SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-Q/A
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
For the Quarter Ended November 30, 1998
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d)
OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number 1-10228
CABLETRON SYSTEMS, INC.
-----------------------
(Exact name of registrant as specified in its charter)
Delaware 04-2797263
-------- ----------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) identification no.)
35 Industrial Way, Rochester, New Hampshire 03867
(Address of principal executive offices and Zip Code)
Registrant's telephone number, including area code: (603) 332-9400
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months, (or for such shorter period that the registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.
YES - X NO -
As of January 11, 1999 there were 172,173,011 shares of the Registrant's common
stock outstanding.
This document contains 28 pages
Exhibit index on page 27
<PAGE>
INDEX
CABLETRON SYSTEMS, INC.
Page
----
Facing Page 1
Index 2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets - November 30, 1998 (unaudited) and
February 28, 1998 3
Consolidated Statements of Operations - Three and nine months
ended November 30, 1998 and 1997 (unaudited) 4
Consolidated Statements of Cash Flows - Nine months ended
November 30, 1998 and 1997 (unaudited) 5
Notes to Consolidated Financial Statements -
November 30, 1998 (unaudited) 6 - 11
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 12 - 22
Item 3. Quantitative and Qualitative Disclosures about
Market Risk 23
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 24
Item 5. Other Information 25
Item 6. Exhibits and Reports on Form 8-K 26
Signatures 26
Index to the Exhibits 27
<PAGE>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CABLETRON SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
(unaudited)
November 30, 1998 February 28, 1998
----------------- -----------------
<S> <C> <C>
Assets
Current Assets:
Cash and cash equivalents $ 129,266 $ 207,078
Short-term investments 87,019 116,979
Accounts receivable, net 225,303 241,181
Inventories, net 243,008 309,667
Deferred income taxes 78,032 81,161
Prepaid expenses and other assets 113,697 78,084
---------- ----------
Total current assets 876,325 1,034,150
---------- ----------
Long-term investments 178,199 123,272
Long-term deferred income taxes 167,295 167,308
Property, plant and equipment, net 211,498 244,730
Intangible assets 98,364 36,867
---------- ----------
Total assets $1,531,681 $1,606,327
========== ==========
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable $ 95,607 $ 79,969
Current portion of long-term obligation 159,002 157,719
Accrued expenses 234,167 235,062
---------- ----------
Total current liabilities 488,776 472,750
Long-term obligation --- 132,500
Long-term deferred income taxes 22,037 12,057
---------- ----------
Total liabilities 510,813 617,307
---------- ----------
Stockholders' equity:
Preferred stock, $1.00 par value. Authorized
2,000 shares; none issued --- ---
Common stock $0.01 par value. Authorized
240,000 shares; issued and outstanding
171,672 and 158,267, respectively 1,717 1,583
Additional paid-in capital 543,975 300,834
Retained earnings 474,973 685,823
---------- ----------
1,020,665 988,240
Accumulated other comprehensive income 203 780
---------- ----------
Total stockholders' equity 1,020,868 989,020
---------- ----------
Total liabilities and stockholders' equity $1,531,681 $1,606,327
========== ==========
See accompanying notes to consolidated financial statements.
</TABLE>
<PAGE>
CABLETRON SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
(unaudited)
Three Months Ended Nine Months Ended
November 30, November 30,
1998 1997 1998 1997
---- ---- ---- ----
<S> <C> <C> <C> <C>
Net sales $329,868 $331,827 $1,066,206 $1,065,808
Cost of sales 197,041 164,254 618,156 476,847
-------- -------- --------- ----------
Gross profit 132,827 167,573 448,050 588,961
-------- -------- --------- ----------
Operating expenses:
Research and development 51,484 46,552 159,633 134,583
Selling, general and administrative 116,965 95,521 327,950 261,848
Special charges 74,650 --- 224,650 ---
-------- -------- --------- ----------
Total operating expenses 243,099 142,073 712,233 396,431
-------- -------- --------- ----------
Income (loss) from operations (110,272) 25,500 (264,183) 192,530
Interest income, net 3,493 4,648 11,413 14,269
-------- -------- --------- ----------
Income (loss) before income taxes (106,779) 30,148 (252,770) 206,799
Income tax expense (benefit) (21,761) 10,250 (21,045) 70,490
-------- -------- --------- ----------
Net income (loss) $(85,018) $ 19,898 $(231,725) $ 136,309
======== ======== ========= ==========
Net income (loss) per share - basic $ (0.50) $ 0.13 $ (1.40) $ 0.87
======== ======== ========= ==========
Weighted average number of shares outstanding
- basic 169,658 157,986 165,884 157,527
========= ======== ========= ==========
Net income (loss) per share - diluted $ (0.50) $ 0.12 $ (1.40) $ 0.85
======== ======= ========= ==========
Weighted average number of shares outstanding
- diluted 169,658 159,875 165,884 159,906
========= ======== ========= ==========
See accompanying notes to consolidated financial statements.
</TABLE>
<PAGE>
CABLETRON SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands of dollars)
(unaudited)
Nine Months Ended
November 30,
1998 1997
---- ----
Cash flows from operating activities:
Net income (loss) ($231,725) $ 136,309
Adjustments to reconcile net income (loss) to net
cash (used in) provided by operating
activities:
Depreciation and amortization 66,884 50,205
Provision for losses on accounts receivable 3,929 1,098
Deferred taxes 2,472 (8,239)
Loss (gain) on disposal of property 1,018 (446)
Purchased research and development from
acquisitions 224,650 ---
Other 575 ---
Changes in assets and liabilities:
Accounts receivable 25,259 (82,031)
Inventories 75,444 (84,233)
Prepaid expenses and other assets 21 (1,755)
Accounts payable, accrued expenses and
long-term obligations (155,731) 39,244
Income taxes payable (28,481) (4,892)
--------- ---------
Net cash (used in) provided by operating
activities (15,685) 45,260
--------- ---------
Cash flows from investing activities:
Capital expenditures (35,840) (64,037)
Proceeds from sale of fixed assets 24,531 ---
Acquisitions of businesses, net of cash acquired (32,193) ---
Purchases of available-for-sale securities (82,375) (86,478)
Purchases of held-to-maturity securities (69,596) (37,228)
Maturities of securities 126,888 113,943
--------- ---------
Net cash used in investing activities (68,585) (73,800)
--------- ---------
Cash flows from financing activities:
Proceeds from stock option exercise 1,593 17,097
Common stock issued to employee stock
purchase plan 5,384 3,311
--------- ---------
Net cash provided by financing activities 6,977 20,408
--------- ---------
Effect of exchange rate changes on cash (519) 230
--------- ---------
Net decrease in cash and cash equivalents (77,812) (7,902)
Cash and cash equivalents, beginning of period 207,078 214,828
--------- ---------
Cash and cash equivalents, end of period $ 129,266 $ 206,926
========= =========
See accompanying notes to consolidated financial statements.
<PAGE>
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited)
1. Basis of presentation
The accompanying unaudited financial statements have been prepared in accordance
with the instructions to Form 10-Q and Article 2 of Regulation S-X. Accordingly,
they do not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements. In the opinion
of management, all adjustments consisting of normal recurring accruals necessary
for a fair presentation of the results of operations for the interim periods
presented have been reflected herein. Certain amounts in the consolidated
financial statements and notes thereto have been reclassified to conform to
current classifications. The results of operations for the interim periods are
not necessarily indicative of the results to be expected for the entire year.
The accompanying financial statements should be read in conjunction with the
consolidated financial statements and footnotes thereto included in the
Company's Annual Report on Form 10-K for the year ended February 28, 1998.
2. Business Combinations
DSLAM division of Ariel Corporation
On September 1, 1998, Cabletron acquired the assets and assumed certain
liabilities of the DSLAM division of Ariel Corporation ("Ariel"), a privately
held designer and manufacturer of digital subscriber line network access
products. Cabletron recorded the cost of the acquisition at approximately $45.1
million, including fees and expenses of $1.1 million related to the acquisition,
which consisted of cash payments of $33.5 million and other assumed liabilities.
This acquisition has been accounted for under the purchase method of accounting.
Based on an independent appraisal, approximately $27.8 million of the purchase
price was allocated to in-process research and development. Accordingly,
Cabletron recorded special charges of approximately $27.8 million ($23.7
million, net of tax) for this in-process research and development, at the date
of acquisition. The excess of cost over the estimated fair value of net assets
acquired was allocated to goodwill. A total of $16.4 million was allocated to
goodwill, and is being amortized on a straight-line basis over a period of 10
years. Cabletron's consolidated results of operations include the operating
results of the DSLAM division of Ariel Corporation from the acquisition date.
FlowPoint Corp.
On September 9, 1998, Cabletron acquired all of the outstanding stock of
FlowPoint Corp., a privately held manufacturer of digital subscriber line router
networking products. Prior to the agreement, Cabletron owned 42.8% of the
outstanding shares of stock. Pursuant to the terms of the agreement, $20.6
million is to be paid in 4 installments, within 9 months after the merger date.
Each installment may be paid in either cash or Cabletron common stock, as
determined by Cabletron management at the time of distribution. In addition,
Cabletron assumed 494,000 options, valued at approximately $2.7 million.
Cabletron recorded the cost of the acquisition at approximately $25.0 million,
including direct costs of $0.4 million. This acquisition has been accounted for
under the purchase method of accounting. Based on an independent appraisal,
approximately $13.0 million of the purchase price was allocated to in-process
research and development. Accordingly, Cabletron recorded special charges of
$13.0 million ($11.1 million, net of tax) for this in-process research and
development, at the date of acquisition. The excess of cost over net assets
acquired was allocated to goodwill and other intangible assets. A total of $10.9
million was allocated to goodwill and other intangible assets, and is being
amortized on a straight-line basis over a period of 5 - 10 years. Cabletron's
consolidated results of operations include the operating results of FlowPoint
Corp. from the acquisition date.
<PAGE>
NetVantage, Inc.
On September 25, 1998, Cabletron acquired NetVantage, Inc., a publicly held
manufacturer of ethernet workgroup switches. Under the terms of the Merger
Agreement, Cabletron issued 6.4 million shares of Cabletron common stock to the
shareholders of NetVantage in exchange for all of the outstanding shares of
stock of NetVantage. In addition, Cabletron assumed 1,309,000 options, valued at
approximately $4.8 million.
Cabletron recorded the cost of the acquisition at approximately $77.8 million,
including direct costs of $4.2 million. This acquisition has been accounted for
under the purchase method of accounting. The cost represents 6.4 million shares
at $9.9375 per share, in addition to direct acquisition costs. Based on an
independent appraisal, approximately $33.9 million of the purchase price was
allocated to in-process research and development. Accordingly, Cabletron
recorded special charges of $33.9 million ($29.0 million, net of tax) for this
in-process research and development, at the date of acquisition. The excess of
cost over net assets acquired was allocated to goodwill and other intangible
assets. A total of $31.1 million was allocated to goodwill and other intangible
assets and is being amortized on a straight-line basis over a period of 5 - 10
years. Cabletron's consolidated results of operations include the operating
results of NetVantage, Inc. from the acquisition date.
Yago Systems, Inc.
On March 17, 1998, Cabletron acquired Yago Systems, Inc. ("Yago"), a privately
held manufacturer of wire speed routing and layer-4 switching products and
solutions. Under the terms of the merger agreement, Cabletron issued 6.0 million
shares of Cabletron common stock to the shareholders of Yago in exchange for all
of the outstanding shares of Yago, not then owned by Cabletron. In addition,
Cabletron assumed Yago stock options for approximately 2.1 million shares of
Cabletron common stock. Prior to the closing of the acquisition, Cabletron held
approximately twenty-five percent of Yago's capital stock, calculated on a fully
diluted basis. Cabletron also agreed, pursuant to the terms of the merger
agreement, to issue up to 5.5 million shares of Cabletron common stock to the
former shareholders of Yago in the event the shares originally issued in the
transaction do not attain a market value of $35 per share eighteen months after
the closing of the transaction.
Cabletron recorded the cost of the acquisition at approximately $165.7 million,
including direct costs of $2.6 million. This acquisition has been accounted for
under the purchase method of accounting. The cost represents 11.5 million shares
at $14.1875 per share, in addition to direct acquisition costs. Based on an
independent appraisal, approximately $150.0 million of the purchase price was
allocated to in-process research and development. Accordingly, Cabletron
recorded special charges of $150.0 million for this in-process research and
development, at the date of acquisition. The excess of cost over net assets
acquired was allocated to goodwill and other intangible assets. A total of $16.3
million was allocated to goodwill and other intangible assets and is being
amortized on a straight-line basis over a period of 5 - 10 years. Cabletron's
consolidated results of operations include the operating results of Yago from
the acquisition date.
<PAGE>
Pro Forma Information
The unaudited pro forma consolidated historical results for the nine months
ended November 30, 1998 and for the nine month period ended November 30, 1997
below assume the acquisitions of Ariel, FlowPoint, NetVantage and Yago occurred
at the beginning of fiscal 1998:
(in thousands, except per share amounts)
Nine months ended
November 30,
1998 1997
---- ----
Net sales $1,069,868 $1,082,720
Net income (loss) $ (56,471) $ 112,916
Net income (loss) per share $ (0.34) $ 0.66
The pro forma results include amortization of the goodwill and other intangible
assets described above. The pro forma results do not include the write-off of
in-process research and development expenses at the date of acquisition. The pro
forma results are not necessarily indicative of the results that would have been
obtained had these events actually occurred at the beginning of the periods
presented, nor are they necessarily indicative of future consolidated results.
3. Restated acquisition related charges
As previously disclosed in the Form 10-Q for its quarter ended August 31, 1998,
the Company received a letter from the staff of the Securities and Exchange
Commission (the "Staff") commenting on the Company's Form 10-K for the year
ended February 28, 1998 and its Form 10-Q for the quarter ended May 31, 1998.
For a more complete description of the Staff's letter and its potential
ramifications for the Company see "Item 5. Other Information" later in this
report. Upon receiving advice from its auditors and other professionals in
reviewing the Forms 10-K and 10-Q and formulating a response to the Staff, the
Company determined to reduce the $57.7 million in special charges the Company
recorded in the fourth quarter of fiscal 1998 in connection with its acquisition
of the DNPG by approximately $33.2 million, and to reflect these expenses as
incurred. As a result of this reduction, (i) the Company's loss from operations
for the first quarter of fiscal 1999 increased by approximately $8.7 million of
acquisition related expenses from the amount previously disclosed (including as
disclosed in the Company's Form 10-Q for such quarter) and (ii) the Company's
income from operations for the second quarter of fiscal 1999 decreased by
approximately $5.0 million of acquisition related expenses from the amount
disclosed in a press release dated September 21, 1998. As a consequence, loss
per share for the first quarter increased by approximately $0.04 to ($0.97) and
earnings per share for the second quarter decreased by approximately $0.02 to
$0.07. In addition, the Company has determined to reclassify $13.6 million of
special charges recorded in its acquisition of Yago Systems, Inc. associated
with the elimination and phase out of superceded product lines to cost of sales
in the first quarter of fiscal 1999. The adjustments described above have been
fully incorporated into the financial statements contained in this report,
excluding the Company's February 28, 1998 balance sheet which does not reflect
these adjustments. The Company intends, after reaching a final resolution with
the Staff, to amend its Form 10-K for fiscal 1998 (including the balance sheet
contained in this report), its Form 10-Q for the first quarter of fiscal 1999
and possibly other filings to reflect the adjustments related to special charges
described above and any additional adjustments required by the Staff.
<PAGE>
Total DNPG acquisition related charges reported in the year
ended February 28, 1998 (in millions) $57.7
Less reductions:
Contract employee benefits and contract
compensation write-offs (12.5)
Professional fees and some facility costs
reclassified to purchase price ( 3.2)
Software licenses and software tools costs (7.0)
Customer warranty and stock rotation (3.0)
Other integration costs reductions in
estimates and classifications (7.5)
-----
Total merger related costs as revised, consisting
of elimination and phase out of overlapping
products $24.5
=====
Offsetting the $33.2 million adjustments were period expenses which relate to
the fourth quarter of fiscal year 1998 totaling $1.6 million. The net pre-tax
adjustment required for fiscal year 1998 totals $31.6 million.
4. New Accounting Pronouncements
Effective March 1, 1998, the Company adopted Financial Accounting Standards
Board Statement No. 130, "Reporting Comprehensive Income" (SFAS 130) which
establishes standards for reporting and display of comprehensive income and its
components in a full set of financial statements. For the Company, comprehensive
income includes net income and unrealized gains and losses from foreign currency
translation.
In June 1997, the Financial Accounting Standards Board issued Statement 131
(SFAS 131), "Disclosures about Segments of an Enterprise and Related
Information," which establishes standards for the way that public business
enterprises report selected information about operating segments in annual
financial statements and requires that those enterprises report selected
information about operating segments in interim financial reports to
shareholders. It also establishes standards for related disclosures about
products and services, geographic areas and major customers. This Statement
becomes effective for the Company in its fiscal year ending February 28, 1999.
The Company is in the process of determining the impact of SFAS 131 on its
footnote disclosures.
In October 1997, the AICPA Accounting Standards Executive Committee issued
Statement of Position (SOP) 97-2, "Software Revenue Recognition" which provides
guidance on applying generally accepted accounting principles in recognizing
revenue for licensing, selling, leasing or otherwise marketing computer software
and supersedes SOP 91-1. The Company will adopt SOP 97-2 for its fiscal year
ended February 28, 1999 and does not anticipate any material impact on revenues
or results from operations.
In June 1998, the FASB issued Financial Accounting Standard No. 133, "Accounting
for Derivative Instruments and Hedging Activities (SFAS 133)." This Statement
requires companies to record derivative instruments on the balance sheet as
assets or liabilities, measured at fair value. Gains or losses resulting from
changes in the values of those derivatives would be accounted for depending on
the use of the derivative and whether it qualifies for hedge accounting. SFAS
133 will be effective for the Company's first quarter of fiscal year ending
February 28, 2001. Management believes that this Statement will not have a
significant impact on the Company.
<PAGE>
5. Inventories
Inventories consist of:
(in thousands)
November 30, February 28,
1998 1998
----------- -----------
Raw materials $ 68,319 $ 70,415
Work-in-process 14,303 24,521
Finished goods 160,386 214,731
-------- --------
Total inventories $243,008 $309,667
======== ========
6. EPS Reconciliation
The reconciliation of the numerators and denominators of the basic and diluted
income (loss) per common share computations for the Company's reported net
income (loss) is as follows:
(in thousands, except per share amounts)
<TABLE>
<CAPTION>
Three months ended Nine months ended
November 30 November 30,
1998 1997 1998 1997
---- ---- ---- ----
<S> <C> <C> <C> <C>
Basic net income (loss) $(85,018) $ 19,898 $(231,725) $136,309
======== ======== ========= ========
Weighted average shares outstanding - basic 169,658 157,986 165,884 157,527
Dilutive Effect:
Net additional common shares upon
exercise of common stock options --- 1,889 --- 2,379
-------- --------- --------- --------
Weighted average shares outstanding -
diluted 169,658 159,875 165,884 159,906
======= ========= ========= ========
Net income (loss) per share - basic $(0.50) $ 0.13 $(1.40) $ 0.87
======== ========= ========= ========
Net income (loss) per share - diluted $(0.50) $ 0.12 $(1.40) $ 0.85
======== ========= ========= ========
</TABLE>
7. Comprehensive Income (Loss)
The Company's total of comprehensive income (loss) was as follows:
(in thousands)
<TABLE>
<CAPTION>
Three months ended Nine months ended
November 30, November 30,
1998 1997 1998 1997
---- ---- ---- ----
<S> <C> <C> <C> <C>
Net income (loss) ($85,018) $19,898 ($231,725) $136,309
Other comprehensive income:
Foreign currency translation
adjustment (2,641) 474 (577) 435
-------- ------- ---------- --------
Total comprehensive income (loss) ($87,659) $20,372 ($232,302) $136,744
======== ======= ========== ========
</TABLE>
<PAGE>
8. Supplemental Information
Supplemental Cash Flow Information and Noncash Investing and Financing
Activities are as follows:
(in thousands)
<TABLE>
<CAPTION>
Nine Months Ended
November 30,
1998 1997
---- ----
<S> <C> <C>
Cash paid during the period for:
Income taxes $ 10,220 $ 46,109
======== ========
Supplemental schedule of non-cash investing and financing activities:
Acquisitions:
Cash Paid $ 38,656 ---
Less cash acquired 6,463 ---
--------
Net cash paid for acquisitions $ 32,193 ---
======== ========
Fair value of assets acquired $ 30,322 ---
======== ========
Liabilities assumed $ 16,081 ---
======== ========
Stock issued $226,989 ---
======== ========
</TABLE>
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Results of the Three Months ended November 30, 1998 vs Three Months ended
November 30, 1997
Cabletron Systems' worldwide net sales in the third quarter of fiscal 1999 (the
three month period ended November 30, 1998) were $329.9 million, a decrease of
less than one percent, compared to net sales of $331.8 million for the third
quarter of fiscal 1998. The slight decrease in net sales for the third quarter
of fiscal 1999 was primarily a result of the continued weakening of sales of
shared media products. The decrease in sales of shared media products was
partially offset by the sales of products from Digital Network Products Group
("DNPG"), a division the Company acquired from Digital Equipment Corporation
("Digital") on February 7, 1998 and which did not contribute to the revenues in
the third quarter of fiscal 1998, increased sales of switched products and
increased service revenues. Sales of switched products increased by
approximately $16.0 million, or 9.1%, to $191.4 million in the third quarter of
fiscal 1999 compared to $175.4 million in the third quarter of fiscal 1998.
Sales of shared media products decreased $33.2 million to $33.0 million in the
third quarter of fiscal 1999 compared to $66.2 million in the same quarter of
fiscal 1998, a decline of approximately 50.2%. Also offsetting the decrease in
sales of shared media products was an increase in service revenue by
approximately $16.4 million, or 38.1%, to $59.4 million in the third quarter of
fiscal 1999 compared to $43.0 million in the third quarter of fiscal 1998.
Service revenue increased largely as a result of the Company's continuing
efforts to grow this portion of the business. The sales of switched products
increased due to sales of the Company's newer switched products. Offsetting this
increase was pricing pressure on the switched 10/100 products and decreased
sales of some older switched products. The decrease in sales of shared media
products was a result of declining unit shipments. The Company expects sales of
its shared media products may continue to decrease this fiscal year as customers
continue to migrate from shared media products to switched products.
International sales were $131.6 million or 39.9% of net sales in the third
quarter of fiscal 1999 as compared to $115.7 million or 34.9% of net sales for
the same period in fiscal 1998. The increase in international sales was largely
a result of sales by DNPG, which has a large percentage of its sales in the
European and Pacific Rim ("Pac Rim") regions. Sales in Europe were $87.3
million, which was an increase of $18.0 million from sales of $69.3 million in
the third quarter of fiscal 1998. Sales in the Pac Rim Region were $25.7
million, which was an increase of $11.7 million from sales of $14.0 million in
the third quarter of fiscal 1998.
Gross profit as a percentage of net sales in the third quarter of fiscal 1999
decreased to 40.3% from 50.5% for the third quarter of fiscal 1998. The decrease
was primarily due to an increase of obsolescence recognition of slower moving
products and the discontinuance of older products. Secondary factors which
negatively impacted the gross margin were (i) that lower than expected sales
resulted in fixed manufacturing expenses, which had been increased in
anticipation of higher sales, being a higher percentage of sales and (ii) a more
competitive pricing environment.
Research and development expenses in the third quarter of fiscal 1999 increased
10.6% to $51.5 million from $46.6 million in the third quarter of fiscal 1998.
The increase in research and development spending reflected the additional
software and hardware engineers acquired as a result of acquisitions, and
associated costs related to the development of new products, offset by a
decrease in spending at existing locations. Research and development spending as
a percentage of net sales increased to 15.6% from 14.0% in the third quarter of
fiscal 1999.
Selling, general and administrative ("SG&A") expenses in the third quarter of
fiscal 1999 increased 22.4% to $117.0 million from $95.5 million in the third
quarter of fiscal 1998. The increase in expenses was due to an increase in
marketing expenses, a revised incentive program and amortization of stay bonuses
and incentive payments to employees added through the recent acquisitions by the
Company.
<PAGE>
Special charges in the third quarter of fiscal 1999 were $74.7 million. This
amount relates to in-process research and development projects which were
ongoing, at the time of acquisition, at the DSLAM division of Ariel Corporation,
FlowPoint Corp. and NetVantage, Inc..
Net interest income in the third quarter of fiscal 1999 decreased $1.1 million
to $3.5 million, as compared to $4.6 million in the same quarter of fiscal 1998.
The decrease reflects lower cash and short-term investments balances due to
payments relating to the acquisitions completed during the last four quarters.
Loss before income taxes was $106.8 million in the third quarter of fiscal 1999
compared to income before income taxes of $30.1 million in the third quarter of
fiscal 1998. The decrease in income (loss) before income taxes was due primarily
to special charges of $74.7 million relating to the acquisitions of the DSLAM
division of Ariel Corporation, FlowPoint Corp. and NetVantage, Inc., and
secondarily, lower gross margins and higher operating expenses. Excluding the
special charges, loss before income taxes was $32.1 million, in the third
quarter of fiscal 1999. For the three months ended November 30, 1998 the actual
tax rate differs from the expected tax rate due to the non-deductibility of the
in-process research and development charges taken in connection with certain
acquisitions completed during the quarter.
Results of the Nine Months ended November 30, 1998 vs Nine Months ended November
30, 1997
Cabletron Systems' worldwide net sales of $1,066.2 million for the nine months
ended November 30, 1998 represented a less than one percent increase over net
sales of $1,065.8 million reported for the same period of the preceding year.
Sales of switched products increased from $509.2 million, during the nine month
period ended November 30, 1997 to $592.0 million, during the nine month period
ended November 30, 1998. The sales of switched products increased due largely to
increased sales of the Company's newer switched products, including switched
products acquired in the Company's acquisition of the DNPG. These sales were
offset by pricing pressure on the switched 10/100 products and decreased sales
of some older switched products. Sales of shared media products decreased from
$267.6 million, during the nine month period ended November 30, 1997, to $139.7
million, during the nine month period ended November 30, 1998. The decrease in
sales of shared media products was a result of declining unit shipments. Also,
offsetting the decrease in shared media revenue was an increase of $34.7 million
in service revenue from $138.3 million, during the nine month period ended
November 30, 1997, to $173.0 million, during the nine month period ended
November 30, 1998. Service revenue increased largely as a result of the
Company's continuing efforts to grow this portion of the business.
International sales as a percentage of total net sales increased to 41.0%
($437.6 million) from 30.2% ($322.1 million) for the same period of the
preceding year. The increase in international sales was largely a result of
sales by DNPG, which has a large percentage of its sales in the European and Pac
Rim regions. Sales in Europe increased $102.4 million, from $189.6 million to
$292.0 million and sales in the Pac Rim Region increased $29.6 million, from
$41.9 million to $71.5 million.
Gross profit as a percentage of net sales for the nine months ended November 30,
1998 was 42.0% compared to 55.3% for the nine months ended November 30, 1997.
The decreased gross profit percentage was due to higher inventory obsolescence,
a more competitive pricing environment and higher relative expenses resulting
from lower than expected sales. Another factor contributing to the lower gross
profit margin is that the Company acquired products that contribute to the
revenue mix at lower margins than the Company's core products.
Research and development costs increased to $159.6 million compared to $134.6
million for the same period of the preceding fiscal year. As a percentage of net
sales, spending for research and development increased to 15.0% from 12.6%. The
higher spending for research and development reflected increased numbers of
software and hardware engineers hired and acquired as a result of acquisitions
and associated costs related to development of new products.
<PAGE>
Spending for selling, general and administrative expenses increased to $328.0
million compared to $261.8 million for the same period of the preceding year. As
a percentage of net sales, spending for selling, general and administration
increased to 30.8% from 24.6% for the same period of the preceding year. The
increase in spending was the result of an increase in sales and technical
personnel, incentive payments to employees added through the recent acquisitions
by the Company and increased marketing programs.
Special charges for the nine months of fiscal 1999 were $224.7 million. This
amount relates to in-process research and development projects which were
ongoing, at the time of acquisition, at Yago Systems, Inc., the DSLAM division
of Ariel Corporation, FlowPoint Corp. and NetVantage, Inc..
Net interest income was $11.4 million compared to $14.3 million in the same
period last year. The decrease reflects lower cash and short-term investments
balances due to cash expended for acquisitions.
Loss before income taxes of $252.8 million represented a decrease from income
before income taxes of $206.8 million for the same period a year ago. The
decrease was due largely to one-time acquisition expenses, special charges, for
Yago Systems, the DSLAM division of Ariel Corporation, FlowPoint Corp. and
NetVantage, Inc.. These special charges totaled $224.7 million. Additionally,
the decrease in income before income taxes was due to lower gross margins and
higher expenses. For the nine months ended November 30, 1998 the actual tax rate
differs from the expected tax rate due to the non-deductibility of the
in-process research and development charges taken in connection with certain
acquisitions completed during the period.
Business Combinations
DSLAM division of Ariel Corporation
On September 1, 1998, Cabletron acquired the assets and liabilities of the DSLAM
division of Ariel Corporation ("Ariel"). Cabletron recorded the cost of the
acquisition at approximately $45.1 million, including fees, expenses and other
costs related to the acquisition. Cabletron's consolidated results of operations
include the operating results of the DSLAM division of Ariel Corporation from
the acquisition date.
In connection with the acquisition of Ariel, the Company allocated $27.8 million
($23.7 million, net of tax) of the purchase price to in-process research and
development projects. The valuation of the in-process research and development
(IPR&D) incorporated the guidance on IPR&D valuation methodologies recently
promulgated by the Securities and Exchange Commission (SEC). These methodologies
incorporate the notion that cash flows attributable to development efforts,
including the effort to be completed on the development effort underway, and
development of future versions of the product that have not yet been undertaken,
should be excluded in the valuation of IPR&D. This allocation represents
risk-adjusted cash flows related to the incomplete products. At the date of
acquisition, the development of these projects had not yet reached technological
feasibility and the research and development ("R&D") in progress had no
alternative future uses. Accordingly, these costs were expensed as of the
acquisition date.
The Company used independent third-party appraisers to assess and allocate
values to the in-process research and development. The value assigned to these
assets was determined by identifying significant research projects for which
technological feasibility had not been established, including development,
engineering and testing activities associated with the introduction of Ariel's
next-generation DSLAM technology.
The nature of the efforts to develop the acquired in-process technology into
commercially viable products principally relate to the completion of all
planning, designing, prototyping, high-volume verification, and testing
activities that are necessary to establish that the proposed technologies meet
their design specifications including functional, technical, and economic
performance requirements.
The value assigned to purchased in-process technology was determined by
estimating the costs to develop the purchased in-process technology into
commercially viable products, estimating the resulting net cash flows from the
projects and discounting the net cash flows to their present value. The revenue
projection used to value the in-process research and development is based on
estimates of relevant market sizes and growth factors, expected trends in
technology and the nature and expected timing of new product introductions by
the Company and its competitors.
<PAGE>
For purposes of the IPR&D valuation, the total revenues attributable to Ariel
were projected to exceed $195 million within 5 years, assuming the successful
completion and market acceptance of the major R&D efforts. As of the valuation
date, Ariel had no existing products and accordingly all revenue growth in the
first several years are related to the in-process technologies. For purposes of
the IPR&D valuation, it was estimated that revenues for the in-process projects
would peak in 2004 and then decline as other new products and technologies were
expected to enter the market.
Cost of sales was estimated based on Ariel's internally generated projections
and discussions with management regarding anticipated gross margin improvements.
Due to the market opportunities in the network equipment arena and Ariel's
unique technology architecture, substantial gross margins were estimated through
the forecast period. Cost of sales as a percentage of sales was forecasted to
decline until 2001 and then remain constant at 55%. SG&A expenses (including
depreciation) as a percentage of sales were projected to decline slightly until
2003 and then remain constant at 26%. R&D expenditures as a percentage of sales
were projected to remain constant at 8% over the projection period.
The rates utilized to discount the net cash flows to their present value were
based on venture capital rates of return. Due to the nature of the forecast and
the risks associated with the projected growth, profitability and developmental
projects, a discount rate of 25.0 percent was determined to be appropriate for
the in-process R&D. These discount rates were commensurate with Ariel's stage of
development; the uncertainties in the economic estimates described above; the
inherent uncertainty surrounding the successful development of the purchased
in-process technology; the useful life of such technology; the profitability
levels of such technology; and, the uncertainty of technological advances that
were unknown at the time of acquisition.
The forecasts used by the Company in valuing in-process research and development
were based upon assumptions the Company believes to be reasonable but which are
inherently uncertain and unpredictable. The Company's assumptions may be
incomplete or inaccurate, and unanticipated events and circumstances are likely
to occur. For these reasons, actual results may vary from the projected results.
The Company believes that the foregoing assumptions used in the forecasts were
reasonable at the time of the acquisition. No assurance can be given, however,
that the underlying assumptions used to estimate expected project sales,
development costs or profitability, or the events associated with such projects,
will transpire as estimated. For these reasons, actual results may vary from the
projected results.
Ariel's in-process research and development value is comprised of several
significant individual on-going projects. Remaining development efforts for
these projects include various phases of design, development and testing.
Anticipated completion dates for the projects in progress are estimated to occur
over the next year. The Company projected to begin generating the economic
benefits from the technologies in the second half of fiscal year 2000. Funding
for such projects was estimated to be obtained from internally generated
sources. Expenditures to complete these projects were estimated to total
approximately $0.5 million over the next year. These estimates are subject to
change, given the uncertainties of the development process, and no assurance can
be given that deviations from these estimates will not occur.
Management expects to continue their support of these efforts and believes the
Company has a reasonable chance of successfully completing the R&D programs.
However, there is risk associated with the completion of the projects and there
is no assurance that any will meet with either technological or commercial
success.
FlowPoint, Corp.
On September 9, 1998, Cabletron acquired FlowPoint, Corp., a privately held
manufacturer of digital subscriber line router networking products. Prior to the
Agreement, Cabletron owned 42.8% of the outstanding shares of FlowPoint stock.
Pursuant to the terms of the Agreement, $20.6 million is to be paid in four
installments, within 9 months after the merger date. Each installment may be
paid in either cash or Cabletron common stock, as determined by Cabletron
management at the time of distribution. In addition, Cabletron assumed 494,000
options, valued at approximately $2.7 million.
Cabletron recorded the cost of the acquisition at approximately $25.0 million,
including direct costs of the acquisition. Cabletron's consolidated results of
operations include the operating results of FlowPoint, Corp. from the
acquisition date.
<PAGE>
In connection with the acquisition of FlowPoint, the Company recorded special
charges of $13.0 million ($11.1 million, net of tax) for in-process research and
development projects. The valuation of the IPR&D incorporated the guidance on
IPR&D valuation methodologies recently promulgated by the SEC. These
methodologies incorporate the notion that cash flows attributable to development
efforts, including the effort to be completed on the development effort
underway, and development of future versions of the product that have not yet
been undertaken, should be excluded in the valuation of IPR&D. This allocation
represents risk-adjusted cash flows related to the incomplete products. At the
date of acquisition, the development of these projects had not yet reached
technological feasibility and the R&D in progress had no alternative future
uses. Accordingly, these costs were expensed as of the acquisition date.
The Company used independent third-party appraisers to assess and allocate
values to the in-process research and development. The value assigned to these
assets were determined by identifying significant research projects for which
technological feasibility had not been established, including development,
engineering and testing activities associated with the introduction of
FlowPoint's next-generation Router technologies.
The nature of the efforts to develop the acquired in-process technology into
commercially viable products principally relate to the completion of all
planning, designing, prototyping, high-volume verification, and testing
activities that are necessary to establish that the proposed technologies meet
their design specifications including functional, technical, and economic
performance requirements.
The value assigned to purchased in-process technology was determined by
estimating the costs to develop the purchased in-process technology into
commercially viable products, estimating the resulting net cash flows from the
projects and discounting the net cash flows to their present value. The revenue
projection used to value the in-process research and development is based on
estimates of relevant market sizes and growth factors, expected trends in
technology and the nature and expected timing of new product introductions by
the Company and its competitors.
For purposes of the in-process R&D valuation, the total revenues attributable to
FlowPoint were projected to exceed $150 million within 5 years, assuming the
successful completion and market acceptance of the major R&D efforts. As of the
valuation date, FlowPoint had a few existing products, which lack the
technological breadth and depth necessary in the evolving networking equipment
market. Accordingly, for purposes of the IPR&D valuation, it was estimated that
significant revenue growth in the first several years would be primarily related
to the in-process technologies. The estimated revenues for the in-process
projects were projected to peak in 2004 and then decline as other new products
and technologies were expected to enter the market.
Cost of sales was estimated based on FlowPoint's internally generated
projections and discussions with management regarding anticipated gross margin
improvements. Due to the market opportunities in the Network Equipment arena and
FlowPoint's unique technology architecture, substantial gross margins were
projected through the forecast period. Cost of sales as a percentage of sales
was forecasted to decline until 2003 and then remain constant at 55%. SG&A
expenses (including depreciation) as a percentage of sales were projected to
remain constant at 23%. R&D expenditures as a percentage of sales were projected
to decline significantly from 30% in 1999 to 10% in 2001 and remain constant at
10% thereafter.
The rates utilized to discount the net cash flows to their present value were
based on venture capital rates of return. Due to the nature of the forecast and
the risks associated with the projected growth, profitability and developmental
projects, a discount rate of 25.0 percent was determined to be appropriate for
the in-process R&D. These discount rates were commensurate with FlowPoint's
stage of development; the uncertainties in the economic estimates described
above; the inherent uncertainty surrounding the successful development of the
purchased in-process technology; the useful life of such technology; the
profitability levels of such technology; and, the uncertainty of technological
advances that were unknown at the time of the acquisition.
The forecasts used by the Company in valuing in-process research and development
were based upon assumptions the Company believes to be reasonable but which are
inherently uncertain and unpredictable. The Company's assumptions may be
incomplete or inaccurate, and unanticipated events and circumstances are likely
to occur. For these reasons, actual results may vary from the projected results.
<PAGE>
The Company believes that the foregoing assumptions used in the forecasts were
reasonable at the time of the acquisition. No assurance can be given, however,
that the underlying assumptions used to estimate expected project sales,
development costs or profitability, or the events associated with such projects,
will transpire as estimated. For these reasons, actual results may vary from the
projected results.
FlowPoint's in-process research and development value is comprised of several
significant individual on-going projects. Remaining development efforts for
these projects include various phases of design, development and testing.
Anticipated completion dates for the projects in progress are estimated to occur
over the first nine months following the acquisition. The Company estimated it
will begin generating the economic benefits from the technologies in the second
half of fiscal year 2000. Funding for such projects was estimated to be obtained
from internally generated sources. Expenditures to complete these projects were
estimated to total approximately $1.0 million over the next six months. These
estimates are subject to change, given the uncertainties of the development
process, and no assurance can be given that deviations from these estimates will
not occur.
Management expects to continue their support of these efforts and believes the
Company has a reasonable chance of successfully completing the R&D programs.
However, there is risk associated with the completion of the projects and there
is no assurance that any will meet with either technological or commercial
success.
NetVantage, Inc.
On September 25, 1998, Cabletron acquired NetVantage, Inc., a publicly held
manufacturer of ethernet workgroup switches. Under the terms of the Merger
Agreement, Cabletron issued 6.4 million shares of Cabletron common stock to the
shareholders of NetVantage in exchange for all of the outstanding shares of
stock of NetVantage.
Cabletron recorded the cost of the acquisition at approximately $77.8 million,
including direct costs of the acquisition. The cost represents 6.4 million
shares at $9.9375 per share, in addition to direct acquisition costs.
Cabletron's consolidated results of operations include the operating results of
NetVantage, Inc. from the acquisition date.
In connection with the acquisition of NetVantage, the Company recorded special
charges of $33.9 million ($29.0 million, net of tax) for in-process research and
development projects. The valuation of the IPR&D incorporated the guidance on
IPR&D valuation methodologies recently promulgated by the SEC. These
methodologies incorporate the notion that cash flows attributable to development
efforts, including the effort to be completed on the development effort
underway, and development of future versions of the product that have not yet
been undertaken, should be excluded in the valuation of IPR&D. This allocation
represents risk-adjusted cash flows related to the incomplete products. At the
date of acquisition, the development of these projects had not yet reached
technological feasibility and the R&D in progress had no alternative future
uses. Accordingly, these costs were expensed as of the acquisition date.
The Company used independent third-party appraisers to assess and allocate
values to the in-process research and development. The value assigned to these
assets were determined by identifying significant research projects for which
technological feasibility had not been established, including development,
engineering and testing activities associated with the introduction of
NetVantage's next-generation Ethernet technologies.
The nature of the efforts to develop the acquired in-process technology into
commercially viable products principally relate to the completion of all
planning, designing, prototyping, high-volume verification, and testing
activities that are necessary to establish that the proposed technologies meet
their design specifications including functional, technical, and economic
performance requirements.
The value assigned to purchased in-process technology was determined by
estimating the costs to develop the purchased in-process technology into
commercially viable products, estimating the resulting net cash flows from the
projects and discounting the net cash flows to their present value. The revenue
projection used to value the in-process research and development was based on
estimates of relevant market sizes and growth factors, expected trends in
technology and the nature and expected timing of new product introductions by
the Company and its competitors.
<PAGE>
For purposes of the IPR&D valuation, the total revenues attributable to
NetVantage were projected to exceed $250 million within 5 years, assuming the
successful completion and market acceptance of the major R&D efforts. As of the
valuation date, NetVantage had a few existing products, which lack the
technological breadth and depth necessary in the evolving networking equipment
market. Accordingly, it was estimated that the significant revenue growth in the
first several years would be primarily related to the in-process technologies.
The estimated revenues for the in-process projects were projected to peak in
2004 and then decline as other new products and technologies were expected to
enter the market.
Cost of sales was estimated based on NetVantage's internally generated
projections and discussions with management regarding anticipated gross margin
improvements. Due to the market opportunities in the Network Equipment arena and
NetVantage's unique technology architecture, substantial gross margins were
projected through the forecast period. Cost of sales as a percentage of sales
was forecasted to remain constant at 57.5%. SG&A expenses (including
depreciation) as a percentage of sales was projected to decline slightly in 2001
and then remain constant at 23%. R&D expenditures as a percentage of sales were
projected to decline slightly in 2000 and remain constant at 10% over the
projection period.
The rates utilized to discount the net cash flows to their present value were
based on venture capital rates of return. Due to the nature of the forecast and
the risks associated with the projected growth, profitability and developmental
projects, a discount rate of 21.0 percent was determined to be appropriate for
the in-process R&D. These discount rates are commensurate with NetVantage's
stage of development; the uncertainties in the economic estimates described
above; the inherent uncertainty surrounding the successful development of the
purchased in-process technology; the useful life of such technology; the
profitability levels of such technology; and, the uncertainty of technological
advances that were unknown at the time of the acquisition.
The forecasts used by the Company in valuing in-process research and development
were based upon assumptions the Company believes to be reasonable but which are
inherently uncertain and unpredictable. The Company's assumptions may be
incomplete or inaccurate, and unanticipated events and circumstances are likely
to occur. For these reasons, actual results may vary from the projected results.
The Company believes that the foregoing assumptions used in the forecasts were
reasonable at the time of the acquisition. No assurance can be given, however,
that the underlying assumptions used to estimate expected project sales,
development costs or profitability, or the events associated with such projects,
will transpire as estimated. For these reasons, actual results may vary from the
projected results.
NetVantage's in-process research and development value is comprised of several
significant individual on-going projects. Remaining development efforts for
these projects include various phases of design, development and testing.
Anticipated completion dates for the projects in progress are estimated to occur
over the next year. The Company projects to begin generating the economic
benefits from the technologies in the second half of fiscal year 2000. Funding
for such projects was estimated to be obtained from internally generated
sources. Expenditures to complete these projects were estimated to total
approximately $2.0 million over the next year. These estimates are subject to
change, given the uncertainties of the development process, and no assurance can
be given that deviations from these estimates will not occur.
Management expects to continue their support of these efforts and believes the
Company has a reasonable chance of successfully completing the R&D programs.
However, there is risk associated with the completion of the projects and there
is no assurance that any will meet with either technological or commercial
success.
Yago Systems, Inc.
In connection with the acquisition of YAGO, the Company allocated $150 million
of the purchase price to in-process research and development projects. This
allocation represents the estimated fair value based on risk-adjusted cash flows
related to the incomplete products. At the date of acquisition, the development
of these projects had not yet reached technological feasibility and the research
and development ("R&D") in progress had no alternative future uses. Accordingly,
these costs were expensed as of the acquisition date.
<PAGE>
The Company used independent third-party appraisers to assess and allocate
values to the in-process research and development. The value assigned to these
assets were determined by identifying significant research projects for which
technological feasibility had not been established, including development,
engineering and testing activities associated with the introduction of YAGO's
next-generation switching router family of products and technologies.
At the time of its acquisition, YAGO was a development stage company that had
spent approximately $5.6 million on research and development focused on the
development of advanced gigabit switching technology. In fact, all of Yago's
efforts since the company's inception had been directed towards the introduction
of an advanced gigabit layer-2, layer-3, and layer-4 switching and router
product family. YAGO had no developed products or technology and had not
generated any revenues as of its acquisition date. At the time, YAGO was testing
the technology related to the MSR8000, its first product to be released, and was
developing its MSR16000/8600 family of products. These two primary development
efforts were made up of six significant research and development components,
which were ongoing at the acquisition date. These component efforts included
continued MSR8000 development and testing, research and development of the
MSR2000 (a desktop version of the MSR8000), development of the MSR8600,
development of Wide Area Network interfaces for its switching products, routing
software research and development, and device management software research and
development.
At the time of YAGO's acquisition, the Company believed that the MSR product
family of switching routers would set a new standard for performance and
functionality by delivering wire-speed layer-2, layer-3 and layer-4
functionality. Designed for the enterprise and ISP backbone markets, upon
completion of their development, the MSR products were intended to offer large
table capacity, a multi-gigabit non-blocking backplane, low latency and seamless
calling. YAGO also intended to develop its MSR products to be interoperable with
other standard-based routers and switches. As of the acquisition date,
management expected the development of the MSR product family would be the only
mechanism to fuel YAGO's revenue growth and profitability in the future. Despite
the incomplete state of YAGO's technology, the Company felt that the projected
size and growth of the market for the MSR product, YAGO's demonstrated promise
in the development of the MSR product family and the consideration paid by
Cabletron's competitors to acquire companies comparable to YAGO all warranted
the consideration paid by Cabletron for YAGO.
The nature of the efforts to develop the acquired in-process technology into
commercially viable products principally related to the completion of all
planning, designing, prototyping, high-volume verification, and testing
activities that were necessary to establish that the proposed technologies met
their design specifications including functional, technical, and economic
performance requirements. Anticipated completion dates for the projects in
progress were expected to occur over the next two years, the Company expected to
begin generating the economic benefits from the technologies in the second half
of 1998. Funding for such projects was expected to be obtained from internally
generated sources. Expenditures to complete the MSR technology were expected to
total approximately $10 million over the next two years. These estimates are
subject to change, given the uncertainties of the development process, and no
assurance can be given that deviations from these estimates will not occur.
The value assigned to purchased in-process technology was determined by
estimating the costs to develop the purchased in-process technology into
commercially viable products, estimating the resulting net cash flows from the
projects and discounting the net cash flows to their present value. The revenue
projection used to value the in-process research and development was based on
estimates of relevant market sizes and growth factors, expected trends in
technology and the nature and expected timing of new product introductions by
the Company and its competitors.
In the model used to value in-process research and development in the YAGO
acquisition, as of March 17, 1998, total revenues attributable to YAGO were
projected to exceed $900 million in 2002, assuming the successful completion and
market acceptance of the major R&D efforts. As of the valuation date, YAGO had
no existing products and accordingly all revenue growth in the first several
years were related to the in-process technologies. The estimated revenues for
the in-process were projected to peak in 2003 and then decline as other new
products and technologies were projected to enter the market.
<PAGE>
Cost of sales was estimated based on YAGO's internally generated projections and
discussions with management regarding anticipated gross margin improvements. Due
to the market opportunities in the Gigabit Ethernet arena and YAGO's unique
product architecture substantial gross margins are expected through 2000.
Thereafter, gross margins are expected to gradually decline as competition
increases. Cost of sales was projected to average approximately 47.5 percent
through 2003. SG&A expenses (including depreciation), was projected to remain
constant as a percentage of sales at approximately 23 percent. R&D expenditures
were projected to decrease as a percentage of sales as the in-process projects
were completed. R&D expenditures were expected to peak in 1998 at 7.1 percent of
sales, decline, and then level out at 5.0 percent of sales in 2000 and
thereafter.
The rates utilized to discount the net cash flows to their present value were
based on venture capital rates of return. Due to the nature of the forecast and
the risks associated with the projected growth, profitability and developmental
projects, discount rates of 45.0 to 50.0 percent were used for the business
enterprise and for the in-process R&D. The Company believes these rates were
appropriate because they were commensurate with YAGO's stage of development; the
uncertainties in the economic estimates described above; the inherent
uncertainty surrounding the successful development of the purchased in-process
technology; the useful life of such technology; the profitability levels of such
technology; and, the uncertainty of technological advances that are unknown at
this time.
The forecasts used by the Company in valuing in-process research and development
were based upon assumptions the Company believes to be reasonable but which are
inherently uncertain and unpredictable. No assurance can be given that the
underlying assumptions used to estimate expected project sales, development
costs or profitability, or the events associated with such projects, will
transpire as estimated. The Company's assumptions may be incomplete or
inaccurate, and unanticipated events and circumstances are likely to occur. For
these reasons, actual results may vary from the projected results.
Management expects to continue their support of these efforts and believes the
Company has a reasonable chance of successfully completing the R&D programs.
However, there is risk associated with the completion of the projects and there
is no assurance that any will meet with either technological or commercial
success. The Company believes as it did at the time of the YAGO acquisition,
that if YAGO does not successfully complete its outstanding in-process research
and development efforts, Cabletron's future operating results would be
materially adversely impacted and the value of the in-process research and
development might never be realized.
Liquidity and Capital Resources
Cash, cash equivalents, marketable securities and long-term investments
decreased to $394.5 million at November 30, 1998 from $447.3 million at February
28, 1998. Net cash used in operating activities was $15.7 million in the nine
month period ended November 30, 1998, compared to net cash provided by operating
activities of $45.3 million in the comparable period of fiscal 1998. The primary
reason operating activities used cash during the period was that the Company
experienced increased costs as it prepared for an increase in sales activity
which increased sales level never occurred. Additionally, the decrease was due
to the use of product credits by Digital. In the Company's acquisition of the
DNPG, Digital received product credits which Digital can use until February 7,
2000 to purchase products from the Company. No cash is exchanged when Digital
purchases products using product credits; instead Digital's remaining product
credits are reduced by the amount of the purchase. The effect of Digital's use
of product credits on net cash provided by operating activities in this period
was partially offset by the Company's reduction of inventories due to improved
inventory controls. Net cash used in investing activities decreased by $5.2
million due in part to the Company having net purchases of securities of $25.1
million. The Company sold buildings, during the third quarter of fiscal 1999,
which provided $24.5 million, while the Company paid $32.2 million, net of cash
received, for acquisitions completed during the quarter.
Net accounts receivable decreased by $15.9 million to $225.3 million at November
30, 1998 from $241.2 million at February 28, 1998. Average days sales
outstanding were 61 days at November 30, 1998 compared to 78 days at February
28, 1998. The decrease in days sales outstanding was due primarily to the use of
product credits by Digital and, secondarily, to the increased collection efforts
of the Company. Digital's use of product credits reduces days sales outstanding
because the Company deems purchases paid in product credits to be collected
immediately.
<PAGE>
The Company has historically maintained higher levels of inventory than its
competitors in the LAN industry in order to implement its policy of shipping
most orders requiring immediate delivery within 24 to 48 hours. Worldwide
inventories at November 30, 1998 were $243.0 million, or 111 days of inventory,
compared to $309.7 million, or 157 days of inventory at the end of the prior
fiscal year. Inventory turnover was 3.3 turns at November 30, 1998, compared to
2.3 turns at February 28, 1998. Inventories decreased and inventory turnover
increased due both to improved inventory control performance and increased
reserves for inventory in connection with reducing the scope of the Company's
product offerings.
Capital expenditures for the first nine months of fiscal 1999 were $35.8 million
compared to $64.0 million for the same period of the preceding year. Capital
expenditures were principally related to upgrades of computer, computer related
and manufacturing equipment.
On November 23, 1998, the Company sold buildings acquired as part of its
acquisition of the Network Products Group of Digital Equipment Corporation. The
Company received cash totaling $24.5 million. Since the sale of the buildings
occurred within 12 months of the business acquisition date, the Company recorded
a $2.6 million gain as an adjustment to goodwill recorded as part of the
business acquisition.
Current liabilities at November 30, 1998 were $488.8 million compared to $472.8
million at the end of the prior fiscal year. This increase was mainly due to
timing of disbursements.
In the opinion of management, internally generated funds from operations and
existing cash, cash equivalents and short-term investments will provide adequate
funds to support the Company's working capital and capital expenditure
requirements for the next twelve months.
Year 2000-compliance
As widely reported, many computer systems were not designed to handle any dates
beyond the year 1999 and, therefore, computer hardware and software will need to
be modified prior to the year 2000 in order to remain functional. The Year 2000
Issue is the result of computer programs being written using two digits rather
than four, to define a specific year. Absent corrective measures, a computer
program that has date-sensitive software may recognize a date using "00" as 1900
rather than the year 2000. This could result in system failures or
miscalculations causing disruptions to various activities and operations. As is
true for most companies, the Year 2000 computer issue creates a risk for the
Company. If the Company's internal systems or the systems of its suppliers do
not correctly recognize date information when the year changes to 2000, there
could be an adverse impact on the Company's operations. To address this issue,
the Company initiated a project to assess and address Year 2000 compliance
issues for its infrastructure, internal systems and suppliers. In addition, the
project is responsible for assessing and addressing the Year 2000 compliance of
the Company's products.
With respect to the Company's infrastructure and internal systems (consisting of
facilities, telecommunications, and the corporate network) and enterprise,
manufacturing, engineering systems, as well as those of third party suppliers,
the phases of the project include: (1) inventorying Year 2000 items; (2)
assigning priorities to identified items and assessing the Year 2000 compliance
of items determined to be critical to the Company; (3) remediation of critical
items that are determined not to be Year 2000 compliant; (4) testing critical
items; and (5) designing and implementing contingency plans.
Cabletron has substantially completed its inventory of critical systems, and
expects to complete the overall inventory within the next two months. The
Company is currently in the process of prioritizing and assessing the
inventoried systems, equipment and facilities. The Company expects to complete
most facets of this assessment program during mid 1999. Remediation and testing
of critical systems is under way and it is expected that this process will be
complete by the end of October 1999. Cabletron Systems is currently contacting
its critical suppliers to determine that the suppliers' operations and the
products and services they provide are Year 2000 compliant. This process will
continue throughout 1999. Even where assurances are received from third parties
there remains a risk that failure of systems and products of other companies on
which the Company relies could have a materially adverse effect on the Company.
In order to achieve these dates, the Company is continuing to allocate
additional resources to the Year 2000 project. At this time, the Company is
still assessing the likely worse case scenario if its critical systems are not
Year 2000 compliant by the Year 2000, but it expects to do so within the next
three months.
<PAGE>
The Company has conducted extensive work regarding the status of its current,
developing and installed base of products. The Company has published a list of
its major products indicating their status of Year 2000 compliance. This list is
available on the Company's World Wide Web page
(http://www.cabletron.com/year-2000) and is updated periodically. The Company
believes that substantially all of its current hardware products are Year 2000
compliant. The Company believes that its older hardware products that are not
Year 2000 compliant will continue to perform all essential and material
functions after the year 2000 but may, in limited circumstances, incorrectly
report the date of events (i.e., events on the network that are reported to a
network management software package) after the year 2000. The Company believes
that its current version of (Version 5.1) Spectrum, its network management
platform, is Year 2000 compliant. Older versions of Spectrum are not Year 2000
compliant. The Company is offering upgrades for some, but not all, of the
non-compliant products previously sold by the Company. For other non-compliant
products, previously sold, the Company is offering customers the opportunity to
purchase equipment offering equivalent functionality. Given that most
non-compliant products previously sold will continue to perform their standard
functions, the Company expects that many customers will decide not to replace
those products. Despite the Company's efforts to date to identify the Year 2000
compliance of its current and installed base of products and the effects of any
non-compliance, the Company cannot be sure that it has identified all areas of
non-compliance or that any solutions it implements to address the non-compliance
will prove satisfactory. Further, since all customer situations cannot be
anticipated, particularly those involving third party products, the Company may
experience an increase in warranty and other claims as a result of the Year 2000
transition. For these reasons, the impact of customer claims could have a
material adverse impact on the Company's results of operations or financial
condition.
Based on the work performed to date, the Company has not incurred material
costs. The Company presently estimates it will incur between $15 and $18 million
of costs, of which approximately 85% will be for capital expenditures, in
connection with its Year 2000 efforts. This estimate is based on information
gathered to date, and may be materially revised as the inventory is completed
and work progresses. If implementation of replacement systems is delayed, or if
significant new non-compliance issues are identified, the Company's results of
operations or financial condition could be materially adversely affected.
Contingency plans are being developed in critical areas, to ensure that any
potential material business interruptions caused by the Year 2000 issue are
mitigated. Preliminary contingency plans are expected to be formalized by March
31, 1999. However, 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. The Company has taken and will
continue to take corrective action to mitigate any significant Year 2000
problems. There can be no guarantee that the Company will not experience
significant business disruptions or loss of business due to the Year 2000 issue.
Specific factors may later become known which could result in a material adverse
impact on the Company's results of operations or financial condition.
<PAGE>
Item 3. Quantitative and Qualitative Disclosures about Market Risk
FOREIGN EXCHANGE RISK MANAGEMENT
As the Company's international sales grow as a percentage of total sales,
exposure to volatility in exchange rates could have a material impact on the
Company's financial results.
The Company uses foreign currency forward and option contracts to manage the
risk of exchange fluctuations. The Company uses these derivative instruments to
reduce its exchange risk by essentially creating offsetting market exposures.
The instruments are not held for trading or speculative purposes.
Based on the Company's overall currency rate exposure at November 30, 1998
including derivative and other foreign currency sensitive instruments, a
near-term change in currency rates based on historic currency rate movements
would not materially affect the consolidated financial position, results of
operations, or cash flows of the Company.
The success of the hedging program depends on forecasts of transaction activity
in various currencies. To the extent that these forecasts are over or
understated during periods of currency volatility, the Company could experience
unanticipated currency gains or losses.
Euro Conversion
Effective January 1, 1999, eleven of the fifteen member countries of the
European Union established fixed conversion rates between their existing
sovereign currencies (the "legacy currencies") and one common currency (the
"Euro"). The participating countries adopted the Euro as their common legal
currency on that date (the "Euro Conversion"). Since that date, the Euro began
trading on currency exchanges and has been used in business transactions. On
January 1, 2002, participating countries will issue new Euro-denominated bills
and coins. The legacy currencies will be withdrawn from circulation as legal
tender effective January 1, 2002. During the period from January 1, 1999 and
June 30, 2002, parties may use either the Euro or a participating country's
legacy currency as legal tender.
Earlier this year, the Company formed a Euro Committee. The Euro Committee has
analyzed the impact of the Euro conversion on the Company in a number of areas,
including the Company's information systems, product pricing, finance and
banking resources, foreign exchange management, contracts, accounting and tax
departments. While the Company has made certain adjustments to its business and
operations to accommodate the Euro conversion, the Euro Committee believes that
the Euro conversion will not have a material adverse impact on the Company's
financial position and results of operations.
INTEREST RATE RISK
The Company maintains an investment portfolio consisting of debt securities of
various issuers, types and maturities. The securities that are classified as
held to maturity are recorded on the balance sheet at amortized cost. A portion
of the investments is classified as available for sale. These instruments are
not held for purposes of trading. The securities are recorded at amortized cost
which approximates market value. Unrealized gains or losses associated with
these securities are not material. Due to the average maturity and conservative
nature of the investment portfolio, a sudden change in interest rates would not
have a material effect on the value of the portfolio.
<PAGE>
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
As previously disclosed in Cabletron's annual report on Form 10-K for fiscal
1998, a consolidated class action lawsuit purporting to state claims against
Cabletron and certain officers and directors of Cabletron was filed and
currently is pending in the United States District Court for the District of New
Hampshire. The complaint alleges that Cabletron and several of its officers and
directors disseminated materially false and misleading information about
Cabletron's operations and acted in violation of Section 10(b) and Rule 10b-5 of
the Exchange Act during the period between March 3, 1997 and December 2, 1997.
The complaint also alleges that certain of the Company's alleged accounting
practices resulted in the disclosure of materially misleading financial results
during the same period. The Complaint does not specify the amount of damages
sought on behalf of the class. Cabletron and other defendants moved to dismiss
the complaint and, by Order dated December 23, 1998, the District Court
expressed its intention to grant Cabletron's motion to dismiss unless the
plaintiffs amended their complaint within 30 days (or January 22, 1999). As of
the date of this filing, no such amendment has been served on Cabletron or the
individual defendants. The legal costs incurred by Cabletron in defending itself
and its officers and directors against this litigation, whether or not it
prevails, could be substantial, and in the event that the plaintiffs prevail,
Cabletron could be required to pay substantial damages. This litigation may be
protracted and may result in a diversion of management and other resources of
Cabletron. The payment of substantial legal costs or damages, or the diversion
of management and other resources, could have a material adverse effect on
Cabletron's business, financial condition or results of operations.
<PAGE>
Item 5. Other Information
As previously disclosed, the Company received a letter from the staff of the
Securities and Exchange Commission (the "Staff") commenting on the Company's
Form 10-K for the year ended February 28, 1998 and its Form 10-Q for the quarter
ended May 31, 1998. The Staff proposes that the Company amend its Forms 10-K and
10-Q to reflect the Staff's comments. The Staff's comments focus primarily on
accounting issues related to the Company's acquisition of the DNPG, Yago
Systems, Inc., and certain earlier acquisitions, including principally the
amount of the purchase price in the DNPG and Yago acquisitions allocated by the
Company to in-process research and development, as well as the extent of the
disclosure related to such allocations, and to special charges the Company
recorded in connection with these acquisitions. The Company believes that the
comments by the Staff are similar to those made to a number of public companies,
particularly in the technology industry, that have reported acquisitions in the
recent past. The accounting for acquisitions reflected in the Forms 10-K and
10-Q is, the Company believes, consistent with industry practice and was based
upon consultation with its auditors and, with respect to in-process research and
development, with an independent third party appraiser.
Upon receiving further advice from its auditors and other professionals in
reviewing the Forms 10-K and 10-Q and formulating a response to the Staff, the
Company has determined to reduce the $57.7 million in special charges the
Company recorded in the fourth quarter of fiscal 1998 in connection with its
acquisition of the DNPG by approximately $33.2 million. The amount being reduced
is comprised primarily of (i) approximately $13 million related to the buy-out
of certain Digital benefits and employee starting bonuses which amount will be
amortized over the six quarters following the closing of the acquisition, (ii)
approximately $3 million of professional fees which will be allocated to the
purchase price and (iii) approximately $16 million of other estimated
acquisition related obligations, which estimates have subsequently been reduced.
As a result, (i) the Company's loss from operations for the first quarter of
fiscal 1999 has been increased by approximately $8.7 million of acquisition
related expenses from the amount previously disclosed (including as disclosed in
the Company's Form 10-Q for such quarter) and (ii) the Company's income from
operations for the second quarter of fiscal 1999 has been decreased by
approximately $5.0 million of acquisition related expenses from the amount
disclosed in a press release dated September 21, 1998. As a consequence, loss
per share for the first quarter of fiscal 1999 has been increased by
approximately $0.04 to ($0.97) and earnings per share for the second quarter has
been reduced by approximately $0.02 to $0.07. The adjustments described in this
paragraph have been fully incorporated into the financial statements contained
in this report, excluding the Company's February 28, 1998 balance sheet which
does not incorporate these adjustments. The Company expects that this
reallocation of acquisition related expenses will have the effect of increasing
operating expenses between $2 and $4 million in each of its next three quarters
(beginning with the third fiscal quarter). In addition, the Company has
determined to reclassify $13.6 million of special charges associated with the
elimination and phase out of superceded product lines recorded in its
acquisition of Yago Systems, Inc. into its cost of sales for the first quarter
of fiscal 1999. This reclassification will not effect future financial results.
The Company is engaged in communication with the Staff. The Staff may seek
additional adjustments of special charges related to the DNPG or other
acquisitions. Together with the adjustments reflected in this report, any such
additional adjustments may have a material adverse impact upon the Company's
operating expenses and earnings in future periods. In addition, the Staff may
seek reductions in the amount of the purchase prices allocated to in-process
research and development in the DNPG and Yago Systems, Inc. acquisitions. The
Company allocated $325.0 million of the DNPG purchase price and $150.0 million
of the Yago purchase price to in-process research and development. In the event
that the Company is required to reduce the charges for in-process research and
development, these amounts will be allocated to other intangible assets, which
would be amortized against earnings on a straight-line basis over approximately
5 - 10 years. Any such allocation may have a material adverse impact upon the
Company's operating expenses and earnings in future periods. The Staff has not
expressed any comment on the Company's accounting for its acquisitions of the
DSLAM division of Ariel Corporation, FlowPoint or NetVantage, but the Staff
could also take exception to the accounting in those acquisitions as well. As in
the DNPG and Yago acquisitions, the Company allocated substantial amounts of the
purchase price in these three recent acquisitions to in-process research and
development. A reallocation of the amounts allocated to in-process research and
development in these three acquisitions could also have a material adverse
impact upon the Company's operating expenses and earnings in future periods. The
Company intends, after reaching a final resolution with the Staff, to amend its
Form 10-K for fiscal 1998 (including the balance sheet contained in this
report), its Form 10-Q for the first quarter of fiscal 1999 and possibly other
filings to reflect the adjustments related to special charges described above
and any additional adjustments required by the Staff and to add additional
textual disclosure concerning these special charges, the in-process research and
development allocations and certain other matters.
<PAGE>
Item 6. Exhibits and Reports on Form 8-K
(a) There were no exhibits filed during the quarter ended November 30, 1998.
(b) The Registrant filed two reports on Form 8-K during the quarter for which
this report is filed. On September 9, 1998 the Registrant announced the
appointment of Michael A. Skubisz to Chief Technology Officer. On October 5,
1998 the Registrant announced the sale of 89,921 shares of its common stock
pursuant to Regulation S under the Securities Act of 1933.
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.
CABLETRON SYSTEMS, INC.
(Registrant)
March 17, 1999 /s/ Craig R. Benson
- ------------- ---------------
Date Craig R. Benson
Chairman, President,
Chief Executive Officer and
Treasurer
March 17, 1999 /s/ David J. Kirkpatrick
- ------------- --------------------
Date David J. Kirkpatrick
Corporate Executive Vice President
of Finance and
Chief Financial Officer
<PAGE>
EXHIBIT INDEX
Exhibit Page
No. Exhibit No.
11.1 Included in notes to consolidated financial statements ---
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from the
consolidated balance sheet, consolidated statement of operations and the
consolidated statement of cash flows included in the Company's Form 10-Q/A for
the period ending November 30, 1998, and is qualified in its entirety by
reference to such financial statements.
</LEGEND>
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<NAME> CABLETRON SYSTEMS, INC.
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