FORM 10-Q
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
|X| QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended June 30, 1999
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number: 0-23110
-------
DIGITAL LINK CORPORATION
(Exact name of registrant as specified in its charter)
California 77-0067742
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
217 Humboldt Court, Sunnyvale, CA 94089
(Address of principal executive offices,
including zip code)
(408) 745-6200
Registrant's telephone number, including area code
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by Sections 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes |X| No |_|
The number of shares outstanding of the registrant's Common Stock as of August
13, 1999, was 8,010,716 shares.
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DIGITAL LINK CORPORATION
INDEX TO FORM 10-Q
Page
----
PART I - FINANCIAL INFORMATION:
ITEM 1 - Financial Statements
Consolidated Balance Sheets as of June 30, 1999 3
and December 31, 1998
Consolidated Statements of Operations for the quarters 4
and six months ended June 30, 1999 and June 30, 1998
Consolidated Statements of Cash Flows for the six 5
months ended June 30, 1999 and June 30, 1998
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 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 Holder 20
ITEM 5 - Other Information 21
ITEM 6 - Exhibits and Reports on Form 8-K 21
SIGNATURE(S) 22
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<TABLE>
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PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements
DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Amounts in thousands, except share amounts)
- -----------------------------------------------------------------------------
June 30, December 31,
1999 1998
----- ----
(Unaudited)
ASSETS
- ------
CURRENT ASSETS:
<S> <C> <C>
Cash and cash equivalents ............................................. $ 2,955 $ 296
Short-term marketable securities ...................................... 2,067 15,738
Accounts receivable, less allowance for doubtful accounts of $316 at
6/30/99 and $540 at 12/31/98 .......................................... 4,935 4,767
Inventories ........................................................... 3,719 4,306
Prepaid and other current assets ...................................... 991 998
Income taxes receivable ............................................... 618 2,501
Deferred income taxes ................................................. 3,069 3,069
-------- --------
Total current assets ......................................... 18,354 31,675
Property and equipment at cost, net ................................... 2,286 2,582
Long-term marketable securities ....................................... 31,178 18,696
Deferred income taxes ................................................. 1,560 1,560
Other assets .......................................................... 376 393
-------- --------
TOTAL ASSETS ................................................. $ 53,754 $ 54,906
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
- ------------------------------------
CURRENT LIABILITIES:
Accounts payable ...................................................... $ 2,655 $ 2,365
Accrued payroll expense ............................................... 2,695 2,168
Other accrued expenses ................................................ 4,893 4,764
Income taxes payable .................................................. 315 243
-------- --------
Total current liabilities .................................... 10,558 9,540
-------- --------
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: 8,001,466 shares at 06/30/99 and
8,490,472 shares at 12/31/98 ..................................... 31,351 33,311
Accumulated other comprehensive income / (loss) ....................... (282) 52
Retained earnings ..................................................... 12,127 12,003
-------- --------
Total shareholders' equity ................................... 43,196 45,366
-------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY ................... $ 53,754 $ 54,906
======== ========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
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<TABLE>
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DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)
FOR THE QUARTERS AND SIX MONTHS ENDED
JUNE 30, 1999 AND 1998
(Amounts in thousands, except per share amounts)
- --------------------------------------------------------------------------------
Quarter Ended Six Months Ended
June 30, June 30,
------------------- -------------------
1999 1998 1999 1998
-------- -------- -------- --------
REVENUES:
<S> <C> <C> <C> <C>
Net sales ................................................... $ 15,623 $ 12,797 $ 30,855 $ 27,317
Cost of sales ............................................... 7,047 6,830 14,345 14,036
-------- -------- -------- --------
Gross profit ......................................... 8,576 5,967 16,510 13,281
-------- -------- -------- --------
EXPENSES:
Research and development .................................... 2,604 3,567 5,185 6,389
Selling, general and administrative ......................... 5,230 4,965 9,843 9,988
Purchased in-process research and development ............... 0 2,299 0 2,299
-------- -------- -------- --------
Total operating expenses ............................. 7,834 10,831 15,028 18,676
-------- -------- -------- --------
Operating income / (loss) ............................ 742 (4,864) 1,482 (5,395)
Other income ................................................ 464 466 940 1,068
-------- -------- -------- --------
Income / (loss) before provision / (benefit) for .... 1,206 (4,398) 2,422 (4,327)
income taxes
Provision / (benefit) for income taxes ...................... 302 (1,712) 605 (1,690)
-------- -------- -------- --------
NET INCOME / (LOSS) .................................. $ 904 $ (2,686) $ 1,817 (2,637)
======== ======== ======== ========
COMPREHENSIVE INCOME / (LOSS) ............................... $ 688 $ (2,652) $ 1,483 $ (2,678)
EARNINGS PER SHARE (Basic)
Net income / (loss) per share ............................... $ 0.11 $ (0.29) $ 0.22 $ (0.28)
======== ======== ======== ========
Shares used in computing per share amounts .................. 8,061 9,422 8,178 9,403
======== ======== ======== ========
EARNINGS PER SHARE (Diluted)
Net income / (loss) per share ............................... $ 0.11 $ (0.29) $ 0.22 $ (0.28)
======== ======== ======== ========
Shares used in computing per share amounts .................. 8,177 9,422 8,260 9,403
======== ======== ======== ========
</TABLE>
The accompanying notes are an integral part of these consolidated financial
statements.
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<TABLE>
<CAPTION>
DIGITAL LINK CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)
FOR THE SIX MONTHS ENDED JUNE 30, 1999 AND 1998
(Amounts in thousands)
- --------------------------------------------------------------------------------
Six Months Ended
June 30,
----------------
1999 1998
---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
<S> <C> <C>
Net income / (loss) ............................................... $ 1,817 $ (2,637)
Adjustments to reconcile net income / (loss) to net cash flows
provided by operating activities:
Depreciation and amortization .................................. 786 789
Purchased research and development ............................. 0 2,299
Changes in:
Accounts receivable ......................................... (168) 933
Inventories .................................................. 587 319
Prepaid and other assets ..................................... 24 341
Accounts payable ............................................. 290 1,263
Accrued payroll and other accrued expenses ................... 656 (1,105)
Income taxes payable and receivable .......................... 1,955 (882)
-------- --------
Net cash flows provided by operating activities .......... 5,947 1,320
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of marketable securities ................................ (16,308) (18,671)
Maturities of marketable securities ............................... 17,163 21,948
Payment in connection with Acquisition of Semaphore Corporation ... 0 182
Acquisition of property and equipment ............................. (490) (887)
-------- --------
Net cash flows provided by investing activities .......... 365 2,572
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of stock options and employee stock purchase 333 419
plan
Repurchase of common stock ........................................ (3,986) (6,096)
-------- --------
Net cash flows used in financing activities .............. (3,653) (5,677)
-------- --------
Net increase / (decrease) in cash and cash equivalents ........ 2,659 (1,785)
Cash and cash equivalents at beginning of period .................. 296 2,504
-------- --------
Cash and cash equivalents at end of period ........................ $ 2,955 $ 719
======== ========
</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 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,
which was filed with the Securities and Exchange Commission on March
29, 1999.
The year-end balance sheet at December 31, 1998 was derived from
audited financial statements, but does not include all disclosures
required by generally accepted accounting principles.
Operating results for the three months and six months ended June 30,
1999 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 / (LOSS) PER SHARE
Basic and diluted net income per share is computed in accordance with
Statement of Financial Accounting Standards No. 128 ("SFAS No. 128").
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<CAPTION>
Quarter Ended Six Months Ended
June 30, June 30,
1999 1998 1999 1998
---- ---- ---- ----
Basic (in thousands, except per share data)
- -----
<S> <C> <C> <C> <C>
Weighted average common shares outstanding for the 8,061 9,422 8,178 9,403
period
Shares used in computing per share amounts ....... 8,061 9,422 8,178 9,403
Net income / (loss) .............................. $ 904 $(2,686) $ 1,817 $(2,637)
Net income / (loss) per share .................... $ 0.11 $ (0.29) $ 0.22 $ (0.28)
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
Quarter Ended Six Months Ended
June 30, June 30,
1999 1998 1999 1998
---- ---- ---- ----
Diluted (in thousands, except per share data)
- -------
<S> <C> <C> <C> <C>
Weighted average number of shares outstanding for 8,061 9,422 8,178 9,403
the period
Common equivalent shares from conversion of stock 116 -- 82 --
options under treasury stock method
Shares used in computing per share amounts ...... 8,177 9,422 8,260 9,403
Net income / (loss) ............................. $ 904 $(2,686) $ 1,817 $(2,637)
Net income / (loss) per share ................... $ 0.11 $ (0.29) $ 0.22 $ (0.28)
</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):
June 30, 1999 December 31, 1998
------------- -----------------
(Unaudited)
Raw materials $1,128 $1,349
Work-in-process 1,312 1,456
Finished goods 1,279 1,501
----- -----
$3,719 $4,306
====== ======
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 matters 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 approximately $950,000
for these matters deemed probable in prior years, it is currently
unable to estimate the ultimate range of loss regarding these matters.
Therefore, it is reasonably possible that the ultimate resolution of
these matters could result in final settlement that could exceed or be
less than the amounts accrued and that the settlement of these matters
could be material to the Company's results of operations. Adjustment to
amounts accrued will take place in the period in which such matters are
resolved.
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
<PAGE>
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. Discovery to date has been limited in the state court action,
and the Superior Court has not set a trial date. In the parallel
Federal proceedings, the Court on September 11, 1997 granted the
Company's motion to dismiss the federal complaint with leave to amend,
and plaintiff filed an amended complaint. The Company moved to dismiss
the amended complaint, the hearing on which was scheduled to take place
in September 1999. Plaintiff has attempted to dismiss the Federal
proceedings without prejudice but has maintained his right to pursue
the State action. The Company has objected to this procedure and has
requested an opportunity to brief the issue in the Federal Court.
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 been made in the accompanying financial
statements.
5. RECENT ACCOUNTING PRONOUNCEMENTS
In March 1998, the American Institute of Certified Public Accountants
("AICPA") issued Statement of Position 98-1 ("SOP 98-1"), "Accounting
for the Costs of Computer Software Developed or Obtained for Internal
Use." This standard requires companies to capitalize qualifying
computer software costs which are incurred during the application
development stage and amortize them over the software's estimated
useful life. SOP 98-1 was effective for the Company's current fiscal
year. The adoption of SOP 98-1 had no impact on the Company's financial
statements.
In April 1998, the AICPA issued Statement of Position 98-5 ("SOP
98-5"), "Reporting on the Costs of Start-Up Activities." This standard
requires companies to expense the costs of start-up activities and
organization costs as incurred. SOP 98-5 was effective for the
Company's current fiscal year. The adoption of SOP 98-5 had no impact
on the Company's results of operations.
In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for
Derivative Instruments and Hedging Activities." SFAS 133 establishes
new standards of accounting and reporting for derivative instruments
and hedging activities. SFAS 133 requires that all derivatives be
recognized at fair value in the statement of financial position, and
that the corresponding gains or losses be reported either in the
statement of operations or as a component of comprehensive income,
depending on the type of hedging relationship that
<PAGE>
exists. SFAS 133 will be effective for the first quarter of 2000. The
Company does not currently hold derivative instruments or engage in
hedging activities.
6. SUBSEQUENT EVENTS
None
<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 ("SEC"), including its Form 10-K for the year ended December
31, 1998 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 SEC
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
possible, in some future quarters that the Company's operating results will be
below the expectations of stock market analysts and investors. In such event,
the price of the Company's Common Stock would likely be materially adversely
affected. Consequently, the purchase or holding of the Company's Common Stock
involves an extremely high degree of risk.
Net Sales
Net sales for the second quarter of 1999 increased 22% to $15,623,000 from
$12,797,000 for the same period of 1998. This increase was primarily
attributable to a significant increase in unit sales of broadband (i.e.,
transmission rates in excess of T1/E1) products, particularly in the inverse
multiplexer product line, offset by a reduction in sales of the Company's
discontinued security products. Net sales for narrowband (i.e., transmission
rates up to T1/E1) products marginally increased for the second quarter of 1999
even though unit sales decreased. This was the result of increased sales of
higher price units offset by a significant decrease in sales of lower price
units, primarily the T1 OEM product.
<PAGE>
Net sales for the six months ended June 30, 1999 increased 13% to $30,855,000
from $27,317,000 for the same period of the prior year. This increase in net
sales was also primarily attributable to an increase in unit sales of broadband
products, particularly in the inverse multiplexer product line, offset by
reduced sales of the Company's discontinued security products.
The increases in unit sales were partly offset by lower average selling prices
on certain narrowband and broadband products as a result of price reductions
made in 1998 and in the first half of 1999. The Company anticipates that the
pricing pressure will continue during the remainder of 1999.
Narrowband sales in absolute dollars increased by 9% but decreased to 53% of net
sales in the second quarter of 1999 as compared to 60% of net sales in the
second quarter of 1998. Broadband sales increased in absolute dollars by 42% and
increased to 47% of net sales in the second quarter of 1999 as compared to 40%
of net sales in the second quarter of 1998. Narrowband sales in absolute dollars
increased by 3% but decreased to 55% of net sales for the first six months of
1999 as compared to 60% of net sales in the first six months of 1998. Broadband
sales increased in absolute dollars by 28% and increased to 45% of net sales for
the first six months of 1999 as compared to 40% of net sales for the same period
in 1998. The changes in narrowband sales and broadband sales as a percentage of
net sales were primarily due to higher sales of broadband products to certain
domestic carrier customers.
International sales, including Canada, represented 26% of net sales in the
second quarter of both 1999 and 1998, and 27% of net sales for the six months
ended June 30, 1999, as compared to 22% for the same periods of the prior year.
These increases were primarily due to an increase in unit sales of broadband and
narrowband 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 increased 44% in the second quarter of 1999 to $8,576,000 from
$5,967,000 for the same period of the prior year. Gross margin increased to
54.9% of net sales in the second quarter of 1999 as compared to 46.6% in the
second quarter of 1998. This increase in gross margin was primarily due to a
shift in the mix of products sold to include more broadband products, which
generally have higher gross margins than narrowband products, and a major
reduction in sales of the T1 OEM units, which have relatively low margins. Gross
profit increased 24% in the six months ended June 30, 1999 to $16,510,000 from
$13,281,000 for the same period of the prior year. Gross margins increased to
53.5% of net sales for the first six months of 1999 as compared to 48.6% for the
same period of the prior year. This increase as a percentage of net sales
reflects a shift in the mix of products sold to include more broadband products,
which generally have a higher gross margin than narrowband products, offset by
the above referenced price reductions.
<PAGE>
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 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 that 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 expense decreased 27% to $2,604,000 in the second quarter of 1999
from $3,567,000 in the second quarter of 1998. R&D expenses decreased 19% to
$5,185,000 for the six months ended June 30, 1999 from $6,389,000 for the same
period of the prior year. The decrease in expenses during both the second
quarter and the first six months of 1999 is primarily due to a reduction in
headcount because of discontinued or de-emphasized products resulting from
restructuring activities in September 1998.
As a percentage of net sales, R&D expenses decreased to 16.8% for the first six
months of 1999 as compared to 23.4% for the same period of the prior year. R&D
expenses were 16.7 % in the second quarter of 1999 as compared to 27.9% in the
second quarter of 1998. The decrease in R&D expenses as percentage of net sales
for the second quarter and the first six months of 1999 is the result of higher
net sales combined with lower costs as a result of discontinued or de-emphasized
products.
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 expense increased 5% in the second quarter of 1999 to
$5,230,000 from $4,965,000 for the same period of the prior year. This increase
in SG&A expense was attributable to an increase in advertising and promotional
activities and costs associated with changes in executive staff, offset by
reduced personnel costs due to headcount reductions. SG&A expense decreased 1%
to $9,843,000 for the first six months of 1999 from $9,988,000 for the
comparable period in 1998. This reduction in SG&A expense was primarily
attributable to reduced personnel costs due to headcount reductions, offset by
increased marketing costs such as advertising and promotional activities.
As a percentage of net sales, SG&A expenses decreased to 33.5% and 31.9%
respectively, for the second quarter and first six months of 1999, compared to
38.8% and 36.6% for the same periods
<PAGE>
of 1998. The decrease in SG&A expense as a percentage of net sales during the
quarter ended June 30, 1999 was primarily the result of higher sales volume
during the second quarter of 1999, offset in part by increased SG&A expense
mentioned above. The decrease in SG&A expense as a percentage of net sales
during the first six months of 1999 was primarily the result of higher sales
volume and reduced costs due to headcount reductions.
Purchased In-Process Research and Development
In the second quarter ended June 30, 1998 the Company incurred an expense of
$2.3 million related to purchased research and development for which
technological feasibility had not been achieved. Such in-process technology was
valued, along with other acquired assets, in accordance with valuation
techniques commonly used in the technology industry and was expensed upon
acquisition in accordance with Financial Accounting Standards No. 2, "Accounting
for Research and Development Costs".
Other Income
Other income is derived primarily from interest income. Other income remained
flat at $464,000 during the second quarter of 1999 as compared to $466,000
during the same period of 1998. Other income decreased 12% to $940,000 during
the first six months of 1999 as compared to $1,068,000 for the first six months
of 1998. These decreases were primarily due to lower interest income due to
reduced interest rates and lower investment balances.
Provision for Income Taxes
The Company's effective tax rate decreased to 25.0% for the second quarter and
first six months of 1999 compared to 39% for the same periods in 1998. The 1998
rate assumed a carryback of the then-current year losses compared to the
effective tax rate applicable if the Company were profitable. The Company's 1999
tax rate reflects the resolution of prior contingencies.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities was $5.9 million for the first half of
1999 and $1.3 million for the same period in 1998. Cash provided by operating
activities during the first six months of 1999 resulted primarily from a net
income and a refund of income taxes. Cash provided by operating activities for
the six months ended June 30, 1998 was due primarily from a write-off of
purchased R&D, an increase in accounts payable and a decrease in accounts
receivable, offset to some extent by a net loss and a decrease in accrued
payroll and other accrued expenses.
Net cash provided by investing activities was $365,000 for the six months ended
June 30, 1999, compared to $2.6 million for the same period in 1998. The 1999
provision of cash resulted from the maturity of $17.2 million of marketable
securities offset by the purchase of $16.3 million in marketable securities and
$490,000 of capital equipment. The net cash provided by investing activities
during the six months ended June 30, 1998 resulted primarily from the maturity
of $21.9 million of marketable securities offset by the purchase of $18.7
million of marketable securities and $887,000 of capital equipment.
<PAGE>
Financing activities consumed $3.7 million of cash during the six months ended
June 30, 1999 and $5.7 million during the comparable period of 1998. The use of
cash during both periods was primarily due to the Company's repurchase of $4.0
million and $6.1 million, respectively, worth of its Common Stock, offset by the
proceeds from the exercise of stock options and the Employee Stock Purchase
Plan.
During the six months ended June 30, 1999 working capital decreased 65% to
$7,796,000 from $22,135,000 at December 31, 1998. This decrease was primarily
due to the shift of $16,308,000 from short-term investment to long-term
investment.
In October 1996, the Company's Board of Directors announced the authorization
for the Company to repurchase 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, at which time the stock will be
retired. The Board authorized additional repurchases of up to 1,000,000 shares
in May 1998, 500,000 shares in December 1998 and 500,000 in April 1999. No time
limit was set for completion of the repurchase program. The Company purchased
372,000 shares of common stock during the first six months of 1999, 1,372,000
shares in 1998, and 142,000 shares in 1997 under this program at a cost of
$3,986,000, $9,364,000 and $2,422,000 for 1999, 1998 and 1997, respectively.
In March 1998, the American Institute of Certified Public Accountants ("AICPA")
issued Statement of Position 98-1 ("SOP 98-1"), "Accounting for the Costs of
Computer Software Developed or Obtained for Internal Use." This standard
requires companies to capitalize qualifying computer software costs which are
incurred during the application development stage and amortize them over the
software's estimated useful life. SOP 98-1 was effective for the Company's
current fiscal year. The adoption of SOP 98-1 had no impact on the Company's
financial statements.
In April 1998, the AICPA issued Statement of Position 98-5 ("SOP 98-5"),
"Reporting on the Costs of Start-Up Activities." This standard requires
companies to expense the costs of start-up activities and organization costs as
incurred. SOP 98-5 was effective for the Company's current fiscal year. The
adoption of SOP 98-5 had no impact on the Company's results of operations.
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 133 ("SFAS 133"), "Accounting for Derivative
Instruments and Hedging Activities." SFAS 133 establishes new standards of
accounting and reporting for derivative instruments and hedging activities. SFAS
133 requires that all derivatives be recognized at fair value in the statement
of financial position, and that the corresponding gains or losses be reported
either in the statement of operations or as a component of comprehensive income,
depending on the type of hedging relationship that exists. SFAS 133 will be
effective for the first quarter of 2000. The Company does not currently hold
derivative instruments or engage in hedging activities.
<PAGE>
OTHER FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
In addition to the factors set forth above in this "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 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. 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. In addition, none of the Company's customers are contractually
obligated to purchase any quantity of products in any particular period, and
product sales to major customers have varied widely from quarter to quarter and
year to year. There can be no assurance that the Company's current customers
will continue to place orders with the Company, that orders from existing
customers will continue at the levels of previous periods or that the Company
will be able to obtain orders from new customers. Other factors that may cause
fluctuations in the Company's operating results include, but are not limited to,
the timing of new product announcements and introductions by the Company and its
competitors, market acceptance of new or enhanced versions of the Company's
products, changes in the product mix sold toward narrowband products that yield
lower gross margins, seasonal capital spending patterns of large domestic
customers, changes in sales volumes through the Company's distribution channels,
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 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. This 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.
<PAGE>
The Company's success and ability to compete are dependent on its ability to
develop and maintain the proprietary aspects of its technology. It relies on a
combination of trademark, trade secret and copyright law and contractual
restrictions to protect these rights. Despite its efforts to protect its
proprietary rights, unauthorized parties may attempt to copy aspects of its
products or to obtain and use information that it regards as proprietary.
Unauthorized use or misappropriation of the Company's intellectual property
could seriously harm its business. To enforce its proprietary rights, the
Company may be required to bring legal action against third parties. For
example, on June 1, 1999, the Company filed a suit in Santa Clara County
Superior Court against Tiara Networks, Inc., its three corporate officers and
certain of its personnel, all of whom are former Digital Link employees
regarding Tiara's business and products being based on the improper disclosure
and use of Digital Link's proprietary and confidential information by its former
employees. See Part II, Item 1 of this Form 10-Q for additional information
regarding this proceeding. There can be no assurance that the Company will
prevail in this or any other legal proceeding. In addition, any legal action
that the Company may bring to protect its intellectual property rights,
including the suit against Tiara, could be expensive and distract management
from day-to-day operations.
The Company's future prospects will depend in part on its ability to enhance the
functionality of its existing WAN access products in a timely manner. It will
also depend on the Company's ability 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. For example, in December 1998,
Lana Vaysburd was hired as Vice President, Engineering, in March 1999, Sherman
Silverman was hired as Vice President, Sales and Marketing, Worldwide and in
June 1999, Naresh C. Kapahi was hired as Vice President, Finance and Operations
and Chief Financial Officer. In addition, in March 1998 Vinita Gupta was
reappointed as the Company's interim President and Chief Executive Officer,
which position she accepted on a full-time basis in January 1999. The current
availability of qualified sales and engineering personnel is quite limited, and
competition among companies for such personnel is intense. The Company is
currently attempting to hire a number of sales and engineering personnel and has
experienced delays in filling such positions. There can be no
<PAGE>
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 internal operating systems
to ensure these systems continue to meet its internal and external requirements.
The Year 2000 compliance efforts will encompass:
All Digital Link products. The incurred cost of this effort is
approximately $250,000 and was financed through working capital and the use
of internal engineering resources.
All Digital Link major operational systems (including ASK MANMAN,
databases, spreadsheets, word processing, and CAD). The cost of these
initiatives is estimated to be $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 internal operational systems.
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. The remaining initiatives to address vendor and
customer compliance are estimated to be complete by the end of August 1999. 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.
To date, the Company has incurred approximately $350,000 in expenses related to
Year 2000 compliance of its products and internal operating systems. All current
active products meet the Company's Year 2000 compliance requirements. Currently,
in excess of 50% of the internal operating systems of the Company is Year 2000
compliant. The Company plans to implement Year 2000 compliance for its internal
operating systems by September 1999.
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.
The Company is concerned that many enterprises and carriers will be devoting a
substantial portion of their information systems spending to addressing the Year
2000 issue. This expense may result in spending being diverted from networking
solutions in the near future. This diversion of information technology spending
could have a material adverse impact on the Company's future sales volume.
<PAGE>
The foregoing statements are based upon management's best estimates at the
present time, which were derived utilizing numerous assumptions of future
events, including the continued availability of certain resources, third party
modification plans and other factors. There can be no guarantee that these
estimates will be achieved and actual results could differ materially from those
anticipated. Specific factors that might cause such material differences
include, but are not limited to, the availability and cost of personnel trained
in this area, the ability to locate and correct all relevant computer codes, the
nature and amount of programming required to upgrade or replace each of the
affected programs, the rate and magnitude of related labor and consulting costs
and the success of the Company's external customers and suppliers in addressing
the Year 2000 issue. The Company's evaluation is on going and it expects that
new and different information will become available to it as that evaluation
continues. Consequently, there is no guarantee that all material elements will
be Year 2000 ready in 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. See paragraphs two and three in Note 4 of Notes to Consolidated
Financial Statements in Part I of this Form 10-Q.
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 DSU/CSUs, may
infringe upon patents held by it. The third party 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. See paragraph one
in Note 4 of Notes to Consolidated Financial Statements in Part I of this Form
10-Q.
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
<PAGE>
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.
ITEM 3. Quantitative and Qualitative Disclosure About Market Risk
The Company has limited exposure to financial market risks, including changes in
interest rates. The Company does not use derivative financial instruments in its
investment portfolio. The Company's investment portfolio is generally comprised
of government agency securities that mature within three years. The Company
places investments in instruments that meet high credit quality standards. These
securities are subject to interest rate risk, and could decline in value if
interest rates increase. Due to the duration and conservative nature of the
Company's investment portfolio, the Company does not expect any material loss
with respect to its investment portfolio. The Company does not have any
significant foreign operations and thus is not materially exposed to foreign
currency fluctuations. The Company does not currently hedge against foreign
currency rate fluctuations.
<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.
The Company on June 1, 1999 filed a lawsuit in Santa Clara County Superior Court
against San Jose-based Tiara Networks, Inc., its three corporate officers and
certain of its personnel, all of whom are former Digital Link employees. The
suit charges that Tiara's business and products are based upon the improper
disclosure and use of Digital Link's proprietary and confidential information by
its former employees. Digital Link complaint alleges the named defendants are
liable for violating confidentiality agreements, fiduciary obligations to the
Company and engaging in unfair business practices. The Company is seeking
damages and injunctive relief.
A demurrer as to the second, third, and fourth causes of action alleging breach
of fiduciary duty, conversion and unfair business practice is pending September
30, 1999.
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
On June 7, 1999, the Company held its annual meeting of shareholders. At that
meeting, five of the Company's incumbent directors were reelected to office by
the following vote:
Votes
Name Votes for Withheld
- ---- --------- --------
Richard C. Alberding 6,880,643 66,207
Louis Golm 6,890,328 56,522
Narendra K. Gupta 6,890,328 56,522
Vinita Gupta 6,890,328 56,522
Stephen L. Von Rump 6,888,943 57,907
Also at the meeting, the shareholders approved an amendment to the Company's
1993 Employee Stock Purchase Plan to increase the number of shares reserved for
issuance thereunder by 300,000. The stockholders cast the following votes:
6,820,768 votes for, 120,125 votes against, 5,957 votes abstaining and 0 broker
non-votes.
Also at that meeting, the shareholders ratified the selection of
PricewaterhouseCoopers LLP as independent auditors for the Company's current
fiscal year, with 6,927,036 votes for, 17,360 votes against, 2,454 votes
abstaining and 0 broker non-votes.
<PAGE>
ITEM 5. Other Information
On June 23, 1999, Stan Kazmierczak resigned his position as the Company's Vice
President, Finance and Operations, Chief Financial Officer and Secretary. On the
same date, Naresh C. Kapahi joined the Company to serve in those positions.
ITEM 6. Exhibits And Reports On Form 8-K
(a) Exhibits
27.01 Financial Data Schedule.
(b) Reports on Form 8-K
There were no reports on Form 8-K filed during the quarter ended June
30, 1999.
<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: August 13, 1999 /s/ N. C. Kapahi
-----------------------------
Naresh C. Kapahi
Vice President, Finance and Operations,
Chief Financial Officer and Secretary
(Duly Authorized Officer and Principal
Financial Officer)
<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 June 30, 1999, and is qualified in its entirety by reference to such
financial statements.
</LEGEND>
<CIK> 0000810467
<NAME> Digital Link Corporation
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