial Accounting Standard (SFAS) No. 123, ACCOUNTING FOR STOCK-BASED
COMPENSATION, which provides for either recognition or disclosure of a
hypothetical charge for stock options. The Company did not recognize any charge
in its income statement, but has provided the required disclosure in Note 11.
NET INCOME PER SHARE
The Company reports two separate earnings per share numbers, basic EPS and
diluted EPS. Diluted EPS includes the dilutive impact of employee stock options
and warrants.
REVENUE RECOGNITION
The Company generally recognizes product revenue upon shipment of product.
The Company accrues for estimated warranty costs, sales returns and other
allowances at the time of shipment based on its experience. Revenue from
maintenance contracts is deferred and recognized over the contractual period the
services are performed. To date, warranty costs and sales returns have not been
material. There is a risk that technical issues on new products could result in
unexpected warranty costs and returns.
As of January 1, 1998, the Company adopted the American Institute of
Certified Public Accountants Statement of Position No. 97-2, SOFTWARE REVENUE
RECOGNITION, which was effective for transactions that the Company entered into
after January 1, 1998. Prior years were not restated. The most significant
impact of SOP 97-2 on the Company's revenue recognition accounting policies is
that for software contracts with multiple elements, revenue will generally be
recognized later than under past practices under SOP 91-1. Adopting SOP 97-2 had
no effect on the Company's net loss for 1998.
RESEARCH AND DEVELOPMENT COSTS
The Company incurs research and development costs that relate primarily to
the development of new products and major enhancements to existing services and
products.
Research development costs are comprised primarily of salaries and related
benefits expenses. The Company expenses or capitalizes, as appropriate, these
research and development costs in accordance with Statement of Financial
Accounting Standards No. 86, "Accounting for the Costs of Computer Software to
F-8
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
2. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
be Sold, Leased or Otherwise Marketed." All research and development costs
related to software development projects incurred prior to the time a project
has reached technological feasibility are expensed. Software development costs
incurred subsequent to reaching technological feasibility are capitalized, if
material. If the process of developing a new product or major enhancement does
not include a detailed program design, technological feasibility is determined
only after completion of a working model. All capitalized software development
costs capitalized are amortized using an amount determined as the greater of:
(i) the ratio that current gross revenues for a capitalized software project
bear to the total of current and future gross revenues for that project or (ii)
the straight-line method over the remaining economic life of the product
(generally three years). The Company did not capitalize any software development
costs in the years ending December 31, 1997 and 1998.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities at the
date of the financial statements and the reported amounts of revenue and
expenses during the reporting period. Estimates are used for, but not limited
to, the accounting for doubtful accounts, sales discounts, sales returns,
warranty costs, inventory obsolescence, depreciation and taxes. Actual results
could differ from these estimates.
INCOME TAXES
The income tax provision is based on pretax financial accounting income or
loss. The Company accounts for income taxes pursuant to SFAS No. 109, ACCOUNTING
FOR INCOME TAXES, which uses the liability method to calculate deferred income
taxes. Deferred tax assets and liabilities are recognized for the expected tax
consequences of temporary differences between the tax basis of assets and
liabilities and their reported amounts. The realization of deferred tax assets
is based on historical tax positions and expectations about future taxable
income. The liability method also requires the recognition of furture tax
benefits such as net operating loss carryforwards, to the extent that
realization of such benefits is more likely than not.
RECLASSIFICATION
Certain amounts in prior year financial statements have been reclassified to
conform with current year presentation.
3. BUSINESS COMBINATIONS AND ACQUISITION OF ASSETS
On May 7, 1998, the Company acquired Essential Communication Corporation
("Essential"), a privately-held company based in Albuquerque, New Mexico.
Essential designs and manufactures high-speed computer network equipment. The
Company exchanged a combination of $5.8 million of cash and approximately
306,000 shares of the Company's common stock for all outstanding shares of
Essential capital stock, and the Company issued approximately 104,000 stock
options in exchange for all unexpired and unexercised options to acquire
Essential capital stock. Essential's operations have been included in the
Company's consolidated financial statements since May 7, 1998, and the
acquisition was accounted for using the purchase method of accounting. The total
purchase price of $9.0 million based on a preliminary allocation was allocated
to the net assets acquired based on their estimated fair market value, which
F-9
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. BUSINESS COMBINATIONS AND ACQUISITION OF ASSETS (CONTINUED)
included approximately $7.4 million of intangible assets to be amortized over
seven years on a straight-line basis; and approximately $2.3 million of
in-process research and development. The in-process research and development was
expensed at the date of the acquisition with the Company recognizing a one-time
charge of $2.3 million, or $0.13 per share. Pro forma financial information has
not been presented.
On September 25, 1998 the Company completed an acquisition of certain assets
from Science Applications International Corporation ("SAIC"), a privately-held
company in San Diego, California. The Company acquired certain assets of the
Computer Misuse and Detection System ("CMDS") Division of SAIC and certain other
information security products under development. In exchange for the CMDS
assets, the information security products under development and $1.5 million
dollars in cash, ODS issued to SAIC 1.6 million shares of the Company's common
stock and warrants to purchase 1,500,000 shares of its common stock. Two
separate warrants each grant SAIC the right to purchase 750,000 shares of ODS
common stock. The first warrant has an exercise price of $8.00 per share and a
term of 18 months. The second warrant has an exercise price of $10.50 per share
and a term of 24 months. ODS' acquisition has been accounted for as a purchase
of software, in-process research and development and certain other assets. The
transaction value of approximately $6.9 million less the $1.5 million cash
received was allocated to the net assets acquired based on their estimated fair
market value. Assets acquired based on a preliminary allocation included
approximately $1.1 million of in-process research and development, $0.1 million
of other intangible assets and approximately $4.2 million of purchased software
to be amortized over seven years on a straight-line basis. During 1998 the
Company recognized a one-time charge of $0.7 million (net of taxes), or $0.04
per share, for write-off of the acquired in-process research and development.
The acquisition of certain assets of SAIC does not meet the reporting
requirements for pro forma financial information.
4. 1998 RESTRUCTURING
On December 31, 1998, the Company's management with the approval of the
Board of Directors committed to and implemented a series of measures to refocus
the Company's efforts on long term strategic objectives. The restructuring plans
are designed to focus the Company's efforts on high-performance network and data
security solutions while reducing the Company's cost structure and improving its
responsiveness to customers, operating efficiencies, and return on assets. The
necessity of restructuring to focus on key growth opportunities was required due
to the Company's performance levels resulting from declining markets for modular
shared media hubs and intense competition in the rapidly consolidating local
area network market.
The restructuring plan included (i) writing down the value of inventory
associated with older technologies, (ii) the write off of certain fixed assets,
(iii) preparation for closure of one of the two facilities in Richardson, Texas,
(iv) the reorganization and/or closure of certain sales offices, (v)
streamlining of research, product development and other functional activities
and (vi) workforce reductions. In connection with the change of the Company's
product focus under the Company's restructuring plan, the company recorded a
$6.7 million charge to cost of sales to write down the value of inventory with
reduced utility, generally associated with older technologies.
The Company also recorded a $3.5 million restructuring charge to write off
the value of certain fixed assets which are no longer in use and are to be
disposed of.
Implementation of the plan in the fourth quarter of 1998 resulted in
workforce reductions of approximately 45 professional staff positions and
approximately 72 manufacturing operations positions.
F-10
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. 1998 RESTRUCTURING (CONTINUED)
Overall employment at the Company has decreased, predominately due to the
restructuring, from approximately 415 employees in September 1998 to
approximately 265 employees as of December 31, 1998, a decrease of 150
employees. In connection with these cost reduction actions, the Company incurred
approximately $0.4 million of severance costs. The Company recognized a
liability and expense for the cost of the involuntary termination benefits in
fiscal 1998 as the Company's management approved the plan of termination during
fiscal 1998 and terminations were complete as of December 31, 1998.
The closure of certain facilities was initiated in 1998 and will be
substantially complete in the second quarter of 1999. The sale of the Company's
excess facility in Richardson, Texas, is expected by Company management to
generate net proceeds in excess of the assets carrying value. Ongoing operating
costs of the facilities from the commitment date through the completion date
will be recognized as incurred. Additionally, costs to sell the assets and gains
from the sale of such assets, if any, will be recognized when realized.
There were no significant accrued liabilities at December 31, 1998 related
to severance or other direct and incremental exit costs.
5. IMPAIRMENT OF EQUITY INVESTMENT
In March 1998, the Company invested $1.25 million in convertible preferred
stock in Blue Ridge Networks, Inc. ("Blue Ridge") which shares are convertible
into common voting stock of Blue Ridge in an amount, if converted, equal to a
minimum of 25% of the then outstanding voting interests of Blue Ridge. Blue
Ridge is a privately held company which provides secure remote access products
for local and wide area networks. This investment was accounted for using the
equity method of accounting with the Company's share of losses of Blue Ridge
reported in the income statement of the Company.
Due to ongoing operating losses and the uncertainty of Blue Ridge obtaining
additional outside financing, all remaining unamortized capitalized costs
related to the Company's investments in Blue Ridge were written off as of
December 31, 1998, resulting in a total charge to expense of approximately $1
million. The loss in value of the investment was determined to be other than
temporary based on a review of Blue Ridge's current and expected operating
performance and the Company's refocused efforts under the strategic
restructuring plan which did not provide for additional Company investments into
Blue Ridge.
F-11
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. BALANCE SHEET DETAIL (IN THOUSANDS)
INVENTORIES
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
--------- ---------
<S> <C> <C>
Raw materials $ 1,845 $ 4,077
Work in process 401 2,004
Finished products 5,669 6,593
Demonstration systems 1,347 1,997
--------- ---------
$ 9,262 $ 14,671
--------- ---------
--------- ---------
</TABLE>
INTANGIBLE ASSETS, NET
<TABLE>
<CAPTION>
1998 1997
--------- ---------
<S> <C> <C>
CMDS purchased software $ 4,136 $ --
CMDS intangible asset 135 --
Essential goodwill 3,971 --
Essential purchased development 3,000 --
Essential intangible asset 340 --
--------- ---------
11,582
Accumulated amortization (968) --
--------- ---------
$ 10,614 $ --
--------- ---------
--------- ---------
</TABLE>
ACCOUNTS PAYABLE AND ACCRUED EXPENSES
<TABLE>
<CAPTION>
1998 1997
--------- ---------
<S> <C> <C>
Trade accounts payable $ 3,345 $ 5,381
Accrued sales commissions 768 563
Accrued incentive bonus 406 --
Accrued vacation 776 724
Accrued property taxes 494 689
Accrued warranty expense 475 475
Other (individually less than 5% of current liabilities) 1,436 877
--------- ---------
$ 7,700 $ 8,709
--------- ---------
--------- ---------
</TABLE>
7. NOTE RECEIVABLE FROM STOCKHOLDER
Note receivable from stockholder of $1.2 million at December 31, 1998
represents amounts loaned to an officer during the third quarter of 1998 secured
by the Company's common stock. These amounts have been classified as
contra-equity because in the event the officer fails to remit payment, the
Company will receive shares of the Company's common stock.
F-12
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
8. LEASES
The Company leases office space for its corporate headquarters in
Richardson, Texas under an operating lease, the base term of which expires in
February 2005, with two seven-year options to extend the term of the lease,
subject to compliance with certain conditions. The Company also leases a
separate warehouse facility adjacent to its headquarters under a lease which
expires in June 2000. The Company leases office space in Albuquerque, New Mexico
for Essential under an operating lease which expires in February 2009. In
addition, the Company leases office space for its U.S. and international sales
and engineering offices. Total rental expense of $2.3 million, $2.1 million and
$1.9 million was charged to operations during 1998, 1997, and 1996,
respectively.
Future minimum lease payments consisted of the following at December 31,
1998 (in thousands):
<TABLE>
<CAPTION>
<S> <C>
1999 $ 1,544
2000 1,267
2001 1,240
2002 1,188
2003 1,150
Thereafter 1,619
---------
$ 8,008
---------
---------
</TABLE>
9. EMPLOYEE BENEFIT PLANS
EMPLOYEE STOCK PURCHASE PLAN
On April 24, 1997 the Company adopted an Employee Stock Purchase Plan (the
Purchase Plan) under which 0.5 million shares of common stock have been reserved
for issuance. Eligible employees may designate not more than 10% of their
compensation to be deducted each pay period for the purchase of common stock
under the Purchase Plan, and each participant may purchase up to 500 shares in
any one calendar year. On January 31 and July 31 of each calendar year, shares
of common stock are purchased with the employees' payroll deductions over the
immediately preceding six months at a price per share of 85% of the lesser of
the market price of the common stock on the purchase date or the market price on
the first day of the six-month period. The Purchase Plan will terminate no later
than April 24, 2007. A total of 20,480 shares have been issued under the
Purchase Plan as of December 31, 1998. Subsequent to December 31, 1998, 9,301
shares of stock were issued under the Purchase Plan for an aggregate purchase
price of $41,482 related to the purchase period which commenced on August 1,
1998 and ended on January 31, 1999.
EMPLOYEE 401(K) PLAN
The Company has adopted a plan known as the ODS 401(k) Savings Plan (the
Plan) to provide retirement and incidental benefits for its employees. The Plan
covers substantially all employees who meet minimum age and service
requirements. As allowed under Section 401(k) of the Internal Revenue Code, the
Plan provides tax deferred salary deductions for eligible employees.
Employees may contribute from 1% to 19% of their annual compensation to the
Plan, limited to a maximum amount as set by the Internal Revenue Service. The
Company matches employee contributions at the rate of $0.25 per each $1.00 of
contribution on the first 4% of deferred compensation. Company
F-13
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
9. EMPLOYEE BENEFIT PLANS (CONTINUED)
matching contributions to the Plan were approximately $119,000, $121,000, and
$110,000 in 1998, 1997 and 1996, respectively.
10. INCOME TAXES
Deferred income taxes reflect the net tax effects of temporary differences
between the carrying amounts of assets and liabilities for financial reporting
purposes and the amounts used for income tax purposes. Significant components of
the Company's deferred tax assets and liabilities as of December 31, 1998 and
December 31, 1997 are as follows (in thousands):
<TABLE>
<CAPTION>
1998 1997
--------- ---------
<S> <C> <C>
Deferred tax assets:
Foreign subsidiaries net operating loss carryforward $ 404 $ 429
Net operating loss carryovers 1,622 --
Minimum tax credit 410 --
Book over tax depreciation 268 --
Intangibles 442 --
Equity investments 471 --
Vacation accrual 292 272
Allowance for doubtful accounts and returns 202 285
Warranty accrual 179 179
Inventory allowance 2,667 973
Deferred revenue 179 --
Other 252 12
--------- ---------
Deferred tax assets 7,388 2,150
Valuation allowance for deferred tax assets (7,388) (429)
--------- ---------
Deferred tax assets, net of allowance -- 1,721
--------- ---------
Deferred tax liabilities:
Tax over book depreciation -- 647
Intangibles 1,361 --
Other -- (19)
--------- ---------
Total deferred tax liabilities 1,361 628
--------- ---------
Net deferred tax assets (liabilities) $ (1,361) $ 1,093
--------- ---------
--------- ---------
</TABLE>
Deferred tax assets are required to be reduced by a valuation allowance if
it is more likely than not that some portion or all of the deferred tax assets
will not be realized. Realization of the future benefits related to the deferred
tax assets is dependent on many factors, including the Company's ability to
generate taxable income within the near to medium term. Management has
considered these factors in determining the valuation allowance in 1998.
F-14
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. INCOME TAXES (CONTINUED)
Significant components of the provision for income taxes for the years ended
1998, 1997 and 1996 are as follows (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Income tax provision
Federal:
Current $ (5,630) $ (2,671) $ 6,437
Deferred 1,478 (176) (403)
State:
Current 200 (249) 766
Deferred (433) (19) (52)
Foreign:
Current 40 111 42
--------- --------- ---------
$ (4,345) $ (3,004) $ 6,790
--------- --------- ---------
--------- --------- ---------
</TABLE>
The differences between the provision for income taxes and income taxes
computed using the federal statutory rate for the years ended 1998, 1997 and
1996 are as follows (in thousands):
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------
1998 1997 1996
---------- --------- ---------
<S> <C> <C> <C>
Reconciliation of income tax provision to statutory rate:
Income tax expense at statutory rate $ (10,513) $ (2,779) $ 6,244
State taxes, less federal benefit (151) (174) 466
Increase in valuation allowance 5,136 -- --
In process research and development 805 -- --
Goodwill amortization 132 -- --
Other 246 (51) 80
---------- --------- ---------
$ (4,345) $ (3,004) $ 6,790
---------- --------- ---------
---------- --------- ---------
</TABLE>
F-15
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
At December 31, 1998, the Company had net operating loss carryforwards of
$0.3 million for income tax purposes that expire in 2018, and net operating loss
carryforwards of approximately $4.0 million subject to both separate return loss
year limitations and ownership change limitations under internal revenue code
Section 382, which begin expiring in 2008. Net operating loss carryforwards of
the foreign subsidiaries of $0.8 million at December 31, 1998 are available
indefinitely for offset only against taxable income generated by the foreign
subsidiaries. In addition, the Company has tentative minimum tax credit
carryovers of approximately $0.4 million which may be carried forward
indefinitely.
The Company made income tax payments of $0.1 million, $0.4 million and $7.4
million during 1998, 1997 and 1996, respectively.
11. STOCK, STOCK OPTIONS AND WARRANTS
On May 7, 1998 in connection with the Company's acquisition of Essential the
Company issued approximately 306,000 shares of the Company's Common Stock for
all outstanding shares of Essential capital stock, and the Company issued
approximately 104,000 stock options in exchange for all unexpired and
unexercised options to acquire Essential capital stock.
On September 25, 1998 in connection with the Company's acquisition of
certain assets from Science Applications International Corporation ("SAIC"), the
Company issued to SAIC 1.6 million shares of the Company's common stock and
warrants to purchase 1,500,000 shares of its common stock. Two separate warrants
each grant SAIC the right to purchase 750,000 shares of its common stock. The
first warrant has an exercise price of $8.00 per share and a term of 18 months.
The second warrant has an exercise price of $10.50 per share and a term of 24
months.
At December 31, 1998, the Company has four stock-based compensation plans,
which are described below. The Company established an Incentive Stock Option
Plan in 1983, which provides for the issuance of options to key employees of the
Company to purchase common stock of the Company. The 1983 Incentive Stock Option
Plan was terminated on November 10, 1993.
In 1987, an additional Incentive Stock Option Plan was established with
similar provisions to allow for further issuance of options. The 1987 Incentive
Stock Option Plan was terminated on January 26, 1997. Each plan provides for the
issuance of up to 1.2 million shares of common stock upon exercise of options
granted pursuant to the plans.
In 1995, the Company adopted the 1995 Stock Option Plan (the 1995 Plan)
which provides for the issuance of up to 1.6 million shares of common stock upon
exercise of options granted pursuant to the 1995 Plan. The 1995 Plan provides
for the issuance of both non-qualified and incentive stock options to employees,
officers, and employee-directors of the Company.
In 1995, the Company adopted the 1995 Non-employee Director Stock Option
Plan (the 1995 Non-employee Director Plan) which provides for the issuance of up
to 160,000 shares of common stock upon exercise of options granted pursuant to
the 1995 Non-employee Director Plan. The Plan provides for the issuance of
non-qualified stock options to non-employee directors.
In 1995 and 1994, options to purchase 60,000 shares, and 12,000 shares,
respectively, were granted to directors. The terms and exercise prices of these
options are similar to the incentive stock options.
Common shares reserved for future issuance under all of the stock option
plans, warrants and employee stock purchase plans amounted to 4.4 million shares
at December 31, 1998.
The Compensation Committee of the Board of Directors determines the term of
each option, option exercise price within limits set forth in the plans, number
of shares for which each option is granted and the
F-16
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
rate at which each option is exercisable (generally ratably over three or five
years from grant date). However, the exercise price of any incentive stock
option may not be less than the fair market value of the shares on the date
granted (or less than 110% of the fair market value in the case of optionees
holding more than 10% of the voting stock of the Company), and the term cannot
exceed ten years (five years for incentive stock options granted to holders of
more than 10% of the Company's voting stock).
A summary of the Company's stock option activity and related information for
the years ended December 31, 1998, 1997 and 1996, is as follows:
<TABLE>
<CAPTION>
1998 1997 1996
------------------------ -------------------------- --------------------------
WEIGHTED WEIGHTED WEIGHTED
NUMBER OF AVERAGE NUMBER OF AVERAGE NUMBER OF AVERAGE
OPTIONS (IN EXERCISE OPTIONS (IN EXERCISE OPTIONS (IN EXERCISE
THOUSANDS) PRICE THOUSANDS) PRICE THOUSANDS) PRICE
----------- ----------- ------------- ----------- ------------- -----------
<S> <C> <C> <C> <C> <C> <C>
Outstanding at beginning of year 1,572 $ 14.34 1,200 $ 13.88 1,086 $ 9.27
Granted 2,358 4.36 605 13.78 431 22.63
Exercised (101) 2.69 (99) 2.93 (173) 3.53
Cancelled (2,146) 9.76 (134) 16.15 (144) 17.80
----------- ----- -----
Outstanding at end of year 1,683 7.53 1,572 14.34 1,200 13.88
----------- ----- -----
----------- ----- -----
Options exercisable at end of year 535 562 481
</TABLE>
Information related to options outstanding at December 31, 1998, is
summarized below:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING
--------------------------------------------- OPTIONS EXERCISABLE
WEIGHTED ----------------------------
AVERAGE WEIGHTED WEIGHTED
OUTSTANDING AT REMAINING AVERAGE EXERCISABLE AT AVERAGE
12/31/98 (IN CONTRACTUAL EXERCISE 12/31/98 (IN EXERCISE
RANGE OF EXERCISE PRICES THOUSANDS) LIFE PRICE THOUSANDS) PRICE
- ------------------------------------------ --------------- --------------- ----------- --------------- -----------
<S> <C> <C> <C> <C> <C>
$ 1.88-$ 2.50 901 9.80 YEARS $ 2.47 14 $ 1.88
2.95- 36.25 782 5.18 YEARS 13.36 521 11.91
----- -----
1,683 7.65 YEARS 7.53 535 11.66
----- -----
----- -----
</TABLE>
SFAS No. 123, ACCOUNTING FOR STOCK BASED COMPENSATION, requires the
disclosure of pro forma net income and earnings per share information computed
as if the Company had accounted for its employee stock options granted
subsequent to December 31, 1994, under the fair value method set forth in SFAS
123. The fair value for these options was estimated using a Black-Scholes option
pricing model with the following weighted-average assumptions:
<TABLE>
<CAPTION>
EMPLOYEE STOCK OPTIONS
-------------------------------
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Expected dividend yield 0.0% 0.0% 0.0%
Risk-free interest rate 4.8% 6.0% 5.1%
Expected volatility 70.0% 67.0% 62.0%
Expected life (in years) 2.0 2.0 2.0
</TABLE>
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's employee stock options have characteristics significantly
different from those of traded options,
F-17
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
and because changes in the subjective input assumptions can materially affect
the fair value estimate, in management's opinion, the existing models do not
necessarily provide a reliable single measure of the fair value of its employee
stock options. In addition, because SFAS 123 is applicable only to options
granted subsequent to December 31, 1994, the pro forma information does not
reflect the pro forma effect of all previous stock option grants of the Company,
and thus the pro forma information is not necessarily indicative of future
amounts until SFAS 123 is applied to all outstanding stock options.
Information relating to the fair value of option grants made during 1998,
1997 and 1996 is as follows:
<TABLE>
<CAPTION>
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
Options granted with exercise price equal to fair value of common stock:
Number of options (in thousands) 2,358 550 393
Weighted average exercise price per share 4.36 $ 13.62 $ 22.35
Weighted average fair value of stock option grants per Black-Scholes option
valuation model $ 2.24 $ 5.65 $ 11.32
Options granted with exercise price greater than fair value of common stock:
Number of options (in thousands) -0- 55 38
Weighted average exercise price per share -0- $ 15.27 $ 25.57
Weighted average fair value of stock option grants per Black-Scholes option
valuation model -0- $ 5.17 $ 10.95
</TABLE>
For purposes of pro forma disclosures, the estimated fair value of the
options is amortized to expense over the options' vesting period. For purposes
of pro forma disclosure, the Company assumed that it would not receive a tax
deduction or tax benefit for financial reporting purposes related to incentive
stock options. In management's opinion, the pro forma disclosure is not
necessarily indicative of the net financial effect assuming the Company was
required to expense the fair value of employee stock options because an
incentive stock option often generates a tax deduction for the Company because
the stock option holder does not comply with the holding period requirements
under applicable tax laws. The Company's pro forma information follows (in
thousands, except earnings per share information):
<TABLE>
<CAPTION>
1998 1997 1996
---------- --------- ---------
<S> <C> <C> <C>
Pro forma net income (loss) (27,201) ($7,535) $ 8,946
Pro forma earnings per share $ (1.58) $(0.46) $ 0.54
</TABLE>
EXCHANGE OF STOCK OPTIONS IN 1998
On January 21, 1998, the Compensation Committee of the Board of Directors
approved a stock option exchange program (the "Initial Exchange Program"),
pursuant to which certain employees and officers holding stock options (i)
awarded under the Company's 1987 Incentive Stock Option Plan (the "1987 Plan")
in 1997 and (ii) awarded prior to December 31, 1997, under the Company's 1995
Stock Option Plan (the "1995 Plan"), were given the opportunity to exchange such
options (the "Existing Options") for new options (the "Initial New Options"),
based on the fair market value of the Company's Common Stock at the close of
business on January 30, 1998. All outside directors of the Company, the
President and Chief Executive Officer, and one Executive Vice President were
ineligible to participate in the Exchange Program.
F-18
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Pursuant to the Initial Exchange Program, holders of the Existing Options
were offered the opportunity to exchange, on a share-for-share basis, such
options for Initial New Options having an exercise price of $7.50 per share, the
fair market value of the Company's Common Stock on the exchange date of January
30, 1998 (the "Exchange Date"). Each Initial New Option was awarded under the
1995 Plan and vests and is exercisable with respect to 20% of the shares covered
thereby on each anniversary date of the Exchange Date. Eligible employees
holding Existing Options for an aggregate of 646,800 shares of Common Stock with
an average per share exercise price of approximately $15.87 elected to
participate in the Initial Exchange Program and were issued Initial New Options
covering the same aggregate number of underlying shares as they had held
pursuant to their respective Existing Options. Other than the new exercise price
and the commencement of a new vesting schedule, the option agreements relating
to the Initial New Options are substantially identical to the option agreements
of the Existing Options they replaced.
On December 11, 1998, the Compensation Committee of the Board of Directors
approved a second stock option exchange program (the "Exchange Program"),
pursuant to which certain employees and officers holding incentive stock options
(i) awarded under the Initial Exchange Program, (ii) awarded under the 1995 Plan
during 1998 (1998 Options) and (iii) assumed in connection with the Company's
assumption of the Essential stock option plan in conjunction with the Company's
acquisition of Essential ("Essential Options"), were given the opportunity,
within certain limitations, to exchange such options (Initial New Options, 1998
Options and Essential Options, together the "Old Options") for new options (the
"New Options"), based on the fair market value of the Company's Common Stock at
the close of business on December 14, 1998. All outside directors of the
Company, the President and Chief Executive Officer, and one Executive Vice
President were ineligible to participate in the Exchange Program.
Pursuant to the Exchange Program, holders of the Old Options were offered
the opportunity to exchange, on a share-for-share basis, such options for New
Options having an exercise price of $2.50 per share, the fair market value of
the Company's Common Stock on the exchange date of December 14, 1998 (the "New
Exchange Date"). In accordance with the 1995 Plan, each employee, unless
otherwise ineligible, could exchange options to purchase up to 50,000 shares of
the Company's Common Stock less all other option grants provided to the employee
during 1998. Each New Option was awarded under the 1995 Plan and vests and is
exercisable with respect to 33.3% of the shares covered thereby on each
anniversary date of the New Exchange Date. Eligible employees holding Old
Options for an aggregate of 859,524 shares of Common Stock with an average per
share exercise price of approximately $7.40 per share elected to participate in
the Exchange Program and were issued New Options covering the same aggregate
number of underlying shares as they had held pursuant to their respective Old
Options. Other than the new exercise price and the commencement of a new vesting
schedule, the option agreements relating to the New Options are substantially
identical to the option agreements of the Old Options they replaced.
Both option exchange programs resulted from the significant declines in the
market value of the Company's Common Stock since issuance of the Existing
Options and Old Options, causing the Existing Options and Old Options to be
exercisable at prices which substantially exceeded the market value of the
Common Stock. In approving both exchange programs and in keeping with the
Company's philosophy of utilizing equity incentives to motivate and retain
qualified employees, the Compensation Committee acknowledged that retention and
attraction of qualified employees are critical to the Company's success and its
ability to continue to meet its performance objectives. Additionally,
recognizing that stock options constitute a significant component of the
Company's compensation structure, the Compensation Committee deemed it important
to regain the incentive intended to be provided by the Existing Options and Old
Options to purchase shares of the Company's Common Stock and therefore serve as
a significant factor in the Company's ability to continue to attract and retain
the services of superior quality personnel.
F-19
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
12. EARNINGS PER SHARE
<TABLE>
<CAPTION>
FOR THE YEAR ENDED DEC. 31,
---------------------------------
1998 1997 1996
---------- ---------- ---------
<S> <C> <C> <C>
Numerator:
Net loss $ (25,750) $ (4,937) $ 11,051
---------- ---------- ---------
Numerator for basic and diluted earnings per share $ (25,750) $ (4,937) $ 11,051
Denominator:
Denominator for basic earnings per share--weighted average common shares
outstanding 17,190 16,437 16,261
Effect of dilutive securities:
Stock options and warrants 0 0 564
---------- ---------- ---------
Denominator for diluted earnings per share--adjusted weighted average common
shares outstanding 17,190 16,437 16,825
---------- ---------- ---------
---------- ---------- ---------
Basic earning (loss) per share $ (1.50) $ (.30) $ 0.68
---------- ---------- ---------
---------- ---------- ---------
Diluted earnings (loss) per share $ (1.50) $ (.30) $ 0.66
---------- ---------- ---------
---------- ---------- ---------
</TABLE>
Total stock options and warrants outstanding in 1998, 1997 and 1996 that are
not included in the diluted earnings per share computation due to the
antidilutive effect are 3.2 million, 1.6 million, and 0.6 million, respectively.
Such options are excluded due to the Company incurring a net loss per share in
that year or due to exercise prices exceeding the average market value of the
Company's common stock in the applicable period.
13. MAJOR CUSTOMERS AND GEOGRAPHIC INFORMATION
The Company's operations were concentrated in one segment--the design,
development and manufacture of secure networking products. Sales to customers
exceeding 10% of total sales were as follows: 1998--$9.8 million to various
agencies of the U.S. Government (aggregated as one); 1997--$14.9 million to EDS
and $10.8 million to various agencies of the U.S. Government (aggregated as
one); 1996-- $22.9 million to EDS, $15.9 million to various agencies of the U.S.
Government (aggregated as one) and $14.2 million to AT&T.
Export sales, primarily to Europe, Asia, Latin America and Canada, were
$14.9 million in 1998, $25.1 million in 1997, and $17.1 million in 1996. No
significant long-lived assets are deployed outside of the United States.
F-20
<PAGE>
ODS NETWORKS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
SUPPLEMENTAL FINANCIAL DATA
SUMMARIZED QUARTERLY DATA (UNAUDITED)
(In thousands, except per share amounts)
<TABLE>
<CAPTION>
1998
-------------------------------------------------------
Q1 Q2(1) Q3(2) Q4(3) TOTAL
--------- --------- --------- ---------- ----------
<S> <C> <C> <C> <C> <C>
Revenue $ 18,213 $ 25,215 $ 18,397 $ 12,785 $ 74,610
Gross profit 8,015 10,826 7,727 (2,188) 24,380
Net income (loss) (1,974) (3,209) (3,525) (17,042) (25,750)
Net income (loss) per share (0.12) (0.19) (0.21) (0.92) (1.50)
</TABLE>
<TABLE>
<CAPTION>
1997
-------------------------------------------------------
Q1 Q2 Q3 Q4 TOTAL
--------- --------- --------- ---------- ----------
<S> <C> <C> <C> <C> <C>
Revenue $ 20,161 $ 27,868 $ 26,231 $ 18,067 $ 92,327
Gross profit 8,996 11,792 10,529 5,215 36,532
Net income (1,178) 129 (431) (3,457) (4,937)
Net income per share (0.07) 0.01 (0.03) (0.21) (0.30)
</TABLE>
- ------------------------
(1) The results for the second quarter of 1998 include a $2.3 million write-off
of acquired in-process research and development as restated for adjustment
to the initial Essential acquisition purchase price allocation wherein
originally $5.3 million was allocated to in-process research and development
and was subsequently reduced by $3.0 million. The Company adjusted the
amount originally allocated to acquired in-process research and development
to reflect the new methodology set forth in the September 1998 letter from
the SEC staff to the American Institute of Certified Public Accountants.
(2) The results for the third quarter of 1998 includes a $0.7 million write-off,
net of taxes, of acquired in-process research and development related to the
Company's acquisition of Computer Misuse Detection System assets from
Science Application International Corporation.
(3) The results for the fourth quarter of 1998 includes a $3.9 million
restructuring charge and a related writedown of inventory of $6.7 million.
F-21
<PAGE>
INDEX TO EXHIBITS
The following Exhibits are filed herewith pursuant to Item 601 of Regulation
S-K or are incorporated herein by reference to previous filings as noted:
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
- --------- ---------------------------------------------------------------------------------------------------
<C> <S> <C>
3.1(1) Certificate of Incorporation of the Registrant.
3.2(1) Bylaws of the Registrant.
4.1(2) Specimen of Common Stock Certificate.
10.1(3) Lease Agreement, dated September 12, 1989, between G.D.A.F. Associates and the Registrant for the
Registrant's headquarters and executive office building.
10.2(3) 1983 Incentive Stock Option Plan of ODS Networks, Inc. (formerly Optical Data Systems, Inc.), as
amended.
10.3(3) 1987 Incentive Stock Option Plan of ODS Networks, Inc. (formerly Optical Data Systems, Inc.), as
amended.
10.4(3) Copy of Stock Option granted to Robert Anderson.
10.5(3) Form of Indemnification Agreement.
10.6(7) Amended and Restated ODS 401(k) Savings Plan, effective April 1, 1997.
10.7(7) Amendment to the ODS 401(K) Savings Plan, effective November 1, 1997.
10.8(4) 1995 Stock Option Plan of ODS Networks, Inc. (formerly Optical Data Systems, Inc.)
10.9(4) 1995 Non-Employee Directors Stock Option Plan of ODS Networks, Inc. (formerly Optical Data Systems,
Inc.)
10.11(5) Supplemental Lease Agreement, dated March 7, 1995, between G.D.A.F. Associates, subsequently
assigned to CIIF Associates II Limited Partnership, Landlord, and the Registrant, as Tenant,
relative to the Registrant's headquarters and executive office building.
10.12(6) 1997 Employee Stock Purchase Plan of ODS Networks, Inc. (formerly Optical Data Systems, Inc.)
10.13(10) Amendment to the ODS 401(K) Savings Plan, effective May 29, 1998.
10.14(10) Amendment to the ODS 401(K) Savings Plan, effective October 1, 1998.
10.15(8) Asset and Securities Purchase Agreement, dated as of September 25, 1998, by and among the
Registrant and Science Applications International Corporation.
10.16(8) Registration Rights Agreement, dated as of September 25, 1998, by and between the Registrant and
Science Applications International Corporation.
10.17(8) $8.00 Warrant to Purchase Common Stock of the Registrant, dated September 25, 1998, issued to
Science Applications International Corporation.
10.18(8) $10.50 Warrant to Purchase Common Stock of the Registrant, dated September 25, 1998, issued to
Science Applications International Corporation.
10.19(8) Stockholder and Voting Agreement, dated as of September 25, 1998, by and among Science Applications
International Corporation, the Registrant and certain stockholders of the Registrant.
10.20(8) Strategic Alliance Agreement, dated as of September 25, 1998, by and between Science Applications
International Corporation and the Registrant.
10.21(8) Software Royalty, Grant Back and Improvements License Agreement, dated as of September 25, 1998, by
and between Science Applications International Corporation and the Registrant.
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION OF EXHIBIT
- --------- ---------------------------------------------------------------------------------------------------
<C> <S> <C>
10.22(8) PartnersPlus Agreement, dated September 25, 1998, by and between the Registrant and Science
Applications International Corporation.
10.23(9) Agreement and Plan of Merger, dated April 30, 1998, by and among the Registrant, ECC Acquisition
Corp., and Essential Communication Corporation.
21(10) Subsidiaries of the Registrant.
23(10) Consent of Independent Auditors.
27(10) Financial Data Schedule.
</TABLE>
- ------------------------
(1) Filed as an Exhibit in the Registrant's Current Report on Form 8-K dated
November 6, 1995 (Date of Earliest Event Reported: October 31, 1995;
Commission File No. 0-20191), which Exhibit is incorporated herein by
reference.
(2) Filed as an Exhibit in the Registrant's Current Report on Form 8-K dated
May 7, 1997 (Date of Earliest Event Reported: April 24, 1997; Commission
File No. 0-20191), which Exhibit is incorporated herein by reference.
(3) Filed as an Exhibit in the Registrant's Registration Statement on Form S-1,
as amended (File No. 33-6899) which was declared effective on May 21, 1992,
by the Securities and Exchange Commission, which Exhibit is incorporated
herein by reference.
(4) Filed as an Exhibit to the Registrant's definitive Proxy Statement in
connection with the solicitation of proxies for its 1995 Annual Meeting of
Stockholders (File No. 0-20191), which Exhibit is incorporated herein by
reference.
(5) Filed as an Exhibit in the Registrant's Annual Report on Form 10-K, for the
fiscal year ended December 31, 1995 (File No. 0-20191), which Exhibit is
incorporated herein by reference.
(6) Filed as an Exhibit in the Registrant's definitive Proxy Statement filed in
connection with the solicitation of proxies for its 1997 Annual Meeting of
Stockholders (File No. 0-20191), which Exhibit is incorporated herein by
reference.
(7) Filed as an Exhibit in the Registrant's Annual Report on Form 10-K for the
fiscal year ended December 31, 1997 (File No. 0-20191), which Exhibit is
incorporated herein by reference.
(8) Filed as an Exhibit in the Registrant's Current Report on Form 8-K (Item
5), dated October 13, 1998 (File No. 0-20191), which Exhibit is
incorporated herein by reference.
(9) Filed as an Exhibit in the Registrant's Current Report on Form 8-K (Item
2), dated May 21, 1998 (File No. 0-20191), which Exhibit is incorporated
herein by reference.
(10) Filed herewith.
<PAGE>
SCHEDULE II
ODS NETWORKS, INC.
VALUATION AND QUALIFYING ACCOUNTS
(IN THOUSANDS)
<TABLE>
<CAPTION>
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND END OF
DESCRIPTION OF PERIOD EXPENSES TRANSFERS DEDUCTIONS PERIOD
- ----------------------------------------------------- ----------- ----------- ------------ ------------ -----------
<S> <C> <C> <C> <C> <C>
Year ended December 31, 1996:
Deducted from asset accounts:
Allowance for Doubtful Accounts and Returns........ $ 617 $ 227 -- $ 22** $ 822
Inventory Obsolescence Reserve..................... $ 631 $ 2,421 -- $ 1,067* $ 1,985
Year ended December 31, 1997:
Deducted from asset accounts:
Allowance for Doubtful Accounts and Returns........ $ 822 $ 86 -- $ 150** $ 758
Inventory Obsolescence Reserve..................... $ 1,985 $ 7,693 -- $ 7,484* $ 2,194
Year ended December 31, 1998:
Deducted from asset accounts:
Allowance for Doubtful Accounts and Returns........ $ 758 $ 146 $ 74*** $ 98** $ 880
Inventory Obsolescence Reserve..................... $ 2,194 $ 5,777 $ 230*** $ 1,627* $ 6,574
</TABLE>
- ------------------------
* Obsolete inventory written off.
** Uncollectible accounts written off.
*** Reserves related to acquisition of Essential Communication Corporation.
S-1
<PAGE>
EXHIBIT 21
SUBSIDIARIES OF THE REGISTRANT
The following table lists the subsidiaries of the Registrant as of December
31, 1998, the state or other jurisdiction of incorporation and the names under
which such subsidiaries do business. The Registrant owns all of the outstanding
voting securities of each subsidiary.
<TABLE>
<CAPTION>
NAME UNDER
JURISDICTION OF WHICH SUBSIDIARY
NAME OF SUBSIDIARY ORGANIZATION IS DOING BUSINESS
- ----------------------------------------------- ------------------- -------------------------------------------
<S> <C> <C>
ODS Networks, Inc. Delaware ODS Networks, Inc.
Optical Data Systems, Inc. Nevada Optical Data Systems, Inc.
ODS, Inc. Nevada ODS, Inc.
Optical Data Systems-Texas, Inc. Texas Optical Data Systems-Texas, Inc.
ODS Networks GmbH Germany ODS Networks GmbH
ODS Networks Ltd. United Kingdom ODS Networks Ltd.
ODS Ltd. United Kingdom ODS Ltd.
ODS Networks SARL France ODS Networks SARL
Optical Data Systems, Ltda. Brazil Optical Data Systems, Ltda.
Optical Data Systems, (Barbados) Ltd. Barbados Optical Data Systems (Barbados) Ltd.
ODS Networks Sdn. Bhd. Malaysia ODS Networks Sdn. Bhd.
Essential Communication Corporation Delaware Essential Communications Corporation
</TABLE>
<PAGE>
CONSENT OF INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statement
(Form S-8, No. 33-58570) pertaining to the 1983 Incentive Stock Option Plan of
ODS Networks, Inc. and the 1987 Incentive Stock Option Plan of ODS Networks,
Inc., the Registration Statement (Form S-8, No. 33-34476) pertaining to the 1995
Stock Option Plan of ODS Networks, Inc., the Registration Statement (Form S-8,
No. 33-34484) pertaining to the 1995 Non-employee Director Stock Option Plan of
ODS Networks, Inc., the Registration Statement (Form S-8, No. 33-42927)
pertaining to the 1997 Employee Stock Purchase Plan of ODS Networks, Inc., the
Registration Statement (Form S-8, No. 33-80898) pertaining to the ODS 401(k)
Savings Plan of ODS Networks, Inc. and the Registration Statement (Form S-8, No.
333-53813) pertaining to the Essential Communication Corporation 1996 Stock
Option Plan of our report dated January 22, 1999, of ODS Networks, Inc. included
in the Annual Report (Form 10-K) for the year ended December 31, 1998.
Our audits also included the financial statement schedule of ODS Networks,
Inc. listed in Item 14(a)2. This schedule is the responsibility of the Company's
management. Our responsibility is to express an opinion based on our audits. In
our opinion, the financial statement schedule referred to above, when considered
in relation to the basic financial statements taken as a whole, presents fairly
in all material respects the information set forth therein.
ERNST & YOUNG LLP
Dallas, Texas
March 26, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEETS AND CONSOLIDATED STATEMENTS OF INCOME FUND ON PAGES
F-2-F-3 OF THE COMPANY'S 10-K FOR THE YEAR TO DATE AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 16,791
<SECURITIES> 4,760
<RECEIVABLES> 7,145
<ALLOWANCES> 880
<INVENTORY> 9,262
<CURRENT-ASSETS> 42,586
<PP&E> 14,137
<DEPRECIATION> 6,510
<TOTAL-ASSETS> 61,710
<CURRENT-LIABILITIES> 10,823
<BONDS> 0
0
0
<COMMON> 185
<OTHER-SE> 49,321
<TOTAL-LIABILITY-AND-EQUITY> 61,710
<SALES> 74,610
<TOTAL-REVENUES> 74,610
<CGS> 50,230
<TOTAL-COSTS> 50,230
<OTHER-EXPENSES> 54,751
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (30,095)
<INCOME-TAX> (4,345)
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (25,750)
<EPS-PRIMARY> (1.50)
<EPS-DILUTED> (1.50)
</TABLE>
