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Previous: PERCLOSE INC, 8-A12G/A, 1999-08-09 |
Next: SDL INC, 10-Q, 1999-08-09 |
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 June 30, 1999
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)
Delaware 77-0331449 (State or Other Jurisdiction of Incorporation or Organization) (I.R.S. Employer Identification No.)
80 Rose Orchard Way, San Jose, CA 95134-1365
(Address of principal executive offices, including zip code)
(408) 943-9411
(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. [X] Yes [ ] No
The number of shares outstanding of the issuer's common stock as of July 30, 1999 was 31,249,752.
SDL, INC.
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited):
Condensed Consolidated Balance Sheets - June 30, 1999 and December 31, 1998
Condensed Consolidated Statements of Operations - three and six months ended June 30, 1999 and 1998
Condensed Consolidated Statements of Cash Flows - six months ended June 30, 1999 and 1998
Notes To Condensed Consolidated Financial Statements
Item 2: Management's Discussion and Analysis of Financial Condition and Results of Operations
Introduction
Results of Operations
Liquidity and Capital Resources
Item 3: Quantitative and Qualitative Disclosures about Market Risks
PART II. OTHER INFORMATION
Item 1: Legal Proceedings
Item 2: Changes in Securities
Item 3: Defaults Upon Senior Securities
Item 4: Submission of Matters to a Vote of Security Holders
Item 5: Other Information
Item 6: Exhibits and Reports on Form 8-K
SIGNATURES
PART I -- FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
SDL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
June 30, December 31,
1999 1998
------------ ------------
(unaudited) (1)
ASSETS
Current Assets:
Cash and cash equivalents ....................... $7,702 $17,023
Short-term marketable securities ................ 19,873 17,635
Accounts receivable, net ........................ 34,754 23,042
Inventories ..................................... 27,076 21,288
Prepaid expenses and other current assets ....... 3,875 3,875
------------ ------------
Total current assets .............................. 93,280 82,863
Property and equipment, net ....................... 49,556 39,848
Long-term marketable securities ................... -- 3,552
Restricted cash ................................... 689 722
Note due from related party ....................... 496 512
Other assets ...................................... 7,250 4,563
------------ ------------
Total assets ...................................... $151,271 $132,060
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ................................ $12,813 $10,014
Accrued payroll and related expenses ............ 3,885 2,354
Income taxes payable ............................ 2,394 1,890
Unearned revenue ................................ 525 643
Current portion of capital leases ............... 1,063 1,098
Other accrued liabilities ....................... 6,721 3,159
------------ ------------
Total current liabilities ......................... 27,401 19,158
Long-term liabilities:
Capital leases .................................. 567 1,416
Notes Payable ................................... -- 612
Other long-term liabilities ..................... 3,967 2,668
------------ ------------
Total long-term liabilities ....................... 4,534 4,696
Commitments and contingencies
Stockholders' equity:
Preferred stock.................................. -- --
Common stock..................................... 31 15
Additional paid-in capital ...................... 146,160 138,895
Accumulated other comprehensive income........... 38 887
Accumulated deficit, $26.3 million relating
to the repurchase of common stock in 1992
and $5.8 million relating to a
recapitalization in 1992 ...................... (26,853) (31,551)
------------ ------------
119,376 108,246
Less common stockholders' notes receivable ...... (40) (40)
------------ ------------
Total stockholders' equity ........................ 119,336 108,206
------------ ------------
Total liabilities and stockholders' equity ........ $151,271 $132,060
============ ============
(1) The balance sheet at December 31, 1998 has been derived from the audited financial statements at that date, as included in the Company's Form 8-K filed with the SEC on June 29, 1999.
See accompanying notes.
SDL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, eccept per share data - unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
------------------- -------------------
1999 1998 1999 1998
--------- --------- --------- ---------
Total revenue:
Product revenue..................... $41,837 $25,424 $78,527 $49,120
Research revenue.................... 1,334 2,962 2,310 6,179
--------- --------- --------- ---------
43,171 28,386 80,837 55,299
Cost of revenue:
Cost of product revenue............. 23,900 17,129 46,030 33,425
Cost of research revenue............ 1,073 2,464 1,976 4,836
--------- --------- --------- ---------
24,973 19,593 48,006 38,261
--------- --------- --------- ---------
Gross margin.......................... 18,198 8,793 32,831 17,038
Operating expenses:
Research and development............ 4,292 3,281 8,073 6,142
Selling, general and administrative. 6,443 4,153 12,123 7,983
Merger costs........................ 2,677 -- 2,677 --
In-process research and development. -- -- 1,495 --
Amortization of purchased
intangibles........................ 210 193 389 389
--------- --------- --------- ---------
Total operating expenses.............. 13,622 7,627 24,757 14,514
--------- --------- --------- ---------
Operating income ..................... 4,576 1,166 8,074 2,524
Interest income, net.................. 297 304 583 597
--------- --------- --------- ---------
Income before income taxes............ 4,873 1,470 8,657 3,121
Provision for income taxes............ 1,662 242 2,823 472
--------- --------- --------- ---------
Net income............................ $3,211 $1,228 $5,834 $2,649
========= ========= ========= =========
Net income per share - basic.......... $0.10 $0.04 $0.19 $0.09
========= ========= ========= =========
Net income per share - diluted........ $0.10 $0.04 $0.18 $0.09
========= ========= ========= =========
Number of weighted average
shares - basic...................... 30,947 28,564 30,518 28,442
========= ========= ========= =========
Number of weighted average
shares - diluted.................... 32,961 30,304 32,554 30,149
========= ========= ========= =========
See accompanying notes.
SDL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands - unaudited)
Six Months Ended
June 30,
--------------------
1999 1998
--------- ---------
OPERATING ACTIVITIES:
Net income............................................ $5,834 $2,649
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization..................... 5,101 4,266
In-process research and development............... 1,495 --
Changes in operating assets and liabilities:
Accounts receivable............................ (11,593) (381)
Inventories.................................... (4,648) (1,802)
Accounts payable............................... 2,668 (1,153)
Accrued payroll and related expenses........... 1,531 326
Income taxes payable........................... 504 (141)
Unearned revenue............................... (118) (200)
Other accrued liabilities...................... 4,005 (38)
Long-term liabilities.......................... 686 872
Other.......................................... (1,069) 1,266
--------- ---------
Total adjustments..................................... (1,438) 3,015
--------- ---------
Net cash provided by operating activities.............. 4,396 5,664
--------- ---------
INVESTING ACTIVITIES:
Acquisition of property and equipment, net............ (14,404) (6,831)
Acquisition of the fiber laser business of Polaroid... (5,055) --
Sale (purchase) of investments, net................... 659 (277)
--------- ---------
Net cash used in investing activities.................. (18,800) (7,108)
--------- ---------
FINANCING ACTIVITIES:
Issuance of stock pursuant to employee stock plans.... 7,277 1,508
Payments on capital leases............................ (762) (657)
Decrease (increase) in restricted cash................ 17 (36)
Payments on notes payable............................. (286) (165)
--------- ---------
Net cash provided by financing activities.............. 6,246 650
--------- ---------
Net decrease in cash and cash equivalents.............. (8,158) (794)
Net cash activity for IOC for the three
months ended December 31, 1998....................... (1,163) --
Cash and cash equivalents at beginning of period....... 17,023 6,170
--------- ---------
Cash and cash equivalents at end of period............. $7,702 $5,376
========= =========
See accompanying notes.
SDL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
June 30, 1999
Basis of Presentation and Business Activities
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 six-month period ended June 30, 1999 are not necessarily indicative of the results that may be expected for the year ended December 31, 1999. For further information, refer to the consolidated financial statements and footnotes thereto included in the Registrant Company's Annual Report on Form 10-K/A for the year ended December 31, 1998 and Form 8-K filed with the SEC on June 29, 1999.
Certain amounts in the financial statements have been reclassified to conform to current period presentation.
The consolidated financial statements include the accounts of SDL, Inc. and its wholly owned subsidiaries, SDL Optics and IOC International plc. Intercompany accounts and transactions have been eliminated in consolidation.
The functional currency of the Company's Canadian subsidiary is the U.S. dollar. These financial statements are remeasured into U.S. dollars for consolidation. The functional currency of the Company's United Kingdom subsidiary is the British Pound Sterling. As such, all assets and liabilities are translated at the exchange rate on the balance sheet date. Revenues and costs and expenses are translated at weighted average rates of exchange prevailing during the period. Translation adjustments are recorded in accumulated other comprehensive income as a separate component of stockholders' equity. Foreign currency transaction gains and losses are included in interest income, 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 second fiscal quarter of 1999 and 1998 ended on July 2, 1999 and July 3, 1998, respectively. For ease of discussion and presentation, all accompanying financial statements have been shown as ending on the last day of the calendar month.
In May 1999, the Company authorized a two-for-one split of its common stock, effected in the form of a stock dividend, which was paid on June 2, 1999 to stockholders of record on May 14, 1999. All of the share and per share data in these financial statements has been adjusted to reflect the stock split.
In May 1999, the Company's stockholders approved an increase in the Company's authorized shares of its common stock to 70 million shares.
As more fully described in Note 8, the Company merged with IOC International plc. ("IOC") in May 1999 in a pooling of interests transaction. The condensed consolidated financial statements for the three and six months ended June 30, 1998 have been restated to include the financial position, results of operations and cash flows of IOC. There were no transactions between IOC and the Company prior to the combination and no significant adjustments were necessary to conform IOC's accounting policies. Because of differing year ends, financial information relating to SDL's three and six months ended June 30, 1998 has been combined with financial information relating to IOC's three and six months ended March 31, 1998. IOC's net loss for the three months ended December 31, 1998 was not combined with SDL's net income, but rather was included as an adjustment to stockholders' equity in the Company's financial results for the three months ended March 31, 1999. IOC's results of operations for the three and six months ended June 30, 1999 has been combined with SDL's results of operations for the three and six months ended June 30, 1999.
In June 1998, the FASB issued Statement of Financial Accounting Standards No. 133, "Accounting for Derivative Instruments and Hedging Activities" ("SFAS 133"). This statement establishes accounting and reporting standards for derivative instruments and for hedging activities. It requires that derivatives be recognized in the balance sheet at fair value and specifies the accounting for changes in fair value. In June 1999, the FASB issued SFAS 137, "Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date of FASB Statement No. 133" to defer the effective date of SFAS 133 until fiscal years beginning after June 15, 2000. The Company generally does not use derivative financial instruments and the impact of SFAS 133 is not anticipated to be material when adopted.
2. Net Income Per Share
In May 1999, the Company authorized a two-for-one split of its common stock, effected in the form of a stock dividend, which was paid on June 2, 1999 to stockholders of record on May 14, 1999. All of the share and per share data in these financial statements has been retroactively adjusted to reflect the stock split.
The following table sets forth the computation of basic and diluted net income per share (in thousands, except per share amounts):
Three Months Ended Six Months Ended
June 30, June 30,
------------------- -------------------
1999 1998 1999 1998
--------- --------- --------- ---------
Numerator:
Net income........................ $3,211 $1,228 $5,834 $2,649
========= ========= ========= =========
Denominator:
Denominator for basic net income
per share - weighted average
shares.......................... 30,947 28,564 30,518 28,442
Incremental common shares
attributable to shares
issuable under employee stock
plans........................... 2,014 1,740 2,036 1,707
--------- --------- --------- ---------
Denominator for diluted net
income per share adjusted
weighted average shares and
assumed conversions............. 32,961 30,304 32,554 30,149
========= ========= ========= =========
Net income per share - basic...... $0.10 $0.04 $0.19 $0.09
========= ========= ========= =========
Net income per share - diluted.... $0.10 $0.04 $0.18 $0.09
========= ========= ========= =========
3. Inventories
The components of inventories consist of the following (in thousands):
June 30, December 31,
1999 1998
------------ ------------
Raw materials ............. $11,319 $7,849
Work-in-process............ 12,578 13,439
Finished Goods............. 3,179 --
------------ ------------
$27,076 $21,288
============ ============
4. Comprehensive Income
Accumulated other comprehensive income presented in the accompanying consolidated balance sheet consists of the accumulated net unrealized gains and losses on available-for-sale marketable securities and foreign currency translation adjustments, net of the related tax effect. The tax effects for other comprehensive income were immaterial for all periods presented.
Total comprehensive income amounted to approximately $3.1 million for the second quarter 1999 compared to a comprehensive income of $0.8 million for the second quarter of 1998. For first half of 1999, comprehensive income amounted to $5.3 million compared to $3.0 million for the corresponding 1998 period.
5. Segment Reporting
SDL has three reportable segments: communications, research, and printing and materials processing. The communications business unit develops, designs, manufactures and distributes lasers for applications in the telecom, cable television, satellite and dense wavelength division multiplexing markets. The research business unit conducts research, development or product customization, involving both communications and printing and material processing applications, for Fortune 500 companies, major international customers, smaller domestic and international companies, and multiple Federal government agencies. The operating results of the research business unit include the results generated from that business unit which includes some revenue classified as product revenue. The printing and materials processing business unit develops, designs, manufacturers and distributes lasers for applications in the surface heat treating, product labeling, digital imaging, digital proofing, and thermal printing solutions markets.
The operating segments reported below are the segments of the Company for which separate financial information is available and for which operating income/loss amounts are evaluated regularly by executive management in deciding how to allocate resources and in assessing performance. The accounting policies of the operating segments are the same as those described in the summary of accounting policies.
The Company's reportable segments are business units that offer different products. The reportable segments are each managed separately because they manufacture and distribute distinct products with different applications. The Company does not allocate assets to its individual operating segments.
Information about reported segment income or loss is as follows (in thousands):
Printing
Communica- and
tion Material
Products Research Processing Total
---------- --------- ----------- ----------
Quarter ended June 30, 1999:
Revenue from external customers... $31,329 $1,378 $10,464 $43,171
Amortization...................... 78 -- 132 210
Segment Operating Income (loss)... $8,542 $15 ($1,304) $7,253
Printing
Communica- and
tion Material
Products Research Processing Total
---------- --------- ----------- ----------
Quarter ended June 30, 1998:
Revenue from external customers... $14,843 $2,059 $11,484 $28,386
Amortization...................... 155 -- 38 193
Segment Operating Income (loss)... ($101) $270 $997 $1,166
Printing
Communica- and
tion Material
Products Research Processing Total
---------- --------- ----------- ----------
Six months ended June 30, 1999:
Revenue from external customers... $58,642 $2,633 $19,562 $80,837
Amortization...................... 156 -- 233 389
Segment Operating Income (loss)... $14,419 ($202) ($1,271) $12,946
Printing
Communica- and
tion Material
Products Research Processing Total
---------- --------- ----------- ----------
Six months ended June 30, 1998:
Revenue from external customers... $27,351 $4,118 $23,830 $55,299
Amortization...................... 310 -- 79 389
Segment Operating Income (loss)... ($627) $471 $2,680 $2,524
For the quarter
ended June 30,
----------------------
1999 1998
----------- ----------
Operating Income
Total operating income from operating
segments............................... $7,253 $1,166
Merger costs.............................. (2,677) --
----------- ----------
Total consolidated operating income ........ $4,576 $1,166
=========== ==========
For the six months
ended June 30,
----------------------
1999 1998
----------- ----------
Operating Income
Total operating income from operating
segments............................... $12,946 $2,524
Merger costs.............................. (2,677) --
In-process R&D and related costs.......... (2,195) --
----------- ----------
Total consolidated operating income ........ $8,074 $2,524
=========== ==========
6. Acquisitions
In February 1999, the Company acquired the fiber laser business of Polaroid for $5.3 million, which includes related transaction costs of $0.1 million. The business acquired includes all the physical assets, intellectual property, including the assignment of 38 patents and the licensing of 22 patents in the fiber laser and fiber amplifier area, and the ongoing operation of the fiber manufacturing facilities and fiber laser subsystem. The acquisition was accounted for under the purchase method of accounting. The Company recorded $1.5 million as in-process research and development for development projects that had not yet reached technological feasibility. Intangible assets are being amortized straight-line over a seven year life. In addition, the Company recorded $0.7 million to accrue for certain pre-existing obligations to integrate the fiber laser business. The results of the fiber laser business are not material to the Company's historical consolidated results of operations.
The purchase price allocation for the fiber laser business acquisition was recorded as follows (in thousands):
Inventory ................. $979
Property and equipment..... 229
Intangibles................ 2,596
In-process R&D............. 1,495
------------
Net assets acquired........ $5,299
============
Liabilities................ $244
Cash paid, including
transaction costs.......... 5,055
------------
Total purchase price....... $5,299
============
7. Contingencies
In 1985, Rockwell International Corporation (Rockwell) asserted, and in 1995 filed suit in the Northern California Federal District Court against the Company alleging that a Company fabrication process infringed certain patent rights set forth in a patent owned by Rockwell. Rockwell sought to permanently enjoin the Company from infringing Rockwell's alleged patent rights and sought unspecified actual and treble damages plus costs. The Company answered Rockwell's complaint asserting, among other defenses, that Rockwell's patent is invalid. Rockwell's suit was stayed in 1995 pending resolution of another suit, involving the same patent, brought by Rockwell against the Federal government, and in which SDL had intervened. The suit between the Federal government and Rockwell was resolved in January 1999, by way of a settlement payment from the Federal government to Rockwell. The Company did not participate in the settlement. As a result of that settlement, the suit was dismissed and the stay of Rockwell's suit against the Company was lifted and the California suit was reactivated. Limited discovery has been conducted by the parties in preparation of the case for trial. Rockwell has also filed a motion for summary judgement relative to certain patent claims of Rockwell's patent alleging that the company has infringed, which motion the Company will vigorously oppose in court. The resolution of this litigation is fact intensive so that the outcome cannot be determined and remains uncertain. If Rockwell prevailed in the litigation, it could be awarded monetary damages against the Company. The Company believes, however, that it has meritorious defenses to the Rockwell's allegations in the litigation.
Shortly after the aforementioned suit between Rockwell and the Federal government was filed, the Federal government had notified the Company that, if the Federal government were liable to Rockwell, then the Federal government might seek indemnification for a portion of its liability from the Company. The Federal government never stated the amount of the Company's alleged indemnity obligation, nor has it ever repeated its assertion that the Company might have some indemnity obligation to the Federal government.
SDL is engaged in various cost-reimbursement type contracts with the Federal government. These contracts utilize allowable costs plus contract fee to determine revenue. 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 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 affect on the Company's financial position, results of operations or cash flows. Nevertheless, based on future developments, the Company's estimate of the outcome of these matters could change in the near term.
During the first half of 1998, supplies of modulators to a customer were withdrawn due to an apparent design problem. It was expected that the replacement modulators would be shipped during the second half of the year. The estimated rework costs of $0.6 million were recorded in the second quarter, but the costs were reversed in the forth quarter since the customer did not return the related modulators. The order has since been cancelled by the customer. While there has been no formal legal claim against the Company, the customer has requested the return of $1.2 million for receivables paid for earlier deliveries. The Company has rejected this request and is confident that if a formal legal claim is received it can be successfully defended.
8. Business Combination
On May 18, 1999, the Company merged with IOC, a United Kingdom-based manufacturer of lithium niobate components for long haul fiber optic transmission systems. The Company has exchanged 1,130,098 shares of SDL common stock and reserved 116,974 shares for IOC options assumed by the Company. Merger related expenses of $2.7 million were recorded in the second quarter of fiscal 1999. Combined and separate unaudited results of SDL and IOC for the periods prior to the acquisition were as follows (in thousands):
Six Months Ended June 30,
1999 1998
---------- ----------
Total revenues:
Prior to April 1, 1999:..
SDL................... $35,730 $51,167
IOC................... 1,936 4,132
Combined results after March 31, 1999.. 43,171 --
---------- ----------
$80,837 $55,299
Net income (loss):
Prior to April 1, 1999:..
SDL................... $3,010 $5,605
IOC................... (387) (2,956)
Combined results after March 31, 1999.. 3,211 --
---------- ----------
$5,834 $2,649
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations
SDL designs, manufactures and markets semiconductor lasers, fiber optic related products and optoelectronic systems. Since 1996, the Company strategy has strongly focused on providing solutions for optical communications. The Company's optical communications products power the transmission of data, voice and Internet information over fiber optic networks to meet the needs of telecommunications, dense wavelength division multiplexing, cable television and satellite communications applications. During the first half of 1999, the Company derived 73% of its revenue from optical communication markets. With the increased focus on commercial communications products, the proportion of SDL's revenue derived from U. S. government related projects has declined from 43% in fiscal 1996 to 15% during the first half of 1999. SDL's optical products also serve a wide variety of non-communications applications, including materials processing, printing, medical and scientific instrumentation. From the original products introduced in 1984, the Company has expanded its product offering to over 150 standard products in addition to providing custom design and packaging for OEM customers. The Company's revenue also includes revenue from customer-funded research programs.
Because of the diversity of products, customers and applications, gross margins tend to fluctuate based in part on the mix of revenue in each reported period. SDL's revenue growth in 1997-1998 was constrained in part by a shortage in qualified manufacturing capacity, especially in the wafer fabrication area. The Company's new wafer fabrication facility received qualification in June 1998, for certain key product lines, allowing a faster ramp-up in production.
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 second fiscal quarter of 1999 and 1998 ended on July 2, 1999 and July 3, 1998, respectively. For ease of discussion and presentation, all accompanying financial statements have been shown as ending on the last day of the calendar month.
In May 1999, the Company merged with IOC International plc. ("IOC") through the issuance of 1,130,098 shares of common stock. The merger was accounted for as a pooling of interests and accordingly all prior period financial statements have been restated to combine the operating results of IOC and the Company for all periods presented. IOC's fiscal year end was September 30. Because of differing year ends, the accompanying statements of income for the three and six months ended June 30, 1998 combine the operating results of IOC for the three and six months ended March 31, 1998 with the operating results of the Company for the three and six months ended June 30, 1998. IOC's results of operations for the three and six months ended June 30, 1999 has been combined with SDL's results of operations for the three and six months ended June 30, 1999. Management's Discussion and Analysis reflects the pooled entity. The comparisons to prior periods below should be read in light of this fact.
RESULTS OF OPERATIONS
Revenue. Total revenue for the quarter ended June 30, 1999 increased 52% to $43.2 million compared to $28.4 million in the corresponding 1998 quarter. For the first half of 1999, total revenue increased 46% to $80.8 million from $55.3 million reported for the comparable period. Product revenue was $41.8 million and $78.5 million for the second quarter and first half of 1999, respectively, which represents increases of 65% and 60% when compared with the corresponding periods in 1998. The increase in product revenue for the second quarter and first half of 1999 was primarily due to revenue growth in the fiber optic communication products, especially 980 nm pump modules and lasers, offset by lower revenues from certain material processing products. Research revenue declined both in dollars and as a percentage of total revenue compared to the second quarter and first half of 1998. This downward trend in research revenue is a result of the Company's continued longer-term strategy focus on commercial communication product opportunities. Revenue derived directly or indirectly from U.S. government sources declined to 13% and 15% of total revenue for the second quarter and first half of 1999, respectively, compared to 31% and 30% for the corresponding periods in 1998.
Results for the three and six month ended June 30, 1999 are not considered indicative of the results to be expected for any future period or for the entire year. In addition, there can be no assurance that the market for the Company's products will grow in future periods at its historical percentage rate or that certain market segments will not decline. Further, there can be no assurance that the Company will be able to increase or maintain its market share in the future or to achieve historical growth rates.
Gross Margin. Excluding one-time charges of $0.7 million for the fiber laser business acquisition in the quarter ended March 31, 1999, gross margins increased to 42% and 41% for the three and six months ended June 30, 1999 from 31% in the comparable 1998 periods. Three factors contributed to the increase in gross margins. These were: (i) a more favorable mix of fiber optic communication product sales, especially increased shipments of pump lasers for undersea fiber cable, as compared to revenue derived from U.S. government contracts and non-communication sales; (ii) increased yields and volumes from the Company's wafer fab; and, (iii) reduction of costs related to 980nm pump lasers. These favorable factors were offset by warranty provisions and declining average selling prices on certain products due to long-term contract arrangements.
The Company's gross margin can be affected by a number of factors, including product mix, customer mix, applications mix, pricing pressures and product yield. Generally, the cost of newer products has tended 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. Considering these factors, gross margin fluctuations are difficult to predict and there can be no assurance that the Company will achieve or maintain gross margins at historical levels in future periods.
Research and Development. Research and development expense was $4.3 million, or 10% of revenue for the quarter ended June 30, 1999 as compared to $3.3 million, or 12% of revenue for the quarter ended June 30, 1998. For the first half of 1999, research and development expense was $8.1 million, or 10% of revenue as compared to $6.1 million, or 11% of revenue for the corresponding 1998 period. The higher levels of 1999 spending were focused on bringing new fiber optic communication products to market.
The Company is committed to continuing its significant research and development expenditures and expects that the absolute dollar amount of research and development expenses will increase as it invests in developing new products and processes, expanding and enhancing its existing product lines, and reducing its costs, although research and development expenses may vary as a percentage of revenue.
Selling, General and Administrative. Selling, general and administrative (SG&A) expense was $6.4 million for the quarter ended June 30, 1999 as compared to $4.2 million for the quarter ended June 30, 1998. SG&A expense, as a percentage of revenue, was 15% for both quarters. For the first half of 1999, SG&A expense was $12.1 million, or 15% of revenue as compared to $8.0 million, or 14% of revenue for the corresponding 1998 period. Four factors drove the increase in SG&A spending during the second quarter and first half of 1999. These were: (i) higher personnel-related costs to support the growth in revenues and operations; (ii) implementation of the Company's new enterprise resource planning software; (iii) increased advertising costs; and, (iv) expansion of the information systems infrastructure to manage the Company's growth. There can be no assurances that current SG&A levels as a percentage of total revenue are indicative of future SG&A as a percentage of total revenue.
In-process research and development. The Company's acquisition of the fiber laser business from Polaroid during the first quarter 1999 resulted in the write-off of purchased in-process research and development of $1.5 million. In the future, additional in-process research and development write-offs can be anticipated to the extent the Company may from time to time acquire companies or new product lines.
Merger Costs. In the quarter ended June 30, 1999, the Company recorded merger related costs of $2.7 million in connection with the acquisition of IOC in a transaction accounted for as a pooling of interest.
Interest Income, net. Net interest income for the three and six months ended June 30, 1999 was $297,000 and $583,000, respectively, compared to $304,000 and $597,000 for the corresponding 1998 periods. Lower average cash and investment balances during the first half of 1999 offset by lower returns on investments in the first half of 1998 resulted in net interest income to be relatively unchanged.
Provision for Income Taxes. The Company recorded a provision for income taxes of $2,823,000 and $472,000 for the six months ended June 30, 1999 and 1998, respectively. Excluding the impact of the in-process research and development charge and IOC merger costs in 1999, the effective tax rate for the first half of 1999 was 22%, compared to 15% for the first half of 1998. In 1998, the Company benefited from previously unrecognized tax loss carryforwards, generated from the 1997 legal settlement, which reduced the federal and state provisions to minimum tax levels offset partially by unbenefited foreign tax losses generated. The increase in the 1999 tax rate is primarily attributable to the Company's utilization of the remainder of federal and state tax loss carryforwards.
Although realization is not assured, the Company believes that it will generate future taxable income sufficient to realize the benefit of the $4.0 million of net deferred tax assets recorded. 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 on a quarterly basis to assess the need for the valuation allowance.
LIQUIDITY AND CAPITAL RESOURCES
As of June 30, 1999, the Company's combined balance of cash, cash equivalents and marketable securities was $28.3 million. Cash provided by operating activities is primarily the result of net income, depreciation and amortization expenses, and increases in accrued liabilities and accounts payable, offset by increases in accounts receivable and inventory.
Cash used in investing activities was $18.8 million in the six months ended June 30, 1999. The Company incurred capital expenditures of $14.4 million for facilities expansion and capital equipment purchases to expand its manufacturing capacities for its fiber optic communication products. The Company currently expects to spend approximately $18 million for capital equipment purchases and leasehold improvements during the remainder of 1999. In addition, the Company acquired Polaroid's fiber laser business during the first quarter of 1999 which resulted in cash payments of $5.1 million.
The Company generated $6.2 million from financing activities during the first half of 1999 primarily from the issuance of stock under employee stock plans, offset by capital lease payments.
The Company believes that current cash balances, cash generated from operations, and cash available through the bank and equity markets will be sufficient to fund capital equipment purchases, acquisitions of complementary businesses, 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 sooner 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 has most changes to critical systems completed. 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 was more cost effective. The project was completed during the quarter ended June 30, 1999.
Assessment and remediation of year 2000 issues in tertiary business information systems is on-going. The Company has determined that over 90% of the Company's desktop PC hardware systems are 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 evaluations of its current manufacturing process, SDL believes it has no material exposure to contingencies directly related directly 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 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 $2.9 million. The Company currently expects that the total cost of these programs, including both incremental spending and redeployed resources, will total approximately $3.1 million, which includes $1.9 million for the purchase of new software and hardware that will be capitalized and $1.2 million that will be expensed as incurred. The Company expects that operating activities will fund these year 2000 remediation costs. 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 Company has not delayed any non-year 2000 projects as a consequence of its year 2000 remediation efforts. 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, identify, 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 is risk that there may 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.
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, plans, intentions, beliefs or strategies regarding the future. Forward-looking statements include statements regarding research and development expenditures, the ability to realize the benefit of net deferred tax assets, capital equipment purchases and leasehold improvement expenditures, the Company's year 2000 plans, the impact and expenses of year 2000 issues, future liability related to year 2000 issues, the Company's year 2000 readiness, and 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 in the Company's Registration Statement on Form S-4 filed with the SEC on April 2, 1999, as amended, and from time to time in the Company's Reports on Forms 10-Q, 8-K, 10-K, 10-K/A and Annual Reports to Stockholders.
Manufacturing Risks
The manufacture of semiconductor lasers and related products and systems that we sell is highly complex and precise, requiring production in a highly controlled and clean environment. Changes in the manufacturing processes or the inadvertent use of defective or contaminated materials by us or our suppliers have in the past and could in the future significantly impair our ability to achieve acceptable manufacturing yields and product reliability. If we do not achieve acceptable yields or product reliability, our operating results and customer relationships will be adversely affected. We rely almost exclusively on our own production capability in:
o computer-aided chip and package design,
o wafer fabrication,
o wafer processing,
o device packaging,
o hybrid microelectronic packaging,
o printed circuit board testing, and
o final assembly and testing of products.
Because we manufacture, package and test these components, products and systems at our own facility, and because these components, products and systems are not readily available from other sources, our business and results of operations will be significantly impaired if our manufacturing is interrupted by any of the following:
o shortages of parts or equipment,
o equipment failures,
o poor yields,
o fire or natural disaster,
o labor or equipment shortages, or
o otherwise.
A significant portion of our production relies or occurs on equipment for which we do not have a backup. To alleviate, at least in part, this situation, we remodeled our front-end wafer fabrication facility and our packaging and test facility. We cannot assure you that we will not experience further start- up costs and yield problems in fully utilizing our increased wafer capacity targeted by these remodeling efforts. In addition, we are deploying a new manufacturing execution software system designed to further automate and streamline our manufacturing processes, and there may be unforeseen deficiencies in this system which could adversely affect our manufacturing processes. In the event of any disruption in production by one of these machines or systems, our business and results of operations could be materially adversely affected. Furthermore, we have a limited number of employees dedicated to the operation and maintenance of our equipment, loss of whom could affect our ability to effectively operate and service our equipment. We experienced lower than expected production yields on some of our products, including certain key product lines over the past 3 years. This reduction in yields:
o adversely affected gross margins,
o delayed component, product and system shipments, and
o to a certain extent, delayed new orders booked.
Although more recently, our yields have improved, we cannot assure you that yields will continue to improve or not decline in the future, nor that in the future our manufacturing yields will be acceptable to ship products on time. To the extent that we experience lower than expected manufacturing yields or experience any shipment delays, gross margins will likely be significantly reduced and we could lose customers and experience reduced or delayed customer orders and cancellation of existing backlog. We presently are ramping production of some of our product lines by:
o changing our shift schedules and equipment coverage,
o hiring and training new personnel,
o acquiring new equipment, and
o expanding our packaging facilities and capabilities.
Difficulties in starting production to meet expected demand and schedules have occurred in the past and may occur in the future including the following:
o quality problems could arise, yields could fall, and gross margins could be reduced during such a ramp.
o aggressive volume pricing for large long-term orders has been provided to certain customers.
o cost reductions in manufacturing are required to avoid a drop in gross margins for certain products sold to customers receiving volume pricing.
These cost reductions may not occur rapidly enough to avoid a decrease in gross margins on products sold under volume pricing terms. In that event, our business and results of operations would be materially adversely affected.
Competition
Our various markets are highly competitive. We face current or potential competition from four primary sources:
o direct competitors,
o potential entrants,
o suppliers of potential new technologies, and
o suppliers of existing alternative technologies.
We offer a range of components, products and systems and have numerous competitors worldwide in various segments of our markets. As the markets for our products grow, new competitors have recently emerged and are likely to continue to do so in the future. We also sell products and services to companies with which we presently compete or in the future may compete and certain of our customers have been or could be acquired by, or enter into strategic relations with our competitors. In most of our product lines, our competitors and we are working to develop new technologies, or improvements and modifications to existing technologies, which will obsolete present products. Many of our competitors have significantly greater financial, technical, manufacturing, marketing, sales and other resources than we do.
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 we. We cannot assure you that:
o our current or potential competitors have not already or will not in the future develop or acquire products or technologies comparable or superior to those that we developed,
o combine or merge with each other or our customers to form significant competitors,
o expand production capacity to more quickly meet customer supply requirements, or
o adapt more quickly than we do 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 our business and results of operations. We cannot assure you that we will be able to compete successfully against current and future competitors or that competitive pressures we face will not have a material adverse effect on our business and results of operations. We expect that both direct and indirect competition will increase in the future. Additional competition could have an adverse material effect on our results of operations through price reductions and loss of market share.
Dependence on Emerging Applications and New Products
Our current products serve many applications in the communications and materials processing and printing markets. In many cases, our products are substantially completed, but the customer's product incorporating our products is not yet completed or the applications or markets for the customer's product are new or emerging. In addition, some of our customers are currently in the process of developing new products that are in various stages of development, testing and qualification, and sometimes are in emerging applications or new markets.
We believe that rapid customer acceptance of our new products is key to our financial results. A substantial portion of our products address markets that are not now, and may never become, substantial commercial markets. We have experienced, and are expected to continue to experience, fluctuation in customer orders and competitive, technological and pricing constraints that may preclude development of markets for our products and our customers' products.
Our customers are often required to test and qualify laser pump modules, transmitters, and marking systems among other new products for potential volume applications. We cannot assure you that:
o we or our customers will continue their existing product development efforts, or if continued that such efforts will be successful,
o markets will develop for any of our technology or that pricing will enable such markets to develop,
o other technology or products will not supersede our products or our customer's products, or
o we will be able to qualify products for certain customers or markets.
We may also be unable to develop new products on a timely schedule. Moreover, even if we are successful in the timely development of new products that are accepted in the market, we often experience lower margins on these products. The lower margins are due to lower yields and other factors, and thus we may be unable to manufacture and sell new products at an acceptable cost so as to achieve acceptable gross margins.
Need To Manage Growth
We have on occasion been unable to manufacture products in quantities sufficient to meet demand of our existing customer base and new customers. The expansion in the scope of our operations has placed a considerable strain on our management, financial, manufacturing and other resources and has required us to implement and improve a variety of operating, financial and other systems, procedures and controls. In addition, we are currently deploying a new enterprise resource planning system and manufacturing execution system.
We cannot assure you that any existing or new systems, procedures or controls will be adequate to support our operations or that our systems, procedures and controls will 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 our business could have a material adverse effect on our business and results of operations.
Our future success is dependent, in part, on our ability to attract, assimilate and retain additional employees, including certain key personnel. We will continue to need a substantial number of additional personnel, including those with specialized skills, to commercialize our products and expand all areas of our business in order to continue to grow. Competition for such personnel is intense, and we cannot assure you that we will be able to attract, assimilate or retain additional highly qualified personnel.
Risks of Acquisitions
Our strategy involves the acquisition and integration of additional companies' products, technologies and personnel. We have limited experience in acquiring outside businesses. Acquisition of businesses requires substantial time and attention of management personnel and may require additional equity or debt financings. Furthermore, integration of newly established or acquired businesses is often disruptive. Since we have acquired or in the future may acquire one or more businesses, we cannot assure you that we will:
o identify appropriate targets,
o acquire such businesses on favorable terms,
o be able to successfully integrate or attain the anticipated synergies expected by bringing such organizations into our business, or
o be able to improve or even maintain the operating results of such businesses.
Failure to do so could significantly impair our business, financial condition and results of operations and a have a material adverse effect on our business and results of operations.
Dependence Upon Government Programs And Contracts
The Company derived approximately 15%, 28%, and 38% of its revenue during the first half of 1999, fiscal 1998, and fiscal 1997, respectively, directly and indirectly from a variety of Federal government sources. The Company received approximately 11%, 14% and 19% of its revenue for the first half of 1999, and fiscal 1998, and fiscal 1997, 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 derived from Federally-funded programs. Revenue from certain of these Lockheed Martin programs are expected to decrease in the near term.
The demand for certain of our services and products is directly related to the level of funding of government programs. We believe that the success and further development of our business is dependent, in significant part, upon the continued existence and funding of such programs and upon our ability to participate in such programs. For example, Federal programs funded substantially all of our research revenue for 1998, 1997 and 1996. Most of our Federally-funded programs are subject to renewal every one or two years, so that continued work by us 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 we 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 our accounting methodology for computing indirect rates and allocating indirect costs to government contracts. The government is currently challenging certain indirect cost allocations. While we believe that amounts recorded on our financial statements are adequate to cover all related risks, the government has not concluded its investigation or agreed to a settlement with us. Although the outcome of this matter cannot be determined at this time, we do not believe that its outcome will have a material adverse effect on our financial position, results of operations and cash flows. However, based on future developments, our estimate of the outcome of these matters could change in the near term. In addition, a change in our accounting practices in this area could result in reduced profit margins on government contracts.
Dependence on Key Employees
Our future performance also depends in significant part upon the continued service of our key technical and senior management personnel. The loss of the services of one or more of our officers or other key employees could significantly impair our business, operating results and financial condition. While many of our current employees have many years of service with us, there can be no assurance that we will be able to retain our existing personnel. If we are unable to retain and hire additional personnel, our business and results of operations could be materially and adversely affected. See also "Our acquisition strategy poses several risks" above.
Risk of Patent Infringement 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 we have 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, we cannot assure you that:
o additional infringement claims (or claims for indemnification resulting from infringement claims) will not be asserted against us, or
o that existing claims or any other assertions will not result in an injunction against the sale of infringing products or otherwise significantly impair our business and results of operations.
In 1985, we first received correspondence from Rockwell International Corporation alleging that we used a fabrication process that infringes Rockwell's patent rights. Those allegations led to two related lawsuits, one of which is still pending. The first lawsuit was filed in August 1993, when Rockwell sued the Federal government in the United States Court of Federal Claims, alleging infringement of these patent rights with respect to the contracts the Federal government has had with at least 15 companies, including us (Rockwell International Corporation v. The United States of America, No. 93-542C (US Ct. Fed. Cl.)). We were not originally named as a party to this lawsuit. However, the Federal government has asserted that, if we were held liable to Rockwell for infringement of Rockwell's patent rights in connection with some of its contracts with us, then we would be liable to indemnify the Federal government for a portion of its liability on certain contracts.
In June 1995, we filed a motion to intervene in the lawsuit filed in August 1993 after Rockwell filed a second lawsuit against us in May, 1995 in California. That motion was granted on August 17, 1995. Upon intervening in the Federal government's lawsuit, we filed an answer to Rockwell's complaint, alleging that:
o Rockwell's patent was invalid and that we did not infringe Rockwell's patent,
o Rockwell's patent was unenforceable under the doctrine of inequitable conduct, and
o Rockwell's action is barred by the doctrines of laches and equitable estoppel.
After extensive discovery, we moved, as did the Federal government, for summary judgment on the ground that Rockwell's patent was invalid. By order dated February 5, 1997, the Court of Federal Claims granted those motions and entered judgment in our favor and in favor of the Federal government. However, Rockwell appealed the Court of Federal Claims' decision, and on June 15, 1998, the United States Court of Appeals for the Federal Circuit issued an opinion vacating the judgment that had been entered in our favor and in favor of the Federal government. The US Circuit Court for 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 could not be decided by summary judgement but instead requires a trial. The Federal Circuit:
o remanded the case back to the trial court for further proceedings, and
o affirmed the Court of Federal Claims' denial of our motion for summary judgment of invalidity based on anticipation, as well as the Court of Federal Claims' claim construction.
Subsequent to the Federal Circuit's action, the United States agreed to pay Rockwell $16.9 million in settlement of the first lawsuit and the first lawsuit was dismissed by the Court of Federal Claims in January, 1999. We did not participate in the settlement. Since the settlement, the Federal government has not again raised the issue of our potential indemnity obligation to them.
As noted above, we made our decision to intervene in the first lawsuit filed after Rockwell filed the second lawsuit against us in the Northern District of California, alleging that we had infringed the Rockwell patent in connection with our manufacture and sale of products to customers other than the United States. Again, the complaint alleges that we used a fabrication process that infringes the Rockwell patent (Rockwell International Corporation v. SDL, Inc., No. C95-01729 MHP (US Dist.Ct., N.D. Cal.)). By its complaint, Rockwell seeks a permanent injunction against us to:
o enjoin us from infringement of the Rockwell patent,
o require us to pay damages in an unspecified amount for our alleged past infringement of the patent, treble damages and attorneys' fees.
The complaint was served on us on June 30, 1995, and we filed an answer to the complaint on August 18, 1995, alleging that:
o Rockwell's patent is invalid,
o we did not infringe Rockwell's patent,
o Rockwell's patent is unenforceable under the doctrine of inequitable conduct, and
o Rockwell's action is barred by the doctrines of laches and equitable estoppel.
On August 11, 1995, prior to filing our answer, we filed a motion to stay this action based upon the pendency of the lawsuit brought by the federal government. The District Court granted our motion to stay on September 15, 1995. Subsequent to the settlement of the first lawsuit, the District Court lifted this stay, and discovery re-commenced in the second lawsuit.
Although the Court of Federal Claims ruled in our favor in the first lawsuit, finding the patent invalid on motion for summary judgment, the Court of Appeals for the Federal Circuit reversed the summary judgment ruling, meaning that the issue of validity needed to go to trial. Such a trial would now occur before a jury in California. The California judge also required that a settlement conference between Rockwell and SDL be scheduled in order to see if the parties can resolve the dispute before trial, which conference occurred in the first part of June 1999. The parties were unable to successfully resolve the lawsuit.
Later in June, 1999, Rockwell filed a motion for summary judgement relative to certain patent claims in their patent rights seeking to have the court summarily find us to have infringed those claims, which motion will be vigorously opposed by the Company. The hearing on the motion will be held in September. Regardless of the outcome of the decision of this motion, the company believes that its other defenses in the litigation of patent invalidity, inequitable conduct, laches and equitable estoppel are meritorious and will be pursued at trial.
The resolution of this litigation is fact intensive so that the outcome cannot be determined and remains uncertain. If Rockwell prevailed in the litigation, it could be awarded monetary damages against the Company. While we believe that we have meritorious defenses to Rockwell's allegations, there can be no assurance that Rockwell will not ultimately prevail in this dispute. If Rockwell were to prevail, Rockwell could be awarded substantial monetary damages and/or an injunction against us for the sale of infringing products. If this injunction were entered, we may seek to obtain a license to use Rockwell's patent. We cannot assure you, however, that a license would be available on reasonable terms or at all. The award of monetary damages against us, or the failure to obtain a license to use Rockwell's patent on commercially reasonable terms could have a material adverse effect on our business and results of operations. Litigation and trial of Rockwell's claim against us is expected to involve significant expense to us and could divert the attention of our technical and management personnel and could have a material adverse effect on our business and results of operations.
In addition, we are involved in various legal proceedings and controversies arising in the ordinary course of our business.
Customer Order Fluctuations
Our product revenue is subject to fluctuations in customer orders. Occasionally, some of our customers have ordered more products than they need in a given period, thereby building up inventory and delaying placement of subsequent orders until such inventory has been reduced. We may also build inventory in anticipation of receiving new orders in the future. Also, customers have occasionally placed large orders that they have subsequently cancelled. In addition, due to the fact that our sales of our 980 nm pump module products comprise a significant portion of our total revenues, our revenues are particularly susceptible to customer order fluctuations for this product. These fluctuations, cancellations and the failure to receive new orders can have adverse effects on our business and results of operations. We may also have incurred significant inventory or other expenses in preparing to fill such orders prior to their cancellation. Virtually our entire backlog is subject to cancellation. Cancellation of significant portions of our backlog, or delays in scheduled delivery dates, could have a material adverse effect on our business and results of operations.
Dependence of Proprietary Technology
Our future success and competitive position is dependent in part upon our proprietary technology, and we rely in part on patent, trade secret, trademark and copyright law to protect our intellectual property. There can be no assurance that:
o any of the over 200 patents, domestic and foreign, owned or approximately 100 patents licensed by us will not be invalidated, circumvented, challenged or licensed to others,
o the rights granted under the patents will provide competitive advantages to us,
o any of our approximately 150 pending or future patent applications will be issued with the scope of the claims sought by us, if at all, or
o that others will not develop technologies that are similar or superior to our technology, duplicate our technology or design around the patents we own, or patent or assert patents on technology which we might use or intend to use.
In addition, effective copyright and trade secret protection may be unavailable, limited or not applied for in certain foreign countries. Our technology is licensed on a non-exclusive basis from Xerox and other third parties that may license such technology to others, including our competitors. There can be no assurance that steps we take to protect our technology will prevent misappropriation of such technology. In addition, litigation has been necessary and may be necessary in the future:
o to enforce our patents and other intellectual property rights,
o to protect our trade secrets,
o to determine the validity and scope of the proprietary rights of others, or
o to defend against claims of infringement or invalidity of intellectual property rights developed internally or acquired from third parties.
Litigation of this type has resulted in substantial costs and diversion of resources and could have a material adverse effect on our business and results of operations. Moreover, we may be required to participate in interference proceedings to determine the propriety of inventions. These proceedings could result in substantial cost to us.
International Distribution Risks
Revenues from customers outside of the United States accounted for approximately 34 percent, 24 percent and 17 percent, of our total revenue in the first half of 1999, fiscal 1998 and 1997, respectively. International revenue carries a number of inherent risks, including:
o reduced protection for intellectual property rights in some countries,
o the impact of unstable environments in economies outside the United States,
o generally longer receivable collection periods,
o changes in regulatory environments,
o tariffs, and
o other potential trade barriers.
In addition, some of our international revenue is subject to export licensing and approvals by the Department of Commerce or other Federal governmental agencies. Although to date, we have experienced little difficulty in obtaining such licenses or approvals, the failure to obtain these licenses or approvals or comply with such regulations in the future could have a material adverse effect on our business and results of operations.
We currently use local distributors in key industrialized countries and local representatives in smaller markets. Although we have formal distribution contracts with some of our distributors and representatives, some of our relationships are currently on an informal basis. Most of our international distributors and representatives offer only our products; however, certain distributors offer competing products and we cannot assure you that additional distributors and representatives will not also offer products that are competitive with our products. We cannot assure you that our international distributors and representatives will enter into formal distribution agreements at all or on acceptable terms, will not terminate informal or contractual relationships, will continue to sell our products or that we will provide the distributors and resellers with adequate levels of support. Our business and results of operations will be affected adversely if we lose a significant number of our international distributors and representatives or experience a decrease in revenue from these distributors and representatives.
Environmental Risks
We are subject to a variety of federal, state and local laws and regulations concerning the storage, use, discharge and disposal of toxic, volatile, or otherwise hazardous or regulated chemicals or materials used in our manufacturing processes. Further, we are subject to other safety, labeling and training regulations as required by local, state and federal law. We have established an environmental and safety compliance program to meet the objectives of applicable federal, state and local laws. Our environmental and safety department administers this compliance program which includes monitoring, measuring and reporting compliance, establishing safety programs and training our personnel in environmental and safety matters. We cannot assure you that changes in these regulations and laws will not have an adverse economic effect on us. Further, these local, state, and federal regulations could restrict our ability to expand our operations. If we do not:
o obtain required permits for,
o operate within regulations for,
o control the use of, or
o adequately restrict the discharge of hazardous or regulated substances or materials under present or future regulations, we may be required to pay substantial penalties, to make costly changes in our manufacturing processes or facilities or to suspend our operations.
Dependence on Single Source And Other Third Party Suppliers
We depend on a single or limited number of outside contractors and suppliers for raw materials, packages and standard components, and to assemble printed circuitboards. We generally purchase these products through standard purchase orders or one-year supply agreements. We do not have long-term guaranteed supply agreements with these suppliers. We seek to maintain a sufficient safety stock to overcome short-term shipping delays or supply interruptions by our suppliers. We also endeavor to maintain ongoing communications with our suppliers to guard against interruptions in supply. To date, we have generally been able to obtain sufficient supplies in a timely manner. However, our business and results of operations have in the past been and could be impaired by:
o a stoppage or delay of supply,
o substitution of more expensive or less reliable parts,
o receipt of defective parts or contaminated materials, and
o an increase in the price of such supplies or our inability to obtain reduced pricing from our suppliers in response to competitive pressures.
Potential Volatility of Stock Price
The market price of our Common Stock may fluctuate significantly because of:
o announcements of technological innovations,
o large customer orders,
o customer order delays or cancellations,
o customer qualification delays,
o new products by us, our competitors or third parties,
o possible acquisition of us by a third party,
o merger or acquisition announcements,
o production problems,
o quarterly variations in our actual or anticipated results of operations, and
o developments in litigation in which we are or may become involved.
Furthermore, the stock market has experienced extreme price and volume volatility, which has particularly affected the market prices of many high technology companies. This volatility has often been unrelated to the operating performance of such companies. This broad market volatility may adversely affect the market price of our Common Stock. Many companies in the optical communications industry have in the past year experienced historical highs in the market prices of their stock. We cannot assure you that the market price of our Common Stock will not experience significant volatility in the future, including volatility that is unrelated to our performance.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
The Company's market risk disclosures set forth in Item 7A of its Annual Report on Form 10-K/A for the year ended December 31, 1998 have not changed significantly.
PART II: OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Not applicable
ITEM 2. CHANGES IN SECURITIES
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
Not applicable
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) List of Exhibits
Exhibit 3.1.3 - Amendment to the Restated Certificate of Incorporation
Exhibit 27.1 - Financial Data Schedule
(b) Reports on Form 8-K
1. The Company filed a report on Form 8-K on June 2, 1999 to report the merger of a wholly-owned subsidiary with and into IOC International plc. on May 18, 1999, which transaction has been accounted for as a pooling of interests.
2. The Company filed a report on Form 8-K on June 29, 1999 to report certain supplemental financial statements of the Company and IOC International plc.
SDL, INC.
SIGNATURES
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) |
Dated: August 9, 1999
| By: | /s/ Michael L. Foster |
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| Michael L. Foster | |
|
Vice President, Finance Chief Financial Officer | |
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(Duly Authorized Officer, and Principal Financial and Accounting Officer) |
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