<PAGE> 1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON DC 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
FOR THE THIRD QUARTER ENDED SEPTEMBER 30, 1999
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 (IRS Employer Identification No.)
incorporation of organization)
14402 FRANKLIN AVENUE, TUSTIN, CALIFORNIA 92780-7013
(Address of principal executive offices)
(714) 832-9922
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filed by section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports ), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
THERE WERE 71,184,180 SHARES OF THE REGISTRANT'S COMMON STOCK, PAR VALUE $.0005
PER SHARE, OUTSTANDING ON SEPTEMBER 30, 1999.
1
<PAGE> 2
PAIRGAIN TECHNOLOGIES, INC.
INDEX
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
Part I. Financial Information
Item 1. Financial Statements
Condensed Consolidated Balance Sheets
at September 30, 1999 and December 31, 1998 3
Condensed Consolidated Statements of Operations
for the three and nine months ended September 30, 1999 and 1998 4
Condensed Consolidated Statements of Comprehensive Income (Loss)
for the three and nine months ended September 30, 1999 and 1998 5
Condensed Consolidated Statements of Cash Flows
for the nine months ended September 30, 1999 and 1998 6
Notes to Condensed Consolidated Financial Statements 7
Item 2. Management's Discussion and Analysis
of Financial Condition and Results of Operations 19
Item 3. Quantitative and Qualitative Disclosures About Market Risk 30
Part II. Other Information
Item 1. Legal Proceedings 31
Item 2. Changes in Securities 33
Item 3. Defaults upon Senior Securities 33
Item 4. Submission of Matters to a Vote of Security Holders 33
Item 5. Other Information 33
Item 6. Exhibits and Reports on Form 8-K 33
Signatures 34
</TABLE>
2
<PAGE> 3
PART I: ITEM 1
FINANCIAL INFORMATION
PAIRGAIN TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
ASSETS
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
------------ ------------
<S> <C> <C>
(UNAUDITED)
Current assets:
Cash and cash equivalents $ 94,762 $ 131,923
Short-term investments (Note 3) 105,224 102,011
Accounts receivable 25,955 20,226
Inventories (Note 4) 40,346 34,320
Other current assets and deferred taxes 21,164 18,712
------------ ------------
TOTAL CURRENT ASSETS 287,451 307,192
Property, plant and equipment, net (Note 5) 25,613 19,482
Long-term investments (Note 6) 5,833 1,500
Other assets 194 346
------------ ------------
TOTAL ASSETS $ 319,091 $ 328,520
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $ 6,345 $ 6,358
Accrued expenses (Note 7) 20,453 27,002
Accrued income taxes 2,443 16,119
Current portion of note payable (Note 8) 32 --
------------ ------------
TOTAL CURRENT LIABILITIES 29,273 49,479
Note payable, net of current portion (Note 8) 1,744 --
------------ ------------
TOTAL LIABILITIES 31,017 49,479
------------ ------------
COMMITMENTS AND CONTINGENCIES (NOTE 11)
Stockholders' equity:
Preferred stock, $.001 par value:
Authorized shares - 2,000,000
Issued and outstanding shares - None -- --
Common stock, $.0005 par value:
Authorized shares - 175,000,000
Issued and outstanding shares - 71,184,180 and 70,039,814
at September 30, 1999 and December 31, 1998, respectively 36 35
Additional paid-in capital 159,646 150,807
Deferred compensation (21) (84)
Accumulated other comprehensive loss (Note 9) (1,445) (501)
Retained earnings 129,858 128,784
------------ ------------
TOTAL STOCKHOLDERS' EQUITY 288,074 279,041
------------ ------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 319,091 $ 328,520
============ ============
</TABLE>
See notes to condensed consolidated financial statements.
3
<PAGE> 4
PAIRGAIN TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------------ ------------------------------
1999 1998 1999 1998
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
REVENUES $ 51,193 $ 76,386 $ 173,260 $ 222,421
Cost of revenues 33,423 39,520 104,632 111,387
---------- ---------- ---------- ----------
Gross profit 17,770 36,866 68,628 111,034
---------- ---------- ---------- ----------
Operating expenses:
Research and development 12,815 9,244 33,438 28,602
Selling and marketing 9,081 7,404 25,251 22,193
General and administrative 6,519 3,416 15,199 9,970
---------- ---------- ---------- ----------
Total operating expenses 28,415 20,064 73,888 60,765
---------- ---------- ---------- ----------
INCOME (LOSS) FROM OPERATIONS (10,645) 16,802 (5,260) 50,269
Write-off of long-term investment -- -- (1,500) --
Interest and other income, net 2,213 2,075 7,034 6,267
---------- ---------- ---------- ----------
Income (loss) before income taxes (8,432) 18,877 274 56,536
Provision for (benefit from)
income taxes (Note 1) (4,270) 6,891 (800) 20,636
---------- ---------- ---------- ----------
NET INCOME (LOSS) $ (4,162) $ 11,986 $ 1,074 $ 35,900
========== ========== ========== ==========
Per Share Data (Note 1):
Earnings (loss) per share
Basic $ (0.06) $ 0.17 $ 0.02 $ 0.51
========== ========== ========== ==========
Diluted $ (0.06) $ 0.16 $ 0.01 $ 0.48
========== ========== ========== ==========
Average shares outstanding
Basic 71,141 70,589 70,834 70,084
========== ========== ========== ==========
Diluted 71,141 74,632 75,397 74,982
========== ========== ========== ==========
</TABLE>
See notes to condensed consolidated financial statements.
4
<PAGE> 5
PAIRGAIN TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------- -----------------------------
1999 1998 1999 1998
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Net income (loss) $ (4,162) $ 11,986 $ 1,074 $ 35,900
---------- ---------- ---------- ----------
Other comprehensive income (loss), net of tax:
Foreign currency translation adjustments (629) 65 (446) (156)
---------- ---------- ---------- ----------
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising
during period (78) 173 (498) 361
Reclassification adjustment for gains
(losses) included in net income (loss) -- 38 -- (44)
---------- ---------- ---------- ----------
Net unrealized gains (losses) on securities (78) 211 (498) 317
---------- ---------- ---------- ----------
Other comprehensive income (loss) (Note 9) (707) 276 (944) 161
---------- ---------- ---------- ----------
Comprehensive income (loss) $ (4,869) $ 12,262 $ 130 $ 36,061
========== ========== ========== ==========
</TABLE>
See notes to condensed consolidated financial statements.
5
<PAGE> 6
PAIRGAIN TECHNOLOGIES, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30,
1999 1998
---------- ----------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 1,074 $ 35,900
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization 8,993 7,362
Loss on sale of equipment -- 73
Loss on long-term investment 1,500 --
Change in operating assets and liabilities:
Accounts receivable (5,734) 6,720
Inventories (6,295) (6,799)
Other current assets (2,179) (1,844)
Other assets 63 79
Accounts payable 75 (1,965)
Accrued expenses (6,629) 2,450
Income taxes (4,100) 4,928
---------- ----------
NET CASH (USED IN) PROVIDED BY OPERATING ACTIVITIES (13,232) 46,904
---------- ----------
Cash flows from investing activities:
Net purchases of short-term investments (5,245) (38,406)
Purchases of property and equipment (13,720) (6,729)
Purchase of long-term investment (5,833) --
---------- ----------
NET CASH USED IN INVESTING ACTIVITIES (24,798) (45,135)
---------- ----------
Cash flows from financing activities:
Proceeds from issuance, net of repurchases, of common stock (747) 4,926
Proceeds from note payable 1,786 --
Payments on note payable (10) --
---------- ----------
NET CASH PROVIDED BY FINANCING ACTIVITIES 1,029 4,926
---------- ----------
Effect of exchange rate changes on cash balances (160) (156)
---------- ----------
(Decrease) increase in cash and cash equivalents (37,161) 6,539
Cash and cash equivalents at beginning of period 131,923 111,602
---------- ----------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 94,762 $ 118,141
========== ==========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Income taxes paid $ 7,537 $ 18,194
========== ==========
Income tax refunds $ 4,266 $ 2,508
========== ==========
</TABLE>
See notes to condensed consolidated financial statements.
6
<PAGE> 7
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
1. THE COMPANY AND SIGNIFICANT ACCOUNTING POLICIES
PairGain Technologies, Inc., ("PairGain" or the "Company") designs,
manufactures, markets and supports a comprehensive line of digital
telecommunications products that allow telecommunications carriers and private
network owners to more efficiently provide high-speed digital services to end
users over the large infrastructure of unconditioned copper wires. These
services enable high-speed data transmission for applications such as T1/E1,
high-speed Internet access, telecommuting, wide area networking and video
conferencing.
INTERIM PERIOD ACCOUNTING POLICIES
In the opinion of the Company's management, the accompanying unaudited
condensed consolidated financial statements contain all normal recurring
adjustments necessary to present fairly the financial position as of September
30, 1999, and consolidated results of operations, comprehensive income and cash
flows for the three and nine months ended September 30, 1999 and September 30,
1998. Results of operations for the three and nine months ended September 30,
1999, are not necessarily indicative of results to be expected for the full year
ending December 31, 1999.
Although the Company believes that the disclosures in the accompanying
financial statements are adequate to make the information presented not
misleading, certain information and footnote information normally included in
financial statements prepared in accordance with generally accepted accounting
principles have been condensed or omitted pursuant to the rules and regulations
of the Securities and Exchange Commission (the "SEC"), and these financial
statements should be read in conjunction with the Company's audited consolidated
financial statements included in the Company's Form 10-K for the year ended
December 31, 1998.
PRINCIPLES OF CONSOLIDATION
The condensed consolidated financial statements include the accounts of
the Company and its wholly owned subsidiaries. All significant intercompany
transactions have been eliminated in consolidation.
7
<PAGE> 8
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED)
(UNAUDITED)
TRANSLATION OF FOREIGN CURRENCIES
Foreign subsidiary financial statements are translated into U.S. dollars
in accordance with Statement of Financial Accounting Standards ("SFAS") No. 52,
Foreign Currency Translations. The functional currency of the Company's Swiss
subsidiary is the Swiss Franc. The functional currency of the Company's Canadian
subsidiary is the Canadian Dollar. The functional currency of the Company's
Brazilian Subsidiary is the Brazilian Real. Assets and liabilities of these
subsidiaries are translated at the exchange rate in effect at each year-end.
Income statement accounts are translated at the average rate of exchange
prevailing during the year. Translation adjustments arising from differences in
exchange rates from period to period are included as accumulated other
comprehensive loss within stockholders' equity. Realized gains or losses from
foreign currency transactions are included in operations as incurred, and have
historically been insignificant.
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.
RECLASSIFICATIONS
Certain prior year amounts have been reclassified to conform with the
current year presentation.
FAIR VALUE OF FINANCIAL INSTRUMENTS
Pursuant to SFAS No. 107, Disclosures about Fair Value of Financial
Instruments, the Company is required to estimate the fair value of all financial
instruments included on its balance sheet at September 30, 1999 and December 31,
1998. The Company considers the carrying value of such amounts in the financial
statements to approximate their fair value due to the relatively short period of
time between origination of the instruments and their expected realization or
the overall immateriality of the amounts.
COMPREHENSIVE INCOME
Pursuant to SFAS No. 130, Reporting Comprehensive Income, the Company
has included Condensed Consolidated Statements of Comprehensive Income (Loss)
for the three and nine month periods ended September 30, 1999 and 1998. (See
Note 9)
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.
8
<PAGE> 9
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED)
(UNAUDITED)
SHORT-TERM INVESTMENTS
Short-term investments are accounted for in accordance with SFAS No.
115, Accounting for Certain Investments in Debt and Equity Securities.
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 holding gains
and losses, net of tax, included in accumulated other comprehensive loss in
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, PLANT AND EQUIPMENT
Property, plant 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 to five years. Leasehold improvements are
amortized over the lesser of five years or the life of the lease. Buildings are
depreciated over twenty years.
WARRANTY RESERVE
The Company accrues warranty reserves, which are charged against cost of
revenues, based upon historical rates and estimated future costs.
CONTINGENCIES
The Company is involved from time to time in litigation incidental to
its business. The Company believes that none of its pending litigation matters,
individually or in the aggregate, will have a material adverse effect on its
financial position or results of operations.
REVENUE RECOGNITION
Revenue from product sales is recognized at the time of shipment.
Provision is made currently for estimated product returns. Revenue from royalty
income and technology licensing fees is recognized when earned. Advance payments
are classified as deferred revenue.
9
<PAGE> 10
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED)
(UNAUDITED)
RESEARCH AND DEVELOPMENT COSTS
Research and development costs are expensed as incurred.
INCOME TAXES
Income taxes are provided at the rate expected to be in effect for the
entire year.
PER SHARE INFORMATION
Pursuant to SFAS No. 128, Earnings Per Share, ("SFAS No. 128"), the
Company provides dual presentation of "Basic" and "Diluted" earnings per share
("EPS"). SFAS No. 128 replaced "Primary" and "Fully diluted" EPS under
Accounting Principles Board ("APB") Opinion No. 15.
Basic EPS excludes dilution from common stock equivalents and is
computed by dividing income available to common stockholders by the weighted
average number of common shares outstanding for the period. Diluted EPS reflects
the potential dilution from common stock equivalents, similar to fully diluted
EPS, but uses only the average stock price during the period as part of the
computation. Due to the net loss recorded for the three months ended September
30, 1999, the impact of common stock equivalents was excluded in the computation
of diluted EPS for the three month period as the effect would have been
anti-dilutive. A pro forma diluted EPS calculation, which included the impact of
common stock equivalents for the third quarter, was used to calculate diluted
EPS for the nine months ended September 30, 1999.
The following table reconciles the weighted average shares outstanding
for basic and diluted earnings per share for the periods presented.
10
<PAGE> 11
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
----------------------------- -----------------------------
1999 1998 1999 1998
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Net income (loss) $ (4,162) $ 11,986 $ 1,074 $ 35,900
========== ========== ========== ==========
Basic earnings (loss) per common share:
Weighted average of common shares outstanding 71,141 70,589 70,834 70,084
========== ========== ========== ==========
Basic earnings (loss) per common share $ (0.06) $ 0.17 $ 0.02 $ 0.51
========== ========== ========== ==========
Diluted earnings (loss) per common share:
Weighted average of common shares outstanding 71,141 70,589 70,834 70,084
Weighted average of common share equivalents:
Weighted average warrants outstanding N/A 20 8 28
Weighted average options outstanding N/A 10,725 11,554 10,983
Anti-dilutive options N/A (4,197) (523) (2,853)
Shares assumed to be repurchased using the
treasury stock method N/A (1,814) (5,638) (2,446)
Shares assumed to be repurchased to reflect the
effects of tax benefits N/A (691) (838) (814)
---------- ---------- ---------- ----------
Weighted average number of common and common
equivalent shares 71,141 74,632 75,397 74,982
========== ========== ========== ==========
Diluted earnings (loss) per common share $ (0.06) $ 0.16 $ 0.01 $ 0.48
========== ========== ========== ==========
</TABLE>
STATEMENT OF CASH FLOWS
The Company recorded noncash tax benefits from exercises of common stock
options aggregating approximately $2.6 million and $5.2 million during the nine
months ended September 30, 1999 and 1998, respectively. The Company also
recognized noncash tax benefits of $7.0 million, related to the exercise of
common stock warrants in 1993 and 1995, for which no benefit had been previously
recorded as there was doubt as to the ultimate realizable benefit. During the
quarter ended September 30, 1999, the Company concluded an audit with the
Internal Revenue Service in the course of which these benefits were allowed.
ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company accounts for stock-based awards to employees using the
intrinsic value method in accordance with APB Opinion No. 25, Accounting for
Stock Issued to Employees.
11
<PAGE> 12
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED)
(UNAUDITED)
2. CONCENTRATION OF CREDIT RISK, MAJOR CUSTOMERS AND PRODUCTS
The Company engages in business activity in only one operating segment
which entails the design, manufacture and sale of a comprehensive line of
digital telecommunications products that allow telecommunications carriers and
private network owners to more efficiently provide high-speed digital services
to end users over the large infrastructure of unconditioned copper wires. The
Company offers a wide variety of products for sale which are manufactured at
common production facilities. The Company sells all of its products to a similar
customer base made up of telecommunications carriers and private network owners
through a common sales organization.
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. 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.
Comparative product revenues as a percentage of sales during the three
and nine months ended September 30, 1999 and 1998 were:
<TABLE>
<CAPTION>
THREE MONTHS ENDED SEPTEMBER 30, NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------- --------------------------------
1999 1998 1999 1998
---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
HiGain / ETSI 53% 64% 54% 65%
Subscriber Carrier 29% 24% 28% 22%
Campus 10% 6% 9% 6%
Megabit Access 4% 2% 3% 2%
OEM 2% 2% 3% 2%
Royalty 2% 2% 3% 3%
---------- ---------- ---------- ----------
Total Revenues 100% 100% 100% 100%
========== ========== ========== ==========
</TABLE>
Export sales represented 29% and 20% of product revenue during the three
months ended September 30, 1999 and 1998, respectively. During the first nine
months of 1999 and 1998, export sales represented 24% and 20% of product
revenues, respectively. Product sales by geographical region are summarized as
follows:
12
<PAGE> 13
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
---------------------------- ----------------------------
1999 1998 1999 1998
---------- ---------- ---------- ----------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
United States $ 35,827 $ 60,082 $ 126,734 $ 173,138
Canada 7,343 6,308 18,625 17,919
Other international 7,391 8,396 22,487 25,741
---------- ---------- ---------- ----------
Total product revenues 50,561 74,786 167,846 216,798
Royalty income and technology licensing fees 632 1,600 5,414 5,623
---------- ---------- ---------- ----------
Total revenues $ 51,193 $ 76,386 $ 173,260 $ 222,421
========== ========== ========== ==========
</TABLE>
3. SHORT-TERM INVESTMENTS
Short-term investments as of September 30, 1999 and December 31, 1998
are summarized as follows:
<TABLE>
<CAPTION>
GROSS GROSS
UNREALIZED UNREALIZED
COST GAINS LOSSES FAIR VALUE
----------- ----------- ----------- -----------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
SEPTEMBER 30, 1999
Municipal bonds $ 105,422 $ -- $ (198) $ 105,224
=========== =========== =========== ===========
DECEMBER 31, 1998
Municipal bonds $ 101,432 $ 579 $ -- $ 102,011
=========== =========== =========== ===========
</TABLE>
There were no realized gains or losses on short-term investments during
the nine months ended September 30, 1999 and 1998. Unrealized holding (losses)
gains on short-term investments, net of tax, included in accumulated other
comprehensive loss in stockholders' equity at September 30, 1999 and December
31, 1998 were ($131,000) and $367,000, respectively.
4. INVENTORIES
Inventories consist of the following:
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
------------ ------------
(IN THOUSANDS)
<S> <C> <C>
Finished goods $ 17,831 $ 18,489
Work in process 6,542 1,647
Raw materials 15,973 14,184
------------ ------------
$ 40,346 $ 34,320
============ ============
</TABLE>
13
<PAGE> 14
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED)
(UNAUDITED)
5. PROPERTY AND EQUIPMENT
Property and equipment consist of the following:
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
------------ ------------
<S> <C> <C>
Land $ 1,995 $ --
Building 2,939 --
Production and engineering equipment 25,701 22,169
Computers, software, furniture and other 19,886 16,155
Leasehold improvements 5,841 4,129
------------ ------------
56,362 42,453
Less accumulated depreciation and amortization (30,749) (22,971)
------------ ------------
$ 25,613 $ 19,482
============ ============
</TABLE>
6. LONG-TERM INVESTMENTS
In July 1999, the Company made a minority investment in @Link
Communications, a Wisconsin-based Competitive Local Exchange Carrier (CLEC)
which provides xDSL-based data communications networking services for
businesses, internet service providers and network integrators. The Company
purchased 3,874,416 shares of @Link's Series A Convertible Preferred Stock for
an aggregate of $833,000.
In March 1999, the Company made a minority investment in ANDA Networks,
Inc., a California-based private company which develops next generation access
systems. The Company purchased 2,500,000 shares of ANDA's Series C Preferred
Stock for an aggregate of $5.0 million.
In June 1996, the Company made a minority investment in E/O Networks of
Hayward, California ("E/O"). E/O supplied low-density fiber optic access
equipment to public carriers both domestically and internationally. The Company
purchased 545,000 shares of E/O's Series D Preferred Stock for an aggregate of
$3.0 million. In the fourth quarter of 1998, the Company recorded an impairment
adjustment of $1.5 million to reflect an impairment in its investment in E/O.
During the second quarter of 1999, E/O filed for protection under
Chapter 11 of the U.S. Bankruptcy Act. Following notification of the bankruptcy
filing, the Company wrote-off the remaining $1.5 million investment in E/O
during the second quarter of 1999.
The Company accounts for long-term investments using the cost method.
However, when it is determined that an investment is permanently impaired, the
Company records an impairment adjustment.
14
<PAGE> 15
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED)
(UNAUDITED)
7. ACCRUED EXPENSES
Accrued expenses consist of the following:
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1999 1998
------------ ------------
<S> <C> <C>
Accrued compensation and related expenses $ 9,520 $ 9,343
Accrued warranty 5,595 7,413
Deferred revenue -- 3,500
Other accrued expenses 5,338 6,746
------------ ------------
$ 20,453 $ 27,002
============ ============
</TABLE>
8. NOTE PAYABLE
In May 1999, the Company purchased its Tustin, California headquarters
facility. The purchase price was $4.9 million, which was paid with $3.1 million
in cash and assumption of a $1.8 million note. The note bears interest at 8.25%
and is due December 1, 2005.
9. OTHER COMPREHENSIVE INCOME (LOSS) AND ACCUMULATED OTHER COMPREHENSIVE INCOME
(LOSS)
The gross amount and related tax effects allocated to each component of
other comprehensive income (loss) consist of:
<TABLE>
<CAPTION>
THREE MONTHS ENDED SEPTEMBER 30,
-------------------------------------------------------------------------------------
1999 1998
------------------------------------------ ----------------------------------------
GROSS AMOUNT INCOME TAX NET AMOUNT GROSS AMOUNT INCOME TAX NET AMOUNT
------------ ------------ ------------ ------------ ------------ ------------
<S> <C> <C> <C> <C> <C> <C>
Foreign currency
translation adjustments $ (629) $ -- $ (629) $ 65 $ -- $ 65
Unrealized gains (losses)
on securities:
Unrealized holding gains
(losses) arising during (117) (39) (78) 272 99 173
period
Reclassification
adjustment for gains -- -- -- 60 22 38
included in net income
(loss)
------------ ------------ ------------ ------------ ------------ ------------
Net unrealized gains
(losses) on securities (117) (39) (78) 332 121 211
------------ ------------ ------------ ------------ ------------ ------------
Other comprehensive
income (loss) $ (746) $ (39) $ (707) $ 397 $ 121 $ 276
============ ============ ============ ============ ============ ============
</TABLE>
15
<PAGE> 16
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30,
-------------------------------------------------------------------------------------------------
1999 1998
---------------------------------------------- ----------------------------------------------
GROSS AMOUNT INCOME TAX NET AMOUNT GROSS AMOUNT INCOME TAX NET AMOUNT
------------ ------------ ------------ ------------ ------------ ------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C>
Foreign currency
translation adjustments $ (446) $ -- $ (446) $ (156) $ -- $ (156)
Unrealized gains (losses)
on securities:
Unrealized holding gains
(losses) arising during (777) (279) (498) 569 208 361
period
Reclassification
adjustment for gains -- -- -- (69) (25) (44)
included in net income
(loss)
------------ ------------ ------------ ------------ ------------ ------------
Net unrealized gains
(losses) on securities (777) (279) (498) 500 183 317
------------ ------------ ------------ ------------ ------------ ------------
Other comprehensive
income (loss) $ (1,223) $ (279) $ (944) $ 344 $ 183 $ 161
============ ============ ============ ============ ============ ============
</TABLE>
The components of accumulated other comprehensive loss at September 30,
1999 and December 31, 1998 included foreign currency translation adjustments and
unrealized gains (losses) on securities.
<TABLE>
<CAPTION>
FOREIGN ACCUMULATED
CURRENCY UNREALIZED OTHER
TRANSLATION GAINS (LOSSES) COMPREHENSIVE
ADJUSTMENT ON SECURITIES LOSS
------------ ------------- -------------
(IN THOUSANDS)
<S> <C> <C> <C>
Balance at December 31, 1998 $ (868) $ 367 $ (501)
Other comprehensive loss for the nine
months ended September 30, 1999 (446) (498) (944)
------------ ------------ ------------
Balance at September 30, 1999 $ (1,314) $ (131) $ (1,445)
============ ============ ============
</TABLE>
16
<PAGE> 17
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED)
(UNAUDITED)
10. SETTLEMENT OF LITIGATION
Harris Corporation
In April 1998, Harris Corporation ("Harris") filed a complaint in
California Superior Court against the Company and others, alleging claims for
breach of contract, breach of the implied covenant of good faith and fair
dealing, breach of fiduciary duty, intentional or negligent interference of
contractual relations and prospective economic advantage and violation of
California Business and Professions Code Section 17200 et seq. These claims
related to an alleged agreement giving Harris the right to buy the Company's
Falcon 1A chipset and the impingement of this alleged agreement by the Company
in entering into a licensing agreement in March 1998 with respect to the Falcon
1A chipset. Under this licensing agreement, the Company granted a third party
the right to manufacture and sell the Falcon 1A chipset to the Company and
others. Harris's complaint sought specific performance, declaratory relief, an
accounting and unspecified compensatory and punitive damages. Harris's claim was
later amended to include a claim for fraud and the Company filed a
cross-complaint for declaratory relief.
In May 1999, the Company reached an agreement with Harris to settle and
dismiss the complaints described above. Under the terms of the settlement, the
Company agreed to pay the sum of $1.5 million to Harris and both parties agreed
to dismiss their actions with prejudice. The Company recorded the impact of the
settlement in May 1999 and it is included in general and administrative expense
for the nine months ended September 30, 1999.
U.S. Attorney's Office and the SEC
On September 2, 1999, the Company announced a tentative agreement with
the U.S. Attorney's office for failing to implement a system of internal
accounting controls and to maintain accurate books and records. The agreement
with the U.S. Attorney's office was finalized on November 8, 1999. In addition
to the agreement reached with the U.S. Attorney's office, the Company, its
Chairman and its Chief Financial Officer also reached a settlement with the SEC.
These settlements relate to the 1995 loss of $15.8 million of the Company's
funds through its former investment manager, S. Jay Goldinger, and his firm,
Capital Insight, Inc., the disclosure of such investments and the disclosure of
the loss incurred.
Based upon these settlements, the Company accrued $1.6 million for
fines, reimbursement of the government's cost of investigation and other
expenses. The $1.6 million accrual is included in general and administrative
expense in the three and nine months ended September 30, 1999.
The Company's Board of Directors authorized the settlement of all
outstanding claims with the U.S. Attorney's office and the SEC in the interest
of avoiding protracted litigation and in order to bring closure to these
matters.
17
<PAGE> 18
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(CONTINUED)
(UNAUDITED)
11. Subsequent Events
In November 1999, the Company announced its decision to sell its
Microelectronics engineering group. In this regard, the Company signed a Mutual
Release and Settlement Agreement with a third party to terminate a Memorandum of
Understanding between the two companies for a joint technology development. In
consideration of the settlement, the Company agreed to pay $2.5 million to the
other party. The impact of this settlement will be recorded in the Company's
financial statements for the quarter and year ended December 31, 1999.
18
<PAGE> 19
PART I: ITEM 2
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
PAIRGAIN TECHNOLOGIES, INC.
The following discussion and other sections of this Form 10-Q may contain
forward-looking statements within the meaning of the Private Securities
Litigation Reform Act of 1995, Section 21E of the Securities Exchange Act of
1934, as amended, and Section 27A of the Securities Act of 1933, as amended,
and is subject to the safe harbors created by those sections. These
forward-looking statements are subject to significant risks and
uncertainties, including without limitation those identified in PairGain's
Form 10-K for the year ended December 31, 1998, as filed with the Securities
and Exchange Commission (the "SEC"). Such risks and uncertainties may cause
actual results to differ materially and adversely from those discussed in
such forward-looking statements. The forward-looking statements within this
Form 10-Q are identified by words such as "believes," "anticipates,"
"expects," "intends," "may" and other similar expressions. However, these
words are not the exclusive means of identifying such statements. In
addition, any statements that refer to expectations, projections or other
characterizations of future events or circumstances are forward-looking
statements. We disclaim any obligation to publicly release the results of
any revisions to these forward-looking statements which may be made to
reflect events or circumstances occurring subsequent to the filing of this
Form 10-Q with the SEC or otherwise to revise or update any oral or written
forward-looking statement that may be made from time to time by or on behalf
of PairGain.
The information contained in this Form 10-Q is not a complete description of
our business or the risks associated with an investment in PairGain. You are
urged to carefully review and consider the various disclosures made by us in
this Form 10-Q and in our other filings with the SEC, including our 1998
Form 10-K, that attempt to advise interested parties of certain risks,
uncertainties and other factors that may affect our business.
RESULTS OF OPERATIONS (quarter and nine months ended September 30, 1999,
compared to quarter and nine months ended September 30, 1998)
REVENUES
Revenues for the quarter ended September 30, 1999 were $51.2 million,
compared to $76.4 million in the corresponding 1998 quarter. Product revenues
for the HiGain, PG-Flex and PG-2 product lines and OEM modules decreased when
compared to the 1998 quarter. Unit shipments for HiGain and PG-2 decreased 20%
and 53%, respectively; unit shipments of PG-Flex systems and OEM modules
decreased 14% and 9%, respectively. Average selling prices for the third quarter
of 1999 for these four product lines decreased when compared to average selling
prices during the third quarter of 1998, with HiGain average selling prices
decreasing 41% compared to the prior year. Product revenues for the ETSI,
PG-Plus, megabit access and Campus product lines increased over the third
quarter of 1998. Third quarter 1999 revenue from sales of the ETSI products
increased 16%, the result of a 44% increase in unit shipments offset by a 19%
decrease in average selling prices. Revenue from sales of the PG-Plus products
increased 89% in the 1999 quarter over the prior year quarter, despite a 22%
decrease in average selling prices. Revenue from shipments of Campus products
increased 16% over the same quarter in 1998, as unit shipments increased 48%
offset by a 22% decrease in average selling prices.
19
<PAGE> 20
Revenue from royalty income and technology licensing fees was $632,000 for the
September 1999 quarter, compared to $1.6 million for the third quarter of 1998,
which included a $1.0 million development and licensing fee for our Falcon chip.
Revenues for the nine months ended September 30, 1999, decreased to
$173.3 million compared to $222.4 million for the first nine months of 1998.
Product revenues decreased 23%, which resulted primarily from a decrease in
average selling prices for the first nine months of 1999 across virtually all
product lines when compared to average selling prices during the first nine
months of 1998. During the first nine months of 1999, unit sales volume of our
T1/E1 access products increased 8% over the same period in 1998, but 11%
declines in average selling prices resulted in lower T1/E1 revenues in 1999.
Sales of our PG-Plus product line in the first nine moths of 1999 were 58%
higher than PG-Plus sales in the same 1998 period, while sales of our PG-Flex
product line were essentially flat. Sales of our Campus and megabit access
products increased 6% and 12%, respectively, when compared to levels sold during
the first nine months of 1998. Sales of our PG-2 products declined 42% from last
year. Revenue from royalty income and technology licensing fees for the first
nine months of 1999 was $5.4 million compared to $5.6 million in the first nine
months of 1998.
GROSS PROFIT
Gross profit represents total revenues for a period, including royalty
income and technology licensing fees, less the cost of revenues for such period.
Cost of revenues represents primarily product costs, together with associated
overhead expenditures and provisions for inventory and related reserves. Gross
profit decreased to $17.8 million for the three months ended September 30, 1999
compared to $36.9 million for the same period in the prior year. As a percentage
of revenues, gross profit was 35% for the quarter ended September 30, 1999, a
decline from 48% in the third quarter of 1998. Gross margin for the first nine
months of 1999 decreased to $68.6 million, or 40% of revenues, compared to
$111.0 million, or 50% of revenues, in the first nine months of 1998. The
decrease in gross margin and gross margin percentage was largely the result of
decreases in average selling prices and increased manufacturing variances caused
by decreased product volume. These effects were partially offset by our cost
reduction efforts. We expect that increased competition will continue to place
downward pressure on average selling prices. To the extent that we are unable to
offset these decreases with our cost reduction efforts, or to introduce and sell
new products with higher gross product margins, we will continue to experience a
decline in our gross margin.
OPERATING EXPENSES
Operating expenses increased $8.4 million, or 42%, for the three months
ended September 30, 1999 as compared with the same period in the prior year. For
the nine month period, operating expenses increased $13.1 million, or 22%, over
the prior year. Included in the third quarter of 1999 is a $1.6 million accrual
for a tentative settlement with federal agencies related to the Company's 1995
investment losses. In addition to the accrual for the government settlement,
operating expenses for the first nine months of 1999 include the impact of a
$1.5 million litigation settlement recorded in the second quarter (see Note 10,
Litigation Settlement, in the Notes to the Condensed Consolidated Financial
Statements in this Report). These settlement costs and costs relating to the
addition of personnel represented the majority of the increases over the 1998
expense levels. As a percentage of revenues, operating expenses were 56% and
43%, respectively, in the three and nine month periods in 1999, compared to 26%
and 27% in the respective 1998 periods. Operating expenses,
20
<PAGE> 21
excluding the government settlement, increased $6.8 million, or 34%, for the
three months ended September 30, 1999 as compared with the same period in the
prior year. For the nine month period, operating expenses, excluding the
litigation settlement and the government settlement, increased $10.0 million, or
16%, over the prior year. As a percentage of revenues, operating expenses,
excluding the government settlement, were 52% for the three month period in
1999. In the first months of 1999, operating expenses, excluding the government
settlement and the litigation settlement, were 41% of revenues.
Research and development expense increased $3.6 million, or 39%, for the
quarter ended September 30, 1999 and $4.8 million, or 17%, for the first nine
months of 1999 over each of the comparable 1998 periods. These increases were
primarily due to the addition of personnel including those specific to
technology development for the subscriber carrier and megabit access product
lines, and outside development consulting fees, temporary labor costs and costs
for prototype materials for the HDSL2 and megabit access product lines. Research
and development expense as a percentage of revenues was 25% in the 1999 quarter
and 19% in the nine month period, compared to 12% and 13% in the corresponding
1998 periods.
Selling and marketing expense increased $1.7 million, or 23%, for the
quarter ended September 30, 1999 and $3.1 million, or 14%, for the first nine
months of 1999 over each of the comparable 1998 periods. The increase in expense
levels was primarily due to the addition of personnel and the associated
increase in salaries, benefits and travel expenses, which was partially offset
by a reduction in advertising, technical documentation and channel marketing
expenses. Selling and marketing expense as a percentage of revenues was 18% and
15% in the 1999 quarter and nine month period, respectively, compared to 10% in
each of the corresponding 1998 periods.
General and administrative expense increased $3.1 million, or 91%, and
$5.2 million, or, 52%, respectively, for the quarter and nine months ended
September 30, 1999, as compared with the same periods in the prior year.
Included in the third quarter of 1999 is a $1.6 million accrual for a tentative
settlement with federal agencies related to the Company's 1995 investment losses
(see Note 10, Litigation Settlement, in the Notes to the Condensed Consolidated
Financial Statements in this Report). In addition to the accrual for the
government settlement, general and administrative expense for the first nine
months of 1999 includes the impact of a $1.5 million litigation settlement
recorded in the second quarter. These settlement costs and costs relating to the
addition of information management personnel along with increases in
expenditures for computer software and hardware maintenance and payments to
outside firms assisting us with upgrades to our software systems and our Year
2000 compliance project represented the majority of the increases over the 1998
expense levels. As a percentage of revenues, general and administrative expense
was 13% and 9% in the 1999 quarter and nine month period, respectively, compared
to 4% in each of the respective corresponding 1998 periods. General and
administrative expense, excluding the government settlement, increased $1.5
million, or 44%, for the three months ended September 30, 1999 as compared with
the same period in the prior year. For the nine month period, general and
administrative expense, excluding the litigation settlement and the government
settlement, increased $2.1 million, or 21%, over the prior year. As a percentage
of revenues, general and administrative expense, excluding the government
settlement, were 10% for the three month period in 1999. In the first months of
1999, general and administrative expense, excluding the government settlement
and the litigation settlement, were 7% of revenues
21
<PAGE> 22
INCOME (LOSS) FROM OPERATIONS
As a result of the above, loss from operations for the quarter ended
September 30, 1999 was $10.6 million compared to income of $16.8 million for the
1998 quarter. Loss from operations for the nine months ended September 30, 1999
was $5.3 million compared to income of $50.3 million for the nine months of
1998. As a percentage of revenues, income from operations was 22% for the 1998
quarter and 23% for the first nine months of 1998. Excluding the effect of the
government settlement in the 1999 quarter, loss from operations was $9.0
million, and excluding the government settlement and the litigation settlement,
loss from operations was $2.2 million for the first nine months of 1999.
INTEREST AND OTHER INCOME, NET
Net interest income increased to $2.3 million and $7.1 million for the
three and nine months ended September 30, 1999, respectively, from $2.1 million
and $6.3 million in the corresponding 1998 periods. These increases resulted
primarily from higher average cash levels available for investment. Interest
expense was $56,000 and $63,000 in the three and nine months ended September 30,
1999, and was related primarily to the assumption of a note in the purchase of
our Tustin, California headquarters facility (see Note 8). There was no interest
expense during 1998.
WRITE-OFF OF LONG-TERM INVESTMENT
In June 1996, we made a minority investment in E/O Networks of Hayward,
California ("E/O"). E/O supplied low-density fiber optic access equipment to
public carriers both domestically and internationally. We purchased
approximately 545,000 shares of E/O's Series D Preferred Stock for an aggregate
of $3.0 million. In the fourth quarter of 1998, we recorded an impairment
adjustment of $1.5 million to reflect an impairment in our investment in E/O.
During the second quarter of 1999, E/O filed for protection under
Chapter 11 of the U.S. Bankruptcy Act. Following notification of the bankruptcy
filing, we wrote-off the remaining $1.5 million investment in E/O during the
second quarter of 1999.
PROVISION FOR (BENEFIT FROM) INCOME TAXES
During the third quarter of 1999, we recorded a benefit from income
taxes of $4.3 million to bring the benefit for the first nine months of 1999 to
$800,000. We recorded a benefit from income taxes because of the current period
loss and its impact on our anticipated effective tax rate for the year. In 1998,
we recorded a provision for income taxes of $6.9 million and $20.6 million for
the quarter and nine months ended September 30, 1998, respectively. Our
effective tax rate for 1998 was 37%.
NET INCOME (LOSS) AND EARNINGS (LOSS) PER SHARE
Net loss for the three months ended September 30, 1999 was $4.2 million
compared to net income of $12.0 million for the 1998 quarter. Net income for the
first nine months of 1999 was $1.1 million compared to $35.9 million for the
first nine months of 1998.
22
<PAGE> 23
Basic loss per share for the three months ended September 30, 1999 was
$0.06 per share compared to basic earnings per share of $0.17 per share for the
1998 quarter. Basic earnings per share for the nine months ended September 30,
1999 were $0.02 per share compared to $0.51 per share for the first nine months
of 1998.
The weighted average number of common shares outstanding was 71.1
million and 70.6 million for the three months ended September 30, 1999 and 1998,
respectively. The weighted average number of common shares outstanding was 70.8
million and 70.1 million for the first nine months of 1999 and 1998,
respectively. This increase in common shares was attributable to the exercise of
stock options and warrants and the issuance of shares under the Employee Stock
Purchase Plan, offset by shares repurchased.
Diluted earnings per share take into account the dilutive effects of
common stock options and warrants, except when the effect would be
anti-dilutive. Due to the net loss recorded for the three months ended September
30, 1999, the impact of common stock equivalents was excluded in the computation
of diluted EPS for the three month period as the effect would have been
anti-dilutive. Diluted earnings per share for the nine months ended September
30, 1999 were $0.01 per share and the weighted average number of common and
common equivalent shares outstanding was 75.4 million. A pro forma diluted EPS
calculation, which included the impact of common stock equivalents for the third
quarter, was used to calculate diluted EPS for the nine months ended September
30, 1999.
Diluted earnings per share were $0.16 per share and $0.48 per share for
the three and nine months ended September 30, 1998. The weighted average number
of common and common equivalent shares outstanding was 74.6 million and 75.0
million for the three and nine months in 1998.
23
<PAGE> 24
SUBSEQUENT EVENTS
In November 1999, the Company announced its decision to sell its
Microelectronics engineering group. In this regard, the Company signed a Mutual
Release and Settlement Agreement with a company to terminate a Memorandum of
Understanding between the two companies for a joint technology development. In
consideration of the settlement, the Company agreed to pay $2.5 million to the
other party. The impact of this settlement will be recorded in the Company's
financial statements for the quarter ended December 31, 1999.
24
<PAGE> 25
LIQUIDITY AND CAPITAL RESOURCES
As of September 30, 1999, we had $200.0 million in cash, cash
equivalents and short-term investments and $258.2 million in working capital.
These figures represent a decrease of $33.9 million in cash, cash equivalents
and short-term investments and an increase of $465,000 in working capital over
the year ended December 31, 1998. The decrease in cash, cash equivalents and
short-term investments was primarily attributable to cash used in operations of
$13.2 million, capital expenditures of $13.7 million, long-term investments of
$5.8 million and repurchases of PairGain common stock of $7.5 million, offset by
the assumption of a note for $1.8 million related to the purchase of our
headquarters facilities and the receipt of $6.8 million from the issuance of
stock under our 1993 Employee Stock Option Plan and Employee Stock Purchase
Plan.
Accounts receivable increased to $26.0 million at September 30, 1999,
compared to $20.2 million at December 31, 1998. Accounts receivable days
outstanding were 46 at September 30, 1999 compared to 30 at December 31, 1998.
Gross inventories increased $1.3 million to $53.0 million at September 30, 1999,
compared to $51.7 million at December 31, 1998. Raw materials decreased $2.7
million, while finished goods and work in process increased $4.0 million.
Reserves for inventory obsolescence, excess quantities, cost reductions and test
and evaluation inventories decreased to $12.7 million at September 30, 1999
compared to $17.4 million at December 31, 1998. The primary reason for the
decrease in these reserves was the disposal of obsolete inventories. Current
liabilities decreased to $29.3 million at September 30, 1999 from $49.5 million
at December 31, 1998, primarily due to a reduction in accrued income taxes as a
result of an $800,000 income tax benefit, a $3.3 million net payment of income
taxes, the recognition of a $7.0 million tax benefit from the exercise of common
stock warrants and the recognition of a $2.6 million tax benefit from the
exercise of common stock options.
Capital expenditures during the nine month period ended September 30,
1999 were $13.7 million, consisting primarily of the purchase of our Tustin,
California headquarters facility for $4.9 million, and purchases of computer
hardware and software, machinery and test equipment. The $4.9 million purchase
of the Tustin facility was paid with $3.1 million in cash and assumption of a
$1.8 million note. The note bears interest at 8.25% and is due December 1, 2005.
Capital expenditures in the first nine months of 1998 aggregated approximately
$6.7 million, primarily related to expenditures for computer equipment and
software, machinery and test equipment and leasehold improvements to a data
center located next door to our Tustin headquarters.
During the third quarter of 1999, we vacated one of our previous
facilities in Tustin and moved into a 41,000 square foot facility located near
our headquarters facility. We spent approximately $674,000 in leasehold
improvements at this new facility in 1999 and plan to spend approximately
$700,000 during the fourth quarter of 1999.
On October 14, 1998, we announced that our Board of Directors approved a
plan to repurchase up to 7,000,000 shares, or approximately 10%, of our
outstanding common shares. During the nine months ended September 30, 1999, we
repurchased 370,000 shares at a cost of approximately $3.8 million, bringing the
total repurchases under the plan to 1,400,000 shares at a cost of approximately
$10.9 million. Future repurchases of shares under this plan, if any, will be
made with existing cash balances.
25
<PAGE> 26
In July 1998, the 1993 Employee Stock Option Plan was amended to include
an automatic share increase feature which allowed us to repurchase shares on the
open market with cash proceeds received from the exercise of options under the
Stock Option Plan. During the nine months ended September 30, 1999, we
repurchased 400,000 shares at a cost of approximately $3.7 million, bringing the
total repurchases under the Option Plan to 421,000 shares at a cost of
approximately $4.0 million.
We accrued $1.6 million during the third quarter of 1999 for fines,
reimbursement of the government's costs of investigation and other expenses
associated with settlements with the U.S. Attorney's Office and the SEC (See
Note 10, Settlement of Litigation, in Notes to the Condensed Consolidated
Financial Statements in this Report). Of this amount, we paid $1.4 million in
November 1999, and will pay the remainder during the fourth quarter of 1999 and
the first quarter of 2000.
Also during the fourth quarter of 1999, we will pay $2.5 million to a
third party under terms of a Mutual Release and Settlement Agreement regarding
a joint technology development. The impact of this settlement will be recorded
in the Company's financial statements for the quarter ended December 31, 1999.
(See Note 11, Subsequent Events, in Notes to the Condensed Consolidated
Financial Statements in this Report).
We believe that our current cash, cash equivalents and short-term
investment balances and internally generated cash flow will be sufficient to
meet our working capital and capital expenditure requirements through 1999. To
the extent that our existing resources, together with future earnings, are
insufficient to fund our future activities, we may need to raise additional
funds through public or private financings.
26
<PAGE> 27
YEAR 2000 READINESS DISCLOSURE
Many of the world's computer systems currently record years in a
two-digit format. Such computer systems will be unable to properly interpret
dates beyond the year 1999, which could lead to business disruptions globally
(the "Year 2000 Issue"). The potential costs and uncertainties associated with
the Year 2000 Issue will depend on a number of factors, including software,
hardware and the nature of the industry in which a company operates.
Additionally, companies must coordinate with other entities with which they
electronically interact, such as customers, creditors and suppliers.
The following discussion addresses the manner in which the Year 2000
Issue affects PairGain, including: our state of readiness; the costs to address
our Year 2000 Issues; the risks of our Year 2000 Issues; and our contingency
plans.
Our State of Readiness
In determining our state of readiness regarding the Year 2000 Issue,
management is assessing compliance in the following areas: our products, our
internal systems and the readiness of our key suppliers and major customers.
We have implemented a Year 2000 Project (the "Project") to address and
correct Year 2000 compliance issues with regard to our operating systems and the
readiness of our suppliers and customers. The Project is administered by a
Steering Committee, which includes senior representatives from operations,
engineering, finance, information management and independent outside
consultants. The Project is composed of five phases:
- Awareness;
- Inventory and Assessment;
- Replacement and Upgrade;
- Testing and Validation; and
- Implementation and Post-Implementation.
The AWARENESS phase is intended to ensure that our senior management,
Board of Directors, associates and customers are aware of the Year 2000 Issue
and the possible problems it may cause. Initial contact has been completed, and
communication will continue throughout the span of the Project and beyond
December 31, 1999 to ensure successful business operation after the Year 2000.
The INVENTORY AND ASSESSMENT phase of the Project will assess the
readiness of all computer hardware and software that we, including all of our
departments, business partners, properties and interfaces to vendors, use in all
aspects of our business operations. This includes, but is not limited to,
information technology systems and non-information technology systems (which may
include embedded technology such as microcontrollers) as follows:
27
<PAGE> 28
<TABLE>
<CAPTION>
Information Technology Systems Non-Information Technology Systems
- ---------------------------------------- -------------------------------------
<S> <C>
- - Personal computer hardware, software - Building systems including
and applications elevators, HVAC, life safety
- - Mainframe hardware, software and systems, public utilities and
applications others
- - Telephone systems - Facsimile and photocopy machines
- - Local Area Networks hardware, - Alarms
software and applications - Access systems and door locks
</TABLE>
Our products that are currently being sold or that have been sold in the
past will be classified into three main categories.
- No Impact: Units with no internal electronics or processing capabilities
or units with processing capabilities that do not perform date math
calculations.
- Minor Impact: Units that possess date math processing capabilities, but
any Year 2000 related failure would either have no impact on the actual
performance of the unit (i.e., incorrect date display only), or would
require a one-time user intervention to rest the unit once the clock
turned from December 31, 1999 to January 1, 2000. Units in this category
will be reviewed on a case by case basis by the Product Manager to
determine whether or not testing is warranted.
- Major Impact: Units that possess significant date math processing
capabilities. Every unit in this classification will be tested for Year
2000 compliance.
We have adopted BellCore GR-2945-CORE, Issue 1 standard for definition
of "Year 2000 Compliant" products as the majority of our products are sold to
Bell operating companies. Testing of our products is being completed by
Nationally Recognized Test Labs. To date, all PairGain products tested have been
Year 2000 compliant without modification. If any products are subsequently
determined not to be compliant, we have pledged to immediately notify all
customers who have purchased any of the non-complaint products and to upgrade or
replace any of the installed, non-compliant products in accordance with our
standard warranty policy, regardless of whether the equipment is still in the
warranty period.
Inventory of our internal systems has been completed. An assessment of
the readiness of the external entities with which we interface such as vendors,
customers, payment systems and others is ongoing. Letters were sent to 100 of
our suppliers. Responses have been received from 90% of those companies with 35%
indicating they were already Year 2000 compliant and the remaining indicating
that they are still working on the issue. We have multiple sources for almost
every part that we use in our products. If any one supplier cannot, for one
reason or another, comply with the Year 2000 requirements, we anticipate being
able to procure the parts from another supplier who is compliant. We plan to
work closely with those suppliers who provide sole source components to ensure
that they are Year 2000 compliant before any interruption occurs or will address
the sole source issue in other ways.
Our major customers have disclosed their intent to be Year 2000
compliant by December 31, 1999 in recent SEC filings and on public websites. We
continue to have formal communications with all of our significant suppliers and
large customers to determine the extent, if any, to which we are vulnerable to
those third parties' failure to remedy their own Year 2000 Issue. There can be
no guarantee that our systems or the systems of other companies will be
compliant in a timely manner. We are aggressively seeking resolution to those
situations which might carry a material impact and might adversely affect us.
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<PAGE> 29
During the REPLACEMENT AND UPGRADE phase of the Project, our internal
software and systems that are not Year 2000 compliant will be repaired or
replaced. In addition, vendor monitoring will be performed to ensure and oversee
efforts made by vendors regarding Year 2000 compliance. It is our intention to
gain Year 2000 compliance assurances with all new contracts and leases, renewals
of existing contracts and purchases of software applications.
During the TESTING AND VALIDATION phase, a standard test methodology
will be used to ensure that all components of our products correctly handle the
century date changes and that those changes do not adversely impact current
functionality and operation of the components. A checklist of ten minimum
requirements was created to certify an internal system or application is
compliant. Testing and validation of these systems will continue through the end
of 1999 to ensure successful business operations.
During the IMPLEMENTATION AND POST-IMPLEMENTATION phase, components of
our products will be implemented into production upon completion of upgrade and
testing, and operated in a production environment. Constant monitoring and
communication will also be a focus point and objective. A system change control
process will be used to ensure that subsequent changes are not made to Year 2000
compliant components unless those changes have been tested for compliance. A
team will be established to cater to all questions and issues that may arise
during and after January 1, 2000. Post-implementation, including continued
monitoring and communication, will continue through March 31, 2000 to ensure our
successful operation after January 1, 2000.
The Costs to Address Our Year 2000 Issues
The total cost to address our Year 2000 Issue is not expected to be
material to our financial condition. We are using both internal and external
resources to reprogram, or replace, and test our programs and systems for Year
2000 modifications. We do not separately track internal costs incurred on the
Year 2000 Project, which principally include payroll and related costs for our
Information Management employees that are being expensed as incurred. Excluding
internal costs, we have budgeted approximately $1.1 million for activities
specific to the Year 2000 compliance of our information systems. An additional
$5.0 million has been budgeted for various other upgrades to software and
hardware related to operational functionality which will also make those systems
Year 2000 compliant. Purchased hardware and software will be capitalized in
accordance with our standard capitalization policy. All other costs related to
the Project are being expensed as incurred. Budgeted amounts are expected to be
spent during 1998 and 1999 but will not be incurred equally over all phases of
the Project. As of September 30, 1999 we had spent approximately $5.3 million of
these budgeted amounts. These costs are being funded through operating cash
flows.
The Risks of Our Year 2000 Issues
We have placed great importance on our Year 2000 Project and anticipate
that our systems will be Year 2000 compliant before the end of 1999. The
following are representative of the types of risks that could result in the
event that we are not fully compliant by the end of 1999:
- Legal risks, including customer, supplier, employee or shareholder
lawsuits over failure to deliver contracted services or product failure.
- Loss of sales due to failure to meet customer quality expectations or
inability to ship products.
29
<PAGE> 30
- Increased operational costs due to manual processing, data corruption or
disaster recovery.
- Inability to bill or invoice customers and collect payments in a timely
manner.
In addition to the Year 2000 compliance issues we face with respect to
our own systems, we face risks that our vendors' and/or customers' systems,
which are not directly under our control, may not become compliant prior to
January 1, 2000. In addition, if certain public infrastructure interruptions in
areas such as utilities (electricity, water or telephone), transportation,
banking or government, result in a disruption of our service, our operations at
individual facilities could be impacted for the duration of the disruption.
As companies shift their information technology budgets toward Year 2000
compliance requirements, it is possible that a reduction in spending for
telecommunications equipment could occur in 1999. Because we market our products
principally to telephone companies in the United States and Canada, a reduction
in telecommunications equipment spending could reduce our revenues and have a
material adverse effect on our financial condition and results of operations.
Our Contingency Plans
A contingency plan has not yet been developed for dealing with the most
reasonably likely worst case scenario with respect to our Year 2000 compliance,
and such scenario has not yet been clearly identified. It is impossible to fully
assess the potential consequences in the event service interruptions from
suppliers occur or in the event that there are disruptions in such
infrastructure areas as utilities, communications, transportation, banking and
government. Assuming no major public infrastructure service disruption occurs,
we believe that we will be able to manage our Year 2000 transition without a
material effect on our results of operations or financial condition. We have not
completed contingency plans in the event that a disruption in the public
infrastructure does occur.
The above information is based upon management's best estimates, which
were derived utilizing numerous assumptions of future events, including the
continued availability of certain resources, third party modification plans and
other factors. There can be no assurance that these estimates can be achieved
and actual results could differ materially from those anticipated. Specific
factors that might cause such material differences include, but are not limited
to, the availability and cost of personnel trained in this area, the ability to
locate and correct all relevant computer codes, the nature and amount of
programming required to upgrade or replace each of the affected programs, the
rate and magnitude of related labor and consulting costs, and the success of our
external customers, suppliers and governmental agencies in addressing the Year
2000 Issue.
The above discussion regarding the Year 2000 Issue contains many
statements that are "forward-looking" within the meaning of the Private
Securities Litigation Reform Act of 1995. When used in the Year 2000 discussion,
the words "believes," "expects," "estimates," "planned," "could" and similar
expression are intended to identify forward-looking statements. Forward-looking
statements included, without limitation, our expectations as to when we will
complete the remediation and testing phases of our Year 2000 Project as well as
any contingency plans we formulate; our estimated cost of achieving Year 2000
readiness; and our belief that our internal systems and equipment will be Year
2000 compliant in a timely manner.
30
<PAGE> 31
PART I: ITEM 3
QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
PAIRGAIN TECHNOLOGIES, INC.
At September 30, 1999, we had an investment portfolio of fixed income
securities, including those classified as cash equivalents, of $197.3 million.
These securities are subject to interest rate fluctuations. An increase in
interest rates could adversely affect the market value of our fixed income
securities.
We limit our exposure to interest rate and credit risk by establishing
and strictly monitoring clear policies and guidelines for our fixed income
portfolios. At the present time, the maximum average maturity of our overall
investment portfolio is limited by policy to 36 months. The guidelines also
establish credit quality standards, limits on exposure to one issue, issuer, as
well as the type of instrument. Due to the limited duration and credit risk
criteria established in our guidelines, the exposure to market and credit risk
is not expected to be material. Accordingly, we do not use derivative financial
instruments in our investment portfolio to manage interest rate risk.
31
<PAGE> 32
PART II. OTHER INFORMATION
PAIRGAIN TECHNOLOGIES, INC.
Item 1. Legal Proceedings
As discussed in Item 3. Legal Proceedings in our Annual Report on Form
10-K for the year ended December 31, 1998, the U.S. Attorney's office
and the Securities and Exchange Commission have been investigating S.
Jay Goldinger and Capital Insight, Inc. in connection with their 1995
loss of nearly $100 million of their clients' funds, including $15.8
million of PairGain's funds.
As discussed in Item 1. Legal Proceedings in our Quarterly Report on
Form 10-Q for the first quarter ended March 31, 1999, the U.S. Attorney
had named PairGain, Charles S. Strauch, our Chairman, and Charles W.
McBrayer, our Chief Financial Officer, as targets of its criminal
investigation.
On November 8, 1999, PairGain announced a final agreement with the U.S.
Attorney's office. Pursuant to the agreement we pled guilty, in U.S.
District Court in Santa Ana, California, to one felony count for failing
to implement a system of internal accounting controls and to maintain
accurate books and records in violation of 15 U.S.C. Sections 78m(b) (2)
and 78ff, and 18 U.S.C. Section 2, for aiding and abetting or causing
these acts to be done.
Under the terms of the agreement, we agreed to pay a fine of $1,000,000,
to reimburse the government $400,000 for the costs of its investigation
and to pay a $200 special assessment. We also agreed to four years
probation. During the term of probation, we:
- agreed not to commit a federal, state or local crime;
- agreed to file a Form 8-K with the SEC within ten days to disclose the
nature of the offense committed, the fact of conviction, the nature of
the punishment and the steps that will be taken to prevent the
recurrence of similar offenses;
- agreed to submit financial statements reviewed by our outside
accountants in connection with the filing of our quarterly reports with
the SEC. In addition, each member of the Board
32
<PAGE> 33
of Directors, with the exception of the Chairman of the Board, will be
required to sign each of our quarterly reports during the probationary
period and certify that he or she has read and reviewed the report and
believes it to be true and correct. The current Chief Financial Officer
and the current Chairman of the Board may not exclusively direct the
preparation of the quarterly reports or financial statements during this
period, but may participate in their review; and
- agreed to engage an expert approved by the Probation Office and the U.S.
Attorney's Office to conduct an examination, at our expense, in order
to: (i) assess whether our internal accounting controls are adequate
such that transactions are recorded as necessary to maintain
accountability for our assets; (ii) assess whether our books, records
and accounts accurately and fairly reflect our transactions and
dispositions of our assets; and (iii) assess whether we properly
disclose our financial transactions in a timely manner in the
appropriate fashion to the appropriate persons or agencies. In addition,
the expert will review our procedures for making and maintaining
corporate documents.
The expert is to make recommendations deemed appropriate to improve our
system of internal accounting controls and record-keeping. The expert
will report the recommendations to the Probation Office and the U.S.
Attorney's Office. The Probation Office will determine which
recommendations must be implemented. We must then implement the
recommendations identified by the Probation Office as soon as reasonably
practical, but in no event later than 60 days, and shall report on the
progress of such implementation to the Probation Office. During the term
of our probation, we are also required to permit the expert to conduct
follow-up examinations on an annual basis to determine that we have
implemented and maintained the recommendations identified by the
Probation Office.
Since the first quarter of 1996, we have requested our outside
accountants and legal counsel to review our quarterly financial
statements and public disclosures, including financial press releases
and periodic SEC reports, prior to publication. In addition, we have
regular meetings with our outside accountants to discuss the accounting
and disclosure of transactions in our books, records and financial
statements. Also, in the first quarter of 1996, we retained our outside
accountants to assist and make recommendations in the preparation of our
"Investment Policy Guidelines" which, among other things, require a
comprehensive system of documentation and record-keeping. These
Guidelines require comprehensive management reports on the status of our
investments to provide assurance of the accuracy of our financial
records and periodic reports to the Board of Directors regarding
compliance with the provisions of the Guidelines. PairGain first adopted
these Guidelines in April 1996.
In addition to the agreement reached with the U.S. Attorney's Office
discussed above, PairGain, our Chairman, Charles S. Strauch, and our
Chief Financial Officer, Charles W. McBrayer, also reached a settlement
with the SEC. Without admitting or denying the SEC's findings, we
consented to an SEC order directing us to cease and desist from
committing or causing any violations or future violations of the
antifraud, periodic reporting, books and records and internal accounting
control provisions. Messrs. Strauch and McBrayer agreed, also without
admitting or denying the SEC's allegations, not to violate the antifraud
provisions. In addition, Mr. McBrayer agreed not to violate the periodic
33
<PAGE> 34
reporting, books and records and internal accounting control provisions.
Messrs. Strauch and McBrayer have also agreed to pay civil money
penalties of $25,000 each.
PairGain's Board of Directors authorized the settlement of all
outstanding claims with the U.S. Attorney's office and the SEC in the
interest of avoiding protracted litigation and in order to bring closure
to these matters.
The agreements with the U.S. Attorney's office and the SEC were
announced in a press release issued on November 8, 1999, a copy of which
is attached to our Form 8-K filed with the SEC on November 15, 1999.
In May 1999, we reached an agreement with Harris Corporation ("Harris")
to settle and dismiss the lawsuit brought by Harris against PairGain and
others, which lawsuit is described in our Quarterly Report on Form 10-Q
for the quarterly period ended March 31, 1998. Under the terms of the
settlement, we agreed to pay the sum of $1.5 million to Harris, and both
parties agreed to dismiss their actions with prejudice. The impact of
the settlement was recorded in our financial statements for the quarter
ended June 30, 1999.
We are involved from time to time in litigation incidental to our
business. We believe that none of our pending litigation matters,
individually or in the aggregate, will have a material adverse effect on
our financial position or results of operations.
Item 2. Changes in Securities
None.
Item 3. Defaults upon Senior Securities
None.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Item 5. Other Information
None.
Item 6. Exhibits and Reports on Form 8-K
(A) Exhibits:
27.1 Financial Data Schedule
(B) Reports on Form 8-K
A Form 8-K was filed on November 15, 1999 citing Item 5, Other
Events, to record the final settlement between the Company, Charles
S. Strauch and Charles W. McBrayer, the U.S. Attorney's Office and
the Securities and Exchange Commission.
34
<PAGE> 35
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the under
signed thereunto duly authorized.
<TABLE>
<CAPTION>
Signature Title Date
- ----------------------------------- ------------------------------------------- -------------------
<S> <C> <C>
/s/ Michael Pascoe President, Chief Executive Officer November 15, 1999
- ----------------------------------- and Director
Michael Pascoe (Principal Executive Officer)
(Registrant)
/s/ Charles W. McBrayer Executive Vice President, November 15, 1999
- ----------------------------------- Chief Financial Officer and Secretary
Charles W. McBrayer (Principal Financial Officer)
/s/ Robert R. Price Vice President and Corporate Controller November 15, 1999
- ----------------------------------- (Principal Accounting Officer)
Robert R. Price
/s/ Howard S. Flagg Executive Vice President and Director November 15, 1999
- -----------------------------------
Howard S. Flagg
/s/ Benedict A. Itri Executive Vice President, November 15, 1999
- ----------------------------------- Chief Technical Officer and Director
Benedict A. Itri
/s/ Howard G. Bubb Director November 15, 1999
- -----------------------------------
Howard G. Bubb
/s/ Robert C. Hawk Director November 15, 1999
- -----------------------------------
Robert C. Hawk
/s/ Robert A. Hoff Director November 15, 1999
- -----------------------------------
Robert A. Hoff
/s/ B. Allen Lay Director November 15, 1999
- -----------------------------------
B. Allen Lay
</TABLE>
35
<PAGE> 36
EXHIBIT INDEX
<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
<S> <C>
27.1 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-START> JAN-01-1999
<PERIOD-END> SEP-30-1999
<CASH> 94,762
<SECURITIES> 105,224
<RECEIVABLES> 25,955
<ALLOWANCES> 0
<INVENTORY> 40,346
<CURRENT-ASSETS> 287,451
<PP&E> 56,362
<DEPRECIATION> 30,749
<TOTAL-ASSETS> 319,091
<CURRENT-LIABILITIES> 29,273
<BONDS> 0
0
0
<COMMON> 36
<OTHER-SE> 288,038
<TOTAL-LIABILITY-AND-EQUITY> 319,091
<SALES> 167,846
<TOTAL-REVENUES> 173,261
<CGS> 104,632
<TOTAL-COSTS> 104,632
<OTHER-EXPENSES> 73,888
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (5,534)
<INCOME-PRETAX> 274
<INCOME-TAX> (800)
<INCOME-CONTINUING> 1,074
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,074
<EPS-BASIC> .02
<EPS-DILUTED> .01
</TABLE>
