<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
---------------------
FORM 10-Q
[x] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange
Act of 1934.
For the quarter ended September 30, 1998 or
[ ] Transition Report Pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934.
For the transition period from ____ to____
Commission file number:
0-28734
-----------------------
ADVANCED FIBRE COMMUNICATIONS, INC.
------------------------------------------------------
(Exact name of registrant as specified in its charter)
Delaware 68-0277743
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
One Willow Brook Court
Petaluma, California 94954
(707) 794-7700
(Address of Registrant's principal
executive offices and telephone number, including area code)
---------------------
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 [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date:
Outstanding as of
Class October 26, 1998
- ----------------------------- -----------------
Common Stock, $0.01 par value 75,658,018
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ADVANCED FIBRE COMMUNICATIONS, INC.
REPORT ON FORM 10-Q
FOR THE QUARTER ENDED SEPTEMBER 30, 1998
TABLE OF CONTENTS
<TABLE>
<CAPTION>
PAGE
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<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets
September 30, 1998 and December 31, 1997......................................2
Condensed Consolidated Statements of Operations
Three and nine months ended September 30, 1998 and 1997.......................3
Condensed Consolidated Statements of Cash Flows
Nine months ended September 30, 1998 and 1997.................................4
Notes to Condensed Consolidated Financial Statements..............................5
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations .......................................................................9
PART II. OTHER INFORMATION
Item 1. Legal Proceedings...................................................................20
Item 2. Changes in Securities and Use of Proceeds...........................................21
Item 3. Defaults Upon Senior Securities.....................................................22
Item 4. Submission of Matters to a Vote of Security Holders.................................22
Item 5. Other Information...................................................................22
Item 6. Exhibits and Reports on Form 8-K....................................................22
</TABLE>
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
ADVANCED FIBRE COMMUNICATIONS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
(Unaudited)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
--------- ---------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 13,451 $ 9,053
Marketable securities 89,595 96,143
Accounts receivable, net 78,988 79,098
Inventories, net 56,442 52,073
Prepaid expenses 7,707 6,090
--------- ---------
Total current assets 246,183 242,457
Property and equipment, net 44,644 24,506
Other assets 10,417 6,330
--------- ---------
TOTAL ASSETS $ 301,244 $ 273,293
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 15,914 $ 18,475
Accrued liabilities 23,817 30,342
--------- ---------
Total current liabilities 39,731 48,817
Long-term liabilities 1,581 756
Commitments and contingencies
Stockholders' equity:
Preferred stock, $0.01 par value; 5,000,000 shares
authorized in 1998 and 1997;
no shares issued and outstanding -- --
Common stock, $0.01 par value; 200,000,000 shares
authorized in 1998 and 1997; 75,564,114 and 72,626,370
shares issued and outstanding in 1998 and 1997,
respectively 756 726
Additional paid-in capital 208,149 193,183
Notes receivable from stockholders (861) (835)
Retained earnings 51,888 30,646
--------- ---------
Total stockholders' equity 259,932 223,720
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 301,244 $ 273,293
========= =========
</TABLE>
See accompanying notes to condensed consolidated financial statements
2
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ADVANCED FIBRE COMMUNICATIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
(Unaudited)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------- ---------------------
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenues $ 66,513 $ 76,790 $237,602 $182,402
Cost of revenues 36,388 41,472 128,659 99,984
-------- -------- -------- --------
Gross profit 30,125 35,318 108,943 82,418
-------- -------- -------- --------
Operating expenses:
Research and development 11,422 7,205 30,163 18,495
Selling, general and
administrative 16,297 12,297 49,126 29,925
-------- -------- -------- --------
Total operating 27,719 19,502 79,289 48,420
expenses -------- -------- -------- --------
Operating income 2,406 15,816 29,654 33,998
Other income, net 896 1,313 3,021 3,694
-------- -------- -------- --------
Income before income 3,302 17,129 32,675 37,692
taxes
Income taxes 1,153 6,338 11,433 13,946
-------- -------- -------- --------
Net income $ 2,149 $ 10,791 $ 21,242 $ 23,746
======== ======== ======== ========
Basic net income per share $ 0.03 $ 0.15 $ 0.28 $ 0.34
======== ======== ======== ========
Shares used in basic per share
computations 75,322 71,951 74,756 69,365
======== ======== ======== ========
Diluted net income per share $ 0.03 $ 0.14 $ 0.27 $ 0.31
======== ======== ======== ========
Shares used in diluted per
share computations 78,719 79,112 79,472 77,437
======== ======== ======== ========
</TABLE>
See accompanying notes to condensed consolidated financial statements
3
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ADVANCED FIBRE COMMUNICATIONS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
<TABLE>
<CAPTION>
Nine Months Ended
September 30,
----------------------
1998 1997
-------- --------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 21,242 $ 23,746
Adjustments to reconcile net income to net cash provided
by operating activities:
Tax benefit from option exercises 8,956 13,898
Deferred incomes taxes (686) (1,324)
Depreciation and amortization 4,734 1,932
Changes in operating assets and liabilities:
Accounts receivable 110 (26,708)
Inventories (4,369) (24,878)
Other current assets (755) (964)
Other long-term assets (3,618) 51
Accounts payable (2,561) 13,356
Other accrued liabilities (6,525) 9,073
Other long-term liabilities 833 (10)
-------- --------
NET CASH PROVIDED BY OPERATING ACTIVITIES 17,361 8,172
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Net sales (purchases) of marketable securities 6,548 (16,497)
Purchase of property and equipment (24,872) (14,956)
Other long-term investments (645) (3,000)
-------- --------
NET CASH USED IN INVESTING ACTIVITIES (18,969) (34,453)
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercise of common stock options and warrants 6,006 2,270
Proceeds from secondary offering of common stock -- 7,843
-------- --------
NET CASH PROVIDED BY FINANCING ACTIVITIES 6,006 10,113
-------- --------
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 4,398 (16,168)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 9,053 24,942
-------- --------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 13,451 $ 8,774
======== ========
</TABLE>
See accompanying notes to condensed consolidated financial statements
4
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ADVANCED FIBRE COMMUNICATIONS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and pursuant to the rules and regulations of the
Securities and Exchange Commission. While these financial statements reflect all
adjustments of a normal and recurring nature which are, in the opinion of
management, necessary to present fairly the results of the interim period, they
do not include all information and footnotes required by generally accepted
accounting principles for complete financial statements. These financial
statements and notes should be read in conjunction with the financial statements
and notes thereto, for the year ended December 31, 1997, contained in the
Company's annual report on Form 10-K.
The condensed consolidated financial statements include Advanced Fibre
Communications, Inc., and its subsidiaries (the "Company"). Significant
intercompany transactions and accounts have been eliminated.
The Company operates on 13-week fiscal quarters ending on the last Saturday of
each fiscal period. For presentation purposes only, the fiscal periods are shown
as ending on the last day of the month of the respective fiscal period. The
results of operations for the three and nine month periods ended September 30,
1998 are not necessarily indicative of the operating results for the full year.
NOTE 2 INVENTORIES
Inventories are valued at the lower of first-in, first-out cost or market and
consisted of the following (in thousands):
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
-------------- --------------
<S> <C> <C>
Raw materials $ 18,143 $ 17,369
Work in progress 576 666
Finished goods 37,723 34,038
-------------- --------------
Inventories, net $ 56,442 $ 52,073
============== ==============
</TABLE>
NOTE 3 BANK BORROWINGS
The Company has a $50.0 million unsecured bank line through two banks with an
interest rate of prime, or LIBOR plus 0.75%. The line of credit expires in July
1999. Under the bank line, the banks may issue letters of credit up to $10.0
million and foreign exchange contracts up to $50.0 million on behalf of the
Company. The bank line requires the Company to comply with certain debt and
financial covenants. As of September 30, 1998, no borrowings were outstanding
under the bank line, and the Company was in compliance with the covenants
contained in the agreement. At September 30, 1998, no amounts were reserved for
letters of credit under the line, and $4.9 million was reserved for foreign
exchange contracts under the line.
NOTE 4 COMMITMENTS AND CONTINGENCIES
ITRI/Acer Netxus, Inc.
In September 1992, the Company entered into agreements (the "ITRI Agreements")
with the Industrial Technology Research Institute ("ITRI"), a Taiwanese
government-sponsored research and development organization, that granted to ITRI
certain license rights to the European Telecommunications Standards Institute
("ETSI") version of the Universal Modular Carrier 1000(TM) ("UMC system"). In
July 1996, the Company became involved in litigation and arbitration
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proceedings with ITRI, certain of ITRI's sub-licensee "Member Companies", and
others, including Acer Netxus, Inc. ("Acer"). These legal proceedings involved
claims for breach of the ITRI Agreements, trade secret misappropriation, unfair
competition, and related claims.
In March 1998, the Company, ITRI, the Member Companies and other parties entered
into a definitive Settlement Agreement that resolved all claims among such
parties, except Acer. Under the Settlement Agreement, all claims involved in the
proceedings between such parties will be dismissed with prejudice. The
Settlement Agreement provides that the Member Companies will pay an aggregate of
$6.3 million to the Company over a five year period, and will pay the Company
royalties on the purchase of certain ASICs by the Member Companies. Under the
Settlement Agreement, the Company granted a limited license to the Member
Companies to certain of the Company's technology, agreed to sell certain ASICs
to the Member Companies, and agreed to pay $500,000 to ITRI over a three year
period for legal fees incurred by ITRI in the proceedings. The Settlement
Agreement does not grant to the Member Companies any rights to the Company's UMC
1000 Third Generation Digital Loop Carrier(TM) ("3GDLC") technology or products.
In addition, the Settlement Agreement does not affect the Company's claims
against Acer.
In September 1998, the Company favorably resolved its litigation with Acer.
Pursuant to a settlement agreement dated September 18, 1998, and a Permanent
Injunction And Final Judgment entered by the United States District Court,
Northern District of California, on September 22, 1998, Acer is enjoined from
selling any digital loop carrier system for at least one year, and from
developing, manufacturing, or selling any device that uses or derives from UMC
technology or that is otherwise not the product of strict clean room development
or based on licensed third party technology. In addition, the injunction
requires that Acer destroy all work product and inventory related to its two
systems that competed with the UMC 1000, and subjects Acer to a $500,000 penalty
for any and each violation of the injunction.
DSC
On December 22, 1997, the Company filed a lawsuit in Sonoma County Superior
Court in California against DSC Communications Corporation ("DSC") related to
its hiring of a former employee of DSC, to become the Company's Vice President,
Product Planning. Since that time, in September 1998, Alcatel Alsthom Compagnie
completed its acquisition of DSC, and for purposes of this footnote, reference
is made to DSC. The Company's complaint responded to DSC's litigation threats,
and sought a declaratory judgment that its hiring of the former DSC employee was
lawful. In April, 1998, DSC filed a cross-complaint against the Company in the
lawsuit filed by the Company in Sonoma County Superior Court in California that
alleges "inevitable" trade secret misappropriation and related claims, and seeks
unspecified damages, and injunctive relief relating to the alleged
misappropriation, attorneys' fees and other relief. During September 1998, DSC's
efforts to obtain trade secret-related discovery was denied, and the Court
struck all material misappropriation allegations from DSC's Cross-Complaint. DSC
filed a First Amended Cross-Complaint on October 2, 1998, alleging "threatened"
trade secret misappropriation and related claims. The Amended Cross-Complaint
seeks the same relief sought by the original Cross-Complaint. There has been no
discovery in the case, and no trial date is set.
On January 22, 1998, DSC filed a lawsuit against the Company and the former DSC
employee in the United States District Court, Eastern District of Texas,
alleging "inevitable" trade secret misappropriation and related claims. DSC also
asserted a separate claim against the Company for patent infringement alleging
that the Company's 3GDLC product infringes a DSC patent. DSC's complaint sought
unspecified damages and injunctive relief relating to the alleged
misappropriation and patent infringement, attorneys' fees and other relief. On
February 5, 1998, the United States District Court, Eastern District of Texas
granted the Company's motion to dismiss all non-patent claims in this lawsuit.
In May 1998, the Company filed a counterclaim against DSC in the Texas patent
action alleging federal antitrust violations, unfair competition, breach of a
prior settlement agreement and other related claims. Between April and August,
1998, certain discovery occurred, and the parties filed various motions,
including cross-motions for summary judgment on the Company's defense that a
prior Settlement Agreement between the Company and DSC barred DSC's patent
claims. By a Report And Recommendation filed October 2, 1998, the United States
Magistrate Judge recommended that the District Court grant summary judgment in
the Company's favor on the patent claim based on the Settlement Agreement. DSC
filed an Objection to this ruling with the District Court on October 16, 1998,
and the matter remains pending.
The Company believes that all of DSC's misappropriation and other claims related
to the hiring of the former DSC employee are without merit, and the Company
intends to defend the lawsuits vigorously. Based on the Company's review of the
patent claim, the Company believes that the Company's 3GDLC product does not
infringe the DSC patent, and that
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the Company has meritorious defenses to such claim. The Company intends to
vigorously defend the litigation against DSC and prosecute its claims against
DSC. However, the Company cannot predict the ultimate outcome of these lawsuits.
In addition, patent litigation is highly complex and can extend for a protracted
period of time, which can divert the attention of the Company's management and
technical personnel and require the Company to incur substantial costs and
expenses. If the patent claim were to be resolved against the Company, this
could have a material adverse effect on the Company's business, results of
operations and financial condition.
RELTEC Corporation
On November 26, 1997, the Company filed a lawsuit in Sonoma County Superior
Court in California against RELTEC Corporation, alleging trade secret
misappropriation, tortuous interference with a contract, and related claims. The
case involves RELTEC's acquisition of the Company's technology through the
Company's Taiwan-based licensee, Vidar-SMS Co., Ltd. On January 21, 1998, the
Company filed for and obtained certain injunctive relief in April and May 1998.
Discovery is ongoing, and trial is scheduled to start on April 12, 1999.
Stockholder Litigation
The Company and various of its current and former officers and directors are
parties to a number of related lawsuits which purport to be class actions filed
on behalf of certain of the Company's stockholders (excluding the defendants and
parties related to them). The lawsuits, which are substantially identical,
allege that the defendants violated certain federal securities laws.
All of these actions are in the early stages of proceedings and the Company is
currently investigating the allegations. Based on its current information, the
Company believes the suits to be without merit and intends to defend itself and
its officers and directors vigorously. Although it is reasonably possible the
Company may incur a loss upon the conclusion of these claims, an estimate of any
loss or range of loss cannot be made. No provision for any liability that may
result upon adjudication has been made in the Company's consolidated financial
statements. In the opinion of management, resolution of this matter is not
expected to have a material adverse effect on the financial position of the
Company. However, depending on the amount and timing, an unfavorable resolution
of this matter could materially affect the Company's future results of
operations or cash flows in a particular period. In connection with these legal
proceedings, the Company expects to incur substantial legal and other expenses.
Stockholder suits of this kind are highly complex and can extend for a
protracted period of time, which can substantially increase the cost of such
litigation and divert the attention of the Company's management.
NOTE 5 COMPREHENSIVE INCOME
The Company has adopted the provisions of Statement of Financial Accounting
Standards (SFAS) No. 130, Reporting Comprehensive Income, effective for fiscal
years beginning after December 15, 1997. SFAS No. 130 requires classification of
items of other comprehensive income by nature in a financial statement and a
breakout of the accumulated balance of other comprehensive income separately
from retained earnings and additional paid in capital in the equity section of a
statement of financial position. Reporting comprehensive income provides a
measure of all changes in equity that result from recognized transactions and
other economic events of the period other than transactions with owners in their
capacity as owners. Adoption of this statement did not have a material effect on
the Company's consolidated financial position or results of operations because
there are no material differences between net income and comprehensive income in
the Company's financial statements.
NOTE 6 NET INCOME PER SHARE
The Company adopted the provisions of Statement of Financial Accounting
Standards (SFAS) No. 128, Earnings Per Share effective December 15, 1997. SFAS
No. 128 requires the presentation of basic net income per share and, for
companies with complex capital structures, diluted net income per share. Basic
net income per share is computed using the weighted average number of shares of
Common Stock outstanding. Diluted net income per share is computed using the
weighted average number of shares of Common Stock and common equivalent shares
from options and warrants to purchase Common Stock using the treasury stock
method, when dilutive.
7
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The following tables set forth the computations of shares and net income used in
the calculation of basic and diluted net income per share for the three and nine
month periods ended September 30, 1998, and 1997 (in thousands, except per share
data):
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
-------------------- --------------------
1998 1997 1998 1997
------- ------- ------- -------
<S> <C> <C> <C> <C>
BASIC NET INCOME PER SHARE:
Net income $ 2,149 $10,791 $21,242 $23,746
======= ======= ======= =======
Actual weighted average common
shares outstanding for 75,322 71,951 74,756 69,365
the period
======= ======= ======= =======
Basic net income per share $ 0.03 $ 0.15 $ 0.28 $ 0.34
======= ======= ======= =======
DILUTED NET INCOME PER SHARE:
Net income $ 2,149 $10,791 $21,242 $23,746
======= ======= ======= =======
Actual weighted average common
shares outstanding for
the period 75,322 71,951 74,756 69,365
Weighted average number of
shares upon exercise of
dilutive options and
warrants 3,397 7,161 4,716 8,072
------- ------- ------- -------
Shares used in per share
calculations 78,719 79,112 79,472 77,437
======= ======= ======= =======
Diluted net income per share $ 0.03 $ 0.14 $ 0.27 $ 0.31
======= ======= ======= =======
</TABLE>
NOTE 7 COMMON STOCK OPTIONS
In August 1998, the Compensation Committee of the Board of Directors authorized
a program to offer to replace option grants made under the 1996 Stock Incentive
Plan that were granted at exercise prices exceeding $12.50 per share. The offer
was made to all employees, 99% of whom participated, involving options to
purchase 4,190,105 shares of Common Stock and was effected on September 14,
1998. The exercise price of each re-priced option was $7.875, based on the
closing market price of the stock on September 14, 1998. The re-pricing is
subject to the condition that the options are not exercised, and employment is
not terminated, prior to March 15, 1999, and September 15, 1999, for employees
and officers, respectively. Vesting of the re-priced options was suspended at
September 14, 1998, and will resume on March 15, 1999 for employees, and
September 15, 1999 for officers. Any employee voluntarily leaving the Company
during the suspended vesting period will lose the affected options, including
previously vested portions of those options.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Except for the historical financial information contained herein, the following
discussion and analysis may contain "forward looking statements" within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section
21E of the Securities Exchange Act of 1934, as amended. Such statements include
declarations regarding the intent, belief or current expectations of the Company
and its management. Prospective investors are cautioned that any such forward
looking statements are not guarantees of future performance and involve a number
of risks and uncertainties; actual results could differ materially from those
indicated by such forward looking statements.
Among the important factors that could cause actual results to differ materially
from those indicated by such forward looking statements, as set forth below
under "Certain Factors That Might Affect Future Operating Results" are:
o Potential Fluctuations in Future Operating Results and Seasonality
o Customer Concentration
o Risks associated with International Markets
o Concentrated Product Line, New Products and Rapid Technological Change
o Dependence on Telecommunications Industry and Small Line Size Market
o Competition
o Dependence on Sole Source and Other Key Suppliers
o Dependence on a Limited Number of Third Party Manufacturers and Support
Organizations
o Risks Associated with Pending Litigation
o Risk of Failure to Manage Expanding Operations
o Limited Protection of Proprietary Technology; Risk of Third Party Claims of
Infringement
o Dependence on Key Personnel
o Year 2000
o Compliance with Regulations and Industry Standards
o Other risks identified from time to time in the Company's reports and
registration statements filed with the Securities and Exchange Commission
The following discussion should be read in conjunction with the Financial
Statements and Notes thereto, pages 2 through 8 of this Form 10-Q.
GENERAL
The Company designs, develops, manufactures, markets and supports the Universal
Modular Carrier 1000(TM) (the "UMC" system), a cost effective, multi-feature
digital loop carrier system developed to serve small line size markets. The
Company's UMC system is designed to enable telephone companies and other service
providers to connect subscribers to the central office switch for voice and data
communications over copper, fiber and analog radio networks. The Company sells
its product worldwide, primarily through its direct sales force in the domestic
market, and through its direct sales force, distributors and agents in
international markets.
RESULTS OF OPERATIONS
REVENUES. For the three months ended September 30, 1998, revenues decreased
$10.3 million, or 13.4%, to $66.5 million compared with $76.8 million for the
same period of 1997. International revenues totaled $14.5 million in the third
quarter of 1998, compared with $15.0 million for the comparable period in 1997,
and represented 21.8% and 19.5% of total revenues, respectively.
For the nine months ended September 30, 1998, revenues increased $55.2 million,
or 30.3%, to $237.6 million compared with $182.4 million for the same period of
1997. International revenues increased $28.0 million, or 64.7% to
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$71.3 million in the nine months ending September 30, 1998, compared with $43.3
million for the comparable period in 1997, and represented 30.0% and 23.7% of
total revenues, respectively.
The decrease in revenues in the third quarter of 1998 from the comparable period
in 1997 was primarily the result of the loss of GTE Communications Systems
("GTE") as a major customer, and lower than expected growth in the international
market due to a number of international economic factors. Revenues increased in
the nine month period of 1998 due to the increase in domestic and international
revenues resulting from wider market acceptance of the UMC 1000 Third Generation
Digital Loop Carrier(TM) and other new features of the UMC system, increasing
penetration into the Competitive Local Exchange Carrier market, and the
expansion of the Company's customer base.
For the quarter ended September 30, 1998, Winstar Equipment Corporation
accounted for 11.4% of total revenues. For the quarter ended September 30, 1997,
GTE accounted for 27.4% of total revenues. For the nine months ended September
30, 1998, Integrators of System Technology (Pty) Ltd. of South Africa accounted
for 11.6% of total revenues. For the comparable nine month period in 1997, GTE
accounted for 20.5% of total revenues. No other customer accounted for 10% or
more of total revenues in any such period. Although the Company's largest
customers have varied from period to period, the Company anticipates that its
results of operations in any given period will continue to depend to a
significant extent upon sales to a small number of customers. There can be no
assurance that the Company's principal customers will continue to purchase
product from the Company at current levels, if at all. The loss of one or more
major customers could have a material adverse effect on the Company's business,
financial condition and results of operations. For example, sales to GTE in the
three and nine month periods ended September 30, 1998 have declined
significantly since the comparable periods in 1997.
GROSS PROFIT. For the three months ended September 30, 1998, gross profit
decreased to $30.1 million from $35.3 million for the comparable period of 1997,
and represented gross margins of 45.3% and 46.0%, respectively. For the nine
months ended September 30, 1998, gross profit increased to $108.9 million from
$82.4 million for the comparable period of 1997, and represented 45.9% and 45.2%
of total revenues, respectively.
The decline in gross margins from 1997 to 1998 for the third quarters was due to
higher overhead rates. The increase in gross margins for the nine month period
ended September 30, 1998, was due to cost savings from engineering design
changes and vendor discounts and higher royalty revenue levels. In the future,
gross profits may fluctuate due to a wide variety of factors, including: the mix
between domestic and international sales, the customer mix, the product mix, the
timing and size of orders which are received and can be shipped in a quarter,
the availability of adequate supplies of key components and assemblies, the
adequacy of manufacturing capacity, the Company's ability to introduce new
products and technologies on a timely basis, the timing of new product
introductions or announcements by the Company or its competitors, price
competition, unit volume, royalty revenue levels, manufacturing variances, and
expanded warranty coverage.
RESEARCH AND DEVELOPMENT. For the three months ended September 30, 1998,
research and development expenses increased 58.3% to $11.4 million compared with
$7.2 million for the same period in 1997. Research and development expenses
represented 17.2% and 9.4% of total revenues in the third quarters of 1998 and
1997, respectively.
For the nine months ended September 30, 1998, research and development expenses
increased 63.2% to $30.2 million compared with $18.5 million for the same period
in 1997. As a percentage of revenues, research and development expenses were
12.7% and 10.1% for the first nine months of 1998 and 1997, respectively.
The increase in research and development expenses from 1997 to 1998 for the
three and nine month periods was primarily due to increased salaries and
benefits and facility costs related to the addition of personnel in engineering,
and the use of outside consultants and services and costs associated with
material and test equipment used to develop and test new products and features.
As of September 30, 1998, the number of employees in research and development
was 268 compared with 170 as of September 30, 1997, an increase of 57.6%. The
Company expects that research and
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development expenditures will generally continue to increase in absolute
dollars, but decrease over time as a percentage of revenues as the Company
supports the continued development of new products and features and the efforts
to reduce product costs. All research and development costs to date have been
expensed as incurred.
SELLING, GENERAL AND ADMINISTRATIVE. For the three months ended September 30,
1998, selling, general and administrative expenses increased 32.5% to $16.3
million compared with $12.3 million for the same period in 1997. Selling,
general and administrative expenses represented 24.5% and 16.0% of revenues for
the third quarter of 1998 and 1997, respectively.
For the nine months ended September 30, 1998, selling, general and
administrative expenses increased 64.2% to $49.1 million compared with $29.9
million for the same period in 1997. As a percentage of revenues, selling,
general and administrative expenses were 20.7% and 16.4% for the first nine
months of 1998 and 1997, respectively.
Increases in costs for litigation, outside services and higher facilities and
operating costs associated with business capacity growth were the predominant
reasons general and administrative costs increased in the three month period
ending 1998 compared with the same period in 1997. The increase in general and
administrative expenses for the nine month period ending September 30, 1998 as
compared with 1997, was primarily due to higher litigation, compensation,
benefits, temporary help, outside services, and facility costs. The increases in
sales and marketing expenses from 1997 to 1998 for the three and nine month
periods ended September 30 were attributable primarily to additional sales and
marketing personnel and associated salaries and benefits, related hiring costs,
and increased spending on travel and outside services. Selling, general and
administrative headcount increased 50.0% to 336 from 224 as of September 30,
1998 and 1997, respectively.
INCOME TAXES. For the three and nine months ended September 30, 1998 and 1997,
the Company recorded income taxes at an effective rate that approximated the
combined federal and state statutory rates. The effective tax rate declined from
37.0% in the first nine months of 1997 to 35.0% in the comparable period of
1998, primarily due to utilization of research and development credits and
benefits from the Company's foreign sales corporation.
LIQUIDITY AND CAPITAL RESOURCES
As of September 30, 1998, the Company's cash and cash equivalents were $13.5
million, compared with $9.1 million as of December 31, 1997. Marketable
securities totaled $89.6 million as of September 30, 1998, compared with $96.1
million as of December 31, 1997.
Net cash of $17.4 million was provided by operating activities in the first nine
months of 1998. This was primarily the result of net income and a tax benefit
obtained from stock option exercises partially offset by decreases in accrued
liabilities and higher inventory levels. Net cash of $19.0 million was used in
investing activities through increased capital expenditures partially offset by
sales of marketable securities. The Company continues to invest in capital
equipment to support its employee and facility growth and its research and
development and manufacturing activities.
The Company has a $50.0 million unsecured bank line through two banks with an
interest rate of prime, or LIBOR plus 0.75%. The line of credit expires in July
1999. Under the bank line, the banks may issue letters of credit up to $10.0
million and foreign exchange contracts up to $50.0 million on behalf of the
Company. The bank line requires the Company to comply with certain debt and
financial covenants. As of September 30, 1998, no borrowings were outstanding
under the bank line, and the Company was in compliance with the covenants
contained in the agreement. At September 30, 1998, no amounts were reserved for
letters of credit under the line, and $4.9 million was reserved for foreign
exchange contracts under the line.
The Company also has lease lines totaling $5.1 million that were used for
equipment and furniture purchases.
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The Company believes that its existing cash and short term investments,
available credit facilities and cash flows will be adequate to support the
Company's financial resource needs, including working capital requirements,
capital expenditures and operating lease obligations for the next twelve months.
CERTAIN FACTORS THAT MIGHT AFFECT FUTURE OPERATING RESULTS
In addition to the other information in this Quarterly Report on Form 10-Q, the
following are important factors that should be considered in evaluating the
Company and its business.
POTENTIAL FLUCTUATIONS IN FUTURE OPERATING RESULTS AND SEASONALITY. The
Company's operating results have been, and will continue to be, affected by a
wide variety of factors, some of which are outside of the Company's control,
that could have a material adverse effect on revenues and results of operations
during any particular period. These factors include:
o The mix between domestic and international sales
o The customer mix
o The product mix
o Timing and size of orders which are received and can be shipped in a
quarter
o Availability of adequate supplies of key components and assemblies
o Adequacy of manufacturing capacity
o The Company's ability to introduce new products and technologies on a
timely basis
o Timing of new product introductions or announcements by the Company or its
competitors
o Price competition
o Unit volume
o Royalty revenue levels
o Customers' ability to pay when due
o Excess or obsolete inventory
o Manufacturing variances
o Expanded warranty coverage
The UMC system is sold primarily to telephone companies installing the UMC
system as part of their access networks. Additions to those networks represent
complex engineering projects which can require from three to twelve months from
project conceptualization to completion. The UMC system typically represents
only a portion of a given project and, therefore, the timing of product shipment
and revenue recognition is often difficult to forecast. The Company's customers
normally install a portion of the UMC system in outdoor locations. Shipments of
the UMC system are subject to the effects of seasonality, with fewer
installation projects scheduled for the winter months. Accordingly, the Company
believes that over time this seasonality will cause revenues in the quarter
ended March 31 to be lower than revenues in the preceding quarter ended December
31. In developing countries, delays and reductions in the planned project
deployment can be caused by additional factors, including currency fluctuations,
reductions in capital availability due to declines in the local economy,
priority changes in governments' budgets, political environment and delays in
receiving government approval for deployment of the UMC system in the local
loop.
The Company's expenditures for research and development, marketing and sales,
and general and administrative functions are based in part on future revenue
projections and in the near term are relatively fixed. The Company may be unable
to adjust spending in a timely manner in response to any unanticipated failure
to meet these revenue projections. Accordingly, any significant decline in
demand for the UMC system relative to planned levels could have a material
adverse effect on the Company's business, financial condition and results of
operations in that quarter or subsequent quarters.
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All of the above factors are difficult to forecast, and these or other factors
could have a material adverse effect on the Company's business, financial
condition and results of operations. As a result, the Company believes that
period to period comparisons are not necessarily meaningful and should not be
relied upon as indications of future performance. There can be no assurance that
the Company will sustain or increase its profitability in the future.
Fluctuations in the Company's operating results may cause volatility in the
price of the Company's Common Stock. Further, it is likely that in some future
quarter the Company's revenues or operating results will be below the
expectations of public market analysts and investors. In such event, the market
price of the Company's Common Stock would likely be materially adversely
affected. Recent periods of volatility in the market price of the Company's
securities resulted in stockholder litigation against the Company and various
officers and directors. Such litigation could result in substantial costs and a
diversion of management's attention and resources, which could have a material
adverse effect on the operating results and financial condition of the Company.
See "Part II, Item 1 - Legal Proceedings" as it pertains to this matter on page
21 of this Form 10-Q.
CUSTOMER CONCENTRATION. For the nine months ended September 30, 1998,
approximately 11.6% of the Company's total revenues were derived from sales to
Integrators of System Technology (Pty) Ltd. in South Africa. For the nine months
ended September 30, 1997, GTE accounted for 20.5% of total revenues. No other
single customer accounted for 10% or more of total revenues in either nine month
period. For the nine months ended September 30, 1998 and 1997, the Company's
five largest customers accounted for approximately 39.2% and 41.8% of revenues,
respectively. Although the Company's largest customers have varied from period
to period, the Company anticipates that its results of operations in any given
period will continue to depend to a significant extent upon sales to a small
number of customers. None of the Company's customers have entered into
agreements requiring them to purchase a minimum amount of product from the
Company. There can be no assurance that the Company's principal customers will
continue to purchase product from the Company at current levels, if at all. In
addition, in the event that a significant existing customer of the Company is
merged with another telecommunications company, there can be no assurance that
such customer will continue to purchase the Company's products. The loss of one
or more major customers could have a material adverse effect on the Company's
business, financial condition and results of operations. For example, sales to
GTE in the three and nine month periods ended September 30, 1998 have declined
significantly compared with the same periods in 1997.
RISKS ASSOCIATED WITH INTERNATIONAL MARKETS. International sales constituted
30.0% and 23.7% of the Company's total revenues for the nine months ended
September 30, 1998 and 1997, respectively. International sales have fluctuated
in absolute dollars and as a percentage of revenues, and are expected to
continue to fluctuate in future periods. The Company relies on a number of third
party distributors and agents to market and sell the UMC system outside of North
America. There can be no assurance that such distributors or agents will provide
the support and effort necessary to service international markets effectively.
The Company is expanding its existing international operations and is entering
new international markets, which demand significant management attention and
financial commitment. There can be no assurance that the Company will continue
to successfully expand its international operations. In addition, a successful
expansion by the Company of its international operations and sales in certain
markets may depend on the Company's ability to establish and maintain productive
strategic relationships. There can be no assurance that the Company will be able
to identify suitable parties for joint ventures or strategic relationships or,
even if such parties are identified, that successful joint ventures or strategic
relationships will result. Moreover, there can be no assurance that the Company
will be able to increase international sales of the UMC system through strategic
relationships or joint ventures. The failure to do so could significantly limit
the Company's ability to expand its international operations and could adversely
affect the Company's business, financial condition and results of operations.
International telephone companies are in many cases owned or strictly regulated
by local authorities. Access to such markets is often difficult due to the
established relationships between a government owned or controlled telephone
company and its traditional indigenous suppliers of telecommunications
equipment. Many of these companies require extended payment terms and financing
options which increase the risk of nonpayment and may have a material adverse
effect on the Company's cash flows. In addition, customers in certain
international markets require the Company to post bid and performance bonds and
could cause the Company to incur contract penalties should it fail to meet
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production and delivery time schedules on large orders. The failure of the
Company to meet these schedules could result in the loss of collateral posted
for the bonds or financial penalties, which could adversely affect the Company's
business, financial condition and results of operations.
Currently, the Company's international sales are primarily U.S. dollar
denominated. As a result, an increase in the value of the U.S. dollar relative
to foreign currencies could make the Company's products less competitive in
international markets. Failure to meet revenue projections in the international
market could adversely affect the Company's business, financial condition and
results of operations.
Operating in international markets subjects the Company to certain additional
risks, including unexpected changes in regulatory requirements, political and
economic conditions, tariffs or other barriers, difficulties in staffing and
managing international operations, exchange rate fluctuations, potential
exchange and repatriation controls on foreign earnings, potentially negative tax
consequences, longer sales and payment cycles and difficulty in accounts
receivable collection. For example, the Asia Pacific and South American regions'
economies have deteriorated recently resulting in the devaluation of currencies
in certain of the countries of these regions. There can be no assurance that
decreases in foreign countries' economic conditions or exchange rates won't have
a material adverse effect on the Company's business, financial condition or
results of operations. In addition, any inability to obtain local regulatory
approval could delay or prevent entrance into international markets, which could
materially impact the Company's business, financial condition and results of
operations. In order to compete in international markets, the Company will need
to comply with various regulations and standards.
CONCENTRATED PRODUCT LINE, NEW PRODUCTS AND RAPID TECHNOLOGICAL CHANGE. The
Company currently derives substantially all of its revenues from the UMC system
and expects that this concentration will continue in the foreseeable future. As
a result, any decrease in the overall level of sales of, or the prices for, the
UMC system due to product enhancements, introductions or announcements by the
Company's competitors, a decline in the demand for the UMC system, product
obsolescence or any other reason could have a material adverse effect on the
Company's business, financial condition and results of operations.
The telecommunications equipment market is characterized by rapidly changing
technology, evolving industry standards, changes in end-user requirements, and
frequent new product introductions and enhancements. The introduction of
products embodying new technologies or the emergence of new industry standards
can render existing products obsolete or unmarketable. The Company's success
will depend upon its ability to enhance the UMC technology and to develop and
introduce, on a timely basis, new products and feature enhancements that keep
pace with technological developments and emerging industry standards and address
changing customer requirements in a cost-effective manner. There can be no
assurance that the Company will be successful in identifying, developing,
manufacturing, and marketing new products or product enhancements that respond
to technological change or evolving industry standards. Additionally, there can
be no assurance that the Company will not experience difficulties that could
delay or prevent the successful development, introduction and marketing of these
products and enhancements, or that its new products or enhancements will
adequately meet the requirements of the marketplace and achieve market
acceptance. Furthermore, from time to time, the Company may announce new
products or enhancements, services or technologies that have the potential to
replace or shorten the life cycle of the UMC system and that may cause customers
to defer purchasing the UMC system. There can be no assurance that future
technological advances in the telecommunications industry will not diminish
market acceptance of the UMC system or render the UMC system obsolete and,
thereby, materially adversely affect the Company's business, financial condition
and results of operations.
The Company has experienced delays in completing development and introduction of
new products, product variations and feature enhancements, and there can be no
assurance that such delays won't continue or recur in the future. Furthermore,
the UMC system contains a significant amount of complex hardware and software
that may contain undetected or unresolved errors as products are introduced or
as new versions are released. The Company has in the past discovered technical
difficulties in certain UMC system installations. There can be no assurance that
despite significant testing by the Company, hardware or software errors will not
be found in the UMC system after
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commencement of shipments, resulting in delays in, or cancellation of, customer
orders or in the loss of market acceptance, any of which could have a material
adverse effect on the Company's business, financial condition and results of
operations.
DEPENDENCE ON TELECOMMUNICATIONS INDUSTRY AND SMALL LINE SIZE MARKET. The
Company's customers are concentrated in the public carrier telecommunications
industry and, in the U.S. market, include: the Regional Bell Operating
Companies, Competitive Local Exchange Carriers, National Local Exchange
Carriers, and Independent Local Exchange Carriers. Accordingly, the Company's
future success depends upon the capital spending patterns of such customers and
the continued demand by such customers for the UMC system. The target markets
for the UMC system are the small line size markets of the U.S. and developing
countries. Historically, these markets have had little access to the advanced
services that can be made available through the UMC system and, accordingly,
there can be no assurance that potential customers will consider the near term
value of these advanced services to be sufficient to influence their purchase
decisions. Furthermore, there can be no assurance that the UMC system will find
widespread acceptance among the telephone companies and other potential
customers in small line size markets or that such customers and potential
customers will not adopt alternative architectures or technologies that are
incompatible with the UMC technology, which could have a material adverse effect
on the Company's business, financial condition and results of operations. In
addition, there can be no assurance that telephone companies, foreign
governments or other customers will pursue infrastructure upgrades that will
necessitate the implementation of advanced products such as the UMC system.
Infrastructure improvements requiring the Company's or similar technology may be
delayed or prevented by a variety of factors, including cost, regulatory
obstacles, the lack of consumer demand for advanced telecommunications services
and alternative approaches to service delivery.
COMPETITION. The market for equipment for local telecommunications networks is
extremely competitive. The Company's competitors range from small companies,
both domestic and international, to large multinational corporations. The
Company's principal competitors include: Alcatel Alsthom Compagnie, Generale
d'Electricite, Ericsson Inc., Fujitsu America, Inc., Hitron Technology, Inc.,
Huawei Technologies Co. Ltd., Lucent Technologies, Inc., NEC America, Inc.,
Nokia Telecommunications, Northern Telecom Ltd., Opnet Technologies Co. Ltd.,
RELTEC Corporation, Shenzhen Zhongxing Telecom Corporation, Ltd., Teledata
Communications Ltd., UT Starcom, Inc. and Vidar-SMS Co. Ltd. Many of these
competitors have more extensive financial, marketing and technical resources
than the Company and enjoy superior name recognition in the market. In addition,
pursuant to the Settlement Agreement and related agreements entered into with
the Industrial Technology Research Institute ("ITRI"), certain of its member
companies have been granted certain rights to manufacture and sell the European
Telecommunications Standards Institute ("ETSI") version of the UMC system
outside of North America. Such entities currently compete with the Company in
international markets, primarily in China. In addition, upon termination of
certain restrictions set forth in such agreements, in January 2005, such member
companies will have a worldwide, non-exclusive, royalty-free, irrevocable
license to use certain UMC technology and, consequently, such member companies
will be able to compete with the Company worldwide at such time. The Company has
successfully settled its litigation against Acer Netxus, Inc. Among other
things, the Settlement Agreement and a related Federal Court judgment
permanently enjoin Acer Netxus, Inc. from developing, manufacturing, or selling
any product that uses or derives from the UMC 1000(TM) technology.
The Company believes rapid technological change, continuing regulatory change
and industry consolidation will continue to cause rapid evolution in the
competitive environment of the telecommunications equipment market, the full
scope and nature of which is difficult to predict. Moreover, the Company
believes that technological and regulatory change will continue to make the
markets in which the Company competes, attractive to new entrants. There can be
no assurance that the Company will be able to compete successfully in the
future. See "Part II, Item 1 - Legal Proceedings" beginning on page 20 of this
Form 10-Q.
DEPENDENCE ON SOLE SOURCE AND OTHER KEY SUPPLIERS. Certain components used in
the Company's products, including the Company's proprietary application specific
integrated circuits ("ASICs"), codec components, certain surface mount
technology components and other components, are only available from a single
source or limited
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number of suppliers. In particular, the Company relies on AMI American
Microsystems, Inc. to manufacture ASICs. Some of the Company's sole source
suppliers are companies who, from time to time, allocate parts to telephone
equipment manufacturers due to market demand for telecommunications components
and equipment. Many of the Company's competitors are much larger and may be able
to obtain priority allocations from these shared suppliers, thereby limiting or
making unreliable the sources of supply for these components. There can be no
assurance that shortages of components will not occur in the future or will not
result in the Company having to pay a higher price for components. If the
Company is unable to obtain sufficient quantities of these or any other
components, delays or reductions in manufacturing or product shipments could
occur which could have a material adverse effect on the Company's business,
financial condition and results of operations.
DEPENDENCE ON LIMITED NUMBER OF THIRD PARTY MANUFACTURERS AND SUPPORT
ORGANIZATIONS. The Company relies on a limited number of independent contractors
to manufacture the subassemblies to the Company's specifications for use in the
Company's products. In particular, the Company relies on:
o Flextronics International Ltd. and Solectron Inc. to manufacture the
Company's printed circuit board assemblies
o Siemens Microelectronics, Inc. for PCBA components
o Paragon, Inc., and Tyco Printed Circuit Group Inc. to manufacture
backplanes and channel bank assemblies
o AMI American Microsystems, Inc. for application specific integrated
circuits
o Sonoma Metal Products, Inc., Cowden Metal San Jose, Inc., and Inventronics
Limited to manufacture the external housing cabinets
In the event that the Company's subcontractors were to experience financial,
operational, production, or quality assurance difficulties that resulted in a
reduction or interruption in supply to the Company or otherwise failed to meet
the Company's manufacturing requirements, the Company's business, financial
condition and results of operations could be adversely affected until the
Company established sufficient manufacturing supply from alternative sources.
There can be no assurance that the Company's current or alternative
manufacturers will be able to meet the Company's future requirements or that
such manufacturing services will continue to be available to the Company at
favorable prices, or at all.
The Company also relies on various third party support organizations to provide
post sales support to the Company's domestic sales customers. There can be no
assurance that these organizations will be able to provide the level of customer
support demanded by the Company's existing or potential customers.
RISKS ASSOCIATED WITH PENDING LITIGATION. The Company is a party to certain
legal proceedings as described in "Part II, Item 1 - Legal Proceedings". The
Company is unable to predict the ultimate outcome of these proceedings or
determine the total expense or possible loss, if any, that may ultimately be
incurred in the resolution of these proceedings. Regardless of the ultimate
outcome of these proceedings, they could result in significant diversion of time
by the Company's management. See "Part II, Item 1 - Legal Proceedings" beginning
on page 20 of this Form 10-Q.
RISK OF FAILURE TO MANAGE EXPANDING OPERATIONS. The Company has experienced a
period of rapid growth, which has placed and could continue to place, a
significant strain on the Company's management, operational, financial and other
resources. The members of the Company's management team have limited experience
in the management of rapidly growing companies. To effectively manage the recent
growth as well as any future growth, the Company will need to recruit, train,
assimilate, motivate and retain qualified managers and employees. Any business
disruption or other system transition difficulties could have a material adverse
effect on the Company's business, financial condition and results of operations.
The failure of the Company to effectively manage its domestic and international
operations or any current or future growth could have a material adverse effect
on the Company's business, financial condition and results of operations. The
Company's results of operations will be adversely affected if revenues do not
increase sufficiently to compensate for the increase in operating expenses
resulting from any expansion.
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In February 1998, the Company moved its domestic manufacturing and distribution
operations into a new facility to double capacity and increase efficiency.
Although the Company expanded its operational capacity, there can be no
assurance that the transition and further utilization of the new facility will
continue without interruption, or that any such interruption will not have a
material adverse effect on the Company's business, manufacturing and
distribution functions.
LIMITED PROTECTION OF PROPRIETARY TECHNOLOGY; RISK OF THIRD PARTY CLAIMS OF
INFRINGEMENT. The Company attempts to protect its technology through a
combination of copyrights, trade secret laws, contractual obligations, and
patents. The Company does not presently hold any patents for its existing
products, but has two patent applications pending. There can be no assurance
that the Company's intellectual property protection measures will be sufficient
to prevent misappropriation of the Company's technology or that the Company's
competitors will not independently develop technologies that are substantially
equivalent or superior to the Company's technology. In addition, the laws of
many foreign countries do not protect the Company's intellectual property rights
to the same extent as the laws of the U.S. The failure of the Company to protect
its proprietary information could have a material adverse effect on the
Company's business, financial condition and results of operations. The Company
is currently involved in a dispute with RELTEC Corporation regarding, among
other things, alleged trade secret misappropriation. See "Part II, Item 1 -
Legal Proceedings" as it pertains to this matter on page 21 of this Form 10-Q.
The increasing dependence of the telecommunications industry on proprietary
technology has resulted in frequent litigation based on allegations of the
infringement of patents and other intellectual property. In June 1996, the
Company settled litigation with DSC under which DSC had claimed proprietary
rights to the UMC technology. In January 1998, DSC filed a lawsuit against the
Company alleging, among other things, that the Company's 3GDLC product infringes
a DSC patent. See "Part II, Item 1 - Legal Proceedings" beginning on page 20 of
this Form 10-Q. In the future, the Company may be subject to additional
litigation to defend against claimed infringements of the rights of others or to
determine the scope and validity of the proprietary rights of others. Future
litigation also may be necessary to enforce and protect trade secrets and other
intellectual property rights owned by the Company. Any such litigation could be
costly and cause diversion of management's attention, either of which could have
a material adverse effect on the Company's business, financial condition and
results of operations. Adverse determinations in such litigation could result in
the loss of the Company's proprietary rights, subject the Company to significant
liabilities, require the Company to seek licenses from third parties, or prevent
the Company from manufacturing or selling its products, any one of which could
have a material adverse effect on the Company's business, financial condition
and results of operations. Furthermore, there can be no assurance that any
necessary licenses will be available on reasonable terms.
DEPENDENCE ON KEY PERSONNEL. The Company's success depends to a significant
extent upon key technical and management employees. The loss of the services of
any of these key employees of the Company could have a material adverse effect
on the Company's business, financial condition and results of operations. The
Company does not have employment agreements with, or key person life insurance
for, any of its employees. Competition for highly qualified employees is intense
and the process of locating key technical and management personnel with the
combination of skills and attributes required to execute the Company's strategy
is often lengthy. There can be no assurance that the Company will be successful
in retaining its existing key personnel or in attracting and retaining the
additional employees it may require.
In June 1998, the Company's President and Chief Executive Officer, Carl Grivner,
resigned and the Company's Chairman and founder, Don Green, assumed the role of
President and Chief Executive Officer on an interim basis. The Company is
currently engaged in a search for a new President and Chief Executive Officer.
There can be no assurance that the Company will be successful in identifying and
hiring a new President and Chief Executive Officer on a timely basis. There can
be no assurance as to the effect that this management transition may have on the
Company's business, financial condition and results of operations.
YEAR 2000. The Company has formed a Year 2000 committee to understand and
address the year 2000 issue as it affects the Company's infrastructure and
operations, and it's product, the UMC system. The UMC system was
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originally designed and developed to be year 2000 compliant. The Company
utilizes operating systems and software applications that were designed and
developed to properly reflect the year 2000 and subsequent years' data. Although
the Company believes that its product and operating systems are year 2000
compliant, the Company's manufacturing suppliers may utilize equipment or
software that is not compliant. The Company is currently in the process of
surveying and assessing its vendors' compliance and developing contingency
plans. The Company is also surveying its facilities and daily operational
vendors to determine the status of embedded technology equipment that could
affect the Company's operations. The Company plans to test and validate its
internal operations, complete the vendor surveys, and finalize and implement any
contingency plans necessary by mid-year 1999. The failure on the part of any
vendor to adequately address its own year 2000 compliance issues could lead to
delays on the part of the vendor in the delivery of subassemblies for use in the
Company's products, or disruption of services provided by a vendor, any of which
could have a material adverse effect on the Company's business, financial
condition and results of operations. The year 2000 compliance activities are not
expected to result in significant incremental operating expenses, although the
Company cannot provide an estimate of the costs at this time.
COMPLIANCE WITH REGULATIONS AND INDUSTRY STANDARDS. The UMC system is required
to comply with a large number of voice and data regulations and standards, which
vary between domestic and international markets, and may vary by the specific
international market into which the Company sells its products. Standards
setting and compliance verification in the U.S. are determined by the Federal
Communications Commission, Underwriters Laboratories, Bell Communications
Research ("Bellcore"), other independent third party testing organizations, and
by independent telephone companies. In international markets, the Company's
products must comply with recommendations issued by the Consultative Committee
on International Telegraph and Telephony and individual regional carriers'
network operating system requirements and specifications. In addition, the
Company's products must comply with standards issued by the European
Telecommunications Standards Institute and implemented and enforced by the
Telecommunications Regulatory Authority of each European nation. Standards for
new services continue to evolve, and the Company will be required to modify its
products or develop and support new versions of its products to meet these
standards. The failure of the Company's products to comply, or delays in meeting
compliance, with the evolving standards both in its domestic and international
markets could have a material adverse effect on the Company's business,
financial condition and results of operations.
In addition, the Company will need to ensure that its products are easily
integrated with the carriers' network management systems. The Regional Bell
Operating Companies ("RBOCs"), which represent a large segment of the U.S.
telecommunications market, in many cases require equipment integrated into their
networks to be tested by Bellcore, indicating that the products are
interoperable with the operations, administration, maintenance and provisioning
systems used by the RBOCs to manage their networks. Bellcore testing requires
significant investments in resources to achieve compliance. The failure to
maintain such compliance or to obtain it on new features released in the future
could have a material adverse effect on the Company's business, financial
condition and results of operations.
In October 1997, Underwriters Laboratories officially registered the Company as
ISO 9001, ANSI/ASQC Q9001-compliant, which assures quality in design,
development, production, installation and servicing. The ISO 9001 standard
consists of all elements which define a quality system aimed primarily at
achieving customer satisfaction by preventing nonconformity at all stages from
design through servicing. There can be no assurance that the Company will
maintain such certification. The failure to maintain such certification may
preclude the Company from selling the UMC system in certain markets and could
materially adversely affect the Company's ability to compete with other
suppliers of telecommunications equipment.
Failure to maintain interoperability with other companies or adopt or maintain
industry standards in the Company's product line could have a material adverse
effect on the Company's ability to compete with other telecommunications
equipment suppliers, and could materially adversely affect its business,
financial condition and results of operations.
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The U.S. Congress recently passed new regulations that affect telecommunications
services, including changes to pricing, access by competitive suppliers and many
other broad changes to the data and telecommunications networks and services.
These changes will have a major impact on the pricing of existing services, and
may affect the deployment of future services. These changes could cause greater
consolidation in the telecommunications industry, which in turn could disrupt
existing customer relationships and have a material adverse effect on the
Company's business, financial condition and results of operations. There can be
no assurance that any regulatory changes will not have a material adverse effect
on the demand for the UMC system. Uncertainty regarding future policies combined
with emerging new competition may also affect the demand for telecommunications
products such as the UMC system.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
ITRI/Acer Netxus, Inc. In September 1992, the Company entered into agreements
(the "ITRI Agreements") with the Industrial Technology Research Institute
("ITRI"), a Taiwanese government-sponsored research and development
organization, that granted to ITRI certain license rights to the European
Telecommunications Standards Institute ("ETSI") version of the Universal Modular
Carrier 1000(TM) ("UMC system"). In July 1996, the Company became involved in
litigation and arbitration proceedings with ITRI, certain of ITRI's sub-licensee
"Member Companies", and others, including Acer Netxus, Inc. ("Acer"). These
legal proceedings involved claims for breach of the ITRI Agreements, trade
secret misappropriation, unfair competition, and related claims.
In March 1998, the Company, ITRI, the Member Companies and other parties entered
into a definitive Settlement Agreement that resolved all claims among such
parties, except Acer. Under the Settlement Agreement, all claims involved in the
proceedings between such parties will be dismissed with prejudice. The
Settlement Agreement provides that the Member Companies will pay an aggregate of
$6.3 million to the Company over a five year period, and will pay the Company
royalties on the purchase of certain ASICs by the Member Companies. Under the
Settlement Agreement, the Company granted a limited license to the Member
Companies to certain of the Company's technology, agreed to sell certain ASICs
to the Member Companies, and agreed to pay $500,000 to ITRI over a three year
period for legal fees incurred by ITRI in the proceedings. The Settlement
Agreement does not grant to the Member Companies any rights to the Company's UMC
1000 Third Generation Digital Loop Carrier(TM) ("3GDLC") technology or products.
In addition, the Settlement Agreement does not affect the Company's claims
against Acer.
In September 1998, the Company favorably resolved its litigation with Acer.
Pursuant to a settlement agreement dated September 18, 1998, and a Permanent
Injunction And Final Judgment entered by the United States District Court,
Northern District of California, on September 22, 1998, Acer is enjoined from
selling any digital loop carrier system for at least one year, and from
developing, manufacturing, or selling any device that uses or derives from UMC
technology or that is otherwise not the product of strict clean room development
or based on licensed third party technology. In addition, the injunction
requires that Acer destroy all work product and inventory related to its two
systems that competed with the UMC 1000, and subjects Acer to a $500,000 penalty
for any and each violation of the injunction.
DSC
On December 22, 1997, the Company filed a lawsuit in Sonoma County Superior
Court in California against DSC Communications Corporation ("DSC") related to
its hiring of a former employee of DSC, to become the Company's Vice President,
Product Planning. Since that time, in September 1998, Alcatel Alsthom Compagnie
completed its acquisition of DSC, and for purposes of this footnote, reference
is made to DSC. The Company's complaint responded to DSC's litigation threats,
and sought a declaratory judgment that its hiring of the former DSC employee was
lawful. In April, 1998, DSC filed a cross-complaint against the Company in the
lawsuit filed by the Company in Sonoma County Superior Court in California that
alleges "inevitable" trade secret misappropriation and related claims, and seeks
unspecified damages, and injunctive relief relating to the alleged
misappropriation, attorneys' fees and other relief. During September 1998, DSC's
efforts to obtain trade secret-related discovery was denied, and the Court
struck all material misappropriation allegations from DSC's Cross-Complaint. DSC
filed a First Amended Cross-Complaint on October 2, 1998, alleging "threatened"
trade secret misappropriation and related claims. The Amended Cross-Complaint
seeks the same relief sought by the original Cross-Complaint. There has been no
discovery in the case, and no trial date is set.
On January 22, 1998, DSC filed a lawsuit against the Company and the former DSC
employee in the United States District Court, Eastern District of Texas,
alleging "inevitable" trade secret misappropriation and related claims. DSC also
asserted a separate claim against the Company for patent infringement alleging
that the Company's 3GDLC
20
<PAGE> 22
product infringes a DSC patent. DSC's complaint sought unspecified damages and
injunctive relief relating to the alleged misappropriation and patent
infringement, attorneys' fees and other relief. On February 5, 1998, the United
States District Court, Eastern District of Texas granted the Company's motion to
dismiss all non-patent claims in this lawsuit. In May 1998, the Company filed a
counterclaim against DSC in the Texas patent action alleging federal antitrust
violations, unfair competition, breach of a prior settlement agreement and other
related claims. Between April and August, 1998, certain discovery occurred, and
the parties filed various motions, including cross-motions for summary judgment
on the Company's defense that a prior Settlement Agreement between the Company
and DSC barred DSC's patent claims. By a Report And Recommendation filed October
2, 1998, the United States Magistrate Judge recommended that the District Court
grant summary judgment in the Company's favor on the patent claim based on the
Settlement Agreement. DSC filed an Objection to this ruling with the District
Court on October 16, 1998, and the matter remains pending.
The Company believes that all of DSC's misappropriation and other claims related
to the hiring of the former DSC employee are without merit, and the Company
intends to defend the lawsuits vigorously. Based on the Company's review of the
patent claim, the Company believes that the Company's 3GDLC product does not
infringe the DSC patent, and that the Company has meritorious defenses to such
claim. The Company intends to vigorously defend the litigation against DSC and
prosecute its claims against DSC. However, the Company cannot predict the
ultimate outcome of these lawsuits. In addition, patent litigation is highly
complex and can extend for a protracted period of time, which can divert the
attention of the Company's management and technical personnel and require the
Company to incur substantial costs and expenses. If the patent claim were to be
resolved against the Company, this could have a material adverse effect on the
Company's business, results of operations and financial condition.
RELTEC Corporation
On November 26, 1997, the Company filed a lawsuit in Sonoma County Superior
Court in California against RELTEC Corporation, alleging trade secret
misappropriation, tortuous interference with a contract, and related claims. The
case involves RELTEC's acquisition of the Company's technology through the
Company's Taiwan-based licensee, Vidar-SMS Co., Ltd. On January 21, 1998, the
Company filed for and obtained certain injunctive relief in April and May 1998.
Discovery is ongoing, and trial is scheduled to start on April 12, 1999.
Stockholder Litigation
The Company and various of its current and former officers and directors are
parties to a number of related lawsuits which purport to be class actions filed
on behalf of certain of the Company's stockholders (excluding the defendants and
parties related to them). The lawsuits, which are substantially identical,
allege that the defendants violated certain federal securities laws.
All of these actions are in the early stages of proceedings and the Company is
currently investigating the allegations. Based on its current information, the
Company believes the suits to be without merit and intends to defend itself and
its officers and directors vigorously. Although it is reasonably possible the
Company may incur a loss upon the conclusion of these claims, an estimate of any
loss or range of loss cannot be made. No provision for any liability that may
result upon adjudication has been made in the Company's consolidated financial
statements. In the opinion of management, resolution of this matter is not
expected to have a material adverse effect on the financial position of the
Company. However, depending on the amount and timing, an unfavorable resolution
of this matter could materially affect the Company's future results of
operations or cash flows in a particular period. In connection with these legal
proceedings, the Company expects to incur substantial legal and other expenses.
Stockholder suits of this kind are highly complex and can extend for a
protracted period of time, which can substantially increase the cost of such
litigation and divert the attention of the Company's management.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS:
(a). CHANGES IN SECURITIES: None
21
<PAGE> 23
(b). USE OF PROCEEDS:
The Company completed its initial public offering in October 1996, in which it
issued and sold 20,700,000 (post-split) shares of Common Stock for aggregate
proceeds to the Company of $120.3 million. Of the aggregate proceeds received in
the offering, $2.2 million were used to defray costs and expenses related to the
offering, resulting in net proceeds of approximately $118.1 million. Of the net
proceeds, $14.8 million was used to reduce debt. The remainder is invested in
cash equivalents and marketable securities.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES: None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS:
The Company's 1998 Annual Meeting of Stockholders (the "Annual Meeting") was
held on August 6, 1998. The following matters were voted on by the stockholders:
1. Election of two Class II Directors. Herbert M. Dwight and Ruann F. Ernst
were elected to the Company's Board of Directors as Class II Directors
to serve the terms extending until the Annual Meeting to be held in the
year 2001 and until their successors have been duly elected and
qualified, or until their resignation or removal. The result of the
voting was as follows: 63,689,922 shares in favor of Herbert M. Dwight,
with 272,957 shares withheld and 62,986,397 shares in favor of Ruann F.
Ernst, with 976,482 shares withheld. The terms of office of the
Company's other Directors, Donald Green and Dan Rasdal, continue until
the 1999 Annual Meeting, and Clifford H. Higgerson and Alex Sozonoff
continue until the 2000 Annual Meeting. -
2. Ratification of the selection of KPMG Peat Marwick LLP as independent
public accountants for the Company for the fiscal year ending December
31, 1998. The result of the vote was 63,883,488 shares in favor, 46,256
shares against and 33,135 shares abstaining.
ITEM 5. OTHER INFORMATION: None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K:
(a). EXHIBITS:
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DOCUMENT DESCRIPTION
- ------- --------------------
<S> <C>
3.3.1 Fifth Amended and Restated Certificate of Incorporation of the Registrant. (3)
3.3.2 Certificate of Designation of Series A Junior Participating Preferred Stock. (5)
3.5 Amended and Restated Bylaws of the Registrant. (2)
4.1 Specimen Certificate of Common Stock. (1)
4.2 Series E Preferred Stock Purchase Agreement, dated September 29,
1995, between the Registrant and certain purchasers of the
Registrant's Series E Preferred Stock. (1)
4.3 Certificate of Incorporation of the Registrant (included in Exhibit 3.3.1).
4.4 Rights Agreement dated as of May 13, 1998, between the Registrant and
BankBoston, N.A.(5)
10.3 Form of Warrant Issued in Connection with the Sale of the Registrant's Series C
Preferred Stock on March 16, 1994. (1)
</TABLE>
22
<PAGE> 24
<TABLE>
<S> <C>
10.4 Form of Performance Warrant Issued in Connection with the Sale of
the Registrant's Series C Preferred Stock on March 16, 1994 and
May 4, 1994. (1)
10.4.1 Form of Amendment to Warrants and Performance Warrants. (1)
10.5 Warrant Issued in Connection with the Sale of the Registrant's Series E
Preferred Stock on September 29, 1995.(1)
10.6 Restricted Stock Issuance Agreement, dated May 19, 1995, between the
Registrant, Donald Green and Maureen Green.(1)
10.7 Compensation Agreement, dated May 19, 1995, between the Registrant and Donald
Green.(1)
10.8 Promissory Note Secured by Pledge Agreement, dated May 31, 1995, by Donald
Green in favor of the Registrant. (1)
10.9 Stock Pledge Agreement, dated June 16, 1995, between the Registrant and Donald
Green.(1)
10.11 Hangzhou Aftek Communication Registrant Ltd. Contract, dated June 18, 1994,
between Advanced Fibre Technology Communication (Hong Kong) Limited and
Hangzhou Communication Equipment Factory of the MPT., HuaTong Branch(1)+
10.12 1445 & 1455 McDowell Boulevard North Net Lease, dated February 1,
1993, between the Registrant and G & W/ Redwood Associates Joint
Venture, for the premises located at 1445 McDowell Boulevard
North. (1)
10.13 Redwood Business Park Net Lease, dated July 9, 1995, between the
Registrant and G & W/Redwood Associates Joint Venture, for the
premises located at 1455 McDowell Boulevard North.(1)
10.14 Redwood Business Park Net Lease, dated July 10, 1995, between the
Registrant and G & W/Redwood Associates Joint Venture, for the
premises located at 1440 McDowell Boulevard North.(1)
10.15 Redwood Business Park Net Lease, dated June 3, 1996, between the
Registrant and G & W/Redwood Associates Joint Venture, for the
premises located at Buildings 1 & 9 of Willow Brook Court.(1)
10.17 Form of Indemnification Agreement for Executive Officers and Directors of the
Registrant. (1)
10.18 The Registrant's 1993 Stock Option/Stock Issuance Plan, as amended (the "1993
Plan").(1)
10.19 Form of Stock Option Agreement pertaining to the 1993 Plan.(1)
10.20 Form of Notice of Grant of Stock Option pertaining to the 1993 Plan.(1)
10.21 Form of Stock Purchase Agreement pertaining to the 1993 Plan.(1)
10.22 The Registrant's 1996 Stock Incentive Plan (the "1996 Plan").(1)
10.23 Form of Stock Option Agreement pertaining to the 1996 Plan.(1)
10.23.1 Form of Automatic Stock Option Agreement pertaining to the 1996 Plan.(1)
10.24 Form of Notice of Grant of Stock Option pertaining to the 1996 Plan.(1)
10.24.1 Form of Notice of Grant of Non-Employee Director Automatic Stock Option
pertaining to the 1996 Plan.(1)
10.25 Form of Stock Issuance Agreement pertaining to the 1996 Plan.(1)
10.26 The Registrant's Employee Stock Purchase Plan.(1)
10.27 Stock Issuance Agreement, dated June 30, 1997, between the Registrant and Peter
A. Darbee.(2)
10.28 Note secured by Stock Pledge Agreement, dated June 30, 1997, by
Peter A. Darbee in favor of the Registrant.(2)
10.29 Stock Pledge Agreement, dated June 30, 1997, between the Registrant and Peter
A. Darbee.(2)
10.30 Consulting Agreement, dated May 19, 1997, between the Registrant and Peter A.
Darbee. (2)
10.31 Cypress Center Net Lease, dated October 9, 1997, between the
Registrant and RNM Lakeville L.P., for the premises located at
2210 South McDowell Boulevard.(4)
10.34 Revolving Credit Agreement, dated July 30, 1998, between the Registrant and
Banque Nationale De Paris and Bank of America National Trust and Savings
Association.(6)
21.1 Subsidiaries of the Registrant.(1)
27.1 Financial data schedule.
27.997 Financial data schedule (restated) for the nine month period
ended September 30, 1997.
</TABLE>
23
<PAGE> 25
(1) Incorporated by reference from the Registrant's Registration Statement
on Form S-1 (no. 333-8921) filed with the Securities and Exchange
Commission on July 26, 1996, as amended, and declared effective
September 30, 1996.
(2) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the quarter ended June 30, 1997, filed with the Securities and
Exchange Commission on August 8, 1997.
(3) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the quarter ended September 30, 1997, filed with the Securities
and Exchange Commission on November 7, 1997.
(4) Incorporated by reference from the Registrant's Annual Report on Form
10-K for the year ended December 31, 1997, filed with the Securities and
Exchange Commission on March 23, 1998.
(5) Incorporated by reference from the Registrant's Current Report on Form
8-K filed with the Securities and Exchange Commission on May 19, 1998.
(6) Incorporated by reference from the Registrant's Quarterly Report on Form
10-Q for the quarter ended June 30, 1998, filed with the Securities and
Exchange Commission on August 10, 1998.
+ Portions of this Exhibit have been granted Confidential Treatment.
(b). REPORTS ON FORM 8-K: None
24
<PAGE> 26
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant had duly caused this Report to be signed on its behalf by the
undersigned thereunto duly authorized.
ADVANCED FIBRE COMMUNICATIONS, INC.
(Registrant)
Dated: November 6, 1998 By: /s/ Peter A. Darbee
--------------------------------
Name: Peter A. Darbee
Title: Vice President, Chief Financial
Officer, Treasurer and Secretary
(Duly Authorized Signatory and
Principal Financial Officer)
25
<PAGE> 27
ADVANCED FIBRE COMMUNICATIONS, INC.
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit
Number Document Description
- ------- --------------------
<S> <C>
27.1 Financial data schedule.
27.997 Financial data schedule (restated) for the nine month period
ending September 30, 1997.
</TABLE>
26
<TABLE> <S> <C>
<ARTICLE> 5
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 13,451
<SECURITIES> 89,595
<RECEIVABLES> 81,710
<ALLOWANCES> (2,722)
<INVENTORY> 56,442
<CURRENT-ASSETS> 246,183
<PP&E> 53,556
<DEPRECIATION> (8,912)
<TOTAL-ASSETS> 301,244
<CURRENT-LIABILITIES> 39,731
<BONDS> 0
0
0
<COMMON> 756
<OTHER-SE> 259,176
<TOTAL-LIABILITY-AND-EQUITY> 301,244
<SALES> 232,094
<TOTAL-REVENUES> 237,602
<CGS> 121,038
<TOTAL-COSTS> 128,659
<OTHER-EXPENSES> 79,464
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (3,197)
<INCOME-PRETAX> 32,675
<INCOME-TAX> 11,433
<INCOME-CONTINUING> 21,242
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 21,242
<EPS-PRIMARY> 0.28
<EPS-DILUTED> 0.27
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> SEP-30-1997
<CASH> 8,774
<SECURITIES> 99,985
<RECEIVABLES> 59,499
<ALLOWANCES> 0
<INVENTORY> 42,227
<CURRENT-ASSETS> 216,626
<PP&E> 25,950
<DEPRECIATION> (3,337)
<TOTAL-ASSETS> 245,854
<CURRENT-LIABILITIES> 39,279
<BONDS> 0
0
0
<COMMON> 722
<OTHER-SE> 205,058
<TOTAL-LIABILITY-AND-EQUITY> 245,854
<SALES> 181,309
<TOTAL-REVENUES> 182,402
<CGS> 93,851
<TOTAL-COSTS> 99,984
<OTHER-EXPENSES> 48,049
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (3,323)
<INCOME-PRETAX> 37,692
<INCOME-TAX> 13,946
<INCOME-CONTINUING> 23,746
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 23,746
<EPS-PRIMARY> 0.34
<EPS-DILUTED> 0.31
</TABLE>
