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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K/A
AMENDMENT NO. 1
(MARK ONE)
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1995
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO
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COMMISSION FILE NUMBER 0-22202
PAIRGAIN TECHNOLOGIES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 33-0282809
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
14402 FRANKLIN AVENUE, TUSTIN, CALIFORNIA 92680
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (714) 832-9922
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SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES TO BE REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $.001 PAR VALUE
(Title of Class)
Indicate by check mark whether the registrant : (1) has filed all
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No
--- ---
Indicate by check mark if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [ ]
Based on the closing sale price of Nasdaq National Market on February
29, 1996, the aggregated market value of the voting stock held by non affiliates
of the registrant was $894,291,000. The number of shares outstanding of the
registrant's common stock, $.001 par value was 15,467,523 on February 29, 1996.
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PART I
ITEM 1. BUSINESS.
PairGain Technologies, Inc. ("PairGain" or the "Company") is a leading
provider of telecommunications products based on High bit rate Digital
Subscriber Line ("HDSL") technology. The Company designs, manufactures, markets
and supports products that allow telecommunications carriers and private network
owners to more efficiently provide high speed digital service to end users over
the large existing infrastructure of unconditioned copper wires. This service,
typically delivered over T1 lines in North America and E1 lines in international
markets, enables high speed data transmission for applications such as wide area
networking and video conferencing.
RISK FACTORS
Except for the historical information contained herein, the matters
discussed in this Annual Report are forward-looking statements which involve
risk and uncertainties, including but not limited to economic, competitive,
governmental and technological factors affecting the Company's operations,
markets, products, services and prices and other factors discussed in the
Company's filings with the Securities and Exchange Commission.
Average Sales Price Reductions
Commencing in mid-1993, the Company began reducing the average sales
prices of its HiGain products in an effort to increase market demand for its
products and in anticipation of expected price competition. These reductions
have been significant, representing a reduction of as much as 35% in average
sales prices over the past 18 months. The Company expects to continue to reduce
the average sales prices of its products, including its HiGain products, in
future periods. Accordingly, the Company's ability to maintain or increase
revenues will depend in part upon its ability to increase unit sales volumes of
HiGain products and to introduce and sell new products at rates sufficient to
compensate for the reduced revenue effect of such continuing reductions in the
average sales prices of the Company's HiGain products. Declining average sales
prices may also adversely affect gross margins on the Company's HiGain products
if the Company is unable to fully offset such reductions in average sales prices
by reductions in the Company's per unit costs. There can be no assurance that
the Company will be able to increase the unit sales volumes of its HiGain
products, introduce and sell new products, reduce its per unit costs or maintain
or increase revenues or margins attributable to such products. See "Management's
Discussion and Analysis of Financial Condition and Results of Operations,"
"Business--Products" and "--Competition."
Product Concentration
Revenues from HiGain products represented approximately 76%, 76% and
75% of the Company's total revenues in 1995, 1994 and 1993, respectively. The
Company expects that revenues from HiGain products will continue to account for
a majority of the Company's revenues for the foreseeable future, although there
can be no assurance that the Company will be able to sustain recent levels of
HiGain product sales. A decline in demand for HiGain products, whether as a
result of competition, deployment of fiber cable, technological change or
otherwise, could have a material adverse effect on the Company's operating
results. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations," "Business--Products."
Future Operating Results Subject to Fluctuation
The Company's operating results may fluctuate in the future as a result
of a number of other factors, including the timing of orders from, and shipments
to, major customers, the timing of new product announcements by the Company or
its competitors, variations in the Company's sales channels or the mix of
products its sells, changes in pricing policies by the Company's suppliers, the
availability and cost of key components, the timing of
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personnel hirings, the market acceptance of new and enhanced versions of the
Company's products and the timing of final product approvals from any of the
RBOCs. Further, the Company's expense levels are based in part on expectations
of future revenues, and the Company has been significantly increasing and
intends to continue to significantly increase operating expenditures and to
increase inventory as its expands its levels of operations. The Company
anticipates that the rate of new orders may vary significantly from month to
month. Consequently, if anticipated sales and shipments in any quarter do not
occur when expected, operating expenses and inventory levels could be
disproportionately high, and the Company's operating results for that quarter,
and potentially future quarters, would be adversely affected.
Competition
Competition in the Company's markets is intense, and the Company
expects that competition will increase. Many of the Company's potential
competitors have substantially greater name recognition and technical, financial
and marketing resources than the Company. There can be no assurance that the
Company will have the financial resources, technical expertise or marketing,
distribution and support capabilities to compete successfully in the future.
Competitive pressures could reduce demand for the Company's products, cause the
Company to further reduce prices on its existing products, increase expenses or
cause delays or cancellations of customer orders, any one of which could
adversely affect the Company's business and results of operations.
Several companies have developed competing HDSL technology and
products, including HDSL chips currently offered by Brooktree Corporation
("Brooktree"), the former supplier of the Company's SPAROW I chip, Level One
Communications ("Level One") and Metalink. Commencing in 1996, the Company
expects to face even more competition from a consortium of telecommunications
supply companies with HDSL products based on the chip designed by Level One. In
addition, Brooktree has the unrestricted right to sell the Company's SPAROW I
chip in component form. The Company expects that additional companies will
introduce competitive products in the future, and there can be no assurance that
the Company will continue to compete successfully in the future. See
"Business--Sales and Marketing and Customer Support" and "--Competition."
All manufacturers of products based on HDSL technology face competition
from fiber optic and conventional repeatered systems as alternate solutions for
the delivery of T1 or E1 services to end users. Many telephone companies have
adopted policies that favor the deployment of fiber. As telephone companies
continue to install fiber cable and conventional repeatered T1 systems to
provide T1 or E1 service in local subscriber loops, the demand for HDSL products
may decline. Further, the deployment of fiber to replace existing HDSL
installations will result in the availability of those existing HDSL systems for
installation elsewhere and may adversely affect future demand for HDSL products.
See "Business--Industry Background" and "--Competition."
Dependence on Suppliers and Subcontractors
Certain components used in the Company's HDSL products are currently
purchased from a single source (including the Company's SPAROW II chip) and
others are available from a limited number of sources. In the past, the Company
has experienced delays in the receipt of certain of its key components, which
have resulted in delays in product deliveries. There can be no assurance that
delays in key component and product deliveries will not occur in the future. The
inability to obtain sufficient key components as required, or to develop
alternative sources if and as required in the future, could result in delays or
reductions in product shipments to the Company's customers. Any such delays or
reductions could have a material adverse effect on the Company's reputation and
customer relationships which could, in turn, have a material adverse effect on
the Company's business and results of operations. In addition, the Company uses
third-party subcontractors for the manufacture of its products. This reliance on
third-party subcontractors involves several risks, including the potential
absence of adequate capacity, the unavailability of or interruptions in access
to certain process technologies and reduced control over product quality,
delivery schedules, manufacturing yields and costs.
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Shortage of raw materials or production capacity constraints at the
Company's subcontractors could negatively affect the Company's ability to meet
its production obligations and result in increased prices for affected parts.
Any such reduction may result in delays in shipments of the Company's products
or increases in the price of components, either of which could have a material
adverse impact on the Company. See "Business--Manufacturing."
Inventory Turns
The Company maintains high levels of inventory and does not turn
inventory rapidly (inventory turns were two-and-a-half times in 1995 and two
times in 1994). High levels of inventory also create risks of inventory
obsolescence. If forecasted sales for certain products are not realized,
increased reserves for product excess and obsolescence may be necessary, or
write-offs in excess of existing reserves may be required, either of which could
have a material adverse effect on the Company's business and results of
operations. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations."
Customer Concentrations
Aggregate sales to local telephone companies affiliated with Bell
Atlantic, BellSouth, NYNEX, Pacific Telesis, and SBC Communications (formerly
Southwestern Bell) accounted for approximately 63%, 66% and 65% of the Company's
total revenues for 1995, 1994 and 1993, respectively. As a result of the
Company's dependence on its largest customers, the Company's future success will
significantly depend upon the timeliness and size of future purchase orders, if
any, from its largest customers, the product requirements of such customers, the
financial and operational success of such customers, and in particular, the
success of such customers' services deployed using the Company's products. The
Company's sales to its largest customers have in the past fluctuated and may in
the future fluctuate significantly from quarter to quarter and year to year. The
loss of any such customer or the occurrence of any such sales fluctuations could
have a material adverse effect on the Company's business and results of
operations. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations," and " Business--Customer."
Dependence on New Markets and Technologies
The use of HDSL in private network applications has not yet gained
widespread acceptance and may not develop as a result of the limited awareness
of this new application of HDSL. The Company's future operating results will be
dependent in part upon the development and growth of the private network market
for its Campus products, and there can be no assurance that his market for HDSL
technology will develop. In addition, servicing the private network market
requires the Company to develop a different sales channel than the one its
employs to sell its HiGain products to public carriers, and there can be no
assurance that the Company will be able to develop an effective sales channel
for the private network market or any market that may develop for the Campus
products. The Company is also evaluating new applications of high speed copper
transmission technologies, is investing significant corporate resources in the
development of Asymmetric Digital Subscriber Line ("ADSL") technology, and
expects to devote significant additional resources to the development of other
new technologies in the future. In addition, the Company does not expect to
generate significant revenues from ADSL products in 1996 or 1997, and there can
be no assurance that the Company will ever generate significant revenues from
ADSL products. There can be no assurance that such technologies will be viable
or that markets for such technologies will develop. Any failure in the
development of new markets and technologies could have a material adverse effect
on the Company's business. "Business--Company Strategy" and "--Product
Development."
Rapid Technological Change and Dependence on New Products
The market for the Company's products is characterized by rapid
technological advances, evolving industry standards, changes in end user
requirements and frequent new product introductions and enhancements. The
introduction of HDSL products involving superior technologies or the emergence
of alternative technologies or
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new industry standards could render the Company's existing products, as well as
products currently under development, obsolete and unmarketable. The Company
believes its future success will depend in part upon its ability to continue, on
a cost-effective and timely basis, to enhance its HDSL products, develop and
introduce new products for the HDSL market and other markets, meet changing
customer needs and achieve broad market acceptance for its products. There can
be no assurance that the Company will be able to respond effectively to
technological changes or new product announcements, that the Company will be
able to successfully develop and market new products or product enhancements or
that such products or enhancement will achieve market acceptance. Any failure by
the Company to anticipate or respond on a cost effective and timely basis to
technological developments, changes in industry standards or end user
requirements, or any significant delays in product development or introduction,
could have a material adverse effect on the Company's business. Further, there
are physical limits to the speed at which transmissions can travel over copper
wire, and the Company's copper-based HDSL products will not be a viable solution
for customers requiring service at performance levels beyond the limits of
copper wire. See "Business--Company Strategy" and "--Product Development."
Need to Generate International Sales
To date, sales of the Company's products outside of the United States
and Canada have been limited. The Company's ability to meet its objectives will
require it to generate significant international sales in 1996 and beyond.
International business is subject to risks in addition to those inherent in the
Company's United States business including substantially different regulatory
requirements in different jurisdictions, varying technical standards, tariffs
and trade barriers, political and economic instability, reduced protection for
intellectual property rights in certain countries, difficulties in staffing and
maintaining foreign operations, difficulties in managing distributors,
potentially adverse tax consequences, foreign currency exchange fluctuations,
the burden of complying with a wide variety of complex foreign laws and treaties
and the possibility of difficulties in collecting accounts receivable and
increased days sales outstanding. There can be no assurance that the Company
will be able to generate significant international sales, or establish new
strategic marketing relationships in the future. In addition, in the event the
Company is successful in doing business outside of the United States, the
Company may also face economic, political and foreign currency situations that
are substantially more volatile than those commonly experienced in the United
States and other international markets. There can be no assurance that any of
these factors will not have a material adverse effect on the Company's business
and results of operations.
Proprietary Technology
The Company's success and future revenue growth will depend, in part,
on its ability to protect trade secrets, obtain or license patents and operate
without infringing on the rights of others. Although the Company regards its
technology as proprietary, it has limited patents on such technology. The
Company relies on a combination of technical leadership, trade secrets,
copyright and trademark law and nondisclosure agreements to protect its
unpatented proprietary know-how. However, there can be no assurance that such
measures will provide meaningful protection for the Company's trade secrets or
other proprietary information. Moreover, in the absence of patent protection,
the Company's business may be adversely affected by competitors who
independently develop substantially equivalent technology. In addition, the laws
of some foreign countries do not protect the Company's proprietary rights to the
same extent as do the laws of the United States. The Company is also subject to
the risk of adverse claims and litigation alleging infringement of the
intellectual property rights of others. From time to time the Company has
received claims of infringement of other parties' proprietary rights, although
the Company is not party to any pending intellectual property litigation. There
can be no assurance that third parties will not assert infringement claims
against the Company in the future or that any such claims will not result in
costly litigation or require the Company to obtain a license to intellectual
property rights of such parties, regardless of the merit of such claims. No
assurance can be given that any necessary licenses will be available or that, if
available, such licenses can be obtained on commercially reasonable terms. See
"Business--Proprietary Rights."
Dependence on Key Personnel
The success of the Company is dependent in large part on two of its
founders, Howard S. Flagg and Benedict A. Itri, on its chairman and Chief
Executive Officer, Charles S. Strauch, and on other key management
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and technical personnel, the loss of one or more of whom could adversely affect
the Company's business. The Company does not have employment contracts with any
of its executive officers. In addition, the Company believes that its future
success will depend in large part upon its continued ability to attract, retain
and motivate highly skilled employees, who are in great demand. There can be no
assurance that the Company will be able to do so.
Management of Expanding Operations
The Company has recently experienced a period of significantly
expanding operations and headcount, which has placed, and will continue to
place, a significant strain on the Company's limited personnel and other
resources. The Company's ability to manage any future increases in the scope of
its operations or headcount, should they occur, will depend on significant
expansion of its manufacturing, research and development, marketing and sales,
management and financial and administrative capabilities. The failure of the
Company's Management to effectively manage any expansion in its business could
have a material adverse effect on the Company's business and results of
operations.
Reliance on Sole Manufacturing Facility
The Company conducts virtually all final assembly and final test
functions at its manufacturing facility in Tustin, California. Any extended
interruption of operations at this facility could have a material adverse effect
on the Company's business and results of operations.
Capital Requirements
Subsequent to 1996, the Company's capital requirements will depend on
many factors, including the levels at which the Company maintains inventory, the
continued market acceptance of the Company's products, the extent to which
growth in unit sales volume affects future reductions in the average sales price
of HiGain products, the extent to which the Company invests in new technology
and improvements to its existing HDSL technology, the marketing expenditures
associated with launching new products and maintaining a competitive position in
the marketplace and the response of competitors to products based on the
Company's technology. To the extent that the Company's existing resources,
together with future earnings, are insufficient to fund the Company's future
activities, the Company may need to raise additional funds through public or
private financings. No assurance can be given that additional financing will be
available or that, if available, it can be obtained on terms favorable to the
Company and its stockholders.
INDUSTRY BACKGROUND
In recent years, demands on the telephone infrastructure have prompted
telephone companies to improve the reliability and increase the speed of
transmission over telephone networks. Telephone networks have evolved from
systems based entirely on low speed analog communication over copper wires to
fiber optic backbones running throughout the interexchange carrier and local
exchange carrier networks. These fiber optic backbones permit digital
communication of much greater volumes of data with greatly enhanced reliability
and increased speed throughout the interexchange network and among the local
carriers. However, the "last mile," the local subscriber loop through which
telephone services are delivered from local carriers to end users, continues to
be predominantly characterized by low speed analog transmission over copper
wires.
The following diagram depicts the public telephone network
infrastructure:
[GRAPHIC OF THE PUBLIC TELEPHONE NETWORK INFRASTRUCTURE]
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The quality of telephone service to end users is determined by the
least reliable and slowest link in the network, and the traditional analog
infrastructure was not designed to provide high speed, high data capacity
service to end users. However, end users are increasingly demanding high speed
data transmission for applications such as video conferencing and wide area
networking, which includes communications among computers, local area networks
and telephone systems. Telephone service carriers are therefore facing
increasing pressure to install digital telecommunications services in the "last
mile." Digital transmission has distinct advantages over analog transmission,
including lower cost, increased speed, higher reliability and better quality.
Installing digital service facilities also provides telephone companies
worldwide with the foundation to offer their customers high speed video and
multimedia services. In addition, international carriers, especially those in
developing countries where the copper wire infrastructure is less extensive, are
facing a growing demand for digital service and are deploying it to provide
multiple voice circuits (telephone lines) rather than the high speed services
requested in the United States.
Competitive pressure from alternate carriers has further accelerated
the telephone companies' deployment of digital service in the "last mile."
Unlike public telephone companies, these alternate carriers are not required to
provide universal service and instead may choose to serve only those customers
with high demand for digital services, an important market targeted by the
telephone companies due to the higher rates and increased usage associated with
these services. By installing primarily fiber cable, these alternate carriers
have provided short delivery intervals and high quality service, which has
enabled them to compete effectively with the local telephone companies for these
high demand customers. As a result of this competitive pressure, the telephone
companies face an increased need to provide digital service approaching the
quality of fiber quickly and efficiently.
The basic building blocks of today's high speed digital
telecommunications networks in North America are T1 lines, which transmit data
at 1.544 Mbps, the equivalent of 24 voice circuits for simple telephone service.
E1 lines, the international functional equivalent of T1 lines, operate at 2.048
Mbps. Telephone companies are seeking cost effective methods of providing T1
service to meet customer demands for high speed digital transmission. By
providing T1 service, telephone companies can provide the means for increased
customer usage which, in turn, expands the revenue base for these telephone
companies. One way that telephone companies have installed T1 service has been
to deploy fiber cable. However, deploying fiber cable in the "last mile" is
capital and labor intensive, so it is only cost efficient if a number of T1
lines are requested in the particular subscriber loop. A fiber system may be
capable of transporting from four to over one hundred T1 lines. The equipment
required at a customer's premises alone can cost a few thousand dollars for a T1
fiber system with four lines to tens of thousands of dollars for higher capacity
systems. In either case, significant additional costs are involved in installing
fiber cable in existing conduit or burying new cable. Installing fiber cable in
the "last mile" is also time consuming, often taking a carrier weeks or months
to complete, depending on the location to which the fiber is deployed, the
timeliness of the carrier's success in obtaining the necessary rights of way and
the extent to which the existing conduit is obstructed or damaged.
As an alternative to fiber deployment, telephone companies use
repeatered T1 lines, which require them to "condition" the existing copper wires
to meet T1 or E1 standards. Conditioning copper wires is accomplished through a
time consuming, capital and labor intensive installation process, which involves
the removal of bridge taps and the installation of repeaters. Repeaters are
devices required about every 3,000 to 5,000 feet to regenerate the signal as it
passes along the line. To condition existing copper wires, telephone company
engineers must (i) identify which copper wires are to be used (only three to
four pairs of wires in a single cable can be used due to "crosstalk," or
interference, from other pairs of wires in the same cable), (ii) define where
repeaters must be installed, (iii) allocate space in repeater housings and
manholes for the necessary equipment and (iv) locate bridge taps (wire leads
from previously disconnected lines) for removal. Technicians, following the
design of the engineers, must then go to each location to remove the bridge
taps, install the repeaters and add new repeater housings when needed. Next,
each repeater span must be measured by the engineers to ensure that the intent
of the design is achieved. The cost of installing a repeatered T1 line varies
widely depending on the amount of conditioning that the copper wires require,
including the number of repeaters that need to be installed. Generally,
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the cost of installing a repeatered T1 line on up to 12,000 feet of
unconditioned copper wire can range from approximately $2,500 to $8,000. While
often deployed as an alternative to fiber, the transmission error rates on
repeatered T1 lines are significantly higher than fiber, which is particularly
detrimental for certain data and video transmissions.
In the late 1980s, Bellcore, the research and development entity
jointly created and funded by the seven regional Bell operating companies
("RBOCs") for the development of new technologies, developed the parameters for
HDSL technology as a high quality, but lower cost and more efficient method for
installing T1 lines in the "last mile" on copper. HDSL utilizes high speed
digital signal processing technology to create a mathematical model of copper
wire that allows the receiver to precisely compensate for the predictable
distortion that the wire imparts on the digital signal sent from the distant
end.
The following diagram depicts a comparison of a conventional repeatered
T1 line with an HDSL circuit:
[GRAPHIC OF A REPEATERED T1 LINE WITH AN HDSL CIRCUIT]
The Company believes that HDSL technology offers a significant
opportunity to meet end user demand for high speed digital telecommunications
services in the local subscriber loop. HDSL technology has a number of
advantages over both fiber cable and conventional repeatered T1 systems,
including lower installation costs and faster deployment time. There are,
however, certain situations in which HDSL technology is disadvantaged relative
to these alternative solutions. For example, if a number of T1 lines are
requested at a single location, fiber cable provides the highest quality digital
transmission and can be more cost effective to deploy. However, because HDSL
technology utilizes the existing copper wire infrastructure, it can be deployed
in one or two days instead of weeks or months. HDSL systems operate over copper
wire without the removal of bridge taps and can tolerate crosstalk, resulting in
reduced engineering design time and lower costs. HDSL systems also eliminate the
need for repeaters, thereby reducing a carrier's initial capital expenditures
and its subsequent maintenance costs for trouble shooting. HDSL provides higher
quality digital transmission than repeatered copper and approaches the low error
rate of fiber cable.
PAIRGAIN STRATEGY
The Company pioneered the development of a very large scale integration
("VLSI") implementation of HDSL technology and is currently a leading provider
of telecommunications products based on HDSL technology. The Company's strategy
for expanding the market for its products consists of three primary elements:
- Maintain Technology Leadership. The Company believes that it is a
leader in HDSL technology and systems. The Company's engineering
organization includes a core development team focused on applying high
speed digital processing ("DSP") techniques to telecommunications
products. The Company leverages this core DSP expertise with an
in-house VLSI design group that designs advanced VLSI components. The
Company's in-house VLSI design group was the first to deliver an HDSL
transceiver on a single chip (the SPAROW I chip). The Company believes
that the close coordination between its VLSI design and product
development teams enables it to reduce its time to market for new
products. The engineering organization places the highest priority on
maintaining the cost and feature competitiveness of the Company's HDSL
product line through aggressive cost reduction and introduction of new
additions to the HiGain(TM)product family. As an example, the Company's
recently developed SPAROW II chip provides lower power consumption and
lowers the individual device cost. The Company is also putting
significant effort into Asymmetric Digital Subscriber Line ("ADSL"), a
technology for higher speed transmission over copper wire. The Company
believes that maintaining its leadership in technology for high speed
digital transmission over copper wire is critical to its ability to
build and maintain strong relationships with the RBOCs and other
customers and to achieve leadership in new markets.
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- Leverage Core Technologies Into New Applications. The Company has
developed its Campus product line based upon the same core HDSL
technology utilized in the Company's HiGain products, which it markets
to private network users such as universities, hospitals, military
bases, corporate complexes and other campus environments. In addition,
potential demand for the delivery of advanced communication services to
residential and business customers, including advanced video services
such as pay-per-view movies, interactive video games, educational video
and many other on-demand services, may present a significant new market
opportunity for products incorporating the Company's DSP and copper
transmission expertise. See "-- Products" and "-- Product Development."
- Develop OEM Opportunities. The Company intends to pursue opportunities
to provide products and chipsets to manufacturers of telecommunications
and data communications equipment. The Company believes that it can
provide added value to third-party products through higher levels of
integration with other elements of wide area networking
infrastructures, such as bridges, routers and multiplexers. The Company
also believes an opportunity exists to utilize its HDSL technology to
connect local wireless communication systems to local subscriber loops.
In addition, the Company believes there may be a market in the public
network for the Campus product line's range of capabilities in
providing a standard platform for delivering a range of medium to high
speed data services over existing copper wire.
PRODUCTS
Core Technology
The core technology for the Company's HiGain and Campus product lines
is based on HDSL and was developed from the Company's dual core competencies in
digital signal processing and microelectronics. HDSL allows the transmission and
receipt of digital data at high speed (784 Kbps) on a single twisted pair of
copper wires to attain an aggregate bi-directional bit rate of 1.544 Mbps, the
standard T1 rate, over two twisted pairs of copper wires. HDSL permits the
delivery of an outbound signal on the same pair of wires on which the return
signal is received. The transmitted signal is canceled by the receiver by
precisely predicting the amount of signal "echo" and subtracting it from the
overall input signal. HDSL-based products tolerate crosstalk and operate not
only on continuous unobstructed pairs of wires, but also on cables with mixed
wire gauges and bridge taps.
The Company's unique implementation of HDSL technology stems from its
development of a special purpose digital signal processing integrated circuit.
This VLSI device, the SPAROW (Signal Processing Adaptive Receiver On Wire) chip,
operates at a speed of 250 million instructions per second, enabling it to
perform the extremely heavy numerical calculations required for the transmission
of signals at HDSL rates. The SPAROW chip has enabled the Company to
significantly reduce the physical size of its HDSL-based products. Two SPAROW
chips are used in each of the Company's HDSL-based products, one for each
twisted pair of copper wires entering the unit. The SPAROW I chip was replaced
by the Company's SPAROW II chip which provides all of the features of the
original SPAROW I chip, costs less to produce and consumes less power.
The Company's microelectronics team has design and development
capabilities that include silicon compilers which allow the Company to develop
chips that are at performance and complexity levels beyond what is achievable on
standard ASIC design systems. The Company has also leveraged its
microelectronics product capabilities into the HiGain and Campus product lines.
The Company is currently focusing its resources on further cost and performance
improvements in HDSL and also is putting significant effort into the new ADSL
technology, for which a highly integrated digital signal processor with over 1.2
million transistors (SPAROW II has 240,000 transistors) is being developed to
perform the Bellcore sanctioned discrete multi-tone transmission algorithms.
By utilizing its HDSL technology in different forms, the Company offers
products for different markets and varied applications.
HiGain Systems
The Company's HiGain systems are used by telephone companies to (i)
provide a T1 link between the central office and a carrier's remote hub and (ii)
provide T1 service in the local subscriber loop between the central
8
<PAGE> 10
office or remote hub and the customer. A HiGain system consists of two units: a
circuit plug-in unit that mounts in a shelf located in the central office or in
a shelf in a remote hub and a unit that mounts at or near the customer's
location. The circuit plug-in unit mounts in standard telephone company shelves
alongside conventional transmission equipment, making it easily deployable in
almost every central office and remote hub.
HiGain systems are capable of providing T1 service over two twisted
pairs of copper wire of up to 12,000 feet in length for 24-gauge copper wire and
up to 9,000 feet for 26-gauge wire without the repeaters or complicated
engineering design required with repeatered T1 systems. According to Bellcore
and the RBOCs, approximately 85% of the business subscriber loops nationwide are
within these distances from the local central office. Each HiGain system
provides a single end user with the service of one T1 line, which is the
equivalent of 24 voice circuits for simple telephone service. An end user
requiring the capacity of multiple T1 lines will require an equivalent number of
HiGain systems. The HiGain system can also be configured to provide E1 service.
The Company also provides HiGain systems in different forms to address
variances in customer installation and configuration requirements. The Company's
Doubler product regenerates the HDSL signal at the end of a wire to a HiGain
remote unit located a similar distance further on, allowing telephone companies
to increase the distance range of HDSL from 12,000 feet to 24,000 feet and
satisfy T1 demands by its more isolated customers. In addition, the Company has
also introduced a product which provides a T1 connection over shorter distances
requiring only one pair instead of two pairs of wire.
To ensure flexibility of installation, the Company's HiGain units are
available with a variety of shelf and mounting hardware, weather resistant
housings and connecting hardware. In addition, all HiGain remote units provide
self-diagnostic testing to detect failures and interface with the central office
alarm system. HiGain systems, consisting of two units, have a list price of
$1,445 per unit, although the Company generally sells such systems at a discount
which may exceed 50% to its high volume customers. The Company first shipped
units of its HiGain system to customers in June 1992. As of December 31, 1995,
the Company had shipped approximately 153,000 HiGain units.
Campus Systems
The Company's Campus systems are HDSL transmission products designed by
the Company to meet the digital communications needs of private networks. Campus
systems are reconfigured versions of the HiGain product and provide high speed
digital connectivity over two twisted pairs of copper wires between user
premises in campus environments. Examples of these environments include
universities, hospitals, utility plants, military bases, industrial parks and
corporate complexes. The Campus systems enable the interconnection of LANs,
video conferencing, computer channel extensions and many other applications.
A Campus system consists of two base units that operate at T1, E1 or
384 Kbps speeds and are compatible with a number of standard data communications
interfaces. These interfaces allow Campus systems to connect directly to LAN
bridges, routers, T1 multiplexers, PBXs, video conferencing systems and other
high speed networking devices. A Campus system, consisting of two base units and
interfaces, has a list price of approximately $2,500 per base unit, although
certain customers receive significant discounts off of list price. The Company
first shipped Campus systems to customers in June 1993. To date, there are over
400 customers that have purchased and installed from a pair to hundreds of
Campus units.
The Company enhanced the Campus family of products in late 1994 with
the Campus-Star access platform. The Campus-Star is a rack mountable module that
incorporates power supplies and SNMP network management capabilities along with
slots for up to 14 Campus unit equivalents. The use of the Campus-Star platform
is driven by the needs of data communications managers to incorporate network
management capabilities into their network components. PairGain is currently
planning the further enhancement of the Campus-Star to provide Ethernet bridging
interfaces and other high bandwidth interfaces. The Campus-Star is being
positioned to provide flexibility in supporting a broad range of access
interfaces and is designed to be a core element of the networking strategy of
Campus data communications managers. The Company continued to enhance the Campus
family of products during 1995 with the introduction of the Campus-REX(TM)
(Remote Ethernet eXpress), a full
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<PAGE> 11
bandwidth Ethernet remote bridge, providing transparent connectivity between
LANs without repeaters at a distance of up to five miles. It provides a 10BaseT
port, one serial port, an embedded SNMP agent and IEEE 802. 1d transparent MAC
level bridging with Spanning Tree protocol support.
PG-2 Products
PG-2 was the Company's first commercial product and was delivered to
customers beginning in 1989. The PG-2 system allows telephone companies to
establish two analog transmission lines over a single twisted pair of copper
wires, where traditional technology only allowed the establishment of one line
over a single twisted pair of copper wires. PG-2 systems are used by telephone
companies to provide emergency service and additional line service to residences
and small businesses. The Company's PG-2 system can also be used to convert a
degraded analog copper pair to high speed digital transmission. In the
international marketplace, where the copper infrastructure is less extensive,
these digital subscriber systems allow the PTTs to expand telephone service
without laying more copper lines.
A PG-2 system consists of a shelf-mounted line unit, located in the
central office, and a remote transceiver mounted near the subscriber premises.
The list price for the Company's PG-2 system is approximately $700 for two
transceivers, one at each end, although many customers receive discounts off of
list price.
The PG-2 system is fully approved by two RBOCs and has been accepted by
many of the independent telephone companies, including six of the large
independents. The Company's PG-2 products compete worldwide with products from a
number of telecommunications equipment manufacturers. The Company considers
itself to be at a competitive disadvantage in the international market for the
two channel digital subscriber carrier business served by its PG-2 system
because it lacks a local manufacturing presence, which results in price
disadvantages caused by import duties.
PG-Flex(TM) Systems
PG-Flex is a small digital loop carrier product. PG-Flex is a hybrid of
the Company's PG-2 and HDSL technologies and provides a system for delivering up
to 32 standard phone lines on two pairs of wire over an operating range of up to
12,000 feet of wire. The Company intends to market the PG-Flex product to both
international and domestic telephone companies and expects significant
competition in both markets. The Company began field trial shipments of PG-Flex
systems in December 1995.
OEM Products
The Company has formed an OEM sales group to establish relationships
with manufacturers to integrate PairGain's HDSL and future ADSL technologies
into their own products. An HDSL module is in production which enables OEMs to
incorporate PairGain's HDSL technology into their products.
PRODUCTS UNDER DEVELOPMENT
ADSL
The Company has a significant engineering development program in
progress to develop a low cost, high performance module to perform ADSL
transmission. ADSL is designed to allow existing telephone lines to deliver high
speed data and video-on-demand services and provides a high speed (up to 6 Mbps)
channel to the customer from the telephone company's central office and a medium
speed (up to 500 Kbps) upstream channel to the central office from the customer.
Although telephone companies have focused on deploying fiber and hybrid fiber
and coaxial cable networks for delivering these advanced services, the Company
believes the high cost and long implementation periods that will be involved in
setting up these networks will provide a window of opportunity for equipment
that can deliver similar capabilities on ordinary telephone wires.
10
<PAGE> 12
Residential Access Products
The Company is also developing two residential access products,
EtherPhone(TM) and Megabit Modem(TM), which will enable telephone companies to
deliver high-speed data to the home for Internet and on-line service access,
telecommuting, and work-at-home applications, over ordinary telephone lines.
These products make use of existing infrastructure and are intended to allow
carriers and other access providers to compete in the residential multimedia
access market. These products are intended to provide a higher level of
performance through existing low-speed analog modems and Integrated Services
Digital Network (ISDN) technology allowing data to be delivered at rates from
768 Kbps to 6 Mbps over ordinary telephone lines. The Company plans to roll out
its residential access products in a phased approach, with its first offerings
available in 1996.
CUSTOMERS
The Company sells its HiGain, PG-2 and PG-Flex products primarily into
the public network market and its Campus products primarily into the private
network market. The Company uses its direct sales force to market its HiGain,
PG-2 and PG-Flex products in the United States and Canada. The Company markets
its domestic Campus products and all international products through direct sales
and distributors.
Public Networks
The public network market consists of the seven RBOCs and their local
telephone company affiliates, as well as independent telephone companies and
international carriers.
RBOCs. Prior to selling products in volume to a local telephone company
affiliated with an RBOC, a vendor must first receive approval of its product
from the RBOC. Although the approval process for a new product varies somewhat
among the seven RBOCs, the process generally consists of the following three
phases:
- Laboratory Evaluation. The product's functions and performance are
tested against all relevant industry standards. This process can take
from two weeks to three months depending on a variety of factors.
- Field Trial. A number of actual telephone lines are equipped with the
product for live operation in a field trial lasting from three weeks to
three months. These field trials are for evaluating performance,
assessing the ease of installation and establishing troubleshooting
procedures. The RBOCs grant conditional approval upon successful
completion of a new product's field trial, enabling field personnel to
order limited quantities of the product under one-time approvals.
- Final Approval and Contract. Prior to final approval, which may take
from one to four months, the RBOC develops and implements a variety of
procedures that cover ordering, stocking, installation, maintenance,
returns and all other activities associated with use of the product.
All seven RBOCs have approved the Company's HiGain system. Sales to
local telephone companies affiliated with Bell Atlantic, Bell South, NYNEX,
Pacific Telesis and SBC Communications (formerly Southwestern Bell) in each case
accounted for more than 8% of the Company's local revenues in 1995 and sales in
the aggregate to local telephone companies affiliated with these five RBOCs
accounted for approximately 63% of the Company's total revenues in 1995.
Ameritech and US WEST, the remaining two RBOCs, have approved
HDSL-based products from Alcatel incorporating the Company's technology. Under
the Company's original agreement with Alcatel, the Company was prohibited from
seeking approval from and selling its HiGain products directly to local
telephone company affiliates of these two RBOCs until October 1994. That
relationship with Alcatel has now been terminated and the Company sells its
HiGain and other HDSL products directly to Ameritech and US WEST.
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<PAGE> 13
Independent Telephone Companies. There are approximately 1,500
telephone companies in the United States that are unaffiliated with any of the
RBOCs. The Company has targeted approximately 50 of the largest independent
telephone companies as potential customers for its HiGain products. Although the
independent telephone company market does not present as large an opportunity as
the RBOC market, the Company's experience has been that the independents are
often more receptive to new technology. As a result, the approval process for
new technology is often less time consuming. Currently, US Sprint, one of the
two largest independent telephone companies, and a number of the smaller
independents have approved and deployed the Company's HiGain system.
International Carriers. In most international markets there is one
telephone company per country; there are no alternate carriers and no
independents. Typically these postal, telegraph and telephone companies ("PTTs")
are highly regulated, government-owned agencies that have an even more rigorous
approval process for new technology than the RBOCs. While the international
carrier network systems are architecturally similar to the domestic public
networks, E1 service is not deployed as extensively in local subscriber loops
internationally as T1 service is in local loops domestically. The demand for E1
service has grown, however, and international carriers are deploying it
primarily to provide multiple voice circuits rather than the high speed service
requested in the United States.
Private Networks
Customers for the Company's Campus products, first introduced in June
1993, include universities, hospitals, military bases and other government
installations, corporate complexes and other campus-like environments with
private network systems. As of the date of this Annual Report, the Company has
shipped over 8,700 units of its Campus product to such customers. Certain of
such customers, none of which individually accounted for more than 1% of the
Company's total revenues in 1995, are identified below:
Alyeska Pipeline Service Co. MCI International
Boeing Computer Services Nextel Communications
Carnegie-Mellon University Sandia National Laboratories
Computer Sciences Corporation Unisys Corporation
GTE Supply University of California, Irvine
Indiana Department of Transportation University of California, Los Angeles
Inland Steel Company University of Illinois
ITT Federal Services Corp. University of Washington
ITT Research Institute Warner Brothers Studios
Westec Communications
SALES, MARKETING AND CUSTOMER SUPPORT
Sales and Marketing
The Company's direct sales force markets its products to the RBOCs and
their local telephone company affiliates and to the larger independent telephone
companies by working closely with the planning, switching and transmission
departments of such customers. The Company sells to other independent carriers
and owners of private networks through direct sales, telesales and distributors.
The Company's North American sales and customer support personnel are
located in the following areas: California, Florida, Georgia, Utah, Texas,
Pennsylvania, Washington, New Hampshire, Illinois, New Jersey, New York, North
Carolina, Oregon, Massachusetts and Washington, D.C. The Company sells its
products outside of North America through its own sales force based in the
United States, the United Kingdom and China, and a network of international data
communications equipment distributors.
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<PAGE> 14
In addition to the specific sales efforts directed at its public and
private network customers, the Company's marketing activities include
participation in industry trade shows and conferences, distribution of sales and
product literature, advertising in trade journals and ongoing communications
with its customers.
Customer Support
All service, repair, and technical support of the Company's products
are performed in-house. The Company offers technical support to its customers on
a 24-hours-a-day, 7-days-a-week basis via an 800 hotline and through paging
systems for all support personnel. The Company's product warranties range
between three and five years. Current products are sold with a five year
warranty.
PRODUCT DEVELOPMENT
The Company believes that its future success depends on its ability to
maintain its technological leadership through enhancements of its existing
products and development of new products that meet a wide range of customer
needs. Accordingly, the Company intends to continue to make substantial
investments in product development.
The Company has organized its product development efforts into three
main groups: microelectronics, software development and hardware development.
Within the microelectronics group, a substantial majority of the Company's
efforts is devoted to the development of ADSL, the enhancement of
microelectronics used in the Company's HiGain and Campus product lines and the
development of microelectronics products based on the Company's existing
products. Within the software development group, the Company's efforts are
devoted to the development and enhancement of network management software and
protocol compliance for its products and the development of firmware for
products such as PG-Flex.
The remainder of the Company's research and development is devoted to
the development, improvement and enhancement of new and existing hardware
products and is directed at the following:
- Cost Reduction. The Company continuously reviews the design and
manufacturing process of its products to determine areas of product
cost savings or enhanced product quality. This review includes, among
other things, an examination of the product design to determine if
further improvements can be made in the VLSI components.
- Product Line Extensions. The Company seeks to extend its existing
product lines through product modifications and enhancements in order
to meet the needs of its different customers and their applications.
Products resulting from the Company's product line extension efforts
include the Campus-Star family of products, the PairGain Management
System for management of HiGain products, long range 384 Kbps Campus
systems, single pair T1 systems, and the HiGain Doubler product.
- New Technology. The Company explores new transmission technologies to
determine whether they represent an opportunity for products
incorporating the Company's DSP and copper transmission expertise.
During 1995, 1994 and 1993, research and development expenses were
approximately $10.7 million, $5.8 million and $3.9 million, respectively. All of
the Company's research and development expenses were charged to operations as
incurred.
MANUFACTURING
The Company's manufacturing operations consist primarily of quality
control, functional testing, final assembly, burn-in and shipping. The Company
uses domestic independent third-party contract assembly and test companies on
primarily a consignment but also on a turnkey basis for circuit board assembly
and in-circuit testing for all of its products. The Company conducts virtually
all final assembly and final test functions at its facility in
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<PAGE> 15
Tustin, California. In addition, the Company performs extensive burn-in, testing
and inspection of all of its products prior to shipping them to customers.
Product quality and reliability are the Company's prime concerns in all phases
of the manufacturing process. Quality control is maintained through incoming
inspection of components and subassemblies, auditing of consignment and turnkey
contractors, in-house final assembly and test functions, plus a final shipping
inspection of all products.
The Company currently procures all of its components from outside
suppliers, either directly or through its consignment and turnkey contractors.
The Company generally purchases and stores the more expensive components at its
location and allows its assembly and test subcontractors to purchase and store
other necessary components. In procuring components, the Company and its
subcontractors rely upon a number of suppliers that are the sole source for
certain of the components. One such sole supplier part is the SPAROW II chip.
Although the Company has utilized its VLSI expertise to design its SPAROW II
chip in a manner that will facilitate transition to multiple sources of supply,
such a transition could result in delays or reductions in product shipments
which, in turn, could have a material adverse effect on the Company's customer
relationships and operating results.
The Company's backlog at December 31, 1995 was approximately $2.7
million. The Company includes in backlog all firm purchase orders for products
regardless of their ship date. Because of the quick turnaround (sometimes one to
two weeks) that the Company's customers expect on their orders, and because of
the possibility of customer changes in delivery schedules or cancellation of
orders, the Company's backlog as of any particular date may not be indicative of
actual revenues expected for any future period.
The Company's products are subject to FCC regulations regarding
emission of electromagnetic energy, which may interfere with other equipment.
All of the Company's currently commercially available products have been tested
and comply with the relevant FCC regulations. The Company's commercially
available products that are sold for use at the end user's premises, such as the
HiGain remote unit and the Campus products, also comply with all required UL
safety specifications.
COMPETITION
Competition in the Company's markets is intense and the Company expects
that competition will increase. Many of the Company's potential competitors have
substantially greater name recognition and technical, financial and marketing
resources than the Company. The Company's most significant competitor is ADTRAN,
Inc., which offers an HDSL system and has often competed with the Company on the
basis of price. The Company may also face competition from the licensees of its
own HDSL technology. Specifically, pursuant to a license and distribution
agreement with the Company, Alcatel was granted exclusive right (even as to the
Company) to sell to a large independent telephone company and telephone
companies affiliated with two of the seven RBOCs, and the nonexclusive right
after October 1, 1994 to enter the rest of the United States HDSL market and
compete directly with the Company. The Company and Alcatel renegotiated the
terms of the companies' relationship in 1995. The existing agreement between
Alcatel and the Company was terminated. Royalty-free cross licenses of current
PairGain HDSL technology to Alcatel and Alcatel's current Network Management
Software to PairGain were granted and the royalty rate for the standalone T1
products incorporating PairGain HDSL technology sold by Alcatel was revised.
Several companies have developed competing HDSL technology and
products, including HDSL chips currently offered by Brooktree Corporation
("Brooktree"), the former supplier of the Company's SPAROW I chip, Level One
Communications ("Level One") and Metalink. Commencing in 1996 the Company
expects to face even more competition from a consortium of telecommunications
supply companies with HDSL products based on the chip designed by Level One. In
addition, Brooktree has the unrestricted right to sell the Company's SPAROW I
chip in component form; however, the Company has developed and is currently
shipping its enhanced SPAROW II chip to which Brooktree does not have access.
The Company expects that additional companies will introduce competitive
products in the future.
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<PAGE> 16
Many companies have introduced or announced HDSL-based products for the
private network market, including both T1 and E1 products. Such companies
include RAD Data Communications, ADTRAN, Inc., General Datacom, Nokia, Ericcson,
ECI Telecom and a number of lesser known manufacturers worldwide. The Company
also faces significant competition from providers of other technologies used by
private network users to transmit information, including fiber and conventional
repeatered T1 lines. To the extent fiber or repeatered lines are used, the
market for the Company's Campus products may be reduced.
The market for the Company's PG-2 products (a product that does not
utilize HDSL technology) is also characterized by intense competition.
Competitive products are offered by several telecommunications device
manufacturers, many of which have substantially greater financial, technical,
marketing and sales resources than the Company. With respect to the Company's
PG-2 products, the Company does not expect that revenues from such products will
grow significantly in future periods, and there can be no assurance that
revenues from PG-2 products will not decline.
All manufacturers of products based on HDSL technology face competition
from fiber optic and conventional repeatered systems as alternate solutions for
the delivery of T1 or E1 services to end users. Many telephone companies have
adopted policies that favor the deployment of fiber. As telephone companies
continue to install fiber cable and conventional repeatered T1 systems to
provide T1 or E1 service in local subscriber loops, the demand for HDSL products
may decline. Further, the deployment of fiber to replace existing HDSL
installations will result in the availability of those existing HDSL systems for
installation elsewhere and may adversely affect future demand for HDSL products.
The Company believes that the principal competitive factors in its
markets are conformance to standard transmission formats, size, price,
performance, product features, reliability, technical support and marketing
expertise. In addition, the Company believes that, with respect to its HiGain
and PG-2 products, product reputation and the speed with which the Company can
obtain approval from the RBOCs for its products are important competitive
factors. The Company believes that it competes favorably with respect to all of
these factors.
PROPRIETARY RIGHTS
The Company relies on a combination of technical leadership, trade
secret, patent, copyright and trademark law and nondisclosure agreements to
establish and protect its proprietary rights in its products. Currently, the
Company holds two United States patents and has an application pending for one
additional patent. The Company also has certain registered and other trademarks.
The Company believes that, because of the rapid pace of technological change in
the networking industry, patent and copyright protection are less significant to
the Company's competitive position than factors such as the knowledge, ability
and experience of the Company's personnel, new product development, market
recognition and ongoing product maintenance and support.
EMPLOYEES
As of December 31, 1995, the Company employed 375 persons, including
171 in manufacturing, 52 in sales and marketing, seven in customer service, 106
in engineering and 39 in finance and administration. The Company also employs a
number of temporary and contract employees and during the last quarter of fiscal
1995, the Company employed between 75 and 85 temporary employees, mostly in
manufacturing. None of the Company's employees is represented by a labor union
and the Company has experienced no work stoppages. The Company does not have any
employment contracts with any of its executive officers.
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<PAGE> 17
ITEM 2. PROPERTIES.
The Company's principal administrative, engineering, manufacturing,
sales and marketing facility is located in an approximately 75,000 square foot
building in Tustin, California, that is leased through February 29, 2000. In
addition, the Company leases a 20,000 square foot warehouse in Santa Ana,
California, a 5,000 square foot research and development facility in Raleigh,
North Carolina, and 15,000 square feet of general office space in Tustin,
California. The expiration dates for these leases are April 14, 1998, November
30, 2000, and July 31, 1999, respectively. The Company believes that such
facilities are either adequate to satisfy its projected requirements, including
its requirements for production capacity, through 1997, or that suitable
additional space will be available as needed.
ITEM 3. LEGAL PROCEEDINGS.
In January 1996, the Company received a copy of a complaint, filed
derivatively by a Company stockholder on behalf of the Company, naming as
defendants the Company's directors and certain officers, as well as Mr. S. Jay
Goldinger and Capital Insight, Inc., a third party investment advisor. This suit
arises out of losses incurred by the Company in 1995 of approximately $15.8
million in connection with investments made by Mr. Goldinger and Capital Insight
on the Company's behalf. The derivative complaint states causes of action for
breach of fiduciary duty, abuse of control, constructive fraud, gross
mismanagement and waste of corporate assets. The complaint seeks in excess of
$15.8 million in damages and legal fees and expenses in connection with the loss
by the Company of the funds it provided to Mr. Goldinger and Capital Insight.
The suit was filed in Superior Court of the State of California, County of
Orange.
In January 1996, the Company filed suit, in Los Angeles federal court,
against Mr. S. Jay Goldinger and Capital Insight, Inc. charging unauthorized
trading, fraudulent misrepresentation, violation of federal securities laws and
breach of fiduciary duties. The suit seeks $15.8 million in damages by reason of
the losses incurred by the Company, as well as punitive damages and legal fees.
Both of these suits arise out of losses the Company incurred in 1995 in
one of its investment accounts. In early 1995, the Company had invested
approximately $28 million of its excess cash with Capital Insight, Inc., a
financial advisor and broker based in Beverly Hills, California, with
instructions that the funds be invested solely in U.S. Treasury securities with
maturities of one year or less. These instructions were consistent with the
investment guidelines which had been approved by the Company's Board of
Directors in October of 1994. However, these instructions were violated and the
funds were used to engage in unauthorized trading in options and futures,
resulting in pre-tax trading losses of $15.8 million in 1995.
The Company's outside directors retained independent legal counsel to
perform a complete investigation of the facts surrounding these losses and the
Company's existing investment policies and procedures. The independent legal
counsel retained forensic accountants to perform a full analysis of the
unauthorized trading activity in order to ascertain both the details of the
transactions involved and the periods in which the losses occurred. This
investigation revealed no improper involvement by any Company officer or
employee in the unauthorized trading.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY-HOLDERS.
No matters were submitted to a vote of security-holders during the
fourth quarter of the fiscal year covered by this report.
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's Common Stock is traded in the over-the-counter market on
the Nasdaq National Market under the symbol PAIR. As of February 29, 1996, there
were approximately 15,467,523 shares of the Company's Common Stock issued and
outstanding. The number of stockholders of record at that date was 133. This
number does not account for Common Stock registered in street name. Accordingly,
the actual number of holders of record of the Company's Common Stock may be
significantly greater than the number indicated above. The following table sets
forth, for the fiscal periods indicated, the high and low sale prices for the
Common Stock as reported on the Nasdaq National Market. The market quotations
set forth below reflect inter-dealer prices, without retail markup, markdown or
commissions, and may not necessarily represent actual transactions. The Company
has never paid cash dividends and has no present intention of declaring a cash
dividend for the foreseeable future.
<TABLE>
<CAPTION>
QUARTERLY QUARTERLY
--------- ---------
HIGH LOW
--------- ---------
<S> <C> <C>
YEAR ENDED DECEMBER 31, 1994
First Quarter $ 14.50 $ 7.75
Second Quarter 10.50 7.00
Third Quarter 10.44 8.25
Fourth Quarter 16.25 8.75
YEAR ENDED DECEMBER 31, 1995
First Quarter $ 26.63 $ 13.25
Second Quarter 24.13 17.63
Third Quarter 35.50 18.75
Fourth Quarter 56.00 27.75
</TABLE>
On February 29, 1996, the last reported sales price for the Company's
stock was $59.25.
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ITEM 6. SELECTED FINANCIAL DATA.
SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data of the Company as of December
31, 1995 and 1994 and for the years ended December 31, 1995, 1994 and 1993 is
derived from audited consolidated financial statements of the Company included
elsewhere in this Annual Report. The selected consolidated financial data of the
Company as of December 31, 1992 and 1991 and the years then ended December 31,
1992 and 1991 is derived from audited consolidated financial statements of the
Company not included in this Annual Report. The following information should be
read in conjunction with the Consolidated Financial Statements of the Company
and the related notes thereto and "Management's Discussion and Analysis of
Financial Condition and Results of Operations" included in a separate section of
the Annual Report beginning on page F-1 and page 19, respectively.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------------------------------------------------
1995 1994 1993 1992 1991
--------- --------- --------- --------- ---------
(IN THOUSANDS, EXCEPT EARNINGS PER SHARE)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues $ 107,224 $ 59,518 $ 36,307 $ 9,502 $ 2,361
Income (loss) from operations 23,532 10,513 8,614 (2,000) (3,393)
Unusual loss due to unauthorized trading of
investments by third parties (15,827) -- -- -- --
Net income (loss) 1,056 8,567 7,612 (2,085) (3,418)
Net income (loss) per share $ 0.06 $ 0.56 $ 0.61 $ (0.22) $ (0.46)
Number of shares used in per share 16,820 15,403 12,485 9,521 7,469
calculations
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------------------------------------------------
1995 1994 1993 1992 1991
-------- -------- -------- -------- ------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Working capital $ 84,766 $ 71,368 $ 62,941 $ 5,218 $ 969
Total assets 105,326 86,625 68,303 9,693 2,587
Long-term debt -- -- -- 2,677 --
Redeemable preferred stock -- -- -- 13,528 9,605
Common stockholders' equity (deficit) 93,931 74,846 65,236 (9,859) (8,068)
</TABLE>
The Company paid no dividends on its Common Stock during any of the
periods presented.
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ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
OVERVIEW
PairGain, founded in February 1988, designs, manufactures and markets
digital telecommunications transmission products. The Company's first product
was PG-2, a two-channel digital subscriber carrier system, which was initially
shipped in late 1989. This product began generating revenues in 1990, but sales
of the PG-2 product alone did not reach volumes sufficient for the Company to
achieve profitability. In 1991, the Company undertook the development of the
HiGain system, which was first shipped in June 1992. The Company's revenue
growth subsequent to 1991 and its profitability beginning in the fourth quarter
of 1992 are attributable to the market acceptance and increased sales of its
HiGain systems. The Company's revenue growth and sustained profitability during
1995, 1994, and 1993 is attributable to increased sales of its HiGain systems,
which represented 76%, 76% and 75% of the Company's total revenues in 1995, 1994
and 1993, respectively. In addition, the Company's Campus products increased as
a percentage of overall revenues to 12% in 1995 from 8% in 1994. Although
revenues from sales of the Company's HiGain products have historically
represented a substantial majority of the Company's total revenues and are
expected to continue to account for a majority of its revenues for the
foreseeable future, the Company believes that revenues from sales of its Campus
and other products will continue to increase as a percentage of the Company's
total revenues in the future.
Commencing in mid-1993, the Company began reducing the average sales
prices of its HiGain products to increase market demand and in anticipation of
expected price competition. These reductions have been significant, representing
a reduction of as much as 35% in the average sales prices of its HiGain products
over the past 18 months. Although future effects of price competition and other
competitive pressures inherent in the Company's business are uncertain, the
Company expects to continue to reduce the average sales prices of its HiGain and
other products. Accordingly, the Company's ability to maintain or increase
revenues will depend in part upon its ability to increase unit sales volumes of
existing products and to introduce and sell new products at rates sufficient to
compensate for the reduced revenue effect of such continuing reductions in the
average sales prices of the Company's existing products. Declining average sales
prices may also adversely affect gross margins on the Company's existing
products if the Company is unable to fully offset such reductions in average
sales prices by reductions in the Company's per unit costs. Declining average
sales prices had a significant effect on gross margins in 1994 as they declined
to 44% from 52% in 1993. During 1995 the Company's continuing effort toward cost
reduction through engineering design changes, reduced prices for components,
increased manufacturing efficiencies, and increases in volume resulted in
improved gross margins, which climbed to 48% for the year. However, there can be
no assurance that the Company will be able to continue to increase unit sales
volumes, introduce and sell new products or further reduce its per unit costs in
the future.
19
<PAGE> 21
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, certain
operating data as a percentage of total revenues.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-------------------------
1995 1994 1993
---- ---- ----
<S> <C> <C> <C>
Revenues:
Product sales 99% 96% 92%
Technology fees and royalty income 1 4 8
---- ---- ----
Total revenues 100 100 100
Cost of revenues 52 56 48
---- ---- ----
Gross profit 48 44 52
Operating expenses:
Research and development 10 10 11
Selling and marketing 9 10 10
General and administrative 6 7 7
---- ---- ----
Total operating expenses 25 27 28
---- ---- ----
Income from operations 23 18 24
Other income (loss):
Interest income (expense), net 2 2 (1)
Net gain on sales of investments -- 2 --
Unusual loss due to unauthorized trading of
investments by third parties (15) -- --
---- ---- ----
Income before income taxes 10 22 23
Provision for income taxes 9 8 2
---- ---- ----
Net income 1% 14% 21%
==== ==== ====
</TABLE>
Revenues
Revenues increased 80% to $107.2 million in 1995 compared with $59.5
million in 1994. This increase was primarily due to a 120% increase in unit
sales volume of the Company's HiGain products and, to a lesser extent, a 218%
and 69% increase in unit sales volume of the Company's Campus and PG-2 products,
respectively. These increases were somewhat offset by declines in the average
sales prices of the products.
Revenues increased 64% to $59.5 million in 1994 compared with $36.3
million in 1993. This increase was primarily due to a 192% increase in unit
sales volume of the Company's HiGain products and, to a lesser extent, the
introduction of the Company's Campus product in June 1993 and 40% increase in
unit sales volume of the Company's PG-2 product. This increase was somewhat
offset by a decline in the average sales prices of the Company's HiGain
products.
Aggregate sales to local telephone companies affiliated with five RBOCs
accounted for approximately 63%, 66% and 65% of the Company's total revenues for
1995, 1994 and 1993, respectively. In addition, included in revenues for 1995,
1994 and 1993 were technology licensing fees and royalty income totaling $1.1
million, $2.1 million and $3.1 million, respectively. The technology licensing
fees and royalties were paid to the Company primarily in connection with
technology licensing agreements entered into with Alcatel and ADC
Telecommunications, Inc. As a result of the renegotiated terms of the agreement
between the Company and Alcatel, technology licensing fees and royalty rates
will continue to decline.
Gross Profit
Gross profit represents total revenues for a period, including
technology fees and royalty income, less the cost of revenues for such period.
Cost of revenues represents primarily product costs, together with associated
overhead expenditures. In 1995, the Company's gross profit as a percentage of
total revenues increased to 48%
20
<PAGE> 22
from 44% in 1994. This increase was primarily the result of the Company's
continuing effort toward cost reduction through engineering design changes,
reduced prices for components, increased manufacturing efficiencies and
increases in volume. These reductions were partially offset by reductions in
average sales prices of products and a decrease in technology fees and royalty
income.
In 1994, the Company's gross margin decreased to 44% from 52% in 1993.
This decrease was primarily due to reductions of as much as 50% in the average
sales prices of the Company's HiGain products and a decrease in technology fees
and royalty income. These decreases in margin were offset by reductions in per
unit costs.
Operating Expenses
Research and development expense increased to $10.7 million in 1995
from $5.8 million in 1994 and $3.9 million in 1993. The research and development
expense ratio during 1995 was consistent with 1994 at 10% of total revenues
compared to 11% in 1993. The increases in absolute expense levels were primarily
due to the addition of personnel for the development of new products and
enhancement of existing products, prototype expenditures as new products were
tested in the lab and payments to consultants where specific resources were
needed in the development process.
Selling and marketing expense increased to $9.9 million in 1995 from
$5.8 million in 1994 and $3.8 million in 1993. These increases in absolute
expense levels were primarily due to the addition of personnel, increases in
salaries and commission, and additional advertising and trade show expenditures.
Selling and marketing expense as a percentage of total revenues was 9% in 1995
compared to 10% in 1994 and 1993. This decrease as a percentage of total
revenues was primarily attributable to the slower growth of personnel, salaries
and commissions relative to overall revenue growth in these periods.
General and administrative expense increased to $6.8 million in 1995
from $4.3 million in 1994 and $2.6 million in 1993. This increase was primarily
due to the addition of personnel and payments to outside consultants related to
the implementation of an information systems upgrade. General and administrative
expense as a percentage of total revenues was 6% in 1995 compared to 7% in 1994
and 1993. This decrease was primarily due to the growth of revenues relative to
general and administrative expense during 1995.
Interest Income (Expense), Net
Net interest income was $2.1 million in 1995 and $1.5 million in 1994.
The increase in interest income principally consisted of net interest income
earned on the cash received by the Company in its secondary offering completed
in March 1995, as well as increased cash balances due to higher revenue levels.
The Company incurred net interest expense of $95,000 in 1993 due to interest on
borrowings with only low levels of offsetting interest income. The increase from
1993 to 1994 resulted from net interest income earned on the cash received from
the initial public offering, which was completed in September 1993.
Net Gain on Sales of Investments
Net realized gains on sales of investments were $415,000 and $1.2
million in 1995 and 1994, respectively. Net unrealized gain (loss) on short-term
investments, net of tax, aggregated $67,000 and ($210,000) in 1995 and 1994,
respectively, and are included as a separate component of stockholders' equity.
Unusual Loss Due to Unauthorized Trading of Investments by Third Parties
In 1993 and 1994, the Company invested a portion of its excess cash
with Capital Insight, Inc. ("Capital Insight"), a financial advisor and broker
based in Beverly Hills, California. The Company had no funds invested with
Capital Insight at either December 31, 1993 or December 31, 1994, as all such
invested funds were returned to the Company prior to the end of each of those
years.
21
<PAGE> 23
In early 1995, the Company again invested a portion of its excess cash
with Capital Insight, with instructions that the funds be invested solely in
U.S. Treasury securities with maturities of one year or less. These instructions
were consistent with the investment guidelines which had been approved by the
Company's Board of Directors in October 1994. However, these instructions were
violated and the funds were used to engage in unauthorized trading in options
and futures. In November 1995, the Company confirmed that it had incurred
non-recurring losses of $15.8 million resulting from these inappropriate and
unauthorized trading activities.
The Company's outside directors retained independent legal counsel and
forensic accountants to determine the facts and circumstances surrounding this
matter. This investigation revealed no improper involvement by any Company
director, officer or employee in the unauthorized trading. Additionally, the
investigation found that the Company was provided with fictitious statements by
Capital Insight, and the Company had actually incurred substantial losses in the
second quarter of 1995. During the third and fourth quarters of 1995, the
unauthorized trading generated significant gains resulting in net trading losses
of $15.8 million for the year. Furthermore, it was determined that the 1994
statements provided by this advisor and relied upon by the Company for its
quarterly reporting were also incorrect. Although total financial results for
1994 were not impacted by these false statements, previously reported 1994
quarterly financial statements did not reflect the proper periods in which the
trading gains and losses occurred. Based on the results of the investigation,
the Company has amended its quarterly statements for both 1994 and 1995 to
reflect the proper reporting of the trading gains and losses. See Note 14 of
Notes to Consolidated Financial Statements beginning on page F-16 of this Annual
Report.
In January 1996, the Company received a copy of a complaint, filed
derivatively by a Company stockholder on behalf of the Company, naming as
defendants the Company's directors and certain officers, as well as Capital
Insight and Mr. S. Jay Goldinger, its president. The derivative complaint states
causes of action for breach of fiduciary duty, abuse of control, constructive
fraud, gross mismanagement and waste of corporate assets. The suit seeks an
award in the amount of all damages sustained by the Company including the losses
of $15.8 million and legal fees and expenses.
In January 1996, the Company filed suit, in Los Angeles federal court,
against Mr. S. Jay Goldinger and Capital Insight, charging unauthorized trading,
fraudulent misrepresentation, violation of federal securities laws and breach of
fiduciary duties. The suit seeks $15.8 million in damages by reason of the
losses incurred by the Company, as well as punitive damages and legal fees.
The Company does not maintain Directors and Officers liability
insurance. However, under the terms of its articles of incorporation, the
Company indemnifies its directors and officers for damages and legal fees
arising from litigation matters. The ultimate outcome of these complaints cannot
presently be determined and, accordingly, no provision for any loss or recovery
that may result has been made in the Company's financial statements.
Provision for Income Taxes
The Company's provision for income taxes increased to $9.2 million in
1995, as compared with a $4.6 million provision in 1994. The effective tax rate
during 1995 was 90%, since the Company did not record any tax benefit on the
unusual trading losses in excess of 1995 and 1994 gains on sales of investments
of $1.6 million.
Excluding the $15.8 million unusual loss, the Company's effective tax
rate in 1995 was 37% compared to 35% in 1994. The principal reason for the
increased effective tax rate was the elimination of the valuation allowance on
deferred tax assets in 1994 as management believes it is more likely than not
that such deferred tax assets will be realized in future periods.
The Company's provision for income taxes increased to $4.6 million in
1994, or an effective tax rate of 35%, as compared with a $0.9 million
provision, or an effective tax rate of 11% in 1993. The 1993 provision was
primarily to provide for state taxes where there was no offset for net operating
loss carryforwards. Provision for
22
<PAGE> 24
federal taxes was offset by net operating loss carryforwards of the Company, the
remaining portion of which was used by the Company in 1993.
Net Income and Earnings Per Share
Net income, excluding the impact of the unauthorized trading loss, for
the year ended December 31, 1995 was $16.5 million or $0.98 per share compared
to $8.6 million or $0.56 per share in 1994. Including the trading loss, 1995 net
income was $1.1 million or $0.06 per share. The weighted average number of
common and common equivalent shares outstanding were 16.8 million and 15.4
million for the years ended December 31, 1995 and 1994, respectively. This
increase in common and common equivalent shares was primarily attributable to
the issuance of 500,000 shares in the Company's secondary offering in March
1995, the granting of options to key employees of the Company, and the reduction
in the number of shares assumed to be repurchased upon the exercise of options
and warrants, using the treasury stock method, as a result of the Company's
higher stock price in 1995 over 1994.
Net income for the year ended December 31, 1994 was $8.6 million or
$0.56 per share compared to $7.6 million or $0.61 per share in 1993. This
reduction in per share earnings was the result of a greater number of common and
common equivalent shares outstanding for all of 1994 due to the initial public
offering of the Company's stock in September 1993. The weighted average number
of common and common equivalent shares outstanding were 15.4 million and 12.5
million for the years ended December 31, 1994 and 1993, respectively.
23
<PAGE> 25
LIQUIDITY AND CAPITAL RESOURCES
In 1995, the Company had cash flow from operations of $12.5 million. In
addition, $15.5 million in cash was generated from the issuance of stock, of
which $11.0 million was from the Company's March 1995 secondary offering. These
amounts were offset by unusual trading losses of $15.8 million, which resulted
from unauthorized trading in options and futures by an independent financial
advisor, as mentioned above. In 1994, the Company generated cash flow from
operations of $4.7 million. In 1993, the Company funded its operations primarily
from $53.6 million in net proceeds from its initial public offering.
As of December 31, 1995, the Company had $55.7 million in cash, cash
equivalents and short-term investments and $84.8 million in working capital,
compared to $53.3 million in cash, cash equivalents and short-term investments
and $71.4 million in working capital in 1994. The increase in the Company's
accounts receivable to $13.0 million at December 31, 1995, compared to $10.2
million at December 31, 1994, was primarily due to increased sales for the
period. Inventories increased to $22.5 million at December 31, 1995, compared to
$16.5 million at December 31, 1994, due to increased stocking levels to support
future shipments. Although, the Company continued to maintain high levels of
inventories in 1995, inventory turns increased from two times in 1994 to
two-and-a-half times in 1995.
Capital expenditures relating primarily to the purchase of computer
equipment, test equipment, furniture and fixtures and leasehold improvements
were $5.9 million, $2.0 million and $1.6 million for the years ended December
31, 1995, 1994 and 1993, respectively. Included in the 1995 additions is
approximately $750,000 of software and equipment purchased to upgrade the
Company's information system capabilities and $1.0 million in leasehold
improvements at the Company's Tustin California manufacturing, engineering and
administrative facility.
During 1995, the Company entered into certain agreements with Sourcecom
Corporation of Valencia, California ("Sourcecom"). Sourcecom designs,
manufactures and markets remote networking devices which enable the integration
of Ethernet local area networks with wide area networking over copper wire. The
agreements provide for the incorporation of Sourcecom's networking technology
into the Company's current and future transmission products. Under the terms of
the agreements, the Company loaned Sourcecom $2.7 million and has rights to
purchase a minority ownership position. The note bears interest at the prime
rate less one percent (7.5% at December 31, 1995), payable monthly, with the
principal balance due July 1999.
The Company has a loan and security agreement with a bank which
provides for a revolving unsecured credit facility of $10.0 million, subject to
amounts utilized for term loans, letters of credit and exchange contracts. The
agreement contains significant financial and operating covenants, including
limitations on the ability of the Company to incur additional indebtedness and
restrictions on the Company's ability to take certain other corporate actions.
The agreement also requires the Company to be in compliance with certain
financial ratios. As a result of the unusual loss in the quarter ended June 30,
1995, the Company violated the Profitability Covenant of the agreement. The
Company received a waiver of this covenant from the bank. Accordingly, the
Company was in compliance with the financial and other covenants at December 31,
1995. At December 31, 1994 the Company had borrowed approximately $1.0 million
under the loan agreement bearing interest at a rate of 8.5%. The loan was repaid
in full during 1995. At December 31, 1995 the Company had no outstanding
borrowings under the agreement. The agreement expires May 1, 1996.
The Company has no other material near-term commitments for its funds.
The Company believes that the current cash and short-term investment balances
and internally generated cash flow will be sufficient to meet its working
capital and capital expenditure requirements through 1996. To the extent that
the Company's existing resources, together with future earnings, are
insufficient to fund the Company's future activities, the Company may need to
raise additional funds through public or private financings.
24
<PAGE> 26
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The Company's consolidated financial statements and schedule appear in
a separate section of this Annual Report on Form 10-K beginning on page F-1 and
S-1, respectively.
SUPPLEMENTARY FINANCIAL DATA
<TABLE>
<CAPTION>
SELECTED QUARTERLY FINANCIAL DATA
(UNAUDITED)
FOR THE THREE MONTHS ENDED
--------------------------------------------------------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
(RESTATED) (RESTATED) (RESTATED) (RESTATED)
---------- ---------- ------------- ------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
1994
Revenues $ 12,482 $ 13,663 $ 15,246 $ 18,127
Gross Profit 5,367 5,959 6,815 8,236
Operating income 2,100 2,223 2,849 3,341
Investment gain (loss) (9,664) 236 (1,237) 11,850
Net income (loss) (8,212) 1,777 771 14,231
Net income (loss) per share $ (0.66) $ 0.12 $ 0.05 $ 0.91
</TABLE>
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED
--------------------------------------------------------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
(RESTATED) (RESTATED)
---------- ---------- ------------- ------------
(IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C> <C>
1995
Revenues $ 19,078 $ 23,919 $ 29,602 $ 34,625
Gross Profit 9,425 11,448 13,768 16,360
Operating income 4,214 4,719 6,459 8,140
Unusual gain (loss) due to unauthorized
trading of investments by third --- (26,774) 1,660 9,287
parties
Net income (loss) 3,142 (22,756) 6,165 14,505
Net income (loss) per share $ 0.20 $ (1.52) $ 0.36 $ 0.83
</TABLE>
The Company restated its quarterly financial statements for the three
month periods ended March 31, 1994, June 30, 1994 and 1995, September 30, 1994
and 1995 and December 31, 1994, as described in Note14 in Notes to Consolidated
Financial Statements, which begins on page F-16 of this Annual Report.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
On July 7, 1995, the Company dismissed Ernst & Young LLP as the
principal independent public auditor for the audit of the Company's financial
statements. There were no disagreements with Ernst & Young LLP on any matter of
accounting principles or practices. Their accountant's reports on the financial
statements of the Company for the years ended December 31, 1994 and 1993 were
unqualified.
Also on July 7, 1995, the Registrant engaged Deloitte & Touche LLP as
principal independent public auditor for the Registrant's financial statements
for the fiscal year ending December 31, 1995.
The decision to dismiss Ernst & Young LLP and appoint Deloitte & Touche
LLP as the Company's principal independent public accountant was approved by the
Company's Board of Directors.
25
<PAGE> 27
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The following table sets forth certain information concerning the
Executive Officers and Directors of the Company.
<TABLE>
<CAPTION>
NAME AGE POSITION
- ----------------------------------------- ------------------ -----------------------------------------------------
<S> <C> <C>
Charles S. Strauch 60 Chairman of the Board and Chief Executive Officer
Howard S. Flagg 41 President and Director
Benedict A. Itri 43 Vice President, Engineering and Director
Stuart R. Davis 43 Vice President, Field Sales
Joseph R. Leonardi 56 Vice President, International Sales
Charles W. McBrayer 47 Vice President, Finance and Administration and
Chief Financial Officer
Dennis Young 53 Vice President, Operations
Robert C. Hawk (1) 56 Director
Robert A. Hoff (1)(2) 43 Director
B. Allen Lay (1)(2) 60 Director
</TABLE>
- ---------------------------
(1) Member of the Audit Committee
(2) Member of the Compensation Committee
Mr. Strauch became a director of the Company in October 1991, Chairman
of the Board of Directors of the Company in November 1991 and Chief Executive
Officer of the Company in April 1992. From May 1989 until December 1991, Mr.
Strauch was self-employed providing management services to technology companies.
From October 1991 to December 1991, in his self-employed role, Mr. Strauch
provided management services to the Company. Also as a part of providing such
management services, from May 1989 to May 1991 he served as Vice Chairman of the
Board of Directors of EECO, Inc., a manufacturer of electronic switches and
computer components. From November 1988 to May 1989, Mr. Strauch served as
President of MSI Data Corporation, a manufacturer of hand-held data collection
devices and then a subsidiary of Symbol Technologies, Inc., having been acquired
by Symbol Technologies in November 1988. Mr. Strauch also served as a member of
the Board of Directors of Symbol Technologies from November 1988 to May 1989.
From August 1984 until November 1988, Mr. Strauch served as Chief Executive
Officer of MSI Data Corporation.
Mr. Flagg, a founder of the Company, has been President and a director
of the Company since November 1991. He served as Chief Executive Officer from
November 1991 to April 1992 and as Vice President, Research and Development from
February 1988 to November 1991. Prior to founding the Company, Mr. Flagg founded
and served as a principal of Advanced Telecommunications, Inc., an aerospace
telecommunications consulting firm.
Mr. Itri, a founder of the Company, has been Vice President,
Engineering of the Company since its inception in February 1988 and a director
of the Company since November 1991. Prior to founding the Company, Mr. Itri
founded and served as a principal of Advanced Telecommunications, Inc.
Mr. Davis joined the Company in August 1989. He became Vice President,
Telco Sales in February 1992 and Vice President, Field Sales in January 1996.
From July 1986 to 1989 Mr. Davis served as Regional Manager, Bell Atlantic for
NEC in its transmission division.
Mr. Leonardi joined the Company in April 1994 as Vice President,
International Sales. Mr. Leonardi served as President of Conveyant Systems,
Inc., a telecommunications software manufacturer, from 1989 to 1994.
26
<PAGE> 28
Mr. McBrayer joined the Company in March 1995 as Vice President,
Finance and Administration and Chief Financial Officer. Mr. McBrayer served as
Vice President, Finance and Chief Financial Officer for Triconex Corporation, a
publicly held corporation, from 1986 to March 1995 and as a director of Triconex
Corporation in 1993 and 1994.
Mr. Young joined the Company in September 1993 as Director, European
Sales and assumed the position of Vice President, Operations in December 1994.
From 1985 to 1993 Mr. Young served in various capacities for the U.K. subsidiary
of EECO, Inc. and for Talley Industries. These companies manufactured and sold
consumer electronic products throughout the European market.
Mr. Hawk became a director of the Company in November 1992. Since 1988,
Mr. Hawk has served as President--Carrier Division of US WEST Communications,
Inc., one of the seven Regional Bell Operating Companies ("RBOCs"). Prior to
that time, Mr. Hawk served as Vice President, Marketing of US WEST and as
Director, Advanced Services of AT&T. Mr. Hawk also serves as a director of
Premisys Communications and Xylan Corporation.
Mr. Hoff became a director of the Company in February 1989. Mr. Hoff
has been a general partner of Crosspoint Venture Partners, a private venture
capital investment company, since September 1983. Mr. Hoff also serves as a
director of privately-held Com21 Incorporated, Timeline Vista, Efficient
Networks, Accredited Home Lenders and US Web Corporation and publicly-held STAC
Inc. and Onyx Acceptance Corporation.
Mr. Lay became a director of the Company in February 1989. Mr. Lay has
been a general partner of Southern California Ventures, a private venture
capital investment company, since May 1983. Mr. Lay also serves as a director of
privately-held Physical Optics Corporation, Medclone, FRS, Inc., Kofax Imaging
Corporation and Meridian Data, and of publicly-held Vestro Foods, a natural food
company.
The Company's Certificate of Incorporation provides for the Company's
Board of Directors to be divided into three classes, as nearly equal in number
as is reasonably possible, serving staggered terms so that Directors' current
terms will expire either at the 1996, 1997 or 1998 Annual Meeting of
Stockholders. At each Annual Meeting of the Company's stockholders, one class of
directors is elected for a three-year term. The terms of Messrs. Strauch, Hoff
and Hawk expire at the 1996 Annual Meeting, Mr. Flagg's expires at the 1997
Annual Meeting, Messrs. Itri and Lay at the 1998 Annual Meeting.
Officers serve at the discretion of the Board of Directors. The Board
of Directors has a Compensation Committee (the "Compensation Committee"), which
administers the Company's stock option plan, and an Audit Committee which
reviews the results and scope of the audit and other services provided by the
Company's independent auditor. The Directors do not receive compensation for
services on the Board of Directors or any committee thereof but are reimbursed
for their out-of pocket expenses. There are no family relationships among any of
the Executive Officers or Directors of the Company. One Director was granted an
option to purchase shares of the Company's Common Stock in connection with his
appointment to the Board of Directors.
27
<PAGE> 29
ITEM 11. EXECUTIVE COMPENSATION.
The following table sets forth the aggregate compensation paid by the
Company to the Chief Executive Officer and to each of the four additional most
highly compensated Executive Officers (the "Named Executive Officers") for the
year ended December 31, 1995. During 1995, no Named Executive Officer received
other compensation in excess of the lesser of $50,000 or 10% of such Officer's
compensation, nor did any such Officer receive any restricted stock award, stock
appreciation right or payment under any long term incentive plan.
TABLE I
SUMMARY COMPENSATION TABLE
<TABLE>
<CAPTION>
LONG TERM
ANNUAL COMPENSATION COMPENSATION
---------------------------------------------------------------------- ---------------------
SECURITIES
NAME AND PRINCIPAL OTHER ANNUAL UNDERLYING
POSITION YEAR SALARY($) BONUS($) COMPENSATION ($) OPTIONS(#)
------------------------ --------------- --------------- ----------------- -------------------- ---------------------
<S> <C> <C> <C> <C> <C>
Charles S. Strauch 1995 255,000 35,000 212,375 (1) 20,000
Chief Executive Officer 1994 253,269 -- 960,750 (2) 70,000
1993 240,000 -- -- --
Howard S. Flagg 1995 119,615 56,635 639,487 (1) 10,000
President 1994 113,269 -- 259,463 (2) 30,000
1993 100,000 -- -- --
Benedict A. Itri 1995 114,615 54,135 572,250 (1) 15,000
Vice President, 1994 108,269 -- 224,025 (2) 30,000
Engineering 1993 95,000 -- -- --
Joseph R. Leonardi 1995 109,154 78,038 611,299 (1) 5,000
Vice President, 1994 72,692 (3) -- -- 105,000
International Sales 1993 -- -- -- --
Stuart R. Davis 1995 97,116 59,189 764,332 (1) 20,000
Vice President, 1994 93,846 27,812 29,995 (4) 20,000
Field Sales 1993 85,000 -- 25,844 (4) 16,666
</TABLE>
(1) "Other Annual Compensation" for Messrs. Strauch, Flagg, Itri, Leonardi
and Davis in the fiscal year ended December 31, 1995 represents the
value received from the exercise of stock options. The amounts shown
are the difference between the exercise price and the closing price of
the Company's Stock on the date of exercise.
(2) "Other Annual Compensation" for Messrs. Strauch, Flagg and Itri in the
fiscal year ended December 31, 1994 represents the value received from
the exercise of stock options. The amounts shown are the difference
between the exercise price and the closing price of the Company's Stock
on the date of exercise
(3) Mr. Leonardi joined the Company in April, 1994. Had Mr. Leonardi been
employed by the Company for all of 1994, his salary would have been
$108,000.
(4) "Other Annual Compensation" for Mr. Davis in the fiscal years ended
December 31, 1994 and 1993 represents the payment of commissions to Mr.
Davis.
28
<PAGE> 30
The following table sets forth information concerning stock option
grants made to each of the Named Executive Officers for the year ended December
31, 1995. No stock appreciation rights were granted to these individuals during
such fiscal year.
TABLE II
OPTION GRANTS IN LAST FISCAL YEAR
<TABLE>
<CAPTION>
Individual Grants Potential Realizable
--------------------------------------------------------------- Value at Assumed
No. of Annual Rates of
Securities Percent of Stock price
Underlying Total Options Appreciation For
Options Granted to Exercise of Option Term(s) (3)
Granted Employees in Basic Price Expiration --------------------------
Name (#)(1) 1995 ($/Sh)(2) Date 5% ($) 10% ($)
------------------------ -------------- ------------------ --------------- ------------- ------------- ------------
<S> <C> <C> <C> <C> <C> <C>
Charles S. Strauch 20,000 1.6 30.500 10/05/05 383,626 972,183
Howard S. Flagg 10,000 0.8 30.500 10/05/05 191,813 486,091
Benedict A. Itri 15,000 1.2 30.500 10/05/05 287,719 729,137
Joseph R. Leonardi 5,000 0.4 30.500 10/05/05 95,906 243,046
Stuart R. Davis 20,000 1.6 18.875 06/22/05 237,408 601,638
</TABLE>
- ------------------------
(1) All of the options were granted under the Company's 1993 Stock
Option/Stock Issuance Plan. The option shares will vest in 48 equal
monthly installments upon the completion of each month of service
beginning one month after the date of grant. Each option will have a
maximum term of 10 years, subject to earlier termination following the
optionee's cessation of service with the Company.
(2) The exercise price per share of the options granted represented the
fair market value of the underlying shares of Common Stock on the dates
the respective options were granted. The exercise price may be paid in
cash or in shares of Common Stock Valued at fair market value on the
exercise date. The Company may also finance the option exercise by
loaning the optionee sufficient funds to pay the exercise price for the
purchased shares.
(3) There is no assurance provided to any executive officer or any other
holder of the Company's securities that the actual stock price
appreciation over the 10-year option term will be at the assumed 5% and
10% levels or at any other defined level. Unless the market price of
the Common Stock does in fact appreciate over the option term, no value
will be realized from the option grants made to the executive officers.
29
<PAGE> 31
The following table sets forth information concerning option exercises
and option holdings for the fiscal year ended December 31, 1995 with respect to
the Named Executive Officers.
TABLE III
AGGREGATE OPTION EXERCISE IN LAST FISCAL YEAR
AND FISCAL YEAR-END OPTION VALUES
<TABLE>
<CAPTION>
Number of Value of Unexercised
Unexercised Options at In-the-Money Options at
Shares Value December 31, 1995 December 31, 1995 ($)
Acquired on Realized ------------------------------- ------------------------------
Name Exercise (#) ($) (1) Exercisable Unexercisable Exercisable Unexercisable
--------------------- --------------- ------------ --------------- --------------- -------------- ---------------
<S> <C> <C> <C> <C> <C> <C>
Charles S. Strauch 10,000 212,375 366,360 (2) 61,252 19,677,355 2,370,779
Howard S. Flagg 31,000 639,487 286,418 (3) 36,857 15,499,904 1,546,793
Benedict A. Itri 20,000 572,250 287,627 (4) 41,649 15,558,989 1,663,000
Joseph R. Leonardi 31,563 611,299 11,144 67,293 518,339 3,048,434
Stuart R. Davis 30,565 764,332 20,082 36,019 1,003,242 1,530,406
</TABLE>
- ---------------------
(1) Based on the market price at the time of exercise less the exercise
price.
(2) Of these, 50,397 shares are subject to immediately exercisable options
but are unvested and, if purchased, are subject to repurchase by the
Company upon termination of the optionee's service prior to vesting.
There were 315,963 vested shares as of December 31, 1995 with a value
of $16,931,348.
(3) Of these, 16,421 shares are subject to immediately exercisable options
but are unvested and, if purchased, are subject to repurchase by the
Company upon termination of the optionee's service prior to vesting.
There were 269,997 vested shares as of December 31, 1995 with a value
of $14,605,165.
(4) Of these, 16,421 shares are subject to immediately exercisable options
but are unvested and, if purchased, are subject to repurchase by the
Company upon termination of the optionee's service prior to vesting.
There were 271,206 vested shares as of December 31, 1995 with a value
of $14,664,250.
30
<PAGE> 32
COMPENSATION COMMITTEE INTERLOCKS AND INSIDER PARTICIPATION
The members of the Company's Compensation Committee (the "Committee")
are Messrs. Hoff and Lay. Neither of these individuals was an officer or
employee of the Company at any time during the year ended December 31, 1995.
COMPENSATION COMMITTEE REPORT
The Compensation Committee of the Board of Directors is composed of two
independent outside directors, Messrs. Hoff and Lay. The Committee reviews the
salary levels of all officers and administers the Company's various plans,
including the Company's Key Management Incentive Compensation Plan and the
Company's 1993 Stock Option/Stock Issuance Plan (the "1993 Plan").
GENERAL COMPENSATION POLICY. The Committee's fundamental compensation
policy is to make a substantial portion of an executive's compensation
contingent upon the financial performance of the Company. Accordingly, in
addition to each executive's base salary, the Company offers bonuses and stock
option awards which are tied to the Company's and executive's performance goals.
Prior to January 1, 1994, executive compensation consisted of salary, benefits
and stock options. Effective January 1, 1994, the Board of Directors approved a
new compensation package for key management which added an incentive
compensation component. The Committee believes that providing incentives to the
executive officers through both a cash bonus and an equity interest in the
Company benefits stockholders by aligning the long-term interests of
stockholders and employees.
There are four components of key management's compensation package:
1. Salary;
2. Benefits, which include only medical, dental, and life insurance
and participation in a 401(k) plan;
3. Eligibility for equity purchase on more favorable terms than those
available to the outside common stockholder (through the 1993 Plan
and through the Company's Stock Purchase Plan); and
4. Eligibility for annual incentive compensation.
The overriding principle of the Key Management Incentive Compensation
Plan is to motivate and reward key management to achieve above average results.
There were 29 participants in the fiscal 1995 Key Management Incentive
Compensation Plan. There are approximately 43 participants in the fiscal 1996
Management Incentive Compensation Plan. Participation is approved on a
year-by-year basis. A bonus plan is offered only to management because they can
influence corporate results more than the other employee group. The bonus
element of the participant's total compensation package is therefore, more
results-oriented than any other element.
FACTORS. Several of the more important factors which were considered in
establishing the components of each executive officer's compensation package for
the 1995 fiscal year are summarized below. Additional factors were also taken
into account, and the Committee may, in its discretion, apply entirely different
factors, particularly different measures of financial performance, in setting
executive compensation for future fiscal years. However, all compensation
decisions will be designed to further the general compensation policy indicated
above.
BASE SALARY. The base salary for each executive officer is set on the
basis of personal performance, the salary levels in effect for comparable
positions with the Company's principal competitors and the Company's financial
performance relative to such competitors. Factors relating to individual
performance that are assessed in setting base compensation are based on the
particular duties and areas of responsibility of the individual executive
officer. Factors relating to the Company's financial performance that may be
related to increasing or decreasing base salary include revenues and earnings.
The establishment of base compensation involves a subjective assessment and
weighing of the foregoing criteria and is not based on any specific formula.
ANNUAL INCENTIVE COMPENSATION. The Company's Management Incentive
Compensation Plan is intended to provide the opportunity for participants to
make long-term investments or special one-time purchases. The plan is
administered by the Committee. The Committee will, in general, rely on the CEO
to establish participant eligibility for the Management Incentive Compensation
Plan, set objectives, and establish awards, except that the Committee will
specifically approve the objectives for the CEO, approve the total amount
proposed for the final payments, interpret, change or establish new rules as
required, and may alter any proposed objectives or awards. The full Board of
Directors must approve awards to the CEO. The Board of Directors, through the
Committee, may amend the Management Incentive Compensation Plan or discontinue
the Management Incentive Compensation Plan at any time.
31
<PAGE> 33
Participants receive an annual cash award, most of which is based on
goals to achieve above average corporate results and some of which is based on
goals to achieve above average performance of the individual and their function
or business unit. Predetermined formulas are used whenever possible to assure
the participants' ability to manage toward their objectives. Final judgment as
to award amounts for all officers except the CEO is determined solely by the CEO
and the Committee regardless of predetermined formulas, in order to assure
fairness of awards relative to special circumstances. Extraordinary performance
can be rewarded above the maximum bonuses allowed, special circumstances may
warrant increasing a bonus above that determined by the plan formula, or a bonus
can be reduced based on special circumstances. For example, the fiscal 1995
Management Incentive Compensation Plan limited the maximum level for the CEO's
cash bonus to assure that his total cash compensation did not exceed generally
accepted levels for comparable companies.
Assessment of any adjustment to bonuses earned is determined by the
Committee. No bonuses are paid to participants if the Company does not achieve a
predetermined threshold level of planned earnings as approved by the Board. The
corporate goals and the threshold level differ from year to year, but are always
aligned with the objective of improving shareholder value.
STOCK OPTIONS. All stock options are granted under the 1993 Plan and
are intended to align the interests of each officer-optionee with those of the
stockholders and provide them with a significant incentive to manage the Company
from the perspective of an owner with an equity interest in the success of the
business. The size of the option grant made to each executive officer under the
1993 Plan is based upon that individual's current position with the Company,
internal comparability with option grants made to other Company executives and
the individual's potential for future responsibility and promotion over the
option term. The Compensation Committee has established certain general
guidelines in making option grants to the Company's executive officers in an
attempt to target a fixed number of unvested option shares for each officer
based upon his or her position with the Company and his or her existing holdings
of unvested option shares.
Options granted under the Discretionary Option Grant Program may be
immediately exercisable for all the option shares, on either a vested or
unvested basis, or may become exercisable for fully-vested shares in
installments over the participant's period of service. Any unvested shares are
subject to repurchase or cancellation by the Company upon the participant's
cessation of service or the Company's non-attainment of the applicable
performance goals. However, the Compensation Committee has full discretionary
authority under the 1993 Plan to accelerate the vesting and the exercisability
of any outstanding option, or to accelerate the vesting of any issued shares, in
whole or in part at any time.
CEO COMPENSATION. The annual base salary for the Company's Chief
Executive Officer, Mr. Charles S. Strauch, was established by the Committee on
February 7, 1994 at $255,000. The Committee's decision was made primarily on Mr.
Strauch's personal performance and the rate of base salary paid to the chief
executive officers of the Company's competitors and at a level equivalent to the
amounts paid by comparably sized companies. Mr. Strauch earned no bonus during
fiscal 1995.
The Committee considers equity-based compensation, in the form of stock
options to be an important component of Mr. Strauch's compensation. Such options
are intended to motivate leadership for long-term Company growth and
profitability. Mr. Strauch was granted options to purchase 20,000 shares on
October 5, 1995, based on the standards discussed above.
COMPLIANCE WITH INTERNAL REVENUE CODE SECTION 162(M)
As a result of Section 162(m) of the Internal Revenue Code, which was
enacted into law in 1993, the Company will not be allowed a federal income tax
deduction for compensation paid to certain executive officers, to the extent
that compensation exceeds $1 million per officer in any one year. This
limitation will be in effect for each fiscal year of the Company beginning after
December 31, 1993 and will apply to all compensation paid to the covered
executive officers which is not considered to be performance based. Compensation
which does qualify as performance-based compensation will not have to be taken
into account for purposes of this limitation.
32
<PAGE> 34
The Compensation Committee does not expect that the compensation to be
paid to the Company's executive officers for the 1996 fiscal year will exceed
the $1 million limit per officer. Accordingly, until final Treasury regulations
are issued with respect to the new $1 million limitation, the Committee will
defer any decision on whether or not to restructure one or more components of
the compensation paid to the executive officers so as to qualify those
components as performance-based compensation that will not be subject to the $1
million limitation.
We conclude our report with the acknowledgment that no member of the
Committee is a former or current officer or employee of the Company or any of
its subsidiaries.
COMPENSATION COMMITTEE
Robert A. Hoff
B. Allen Lay
33
<PAGE> 35
PERFORMANCE MEASUREMENT COMPARISON (1)
The following graph shows a comparison of cumulative total returns for
the Company, the Standard and Poor's 500, the Center for Research in Securities
Prices Index for the Nasdaq Stock Market Telecommunication Stocks (the "CRSP
Nasdaq Telecommunication Index") and the Company's self-determined peer group
(the "Peer Group", detailed below) for the period that commenced September 15,
1993 (the date on which the Company's Common Stock was first traded on the
Nasdaq National Market System) and ended on December 31, 1995. The cumulative
total return assumes that a stockholder invested $100 at the beginning of the
period in PairGain Common Stock, the S&P 500, the Nasdaq Telecommunications
Index and the Peer Group. It also assumes that all dividends have been
reinvested and is adjusted for any stock splits. Past financial performance
should not be considered to be a reliable indicator of future performance, and
investors should not use historical trends to anticipate results or trends in
future periods.
The Peer Group consists of the following companies: Comdial
Corporation; Communications Systems, Inc.; Converse Technology, Inc.; EIS
International, Inc.; Intervoice, Inc.; Microcom, Inc.; Porta Systems
Corporation; and Zoom Telephonics, Inc. The Peer Group was determined by the
Company for comparison in the Proxy for the 1995 Annual Meeting and is comprised
of companies sharing PairGain's SIC number and having 1994 year-end sales within
$10 million of the Company's 1994 year-end sales. This Peer Group will not be
used in future years for Performance Measurement Comparisons. The CRSP Nasdaq
Telecommunication Index was chosen for comparison purposes for this and
subsequent years because it was determined to be a broader and more
comprehensive representation of the Company's industry than the previously
chosen Peer Group.
COMPARISON OF CUMULATIVE TOTAL RETURNS
(PAIRGAIN TECHNOLOGIES, INC., S&P 500, CRSP NASDAQ
TELECOMMUNICATION INDEX, PEER GROUP)
[GRAPH OF CUMULATIVE TOTAL RETURNS]
The data points depicted on the graph are as follows:
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------
Index Description 9/15/93 12/31/93 12/31/94 12/31/95
- ------------------------------------------------------ --------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
PairGain Technologies, Inc. 100.000 98.21 101.79 391.07
S&P 500 Index 100.000 101.53 99.50 133.43
CRSP Nasdaq Telecommunication Index 100.000 101.66 85.10 102.50
Peer Group 100.000 102.06 97.49 138.74
- ----------------------------------------------------------------------------------------------------
</TABLE>
34
<PAGE> 36
Percentage annual returns for the Company's stock and the Indexes listed above
are shown below:
<TABLE>
<CAPTION>
- --------------------------------------------------------------------------------------------------------------
ANNUAL RETURN PERIOD
------------------------------------------------------------------
Index Description 9/15/93-12/31/93 (a) 12/31/93-12/31/94 12/31/94-12/31/95
- ------------------------------------------- --------------------- --------------------- ---------------------
<S> <C> <C> <C>
PairGain Technologies, Inc. -1.79% 3.64% 284.21%
S&P 500 Index 1.53% -2.00% 34.11%
CRSP Nasdaq Telecommunication Index 1.66% -16.28% 20.44%
Peer Group 2.06% -4.48% 42.31%
- --------------------------------------------------------------------------------------------------------------
</TABLE>
(a) Indicates the return for the 105 day period only
(1) This Section is not "soliciting material", is not deemed filed with the
SEC and is not to be incorporated by reference into any filing of the
Company under the Securities Act or the Exchange Act whether made
before or after the date hereof and irrespective of any general
incorporation language in such filing.
MANAGEMENT CONTRACTS AND CHANGE IN CONTROL AGREEMENTS
None of the Company's executive officers have employment agreements
with the Company, and their employment may be terminated at any time at the
discretion of the Board of Directors. The Compensation Committee has the
discretionary authority as administrator of the Company's 1993 Plan to provide
for the accelerated vesting of the shares of Common Stock subject to outstanding
options upon the happening of certain events, including, without limitation, a
change in control of the Company whether by successful tender offer for more
than 50% of the outstanding voting stock or by a proxy contest for the election
of Board of Directors members or the subsequent termination of the optionee's
service within a designated time period following the change in control.
35
<PAGE> 37
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The following table sets forth information concerning the beneficial
ownership of shares of the Company's Common Stock by (i) each beneficial owner
of more than 5% of the outstanding shares of Common Stock; (ii) each Director of
the Company; (iii) the Chief Executive Officer and the four most highly
compensated other Executive Officers; and (iv) by all directors and executive
officers of the Company as a group. This information is presented as of April
22, 1996. Except as otherwise noted, each beneficial owner listed has sole
investment and voting power with respect to the Common Stock indicated.
<TABLE>
<CAPTION>
NAME OF INDIVIDUAL OR NUMBER OF POSITION WITH NUMBER OF SHARES OF COMMON PERCENT
PERSONS IN GROUP COMPANY STOCK BENEFICIALLY OWNED OF CLASS
- ---------------------------------------- ---------------------- ---------------------------------- ------------------
<S> <C> <C> <C>
Putnam Investments, Inc. (1) 1,986,457 12.8%
One Post Office Square
Boston, MA 02109
A I M Management Group, Inc. (2) 1,150,200 7.4%
11 Greenway Plaza Suite 1919
Houston, TX 77046
Robert C. Hawk (3) Director 4,876 *
Robert A. Hoff Director 12,495 *
B. Allen Lay Director 38,120 *
Charles S. Strauch (4) Chairman, Chief 479,545 3.0%
Executive
Officer
Howard S. Flagg (5) President and 348,009 2.2%
Director
Benedict A. Itri (6) Vice President, 333,609 2.1%
Engineering and
Director
Joseph R. Leonardi (7) Vice President, 47,889 *
International Sales
Stuart R. Davis (8) Vice President, 17,392 *
Field Sales
All Directors and Officers 1,323,313 8.0%
as a Group (10 persons) (9)
</TABLE>
- ----------------------------------------
*Less than 1%
36
<PAGE> 38
(1) Information obtained from Schedule 13G filed with the Securities and
Exchange Commission on September 7, 1995 and Amendment No. 1 to Schedule
13G filed on January 15, 1996. This information was also confirmed
telephonically.
(2) Information obtained from Schedule 13G filed with the Securities and
Exchange Commission on February 12, 1996. This information was also
confirmed telephonically.
(3) Includes 4,876 shares subject to options exercisable within 60 days of
April 22, 1996.
(4) Includes 377,610 shares subject to options exercisable within 60 days of
April 22, 1996.
(5) Includes 259,317 shares subject to options exercisable within 60 days of
April 22, 1996.
(6) Includes 261,151 shares subject to options exercisable within 60 days of
April 22, 1996.
(7) Includes 6,773 shares subject to options exercisable within 60 days of
April 22, 1996.
(8) Includes 17,227 shares subject to options exercisable within 60 days of
April 22, 1996.
(9) Includes 957,670 shares subject to options exercisable within 60 days of
April 22, 1996.
COMPLIANCE WITH SECTION 16(A) OF THE SECURITIES EXCHANGE ACT OF 1934
Section 16(a) of the Securities Exchange Act of 1934 (the "Exchange
Act") requires the Company's officers and directors, and persons who own more
than 10% of a registered class of the Company's equity securities, to file
reports of ownership and changes in ownership with the Securities Commission
("SEC") and the Common Stock of the Company are required by SEC Regulation to
furnish the Company with copies of all reports filed pursuant to Section 16(a).
Based solely on its review of copies of such reports received
by it, or written representations of certain reporting persons that no Form 5's
were required for such persons, the Company believes that, during 1995, all
filing requirements applicable to its executive officers, directors and greater
than ten percent stockholders were complied with, with the following exceptions:
Mr. Strauch failed to timely file a Form 4 for the month of August 1995
reporting a change in beneficial ownership of 5,000 shares of the Company's
Common Stock. Mr. Strauch filed a Form 4 on September 18, 1995 reporting
this change.
Mr. Flagg filed an amended Form 4 to report the change in beneficial
ownership of 1,000 shares of the Company's Common Stock. The amended Form 4
was filed on March 31, 1996.
Mr. Itri failed to timely file a Form 4 for the month of November 1995
reporting a change in beneficial ownership of 16,000 shares of the Company's
Common Stock. Mr. Itri filed a Form 4 on December 18, 1995 reporting this
change.
37
<PAGE> 39
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
INDEMNIFICATION AGREEMENTS
The Company has entered into an Indemnity Agreement with each of its
directors and officers (the "Indemnity Agreements") which provides that, with
certain exceptions, the Company will hold harmless and indemnify its directors
and officers to the fullest extent permitted under Delaware Law. Under the
Indemnity Agreements, the Company is obligated to indemnify each of its
directors and officers against all expenses (including attorneys' fees), fines,
judgments and settlement amounts that such director or officer may incur in
connection with any action or proceeding (including actions brought by or on
behalf of the Company such as stockholder derivative actions) to which the
director or officer is or may be made a party to by reason of such director's or
officer's position as a director, officer, employee or agent of the Company or
any other company or enterprise to which the person provides services at the
request of the Company. This additional indemnity goes beyond the rights
expressly provided under the Delaware Law primarily in the availability of
indemnification in connection with actions brought by or on behalf of the
Company, such as stockholder derivative actions, and in the provisions for
advancement of litigation expenses prior to settlement or judgment.
38
<PAGE> 40
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K.
(a)(1) FINANCIAL STATEMENTS:
The following financial statements are included in a separate section
of this Annual Report on Form 10-K commencing on page F-1:
Independent Auditors' Reports
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statement of Stockholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
(2) FINANCIAL STATEMENT SCHEDULE:
The following financial schedule for the years 1995, 1994 and 1993 is
included in a separate section of this Annual Report on Form 10-K commencing on
page S-1:
Schedule II - Valuation and Qualifying Accounts.
All other schedules are omitted because they are not applicable or the
required information is shown in the financial statements or notes thereto.
(3) EXHIBITS:
*3.4 Certificate of Incorporation of Registrant, a Delaware
corporation.
*3.5 Form of Agreement and Plan of Merger of Registrant, a
Delaware corporation, and Registrant, a California
corporation.
*3.6 Bylaws of Registrant, a Delaware corporation.
*10.1 PairGain Technologies, Inc. 1990 Stock Option Plan
(the "1990 Plan").
*10.2 Form of Incentive Stock Option Agreement pertaining to
the 1990 Plan.
*10.3 Form of Supplemental Incentive Stock Option Agreement
pertaining to the 1990 Plan.
*10.4 Form of Nonstatutory Stock Option Agreement pertaining
to the 1990 Plan.
*10.5 PairGain Technologies, Inc. 1993 Option/Stock Issuance
Plan (the "1993 Plan").
*10.6 Form of Stock Option Agreement pertaining to the 1993
Plan.
*10.7 Form of Stock Issuance Agreement pertaining to the
1993 Plan.
*10.8 Contract No. BA07617 dated as of October 27, 1990,
between the Registrant and Bell Atlantic Network
Services, Inc., as amended.
*10.9 Stock Option Agreement dated June 23, 1992 between the
Registrant and Charles S. Strauch.
39
<PAGE> 41
*10.10 Stock Option Agreement dated June 23, 1992 between the
Registrant and Howard S. Flagg.
*10.11 Stock Option Agreement dated June 23, 1992 between the
Registrant and Benedict A. Itri.
*10.12 Agreement dated April 26, 1991 between the Registrant
and Brooktree Corporation.
*10.13 Loan and Security Agreement dated as of July 31, 1991,
between the Registrant and Silicon Valley Bank, as
amended.
*10.14 Standard Sublease dated as of October 29, 1991,
between the Registrant and Kirkwood Dynaelectric
Company.
*10.15 Series B Preferred Stock Purchase Agreement dated as
of January 17, 1992, among the Registrant and the
investors listed therein.
*10.16 Industrial Lease dated as of March 17, 1992, between
the Registrant and Alondra Shoemaker Associates.
*10.17 Warrant to Purchase Stock dated June 22, 1992, issued
to Silicon Valley Bank.
*10.18 Development and license Agreement and Remote HDSL OEM
Agreement both dated June 30, 1992, between the
Registrant and ADC Telecommunications, Inc.
*10.19 Agreement No. PR-6727-A dated September 11, 1992,
between the Registrant and Bell South
Telecommunications, Inc., as amended.
*10.20 Series B Preferred Stock Purchase Agreement dated as
of September 30, 1992, among the Registrant and the
investors listed therein.
*10.21 Registration Rights Agreement dated as of September
30, 1992, among the Registrant, Alcatel Network
Systems, Inc., and the investors listed therein.
*10.22 License and Distribution Agreement dated September 30,
1992, between the Registrant and Alcatel Network
Systems, Inc.
*10.23 PairGain Technologies, Inc. Series D Preferred Stock
Purchase Warrant dated September 30, 1992, issued to
Alcatel Network Systems, Inc.
*10.24 Subordinated Demand Promissory Note, principal amount
$3,000,000, dated September 30, 1992, issued to
Alcatel Network Systems, Inc.
*10.25 PairGain Technologies, Inc. Common Stock Purchase
Warrant dated March 25, 1993, issued to Ventana
Leasing, Inc.
*10.26 PairGain Technologies, Inc. Common Stock Purchase
Warrant dated March 25, 1993, issued to
Praktikerfinans A.B.
*10.27 Form of Indemnification Agreement
**10.28 Sublease Agreement dated as of August 1, 1994, between
the Registrant and LH Research.
40
<PAGE> 42
**10.29 Lease Agreement dated January 30, 1995 between the
Registrant and Mr. Niles Gates.
***10.30 Senior Note and Warrant Purchase Agreement dated July
24, 1995 between PairGain Technologies, Inc. and
Sourcecom Corporation
***10.31 Warrant Agreement dated July 24, 1995 between PairGain
Technologies, Inc. Sourcecom Corporation
***10.32 Investor Right Agreement dated July 24, 1995 between
PairGain Technologies, Inc. Sourcecom Corporation
***10.33 Stock Purchase Agreement dated July 24, 1995 between
PairGain Technologies, Inc. Sourcecom Corporation
****10.34 PairGain Technologies, Inc. Common Stock Purchase
Warrant dated May 10, 1995, issued to Brobeck, Phleger
& Harrison
****10.35 PairGain Technologies, Inc. Common Stock Purchase
Warrant dated August 3, 1995, issued to Nexus Applied
Research, Inc.
****10.36 Amendment to Loan and Security Agreement dated May 3,
1995, between the Registrant and Silicon Valley Bank
11.1 Statement Regarding Computation of Earnings Per Share
**21. Subsidiaries of the Registrant
**23.1 Consent of Ernst & Young LLP, Independent Auditors
23.2 Consent of Deloitte & Touche LLP, Independent Auditors
27 Financial Data Schedule
- ----------------------
* Incorporated herein by reference to the same Exhibit number to the
Company's Registration Statement on Form S-1 (Registration No.
33-66680) declared effective by the Commission on September 14, 1993,
as amended.
** Incorporated herein by reference to the same Exhibit number to the
Company's Annual Report on Form 10-K for the fiscal year ended
December 31, 1994, as filed with the Commission on February 22, 1995.
*** Incorporated herein by reference to the same Exhibit number to the
Company's Quarterly Report on Form 10-Q for the second quarter ended
June 30, 1995, as filed with the Commission on August 10, 1995.
**** Incorporated herein by reference to the same Exhibit number to the
Company's Quarterly Report on Form 10-Q for the third quarter ended
September 30, 1995, as filed with the Commission on November 6, 1995.
(b) REPORTS ON FORM 8-K:
A Form 8-K, dated December 5, 1995, was filed during the quarter ended
December 31, 1995. The Form announces non-operating losses of $15.8
million due to unauthorized trading activity by outside financial
advisors in one of the Company's brokerage accounts.
41
<PAGE> 43
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this Amendment No. 1 to its
Annual Report on Form 10-K to be signed on its behalf by the undersigned,
thereunto duly authorized.
PAIRGAIN TECHNOLOGIES, INC.
Date: April 29, 1996 By: /S/ CHARLES S. STRAUCH
------------------------------------------
Charles S. Strauch
(Registrant)
Chairman and Chief Executive Officer
(Principal Executive Officer)
Date: April 29, 1996 By: /S/ CHARLES W. MCBRAYER
------------------------------------------
Charles W. McBrayer
Vice President, Finance and Administration
Chief Financial Officer
(Principal Financial Officer)
Date: April 29, 1996 By: /S/ ROBERT R. PRICE
------------------------------------------
Robert R. Price
Corporate Controller
(Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this
Amendment No. 1 to its Annual Report on Form 10-K is signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
--------- ------ -----
<S> <C> <C>
/S/ CHARLES S. STRAUCH Chairman, Chief Executive April 29, 1996
------------------------------------ Officer and Director
Charles S. Strauch
/S/ HOWARD S. FLAGG President and Director April 29, 1996
------------------------------------
Howard S. Flagg
/S/ BENEDICT A. ITRI Vice President, Engineering April 29, 1996
------------------------------------ and Director
Benedict A. Itri
/S/ ROBERT C. HAWK Director April 29, 1996
------------------------------------
Robert C. Hawk
/S/ ROBERT A. HOFF Director April 29, 1996
------------------------------------
Robert A. Hoff
/S/ B. ALLEN LAY Director April 29, 1996
------------------------------------
B. Allen Lay
</TABLE>
42
<PAGE> 44
PAIRGAIN TECHNOLOGIES, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1995, 1994 AND 1993
CONTENTS
<TABLE>
<CAPTION>
PAGE
------
<S> <C>
Independent Auditors' Reports F-2
Consolidated Financial Statements:
Consolidated Balance Sheets F-4
Consolidated Statements of Income F-5
Consolidated Statements of Stockholders' Equity F-6
Consolidated Statements of Cash Flows F-7
Notes to Consolidated Financial Statements F-8
</TABLE>
F-1
<PAGE> 45
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders
PairGain Technologies, Inc.
Tustin, California
We have audited the accompanying consolidated balance sheet of PairGain
Technologies, Inc. and subsidiaries as of December 31, 1995, and the related
consolidated statements of income, stockholders' equity, and cash flows for the
year then ended. Our audit also included the financial statement schedule listed
in the index at Item 14 (a)(2). These financial statements and schedule are the
responsibility of the Company's management. Our responsibility is to express an
opinion on these financial statements and schedule based on our audit.
We conducted our audit in accordance with generally accepted auditing standards.
Those standards require that we plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audit provides a reasonable basis for our opinion.
In our opinion, such consolidated financial statements present fairly, in all
material respects, the financial position of the Company and subsidiaries as of
December 31, 1995, and the results of their operations and their cash flows for
the year then ended, in conformity with generally accepted accounting
principles. Also, in our opinion, the related financial statement schedule, when
considered in relation to the basic financial statements taken as a whole,
presents fairly in all material respects the information set forth therein.
DELOITTE & TOUCHE LLP
Costa Mesa, California
January 23, 1996
F-2
<PAGE> 46
INDEPENDENT AUDITORS' REPORT
Board of Directors
PairGain Technologies, Inc.
We have audited the accompanying consolidated balance sheets of PairGain
Technologies, Inc. as of December 31, 1994, and the related consolidated
statements of income, stockholders' equity and cash flows for the years ended
December 31, 1994 and 1993. Our audits also included the financial statement
schedule listed in the index at Item 14 (a)(2). These financial statements and
schedule are the responsibility of the Company's management. Our responsibility
is to express an opinion on these financial statements and schedule based on our
audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of PairGain
Technologies, Inc. as of December 31, 1994, and the consolidated results of its
operations and its cash flows for the years ended December 31, 1994 and 1993, in
conformity with generally accepted accounting principles. Also, in our opinion,
the related financial statement schedule, when considered in relation to the
basic financial statements taken as a whole, presents fairly in all material
respects the information set forth therein.
ERNST & YOUNG LLP
Orange County, California
February 17, 1995
F-3
<PAGE> 47
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED BALANCE SHEETS
ASSETS
<TABLE>
<CAPTION>
DECEMBER 31,
---------------------------------
1995 1994
-------------- ----------------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 24,576 $ 711
Short-term investments (Note 3) 31,149 52,565
Accounts receivable, less allowance for doubtful accounts of
$469 and $298 at December 31, 1995 and 1994, respectively 13,044 10,168
Inventories (Note 4) 22,522 16,474
Deferred tax assets (Note 9) 3,353 2,133
Other current assets 1,517 1,096
-------------- ----------------
Total current assets 96,161 83,147
Property and equipment, net (Note 5) 6,402 3,431
Note receivable (Note 6) 2,708 --
Other assets 55 47
============== ================
Total assets $105,326 $ 86,625
============== ================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $ 6,402 $ 6,670
Bank line of credit (Note 7) -- 1,000
Accrued compensation and related expenses 2,605 1,346
Accrued expenses 2,388 754
Accrued income taxes -- 2,009
-------------- ----------------
Total current liabilities 11,395 11,779
-------------- ----------------
Commitments and contingencies (Notes 10 and 15)
Stockholders' equity (Note 11): Preferred stock, $.001 par value:
Authorized shares -- 2,000,000
Issued and outstanding shares -- None -- --
Common stock, $.001 par value:
Authorized shares -- 30,000,000
Issued and outstanding shares-- 15,177,267 and 12,708,636
at December 31, 1995 and 1994, respectively 15 13
Additional paid-in-capital 87,175 69,513
Deferred compensation (82) (170)
Unrealized gain (loss) on short-term investments 67 (210)
Retained earnings 6,756 5,700
-------------- ----------------
Total stockholders' equity 93,931 74,846
-------------- ----------------
Total liabilities and stockholders' equity $105,326 $ 86,625
============== ================
</TABLE>
See notes to consolidated financial statements.
F-4
<PAGE> 48
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------------------------------
1995 1994 1993
-------------- -------------- --------------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<S> <C> <C> <C>
Revenue:
Product sales $ 106,173 $ 57,417 $ 33,232
Technology fees and royalty income (Note 8) 1,051 2,101 3,075
-------------- -------------- --------------
Total revenues 107,224 59,518 36,307
Cost of revenues 56,223 33,141 17,350
-------------- -------------- --------------
Gross profit 51,001 26,377 18,957
-------------- -------------- --------------
Operating expenses:
Research and development 10,728 5,849 3,917
Selling and marketing 9,944 5,765 3,797
General and administrative 6,797 4,250 2,629
-------------- -------------- --------------
Total operating expenses 27,469 15,864 10,343
-------------- -------------- --------------
Income from operations 23,532 10,513 8,614
Other income (loss):
Interest income (expense), net 2,118 1,482 (95)
Net gain on sales of investments 415 1,185 --
Unusual loss due to unauthorized trading of investments by third
parties (Note 14) (15,827) -- --
-------------- -------------- --------------
Income before income taxes 10,238 13,180 8,519
Provision for income taxes (Note 9) 9,182 4,613 907
-------------- -------------- --------------
Net income $ 1,056 $ 8,567 $ 7,612
============== ============== ==============
PER SHARE DATA (Note 1):
Earnings per share $ 0.06 $ 0.56 $ 0.61
============== ============== ==============
Weighted average number of common and common
equivalent shares 16,820,000 15,403,000 12,485,000
============== ============== ==============
</TABLE>
See notes to consolidated financial statements.
F-5
<PAGE> 49
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS, EXCEPT COMMON STOCK SHARES)
<TABLE>
<CAPTION>
UNREALIZED
COMMON STOCK ADDITIONAL GAIN(LOSS) RETAINED TOTAL
------------------------ PAID-IN DEFERRED ON SHORT-TERM EARNINGS STOCKHOLDERS'
SHARES AMOUNT CAPITAL COMPENSATION INVESTMENTS (DEFICIT) EQUITY
------------- ---------- ----------- ------------- ------------- ------------- ------------
<S> <C> <C> <C> <C> <C> <C> <C>
Balance at January 1, 1993 530,063 $ 614 $ -- $ (139) $ -- $ (10,334) $ (9,859)
Reincorporation in Delaware -- (614) 614 -- -- -- --
Exercise of common stock options 133,295 -- 38 -- -- -- 38
Deferred compensation related
to stock options -- -- 212 (212) -- -- --
Amortization of deferred
compensation -- -- -- 94 -- -- 94
Accretion of redeemable
preferred stock to redemption -- -- -- -- -- (145) (145)
price
Conversion of redeemable
preferred stock into common
stock 7,319,228 8 13,675 -- -- -- 13,683
Issuance of common stock for
cash, net of offering costs
of $4,643 4,140,000 4 53,313 -- -- -- 53,317
Exercise of warrants 215,024 -- 496 -- -- -- 496
Net income -- -- -- -- -- 7,612 7,612
------------- ---------- ----------- ------------- ------------- ------------- ------------
Balance at December 31, 1993 12,337,610 12 68,348 (257) -- (2,867) 65,236
Exercise of common stock options 371,026 1 203 -- -- -- 204
Tax benefits from exercise of
common stock options -- -- 962 -- -- -- 962
Amortization of deferred
compensation -- -- -- 87 -- -- 87
Unrealized loss on short-term
investments, net of tax
benefit of $141 -- -- -- -- (210) -- (210)
Net income -- -- -- -- -- 8,567 8,567
------------- ---------- ----------- ------------- ------------- ------------- ------------
Balance at December 31, 1994 12,708,636 13 69,513 (170) (210) 5,700 74,846
Issuance of common stock for
cash, net of offering costs
of $842 500,000 1 10,969 -- -- -- 10,970
Exercise of warrants 1,442,781 1 2,726 -- -- -- 2,727
Exercise of common stock 506,095 -- 1,440 -- -- -- 1,440
options
Issuance of common stock
sold under Employee Stock
Purchase Plan 19,755 -- 386 -- -- -- 386
Tax benefits from exercise of
common stock options -- -- 2,141 -- -- -- 2,141
Amortization of deferred
compensation -- -- -- 88 -- -- 88
Unrealized gain on short-term
investments, net of tax of -- -- -- -- 277 -- 277
$181
Net income -- -- -- -- -- 1,056 1,056
============= ========== =========== ============= ============= ============= ============
Balance at December 31, 1995 15,177,267 $ 15 $ 87,175 $ (82) $ 67 $ 6,756 $ 93,931
============= ========== =========== ============= ============= ============= ============
</TABLE>
See notes to consolidated financial statements.
F-6
<PAGE> 50
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
---------------------------------------------
1995 1994 1993
-------------- -------------- -------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net income $ 1,056 $ 8,567 $ 7,612
Adjustments to reconcile net income to net cash provided by
(used in) operating activities:
Depreciation and amortization 4,048 1,726 662
Gains on sales of investments (415) (1,185) --
Write-off of debt discount -- -- 345
Unusual loss due to unauthorized trading of investments by
third parties 15,827 -- --
Provision for deferred tax assets (1,400) (2,133) --
Change in operating assets and liabilities:
Accounts receivable (2,876) (4,718) (3,769)
Inventories (6,048) (5,875) (6,929)
Other current assets (421) (508) (37)
Other assets (8) (17) (5)
Trade accounts payable (268) 4,408 626
Accrued compensation 1,259 758 361
Accrued expenses 1,634 537 (33)
Accrued income taxes 132 3,112 --
Deferred revenue -- -- (300)
-------------- -------------- --------------
Net cash provided by (used in) operating activities 12,520 4,672 (1,467)
-------------- -------------- --------------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of investments (43,272) (115,610) (68,439)
Proceeds from sales of investments 48,711 98,817 32,169
Issuance of note receivable (2,708) -- --
Purchase of property and equipment (5,909) (2,022) (1,639)
-------------- -------------- --------------
Net cash used in investing activities (3,178) (18,815) (37,909)
-------------- -------------- --------------
CASH FLOWS FROM FINANCING ACTIVITIES
Borrowings under bank line of credit 4,400 1,000 --
Payments on bank line of credit (5,400) -- (985)
Payment on notes payable to the stockholder -- -- (2,707)
Payments on capital lease -- -- (143)
Proceeds from issuance of common stock 15,523 204 53,559
-------------- -------------- --------------
Net cash provided by financing activities 14,523 1,204 49,724
-------------- -------------- --------------
Increase (decrease) in cash and cash equivalents 23,865 (12,939) 10,348
Cash and cash equivalents at beginning of year 711 13,650 3,302
-------------- -------------- --------------
Cash and cash equivalents at end of year $ 24,576 $ 711 $ 13,650
============== ============== ==============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Interest paid $ 18 $ 18 $ 386
============== ============== ==============
Income taxes paid $ 10,887 $ 3,625 $ 1,082
============== ============== ==============
</TABLE>
See notes to consolidated financial statements.
F-7
<PAGE> 51
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. THE COMPANY AND SIGNIFICANT ACCOUNTING POLICIES
PairGain Technologies, Inc., (the "Company") designs, manufactures,
markets and supports a comprehensive line of digital telecommunications products
that enable telecommunication exchange carriers and private networks to more
efficiently provide high speed digital service to end users over the large
infrastructure of unconditioned copper wires.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the
Company and its wholly owned subsidiaries: PairGain Services Group, Inc., which
provides support services for the Company's customers throughout the United
States; PairGain Canada Inc., a sales company focused on the Canadian market;
and PairGain International Sales Corporation, a foreign sales corporation
("FSC"). All significant intercompany transactions have been eliminated in
consolidation.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform with the
1995 presentation.
CASH AND CASH EQUIVALENTS
The Company considers all highly liquid investments with maturities at
the date of purchase of less than three months to be cash equivalents.
SHORT-TERM INVESTMENTS
Effective January 1, 1994, the Company adopted the provisions of
Statement of Financial Accounting Standards No. 115, Accounting for Certain
Investments in Debt and Equity Securities. The adoption did not have a
significant impact on the Company's consolidated financial statements.
Management determines the appropriate classification of such securities at the
time of purchase and reevaluates such classification as of each balance sheet
date. Based on its intent, the Company's investments are classified as
available-for-sale and are carried at fair value, with unrealized gains and
losses, net of tax, reported as a separate component of stockholders' equity.
The investments are adjusted for amortization of premiums and discounts to
maturity and such amortization is included in interest income. Realized gains
and losses and declines in value judged to be other than temporary are
determined based on the specific identification method and are reported in the
consolidated statements of income.
INVENTORIES
Inventories are stated at lower of cost (determined on a first-in,
first-out basis) or market. The Company maintains allowances for estimated
obsolete and excess inventories based upon projected sales levels.
PROPERTY AND EQUIPMENT
Property and equipment are carried at cost. The Company provides for
depreciation and amortization using the straight-line method. The estimated
useful life of equipment is three years. Leasehold improvements are amortized
over the lesser of five years or the life of the lease.
F-8
<PAGE> 52
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
REVENUE RECOGNITION
Revenue from product sales is recognized at the time of shipment.
Provision is made currently for estimated product returns. Revenue for
technology and licensing fees and royalty income is recognized when earned.
RESEARCH AND DEVELOPMENT COSTS
Research and development costs are expensed as incurred.
PER SHARE INFORMATION
Net income per share is computed using the weighted average number of
common shares and common share equivalents outstanding during the periods
presented. Common share equivalents result from outstanding options and warrants
to purchase common stock and are calculated using the treasury stock method.
Weighted average number of common and common equivalent shares for 1993
were calculated pursuant to the requirements of the Securities and Exchange
Commission. Accordingly, common and preferred shares issued by the Company
during the twelve months immediately preceding the initial public offering, plus
the number of shares issuable upon exercise of stock options and warrants
granted during this period, have been included in the calculation of the shares
used in computing net income per share as if they were outstanding for the
period (using the treasury stock method and the estimated public offering price
in calculating equivalent shares). In addition, the calculation of shares used
in computing net income per share also includes shares of convertible preferred
stock which converted into common stock in connection with the initial public
offering of the Company's common stock as if they were outstanding from their
original dates of issuance.
TRANSLATION OF FOREIGN CURRENCIES
Foreign subsidiary financial statements are translated into U.S.
dollars in accordance with Statement of Financial Accounting Standards No. 52,
Foreign Currency Translations. The functional currency of the Company's Canadian
subsidiary is the U.S. dollar, therefore, translation gains and losses are
included in results of operations. Transaction and translation gains and losses
were not significant in 1995 or 1994.
STATEMENT OF CASH FLOWS
Significant noncash transactions in 1995, 1994 and 1993 affecting the
Company's accounts consisted of the following:
- Conversion of preferred stock to common stock in the amount of
$13,683,000 in 1993.
- Reduction of note payable in 1993 in the amount of $293,000 for the
exercise of certain warrants.
- Tax benefits for exercises of common stock options of $2,141,000 and
$962,000 in 1995 and 1994, respectively.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting periods. Actual results could differ from those estimates.
F-9
<PAGE> 53
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NEW ACCOUNTING PRONOUNCEMENT
The Financial Accounting Standards Board has issued Statement of
Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation
("Statement No. 123"). Statement No. 123 requires the Company to value all
stock-based compensation based on the estimated fair market value at the grant
date and spread the deemed cost over the vesting period. Statement No. 123
permits a choice of whether to charge operations or disclose the calculated cost
as pro forma information. This standard requires disclosure, beginning in 1996,
of the deemed cost effective with 1995 grants. The Company has not yet
quantified its cost or determined its method of adoption under Statement No.
123.
2. CONCENTRATION OF CREDIT RISK, MAJOR CUSTOMERS AND PRODUCTS
The Company markets its products principally to telephone companies in
the United States. Credit is extended based on an evaluation of the customer's
financial condition and collateral is not required. Credit losses are provided
for in the financial statements and consistently have been minimal. Sales to
major customers as a percentage of total product revenue were as follows:
<TABLE>
<CAPTION>
1995 1994 1993
------------- ------------ -----------
<S> <C> <C> <C>
Customer A 17% 19% 29%
Customer B 15% 18% 16%
Customer C 12% 13% 13%
Customer D 11% 10% --
</TABLE>
A decision by a significant customer to substantially decrease or delay
purchases from the Company or the Company's inability to collect receivables
from these customers could have a material adverse effect on the Company's
financial condition and results of operations.
Revenues from HiGain products represented approximately 76%, 76% and
75% of the Company's total revenues in 1995, 1994 and 1993, respectively. A
decline in demand for HiGain products, whether as a result of competition,
deployment of fiber cable, technological change or otherwise, could have a
material adverse effect on the Company's operating results.
3. SHORT-TERM INVESTMENTS
Short-term investments as of December 31, 1995 and 1994 are summarized
as follows:
<TABLE>
<CAPTION>
GROSS GROSS
UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------------- ---------------- -------------- ----------------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
1995
Municipal bonds $ 31,042 $ 107 $ -- $ 31,149
1994
Municipal bonds $ 52,916 $ -- $ 351 $ 52,565
</TABLE>
F-10
<PAGE> 54
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Net realized gains were $415,000 and $1,185,000 in 1995 and 1994,
respectively. Unrealized gain (loss) on short-term investments, net of tax,
included as a separate component of stockholders' equity was $67,000 and
($210,000) in 1995 and 1994, respectively.
The amortized cost and estimated fair value of investments at December
31, 1995 by contractual maturity are shown below. Actual maturities may differ
from contractual maturities because the issuer of the securities may have the
right to repurchase such securities.
<TABLE>
<CAPTION>
FAIR
COST VALUE
---------------- -----------------
(IN THOUSANDS)
<S> <C> <C>
Due in one year or less $ 15,988 $ 15,974
Due after one year through three years 15,054 15,175
================ =================
$ 31,042 $ 31,149
================ =================
</TABLE>
4. INVENTORIES
Inventories consist of:
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------------------------
1995 1994
------------------ ------------------
(IN THOUSANDS)
<S> <C> <C>
Finished goods $ 7,842 $ 4,743
Work in process 9,693 9,529
Purchased parts 4,987 2,202
================== ==================
$ 22,522 $ 16,474
================== ==================
</TABLE>
5. PROPERTY AND EQUIPMENT
Property and equipment consist of:
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------------------------
1995 1994
------------------ ------------------
(IN THOUSANDS)
<S> <C> <C>
Furniture and fixtures $ 50 $ 38
Machinery and equipment 9,722 4,784
Leasehold improvements 1,111 379
------------------ ------------------
10,883 5,201
Less accumulated depreciation and amortization 4,481 1,770
================== ==================
$ 6,402 $ 3,431
================== ==================
</TABLE>
F-11
<PAGE> 55
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
6. NOTE RECEIVABLE
On July 20, 1995, the Company entered into certain agreements with
Sourcecom Corporation of Valencia, California ("Sourcecom"). Sourcecom designs,
manufactures and markets remote networking devices which enable the integration
of Ethernet local area networks with wide area networking over copper wire. The
agreements provide for the incorporation of Sourcecom's networking technology
into the Company's current and future transmission products. Under the terms of
the agreements, the Company loaned Sourcecom $2.7 million and has rights to
purchase a minority ownership position. The note bears interest at the prime
rate less one percent (7.5% at December 31, 1995), payable monthly, with the
principal balance due July 1999.
7. BANK LINE OF CREDIT
The Company maintains an unsecured line of credit with a bank. The line
allows maximum borrowings of $10,000,000, of which up to $2,000,000 may be
utilized for the secured purchase of fixed assets (term loan), $2,000,000 for
letters of credit and $2,000,000 for foreign exchange contracts. The line bears
interest at prime (8.5% at December 31, 1995) and borrowings under term loan
provisions of the agreement bear interest at prime plus 1%. At December 31,
1995, the Company had no outstanding borrowings under this line of credit. The
debt agreement specifies certain financial and other covenants. As a result of
the unusual loss in the quarter ended June 30, 1995, the Company violated the
Profitability Covenant of the agreement. The Company received a waiver of this
covenant from the bank. Accordingly, the Company was in compliance with the
financial and other covenants at December 31, 1995. The agreement expires May 1,
1996.
8. LICENSE AND DISTRIBUTION AGREEMENTS
In 1992, the Company granted an exclusive worldwide noncancelable
license to its HDSL technology configured for general use in specified markets
outside the U.S. and a nonexclusive, worldwide, noncancelable license to its
HDSL technology configured for general use in the U.S. to a U.S. subsidiary of
Alcatel, SA, a French telecommunications company. In November 1995, this
agreement was terminated. As part of terminating the agreement, the Company
granted royalty-free licenses of current company technology to Alcatel and
Alcatel granted a royalty-free license of its network management software to the
Company. The agreement also revised the royalty rate for standalone T1 products
which incorporate the Company's HDSL technology being sold by Alcatel.
9. INCOME TAXES
The components of the provision for income taxes are as follows:
<TABLE>
<CAPTION>
1995 1994 1993
----------- ------------ -----------
(IN THOUSANDS)
<S> <C> <C> <C>
Current:
Federal $ 8,150 $ 5,546 $ 340
State 2,432 1,200 567
----------- ------------ -----------
Total current 10,582 6,746 907
----------- ------------ -----------
Deferred:
Federal (1,207) (1,875) --
State (193) (258) --
----------- ------------ -----------
Total deferred (1,400) (2,133) --
----------- ------------ -----------
Total provision $ 9,182 $ 4,613 $ 907
=========== ============ ===========
</TABLE>
F-12
<PAGE> 56
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The actual tax expense for the years ended December 31, 1995, 1994, and
1993 differs from the U.S. federal statutory tax expense for the years as
follows:
<TABLE>
<CAPTION>
1995 1994 1993
----------- ------------ -----------
(IN THOUSANDS)
<S> <C> <C> <C>
U.S. federal statutory tax expense $ 3,583 $ 4,481 $ 3,013
Unusual loss due to unauthorized trading of investments by third parties 4,980 -- --
State taxes net of operating loss carryforwards and federal income tax benefit 1,422 792 369
Benefit of net operating loss carryforward -- -- (3,365)
Increase (decrease) in valuation allowance for deferred tax assets -- (994) 606
Other items, net (803) 334 284
---------- ------------ -----------
Income tax expense $ 9,182 $ 4,613 $ 907
=========== ============ ===========
</TABLE>
Deferred income taxes reflect the net tax effects of temporary
differences between the carrying amounts of assets and liabilities for financial
reporting purposes and the amounts used for income tax purposes. Significant
components for the Company's deferred tax liabilities and assets at December 31
are as follows:
<TABLE>
<CAPTION>
1995 1994
----------------- ----------------
<S> <C> <C>
(IN THOUSANDS)
Deferred tax liabilities:
Tax over book depreciation $ -- $ 112
----------------- ----------------
Total deferred tax liabilities -- 112
----------------- ----------------
Deferred tax assets:
Book over tax depreciation 246 --
Inventory and related reserves 1,695 756
Book over tax deduction for state taxes 291 451
Tax over book valuation of inventory 220 325
Other 901 713
----------------- ----------------
Total deferred tax assets 3,353 2,245
----------------- ----------------
Net deferred taxes $ 3,353 $ 2,133
================= ================
</TABLE>
10. COMMITMENTS
The Company has entered into several operating leases for its
facilities with varying terms and escalation clauses. Future annual minimum
lease payments under the noncancelable operating leases are as follows (in
thousands):
<TABLE>
<CAPTION>
Years ending December 31,
<S> <C>
1996 $ 625
1997 633
1998 553
1999 215
2000 60
---------------
$ 2,086
===============
</TABLE>
F-13
<PAGE> 57
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Rent expense for the years ended December 31, 1995, 1994 and 1993
aggregated $424,000, $298,000 and $220,000, respectively.
11. STOCKHOLDERS' EQUITY
REINCORPORATION AND PUBLIC OFFERINGS
In June 1993, the Board of Directors approved the reincorporation of
the Company in the State of Delaware, which was effective in September 1993. The
reincorporation resulted in a change in the authorized number of shares of
common stock to 30,000,000 shares of $.001 par value per share and 2,000,000
shares of undesignated preferred stock, $.001 par value per share. In addition,
the Company approved a three-for-two reverse split of its common stock which was
effected prior to the closing of the initial public offering of the Company's
common stock. All references in the accompanying consolidated financial
statements to the number of shares of common stock have been retroactively
restated to reflect this reverse stock split.
In September 1993, the Company completed an initial public offering and
sold 4,140,000 shares of its common stock at a price of $14.00 per share. The
net proceeds raised by the Company were approximately $53,317,000. In connection
with the offering, certain outstanding warrants were exercised to purchase
215,024 shares of common stock and all of the Company's outstanding Series A
Preferred Stock (1,800,000 shares) and Series B Preferred Stock (9,178,842
shares) were converted into a total of 7,319,228 shares of common stock.
In March 1995, the Company completed a secondary offering and sold
500,000 shares of its common stock at a price of $23.625 per share. The net
proceeds raised by the Company were approximately $10,970,000. In connection
with the offering, certain outstanding warrants were exercised to purchase
1,437,655 shares of common stock at an aggregate exercise price of $2,717,000.
STOCK OPTIONS AND WARRANTS
Under the Company's 1993 Stock Option/Stock Issuance Plan (the Plan),
which is the successor plan to its 1990 Stock Option Plan (the 1990 Plan), a
Committee consisting of non-employee members of its Board of Directors, is
authorized to grant stock options or issue common stock to its officers, key
employees, members of the Board of Directors, and certain consultants or other
independent contractors. In addition, the Plan also provides for the purchase of
the Company's common stock by eligible individuals at a price per share not less
than 85% of the fair market value at the time of issuance. No shares have been
issued under the purchase provisions. Incentive options are granted at a price
equal to 100% of the fair market value at the date of grant (at least 85% of the
fair market value for non-qualified options) and vested options are exercisable
for a period determined by the Committee that is not to exceed ten years from
the date of grant. Options issued under the 1990 Plan are exercisable
immediately upon grant and shares issued related to options exercised but not
vested are subject to repurchase by the Company at the exercise price of such
options. At the discretion of the Committee, the Plan provides option holders
stock appreciation rights which allow the holder to exercise such options in
exchange for the payment of the difference between the fair market value and
option price of the underlying shares in the form of cash or shares of common
stock. Under certain circumstances in the event of a merger, sale or other
significant transaction involving the Company, the options and stock issued may
become fully vested and exercisable.
In January 1995, the Company's Board of Directors approved an increase
in the number of common shares reserved and available for issuance under the
Plan from 3,700,000 shares to 4,700,000 shares.
F-14
<PAGE> 58
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The following is a summary of changes in common stock options
outstanding:
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------------
1995 1994 1993
-------------- -------------- --------------
<S> <C> <C> <C>
Outstanding options at beginning of year 2,670,293 2,407,696 1,978,295
Granted 1,239,100 810,100 642,303
Exercised (506,095) (371,026) (99,883)
Canceled (71,675) (176,477) (113,019)
-------------- -------------- --------------
Outstanding options at end of year 3,331,623 2,670,293 2,407,696
============== ============== ==============
Exercisable at end of year 1,423,033 1,162,311 892,940
============== ============== ==============
Exercise prices of options exercised during the year $0.15 to $0.15 to $0.15 to
$18.88 $7.50 $3.30
Exercise prices of options outstanding at end of year $0.15 to $0.15 to $0.15 to
$30.50 $13.75 $13.00
</TABLE>
The outstanding stock options primarily vest ratably over a four year
period. The outstanding options at December 31, 1995 include options for 610,163
shares issued outside the Plan.
In 1993, the Company granted warrants for the purchase of 14,310 shares
of its common stock at an exercise price of $1.87 per share to a company and its
affiliate in connection with an equipment leasing transaction. Such warrants
were exercised during 1995.
During 1995, the Company granted warrants for the purchase of 10,000
shares of its common stock at exercise prices of $20.00 to $25.00 per share in
exchange for services. Such warrants were outstanding at December 31, 1995 and
expire beginning in May 1998 through September 1999.
12. EMPLOYEE BENEFIT PLANS
The Company sponsors a defined contribution 401(K) Savings and
Investment Plan, which was established in 1993, covering substantially all of
the Company's employees subject to certain eligibility requirements. At its
discretion, the Company may make contributions to the plan. No contributions
were made by the Company in 1995 or 1994.
In January 1995, the Company established a stock purchase plan covering
substantially all of its employees. The stock purchase plan provides for the
purchase of the Company's common stock at a minimum of 85% of the closing price
per share on the first or last day of the purchase period, whichever is lowest.
The Company issued 19,755 shares under the plan for an aggregate price of
$386,000 in 1995.
13. RELATED PARTY TRANSACTIONS
The Company purchases raw material components from one of its
stockholders. During 1994 and 1993 purchases from this stockholder were
$3,503,000 and $4,262,000, respectively. Additionally, the Company licensed
certain HDSL technology to this stockholder for which the Company earned
royalties of $114,000 and $4,600 in 1994 and 1993, respectively. Amounts payable
to this stockholder were $1,089,000 at December 31, 1994, and are included in
trade accounts payable in the accompanying consolidated balance sheet.
F-15
<PAGE> 59
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
14. UNUSUAL LOSS DUE TO UNAUTHORIZED TRADING OF INVESTMENTS BY THIRD PARTIES
In 1993 and 1994, the Company invested a portion of its excess cash
with Capital Insight, Inc. ("Capital Insight"), a financial advisor and broker
based in Beverly Hills, California. The Company had no funds invested with
Capital Insight at either December 31, 1993 or December 31, 1994, as all such
invested funds were returned to the Company prior to the end of each of those
years.
In early 1995, the Company again invested a portion of its excess cash
with Capital Insight, with instructions that the funds be invested solely in
U.S. Treasury securities with maturities of one year or less. These instructions
were consistent with the investment guidelines which had been approved by the
Company's Board of Directors in October 1994. However, these instructions were
violated and the funds were used to engage in unauthorized trading in options
and futures. In November 1995, the Company confirmed that it had incurred
non-recurring losses of $15.8 million resulting from these inappropriate and
unauthorized trading activities.
The Company's outside directors retained independent legal counsel and
forensic accountants to determine the facts and circumstances surrounding this
matter. This investigation revealed no improper involvement by any Company
director, officer or employee in the unauthorized trading. Additionally, the
investigation found that the Company was provided with fictitious statements by
Capital Insight, and the Company had actually incurred substantial losses in the
second quarter of 1995. During the third and fourth quarters of 1995, the
unauthorized trading generated significant gains resulting in net trading losses
of $15.8 million for the year. Furthermore, it was determined that the 1994
statements provided by this advisor and relied upon by the Company for its
quarterly reporting were also incorrect. Although total financial results for
1994 were not impacted by these false statements, previously reported 1994
quarterly financial statements did not reflect the proper periods in which the
trading gains and losses occurred. Based on the results of the investigation,
the Company has amended its quarterly statements for both 1994 and 1995 to
reflect the proper reporting of the trading gains and losses. The effect on net
income and net income per share for the quarterly and year end periods in 1995
and 1994 was as follows:
F-16
<PAGE> 60
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED YEAR ENDED
---------------------------------------------------------- -------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31, 1995
------------- ------------- --------------- -------------- -------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Net income as previously reported $ 3,142 $ 3,603 $ 4,505 $ 14,505 $ 1,056
============= ============= =============== ============== =============
Net income before adjustment for
unusual gains (losses) $ 3,142 $ 3,603 $ 4,505 $ 5,218 $ 16,468
Adjustments to properly reflect gains
and (losses) and unauthorized
activity:
Unauthorized trading losses -- (26,774) 1,660 9,287 (15,827)
Provision for income taxes -- 415 -- -- 415
------------- ------------- --------------- -------------- -------------
Net income (loss) after
adjustment for unusual gain (loss) $ 3,142 $ (22,756) $ 6,165 $ 14,505 $ 1,056
============= ============= =============== ============== =============
Net income (loss) per share $ 0.20 $ (1.52) $ 0.36 $ 0.83 $ 0.06
============= ============= =============== ============== =============
Weighted average shares outstanding
used to compute net income (loss)
per share 16,103 14,922 17,051 17,403 16,820
============= ============= =============== ============== =============
Net income per share, as previously
reported $ 0.20 $ 0.22 $ 0.26 $ 0.83 $ 0.06
============= ============= =============== ============== =============
Weighted average shares outstanding used
to compute net income per share, as
previously reported 16,103 16,717 17,051 17,403 16,820
============= ============= =============== ============== =============
</TABLE>
<TABLE>
<CAPTION>
THREE MONTHS ENDED YEAR ENDED
---------------------------------------------------------- -------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31, 1994
------------- ------------- --------------- -------------- -------------
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<S> <C> <C> <C> <C> <C>
Net income as previously reported $ 1,620 $ 1,765 $ 2,239 $ 2,943 $ 8,567
============= ============= =============== ============== =============
Net income before adjustment for
investment gains (losses) $ 1,620 $ 1,765 $ 2,239 $ 2,943 $ 8,567
Adjustments to properly reflect
investment gains (losses):
Investment gains (losses) (9,950) (108) (1,579) 11,637 --
Provision for income taxes 118 120 111 (349) --
------------- ------------- --------------- -------------- -------------
Net income (loss) after adjustment
for investment gains (losses) $ (8,212) $ 1,777 $ 771 $ 14,231 $ 8,567
============= ============= =============== ============== =============
Net income (loss) per share $ (0.66) $ 0.12 $ 0.05 $ 0.91 $ 0.56
============= ============= =============== ============== =============
Weighted average shares outstanding
used to compute net income (loss) per
share 12,375 15,236 15,319 15,694 15,403
============= ============= =============== ============== =============
Net income per share, as previously
reported $ 0.11 $ 0.12 $ 0.15 $ 0.19 $ 0.56
============= ============= =============== ============== =============
Weighted average shares outstanding used
to compute net income per share, as
previously reported 15,305 15,236 15,319 15,694 15,403
============= ============= =============== ============== =============
</TABLE>
F-17
<PAGE> 61
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
15. SUBSEQUENT EVENTS
In January 1996, the Company received a copy of a complaint, filed
derivatively by a Company stockholder on behalf of the Company, naming as
defendants the Company's directors and certain officers, as well as Capital
Insight and Mr. S. Jay Goldinger, its president. The derivative complaint states
causes of action for breach of fiduciary duty, abuse of control, constructive
fraud, gross mismanagement and waste of corporate assets. The suit seeks an
award in the amount of all damages sustained by the Company including the losses
of $15.8 million and legal fees and expenses.
In January 1996, the Company filed suit, in Los Angeles federal court,
against Mr. S. Jay Goldinger and Capital Insight, charging unauthorized trading,
fraudulent misrepresentation, violation of federal securities laws and breach of
fiduciary duties. The suit seeks $15.8 million in damages by reason of the
losses incurred by the Company, as well as punitive damages and legal fees.
The Company does not maintain Directors and Officers' liability
insurance. However, under the terms of its articles of incorporation, the
Company indemnifies its directors and officers for damages and legal fees
arising from litigation matters. The ultimate outcome of these complaints cannot
presently be determined and, accordingly, no provision for any loss or recovery
that may result has been made in the Company's financial statements.
F-18
<PAGE> 62
PAIRGAIN TECHNOLOGIES, INC.
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
ADDITIONS
--------------------------------
BALANCE AT CHARGED TO CHARGED TO
BEGINNING OF COSTS AND OTHER ACCOUNTS BALANCE AT
DESCRIPTION PERIOD EXPENSES DEDUCTIONS END OF PERIOD
--------------- --------------- ---------------- --------------- ---------------
(DOLLARS IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Year ended December 31, 1995:
Allowance for doubtful accounts
receivable $ 298 $ 159 $ 91 $ 79 $ 469
Inventory reserves 1,882 3,353 -- 1,000 4,235
--------------- --------------- ---------------- --------------- ---------------
Total $ 2,180 $ 3,512 $ 91 $ 1,079 $ 4,704
=============== =============== ================ =============== ===============
Year ended December 31, 1994:
Allowance for doubtful accounts
receivable $ 155 $ 150 $ -- $ 7 $ 298
Inventory reserves 1,183 812 -- 113 1,882
--------------- --------------- ---------------- --------------- ---------------
Total $ 1,338 $ 962 $ -- $ 120 $ 2,180
=============== =============== ================ =============== ===============
Year ended December 31, 1993:
Allowance for doubtful accounts
receivable $ 22 $ 150 $ -- $ 17 $ 155
Inventory reserves 241 1,047 -- 105 1,183
--------------- --------------- ---------------- --------------- ---------------
Total $ 263 $ 1,197 $ -- $ 122 $ 1,338
=============== =============== ================ =============== ===============
</TABLE>
S-1
<PAGE> 1
PAIRGAIN TECHNOLOGIES, INC.
EXHIBIT 11.1--COMPUTATION OF EARNINGS PER SHARE
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------------------------------------
PRIMARY EARNINGS PER SHARE 1995 1994 1993
----------------- ----------------- -----------------
(IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C>
Net income $ 1,056 $ 8,567 $ 7,612
================= ================= =================
Calculation of shares outstanding for computing income per share
Weighted average common and common stock equivalents shares
outstanding used in calculating net income per share in
accordance with generally accepted accounting principles 17,083 15,628 10,807
Adjustment to reflect requirements of the SEC:
Effects of SAB 83 -- -- 1,753
Adjustment to reflect the effects of tax benefit repurchase (263) (225) (75)
----------------- ----------------- -----------------
Shares used in computing net income per share 16,820 15,403 12,485
================= ================= =================
Net income per share $ 0.06 $ 0.56 $ 0.61
================= ================= =================
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------------------------------------
FULLY DILUTIVE EARNINGS PER SHARE 1995 1994 1993
----------------- ----------------- -----------------
(IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C>
Net income $ 1,056 $ 8,567 $ 7,612
================= ================= =================
Calculation of shares outstanding for computing income per share
Weighted average common and common stock equivalents shares
outstanding used in calculating net income per share in
accordance with generally accepted accounting principles 17,473 15,876 10,867
Adjustment to reflect requirements of the SEC:
Effects of SAB 83 -- -- 1,753
Adjustment to reflect the effects of tax benefit repurchase (296) (230) (75)
----------------- ----------------- -----------------
Shares used in computing net income per share 17,177 15,646 12,545
================= ================= =================
Net income per share $ 0.06 $ 0.55 $ 0.61
================= ================= =================
</TABLE>
E-1
<PAGE> 1
PAIRGAIN TECHNOLOGIES, INC.
EXHIBIT 23.2--INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in the Registration Statements of
PairGain Technologies, Inc. and subsidiaries on Form S-8 Nos. 33-72792 and
33-96080 of our report dated January 23, 1996, appearing in this Annual Report
on Form 10-K/A of PairGain Technologies, Inc. and subsidiaries for the year
ended December 31, 1995.
DELOITTE & TOUCHE LLP
Costa Mesa, California
April 29, 1996
E-2
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1995
<PERIOD-START> JAN-01-1995
<PERIOD-END> DEC-31-1995
<CASH> 24,576
<SECURITIES> 31,149
<RECEIVABLES> 13,513
<ALLOWANCES> 469
<INVENTORY> 22,522
<CURRENT-ASSETS> 96,161
<PP&E> 10,883
<DEPRECIATION> 4,481
<TOTAL-ASSETS> 105,326
<CURRENT-LIABILITIES> 11,395
<BONDS> 0
0
0
<COMMON> 15
<OTHER-SE> 93,916
<TOTAL-LIABILITY-AND-EQUITY> 105,326
<SALES> 106,173
<TOTAL-REVENUES> 107,224
<CGS> 56,223
<TOTAL-COSTS> 56,223
<OTHER-EXPENSES> 27,469
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 10,238
<INCOME-TAX> 9,182
<INCOME-CONTINUING> 1,056
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,056
<EPS-PRIMARY> .06
<EPS-DILUTED> .06
</TABLE>
