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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 10-K
(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, 1998
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
------------------- ---------------
COMMISSION FILE NUMBER 0-22202
PAIRGAIN TECHNOLOGIES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 33-0282809
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
14402 FRANKLIN AVENUE, TUSTIN, CALIFORNIA 92780 (Address of
principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (714) 832-9922
- --------------------------------------------------------------------------------
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
COMMON STOCK, $.0005 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/A or any
amendment to this Form 10-K/A. [ ]
Based on the closing sale price on The Nasdaq Stock MarketSM on February
26, 1999, the aggregated market value of the voting stock held by non affiliates
of the registrant was $593,718,000. The number of shares outstanding of the
registrant's Common Stock, $.0005 par value, was 70,383,545 on February 26,
1999.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's Proxy Statement for the Annual Meeting of
Stockholders currently expected to be held on June 16, 1999, as filed with the
Commission pursuant to Regulation 14A, are incorporated by reference in Part III
of this Report.
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GLOSSARY OF TERMS USED IN THIS ANNUAL REPORT
10BASE-T--The Institute of Electrical and Electronic Engineers (IEEE) 802.3
specification for Ethernet over unshielded twisted pair cable.
2B1Q--2 binary, one quarternary. A one-dimensional modulation for transmitting 2
bits per symbol. 2B1Q is a 4-level PAM (pulse amplitude modulation) system used
for HDSL, S-HDSL, and ISDN BRI.
ACCESS PROVIDER--Organization providing and maintaining network services for
subscribers.
ASYMMETRIC DIGITAL SUBSCRIBER LINE (ADSL)--A method of transmitting at speeds of
approximately 8 Mbps in one direction over a single copper telephone line and at
speeds of approximately 1 Mbps in the other direction.
ANSI T1.403--The performance-monitoring, data-link and network-interface
requirements for ESF CSUs as defined by the Exchange Carriers Standards
Association. T1.403 specifies automatic performance reports transmitted to the
network once per second via the data link. (In an E1 environment, Performance
Monitor is the equivalent of T1.403).
ANSI T1.413--The interface standard for DMT ADSL.
ASYNCHRONOUS TRANSFER MODE (ATM)--A key emerging technology that uses
fixed-length packets or cells to switch voice, data and video traffic over the
local- and wide-area network.
BACKBONE NETWORK--The main artery or link for a private or public network.
Typically the backbone carries a greater quantity of traffic (data, voice, video
or some combination), is capable of carrying significant bandwidth and is the
network to which small/remote networks/links are attached.
BANDWIDTH--A term now used to describe the capacity or amount of traffic (data,
voice or video) a certain communications line is capable of accommodating.
Bandwidth is often measured or stated in kilobits per second (kbps) or Megabits
per second (Mbps) for data transmission.
BASIC ENCODING RATE (BER)--Rule for encoding data units described in ANS.1.
BASIC RATE INTERFACE (BRI)--Reference ISDN.
BIT ERROR RATE (BER)--The ratio of received bits that are in error.
BITS PER SECOND (bps)--The number of bits passing a point every second. The
transmission rate for digital information.
BRIDGE/ROUTER--A device that can provide the functions of a bridge, router or
both concurrently. Bridge/router can route one or more protocols, such as TCP/IP
and/or XNS, and bridge all other traffic.
BROADBAND--Data transmission at a high rate, generally greater than T1 speeds
(1.5 Mbps). This allows the transmission of voice, data and video signals over a
single medium.
CABLE MODEM--Modem designed for use on TV coaxial cable circuit.
CAMPUS AREA NETWORK--A network which encompasses interconnectivity between
floors of a building and/or buildings in a confined geographic area such as a
campus or industrial park. Such networks would not require public rights-of-way
and operate over fairly short distances.
CAP--Carrierless Amplitude Phase Modulation. A two-dimensional line code used in
ADSL.
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GLOSSARY OF TERMS
CONTINUED
CENTRAL OFFICE (CO)--A local telephone company office which connects to the main
system where circuit switching of customer lines occurs.
COMPETITIVE ACCESS PROVIDER (CAP)--Alternative access provider to Inter-Exchange
Carriers (IXCs).
CIRCUIT SWITCHING--Switching system in which a dedicated physical circuit path
must exist between sender and receiver for the duration of the "call". Used
heavily in the phone company network, circuit switching often is contrasted with
contention and token passing as a channel-access method, and with message
switching and packet switching as a switching technique.
CLEC--A Competitive Local Exchange Carrier. Provides competitive local access
services to Local Exchange Carrier (LEC) or Incumbent LEC (ILEC).
CONCENTRATOR--Device that serves as a wiring hub in star-topology network.
Sometimes refers to a device containing multiple modules of network equipment.
COPPEROPTICS--A PairGain trademark referring to the functionality of the our
xDSL technology. In essence, with PairGain xDSL products, users can achieve
fiber optic-quality signal transmission over copper cable.
CROSSTALK--Interference that can occur when wire pairs within the same bundles
are used for separate signal transmission. Especially evident with repeatered
T1/E1 transmission.
CUSTOMER PREMISES EQUIPMENT (CPE)--Terminating equipment, such as terminals,
phones, routers and modems, supplied by the phone company, installed at customer
sites, and connected to the phone company network.
DEDICATED LINE--A transmission circuit installed between two sites of a private
network and "open," or available, at all times.
DIGITAL SIGNAL 0 (DS-0)--(1) North American Digital Hierarchy signaling standard
for transmission at 64 kbps. (2) Digital Signal Level 0 is the worldwide
standard transmission rate (64 kbps) for PCM digitized voice channels. 24 DS-0s
exist in each DS-1 (T1) signal.
DIGITAL SIGNAL 1 (DS-1)--North American Digital Hierarchy signaling standard for
transmissions at 1.544 Mbps. Supports 24 simultaneous DS-0 signals. Term often
used interchangeably with T-1, although DS-1 signals may be exchanged over other
transmission systems.
DIGITAL SUBSCRIBER LINE (DSL)--Another name for an ISDN BRI channel. Operated at
the Basic Rate Interface (with two 64 kbps circuit switched channels and one 16
kbps packet switched channel), the DSL can carry both voice and data signal at
the same time, in both directions, as well as the signaling data used for call
information and customer data. Also used to represent other DSL-based solutions,
including HDSL and ADSL.
DIGITAL SUBSCRIBER LINE ACCESS MULTIPLEXER (DSLAM)--Delivers high-speed Internet
access, voice and video with a frame-switching network.
DIGITAL SIGNAL PROCESSING (DSP)--The processing of signal transmission using
digital techniques.
DMT--Discrete Multitone. In DMT, a large number of low-rate carrier frequencies
are QAM-modulated at a low rate to transmit a single high-rate data stream. DMT
is used for ADSL and proposed for VDSL.
E1--The term for a digital facility used for transmitting data over a telephone
network at 2.048 Mbps. The European equivalent of T1.
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GLOSSARY OF TERMS
CONTINUED
E3--The highest transmission rate generally available in the European digital
infrastructure (34 Mbps).
ENTERPRISE NETWORK--A large typical corporate network under the auspices of one
organization.
ETHERNET--A baseband LAN specification invented by Xerox Corporation and
developed jointly by Xerox, Intel and Digital Equipment Corporation. Ethernet
networks typically operate at 10 Mbps or 100 Mbps over twisted pair, coaxial or
fiber optic cable. Ethernet transmission standards are produced by IEEE and are
referred to as IEEE 802.3.
FIBER OPTICS--A method for the transmission of information (sound, pictures,
data). Light is modulated and transmitted over high purity, hair-thin fibers of
glass. The potential bandwidth capacity of fiber optic cable is much greater
than that of conventional cable or copper wire.
FIBER OPTIC CABLE--A transmission medium that uses glass or plastic fibers,
rather than copper wire, to transport data or voice signals. The signal is
imposed on the fiber via pulses (modulation) of light from a laser or a
light-emitting diode (LED). Because of its high bandwidth and lack of
susceptibility to interference, fiber-optic cable is used in long-haul or other
applications where electromagnetic noise is problematic.
FRACTIONAL T1--A WAN communications service that provides the user with some
portion of a T1 circuit which has been divided into 24 separate 64 kbps
channels.
FRAME RELAY--A streamlined packet switching protocol designed to provide
high-speed frame or packet switching with minimal delay and efficient bandwidth
usage.
G.992.2 SPLITTERLESS ASYMMETRICAL DIGITAL SUBSCRIBER LINE TRANSFERS
(G.LITE)--International standard adopted by the International Telecommunications
Union as a splitterless version of the ANSI standard T1.413 "full-rate" ADSL.
GIGABITS PER SECOND (GBPS)--1,000,000,000 (one billion) bits per second. A
measure of transmission speed.
HIGH-BIT-RATE DIGITAL SUBSCRIBER LINE (HDSL)--Designed to be a cost-effective
method of delivering T1/E1 line speeds over unconditioned copper cable, without
the use of repeaters.
HDSL2--Second generation HDSL designed to deliver full T1 performance over a
single twisted pair cable, with the same reach, robustness and spectral
compatibility of two-pair HDSL technology. HDSL2 is also designed with an
interoperability standard.
INTEGRATED ACCESS CONCENTRATOR--Telecommunications platform that combines
multiple technologies in order to support voice, data and video transmission
from a single entity. This enables service providers to offer a wider variety of
services as a lower cost while maintaining profitability.
INTEGRATED SERVICES DIGITAL NETWORK (ISDN)--a CCITT networking standard devised
to provide end-to-end, simultaneous handling of digitized voice and data traffic
on the same link.
INTEREXCHANGE CARRIER (IXC)--(1) A long-distance telephone company offering
circuit-switched, leased-line or packet-switched service or some combination.
(2) Any individual, partnership, association, joint-stock company, trust,
governmental entity or corporation engaged for hire in interstate or foreign
communication by wire or radio, between two or more exchanges.
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GLOSSARY OF TERMS
CONTINUED
INTERFACE--(1) The point at which two systems or pieces of equipment are
connected. (2) A connection between two systems or devices. A shared boundary
defined by common physical interconnection characteristics, signal
characteristics and meaning of interchange signals.
ISP--Internet Service Provider
INTRANET--A private network that uses Internet software and standards.
KILOBITS PER SECOND (KBPS)--1,000 bits per second. A measure of transmission
speed.
LAST MILE--A reference to the local loop, the distance between a local telco
wire center and the subscriber, a distance of about 0 to 3 miles (0 to 4
kilometers).
LIFELINE POTS--A minimal telephone service designed to extend "lifeline"
communications service to the subscriber in case of emergency, particularly when
electric power is lost.
LINE CODE--Any method of converting digital information to analog form for
transmission on a telephone line. 2B1Q, DMT, and CAP are all line codes.
LOCAL AREA NETWORK (LAN)--The means by which a community of computer users can
share information and resources electronically. Many communications protocols
are used to accomplish this, the most prevalent of which is Ethernet.
LOCAL LOOP--Refers to the physical copper pair or loop of wire from the
telephone company's wire center to the subscriber.
MODULATION--Process by which signal characteristics are transformed to represent
information. Types of modulation include frequency modulation (FM), where
signals of different frequencies represent different data values.
MULTIPLEXER (MUX)--A device that enables several data streams to be sent over a
single physical line.
NETWORK MANAGEMENT SYSTEM (NMS)--A system responsible for managing at least part
of a network. NMSs communicate with agents to help keep track of network
statistics and resources.
PACKET SWITCHED NETWORK--A network in which data is transmitted in units called
packets. The packets can be routed individually over the best available network
connection and reassembled to form a complete message at the destination.
PAIR GAIN--The multiplexing of "x" phone conversations over a lesser number of
physical lines. "Pair gain" is the number of conversations obtained, divided by
the number of wire pairs used by the system.
POTS--Plain old telephone service.
POSTAL, TELEGRAPH AND TELEPHONE COMPANY (PTT)--Generic term for a provider of
these services. A governmental agency in many countries.
QAM--Quadrature Amplitude Modulation. A two-dimensional modulation scheme used
for ADSL, cable modems and proposed for VDSL. CAP is a special case of QAM.
G-4
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GLOSSARY OF TERMS
CONTINUED
RADSL--Rate-Adaptive DSL. A simple extension of ADSL to encompass a wide variety
of data rates depending on the line's transmission capability. Rate adaption can
be achieved via CAP or DMT ADSL.
REGIONAL BELL OPERATING COMPANIES (RBOCS) --The local exchange carrier telephone
companies created after AT&T divestiture and subsequent mergers; presently,
there are five: Bell Atlantic, BellSouth, Ameritech, SBC Communications and U S
WEST.
REMOTE LAN ACCESS--A data communications such as a corporate or campus
environment in which the computer networks can be accessed remotely via public
telecommunications networks.
REPEATER--An electronic device used to regenerate digital signals and restore
signal quality across a certain distance of cable.
SDSL--Symmetric, single-pair 2B1Q-based xDSL.
S-HDSL--Single-pair transmission using HDSL technology, normally 2B1Q.
SIMPLE NETWORK MANAGEMENT PROTOCOL (SNMP)--A network management standard
established to allow multi-vendor networks to be managed more easily using
common management tools.
SPANNING TREE--An algorithm, standardized by the IEEE to prevent bridge loops
and allow backup network paths.
SYMMETRIC TRANSMISSION--Transmission in which a channel sends and receives data
at the same rate.
SYNCHRONOUS OPTICAL NETWORK (SONET)--A networking standard that utilizes fiber
optics to create backbone networks, capable of transmitting at very high speeds
and accommodating gigabit-level bandwidth.
T1--Digital transmission facility operating with a nominal bandwidth of 1.544
Mbps. Also known as Digital Signal Level 1 (D1). Composed of 24 DS-0 channels in
many cases. T1 is the most common digital transmission technique in North
America.
T3--Digital transmission facility operating at 45 Mbps bandwidth. Composed of 28
DS-1 channels in many cases.
TELECOMMUTER--Person who performs work at home while linked to the office by
means of a telecommunications-equipped computer system.
TRANSMISSION CONTROL PROTOCOL/INTERNET PROTOCOL (TCP/IP)--A reliable, full
duplex, connection-oriented end to end transport protocol running on top of IP.
TRANSPARENT LAN SERVICE--Service offered by a provider that is used to connect
LANs at geographically separated sites. "Transparent" means the connection is
invisible to the user.
TWISTED PAIR--Cable consisting of two 18 to 24 AWG (American Wire Gauge) solid
copper strands twisted around each other. The twisting provides a measure of
protection from electromagnetic and radio-frequency interference.
VLSI--Very large scale integration.
WIDE AREA NETWORK (WAN)--A network which encompasses interconnectivity between
devices over a wide geographic area.
XDSL--High-speed Digital Subscriber Line technology. A family of technologies
that provide high bandwidth over copper twisted pair. Varieties of xDSL include
HDSL, ADSL and RADSL.
G-5
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PART I
ITEM 1. BUSINESS.
PairGain Technologies, Inc. ("PairGain"), founded in 1988, is a leading
provider of telecommunications products based on xDSL technology. We design,
manufacture, market and support products that allow telecommunications carriers
and private network owners to expand the capabilities of copper cable and more
efficiently provide high-speed digital services to end users over the large
existing infrastructure of unconditioned copper wires. These services enable
high-speed data transmission for applications such as T1/E1, POTS, high-speed
Internet access, telecommuting, local and wide area networking and video
conferencing.
RISK FACTORS
In addition to the historical information, this annual report contains
forward-looking statements which involve risk and uncertainties, including but
not limited to economic, competitive, governmental and technological factors
affecting our operations, markets, products, services and prices and other
factors discussed in our filings with the Securities and Exchange Commission.
WE WILL CONTINUE TO REDUCE THE AVERAGE SALES PRICES OF OUR PRODUCTS.
In mid-1993, we began reducing the average sales prices of our HiGain(R)
products in an effort to increase demand and to compete with expected price
competition. We reduced our prices on HiGain products 42% during 1998, 30%
during 1997 and 17% during 1996. We expect to continue to reduce the average
sales prices of all of our products, including HiGain. Our ability to maintain
or increase revenues depends in part on our ability to increase unit sales of
our HiGain and other product lines in an effort to make up for lost revenues
resulting from price reductions. Gross margins on our products may also be
reduced if we cannot reduce our per unit costs of production. We cannot be
certain that we will be able to:
o increase unit sales volumes;
o introduce and sell new products with higher margins; or
o reduce per unit costs.
Our failure to maintain our margins and increase our product revenues could
seriously harm our business, financial condition and results of operations. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," "Business--Products" and "--Competition."
WE CONTINUE TO RELY ON REVENUES FROM OUR HIGAIN PRODUCTS.
Our HiGain product revenues represented 59% of our total revenues in
1998, 67% in 1997 and 76% in 1996. We expect that revenues from HiGain products
may continue to account for a majority of our future sales. However, we may not
be able to maintain these sales levels. A decline in demand for HiGain products
may result from, among other things:
o competition;
o industry use of fiber cable; or
o technological change.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations," "Business--Products."
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OUR FUTURE OPERATING RESULTS MAY FLUCTUATE.
Our future operating results may fluctuate due to various factors,
including, but not limited to:
o the timing of shipments to major customers;
o the timing of new product announcements by us or our competitors;
o variations in our sales channels;
o variations in the mix of the products we sell;
o price competition;
o the availability and cost of key components;
o the timing of personnel hirings;
o the market acceptance of new and enhanced versions of our products;
and
o the timing of final product approvals from any of our major
customers.
WE HAVE LIMITED BACKLOG ORDERS.
We generally ship products within a short time after receipt of an
order. We typically do not have a significant backlog of unfilled orders. As a
result, revenues in any quarter are substantially dependent on orders booked and
shipped in that quarter. Our expense levels are relatively fixed in the
short-term. Our inability to accurately predict future product demand may affect
our operating margins and the ability to support our expense levels. We intend
to continue to increase operating expenditures and inventories as we expand our
levels of operations. We may be unable to adjust spending in a timely manner to
compensate for any unexpected shortfall of orders. If demand is lower than our
expectations or we experience material delays in our customers orders, there
would be an immediate adverse impact on our business and results of operations.
WE FACE INTENSE COMPETITION.
We face intense and increasing competition. Competitive pressures could
reduce the demand for our products, cause us to further reduce our prices,
increase our expenses or cause delays or cancellations of our customer's orders.
High-bit rate digital subscriber line technology, commonly known as
HDSL, uses high-speed digital signal processing to compensate for distortions
caused by sending a signal over a copper wire. All manufacturers of products
based on HDSL technology face competition from fiber optic and conventional
repeatered systems as alternate solutions for the delivery of high-bandwidth
services to end users. As telephone companies continue to install fiber cable
and conventional repeatered systems to provide high-bandwidth service from the
local telephone company office to end users, the demand for HDSL products may
decline. In addition, as fiber optics are more readily deployed to replace HDSL
systems, companies may reuse the replaced systems and will not need to buy new
systems from us.
The group of digital subscriber line technologies, including HDSL, are
commonly referred to as xDSL. We are devoting substantial resources in the
development and marketing of xDSL products. The market for xDSL-based products
is emerging and will change dramatically over a very short time. The xDSL
products that we develop may not be commercially successful. See
"Business--Industry Background" and "--Competition."
WE SUBSTANTIALLY DEPEND ON OUR LARGEST CUSTOMERS.
Our aggregate sales to local telephone companies affiliated with the
five major telephone companies, commonly known as RBOCs, accounted for
approximately 55% of our total revenues in 1998, 58% in 1997 and 63% in 1996.
Our future success will significantly depend upon several factors related these
large customers, such as:
o the timeliness and size of their future orders placed to us;
o their product requirements;
o their financial and operational success; and
o the success of their services deployed using our products.
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Sales to our largest customers may continue to fluctuate significantly from
quarter-to-quarter. In addition, the RBOCs have been going through a period of
consolidation, resulting in larger portions of our revenues being attributable
to certain RBOCs. Future sales fluctuations or the loss of any major customer
may harm our business and results of operations. See "Management's Discussion
and Analysis of Financial Condition and Results of Operations," and
"Business--Customers."
WE DEPEND ON OUR SUPPLIERS AND SUBCONTRACTORS.
We purchase certain components for our HDSL products, including our
SPAROW II chip, from a single source. Certain other components are only
available from a limited number of sources. In the past, we have experienced
delays in the receipt of certain key components, which has resulted in delays in
product deliveries. We cannot be certain that key component and product
deliveries will be timely in the future. If delays occur and alternative sources
cannot be found, we may experience delays or reductions in product shipments to
our customers. Such delays or reductions could harm our reputation, customer
relationships, business and results of operations.
In addition, we use third-party subcontractors to manufacture our
products. Our reliance on third-party subcontractors involves several risks,
including but not limited to inadequate capacity and reduced control over
product quality, delivery schedules, manufacturing yields and costs.
If we experience a shortage of raw materials or if our subcontractors
experience production capacity constraints, we may not be able to meet our
production obligations. This may cause our product costs to increase. Increased
product costs or failure to meet our production obligations may harm our
business and results of operations. See "Business--Manufacturing."
WE ARE DEVELOPING PRODUCTS AND TECHNOLOGIES FOR NEW MARKETS.
We continually evaluate new applications of high-speed copper
transmission technologies. We are committing significant corporate resources to
the development of asymmetric digital subscriber line technology, commonly known
as ADSL. We also expect to devote significant additional resources to the
development of other new technologies in the future. We do not expect to
generate significant revenues from ADSL products until late 1999. We cannot be
certain that products based on ADSL technologies will be viable or that markets
for such technologies will develop. See "Business--Company Strategy" and
"--Product Development."
WE MUST RESPOND TO RAPID TECHNOLOGICAL CHANGE.
The market for our products is characterized by:
o rapid technological advances;
o evolving industry standards;
o changes in end user requirements; and
o frequent new product introductions and enhancements.
New industry standards, alternative technologies and new product introductions
which use superior xDSL technologies could render our existing products, and the
products currently under development, obsolete and unmarketable. We believe our
future success depends in part on our efficient and timely ability to continue
to:
o enhance our xDSL products;
o develop and introduce new products for the xDSL market and other
markets;
o meet changing customer needs; and
o achieve broad market acceptance for our products.
We may not be able to continue to respond effectively to these market risks. Our
failure to anticipate or respond to such technological developments, changes in
industry standards or end user requirements could harm our business. Any
significant delays in product development or introduction could also adversely
affect our business. Further, there are physical limits to the speed at which
transmissions can travel over copper wire. Our copper-based xDSL 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."
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WE NEED TO GENERATE INTERNATIONAL SALES.
To date, we have sold a limited amount of products outside of the United
States and Canada. Our ability to meet our objectives will require us to
generate significant international revenues in 1999 and beyond. International
business is subject to risks in addition to those inherent in our North American
business, including:
o substantially different regulatory requirements in different
jurisdictions;
o varying technical standards;
o tariffs and trade barriers;
o political and economic instability;
o reduced protection for intellectual property rights in certain
countries;
o difficulties in staffing and maintaining foreign operations;
o difficulties in managing distributors;
o potentially adverse tax consequences;
o foreign currency exchange fluctuations;
o the burden of complying with a wide variety of complex foreign laws
and treaties; and
o the possibility of difficulties in collecting accounts receivable.
We may not be able to generate significant future international sales or
establish new strategic marketing relationships. In addition, if our
international business operations are successful, we may also face economic,
political and foreign currency situations that are substantially more volatile
than those we commonly experience. These factors may have an adverse effect on
our business and results of operations.
PROTECTION OF OUR PROPRIETARY RIGHTS IS UNCERTAIN.
Our success and future revenue growth will depend, in part, on our
ability to protect trade secrets, obtain or license patents and operate without
infringing on the rights of others. Although we regard our technology as
proprietary, we have limited patents on such technology. We rely on a
combination of technical leadership, trade secrets, copyright and trademark law
and nondisclosure agreements to protect our unpatented proprietary know-how.
However, we cannot be certain that we have taken adequate steps to protect our
trade secrets or other proprietary information. In the absence of patent
protection, our business may be adversely affected by competitors who
independently develop substantially equivalent technology. The laws of some
foreign countries do not protect our proprietary rights to the same extent as do
the laws of the United States.
We are also subject to potential claims and litigation alleging
infringement of others' intellectual property rights. From time to time, we have
received claims of infringement of other parties' proprietary rights, although
we are not party to any pending intellectual property litigation. Regardless of
their merit, future third party claims against us could result in costly
litigation or require us to license the intellectual property rights of such
parties. We may not be able to obtain such licenses on commercially reasonable
terms, if at all. See "Business--Proprietary Rights."
WE DEPEND ON KEY PERSONNEL.
We depend on the continued services and performance of certain key
management and technical personnel, our Chairman of the Board, Charles S.
Strauch, and on two of our founders, Howard S. Flagg and Benedict A. Itri. In
addition, our success depends on the ability of our recently appointed President
and Chief Executive Officer, Michael Pascoe, to develop and enhance our
strategic opportunities. Although we do not have employment contracts with any
of our executive officers, the loss of any of these key personnel could disrupt
our business. Our future success also depends on our ability to identify,
attract, hire and retain other highly skilled technical and managerial
personnel. Competition for such personnel is intense and we may be unable to
successfully find and retain sufficiently qualified personnel.
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WE MUST MANAGE OUR GROWING OPERATIONS.
We have significantly expanded our operations and headcount. This
expansion has placed, and will continue to place, a significant strain on our
personnel and other resources. Our ability to successfully increase the scope of
our operations or headcount, if at all, will depend on our ability to manage
growth in the following areas:
o manufacturing;
o research and development;
o marketing and sales; and
o finance and administration.
Our management's failure to effectively integrate any expansion could adversely
affect our business and results of operations.
WE RELY ON OUR PRIMARY MANUFACTURING FACILITIES.
We historically conducted virtually all final assembly and final test
functions at our manufacturing facility in Tustin, California. In 1996, we
entered into an agreement to have our subscriber carrier products manufactured,
on a turnkey basis, by Jabil Circuits at their St. Petersburg, Florida facility.
Any extended interruption of operations at either of these facilities could
adversely affect our business and results of operations.
OUR STOCK PRICE MAY BE VOLATILE.
The market price of our common stock has increased significantly since
our initial public offering in September 1993. The market price of our common
stock has been volatile and may continue to be volatile in the future. Factors
that may cause fluctuations in the trading price of our common stock include,
but are not limited to:
o quarter-to-quarter variations in operating results;
o changes in revenue and earnings estimates by analysts;
o announcements of technological innovations or new products by us or
our competitors;
o developments in our relationships with our suppliers or customers;
o challenges associated with integration of businesses; and
o competitive pressures.
In addition, the stock market has from time to time experienced extreme price
and volume fluctuations which have particularly affected the market price for
many high technology companies, often without regard to their operating
performance. These broad market fluctuations may adversely affect the market
price of our common stock.
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 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 higher speed
data transmission for applications such as Internet access, telecommuting,
remote LAN access, video conferencing and wide area networking, which includes
communications among computers 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 increased speed, higher reliability lower costs,
ease of installation
5
<PAGE> 12
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. In addition, telephone companies are facing competition from
cable companies that offer high-speed cable modem service. As a result of this
competitive pressure, the telephone companies face an increased need to provide
digital service approaching the quality of fiber optic cable quickly and
efficiently.
T1/E1 ACCESS
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 optic 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 bridged 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 bridged 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 bridged
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, 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 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
6
<PAGE> 13
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.
A cost and performance comparison of a two-mile connection for the three
types of T1 deployment follows:
<TABLE>
<CAPTION>
APPROXIMATE
TRANSMISSION TYPE AVERAGE COST INSTALLATION TIME BANDWIDTH QUALITY ACHIEVED
- ----------------- ----------------- ----------------- -------------- ----------------
<S> <C> <C> <C> <C>
Fiber More than $20,000 2 to 4 Months T1 (1.54 Mbps) 10 to the minus 10
Repeatered T1 Less than $10,000 4 to 8 Weeks T1 (1.54 Mbps) 10 to the minus 7
HDSL Less than $1,500 Less than 1 Hour T1 (1.54 Mbps) 10 to the minus 10
</TABLE>
BER 10 to the minus 10 = one bit error every week in a constant transmission
versus BER 10 to the minus 7 which is one bit error every 6 to 7 seconds. The
fiber optics and repeatered T1 cost and installation estimates are based on
industry averages and will vary on a case by case basis. Average costs include
equipment, engineering and labor.
The following diagram depicts a comparison of a conventional repeatered
T1 line with an HDSL circuit:
[REPEATERED T1 LINE GRAPHIC]
We believe 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. 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 bridged
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 optic cable.
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 may be more cost effective to
deploy.
7
<PAGE> 14
We have been collaborating with leading telecommunications companies to
develop a new standard for second generation HDSL technology, known as HDSL2.
The purpose of setting a standard is to move the industry toward
interoperability. HDSL2 is being developed to deliver full T1 performance over a
single twisted pair cable, with the same reach, robustness and spectral
compatibility of current two-pair HDSL technology. The T1E1.4 approved
transmission scheme enables HDSL2 to coexist in the same cable bundle with T1,
ADSL and ISDN without crosstalk interference. HDSL2 operates at 1.552 Mbps for
up to 12,000 feet in length with 5 dB of noise margin.
SUBSCRIBER CARRIER SYSTEMS
Subscriber carrier systems use HDSL technology allowing for rapid
deployment of new telephone service, cable capacity transmission and
full-featured services over existing copper lines. The systems increase the
channel capacity of copper lines in the local loop. Subscriber carrier systems
can be used to satisfy additional line demand from businesses, apartment
complexes, hotels, etc. In addition, some subscriber carrier systems can provide
access through a digital loop carrier.
MEGABIT ACCESS
Various telecommuting, Internet access and remote LAN access
applications are driving the need for new higher-speed access technologies. T1
lines are not feasible for use by small businesses and residential customers.
Solutions for these customers have historically been limited to ISDN or analog,
voice grade circuits, which when equipped with 28.8 modems offer some minimally
useful capacities.
Megabit access products, including the AvidiaTM system, go beyond modem
and ISDN capabilities, offering high-speed data services to business and
residential customers. These services include high-speed Internet and Intranet
access, remote LAN access, advanced services such as pay-per-view movies,
telemedicine, distance learning, interactive video games, educational video and
many other on-demand services. The following chart shows the relative efficiency
of the various transmission methodologies.
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------
MODEM ISDN XDSL XDSL XDSL XDSL
APPLICATION FILE TYPE FILE SIZE 28.8 KBPS 128 KBPS 384 KBPS 768 KBPS 1,544 KBPS 6,144 KBPS
- ----------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
E-mail Users 30 Kbytes 8.3 sec. 1.9 sec. 0.63 sec. 0.31 sec. 0.16 sec. 0.04 sec.
- ----------------------------------------------------------------------------------------------------------------------
Consumer Digitized Photo 125 Kbytes 34.7 sec. 7.8 sec. 2.6 sec. 1.3 sec. 0.6 sec. 0.2 sec.
- ----------------------------------------------------------------------------------------------------------------------
Business User Word Files 250 Kbytes 69.4 sec. 15.6 sec. 5.2 sec. 2.6 sec. 1.3 sec. 0.3 sec.
- ----------------------------------------------------------------------------------------------------------------------
Telecommuter 384 kbps No No Yes Yes Yes Yes
Videoconferencing
- ----------------------------------------------------------------------------------------------------------------------
Telemedicine X-ray 5 Mbytes 23.1 min. 5.2 min 1.7 min. 52.1 sec. 25.9 sec. 6.5 sec.
- ----------------------------------------------------------------------------------------------------------------------
Remote LAN Access Bulk File 20 Mbytes 1.5 hr. 20.0 min. 6.9 min. 3.5 min. 1.7 min. 26.0 sec.
- ----------------------------------------------------------------------------------------------------------------------
</TABLE>
Desired and acceptable response time is less than 3.0 seconds.
PAIRGAIN STRATEGY
We pioneered the development of a VLSI implementation of HDSL technology
and are currently a leading provider of telecommunications products based on
xDSL technology. Our strategy for expanding the market for our products consists
of several elements:
o MAINTAIN TECHNOLOGY LEADERSHIP. We believe that we are a leader in xDSL
technology and systems. We intend to be able to offer clients whatever
form of xDSL they desire at competitive prices. In response to changes in
the marketplace, we have placed emphasis on providing platform-oriented,
end-to-end solutions using its in-depth knowledge of ATM and IP
networking, traditional telco circuit switching, DSL and local loop
operations. Many of these solutions require a combination of hardware and
software, and value added services, such as training and support.
Our engineering organization includes a core development team focused on
applying DSP techniques to telecommunications products. We leverage this
core DSP expertise with an in-house VLSI design group that designs
advanced VLSI components. Our in-house VLSI design group was the first to
deliver an
8
<PAGE> 15
HDSL transceiver on a single chip (the SPAROW I chip). We believe that
the close coordination between our VLSI design and product development
teams enables us to reduce our time to market for new products. The
engineering organization places the highest priority on maintaining the
cost and feature competitiveness of our HDSL product line through
aggressive cost reduction and introduction of new products that provide
high-speed transmission over copper wire.
We believe that maintaining our leadership in technology for high-speed
digital transmission over copper wire is critical to our ability to build
and maintain strong relationships with the RBOCs and other customers and
to achieve leadership in new markets.
o LEVERAGE CORE TECHNOLOGIES INTO NEW APPLICATIONS. We developed our Campus
product line and our PG-PlusTM and PG-FlexTM products based on the same
core HDSL technology utilized in our HiGain products. We market our
Campus products to private network users such as universities, hospitals,
military bases, corporate complexes and other campus environments.
In addition to providing HDSL-based products, we plan to provide products
that use ADSL technology. We released our FalconTM DMT ADSL chip in 1998,
which supports DMT ADSL and "splitterless" ADSL, or G.lite. The Avidia
system is an integrated access concentrator that includes support for a
wide range of service options including G.lite, full rate DMT ADSL, SDSL
T1, E1 and frame relay. The Avidia system was developed in response to
increasing demand for the delivery of advanced communication services to
residential and business customers, including high-speed Internet access,
advanced video services such as pay-per-view movies, interactive video
games, educational video and many other on-demand services. See "--
Products" and "-- Product Development."
o SUBSCRIBER CARRIER SYSTEMS. Due to a shortage in copper lines, our
subscriber carrier systems, PG-Flex and PG-Plus, represent an enormous
potential market as carriers look to offer competitive local access and
to provision second and third lines quickly and cost-effectively. The
systems increase the channel capacity of copper cables in the local loop,
allowing service providers to maximize the utility of the lines.
o DEVELOP OEM OPPORTUNITIES. We will continue to pursue opportunities to
provide products and chipsets to manufacturers of telecommunications and
data communications equipment. We believe that we 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. We also believe an opportunity exists to
utilize our xDSL technology to connect local wireless communication
systems to local central offices.
o CREATE DEVELOPMENT PARTNERSHIPS AND ALLIANCES. We have and will continue
to establish partnerships with industry leaders in an effort to pursue
new market opportunities. We are collaborating with leading
telecommunications companies to develop an HDSL2 standard. We are also
supporting a new open systems standard for T1 access. The Open Span
Termination Systems ("OSTS") standard was developed in an effort to make
T1 access equipment within central office networks standard for easy
integration and maintenance and deployment cost savings. The purpose of
setting a standard is to move the industry toward interoperability.
In addition, we are a member of the Universal ADSL Working Group ("UAWG")
aimed at accelerating the adoption and availability of high-speed
Internet access for the mass market by creating an open interoperable
International Telecommunication Union ("ITU") standard.
PRODUCTS
CORE TECHNOLOGY
The core technology for our HiGain, Campus, PG-Flex and PG-Plus product
lines is based on HDSL and was developed from our dual core competencies in
digital signal processing and microelectronics. HDSL allows the symmetric
transmission and receipt of digital data at T1 rates (1.544 Mbps) over two
twisted pair of copper wires or at 768 kbps over a single twisted pair of copper
wire. HDSL permits the delivery of an outbound signal on the same
9
<PAGE> 16
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 bridged taps.
Our unique implementation of HDSL technology stems from our 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 us to significantly reduce the
physical size of our HDSL-based products. Two SPAROW chips are used in each of
our HDSL-based products, one for each twisted pair of copper wires entering the
unit. The SPAROW I chip was replaced by our SPAROW II chip which provides all of
the features of the original SPAROW I chip, costs less to produce and consumes
less power. Currently under development is our SPAROW III chip which will be
specially designed to handle pure data transport and include a built-in timing
function to enhance RADSL products and a new interface to use a lower cost
analog chip. In addition, the SPAROW III chip will use less power, cost less to
produce and run faster than the SPAROW II chip. The SPAROW III chip also
conforms to the requirements of the European Telecommunication Standards
Institute ("ETSI").
Our microelectronics team has design and development capabilities that
include silicon compilers which allow us to develop chips that are at
performance and complexity levels beyond what is achievable on standard ASIC
design systems. We have also leveraged our microelectronics product capabilities
into the HiGain and Campus product lines. We are currently focusing our
resources on further cost and performance improvements in HDSL including an
HDSL2 standard that will let service providers deliver full T1 performance over
a single twisted pair cable with the same reach, robustness and spectral
compatibility of today's two-pair HDSL. Additionally, we are placing significant
effort on new ADSL technology such as the Falcon chip, which is capable of
transferring data, voice and video at rates over 8 Mbps downstream and 1 Mbps
upstream over a single copper telephone line, and the RADSL product series,
which allow for consumer and business internet access, transparent LAN access
and telecommuting applications.
We are a supporter and contributor in the UAWG. The goal of the UAWG is
to accelerate the adoption and availability of high-speed digital Internet
access for the mass market by proposing a simplified version of ADSL which will
deliver to consumers high-speed modem communications over existing phone lines
based on an open, interoperable ITU standard. The UAWG is led by PC,
semiconductor and telecommunications industry leaders. We have also joined with
three other T1 access manufacturers in support a new open systems standard for
T1 access. The new Open Span Termination System ("OSTS") standard was developed
in response to service providers' demand for equipment compatible with existing
central office networks. The OSTS standard is based on the widely used STS
mechanical dimensions and backplane connections, also known as 3191 mechanics, a
telecommunications standard upon which many systems have been built, including
central office shelves and line cards.
By utilizing our HDSL and ADSL technology in different forms, we offer
products for different markets and varied applications.
T1/E1 ACCESS
HIGAIN SYSTEMS
Our HiGain systems are used by telephone companies to (i) provide a T1
or fractional T1 link between the central office and a carrier's remote hub and
(ii) provide T1 or fractional T1 service in the local subscriber loop between
the central 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 over 24-gauge copper wire
and up to 9,000 feet over 26-gauge wire without the repeaters or
10
<PAGE> 17
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.
We also provide HiGain systems in different forms to address variances
in customer installation and configuration requirements. Our 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
our more isolated customers. In addition, we offer a product which provides a T1
connection over shorter distances requiring only one pair instead of two pairs
of wire. We recently introduced a comprehensive range of HDSL-based HiGain
products designed specifically to be deployed in digital loop carrier ("DLC")
feeder environments where multiple T1s are used to link remote DLC systems to
telephone company central offices.
To ensure flexibility of installation, our 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. We first shipped units of our HiGain system to customers in June
1992. As of December 31, 1998, we had shipped approximately 958,000 HiGain
units.
[ILLUSTRATION OF HIGAIN SYSTEM GRAPHIC]
HIGAIN '98 SYSTEMS
We introduced HiGain '98 systems in 1998. HiGain '98 systems expand the
reach capability of a traditional HiGain system up to 11 miles and at the same
time reduce the power consumption and unit size. These changes allow for high
density and lower deployment and maintenance costs. HiGain '98 systems are
backward compatible and fully interoperable and interchangeable with original
HiGain products.
HIGAIN WIDEBAND SYSTEM 3190
We introduced the HiGain Wideband System 3190 ("WBS-3190") in January
1999. The WBS-3190 is a managed DS3-based T1 access platform that is OSTS
standard compliant, which means that it is completely interoperable with any
product conforming to the OSTS specification. The WBS-3190 is an open T1 access
platform which enables service providers to deploy T1 services from a managed
platform that is not proprietary, it can be used with existing HDSL 3192
mechanics cards.
ETSI HIGAIN SYSTEMS
In order to provide digital E1 solutions to our customers outside of
North America, including public carriers and private network operators, we
introduced the HiGain ETSI Global Access product line. These products
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<PAGE> 18
apply HDSL-based technology in compliance with ETSI requirements. They allow
service providers to rapidly establish E1 connections between central offices
and the customer. The equipment transfers data at rates of 2.048 kbps over
four-wire circuits. ETSI applications include LAN and PBX networking, WAN
connections, high-speed Internet access and videoconferencing. Our ETSI HiGain
systems were approved by the British Approvals Board for Telecommunications for
use with unconditioned, two-wire and four-wire circuits from British
Telecommunications. This allows service providers to link their private circuit
networks into British Telecom's public network over unconditioned copper
telephone lines.
SUBSCRIBER CARRIER SYSTEMS
PG-2
PG-2 was our 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. Our 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 PTTs to expand telephone service without laying more copper lines.
Our PG-2 products compete worldwide with products from a number of
telecommunications equipment manufacturers. We believe that we are at a
competitive disadvantage in the international market for the two channel digital
subscriber carrier business served by our PG-2 system because it lacks a local
manufacturing presence, which results in price disadvantages caused by import
duties.
PG-FLEX SYSTEMS
PG-Flex is a subscriber carrier product. PG-Flex employs HDSL technology
to provide 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. The PG-Flex system operates
in the local loop at carrier service area distances. The remote terminals are
powered from the central office which enables virtually uninterrupted service
during local power outages. We market the PG-Flex product to both international
and domestic telephone companies and expects significant competition in both
markets. We began production shipments of PG-Flex systems in 1996. PG-Flex has
received numerous approvals from RBOCs and independent telcos.
[ILLUSTRATION OF PG-FLEX SYSTEM]
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<PAGE> 19
PG-PLUS
In 1997, we introduced PG-Plus, a subscriber carrier system based on
HDSL technology. The PG-Plus system can be configured to support four or six
channels for POTS or ISDN over one unconditioned copper telephone line at
distances up to 21,000 feet. PG-Plus can be deployed rapidly and is intended to
offer low cost solutions to business and residential users who require
additional voice, fax or data lines, or in emergency situations for temporary
voice communications. The PG-Plus system consists of central office terminal and
remote terminal equipment along with the alarm unit which is the central point
of communication within the PG-Plus system.
CAMPUS SYSTEMS
Our Campus systems are xDSL transmission products that we designed to
meet the digital communications needs of organizations operating their own
private networks. Campus systems are reconfigured versions of the HiGain product
and provide high-speed digital connectivity over one or 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, Internet and Intranet access, PBX
extensions and many other applications.
A Campus system consists of two base units that operate at T1, E1, 768
kbps 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. We first shipped Campus systems
to customers in June 1993.
CAMPUS STAR(TM)
We 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. We have further enhanced
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.
CAMPUS-REX(TM)
We continued to enhance the Campus family of products with the
introduction of the Campus-REX(TM) (Remote Ethernet eXpress), a full bandwidth
Ethernet remote bridge, providing transparent connectivity between LANs without
repeaters at a distance of up to five miles. It provides a 10BASE-T port, one
serial port, an embedded SNMP agent and IEEE 802. 1d transparent MAC level
bridging with Spanning Tree protocol support.
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<PAGE> 20
[PAIRGAIN CAMPUS PRODUCT APPLICATIONS GRAPHIC]
CAMPUS-HRS(TM)
In 1998, we introduced the Campus-HRS (HDSL Rate Selectable) group of
products, an extension our existing Campus product line. The Campus-HRS products
allow organizations with private enterprise networks to interconnect LANs,
providing remote data and internet access at high speeds over ordinary copper
telephone lines. Applications of the Campus-HRS products include LAN
internetworking, fiber backbone extensions, PBX networking, remote LAN access,
Internet access, video applications and distance learning. New features of the
Campus-HRS systems include rate selectability for greater reach, speed and
scaleability and single platform operations to simplify deployment and
management.
OEM PRODUCTS
We formed an OEM sales group to establish relationships with
manufacturers to integrate our xDSL technologies into their products. We
currently have relationships with Nortel (Northern Telecom), DSC Communications
and Motorola.
MEGABIT ACCESS PRODUCTS
Our megabit access products offer high-speed solutions for a wide range
of consumer and business applications, including Internet and remote LAN access.
Megabit access products are designed for local exchange carriers, ISPs and
private network owners.
MEGABIT MODEM(TM)
Our Megabit Modem products provide high-speed access to the Internet or
corporate LANs at speeds up to 768 kbps in each direction. The Megabit Modem may
also be installed at remote office sites to extend high-speed
14
<PAGE> 21
services across wide area networks. It operates over a single copper telephone
line and outperforms ISDN, cable modems and dial-up modems.
MEGABIT MODEM CRA(TM)
The Megabit Modem CRA are RADSL modems that were designed to support a
variety of applications in residential and business environments. The modems
automatically adjust transmission speeds to the highest rate possible according
to distance, traffic, line quality and other factors. The Megabit Modem CRA
transfers data at speeds up to 3.2 Mbps downstream (to the subscriber) and 1
Mbps upstream to distances as far as 25,000 feet. With the addition of a S1 NID
ADSL Splitter, both digital and analog signals can be transmitted
simultaneously. The network management function for the RADSL products can be
integrated with other xDSL products, consolidating network management functions
for all network elements into one system. RADSL modems are easy to install and
require no end user configuration.
ETHERPHONE(TM)
Our EtherPhone products provide both an Ethernet network connection and
an analog POTS voice connection over a single telephone line. The unit mounts on
the outside of a residence or small office, and does not require any end user
configuration. The EtherPhone provides a 64 kbps voice channel and transmits
data at speeds up to 704 kbps in each direction. EtherPhone products facilitate
telecommuting applications and allow high-speed Internet access.
AVIDIA(TM) SYSTEM
In late 1998, we introduced the Avidia System, an integrated access
concentrator based on a fully distributed ATM packet and circuit switched
architecture that combines redundancy, scaleability and quality of service
support. Avidia means Audio, VIDeo and Internet over ATM. The Avidia System
includes support for a wide range of service options including G.lite, full-rate
DMT ADSL, SDSL, T1, E1 and frame relay. The system can be configured as a DSLAM,
access server of LAN extension concentrator. Uses of the Avidia System include
high-speed internet access, telecommuting and private network connection
services.
In conjunction with the introduction of the Avidia System, we introduced
a suite of Megabit Modems designed for use with the Avidia System. These new
Megabit Modems, based on our Falcon chip, include G.lite-rate and full-rate DMT
ADSL, ATM over ADSL functionality and splitterless ADSL. These modems will allow
service providers to deploy high-speed remote access service for a wide variety
of customers, including those who require maximum voice quality and consumers
that install the modem by themselves.
[NETWORK MODEL USING THE AVIDIA SYSTEM GRAPHIC]
15
<PAGE> 22
ADSL CHIPS
In 1998, we introduced our Falcon DMT ADSL chip which is the industry's
first single-chip DMT ADSL processor. The Falcon chip will support DMT ADSL and
"splitterless ADSL," or G.lite, a standard currently under development by the
ITU to simplify modem deployment by eliminating customer premises splitter
installation for simultaneous data and analog voice connections. Although
telephone companies have focused on deploying fiber and hybrid fiber and coaxial
cable networks for delivering these advanced services, we believe 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.
[CONSUMER APPLICATIONS GRAPHIC]
CUSTOMERS
We sell our HiGain, PG-2, PG-Flex, PG-Plus and megabit access products
primarily into the public network market and our Campus products primarily into
the private network market. We use our direct sales force to market our products
to the public network market in the United States and Canada. We market our
domestic Campus products and all international products through both direct
sales and distributors.
PUBLIC NETWORKS
The public network market consists of the five RBOCs and their local
telephone company affiliates, as well as independent telephone companies, CLECs,
ISPs 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 our product
from the RBOC. Although the approval process for a new product varies somewhat
among the five RBOCs, the process generally consists of the following three
phases:
o 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, or longer, depending on a variety of factors.
o 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, or longer. 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.
16
<PAGE> 23
o FINAL APPROVAL AND CONTRACT. Prior to final approval, which may take from
one to four months, or longer, 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 five U.S. RBOCs and Bell Canada have approved our HiGain products.
In addition, several carriers have approved our subscriber carrier systems: one
RBOC and Bell Canada have approved our PG-2 system, four RBOCs have approved the
PG-Flex system and one RBOC has approved the PG-Plus system. Sales in the
aggregate to local telephone companies affiliated with the five RBOCs accounted
for approximately 55% of our total revenues in 1998. See Note 3 of Notes to
Consolidated Financial Statements contained in a separate section of this Annual
Report on Form 10-K commencing on page F-1.
INDEPENDENT TELEPHONE COMPANIES. There are approximately 1,500 telephone
companies in the United States that are unaffiliated with any of the RBOCs. We
have targeted approximately 50 of the largest independent telephone companies as
potential customers for our carrier products. Although the independent telephone
company market does not present as large an opportunity as the RBOC market, our
experience has been that the independent telephone companies are often more
receptive to new technology. As a result, the approval process for new
technology is often less time consuming. Several of the large and small
independent telephone companies have approved and deployed our HiGain system.
One large independent telephone company has approved our PG-Flex and PG-2
subscriber carrier systems.
CLECS AND ISPS. There are numerous competitive local exchange carriers
and Internet service providers throughout North America. These providers supply
Internet access, T1, long distance and other residential services to consumers
or businesses. In many cases, CLECs will lease unbundled network elements from
the local exchange carrier to deliver digital services using their own
transmission equipment. Most CLECs are focused on new types of data or voice
services and are potential customers for our products. The CLEC market is
relatively new (since the 1996 Telecom Act), and it is unknown at this point how
CLECs will evolve.
INTERNATIONAL CARRIERS. In most international markets there is one
telephone company per country; there are no alternate carriers and no
independents. Typically these 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. Our
products have been successfully deployed in over 95 countries, and in 1998,
sales outside of North America comprised approximately 12% of total revenues.
PRIVATE NETWORKS
Customers for our Campus products, first introduced in 1993, include
universities, hospitals, military bases and other government installations,
corporate complexes and other campus-like environments with private network
systems.
SALES, MARKETING AND CUSTOMER SUPPORT
SALES AND MARKETING
Our direct sales force markets our 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. We sell to other independent carriers, CLECs and owners of
private networks through direct sales, telesales and distributors.
17
<PAGE> 24
Our North American sales personnel are located in the following areas:
<TABLE>
<CAPTION>
States: Provinces:
------ ---------
<S> <C> <C> <C>
California Massachusetts Texas Alberta
Colorado Michigan Utah British Columbia
Florida Missouri Virginia Manitoba
Georgia New Hampshire Washington DC Quebec
Illinois New York Washington
Kansas North Carolina
Maryland Pennsylvania
</TABLE>
We sell our products outside of North America through our own sales
force based in the United States, Switzerland, Germany, Israel, United Arab
Emirates, Brazil, Columbia, Hong Kong and China, and a network of international
data communications equipment distributors.
In addition to the specific sales efforts directed at our public and
private network customers, our marketing activities include participation in
industry trade shows and conferences, distribution of sales and product
literature, media relations, advertising in trade journals, direct mail and
ongoing communications with our customers and industry analysts. We also
maintain a website (www.pairgain.com) which provides up-to-date product, sales
and support information.
CUSTOMER SUPPORT
Service, repair and technical support of our products are performed
primarily in-house, however, we also use an independent third party repair
service. Our field service personnel are located in:
<TABLE>
<CAPTION>
States: Other Countries:
------- ----------------
<S> <C> <C> <C>
California Illinois New York Ontario, Canada
Florida Maryland North Carolina United Arab Emirates
Georgia Massachusetts Texas Brazil
</TABLE>
We offer technical support to our customers on a 24-hours-a-day,
7-days-a-week basis via an 800 hotline and through paging systems for all
support personnel. Our products are sold with a five year warranty.
PRODUCT DEVELOPMENT
We believe that our future success depends on our ability to maintain
our technological leadership through enhancements of our existing products and
development of new products that meet a wide range of customer needs.
Accordingly, we intend to continue to make substantial investments in product
development.
Our engineering efforts consist of microelectronics, software
development and hardware development. Within the microelectronics group, a
substantial majority of our efforts are devoted to the development of ADSL, the
enhancement of microelectronics used in our HiGain and Campus product lines and
the development of microelectronics products based on our existing products.
Within the software development group, our efforts are devoted to the
development and enhancement of network management software and protocol
compliance for our products and the development of firmware for products such as
PG-Flex, PG-Plus and ETSI.
The remainder of our research and development is devoted to the
development, improvement and enhancement of new and existing hardware products
and is directed at the following:
o Cost Reduction. We continuously review the design and manufacturing process
of our 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.
18
<PAGE> 25
o Product Line Extensions. We seek to extend our existing product lines
through product modifications and enhancements in order to meet the needs of
our different customers and their applications. Products resulting from our
product line extension efforts include the PairGain Management System for
management of HiGain products, long range 384 kbps Campus systems, single
pair T1 systems and the HiGain Doubler product.
o New Technology. We explore new transmission technologies to determine
whether they represent an opportunity for products incorporating our DSP and
copper transmission expertise.
During 1998, 1997 and 1996, research and development expenses were
approximately $37.6 million, $32.0 million and $19.5 million, respectively. All
of our research and development expenses were charged to operations as incurred.
MANUFACTURING
Our manufacturing operations consist primarily of final assembly,
burn-in, full system test, packaging and shipping. We use domestic independent
third-party contract assembly companies on a consignment basis for circuit board
assembly, including in-circuit and functional testing, for many of our products.
We conduct final assembly and final test functions for those products at our
facility in Tustin, California. In addition, we perform extensive burn-in,
testing and inspection of all of our products prior to shipping them to
customers. Product quality and reliability are our 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. During 1996, we entered into an agreement to have
our PG-2 and PG-Plus products manufactured, on a turnkey basis, by Jabil
Circuits at their St. Petersburg, Florida facility. Under the terms of this
agreement, Jabil manufactures, tests, packages and ships these products directly
to our customers. During the fourth quarter of 1998, we entered into an
agreement to have our ETSI products manufactured, on a turnkey basis, by SCI at
their facility in Sao Paulo, Brazil. Under the terms of this agreement, SCI
manufactures, tests, packages and ships these products directly to our Brazilian
customers.
In April 1996 we achieved ISO 9001 certification for our manufacturing
operations located in Tustin, California. ISO 9000 Quality Standards were
developed by the International Organization for Standardization. It is a quality
system standard for ensuring a total quality management system in engineering
and manufacturing and is becoming an accepted prerequisite for international
trade. ISO 9001 is the most comprehensive standard, covering design and
development as well as production, installation and service.
We currently procure all of our components from outside suppliers,
either directly from manufacturers or distributors or through our consignment
and turnkey contractors. We generally purchase and store the more expensive
components at our location and allow our assembly and test subcontractors to
purchase and store other necessary components. In procuring components, we and
our 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 we have utilized our VLSI expertise to design our 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 our customer relationships and
operating results.
Our backlog at December 31, 1998 was approximately $5.8 million. We
include in backlog all firm purchase orders for products regardless of their
ship date. Because of the quick turnaround that our customers expect on their
orders, and because of the possibility of customer changes in delivery schedules
or cancellation of orders, our backlog as of any particular date may not be
indicative of actual revenues expected for any future period.
Our products are subject to FCC regulations regarding emission of
electromagnetic energy, which may interfere with other equipment. All of our
currently commercially available products have been tested and comply with the
relevant FCC regulations. Our 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.
19
<PAGE> 26
COMPETITION
Competition in our markets is intense, and we expect that competition
will increase. Many of our potential competitors have substantially greater name
recognition and technical, financial and marketing resources than us. There can
be no assurance that we 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 our products, cause us
to further reduce prices on our existing products, increase expenses or cause
delays or cancellations of customer orders, any one of which could adversely
affect our business and results of operations.
Some companies that offer competitive products in our primary revenue
markets are listed below:
<TABLE>
<CAPTION>
---------------------------------------------------------------------------
SUBSCRIBER
T1/E1 CARRIER CAMPUS &
COMPETITOR ACCESS SYSTEMS MEGABIT ACCESS
---------------------------------------------------------------------------
<S> <C> <C> <C>
ADC Telecommunications X
---------------------------------------------------------------------------
Adtran, Inc., X X
---------------------------------------------------------------------------
Alcatel Network Systems, Inc. X
---------------------------------------------------------------------------
Cisco / Netspeed X
---------------------------------------------------------------------------
DSC Communications Corporation X
---------------------------------------------------------------------------
ECI Telecom X
---------------------------------------------------------------------------
E/O Networks X
---------------------------------------------------------------------------
GoDigital Telecommunications, X
Inc.
---------------------------------------------------------------------------
Lucent Technologies X
---------------------------------------------------------------------------
Paradyne X
---------------------------------------------------------------------------
Raychem Corporation X
---------------------------------------------------------------------------
Siemens X
---------------------------------------------------------------------------
Tut Systems X
---------------------------------------------------------------------------
Wescom Communications, Inc. X
---------------------------------------------------------------------------
Westell, Inc. X
---------------------------------------------------------------------------
</TABLE>
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, E1 and other high-bandwidth services to end users. As
telephone companies continue to install fiber cable and conventional repeatered
T1 systems to provide high-bandwidth 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.
We are investing heavily in xDSL developments. The market for xDSL-based
products is emerging and will change dramatically over a very short time. There
can be no assurance that the products we develop will be commercially
successful.
PROPRIETARY RIGHTS
We rely on a combination of technical leadership, trade secret, patent,
copyright and trademark law and nondisclosure agreements to establish and
protect our proprietary rights in our products. As of December 31, 1998, we held
three United States patents and had applications pending for two additional
patents. We also have certain registered and other trademarks. We believe that,
because of the rapid pace of technological change in the networking industry,
patent and copyright protection are less significant to our competitive position
than factors such as the knowledge, ability and experience of our personnel, new
product development, market recognition and ongoing product maintenance and
support.
20
<PAGE> 27
EMPLOYEES
As of December 31, 1998, we employed 692 persons, including 235 in
manufacturing, 117 in sales and marketing, 27 in customer service, 259 in
engineering and 54 in finance and administration. We also employ a number of
temporary and contract employees. During the last quarter of fiscal 1998, we
employed between 60 and 69 temporary employees. None of our employees is
represented by a labor union and we have experienced no work stoppages. We do
not have any employment contracts with any of our executive officers, however,
executive officers and other key employees have agreements which provide for
severance payments and certain other benefits in the event the employee is
terminated without cause following a change in control.
ITEM 2. PROPERTIES.
The Company has several property leases, as detailed below:
<TABLE>
<CAPTION>
Approx. Lease
Use / Location Square Feet Expiration
- --------------------------------------------------------------------- ------------ ------------
<S> <C> <C>
Principal administrative, engineering, manufacturing,
sales and marketing facilities
Tustin, California(1) 75,000 02/29/00
Tustin, California 66,000 12/31/04
Tustin, California 15,000 07/31/99
Research and development facilities
Raleigh, North Carolina(2) 20,000 08/31/01
Wallingford, Connecticut 14,000 09/30/99
Sales offices
Landover, Maryland 1,000 10/31/99
Miami, Florida 2,000 03/31/01
Baden-Daettwil, Switzerland 2,000 06/30/98
Wanchai, Hong Kong 2,000 07/31/99
</TABLE>
(1) The Company has signed an agreement to purchase its Tustin,
California headquarters facility. See the section entitled "Liquidity and
Capital Resources" in Item 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations.
(2) In December 1998, the Company entered into a lease with its current
landlord in Raleigh, North Carolina for a new 40,000 square foot facility. This
facility is being built to the Company's specifications and occupancy is
expected to commence late in the third quarter of 1999. Once occupancy begins,
the lease for the old facility will be terminated without penalty. The new lease
expires 8 years and one month following the first month of occupancy. See the
section entitled "Liquidity and Capital Resources" in Item 7. Management's
Discussion and Analysis of Financial Condition and Results of Operations.
21
<PAGE> 28
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
arose out of losses incurred by the Company in 1995 of approximately $15.8
million in connection with unauthorized trading of investments made by Mr.
Goldinger and Capital Insight on the Company's behalf. The derivative complaint
alleged causes of action for breach of fiduciary duty, abuse of control,
constructive fraud, gross mismanagement and waste of corporate assets. The
complaint sought 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. Additionally, the same stockholder filed
a separate, related complaint, brought derivatively on behalf of the Company, in
the Orange County Superior Court, against a brokerage firm involved in the
Capital Insight matter.
In September 1996, the Company and other parties to the derivative suits
described above executed definitive settlement agreements to settle and dismiss
the derivative suits. The Court approved the settlement on November 19, 1996.
Under the terms of the settlement, the Company received $2.5 million from a
brokerage firm involved in processing the investments for Capital Insight, and
paid plaintiff's attorneys fees of $450,000. The impact of the settlement was
recorded in the Company's financial statements for the year ended December 31,
1996.
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.
As previously reported, 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 loss of nearly $100 million of their
clients' funds, including $15.8 million of PairGain's funds. The U.S. Attorney
and the SEC are also investigating whether PairGain and some of its past and
present officers and employees engaged in any wrongdoing with respect to
PairGain's investment of its excess cash with Capital Insight, the disclosure of
such investments and the disclosure of losses incurred.
In April 1998, Harris Corporation ("Harris") filed a complaint in the
Superior Court of the State of California, County of Orange, against the Company
and others. In October 1998, Harris amended its complaint a third time, alleging
claims for quantum meruit, promissory estoppel, intentional interference with
prospective economic advantage, violations of California Business & Professions
Code Section 17200, ET SEQ. and fraud. These claims relate to an alleged
agreement giving Harris the right to buy the Company's Falcon 1A chipset and the
breach 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 third amended
complaint seeks injunctive relief, and unspecified compensatory and punitive
damages. Harris has also threatened to seek to enjoin performance of the third
party licensing agreement at some point in the future. The Company believes that
it has well-taken defenses to the third amended complaint, including but not
limited to the fact that the Company never reached an agreement with Harris to
license the Falcon chipset and that the Company has competed fairly. The Company
intends to vigorously defend itself against Harris in this matter. A trial date
has been set for mid-April 1999.
Under the terms of its certificate of incorporation, the Company
indemnifies its directors and officers for certain damages and legal fees
arising from litigation matters.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
22
<PAGE> 29
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's Common Stock is traded on The Nasdaq Stock MarketSM under
the symbol PAIR. As of February 26, 1999, there were 70,383,545 shares of the
Company's Common Stock issued and outstanding. The number of stockholders of
record at that date was 777. 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 Stock MarketSM. 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, 1998
Fourth Quarter $ 13.63 $ 6.00
Third Quarter 17.50 7.38
Second Quarter 24.13 12.75
First Quarter 24.38 15.50
YEAR ENDED DECEMBER 31, 1997
Fourth Quarter $ 31.25 $ 17.38
Third Quarter 30.00 15.50
Second Quarter 32.75 14.63
First Quarter 43.25 22.38
</TABLE>
On February 26, 1999, the last reported sales price for the Company's
stock was $8.63.
USE OF PROCEEDS FROM REGISTERED SECURITIES
The effective date of the Company's first registration statement (the
"Registration Statement") filed on Form S-1 (Registration No. 33-66680) under
the Securities Act of 1993, as amended, was September 13, 1993. The class of
securities registered was Common Stock. The offering commenced on September 15,
1993 and all securities were sold in the offering. The managing underwriters for
the offering were Lehman Brothers, Inc. and Hambrecht & Quist, Inc.
Pursuant to the Registration Statement, the Company sold 4,140,000
shares of its Common Stock for an aggregate offering price of $58.0 million, and
certain selling shareholders sold 632,500 shares of the Common Stock of the
Company for an aggregate offering price of $8.9 million.
The Company incurred expenses of $4.7 million of which $4.1 million
represented underwriting discounts and commissions and $573,000 represented
other expenses. All such expenses were direct or indirect payments to others.
The net offering proceeds to the Company after total expenses was $53.3 million.
Of the net proceeds from the offering, $5.3 million was used to pay off
indebtedness in 1993 and $48.0 million has been invested in short-term
investments. In 1995, the Company realized a $15.8 million unauthorized trading
loss on a portion of the proceeds invested in short-term securities.
The use of the proceeds from the offering does not represent a material
change in the use of the proceeds described in the prospectus, which is part of
the Registration Statement.
23
<PAGE> 30
ITEM 6. SELECTED FINANCIAL DATA.
SELECTED CONSOLIDATED FINANCIAL DATA
The selected consolidated financial data of the Company as of December
31, 1998 and 1997 and for the years ended December 31, 1998, 1997 and 1996 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, 1996, 1995 and 1994 and for the years ended December
31, 1995 and 1994 are derived from audited consolidated financial statements of
the Company not included in this Annual Report but filed previously with the
Commission. 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 separate sections of this Annual Report.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
----------------------------------------------------------
1998 1997 1996 1 1995 1994
----------- ----------- ----------- ----------------------
(IN THOUSANDS, EXCEPT EARNINGS PER SHARE)
<S> <C> <C> <C> <C> <C>
STATEMENT OF OPERATIONS DATA:
Revenues $ 283,100 $ 282,325 $ 205,505 $ 107,224 $ 59,518
Income from operations 55,536 71,739 51,526 23,532 10,513
Settlement income related
to (unusual loss due to)
unauthorized trading of
investments by third parties -- -- 2,500 (15,827) --
Net income 39,499 47,637 34,908 1,056 8,567
Earnings per common share(2)
Basic $ 0.56 $ 0.70 $ 0.54 $ 0.02 $ 0.17
Diluted $ 0.53 $ 0.63 $ 0.47 $ 0.02 $ 0.14
Average shares outstanding(2)
Basic 70,234 67,991 64,247 58,225 50,131
Diluted 74,802 75,225 73,768 67,280 61,612
</TABLE>
<TABLE>
<CAPTION>
DECEMBER 31,
----------------------------------------------------------
1998 1997 1996(1) 1995 1994
----------- ----------- ----------- ----------------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA:
Working capital $ 257,713 $ 214,724 $ 140,681 $ 84,766 $ 71,368
Total assets 328,520 282,419 195,004 105,326 86,625
Long-term debt -- -- -- -- --
Total stockholders' equity 279,041 235,517 157,596 93,931 74,846
</TABLE>
The Company paid no dividends on its Common Stock during any of the
periods presented.
(1) Financial data for 1996 reflect the February 27, 1997 business combination
between PairGain and Avidia Systems, Inc. accounted for on a
pooling-of-interests basis. Avidia was formed in December 1995 and had no
significant transactions prior to January 1, 1996. See Notes 1 and 2 of
Notes to the Consolidated Financial Statements contained in a separate
section of this Annual Report on Form 10-K commencing on page F-1.
(2) All share and per share amounts have been adjusted for the June 18, 1996 and
December 18, 1996 two-for-one stock splits and have been restated to reflect
the adoption of SFAS No. 128, EARNINGS PER SHARE ("SFAS No. 128").
24
<PAGE> 31
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
THE FOLLOWING DISCUSSION AND OTHER SECTIONS OF THIS FORM 10-K 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 THE SECTION ENTITLED "RISK FACTORS" IN ITEM 1 OF THIS ANNUAL REPORT.
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-K 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-K WITH THE SECURITIES AND EXCHANGE COMMISSION (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 US. THE
FOLLOWING DISCUSSION SHOULD BE READ IN CONJUNCTION WITH THE CONSOLIDATED
FINANCIAL STATEMENTS AND RELATED NOTES INCLUDED ELSEWHERE HEREIN.
READERS ARE URGED TO CAREFULLY REVIEW AND CONSIDER THE VARIOUS
DISCLOSURES MADE BY THE COMPANY IN THIS REPORT THAT ATTEMPT TO ADVISE
INTERESTED PARTIES OF CERTAIN RISKS, UNCERTAINTIES AND OTHER FACTORS
THAT MAY AFFECT OUR BUSINESS.
OVERVIEW
PairGain Technologies, Inc. ("PairGain") is a leading provider of
telecommunications products based on high-speed Digital Subscriber Line ("xDSL")
technology. We design, manufacture, market and support 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 existing 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.
Our first product was PG-2, a two-channel digital subscriber carrier
system, which was initially shipped in late 1989. In 1991, we undertook the
development of our HiGain products, which were first shipped in June 1992. In
June 1993, we introduced our Campus line of products, and in 1996, began
shipping our PG-Flex product, a subscriber carrier system for delivering up to
32 voice channels over two pair of copper wires. In the first quarter of 1997,
we commenced shipments of our PG-Plus and ETSI products.
Revenues from HiGain products represented approximately 59% of our total
revenues in 1998, and 67% and 76% of our total revenues in 1997 and 1996,
respectively. Although revenues from sales of HiGain products are expected to
continue to account for a majority of our revenues for the foreseeable future,
we believe that revenues from sales of our PG-Flex, PG-Plus and other new
products will continue to increase as a percentage of total revenues in the
future.
Commencing in mid-1993, we began reducing the average selling prices of
our HiGain products in an effort to increase market demand for our products and
in anticipation of expected price competition. These reductions have been
significant, representing reductions of then current prices averaging as much as
34% in 1998, 16% in 1997 and 14% in 1996. Although future effects of price
competition and other competitive pressures inherent in our business are
uncertain, we expect to continue to reduce the average selling prices of our
HiGain and other products. Accordingly, our ability to maintain or increase
revenues will depend in part upon our 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 selling prices of our existing products. Declining average selling
prices may also adversely affect gross margins on our existing products if we
are unable to fully offset such reductions in average selling prices by
reductions in our per unit costs through cost
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reduction resulting from engineering design changes, reduced prices for
components, increased manufacturing efficiencies and increases in volume.
However, there can be no assurance that we will be able to continue to increase
unit sales volumes, introduce and sell new products or further reduce our per
unit costs in the future.
RESULTS OF OPERATIONS
The results of operations discussed below are comprised of two sections.
The first section compares 1998 to 1997 for all items noted on the Consolidated
Statements of Income contained in a separate section of this Annual Report on
Form 10-K commencing on page F-1. The second section compares 1997 to 1996 for
the same items.
All share and per share amounts have been adjusted to reflect the
two-for-one stock splits effective June 18, 1996 and December 18, 1996 and have
been restated to reflect the adoption of SFAS No. 128, for all periods
presented.
The following table sets forth, for the periods indicated, certain
operating data as a percentage of total revenues.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Revenues:
Product sales 97% 100% 100%
Royalty income and technology
licensing fees 3 -- --
----- ----- -----
Total revenues 100 100 100
Cost of revenues 52 51 52
----- ----- -----
Gross profit 48 49 48
Operating expenses:
Research and development 13 11 9
Selling and marketing 11 8 9
General and administrative 5 4 5
Merger expenses -- 1 --
----- ----- -----
Total operating expenses 29 24 23
----- ----- -----
Income from operations 19 25 25
Other income, (loss):
Interest and other income, net 3 3 2
Impairment adjustment and loss
on note receivable and
long-term investments -- -- --
Settlement income related to
unauthorized trading of investments
by third parties -- -- 1
----- ----- -----
Income before income taxes 22 28 28
Provision for income taxes 8 11 11
----- ----- -----
Net income 14% 17% 17%
===== ===== =====
</TABLE>
1998 COMPARED TO 1997
REVENUES
Revenues of $283.1 million in 1998 were essentially flat when compared
with 1997 revenues of $282.3 million. Although product revenues decreased 3% to
$274.4 million in 1998 compared to $282.1 million in 1997, royalty income and
technology fees increased to $8.7 million in 1998 versus $208,000 in 1997. The
decrease in product revenues was largely the result of a 12% decrease in
revenues from sales of HiGain products. Unit shipments of HiGain products during
1998 were 30% higher than 1997 unit shipments, but average selling prices
decreased 34%. This decline in HiGain revenue was offset by increases in sales
of ETSI, PG-Flex and PG-Plus products. Revenues from sales of ETSI products
increased 87% in 1998 despite a 16% decrease in average selling prices for those
products. Revenues from 1998 sales of PG-Flex and PG-Plus products were more
than three times the level of sales in 1997. PG-Flex and PG-Plus revenues
represented 17% of total revenue, up from 5% of total
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<PAGE> 33
1997 revenues. We expect that PG-Flex and PG-Plus revenues will continue to
become a greater portion of total revenue in the future. Revenues from sales of
PG-2 and Campus products decreased 39% and 40%, respectively, in 1998 compared
to 1997, the result of decreased unit shipments and lower average selling
prices. Unit shipments of PG-2 products decreased 35% and average selling prices
decreased 6% in 1998. Unit shipments of Campus products decreased 33% and
average selling prices decreased 10% in 1998. The increase in royalty income and
technology fees was primarily the result of the Falcon chip licensing agreement
entered into during the first quarter of 1998.
Aggregate sales to local telephone companies affiliated with the five
RBOCs accounted for approximately 55% and 58% of our total revenues for 1998 and
1997, respectively. Revenue per average employee decreased to $381,000 in 1998,
compared to $432,000 in 1997.
As reported in Form 10-Q for the quarter ended September 30, 1998, a
large customer awarded a primary source HDSL contract to one of our competitors
during the fourth quarter of 1998. We previously supplied the dominant share of
HDSL product to this account. We expect there will be a decline in HDSL revenue
sold to this account, although the amount of the decline is not known. This
decline could have a material adverse effect on our future operating results.
GROSS PROFIT
Gross profit represents total revenues for a period, including royalty
income, 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 warranty reserves. In 1998, our gross profit as a
percentage of total revenues decreased to 48% from 49% in 1997. The decrease in
gross margin percentage was largely the result of decreases in average selling
prices, which were partially offset by our cost reduction efforts and higher
margin royalty income. We continue to place emphasis on continuing cost
reduction through engineering design changes, reduced prices for components,
increased manufacturing efficiencies and increase in volume to offset declining
average selling prices of our products. 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, excluding merger expenses, increased 24% to $81.0
million in 1998 from $65.4 million in 1997. Nearly half of the increase in
absolute operating expense levels related to selling and marketing expenditures
and approximately one third of the increase related to research and development
expenses. We plan to increase our relative spending in engineering and field
sales support in an effort to continue to develop and market new products and
technologies. As a percentage of revenue, operating expenses, excluding merger
expenses in 1997, were 29% for 1998 and 23% for 1997.
Research and development expense increased 17% to $37.6 million in 1998
from $32.0 million in 1997. Research and development expense was 13% of total
revenues in 1998 compared to 11% in 1997. The increase in expenses was primarily
due to the addition of personnel for the development of new products,
specifically, development programs for PG-Plus II and megabit access products,
including the Avidia System integrated access concentrator, and sustaining,
enhancement and cost reduction programs for HiGain, PG-Flex, PG-Plus, Falcon
chip technology and Campus products. The remainder of the increases consisted of
outside development consulting fees, external engineering charges and costs
specific to achieving new product approval, offset by reimbursement for
development services sold to outside parties.
Selling and marketing expense increased 32% to $30.1 million in 1998
from $22.8 million in 1997. The increase in expense levels was primarily due to
the addition of personnel and the associated increase in salaries, benefits and
travel expenses, and additional advertising, trade show and other promotional
expenditures designed to market our new products and technology. In addition,
costs related to the expansion of our presence in the international market
increased 30% over the prior year. We anticipate higher selling and marketing
spending levels in the future in order to maintain our leadership position in
the xDSL market and to secure market share in the subscriber and megabit access
markets. Selling and marketing expense as a percentage of total revenues was 11%
in 1998 and 8% in 1997.
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<PAGE> 34
General and administrative expense increased to $13.3 million in 1998
from $10.6 million in 1997. Fees for outside services related to the upgrade of
our software systems, and increases in expenditures for computer software and
equipment repair and maintenance, insurance and legal fees represented the
majority of these increases. General and administrative expense as a percentage
of total revenues was 5% in 1998 compared to 4% in 1997.
MERGER EXPENSES
Expenses related to the acquisition of Avidia Systems, Inc. aggregating
approximately $2.6 million were charged against PairGain's operations in the
quarter ended March 31, 1997. These expenses consisted of $1.8 million in
investment banking fees, $588,000 in legal fees, $120,000 in accounting fees and
$121,000 in other expenses.
INCOME FROM OPERATIONS
As a result of the above, income from operations for 1998 was $55.5
million compared to $71.7 million in 1997. As a percentage of revenues, income
from operations was 19% in 1998 and 25% in 1997. Excluding merger expenses,
income from operations was $74.4 million or 26% of revenues in 1997.
INTEREST AND OTHER INCOME, NET
Net interest income was $9.1 million in 1998 and $6.9 million in 1997.
The increase in interest income was the result of increased average cash
balances. Included in interest and other income in 1998 is $73,000 loss on the
sale of a fixed asset.
IMPAIRMENT ADJUSTMENT AND LOSS ON NOTE RECEIVABLE AND LONG-TERM
INVESTMENTS
In June 1996, we made a minority investment in E/O Networks of Hayward,
California ("E/O"). E/O supplies 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 determined that E/O's market
value had decreased. Based upon that determination, we recorded an impairment
adjustment of $1.5 million during the fourth quarter of 1998 to reflect an
impairment in our investment in E/O.
In July 1995, we entered into certain agreements with Sourcecom
Corporation of Westlake, California ("Sourcecom"). The agreements provided for
the incorporation of Sourcecom's networking technology into our current and
future transmission products. Under the terms of the agreements, we loaned
Sourcecom $2.7 million and had rights to purchase a minority ownership position.
The note bore interest at the prime rate less one percent, payable monthly, with
the principal balance due July 1999.
In April 1996, we purchased approximately 150,000 shares of Sourcecom's
Series A Preferred Stock for an aggregate of $273,000. In September 1996, we
purchased approximately 321,000 shares of Sourcecom's Common Stock for an
aggregate of $271,000. Shares purchased have been adjusted to reflect
Sourcecom's two-for-one stock split, effective September 24, 1996.
In the third quarter of 1997, Sourcecom filed for protection from
creditors under the U.S. Bankruptcy Act. Accordingly, we recorded an impairment
adjustment of $544,000 during the third quarter of 1997 to reflect an impairment
in our investment in Sourcecom. In December 1997, Sourcecom and PairGain reached
an agreement for a mutual release of all claims. Under the terms of the release,
Sourcecom paid us $2.6 million to settle the loan made under the original
agreements. In the fourth quarter of 1997, we wrote-off the balance of the note
and associated legal fees aggregating $200,000.
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<PAGE> 35
PROVISION FOR INCOME TAXES
Our provision for income taxes decreased to $23.6 million in 1998,
compared to $30.3 million in 1997. The effective tax rate during 1998 was 37%.
The effective tax rate during 1997 was 39%.
Excluding non-deductible merger expenses, the 1997 effective tax rate
was 38%. The primary reason for the reduction in our effective tax rate was due
to an increase in non-taxable interest income.
NET INCOME AND EARNINGS PER SHARE
Net income for the year ended December 31, 1998 was $39.5 million
compared to $47.6 million for the year ended December 31, 1997. Excluding merger
expenses, net income was $50.3 million in 1997.
Basic earnings per share for 1998 were $0.56 per share compared to $0.70
per share for 1997. Excluding merger expenses, basic earnings per share for 1997
were $0.74 per share.
The weighted average number of common shares outstanding were 70.2
million for 1998 and 68.0 million for 1997. This increase in common shares
outstanding was attributable to the exercise of stock options and warrants and
the issuance of shares under the Employee Stock Purchase Plan, offset by the
repurchase of shares during 1998 under the Employee Incentive Stock Option/Stock
Issuance Plan, the Employee Stock Purchase Plan and the Share Buyback Plan.
Dilutive earnings per share, which take into account the dilutive
effects of common stock options and warrants, were $0.53 per share in 1998
compared to $0.63 per share in 1997. Excluding merger expenses, dilutive
earnings per share were $0.67 per share in 1997. The weighted average number of
common and common equivalent shares outstanding was 74.8 million in 1998 and
75.2 million in 1997.
1997 COMPARED TO 1996
REVENUES
Revenues increased 37% to $282.3 million in 1997 compared with $205.5
million in 1996. This increase was primarily due to a 39% increase in unit sales
volume of our HiGain products and, to a lesser extent, a 57% and 41% increase in
unit sales volume of our Campus and PG-2 products, respectively. These increases
were partially offset by declines in the average selling prices of HiGain and
Campus products of 16% and 13%, respectively. In addition, revenues from our
PG-Flex, PG-Plus and megabit access products increased to 7% of total revenues
in 1997 compared to 2% in 1996. Revenue per average employee increased to
$432,000 in 1997, compared to $399,000 in 1996.
Aggregate sales to local telephone companies affiliated with the five
RBOCs accounted for approximately 58% and 63% of our total revenues for 1997 and
1996, respectively.
GROSS PROFIT
Gross profit represents total revenues for a period, including royalty
income, 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 warranty reserves. In 1997, our gross profit as a
percentage of total revenues increased to 49% from 48% in 1996 despite decreases
in average selling prices and increases in overhead spending and provisions for
inventory and warranty reserves. Our continuing effort toward cost reduction
through engineering design changes, reduced prices for components, increased
manufacturing efficiencies and increases in volume was the primary reason for
our ability to increase gross margin to 49% of revenues in 1997.
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<PAGE> 36
OPERATING EXPENSES
Operating expenses, excluding merger expenses, increased 38% to $65.4
million in 1997 from $47.5 million in 1996. As a percentage of revenue,
operating expenses, excluding merger expenses in 1997, were 23% for 1997 and
1996. The majority of the increase in absolute operating expense levels was in
the area of research and development with the remainder of the increase coming
from selling and marketing expenses. We plan to increase our relative spending
in engineering and field sales support in an effort to continue to develop and
market new products and technologies such as the subscriber and megabit access
product lines and the newly released FalconTM DMT ADSL chip.
Research and development expense increased 64% to $32.0 million in 1997
from $19.5 million in 1996. Research and development expense was 11% of total
revenues in 1997 compared to 9% in 1996. The increase in expenses was primarily
due to the addition of personnel for the development of new products,
specifically, development programs for PG-Flex, PG-Plus, Falcon chip technology
and megabit access products, and sustaining, enhancement and cost reduction
programs for HiGain and Campus products. Costs for prototype expenditures as new
products were tested in the lab and payments to consultants where specific
resources were needed in the development process also increased in 1997 over the
prior year. We anticipate that research and development expenses will continue
to increase as new products are further developed and other xDSL technologies
and applications are pursued.
Selling and marketing expense increased 30% to $22.8 million in 1997
from $17.6 million in 1996. Selling and marketing expense as a percentage of
total revenues was 8% in 1997 and 9% in 1996. The increase in absolute expense
levels was primarily due to the addition of personnel and the associated
increase in salaries, benefits and travel expenses, and additional advertising
and trade show expenditures designed to market our new products and technology.
In addition, costs related to the expansion of our presence in the international
market more than doubled over the prior year. We anticipate higher selling and
marketing spending levels in the future in order to maintain our leadership
position in the xDSL market and to secure market share in the subscriber and
megabit access markets.
General and administrative expense increased to $10.6 million in 1997
from $10.4 million in 1996. Increases in personnel-associated costs and
expenditures for computer equipment, software maintenance and consulting fees
related to upgrading our information system capabilities were offset by
decreases in legal fees and provisions for bad debts. General and administrative
expense as a percentage of total revenues was 4% in 1997 compared to 5% in 1996.
MERGER EXPENSES
Expenses related to the acquisition of Avidia Systems, Inc. aggregating
approximately $2.6 million were charged against our operations in the quarter
ended March 31, 1997. These expenses consisted of $1.8 million in investment
banking fees, $588,000 in legal fees, $120,000 in accounting fees and $121,000
in other expenses.
INTEREST AND OTHER INCOME, NET
Net interest income was $6.9 million in 1997 and $3.7 million in 1996.
The increase in interest income was the result of increased average cash
balances. Included in interest and other income were realized gains on sales of
short-term investments of $23,000 in 1997.
LOSS ON NOTE RECEIVABLE AND LONG-TERM INVESTMENT
In July 1995, we entered into certain agreements with Sourcecom
Corporation of Westlake, California ("Sourcecom"). The agreements provided for
the incorporation of Sourcecom's networking technology into our current and
future transmission products. Under the terms of the agreements, we loaned
Sourcecom $2.7 million and had rights to purchase a minority ownership position.
The note bore interest at the prime rate less one percent, payable monthly, with
the principal balance due July 1999.
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In April 1996, we purchased approximately 150,000 shares of Sourcecom's
Series A Preferred Stock for an aggregate of $273,000. In September 1996, we
purchased approximately 321,000 shares of Sourcecom's Common Stock for an
aggregate of $271,000. Shares purchased have been adjusted to reflect
Sourcecom's two-for-one stock split, effective September 24, 1996.
In the third quarter of 1997, Sourcecom filed for protection from
creditors under the U.S. Bankruptcy Act. Accordingly, we recorded an impairment
adjustment of $544,000 during the third quarter of 1997 to reflect an impairment
in our investment in Sourcecom. In December 1997, Sourcecom and PairGain reached
an agreement for a mutual release of all claims. Under the terms of the release,
Sourcecom paid us $2.6 million to settle the loan made under the original
agreements. In the fourth quarter of 1997, we wrote-off the balance of the note
and associated legal fees aggregating $200,000.
SETTLEMENT INCOME RELATED TO UNAUTHORIZED TRADING OF INVESTMENTS BY
THIRD PARTIES
As described in Note 16 of Notes to the Consolidated Financial
Statements, we incurred a loss of $15.8 million from unauthorized and
inappropriate trading of investments by third parties in 1995.
In January 1996, we received copies of complaints filed derivatively by
a PairGain stockholder on behalf of PairGain, naming as defendants our directors
and certain officers, as well as Capital Insight and Mr. S. Jay Goldinger, its
president, and a brokerage firm used in executing and clearing transactions
authorized by Mr. Goldinger. The derivative complaint stated causes of action
for breach of fiduciary duty, abuse of control, constructive fraud, gross
mismanagement and waste of corporate assets. The suit sought an award in the
amount of all damages sustained by us including the losses of $15.8 million and
legal fees and expenses.
In September 1996, PairGain and other parties to the derivative suits
described above executed definitive settlement agreements to settle and dismiss
the derivative suits. The Court approved the settlement on November 19, 1996.
Under the terms of the settlement, we received $2.5 million from a brokerage
firm involved in processing the investments for Capital Insight, and we paid
plaintiff's attorneys fees of $450,000. The impact of the settlement was
recorded in our financial statements for the year ended December 31, 1996.
PROVISION FOR INCOME TAXES
Our provision for income taxes increased to $30.3 million in 1997,
compared to $22.8 million in 1996. The effective tax rate during 1997 was 39%.
The effective tax rate during 1996 was 40%.
Excluding non-deductible merger expenses, the 1997 effective tax rate
was 38%. The primary reason for the reduction in our effective tax rate was due
to additional research and development tax credits.
NET INCOME AND EARNINGS PER SHARE
Net income for the year ended December 31, 1997 was $47.6 million
compared to $34.9 million for the year ended December 31, 1996. Excluding merger
expenses, net income was $50.3 million in 1997.
Basic earnings per share for 1997 were $0.70 per share compared to $0.54
per share for 1996. Excluding merger expenses, basic earnings per share for 1997
were $0.74 per share.
The weighted average number of common shares outstanding were 68.0
million for 1997 and 64.2 million for 1996. This increase in common shares
outstanding was attributable to the exercise of stock options and warrants and
the issuance of shares under the Employee Stock Purchase Plan.
Dilutive earnings per share, which take into account the dilutive
effects of common stock options and warrants, were $0.63 per share in 1997
compared to $0.47 per share in 1996. Excluding merger expenses, dilutive
earnings per share were $0.67 per share in 1997. The weighted average number of
common and common equivalent shares outstanding was 75.2 million in 1997 and
73.7 million in 1996.
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LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 1998, we had $233.9 million in cash, cash equivalents
and short-term investments and $257.7 million in working capital, compared to
$176.6 million in cash, cash equivalents and short-term investments and $214.7
million in working capital in 1997. These figures represent an increase of $57.3
million in cash, cash equivalents and short-term investments and $43.0 million
in working capital over December 31, 1997. These increases were primarily
attributable to cash generated from operations of $70.3 million offset by
capital expenditures of $10.6 million and the net effect of cash generated from
the issuance of Common Stock resulting from exercises of options and warrants
and Common Stock sold under the Employee Stock Purchase Plan of $6.8 million,
less $8.0 million for the repurchase of shares in 1998 under the Employee
Incentive Stock Option/Stock Issuance Plan, the Employee Stock Purchase Plan and
the Share Buyback Plan. In 1997, we had cash flow from operations of $66.3
million. In addition, $8.5 million in cash was generated from the issuance of
stock resulting from the exercises of common stock options and Common Stock sold
under the Employee Stock Purchase Plan.
Accounts receivable decreased to $20.2 million at December 31, 1998,
compared to $35.4 million at December 31, 1997. The decrease in accounts
receivable at December 31, 1998 was primarily due to lower revenue levels during
the fourth quarter of 1998 compared to the fourth quarter of 1997. Gross
inventories increased $1.1 million to $51.7 million at December 31, 1998
compared to $50.6 million at December 31, 1997, due to increased stocking levels
to support future shipments. Reserves for inventory obsolescence, excess
quantities, cost reductions and test and evaluation inventories decreased to
$17.4 million at December 31, 1998 compared to $20.1 million at December 31,
1997. The decrease in these reserves resulted primarily from the write-off of
scrap materials, excess and obsolete inventories and test and evaluation
inventories of $4.8 million, offset by an increase in the reserve of $2.2
million. Our net inventory turns were 4.3 times in 1998 compared to 4.7 times in
1997.
Capital expenditures were $10.6 million, $13.5 million, and $7.6 million
for the years ended December 31, 1998, 1997 and 1996, respectively. Included in
1998 expenditures was $5.8 million of software and equipment purchased to
upgrade our information system capabilities, including $2.2 million in software
development costs capitalized under the provisions of AICPA Statement of
Position 98-1, "Accounting For The Costs of Computer Software Developed or
Obtained For Internal Use." Software and equipment purchased to upgrade our
information system capabilities in 1997 and 1996 were $3.5 million and $450,000,
respectively.
Additional expenditures in 1998 included expenditures for test equipment
of $3.6 million, leasehold improvements of $460,000 related to a data center and
warehouse located in our engineering and production facility adjacent to our
Tustin headquarters and a $193,000 prepayment for leasehold improvements to a
new facility for our research and development office in Raleigh, North Carolina,
made pursuant to the terms of a lease we entered into with the current landlord
in Raleigh in December 1998 for a new 40,000 square foot facility. This facility
is being built to our specifications at a total cost of $860,000, with
additional payments for the improvements to be made at quarterly intervals until
one month after occupancy. Occupancy is expected to commence in August or
September 1999. Once occupancy begins, the lease for the old facility will be
terminated without penalty.
Additional expenditures in 1997 included $1.2 million for a
manufacturing and material handling system, $1.8 million in improvements to our
new engineering and production facility adjacent to our main Tustin facility and
$4.8 million for test equipment primarily related to new products. Expenditures
in 1996 also included $251,000 in leasehold improvements at two of our Tustin
facilities and $158,000 in leasehold improvements at our Raleigh, North Carolina
research and development center.
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. As of December 31, 1998, we had repurchased 1,000,000
shares at a cost of approximately $7.2 million. We intend to use our current
cash for any future repurchase of shares under this plan.
In December 1996, we received $2.6 million from Sourcecom in full
payment of a $2.7 million loan made in 1995. See Note 7 of Notes to the
Consolidated Financial Statements.
We maintain an unsecured line of credit with a bank. The line allows
maximum borrowings of $5.0 million, including the issuance of letters of credit
and foreign exchange contracts. The line bears interest at the prime rate
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(7.75% at December 31, 1998). At December 31, 1998, we had no outstanding
borrowings under this line of credit. The debt agreement specifies certain
financial and other covenants. We were in compliance with the financial and
other covenants at December 31, 1998. The agreement expires May 1, 1999. We
typically renew the line upon expiration.
We have signed an agreement to purchase our Tustin, California
headquarters facility from our current landlord. The purchase price is $4.9
million, which will be 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.
Escrow is expected to close during the second quarter of 1999.
We have no other material near-term commitments for our funds. We
believe that the current cash 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.
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:
o Awareness;
o Inventory and Assessment;
o Replacement and Upgrade;
o Testing and Validation; and
o 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:
33
<PAGE> 40
<TABLE>
<CAPTION>
Information Technology Systems Non-Information Technology Systems
- ----------------------------------------------- -----------------------------------
<S> <C>
o Personal computer hardware, software and o Alarms
applications o Access systems and door locks
o Local Area Networks hardware, software and o Facsimile and photocopy machines
applications o Building systems including elevators,
o Mainframe hardware, software and applications HVAC, life safety systems, public
o Telephone systems utilities and others
</TABLE>
Our products that are currently being sold or that have been sold in the
past will be classified into three main categories.
o NO IMPACT: Units with no internal electronics or processing capabilities
or units with processing capabilities that do not perform date math
calculations.
o MINOR IMPACT: Units that possess date math processing capabilities, but
any Year 2000 related failure with 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.
o 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 ("NRTL"). 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 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. We have established a target date of July 1, 1999 for completion of this
task.
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.
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. This phase is
expected to be completed by July 1, 1999.
During the TESTING AND VALIDATION phase, a standard test methodology
will be used to ensure that all components 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. The target date for
completion of the initial testing and validation of components has been set for
July 1, 1999. Testing and validation of these systems will continue through the
end of 1999 to ensure successful business operations.
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<PAGE> 41
During the IMPLEMENTATION AND POST-IMPLEMENTATION phase, components 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. Implementation
of the Project is expected to be completed by July 1, 1999. A team will be
established to cater to all questions and issues that may arise during and post
century change. 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 software 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 December 31, 1998 we had spent approximately $3.8 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:
o Legal risks, including customer, supplier, employee or shareholder
lawsuits over failure to deliver contracted services or product failure.
o Loss of sales due to failure to meet customer quality expectations or
inability to ship products.
o Increased operational costs due to manual processing, data corruption or
disaster recovery.
o 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
35
<PAGE> 42
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 Year 2000 contains many statements that
are "forward-looking" within the meaning of the Reform Act. 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 Plan 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.
NEW ACCOUNTING PRONOUNCEMENTS
In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures
About Pensions and Other Postretirement Benefits," ("SFAS No. 132"). This
statement revises and standardizes employers' disclosure requirements about
pension and other postretirement benefit plans, requires additional information
on changes in the benefit obligations and fair values of plan assets that will
facilitate financial analysis and eliminates certain disclosures that are no
longer useful. We do not maintain an employee pension plan or any other
postretirement benefit plans.
In June 1998, the FASB issued SFAS No. 133, "Accounting For Derivative
Instruments and Hedging Activities," ("SFAS No. 133"). This statement
establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts and for
hedging activities. We do not invest in derivative investments nor do we engage
in hedging activity.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
At December 31, 1998, we had an investment portfolio of fixed income
securities, including those classified as cash equivalents, of $222.0 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.
A sensitivity analysis was performed on our investment portfolio as of
December 31, 1998. This sensitivity analysis is based on a modeling technique
that measures the hypothetical market value changes that would result from a
parallel shift in the yield curve of plus 50, plus 100 or plus 150 basis points
over a 12-month time horizon. The market value changes for a 50, 100 or 150
basis point increase in short-term treasury security yields were not material
due to the overall short-term maturity of our portfolio. As of December 31,
1998, the weighted average maturity of our portfolio is 208 days.
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. We do not use derivative financial instruments
in our investment portfolio to manage interest rate risk.
36
<PAGE> 43
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,
------------------------------ -------------- ---------------
(IN THOUSANDS, EXCEPT EARNINGS PER SHARE)
<S> <C> <C> <C> <C>
1998
Revenues $ 72,619 $ 73,416 $ 76,386 $ 60,679
Gross profit 36,885 37,283 36,866 25,497
Income from operations 17,061 16,406 16,802 5,267
Net income 12,162 11,752 11,986 3,599
Earnings per common share (1)
Basic $ 0.17 $ 0.17 $ 0.17 $ 0.05
Diluted $ 0.16 $ 0.16 $ 0.16 $ 0.05
Average shares outstanding(1)
Basic 69,543 70,120 70,589 70,682
Diluted 75,203 75,111 74,632 74,257
</TABLE>
<TABLE>
<CAPTION>
FOR THE THREE MONTHS ENDED
-------------------------------------------------------------
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
------------ ------------- ------------- --------------
(IN THOUSANDS, EXCEPT EARNINGS PER SHARE)
<S> <C> <C> <C> <C>
1997
Revenues $ 70,749 $ 66,369 $ 70,697 $ 74,510
Gross profit 34,969 32,786 34,925 37,074
Income from operations 18,936 16,841 17,585 18,377
Net income 11,374 11,720 11,797 12,746
Earnings per common share(1)
Basic $ 0.17 $ 0.17 $ 0.17 $ 0.19
Diluted $ 0.15 $ 0.16 $ 0.16 $ 0.17
Average shares outstanding(1)
Basic 66,865 67,838 68,387 68,874
Diluted 75,539 74,736 75,165 75,458
</TABLE>
(1) All share and per share amounts have been adjusted for the June 18, 1996 and
December 18, 1996 two-for-one stock splits and have been restated to reflect
the adoption of SFAS No. 128.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
37
<PAGE> 44
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The sections tilted "Directors and Nominees" and "Compliance with
Section 16(a) of the Exchange Act" appearing in the Company's Proxy Statement
for the 1999 Annual Meeting of Stockholders is incorporated herein by reference.
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 63 Chairman of the Board
Michael Pascoe 46 Chief Executive Officer, President and Director
Howard S. Flagg 44 Executive Vice President, Business Development and
Director
Benedict A. Itri 45 Executive Vice President, Chief Technical Officer and
Director
Charles W. McBrayer 50 Senior Vice President, Chief Financial Officer and
Secretary
Dennis Young 56 Senior Vice President, Operations and Product Line
Management
Howard G. Bubb(1) 44 Director
Robert C. Hawk(1) 59 Director
Robert A. Hoff(2) 46 Director
B. Allen Lay(1,2) 64 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 and has
been Chairman of the Board of Directors of the Company since November 1991. Mr.
Strauch served as Chief Executive Officer of the Company from April 1992 until
December 1998. Prior to his employment with the Company, Mr. Strauch held
executive management positions and directorships with various publicly traded
companies including Chief Executive Officer of MSI Data Corporation, a
manufacturer of hand-held data collection devices (AMEX); Chief Executive
Officer of Magnuson Computer Systems, a manufacturer of main frame computers
(Nasdaq); and President/Chief Operating Officer of Memorex, a manufacturer of
computer peripherals (NYSE). Mr. Strauch has also held several directorships
including Symbol Technologies, EECO Inc. and BMC Industries.
Mr. Pascoe joined the Company in December 1998 as Chief Executive
Officer, President and a member of the Board of Directors. Mr. Pascoe was
employed by Newbridge Networks from 1986 to 1998, where his most recent position
was President, Newbridge Networks - US and Executive Vice President, North and
South America. Mr. Pascoe has also held senior sales, marketing and technical
management positions at Rockwell Telcom, MiTel and Nortel/Bell Northern
Research.
Mr. Flagg, a founder of the Company, was named Executive Vice President,
Business Development in December 1998, and has been a director of the Company
since November 1991. He served as President from November 1991 to December 1998,
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, was named Chief Technical Officer in
April 1996. Previously, Mr. Itri was Vice President, Engineering of the Company
since its inception in February 1988 and has been 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.
38
<PAGE> 45
Mr. McBrayer was named Senior Vice President and Chief Financial Officer
in February 1998. 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 (Nasdaq), from 1986 to March 1995 and
was named to the Board of Directors of Triconex in January 1994.
Mr. Young was named Senior Vice President, Operations and Product Line
Management in February 1998. Mr. Young joined the Company in September 1993 as
Director, European Operations and assumed the position of Vice President,
Operations in December 1994. From 1985 to 1993, Mr. Young served as Managing
Director of Talley (UK) Ltd. and EECO (UK) Ltd. These companies designed,
manufactured and marketed both consumer and industrial products throughout the
United Kingdom, Europe and certain world markets.
Mr. Bubb became a director of the Company in December 1997. Mr. Bubb has
been President and CEO of Dialogic Corporation since June 1993. From July 1991
through June 1993, Mr. Bubb was an Executive Vice President of Dialogic. Mr.
Bubb has served as director for Dialogic since 1994. Mr. Bubb joined Dialogic
from Telenova's Lexar subsidiary where he was senior vice president and general
manager. Mr. Bubb also held senior management positions at United Technologies,
Memorex and Telex corporations.
Mr. Hawk became a director of the Company in November 1992. Mr. Hawk is
President of Hawk Communications and recently retired as President and CEO of U
S WEST Multimedia Communications, Inc. From 1988 until 1996, Mr. Hawk served as
President of the Carrier Division of U S WEST Communications, Inc. Prior to that
time, Mr. Hawk served as Vice President, Marketing and Strategic Planning for
CXC Corporation and as Director, Advanced Systems Development for AT&T/American
Bell. Mr. Hawk also serves as a director of Covad Communications Group, Inc.
(Nasdaq), Xylan Corporation (Nasdaq), Concord Communications (Nasdaq), Radcom
(Nasdaq) and Com21 Incorporated (Nasdaq).
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 Efficient Networks, Sonoma Systems and Accredited Home Lenders
and publicly-held Onyx Acceptance Corporation (Nasdaq), Com21 Incorporated
(Nasdaq) and US Web Corporation (Nasdaq).
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 partnership, since May 1983. Mr. Lay serves as a director of
privately-held Physical Optics Corporation and Waveband, Inc. and of
publicly-held ViaSat, Inc. (Nasdaq) and Kofax Imaging Corporation (Nasdaq).
ITEM 11. EXECUTIVE COMPENSATION.
The section titled "Executive Compensation and Related Information"
appearing in the Company's Proxy Statement for the 1999 Annual Meeting of
Stockholders is incorporated herein by reference.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The section titled "Principal Stockholders" appearing in the Company's
Proxy Statement for the 1999 Annual Meeting of Stockholders is incorporated
herein by reference.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The section titled "Certain Transactions" appearing in the Company's
Proxy Statement for the 1999 Annual Meeting of Stockholders is incorporated
herein by reference.
39
<PAGE> 46
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' Report
Consolidated Balance Sheets
Consolidated Statements of Income
Consolidated Statements of Stockholders' Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
(2) FINANCIAL STATEMENT SCHEDULE:
The following financial schedule for the years 1998, 1997 and 1996 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:
(a) 3.4 Certificate of Incorporation of Registrant, a Delaware corporation
(a) 3.5 Form of Agreement and Plan of Merger of Registrant, a Delaware
corporation, and Registrant, a California corporation
(a) 3.6 Bylaws of Registrant, a Delaware corporation
(a)10.1 PairGain Technologies, Inc. 1990 Stock Option Plan (the "1990
Plan")
(a)10.2 Form of Incentive Stock Option Agreement pertaining to the 1990
Plan
(a)10.3 Form of Supplemental Incentive Stock Option Agreement pertaining to
the 1990 Plan
(a)10.4 Form of Nonstatutory Stock Option Agreement pertaining to the 1990
Plan
(a)10.5 PairGain Technologies, Inc. 1993 Option/Stock Issuance Plan (the
"1993 Plan")
(a)10.6 Form of Stock Option Agreement pertaining to the 1993 Plan
(a)10.7 Form of Stock Issuance Agreement pertaining to the 1993 Plan
(a)10.8 Contract No. BA07617 dated as of October 27, 1990, between the
Registrant and Bell Atlantic Network Services, Inc., as amended
(a)10.9 Stock Option Agreement dated June 23, 1992 between the Registrant
and Charles S. Strauch
(a)10.10 Stock Option Agreement dated June 23, 1992 between the Registrant
and Howard S. Flagg
40
<PAGE> 47
(a)10.11 Stock Option Agreement dated June 23, 1992 between the Registrant
and Benedict A. Itri
(a)10.12 Agreement dated April 26, 1991 between the Registrant and Brooktree
Corporation
(a)10.13 Loan and Security Agreement dated as of July 31, 1991, between the
Registrant and Silicon Valley Bank, as amended
(a)10.14 Standard Sublease dated as of October 29, 1991, between the
Registrant and Kirkwood Dynaelectric Company
(a)10.15 Series B Preferred Stock Purchase Agreement dated as of January
17, 1992, among the Registrant and the investors listed therein
(a)10.16 Industrial Lease dated as of March 17, 1992, between the Registrant
and Alondra Shoemaker Associates
(a)10.17 Warrant to Purchase Stock dated June 22, 1992, issued to Silicon
Valley Bank
(a)10.18 Development and license Agreement and Remote HDSL OEM Agreement
both dated June 30, 1992, between the Registrant and ADC
Telecommunications, Inc.
(a)10.19 Agreement No. PR-6727-A dated September 11, 1992, between the
Registrant and Bell South Telecommunications, Inc., as amended
(a)10.20 Series B Preferred Stock Purchase Agreement dated as of September
30, 1992, among the Registrant and the investors listed therein
(a)10.21 Registration Rights Agreement dated as of September 30, 1992,
among the Registrant, Alcatel Network Systems, Inc., and the
investors listed therein
(a)10.22 License and Distribution Agreement dated September 30, 1992,
between the Registrant and Alcatel Network Systems, Inc.
(a)10.23 PairGain Technologies, Inc. Series D Preferred Stock Purchase
Warrant dated September 30, 1992, issued to Alcatel Network
Systems, Inc.
(a)10.24 Subordinated Demand Promissory Note, principal amount $3,000,000,
dated September 30, 1992, issued to Alcatel Network Systems, Inc.
(a)10.25 PairGain Technologies, Inc. Common Stock Purchase Warrant dated
March 25, 1993, issued to Ventana Leasing, Inc.
(a)10.26 PairGain Technologies, Inc. Common Stock Purchase Warrant dated
March 25, 1993, issued to Praktikerfinans A.B.
(a)10.27 Form of Indemnification Agreement
(b)10.28 Sublease Agreement dated as of August 1, 1994, between the
Registrant and LH Research
(b)10.29 Lease Agreement dated January 30, 1995 between the Registrant and
Mr. Niles Gates
(c)10.30 Senior Note and Warrant Purchase Agreement dated July 24, 1995
between PairGain Technologies, Inc. and Sourcecom Corporation
(c)10.31 Warrant Agreement dated July 24, 1995 between PairGain
Technologies, Inc. Sourcecom Corporation
41
<PAGE> 48
(c)10.32 Investor Right Agreement dated July 24, 1995 between PairGain
Technologies, Inc. Sourcecom Corporation
(c)10.33 Stock Purchase Agreement dated July 24, 1995 between PairGain
Technologies, Inc. Sourcecom Corporation
(d)10.34 PairGain Technologies, Inc. Common Stock Purchase Warrant dated
May 10, 1995, issued to Brobeck, Phleger & Harrison
(d)10.35 PairGain Technologies, Inc. Common Stock Purchase Warrant dated
August 3, 1995, issued to Nexus Applied Research, Inc.
(d)10.36 Amendment to Loan and Security Agreement dated May 3, 1995,
between the Registrant and Silicon Valley Bank
(e)10.37 Lease Agreement dated May 30, 1996 between the Registrant and
Parker-Raleigh Development XXIII, Limited Partnership
(f)10.38 PairGain Technologies, Inc. 1996 Non-Employee Directors Stock
Option Plan
(g)10.39 Amendment to Certificate of Incorporation of PairGain
Technologies, Inc.
(i)10.40 Amendment to Certificate of Incorporation of PairGain
Technologies, Inc.
(j)10.41 Lease Agreement dated December 25, 1996 between the Registrant and
the Cheek Family Trust "D"
(j)10.42 Lease Agreement dated January 7, 1997 between the Registrant and
Catellus Development Corporation
(k)10.43 Avidia Systems, Inc. 1996 Stock Plan (the "Avidia Plan")
(k)10.44 Form of Incentive Stock Option Agreement pertaining to the Avidia
Plan
(k)10.45 Form of Non-Qualified Stock Option Agreement pertaining to the
Avidia Plan
(k)10.46 Form of Stock Option Assumption Agreement pertaining to the Avidia
Plan
(l)10.47 PairGain Technologies, Inc. 1993 Option/Stock Issuance Plan as
amended (the "1993 Plan")
(m)10.48 PairGain Technologies, Inc. 1993 Option/Stock Issuance Plan as
amended (the "1993 Plan")
(n)10.49 Rights Agreement between PairGain Technologies, Inc. and U.S.
Stock Transfer Corporation as Rights Agent, dated as of December 3,
1998
10.50 Form of Change in Control Agreement with Executive Officers and
Other Key Employees
(h) 20.1 Notice to Company Shareholders of Hearing on Proposed Settlement of
Derivative Action, Case No. 758117
(b) 21 Subsidiaries of the Registrant
21.1 Subsidiaries of the Registrant
23.1 Consent of Deloitte & Touche LLP, Independent Auditors
27.1 Financial Data Schedule
42
<PAGE> 49
- --------------------
(a) 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.
(b) 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.
(c) 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.
(d) 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.
(e) 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, 1996, as filed with the Commission on August 13, 1996.
(f) Incorporated herein by reference to Exhibit number 99-1 of Form S-8
Registration Statement as filed with the Commission on July 23, 1996.
(g) Incorporated herein by reference to Appendix A of Proxy Statement for
the Annual Meeting of Stockholders to be held June 12, 1996 as filed
with the Commission on May 9, 1996.
(h) 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, 1996, as filed with the Commission on November 8, 1996.
(i) Incorporated herein by reference to Appendix A of Proxy Statement for
the Special Meeting of Stockholders to be held December 10, 1996 as
filed with the Commission on November 12, 1996.
(j) 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, 1996, as filed with the Commission on March 19, 1997.
(k) Incorporated herein by reference to Exhibit number 99.1 to the Company's
Registration Statement on Form S-8, as filed with the Commission on May
7, 1997.
(l) Incorporated herein by reference to Exhibit number 99.1 to the Company's
Registration Statement on Form S-8, as filed with the Commission on
August 15, 1997.
(m) Incorporated herein by reference to Exhibit number 99.1 to the Company's
Registration Statement on Form S-8, as filed with the Commission on July
28, 1998.
(n) Incorporated herein by reference to Exhibit number 1 to the Company's
Registration Statement on Form 8-A, as filed with the Commission on
December 15, 1998.
43
<PAGE> 50
(B) REPORTS ON FORM 8-K:
A Form 8-K was filed on December 10, 1998 citing Item 5, Other Events,
following the Company's December 3, 1998 press release which announced the
appointment of Michael Pascoe to the position of President, Chief Executive
Officer and member of the Board of Directors. In addition, the Company announced
that it expected that both revenues and operating earnings for the fourth
quarter of 1998 would be significantly below current market expectations.
A Form 8-K was filed on December 15, 1998 citing Item 5, Other Events,
following the Company's December 8, 1998 press release which announced the
adoption of a Stockholder Rights Plan in which preferred stock purchase rights
will be distributed as a dividend at the rate of one Right for each share of
Common Stock held at the close of business on December 14, 1998. The Rights
Agreement, dated as of December 3, 1998, was submitted with the Company's
Registration Statement on Form 8-A filed with the Securities and Exchange
Commission on December 15, 1998.
44
<PAGE> 51
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
PAIRGAIN TECHNOLOGIES, INC.
Date: March 29, 1999 By: /S/ MICHAEL PASCOE
----------------------------------------
Michael Pascoe
(Registrant)
Chief Executive Officer and President
(Principal Executive Officer)
Date: March 29, 1999 By: /S/ CHARLES W. MCBRAYER
----------------------------------------
Charles W. McBrayer
Senior Vice President,
Chief Financial Officer and Secretary
(Principal Financial Officer)
Date: March 29, 1999 By: /S/ ROBERT R. PRICE
----------------------------------------
Robert R. Price
Vice President and Corporate Controller
(Principal Accounting Officer)
Pursuant to the requirements of the Securities Exchange Act of 1934, this 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 of the Board March 29, 1999
------------------------------
Charles S. Strauch
/S/ MICHAEL PASCOE Chief Executive Officer, March 29, 1999
------------------------------ President and Director
Michael Pascoe
/S/ HOWARD S. FLAGG Executive Vice President, March 29, 1999
------------------------------ Business Development
Howard S. Flagg and Director
/S/ BENEDICT A. ITRI Executive Vice President, March 29, 1999
------------------------------ Chief Technical Officer and
Benedict A. Itri Director
/S/ HOWARD G. BUBB Director March 29, 1999
------------------------------
Howard G. Bubb
/S/ ROBERT C. HAWK Director March 29, 1999
------------------------------
Robert C. Hawk
/S/ ROBERT A. HOFF Director March 29, 1999
------------------------------
Robert A. Hoff
/S/ B. ALLEN LAY Director March 29, 1999
------------------------------
B. Allen Lay
</TABLE>
45
<PAGE> 52
PAIRGAIN TECHNOLOGIES, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 1998, 1997 AND 1996
CONTENTS
<TABLE>
<CAPTION>
PAGE
----
<S> <C>
Independent Auditors' Report F-2
Consolidated Financial Statements:
Consolidated Balance Sheets F-3
Consolidated Statements of Income F-4
Consolidated Statements of Comprehensive 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> 53
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders
PairGain Technologies, Inc.
Tustin, California
We have audited the accompanying consolidated balance sheets of PairGain
Technologies, Inc. and subsidiaries (the "Company") as of December 31, 1998 and
1997, and the related consolidated statements of income, comprehensive income,
stockholders' equity, and cash flows for each of the three years in the period
ended December 31, 1998. 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, such consolidated financial statements present fairly, in all
material respects, the financial position of PairGain Technologies, Inc. and
subsidiaries as of December 31, 1998 and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
December 31, 1998, 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 26, 1999
F-2
<PAGE> 54
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
ASSETS
DECEMBER 31,
--------------------------
1998 1997
---------- ----------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 131,923 $ 111,602
Short-term investments (Note 4) 102,011 64,983
Accounts receivable, less allowance for doubtful accounts of
$900 and $955 at December 31, 1998 and 1997, respectively 20,226 35,429
Inventories (Note 5) 34,320 30,538
Deferred tax assets (Note 10) 13,249 15,419
Other current assets 5,463 3,655
---------- ----------
TOTAL CURRENT ASSETS 307,192 261,626
Property and equipment, net (Note 6) 19,482 17,423
Long-term investment (Note 7) 1,500 3,000
Other assets 346 370
---------- ----------
TOTAL ASSETS $ 328,520 $ 282,419
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $ 6,358 $ 8,527
Accrued expenses (Note 9) 27,002 21,702
Accrued income taxes (Note 10) 16,119 16,673
---------- ----------
TOTAL CURRENT LIABILITIES 49,479 46,902
---------- ----------
COMMITMENTS AND CONTINGENCIES (NOTE 11)
Stockholders' equity (Notes 12 and 13):
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 -- 70,039,814 and 69,023,713
at December 31, 1998 and 1997, respectively 35 34
Additional paid-in-capital 150,807 146,704
Deferred compensation (84) (161)
Accumulated other comprehensive loss (Note 15) (501) (345)
Retained earnings 128,784 89,285
---------- ----------
TOTAL STOCKHOLDERS' EQUITY 279,041 235,517
---------- ----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 328,520 $ 282,419
========== ==========
</TABLE>
See notes to consolidated financial statements.
F-3
<PAGE> 55
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF INCOME
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------------------
1998 1997 1996
------------ ------------ ------------
<S> <C> <C> <C>
Revenues (Note 3):
Product sales $ 274,377 $ 282,117 $ 205,408
Royalty income and technology licensing fees 8,723 208 97
------------ ------------ ------------
TOTAL REVENUES 283,100 282,325 205,505
Cost of revenues 146,569 142,571 106,518
------------ ------------ ------------
Gross profit 136,531 139,754 98,987
------------ ------------ ------------
Operating expenses:
Research and development 37,576 31,982 19,512
Selling and marketing 30,098 22,808 17,585
General and administrative 13,321 10,583 10,364
Merger expenses (Note 2) -- 2,642 --
------------ ------------ ------------
Total operating expenses 80,995 68,015 47,461
------------ ------------ ------------
INCOME FROM OPERATIONS 55,536 71,739 51,526
Other income (loss):
Interest and other income, net 9,029 6,948 3,698
Impairment adjustment and loss on note receivable and
long-term investments (Note 7) (1,500) (744) --
Settlement income related to unauthorized trading of
investments by third parties (Note 16) -- -- 2,500
------------ ------------ ------------
Income before income taxes 63,065 77,943 57,724
Provision for income taxes (Note 10) 23,566 30,306 22,816
------------ ------------ ------------
NET INCOME $ 39,499 $ 47,637 $ 34,908
============ ============ ============
Per Share Data (Note 1):
Earnings per common share
Basic $ 0.56 $ 0.70 $ 0.54
============ ============ ============
Diluted $ 0.53 $ 0.63 $ 0.47
============ ============ ============
Weighted average shares outstanding
Basic 70,234,000 67,991,000 64,247,000
============ ============ ============
Diluted 74,802,000 75,225,000 73,768,000
============ ============ ============
</TABLE>
See notes to consolidated financial statements.
F-4
<PAGE> 56
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------
1998 1997 1996
-------- -------- --------
<S> <C> <C> <C>
Net income $ 39,499 $ 47,637 $ 34,908
-------- -------- --------
Other comprehensive (loss) income, net of tax:
Foreign currency translation adjustments (441) (427) --
-------- -------- --------
Unrealized gains (losses) on securities:
Unrealized holding gains (losses) arising during period 292 (34) 4
Reclassification adjustment for gains (losses)
included in net income (7) 45 --
-------- -------- --------
Net unrealized gains on securities 285 11 4
-------- -------- --------
Other comprehensive (loss) income (Note 15) (156) (416) 4
-------- -------- --------
Comprehensive income $ 39,343 $ 47,221 $ 34,912
======== ======== ========
</TABLE>
See notes to condensed consolidated financial statements.
F-5
<PAGE> 57
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
COMMON STOCK ADDITIONAL
-------------------------- PAID-IN DEFERRED
SHARES AMOUNT CAPITAL COMPENSATION
----------- ------ ----------- ------------
<S> <C> <C> <C> <C>
BALANCE AT JANUARY 1, 1996 60,709,068 $15 $ 87,175 $ (82)
Exercise of common stock options 3,258,320 1 6,252 --
Issuance of common stock 2,235,697 1 3,014 --
Issuance of common stock under
Employee Stock Purchase Plan 75,208 -- 1,110 --
Tax benefits from exercise of
common stock options -- -- 18,245 --
Deferred compensation related to
stock options -- -- 285 (285)
Amortization of deferred
compensation -- -- -- 130
Other comprehensive income
(Note 15) -- -- -- --
Stock split effected as
a stock dividend -- 16 -- --
Net income -- -- -- --
----------- --- --------- -----
BALANCE AT DECEMBER 31, 1996 66,278,293 33 116,081 (237)
Exercise of common stock options 2,556,330 1 6,955 --
Exercise of common stock warrants 131,168 -- 495 --
Issuance of common stock under
Employee Stock Purchase Plan 57,922 -- 1,059 --
Tax benefits from exercise of
common stock options -- -- 22,114 --
Amortization of deferred
compensation -- -- -- 76
Other comprehensive loss (Note 15) -- -- -- --
Net income -- -- -- --
----------- --- --------- -----
BALANCE AT DECEMBER 31, 1997 69,023,713 34 146,704 (161)
Exercise of common stock options 1,907,226 1 4,520 --
Exercise of common stock warrants 15,046 -- -- --
Issuance of common stock under
Employee Stock Purchase Plan 144,029 -- 2,295 --
Common stock repurchased
(Notes 12 and 13) (1,050,200) -- (7,999) --
Tax benefits from exercise of
common stock options -- -- 5,287 --
Amortization of deferred
compensation -- -- -- 77
Other comprehensive loss (Note 15) -- -- -- --
Net income -- -- -- --
----------- --- --------- -----
BALANCE AT DECEMBER 31, 1998 70,039,814 $35 $ 150,807 $ (84)
=========== === ========= =====
</TABLE>
<TABLE>
<CAPTION>
ACCUMULATED
OTHER TOTAL
COMPREHENSIVE RETAINED STOCKHOLDERS'
INCOME(LOSS) EARNINGS EQUITY
------------- --------- -------------
<S> <C> <C> <C>
BALANCE AT JANUARY 1, 1996 $ 67 $ 6,756 $ 93,931
Exercise of common stock options -- -- 6,253
Issuance of common stock -- -- 3,015
Issuance of common stock under
Employee Stock Purchase Plan -- -- 1,110
Tax benefits from exercise of
common stock options -- -- 18,245
Deferred compensation related to
stock options -- -- --
Amortization of deferred
compensation -- -- 130
Other comprehensive income
(Note 15) 4 -- 4
Stock split effected as
a stock dividend -- (16) --
Net income -- 34,908 34,908
----- --------- ---------
BALANCE AT DECEMBER 31, 1996 71 41,648 157,596
Exercise of common stock options -- -- 6,956
Exercise of common stock warrants -- -- 495
Issuance of common stock under
Employee Stock Purchase Plan -- -- 1,059
Tax benefits from exercise of
common stock options -- -- 22,114
Amortization of deferred
compensation -- -- 76
Other comprehensive loss (Note 15) (416) -- (416)
Net income -- 47,637 47,637
----- --------- ---------
BALANCE AT DECEMBER 31, 1997 (345) 89,285 235,517
Exercise of common stock options -- -- 4,521
Exercise of common stock warrants -- -- --
Issuance of common stock under
Employee Stock Purchase Plan -- -- 2,295
Common stock repurchased
(Notes 12 and 13) -- -- (7,999)
Tax benefits from exercise of
common stock options -- -- 5,287
Amortization of deferred
compensation -- -- 77
Other comprehensive loss (Note 15) (156) -- (156)
Net income -- 39,499 39,499
----- --------- ---------
BALANCE AT DECEMBER 31, 1998 $(501) $ 128,784 $ 279,041
===== ========= =========
</TABLE>
See notes to consolidated financial statements.
F-6
<PAGE> 58
PAIRGAIN TECHNOLOGIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
-----------------------------------------
1998 1997 1996
---------- ---------- --------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income $ 39,499 $ 47,637 $ 34,908
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization 10,002 7,677 4,749
Gains on sales of investments -- (23) --
Provision for deferred taxes 2,011 (5,663) (7,721)
Valuation adjustment and loss on note receivable and
long-term investments 1,500 -- --
Loss on note receivable and long-term investment -- 652 --
Change in operating assets and liabilities:
Accounts receivable 15,043 (11,541) (10,844)
Inventories (3,905) (4,389) (3,627)
Other current assets (1,805) (872) (1,667)
Other assets 102 (97) (229)
Trade accounts payable (2,168) 2,188 (63)
Accrued expenses 5,294 6,459 10,213
Income taxes (Note 1) 4,767 24,273 34,472
---------- ---------- --------
NET CASH PROVIDED BY OPERATING ACTIVITIES 70,340 66,301 60,191
---------- ---------- --------
Cash flows from investing activities:
Purchases of short-term investments (120,986) (81,034) (68,620)
Proceeds from sales of short-term investments 82,937 80,724 33,025
Purchase of property and equipment (10,597) (13,488) (7,590)
Repayment of note receivable -- 2,600 --
Purchases of long-term investments -- -- (3,544)
---------- ---------- --------
NET CASH USED IN INVESTING ACTIVITIES (48,646) (11,198) (46,729)
---------- ---------- --------
Cash flows from financing activities:
Payments for repurchase of common stock (7,999) -- --
Proceeds from issuance of common stock 6,816 8,510 10,378
---------- ---------- --------
NET CASH (USED IN) PROVIDED BY FINANCING ACTIVITIES (1,183) 8,510 10,378
---------- ---------- --------
Effect of exchange rate changes on cash balances (190) (427) --
---------- ---------- --------
Increase in cash and cash equivalents 20,321 63,186 23,840
Cash and cash equivalents at beginning of year 111,602 48,416 24,576
---------- ---------- --------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 131,923 $ 111,602 $ 48,416
========== ========== ========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Income taxes paid $ 18,999 $ 12,719 $ 4,335
========== ========== ========
Income tax refunds received $ 2,202 $ 1,055 $ 8,342
========== ========== ========
</TABLE>
See notes to consolidated financial statements.
F-7
<PAGE> 59
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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.
The accompanying consolidated financial statements reflect the February
27, 1997 business combination between PairGain and Avidia Systems, Inc.
("Avidia") accounted for on a pooling-of-interests basis. Avidia was formed in
December 1995 and had no significant transactions prior to January 1, 1996. (See
Note 2)
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of the
Company and its wholly-owned subsidiaries. All significant intercompany balances
and transactions have been eliminated in consolidation.
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. 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 income (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 sheets at December 31, 1998 and
December 31, 1997. 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.
F-8
<PAGE> 60
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
COMPREHENSIVE INCOME
Pursuant to SFAS No. 130, "Reporting Comprehensive Income," the Company
has included Consolidated Statements of Comprehensive Income for the years ended
December 31, 1998, 1997 and 1996. See Note 15 for further discussion.
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
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 gains and
losses, net of tax, included in accumulated other comprehensive income 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 AND EQUIPMENT
Property and equipment are carried at cost. The Company provides for
depreciation and amortization using the straight-line method. Equipment is
depreciated over an estimated useful life of three years. Leasehold improvements
are amortized over the lesser of five years or the life of the lease.
WARRANTY RESERVE
The Company accrues warranty reserves, which are charged against cost
of goods sold, based upon historical rates and estimated future costs.
REVENUE RECOGNITION
Revenue from product sales is recognized at the time of shipment.
Provision is made currently for estimated product returns which historically
have been insignificant. Royalty income and technology fees are recognized when
earned. Advance payments are classified as deferred revenue.
RESEARCH AND DEVELOPMENT COSTS
Research and development costs are expensed as incurred.
F-9
<PAGE> 61
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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.
The following table reconciles the weighted average shares outstanding
for basic and diluted earnings per share for the periods presented.
<TABLE>
<CAPTION>
YEAR ENDED DECEMBER 31,
--------------------------------------
1998 1997 1996
-------- -------- --------
(IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C>
Net income $ 39,499 $ 47,637 $ 34,908
======== ======== ========
Basic earnings per common share:
Weighted average of common shares outstanding 70,234 67,991 64,247
======== ======== ========
Basic earnings per common share $ 0.56 $ 0.70 $ 0.54
======== ======== ========
Diluted earnings per common share:
Weighted average of common shares outstanding 70,234 67,991 64,247
Weighted average of common share equivalents:
Weighted average warrants outstanding 26 62 119
Weighted average options outstanding 11,133 11,853 13,111
Anti-dilutive options (2,972) (1,256) --
Shares assumed to be repurchased using the
treasury stock method (2,804) (2,265) (2,385)
Shares assumed to be repurchased to reflect the
effects of tax benefits (815) (1,160) (1,324)
-------- -------- --------
Weighted average number of common and common
equivalent shares 74,802 75,225 73,768
======== ======== ========
Diluted earnings per common share $ 0.53 $ 0.63 $ 0.47
======== ======== ========
</TABLE>
RECENTLY ISSUED ACCOUNTING STANDARDS
In June 1997, the Financial Accounting Standards Board ("FASB") issued
SFAS No. 131, "Disclosures About Segments of an Enterprise and Related
Information," ("SFAS No. 131"). This statement establishes standards for the way
companies report information about operating segments in annual financial
statements. It also establishes standards for related disclosure about products
and services, geographic areas and major customers. (See Note 3)
F-10
<PAGE> 62
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In February 1998, the FASB issued SFAS No. 132, "Employers' Disclosures
about Pensions and Other Postretirement Benefits," ("SFAS No. 132"). This
statement revises and standardizes employers' disclosure requirements about
pension and other postretirement benefit plans, requires additional information
on changes in the benefit obligations and fair values of plan assets that will
facilitate financial analysis and eliminates certain disclosures that are not
longer useful. The Company does not maintain an employee pension plan or any
other postretirement benefit plans.
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities," ("SFAS No. 133"). This statement
establishes accounting and reporting standards for derivative instruments,
including certain derivative instruments embedded in other contracts and for
hedging activities. The Company does not invest in derivative investments nor
does it engage in hedging activity.
STOCK SPLITS
All share and per share amounts have been adjusted to reflect the
two-for-one stock splits, effective June 18, 1996 and December 18, 1996, for all
periods presented. (See Note 12)
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." (See Note 13)
STATEMENT OF CASH FLOWS
Significant noncash transactions in 1998, 1997 and 1996 affecting the
Company's accounts consisted of tax benefits from exercises of common stock
options of $5.3 million, $22.1 million and $18.2 million, respectively, and
$285,000 in deferred compensation related to stock options issued in 1996.
2. ACQUISITION OF AVIDIA
On February 27, 1997, the Company acquired Avidia pursuant to an
Agreement and Plan of Reorganization (the "Merger Agreement") among Avidia and
others, with Avidia surviving as a wholly-owned subsidiary of the Company (the
"Acquisition") in a transaction accounted for as a pooling-of-interests.
Pursuant to the Merger Agreement, the Company issued 2,235,697 shares of
PairGain Common Stock to Avidia stockholders in exchange for all outstanding
Avidia Common Stock, Preferred Stock and vested warrants to purchase Avidia
Common Stock. In addition, outstanding options and unvested warrants to purchase
Avidia Common Stock were exchanged for options and warrants to purchase 232,521
and 131,168 shares, respectively, of the Company's Common Stock. Merger expenses
of $2.6 million, which consisted of investment banking, legal, accounting and
other costs, were charged to expense upon the closing of the Acquisition. The
Company's historical consolidated financial statements have been restated to
reflect the financial position and results of operations of Avidia.
3. CONCENTRATION OF CREDIT RISK, MAJOR CUSTOMERS, PRODUCTS AND MARKET DATA
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.
F-11
<PAGE> 63
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
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 are shown in the table below.
Prior year amounts have been reclassified due to the consolidation of several
major customers.
<TABLE>
<CAPTION>
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Customer A 23% 24% 26%
Customer B 14% 17% 20%
Customer C 11% 13% 13%
</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.
Comparative product revenues as a percentage of sales in 1998, 1997 and
1996 were:
<TABLE>
<CAPTION>
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
HiGain / ETSI 63% 70% 76%
Subscriber Carrier 23% 15% 12%
Campus 7% 11% 11%
Megabit Access 2% 2% 0%
OEM 2% 2% 1%
Royalty 3% 0% 0%
--- --- ---
Total Revenues 100% 100% 100%
=== === ===
</TABLE>
Export sales represented 21%, 17% and 13% of product revenue during
1998, 1997 and 1996, respectively. Product sales by geographical region is
summarized as follows:
<TABLE>
<CAPTION>
1998 1997 1996
--------- --------- ---------
<S> <C> <C> <C>
United States $ 217,308 $ 234,138 $ 178,135
Canada 23,547 21,467 16,418
Other international 33,522 26,512 10,855
--------- --------- ---------
Total product sales $ 274,377 $ 282,117 $ 205,408
========= ========= =========
</TABLE>
4. SHORT-TERM INVESTMENTS
Short-term investments as of December 31, 1998 and 1997 are summarized
as follows:
<TABLE>
<CAPTION>
GROSS GROSS
UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
-------- ---------- ---------- --------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
1998
Municipal bonds $ 101,432 $ 579 $ -- $102,011
======== ===== ==== ========
1997
Municipal bonds $ 62,695 $ 140 $ -- $ 62,835
Other short-term investments 2,160 -- (12) 2,148
-------- ----- ---- --------
$ 64,855 $ 140 $(12) $ 64,983
======== ===== ==== ========
</TABLE>
F-12
<PAGE> 64
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
There were no realized gains or losses for the year ended December 31,
1998. For the year ended December 31, 1997 there was a realized gain of $23,000.
Unrealized holding gains on short-term investments, net of tax, included in
accumulated other comprehensive income in stockholders' equity at December 31,
1998 and December 31, 1997 were $367,000 and $82,000, respectively.
The amortized cost and estimated fair value of investments at December
31, 1998 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. The Company classifies short-term
investments as current assets as all such investments are available for current
operations.
<TABLE>
<CAPTION>
COST FAIR VALUE
-------- ----------
(IN THOUSANDS)
<S> <C> <C>
Due in one year or less $ 45,449 $ 45,610
Due after one year through three years 55,983 56,401
-------- --------
$101,432 $102,011
======== ========
</TABLE>
5. INVENTORIES
Inventories consist of:
<TABLE>
<CAPTION>
DECEMBER 31,
------------------------
1998 1997
------- -------
(IN THOUSANDS)
<S> <C> <C>
Finished goods $18,489 $14,119
Work in process 1,647 6,982
Purchased parts 14,184 9,437
------- -------
$34,320 $30,538
======= =======
</TABLE>
6. PROPERTY AND EQUIPMENT
Property and equipment consist of:
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------
1998 1997
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Production and engineering equipment $ 22,169 $ 18,253
Computers, software, furniture and other 16,155 10,302
Leasehold improvements 4,129 3,444
-------- --------
42,453 31,999
Less accumulated depreciation and amortization (22,971) (14,576)
-------- --------
$ 19,482 $ 17,423
======== ========
</TABLE>
F-13
<PAGE> 65
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
7. NOTE RECEIVABLE AND LONG-TERM INVESTMENTS
In June 1996, the Company made a minority investment in E/O Networks of
Hayward, California ("E/O"). E/O supplies low-density fiber optic access
equipment to public carriers both domestically and internationally. The Company
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, the Company recorded
an impairment adjustment of $1.5 million to reflect an impairment in its
investment in E/O.
In July 1995, the Company entered into certain agreements with
Sourcecom Corporation of Westlake, California ("Sourcecom"). The agreements
provided 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 had rights to purchase
a minority ownership position. The note bore interest at the prime rate less one
percent, payable monthly, with the principal balance due July 1999.
In April 1996, the Company purchased approximately 150,000 shares of
Sourcecom's Series A Preferred Stock for an aggregate of $273,000. In September
1996, the Company purchased approximately 321,000 shares of Sourcecom's Common
Stock for an aggregate of $271,000. Shares purchased have been adjusted to
reflect Sourcecom's two-for-one stock split, effective September 24, 1996.
In the third quarter of 1997, Sourcecom filed for protection from
creditors under the U.S. Bankruptcy Act. In addition, Sourcecom sold all of its
assets to an unrelated third party for $8.0 million. Based upon the information
available, the Company recorded an impairment adjustment of $544,000 during the
third quarter of 1997 to reflect an impairment in its investment in Sourcecom. A
mutual release of all claims between Sourcecom and the Company was reached in
December 1997. Under the terms of the release, Sourcecom paid $2.6 million to
the Company to offset the loan made under the original agreements. In the fourth
quarter of 1997, the Company wrote off the balance of the note and associated
legal fees aggregating $200,000.
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.
8. BANK LINE OF CREDIT
The Company maintains an unsecured line of credit with a bank. The line
allows maximum borrowings of $5.0 million, including the issuance of letters of
credit and foreign exchange contracts. The line bears interest at the prime rate
(7.75% at December 31, 1998). At December 31, 1998, the Company had no
outstanding borrowings under this line of credit. The debt agreement specifies
certain financial and other covenants. The Company was in compliance with the
financial and other covenants at December 31, 1998. The agreement expires May 1,
1999.
9. ACCRUED EXPENSES
Accrued expenses consist of:
<TABLE>
<CAPTION>
DECEMBER 31,
--------------------
1998 1997
------- -------
(IN THOUSANDS)
<S> <C> <C>
Accrued compensation and related expenses $ 9,343 $ 8,836
Accrued warranty 7,413 9,161
Deferred revenue 3,500 --
Other accrued expenses 6,746 3,705
------- -------
$27,002 $21,702
======= =======
</TABLE>
F-14
<PAGE> 66
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
10. INCOME TAXES
The components of the provision for income taxes are as follows:
<TABLE>
<CAPTION>
1998 1997 1996
------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
Current:
Federal $17,596 $ 28,822 $ 25,179
State 2,724 5,859 4,358
Foreign 1,235 1,288 1,000
------- -------- --------
Total current 21,555 35,969 30,537
------- -------- --------
Deferred:
Federal 747 (5,129) (7,047)
State 884 (1,031) (1,371)
Foreign -- -- --
------- -------- --------
Total deferred 1,631 (6,160) (8,418)
Valuation allowance 380 497 697
------- -------- --------
Total provision $23,566 $ 30,306 $ 22,816
======= ======== ========
</TABLE>
The provision for income taxes for the years ended December 31, 1998,
1997, and 1996 differs from the U.S. federal statutory tax expense for the years
as follows:
<TABLE>
<CAPTION>
1998 1997 1996
-------- -------- --------
(IN THOUSANDS)
<S> <C> <C> <C>
U.S. federal statutory tax expense $ 22,073 $ 27,280 $ 20,204
State taxes, net of federal tax benefit 2,980 3,179 1,942
Research and development credit (1,983) (2,387) (737)
Non-taxable interest income (1,178) (838) (623)
Merger expenses -- 925 --
Increase in valuation allowance for deferred tax assets 380 497 697
Other items, net 1,294 1,650 1,333
-------- -------- --------
Total provision $ 23,566 $ 30,306 $ 22,816
======== ======== ========
</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 of the Company's deferred tax assets are as follows:
<TABLE>
<CAPTION>
DECEMBER 31,
-----------------------
1998 1997
-------- --------
(IN THOUSANDS)
<S> <C> <C>
Deferred tax assets:
Inventory and related reserves $ 6,978 $ 9,739
Warranty reserve 2,988 3,893
Other reserves and accruals 2,217 1,645
Other 1,075 299
Capital loss carryforwards 600 312
Net operating loss and research and
development credit carryforwards 965 725
-------- --------
Gross deferred tax assets 14,823 16,613
Valuation allowance (1,574) (1,194)
-------- --------
Net deferred tax assets $ 13,249 $ 15,419
======== ========
</TABLE>
F-15
<PAGE> 67
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
At December 31, 1998, the Company had federal and state capital loss
carryforwards for income tax purposes of approximately $1.5 million which will
begin expiring in 2003. The Company also had net operating loss carryforwards
and research and development credit carryforwards of $2.1 million and $76,000,
respectively, which will expire beginning in 2011 and 2012. The net operating
loss and tax credit carryforwards are subject to separate return limitation year
rules related to the Company's acquisition of Avidia. The Company has
established a valuation allowance of $1.6 million related to these carryforwards
and an additional $9,000 related to non-California state deferred tax assets
since the realization of the benefit from these items is not reasonably assured
at the end of 1998.
11. COMMITMENTS AND CONTINGENCIES
The Company has entered into several operating leases for its
facilities with varying terms. Future annual minimum lease payments under
non-cancelable operating leases are as follows:
<TABLE>
<CAPTION>
YEARS ENDING DECEMBER 31, (IN THOUSANDS)
------------------------ -------------
<S> <C>
1999 $1,298
2000 770
2001 739
2002 739
2003 782
Thereafter 1,551
------
$5,879
======
</TABLE>
In December 1998, the Company entered into a lease with its current
landlord in Raleigh, North Carolina for a new 40,000 square foot facility. This
facility is being built to the Company's specifications and occupancy is
expected to commence late in the third quarter of 1999. Once occupancy begins,
the lease for the old facility will be terminated without penalty. The new lease
expires 8 years and one month following the first month of occupancy. This
arrangement has been reflected in the calculation of lease payments above.
In January 1999, the Company entered into an agreement to purchase its
Tustin, California headquarters facility from its current landlord. The purchase
price is $4.9 million, which will be 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. Escrow is expected to close during the second quarter of 1999.
Rent expense for the years ended December 31, 1998, 1997 and 1996
aggregated $1.4 million, $1.3 million and $747,000, respectively.
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.
12. STOCKHOLDERS' EQUITY
STOCK SPLITS
In June 1996, the Company's stockholders approved an amendment to the
Company's Certificate of Incorporation (the "Amendment") to increase the
authorized Common Stock of the Company from 30 million shares, par value $.001,
to 60 million shares, par value $.0005, and to effect a two-for-one stock split
(the "Stock Split").
F-16
<PAGE> 68
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In December 1996, the Company's stockholders approved an amendment to
the Company's Amended and Restated Certificate of Incorporation (the "Second
Amendment") to increase the authorized Common Stock of the Company from 60
million shares, par value $.0005, to 175 million shares, par value $.0005. The
Second Amendment was proposed to facilitate a two-for-one stock split (the
"Second Stock Split") which was effected in the form of a 100% stock dividend.
All references in the accompanying consolidated financial statements
related to Common Stock, common stock options, common stock warrants and
earnings per share have been adjusted to reflect both stock splits.
STOCK OFFERINGS
In a series of private placements during 1996, Avidia sold common and
preferred shares which converted in the Merger into 2,235,697 of the Company's
shares. The net proceeds raised were approximately $3,015,000.
WARRANTS
In 1996, Avidia granted warrants to certain stockholders which
converted in the Merger into the right to purchase 131,168 shares of the
Company's Common Stock at an aggregate exercise price of $495,000. Such warrants
were exercised in February 1997.
In 1995, the Company granted a warrant for the purchase of 20,000
shares of its Common Stock at an exercise price of $5.00 per share in exchange
for services. The warrant had a net exercise provision which allowed for the
exercise price to be paid by tendering shares of the Company's Common Stock with
a fair market value equal to the exercise price. The warrant was exercised in
April 1998 using the net exercise provision. Accordingly, 15,046 shares of
Common Stock were issued. Another warrant for the purchase of 20,000 shares at
an exercise price of $6.25 per share was also issued in 1995 in exchange for
services. This warrant was outstanding at December 31, 1998 and expires in
September 1999.
PREFERRED STOCK
Preferred stock consists of Series A Junior Participating Preferred
Stock ("Series A Preferred Stock"), 200,000 shares authorized (see below), and
other preferred stock, 1,800,000 shares authorized. There are no shares of
preferred stock issued and outstanding.
Stockholder Rights Plan
In December 1998, the Board of Directors adopted a Stockholder Rights
Plan in which preferred stock purchase rights were distributed as a dividend at
the rate of one Right for each share of Common Stock held as of the close of
business on December 14, 1998. The Rights will expire on December 14, 2008.
Each Right entitles Stockholders to buy one ten-thousandth of a share
of a newly created series of preferred stock of the Company, Series A Preferred
Stock, at an Exercise Price of $55.00. The Rights will be exercisable only if a
person or group acquires 15% or more of the Company's Common Stock or announces
a tender offer the consummation of which would result in ownership by a person
or group of 15% or more of the Company's Common Stock.
F-17
<PAGE> 69
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Rights are exercisable for fractional shares of Series A Preferred
Stock rather than shares of Common Stock to avoid the Company having to reserve
a significant amount of its Common Stock for issuance upon exercise of the
Rights. The Series A Preferred Stock is designed such that each one
ten-thousandth of a share is the economic equivalent of one share of the
Company's Common Stock. If the Rights to purchase these fractional shares of
Series A Preferred Stock become exercisable by virtue of a person or group
acquiring 15% or more of PairGain's outstanding Common Stock, then each
Stockholder, other than the acquiror, is entitled to purchase, for $55.00, that
number of fractional shares of Series A Preferred Stock (or, in certain
circumstances, shares of the Company's Common Stock, property or other
securities of the Company) having a market value worth twice that amount, or
$110.00. If, after the Rights become exercisable, PairGain is acquired by
another company in a merger or other business combination transaction, or sells
50% or more of its assets or earnings power, the Rights entitle each PairGain
Stockholder to purchase, for $55.00, that number of the acquiring company's
common shares having a market value worth $110.00. Each scenario results in
substantial economic dilution to the acquiring entity.
At any time on or prior to the close of business on the tenth business
day after the date of a public announcement that a person or group has acquired
beneficial ownership of 15% or more of the Company's Common Stock, the Rights
are redeemable for $.001 per Right at the option of the Board of Directors.
STOCK REPURCHASES
On October 14, 1998 the Company announced that its Board of Directors
approved a plan to repurchase up to 7,000,000 shares, or approximately 10%, of
the Company's outstanding Common Stock. The timing and amount of any repurchase
is at the discretion of the Company's management. The Company's management
could, in the exercise of its judgment, decide to repurchase fewer shares than
authorized. Repurchased shares are subsequently cancelled. As of December 31,
1998, the Company had repurchased 1,000,000 shares at a cost of approximately
$7.2 million. The Company also repurchases shares for purposes of certain
stock-based incentive plans. (See Note 13)
13. STOCK-BASED INCENTIVE PLANS
1993 EMPLOYEE STOCK OPTION PLAN
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 officers, key
employees, members of the Board of Directors and certain consultants or other
independent contractors of the Company. 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 1997, the Company's Board of Directors approved an increase
in the number of shares of Common Stock reserved and available for issuance
under the Plan from 18,800,000 shares to 21,800,000 shares.
F-18
<PAGE> 70
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
In July 1998, the Plan was amended to include an automatic share
increase feature. Pursuant to the share increase feature, the number of shares
of Common Stock available for issuance under the Plan will automatically
increase by the number of shares of Common Stock repurchased by the Company on
the open market with the cash proceeds received by the Company from the exercise
of outstanding options under the Plan. Such share increases can not exceed
500,000 shares of Common Stock in any one calendar year. In 1998, 21,400 shares
were repurchased under the terms of the Plan at a cost of approximately
$300,000.
In 1998, the Board of Directors approved stock option repricing
programs pursuant to which optionholders having options with exercise prices in
excess of $12.75 per share at August 5, 1998 and $7.03 per share at December 4,
1998 could elect to exchange their higher priced options for new stock options
with exercise prices of $12.75 and $7.03, the fair market values on those dates.
The higher priced options were cancelled and all vesting in those options was
forfeited by the optionholders. The new options vest monthly over a 48 month
period beginning on August 5, 1998 and December 4, 1998. A total of 3,648,283
and 4,127,597 options with exercise prices ranging from $13.63 to $30.00 per
share and $7.41 to $30.00 per share, respectively, were exchanged under these
programs.
SHARES GRANTED OUTSIDE THE PLAN
In December 1998, the Company's granted a non-qualified option to
purchase 450,000 shares at a price of $7.00 per share outside of the Plan in
connection with the hiring of a new President and Chief Executive Officer. The
terms of this grant are identical to the terms of grants issued under the Plan.
1996 NON-EMPLOYEE DIRECTORS STOCK OPTION PLAN
In June 1996, the Company's stockholders approved the 1996 Non-Employee
Directors Stock Option Plan (the "Directors Plan"). Under the terms of the
Directors Plan, 400,000 shares of Common Stock have been reserved for issuance
to non-employee members of the Board. Following the 1996 Annual Meeting, initial
options to purchase 40,000 shares of the Company's Common Stock were granted to
each non-employee director who had not previously received any stock option
grants from the Company. On an annual basis beginning with the 1997 Annual
Meeting, an option to purchase an additional 20,000 shares of Common Stock will
be granted to each individual who is to continue to serve as a non-employee
Board member. There is no limit to the number of such annual 20,000-share option
grants any one non-employee Board member may receive over his or her period of
continued Board service during the term of the Directors Plan. Each option will
have an exercise price per share equal to 100% of the fair market value per
share of Common Stock on the option grant date and a maximum term of ten years
measured from the option grant date. Each option will be immediately exercisable
for all the option shares, but any purchased shares will be subject to
repurchase by the Company, at the exercise price paid per share, upon the
optionee's cessation of Board service. Each initial option grant will vest (and
the Company's repurchase rights will lapse) in four successive equal annual
installments over the optionee's period of Board service, with the first such
installment to vest upon the completion of one year of Board service measured
from the option grant date. Additional option grants will vest (and the
Company's repurchase rights will lapse) upon the completion of one year of Board
service measured from the option grant date. The term of the Directors Plan is
ten years.
AVIDIA STOCK OPTION AND INCENTIVE AWARD PLAN
In 1996, Avidia established the 1996 Stock Option and Incentive Award
Plan (the "Avidia Plan") which provides for the grant of any or all of the
following types of awards: (1) stock options, including incentive stock options
and non-qualified stock options, and (2) performance share awards. Under the
terms of the Avidia Plan, 232,521 shares of Common Stock have been reserved for
issuance to directors, employees, consultants, advisors and vendors of Avidia
and any related corporations. The majority of the stock options vest over a
four-year period, with 25% of the shares becoming exercisable on each of the
first four anniversaries of the grant date. The Board of Directors at its
discretion may grant accelerated vesting. The options expire ten years from the
date of the grant.
F-19
<PAGE> 71
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
During 1996, all of the options under the Avidia Plan were granted at less than
market value, which resulted in total compensation of $285,000. This
compensation is being amortized over a period of four years, and has resulted in
charges to earnings of $77,000, $76,000 and $48,000 in 1998, 1997 and 1996,
respectively.
OPTION ACTIVITY UNDER THE PLANS
<TABLE>
<CAPTION>
WEIGHTED
NUMBER OF AVERAGE
SHARES EXERCISE PRICE
----------- --------------
<S> <C> <C>
Outstanding, January 1, 1996
(5,692,132 exercisable at a weighted average price of $0.66) 13,326,492 $ 2.48
Granted (weighted average fair value of $11.39) 3,025,386 $19.70
Exercised (3,258,320) $ 1.92
Cancelled (228,611) $ 6.87
-----------
Outstanding, December 31, 1996
(6,094,404 exercisable at a weighted average price of $2.15) 12,864,947 $ 6.59
Granted (weighted average fair value of $11.99) 1,634,135 $19.72
Exercised (2,556,330) $ 2.80
Cancelled (441,417) $19.62
-----------
Outstanding, December 31, 1997
(6,608,473 exercisable at a weighted average price of $5.16) 11,501,335 $ 8.89
Granted (weighted average fair value of $7.03) 10,744,480 $ 9.75
Exercised (1,907,226) $ 2.37
Cancelled (8,206,250) $16.59
-----------
Outstanding, December 31, 1998 12,132,339 $ 5.42
===========
</TABLE>
The outstanding stock options primarily vest ratably over a four year
period. Stock options outstanding at December 31, 1998 are summarized as
follows:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
--------------------------------------------------- -----------------------------------
WEIGHTED
AVERAGE
NUMBER OUTSTANDING REMAINING WEIGHTED NUMBER EXERCISABLE WEIGHTED
RANGE OF AT CONTRACTUAL AVERAGE AT AVERAGE
EXERCISE PRICES DECEMBER 31, 1998 LIFE EXERCISE PRICE DECEMBER 31, 1998 EXERCISE PRICE
--------------- ------------------ ----------- -------------- ----------------- --------------
<S> <C> <C> <C> <C> <C>
$ 0.04 - $ 0.07 1,950,832 3.3 $ 0.07 1,950,832 $ 0.07
$ 0.25 - $ 3.44 1,636,143 5.6 $ 2.58 1,589,679 $ 2.60
$ 4.00 - $ 7.63 8,011,140 9.1 $ 6.64 1,606,411 $ 5.94
$10.31 - $16.88 438,224 7.9 $12.87 318,161 $13.32
$26.06 - $27.25 96,000 7.6 $27.05 86,999 $27.15
---------- ---------
$ 0.04 - $27.25 12,132,339 7.6 $ 5.42 5,552,082 $ 3.67
========== =========
</TABLE>
F-20
<PAGE> 72
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
At December 31, 1998, 926,261 and 160,000 shares were available for
future grants under the 1993 Employee Stock Option Plan and 1996 Non-Employee
Directors Stock Option Plan, respectively.
EMPLOYEE STOCK PURCHASE PLAN
Under the Company's Employee Stock Purchase Plan, (the "Purchase
Plan"), eligible employees are permitted to have salary withholdings to purchase
shares of Common Stock at a price equal to 85% of the lower of the market value
of the stock at the beginning or end of each six-month offer period, subject to
an annual limitation. Activity under the Purchase Plan is summarized as follows:
<TABLE>
<CAPTION>
WEIGHTED AVERAGE PRICE WEIGHTED AVERAGE FAIR
YEAR SHARES ISSUED PER SHARE VALUE PER SHARE
---- ------------- ----------------------- ---------------------
<S> <C> <C> <C>
1998 144,029 $13.19 $15.51
1997 57,922 $18.28 $21.50
1996 75,208 $14.77 $17.38
</TABLE>
Under the provisions of the Purchase Plan, the Company may issue new
shares or issue shares acquired in open market purchases. During 1998, the
Company issued 115,229 new shares and 28,800 shares acquired through open market
purchases (at a cost of approximately $500,000). At December 31, 1998, 613,834
shares were reserved for future issuances under the Purchase Plan.
ADDITIONAL STOCK PLAN INFORMATION (SFAS NO. 123)
As discussed in Note 1, the Company accounts for its stock-based awards
using the intrinsic value method in accordance with APB Opinion No. 25,
"Accounting for Stock Issued to Employees," and its related interpretations.
SFAS No. 123, "Accounting for Stock-Based Compensation," requires the
disclosure of pro forma net income and earnings per share had the Company
adopted the fair value method as of the beginning of fiscal 1995. Under SFAS No.
123, the fair value of stock-based awards to employees is calculated through the
use of option pricing models, even though such models were developed to estimate
the fair value of freely tradable, fully transferable options without vesting
restrictions, which significantly differ from the Company's stock option awards.
These models also require subjective assumptions, including future stock price
volatility and expected time to exercise, which greatly affect the calculated
values.
The Company's calculations were made using the Black-Scholes option
pricing model with the following weighted average assumptions:
<TABLE>
<CAPTION>
FOR OPTIONS GRANTED DURING:
------------------------------------------
ASSUMPTIONS 1998 1997 1996
-------------------------------- ----------- ----------- ----------
<S> <C> <C> <C>
Expected life, following vesting nine months nine months six months
Stock volatility 93% 71% 65%
Risk free interest rate 4.98% 6.22% 6.26%
Dividends during expected term none none none
</TABLE>
The Company's calculations are based on a single option valuation
approach and forfeitures are recognized as they occur. The computed fair values
for stock-based compensation awards are $35.9 million (net of valuation credits
for repriced options), $20.5 million and $34.7 million in 1998, 1997 and 1996,
respectively. If the fair values of the awards had been amortized to expense
over the vesting period of the awards, results would have been as follows:
F-21
<PAGE> 73
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
<TABLE>
<CAPTION>
1998 1997 1996
------- ------- -------
(IN THOUSANDS, EXCEPT EARNINGS PER SHARE)
<S> <C> <C> <C>
Net income as reported $39,499 $47,637 $34,908
Pro forma net income $27,976 $38,361 $29,563
Pro forma earnings per share:
Basic $ 0.40 $ 0.56 $ 0.46
Diluted $ 0.37 $ 0.51 $ 0.40
</TABLE>
The impact of stock-based compensation awards granted prior to 1995 has
been excluded from the pro forma calculation; accordingly, the 1998, 1997 and
1996 pro forma adjustments may not be indicative of future period pro forma
adjustments, when the calculation will be applicable to all stock-based
compensation awards.
14. EMPLOYEE BENEFIT PLANS
401 (K) MATCHING CONTRIBUTION
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. Employee deferrals
during 1998 were eligible for a matching contribution equal to fifty percent
(50%) of the employee's salary deferral, not to exceed $1,000 and not less than
$500 per employee. Employee deferrals during 1998, 1997 and from April 28, 1996
through December 31, 1996 were eligible for a matching contribution equal to
fifty percent (50%) of the employee's salary deferral, not to exceed $500 per
employee. Matching contributions vest over a period of four years of service.
The aggregate expense related to the contributions was $464,000 in 1998,
$221,000 in 1997 and $145,000 in 1996.
PROFIT SHARING
In October 1996, the Company established a company-wide Profit Sharing
Plan for fiscal years beginning after December 31, 1996. Under the terms of the
Profit Sharing Plan, a pool equal to 2.5% of pre-tax income was established for
payments to be made on a pro rata basis, based on the amount of each
participant's base compensation. Plan participants include all employees in the
Company except those on an incentive compensation or sales commission plan who
are employed as of the date of the Profit Sharing payment. Payment is subject to
achieving a predetermined threshold earnings per share level as established by
the Board of Directors and is to take place approximately one month after the
end of the year for which the Profit Sharing applies. Amounts earned under the
plan were $0 in 1998 and $2.0 million in 1997.
MANAGEMENT DEFERRED COMPENSATION PLAN
The Company established a Management Deferred Compensation Plan in
1996. The purpose of the plan is to provide a tax deferred capital accumulation
opportunity to senior management. Employees whose annual base salary is $100,000
or greater are eligible to participate. The minimum deferral is $5,000 per Plan
year (January 1 to December 31) and can be satisfied from salary, commission
and/or incentive compensation payments. Deferrals may be increased, decreased or
terminated for any subsequent years by filing an election by December 1 of the
prior year. The Company may make discretionary Company contributions at any time
as approved by the Compensation Committee of the Board of Directors. To date, no
Company contributions have been made to the Deferred Compensation Plan.
F-22
<PAGE> 74
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
CHANGE IN CONTROL AGREEMENTS
In November 1998, the Company issued agreements to its 13 senior
officers and 24 other key employees which will provide severance benefits in the
event of involuntary termination following a substantial change in ownership or
control of the Company. In the event of involuntary termination without cause
within 18 months of change of control, the agreements specify a salary
continuation period of between nine and eighteen months (depending upon
position), acceleration of unvested stock options and continuation of life
insurance coverage during the salary continuation period. Participation in all
other benefit plans would cease upon termination.
15. 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>
YEAR ENDED DECEMBER 31,
-----------------------------------------------------------------------------------
1998 1997 1996
------------------------ ------------------------ ---------------------------
GROSS INCOME NET GROSS INCOME NET GROSS INCOME NET
AMOUNT TAX AMOUNT AMOUNT TAX AMOUNT AMOUNT TAX AMOUNT
------ ------ ------ ----- ------- ------- ------ ------ ------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Foreign currency translation
adjustments $(441) $ -- $(441) $(427) $ -- $(427) $ -- $ -- $ --
Unrealized gains (losses)
on securities:
Unrealized holding gains
(losses) arising
during period 462 170 292 (53) (19) (34) 5 1 4
Reclassification adjustment
for gains (losses)
included in net income (12) (5) (7) 70 25 45 -- -- --
----- ----- ----- ----- ---- ----- ---- ---- ----
Net unrealized gains
on securities 450 165 285 17 6 11 5 1 4
----- ----- ----- ----- ---- ----- ---- ---- ----
Other comprehensive income
(loss) $ 9 $ 165 $(156) $(410) $ 6 $(416) $ 5 $ 1 $ 4
===== ===== ===== ===== ==== ===== ==== ==== ====
</TABLE>
The components of accumulated other comprehensive income (loss) at
December 31, 1998 and December 31, 1997 included foreign currency translation
adjustments and unrealized gains on securities.
<TABLE>
<CAPTION>
FOREIGN ACCUMULATED
CURRENCY UNREALIZED GAINS OTHER
TRANSLATION (LOSSES) ON COMPREHENSIVE
ADJUSTMENT SECURITIES INCOME (LOSS)
------------ ----------------- -------------
(IN THOUSANDS)
<S> <C> <C> <C>
Balance at January 1, 1996 $ -- $ 67 $ 67
1996 Change -- 4 4
----- ---- -----
Balance at December 31, 1996 -- 71 71
1997 Change (427) 11 (416)
----- ---- -----
Balance at December 31, 1997 (427) 82 (345)
1998 Change (441) 285 (156)
----- ---- -----
Balance at December 31, 1998 $(868) $367 $(501)
===== ==== =====
</TABLE>
F-23
<PAGE> 75
PAIRGAIN TECHNOLOGIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
16. SETTLEMENT INCOME RELATED TO UNAUTHORIZED TRADING OF INVESTMENTS BY THIRD
PARTIES
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
arose out of losses incurred by the Company in 1995 of approximately $15.8
million in connection with unauthorized trading of investments made by Mr.
Goldinger and Capital Insight on the Company's behalf. The derivative complaint
alleged causes of action for breach of fiduciary duty, abuse of control,
constructive fraud, gross mismanagement and waste of corporate assets. The
complaint sought 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. Additionally, the same stockholder filed
a separate, related complaint, brought derivatively on behalf of the Company, in
the Orange County Superior Court, against a brokerage firm involved in the
Capital Insight matter.
In September 1996, the Company and other parties to the derivative
suits described above executed definitive settlement agreements to settle and
dismiss the derivative suits. The Court approved the settlement in November
1996. Under the terms of the settlement, the Company received $2.5 million from
a brokerage firm involved in processing the investments for Capital Insight, and
paid plaintiff's attorneys fees of $450,000. The impact of the settlement has
been recorded in the Company's financial statements for the year ended December
31, 1996.
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.
F-24
<PAGE> 76
PAIRGAIN TECHNOLOGIES, INC.
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
ADDITIONS
------------------------
BALANCE AT CHARGED TO CHARGED TO
BEGINNING OF COSTS AND OTHER BALANCE AT
DESCRIPTION PERIOD EXPENSES ACCOUNTS DEDUCTIONS END OF PERIOD
- -------------------------------- ------------ ---------- ----------- ---------- -------------
(IN THOUSANDS)
<S> <C> <C> <C> <C> <C>
Year ended December 31, 1998:
Allowance for doubtful accounts
receivable $ 955 $ 28 $ -- $ 83 $ 900
Inventory reserves 20,106 2,159 -- 4,837 17,428
------- ------- ---- ------ -------
Total $21,061 $ 2,187 $ -- $4,920 $18,328
======= ======= ==== ====== =======
Year ended December 31, 1997:
Allowance for doubtful accounts
receivable $ 935 $ 20 $ -- $ -- $ 955
Inventory reserves 14,656 7,929 -- 2,479 20,106
------- ------- ---- ------ -------
Total $15,591 $ 7,949 $ -- $2,479 $21,061
======= ======= ==== ====== =======
Year ended December 31, 1996:
Allowance for doubtful accounts
receivable $ 469 $ 463 $ 3 $ -- $ 935
Inventory reserves 4,235 13,877 -- 3,456 14,656
------- ------- ---- ------ -------
Total $ 4,704 $14,340 $ 3 $3,456 $15,591
======= ======= ==== ====== =======
</TABLE>
S-1
<PAGE> 77
EXHIBIT INDEX
<TABLE>
<S> <C>
(a) 3.4 Certificate of Incorporation of Registrant, a Delaware corporation
(a) 3.5 Form of Agreement and Plan of Merger of Registrant, a Delaware corporation,
and Registrant, a California corporation
(a) 3.6 Bylaws of Registrant, a Delaware corporation
(a) 10.1 PairGain Technologies, Inc. 1990 Stock Option Plan (the "1990 Plan")
(a) 10.2 Form of Incentive Stock Option Agreement pertaining to the 1990 Plan
(a) 10.3 Form of Supplemental Incentive Stock Option Agreement pertaining to the 1990 Plan
(a) 10.4 Form of Nonstatutory Stock Option Agreement pertaining to the 1990 Plan
(a) 10.5 PairGain Technologies, Inc. 1993 Option/Stock Issuance Plan (the "1993 Plan")
(a) 10.6 Form of Stock Option Agreement pertaining to the 1993 Plan
(a) 10.7 Form of Stock Issuance Agreement pertaining to the 1993 Plan
(a) 10.8 Contract No. BA07617 dated as of October 27, 1990, between the Registrant and Bell
Atlantic Network Services, Inc., as amended
(a) 10.9 Stock Option Agreement dated June 23, 1992 between the Registrant and Charles S. Strauch
(a) 10.10 Stock Option Agreement dated June 23, 1992 between the Registrant and Howard S. Flagg
</TABLE>
<PAGE> 78
<TABLE>
<S> <C>
(a) 10.11 Stock Option Agreement dated June 23, 1992 between the Registrant and Benedict A. Itri
(a) 10.12 Agreement dated April 26, 1991 between the Registrant and Brooktree Corporation
(a) 10.13 Loan and Security Agreement dated as of July 31, 1991, between the Registrant and
Silicon Valley Bank, as amended
(a) 10.14 Standard Sublease dated as of October 29, 1991, between the Registrant and Kirkwood
Dynaelectric Company
(a) 10.15 Series B Preferred Stock Purchase Agreement dated as of January 17, 1992, among the
Registrant and the investors listed therein
(a) 10.16 Industrial Lease dated as of March 17, 1992, between the Registrant and Alondra
Shoemaker Associates
(a) 10.17 Warrant to Purchase Stock dated June 22, 1992, issued to Silicon Valley Bank
(a) 10.18 Development and license Agreement and Remote HDSL OEM Agreement both dated June 30,
1992, between the Registrant and ADC Telecommunications, Inc.
(a) 10.19 Agreement No. PR-6727-A dated September 11, 1992, between the Registrant and Bell South
Telecommunications, Inc., as amended
(a) 10.20 Series B Preferred Stock Purchase Agreement dated as of September 30, 1992, among the
Registrant and the investors listed therein
(a) 10.21 Registration Rights Agreement dated as of September 30, 1992, among the Registrant, Alcatel
Network Systems, Inc., and the investors listed therein
(a) 10.22 License and Distribution Agreement dated September 30, 1992, between the Registrant and Alcatel
Network Systems, Inc.
(a) 10.23 PairGain Technologies, Inc. Series D Preferred Stock Purchase Warrant dated September 30, 1992,
issued to Alcatel Network Systems, Inc.
(a) 10.24 Subordinated Demand Promissory Note, principal amount $3,000,000, dated September 30, 1992,
issued to Alcatel Network Systems, Inc.
(a) 10.25 PairGain Technologies, Inc. Common Stock Purchase Warrant dated March 25, 1993, issued to Ventana
Leasing, Inc.
(a) 10.26 PairGain Technologies, Inc. Common Stock Purchase Warrant dated March 25, 1993, issued to
Praktikerfinans A.B.
(a) 10.27 Form of Indemnification Agreement
(b) 10.28 Sublease Agreement dated as of August 1, 1994, between the Registrant and LH Research
(b) 10.29 Lease Agreement dated January 30, 1995 between the Registrant and Mr. Niles Gates
(c) 10.30 Senior Note and Warrant Purchase Agreement dated July 24, 1995 between PairGain Technologies, Inc.
and Sourcecom Corporation
(c) 10.31 Warrant Agreement dated July 24, 1995 between PairGain Technologies, Inc. Sourcecom Corporation
</TABLE>
<PAGE> 79
<TABLE>
<S> <C>
(c) 10.32 Investor Right Agreement dated July 24, 1995 between PairGain Technologies, Inc. Sourcecom
Corporation
(c) 10.33 Stock Purchase Agreement dated July 24, 1995 between PairGain Technologies, Inc. Sourcecom
Corporation
(d) 10.34 PairGain Technologies, Inc. Common Stock Purchase Warrant dated May 10, 1995, issued to Brobeck,
Phleger & Harrison
(d) 10.35 PairGain Technologies, Inc. Common Stock Purchase Warrant dated August 3, 1995, issued to Nexus
Applied Research, Inc.
(d) 10.36 Amendment to Loan and Security Agreement dated May 3, 1995, between the Registrant and Silicon
Valley Bank
(e) 10.37 Lease Agreement dated May 30, 1996 between the Registrant and Parker-Raleigh Development XXIII,
Limited Partnership
(f) 10.38 PairGain Technologies, Inc. 1996 Non-Employee Directors Stock Option Plan
(g) 10.39 Amendment to Certificate of Incorporation of PairGain Technologies, Inc.
(i) 10.40 Amendment to Certificate of Incorporation of PairGain Technologies, Inc.
(j) 10.41 Lease Agreement dated December 25, 1996 between the Registrant and the Cheek Family Trust "D"
(j) 10.42 Lease Agreement dated January 7, 1997 between the Registrant and Catellus Development Corporation
(k) 10.43 Avidia Systems, Inc. 1996 Stock Plan (the "Avidia Plan")
(k) 10.44 Form of Incentive Stock Option Agreement pertaining to the Avidia Plan
(k) 10.45 Form of Non-Qualified Stock Option Agreement pertaining to the Avidia Plan
(k) 10.46 Form of Stock Option Assumption Agreement pertaining to the Avidia Plan
(l) 10.47 PairGain Technologies, Inc. 1993 Option/Stock Issuance Plan as amended (the "1993 Plan")
(m) 10.48 PairGain Technologies, Inc. 1993 Option/Stock Issuance Plan as amended (the "1993 Plan")
(n) 10.49 Rights Agreement between PairGain Technologies, Inc. and U.S. Stock Transfer Corporation as
Rights Agent, dated as of December 3, 1998
10.50 Form of Change in Control Agreement with Executive Officers and Other Key Employees
(h) 20.1 Notice to Company Shareholders of Hearing on Proposed Settlement of Derivative Action, Case No. 758117
(b) 21 Subsidiaries of the Registrant
21.1 Subsidiaries of the Registrant
</TABLE>
<PAGE> 80
<TABLE>
<S> <C>
23.1 Consent of Deloitte & Touche LLP, Independent Auditors
27.1 Financial Data Schedule
</TABLE>
- -------------
(a) 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.
(b) 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.
(c) 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.
(d) 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.
(e) 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, 1996, as filed with the Commission on August 13, 1996.
(f) Incorporated herein by reference to Exhibit number 99-1 of Form S-8
Registration Statement as filed with the Commission on July 23, 1996.
(g) Incorporated herein by reference to Appendix A of Proxy Statement for
the Annual Meeting of Stockholders to be held June 12, 1996 as filed
with the Commission on May 9, 1996.
(h) 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, 1996, as filed with the Commission on November 8, 1996.
(i) Incorporated herein by reference to Appendix A of Proxy Statement for
the Special Meeting of Stockholders to be held December 10, 1996 as
filed with the Commission on November 12, 1996.
(j) 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, 1996, as filed with the Commission on March 19, 1997.
(k) Incorporated herein by reference to Exhibit number 99.1 to the
Company's Registration Statement on Form S-8, as filed with the
Commission on May 7, 1997.
(l) Incorporated herein by reference to Exhibit number 99.1 to the
Company's Registration Statement on Form S-8, as filed with the
Commission on August 15, 1997.
(m) Incorporated herein by reference to Exhibit number 99.1 to the
Company's Registration Statement on Form S-8, as filed with the
Commission on July 28, 1998.
(n) Incorporated herein by reference to Exhibit number 1 to the Company's
Registration Statement on Form 8-A, as filed with the Commission on
December 15, 1998.
<PAGE> 1
EXHIBIT 10.50
FORM OF CHANGE IN CONTROL AGREEMENT
WITH EXECUTIVE OFFICERS AND OTHER KEY EMPLOYEES
[Date]
[Person's Name and Address]
Dear [name]:
We are pleased to inform you that the Company's Board of Directors has approved
a special severance benefit program for you. The purpose of this letter
agreement is to set forth the terms and conditions of your severance benefits
and to explain the limitations that will govern their overall value.
Your severance package will become payable should the Company
terminate your employment, or should you otherwise resign from the Company,
under certain circumstances following a substantial change in ownership or
control of the Company. To understand the full scope of your benefits, you
should familiarize yourself with the definitional provisions of Part One of this
letter agreement. The benefits comprising your severance package are detailed in
Part Two, and the dollar limitations on the overall value of your benefit
package and other applicable restrictions are specified in Parts Three and Four.
Part Five deals with ancillary matters affecting your severance arrangement.
PART ONE--DEFINITIONS
For purposes of this letter agreement, the following definitions will be in
effect:
AVERAGE COMPENSATION means the average of your W-2 wages from the
Company for the five (5) calendar years (or such fewer number of calendar years
of employment with the Company) completed immediately prior to the calendar year
in which the Change in Control is effected. Any W-2 wages for a partial year of
employment will be annualized, in accordance with the frequency which such wages
are paid during such partial year, before inclusion in your Average
Compensation.
BASE SALARY means the monthly rate of base salary in effect for
you immediately prior to the Change in Control or (if greater) the monthly rate
of base salary in effect at the time of your Involuntary Termination or
Voluntary Resignation (as applicable).
BOARD means the Company's Board of Directors.
<PAGE> 2
CHANGE IN CONTROL means a change in the ownership or control of
the Company effected through any of the following transactions:
(i) a merger or consolidation approved by the Company's
stockholders in which securities possessing more than fifty
percent (50%) of the total combined voting power of the Company's
outstanding securities are transferred to a person or persons
different from the persons holding those securities immediately
prior to such transaction;
(ii) any stockholder-approved sale, transfer or other
disposition of all or substantially all of the Company's assets
in complete liquidation or dissolution of the Company;
(iii) the acquisition, directly or indirectly, by any
person or related group of persons (other than the Company or a
person that directly or indirectly controls, is controlled by or
is under common control with, the Company) of beneficial
ownership (within the meaning of Rule 13d-3 of the Securities
Exchange Act of 1934, as amended) of securities possessing more
than fifty percent (50%) of the total combined voting power of
the Company's outstanding securities pursuant to a tender or
exchange offer made directly to the Company's stockholders; or
(iv) a change in the composition of the Board over a
period of thirty-six (36) consecutive months or less such that a
majority of the Board members ceases, by reason of one or more
contested elections for Board membership, to be comprised of
individuals who either (A) have been Board members continuously
since the beginning of such period or (B) have been elected or
nominated for election as Board members during such period by at
least a majority of the Board members described in clause (A) who
were still in office at the time the Board approved such election
or nomination.
CODE means the Internal Revenue Code of 1986, as amended.
COMMON STOCK means the Company's common stock.
COMPANY means PairGain Technologies, Inc., a Delaware
corporation, or any successor corporation, whether or not resulting from a
Change in Control.
DISABILITY means your inability to perform the normal and usual
duties of your position with the Company by reason of any physical or medical
impairment which is expected to result in death or continue for a period of
twelve (12) consecutive months or more.
FAIR MARKET VALUE means, with respect to the shares of Common
Stock subject to any of your Options, the closing selling price per share of
Common Stock on the date in question, as such price is reported by the National
Association of Securities Dealers on the Nasdaq National Market. If there is no
closing selling price reported for the Common Stock on
<PAGE> 3
the date in question, then the Fair Market Value will be the closing selling
price on the last preceding date for which such report exists.
INVOLUNTARY TERMINATION means (i) the involuntary termination of
your employment with the Company other than a Termination for Cause or (ii) your
voluntary resignation following (A) a change in your position with the Company
which materially reduces your duties and responsibilities or the level of
management to which you report, (B) a reduction in your level of compensation
(including Base Salary, fringe benefits and target bonus under any
corporate-performance based bonus or incentive programs) by more than fifteen
percent (15%) or (C) a relocation of your principal place of employment by more
than fifty (50) miles, provided and only if such change, reduction or relocation
is effected by the Company without your consent.
An Involuntary Termination will not be deemed to occur in the
event your employment terminates by reason of your death or Disability or a
Termination for Cause.
LIFE INSURANCE COVERAGE means the continued coverage to which you
will be entitled under the Company's group-term and executive life insurance
plans during any Salary Continuation Period in effect for you under this letter
agreement.
OPTION means any option granted to you under the Plan which is
outstanding at the time of the Change in Control or upon your subsequent
Involuntary Termination or Voluntary Resignation (as applicable). Your Options
will be divided into two (2) separate categories as follows:
Acquisition-Accelerated Options: any outstanding Option
(or installment thereof) which automatically accelerates, pursuant to
the acceleration provisions of the agreement evidencing that Option,
upon a Change in Control.
Severance-Accelerated Options: any outstanding Option (or
installment thereof) which, pursuant to Part Two of this letter
agreement, accelerates upon an Involuntary Termination or a Voluntary
Resignation.
OPTION PARACHUTE PAYMENT means, with respect to any
Acquisition-Accelerated Option or any Severance-Accelerated Option, the portion
of that Option deemed to be a parachute payment under Code Section 280G and the
Treasury Regulations issued thereunder. The portion of such Option which is
categorized as an Option Parachute Payment will be calculated in accordance with
the valuation provisions established under Code Section 280G and the applicable
Treasury Regulations and will include an appropriate dollar adjustment to
reflect the lapse of your obligation to remain in the Company's employ as a
condition to the vesting of the accelerated installment. In no event, however,
will the Option Parachute Payment attributable to any Acquisition-Accelerated
Option or Severance-Accelerated Option (or accelerated installment) exceed the
spread (the excess of the Fair Market Value of the accelerated option shares
over the option exercise price payable for those shares) existing at the time of
acceleration.
<PAGE> 4
OTHER PARACHUTE PAYMENT means any payment in the nature of
compensation (other than the benefits to which you become entitled under Part
Two of this letter agreement) which are made to you in connection with the
Change in Control and which accordingly qualify as parachute payments within the
meaning of Code Section 280G(b)(2) and the Treasury Regulations issued
thereunder. Your Other Parachute Payment will include (without limitation) the
Present Value, measured as of the Change in Control, of the aggregate Option
Parachute Payment attributable to your Acquisition-Accelerated Options (if any).
PARACHUTE PAYMENT means any payment or benefit provided you under
Part Two of this letter agreement (other than the Option Parachute Payment
attributable to your Severance-Accelerated Options) which is deemed to
constitute a parachute payment within the meaning of Code Section 280G(b)(2) and
the Treasury Regulations issued thereunder.
PLAN means (i) the Company's 1993 Stock Option/Stock Issuance
Plan, as amended or restated from time to time, and (ii) any successor stock
incentive plan subsequently implemented by the Company.
PRESENT VALUE means the value, determined as of the date of the
Change in Control, of any payment in the nature of compensation to which you
become entitled in connection with the Change in Control or your subsequent
Involuntary Termination or Voluntary Resignation (as applicable), including
(without limitation) the Option Parachute Payment attributable to your
Severance-Acceleration Options, the additional benefits to which you become
entitled under Part Two of this letter agreement and the Option Parachute
Payment attributable to your Acquisition-Accelerated Options. The Present Value
of each such payment will be determined in accordance with the provisions of
Code Section 280G(d)(4), utilizing a discount rate equal to one hundred twenty
percent (120%) of the applicable Federal rate in effect at the time of such
determination, compounded semi-annually to the effective date of the Change in
Control.
SALARY CONTINUATION PERIOD means the period for which payment of
your Base Salary may, pursuant to Part Two of this letter agreement, be
continued following an Involuntary Termination of your employment or your
Voluntary Resignation within a specified period following a Change in Control.
TERMINATION FOR CAUSE means the Company's termination of your
employment for any of the following reasons: (i) your commission of any act of
fraud, embezzlement or dishonesty, (ii) your unauthorized use or disclosure of
any confidential information or trade secrets of the Company, (iii) any
intentional misconduct by you which has a materially adverse effect upon the
Company's business or reputation or (iv) your continued failure to perform the
major duties, functions and responsibilities of your position after written
notice from the Company identifying the deficiencies in your performance.
PART TWO--CHANGE IN CONTROL BENEFITS
Should your employment with the Company terminate by reason of an
Involuntary Termination within _____ months after a Change in Control, then you
will become
<PAGE> 5
entitled to receive the severance benefits provided under this Part Two.
However, those benefits will in all events be subject to the benefit limitations
of Part Three and the restrictive covenants of Part Four of this letter
agreement and will be in lieu of all other severance benefits to which you might
otherwise be entitled upon such termination of your employment.
Charles S. Strauch shall, during his period of service as an
officer, employee or Board member of the Company, have the sole and exclusive
authority to resolve any issues relating to whether or not any termination of
your employment within ______ months after a Change in Control qualifies as an
Involuntary Termination for purposes of this letter agreement, and his decision
on such issues shall be final, binding and conclusive upon both you and the
Company.
1. Accelerated Vesting.
Each outstanding Option which you hold at the time of your
Involuntary Termination, to the extent not otherwise exercisable for all the
shares of Common Stock subject to that Option, will immediately become
exercisable for all those option shares and may be exercised for any or all of
those shares as fully vested shares. Each such accelerated Option granted prior
to the date of this letter agreement with an exercise price per share below the
fair market value per share of Common Stock on the execution date of this letter
agreement will remain exercisable until the earlier of (i) the expiration of the
option term or (ii) the end of the three (3)-month period following the date of
your Involuntary Termination, and each such accelerated Option granted prior to
the execution date of this letter agreement with an exercise price per share
higher than the fair market value per share of Common Stock on the execution
date of this letter agreement, together with each such accelerated Option
granted after the date of this letter agreement, will remain exercisable until
the earlier of (x) the expiration of the option term or (y) the end of the
twelve (12)-month period following the date of your Involuntary Termination. Any
Options not exercised prior to the expiration of the applicable post-service
exercise period will lapse and cease to remain exercisable.
2. Severance Payment.
You will be entitled to salary continuation payments at one
hundred ten percent (110%) of your applicable rate of Base Salary for a Salary
Continuation Period of months. These salary continuation payments will be made
to you at bi-monthly intervals in accordance with the Company's normal payroll
practices.
You will immediately vest in any and all unpaid deferred bonuses
credited to you under the Company's management incentive plan for one or more
prior fiscal years, and those deferred bonuses will be paid to you in a lump sum
within thirty (30) days after your Involuntary Termination.
3. Life Insurance Coverage.
You will be entitled to Life Insurance Coverage through your
continued participation in the Company's group term and executive life insurance
plans following your Involuntary Termination, and the Company will pay the
entire premium charged for such
<PAGE> 6
continued Life Insurance Coverage. Such Company-paid coverage will continue
until the earlier of (i) the expiration of your Salary Continuation Period or
(ii) the first date on which you are covered under another employer's life
insurance plan. However, you will be responsible for the satisfaction of any
income tax liability attributable to your Company-paid Life Insurance Coverage.
Your payments and benefits under Paragraphs 2 and 3 of this Part
Two will immediately terminate in the event you fail to abide by the restrictive
covenants set forth in Part Four of this letter agreement. Your Paragraph 2
payments will be subject to the Company's collection of all applicable federal
and state income and employment withholding taxes.
PART THREE--LIMITATION ON BENEFITS
1. Benefit Limit.
The aggregate Present Value (measured as of the Change in
Control) of the benefits to which you become entitled under Part Two at the time
of your Involuntary Termination, namely, the salary continuation payments, the
Option Parachute Payment attributable to your Severance-Accelerated Options and
your Company-paid Life Insurance Coverage, will in no event exceed in amount the
greater of the following dollar amounts (the "Benefit Limit"):
(a) 2.99 times your Average Compensation, less the Present
Value, measured as of the Change in Control, of all Other Parachute
Payments to which you are entitled, or
(b) the amount which yields you the greatest after-tax
amount of benefits under Part Two of this letter agreement after taking
into account any excise tax imposed under Code Section 4999 on the
payments and benefits which are provided you under Part Two or which
constitute Other Parachute Payments.
The Option Parachute Payment attributable to the accelerated
vesting of your Acquisition-Accelerated Options at the time of the Change in
Control shall also be subject to the Benefit Limitation.
2. Resolution Procedure.
In the event there is any disagreement between you and the
Company as to whether one or more payments to which you become entitled in
connection with either the Change in Control or your subsequent Involuntary
Termination constitute Parachute Payments, Option Parachute Payments or Other
Parachute Payments or as to the determination of the Present Value of any of
those payments, such dispute will be resolved as follows:
(i) In the event temporary, proposed or final Treasury
Regulations in effect at the time under Code Section 280G (or
applicable judicial decisions) specifically address the status of
any such payment or
<PAGE> 7
the method of valuation therefor, the characterization afforded
to such payment by the Regulations (or such decisions) will,
together with the applicable valuation methodology, be
controlling.
(ii) In the event Treasury Regulations (or applicable
judicial decisions) do not address the status of any payment in
dispute, the matter will be submitted for resolution to
independent tax counsel mutually acceptable to you and the
Company ("Independent Counsel"). The resolution reached by
Independent Counsel will be final and controlling; provided,
however, that if in the judgment of Independent Counsel the
status of the payment in dispute can be resolved through the
obtainment of a private letter ruling from the Internal Revenue
Service, a formal and proper request for such ruling will be
prepared and submitted by Independent Counsel, and the
determination made by the Internal Revenue Service in the issued
ruling will be controlling. All expenses incurred in connection
with the retention of Independent Counsel and (if applicable) the
preparation and submission of the ruling request will be shared
equally by you and the Company.
(iii) In the event Treasury Regulations (or applicable
judicial decisions) do not address the appropriate valuation
methodology for any payment in dispute, the Present Value thereof
will, at the Independent Counsel's election, be determined
through an independent third-party appraisal, and the expenses
incurred in obtaining such appraisal will be shared equally by
you and the Company.
3. Status of Benefits.
A. No benefits shall be provided you under Part Two of
this letter agreement (including the accelerated vesting of your outstanding
Options, the salary continuation payments and the Company-paid Life Insurance
Coverage) until the Present Value of the Option Parachute Payment attributable
to both your Severance-Accelerated Options and your Acquisition-Accelerated
Options has been determined and the status of any payments in dispute under
Paragraph 5 above has been resolved in accordance therewith. The post-service
exercise period in effect for your Options shall be stayed and shall not run
until the resolution process hereunder is completed.
B. Once the requisite determinations under Paragraph 5
have been made, then to the extent the aggregate Present Value, measured as of
the Change in Control, of (i) the Option Parachute Payment attributable to your
Severance-Accelerated Options (or installments thereof) plus (ii) the Parachute
Payment attributable to your other benefit entitlements under Part Two of this
letter agreement would, when added to the Present Value of all your Other
Parachute Payments (including the Option Parachute Payment attributable to your
Acquisition-Accelerated Options), exceed the Benefit Limit, first your salary
continuation payments will be reduced and then the period of your Company-paid
Life Insurance Coverage will be shortened, to the extent necessary to assure
that such Benefit Limit is not exceeded.
<PAGE> 8
PART FOUR -- CONSULTING SERVICES AND SPECIAL RESTRICTIVE COVENANTS
1. Consulting Services.
In consideration for the salary continuation payments to which
you become entitled under Part Two, you will make yourself available during the
Salary Continuation Period to render such consulting services to the Company
within your area of expertise as may reasonably be requested by the Company's
Chief Executive Officer, but in no event may more than ten (10) hours of such
services will be required of you per month.
2. Cessation of Benefits.
Your Salary Continuation Period will immediately terminate, and
all salary continuation payments and Company-paid Life Insurance Coverage will
immediately cease, should you:
(a) own, manage, operate, join, control or participate in
the ownership, management, operation or control of, or be employed by or
connected in any manner with, any enterprise which is engaged in any
business competitive with or similar to that of the Company; provided,
however, that such restriction will not apply to any passive investment
representing an interest of less than two percent (2%) of an outstanding
class of publicly-traded securities of any corporation or other
enterprise;
(b) encourage or solicit any of the Company's employees to
leave the Company's employ for any reason or interfere in any other
manner with employment relationships at the time existing between the
Company and its employees; or
(c) induce any of the Company's clients, customers,
suppliers, vendors, distributors, licensors or licensees to terminate
their existing business relationships with the Company or interfere in
any other manner with any existing business relationship between the
Company and any client, customer, supplier, vendor, distributor,
licensor, licensee or other third party.
PART FIVE--MISCELLANEOUS
1. Termination for Cause.
Should your employment cease by reason of a Termination for Cause
or should you voluntarily resign under circumstances which would otherwise
constitute grounds for a Termination for Cause, then the Company will only be
required to pay you (i) any unpaid compensation earned for services previously
rendered through the date of such termination and (ii) any accrued but unpaid
vacation benefits or sick days, and no benefits will be payable to you under
Part Two of this letter agreement.
<PAGE> 9
2. Deferred Compensation.
Solely for purposes of determining the commencement date for the
payment of any deferred compensation to which you may be entitled under the
Company's Management Deferred Compensation Plan, your employment with the
Company will be deemed to continue for the duration of your Salary Continuation
Period, and no deferred compensation under that Plan will be paid to you during
such Salary Continuation Payment. However, no portion of the salary continuation
payments you receive under Part Two of this letter agreement will be eligible
for deferral under that Plan, and for no other purpose will be you considered an
active employee during your Salary Continuation Period.
3. Death.
Should you die before receipt of one or more salary continuation
payments to which you become entitled under this letter agreement, then those
payments will be made to the executors or administrators of your estate. Should
you die before you exercise all your outstanding Options as accelerated
hereunder, then such Options may be exercised, within twelve (12) months after
your death, by the executors or administrators of your estate or by persons to
whom the Options are transferred pursuant to your will or in accordance with the
laws of inheritance. In no event, however, may any such Option be exercised
after the specified expiration date of the option term.
4. General Creditor Status.
All cash payments to which you become entitled hereunder will be
paid, when due, from the general assets of the Company, and no trust fund,
escrow arrangement or other segregated account will be established as a funding
vehicle for such payment. Accordingly, your right (or the right of the personal
representatives or beneficiaries of your estate) to receive such cash payments
hereunder will at all times be that of a general creditor of the Company and
will have no priority over the claims of other general creditors.
5. Indemnification.
The indemnification provisions for Officers and Directors under
the Company By-Laws will (to the maximum extent permitted by law) be extended to
you, during the period following your Involuntary Termination or Voluntary
Resignation, with respect to any and all matters, events or transactions
occurring or effected during your employment with the Company.
6. Miscellaneous.
This letter agreement will be binding upon the Company, its
successors and assigns (including, without limitation, the surviving entity in
any Change in Control) and is to be construed and interpreted under the laws of
the State of California. This letter agreement supersedes all prior agreements
between you and the Company relating to the subject of severance benefits
payable upon a change in control or ownership of the Company, and you will not
be entitled to any other severance benefits upon such a termination other than
those that are provided in this letter agreement. This letter may only be
amended by written instrument signed
<PAGE> 10
by you and an authorized officer of the Company. If any provision of this letter
agreement as applied to you or the Company or to any circumstance should be
adjudged by a court of competent jurisdiction to be void or unenforceable for
any reason, the invalidity of that provision will in no way affect (to the
maximum extent permissible by law) the application of such provision under
circumstances different from those adjudicated by the court, the application of
any other provision of this letter agreement, or the enforceability or
invalidity of this letter agreement as a whole. Should any provision of this
letter agreement become or be deemed invalid, illegal or unenforceable in any
jurisdiction by reason of the scope, extent or duration of its coverage, then
such provision will be deemed amended to the extent necessary to conform to
applicable law so as to be valid and enforceable or, if such provision cannot be
so amended without materially altering the intention of the parties, then such
provision will be stricken and the remainder of this letter agreement will
continue in full force and effect.
7. At Will Employment.
Nothing in this letter agreement is intended to provide you with
any right to continue in the employ of the Company (or any subsidiary) for any
period of specific duration or interfere with or otherwise restrict in any way
your rights or the rights of the Company (or any subsidiary), which rights are
hereby expressly reserved by each, to terminate your employment at will or as
otherwise specified in your employment contract.
Please indicate your acceptance of the foregoing by signing the
enclosed copy of this letter and returning it to the Company.
Very truly yours,
PAIRGAIN TECHNOLOGIES, INC.
By:
---------------------------------
Title:
---------------------------------
ACCEPTANCE
I hereby agree to all the terms and provisions of the foregoing
letter agreement governing the special benefits to which I may become entitled
upon an involuntary termination of my employment or if I voluntarily resign my
employment under certain prescribed circumstances following a substantial change
in control or ownership of the Company.
Signature:
------------------------------
Dated:
---------------------------------
<PAGE> 1
PAIRGAIN TECHNOLOGIES, INC.
EXHIBIT 21.1--LIST OF SUBSIDIARIES
<TABLE>
STATE OR JURISDICTION
NAME OF LEGAL ENTITY OF INCORPORATION
- ---------------------------------------- ---------------------
<S> <C>
PairGain Services Group, Inc. Delaware
PairGain Canada Holding Ltd. Canada
PairGain Canada, Inc. Canada
PairGain International Sales Corp. U. S. Virgin Islands
PairGain Technologies AG Switzerland
PairGain Wallingford Design Center, Inc. Delaware
PairGain do Brasil Ltda. Brazil
</TABLE>
All are wholly-owned subsidiaries of PairGain Technologies, Inc.
<PAGE> 1
PAIRGAIN TECHNOLOGIES, INC.
EXHIBIT 23.1--INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statements No.
33-72792 and 33-96080 on Form S-8 and No. 333-23067 on Form S-3, as amended, of
PairGain Technologies, Inc. of our report dated January 26, 1999, appearing in
this Annual Report on Form 10-K of PairGain Technologies, Inc. for the year
ended December 31, 1998.
DELOITTE & TOUCHE LLP
Costa Mesa, California
March 29, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 131,923
<SECURITIES> 102,011
<RECEIVABLES> 20,226
<ALLOWANCES> 0
<INVENTORY> 34,320
<CURRENT-ASSETS> 307,192
<PP&E> 42,453
<DEPRECIATION> 22,971
<TOTAL-ASSETS> 328,520
<CURRENT-LIABILITIES> 49,479
<BONDS> 0
0
0
<COMMON> 35
<OTHER-SE> 279,006
<TOTAL-LIABILITY-AND-EQUITY> 328,520
<SALES> 274,377
<TOTAL-REVENUES> 283,100
<CGS> 146,569
<TOTAL-COSTS> 136,531
<OTHER-EXPENSES> 80,995
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> (7,529)
<INCOME-PRETAX> 63,065
<INCOME-TAX> 23,566
<INCOME-CONTINUING> 39,499
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 39,499
<EPS-PRIMARY> 0.56<F1>
<EPS-DILUTED> 0.53
<FN>
<F1>For Purposes of This Exhibit, Primary Means Basic.
</FN>
</TABLE>
