<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
______________________
Form 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended March 31, 1998
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from __________ to __________
COMMISSION FILE NUMBER 0-27764
______________________________
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.)
26707 WEST AGOURA ROAD
CALABASAS, CALIFORNIA 91302
(Address of principal executive offices)
TELEPHONE: (818) 880-3500
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports
required to be filled by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding twelve months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
The number of shares outstanding of the registrant's Common Stock as of April
30, 1998, was 43,131,891.
<PAGE>
XYLAN CORPORATION
QUARTERLY REPORT ON FORM 10-Q
FOR THE PERIOD ENDED MARCH 31, 1998
INDEX
Page
----
PART I Financial Information
Item 1. Financial Statements:
Condensed Consolidated Balance Sheets March 31,
1998 and December 31, 1997 3
Condensed Consolidated Income Statements --
Three Months Ended March 31, 1998, December 31,
1997 and March 31, 1997 4
Condensed Consolidated Statements of Cash Flows --
Three Months Ended March 31, 1998, December 31,
1997 and March 31, 1997 5
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations 9
Item 3. Quantitative and Qualitative Disclosures About Market Risks N/A
PART II Other Information
Item 1. Legal Proceedings 22
Item 2. Changes in Securities and Use of Proceeds 22
Item 3. Defaults upon Senior Securities 22
Item 4. Submission of Matters to a Vote of Security Holders 22
Item 5. Other Information 22
Item 6. Exhibits and Reports on Form 8-K 23
Signature 24
Exhibit Index 25
2
<PAGE>
PART I -- FINANCIAL INFORMATION
ITEM 1. Financial Statements
XYLAN CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands)
<TABLE>
<CAPTION>
March 31, December 31,
1998 1997
----------- ------------
ASSETS (Unaudited)
<S> <C> <C>
Current assets:
Cash and cash equivalents......................... $ 28,052 $ 35,917
Short-term investments............................ 35,345 43,171
Accounts receivable, net.......................... 53,701 53,013
Inventories, net.................................. 23,246 17,731
Deferred income taxes, net........................ 6,438 6,100
Prepaid expenses and other current assets......... 3,879 2,892
-------- --------
Total current assets........................... 150,661 158,824
Investments........................................... 69,494 59,382
Note receivable....................................... 7,500 7,500
Property and equipment, net........................... 23,798 20,894
Other assets.......................................... 4,788 4,306
-------- --------
Total assets................................... $256,241 $250,906
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable and accrued expenses............. $ 22,282 $ 26,382
Current installments of capital lease obligations. 145 189
Deferred revenue.................................. 7,667 4,317
Income taxes payable.............................. 3,277 3,002
-------- --------
Total current liabilities...................... 33,371 33,890
Capital lease obligations, less current installments.. -- 17
Deferred revenue...................................... 1,229 899
-------- --------
Total liabilities.............................. 34,600 34,806
-------- --------
Shareholders' equity:
Common stock and additional paid-in capital....... 187,930 190,774
Retained earnings................................. 33,711 25,326
-------- --------
Shareholders' equity........................... 221,641 216,100
-------- --------
Total shareholders' equity..................... $256,241 $250,906
======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
3
<PAGE>
XYLAN CORPORATION
CONDENSED CONSOLIDATED INCOME STATEMENTS
(Unaudited)
(in thousands, except per share data)
<TABLE>
<CAPTION>
Three Months Ended
------------------------------------
March 31, December 31, March 31,
1998 1997 1997
--------- ------------ ---------
<S> <C> <C> <C>
Revenue.................................. $75,370 $64,202 $48,008
Cost of revenue.......................... 32,652 27,915 20,663
------- ------- -------
Gross profit..................... 42,718 36,287 27,345
------- ------- -------
Operating expenses:
Research and development.............. 8,787 7,512 5,506
Sales and marketing................... 20,108 18,122 12,621
General and administrative............ 2,237 2,044 1,577
------- ------- -------
Total operating expenses................. 31,132 27,678 19,704
------- ------- -------
Operating income................. 11,586 8,609 7,641
Interest income, net..................... 1,491 1,504 1,828
------- ------- -------
Income before income taxes............... 13,077 10,113 9,469
Income tax expense....................... 4,692 3,551 3,601
------- ------- -------
Net income............................ $ 8,385 $ 6,562 $ 5,868
======= ======= =======
Net income per share:
Basic................................. $ .19 $ .15 $ .14
Diluted............................... $ .18 $ .14 $ .13
======= ======= =======
Shares used in per share calculations:
Basic................................. 43,109 42,945 42,147
Diluted............................... 47,434 47,115 46,594
======= ======= =======
</TABLE>
The accompanying notes are an integral part of these financial statements.
4
<PAGE>
XYLAN CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
(in thousands)
<TABLE>
<CAPTION>
Three Months Ended
------------------------------------
March 31, December 31, March 31,
1998 1997 1997
--------- ------------ ---------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income.................................................. $ 8,385 $ 6,562 $ 5,868
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation and amortization............................ 2,474 2,407 1,540
Deferred income taxes.................................... (338) 494 --
Expense related to warrants.............................. -- -- 190
Unearned compensation amortization....................... 114 114 114
Change in:
Accounts receivable.................................... (688) (10,186) (10,064)
Inventories............................................ (5,515) (6,360) 3,279
Prepaid expenses and other current assets.............. (986) 498 (601)
Other assets........................................... (482) 584 (2,081)
Accounts payable and accrued expenses.................. (4,100) 5,363 2,931
Deferred revenue....................................... 3,679 183 844
Income taxes payable................................... 1,775 2,870 1,841
------- -------- --------
Net cash provided by operating activities............ 4,318 2,529 3,861
------- -------- --------
Cash flows from investing activities:
Purchases of property and equipment......................... (5,377) (3,202) (2,302)
Sales (purchases) of investments............................ (2,287) 1,785 (19,701)
------- -------- --------
Net cash used in investing activities................ (7,664) (1,417) (22,003)
------- -------- --------
Cash flows from financing activities:
Common stock issued......................................... 2,453 298 1,375
Common stock repurchased.................................... (6,912) -- --
Principal payments under capital lease obligations.......... (60) (65) (86)
------- -------- --------
Net cash provided by (used in) financing activities...... (4,519) 233 1,289
------- -------- -------
Net increase (decrease) in cash and cash equivalents. (7,865) 1,345 (16,853)
Cash and cash equivalents at beginning of period............... 35,917 34,572 62,483
------- -------- --------
Cash and cash equivalents at end of period..................... $28,052 $ 35,917 $ 45,630
======= ======== ========
Supplemental disclosure of cash flow information:
Cash paid during the period for interest............. $ 6 $ 6 $ 11
Cash paid during the period for taxes................ $ 3,214 $ 228 $ 735
======= ======== ========
Supplemental disclosure of noncash investing and
financing activities:
Income tax benefit resulting from exercise of
employee stock options............................. $ 1,500 $ 739 $ 600
======= ======== ========
</TABLE>
The accompanying notes are an integral part of these financial statements.
5
<PAGE>
XYLAN CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1. Basis Of Presentation
The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, these statements include
all adjustments, consisting of normal and recurring adjustments, considered
necessary for a fair presentation of results for such periods. The results of
operations for the three month period ending March 31, 1998 are not necessarily
indicative of results which may be achieved for the full fiscal year or for any
future period. The unaudited consolidated interim financial statements should
be read in conjunction with the financial statements and notes thereto contained
in Xylan Corporation's ("Xylan" or the "Company") Form 10-K.
NOTE 2. Investments
Investments at March 31, 1998, and December 31, 1997, consist of corporate
and municipal debt, U.S. Treasuries and Federal Government Agency debt. In
accordance with the provisions of Statement of Financial Accounting Standards
Board No. 115, "Accounting for Certain Investments in Debt and Equity
Securities," the Company classifies its investments as held-to-maturity
securities. The market value of these securities at March 31, 1998, and December
31, 1997, approximated cost.
NOTE 3. Inventories
Inventories, primarily component parts, are stated at the lower of cost or
market, cost being determined using the first-in, first-out method.
NOTE 4. Accounts Payable and Accrued Expenses
Accounts payable and accrued expenses consist of the following:
<TABLE>
<CAPTION>
March 31, December 31,
1998 1997
----------- ------------
(Unaudited)
<S> <C> <C>
Accounts payable............................... $ 6,941 $10,926
Accrued payroll and related costs.............. 7,357 7,890
Accrued warranty............................... 1,119 1,256
Other accrued expenses......................... 6,865 6,310
------- -------
Total accounts payable and accrued expenses. $22,282 $26,382
======= =======
</TABLE>
6
<PAGE>
NOTE 5. Shareholder's Equity
The Company's Board of Directors has authorized the Company to repurchase
up to 2,000,000 shares of the Company's common stock to offset the dilutive
effect of new issuances of common stock under the Company's stock option and
stock purchase plans. During the three months ended March 31, 1998, the Company
repurchased 302,000 shares of its common stock for $6,912,000.
The Company has a 1993 Stock Incentive Plan which reserves 8,000,000 shares
of the Company's authorized but unissued common stock for option or stock
purchase grants. As of March 31, 1998, the Company has issued 2,669,654 shares
of common stock under this plan and options to purchase 4,968,116 shares of
common stock are outstanding. In connection with the grant of stock options,
for financial statement presentation purposes, the Company has recorded unearned
compensation, net of cancellations, of $2,336,000 representing the difference
between the grant price and the deemed fair market value. This amount will be
recorded as compensation expense ratably over the vesting period for each
option. For each of the quarters ended March 31, 1998, December 31, 1997, and
March 31, 1997, the Company recorded $114,000 of compensation expense.
The Company has a 1996 Stock Option Plan which reserves 5,000,000 shares of
the Company's authorized but unissued common stock for option grants. As of
March 31, 1998, the Company has issued 72,592 shares of common stock under this
plan and options to purchase 4,882,222 shares of common stock are outstanding.
The Company has a 1996 Directors' Stock Option Plan which reserves 150,000
shares of the Company's authorized but unissued common stock for option grants.
As of March 31, 1998, the Company has not issued any shares of common stock
under this plan and options to purchase 45,000 shares of common stock are
outstanding.
The Company has a 1996 Employee Stock Purchase Plan which reserves
1,500,000 shares of authorized but unissued common stock for issuance. As of
March 31, 1998, the Company has issued 120,856 shares of common stock under this
plan.
The Company has a 1998 stock option plan which reserves 1,000,000 shares of
the Company's authorized but unissued common stock for option grants. As of
March 31, 1998, the Company has issued 500 shares of common stock under this
plan and options to purchase 991,250 shares of common stock are outstanding.
In 1996, the Company and IBM entered into an agreement whereby Xylan
committed to grant IBM warrants to purchase up to 2,350,000 shares of Xylan
common stock based on the achievement of specific business goals. During 1996,
the Company recognized $274,000 of expense related to these warrants. In 1997,
the commitment to grant warrants to IBM was cancelled and the $274,000 of
expense was reversed.
NOTE 6. Income Taxes
The Company's quarterly provision for income taxes is based upon the
Company's estimate of the effective tax rate for the respective fiscal year. For
the three months ended March 31, 1998, December 31, 1997, and March 31, 1997,
the Company recorded an effective tax rate of approximately 36%, 35% and 38%,
respectively.
For the quarters ended March 31, 1998, December 31, 1997, and March 31,
1997, the Company realized an income tax benefit of $1,500,000, $739,000 and
$600,000, respectively, for certain stock option transactions. This benefit is
used to reduce taxable income prior to the utilization of net operating loss
carryforwards, and results in a decrease in current income taxes payable and an
increase in additional paid-in capital.
7
<PAGE>
NOTE 7. Computation of Net Income Per Share
In February 1997, the Financial Accounting Standards Board issued SFAS No.
128, "Earnings per Share." SFAS No. 128 replaced the previously reported primary
and fully diluted earnings per share with basic and diluted earnings per share
and became effective for both interim and annual periods ending after December
15, 1997. Unlike primary earnings per share, basic earnings per share excludes
any dilutive effects of options and convertible securities. Diluted earnings per
share is very similar to the previously reported fully diluted earnings per
share. All earnings per share amounts for all periods have been restated to
conform to the SFAS No. 128 requirements.
The following table sets forth the computation of basic and diluted net
income per share (In thousands, except per share data):
<TABLE>
<CAPTION>
Three Months Ended
--------------------------------
March 31, Dec. 31, March 31,
1998 1997 1997
--------- -------- ---------
<S> <C> <C> <C>
Numerator for basic and diluted per share
computations:
Net income available to common shareholders.. $8,385 $6,562 $5,868
====== ====== ======
Denominator:
Shares used for basic per share computations
weighted average shares outstanding......... 43,109 42,945 42,147
Effect of dilutive securities--stock options. 4,325 4,170 4,447
------ ------ ------
Shares used for diluted per share
computations.............................. 47,434 47,115 46,594
====== ====== ======
Net income per share:
Basic........................................ $ .19 $ .15 $ .14
Diluted...................................... $ .18 $ .14 $ .13
====== ====== ======
</TABLE>
Options to purchase 1,040,000, 672,000 and 2,796,000 shares at an average
exercise price of $21.86, $21.53 and $38.90 were outstanding at March 31, 1998,
December 31, 1997, and March 31, 1997, respectively, but were not included in
the computation of diluted net income per share for the respective periods
because the exercise price of the options was greater than the average market
price of the common shares and therefore, the effect would be antidilutive.
NOTE 8. Recently Adopted Accounting Standards
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130,
"Reporting Comprehensive Income" effective for fiscal years beginning after
December 15, 1997. SFAS No. 130 established standards for the reporting and
display of comprehensive income and its components (revenues, expenses, gains
and losses) in a full set of general-purpose financial statements. The Company
adopted SFAS No. 130 effective January 1, 1998. Under the provisions of SFAS
No. 130 no amounts are required to be disclosed as they are either not
applicable or immaterial.
In June 1997, the Financial Accounting Standards Board issued SFAS No. 131,
"Disclosures about Segments of an Enterprise and Related Information" effective
for financial statements for periods beginning after December 15, 1997. SFAS No.
131 establishes standards for the way that public business enterprises report
financial and descriptive information about reportable operating segments. The
Company adopted SFAS No. 131 effective January 1, 1998. The disclosures
regarding operating segments is not applicable as the Company only has one
operating segment. Disclosure regarding significant customers and revenue by
sales channel and geographic region follows.
8
<PAGE>
For the quarter ended March 31, 1998, IBM and Alcatel accounted for 22% and
20%, respectively, of revenue. For the quarter ended December 31, 1997, IBM and
Alcatel accounted for 22% and 15%, respectively, of revenue. For the quarter
ended March 31, 1997, IBM accounted for 26% of revenue.
The following table sets forth the Company's revenue by sales channel and
geographic region as a percentage of total revenue:
<TABLE>
<CAPTION>
Three Months ended
------------------------------
March 31, Dec. 31, March 31,
1998 1997 1997
--------- -------- ---------
<S> <C> <C> <C>
Channel:
OEM 42% 38% 43%
Non-OEM 58% 62% 57%
== == ==
Region (1):
North America (2) 45% 49% 45%
Europe 36% 30% 26%
Asia Pacific 16% 18% 25%
Latin America 3% 3% 4%
== == ==
</TABLE>
(1) Revenues to IBM and Alcatel are attributed to regions based on
"point of sale" information. All other revenues are attributed to
regions based on the location of the customer.
(2) North America primarily consists of the United States.
Substantially all of the Company's long-lived assets are located in the
United States.
ITEM 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
This quarterly report on Form 10-Q 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
"Factors Affecting Future Results" section of this Management's Discussion and
Analysis of Financial Condition and Results of Operations which identify
important risk factors that could cause actual results to differ from those
contained in the forward looking statements. The Company undertakes no
obligation to update the information, including the forward-looking statements,
in this Report on Form 10-Q.
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 to an aggregate of $210.5 million in fiscal year 1997
from $29.7 million in fiscal year 1995. On a quarterly basis revenue increased
to $75.4 million in the quarter ended March 31, 1998 from $48.0 million in the
quarter ended March 30, 1997. The increases in revenue are discussed below. The
Company 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 March 31, 1998, the Company had retained earnings of $33.7
million.
The Company intends to continue 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
9
<PAGE>
impossible. Although the Company has experienced revenue growth in all but one
quarter since revenue was first recognized, such growth rates may not be
sustainable and are not indicative of future operating results. There can be no
assurance that the Company will sustain profitability.
Results Of Operations
Revenue
Revenue for the quarter ended March 31, 1998, was $75.4 million compared to
$64.2 million for the quarter ended December 31, 1997, an increase of 17%.
Revenue for the quarter ended March 31, 1997, was $48.0 million. Comparing
revenue for the quarter ended March 31, 1998, to the quarter ended March 31,
1997, revenue increased 57%. 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 OmniStack product family, the
continued strategic relationships with IBM and Alcatel, and the Company's
investment in sales and marketing resources, which offset lower demand in
certain Asian markets. The relative contribution of most of these factors cannot
be quantified, and future changes in an individual factor therefore cannot be
used to predict future revenue growth. While the Company achieved revenue growth
of 57% from the three months ended March 31, 1997, to the three months ended
March 31, 1998, the Company cannot insure this rate of sequential growth if at
all in future periods.
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 March 31, 1998, the Company has earned no royalties.
Product revenue could be adversely impacted if IBM elects to manufacture the
Company's products.
For the quarter ended March 31, 1998, IBM and Alcatel accounted for 22% and
20%, respectively, of revenue. For the quarter ended December 31, 1997, IBM and
Alcatel accounted for 22% and 15%, respectively, of revenue. For the quarter
ended March 31, 1997, IBM accounted for 26% of revenue.
10
<PAGE>
The following table sets forth the Company's revenue by sales channel and
geographic region as a percentage of total revenue:
<TABLE>
<CAPTION>
Three Months ended
------------------------------
March 31, Dec. 31, March 31,
1998 1997 1997
--------- -------- ---------
<S> <C> <C> <C>
Channel:
OEM 42% 38% 43%
Non-OEM 58% 62% 57%
== == ==
Region (1):
North America (2) 45% 49% 45%
Europe 36% 30% 26%
Asia Pacific 16% 18% 25%
Latin America 3% 3% 4%
== == ==
</TABLE>
(1) Revenues to IBM and Alcatel are attributed to regions based on "point
of sale" information. All other revenues are attributed to regions
based on the location of the customer.
(2) North America primarily consists of the United States.
Gross Profit
Gross margins were 56.7%, 56.5% and 57.0% for the quarters ended March 31,
1998, December 31, 1997 and March 31, 1997, respectively. The slight changes in
gross margins when comparing the quarter ended March 31, 1998, to the quarter
ended December 31, 1997, and to the quarter ended March 31, 1997, resulted from
a number of factors, including reductions in component costs, sales channel mix,
product mix (the Company's OmniStack products generally have lower gross margins
than the OmniSwitch products), competitive market pricing and discount levels
and manufacturing volumes. 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 and ASICs may impact gross margins and result in
excess or obsolete inventories.
Research and Development Expenses
Research and development expenses were $8.8 million, $7.5 million and $5.5
million for the quarters ended March 31, 1998, December 31, 1997, and March 31,
1997, respectively. This represents an increase of 17% from the fourth quarter
of 1997 to the first quarter of 1998 and an increase of 60% from the first
quarter of 1997 to the first quarter of 1998. These increases were primarily
due to the hiring of additional engineers and an increase in prototype material
costs for new product development. As a percentage of revenue, research and
development expenses were 12% for each of the quarters ended March 31, 1998,
December 31, 1997, and March 31, 1997.
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 expenses will continue to increase in 1998 in absolute dollars. To
date, the Company has not capitalized any development costs and does not
anticipate capitalizing any such costs in the foreseeable future.
11
<PAGE>
Sales and Marketing Expenses
Sales and marketing expenses were $20.1 million, $18.1 million and $12.6
million for the quarters ended March 31, 1998, December 31, 1997, and March 31,
1997, respectively. This represents an increase of 11% from the fourth quarter
of 1997 to the first quarter of 1998 and an increase of 59% from the first
quarter of 1997 to the first quarter of 1998. These increases were primarily
due to expenses related to the addition of direct sales personnel throughout the
United States, Europe and Asia, advertising and promotional campaigns in support
of the Company's direct sales and system integrator channels and increased
commission expenses on higher revenues. As a percentage of revenue, sales and
marketing expenses were 27%, 28% and 26% for the quarters ended March 31, 1998,
December 31, 1997, and March 31, 1997, respectively. As the Company continues
to expand its direct sales force, adding personnel and offices worldwide, and to
introduce new products and enhancements to its existing products, it expects
that sales and marketing expenses will continue to increase in 1998 in absolute
dollars.
General And Administrative Expenses
General and administrative expenses were $2.2 million, $2.0 million and
$1.6 million for the quarters ended March 31, 1998, December 31, 1997, and March
31, 1997, respectively. As a percentage of revenue, general and administrative
expenses were 3%, for each of the quarters ended March 31, 1998, December 31,
1997, and March 31,1997. As the Company continues to add personnel and introduce
new products and enhancements to its existing products, it expects that general
and administrative expenses will continue to increase in 1998 in absolute
dollars.
Interest Income
Interest income, net, was $1.5 million, $1.5 million and $1.8 million for
the quarters ended March 31, 1998, December 31, 1997, and March 31, 1997,
respectively. The decrease in interest income from the three months ended March
31, 1997, to the three months ended March 31, 1998, resulted from the Company
earning more interest on tax-exempt investments which have a lower pre-tax yield
but higher after-tax yield than taxable investments.
Provision For Income Taxes
The Company's quarterly provision for income taxes is based upon the
Company's estimate of the effective tax rate for the respective fiscal year. For
the three months ended March 31, 1998, December 31, 1997, and March 31, 1997,
the Company recorded an effective tax rate of approximately 36%, 35% and 38%,
respectively.
For the quarters ended March 31, 1998, December 31, 1997, and March 31,
1997, the Company realized an income tax benefit of $1,500,000, $739,000 and
$600,000, respectively, for certain stock option transactions. This benefit is
used to reduce taxable income prior to the utilization of net operating loss
carryforwards, and results in a decrease in current income taxes payable and an
increase in additional paid-in capital.
Liquidity and Capital Resources
The Company's principal source of liquidity as of March 31, 1998, consisted
of $28 million in cash and cash equivalents, $35 million in short-term
investments and a $6 million bank credit facility. Additionally, the Company has
$69 million in long-term investments. For the three months ended March 31, 1998,
December 31, 1997, and March 31, 1997, cash provided by operating activities was
$4.3 million, $2.5 million and $3.9 million, respectively. 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 twelve months.
12
<PAGE>
The Company's Board of Directors has authorized the Company to repurchase
up to 2,000,000 shares of the Company's common stock to offset the dilutive
effect of new issuances of common stock under the Company's stock option and
stock purchase plans. During the three months ended March 31, 1998, the Company
repurchased 302,000 shares of its common stock for $6,912,000. Additional
repurchases, if any, of the Company's common stock will be funded from the
Company's existing cash and investment balances.
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.
Factors Affecting Future Results
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 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 generally experienced 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. In fiscal 1998, the Company intends to continue 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,
ASICs and new products, (iii) the Company's ability to support its current and
new products, (iv) the ability to obtain sufficient supplies of sole or limited
source components for the Company's products, (v) the ability to attain and
maintain production volumes and quality levels for its products (including
ASICs), (vi) the mix of distribution channels and products, (vii) new product
introductions by the Company's competitors, (viii) pricing actions by the
Company or its competitors, (ix) changes in material costs, (x) mix of products
manufactured or purchased by IBM and Alcatel, and (xi) general economic
conditions. See "Dependence on OEM Partners and System Integrators; IBM and
Alcatel; 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." For example, the Company's revenue in the quarter ended June 30,
1997 declined as compared to the immediately preceding quarter primarily due to
lower than expected orders from a large OEM customer, material availability for
the Company's ATM switch product, and lower than expected shipments of the
Company's new Ethernet/Fast Ethernet products.
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The Company's revenue in any period is highly dependent upon the sales
efforts and success of Xylan's OEM partners (including IBM and Alcatel) 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 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, purchase orders and product availability, significant volume
shipments of products have occurred and may continue to occur at the end of the
Company's fiscal quarter. Failure to ship such products by the end of a quarter
may adversely affect the Company's operating results. 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, the Company's operating results has and
may in the future 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. 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 may 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
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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 "Dependence on Proprietary Technology, Intellectual Property
Litigation."
Dependence on OEM Partners and System Integrators; IBM and Alcatel;
Customer Concentration. The Company pursues a sales and marketing strategy
focused on developing two channels of distribution for its products: worldwide
OEM partners and non-OEM sales. The Company has established OEM partnerships
with leading communications and networking companies, including IBM, 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 March 31, 1998, sales to IBM comprised 22% 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 March 31, 1998, either company has
earned no royalties. However, sales by IBM of IBM manufactured or other campus
switch products could have a material adverse effect on the Company's product
revenues. In addition, the parties have formed 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 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 accounted for 42% for the
quarter ended March 31, 1998, and 43% for the quarter ended March 31, 1997.
Each of the Company's OEM partners 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 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. Certain of the
Company's OEM partners have developed and may continue to 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.
For example, in July 1997, IBM announced that it had also formed an alliance
with 3Com, a competitor of the Company. In addition, Xylan's OEM partners and
system integrators could sell competitive products 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 non-OEM
sales than on sales
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through its OEM partners. Accordingly, if the Company's OEM partners were to
account for an increased portion of the Company's revenue, its gross margin
would decline.
Substantial Increase in Manufacturing Operations; Dependence on Contract
Manufacturing. As demand for the Company's products grow, the Company will
increase its flow of materials, contract manufacturing capacity and internal
test and quality functions to respond to such customer demand and to reduce its
order lead times. Any inability or delay in 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. 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 also requires additional
manufacturing space and 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.
Xylan's operational strategy relies on outsourcing of manufacturing. The
Company currently subcontracts component procurement and printed circuit board
assembly to two companies. The Company also subcontracts assembly of chassis to
a number of companies, each of which specialize 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 one of its contract manufacturers
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
March 31, 1998, the note had an outstanding balance of $7.5 million. Also,
during 1996 and 1997, the Company guaranteed up to $5.0 million of such contract
manufacturer's debt for certain raw material and electronic component purchases.
Any additional loans or guaranties to contract manufacturer, or defaults or
financial insolvency of such 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 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, certain 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, many of these ASICs are initially being
manufactured 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
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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.
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 or acquisition 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, support or acquire 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. Such delays have, and any
future delays could have, a material adverse effect on the Company's business,
operating results and financial condition. 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 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. The Company introduced its
OmniStack series of products in March of 1998. The Company expects that revenue
from these products will account for a substantial portion of the Company's
revenue through 1998. 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 and support 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
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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 and System 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. In addition, end
users use the Company's products in complex systems or networks with products
from multiple vendors. As a result, the Company's products must successfully
interoperate with products from other vendors and at times, a system problem (if
one exists) may be difficult to identify the source of the problem. 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.
Management of Growth. The Company's growth has resulted in a continuing
increase in the level of responsibility for both existing and new management
personnel. The Company recently has implemented and continues to implement 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 the
Company's 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 Proprietary Technology; Intellectual Property Litigation. The
Company's success and its ability to compete are 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
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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 Product
Development. The Company does not have employment contracts with, and does not
currently maintain key man life insurance covering, its key personnel. The
Company believes its future success will also depend in large part upon its
ability to attract and retain highly skilled managerial, engineering, sales and
marketing, finance and manufacturing personnel. Competition for such personnel
is intense, and there can be no assurance that the Company will be successful in
attracting and retaining such personnel. The loss of the services of any of the
key personnel, the inability to attract or retain qualified personnel in the
future or delays in hiring required personnel, particularly 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 55% of the Company's revenue for each of the
quarters ended March 31, 1998 and 1997. 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
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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. The Company's international business is subject to risks customarily
encountered in foreign operations, including changes in a specific country's or
region's political or economic conditions, trade protection measures, import or
export licensing requirements, the overlap of different tax structures,
unexpected changes in regulatory requirements and natural disasters. For
example, due to the recent financial turmoil in Asia, the Company's revenues
from Asia declined from 25% of total revenues in the third quarter of 1997 to
18% in the fourth quarter of fiscal 1997. 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. 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.
Year 2000. Many computer systems experience problems handling dates beyond the
year 1999. Therefore, some computer hardware and software will need to be
modified prior to the Year 2000 in order to remain functional. The Company is
assessing both the internal readiness of its computer systems and the compliance
of its computer products and software sold to customers for handling the Year
2000. The Company expects to implement successfully the systems and programming
changes necessary to address Year 2000 issues, and does not believe that the
cost of such actions will have a material effect on the Company's results of
operations or financial condition. There can be no assurance, however, that
there will not be a delay in, or increased costs associated with, the
implementation of such changes, and the Company's inability to implement such
changes could have an adverse effect on future results of operations.
The Company is also assessing the possible effects on the Company's operations
of the Year 2000 readiness of key suppliers and subcontractors. The Company's
reliance on suppliers and subcontractors, and, therefore, on the proper
functioning of their information systems and software, means that failure to
address Year 2000 issues could have a material impact on the Company's
operations and financial results; however, the potential impact and related
costs are not known at this time.
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 next twelve months, although
the Company could be required, or could elect, to seek to raise additional
capital. The Company's future capital requirements will depend on many factors,
including the rate of revenue growth, the timing and extent of spending to
support product development efforts and expansion of sales and marketing, the
timing of introductions of new products and enhancements to existing products,
and market acceptance of the Company's products. The Company expects that it
may need to raise additional equity or debt financing in the future. There can
be no assurance that additional equity or debt financing, if required, will be
available on acceptable terms or at all.
Regulatory Matters. The Company's products must meet industry standards and
receive certification for connection to certain public telecommunications
networks prior to their sale. In the United States, the Company's products must
comply with various regulations defined by the Federal Communications Commission
and Underwriters Laboratories. Internationally, the Company's products must
comply with standards established by telecommunications authorities in various
countries as well as with recommendations of the International Telecommunication
Union. Although the Company's products have not been denied any regulatory
approvals or certifications to date, any future inability to obtain on a timely
basis or retain domestic or foreign regulatory
20
<PAGE>
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, the Company's Board of Directors are divided between
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. In October of 1997, the Company's Board of Directors approved
acceleration of vesting of stock options held by the Company's Executive
Officers and certain key employees in the event of a change of control, which
could also make a change in control or management of the Company more difficult.
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. In addition, on April 17, 1997, the Company's Board of
Directors declared a dividend of one right (a "Right") to purchase 1/1000th of a
share of Series A Participating Preferred Stock (the "Series A Preferred") on
each share of Common Stock. The Rights will become exercisable only if a person
or group acquires 15.0% or more of the Company's Common Stock (in the case of
Steve Y. Kim, Yuri Pikover, John L. Walecka or Brentwood Associates VI, L.P.,
this threshold only applies to shares acquired after April 17, 1997 and if such
acquisition is not approved by the Board of Directors) or announces a tender or
exchange offer, the consummation of which would result in ownership by a person
or a group of 15.0% or more of the Company's Common Stock. Each Right has an
exercise price of $75.00 for each 1/1000th of a share of Series A Preferred.
The rights of the holders of the Company's Common Stock will be subject to,
and may be adversely affected by, the existence of the Rights and the rights of
the holders of any Preferred Stock that may be issued in the future. The Rights
and any future 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.
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 affect the market
price of the Company's Common Stock.
In October 1996, Steve Kim and Yuri Pikover, executive officers and members of
the Board of Directors of the Company, entered into a program of periodic sales
of shares of their Xylan Common Stock through a blind trust for the purpose of
diversifying their personal holdings. At the beginning of each calendar
quarter, Steve Kim and Yuri Pikover will deliver 125,000 and 55,000 shares,
respectively, to their blind trust for sale within the quarter, provided,
however, the amount of shares to be delivered by Mr. Kim will be reduced to
80,000 shares commencing with the second quarter of 1998. Furthermore, the
trust for Steve Kim's children will sell 25,000 shares and Yuri Pikover's trusts
will sell 20,000 shares within each quarter. 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.
21
<PAGE>
PART II -- OTHER INFORMATION
ITEM 1. Legal Proceedings
None.
ITEM 2. Changes in Securities and Use of Proceeds
None.
ITEM 3. Defaults Upon Senior Securities
None.
ITEM 4. Submission Of Matters To A Vote Of Security Holders
None.
ITEM 5. Other Information
None.
ITEM 6. Exhibits And Reports On Form 8-K
(a) Exhibits
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)
4.2 Preferred Shares Rights agreement dated as of April 17, 1997 between the
Registrant and the First National Bank of Boston, including Certificate
of Determination of Rights, Preferences and Privileges of Series A
Participating Preferred Stock, the Form of Rights Certificate and
Summary of rights attached thereto as Exhibits A,B and C,
respectively.(2)
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 amended 1996 Stock Plan.(4)
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)
22
<PAGE>
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.(3)
10.20 Dale Bartos Employment Agreement dated as of January 4, 1997.(3)
10.21 Form of 1998 Employee Stock Option Plan and related Agreements.(4)
10.22 Form of Change of Control Agreement.(4)
27.1 Financial Data Schedule (Current) 3 months ended Mar-31-1997.(5)
- ------------------
(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.
(2) Incorporated by reference to Exhibit 1 of the Registrant's Registration
Statement on Form 8-A filed with the Commission on August 24, 1997.
(3) Incorporated by reference to identically numbered exhibits filed in the
Company's Annual Report on Form 10-K filed on March 31, 1997.
(4) Incorporated by reference to identically numbered exhibits filed in the
Company's Annual Report on Form 10-K filed on March 31, 1998.
(5) Filed herewith.
(b) Reports on Form 8-K
23
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Act of 1934, the Registrant has
duly caused this report to be signed on its behalf by the undersigned, thereunto
duly authorized.
XYLAN CORPORATION
By: /s/ Dale J. Bartos
------------------------------------------
Date: May ___, 1998 Dale J. Bartos
Vice President and Chief Financial Officer
(Principal Financial Officer)
By: /s/ Thomas S. Burns
------------------------------------------
Thomas S. Burns
Vice President of Finance
(Chief Accounting Officer)
24
<PAGE>
INDEX TO EXHIBITS
Exhibit Description
- ------- -----------
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)
4.2 Preferred Shares Rights agreement dated as of April 17, 1997 between
the Registrant and the First National Bank of Boston, including
Certificate of Determination of Rights, Preferences and Privileges of
Series A Participating Preferred Stock, the Form of Rights Certificate
and Summary of rights attached thereto as Exhibits A,B and C,
respectively.(2)
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 amended 1996 Stock Plan.(4)
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.(3)
10.20 Dale Bartos Employment Agreement dated as of January 4, 1997.(3)
10.21 Form of 1998 Employee Stock Option Plan and related Agreements.(4)
10.22 Form of Change of Control Agreement.(4)
27.1 Financial Data Schedule (Current) 3 months ended Mar-31-1997.(5)
25
<PAGE>
_________
(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.
(2) Incorporated by reference to Exhibit 1 of the Registrant's Registration
Statement on Form 8-A filed with the Commission on August 24, 1997.
(3) Incorporated by reference to identically numbered exhibits filed in the
Company's Annual Report on Form 10-K filed on March 31, 1997.
(4) Incorporated by reference to identically numbered exhibits filed in the
Company's Annual Report on Form 10-K filed on March 31, 1998.
(5) Filed herewith.
26
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