<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 000-23698
APPLIED DIGITAL ACCESS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 68-0132939
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
9855 SCRANTON ROAD, SAN DIEGO, CALIFORNIA 92121
(Address of principal executive offices, zip code)
(619) 623-2200
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes [X] No [ ]
There were 12,832,197 shares of the registrant's Common Stock, $.001 par
value, outstanding as of October 31, 1998.
1
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APPLIED DIGITAL ACCESS, INC.
INDEX TO FORM 10-Q
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets at September 30, 1998
and December 31, 1997 . . . . . . . . . . . . . . . . . . . . . . 3
Condensed Consolidated Statements of Operations for the
three and nine months ended September 30, 1998 and
September 30, 1997. . . . . . . . . . . . . . . . . . . . . . . . 4
Condensed Consolidated Statements of Cash Flows for the nine
months ended September 30, 1998 and September 30, 1997. . . . . . 5
Notes to Condensed Consolidated Financial Statements. . . . . . . 6-7
Item 2. Management's Discussion and Analysis of Financial Condition
and Results of Operations . . . . . . . . . . . . . . . . . . . . 8-11
Risks and Uncertainties . . . . . . . . . . . . . . . . . . . . .11-18
Item 3. Quantitative and Qualitative Disclosures About Market Risk . . . 19
PART II. OTHER INFORMATION
Item 1. Legal Proceedings . . . . . . . . . . . . . . . . . . . . . . . . 20
Item 2. Changes in Securities . . . . . . . . . . . . . . . . . . . . . . 20
Item 3. Defaults Upon Senior Securities . . . . . . . . . . . . . . . . . 20
Item 4. Submission of Matters to a Vote of Security Holders. . . . . . . 20
Item 5. Other Information . . . . . . . . . . . . . . . . . . . . . . . . 20
Item 6. Exhibits and Reports on Form 8-K. . . . . . . . . . . . . . . . . 20
SIGNATURES. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21
2
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PART I
FINANCIAL INFORMATION
Item 1. FINANCIAL STATEMENTS
APPLIED DIGITAL ACCESS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(Unaudited)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------- ------------
(DOLLARS IN THOUSANDS)
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 5,604 $ 4,400
Investments 6,544 8,779
Accounts receivable, net 5,746 12,981
Inventory, net 7,884 5,859
Deferred income taxes 130 130
Prepaid expenses and other current assets 1,825 3,775
------------- ------------
Total current assets 27,733 35,924
Property and equipment, net 5,921 6,165
Deferred income taxes 1,426 1,372
Other, net 1,500 2,822
------------- ------------
$ 36,580 $ 46,283
------------- ------------
------------- ------------
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 4,899 $ 3,478
Acquisition payments due to licensor -- 867
Accrued expenses 1,489 1,997
Accrued warranty 1,288 1,323
Deferred revenue 2,188 1,471
------------- ------------
Total current liabilities 9,864 9,136
Obligations under capital leases, net of
current portion 0 15
------------- ------------
Total liabilities 9,864 9,151
------------- ------------
Shareholders' equity:
Preferred stock, $.001 par value, 7,500,000
shares authorized, no shares issued -- --
Common stock, $.001 par value, 30,000,000
shares authorized, 12,825,992 and
12,605,082 shares issued and outstanding
at September 30, 1998 and
December 31, 1997, respectively 52,215 51,610
Additional paid-in capital 2,519 2,492
Unrealized gain on investments 70 84
Accumulated deficit (28,088) (17,054)
------------- ------------
Total shareholders' equity 26,716 37,132
------------- ------------
$ 36,580 $ 46,283
------------- ------------
------------- ------------
</TABLE>
The accompanying notes are an integral part of the
condensed consolidated financial statements.
3
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APPLIED DIGITAL ACCESS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
<TABLE>
<CAPTION>
FOR THE THREE MONTHS FOR THE NINE MONTHS
ENDED SEPTEMBER 30, ENDED SEPTEMBER 30,
------------------------ ------------------------
1998 1997 1998 1997
----------- ---------- ----------- ----------
(AMOUNTS IN THOUSANDS, (AMOUNTS IN THOUSANDS,
EXCEPT PER SHARE AMOUNTS) EXCEPT PER SHARE AMOUNTS)
<S> <C> <C> <C> <C>
Revenue $6,764 $8,750 $20,616 $23,302
Cost of revenue 2,747 3,873 10,152 10,795
----------- ---------- ----------- ----------
Gross profit 4,017 4,877 10,464 12,507
Operating expenses:
Research and
development 3,583 1,963 10,904 6,498
In-process research
and development
related to asset
acquisition -- -- -- 1,578
Sales and marketing 2,458 2,230 7,289 5,590
General and
administrative 1,258 1,379 3,672 3,816
----------- ---------- ----------- ----------
Total operating expenses 7,299 5,572 21,865 17,482
----------- ---------- ----------- ----------
Operating loss (3,282) (695) (11,401) (4,975)
Interest income 165 236 508 746
Other income (expense),
net (14) (24) (31) (13)
----------- ---------- ----------- ----------
Loss before income taxes (3,131) (483) (10,924) (4,242)
Provision for income
taxes 37 43 110 107
----------- ---------- ----------- ----------
Net loss $(3,168) $(526) $(11,034) $(4,349)
----------- ---------- ----------- ----------
----------- ---------- ----------- ----------
Net loss per share $(0.25) $(0.04) $(0.87) $(0.35)
----------- ---------- ----------- ----------
----------- ---------- ----------- ----------
Number of shares used in
per share computations 12,712 12,512 12,671 12,425
Comprehensive loss $(3,171) $(509) $(11,049) $(4,318)
----------- ---------- ----------- ----------
----------- ---------- ----------- ----------
</TABLE>
The accompanying notes are an integral part of the
condensed consolidated financial statements.
4
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APPLIED DIGITAL ACCESS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)
<TABLE>
<CAPTION>
FOR THE NINE MONTHS
ENDED SEPTEMBER 30,
-------------------
1998 1997
------- -----
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Cash flows from operating activities:
Net loss $(11,034) $(4,349)
Adjustments to reconcile net loss to net
cash provided (used) by operating
activities:
In-process research and development
related to asset acquisition -- 1,578
Depreciation and amortization 2,706 2,167
Other (88) 87
Changes in assets and liabilities:
Accounts receivable 7,235 (2,961)
Inventory (2,025) (808)
Prepaid expenses and other current assets 1,950 (1,726)
Deferred income taxes (54) --
Accounts payable 1,421 537
Acquisition payments due licensor (867) 1,733
Accrued expenses (652) 137
Accrued warranty (34) 51
Deferred revenue 867 (157)
-------- --------
Net cash used by operating activities (575) (3,711)
-------- -------
Cash flows from investing activities:
Purchases of investments (10,901) (12,716)
Maturities of investments 13,210 20,743
Purchases of property and equipment (1,641) (1,475)
Purchase costs related to asset acquisitions 500 (3,383)
-------- -------
Net cash provided (used) by investing
activities 1,168 3,169
-------- -------
Cash flows from financing activities:
Principal payments on capital leases (21) (12)
Proceeds from the issuance of common
stock under stock option plans 632 708
-------- -------
Net cash provided by financing
activities 611 696
-------- -------
Net increase (decrease) in cash and cash
equivalents 1,204 154
Cash and cash equivalents, beginning of
period 4,400 1,504
-------- -------
Cash and cash equivalents, end of period $ 5,604 $ 1,658
-------- -------
-------- -------
</TABLE>
The accompanying notes are an integral part of the
condensed consolidated financial statements.
5
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APPLIED DIGITAL ACCESS, INC.
Notes to Condensed Consolidated Financial Statements
September 30, 1998
(Unaudited)
1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements
include the accounts of Applied Digital Access, Inc. (the "Company" or
"ADA") and its wholly owned subsidiary: Applied Digital Access - Canada, Inc.
All significant intercompany balances and transactions have been eliminated
in consolidation. These financial statements have been prepared in accordance
with the interim reporting requirements of Form 10-Q, pursuant to the rules
and regulations of the Securities and Exchange Commission ("SEC").
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, all adjustments (consisting of only normal
recurring adjustments) considered necessary for a fair presentation have been
included. Operating results for the three and nine month periods ended
September 30, 1998 are not necessarily indicative of the results that may be
expected for the year ending December 31, 1998. These financial statements
should be read in conjunction with the Company's audited financial statements
and notes thereto, together with Management's Discussion and Analysis of
Financial Condition and Results of Operations, and Risks and Uncertainties,
contained in the Company's Annual Report on Form 10-K for the fiscal year
ended December 31, 1997 filed with the SEC.
2. New Accounting Pronouncements
The Company has adopted the provisions of Statement of Financial Accounting
Standards No. 130, "Reporting of Comprehensive Income," effective January 1,
1998. This statement requires the disclosure of comprehensive income and its
components in a full set of general-purpose financial statements.
Comprehensive income is defined as net income plus revenues, expenses,
gains and losses that, under generally accepted accounting principles, are
excluded from net income. The components of comprehensive income, which are
excluded from net income are foreign currency gains/losses and unrealized
gains/losses on securities and have been included in the calculation of
comprehensive income.
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131, "Disclosures about Segments of an
Enterprise and Related Information" ("SFAS 131"), which supersedes Statement
of Financial Accounting Standards, "Financial Reporting of Segments of a
Business Enterprise" ("SFAS 14"). SFAS 131 changes current practice under
SFAS 14 by establishing a new framework on which to base segment reporting
and also requires interim reporting of segments information. This statement
is effective for fiscal years beginning after December 15, 1997. This
statement's interim reporting disclosures are not required until the first
quarter immediately subsequent to the fiscal year in which SFAS 131 is
effective.
3. Inventory
Inventory is valued at the lower of cost (determined using the first-in,
first-out method) or market. Inventory was as follows:
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------- ------------
(DOLLARS IN THOUSANDS)
<S> <C> <C>
Raw materials $ 4,574 $ 3,419
Work-in-process 2,881 2,223
Finished goods 913 787
------------- ------------
8,368 6,429
Less inventory reserve (484) (570)
------------- ------------
$ 7,884 $ 5,859
------------- ------------
------------- ------------
</TABLE>
6
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4. Per Share Information
The Company has adopted the provisions of Statement of Financial Accounting
Standards No. 128, "Earnings per Share" ("SFAS 128"), effective December 31,
1997. SFAS 128 requires the presentation of basic and diluted earnings per
share. Basic EPS is computed by dividing income available to common
stockholders by the weighted average number of common shares outstanding for
the period. Diluted EPS is computed giving effect to all dilutive potential
common shares that were outstanding during the period. Dilutive potential
common shares consist of the incremental common shares issuable upon the
conversion of convertible preferred stock (using the "if converted") method
and exercise of stock options and warrants for all periods. All prior period
earnings per share amounts have been restated to comply with SFAS 128.
In accordance with the disclosure requirements of SFAS 128, a reconciliation
of the numerator and denominator of basic and diluted EPS is provided as
follows (dollars in thousands, except per share amounts).
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
------------------ -------------------
Sept. 30, Sept. 30,
1998 1997 1998 1997
-------- -------- -------- -------
<S> <C> <C> <C> <C>
Numerator - basic and diluted
EPS:
Net loss $(3,168) $ (526) $(11,034) $(4,349)
Denominator - basic and diluted
EPS:
Weighted average common
stock outstanding 12,712 12,512 12,671 12,425
Basic and diluted earnings per $ (0.25) $ (0.04) $ (0.87) $( 0.35)
share
</TABLE>
7
<PAGE>
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THE STATEMENTS CONTAINED IN THIS FORM 10-Q THAT ARE NOT PURELY HISTORICAL ARE
FORWARD LOOKING STATEMENTS. STATEMENTS WHICH USE THE WORDS " SEEK," "INTEND,"
"WILL," "ANTICIPATE," "CAN," "MAY," "CONTINUE," AND "EXPECT" ARE FORWARD
LOOKING STATEMENTS. THESE FORWARD LOOKING STATEMENTS, INCLUDING STATEMENTS
REGARDING THE COMPANY'S (I) PLANS FOR DEVELOPMENT OR ACQUISITION OF NEW
PRODUCTS OR ENHANCEMENT OF EXISTING PRODUCTS, (II) STRATEGY AND (III)
EXPANDED SALES AND MARKETING EFFORTS, ARE BASED ON INFORMATION AVAILABLE TO
THE COMPANY AS OF THE DATE HEREOF. THE COMPANY ASSUMES NO OBLIGATION TO
UPDATE ANY SUCH FORWARD LOOKING STATEMENT. IT IS IMPORTANT TO NOTE THAT THE
COMPANY'S ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE IN SUCH FORWARD
LOOKING STATEMENTS. AMONG THE FACTORS THAT COULD CAUSE ACTUAL RESULTS TO
DIFFER MATERIALLY ARE THE FACTORS SET FORTH BELOW UNDER THE HEADING "RISKS
AND UNCERTAINTIES."
The following should be read in conjunction with "Management's Discussion and
Analysis of Financial Condition and Results of Operations" and "Risks and
Uncertainties", contained in the Company's Annual Report on Form 10-K for the
fiscal year ended December 31, 1997 filed with the Securities and Exchange
Commission.
OVERVIEW
ADA is a leading provider of network performance management products that
include systems, software, and services used to manage the quality,
performance, availability and reliability of telecommunications service
providers' ("TSP") networks. ADA's products are designed to enable TSPs to
improve their quality of service, to increase productivity, to lower
operating expenses and to effectively deploy new services. ADA has
positioned its business to assist TSPs in addressing the rapidly increasing
demand for new services, higher bandwidth and access to the Internet. ADA's
systems and software provide network management functions such as service
activation and circuit provisioning, network configuration management,
network performance management, circuit and facilities testing, and traffic
management of the public switched network. ADA has addressed the industry
demand for network management products with a three-faceted approach: (1)
network systems that provide testing and performance monitoring functions as
well as selected transport functions; (2) network management software that
enables TSPs to manage their network operations; and (3) services that are
customized to meet the evolving needs of the Company's TSP market. The
Company has two business units: the Network Systems business unit and the
Network Management business unit. The business units are the result of the
evolution of the Company from a single product line to multiple product
lines. The Network Systems business unit is built around the Company's test
and performance management products and services, including its T3AS Test
and Performance Monitoring System ("T3AS"), Centralized Test System ("CTS"),
Remote Module, a DS1 network interface unit ("NIU"), and Protocol Analysis
Access System ("PAAS"). The Network Management business unit focuses on
Operations Systems ("OS") software products and services, including
.Provisioner, Test OS, Graphical Test Assistant ("GTA"), Sectionalizer, Fault
Management System ("FMS"), Traffic Data Collection and Engineering System
("TDC&E"), and OS design services.
RESULTS OF OPERATIONS
Revenue totaled $6,764,000 for the three months ended September 30, 1998, a
23% decrease from revenue of $8,750,000 for the three months ended September
30, 1997. The decrease for the quarter was primarily the result of decreased
sales of the Company's network management OS software products. Revenue
from network management OS software products and services for the three
months ended September 30, 1998 totaled $3,628,000, a 34% decrease from
$5,534,000 in the same period last year. The decrease resulted from
decreased sales of the Company's Test OS, .Provisioner and FMS software
products partially offset by increased sales of the Company's TDC&E software
product.
8
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Revenue from the Company's network systems test and performance management
products for the three months ended September 30, 1998 totaled $3,136,000, a
2% decrease from $3,216,000 in the same period last year. The decrease was
the net result of decreased sales of the Company's Remote Module product
offset by increased sales of the Company's T3AS and CTS products. The Company
believes revenue for the third quarter of 1998 was negatively impacted by
decreased spending by the Company's customers due to merger activity, capital
spending constraints, order delays for the Company's Remote Module product
due to customer inventory reductions and tightening of inventory control
procedures, and to a lesser extent, order delays resulting from the impact of
short strikes and strike preparations at two of the Company's customers at
the beginning of the quarter. In addition, revenue for the third quarter was
negatively impacted by delays in the completion of an OS software
installation at one of the Company's customers. The Company recognizes
revenue from sales of its OS software products only upon satisfaction of the
customer's specific delivery and acceptance criteria. In any period,
significant revenue may be derived from a small number of large OS software
product sales and, as a result of various customer delivery and acceptance
criteria, the Company may experience fluctuations in quarterly revenue. As a
result of the factors discussed above, the Company has experienced and may in
the future continue to experience quarterly revenue fluctuations that could
have a material adverse effect on the Company's business, operating results
and financial condition. See "Risks and Uncertainties--Fluctuations in
Quarterly Operating Results; History of Losses".
Revenue for the nine months ended September 30, 1998 totaled $20,616,000, a
12% decrease from $23,302,000 in the same period last year. The decrease for
the nine months ended September 30, 1998 resulted from a net decrease in
revenue from the Company's network management OS software design services and
products partially offset by a net increase in sales from the Company's
network systems test and performance management products. Revenue from the
Company's network systems test and performance management products for the
nine months ended September 30, 1998 totaled $11,266,000, an 8% increase from
$10,405,000 in the same period last year. The majority of the increase
resulted from increased sales of the Company's Remote Module product
partially offset by decreased sales of the Company's CTS products. Revenue
from network management OS software products and services for the nine months
ended September 30, 1998 totaled $9,350,000, a 28% decrease from $12,897,000
in the same period last year. The majority of the decrease was the result of
decreased sales of the Company's OS design services to Northern Telecom, Ltd.
("Northern Telecom") and decreased sales of the Company's Test OS software
product partially offset by increased sales of the Company's TDC&E and
.Provisioner software products. The decreased revenue from OS design
services and increased sales of the Company's .Provisioner product resulted
from the Company's acquisition of an exclusive license to Northern Telecom's
DSS II software product in June 1997. Prior to the acquisition, the Company
provided OS design services to Northern Telecom that supported the DSS II
product. As a result of the acquisition, the Company's OS design services
business supporting DSS II shifted to a product-based business. The Company
now markets and supports the DSS II product and technology under the new name
.Provisioner. Unlike revenue from OS software design services which is
recognized as the service is performed, revenue from OS software product
sales requires the satisfaction of specific delivery and acceptance criteria
prior to revenue recognition. The Company believes the same factors that
negatively impacted revenue for the three months ended September 30, 1998
also negatively impacted revenue for the nine months ended September 30,
1998. There can be no assurances that the factors discussed above will not
continue in the future, or that revenue increases that occurred for
individual products during the three and nine months ended September 30, 1998
will continue in the future, each of which could have a material adverse
effect on the Company's business, operating results and financial condition.
See "Risks and Uncertainties -- Fluctuations in Quarterly Operating Results;
History of Losses", "--Customer Mergers" and "--Concentration of Major
Customers; Telephone Company Qualification Requirements."
Gross profit totaled $4,017,000 for the three months ended September 30,
1998, an 18% decrease from $4,877,000 in the same period last year. The
decrease in gross profit was the result of lower revenue levels. Gross profit
as a percent of revenue was 59% for the three months ended September 30, 1998
compared to 56% for the three months ended September 30, 1997. The increase
in gross profit as a percent of revenue was primarily the result of a product
mix weighted towards T3AS and CTS products combined with decreased sales of
the Company's Remote Module NIU products partially offset by lower overall
sales of the Company's network management OS software products. Generally,
the Company's T3AS and CTS products have a higher gross profit margin than
NIU products. The highly competitive NIU market is subject to severe pricing
pressures which have contributed to significantly lower overall gross profits
on this product.
Gross profit totaled $10,464,000 for the nine months ended September 30,
1998, a 16% decrease from $12,507,000 in the same period last year. Gross
profit as a percent of revenue was 51% for the nine months ended September
30, 1998 compared to 54% in the same period last year. The decrease in gross
profit was the result of a product mix weighted toward the Company's
lower-margin Remote Module NIU, decreased revenue and the impact of a
$378,000 one-time inventory obsolescence charge in the first quarter of 1998.
The Company's relatively fixed manufacturing overhead costs allocated over
lower revenue levels in the first nine months of 1998 resulted in lower
overall gross profit levels. The net decrease in gross profit as a percent
of revenue resulted from the factors discussed above substantially offset by
the shift in the Company's OS software design services business to an OS
software product-based business. As a result of the .Provisioner (formerly
DSS II) license acquisition, a majority of engineering labor previously
associated with OS design services revenue shifted from the cost of revenue
line to research and development operating expenses supporting OS software
product development. There can be no assurance that the Company will be able
to maintain current gross profit or gross profit as a percent of revenue
levels. Factors which may materially and adversely affect the Company's gross
9
<PAGE>
profit in the future include its level of revenue, competitive pricing
pressure in the telecommunication network management market, fluctuations in
quarterly order bookings and revenue, new product introductions by the
Company or its competitors, potential inventory obsolescence and scrap,
possible recalls, production or quality problems, timing of development
expenditures, changes in material cost, disruptions in sources of supply,
regulatory changes, capital spending, and changes in general economic
conditions.
Research and development expenses totaled $3,583,000 for the three months
ended September 30, 1998, an 83% increase from $1,963,000 for the three
months ended September 30, 1997. Research and development expenses totaled
$10,904,000 for the nine months ended September 30, 1998, a 68% increase from
$6,498,000 for the nine months ended September 30, 1997. The majority of the
increase for the three and nine months ended September 30, 1998 was due to
the shift in engineering labor from cost of revenue to research and
development operating expenses as a result of the .Provisioner license
acquisition discussed above in the gross profit analysis, the addition of
research and development personnel to support the Joint Development Agreement
("JDA") with Northern Telecom Inc. ("Nortel") and increased non-recurring
engineering expenses related to the JDA and other product developments. In
September 1997, the Company entered into the JDA with Nortel to develop
unique synchronous optical network ("SONET") products for the
telecommunications industry. Nortel and ADA both contribute technology and
development resources to projects conducted under the JDA and equally share
the development costs. For the three and nine months ended September 30,
1998, the Company's research and development expenses include a $1.1 million
and $2.8 million reduction, respectively, representing Nortel's proportionate
share of development costs incurred under the initial project being conducted
under the JDA, compared to an offset of $1.0 million for the three and nine
months ended September 30, 1997. The Company believes that its future
success depends on its ability to maintain its technological leadership
through enhancement of its existing products and development of innovative
new products and services that meet customer needs. Therefore, the Company
intends to continue to make significant investments in research and product
development in association with planned development projects.
In the nine months ended September 30, 1997 the Company recorded a charge of
approximately $1.6 million for purchased research and development costs
related to the acquisition of the .Provisioner license and related assets
from Northern Telecom.
Sales and marketing expenses totaled $2,458,000 for the three months ended
September 30, 1998, a 10% increase from $2,230,000 for the three months ended
September 30, 1997. Sales and marketing expenses totaled $7,289,000 for the
nine months ended September 30, 1998, a 30% increase from $5,590,000 for the
nine months ended September 30, 1997. The majority of the increases for the
three and nine months is the result of increased staff in sales to support
increased sales efforts and new customer accounts and increased personnel
costs in technical support and marketing to support the shift of a majority
of the Company's OS design services business to an OS software product-based
business. The Company expects that sales and marketing expenses will
continue to increase in absolute dollars as the Company continues to hire
additional sales, marketing and technical support personnel to support both
current products and planned product introductions.
General and administrative expenses totaled $1,258,000 for the three months
ended September 30, 1998, a 9% decrease from $1,379,000 for the three months
ended September 30, 1997. General and administrative expenses totaled
$3,672,000 for the nine months ended September 30, 1998, a 4% decrease from
$3,816,000 for the nine months ended September 30, 1997. The majority of the
decrease for the three months ended September 30, 1998 resulted from lower
corporate expenses. The majority of the decrease for the nine months ended
September 30, 1998 resulted from lower consulting and recruiting costs offset
by increased expenses for the amortization of intangible assets and legal
expenses. The Company expects that general and administrative expenses may
increase in absolute dollars in the future as the Company expands its
internal networking capabilities to support the integration of its
geographically distributed organization.
Interest income totaled $165,000 for the three months ended September 30,
1998, a 30% decrease from $236,000 in the same quarter a year ago. Interest
income totaled $508,000 for the nine months ended September 30, 1998, a 32%
decrease from $746,000 for the nine months ended September 30, 1997. The
decreases resulted from decreased levels of cash investments compared to the
same periods last year.
10
<PAGE>
For the three and nine months ended September 30, 1998 and September 30,
1997, the Company provided for income taxes related to the operations of the
Company's Canadian subsidiary, based on an annual effective Canadian tax rate
of 46%. The Company did not provide for U.S. income taxes for the three or
nine months ended September 30, 1998 or September 30, 1997 due to net losses.
The Company expects to provide for foreign, federal and state income taxes
for 1998 at applicable statutory rates, after giving effect to net operating
losses, remaining available net operating loss carryforwards, and any
available tax credits.
As a result of the factors discussed above, the Company incurred a net loss
of $3,168,000, or $.25 per basic and diluted share, for the three months
ended September 30, 1998 compared to a net loss of $526,000, or $.04 per
basic and diluted share, for the three months ended September 30, 1997.
The Company incurred a net loss of $11,034,000, or $.87 per basic and diluted
share, for the nine months ended September 30, 1998 compared to a net loss of
$4,349,000, or $.35 per basic and diluted share, for the nine months ended
September 30, 1997. Excluding the above referenced $1.6 million charge for
purchased research and development associated with the .Provisioner license
acquisition, the Company would have incurred a net loss of $2,771,000 or
$.22 per share, for the nine months ended September 30, 1997.
LIQUIDITY AND CAPITAL RESOURCES
At September 30, 1998 the Company had approximately $12,148,000 in cash, cash
equivalents and investments, compared to $13,179,000 at December 31, 1997, a
decrease of $1,031,000. The decrease in cash, cash equivalents and
investments was primarily the result of net operating losses and, to a lesser
extent, purchases of capital equipment.
Working capital totaled $17,869,000 at September 30, 1998, a decrease of
$8,919,000 from $26,788,000 at December 31, 1997. The decrease in working
capital was primarily the result of net operating losses, decreased accounts
receivable and other current assets as well as an increase in accounts
payable and other current liabilities.
For the nine months ended September 30, 1998 the Company's operating
activities used $575,000 in cash, primarily the result of net operating
losses offset by decreased accounts receivable and other current assets and
increased accounts payable compared to the use of $3,711,000 in cash for the
nine months ended September 30, 1997.
For the nine months ended September 30, 1998 cash used for capital
expenditures totaled approximately $1,641,000. Most of the capital equipment
additions were for software tool kits, computer workstations and lab
equipment related to the Company's expanded research and development
efforts and tenant improvements for the Company's Richardson, Texas office.
The Company expects the level of capital expenditures will increase in 1998
and 1999 as a result of investments in research and development projects.
Assuming no material changes in the Company's current operating plans, the
Company believes that cash generated from operations, and the total of its
cash and investments, will be sufficient to meet its working capital and
capital expenditure requirements for at least the next twelve months.
However, there can be no assurance that the Company will not need to seek
additional capital resources to meet working capital and capital expenditure
requirements. Additionally, significant additional capital resources may be
required to fund acquisitions of complementary businesses, products or
technologies. The Company may need to issue additional shares of its capital
stock or incur indebtedness in connection with any such acquisitions or
future operations. At present, the Company does not have any agreements or
commitments with respect to any such acquisitions.
The Company believes the impact of inflation on its business activities has
not been significant to date.
RISKS AND UNCERTAINTIES
FLUCTUATIONS IN QUARTERLY OPERATING RESULTS; HISTORY OF LOSSES. The Company
has experienced significant fluctuations in bookings, revenue and operating
results from quarter to quarter due to a combination of factors and expects
such fluctuations to continue in future periods. Factors that may cause the
Company's results of operations to vary significantly from quarter to quarter
include but are not limited to the size and timing of customer orders and
subsequent shipment of systems products and implementation of OS software
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products to major customers, timing and market acceptance of product
introductions or enhancements by the Company or its competitors, customer
order deferrals in anticipation of new products, technological changes in the
telecommunications industry, competitive pricing pressures, changes in the
Company's operating expenses, personnel changes, management of a changing
business, changes in the mix of products sold and licensed, disruption in
sources of supply, changes in pricing policies by the Company's suppliers,
regulatory changes, capital spending, delays of payments by customers and
general economic conditions. The Company believes that in late 1997 it began
experiencing seasonality in its product shipments and OS software licensing.
Generally, TSPs placed more orders for products and licenses in the second and
fourth quarters, with the orders significantly down in the first quarter and
relatively flat in the third quarter of each year. The Company expects that
revenue may begin to reflect these seasonal order cycles more closely, which
could result in quarterly fluctuations. There can be no assurance that the
TSPs will not defer or delay orders contrary to the historical seasonal
pattern or that they will not change their ordering patterns. Because of the
relatively fixed nature of most of the Company's costs, including personnel
and facilities costs, any unanticipated shortfall in revenue in any fiscal
quarter would have a proportionately greater impact on the Company's
operating income in that quarter and may result in fluctuations in the price
of the Company's Common Stock.
As the impact of the Company's Network Management business unit on the
Company's revenue increases, the Company may be faced with greater
fluctuations in operating income. The licensing and implementation of the
Company's OS products generally involves a significant capital expenditure
and a commitment of resources by prospective customers. Accordingly, the
Company is dependent on its customers' decisions as to the timing and level
of commitment and expenditures. In addition, the Company typically realizes a
significant portion of license revenues in the last weeks or even days of a
quarter. As a result, the magnitude of quarterly fluctuations in the Network
Management business unit may not become evident until late in, or after the
close of, a particular quarter. In addition, the Company does not recognize
service revenues until the services are rendered. The time required to
implement the Company's OS products can vary significantly with the needs of
its customers and is generally a process that extends for several months.
Because of their complexity, larger implementations may take multiple
quarters to complete. Additionally, quarter-to-quarter product mix
variations, customer orders tending to be placed late in the quarter, and
competitive pressures on pricing could have a materially adverse effect on
the Company's operating results in any one quarter. The Company's expenses
are based in part on the Company's expectations as to future revenues and to
a large extent are fixed in the short term. If revenues do not meet
expectations, the Company's business, operations and financial condition are
likely to be materially adversely affected. The Company has experienced
losses in the past and there can be no assurance that the Company will not
experience losses in the future.
COMPETITION. Competition in the Company's markets is intense and is
characterized by rapidly changing technologies, conformance with evolving
industry standards, frequent new product introductions and enhancements,
rapid changes in customer requirements, and price-competitive bidding. To
maintain and improve its competitive position, the Company must continue to
develop and introduce, in a timely and cost-effective manner, new products
and features that keep pace with increasing customer requirements. The
Company expects competition in its markets to increase from existing
competitors and from other companies which may enter the Company's current or
future markets. The Company believes the principal competitive factors
affecting the market for its network systems test and performance monitoring
products are product features, price, conformance with BellCore and other
industry transmission standards and specifications, performance and
reliability, technical support, and the maintenance of close working
relationships with customers. The Company's network systems products,
especially CTS and Remote Module, are currently focused in highly competitive
market niches. The environment for CTS and Remote Module is fiercely
competitive with respect to price, product features, established
customer-supplier relationships and conformance with industry standards. The
Company believes the current competitors that provide partial solutions to
either performance monitoring or testing of the DS3, and the DS1 and DS0
circuits that make up the DS3 circuit, include Hekimian Laboratories, Inc.,
Telecommunications Techniques Corporation, Anritsu Wiltron Corporation and
some of the manufacturers of large transmission equipment and digital
cross-connect test and performance monitoring equipment such as Lucent
Technologies, Inc. ("Lucent"), Alcatel Data Networks, Ericsson Communication
Inc. ("Ericsson"), ADC Telecommunications, and Tellabs, Inc. The Company's
Remote Module product addresses the DS1 NIU market in which current
competitors include Westell Inc., Teltrend Inc., and Troncom, Inc. Many of
these competitors have significantly greater technical, financial,
manufacturing, and marketing resources than the Company. In addition, in
1997, ANSI adopted certain of the Company's technology
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as an industry standard. As a result, the Company is obligated to grant
licenses of this technology to third parties, including competitors, on fair
and equitable terms and thus, also faces competition from the licensees of
its own technology.
The Company believes there are an increasing number of current competitors in
the network management OS market that provide network management OS
applications for circuit and services provisioning and services management,
testing and test management, fault and alarm management and surveillance,
network and circuit performance monitoring and traffic management
telecommunications functions. The OS market is characterized by a wide range
of companies that have varying degrees of market influence. The nature of the
network management OS market is such that improved technologies and tool sets
have made the barriers to entry in this market relatively small resulting in
fierce competition. The principal competitive factors affecting the Company's
network management OS products include product quality, performance, price,
customer support, corporate reputation, and product features such as
scalability, interoperability, functionality and ease of use. The Company's
existing and potential competitors offer a variety of solutions to address
network management needs. Competitors include suppliers of standard
off-the-shelf products, custom software developers, large telecommunications
equipment vendors that offer software applications to manage their own and
other suppliers' equipment, such as Lucent, Northern Telecom, Inc., Fujitsu,
and Ericsson, hardware and software vendors, including IBM, Sun Microsystems
and Hewlett Packard, and providers of specific network management and OS
applications, such as BellCore, Objective Systems Integrators, Inc., TCSI
Corporation, Architel Systems Corporation and others. Additionally, many of
the Company's existing and potential customers continuously evaluate whether
they should develop their own network management and OS applications or
license them from outside vendors. The Company expects competition in the OS
market to increase significantly in the future. Additionally, several of the
Company's competitors have long-established relationships with the Company's
current and prospective customers which may adversely affect the Company's
ability to successfully compete for business with these customers. In
addition, product price reductions resulting from market share penetration
initiatives or competitive pricing pressures could have a material and
adverse effect on the Company's business, operating results, and financial
condition. There can be no assurance that the Company will have the financial
resources, technical expertise or manufacturing, marketing, distribution and
support capabilities to compete successfully in the future.
CONCENTRATION OF MAJOR CUSTOMERS; TELEPHONE COMPANY QUALIFICATION REQUIREMENTS.
The market for the Company's products and services currently consists of the
five regional Bell operating companies ("RBOCs"), long distance or
"interexchange carriers" ("IXCs"), local exchange carriers ("LECs"),
competitive local exchange carriers ("CLECs"), competitive access providers
("CAPs"), Internet service providers ("ISPs"), enterprise networks and other
TSPs. Historically, the Company's marketing efforts focused primarily on the
RBOCs, which accounted for approximately 99%, 73%, 31%, and 46% of the
Company's total revenue in 1995, 1996, 1997, and the first nine months of
1998, respectively. However, the Company's strategy has been to focus its
efforts on diversifying its customer base. RBOCs, IXCs and enterprise
customers accounted for 31%, 27% and 20% of the Company's total revenue in
1997, and 46%, 31% and 0% of the Company's total revenue for the first nine
months of 1998. The increased customer base is primarily a function of the
Company's acquisitions in 1996 of Applied Computing Devices, Inc. ("ACD")
and the Special Services Network ("SSN") division of MPR Teltech Inc. and
the acquisition of the DSS II license from Northern Telecom in 1997. As a
result of these acquisitions, the Company added OS related products and
services that the Company has been able to market to a wider group of
customers. In addition, the Company added a number of TSPs that were new
customers to the Company. To date, the OS customers tend to be IXCs, CAPs
and enterprise vendors who have not invested in legacy systems from BellCore.
While the Company believes its customer base diversification is beneficial to
the Company, there can be no assurances that the Company will be able to
continue expanding the distribution of its OS and system products and
services to additional prospective customers. In addition, the Company's
customers are significantly larger than the Company and may be able to exert
a high degree of influence over the Company. The loss of one or more of the
Company's major customers, the reduction of orders, a delay in deployment of
the Company's products, a labor strike at one or more of the Company's major
customers, such as the recent Bell Atlantic and US West strikes, or the
cancellation, modification or non-renewal of license or maintenance
agreements could materially and adversely affect the Company's business,
operating results and financial condition. BellSouth, Bell Atlantic,
Ameritech, Southwestern Bell and MCI have entered into purchase contracts
with the Company. MCI has also entered into license agreements with the
Company. Other TSPs purchase the Company's network system products and
license OS products under standard purchase orders. Since the RBOC and MCI
contracts may be
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terminated at either the customer's or the Company's convenience, the
Company believes that the purchase contracts and license agreements are not
materially different than purchasing or licensing under purchase orders.
Prior to selling products to RBOCs and certain other TSPs, a vendor must
often first undergo a product qualification process with the TSP for its
products. Although the qualification process for a new product varies
somewhat among these prospective customers, the Company's experience is that
the process often takes a year or more. Currently, the five RBOCs, MCI,
Worldcomm and several other customers have qualified the Company's products,
when required. Any failure on the part of any of the Company's customers to
maintain their qualification of the Company's products, failure of any of the
TSPs to deploy the Company's products, or any attempt by any of the TSPs to
seek out alternative suppliers could have a material adverse effect on the
Company's business, operating results and financial condition. There can be
no assurance that the Company's products will be qualified by new customers,
or that such qualification will not be significantly delayed. Furthermore,
work force reductions and staff reassignments by some of the Company's
customers have in the past delayed the product qualification process, and the
Company expects such reductions and reassignments to continue in the future.
There can be no assurance that such reductions and reassignments will not
have a material adverse effect on the Company's business, operating results
and financial condition.
HIGH DEPENDENCE ON TWO PRODUCT LINES. Historically, the majority of the
Company's revenue has been derived from the sale of its network systems
products and services. However, as a result of acquisitions completed in 1996
and 1997, the Company added additional product lines and derived revenue from
a product mix of both network systems products and services and network
management OS software products and services. Revenue from network systems
products and services, including CTS, T3AS and Remote Module, generated 74%,
50% and 55% of the Company's total revenues in 1996, 1997 and first nine
months of 1998, respectively. Revenue from network management OS products and
services, including software design services, .Provisioner, Test OS, TDC&E
and FMS, generated 26%, 50% and 45% of the Company's total revenue in 1996,
1997 and first nine months of 1998, respectively. However, there can be no
assurance that the Company's future revenues will not be heavily dependent on
sales from one of its primary product lines. The Company is investing in the
expansion of these two product lines through the enhancement, development and
marketing of its Remote Module, CTS, PAAS, T3AS and OS products and through
new product development. Failure by the Company to enhance either its
existing products and services or to develop new product lines and new
markets could materially and adversely affect the Company's business,
operating results and financial condition. There is no assurance that the
Company will be able to develop and market new products and technology or
otherwise diversify its source of revenue.
MANAGEMENT OF CHANGING BUSINESS. As a result of acquisitions in 1996, the
Company obtained additional office space and hired additional personnel in
both Terre Haute, Indiana and British Columbia, Canada to support the
business operations of the new products, services and technologies acquired.
The Company continues to face significant management challenges related to
the integration of the business operations of the new organizations'
personnel, products, services and technologies acquired. In 1996, the Company
formed two business units: the Network Systems business unit and the Network
Management business unit. The business units are a result of the evolution of
the Company from a single product line to multiple product lines. The Network
Management business unit focuses on OS software products including
.Provisioner, Test OS, GTA, Sectionalizer, FMS, TDC&E, and OS design
services. The Network Systems business unit is built around the Company's
test and performance management products, including T3AS, CTS, Remote Module
and PAAS products. There can be no assurance that the Company will be
successful in managing its new business unit structure. In June 1997, the
Company acquired a license from Northern Telecom to its DSS II software
product and technology. The Company markets and supports the DSS II product
and technology under the new name .Provisioner. The Company is integrating
the licensed technology into new product development. The acquisition of the
software license has generated a shift in the Company's Canadian subsidiary's
operations from a software design services business to a product business and
the transition will likely place a significant strain on the Company's
management, information systems and operations and there can be no assurance
that such a transition can be successfully managed. In addition, in November
1997, the Company opened an office in Richardson, Texas to expand new product
development efforts. The acquisitions and resultant growth in the Company's
infrastructure have placed, and are expected to continue to place, a
significant strain on the Company's management, information systems and
operations. The strain experienced to date has chiefly been in management of
a geographically distributed organization, and in hiring sufficient numbers
of qualified personnel to support the expansion of the business. The Company
may also make future acquisitions where it believes it can acquire new
products or otherwise rapidly enter new or emerging markets. Mergers and
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acquisitions of high technology companies are inherently risky and can place
significant strains on the Company's management, information systems and
operations. The Company is not able to forecast additional strains that may
be placed on the Company's management, information systems and operations as
a result of recent or future acquisitions or in the future. The Company's
potential inability to manage its changing business effectively could have a
material adverse effect on the Company's business, operating results, and
financial condition.
CUSTOMER MERGERS. Of the nine major TSPs currently involved in or that have
recently completed merger transactions, seven are customers of the Company.
Several of the mergers involve companies that purchase network systems and
software products and services from the Company's competitors. Consequently,
the completion of certain of these mergers may result in the loss of
business and customers for the Company. Additionally, the impact of capital
spending constraints during the merger transitions and thereafter could have
a material adverse effect on the Company's business, operating results and
financial condition. In addition, future merger transactions involving or
contemplated by the Company's current or prospective customers may cause
increased concentration among some of the Company's major customers or delays
or decreases in their capital spending decisions, any of which could have a
material adverse effect on the Company's business, operating results and
financial condition.
RAPID TECHNOLOGICAL CHANGE AND DEPENDENCE ON NEW PRODUCTS. The market for
the Company's products is characterized by rapid technological advances,
evolving industry transmission standards, changing regulatory environments,
price-competitive bidding, changes in customer requirements, and frequent new
product introductions and enhancements. The introduction of
telecommunications network performance management products involving
superior technologies or the evolution of alternative technologies or new
industry transmission standards could render the Company's existing products,
as well as products currently under development, obsolete and unmarketable.
The Company believes its future success will depend in part upon its
ability, on a cost-effective and timely basis, to continue to enhance its
products, to develop and introduce new products for the telecommunications
network performance management market, to address new industry standards and
changing customer needs and to achieve broad market acceptance for its
products. In particular, the Company anticipates that the SONET and SDH
optical transmission standards will become the industry transmission
standards over the coming years for the North American and international
networks, respectively. The Company's current network circuit test and
performance monitoring systems do not address either the SONET or SDH
transmission standards. The Company intends to extend its current products
and develop new products to accommodate such new transmission standards and
other advances in technology, as they evolve. The widespread adoption of
SONET and/or SDH as industry transmission standards before the Company is
able to successfully develop products which address such transmission
standards could in the future adversely affect the sale and deployment of the
Company's products.
The Company's OS products are designed to operate on a variety of hardware
and software platforms and with a variety of databases employed by its
customers in their networks. The Company must continually modify and enhance
its OS products to keep pace with changes in hardware and software platforms
and database technology. As a result, uncertainties related to the timing
and nature of new product announcements, introductions or modifications by
systems vendors, particularly, Sun Microsystems and Hewlett Packard, and by
vendors of relational database software, particularly, Oracle Corporation,
could materially adversely impact the Company's business, operating results
and financial condition. In addition, the failure of the Company's OS
products to operate across the various existing and evolving versions of
hardware and software platforms and database environments employed by
customers would have a material adverse effect on the Company's business,
operating results and financial condition.
The introduction or announcement of products by the Company or one or more of
its competitors embodying new technologies, or changes in industry standards
or customer requirements, could render the Company's existing products and
solutions obsolete and unmarketable. The introduction of new or enhanced
versions of its products requires the Company to manage the transition from
older products in order to minimize disruption in customer ordering. There
can be no assurance that the introduction or announcement of new product
offerings by the Company or its competitors will not cause customers to defer
licensing or purchasing of existing Company products or engaging the
Company's services. Any deferral of revenues could have a material adverse
effect on the Company's business, operating results and financial condition.
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Any failure by the Company to anticipate or respond on a cost-effective and
timely basis to technological developments, changes in industry transmission
standards or customer requirements, or any significant delays in product
development or introduction could have a material adverse effect on the
Company's business. There can be no assurance that the Company will be able
to successfully develop new products to meet customer requirements, to
address new industry transmission standards and technological changes or to
respond to new product announcements by others, or that such products will
achieve market acceptance.
DEPENDENCE ON SUPPLIERS AND SUBCONTRACTORS. Certain components used in the
Company's T3AS, CTS, PAAS and Remote Module products, including its VLSI
ASICs, are available from a single source and other components are available
from only a limited number of sources. The Company has few supply agreements
and generally makes its purchases with purchase orders. Further, certain
components require an order lead time of up to one year. Other components
that currently are readily available may become difficult to obtain in the
future. Failure of the Company to order sufficient quantities of these
components in advance could prevent the Company from increasing production in
response to customer orders in excess of amounts projected by the Company. In
the past, the Company has experienced delays in the receipt of certain of its
key components, which have resulted in delays in product deliveries. There
can be no assurance that delays in key component and part deliveries will not
occur in the future.
The inability to obtain sufficient key components as required or to develop
alternative sources if and as required in the future could result in delays
or reductions in product shipments, which in turn could have a material
adverse effect on the Company's customer relationships and operating results.
Additionally, the Company uses third-party subcontractors for the
manufacture of its sub-assemblies, some of which are located in Asia. This
reliance on third-party subcontractors involves several risks, including the
potential absence of adequate capacity, the unavailability of or interruption
in access to certain process technologies, and reduced control over product
quality, delivery schedules, manufacturing yields and costs. The Company
believes that the recent significant economic downturns in Asia may increase
these risks with respect to its Asian third-party subcontractors. Shortages
of raw materials or production capacity constraints at the Company's
subcontractors could negatively affect the Company's ability to meet its
production obligations and could result in increased prices for affected
parts.
HIGH INVENTORY LEVELS AND NEED TO MAKE ADVANCE PURCHASE COMMITMENTS. To
respond to anticipated customer demand, the Company maintains high inventory
levels. Maintaining high inventory levels substantially increases the risk
that the Company's profitability and results of operations may from time to
time be materially and adversely affected by inventory obsolescence. To
procure adequate supplies of certain products or components, the Company must
make advance commitments to purchase relatively large quantities of such
products or components in a number of circumstances. A large portion of the
Company's purchase commitments consists of custom parts, some of which are
sole-source such as VLSI ASICs, for which there is no alternative use or
application. The inability of the Company to sell such products or
incorporate such components in its other products could have a material
adverse effect on the Company's business, operating results and financial
condition.
YEAR 2000 COMPLIANCE. Many currently installed computer systems and software
products are coded to accept only two digit entries in the date code field.
Without modification, these systems and software will be unable to
appropriately interpret or recognize dates beyond the calendar year 1999.
The Year 2000 computer issue could result in system failures or
miscalculations causing disruptions in business operations worldwide
(including, without limitation, disruptions in order processing, invoicing,
manufacturing and similar functions).
The risk to ADA exists in four areas: systems used by the Company to run its
business, systems used by the Company's suppliers, potential warranty or
other claims from Company customers, and the potential reduced spending by
TSPs on network performance management products as a result of significant
information systems spending on Year 2000 remediation.
The Company is continuing to conduct an assessment and analysis of its
internal information technology ("IT") systems to determine the potential
costs and scope of any Year 2000 issues. Based on a preliminary assessment,
ADA has determined that certain of its IT systems need to be upgraded or
replaced to address Year 2000 issues. The Company believes that all
necessary upgrades or replacements of its IT systems will be completed by
June 30, 1999. Validation testing will be conducted as IT systems are
upgraded and replaced. All IT systems that have been purchased in 1999 or
1998 are Year 2000 compliant. The upgrades are generally covered by service
contracts
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previously entered into by the Company in the ordinary course of business and
the cost of the upgrades and remediation is not expected to be material to
the Company's operating results. If implementation of upgrades or
replacement systems is delayed, or if significant new non-compliance issues
are identified, the Company's results of operations or financial condition
could be materially adversely affected.
ADA is also in the process of conducting a comprehensive evaluation of its
non-IT systems and equipment (e.g., facilities, and test equipment containing
microprocessors or other similar circuitry, etc.). Based on this evaluation
to date, ADA is not aware of any Year 2000 issues which are expected to have
a material adverse effect on the Company's non-IT systems and equipment.
However, as the Company is still in the process of evaluating possible Year
2000 issues with respect to certain key test equipment, there can be no
assurance that ADA will not experience a material adverse effect due to Year
2000 issues affecting this equipment. ADA anticipates completing its
assessment and analysis of this equipment by December 31, 1998.
In addition, the Company is in the process of making inquiries of its third
party suppliers to determine if they have any Year 2000 issues that will
materially and adversely impact the Company. To date, the Company has not
been made aware of any material Year 2000 issues which would adversely affect
ADA. The Company expects to complete a survey of all such suppliers and
vendors by December 31, 1998.
The Company believes that the majority of its current products are Year 2000
compliant. It is expected that the remaining Company products will be Year
2000 compliant by December 31, 1998. Internal validation testing is being
conducted as products are being upgraded. An independent third party also
performed validation testing on one of the Company's test and performance
management products. However, since all customer situations cannot be
anticipated, particularly those involving third party products, the Company
may see an increase in warranty and other claims as a result of the Year 2000
transition. In addition, litigation regarding Year 2000 compliance issues is
expected to escalate. For these reasons, the impact of customer claims could
have a material adverse impact on the Company's operating results or
financial condition.
Year 2000 compliance is an issue for virtually all businesses, whose computer
systems and applications may require significant hardware and software
upgrades or modifications. TSPs may plan to devote a substantial portion of
their information systems' spending to fund such upgrades and modifications
and divert spending away from network performance management products. Such
changes in customers' spending patterns could have a material adverse impact
on the Company's sales, operating results or financial condition.
The Company intends to continue the review, remediation and testing of its
Year 2000 status and, to the extent necessary, it will develop Year 2000
contingency plans for critical business purposes. In addition, there can be
no assurance that Year 2000 issues will not have a material adverse effect on
the Company if ADA and/or those with whom it conducts business are
unsuccessful in identifying or implementing timely solutions to any Year 2000
problems.
PRODUCT RECALL AND DEFECTS. Producers of telecommunications network
performance management products such as those being marketed by the Company,
are often required to meet rigorous standards imposed by BellCore, the
research and development entity created following the divestiture of AT&T to
provide ongoing engineering support to the RBOCs. In addition, the Company
must meet specialized standards imposed by many of its customers. The
Company's products are also required to interface in a complex and changing
environment with telecommunication network equipment made by numerous other
suppliers. Since many of these suppliers are competitors of the Company,
there can be no assurance that they will cooperate with the Company. In the
event there are material deficiencies or defects in the design or manufacture
of the Company's systems, or if the Company's systems become incompatible
with existing third-party network equipment, the affected products could be
subject to a recall. The Company has experienced two significant product
recalls in its history and there can be no assurance that the Company will
not experience any product recalls in the future. The cost of any subsequent
product recall and associated negative publicity could have a material
adverse effect on the Company's business, operating results and financial
condition. In addition, the Company's development and enhancement of its
complex OS products entails substantial risks of product defects. There can
be no assurance that software errors will not be found in existing or new
products or releases after commencement of commercial licensing, which may
result in delay or loss of revenue, loss of market share, failure to achieve
market acceptance, or may otherwise adversely impact the Company's business,
operating results and financial condition.
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GOVERNMENT REGULATION. The majority of the Company's customers operate
within the telecommunications industry which is subject to regulation in the
United States and other countries. Most of the Company's customers must
receive regulatory approvals in conducting their businesses. Although the
telecommunications industry has recently experienced government deregulation,
there is no assurance this trend will continue. Moreover, the federal and
state courts and the FCC continue to interpret and clarify the provisions of
the 1996 Telecommunications Act. In fact, recent regulatory rulings have
affected the ability of the Company's customers to enter new markets and
deliver new services which could impact their ability to make significant
capital expenditures. The effect of judicial or regulatory rulings by federal
and state agencies on the Company's customers may adversely impact the
Company's business, operating results and financial condition.
POTENTIAL COMPETITION FROM RBOCS. The 1996 Telecommunications Act has
generally eliminated the restrictions which had previously prohibited the
RBOCs from manufacturing telecommunications equipment (subject to first
satisfying certain conditions designed to facilitate local exchange
competition and receipt of prior approval by the FCC). These restrictions had
been imposed under the Modification of Final Judgment, which governed the
structure of the 1984 divestiture by AT&T of its local operating telephone
company subsidiaries. The passage of the 1996 Telecommunications Act may have
an adverse effect on the Company because the RBOCs, which are presently the
Company's principal customers, may now become manufacturers of some or all of
the products currently manufactured and sold by the Company and,
consequently, may no longer purchase telecommunications equipment produced by
the Company at the levels historically experienced.
PROPRIETARY TECHNOLOGY. The Company relies on a combination of technical
leadership, patent, trade secret, copyright and trademark protection and
non-disclosure agreements to protect its proprietary rights. Although the
Company has pursued and intends to continue to pursue patent protection of
inventions that it considers important and for which such protection is
available, the Company believes its success will be largely dependent on its
reputation for technology, product innovation, affordability, marketing
ability and response to customers needs. Currently, the Company has fourteen
U.S. patents granted and five U.S. patent applications allowed. Four of the
granted patents relates to the Company's Remote Module product.
Additionally, the Company has five pending U.S. patent applications and four
international (Patent Cooperation Treaty and European Patent Office)
applications on file covering various circuit and system aspects of its
products. There can be no assurance that the Company will be granted
additional patents or that, if any patents are granted, they will provide the
Company's products with significant protection or will not be challenged.
Additionally, should a third party challenge any of the Company's current or
future patents, there can be no assurance that the Company will be successful
in defending its patents or that any litigation, regardless of outcome, will
not result in substantial cost to and diversion of efforts by the Company.
As part of its confidentiality procedures, the Company generally enters into
non-disclosure agreements with its employees, consultants and suppliers, and
limits access to and distribution of its proprietary information. Despite
these precautions, it may be possible for a third party to copy or otherwise
obtain and use the Company's technology without authorization. Accordingly,
there can be no assurance that the Company will be successful in protecting
its proprietary technology or that ADA's proprietary rights will preclude
competitors from developing products or technology equivalent or superior to
that of the Company. The telecommunications industry is characterized by the
existence of a large number of patents and frequent litigation based on
allegations of patent infringement. The Company is currently not party to any
litigation regarding any patents or other intellectual property rights.
However, there can be no assurance that third parties will not assert
infringement claims against the Company in the future or that any such
assertions will not result in costly litigation or require the Company to
obtain a license to intellectual property rights of such parties. There can
be no assurance that any such licenses would be available on terms acceptable
to the Company, if at all. Further, litigation, regardless of outcome, could
result in substantial cost to and diversion of efforts by the Company. Any
infringement claims or litigation by or against the Company could materially
and adversely affect the Company's business, operating results and financial
condition. Moreover, the laws of some foreign countries do not protect the
Company's proprietary rights in the products to the same extent as do the
laws of the United States.
The Company relies on certain software that it licenses from third parties,
including software that is integrated with internally developed software and
used in the Company's products to perform key functions. There can be no
assurance that these third party software licenses will continue to be
available to the Company on commercially
18
<PAGE>
reasonable terms or that such licenses will not be terminated. Although the
Company believes that alternative software is available from other third
party suppliers, the loss of or inability of the third parties to enhance
their products in a timely and cost-effective manner could result in delays
or reductions in product shipments by the Company until equivalent software
could be developed internally or identified, licensed, and integrated, which
could have a material adverse effect on the Company's business, operating
results and financial condition.
DEPENDENCE ON KEY PERSONNEL. The success of the Company is dependent, in
part, on its ability to attract and retain highly qualified personnel.
Competition for such personnel is intense and the inability to attract and
retain additional key employees or the loss of one or more current key
employees could adversely affect the Company. There can be no assurance that
the Company will be successful in hiring or retaining requisite personnel.
VOLATILITY OF STOCK PRICE. The Company's future earnings and stock price
may be subject to significant volatility, particularly on a quarterly basis.
Any shortfall in revenue or earnings from levels expected by public market
analysts and investors could have an immediate and significant adverse effect
on the trading price of the Company's Common Stock. Fluctuation in the
Company's stock price may also have an effect on customer decisions to
purchase the Company's products which could have a material adverse effect on
the Company's business, operating results and financial condition.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
19
<PAGE>
PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS.
From time to time, ADA may be involved in litigation relating to claims
arising out of its operations in the normal course of business. As of the
date of this Quarterly Report, the Company is not a party to any legal
proceedings.
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.
Proposals of stockholders intended to be presented at the next Annual
Meeting of the Stockholders of the Company must be received by the Company
at its offices at 9855 Scranton Road, San Diego, CA, 92121 not later than
December 14, 1998.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) Exhibits.
EXHIBIT NUMBER DESCRIPTION
------------- -----------
3.3(1) Certificate of Incorporation of the Company.
3.4(2) Certificate of Agreement of Merger of the Company
and its California predecessor.
3.5(1) Bylaws of the Company.
27.1 Financial Data Schedule.
(1) Incorporated by reference to the Company's Current Report on Form 8-K
dated December 23, 1997 (File No. 0-23698).
(2) Incorporated by reference to the Company's Current Report on Form
8-K/A dated January 12, 1998 (File No. 0-26398).
(b) Reports on Form 8-K.
None.
20
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Applied Digital Access, Inc.
Date: November 16, 1998 /s/ PETER P. SAVAGE
--------------------------
Peter P. Savage
Director
President and Chief Executive Officer
Date: November 16, 1998 /s/ JAMES L. KEEFE
---------------------------
James L. Keefe
Vice President Finance and
Administration and Chief Financial Officer
21
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