FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 1998
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: 0-23110
-------
DIGITAL LINK CORPORATION
(Exact name of registrant as specified in its charter)
California 77-0067742
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
217 Humboldt Court, Sunnyvale, CA 94089
(Address of principal executive offices, including zip code)
(408) 745-6200
Registrant's telephone number, including area code
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Sections 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 |_|
The number of shares outstanding of the registrant's Common Stock as of August
14, 1998, was 9,135,178 shares.
<PAGE>
DIGITAL LINK CORPORATION
INDEX TO FORM 10-Q
Page
PART I - FINANCIAL INFORMATION:
ITEM 1 - Financial Statements
Consolidated Balance Sheets as of June 30, 1998 3
and December 31, 1997
Consolidated Statements of Operations for the quarters 4
and six months ended June 30, 1998 and 1997
Consolidated Statements of Cash Flows for the six 5
months ended June 30, 1998 and 1997
Notes to Consolidated Financial Statements 6
ITEM 2 - Management's Discussion and Analysis of 11
Financial Condition and Results of Operations
ITEM 3 - Quantitative and Qualitative Disclosure About 21
Market Risk
PART II- OTHER INFORMATION
ITEM 1 - Legal Proceedings 22
ITEM 1 - Legal Proceedings
ITEM 2 - Changes in Securities and Use of Proceeds 22
ITEM 3 - Defaults Upon Senior Securities 22
ITEM 4 - Submission of Matters to a Vote of Security Holders 22
ITEM 5 - Other Information 23
ITEM 6 - Exhibits and Reports on Form 8-K 23
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<TABLE>
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements
DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share amounts)
<CAPTION>
- --------------------------------------------------------------------------------------------------------------------
June 30, December 31,
1998 1997
---------------- ------------------
(Unaudited)
<S> <C> <C>
ASSETS
- ------
CURRENT ASSETS:
Cash and cash equivalents $ 719 $ 2,504
Short-term marketable securities 16,420 18,026
Accounts receivable, less allowance for doubtful accounts of
$434 at 6/30/98 and $517 at 12/31/97 4,461 5,193
Inventories 8,292 8,163
Prepaid and other current assets 1,383 1,433
Income taxes receivable 696 -
Deferred income taxes 2,304 2,304
---------------- ----------------
Total current assets 34,275 37,623
Property and equipment at cost, net 4,000 3,325
Long-term marketable securities 20,187 21,899
Deferred income taxes 2,062 2,062
Other assets 969 1,147
---------------- ----------------
TOTAL ASSETS $ 61,493 $ 66,056
================ ================
LIABILITIES AND SHAREHOLDERS' EQUITY
- ------------------------------------
CURRENT LIABILITIES:
Accounts payable $ 3,670 $ 2,407
Accrued payroll expense 2,102 2,344
Other accrued expenses 3,542 3,785
Income taxes payable - 186
---------------- ----------------
Total current liabilities 9,314 8,722
---------------- ----------------
CONTINGENCIES (Note 4)
SHAREHOLDERS' EQUITY:
Preferred stock, no par value:
Authorized: 5,000,000 shares;
Issued and outstanding: None
Common stock, no par value:
Authorized: 25,000,000 shares;
Issued and outstanding: 9,133,978 shares at 06/30/98 and
9,427,306 shares at 12/31/97 35,855 34,609
Other Comprehensive Income--Unrealized gain on marketable securities
66 107
Retained earnings 16,258 22,618
---------------- ----------------
Total shareholders' equity 52,179 57,334
---------------- ----------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 61,493 $ 66,056
================ ================
<FN>
The accompanying notes are an integral part of these consolidated financial
statements.
</FN>
</TABLE>
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<TABLE>
DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
FOR THE QUARTERS AND SIX MONTHS ENDED
JUNE 30, 1998 AND 1997
(Amounts in thousands, except per share amounts)
<CAPTION>
- ---------------------------------------------------------------------------------------------------------------------------
Quarter Ended Six Months Ended
June 30, June 30,
------------------------------- -------------------------------
1998 1997 1998 1997
---- ---- ---- ----
<S> <C> <C> <C> <C>
REVENUES:
Net sales $ 12,797 $ 17,033 $ 27,317 $ 33,071
Cost of sales 6,830 6,856 14,036 13,672
------------- ------------- -------------- -------------
Gross profit 5,967 10,177 13,281 19,399
------------- ------------- -------------- -------------
EXPENSES:
Research and development 3,567 2,594 6,389 5,627
Selling, general and administrative 4,965 5,768 9,988 10,683
Purchased research and development 2,299 - 2,299 -
------------- ------------- -------------- -------------
Total operating expenses 10,831 8,362 18,676 16,310
------------- ------------- -------------- -------------
Operating income / (loss) (4,864) 1,815 (5,395) 3,089
Other income 466 638 1,068 1,278
------------- ------------- -------------- -------------
Income / (loss) before provision for (4,398) 2,453 (4,327) 4,367
income taxes
Provision / (benefit) for income taxes (1,712) 748 (1,690) 1,331
------------- ------------- -------------- -------------
NET INCOME / (LOSS) $ (2,686) $ 1,705 $ (2,637) $ 3,036
============= ============= ============== =============
COMPREHENSIVE INCOME / (LOSS) $ (2,652) $ 1,747 $ (2,678) $ 2,962
EARNINGS PER SHARE (Basic)
Net income / (loss) per share $ (0.29) $ 0.19 $ (0.28) $ 0.33
Shares used in computing per share amounts 9,422 9,188 9,403 9,189
============= ============= ============== =============
EARNINGS PER SHARE (Diluted)
Net income / (loss) per share $ (0.29) $ 0.18 $ (0.28) $ 0.32
Shares used in computing per share amounts 9,422 9,506 9,403 9,541
============= ============= ============== =============
<FN>
The accompanying notes are an integral part of these consolidated financial
statements.
</FN>
</TABLE>
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<TABLE>
DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
FOR THE SIX MONTHS ENDED JUNE 30, 1998 AND 1997
(Amounts in thousands)
<CAPTION>
- -----------------------------------------------------------------------------------------------------------------
Six Months Ended
June 30,
--------------------------------------
1998 1997
---- ----
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income / (loss) $ (2,637) $ 3,036
Adjustments to reconcile net income / (loss) to net cash flows
provided by operating activities:
Depreciation and amortization 727 577
Amortization of goodwill 62
Purchased research and development 2,299
Changes in:
Accounts receivable 933 (411)
Inventories 319 (559)
Prepaid and other assets 341 (399)
Accounts payable 1,263 1,265
Accrued payroll and other accrued expenses (1,105) 51
Income taxes payable (882) (243)
------------- -----------
Net cash flows provided by operating activities 1,320 3,317
------------- -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of marketable securities (18,671) (7,020)
Maturities of marketable securities 21,948 8,073
Payment in connection with Acquisition of Semaphore Corporation 182 -
Acquisition of property and equipment (887) (1,007)
------------- -----------
Net cash flows provided by investing activities 2,572 46
------------- -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options 419 585
Repurchase of common stock (6,096) (1,946)
------------- -----------
Net cash flows used in financing activities (5,677) (1,361)
------------- -----------
Net increase / (decrease) in cash and cash equivalents (1,785) 2,002
Cash and cash equivalents at beginning of year 2,504 2,043
------------- -----------
Cash and cash equivalents at end of period $ 719 $ 4,045
============= ===========
<FN>
The accompanying notes are an integral part of these consolidated financial
statements.
</FN>
</TABLE>
5
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DIGITAL LINK CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared
by the Digital Link Corporation (the "Company" or "Digital Link")
without audit in accordance with generally accepted accounting
principles for interim financial information and pursuant to rules and
regulations of the Securities and Exchange Commission. In the opinion
of management, all adjustments (consisting of only normal recurring
adjustments) considered necessary for a fair representation have been
included. These financial statements should be read in conjunction with
the Company's consolidated financial statements and notes thereto
contained in the Company's Annual Report on Form 10-K for the year
ended December 31, 1997, which was filed with the Securities and
Exchange Commission on March 26, 1998.
The year-end balance sheet at December 31, 1997 was derived from
audited financial statements, but does not include all disclosures
required by generally accepted accounting principles.
Operating results for the three months and six months ended June 30,
1998 may not necessarily be indicative of the results to be expected
for any other interim period or for the full year.
<TABLE>
2. COMPUTATION OF NET INCOME / (LOSS) PER SHARE
Basic and diluted income / (loss) per share is computed in accordance
with Statement of Financial Accounting Standards No. 128 ("SFAS No.
128"). All per share amounts have been restated in accordance with SFAS
No. 128.
<CAPTION>
Quarter Ended Six Months Ended
June 30, June 30,
1998 1997 1998 1997
---- ---- ---- ----
Basic (in thousands, except per share data) (in thousands, except per share data)
- -----
<S> <C> <C> <C> <C>
Weighted average common shares outstanding for the 9,422 9,188 9,403 9,189
period
Shares used in computing per share amounts 9,422 9,188 9,403 9,189
Net income / (loss) $ (2,686) $ 1,705 $ (2,637) $ 3,036
Net income / (loss) per share $ (0.29) $ 0.19 $ (0.28) $ 0.33
</TABLE>
6
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<TABLE>
<CAPTION>
Quarter Ended Six Months Ended
June 30, June 30,
1998 1997 1998 1997
---- ---- ---- ----
Diluted (in thousands, except per share data) (in thousands, except per share data)
- -------
<S> <C> <C> <C> <C>
Weighted average number of shares outstanding for 9,422 9,188 9,403 9,189
the period
Common equivalent shares from conversion of stock - 318 - 352
options under treasury stock method
Shares used in computing per share amounts 9,422 9,506 9,403 9,541
Net income / (loss) $ (2,686) $ 1,705 $ (2,637) $ 3,036
Net income / (loss) per share $ (0.29) $ 0.18 $ (0.28) $ 0.32
</TABLE>
In the above computations, common equivalent shares totaling 20,563 and 73,469
for the quarter and six months ended June 30, 1998 respectively are excluded
from the diluted calculation as their effect is anti-dilutive.
3. INVENTORIES
Inventories are valued at the lower of cost (determined using the
first-in, first-out method) or market. Inventories consisted of (in
thousands):
June 30, 1998 December 31, 1997
------------- -----------------
(Unaudited)
Raw materials $2,649 $2,952
Work-in-process 2,569 2,275
Finished goods 3,074 2,936
------ ------
$8,292 $8,163
====== ======
4. CONTINGENCIES
Certain third parties have expressed their belief that certain of the
Company's products may infringe patents held by them and have suggested
that the Company acquire licenses to such patents. The Company believes
that licenses, to the extent required, will be available; however, no
assurance can be given that the terms of any offered licenses would be
favorable to the Company. Management, after review and consultation
with counsel, believes that the ultimate resolution of these
allegations is uncertain and there can be no assurance that these
assertions will be resolved without costly litigation or in a manner
that is not adverse to the Company. While the Company has accrued
certain amounts for these matters in prior years, it is currently
unable to
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estimate the possible loss or range of loss regarding these matters.
Therefore, the ultimate resolution of these matters could result in
payments in excess of the amounts accrued in the accompanying financial
statements and require royalty payments in the future which could
adversely impact gross margins.
In April 1996, a class action complaint was filed against the Company
and certain of its officers and directors in the Santa Clara Superior
Court of the State of California, alleging violations of the California
Corporations Code and California Civil Code. In October 1996, a similar
parallel lawsuit against the Company and the same individuals was filed
in the United States District Court for the Northern District of
California alleging violations of the federal securities laws. The
class period in both of these lawsuits runs from September 12, 1994
through December 29, 1995, and both complaints allege that the
defendants concealed and/or misrepresented material adverse information
about the Company and that the individual defendants sold shares of the
Company's stock based upon material nonpublic information. The
complaints seek unspecified monetary damages. To date, the Superior
Court has dismissed portions of plaintiff's state court complaint
without leave to amend. The Superior Court also dismissed five of the
individual defendants without the leave to amend. Plaintiff has filed a
third amended complaint that names the Company and three individual
defendants. Discovery to date has been limited in the state court
action, and the Superior Court has not set a trial date. In the federal
action, the Court granted the Company's motion to dismiss the federal
complaint with leave to amend on September 11, 1997, and plaintiff has
filed an amended complaint. The Company has moved to dismiss the
amended complaint. A hearing on the motion to dismiss the amended
complaint is scheduled for September 4, 1998. There has been no
discovery in the federal action, and no trial date has been set.
The Company believes that both actions are without merit and intends to
defend both actions vigorously. However, litigation is subject to
inherent uncertainties and, thus, there can be no assurance that these
lawsuits will be resolved favorably to the Company or that they will
not have a material adverse affect on the Company's financial condition
and results of operations. No provision for any liability that may
result upon adjudication has been made in the accompanying financial
statements.
5. RECENT ACCOUNTING PRONOUNCEMENT
The Company has adopted the provisions of Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income,"
effective January 1, 1998. This statement requires the disclosure of
comprehensive income and its components in a full set of general-
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purpose financial statements. Comprehensive income is defined as net
income plus revenues, expenses, gains and losses that, under generally
accepted accounting principles, are excluded from net income. The
component of comprehensive income, which is excluded by the Company
from net income is the change in the unrealized gain or loss on
securities, and this has been included in the computation of
comprehensive income.
In June 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 131, "Disclosures About Segments
of an Enterprise and Related Information" ("SFAS 131"), which
supersedes Statement of Financial Accounting Standards, "Financial
Reporting for Segments of a Business Enterprise" ("SFAS 14"). SFAS 131
changes current practice under SFAS 14 by establishing a new framework
on which to base segment reporting and also requires interim reporting
of segment information. This statement is effective for fiscal years
beginning after December 15, 1997. The statement's interim reporting
disclosures are not required until the first quarter immediately
subsequent to the fiscal year in which SFAS 131 is effective.
6. ACQUISITION OF ASSETS OF SEMAPHORE COMMUNICATIONS CORPORATION
On April 3, 1998, the Company entered into an Asset Sale Agreement (the
"Agreement") with Semaphore Communications Corporation, a Delaware
corporation ("Semaphore"), to acquire substantially all of Semaphore's
non-cash assets (excluding furniture and fixtures) (the "Assets"). This
acquisition of assets (the "Asset Acquisition") was consummated as of
such date. Semaphore is a supplier of security management and virtual
private network solutions for Internet/intranet and Frame relay
applications.
The Assets acquired pursuant to the Agreement include intellectual
property, inventory, trade receivables and rights under certain assumed
contracts. Under the terms of the Agreement, the Company issued 291,182
shares of the Company's Common Stock (the "Shares") to Semaphore,
valued at approximately $3,200,000, on April 3, 1998 and assumed
certain liabilities (the "Liabilities"). The Liabilities include
certain obligations under assumed contracts and under various
outstanding purchase orders as well as certain warranty obligations.
The Company received $182,000 from Semaphore with respect to the
assumption of certain of such Liabilities. In addition, in connection
with the Asset Acquisition, approximately 20 of Semaphore's employees
became employees of the Company.
9
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The following unaudited pro forma condensed combined results of
operations information has been presented to give effect to the
purchase as if such transaction had occurred at the beginning of each
of the periods presented. The historical results of operations have
been adjusted to reflect additional depreciation and amortization
expense based on the value allocated to assets acquired in the
purchase. In-process research and development costs in the amount of
$2,299,000 which were written off immediately after the purchase was
completed, have been included in the results of both periods presented.
The pro forma results of operations information is presented for
informational purposes only and is not necessarily indicative of the
operating results that would have occurred had the acquisition been
consummated as of the beginning of the periods presented, nor is it
necessarily indicative of future operating results.
Unaudited Pro Forma Condensed Combined Results of Operations
(amounts in thousands except per share data)
Six Months Ended June 30,
1998 1997
---- ----
Revenue $27,803 $34,072
Net loss (1,729) (2,357)
EARNINGS PER SHARE (BASIC)
Net loss per share $ (0.18) $ (0.25)
Shares used in per share calculation 9,694(1) 9,480(1)
EARNINGS PER SHARE (DILUTED)
Net loss per share $ (0.18) $ (0.25)
Shares used in per share calculation 9,694(1) 9,480(1)
(1) Shares used in the per share calculation reflect Digital Link shares issued
to Semaphore as if they were outstanding from the beginning of each period
presented and existing Digital Link Shares.
Shares used in pro forma income (loss) per share basic and diluted calculations
for the six months ended June 30,1998 are as follows (in thousands):
10
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Digital Link shares issued in asset acquisition 291(2)
Existing Digital Link shares 9,403
-----
9,694
Shares used in pro forma income (loss) per share basic and diluted calculations
for the six months ended June 30, 1997 are as follows (in thousands):
Digital Link shares issued in asset acquisition 291(2)
Existing Digital Link shares 9,189
-----
9,480
(2) The number of shares issues was determined by dividing $3,200,000 by the
volume-weighted average price per share (as reported by Bloomberg Financial
Services) at which Digital Link's common stock traded on the five business days
immediately preceding the execution of the Asset Sale Agreement by the parties.
DIGITAL LINK CORPORATION
ITEM 2. Management's Discussion And Analysis of Financial Condition and Results
of Operations
RESULTS OF OPERATIONS
Except for the historical statements contained herein, this Form 10-Q contains
forward looking statements within the meaning of Section 21E of the Securities
Exchange Act of 1934, as amended (the "Exchange Act"). These forward looking
statements involve a number of risks, known and unknown, and uncertainties, such
as the loss of, or difference in actual from anticipated levels of purchases
from, the Company's major customers, the impact of competitive products and
pricing, the ability to retain and attract key personnel and other risks which
are described throughout the Company's reports filed with the Securities and
Exchange Commission, including its Form 10-K for the year ended December 31,
1997, and within "Management's Discussion and Analysis of Financial Condition
and Results of Operations," including under the title "Other Factors That May
Affect Future Operating Results." The actual results that the Company achieves
may differ materially from any forward looking statements due to such risks and
uncertainties.
When used in this Form 10-Q words such as "believes," "anticipates," "expects,"
"intends," and similar expressions are intended to identify forward looking
statements, but are not the exclusive means of identifying such statements.
Readers are urged to carefully review and consider the various disclosures made
by the Company in this report and in the Company's reports filed with the
Securities and Exchange Commission that attempt to advise
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interested parties of the risks and factors that may affect the Company's
business.
Due to all the foregoing factors, the Company believes that period-to-period
comparisons of its results of operations are not necessarily meaningful and
should not be relied upon as an indication of future performance. Similarly,
past performances are not necessarily indicative of future results. It is likely
that, in some future quarters, the Company's operating results will be below the
expectations of stock market analysts and investors. In such event, the price of
the Company's Common Stock would likely be materially adversely affected.
Consequently, the purchase or holding of the Company's Common Stock involves an
extremely high degree of risk.
Net Sales
Net sales for the second quarter of 1998 decreased 25% to $12,797,000 from
$17,033,000 for the same period of the prior year. Net sales for the six months
ended June 30, 1998 decreased 17% to $27,317,000 from $33,071,000 for the same
period of the prior year. These decreases in net sales were primarily
attributable to a decrease in unit sales of broadband (i.e., transmission rates
in excess of T1/E1) products, as a result of lower sales to certain domestic
carrier customers, including MCI, and a decrease in the average selling prices
on certain broadband products as a result of price reductions made in 1997. The
Company anticipates that lower sales to certain domestic carrier customers will
continue for at least the remainder of 1998. In addition, the Company
anticipates that this increased pricing pressure will continue for the
foreseeable future. However, actual results could vary from the foregoing
forward looking statements in the prior two sentences due to, among other
factors set forth or referenced in "Other Factors That May Affect Future
Operating Results" below, and as a result of the loss of, or difference in
actual from anticipated levels of purchases from, the Company's major customers,
the impact of competitive products and pricing and other risks described
throughout this Form 10-Q.
Narrowband sales in absolute dollars remained flat but increased to 60% of net
sales in the second quarter of 1998 as compared to 45% in the second quarter of
1997. Broadband sales decreased in absolute dollars by 45% and decreased as a
percentage of net sales to 40% in the second quarter of 1998 as compared to 55%
in the second quarter of 1997. Narrowband sales in absolute dollars decreased by
1% but increased to 60% of net sales in the first six months of 1998 as compared
to 50% in the first six months of 1997. Broadband sales decreased in absolute
dollars by 34% and decreased as a percentage of net sales to 40% in the first
six months of 1998 as compared to 50% for the same period in 1997. The changes
in narrowband sales and broadband sales as a percentage of net sales were
primarily due to lower sales of broadband products to certain domestic carrier
customers, including MCI.
International sales, including Canada, represented 26% of net sales in the
second quarter of 1998 as compared to 19% in the second quarter of 1997, and 22%
of net sales for the first six months of 1998 as compared to 17% for the same
period of the prior year. These increases were
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primarily due to sales of the products developed by Semaphore Communications
Corporation ("Semaphore") that the Company acquired in connection with the
acquisition of Semaphore in April 1998. International sales are subject to
inherent risks, including difficulties in homologating products in other
countries, difficulties in staffing and managing foreign operations, greater
difficulty in accounts receivable collection, and unexpected changes in
regulatory requirements and tariffs, which may in the future contribute to
fluctuations in the Company's business and results.
Gross Profit
Gross profit decreased 41% in the second quarter of 1998 to $5,967,000 from
$10,177,000 for the same period of the prior year. Gross profit decreased to
46.6% of net sales in the second quarter of 1998 as compared to 59.7% in the
second quarter of 1997. Gross profit decreased 32% in the six months ended June
30, 1998 to $13,281,000 from $19,399,000 for the same period of the prior year.
Gross profit decreased to 48.6% of net sales for the first six months of 1998 as
compared to 58.7% for the same period of the prior year. These decreases in
gross profit are primarily a result of decreased sales volumes and the above
mentioned price reductions. Gross profits may vary significantly from quarter to
quarter depending on many factors including competitive pricing pressures and
changes in the mix of products sold. A significant portion of the Company's
business is very price competitive, which has in the past and will in the future
require the Company to lower its prices, resulting in fluctuations in the
Company's business and operating results. The Company anticipates that this
increased pricing pressure will continue for the foreseeable future. In
addition, the mix of products sold may change to include a higher percentage of
narrowband products which generally have lower gross margins and would therefore
adversely affect the Company's overall gross profits.
Research and Development
The primary types of expenses included in research and development ("R&D")
expenses are personnel, consulting, prototype materials and professional
services. R&D expenses increased 38% to $3,567,000 in the second quarter of 1998
from $2,594,000 in the second quarter of 1997. This increase was due primarily
to an increase in personnel-related expenses associated with the acquisition of
Semaphore. As a percentage of net sales, R&D expenses were 27.9% in the second
quarter of 1998 as compared to 15.2% in the second quarter of 1997. R&D
expenses increased 14% to $6,389,000 for the six months ended June 30, 1998 from
$5,627,000 for the same period of the prior year. As a percentage of net sales,
R&D expenses increased to 23.4% for the first six months of 1998 as compared to
17.0% for the same period of the prior year. The increases in R&D expenses as a
percentage of net sales primarily is due to lower sales volumes during the
second quarter and first six months of 1998. The absolute dollar increase for
the six-month period is attributable to
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higher personnel-related expenses associated with the acquisition of Semaphore.
The Company anticipates that its R&D expenses, excluding purchased R&D, for at
least the remainder of 1998 will continue to increase in absolute dollars and as
a percentage of sales as a result of the Company's acquisition of Semaphore and
the expected on-going development of the Semaphore technology. However, actual
results could vary from the foregoing forward looking statement due to, among
other factors set forth or referenced in "Other Factors That May Affect Future
Operating Results," below, the Company's ability to successfully develop and
market its products, and the Company's ability to accelerate or defer operating
expenses, achieve revenue levels during such periods and hire new personnel.
All of the Company's R&D expenditures to date have been expensed as incurred. In
the future, the Company may be required to capitalize a portion of its software
development costs pursuant to Statement of Financial Accounting Standards No.
86, "Accounting for Costs of Computer Software to be Sold, Leased or Otherwise
Marketed."
Selling, General and Administrative
The primary types of expenses included in selling, general and administrative
(SG&A) expenses are personnel, advertising, other promotional, and travel and
entertainment. SG&A expenses decreased 14% in the second quarter of 1998 to
$4,965,000 from $5,768,000 for the same period of the prior year. As a
percentage of net sales, SG&A expenses increased to 38.8% in the second quarter
of 1998 from 33.9% in the second quarter of 1997. SG&A expenses decreased 7% for
the six months ended June 30, 1998 to $9,988,000 from $10,683,000 for the same
period of the prior year. As a percentage of net sales, SG&A expenses increased
to 36.6% for the first six months of 1998 from 32.3% for the same period of the
prior year. The decreases in SG&A expenses in absolute dollars were primarily
due to lower personnel-related expenses and travel and entertainment, primarily
within the sales organization, and an decrease in consulting fees. The increases
in SG&A expenses as a percentage of net sales were primarily the result of lower
sales volumes during the second quarter and the first six months of 1998.
Purchased Research and Development
The Company incurred an expense of $2.3 million related to purchased research
and development for which technological feasibility had not been achieved in the
second quarter of 1998 related to the acquisition of Semaphore. Such in-process
technology was valued, along with other acquired assets, in
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accordance with valuation techniques commonly used in the technology industry
and was expensed upon acquisition in accordance with Financial Accounting
Standards No. 2, "Accounting for Research and Development Costs". See Notes 6 of
Notes to Financial Sections in this Form 10-Q.
Other Income
Other income primarily includes interest income. Other income decreased 27% in
the second quarter of 1998 to $466,000 from $638,000 for the same period of the
prior year. For the six months ended June 30, 1998, other income decreased 16%
to $1,068,000 from $1,278,000 for the same period of the prior year. These
decreases were primarily due to lower interest income due to lower interest
rates and lower cash balances.
Provision / Benefit for Income Taxes
The Company's effective tax rate increased to 39% for the second quarter and
first six months of 1998 compared to 30.5% for the same periods in 1997. This
increase is due primarily to the higher rate available assuming a carryback of
current year losses compared to the effective tax rate applicable if the Company
were profitable.
LIQUIDITY AND CAPITAL RESOURCES
The Company had working capital of $25.0 million and cash, cash equivalents and
marketable securities of $37.3 million at June 30, 1998. Net cash provided by
operating activities was $1.3 million for the first half of 1998 primarily due
to a write-off of purchased R&D, an increase in accounts payable and decrease in
accounts receivable, offset to some extent by net loss and a decrease in accrued
payroll and other accrued expenses. Net cash provided by operating activities
was $3.3 million for the first half of 1997 primarily as a result of a
generation of net income and an increase in accounts payable, offset to some
extent by an increase in inventories and accounts receivable. Cash provided by
investing activities during the first half of 1998 was primarily from the
maturity of marketable securities of $21.9 million offset by additional
purchases of marketable securities of $18.7 million. Cash provided by investing
activities during the first half of 1997 was primarily from the maturity of
marketable securities of $8.1 million offset by additional purchases of
marketable securities of $7.0 million. Leasehold improvements and capital
equipment additions were $887,000 in the first half of 1998 as compared to $1.0
million in the first half of 1997.
In May 1998, the Company approved the repurchase of up to an additional
1,000,000 shares of Common Stock for cash from time-to-time at market prices and
as market and business conditions warrant, in open market, negotiated, or
15
<PAGE>
block transactions. On October 17, 1996, the Company previously announced its
initial intentions to repurchase up to 500,000 shares of Common Stock, which
shares have been repurchased since that announcement. Net cash used in financing
activities was $5.7 million in the first half of 1998, primarily due to the
repurchase of common stock offset by the proceeds from the exercise of stock
options. Net cash used in financing activities was $1.4 million in the first
half of 1997, primarily from the repurchase of common stock offset by the
proceeds from the exercise of stock options and employee stock purchases. During
the first six months of 1998, the Company repurchased on the open market a total
of 646,500 shares of common stock at prices ranging from $6.8125 to $11.50 a
share. This stock has subsequently been retired.
The Company believes that existing cash and cash flows from operations will be
sufficient to meet its anticipated cash requirements for working capital and
capital expenditures for at least the next 12 months.
OTHER FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
In addition to the factors set forth above in the "Management's Discussion and
Analysis of Financial Condition and Results of Operations," there are a number
of other factors that may affect the Company's future operating results. Most of
the following discussion consists of forward looking statements and accompanying
risks.
The Company believes that the loss of, or difference in actual from anticipated
levels of purchases from, the Company's major customers have in the past
adversely affected the Company and could in the future adversely affect
operating results. A significant portion of the Company's business is derived
from substantial orders placed by large end users and telephone companies, and
the timing of such orders, including the completion of the build out of carrier
and network service providers infrastructures, could cause material fluctuations
in the Company's business and operating results. For example, in the fourth
quarter of 1997 and in the second quarter of 1998, the Company had lower
operating results than expected due in part to a weaker than expected demand
from certain domestic carrier customers including MCI. Other factors that may
cause fluctuations in the Company's operating results include, but are not
limited to, seasonal capital spending patterns of large domestic customers,
changes in the product mix sold toward narrowband products that yield lower
gross margins, the timing of new product announcements and introductions by the
Company and its competitors, changes in sales volumes through the Company's
distribution channels, market acceptance of new or enhanced versions of the
Company's products, availability and cost of components from the Company's
suppliers and economic conditions generally or in various geographic areas. In
addition, the Company's expense levels are based in part on its expectations of
future revenue. The Company operates with limited order backlog, and a
substantial
16
<PAGE>
majority of its revenues in each quarter result from orders booked in that
quarter. If revenue levels are below expectations, the Company may be unable to
adjust spending in a timely manner which would adversely affect operating
results. The Company's industry has in the last several years been characterized
by declining prices on existing products, therefore continual improvement of
manufacturing efficiencies and enhancements to existing products are required to
maintain gross margins.
The market for the Company's products is highly competitive. The Company expects
competition to increase in the future from existing competitors and from other
companies that may enter the Company's existing or future markets. In addition,
the Company faces competition from suppliers of internetworking equipment, such
as routers, and telephone equipment, such as switches, which are including a
direct WAN interface in certain of their products. An increased reliance by
customers on such suppliers for WAN access would reduce demand for the Company's
products, which would have a material adverse affect on the Company's business
and operating results. As discussed above, increased competition has also placed
increasing pressures on the pricing of the Company's products, which has
resulted in lower operating results. The Company anticipates that this pricing
pressure will continue for the foreseeable future.
The Company's future prospects will depend in part on its ability to enhance the
functionality of its existing WAN access products and DL7100 products (formerly
known as the W/ATM GateWay Products) in a timely manner and to identify, develop
and achieve market acceptance of new products that address new technologies and
meet customer needs in the WAN access market. Any failure by the Company to
anticipate or to respond adequately to competitive solutions, technological
developments in its industry, changes in customer requirements, or changes in
regulatory requirements or industry standards, or any significant delays in the
development, introduction or shipment of products, could have a material adverse
effect on the Company's business and operating results. There can be no
assurance that the Company's product development efforts will result in
commercially successful products or that product delays will not result in
missed market opportunities. In addition, customers could refrain from
purchasing the Company's existing products in anticipation of new product
introductions by the Company or its competitors. New products could also render
certain of the Company's existing products obsolete. Either of these events
could materially adversely affect the Company's business and operating results.
17
<PAGE>
The Company is currently developing and may in the future develop products with
which the Company has only limited experience and/or that are targeted at
emerging market segments, including the Company's DL7100 product. The Company
has experienced delays in the development of the DL7100 product, in part related
to technical problems that required some software to be redesigned. This became
available for revenue shipments in the second half of 1997. The Company has
experienced very limited customer interest to date in this product. The Company
continues to evaluate the long-term viability of the DL7100 product. Given its
complexity, there can be no assurance that this product will not encounter
further technical or other difficulties that could significantly delay its
deployment or acceptance or could result in the termination of the development
program for this product. There can be no assurance that the market for ATM
infrastructure products will continue to develop, that the DL7100 will meet the
needs of the emerging ATM market or any other market or, that products currently
available or under development by competitors will not directly compete with the
DL7100 product. The occurrence of any of these events could have a material
adverse affect on the Company's business and operating results.
The Company believes that its future success will depend in large part upon the
continued contributions of members of the Company's senior management and other
key personnel, and upon its ability to attract and retain highly skilled
managerial, engineering, sales, marketing and operations personnel, the
competition for whom is intense. Certain of the Company's key management
personnel have only recently joined the Company and certain personnel have only
limited experience in the Company's industry. In February 1998, Alan I. Fraser,
the Company's President and Chief Executive Officer resigned to pursue other
interests. Vinita Gupta, Chairman of the Board, assumed the responsibilities of
President and Chief Executive Officer upon Mr. Fraser's departure, and the
Company is searching for an individual to succeed Ms. Gupta as President and
Chief Executive Officer. In addition, the Company is searching for a Vice
President, Sales. The Company is also currently attempting to hire a number of
sales and engineering personnel and has experienced delays in filling such
positions. The current availability of qualified sales and engineering personnel
is quite limited, and competition among companies for such personnel is intense.
There can be no assurance that the Company will be successful in attracting and
retaining skilled personnel to hold these important positions.
The Company completed an acquisition of Performance Telecom in the third quarter
of 1997 and an acquisition of substantially all of the assets of Semaphore in
the second quarter of 1998 and may complete additional acquisitions in the
future. The process of integrating an acquired company's business into the
Company's operations may result in unforeseen operating difficulties and
expenditures and may absorb significant management attention that would
otherwise be available for the ongoing development of the Company's business.
Moreover, there can be no assurance that the anticipated benefits of an
acquisition will be realized. The Company
18
<PAGE>
has experienced declining revenues from the products acquired in the Performance
Telecom acquisition. In addition, acquisitions involve numerous risks, including
difficulties in managing diverse geographic sales and research and development
operations, risks of entering markets in which the Company has no or limited
direct prior experience, difficulties in the assimilation of the technologies
and products of the acquired companies and the potential loss of key employees
of the acquired company. The inability of the Company's management to respond to
changing business conditions effectively, including the changes associated with
its recent acquisitions, could have a material adverse affect on the Company's
business, financial condition and results of operations.
The Company has assessed and continues to assess the impact of the Year 2000
issue on its operations, including the development of cost estimates for, and
the extent of programming changes required to address, this issue. Although
final cost estimates have yet to be determined, it is anticipated that these
Year 2000 costs will not be material to the Company's expenses during 1998 and
1999. The Company does not currently have any information concerning the Year
2000 compliance status of its suppliers and customers. In the event that any of
the Company's significant suppliers or customers does not successfully and
timely achieve Year 2000 compliance, the Company's business or operations could
be adversely affected.
In April 1996, a class action complaint was filed against the Company and
certain of its officers and directors in the Santa Clara Superior Court of the
State of California, alleging violations of the California Corporations Code and
California Civil Code. In October 1996, a similar parallel lawsuit against the
Company and the same individuals was filed in the United States District Court
for the Northern District of California alleging violations of the federal
securities laws. The class period in both of these lawsuits runs from September
12, 1994 through December 29, 1995, and both complaints allege that the
defendants concealed and/or misrepresented material adverse information about
the Company and that the individual defendants sold shares of the Company's
stock based upon material nonpublic information. The complaints seek unspecified
monetary damages. To date, the Superior Court has dismissed portions of
plaintiff's state court complaint without leave to amend. The Superior Court
also dismissed five of the individual defendants without leave to amend and
another individual defendant with leave to amend. The Superior Court also denied
motions to dismiss filed by the Company and two other individual defendants with
respect to the remaining portions of the complaint. Plaintiff has filed a third
amended complaint that names the Company and three individual defendants.
Discovery to date has been limited in the state court action, and the Superior
Court has not set a trial date. On September 11, 1997, the Court granted the
Company's motion to dismiss the federal complaint with leave to amend, and
plaintiff has filed an amended complaint. The Company has moved to dismiss the
amended complaint. There has been no discovery in the federal action, and no
trial date has been set. The Company believes that both actions are without
merit and intends to defend
19
<PAGE>
both actions vigorously. However, litigation is subject to inherent
uncertainties and, thus, there can be no assurance that these lawsuits will be
resolved favorably to the Company or that they will not have a material adverse
affect on the Company's financial condition and results of operations. No
provision for any liability that may result upon adjudication has been made in
the accompanying financial statements.
The telecommunications industry is characterized by the existence of a large
number of patents and frequent litigation based on allegations of patent
infringement. For example, a third party has on several occasions expressed its
belief that certain of the Company's products, including its CSU/DSUs, may
infringe upon patents held by it and has suggested on such occasions that the
Company acquire a license to such patents. The Company believes that a license,
to the extent required, will be available; however, no assurance can be given
that the terms of any offered license would be favorable to the Company. Should
a license be unavailable, the Company could be required to discontinue the sale
of or to redesign certain of its products. In addition, Larscom, a competitor of
the Company, has continued to express its belief that the Company's inverse
multiplexer products may infringe a patent jointly owned by Larscom and a third
party and has suggested that the Company acquire a license to the patent. The
Company does not believe that there is merit to Larscom's claim. Management,
after review and consultation with counsel, believes that the ultimate
resolution of both these allegations is uncertain and there can be no assurance
that these assertions will be resolved without costly litigation or in a manner
that is not adverse to the Company. While the Company accrued certain amounts
for these matters in prior years, it is currently unable to estimate the
possible loss or range of loss regarding these matters. Therefore, the ultimate
resolution of these matters could result in payments in excess of the amounts
accrued in the accompanying financial statements and require royalty payments in
the future which could adversely impact gross margins. There can be no assurance
that other third parties will not assert infringement claims against the Company
in the future, that any such claims will not result in costly litigation or that
the Company will prevail in any such litigation or be able to license any valid
and infringed patents from third parties on commercially reasonable terms.
The risks outlined herein are difficult for the Company to forecast, and these
or other factors can materially affect the Company's operating results and stock
price for one quarter or a series of quarters. Further, in recent years the
stock market has experienced extreme price and volume fluctuations that have
particularly affected the market prices of securities of many high technology
companies, for reasons frequently unrelated to the operating performance of the
specific companies. These fluctuations, as well as general economic, political
and market conditions may materially adversely affect the market price of the
Company's common stock.
20
<PAGE>
The Company has adopted the provisions of Statement of Financial Accounting
Standards No. 130, "Reporting Comprehensive Income," effective January 1, 1998.
This statement requires the disclosure of comprehensive income and its
components in a full set of general-purpose financial statements. Comprehensive
income is defined as net income plus revenues, expenses, gains and losses that,
under generally accepted accounting principles, are excluded from net income.
The component of comprehensive income, which is excluded from net income, is the
change in the unrealized gain or loss on securities and has been included in the
computation of comprehensive income.
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131, "Disclosures About Segments of an
Enterprise and Related Information" ("SFAS 131"), which supersedes Statement of
Financial Accounting Standards, "Financial Reporting for Segments of a Business
Enterprise" ("SFAS 14"). SFAS 131 changes current practice under SFAS 14 by
establishing a new framework on which to base segment reporting and also
requires interim reporting of segment information. This statement is effective
for fiscal years beginning after December 15, 1997. The statement's interim
reporting disclosures are not required until the first quarter immediately
subsequent to the fiscal year in which SFAS 131 is effective.
ITEM 3. Quantitative and Qualitative Disclosure About Market Risk
Not Applicable.
21
<PAGE>
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company and certain of its officers and directors are parties to various
lawsuits described in paragraphs two and three in Note 4 of Notes to
Consolidated Financial Statements in Part I of this Form 10-Q. See also the
Company's Form 10-Q for the period ended March 31, 1998 and its Form 10-K for
the period ended December 31, 1997 for previous disclosures about such lawsuits.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
On April 3, 1998, the Company entered into an Asset Sale Agreement (the
"Agreement") with Semaphore Communications Corporation, a Delaware corporation
("Semaphore"), to acquire substantially all of Semaphore's non-cash assets
(excluding furniture and fixtures) (the "Assets"). This acquisition of assets
(the "Asset Acquisition") was consummated as of such date. The Assets acquired
pursuant to the Agreement include intellectual property, inventory, trade
receivables and rights under certain assumed contracts. Under the terms of the
Agreement, the Company issued 291,182 shares of the Company's Common Stock (the
"Shares"), valued at approximately $3,200,000, to Semaphore on April 3, 1998 and
assumed certain liabilities (the "Liabilities"). The Liabilities include certain
obligations under assumed contracts and under various outstanding purchase
orders as well as certain warranty obligations. The Company received $182,000
from Semaphore with respect to the assumption of certain of such Liabilities.
The Shares issued to Semaphore in the Asset Acquisition were issued in a private
placement pursuant to the exemption from registration under the Securities Act
of 1933, as amended, under Section 4(2) of such Act.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On May 20, 1998, the Company held its annual meeting of shareholders. At that
meeting, the Company's six incumbent directors were reelected to office by the
following vote:
Votes
Name Votes for Withheld
- ---- --------- --------
Vinita Gupta 8,678,410 12,678
Richard C. Alberding 8,678,560 12,528
Gregory M. Avis 8,678,560 12,528
Lance B. Boxer 8,678,560 12,528
22
<PAGE>
Alan I. Fraser 8,641,806 49,282
Narendra K. Gupta 8,676,410 12,678
Also at that meeting, the shareholders ratified the selection of
PricewaterhouseCoopers, L.L.P. as independent auditors for the Company's current
fiscal year, with 8,658,853 votes for, 2,800 votes against, and 29,435 votes
abstaining.
ITEM 5. OTHER INFORMATION
Not applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
27.01 Financial Data Schedule.
(b) Reports on Form 8-K
The Company filed a report on Form 8-K on April 17, 1998 and a report
on Form 8-K/A on June 16, 1998 in connection with the acquisition of
assets of Semaphore Communications Corporation. The Form 8-K provided
information under Items 2 and 7 with respect to the Semaphore
acquisition and the Form 8-K/A provided information under Item 7 with
respect to such acquisition, including audited financial statements of
Semaphore as of December 31, 1996 and 1997 and for the years then ended
and unaudited pro forma condensed combined Statements of Operations for
the year ended December 31, 1997 and the three months ended March 31,
1998 and an unaudited pro forma condensed combined Balance Sheet as of
March 31, 1998.
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.
DIGITAL LINK CORPORATION
Date: August 14, 1998 /s/ Stanley E. Kazmierczak
------------------------------
Stanley E. Kazmierczak
23
<PAGE>
Vice President, Finance and
Administration, Chief Financial Officer
and Secretary
(Duly Authorized Officer and Principal
Financial Officer)
24
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