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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
________________
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the Fiscal Year Ended December 31, 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, CA 91302
(Address of principal executive offices)
Registrant's telephone number, including area code: (818)880-3500
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $.001 par value
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days. YES [X] NO [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained to the best
of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [X]
The aggregate market value of the voting stock held by non-affiliates of the
Registrant was approximately $423,813,608 as of February 28, 1997, based upon
the closing sale price on the Nasdaq National Market reported for such date.
Shares of Common Stock held by each officer and director and by each person who
owns 5% of more of the outstanding Common Stock have been excluded in that such
persons may be deemed to be affiliates. This determination of affiliate status
is not necessarily a conclusive determination for other purposes.
There were 42,222,780 shares of Registrant's Common Stock issued and outstanding
as of February 28, 1997.
________________________________
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Proxy Statement of the Registrant for the 1997 Annual Meeting of
Shareholders are incorporated in Part III of this Form 10-K.
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INTRODUCTORY STATEMENT
Except for the historical information contained in this Annual Report
on Form 10-K, the matters discussed herein include forward-looking statements
that are subject to certain risks and uncertainties that could cause the
actual results to differ materially from those projected. Factors that could
cause actual results to differ materially include, but are not limited to, the
timing of orders and shipments, the timely development and market acceptance
of new products, the impact of competitive products and pricing, the Company's
ability to further expand into domestic and international markets and other
risks detailed below and included from time to time in the Company's other SEC
reports and press releases, copies of which are available from the Company
upon request. The Company assumes no obligation to update any forward-looking
statements contained herein.
References made in this Annual Report on Form 10-K to "Xylan
Corporation" or the "Company" refer to Xylan Corporation and its subsidiaries.
The following Xylan Corporation trademarks are mentioned in this Annual
Report: Xylan(R) and OmniSwitch(R) are registered trademarks of the Company,
and AutoTracker(TM), OmniVision Optimized Device Switching(TM),
PizzaSwitch(TM) and X-Cell(TM) are trademarks of the Company.
PART I
ITEM 1. BUSINESS
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OVERVIEW
Xylan Corporation ("Xylan" or the "Company") is a leading provider of high-
bandwidth switching systems that enhance the performance of existing local area
networks and facilitate migration to next-generation networking technologies
such as ATM. Current hub- and router-based networks are facing performance
degradation due to the continued growth in the size of networks, increasing
demands of high-performance personal computers and workstations, and emergence
of graphical applications, such as Intranet / Java applications, document image
processing, desktop video, medical imaging, modeling and simulation, and the
World Wide Web. To address these issues, a new generation of "switched-media"
technologies has emerged, including LAN switching, ATM switching, IP switching
and virtual LANs.
Xylan offers the OmniSwitch and PizzaSwitch product families, which support
all popular LAN types with "any-to-any" MAC-layer translation, and allow the
use of LAN switches in place of shared-media hubs. The Company's switches are
based on a distributed, modular, multiprocessor architecture that currently
combines LAN switching, virtual LANs, ATM switching, wide area access, security,
and routing in a single product and allows switching performance to increase in
linear proportion to the number of ports. Xylan's AutoTracker product supports
flexible virtual LANs and simplifies network management. The Company has
developed and continues to develop ATM switching technology and ASICs
(application-specific integrated circuits) for integration into its product
line.
Xylan has strategic OEM partnerships with leading communications and
networking companies, including Alcatel, Hitachi, IBM and Samsung, that have
significant customer relationships already in place. Xylan pursues direct sales
to organizations in North America with large networking requirements and employs
network integrators to target customers worldwide. The Company's products have
been deployed by a broad range of organizations, ranging from companies in the
telecommunications, manufacturing, medical, computer services, media and
finance/insurance industries to educational institutions and the federal
government.
INDUSTRY BACKGROUND
Networking technologies have evolved over the last several decades in
response to changes in the ways organizations use computers. Approximately ten
years ago a transition in networking technologies occurred in response to the
increasing use of personal computers within organizations. As personal
computers proliferated, local area network technologies such as Ethernet and
token ring were widely implemented to connect these workstations to shared
resources. Intelligent hubs emerged as a reliable and structured method of
connecting workstations into LANs. As the networks continued to grow, a single
Ethernet or token ring LAN could
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not accommodate the proliferation of data, making it necessary to divide the
network into separate domains. The first devices used for this purpose were
bridges; however, one limitation of bridges is that they indiscriminately
broadcast some types of information throughout the entire network. The amount of
this "broadcast traffic" increases as the network grows, and in a large
network can create a heavy load on all workstations. To solve this problem,
routers were developed to intercept broadcast traffic and forward that
information "intelligently," minimizing the load on the network. As a result,
hub- and router-based networks became the most widely used network environments.
<TABLE>
<CAPTION>
MAINFRAME ERA MINICOMPUTER ERA SHARED-MEDIA NETWORK SWITCHED NETWORK ERA
1965-1975 1975-1985 ERA 1985-1995 1995-
<S> <C> <C> <C> <C>
COMPUTING PLATFORMS mainframes minicomputers personal computers graphical workstations
INFORMATION TRANSMITTED textual data textual data program and data files graphical data
BANDWIDTH REQUIREMENTS shared, low-speed dedicated, low-speed shared, high-speed dedicated, high-speed
bandwidth bandwidth bandwidth bandwidth
KEY NETWORKING TECHNOLOGIES front end processors, statistical intelligent hubs, LAN switches and ATM
controllers multiplexers, data PBXs bridges and routers switches with routing
functionality
</TABLE>
Currently, LANs are again facing performance degradation due to the
continued growth in the size of networks and increasing demands of high-
performance personal computers and workstations. The increasing bandwidth
requirements are also being driven by the emergence of graphical applications,
such as Intranet / Java applications, document image processing, desktop video,
medical imaging, modeling and simulation, and the World Wide Web. A new
generation of switching technologies is currently emerging to address these
issues and migrate customers to next-generation networking systems.
Shared-Media LANs
Traditional LAN types, such as Ethernet, token ring, and Fiber Distributed
Data Interface ("FDDI"), are often referred to as "shared-media"
technologies because they require computers to take turns communicating on a
single LAN. On these LANs, a computer can only send information when another
computer is not doing so. This technology works well when workstations only need
short, infrequent bursts of network access, such as the transfer of a file from
a file server or to a network printer. As more workstations share a single LAN,
demands for access to the network increase. As a result, individual users
experience slower network response times.
In a typical shared-media LAN, workstations and servers are connected to a
hub, which functions as a single LAN. In order to improve network performance,
larger networks are often divided into multiple LANs. Individual LANs, which are
built using hubs, are connected to each other using routers which are the
backbone of most present-day networks. Routers facilitate the flow of traffic
between LANs by intercepting broadcast traffic and only forwarding the necessary
traffic to its appropriate destination, minimizing the load on the network.
Routers are relatively expensive, since intelligent control of network traffic
requires complex software and high-performance hardware.
In addition, as the number of LANs increases, a routed network becomes more
difficult and costly to manage. A hub- and router-based network is based on
physical LANs, where all workstations on a single physical Ethernet or token
ring are assigned the same network address. Routers, by moving traffic between
hubs using these addresses, require network administrators to change the network
address of a workstation when it is relocated. This results in substantial work
for network administrators when moves are common.
New graphical applications have increased network loads enormously, which
can overwhelm shared-media networks. Shared-media LANs require workstations and
servers to contend for the total capacity or "bandwidth" of the network. As a
result, the effective bandwidth available to each computer declines with the
growth of the number of computers connected to the LAN and the volume of network
traffic. Network users employing data-intensive applications also can "crowd
out" other users who require less bandwidth.
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LAN Switching
Network administrators are increasingly using a new LAN technology based on
switching to avoid the performance degradation experienced by users of shared-
media LANs. In a network switch, each workstation and server has its own
dedicated connection, so that they do not have to take turns transmitting over
the LAN. Current LAN switches support some combination of existing LAN types,
such as Ethernet, Fast Ethernet (100BaseT), token ring and FDDI. These switches
increase the throughput of an existing LAN with minimal cost and disruption,
because users do not have to change network interface cards, cabling or
workstation software. As a result, LAN switches are starting to replace hubs and
routers. According to the Dell'Oro Group, the worldwide market for LAN
switches was approximately $4.0 billion in 1996 and is expected to double to
$8.0 billion in 1997.
Local area networks typically use one or more "wiring closets" on each
floor of a building. Wiring connects from 30 to 150 workstations in each part of
the building into a single closet where the hubs have been located. This closet
is, accordingly, the logical place for the switches. Large networks need
switches that share the characteristics of today's high-end hubs: support for a
large number of ports, hot-swappable (exchangeable while the system is
operational) input/output ("I/O") modules, redundant power and common logic.
However, most current LAN switches only support a limited number of devices and
lack other characteristics required for optimal use in wiring closets.
Since large, complex networks generally use multiple LAN types, users need
LAN switches that provide translation among a number of the more widely used
protocols, which the Company refers to as "any-to-any" translation. This
allows workstations using Ethernet and token ring to access servers and
backbones using high-speed technologies, such as FDDI, 100BaseT and ATM. Routers
can achieve this result, but a router's complexity slows down the data traffic.
Many large organizations have built FDDI backbones over the last six years,
and LAN switches need to be able to operate across these backbones. Many of
these organizations are also expected to install ATM backbones, and LAN switches
will need to be able to operate across these as well. Few current LAN switches
support both FDDI and ATM backbones.
ATM Switching
Organizations generally employ multiple networks, each dedicated to a
single traffic type, such as data, voice or video. In contrast, a single ATM
network can support textual data, graphical data, voice and video. ATM cells can
be transmitted more predictably than traditional, variable-length packets, and
at much higher rates. However, most current workstations are equipped to support
Ethernet, token ring or FDDI, rather than ATM. In addition, ATM workstation
interface cards and ATM switches are still relatively expensive. As a result,
ATM can be deployed more cost-effectively in LAN backbones and wide area
networks ("WANs") where the cost of the ATM switch is amortized over a large
number of workstations.
Some LAN switches include ATM "uplinks" in which workstations are
attached to the LAN switch and the LAN switch is in turn attached to the ATM-
switched network acting as a campus backbone. Eventually, however, many
customers will want to be able to connect their workstations directly to the ATM
switches. Today few LAN switches can provide ATM switching capabilities, and
those that can do so have relatively little ATM switching capacity. According
to the Yankee Group, the 1996 worldwide market for ATM switches was $261
million and is expected to more than quadruple to over $1 billion in 1998.
Virtual LANs
LAN switching makes it possible to use virtual LANs. With virtual LANs,
network managers can organize users into domains in order to prevent broadcasts
from overloading the network. Broadcast traffic is kept within a virtual LAN,
which is connected to other virtual LANs by routing. Virtual LANs enable network
managers to group
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users logically rather than based upon physical location within the network. In
addition, virtual LANs can simplify network administration as users move around
the campus.
Effective virtual LANs must have the ability to:
. sustain the high throughput of switched networks;
. accommodate a variety of LAN types;
. span both FDDI and ATM backbones;
. allow virtual LANs to be defined flexibly by switch port, MAC
address or network-layer address;
. track workstations automatically when they are moved within a
building or across a campus;
. "look past" hubs to the workstations connected to them; and
. provide easy configuration and management.
The combination of LAN switching, ATM switching and virtual LANs enables
organizations to increase the throughput of today's networks and simplify
network management, while providing a migration path to next-generation high-
speed switched networks.
THE XYLAN SOLUTION
Xylan was founded to provide high-bandwidth switching systems that
enhance the performance of existing LANs and facilitate migration to next-
generation networking technologies such as ATM. The Company's products
accomplish these goals by: providing "any-to-any" MAC-layer translation;
supporting widely used LAN types such as Ethernet, token ring, and FDDI; and
enabling the customer to replace shared-media hubs with LAN switches. Xylan's
AutoTracker product is designed to support powerful, flexible virtual LANs and
to simplify network management.
Xylan has designed its product architecture specifically to support LAN
switching, ATM switching, virtual LANs, security, and routing. The Company's
switches are based on a distributed, modular, multiprocessor architecture. This
architecture allows switching performance to increase in linear proportion to
the number of ports, unlike many other switches based on a central switching
engine, which generally cannot increase performance as ports are added. The
Company's virtual LAN capability is integrated directly into its hardware
architecture and controlled by distributed reduced instruction set computing
("RISC") processors and ASICs to achieve high throughput and flexibility.
Xylan's products can switch within virtual LANs and route between them, and can
establish security firewalls between them. The Company has also developed a
substantial number of LAN interface modules, enabling the customer to tailor the
product to a particular application. The Company is developing multiple ASICs to
increase system performance and reduce manufacturing costs, thereby enhancing
price/performance of the Company's products.
COMPANY STRATEGY
Xylan's objective is to facilitate the migration of computer networking
to switched, dedicated-bandwidth, high-speed connections by providing a family
of network switching products that exceed competitive offerings in features,
flexibility, and price/performance. The key elements of the Company's strategy
are highlighted below:
Invest to Establish Early Market Leadership
Xylan's strategy has been and continues to be to establish a position as
an early leader in the emerging market for LAN and ATM switching. The Company
believes that early leadership translates into a better understanding of
customer needs, the opportunity to optimize products to meet those needs, and
the ability to maintain the reputation of a market leader as switching
technology becomes more widely adopted. To date, Xylan has moved rapidly to
build strong sales and marketing functions in order to establish early customer
relationships. Xylan believes that evaluation purchases by a customer can lead
to volume purchases from the Company as the
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customer implements switching solutions more broadly. Xylan intends to continue
investing in its infrastructure in order to fully capitalize on the growth of
the LAN and ATM switch markets.
Maintain Technology Leadership
Xylan was founded to design leading-edge switching technology. The
Company has assembled a development team of 122 employees at December 31, 1996
and invested heavily in design and simulation tools. Xylan believes that its
current products offer a range of features and price/performance characteristics
that exceed competitive offerings. The Company's goal is to combine, in a single
switch, advanced LAN switching, ATM switching, routing, layer-three switching,
virtual LAN, and wide area access architectures, and to make extensive use of
ASICs to reduce costs and increase performance.
Focus on High-End Premise Switch Markets
Xylan has focused on the high end of the premise switch market. The
Company offers products that provide modularity, redundancy, high port count,
routing capabilities and extensive interfaces. Xylan believes that continuing to
incorporate high-end product features into its products will facilitate the
Company's ability to sell to high-end customers, who tend to be early adopters
of new technologies.
Enhance Existing LANs and Facilitate Migration to High-Speed Networks
Xylan's products increase the performance of a hub- and router-based
network by adding switching technology to the network. The Company's products
support all popular LAN types and provide any-to-any MAC-layer translation. In
addition, the Company's virtual LAN capabilities make an existing network easier
to manage. At the same time, the Company's products facilitate user migration to
future high-speed networks such as ATM, Fast Ethernet, Gigabit Ethernet, and
layer-three switching, making these products long-term strategic networking
solutions.
Leverage Strategic Distribution Relationships
Xylan has established strategic OEM relationships with leading
communications and networking companies that have significant customer
relationships already in place and provide such customers with worldwide service
and support. The Company believes that this strategy has allowed it to more
quickly penetrate the premises switching market and to reduce the expenses of
product introduction, marketing, and support. The Company uses its own sales
force in part to optimize the selling efforts of its OEM partners.
Expand Global Distribution Presence
Xylan pursues both direct sales to large organizations in North America,
focusing on early adopters of new technologies and the government, and
international sales, which broaden the market for the Company's products. The
Company intends to continue to use a broad variety of global distribution
channels to introduce and maintain the presence of its products in the market
through the combination of OEM partners and network integrators supported by
Xylan's own sales force.
PRODUCTS AND TECHNOLOGY
Xylan offers a family of products that are designed to serve as a
complete switching system for a building or campus. The Company's OmniSwitch and
PizzaSwitch products provide flexible high-end LAN switching, virtual LANs,
high-speed routing, ATM switching, wide-area access, and comprehensive network
management capabilities. The Company's OmniVision software provides a graphical
network management capability designed to be compatible with the user's network
environment, and the Company believes that its AutoTracker capability
facilitates virtual LAN configuration and management.
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OmniSwitch
The OmniSwitch is a modular, chassis-based switch that provides high-
performance switching within virtual LANs and routing between virtual LANs. The
OmniSwitch supports a variety of LAN types, interconnecting Ethernet, Fast
Ethernet, token ring, FDDI, frame relay, and ATM with any-to-any MAC-layer
protocol translation. The Company offers the OmniSwitch in both five-slot and
nine-slot enclosures, which can be configured with a mix of switching modules to
meet a customer's specific needs. Both enclosures use the same hardware and
software and provide redundant, load-sharing power supplies with separate AC or
DC inputs. The OmniSwitch is designed to be located either in the customer's
wiring closet or in the computer room. The list price for a fully configured
OmniSwitch typically ranges from $15,000 to $100,000, depending on the
configuration necessary to meet the needs of a specific customer. A network
could use one OmniSwitch, or could use hundreds, depending on network size and
the extent to which switching is deployed.
The Xylan OmniSwitch family of products is based on a distributed,
modular, multiprocessor and multi-ASIC switching architecture. This distributed
architecture eliminates the traditional central switching engine, enabling data
to move more quickly through the Company's switching modules. In addition, users
can increase the processing capacity of an OmniSwitch by simply adding switching
modules.
The OmniSwitch serves as a platform for a broad array of LAN, ATM, and
wide area switching modules. Each module not only performs I/O functions, but
also acts as an independent switching engine, communicating directly with other
modules in the OmniSwitch.
PizzaSwitch
The Company's PizzaSwitch product, which was introduced during the first
quarter of 1996, is based on the same hardware architecture and incorporates
many of the same LAN switching and software capabilities as the OmniSwitch.
Consequently, the PizzaSwitch has much more robust features and functionality
than traditional small switches, making it suitable for a wide range of
customers and applications. The PizzaSwitch is designed to be cost-effective in
smaller configurations. The PizzaSwitch may be used alone in a small network or
in combination with multiple OmniSwitch and PizzaSwitch devices in a larger
network. While the OmniSwitch is fully modular, the PizzaSwitch combines twelve
Ethernet ports with a small number of modular high-speed ports, which can be
FDDI, Fast Ethernet, frame relay, or ATM.
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Xylan's products currently offer the following LAN interfaces and
switching capabilities:
LAN INTERFACES SUPPORTED BY XYLAN PRODUCTS
LAN Switching
. any-to-any MAC layer translation
. multi-RISC, multi-ASIC frame switching
. up to 96 switched Ethernet ports
. Ethernet 10BaseT, 10Base2, 10Base5, 10BaseFL
. up to 48 switched Token Ring ports
. Token Ring lobe, device, RI/RO, UTP, STP, fiber
. up to 16 switched FDDI ports
. up to 64 FDDI TP/PMD (CDDI) ports
. up to 64 100BaseTX ports
. up to 16 100BaseFX ports
. up to 16 ATM DS-3 / E3 uplink ports
. up to 16 ATM OC-3 uplink ports
. broadcast throttling, configurable per port
. 802.1d transparent Spanning Tree bridging
. source route bridging
. LAN / ATM encapsulation (RFC 1483)
. Classical IP over ATM (RFC 1577)
. ATM Forum LANE client
ATM Switching
. 13.2 Gbps cell matrix fabric rate
. single-stage non-blocking distributed processing cell matrix
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. support for CBR, rt-VBR, nrt-VBR, ABR, and UBR
. switched and permanent point-to-point circuits
. switched and permanent point-to-multipoint circuits
. up to 64 ATM OC-3 / STM-1 ports
. up to 2,097,152 cell buffers per switch
. up to 32,000 cell buffers per port
. up to 16,000 point-to-multipoint virtual circuits per port
. up to 65,000 point-to-point virtual circuits per port
. ATM Forum LANE server
. ATM Forum PNNI 1.0
. ATM Forum IISP
. ATM Forum UNI 3.0 and 3.1
. ATM Forum Traffic Management 4.0
. Early Packet Discard (EPD)
. Partial Packet Discard (PPD)
. Random Early Detect (RED)
. Explicit Rate and Relative Rate compatible flow control
. Explicit Forward Congestion Indication bit
LAN / ATM Integration
. LAN and ATM in a single switch
. full slot transparency: any slot can switch cells or frames
. single management agent for all switching
. cell and frame modules linked with high-speed SAR function
Routing and Security
. IP RIP
. IP RIP II
. IP OSPF
. IP multicast (DVMRP, IGMP)
. DHCP BootP relay
. IPX (RIP)
. high-speed hardware-based routing engine
Virtual LANs
. automatic policy-based VLANs
. up to 65,000 VLANs per network
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. up to 31 VLAN memberships per workstation or server
. VLAN defined as a collection of switch ports
. VLAN defined as a list of MAC addresses
. VLAN defined as a protocol type
. VLAN defined as an IP subnet
. VLAN defined as an IPX network number
. VLAN defined by a custom field
. VLAN defined as a multicast group
. VLANs trunked across FDDI
. VLANs trunked across Fast Ethernet
. VLANs trunked across ATM
. VLANs trunked across frame relay
. VLANs integrated with LAN Emulation
. VLAN membership maintained for mobile users
. modified 802.10 VLAN trunking
WAN Access
. up to 64 Frame Relay ports
. V.35, RS-232 (V.24 / V.28), RS-422 / RS-449, RS-530, and X.21 ports
. routed frame relay (RFC 1490)
. switched frame relay integrated with VLANs
. multiple VLANs in a single DLCI
. Frame Relay Forum data compression (FRF.9)
Platforms
. all platforms share software, hardware, ASICs, and management agent
. redundant management modules
. optical bypass support for FDDI
. redundant, load-sharing power supplies
. -48 VDC power option
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. passive backplane
. hot-swappable cooling fans
Network Management
. graphical VLAN management application
. access via any LAN type, ATM, frame relay, serial port, TELNET, TFTP, and
BootP
. graphical traffic management application
. graphical RMON application
. OpenView for Windows
. OpenView for Unix
. Sunnet Manager
. NetView for AIX
AutoTracker-Virtual LANs
The OmniSwitch hardware and software architecture was designed to
support flexible virtual LANs. The Company's AutoTracker capability allows a
network manager to group devices logically, rather than physically, using
policy-based management. Workstation movements can be automatically tracked for
the network manager through the network. Virtual LAN processing is integrated
into the OmniSwitch's hardware and software architecture in order to maintain
switching performance. A virtual LAN supported by AutoTracker can include any
combination of LAN types supported by the OmniSwitch. For example, a single
virtual LAN could include Ethernet and token ring workstations as well as FDDI
and ATM servers. Virtual LANs supported by AutoTracker can span multiple
switches, across FDDI and/or ATM backbones. Any given workstation or server can
belong to as many as 31 virtual LANs. AutoTracker also allows workstations
attached to a single hub to be assigned to different virtual LANs.
OmniVision Network Management
Xylan's OmniVision network management software operates within a
customer's existing network management environment. It supports the OmniSwitch
and PizzaSwitch with a graphical interface which operates on industry-standard
applications for both Windows (Hewlett-Packard's OpenView) and UNIX (OpenView,
SunSoft's SunNet Manager, and IBM's NetView for AIX). Network managers can also
control the OmniSwitch and PizzaSwitch with an ASCII menu-driven interface.
ATM Switching Technology
Xylan has incorporated ATM switching capability into the OmniSwitch, in
combination with its existing LAN switching capability. The Company believes
that its new ATM switching architecture, Distributed Input Buffering with Output
Control, allows both data-based and real-time traffic to be handled with minimal
cell loss even under heavy loads. Video streams and other real-time traffic are
also supported. The ATM switching capability, known as X-Cell, supports large
cell buffers, offers intelligent cell discard mechanisms, and supports a
number of important ATM Forum standards.
Product Development
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. Xylan intends to make substantial investments
in product development and to participate in the development of industry
standards. The Company monitors changing customer needs and works closely with
its OEM partners, network integrators, end-user customers and market research
organizations to track changes in the marketplace, including emerging industry
standards and local area networking protocols.
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The Company's products are developed using a distributed architecture
that allows multiple development teams to work in parallel. The Company believes
that this accelerates the product development cycle and reduces the time to
bring new products and features to market. Xylan intends to continue to use this
approach to develop and introduce additional products and enhancements in the
future.
The Company is focusing development efforts on expanding the LAN and ATM
interfaces and routing protocol capabilities of its products, supporting carrier
services and additional industry standards, adding higher capacity platforms and
expanding the Company's network management capabilities. In addition, Xylan has
devoted and continues to devote significant resources to the design, simulation
and fabrication of ASICs to reduce costs and increase the performance of its
products. No assurances can be given that the Company will be able to introduce
any or all of these products, or any future products, on a timely basis, if at
all. Furthermore, there can be no assurance that the Company will be able to
identify, develop, manufacture, market or support new products or enhancements
to its existing 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.
The Company's research and development expenditures totaled $15.8
million, $7.2 million and $2.4 million for the years ended December 31, 1996,
1995 and 1994, respectively. At December 31, 1996, the Company employed 122
employees in research and product development. The Company performs its research
and product development activities at its headquarters and in offices located in
Irvine, California and Salt Lake City, Utah. The Company is seeking to hire
additional skilled development engineers, who are currently in short supply. The
Company's business, operating results and financial condition could be adversely
affected if it encounters delays in hiring required engineers.
SALES AND MARKETING
The Company's sales and marketing strategy is focused on three channels
of distribution: worldwide OEM partners, network integrators in North America
and overseas, and direct sales. In general, the Company's resale agreements with
its OEM partners and system integrators are not exclusive and each of the
Company's OEM partners and system integrators can cease marketing the Company's
products at their option with limited notice and with little or no penalty. In
addition, these agreements 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.
OEM Partners
The Company has established OEM partnerships with leading communications
and networking companies, including Alcatel, Hitachi, IBM and Samsung.
For the year ended December 31, 1996, Hitachi Computer Products and
IBM accounted for 13.5% and 11.7% of revenue, respectively. For the year ended
December 31, 1995, Hitachi, Digital Equipment Corp. and Alcatel accounted for
17.6%, 17.2% and 10.5% of revenue, respectively. Each of the Company's OEM
partners resells the Company's products under its own name. Certain of them have
also agreed to supply Xylan with technology to be incorporated into the
OmniSwitch. Each of Xylan's OEM partners is a major system integrator, as well
as a manufacturer. The Company believes that its OEM partnerships enhance its
ability to penetrate large organizations because these resellers have long-term
supplier relationships with these potential customers. Since OEM partners
provide support to their customers, Xylan is also able to focus its support
efforts on its direct customers, and on training and high-level backup support
to OEM partners and system integrators.
System Integrators
12
<PAGE>
The Company also currently sells its products through more than 100
system integrators worldwide. The Company's system integrators supplement the
direct and OEM channels. System integrators generally are responsible for
system installation, technical support and follow-on services to customers in
their respective territories. System integrators accounted for approximately
42% and 33% of revenue for the year ended December 31, 1996 and 1995,
respectively. NTT PC Communications accounted for 12.3% of revenue
for the year ended December 31, 1996. No individual network integrator
accounted for more than 10% of the Company's revenue in 1995.
Direct Sales in North America
Xylan maintains a direct sales organization to focus on major account
sales, promote the Company's products and ensure direct contact with the
Company's current and potential customers. Xylan's sales organization also
provides support to OEM partners and system integrators, assists end-user
customers in addressing complex switching problems, and promotes the features
and capabilities of the Company's products. In addition, the Company believes
that direct sales helps the Company to monitor changing customer requirements.
Xylan's International Sales Organization
The Company has designed its products and established its marketing and
sales channels to address the global market opportunities for LAN switching
products. The Company's international sales are conducted primarily through its
OEM partners and independent, territory-specific network integrators. The
Company believes that there is a strong international market for its products.
Sales to customers outside of North America accounted for approximately 51% and
49% of the Company's revenue for the year ended December 31, 1996 and 1995,
respectively, with approximately 37% and 13% of 1996 revenue being attributable
to sales to customers in Asia-Pacific and Europe, 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 market the
Company's products abroad. This international sales organization provides
support to OEM partners and system integrators and promotes the features and
capabilities of the Company's products.
End Users
The Company's products have been deployed by a broad range of
organizations, ranging from companies in the telecommunications, manufacturing,
medical, computer services, media and finance/insurance industries to
educational institutions and the federal government.
13
<PAGE>
Marketing
The Company has a number of marketing programs to support the sale and
distribution of its products. The objective of these programs is to inform OEM
partners, system integrators and prospective end-user customers about the
capabilities and benefits of the Company's products. Marketing programs include
participation in industry tradeshows, technical conferences and technology
seminars; preparation of competitive analyses; sales training; publication of
technical and educational articles in industry journals; maintenance of Xylan's
World Wide Web site; advertising; and direct mail distribution of Company
literature.
14
<PAGE>
CUSTOMER SERVICE AND SUPPORT ENGINEERING
Xylan's customer service and support organization installs, maintains
and supports products sold in North America by the Company's direct sales force
as well as certain sales by the Company's OEM partners and network integrators.
The Company's OEM partners and system integrators generally provide
installation, maintenance and support services to their customers, with the
Company providing backup support.
The Company offers maintenance programs in North America that provide 7
days a week and 24 hours a day technical phone support, software updates, and
on-site harware replacement through a network of service delivery partners.
Xylan employs systems engineers who work closely with the Company's OEM
partners, system integrators and direct sales personnel to assist end-users
with pre- and post-sales support matters. These systems engineers provide input
to the product development process based on their experiences in the field.
Xylan typically provides its system integrators with a one year
hardware warranty and a three month software warranty, commencing on product
shipment. Warranty terms for OEM partners are negotiated on a case-by-case
basis.
MANUFACTURING
Xylan's manufacturing operations consist primarily of material planning
and procurement, final assembly, software loading, test and quality assurance.
Xylan's operational strategy relies on outsourcing of manufacturing to reduce
fixed costs and to provide flexibility in meeting market demand. The Company
currently subcontracts component procurement and kitting and printed circuit
board assembly to a company that specializes in these services. The Company
takes the printed circuit board-based modules produced by its contract
manufacturer and inserts them into product enclosures in combination with
Xylan's software to meet the needs of individual customers.
In connection with its outsourcing 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 quality, quantity
and on-time delivery. In addition, the Company may in the future experience
pricing pressures 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 contract 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 1997
and 1998, 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 have a material adverse effect
on the Company's business, operating results and financial condition.
The Company uses a rolling six-month forecast based on anticipated
product orders to determine its general materials and component 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. Currently, the Company
acquires materials and completes certain standard subassemblies based on the
Company's forecast. Upon receipt of firm orders from customers, the Company
assembles fully-configured systems and subjects them to a number of tests before
shipment. If orders do not match forecasts, the Company may have excess or
inadequate inventory of certain materials and components. 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 and controls 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 and to accurately record and control inventory levels and to
record and report financial and management information on a timely and accurate
basis.
15
<PAGE>
Although the Company generally uses standard parts and components for
its products, 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 programmable integrated circuits,
selected other integrated circuits and cables and custom-tooled sheet metal; and
limited-sourced components include flash memories, DRAMs, printed circuit boards
and ASICs. 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. Each of these ASICs is initially
being manufactured only by a single source, particularly LSI Logic Corporation,
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. From time to time the Company has
experienced shortages and allocations of certain components and has experienced
delays in fulfilling orders while waiting to receive the necessary components.
Given current worldwide demand for integrated circuits and certain other
components used by the Company, such shortages and allocations are likely to
occur again in the future and could have a material adverse effect on the
Company's business, operating results and financial condition.
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. Recent consolidations in the industry have
resulted in competitors that may have broader product lines, greater access to
capital or greater research and development resources which could adversely
affect the ability of the Company to compete. 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. 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 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.
Xylan believes that the principal competitive factors in its market are:
(i) expertise and familiarity with LAN and ATM protocols, LAN and ATM switching,
and network management; (ii) product performance, features, functionality, and
reliability; (iii) price/performance; (iv) timeliness of new product
introductions; (v) adoption of emerging industry standards; (vi) customer
service and support; (vii) size and scope of distribution network; (viii) access
to customers; (ix) size of installed customer base; and (x) corporate operating
history and financial resources. The Company believes that it is competitive
with respect to the first seven of these factors and intends to become
competitive with respect to the remaining factors.
EMPLOYEES
16
<PAGE>
As of February 28, 1997, the Company employed 455 persons, including
122 in research and product development, 239 in sales and marketing, 52 in
operations, and 42 in finance and administration. None of the Company's
employees is represented by a labor union. The Company has experienced no work
stoppages and believes that its relationship with its employees is good.
Competition for qualified personnel in the computer networking and
communications industry is intense. There can be no assurance that the Company
will be successful in retaining its key employees or that it can attract the
additional skilled personnel required for the Company's future growth. 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.
EXECUTIVE OFFICERS OF THE COMPANY
The executive officers of the Company and their ages as of February 28,
1997 are as follows:
<TABLE>
<CAPTION>
NAME AGE POSITION
- ---- --- --------
<S> <C> <C>
Steve Y. Kim 47 President, Chief Executive Officer and Chairman
John Bailey 39 Vice President of Product Development
Dale J. Bartos 46 Vice President of Finance and Chief Financial Officer
Douglas Hill 44 Vice President of Corporate Communications
Phil Lichtenberger 40 Vice President of Operations
Yuri Pikover 35 Vice President of Worldwide Sales and Director
Kevin T. Walsh 39 Vice President of Marketing
</TABLE>
The officers of the Company are appointed annually by the Board of
Directors and serve at the discretion of the Board. There are no family
relationships among the directors or officers of Xylan.
Mr. Kim, a co-founder of the Company, has served as the Company's
President and Chief Executive Officer and Chairman of the Board of Directors
since the Company's inception in July 1993. Prior to co-founding the Company,
Mr. Kim founded and served as President and Chief Executive Officer of Fibermux
Corporation ("Fibermux"), a networking company, from November 1984 to June
1993. Prior to founding Fibermux, Mr. Kim held management and design positions
with a number of companies, including Phalo Optical Systems Division, Litton
Data Systems, and Burroughs Corporation.
Mr. Bailey joined the Company in January 1994 and has served in various
engineering management positions, most recently as Vice President of Product
Development. Prior to joining the Company, Mr. Bailey was an Assistant Vice
President for LAN Internetworking Technology at Ascom Timplex, a networking
company, from September 1992 to January 1994. From January 1990 to September
1992, Mr. Bailey served in various engineering management and design positions
at Unisys Corporation, a computer manufacturer.
Mr. Bartos joined the Company in January 1996 as the Company's Vice
President of Finance and Chief Financial Officer. Prior to joining the Company,
Mr. Bartos was the Chief Financial Officer at ADFlex Solutions, Inc. from May
1996 to January 1997. Prior to that, Mr. Bartos served as the Chief Financial
Officer at Integral Peripherals, Inc. from March 1995 to May 1996, and
Micropolis Corporation from December 1989 to March 1995. Mr. Bartos has also
held senior financial positions at DataProducts Corporation and Harris
Corporation. Mr. Bartos is a certified public accountant.
Mr. Hill joined the Company in January 1994 and has served in various
marketing management positions, most recently as Vice President of Corporate
Communications. Prior to joining the Company, Mr. Hill was Senior Consultant at
Western Data Group, a network integration company, from October 1989 to January
1994. Mr. Hill has also served as Vice President, Marketing and Sales at ACT
Networks, Inc., a networking company, and as Assistant Vice President at MICOM
Systems, Inc. ("MICOM Systems"), a networking company.
17
<PAGE>
Mr. Lichtenberger joined the Company in December 1995 and has served
in various operations management positions, most recently as Vice President of
Operations. Prior to joining the Company, Mr. Lichtenberger served as General
Manager of the Video Products Group of Hewlett-Packard Company from August
1993 to December 1995. From October 1991 to August 1993, Mr. Lichtenberger
served as General Manager of the Video Products Group of BT&D Technologies,
Ltd. ("BT&D"), until BT&D was acquired by Hewlett-Packard Company. Mr.
Lichtenberger has also held senior level manufacturing management and R&D
positions at a number of companies, including White Technology Group, Inc.,
and Motorola, Inc.
Mr. Pikover, a co-founder of the Company, has served in various sales
and management positions and as a member of the Board of Directors since the
Company's inception in July 1993, most recently as Vice President of Worldwide
Sales. From August 1988 to June 1993, Mr. Pikover served as Regional Sales
Manager at Fibermux. Mr. Pikover served in various sales, marketing and
technical positions at MICOM Systems from September 1982 to August 1988.
Mr. Walsh joined the Company in May 1995 and has served in various
marketing management positions, most recently as Vice President of Marketing.
Prior to joining the Company, Mr. Walsh served in various management positions
at Ascom Timeplex from August 1990 to May 1995, most recently as Director,
Technical Marketing.
The Board of Directors has a Compensation Committee (consisting of
Messrs. Hall, Taylor and Walecka), which makes recommendations concerning
salaries and incentive compensation for employees of the Company and administers
the Company's equity incentive plans, and an Audit Committee (consisting of
Messrs. Hall, Taylor and Walecka), which reviews the results and scope of the
audit and other services provided by the Company's independent accountants.
Currently all directors hold office until the next annual meeting of the
shareholders and until their successors have been duly elected and qualified.
The Company's Articles of Incorporation, however, provide that at such time as
the Company becomes a "listed corporation" under the California Corporations
Code (defined as a corporation having at least 800 shareholders as of the record
date of its most recent annual meeting of shareholders), the Board of Directors,
without further action by the shareholders, will be divided into two classes.
Each class of directors will consist of three directors, who will serve for a
one or two year period or until their successors are elected and qualified.
Thereafter, directors will serve staggered two year terms.
ITEM 2. PROPERTIES
- ------ ----------
The Company leases approximately 80,000 square feet of office,
development and manufacturing space in three adjacent facilities in Calabasas,
California. The current leases on this space expire through 2002. The
Company also has 64 sales and support offices worldwide. Xylan may also need to
obtain additional office, development and manufacturing space to accommodate
expected business growth during 1997. There can be no assurance that such
additional facilities, if required, will be available in a timely manner or on
commercially reasonable terms.
ITEM 3. LEGAL PROCEEDINGS
- ------ -----------------
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 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. During 1996, the Company and Ascom
Timeplex settled the suit by signing a binding memorandum of understanding that
dismissed 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 released 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
18
<PAGE>
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.
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. These claims may be asserted against the Company directly in a lawsuit
naming the Company as a defendant, or may be asserted against the Company
indirectly in a lawsuit naming as a defendant one or more customers or resellers
of the Company which the Company is contractually obligated to indemnify in the
event of a lawsuit alleging that products purchased from Company infringe third
party intellectual property rights. In addition to the claims of Ascom Timeplex,
Xylan has, from time to time, received claims, directly or indirectly, 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 any 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.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
- ------ ---------------------------------------------------
Not Applicable.
PART II
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND SHAREHOLDER MATTERS
- ------ ----------------------------------------------------------------
The Company completed its initial public offering on March 11, 1996, and
a secondary public offering on May 29, 1997 and the Company's common stock is
traded on the Nasdaq National Market under the symbol XYLN. As of February 28,
1997 the Company had approximately 495 shareholders of record.
The following table shows the Company's high and low closing bid prices
for the fiscal year ended December 31, 1996 as reported by Nasdaq:
<TABLE>
<CAPTION>
1996
-----------------
High Bid Low Bid
-------- -------
<S> <C> <C>
First Quarter $58 3/8 $51 1/4
Second Quarter $74 5/16 $46 1/2
Third Quarter $56 3/4 $34 3/4
Fourth Quarter $58 1/4 $24
</TABLE>
19
<PAGE>
Future stock prices may be subject to volatility particularly on a
quarterly basis. Any shortfall in revenues or net income from amounts expected
by securities analysts could have an immediate and significant adverse effect on
the trading price of the Company's stock.
DIVIDEND POLICY
The Company has not paid dividends on its common stock and has no
present plans to do so.
CERTAIN RISK FACTORS
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 LAN switching products. Accordingly,
the Company has only a limited operating history upon which an evaluation of the
Company and its prospects can be based. 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 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 (ix) mix of products manufactured or purchased
by IBM and (x) general economic conditions. See "Certain Risk Factors--
Dependence on OEM Partners and System Integrators; IBM; 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 (including IBM) 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 system integrators. Accordingly, if the Company's OEM
partners and system integrators were to account for an increased portion of the
Company's revenue, gross margins would decline. In addition, if IBM elects to
manufacture products using technology licensed from the Company, the Company's
product revenue and product gross margin will be adversely affected. New
products may have different gross margins than existing products. A significant
portion of the Company's expenses, such as rent, headcount and 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
20
<PAGE>
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. In addition, due in part to the timing of product release dates,
significant volume shipments of products may occur at the end of the Company's
fiscal 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, significant price reductions, 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. Recent consolidations in the industry have resulted in competitors that
may have broader product lines, greater access to capital or greater research
and development resources, which could adversely affect the ability of the
Company to compete. Recent consolidations in the industry have resulted in
competitors that may have broader product lines, greater access to capital or
greater research and development resources which could adversely affect the
ability of the Company to compete. 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 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
"Certain Risk Factors--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 orderlead 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. During 1996, the Company
leased an additional 40,000 square feet of space, a portion of which is being
used for manufacturing. Any interruption or delay in the normal flow of
production,or defaults or financial insolvency of the contract manufacturer
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, if at all.
21
<PAGE>
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 1996, the Company agreed to loan up to $10 million
to its contract manufacturer that performs circuit board assembly. The loan,
which assists the contract manufacturer to meet the Company's increasing
production requirements, is non-interest bearing, does not have a defined due
date and is secured by raw materials and electronic components purchased by the
contract manufacturer. At December 31, 1996, the note had an outstanding balance
of $6 million. Also, during 1996, the Company guaranteed up to $5 million of
such contract manufacturer's debt for raw material and electronic component
purchases. Any additional loans or guaranties to the Company's contract
manufacturer, or defaults or financial insolvency of the contract manufacturer,
could have an adverse effect 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 1997 and 1998,
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 on-time 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 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 or delay 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, which could have a material adverse effect on
the Company's financial condition. From time to time the Company has experienced
shortages and allocations of certain components, delays in filling orders while
waiting to obtain the necessary components and delays in prototyping of its
ASICs. 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
allocations and delays 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
22
<PAGE>
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; IBM; 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
signed a licensing agreement with Samsung under which the Company will modify
its OmniVision network management software to control Samsung's ATM switches, in
addition to Xylan's 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.
In the field of campus network switching products, IBM and Xylan are
offering the other company's campus switch products for resale. For the quarter
ended December 31, 1996, sales to IBM comprised 23% of the Company's revenue.
There is no assurance that IBM will continue to purchase the Company's products.
In addition, the Company has limited information as to the sell-through of its
products by IBM. There is no assurance that even if IBM does purchase such
products, that IBM will sell such products to its customers. Both companies have
the right to manufacture and sell certain of each other's campus switching
products in exchange for a royalty. As of December 31, 1996, no royalties have
been earned by either company. However, sales by IBM of IBM manufactured campus
switch products could have a material adverse effect on the Company's product
revenues. In addition, the parties are forming a joint development organization
to develop new products using certain of the other company's LAN technology. Any
reduction or delay in sales of the Company's products by IBM could have a
material adverse effect on the Company's business, financial condition and
results of operations.
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 46% and 42%, respectively, for the year ended December
31, 1996, and 60% and 33%, respectively, for the year ended December 31, 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 system
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. In addition, Xylan's OEM partners and
system integrators could sell to the Company's existing customers, which could
have a material adverse effect on the Company's business, operating results and
financial condition. 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.
23
<PAGE>
RAPID TECHNOLOGICAL CHANGE; NEW PRODUCTS AND EVOLVING MARKETS. The
market for the Company's products is characterized by frequent new product
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 switching 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. However, ASICs are
generally complex and may contain undetected errors. 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 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.
24
<PAGE>
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. These claims may be asserted against the Company directly in a lawsuit
naming the Company as a defendant, or may be asserted against the Company
indirectly in a lawsuit naming as a defendant one or more customers or
resellers of the Company which the Company is contractually obligated to
indemnify in the event of a lawsuit alleging that products purchased from the
Company infringe third party intellectual property rights. In addition
to the claims of Ascom Timeplex, Xylan has, from time to 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,
25
<PAGE>
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 engineers and sales personnel, could have a material adverse
effect on the Company's business, operating results or financial condition.
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 51% and 49% of the Company's revenue for the years
ended December 31, 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 and investment 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.
26
<PAGE>
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 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. In addition, recent changes in the
rules regarding resales of restricted securities pursuant to Rule 144 of the
Securities Act of 1933, as amended, may result in a greater number of shares of
the Company's Stock becoming available for resale sooner than anticipated, and
could have an adverse effect on the market price of the Company's Stock.
ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA
- ------ ------------------------------------
THE FOLLOWING SELECTED FINANCIAL INFORMATION HAS BEEN DERIVED FROM THE AUDITED
CONSOLIDATED FINANCIAL STATEMENTS. THE INFORMATION SET FORTH BELOW IS NOT
NECESSARILY INDICATIVE OF RESULTS OF FUTURE OPERATIONS, AND SHOULD BE READ IN
CONJUNCTION WITH "MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS
27
<PAGE>
OF OPERATIONS" AND THE CONSOLIDATED FINANCIAL STATEMENTS AND RELATED
NOTES THERETO INCLUDED ELSEWHERE IN THE FORM 10-K.
<TABLE>
<CAPTION>
PERIOD
ENDED
DECEMBER
YEAR ENDED DECEMBER 31, 31,
--------------------------- ------
1996 1995 1994 1993
------- ------ ------- ------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
Revenue.................................................... $128,456 $29,662 $ 443 $ --
Cost of revenue............................................ 57,830 15,418 327 --
-------- ------- ------- -------
Gross profit............................................ 70,626 14,244 116 --
-------- ------- ------- -------
Operating expenses:
Research and development................................ 15,823 7,154 2,404 343
Sales and marketing..................................... 32,590 13,011 695 --
General and administrative.............................. 4,397 3,593 1,168 188
-------- ------- ------- -------
Total operating expenses.............................. 52,810 23,758 4,267 531
-------- ------- ------- -------
Operating income (loss) ................................... 17,816 (9,514) (4,151) (531)
Interest income, net.................................... 5,240 73 68 9
-------- ------- ------- -------
Income (loss) before income taxes.......................... 23,056 (9,441) (4,083) (522)
Income tax expense...................................... 7,811 -- -- --
-------- ------- ------- -------
Net income (loss) ......................................... $ 15,245 $(9,441) $(4,083) $ (522)
======== ======= ======= =======
Net income (loss) per share (1) ........................... $0.33 $(0.45) $(0.19) $(0.02)
======== ======= ======= =======
Shares used in per share computation (1) .................. 46,381 21,151 21,109 21,067
======== ======= ======= =======
<CAPTION>
DECEMBER 31,
----------------------------------------
1996 1995 1994 1993
------- ------ ------- -------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
CONSOLIDATED BALANCE SHEET DATA:
Cash, cash equivalents and short-term investments.......... $112,981 $ 6,034 $ 4,584 $ 1,306
Working capital............................................ 134,615 11,130 4,186 1,216
Total assets............................................... 207,251 27,248 6,613 1,411
Capital lease obligations, long-term....................... 206 509 239 --
Net shareholders' equity................................... 185,638 16,105 5,367 1,269
</TABLE>
(1) See Note 1 of Notes to Consolidated Financial Statements for an explanation
of the determination of the number of shares used to compute net income
(loss) per share.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
- ------ ---------------------------------------------------------------
RESULTS OF OPERATIONS
---------------------
This Annual Report on Form 10-K may consist of forward-looking
statements that involve risks and uncertainties. These statements may differ
materially from actual future events or results. Readers are referred to the
"Certain Risk Factors" section of this Form 10-K, which identify important risk
factors that could cause actual results to differ from those contained in the
forward-looking statements.
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. Since then, revenue has
increased significantly on a quarterly basis to an aggregate of $128.5 million
in fiscal year 1996 from $29.7 million in fiscal year 1995. The increase in
quarterly revenue reflects substantial growth of the LAN switching market, the
continued introduction by the Company of additional features and enhancements to
its OmniSwitch product family and the introduction of the PizzaSwitch product in
March 1996, all of which expanded the portion of the market addressed by Xylan's
products. The increase in quarterly revenue was also the result of continued
market acceptance of the Company's LAN switching products, and investment in
sales and marketing efforts, including significant expansion of the Company's
domestic and international product distribution network. The Company
28
<PAGE>
markets its products worldwide through OEM partners, system integrators and its
own sales force and first achieved profitability in the fourth quarter of 1995.
As of December 31, 1996 and 1995, the Company had retained earnings of $1.2
million and an accumulated deficit of $14.0 million, respectively.
The Company intends to increase significantly its investments in
research and development, sales and marketing and related infrastructure. Such
increases will be dependent on factors including the continued growth of the
Company's revenues 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.
YEARS ENDED DECEMBER 31, 1996 AND 1995
Revenue
Revenue for the year ended December 31, 1996 was $128.5 million compared
to $29.7 million for the year ended December 31, 1995, an increase of 333%. The
increases in revenue were due to a number of factors, including substantial
growth of the LAN switching market, continued introduction by the Company of
additional features and functions to its OmniSwitch product family, the
introduction of the PizzaSwitch product family, market acceptance of the
Company's LAN switching products, the addition of IBM in July 1996, and the
Company's investment in sales and marketing resources. Under an agreement
with IBM and the Company, IBM has the right to manufacture certain Company
products after a specified period of time and pay a royalty to Xylan. As
of December 31, 1996, no royalties have been earned by the Company. Product
revenue could be adversely impacted if IBM elects to manufacture the
Company's products. While the Company achieved revenue growth of 333% from
1995 to 1996, the Company does not expect to sustain this rate of sequential
revenue growth if at all in future periods.
For the year ended December 31, 1996, Hitachi Computer Products, NTT PC
Communications, Inc. and IBM accounted for 13.5%, 12.3% and 11.7% of revenue,
respectively. For the year ended December 31, 1995, Hitachi Computer Products,
Digital Equipment Corp. and Alcatel accounted for 17.6%, 17.2% and 10.5% of
revenue, respectively. For the year ended December 31, 1994, substantially all
of the Company's revenue was derived from network integration services, and one
customer accounted for 13.8% of revenue.
The Company markets its products worldwide through OEM partners, system
integrators and a direct sales force. The following table sets forth the
Company's revenue by sales channel and geographic region as a percentage of
total revenue for the years ended December 31, 1996 and 1995:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------
1996 1995
---- ----
<S> <C> <C>
CHANNEL:
OEM 46% 60%
Network Integrator 42% 33%
Direct Sales 12% 7%
=== ===
REGION(1):
North America 49% 51%
International 51% 49%
=== ===
</TABLE>
(1) 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.
Gross Profit
29
<PAGE>
Gross margins were 55.0% and 48.0% for the years ended December 31, 1996
and 1995, respectively. The increase in gross margins resulted from component
cost reductions due to increased volume, the use of application specific
integrated circuits ("ASICs") and design improvements along with the allocation
of fixed costs over a larger revenue base. 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.
Research and Development Expenses
Research and development expenses increased to $15.8 million in 1996
from $7.2 million in 1995, while declining as a percentage of revenue to 12% in
1996 from 24% in 1995. The increase in spending was primarily due to the hiring
of additional engineers and increases in prototype material costs for new
product development. At December 31, 1996, the Company employed 122 employees in
research and development compared to 64 employees at December 31, 1995. The
decline in research and development expenses as a percentage of revenue is
primarily due to the increase 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 impact Xylan's existing product offerings. 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 spending will continue to increase in 1997. To date, the Company has
not capitalized any development costs and does not anticipate capitalizing any
such costs in the foreseeable future.
Sales And Marketing Expenses
Sales and marketing expenses increased to $32.6 million in 1996 from
$13.0 million in 1995, while declining as a percentage of revenue to 25% in 1996
from 44% in 1995. During 1996 the Company established an expanded
infrastructure, including the addition of Xylan sales personnel and sales
offices 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. At
December 31, 1996, the Company employed 216 employees in sales and marketing
compared to 88 employees at December 31, 1995. The decline in sales and
marketing expenses as a percentage of revenue is primarily due to the increase
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 spending will continue to
increase in 1997.
General And Administrative Expenses
General and administrative expenses increased to $4.4 million in 1996
from $3.6 million in 1995, while declining as a percentage of revenue. The
increase in absolute dollars reflects the addition of personnel and systems
30
<PAGE>
to support the growth of Xylan's business. The decline in general and
administrative expenses as a percentage of revenue is primarily due to the
increases in revenue. 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 1997 in absolute dollars.
Interest Income
Interest income was $5.2 million and $73,000 for the years ended
December 31, 1996 and 1995, respectively. This increase is 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.
Provision For Income Taxes
The Company recorded a provision for income taxes of $7.8 million for
the year ended December 31, 1996 and recorded a deferred tax asset at December
31, 1996 of $1.8 million. The net deferred tax asset is included in prepaids and
other current assets in the accompanying consolidated financial statements.
Also, during 1996, the Company realized an income tax benefit of $9.5 million
for certain stock option transactions. This benefit is used to reduce taxable
income prior to the utilization of net operating loss carryforwards, and
resulted in a decrease in current income taxes payable and an increase in
additional paid in capital. As a result of net operating losses, no provision
for income taxes was recorded for 1995.
As of December 31, 1996, the Company had net operating loss
carryforwards for federal income tax purposes of approximately $7.7 million,
which are available to offset future taxable income, if any, through 2010.
Additionally, the Company had research and development tax credit carryforwards
for Federal and state income tax purposes of $1 million and $421,000,
respectively, which are available to offset future income taxes, if any, through
2011.
YEARS ENDED DECEMBER 31, 1995 AND 1994
As described above, in 1993 the Company commenced operations and was
primarily engaged in the development of systems and operations and initial
research and development for the Company's products, whereas in 1994 the
Company was primarily engaged in the research, development and testing of its
products and conducted an ancillary network integration business. In 1995, the
Company began commercial sales of its products and devoted attention to adding
additional features and functionality to such products. Because of the Company's
significantly different levels of operations during 1995 and 1994, year-to-year
comparisons are not meaningful. The following discussion summarizes the
Company's quarterly results of operations in 1995 . Where more than one factor
affecting a change in an item is discussed, the Company has attempted, but has
been unable, to quantify the relative contribution of each factor due to the
unsophisticated nature of the Company's financial and management information
systems during most of 1995, which severely limited the Company's ability at
that time to allocate reliably dollar amounts among different factors. However,
the Company believes that it has placed such factors in their relative order of
importance.
31
<PAGE>
The following tables present quarterly operating results for each of the
four quarters of 1995 and such data as a percentage of revenue for each quarter.
This information is unaudited, but in the opinion of management reflects all
adjustments (consisting only of normal recurring adjustments) that the Company
considers necessary for a fair presentation of such information in accordance
with generally accepted accounting principles. The results for any quarter are
not necessarily indicative of results for any future period.
<TABLE>
<CAPTION>
THREE MONTHS ENDED
------------------------------------------
DEC. 31, SEPT. 30, JUNE 30, MAR. 31,
1995 1995 1995 1995
------ ------- ------ -------
(IN THOUSANDS)
<S> <C> <C> <C> <C>
Revenue...................................... $15,522 $ 8,240 $ 4,503 $ 1,397
Cost of revenue.............................. 7,412 4,386 2,659 961
------- ------- ------- -------
Gross profit.............................. 8,110 3,854 1,844 436
------- ------- ------- -------
Operating expenses:
Research and development.................. 2,429 2,040 1,646 1,039
Sales and marketing....................... 3,808 3,779 3,336 2,088
General and administrative................ 1,422 1,216 605 350
------- ------- ------- -------
Total operating expenses............... 7,659 7,035 5,587 3,477
------- ------- ------- -------
Operating income (loss)...................... 451 (3,181) (3,743) (3,041)
Interest income (expense), net............... (14) (14) 30 71
------- ------- ------- -------
Net income (loss) before income taxes........ 437 (3,195) (3,713) (2,970)
Income tax expense........................... -- -- -- --
------- ------- ------- -------
Net income (loss)............................ $ 437 $(3,195) $(3,713) $(2,970)
======= ======= ======= =======
</TABLE>
32
<PAGE>
<TABLE>
<CAPTION>
AS A PERCENTAGE OF REVENUE
-------------------------------------------------------------
DEC. 31, SEPT. 30, JUNE. 30, MARCH 31,
1995 1995 1995 1995
-------- ------- ------- --------
<S> <C> <C> <C> <C>
Revenue................................ 100.0 % 100.0 % 100.0 % 100.0%
Cost of revenue........................ 47.8 53.2 59.0 68.8
------ ------ ------ ------
Gross margin........................ 52.2 46.8 41.0 31.2
------ ------ ------ ------
Operating expenses:
Research and development............ 15.6 24.7 36.6 74.4
Sales and marketing................. 24.5 45.9 74.1 149.5
General and administrative.......... 9.2 14.8 13.4 25.1
------ ------ ------ ------
Total operating expenses............ 49.3 85.4 124.1 249.0
------ ------ ------ ------
Operating income (loss).................. 2.9 (38.6) (83.1) (217.8)
Interest income (expense), net........... (0.1) (0.2) 0.7 5.1
------ ------ ------ ------
Net income (loss) before income taxes.... 2.8 (38.8) (82.4) (212.7)
Income tax expense....................... -- -- -- --
------ ------ ------ ------
Net income (loss)........................ 2.8% (38.8)% (82.4)% (212.7)%
====== ====== ====== ======
</TABLE>
Revenue
The Company's revenue increased by 222%, 83% and 88% from the first to
second, second to third and third to fourth quarter, respectively, of fiscal
1995. The increase in revenues was due to a number of factors, including
substantial growth of the LAN switching market, continued introduction by the
Company of additional features and enhancements to its OmniSwitch product
family, which expanded the portion of the market addressed by Xylan's products,
market acceptance of the Company's LAN switching products, and the Company's
investment in sales and marketing efforts. The large percentage increases are
due primarily to the relatively small dollar value of revenue in each period,
which magnifies absolute dollar changes in revenue from period to period. The
relative contribution of each of these factors cannot be quantified, so future
changes in a factor cannot be used to predict future revenue growth.
Gross Profit
Gross margins increased in 1995 by 323% from the first to second
quarter, 109% from the second to third quarter, and 110% from the third to
fourth quarter. The increases were primarily due to decreased unit manufacturing
costs resulting from higher volumes. The Company's gross margins in the future
will be affected by a number of factors, including competitive market pricing
and discount levels, manufacturing volumes and fluctuations in component costs.
The large percentage increase in all quarters is due primarily to the small
dollar value of gross profit in each period, particularly the percentage
increase arising from $436,000 of gross profit in the first quarter to $1.8
million in the second quarter. The percentage increases from the second to third
and third to fourth quarters correlate with revenue increases in those periods.
Research and Development Expenses
Research and development expenses increased during each quarter of
1995, by 58% from the first to second quarter, 24% from the second to third
quarter, and 19% from the third to fourth quarter. These increases were
primarily due to a significant increase in the number of development personnel
and additional product development expenses incurred in connection with
ongoing development of new products and enhancements to the OmniSwitch product
family. As shown in the table, research and development expenses as a
percentage of revenue declined substantially in each quarter of 1995 due to
the significant quarter-to-quarter increases in revenue. The Company expenses
research and development costs as incurred.
33
<PAGE>
Sales and Marketing Expenses
Sales and marketing expenses increased by 60% from the first to second
quarter of 1995, and by 13% from the second to third quarter. The increase from
the third to fourth quarter was nominal. The increases in the first three
quarters were primarily due to expenses related to the Company's initial product
launch, the addition of direct sales personnel throughout the United States,
Europe and Asia and increased commission expenses resulting from higher sales.
The introduction of additional features and enhancements to the OmniSwitch
product family in 1995, and related expenditures for demonstration equipment
used for customer trials and promotional activities, resulted in fluctuations in
quarterly sales and marketing expenses, particularly the substantial increase in
such expenses in the third quarter of 1995. In addition, the quarterly results
reflect the impact of an aggregate adjustment of approximately $2 million
relating to a change in the Company's method of accounting for demonstration
units to expense the cost of such units which had previously been capitalized.
This adjustment resulted in an increase in sales and marketing expense,
allocated among quarters based on the quarter in which demonstration units were
shipped.
General and Administrative Expenses
General and administrative expenses increased by 73% from the first to
second quarter of 1995, by 101% from the second to third quarter and by 17% from
the third to fourth quarter, reflecting hiring of administrative personnel to
support the growth of Xylan's business and costs related to enhancing the
Company's financial and management information systems. In addition, beginning
in the third quarter of 1995, general and administrative expenses were
substantially increased by spending associated with the Ascom Timeplex
litigation.
Interest Income (Expense)
Interest income (expense) fluctuated on a quarter-to-quarter basis
during 1995, primarily depending upon the level of the Company's cash balances
and the funding required for daily operations.
Provision for Income Taxes
As a result of net operating losses, no provision for income taxes was
recorded for 1995.
FACTORS AFFECTING FUTURE 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. 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 system integrators. Accordingly, if the Company's OEM
partners and system integrators were to account for an increased portion of the
Company's revenue, gross margins would decline. Any decline in sales to OEM
partners and system integrators, or the loss of any 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. In addition, new
products may have different gross margins than existing products. In particular,
the Company's PizzaSwitch product, which became commercially available during
the first quarter of 1996, currently has a lower gross margin than the
OmniSwitch. A significant portion of the Company's expenses, such as rent,
headcount and lease expenses, are relatively fixed in advance, based in large
part on the Company's forecasts of future sales. If sales are below expectations
in any given period, the adverse effect of a shortfall in sales 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
34
<PAGE>
of each quarter 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. In addition, due in part to
the timing of product release dates, significant volume shipments of products
may occur at the end of the Company's fiscal 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. The Company intends to introduce
a number of new products and product enhancements in 1997, which will require
that the Company rapidly achieve volume production by coordinating its efforts
with those of its suppliers and contract manufacturers and the inability of the
Company's contract manufacturers to provide the Company with adequate supplies
of high-quality products or the loss of any of the Company's contract
manufacturers could cause a delay in the Company's ability to fulfill customer
orders, which in turn could cause the Company to fail to meet its revenue
objectives for a particular period. 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. 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.
LIQUIDITY AND CAPITAL RESOURCES
In March 1996, the Company completed its initial public offering and
raised $87.4 million, net of issuance costs and in May 1996 the Company
completed a secondary offering which raised $56.2 million, net of issuance
costs. Additionally, during 1996, cash provided by operating activities
aggregated $12.2 million.
From inception to December 31, 1995, the Company financed its operations
and capital expenditures through the sale of Common and Preferred Stock, for
aggregate proceeds of $30.0 million, and capital lease and other debt financing.
During 1995, cash utilized by operating activities was $14.3 million, compared
to $4.0 million in 1994. The increase in cash utilized during 1995 reflected the
increased working capital necessary to fund significantly expanded operations
and the resulting inventory and accounts receivable.
The Company requires substantial working capital to fund its business,
particularly to finance inventories and accounts receivable and for capital
expenditures. Capital expenditures aggregated $15.2 million and $4.3 million in
1996 and 1995, respectively. The Company has also agreed to loan a contract
manufacturer up to $10 million, of which $6 million was outstanding as of
December 31, 1996. Additionally, the Company has guaranteed up to $5 million
of this contract manufacturer's debt for raw material and electronic components
purchases. 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 source of liquidity as of December 31, 1996,
consisted of $62.5 million in cash and cash equivalents, $50.5 million in short-
term investments and a $6.0 million bank credit facility. The Company believes
that existing cash and investment balances and cash flow expected to be
generated from future operations, will be sufficient to meet the Company's
requirements for at least the next 12 months.
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.
35
<PAGE>
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 disclosure
requirements of Statement No. 123. The adoption of this standard had no impact
on the Company's consolidated financial statements.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
- ------ -------------------------------------------
The Company's Consolidated Financial Statements are included in this
Form 10-K starting at page F-1.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANT ON ACCOUNTING AND
- ------ --------------------------------------------------------------
FINANCIAL DISCLOSURE
--------------------
Not applicable.
36
<PAGE>
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
- ------- --------------------------------------------------
Information regarding Registrant's directors will be set forth under the
caption "Election of Directors - Nominees" in Registrant's proxy statement for
use in connection with the Annual Meeting of Shareholders to be held May 29,
1997, (the "1997 Proxy Statement") and is incorporated herein by reference. The
1997 Proxy Statement will be filed with the Securities and Exchange Commission
within 120 days after the end of the Registrant's fiscal year. See also the
section entitled "Executive Officers" in Part I, Item 1.
ITEM 11. EXECUTIVE COMPENSATION
- ------- ----------------------
The information required by this item is incorporated by reference into
this Form 10-K from the information set forth under the caption "Compensation of
Executive Officers" in the Company's 1997 Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
- ------- --------------------------------------------------------------
The information required by this item is incorporated by reference into
this Form 10-K from the information set forth under the caption "Common Stock
Ownership of Certain Beneficial Owners and Management" in the Company's 1997
Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
- ------- ----------------------------------------------
The information required by this item is incorporated by reference into
this Form 10-K from the information set forth under the caption "Certain
Relationships and Related Transactions" in the Company's 1997 Proxy Statement.
PART IV
- -------
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
- ------- ---------------------------------------------------------------
Page
----
(a) (1) Consolidated Financial Statements:
Independent Auditors' Report................................ F-1
Consolidated Balance Sheets at December 31, 1996 and 1995... F-2
Consolidated Statements of Operations for the Years ended
December 31, 1996, 1995, and 1994....................... F-4
Consolidated Statements of Shareholders' Equity for the
Years ended December 31, 1996, 1995, and 1994........... F-5
Consolidated Statements of Cash Flows for the Years ended
December 31, 1996, 1995, and 1994...................... F-6
Notes to Consolidated Financial Statements.................. F-8
(2) Consolidated Financial Statement Schedule:
Independent Auditors' Report on Consolidated Financial
Statement Schedule...................................... S-1
II-Valuation and Qualifying Accounts....................... S-2
All other schedules are omitted because they are not applicable or
the required information is included in the consolidated financial
statements or notes thereto.
(3) Exhibits included herein (numbered in accordance with Item 601
of Regulation S-K):
37
<PAGE>
Exhibit
Number Description
- ------- -----------
1.1 Form of Underwriting Agreement.(1)
3.1 Amended and Restated Articles of Incorporation of Registrant.(1)
3.2 Amended and Restated Bylaws of Registrant.(1)
4.1 Form of Common Stock Certificate.(1)
5.1 Opinion of Venture Law Group, A Professional Corporation.(1)
10.1 Form of Indemnification Agreement.(1)
10.2 1993 Stock Incentive Plan.(1)
10.3 Form of 1996 Employee Stock Purchase Plan and related agreements.(1)
10.4 Form of 1996 Directors' Option Plan and related agreements.(1)
10.5 Form of 1996 Stock Plan and related agreements.(1)
10.6 Fourth Restated Registration Rights Agreement among the Registrant and
certain securityholders of the Registrant, dated as of December 11,
1995.(1)
10.7 Lease Agreement between the Registrant and Malibu Canyon Office
Partners, L.P. dated as of April 14, 1994, as amended November 3,
1994, January 2, 1995, and April 25, 1995.(1)
10.8 Security and Loan Agreement dated September 1, 1995 between the
Registrant and Imperial Bank.(1)
10.9 Master Lease Agreement dated as of May 31, 1994, as amended between
the Registrant and Dominion Ventures, Inc.(1)
10.10 Master Lease Agreement dated as of June 9, 1995 between the
Registrant and Copelco Capital, Inc.(1)
10.11 Value-Added Product Sales Agreement dated as of July 1, 1995 between
the Registrant and Hamilton Hallmark, a division of Avnet, Inc.(1)
10.12 401(k) Plan.(1)
10.13 Series C Preferred Stock Agreement dated as of March 13, 1995
between the Registrant and Alcatel Data Networks S.A.(1)
10.14 International Distributor Agreement between the Registrant and
Alcatel N.V., dated as of March 13, 1995.(1)
10.15 Product and Technology Agreement between the Registrant and Alcatel
N.V. dated as of March 13, 1995.(1)
10.16 Original Equipment Manufacturer Agreement dated as of June 14, 1995
between the Registrant and Hitachi Computer Products (America),
Inc.(1)
10.17 Original Equipment Manufacturer Agreement dated as of April 12, 1995
between the Registrant and Digital Equipment Corporation.(1)
10.18 Manufacturing and Purchase Agreement dated as of March 28, 1996
between the Registrant and Victron, Inc.(1)
10.19 Amendment to Manufacturing and Purchase Agreement between Xylan and
Victron, Inc. dated as of December 30, 1996.(2)
10.20 Dale Bartos Employment Agreement dated as of January 4, 1997.(2)
11.1 Statement Regarding Computation of Net Income (Loss) Per Share.(2)
23.1 Consent of KPMG Peat Marwick LLP.(2)
23.2 Consent of Counsel (included in Exhibit 5.1).(1)
24.1 Power of Attorney (see page II-5).(2)
27 Financial Data Schedule(2)
- -------------------------------------------------------------------------------
(1) Incorporated by reference to identically numbered exhibits filed in
response to Item 16(a), "Exhibits," of the Registrant's Registration
Statement on Form S-1 and Amendments thereto (File No. 333-03623), which
became effective on May 29, 1996.
38
<PAGE>
(2) Filed herewith.
(b) Reports on Form 8-K: None.
39
<PAGE>
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.
XYLAN CORPORATION
Date: March 28, 1997 By: /s/ Steve Y. Kim
--------------------------
Steve Y. Kim
President and Chief
Executive Officer
40
<PAGE>
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Steve Y. Kim and Dale Bartos, his
attorneys-in-fact, each with the power of substitution, for him in any and all
capacities, to sign any amendments to this Report on Form 10-K, and to file the
same, with exhibits thereto and other documents in connection therewith with the
Securities and Exchange Commission, hereby ratifying and confirming all that
each of said attorneys-in-fact, or his substitute or substitutes may do or cause
to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below by the following persons in the capacities and
on the dates indicated.
Signature Title Date
- --------------------------------------------------------------------------------
/s/ Steve Y. Kim President, Chief Executive March 28, 1997
- ---------------------- Officer and Chairman
(Steve Y. Kim)
/s/ Dale Bartos Vice President of Finance March 28, 1997
- ---------------------- (Principal Financial and
(Dale Bartos) Accounting Officer)
/s/ Yuri Pikover Vice President of Worldwide Sales March 28, 1997
- ---------------------- and Director
(Yuri Pikover)
/s/ Kevin G. Hall Director March 28, 1997
- ----------------------
(Kevin G. Hall)
/s/ Robert C. Hawk Director March 28, 1997
- ----------------------
(Robert C. Hawk)
/s/ Trude C. Taylor Director March 28, 1997
- ----------------------
(Trude C. Taylor)
/s/ John L. Walecka Director March 28, 1997
- ----------------------
(John L. Walecka)
41
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Board of Directors and Shareholders
Xylan Corporation:
We have audited the accompanying consolidated balance sheets of Xylan
Corporation and subsidiaries as of December 31, 1996 and 1995 and the related
consolidated statements of operations, shareholders' equity and cash flows for
each of the years in the three-year period ended December 31, 1996. These
consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Xylan Corporation
and subsidiaries as of December 31, 1996 and 1995 and the results of their
operations and their cash flows for each of the years in the three-year period
ended December 31, 1996 in conformity with generally accepted accounting
principles.
Los Angeles, California
January 31, 1997
F-1
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 1996 and 1995
(In thousands, except share data)
<TABLE>
<CAPTION>
ASSETS 1996 1995
-------- -------
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 62,483 $ 6,034
Short-term investments 50,498 --
Accounts receivable, net of allowance for
doubtful accounts of $.3 in 1996 and
$.4 in 1995 26,956 13,142
Inventories 11,578 2,128
Prepaid expenses and other current assets 4,013 383
-------- -------
Total current assets 155,528 21,687
Investments 27,785 --
Note receivable 6,000 --
Property and equipment, net 16,665 5,073
Other assets 1,273 488
-------- -------
$207,251 $27,248
======== =======
</TABLE>
F-2
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Consolidated Balance Sheets
December 31, 1996 and 1995
(In thousands, except share data)
<TABLE>
<CAPTION>
LIABILITIES AND SHAREHOLDERS' EQUITY 1996 1995
-------- --------
<S> <C> <C>
Current liabilities:
Current installments of capital lease
obligations $ 303 $ 329
Accounts payable and accrued expenses 17,760 9,629
Deferred revenue 2,838 599
Income taxes payable 12 --
-------- --------
Total current liabilities 20,913 10,557
Capital lease obligations, less current
installments 206 509
Deferred revenue 494 77
-------- --------
Total liabilities 21,613 11,143
-------- --------
Commitments and contingencies
Shareholders' equity:
Preferred stock, no par value.
Authorized 5,000,000 shares -- --
Convertible preferred stock, $0.001
par value:
Series A, Authorized 12,000,000
shares; issued and outstanding
11,801,330 shares in 1995 -- 12
Series B, Authorized, issued and
outstanding 7,718,600 shares in 1995 -- 8
Series C, Authorized, issued and
outstanding 3,964,244 shares in 1995 -- 4
Series D, Authorized, issued and
outstanding 1,262,120 shares in 1995 -- 1
Series E, Authorized, issued and
outstanding 952,382 shares in 1995 -- 1
Common stock, $0.001 par value.
Authorized 200,000,000 shares;
issued and outstanding 41,947,025
and 10,320,426 shares, respectively 42 10
Additional paid-in capital 184,397 30,115
Retained earnings (accumulated deficit) 1,199 (14,046)
-------- --------
Net shareholders' equity 185,638 16,105
-------- --------
$207,251 $ 27,248
======== ========
</TABLE>
See accompanying notes to consolidated financial statements.
F-3
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
Years ended December 31, 1996, 1995 and 1994
(In thousands, except per share data)
<TABLE>
<CAPTION>
1996 1995 1994
---------- ------- -------
<S> <C> <C> <C>
Revenue $128,456 $29,662 $ 443
Cost of revenue 57,830 15,418 327
-------- ------- -------
Gross profit 70,626 14,244 116
-------- ------- -------
Operating expenses:
Research and development 15,823 7,154 2,404
Sales and marketing 32,590 13,011 695
General and administrative 4,397 3,593 1,168
-------- ------- -------
Total operating expenses 52,810 23,758 4,267
-------- ------- -------
Operating income (loss) 17,816 (9,514) (4,151)
Interest income, net 5,240 73 68
-------- ------- -------
Income (loss) before income taxes 23,056 (9,441) (4,083)
Income tax expense 7,811 -- --
-------- ------- -------
Net income (loss) $ 15,245 $(9,441) $(4,083)
======== ======= =======
Net income (loss) per share $ 0.33 $ (0.45) $ (0.19)
======== ======= =======
Weighted average common and common
equivalent shares outstanding 46,381 21,151 21,109
======== ======= =======
</TABLE>
See accompanying notes to consolidated financial statements.
F-4
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Shareholders' Equity
Years ended December 31, 1996, 1995 and 1994
(In thousands)
<TABLE>
<CAPTION>
Retained Net
Convertible preferred stock Additional earnings share-
------------------------------------------------ Common paid-in (accumulated holders
Series A Series B Series C Series D Series E stock capital deficit) equity
-------- -------- -------- -------- -------- ----- -------- ------------ -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1993 $ 5 $-- $-- $-- $-- $10 $ 1,776 $ (522) $ 1,269
Issuances of preferred stock 7 8 -- -- -- -- 8,160 -- 8,175
Issuances of common stock -- -- -- -- -- -- 6 -- 6
Net loss -- -- -- -- -- -- -- (4,083) (4,083)
---- --- --- --- --- --- -------- ------- --------
Balance at December 31, 1994 12 8 -- -- -- 10 9,942 (4,605) 5,367
Issuances of preferred stock -- -- 4 1 1 -- 20,008 -- 20,014
Issuances of common stock -- -- -- -- -- -- 108 -- 108
Issuances of common stock
warrants -- -- -- -- -- -- 3 -- 3
Unearned compensation
amortization -- -- -- -- -- -- 54 -- 54
Net loss -- -- -- -- -- -- -- (9,441) (9,441)
---- --- --- --- --- --- -------- ------- --------
Balance at December 31, 1995 12 8 4 1 1 10 30,115 (14,046) 16,105
Conversion of preferred
stock to common stock (12) (8) (4) (1) (1) 26 -- -- --
Issuances of common stock -- -- -- -- -- 6 144,002 -- 144,008
Issuance of common stock
warrants -- -- -- -- -- -- 274 -- 274
Tax benefit attributable to
stock option plan -- -- -- -- -- -- 9,507 -- 9,507
Unearned compensation
amortization -- -- -- -- -- -- 499 -- 499
Net income -- -- -- -- -- -- -- 15,245 15,245
---- --- --- --- --- --- -------- ------- --------
Balance at December 31, 1996 $ -- $-- $-- $-- $-- $42 $184,397 $ 1,199 $185,638
==== === === === === === ======== ======= ========
</TABLE>
See accompanying notes to consolidated financial statements.
F-5
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Years ended December 31, 1996, 1995 and 1994
(In thousands)
<TABLE>
<CAPTION>
1996 1995 1994
-------- -------- -------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income (loss) $ 15,245 $ (9,441) $(4,083)
Adjustments to reconcile net income
(loss) to net cash provided by (used
in) operating activities:
Depreciation and amortization 3,581 928 131
Deferred income taxes (1,766) -- --
Consulting expense paid in common stock -- 108 1
Expense related to warrants 274 -- --
Unearned compensation amortization 499 54 --
Change in:
Accounts receivable (13,814) (13,020) (122)
Inventories (9,450) (1,846) (282)
Prepaid expenses and other current
assets (1,864) (178) (154)
Other assets (785) (294) (180)
Accounts payable and accrued expenses 8,131 8,741 746
Deferred revenue 2,656 676 --
Income taxes payable 9,519 -- --
-------- -------- -------
Net cash provided by (used
in) operating activities 12,226 (14,272) (3,943)
-------- -------- -------
Cash flows from investing activities:
Purchases of property and equipment (15,173) (4,295) (959)
Issuance of note receivable (6,000) -- --
Purchases of investments (147,125) -- (3,890)
Maturities of investments 68,842 3,890 --
-------- -------- -------
Net cash used in investing
activities (99,456) (405) (4,849)
-------- -------- -------
Cash flows from financing activities:
Proceeds from issuances of common
stock and common stock warrants 144,008 3 5
Proceeds from issuances of convertible
preferred stock -- 20,014 8,175
Principal payments under capital lease
obligations (329) -- --
-------- -------- -------
Net cash provided by financing
activities 143,679 20,017 8,180
-------- -------- -------
Net increase (decrease) in cash
and cash equivalents 56,449 5,340 (612)
Cash and cash equivalents at beginning
of year 6,034 694 1,306
-------- -------- -------
Cash and cash equivalents at end of year $ 62,483 $ 6,034 $ 694
======== ======== =======
(Continued)
</TABLE>
F-6
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Consolidated Statements of Cash Flows, (Continued)
<TABLE>
<CAPTION>
1996 1995 1994
------ ---- ----
<S> <C> <C> <C>
Supplemental disclosure of cash flow
information:
Cash paid during the year for interest $ 97 $101 $ 18
Cash paid during the year for income taxes $ 222 -- --
====== ==== ====
Supplemental disclosure of noncash
investing and financing activities:
Financed capital expenditures $ -- $480 $359
Income tax benefit resulting from
exercise of employee stock options $9,507 -- --
====== ==== ====
</TABLE>
See accompanying notes to consolidated financial statements.
F-7
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
December 31, 1996 and 1995
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
Since its incorporation in July 1993, Xylan Corporation has focused on the
development, marketing and sale of dedicated, high-bandwidth switching
systems that easily integrate with and enhance the performance of customers'
existing LANs, as well as facilitate migration to new networking
technologies.
PRINCIPLES OF CONSOLIDATION
The consolidated financial statements include the accounts of Xylan
Corporation and its wholly and majority-owned subsidiaries (collectively,
the Company). All significant intercompany accounts and transactions have
been eliminated in consolidation. The minority interest is not considered
material.
CASH EQUIVALENTS
The Company considers all highly liquid investments with an original
maturity of three months or less to be cash equivalents.
INVESTMENT SECURITIES
The Company's investments consist of corporate and municipal debt, U.S.
Treasuries and Federal Government Agency debt. The Company accounts for its
investments in accordance with Statement of Financial Accounting Standards
(SFAS) No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," which requires investments to be classified based on
management's intent in one of three categories: held-to-maturity securities,
available-for-sale securities and trading securities. The Company has the
positive intent and ability to hold its investments to maturity and,
accordingly, classifies both long-term and short-term investments at
amortized cost.
INVENTORIES
Inventories, consisting principally of component parts, are stated at the
lower of cost or market being determined using the first-in, first-out
method. Inventories are shown net of valuation reserves of $458,000 and
$132,000 at December 31, 1996 and 1995, respectively.
NOTE RECEIVABLE
The Company accounts for its note receivable in accordance with the
provisions of SFAS No. 114, "Accounting by Creditors for Impairment of a
Loan," as amended by SFAS No. 118, "Accounting by Creditors for Impairment
of a Loan Income Recognition and Disclosure." Management, considering
current information and events regarding the borrowers' ability to repay
their obligations, considers a note to be impaired when it is probable that
the Company will be unable to collect all amounts due according to the
contractual terms of the note agreement. The note receivable is recorded at
cost.
F-8
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
LONG-LIVED ASSETS
The Company adopted the provisions SFAS No. 121, "Accounting for the
Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of," on January 1, 1996. This Statement requires that long-lived assets be
reviewed for impairment whenever events or changes in circumstances indicate
that the carrying amount of the asset may not be recoverable. Recoverability
of assets to be held and used is measured by a comparison of the carrying
amount of an asset to undiscounted operating cash flows expected to be
generated by the asset. If such assets are considered to be impaired, the
impairment to be recognized is measured by the amount by which the carrying
amount of the assets exceeds the fair value of the assets. Adoption of this
Statement did not have a material impact on the Company's financial
position, results of operations or liquidity.
FINANCIAL INSTRUMENTS
The estimated fair values of cash and cash equivalents, accounts receivable,
note receivable, capital lease obligations, accounts payable and accrued
expenses, deferred revenue and income taxes payable approximate their
carrying values due to the short-term maturity of these instruments or
because the stated interest rates are indicative of market interest rates.
The fair values of short-term and long-term investment securities are based
on quoted market prices at the reporting date for those investments. The
carrying values of investments are described in note 3.
REVENUE RECOGNITION
The Company generally recognizes product revenue at the time of shipment,
unless the Company has future obligations for installation or has to obtain
customer acceptance in which case revenue is deferred until earned. Revenue
from service obligations is deferred and recognized on a straight-line basis
over the contractual period. Amounts billed in excess of revenue recognized
are included as deferred revenue in the accompanying consolidated balance
sheets. Allowances for sales returns are established based upon historical
experience and management's estimates as shipments are made.
WARRANTY AND TECHNICAL SUPPORT OBLIGATIONS
The Company accrues the estimated costs to fulfill customer warranty and
technical support obligations upon the recognition of the related revenue.
The Company accrued $1,535,000 and $446,000 for these obligations at December
31, 1996 and 1995, respectively, and such amounts are included in accounts
payable and accrued expenses on the accompanying consolidated balance sheets.
DEPRECIATION AND AMORTIZATION
Depreciation of property and equipment is calculated on the straight-line
method over estimated useful lives ranging from three to five years, or in
the case of capital lease assets over the shorter of the lease term or the
estimated useful life of the asset.
RESEARCH AND DEVELOPMENT COSTS
The Company charges all research and development costs to expense as
incurred.
F-9
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
INCOME TAXES
The Company accounts for income taxes under SFAS No. 109, "Accounting for
Income Taxes." Under the asset and liability method of SFAS No. 109,
deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between the financial statement
carrying amounts of existing assets and liabilities and their respective tax
bases and operating loss and tax credit carryforwards. Deferred tax assets
and liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are expected
to be recovered or settled. Under SFAS No. 109, the effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in
the period that includes the enactment date.
COMPUTATION OF NET INCOME (LOSS) PER SHARE
Net income (loss) per 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 common stock split described in note 8 for
all periods presented. All stock options, warrants and convertible preferred
stock issued prior to 1995 are excluded from the computation of weighted
average common share equivalents for the years ended 1995 and 1994, as their
inclusion would be antidilutive. The difference between fully diluted and
primary net income (loss) per share is immaterial for all periods presented.
The shares used in the net income (loss) per share calculation for the years
ended December 31, 1996, 1995 and 1994 are summarized as follows (in
thousands):
<TABLE>
<CAPTION>
1996 1995 1994
------ ------ ------
<S> <C> <C> <C>
Weighted average common stock
outstanding 40,834 10,320 10,278
Weighted average common stock
equivalents 5,547 10,831 10,831
------ ------ ------
Shares used in net income (loss) per
share calculation 46,381 21,151 21,109
====== ====== ======
</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 Company's
initial public offering have been included in the calculation of the weighted
average common and common shares outstanding for all periods presented using
the treasury stock method based on the initial public offering price.
Accordingly, for the years ended December 31, 1995 and 1994, weighted average
common shares outstanding includes 253,160 shares of common stock issued
during fiscal 1995, and weighted average common stock equivalents includes
3,977,236 common share equivalent shares for options issued during fiscal
1995, 6,178,746 common stock equivalents shares from the issuance of
convertible preferred stock during fiscal 1995 and 674,182 common stock
equivalent shares for options issued from January 1, 1996 to March 4, 1996.
ACCOUNTING FOR STOCK OPTIONS
Prior to January 1, 1996, the Company accounted for its stock option plan in
accordance with the provisions of Accounting Principles Board (APB) Opinion
No. 25, "Accounting for Stock Issued to Employees," and related
interpretations. As such, compensation expense would be recorded on the date
of grant only if the current market price of the underlying stock exceeded
the exercise price. On January 1, 1996, the Company adopted SFAS No. 123,
"Accounting for Stock-Based Compensation," which permits entities to
recognize as expense over the vesting period the fair value of all stock-
based awards on the date of grant. Alternatively, SFAS No. 123 also allows
entities to continue to apply the provisions of APB Opinion No. 25 and
provide pro forma net income and pro forma net income per share disclosures
for employee stock option grants made in 1995 and future years as if the
fair-value-based method defined in
F-10
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
SFAS No. 123 had been applied. The Company has elected to continue to apply
the provisions of APB Opinion No. 25 and provide the pro forma disclosure
provisions of SFAS No. 123.
USE OF ESTIMATES
Company management has made a number of estimates and assumptions relating
to the reporting of assets and liabilities in conformity with generally
accepted accounting principles. Actual results could differ from these
estimates.
RECLASSIFICATIONS
Certain amounts in the prior period financial statements have been
reclassified to conform with current period presentation.
(2) PROPERTY AND EQUIPMENT
Property and equipment, stated at cost, at December 31, 1996 and 1995 are
summarized as follows:
<TABLE>
<CAPTION>
1996 1995
------- ------
(In thousands)
<S> <C> <C>
Furniture and fixtures $ 1,825 $ 253
Manufacture and test equipment 4,870 1,323
Computer equipment and purchased software 13,636 4,301
Leasehold improvements 966 247
------- ------
21,297 6,124
Less accumulated depreciation and
amortization 4,632 1,051
------- ------
Net property and equipment $16,665 $5,073
======= ======
</TABLE>
Assets acquired through capitalized leases, which are included in property
and equipment, aggregated $1,176,000 at December 31, 1996 and 1995.
Accumulated depreciation related to these assets aggregated $654,000 and
$304,000 at December 31, 1996 and 1995, respectively.
F-11
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(3) INVESTMENT SECURITIES
The Company's held-to-maturity investments at December 31, 1996 consist of
corporate and municipal debt, U.S. Treasuries and Federal Government Agency
debt and are summarized as follows:
<TABLE>
<CAPTION>
AMORTIZED COST
--------------
<S> <C>
Corporate debt $32,821
Municipal debt 2,235
U.S. Treasuries 7,910
Federal Government Agency debt 35,317
-------
78,283
Due within one year 50,498
-------
Due after one year through three years $27,785
=======
</TABLE>
The Company has the positive intent and ability to hold its investments to
maturity and, accordingly, classifies both long-term and short-term
investments at amortized cost. At December 31, 1996, total net unrealized
holding gains and losses were immaterial.
(4) NOTE RECEIVABLE
During 1996, the Company agreed to loan up to $10 million to a contract
manufacturer that the Company has subcontracted component procurement,
kitting and printed circuit board assembly. The Company entered into the
agreement to assist the contract manufacturer in meeting the Company's
increasing production requirements. The Company purchases a majority of its
inventory components from this contract manufacturer. The loan is non-
interest bearing, does not have a defined due date and is secured by raw
materials and electronic components purchased by the contract manufacturer.
At December 31, 1996, the note had an outstanding balance of $6 million and
is classified as a noncurrent asset on the accompanying consolidated balance
sheet.
(5) NOTE PAYABLE
The Company has a revolving line of credit agreement providing for
borrowings up to the lesser of $6,000,000 or 80% of eligible accounts
receivable, as defined. Interest is payable monthly at the bank's prime rate
(8.25% at December 31, 1996 and 1995) plus 0.5% and expires January 30,
1998. The Company had available borrowings of $6,000,000 at December 31,
1996.
As of December 31, 1996 and 1995, the Company had no outstanding borrowings
on the aforementioned note payable. Additionally, the note is secured by all
Company personal property and contains certain financial covenants and
restrictions. As of December 31, 1996, the Company was in compliance with
such covenants and restrictions.
F-12
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(6) ACCRUED EXPENSES
Accrued expenses at December 31, 1996 and 1995 consist of the following:
<TABLE>
<CAPTION>
1996 1995
------- ------
(In thousands)
<S> <C> <C>
Accounts payable $ 9,336 $7,371
Accrued payroll and related costs 4,281 1,003
Accrued warranty 1,535 446
Other accrued expenses 2,608 809
------- ------
Total accrued expenses $17,760 $9,629
======= ======
</TABLE>
(7) CAPITAL LEASE OBLIGATIONS
Capital lease obligations at December 31, 1996 and 1995 are summarized as
follows:
1996 1995
---- ----
(In thousands)
Capital lease obligations, secured
by related assets, payable in
monthly installments including
interest ranging from 4% to 21%
through January 1999 $509 $838
Less current installments 303 329
---- ----
$206 $509
==== ====
Future minimum capital lease payments at December 31, 1996 are as follows
(in thousands):
Year ending December 31:
1997 $330
1998 180
1999 39
----
549
Less amounts representing interest 40
----
$509
====
(8) SHAREHOLDERS' EQUITY
CONVERTIBLE PREFERRED STOCK
During 1994, the Company issued 6,666,666 shares of series A convertible
preferred stock for cash consideration of $2,000,000 and 7,718,600 shares of
series B convertible preferred stock for cash consideration of $6,174,880.
During 1995, the Company issued 3,964,244 shares of series C convertible
preferred stock for cash consideration of $10,000,004, 1,262,120 shares of
series D convertible preferred stock for cash
F-13
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
consideration of $5,048,480 and 952,382 shares of series E convertible
preferred stock for cash consideration of $5,000,006. Legal expenses of
approximately $34,000 were netted against the proceeds of the 1995
convertible preferred stock issuances.
Upon the effectiveness of the Company's initial public offering in March
1996, all of the Company's 25,698,676 outstanding shares of convertible
preferred stock which had certain liquidation preferences, voting rights, and
cumulative dividend provisions were converted into the same number of shares
of common stock upon the effectiveness of the Company's initial public
offering.
PREFERRED STOCK
During January 1996, the Board of Directors authorized 5,000,000 shares of
undesignated preferred stock.
COMMON STOCK
During 1994, the Company issued 61,134 shares of common stock for cash
consideration of $5,268 and 19,132 shares of common stock for services with a
fair value of $1,148.
During 1995, the Company issued 68,080 shares of common stock to a director
for promissory notes of $25,530. Such notes were repaid subsequent to
December 31, 1995. The Company determined subsequent to the grant of such
stock, based in part on an independent appraisal of the common stock as of
September 30, 1995, to record for financial statement reporting purposes
compensation expense of $5,050 for the difference between the grant price and
the deemed fair market value. Additionally during 1995, the Company issued
167,080 shares of common stock for services with a fair value of $77,161.
During January 1996, the Board of Directors approved a two-for-one stock
split of the Company's capital stock. Accordingly, all references to the
number of shares authorized, issued and outstanding and per share information
for all periods presented have been adjusted to give effect to the
aforementioned stock split. The stock split became effective during February
1996. Additionally, the Board of Directors authorized increasing the common
stock authorized shares to 200,000,000.
During March 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 selling shareholders.
Aggregate net proceeds to the Company were $87.4 million.
During May 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 selling shareholders. Aggregate
net proceeds to the Company were $56.2 million.
STOCK WARRANTS
During 1994, the Company granted to an equipment lessor a warrant to purchase
188,076 shares of series A convertible preferred stock of the Company at a
price per share of $.325. This warrant was exercisable at grant date and on
the effectiveness of the Company's initial public offering was converted into
185,725 shares of common stock.
During 1995, in connection with the issuance of series D convertible
preferred stock, the Company sold warrants, at $0.005 per share, to purchase
315,528 shares of common stock of the Company at an exercise price per share
of $3.50, and in connection with the issuance of series E convertible
preferred stock, the Company sold warrants, at $0.005 per share, to purchase
238,096 shares of common stock of the Company at a price per share of $4.60.
These warrants expired upon the closing of the Company's initial public
offering.
In July 1996, Xylan and IBM entered into an agreement whereby Xylan has
committed to grant to IBM warrants to purchase up to a maximum of 2,350,000
shares of Xylan common stock based on the
F-14
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
achievement of specific business goals. The exercise price of the warrants
will be a 25% premium over the Xylan closing stock price on the day earned.
During 1996, the Company recognized $274,000 of expense related to these
warrants.
(9) STOCK OPTION PLANS
1993 STOCK INCENTIVE PLAN
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 issuable to officers,
employees, consultants and the members of the Board of Directors of the
Company.
The Board of Directors or committees named by the Board of Directors (Plan
Administrator) have sole discretion and authority to promulgate, amend and
rescind rules and regulations relating to the administration of the 1993
Plan and to select the eligible participants to whom options will be granted
or shares sold, the number of shares covered by the option or to be sold,
the exercise or purchase price and the form and terms of agreement to be
used. Outstanding options under the 1993 Plan vest in varying increments and
expire five to ten years after grant or upon earlier termination. Stock
options shall be exercisable over the exercise period as determined by the
Plan Administrator, not to exceed five years from the date the option is
granted in the case of optionees who own at least 10% of the total combined
voting power of all classes of stock of the Company.
The Company determined subsequent to the grant of certain options, based in
part on an independent appraisal of the common stock at September 30, 1995,
to record for financial statement presentation purposes unearned
compensation of $941,000 for the difference between the exercise price and
the deemed fair market value. The methods of valuation used by the
independent appraiser to determine fair market value (based on an arms-
length transaction) were primarily estimates of future cash flows, and also
a comparison to similar publicly traded companies, with a discount applied
for the lack of a public market for the Company's stock.
During 1996, the Company recorded additional unearned compensation of
$1,395,000, for the difference between the grant price and the deemed fair
market value for options issued during the period from January 1, 1996
through March 4, 1996.
The unearned compensation is recorded as an offset to additional paid-in
capital and will be recorded as compensation expense ratably over the
related vesting periods. During 1996 and 1995, the Company recorded $499,000
and $54,000 of compensation expense, respectively.
Additionally under the 1993 Plan, the Company issued 235,160 and 80,266
shares of common stock, respectively, pursuant to stock purchase grants
during the years ended December 31, 1995 and 1994.
In June and July 1996, the Board of Directors approved the repricing of
options granted at prices in excess of $50.75 and $34.75, respectively, for
all employees excluding executive officers.
1996 STOCK OPTION PLAN
During January 1996, the Board of Directors adopted the 1996 Stock Option
Plan (the 1996 Plan) which reserves 3,000,000 shares of common stock for
issuance under this plan. The 1996 Plan provides for the grant to Company
employees of incentive stock options and for the grant of nonstatutory stock
options to employees and consultants of the Company. Incentive stock options
are granted at 100% of fair market value. Nonstatutory stock options granted
to certain of the Company's executive officers must be at fair market value
and grants to all other persons must be at least 85% of fair market value at
grant date. Outstanding options under the 1996 Plan vest in varying
increments and expire five to ten years after grant or upon earlier
termination.
F-15
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
The Board of Directors or a committee consisting of not less than two Board
members (Plan Administrator) have sole discretion and authority to
promulgate, amend and rescind rules and regulations relating to the
administration of the 1996 Plan and to select the eligible participants to
whom options will be granted, the number of shares covered by the option, the
exercise price and the form and terms of agreement to be used.
In June and July 1996, the Board of Directors approved the repricing of
options granted at prices in excess of $50.75 and $34.75, respectively, for
all employees excluding executive officers.
1996 STOCK PURCHASE PLAN
During January 1996, the Board of Directors adopted the 1996 Employee Stock
Purchase Plan (the Purchase Plan) which reserves 1,500,000 shares of common
stock for issuance under this plan. The Purchase Plan permits eligible
employees to purchase common stock through payroll deductions, which may not
exceed 10% of an employee's salary, at a price equal to the lower of 95% of
the fair market value of the Company's common stock at the beginning of the
offering period or the purchase date. The Purchase Plan expires in 20 years.
The Board of Directors or committees named by the Board of Directors (Plan
Administrator) have sole discretion and authority to promulgate, amend and
rescind rules and regulations relating to the administration of the Purchase
Plan and to select the eligible participants to whom shares are to be sold,
the number of shares to be sold, the purchase price and the form and terms of
agreement to be used.
For the year ended December 31, 1996, the Company recorded $1,023,000 in
employee payroll deductions which have been included in accounts payable and
accrued expenses on the accompanying consolidated balance sheet. At December
31, 1996, no shares had been issued pursuant to the Purchase Plan.
1996 DIRECTORS' STOCK OPTION PLAN
During January 1996, the Board of Directors adopted the 1996 Directors' Stock
Option Plan (the Directors' Plan) which reserves 150,000 shares of common
stock for issuance related to nonstatutory stock options to nonemployee
directors of the Company. Options are exercisable at the fair market value of
common stock on the grant date and have a term of ten years.
The Board of Directors has sole discretion and authority to promulgate, amend
and rescind rules and regulations relating to the administration of the
Directors' Plan and to select the eligible participants to whom options will
be granted, the number of shares covered by the option, the exercise and the
form and terms of agreement to be used. At December 31, 1996, no options had
been issued pursuant to the Directors' Plan.
F-16
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
SUMMARY STOCK OPTION ACTIVITY
Summary stock option activity during the years ended December 31, 1996, 1995
and 1994 is as follows:
<TABLE>
<CAPTION>
WEIGHTED
NUMBER OF OPTIONS AVERAGE
------------------------------------- EXERCISE
1993 PLAN 1996 PLAN TOTAL PRICE
---------- --------- ---------- --------
<S> <C> <C> <C> <C>
Balance at December 31, 1993 400,000 -- 400,000 $ .06
Granted 2,250,000 -- 2,250,000 .09
---------- --------- ---------- --------
Balance at December 31, 1994 2,650,000 -- 2,650,000 .08
Granted 4,719,000 -- 4,719,000 .67
Canceled (994,000) -- (994,000) .26
---------- --------- ---------- --------
Balance at December 31, 1995 6,375,000 -- 6,375,000 .48
Granted 2,262,000 1,968,000 4,230,000 35.98
Exercised (1,062,000) -- (1,062,000) .33
Canceled (1,238,000) (37,000) (1,275,000) 27.19
---------- --------- ---------- --------
Balance at December 31, 1996 6,337,000 1,931,000 8,268,000 14.75
========== ========= ========== ========
Reserved for future issuance 286,000 1,069,000 1,355,000
========== ========= ==========
</TABLE>
(10) ACCOUNTING FOR STOCK-BASED COMPENSATION
The Company has adopted the disclosure-only provisions of SFAS 123,
"Accounting for Stock-Based Compensation," but applies Accounting
Principles Board Opinion No. 25 and related interpretations in accounting
for its plans and warrants. If the Company had elected to recognize
compensation cost based on the fair value at the date of grants for award
under the plans and warrants (including modified awards), consistent with
the method as prescribed by SFAS No. 123, net income (loss) and net income
(loss) per share would have changed to the pro forma amounts indicated
below (in thousands, except per share data):
1996 1995
------- -------
Net income (loss) As reported $15,245 $(9,441)
Pro forma 7,690 (9,562)
======= =======
Net income (loss) per share As reported $ 0.33 $ (0.45)
Pro forma 0.17 (0.45)
======= =======
F-17
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
The pro forma disclosure of compensation cost under this pronouncement was
based on the Black-Scholes single-option pricing model with the following
weighted average assumptions for 1996 and 1995: volatility of 55%, risk-free
interest rate of 6.21% and an expected option life of 5.5 years.
Pro forma net income (loss) reflects only options granted in 1996 and 1995.
Therefore the full amount of calculating compensation cost for stock options
under SFAS No. 123 is not reflected in the pro forma net income (loss)
amounts presented above because compensation cost is reflected over the
options' vesting period of five years and compensation cost for options
granted prior to January 1, 1995 is not considered. The disclosure of
compensation cost under this pronouncement may not be representative of the
effects on net income (loss) for future years.
The weighted average fair value of options granted in 1996 and 1995 were
$35.98 and $0.67, respectively. The following table summarizes information
regarding options outstanding and options exercisable at December 31, 1996:
<TABLE>
<CAPTION>
OPTIONS OUTSTANDING OPTIONS EXERCISABLE
- ----------------------------------------------------------------- --------------------------------
WEIGHTED WEIGHTED
RANGE OF OUTSTANDING AT REMAINING AVERAGE EXERCISABLE AVERAGE
EXERCISE DECEMBER 31, CONTRACTUAL EXERCISE AT DECEMBER EXERCISE
PRICES 1996 LIFE PRICE 31, 1996 PRICE
- ---------------- -------------- ----------- --------- -------------- ----------
<S> <C> <C> <C> <C> <C>
$ 0.06 - 0.38 3,368,000 8.0 years $ 0.20 861,000 $ 0.15
1.00 - 34.75 3,228,000 9.3 14.82 286,000 3.49
35.00 - 58.00 1,672,000 12.5 43.92 5,000 48.87
--------- ----------
0.06 - 58.00 8,268,000 9.4 years 14.75 1,152,000 $ 1.08
========= ========== ====== ========== ======
</TABLE>
(11) INCOME TAXES
The components of income tax expense for the year ended December 31, 1996
are summarized as follows (in thousands):
Current:
Federal $ 7,454
State 2,123
-------
Total current 9,577
-------
Deferred:
Federal (823)
State (943)
-------
Total deferred (1,766)
-------
Total income taxes $ 7,811
=======
F-18
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
The provision for income taxes, all current, for the years ended December 31,
1995 and 1994 consists solely of the annual minimum California franchise tax
of $800. Such amounts are included in general and administrative expense in
the accompanying consolidated statements of operations.
F-19
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
Total income tax expense differs from expected income tax expense (computed
by applying the U.S. Federal corporate tax rate of 35%) for the year ended
December 31, 1996 as follows (in thousands):
<TABLE>
<S> <C>
Computed U.S. Federal income taxes $8,070
Computed state income taxes, net of
Federal benefit 1,401
Benefit from foreign sales corporation (867)
Nondeductible travel and entertainment
expense 86
Federal alternative minimum tax 71
Research and experimentation credits (598)
Net change in valuation allowance (443)
Other 91
------
Income tax expense $7,811
======
</TABLE>
The net change in the valuation allowance for the years ended December 31,
1995 and 1994 was an increase of $4,085,000 and $1,775,000, respectively.
During the year ended December 31, 1996, the Company realized income tax
benefits totaling $7,383,000 and $2,124,000 for Federal and state income tax
purposes, respectively, related to stock options. The total income tax
benefit related to these deductions is recorded as an addition to additional
paid-in capital in the accompanying consolidated balance sheet at December
31, 1996.
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets at December 31, 1996 and 1995 are
summarized as follows:
<TABLE>
<CAPTION>
1996 1995
------ ------
(In thousands)
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforwards $2,387 $4,796
Research and development tax credit
carryforwards 1,357 630
Allowances and reserves 1,394 239
Accrued expenses 1,578 305
Other 668 91
-------- ------
Total gross deferred tax assets 7,384 6,061
Less valuation allowance 5,618 6,061
-------- ------
Net deferred tax assets $ 1,766 --
======== ======
</TABLE>
In assessing the realizability of deferred tax assets, management considered
whether it is more likely than not that some portion or all of the deferred
tax assets will not be realized. The ultimate realization of deferred tax
assets is dependent upon the generation of future taxable income during the
periods in which those temporary differences become deductible. Management
considers the projected future taxable
F-20
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
income and tax planning strategies in making this assessment. In order to
fully realize the deferred tax asset, the Company will need to generate
future taxable income of approximately $20,000,000 prior to the expiration
of the net operating loss carryforwards and research and development tax
credit carryforwards in 2010 and 2011, respectively. Based upon the level
of historical taxable income and projections for future taxable income over
the periods in which the deferred tax assets are deductible, the Company
has established a valuation allowance of $5,618,000. The net deferred tax
asset of $1,766,000 is included in prepaids and other current assets in the
accompanying consolidated balance sheet at December 31, 1996.
As of December 31, 1996, the Company had net operating loss carryforwards
for Federal income tax purposes of approximately $7,700,000, which are
available to offset future taxable income, if any, through 2010.
Additionally, the Company had research and development tax credit
carryforwards for Federal and state income tax purposes of $936,000 and
$421,000, respectively, which are available to offset future income taxes,
if any, through 2011.
(12) SIGNIFICANT CUSTOMERS, CONCENTRATION OF CREDIT RISK AND EXPORT SALES
The Company operates in a single industry segment encompassing the design,
development, manufacture, marketing and technical support of
internetworking products and services.
SIGNIFICANT CUSTOMERS
For the years ended December 31, 1996 and 1995, one customer accounted for
13.5% and 17.6% of revenue, respectively. For the year ended December 31,
1996, two other customers accounted for 12.3% and 11.7% of revenue. For the
year ended December 31, 1995, two other customers accounted for 17.2% and
10.5% of revenue. For the year ended December 31, 1994, substantially all
of the Company's revenue was derived from network integration services, and
one customer accounted for 13.8% of revenue.
CONCENTRATION OF CREDIT RISK
Financial instruments which potentially subject the Company to
concentration of credit risk consist primarily of accounts receivable. The
credit risk associated with accounts receivable is mitigated by the
Company's credit evaluation process, reasonably short collection terms and
the geographical dispersion of sales transactions.
One of the Company's major customers in 1996, who accounted for more than
10% of revenue, aggregated 18% of gross accounts receivable at December 31,
1996.
The Company's three major customers in 1995, each of whom accounted for
more than 10% of revenue, aggregated 22%, 21% and 9%, respectively, of
accounts receivable at December 31, 1995.
REVENUES BY GEOGRAPHIC AREA
Revenues by geographic area for the years ended December 31, 1996, 1995 and
1994 are as follows:
<TABLE>
<CAPTION>
1996 1995 1994
------- ------- ----
(IN THOUSANDS)
Revenue:
<S> <C> <C> <C>
North America $62,767 $15,267 $443
Asia 48,092 9,780 --
Europe 16,359 4,508 --
Other 1,238 107 --
------- ------- ----
$128,456 29,662 443
========== ======= ===
</TABLE>
F-21
<PAGE>
XYLAN CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements, Continued
(13) EMPLOYEE BENEFIT PLAN
In May 1995, the Company adopted a defined contribution 401(k) plan. The
plan covers all full-time employees who are at least 21 years of age and
have completed one year of service. Participants may contribute 1% to 12%
of their pretax compensation. The plan permits the Company to make matching
contributions up to 25% of the participant's contribution and vest over
five years. The Company's matching contribution for 1996 and 1995 was
$265,000 and $60,000, respectively.
(14) COMMITMENTS AND CONTINGENCIES
The Company is obligated under noncancelable operating lease agreements for
equipment and facilities expiring on various dates through 2002. Rental
expense for the years ended December 31, 1996, 1995 and 1994 aggregated
$1,482,000, $718,000 and $93,000, respectively.
Future annual minimum rental commitments under noncancelable operating
leases at December 31, 1996 are as follows (in thousands):
Year ending December 31:
1997 $1,810
1998 1,302
1999 917
2000 736
2001 708
Thereafter 510
------
$5,983
======
During 1995, a suit alleging misappropriation of trade secrets, patent
infringement and improper hiring of employees was brought against the
Company by Ascom Timeplex Inc. in the U.S. District Court for the Central
District of California in Los Angeles, California. During 1996, the Company
and Ascom Timeplex Inc. settled the suit by signing a binding memorandum of
understanding that dismissed all of Ascom Timeplex Inc.'s charges against
the Company and certain named Xylan employees. The settlement included a
royalty free license to Ascom Timeplex Inc. of certain technology embodied
in the Company's products as of the settlement date.
The Company is also involved in various other investigations, lawsuits and
claims arising in the ordinary course of business. In the opinion of
management, the ultimate disposition of these matters will not have a
material adverse effect on the Company's consolidated financial position,
results of operations or liquidity.
In July 1996, the Company guaranteed up to $5,000,000 of its contract
manufacturer's debt for raw material and electronic components purchases,
in addition to the note agreement as disclosed in note 4.
(15) SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
Selected quarterly financial data for 1996 and 1995 is as follows:
<TABLE>
<CAPTION>
Three months ended
------------------------------------------------------
December 31 September 30 June 30 March 31
----------- ------------- --------- -----------
(In thousands, except per share data)
<S> <C> <C> <C> <C>
1996:
Revenue.................. $ 41,452 $ 35,425 $ 28,187 $ 23,392
Gross profit............. 23,574 19,521 14,962 12,569
Operating income......... 6,217 5,655 3,358 2,586
Net income............... 5,031 4,630 2,901 2,683
Net income per share..... 0.11 0.10 0.06 0.06
1995:
Revenue.................. 15,522 8,240 4,503 1,397
Gross profit............. 8,110 3,854 1,844 436
Operating income (loss).. 451 (3,181) (3,743) (3,041)
Net income (loss)........ 437 (3,195) (3,713) (2,970)
Net income (loss) per
share.................. $ 0.01 $ (0.15) $ (0.18) $ (0.14)
</TABLE>
F-22
<PAGE>
Independent Auditors' Report
The Board of Directors and Shareholders
Xylan Corporation:
Under date of January 31, 1997, we reported on the consolidated balance sheets
of Xylan Corporation and subsidiaries as of December 31, 1996 and 1995 and the
related consolidated statements of operations, shareholders' equity and cash
flows for each of the years in the three-year period ended December 31, 1996. In
connection with our audits of the aforementioned consolidated financial
statements, we also audited the related consolidated financial statement
schedule. This financial statement schedule is the responsability of the
Company's management. Our responsablilty is to express an opinion on this
financial statement schedule based on our audits.
In our opinion, such financial statement schedule, when considered in relation
to the basic consolidated financial statements taken as a whole, presents
fairly, in all material respects, the information set forth therein.
/s/ KPMG Peat Marwick LLP
Los Angeles, California
January 31, 1997
S-1
<PAGE>
XYLAN CORPORATION
Schedule II
Valuation and Qualifying Accounts
<TABLE>
<CAPTION>
Balance at Balance at
Beginning Charged to End
<S> of Year Expense Deductions of Year
---------------- ---------------- ---------------- ----------------
Year ended December 31, 1996: <C> <C> <C> <C>
Allowance for doubtful accouts $376,644 $ 35,056 $141,700 $270,000
Allowance for excess and obsolete
inventory 132,400 355,423 29,480 458,343
Year ended December 31, 1995:
Allowance for doubtful accounts - 376,644 - 376,644
Allowance for excess and obsolete
inventory - $132,400 - $132,400
</TABLE>
There were no valuation and qualifying accounts for the year ended December 31,
1994.
S-2
<PAGE>
INDEX TO EXHIBITS
Exhibit
Number Description
- ------ -----------
10.19 Amendment to Manufacturing and Purchase Agreement between Xylan and
Victron, Inc. Dated as of December 30, 1996. (1)
10.20 Dale Bartos Employment Agreement dated as of January 4, 1997.(1)
11.1 Statement Regarding Computation of Net Income (Loss) Per Share.(1)
23.1 Consent of KPMG Peat Marwick LLP.(1)
24.1 Power of Attorney (see page 11-5).(1)
27 Financial Data Schedule.(1)
(1) Filed herewith.
<PAGE>
EXHIBIT 10.19
EXHIBIT C, CREDIT AGREEMENT, AMENDMENT, TO MANUFACTURING AND PURCHASE
AGREEMENT BETWEEN XYLAN AND VICTRON INC., DATED AS OF DECEMBER 30, 1996
AMENDMENT TO THE LOAN AND SECURITY AGREEMENT
--------------------------------------------
This Amendment to the LOAN AND SECURITY AGREEMENT is made as of December
30, 1996 by and between VICTRON, INC. (the "Seller") and XYLAN CORPORATION (the
"Buyer").
WHEREAS, the Seller and the Buyer entered into the LOAN AND SECURITY
AGREEMENT effective as of March 28, 1996 (the "Agreement") which remains in full
force and effect; and
WHEREAS, the Seller and the Buyer desire to modify certain terms of the
Agreement;
NOW THEREFORE, IT IS AGREED THAT:
1. The aggregate amount of loans set forth in Section 2.1 of the Agreement
shall hereby be amended to not to exceed Ten Million Dollars ($10,000,000).
2. Pursuant to the amendment to the aggregate amount of the loans as
described, the reference of Six Million Dollars ($6,000,000) in Section 2.4
shall be read to Ten Million Dollars ($10,000,000).
3. Except for the terms amended hereunder, all other terms and conditions
of the Agreement shall remain in full force and effect until the Maturity Date
as defined in the Agreement.
VICTRON, INC.
By: /s/ Todd Yun
------------
Name: Todd Yun
Title: President
XYLAN CORPORATION
By: /s/ Steve Kim
-------------
Name: Steve Kim
Title: President
<PAGE>
EXHIBIT 10.20
DALE BARTOS EMPLOYMENT AGREEMENT
DATED AS OF JANUARY 4, 1997
January 4, 1997
Dale J. Bartos
6767 East Arroyo Court
Paradise Valley, AZ 85253
Dear Mr. Bartos:
This is a revision to our previous offer. We are pleased to make our offer of
employment with Xylan Corporation as Vice President of Finance and Chief
Financial Officer. Your compensation and benefits are outlined on the attached
pages of this letter and on the attached Individual Compensation Letter.
The offer contained in this letter constitutes the entire compensation agreement
between you and the Company. Any verbal agreement, assurance or understanding
will not alter this offer. Please sign the copy of this letter indicating your
acceptance of this offer and also sign the Compensation Plan indicating
acceptance of the Plan.
You understand and acknowledge that your employment with the Company is for an
unspecified duration and constitutes "at-will" employment and any representation
to the contrary is unauthorized and not valid unless obtained in writing and
signed by the President of the Company. You acknowledge that this employment
relationship may be terminated at any time, with or without good cause or for
any or no cause, at the option either of the Company or yourself, with or
without notice. This offer is made contingent upon your reading and signing the
standard Xylan Corporation Non-Disclosure Agreement.
For purposes of federal immigration law, you will be required to provide to the
Company documentary evidence of your identity and eligibility for employment in
the United States. Such documentation must be provided to us within three (3)
business days of our date of hire, or our employment relationship with you may
be terminated.
Very truly yours,
/s/ Andrew Jentis
_________________________________
Andrew Jentis
Director, Human Resources
Acceptance:
/s/ Dale Bartos 1/31/97
_________________________________ ______________
By: Mr. Dale Bartos Start Date
<PAGE>
BENEFITS PACKAGE
STANDARD BENEFITS
- -----------------
VACATION: 10 days per year, vacation is accrued daily.
HOLIDAYS: 10 paid holidays per calendar year.
FLOATING DAY: 1 per year.
EDUCATION PROGRAM: Up to $2,000 per year in reimbursement for
successfully completed courses.
LIFE INSURANCE: Two times your base salary; if
commissioned employee, two times your
targeted compensation plan.
EMPLOYMENT ASSISTANCE
PROGRAM (EAP): Five (5) sessions per employee and/or
family member per calendar year with a
participating Provider.
SHORT TERM DISABILITY: 66 2/3% of your salary after 7 days to 90
days (maximum of $500/week).
LONG TERM DISABILITY: 66 2/3% of your salary after 90 days of
disability.
OPTIONAL BENEFITS
- -----------------
MEDICAL, DENTAL, VISION: $7.00 deduction for employee coverage Semi
Monthly, $15.00 Semi Monthly for employee and
dependent coverage. All Medical/dental/vision
benefits are effective on your date of hire.
401(K): 25% Employer match on our 401(k)
contribution to a maximum of $2,000 per
year.
FLEX BENEFITS: Pre-taxed health care and dependent care
accounts.
EMPLOYEE STOCK PURCHASE PLAN: Can contribute from 1-10% of your base
salary and purchase Xylan Stock with out
Employee Stock Purchase Plan (enrollment
date Feb. 1).
<PAGE>
COMPENSATION PACKAGE FOR
MR. DALE BARTOS
TITLE: Vice President of Finance and CFO
BASE LOCATION: Calabasas
POSITION REPORTS TO: Steve Kim
COMPENSATION
- ------------
BASE SALARY: $16,667 per month
MANAGEMENT BONUS: Eligible to participate in the Management Bonus
plan for 1997; the plan has an incentive payout
of 5% (maximum) of annual salary for achieving
MBO targets and 33% (maximum) of annual salary
for achieving Corporate financial goals.
If Adflex does not pay your January, 1997
bonus of $28,000, Xylan will pay this bonus
by the end of January, 1997 if you start by
the end of January.
In the quarter ending June 30, 1997, Xylan will
guarantee a bonus payment of $28,000--to be paid
by July 31, 1997.
FLSA STATUS: Exempt (salaried)
RELOCATION: Up to $125,000 reimbursement including gross up
(per attached policy).
In addition, Xylan will pay your monthly
costs of your Phoenix house until it sells
including mortgage, property taxes,
homeowners feed, insurance and maintenance
costs and will gross up this amount for
income taxes.
If Adflex requires you to pay back the
relocation expenses for your move to Phoenix,
Xylan will pay back Adflex.
<PAGE>
COMPENSATION PACKAGE FOR
MR. DALE BARTOS
(continued)
Xylan will fund you a non-interest bearing
"bridge loan" up to $350,000 to assist you
to purchase a home in Southern California--
to be repaid upon sale of your Phoenix
house.
TEMPORARY LIVING: Xylan will pay for temporary living at the
company furnished apartment or an apartment of
your choice.
STOCK OPTIONS: 100,000 ISO's (subject to IRS $100k limit)
OPTION PRICE: At fair market value on date of grant by BOD.
VESTING: 20% after the first year, then the remaining
vest only (1/48 per month for 4 years).
PLEASE NOTE: All stock options require approval by Xylan's Board of Directors
and must be issued in compliance with the terms of 1996 Stock Incentive Plan and
in compliance with all applicable security laws.
Review and accepted by:
/s/ Dale Bartos 1/4/97
- ------------------------- -------
Mr. Dale Bartos Date
<PAGE>
XYLAN CORPORATION
RELOCATION POLICY & PROCEDURE
The following expense items qualify as reimbursable under the Xylan relocation
plan. Appropriate documentation and/or receipts must be submitted on a Xylan
expense report.
All expense reports must be submitted to Human Resources for review prior to
being submitted to Accounts Payable.
Other items not listed must be pre-approved by Human Resources prior to
incurring the expense.
ELIGIBLE RELOCATION EXPENSES
. Moving expense (furniture, autos, personal items)
. Points, fees, and other closing costs
. Temporary housing during visits
. Temporary automobile expenses during visits
. Airfare for visits
. Meals during visits
Xylan's relocation policy is to reimburse for relocation expenses on a dollar-
for-dollar basis with no off-set for taxes unless stated in your offer letter.
All employees should be aware that some of Xylan's reimbursable expenses may not
be deductible for tax purposes. It is recommended that recipients seek the
advice of a tax advisor.
<PAGE>
EXHIBIT 11.1
STATEMENT REGARDING COMPUTATION OF NET INCOME (LOSS) PER SHARE
FOR THE YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994
(IN THOUSANDS)
<TABLE>
<CAPTION>
1996 1995 1994
------- ------- -------
<S> <C> <C> <C>
Net income (loss).......................................... $15,245 $(9,441) $(4,083)
======= ======== =======
Weighted average common shares outstanding................. 40,834 10,320 10,278
------- ------- -------
Weighted average common share equivalents(1):
Stock options determined using the treasury
stock method............................................. 5,547 4,652 4,652
Convertible preferred stock............................... -- 6,179 6,179
------- ------- -------
Total weighted average common share
equivalents............................................. 5,547 10,831 10,831
------- ------- -------
Weighted average common and common equivalent
shares outstanding................................... 46,381 21,151 21,109
======= ======= =======
Net income (loss) per share.............................. $ 0.33 $ (0.45) $ (0.19)
======= ======= =======
</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 common and common equivalent shares outstanding for all periods
presented using the treasury stock method based on the initial public
offering price. Stock options, warrants and convertible preferred stock
issued prior to 1995 are excluded from the computation of weighted average
common share equivalents for the years ended 1995 and 1994, as their
inclusion would be antidilutive.
<PAGE>
EXHIBIT 23.1
The Board of Directors and Shareholders
Xylan Corporation:
We consent to incorporation by reference in the registration statement (No. 333-
3944) on Form S-8 of Xylan Corporation of our report dated January 31, 1997,
relating to the consolidated balance sheets of Xylan Corporation and
subsidiaries as of December 31, 1996, and 1995, and the related consolidated
statements of operations, shareholders' equity, and cash flows for each of the
years in the three-year period ended December 31, 1996, and related schedule,
which reports appear in the December 31, 1996, annual report on Form 10-K of
Xylan Corporation
/s/ KPMG Peat Marwick LLP
Los Angeles, California
March 28, 1997
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
<CASH> 62,483
<SECURITIES> 50,498
<RECEIVABLES> 27,226
<ALLOWANCES> 270
<INVENTORY> 11,578
<CURRENT-ASSETS> 155,528
<PP&E> 21,297
<DEPRECIATION> 4,632
<TOTAL-ASSETS> 207,251
<CURRENT-LIABILITIES> 20,913
<BONDS> 0
0
0
<COMMON> 42
<OTHER-SE> 185,638
<TOTAL-LIABILITY-AND-EQUITY> 207,251
<SALES> 128,456
<TOTAL-REVENUES> 128,456
<CGS> 57,830
<TOTAL-COSTS> 57,830
<OTHER-EXPENSES> 52,810
<LOSS-PROVISION> 26
<INTEREST-EXPENSE> 97
<INCOME-PRETAX> 23,056
<INCOME-TAX> 7,811
<INCOME-CONTINUING> 15,245
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 15,245
<EPS-PRIMARY> .33
<EPS-DILUTED> .33
</TABLE>
