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FORM 10-K
U.S. Securities and Exchange Commission
Washington, D.C. 20549
(Mark One)
[x] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
OR
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission file number: 0-21352
APPLIED INNOVATION INC.
(Name of registrant as specified in its charter)
DELAWARE 31-1177192
(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)
5800 INNOVATION DRIVE, DUBLIN, OHIO 43016
(Address of principal executive offices)(Zip Code)
Issuer's telephone number: 614-798-2000
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 PER SHARE
(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, and (2) has been subject to the filing requirements for
at least 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 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]
Aggregate market value of voting stock held by non-affiliates of the registrant,
9,049,650 shares, based on the $3.94 closing sale price on March 5, 1999, was
$35,655,621.
Indicate the number of shares outstanding of each of the registrant's classes of
common stock, as of the latest practicable date: 15,771,632 shares of Common
Stock were outstanding at March 12, 1999.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Annual Report to the Stockholders for the fiscal
year ended December 31, 1998, are incorporated by reference in Part II.
Part III - Proxy Statement for the 1998 Annual Meeting of Stockholders to be
held April 22, 1999, in part, as indicated.
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This Annual Report on Form 10-K contains forward-looking statements
within the meaning of Section 21E of the Securities Exchange Act of 1934, as
amended, and Section 26A of the Securities Act of 1933, as amended. The words
"anticipate," "believe," "expect," "estimate," and "project" and similar words
and expressions identify forward-looking statements which speak only as of the
date hereof. Investors are cautioned that such statements involve risks and
uncertainties that could cause actual results to differ materially from
historical or anticipated results due to many factors, including, but not
limited to, the factors discussed in "Business - Business Risks." The Company
undertakes no obligation to publicly update or revise any forward-looking
statements.
PART I
ITEM 1. BUSINESS.
---------
GENERAL
Applied Innovation Inc. (the "Company") develops, manufactures and
markets network mediation and network bridging products and associated services
to support the operation, maintenance, administration and provisioning of the
internal data network that is used by telecommunications service providers to
manage elements in their customer service network systems.
The Company's predecessor was incorporated in 1983 and engaged primarily
in development and preliminary testing activities until September 1984. In June
1986, the Company was formed as a Delaware corporation and the Company's
predecessor, an Ohio corporation, was merged into the Company solely for the
purpose of effecting a change in domicile. In 1995, the Company formed its
wholly owned subsidiary, Applied Innovation International Inc., a U.S. Virgin
Islands corporation, to act as a foreign sales corporation to market the
Company's products outside of the United States.
The Company's executive offices and manufacturing facilities are located
at 5800 Innovation Drive, Dublin, Ohio, 43016, telephone (614) 798-2000.
THE COMPANY'S MARKETS
The Company's products provide the data network used to support
Operations Support Systems needed to monitor and maintain thousands of pieces of
electronic equipment, or Network Elements, used by telecommunications service
providers. Network Elements provide the switching, connections and support
products required to transmit voice and data calls through one or more Central
Offices. Telecommunications service providers continually upgrade and expand the
equipment needed to provide service to their customers. As each piece of new
equipment is installed, it is connected to the Company's data monitoring network
that is used to report alarms, gather performance information, and to provide
test access and equipment reprogramming for establishing and maintaining
customer service. The Company's customers can use the Operations Support Systems
to perform a variety of tasks that include: fault management, configuration
management, performance management, security and inventory management.
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The Company is seeking to expand distribution for its products outside
the United States. The Company has taken early steps to establish a presence in
Australia, China, Taiwan, and South Africa. The Company believes that countries
currently building telecommunications infrastructures will require centralized
network management and the supporting data communications capability supplied by
its products.
The Company estimates that the Regional Bell Operating Companies
("RBOCs") control approximately half of the estimated 20,000 telecommunications
Central Office locations in the United States. The remaining locations are
controlled by a few large firms like GTE, Sprint, AT&T, MCIWorldcom, and over
1,000 smaller independent firms, competitive local exchange carriers ("CLECs"),
and long distance companies. Because of their relative size, demand for product,
and importance, the Company has concentrated its marketing efforts on the larger
telecommunications service providers. The Company has historically received a
large percentage of its annual net sales from RBOCs. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."
Each telecommunications service provider has a finite number of Central
Office facilities which limit their total capacity for the Company's products.
To the extent that the Company achieves significant penetration with the
Company's products into any single customer's Central Office facilities, it
cannot anticipate substantial additional sales of those existing products to the
customer. Future domestic sales growth to these customers depends on the
development and acceptance of new products and new releases of existing
products. Additional sales growth may be derived from additional sales to other
RBOCs, CLECs, and long distance phone companies. See "Business - Business Risks
- - Risks Associated with Customer Concentration; Dependence on Telecommunications
Industry."
PRODUCTS
AISWITCH(TM) SERIES 180
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The AISwitch Series 180, connects multiple generations of
telecommunications network equipment to computers that monitor, control and
analyze field conditions. The AISwitch Series 180 incorporates the latest high
speed microprocessor and programmable gate array technology to bridge the
hardware and software gaps between old and new equipment, providing productivity
gains and cost savings at both the customer's Central Office and Operations
Centers. Substantially all vintages of telecommunications network equipment can
be integrated with support systems through the use of the AISwitch Series 180.
Within a typical telecommunications service region, there may be as many
as 10,000 Network Elements to interface with a variety of equipment using
various communications protocols. Communications protocols are standards which
describe the way in which data is transmitted between computer systems.
Replacing existing equipment and updating it to conform to newer standards takes
place on extended schedules of up to twenty years, with successive introductions
of
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new technologies. For this reason, many of the Central Office and local site
locations utilize multiple generations of equipment from different vendors, each
with unique operating conditions. The Company's products offer one of the most
comprehensive solutions available for connecting these dissimilar
telecommunications elements.
A unique capability of the AISwitch Series 180 and the Company's
technical organization is the ability to engineer custom interfaces for
telecommunications equipment produced by a variety of different manufacturers
for telecommunications service providers. Each AISwitch Series 180 includes a
wide variety of functions and options that are configured to fit client needs.
The key to the AISwitch Series 180 integration capability is its
flexible microprocessor controlled digital switching and protocol processing
capabilities. The AISwitch Series 180 permits the use of industry-standard, open
architecture network building blocks to more easily connect different computers,
Network Elements and other intelligent Central Office equipment with one or more
network destinations. The Company transforms a complex multi-vendor environment
into an easily managed seamless network to increase the total efficiency of
Operations, Administration, Maintenance and Provisioning ("OAM&P") systems.
The Company has licensed technology from Cisco Systems, Inc. ("Cisco")
which allows the Company to integrate a Cisco router into the AISwitch. Cisco's
routing technology is the most widely used and allows the AISwitch to work
smoothly with the routing technology already in use by most of the Company's
customers. See "Business - Business Risks - Reliance on Suppliers."
APPLIEDVIEW(TM)
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AppliedView is the Company's network management application for AISwitch
products. AppliedView provides industry standard Simple Network Management
Protocol ("SNMP") management of the OAM&P network, which connects Network
Elements with Operations Support Systems. Because AppliedView is based on
Hewlett-Packard Company's Open View ("HP Open View"), the same system can also
monitor other data communications networks and systems. AppliedView also
provides a platform for Telecommunications Management Network ("TMN"), and
Element Management Layer ("EML"). AppliedView enables customers to make basic
configuration changes to every AISwitch in their network from a single location.
AppliedView also provides centralized configuration backup and control, and
automatically stores status, alias, destination and alarm events in the HP Open
View database.
AIM(TM)
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The AIM is a scaled down version of the AISwitch 180 that provides
operations center management of small office network elements in small central
offices, controlled environment vaults, cell sites, and huts. It is designed to
provide data paths for remote monitoring, provisioning, and software downloads.
The AIM also integrates diverse protocols and physical interfaces of network
elements for OAM&P applications.
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NEWEB(TM)
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NEWEB is a powerful combination of AISwitch and Web technology used to
enable simple and secure access to network elements from anywhere. NEWEB is
easily customizable and provides a simplified interface for complex network
element commands. NEWEB allows the customer to turn up services more quickly by
giving control center technicians direct access to remote network elements.
NEWEB also allows the customer to diagnose and repair network faults more
quickly and, therefore, improve productivity.
AISPY(TM)
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AIspy is a comprehensive system for managing remote, unmanned
facilities, such as controlled environment vaults, communication shelters,
cabinets, and huts. AIspy provides monitoring capabilities for the entire
facility through a multitude of alarms and sensors. AIspy is built to telephone
company standards and provides the customer with multiple management and
communication path options.
ACCESS PRODUCTS GROUP
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The Company previously undertook a major project, known as the Access
Products Group, to develop a product to serve as a remote access concentrator
which recognized and off-loaded digital data calls from the public switched
telephone network. In March 1998, the Company made an announcement that it was
seeking a strategic partner for its Access Products Group and subsequently
retained an investment banking firm to conduct the search. In September 1998,
the Company terminated all product development and related activities of its
Access Products Group due to an unsuccessful search for a strategic partner.
MANUFACTURING AND OPERATIONS
All of the printed circuit boards used within the Company's products are
proprietary designs of the Company. Printed circuit boards and power supplies
used in each of the Company's products are contracted out to third party
manufacturing firms for assembly. These subassemblies are then shipped to the
Company for testing and final assembly. Procurement of materials is driven
through an enterprise resource planning ("ERP") system with production forecasts
supplied to contract firms for component ordering from sources supplied and
approved by the Company. The Company maintains and controls all documentation
and process requirements for products manufactured by the contract assembly
firms. The Company utilizes multiple assembly firms and is, therefore, not
dependent on any single third party manufacturer.
The Company performs multiple inspections on its products as well as
various test procedures prior to shipment to customers. These processes are
designed to assure product performance and reliability in the environments the
products will be used. The Company has made and continues to make significant
investments to attain quality assurance consistent with stringent industry
standards. The Company develops and manufactures its products in accordance with
NEBS
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and Generic Equipment Requirements guidelines. The Company is International
Standards Organization 9001 ("ISO 9001") certified.
SALES AND MARKETING
The Company's products and services are sold primarily through its own
sales force, except for independent sales agents in Canada and Taiwan. The
Company is exploring alternative distribution channels to allow sales of the
Company's products to markets that are not easily accessible nor cost effective
for its own sales force. In addition to the Dublin, Ohio headquarters, the
Company maintains sales offices in Atlanta, Chicago, Dallas, Denver, New York,
and San Francisco.
The Company's sales and marketing staff consists of a Senior Vice
President of Sales and Marketing, a Director of Marketing, Divisional Sales
Managers, Senior Account Managers, Account Managers, New Account Managers, Sales
Engineers, Product Line Managers and an administrative staff. Sales leads are
currently generated primarily through target marketing to telecommunications
service providers, direct mail and trade shows. Sales leads are followed up by
personal contact from the Company's sales and marketing staff. If sufficient
interest exists, an on-site visit may be scheduled for the purpose of making a
sales presentation, which may include a product demonstration.
The technical complexity of the Company's products and the relative
large size of customers creates a long sales cycle for the Company's products.
The technical nature of the products and Central Office environment also
mandates a very technical sales force. The Company's sales force receives
incentive compensation based on increased levels of sales.
RESEARCH AND DEVELOPMENT
The Company's research and development ("R&D") activity is coordinated
with product management to create product development teams which focus on
customer requirements. Enhancements to the AISwitch are focused on increasing
its capacity and adapting to the emerging Open Systems Interconnection (OSI)
applications being driven into Network Elements by worldwide standardization
efforts. At the same time, the AISwitch is being enhanced to accommodate older
data communication standards in order to broaden its range of application. The
R&D staff consists of 66 engineers.
The Company spent $11,979,875, $12,897,072, and $7,646,796 on
Company-sponsored R&D during the fiscal years ended December 31, 1998, 1997, and
1996, respectively. R&D expenditures represented approximately 22.3%, 27.6%, and
18.6% of annual net sales in fiscal 1998, 1997, and 1996, respectively. During
1998 and 1997, the Company incurred $6,263,000 and $6,536,000, respectively, in
R&D related to the terminated Access Products Group development activity. The
Company continues to expect to commit a substantial amount of resources and cash
to its research and development efforts during 1999. See "Business - Business
Risks - New Products and Rapid Technological Change; Need to Manage Product
Transitions."
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CUSTOMER SERVICE AND WARRANTY
The Company offers its customers a variety of support services such as
project management, training, detail engineering, installation, and test and
turn-up. Project managers interface between the Company and customers for
installation of new products and service and upgrades of existing products. The
project manager is also responsible for assuring that all possible circumstances
are anticipated prior to certifying the system for full operation. Following
installation, the project manager continues to monitor the customer's system to
ensure proper satisfaction.
The Company designs training programs to educate the customer's system
administration, operations and maintenance personnel to operate the system.
Classes are available at the customer's site or at the Company's headquarters.
Additional training is also offered to the customer during system upgrades and
for new operations personnel.
The Company's field service department provides custom design and
installation services for telecommunications network equipment. The Company
believes that its field service department complements and enhances the sale of
its products.
The Company warrants its products for a minimum of one year and up to
three years, as negotiated under contract. Customers may also purchase extended
warranty contracts with guaranteed overnight factory replacement service for
circuit boards or system modules in the event of equipment failure. Software
revisions to the Company's products are also available as part of the warranty
package. In addition, for an additional charge, on-site spares are available for
those customers who require immediate replacement. The Company also provides a
24-hour Service Hotline for instant access to its field service and support
departments. A toll-free 800 number is also offered.
Warranty expense represented approximately 4.0%, 3.6%, and 10.2% of
annual net sales in 1998, 1997, and 1996, respectively. Warranty expense was
abnormally high in 1996 because of repair costs on units which the Company
agreed to repair to avoid future product difficulties and to demonstrate the
Company's quality assurance commitment to customers. See "Business - Business
Risks - Risk of Product Defects."
COMPETITION
There are numerous manufacturers of data communications equipment.
Manufacturers of these products frequently specialize their products for
specific applications and could enter the Company's target markets. Significant
competition exists from several well-established companies having resources
superior to those of the Company and from relatively new but aggressive
companies.
Competition for the Company's products has traditionally come primarily
from suppliers of telecommunications switching and transmission equipment.
Lucent Technologies has a product line, Datakit, which competes directly with
the Company's products when selling into the
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telecommunications industry. Competition also comes from other data
communications suppliers, such as Cisco Systems, Inc., Dantel, and Harris
Corporation's Westronics division. In some cases, newer products or redesigned
older products from these suppliers compete with the Company's products. See
"Business - Business Risks - Competition."
PERSONNEL
As of February 26, 1999, the Company had 220 full-time and part-time
employees. The Company's employees are distributed among the following
departments: Sales and Marketing (33); Research and Development (66); Customer
Service (52); Manufacturing (39) and Operations (30). The Company anticipates
that it will continue to increase the number of its employees as it grows.
BUSINESS RISKS
The Company desires to take advantage of the "safe harbor" provisions of
the Private Securities Litigation Reform Act of 1995. In addition to the other
information in this report, readers should carefully consider that the following
important factors, among others, in some cases have affected, and in the future
could affect, the Company's actual results and could cause the Company's actual
consolidated results of operations for the year ended December 31, 1999, and
beyond, to differ materially from those expressed in any forward-looking
statements made by, or on behalf of, the Company.
Risks Associated with Customer Concentration; Dependence on
Telecommunications Industry. A significant portion of the Company's revenues in
each fiscal quarter since inception has been derived from substantial orders
placed by large organizations, such as the RBOCs. As a result, the Company's net
sales often have been concentrated among a relatively small number of customers.
In fiscal 1998, 1997, and 1996, net sales from the Company's five, five and
three largest customers represented approximately 75%, 76%, and 53%,
respectively, of the Company's total net sales. The Company expects that it will
continue to be dependent upon a limited number of customers for a significant
portion of its revenues in future periods. None of the Company's customers are
contractually obligated to license or purchase additional products or services
from the Company. As a result of this customer concentration, the Company's
business, operating results and financial condition could be materially
adversely affected by the failure of anticipated orders to materialize or by
deferrals or cancellations of orders. In addition, there can be no assurance
that revenue from customers that have accounted for significant net sales in
past periods, individually or as a group, will continue, or if continued will
reach or exceed historical levels in any future period. Furthermore, such
customers are concentrated in the telecommunications industry. Accordingly, the
Company's future success depends upon the capital spending patterns of such
customers and the continued demand by such customers for the Company's products
and services. The Company's operating results may in the future be subject to
substantial period-to-period fluctuations as a consequence of such customer
concentration and factors affecting capital spending in the telecommunications
industry.
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Product Concentration. Revenue from the sale, service and support of the
Company's AISwitch family of products has accounted for substantially all of the
Company's net sales since inception. The Company believes that revenue from the
sale, service and support of the AISwitch will continue to account for
substantially all of the Company's net sales in fiscal 1999. Therefore, the
Company's future operating results, particularly in the near term, are
significantly dependent upon the continued market acceptance of the AISwitch,
improvements to the AISwitch framework and new and enhanced development tools
and network operations support. There can be no assurance that the AISwitch will
continue to achieve market acceptance or that the Company will be successful in
developing, introducing or marketing improvements to the AISwitch framework or
new or enhanced development tools and applications. The life cycles of products,
including development tools and applications, are difficult to estimate due in
large part to the recent emergence of many of the Company's markets, the effect
of future product enhancements and competition. A decline in the demand for the
AISwitch as a result of competition, technological change or other factors would
have a material adverse effect on the Company's business, operating results and
financial condition.
New Products, Research and Development, and Rapid Technological Change;
Need to Manage Product Transitions. The market for the Company's products is
characterized by rapidly changing technologies, evolving industry standards,
frequent new product introductions and rapid changes in customer requirements.
The introduction of products embodying new technologies and the emergence of new
industry standards and practices can render existing products obsolete and
unmarketable. As a result, the life cycles of the Company's products are
difficult to estimate. The Company's future success will depend on its ability
to enhance its existing products and to develop and introduce, on a timely and
cost-effective basis, new products and product features that keep pace with
technological developments and emerging industry standards and address the
increasingly sophisticated needs of its customers. The Company is attempting to
ensure future success by investing heavily in its research and development
effort. However, there can be no assurance that the Company will be successful
in developing and marketing new products or product features 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 marketing of these new products and features, or that its new
products or product features will adequately meet the requirements of the
marketplace and achieve market acceptance. If the Company is unable, for
technological or other reasons, to develop and introduce enhancements of
existing products or new products in a timely manner, the Company's business,
operating results and financial condition will be materially adversely affected.
The introduction or announcement of products by the Company or one or
more of its competitors embodying new technologies, or changes in industry
standards or customer requirements, could render the Company's existing products
obsolete or unmarketable. The introduction of new or enhanced versions of its
products requires the Company to manage the transition from older products in
order to minimize disruption in customer ordering. 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
existing Company products.
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Such deferment of purchases could have a material adverse effect on the
Company's business, operating results and financial condition.
Competition. Most of the Company's current and potential competitors
have longer operating histories and significantly greater financial, technical,
sales, customer support, marketing and other resources, as well as greater name
recognition and a larger installed base of their products and technologies than
the Company. There can be no assurance that the Company's current or potential
competitors will not develop products comparable or superior to those developed
by the Company or adapt more quickly than the Company to new technologies,
evolving industry trends or changing customer requirements. There can be no
assurance that the Company will be able to compete successfully against current
and future competitors or that competitive pressures faced by the Company will
not have a material adverse effect on its business, operating results and
financial condition.
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 software technology. The Company relies on a combination of
trade secret, copyright and trademark laws, nondisclosure and other contractual
agreements and technical measures to protect its proprietary rights. The Company
currently has no patents or patent applications pending. Despite the Company's
efforts to protect its proprietary rights, unauthorized parties may attempt to
copy aspects of the Company's products or to obtain and use information that the
Company regards as proprietary. 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
the Company's products. In addition, effective copyright and trade secret
protection may be unavailable or limited in certain foreign countries. 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, the proprietary rights of third
parties. The Company expects that software product developers will be
increasingly subject to infringement claims as a number of products and
competitors in the Company's industry segment grows and the functionality 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. Such royalty or licensing agreements, if
required, may not be available on terms acceptable to the Company or at all. In
the event of a successful claim of product infringement against the Company and
failure or inability of the Company to develop non-infringing technology or
license the infringed or similar technology, the Company's business, operating
results and financial condition could be materially adversely affected.
The Company relies on certain software that it licenses from third
parties, including software that is integrated with internally developed
software and used in the Company's products to perform key functions. There can
be no assurance that these third party software licenses will continue to be
available to the Company on commercially reasonable terms or at all. Although
the Company
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believes that alternative software is available from other third-party
suppliers, the loss of or inability to maintain any of these software licenses
or the inability of the third parties to timely and cost-effectively enhance
their products in response to changing customer needs, industry standards or
technological developments could result in delays or reductions in product
shipments by the Company until equivalent software could be developed internally
or identified, licensed and integrated, which would have a material adverse
effect on the Company's business, operating results and financial condition.
Reliance on Suppliers. The Company purchases raw material and licenses
technology from a number of domestic and foreign sources. The Company believes
that currently there are acceptable alternatives to the suppliers of raw
material and technology used in its products, with the exception of network
routing products supplied by Cisco Systems, Inc. The Company currently purchases
network routing products and licenses technology regarding the same from Cisco
Systems, Inc. pursuant to a Technology Agreement. The term of the Technology
Agreement expires on December 31, 1999 and automatically renews for one year
periods, unless either party elects not to renew. Additionally, the Technology
Agreement may be terminated by either party for any reason upon six months
notice. The Company believes that its customers place a high value on the
incorporation of network routing products and technology from Cisco Systems,
Inc. into the Company's products. While the Company believes that it could
obtain similar quality network routing products and technology from other
vendors, the termination of the Technology Agreement could materially adversely
affect the acceptance of the Company's products, which could have a material
adverse effect on the Company's business, financial condition and results of
operations.
Future Capital Needs; Uncertainty of Additional Financing. The Company
currently anticipates that its existing cash, cash equivalents, cash to be
generated from future operations, and funds which may be obtained from future
financing activities will provide sufficient capital to meet the business needs
of the Company. See "Management's Discussion and Analysis of Financial Condition
and the Results of Operations - Liquidity and Capital Resources." The Company
may need to raise additional funds through public or private debt or equity
financings in order to take advantage of unanticipated opportunities, including
more rapid expansion or acquisitions of complementary businesses or
technologies, or to develop new or enhanced services and related products or
otherwise respond to unanticipated competitive pressures. If additional funds
are raised through the issuance of equity securities, the percentage ownership
of the then current stockholders of the Company may be reduced and such equity
securities may have rights, preferences or privileges senior to those of the
holders of the Company's common stock. There can be no assurance that additional
financing will be available on terms favorable to the Company, or at all. If
adequate funds are not available or are not available on acceptable terms, the
Company may not be able to take advantage of unanticipated opportunities,
develop new or enhanced services and related products or otherwise respond to
unanticipated competitive pressures and the Company's business, operating
results and financial condition could be materially adversely affected.
Future Operating Results Uncertain. Although the Company has previously
experienced growth in revenues and net income, the Company expects that
historical growth rates are not sustainable and such growth rates should not be
considered indicative of future growth, if any.
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There can be no assurance that the Company's revenues will grow or be sustained
in future periods or that the Company will be profitable in any future period.
Risk of Product Defects. Products as complex as those offered by the
Company may contain defects or failures when introduced or when new versions or
enhancements are released. The Company has in the past discovered defects in
certain of its products. Although the Company has remedied all known material
defects in its products, there can be no assurance that, despite testing by the
Company and its customers, errors will not be found in existing or new products
or releases, resulting in delay or loss of revenue, loss of market share or
failure to achieve market acceptance or substantial warranty expense. Any such
occurrence could have a material adverse effect upon the Company's business,
operating results and financial condition.
Year 2000. The Company faces year 2000 compliance issues similar to
those faced by other companies which design, manufacture, and sell equipment
used in the telecommunications industry. Year 2000 compliance issues typically
arise with respect to computer software systems and programs that use only two
digits, rather than four digits, to represent a particular year. Consequently,
these systems and programs may not process dates beyond the year 1999 and may
result in miscalculation or system failures causing disruptions of business
operations. Although the products currently offered by the Company have been
tested for year 2000 compliance, any failure of the Company's products to
perform, including the failure to process dates beyond the year 1999, could have
a material adverse effect on the Company's business, financial condition, and
results of operations. The Company's future revenue could be impacted if
customers divert portions of their capital expenditure budgets toward the year
2000 issue and away from programs that include purchases of the Company's
products. The Company has addressed, and will continue to address, the year 2000
issue, however, the Company cannot guarantee that its year 2000 compliance
efforts will prevent all consequences, and there may be undetermined future
costs due to business disruption that may be caused by customers, suppliers, or
unforeseen circumstances.
Potential Fluctuations in Quarterly Results; Seasonality. The Company's
quarterly operating results have in the past and will in the future vary
significantly depending on factors such as the timing of significant orders and
shipments, capital spending patterns of the Company's customers, changes in
pricing policies by the Company or its competitors, the lengthy sales cycle of
the Company's products, increased competition, changes in operating expenses,
personnel changes, demand for the Company's products, the number, timing and
significance of new product and product enhancement announcements by the Company
and its competitors, the ability of the Company to develop, introduce and market
new and enhanced versions of its products on a timely basis, the mix of direct
and indirect sales and general economic factors, among others. A significant
portion of the Company's revenues have been, and will continue to be, derived
from substantial orders placed by large organizations, such as the RBOCs, and
the timing of such orders and their fulfillment has caused and will continue to
cause material fluctuations in the Company's operating results, particularly on
a quarterly basis. Due to the foregoing factors, quarterly net sales and
operating results have been and will continue to be difficult to forecast.
Revenues are also difficult to forecast because the Company's sales cycle, from
initial evaluation to product shipment, varies substantially from customer to
customer. For these and other reasons, the sales cycle associated
- 12 -
<PAGE> 13
with the purchase of the Company's products is typically lengthy and subject to
a number of significant risks, including customers' budgetary constraints and
internal acceptance reviews, over which the Company has little or no control.
The Company's expense levels are based, in part, on its expectations as to
future revenue levels. If revenue levels are below expectations, operating
results are likely to be materially adversely affected. In particular, because
only a small portion of the Company's expenses varies with net sales, net income
(loss) may be disproportionately affected by a reduction in net sales. The
Company's business has experienced and is expected to continue to experience
significant seasonality, in part due to an increase in capital expenditures by
customers in certain quarters. Based upon all of the foregoing, the Company
believes that quarterly net sales and operating results are likely to vary
significantly in the future and that period-to-period comparisons of its results
of operations are not necessarily meaningful and should not be relied upon as
indications of future performance. Further, it is likely that in some future
quarter, the Company's net sales 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 could be materially adversely affected.
Dependence on Key Personnel. The Company's success depends to a
significant degree upon the continuing contributions of its key management,
sales, professional services, customer support and product development
personnel. In particular, the Company would be materially adversely affected if
it were to lose the services of Gerard B. Moersdorf, Jr., Chief Executive
Officer, President, Treasurer and a director of the Company, who has provided
significant leadership and direction to the Company since its inception. The
Company has obtained key man life insurance on the life of Mr. Moersdorf in the
amount of $1,000,000, payable to the Company. The loss of other key management
or technical personnel could adversely affect the Company. The Company believes
that its future success will depend in large part upon its ability to attract
and retain highly-skilled managerial, sales, professional services, customer
support and product development personnel. The Company has at times experienced
and continues to experience difficulty in recruiting qualified personnel.
Competition for qualified personnel is intense, and there can be no assurance
that the Company will be successful in attracting and retaining such personnel.
In addition, there are only a limited number of qualified professional services
and customer support engineers, and competition for such individuals is
especially intense. Furthermore, competitors have in the past and may in the
future attempt to recruit the Company's employees. Failure to attract and retain
key personnel could have a material adverse effect on the Company's business,
operating results and financial condition.
Limited Market; Volatility of Stock Price. Although the Company is
listed on the Nasdaq National Market, there can be no assurance that an active
or liquid trading market in the Company's common stock will continue. The market
price of the shares of the Company's common stock is likely to be highly
volatile and may be significantly affected by factors such as actual or
anticipated fluctuations in the Company's operating results, announcements of
technological innovations, new products or new contracts by the Company or its
competitors, developments with respect to copyrights or proprietary rights,
general market conditions and other factors. In addition, the stock market has
from time to time experienced significant price and volume fluctuations that
have particularly affected the market prices for the common stocks of technology
companies. These types of broad market fluctuations may adversely affect the
market price of the Company's common stock.
- 13 -
<PAGE> 14
In the past, following periods of volatility in the market price of a company's
securities, securities class action litigation has often been initiated against
such company. Such litigation could result in substantial costs and a diversion
of management's attention and resources, which could have a material adverse
effect upon the Company's business, operating results and financial condition.
Anti-Takeover Provisions; Certain Provisions of Delaware Law;
Certificate of Incorporation and By-Laws. Certain provisions of Delaware law and
the Company's Certificate of Incorporation and By-Laws could have the effect of
making it more difficult for a third party to acquire, or of discouraging a
third party from attempting to acquire, control of the Company. The Company's
By-Laws provide for the Board of Directors to be divided into three classes of
directors serving staggered three-year terms. Such classification of the Board
of Directors expands the time required to change the composition of a majority
of directors and may tend to discourage a proxy contest or other takeover bid
for the Company. Additionally, the directors, executive officers and existing
principal stockholders of the Company and their affiliates beneficially own
approximately 43.5% of the outstanding shares of the Company's Common Stock.
Such concentration of ownership may have the effect of delaying or preventing a
change in control of the Company.
Concentration of Stock Ownership. The present directors, executive
officers and principal stockholders of the Company and their affiliates
beneficially own approximately 43.5% of the outstanding shares of the Company's
Common Stock. In particular, Gerard B. Moersdorf, Jr. and his spouse own
approximately 41.5% of the outstanding shares of Common Stock. As a result,
these stockholders are able to exercise significant influence over matters
requiring stockholder approval, including the election of directors and approval
of significant corporate transactions. Such concentration of ownership may have
the effect of delaying or preventing a change in control of the Company.
ITEM 2. PROPERTIES.
-----------
The Company headquarters is a 115,000 square foot modern corporate
office and manufacturing facility in Dublin, Ohio. All of the Company's
manufacturing, administrative and research and development activities and a
substantial portion of its marketing activities are conducted at this location.
The Company owns the building and the approximately 33 acres of land on which it
is situated.
ITEM 3. LEGAL PROCEEDINGS.
------------------
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
----------------------------------------------------
Not applicable.
- 14 -
<PAGE> 15
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
----------------------------------------------------------------------
The Company's common stock has been traded in the over-the-counter
market since 1986. The common stock was traded on the NASDAQ OTC Bulletin Board
until May 18, 1993. From May 18, 1993 to November 26, 1993 the common stock was
traded on the NASDAQ Small Cap Market. On November 29, 1993 the common stock
began trading on the NASDAQ National Market. The following table sets forth, for
the periods indicated, the high and low bid prices for the Company's common
stock. The prices shown represent quotations between dealers, without adjustment
for retail markups, markdowns or commissions and may not represent actual
transactions.
<TABLE>
<CAPTION>
1998 1997
---- ----
High Low High Low
<S> <C> <C> <C> <C>
Q1 $8.00 $5.38 $6.50 $4.38
Q2 $11.75 $7.00 $6.38 $3.25
Q3 $11.25 $2.38 $4.75 $3.75
Q4 $4.50 $2.19 $8.13 $4.13
-----------------------------------------------
</TABLE>
At March 5, 1999, the Company had 745 stockholders of record.
The Company has not paid any cash dividends and presently anticipates
that all of its future earnings will be retained for development of its
business. The Company does not anticipate paying cash dividends on its Common
Stock in the foreseeable future. The payment of any future dividends would be at
the discretion of the Company's Board of Directors and would depend upon, among
other things, future earnings, operations, capital requirements, the general
financial condition of the Company and general business conditions. Although the
Company's ability to pay dividends is not currently restricted by any of its
financing agreements, the Company may be subject to such restrictions in the
future.
- 15 -
<PAGE> 16
ITEM 6. SELECTED FINANCIAL DATA.
------------------------
The information required by this item is included under the caption
"Financial Highlights" in the Company's Annual Report to Stockholders and is
incorporated herein by reference.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
-----------------------------------------------------------------------
OF OPERATIONS.
--------------
The information required by this item is included under the caption
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" in the Company's Annual Report to Stockholders and is incorporated
herein by reference.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
-----------------------------------------------------------
None.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
--------------------------------------------
The information required by this item is included under the caption
"Consolidated Financial Statements" in the Company's Annual Report to
Stockholders and is incorporated herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
---------------------------------------------------------------
FINANCIAL DISCLOSURE.
---------------------
None.
- 16 -
<PAGE> 17
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
---------------------------------------------------
The information appearing under the caption "ELECTION OF DIRECTORS" on
pages 4 through 11 of the Company's Proxy Statement relating to the Company's
Annual Meeting of Stockholders to be held on April 22, 1999 (the "Proxy
Statement"), and the information appearing under the caption "SECTION 16(a)
BENEFICIAL OWNERSHIP REPORTING COMPLIANCE" on page 13 of the Proxy Statement is
incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION.
-----------------------
The information appearing in the Proxy Statement under the caption
"ELECTION OF DIRECTORS - Executive Compensation" on pages 7 through 11 of the
Proxy Statement is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
---------------------------------------------------------------
The information appearing in the Proxy Statement under the caption
"OWNERSHIP OF COMMON STOCK BY PRINCIPAL STOCKHOLDERS" on page 2, and under the
caption "SECURITY OWNERSHIP OF MANAGEMENT" on page 3 of the Proxy Statement, is
incorporated herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
-----------------------------------------------
The information appearing in the Proxy Statement under the caption
"ELECTION OF DIRECTORS - Related Party Transactions" on pages 9 and 10 is
incorporated herein by reference.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
--------------------------------------- ------------------------
(a)(1) The following documents are filed as part of this report:
Consolidated Balance Sheets as of December 31, 1998 and 1997
Consolidated Statements of Operations for the years ended December 31,
1998, 1997, and 1996
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 1998, 1997, and 1996
Consolidated Statements of Cash Flows for the years ended December 31,
1998, 1997, and 1996
Notes to Consolidated Financial Statements
- 17 -
<PAGE> 18
(a)(2) No schedules are included because of the absence of the conditions
under which they are required or because the required information is
included in the financial statements or the notes thereto.
(a)(3) Exhibits: The following exhibits are filed as part of this report:
<TABLE>
<CAPTION>
EXHIBIT NO. DESCRIPTION
PAGE
<S> <C>
3.1 Certificate of Incorporation of the Company.....................................(1)
3.2 By-laws of the Company, as amended..............................................(1)
10.1 Company's Amended and Restated 1986 Incentive Stock
Option Plan, including form of Stock Option Agreement..........................(1)*
10.2 Company's 1986 Amended and Restated Non-Statutory
Stock Option Plan, including form of Stock Option Agreement....................(1)*
10.3 Form of Confidentiality, Assignment and Non-Competition
Agreement between the Company and employee officers............................(1)*
10.4 Technology Agreement, dated November 12, 1996, between
the Company and Cisco Systems, Inc..............................................(4)
10.5A Letter Agreement between the Company and William H. Largent
regarding employment...........................................................(4)*
10.5B Employment Agreement between the Company and William H. Largent................(4)*
10.6 Letter Agreement between the Company and
John M. Spiegel re: employment.................................................(1)*
10.7 Employment Agreement between the Company and
William J. Mrukowski...........................................................(4)*
10.8 Form of Indemnification Agreement between the Company
and officers and directors.....................................................(2)*
10.9 Schedule of Indemnification Agreements.........................................(2)*
10.10 Omitted
10.11 Omitted
</TABLE>
- 18 -
<PAGE> 19
<TABLE>
<S> <C>
10.12 Omitted
10.13 Company's 1996 Stock Option Plan...............................................(3)*
11 Statement re: computation of earnings per share.................................(5)
13 Portions of the Annual Report to Stockholders...................................(5)
23.1 Consent of KPMG LLP.............................................................(5)
24 Powers of Attorney .........................................................(5)
26 Financial Data Schedule.........................................................(5)
</TABLE>
- -------------------
(1) Previously filed with the same exhibit number with the Company's
Form 10-SB filed March 10, 1993 and incorporated herein by
reference.
(2) Previously filed with the same exhibit number with the Company's
Form 10-KSB filed March 31, 1994 and incorporated herein by
reference.
(3) Previously filed with the same exhibit number with the Company's
Form 10-K filed March 31, 1996 and incorporated herein by
reference.
(4) Previously filed with the same exhibit number with the Company's
Form 10-K filed March 31, 1998 and incorporated herein by
reference.
(5) Filed herewith.
* Management contract or compensatory plan or arrangement required
to be filed as an exhibit to this form.
(b) Form 8-K filed October 27, 1998, reporting that on October 23, 1998, the
Company's Board of Directors authorized the Company to repurchase up to
1,000,000 shares of its outstanding common stock through October 22,
1999 (Item 5).
(c) Exhibits - The exhibits to this report follow the signature page.
(d) Financial Statement Schedules - None.
- 19 -
<PAGE> 20
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.
APPLIED INNOVATION INC.
Date: March 26, 1999 By: /s/ Gerard B. Moersdorf, Jr.
------------------------------------
Gerard B. Moersdorf, Jr., Chairman,
President and Treasurer
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.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
--------- ----- ----
<S> <C> <C>
/s/ Gerard B. Moersdorf, Jr. Chairman, President March 26, 1999
- ------------------------------ and Treasurer (Principal
Gerard B. Moersdorf, Jr. Executive Officer)
/s/ William H. Largent Senior Vice President of March 26, 1999
- ------------------------------ Operations and Chief Financial
William H. Largent Officer (Principal Financial
Officer)
/s/ John M. Spiegel Controller March 26, 1999
- ------------------------------ (Principal Accounting Officer)
John M. Spiegel
*James H. Blough
- ------------------------------
James H. Blough Director March 26, 1999
*Curtis A. Loveland
- ------------------------------
Curtis A. Loveland Director March 26, 1999
*Gerard B. Moersdorf, Sr.
- ------------------------------
Gerard B. Moersdorf, Sr. Director March 26, 1999
*Richard W. Oliver
- ------------------------------
Richard W. Oliver Director March 26, 1999
*Thomas W. Huseby
- ------------------------------
Thomas W. Huseby Director March 26, 1999
</TABLE>
- 20 -
<PAGE> 21
<TABLE>
<S> <C> <C>
*Alexander B. Trevor
- ------------------------------
Alexander B. Trevor Director March 26, 1999
*By: /s/ Gerard B. Moersdorf, Jr.
-----------------------------
Gerard B. Moersdorf, Jr.
(Attorney-in-Fact)
</TABLE>
- 21 -
<PAGE> 22
APPLIED INNOVATION INC.
-----------------------
EXHIBIT INDEX
TO
ANNUAL REPORT ON FORM 10-K
for the fiscal year ended
December 31, 1998
EXHIBIT NO. DESCRIPTION
PAGE
3.1 Certificate of Incorporation of the Company........................(1)
3.2 By-laws of the Company, as amended.................................(1)
10.1 Company's Amended and Restated 1986 Incentive Stock
Option Plan, including form of Stock Option Agreement.............(1)*
10.2 Company's 1986 Amended and Restated Non-Statutory
Stock Option Plan, including form of Stock Option Agreement.......(1)*
10.3 Form of Confidentiality, Assignment and Non-Competition
Agreement between the Company and employee officers...............(1)*
10.4 Technology Agreement, dated November 12, 1996, between
the Company and Cisco Systems, Inc.................................(4)
10.5A Letter Agreement between the Company and William H. Largent
regarding employment..............................................(4)*
10.5B Employment Agreement between the Company and William H. Largent...(4)*
10.6 Letter Agreement between the Company and
John M. Spiegel re: employment....................................(1)*
10.7 Employment Agreement between the Company and
William J. Mrukowski..............................................(4)*
10.8 Form of Indemnification Agreement between the Company
and officers and directors........................................(2)*
10.9 Schedule of Indemnification Agreements............................(2)*
10.10 Omitted
10.11 Omitted
10.12 Omitted
10.13 Company's 1996 Stock Option Plan..................................(3)*
11 Statement re: computation of earnings per share....................(5)
13 Portions of the Annual Report to Stockholders......................(5)
23.1 Consent of KPMG LLP................................................(5)
24 Powers of Attorney ............................................(5)
26 Financial Data Schedule............................................(5)
- -------------------
(1) Previously filed with the same exhibit number with the Company's
Form 10-SB filed March 10, 1993 and incorporated herein by
reference.
(2) Previously filed with the same exhibit number with the Company's
Form 10-KSB filed March 31, 1994 and incorporated herein by
reference.
(3) Previously filed with the same exhibit number with the Company's
Form 10-K filed March 31, 1996 and incorporated herein by
reference.
(4) Previously filed with the same exhibit number with the Company's
Form 10-K filed March 31, 1998 and incorporated herein by
reference.
(5) Filed herewith.
* Management contract or compensatory plan or arrangement required
to be filed as an exhibit to this form.
<PAGE> 1
APPLIED INNOVATION INC.
Exhibit 11
Statement Regarding Computation of Earnings Per Share
For the years ended December 31, 1998, 1997, and 1996
<TABLE>
<CAPTION>
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Weighted average number of common
shares outstanding - used for
computation of basic earnings (loss)
per share 15,804,608 15,786,332 15,742,760
Add net shares issuable pursuant to stock
option plans less shares assumed
repurchased at the average market price 158,238 0 119,488
----------- ----------- -----------
Number of shares for computation of
diluted earnings (loss) per share 15,962,846 15,786,332 15,862,248
=========== =========== ===========
Net income (loss) for basic and diluted
earnings (loss) per share $ 2,309,652 $ (637,195) $ 2,154,568
=========== =========== ===========
Basic earnings (loss) per share $ .15 $ (.04) $ .14
=========== =========== ===========
Diluted earnings (loss) per share $ .14 $ (.04) $ .14
=========== =========== ===========
</TABLE>
<PAGE> 1
Exhibit 13
Management's Discussion and Analysis of Financial
- --------------------------------------------------------------------------------
OVERVIEW
Applied Innovation Inc. ("AI") develops, manufactures, and markets network
mediation and bridging products and related services to the telecommunications
industry. AI's products and services support the operation, maintenance,
administration and provisioning of a variety of switching and transmission
devices used by telecommunications providers to assist in the management of
their customer service networks. AI's primary emphasis is on providing
integrated hardware and software solutions to companies in the
telecommunications industry.
Through the AISwitch(TM) Series 180, AIM(TM) series, AIspy(TM) series, and
NEWEB(TM) series of products, AI provides the data network needed to monitor and
maintain thousands of pieces of electronic equipment used to deliver
telecommunication services. Telecommunications providers continually upgrade and
expand the equipment they use to provide service to their customers. As each new
piece of equipment is installed, it is connected to a data-monitoring network
that is used to report alarms, gather performance information, provide test
access and reprogram equipment to establish, maintain and improve customer
service. The new equipment, along with the immense installed base of older
equipment, must be connected and integrated to efficiently communicate with the
data-monitoring network. AI's products perform this critical bridging and
mediation function.
AI's products are sold to the Regional Bell Operating Companies ("RBOCs"), other
telecommunications providers, such as Competitive Local Exchange Carriers
("CLECs"), long distance carriers, other public and private network providers,
including cable TV operators, international network operators and original
equipment manufacturers. AI has historically concentrated its marketing efforts
on the RBOCs because of their relative size and demand for AI's products. As a
result, AI has historically received a large percentage of its annual net sales
from the RBOCs.
Each of the RBOCs has a finite number of central office facilities, which limits
its total demand for existing AI products. To the extent that AI achieves
significant penetration with existing products in any of the RBOCs central
office facilities, it cannot anticipate substantial additional sales of these
products to the same RBOCs. Future sales to these customers will depend on the
development of new products and new releases or upgrades of existing products.
AI anticipates that sales growth for existing products, as well as new products,
will be achieved through sales to RBOCs, CLECs and continued penetration of the
diverse market of other telecommunications providers.
AI sells its products and services primarily through its own direct sales force.
Original equipment manufacturers, resellers, systems integrators, and
distributors are also utilized in markets that AI's direct sales force cannot
reach cost effectively.
Beginning in 1996, AI undertook a major project, known as the Access Products
Group ("APG"), to develop a product to serve as a remote access concentrator
which recognized and off-loaded digital data calls from the public switched
telephone network. This product offering was targeted for sale primarily to the
RBOCs. In early 1998, AI determined that a strategic partner was needed to
assist in marketing, sales and other product related activities for the APG.
After an unsuccessful search for a strategic partner, the APG development
activity was terminated in September 1998. A non-recurring charge of $3.8
million was taken in the third quarter of 1998 to account for the termination of
the APG development activity. Sales in 1998 of the APG products were minimal and
all research and development costs were previously expensed.
<PAGE> 2
COMPARISON OF 1998 TO 1997
Net sales increased to $53,628,000 for the year ended December 31, 1998 from
$46,661,000 for the year ended December 31, 1997, or an increase of 15%. Most of
the increase resulted from additional unit sales of AI's core product offering,
the AISwitch Series 180. Because sales are concentrated among the RBOCs, a small
number of customers have accounted for a substantial portion of AI's annual net
sales. Five companies accounted for 75% of AI's net sales in 1998. Each of these
five customers contributed between 11% and 21% of net sales. Net sales of the
terminated APG products were less than 1% of total net sales in 1998.
Gross profit, as a percentage of net sales, increased to 59% in 1998, from 57%
in 1997. The improved gross profit for 1998 was due to higher production volume
and cost improvement programs implemented during 1998. AI expects 1999 gross
profit, as a percentage of net sales, to be two to three percentage points lower
than the 1998 percentage due to competitive pressure to reduce product pricing.
Selling, general and administrative ("SG&A") expenses decreased to $14,428,000
in 1998, from $15,091,000 in 1997. The decrease was primarily attributable to a
$740,000 expense in 1997 for accounts receivable determined to be not
collectible. This type of expense did not occur in 1998. To support planned
sales growth, AI expects to increase SG&A expenses in 1999 for the planned
addition of sales, customer service and other support personnel and related
costs, as well as increased marketing activities.
Research and development ("R&D") expenses decreased to $11,980,000 in 1998, from
$12,897,000 in 1997. The decrease was the result of a reduction in R&D
associated with AI's core product offering and the termination of the APG
development activities and related closure of the Raleigh, North Carolina
facility in September 1998. During 1998 and 1997, AI incurred $5,717,000 and
$6,361,000, respectively, in R&D expenses related to the core product offering
along with $6,263,000 and $6,536,000, respectively, in R&D expenses related to
the terminated APG development activity. AI plans to increase spending for R&D
related to the core product offering in 1999. As a result, 1999 R&D expenses are
anticipated to be higher than the $5,717,000 expended in 1998 due to increased
staffing.
A non-recurring charge of $3.8 million was taken in the third quarter of 1998
for the termination of the APG development activity. This charge is separately
stated on the Consolidated Statements of Operations and reflects costs
associated with the termination of the APG. The charge includes $1.1 million of
severance related costs, $2.3 million to write down specific APG assets and $0.4
million related to occupancy costs, asset moving costs and other associated
termination costs.
As a result of the above changes in sales and expenses, income from operations
was $1,183,000 in 1998, compared to a loss from operations of $1,419,000 in
1997.
Net other income increased to $1,665,000 in 1998, compared to $401,000 in 1997.
Net other income for 1998 included a reversal of a previously accrued third
party sales expense of $1,049,000. AI was released in 1998 from any obligation
to pay such expense due to a change in the relationship with a third party. AI
previously expensed and accrued $746,000 in 1997 and $303,000 in 1998 related to
the reversed sales expense.
<PAGE> 3
Income before income taxes in 1998 was $2,848,000 compared to a loss before
income taxes of $1,017,000 in 1997.
The effective income tax rate was 19% in 1998 compared to an income tax benefit
of 37% in 1997. The decrease in the effective income tax rate is the result of
AI receiving a tax credit for R&D activities.
Net income was $2,310,000, or $0.14 diluted earnings per share in 1998, compared
to a net loss of $637,000, or $0.04 diluted loss per share in 1997. The diluted
weighted average number of shares outstanding remained relatively unchanged at
15,963,000 for 1998, compared to 15,786,000 for 1997.
COMPARISON OF 1997 TO 1996
Net sales increased to $46,661,000 for the year ended December 31, 1997 from
$41,146,000 for the year ended December 31, 1996, an increase of 13%. Most of
the increase resulted from additional unit sales of AI's core product offering,
the AISwitch Series 180. Because sales are concentrated among the RBOCs, a small
number of customers have accounted for a substantial portion of AI's annual net
sales. Five companies accounted for 76% of AI's net sales in 1997. Each of these
five customers contributed between 13% and 22% of net sales.
Gross profit, as a percentage of net sales, increased to 57% in 1997, from 50%
in 1996. The improved gross profit for 1997 was due to increased production
efficiencies as a result of higher production volumes. Additionally, gross
profit in 1996 was adversely impacted by increased warranty expenses
attributable to units which AI agreed to repair to avoid future product
difficulties, and to demonstrate a high quality assurance commitment to AI's
customers.
SG&A expenses increased to $15,091,000 in 1997, from $10,213,000 in 1996. The
increase was primarily attributable to an increase of $1,975,000 for additional
product management, marketing and administrative personnel to support current
operations and planned sales growth. Other significant SG&A expense increases in
1997 were for commissions due on the sale of products containing licensed
technology, bad debts, and consulting fees.
R&D expenses increased to $12,897,000 in 1997, from $7,647,000 in 1996. The
increase for 1997 over 1996 resulted from the hiring of additional APG personnel
and the opening of the R&D facility in North Carolina for the APG development
activity. In 1997, AI incurred $6,361,000 in R&D expenses related to core
products as compared to $7,647,000 in 1996. During 1997, AI incurred $6,536,000
in R&D expenses related to the APG development activity.
As a result of the above changes in sales and expenses, there was a loss from
operations of $1,419,000 in 1997, compared to income from operations of
$2,883,000 in 1996.
Net other income decreased to $401,000 in 1997, from $528,000 in 1996. The
decrease is primarily attributable to losses of $134,000 recognized upon the
disposal of assets in 1997.
<PAGE> 4
There was a loss before income taxes in 1997 of $1,017,000, compared to income
before income taxes of $3,411,000 in 1996.
The Company's effective income tax rate was 37% in 1997 and 1996.
LIQUIDITY AND CAPITAL RESOURCES
Cash and cash equivalents were $17,211,000 at December 31, 1998, compared to
$8,195,000 at December 31, 1997. This increase is primarily a result of cash
generated by operations, including net income of $2,310,000 and a decrease in
accounts receivable of $4,246,000 in 1998. The decrease in accounts receivable
at December 31, 1998 is primarily a result of a single $5.4 million receivable
for a sale that occurred in December of 1997 that was collected in early 1998. A
single sale of that amount and related receivable balance did not occur at the
end of 1998.
Net cash provided by operating activities totaled $10,242,000 and $309,000 for
1998 and 1997, respectively. In 1998, net income plus depreciation provided
$4,969,000 of operating cash flow, while in 1997, a net loss plus depreciation
provided $1,811,000 of operating cash flow.
Net working capital was $22,173,000 at December 31, 1998, compared to
$16,655,000 at December 31, 1997. Current ratios on those dates were 3.8:1 and
3.1:1, respectively. AI had no long-term debt in 1998 or 1997.
Capital expenditures totaled $1,216,000 and $4,454,000 in 1998 and 1997,
respectively.
In October 1998, AI's Board of Directors approved a stock repurchase program
which allows AI to repurchase up to one million shares of its Common Stock
through October 1999. As of December 31, 1998, 33,800 shares had been purchased
under this program. AI intends to finance any additional purchases under the
stock repurchase program using currently available cash balances.
AI's management believes that its current cash and equivalents and cash
generated from future operations will provide sufficient capital to meet the
business needs of AI through 1999.
YEAR 2000
AI faces year 2000 compliance issues similar to those faced by other companies
which design, manufacture, and sell equipment used in the telecommunications
industry. Year 2000 compliance issues typically arise with respect to computer
software systems and programs that use only two digits, rather than four digits,
to represent a particular year. Consequently, these systems and programs may not
process dates beyond the year 1999 and may result in miscalculation or system
failures causing disruptions of business operations.
<PAGE> 5
AI's product development processes currently contain steps to include year 2000
compliance verification for all current and future products. All of AI's current
products are believed to be year 2000 compliant. Customers may upgrade older
non-compliant products by purchasing existing compliant products. Although the
products currently offered by AI have been tested for year 2000 compliance, any
failure of AI's products to perform, including the failure to process dates
beyond the year 1999, could have a material adverse effect on AI's business,
financial condition, and results of operations. AI's future revenue could be
impacted if customers divert portions of their capital expenditure budgets
toward the year 2000 issue and away from programs that include purchases of AI's
products.
AI has completed its initial assessment of its internal computer information
systems and non-computer systems, which contain embedded computer technology, to
determine if such systems are year 2000 compliant. Non-compliant systems have
been categorized by their importance to AI's operations as critical, moderate,
or non-critical. AI is currently correcting known non-compliant systems and
presently believes that the amount of remediation work required to address year
2000 problems is not extensive. AI has replaced most of its financial and
operational systems in the last several years, and management believes that the
new equipment and software substantially address year 2000 issues.
AI currently estimates that the total cost of addressing year 2000 issues will
be approximately $700,000. Through 1998, AI incurred approximately $100,000 to
address year 2000 evaluation and remediation work. All costs related to year
2000 evaluation and compliance are being expensed as incurred. AI cannot
guarantee that its year 2000 compliance efforts will prevent all consequences,
and there may be undetermined future costs due to business disruption that may
be caused by customers, suppliers, or unforeseen circumstances.
AI is still in the process of developing a contingency plan addressing its most
likely year 2000 worst case scenario. AI anticipates that a contingency plan
will be completed by August 1999. AI believes that the potential impact of a
failure of its products in its customers' telecommunications networks would be
minimal due to the function that its products serve. AI's products assist
customers in managing their telecommunications networks but do not carry
customer telecommunications traffic. AI believes that the potential impact of a
failure of its internal computer information systems and its non-computer
systems would be minimal because the nature of its business would allow it to
promptly identify and address such issues without a permanent and substantial
loss of revenue.
SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
This Annual Report, including Management's Discussion and Analysis of Financial
Condition and Results of Operations, contains various forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended, which are
intended to be covered by the safe harbors created thereby. These
forward-looking statements include, but may not be limited to, all statements
regarding intent, beliefs, expectations, projections, forecasts, and plans of AI
and its management, and include statements regarding future sales and gross
profit percentages, future R&D and SG&A expenditures, the sufficiency of AI's
cash balances and cash generated from operating activities, implementation and
financing of the stock repurchase program, preparedness and compliance with year
2000 issues and the future of the communications industry or AI's business.
<PAGE> 6
These forward-looking statements involve numerous risks and uncertainties,
including, without limitation, the ability of AI to increase sales of existing
products and develop new products which will be accepted in the market place,
the possibility that AI may decide to substantially increase R&D and SG&A
expenditures to meet the needs of its business and customers, currently
unforeseen circumstances which could require the use of capital resources, the
possibility that year 2000 issues are not fully determined and resolved and
could require additional efforts and expenditures and could impose additional
and unknown risks, and the various risks inherent in AI's business and other
risks and uncertainties detailed from time to time in AI's periodic reports
filed with the Securities and Exchange Commission, including, AI's Annual Report
on Form 10-K. One or more of these factors have affected, and could in the
future affect, AI's business and financial results in future periods and could
cause actual results to differ materially from plans and projections. Therefore,
there can be no assurance that the forward-looking statements included herein
will prove to be accurate. In light of the significant uncertainties inherent in
the forward-looking statements included herein, the inclusion of such
information should not be regarded as a representation by AI, or any other
person, that the objectives and plans of AI will be achieved. All
forward-looking statements made herein are based on information presently
available to the management of AI. AI assumes no obligation to update any
forward-looking statements.
Independent Auditors' Report
- --------------------------------------------------------------------------------
Applied Innovation Inc.
To the Board of Directors and Stockholders of Applied Innovation Inc.
We have audited the accompanying consolidated balance sheets of Applied
Innovation Inc. and subsidiary as of December 31, 1998 and 1997, and the related
consolidated statements of operations, stockholders' equity, and cash flows for
each of the years in the three year period ended December 31, 1998. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
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 audits to obtain
reasonable assurance about whether the financial statements are free of 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 consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Applied Innovation
Inc. and subsidiary as of December 31, 1998 and 1997, and the results of their
operations and their cash flows for each of the years in the three year period
ended December 31, 1998 in conformity with generally accepted accounting
principles.
/s/ KPMG LLP
Columbus, Ohio
February 12, 1999
<PAGE> 7
<TABLE>
Applied Innovation Inc. and Subsidiary
- --------------------------------------------------------------------------------
Consolidated Balance Sheets
<CAPTION>
At December 31,
---------------
Assets 1998 1997
- ------ ---- ----
<S> <C> <C>
Current assets:
Cash and cash equivalents $17,211,499 $ 8,195,156
Accounts receivable, net of allowance of
$256,117 in 1998 and $228,284 in 1997 7,698,250 11,944,692
Inventory 3,620,655 3,176,299
Prepaid expenses 295,923 298,362
Deferred income taxes 1,410,000 1,145,000
----------- -----------
Total current assets 30,236,327 24,759,509
----------- -----------
Property, plant and equipment:
Land 1,639,303 1,639,303
Building 4,875,476 4,851,032
Leasehold improvements 266,040
Equipment 6,238,173 8,100,780
Furniture 1,949,575 2,218,569
----------- -----------
14,702,527 17,075,724
Less accumulated depreciation 5,276,287 4,241,781
----------- -----------
Property, plant and equipment, net 9,426,240 12,833,943
Other assets 107,106 114,096
----------- -----------
$39,769,673 $37,707,548
=========== ===========
Liabilities and Stockholders' Equity
- ------------------------------------
Current liabilities:
Accounts payable $ 1,051,922 $ 3,365,815
Accrued expenses:
Warranty 2,644,738 2,155,325
Income taxes 2,250,554 107,522
Payroll and related expenses 1,062,453 1,105,182
Royalties 272,269 1,001,323
Property taxes 382,315 336,568
Access Products termination charge 387,478
Deferred revenue 11,261 32,831
----------- -----------
Total current liabilities 8,062,990 8,104,566
Deferred income taxes 64,000 200,000
----------- -----------
Total liabilities 8,126,990 8,304,566
----------- -----------
Stockholders' equity:
Common stock, $0.01 par value; authorized
30,000,000 shares; issued and outstanding
15,786,132 shares in 1998 and
15,790,832 shares in 1997 157,861 157,908
Additional paid-in capital 8,337,154 8,407,058
Retained earnings 23,147,668 20,838,016
----------- -----------
Total stockholders' equity 31,642,683 29,402,982
----------- -----------
$39,769,673 $37,707,548
=========== ===========
</TABLE>
See accompanying notes to consolidated financial statements.
<PAGE> 8
<TABLE>
Applied Innovation Inc. and Subsidiary
- ------------------------------------------------------------------------------------------------------
Consolidated Statements of Operations
<CAPTION>
Years Ended December 31,
------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Net sales $53,627,516 $46,661,054 $41,145,876
Cost of sales 22,236,650 20,091,096 20,403,555
----------- ----------- -----------
Gross profit 31,390,866 26,569,958 20,742,321
----------- ----------- -----------
Operating expenses:
Selling, general and administrative 14,428,447 15,091,470 10,212,917
Research and development 11,979,875 12,897,072 7,646,796
Non-recurring charge related to termination
of Access Products development activity 3,800,000
----------- ----------- -----------
Total operating expenses 30,208,322 27,988,542 17,859,713
----------- ----------- -----------
Income (loss) from operations 1,182,544 (1,418,584) 2,882,608
----------- ----------- -----------
Other income (expense):
Interest income 614,705 535,409 523,956
Other income 1,049,100
Gain (loss) on disposal of assets 1,303 (134,020) 4,004
----------- ----------- -----------
Total other income (expense), net 1,665,108 401,389 527,960
----------- ----------- -----------
Income (loss) before income taxes 2,847,652 (1,017,195) 3,410,568
Income taxes 538,000 (380,000) 1,256,000
----------- ----------- -----------
Net income (loss) $ 2,309,652 $ (637,195) $ 2,154,568
=========== =========== ===========
Earnings (loss) per share:
Basic earnings (loss) per share $ 0.15 $ (0.04) $ 0.14
=========== =========== ===========
Diluted earnings (loss) per share $ 0.14 $ (0.04) $ 0.14
=========== =========== ===========
Weighted average shares outstanding
for basic earnings (loss) per share 15,804,608 15,786,332 15,742,760
=========== =========== ===========
Weighted average shares outstanding
for diluted earnings (loss) per share 15,962,846 15,786,332 15,862,248
=========== =========== ===========
</TABLE>
See accompanying notes to consolidated financial statements.
<PAGE> 9
<TABLE>
Applied Innovation Inc. and Subsidiary
- ----------------------------------------------------------------------------------------------------------
Consolidated Statements of Stockholders' Equity
<CAPTION>
Common stock
------------
Number of Additional
shares paid-in Deferred Retained
outstanding Amount capital compensation earnings Totals
----------- ------ ------- ------------ -------- ------
<S> <C> <C> <C> <C> <C> <C>
Balance--December 31, 1995 15,683,264 $156,832 $7,980,124 $(142,669) $19,320,643 $27,314,930
Stock options exercised 77,120 771 223,958 224,729
Tax benefit associated with
exercise of stock options 192,000 192,000
Amortization of deferred
compensation 55,631 55,631
Net income 2,154,568 2,154,568
Restricted stock awards 4,248 43 (35,580) 35,537
---------- -------- ---------- --------- ----------- -----------
Balance--December 31, 1996 15,764,632 157,646 8,360,502 (51,501) 21,475,211 29,941,858
Stock options exercised 26,200 262 16,863 17,125
Tax benefit associated with
exercise of stock options 29,693 29,693
Amortization of deferred
compensation 51,501 51,501
Net loss (637,195) (637,195)
---------- -------- ---------- --------- ----------- -----------
Balance--December 31, 1997 15,790,832 157,908 8,407,058 0 20,838,016 29,402,982
Stock options exercised 29,100 291 49,982 50,273
Tax benefit associated with
exercise of stock options 8,079 8,079
Common stock repurchased (33,800) (338) (127,965) (128,303)
Net income 2,309,652 2,309,652
---------- -------- ---------- --------- ----------- -----------
Balance--December 31, 1998 15,786,132 $157,861 $8,337,154 $ 0 $23,147,668 $31,642,683
========== ======== ========== ========= =========== ===========
</TABLE>
See accompanying notes to consolidated financial statements.
<PAGE> 10
<TABLE>
Applied Innovation Inc. and Subsidiary
- ---------------------------------------------------------------------------------------------------------------
Consolidated Statements of Cash Flows
<CAPTION>
Years Ended December 31,
------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss) $ 2,309,652 $ (637,195) $ 2,154,568
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Depreciation 2,658,968 2,448,009 1,425,381
(Gain) loss on disposal of assets (1,303) 134,020 (4,004)
Provision for deferred compensation 51,501 55,631
Deferred income tax expense (benefit) (477,000) 80,000 (699,000)
Write down of assets related to termination of
Access Products development activity 2,322,634
Effects of changes in operating assets and liabilities:
Accounts receivable 4,246,442 (4,298,175) (1,074,191)
Inventory (861,343) (170,378) 1,055,018
Prepaid expenses 2,439 (27,751) (41,923)
Other assets 6,990 3,340 (50,171)
Accounts payable (2,313,893) 1,848,624 (139,774)
Accrued expenses 2,369,887 843,750 2,529,783
Deferred revenue (21,570) 32,831
----------- ----------- -----------
Net cash provided by operating activities 10,241,903 308,576 5,211,318
----------- ----------- -----------
Cash flows from investing activities:
Purchases of property, plant and equipment (1,216,487) (4,453,540) (2,531,577)
Proceeds from sale of property, plant and equipment 60,878 15,210 5,335
----------- ----------- -----------
Net cash used by investing activities (1,155,609) (4,438,330) (2,526,242)
----------- ----------- -----------
Cash flows from financing activities:
Tax benefit associated with exercise of stock options 8,079 29,693 192,000
Proceeds from issuance of common stock 50,273 17,125 224,729
Common stock repurchased (128,303)
----------- ----------- -----------
Net cash provided (used) by financing
activities (69,951) 46,818 416,729
----------- ----------- -----------
Increase (decrease) in cash and cash equivalents 9,016,343 (4,082,936) 3,101,805
Cash and cash equivalents--beginning of year 8,195,156 12,278,092 9,176,287
----------- ----------- -----------
Cash and cash equivalents--end of year $17,211,499 $ 8,195,156 $12,278,092
=========== =========== ===========
SUPPLEMENTAL CASH FLOW DISCLOSURE:
Income taxes paid $ 1,232 $ 75,801 $ 1,558,832
=========== =========== ===========
</TABLE>
See accompanying notes to consolidated financial statements.
<PAGE> 11
Applied Innovation Inc. and Subsidiary
- --------------------------------------------------------------------------------
Notes to Consolidated Financial Statements
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The following accounting principles and practices of Applied Innovation Inc. and
subsidiary (the Company) are set forth to facilitate the understanding of data
presented in the consolidated financial statements:
DESCRIPTION OF BUSINESS ACTIVITY
The Company is a leading provider of network solutions for telecommunications
service providers. The Dublin, Ohio, based company designs and manufactures
products for network management, protocol conversion, mediation and data
communication between network elements and operations support systems. The
Company's products enable operations systems to manage all the elements in
multivendor, multiprotocol telecommunications networks. The majority of the
Company's customers are regional bell operating companies, competitive local
exchange carriers, and long distance phone companies.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Applied Innovation
Inc. and its wholly owned subsidiary. All significant intercompany balances and
transactions have been eliminated in consolidation.
CASH EQUIVALENTS
Cash equivalents represent short-term investments with original maturities of
three months or less. At December 31, 1998 and 1997, cash equivalents of
$11,524,611 and $5,293,731, respectively, were invested in taxable and tax
exempt bonds with seven-day put options.
REVENUE RECOGNITION
Sales revenue is recognized when products are shipped. Field service revenue is
recognized as projects are completed.
INVENTORY
Inventory is stated at the lower of cost or market using the first-in, first-out
method.
PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment are recorded at cost. Depreciation is provided on
the straight-line method over the estimated useful lives as follows:
<TABLE>
<CAPTION>
Lives (in years)
----------------
<S> <C>
Building 40
Equipment 3-5
Furniture 7
</TABLE>
WARRANTY
The Company warrants its products for a minimum of one year after sale and up to
three years as negotiated under contract. Additionally, the Company may agree to
repair, replace or service its products beyond the warranty period. Accordingly,
the Company accrues the estimated costs of such warranties and services.
<PAGE> 12
INCOME TAXES
Income taxes are accounted for under the asset and liability method. Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amounts of
existing assets and liabilities and their respective tax bases and operating
loss and tax credit carryforwards. Deferred tax assets and liabilities are
measured using enacted tax rates expected to apply to taxable income in the
years in which those temporary differences are expected to be recovered or
settled. The effect on deferred tax assets and liabilities of a change in tax
rates is recognized in income in the period that includes the enactment date.
EARNINGS PER SHARE
The Company adopted Statement of Financial Accounting Standards (SFAS) No. 128,
Earnings Per Share, in 1997 and retroactively restated all prior periods to
conform with SFAS No. 128 as required. Basic earnings per share is computed as
net income divided by the weighted average number of common shares outstanding
during the period. Diluted earnings per share is computed as net income divided
by the weighted average number of common shares and potential common shares,
using the treasury stock method, outstanding during the period.
STOCK OPTION PLANS
On January 1, 1996, the Company adopted SFAS No. 123, Accounting for Stock-Based
Compensation, which permits entities to recognize as expense over the vesting
period the fair value of all stock-based awards on the date of grant
(fair-value-based method). Alternatively, SFAS No. 123 also allows entities to
continue to apply the provisions of Accounting Principles Board (APB) Opinion
No. 25 and provide pro forma net income and pro forma earnings per share
disclosures for employee stock option grants made in 1995 and future years as if
the fair-value-based method defined in SFAS No. 123 had been applied. The
Company has elected to continue to apply the provisions of APB Opinion No. 25
and provide the pro forma disclosure provisions of SFAS No. 123.
RESEARCH AND DEVELOPMENT
Research and development costs are expensed when incurred.
GENERAL CREDIT RISK
The Company grants credit on open account to its customers, substantially all of
whom are in the telecommunications industry.
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 and disclosure of
contingent 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, inventory obsolescence, depreciation and amortization, sales returns,
warranty costs, taxes, and contingencies. Actual results could differ from these
estimates.
<PAGE> 13
(2) INVENTORY
Major classes of inventory at December 31, 1998 and 1997 are summarized below:
<TABLE>
<CAPTION>
1998 1997
---- ----
<S> <C> <C>
Raw materials $2,280,652 $1,715,268
Work-in-process 235,062 1,092,754
Finished goods 1,264,941 480,393
---------- ----------
3,780,655 3,288,415
Reserve for obsolescence (160,000) (112,116)
---------- ----------
$3,620,655 $3,176,299
========== ==========
</TABLE>
(3) FAIR VALUE OF FINANCIAL INSTRUMENTS
The fair values of all financial instruments approximate carrying values because
of the short maturities of those instruments.
(4) EARNINGS (LOSS) PER SHARE
The calculations of earnings (loss) per share for the years ended December 31,
1998, 1997, and 1996 are based upon the weighted average shares outstanding
during the periods and, when applicable, those stock options that are dilutive,
using the treasury stock method. Reconciliations of the numerators and
denominators of the basic and diluted earnings (loss) per share calculations
follow:
<TABLE>
<CAPTION>
Year ended December 31, 1998
----------------------------
Income Shares Per share
(numerator) (denominator) amount
----------- ------------- ------
<S> <C> <C> <C>
Basic earnings per share--
Net income available to common stockholders $2,309,652 15,804,608 $ 0.15
========
Effect of dilutive securities--
Stock options 158,238
---------- ----------
Diluted earnings per share--
Net income available to common stockholders
including assumed conversions $2,309,652 15,962,846 $ 0.14
========== ========== ========
<CAPTION>
Year ended December 31, 1997
----------------------------
Income Shares Per share
(numerator) (denominator) amount
----------- ------------- ------
<S> <C> <C> <C>
Basic and diluted loss per share $ (637,195) 15,786,332 $ (0.04)
=========== ========== ========
</TABLE>
<PAGE> 14
<TABLE>
<CAPTION>
Year ended December 31, 1996
----------------------------
Income Shares Per share
(numerator) (denominator) amount
----------- ------------- ------
<S> <C> <C> <C>
Basic earnings per share--
Net income available to common stockholders $2,154,568 15,742,760 $ 0.14
========
Effect of dilutive securities--
Stock options 119,488
---------- ----------
Diluted earnings per share--
Net income available to common stockholders
including assumed conversions $2,154,568 15,862,248 $ 0.14
========== ========== ========
</TABLE>
Stock options which are antidilutive under the treasury stock method have been
excluded from the above earnings (loss) per share calculations.
(5) MAJOR CUSTOMERS
Net sales to major customers comprised 75%, 76%, and 53% of net sales for 1998,
1997, and 1996, respectively. The number of major customers previously referred
to were five, five, and three for 1998, 1997, and 1996, respectively, with trade
accounts receivable balances of $4,746,738, $9,374,203, and $2,306,795 at
December 31, 1998, 1997, and 1996, respectively.
(6) STOCK OPTION PLANS
The Company's 1996 Stock Option Plan (the 1996 Plan) was adopted by the Board of
Directors on February 1, 1996 and approved by the stockholders of the Company as
of April 25, 1996, with 1,000,000 shares of common stock reserved for issuance
under the 1996 Plan. The 1996 Plan was amended by the Board of Directors and
approved by the stockholders of the Company on April 23, 1998 to increase the
shares available for issuance under the 1996 Plan from 1,000,000 to 2,000,000.
Options granted under the 1996 Plan may be either incentive stock options or
nonstatutory stock options, with maximum terms of ten years. The exercise price
of each incentive stock option must be at least 100% of the fair market value
per share of the Company's common stock as determined by the Stock Option and
Compensation Committee on the date of grant.
Previously, the Company had adopted the 1986 Incentive Stock Option Plan and the
1986 Non-statutory Stock Option Plan (the 1986 Plans). Options granted under the
1986 Plans have maximum terms of ten years. The exercise price of each incentive
stock option must be at least 100% of the fair market value per share of the
Company's common stock as determined by the Stock Option and Compensation
Committee on the date of grant.
Tax benefits realized by the Company for deductions in excess of compensation
expense under these plans are credited to additional paid-in capital.
<PAGE> 15
Effective March 1, 1997, the Company repriced all stock options outstanding with
exercise prices exceeding the fair market value per share of the Company's
common stock on that date. The stock options were repriced at $5, the fair
market value on March 1, 1997.
At December 31, 1998, there were 1,458,050 additional shares available for grant
under the 1996 Plan. The per share weighted-average fair value of stock options
granted during 1998, 1997, and 1996 was $4.15, $2.35, and $6.33, respectively,
on the date of grant using the Black Scholes option-pricing model with the
following weighted-average assumptions used for grants in the years ended
December 31, 1998, 1997, and 1996, respectively: dividend yield of 0% for all
years; expected volatility of 71%, 67%, and 66%; risk-free interest rate of 6%
for all years; and expected life of 4.5, 4.2, and 4.3 years.
The Company applies APB Opinion No. 25 in accounting for its plans and,
accordingly, no compensation cost has been recognized for its stock options in
the financial statements. Had the Company determined compensation cost based on
the fair value at the grant date for its stock options under SFAS No. 123,
including the impact of the options repriced in 1997, the Company's net income
(loss) and earnings (loss) per share, net of related income tax effects, would
have been reduced to the pro forma amounts indicated below:
<TABLE>
<CAPTION>
1998 1997 1996
---- ---- ----
<S> <C> <C> <C> <C>
Net income (loss) As reported $2,309,652 $ (637,195) $2,154,568
Pro forma 1,877,467 (1,664,539) 1,709,554
Basic earnings As reported $ 0.15 $ (0.04) $ 0.14
(loss) per share Pro forma 0.12 (0.11) 0.11
Diluted earnings As reported $ 0.14 $ (0.04) $ 0.14
(loss) per share Pro forma 0.12 (0.11) 0.11
</TABLE>
Pro forma net income (loss) reflects only options granted since January 1, 1995.
Therefore, the full impact of calculating compensation cost for stock options
under SFAS No. 123 is not reflected in the pro forma net income (loss) amounts
presented above because compensation cost is reflected over the options' vesting
period, and compensation cost for options granted prior to January 1, 1995 is
not considered.
<PAGE> 16
A summary of stock option activity follows:
<TABLE>
<CAPTION>
Number Weighted-average
of shares exercise price
--------- --------------
<S> <C> <C>
Balance at December 31, 1995 573,000 $ 8.65
Granted 265,000 11.19
Exercised (77,120) 2.91
Canceled/expired (58,480) 8.39
---------
Balance at December 31, 1996 702,400 10.26
Granted 1,179,150 5.20
Exercised (26,200) 0.65
Canceled/expired (821,100) 9.98
---------
Balance at December 31, 1997 1,034,250 4.96
Granted 349,250 6.87
Exercised (29,100) 1.73
Canceled/expired (409,750) 5.73
---------
Balance at December 31, 1998 944,650 5.43
=========
</TABLE>
The following table summarizes information about options outstanding at December
31,1998:
<TABLE>
<CAPTION>
Options outstanding Options exercisable
---------------------------------- ---------------------
Weighted-
average Weighted- Weighted-
Number remaining average Number average
Range of of contractual exercise of exercise
exercise prices shares life price shares price
- --------------- ------ ---- ----- ------ -----
<S> <C> <C> <C> <C> <C>
$4.25 - 4.88 92,450 0.5 $4.77 89,050 $4.78
5.00 555,450 3.3 5.00 407,570 5.00
5.25 - 5.63 85,000 4.5 5.40 17,000 5.40
6.44 - 7.53 211,750 6.6 6.87 600 6.44
------- -------
944,650 3.9 5.43 514,220 4.98
======= =======
</TABLE>
(7) DEFINED CONTRIBUTION PLAN
The Company sponsors a defined contribution 401(k) and profit sharing plan which
covers all eligible employees. Since April 1, 1998, the Company matched 35% of
each participant's contribution, up to 6% of that participant's compensation.
Prior to April 1, 1998, the Company matched 25% of each participant's
contribution, up to 6% of that participant's compensation. The Company may also
make profit sharing contributions at the discretion of the Board of Directors.
For 1998, 1997, and 1996, the profit sharing contribution was $100,000, $0, and
$200,000, respectively, and the total expense related to the plan was $329,918,
$141,798, and $259,061, respectively.
<PAGE> 17
(8) INCOME TAXES
Income tax expense (benefit) consists of:
<TABLE>
<CAPTION>
Current Deferred Total
------- -------- -----
<S> <C> <C> <C>
Year ended December 31, 1998:
Federal $ 912,000 $(438,000) $ 474,000
State and local 103,000 (39,000) 64,000
---------- --------- ----------
$1,015,000 $(477,000) $ 538,000
========== ========= =========
Year ended December 31, 1997:
Federal $ (460,000) $ 36,000 $(424,000)
State and local 44,000 44,000
---------- --------- ----------
$ (460,000) $ 80,000 $(380,000)
========== ========= =========
Year ended December 31, 1996:
Federal $1,706,000 $(631,000) $1,075,000
State and local 249,000 (68,000) 181,000
---------- --------- ----------
$1,955,000 $(699,000) $1,256,000
========== ========= =========
</TABLE>
A reconciliation of income tax expense (benefit) at the expected federal
statutory rate (34%) to income tax expense (benefit) at the Company's effective
rates for continuing operations is as follows:
<TABLE>
<CAPTION>
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Computed tax at the expected federal statutory rate $ 968,000 $(346,000) $1,160,000
State and local income taxes, net of federal income
tax effect 29,000 43,000 97,000
Meals and entertainment expenses 40,000 66,000 38,000
Research and experimentation credit (464,000) (104,000)
Tax-exempt interest income (36,000) (43,000) (35,000)
Other 1,000 4,000 (4,000)
--------- --------- ----------
$ 538,000 $(380,000) $1,256,000
========= ========= ==========
</TABLE>
The tax effects of temporary differences that give rise to significant portions
of the deferred tax assets and deferred tax liabilities at December 31, 1998 and
1997 are presented below:
<TABLE>
<CAPTION>
1997 1996
---- ----
<S> <C> <C>
Deferred tax assets:
Warranty reserve $ 979,000 $ 798,000
Accounts receivable allowance 95,000 84,000
Inventory, principally due to additional costs
inventoried for tax purposes 189,000 263,000
Access Products termination charge 144,000
Other 3,000
---------- ----------
Total gross deferred tax assets 1,410,000 1,145,000
---------- ----------
Deferred tax liabilities:
Property, plant and equipment, principally due
to differences in depreciation 64,000 200,000
---------- ----------
Total gross deferred tax liabilities 64,000 200,000
---------- ----------
Net deferred tax asset $1,346,000 $ 945,000
========== ==========
</TABLE>
<PAGE> 18
(9) OTHER INCOME
In 1998, there was a change in the Company's business relationship with a third
party regarding compensation to the third party for sales efforts related to the
Company's products. The change in the relationship resulted in both parties
agreeing that certain obligations due the third party by the Company would be
released and would not be paid. The Company previously expensed and accrued
$745,875 in 1997 and $303,225 in 1998 related to the sales efforts. As a result
of the change, the Company reversed the accrued liability and recognized other
income of $1,049,100 in the fourth quarter of 1998.
(10) BONUS PLAN
In 1996, the Company offered a bonus plan to certain officers and managers.
Depending on the level of pretax, prebonus earnings achieved, participants were
entitled to specified percentages of their base salaries as bonuses. The bonuses
were payable on March 15 following the year end with 50% payable in cash and 50%
payable in restricted, forfeitable shares of common stock at specified values.
The shares vest and become nonforfeitable if the participants are still employed
by the Company three years after the payable date. In 1997, the Company modified
the bonus plan to make bonuses 100% payable in cash.
The deferred compensation represents a contra equity account to be amortized
over the vesting period. The related shares of common stock are included as
common stock equivalents in the earnings per share calculation.
(11) LEASE COMMITMENTS
The Company is obligated for office space in North Carolina under a five-year
operating lease, with termination rights after three years upon payment of a
specified termination fee. Rental payments include minimum base rent plus
payments for taxes, insurance and certain operating, repair, and maintenance
expenses of the facility. The Company vacated this office space in 1998.
The Company is also obligated for office space in Colorado, Georgia, and Texas
under various operating leases.
Future minimum lease payments under the operating leases as of December 31, 1998
are:
<TABLE>
<S> <C>
Year ending December 31:
1999 $307,150
2000 273,960
2001 244,011
2002 26,645
--------
Total minimum lease payments $851,766
========
</TABLE>
Total rent expense in 1998, 1997, and 1996 was $349,889, $283,040, and $47,069,
respectively.
<PAGE> 19
(12) STOCK REPURCHASE PROGRAM
In October 1998, the Company announced a stock repurchase program under which
the Company may purchase up to one million shares of common stock through
October 1999. As of December 31, 1998, 33,800 shares have been purchased under
this program
(13) NON-RECURRING CHARGE
In March of 1998, the Company made an announcement that it was seeking a
strategic partner for its Access Products Group and subsequently retained an
investment banking firm to conduct the search. In September of 1998, the Company
terminated all product development and related activities of its Access Products
Group due to an unsuccessful search for a strategic partner.
The termination resulted in a one-time non-recurring charge of $3.8 million
which was taken in the third quarter of 1998. This charge accounted for costs
associated with the termination of the Access Products Group, including the
closing of the Raleigh, North Carolina facility. The charge resulted in $1.1
million of severance related costs, a charge of $2.3 million to write down
specific assets and $.4 million related to occupancy and other associated
termination costs.
(14) QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
A summary of quarterly financial information follows (in thousands, except per
share amounts):
<TABLE>
<CAPTION>
1998
Q1 Q2 Q3 Q4
------- ------- ------- -------
<S> <C> <C> <C> <C>
Net sales $11,518 $14,784 $14,020 $13,306
Gross profit 6,653 8,272 8,422 8,044
Income (loss) before income taxes (176) 434 (2,101) 4,691
Net income (loss) (116) 286 (1,386) 3,526
Net income (loss) per share (0.01) 0.02 (0.09) 0.22
<CAPTION>
1997
Q1 Q2 Q3 Q4
------- ------- ------- -------
<S> <C> <C> <C> <C>
Net sales $ 8,410 $12,234 $10,527 $15,490
Gross profit 4,771 6,720 5,659 9,420
Income (loss) before income taxes (841) 244 (2,099) 1,679
Net income (loss) (528) 153 (1,319) 1,057
Net income (loss) per share (0.03) 0.01 (0.08) 0.07
</TABLE>
<PAGE> 1
Exhibit 23.1
[KPMG LOGO]
Two Nationwide Plaza Telephone 614 249 2300
Columbus, Ohio 43215 Fax 614 249 2348
CONSENT OF INDEPENDENT PUBLIC ACCOUNTANTS
The Board of Directors
Applied Innovation Inc.:
We consent to incorporation by reference in the registration statements (No.
33-62646, 33-94582, 333-4432 and 333-67259) on Form S-8 of Applied Innovation
Inc. of our report dated February 12, 1999, relating to the consolidated balance
sheets of Applied Innovation Inc. and subsidiary as of December 31, 1998 and
1997, and the related consolidated statements of operations, stockholders'
equity, and cash flows for each of the years in the three-year period ended
December 31, 1998, which report appears in the December 31, 1998, annual report
on Form 10-K of Applied Innovation Inc.
/s/ KPMG LLP
Columbus, Ohio
March 26, 1999
<PAGE> 1
EXHIBIT 24
POWER OF ATTORNEY
-----------------
Each of the undersigned officers and directors of Applied Innovation
Inc., a Delaware corporation (the "Company"), hereby appoints Gerard B.
Moersdorf, Jr. and Curtis A. Loveland as his true and lawful attorneys-in-fact,
or either of them, with power to act without the other, as his true and lawful
attorney-in-fact, in his name and on his behalf, and in any and all capacities
stated below, to sign and to cause to be filed with the Securities and Exchange
Commission the Company's annual report on Form 10-K, for the fiscal year ended
December 31, 1998, and any and all amendments thereto, hereby granting unto said
attorneys, and to each of them, full power and authority to do and perform in
the name and on behalf of the undersigned, in any and all such capacities, every
act and thing whatsoever necessary to be done in and about the premises as fully
as each of the undersigned could or might do in person, hereby granting to each
such attorney full power of substitution and revocation, and hereby ratifying
all that either such attorney or his substitute may do by virtue hereof.
IN WITNESS WHEREOF, the undersigned have executed this Power of
Attorney in counterparts if necessary, effective as of March 19, 1999.
DIRECTORS/OFFICERS:
Signature Title
--------- -----
/s/ Gerard B. Moersdorf, Jr. Chairman, President and Treasurer
- -------------------------------- (Principal Executive Officer)
Gerard B. Moersdorf, Jr.
/s/ William H. Largent Senior Vice President - Operations,
- -------------------------------- Chief Financial Officer
William H. Largent (Principal Financial Officer)
/s/ John M. Spiegel Controller
- -------------------------------- (Principal Accounting Officer)
John M. Spiegel
/s/ James H. Blough Director
- --------------------------------
James H. Blough
/s/ Curtis A. Loveland Director
- --------------------------------
Curtis A. Loveland
/s/ Gerard B. Moersdorf, Sr. Director
- --------------------------------
Gerard B. Moersdorf, Sr.
/s/ Richard W. Oliver Director
- --------------------------------
Richard W. Oliver
/s/ Thomas H. Huseby Director
- --------------------------------
Thomas H. Huseby
/s/ Alexander B. Trevor Director
- --------------------------------
Alexander B. Trevor
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 17,211,497
<SECURITIES> 0
<RECEIVABLES> 7,954,367
<ALLOWANCES> 256,117
<INVENTORY> 3,620,655
<CURRENT-ASSETS> 30,236,327
<PP&E> 14,702,527
<DEPRECIATION> 5,276,287
<TOTAL-ASSETS> 39,769,673
<CURRENT-LIABILITIES> 8,062,990
<BONDS> 0
0
0
<COMMON> 157,861
<OTHER-SE> 31,484,822
<TOTAL-LIABILITY-AND-EQUITY> 39,769,673
<SALES> 53,627,516
<TOTAL-REVENUES> 53,627,516
<CGS> 22,236,650
<TOTAL-COSTS> 22,236,650
<OTHER-EXPENSES> 30,088,322
<LOSS-PROVISION> 120,000
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 2,847,652
<INCOME-TAX> 538,000
<INCOME-CONTINUING> 2,309,652
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,309,652
<EPS-PRIMARY> .15
<EPS-DILUTED> .14
</TABLE>
