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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 March 31, 2000
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 May 10, 2000 was 76,549,877.
SDL, INC.
FORM 10-Q
INDEX
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (unaudited):
Condensed Consolidated Balance Sheets - March 31, 2000 and December 31, 1999
Condensed Consolidated Statements of Operations - three months ended March 31, 2000 and 1999
Condensed Consolidated Statements of Cash Flows - three months ended March 31, 2000 and 1999
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
Impact of Year 2000
Risk Factors
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
SDL, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
March 31, December 31,
2000 1999
------------ ------------
(unaudited) (1)
ASSETS
Current Assets:
Cash and cash equivalents .................... $238,239 $153,016
Short-term marketable securities ............. 76,903 161,120
Accounts receivable, net ..................... 49,652 41,445
Inventories .................................. 36,971 32,070
Prepaid expenses and other current assets .... 3,628 3,659
------------ ------------
Total current assets ........................... 405,393 391,310
Property and equipment, net .................... 65,670 59,772
Long-term marketable securities ................ 0 --
Restricted cash ................................ 680 686
Goodwill and other intangibles, net............. 93,258 2,948
Other assets ................................... 15,271 6,237
------------ ------------
Total assets ................................... $580,272 $460,953
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable ............................. $19,151 $18,277
Accrued payroll and related expenses ......... 4,118 10,717
Income taxes payable ......................... 8,854 1,093
Current portion of capital leases ............ 874 1,011
Other accrued liabilities .................... 7,498 4,950
------------ ------------
Total current liabilities ...................... 40,495 36,048
Long-term liabilities:
Capital leases ............................... 860 965
Other long-term liabilities .................. 13,667 3,792
------------ ------------
Total long-term liabilities .................... 14,527 4,757
Commitments and contingencies
Stockholders' equity:
Preferred stock............................... -- --
Common stock.................................. 73 72
Additional paid-in capital ................... 518,191 425,993
Accumulated other comprehensive income........ 216 1,557
Retained Earnings (Accumulated deficit)....... 6,770 (7,474)
------------ ------------
Total stockholders' equity ..................... 525,250 420,148
------------ ------------
Total liabilities and stockholders' equity ..... $580,272 $460,953
============ ============
(1) The balance sheet at December 31, 1999 has been derived from the audit financial statements at that date.
SDL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(in thousands, except per share data - unaudited)
Three Months Ended
March 31,
--------------------
2000 1999
--------- ----------
Revenue................................ $72,206 $37,666
Cost of revenue........................ 37,616 23,033
--------- ----------
Gross margin......................... 34,590 14,633
Operating expenses:
Research and development............ 5,903 3,781
Selling, general and administrative. 7,298 5,680
In-process research and development. 1,200 1,495
Amortization of purchased
intangibles........................ 1,744 179
--------- ----------
Total operating expenses.............. 16,145 11,135
--------- ----------
Operating income ..................... 18,445 3,498
Interest income and other, net........ 4,485 286
--------- ----------
Income before income taxes............ 22,930 3,784
Provision for income taxes............ 8,686 1,161
--------- ----------
Net income............................ $14,244 $2,623
========= ==========
Net income per share - basic.......... $0.20 $0.04
========= ==========
Net income per share - diluted........ $0.19 $0.04
========= ==========
Number of weighted average
shares - basic...................... 72,019 60,176
========= ==========
Number of weighted average
shares - diluted.................... 76,507 64,296
========= ==========
See accompanying notes.
SDL, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands - unaudited)
Three Months Ended
March 31,
--------------------
2000 1999
--------- ---------
OPERATING ACTIVITIES:
Net income............................................ $14,244 $2,623
--------- ---------
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation ..................................... 3,148 3,010
Amortization of intangibles....................... 1,744 179
Stock-based compensation.......... 654 68
In-process research and development............... 1,200 1,495
Changes in operating assets and liabilities:
Accounts receivable............................ (6,578) (5,687)
Inventories.................................... (3,236) (2,029)
Accounts payable............................... (1,532) (1,457)
Accrued payroll and related expenses........... (6,748) 342
Income taxes payable........................... 7,761 (438)
Other accrued liabilities...................... (486) 447
Long-term liabilities.......................... (962) 623
Other.......................................... (552) (428)
--------- ---------
Total adjustments..................................... (5,587) (3,875)
--------- ---------
Net cash provided by (used in) operating activities.... 8,657 (1,252)
--------- ---------
INVESTING ACTIVITIES:
Acquisition of property and equipment, net............ (6,479) (7,393)
Acquisition of the fiber laser business of Polaroid... -- (5,055)
Acquisition of Queensgate, net of cash acquired....... (3,988) --
Sale (purchase) of marketable securities, net......... 83,013 2,147
--------- ---------
Net cash provided by (used in) investing activities.... 72,546 (10,301)
--------- ---------
FINANCING ACTIVITIES:
Issuance of stock pursuant to employee stock plans.... 4,385 3,016
Payments on capital leases............................ (371) (380)
Decrease (increase) in restricted cash................ 6 36
Other................................................. -- (232)
--------- ---------
Net cash provided by financing activities.............. 4,020 2,440
--------- ---------
Net increase (decrease) in cash and cash equivalents... 85,223 (9,113)
Net cash activity of IOC for the three
months ended December 31, 1998....................... -- (1,163)
Cash and cash equivalents at beginning of period....... 153,016 17,023
--------- ---------
Cash and cash equivalents at end of period............. $238,239 $6,747
========= =========
See accompanying notes.
SDL, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
March 31, 2000
1. 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 adjustments) considered necessary for a fair presentation have been included. Operating results for the three month period ended March 31, 2000 are not necessarily indicative of the results that may be expected for the year ending December 31, 2000. For further information, refer to the consolidated financial statements and footnotes thereto included in the Registrant's Annual Report on Form 10-K for the year ended December 31, 1999.
The consolidated financial statements include the accounts of SDL, Inc. and its wholly owned subsidiaries, SDL Optics, SDL Integrated Optics and SDL Queensgate. Intercompany accounts and transactions have been eliminated in consolidation.
The functional currency of the Company's Canadian subsidiary (SDL Optics) is the U.S. dollar. The financial statements of the Canadian subsidiary are remeasured into U.S. dollars for the purposes of consolidation using the historical exchange rates in effect at the date of the transactions. Remeasurement gains and losses are recorded in the income statement and have not been material to date. The functional currency of the Company's United Kingdom subsidiaries is the British Pound Sterling. All assets and liabilities of the Company's United Kingdom subsidiaries (SDL Integrated Optics and SDL Queensgate) 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 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 first fiscal quarter of 2000 and 1999 ended on March 31, 2000 and April 2, 1999, respectively. For ease of discussion and presentation, all accompanying financial statements have been shown as ending on the last day of the calendar quarter.
In December 1999, the Company authorized a two-for-one split of its common stock, effected in the form of a 100 percent stock dividend, which was paid on March 14, 2000 to stockholders of record on February 29, 2000. All of the share and per share data in these financial statements have been retroactively adjusted to reflect the stock split.
In February 2000, the Company's stockholders approved an increase in the Company's authorized shares of its common stock from 70 million shares to 140 million shares.
On March 8, 2000 Queensgate was acquired by SDL in a transaction accounted for as a purchase. Queensgate was a privately held company and is located in Bracknell, United Kingdom. Queensgate designs, develops, manufactures and markets optical network monitoring modules for long haul terrestrial fiber optic transmission systems. The acquisition agreement provided for initial consideration of $3 million of cash and 347,962 shares of the Company's common stock with a fair value of approximately $77 million, and contingent payments of up to an additional $150 million in common stock based on Queensgate's pretax profits for the 10 months ending December 31, 2000 and the twelve months ending December 31, 2001. In addition, SDL issued options in exchange for outstanding Queensgate options with the number of shares and the exercise price appropriately adjusted by the exchange ratio. See note 6, Acquisitions.
In April 2000, the Company acquired Veritech Microwave, Inc. ("Veritech") for 3,000,000 shares of the Company's common stock with a fair value of approximately $621 million. Veritech was a privately held company located in South Plainfield, New Jersey. Veritech designs, develops, manufactures and markets optoelectronic modules for long haul undersea and terrestrial fiber optic transmission systems. The acquisition will be accounted for under the purchase method of accounting. The Company believes it may write-off significant amounts related to in-process research and development during the second quarter of fiscal 2000.
In May 2000, the Company entered into an agreement to acquire Photonic Integration Research, Inc. (PIRI) for 10,200,000 shares of the Company's common stock with a fair value of approximately $1.8 billion and a $31.25 million cash payment. PIRI, a privately held company located in Columbus, Ohio, is a leading manufacturer of arrayed waveguide gratings (AWGs) that enable the routing of individual wavelength channels in fiber optic systems. These products are used in optical multiplexing (mux) and demultiplexing (demux) applications for dense wavelength division multiplexed (DWDM) fiber optic systems. The acquisition is anticipated to close in the second quarter of fiscal 2000 and will be accounted for under the purchase method of accounting. The Company believes it may write-off significant amounts related to in-process research and development when the acquisition is completed and that quarterly amortization of purchased intangibles will also be substantial.
As a result of the substantial increase in the market price of the Company's Common Stock beginning in the fourth quarter of 1998, and the resulting increased levels of employee participation in the Company's Employee Stock Purchase Plan ("ESPP"), it is currently contemplated that the number of shares issuable pursuant to the Company's ESPP in fiscal 2000 will exceed the number of shares that were available under the Plan at the beginning of the October 1998 employee purchase period. As a result, the Company expects to incur non-cash charges to operating results aggregating approximately $12.1 million. These charges will occur primarily in the second and third quarters of fiscal 2000.
In December 1999, the staff of the Securities and Exchange Commission issued Staff Accounting Bulletin No. 101, "Revenue Recognition in Financial Statements" ("SAB 101"). The SAB summarizes certain of the Staff's views in applying generally accepted accounting principles to revenue recognition in financial statements. SAB 101 provides that if registrants have not applied the accounting therein they should implement the SAB and report a change in accounting principle. SAB 101, as subsequently amended, will be effective for the Company no later than the second quarter of 2000. The Company does not believe that adoption of SAB 101 will have a material impact on its financial condition or results of operations.
2. Net Income Per Share
The following table sets forth the computation of basic and diluted net income per share (in thousands, except per share amounts):
Three Months Ended
March 31,
-------------------
2000 1999
--------- ---------
Numerator:
Net income........................ $14,244 $2,623
========= =========
Denominator:
Denominator for basic net income
per share - weighted average
shares.......................... 72,019 60,176
Incremental common shares
attributable to shares
issuable under employee stock
plans........................... 4,488 4,120
--------- ---------
Denominator for diluted net
income per share adjusted
weighted average shares and
assumed conversions............. 76,507 64,296
========= =========
Net income per share - basic...... $0.20 $0.04
========= =========
Net income per share - diluted.... $0.19 $0.04
========= =========
3. Inventories
The components of inventories consist of the following (in thousands):
March 31, December 31,
2000 1999
------------ ------------
Raw materials ............. $12,956 $15,115
Work-in-process............ 21,174 14,615
Finished Goods............. 2,841 2,340
------------ ------------
$36,971 $32,070
============ ============
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 effects. The tax effects for other comprehensive income were immaterial for all periods presented.
Total comprehensive income amounted to approximately $12.9 million for the first quarter 2000 compared to a comprehensive income of $1.9 million for the first quarter of 1999.
5. Segment Reporting
SDL has two reportable segments: communications and industrial laser. The communications business unit develops, designs, manufactures and distributes lasers, modulators, drivers, modules and subsystems for applications in the telecom, cable television, satellite and dense wavelength division multiplexing markets. The industrial laser business unit develops, designs, manufacturers and distributes lasers and subsystems for applications in the surface heat treating, product marking, 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):
Communica-
tion Industrial
Products Laser Total
---------- --------- -----------
Quarter ended March 31, 2000:
Revenue from external customers... $60,876 $11,330 $72,206
Segment Operating Income (loss)... $23,245 ($1,856) $21,389
Communica-
tion Industrial
Products Laser Total
---------- --------- -----------
Quarter ended March 31, 1999:
Revenue from external customers... $28,568 $9,098 $37,666
Segment Operating Income ......... $5,738 $134 $5,872
A reconciliation of the totals reported for the operating segments to the applicable line items in the consolidated financial statements is as follows (in thousands):
For the three months
ended March 31,
----------------------
2000 1999
----------- ----------
Operating Income
Total operating income from operating
segments............................... $21,389 $5,872
Amortization of intangibles............... (1,744) (179)
In-process R&D and related costs.......... (1,200) (2,195)
----------- ----------
Total consolidated operating income ........ $18,445 $3,498
=========== ==========
Major Customers
During the first three months of 2000, four communication product customers and their affiliates accounted for 17 percent, 16 percent, 13 percent and 13 percent of revenues, respectively. During fiscal 1999, three communication product customers and their affiliates accounted for 15 percent, 11 percent and 11 percent of revenues, respectively.
6. Acquisitions
Queensgate
Overview
On March 8, 2000 Queensgate merged with SDL in a transaction accounted for as a purchase. Queensgate was a privately held company and is located in Bracknell, United Kingdom. Queensgate designs, develops, manufactures and markets optical network monitoring modules for long haul terrestrial fiber optic transmission systems. The merger agreement provided for initial consideration of $3 million of cash and 347,962 shares of the Company's common stock with a fair value of approximately $77 million, and contingent payments of up to an additional $150 million in common stock based on Queensgate's pretax profits for the 10 months ended December 31, 2000 and the twelve months ended December 31, 2001. In addition, SDL issued options in exchange for outstanding Queensgate options with the number of shares and the exercise price appropriately adjusted by the exchange ratio.
Valuation Methodology
In accordance with the provisions of Accounting Principle Board Opinion No. 16 (APB No. 16), Business Combinations, all identifiable assets, including identifiable intangible assets, were assigned a portion of the cost of the acquired business (purchase price) on the basis of the respective fair values. This included the portion of the purchase price properly attributable to incomplete research and development projects that should be expensed according to the requirements of Interpretation 4 of Statement of Financial Accounting Standards No. 2.
Intangible assets were identified through: (i) analysis of the acquisition agreement, (ii) consideration of the Company's intentions for future use of the acquired assets; and (iii) analysis of data available concerning the business products, technologies, markets, historical financial performance, estimates of future performance and the assumptions underlying those estimates.
The economic and competitive environment in which the Company and Queensgate operate was also considered in the valuation.
Specifically, in-process research and development, core technology and existing technology was identified and valued through extensive interviews and discussion with the Company and Queensgate's management. The valuation of in-process research and development included an analysis of data provided by Queensgate concerning the products in development, their respective stage of development, the time and resources needed to complete them, their expected income generating ability, target markets and associated risks. The Income Approach, which included an analysis of the markets, cash flows, and risks associated with achieving such cash flows, was the primary technique utilized in valuing the in-process research and development, core technology and existing technology. Tradename was valued using the Brand Savings approach and workforce was valued using the estimated cost of recruiting and training replacement workers.
The total purchase cost and purchase price allocation of the Queensgate merger is as follows (in thousands):
Value of securites issued......... $77,376
Cash.............................. 3,000
Assumption of Queensgate options.. 1,502
----------
81,878
Estimated transaction costs...... 1,125
----------
Total purchase cost.............. 83,003
Annual
Amount Amortization
Purcahse price allocation:
Tangible net deficit........... (1,570) n/a n/a
Tradename...................... 2,000 400 5 years
Core technologoy............... 12,000 2,400 5 years
Existing technology............ 6,200 1,240 5 years
In process technology.......... 1,200 n/a n/a
Workforce...................... 1,500 300 5 years
Goodwill....................... 70,353 14,071 5 years
Deferred tax liabilities....... (8,680) n/a n/a
---------- ------------
Total estimated purchase
price allocation............. 83,003 18,411
The purchase price allocation is preliminary and, therefore, subject to change based on the Company's final analysis and receipt of a final report by a valuation specialist used by the Company to assist in the purchase price allocation.
Assumptions
The Income Approach used by the Company to value in-process research and development, core technology and existing technology included assumptions relating to revenue estimates, operating expenses, income taxes and discount rates.
Revenue
Revenue estimates were developed based on: (i) aggregate revenue growth rates for the business as a whole, (ii) individual product revenues, (iii) growth rates for the telecommunications industry, (iv) the aggregate size of the telecommunication industry, (v) anticipated product development and introduction schedules, (vi) product sales cycles, and (vii) the estimated life of a product's underlying technology.
The estimated product development cycle for the new product was 12 months.
Operating Expenses
Operating expenses used in the valuation analysis of Queensgate included: cost of goods sold, selling, general and administrative expenses, and research and development expenses.
In developing future expense estimates, an evaluation of both the Company and Queensgate's overall business model, specific product results, including both historical and expected direct expense levels, as appropriate, and an assessment of general industry metrics was conducted.
Cost of goods sold
Costs of goods sold, expressed as a percentage of revenue, for the core, existing and in-process technologies ranged from 61 percent for the twelve months ending March 31, 2001 to 53 percent in fiscal 2002 and beyond.
Selling, general and administrative expenses
Selling, general and administrative expenses, expressed as a percentage of revenue, for the core, existing, and in-process technologies 17 percent for the twelve months ending March 31, 2001 to 11 percent in fiscal 2002 and beyond.
Research and development expense
Research and development expense consists of the costs associated with activities undertaken to correct errors or keep products updated with current information, also referred to as "maintenance" research and development. Maintenance research and development includes all activities undertaken after a product is available for general release to customers to keep the product updated with current customer specifications. These activities include routine changes and additions. The maintenance research and development expense was estimated to be 1 percent of revenue for the core, existing, and in-process technologies throughout the estimation period.
Effective tax rate
The effective tax rate was determined based on federal and state statutory tax rates and was determined to be 41 percent.
Discount rate
The discount rate for Queensgate's core, existing, and in-process technologies were 18 percent, 14 percent and 20 percent, respectively. In the selection of the appropriate discount rates, consideration was given to (i) the weighted average cost of capital and (ii) the weighted average return on assets. The discount rate utilized for the in-process technology was determined to be higher than the Company's weighted average cost of capital because the technology had not yet reached technological feasibility as of the date of valuation. In utilizing a discount rate greater than the Company's weighted average cost of capital, management has reflected the risk premium associated with achieving the forecasted cash flows associated with these projects.
The in-process research and development was comprised of one project and amounted to $1.2 million of the total purchase price and was charged to expense during the quarter ended March 31, 2000. The estimated cost of completion of the in-process research and development project is $0.2 million. The acquired existing technology is comprised of products in Queensgate portfolio that are already technologically feasible. The Company expects to amortize the acquired existing technology of approximately $6.2 million on a straight-line basis over an estimated remaining useful life of 5 years.
The core technology represents Queensgate trade secrets and patents developed through years of experience designing and manufacturing optical network monitoring modules. This know-how enables the Company to develop new and improve existing optical network monitoring modules, processes, and manufacturing equipment. The Company expects to amortize the core technology of approximately $12.0 million on a straight-line basis over an average estimated remaining useful life of 5 years.
The trade names include the Queensgate trademark and trade name as well as all branded Queensgate products. The Company expects to amortize the trade names of approximately $2.0 million on a straight-line basis over an estimated remaining useful life of 5 years.
The acquired assembled workforce is comprised of over 100 skilled employees across Queensgate's General and Administration, Research and Development, Sales and Marketing, and Manufacturing groups. The Company expects to amortize the assembled workforce of approximately $1.5 million on a straight-line basis over an estimated remaining useful life of 5 years.
Goodwill, which represents the excess of the purchase price of an investment in an acquired business over the fair value of the underlying net identifiable assets, is amortized on a straight-line basis over an estimated useful life of 5 years.
The following unaudited pro forma information presents the results of operations of the Company as if the acquisition had taken place on January 1, 1999 and excludes the write-off of purchased in process research and development of $1.2 million:
(In thousands, For the three months
except per share amounts) ended March 31,
---------------------------
2000 1999
------------ ------------
Revenues.......................... $73,897 $40,122
Net income (loss)................. $11,901 ($5,126)
Earnings (loss) per share-basic... $0.16 ($0.08)
Earnings (loss) per share-diluted. $0.15 ($0.08)
These pro-forma results of operations have been prepared for comparative purposes only and do not purport to be indicative of the results of operations which actually would have resulted had the acquisition occurred on the date indicated, or which may result in the future.
Polaroid Corporation's fiber laser business
In February 1999, the Company acquired the fiber laser business of Polaroid Corporation for $5.3 million in cash, which includes related transaction costs of $0.1 million. The business acquired included 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-process research and development was identified and valued through analysis of data provided by Polaroid concerning developmental products, their stage of development, the time and resources needed to complete them, their expected income generating ability, target markets and associated risks. The Income Approach, which includes an analysis of the markets, cash flows, and risks associated with achieving such cash flows, was the primary technique utilized in valuing purchased research and development project. The Company considered, among other factors, the importance of each project to the overall development plan, and the projected incremental cash flows from the projects when completed and any associated risks. The projected incremental cash flows were discounted back to their present value using a discount rate of 25 percent. This discount rate was determined after consideration of the Company's weighted average cost of capital and the weighted average return on assets. Associated risks include the inherent difficulties and uncertainties in completing each project and thereby achieving technological feasibility, anticipated levels of market acceptance and penetration, market growth rates and risks related to the impact of potential changes in future target markets.
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 assumed........ $94
Cash paid, including
transaction costs.......... 5,205
---------
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 of $16.9 million 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. Thereafter, Rockwell filed motions for partial summary judgment alleging that the Company has infringed certain claims of the Rockwell patent and that certain invalidity evidence presented by the Company is not applicable, which motions the Company vigorously opposed in court. A decision on the motions was rendered in the beginning of February 2000. The District Court ruled that the Company infringed the specified claims of Rockwell's patent. The District Court also ruled that the Company could not make the invalidity argument specified by Rockwell's motion. The District Court's ruling prevents the Company from defending against Rockwell's lawsuit on the ground that the Company does not infringe Rockwell's patent. The District Court's ruling will also prevent the Company from making one (but not all) of its invalidity arguments. No trial date has been set and additional discovery, which had been stayed pending the decision on the Rockwell's motions, is necessary prior to trial. Despite the District Court's decisions on Rockwell's motions, the Company believes that Rockwell is not entitled to any damages because the patent is invalid and unenforceable, and because Rockwell is guilty of laches and equitable estoppel. Rockwell's patent expired in January 2000, so that it is no longer possible for Rockwell to obtain an injunction stopping the Company from using the fabrication process allegedly covered by Rockwell's patent. While the Company believes that it has meritorious defenses to Rockwell's lawsuit, there can be no assurance that Rockwell will not ultimately prevail in this dispute. The resolution of this litigation is fact intensive so that the outcome cannot be determined and remains uncertain. If Rockwell prevailed in the litigation, Rockwell could be awarded substantial monetary damages. The award of monetary damages against the Company, including past damages, could have a material adverse effect on the Company's results of operations. Litigation and trial of Rockwell's claim against the Company is also expected to involve significant expense to the Company and could divert the attention of the Company's technical and management personnel. However, because the patent expired in January 2000, the Company will not need a license regardless of the outcome of the litigation.
8. Subsequent Events
In April 2000, the Company acquired Veritech Microwave, Inc. ("Veritech") for 3,000,000 shares of the Company's common stock with a fair value of approximately $621 million. Veritech was a privately held company located in South Plainfield, New Jersey. Veritech designs, develops, manufactures and markets optoelectronic modules for long haul undersea and terrestrial fiber optic transmission systems. The acquisition will be accounted for under the purchase method of accounting. The Company believes it may write-off significant amounts related to in-process research and development during the second quarter of fiscal 2000.
In May 2000, the Company entered into an agreement to acquire Photonic Integration Research, Inc. (PIRI) for 10,200,000 shares of the Company's common stock with a fair value of approximately $1.8 billion and a $31.25 million cash payment. PIRI, a privately held company located in Columbus, Ohio, is a leading manufacturer of arrayed waveguide gratings (AWGs) that enable the routing of individual wavelength channels in fiber optic systems. These products are used in optical multiplexing (mux) and demultiplexing (demux) applications for dense wavelength division multiplexed (DWDM) fiber optic systems. The acquisition is anticipated to close in the second quarter of fiscal 2000 and will be accounted for under the purchase method of accounting. The Company believes it may write-off significant amounts related to in-process research and development when the acquisition is completed and that quarterly amortization of purchased intangibles will also be substantial.
Item 2. Management's Discussion and Analysis of Financial Condition and
SDL designs, manufactures and markets semiconductor lasers, fiber optic related products and optoelectronic modules and systems. Since 1996, the Company strategy has strongly focused on providing solutions for optical communications. The Company's optical communication dense wavelength division multiplexing (DWDM) products power the transmission of data, voice and Internet information over fiber optic networks to meet the needs of telecommunications, data communications, cable television and satellite communications applications. The demand for DWDM solutions accelerated significantly in 1999 due to the technology's unique ability to expand network bandwidth and provide much faster transmission of data, voice and video signals. With the qualification of the Company's new wafer fabrication facility in the first half of 1998 and expansion of yields and assembly and test capacity in 1999 and the first quarter of 2000, the Company was able to successfully ramp capacity and achieve significant revenue and profit growth. Revenue from fiber optic communications products increased by 179 percent in 1999 compared to 1998; this continued in the first quarter of 2000 as fiber communication revenue rose 35 percent sequentially. SDL products were also able to capture a strong position in the undersea fiber optic communications market, where Company revenue increased from less than 1 percent of total revenue in 1998 to 31 percent of total revenue in the first quarter of 2000. SDL's optical products also serve a wide variety of non- communications applications, including materials processing and high resolution printing. Because of the diversity of products, customers and applications, gross margin tends to fluctuate based in part on the mix of revenue in each reported period.
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 first fiscal quarter of 2000 and 1999 ended on March 31, 2000 and April 2, 1999, 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 March 31, 2000 increased 92 percent to $72.2 million compared to $37.7 million in the corresponding 1999 quarter. Demand for the Company's dense wavelength division multiplexing (DWDM) products provided substantially all of the revenue growth during the three months ended March 31, 2000 compared to the three months ended March 31, 1999. Revenue generated from SDL's DWDM products, including 980nm undersea pump lasers and terrestrial pump modules, lithium niobate light modulators and drivers, light amplifiers, fiber gratings, and optical network monitoring products, increased 163 percent from the prior year quarter. Undersea DWDM revenue is up over twelve times that of the prior year quarter. During the three months ended March 31, 2000, the communication products represented 83 percent of total revenue compared to 73 percent in the prior year quarter. Results of the first quarter 2000 include the results of Queensgate from the closing of its acquisition on March 8th. SDL Queensgate contributed $0.9 million to consolidated revenue for the quarter ended March 31, 2000.
Revenues for the three months ended March 31, 2000 are not considered indicative of the results to be expected for any future period. In addition, there can be no assurance that the market for our 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 we will be able to increase or maintain our market share in the future or to achieve historical growth rates.
Gross Margin. Gross margin increased 9 percentage points from the prior year quarter to 48 percent for the three months ended March 31, 2000 compared to 39 percent from the prior year quarter. The increase in gross margin was primarily due to the following: (i) a more favorable mix of higher margin DWDM revenue, especially increased shipments of pump lasers for undersea fiber systems, as compared to revenue derived from lower margin industrial laser and satellite communication revenue, and (ii) reduction of costs due to increased yields and factory volume. These favorable factors were partially offset by higher employee benefit costs.
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 revenue than that of more mature, higher volume products. Considering these factors, gross margin fluctuations are difficult to predict and there can be no assurance that the Company will achieve or maintain gross margin percentages at historical levels in future periods.
Research and Development. Research and development expense was $5.9 million, or 8 percent of revenue for the quarter ended March 31, 2000 as compared to $3.8 million, or 10 percent of revenue for the quarter ended March 31, 1999. The increase in research and development spending is primarily due to the continued development and enhancement of the Company's fiber optic communication products. The Company expects to commit substantial resources to product development in future periods. As a result, the Company expects research and development expenses to continue to increase in absolute dollars in future periods, although research and development expenses may vary as a percentage of revenue.
Selling, General and Administrative. Selling, general and administrative (SG&A) expense was $7.3 million, or 10 percent of revenue for the quarter ended March 31, 2000 as compared to $5.7 million, or 15 percent of revenue for the quarter ended March 31, 1999. The increase in SG&A spending was primarily due to the following: (i) higher personnel-related costs to support the growth in revenues and operations; (ii) increased professional service expenses; and, (iii) increase in non-cash stock compensation charges of $0.6 million. These factors were partially offset by charges incurred related to the implementation of the Company's enterprise resource planning software during the prior year quarter. 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. During March 2000, the Company acquired Queensgate Instruments, Limited which resulted in the write-off of purchased in-process research and development (IPR&D) of $1.2 million. The Company's acquisition of the fiber laser business from Polaroid during the first quarter 1999 resulted in the write-off of purchased IPR&D of $1.5 million. In the second quarter of 2000, an IPR&D write-off is anticipated related to the Company's acquisition of Veritech Microwave, Inc. and Photonic Integration Research, Inc.
The fair value of the IPR&D for each of the acquisitions was determined using the income approach, which discounts expected future cash flows from projects under development to their net present value. Each project was analyzed to determine the technological innovations included; the utilization of core technology; the complexity, cost and time to complete the remaining development efforts; any alternative future use or current technological feasibility; and the stage of completion. Future cash flows were estimated based on forecasted revenues and costs, taking into account the expected life cycles of the products and the underlying technology, relevant market sizes and industry trends.
Discount rates were derived from a weighted average cost of capital analysis, adjusted to reflect the relative risks inherent in each entity's development process, including the probability of achieving technological success and market acceptance. The IPR&D charge includes the fair value of IPR&D completed. The fair value assigned to developed technology is included in identifiable intangible assets, and no value is assigned to IPR&D to be completed or to future development. The Company believes the amounts determined for IPR&D, as well as developed technology, are representative of fair value and do not exceed the amounts an independent party would pay for these projects. Failure to deliver new products to the market on a timely basis, or to achieve expected market acceptance or revenue and expense forecasts, could have a significant impact on the financial results and operations of the acquired businesses.
Interest Income, net. Net interest income for the three months ended March 31, 2000 was $4.5 million compared to $0.3 million for the corresponding 1999 period. The increase in interest income was primarily due to the interest earned on interest bearing securities purchased with proceeds from the Company's September 1999 stock offering.
Provision for Income Taxes. The Company recorded a provision for income taxes of $8.7 million for the three months ended March 31, 2000. Excluding the impact of the in-process research and development charge in 2000, the effective tax rate for the first three months of 2000 was 36 percent, compared to 31 percent for the first three months of 1999. The increase in the 2000 tax rate is primarily attributable to the Company's utilization of the remainder of federal and state tax loss carryforwards.
LIQUIDITY AND CAPITAL RESOURCES
As of March 31, 2000, the Company's combined balance of cash, cash equivalents and marketable securities was $315.1 million. Operating activities generated $8.7 million during the three months ended March 31, 2000 primarily the result of net income, non-cash expenses for depreciation and amortization, and an increase in income taxes payable offset by increases in accounts receivable and inventory and decreases in accrued payroll and accounts payable.
Cash used in investing activities was $72.5 million in the three months ended March 31, 2000. The Company incurred capital expenditures of $6.5 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 $50 million for capital equipment purchases and leasehold improvements during the remainder of 2000. During the first three months of 2000, the Company invested excess net cash of $83.0 million in short term investments. In addition, the Company acquired Queensgate during the first quarter of 2000 resulting in net cash payments of $3.9 million.
The Company generated $4.4 million from financing activities during the first three months of 2000 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.
BUSINESS ACQUISITIONS
Queensgate
The Income Approach used by the Company to value in-process research and development, core technology and existing technology included assumptions relating to revenue estimates, operating expenses, income taxes and discount rates.
Revenue estimates were developed based on: (i) aggregate revenue growth rates for the business as a whole, (ii) individual product revenues, (iii) growth rates for the telecommunications industry, (iv) the aggregate size of the telecommunication industry, (v) anticipated product development and introduction schedules, (vi) product sales cycles, and (vii) the estimated life of a product's underlying technology.
The estimated product development cycle for the new product was 12 months.
Operating expenses used in the valuation analysis of Queensgate included: cost of goods sold, selling, general and administrative expenses, and research and development expenses.
In developing future expense estimates, an evaluation of both the Company and Queensgate's overall business model, specific product results, including both historical and expected direct expense levels, as appropriate, and an assessment of general industry metrics was conducted.
The effective tax rate was determined based on federal and state statutory tax rates and was determined to be 41 percent.
The discount rate for Queensgate's core, existing, and in-process technologies were 18 percent, 14 percent and 20 percent, respectively. In the selection of the appropriate discount rates, consideration was given to (i) the weighted average cost of capital and (ii) the weighted average return on assets. The discount rate utilized for the in-process technology was determined to be higher than the Company's weighted average cost of capital because the technology had not yet reached technological feasibility as of the date of valuation. In utilizing a discount rate greater than the Company's weighted average cost of capital, management has reflected the risk premium associated with achieving the forecasted cash flows associated with these projects.
The in-process research and development was comprised of one project and amounted to $1.2 million of the total purchase price and was charged to expense during the quarter ended March 31, 2000. The estimated cost of completion of the in-process research and development project is $0.2 million.
IMPACT OF YEAR 2000
In prior years, the Company discussed the nature and progress of its plans to become year 2000 ready. In late 1999, the Company completed its remediation and testing of systems. As a result of those planning and implementation efforts, the Company experienced no significant disruptions in mission critical information technology and non- information technology systems and believes those systems successfully responded to the Year 2000 date change. The Company expensed approximately $1.6 million in connection with remediating its systems. The Company is not aware of any material problems resulting from Year 2000 issues, either with its products, its internal systems, or the products and services of third parties. The Company will continue to monitor its mission critical computer applications and those of its suppliers and vendors throughout the year 2000 to ensure that any latent Year 2000 matters that may arise are addressed promptly.
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, capital equipment purchases and leasehold improvement expenditures, expected effective tax rate, expected expenditures during 2000, sufficiency of cash an 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 (MD&A)." 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 risks discussed above in the MD&A and the factors detailed below. You should also consult the risk factors listed in the Company's Registration Statement on Form 10-K filed with the SEC on March 30, 2000, and from time to time in the Company's Reports on Forms 10-Q, 8-K, 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:
- computer-aided chip and package design,
- wafer fabrication,
- wafer processing,
- device packaging,
- fiber production and grating fabrication,
- hybrid microelectronic packaging,
- module assembly,
- printed circuit board testing, and
- 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:
- shortages of parts or equipment,
- equipment failures,
- poor yields,
- fire or natural disaster,
- delays in bringing new facilities on line,
- labor or equipment shortages, or
- 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:
- adversely affected gross margins,
- delayed component, product and system shipments, and
- 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:
- changing our shift schedules and equipment coverage,
- hiring and training new personnel,
- acquiring new equipment, and
- expanding our 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:
- quality problems could arise, yields could fall, and gross margins could be reduced during such a ramp, or
- cost reductions in manufacturing are required to avoid a drop in gross margins for certain products sold to customers receiving volume pricing.
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.
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 circuit boards. 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:
- a stoppage or delay of supply,
- substitution of more expensive or less reliable parts,
- receipt of defective parts or contaminated materials, and
- an increase in the price of such supplies or our inability to obtain reduced pricing from our suppliers in response to competitive pressures.
Competition
Our various markets are highly competitive. We face current or potential competition from four primary sources:
- direct competitors,
- potential entrants,
- suppliers of potential new technologies, and
- 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 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 us. We cannot assure you that:
- 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,
- combine or merge with each other or our customers to form significant competitors,
- expand production capacity to more quickly meet customer supply requirements, or
- 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.
Potential Volatility of Stock Price
The market price of our Common Stock may fluctuate significantly because of:
- announcements of technological innovations,
- large customer orders,
- customer order delays or cancellations,
- customer qualification delays,
- new products by us, our competitors or third parties,
- possible acquisition of us or our customers or our competitors by a third party,
- merger or acquisition announcements, by us or others,
- production problems,
- stock compensation charges due to stock option plans or stock purchase plans,
- quarterly variations in our actual or anticipated results of operations, and
- 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.
Future Operating Results
We will report operating losses for the foreseeable future as a result of accounting charges for amortization of intangible assets and for in process research and development related to acquisitions and expenses related to the issuance of stock pursuant to our employee stock plans. In the first quarter of 2000, we began presenting earnings in our press release that exclude acquisition costs and expenses related to the issuance of stock pursuant to our employee stock plans.
In March 2000, the Company acquired Queensgate Instruments, Limited ("Queensgate") for initial consideration of $3 million of cash and 347,962 shares of the Company's common stock with a fair value of approximately $77 million, and contingent payments of up to an additional $150 million in common stock based on Queensgate's pretax profits for the ten months ended December 31, 2000 and the twelve months ended December 31, 2001. In addition, we closed the Veritech Microwave, Inc. ("Veritech") acquisition in April 2000. We entered into an agreement to acquire Veritech in February 2000 for 3,000,000 shares of the Company's common stock with a fair value of approximately $621 million. We also entered into an agreement to acquire Photonic Integration Research, Inc. (PIRI) for 10,200,000 shares of the Company's common stock with a fair value of approximately $1.8 billion and a $31.25 million cash payment in May 2000 and expect to close the acquisition in June 2000. The acquisitions will be accounted for under the purchase method of accounting. Under purchase accounting, we will record the market value of our common shares issued in connection with the purchases and the amount of direct transaction costs as the cost of acquiring the companies. That cost will be allocated to the individual assets acquired and liabilities assumed, including various identifiable intangible assets such as in-process research and development, acquired technology, acquired trademarks and trade names and acquired workforce, based on their respective fair values. We will allocate the excess of the purchase cost over the fair value of the net assets to goodwill. The amortization of goodwill and other intangible assets and the write-off of in-process research and development will result in significant non- cash expenses that will result in a net loss for the foreseeable future, which could have a material adverse effect on the market value of our stock.
We expect to incur approximately $12.1 million, primarily in the 2nd and 3rd quarters of fiscal 2000, of non-cash expenses relating to shares issued under our 1995 Employee Stock Purchase Plan. These expenses are a result of demand for shares during the purchase period for the two years ending October 2000 exceeding the number of shares that were authorized at the beginning of the purchase period. In addition, stock options exercised by employees of our United Kingdom subsidiary may result in significant expenses. Under United Kingdom law, we are required to pay national insurance tax on the gain on stock options exercised by employees in the United Kingdom. Based on the stock price at March 31, 2000, we have a $6.1 million contingent liability that will be charged to operations in the period that the options are exercised. The options were granted to United Kingdom employees beginning in May 1999 and have a 10 year option exercise period and vest 25% per year of employment. The expenses related to issuance of stock pursuant to our employee stock plans could have a material adverse effect on the market value of our stock.
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. We regularly review acquisition and investment prospects that would complement our existing product offerings, augment our market coverage, secure supplies of critical materials or enhance our technological capabilities. Acquisitions or investments could result in a number of financial consequences, including:
- potentially dilutive issuances of equity securities;
- large one-time write-offs;
- reduced cash balances and related interest income;
- higher fixed expenses which require a higher level of revenues to maintain gross margins;
- the effect of local laws and taxes in foreign subsidiaries;
- the incurrence of debt and contingent liabilities; and
- amortization expenses related to goodwill and other intangible assets.
Furthermore, acquisitions involve numerous operational risks, including:
- difficulties in the integration of operations, personnel, technologies, products and the information systems of the acquired companies;
- diversion of management's attention from other business concerns;
- diversion of resources from our existing businesses, products or technologies;
- risks of entering geographic and business markets in which we have no or limited prior experience; and
- potential loss of key employees of acquired organizations.
If we are unable to successfully address any of these risks, our business could be materially and adversely affected.
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 980 nm pump lasers products comprise a significant portion of our total revenues, our revenues are particularly susceptible to customer order fluctuations for these products. 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.
Risks from Customer Concentration
A relatively limited number of OEM customers accounted for a substantial portion of revenue from communication products in fiscal 1999. During fiscal 1999, three communication product customers and their affiliates accounted for 15 percent, 11 percent and 11 percent of revenues, respectively. Revenue to any single customer is also subject to significant variability from quarter to quarter. Such fluctuations could have a material adverse effect on our business, operating results or financial condition. We expect that revenue to a limited number of customers will continue to account for a high percentage of the net sales for the foreseeable future. Moreover, there can be no assurance that current customers will continue to place orders or that we will be able to obtain new orders from new communication customers.
Dependence on Emerging Applications and New Products
Our current products serve many applications in the communications and industrial laser 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 and qualification of our new products is key to our financial results. Substantial portions 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, delays in qualification, 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 and we are often required to test and qualify pump lasers and modules, modulators, amplifiers, network monitors, receivers and transmitters among other new products for potential volume applications. In the communications market qualification is an especially costly, time consuming and difficult process. We cannot assure you that:
- we or our customers will continue their existing product development efforts, or if continued that such efforts will be successful,
- markets will develop for any of our technology or that pricing will enable such markets to develop,
- other technology or products will not supersede our products or our customer's products, or
- we or our customers will be able to qualify products for certain customers or markets.
We may also be unable to develop or qualify 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 have recently deployed a new enterprise resource planning system and manufacturing execution system.
We cannot assure you that any existing or new systems, procedures or controls will adequately 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.
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.
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:
- additional infringement claims (or claims for indemnification resulting from infringement claims) will not be asserted against us, or
- 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 asserted that, if the Federal government were held liable to Rockwell for infringement of Rockwell's patent in connection with some of its contracts with us, then we might 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 in that lawsuit, alleging that:
- Rockwell's patent was invalid and that we did not infringe Rockwell's patent,
- Rockwell's patent was unenforceable under the doctrine of inequitable conduct, and
- 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 judgment but instead requires a trial. The Federal Circuit:
- remanded the case back to the Court of Federal Claims for further proceedings, and
- 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 sought a judgment against us to:
- permanently enjoin us from using the fabrication processes allegedly covered by Rockwell's patent,
- 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:
- Rockwell's patent is invalid,
- we did not infringe Rockwell's patent,
- Rockwell's patent is unenforceable under the doctrine of inequitable conduct, and
- 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 recommenced 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 needs 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 judgment relative to certain claims in the Rockwell patent. That motion sought to have the court summarily find us to have infringed those claims. Rockwell filed a separate motion seeking to have the court summarily find that we could not argue that Rockwell's patent was invalid on a particular ground. A decision on the motions was rendered in the beginning of February 2000. The District Court ruled that the Company infringed the specified claims of Rockwell's patent. The District Court also ruled that we could not make the invalidity argument specified by Rockwell's motion.
The District Court's ruling will prevent us from defending against Rockwell's lawsuit on the ground that we do not infringe Rockwell's patent. The District Court's ruling will also prevent us from making one (but not all) of our invalidity arguments, unless it is changed. However, the District Court's ruling has no effect on our other pending defenses, as outlined above. We believe that these defenses in the litigation of patent invalidity, inequitable conduct, laches and equitable estoppel are meritorious and we will pursue these defenses.
Rockwell's patent expired in January 2000 so that it is no longer possible for Rockwell to obtain an injunction stopping us from using the fabrication process allegedly covered by Rockwell's patent.
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. Although 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 against us for the sale of infringing products. The award of monetary damages against us, including past damages, 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.
Dependence on 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:
- any of the over 200 patents, domestic and foreign, owned or approximately 95 patents licensed by us will not be invalidated, circumvented, challenged or licensed to others,
- the rights granted under the patents will provide competitive advantages to us,
- any of our approximately 170 pending or future patent applications will be issued with the scope of the claims sought by us, if at all, or
- 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 obtain a license to the patents we own or license, or patent or assert patents on technology that 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. A portion of 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:
- to enforce our patents and other intellectual property rights,
- to protect our trade secrets,
- to determine the validity and scope of the proprietary rights of others, or
- 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 41 percent, 27 percent and 25 percent, of our total revenue in fiscal 1999, 1998 and 1997, respectively. International revenue carries a number of inherent risks, including:
- reduced protection for intellectual property rights in some countries,
- the impact of unstable environments in economies outside the United States,
- generally longer receivable collection periods,
- changes in regulatory environments,
- tariffs, and
- 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. Certain of our acquisitions have contracts with distributors or representatives that may have conflicts with our existing distributors and representatives or in any event may desires to terminate certain distributors or representatives relationships. Such a termination may result in monetary expenses or a loss of revenue. 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, as well as our acquisitions, 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 or our acquisitions. Further, these local, state, and federal regulations could restrict our ability to expand our operations. If we do not:
- obtain required permits for,
- operate within regulations for,
- control the use of, or
- 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.
If we are unable to successfully address any of these risks, our business could be materially and adversely affected.
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 for the year ended December 31, 1999 have not changed significantly.
PART II: OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Information disclosed in the Company's Form 10-K for the year ended December 31, 1999 under heading Part I Item 3, Legal Proceedings, is incorporated herein by this reference. As reported in the disclosure, the Company sought to have the court in the Rockwell matter reconsider its decision with respect to a particular invalidity argument that the court had ruled upon in February 2000. Since the date of the disclosure, the court has denied our request.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
(c)(1) On March 8, 2000 the Company acquired all of the outstanding share capital of Queensgate Instruments Limited located in the United Kingdom ("Queensgate") in exchange for the issuance of 347,962 shares of the Company's Common Stock plus an earnout of up to an additional 3,990,000 shares. The shares of the Company's Common Stock were issued and the earnout shares, if any, will be issued to the shareholders of Queensgate pursuant to exemptions from the registration requirements of the Securities Act of 1933, (the "1933 Act") set forth in Regulation S, Section 4(2) and Regulation D under the 1933 Act. The Company relied on the exemption set forth in Regulation S for the issuance of shares of the Company's Common Stock to Queensgate shareholders resident outside of the United States and on the exemption set forth in Section 4(2) of the 1933 Act and in Regulation D under the 1933 Act for the issuance of shares of the Company's Common Stock to one Queensgate shareholder located in the United States. The Company shares issued and issuable pursuant to the earnout, if any, to the Queensgate shareholders have been registered by the Company on Form S-3 (File No. 333-32068) for resale by the Queensgate shareholders.
(2) On April 3, 2000, the Company acquired by merger all of the outstanding share capital of Veritech Microwave, Inc., located in New Jersey ("Veritech") in exchange for the issuance of up to a maximum of 3,000,000 shares of the Company's Common Stock. The shares of the Company's Common Stock were issued to the shareholders of Veritech pursuant to the exemption from the registration requirements of the 1933 Act set forth in Section 3(a)(10) of the 1933 Act.
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
Not applicable
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
A Special Meeting of Stockholders (the "Special Meeting") of the Company was held on February 28, 2000.
At the Special Meeting, the following item was put to a vote of the stockholders:
An amendment to the Company's Amended and Restated Certificates of Incorporation to increase the aggregate number of shares of common stock which the Company is authorized to issue from 70 million to 140 million shares.
The proposal was approved by the following votes:
For Against Abstain
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30,698,080 36,579 47,826
ITEM 5. OTHER INFORMATION
Not applicable
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) List of Exhibits
Exhibit 27.1 - Financial Data Schedule
(b) Reports on Form 8-K
We filed a report on Form 8-K on March 21, 2000 reporting the acquisition of all of the outstanding share capital of Queensgate Instruments Limited pursuant to a Share Purchase Agreement dated March 8, 2000 among SDL and the shareholders and optionholders of Queensgate Instruments Limited.
We filed a report on Form 8-K on April 11, 2000 reporting the acquisition of Veritech Microwave, Inc. ("Veritech") pursuant to an Agreement and Plan of Merger dated as of February 28, 2000 among SDL, VMI Acquisition Corporation, Veritech and certain shareholders of Veritech.
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: May 12, 2000
| 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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