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 March 31, 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 May 13,
1998, was 9,472,978 shares.
<PAGE>
DIGITAL LINK CORPORATION
INDEX TO FORM 10-Q
Page
PART I - FINANCIAL INFORMATION:
ITEM 1 - Financial Statements
Consolidated Balance Sheets as of March 31, 1998 3
and December 31, 1997
Consolidated Statements of Income and Comprehensive Income
for the three months ended March 31, 1998 and March 31, 1997 4
Consolidated Statements of Cash Flows for the three 5
months ended March 31, 1998 and March 31, 1997
Notes to Consolidated Financial Statements 6
ITEM 2 - Management's Discussion and Analysis of 10
Financial Condition and Results of Operations
ITEM 3 - Quantitative and Qualitative Disclosures About 17
Market Risk
PART II - OTHER INFORMATION
ITEM 1 - Legal Proceedings 18
ITEM 2 - Changes in Securities and Use of Proceeds 18
ITEM 3 - Defaults Upon Senior Securities 18
ITEM 4 - Submission of Matters to a Vote of Security Holders 18
ITEM 5 - Other Information 18
ITEM 6 - Exhibits and Reports on Form 8-K 18
SIGNATURE(S) 20
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements
- ------- --------------------
DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share amounts)
- ----------------------------------------------------------------------------
<TABLE>
<CAPTION>
March 31, December 31,
1998 1997
------------- --------------
(Unaudited)
ASSETS
CURRENT ASSETS:
<S> <C> <C>
Cash and cash equivalents ............................................. $ 7,824 $ 2,504
Short-term marketable securities ...................................... 9,838 18,026
Accounts receivable, less allowance for doubtful accounts of $534 at
3/31/98 and $517 at 12/31/97 ..................................... 6,802 5,193
Inventories ........................................................... 6,984 8,163
Prepaid and other current assets ...................................... 1,413 1,433
Deferred income taxes ................................................. 2,304 2,304
------- -------
Total current assets ......................................... 35,165 37,623
Property and equipment at cost, net ................................... 3,281 3,325
Long-term marketable securities ....................................... 24,799 21,899
Deferred income taxes ................................................. 2,062 2,062
Other assets .......................................................... 1,149 1,147
------- -------
TOTAL ASSETS ................................................. $66,456 $66,056
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable ...................................................... $ 3,510 $ 2,407
Accrued payroll expense ............................................... 2,600 2,344
Other accrued expenses ................................................ 3,254 3,785
Income taxes payable .................................................. 1,167 186
------- -------
Total current liabilities .................................... 10,531 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: 9,314,006 shares at 3/31/98 and 9,427,306
shares at 12/31/97 ............................................... 34,195 34,609
Unrealized gain on marketable securities .............................. 32 107
Retained earnings ..................................................... 21,698 22,618
------- -------
Total shareholders' equity ................................... 55,925 57,334
------- -------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY ................... $66,456 $66,056
======= =======
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE>
DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME
(Unaudited)
FOR THE THREE MONTHS ENDED
MARCH 31, 1998 AND 1997
(Amounts in thousands, except per share amounts)
- --------------------------------------------------------------------------------
Three Months Ended
March 31,
--------------------
1998 1997
---- ----
REVENUES:
Net sales ..................................... $ 14,519 $ 16,038
Cost of sales ................................. 7,204 6,816
-------- --------
Gross profit ........................... 7,315 9,222
-------- --------
EXPENSES:
Research and development ...................... 2,822 3,032
Selling, general and administrative ........... 5,023 4,916
-------- --------
Total operating expenses ............... 7,845 7,948
-------- --------
Operating income (loss) ................ (530) 1,274
Other income .................................. 601 641
-------- --------
Income before provision for income taxes 71 1,915
Provision for income taxes .................... 22 583
-------- --------
NET INCOME ............................. $ 49 $ 1,332
======== ========
COMPREHENSIVE INCOME .......................... $ (26) $ 1,216
======== ========
EARNINGS PER SHARE (Basic)
Net income (loss) per share ................... $ 0.01 $ 0.14
======== ========
Shares used in computing per share amounts .... 9,383 9,190
======== ========
EARNINGS PER SHARE (Diluted)
Net income (loss) per share ................... $ 0.01 $ 0.14
======== ========
Shares used in computing per share amounts .... 9,436 9,577
======== ========
The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE>
DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
FOR THE THREE MONTHS ENDED MARCH 31, 1998 AND 1997
(Amounts in thousands)
- --------------------------------------------------------------------------------
<TABLE>
<CAPTION>
Three Months Ended
March 31,
-----------------------
1998 1997
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
<S> <C> <C>
Net income ................................................. $ 49 $ 1,332
Adjustments to reconcile net income to net cash flows
provided by operating activities:
Depreciation and amortization ........................... 428 323
Amortization of goodwill ................................ 28 0
Provision for doubtful accounts ......................... 18 62
Provision for excess and obsolete inventories ........... 33 58
Accounts receivable ............................... (1,627) 127
Inventories ....................................... 1,146 (116)
Prepaid and other assets .......................... (10) (516)
Accounts payable .................................. 1,103 1,026
Accrued payroll and other accrued expenses ........ (275) (107)
Income taxes payable .............................. 981 475
-------- --------
Net cash flows provided by operating activities 1,874 2,664
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of marketable securities ......................... (9,487) (1,030)
Maturities of marketable securities ........................ 14,700 4,340
Acquisition of property and equipment ...................... (384) (485)
-------- --------
Net cash flows provided by investing activities 4,829 2,825
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options .................... 42 138
Repurchase of common stock ................................. (1,425) (1,946)
-------- --------
Net cash used in financing activities ......... (1,383) (1,808)
-------- --------
Net increase in cash and cash equivalents 5,322 3,681
Cash and cash equivalents at beginning of year ............. 2,504 2,043
-------- --------
Cash and cash equivalents at end of period ................. $ 7,824 $ 5,724
======== ========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
<PAGE>
DIGITAL LINK CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared
by the Company 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,
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 ended March 31, 1998 may not
necessarily be indicative of the results to be expected for any other
interim period or for the full year.
2. COMPUTATION OF NET INCOME PER SHARE
Basic and diluted income 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.
<TABLE>
<CAPTION>
Quarter Ended
March 31, March 31,
1998 1997
---- ----
Basic (in thousands, except per share data)
<S> <C> <C>
Weighted average common shares outstanding for
the period .......................................... 9,383 9,191
Shares used in computing per share amounts .......... 9,383 9,191
====== ======
Net income .......................................... $ 49 $1,332
------ ------
Net income per share ................................ $ 0.01 $ 0.14
====== ======
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
Quarter Ended
March 31, March 31,
1998 1997
---- ----
Diluted (in thousands, except per share data)
<S> <C> <C>
Weighted average number of shares outstanding for
the period ........................................... 9,383 9,191
Common equivalent shares from conversion of stock
options under treasury stock method .................. 53 386
------ ------
Shares used in computing per share amounts ........... 9,436 9,577
====== ======
Net income ........................................... $ 49 $1,332
------ ------
Net income per share ................................. $ 0.01 $ 0.14
====== ======
</TABLE>
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):
March 31, 1998 December 31, 1997
-------------- -----------------
(Unaudited)
Raw materials $2,698 $2,952
Work-in-process 2,455 2,275
Finished goods 1,831 2,936
------ ------
$6,984 $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 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.
<PAGE>
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 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 PRONOUNCEMENTS
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.
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
currently located in Semaphore's Santa Clara, California headquarters
are expected to become employees of the Company.
<PAGE>
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 Digital Link
Corporation (the "Company" or "Digital Link") 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 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 first quarter of 1998 decreased 9% to $14,519,000 from
$16,038,000 for the same period of the prior year. This decrease in net sales
was primarily attributable to a decrease in unit sales of broadband (i.e.,
transmission rates in excess of T1/E1) products, primarily as a result of lower
sales to certain domestic carrier customers 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 second quarter of 1998. The
Company does not believe that the percentage change in net sales in the first
quarter of 1998 as compared to the same period of the prior year is necessarily
indicative of the percentage change in net sales to be expected for the entire
fiscal year.
Narrowband sales in absolute dollars decreased by 2% and increased to 60% of net
sales in the first quarter of 1998 as compared to 56% in the first quarter of
1997. Broadband sales decreased in absolute dollars by 19% and decreased as a
percentage of net sales to 40% in the first quarter of 1998 as compared to 44%
in the first quarter of 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.
International sales (including sales in Canada) represented 19% of net sales in
the first quarter of 1998 as compared to 14% in the first quarter of fiscal
1997. This increase was primarily due to an increase in unit sales in Europe of
the Company's narrowband and broadband products. 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, unexpected changes in regulatory
requirements and tariffs, and potentially adverse tax consequences, which may in
the future contribute to fluctuations in the Company's business and operating
results.
Gross Profit
Gross profit decreased 21% in the first quarter of 1998 to $7,315,000 from
$9,222,000 for the same period of the prior year. Gross margin decreased to
50.4% of net sales in the first quarter of 1998 as compared to 57.5% in the
first quarter of 1997. This decrease in gross margin is primarily a result of
decreased sales volumes and the above mentioned price reductions. Gross margins
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 at least
throughout 1998. 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
margins.
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 decreased 7% to $2,822,000 in the first quarter of 1998
from $3,032,000 in the first quarter of 1997. This decrease is primarily due to
lower consulting fees and material cost for prototype products, offset to some
extent by higher personnel related costs related to the Company's DL7100
product. As a percentage of net sales, R&D expenses were 19.4% in the first
quarter of 1998 as compared to 18.9% in the first quarter of 1997. This increase
as a percentage of net sales was primarily the result of lower net sales in the
first quarter of 1998 as compared to the first quarter of 1997. 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
Communications Corporation ("Semaphore") and the expected on-going development
with 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 accelerate or defer operating expenses, achieve revenue
levels during such periods and hire new personnel.
In addition, the Company will expense, in the range of $1.8 million to $2.5
million, purchased R&D in the second quarter of 1998 as a result of the
acquisition of Semaphore. See Note 6 to Consolidated Financial Statements in
Part I of this Form 10-Q.
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 increased 2% in the first quarter of 1998 to
$5,023,000 from $4,916,000 for the same period of the prior year. The increase
in absolute dollars was primarily the result of higher personnel-related
expenses, primarily within the sales and marketing organization. As a percentage
of net sales, SG&A expenses increased to 34.6% in the first quarter of fiscal
1998 as compared to 30.7% in the first quarter of fiscal 1997. The increase as a
percentage of net sales was primarily the result of lower sales volumes.
Other Income
Other income includes primarily interest income. Other income decreased 6% in
the first quarter of 1998 to $601,000 from $641,000 for the same period of the
prior year. This decrease was primarily due to lower interest income due to
lower interest rates.
Provision for Income Taxes
The Company's effective tax rate increased to 30.5% for the first quarter of
1998 compared to 30.4% for the first quarter of 1997.
LIQUIDITY AND CAPITAL RESOURCES
The Company had working capital of $24.6 million and cash, cash equivalents and
marketable securities of $42.5 million at March 31, 1998. Net cash provided by
operating activities was $1.9 million for the first three months of 1998,
primarily as a result of a decrease in inventories, an increase in accounts
payable and income taxes payable and net income before depreciation and
amortization, offset by an increase in accounts receivable. This compares to net
cash provided by operating activities of $2.7 million for the first three months
of 1997, primarily as a result of net income before depreciation and
amortization and an increase in accounts payable, offset to some extent by an
increase in prepaid and other expenses. Cash provided by investing activities
during the first three months of 1998 was primarily from the maturity of
marketable securities of $14.7 million offset by additional purchases of $9.5
million. Cash provided by investing activities during the first three months of
1997 was primarily from the maturity of marketable securities of $4.3 million
offset by additional purchases of $1.0 million. Leasehold improvements and
capital equipment additions were $384,000 in the first quarter of 1998 as
compared to $485,000 in the first quarter of 1997.
In October 1996, the Company approved the repurchase of up to 500,000 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 block transactions.
During the first three months of 1998, the Company repurchased on the open
market a total of 131,000 shares of common stock at a price ranging from $10.50
to $11.50 a share. This stock has subsequently been retired. Net cash used in
financing activities was $1.4 million and $1.8 million, respectively for the
first three months of 1998 and 1997 due mainly to the repurchase of common stock
as discussed above, offset in part by the proceeds from the exercise of stock
options.
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 Conditions and Results of Operations," there are a number
of other factors that may affect the Company's future operating results.
The Company believes that the loss of, or difference in actual from anticipated
levels of purchases from, the Company's major customers could in the future
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 ISP infrastructures, could cause material fluctuations in the
Company's business and operating results. For example, in the fourth quarter of
1997, the Company had lower operating results than expected due in part to a
weaker than expected demand from certain domestic carrier customers. 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, completion of the build out of carrier and ISP
infrastructures, 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 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 at least through 1998.
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 recently began 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. 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'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.
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
does not anticipate that revenue from shipments of the DL7100 will become a
significant portion of the Company's revenue until at least 1999, if at all.
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 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 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
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.
<PAGE>
ITEM 3. Quantitative and Qualitative Disclosures About Market Risk
- ------- ----------------------------------------------------------
Not Applicable.
<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.
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
- ------- ---------------------------------------------------
Not applicable.
ITEM 5. OTHER INFORMATION
- ------- -----------------
Not applicable.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
- ------- --------------------------------
(a) Exhibits
2.01 Asset Sale Agreement between Registrant and Semaphore Communications
Corporation dated April 3, 1998. (1)
4.01 Registration Rights Agreement between Registrant and Semaphore
Communications Corporation dated April 3, 1998. (1)
10.22 Separation Agreement between Registrant and Jack A. Musgrove
dated March 16, 1998.
27.01 Financial Data Schedule
-----
(1) Filed as an exhibit to Registrant's Form 8-K filed on April 17, 1998
and incorporated herein by reference.
(b) Reports on Form 8-K
There were no reports on Form 8-K filed during the quarter ended March
31, 1998. After the end of such quarter, the Company filed a report on Form 8-K
on April 17, 1998 in connection with the Semaphore acquisition.
<PAGE>
SIGNATURES
----------
Pursuant to the requirements of the Securities and 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: May 13, 1998 /s/ Stanley E. Kazmierczak
----------------------------
Stanley E. Kazmierczak
Vice President, Finance and Administration,
Chief Financial Officer and Secretary
(Duly Authorized Officer and Principal
Financial Officer)
<PAGE>
EXHIBIT INDEX
-------------
Exhibits
- --------
2.01 Asset Sale Agreement between Registrant and Semaphore
Communications Corporation dated April 3, 1998. (1)
4.02 Registration Rights Agreement between Registrant and Semaphore
Communications Corporation dated April 3, 1998. (1)
10.22 Separation Agreement between Registrant and Jack A. Musgrove
dated March 16, 1998.
27.01 Financial Data Schedule
-----
(1) Filed as an exhibit to Registrant's Form 8-K filed on April 17,
1998 and incorporated herein by reference.
Exhibit 10.22
March 16, 1998
Mr. Jack Musgrove
33206 Falcon Drive
Fremont, CA 94555
Re: Separation Terms
Dear Jack,
This letter confirms the terms of your separation from your employment with
Digital Link Corporation.
1. Termination Date. Your employment with the Company is terminated effective
March 16, 1998.
2. Acknowledge of Payment of Wages. We herewith deliver to you a final paycheck
for all accrued wages, salary, bonuses, accrued but unused PTO and any similar
payments due and owing to you from the Company as of the termination date. You
also have 10,000 shares of the Company's Common Stock available to purchase from
stock option grant # 1458 pursuant to the terms and condition of the grant. You
have no other vested options. Your rights under ESPP will be governed by the
provisions of the plan.
3. COBRA Coverage. Your health coverage expires March 31, 1998. You have the
option, at your own expense, to extend the health insurance coverage currently
provided by the Company for a period of 18 months from March 31, 1998 pursuant
to the terms and conditions of COBRA. You have 60 days from the termination date
to notify the Company in writing of your election to so continue your
continuation coverage. You will receive a packet, by certified mail, from the
Company providing additional information regarding your COBRA benefits.
4. Payment. In addition, it has been agreed that you will receive additional
compensation for 6 months of base pay as severance pay. The Company will also
pay an amount equal to your current health insurance benefits for a period of 6
months beginning April 1, 1998. In addition, the Company will pay $15,000 for
documented outplacement services for assistance in finding new employment. These
severance benefits are in addition to any amounts due you from the Company and
are given as consideration for the release set forth below. All normal
withholding will be applied to the 6 months of severance pay.
If you choose to sign this agreement, you will then be given seven (7) days
after you sign the agreement to revoke it and the agreement will not be
effective until after this seven-day period has lapsed. You also acknowledge
that the Company will not begin your severance benefits until seven days from
the time you sign this agreement has expired.
5. Return of Company Property. You hereby represent and warrant to the Company
that you will return to the Company any and all property or data of the Company
of any type whatsoever that may have been in your possession or control by March
20, 1998.
6. Proprietary Information. You hereby acknowledge that you are bound by the
attached Employee Invention Assignment and Confidentiality Agreement, dated
September 18, 1995, that as a result of your employment with the Company you
have had access to the Proprietary Information (as defined in such agreement) of
the Company, that you will hold all such Proprietary Information in strictest
confidence and that you may not make any use of such Proprietary Information on
behalf of any third party. You further confirm that you have delivered to the
<PAGE>
Company all documents and data of any nature containing or pertaining to such
Proprietary Information and that you have not take with you any such documents
or data or any reproduction thereof.
7. Waiver of Claims. The payments and agreements set forth in this Agreement are
in full satisfaction of any and all accrued salary, PTO pay, bonus pay,
profit-sharing, termination benefits or other compensation to which you may be
entitled by virtue of your employment with the Company or your termination of
employment. You hereby release and waive any and all claims you may have against
the Company or any of their officers, directors, employees, managers,
shareholders, partners, agents, attorneys, subsidiaries, successors, and
assigns, including without limitation claims for any additional compensation or
benefits arising out of the termination of your employment, any claims of
wrongful termination, breach of contract or discrimination under state or
federal law, and any claims you may have based on age or under the Age
Discrimination in Employment Act or Older Workers Benefit Protection Act. This
section 7 shall remain in full force and effect even if there is a breach of
this Agreement by either party.
You hereby expressly waive any benefits of Section 1542 of the Civil Code of the
State of California, or any other state law of similar effect, which provides as
follows:
" A GENERAL RELEASE DOES NOT EXTEND TO CLAIMS WHICH THE CREDITOR DOES
NOT KNOW OR SUSPECT TO EXIST IN HER FAVOR AT THE TIME OF EXECUTING THE
RELEASE, WHICH IF KNOWN BY HER MUST HAVE MATERIALLY AFFECTED HER
SETTLEMENT WITH THE DEBTOR."
8. Review of Severance Agreement You acknowledge your understanding that you may
take up to twenty-one (21) days to consider this Agreement and that you have
been advised to consult with an attorney prior to executing this Agreement. You
further acknowledge that you understand that you may revoke your agreement
within seven (7) days of your execution of this document and that the
consideration to be paid to you pursuant to paragraph 4 above for your agreement
will be paid only at the end of that seven (7) day revocation period.
9. Nondisparagement. You agree that you will not disparage the Company or its
products, services, agents, representatives, directors, officers, shareholder,
attorneys, employees, vendors, affiliates, successors or assigns, or any person
acting by, through, under or in concert with any of them, with any written or
oral statement.
10. Legal and Equitable Remedies. You agree that the Company shall have the
right to enforce this Agreement and any of its provisions by injunction,
specific performance or other equitable relief without prejudice to any other
rights or remedies the Company may have at law or in equity for breach of this
Agreement.
11. Attorney's Fees. If any action at law or in equity is brought to enforce the
terms of the Agreement, the prevailing party shall be entitled to recover its
reasonable attorneys' fees, costs and expenses from the other party, in addition
to any other relief to which such prevailing party may be entitled.
12. Confidentiality. The contents, terms and conditions of the Agreement shall
be kept confidential by you and shall not be disclosed except to your attorneys
or pursuant to subpoena or court order. Any breach of this confidentiality
provision shall be deemed a material breach of this Agreement.
13. No Admission of Liability. This Agreements is not and shall not be construed
or contended by you to be an admission or evidence of any wrongdoing or
liability on the part of the Company, its representatives, heirs, executors,
attorneys, agents, partners, officers, shareholders, directors, employees,
subsidiaries, affiliates, divisions, successors or assigns. This Agreement shall
be afforded the maximum protection allowable under California Evidence Code
Section 1152 and/or any other state or Federal provisions of similar effect.
<PAGE>
14. Entire Agreement. This Agreement constitutes the entire agreement between
you and the Company with respect to the subject material hereof and supersedes
all prior negotiations and agreements, whether written or oral, relating to such
subject matter. You acknowledge that neither the Company nor its agents or
attorneys, have made any promise, representation or warranty whatsoever, either
express or implied, written or oral, which is not contained in this Agreement
for the purpose of inducing you to execute the Agreement, and you acknowledge
that you have executed this Agreement in reliance only upon such promises,
representations and warranties as are contained herein.
15. Modification. It is expressly agreed that this Agreement may not be altered,
amended, modified, or otherwise changed in any respect except by another written
agreement that specifically refers to this Agreement, duly executed by
authorized representatives of each the parties hereto.
If this letter accurately sets forth the terms of your separation from the
Company, please sign the attached copy and return it to the undersigned
postmarked no later than April 6, 1998.
Very truly yours,
/s/ Vinita Gupta
Vinita Gupta
Chairman and Chief Executive Officer
READ, UNDERSTOOD, AND AGREED
/s/ Jack A. Musgrove 3/26/98
- ----------------------- ------------
Signature Date
Jack A. Musgrove
- ------------------
Print Name
<PAGE>
March 25, 1998
Mr. Jack Musgrove
33206 Falcon Drive
Fremont, CA 94555
Re: Addendum to Separation Term Letter Dated March 16, 1998
Dear Jack,
Item number 2 was incorrect in our letter, dated March 16, 1998, regarding the
status of your stock options. As the attached document indicates, you do have
5,208 shares vested in stock option grant #000627. In addition to the benefits
listed under item number 4, we will provide you $5,000 in lieu of an extra six
months of vesting on stock option grant #000627.
You will receive this benefit, in addition to the benefits listed in item number
4, as consideration for the release set forth in the letter. If you decide to
execute the March 16, 1998 letter you will receive the additional $5,000 seven
days following the date you sign the agreement.
If you have any questions regarding the terms stated above please call.
Regards,
/s/ Dianne Mastilock
Dianne Mastilock
Vice President, Human Resources
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
consolidated balance sheet, consolidated statement of income and consolidated
statement of cash flows included in the Company's Form 10-Q for the period
ending March 31, 1998, and is qualified in its entirety by reference to such
financial statements.
</LEGEND>
<CIK> 0000810467
<NAME> Digital Link Corporation
<MULTIPLIER> 1
<CURRENCY> U.S. Dollars
<S> <C>
<PERIOD-TYPE> 3-Mos
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> MAR-31-1998
<EXCHANGE-RATE> 1.000
<CASH> 7,824
<SECURITIES> 9,838
<RECEIVABLES> 6,802
<ALLOWANCES> 534
<INVENTORY> 6,984
<CURRENT-ASSETS> 35,165
<PP&E> 10,447
<DEPRECIATION> 7,166
<TOTAL-ASSETS> 66,456
<CURRENT-LIABILITIES> 10,531
<BONDS> 0
0
0
<COMMON> 34,195
<OTHER-SE> 21,730
<TOTAL-LIABILITY-AND-EQUITY> 66,456
<SALES> 14,519
<TOTAL-REVENUES> 14,519
<CGS> 7,204
<TOTAL-COSTS> 15,049
<OTHER-EXPENSES> (601)
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 71
<INCOME-TAX> 22
<INCOME-CONTINUING> 49
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 22
<EPS-PRIMARY> 0.01
<EPS-DILUTED> 0.01
</TABLE>
