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 September 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 November
11, 1998 was 8,973,672 shares.
<PAGE>
DIGITAL LINK CORPORATION
INDEX TO FORM 10-Q
Page
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PART I - FINANCIAL INFORMATION:
ITEM 1 - Financial Statements
Consolidated Balance Sheets as of September 30, 1998 3
and December 31, 1997
Consolidated Statements of Operations for the quarters 4
and nine months ended September 30, 1998 and 1997
Consolidated Statements of Cash Flows for the nine 5
months ended September 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 19
Market Risk
PART II - OTHER INFORMATION
ITEM 1 - Legal Proceedings 20
ITEM 2 - Changes in Securities and Use of Proceeds 20
ITEM 3 - Defaults Upon Senior Securities 20
ITEM 4 - Submission of Matters to a Vote of Security Holders 20
ITEM 5 - Other Information 20
ITEM 6 - Exhibits and Reports on Form 8-K 20
SIGNATURE(S) 21
2
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PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements
<TABLE>
DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share amounts)
- ------------------------------------------------------------------------------------------------------------------------------------
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
(Unaudited)
<S> <C> <C>
ASSETS
CURRENT ASSETS:
Cash and cash equivalents $ 6,105 $ 2,504
Short-term marketable securities 11,805 18,026
Accounts receivable, less allowance for doubtful accounts of $437 at
9/30/98 and $517 at 12/31/97 4,857 5,193
Inventories 5,411 8,163
Prepaid and other current assets 1,072 1,433
Income taxes receivable 2,150 0
Deferred income taxes 2,773 2,304
------- -------
Total current assets 34,173 37,623
Property and equipment at cost, net 2,821 3,325
Long-term marketable securities 18,565 21,899
Deferred income taxes 2,992 2,062
Other assets 390 1,147
------- -------
TOTAL ASSETS $58,941 $66,056
======= =======
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 4,305 $ 2,407
Accrued payroll expense 2,032 2,344
Other accrued expenses 4,980 3,785
Income taxes payable 0 186
------- -------
Total current liabilities 11,317 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: 9,066,678 shares at 09/30/98 and
9,427,306 shares at 12/31/97 35,587 34,609
Other comprehensive income -unrealized gain on marketable securities 87 107
Retained earnings 11,950 22,618
------- -------
Total shareholders' equity 47,624 57,334
------- -------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $58,941 $66,056
======= =======
<FN>
The accompanying notes are an integral part of these consolidated financial statements.
</FN>
</TABLE>
3
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<TABLE>
DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
FOR THE QUARTERS AND NINE MONTHS ENDED
SEPTEMBER 30, 1998 AND 1997
(Amounts in thousands, except per share amounts)
- ------------------------------------------------------------------------------------------------------------------------------------
<CAPTION>
Quarter Ended Nine Months Ended
September 30, September 30,
-------------------------- --------------------------
1998 1997 1998 1997
---- ---- ---- ----
<S> <C> <C> <C> <C>
REVENUES:
Net sales $ 13,271 $ 18,529 $ 40,587 $ 51,600
Cost of sales 10,168 7,948 24,203 21,620
-------- -------- -------- --------
Gross profit 3,103 10,581 16,384 29,980
-------- -------- -------- --------
EXPENSES:
Research and development 3,856 2,602 10,245 8,229
Selling, general and administrative 4,413 5,859 14,401 16,542
Purchased research and development 0 3,651 2,299 3,651
Restructuring charges 2,506 0 2,506 0
-------- -------- -------- --------
Total operating expenses 10,775 12,112 29,451 28,422
-------- -------- -------- --------
Operating income / (loss) (7,672) (1,531) (13,067) 1,558
Other income 551 646 1,619 1,924
-------- -------- -------- --------
Income / (loss) before provision for income taxes (7,121) (885) (11,448) 3,482
Provision / (benefit) for income taxes (2,848) (270) (4,538) 1,061
-------- -------- -------- --------
NET INCOME / (LOSS) $ (4,273) $ (615) $ (6,910) $ 2,421
======== ======== ======== ========
COMPREHENSIVE INCOME / (LOSS) $ (4,252) $ (639) $ (6,930) $ 2,323
======== ======== ======== ========
EARNINGS PER SHARE (Basic)
Net income / (loss) per share $ (0.47) $ (0.07) $ (0.74) $ 0.26
Shares used in computing per share amounts 9,129 9,240 9,311 9,206
======== ======== ======== ========
EARNINGS PER SHARE (Diluted)
Net income / (loss) per share $ (0.47) $ (0.07) $ (0.74) $ 0.25
Shares used in computing per share amounts 9,129 9,240 9,311 9,585
======== ======== ======== ========
<FN>
The accompanying notes are an integral part of these consolidated financial statements.
</FN>
</TABLE>
4
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<TABLE>
DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
FOR THE NINE MONTHS ENDED SEPTEMBER 30 , 1998 AND 1997
(Amounts in thousands)
- ------------------------------------------------------------------------------------------------------------------------------------
<CAPTION>
Nine Months Ended
September 30,
----------------------------
1998 1997
---- ----
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income / (loss) $ (6,910) $ 2,421
Adjustments to reconcile net income / (loss) to net cash flows
provided by operating activities:
Depreciation and amortization 2,759 865
Provision / (reduction in allowance) for doubtful accounts (76) 30
Provision / (reduction in allowance) for excess and obsolete
Inventories 2,944 259
Purchased research and development 2,299 3,651
Deferred tax on acquisition (1,399) (1,115)
Changes in:
Accounts receivable 613 (1,580)
Inventories 256 (1,581)
Prepaid and other assets 629 (332)
Accounts payable 1,898 2,129
Accrued payroll and other accrued expenses 263 1,094
Income taxes (receivable) / payable (2,336) 59
-------- --------
Net cash flows provided by operating activities 940 5,900
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of marketable securities (25,664) (10,025)
Maturities of marketable securities 35,199 13,117
Acquisition of Performance Telecom Corporation assets 0 (5,000)
Payment in connection with Acquisition of Semaphore Corporation 182 0
Acquisition of property and equipment (1,075) (1,749)
-------- --------
Net cash flows provided by / (used in) investing activities 8,642 (3,657)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options 421 1,692
Repurchase of common stock (6,402) (2,424)
-------- --------
Net cash flows used in financing activities (5,981) (732)
-------- --------
Net increase in cash and cash equivalents 3,601 1,511
Cash and cash equivalents at beginning of year 2,504 2,043
-------- --------
Cash and cash equivalents at end of period $ 6,105 $ 3,554
======== ========
<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 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 presentation 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 nine months ended September
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 Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
---- ---- ---- ----
Basic (in thousands, except (in thousands, except
per share data) per share data)
<S> <C> <C> <C> <C>
Weighted average common shares outstanding for the period 9,129 9,240 9,311 9,206
Shares used in computing per share amounts 9,129 9,240 9,311 9,206
Net income / (loss) $(4,273) $ (615) $(6,910) $ 2,421
Net income / (loss) per share $ (0.47) $ (0.07) $ (0.74) $ 0.26
</TABLE>
6
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<TABLE>
<CAPTION>
Quarter Ended Nine Months Ended
September 30, September 30,
1998 1997 1998 1997
---- ---- ---- ----
Diluted (in thousands, except (in thousands, except
- ------- per share data) per share data)
<S> <C> <C> <C> <C>
Weighted average number of shares outstanding for 9,129 9,240 9,311 9,206
the period
Common equivalent shares from conversion of stock 379
options under treasury stock method
Shares used in computing per share amounts 9,129 9,240 9,311 9,585
Net income / (loss) $(4,273) $ (615) $(6,910) $ 2,421
Net income / (loss) per share $ (0.47) $ (0.07) $ (0.74) $ 0.25
</TABLE>
In the above computations, common equivalent shares totaling 13,360, 432,031 and
86,829 for the quarters ended September 30, 1998, and September 30, 1997 and the
nine months ended September 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):
September 30, 1998 December 31, 1997
------------------ -----------------
(Unaudited)
Raw materials $2,079 $2,952
Work-in-process 1,588 2,275
Finished goods 1,744 2,936
------ ------
$5,411 $8,163
====== ======
4. RESTRUCTURING CHARGES
The Company incurred an expense of $2.5 million in the quarter ended
September 30, 1998 related to the termination of its DL7100 and Virtual
Private Network product lines including termination of 25 project
employees and abandonment of a leased facility. Since the products
included use of, or planned integration of, technologies and other
assets acquired through the Company's acquisitions of Semaphore and
Performance Telecom, the Company also evaluated those acquired assets,
which had no alternative future use, for realizability. The
restructuring expense of $2.5 million consisted primarily of severance
costs of $0.5 million, legal and lease commitment costs of $0.5 million
and the write-off of goodwill and fixed assets of $1.5 million related
to the aforementioned acquisitions. In addition to these costs the
Company reflected $3.2 million of restructuring related costs in cost
of sales for inventory write-downs and warranty reserves.
7
<PAGE>
All 25 project employees were notified of their termination severance
benefits by September 30, 1998 and 64% of these benefits were actually
paid by the end of October 1998. The Company's leased facility will be
exited during the first quarter of 1999. Remaining accrued
restructuring charges amounted to $2.4 million at September 30, 1998.
5. 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 deemed probable for these matters in prior years, it is
currently unable to estimate the ultimate range of loss regarding these
matters. Therefore, the ultimate resolution of these matters could
result in payments in excess of, or less than, 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 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 December 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 effect on the Company's financial condition
and results of operations. No provision for any liability that may
result upon adjudication has
8
<PAGE>
been made in the accompanying financial statements.
6. 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 by the Company
from net income is the change in the unrealized gain or loss on
securities, and thus 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 No. 14,
"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.
7. 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). Semaphore is a
supplier of security management and Virtual Private Network solutions
for Internet/intranet and Frame relay applications. The acquisition was
accounted for as a purchase. The results of operations of Semaphore has
been included since April 3, 1998.
The assets acquired pursuant to the Agreement include technology,
including in-process research and development, 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 to Semaphore, valued at
approximately $3,200,000 and assumed certain liabilities amounting to
$212,000. The liabilities assumed include certain obligations under
assumed contracts and under various outstanding purchase orders as well
as certain warranty obligations. Goodwill related to the acquisition is
being amortized over five years.
In September of 1998, the Company discontinued and terminated the
Semaphore product line. In addition, the Company has terminated all the
Semaphore employees hired by the Company in April of 1998 and abandoned
the integration of and potential use of the acquired in-process
technology. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations" below.
9
<PAGE>
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)
Nine Months Ended September 30,
1998 1997
---- ----
Revenue $ 41,073 $ 53,485
Net loss (8,295) (4,493)
EARNINGS PER SHARE (BASIC)
Net loss per share $ (0.86) $ (0.47)
Shares used in per share calculation 9,602(1) 9,497(1)
EARNINGS PER SHARE (DILUTED)
Net loss per share $ (0.86) $ (0.47)
Shares used in per share calculation 9,602(1) 9,497(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 nine months ended September 30,1998 are as follows (in thousands):
Digital Link shares issued in asset acquisition 291(2)
Existing Digital Link shares 9,311
-----
9,602
-----
Share used in pro forma income (loss) per share basic and diluted calculations
for the nine months ended September 30, 1997 are as follows (in thousands):
10
<PAGE>
Digital Link shares issued in asset acquisition 291(2)
Existing Digital Link shares 9,206
-----
9,497
-----
(2) The number of shares issued was determined by dividing $3,200 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.
8. DEFERRED TAX ASSET
The Company has recorded a deferred tax asset of $5.8 million reflecting
the benefit of $0.9 million in loss carryforwards, which expire in varying
amounts between 2003 and 2019. Deferred tax asset also includes $2.6
million in depreciation and amortization, and $2.3 million in reserves.
Realization is dependent on generating sufficient taxable income prior to
expiration of the loss carryforwards. Although realization is not assured,
management believes it is more likely than not that all of the deferred tax
asset will be realized. The amount of the deferred tax asset considered
realizable, however, could be reduced in the near term if estimates of
future taxable income during the carryforward period are reduced.
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 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
11
<PAGE>
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 third quarter of 1998 decreased 28% to $13,271,000 from
$18,529,000 for the same period of the prior year. Net sales for the nine months
ended September 30, 1998 decreased 21% to $40,587,000 from $51,600,000 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, 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 decreased in absolute dollars by 18% but increased to 65% of
net sales in the third quarter of 1998 as compared to 56% in the third quarter
of 1997. Broadband sales decreased in absolute dollars by 42% and decreased as a
percentage of net sales to 35% in the third quarter of 1998 as compared to 44%
in the third quarter of 1997. Narrowband sales in absolute dollars decreased by
8% but increased to 62% of net sales in the first nine months of 1998 as
compared to 52% in the first nine months of 1997. Broadband sales decreased in
absolute dollars by 36% and decreased as a percentage of net sales to 38% in the
first nine months of 1998 as compared to 48% 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 20% of net sales in the third
quarter of 1998 as compared to 19% in the third quarter of 1997, and 22% of net
sales for the first nine months of 1998 as compared to 18% for the same period
of the prior year. These increases were primarily due to sales of the products
developed by Semaphore Communications Corporation ("Semaphore") acquired by the
Company in connection with the acquisition of Semaphore in April 1998. These
increases in net sales relating to the Semaphore product will not continue as a
result of the Company's discontinuation and termination of the Semaphore product
lines. 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
12
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Gross profit decreased 71% in the third quarter of 1998 to $3,103,000 from
$10,581,000 for the same period of the prior year. Gross profit decreased to 23%
of net sales in the third quarter of 1998 as compared to 57% in the third
quarter of 1997. Gross profit decreased 45% in the nine months ended September
30, 1998 to $16,384,000 from $29,980,000 for the same period of the prior year.
Gross profit decreased to 40% of net sales for the first nine months of 1998 as
compared to 58% for the same period of the prior year. These decreases in gross
profit are primarily a result of restructuring related charges related to the
termination of the Company's DL7100 and VPN product lines. The charges related
to the restructuring that were included in cost of goods sold amounted to
approximately $3.2 million in the third quarter of 1998 as discussed under
"Restructuring Charges" below. These restructuring charges were primarily
related to the write-down of inventory due to the discontinuation or de-emphasis
of certain product lines. To a lesser extent, gross profit decreased as 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 48% to $3,856,000 in the third quarter of 1998
from $2,602,000 in the third quarter of 1997. This increase was due primarily to
an increase in personnel-related expenses associated with the acquisition of
Semaphore and to a lesser extent, consulting expenses associated with other
product development projects. As a percentage of net sales, R&D expenses were
29% in the third quarter of 1998 as compared to 14% in the third quarter of
1997. R&D expenses increased 24% to $10,245,000 for the nine months ended
September 30, 1998 from $8,229,000 for the same period of the prior year. As a
percentage of net sales, R&D expenses increased to 25% for the first nine months
of 1998 as compared to 16% for the same period of the prior year. The absolute
dollar increase for the nine-month period is attributable to higher
personnel-related expenses including personnel-related expense associated with
the acquisition of Semaphore. The increases in R&D expenses as a percentage of
net sales is due primarily to lower sales volumes during the third quarter and
first nine months of 1998. The Company anticipates that its R&D expenses,
excluding purchased R&D, for at least the remainder of 1998 will decrease in
absolute dollars and as a percentage of sales from the levels experienced in the
third quarter of 1998 as a result of the Company's restructuring related to the
termination of the DL7100 and Virtual Private Network (VPN) developments.
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," including the Company's ability to achieve
revenue levels during such period.
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
13
<PAGE>
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 25% in the third quarter of 1998 to
$4,413,000 from $5,859,000 for the same period of the prior year. As a
percentage of net sales, SG&A expenses increased to 33% in the third quarter of
1998 from 32% in the third quarter of 1997. SG&A expenses decreased 13% for the
nine months ended September 30, 1998 to $14,401,000 from $16,542,000 for the
same period of the prior year. As a percentage of net sales, SG&A expenses
increased to 35% for the first nine months of 1998 from 32% 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 a decrease in consulting fees and
promotional expenses. The increases in SG&A expenses as a percentage of net
sales were primarily the result of lower sales volumes during the third quarter
and the first nine 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, using a discounted cash
flow analysis with separate cash flow projections for existing and in-process
technology. The value of in-process technology for which technological
feasibility has not been established and for which there was no alternative use
was expensed upon acquisition in accordance with Financial Accounting Standards
No. 2, "Accounting for Research and Development Costs". See Note 7 of "Notes to
Consolidated Financial Statements" above. Such acquired in-process technology
was subsequently abandoned in September 1998 as discussed below.
Restructuring Charges
The Company incurred an expense of $2.5 million in the quarter ended September
30, 1998 related to the termination of its DL7100 and Virtual Private Network
product lines including termination of 25 project employees and abandonment of a
leased facility. Since the products included use of, or planned integration of,
technologies and other assets acquired through the Company's acquisitions of
Semaphore and Performance Telecom, the Company also evaluated those acquired
assets, which had no alternative future use, for realizability. The
restructuring expense of $2.5 million consisted primarily of severance costs of
$0.5 million, legal and lease commitment costs of $0.5 million and the write-off
of goodwill and fixed assets of $1.5 million related to the aforementioned
acquisitions. In addition to these costs the Company reflected $3.2 million of
restructuring related costs in cost of sales for inventory write-downs and
warranty reserves.
All 25 project employees were notified of their termination severance benefits
by September 30, 1998 and 64% of these benefits were actually paid by the end of
October 1998. The Company's
14
<PAGE>
leased facility will be exited during the first quarter of 1999. Remaining
accrued restructuring charges amounted to $2.4 million at September 30, 1998.
Other Income
Other income primarily includes interest income. Other income decreased 15% in
the third quarter of 1998 to $551,000 from $646,000 for the same period of the
prior year. For the nine months ended September 30, 1998, other income decreased
16% to $1,619,000 from $1,924,000 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 40% for the third quarter and
first nine 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 carry-back 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 $22.9 million and cash, cash equivalents and
marketable securities of $36.5 million at September 30, 1998. Net cash provided
by operating activities was $940,000 for the first nine months of 1998 primarily
due to an increase in inventory, a write-off of purchased R&D, depreciation,
amortization and an increase in accounts payable, offset to some extent by net
loss and income taxes payable. Net cash provided by operating activities was
$5.9 million for the first nine months of 1997, primarily as a result of net
income, a write-off of purchased R&D and an increase in accounts payable, offset
by an increase in accounts receivable and an increase in inventories. Cash
provided by investing activities during the first nine months of 1998 was
primarily from the maturity of marketable securities of $35.2 million offset by
additional purchases of marketable securities of $25.2 million. Cash used in
investing activities during the first nine months of 1997 was primarily from
purchases of marketable securities of $10.8 million and the acquisition of
Performance Telecom assets of $5.0 million, offset by the maturity of marketable
securities of $13.1 million. Leasehold improvements and capital equipment
additions were $1.1 million in the first nine months of 1998 as compared to $1.7
million in the first nine months 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 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 $6.0 million in the first nine months of 1998, primarily due to the
repurchase of common stock, offset by the proceeds from the exercise of stock
options and employee stock purchase rights. Net cash used in financing
activities was $732,000 in the first nine months of 1997, primarily from the
repurchase of common stock offset by the proceeds from the exercise of stock
options and employee stock purchase rights. During the first nine months of
1998, the Company repurchased on the open market a total of 715,000 shares of
common stock at prices ranging from $4.13 to $11.50 a share. This stock has
subsequently been retired.
15
<PAGE>
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 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
16
<PAGE>
its existing WAN access 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 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. There can be no assurance that the Company will be successful
in attracting and retaining skilled personnel to hold these important positions.
The Company utilizes management information systems and software technology that
may be affected by Year 2000 issues throughout its businesses. During 1998, the
Company began to implement plans for certain of its operations to ensure those
systems continue to meet its internal and external requirements. The Year 2000
compliance efforts will encompass:
o All Digital Link products. The cost of this effort will be
approximately $250,000 and will be financed through working capital and
the use of internal engineering resources.
o All Digital Link major operational systems (including ASK MANMAN,
databases, spreadsheets, word processing, and CAD). The cost of these
initiatives will be approximately $150,000. The Company has contracted
with a third party to perform the MANMAN compliance work and will use a
combination of consultants and internal resources to address the
compliance issues with other operational systems.
The remaining initiatives to address vendor and customer compliance are
estimated to be complete by the end of June 1999. In addition, the Company has
developed questionnaires and contacted key suppliers and customers regarding
their Year 2000 compliance to determine any impact on its operations. In
general, the Company's suppliers and customers have advised it that they have
developed or are in the process of developing plans to address Year 2000 issues.
The Company will continue to monitor and evaluate the progress of its suppliers
and customers on this critical matter. The Company is also reviewing its
non-information technology systems to determine the extent of any changes that
may be necessary and believes that there will be minimal changes necessary for
compliance.
17
<PAGE>
Based on the progress the Company has made in addressing its Year 2000 issues
and the Company's plan and timeline to complete its compliance program, the
Company does not foresee significant risks associated with its Year 2000
compliance at this time. As the Company's plan is to address its significant
Year 2000 issues prior to being affected by them, it has not developed a
comprehensive contingency plan. However, if the Company identifies significant
risks related to its Year 2000 compliance or its progress deviates from the
anticipated timeline, the Company will develop contingency plans as deemed
necessary at that time.
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
18
<PAGE>
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 deemed probable for these matters in prior years, it is
currently unable to estimate the ultimate range of loss regarding these matters.
Therefore, the ultimate resolution of these matters could result in payments in
excess of, or less than, 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 Company has recorded a deferred tax asset of $5.8 million reflecting the
benefit of $0.9 million in loss carryforwards, which expire in varying amounts
between 2003 and 2019. Deferred tax asset also includes $2.6 million in
depreciation and amortization, and $2.3 million in reserves. Realization is
dependent on generating sufficient taxable income prior to expiration of the
loss carryforwards. Although realization is not assured, management believes it
is more likely than not that all of the deferred tax asset will be realized. The
amount of the deferred tax asset considered realizable, however, could be
reduced in the near term if estimates of future taxable income during the
carryforward period are reduced.
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.
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 No. 14, "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
19
<PAGE>
Not Applicable.
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 Forms 10-Q for the periods ended June 30, 1998 and 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
Not applicable.
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
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.
20
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DIGITAL LINK CORPORATION
Date: November 16, 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)
21
<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 September 30, 1998, and is qualified in its entirety by reference to such
financial statements.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 6,105
<SECURITIES> 11,805
<RECEIVABLES> 4,857
<ALLOWANCES> 437
<INVENTORY> 5,411
<CURRENT-ASSETS> 34,173
<PP&E> 10,766
<DEPRECIATION> 7,945
<TOTAL-ASSETS> 58,941
<CURRENT-LIABILITIES> 11,317
<BONDS> 0
0
0
<COMMON> 35,587
<OTHER-SE> 12,037
<TOTAL-LIABILITY-AND-EQUITY> 58,941
<SALES> 40,587
<TOTAL-REVENUES> 40,587
<CGS> 24,203
<TOTAL-COSTS> 53,654
<OTHER-EXPENSES> (1,619)
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> (11,448)
<INCOME-TAX> (4,538)
<INCOME-CONTINUING> (6,910)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (6,910)
<EPS-PRIMARY> (0.74)
<EPS-DILUTED> (0.74)
</TABLE>
