UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON DC 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended December 31, 1997
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD OF FROM__________________TO________________
Commission file number 0-21077
INTERLINK COMPUTER SCIENCES, INC.
(Exact name of registrant as specified in its charter)
Delaware 94-2990567
(State of incorporation) (IRS Employer Identification Number)
47370 Fremont Boulevard
Fremont, California 94538
(510) 657-9800
(Address and telephone number of principal executive offices)
-----------------
Indicate by check mark whether 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, and (2) has been subject to such filing requirements
for the past 90 days.
YES X NO__
7,984,233 shares of the registrant's Common stock, $0.001 par value,
were outstanding as of February 2, 1998.
1
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<TABLE>
INTERLINK COMPUTER SCIENCES, INC.
AND SUBSIDIARIES
CONTENTS
<CAPTION>
Page
----
PART I: FINANCIAL INFORMATION
<S> <C> <C>
Item 1. Financial Statements
Condensed Consolidated Balance Sheets:
December 31, 1997 and June 30, 1997.................................................................4
Condensed Consolidated Statements of Operations:
Three and six months ended December 31, 1997 and 1996...............................................5
Condensed Consolidated Statements of Cash Flows:
Six months ended December 31, 1997 and 1996.........................................................6
Notes to Condensed Consolidated Financial Statements....................................................7
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations....................................................................11
PART II: OTHER INFORMATION
Item 1. Legal Proceedings..........................................................................................25
Item 6. Exhibits and Reports on Form 8-K...........................................................................25
Signatures ...........................................................................................................26
</TABLE>
2
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PART I: FINANCIAL INFORMATION
3
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<TABLE>
INTERLINK COMPUTER SCIENCES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
<CAPTION>
December 31, June 30,
1997 1997
-------- --------
(unaudited)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents .................................... $ 21,115 $ 28,106
Accounts receivable, net ..................................... 8,069 9,752
Inventories .................................................. 620 674
Current deferred tax asset ................................... 7,140 2,092
Other current assets ......................................... 885 1,240
-------- --------
Total current assets ..................................... 37,829 41,864
Property and equipment, net ....................................... 2,726 1,676
Long-term deferred tax asset ...................................... 2,195 1,541
Purchased software products and other non-current assets .......... 1,299 3,282
-------- --------
Total assets ............................................. $ 44,049 $ 48,363
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Current portion of long-term debt ............................ $ 30 $ 314
Accounts payable ............................................. 1,523 1,421
Accrued liabilities .......................................... 5,664 7,286
Deferred maintenance and product revenue ..................... 6,874 7,488
-------- --------
Total current liabilities ................................ 14,091 16,509
Long-term debt, less current portion .............................. 147 802
Deferred maintenance revenue ...................................... 1,052 1,403
Other liabilities ................................................. 2,662 975
Liabilities retained in connection with sale of HARBOR product line 1,232 --
-------- --------
Total liabilities ........................................ 19,184 19,689
-------- --------
Commitments and contingencies (Note 6)
Common stock ...................................................... 7 7
Additional paid-in capital ........................................ 51,126 50,814
Cumulative translation adjustment ................................. (522) (591)
Accumulated deficit ............................................... (25,746) (21,556)
-------- --------
Total stockholders' equity ................................... 24,865 28,674
-------- --------
Total liabilities and stockholders' equity ............... $ 44,049 $ 48,363
======== ========
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
</TABLE>
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<TABLE>
INTERLINK COMPUTER SCIENCES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
<CAPTION>
Three months ended Six months ended
December 31, December 31,
----------------- -----------------
1997 1996 1997 1996
-------- -------- -------- --------
(unaudited) (unaudited)
<S> <C> <C> <C> <C>
Revenues:
Product ................................. $ 3,388 $ 5,960 $ 6,221 $ 10,792
Maintenance and consulting .............. 3,360 3,673 6,842 7,566
-------- -------- -------- --------
Total revenues .................... 6,748 9,633 13,063 18,358
-------- -------- -------- --------
Cost of revenues:
Product ................................. 348 678 628 1,363
Maintenance and consulting .............. 1,176 1,209 2,505 2,446
-------- -------- -------- --------
Total cost of revenues ............ 1,524 1,887 3,133 3,809
-------- -------- -------- --------
Gross profit .................................. 5,224 7,746 9,930 14,549
-------- -------- -------- --------
Operating expenses:
Product development ..................... 3,233 1,969 5,551 3,870
Sales and marketing ..................... 3,020 3,194 5,798 6,258
General and administrative .............. 1,933 1,107 3,257 2,019
Purchased research and development and
product amortization ................. 117 139 3,863 301
Loss on sale of HARBOR product line ..... 2,171 -- 2,171 --
-------- -------- -------- --------
Total operating expenses .......... 10,474 6,409 20,640 12,448
-------- -------- -------- --------
Operating income (loss) ....................... (5,250) 1,337 (10,710) 2,101
Interest and other income, net ................ 255 144 520 88
-------- -------- -------- --------
Income (loss) before provision for income taxes (4,995) 1,481 (10,190) 2,189
Benefit from (provision for) income taxes ..... 4,546 (578) 6,000 (847)
-------- -------- -------- --------
Net income (loss) ............................. ($ 449) $ 903 ($ 4,190) $ 1,342
======== ======== ======== ========
Net income (loss) per share:
Basic .................................... ($ .06) $ .14 ($ .55) $ .23
======== ======== ======== ========
Diluted .................................. ($ .06) $ .12 ($ .55) $ .19
======== ======== ======== ========
Shares used in per share calculation:
Basic .................................... 7,615 6,492 7,586 5,740
Diluted .................................. 7,615 7,671 7,586 6,886
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
</TABLE>
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<TABLE>
INTERLINK COMPUTER SCIENCES, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<CAPTION>
Six months ended December 31,
1997 1996
-------- --------
(unaudited)
<S> <C> <C>
Cash flows from operating activities:
Net income (loss) .............................................................................. ($ 4,190) $ 1,342
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Purchased research and development and other .......................................... 3,599 --
Loss on sale of HARBOR product line ................................................... 2,171 --
Depreciation and amortization ......................................................... 1,092 848
Provision for excess and obsolete inventory ........................................... 122 --
Provision for doubtful accounts ...................................................... 43 100
Exchange loss ......................................................................... 50 (32)
Deferred income taxes ................................................................. (6,161) --
Changes in operating assets and liabilities:
Accounts receivable ............................................................... 2,319 (195)
Inventories ....................................................................... (70) (623)
Other assets ...................................................................... (368) 1,027
Accounts payable .................................................................. 107 (133)
Accrued liabilities ............................................................... (1,878) (618)
Deferred maintenance and product revenue .......................................... (551) (713)
Other liabilities ................................................................. (115) (156)
-------- --------
Net cash provided by (used in) operating activities ........................... (3,830) 847
-------- --------
Cash flows from investing activities:
Acquisition of NetLOCK network security technology ............................................. (1,175) --
Acquisition of property and equipment .......................................................... (2,007) (714)
Capitalization of software development costs.................................................... -- (56)
-------- --------
Net cash used in investing activities ......................................... (3,182) (770)
-------- --------
Cash flows from financing activities:
Payments on capital lease obligations .......................................................... (32) (130)
Payments on notes payable and other ............................................................ (147) (2,915)
Payments on bank line of credit ................................................................ -- (5,000)
Proceeds from issuance of common stock, net .................................................... 313 29,012
-------- --------
Net cash provided by financing activities ..................................... 134 20,967
-------- --------
Net increase (decrease) in cash and cash equivalents ..................... (6,878) 21,044
Effect of exchange rate changes on cash ............................................................. (113) (104)
Cash and cash equivalents, beginning of period ...................................................... 28,106 6,121
-------- --------
Cash and cash equivalents, end of period ............................................................ $ 21,115 $ 27,061
======== ========
<FN>
See accompanying notes to condensed consolidated financial statements.
</FN>
</TABLE>
6
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INTERLINK COMPUTER SCIENCES, INC. AND SUBSIDIARIES
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
1. Basis of Presentation:
The unaudited condensed consolidated financial statements included herein have
been prepared by Interlink Computer Sciences, Inc. and its subsidiaries
(collectively, the "Company") in accordance with generally accepted accounting
principles and reflect all adjustments, consisting only of normal recurring
adjustments, which in the opinion of management are necessary to fairly present
the Company's consolidated financial position, results of operations, and cash
flows for the periods presented. The financial statements include the accounts
of the Company and its wholly owned subsidiaries after all material intercompany
balances and transactions have been eliminated. The Notes to the Consolidated
Financial Statements contained in the fiscal year 1997 report on Form 10-K
should be read in conjunction with these Condensed Consolidated Financial
Statements. The consolidated results of operations for the three and six months
ended December 31, 1997 are not necessarily indicative of the results to be
expected for any subsequent period or for the entire fiscal year ending June 30,
1998. The June 30, 1997 balance sheet was derived from audited financial
statements, but does not include all disclosures required by generally accepted
accounting principles.
2. Inventories:
Inventories are stated at the lower of cost (determined on a first-in, first-out
basis) or market. Inventories are principally comprised of finished goods at
December 31, 1997 and June 30, 1997.
3. NetLOCK Network Security Technology Acquisition:
On September 18, 1997, the Company acquired the NetLOCK technology, an
end-to-end network security technology, that encrypts data and helps prevent
security break-ins, and certain assets from Hughes Aircraft Company for
approximately $2,144,000 in cash and incurred related acquisition costs of
$300,000. The Company also licensed certain core technology that is incorporated
into the NetLOCK technology from a third party licensor. Under the terms of the
license agreement, the Company paid an up front fee of $175,000 and is obligated
to pay royalties ranging from 3% to 9% of future NetLOCK revenues on an ongoing
basis, with guaranteed future minimum royalties of $2,300,000 through 2002. As
of the date of the acquisition, the NetLOCK technology had not reached
technological feasibility nor did it have any future alternative use.
Accordingly, $3.1 million has been recorded as purchased research and
development, which consists of the amount of the purchase price allocated to
purchased research and development and the guaranteed minimum royalty payments,
net of present value discount of $724,000. The remaining portion of the purchase
price of $1,144,000 has been recorded as property and equipment. The Company has
recorded a tax benefit equal to 28% of its losses before income taxes with the
exception of a $1.2 million tax benefit recorded related to the charge to
operations for purchased research and development. In conjunction with the
NetLOCK technology purchase, the Company employed approximately 25 people and
entered into an operating lease for facilities with a third party. The related
employee and facility costs have been included in the Company's results of
operations from the date of the acquisition of the technology.
Under the terms of the NetLOCK facility operating lease, the Company is
obligated to make monthly future minimum lease payments totaling $364,000
through fiscal 2001.
4. Write-Down of the HARBOR Purchased Software and Sale of the HARBOR Product
Line.
On December 29, 1995, the Company acquired all of the outstanding stock of New
7
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Era Systems Services Ltd. ("New Era"), a Canadian company that develops, markets
and supports the HARBOR storage management and software distribution products
and recorded $3.2 million on the balance sheet as purchased software products.
During the quarter ended September 30, 1997, revenue expectations for the HARBOR
product line declined. As a result, the Company determined that the recorded
amount for purchased software had been impaired and recorded a loss of
approximately $550,000, the amount by which the recorded intangible at September
30, 1997 exceeded the present value of the estimated future net cash flows. On
December 18, 1997 the Company sold substantially all of the assets of the HARBOR
product line to a former executive and member of the board of directors of the
Company who resigned both posts effective as of the date of the sale. The
consideration paid to the Company consisted of $1,250,000 in installment notes
receivable plus a $600,000 convertible note receivable that may, upon the
occurrence of certain events, entitle the Company to an additional payment of
$150,000. In addition the purchasers assumed certain liabilities and
obligations, including a note payable in the amount of $1,232,000 for which the
Company is the guarantor, and $356,000 in deferred maintenance obligations. As
the Company has continuing involvement in the HARBOR business, primarily through
its guarantee of the note payable, and there is substantial uncertainty about
the ability of HARBOR to meet its obligations, the Company has (i) not recorded
the notes receivable, (ii) provided a valuation allowance on all assets
transferred to the purchaser and (iii) recorded a liability equal to the amount
of the guarantee of the note assumed. As a result of this treatment, the Company
recorded a loss of $2,171,000 on the sale of the HARBOR product line. The
Company also recorded a tax benefit of $3.2 million relating to the sale of the
HARBOR product line, of which, $2.8 million will be realized as a refund of
federal income taxes previously paid, once the Company files its tax return for
the current fiscal year.
5. Computation of Net Income (Loss) Per Share:
The Company has adopted the provisions of Statement of Financial Accounting
Standards No. 128 ("SFAS 128") effective December 31, 1997. SFAS 128 requires
the presentation of basic and diluted earnings per share. Basic EPS is computed
by dividing income available to common shareholders by the weighted average
number of common shares outstanding for the period. Diluted EPS is computed by
giving effect to all dilutive potential common shares that were outstanding
during the period. For the Company, dilutive potential common shares consist of
the incremental common shares issuable upon the exercise of stock options and
warrants for all periods. In accordance with SFAS 128, all prior period earnings
per share amounts have been restated to reflect this method of calculation.
<TABLE>
Basic and diluted earnings per share are calculated as follows during the three
and six month periods ended December 31, 1997 and 1996 (in thousands except for
per share amounts):
<CAPTION>
Three months ended Six months ended
------------------ -----------------
December 31, December 31,
------------------ -----------------
1997 1996 1997 1996
------- ------- ------- -------
(unaudited) (unaudited)
<S> <C> <C> <C> <C>
Basic:
Weighted average shares ................... 7,615 6,492 7,586 5,740
------- ------- ------- -------
Shares used in per share calculation ...... 7,615 6,492 7,586 5,740
------- ------- ------- -------
Net income (loss) ......................... $ (449) $ 903 $(4,190) $ 1,342
======= ======= ======= =======
Net income (loss) per share ............... $ (0.06) $ 0.14 $ (0.55) $ 0.23
======= ======= ======= =======
Diluted:
Weighted average shares ................... 7,615 6,492 7,586 5,740
Common equivalent shares from stock options
and warrants .......................... -- 1,179 -- 1,146
------- ------- ------- -------
Shares used in per share calculation ...... 7,615 7,671 7,586 6,886
======= ======= ======= =======
Net income (loss) ......................... $ (449) $ 903 $(4,190) $ 1,342
======= ======= ======= =======
Net income (loss) per share ............... $ (0.06) $ 0.12 $ (0.55) $ 0.19
======= ======= ======= =======
</TABLE>
8
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Options and warrants to purchase the following shares of common stock at the
indicated range of price per share were outstanding during the three and six
month periods ended December 31, 1997 and 1996, but were not included in the
computation of diluted earnings per share because the exercise price of the
options and warrants was greater than the average market price of the common
shares for each period or the inclusion of the options and warrants in the
diluted per share calculation was antidilutive (in thousands except for per
share amounts):
Options and warrants Range of
excluded exercise prices
-------- ---------------
Three months ended:
December 31, 1997 2,089 $0.70-$15.00
December 31, 1996 17 $16.25
Six months ended:
December 31, 1997 2,089 $0.70-$15.00
December 31, 1996 19 $10.50-$16.25
6. Contingencies:
The Company is involved in a commercial dispute with a former Italian
distributor ("Claimant"), which has alleged that the Company and two of its
subsidiaries have breached and unlawfully terminated various distributorship
agreements for distribution of the Company's TCPaccess and HARBOR Products in
Italy, and which has asserted various claims in two lawsuits against the
Company, its subsidiaries, and several officers of the Company.
In January 1997, the former distributor initiated a lawsuit in Milan, Italy
against the Company's Canadian Subsidiary, New Era Systems Services Ltd. ("New
Era"); the Company; the Company's French subsidiary, Interlink France
S.A.R.L.,("Interlink France"); and the Company's current distributor in Italy,
an unrelated Italian Corporation. The litigation is based on the Claimant's
distribution of the Company's HARBOR products pursuant to a distributor
agreement with New Era Systems Services Ltd., an affiliated Irish corporation
("New Era Ireland"), which pre-dates the Company's acquisition of New Era. The
distributor relationship with the Claimant for the distribution of HARBOR
products in Italy and Spain has terminated. Pursuant to court documents,
Claimant alleges damages for breach of contract and related tort claims in the
amount of 2,500,000,000 Italian Lira (approximately $1,500,000) and requests
that the defendants pay all expenses resulting from the litigation. New Era
Ireland has filed a lawsuit against the Claimant in Ireland for recovery of
amounts due on outstanding invoices and a declaration that the distributor
relationship has terminated.
In March 1997 the former distributor initiated a separate lawsuit in Alameda
County, California against the Company, certain officers of the Company and of
Interlink France, and the Company's current Italian distributor. In the
complaint, Claimant alleges various tort claims related to the defendants'
alleged actions with respect to prior distribution agreements between Claimant,
the Company, and Interlink France for distribution of the Company's TCPaccess
products in Italy. The claims alleged include fraud, deceit, defamation, trade
libel, unfair competition, misappropriation, breach of confidential
relationship, and conversion. Claimant demands compensatory damages in excess of
$2,000,000, unspecified punitive damages, interest, attorneys' fees, and costs
of the litigation. The Company has successfully moved to compel arbitration of
the claims in accordance with the arbitration clauses in the earlier
distributorship agreements with the Claimant. Claimant has stated its intention
to commence arbitration proceedings.
The Company has accrued $300,000 for litigation or settlement of any liability
that may result upon resolution of these matters. No estimate of the ultimate
liability that may result upon the resolution of these matters is
9
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presently determinable. Should the Company be unsuccessful in defending any of
these claims, the Company's business, financial condition and results of
operations could be materially adversely affected.
<TABLE>
7. Supplemental Cash Flow Disclosures (in thousands):
<CAPTION>
Six months ended December 31,
1997 1996
------ ------
<S> <C> <C>
Interest paid .................................................... $ 9 $ 177
Income taxes paid ................................................ $1,229 $1,412
Non cash transactions from financing activities:
Conversion of preferred stock to common
stock in connection with initial public offering ........ -- $6,310
Liabilities assumed in connection with the purchase of the
NetLOCK network security technology ..................... $1,876 --
Assets of the HARBOR product line sold to a related party .... $2,265 --
Liabilities of the HARBOR product line sold to a related party 356 --
Costs accrued related to the sale of the HARBOR product line . $ 262 --
</TABLE>
8. Concentrations of Revenues:
During the three and six months ended December 31, 1997, 11% and 13%,
respectively, of the Company's total revenues were derived from sales to and
through Cisco Systems, Inc. ("Cisco"). During the three and six months ended
December 31, 1996, no one customer accounted for more than 10% of total
revenues.
9. Recent Pronouncements:
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130 (SFAS 130), Reporting Comprehensive
Income. This statement establishes requirements for disclosure of comprehensive
income and becomes effective for the Company for fiscal years beginning after
December 15, 1997, with reclassification of earlier financial statements for
comparative purposes. Comprehensive income generally represents all changes in
stockholders' equity except those resulting from investments or contributions by
stockholders. The Company is evaluating alternative formats for presenting this
information, but does not expect this pronouncement to materially impact the
Company's results of operations.
In June 1997, The Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131 (SFAS 131), Disclosures about Segments of
an Enterprise and Related Information. This statement establishes standards for
disclosure about operating segments in annual financial statements and selected
information in interim financial reports. It also establishes standards for
related disclosures about products and services, geographic areas and major
customers. This statement supersedes Statement of Financial Accounting Standards
No. 14, Financial Reporting for Segments of a Business Enterprise. The new
standard becomes effective for fiscal years beginning after December 15, 1997,
and requires that comparative information from earlier years be restated to
conform to the requirements of this standard. The Company is evaluating the
requirements of SFAS 131 and the effects, if any, on the Company's current
reporting and disclosures.
In October 1997, the Accounting Standards Executive Committee issued Statement
of Position 97-2 (SOP 97-2), Software Revenue Recognition, which delineates the
accounting for software product and maintenance revenues. SOP 97-2 supersedes
the Accounting Standards Executive Committee Statement of Position 91-1,
Software Revenue Recognition, and is effective for transactions entered into in
fiscal years beginning after December 15, 1997. The Company is evaluating the
requirements of SOP 97-2 and the effects, if any on the Company's current
revenue recognition policies.
10
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10. Subsequent Events:
On January 13, 1998, the Company acquired Networkers Engineering Limited, a
software development company based in the United Kingdom. Under the terms of the
agreement, the Company purchased Networkers Engineering, including all
technology rights, in exchange for cash of $600,000, deferred cash payments of
$1,000,000 and 239,578 shares of the Company's common stock. The Company
believes a substantial portion of the purchase price, together with $400,000 of
costs related to the acquisition of customer contracts in a related company,
previously paid minimum license fees and acquisition costs, will be charged to
purchased research and development in the quarter ended March 31, 1998.
On January 14, 1998 the Board of Directors granted employees the right to
convert certain outstanding stock options into option grants with an exercise
price of $4.875 per share (the fair market value as of February 6, 1998, the
date specified by the Board's authorization). The converted options vest on
dates six months after the dates such installments would have vested had the
option not been amended by the employee exercising this conversion right.
Options for approximately 700,000 shares of Common Stock (having exercise prices
ranging from $5.00 to $15.00) were repriced pursuant to this program.
11
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MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
The following Management's Discussion and Analysis of Financial Condition and
Results of Operations contains forward-looking statements that involve risks and
uncertainties. The Company's actual results could differ materially from those
discussed herein. Factors that could cause or contribute to such differences
include, but are not limited to, those discussed in the section below entitled
"Risk Factors That May Affect Future Results," as well as those risks discussed
in this section and elsewhere in this Report.
Overview
The Company offers a suite of high-performance, network transport products and
system management applications, which efficiently transport, store and protect
the integrity of mission-critical data and applications. The Company sells its
products principally for use in data centers of Fortune 1000 companies. The
principal products include TCP/IP connectivity, fault tolerance, remote printing
services, and CICS and IMS-to-LAN application integration, as well as management
and control products built on its new "OpenMAX" technology. Interlink also
offers a suite of security products, which includes NetLOCK, the first
transparent solution to provide enterprise-wide, end-to-end protection of all
information that crosses the network; and Sentinel/IP, which provides audit and
access control for mainframe users.
In December 1996, the Company entered into a strategic alliance with Cisco
Systems, Inc. pursuant to which Cisco acquired 622,000 shares of the Company's
Common Stock for $6.8 million. In January 1997, Cisco and the Company agreed to
cooperate to develop and market certain TCP/IP software known as IOS/390. As a
result of the agreement, the Company's sales personnel significantly reduced
direct selling efforts in favor of supporting the Cisco sales teams. However,
the level of sales achieved by Cisco fell short of expectations, and in August
1997, the Company and Cisco amended the agreement to provide that Interlink
would resume selling its TCP/IP product and would also resell the IOS/390
software and certain Cisco router products. In October 1997, the Company
formally amended the development and marketing agreement.
In September 1997, the Company acquired the NetLOCK network security technology
from Hughes Electronics Corporation and recorded a charge in its fiscal first
quarter of approximately $3.1 million relating to in-process software
development. Revenue from the NetLOCK product commenced in January 1998.
In December 1997, the Company sold its HARBOR product line and recorded a charge
of $2.2 million, offset by a tax credit of $3.2 million. Most of the tax credit,
or $2.8 million, will be realized as a refund of federal income taxes previously
paid. The sale of the HARBOR product line resulted in a charge to earnings
because the Company guaranteed a Canadian loan in the amount of $1.2 million,
which was assumed by the buyers, and because the notes receivable of $1.9
million from the sale could not presently be recognized. Revenues from HARBOR
products were $667,000 and $1.4 million and direct expenses were $775,000 and
$1.5 million for the three and six-month periods ended December 31, 1997,
respectively.
In January 1998, subsequent to the close of the fiscal quarter, the Company
purchased Networkers Engineering, Limited and the customer contracts of a
related business, for a combined cost of approximately $2.9 million, a
substantial portion of which will be charged to purchased research and
development in the quarter ended March 31, 1998.. The acquisition gives the
Company a base of technology and additional resources for the development of its
management and control products. Revenues from these new products are expected
to commence in the second half of the current fiscal year but will not be
significant until fiscal year 1999.
12
<PAGE>
Results of Operations
<TABLE>
The following table sets forth, as a percentage of total revenues, certain
condensed consolidated statement of operations data for the periods indicated:
<CAPTION>
Three months Six months
ended December 31, ended December 31,
--------------- ---------------
1997 1996 1997 1996
----- ----- ----- -----
<S> <C> <C> <C> <C>
Revenues:
Product ......................................... 50.2% 61.9% 47.6% 58.8%
Maintenance and consulting ...................... 49.8 38.1 52.4 41.2
----- ----- ----- -----
Total revenues .............................. 100.0 100.0 100.0 100.0
----- ----- ----- -----
Cost of revenues:
Product ......................................... 5.2 7.0 4.8 7.4
Maintenance and consulting ...................... 17.4 12.6 19.2 13.3
----- ----- ----- -----
Total cost of revenues ...................... 22.6 19.6 24.0 20.7
----- ----- ----- -----
Gross profit ......................................... 77.4 80.4 76.0 79.3
Operating expenses:
Product development ............................. 47.9 20.4 42.5 21.1
Sales and marketing ............................. 44.8 33.2 44.4 34.1
General and administrative ...................... 28.6 11.5 24.9 11.0
Purchased research and development and product
amortization ............................ 1.7 1.4 29.6 1.7
Loss on sale of HARBOR Product Line ............. 32.2 -- 16.6 --
----- ----- ----- -----
Total operating expenses .................... 155.2 66.5 158.0 67.9
----- ----- ----- -----
Operating income (loss) .............................. (77.8) 13.9 (82.0) 11.4
Interest and other income, net ....................... 3.8 1.5 4.0 .5
----- ----- ----- -----
Income (loss) before income taxes ............... (74.0) 15.4 (78.0) 11.9
Benefit from (provision for) income taxes ............ 67.4 (6.0) 45.9 (4.6)
----- ----- ----- -----
Net income (loss) ............................... (6.7)% 9.4% (32.1)% 7.3%
===== ===== ===== =====
Cost of sales as a percentage of the related revenues:
Product ......................................... 10.3% 11.4% 10.1% 12.6%
Maintenance and consulting ...................... 35.0% 32.9% 36.6% 32.3%
</TABLE>
Revenues:
Total revenues were $6.7 million and $9.6 million for the three months and $13.1
million and $18.4 million for the six months ended December 31, 1997 and 1996,
respectively, representing a decrease of approximately 30% for both periods.
Product sales were $3.4 million and $6.0 million for the three months and $6.2
million and $10.8 million for the six months ended December 31, 1997 and 1996,
respectively, representing a decrease of 42%. These decreases were primarily due
to fewer sales through the Cisco sales force than the Company anticipated.
During the period from January 1997 through August 1997, the Company's sales
force focused attention to supporting the Cisco sales effort pursuant to its
strategic relationship instead of continuing its direct selling efforts. From
September 1997 forward, the Company's sales force was again focused on
rebuilding its sales leads as well as supporting Cisco's efforts to sell the
Company's software. Also a factor in the decrease was $1.0 million recorded in
December 1996 relating to prepaid licenses from Cisco. Maintenance and
consulting revenues were $3.4 million and $3.7 million for the three months and
$6.8 million and $7.6 million for the six months ended December 31, 1997 and
1996, respectively, representing a decrease of 9% and 10%, respectively. These
decreases resulted principally from a decrease in maintenance revenues from the
DECnet product line.
13
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Cost of Revenues:
Product. Cost of revenues from product sales consists primarily of hardware,
product media, documentation and packaging costs. Cost of revenues for product
sales was $348,000 and $678,000, representing 10% and 11% of total product
revenues for the three months ended December 31, 1997 and 1996, respectively.
Cost of revenues for product sales was $628,000 and $1.4 million, representing
10% and 13% of total product revenues for the six months ended December 31, 1997
and 1996, respectively. Both the revenue and cost of revenue from selling
hardware products declined while the Company was receiving credit from Cisco for
Cisco's sales of hardware into accounts using the Company's products in favor of
reselling hardware directly. These credits from Cisco will cease when the
Company receives total credits of $1.2 million but not later than June 30, 1998.
At that time, the Company presently intends to resell third party hardware
products once again.
Maintenance and Consulting. Cost of revenues from maintenance and consulting
consists primarily of personnel related costs incurred in providing telephone
support and software updates. Cost of revenues from maintenance and consulting
was $1.2 million in both of the three month periods ended December 31, 1997 and
1996, representing 35% and 33% of total maintenance and consulting revenues,
respectively. Cost of revenues from maintenance and consulting was $2.5 million
and $2.4 million, representing 37% and 32% of total maintenance and consulting
revenues for the six months ended December 31, 1997 and 1996, respectively.
These increases in maintenance and consulting costs as a percentage of the
related revenue is due to lower annual maintenance prices as a percentage of
related product revenue, with costs remaining stable as the majority of costs
are fixed.
Operating Expenses:
Total operating expenses were $10.5 million and $6.4 million, representing 155%
and 67% of total revenues for the three months ended December 31, 1997 and 1996,
respectively. Total operating expenses were $20.6 million and $12.4 million,
representing 158% and 68% of total revenues for the six months ended December
31, 1997 and 1996, respectively. The increases in total operating expenses is
primarily due to the purchased research and development expense relating to the
acquisition of NetLOCK incurred in the quarter ended September 30, 1997, the
charge relating to the sale of the HARBOR product line in the quarter ended
December 31, 1997, the costs associated with operating both HARBOR and NetLOCK
operations during the periods and one-time charges of approximately $500,000 for
legal and severance costs. See further discussion below.
Product Development. Product development expenses consist primarily of personnel
related costs. Product development expenses were $3.2 million and $2.0 million,
representing 48% and 20% of total revenues for the three months ended December
31, 1997 and 1996, respectively. Product development expenses were $5.6 million
and $3.9 million, representing 43% and 21% of total revenues for the six months
ended December 31, 1997 and 1996, respectively. These increases in product
development expenses resulted from the expansion of the Company's product line
as a result of the acquisition of NetLOCK network security technology and
ongoing product development efforts.
Sales and Marketing. Sales and marketing expenses consist primarily of salaries
and commissions for sales and marketing personnel, the fixed costs of worldwide
sales offices, and promotional costs. The Company sells through its direct sales
force, resellers and distributors. The direct channel produced 87% and 89% of
product revenues for the three months ended December 31, 1997 and 1996,
respectively, and 89% and 85% of product revenues for the six months ended
December 31, 1997 and 1996, respectively. Sales and marketing expenses were $3.0
million and $3.2 million, representing 45% and 33% of total revenues for the
three months ending December 31, 1997 and 1996, respectively. Sales and
marketing expenses were $5.8 million and $6.3 million, representing 44% and 34%
of total revenues for the six months ending December 31, 1997 and 1996,
respectively. The decreased cost was a result of lower commission expense on
lower revenues.
14
<PAGE>
General and Administrative. General and administrative expenses include
personnel and other costs of the finance, human resources, legal and
administrative departments of the Company. General and administrative expenses
were $1.9 million and $1.1 million, representing 29% and 11% of total revenues
for the three months ended December 31, 1997 and 1996, respectively. General and
administrative expenses were $3.3 million and $2.0 million, representing 25% and
11% of total revenues for the six months ended December 31, 1997 and 1996,
respectively. The increases were a result of higher legal costs, recruiting
costs, severance costs and consulting expenses, including approximately $500,000
in one-time expenses in the three months ended December 31, 1997.
Purchased Research and Development and Product Amortization. Purchased research
and development and product amortization was $117,000 and $139,000, representing
2% and 1% of total revenues for the three months ended December 31, 1997 and
1996, respectively. Purchased research and development and product amortization
was $3.9 million and $301,000, representing 30% and 2% of total revenues for the
six months ended December 31, 1997 and 1996, respectively. A one-time charge of
$3.1 million for purchased research and development related to the NetLOCK
acquisition, and a write-down of $550,000 relating to purchased research and
development in connection with the HARBOR acquisition were recorded in September
1997. (See Notes 3 and 4 to Condensed Consolidated Financial Statements)
Loss on Sale of HARBOR Product Line. The loss on sale of the HARBOR product line
was $2.2 million, representing 32% and 17% of total revenues for the three and
six months ended December 31, 1997, respectively. The sale of the HARBOR product
line occurred in December 1997 and included the establishment of a valuation
allowance related to certain assets and liabilities and the continuing guarantee
of a Canadian loan in the amount of $1.2 million, which was assumed by the
buyers. (See Note 4 to Condensed Consolidated Financial Statements)
Interest and Other Income, Net. Net interest and other income was $255,000 and
$144,000 for the three months ended December 31, 1997 and 1996, respectively.
Net interest and other income was $520,000 and $88,000 for the six months ended
December 31, 1997 and 1996, respectively. The increases in net interest and
other income was due primarily to a reduction of bank borrowings related to the
Harbor acquisition and interest earned on the larger cash balances which
resulted from the Company's initial public offering in August 1996 and the sale
of stock to Cisco in December 1996.
Benefit from (Provision for) Income Taxes. The benefit from (provision for)
income taxes was $4.5 million and ($578,000) for the three months ended December
31, 1997 and 1996, respectively. The benefit from (provision for) income taxes
was $6.0 million and ($847,000) for the six months ended December 31, 1997 and
1996, respectively. Included in the three and six months ended December 31, 1997
is a tax benefit of $3.2 million relating to the sale of the HARBOR product
line. Of this tax benefit, $2.8 million will be realized as a refund of federal
income taxes previously paid, once the Company files its tax return for the
current fiscal year. The effective tax rate was approximately 28% and 39% for
the three and six month periods ended December 31, 1997 and 1996, respectively.
The decrease in the effective tax rate is due to operating losses experienced
during the three and six months ended December 31, 1997. The Company will
continue to evaluate the recoverability of its deferred tax assets.
Recent Pronouncements
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130 (SFAS 130), Reporting Comprehensive
Income. This statement establishes requirements for disclosure of comprehensive
income and becomes effective for the Company for fiscal years beginning after
December 15, 1997, with reclassification of earlier financial statements for
comparative purposes. Comprehensive income generally represents all changes in
stockholders' equity except those resulting from investments or contributions
15
<PAGE>
by stockholders. The Company is evaluating alternative formats for presenting
this information, but does not expect this pronouncement to materially impact
the Company's results of operations.
In June 1997, The Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131 (SFAS 131), Disclosures about Segments of
an Enterprise and Related Information. This statement establishes standards for
disclosure about operating segments in annual financial statements and selected
information in interim financial reports. It also establishes standards for
related disclosures about products and services, geographic areas and major
customers. This statement supersedes Statement of Financial Accounting Standards
No. 14, Financial Reporting for Segments of a Business Enterprise. The new
standard becomes effective for fiscal years beginning after December 15, 1997,
and requires that comparative information from earlier years be restated to
conform to the requirements of this standard. The Company is evaluating the
requirements of SFAS 131 and the effects, if any, on the Company's current
reporting and disclosures.
In October 1997, the Accounting Standards Executive Committee issued Statement
of Position 97-2 (SOP 97-2), Software Revenue Recognition, which delineates the
accounting for software product and maintenance revenues. SOP 97-2 supersedes
the Accounting Standards Executive Committee Statement of Position 91-1,
Software Revenue Recognition, and is effective for transactions entered into in
fiscal years beginning after December 15, 1997. The Company is evaluating the
requirements of SOP 97-2 and the effects, if any on the Company's current
revenue recognition policies.
Liquidity and Capital Resources
Working capital was $23.7 million and $25.4 million at December 31, 1997 and
June 30, 1997, respectively. The decrease in working capital was primarily due
to the acquisition of NetLOCK network security technology and related assets and
net losses for the three and six months ended December 31, 1997.
For the six months ended December 31, 1997, net cash used in operating
activities resulted primarily from the net loss, decreases in accrued
liabilities and deferred maintenance and product revenue, and an increase in
deferred tax assets, partially offset by a decrease in accounts receivable, a
write-off of purchased research and development, and sale of the HARBOR product
line. For the six months ended December 31, 1996, net cash provided by
operations resulted primarily from net income, depreciation and amortization,
decrease in accounts receivable and other assets, partially offset by a decrease
in accrued liabilities, a decrease in deferred maintenance and product revenue
and an increase in inventories.
For the six months ended December 31, 1997, the Company's investing activities
have consisted primarily of the acquisition of NetLOCK network security
technology and purchases of property and equipment including $1.1 million
purchased in the NetLOCK acquisition. For the six months ended December 31,
1996, the Company's investing activities consisted primarily of purchases of
property and equipment.
For the six months ended December 31, 1997, the Company's financing activities
have consisted primarily of payments on notes payable and proceeds from the
issuance of common stock. For the six months ended December 31, 1996, the
Company's financing activities consisted of proceeds from the initial public
offering and the equity investment by Cisco partially offset by payments on the
Company's bank line of credit and notes payable.
At December 31, 1997, the Company had $21.1 million in cash and cash
equivalents. The Company had $8.1 million in accounts receivable, net of
allowance for doubtful accounts, and $7.9 million of unearned revenues, the
majority of which are expected to be earned over the 12 month period following
December 31, 1997.
The Company believes that its current cash and cash equivalents balances as well
as its cash flow from operations, if any, will be sufficient to meet its
anticipated working capital and capital expenditure requirements for at least
the next 12 months.
16
<PAGE>
RISK FACTORS THAT MAY AFFECT FUTURE RESULTS
The Company operates in a rapidly changing environment that involves a number of
risks, some of which are beyond the Company's control, and include the
following:
Dependence on Current Products
During the three months ended December 31, 1997 and 1996, sales of the network
transport products, excluding maintenance and hardware, accounted for
approximately 31% and 34%, and, including related maintenance and hardware,
accounted for approximately 88% and 85%, respectively, of the Company's total
revenues. The Company's operating results have historically been significantly
dependent upon sales of the network transport products. Approximately $1.0
million per quarter of maintenance revenues is from customers of the Company's
DECnet product. The Company no longer actively markets the DECnet product, and
maintenance revenues from DECnet customers have declined each year since the
fiscal year ended June 30, 1993, and are expected to continue to decline.
Since its availability on May 13, 1997, the Company has experienced difficulty
in deriving significant revenues from sales by Cisco of the IOS/390 product. As
a result of renegotiating its agreement with Cisco in August 1997, the Company
has resumed direct sales of its TCPaccess product and continues to support Cisco
in its sales of IOS/390. Increased sales of network transport products is
dependent upon the Company's ability to continue to expand its sales leads and,
in part, on cooperation with Cisco in the sale of IOS/390 into larger accounts.
The failure to increase sales levels of TCPaccess or IOS/390 could adversely
affect the Company's results of operations.
Reliance on IBM and the Mainframe as an Enterprise Server
The Company's network transport products are designed for use with IBM and
IBM-compatible mainframe computers. Specifically, these software products target
users of the MVS operating system, the Customer Information Control System
communications subsystem and the IMS and DB2 database management systems. As a
result, future sales of the Company's existing products and associated recurring
maintenance revenues are dependent upon continued use of mainframes and their
related systems software. In addition, because the Company's products operate in
conjunction with IBM systems software, changes to such software may require the
Company to adapt its products to these changes, and any inability to do so, or
delays in doing so, may adversely affect the Company's business, financial
condition and results of operations.
Currently, TCP/IP is the communications protocol for the Internet and is being
adopted by many organizations as the communications protocol for their
client/server local area networks and wide area networks. This adoption has
allowed IBM MVS mainframe computers to act as enterprise servers on such
networks. The use of mainframes as enterprise servers is relatively new and
still emerging. The Company's future financial performance will depend in large
part on the acceptance and growth in the market for centralized network
management. Adoption of another communications protocol on client/server
networks could make TCP/IP communication not viable, which would undermine the
demand for the Company's IOS/390 and TCPaccess product, and have a material
adverse effect on the Company's business, financial condition and results of
operations.
New TCP/IP Products and Rapid Technological Change
The markets for the Company's network transport products and systems management
applications are characterized by rapidly changing technologies, evolving
industry standards, frequent new product introductions and rapid changes in
customer requirements. The Company believes that its future success will
17
<PAGE>
depend upon its ability to develop and market products which meet changing user
needs, to continue to enhance its products and to develop and introduce in a
timely manner new products that take advantage of technological advances, keep
pace with emerging industry standards, and address the increasingly
sophisticated needs of its customers. There can be no assurance that TCP/IP will
continue to be accepted as a communications protocol on client/server networks.
Furthermore, there can be no assurance that the Company will be successful in
acquiring, developing or marketing, on a timely basis, product enhancements or
new products (including new versions of TCPaccess or IOS/390), either
independently or with strategic partners, that respond to technological change
or evolving industry standards, that the Company will not experience
difficulties that could delay or prevent the successful development,
introduction and sale of these products, or that any such new products or
product enhancements will adequately meet the requirements of the marketplace
and achieve market acceptance. The Company's failure or inability to adapt its
products to technological changes or to acquire or develop new products
successfully would have a material adverse effect on the Company's business,
financial condition and results of operations.
The introduction or announcement of products by the Company or one or more of
its competitors, including, but not limited to IBM, embodying new technologies,
or changes in customer requirements or the emergence of new industry standards
and practices could render the Company's existing products obsolete and
unmarketable. There can be no assurance that the introduction or announcement of
new product offerings by the Company or one or more of its competitors will not
cause customers to defer purchasing the existing products of the Company or that
the Company will successfully manage the transition from older products. Such
deferment of purchases or inability to manage the transition of products could
have a material adverse effect on the Company's business, financial condition
and results of operations.
Customer Acceptance and Scalability of New Products; History of Acquired
Technologies
During the past several quarters, the Company has expanded its market focus to
include products that provide security for and management and control of data
and programs in electronic commerce. In pursuit of that vision, the Company
acquired the NetLOCK product technology in September 1997 and the OpenMAX
technology in January 1998. Further development of these technologies is
required. There can be no assurance that the Company will be successful in
integrating the operations and personnel associated with these new product
lines, successfully commercializing the technologies, deriving significant
future sales therefrom, or in establishing and maintaining uniform standards,
controls, procedures and policies, or overcoming other problems that may be
encountered in connection with these acquisitions. To the extent that the
Company is unable to accomplish the foregoing, the Company's business, financial
condition and results of operations may be materially adversely affected.
To date, the Company's core technologies for its principal network transport
products and systems management applications have been acquired and have not
been developed internally. There can be no assurance that the Company will have
the opportunity to successfully acquire or develop new technologies in the
future or that such technology, if acquired, can be successfully integrated and
commercialized by the Company. An inability to acquire, develop or commercialize
new technologies would have a material adverse effect on the Company's business,
financial condition and results of operations. The Company may also seek to
acquire or invest in businesses, products or technologies that expand,
complement or otherwise relate to the Company's current business or product
line. There can be no assurance that such acquisitions will be successfully or
cost-effectively integrated into the Company's current operations, or that the
acquired technologies will provide the necessary complement to the Company's
current products.
Competition
General. The market in which the Company operates is intensely competitive and
is characterized by extreme price competition and rapid technological change.
The competitive factors influencing the markets for the
18
<PAGE>
Company's products include product performance, price, reliability, features,
scalability, interoperability across multiple platforms, adherence to industry
standards, and the provision of support and maintenance services. The Company
competes with a number of companies, principally IBM, that specialize in one or
more of the Company's product lines, and such competitors may have greater
financial, technical sales and marketing resources to devote to the development,
promotion and sale of their products, and may have longer operating histories,
greater name recognition, and greater market acceptance for their products and
services compared to those of the Company. There can be no assurance that the
Company's current competitors or any new market entrants will not develop
networked systems management products or other technologies that offer
significant performance, price or other advantages over the Company's
technologies, the occurrence of which would have a material adverse effect on
the Company's business, financial condition and results of operations.
Network Transport Products. The Company historically sold its TCPaccess suite of
products principally to customers who had installed IBM mainframes using the MVS
operating system. The Company's main competition for its IOS/390 and TCPaccess
products is IBM. IBM sells TCP/IP and associated products for its MVS mainframe
systems that compete directly with the Company's products. IBM has continued to
enhance the functionality and performance of its TCP/IP product. In addition,
IBM's OS/390 operating system, which includes TCP/IP communications software in
a bundle of software provided to purchasers of OS/390, has been and is
aggressively marketed by IBM, and the Company believes it has lost and may
continue to lose sales of the Company's IOS/390 and TCPaccess products as a
result. IBM has in some cases included and may continue to include its TCP/IP
product in the bundle of software provided to purchasers of its OS/390 operating
system without charge. The Company believes that any general reduction in price
of the IBM TCP/IP products, or the widespread bundling of those products without
charge in its OS/390 operating system, would make marketing of the Company's
IOS/390 and TCPaccess products difficult, which would have a material adverse
effect on the Company's business, financial condition and results of operations.
Security and System Management Products. The primary competitors for the NetLOCK
products based on the Company's recently acquired end-to-end network security
product, is Network Associates, Inc., Security Dynamics Technologies, Inc.,
Cylink, Time Step, Red Creek Communications Inc., V-One Technologies, Inc., and
Security First Technologies, Inc. In addition, security products comparable to
NetLOCK are currently available and are already incorporated into some operating
systems, thereby significantly diminishing the market for NetLOCK. The primary
competitors for the management and control products to be developed on the
OpenMAX technology acquired with the purchase of Networkers Engineering,
Limited, include IBM, Computer Associates and Sterling Software. Many other
companies in the computer industry have announced products and plans to compete
in the management and control of computer systems and networks.
Other Factors. The Company's ability to compete successfully depends on many
factors, including the Company's success in developing new products that
implement new technologies, performance, price, product quality, reliability,
success of competitors' products, general economic conditions, and protection of
Interlink products by effective utilization of intellectual property laws. In
particular, competitive pressures from existing or new competitors who offer
lower prices or other incentives or introduce new products could result in price
reductions, which would adversely affect the Company's profitability. There can
be no assurance that the Company's current or other new competitors will not
develop enhancements to, or future generations of, competitive products that
offer superior price or performance features, that the Company will be able to
compete successfully in the future, or that the Company will not be required to
incur substantial additional investment costs in connection with its
engineering, research, development, marketing and customer service efforts in
order to meet any competitive threat. The Company expects competition to
intensify, and increased competitive pressure could cause the Company to lower
prices for its products, or result in reduced profit margins or loss of market
share, any of which could have a material adverse effect on the Company's
business, financial condition and results of operations.
19
<PAGE>
Dependence on Distributors and New Sales Channels
The Company's sales are primarily made through the Company's direct sales force
and its distributors in some international markets. The Company is currently
investing, and plans to continue to invest, significant resources to develop new
strategic marketing relationships and channels of distribution, which
investments could adversely affect the Company's operating margins. In
particular, the Company plans to develop new channels of distribution, including
new distributors and resellers and a tele-sales marketing organization in
connection with sales of its new security products. The Company believes that
its success in penetrating markets for its products depends in large part on its
ability to maintain its existing marketing and distribution relationships, to
cultivate additional relationships and to develop these new sales channels.
There can be no assurance that any distributor, systems integrator or strategic
partner will not discontinue its relationship with the Company, for competing
arrangements with the Company's competitors, or dispute the Company's other
strategic relationships.
The loss of or a significant reduction in revenues from, the Company's
international distributors through which the Company sells certain of its
products could have a material adverse effect on the Company's business,
financial condition and results of operations. In addition, if one of the
Company's distributors declares bankruptcy, becomes insolvent, or is declared
bankrupt before the distributor remits to the Company the payments for the
Company's products, the Company may not be able to obtain the revenues to which
it would be entitled for sales made by such distributor prior to the bankruptcy
or insolvency proceeding. In addition, the Company's distributors generally
offer other products and these distributors may give higher priority to sales of
such other products.
The Company is involved in a commercial dispute and litigation with a former
distributor (See Notes to Condensed Consolidated Financial Statements). Although
the Company has accrued amounts for potential liabilities related to this
dispute, should the distributor prevail on its claims to a greater degree, the
Company's business, financial condition and results of operations could be
materially adversely affected.
Dependence on Key Personnel
The Company is highly dependent on the continued service of, and on its ability
to attract and retain, qualified technical, sales, marketing and managerial
personnel. The competition for qualified personnel in the software industry is
intense, and the loss of any such persons, as well as the failure to recruit
additional key personnel in a timely manner, could have a material adverse
effect on the Company's business, financial condition and results of operations.
There can be no assurance that the Company will be able to continue to attract
and retain the qualified personnel necessary for the development of its
business. The Company has employment agreements with certain executive officers,
but such agreements do not ensure their continued service to the Company or
prevent their competition with the Company following a termination of
employment. The Company does not maintain key man life insurance on the lives of
its key employees.
Product Errors; Product Liability
Software products as complex as those offered and being developed by the Company
often contain undetected errors or failures when first introduced or as new
versions are released. Testing of the Company's products is particularly
challenging because it is difficult to simulate the wide variety of computing
environments in which the Company's customers may deploy its products.
Accordingly, there can be no assurance that, despite testing by the Company and
by current and potential customers, errors will not be found after commencement
of commercial shipments, resulting in lost revenues, loss of or delay in market
acceptance and negative publicity about the Company and its products, any of
which could have a material adverse effect on the Company's business, financial
condition and results of operations. In addition, in the process of
commercializing new products the Company may detect errors or failures that
delay or prevent commercialization, any of which could
20
<PAGE>
have a material adverse effect on the Company's business, financial condition
and results of operations.
The Company's license agreements with customers typically contain provisions
designed to limit the Company's exposure to potential product liability claims.
The limitation of liability provisions contained in such license agreements may
not be effective under the laws of some jurisdictions, particularly if the
Company in the future relies on "shrink wrap" licenses that are not signed by
licensees. The Company's products are generally used to manage data critical to
organizations, and as a result, the sale and support of products by the Company
may entail the risk of product liability claims. A successful liability claim
brought against the Company could have a material adverse effect on the
Company's business, financial condition and results of operations.
Fluctuations in Operating Results; Absence of Backlog; Seasonality
The Company's operating results have historically been subject to quarterly
fluctuations due to a variety of factors. The Company has typically sold its
products through a trial process to allow customers to evaluate the
effectiveness of the Company's products before determining whether to proceed
with broader deployment of such products. The Company's sales cycle, from the
date the sales agent first contacts a prospective customer to the date a
customer ultimately purchases the Company's product, has typically been three to
nine months. In recent periods, the Company has experienced longer sales cycles
in certain instances. There can be no assurance that customers will purchase the
Company's products after a trial period or that the Company's sales cycle will
not lengthen, exposing it to the possibility of shortfalls in quarterly
revenues, which could have a material adverse effect on the Company's business,
financial condition or results of operations and cause results to vary from
period to period. The Company's operating results will also be affected by
general economic and other conditions affecting the timing of customer orders
and capital spending, and order cancellations or rescheduling.
The Company operates with very little backlog and most of its product revenues
in each quarter result from orders closed in that quarter, and a substantial
majority of those orders are completed at the end of that quarter. The Company
establishes its expenditure levels for sales, marketing, product development and
other operating expenses based in large part on its expectations as to future
revenues, and revenue levels below expectations could cause expenses to be
disproportionately high. If revenues fall below expectations in a particular
quarter, operating results and net income are likely to be materially adversely
affected. Any inability of the Company to adjust spending to compensate for
failure to meet sales forecasts or to collect accounts receivable, or any
unexpected increase in product returns or other costs, could magnify the adverse
impact of such events on the Company's operating results.
The Company's business has historically experienced and is expected to continue
to experience significant seasonality. The Company has had higher sales of its
software products in the quarters ending in December and June and weaker sales
in the quarters ending in September and March. The decrease in product revenues
in the quarters ending in September is due to the international customer
seasonal buying patterns. The quarters ending in March are historically weak due
to government and large organization annual budgeting cycles. Due to the
foregoing factors, quarterly revenue and operating results are likely to vary
significantly in the future and period-to-period comparisons of its results of
operations are not necessarily meaningful and should not be relied upon as
indications of future performance. Further, it is likely that in some future
quarters the Company's revenue or operating results will be below the
expectations of public market analysts and investors. In such event, the price
of the Company's Common Stock would likely be materially adversely affected.
Reliance on and Risks Associated with International Sales
During the three months ended December 31, 1997 and 1996, 40% of the Company's
total revenues were derived from sales to international customers. During the
six months ended December 31, 1997 and 1996, 36% and 44%, respectively, of the
Company's total revenues were derived from sales to international customers. The
decrease in sales in the six months period ended December 31, 1997 is indicative
of the risks associated
21
<PAGE>
with international sales and there can be no assurance that such a decrease will
not occur again in the future. The Company's international sales have been
primarily to European markets, and sales are generally denominated in local
currencies. Although the Company plans to focus its initial NetLOCK sales
efforts in the U.S. market, the regulatory environment with respect to sales of
NetLOCK to international customers is complex and uncertain. Should the Company
wish to sell NetLOCK internationally it may be unable to do so or may be
required to incur considerable regulatory costs to do so.
Sales to international customers are subject to additional risks including
longer receivables collection periods, greater difficulty in accounts receivable
collection, failure of distributors to report sales of the Company's products,
political and economic instability, nationalization, trade restrictions, the
impact of possible recessionary environments in economies outside the United
States, reduced protection for intellectual property rights in some countries,
currency fluctuations and tariff regulations and requirements for export and
import licenses. There can be no assurance that foreign intellectual property
laws will adequately protect the Company's intellectual property rights. In
addition, effective copyright and trade secret protection may be unavailable or
limited in certain foreign countries. Substantially all of the Company's
distribution and other agreements with international distributors require any
dispute between the Company and any distributor to be settled by arbitration.
Under these agreements, the party bringing the action, suit or claim is required
to conduct the arbitration in the domicile of the defendant. The result is that,
if the Company has a cause of action against a party, it may not be feasible for
the Company to pursue such action, as arbitration in a foreign country could
prove to be excessively costly and have a less certain outcome depending on the
laws and customs in the foreign country. These international factors could have
a material adverse effect on future sales of the Company's products to
international end users and, consequently, the Company's business, financial
condition and results of operations.
Most of the Company's international sales are denominated in local currencies.
The Company generally has not attempted to reduce the risk of currency
fluctuations by hedging except in certain limited circumstances where the
Company expects to hold an account receivable for a period of at least 6 months.
The Company may be disadvantaged with respect to its competitors operating in
foreign countries by foreign currency exchange rate fluctuations that make the
Company's products more expensive relative to those of local competitors. The
Company may attempt to reduce these risks by continuing to hedge in certain
limited transactions in the future. Accordingly, changes in the exchange rates
or exchange controls may adversely affect the Company's results of operations.
There can be no assurance that the Company's current or any future currency
exchange strategy will be successful in avoiding exchange related losses or that
any of the factors listed above will not have a material adverse effect on the
Company's future international sales and, consequently, on the Company's
business, financial condition and results of operations.
Dependence Upon Proprietary Technology; Risk of Third-Party Claims of
Infringement
The Company's success and ability to compete is dependent in part upon its
proprietary information. The Company relies primarily on a combination of
copyright and trademark laws, trade secrets, software security measures, license
agreements and nondisclosure agreements to protect its proprietary technology
and software products. There can be no assurance, however, that such protection
will be adequate to deter misappropriation, deter unauthorized third parties
from copying aspects of, or otherwise obtaining and using, the Company's
software products and technology without authorization, or that the rights
secured thereby will provide competitive advantages to the Company.
There can be no assurance that others will not independently develop similar
products or duplicate the Company's products. There can be no assurance that the
steps taken by the Company to protect its proprietary technology will prevent
misappropriation of such technology, and such protections may not preclude
competitors from developing products with functionality or features similar to
or superior to the Company's products. A substantial amount of the Company's
sales are in international markets, and the laws of other
22
<PAGE>
countries may afford the Company little or no effective protection of its
intellectual property.
While the Company believes that its products and trademarks do not infringe upon
the proprietary rights of third parties, there can be no assurance that the
Company will not receive future communications from third parties asserting that
the Company's products infringe, or may infringe, on the proprietary rights of
third parties. The Company was denied a trademark registration of the name
"Interlink" based on the use of similar names by other companies in the computer
industry. The Company expects that software product developers will be
increasingly subject to infringement claims as the number of products and
competitors in the Company's industry segments grow and the functionality's of
products in different industry segments overlap. Any such claims, with or
without merit, could be time consuming, result in costly litigation and
diversion of technical and management personnel, cause product shipment delays
or require the Company to develop non-infringing technology or enter into
royalty or licensing agreements, any of which could have a material adverse
effect on the Company's business, financial condition and results of operations.
Moreover, an adverse outcome in litigation or similar adversarial proceedings
could subject the Company to significant liabilities to third parties, require
expenditure of significant resources to develop non-infringing technology,
require disputed rights to be licensed from others or require the Company to
cease the marketing or use of certain products, any of which could have a
material adverse effect on the Company's business, financial condition and
results of operations.
Possible Volatility of Share Price
There can be no assurance that the market price of the Company's Common Stock
will not decline or remain below current levels. The trading prices of the
Company's Common Stock may be subject to wide fluctuations in response to a
number of factors, including variations in operating results, alliances, changes
in earnings estimates by securities analysts, announcements of extraordinary
events such as litigation, alliances, or acquisitions, announcements of
technological innovations or new products or new contracts by the Company or its
competitors, announcements and reports about the number of mainframe computers
shipped, press releases or reports of IBM or other competitors introducing
competitive or substitute products, as well as general economic, political and
market conditions. In addition, the stock market has from time-to-time
experienced significant price and volume fluctuations that have particularly
affected the market prices for the common stocks of technology companies and
that have often been unrelated to the operating performance of particular
companies. These broad market fluctuations may also adversely affect the market
price of the Company's Common Stock. In the past, following periods of
volatility in the market price of a company's securities, securities class
action litigation has occurred against the issuing company. There can be no
assurance that such litigation will not occur in the future with respect to the
Company. Such litigation could result in substantial costs and a diversion of
management's attention and resources, which would have a material adverse effect
on the Company's business, financial condition and results of operations. Any
adverse determination in such litigation could also subject the Company to
significant liabilities.
23
<PAGE>
PART II: OTHER INFORMATION
24
<PAGE>
ITEM 1. Legal Proceedings
Incorporated by reference from the Notes to Condensed
Consolidated Financial Statements- Item 6. Contingencies,
provided in Part I hereto.
ITEM 6. Exhibits and Reports on Form 8-K
(a) Exhibit 27 Financial Data Schedule
(EDGAR version only)
(b) Reports on Form 8-K The Company filed a current
reports on Form 8-K on October
3, 1997, October 15, 1997 and
December 18, 1997.
25
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: February 13, 1998 INTERLINK COMPUTER SCIENCES INC.
AND SUBSIDIARIES
(Registrant)
By: /s/ James A. Barth
-------------------------------------
James A. Barth
Chief Financial Officer and Secretary
By: /s/ Augustus J. Berkeley
-------------------------------------
Augustus J. Berkeley
President and Chief Executive Officer
26
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