<PAGE>
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED MARCH 31, 1998 OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM ___ TO ___
COMMISSION FILE NUMBER 0-23289
HYBRID NETWORKS, INC.
(Exact name of registrant as specified in its charter)
Delaware 77-0252931
- --------------------------------------------------------------------------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
10161 Bubb Road, Cupertino, California 95014
- --------------------------------------------------------------------------------
(Address of principal executive offices) (Zip code)
(408) 725-3250
- --------------------------------------------------------------------------------
(Registrant's telephone number, including area code)
Not Applicable
- --------------------------------------------------------------------------------
(Former name, former address and former fiscal year, if
changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934
during the preceding 12 months (or for such 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:
Common shares outstanding at May 1, 1998: 10,410,050
- --------------------------------------------------------------------------------
- --------------------------------------------------------------------------------
<PAGE>
HYBRID NETWORKS, INC.
INDEX
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION PAGE NO.
--------------------- --------
<S> <C>
ITEM 1. FINANCIAL STATEMENTS
Balance Sheets as of March 31, 1998
and December 31, 1997 (unaudited) 3
Statements of Operations for the Three Months
Ended March 31, 1998 and 1997 (unaudited) 4
Statements of Cash Flows for the Three Months
Ended March 31, 1998 and 1997 (unaudited) 5
Notes to Unaudited Financial Statements 6
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS 8
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES
ABOUT MARKET RISK 36
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS 37
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS 37
ITEM 5. OTHER INFORMATION 38
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 38
SIGNATURES 39
INDEX TO EXHIBITS 40
</TABLE>
2
<PAGE>
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
HYBRID NETWORKS, INC.
BALANCE SHEETS (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
1998 1997
------------ -------------
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . $ 7,248 $ 26,167
Short-term investments. . . . . . . . . . . . . . . . . . . . . . . . 12,753 981
Accounts receivable, net of allowance for doubtful accounts
of $2,133 in 1998 and $1,175 in 1997. . . . . . . . . . . . . . . . 6,606 8,870
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,298 3,368
Prepaid expenses and other current assets . . . . . . . . . . . . . . 369 362
-------- --------
Total current assets. . . . . . . . . . . . . . . . . . . . 34,274 39,748
Property and equipment, net. . . . . . . . . . . . . . . . . . . . . . . . 1,768 1,808
Intangibles and other assets . . . . . . . . . . . . . . . . . . . . . . . 1,628 1,563
-------- --------
Total assets. . . . . . . . . . . . . . . . . . . . . . . . $ 37,670 $ 43,119
-------- --------
-------- --------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,080 $ 2,033
Accrued liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . 1,278 1,394
Current portion of capital lease obligations. . . . . . . . . . . . . . 455 410
-------- --------
Total current liabilities . . . . . . . . . . . . . . . . . 3,813 3,837
Convertible debenture. . . . . . . . . . . . . . . . . . . . . . . . . . . 5,500 5,500
Capital lease obligations, less current portion. . . . . . . . . . . . . . 587 618
-------- --------
Total liabilities . . . . . . . . . . . . . . . . . . . . . 9,900 9,955
-------- --------
Contingencies
Stockholders' equity:
Convertible preferred stock, $.001 par value:
Authorized: 5,000 shares;
Issued and outstanding: no shares in 1998 or 1997 . . . . . . . . . . -- --
Common stock, $.001 par value:
Authorized: 100,000 shares;
Issued and outstanding: 10,364 shares in 1998 and
10,342 shares in 1997 . . . . . . . . . . . . . . . . . . . . . . . 10 10
Additional paid-in capital. . . . . . . . . . . . . . . . . . . . . . . 63,916 64,086
Accumulated deficit . . . . . . . . . . . . . . . . . . . . . . . . . . (36,156) (30,932)
-------- --------
Total stockholders' equity. . . . . . . . . . . . . . . . . . . . . 27,770 33,164
-------- --------
Total liabilities and stockholders' equity. . . . . . . . . $ 37,670 $ 43,119
-------- --------
-------- --------
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
<PAGE>
HYBRID NETWORKS, INC.
STATEMENTS OF OPERATIONS (UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
-----------------------
1998 1997
-------- --------
<S> <C> <C>
Net sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 915 $ 1,852
Cost of sales. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,181 1,974
-------- --------
Gross loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (266) ( 122)
-------- --------
Operating expenses:
Research and development . . . . . . . . . . . . . . . . . . . . . . . . 2,042 1,726
Sales and marketing. . . . . . . . . . . . . . . . . . . . . . . . . . . 977 1,274
General and administrative . . . . . . . . . . . . . . . . . . . . . . . 2,017 1,233
-------- --------
Total operating expenses. . . . . . . . . . . . . . . . . . . . . . . 5,036 4,233
-------- --------
Loss from operations. . . . . . . . . . . . . . . . . . . . . . . . (5,302) (4,355)
Interest income and other expenses, net. . . . . . . . . . . . . . . . . . 302 87
Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (224) (12)
-------- --------
Net loss. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ (5,224) $ (4,280)
-------- --------
-------- --------
Basic and diluted loss per share . . . . . . . . . . . . . . . . . . . . . $ (0.51) $ (1.67)
-------- --------
-------- --------
Shares used in basic and diluted per share calculation . . . . . . . . . . 10,353 2,561
-------- --------
-------- --------
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE>
HYBRID NETWORKS, INC.
STATEMENTS OF CASH FLOWS (UNAUDITED)
(AMOUNTS IN THOUSANDS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
MARCH 31,
-----------------------
1998 1997
-------- --------
<S> <C> <C>
Cash flows from operating activities:
Net loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $(5,224) $(4,280)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization . . . . . . . . . . . . . . . . . . . . 304 131
Provision for sales returns . . . . . . . . . . . . . . . . . . . . . 2,386 --
Provision for doubtful accounts . . . . . . . . . . . . . . . . . . . 1,077 675
Change in assets and liabilities:
Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . (1,199) (269)
Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (3,930) (757)
Prepaid expenses and other current assets . . . . . . . . . . . . . . (7) 31
Accounts payable. . . . . . . . . . . . . . . . . . . . . . . . . . . 47 394
Accrued liabilities and other . . . . . . . . . . . . . . . . . . . . (116) 9
-------- --------
Net cash used in operating activities . . . . . . . . . . . . . . . (6,662) (4,066)
-------- --------
Cash flows from investing activities:
Purchase of property and equipment . . . . . . . . . . . . . . . . . . . (51) (228)
Change in other assets . . . . . . . . . . . . . . . . . . . . . . . . . (154) (18)
Purchase of short-term investments . . . . . . . . . . . . . . . . . . . (12,753) --
Proceeds from maturity of short-term investments . . . . . . . . . . . . 981 --
-------- --------
Net cash used in investing activities . . . . . . . . . . . . . . . (11,977) (246)
-------- --------
Cash flows from financing activities:
Repayment of capital lease obligations . . . . . . . . . . . . . . . . . (110) (51)
Net proceeds from issuance of preferred stock. . . . . . . . . . . . . . -- 2,000
Net proceeds from issuance of common stock . . . . . . . . . . . . . . . (170) 30
-------- --------
Net cash provided by (used in) financing activities . . . . . . . . (280) 1,979
-------- --------
Decrease in cash and cash equivalents. . . . . . . . . . . . . . . . . . . (18,919) (2,333)
Cash and cash equivalents, beginning of period . . . . . . . . . . . . . . 26,167 6,886
-------- --------
Cash and cash equivalents, end of period . . . . . . . . . . . . . . . . . $ 7,248 4,553
-------- --------
-------- --------
SUPPLEMENTAL SCHEDULE OF NONCASH FINANCING ACTIVITIES:
Property and equipment acquired under capital leases . . . . . . . . . . $ 124 $ 268
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 224 $ 12
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE>
HYBRID NETWORKS, INC.
NOTES TO UNAUDITED FINANCIAL STATEMENTS
BASIS OF PRESENTATION
The accompanying condensed financial statements of Hybrid Networks, Inc.
(the "COMPANY") have been prepared in accordance with generally accepted
accounting principles for interim financial information and with the
instructions for Form 10-Q and Article 10 of Regulation S-X. The balance sheet
as of March 31, 1998, the statements of operations for the three months ended
March 31, 1998 and 1997 and the statements of cash flows for the three month
periods ended March 31, 1998 and 1997 are unaudited but include all adjustments
(consisting of normal recurring adjustments) which the Company considers
necessary for a fair presentation of the financial position at such dates and
the operating results and cash flows for those periods. Although the Company
believes that the disclosures in these financial statements are adequate to make
the information presented not misleading, certain information normally included
in financial statements and related footnotes prepared in accordance with
generally accepted accounting principles have been condensed or omitted pursuant
to the rules and regulations of the Securities and Exchange Commission. The
December 31, 1997 condensed balance sheet data were derived from audited
financial statements but do not include all disclosures required by generally
accepted accounting principles. The accompanying financial statements should be
read in conjunction with the financial statements as contained in the Company's
Annual Report on Form 10-K for the year ended December 31, 1997.
Results for any interim period are not necessarily indicative of results
for any other interim period or for the entire year.
REVENUE RECOGNITION
Commencing for the quarter ended March 31, 1998 the Company revised its
revenue recognition policy to provide that revenue from shipments of product
to distributors will be recognized upon receipt of payment for such shipments.
As a result of the revised revenue recognition policy, shipments to
distributors of approximately $226,000 of products were not recognized as
sales during the quarter ended March 31, 1998.
COMPUTATION OF BASIC AND DILUTED LOSS PER SHARE
The Company adopted Financial Accounting Standards Board No. 128
"Earnings Per Share" and accordingly all prior periods have been restated.
Basic and diluted loss per share are computed using the weighted average
number of shares of common stock outstanding. Common equivalent shares from
stock options, warrants and preferred stock are excluded from the
computation of diluted loss per share as their effect is antidilutive. In
February 1998, the Securities and Exchange Commission issued Staff Accounting
Bulletin (SAB) No. 98, which addresses the computation of earnings per share
in an initial public offering. The Company has determined that no
incremental shares should be included in the computation of earnings per
share in accordance with the SAB and basic and diluted loss per share has
been restated accordingly. Stock options and warrants to purchase 3,493,885
shares of common stock at prices ranging from $0.001 to $11.05 per share were
outstanding as of March 31, 1998 but were not included in the computation of
diluted income per share because they were antidilutive.
RECENT ACCOUNTING PRONOUNCEMENT
In June 1997, the Financial Accounting Standards Board issued Statement No.
130, "Reporting Comprehensive Income." This Statement establishes standards for
reporting and display of comprehensive income and its components (revenues,
expenses, gains and losses) in a full set of general-purpose financial
statements. Such items may include foreign currency translation adjustments,
unrealized gains/losses from investing and hedging activities, and other
transactions. This Statement requires that all items that are required to be
recognized under accounting standards as components of comprehensive income be
reported in a financial
6
<PAGE>
statement that is displayed with the same prominence as other financial
statements. This Statement was adopted in the Company's first quarter of 1998,
and its effect on the financial statements was not material.
INVENTORIES
Inventories comprise the following:
<TABLE>
<CAPTION>
MARCH 31, DECEMBER 31,
1998 1997
------- -------
<S> <C> <C>
Raw materials . . . . . . . . . . $ 2,467 $ 1,952
Work in progress . . . . . . . . . 469 292
Finished goods . . . . . . . . . . 4,362 1,124
------- -------
$ 7,298 $ 3,368
------- -------
------- -------
</TABLE>
CONTINGENCIES
The Company is engaged in certain legal and administrative proceedings
incidental to its normal business activities. While it is not possible to
determine the ultimate outcome of these actions at this time, management
believes that any liabilities resulting from such proceedings, or claims which
are pending or known to be threatened, will not have a material adverse effect
on the Company's financial position or results of operations.
The Company initiated a civil action for patent infringement against Com21,
Inc. and Celestica, Inc. in January 1998 in the U.S. District Court for the
Eastern District of Virginia. In response to the Company's action, Com21, Inc.
initiated a declaratory judgment action on January 29, 1998 against the Company
in the U.S. District Court for the Northern District of California to obtain a
declaration of invalidity, unenforceability and non-infringement of the
Company's patents and the collection of attorneys fees. The action in the
Eastern District of Virginia was subsequently transferred to the Northern
District of California in February 1998. The litigation is expected to be time
consuming and costly, and, although no monetary claim other than attorneys fees
is asserted against the Company, the action, if resolved adversely to the
Company, could have a material adverse effect on the Company's business,
operating results or financial condition.
7
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The following discussion of the financial condition and results of
operations of Hybrid Networks, Inc. (the "COMPANY" or "HYBRID") should be read
in conjunction with the financial statements and notes thereto included
elsewhere in this report on Form 10-Q. This report on Form 10-Q contains
forward-looking statements within the meaning of Section 21E of the Securities
Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933,
as amended. In addition, the sections labeled "OVERVIEW," "LIQUIDITY AND
CAPITAL RESERVES" and "OTHER FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS"
consist primarily of forward-looking statements. These forward-looking
statements involve a number of risks and uncertainties which are described
throughout this Form 10-Q, including, without limitation, See "OVERVIEW,"
"LIQUIDITY AND CAPITAL RESERVES" and "OTHER FACTORS THAT MAY AFFECT FUTURE
OPERATING RESULTS --RISKS OF THE PROPOSED MERGER WITH PACIFIC," "--POSSIBLE NEED
FOR ADDITIONAL FINANCING," "--LIMITED OPERATING HISTORY; HISTORY OF LOSSES,"
"--FLUCTUATIONS IN OPERATING RESULTS; ABSENCE OF SIGNIFICANT BACKLOG;
CONTINUING DECLINE OF AVERAGE SELLING PRICES," "--LENGTHY SALES CYCLE,"
"--DEPENDENCE ON RECENTLY INTRODUCED PRODUCTS AND PRODUCTS UNDER DEVELOPMENT;
RAPID TECHNOLOGICAL CHANGE," " COMPETING TECHNOLOGICAL AND EVOLVING INDUSTRY
STANDARDS" and "--COMPETITION." The actual results that the Company achieves may
differ materially from any forward-looking statements due to such risks and
uncertainties. The forward-looking statements within this report on Form 10-Q
are identified by words such as "believes," "anticipates," "expects," "intends,"
"will," "may" and other similar expressions. In addition, any statements which
refer to expectations, projections or other characterizations of future events
or circumstances are forward-looking statements. The Company undertakes no
obligation to publicly release the results of any revisions to these
forward-looking statements which may be made to reflect events or circumstances
occurring subsequent to the filing of this report on Form 10-Q with the
Securities and Exchange Commission. Readers are urged to carefully review and
consider the various disclosures made by the Company in this report, including
the disclosure in the sections labeled "OVERVIEW" and "OTHER FACTORS THAT MAY
AFFECT FUTURE OPERATING RESULTS, and in the Company's other reports filed with
the Securities and Exchange Commission that attempt to advise interested parties
of the risks and factors that may affect the Company's business.
OVERVIEW
The Company is a broadband access equipment company that designs, develops,
manufactures and markets wireless and cable systems that provide high speed
access to the Internet and corporate intranets for both businesses and
consumers. The Company's products remove the bottleneck over the "last mile"
connection to the end-user which causes slow response time for those accessing
bandwidth-intensive information over the Internet or corporate intranets. The
Company's Series 2000 product line ("SERIES 2000") consists of secure headend
routers, wireless and cable modems and management software for use with either
wireless transmission or cable TV facilities.
From its inception in June 1990 until September 1996, the Company focused
on the design, development, manufacturing and market introduction of the first
two generations of the Company's Series 1000 ("SERIES 1000") product line.
These product generations offered 5 and 10 Mbps access speeds for downstream
data. In October 1996, the Company introduced its third generation product
8
<PAGE>
line, the Series 2000, which provides 30Mbps downstream access speeds. The
Company expects to generate substantially all of its future sales from its
Series 2000 products, enhancements to these products, new products and
related support and networking services. The Company recognizes revenue upon
shipment of products provided that no significant contractual obligations
remain outstanding and collection is probable; however, commencing for the
quarter ended March 31, 1998, the Company revised its revenue recognition
policy with respect to distributors to provide that revenue is recognized
only upon receipt of payment for such shipments. As a result of the revised
revenue recognition policy, shipments to distributors of approximately
$226,000 of products were not recognized as sales during the quarter ended
March 31, 1998. See "NOTES TO UNAUDITED FINANCIAL STATEMENTS." The Company
accrues for warranty costs at the time of shipment. To date, net sales
include principally product sales and, to a lesser extent, support and
networking services.
The Company sells its products primarily in the United States, and markets
its products to a variety of customers, including broadband wireless system
operators, cable system operators, Internet Service Providers ("ISPS"),
resellers and certain distributors and communications equipment resellers.
Historically, a small number of customers has accounted for a substantial
portion of the Company's net sales. From quarter-to-quarter, the Company has
experienced a significant variation in the mix of type of customers, as well as
the identity of its largest customers. Although the Company has expanded its
customer base, the Company expects that a limited number of customers will
continue to account for a substantial portion of the Company's net sales for the
foreseeable future. The Company expects that its largest customers in future
periods could be different from its largest customers in prior periods due to a
variety of factors, including customers' deployment schedules and budget
considerations. As a result, the Company has experienced, and expects to
continue to experience, significant fluctuations in its results of operations on
a quarterly and an annual basis. If orders from significant customers are
delayed, canceled or otherwise fail to materialize in any particular period, or
any significant customer delays payment or fails to pay, the Company can
experience significant operating losses in such period. In addition,
historically, a substantial majority of the Company's net sales in a given
quarter have been recorded in the third month with a concentration in the last
two weeks of the quarter. Accordingly, any delay in the closing of quarter end
transactions can have a significant impact on the Company's operating results
for a particular quarter.
Further, the Company's customers include companies in the early stage of
development or in need of capital to upgrade or expand their services,
particularly in the wireless cable marketplace. In order to address the
needs and competitive factors facing the emerging broadband access market,
the Company on occasion has provided customers extended payment, promotional
pricing or other terms. Recent events have reflected an increasing weakness
in the broadband wireless access market and in the financial condition of
certain wireless cable operators, including customers of the Company. In
addition, the Company recently accepted the request of its largest customer
in 1997 and the major distributor servicing the wireless cable market to
return a substantial amount of inventory due to the weakness in the wireless
market. Other broadband wireless access distributors have made similar
requests or indicated they may do so. As a result of these events, the
Company took a $2,386,000 sales return reserve for the quarter ended March
31, 1998, which reduced net sales from $3,301,000 ("GROSS SALES") to
$915,000. The Company has also experienced collectibility problems with a
number of its customers, including major customers. For example, as of March
31, 1998, 18.4% of the Company's outstanding accounts receivable was owed by
its one principal customer for the quarter ended March 31, 1998. This
customer accounted for 24.2% of Gross Sales for that quarter. The provision
of extended credit terms and collection problems has also contributed to
increases in accounts receivable. The amounts of outstanding accounts
receivable, excluding any allowance for doubtful accounts, increased from
$1,348,000 as of December 31, 1996 to $10,045,000 as of December 31, 1997 and
to $8,739,000 as of March 31, 1998, and the days of sales outstanding
increased from 71 as of
9
<PAGE>
December 31, 1996 to 156 as of December 31, 1997 and to 180 as of March 31,
1998. As of December 31, 1997, the Company established a reserve of
$1,175,000 for doubtful accounts and increased the reserve by $1,077,000 for
the quarter ended March 31, 1998. These increases in accounts receivable and
collectibility issues have adversely affected the Company's business,
operating results and financial condition. See "FACTORS THAT MAY AFFECT
FUTURE OPERATING RESULTS--INEXPERIENCE IN EMERGING MARKET," "--DEPENDENCE ON
BROADBAND WIRELESS SYSTEM OPERATORS," "--DEPENDENCE ON CABLE SYSTEM
OPERATORS," "--CUSTOMER CONCENTRATION" and "--COMPETITION."
The market for high speed network connectivity products and services is
intensely competitive and is characterized by rapid technological change, new
product development and product obsolescence and evolving industry standards.
The Company's ability to develop and offer competitive products on a timely
basis that satisfy industry demands and standards, such as MCNS, could have a
material effect on the Company's business, operating results or financial
condition. See "FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS--COMPETING
TECHNOLOGIES AND EVOLVING INDUSTRY STANDARDS" and "--COMPETITION." In
addition, the market for the Company's products has historically experienced
significant price erosion over the life of a product, and the Company has
experienced and expects to continue to experience pressure on its unit average
selling prices. While the Company has initiated cost reduction programs to
offset pricing pressures on its products, there can be no assurance that these
cost reduction efforts will keep pace with competitive price pressures or lead
to improved gross margins. If the Company is unable to reduce costs, its gross
margins and profitability will be adversely affected. The Company's gross
margins are also affected by the sales mix of points of presence headend
equipment ("POPS" or "HEADENDS") and modems. The Company's single-user modems
generally have lower margins than its multi-user modems, both of which have
lower margins than the Company's headends. Due to current customer demand, the
Company anticipates that the sales mix of modems will be weighted toward
lower-margin single-user modems in the foreseeable future. As a result, gross
margins could be adversely affected in the near term. See "FACTORS THAT MAY
AFFECT FUTURE OPERATING RESULTS--COMPETITION," "--NEED TO REDUCE COST OF CLIENT
MODEMS, DOWNCONVERTERS, ANTENNAS AND VIDEO DECODERS" and "--LIMITED
MANUFACTURING EXPERIENCE; SOLE SOURCE MANUFACTURING."
The Company has recently initiated patent infringement litigation against
two parties, who in response are seeking declarations of invalidity,
unenforceability and non-infringement of the Company's patents. Such litigation
could be time consuming and costly and therefore have a material adverse effect
on the Company's business, operating results or financial condition.
The Company incurred net losses for the quarter ended March 31, 1998 and
the years ended December 31, 1997, 1996 and 1995 of $5,224,000, $13,590,000,
$8,515,000 and $5,269,000, respectively. As a result, the Company had an
accumulated deficit of $36,156,000 as of March 31, 1998. The Company expects
to increase its capital expenditures, as well as its research and development
and other operating expenses, in order to support and expand the Company's
operations. As a result, the Company expects to incur losses for the
foreseeable future. See "LIQUIDITY AND CAPITAL RESOURCES" and "FACTORS THAT
MAY AFFECT FUTURE OPERATING RESULTS--RISKS OF PROPOSED MERGER WITH PACIFIC;"
"--POSSIBLE NEED FOR ADDITIONAL FINANCING," "--LIMITED OPERATING HISTORY;
HISTORY OF LOSSES," --FLUCTUATIONS IN OPERATING RESULTS," "--ABSENCE OF
SIGNIFICANT BACKLOG; CONTINUING DECLINE OF AVERAGE SELLING PRICES" and
"--LENGTHY SALES CYCLE."
During the first quarter of 1998, the Company entered into an Agreement and
Plan of Reorganization ("REORGANIZATION AGREEMENT") whereby a wholly-owned
subsidiary of the
10
<PAGE>
Company will merge (the "MERGER") with and into Pacific Monolithics, Inc.
("PACIFIC"). In the past, each of the Company and Pacific has required
substantial amounts of capital to design, develop, market, sell and manufacture
its products and to finance customer purchases by providing extended credit
terms and other accommodations. Neither the Company nor Pacific has been able
to generate sufficient cash from operations to meet its cash flow needs. See
"LIQUIDITY AND CAPITAL RESOURCES" and "FACTORS THAT MAY AFFECT FUTURE OPERATING
RESULTS--RISKS OF THE PROPOSED MERGER WITH PACIFIC," "POSSIBLE NEED FOR
ADDITIONAL FINANCING" and "--LIMITED OPERATING HISTORY; HISTORY OF LOSSES." In
connection with the proposed Merger, the Company anticipates incurring a charge
of from $3.0 million to $3.5 million in the quarter in which the Merger occurs
and paying Pacific's indebtedness of approximately $2.0 million (inclusive of
accrued interest) for bridge loans made by principal shareholders of Pacific.
See "LIQUIDITY AND CAPITAL RESOURCES" and "FACTORS THAT MAY AFFECT FUTURE
OPERATING RESULTS --RISKS OF THE PROPOSED MERGER WITH PACIFIC."
RESULTS OF OPERATIONS
The following table sets forth the percentage of net sales represented by
the items in the Company's statements of operations for the periods indicated:
<TABLE>
<CAPTION>
THREE MONTHS ENDED MARCH 31,
----------------------------
1998 1997
------- -------
<S> <C> <C>
Net Sales . . . . . . . . . . . . . . . . . . . . . . . . . 100.0% 100.0%
Cost of sales . . . . . . . . . . . . . . . . . . . . . . . 129.1 106.6
------- -------
Gross margin. . . . . . . . . . . . . . . . . . . . . . (29.1) (6.6)
------- -------
Operating expenses:
Research and development. . . . . . . . . . . . . . . . 223.1 93.2
Sales and marketing . . . . . . . . . . . . . . . . . . 106.8 68.8
General and administrative . . . . . . . . . . . . . . 220.4 66.6
------- -------
Total operating expenses . . . . . . . . . . . . . . (550.3) 228.6
------- -------
Loss from operations. . . . . . . . . . . . . . . (579.4) 235.2
------- -------
Interest income and other expense, net . . . . . . . . . . . 33.0 4.7
Interest expense . . . . . . . . . . . . . . . . . . . . . . (24.5) (0.6)
------- -------
Net loss . . . . . . . . . . . . . . . . . . . . . . (570.9)% (231.1)%
------- -------
------- -------
</TABLE>
QUARTER ENDED MARCH 31, 1998 COMPARED TO QUARTER ENDED MARCH 31, 1997.
NET SALES. Net sales were $915,000 for the quarter ended March 31,
1998, compared to net sales of $1,852,000 for the comparable period in 1997.
Net sales for the quarter ended March 31, 1998 reflect a sales return reserve
of $2,386,000. The sales return reserve is for sales recorded in 1997
(substantially all of which were recorded in the three months ended December
31, 1997) to distributors who, although generally not having the contractual
right to return the products purchased, have requested or indicated that they
might request the Company to accept the return of certain of those products.
In view of the current weakness in the broadband wireless access marketplace,
the Company expressed a willingness to accept such returns or believes the
sales reserve for such returns is otherwise appropriate.
11
<PAGE>
For the quarter ended March 31, 1998 net sales would have been $3,301,000
without the sales return reserve, (herein referred to as "Gross Sales"). For
comparative purposes the discussion below generally refers to Gross Sales as
well as the net sales for the quarter ended March 31, 1998.
Net sales for the quarter ended March 31, 1998 were $915,000, a 51%
decrease from net sales for the quarter ended March 31, 1997, primarily
because the increase in Gross Sales for the first quarter of 1998 was more
than offset by the $2,386,000 sales return reserve for the quarter. Without
regard to the sales return reserve, Gross Sales for the quarter ended March
31, 1998 increased as compared to the quarter ended March 31, 1997 primarily
due to increased unit shipments as a result of the introduction of the Series
2000 product line in October 1996 offset in part by price declines on certain
products as a result of competitive pressures and volume purchase
commitments. Both Gross Sales and net sales for the quarter ended March 31,
1998 decreased from net sales of $5,118,000 for the quarter ended December
31, 1997 by $1,817,000 (35.5%) and $4,203,000 (82.1%), respectively,
primarily as a result of delays in anticipated orders and weakness in demand
for both cable and wireless systems that utilize telephone return. Net sales
for the quarter ended March 31, 1998 were also adversely affected by
cancellation by a major customer of an order for approximately $400,000 of
telco return products that were scheduled for delivery in the quarter. The
cancellation resulted from litigation involving the customer and others
which, through unrelated to the Company or its products, remains unresolved
and may affect orders for future quarters. In addition, orders for the
quarter ended March 31, 1998 were slowed, reducing net sales by approximately
$300,000 from the amount anticipated, due to a delay in the introduction of
the Company's new QPSK two-way transmission product for both cable and
wireless environments. For the three months ended March 31, 1998, broadband
wireless systems operators, cable system operators and ISPs accounted for
60.7%, 37.9% and 1.4% of Gross Sales, respectively. During the same period
in 1997, ISPs accounted for 56.0% of net sales, broadband wireless system
operators accounted for 29.5% of net sales and cable system operators
accounted for 14.5% of net sales. International sales accounted for 14.7% of
Gross Sales for the quarter ended March 31, 1998 and accounted for 7.4% of
net sales for the quarter ended March 31, 1997. The Company had two
customers that accounted for 24.2% and 14.5% of Gross Sales during the three
months ended March 31, 1998. The Company had one customer that accounted for
50.9% of net sales for the comparable period in 1997.
GROSS MARGIN. Gross margin was a negative 29.1% of net sales, for the
quarter ended March 31, 1998 as compared to a negative 6.6% for the quarter
ended March 31, 1997. The decline in gross margin resulted primarily from
the loss of gross margin on sales returns and the lack of absorption of
manufacturing costs. Gross margins for the first quarter of 1998 declined
from 21.0% in the quarter ended December 31, 1997, due to lower net sales
which affected the absorption of manufacturing costs, the continuing
competitive price pressures in the broadband access market and reserves
accrued in the quarter ended March 31, 1998.
RESEARCH AND DEVELOPMENT. Research and development expenses include
ongoing headend, software and cable modem development expenses, as well as
design expenditures associated with product cost reduction programs and
improving manufacturability of its existing products. Research and
development expenses were $2,042,000 and $1,726,000 during the quarters ended
March 31, 1998 and 1997, respectively, representing 223.1% and 93.2% of net
sales, respectively. Research and development expenses grew in absolute
dollars as a result of increased staffing and associated engineering costs
related to new and existing product development. The Company intends to
continue to increase its investment in research and development programs in
future periods.
SALES AND MARKETING. Sales and marketing expenses consist primarily of
salaries and related payroll costs of sales and marketing personnel,
commissions, advertising, promotions and travel. Sales and marketing expenses
were $977,000 and $1,274,000 during the three months ended March 31, 1998 and
1997, respectively, representing 106.8% and 68.8% of net sales, respectively.
The decrease in sales and marketing expenses in absolute dollars was
principally due to lower trade show, promotion and outside service costs.
The decrease in sales and marketing expenses was offset by increased
headcount and related payroll costs and, increased commissions as a result of
higher net sales.
12
<PAGE>
GENERAL AND ADMINISTRATIVE. General and administrative expenses consist
primarily of executive personnel salaries, provision for doubtful accounts,
travel expenses, legal fees and costs of outside services. General and
administrative expenses were $2,017,000 and $1,233,000 during the quarters
ended March 31, 1998 and 1997, respectively, representing 220.4% and 66.6% of
net sales, respectively. The increase in absolute dollars was due to
increased provision for doubtful accounts, increased headcount and related
payroll costs, increased legal costs to support the Company's patent program
and higher outside service costs. Included in general and administrative
expense in the first quarter of 1998 and 1997 was a bad debt provision of
$1,077,000 and $650,000, respectively, for potential customer account
write-offs as a result of the financial condition of certain customers.
INTEREST INCOME (EXPENSE) AND OTHER EXPENSE, NET. The Company earned net
interest income of $78,000 and $75,000 during the quarters ended March 31, 1998
and 1997, respectively. Net interest income earned during the quarter ended
March 31, 1998 was the result of higher cash balances as a result of the
issuance of Common Stock in the Company's initial public offering in November
1997, offset in part by the interest expense incurred on outstanding capital
lease obligations and the $5.5 million Secured Convertible Debenture due 2002
(the "$5.5 MILLION DEBENTURE"). Net interest income earned during the first
quarter of 1997 was primarily due to higher cash balances as a result of the
issuance of Preferred Stock in February 1997, offset in part by the interest
expense incurred on outstanding capital lease obligations.
LIQUIDITY AND CAPITAL RESOURCES
The Company has historically financed its operations primarily through a
combination of debt and equity and equipment lease financing. As of March
31, 1998, the Company had working capital of $30,461,000, including
$20,001,000 in cash, cash equivalents and short-term investments, as compared
to working capital of $35,911,000 and $27,148,000 in cash and cash
equivalents as of December 31, 1997. This $7,147,000 decrease in cash, cash
equivalents and short-term investments during the three months ended March
31, 1998 resulted from the use of cash in operating activities, investing
activities and financing activities discussed below.
Cash used in operating activities during the quarter ended March 31,
1998 was $6,662,000, resulting from the net loss of $5,224,000; an increase
in accounts receivable of $1,199,000 attributable principally to net sales
made late in the quarter and the limited capital resources of and extended
payment terms given to certain customers; the increase in inventories of
$3,930,000 due to anticipated sales increases that did not occur, the delay
of sales orders by several customers in the quarter and anticipated product
returns; and a decrease in accrued liabilities of $116,000. Cash used in
operating activities during the quarter ended March 31, 1998 was offset
principally by the $2,386,000 in reserves for potential sales returns by
distributors and the increase of $1,077,000 in reserves for doubtful accounts
as a result of the Company's assessment of the risks associated with several
slow paying customers and with continuing collection problems reflected in an
increase of $1,940,000 in accounts receivable past due during the quarter,
from $5,325,000 as of December 31, 1997 to
13
<PAGE>
$7,265,000 as of March 31, 1998. Cash used in operating activities during
the quarter was further offset by depreciation and amortization of $304,000.
Cash used in investing activities during the quarter ended March 31, 1998
was $11,977,000, resulting primarily from purchases of short term investments of
$12,753,000, the change in other assets of $154,000 and purchases of property
and equipment of $51,000, offset by the proceeds from the maturity of short term
investments of $981,000. During the quarter ended March 31, 1998, capital
expenditures for property and equipment were primarily for computers, furniture,
fixtures and engineering test equipment. The Company has funded and expects to
continue to fund a substantial portion of its property and equipment
expenditures from a variety of sources including direct vendor leasing programs
and third party commercial leasing arrangements. As of March 31, 1998, the
Company is committed to $1.5 to $2.0 million in capital expenditures for tenant
improvements in connection with new subleased headquarters. The Company expects
capital expenditures for the next twelve months (including such tenant
improvements) to be between $4.0 million to $5.0 million.
Cash used in financing activities during the quarter ended March 31, 1998
was $280,000, attributable primarily to payment of capital lease obligations and
additional costs incurred in connection with the Company's initial public
offering.
The Company's principal sources of liquidity at March 31, 1998 were cash,
cash equivalents and short-term investments of $20,001,000 and the Company's
$4.0 million bank credit facility (the "$4.0 MILLION CREDIT FACILITY"). The
$4.0 Million Credit Facility, which expires in October 1998, bears interest at
the bank's prime rate and is collateralized by certain of the Company's assets.
As of March 31, 1998, the Company has no borrowings outstanding under the $4.0
Million Credit Facility.
Under the $5.5 Million Debenture, the Company is subject to limitations on
the amount of capital expenditures it may incur in any 12-month period and may
not declare dividends, retire any subordinated debt other than in accordance
with its terms or distribute its assets to any stockholder so long as the
$5.5 Million Debenture remains outstanding. In addition, under the $4.0 Million
Credit Facility, the Company may not declare dividends. The $5.5 Million
Debenture is collateralized by substantially all of the Company's assets. Any
borrowings under the $4.0 Million Credit Facility will be collateralized by a
first priority security interest in certain of the Company's assets. See
"FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS--RESTRICTIVE DEBT COVENANTS."
The Company's proposed Merger with Pacific is intended to be treated as a
pooling of interests for accounting purposes. The Company anticipates utilizing
additional cash in connection with the Merger. The Company expects to incur a
charge of approximately $3.0 to $3.5 million in the quarter in which the Merger
occurs in connection with the write-off of certain assets, personnel severance
costs, the cancellation and continuation of contractual obligations and direct
transaction fees for investment bankers, attorneys, accountants, financial
printing and other related charges. Actual costs may substantially exceed such
estimates. In addition, upon consummation of the Merger, the Company
anticipates paying Pacific's indebtedness of approximately $2.0 million in
bridge loans (inclusive of accrued interest) made by principal shareholders of
Pacific. Such repayment is not required under the terms of the Merger, and the
Company does not expect to make any other cash payments to former shareholders
of Pacific. Total costs associated with the Merger are anticipated to result in
an operating loss and a net loss for the quarter in which the Merger is
consummated
14
<PAGE>
and for its fiscal year ending December 31, 1998 and could negatively
affect financial results in future periods. See "FACTORS THAT MAY AFFECT FUTURE
OPERATING RESULTS--PROPOSED MERGER WITH PACIFIC," "--POSSIBLE NEED FOR
ADDITIONAL FINANCING" and "--LIMITED OPERATING HISTORY; HISTORY OF LOSSES."
The Company is seeking to reduce its cash utilization in operations and
believes that, notwithstanding the proposed Merger with Pacific, cash generated
from operations, if any, and existing cash resources and credit facilities will
provide the Company with sufficient funds to finance its operations for the next
12 months. However, the Company may require additional funds to support its
working capital requirements or for other purposes, and may seek to raise such
additional funds through the sale of public or private equity or debt financing
or from other sources. The sale of additional equity or convertible debt
securities may result in additional dilution to the Company's stockholders. No
assurance can be given that additional financing will be available or that, if
available, such financing can be obtained on terms favorable to the Company or
its stockholders.
ADOPTION OF NEW ACCOUNTING STANDARD
In June 1997, the Financial Accounting Standards Board issued Statement No.
130, "Reporting Comprehensive Income." This Statement establishes standards for
reporting and display of comprehensive income and its components (revenues,
expenses, gains and losses) in a full set of general-purpose financial
statements. Such items may include foreign currency translation adjustments,
unrealized gains/losses from investing and hedging activities, and other
transactions. This Statement requires that all items that are required to be
recognized under accounting standards as components of comprehensive income be
reported in a financial statement that is displayed with the same prominence as
other financial statements. This Statement was adopted in the Company's first
quarter of 1998, and its effect on the financial statements was not material.
RECENT ACCOUNTING PRONOUNCEMENT
In June 1997, the Financial Accounting Standards Board issued Statement No.
131, "Disclosures about Segments of an Enterprise and Related Information." This
Statement establishes standards for the way that public business enterprises
report information about operating segments in annual financial statements and
requires that those enterprises report selected information about operating
segments in interim financial reports issued to stockholders. It also
establishes standards for related disclosures about products and services,
geographic areas and major customers. This Statement is required to be adopted
for fiscal years beginning after December 15, 1997. The Company has yet to
determine the affect of adoption of this statement.
YEAR 2000 COMPLIANCE
The Company is aware of the issues associated with the programming code
in existing computer systems as the millennium ("YEAR 2000") approaches. The
year 2000 problem is pervasive and complex, as virtually every computer
operation will be affected in some way by the rollover of the two digit year
value to 00. The issue is whether computer systems will properly recognize
date sensitive information when the year changes to 2000. Systems that do not
properly recognize such information could generate erroneous data or cause a
system to fail.
The Company is utilizing both internal and external resources to
identify, correct or reprogram, and test the systems for the year 2000
compliance. It is anticipated that all reprogramming efforts will be
completed by the year 2000 allowing adequate time for testing. Management
believes that there will not be a material effect on the Company's earnings
as a result of this compliance. Failure of key business partners or vendors
to identify and correct year 2000 issues could have a material adverse effect
on the Company's operations.
15
<PAGE>
FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS
As indicated in the first paragraph of this Item 2, this section consists
primarily of forward looking statements that involves risks and uncertainties.
Words such as "expects," "anticipates," "intends," "plans," "believes," "seeks,"
variations of such words and similar expressions are intended to identify these
forward-looking statements. The forward-looking statements reflect the best
judgment of the management of Hybrid based on factors currently known and
involve risks and uncertainties. Actual results could differ materially from
those discussed in the forward-looking statements as a result of certain
factors, including those set forth below and elsewhere in this report on Form
10-Q.
RISKS OF THE PROPOSED MERGER WITH PACIFIC
SHORT TERM DILUTION OF INTEREST. A substantial number of shares and shares
subject to options and warrants will be issued or subject to issuance to the
securityholders of Pacific upon consummation of the Merger and will cause a
dilution of earnings per share which may negatively affect Hybrid's stock price
in the near term.
Under the terms of the Reorganization Agreement, each outstanding share of
Pacific capital stock will be converted into an amount of Hybrid Common Stock
equal to a fraction, the numerator of which is obtained by dividing $12,500,000
by the Closing Price and the denominator of which is the total number of shares
of Pacific capital stock outstanding plus the total number of shares of Pacific
capital stock issuable upon the exercise of outstanding Pacific options and
warrants (the "EXCHANGE RATIO"). The "CLOSING PRICE" will equal the average of
the closing sale prices of one share of Hybrid Common Stock reported in THE WALL
STREET JOURNAL for each of the ten trading days ending two trading days
preceding the closing date of the Merger; provided, however, that in no event
will the Closing Price be greater than $8.40 (resulting in an Exchange Ratio of
0.0688078, assuming the number of Pacific shares, options and warrants
outstanding as of April 30, 1998 (the "LOW EXCHANGE RATIO")) or less than $5.17
(resulting in an Exchange Ratio of 0.1117959, assuming the number of Pacific
shares, options and warrants outstanding as of April 30, 1998 (the "HIGH
EXCHANGE RATIO")). Ten percent of the shares of Hybrid Common Stock issuable to
each of the Pacific shareholders pursuant to the Merger will be deposited into
escrow as collateral for the indemnification obligations of the Pacific
shareholders under the Reorganization Agreement. Outstanding Pacific options
and warrants will be assumed into option or warrants, respectively, to purchase
a number of shares of Hybrid Common Stock equal to the Exchange Ratio multiplied
by the number of shares purchasable under the Pacific options or warrants,
respectively (in the case of each option or warrant, rounded down to the nearest
whole share), at an exercise price equal to the exercise price of the particular
Pacific options or warrants, as applicable, divided by the Exchange Ratio (in
the case of each option or warrant, rounded up to the nearest whole share).
At the Low Exchange Ratio (if the Closing Price is $8.40 or more),
approximately 14.3% of Hybrid's outstanding Common Stock would be issued or
issuable in the Merger, and at the High Exchange Ratio (if the Closing Price is
$5.17 or less), approximately 23.2% would be issued or issuable. Further, as a
result of the antidilution provisions of the $5.5 Million Debenture, the number
of shares of Hybrid Common Stock issuable upon conversion of the debenture
(currently 513,433 shares) will be increased by virtue of the Merger, and the
amount of the increase will depend upon the per share market price of Hybrid
Common Stock at the time of the Merger (the lower the market price, the greater
number of shares will be issuable upon conversion of the
16
<PAGE>
debenture). For example, if the market price were $6.00 at the time of the
Merger, the number of shares issuable upon conversion of the debenture would
increase by approximately 103,000 shares over the current amount; and if the
market price were $5.00, the number of shares issuable upon conversion would
increase by approximately 587,000 over the current amount. While Hybrid
believes that the dilution resulting from the Merger will be temporary and
that the Merger will ultimately be accretive to the combined company's
earnings per share, there can be no assurance that this will be the case or
that Hybrid's stock price will not continue to be negatively affected, or
that actual results will be as expected.
PACIFIC'S NEED FOR IMMEDIATE ADDITIONAL FINANCING. Pacific is currently
in need of immediate additional capital to finance its operations and to meet
its short term liquidity needs. Pacific has had a history of losses, and as
of March 31, 1998 had an accumulated deficit of over $25 million. While
Pacific is seeking additional financing up to an approximate amount of up to
$1.0 million, there can be no assurance that the additional required
financing will be available through equity offerings, bank borrowings or
otherwise, or that, if such financing is available, it will be available on
terms favorable to Pacific or its shareholders. If Pacific is unable to
secure financing prior to the consummation of the Merger, Pacific will have
to scale back sales and marketing and research and development efforts and
Pacific's business, financial condition and operating results will be
materially adversely affected.
INCREASED NEED FOR ADDITIONAL FINANCING. As indicated below in "--POSSIBLE
NEED FOR ADDITIONAL FINANCING," it is likely that Hybrid will need additional
financing even if the Merger is not consummated. However, in view of Pacific's
need for immediate capital, as indicated above, and Pacific's likely need for
substantial further financing due to anticipated future operating losses and
costs, consummation of the Merger is likely to accelerate and increase Hybrid's
need for further financing. There can be no assurance that additional financing
will be available or, if available, that the terms of such financing will not be
unfavorable to Hybrid and its stockholders.
COSTS OF INTEGRATION; TRANSACTION EXPENSES. Hybrid expects to incur a
charge of approximately $3.0 million to $3.5 million in the quarter in which
the Merger occurs in connection with the write-off of certain assets,
personnel severance costs, the cancellation and continuation of contractual
obligations and direct transaction fees for investment bankers, attorneys,
accountants, financial printing and other related charges. Actual costs may
substantially exceed such estimates, unanticipated expenses associated with
the integration of the two companies may arise, or Hybrid may incur
additional material charges in subsequent quarters to reflect additional
costs associated with the integration of the two companies. In addition,
upon consummation of the Merger, the Company will pay Pacific's indebtedness
of approximately $2.0 million in bridge loans (inclusive of accrued interest)
made by principal shareholders of Pacific. Total costs associated with the
Merger are anticipated to result in an operating loss and a net loss for
Hybrid's quarter in which the Merger occurs and for the year ending
December 31, 1998, and could negatively affect financial results in future
periods for the reasons discussed above.
GENERAL RISKS ASSOCIATED WITH INTEGRATION OF OPERATIONS. Hybrid and
Pacific have entered into the Reorganization Agreement with the expectation that
the proposed Merger will result in long-term strategic benefits. These
anticipated benefits will depend in part on whether the companies' operations
can be integrated in an efficient and effective manner. There can be no
assurance that this will occur. The successful integration of Pacific with
Hybrid will require, among other things, integration of the companies'
respective product offerings and coordination of the companies' management,
sales and marketing and research and development efforts. It is possible
17
<PAGE>
that this integration will not be accomplished smoothly or successfully, and
that efforts to achieve integration may require more time, expense and
management attention than anticipated. The diversion of the attention of
management from day-to-day operations and any difficulties encountered in the
transition process could have an adverse impact on the combined company's
business, operating results or financial condition. Disruption of the combined
company's business might result from employee uncertainty or lack of focus, as
well as from customer or supplier confusion, following announcement of the
Merger. The process of combining the operations of the two organizations could
cause the interruption of, or a loss of momentum in, the activities of either or
both of the companies' businesses, which could have an adverse effect on their
combined operations. In addition, during the pre-Merger and integration phase,
competitors may try to recruit key employees of Hybrid or Pacific and to gain a
competitive advantage with Hybrid's or Pacific's prospective and existing
customers. Despite the efforts of the combined company, it might not be able to
retain key management, technical and sales personnel.
EXECUTION BY COMBINED SALES AND MARKETING FORCES. The combined company may
experience disruption in sales and marketing as a result of attempting to
integrate Hybrid's and Pacific's sales forces, and may be unable to effectively
correct such disruption, or to successfully execute on its sales and marketing
objectives, even after the companies' respective sales and marketing forces have
been combined. In addition, sales models for the various products that will
make up the combined company's new product line may vary significantly from
product to product. Sales personnel not accustomed to the different approaches
required for products newly added to their portfolio may experience delays and
difficulties in selling these newly added products. Furthermore, it may be
difficult to retain key sales personnel during the period prior to and after the
effectiveness of the Merger. As a result, the combined company may be unable to
take full advantage of the combined sales forces' efforts, and the sales
approach and distribution channels of one company may be ineffective in
promoting the products of the other. Hybrid and Pacific also use a number of
distribution channels in the various geographic locations in which their
respective products are sold, and channel conflicts may develop following the
Merger.
INTEGRATION OF PRODUCTS AND ENGINEERING TEAMS; DELAY IN DEVELOPMENT OF
INTEGRATED PRODUCTS. After the Merger, the combined company plans to combine
its product offerings and to develop products to work together in integrated
suites. It is possible that such integration and development efforts will not
be accomplished in a timely manner or prove to be technologically infeasible.
There can be no assurance that either company will retain its key technical
personnel, that the engineering teams of the two companies will successfully
cooperate and realize any technological benefits, or that the focus on product
integration and extension efforts will not have an adverse effect on the
development, introduction or delivery of new or enhanced Hybrid or Pacific
products. Any delays that occur in the development and introduction of the
integrated, end-to-end, system solutions for high speed Internet access that
Hybrid plans to pursue following the Merger could have a materially adverse
effect upon the combined company's business, operating results or financial
condition.
FINANCIAL IMPACT OF FAILURE TO ACHIEVE SYNERGIES. If the integration of
Hybrid's and Pacific's operations is not successful, or the combined company
does not achieve the operational efficiencies and other business synergies that
are anticipated or if such synergies are not achieved as quickly as may be
expected by financial analysts or at the level expected by financial analysts,
or if the effect of the Merger on earnings per share is not in line with the
expectation of financial
18
<PAGE>
analysts, the market price of Hybrid's Common Stock will be significantly and
adversely affected. See "-VOLATILITY OF STOCK PRICE" below.
RISKS ASSOCIATED WITH EFFECT OF MERGER ON SUPPLIERS, RESELLERS AND
CUSTOMERS; UNCERTAINTIES OF THE WIRELESS MARKET. The announcement and
consummation of the Merger could cause suppliers, resellers and present and
potential customers of either company to delay or cancel orders for products as
a result of concerns and uncertainty over evolution, integration and support of
Hybrid's and Pacific's products following the Merger. The combined company's
combination of products and creation of integrated suites could cause present
and potential customers of Hybrid and Pacific to delay or cancel orders for
products. Such delays or cancellations of orders could have a material adverse
effect on the business, operating results or financial condition of Hybrid,
Pacific or the combined company. In particular, such delays or cancellations
could be expected to disrupt revenue and earnings, which in turn would have a
negative effect on the market price of Hybrid Common Stock. In addition,
Hybrid's focus on the broadband wireless market may increase following the
Merger, and there are uncertainties regarding the general economic condition of
that market. There is a risk that the financial condition of increasing numbers
of customers for the combined company's wireless products will adversely affect
such customers' ability or willingness to purchase or pay for those products,
thereby adversely affecting the combined company's business, results of
operation and financial condition.
POOLING OF INTERESTS. In order to qualify the Merger as a pooling of
interests for accounting and financial reporting purposes, affiliates of Hybrid
and Pacific have agreed not to sell, or otherwise reduce their risk with respect
to, any shares of stock, except for a de minimus number as defined by certain
SEC rules and regulations, of either Hybrid or Pacific during the period
beginning 30 days preceding the Effective Time and continuing until the day that
Hybrid publicly announces financial results covering at least 30 days of
combined operations of Hybrid and Pacific. If the Merger is completed and the
Effective Time occurs after May 1998, it is not expected that such combined
financial results would be published until mid to late October. If affiliates
of Hybrid or Pacific sell their Hybrid Common Stock despite their contractual
obligation not to do so, the Merger may not qualify for accounting as a pooling
of interests for financial reporting purposes in accordance with generally
accepted accounting principles, which would in turn materially and adversely
affect Hybrid's reported earnings and, potentially, its stock price.
POSSIBLE NEED FOR ADDITIONAL FINANCING
In the past, the Company has required substantial amounts of capital to
design, develop, market, sell and manufacture its products and to finance
customer purchases by providing extended payment terms and other
accommodations and to fund continuing operations. It is anticipated that
these costs will continue. The Company's future capital requirements will
depend on many factors, including, but not limited to, the evolution of the
market for broadband access systems, the market acceptance of the Company's
products, competitive pressure on the price of the Company's products, the
level at which the Company maintains inventory, the levels of promotion and
marketing required to launch such products and attain a competitive position
in the marketplace, the extent to which the Company invests in new technology
and improvements on its existing technology, and the response of competitors
to the Company's products. As indicated above, in "--RISKS OF THE PROPOSED
MERGER WITH PACIFIC--INCREASED NEED FOR ADDITIONAL FINANCING." While the
Company believes that available bank borrowings, existing cash balances and
funds generated from operations, if any, will provide the Company with
sufficient funds to pay
19
<PAGE>
the costs referred to in "--RISKS OF THE PROPOSED MERGER WITH PACIFIC--COSTS
OF INTEGRATION; TRANSACTION EXPENSES" above and to finance its operations for
at the next 12 months, to the extent that existing resources are insufficient
to fund the combined company's activities over the long-term, the combined
company may need to raise additional funds through public or private equity
or debt financing or from other sources. The sale of additional equity or
convertible debt may result in additional dilution to Hybrid's stockholders,
and such securities may have rights, preferences or privileges senior to
those of the Hybrid Common Stock. To the extent that the Company relies upon
debt financing, the Company will incur the obligations to repay the funds
borrowed with interest and may become subject to covenants and restrictions
that restrict operating flexibility. No assurance can be given that
additional equity or debt financing will be available or that, if available,
it can be obtained on terms favorable to the combined company or its
stockholders.
LIMITED OPERATING HISTORY; HISTORY OF LOSSES
The Company was organized in 1990 and has experienced operating losses
each year since that time. As of March 31, 1998, the Company had an
accumulated deficit of approximately $36.2 million. Because the Company and
the market for broadband access through cable modems is still in an emerging
stage, there can be no assurance that the Company will ever achieve
profitability on a quarterly or an annual basis or will sustain profitability
once achieved. The Company began shipment of its first products, the Series
1000 product line in 1994 and sold only minimal quantities before replacing
them with its Series 2000 product line, which was first shipped in October
1996. The revenue and profit potential of the Company's business and the
industry is unproven, and the Company's limited operating history makes its
future operating results difficult to predict. The Company believes that its
growth and future success will be substantially dependent upon broadband
wireless system operators, cable system operators and ISPs adopting its
technologies, purchasing its products and selling its client modems to cable,
wireless and ISP subscribers. The Company has had limited experience selling
its products to broadband wireless system operators, cable system operators,
ISPs, resellers and other businesses, and there are many impediments to its
being able to do so. See "--INEXPERIENCE IN EMERGING MARKET." The market
for the Company's products has only recently begun to develop, is rapidly
changing and is characterized by an increasing number of competitors and
competing technologies. Certain competitors of the Company currently offer
more price competitive products. In the event that the Company's current or
future competitors release new products or technologies with more advanced
features, better performance or lower prices than the Company's current and
future products, demand for the Company's products would decline. See
"--COMPETITION" below. Failure of the Company's products to achieve market
acceptance could have a material adverse effect on the Company's business,
operating results or financial condition. Although the Company has
experienced growth in net sales in the past year, the Company does not
believe that its growth rate during the past year is sustainable or
indicative of future operating results. For the three months ended March 31,
1998, Hybrid's net sales declined by 82.1% from its net sales for the three
months ended December 31, 1997. In addition, the Company has had negative
gross margins in past periods, and there can be no assurance that any
continued growth in net sales will result in positive gross profits or
operating profits. Future operating results will depend on many factors,
including the growth of the wireless and cable modem system markets, demand
for the Series 2000 and future product lines, purchasing decisions by
wireless and cable companies and their subscribers, the level of product and
price competition, market acceptance of competing technologies to deliver
high speed Internet access, evolving industry standards, the ability of the
Company to develop and market new products
20
<PAGE>
and control costs, general economic conditions and other factors. The Company
believes that it will continue to experience net losses for the foreseeable
future.
FLUCTUATIONS IN OPERATING RESULTS; ABSENCE OF SIGNIFICANT BACKLOG; CONTINUING
DECLINE OF AVERAGE SELLING PRICES
The Company has experienced, and expects to continue to experience,
significant fluctuations in its results of operations on a quarterly and an
annual basis. Historically, the Company's quarterly net sales have been
unpredictable due to a number of factors. Factors that have influenced and
will continue to influence the Company's results of operations in a
particular period include: the size and timing of customer orders and
subsequent shipments, particularly with respect to the Company's headend
equipment; customer order deferrals in anticipation of new products or
technologies; timing of product introductions or enhancements by the Company
or its competitors; market acceptance of new products; technological changes
in the cable, wireless and telecommunications industries; competitive pricing
pressures; the effects of extended payment terms, promotional pricing,
service, marketing or other terms offered to customers; accuracy of customer
forecasts of end-user demand; changes in the Company's operating expenses;
personnel changes; quality control of products sold; regulatory changes;
customer's capital spending; delays of orders by customers; customers' delay
in or failure to pay accounts receivable; and general economic conditions.
For example, for the three months ended March 31, 1998, Hybrid's net sales
declined 82.1% from its net sales for the three months ended December 31,
1997, and Hybrid recorded a $2,386,000 sales return reserve. Further, Hybrid
increased its reserves for doubtful accounts in the fourth quarter of 1997
and the first quarter of 1998 by $500,000 and $1,077,000, respectively. In
addition, the inability to obtain components from suppliers or manufacturers
has adversely affected the Company's operating results in the past and may
materially adversely affect the Company's operating results in the future.
For example, in the second quarter and a portion of the third quarter of
1997, the Company did not receive the full shipment of modems anticipated
from Sharp Corporation ("SHARP"), its primary modem manufacturer, because of
technical delays in product integration. As a result, the Company was unable
to fill all customer orders for the second quarter. While such problems have
since been resolved, there can be no assurance that the Company will not
experience similar supply problems in the future with respect to Sharp or any
other supplier or manufacturer.
The timing and volume of customer orders are difficult to forecast because
wireless and cable companies typically require delivery of products within 30
days, thus a substantial majority of the Company's net sales are booked and
shipped in the same quarter. Accordingly, the Company has a limited backlog of
orders, and net sales for any future quarter are difficult to predict. The
Company, at any given time, has a limited backlog of orders and currently has no
backlog. Further, sales are generally made pursuant to purchase orders, which
can be rescheduled, reduced or cancelled with little or no penalty.
Historically, a substantial majority of the Company's net sales in a given
quarter have been recorded in the third month of the quarter, with a
concentration of such net sales in the last two weeks of the quarter. Because
of the relatively large dollar size of the Company's typical transaction, any
delay in the closing of a transaction can have a significant impact on the
Company's operating results for a particular period. See "--LENGTHY SALES
CYCLE."
Historically, average selling prices ("ASPs") in the wireless and cable
systems industry have decreased over the life of individual products and
technologies. In the past, the Company has experienced decreases in unit ASPs
of each of its products. The Company anticipates that unit
21
<PAGE>
ASPs of its products will continue to decrease, which would cause continuing
downward pressure on the gross margins for these products. The Company's gross
margins are also impacted by the sales mix of PoPs and modems. The Company's
single-user modems generally have lower margins than its multi-user modems, both
of which have lower margins than the Company's headends. Due to current
customer demand, the Company anticipates that the sales mix of modems will
continue to be weighted toward lower-margin single-user modems in the
foreseeable future. See "--NEED TO REDUCE COST OF CLIENT MODEMS,
DOWNCONVERTERS, ANTENNAS AND VIDEO DECODERS" below.
LENGTHY SALES CYCLE
The sale of the Company's products typically involves a significant
technical evaluation and commitment of capital and other resources, with the
delays frequently associated with customers' internal procedures to approve
large capital expenditures, to engineer deployment of new technologies within
their networks and to test and accept new technologies that affect key
operations. For these and other reasons, the sales cycle associated with the
Company's products is typically lengthy, generally lasting three to nine months
and is subject to a number of significant risks, including customers' budgetary
constraints and internal acceptance reviews, that are beyond the Company's
control. Because of the lengthy sales cycle and the large size of customers'
orders, if orders forecasted for a specific customer for a particular quarter
are not realized in that quarter, the Company's operating results for that
quarter could be materially adversely affected. See "--FLUCTUATIONS IN
QUARTERLY OPERATING RESULTS; ABSENCE OF SIGNIFICANT BACKLOG; AND CONTINUING
DECLINE OF AVERAGE SELLING PRICES."
DEPENDENCE ON RECENTLY INTRODUCED PRODUCTS AND PRODUCTS UNDER DEVELOPMENT; RAPID
TECHNOLOGICAL CHANGE
The market for high speed Internet access products is characterized by
rapidly changing technologies and short product life cycles. Prior to
October 1996, substantially all of the Company's product sales were
attributable to its Series 1000 product line. In October 1996, the Company
introduced its Series 2000 product line (which replaced the Series 1000
product line). The Company is currently generating, and expects to continue
to generate in the near term, substantially all of its net sales from its
Series 2000 product line and related support and networking services. To
date, substantially all products sold have been for telephone return based
systems and have involved single-user modems. Since the Series 2000 products
have been subject to only limited single-user testing, the reliability,
performance and market acceptance of the Company's products are uncertain,
and there is increased risk that the products will be affected by problems
beyond those that are generally associated with new products. The failure of
the current generation of products to perform acceptably in certain beta test
situations has caused the Company to make engineering changes to such
products, and the Company continues to modify the designs of its products in
an attempt to increase their reliability and performance. There can be no
assurance that the Company's engineering and product design efforts will be
successful. The Company's future success will depend in part upon its
ability to develop, introduce and market new products or enhancements to
existing products in a timely manner and to respond to competitive pressures,
changing industry standards or technological advances. For example, in the
quarter ended March 31, 1998, the Company began offering products for two-way
cable transmission using QPSK technology in response to customer
requirements. In addition, the Company is developing products for two-way
broadband wireless transmission. There can be no assurance that the Company
will successfully develop or introduce new products, or that any new products
will achieve market acceptance. Any failure to release new products or to
22
<PAGE>
fix, upgrade or redesign existing products on a timely basis could have a
material adverse effect on the Company's business, operating results and
financial condition. In addition, as the Company introduces new products
that cause existing products to become obsolete, the Company could experience
inventory writeoffs, which could have a material adverse effect on the
Company's business, operating results and financial condition. For example,
to the extent customers demand two-way products, demand for the Company's
wireless and cable systems that utilize telephone return could be adversely
effected.
COMPETING TECHNOLOGIES AND EVOLVING INDUSTRY STANDARDS
The market for high speed Internet access products is characterized by
competing technologies, evolving industry standards and frequent new product
introductions. Market acceptance of alternative wired technologies, such as
Integrated Services Digital Network ("ISDN") or Digital Subscriber Line
("xDSL"), or wireless technologies, such as DBS, could decrease the demand for
the Company's products or render such products obsolete if such alternatives are
viewed as providing faster access, greater reliability or improved
cost-effectiveness. In particular, it is possible that the perceived high speed
access advantage provided by cable and broadband wireless systems may be
undermined by the need to share bandwidth, which results in the reduction in
individual throughput speeds. In addition, the emergence or evolution of
industry standards, through either adoption by official standards committees or
widespread use by cable system operators, broadband wireless system operators or
telephone companies ("TELCOs"), could require the Company to redesign its
products to meet such standards, resulting in delays in the introduction of such
products. For instance, the Company's products are not in full compliance with
the DAVIC specifications that are supported in Europe or the versions of the
Multimedia Cable Network Systems ("MCNS") specifications or IEEE standards.
Cable customers and competitors are giving increased emphasis to the value of
compliance with MCNS specifications. If the Company's products are not in
compliance with such standards or specifications, the Company's customers and
potential customers may refuse to purchase the Company's products, materially
adversely affecting its business, operating results or financial condition.
Further, the Company's products are not compatible with headend equipment and
modems of other suppliers of broadband Internet access products. As a result,
potential customers who wish to purchase broadband Internet access products from
multiple suppliers may be reluctant to purchase the Company's products. The
rapid development of new competing technologies and standards increases the risk
that current or new competitors could develop products that would reduce the
competitiveness of the Company's products. Market acceptance of new
technologies or the failure of the Company to develop and introduce new products
or enhancements directed at new industry standards could have a material adverse
effect on the Company's business, operating results or financial condition.
INEXPERIENCE IN EMERGING MARKET
Cable system operators, broadband wireless system operators,
distributors and other customers may prefer to purchase products from larger,
more established manufacturing companies, including certain of the Company's
competitors, that can demonstrate the capability to supply large volumes of
products on short notice. In addition, many cable system operators,
broadband wireless system operators and other customers may be reluctant to
adopt technologies that have not gained wide acceptance among their industry
peers. Certain competitors of the Company have already established
relationships in the market, further limiting the Company's ability to sell
products to such potential customers. While the Company has sold products to
certain cable system operators, broadband wireless system operators and other
23
<PAGE>
customers, most of these sales are not based on long-term contracts and such
customers may terminate their relationships with the Company at any time.
Further, the Company's contracts generally do not contain significant minimum
purchase requirements. In addition, in order to address the needs and
competitive factors facing the broadband access market sales the Company has
and in the future may need to offer extended payment, pricing, service,
marketing or other promotional terms which can have a material adverse effect
on the Company's business, operating results or financial condition. For
example, the Company increased its reserves for doubtful accounts in the
fourth quarter of 1997 and the first quarter of 1998 due to the assessment of
the risk associated with the slow pay of several customers, which adversely
effected operating results. If the Company is unable to market and sell its
products to a significant number of broadband wireless system operators,
cable system operators and other customers, or if such entities should cease
doing business with the Company, the Company's business, operating results or
financial condition could be materially adversely affected.
LIMITED PENETRATION OF TWO-WAY CABLE; DEPENDENCE ON CABLE OPERATOR INSTALLATIONS
Although wired cable systems pass a significant percentage of U.S.
households, very few of those households are currently served by cable plants
that support two-way data access. Further, a limited number of businesses, a
major target market for the Company, currently have cable access. To support
upstream data on existing hybrid fiber coax ("HFC") cable plants, a cable
operator must install two-way amplifiers in the cable network to use the portion
of the cable spectrum allocated for upstream use. There can be no assurance
that cable system operators will choose to upgrade existing cable systems or
provide new cable systems with two-way capability. In particular, certain large
cable system operators have announced their intention to slow or halt plans to
upgrade existing cable systems. Adding upstream capabilities to new or existing
cable systems is expensive and generally requires portions of existing systems
to be unavailable during the installation process. Cable system operators may
decide to wait for the next generation of wired infrastructure, such as optical
fiber, before deciding whether to provide two-way communication. The Federal
Communications Commission ("FCC") has required cable system operators to
dedicate the frequency spectrum from 5 MHz to 42 MHz for upstream transmissions,
but because this portion of spectrum is small in comparison to the downstream
portion, it is more susceptible to ingress noise and other impairments and it
can support a more limited bandwidth. Due to a scarcity of channels, cable
system operators have been and may continue to be reluctant to dedicate a
portion of their frequency spectrum to new uses such as those for which the
Company's products are designed. Consequently, the Company expects that
upstream data traffic on cable systems will be limited to narrow or congested
parts of the spectrum, thus limiting the number of potential simultaneous users.
If cable system operators do not install two-way capability on their cable
systems in a timely fashion or if such operators do not dedicate sufficient
frequency spectrum for upstream traffic, the use of cable for upstream data
traffic will be limited. Any such limitation could have a material adverse
effect on the Company's business, operating results or financial condition.
DEPENDENCE ON BROADBAND WIRELESS SYSTEM OPERATORS
The Company depends on broadband wireless system operators and
distributors to purchase its wireless modem products and to sell its client
wireless modems to end-users. Approximately 60.7% of the Company's Gross
Sales in the first quarter of 1998 and 29.5% of the Company's net sales in
1997 were attributable to customers in the broadband wireless industry. Many
broadband wireless system companies are in the early stage of development or
are in need of capital to upgrade and expand their services in order to
compete effectively with cable system operators, satellite TV and telcos.
Many of these broadband wireless system companies in need of such significant
capital have had difficulties financing their businesses and are
under-capitalized.
24
<PAGE>
The broadband wireless access market has recently been experiencing
increasing weakness. Several broadband wireless access operators, including
customers of the Company, have also experienced increasing financial
difficulties. These events have caused the Company's major distributor to
the broadband wireless access market to ask the Company to accept the return
of substantial inventory. Other broadband wireless access distributors have
made similar requests or indicated that they may do so. As a result, the
Company has reported a $2,386,000 sales return reserve for the quarter ended
March 31, 1998. Further, to address the needs of and competitive factors
facing the wireless cable customers, the Company on occasion has provided
certain broadband wireless system operators extended payment, promotional
pricing or other terms which had had and are likely to continue to have a
material adverse effect on the Company's business, operating results or
financial condition.
The principal disadvantage of wireless cable is that it requires a
direct line of sight between the wireless cable system operator's antenna and
the customer's location. Therefore, despite a typical range of up to 35
miles, a number of factors, such as buildings, trees or uneven terrain, can
interfere with reception, thus limiting broadband wireless system operators'
customer bases. It is estimated that there are only approximately 1.0
million wireless cable customers in the United States today. In addition,
current technical and legislative restrictions have limited the number of
analog channels that wireless cable companies can offer to 33. In order to
better compete with cable system operators, satellite TV and telcos,
broadband wireless system operators have begun to examine the implementation
of both digital TV and Internet access to create new revenue streams. To the
extent that such operators choose to invest in digital TV, such decision will
limit the amount of capital available for investment in deploying other
services, such as Internet access. Broadband wireless system operators will
require substantial capital to introduce and market Internet access products.
There can be no assurance that broadband wireless system operators will have
the capital to supply Internet services in a competitive environment. In
addition, there can be no assurance that the broadband wireless system
operators' current customer bases have significant interest in high speed
Internet connectivity at a price greater than that offered by telcos or that
broadband wireless system operators can attract customers, particularly in
the business community, which have not traditionally subscribed to wireless
cable services. While broadband wireless system operators are currently
utilizing telephone return for upstream data transmission, the Company
believes that wireless operators will demand two-way wireless transmission as
more of these entities obtain licenses for additional frequencies.
Currently, the Company is developing its products to satisfy the two-way
transmission needs of the broadband wireless system operators. There can be
no assurance that the Company will be successful in such development efforts,
or if successful, that the products will be developed on a timely basis. The
failure of the Company's products to gain market acceptance could have a
material adverse effect on the Company's business, operating results or
financial condition.
DEPENDENCE ON CABLE SYSTEM OPERATORS
The Company depends on cable system operators to purchase its cable modem
systems and to sell its client cable modems to end-users. Cable system
operators have a limited number of programming channels over which they can
offer services, and there can be no assurance that they will choose to provide
Internet access. Even if cable system operators choose to provide Internet
access, there can be no assurance that they would provide such access over
anything other than that portion of their cable system that has two-way cable
transmission capabilities. In addition, there can be no assurance that if such
cable system operators provide Internet access, they would use the Company's
products. The Company began selling in the first quarter of 1998 a two-way
cable
25
<PAGE>
transmission solution utilizing the QPSK technology required by cable system
operators, but there can be no assurance that the Company will be successful in
such efforts or that once introduced such products will gain market acceptance.
While many cable system operators are in the process of upgrading, or have
announced their intention to upgrade, their HFC cable infrastructures to provide
increased quality and speed of transmission and, in certain cases, two-way
transmission capabilities, some cable operators have delayed their planned
upgrades indefinitely. Cable system operators have limited experience with
these upgrades, and investments in upgrades have placed a significant strain on
the financial, managerial, operational and other resources of the cable system
operators, most of which are already highly leveraged and facing intense
competition from telcos, satellite TV and broadband wireless system operators.
Because of the substantial capital cost of upgrading cable systems for higher
quality and two-way data transmission, it is uncertain whether such cable
upgrades and additional services, such as Internet access, will be offered in
the near term, or at all. For example, to increase television programming
capacity to compete with other modes of multichannel entertainment delivery
systems, cable system operators may choose to roll out digital set-top boxes,
which do not support high speed Internet access. Cable system operators may not
have the capital required to upgrade their infrastructure or to offer new
services that require substantial start-up costs. In addition, the Company is
highly dependent on cable system operators to continue to maintain their cable
infrastructure in such a manner that the Company will be able to provide
consistently high performance and reliable service. Therefore, the success and
future growth of the Company's business is subject to economic and other factors
affecting the cable television industry generally, particularly the industry's
ability to finance substantial capital expenditures.
CUSTOMER CONCENTRATION
To date, a small number of customers have accounted for a substantial
portion of the Company's net sales. The Company expects that net sales from
the sale of its Series 2000 products to a small number of customers will
continue to account for a substantial portion of its net sales for the
foreseeable future. The Company expects that its largest customers in future
periods could be different from its largest customers in prior periods due to
a variety of factors, including customers' deployment schedules and budget
considerations. In addition, the mix of Hybrid's customers, whether cable,
wireless, ISP or distributors, has changed from quarter to quarter. As a
result, the Company has experienced, and expects to continue to experience,
significant fluctuations in its results of operations on a quarterly and
annual basis. Because limited numbers of cable system operators and
broadband wireless system operators account for a majority of capital
equipment purchases in their respective markets, the Company's future success
will depend upon its ability to establish and maintain relationships with
these companies. Further, the during the latter part of 1997 and the first
quarter of 1998, the Company has increased sales through distributors.
However, during the first quarter of 1998, Hybrid recorded an $2,386,000
sales return reserve for actual and potential adjustments to inventory held
by distributors. While these customers generally do not have the contractual
right to require product returns or stock rotation, some have requested or
indicated they might request the Company to accept the return of certain of
these products in view of the current weakness in the broadband wireless
access market place. The Company expressed a willingness to accept such
returns or believes the sales reserve for such returns is otherwise
appropriate. In addition, as the market for high speed Internet and
corporate intranet access over cable and broadband wireless systems continues
to evolve, the composition of companies participating in this market will
continue to change. For instance, in 1994, 1995 and 1996, Intel Corporation
("INTEL") accounted for 59.6%, 51.6% and 20.7%, respectively, of the
Company's net sales. From 1994 to 1996, Intel
26
<PAGE>
manufactured certain products based on the Company's design and jointly
marketed the Company's products with its own. However, in 1996 Intel stopped
purchasing products from the Company as it scaled back its direct
participation in the wireless and cable market, though it continues to be a
significant stockholder of the Company and maintains certain licensing and
manufacturing rights to certain of the Company's products. A decision by
Intel to purchase or support designs or products from competitors of Hybrid
could have a material adverse effect on the Company's business, operating
results and financial condition. The loss of any one of the Company's major
customers could have a material adverse effect on the Company's business,
financial condition or results of operations. Further, the Company's
customers include companies in the early stage of development or in need of
capital to upgrade or expand their services. Accordingly, in order to address
the needs of and competitive factors facing the emerging broadband access
markets, the Company on occasion has provided customers extended payment,
promotional pricing or other terms. The provision of extended payment terms,
or the extension of promotional payment, pricing or other terms can have a
material adverse effect on the Company's business, operating results or
financial condition. For example, the Company increased its reserves for
doubtful accounts in the fourth quarter of 1997 and the first quarter of 1998
by $500,000 and $1,077,000, respectively, due to the assessment of the risk
associated with the slow pay of several customers which adversely effected
operating results. As of March 31, 1998 18.4% of the Company's outstanding
accounts receivable was owed by its principal customer for the quarter ended
March 31, 1998. The Company's future success will depend in significant part
upon the decision of the Company's current and prospective customers to
continue to purchase products from the Company. There can be no assurance
that the Company's current customers will continue to place orders with the
Company or that the Company will be able to obtain orders from new customers.
If orders from current customers are cancelled, decreased or delayed, or the
Company fails to obtain significant orders from new customers, or any
significant customer delays payment or fails to pay, the Company's business,
operating results or financial condition could be materially adversely
affected. Further, the Company's headend equipment does not operate with
other companies' modems and, accordingly, the Company is typically a sole
source provider to its customers. As a result, the Company's operating
results could be materially and adversely affected if a major customer were
to implement other technologies that impact the future utilization of the
Company's products.
COMPETITION
The market for high speed network connectivity products and services is
intensely competitive. The principal competitive factors in this market include
product performance and features (including speed of transmission and upstream
transmission capabilities), reliability, price, size and stability of
operations, breadth of product line, sales and distribution capability,
technical support and service, relationships with broadband wireless system
operators, cable system operators and ISPs, standards compliance and general
industry and economic conditions. Certain of these factors are outside of the
Company's control. The existing conditions in the high speed network
connectivity market could change rapidly and significantly as a result of
technological changes, and the development and market acceptance of alternative
technologies could decrease the demand for the Company's products or render them
obsolete. Similarly, the continued emergence or evolution of industry standards
or specifications may put the Company at a disadvantage in relation to its
competitors.
The Company's current and potential competitors include providers of
asymmetric cable modems, other types of cable modems and other broadband access
products. Most of the
27
<PAGE>
Company's competitors are substantially larger and have greater financial,
technical, marketing, distribution, customer support and other resources, as
well as greater name recognition and access to customers than the Company. In
addition, many of the Company's competitors are in a better position to
withstand any significant reduction in capital spending by cable or broadband
wireless system operators. Certain of the Company's competitors have
established relationships with cable system operators and telcos and, based on
these relationships, may have more direct access to the personnel of such cable
system operators and telcos that are responsible for making purchasing
decisions. In addition, the Company could face potential competition from
certain of its suppliers, such as Sharp if it were to develop or license modems
for sale to others. In addition, suppliers such as Cisco Systems, which
manufactures routers, could become competitors should they decide to enter the
Company's market directly. Stanford Telecom, which manufacturers QPSK
components and is the sole supplier for certain components used in the Company's
products, has become a competitor for at least one of the Company's products in
the broadband wireless market. There can be no assurance that the Company will
be able to compete effectively in its target markets.
The Company's principal competitors in the wireless modem market are Bay
Networks, Harmonic Lightwaves through its acquisition of New Media
Communications, Motorola, General Instrument through NextLevel Systems and
Stanford Telecom.
The principal competitors in the cable modem market include Bay
Networks, Motorola, NextLevel Systems and 3Com and its subsidiary U.S.
Robotics. Other cable modem competitors include Cisco Systems, Com21, Hayes
Microcomputer Products, Phasecom, Scientific-Atlanta, Terayon, Toshiba and
Zenith Electronics, as well as a number of smaller, more specialized
companies. Certain competitors have entered into partnerships with computer
networking companies that may give such competitors greater visibility in
this market. For example, Cisco has announced intentions to develop
solutions based on the MCNS standard with several cable modem vendors and in
December 1997 announced a MCNS-compliant integrated router and cable modem to
offer high-speed Internet access. Certain of the Company's competitors have
already introduced or announced high speed connectivity products that are
priced lower than the Company's, and certain other competitors are more
focused on and experienced in selling and marketing two-way cable
transmission products. There can be no assurance that additional competitors
will not introduce new products that will be priced lower, provide superior
performance or achieve greater market acceptance than the Company's products.
To be successful, the Company's Series 2000 products must achieve market
acceptance and the Company must respond promptly and effectively to the
challenges of new competitive products and tactics, alternate technologies,
technological changes and evolving industry standards. The Company must
continue to develop products with improved performance over two-way cable
transmission facilities and with the ability to perform over two-way wireless
transmission facilities. There can be no assurance that the Company will meet
these challenges, that it will be able to compete successfully against current
or future competitors, or that the competitive pressures faced by the Company
will not materially and adversely affect the Company's business, operating
results or financial condition. Further, as a strategic response to changes in
the competitive environment, the Company may make certain promotional pricing,
service, marketing or other decisions or enter into acquisitions or new ventures
that can have a material adverse effect on the Company's business, operating
results or financial condition.
28
<PAGE>
Broadband wireless and cable system operators face competition from
providers of alternative high speed connectivity systems. In the wireless high
speed access market, broadband wireless system operators compete with satellite
TV providers. In telephony networks, xDSL technology enables digitally
compressed video signals to be transmitted through existing telephone lines to
the home. Recently several companies, including Compaq, Intel, Microsoft, 3Com,
Alcatel, Lucent, several RBOCs, MCI and others announced the formation of a
group focused on accelerating the pace of ADSL service. In the event that any
competing architecture or technology were to limit or halt the deployment of
coaxial or HFC systems, the Company's business, operating results or financial
condition would be materially adversely affected.
NEED TO REDUCE COST OF CLIENT MODEMS
The list prices for the Series 2000 client modems currently range from
approximately $440 to $795, depending upon features and volume purchased.
Customers wishing to purchase client modems generally must also purchase an
Ethernet adapter for their computer. These prices make the Company's products
relatively expensive for the consumer electronics and the small office or home
office markets. Market acceptance of the Company's products, and the Company's
future success, will depend in significant part on reductions in the unit cost
of the Company's client modems. Certain of the Company's competitors currently
offer products at prices lower than those for the Company's modems. While the
Company has initiated cost reduction programs to offset pricing pressures on its
products, there can be no assurance that these cost reduction efforts will keep
pace with competitive pricing pressures or lead to improved gross margins. If
the Company is unable to obtain cost reductions, its gross margins and
profitability will be adversely affected. To address continuing competitive and
pricing pressures, the Company expects that it will have to reduce the cost of
manufacturing client modems significantly through design and engineering
changes. Such changes may involve redesigning the Company's products to utilize
more highly integrated components and more automated manufacturing techniques.
The Company has entered into high-volume purchase and supply agreements with
Sharp and Itochu Corporation ("ITOCHU") and may evaluate the use of low-cost
third party suppliers and manufacturers to further reduce costs. There can be
no assurance that the Company will be successful in redesigning its products or
using more automated manufacturing techniques, that a redesign can be made on a
timely basis and without introducing significant errors and product defects, or
that a redesign will result in sufficient cost reductions to allow the Company
to reduce the list price of its client modems. Moreover, there can be no
assurance that additional volume purchase or manufacturing agreements will be
available to the Company on terms that the Company considers acceptable. To the
extent that the Company enters into a high-volume or long-term purchase or
supply agreement and then decides that it cannot use the products or services
provided for in the agreement, the Company's business, operating results or
financial condition could be materially adversely affected.
LIMITED MANUFACTURING EXPERIENCE; SOLE SOURCE MANUFACTURING
The Company's future success will depend, in significant part, on its
ability to manufacture, or have others manufacture, its products successfully,
cost-effectively and in sufficient volumes. The Company maintains a limited
in-house manufacturing capability at its headquarters in Cupertino for
performing system integration and testing on all headend products and for
manufacturing small quantities of modems. The Company entered into an agreement
pursuant to which Sharp to date has been the exclusive OEM supplier through
Itochu of certain of the Company's client modems, including the substantial
majority of those utilized in the Series 2000.
29
<PAGE>
In the second quarter and a portion of the third quarter of 1997, the Company
did not receive the full shipment of modems anticipated from Sharp because of
technical delays in product integration. While these problems have since been
resolved, there can be no assurance that the Company will not experience similar
supply problems in the future from Sharp or any other manufacturer. The Company
is exploring the possibility of entering into supply arrangements with other
manufacturers to provide additional or alternative sources of supply for certain
of the Company's products, although there can be no assurance that such
arrangements will be entered into or that they will provide for the prompt
manufacture of products or subassemblies in quantities or on terms required to
meet the needs of the Company's customers. The Company has had only limited
experience manufacturing its products to date, and there can be no assurance
that the Company or Sharp or any other manufacturer of the Company's products
will be successful in increasing the volume of its manufacturing efforts. The
Company may need to procure additional manufacturing facilities and equipment,
adopt new inventory controls and procedures, substantially increase its
personnel and revise its quality assurance and testing practices, and there can
be no assurance that any of these efforts will be successful. Failure to do so
could have a material adverse effect on the Company's business, operating
results or financial condition.
DEPENDENCE ON COMPONENT AVAILABILITY AND KEY SUPPLIERS
The Company is dependent upon certain key suppliers for a number of the
components for its products. For example, the Company currently only has one
vendor, BroadCom Corporation, for the 64 QAM demodulator semiconductors that are
used in the Company's server and client modem products, and in past periods
these semiconductors have been in short supply. Recently, BroadCom announced a
program to develop with certain of the Company's competitors high-speed cable
data modems and headend equipment based on BroadCom's MCNS compliant
semiconductor. As a result of such program, certain of BroadCom's technological
and product enhancements may be made available to certain of the Company's
competitors before making them available to the Company. This could have the
effect of putting the Company at a competitive disadvantage with regard to time
to market or cause the Company to have to redesign its products if competitors
influence changes in BroadCom's products. Hitachi is the sole supplier of
components used in the processors used in certain of the Company's modems. In
addition, certain other components for products that the Company has under
development are currently only available from a single source. For example,
Stanford Telecom, which is a competitor for at least one of the Company's
broadband wireless products, is currently the sole supplier for certain
components used in the Company's products, although the Company is in the
process of developing one or more alternative sources. There can be no
assurance that delays in key components or product deliveries will not occur in
the future due to shortages resulting from a limited number of suppliers, the
financial or other difficulties of such suppliers or the possible limitation in
component product capacities due to significant worldwide demand for such
components. Any significant interruption or delay in the supply of components
for the Company's products or significant increase in the price of components
due to short supply or otherwise could have a material adverse effect on the
Company's ability to manufacture its products and, therefore, could have a
material adverse effect on its business, operating results or financial
condition.
DEPENDENCE ON THE INTERNET AND INTERNET INFRASTRUCTURE DEVELOPMENT
The commercial market for products designed for the Internet and the TCP/IP
networking protocol has only recently begun to develop, and the Company's
success will depend in large part
30
<PAGE>
on increased use of the Internet. Critical issues concerning the commercial use
of the Internet, including security, reliability, cost, ease of access and
quality of service, remain unresolved and are likely to affect the development
of the market for the Company's products. The adoption of the Internet for
commerce and communications, particularly by enterprises that have historically
relied upon alternative means of commerce and communications, generally requires
the acceptance of a new way of conducting business and exchanging information.
In addition, the Company is dependent on the growth of the use of the Internet
by businesses, particularly for applications that utilize multimedia content and
thus require high bandwidth. If the Internet as a commercial or business medium
fails to develop or develops more slowly than expected, the Company's business,
operating results and financial condition could be materially adversely
affected. The recent growth in the use of the Internet has caused frequent
periods of performance degradation, requiring the upgrade of routers,
telecommunications links and other components forming the infrastructure of the
Internet by ISPs and other organizations with links to the Internet. Any
perceived degradation in the performance of the Internet as a whole could
undermine the benefits of the Company's products. Potentially increased
performance provided by the products of the Company and others is ultimately
limited by and reliant upon the speed and reliability of the Internet backbone
itself. Consequently, the emergence and growth of the market for the Company's
products is dependent on improvements being made to the entire Internet
infrastructure to alleviate overloading and congestion.
DEPENDENCE ON ACCEPTANCE OF ASYMMETRIC NETWORKING
The Company's products are designed to transmit data from the Internet in
the downstream direction (i.e., to the end-user) much more quickly than data is
transmitted in the upstream direction (i.e., from the end-user). This
"asymmetric" architecture has not been widely used and is relatively unproven in
computer networking. Certain networking protocols and standards, including the
TCP/IP protocol, were designed with the expectation that the network would be
symmetric, and the Company has spent considerable engineering resources to
enable its products to work with such protocols. There can be no assurance that
the Company's current or future products will be compatible with symmetric
standards or that errors will not occur in connecting the symmetric protocols
with the Company's asymmetric design. Because of this asymmetric design,
certain applications do not benefit from the connection to a high bandwidth
cable system. Computer applications that need to transmit data as quickly to
the Internet as from the Internet will not exhibit the performance improvements
that are only available to downstream data traffic, particularly if the upstream
traffic is sent via Plain Old Telephone Service ("POTS"). Certain applications
will not run fast enough in the upstream direction to be acceptable for some
users. As a result, some end-users may not perceive a significant benefit from
the greater downstream performance of the Company's products. There can be no
assurance that potential customers will consider the downstream performance
benefits sufficient to justify the purchase and installation costs of the
Company's asymmetric products. Failure of asymmetric networking to gain market
acceptance, or any delay in such acceptance, could have a material adverse
effect on the Company's business, operating results or financial condition.
RISK OF PRODUCT DEFECTS, PRODUCT RETURNS AND PRODUCT LIABILITY
Products as complex as those offered by the Company frequently contain
undetected errors, defects or failures, especially when first introduced or when
new versions are released. In the past, such errors have occurred in the
Company's products and there can be no assurance that errors will
31
<PAGE>
not be found in the Company's current and future products. The occurrence of
such errors, defects or failures could result in product returns and other
losses to the Company or its customers. Such occurrence could also result in
the loss of or delay in market acceptance of the Company's products, which could
have a material adverse effect on the Company's business, operating results or
financial condition. The Company's products generally carry a one year warranty
which includes factory and on-site repair services as needed for replacement of
parts. In addition, the Company's third party manufacturer provides a fifteen
month warranty period on all cable modems manufactured by them. The warranty
period begins on the date the modems are completely assembled. Due to the
relatively recent introduction of the Series 2000 products, the Company has
limited experience with the problems that could arise with this generation of
products. In addition, the Company's purchase agreements with its customers
typically contain provisions designed to limit the Company's exposure to
potential product liability claims. It is possible, however, that the
limitation of liability provisions contained in the Company's purchase
agreements may not be effective as a result of federal, state or local laws or
ordinances or unfavorable judicial decisions. Although the Company has not
experienced any product liability claims to date, the sale and support of the
Company's products entails the risk of such claims. A successful product
liability claim brought against the Company could have a material adverse effect
on the Company's business, operating results or financial condition.
DEPENDENCE ON KEY PERSONNEL
The Company's success depends in significant part upon the continued
services of its key technical, sales and senior management personnel, including
the Company's President and Chief Executive Officer, Carl S. Ledbetter. The
Company carries a $1.5 million "key man" life insurance policy on Mr. Ledbetter
as required under the terms of the $5.5 Million Debenture but does not have an
employment agreement with him. Any officer or employee of the Company can
terminate his or her relationship with the Company at any time. The Company's
future success will also depend on its ability to attract, train, retain and
motivate highly qualified technical, marketing, sales and management personnel.
Competition for such personnel is intense, and there can be no assurance that
the Company will be able to attract and retain key personnel. The loss of the
services of one or more of the Company's executive officers or key employees or
the Company's failure to attract additional qualified personnel could have a
material adverse effect on the Company's business, operating results or
financial condition.
REGULATION OF THE COMMUNICATIONS INDUSTRY
The Company and its customers are subject to varying degrees of federal,
state and local regulation. For instance, the jurisdiction of the FCC extends
to high speed Internet access products such as those of the Company. The FCC
has promulgated regulations that, among other things, set installation and
equipment standards for communications systems. Further, regulation of the
Company's customers may adversely impact the Company's business, operating
results and financial condition. For example, FCC regulatory policies affecting
the awarding and availability of cable, wireless and telco licenses, services,
and other terms on which cable, wireless and telco companies conduct their
business, may impede the Company's penetration of certain markets. Changes in
current or future laws or regulations which negatively impact the Company's
products and technologies, in the United States or elsewhere, could materially
and adversely affect the Company's business, operating results or financial
condition.
32
<PAGE>
In March 1997, the FCC was petitioned to grant to broadband wireless
operations the right to use their spectrum for two-way access. Two-way access
would enable voice, video and data over that spectrum. Failure to obtain FCC
clearance of two way authorization for such spectrum would materially adversely
affect sales of Hybrid's and Pacific's products and would materially adversely
affect the combined company's business operating results and financial
condition. In addition, international regulatory authorities for broadband
wireless communications are currently conducting spectrum auctions. Failure to
complete these auctions in a timely manner would have a material adverse effect
on sales of Pacific's downconverter, antenna and video encoding products and
would materially adversely affect the combined company's business, operating
results and financial condition.
PROTECTION AND ENFORCEMENT OF INTELLECTUAL PROPERTY RIGHTS
The Company relies on a combination of patent, trade secret, copyright and
trademark laws and contractual restrictions to establish and protect proprietary
rights in its products. The Company currently has two patents issued in the
United States, as well as pending patent applications in the United States,
Europe and Japan that relate to its network and modem technology and the
communication processes implemented in those devices. In the future, the
Company intends to seek additional United States and foreign patents on its
technology. There can be no assurance any of these patents will issue from any
of the Company's pending applications or applications in preparation or that any
claims allowed will be of sufficient scope or strength, or issue in sufficient
countries where the Company's products can be sold, to provide meaningful
protection or any commercial advantage to the Company. Moreover, any patents
that have been or may be issued might be challenged, as is the case with the
recently initiated Company's patent litigation discussed below. Any such
challenge could result in time consuming and costly litigation and result in the
Company's patents being held invalid or unenforceable. Furthermore, even if the
patents are not challenged or are upheld, third parties might be able to develop
other technologies or products without infringing any such patents.
The Company has entered into confidentiality and invention assignment
agreements with its employees, and non-disclosure agreements with certain of its
suppliers, distributors and customers in order to limit access to and disclosure
of its proprietary information. There can be no assurance that these
contractual arrangements or the other steps taken by the Company to protect its
intellectual property will prove sufficient to prevent misappropriation of the
Company's technology or to deter independent third-party development of similar
technologies. The laws of certain foreign countries may not protect the
Company's products or intellectual property rights to the same extent as do the
laws of the United States.
In the past, the Company has received, and in the future may receive,
notices from third parties claiming that the Company's products or proprietary
rights infringe the proprietary rights of third parties. The Company expects
that developers of wireless and cable modems will be increasingly subject to
infringement claims as the number of products and competitors in the Company's
industry segment grows. Any such claim, whether meritorious or not, could be
time consuming, result in costly litigation, cause product shipment delays or
require the Company to enter into royalty or licensing agreements. Such royalty
or licensing agreements might not be available on terms acceptable to the
Company or at all, which could have a material adverse effect upon the Company's
business, operating results or financial condition.
33
<PAGE>
The Company has and in the future may license its patents or proprietary
rights, for commercial or other reasons, to parties who are or may become
competitors of the Company. Further the Company has recently and may in the
future elect to initiate claims or litigation against third parties for
infringement of the Company's patents or proprietary rights or to establish the
validity of the Company's patents or proprietary rights. The Company recently
initiated patent infringement litigation against two companies, and in response
one company is seeking a declaration of invalidity, unenforceability and
non-infringement of the Company's patents and attorneys fees, and the other
company is seeking to be dismissed from the litigation. The Company has not yet
determined if it will initiate litigation against other parties as well. In
addition, the Company has sent notices to certain third parties offering to
license the Company's patents for products that may be infringing the Company's
patent rights. There can be no assurance that such notifications will not lead
to potential additional litigation, including claims by third parties seeking to
challenge the Company's patents or asserting infringement by the Company. The
current litigation and any additional litigation could be time consuming and
costly and have a material adverse effect on the Company's business, operating
results or financial condition.
RISKS OF INTERNATIONAL SALES
To date, sales of the Company's products outside of the United States have
represented an insignificant portion of net sales. While the Company intends to
expand its operations in North America and Europe, this will require significant
management attention and financial resources. In order to gain market
acceptance internationally, the Company's products will have to be designed to
meet industry standards of foreign countries, such as the DAVIC specifications
that are supported in Europe. The Company has committed and continues to commit
resources to developing international sales and support channels. International
sales are subject to a number of risks, including longer payment cycles, export
and import restrictions and tariffs, including existing United States
restrictions on the export of certain high technology products that could limit
the Company's sales abroad, unexpected changes in regulatory requirements, the
burden of complying with a variety of foreign laws, greater difficulty in
accounts receivable collection, potentially adverse tax consequences, currency
fluctuations and political and economic instability. Sales to international
customers are typically made in U.S. dollars to minimize the risks associated
with fluctuating foreign currency exchange rates. To the extent that
international revenues increase as a percentage of total revenues in the future,
foreign currency fluctuation exposure may also increase. There can be no
assurance that future economic or political instability in countries where
Hybrid sells its products will not have a material adverse effect on Hybrid's
sales in such countries, and consequently, on the business financial condition
or results of operations of Hybrid. Additionally, the protection of
intellectual property may be more difficult to enforce outside of the United
States. In the event the Company is successful in expanding its international
operations, the imposition of exchange or price controls or other restrictions
on foreign currencies could materially adversely affect the Company's business,
operating results and financial condition. If the Company increases its
international sales, its net sales may also be affected to a greater extent by
seasonal fluctuations resulting from lower sales that typically occur during the
summer months in Europe and other parts of the world.
RESTRICTIVE DEBT COVENANTS
Under the terms of the outstanding $5.5 Million Debenture, Hybrid is
subject to certain restrictive covenants which could adversely affect the
combined company's operations, including
34
<PAGE>
limitations on the amount of capital expenditures it may incur in any 12-month
period and prohibitions against declaring dividends, retiring any subordinated
debt other than in accordance with its terms or distributing assets to any
stockholder, as long as the $5.5 Million Debenture remains outstanding. In
October 1997, the Company entered into the $4.0 million Credit Facility, which
contains a number of restrictive covenants, including covenants prohibiting the
declaration of dividends. The $5.5 Million Debenture and the Credit Facility
are collateralized by substantially all of the Company's assets. In addition,
the $5.5 Million Debenture contains "full ratchet" antidilution provisions under
which the number of shares of the Company's Common Stock into which the $5.5
Million Debenture will be convertible, at the option of the holder, may be
increased if the Company issues any shares (with certain exceptions for employee
stock options and the like) prior to October 1998 for consideration less than
$10.71 per share. Commencing with October 1998, any such issuance would be
subject to certain "weighted average" antitilution provisions.
SHARES ELIGIBLE FOR FUTURE SALE
Sales of substantial amounts of the Company's Common Stock (including
shares issued upon the exercise of outstanding options and warrants and upon
the conversion of its $5.5 million debenture) in the public market could
adversely affect the market price of the Common Stock prevailing from time to
time and could impair the Company's ability to raise capital through the sale
of equity or debt securities. There are approximately 7,180,307 shares of
Common Stock outstanding that are restricted shares ("RESTRICTED SHARES")
under the Securities Act of 1933, as amended. The 7,180,307 Restricted
Shares became available for sale in the public market following the
expiration of 180-day lock-up agreements on May 12, 1998. Currently, the
$5.5 Million Debenture can be converted into 513,423 shares of Common Stock
at any time at the option of the holder (subject to certain anti-dilution
adjustments which could result from certain offerings of securities by the
Company at a market price below $10.71 per share, see "--RESTRICTIVE DEBT
COVENANTS" above), although the number of shares subject to issuance upon
conversion of the debenture may increase substantially upon the Merger. See
"--RISKS OF THE PROPOSED MERGER WITH PACIFIC--SHORT TERM DILUTION OF
INTEREST" above. Furthermore, the holders of warrants for 1,340,656 shares of
Hybrid Common Stock can exercise such warrants at any time.
POSSIBLE VOLATILITY OF STOCK PRICE
The market price of the shares of the Company's Common Stock is likely to
be highly volatile and could be subject to wide fluctuations in response to
factors such as actual or anticipated variations in the Company's results of
operations, announcements of technological innovations, new products introduced
by the Company or its competitors, developments with respect to patents,
copyrights or proprietary rights, changes in financial estimates by securities
analysts, conditions and trends in the Internet and modem systems industries,
general market conditions and other factors. Further, the stock markets, and in
particular the Nasdaq National Market, have experienced extreme price and volume
fluctuations that have particularly affected the market prices of equity
securities of many technology companies and that often have been unrelated or
disproportionate to the operating performance of such companies. The trading
prices of many technology companies' stocks are at or near historical highs and
reflect price earnings ratios substantially above historical levels. There can
be no assurance that these trading prices and price earnings ratios will be
sustained. These broad market factors may adversely affect the market price of
the Company's Common Stock. These market fluctuations, as well as general
economic, political and market conditions such as recessions, interest rates or
international currency fluctuations, may adversely affect the market price of
the
35
<PAGE>
Common Stock. In the past, following periods of volatility in the market price
of a company's securities, securities class action litigation has often been
instituted against such company. Such litigation, if instituted, could result
in substantial costs and a diversion of management's attention and resources,
which would have a material adverse effect on the Company's business, operating
results or financial condition.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable.
36
<PAGE>
PART II. OTHER INFORMATION
II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company initiated a civil action for patent infringement against Com21,
Inc. and Celestica, Inc. on January 23, 1998 in the U.S. District Court for the
Eastern District of Virginia. In response to the Company's action, Com21, Inc.
initiated a declaratory judgment action on January 29, 1998 against the Company
in the U.S. District Court for the Northern District of California to obtain a
declaration of invalidity, unenforceability and non-infringement of the
Company's patents and the collection of attorneys fees. Separately, Celestica
is seeking to be dismissed from the action. The action in the Eastern District
of Virginia was subsequently transferred to the Northern District of California
on February 23, 1998. The litigation is expected to be time consuming and
costly, and, although no monetary claim is asserted against the Company, other
than attorney's fees, the action, if resolved adversely to the Company, could
have a material adverse effect on the Company's business, operating results or
financial condition.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
The Form S-1 Registration Statement (SEC File No. 33-36001) related to
the Company's initial public offering of Common Stock, $0.001 par value per
share, was declared effective by the SEC on November 11, 1997. A total of
3,105,000 shares of the Company's Common Stock was registered with the SEC
with an aggregate registered offering price of $43,470,000, which consisted
of 2,836,053 shaes registered on behalf of the Comapny (with an aggregate
registered offering price of $39,704,742) and 268,947 shares registered on
behalf of certain stockholders of the Company (with an aggregate registered
offering price of $3,765,258). The offering commenced on November 12, 1997
and all 2,836,053 and 268,947 shares of Common Stock being offered by the
Company and certain stockholders of the Company, respectively, were sold for
the aggregate registered offering price through a syndicate of underwriters
managed by NationsBanc Montgomery Securities and UBS Securities. The
offering terminated on November 12, 1997, immediately after all of the Common
Stock was sold.
The Company and the selling stockholders paid to the underwriters an
underwriting discount totaling $2,779,332 and $263,568, respectively, in
connection with the offering. In addition the Company reasonably estimates
that it incurred additional expenses of approximately $1,280,000 in
connection with the offering. Thus the net offering proceeds to the Company
and the selling stockholders were approximately $35,645,410 and $3,501,690,
respectively. The underwriting discount and the other offering expenses were
not made directly or indirectly to any directors, officers of the Company (or
their associates), or persons owning 10% or more of any class of
equity Securities of the Company or to any other affiliates of the Company.
37
<PAGE>
Through March 31, 1998 the net offering proceeds to the Company have been
utilized as follows:
<TABLE>
<CAPTION>
Direct or indirect payments to
directors, officers, general partners
of the Company or their associates;
to persons owning ten percent or
more of any class of equity
securities of the Company; and
Use to affiliates of the Company Direct or indirect payments to others
- ---------------------------------- -------------------------------------- -------------------------------------
<S> <C> <C>
Construction of plant, -- --
building and facilities
Purchase and installation of -- $230,000
machinery and equipment
Purchase of real estate -- --
Acquisition of other business(es) -- --
Repayment of indebtedness $1,371,319 5,627,497
Working capital -- 8,415,594
Temporary investment (specify) -- 20,001,000
Alex Brown Investment Account
and General Bank Account
Other purposes (specify) -- --
</TABLE>
ITEM 5. OTHER INFORMATION
This report on Form 10-Q was required under the rules of the Securities
and Exchange Commission to be filed on or before May 20, 1998. The filing of
the report has been delayed because the Comapny has been engaged in a review
of the impact upon the Company and its financial results of the increasing
weakness in the broadband wireless access market and the request of the
Company's major distributor servicing the wireless market to return the
substantial amount of unsold inventory it had purchased previously. The
Company has completed that review for the three months ended March 31, 1998,
and the results thereof are reflected in this report. The Company is
continuing to review with its independent accountants the impact of
developments in 1998 upon the Company's results of operations for the year
ended December 31, 1997 and its financial condition at that date and is
engaged in discussions with the Securities and Exchange Commission regarding
these matters. There can be no assurance that such review and discussions
will not result in changes in the Company financial statements for 1997,
which changes may, in turn, affect certain of the financial information
reflected in this report.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
The following exhibits are filed as part of this report:
<TABLE>
<CAPTION>
Exhibit No. Description of Exhibit
----------- ----------------------
<S> <C>
3.01 Registrant's Amended and Restated Bylaws. (1)
10.24 Sublease by and between Viking Freight, Inc. and the
Registrant dated February 9, 1998. (1)
10.25 Volume Purchase Agreement between the Registrant and 3D
Communications dated as of May 1997. (1)
27.01 Financial Data Schedule. (1)
</TABLE>
- ---------------
(1) Incorporated by reference to the same exhibit number of the Registrant's
Form S-4 (File No. 333-52083) originally filed with the Securities and
Exchange Commission on May 7, 1998.
(b) Reports on Form 8-K
Report dated March 19, 1998, reporting under Item 5 the announcement of the
proposed acquisition by the Registrant of Pacific Monolithics, Inc.
38
<PAGE>
HYBRID NETWORKS, INC.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: June 1, 1998 HYBRID NETWORKS, INC.
/s/ Carl S. Ledbetter
----------------------------------
Carl S. Ledbetter, President,
Chief Executive Officer and
Acting Chief Financial Officer
(Principal Financial Officer)
39
<PAGE>
HYBRID NETWORKS, INC.
Index to Exhibits
<TABLE>
<CAPTION>
EXHIBIT
NUMBER EXHIBIT TITLE
- ------ -------------
<S> <C>
3.01 Registrant's Amended and Restated Bylaws. (1)
10.24 Sublease by and between Viking Freight, Inc. and the Registrant dated
February 9, 1998. (1)
10.25 Volume Purchase Agreement between the Registrant and 3D Communications
dated as of May 1997. (1)
27.01 Financial Data Schedule. (1)
</TABLE>
- ---------------
(1) Incorporated by reference to the same exhibit number of the Registrant's
Form S-4 (File No. 333-52083) originally filed with the Securities and
Exchange Commission on May 7, 1998.
40
