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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
-----------
FORM 10-Q
(Mark One)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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 0-25688
SDL, INC.
(Exact name of registrant as specified in its charter)
<TABLE>
<S> <C>
Delaware 77-0331449
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
80 Rose Orchard Way, San Jose, CA 95134-1365
(Address of principal executive offices) (Zip code)
</TABLE>
Registrant's telephone number, including area code (408) 943-9411
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 [ ]
The number of shares outstanding of the issuer's common stock as of November 6,
1998 was 14,111,100.
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SDL, INC.
INDEX
<TABLE>
<CAPTION>
PAGE NO.
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<S> <C>
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 1997 4
Condensed Consolidated Statements of Cash Flows for
the nine months ended September 30, 1998 and 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 Risk 15
PART II. OTHER INFORMATION
Item 1. Legal Proceedings 16
Item 5. Other Information 16
Item 6. Exhibits and Reports on Form 8-K 16
SIGNATURES 17
</TABLE>
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SDL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
(unaudited) (1)
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 7,227 $ 4,593
Short-term investments 12,623 10,400
Accounts receivable, net 20,359 19,960
Inventories 17,165 13,938
Prepaid expenses and other current assets 3,233 2,738
--------- ---------
Total current assets 60,607 51,629
Property and equipment, net 31,609 26,298
Long-term investments 6,438 11,613
Note due from related party 518 536
Other assets 4,218 4,148
--------- ---------
$ 103,390 $ 94,224
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities:
Accounts payable $ 7,561 $ 8,469
Accrued payroll and related expenses 3,319 2,945
Income taxes payable 722 828
Other accrued liabilities 2,142 3,375
--------- ---------
Total current liabilities 13,744 15,617
Other long-term liabilities 2,557 2,020
Commitments and contingencies
Stockholders' equity:
Preferred stock -- --
Common stock 14 14
Additional paid-in-capital 117,852 116,409
Accumulated other comprehensive income 151 (208)
Accumulated deficit ($32,084 relating to the repurchase
of common stock and recapitalization in 1992) (30,882) (39,586)
--------- ---------
87,135 76,629
Less: Stockholders' notes receivable (46) (42)
--------- ---------
Total Stockholders' equity 87,089 76,587
--------- ---------
$ 103,390 $ 94,224
========= =========
</TABLE>
(1) The balance sheet at December 31, 1997 has been derived from the audited
financial statements at that date.
See accompanying notes.
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SDL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE DATA - UNAUDITED)
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
---------------------- ----------------------
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Total revenue:
Product revenue $ 23,111 $ 19,724 $ 68,099 $ 54,681
Research revenue 2,460 4,227 8,639 11,856
-------- -------- -------- --------
25,571 23,951 76,738 66,537
Cost of revenue:
Cost of product revenue 14,594 13,140 43,803 39,000
Cost of research revenue 1,748 3,185 6,584 9,676
-------- -------- -------- --------
Gross margin 9,229 7,626 26,351 17,861
Operating expenses:
Research and development 2,684 2,340 7,856 7,649
Selling, general and administrative 3,337 2,799 9,420 36,874
Amortization of purchased intangibles 193 163 582 487
-------- -------- -------- --------
Operating income (loss) 3,015 2,324 8,493 (27,149)
Interest income and other, net 335 266 917 1,003
-------- -------- -------- --------
Income (loss) before income taxes 3,350 2,590 9,410 (26,146)
Provision for income taxes 251 139 706 367
-------- -------- -------- --------
Net income (loss) $ 3,099 $ 2,451 $ 8,704 $(26,513)
======== ======== ======== ========
Net income (loss) per share - basic $ 0.22 $ 0.18 $ 0.63 $ (1.97)
======== ======== ======== ========
Net income (loss) per share - diluted $ 0.21 $ 0.17 $ 0.59 $ (1.97)
======== ======== ======== ========
Number of weighted average shares - basic 13,882 13,546 13,806 13,449
Number of weighted average shares - diluted 14,666 14,431 14,637 13,449
</TABLE>
See accompanying notes
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SDL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS - UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
-----------------------
1998 1997
-------- --------
<S> <C> <C>
OPERATING ACTIVITIES:
Net income (loss) $ 8,704 $(26,513)
Adjustments to reconcile net income (loss) to
net cash provided by (used in) operating activities
Depreciation and amortization 5,447 4,130
Deferred income taxes -- 477
Changes in operating assets and liabilities
Accounts receivable (399) (8,369)
Inventories (3,227) 806
Prepaid expenses and other current assets (495) 1,038
Accounts payable (908) 1,144
Accrued payroll and related expenses 374 1,269
Income taxes payable (106) 2,022
Other accrued liabilities (1,233) 1,690
Other long-term liabilities 537 285
Other (501) (1,909)
-------- --------
Total adjustments (511) 2,583
-------- --------
Net cash provided by (used in) operating activities 8,193 (23,930)
INVESTING ACTIVITIES:
Acquisition of property and equipment, net (10,174) (7,344)
Payments on acquisition obligations -- (2,712)
Sale of investments, net 3,172 34,438
-------- --------
Net cash provided by (used in) investing activities (7,002) 24,382
FINANCING ACTIVITIES:
Issuance of stock pursuant to employee stock plans 1,443 1,078
Payments on stockholders' notes receivables -- 212
-------- --------
Net cash provided by financing activities 1,443 1,290
Net increase in cash and cash equivalents 2,634 1,742
Cash and cash equivalents at beginning of period 4,593 2,605
-------- --------
Cash and cash equivalents at end of period $ 7,227 $ 4,347
======== ========
</TABLE>
See accompanying notes.
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SDL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
SEPTEMBER 30, 1998
1. BASIS OF PRESENTATION
The accompanying unaudited condensed 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,
all adjustments (consisting only of normal recurring accruals) considered
necessary for a fair presentation have been included. Operating results for
the nine-month period ended September 30, 1998 are not necessarily
indicative of the results that may be expected for the year ended December
31, 1998. For further information, refer to the consolidated financial
statements and footnotes thereto included in the Registrant Company's
Annual Report on Form 10-K for the year ended December 31, 1997.
The consolidated financial statements include the accounts of SDL, Inc. and
its wholly owned subsidiary, SDL Optics. Intercompany accounts and
transactions have been eliminated in consolidation.
The functional currency of the Company's foreign subsidiary is the U.S.
dollar. Subsidiary financial statements are remeasured into U.S. dollars
for consolidation. Foreign currency transaction gains and losses are
included in interest income and other, net and were immaterial for all
periods presented.
The Company operates and reports financial results on a fiscal year of 52
or 53 weeks ending on the Friday closest to December 31. The third fiscal
quarter of 1998 and 1997 ended on October 2, 1998 and September 26, 1997,
respectively. For ease of discussion and presentation, all accompanying
financial statements have been shown as ending on the last day of the
calendar month.
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2. NET INCOME (LOSS) PER SHARE
The following table sets forth the computation of basic and diluted net
income (loss) per share (in thousands, expcept per share amounts):
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30, September 30,
---------------------- -------------------
1998 1997 1998 1997
-------- --------- -------- --------
<S> <C> <C> <C> <C>
Numerator:
Net income (loss) $ 3,099 $ 2,451 $ 8,704 $(26,513)
======== ========= ======== ========
Denominator:
Denominator for basic net income (loss) per share-
weighted average shares 13,882 13,546 13,806 13,449
Incremental common shares attributable to shares
issuable under employee stock plans 784 885 831 --
======== ========= ======== ========
Denominator for diluted net income (loss) per share
adjusted weighted average shares and assumed
conversions 14,666 14,431 14,637 13,449
======== ========= ======== ========
Net income (loss) per share - basic $ 0.22 $ 0.18 $ 0.63 $ (1.97)
======== ========= ======== ========
Net income (loss) per share - diluted $ 0.21 $ 0.17 $ 0.59 $ (1.97)
======== ========= ======== ========
</TABLE>
3. COMPREHENSIVE INCOME
As of January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130 (SFAS 130),"Reporting Comprehensive Income."
SFAS 130 establishes new rules for the reporting and display of
comprehensive income and its components; however, the adoption of this
statement had no impact on the Company's net income or stockholders'
equity. SFAS 130 requires unrealized gains or losses on the Company's
available-for-sale securities and foreign currency translation adjustments,
which have been consistently included in stockholders' equity and excluded
from net income, to be included in comprehensive income. Prior year
financial statements have been reclassified to conform to the requirements
of SFAS 130.
Total comprehensive income amounted to approximately $3.4 million for the
third quarter 1998 compared to a comprehensive income of $2.5 million for
the third quarter of 1997. For the nine months ended September 30, 1998,
comprehensive income amounted to $9.1 million compared to a $26.6 million
comprehensive loss for the nine months ended September 30, 1997.
4. RECENT PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 131 (SFAS 131), "Disclosures about
Segments of an Enterprise and Related Information." SFAS No. 131
establishes new requirements for the reporting of information regarding
operating segments, products, services, geographic areas and major
customers. The Company will provide the disclosures required by SFAS 131 in
its Form 10-K for the year ended December 31, 1998.
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5. INVENTORIES
The components of inventories consist of the following (in thousands):
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- ------------
<S> <C> <C>
Raw materials $ 7,923 $ 6,087
Work in process 9,242 7,851
-------- --------
$ 17,165 $ 13,938
======== ========
</TABLE>
No significant amounts of finished goods are maintained.
6. CONTINGENCIES
See Part II, Item 1, Legal Proceedings for discussion of legal matters.
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
SDL designs, manufactures and markets semiconductor optoelectronic integrated
circuits (OEICs), semiconductor lasers, fiber optic related products and
optoelectronic systems. The Company's revenue consists of product and research
revenue. The Company's product revenue is primarily derived from the sale of
standard and customized products to a variety of customers, in volumes ranging
from single products sold to numerous organizations to high unit volumes sold to
certain original equipment manufacturer (OEM) customers. As a result, product
gross margins tend to fluctuate based in part on the mix of products sold in any
reported period. From the original products introduced in 1984, the Company has
expanded its product offering to over 200 standard products in addition to
providing custom design and packaging for OEM customers. OEM customers often
fund the design or customization as well as the manufacturing and testing of
their volume products. The primary applications for the Company's products
include long haul telecommunications, CATV, undersea fiber optic communications,
satellite communications, printing, medical, and materials processing markets.
The Company's research revenue is derived from customer-funded research
programs. The Company's research and engineering staff, which currently includes
over 50 Ph.D.s, provides state-of-the-art research and proof-of-concept
prototypes over a broad range of semiconductor OEIC and laser technologies. The
Company has been issued over 88 U.S. and foreign patents and has approximately
94 U.S. patent applications pending. Customer-funded research revenue is
typically based on material and labor costs incurred, plus coverage for overhead
and operating expenses, and in most cases, an additional profit component.
Cost-based pricing has generally resulted in lower gross margins for research
revenue than for product revenue. The Company typically retains rights to the
technology developed under customer-funded research programs and therefore is
able to leverage these programs to continue to broaden its product and
technology offerings. All internally-funded research and development costs are
expensed in the period incurred.
The Company operates and reports financial results on a fiscal year of 52 or 53
weeks ending on the Friday closest to December 31. The third fiscal quarter of
1998 and 1997 ended on October 2, 1998 and September 26, 1997, respectively. For
ease of discussion and presentation, all accompanying financial statements have
been shown as ending on the last day of the calendar month.
RESULTS OF OPERATIONS
REVENUE. Total revenue for the quarter ended September 30, 1998 increased 7% to
$25.6 million compared to $24.0 million in the corresponding 1997 quarter. For
the nine months ended September 30, 1998, total revenue increased to $76.7
million from $66.5 million reported for the comparable period. Product revenue
reported for the third quarter of 1998 increased 17% compared to product revenue
for the third quarter of 1997. The increase in third quarter product revenue
resulted primarily from a 72% quarter-over-quarter increase in dense wavelength
division multiplexing (DWDM) product sales from a continuing strong demand for
SDL's 980 nm pump module. The growth in DWDM revenue was partially offset by a
decrease in space communication product sales. Research revenue declined both in
dollars and as a percentage of total revenue compared to the corresponding
quarter and nine month period ended September 30, 1997. This downward trend is a
result of the Company continuing to focus on commercial product opportunities.
Revenue derived directly or indirectly from U.S. government sources declined to
30% of total revenue reported for the first nine months of 1998, compared to 41%
for the first nine months of 1997. Additionally, revenue received from Lockheed
Martin decreased to 14% of total revenue during the nine month period ended
September 30, 1998 compared to 19% in the prior period.
International revenue as a percentage of total revenue for the nine months ended
September 30, 1998 increased to 22% from 17% for the corresponding 1997 period.
The 1998 export growth was primarily within the European region, where revenue
increased 65% for the nine months ended September 1998 over that of the
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corresponding 1997 period. European and Asia-Pacific revenue represented 12% and
10%, respectively, of total revenue for the nine months ended September 1998.
There can be no assurance that the application markets for SDL's products will
grow in future periods at historical percentage rates. Further, there can be no
assurance that the Company will be able to increase or maintain its market share
in the future or to sustain historical growth rates.
GROSS MARGIN. Gross margins increased to 36.1% and 34.3% for the three and nine
months ended September 30, 1998 from 31.8% and 26.8% in the comparable 1997
periods. Three factors contributed to the year-over-year increase in gross
margin. These were: i) a more favorable mix in the ratio of commercial product
revenue as compared to revenue derived from U.S. government sources; ii)
increased yields and volumes from the new wafer fab and reduction of costs
related to the 980 nm pump module; and to a lesser degree, iii) lower research
contract costs. Gross margins reported for the first nine months of 1997 were
adversely impacted by start-up costs for the expansion of the Company's wafer
fab and packaging capacities, together with write-offs totaling $1.4 million for
excess and obsolete inventory and additional reserves of $1.6 million for
changes in estimable reimbursable costs.
The Company's gross margin can be affected by a number of factors, including
product mix, pricing pressures, and product yield. Generally, the cost of newer
products tends to be higher as a percentage of product revenue than that of more
mature, higher volume products. In addition, the cost of research revenue is
significantly higher as a percentage of revenue, as research revenue is
typically based on costs incurred rather than market pricing. As a result of
these factors, gross margin fluctuations are difficult to predict and there can
be no assurance that the Company will maintain gross margins at current levels
in future periods.
RESEARCH AND DEVELOPMENT. Research and development expense for the three and
nine months ended September 30, 1998 was $2.7 million and $7.9 million,
respectively, compared to $2.3 million and $7.6 million for the corresponding
1997 periods. Research and development expense has remained relatively
consistent at approximately 10% of revenue for all periods reported. The 1997
research and development spending was focused on addressing manufacturing
process improvements, primarily production yields, and to a lesser extent, new
product development. Conversely, during 1998 the emphasis of research and
development has been to bring new communication, laser and system products to
market. Approximately 60% of the research and development expenses incurred for
the three months ended September 30, 1998 was targeted at new product and
process development in the dense wavelength division multiplexing area.
The level of research and development incurred in future periods may vary. In
addition, there can be no assurance that expenditures for manufacturing
improvements or for other advanced research projects will be successful, or that
improved processes or commercial products will result from these projects.
SELLING, GENERAL AND ADMINISTRATIVE. For the three months ended September 30,
1998, selling, general and administrative (SG&A) expense was $3.3 million or 13%
of net revenue, compared to $2.8 million or 12% of net revenue for the
corresponding 1997 three month period. The increase in SG&A expense was
primarily due to continued expansion of the Company's business and personnel,
especially within sales and marketing, and to a lesser extent, the commencement
of the implementation process for the Company's new enterprise resource planning
software. For the nine months ended September 30, 1998, SG&A expense was $9.4
million or 12% of net revenue, compared to $36.9 million for the prior year
period. Excluding non-recurring amounts of approximately $29 million for the
settlement and related legal costs incurred during the first half of 1997 for
the Spectra-Physics vs. SDL, Inc. legal dispute, SG&A has remained relatively
consistent at approximately 12% of revenue for the 1998 and 1997 nine month
periods.
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INTEREST INCOME AND OTHER, NET. For the three months ended September 30, 1998
interest income was $335,000, which represented a $69,000 increase from the
corresponding 1997 period. The increase was due to higher average cash and
investment balances for the three months ended September 30, 1998 compared to
the corresponding 1997 period. For the nine months ended September 30, 1998
interest income was $917,000, compared to $1,003,000 for the prior year period.
Lower average cash and investment balances during the nine months ended 1998
resulted in lower interest income compared to the corresponding 1997 period.
PROVISION FOR INCOME TAXES. The income tax provision for the nine months ended
September 30, 1998 and 1997 consists principally of foreign income taxes and
Federal and state minimum taxes. The Company's provision has benefited from
previously unrecognized federal and state net operating loss carryforwards.
Although realization is not assured, the Company continues to believe that it
will generate future taxable income sufficient to realize the benefit of the
$3.0 million of net deferred tax assets previously recognized. The amount of the
net deferred tax assets considered realizable could be reduced or increased in
the near term if estimates of future taxable income are changed. Management
intends to evaluate the realizability of the net deferred tax assets each
quarter to assess the need for the valuation allowance.
LIQUIDITY AND CAPITAL RESOURCES
The Company's operating and financing activities generated cash and cash
equivalents of $9.8 million during the nine months ended September 30, 1998.
During this same period the Company acquired capital equipment and funded
facilities expansion for approximately $10.2 million. As a result of these
activities, cash, cash equivalents and investments decreased from $26.6 million
at December 31, 1997 to $26.3 million at September 30, 1998.
The Company believes that current cash balances, cash generated from operations,
and cash available through the equity markets and banks will be sufficient to
fund capital equipment purchases, acquisitions of complementary businesses,
products or technologies and working capital requirements for the foreseeable
future. However, there can be no assurances that events in the future will not
require the Company to seek additional capital or, if so required, that adequate
capital will be available on terms acceptable to the Company.
IMPACT OF YEAR 2000
Like many other companies, the year 2000 computer issue creates risks for SDL.
Some of the Company's older computer programs were written using two digits
rather than four to define the applicable year. As a result, those computer
programs have time-sensitive software that recognize a date using "00" as the
year 1900 rather than the year 2000. If internal systems do not correctly
recognize and process date information beyond the year 1999, there could be a
material adverse impact on the Company's business and results of operations.
To address these year 2000 issues within its internal systems, the Company has
established a task team and initiated a comprehensive program designed to deal
with the most critical systems first. Assessment and remediation are proceeding
in tandem, and the Company currently plans to have changes to critical systems
completed and tested by mid-1999. These activities are intended to encompass all
systems software applications in use by the Company, including front and
back-end manufacturing, facilities, sales, finance and human resources.
As newer, more functional software solutions are currently available and are
Year 2000 compliant, the Company has concluded that the conversion to enterprise
resource planning software programs supporting the Company's manufacturing,
finance, distribution / logistics and human resource operations is more cost
effective. The project is estimated to be completed during the quarter ended
June 30, 1999. In addition, as a
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contingency plan, the Company's existing management information software
applications have been successfully upgraded to a year 2000 compliant version.
Assessment and remediation of year 2000 issues in tertiary business information
systems is on-going. Well over 80% of the Company's investment in desktop PC
hardware is known to be year 2000 compliant. Additionally, the Company has
concluded that the purchase of newer, more functional software for its network
server applications is more cost effective than upgrading its existing software
to a year 2000 compliant version. Completing the remediation of the Company's
tertiary business information systems is not expected to be a significant burden
on the Company.
To date, based on its current manufacturing process, SDL has determined it has
no exposure to contingencies related to the Year 2000 issue for the products it
has sold or will sell in the future.
SDL is also actively working with critical suppliers of products and services to
determine that the suppliers' operations and the products and services they
provide are year 2000 compatible or to monitor their progress toward year 2000
compatibility. In addition, the Company has commenced work on various types of
contingency planning to address potential problem areas with internal systems
and with suppliers and other third parties. It is expected that assessment,
remediation and contingency planning activities will be on-going throughout 1998
and 1999 with the goal of appropriately resolving all material internal systems
and third party issues.
The costs incurred to date related to these programs are less than $1.1 million.
The Company currently expects that the total cost of these programs, including
both incremental spending and redeployed resources, will not exceed $2.8
million, which includes $1.8 million for the purchase of new software and
hardware that will be capitalized and $1.0 million that will be expensed as
incurred. In some instances, the installation schedule of new software and
hardware in the normal course of business is being accelerated to also afford a
solution to year 2000 capability issues. The costs of these projects and dates
on which the Company believes it will complete the year 2000 modifications are
based on management's best estimates, which were derived utilizing numerous
assumptions of future events, including the continued availability of certain
resources and other factors.
Based on currently available information, management does not believe that the
year 2000 matters discussed above related to internal systems or products sold
to customers will have a material adverse impact on the Company's financial
condition or overall trends in results of operations; however, it is uncertain
to what extent the Company may be affected by such matters. Any failure to
timely, successfully and cost-effectively assess, remediate and resolve the
Company's year 2000 issues, including those regarding its own as well as
suppliers' and third parties' internal systems, products, services and
contingency plans, may have a material adverse effect on the Company's business
and results of operations. The Company is continuing its efforts to ensure year
2000 readiness, and there can be no assurance that there will not be new year
2000 issues not identified above and significant delays in or increased costs
associated with such efforts which could have a material adverse effect on the
Company's business and results of operations.
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RISK FACTORS
The statements contained in this Report on Form 10-Q that are not purely
historical are forward looking statements within the meaning of Section 27A of
the Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934, including statements regarding the Company's expectations, hopes,
intentions, beliefs or strategies regarding the future. Forward-looking
statements include the Company's long-term strategic focus on commercial product
opportunities, the ability to realize the benefit of net deferred tax assets,
the expected completion date of software conversion, as well as the Company's
liquidity and anticipated cash needs and availability under the heading
"Management's Discussion and Analysis of Financial Condition and Results of
Operations." All forward-looking statements included in this document are based
on information available to the Company on the date hereof, and SDL 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 detailed below. You should also consult the
risk factors listed from time to time in the Company's Reports on Forms 10-Q,
8-K, 10-K and Annual Reports to Stockholders.
MANUFACTURING RISKS. The manufacture of semiconductor OEIC and laser components,
products and systems such as those sold by the Company is highly complex and
precise, requiring production in a highly controlled and clean environment.
Changes in the Company's or its suppliers' manufacturing processes or the
inadvertent use of defective or contaminated materials by the Company or its
suppliers has in the past and could in the future adversely affect the Company's
ability to achieve acceptable manufacturing yields and product reliability. To
the extent the Company does not achieve such yields or product reliability, its
operating results and customer relationships would be adversely affected.
The Company relies almost exclusively on its own production capability in
computer-aided chip and package design, wafer fabrication, wafer processing,
device packaging, hybrid microelectronic packaging, printed circuit board
testing, final assembly and testing of products. Because the Company
manufactures, packages and tests these components, products and systems at its
own facility, and such components, products and systems are not readily
available from other sources, any interruption in manufacturing resulting from
shortages of parts of equipment, fire, natural disaster, equipment failures,
poor yields or otherwise would have a material adverse effect on the Company's
business and results of operations. In particular, a significant portion of the
Company's production relies or occurs on equipment for which the Company does
not have a backup. To alleviate, at least in part, this situation, the Company
remodeled its front-end wafer fabrication facility and its packaging and test
facility. During this time, front-end production activities were operated in
parallel to allow adequate time for customer acceptance and to validate yields,
thereby increasing production costs. There can be no assurances that the Company
will not experience further start-up costs and yield problems in fully utilizing
its increased wafer capacity. In the event of any disruption in production by
one of these machines, the Company's business and results of operations could be
materially adversely affected. Furthermore, the Company has a limited number of
employees dedicated to the operation and maintenance of its equipment, loss of
whom could affect the Company's ability to effectively operate and service such
equipment.
The Company experienced lower than expected production yields on some of its
products, including certain key product lines during 1997 and the first half of
1998. This reduction in yields adversely affected gross margins, delayed
component, product and system shipments and, to a certain extent, new orders
booked. There can be no assurance that the Company's manufacturing yields will
be acceptable to ship products on time in the future. To the extent the Company
experiences lower than expected manufacturing yields or experiences any shipment
delays, the Company could lose customers and experience reduced or delayed
customer orders and cancellation of existing backlog. The Company presently is
ramping production of certain of its product lines. This requires hiring and
training of new personnel, acquiring new equipment, and expanding its packaging
facilities and capabilities. Difficulties in ramping production to meet expected
demand and schedules have occurred in the past and may occur in the future.
Quality problems could arise, yields could fall, and gross margins could be
adversely impacted during such a ramp. Aggressive volume pricing for large
long-term order has been provided to certain customers. Cost reductions in
manufacturing are required to avoid a drop in gross margins for certain
13
<PAGE> 14
products. Such cost reductions may not occur rapidly enough to avoid a decrease
in gross margins on these products. In such event, the Company's business and
results of operations would be materially adversely affected.
DEPENDENCE ON EMERGING APPLICATIONS AND NEW PRODUCTS. The Company's current
products serve many applications in the communications, materials processing,
information and light source replacement markets. In many cases, the Company's
products are substantially completed, but the customer's product is not yet
completed, and the applications are emerging or are otherwise in new markets. In
addition, the Company and certain of its customers are currently in the process
of developing new products, in various stages of development, testing and
qualification, sometimes in emerging applications or new markets. The Company
believes that rapid customer acceptance of its new products are key to the
Company's financial results. A substantial portion of the Company's products
address markets that are not now, and may never become substantial commercial
markets. The Company has experienced, and is expected to continue to experience,
competitive, technological and pricing constraints that may preclude development
of markets and fluctuation in customer orders. The Company's customers are often
required to test laser pump modules, transmitters, and marking systems among
other new products for potential volume applications. No assurances can be given
that the Company or its customers will qualify these new products, will continue
their existing product development efforts, or if continued that such efforts
will be successful, that markets will develop for any of the Company's
technology or pricing will enable such markets to develop, or that the Company's
and its customer's products will not be superseded by other technology or
products. The Company may also be unable to develop new products on a timely
schedule or be able to manufacture such new products at an acceptable cost so as
to maintain profitability.
COMPETITION. The Company's various markets are highly competitive. The Company
faces current or potential competition from four primary sources: (i) direct
competitors, (ii) potential entrants, (iii) suppliers of potential new
technologies and (iv) suppliers of existing alternative technologies. The
Company offers a range of components, products and systems and has numerous
competitors worldwide in various segments of its markets. As the markets for the
Company's products grow, new competitors have recently emerged and are likely to
continue to do so in the future. The Company also sells products and services to
companies with which it presently competes or in the future may compete. In most
of the Company's product lines, both the Company and competitors are working to
develop new technologies, or improvements and modifications to existing
technologies, which will obsolete present products. Many of the Company's
competitors have significantly greater financial, technical, manufacturing,
marketing, sales and other resources than SDL. In addition, many of these
competitors may be able to respond more quickly to new or emerging technologies,
evolving industry trends and changes in customer requirements and to devote
greater resources to the development, promotion and sale of their products than
the Company. There can be no assurance that the Company's current or potential
competitors have not already or will not in the future develop or acquire
products or technologies comparable or superior to those developed by the
Company, combine or merge to form significant competitors, or adapt more quickly
than the Company to new technologies, evolving industry trends and changing
customer requirements. Increased competition has resulted and could, in the
future, result in price reductions, reduced margins or loss of market share, any
of which could materially and adversely affect the Company's business and
results of operations. There can be no assurance that the Company will be able
to compete successfully against current and future competitors or that
competitive pressures faced by the Company would not have a material adverse
effect on its business and results of operations. The Company expects that both
direct and indirect competition will increase in the future. Additional
competition could have a material adverse effect on the Company's results of
operations through price reductions and loss of market share.
NEED TO MANAGE GROWTH. The Company has on occasion been unable to manufacture
certain products in quantities sufficient to meet demand of its existing
customer base and new customers. The expansion in the scope of its operations
has placed a considerable strain on its management, financial, manufacturing and
other resources and has required the Company to implement and improve a variety
of operating, financial and other systems, procedures and controls. There can be
no assurance that any existing or new systems, procedures or controls will be
adequate to support the Company's operations or that its systems, procedures and
controls will
14
<PAGE> 15
be designed, implemented or improved in a cost-effective and timely manner. Any
failure to implement, improve and expand such systems, procedures and controls
in an efficient manner at a pace consistent with the Company's business could
have a material adverse effect on the Company's business and results of
operations.
The future success of the Company is dependent, in part, on its ability to
attract, assimilate and retain additional employees, including certain key
personnel. The Company will continue to need a substantial number of additional
personnel, including those with specialized skills, to commercialize its
products and expand all areas of its business in order to continue to grow.
Competition for such personnel is intense, and there can be no assurance that
the Company will be able to attract, assimilate or retain additional highly
qualified personnel.
DEPENDENCE UPON GOVERNMENT PROGRAMS AND CONTRACTS. The Company derived
approximately 30%, 38%, and 43% of its revenue during the first nine months of
1998 and during fiscal 1997 and 1996, respectively, directly and indirectly from
a variety of Federal government sources. The Company received approximately 14%,
19% and 21% of its revenue for the first nine months of 1998, and fiscal 1997
and 1996, respectively, from Lockheed Martin through several U.S. government and
commercial programs. Almost all of the Company's revenue from Lockheed Martin
during these periods was, and during the remainder of 1998 is expected to be,
derived from Federally-funded programs. The demand for certain of the Company's
services and products is directly related to the level of funding of government
programs. The Company believes that the success and further development of its
business is dependent, in significant part, upon the continued existence and
funding of such programs and upon the Company's ability to participate in such
programs. For example, substantially all of the Company's research revenue for
1998, 1997 and 1996 was funded by Federal programs. Most of the Company's
Federally-funded programs are subject to renewal every one or two years, so that
continued work by the Company under these programs in future periods is not
assured. Federally-funded programs are subject to termination for convenience of
the government agency, at which point the Company would be reimbursed for
related allowable costs incurred to the termination date. Federally-funded
contracts are subject to audit of pricing and actual costs incurred, which have
resulted, and could result in the future, in price adjustments. The Federal
government has in the past, and could in the future, challenge the Company's
accounting methodology for computing indirect rates and allocating indirect
costs to government contracts. The government is currently challenging certain
indirect cost allocations. While management believes that amounts recorded on
its financial statements are adequate to cover all related risks, the government
has not concluded its investigation or agreed to a settlement with the Company.
Although the outcome of this matter cannot be determined at this time,
management does not believe that its outcome will have a material adverse effect
on the Company's financial position, results of operations and cash flows.
However, based on future developments, the Company's estimate of the outcome of
these matters could change in the near term. In addition, a change in the
Company's accounting practices in this area could result in reduced profit
margins on government contracts. During the fourth quarter of 1996, the Company
exceeded the maximum number of employees allowed under eligibility requirements
for the U.S. government's Small Business Innovative Research (SBIR) programs and
is no longer able to compete for research contract awards within SBIR programs.
Previously awarded SBIR contracts will not terminate but, depending on the
contract, can continue through contract completion, which can be up to two years
from the initial contract award date. SBIR contracts accounted for approximately
3%, 5% and 6% of revenue in the first nine months of 1998, and fiscal years 1997
and 1996, respectively.
RISK OF PATENT INFRINGEMENTS CLAIMS. The semiconductor, optoelectronics,
communications, information and laser industries are characterized by frequent
litigation regarding patent and other intellectual property rights. From time to
time the Company has received and may receive in the future, notice of claims of
infringement of other parties' proprietary rights and licensing offers to
commercialize third party patent rights. In addition, there can be no assurance
that additional infringement claims (or claims for indemnification resulting
from infringement claims) will not be asserted against the Company, or that
existing claims, including the claim by Rockwell discussed herein under the
heading legal proceedings, or any other assertions will not result in an
injunction against the sale of infringing products or otherwise materially
adversely affect the Company's business and results of operations.
15
<PAGE> 16
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
Not applicable
16
<PAGE> 17
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS. Information disclosed in the Company's Form 10-K for
the year ended December 31, 1997 under heading Part I Item 3, Legal
Proceedings, is incorporated herein by this reference. Since the date of
that disclosure, in regards to the litigation with Rockwell discussed
therein, the United States Court of Appeals for the Federal Circuit
issued an opinion vacating the Court of Federal Claims' grant of the
Company's motion for summary judgment of invalidity based on
obviousness. The Federal Circuit held that the Court of Federal Claims
had erred in finding that there were no genuine disputes of material
fact concerning the obviousness of the Rockwell patent, and that the
resolution of these disputes requires a trial. The Federal Circuit thus
remanded the case back to the trial court for further proceedings. The
Federal Circuit also affirmed the Court of Federal Claims' denial of the
Company's motion for summary judgment of invalidity based on
anticipation, as well as the Court of Federal Claims' claim
construction.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS. Not Applicable
ITEM 3. DEFAULTS UPON SENIOR SECURITIES. Not Applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS. Not Applicable
ITEM 5. OTHER INFORMATION.
Any stockholder proposal submitted outside the processes of Rule 14a-8,
under the Securities Exchange Act for presentation to Registrants 1999
Annual Meeting of Stockholders will be considered untimely for the
purposes of Rules 14a-4 and 14a-5 if notice thereof is received by the
Registrants after March 3, 1999.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.
(a) List of Exhibits
<TABLE>
<CAPTION>
Number Exhibit Description
------ -------------------
<S> <C>
27.1 Financial Data Schedule
</TABLE>
(b) Reports on Form 8-K
None
17
<PAGE> 18
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
SDL, INC.
Registrant
November 11, 1998 /s/ Michael L. Foster
---------------------------------------
Michael L. Foster
Chief Financial Officer and
Vice President of Finance
(duly authorized officer, and principal
financial and accounting officer)
18
<PAGE> 19
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Number Description
- ------ -----------
<S> <C>
27.1 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM SEPTEMBER
30, 1998 FINANCIAL STATEMENTS AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO
SUCH FORM 10-Q
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 7,227
<SECURITIES> 19,061
<RECEIVABLES> 21,267
<ALLOWANCES> 908
<INVENTORY> 17,165
<CURRENT-ASSETS> 60,607
<PP&E> 58,597
<DEPRECIATION> 26,988
<TOTAL-ASSETS> 103,390
<CURRENT-LIABILITIES> 13,744
<BONDS> 0
0
0
<COMMON> 14
<OTHER-SE> 87,075
<TOTAL-LIABILITY-AND-EQUITY> 103,390
<SALES> 68,099
<TOTAL-REVENUES> 76,738
<CGS> 43,803
<TOTAL-COSTS> 50,387
<OTHER-EXPENSES> 17,858
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 9,410
<INCOME-TAX> 706
<INCOME-CONTINUING> 8,704
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 8,704
<EPS-PRIMARY> 0.63
<EPS-DILUTED> 0.59
</TABLE>
