<PAGE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
------------------------
FORM 10-Q
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE PERIOD ENDED SEPTEMBER 30, 1997
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER 0-21409
------------------------
CELLNET DATA SYSTEMS, INC.
(Exact Name of Registrant as Specified in Its Charter)
<TABLE>
<S> <C>
DELAWARE 94-2951096
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification
No.)
125 SHOREWAY ROAD
SAN CARLOS, CALIFORNIA 94070
(Address of principal executive (Zip Code)
offices)
</TABLE>
(650) 508-6000
(Registrant's Telephone Number, Including Area Code)
------------------------
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes /X/ No / /
As of October 31, 1997, 41,690,490 shares of the Registrant's Common Stock,
$0.001 par value, were issued and outstanding.
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
CELLNET DATA SYSTEMS, INC.
INDEX
<TABLE>
<CAPTION>
PAGE NO.
-----------
<S> <C> <C> <C>
PART I.
FINANCIAL INFORMATION
Item 1.
Financial Statements - Condensed Consolidated Financial Statements (unaudited).
(a) Condensed Consolidated Balance Sheets--As of September 30, 1997 and December 31,
1996.............................................................................. 3
(b) Condensed Consolidated Statements of Operations--Three months ended September 30,
1997 and 1996 and Nine months ended September 30, 1997 and 1996................... 4
(c) Condensed Consolidated Statements of Cash Flows--Nine months ended September 30,
1997 and 1996..................................................................... 5
(d) Notes to Condensed Consolidated Financial Statements.............................. 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations........ 9
Item 3. Quantitative and Qualitative Disclosure About Market Risk.................................... 29
PART II.
OTHER INFORMATION
Item 1. Legal Proceedings............................................................................ 30
Item 2. Changes in Securities and Use of Proceeds.................................................... 30
Item 3. Defaults Upon Senior Securities.............................................................. 31
Item 4. Submission of Matters to a Vote of Security Holders.......................................... 31
Item 5. Other Information............................................................................ 31
Item 6. Exhibits and Reports on Form 8-K............................................................. 31
SIGNATURES................................................................................................... 32
</TABLE>
2
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CELLNET DATA SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
UNAUDITED
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1997 1996
------------- ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents......................................................... $ 150,356 $ 124,232
Short-term investments............................................................ 30,300 54,643
Accounts receivable - trade....................................................... 1,535 850
Accounts receivable - other....................................................... 3,516 1,264
Prepaid expenses and other........................................................ 2,150 1,124
------------- ------------
Total current assets............................................................ 187,857 182,113
Network components and inventory.................................................... 19,903 11,211
Networks in progress - net.......................................................... 80,410 48,426
Property - net...................................................................... 15,172 12,236
Investment in unconsolidated affiliate.............................................. -- --
Debt issuance costs and other - net................................................. 4,228 5,565
------------- ------------
Total assets........................................................................ $ 307,570 $ 259,551
------------- ------------
------------- ------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable.................................................................. $ 9,274 $ 8,133
Accrued compensation and related benefits......................................... 3,969 2,371
Accrued liabilities............................................................... 2,567 950
Current portion of capital lease obligations...................................... 347 308
------------- ------------
Total current liabilities....................................................... 16,157 11,762
------------- ------------
Senior discount notes - 1997, 14% and 1996, 13%..................................... 257,849 207,178
------------- ------------
Capital lease obligations - net..................................................... 563 366
------------- ------------
Commitment and Contingencies (Notes 1 and 4)
Stockholders' equity:
Preferred stock - $.001 par value; 15,000,000 shares authorized; shares
outstanding, 1997: none; 1996: none............................................. -- --
Common stock - $.001 par value; 100,000,000 shares authorized; shares outstanding,
1997: 41,668,128; 1996: 38,537,517.............................................. 209,397 205,793
Notes receivable from sale of common stock........................................ (676) (814)
Warrants.......................................................................... 74,546 2,984
Accumulated deficit............................................................... (250,266) (167,715)
Net unrealized loss on short-term investments..................................... -- (3)
------------- ------------
Total stockholders' equity...................................................... 33,001 40,245
------------- ------------
Total liabilities and stockholders' equity.......................................... $ 307,570 $ 259,551
------------- ------------
------------- ------------
</TABLE>
See accompanying notes to condensed consolidated financial statements
3
<PAGE>
CELLNET DATA SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
UNAUDITED
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------- ----------------------
1997 1996 1997 1996
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Revenues:
Network service revenues........................................ $ 1,338 $ 368 $ 3,451 $ 612
Product sales................................................... 67 122 366 248
Other revenues.................................................. 128 25 209 75
---------- ---------- ---------- ----------
Total revenues................................................ 1,533 515 4,026 935
---------- ---------- ---------- ----------
Costs and expenses:
Cost of network operations...................................... 4,900 2,478 12,398 5,398
Cost of product sales........................................... 106 110 443 219
Research and development........................................ 5,717 6,884 18,765 18,704
Marketing and sales............................................. 3,652 1,474 7,321 4,340
General and administrative...................................... 4,164 3,261 13,233 8,289
Depreciation and amortization................................... 2,893 1,882 8,032 3,967
---------- ---------- ---------- ----------
Total costs and expenses...................................... 21,432 16,089 60,192 40,917
---------- ---------- ---------- ----------
Loss from operations.............................................. (19,899) (15,574) (56,166) (39,982)
Equity in loss of unconsolidated affiliate........................ (670) -- (2,009) --
Other income (expense):
Interest income................................................. 1,524 1,300 5,762 4,758
Interest expense................................................ (6,124) (6,238) (18,683) (17,502)
Other - net..................................................... (39) 58 (37) (39)
---------- ---------- ---------- ----------
Total other income (expense)...................................... (4,639) (4,880) (12,958) (12,783)
---------- ---------- ---------- ----------
Net loss before income taxes and extraordinary loss on early
extinguishment of 1995 Senior Notes............................. (25,208) (20,454) (71,133) (52,765)
Provision for income taxes........................................ -- -- 1 2
---------- ---------- ---------- ----------
Net loss before extraordinary loss on early extinguishment of 1995
Senior Notes.................................................... (25,208) (20,454) (71,134) (52,767)
Extraordinary loss on early extinguishment of 1995 Senior Notes... (11,417) -- (11,417) --
---------- ---------- ---------- ----------
Net loss.......................................................... $ (36,625) $ (20,454) $ (82,551) $ (52,767)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Loss per share before extraordinary loss on early extinguishment
of 1995 Senior Notes............................................ $ (0.62) $ -- $ (1.78) $ --
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Net loss per share................................................ $ (0.89) $ (0.60) $ (2.05) $ (1.55)
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
Shares used in computing per share amounts........................ 41,614 34,345 40,157 33,952
---------- ---------- ---------- ----------
---------- ---------- ---------- ----------
</TABLE>
See accompanying notes to condensed consolidated financial statements
4
<PAGE>
CELLNET DATA SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
UNAUDITED
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
--------------------
1997 1996
--------- ---------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss................................................................................... $ (82,551) $ (52,767)
Adjustments to reconcile net loss to net cash used for operating activities:
Depreciation and amortization............................................................ 8,032 3,967
Accretion on senior discount notes....................................................... 18,114 18,143
Write-off of unamortized 1995 senior discount note debt issuance costs................... 4,791 --
Accelerated accretion on 1995 senior discount notes...................................... 3,127 --
1997 senior discount notes issued as non-cash consent fees............................... 912 --
Amortization of debt issuance costs...................................................... 466 448
Deferred rent.............................................................................. -- 32
Equity in loss of unconsolidated affiliate................................................. 2,009 --
Changes in:
Accounts receivable - trade.............................................................. (685) 498
Accounts receivable - other.............................................................. (2,252) --
Prepaid expenses and other............................................................... (1,026) (361)
Accounts payable......................................................................... 1,141 (411)
Accrued compensation and related benefits................................................ 1,598 714
Accrued liabilities...................................................................... 1,617 (1)
--------- ---------
Net cash used for operating activities................................................. (44,707) (29,738)
--------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Network components and inventory........................................................... (8,692) 1,050
Purchase of property....................................................................... (7,761) (5,822)
Networks in progress....................................................................... (31,895) (28,736)
Investment in unconsolidated affiliate..................................................... (2,009) --
Other assets............................................................................... (406) (300)
Purchase of short-term investments......................................................... (25,490) (265,480)
Proceeds from sales and maturities of short-term investments............................... 49,836 331,062
--------- ---------
Net cash (used) provided for investing activities...................................... (26,417) 31,774
--------- ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Issuance of 1997 senior discount notes and warrants........................................ 100,324 --
Debt issuance costs for 1997 senior discount notes......................................... (3,514) --
Repayment of capital lease obligations..................................................... (321) (226)
Proceeds from sale of common stock......................................................... 621 160
Proceeds from sale of preferred stock...................................................... -- 23
Collection of note receivable from sale of common stock.................................... 138 15
--------- ---------
Net cash provided (used) by financing activities....................................... 97,248 (28)
--------- ---------
INCREASE IN CASH AND CASH EQUIVALENTS........................................................ 26,124 2,008
CASH AND CASH EQUIVALENTS, Beginning of period............................................... 124,232 48,018
--------- ---------
CASH AND CASH EQUIVALENTS, End of period..................................................... $ 150,356 $ 50,026
--------- ---------
--------- ---------
SUPPLEMENTAL NONCASH INVESTING AND FINANCING ACTIVITIES:
Acquisition of property under capital leases............................................... $ 557 $ 133
Capitalization of interest into networks in progress....................................... $ 2,739 --
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for interest..................................................... $ 89 $ 88
Cash paid for income taxes................................................................. $ 1 $ 2
</TABLE>
See accompanying notes to condensed consolidated financial statements
5
<PAGE>
CELLNET DATA SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION.
In the opinion of management, these unaudited condensed consolidated
financial statements include all adjustments, consisting only of normal
recurring adjustments and accruals the Company considers necessary for a fair
presentation of the Company's financial position as of September 30, 1997, and
the results of operations and cash flows for the nine months ended September 30,
1997 and 1996. This unaudited interim information should be read in conjunction
with the audited consolidated financial statements of CellNet Data Systems, Inc.
and the notes thereto for the year ended December 31, 1996. Operating results
for the nine months ended September 30, 1997 are not necessarily indicative of
the results that may be expected for the year ended December 31, 1997.
Investment in affiliate is accounted for using the equity method. Income or
loss of affiliate is based upon the Company's beneficial interest (50%).
In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 128, EARNINGS PER SHARE (SFAS 128). The
Company is required to adopt SFAS 128 in the fourth quarter of fiscal 1997 and
will restate at that time earnings per share ("EPS") data for prior periods to
conform with SFAS 128. Earlier application is not permitted. The Company has
determined that adoption of SFAS 128 will not have a material effect on losses
per share which have been previously reported.
In June 1997, the Financial Accounting Standards Board adopted Statements of
Financial Accounting Standards No. 130, REPORTING COMPREHENSIVE INCOME, which
requires that an enterprise report, by major components and as a single total,
the change in its net assets during the period from nonowner sources; and No.
131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION, which
establishes annual and interim reporting standards for an enterprise's business
segments and related disclosures about its products, services, geographic areas,
and major customers. Adoption of these statements will not impact the Company's
consolidated financial position, results of operations or cash flows. The
Company expects to adopt these statements in fiscal 1998.
Certain amounts in the 1996 financial statements have been reclassified to
conform with the 1997 financial statement presentation.
2. NET LOSS PER SHARE.
Net loss per share is computed using the weighted average number of common
and common equivalent shares outstanding during the nine months ended September
30, 1997 and the year ended December 31, 1996. For the nine months ended
September 30, 1996, common equivalent shares include all outstanding preferred
stock and warrants that were converted in connection with the initial public
offering completed October 2, 1996, even when the effect is anti-dilutive.
3. ISSUANCE OF SENIOR DISCOUNT NOTES.
On September 29, 1997, the Company raised $100,324,000 in gross proceeds
from the sale and issuance of 14% Senior Discount Notes due 2007 (the "1997
Notes"). All holders of outstanding Series B 13% Senior Discount Notes due 2005
(the "1995 Notes") tendered and exchanged their 1995 Notes for 1997 Notes having
an initial accreted value of $231,039,000. Warrants to purchase 8,942,517 shares
of the Company's Common Stock with an exercise price of $14.30 per share were
attached to the 1997 Notes. Aggregate proceeds of $74.5 million were
attributable to such common stock warrants. The 1997 Notes were issued at an
initial accreted value of $332,275,000 and will fully accrete to a face value of
$654,133,000
6
<PAGE>
CELLNET DATA SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
3. ISSUANCE OF SENIOR DISCOUNT NOTES. (CONTINUED)
on October 1, 2002. From and after October 1, 2002, the 1997 Notes will begin to
accrue interest payable in cash at an annual rate of 14% payable each April 1
and October 1, commencing April 1, 2003.
4. COMMITMENTS AND CONTINGENCIES.
The industry in which the Company operates is characterized by frequent
litigation regarding patent and other intellectual property rights. The Company
is a party to three such claims. Although the ultimate outcome of these matters
is not presently determinable, management believes that the resolution of these
matters will not have a material adverse effect on the Company's business,
operating results, financial condition and cash flow.
Although the Company has been granted federal registration of its "CellNet"
trademark, in January 1995, Century Telephone Enterprises, Inc. ("Century
Telephone") filed a petition for cancellation in an attempt to challenge such
registration. The matter is currently pending before the Trademark Trial and
Appeal Board of the U.S. Patent and Trademark Office. CellNet and Century
Telephone are the sole parties in the action. If such challenge were successful,
the Company could lose its registration and could be required to adopt a new
trademark and possibly a new or modified corporate name. CellNet could encounter
similar challenges in the future.
In October 1996, Itron, one of the Company's competitors, filed a complaint
against the Company in the Federal District Court in Minnesota alleging that the
Company infringes an Itron patent which was issued in September 1996. Itron is
seeking a judgment for damages, attorneys fees and injunctive relief. The
Company believes, based on its current information, that the Company's products
do not infringe any valid claim in the Itron patent, and in the Company's
opinion, the ultimate outcome of the lawsuit is not expected to have a material
adverse effect on the Company's business, operating results, financial condition
and cash flow.
On October 31, 1996, a complaint, SETTLE V. SEIDL, ET AL. No. 398464, was
filed in the Superior Court of California for the County of San Mateo against
the Company, certain of its officers and directors and underwriters of the
Company's Initial Public Offering. The complaint, which is a purported class
action filed on behalf of those purchasing the Company's stock from the period
beginning on September 26, 1996 and ending on October 31, 1996, seeks
unspecified damages and rescission for alleged liability under various
provisions of the federal securities laws and California state law. Plaintiff
alleges that the Prospectus and Registration Statement dated September 26, 1996,
pursuant to which the Company issued 5,000,000 shares of Common Stock to the
public, contained materially misleading statements and/or omissions in that
defendants were obligated to disclose, but failed to disclose, that a patent
conflict with Itron, Inc. was likely to ensue. On November 8 and 13, 1996, two
additional complaints, KAREN ZULLY V. CELLNET DATA SYSTEMS, INC. ET AL. No.
398551 and HOWARD FIENMAN AND GERALD SAPSOWITZ V. CELLNET DATA SYSTEMS, INC. ET
AL. No. 398560, were filed in the Superior Court of California for the County of
San Mateo. These cases are essentially similar in nature to the Settle case. The
Court has ordered consolidation of the SETTLE and ZULLY actions. The Fienman
action was voluntarily dismissed with prejudice. The Company believes that the
allegations in these complaints are without merit and intends to defend the
actions vigorously. The Company has filed demurrers seeking dismissal of these
complaints. The motions were assigned by the Court to a special master, who
recommended that the cases be dismissed with prejudice. Plaintiffs have objected
to the special master's recommendation, which is currently under submission
before the Court. In the Company's opinion, the ultimate outcome of these
lawsuits is not expected to have a material adverse effect on the Company's
business, operating results, financial condition and cash flow.
7
<PAGE>
CELLNET DATA SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
4. COMMITMENTS AND CONTINGENCIES. (CONTINUED)
In April 1997, the Company filed a patent infringement suit against Itron in
the Federal District Court for the Northern District of California, claiming
that Itron's use of its electronic meter reading Encoder Receiver Transmitter
("ERT-Registered Trademark-") device infringes CellNet's U.S. Patent No.
4,783,623. The Company seeks an injunction, damages and other relief.
5. EXTRAORDINARY LOSS ON EARLY EXTINGUISHMENT OF DEBT.
In 1997, the Company exchanged $654,133,000 aggregate value at maturity 1997
Notes and related warrants (the "1997 Warrants") for $100,324,000 of new
proceeds and the extinguishment of its $325,000,000 aggregate value at maturity
1995 Notes. The exchange of the 1995 Notes was accounted for as an early
extinguishment of debt, resulting in an extraordinary charge of $11,417,000,
consisting of the unamortized portion of the debt issuance cost of the 1995
Notes of $4,791,000, $3,514,000 attributable to consent fees and other costs
related to the extinguishment of the 1995 Notes and accelerated accretion of
interest on the 1995 Notes of $3,127,000.
In October 1997, the Company filed a registration statement registering
under the Securities Act of 1933, as amended (the "Securities Act"), offering to
exchange the unregistered 1997 Notes for new, registered 1997 Notes with
identical terms. Costs associated with the Company's registration of the 1997
Notes under the Securities Act will be capitalized as part of debt issue costs
in the fourth quarter.
8
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
THE FOLLOWING DISCUSSION OF THE FINANCIAL CONDITION AND RESULTS OF
OPERATIONS CONTAINS TREND ANALYSIS AND OTHER 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, THAT INVOLVE
RISKS AND UNCERTAINTIES. ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE SET
FORTH IN SUCH FORWARD-LOOKING STATEMENTS AS A RESULT OF THE FACTORS SET FORTH
UNDER "FACTORS THAT MAY AFFECT FUTURE OPERATING PERFORMANCE" AND OTHER RISKS
DETAILED FROM TIME TO TIME IN THE COMPANY'S REPORTS FILED WITH THE SECURITIES
AND EXCHANGE COMMISSION.
OVERVIEW
The Company intends to deploy and operate a series of wireless data
communications networks pursuant to services agreements with utilities and new
power market participants, to earn recurring revenues by providing Network Meter
Reading ("NMR") services, and to use the networks to support a variety of
non-utility applications. The Company may also provide NMR services pursuant to
(i) contracts and deployments with new market participants, (ii) broad,
selective network deployments with utilities and others aimed at serving the
meter reading requirements of high-value commercial and industrial customers (in
addition to saturation network deployments aimed at providing meter reading
services for all meters within a utility's service area), with other customers
to be added over time, (iii) contracts of shorter duration than those the
Company has previously entered into, and (iv) joint ventures or alliances with
utilities and others to form, own and/or operate metering companies or to
provide metering services. The Company's business strategy has affected and will
continue to affect its financial condition and results of operations as follows:
COMPOSITION OF REVENUES. The Company derives substantially all of its
revenues from fees earned under services agreements related to its wireless
communications networks. Under the Company's existing services agreements with
Kansas City Power & Light Company ("KCPL"), Union Electric Company ("UE"),
Northern States Power Company ("NSP"), Pacific Gas & Electric ("PG&E"), Puget
Sound Energy, Inc. ("Puget") and Indianapolis Power & Light Company ("IP&L"),
the Company receives monthly NMR service fees based on the number of endpoint
devices that are in revenue service during the applicable month.
UNEVEN REVENUE GROWTH. The timing and amount of the Company's future
revenues will depend upon its ability to obtain additional services agreements
with utilities and new power market participants and upon the Company's ability
to deploy and operate successfully its wireless communications networks for
utility and non-utility applications. New services agreements are expected to be
obtained on an irregular basis, and there may be prolonged periods during which
the Company does not enter into any additional services agreements or other
arrangements. As a result, the Company expects that its revenues will not grow
smoothly over time, but will increase unevenly as the Company enters into new
services agreements and other commercial relationships, and may decrease sharply
in the event that any of its existing services agreements are terminated or not
renewed. See "Factors That May Affect Future Operating Performance--Uncertainty
of Future Revenues; Need for Additional Services Contracts and Fluctuating
Operating Results."
UNCERTAINTY OF MARKET ACCEPTANCE. The Company's future revenues will depend
on the number of new services agreements with established utilities and new
power market participants and on the amount of NMR services to be provided
thereunder. The Company's only existing contracts are with established
utilities. During 1996, approximately 90% of the Company's revenues were derived
from its contracts with KCPL and UE. During the first nine months of 1997,
approximately 89% of the Company's revenues were derived from its contracts with
KCPL and UE. The utility industry is historically characterized by long
purchasing cycles and cautious decision making, and purchases of the Company's
services are, to a substantial extent, deferrable in the event that utilities
seek to limit capital expenditures or decide to defer such purchases for other
reasons. Only a limited number of utilities have made a commitment to purchase
9
<PAGE>
the Company's services to date. Although the uncertainty surrounding proposed
regulatory changes in some states may have caused, and may continue to cause,
additional delays in purchasing decisions by established utilities, the Company
believes that implementation of utility deregulation will ultimately accelerate
the utility decision-making process. The Company believes that it will enter
into additional services contracts with other utilities and new power market
participants; however, if the Company's services do not gain widespread industry
acceptance, its revenues would not increase significantly after services
contracts for existing network systems have been fully installed.
With the advent of utility industry deregulation, the Company is seeking
opportunities to provide its NMR services to new power market participants. The
Company believes it is well positioned to offer competitive advantages to both
established utilities and new power market participants. However, the Company
has not yet entered into any contracts with new power market participants, and
there can be no assurance that the Company will be able to enter into any such
contracts covering a sufficient number of meters to recoup its costs of
deployment, on terms favorable to the Company, or at all. The Company also
anticipates that, under contracts with new power market participants, it would
build out its networks, at least in part, before the capacity was fully
committed. For these reasons, the Company's ability to obtain financing for the
capital expenditures associated with these contracts may be limited, although
the Company also believes that it will be able to defer a significant portion of
the capital expenditures by building out its networks incrementally as needed,
and that the new power market participants would lease or acquire the endpoints
from the Company, reducing the Company's costs. The Company also anticipates
that its contracts with new power market participants will be shorter-term than
those it has entered into with established utilities, and may therefore not
fully cover the costs of network build-out and associated operating costs. The
Company intends to reduce this risk by marketing its services to a wide range of
new power market participants, but there can be no assurance that the Company
will be successful in such marketing efforts, or that the new power market
participants will be successful in capturing any significant share of the energy
service market.
The Company's long-term business plan contemplates the generation of a
significant percentage of future revenues from non-utility services. The Company
believes its future ability to service its indebtedness and to achieve
profitability will be affected by its success in generating substantial revenues
from such additional services. The Company currently has no services contracts
which provide for the implementation of such services, and the Company has not
yet deployed such services on a commercial scale. In addition, unless the
Company is successful in deploying its wireless networks in targeted service
areas, the Company may not be able to offer any such services in such areas or
may be able to offer these services only on a limited basis.
REVENUES LAG NETWORK DEPLOYMENT. The Company expects to realize network
service revenue under a services agreement with a utility or new power market
participant only when a portion of the network is installed and they have begun
billing their customers based upon the NMR data obtained. The Company expects
that its receipt of network service revenue will lag the signing of the related
services agreements by a minimum of six months and that it will generally take
two to four years to complete installation of a network after each services
agreement has been signed. A network's service revenues are not expected to
exceed the Company's capital investments and expenses incurred to deploy such
network for several years. As of September 30, 1997, the Company had
approximately 2,680,000 meters under long-term contracts, of which approximately
678,000 meters were in revenue service. The Company signed agreements with KCPL
and UE in August 1994 and August 1995, respectively, and did not receive its
first revenue under the KCPL and UE services agreements until September 1995 and
May 1996, respectively. The Company has completed the installation of its NMR
network for KCPL and had installed approximately 407,000 meters on the network
by the end of September 1997. The Company expects to add an additional 8,000
meters to the KCPL network in the last quarter of 1997 and in 1998 which would
be added to the total number of meters in revenue service upon acceptance by
KCPL for billing purposes. The remaining meters (approximately 5,000) under
contract with KCPL may be automated or read manually. As of the end of
10
<PAGE>
September 1997, the Company completed the on-line deployment of approximately
447,000 meters to the UE network. The Company began the installation of both the
NSP and Puget networks in August 1996 and began receiving revenue from Puget in
January 1997. The Company has also successfully completed a demonstration
project with PG&E in San Francisco pursuant to which the Company has installed a
network that will cover approximately 30,000 electric and gas meters. PG&E has
acknowledged that the data collection, cost savings, customer service and other
objectives of the demonstration network have been met. In September 1997, the
Company entered into a services contract with IP&L for the installation of its
NMR network that will cover approximately 415,000 meters. Installation of the
IP&L network is scheduled to begin in November 1997. In October 1997, the
Company entered into a services contract with Puget for the installation of an
NMR network that will cover approximately 550,000 electricity and 150,000 gas
residential, commercial and industrial customers. Network installation is
scheduled to begin in March 1998. As additional segments of the Company's
networks are installed and used by its customers for billing purposes, the
Company expects to realize a corresponding increase in its network service
revenues. However, if the Company is able to deploy successfully an increasing
number of networks over the next few years, the operating losses created by this
lag in revenues, and negative cash flow resulting from such operating losses and
the capital expenditures expected to be required in connection with the
installation of such networks, are expected to widen for a period of time and
will continue until the operating cash flow from installed networks exceeds the
costs of deploying and operating additional networks.
IMPACT OF RAPID EXPANSION. CellNet will not typically invest the capital
necessary to deploy a wireless communications network prior to entering into a
services agreement with a utility or new power market participant. However,
during its expansion phase, the Company will be required to invest significant
amounts of capital in its networks and to incur substantial and increasing sales
and marketing expenses before receiving any return on such expenditures through
network service revenues. The Company has incurred substantial operating losses
since its inception and, as of September 30, 1997, had an accumulated deficit of
$250.3 million. The Company does not expect significant revenues relative to
anticipated operating costs during 1997 and 1998 and expects to incur
substantial and increasing operating losses and negative net cash flow after
capital expenditures for the foreseeable future as it expands its research and
development and marketing efforts and installs additional networks. The Company
does not expect positive cash flow after capital expenditures from its NMR
services operations for several years. The Company will require substantial
capital to fund cash flow deficits and capital expenditures for the foreseeable
future and expects to finance these requirements through significant additional
external financing. See "Factors That May Affect Future Operating
Performance--History and Continuation of Operating Losses" and "--Substantial
Leverage and Ability to Service Debt; Substantial Future Capital Needs."
INTEREST INCOME. The Company has earned substantial amounts of interest
income on short-term investments of the proceeds of its financing activities.
The Company expects to utilize substantially all of its cash, cash equivalents
and short-term investments in deploying its wireless communications networks, in
continuing research and development activities related thereto, in related
selling and marketing activities and for general and administrative purposes. As
such funds are expended, interest income is expected to decrease.
RESULTS OF OPERATIONS
REVENUES
Revenues for the nine months ended September 30, 1997 and 1996 were $4.0
million and $0.9 million, respectively. The increase in revenues was principally
due to the increase in network service revenues. During the first nine months of
1997, KCPL and UE accounted for approximately 89% of the Company's revenues. The
Company's NMR service revenues for the nine months ended September 30, 1997 and
1996 were $3.5 million and $0.6 million, respectively. In connection with the
purchase of $15.0 million of restricted Common Stock by NSP concurrent with the
Company's initial public offering on October 2, 1996
11
<PAGE>
("Initial Public Offering"), the Company placed shares in escrow (the "Escrow
Shares") which will be released if the Company enters into an NMR services
agreement with Wisconsin Electric Power Company ("WEPC") by December 1997. The
fair value of these Escrow Shares will be expensed as a sales discount over the
term of the WEPC services agreement if such services agreement is entered into.
The Company expects to realize network service revenues under its services
agreements with utilities and new power market participants only when its
networks or portions thereof are successfully installed and operating and they
commence billing their customers based upon the NMR data obtained. Revenues are
expected to increase as the Company continues to install its networks, the
networks or portions thereof become operational, and utilities and new power
market participants begin billing their customers based upon data obtained over
the CellNet system. Due primarily to the nature, amount and timing of revenues
received to date, no meaningful period-to-period comparisons can be made.
Revenues received for the nine months ended September 30, 1997 and 1996 are not
reliable indicators of revenues that might be expected in the future.
COST OF REVENUES
For the nine months ended September 30, 1997 and 1996, cost of revenues
primarily consisted of network operations costs. Costs of revenues for the nine
months ended September 30, 1997 and 1996 were $12.8 million and $5.6 million,
respectively. The increase in cost of revenues was driven by increasing costs of
providing network services, due primarily to growth in the number of employees
and associated costs necessary for network monitoring operations at customer
sites and at the Company's headquarters, network deployment management and
customer training. Costs of network services also include the increased
installation, applications and RF engineering staffing at the Company's
headquarters to support anticipated additional services contracts. Network
services do not currently generate a profit as the Company has not yet achieved
a scale of services sufficient to cover network costs. The Company will incur
significant and increasing costs primarily attributable to network operation and
depreciation. Once a network has been fully installed, costs associated with
generating network revenues will consist primarily of maintaining a monitoring
center for such network, network depreciation and miscellaneous maintenance and
operating expenses.
OPERATING EXPENSES
Operating expenses, consisting of research and development, marketing and
sales, general and administrative costs and depreciation and amortization
expenses, for the nine months ended September 30, 1997 and 1996 were $47.4
million and $35.3 million, respectively. The increase in operating expenses on a
period to period basis is attributable to the Company's rapid growth and to
increasing research and development, general and administrative, and marketing
and sales expenditures. The Company expects to continue to spend a significant
portion of its resources on research and development activities for the
foreseeable future. Marketing and sales and general and administrative costs are
expected to increase in the future as the Company seeks to sign new services
agreements.
RESEARCH & DEVELOPMENT
Research and development expenses are attributable largely to continuing
system software, firmware and equipment development costs, prototype
manufacturing, testing, personnel costs, consulting fees, and supplies. Research
and development costs are expensed as incurred. The Company's networks include
certain software applications which are integral to their operation. The costs
to develop such software have not been capitalized as the Company believes its
software development is essentially completed when technological feasibility of
the software is established and/or development of the related network hardware
is complete. Research and development expenses for the nine months ended
September 30, 1997 and 1996 were $18.8 million and $18.7 million, respectively.
Research and development spending increases for the nine months ended September
30, 1997 reflect primarily additions to the Company's engineering staff. The
12
<PAGE>
Company expects that research and development expenses will increase moderately
for additional investments in research and development projects for the
principal purposes of increasing network functionality and performance and
lowering networking costs, and in connection with the establishment of
international operations.
MARKETING & SALES
Marketing and sales expenses consist principally of compensation, including
commissions paid to sales and marketing personnel, travel, advertising, trade
show and other promotional costs. Marketing and sales expenses for the nine
months ended September 30, 1997 and 1996 were $7.3 million and $4.3 million,
respectively. These expenses have increased due to the Company's accelerated
efforts to sign new services agreements and a significantly larger advertising
program.
GENERAL & ADMINISTRATIVE
General and administrative expenses include compensation paid to general
management and administrative personnel, home office expense, communications
charges, recruiting costs, travel, and communications and other general
administrative expenses, including fees for professional services. General and
administrative expenses for the nine months ended September 30, 1997 and 1996
were $13.2 million and $8.3 million, respectively. The Company expects general
and administrative expenses to continue to increase in absolute dollars as the
Company increases staffing and continues developing information systems to
support its planned growth. The Company will need to increase administrative
expenditures in the longer term to expand domestic and establish international
operations.
INTEREST INCOME AND EXPENSE
Prior to June 1995, the Company funded its liquidity needs primarily from
the issuance of equity securities. In June and November 1995, the Company issued
and sold a total of $325.0 million aggregate principal amount at maturity of the
Company's 13% Senior Discount Notes due 2005 (the "1995 Notes") and related
warrants (the "1995 Warrants") for proceeds, net of issuance costs, of $169.9
million. On October 2, 1996, the Company completed its Initial Public Offering
in which it sold 5,000,000 shares of its Common Stock at an offering price of
$20 per share for net proceeds of $92.2 million after deducting underwriting
discounts and commissions and offering expenses payable by the Company. In
connection with the Initial Public Offering, the Company also received $1.2
million in proceeds from the cash exercise of the 1995 Warrants (the "Warrant
Exercise") to purchase securities converted into 495,918 shares of its Common
Stock. In addition, on October 2, 1996, the Company completed certain direct
placements (the "Direct Placements") in which it sold 1,579,404 shares of its
Common Stock for proceeds of approximately $28.0 million. Accordingly, the
Company has earned interest income on the invested proceeds from the 1995 Notes,
the 1995 Warrants, the Initial Public Offering, the Warrant Exercise and the
Direct Placements. On September 29, 1997, the Company issued 14% Senior Discount
Notes due 2007 (the "1997 Notes") at an initial accreted value of $332.3
million, which will fully accrete to face value of $654.1 million on October 1,
2002. From and after October 1, 2002, the 1997 Notes will begin to accrue
interest payable in cash at an annual rate of 14%. All of the outstanding 1995
Notes were tendered and exchanged for a portion of the issued 1997 Notes. The
Company has also incurred significant interest expense from the amortization of
the original issue discount on the 1995 Notes. Interest expense will increase
significantly in future periods as a result of the issuance of the 1997 Notes.
Interest income has been and will continue to be received by the Company
from the short-term investment of proceeds from the issuance of equity and debt
securities pending the use of such proceeds by the Company for capital
expenditures and operating and other expenses. Interest income is expected to be
highly variable over time as proceeds from the issue and sale of additional
equity and debt securities are received and as funds are used by the Company in
its business. Interest income for the nine months ended September 30, 1997 and
1996 was $5.8 million and $4.8 million, respectively.
13
<PAGE>
Interest expense for the nine months ended September 30, 1997 and 1996 was
$18.7 million and $17.5 million, respectively.
PROVISION FOR INCOME TAXES
The Company has not provided for or paid federal income taxes due to the
Company's net losses. A nominal provision has been recorded for various state
minimum income and franchise taxes.
As of December 31, 1996, the Company had net operating loss carryforwards of
approximately $127.9 million and $71.9 million available to offset future
federal and state taxable income, respectively. The extent to which the loss
carryforwards can be used to offset future taxable income may be limited,
depending on the extent of ownership changes within any three-year period as
provided in the Tax Reform Act of 1986 and the California Conformity Act of
1987. Such state carryforwards will expire between 1997 and 2011. Such federal
carryforwards will expire between 2001 and 2011. Equity issuances in April 1991
and the Initial Public Offering in 1996 triggered such limitations on loss
carryforwards. As of December 31, 1996, approximately $108.0 million of net
operating losses remain limited to an annual usage of approximately $36.4
million for federal tax purposes. Based upon the Company's history of operating
losses and the expiration dates of the loss carryforwards, the Company has
recorded a valuation allowance to the full extent of its net deferred tax
assets.
EXTRAORDINARY LOSS ON EARLY EXTINGUISHMENT OF DEBT
In 1997, the Company exchanged $654,133,000 aggregate value at maturity 1997
Notes and related warrants (the "1997 Warrants") for $100,324,000 of new
proceeds and the extinguishment of its $325,000,000 aggregate value at maturity
1995 Notes. The exchange of the 1995 Notes was accounted for as an early
extinguishment of debt, resulting in an extraordinary charge of $11,417,000,
consisting of the unamortized portion of the debt issuance cost of the 1995
Notes of $4,791,000, $3,514,000 attributable to consent fees and other costs
related to the extinguishment of the 1995 Notes and accelerated accretion of
interest on the 1995 Notes of $3,127,000.
In October 1997, the Company filed a registration statement registering
under the Securities Act of 1933, as amended (the "Securities Act"), offering to
exchange the unregistered 1997 Notes for new, registered 1997 Notes with
identical terms. Costs associated with the Company's registration of the 1997
Notes under the Securities Act will be capitalized as part of debt issue costs
in the fourth quarter.
LIQUIDITY AND CAPITAL RESOURCES
The Company requires significant amounts of capital for research and
development in connection with the development of its proprietary wireless
communications network and related products and services, for investments in the
installation and testing of such networks and for related sales and marketing
and general and administrative expenses. Historically, the Company has satisfied
its liquidity requirements primarily through external financings, including
private placements of equity and debt securities and interest income derived
from the investment of the proceeds of its financing activities.
In the first nine months of 1997 and 1996, net cash used in the Company's
operating activities totaled $44.7 million and $29.7 million, respectively. Net
cash used in operating activities resulted primarily from cash used to fund net
operating losses.
14
<PAGE>
In the first nine months of 1997 and 1996, net cash (used) provided for
investing activities was $(26.4) million and $31.8 million, respectively. The
Company's investing activities consisted primarily of purchases of network
components and inventory, the construction and installation of networks,
purchases of property and equipment, and purchases, sales and maturities of
short-term investments. The $31.8 million of net cash provided by investing
activities in the first nine months of 1996 was largely attributable to proceeds
from the sale of short-term investments. These proceeds exceed investments in
short-term instruments as the Company used the proceeds of short-term
investments to fund its operating activities.
In the first nine months of 1997 and 1996, net cash provided (used) by the
Company's financing activities totaled $97.2 million and $(0.1) million,
respectively. During 1996, the Company financed its operations primarily from
the proceeds of the offering of the 1995 Notes and 1995 Warrants, together with
interest income of $7.4 million. On October 2, 1996, the Company completed its
Initial Public Offering in which it sold 5,000,000 shares of its Common Stock at
an offering price of $20 per share for net proceeds of $92.2 million after
deducting underwriting discounts and commissions and offering expenses payable
by the Company. In addition, on October 2, 1996, the Company completed the
Direct Placements in which it sold 1,579,404 shares of its Common Stock for
proceeds of approximately $28.0 million. In September 1997, the Company issued
in a private sale $654.1 million aggregate value at maturity of the 1997 Notes
and 1997 Warrants, in exchange for new proceeds of $100.3 million and the early
extinguishment of its $325.0 million aggregate value at maturity 1995 Notes.
Aggregate proceeds of $74.5 million have been attributed to the 1997 Warrants.
The 1997 Notes were issued at a substantial discount from the aggregate
principal amount at maturity of $654.1 million. Although interest is not payable
on the 1997 Notes prior to April 1, 2003, the carrying amount of such
indebtedness will increase as the original issue discount is accreted through
maturity in October 2007. Beginning October 1, 2002, the 1997 Notes will bear
interest payable semi-annually, at a rate of 14% per annum, with payments
commencing April 1, 2003. No principal payments on the 1997 Notes are due prior
to maturity in October 2007. Costs associated with the Company's September 1997
private sale of the 1997 Notes were capitalized as part of debt issue costs.
There is a risk that the Company would be unable if needed to refinance the 1997
Notes prior to the date cash interest payments become due and payable on such
Notes or at their maturity date, given uncertainty about prevailing capital
market conditions, the Company's then performance and financial position and the
Company's projected high levels of indebtedness and that any inability to so
refinance such Notes would limit the Company's ability to meet its obligations
on such Notes.
As of September 30, 1997, the Company had cash, cash equivalents and
short-term investments totaling $180.7 million. As of December 31, 1996, the
Company had cash, cash equivalents, and short-term investments totaling $178.9
million. The increase of $1.8 million from December 31, 1996 resulted from
proceeds related to the issuance of the 1997 Notes and 1997 Warrants, offset by
operating costs and the development and construction of the Company's wireless
communications networks.
Deployments of the Company's wireless communications networks will require
substantial additional capital. In addition, funds will be required for further
enhancements to the system software, firmware, hardware and other equipment to
increase the speed, capacity and functionality of the system, to enhance system
productivity over time and to expand the scope of utility and other network
information services that may be offered on the CellNet system. The Company
expects that cash used for the construction and installation of networks and for
the purchase of property and equipment will increase substantially as and when
the Company obtains new services agreements or enters into other arrangements
for the installation of its networks, and that the Company will require
significant amounts of additional capital from external sources. Sources of
additional capital for the Company and its subsidiaries may include project or
conventional bank financing, public and private offerings of debt and equity
securities and revenues generated from operating activities. The Company expects
that a substantial portion of its future financing will be at the subsidiary
level on a project basis. The Company expects to obtain third party financing
for the construction of wireless networks, based on the projected cash flow
expected to be generated from such
15
<PAGE>
projects. The Company expects that the recurring revenue stream from services
contracts and other arrangements will support the amortization of debt raised
for the project involved. The Company does not anticipate deriving any
significant cash from such operations for several years.
The Company believes that the net proceeds from the offering of the 1997
Notes, existing cash, cash equivalents and anticipated interest income and other
revenues, will be sufficient to meet its cash requirements for at least the next
twelve months using management's best estimates. Thereafter, the Company expects
that it will require substantial additional capital. The extent of additional
financing will depend on the success of the Company's business. The Company
expects to incur significant operating losses and to generate increasingly
negative net cash flow during the next several years while it develops and
installs its network communications systems. There can be no assurance that
additional financing will be available to the Company or, if available, that it
can be obtained on terms acceptable to the Company and within the limitations on
incurrence of indebtedness contained in the Indenture or that may be contained
in any additional financing arrangements. Failure to obtain such financing could
result in the delay or abandonment of some or all of the Company's development
and expansion plans and expenditures, which could limit the ability of the
Company to meet its debt service requirements and could have a material adverse
effect on the Company's business, operating results, financial condition and
cash flow and on the ability of the Company to meet its obligations, including
with respect to the 1997 Notes. See "Factors That May Affect Future Operating
Performance--Substantial Leverage and Ability to Service Debt; Substantial
Future Capital Needs."
FACTORS THAT MAY AFFECT FUTURE OPERATING PERFORMANCE
DEPENDENCE ON AND UNCERTAINTY OF MARKET ACCEPTANCE
The Company's success will be almost entirely dependent on whether
established utilities and new power market participants sign services contracts
with CellNet or enter into other arrangements which allow CellNet to install NMR
networks servicing a substantial number of meters.
Because automation of utility meter reading and distribution is a relatively
new and evolving market and is likely to be significantly affected by
deregulation, it is difficult to predict the future growth rate and size of this
market. Utilities are testing products from various suppliers for various
applications, and no industry standard has been broadly adopted. The CellNet
system is one possible solution for automated meter reading and distribution.
There can be no assurance that the Company will be successful in achieving the
large-scale adoption of its system. In the event that the utilities or new power
market participants do not adopt the Company's technology, or does so less
rapidly than expected by the Company, the Company's future results, including
its ability to service its indebtedness and achieve positive cash flow or
profitability, will be materially and adversely affected. In recent competitive
bids, potential electric and gas utility customers have selected competing
systems to perform services offered by the Company, and energy service providers
may from time to time select competing services in the future. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations."
The Company's only existing contracts are with established electric and gas
utilities. During 1996, approximately 90% of the Company's revenues were derived
from its contracts with KCPL and UE. During the first nine months of 1997,
approximately 89% of the Company's revenues were derived from its contracts with
KCPL and UE. Any decision by a utility or new power market provider to utilize
the Company's services will involve a significant organizational, technological
and financial commitment. The utility industry historically is characterized by
long purchasing cycles and cautious decision making. Utilities typically go
through numerous steps before making a final purchase decision. These steps,
which can take up to several years to complete, may include the formation of a
committee to evaluate the purchase, the review of different technical options
with vendors, performance and cost justifications, regulatory review and the
creation and issuance of requests for quotes and proposals, as well as the
utilities' normal budget approval process. Although the uncertainty surrounding
proposed regulatory
16
<PAGE>
changes in some states may have caused, and may continue to cause, additional
delays in purchasing decisions by established utilities, the Company believes
that implementation of utility deregulation will ultimately accelerate the
utility decision-making process. Purchases of the Company's services are, to a
substantial extent, deferrable in the event that utilities seek to limit capital
expenditures or decide to defer such purchases for other reasons. Only a limited
number of utilities have made a commitment to purchase the Company's services to
date, and there can be no assurance as to when or if the Company will enter into
additional services contracts or that any such contracts would be on terms
favorable to the Company.
With the advent of utility industry deregulation, the Company is seeking
opportunities to provide its NMR services to new power market participants. The
Company believes it is well positioned to offer competitive advantages to both
established utilities and new power market participants. However, the Company
has not yet entered into any contracts with new power market participants, and
there can be no assurance that the Company will be able to enter into any such
contracts covering a sufficient number of meters to recoup its costs of
deployment, on terms favorable to the Company, or at all. The Company's ability
to enter into contracts with new power market participants depends, in part, on
the timing and type of deregulation in each state. The Company also anticipates
that, under contracts with new power market participants, it would build out its
networks, at least in part, before the capacity was fully committed. For these
reasons, the Company's ability to obtain financing for the capital expenditures
associated with these contracts may be limited. The Company believes, however,
that it will be able to defer a significant portion of the required capital
expenditures by building out its networks incrementally as needed, and that the
new power market participants would lease or acquire the endpoints from the
Company, reducing the Company's costs. The Company also anticipates that its
contracts with new power market participants will be shorter-term than those it
has entered into with established utilities, and the revenues may therefore not
fully cover the costs of network build-out and associated operating costs. The
Company intends to reduce this risk by marketing its services to a wide range of
new power market participants, but there can be no assurance that the Company
will be successful in such marketing efforts, or that the new power market
participants will be successful in capturing any significant share of the energy
service market.
UNCERTAINTY OF FUTURE REVENUES; NEED FOR ADDITIONAL SERVICES CONTRACTS AND
FLUCTUATING OPERATING RESULTS
The timing and amount of future revenues will depend almost entirely upon
the Company's ability to obtain new services agreements with established
utilities and new power market participants and upon the successful deployment
and operation of the Company's wireless data communications networks. The
signing of any new services contracts is expected to occur on an irregular
basis, if at all. The Company expects that it will generally take two to four
years to complete the installation of each network after a services contract has
been signed. Service revenues from such networks are not expected to exceed the
Company's capital investments and expenses incurred to deploy and operate such
network for several years. The Company will not begin to receive recurring
revenues under a services contract until portions of the network become
operational, which is expected to occur no earlier than six months after the
execution of the applicable services contract. The Company's results of
operations may be adversely affected by delays or difficulties arising in the
network installation process. The cost of network deployments will be highly
variable and depend upon a wide variety of factors, including radio frequency
characteristics, the size of a service territory and density of endpoints within
such territory, the nature and sophistication of services being provided, the
cost of spectrum acquisition, local labor rates and other economic factors.
CellNet currently derives almost all of its revenues from long-term services
contracts with a limited number of established utilities. The Company will not
generate sufficient cash flow to service its indebtedness or achieve
profitability unless it enters into additional services contracts covering a
significant number of additional meters. There can be no assurance that the
Company will complete commercial deployments of the CellNet system under current
services contracts successfully or that it will obtain enough additional
services contracts on satisfactory terms for network deployments in a sufficient
number
17
<PAGE>
of locations to allow the Company to achieve adequate cash flow to service its
indebtedness or achieve positive cash flow or profitability. The Company's
operating results will fluctuate significantly in the future as a result of a
variety of factors, some of which are outside of the Company's control,
including the rate at which established utilities and new power market
participants enter into new services contracts, general economic conditions,
economic conditions in the utility industry, the effects of governmental
regulations and regulatory changes, capital expenditures and other costs
relating to the expansion of operations, the introduction of new services by the
Company or its competitors, the mix of services sold, pricing changes and new
service introductions by the Company and its competitors and prices charged by
suppliers. In response to a changing competitive environment, the Company may
elect from time to time to make certain pricing, service or marketing decisions
or enter into strategic alliances or investments that could result in a material
adverse effect on the Company's business, operating results, financial condition
and cash flow. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations."
UNCERTAINTY OF ACCEPTANCE OF AND DEPENDENCE ON OTHER APPLICATIONS
The Company's long-term business plan contemplates the generation of a
significant percentage of future revenues from non-utility services. The Company
believes its future ability to service its indebtedness and to achieve
profitability will be affected by its success in generating substantial revenues
from such additional services. The Company currently has no services contracts
which provide for the implementation of such services, and the Company has not
yet deployed any such services on a commercial scale. In addition, unless the
Company is successful in deploying its wireless networks in targeted service
areas, the Company may not be able to offer any such services in such areas or
may be able to offer these services only on a limited basis.
DEPENDENCE ON BUSINESSES ALLIANCES
A key element of the Company's business strategy is the formation of
corporate alliances with leading companies. The Company is currently investing,
and plans to continue to invest, significant resources to develop these
relationships. The Company believes that its success in penetrating markets for
utility and non-utility applications of its network will depend in large part on
its ability to maintain these relationships and to cultivate additional or
alternative relationships. There can be no assurance that the Company will be
able to develop additional corporate alliances with such companies, that
existing relationships will continue or be successful in achieving their
purposes or that such companies will not form competing arrangements.
SUBSTANTIAL LEVERAGE AND ABILITY TO SERVICE DEBT; SUBSTANTIAL FUTURE CAPITAL
NEEDS
The Company has substantial outstanding indebtedness, including $654.1
million in aggregate principal amount at maturity of 1997 Notes. The Company
will be required to pay cash interest on the 1997 Notes commencing April 1, 2003
and repay the 1997 Notes on October 1, 2007. The Company intends to incur
substantial additional indebtedness, primarily in connection with installing
future networks. As a result, the Company will have substantial debt service
obligations. The Company's capital expenditures will increase significantly if
new services contracts are signed, and the Company expects that its cash flow,
taking into account capital expenditures, will be increasingly negative over the
next several years. The ability of the Company to meet its debt service
requirements will depend upon achieving significant and sustained growth in the
Company's cash flow, which will be affected by its success in implementing its
business strategy, prevailing economic conditions and financial, business and
other factors, certain of which are beyond the Company's control. The Company's
ability to generate such cash flow is subject to a number of risks and
contingencies. Included among these risks are the possibilities that: (i) the
Company may not obtain sufficient additional services agreements or complete
scheduled installations on a timely basis, (ii) revenues may not be generated
quickly enough to meet the Company's operating costs and debt service
obligations, (iii) the operating and/or capital costs associated with the
installation and maintenance
18
<PAGE>
of the network could be higher than projected, (iv) the Company's wireless
systems could experience performance problems, or (v) adoption of the Company's
services within a network could be less widespread than anticipated.
Accordingly, there can be no assurance as to whether or when the Company's
operations will generate positive cash flow or become profitable or whether the
Company or its subsidiaries will at any time have sufficient resources to meet
their debt service obligations. If the Company is unable to generate sufficient
cash flow or obtain alternate liquidity to service its indebtedness, it will
have to reduce or delay planned capital expenditures, sell assets, restructure
or refinance its indebtedness or seek additional equity capital. There can be no
assurance that any of these strategies could be effected on satisfactory terms,
if at all, or that effecting any of these strategies would yield sufficient
proceeds to make the required payments on the 1997 Notes. In particular, there
is a risk that the Company would be unable, if needed, to refinance the 1997
Notes prior to the date cash interest payments become due and payable on such
Notes or at their maturity date, given uncertainty about prevailing capital
market conditions, the Company's then performance and financial position and the
Company's projected high levels of indebtedness. Such inability to refinance the
1997 Notes could result in cross-defaults under other indebtedness and limit the
Company's ability to meet its obligations on such 1997 Notes.
In addition, the degree to which the Company is leveraged could have
significant consequences, including, but not limited to, the following: (i) the
Company's ability to obtain additional financing in the future for working
capital, capital expenditures, research and development, acquisitions, and other
general corporate purposes may be materially limited or impaired, (ii) the
Company's cash flow, if any, cannot be used in the Company's business as a
substantial portion of the Company's cash flow from operations must be dedicated
to the payment of principal and interest on its indebtedness, and (iii) the
Company's high degree of leverage may make it more vulnerable to economic
downturns, may limit its ability to withstand competitive pressures and may
reduce its flexibility in responding to changing business and economic
conditions.
The Company will require substantial additional funds for the development,
commercial deployment and expansion of its networks, and for funding operating
losses. As of September 30, 1997, the Company had $180.7 million in cash, cash
equivalents and short-term investments. The Company believes the proceeds from
the offering of the 1997 Notes, its existing cash, cash equivalents and
short-term investments and anticipated interest income and other revenues will
be sufficient to meet its cash requirements for at least the next twelve months
based on management's best estimates. Thereafter, the Company expects that it
will require substantial additional capital. Depending upon the number and
timing of any new services agreements and upon the associated network deployment
costs and schedules, the Company may require additional equity or debt financing
earlier than estimated in order to fund its working capital and other
requirements. There can be no assurance that additional financing will be
available when required or, if available, that it will be on terms satisfactory
to the Company. See "Management's Discussion and Analysis of Financial Condition
and Results of Operations--Liquidity and Capital Resources."
In the event that the Company is unable to generate sufficient cash flow and
is otherwise unable to obtain funds necessary to meet required payments on its
indebtedness, the Company could be in default under the terms of the agreements
governing its indebtedness, including the 1997 Notes. In the event of such
default, the holders of such indebtedness would have certain enforcement rights,
including the right to accelerate such debt and the right to commence an
involuntary bankruptcy proceeding against the Company.
19
<PAGE>
HISTORY AND CONTINUATION OF OPERATING LOSSES
The Company has incurred substantial and increasing operating losses since
inception. As of September 30, 1997, the Company had an accumulated deficit of
$250.3 million, primarily resulting from expenses incurred in the development of
the Company's wireless data communications system, marketing of the Company's
NMR, distribution automation and other services, the installation of its
wireless data communications networks and the payment of other normal operating
costs.
The Company does not expect significant revenues relative to anticipated
operating costs during 1997 and 1998 and expects to incur substantial and
increasing operating losses and negative net cash flow after capital
expenditures for the foreseeable future. The Company expects that its receipt of
network service revenues will lag the signing of the related services agreements
by a minimum of six months and that it will generally take two to four years to
complete installation of a network after each services agreement has been
signed. The Company's network service revenues from a particular network are
expected to lag significantly behind network installation expenses until such
network is substantially complete. If the Company is able to deploy additional
networks, the losses created by this lag in revenues are expected to increase
until the revenues from the installed networks overtake the costs associated
with the deployment and operation of such additional networks. The Company does
not expect positive cash flow after capital expenditures from its NMR services
operations for several years. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations."
SUBSTANTIAL AND INCREASING COMPETITION
The emerging market for utility NMR systems, the deregulation of the
electric utility industry and the potential market for other applications once a
common infrastructure is in place, have led electronics, communications and
utility product companies to begin developing various systems, some of which
currently compete, and others of which may in the future compete, with the
CellNet system. Deregulation will likely cause competition to increase. The
Company believes that its only significant direct competitor in the marketplace
at present is Itron, Inc. ("Itron"), an established manufacturer and seller of
hand-held and drive-by automated meter reading ("AMR") equipment for utilities.
Itron is currently providing to customers its Genesis-TM- system, a radio
network system similar to the Company's, for meter reading purposes.
There may be many potential alternative solutions to the Company's NMR
services including traditional wireless solutions. SkyTel, a subsidiary of Mtel,
and Motorola are examples of companies whose technology might be adapted for NMR
and who may become direct competitors of the Company in the future. Whisper
Communications (formerly, a part of Diablo Research) now offers its True 2
Way-TM- fixed-based radio frequency ("RF") architecture communications
technology for automated meter reading and other services and has several trials
underway. Metricom, a provider primarily of subscriber-based, wireless data
communications for users of portable and desktop computers, is currently
involved in the AMR market through trials with Whisper Communications.
Schlumberger Industries, Inc. ("Schlumberger") and Greenland are among the
companies that have conducted, or are in the process of conducting, pilot trials
of utility network automation systems. Several companies are offering
telephone-based network automated meter reading services or equipment. Among
these are International Teldata and American Innovations. Established suppliers
of equipment, services and technology to the utility industry such as Asea Brown
Boveri and General Electric could expand their current product and service
offerings so as to compete directly with the Company, although they have not yet
done so. Many of the Company's present and potential future competitors have
substantially greater financial, marketing, technical and manufacturing
resources, name recognition and experience than the Company. The Company's
competitors may be able to respond more quickly to new or emerging technologies
and changes in customer requirements or to devote greater resources to the
development, promotion and sale of their products and services than the Company.
While the Company believes its technology, including its software, is widely
regarded as competitive at the present time, there can be no assurance that the
Company's competitors will not
20
<PAGE>
succeed in developing products, technologies or software that are better or more
cost effective. In addition, current and potential competitors may make
strategic acquisitions or establish cooperative relationships among themselves
or with third parties that increase their ability to address the needs of the
Company's prospective customers. Accordingly, it is possible that new
competitors or alliances among current and new competitors may emerge and
rapidly gain significant market share. In addition, if the Company achieves
significant success it could draw additional competitors into the market.
Traditional providers of wireless services may in the future choose to enter the
Company's markets. Such existing and future competition could materially
adversely affect the pricing for the Company's services and the Company's
ability to sign new services contracts and maintain existing agreements.
Competition for services relating to non-utility applications may be more
intense than competition for NMR services, and additional competitors may emerge
as the Company continues to develop non-utility applications. There can be no
assurance that the Company will be able to compete successfully against current
and future competitors, and any failure to do so would have a material adverse
effect on the Company's business, operating results, financial condition and
cash flow.
TECHNOLOGICAL PERFORMANCE AND BUILD-OUT OF THE SYSTEM; RAPID TECHNOLOGICAL
CHANGE AND UNCERTAINTY
The Company's initial target market is the monitoring, control and
automation of utilities' electric, gas and water meters and distribution
networks. There can be no assurance that unforeseen problems will not develop
with respect to the Company's technology, products or services, or that the
Company will be successful in completing the development and commercial
implementation of its technology on a wider scale. The Company must continue to
expand and upgrade its capabilities in connection with such commercial
implementation, the success of which cannot be assured. There can be no
assurance that the Company will be able to develop successfully a full range of
endpoint devices. The Company must also continue to develop the hardware
enhancements necessary to utilize its system on a commercial basis with a
variety of different electric, gas and water meters. The Company's future
success will be materially adversely affected if it is not successful or is
significantly delayed in continuing technology development and enhancement
programs.
The Company's future success will also depend, in part, on its ability to
enhance its existing hardware, software and wireless communications technology.
The telecommunications industry has been characterized by rapid, significant
technological advances. The advent of computer-linked electronic networks, fiber
optic transmission, advanced data digitization technology, cellular and
satellite communications capabilities and personal communications systems
("PCS") have radically expanded communications capabilities and market
opportunities. Future advances may render the Company's technology obsolete or
less cost effective than competitive systems or erode the Company's market
position. Many companies from diverse industries are seeking solutions for the
transmission of data over traditional communications media, including radio and
paging, as well as more recently developed media such as cellular and PCS-based
networks. Competitors may be capable of offering significant cost savings or
other benefits to the Company's customers, and there can be no assurance that
the Company will maintain competitive services or obtain appropriate new
technologies on a timely basis or on satisfactory terms. The Company's future
performance will also depend significantly on its ability to respond to future
regulatory changes.
The Company's necessary development efforts will require it to make
continued substantial investments. The Company has encountered product
development delays in the past affecting both software and hardware components
of its system.
ACCESS TO RADIO FREQUENCY ("RF") SPECTRUM; REGULATION BY THE FEDERAL
COMMUNICATIONS (THE "FCC")
The Company will attempt to obtain exclusive usage of licensed bandwidth
and/or secure its own licenses. The Company has focused its spectrum acquisition
strategy on the top 60 MSAs in the United States. As of September 30, 1997, the
Company had acquired 70 spectrum licenses in 48 of the top 60 MSAs. However,
sufficient frequency spectrum may not be available to fully enable the delivery
of all or a
21
<PAGE>
part of the Company's wireless data communications services or the Company may
be required to find alternative frequencies. The cost of obtaining such spectrum
is currently difficult to estimate and may involve time delays and/or increased
cost to the Company. The Company could also be unable to obtain frequency in
certain areas. Any of these circumstances could have a material adverse impact
on the Company's future ability to provide its network services and on the
Company's business, operating results, financial condition and cash flow.
The Company's network equipment uses radio spectrum and, as such, is subject
to regulation by the FCC. The Company's network equipment uses both licensed RF
spectrum allocated for multiple address system ("MAS") operations in the 928/952
MHz band and unlicensed spectrum in the 902-928 MHz band. In order to obtain a
license to operate the Company's network equipment in the 928/952 MHz band,
license applicants may need to obtain a waiver of various sections of the FCC's
rules. There can be no assurance that the Company will be able to obtain such
waivers on a timely basis or to obtain them at all. In addition, as the amount
of spectrum in the 928/952 MHz band is limited, issuance of these licenses is
contingent upon the availability of spectrum in the area(s) for which the
licenses are requested. The Company might not be able to obtain licenses to the
spectrum it needs in every area in which it has prospective customers. The FCC's
current rules, subject to a number of limited exceptions, permit third parties
such as CellNet to operate on spectrum licensed to utilities to provide other
services. The Company plans to use these provisions of the FCC's rules to expand
its network system.
The FCC requires that a minimum configuration of an MAS system be in
operation within eighteen months from the initial date of the grant of the
system authorization or risk forfeiture of the license for the MAS frequencies.
The eighteen-month deadline may be extended upon a showing of good cause, but
there is no assurance that the FCC will grant any such extension. The Company is
responding to this requirement by selectively building out transmission capacity
in some areas where it does not yet have utility telecommunications services
contracts and may return licenses to the FCC in certain areas.
No license is needed to operate the Company's equipment utilizing the
902-928 MHz band, although the equipment must be certified by the Company and
the FCC as being compliant with certain FCC restrictions on radio frequency
emissions designed to protect licensed services from objectionable interference.
While the Company believes it has obtained all required certifications for its
products, the FCC could modify the limits imposed on such products or otherwise
impose new authorization requirements, and in either case, such changes could
have a material adverse impact on the Company's business, operating results,
financial condition and cash flow. The FCC recently completed a rulemaking
proceeding designed to better accommodate the cohabitation in the 902-928 MHz
band of existing licensed services with newly authorized and expanded uses of
licensed systems, and existing and newly designed unlicensed devices like those
used by the Company. In this proceeding, the FCC expressly recognized the rights
of such unlicensed services to operate under certain delineated operating
parameters even if the potential for interference to the licensed operations
exists. The Company's systems will operate within those specified parameters.
The FCC is currently reviewing these rules in response to numerous petitions for
reconsideration and the agency could modify those rules or allow for other uses
of this spectrum that might create interference to the Company's systems, which
could, in either case, have a material adverse impact on the Company's business,
operating results, financial condition and cash flow.
While the Company intends to offer alternate market services over its
private, internal network, some of those services may include the use of the
Company's network for private carrier service offerings. The Company's offerings
would be structured to comply with FCC rules governing the offering of private
carrier services, and each such service offering would need to be reviewed
relative to these rules. The FCC's rules currently prohibit the use of the MAS
frequencies on which the Company is operating its systems for the provision of
common carrier service offerings. In the event that it is determined that a
particular service offering does not comply with the rules, the Company may be
required to restructure such offering or to utilize other frequencies for the
purpose of providing such service. There can be no
22
<PAGE>
assurances that the Company will gain access to such other frequencies. Future
interpretation of regulations by the FCC or changes in the regulation of the
Company's industry by the FCC or other regulatory bodies or legislation by
Congress could have a material adverse effect on the Company's business,
operating results, financial condition and cash flow.
In February 1997, the FCC published for public comment a Notice of Proposed
Rule Making in WT Docket No. 97-81 regarding the future licensing of frequencies
for use by Multiple Address Systems. The FCC has reached certain tentative
conclusions which, if adopted without any change, would result in (i) the
restriction on future licenses in the 928/952/956 MHz band (in which the Company
now operates its wide area network) for systems exclusively used for private
internal purposes, and the prohibition on future licensing in this band for
systems which provide "subscriber-based" services, (ii) the designation of the
932/941 and 928/959 MHz bands for licensees offering subscriber-based services,
(iii) the use of geographic licensing (using very large licensed service areas)
in lieu of site-by-site licensing for the bands designated for subscriber-based
services, (iv) the use of competitive bidding to award licenses for
subscriber-based services, (v) the grandfathering and protection from
interference of existing licensees, but only to the extent of their current
service areas, (vi) with respect to new geographic service area licensees,
liberalizing the time periods by which construction must be completed, but
imposing more burdensome construction requirements over the term of the license,
and (vii) for incumbent and new licensees, liberalizing some of the technical
and operational restrictions on the use of the licensed channels.
These proposals have engendered substantial public comment from a wide range
of industry sectors currently utilizing the MAS channels, including extensive
comments from the Company. The Company has urged, in particular, that there
should not be any restrictions imposed on the use of the 928/952 MHz bands in
which the Company has developed its network facilities that would unreasonably
limit the Company's ability to provide its current and anticipated utility and
non-utility service offerings. The Company has also urged that competitive
bidding and geographic licensing should not be the primary basis for awarding
licenses in this highly encumbered, heavily utilized band. The Company has also
supported many of the proposed changes that will make the use of the band more
technically efficient, although the Company has also opposed any use of the band
that would change its fundamental use for point-to-multipoint fixed operations,
and in particular, the use of the band for mobile operations. The Company's
positions have substantial support in the record, although the effort to retain
the status quo eligibility for the 928/952 MHz band has been opposed by
representatives of the utility and transportation industries who would prefer to
limit the use of this band solely to private internal networks and to prohibit
any private carrier or subscriber-based service offerings.
The Company is currently working with a coalition of interested parties,
including representatives of the utility and transportation industries, to
attempt to develop a compromise consensus proposal that would satisfy most of
the interested parties' concerns for presentation to the FCC in this proceeding.
However, the Company is unable to predict whether such a compromise can be
developed, or if it is developed, whether the FCC will view it favorably, and if
not, what form the final rules adopted in this proceeding will take. Given the
current proposal and the variety of comments submitted, it is possible that some
or all of the Company's uses of the MAS channels could be determined to be the
offering of private carrier or subscriber-based services, and that future
licenses for such offerings would be prohibited in the 928/952 MHz band in which
the Company currently operates, requiring the Company to develop equipment
capable of operating in one of the other MAS bands, and further requiring the
Company to obtain future licenses in a competitive bidding process. Although the
Company believes that additional licensed frequency will be generally available
to it as required, the cost associated with acquiring such licensed frequency as
well as the Company's operating costs could increase, perhaps substantially, and
the Company could experience substantial delays in adapting its networks if the
proposed rules were adopted. The adoption of new rules, depending upon the form
in which such rules are adopted, could have a material adverse effect upon the
Company's business, operating results, financial condition and cash flow.
23
<PAGE>
In connection with the foregoing, the FCC has temporarily suspended
acceptance of MAS applications for new licenses, major amendments, or major
modifications for the 928/959 MHz bands and applications to provide
subscriber-based services in the 928/952/956 MHz bands. This temporary
suspension does not affect applications for MAS licenses for private internal
purposes in the 928/952/956 MHz bands or applications for assignment of licenses
or transfer of control. Subject to certain limitations, pending applications at
the time of the suspension will continue to be processed. All of the Company's
pending applications for licenses in the 928/952 MHz band have been or are being
processed in due course. In addition, the Company's applications for the
assignment of licenses held by others have been processed during the processing
suspension. However, the FCC has tentatively concluded that the Company's
applications for licenses involve the offering of subscriber-based services, and
have therefore returned any applications newly filed after the initiation of the
processing suspension, precluding the Company from obtaining any new licenses
(other than through the assignment process) while the processing suspension is
in place. The Company has requested reconsideration of this determination since
the currently proposed uses of these licenses constitutes, in the Company's
view, a private, internal use network. If the FCC does not change its tentative
conclusion on this matter, the Company will not be able to file any applications
for new facilities until the suspension is lifted, which is expected to occur
when the proceedings in Docket 97-81 are concluded. This may adversely affect
the Company's ability to service areas where it has not yet acquired adequate
frequencies.
RISKS ASSOCIATED WITH INTERNATIONAL EXPANSION
The Company plans to expand into international markets and has begun initial
marketing efforts. The Company does not anticipate that it will have any
material international operations for at least the next twelve months. The
Company has incurred, and anticipates that it will continue to incur,
significant and increasing expenses in connection with the establishment of
international operations. If revenues generated by international activities are
not adequate to offset the expense of establishing and maintaining these
activities, the Company's business, operating results, financial condition and
cash flow could be materially adversely affected. International demand for the
Company's services and systems is expected to vary by country, based on such
factors as the regulatory environment, electric power generating capacity and
demand, labor costs, costs of spectrum acquisition and other political and
economic conditions. To date, the Company has little experience in developing a
localized version of its wireless data communications system for foreign
markets. The Company believes its ability to establish business alliances in
each international market will be critical to its success. There can be no
assurance that the Company will be able to successfully develop, market and
implement its system in international markets or establish successful business
alliances for these markets. In addition, there are certain risks inherent in
doing business internationally, such as unexpected changes in regulatory
requirements, export restrictions, tariffs and other trade barriers,
difficulties in staffing and managing foreign operations, longer payment cycles,
problems in collecting accounts receivable, political instability, fluctuations
in currency exchange rates and potentially adverse tax consequences, any of
which could adversely impact the Company's potential international operations.
There can be no assurance that one or more of such factors will not have a
material adverse effect on the Company's future international operations and,
consequently, on its business, operating results, financial condition and cash
flow.
The Company's strategy is to pursue international markets through a joint
venture with Bechtel Enterprises, Inc. which could involve additional partners
in local operating project entities in particular countries. The Company may not
have a majority interest or control of the board of directors of any such local
operating project entity. In any such joint venture in which the Company may
determine to participate, there is a risk that the other joint venture partner
may at any time have economic, business or legal interests or goals that are
inconsistent with those of the joint venture or the Company or that such partner
will not impose the same or similar accounting and financial controls as the
Company. The risk is also present that a joint venture partner may be unable to
meet its economic or other obligations and that the Company may be required to
fulfill those obligations. In addition, in any joint venture in which the
24
<PAGE>
Company does not have a majority interest, the Company may not have control over
the operations or assets of such joint venture. Furthermore, the joint venture
structure may limit the amount of funds that can be upstreamed to the Company.
MANAGEMENT OF GROWTH; DEPENDENCE ON KEY PERSONNEL
The Company's recent growth has placed, and is expected to continue to
place, a significant strain on its managerial, operational and financial
resources. The Company's ability to manage growth effectively will require it to
continue to implement and improve its operational and financial systems and to
expand and manage its employee base. These demands are expected to require the
addition of new management personnel and the development of additional expertise
by existing management personnel. There can be no assurance that the Company
will be able to effectively manage the expansion of its operations, that its
systems, procedures or controls will be adequate to support the Company's
operations or that Company management will be able to exploit opportunities for
the Company's services. An inability to manage growth, if any, could have a
material adverse effect on the Company's business, results of operations,
financial condition and cash flow.
The success of the Company is substantially dependent on its key management
and technical personnel, the loss of one or more of whom could adversely affect
the Company's business. Substantially all of the Company's employees and
officers are employed on an at-will basis. Presently, the Company does not
maintain a "key man" life insurance policy on any of its executives or
employees. The Company's future success also depends on its continuing ability
to identify, hire, train and retain other highly qualified technical and
managerial personnel. Competition for such personnel is intense, and there can
be no assurance that the Company will be able to attract or retain highly
qualified technical and managerial personnel in the future. An inability to
attract and retain the necessary technical and managerial personnel could have a
material adverse effect on the Company's business, operating results, financial
condition and cash flow.
UNCERTAINTY OF PROTECTION OF COPYRIGHTS, PATENTS AND PROPRIETARY RIGHTS
The Company relies on a combination of trade secret protection, copyright,
patent, trademark and confidentiality agreements and licensing arrangements to
establish and protect its proprietary rights. The Company's success will depend
in part on its ability to maintain copyright and patent protection for its
products, to preserve its trade secrets and to operate without infringing the
proprietary rights of third parties. While the Company has obtained and applied
for patents, and intends to file applications as appropriate for patents
covering its products and processes, there can be no assurance that additional
patents will be issued or, if issued, that the scope of any patent protection
will be significant, or that any patents issued to the Company or licensed by
the Company will not be challenged, invalidated or circumvented, or that the
rights granted thereunder will provide proprietary protection to the Company.
Since United States patent applications are maintained in secrecy until
patents are issued, and since publication of inventions in the technical or
patent literature tend to lag behind such inventions by several months, CellNet
cannot be certain that it was the first creator of inventions covered by its
issued patents or pending patent applications, that it was the first to file
patent applications for such inventions or that no patent conflict will exist
with other products or processes which could compete with the Company's products
or approach. Despite the Company's efforts to safeguard and maintain these
proprietary rights, there can be no assurance that the Company will be
successful or that the Company's competitors will not independently develop and
patent technologies that are substantially equivalent or superior to the
Company's technologies. Participants in the wireless industry, including
competitors of the Company, typically seek to obtain patents which will provide
as broad a protection as possible for their products and processes. There is a
substantial backlog of patents at the United States Patent and Trademark Office.
It is
25
<PAGE>
uncertain whether any such third-party patents will require the Company to alter
its products or processes, obtain licenses or cease certain activities. An
adverse outcome with regard to a third-party patent infringement claim could
subject the Company to significant liabilities, require disputed rights to be
licensed or restrict the Company's ability to use such technology. The Company
also relies to a substantial degree upon unpatented trade secrets, and no
assurance can be given that others, including the Company's competitors, will
not independently develop or otherwise acquire substantially equivalent trade
secrets. In addition, whether or not additional patents are issued to the
Company, others may receive patents which contain claims applicable to products
or processes developed by the Company. If any such claims were to be upheld, the
Company would require licenses, and no assurance can be given that licenses
would be available on acceptable terms, if at all. In addition, the Company
could incur substantial costs in defending against suits brought against it by
others for infringement of intellectual property rights or in prosecuting suits
which the Company might bring against other parties to protect its intellectual
property rights. From time to time the Company receives inquiries with respect
to the coverage of its intellectual property rights, and there can be no
assurance that such inquiries will not develop into litigation.
In October 1996, Itron, one of the Company's competitors, filed a complaint
against the Company in the Federal District Court in Minnesota, alleging that
the Company infringes an Itron patent which was issued in September 1996. Itron
is seeking a judgment for damages, attorneys' fees and injunctive relief. The
Company believes, based on information currently known, that the Company's
products do not infringe any valid claim in the Itron patent, and in the
Company's opinion, the ultimate outcome of the lawsuit is not expected to have a
material adverse effect on the Company's business, operating results, financial
condition and cash flow.
Although the Company has been granted federal registration of its "CellNet"
trademark, another company has filed a petition for cancellation in an attempt
to challenge such registration which, if successful, would mean the Company
could lose its registration and be required to adopt a new trademark and
possibly a new or modified corporate name. CellNet could encounter similar
challenges to its trademark and corporate name in the future. While the
requirement to adopt a new trademark or new or modified corporate name could
involve a significant expense and could result in the loss of any goodwill and
name recognition associated with the Company's current trademark and corporate
name, the Company does not believe this would have a long-term material adverse
impact on the Company's business, operating results, financial condition and
cash flow.
DEPENDENCE ON THIRD-PARTY MANUFACTURERS; EXPOSURE TO COMPONENT SHORTAGES
The Company relies and will continue to rely on outside parties to
manufacture a majority of its network equipment such as radio devices and
printed circuit boards. As the Company signs additional services contracts,
there will be a significant ramp-up in the amount of manufacturing by third
parties in order to enable the Company to meet its contractual commitments.
There can be no assurance that these manufacturers will be able to meet the
Company's manufacturing needs in a satisfactory and timely manner or that the
Company can obtain additional manufacturers when and if needed. Although the
Company believes alternative manufacturers are available, an inability of the
Company to develop alternative suppliers quickly or cost-effectively could
materially impair its ability to manufacture and install systems. The Company's
reliance on third-party manufacturers involves a number of additional risks,
including the absence of guaranteed capacity and reduced control over delivery
schedules, quality assurance, production yields and costs. Although the Company
believes that these manufacturers would have an economic incentive to perform
such manufacturing for the Company, the quality, amount and timing of resources
to be devoted to these activities is not within the control of the Company, and
there can be no assurance that manufacturing problems will not occur in the
future. A significant price increase, a quality control problem, an interruption
in supply from one or more of such manufacturers or the inability to obtain
additional manufacturers when and if needed could have a material adverse effect
on the Company's business, operating results, financial condition and cash flow.
26
<PAGE>
Certain of the Company's subassemblies, components and network equipment are
procured from single sources and others are procured only from a limited number
of sources. In addition, CellNet may be affected by general shortages of certain
components, such as surface mounted integrated circuits and memory chips. There
have been shortages of such materials generally in the marketplace from time to
time in the past. The Company's reliance on such components and on a limited
number of vendors and subcontractors involves certain risks, including the
possibility of shortages and reduced control over delivery schedules,
manufacturing capability, quality and cost. A significant price increase or
interruption in supply from one or more of such suppliers could have a material
adverse effect on the Company's business, operating results, financial condition
and cash flow. Although the Company believes alternative suppliers of
sub-assemblies, components and network equipment are available, the inability of
the Company to develop alternative sources quickly or cost-effectively could
materially impair its ability to manufacture and install systems. Lead times can
be as long as a year for certain components, which may require the Company to
use working capital to purchase inventory significantly in advance of receiving
any revenues.
A significant number of new electric meters are required to initiate meter
retrofit and replacement in connection with each network deployment and to
replace existing meters in the field which are found to be obsolete, worn out or
otherwise unsuitable for retrofit and redeployment. Any sudden or material
increase in the number of deployments would result in an increase in the number
of new electric meters ordered by electric utilities and new power market
participants over and above those ordered on account of normal growth and
replacement within their service areas. To the extent that electric meter
manufacturers are unable or unwilling to increase production in line with such
increase in demand, temporarily or over a longer term, deployments may be
delayed or postponed, with the result that revenues from such deployments will
be likewise delayed or postponed.
POSSIBLE TERMINATION OF CONTRACTS
The Company expects that a substantial portion of its future revenues will
be provided pursuant to services contracts. These contracts will generally be
subject to cancellation or termination in certain circumstances in the event of
a material and continuing failure on CellNet's part to meet agreed NMR
performance standards on a consistent basis over agreed time periods, subject to
certain rights to cure any such failure. Each of the Company's existing utility
services contracts provides for termination of such contracts by the respective
utility without cause in less than ten years, subject to certain reimbursement
provisions. Such contracts also provide that CellNet will be required to
compensate such utilities for the use of its system for non-utility
applications. Future services contracts with utilities and new power market
participants may contain similar provisions. In the event that such a services
contract is terminated, the Company would incur substantial losses. In addition,
the Company anticipates that any contracts with new power market participants
will have shorter terms than the Company's existing utility contracts. A
network's service revenues are not expected to exceed the Company's capital
investments to deploy such network for several years. Termination or
cancellation of one or more services contracts would have a material adverse
effect on the Company's business, results of operations, financial condition and
cash flow.
SHAREHOLDERS' AGREEMENT
Under the terms of a Shareholders' Agreement among the Company and certain
stockholders of the Company (the "Shareholders' Agreement"), so long as certain
parties to the Shareholders' Agreement continue to hold not less than 700,000
shares of Common Stock (as such number is adjusted for stock splits,
consolidations or other similar events), the Company is obligated to nominate
for election representatives of certain stockholders as directors at each
meeting of the Company's stockholders at which a vote for directors will be
taken. The effect of the Shareholders' Agreement is to give certain stockholders
greater influence over the management of the Company than they would otherwise
have and to provide certain stockholders with, among other things, certain
registration, first refusal, co-sale and other rights.
27
<PAGE>
VOLATILITY OF STOCK PRICE
The trading price of the Company's Common Stock has been highly volatile at
relatively low trading volumes since the Company's Initial Public Offering and
has been and is likely to continue to be subject to wide fluctuations in
response to a variety of factors, including quarterly variations in operating
results, the signing of services contracts, new customers, consolidations in the
industry, technological innovations or new products by the Company or its
competitors, developments in patents or other intellectual property rights,
general conditions in the NMR services industry, revised earnings estimates,
comments or recommendations issued by analysts who follow the Company, its
competitors or the NMR services industry and general economic and market
conditions. In addition, it is possible that in some future period the Company's
operating results may 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. Additionally, the stock market in general, and
the market for technology stocks in particular, have experienced extreme price
volatility in recent years. Volatility in price and volume has had a substantial
effect on the market prices of many technology companies for reasons unrelated
or disproportionate to the operating performance of such companies. These broad
market fluctuations could have a significant impact on the market price of the
Common Stock.
NO DIVIDENDS; DIVIDEND RESTRICTIONS
The Company has not declared or paid any dividends on its capital stock
since its inception. The Company currently anticipates that it will retain all
of its future earnings, if any, for use in the operation and expansion of its
business and does not anticipate paying any cash dividends in the foreseeable
future. In addition, the Company's existing financing arrangements restrict the
payment of any dividends.
LITIGATION
In October 1996, Itron, one of the Company's competitors, filed a complaint
against the Company in the Federal District Court in Minnesota alleging that the
Company infringes an Itron patent which was issued in September 1996. Itron is
seeking a judgment for damages, attorneys fees and injunctive relief. The
Company believes, based on its current information, that the Company's products
do not infringe any valid claim in the Itron patent, and in the Company's
opinion, the ultimate outcome of the lawsuit is not expected to have a material
adverse effect on the Company's business, operating results, financial condition
and cash flow.
On October 31, 1996, a complaint, SETTLE V. SEIDL, ET AL. No. 398464, was
filed in the Superior Court of California for the County of San Mateo against
the Company, certain of its officers and directors and underwriters of the
Company's Initial Public Offering. The complaint, which is a purported class
action filed on behalf of those purchasing the Company's stock from the period
beginning on September 26, 1996 and ending on October 31, 1996, seeks
unspecified damages and rescission for alleged liability under various
provisions of the federal securities laws and California state law. Plaintiff
alleges that the Prospectus and Registration Statement dated September 26, 1996,
pursuant to which the Company issued 5,000,000 shares of Common Stock to the
public, contained materially misleading statements and/or omissions in that
defendants were obligated to disclose, but failed to disclose, that a patent
conflict with Itron, Inc. was likely to ensue. On November 8 and 13, 1996, two
additional complaints, KAREN ZULLY V. CELLNET DATA SYSTEMS, INC. ET AL. No.
398551 and HOWARD FIENMAN AND GERALD SAPSOWITZ V. CELLNET DATA SYSTEMS, INC. ET
AL. No. 398560, were filed in the Superior Court of California for the County of
San Mateo. These cases are essentially similar in nature to the SETTLE case. The
Court has ordered consolidation of the SETTLE and ZULLY actions. The Fienman
action was voluntarily dismissed with prejudice. The Company believes that the
allegations in these complaints are without merit and intends to defend the
actions vigorously. The Company has filed demurrers seeking dismissal of these
complaints. The motions were assigned by the Court to a special master, who
recommended that the cases be dismissed with prejudice. Plaintiffs have objected
to the special master's recommendation, which is currently under submission
28
<PAGE>
before the Court. In the Company's opinion, the ultimate outcome of these
lawsuits is not expected to have a material adverse effect on the Company's
business, operating results, financial condition and cash flow.
In April 1997, the Company filed a patent infringement suit against Itron in
the Federal District Court for the Northern District of California, claiming
that Itron's use of its electronic meter reading Encoder Receiver Transmitter
("ERT-Registered Trademark-") device infringes CellNet's U.S. Patent No.
4,783,623. The Company seeks an injunction, damages and other relief.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Not Applicable.
29
<PAGE>
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The industry in which the Company operates is characterized by frequent
litigation regarding patent and other intellectual property rights. The Company
is a party to three such claims. Although the ultimate outcome of these matters
is not presently determinable, management believes that the resolution of these
matters will not have a material adverse effect on the Company's financial
position or results of operations.
Although the Company has been granted federal registration of its "CellNet"
trademark, in January 1995, Century Telephone Enterprises, Inc. ("Century
Telephone") filed a petition for cancellation in an attempt to challenge such
registration. The matter is currently pending before the Trademark Trial and
Appeal Board of the U.S. Patent and Trademark Office. CellNet and Century
Telephone are the sole parties in the action. If such challenge were successful,
the Company could lose its registration and could be required to adopt a new
trademark and possibly a new or modified corporate name. CellNet could encounter
similar challenges in the future.
In October 1996, Itron, one of the Company's competitors, filed a complaint
against the Company in the Federal District Court in Minnesota alleging that the
Company infringes an Itron patent which was issued in September 1996. Itron is
seeking a judgment for damages, attorneys fees and injunctive relief. The
Company believes, based on its current information, that the Company's products
do not infringe any valid claim in the Itron patent, and in the Company's
opinion, the ultimate outcome of the lawsuit is not expected to have a material
adverse effect on the Company's business, operating results, financial condition
and cash flow.
On October 31, 1996, a complaint, SETTLE V. SEIDL, ET AL. No. 398464, was
filed in the Superior Court of California for the County of San Mateo against
the Company, certain of its officers and directors and underwriters of the
Company's Initial Public Offering. The complaint, which is a purported class
action filed on behalf of those purchasing the Company's stock from the period
beginning on September 26, 1996 and ending on October 31, 1996, seeks
unspecified damages and rescission for alleged liability under various
provisions of the federal securities laws and California state law. Plaintiff
alleges that the Prospectus and Registration Statement dated September 26, 1996,
pursuant to which the Company issued 5,000,000 shares of Common Stock to the
public, contained materially misleading statements and/or omissions in that
defendants were obligated to disclose, but failed to disclose, that a patent
conflict with Itron, Inc. was likely to ensue. On November 8 and 13, 1996, two
additional complaints, KAREN ZULLY V. CELLNET DATA SYSTEMS, INC. ET AL. No.
398551 and HOWARD FIENMAN AND GERALD SAPSOWITZ V. CELLNET DATA SYSTEMS, INC. ET
AL. No. 398560, were filed in the Superior Court of California for the County of
San Mateo. These cases are essentially similar in nature to the SETTLE case. The
Court has ordered consolidation of the SETTLE and ZULLY actions. The Fienman
action was voluntarily dismissed with prejudice. The Company believes that the
allegations in these complaints are without merit and intends to defend the
actions vigorously. The Company has filed demurrers seeking dismissal of these
complaints. The motions were assigned by the Court to a special master, who
recommended that the cases be dismissed with prejudice. Plaintiffs have objected
to the special master's recommendation, which is currently under submission
before the Court. In the Company's opinion, the ultimate outcome of these
lawsuits is not expected to have a material adverse effect on the Company's
business, operating results, financial condition and cash flow.
In April 1997, the Company filed a patent infringement suit against Itron in
the Federal District Court for the Northern District of California, claiming
that Itron's use of its ERT-Registered Trademark- device infringes CellNet's
U.S. Patent No. 4,783,623. The Company seeks an injunction, damages and other
relief.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On September 29, 1997, the Company raised $100.3 million in gross proceeds
from the sale and issuance of the 1997 Notes and 1997 Warrants. All holders of
outstanding 1995 Notes tendered and
30
<PAGE>
exchanged their 1995 Notes for 1997 Notes having an initial accreted value of
$231.0 million. The 1997 Warrants to purchase 8,942,517 shares of the Company's
Common Stock with an exercise price of $14.30 per share were attached to the
1997 Notes. The 1997 Notes were issued at an initial accreted value of $332.3
million and will fully accrete to face value of $654.1 million on October 1,
2002. From and after October 1, 2002, the 1997 Notes will bear interest at an
annual rate of 14% payable each April 1 and October 1, commencing April 1, 2003.
The Initial Purchasers of the 1997 Notes were Morgan Stanley & Co.
Incorporated and Donaldson, Lufkin, Jenrette Securities Corporation. The Company
relied on the exemption set forth in Section 4(2) of the Securities Act for the
sale of the 1997 Notes to the Initial Purchasers. The Initial Purchasers resold
the 1997 Notes to qualified institutional buyers under Rule 144A under the
Securities Act and to a limited number of other institutional "accredited
investors" as defined in Rule 501 of the Securities Act and outside the United
States to non-U.S. persons in reliance under Regulation S under the Securities
Act.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
ITEM 5. OTHER INFORMATION
None.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------------- -------------------------------------------------------------------------
<S> <C>
27.1 Financial Data Schedule
</TABLE>
(b) Reports on Form 8-K
There have been no reports on Form 8-K filed during the quarter ended
September 30, 1997.
31
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
<TABLE>
<S> <C> <C>
CELLNET DATA SYSTEMS, INC.
Date: November 13, 1997 By: /s/ PAUL G. MANCA
-----------------------------------------
Paul G. Manca
VICE PRESIDENT AND CHIEF FINANCIAL OFFICER
(PRINCIPAL FINANCIAL AND ACCOUNTING
OFFICER)
</TABLE>
32
<PAGE>
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION PAGE
- ------------- ------------------------------------------------------------------------------------------------ -----
<S> <C> <C>
27.1 Financial Data Schedule.........................................................................
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1997
<PERIOD-END> SEP-30-1997
<CASH> 150,356
<SECURITIES> 30,300
<RECEIVABLES> 5,051
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 187,857
<PP&E> 133,263
<DEPRECIATION> (17,778)
<TOTAL-ASSETS> 307,570
<CURRENT-LIABILITIES> (16,157)
<BONDS> (257,849)
0
0
<COMMON> (209,397)
<OTHER-SE> (73,870)
<TOTAL-LIABILITY-AND-EQUITY> (307,570)
<SALES> 366
<TOTAL-REVENUES> 4,026
<CGS> (443)
<TOTAL-COSTS> (12,841)
<OTHER-EXPENSES> (47,351)
<LOSS-PROVISION> (2,009)
<INTEREST-EXPENSE> (18,683)
<INCOME-PRETAX> (71,133)
<INCOME-TAX> (1)
<INCOME-CONTINUING> (71,134)
<DISCONTINUED> 0
<EXTRAORDINARY> (11,417)
<CHANGES> 0
<NET-INCOME> (82,551)
<EPS-PRIMARY> (2.05)
<EPS-DILUTED> (2.05)
</TABLE>
