<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
______________________
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 1996
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 0-27764
______________________________
XYLAN CORPORATION
(Exact name of registrant as specified in its charter)
California 95-4433911
----------------- ---------------
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
26679 WEST AGOURA ROAD
CALABASAS, CALIFORNIA 91302
(Address of principal executive offices)
TELEPHONE: (818) 880-3500
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filled 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 [_]
The number of shares outstanding of the registrant's Common Stock as of
September June 30, 1996, was 41,836,797.
1
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XYLAN CORPORATION
QUARTERLY REPORT ON FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 30, 1996
INDEX
<TABLE>
<CAPTION>
PAGE
----
<S> <C> <C>
PART I FINANCIAL INFORMATION
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets -- September 30, 1996
and December 31, 1995 3
Condensed Consolidated Statements of Operations -- Three Months
Ended September 30, 1996, June 30, 1996, and September 30, 1995 4
Nine Months Ended September 30, 1996 and 1995 5
Condensed Consolidated Statements of Cash Flows -- Nine Months
Ended September 30, 1996 and 1995 6
Notes to Condensed Consolidated Financial Statements 7-11
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations 12-26
PART II OTHER INFORMATION
Item 1. Legal Proceedings 27
Item 2. Changes in Securities 27
Item 3. Defaults in Senior Securities 27
Item 4. Submission of Matters to a Vote of Security Holders 27
Item 5. Other Information 27
Item 6. Exhibits and Reports on Form 8-K 27
Signature 28
Exhibit Index 29
</TABLE>
2
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PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
XYLAN CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1996 1995
------------- ------------
ASSETS (UNAUDITED)
<S> <C> <C>
Current assets:
Cash and cash equivalents............................. $ 54,634 $ 6,034
Short-term investments................................ 60,666 --
Accounts receivable, net.............................. 23,700 13,142
Inventories........................................... 10,774 2,128
Note receivable....................................... 6,000 --
Prepaid expenses and other current assets............. 2,000 383
---------- --------
Total current assets................................. 157,774 21,687
Investments............................................ 20,546 --
Property and equipment, net............................ 12,740 5,073
Other assets........................................... 1,272 488
---------- --------
$ 192,332 $ 27,248
========== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Current installments of capital lease obligations..... $ 324 $ 329
Accounts payable...................................... 4,185 7,371
Accrued expenses...................................... 8,103 2,258
Deferred revenue...................................... 3,444 599
---------- --------
Total current liabilities............................ 16,056 10,557
Capital lease obligations, less current installments... 271 509
Deferred revenue....................................... 584 77
---------- --------
Total liabilities.................................... 16,911 11,143
---------- --------
Shareholders' equity:
Convertible preferred stock........................... -- 26
Common stock and additional paid-in capital........... 179,253 30,125
Accumulated deficit................................... (3,832) (14,046)
---------- --------
Net shareholders' equity............................. 175,421 16,105
---------- --------
$ 192,332 $ 27,248
========== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
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XYLAN CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(in thousands, except per share data)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
-------------------------------------------------------------
SEPTEMBER 30, JUNE 30, SEPTEMBER 30,
1996 1996 1995
------------- --------- --------------
<S> <C> <C> <C>
Revenue...................................... $35,425 $28,187 $ 8,240
Cost of revenue.............................. 15,904 13,225 4,386
------- ------- -------
Gross profit............................... 19,521 14,962 3,854
------- ------- -------
Operating expenses:
Research and development................... 4,255 3,484 2,040
Sales and marketing........................ 8,594 7,039 3,779
General and administrative................. 1,017 1,081 1,216
------- ------- -------
Total operating expenses................... 13,866 11,604 7,035
------- ------- -------
Operating income (loss)................... 5,655 3,358 (3,181)
Interest income (expense), net............... 1,861 1,321 (14)
------- ------- -------
Income (loss) before income taxes............ 7,516 4,679 (3,195)
Income tax expense........................... 2,886 1,778 --
------- ------- -------
Net income (loss).......................... $ 4,630 $ 2,901 $(3,195)
======= ======= =======
Net income (loss) per share.................. $ 0.10 $ 0.06 $ (0.15)
======= ======= =======
Weighted average common and common
equivalent shares outstanding............... 47,451 46,996 21,151
======= ======= =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE>
XYLAN CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
(in thousands, except per share data)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------
1996 1995
------- -------
<S> <C> <C>
Revenue........................................ $87,004 $14,140
Cost of revenue................................ 39,952 8,006
------- -------
Gross profit................................. 47,052 6,134
------- -------
Operating expenses:
Research and development..................... 10,933 4,725
Sales and marketing.......................... 21,433 9,203
General and administrative................... 3,087 2,171
------- -------
Total operating expenses..................... 35,453 16,099
------- -------
Operating income (loss)...................... 11,599 (9,965)
Interest income................................ 3,359 87
------- -------
Income (loss) before income taxes.............. 14,958 (9,878)
Income tax expense............................. 4,744 --
------- -------
Net income (loss)............................ $10,214 $(9,878)
======= =======
Net income (loss) per share.................... $ 0.22 $ (0.47)
======= =======
Weighted average common and common
equivalent shares outstanding................. 46,320 21,151
======= =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE>
XYLAN CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(in thousands)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
----------------------
1996 1995
-------- ---------
<S> <C> <C>
Cash flows from operating activities:
Net income (loss)......................................... $ 10,214 $ (9,878)
Adjustments to reconcile net income (loss) to net cash
provided by (used in) operating activities:
Depreciation and amortization............................ 2,283 515
Income tax expense....................................... 4,664 --
Consulting expense paid in common stock.................. -- 55
Unearned compensation amortization....................... 385 --
Changes in operating assets and liabilities:
Accounts receivable.................................... (10,558) (7,756)
Inventories............................................ (8,646) (588)
Prepaid expenses and other current assets.............. (1,617) (224)
Other assets........................................... (784) (59)
Accounts payable....................................... (3,186) 3,401
Accrued expenses....................................... 5,845 2,119
Deferred revenue....................................... 3,352 610
-------- ---------
Net cash provided by (used) in operating
activities........................................... 1,952 (11,805)
-------- ---------
Cash flows from investing activities:
Purchases of property and equipment...................... (9,950) (2,741)
Note receivable.......................................... (6,000) --
Sales (purchases) of investments......................... (81,212) 3,879
-------- ---------
Net cash provided by (used in) investing activities... (97,162) 1,138
-------- ---------
Cash flows from financing activities:
Proceeds from issuances of common stock and
common stock warrants................................... 144,053 --
Proceeds from issuances of convertible preferred stock... -- 9,986
Long-term loans from bank................................ -- 1,000
Repayments of debt....................................... (243) --
-------- ---------
Net cash provided by financing activities............. 143,810 10,986
-------- ---------
Net increase in cash and cash equivalents............. 48,600 319
Cash and cash equivalents at beginning of period........... 6,034 747
-------- ---------
Cash and cash equivalents at end of period................. $ 54,634 $ 1,066
======== =========
Supplemental disclosure of cash flow information--
cash paid during the period for interest................. $ 36 $ 44
======== =========
Supplemental disclosure of non-cash investing and financing
activities - financed capital expenditures............... $ -- $ 562
======== =========
</TABLE>
The accompanying notes are an integral part of these financial statements.
6
<PAGE>
XYLAN CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1. Basis Of Presentation
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, these statements include all
adjustments, consisting of normal and recurring adjustments, considered
necessary for a fair presentation of results for such periods. The results of
operations for the three and nine month periods ending September 30, 1996 are
not necessarily indicative of results which may be achieved for the full fiscal
year or for any future period. The unaudited consolidated interim financial
statements should be read in conjunction with the financial statements and notes
thereto contained in Xylan Corporation's ("Xylan" or the "Company") Registration
Statement on Form S-1, File No. 333-03623, declared effective by the Securities
and Exchange Commission on May 29, 1996.
NOTE 2. Investments
Investments at September 30, 1996 consist of corporate and government debt
securities. In accordance with the provisions of Statement of Financial
Accounting Standards Board No. 115, "Accounting for Certain Investments in Debt
and Equity Securities," the Company classifies its investments as held-to-
maturity securities. The market value of these securities at September 30, 1996,
approximated cost.
NOTE 3. Inventories
Inventories are stated at the lower of cost or market, cost being
determined using the first-in, first-out method. At September 30, 1996 and
December 31, 1995, inventories were primarily components parts.
NOTE 4. Note Receivable
During the nine months ended September 30, 1996, the Company
loaned its contract manufacturer $6 million. The loan, which enables the
Contract manufacturer to meet the Company's increasing production requirements,
is classified as a current asset and is secured by raw materials and electronic
components purchased by the contract manufacturer. In July 1996, the Company
also guaranteed up to $5 million of the contract manufacturer's debt for
inventory purchases.
7
<PAGE>
NOTE 5. Accrued Expenses
Accrued expenses consist of the following:
<TABLE>
<CAPTION>
September 30, December 31,
1996 1995
------------- ------------
<S> <C> <C>
Accrued payroll and related costs $2,908 $1,003
Accrued warranty 1,259 446
Other 3,936 809
------ ------
Total accrued expenses $8,103 $2,258
====== ======
</TABLE>
8
<PAGE>
NOTE 6. Shareholders' Equity
On March 12, 1996, the Company completed its initial public offering
of a total of 4,830,000 shares of common stock, of which 3,680,000 shares were
sold by the Company, and 1,150,000 shares were sold by a selling shareholder.
Aggregate net proceeds to the Company were approximately $87.4 million.
Upon the effectiveness of the initial public offering, all of the
25,698,676 outstanding shares of preferred stock were converted into the same
number of shares of common stock. Additionally, a warrant containing an
automatic net exercise provision was converted into 185,725 shares of common
stock.
On May 30, 1996, the Company completed a secondary public offering of
4,600,000 shares of common stock, of which 1,000,000 shares were sold by the
Company, and 3,600,000 shares were sold by certain selling shareholders.
Aggregate net proceeds to the Company were approximately $56.2 million.
The Company has a 1993 Stock Incentive Plan (the "1993 Plan"). Under the
1993 Plan, 8,000,000 shares of the Company's authorized but unissued common
stock are reserved for options or stock purchase grants. As of September 30,
1996, the Company has issued 1,272,306 shares of common stock under the 1993
Plan and options to purchase 6,701,870 shares of common stock are outstanding.
In connection with the grant of stock options, for financial statement
presentation purposes, the Company has recorded unearned compensation, net of
cancellations, of $2,336,000 representing the difference between the grant price
and the deemed fair market value. This amount will be recorded as compensation
expense ratably over the vesting period for each option. For the quarters ended
September 30, 1996,and June 30, 1996, the Company recorded $114,000 and $114,000
of compensation expense, respectively. For the nine months ended September 30,
1996 the Company recorded $385,000 of compensation expense.
In January 1996, the Board of Directors adopted the 1996 Stock Option Plan.
As of September 30, 1996 the Company has not issued any shares of common stock
under this plan and options to purchase 897,750 are outstanding.
In January 1996, the Board of Directors also adopted the 1996 Employee Stock
Purchase Plan and the 1996 Directors Stock Option Plan. As of September 30, 1996
no options have been granted under these plans.
In July 1996 the Company and IBM entered into an alliance in the field
of campus networking switching products. The Company has committed to grant IBM
warrants to purchase up to 2,350,000 shares of Xylan common stock based on the
achievement of specific business goals. The exercise price of the warrants will
be at a 25% premium over the Xylan closing stock price when earned.
NOTE 7. Income Taxes
The Company's provision for income taxes for the three months ended
September 30, 1996 and June 30, 1996 and the nine months ended September 30,
1996 is based upon the Company's estimate of the effective tax rate for fiscal
1996. For the quarter ended September 30, and June 30, 1996, the Company
realized an income tax benefit for certain stock option transactions. This
benefit is used to reduce taxable income prior to the utilization of net
operating loss carryforwards, and results in a decrease in current income taxes
payable and an increase in additional paid in capital. Accordingly, the Company
recorded an income tax provision equal to approximately 38% of pretax income but
did not incur an income tax liability. For the quarter ended March 31, 1996, the
Company reduced the income tax provision and income tax liability to 3% of
pretax income by utilizing net operating loss carryforwards. As a result of net
9
<PAGE>
operating losses, no provision for income taxes was recorded for 1995. For the
remainder of 1996, the Company expects to record a 38% provision for income
taxes, although such percentage may vary depending on several factors, including
tax benefits associated with certain stock option transactions, the assessment
of the deferred tax asset realization probability and the international
component of the Company's business. As of December 31, 1995, the Company had
available net operating loss carryforwards for federal and state tax purposes of
approximately $12.4 million and $6.2 million, respectively, to offset future
United States tax obligations.
NOTE 8. Computation Of Net Income (Loss) Per Share
Net income (loss) per common and common equivalent share has been
computed using the weighted average number of common and common equivalent
shares outstanding using the treasury stock method, as adjusted for the two-for-
one common stock split, effective as of February 28, 1996, for all periods
presented. Shares used in the net income (loss) per share calculation are
summarized as follows (in thousands):
<TABLE>
<CAPTION>
THREE MONTHS NINE SIX MONTHS
ENDED ENDED
----------------------------- --------------------
SEPT 30, JUNE 30, SEPT 30, SEPT 30, SEPT 30,
1996 1996 1995 1996 1995
-------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C>
Weighted average common
stock outstanding 41,837 40,963 10,320 40,332 10,320
Weighted average common
stock equivalents outstanding 5,614 6,033 10,831 5,988 10,831
------ ------ ------ ----- ------
Shares used in net income
(loss) per share calculation 47,451 46,996 21,151 46,320 21,151
====== ====== ====== ====== ======
</TABLE>
Pursuant to the requirements of the Securities and Exchange
Commission, common stock, stock options, warrants and convertible preferred
stock issued by the Company during the twelve months immediately preceding the
initial public offering date have been included in the calculation of the
weighted average shares outstanding for all periods presented using the treasury
stock method. Stock options, warrants and convertible preferred stock issued
prior to 1995 are excluded from the computation for the three and nine months
ended September 30, 1995, as their inclusion would be antidilutive.
NOTE 9. Newly Adopted Financial Accounting Standards
Effective January 1, 1996, the Company adopted Statement of Financial
Accounting Standards No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to Be Disposed Of". This statement provides
guidelines for recognition of impairment losses related to long-term assets. The
adoption of this new standard did not have a material effect on the Company's
consolidated financial statements.
Effective January 1, 1996, the Company adopted Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation"
("Statement No. 123"). This statement encourages, but does not require, a fair
value based method of accounting for employee stock options. The Company
elected to continue to measure compensation costs under APB Opinion No. 25,
"Accounting for Stock Issued to Employees" and to comply with the pro forma
10
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disclosure requirements of Statement No. 123. The adoption of this standard had
no impact on the Company's consolidated financial statements.
NOTE 10. Segment Information
Customers comprising 10% or more of revenue are as follows:
<TABLE>
<CAPTION>
Three months ended Nine months ended
----------------------------------------- September 30,
September 30, June 30, September 30, ----------------------
1996 1996 1995 1996 1995
------------- -------- ------------- --------- ---------
<S> <C> <C> <C> <C> <C>
Customer A 15% * * * *
Customer B 11% 27% 11% 17% *
Customer C 11% * * * *
Customer D * * * 13% *
Customer E * * 12% * 13%
Customer F * * 12% * *
Customer G * * 11% * *
</TABLE>
______________________
* Revenue to these customers comprised less than 10% of revenue for the
respective period.
Sales to customers outside of North America accounted for
approximately 39%, 65% and 44% of the Company's revenue in the three months
ended September 30, 1996, June 30, 1996 and September 30, 1995, respectively.
Sales to customers outside of North America accounted for approximately 55% and
43% of the Company's revenue in the nine months ended September 30, 1996 and
1995, respectively. However, these percentages may understate sales of the
Company's products to international end users because certain of the Company's
U.S.-based OEM partners sell the Company's products abroad.
11
<PAGE>
ITEM 2. Management's Discussion And Analysis Of Financial Condition And
Results Of Operations
Except for the historical information contained herein, the matters
discussed in this report are forward looking statements that involve certain
risks and uncertainties that could cause actual results to differ materially
from those in the forward-looking statements. Potential risks and uncertainties
include, without limitation, those mentioned in this report and, in particular
the factors described below under the heading "Factors Affecting Future
Results," and those mentioned in the Company's prospectus dated May 29, 1996,
under the heading "Risk Factors."
Overview
Xylan is a leading provider of high-bandwidth switching systems that
enhance the performance of existing local area networks ("LANs") and facilitate
migration to next-generation networking technologies such as asynchronous
transfer mode ("ATM"). From inception (July 9, 1993) to December 31, 1994, the
Company was primarily engaged in product research and development and in the
development of systems and operations. The Company began commercial shipments of
its initial OmniSwitch products in January 1995 and introduced the PizzaSwitch
product family in March 1996. The Company first achieved profitability in the
fourth quarter of 1995. As of September 30, 1996, the Company had an accumulated
deficit of $3.8 million.
The Company markets its products worldwide through OEM partners, system
integrators and its own sales force. As a percentage of revenue aggregate sales
to OEM partners and system integrators accounted for 47% and 37%, respectively,
for the quarter ended September 30, 1996, 47% and 48%, respectively, for the
quarter ended June 30, 1996, 49% and 33%, respectively, for the quarter ended
September 30, 1995, 46% and 41%, respectively, for the nine months ended
September 30, 1996 and 46% and 40%, respectively, for the nine months ended
September 30, 1995.
The Company intends to continue to significantly increase its
investments in research and development, sales and marketing and related
infrastructure. Any such increases will be highly dependent on factors including
the continued growth of the Company's revenue and the rate thereof, success in
hiring the appropriate personnel and market acceptance of the Company's
products. Due to the anticipated increases in the Company's operating expenses,
the Company's operating results will be materially and adversely affected if
revenue does not increase. Xylan's limited operating history makes the
prediction of future annual or quarterly operating results difficult or
impossible. Although the Company has experienced revenue growth in all quarters
since revenue was first recognized, such growth rates will not be sustainable
and are not indicative of future operating results. There can be no assurance
that the Company will sustain profitability.
As Xylan only began commercial shipments of its OmniSwitch products in
January 1995, and due to the significant growth in both revenue and operating
expenses for the quarter ended September 30, 1996, versus the same quarter in
1995, the Company believes that the comparison of the operating results for the
quarter ended September 30, 1996, versus the quarter ended June 30, 1996, is
more meaningful than the comparison of the quarter and nine months ended
September 30, 1996, versus the quarter and nine months ended September 30, 1995,
respectively.
12
<PAGE>
Results Of Operations
Revenue
Revenue for the quarter ended September 30, 1996 was $35.4 million compared
to $28.2 million for the quarter ended June 30, 1996, an increase of 26%.
Revenue for the quarter ended September 30, 1995 was $8.2 million. Revenue for
the nine months ended September 30, 1996 was $87.0 million compared to $14.1
million for the nine months ended September 30, 1995. The increases in revenue
were due to a number of factors, including the addition of IBM as a strategic
partner in July 1996, substantial growth of the LAN switching market, continued
introduction by the Company of additional features and functions to its
OmniSwitch product family, market acceptance of the Company's LAN switching
products, and the Company's investment in sales and marketing efforts. The
relative contribution of most of these factors cannot be quantified, and future
changes in an individual factor therefore cannot be used to predict future
revenue growth. While the Company has achieved quarter-to-quarter revenue growth
in previous quarters, there can be no assurances that the Company will be able
to sustain this rate of sequential quarterly revenue growth in future periods.
Customers comprising 10% or more of revenue are as follows:
<TABLE>
<CAPTION>
Three months ended Nine months ended
----------------------------------------- September 30,
September 30, June 30, September 30, -------------------------
1996 1996 1995 1996 1995
------------- -------- ------------- ----------- ----------
<S> <C> <C> <C> <C> <C>
Customer A 15% * * * *
Customer B 11% 27% 11% 17% *
Customer C 11% * * * *
Customer D * * * 13% *
Customer E * * 12% * 13%
Customer F * * 12% * *
Customer G * * 11% * *
</TABLE>
_____________________________
* Revenue to these customers comprised less than 10% of revenue for the
respective period.
Sales to customers outside of North America accounted for
approximately 39%, 65% and 44% of the Company's revenue in the three months
ended September 30, 1996, June 30, 1996 and September 30, 1995, respectively.
Sales to customers outside of North America accounted for approximately 55% and
43% of the Company's revenue in the nine months ended September 30, 1996 and
1995, respectively. However, these percentages may understate sales of the
Company's products to international end users because certain of the Company's
U.S.-based OEM partners sell the Company's products abroad.
As a percentage of revenue aggregate sales to OEM partners and system
integrators accounted for 47% and 37%, respectively, for the quarter ended
September 30, 1996, 47% and 48% respectively, for the quarter ended June 30,
1996, 49% and 33%, respectively, for the quarter ended September 30, 1995, 46%
and 41%, respectively, for the nine months ended September 30, 1996 and 46% and
40%, respectively, for the nine months ended September 30, 1995. The Company's
OEM partners and system integrators are expected to continue to account, for a
substantial portion of he Company's net revenue.
Gross Profit
Gross margins were approximately 55.1%, 53.1% and 46.8% for the quarters
ended September 30, 1996, June 30, 1996 and September 30, 1995, respectively.
Gross margins were approximately 54.1% and 43.4% for the nine
13
<PAGE>
months ended September 30, 1996 and 1995, respectively. The increase in gross
margins in the third quarter of 1996 from the previous quarter resulted
primarily from design changes and component cost reductions. Such savings more
than offset the downward margin pressure from sales to OEM partners. The higher
gross margins in the three and nine months ended September 30, 1996 as compared
to the respective periods in 1995 resulted from component cost reductions,
allocating fixed costs over a larger revenue base, costs associated with tooling
charges and smaller lot sizes during the early months of the Company's initial
product introduction.
The Company's gross margins in the future will be affected by a number
of factors, including competitive market pricing and discount levels, product
mix, manufacturing volumes and fluctuations in component costs. After initial
product introduction, the Company's strategy is to seek to reduce component
costs, particularly by integrating newly-developed ASICs into such products. In
addition, the timing and execution of new product introductions may impact gross
margins and result in excess or obsolete inventories. The Company's gross
margins may also fluctuate due to the mix of distribution channels employed. The
Company expects to realize higher gross margins on direct sales than on sales
through its OEM partners and system integrators. The Company has entered into an
agreement with IBM and may in the future enter into additional OEM agreements,
which could adversely affect gross margins. Although gross margins may vary
from quarter to quarter, the Company does not anticipate significant
improvements in gross margins during the fourth quarter of 1996.
Research and Development Expenses
Research and development expenses were $4.3 million, $3.5 million and
$2.0 million for the quarters ended September 30, 1996, June 30, 1996 and
September 30, 1995, respectively. Research and development expenses were $10.9
million and $4.7 million for the nine months ended September 30, 1996 and 1995,
respectively. This represents an increase of 22.1% from the second quarter of
1996 to the third quarter of 1996, an increase of 109% from the third quarter of
1995 to the third quarter of 1996 and an increase of 131% from the nine months
ended September 30, 1995 to the nine months ended September 30, 1996. These
increases were primarily due to a significant increase in the number of
development personnel, additional product development expenses incurred in
connection with ongoing development of new products and enhancements to the
OmniSwitch and PizzaSwitch product family. As a percentage of revenue, research
and development expenses were 12%, 12% and 25% for the quarters ended September
30, 1996, June 30, 1996 and September 30, 1995, respectively. For the nine
months ended September 30, 1996 and 1995, research and development expenses as a
percentage of revenue were 13% and 33%, respectively. These declines were
primarily due to the increases in revenue.
The market for the Company's products is characterized by frequent new
product introductions and rapidly changing technology and industry standards,
any of which can render Xylan's existing products obsolete. As a result, the
Company's success will depend to a substantial degree upon its ability to
develop and introduce in a timely fashion new products and enhancements to its
existing products that meet changing customer requirements and emerging industry
standards. Accordingly, the Company expects to continue to make substantial
investments in research and development and anticipates that research and
development expenses will continue to increase in 1996 in absolute dollars.
Sales And Marketing Expenses
Sales and marketing expenses were $8.6 million, $7.0 million and $3.8
million for the quarters ended September 30, 1996, June 30, 1996 and September
30, 1995, respectively. Sales and marketing expenses were $21.4 million and $9.2
14
<PAGE>
million for the nine months ended September 30, 1996 and 1995, respectively.
This represents an increase of 22% from the second quarter of 1996 to the third
quarter of 1996, an increase of 127% from the third quarter of 1995 to the third
quarter of 1996 and an increase of 133% from the nine months ended September 30,
1995 to the nine months ended September 30, 1996. These increases were primarily
due to expenses related to the addition of Xylan sales personnel throughout
North America, Europe and Asia, increased commission expenses resulting from
higher revenue, and advertising and promotional campaigns in support of the
Company's direct sales and system integrator channels.
As a percentage of revenue, sales and marketing expenses were 24%, 25%
and 46% for the quarters ended September 30, 1996, June 30, 1996 and September
30, 1995, respectively. For the nine months ended September 30, 1996 and 1995
sales and marketing expenses as a percentage of revenue were 25% and 65%,
respectively. The declines in the three and nine months ended September 30, 1996
as compared to the respective periods in 1995 were primarily due to the
increases in revenue.
As the Company continues to expand its sales force, adding personnel and
offices worldwide, and to introduce new products and enhancements to its
existing products, it expects that sales and marketing expenses will continue to
increase in 1996 in absolute dollars.
General And Administrative Expenses
General and administrative expenses were $1.0 million, $1.1 million
and $1.2 million for the quarters ended September 30, 1996, June 30, 1996 and
September 30, 1995, respectively. General and administrative expenses were $3.1
million and $2.2 million for the nine months ended September 30, 1996 and 1995,
respectively. This represents a decrease of 6% from the second quarter of 1996
to the third quarter of 1996, a decrease of 16% from the third quarter of 1995
to the third quarter of 1996 and an increase of 42% from the nine months ended
September 30, 1995 to the nine months ended September 30, 1996. The decreases
when comparing the quarter ended September 30, 1996 with the quarters ended June
30, 1996 and September 30, 1995 reflect the Company incurring lower legal
expenses due to the settlement of litigation during the June quarter of 1996.
The increases for the nine months ended September 30, 1996 as compared to the
same period in 1995 reflects the addition of personnel and systems to support
the growth of Xylan's business.
As a percentage of revenue, general and administrative expenses were
3%, 4% and 15% for the quarters ended September 30, 1996, June 30, 1996 and
September 30, 1995, respectively. For the nine months ended September 30, 1996
and 1995 general and administrative expenses as a percentage of revenue were 4%
and 15%, respectively. The decreases reflect the increases in revenue in the
current-year periods. As the Company continues to expand its sales force, add
personnel and offices worldwide, and introduce new products and enhancements to
its existing products, it expects that general and administrative expenses will
increase in 1996 in absolute dollars.
Interest Income
Interest income (expense) was $1.9 million, $1.3 million and $(14,000) for
the quarters ended September 30, 1996, June 30, 1996 and September 30, 1995,
respectively. Interest income was $3.4 million and $87,000 for the nine months
ended September 30, 1996 and 1995, respectively. These increases are the result
of interest income earned on the net proceeds of $87.4 million and $56.2 million
from the Company's initial public offering in March 1996 and the Company's
secondary public offering in May 1996, respectively.
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Provision For Income Taxes
The Company's provision for income taxes for the three months ended
September 30, 1996 and June 30, 1996, and the nine months ended September 30,
1996 is based upon the Company's estimate of the effective tax rate for fiscal
1996. For the quarters ended September 30, 1996 and June 30, 1996, the Company
realized an income tax benefit for certain stock option transactions. This
benefit is used to reduce taxable income prior to the utilization of net
operating loss carryforwards, and results in a decrease in current income taxes
payable and an increase in additional paid in capital. Accordingly, the
Company recorded an income tax provision equal to 38% of pretax income but did
not incur an income tax liability.
As a result of net operating losses, no provision for income taxes was
recorded for 1995. For the remainder of 1996, the Company expects to record a
38% provision for income taxes, although such percentage may vary depending on
several factors, including tax benefits associated with certain stock option
transactions, the availability of research and development tax credits and the
international component of the Company's business. As of December 31, 1995, the
Company had available net operating loss carryforwards for federal and state tax
purposes of approximately $12.4 million and $6.2 million, respectively, to
offset future United States tax obligations.
Liquidity And Capital Resources
Since inception, the Company has financed its operations and capital
expenditures principally through the sale of Common Stock and Preferred Stock,
for aggregate proceeds of approximately $178 million, and capital lease and
other debt financing. For the nine months ended September 30, 1996 and 1995 cash
provided by (utilized in) operating activities was $2 million and ($11.8
million), respectively. The increase in cash provided by operations is primarily
the result of the increase in net income partially offset by increased working
capital necessary to fund the significantly expanded operations and the
resulting inventories and accounts receivable.
For the nine months ended September 30, 1996 and 1995 capital expenditures
aggregated $10.0 million and $2.7 million, respectively. During the nine months
ended September 30, 1996, the Company loaned its contract manufacturer $6
million. The loan, which enables the Contract manufacturer to meet the Company's
increasing production requirements, is classified as a current asset and is
secured by raw materials and electronic components purchased by the contract
manufacturer. In July 1996, the Company also guaranteed up to $5 million of the
contract manufacturer's debt for inventory purchases.
The Company requires substantial working capital to fund its business,
particularly to finance inventories and accounts receivables (which are
increasing in connection with increased product sales) and for capital
expenditures. The Company's future capital requirements will depend on many
factors, including the rate of revenue growth, the timing and extent of spending
to support product development efforts and expansion of sales and marketing, the
timing of introductions of new products and enhancements to existing products,
and market acceptance of the Company's products. There can be no assurance that
additional equity or debt financing, if required, will be available on
acceptable terms or at all.
The Company's principal sources of liquidity as of September 30, 1996
consisted of $54.6 million in cash and cash equivalents, $60.7 million in short-
term investments and a $7.5 million bank credit facility. The Company believes
that existing cash and investment balances and cash flow expected to be
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generated from future operations, will be sufficient to meet the Company's
requirements for at least the next 12 months.
Factors Affecting Future Results
LIMITED OPERATING HISTORY; RECENT PROFITABILITY; UNCERTAIN FUTURE
PROFITABILITY. The Company was organized in July 1993 and began shipping its
first LAN switching products in volume in the first quarter of 1995. The
Company's initial products offered limited interfaces and, in September 1995,
the Company began offering fully-featured products. Accordingly, the Company has
only a limited operating history upon which an evaluation of the Company and its
prospects can be based. As of September 30, 1996, the Company had an accumulated
deficit of $3.8 million. The Company has experienced substantial revenue growth
since January 1995, and first achieved profitability in the fourth quarter of
1995. Due to the Company's limited operating history, there can be no assurance
of revenue growth and profitability on a quarterly or annual basis in the
future. While the Company achieved significant quarter-to-quarter revenue growth
since it introduced its products in 1995, there can be no assurance that the
Company will be able to sustain the same rate of sequential quarterly revenue
growth in future periods. In the fourth quarter of 1996 and in fiscal 1997, the
Company intends to increase significantly its investments in research and
development, sales and marketing and related infrastructure. Any such increases
will be highly dependent on factors including the continued growth of the
Company's revenue and the rate thereof, success in hiring the appropriate
personnel and market acceptance of the Company's products. Due to the
anticipated increases in the Company's operating expenses, the Company's
operating results will be adversely affected if revenue does not increase. The
Company's prospects must be considered in light of the risks, expenses and
difficulties frequently encountered by companies in their early stage of
development, particularly companies in rapidly evolving markets. To address
these risks, the Company must, among other things, successfully increase the
scope of its operations, respond to competitive developments, continue to
attract, retain and motivate qualified personnel and continue to commercialize
products incorporating advanced technologies. There can be no assurance that the
Company will be successful in addressing such risks.
FLUCTUATIONS IN OPERATING RESULTS. The Company's revenue and operating
results may fluctuate from quarter to quarter and from year to year due to a
combination of factors, including (i) the timing and amount of significant
orders from the Company's OEM partners and system integrators, (ii) the
Company's success in developing, introducing and shipping product enhancements
and new products, (iii) the ability to obtain sufficient supplies of sole or
limited source components for the Company's products, (iv) the ability to attain
and maintain production volumes and quality levels for its products, (v) the mix
of distribution channels and products, (vi) new product introductions by the
Company's competitors, (vii) pricing actions by the Company or its competitors,
(viii) changes in material costs and (ix) general economic conditions. See
"Factors Affecting Future Results--Dependence on OEM Partners and Network
Integrators; Customer Concentration," "--Dependence on Sole and Limited Source
Suppliers and Availability of Components," "--Substantial Increase in
Manufacturing Operations; Dependence on Contract Manufacturing,"
"--Competition," "--Rapid Technological Change; New Products and Evolving
Markets," "--Uncertain Market Acceptance of the Company's Products; Product
Concentration" and "--Product Complexity."
The Company's revenue in any period is highly dependent upon the sales
efforts and success of Xylan's OEM partners and system integrators, which are
not within the control of the Company. The Company generally realizes a higher
gross margin on direct sales than on sales through its OEM partners and network
integrators. Accordingly, if the Company's OEM partners and system integrators
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were to account for an increased portion of the Company's revenue, gross margins
would decline. In addition, new products may have different gross margins than
existing products. In particular, the Company's PizzaSwitch product, introduced
in the first quarter of 1996, currently has a lower gross margin than the
OmniSwitch product. A significant portion of the Company's expenses, such as
rent, headcount and capital lease expenses, are relatively fixed in advance,
based in large part on the Company's forecasts of future revenue. If revenues
are below expectations in any given period, the adverse effect of a shortfall in
revenue on the Company's operating results may be magnified by the Company's
inability to adjust spending to compensate for such shortfall. The Company's
backlog at the beginning of each quarter typically is not sufficient to achieve
expected revenue for that quarter. To achieve its revenue objectives, the
Company is dependent upon obtaining orders in a quarter for shipment in that
quarter. Furthermore, the Company's agreements with its customers typically
provide that they may change delivery schedules and cancel orders within
specified timeframes without significant penalty. The Company's industry is
characterized by short product life cycles and declining prices of existing
products, which requires continual improvement of manufacturing efficiencies and
introduction of new products and enhancements to existing products to maintain
gross margins. Moreover, in response to competitive pressures or to pursue new
product or market opportunities, the Company may take certain pricing or
marketing actions that could materially and adversely affect the Company's
operating results. For example, a reduction in prices of the Company's products
could result in lower revenue, an increase in discounts offered to the
Company's OEM partners or system integrators would adversely affect the
Company's operating margins, and a substantial targeted marketing campaign could
significantly increase marketing expense and result in decreased profitability.
As a result of all of the foregoing, there can be no assurance that the Company
will be able to achieve or sustain profitability on a quarterly or annual basis.
In addition, it is possible that in some future quarter the Company's operating
results may be below the expectations of public market analysts and investors.
In such event, the price of the Company's Common Stock would likely be
materially and adversely affected.
COMPETITION. The market for network switching products is intensely
competitive and subject to frequent product introductions with improved
price/performance characteristics, rapid technological change and continued
emergence of new industry standards. Many networking companies, including Bay
Networks, Inc., Cabletron Systems, Inc., Cisco Systems, Inc., FORE Systems, Inc.
and 3Com Corporation, have introduced, or have announced their intention to
develop, network switching products that are or will be competitive with the
Company's products. In addition, many of the Company's large competitors offer
customers a broader product line which provides a more comprehensive networking
solution than the Company currently offers. Xylan expects that other companies
will also enter markets in which the Company competes. In addition to
competition from providers of network switching products, the Company expects to
face competition from other vendors in the networking market who may incorporate
switching functionality into their products or provide alternative network
solutions. Furthermore, the Company's OEM partners may in the future develop
competitive products and may then decide to terminate their relationships with
the Company. In addition, certain of the Company's OEMs could sell competitive
products using the Company's technology. Many of the Company's current and
potential competitors have longer operating histories and substantially greater
financial, technical, sales, marketing and other resources, as well as greater
name recognition and a larger installed customer base, than the Company. As a
result, these competitors may be able to devote greater resources to the
development, promotion, sale and support of their products than the Company. In
addition, competitors with a larger installed customer base may have a
competitive advantage over the Company when selling similar products or
alternative networking solutions to such customers. Increased competition could
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result in significant price competition, reduced profit margins or loss of
market share, any of which could have a material adverse effect on the Company's
business, operating results and financial condition. There can be no assurance
that the Company will be able to compete successfully against either current or
potential competitors in the future. See "Factors Affecting Future Results--
Dependence on Proprietary Technology; Intellectual Property Litigation."
SUBSTANTIAL INCREASE IN MANUFACTURING OPERATIONS; DEPENDENCE ON
CONTRACT MANUFACTURING. The Company is in the process of substantially
increasing its flow of materials, contract manufacturing capacity and internal
test and quality functions to respond to customer demand and reduce its order
lead times. Any inability or delay in increasing product flow would limit the
Company's revenue, could adversely affect the Company's competitive position and
could result in late fees or cancellation of orders under agreements with the
Company's OEM partners, although these have not occurred to date. The Company
recently leased an additional 40,000 square feet of space (a portion of which is
being used for manufacturing). Any interruption in the normal flow of production
as the Company expands manufacturing activities to this new facility, could have
a material adverse effect on the Company's business, operating results and
financial condition. The Company may also require manufacturing space beyond
this additional 40,000 square foot facility. There can be no assurance that such
additional space, if required, will be available in a timely manner or on
commercially reasonable terms.
Xylan's operational strategy relies on outsourcing of manufacturing. The
Company currently subcontracts component procurement and assembly of chassis to
a single company, and printed circuit board assembly to a single company each of
which specializes in the particular services provided. In connection with its
operational strategy, the Company is seeking to secure additional sources of
supply, including additional contract manufacturers. The Company has experienced
in the past, and may in the future experience, problems with its contract
manufacturers, such as inferior quality, insufficient quantities and late
delivery of product. While such problems have not resulted in any material
liabilities from the Company to its customers or end-users to date, there can be
no assurance that such problems will not generate material liabilities for the
Company or adversely impact the Company's relations with its customers and end-
users in the future. During the nine months ended September 30, 1996, the
Company loaned its contract manufacturer $6 million. The loan, which enables the
Contract manufacturer to meet the Company's increasing production requirements,
is classified as a current asset and is secured by raw materials and electronic
components purchased by the contract manufacturer. In July 1996, the Company
also guaranteed up to $5 million of the contract manufacturer's debt for
inventory purchases. Any additional loans or guaranties to the Company's
contract manufacturer could have an adverse affect upon the Company's business,
operating results and financial condition. In addition, the Company may in the
future experience pricing pressure from its contract manufacturers. To date, the
Company has had only limited experience with the use of contract manufacturers.
There can be no assurance that the Company will effectively manage its contract
manufacturers or that these manufacturers will meet the Company's future
requirements for timely delivery of products of sufficient quality and quantity.
The Company intends to introduce a number of new products and product
enhancements in 1996 and 1997, which will require that the Company rapidly
achieve volume production by coordinating its efforts with those of its
suppliers and contract manufacturers. Certain of the Company's products in
development will require contract manufacturers to adopt or develop advanced
manufacturing techniques, which could inhibit volume manufacturing of those
products. The inability of Xylan's contract manufacturers to provide it with
adequate supplies of high-quality products or the loss of any of the Company's
contract manufacturers could cause a delay in Xylan's ability to fulfill orders
while the Company identifies a replacement manufacturer and could
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have a material adverse effect upon the Company's business, operating results
and financial condition.
DEPENDENCE ON SOLE AND LIMITED SOURCE SUPPLIERS AND AVAILABILITY OF
COMPONENTS. Several key components used in the manufacture of the Company's
products are currently purchased only from single or limited sources. At
present, single-sourced components include ASICs, processors, selected
integrated circuits, programmable integrated circuits, cables and custom-tooled
sheet metal; and limited-sourced components include flash memories, dynamic
random access memories ("DRAMs"), and printed circuit boards. The Company
generally does not have long-term agreements with any of these single or limited
sources of supply. The Company is in the process of incorporating ASICs in many
of its products. As stated above, each of these ASICs is initially being
manufactured only by a single source, LSI Logic Corporation in most cases, and
accordingly the risks of relying on sole sources is expected to increase. Any
interruption in the supply of any of these components, or the inability of the
Company to procure these components from alternate sources at acceptable
prices and within a reasonable time, could have a material adverse effect upon
the Company's business, operating results and financial condition. Qualifying
additional suppliers is time consuming and expensive and the likelihood of
errors is greater with new suppliers. The Company uses a rolling six-month
forecast based on anticipated product orders to determine its general materials
and components requirements. Lead times for materials and components ordered by
the Company vary significantly, and depend on factors such as the specific
supplier, contract terms and demand for a component at a given time. If orders
do not match forecasts, the Company may have excess or inadequate inventory of
certain materials and components. From time to time the Company has experienced
shortages and allocations of certain components and has experienced delays in
filling orders while waiting to obtain the necessary components. Given current
worldwide demand for integrated circuits and certain other components used by
the Company and the complexity and yield problems in manufacturing such
integrated circuits and components, such shortages and allocations are likely to
occur in the future and could have a material adverse effect on the Company's
business, operating results and financial condition.
MANAGEMENT OF GROWTH. The Company's recent growth has placed a
significant strain on the Company's financial and management personnel and
information systems and controls. This growth has resulted in a continuing
increase in the level of responsibility for both existing and new management
personnel. The Company recently implemented new and enhanced financial and
management information systems and controls and is training its personnel to
operate such systems. Any difficulty in the operation of such new and enhanced
systems or the training of personnel, or any disruptions in the transition to
such new or enhanced systems and controls, could adversely affect the Company's
ability to accurately forecast sales demand and calibrate manufacturing to such
demand, to calibrate purchasing levels, to accurately record and control
inventory levels, and to record and report financial and management information
on a timely and accurate basis. Due to its rapid growth the Company experienced
each of these problems in the past. The occurrence or recurrence of any of these
events could have a material adverse effect on the Company's business, financial
condition and results of operations.
DEPENDENCE ON OEM PARTNERS AND SYSTEM INTEGRATORS; CUSTOMER
CONCENTRATION. The Company is pursuing a sales and marketing strategy focused on
developing three channels of distribution for its products: worldwide OEM
partners, system integrators in North America and overseas and direct sales.
The Company has established OEM partnerships with leading communications and
networking companies, including, IBM, Hitachi Computer Products (America), Inc.
("Hitachi"), and Alcatel N.V. ("Alcatel"). In November 1996, the Company entered
into an OEM agreement with Samsung Electronics Company Ltd. ("Samsung") and also
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signed a licensing agreement with Samsung under which the Company will modify
its OmniVision network management software to control Samasung's ATM switches,
in addition to Xylan LAN switches. Samsung will also be combining Samsung's ATM
switching technology, Xylan's LAN switching technology and the new integrated
network management system to provide a complete solution to the needs of
Samsung's customers. Under the alliance with IBM, in the field of campus network
switching products, IBM and Xylan will be able to offer the other company's LAN
products for resale. In addition, the parties are forming a joint development
organization using certain of the other company's LAN technology. Both companies
have the right to manufacture and sell each other's campus switching products in
exchange for a royalty. As of September 30, 1996 no royalties have been earned
by either company.
Although there is a large number of end-users of Xylan's products, the
Company's customer base is highly concentrated and a relatively small number of
customers have accounted for a significant portion of the Company's revenue to
date. The Company's OEM partners and system integrators account, and are
expected to continue to account, for a substantial portion of the Company's net
revenue. As a percentage of revenue aggregate sales to OEM partners and system
integrators accounted for 47% and 37%, respectively, for the quarter ended
September 30, 1996, 47% and 48% respectively, for the quarter ended June 30,
1996, 49% and 33%, respectively, for the quarter ended September 30, 1995, 46%
and 41%, respectively, for the nine months ended September 30, 1996 and 46% and
40%, respectively, for the nine months ended September 30, 1995. Each of the
Company's OEM partners and system integrators can cease marketing the Company's
products with limited notice to Xylan and with little or no penalty. In
addition, the Company's agreements with its OEM partners and system integrators
generally provide for discounts based on expected or actual volumes of products
purchased or resold by the reseller in a given period and do not require minimum
purchases. Certain of these agreements provide manufacturing rights and access
to source code upon the occurrence of specified conditions or defaults.
Certain of the Company's OEM agreements provide for limited exclusivity. The
Company expects that certain of its OEM partners will in the future develop
competitive products and, if they do so, they may decide to terminate their
relationship with the Company. In addition, many of the Company's resellers
offer competitive products manufactured either by third parties or by
themselves. Furthermore, certain of the Company's OEM partners and network
integrators offer alternative networking solutions, designed by themselves or
third parties, or have pre-existing relationships with current or potential
competitors of the Company. There can be no assurance that the Company's OEM
partners and system integrators will give a high priority to the marketing of
the Company's products as compared to competitive products or alternative
networking solutions or that Xylan's OEM partners and system integrators will
continue to offer the Company's products. Any reduction or delay in sales of the
Company's products by its OEM partners and system integrators could have a
material adverse effect on the Company's business, operating results and
financial condition. There can be no assurance that the Company will retain its
current OEM partners or system integrators or that it will be able to recruit
additional or replacement OEM partners or system integrators. The loss of one or
more of the Company's OEM partners or system integrators could have a material
adverse effect on the Company's business, operating results and financial
condition. The Company generally realizes a higher gross margin on direct sales
than on sales through its OEM partners and system integrators. Accordingly, if
the Company's OEM partners and system integrators were to account for an
increased portion of the Company's revenue, its gross margin would decline.
RAPID TECHNOLOGICAL CHANGE; NEW PRODUCTS AND EVOLVING MARKETS. The
market for the Company's products is characterized by frequent new product
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introductions, rapidly changing technology and continued emergence of new
industry standards, any of which could render Xylan's existing products
obsolete. The Company's success will depend to a substantial degree upon its
ability to develop and introduce in a timely fashion new products and
enhancements to its existing products that meet changing customer requirements
and emerging industry standards. The development of new, technologically
advanced products is a complex and uncertain process requiring high levels of
innovation, as well as the accurate anticipation of technological and market
trends. There can be no assurance that the Company will be able to identify,
develop, manufacture, market or support new or enhanced products successfully or
on a timely basis, that new Company products will gain market acceptance or that
the Company will be able to respond effectively to product announcements by
competitors, technological changes or emerging industry standards. In addition,
the Company has on occasion experienced delays in the introduction of new
products and product enhancements. Furthermore, from time to time, the Company
may announce new products or product enhancements, capabilities or technologies
that have the potential to replace or shorten the life cycle of the Company's
existing product offerings and that may cause customers to defer purchasing
existing Company products or cause resellers to return products to the Company.
The market for LAN switch products is evolving and the Company believes its
ability to compete successfully in this market is dependent upon the continued
compatibility and interoperability of its products with products and
architectures offered by various vendors, including workstation and personal
computer architectures and computer and network operating systems. There can be
no assurance that the Company will be able to effectively address the
compatibility and interoperability issues raised by technological changes or
evolving industry standards.
A key element of the Company's strategy is the development of multiple
ASICs to increase system performance and reduce manufacturing costs, thereby
enhancing the price/performance of the Company's products. Any failure to
continue to introduce new products or product enhancements and develop and
incorporate ASICs effectively and on a timely basis, customer delays in
purchasing products in anticipation of new product introductions or any
inability of the Company to respond effectively to product announcements by
competitors, technological changes or emerging industry standards could have a
material adverse effect on the Company's business, operating results and
financial condition.
UNCERTAIN MARKET ACCEPTANCE OF THE COMPANY'S PRODUCTS; PRODUCT
CONCENTRATION. The Company currently derives substantially all of its revenue
from its OmniSwitch and PizzaSwitch products and the Company expects that
revenue from these products will continue to account for a substantial portion
of the Company's revenue at least through 1997. Broad market acceptance of these
products is, therefore, critical to the Company's future success. Factors that
may affect the market acceptance of the Company's products include market
acceptance of network switching products, the availability and price of
competing products and technologies and the success of the sales efforts of the
Company and its OEM partners and system integrators. Moreover, the Company's
operating history in the network switching market and its resources are limited
relative to those of certain of its current and potential competitors. The
Company's future performance will also depend in part on the successful
development, introduction and market acceptance of new and enhanced products.
Failure of the Company's products to achieve market acceptance would have a
material adverse effect on the Company's business, operating results and
financial condition.
PRODUCT COMPLEXITY. Products as complex as those offered by the
Company frequently contain undetected software or hardware errors when first
introduced or as new versions are released. As is common among participants in
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the Company's industry, the Company has experienced such errors in the past in
connection with product upgrades and new products. Despite testing by the
Company and by current and potential customers, Xylan expects that such errors
will be found from time to time in new or enhanced products after commencement
of commercial shipments. The Company believes it has addressed these errors when
they have occurred through software and hardware revisions. However, the
occurrence of such errors could, and the inability to correct such errors would,
result in the delay or loss of market acceptance of the Company's products,
additional expense, diversion of engineering and other resources from the
Company's product development efforts and the loss of credibility with Xylan's
OEM partners, system integrators and end users, any of which would have a
material adverse effect on the Company's business, operating results and
financial condition.
DEPENDENCE ON PROPRIETARY TECHNOLOGY; INTELLECTUAL PROPERTY LITIGATION.
The Company's success and its ability to compete is dependent, in part, upon its
proprietary technology. The Company does not hold any issued patents and
currently relies on a combination of contractual rights, trade secrets and
copyright laws to establish and protect its proprietary rights in its products.
There can be no assurance that the steps taken by the Company to protect its
intellectual property will be adequate to prevent misappropriation of its
technology or that the Company's competitors will not independently develop
technologies that are substantially equivalent or superior to the Company's
technology. In the event that protective measures are not successful, the
Company's business, operating results and financial condition could be
materially and adversely affected. In addition, the laws of some foreign
countries do not protect the Company's proprietary rights to the same extent as
do the laws of the United States.
The Company is also subject to the risk of adverse claims and
litigation alleging infringement of intellectual property rights of others. On
June 8, 1995, a suit alleging misappropriation of trade secrets, infringement of
U.S. Patent No. 5,394,402 and improper hiring of employees was brought against
Xylan by Ascom Timeplex Inc. ("Ascom Timeplex") in the U.S. District Court for
the Central District of California in Los Angeles, California, seeking
injunctive relief and unspecified monetary damages. The Company and Ascom
Timeplex have signed a binding memorandum of understanding to settle this
litigation and dismiss all of Ascom Timeplex's charges against the Company and
against Steve Y. Kim, John Bailey and another employee named in Ascom Timeplex's
complaint, and otherwise release the parties from all claims. The settlement
also involves a royalty-free license to the Company of Ascom Timeplex's virtual
LAN technology covered by the patent and a royalty-free license to Ascom
Timeplex of certain technology embodied in the Company's currently available
products for use in and in connection with Ascom Timeplex's Synchrony product
family. These licenses are not assignable other than to a successor-in-interest
to Ascom Timeplex. The Company also undertakes to transfer a copy of the
licensed technology to Ascom Timeplex and for a specified time not to hire Ascom
Timeplex employees. The release by Ascom Timeplex is conditioned on transfer of
this technology. While the court dismissed Ascom Timeplex's charges with
prejudice in connection with the settlement, there can be no assurance that
future disputes will not arise between the parties with respect to the
settlement or otherwise.
Since patent applications in the United States are not publicly
disclosed until the patent issues, applications may have been filed which, if
issued as patents, would relate to the Company's products. In addition, the
Company has not conducted a comprehensive patent search relating to the
technology used in its products. The Company is subject to the risk of claims
and litigation alleging infringement of the intellectual property rights of
others. In addition to the claims of Ascom Timeplex, Xylan has, from time to
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time, received claims from third parties alleging infringement of such third
parties' intellectual property rights. The Company believes that none of the
current claims against the Company would result in material liability if
successful. Although such claims have not resulted in material litigation
to date, there can be no assurances that such claims will not be successful
or generate material litigation in the future.
Furthermore, there can be no assurance that third parties will not assert
infringement claims against the Company in the future based on patents or trade
secrets or that such claims will not be successful. The Company could incur
substantial costs in defending itself and its customers against any such claims,
regardless of the merits of such claims. Parties making such claims may be able
to obtain injunctive or other equitable relief which could effectively block the
Company's ability to sell its products in the United States and abroad, and
could result in an award of substantial damages. In the event of a successful
claim of infringement, the Company, its customers and end-users may be required
to obtain one or more licenses from third parties. There can be no assurance
that the Company or its customers could obtain necessary licenses from third
parties at a reasonable cost or at all. The defense of any lawsuit could result
in time-consuming and expensive litigation, damages, license fees, royalty
payments and restrictions on the Company's ability to sell its products, any of
which could have a material adverse effect on the Company's business, financial
condition and results of operations.
DEPENDENCE ON KEY PERSONNEL AND HIRING OF ADDITIONAL PERSONNEL. The
Company's success depends to a significant degree upon the continued
contributions of its key management, engineering, sales and marketing and
manufacturing personnel, many of whom would be difficult to replace. In
particular, the Company believes that its future success is highly dependent on
Steve Y. Kim, Chairman, President and Chief Executive Officer and John Bailey,
Vice President of Development. The Company does not have employment contracts
with, and does not currently maintain key man life insurance covering, its key
personnel. The Company believes its future success will also depend in large
part upon its ability to attract and retain highly skilled managerial,
engineering, sales and marketing, finance and manufacturing personnel.
Competition for such personnel is intense, and there can be no assurance that
the Company will be successful in attracting and retaining such personnel. The
loss of the services of any of the key personnel, the inability to attract or
retain qualified personnel in the future or delays in hiring required personnel,
particularly the chief financial officer, engineers and sales personnel, could
have a material adverse effect on the Company's business, operating results or
financial condition. In July 1996, the Company announced the resignation of C.
Stephen Cordial as the Company's vice president and chief financial officer. Mr.
Cordial will remain an employee of the Company to investigate strategic
investment opportunities and potential acquisitions and other projects. In
addition, companies in the networking industry whose employees accept positions
with competitive companies frequently claim that their competitors have engaged
in unfair hiring practices. Xylan has, from time to time, received such claims
from other companies and, although claims to date have not resulted in material
litigation other than in connection with Ascom Timeplex, there can be no
assurance that the Company will not receive additional claims in the future as
it seeks to hire qualified personnel or that such claims will not result in
material litigation involving the Company. The Company could incur substantial
costs in defending itself against any such claims, regardless of the merits of
such claims. To date, the Company has not lost any employees as a result of such
claims.
INTERNATIONAL OPERATIONS. Sales to customers outside of North America
accounted for approximately 39%, 65% and 44% of the Company's revenue in the
three months ended September 30, 1996, June 30, 1996 and September 30, 1995,
24
<PAGE>
respectively. Sales to customers outside of North America accounted for
approximately 55% and 43% of the Company's revenue in the nine months ended
September 30, 1996 and 1995, respectively. However, these percentages may
understate sales of the Company's products to international end users because
certain of the Company's U.S.-based OEM partners sell the Company's products
abroad. The Company's international sales are conducted primarily through its
OEM partners and independent territory-specific system integrators. Failure of
the Company's OEM partners and system integrators to effectively market the
Company's products internationally or the loss of any of these resellers could
have a material adverse effect on the Company's business, operating results and
financial condition. A number of additional risks are inherent in international
operations. The Company's international sales currently are U.S. dollar-
denominated. As a result, an increase in the value of the U.S. dollar relative
to foreign currencies could make the Company's products less competitive in
international markets. International sales may also be limited or disrupted by
the imposition of governmental controls, export license requirements,
restrictions on the export of critical technology, currency exchange
fluctuations, political instability, trade restrictions and changes in tariffs.
The Company's operating results could also be adversely affected by seasonality
of international sales. These international factors could have a material
adverse effect on future sales of the Company's products to international end-
users and, consequently, the Company's business, operating results and financial
condition.
MARKET FOR NETWORK SWITCHES; GENERAL ECONOMIC CONDITIONS. Demand for
the Company's products depends in large part on overall demand for network
switching products, which may in the future fluctuate significantly based on
numerous factors, including adoption of alternative technologies, capital
spending levels and general economic conditions. While certain analysts believe
that there is a significant market for network switches, there can be no
assurance as to the rate or extent of the growth of this market. There can be no
assurance that the Company will not experience a decline in demand for its
products, which would have a material adverse effect on the Company's business,
operating results and financial condition.
NEED FOR ADDITIONAL CAPITAL. The Company requires substantial working
capital to fund its business, particularly to finance inventories and accounts
receivable and for capital expenditures. The Company believes that its existing
cash balances, together with its line of credit and cash flow expected to be
generated from future operations, will be sufficient to meet the Company's
capital requirements through at least the end of 1997, although the Company
could be required, or could elect, to seek to raise additional capital. The
Company's future capital requirements will depend on many factors, including the
rate of revenue growth, the timing and extent of spending to support product
development efforts and expansion of sales and marketing, the timing of
introductions of new products and enhancements to existing products, and market
acceptance of the Company's products. The Company expects that it may need to
raise additional equity or debt financing in the future. There can be no
assurance that additional equity or debt financing, if required, will be
available on acceptable terms or at all.
REGULATORY MATTERS. The Company's products must meet industry
standards and receive certification for connection to certain public
telecommunications networks prior to their sale. In the United States, the
Company's products must comply with various regulations defined by the Federal
Communications Commission and Underwriters Laboratories. Internationally, the
Company's products must comply with standards established by telecommunications
authorities in various countries as well as with recommendations of the
International Telecommunication Union. Although the Company's products have not
been denied any regulatory approvals or certifications to date, any future
25
<PAGE>
inability to obtain on a timely basis or retain domestic or foreign regulatory
approvals or certifications or to comply with existing or evolving industry
standards could have a material adverse effect on the Company's business,
operating results and financial condition.
ANTI-TAKEOVER PROVISIONS. Certain provisions of the Company's charter
documents, including provisions eliminating the ability of shareholders to take
action by written consent and limiting the ability of shareholders to raise
matters at a meeting of shareholders without giving advance notice, may have the
effect of delaying or preventing changes in control or management of the
Company, which could have an adverse effect on the market price of the Company's
Common Stock. In addition, effective upon qualification of the Company as a
"listed corporation," as defined in Section 301.5(d) of the California
Corporations Code (the "California Code"), the Company's charter documents will
eliminate cumulative voting and provide that the Company's Board of Directors
will be divided into two classes, each of which serves for a staggered two-year
term, which may make it more difficult for a third party to gain control of the
Company's Board of Directors. The Board of Directors has authority to issue up
to 5,000,000 shares of Preferred Stock and to fix the rights, preferences,
privileges and restrictions, including voting rights, of these shares without
any further vote or action by the shareholders. The rights of the holders of the
Company's Common Stock will be subject to, and may be adversely affected by, the
rights of the holders of any Preferred Stock that may be issued in the future.
The issuance of Preferred Stock, while providing desirable flexibility in
connection with possible acquisitions and other corporate purposes, could have
the effect of making it more difficult for a third party to acquire a majority
of the outstanding voting stock of the Company, thereby delaying, deferring or
preventing a change in control of the Company. Furthermore, such Preferred Stock
may have other rights, including economic rights, senior to the Common Stock,
and as a result, the issuance of such Preferred Stock could have a material
adverse effect on the market value of the Common Stock. The Company has no
present plan to issue shares of Preferred Stock.
POSSIBLE VOLATILITY OF STOCK PRICE. The market price of the shares of
Common Stock has been and is likely to continue to be highly volatile and may be
significantly affected by factors such as actual or anticipated fluctuations in
the Company's operating results, announcement of technological innovations or
new product introductions by the Company or its competitors, changes of
estimates of the Company's future operating results by securities analysts,
developments with respect to copyrights or proprietary rights, general market
conditions and other factors. In addition, the stock market has from time to
time experienced significant price and volume fluctuations that have
particularly affected the market prices for the Common Stocks of technology
companies. These broad market fluctuations may adversely effect the market price
of the Company's Common Stock.
Steve Kim and Yuri Pikover, executive officers and members of the Board of
Directors of the Company, have each recently entered into a program of periodic
sales of shares of their Xylan Common Stock for the purpose of diversifying
their personal holdings. In addition, certain of the venture capital
partnerships that invested in the Company have begun to distribute portions of
their holdings to their general and limited partners, who in turn have begun to
resell such shares on the open market. Any such sales by insiders or
distributions by large investors may also have an adverse effect on the market
price of the Company's Common Stock.
26
<PAGE>
PART II -- OTHER INFORMATION
ITEM 1. Legal Proceedings
On June 8, 1995, a suit alleging misappropriation of trade secrets,
infringement of U.S. Patent No. 5,394,402 and improper hiring of employees was
brought against Xylan by Ascom Timeplex Inc. ("Ascom Timeplex") in the U.S.
District Court for the Central District of California in Los Angeles, California
seeking injunctive relief and unspecified monetary damages. The Company and
Ascom Timeplex have signed a binding memorandum of understanding to settle this
litigation and dismiss all of Ascom Timeplex's charges against the Company and
against Steve Y. Kim, John Bailey and another employee named in Ascom Timeplex's
complaint, and otherwise release the parties from all claims. The settlement
also involves a royalty-free license to the Company of Ascom Timeplex's virtual
LAN technology covered by the patent and a royalty-free license to Ascom
Timeplex of certain technology embodied in the Company's currently available
products for use in connection with Ascom Timeplex's Synchrony product family.
These licenses are not assignable other than to a successor-in-interest to Ascom
Timeplex. The Company also undertakes to transfer a copy of the licensed
technology to Ascom Timeplex and for a specified time not to hire Ascom Timeplex
employees. The release by Ascom Timeplex is conditioned on transfer of this
technology. While the court dismissed Ascom Timeplex's charges with
prejudice in connection with the settlement, there can be no assurance that
future disputes will not arise between the parties with respect to the
settlement or otherwise.
ITEM 2. Changes In Securities
None.
ITEM 3. Defaults In Senior Securities
None.
ITEM 4. Submission Of Matters To A Vote Of Security Holders
None.
ITEM 5. Other Information
None.
ITEM 6. Exhibits And Reports On Form 8-K
(a) Exhibits
Exhibit Description
------- -----------
11.1 Statement of Computation of Earnings Per Share.
27 Financial Data Schedule
(b) Reports on Form 8-K
No reports on Form 8-K were filed by Xylan during the quarter
ended September 30, 1996.
27
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
XYLAN CORPORATION
Date: November 14, 1996 By: /s/Eugene E. Spies
----------------------------
Eugene E. Spies
Acting Chief Financial Officer
(Principal Financial and Chief
Accounting Officer)
28
<PAGE>
INDEX TO EXHIBITS
Exhibit Description
------- -----------
11.1 Statement of Computation of Earnings Per Share.
27 Financial Data Schedule
<PAGE>
EXHIBIT 11.1
STATEMENT REGARDING COMPUTATION OF NET INCOME (LOSS) PER SHARE
(IN THOUSANDS)
<TABLE>
<CAPTION>
THREE MONTHS ENDED
--------------------------------
Sept. 30, JUNE 30, Sept. 30,
1996 1996 1995
------- ------- -------
<S> <C> <C> <C>
Weighted average common shares outstanding.............................. 41,837 40,963 10,320
------- ------- -------
Weighted average common stock equivalents:
Stock options determined using the treasury
stock method.......................................................... 5,614 6,033 4,652
Convertible preferred stock............................................ -- -- 6,179
------- ------- -------
Total weighted average common stock
equivalents outstanding........................................... 5,614 6,033 10,831
------- ------- -------
Shares used in net income (loss) per share
calculation....................................................... 47,451 46,996 21,151
======= ======= =======
Detailed calculation of shares issuable from the
assumed exercise of stock options:
Calculation of proceeds upon exercise of options:
Number of stock options considered to be
common stock equivalents (1)..................................... 7,764 6,929 5,376
Weighted average exercise price.................................... $ 11.44 $ 5.75 $ 3.50
------- ------- -------
Proceeds upon exercise of options.............................. $88,810 $39,842 $18,839
======= ======= =======
Calculation of shares that could be repurchased
upon exercise of stock options:
Proceeds upon exercise of options.................................... $88,810 $39,842 $18,839
Repurchase price..................................................... $ 44.39 $ 60.19 $ 26.00
------- ------- -------
Shares that could be repurchased................................... 2,000 662 724
------- ------- -------
Common stock equivalents for stock options
determined using the treasury stock method....................... 5,764 6,267 4,652
Adjustment for portion of period the options
were not outstanding............................................. 150 234 --
------- ------- -------
Weighted average common stock equivalents for
stock options using the treasury stock method................. 5,614 6,033 4,652
======= ======= =======
Detailed calculation of shares issuable from the assumed
conversion of convertible preferred stock:
Convertible preferred stock considered to be
common stock equivalents (1)....................................... -- -- 6,179
Conversion ratio..................................................... -- -- 1 for 1
------- ------- -------
Common stock equivalents for convertible
preferred stock................................................. -- -- 6,179
======= ======= =======
</TABLE>
(1) Pursuant to the requirements of the Securities and Exchange Commission,
common stock, stock options, warrants and convertible preferred stock issued by
the Company during the twelve months immediately preceding the initial public
offering date have been included in the calculation of the weighted average
shares outstanding for all periods presented using the treasury stock method.
Stock options, warrants and convertible preferred stock issued prior to 1995 are
excluded from the computation for the three and nine months ended September 30,
1995, as their inclusion would be antidilutive.
<PAGE>
EXHIBIT 11.1
STATEMENT REGARDING COMPUTATION OF NET INCOME (LOSS) PER SHARE
(IN THOUSANDS)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
September 30,
------------------
1996 1995
-------- -------
<S> <C> <C>
Weighted average common shares outstanding......................... 40,332 10,320
-------- -------
Weighted average common stock equivalents:
Stock options determined using the treasury stock method.......... 5,988 4,652
Convertible preferred stock....................................... -- 6,179
-------- -------
Total weighted average common stock equivalents outstanding.... 5,988 10,831
-------- -------
Shares used in net income (loss) per share calculation......... 46,320 21,151
======== =======
Detailed calculation of shares issuable from the
assumed exercise of stock options:
Calculation of proceeds upon exercise of options:
Number of stock options considered to be
common stock equivalents (1)................................ 9,206 5,376
Weighted average exercise price............................... $ 10.88 $ 3.50
-------- -------
Proceeds upon exercise of options......................... $100,197 $18,839
======== =======
Calculation of shares that could be repurchased
upon exercise of stock options:
Proceeds upon exercise of options............................... $100,197 $18,839
Repurchase price................................................ $ 45.37 $ 26.00
-------- -------
Shares that could be repurchased.............................. 2,208 724
-------- -------
Common stock equivalents for stock options
determined using the treasury stock method.................. 6,998 4,652
Adjustment for portion of period the options
were not outstanding........................................ 1,010 --
-------- -------
Weighted average common stock equivalents for
stock options using the treasury stock method............ 5,988 4,652
======== =======
Detailed calculation of shares issuable from the assumed
conversion of convertible preferred stock:
Convertible preferred stock considered to be
common stock equivalents (1).................................. -- 6,179
Conversion ratio................................................ -- 1 for 1
-------- -------
Common stock equivalents for convertible
preferred stock............................................ -- 6,179
======== =======
</TABLE>
(1) Pursuant to the requirements of the Securities and Exchange Commission,
common stock, stock options, warrants and convertible preferred stock issued by
the Company during the twelve months immediately preceding the initial public
offering date have been included in the calculation of the weighted average
shares outstanding for all periods presented using the treasury stock method.
Stock options, warrants and convertible preferred stock issued prior to 1995 are
excluded from the computation for the three and nine months ended September 30,
1995, as their inclusion would be antidilutive.
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> SEP-30-1996
<CASH> 54,634
<SECURITIES> 60,666
<RECEIVABLES> 30,563
<ALLOWANCES> 516
<INVENTORY> 10,774
<CURRENT-ASSETS> 157,774
<PP&E> 3,234
<DEPRECIATION> 192,332
<TOTAL-ASSETS> 16,056
<CURRENT-LIABILITIES> 0
<BONDS> 0
0
41
<COMMON> 175,380
<OTHER-SE> 175,421
<TOTAL-LIABILITY-AND-EQUITY> 192,332
<SALES> 86,113
<TOTAL-REVENUES> 87,004
<CGS> 39,952
<TOTAL-COSTS> 39,952
<OTHER-EXPENSES> 35,453
<LOSS-PROVISION> 226
<INTEREST-EXPENSE> 36
<INCOME-PRETAX> 14,958
<INCOME-TAX> 4,744
<INCOME-CONTINUING> 10,214
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 10,214
<EPS-PRIMARY> .22
<EPS-DILUTED> .22
</TABLE>
